The New Non-Territorial U.S. International Tax System

I. Introduction

A fading truism — and not, as we will see, a very useful one — holds that countries may apply either of two distinct types of international tax systems to multinational companies (MNCs) that they classify as domestic residents. Under a pure worldwide system, resident MNCs’ foreign-source income is taxed, but foreign tax credits are allowed. Under a pure territorial system, foreign-source income is exempted and foreign taxes are ignored.

Before the enactment of the Tax Cuts and Jobs Act (P.L. 115-97),¹ it was still sometimes said that the United States had a worldwide system while all other major countries had territorial systems. Suppose we initially assume this description’s accuracy and usefulness. Then what about afterward? The TCJA exempted dividends paid to U.S. companies by their foreign subsidiaries,² in keeping with common practice abroad.³ In other words, its core international feature was repealing deferral, or the postponement of U.S. taxation of foreign-source income until the U.S. parent’s receipt of a dividend. Does this change mean that the United States now has a territorial system?

The answer would clearly be yes if the TCJA had eliminated, not only (nearly all) deferred taxation of U.S. MNCs’ foreign-source income,⁴ but also any current taxation of it. Instead, however, the act not only generally retained preexisting current taxation of foreign-source income (under subpart F⁵) but significantly expanded it.⁶ In short, the TCJA took a preexisting “now or later” model for taxing foreign-source income and changed it to a “now or never” model — with greater “now” taxation than previously. So deferral was cashed in for changes in both directions — that is, both toward “now” and toward “never” — not just to MNCs’ benefit.

Given this point, sophisticated observers immediately recognized that the newly enacted system could not accurately be described as territorial. For example, Davis Polk & Wardwell LLP, in a nearly contemporaneous client memorandum concerning the TCJA that it made publicly available, called the new U.S. system a “not quite territorial” or “modified territorial” system.⁷ KPMG LLP backed even further away from the territorial label. It concluded that while the new law had “substantially eliminate[d] any element of deferred taxation of foreign income within a U.S.-parented multinational group,” the “sum total of [other] changes represents a significant expansion of the base of cross-border income to which current U.S. taxation applies.”⁸ International tax practitioner Nathan Boidman asserted, not just that the United States had merely changed between “type[s] of quasi-worldwide system,” but that the new system was harsher than the old one in its treatment of foreign-source income.⁹

Given the expansion of the “now” category for taxing U.S. MNCs’ foreign-source income, continued use of the worldwide and territorial labels would require characterizing the United States as having a hybrid system. Only it already had a hybrid system under pre-2017 law,¹⁰ albeit of a significantly different kind. Moreover, peer countries’ putatively territorial systems are likewise best viewed as hybrids.¹¹

It is easy to see that, when a term such as “hybrid” can be used to describe practically all existing or recent systems, it ends up providing useful information about none of them. Yet this is not the only reason why the “worldwide” and “territorial” labels, which make use of the term “hybrid” necessary, should be retired. In addition to there generally being no pure worldwide or territorial systems in peer countries, the labels are in many respects analytically unhelpful. As we will see, among the important margins that international tax systems may affect, the worldwide and territorial labels affirmatively ignore some, while conflating and unduly narrowing the purportedly available choices in others. Thus, apart from their offering fixed reference points to which one can compare existing systems, “worldwide” and “territorial” fail the prime test of a classification system, which is that it be informative and useful.

A better, although unfortunately messier, classification scheme requires recognizing that there are multiple important margins at which international tax systems can independently differ. The core issues include, not just what foreign-source income is taxed domestically and at what rate, but also at least the following: (1) how to define corporate residence, (2) how to define the source of income, (3) how to respond to suspected profit-shifting between jurisdictions,¹² and (4) how companies’ foreign tax liabilities should affect their domestic tax liabilities. Given this slew of distinct issues, the use of broad and simplistic labels can get one only so far.

Happily, the complexities associated with international tax policymaking make assessment of the TCJA’s international changes considerably more interesting and ambiguous than if the act had simply made the U.S. system a territorial one, in an alternative universe in which that was actually a useful classification. This report’s main purpose, other than proposing a better set of categories for parsing key international policy issues, is to offer a broad and preliminary assessment of several of the main international provisions in the TCJA.

In general, I find three main grounds for examining the new provisions in a relatively lenient spirit. First, considering deferral’s defects,¹³ prior law was so bad that even if the provisions as they stand have not improved U.S. international tax law — a low bar indeed — they could readily be tweaked to do so. Although this will not necessarily end up happening, its nonoccurrence would implicate future policymakers, not just current ones.

Second, the international tax provisions were significantly tougher than U.S. MNCs seem to have expected. This might be either good or bad as a policy matter, depending on one’s sense of the complex and multifaceted underlying merits. But at least it helps to show that — in contrast to, say, the passthrough rules, which (for no discernible policy reason) offer a special 20 percent deduction to favored businesses¹⁴ — they cannot be dismissed as merely a crass giveaway to the Republican congressional leadership’s friends and donors. Perhaps the difference was that, in Willy Loman’s terminology from Death of a Salesman, MNCs were merely “liked” by the TCJA’s proponents, whereas passthroughs in favored sectors such as real estate were evidently “well liked.” Hence, given overall revenue constraints, the MNCs had to help pay, whether by fair means or foul, for the benefits that were being showered on closer friends.¹⁵ While this is hardly grounds for turning cartwheels over the TCJA’s international provisions, it can help to motivate approaching them in a more tolerant spirit. After all, once Congress had decided to be revenue-conscious in the international sector, there was reason to hope (whether or not to expect) that it would tend to look in the right places.

