A territorial tax system is a framework within international taxation where a country taxes its resident individuals and corporations only on income earned within its borders, largely exempting income generated from foreign sources.72, 73 This approach falls under the broader category of International Taxation and is distinct from other global taxation models. Under a territorial tax system, income earned by a domestic company's foreign subsidiary, for instance, is typically taxed only in the country where the subsidiary operates, and not again when those profits are brought back to the parent company's home country.71
History and Origin
The concept of taxing income based on its source rather than the residence of the recipient has historical roots, though its widespread adoption in modern corporate taxation is a more recent development. Historically, many countries, including the United States, operated under a worldwide tax system, where domestic corporations were taxed on their global income, regardless of where it was earned.69, 70 However, with the rise of multinational corporations and increasing global trade, the complexities and competitive disadvantages of worldwide systems became more apparent.68
Many countries began transitioning towards territorial or hybrid systems to enhance the competitiveness of their domestic businesses on the international stage.67 A significant shift occurred with the OECD's Corporate Tax Reform initiative, which highlighted the increasing adoption of territorial approaches among its member countries. OECD Corporate Tax Reform This collective movement reflects an effort to streamline taxation for cross-border activities and reduce the burden of double taxation. The United States, for example, largely moved from a worldwide system to a modified territorial system with the Tax Cuts and Jobs Act of 2017 (TCJA).65, 66
Key Takeaways
- A territorial tax system primarily taxes income generated within a country's borders, generally exempting foreign-sourced income.63, 64
- It aims to prevent double taxation of foreign earnings and enhance the international competitiveness of domestic companies.61, 62
- While simplifying some aspects of international tax planning, it necessitates robust anti-tax avoidance measures.59, 60
- Many developed nations have adopted or moved towards a territorial tax system for corporate income.57, 58
Interpreting the Territorial Tax System
In a territorial tax system, the key principle revolves around the "source" of income. If income is deemed to be generated within the taxing country's tax jurisdiction, it is subject to that country's corporate income tax.55, 56 Conversely, if the income is considered foreign-sourced, it is generally exempt from domestic taxation.54 This distinction is crucial for multinational corporations determining where to report profits and how to structure their global operations.
For example, a company operating under a territorial tax system might have a lower effective tax rate on its overall global income if a significant portion of its profits are earned in foreign countries with lower tax rates or are entirely exempt from home-country taxation. This differs from a worldwide tax system where foreign income is generally subject to domestic taxation, often with provisions like foreign tax credit to mitigate double taxation.53 The interpretation of what constitutes "foreign-sourced income" can be complex and is often defined by specific country tax laws, sometimes involving rules related to substance and economic activity.51, 52
Hypothetical Example
Consider "Global Innovations Inc.," a hypothetical technology company headquartered in a country with a territorial tax system. Global Innovations has a domestic operation generating $100 million in taxable income. It also has a subsidiary, "Global Innovations Europe," based in Ireland, which earns $50 million in profits from its European sales.
- Domestic Income: The $100 million earned by Global Innovations Inc. in its home country is subject to that country's domestic corporate income tax rate (e.g., 25%).
- Foreign Income: Global Innovations Europe's $50 million profit is taxed in Ireland at the Irish corporate tax rate (e.g., 12.5%).
- Repatriation: When Global Innovations Europe decides to remit its after-tax profits (or dividends) back to Global Innovations Inc. in the home country, those funds are generally not subject to additional taxation in the home country under the territorial system's participation exemption.50
In this scenario, Global Innovations Inc. avoids a second layer of taxation on its foreign earnings, effectively only paying tax in the jurisdiction where the income was generated.
Practical Applications
A territorial tax system has significant implications for global business operations and economic growth. It influences how multinational corporations structure their subsidiaries, make capital allocation decisions, and manage their global supply chain. Many countries, including major economies in Europe and Asia, have adopted some form of a territorial system.46, 47, 48, 49 This approach is often seen as a way to encourage domestic companies to compete more effectively abroad, as it reduces the overall tax burden on their international profits.45
The OECD's Base Erosion and Profit Shifting (BEPS) project is a key initiative that directly impacts the practical application of territorial tax systems. OECD BEPS Project This international effort aims to address strategies used by multinational companies to exploit gaps and mismatches in tax rules to artificially shift profits to low- or no-tax locations, thereby eroding the tax bases of countries where economic activity actually takes place. The BEPS framework introduces recommendations and minimum standards that countries with territorial systems implement to protect their domestic tax base and ensure profits are taxed where value is created.
