How 'territorial' taxing of US foreign profit might work

US taxes
Many large corporations want the US government to adopt a "territorial system" that would exempt their active overseas corporate profits from US taxes, in whole or in part.

John Engler, head of the Business Roundtable, a group that lobbies for corporate chief executives, said on Thursday that President Barack Obama might back such a change. A White House spokesman responded by saying that Obama "does not believe that a pure territorial system is the best way" to reduce corporate taxes.

That comment left the door open to something less than a "pure" system, perhaps one that resembles systems in place in other countries that exempt only some overseas profits.

Opponents say alternatives should be considered, however, such as repealing a law that lets companies defer payment of taxes on foreign profits and making those profits subject to immediate taxation, just like US domestic profits.

Here is a look at the current law on taxing international profits of corporations and some reform proposals.

CURRENT LAW. The top US corporate income tax rate is 35 percent. Profits earned in the United States are taxed at that rate on a current basis, meaning right away.

Most foreign profits are not taxed on a current basis because of another law that allows income tax to be deferred on overseas profits as long as they are not brought into the United States. Corporations with overseas profits must pay tax on them to the host country where they are booked. But as long as those profits stay outside the United States, no US tax is due.

As a result, more than $1.5 trillion in corporate profits is estimated to be parked overseas avoiding US tax. Much of these unrepatriated profits belong to large technology and drug firms.

TERRITORIAL SYSTEM. This proposal would exempt active overseas profits from US taxes.

Passive income - for things like investments an owner is not actively involved in - is subject to immediate taxation under US rules, though there are ways around that as well.

In its purest form, a "territorial system" would mean repealing the deferral law and exempting all active foreign profits earned by US companies from taxation. Such a system would let US companies bring home foreign profits tax-free.

Previous actual proposals have been more limited, however, including one put forward by Congress's nonpartisan Joint Committee on Taxation, and one made in 2005 by a presidential tax reform panel assembled by the Bush administration.

Many countries have territorial systems, but they limit the amounts and types of foreign profit that are exempted from taxation, as the earlier US proposals did.

Critics of a territorial system say it would give US corporations a strong incentive to move even more income and jobs offshore. Backers say this problem could be addressed by lowering the corporate income tax rate to a level closer to other countries' rates and by making other adjustments.

REPEAL OF DEFERRAL. An alternative to the territorial system would be to end the law that allows deferral of US taxes on foreign profits. If this law were repealed, all active corporate profits - at home and abroad - would be taxed on a current basis at the full rate of 35 percent, minus credits for foreign taxes paid and other tax breaks.

PARTIAL REPEAL OF DEFERRAL. Another option might be to repeal deferral only partially, perhaps rolling it back only for tax-haven countries targeted by the government. Choosing which countries to target would be a process fraught with politics.

Obama has proposed this in past budget proposals. He may do the same again, as the White House is only likely to move away from that idea in the context of broader tax reform.

Another way might be to end deferral for countries with tax rates that are too far below the US rate. A third approach might be to end deferral for profits made in the production of goods that are then imported into the United States. But tracing their origins would be complicated.

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