How is the taxation process as related to income earned through foreign subsidiaries? Is the following appropriate?The tax code is written in a way that allows companies not to pay the full 35%...

How is the taxation process as related to income earned through foreign subsidiaries? Is the following appropriate?

The tax code is written in a way that allows companies not to pay the full 35% U.S. corporate tax rate on foreign income when that money remains invested overseas.

Backing up a step, here's how it works before the loophole: A company earns $100 million abroad in Lowtaxistan where the corporate tax rate is 20%. The foreign subsidiary pays that money to the U.S. parent. The parent then pays $35 million to the U.S. government and takes a credit for the 20% (or
 $20 million) payment to the Lowtaxistan government. So the net to the U.S. Internal Revenue Service is $15 million.

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justaguide | College Teacher | (Level 2) Distinguished Educator

Posted on

This has to do with regulations that allow US corporations to claim tax credits.

If a company has paid the taxes on the income it has earned through its subsidiaries in a foreign country, it is allowed a tax credit so it doesn't have to pay income tax on the same amount in the US again. This benefits the corporation though it reduces US revenue.

In the example you have provided, the company earns $100 million abroad and pays an income tax of $20 million in the foreign country. When the income is transferred to the US, it pays a tax at the rate of 35% prevailing in the US and then can take credit for the $20 million that have already been paid. The net income tax paid in the US to the IRS is $15 million.

As can be seen, on the whole, the company had to pay a total income tax at the rate of 35%, but 20% were paid in the country its subsidiary is based in and the rest in the US. This makes sense as the foreign subsidiary has not used any infrastructure or other resources of the US, so it does not have these kinds of obligations towards the US. Tax credits "influence the magnitude of foreign investment" as well as implementing "tax avoidance activities of investors" in foreign business (James R. Hines Jr., University of Michigan and NBER).

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