Modify the Rules for the Sourcing of Income From Exports

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

(Billions of dollars) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023  2014-2018 2014-2023
Change in Revenues 0.4 0.8 0.8 0.8 0.8 0.7 0.5 0.5 0.5 0.6 3.6 6.4

Source: Staff of the Joint Committee on Taxation.

Note: This option would take effect in January 2014.

To prevent the income that U.S. corporations earn abroad from being subject to both foreign and U.S. taxation, the federal government provides a credit that reduces those companies’ domestic tax liability by the amount of taxes they have paid to foreign governments. Under the rules governing that tax credit, it cannot exceed the amount of U.S. tax those businesses otherwise would have owed on their foreign income, nor can it be used to reduce taxes on income earned in the United States. However, if tax rates are higher in a host country than they are in the United States, and a corporation consequently pays more in foreign taxes than it would owe to the U.S. government, it accrues what are known as excess foreign tax credits under the U.S. tax code. A business can then use those excess credits to offset U.S. taxes on income earned in low-tax countries.

To calculate the limit on foreign taxes—which would also affect the amount of excess credits—a firm’s income must be allocated between foreign and domestic sources. For the purposes of determining the foreign tax credit, the U.S. tax code distinguishes between two categories of income derived from the sale of goods:

  • Income resulting from the sale of goods that a U.S. firm buys from another business and then resells abroad; and
  • Income resulting from the sale of goods that a U.S. firm manufactures and then sells directly to buyers in other countries.

Income in the first category is governed by the U.S. tax code’s “title passage rule,” which specifies that such earnings be “sourced” in the country where the sale occurs. However, for the second category of income, a special rule applies: When the goods are produced in the United States and then sold by that firm to foreign buyers, half of the resulting income is sourced in the United States; the rest of the income is subject to the title passage rule and allocated to the country where the sale took place.

The special rule for determining the source of income from the sales of goods that were manufactured domestically and then sold abroad by U.S. firms allows those firms to classify up to half of their exports as foreign sourced—even though the value of those goods was generally created or added in the United States. The result is that a business can classify more of its income from exports as foreign than could be justified solely on the basis of where the goods were produced. A multinational corporation can then use any excess foreign tax credits to offset U.S. taxes on that income. The income allocation rules give those companies an incentive to produce goods domestically for sale by their overseas subsidiaries.

Under this option, the title passage rule would no longer apply to income from the sale of goods manufactured in the United States and then sold abroad. Instead, all income from such transactions would be sourced to the United States. That change would increase revenues by $6 billion over the 2014–2023 period, the staff of the Joint Committee on Taxation estimates.

One rationale for the option is that export incentives, such as those embodied in the title passage rule, do not boost domestic investment and employment overall or affect the trade balance. They do increase profits—and thus investment and employment—in industries that sell substantial amounts of their products abroad. However, the value of the U.S. dollar is boosted as a result, making foreign goods cheaper and thereby reducing profits, investment, and employment for U.S. companies whose products compete with imported goods. Thus, export incentives distort the allocation of resources by misaligning the prices of goods relative to their production costs, regardless of where the goods are produced.

Another argument in favor of the option is that it also would end a feature of U.S. tax law that allows businesses to avoid taxes on certain types of income earned abroad. Foreign tax credits were intended to prevent the income of U.S. businesses from being taxed twice. But the title passage rule allows domestic export income that is not subject to foreign taxes to be exempted from U.S. taxes as well, so the income escapes corporate taxation altogether.

A rationale against this option is that the application of the title passage rule to exports of goods manufactured in the United States reduces the amount of taxes that many U.S. multinational corporations pay, narrowing the gap between the total taxes paid by those firms and companies from lower-tax jurisdictions that operate in the same foreign markets. (However, U.S. multinational firms that do not have excess foreign tax credits receive no benefit from the title passage rule.) Another argument against the option is that allocating some income under the title passage rule would, to some extent, be less complicated than doing so under the normal rules for income allocation.