Should the U.S. Move to a Territorial Tax System?

The United States is one of the few remaining nations that have a worldwide tax regime in today’s global economy. Among the 26 members of the Organization for Economic Cooperation and Development (OECD), the U.S. is only one of seven nations to use a worldwide tax system. If we drilled down a bit further, the U.S. is the only nation from the G-7 pact to currently use this system.

But, what exactly is a worldwide tax system? In a pure sense, a government taxes a business based on net profits regardless of where it was earned and without the benefit of tax incentives or tax credits to shelter those profits. To be fair, the U.S. is not exactly a pure worldwide taxing regime. In the U.S., a taxpayer does not always pay tax currently on its profits earned outside the U.S. This is because the U.S. uses what is best described as a hybrid tax regime, using principles from both the worldwide and territorial-based taxing systems. For example, the U.S. allows foreign tax credits to attach to foreign earnings repatriated back to the U.S. to provide some shelter against profits from being doubled-taxed. There are also deferral mechanisms for certain types of foreign investments whereby foreign profits can remain un-taxed until some event or exception triggers them to be taxed in the U.S.

However, despite the U.S. permitting foreign tax credit offsets and temporary deferral opportunities, this still has not stopped the on-going debate as to whether the U.S. should reconsider the tax rules our businesses play by when it comes to competing on a global scale. Several lobbying and interest groups as well as Rep. David Camp, Chairman of the House Ways and Means Committee, have sought to introduce proposals that would put the U.S. on a path to work towards a territorial tax system.

An added layer of complexity to the over-arching issue is whether the U.S. should also consider lowering its domestic tax rate. Currently, the U.S. has one of the highest corporate tax rates in the world at 35%.

Here are some common arguments put forth by proponents and opponents of the territorial tax system plan that is currently being debated:

Advantages of a Territorial Tax System

• Puts U.S. businesses on a more even playing field
• Would alleviate the “trapped income” problem by allowing U.S. firms to repatriate profits back into the U.S. economy
• Increases attractiveness of locating headquarters in the U.S.
• Reduces regulatory and administrative burdens

Disadvantages of a Territorial Tax System

• U.S. firms could be compelled to shift greater profits offshore to lower-taxing jurisdictions
• Current proposals fail to address the threat of eroding the U.S. domestic tax base
• Potential for the abuse of transfer pricing practices

Whether we will see a shift towards a territorial tax system remains to be seen. There is no doubt that further debate and planning is needed in this area before the U.S. will be ready to go forward with such an overhaul to our current tax system.

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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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