Key Issues in Tax Reform: International Tax Issues

Key Issues in Tax Reform: International Tax Issues

Updated December 12, 2017
Key Issues in Tax Reform: International Tax Issues
Issues surrounding the taxation of U.S. multinational
however, by encouraging more investment in the United
corporations have been a major impetus for tax reform and
States. (For a discussion of these principles, as well as other
are some of the main arguments for tax measures to lower
international issues and details of various proposals, see
the statutory corporate tax rate of 35% and revise the
CRS Report RL34115, Reform of U.S. International
current system for taxing foreign source income.
Taxation: Alternatives, by Jane G. Gravelle.) Some of the
arguments for lowering the U.S. statutory corporate tax
Current Law
rate, which is the highest of almost all countries, relate to
A territorial or source-based system taxes only income
the concern about domestic investment. The location of
earned in the country and excludes foreign source income.
investment, however, is driven by effective rather than
A worldwide system taxes both income earned in the
statutory tax rates; U.S. effective tax rates are more in line
country and foreign source income, but allows a credit for
with those in other countries (see CRS Report R41743,
income taxes paid to foreign jurisdictions. Most countries
International Corporate Tax Rate Comparisons and Policy
have largely territorial systems.
Implications, by Jane G. Gravelle).
The U.S. system has elements of both. While it taxes
Profit Shifting
worldwide income, earnings of foreign subsidiaries of U.S.
Profit shifting involves the movement of profits without
multinationals are not taxed until they are repatriated (paid
real activities to countries with low tax rates, such as the
as dividends to the parent). Earnings of foreign branches
Cayman Islands and Bermuda. Considerable evidence
and royalties and interest payments are taxed currently. A
points to significant profit shifting by U.S. multinationals.
foreign tax credit is allowed, but limited to the total U.S. tax
Profit shifting is driven by statutory tax rates.
due. This limit is applied separately to active and passive
income. This overall limit allows cross-crediting so that
Profit shifting primarily rests on two methods: leveraging
firms can use excess credits from high-tax countries to
and transfer pricing of intangibles. Firms can shift profits
offset U.S. tax on earnings in low-tax countries. Deferral of
by borrowing in high-tax countries. Transfer pricing
tax on earnings of foreign subsidiaries and cross-crediting
involves the sale of intangible assets (such as drug
introduce elements of territorial taxation, and the United
formulas, technological advances, and trademarks),
States collects relatively little foreign source income.
charging a low price to subsidiaries in low-tax countries.
Firms also use cost contribution arrangements where a low-
In common with many other countries, the United States
tax subsidiary contributes to research in the United States
taxes certain easily shifted income of foreign subsidiaries
for a share of the rights to the intangible.
on a current basis. These rules are called CFC rules (for
controlled foreign corporations) or Subpart F rules (for the
Repatriation
tax code section). Subpart F income includes passive
Deferral of tax causes a tax to be triggered when foreign
income of subsidiaries and certain other income such as
subsidiaries repatriate income. When there are no foreign
income from sales and services subsidiaries in foreign
tax credits to offset U.S. tax, each dollar repatriated results
countries where the production and consumption takes
in a tax at the statutory rate. Estimates indicate that firms
place in other countries. The effectiveness of Subpart F has
have around $2.5 trillion of accumulated profits offshore.
been reduced by check-the-box regulations that allow
This repatriation tax could be eliminated in a system that
payments between subsidiaries to be disregarded.
taxed foreign source income currently (a worldwide tax
without deferral) or a territorial tax where foreign source
Issues
income is not taxed.
Four issues are of concern: the effect on investment abroad,
revenue losses due to profit-shifting, repatriation, and
Inversions
inversion.
Inversions occur when a U.S. firm moves its headquarters
abroad, currently by merging with a foreign firm. Mergers
Allocation of Investment
where the U.S. firm maintains 80% or more ownership are
Broadly speaking, strong territorial elements of the U.S.
treated as U.S. firms, while 60% to 80% ownership triggers
system provide an incentive to invest in countries with low
other, less costly tax effects. Inversions grew rapidly in
tax rates of their own and a disincentive to invest in high-
2014 and 2015, but have declined somewhat in 2016
tax countries, including a disincentive to invest in the
according to Commerce Department data. Some of the
domestic economy. According to traditional economic
decline in inversions may be due to a series of regulations
analysis, world economic welfare is maximized by a system
that made it more difficult to invert and limited some of the
that applies the same tax burden to prospective (marginal)
potential benefits, such as indirect repatriations through
foreign and domestic investment so that taxes do not distort
loans to the new parent and leveraging. (See CRS Report
investment decisions. National welfare is maximized,
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Key Issues in Tax Reform: International Tax Issues
R43568, Corporate Expatriation, Inversions, and Mergers:
apply if the firm elects to treat the income as effectively
Tax Issues, by Donald J. Marples and Jane G. Gravelle.)
