Under a worldwide tax system, foreign earnings are included in a company’s taxable income. With a territorial tax, only the country in which the income is earned imposes a tax. The U.S currently operates with a worldwide system, although with some elements of a territorial tax system.
New Zealand, a country often known for its kiwis – both the bird and the fuzzy fruit – as well as its rugby teams also has the distinction of being one of just a handful to have switched from a territorial tax system to a worldwide system, and then back again. The country’s moves may provide some lessons for the U.S., which remains on a worldwide tax system.
Under a worldwide tax system, foreign earnings are included in a company’s taxable income. With a territorial tax, only the country in which the income is earned imposes a tax. The U.S currently operates with a worldwide system, although with some elements of a territorial tax system, as this 2012 report from the Congressional Research Services, “Moving to a Territorial Income Tax: Options and Challenges,” notes.
One such element is deferral, which allows a firm to delay taxation of its earnings in foreign subsidiaries until the income is paid as a dividend to the U.S. parent company. The other is cross-crediting; this occurs when credits for taxes paid to one country can offset U.S. tax due on income earned in a second country.
As of 2012, 28 of the 34 OECD member countries had adopted territorial tax systems (also referred to as participation exemption systems) that exempted most active earnings repatriated from subsidiaries resident in other countries, according to a 2013 report, “Evolution of Territorial Tax Systems in the OECD,” prepared for the Technology CEO Council by PWC.
In fact, the argument most often heard in the U.S. for a territorial tax is that without one, American-based companies are at a disadvantage. “They suffer higher tax rates than their competitors when they try to compete in other countries,” says William McBride, Ph.D., chief economist with the Tax Foundation. And, since the rest of the world is moving to a territorial system, it only makes sense for the U.S. to follow.
A recent report from McBride, “New Zealand’s Experience with Territorial Taxation,” includes graphs that illustrate how New Zealand’s real GDP per capita and outbound foreign direct investment (FDI) began to lag the OECD average during the time period under which it operated with a worldwide tax system.
The U.S.’s current worldwide tax system, along with a corporate tax rate that’s higher than most other countries, hinders companies’ ability to compete, which ultimately hamstrings economic growth, McBride said.
While a number of trade and professional groups advocate moving to a territorial system, McBride says he doubts such a move would occur this year. Next year, however, it might be a possibility.
The Hill reported in January that President Obama might be warming to the idea of some sort of territorial system. Representative Dave Camp (R-MI), chair of the House Ways and Means Committee, has supported moving to a territorial system for at least several years. The 2010 Simpson-Bowles report, “The Moment of Truth,” also called for a move to a territorial system.
That’s not to say that territorial systems don’t bring their own concerns. Eric Toder with the Urban-Brookings Tax Policy Center, writing in the Christian Science Monitor earlier this year, noted that most territorial tax structures actually include elements of a worldwide tax. “All countries have rules to protect their domestic corporate tax base,” Toder wrote. He provided several examples: Some require companies to pay an immediate tax on passive income earned in foreign jurisdictions, and/or impose a minimum tax on income from tax havens.