Limitations and Criticisms
While a territorial tax system offers benefits like simplifying cross-border taxation and promoting international competitiveness, it faces several criticisms. One primary concern is that it can create strong incentives for multinational corporations to engage in profit shifting.42, 43, 44 Companies might artificially reallocate profits from high-tax jurisdictions to low-tax countries or tax havens to minimize their overall tax liability, even if the actual economic activity generating those profits occurs elsewhere.40, 41 This can lead to a "race to the bottom" in global corporate tax rates.39
The International Monetary Fund (IMF) has highlighted how moving to a territorial tax system can increase incentives for outward profit shifting, impacting global tax revenues. IMF Finance & Development: The New Corporate Tax Race to the Bottom Such systems can also disadvantage purely domestic businesses that do not have the same opportunities to shift profits offshore, potentially leading to an uneven playing field.38 Designing effective anti-tax avoidance rules within a territorial system is complex and often requires intricate regulations to prevent base erosion.36, 37 Critics also argue that it could incentivize companies to move real investments and jobs offshore, impacting domestic economic growth and wages.34, 35
Territorial Tax System vs. Worldwide Tax System
The fundamental difference between a territorial tax system and a worldwide tax system lies in how a country taxes the foreign-sourced income of its resident individuals and corporations.
| Feature | Territorial Tax System | Worldwide Tax System |
|---|---|---|
| Tax Base (Foreign Income) | Generally excludes foreign-sourced income.33 | Includes all global income, regardless of source.31, 32 |
| Double Taxation | Prevents double taxation by exemption.30 | Prevents double taxation through foreign tax credit or deferral.28, 29 |
| Complexity for MNCs | Can simplify aspects by not taxing repatriation of foreign profits.27 | Can be more complex due to foreign tax credit calculations.26 |
| Incentive for Profit Shifting | Higher incentive to shift profits to low-tax foreign jurisdictions.24, 25 | Lower incentive to shift profits, but may encourage deferral of repatriation.23 |
| International Competitiveness | Aims to enhance it by reducing the tax burden on foreign profits.22 | May place domestic companies at a competitive disadvantage if other countries have territorial systems.20, 21 |
While a worldwide system taxes income wherever it is earned, it typically offers mechanisms like foreign tax credit to offset taxes paid to foreign governments, preventing the same income from being taxed twice.19 The Tax Foundation provides insights into how corporate tax rates vary globally, further highlighting the strategic considerations for businesses operating under different tax systems. The move from one system to another, as seen in the U.S. with the TCJA, often involves complex transitional rules and significant debate regarding their impact on economic growth and fairness.18
FAQs
What does "territorial" mean in taxation?
In taxation, "territorial" means that a country's tax authority primarily taxes income that is generated or sourced within its geographical borders. Income earned outside these borders, such as profits from a foreign subsidiary, is generally exempt from domestic taxation.16, 17
Which countries use a territorial tax system?
Many countries around the world use some form of a territorial tax system for corporate income. Examples include France, Belgium, the Netherlands, Hong Kong, Singapore, and many other OECD nations.13, 14, 15 The United States also shifted to a modified territorial system in 2017.12
How does a territorial tax system affect multinational corporations?
A territorial tax system can make it more attractive for multinational corporations to invest and operate abroad because they typically won't face additional home-country taxes when they bring their foreign earnings back.10, 11 This can lower their overall effective tax rate on global income and enhance their international competitiveness. However, it also creates incentives for strategic tax planning to shift profits to low-tax jurisdictions.8, 9
Does a territorial tax system eliminate all taxes on foreign income?
Not necessarily. While a territorial tax system generally exempts foreign-sourced income from domestic taxation, that income is still subject to the taxes of the foreign country where it was earned.6, 7 Additionally, some territorial systems may have exceptions for certain types of income (e.g., passive income) or rules to prevent artificial profit shifting, meaning some foreign income might still be subject to domestic tax.4, 5
What are the main benefits of a territorial tax system?
Key benefits of a territorial tax system include the prevention of double taxation on foreign income, increased international competitiveness for domestic companies, and potential simplification of tax compliance for businesses with extensive foreign operations.2, 3 It can also encourage repatriation of foreign profits back to the home country without additional tax penalties.1