Multinationals earn income through foreign subs all over the world. The parent company is basically creating a separate legal entity in another country and earning that income in the foreign country. Countries are faced with the difficult task of taxing this income that is in a separate legal entity and earned in another country. Countries have three options of how to tax the income earned in foreign subs: tax currently with a foreign tax credit, exempt the income, and no current taxation, but tax on repatriation with a foreign tax credit.
Tax Currently With a Foreign Tax Credit
The first option is to tax the parent corporation currently on the income earned in the foreign sub and give the parent corporation a foreign tax credit for the foreign taxes paid by the foreign sub on that income. The foreign tax credit is given to the parent corporation in this situation to avoid double taxation of the income. This option is utilized by countries under their controlled foreign corporation (CFC) rules. The CFC rules tax the parent country currently on the income earned by the foreign sub depending on whether certain requirements are met. The advantage of this option is that it gets rid of any disincentive to repatriate the income earned by the foreign sub. Multinationals do not like this option at all, and their argument against it is that it puts companies at a competitive disadvantage. The theory behind this argument is that current taxation puts corporations at a competitive disadvantage against its foreign competitors whose home countries do not currently tax this income.
Exempt the Income
The second option is to exempt the income earned by the foreign sub from taxation in the parent corporation’s country. The issue with this option is that it encourages companies to invest in low tax jurisdictions. Companies are encouraged to invest in low tax jurisdictions because the foreign corporation’s country of residence is the only place it will be taxed, so the parent corporation will want these foreign corporations in countries with low tax rates. This issue can be resolved by only exempting business income earned in countries with comparable tax rates. 26 of the 34 OECD countries use some variation of an exemption system.
No Current Taxation, But Tax on Repatriation With a Foreign Tax Credit
The third option is to basically give corporations a deferral by not taxing the income until it is repatriated to the parent corporation. The issue with this option is that it creates a disincentive to repatriate funds unless the foreign tax rate is equal to or greater than the domestic tax rate. Multinationals like this rule because of the deferral feature, but from a policy standpoint this option makes the least sense. Deferring the income while also creating the disincentive to repatriate the funds is not a good option for countries, especially today when countries need funds and investments flowing into their countries.
Each of the three options has problems, so the best approach would be a combination of the three options. The hybrid approach would apply option one to passive income, which is what countries do with their CFC rules. Option two would apply to high taxed active business income, because this type of income makes it look like the foreign sub is conducting a real business in the foreign country, and the income is already being taxed at a high rate. Option three would apply to everything else, which is not much since the first two options capture passive income and high taxed active business income. The hybrid approach is the best from a policy standpoint, but countries do not always have the ability to use the best policy option because of political and other reasons.