What is a Territorial Tax System?

By August 29, 2012 Businesses

As the election approaches, both candidates will begin to reveal more details about their separate tax plans.  Some aspects of the two tax plans are pretty simple to understand, such as rate reductions or increases.  Other things are not so easy to understand.  For example, what is a territorial tax system?  This is a question that you will probably hear over the next two months as we approach the election.  This has to do with money that American companies make overseas.

The way our current tax system works is that every individual is taxed on their worldwide income.  The residency rules are complex, and multi-national firms based in the United States often are able to earn income overseas and avoid taxation in the US by not repatriating the funds.  While a residency based tax system for foreign income is designed to keep companies from developing overseas by taxing repatriated money, the result is often the opposite.  Companies simply keep the money invested overseas and don’t bring it home.

A territorial tax system only taxes money earned within the borders of the United States.  In other words, if a multi-national US company operates and pays taxes in Mexico, China and the United Kingdom, they could then bring those profits home without paying taxes on them.  The downside is a loss in tax revenue on repatriated funds.  The upside is capital from foreign profits being brought home to invest in the United States economy, eventually producing more taxable US income.  This is why the Simpson-Bowles commission and the President’s Export Council have both recommended moving to a territorial system.

The question to be debated is how much incentive the United States should give companies to bring their foreign profits home.  Does too much incentive encourage companies to move profitable business to nations with lower corporate taxes?  Do higher taxes on repatriated funds effectively do the same thing?

The President’s plan involves a cut in the top corporate tax rate to 28% (25% for manufacturers) and a 20% credit for companies who move operations back to the United States.  However, it is a carrot and stick plan.  US based companies with foreign income would be required to pay a minimum tax on income as it is earned overseas rather than when it is repatriated.  There would also be a loss of deductions on the expenses of moving operations overseas.

While the President’s plan is designed to maximize tax revenues on the foreign operations of US based companies, there is a risk that companies will simply move their base to lower tax regions and become foreign companies.  The plan would also be difficult to regulate, especially when it comes to related entities and jurisdiction issues.

Presidential candidate Mitt Romney’s plan is a territorial tax plan where only income earned within the United States is taxable.  He would also reduce the maximum corporate rate to 25%.  Companies with capital earned overseas could bring the money home without paying taxes on them.

While Romney’s plan is designed to increase private capital and growth in the US economy and make the US tax code more competitive with other countries, opponents fear that the plan would encourage US businesses to avoid payroll taxes and other regulation by moving profitable operations overseas to lower tax countries.

The goal of tax reform for multi-national companies is to find a way to incentivize businesses to invest in the United States.  The approaches range from finding ways to discourage companies from leaving to finding ways of encouraging companies to stay.  This will be one of the least understood, yet hotly contested issues of this election.