Third, at least some of the provisions respond meaningfully, and not entirely unreasonably, to important trade-offs in international tax policy that lack clear answers. On the other hand, it is true that the provisions have many basic design flaws,¹⁶ failed to specify how they apply in several crucial respects,¹⁷ and include significant drafting errors¹⁸ — all presumably reflecting their highly rushed enactment with only minimal vetting and public feedback. Thus, how positively one should view them depends in part on whether one is assessing them exactly as they now are, or at a level of Platonic abstraction that permits one to discern underlying purposes that might have been (and perhaps might still be) more artfully accomplished.

The remainder of Part 1 of this report discusses how one could more crisply, comprehensively, and accurately conceptualize international tax policy than through the outdated and unhelpful language of “worldwide versus territorial.” It also explores the reasons for several key margins’ normative ambiguity, which include the tension between what I call unilateral and strategic approaches to international tax policymaking. Only the latter involves considering how a given country’s international tax policy choices might subsequently affect other countries’ behavior. Thus, for example, engaging in tax competition is not inherently strategic in my sense of the term. Indeed, tax competition fails to be strategic if it involves overlooking how one’s own tax law changes might affect what other countries later do. Unfortunately, although all sophisticated actors in international tax policy should consider the strategic aspect, it tends to make the underlying policy choices even harder to parse confidently. Strategic interactions are often unpredictable, and even more so when they involve government actors who are subject to the vagaries of domestic politics.

Part 2 of this report will evaluate three of the TCJA’s main international features in light of the forgoing analysis: (1) the base erosion and antiabuse tax,¹⁹ a measure that appears to have been designed primarily to address inbound base erosion engaged in by foreign MNCs investing in the United States²⁰ but that can also affect outbound profit-shifting by U.S. MNCs;²¹ (2) global intangible low-taxed income,²² an anti-tax-haven provision that targets outbound profit-shifting by U.S. MNCs;²³ and (3) foreign-derived intangible income (FDII),²⁴ which Lee A. Sheppard has called “a stingy patent box laid on in the hope that some [U.S.] companies will want to keep intangibles onshore.”²⁵

I conclude that the BEAT and GILTI, although not FDII, have the potential (with suitable revisions) to serve as important parts of an improved U.S. international tax system that eschews deferral. Or at least, with suitable revisions they would be reasonably defensible, subject to the underlying conceptual challenges in specifying good international tax policy design. As for FDII, while major reworking would be necessary before one could reach such optimistic ground, the likelihood of its being held to violate WTO rules²⁶ may give optimists grounds for hoping that it will not long persist, at least in its current form. Part 2 also discusses possible next steps for the BEAT, GILTI, and FDII.

II. Beyond ‘Worldwide Versus Territorial’

A. ‘Inbound’ and ‘Outbound’

International tax policy addresses the tax consequences of “inbound” and “outbound” economic activity for a given country. However, those two terms merit scare quotes given that the act of crossing the border, in the eyes of a typical income tax system, can be formal rather than substantive. For example, a New Yorker’s operation of a pizza parlor in Brooklyn involves inbound investment, by the lights of the U.S. tax system, if for some reason she chooses to incorporate the business abroad. Likewise, if French investors incorporate in Delaware to run a trading desk in EU stocks across the street from the Euronext Paris headquarters, this looks, to the U.S. tax system, like outbound investment (presumably yielding foreign-source income) by a U.S. company.

In both of those examples, although entity-level corporate taxation yields a formalistic view of where the relevant taxpayer resides, at least the source of the income seems reasonably clear. However, source determinations can likewise end up being made formally, in the sense of without regard to where people are actually doing things on either the production or consumption side. In 2010, for example, U.S. companies reported earning $94 billion in Bermuda, a nation where GDP for the year was only $6 billion.²⁷ This helps to demonstrate massive profit shifting, or the creation of foreign-source income in tax haven jurisdictions where little actually happens.

The artificiality of corporate residence and source rules, and thus of the inbound and outbound categories in practice, powerfully influences a wide range of international tax policy issues. Indeed, it blurs the lines between domestic and international tax policy by suggesting that even transactions that seemingly are not cross-border at all — involving domestic-source income earned by domestic companies, or foreign-source income earned by foreign companies — may affect one’s policy choices across the board. Thus, rather than just focusing on inbound investment, one must also keep international considerations in mind when addressing domestic investment by domestic companies. And there may be reason to have the rules for outbound investment consider foreign-to-foreign tax planning between affiliated foreign companies, at least if there is also a domestic affiliate somewhere in the picture.

B. Taxing Domestic-Source Income

1. Relevance of Tax Competition

If not for the artificiality, and consequent manipulability, of the residence concept, global tax competition might simply not be an issue regarding the domestic tax rate for business income earned by resident individuals. Thus, suppose that, in lieu of there being entity-level corporate income taxation, resident individuals could be and were taxed on a current annual basis on all of their worldwide income, no matter where earned, including when they invested through a corporation. Those individuals would thus be unable to avoid the domestic business rate by investing abroad (even through a foreign entity). From the standpoint of domestic tax liability, it would be almost as if they were living in a closed economy.²⁸ Thus, global tax competition would mainly be irrelevant to the choice of tax rate for those individuals’ business and investment income, unless their own mobility (by ceasing to be residents) was an issue.

