Eliminate the Source-Rules Exception for Exports

To prevent the income that U.S. corporations earn abroad from being subject to both foreign and U.S. taxation, the federal government provides a credit that reduces those companies' domestic tax liability by the amount of income and withholding taxes they have paid to foreign governments. Under the rules governing that foreign tax credit, it cannot exceed the amount of U.S. tax those businesses otherwise would have owed, nor can it be used to reduce taxes on the income they earned in the United States. If a corporation pays more foreign tax on its foreign income than it otherwise would have paid on identical domestic income, it accrues what is known as excess foreign tax credits under the U.S. tax code.

Unlike income from overseas operations, income from goods that are produced domestically but sold abroad results almost entirely from the value created or added in the United States. Hence, the income that U.S. corporations receive from exports typically is not taxed by foreign nations. But, according to the tax code, if a firm produces its goods within the United States and then sells its inventory abroad as exports, only half of the income is allocated to the United States; the other half is governed by the U.S. tax code's "title passage rule" and allocated to the jurisdiction in which the sale took place. (The title passage rule specifies that, when a firm's inventory is sold, the income from that sale is treated as earned in the country in which the sale occurred--and is subject to that country's tax laws.) In practice, if the company's inventory is produced in the United States and sold elsewhere, half of the income from those sales is treated as originating abroad, even if the company has no branch or subsidiary located in the place of sale and the foreign jurisdiction does not tax the income.

The result is that a business can classify more of its income from exports as foreign than could be justified solely on the basis of where the underlying economic activity occurred. A multinational corporation can then use any excess foreign tax credits to offset U.S. taxes on that income. About half of the export income that companies with such excess credits receive is effectively exempted from U.S. taxation, and the income allocation rules give those companies an incentive to produce goods domestically for sale by their overseas subsidiaries.

This option would eliminate the title passage rule and require taxpayers to allocate income for the purpose of taxation on the basis of where the economic activity actually occurs. That change would increase revenues by $21 billion from 2012 through 2016 and by $54 billion over the 2012-2021 period.

One rationale in favor of the option is that export incentives, such as those embodied in the title passage rule, do not boost domestic investment and employment overall or affect the trade balance. They do increase profits-- and thus investment and employment--in industries that sell substantial amounts of their products abroad. However, the value of the U.S. dollar is boosted as a result, making foreign goods cheaper and thereby reducing profits, investment, and employment for U.S. companies whose products compete with imported goods. Thus, export incentives distort the allocation of resources by misaligning the prices of goods relative to their production costs, regardless of where the goods are produced.

This option also would end a feature of U.S. tax law that allows businesses to avoid taxes on certain types of income earned abroad. Foreign tax credits were intended to prevent the income of U.S. businesses from being taxed twice. But the title passage rule allows domestic export income that is not usually subject to foreign taxes to be exempted from U.S. taxes as well, so the income escapes corporate taxation altogether.

An argument against this option is that the title passage rule gives U.S. corporations an advantage over foreign companies operating in the same markets. (However, enterprises that lack excess foreign tax credits--such as some U.S. multinationals and U.S. exporters that carry out all of their production domestically--receive no such complicated than doing so under the normal rules for advantage.) Some opponents of this option also argue income allocation. that allocating income under the title passage rule is less