Tax Reform: Territoriality Breeds De Facto Inverters, Trump's Proposal to End Deferral, and Logic Says Yes to Imputation

Abstract

It looks like the Republicans will be successful in enacting the Tax Cut and Jobs Act (TCAJA), which will likely include a move to a territorial system for active business income. Under this system, foreign active business income of foreign subsidiaries of U.S. parent corporations would be exempt from the Federal Income Tax both at (1) the time the income is earned, and (2) the time the income is brought back to the U.S. (i.e., repatriated).

Like many tax professionals, I have argued that rather than adopting a territorial system, Congress should adopt an imputation system, which would tax foreign income of foreign subsidiaries of U.S. parent corporations on a current basis, with a foreign tax credit for foreign taxes paid. Such a system would, inter alia, (1) level the tax playing field between foreign and domestic investment, and (2) significantly eliminate the possibilities for base erosion, which is inherent in our current deferral system and will become even more significant with a territorial system.

From an income tax perspective, rather than putting “America First,” a territorial system will put “America Last.” On the other hand, an imputation system would put America on a “Level Playing Field” with foreign countries that have lower tax rates than ours.

An imputation system is not some left-wing idea. It has been proposed by two presidents: John F. Kennedy in 1962 and Donald Trump in 2016, when he was a candidate for president. The attached paper is a reverse-chronological compilation of my recent articles on this issue, all of which appeared in Tax Notes:

Territoriality Would Make All U.S. Companies De Facto Inverters, 149 Tax Notes 1403 (Dec. 14, 2015) (begins at page 1 of the attached paper); Hooray for Trump's Proposal to End Deferral, 149 Tax Notes 157 (Oct. 5, 2015) (begins at page 4 of the attached paper); and

Logic Says No to Options Y, Z, and C, But Yes to Imputation, 143 Tax Notes 579 (May 5, 2014) (begins at page 6 of the attached paper). One prediction: if we move to a territorial system, virtually every tax lawyer in America will be trying to figure out how to convert what would otherwise be a dollar taxed in the U.S. into a dollar taxed, if at all, abroad. This will happen because any dollar that can be taxed abroad at a lower rate than the U.S. rate (even with a 20% corporate rate) can be brought home tax-free. Thus, there will a special premium on base erosion transactions. The IRS, like the tax agencies in countries with territorial systems, will struggle with the inherent base erosion that will certainly become more acute with a territorial system. Hopefully, someday Congress will see the logic in imputation and adopt such a system.

Assuming Congress does adopt a territorial regime, I strongly recommend that Congress also adopt robust anti-base erosion provisions like the provision discussed in my letter to the editor of Tax Notes: Hooray for the BAT-Lite Provision of the Tax Cuts and Jobs Act, 157 Tax Notes 989 (Nov. 13, 2017). The Letter and related articles are posted on SSRN. As I explained in this letter: “[R]ather than adopting a territorial system like the one proposed in the TCAJA, Congress should follow in the footsteps of proposals made by President Kennedy and President Trump (when he was a candidate) and adopt an imputation system for taxing the income of foreign subs.” In addition to this post on the TCAJA, see my following posts on SSRN regarding other issues under the TCAJA:

1. Tax Reform: If Territoriality, Then BAT Lite, the Child of the Rejected DBCFT at http://ssrn.com/abstract=3081308. 2. Tax Reform: Taxing Trump and Curry under the Republican Plan (dealing with the 25% rate for income from pass-through entities) at http://ssrn.com/abstract=3082511.

Keywords: Tax Reform, International Tax, Territoriality, Deferral, Imputation