To be sure, in this scenario global tax competition would still be highly relevant to the choice of tax rate for domestic-source income that was earned by nonresidents on inbound investment. Indeed, insofar as foreigners would merely be earning a normal return on the investment that they could equally earn elsewhere, the optimal domestic tax rate on their income from that investment might even be zero,²⁹ because they might not be expected to bear the incidence of any such tax.³⁰

In short, if not for the artificiality and consequent manipulability of both the residence and source concepts, (1) residents’ purely domestic and outbound investments might be treated the same (leaving aside for now the treatment of foreign taxes), while (2) inbound investment might even be exempted, at least as far as normal returns are concerned. With manipulability, however, the lines start to blur. Concern that resident individuals can camouflage their domestic-source income as inbound places upward pressure on the choice of inbound rate. And if resident individuals can avoid current taxation of their foreign-source income by investing abroad through foreign corporations, that places downward pressure on the choice of outbound rate. Global tax competition therefore is generally relevant, after all, to all realms of business taxation.

2. Corporations and Global Tax Competition

a. Lower corporate tax rates? Through almost the entire history of the U.S. federal income tax, the top corporate income tax rate has been lower than the top individual rate.³¹ This has also been common in other countries. The rate disparity has tended to grow in recent decades — most recently, in the United States, which in 2017 lowered the top individual rate only from 39.6 percent to 37 percent, while the corporate rate declined from 35 percent to 21 percent. This more than tripled the gap between the top individual rate and the corporate rate, from 4.6 percentage points pre-TCJA to 16 percentage points afterward.³²

At one time, the most prominent rationale for setting the top corporate rate below the top individual rate was to mitigate the discouragement of corporate equity investment that might otherwise result from shareholder-level taxation of corporate income that had already been taxed at the entity level.³³ However, concern in the United States about this issue has recently eased. This reflects not just the lowering of the tax rate on dividends, which now stands at 20 percent,³⁴ but also the fact that the stock of dividend-paying U.S. companies is now predominantly held by tax-exempt shareholders, for whom the second level of tax is not an issue.³⁵

Today the more prominent rationale for setting the top corporate rate well below the top individual rate pertains to global tax competition. Reflecting the artificiality and consequent manipulability of corporate residence determinations, effective residence electivity for corporations is presumably substantially higher than that for individuals.³⁶ Also, corporations are generally considered the main vehicle for attracting investment capital from around the world, for making mobile investments, and for engaging in profit shifting. This makes the corporate tax rate a plausible proxy, if an imperfect one, for the tax rate on income that is especially mobile and hence subject to global tax competition.

b. Still-lower effective tax rates for MNCs? Even with a corporate tax rate well below that applying to resident individuals, there is still further scope for differentiation in response to global tax competition. Suppose there are two types of corporations: those that operate purely in the residence country, and those that are MNCs engaged in global operations (at least through affiliated companies). Further suppose that one has some ability to tell the two types of companies apart and that they are imperfect substitutes for each other. Finally, suppose that MNCs are more able than purely domestic companies to respond to global tax competition, both by shifting actual operations abroad and through artificial profit shifting that involves no actual, or at least commensurate, shift in where significant activities occur.³⁷ Under those conditions, a source country might reasonably strive to impose lower effective tax rates on MNCs than on purely domestic companies.³⁸

An easy mechanism for achieving such a differentiation in effective tax rates is to deliberately tolerate some degree of profit shifting by MNCs. To be sure, the notion of profit shifting presumes an underlying true source of income, which may often be hard or even impossible to define.³⁹ This, however, implies only that source determinations for MNCs that are operating domestically must at times be inaccurate, or at least arbitrary — not that measures of their domestic-source income must systematically aim to be lenient rather than harsh. Thus, deliberately allowing some profit shifting to occur is best seen as a deliberate choice, and plausibly a rational one from the domestic national welfare standpoint.⁴⁰

This does not, however, automatically establish that one should welcome any and all such profit shifting, and thus reduction of the domestic tax rate on MNCs to zero (or below), when purely domestic companies are paying tax at a positive effective rate. Unfortunately, as I have observed before, although it is perfectly logical to favor some, but not too much, profit shifting by MNCs, “quantifying the analysis is considerably harder. Source countries lack clear guidelines for determining how much profit shifting is ‘too much.’”⁴¹

In short, determining how much profit shifting by MNCs to tolerate (or even encourage) presents a Goldilocks problem. When is the amount just right, rather than too great or too small? As I discuss later, this problem becomes even more complicated if countries are interacting strategically — that is, if one’s own anti-profit-shifting efforts will affect what other countries do, either in this regard or others of interest to one’s own national welfare.

c. Resident versus nonresident MNCs. A further design question regarding combating profit shifting by MNCs concerns the distinction between MNCs classified as domestic residents and those classified as nonresidents.⁴² As an initial matter, policy-relevant systematic differences between these two types of MNCs might conceivably offer a rationale for treating them differently regarding profit shifting. Suppose, for example, that U.S. investment by resident MNCs was less tax-elastic than that by foreign MNCs. That might support a more rigorous U.S. effort to combat profit shifting by resident MNCs, under the view that (under the Ramsey or inverse elasticity rule from public economics) this supported imposing a higher effective tax rate on their U.S. activity.⁴³

Now suppose instead that there are no pertinent differences between resident and foreign MNCs. There remains a possible rationale for addressing profit shifting by resident MNCs more vigorously than that by foreign MNCs. This relates to the distinction between the tools legally and practically available for combating profit shifting by each type of MNC.

