7.1 Worldwide vs. territorial tax systems
5 min read•august 15, 2024
International taxation is a complex puzzle for businesses operating globally. Countries use either worldwide or territorial tax systems, each with unique implications for corporate strategy and competitiveness. The choice between these systems affects how companies structure their operations, manage profits, and navigate cross-border transactions.
Understanding these tax systems is crucial for multinational corporations. It impacts decisions on where to invest, how to repatriate earnings, and how to optimize global tax burdens. As countries shift their approaches, businesses must adapt their strategies to stay competitive in the international marketplace.
Worldwide vs Territorial Tax Systems
Defining Characteristics of Tax Systems
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- Worldwide tax systems require resident corporations to pay taxes on their global income, regardless of where it is earned
- Territorial tax systems only tax income earned within the country's borders, exempting foreign-source income
- United States historically used a but transitioned to a modified territorial system with the of 2017
- Worldwide tax systems often provide to avoid on income taxed by foreign jurisdictions
- Example: A U.S. company earning profits in Germany would receive a credit for taxes paid to Germany, reducing its U.S. tax liability
Anti-Abuse Measures and Economic Considerations
- Territorial systems typically employ anti-abuse measures to prevent
- (CFC) rules target passive income in low-tax jurisdictions
- Example: UK's CFC rules apply to subsidiaries where the local tax rate is less than 75% of the UK rate
- Choice between worldwide and territorial systems reflects a country's economic goals, international competitiveness strategy, and approach to
- Capital export neutrality aims to make investment decisions independent of tax considerations
- Example: A worldwide system with full foreign tax credits theoretically achieves capital export neutrality
Impact of Tax Systems on Businesses
Corporate Decision-Making and Strategy
- Tax system choice influences corporate decisions on foreign investment, of profits, and global expansion strategies
- Worldwide systems may encourage companies to defer repatriation of foreign earnings to avoid domestic taxation
- Example: U.S. companies under the old worldwide system accumulated over $2.6 trillion in overseas cash holdings
- Territorial systems can promote the free flow of capital and simplify tax compliance for multinational corporations
- Reduced barriers to repatriation can lead to increased domestic investment and dividends
- Tax system affects strategies and the location of intellectual property holdings within a corporate structure
- Example: Companies may locate IP in low-tax jurisdictions under a territorial system to minimize global tax burden
Corporate Restructuring and Global Tax Planning
- Corporate restructuring and merger and acquisition activities may be influenced by the prevailing tax system in different jurisdictions
- Example: where U.S. companies merged with foreign entities to relocate their tax residence
- Interaction between a company's home country tax system and those of its foreign subsidiaries impacts overall global tax planning
- Firms must consider the interplay of multiple tax regimes when structuring international operations
- Example: A U.S. multinational must navigate both U.S. provisions and local country tax rules for its foreign subsidiaries
Advantages and Disadvantages of Tax Systems
Revenue and Competitiveness Trade-offs
- Worldwide systems potentially offer greater revenue for governments but may reduce international competitiveness for domestic corporations
- Higher tax burden on global income can disadvantage companies competing against firms from territorial systems
- Territorial systems can enhance competitiveness but may encourage profit shifting to low-tax jurisdictions
- Example: A company might locate more profitable activities in countries with lower tax rates
- Worldwide systems provide neutrality in investment location decisions but may create complex foreign tax credit calculations
- Neutrality means domestic and foreign investments face similar tax treatment
- Complexity arises from tracking foreign taxes paid and applying limitations on credits
Compliance and Anti-Avoidance Considerations
- Territorial systems simplify tax compliance but may require more robust anti-avoidance measures to protect the tax base
- Reduced need to track global income and foreign tax payments
- Increased focus on transfer pricing rules and anti-deferral regimes
- Impact on a corporation's effective tax rate varies between the two systems, affecting profitability and shareholder returns
- Territorial systems may lead to lower effective tax rates for companies with significant foreign operations
