Are U.S. Taxes causing a global disadvantage?

• Author: Rush, Patrick
• Position: COVER STORY - Cover story

Business leaders, certain politicians and others have been calling for fundamental reform of the United states international tax system in recent years. Although many countries have responded to changing times, increasing global competition and the increased flow of capital and investment across borders, there are those who feel the U.S. has been slow to act--particularly from the standpoint of tax policy.

The U.S. still relies on international tax provisions that were codified into the Internal Revenue Code in the 1960s. This system taxes U.S. citizens and enterprises on their worldwide income. While U.S. international tax law has been endlessly tweaked, modified, patched and clarified, many in the U.S. business community feel it still has grown outdated, overly complex, burdensome and increasingly ineffective in helping U.S. business compete internationally.

Unlike the U.S., systems in other developed countries have been revamped in recent years to keep up with changes in global markets, competition and the international flow of funds. These other developed countries have also lowered their corporate tax rates to help companies compete in a global economy. Not so in the U.S. where, in fact, Congress is considering adding yet more layers to an already complex system.

Two Predominant Income Tax Systems

The following outlines the two predominant income tax systems currently in use in the developed countries around the globe.

Most developed countries have corporate income tax systems in place. While varying widely, these systems fall into one of two overall patterns. Governments will tend to either limit the scope of their taxation to activity and income within their own borders (territorial taxation) or will tax worldwide income and then provide for offsets, tax credits or exclusions to mitigate double taxation (worldwide taxation). While no country employs a purely territorial or worldwide system of taxation, most countries have a predominant focus on one side or the other.

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WORLDWIDE SYSTEM

In a worldwide tax system, a country's residents and enterprises are taxable on their international income, regardless of its source or where it is derived. Income earned outside the resident country will likely be taxed by the host country as well. Since this can result in double taxation, it is generally mitigated through the allowance of foreign tax credits granted by the resident country.

Such credits are generally limited to ensure that the resident country maintains its right to tax income derived from within its own borders. In the U.S., active business income earned abroad by U.S.-controlled corporations will ultimately be subject to U.S. taxation, but generally is not taxed immediately. Taxation is usually deferred until the earnings are actually repatriated back to the United States. This concept of deferral is a departure from an otherwise pure form of worldwide taxation.

Benefits of Worldwide System. A pure worldwide tax system arguably promotes economic efficiency. The classic view is that taxes do not distort the decision by a resident as to where to locate an investment. A resident has no incentive either to move business operations overseas or keep them at home, on account of tax considerations, as the resident should generally be subject to taxation at the resident rate in either case.

Therefore, business location decisions are governed by business considerations instead of by taxation systems. This efficiency is generally referred to as "capital export neutrality."

Criticism of a Worldwide System. A noted criticism of a worldwide tax system is that it places enterprises at a competitive disadvantage by taxing them on income earned abroad, thereby making their tax burdens much larger than those imposed on their foreign counterparts, most of which come from countries with a territorial taxation system. In the case of the U.S. system, foreign tax credits and double tax relief are less than perfect, due to limitations on the foreign tax credit, thus reducing the benefit of capital export neutrality.

In addition, the U.S. will not grant foreign tax credits...