A country can directly tax resident MNCs’ foreign-source income, such as by imposing deemed repatriation taxes, even if the foreign-source income is earned through foreign subsidiaries that are viewed as themselves nonresidents. This helps distinguish between what the residence country may deem to be “bad” foreign-source income of resident MNCs as opposed to “good” foreign-source income — a distinction that, as I discuss shortly, they commonly make for reasons apparently connected to concerns about profit shifting.⁴⁴ By contrast, nonresident MNCs’ foreign-source income can only be taxed indirectly, such as by denying domestically incurred interest deductions — an approach that I have described as arithmetically equivalent to indirectly taxing foreign-source income generally in an amount that equals the disallowed deductions.⁴⁵ Thus, absent other routes to the same end, countries may lack a comparable ability to distinguish between good and bad foreign-source income earned by foreign MNCs.

Insofar as distinguishing between bad and good foreign-source income permits one to deploy more refined and better-directed tools against undesired profit shifting by resident MNCs than against profit shifting by foreign MNCs, one may choose to more rigorously combat profit shifting by the former than by the latter. However, use of the more refined tools comes at a price, to the extent that one does not otherwise want to treat the two groups differently. I have argued that, before the TCJA, the United States, in contrast to peer countries such as Germany, appeared to be overusing residence-based anti-profit-shifting approaches relative to non-residence-based approaches.⁴⁶

C. Taxing Foreign-Source Income

1. Worldwide-Versus-Territorial Framework

When we turn to the international tax policy choices underlying the taxation (or not) of resident MNCs’ outbound investment, we are finally in the realm of the supposed divide between worldwide and territorial systems. Even here, however, the distinction serves little good purpose because of its undernourished presentation of the rich set of possible choices that countries consider. These involve: (1) how one taxes foreign-source income, including different categories thereof; (2) how foreign taxes paid affect the domestic tax burdens on foreign-source income; and (3) the role, if any, played by deferral in a given system.

Neither a pure worldwide system nor a pure territorial one would use deferral. So they are in agreement here, but not on the first two elements. Again, foreign-source income is taxed at the full domestic rate in a pure worldwide system, and at a 0 percent rate in a pure territorial system. Likewise, foreign taxes are fully creditable in a pure worldwide system (without even FTC limits), while being ignored in a pure territorial system.

This, in turn, means that foreign taxes have a marginal reimbursement rate (MRR) of 100 percent in a pure worldwide system, in which each dollar of foreign taxes paid triggers a full $1 reduction in domestic tax liability.⁴⁷ As I have observed before, that system thereby induces resident companies to maximize before-foreign-tax foreign-source income and to have zero cost-consciousness regarding foreign taxes paid.⁴⁸ By contrast, in a pure territorial system, the MRR for foreign taxes is 0 percent. However, because this causes the MRR to equal the 0 percent marginal tax rate for foreign-source income, territoriality is an implicit deductibility system for foreign taxes. Just like explicit foreign tax deductibility in the face of a positive tax rate on foreign-source income, it induces resident companies to maximize after-foreign-tax foreign-source income.⁴⁹

Given the two distinct margins at which worldwide and territorial taxation differ, they are actually compound systems, combining rival approaches at each of two distinct margins. This raises the question of why it would not be preferable, from the standpoint of analytical clarity, to focus the analysis on one margin at a time.⁵⁰ It also raises the question of whether it might be fruitful to consider intermediate approaches at either or both margins, rather than just the polar alternatives that the two compound systems offer.

Despite these problems with the worldwide-versus-territorial framework, much international tax policy scholarship used to focus intensively on comparing them at an abstract level as unitary alternatives. Often those comparisons were mystifyingly based on the supposed choice between two rival global efficiency norms: capital export neutrality (CEN), which supports the worldwide approach, and capital import neutrality (CIN), which supports territoriality.⁵¹ That emphasis on CEN versus CIN prompted the question of why countries should be expected to focus on global rather national economic welfare. Mercifully, the CEN versus CIN debate seems to have largely abated in recent years.⁵²

From the standpoint of contemporary international tax policy debate, the reasons why the worldwide-versus-territorial framework is inadequate are not limited to its conflating two distinct margins and seemingly requiring a choice between polar, rather than intermediate, approaches at each margin. The framework also fails to address or illuminate the key issues at each margin that countries appear to actually care about. This is best shown by looking more closely at each margin, as well as at the issues raised by deferral.

