Posted: May 25th, 2022

Approach to Taxes on Trade and Business Income

Accounting/Finance

Alternative Approach to Taxes on Trade and Business Income

Analyze how foreign persons in the U.S. are taxed on trade and business income and suggest an alternative to the current system.

persons are subject to tax on an international basis, that is, despite the geographic source of their income. Conventionally, this principle has been referred to as residence-based jurisdiction since it is based on the personal association of the taxpayer to the taxing jurisdiction. On the other hand, foreign persons are subject to tax only on income from U.S. sources and then only on certain categories of earnings. People are considered U.S. persons if they are citizens of the United States or if they reside there. Corporations are considered U.S. persons if they are incorporated in the United States. The test is merely formal, and residence of the shareholders, place of administration of the corporation, place of business, and so forth are all immaterial. Foreign persons are all those not classified as U.S. persons (Ault & Bradford, 1990).

As a result of the rules outlined above, a foreign-incorporated corporation is treated as a foreign person even if its shareholders are all U.S. persons. The foreign corporation is taxed by the United States only on its U.S. source earnings, and the U.S. shareholder is taxed only when profits are dispersed as a dividend. Therefore, the U.S. tax on foreign income of a foreign subsidiary is deferred until distribution to the U.S. shareholder. A special set of requirements introduced in 1962 and modified in 1986, known as the Subpart F rules, limits the capability to defer U.S. tax on the foreign income of a U.S. controlled foreign corporation in certain situations (Ault & Bradford, 1990).

Taxpayers subject to U.S. taxation on foreign sourced income are normally entitled to the Foreign Tax Credit. The reason for the Foreign Tax Credit (FTC) is to offer relief from double taxation. Double taxation may take place when the U.S. taxes foreign sourced income. FTC limits the overall tax rate on foreign sourced income to the higher of the taxpayer’s foreign or U.S. tax rate. The United States does not enforce additional tax on foreign income when the foreign tax rate is higher than the U.S. rate. On the other hand, if the tax rate on the foreign sourced income is lower than the U.S. tax rate, the FTC causes the overall tax on the foreign income to match the U.S. rate (Foreign Tax Credit, n.d.).

An alternative to the current tax system would be to tax all foreign income as if it were domestic income. The Foreign Tax Credit should be done away with. The fact that this tax credit exists causes many people to be able to avoid paying any income tax on their foreign income (Overview of Present-Law Rules and Economic Issues in International Taxation, 1999). This can be due to the fact that the foreign country where the income is being made has a tax rate that is less than that of the U.S. Or because of the way that income is defined in the foreign country there is no income to be taxed by the U.S.

2. Discuss whether the tax laws help or hurt the U.S. economy.

International tax policy is not written in black or white but rather in shades of gray. The ambiguity results because there is no clear answer to the question of whether foreign income of U.S. multinationals should be taxed at the U.S. rate or the foreign rate. Economists want a level playing field, but for international tax policy, they don’t know which level to pick. The common guiding principles of economics provide little direction. As a consequence, U.S. international tax policy is a clutter of rules with a diversity of political and economic reasons. It is frequently described as a concession that strikes a balance. Policy leans toward tightening foreign tax rules and putting foreign income on equal footing with U.S. income when it is thought that foreign investment hurts the U.S. economy. Then policy leans toward relaxing the rules and giving foreign income favorable treatment if it is thought that foreign investment promotes U.S. interests (Sullivan, n.d.).

Due to the fact tat every government charges taxes by its own process and at its own rates, the ensuing system of international taxation often warps investment and adds to reductions in international economic well-being. The environment of these alterations depends on the way of taxing profits from international investment. If investment earnings are taxed only at the source, substantial amounts of capital could be diverted to jurisdictions with the lowest tax rates as an alternative o flowing to investment development with the highest pre-tax rate of return. If a classification of residence taxation is the universal norm, businesses residing in low-tax nations might be able to draw more investment capital or possibly augment their market share by way of lower prices to the loss of businesses residing in high-tax jurisdictions. In either circumstance, capital is sidetracked from its more prolific uses, and international income and effectiveness suffer (Overview of Present-Law Rules and Economic Issues in International Taxation, 1999)

The most basic solution to this dilemma is equalization of effective tax rates, but this may not be a sensible answer given the differences in national preferences for the quantity and method of taxation. “There is no consensus on what method of taxing international investment income minimizes distortions in the allocation of capital when nations tax income at different effective rates, but the alternatives of capital export neutrality and capital import neutrality are the most cited guiding principles. These two standards are each striking goals of international tax policy. The problem is that, with unequal tax rates, these two goals are not mutually attainable” (Overview of Present-Law Rules and Economic Issues in International Taxation, 1999)

Overall the current tax laws, both domestically and internationally hurt the U.S. economy. Domestically the current laws make it so that those people who make income in foreign lands often do not have to pay any income tax on that money here in the U.S. On an international basis the current tax laws make it so that countries with lower tax rates can often entice businesses to set up shop there instead of in other places where they might be more successful. There needs to be uniformity on both levels in order to make the economy stronger going forward.

References

Ault, H.J. & Bradford, D.F. (1990). Taxing International Income: An Analysis of the U.S.

System and Its Economic Premises. Retrieved from http://www.nber.org/chapters/c7203.pdf

Foreign Tax Credit. (n.d.). Retrieved from http://www.irs.gov/irm/part4/irm_04-061-010.html

Overview of Present-Law Rules and Economic Issues in International Taxation. (1999)

Retrieved from http://www.jct.gov/jct_html/x-13-99.htm

Sullivan, M.A. (n.d.). A Challenge to Conventional International Tax Wisdom. Retrieved http://www.tax.com/taxcom/features.nsf/Articles/D5817DA1C18C1341852576BD00

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References

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