“Territoriality” is one of the key buzz words in this year’s tax reform lingo, with many proposals urging a shift away from our current “worldwide” system of income taxation for business income. This post expands on what features a “territorial” system might include.
The Basics. A worldwide system of income taxation taxes residents of the taxing jurisdiction on all of their income, both foreign and domestic (usually with a credit for foreign taxes paid). A territorial system, on the other hand, theoretically taxes only income earned in the taxing jurisdiction. In practice, however, the lines between a territorial and worldwide system are rarely, if ever, this clear. The U.S. is often said to have a “worldwide” system of taxation. However, in reality it is more of a hybrid system because it permits deferral of active income earned by foreign subsidiaries until such income is repatriated. On a present value basis this deferral can be the economic equivalent of an exemption for offshore earnings.
One Option – the DBCFT. The destination based cash-flow tax (or DBCFT) that is at the heart of the House Republican “Blueprint” for tax reform is about as close to a “pure” territorial system as you can get with respect to business taxes, in that it would tax only revenues derived from customers located in the United States. However, as noted in our earlier post, no country has adopted a pure destination based cash-flow tax system. While the House is likely to pursue territoriality in the form of a DBCFT, it would mark a radical and controversial shift away from the current income tax system. We would not be surprised to see the Senate pursue an alternative approach.
Other Options. If Congress were to opt for reform within the existing income tax system, territoriality could take several different forms.
The U.K. Experience. Congress could consider something like the newly-revamped U.K. corporate tax system. Until 2009, the U.K.’s system was similar in many ways to the current system in the United States. In part to reverse the trend of companies leaving the U.K. for tax reasons, and in part to comply with new EU rules, the government adopted a series of reforms intended to make the U.K. corporate tax system more competitive. At the center of the reform was a shift towards territoriality.
Lawmakers added a new exemption for dividends paid by non-U.K. companies to their U.K. parents, and granted U.K. companies the ability, in certain circumstances, to elect to exempt profits derived by foreign permanent establishments. U.K. companies are also (generally) not taxed on the sale of non-U.K. trading subsidiaries, although this exemption applies equally to the sale of U.K. trading subsidiaries. Moreover, lawmakers pared back the CFC regime in 2012, so that it now captures, very broadly, only profits that have been artificially diverted from the U.K.
The U.K. has also implemented a number of provisions that police its newly-redefined tax base. For example, lawmakers recently implemented comprehensive “anti-hybrid” rules (introduced in light of BEPS), as well as a number of provisions that limit the ability of taxpayers to use interest deductions to reduce U.K. taxable income (including a group-wide limit on the deductibility of interest payments (soon to be changed in light of BEPS developments), “thin cap” rules that apply principally to a U.K. holding company owned by a non-U.K. parent, rules which can recharacterize certain interest payments as non-deductible distributions and an anti-avoidance rule that denies deductions for debt raised for non-commercial purposes). These provisions, together with the recast CFC regime, add a flavor of worldwide taxation into the U.K.’s otherwise territorial system.
This type of “territorial” system is common across developed countries, particularly in recent decades. Currently 28 of the 35 OECD member countries exempt active earnings repatriated from foreign subsidiaries; 21 exempt gains on sale of foreign subsidiary stocks; 11 also exempt active income of foreign branches.
Prior U.S. Proposals. Past proposals put forth in the U.S. could also serve as precedents. In 2005, President Bush’s Advisory Panel on Tax Reform released, as one of two proposals, the “Simplified Income Tax Plan,” (similar to a 2001 American Enterprise Institute proposal), which exempted dividends attributable to active foreign income from taxation, treated foreign branches the same as subsidiaries, and retained anti-abuse rules for passive foreign income. More recently, Senator Michael Enzi (R-WY) and former House Ways and Means Committee Chairman Dave Camp (R-MI) released proposals (Enzi’s in 2012 (bill and technical explanation) and Camp’s most recently in 2014 (discussion draft and official summary)) suggesting a 95% dividend exemption on active foreign income (including any sales proceeds recharacterized as a dividend under Section 1248). Both plans proposed to retain the Subpart F regime (with certain modifications), taxing passive income on a current basis. The Camp plan also included a deemed repatriation provision that would have taxed accumulated past foreign earnings held in cash at a 8.75% rate, and non-cash earnings at a 3.5% rate. The Enzi plan proposed an optional opportunity to repatriate pre-enactment foreign earnings at a single lower rate.
What We Expect to See in Non-DBCFT Reform. If the U.S. were to move to a territorial system without adopting the DBCFT, experiences in the United States and in other countries indicate that we would likely see an exemption from U.S. taxation for some or all foreign dividends. We may also see exemptions for gain from the sale of foreign subsidiary stock and an end to taxation of branch profits. There may very well be limits on the scope of exemptions granted. For example, an exemption for dividends by foreign subsidiaries might apply only for significant shareholders (as was the case in the Camp and Enzi proposals). Congress could also choose to retain a limited CFC regime that continues to tax income derived in low-tax jurisdictions (akin to the U.K. rules and the Simplified Income Tax Plan).
Transition Tax for a Move to Territoriality. Whether through the enactment of a DBCFT or within the current income tax system, we expect that any move toward territoriality will come with a transition tax, i.e. a one-time deemed repatriation of offshore earnings not yet taxed by the U.S. This transition tax may be a key revenue raiser to support deficit-neutral tax reform.
One Final Thought. We end this post with one final thought. Although proposals at the forefront of this year’s reform call for a shift toward territoriality, it is possible that Congress may ultimately decide to punt. Senator Hatch (R-UT), chairman of the Senate Finance Committee has long championed corporate integration (one approach would be to allow corporations to deduct dividends distributed to shareholders). Similar proposals have been put forth a number of times in past decades, although never enacted. Some commentators have observed (for example, here, here) that corporate integration could be a “simple” way to reduce the effective tax rates of U.S. companies as reported for GAAP purposes, permit U.S. companies to repatriate cash trapped abroad on a tax-free basis to pay dividends and reduce the pressure to enact legislation that would effect a switch from a worldwide system of taxation to a territorial one. The JCT reportedly found that Hatch’s proposal would achieve these goals without adding to the deficit or shifting more of the overall tax burden from those with higher incomes to middle- and lower-income taxpayers. Although Hatch refrained from introducing his proposal at the end of last year in light of the push for comprehensive tax reform, corporate integration could become the fallback proposal if comprehensive tax reform proves too politically difficult to achieve.