- Transition costs and complexities arise when countries shift between worldwide and territorial systems, as seen in recent U.S. tax reform
- Example: U.S. transition tax on deemed repatriation of foreign earnings during the 2017 tax system change
Tax System Choice and Global Competitiveness
Investment Attraction and Corporate Retention
- Tax system design influences a country's ability to attract foreign direct investment and retain domestic corporate headquarters
- Territorial systems may be more attractive for multinational corporations seeking to expand globally
- Interplay between tax rates and tax base definition in different systems affects cross-border competitiveness
- Example: A country with a territorial system and a 25% tax rate may be more attractive than one with a worldwide system and a 20% rate
- Territorial systems may create a more level playing field for domestic companies competing in foreign markets
- Domestic firms face similar tax burdens to local competitors on foreign-source income
Global Tax Dynamics and Trends
- Worldwide systems with high corporate tax rates can potentially disadvantage domestic companies in global markets
- Example: Before 2017, U.S. companies faced higher global tax burdens compared to competitors from territorial system countries
- Choice of tax system impacts a country's negotiating position in international tax treaties and agreements
- Territorial systems may reduce the need for extensive treaty networks to prevent double taxation
- Global trends in tax system adoption influence competitive dynamics, with many countries moving towards territorial systems to remain attractive to multinational corporations
- OECD countries have increasingly adopted territorial or hybrid systems over the past two decades
- Example: Japan and the UK switched from worldwide to territorial systems in 2009 and 2010, respectively, to enhance their global competitiveness
Key Terms to Review (18)
Base erosion and profit shifting: Base erosion and profit shifting (BEPS) refers to strategies used by multinational companies to shift profits from high-tax jurisdictions to low or no-tax locations, thereby reducing their overall tax liabilities. This practice undermines the tax base of countries, creating an imbalance and leading to significant revenue losses for governments worldwide. Understanding BEPS is crucial in assessing the differences between worldwide and territorial tax systems, as well as the implications for due diligence and tax structuring.
Capital Export Neutrality: Capital export neutrality is a principle in taxation that seeks to eliminate the bias against domestic investment when capital is exported abroad. It ensures that a country's tax system does not favor domestic investment over foreign investment, allowing firms to operate in global markets without facing discriminatory tax treatment. This principle is particularly relevant when comparing worldwide and territorial tax systems, as it influences how businesses allocate their resources internationally.
Controlled Foreign Corporation: A controlled foreign corporation (CFC) is a foreign corporation in which U.S. shareholders own more than 50% of the total combined voting power or value of the stock. This term is particularly important in understanding how U.S. tax laws apply to foreign income and the differences between worldwide and territorial tax systems, as CFCs are subject to specific tax rules that can impact how income is reported and taxed for U.S. shareholders.
Disincentives: Disincentives are factors or mechanisms that discourage specific behaviors or actions, often through the imposition of costs or penalties. In the context of taxation systems, disincentives can arise from policies that create a financial burden on individuals or businesses, ultimately affecting their decisions about income generation, investment, and compliance with tax regulations. Understanding disincentives is crucial for evaluating how different tax structures influence economic behavior and overall growth.
Double Taxation: Double taxation refers to the taxation of the same income or financial transaction in more than one jurisdiction, which often happens with corporations and their shareholders. This concept is crucial when considering the choice of business entity, as it significantly affects the overall tax burden and decision-making in structuring a business.
Foreign Account Tax Compliance Act: The Foreign Account Tax Compliance Act (FATCA) is a U.S. federal law aimed at combating tax evasion by U.S. taxpayers holding accounts and other financial assets abroad. It requires foreign financial institutions to report information about financial accounts held by U.S. citizens or residents to the Internal Revenue Service (IRS). This act significantly impacts the global tax landscape, particularly in the context of how different countries handle international tax compliance.
