The World Trade Organization (WTO) has repeatedly sided with the European Union (EU) and ruled that provisions of U.S. tax law provide impermissible "subsidies" because business income from exports is sometimes not taxed at the same rate as other forms of corporate income. More specifically, the WTO twice ruled that the Foreign Sales Corporation (FSC) portion of the tax code violated trade rules, leading U.S. lawmakers to replace FSC with the Extraterritorial Income Act (ETI). But the EU argued that the new law also was an impermissible subsidy, and the WTO subsequently ruled two more times against the United States.

The WTO decisions put the United States in a difficult position. If FSC/ETI is not repealed, the EU has the right to impose more than $4 billion of "compensatory" tariffs on American products each year. These taxes on U.S. exports, which could be as high as 100 percent, would fall on over 1,800 different products including agriculture, jewelry, steel, machinery and mechanical appliances, wool and cotton textiles, and toys. Yet repealing the law means higher corporate income taxes--also about $4 billion annually--for companies that benefit from the law. This seems like a no-win situation--either higher taxes on corporate income or higher taxes on exports.

An Unexpected Opportunity
While not desirable, the WTO decisions could be a blessing in disguise if they spurred much-needed tax reform. Ideally, lawmakers should engage in wholesale change, junking America's "worldwide" tax system (whereby companies are taxed on income earned in other countries) and replacing it with a "territorial" tax system (the common-sense practice of taxing only income earned inside national borders). This reform would allow U.S.-based companies to compete on a level playing field with foreign competitors, particularly if it is accompanied by a significant reduction in the corporate tax rate.

Worldwide taxation is very anti-competitive, subjecting U.S. companies to higher tax rates than those paid by companies based in other nations. For example, an American-based company operating in Ireland is at a disadvantage since its profits are subject to the 35 percent U.S. corporate income tax in addition to Ireland's 12.5 percent corporate tax. The U.S. company generally can claim a credit for the taxes paid to Ireland, so the overall tax rate on Irish-source income should not exceed 35 percent. But this still means the U.S. firm pays nearly three times as much tax as an Irish company. It also means that the U.S. firm pays nearly three times as much tax as a Dutch firm competing in Ireland, since Holland has a territorial tax system. Furthermore, foreign tax credits are not always available, as they can expire or be limited by other factors.

Incremental Reform
A wholesale shift to territorial taxation is a major undertaking, especially with the pressure to act quickly in order to avoid EU sanctions. But this does not preclude progress. Even incremental reform could significantly improve U.S. competitiveness and boost economic performance. In particular, lawmakers could:

• Make interest expense allocation less onerous. Companies should not be required to pretend some interest costs are incurred overseas, a policy that results in higher tax burdens.
• Reduce foreign tax credit baskets. Companies should not be required to engage in complicated calculations that limit their ability to avoid double taxation.
• Allow deferral of foreign base company sales and services income. Companies should not be required to pay U.S. tax when a subsidiary in one foreign country sells to a subsidiary in another foreign country, so any delay in a U.S. tax liability is a positive step.
• Protect against expiring foreign tax credits. Companies should be allowed to benefit fully from their foreign tax credits to minimize the adverse impact of worldwide taxation.
• Permit repatriation of overseas income. Companies should be encouraged to bring profits back to the U.S., a policy that will boost domestic investment and move the tax code closer to territorial system.

Reform or Else
In 1960, America was home to 18 of the world's 20 largest corporations. By 1996, however, only eight of the world's 20 largest companies were based in America. Tax policy surely was not the only factor in this shift, but worldwide taxation is unquestionably hindering the competitiveness of U.S.-based companies. American companies that compete in global markets face significantly higher effective tax rates than their foreign counterparts.

There are many other signs that worldwide taxation imposes unacceptably high costs, including corporate inversions. Most companies that have rechartered in jurisdictions with better tax law presumably would have remained U.S. companies if America had a territorial tax system, but they were not willing to sacrifice the interests of their workers and shareholders just for the "privilege" of enduring worldwide taxation.

Cross-border mergers are another warning sign. In general, there is no reason for concern if a foreign-based company becomes the "parent" following a merger with a U.S.-based company. However, if foreign-based companies are taking over U.S.-based companies because worldwide taxation reduces the competitiveness and lowers the value of American companies--a factor that has been cited in some high-profile acquisitions of U.S. companies, such as Daimler's merger with Chrysler--worldwide taxation should be repealed.

Territorial taxation is good tax policy. It is simple, it is pro-tax reform, and it will help the U.S. economy. Territorial taxation means more jobs, better jobs, and improved competitiveness of U.S. companies.

By dragging America to the WTO, the European Union has unwittingly given policymakers a golden opportunity to improve the tax treatment of internationally active U.S. companies. If Congress lacks the political will to engage in fundamental reform, it should at least go as far toward a territorial tax system as possible.

Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.