2. Resident MNCs’ Foreign-Source Income

a. Good versus bad foreign-source income. I have suggested in earlier work that reasoning like that which underlies the Ramsey rule⁵³ might support taxing U.S. companies’ foreign-source income at a rate that is above zero but below the tax rate for domestic-source income. The rationale is that the United States will likely have “significantly more market power with respect to domestic investment than with respect to the use of a resident entity to invest abroad,”⁵⁴ thus helping to make resident companies’ foreign-source income more tax-elastic than domestic-source income. The rationale for not wholly exempting foreign-source income is that doing so would forgo the opportunity to reduce overall deadweight loss by using a positive rate on it to fund a reduction in the domestic-source-based rate.⁵⁵ Unfortunately, the choice of an optimal outbound rate is no less difficult and inevitably context-specific than that of an effective rate for domestic and foreign MNCs’ U.S.-source income.

One reason for taxing foreign-source income at a greater-than-zero rate (at least if one has some market power at the corporate residence margin) relates to profit shifting. Apparently because of concerns about this issue, countries that have MNCs engaged in significant outbound investment — including putatively territorial countries — pervasively tend to distinguish between different types of foreign-source income. Under controlled foreign corporation rules that apply to resident MNCs,⁵⁶ specified types of foreign-source income trigger deemed dividends from foreign subsidiaries to the domestic parents, thereby rendering that foreign-source income taxable rather than exempt. As Kimberly A. Clausing has noted, “The point of CFC laws is to distinguish ‘good’ foreign income from ‘bad’ foreign income”⁵⁷ — a distinction that lies wholly outside the worldwide-versus-territorial framework.

When one surveys CFC rules from around the world, as three recent studies have,⁵⁸ three perhaps surprising things become clear. The first is how much consensus CFC rules exhibit regarding the general characteristics of “bad,” as distinct from “good,” foreign-source income. The second is how much they overlap regarding how bad foreign-source income may in principle be identified. The third is how little consensus there is — even within a single country across time — regarding how rigorously or leniently one should search for bad foreign-source income.

i. Defining bad foreign-source income in principle. As Brian J. Arnold has noted, “At a fundamental level, the policy and operation of CFC rules is the same in all countries [that have them. Their] policy . . . is to prevent the diversion of certain income . . . but, at the same time, not to interfere with the ability of resident multinationals to carry on legitimate foreign business activities.”⁵⁹ He adds that CFC rules “are widely known and referred to as anti-tax haven measures.”⁶⁰ Thus, the goodness or badness of foreign-source income tends to be defined in terms of an underlying anti-tax-haven policy. Tax havens are conceptualized, for this purpose, as countries that do not merely offer extremely low (or even zero) income tax rates but that operate as convenient places to locate profits that can be divorced from actual activity of any non-formalistic kind in the jurisdiction.⁶¹

ii. Identifying bad foreign-source income in practice. To put this aim into operation, countries have tended, through their foreign-source income rules, to choose from a relatively limited menu of implementation strategies. In general, according to the three studies, there are three main types of circumstances under which resident companies are denied exemption for their CFCs’ foreign-source income. First, “passive investment-type income is the principal target for all countries’ CFC rules.”⁶² Arnold attributes this to the fact that “such income is more easily shifted among group [members] in various countries than other types of income” and thus can readily be placed in a tax haven.⁶³

Second, subpart F addresses the use of intermediary arrangements to shift foreign-source income away from the countries where it is produced or consumed.⁶⁴ Similar rules can be found in other countries, although they are less common than rules addressing passive income.⁶⁵ Once again, the issue raised is that the use of a mere intermediary, along with aggressive transfer pricing, facilitates locating profits in a tax haven.

Third, some countries base the application of CFC rules on where foreign-source income was reported. In effect, rather than inferring tax haven placement from the income’s being passive or earned by an intermediary, rules of this sort aim to observe the use of a tax haven directly, by measuring the effective foreign tax rate on particular foreign-source income.⁶⁶ Some countries instead use blacklists, under which foreign-source income from designated tax havens is denied exemption,⁶⁷ or whitelists, under which foreign-source income from designated (and generally non-haven) countries is allowed exemption.⁶⁸

iii. Lack of consensus on how rigorously to address bad foreign-source income. CFC rules matter only insofar as they are potentially binding, or at least costly to avoid. Thus, even two countries with formally similar sets of CFC rules might in fact be imposing very different tax burdens and incentives if they differ in this dimension. Indeed, a single country’s rules may be very different in this sense at time 1 as opposed to time 2, even if they do not facially change at all, if tax planning technologies evolve in the interim in a way that alters the practical trade-offs resident MNCs face.

Here, in contrast to the first two attributes, there is little consensus. Indeed, even just within the United States, both the apparently intended and actual rigor of subpart F have greatly fluctuated over time.⁶⁹ This reflects (whether or not influenced by) pervasive disagreement among American tax policy experts regarding where the national interest lies in using this tool to address profit shifting.⁷⁰ It also reflects a related ambiguity affecting revenue estimates for proposals that would make subpart F more rigorous.

