Key Issues in Tax Reform: International Tax Issues

Updated December 12, 2017

Key Issues in Tax Reform: International Tax Issues

Issues surrounding the taxation of U.S. multinational

corporations have been a major impetus for tax reform and

are some of the main arguments for tax measures to lower

the statutory corporate tax rate of 35% and revise the

current system for taxing foreign source income.

Current Law

A territorial or source-based system taxes only income

earned in the country and excludes foreign source income.

A worldwide system taxes both income earned in the

country and foreign source income, but allows a credit for

income taxes paid to foreign jurisdictions. Most countries

have largely territorial systems.

The U.S. system has elements of both. While it taxes

worldwide income, earnings of foreign subsidiaries of U.S.

multinationals are not taxed until they are repatriated (paid

as dividends to the parent). Earnings of foreign branches

and royalties and interest payments are taxed currently. A

foreign tax credit is allowed, but limited to the total U.S. tax

due. This limit is applied separately to active and passive

income. This overall limit allows cross-crediting so that

firms can use excess credits from high-tax countries to

offset U.S. tax on earnings in low-tax countries. Deferral of

tax on earnings of foreign subsidiaries and cross-crediting

introduce elements of territorial taxation, and the United

States collects relatively little foreign source income.

In common with many other countries, the United States

taxes certain easily shifted income of foreign subsidiaries

on a current basis. These rules are called CFC rules (for

controlled foreign corporations) or Subpart F rules (for the

tax code section). Subpart F income includes passive

income of subsidiaries and certain other income such as

income from sales and services subsidiaries in foreign

countries where the production and consumption takes

place in other countries. The effectiveness of Subpart F has

been reduced by check-the-box regulations that allow

payments between subsidiaries to be disregarded.

Issues

Four issues are of concern: the effect on investment abroad,

revenue losses due to profit-shifting, repatriation, and

inversion.

Allocation of Investment

Broadly speaking, strong territorial elements of the U.S.

system provide an incentive to invest in countries with low

tax rates of their own and a disincentive to invest in hightax countries, including a disincentive to invest in the

domestic economy. According to traditional economic

analysis, world economic welfare is maximized by a system

that applies the same tax burden to prospective (marginal)

foreign and domestic investment so that taxes do not distort

investment decisions. National welfare is maximized,

however, by encouraging more investment in the United

States. (For a discussion of these principles, as well as other

international issues and details of various proposals, see

CRS Report RL34115, Reform of U.S. International

Taxation: Alternatives, by Jane G. Gravelle.) Some of the

arguments for lowering the U.S. statutory corporate tax

rate, which is the highest of almost all countries, relate to

the concern about domestic investment. The location of

investment, however, is driven by effective rather than

statutory tax rates; U.S. effective tax rates are more in line

with those in other countries (see CRS Report R41743,

International Corporate Tax Rate Comparisons and Policy

Implications, by Jane G. Gravelle).

Profit Shifting

Profit shifting involves the movement of profits without

real activities to countries with low tax rates, such as the

Cayman Islands and Bermuda. Considerable evidence

points to significant profit shifting by U.S. multinationals.

Profit shifting is driven by statutory tax rates.

Profit shifting primarily rests on two methods: leveraging

and transfer pricing of intangibles. Firms can shift profits

by borrowing in high-tax countries. Transfer pricing

involves the sale of intangible assets (such as drug

formulas, technological advances, and trademarks),

charging a low price to subsidiaries in low-tax countries.

Firms also use cost contribution arrangements where a lowtax subsidiary contributes to research in the United States

for a share of the rights to the intangible.

Repatriation

Deferral of tax causes a tax to be triggered when foreign

subsidiaries repatriate income. When there are no foreign

tax credits to offset U.S. tax, each dollar repatriated results

in a tax at the statutory rate. Estimates indicate that firms

have around $2.5 trillion of accumulated profits offshore.

This repatriation tax could be eliminated in a system that

taxed foreign source income currently (a worldwide tax

without deferral) or a territorial tax where foreign source

income is not taxed.

Inversions

Inversions occur when a U.S. firm moves its headquarters

abroad, currently by merging with a foreign firm. Mergers

where the U.S. firm maintains 80% or more ownership are

treated as U.S. firms, while 60% to 80% ownership triggers

other, less costly tax effects. Inversions grew rapidly in

2014 and 2015, but have declined somewhat in 2016

according to Commerce Department data. Some of the

decline in inversions may be due to a series of regulations

that made it more difficult to invert and limited some of the

potential benefits, such as indirect repatriations through

loans to the new parent and leveraging. (See CRS Report

https://crsreports.congress.gov

Key Issues in Tax Reform: International Tax Issues

R43568, Corporate Expatriation, Inversions, and Mergers:

Tax Issues, by Donald J. Marples and Jane G. Gravelle.)

