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 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 4.1 7.9 7.6 8.1 8.7 9.4 9.7 8.6 8.5 9.3 36.4 82.0

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

The U.S. government taxes both the domestic and foreign income of businesses that are incorporated in the United States and operate in this country and abroad. 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 generally 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. U.S. corporate income taxes are then assessed on income that exceeds those companies’ expenses. Current law provides a system of credits for taxes that U.S. businesses pay to foreign governments; the credits typically offer some relief from what otherwise would amount to double taxation of that repatriated income.

Under current law, the value of a company’s foreign tax credit cannot exceed the U.S. taxes the company would pay on that amount of income. 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. Absent any further provisions of tax law, the company would face a residual tax in the United States on the income from that lower-tax country.

However, U.S. tax law allows firms to combine the credits generated by repatriating income from high- and low- tax-rate countries on their tax returns. Thus, the excess credits arising from the taxes paid on income repatriated from 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 the current system is that, for any given amount of foreign income that it repatriates, a company can increase the value 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 from all foreign countries and the taxes paid to those countries. The total credit would equal the product of all taxes paid to foreign governments and the percentage of 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 $82 billion over the 2017–2026 period.

If this option was implemented, the overall credit rate—the credit as a percentage of total repatriated income—would not depend on the distribution of the repatriated income across foreign countries but would equal the average foreign tax rate on all foreign earnings. 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 is 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.