To illustrate the underlying problem, suppose that a provision strengthening subpart F would prevent U.S. MNCs from engaging in foreign-to-foreign profit shifting that allowed the placement of substantial foreign-source income in tax havens. The correct revenue estimate for that proposal might be high if U.S. MNCs responded primarily either by incurring subpart F liability on continuing intragroup transactions, or by shifting less taxable income out of the United States to begin with. It might be low, however, if they responded primarily by just accepting that they would now have to pay more foreign tax.

b. The underlying unilateral national welfare dilemma or trade-off. The reasons should be clear for the ambiguity both of those revenue estimates and of underlying judgments regarding the unilateral national welfare effects of rigorously enforcing anti-tax-haven CFC rules. Placing foreign-source income in tax havens permits MNCs to avoid foreign taxes, which (as far as it goes) is all to the good from a unilateral national welfare standpoint, because resident individuals (some of whom may be shareholders) do not get to use the revenues paid to foreign governments. Yet foreign-to-foreign tax planning that MNCs use to reduce their foreign tax liabilities may be complementary with reducing home country taxes (whether through mere profit shifting or more substantive locational changes). Moreover, even if one wishes to allow some profit shifting, based on the view that MNCs are more mobile than purely domestic taxpayers, at some point it may exceed the desired level. The use of anti-tax-haven CFC rules may therefore usefully expand one’s arsenal of tools against undesired tax avoidance.

Just as we have seen at other margins, however, there is a fundamental ambiguity about just how much use of CFC rules is unilaterally nationally optimal. It may come at the price not only of inducing resident MNCs to accept higher foreign tax liabilities that are just a cost from the domestic standpoint, but also of disfavoring foreign investment by those MNCs relative to that by nonresident companies (which are not subject to domestic CFC rules). Accordingly, the optimal usage level for this tool is ambiguous and hard to judge.

These trade-offs are present even in the (relatively) consensus case of taxing passive foreign-source income. If resident MNCs are not taxable domestically on the passive income that they report abroad through tax haven MNCs, they have reason to try to shift all their passive income to tax havens. One cannot stop foreign MNCs from doing this (if not constrained by their own home country rules). Thus, CFC rules that tax passive foreign-source income discourage domestic residence by MNCs, relative to not having those rules. Moreover, if one allows FTCs for passive foreign-source income, one may wholly eliminate resident MNCs’ incentive to seek to reduce foreign taxes on that foreign-source income to anything below the applicable domestic rate.⁷¹ The same basic trade-offs apply to rules addressing intermediary arrangements and directly observed tax haven income. Thus, the optimal level of countries’ use of anti-tax-haven CFC rules cannot be determined in the abstract, and may vary between countries and across time.

3. MRR for Foreign Taxes

On the MRR for foreign taxes, the analysis would be considerably simpler if not for the anti-tax-haven aspect of the profit-shifting analysis. Actual or implicit deductibility — the result under pure territoriality — follows logically from the fact that foreigners, rather than resident individuals, get the revenue from foreign tax payments. As Joel Slemrod notes, “The return to [any] country includes taxes paid to the country and not taxes paid to [another] country. Thus . . . deductibility [for] foreign taxes paid is unilaterally appropriate [even though it is] not consistent with global free trade in the presence of ubiquitous source-based taxes” and a positive domestic tax rate on foreign-source income.⁷²

On the other hand, even absent concern about profit shifting, strategic considerations (which I discuss more fully later) might complicate the analysis. For example, suppose that countries A and B are crediting each other’s taxes. If A is thinking about making B’s taxes merely deductible when incurred by its own MNCs, it may need to consider the possibility that B would respond by making A’s taxes merely deductible when incurred by B’s MNCs. That might hurt A, by causing B’s MNCs to be more averse to investing in A or to incurring A’s taxes. The possibility of such a response thereby inevitably complicates whether A should make the change, and it potentially reverses the answer.

Suppose, however, that those strategic considerations are immaterial — for example, because peer countries already predominantly do not credit one’s own taxes. If a putatively territorial country has anti-tax-haven CFC rules, this can cause the foreign taxes that resident MNCs incur in lieu of facing domestic tax liability under those rules to be better than deductible at the margin — and indeed, even, in some realistic hypotheticals, better than creditable.

For example, suppose that paying $20 (rather than zero) in foreign taxes on $100 of foreign-source income would permit a resident MNC to eliminate $21 of domestic tax liability under a particular CFC rule. In effect, those foreign taxes face a 105 percent MRR. Although they were not literally creditable, incurring them in the amount of $20 reduced the MNC’s U.S. tax liability by $21. So the marginal effect of paying the extra $20 in foreign taxes is arithmetically the same as offering 105 percent FTCs. Either way, under the assumed facts, incurring those particular foreign taxes permits the MNC to reduce its domestic tax liability by more than the full amount of the foreign taxes.

This particular scenario, at least when considered in isolation, seems unlikely to have positive unilateral national welfare effects. With a 105 percent MRR, the MNC simply pays more foreign taxes than it would have if the relevant CFC rule did not exist, and the rule raises zero revenue (in this instance) for the United States. Charging the MNC a domestic tax price of no more than $19 — and perhaps as little as zero, given the multiple considerations discussed above — would have been preferable under these particular facts. Suppose, however, that absent the CFC rule at issue, the MNC would have shifted substantial domestic profits, and not just the above-noted $100 of foreign-source income, to a tax haven. Then the CFC rule might conceivably have positive national welfare effects on balance.

All this should help show that there is no right answer to the optimal MRR question once the rationale for anti-tax-haven CFC rules has been added to the analysis. Still, reasonable guidelines may be available from a design standpoint. For example, one may generally wish to minimize the creation of MRRs exceeding 100 percent.

