A recent Tax Notes International article provides a useful reminder about the nature of global tax competition: The Irish government might soon adopt a participation exemption. That’s a fancy way of saying Ireland might replace its worldwide corporate tax regime with a territorial regime.
Many American readers will have the same reaction: “Doesn’t Ireland already have a territorial system?” It doesn’t, but you could be forgiven for thinking it does.
By way of review, a worldwide or extraterritorial system generally taxes corporations on both foreign and domestic profits and relieves double taxation via a foreign tax credit.
By contrast, a territorial system primarily taxes corporations on their domestic-source income and relieves double taxation by excluding foreign-source income from the normative tax base. The idea is that you shouldn’t need a credit for any foreign taxes paid if the corresponding profits weren’t included in taxable income to begin with.
Ireland is famous for its business-friendly tax environment. Legions of multinational corporations have flocked there to establish regional headquarters or holding companies.
The national economy – sometimes referred to as the “Celtic Tiger” – is a bastion of international tax competition. Yet here we are reminded that Ireland retains a stodgy old FTC system. Worldwide regimes are associated with last century’s way of thinking; a frequent criticism is that they’re a poor fit in the era of globalization.
To borrow a crude automotive analogy, a worldwide system is like your grandfather’s rusted-out Oldsmobile, while a territorial system is like a gleaming new Tesla
In broad terms, Ireland’s traditional FTC regime is the same kind of mechanism the United States used for generations. The United States moved to a territorial regime only recently, with the enactment of the Tax Cuts and Jobs Act in 2017.
The U.S. FTC framework survived the TCJA reforms, but cross-border tax planning around the availability of those credits doesn’t hold quite the same relevance as before. (For instance, Congress chose to disallow some FTC carryforwards and carrybacks. It further decided that some foreign taxes paid would be only partially creditable.)
Part of the sales pitch behind the TCJA was that exempting foreign profits would lead to increased growth and investment and generally make life easier for corporate taxpayers.
The U.S. FTC rules were a source of chronic friction between taxpayers and the IRS because the government sought to restrict the rules’ application when the outcomes were deemed inappropriate. Some of those disputes have gone away entirely under the TCJA, which disallows the credit for taxes paid on foreign-source dividends that are received tax free under the participation exemption.
I wonder if similar salesmanship is taking place today in Dublin. Probably not, because the Irish are better positioned to manage their collective expectations of what territoriality would actually get them. They understand a few basic observations about tax competition, including three salient points.
First, for a country like Ireland, there’s little practical difference between a worldwide and territorial regime. FTC rules typically result in a residual layer of taxation when the taxes paid in the foreign country do not completely offset the corresponding home-country tax on the same pool of income.
That’s unlikely to happen because the Irish corporate rate is already low by international standards. Unless the relevant foreign jurisdiction is a pure tax haven, Irish companies might not notice the difference between the two systems. A properly drafted worldwide regime can be highly competitive under the right circumstances. Ireland’s success over the last 20 years underscores that point.
Second, from the perspective of many U.S. taxpayers, the difference between the previous worldwide system and the TCJA’s version of territoriality was overhyped. Yes, there’s a participation exemption, which operates like a 100% dividends received deduction.
However, so much foreign-source income is clawed back through various base protectors that it doesn’t feel like a true water’s-edge approach. That’s not to say the TCJA accomplished nothing: It repealed deferral and significantly lowered the corporate rate. But the overall experience of the last few years illustrates how our illusions of territorial treatment often don’t square with the reality.
Finally, the whole process of lumping countries’ international tax systems into two camps – worldwide or territorial – is of limited usefulness. It suggests binary options when a spectrum of alternatives is more realistic.
No country operates a pure system of either variety. In practice, every country relies on a hybrid approach that mixes and matches selective attributes of each model. Labels will be tossed around, but they don’t always say much about genuine competitiveness.
The bottom line is that Ireland, or any other country thinking about territorial reforms, should kick the tires before they commit to fundamental change. It might be that their traditional mechanisms for relieving double taxation are just fine.