Options for Reform

Fundamental options include eliminating deferral (tax

foreign source income currently) at one end of the spectrum

or moving to a territorial system (exempt that income) at

the other. A choice could also be made for an intermediate

approach where foreign source income is taxed currently,

but at a lower rate. These approaches would likely be

accompanied by a deemed repatriation of existing earnings,

possibly at a lower rate.

Any of these approaches would eliminate the incentive to

retain earnings abroad. Eliminating deferral would raise

revenue and eliminate incentives for profit shifting, but

would make inversions much more attractive. Thus, such an

approach might need to be accompanied by tighter rules on

inversions. A territorial tax would make inversions less

likely but might encourage more profit shifting because

profits shifted would never be taxed. For that reason,

moving to a territorial tax system might require stronger

anti-abuse rules, such as allocation of interest deductions

based on the worldwide share of profits and a minimum tax

on intangible income in low-tax jurisdictions. A system that

taxes foreign source income at a lower rate might represent

a compromise for dealing with profit shifting and

inversions.

Narrower revisions would restrict deferral and crosscrediting, profit shifting, and inversions in the context of

the current system.

The Current Tax Reform Proposals

The current tax reform proposals passed by the House (H.R.

1) and reported out of the Senate Finance Committee would

move to a largely territorial tax by exempting dividends

from 10% owned foreign subsidiaries. It would lower the

corporate tax rate to 20% and provide a deemed repatriation

of existing earnings abroad (at a rate of 14% on cash and

7% on other assets in the House and 10% and 5%,

respectively, in the Senate).

Both proposals have new anti-abuse provisions. First, the

House bill would tax 50% of the income of foreign

subsidiaries in excess of a return on tangible assets of 7%

plus the federal short-term rate. The objective is to tax

intangible income by exempting a normal return to tangible

assets. Since the new tax rate is 20%, the tax rate will be

10%. A foreign tax credit is allowed for 80% of foreign

taxes paid. The treatment is global and not per-country

(allowing cross-crediting between low- and high-tax

countries), but the income and credits are in a separate

basket to prevent cross-crediting with other income.

Second, the House bill provides an allocation of interest

rule for affiliated firms that limits the share deducted to

110% of the share based on the share of the affiliate’s

earnings before interest, taxes, and depreciation. This

provision is aimed at profit-shifting through leveraging.

apply if the firm elects to treat the income as effectively

connected (and thus subject to the corporate tax at the same

rate), and firms that so elect can get a credit for 80% of

foreign taxes paid. The payments exclude interest, certain

other financial payments, and the cost of services with no

markup if the payor uses a services cost method under

Section 482 (transfer pricing rules). This rule is aimed in

part at profit shifting through transfer pricing of goods and

royalties.

The Senate has four major provisions, with some

corresponding in general intent to the House provisions.

First, it imposes a tax on foreign source income also on a

global basis, with an exclusion for a 10% return on tangible

assets. A deduction will be allowed for 50% of income

through 2025 and 37.5% thereafter. Thus, the tax rate will

begin at 10% and rise to 12.5%. A foreign tax credit will be

allowed for 80% of foreign taxes paid.

Second, a tax deduction is allowed for foreign derived

intangible income of domestic firms of 37.5% through 2025

and 21.875% thereafter. Thus the rates would be 12.5% and

then 15.625%. Foreign derived intangible income is total

intangible income of the domestic firm multiplied by the

ratio of its exports (sales of goods and services abroad) to

gross income. The purpose of this provision is to encourage

intangible assets to stay in or return to the United States.

(There is also a provision to treat the fair-market value of

intangible property transferred by a foreign subsidiary to a

U.S. firm as the adjusted basis so that it makes the transfer

tax free.)

Third, the bill contains an allocation-of-interest rule for

affiliate firms that limits the share deducted to 110%

(beginning at 130% in 2018 and phased down to 110% by

2022) of the share allowed if it were proportional to the

share of debt to equity.

Fourth, a base erosion minimum tax imposes a minimum

tax of 10% (12.5% after 2025) on the total of base erosion

plus taxable income.

Arguments have been made that some elements of these

provisions would violate World Trade Organization rules

against export subsidies or violate existing tax treaties. The

foreign derived intangible income deduction may be viewed

as an export subsidy, while the base erosion taxes may be

viewed as a tax on imports. The requirement in the House

bill to consider foreign income as effectively connected

U.S. income to receive the foreign tax credit for intangible

income may violate treaty agreements about the rules for

permanent establishments, and the base erosion taxes may

also violate treaties.

This In Focus is part of a series of short CRS products on

tax reform. For more information, visit the “Taxes, The

Budget, & the Economy” Issue Area page at www.crs.gov.

Jane G. Gravelle, Senior Specialist in Economic Policy

Third, a base erosion tax of 20% is imposed on payments

by U.S. firms to foreign affiliates. The excise tax does not

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Key Issues in Tax Reform: International Tax Issues

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