Determine Foreign Tax Credits on a Pooling Basis

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 0.9 2.4 3.3 4.4 4.9 4.3 4.1 5.3 6.8 7.6 15.9 43.9

Source: Staff of the Joint Committee on Taxation.

Note: This option would take effect in January 2014.

The U.S. government taxes both the domestic income and foreign income of businesses that are incorporated in the United States and operate abroad as well as in this country. Often, such corporations must also pay income taxes to their foreign host countries. The income that foreign subsidiaries of U.S. multinational corporations earn is not subject to U.S. taxation until it is paid to the U.S. parent company—that is, the tax is deferred until the income is repatriated. Once that income is repatriated, those companies are assessed U.S. corporate income taxes on income that exceeds their expenses. However, current law provides for a system of credits for taxes paid to foreign governments that generally allows those businesses some relief from what otherwise would amount to double taxation of that income.

Under current law, a company’s foreign tax credit cannot exceed the taxes a company would pay to the United States on its income from that foreign country. Income that is repatriated from a country with a higher corporate tax rate than that in the United States generates “excess credits” (credits from foreign tax liabilities that cannot be used because they exceed the amount owed to the U.S. government). In contrast, income that is repatriated from a country with a lower tax rate generates credits that are not sufficient to offset the entire U.S. tax owed on that income. Under those circumstances, the company would face a residual tax in the United States, absent any further provisions of tax law.

However, U.S. tax law allows firms to combine the income and credits from high- and low-tax-rate countries on income tax returns. Thus, the excess credits arising from the taxes paid on income earned in high-tax countries can be applied to the income repatriated from low-tax countries, effectively offsetting some or all of the U.S. tax liability on income from low-tax countries. One consequence of this system is that, for any given amount of foreign income that it repatriates, a company can increase the size of its foreign tax credit by repatriating more income from countries with higher tax rates and less from countries with lower tax rates.

Under this option, a company’s foreign tax credit would be determined by pooling the company’s total income and taxes from all foreign countries. The total credit would equal the product of the total taxes paid to foreign governments and the percentage of total foreign income that was repatriated. The credit would not exceed the total amount of U.S. taxes owed on repatriated income. The staff of the Joint Committee on Taxation estimates that the option would increase revenues by $44 billion over the 2014–2023 period.

A result of the option is that the overall credit rate—the credit as a percentage of total repatriated income—would not depend on the distribution of the repatriated income but would be the average tax rate on earnings in all foreign countries. In contrast, under current law, a company’s overall credit rate is higher if a larger share of its repatriated income is from countries with higher tax rates. Hence, the foreign tax credit would be smaller under the pooling option than under current law for companies that repatriate a greater share of their earnings from countries with higher-than-average tax rates.

One argument in favor of this option is that it would restrict companies’ ability to use excess credits from countries with high taxes to offset the U.S. corporate tax on income from countries with low taxes. The current method for computing excess credits makes it advantageous for firms to design and use accounting or other legal strategies to report income and expenses for their U.S. and foreign operations in ways that reduce their overall tax liabilities. By basing the credit on total foreign income and taxes, this option would reduce the incentive for companies to strategically choose subsidiaries from which to repatriate income so as to reduce the amount of taxes they owed—and thus also reduce the incentive for firms to devote resources to strategic tax planning rather than to more productive activities.

An argument against the option would be that it would increase incentives to invest in low-tax countries and to retain more of the resulting earnings abroad. Firms would be encouraged to shift investment from high-tax to low-tax countries because of the decline in the value of excess credits. The option would also increase incentives to keep profits from those investments abroad to avoid the higher U.S. taxes on repatriated income. However, many other factors—such as the skill level of a country’s workforce and its capital stock—also affect corporations’ decisions about where to invest.