When evaluating MRRs in practice, an important point is that they can depend on more than just how a given system expressly treats foreign taxes (such as by making them creditable, deductible, or neither). The above hypothetical, in which anti-tax-haven CFC rules caused foreign tax liability to vary with the scope of domestically taxable foreign-source income, is only one illustration of this. For another example, suppose a country imposed a minimum tax on resident MNCs’ worldwide income, requiring that it equal at least 15 percent, with domestic taxation of foreign-source income replacing any shortfall.

Suppose that under that provision a resident MNC with $100 billion of worldwide income would pay $15 billion of domestic tax if it otherwise paid zero worldwide, declining to zero domestic tax liability if the MNC paid $15 billion or more of tax abroad. Even if the legislation made no express mention of FTCs as such, its effect would be to create a 100 percent MRR as foreign tax liability rose from zero to $15 billion, followed by a 0 percent MRR after that point. A minimum tax designed in this way would be expected to eliminate all foreign tax cost-consciousness by resident MNCs within the range of the effective full creditability.

4. Deferral

Although the TCJA did not cause the United States to have a territorial system, it did indeed repeal deferral by generally exempting dividends paid by CFCs. Thus, for particular current-year foreign-source income, U.S. MNCs will henceforth, in the main, be taxable in the United States either now or never but not later. Deferral’s repeal raises three main questions for analysis: why it existed in the first place, what main incentive effects it had while in place, and what main issues its repeal raises.

a. Why would one have deferral? As a matter of history, deferral arose purely formalistically, as an application of the realization requirement. Just as an individual who owns a share of General Electric stock does not have taxable income from it until she receives dividends or sells the stock, GE does not, as a general matter, have taxable income merely because it owns 100 percent of the stock of a foreign subsidiary. However, while the two cases are equivalent from a formal legal standpoint, few if any of the practical or administrative arguments for awaiting realization⁷³ will likely apply to an MNC’s foreign subsidiary that the MNC completely controls, and that is effectively almost identical to an unincorporated foreign branch.

In 1962, when the Kennedy administration sought to repeal deferral and make foreign subsidiaries’ income immediately taxable to the U.S. parents, it emphasized the lack of any significant practical distinction between foreign subsidiaries and foreign branches. In the course of fighting back politically, U.S. MNCs made no significant effort to rebut this line of argument. Instead, they invoked policy considerations — “arguing that their ability to compete with foreign companies that did not have to pay U.S. tax would be adversely affected.”⁷⁴ The policy dispute ended in compromise between the basically worldwide system that the Kennedy administration favored, and the shift to a purely territorial system that the companies’ arguments supported. Deferral was retained, subject to the enactment of subpart F, but this was essentially a ceasefire in place between the proponents of higher and lower U.S. tax burdens for U.S. MNCs.⁷⁵ While deferral remained a key component of the compromise outcome, simply because it was already there, it had “a particular structure that surely no one would have deliberately chosen from a design standpoint.”⁷⁶ It persisted as long as it did merely because of political inertia, plus the difficulty of resolving the fraught question of what, exactly, should replace it.

b. What were deferral’s main incentive effects? To illustrate deferral’s main incentive effects while it remained in force (and while the U.S. corporate tax rate was 35 percent), suppose Acme-US, an American MNC, owned stock of a CFC that, in its first year of operations, earned pre-foreign-tax profits of $100x, on which it paid foreign taxes of $10x. An immediate repatriation to Acme-US of the $90x that remained after paying those taxes would cause it to have $100x of U.S. taxable income, generating a U.S. tax liability of $25x after claiming $10x of FTCs.

The deferral of Acme-US’s $25x tax liability until repatriation occurred would have two particularly salient features. First, all the above amounts would ordinarily be expected to grow over time as a result of the CFC earning income from the retained earnings (generating additional FTCs and residual U.S. liability) while it held them. Under specified circumstances that included the constancy of the U.S. repatriation tax rate over time, the annually rising residual tax might make Acme-US indifferent between repatriating the funds sooner as opposed to later.⁷⁷ Second, deferring the taxable repatriation would have option value if the U.S. tax rate that would apply to it might be lower in the future. That option value would be especially high if there was reason to expect a future rate decline — for example, a repeat of the 2004 repatriation tax holiday,⁷⁸ the repeal of deferral (as actually happened in 2017), or simply a reduction in the corporate rate (as also happened in 2017). The resulting expectation of a future lower repatriation tax rate helped make U.S. MNCs in many cases extremely reluctant to repatriate foreign earnings currently.⁷⁹

This was commonly called a “trapped earnings” problem, although the phrase was more of a metaphor than literally accurate. The financial value arising from past profits, even if embodied in cash, is intangible rather than being held in a particular place (although, for that matter, U.S. MNCs’ unrepatriated profits could take the form of dollar-denominated deposits in U.S. banks). What still made deferral relevant to daily operations was that the need to avoid a taxable repatriation could “disrupt MNC internal capital markets, creating liquidity constraints that require[d] cash-rich MNCs like Apple to borrow to fund domestic operations, investments, and even shareholder payouts.”⁸⁰ The real cost of all this could be significant, especially as the profits that one had booked offshore grew relative to one’s total financial capital.⁸¹

