A Payoff to Second-Best Pragmatism: Rethinking Entity Classification for Foreign Companies
Posted: 13 May 2017 Last revised: 25 Dec 2017
Date Written: February 1, 2017
Whether it is an attempt by the Obama administration to curb corporate inversions or a strategy by the Trump administration to make U.S. businesses more competitive abroad, the world of international taxation seems primed to occupy policy conversations for the foreseeable future.
Yet few areas of law are as contentious while remaining so abstruse. Indeed, international taxation — while enormously important for global commerce and domestic companies alike — is extraordinarily complex. Consequently, companies with the resources to dream up sophisticated tax shelters are better positioned to take advantage of U.S. tax laws when operating transnationally.
The following example of this is illustrative. Suppose two companies (one domiciled in the United States and one domiciled overseas) sold the exact same products in both the United States and overseas. The U.S. company would be treated differently under U.S. tax law — and would have to pay higher taxes by consequence — solely because of its status as a U.S. domiciliary. While the foreign company would be exempt from U.S. taxation on all of its foreign revenue, the U.S. company would merely get a tax credit against its U.S. taxes on any income earned overseas. This reality has led companies to come up with tax strategies (including inversions) that enable them to avoid this competitive disadvantage in the global marketplace.
The status quo is untenable, but it remains frustratingly difficult to reach a consensus on how to solve the problem. Many countries — including the United Kingdom and Japan — have followed a global trend towards a territorial system, or taxing companies only on revenue earned in that particular country. With the current state of political affairs, bipartisan comprehensive tax overhaul legislation remains elusive, even if the Republican-backed Tax Cuts and Jobs Act of 2017 becomes law. This paper argues for an elegant “second best” solution that could help crack down on corporate tax games while providing a road map towards a territorial system, bringing the United States into alignment with global trends.
Namely, this proposal suggests that in the same vein as the corporate check-the-box regulations promulgated during the Clinton administration, companies could simply elect whether they wish to be treated as a foreign or a domestic entity. While this would leave the vast majority of the tax code largely intact, it would have wide-reaching implications for tax law and corporate structuring (without upsetting the legal form of current structures), provide a pathway towards a true territorial system, and potentially help uncover abusive tax shelters in the process.
Keywords: Taxation, International Taxation, Tax Shelters
JEL Classification: K34
Suggested Citation: Suggested Citation