[Kyle Pomerleau| November 23, 2016 |The Tax Foundation]
The House GOP blueprint will likely be the starting point for the tax reform debate in 2017. As with most tax reform plans, it proposes to reform the current system of taxing U.S. multinationals’ foreign profits. Under current law, U.S. multinationals are taxed on their worldwide income up to 35 percent, but are allowed to defer the additional U.S. tax until they bring those profits back. The current system encourages companies to expatriate or “invert” and discourages them from bringing profits back to the United States.
Due to these flaws, most tax reform plans propose some sort of fix. Typically, Republicans push for what is called a “territorial” tax system. However, the most recent House GOP plan actually proposes something a little different. Rather than proposing a purely territorial tax system, the House GOP’s plan would enact what is called a “destination-based” tax. This tax would fix many of the problems with the current worldwide system and would have some similarities with a “territorial” tax system. However, there would be important differences in terms of the base of the tax and the potential for base erosion.
A Territorial Tax System
Under a territorial tax system, corporations are taxed based on where their profits are located rather than where they are headquartered. If the United States were to move to a territorial tax system, U.S. multinationals would only pay corporate income tax on the profits they earn in the United States. Profits earned in, say, the United Kingdom by a U.S. corporation, would only be subject to the British corporate tax.
Territorial tax systems are considered more economically efficient. They eliminate the incentive to move legal headquarters; doing so would not change your tax situation under a territorial tax system. It also allows companies to freely bring profits back to the United States to either invest or to distribute as dividends to their shareholders.
Although these systems are more economically efficient, they can come with some base erosion concerns. Companies that can shift profits out of the United States under a territorial tax system would be able to completely avoid U.S. tax on those profits. As such, territorial tax systems typically come with anti-base erosion provisions. These provisions usually limit interest deductions on cross-border lending and “CFC rules” to capture excessive passive income earned in low-income jurisdictions. Dave Camp’s tax reform proposal came with a number of “options” that were aimed at preventing significant base erosion.
A Destination-Based Tax System
The House GOP’s tax reform blueprint would reform the current international tax system, but it would not exactly move to a territorial tax system. Instead, it is proposing to enact a “destination-based” tax. Under a destination based tax system, companies are not tax based on where they are headquartered like a worldwide tax system. Nor would companies be taxed based on where their profits are located like a territorial tax system. Under this system, companies are taxed based on where they sell their goods and services, regardless of where their production, management, or income is located.
A destination-based system starts in the same place as a territorial tax system. Overseas profits earned by U.S. multinationals that are brought back to the United States would be exempt from additional U.S. taxation. As such, this system would also eliminate the incentive to expatriate and the foreign profit “lock-out.”
A destination-based system adds one additional piece to this: a “border adjustment.” A border adjustment disallows the deduction for the cost of any purchases from overseas, but exempts from taxation of any revenue derived from sales of goods and services overseas. For example, if a U.S. company purchases a widget from a British company, that cost would not be deductible. However, if a U.S. company sells a widget to a British company, that revenue would be exempt from taxation.
A border adjustment makes a destination-based tax system different than a territorial system in two important ways:
First, a destination-based system does not come with the same base-erosion concerns as a territorial tax system. This is because transactions that usually facilitate profit shifting under a territorial tax system are ignored under a border adjustment. For example, one way companies shift profits out of the United States is by overpricing a good, such as intellectual property, it buys from a related foreign corporation. Under a corporate income tax, this transaction results in more costs being reported in the United States and more profits being reporting in the foreign country. This isn’t possible with the border adjustment. This transaction would be an import and the cost would be nondeductible or ignored to begin with. Thus, this strategy would not yield any tax benefit for the corporation.
Second, a destination-based system has a much broader tax base than a territorial tax system. A territorial tax system is a net tax cut because it is eliminating the additional tax on foreign profits. A destination-based system actually raises revenue relative to current law. This is because a border adjustment essentially applies the business tax to net imports, or the amount the U.S. imports over what it exports. The United States currently has a trade deficit of about $500 billion annually. We estimated that it would raise about a trillion dollars over the next decade.
A territorial tax system and a destination-based tax are similar in that they would not have the same issues as our current worldwide system. However, they are not exactly the same. A destination-based tax system does not have the same base erosion issue as a territorial tax system and actually raises revenue relative to current law.
Click here to read more about the House GOP’s destination-based cash-flow tax
Click here to read our analysis of the House GOP’s tax reform plan