One key incentive effect, then, was discouraging taxable repatriations. In effect, U.S. MNCs were being induced to play Twister with their internal finances until the repatriation tax rate was at least temporarily lowered. However, deferral also affected the expected tax burden on foreign-source income and the expected MRR for foreign taxes paid. As for the expected tax burden, both the possibility that some positive repatriation tax rate might be paid in the future and the deadweight loss associated with disrupting MNCs’ internal capital markets in the interim meant that a U.S. MNC with foreign profits (whether the fruit of substantive economic activity abroad or profit shifting) generally would face an expected U.S. tax burden on foreign-source income that was higher than that under a pure territorial system but lower than that under a pure worldwide system. As for the expected MRR, FTCs would have some value, unlike under a pure territorial system (under which they would never be claimed) but less than under a pure worldwide system (under which they were certain to be claimed). Hence, U.S. MNCs engaged in overseas tax planning that showed they were foreign-tax-averse rather than viewing their MRRs for foreign taxes as actually being 100 percent.⁸²

Post-repeal, the end of deferral’s disrupting influence on U.S. MNCs’ internal capital markets should not as such be mourned by anyone — except perhaps the tax, accounting, and financial planners who kept busy by dealing with its complexities. Even if one favored its effect on expected tax rates for U.S. companies’ foreign-source income relative to that of a pure territorial system, or on foreign tax MRRs relative to that under a pure worldwide system, it exacted in return a high and seemingly gratuitous efficiency price. Although anomalous side effects are surely inevitable in these uncertain and acutely second-best realms, deferral’s lack of any underlying rationale (beyond its formalistic origins) inspires hope that, through deliberate design, one might be able to do better.

In any event, however, given deferral’s effects on the tax burden on foreign-source income and on foreign tax MRRs, its repeal logically called for reevaluating both margins. Regarding the former, U.S. policymakers in 2017 concluded that the increase in profit shifting from eliminating deferral’s overhang called for otherwise expanding outbound taxation. As for MRRs, replacing deferral with increased immediate taxation of specified foreign-source income meant that this issue would inevitably require fresh attention. U.S. MNCs’ foreign tax cost-consciousness might be affected either by offering them FTCs for immediately taxable foreign-source income, or as an indirect consequence of having anti-tax-haven rules that in effect penalized avoiding foreign taxes.⁸³

D. Unilateral Versus Strategic Analyses

A given country’s international tax policy (and other) choices may influence what other countries do. Thus, there is reason to think strategically, rather than just unilaterally — that is, to incorporate into one’s own decisional processes the question of how what one does might affect what other countries later do, rather than simply assuming that there is no such effect. The strategic perspective is relevant regardless of whether policymakers in other countries are deliberately acting strategically. All that matters is that their future decisions might be affected in some way.

To be clear about the underlying issue, I define a country as acting unilaterally if (or insofar as) its policymakers assume that other countries’ choices, in international tax policy or otherwise, will not be affected by its own. This could either reflect ignoring the question of how other countries might respond — say, because of limited decisional bandwidth or policymakers’ indifference to those considerations — or expressly believing that other countries will not respond. A country’s decisions can be unilateral in this sense even if its policymakers are highly mindful, say, of other countries’ tax rules, of countries’ mutual incentive to compete for investment and tax revenue, and of how its own choices might affect other countries’ welfare. The question is one of interdependent decisions — not of positively or negatively interdependent welfare.

By contrast, a country is acting strategically if its policymakers assume that its choices might affect other countries’ choices. This can reflect multiple causal pathways. For example, suppose that the United States is influential, in the sense that other countries tend to imitate its policies, for whatever reason. In addition or instead, other countries might be prone to reward what they regard as friendly acts and to retaliate against what they deem as unfriendly acts, even if the impetus is emotional rather than consciously strategic. Or the effects might simply reflect new constraints or opportunities for other countries that result from one’s own actions. No matter what the underlying cause, if our behavior might influence theirs (and regardless of whether they are acting strategically), we ourselves have reason to be strategic.

An example from the TCJA concerns the decision to lower the U.S. corporate tax rate to 21 percent, at least partly in response to pressures of global tax competition. Official dynamic revenue estimates by the Joint Committee on Taxation were made under the assumption that other countries’ corporate tax rates would remain the same as under their existing laws.⁸⁴ That involved ignoring, not only the unilateral possibility that those rates might have changed in any event, but also the strategic concern that other countries would respond to the substantial U.S. rate cut by lowering their own corporate rates.⁸⁵ Yet, as one practitioner observed, “even before the ink was dry on the bill,” other countries were making plans to reduce their tax rates in response.⁸⁶

As this discussion has shown, even a purely unilateral perspective reveals that many of the main issues in international tax policy are complicated and indeterminate, such as by reason of their involving Goldilocks problems that lack clear answers. A strategic perspective can make the analysis murkier still. Even predicting the next steps that other countries might take in response to one’s own — much less the full iterative process that might unfold over time — can be highly challenging.⁸⁷

Part 2 of this report will apply the above analysis in evaluating the TCJA provisions concerning the base erosion and antiabuse tax, global intangible low-taxed income, and foreign-derived intangible income. As we will see, the imponderability of so many key issues in international tax policy impedes either accepting or rejecting their core aims with any definitiveness, but does not prevent one from identifying design flaws and grounds for roughly policy-neutral improvement.