Question

Until 2018, the U.S. was the only significant country that taxed its domestic companies based on worldwide income. You are an advisor to Representative Smith of the U.S. House of Representatives. The House is conducting a hearing on repealing the worldwide system of taxation and replacing it with a territorial system of taxation. What is the difference between a worldwide system of taxation and a territorial system of taxation?

Answer 1

Solution:-

In a pure worldwide tax system, resident individuals and entities are taxable on their worldwide income regardless of where the income is derived. By contrast, in a pure territorial tax system, the country taxes only income derived within its borders, irrespective of the residence of the taxpayer.

There have been proposals that the United States move from a worldwide tax system (its current tax system) to a territorial tax system. As alluded to earlier, under the territorial system most income earned overseas would not be taxed in the United States. Therefore, if the United States moves toward the territorial system the taxpayer will need to model and think about what a territorial system might mean. Specifically, the system would not offer the same strategies to reduce U.S. taxes, such as by foreign tax credits. However, a territorial system should eliminate the need for complicated rules such as the controlled foreign corporation (CFC or Subpart F) rules and the passive foreign investment company (PFIC) rules that subject foreign earnings to current U.S. taxation in certain situations.

Congress and the President are also considering a combined version of a territorial system and a "border-adjustable" system which would involve taxing imports and exempting exports, referred to as the "import tax". This may be done with direct duties or by denying the United States income tax deduction to U.S. companies for the cost of the goods imported into the United States.

Deemed Repatriation

The Republican’s proposed legislation and President Trump’s proposal also calls for the repatriation of assets held outside of the United States. Specifically, President Trump has promised to allow United States’ companies to repatriate to the United States corporate profits not previously taxed in the United States and held offshore at a one-time tax rate of 10 percent. However, given that a territorial system would allow for the “parking” of corporate profits from foreign jurisdictions offshore, it is unclear whether this repatriation allowance would be incorporated into the new territorial system or be a one-time revenue raiser to offset the revenue lost from the move to a territorial system.

Differences:-

Although worldwide and territorial tax regimes differ in principle, they may have similar effects in practice, depending for example on the corporation tax rate in the parent country, the rules of the worldwide system and the controlled foreign company rules.

First, for example, no additional tax burden may arise, even on repatriation, if MNEs are allowed to mix dividends from high tax and low tax affiliates.2 Further, in some countries affiliates are allowed to lend their “profits” to the parent company (up-stream loans) without triggering tax consequences. From an economic perspective this has similar effects to repatriating profits. If upstream loans are not permitted, low tax affiliates can lend their profits to high tax affiliates which can then repatriate to the parent country.

Second, the tax burden on foreign profits under a worldwide tax regime depends on the parent tax rate on corporate profits. Ireland, for example, has a worldwide tax regime but a corporate tax rate of only 12.5 %. Thus, there is likely to be little parent company taxation for repatriations from foreign subsidiaries to Irish parents.

Third, countries with a territorial tax regime may tax parts of foreign profits under controlled foreign company rules (CFC rules) or other anti-avoidance regulations. CFC rulesare designed to prevent profit shifting and are usually targeted at passive income (e.g. royalties or interest). If affiliates’ (passive) income is taxed at a rate sufficiently lower than the national rate, then under CFC rules, this passive income may be included in the domestic tax base (see e.g. Albertus (2017) and Clifford (2017)). In some countries, these rules apply not only to passive but to all types of income. For example, the income of a French affiliate located outside the EU is included in the French tax base if it is taxed at an effective rate that is at least 50 % lower than the tax rate in France.