connected (and thus subject to the corporate tax at the same
rate), and firms that so elect can get a credit for 80% of
Options for Reform
foreign taxes paid. The payments exclude interest, certain
Fundamental options include eliminating deferral (tax
other financial payments, and the cost of services with no
foreign source income currently) at one end of the spectrum
markup if the payor uses a services cost method under
or moving to a territorial system (exempt that income) at
Section 482 (transfer pricing rules). This rule is aimed in
the other. A choice could also be made for an intermediate
part at profit shifting through transfer pricing of goods and
approach where foreign source income is taxed currently,
royalties.
but at a lower rate. These approaches would likely be
accompanied by a deemed repatriation of existing earnings,
The Senate has four major provisions, with some
possibly at a lower rate.
corresponding in general intent to the House provisions.
First, it imposes a tax on foreign source income also on a
Any of these approaches would eliminate the incentive to
global basis, with an exclusion for a 10% return on tangible
retain earnings abroad. Eliminating deferral would raise
assets. A deduction will be allowed for 50% of income
revenue and eliminate incentives for profit shifting, but
through 2025 and 37.5% thereafter. Thus, the tax rate will
would make inversions much more attractive. Thus, such an
begin at 10% and rise to 12.5%. A foreign tax credit will be
approach might need to be accompanied by tighter rules on
allowed for 80% of foreign taxes paid.
inversions. A territorial tax would make inversions less
likely but might encourage more profit shifting because
Second, a tax deduction is allowed for foreign derived
profits shifted would never be taxed. For that reason,
intangible income of domestic firms of 37.5% through 2025
moving to a territorial tax system might require stronger
and 21.875% thereafter. Thus the rates would be 12.5% and
anti-abuse rules, such as allocation of interest deductions
then 15.625%. Foreign derived intangible income is total
based on the worldwide share of profits and a minimum tax
intangible income of the domestic firm multiplied by the
on intangible income in low-tax jurisdictions. A system that
ratio of its exports (sales of goods and services abroad) to
taxes foreign source income at a lower rate might represent
gross income. The purpose of this provision is to encourage
a compromise for dealing with profit shifting and
intangible assets to stay in or return to the United States.
inversions.
(There is also a provision to treat the fair-market value of
intangible property transferred by a foreign subsidiary to a
Narrower revisions would restrict deferral and cross-
U.S. firm as the adjusted basis so that it makes the transfer
crediting, profit shifting, and inversions in the context of
tax free.)
the current system.
Third, the bill contains an allocation-of-interest rule for
The Current Tax Reform Proposals
affiliate firms that limits the share deducted to 110%
The current tax reform proposals passed by the House (H.R.
(beginning at 130% in 2018 and phased down to 110% by
1) and reported out of the Senate Finance Committee would
2022) of the share allowed if it were proportional to the
move to a largely territorial tax by exempting dividends
share of debt to equity.
from 10% owned foreign subsidiaries. It would lower the
corporate tax rate to 20% and provide a deemed repatriation
Fourth, a base erosion minimum tax imposes a minimum
of existing earnings abroad (at a rate of 14% on cash and
tax of 10% (12.5% after 2025) on the total of base erosion
7% on other assets in the House and 10% and 5%,
plus taxable income.
respectively, in the Senate).
Arguments have been made that some elements of these
Both proposals have new anti-abuse provisions. First, the
provisions would violate World Trade Organization rules
House bill would tax 50% of the income of foreign
against export subsidies or violate existing tax treaties. The
subsidiaries in excess of a return on tangible assets of 7%
foreign derived intangible income deduction may be viewed
plus the federal short-term rate. The objective is to tax
as an export subsidy, while the base erosion taxes may be
intangible income by exempting a normal return to tangible
viewed as a tax on imports. The requirement in the House
assets. Since the new tax rate is 20%, the tax rate will be
bill to consider foreign income as effectively connected
10%. A foreign tax credit is allowed for 80% of foreign
U.S. income to receive the foreign tax credit for intangible
taxes paid. The treatment is global and not per-country
income may violate treaty agreements about the rules for
(allowing cross-crediting between low- and high-tax
permanent establishments, and the base erosion taxes may
countries), but the income and credits are in a separate
also violate treaties.
basket to prevent cross-crediting with other income.
This In Focus is part of a series of short CRS products on
Second, the House bill provides an allocation of interest
tax reform. For more information, visit the “Taxes, The
rule for affiliated firms that limits the share deducted to
Budget, & the Economy” Issue Area page at www.crs.gov.
110% of the share based on the share of the affiliate’s
earnings before interest, taxes, and depreciation. This
Jane G. Gravelle, Senior Specialist in Economic Policy
provision is aimed at profit-shifting through leveraging.
IF10699
Third, a base erosion tax of 20% is imposed on payments
by U.S. firms to foreign affiliates. The excise tax does not
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Key Issues in Tax Reform: International Tax Issues

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