The Territorial Tax System Under the Tax Cuts and Jobs Act

By: Jeffrey Hamlin

Last year, the Senate and House approved the Tax Cuts and Jobs Act along partisan lines; on December 21st, President Trump signed the bill into law. Nearly 1100 pages long, the Act makes a number of sweeping changes to the U.S. tax code. Among other things, the bill reduces individual income tax rates, nearly doubles the standard deduction, eliminates the personal exemption, and caps deductions for mortgage interest as well as state, local, sales, and property taxes. In addition, the legislation nearly doubles the exclusion for estate taxes, repeals the individual mandate under the Affordable Care Act, and allows for oil and gas drilling on 1.5 million acres in the Arctic National Wildlife Refuge.

During a cabinet meeting on December 20, 2017, the President reportedly said that the “biggest factor” in the tax reform package is lower taxes on business. Not only does the Act reduce corporate tax rates from 35% to 21%, the Act also replaces the United States’ current “worldwide tax system” with a “territorial tax system”—a system more favorable to multinational companies. Under the current system, businesses are taxed at the higher rate on their worldwide income (with credits for taxes paid to foreign jurisdictions). However, U.S. businesses can defer taxes on profits generated outside the U.S. by stashing that money offshore. Taxes on the offshore profits do not become due until they are transferred to the U.S. The Tax Cuts and Jobs Act does away with the worldwide tax system in hopes of reducing profit shifting and tax-avoidance schemes that hurt U.S. workers.

Under the territorial system, U.S. companies will be taxed at a lower rate only on profits generated in the U.S. Profits generated outside the U.S. will be subject to the tax laws of the jurisdiction in which the profits are generated. Thus, if a multi-national company is based in a tax-friendly jurisdiction, like the Cayman Islands or Seychelles Islands, profits attributable to that operation will subject to extraordinarily low rates, whereas profits attributable to the U.S. business would be subject to the new corporate rate of 21%. Proponents of the territorial system argue that it will enhance competition and discourage domestic businesses from engaging in corporate inversion and shifting profits offshore. If so, we may see a race to the bottom as tax-friendly jurisdictions attempt to recapture business lost to the U.S. Critics of the territorial system fear that it will encourage companies to shift jobs and operations to the U.S. and other industrialized nations, but shift a greater percentage of profits to tax havens.

Quartz reporter Tim Fernholz has observed that the President’s nationalist politics and promise to put “America First” do not jibe with the new tax law. A year ago, President-elect Trump threatened to impose a 35% tax on domestic businesses that leave the U.S. or send jobs overseas. The Tax Cuts and Jobs Act does the opposite: it lowers the corporate rate on business generated in the U.S. (regardless of whether the company sends jobs elsewhere) and exempts from the U.S. tax system any profits generated outside the U.S. Put simply, the Act encourages globalization and may well shift jobs from the U.S. to jurisdictions with the most favorable tax laws.