Foreign tax credits: Foreign tax credits are a tax benefit that allows taxpayers to reduce their U.S. tax liability by the amount of foreign taxes paid on income earned outside the United States. This system is particularly important for individuals and businesses operating in a global marketplace, as it helps prevent double taxation on the same income. By allowing taxpayers to claim credits for taxes paid to foreign governments, this mechanism encourages international investment and economic activity.
GILTI: GILTI, or Global Intangible Low-Taxed Income, is a provision in the U.S. tax code that targets income earned by foreign subsidiaries of U.S. corporations which exceeds a certain threshold. It was introduced as part of the Tax Cuts and Jobs Act of 2017 to discourage companies from shifting profits to low-tax jurisdictions and promote repatriation of foreign earnings. GILTI essentially imposes a minimum tax on foreign income, influencing corporate tax strategies and the location of intangible assets.
Incentives: Incentives are factors that motivate individuals or organizations to take specific actions or make certain decisions. They play a crucial role in shaping behavior by creating rewards or penalties, influencing economic choices and strategic business practices, especially in the context of taxation systems.
Martin Sullivan: Martin Sullivan is a prominent figure in the field of international taxation, known for his contributions to the understanding of tax policy and administration, particularly in the context of worldwide versus territorial tax systems. His work has highlighted the implications of different tax frameworks on multinational corporations and how these systems affect global business strategy and economic behavior. Sullivan's insights help frame discussions on how countries design their tax codes to encourage or deter foreign investment and economic activity.
Repatriation: Repatriation refers to the process of bringing back profits, income, or assets earned in a foreign country to the home country of the business or individual. This term is particularly relevant in discussions about tax implications and strategies that businesses employ to manage their international operations effectively. The manner in which repatriated funds are taxed can vary significantly depending on whether a country operates under a worldwide or territorial tax system, influencing corporate decisions on where to allocate resources and how to maximize profitability.
Tax avoidance: Tax avoidance refers to the legal strategies and methods that individuals and businesses use to minimize their tax liability while complying with tax laws. It encompasses the use of deductions, credits, and other planning techniques to reduce taxable income and ultimately lower the amount of taxes owed.
Tax Cuts and Jobs Act: The Tax Cuts and Jobs Act (TCJA) is a significant piece of tax legislation enacted in December 2017 that overhauled the U.S. tax code, aiming to stimulate economic growth by reducing tax rates for individuals and businesses. This act brought about numerous changes, including adjustments to deductions, credits, and the overall structure of the tax system, impacting various sectors and types of taxpayers.
Tax Inversions: Tax inversions are a strategy used by corporations to reduce their tax liabilities by merging with or acquiring a foreign company and relocating their legal domicile to that country. This practice is particularly relevant in discussions around worldwide versus territorial tax systems, as companies seek to exploit differences in how countries tax corporate income. The move is often motivated by the desire to take advantage of lower tax rates and more favorable regulatory environments offered by certain jurisdictions.
Territorial tax system: A territorial tax system is a method of taxation where a country only taxes income earned within its borders, rather than taxing worldwide income. This approach allows residents and corporations to avoid paying taxes on foreign income, leading to a more favorable environment for international business and investment.
Thomas Piketty: Thomas Piketty is a French economist best known for his work on wealth and income inequality, particularly through his influential book 'Capital in the Twenty-First Century.' His research examines how wealth accumulation and distribution impact economic growth, and he advocates for progressive taxation as a means to address rising inequality. Piketty's ideas are critical in understanding the dynamics of worldwide and territorial tax systems and their effects on economic disparity.
Transfer pricing: Transfer pricing refers to the pricing of goods, services, and intangibles between related entities within a multinational corporation. It plays a crucial role in determining taxable income and can significantly affect tax liabilities across different jurisdictions, impacting overall business strategy and compliance with various tax regulations.
Worldwide tax system: A worldwide tax system is a method of taxation where a country taxes its residents on their global income, regardless of where that income is earned. This system contrasts with other tax frameworks, as it encompasses income from all sources, both domestic and foreign, and is based on the principle that residents should contribute to their home country's revenues based on their total economic activity.