Tax reform is a perennial issue before Congress. One area of increasing attention is the taxation of U.S. companies on the income they earn abroad. Recently, proposals have been made to, in some cases, decrease taxes and in others to increase these taxes. Businesses leaders have been urging a movement toward a territorial tax, which would generally eliminate U.S. income taxes on active foreign source income. Such a proposal (presumably based on one developed by Grubert and Mutti) was included in the President's Advisory Panel on Tax Reform in 2005, more recently in a draft proposal by Ways and Means Committee Chairman Dave Camp, and in a bill, S. 2091 , introduced by Senator Enzi. The National Commission on Fiscal Responsibility and Reform (referred to as the Fiscal Commission) also proposed a territorial tax in general terms. Proposals have also been made to move in the opposite direction and increase the taxation of foreign source income, including S. 727 , introduced by Senators Wyden and Coats, which would use the significant revenues gained to help finance a corporate income tax rate cut. President Obama has included increased taxes on foreign source income in his budget outlines and, more recently, in his framework for business tax reform, as a revenue source for rate reduction. Because of various features in the current tax system, the U.S. tax system already bears a close resemblance, in terms of revenue collected, to a territorial tax. Tax on the income of foreign subsidiaries is deferred until repatriated (paid as dividends to the U.S. parent) and tax can be avoided by not repatriating income. The system limits credits claimed for foreign taxes paid to U.S. tax on foreign income. The limit, however, is on an overall basis, permitting unused credits from high-tax countries to shield income from low-tax countries, or income that bears little foreign tax, from being taxed in the United States. Because firms have flexibility in timing repatriations, the residual effective tax rate on foreign income is estimated at only 3.3%. Some types of income, such as royalties, are treated more favorably under the current system than they would be under a territorial tax. Economists have traditionally analyzed the foreign tax system in terms of economic efficiency. Economic theory tends to support, on efficiency grounds, a worldwide system in which income from U.S. investment earned abroad is subject to the same tax, or as close to the same tax as possible, as that on domestic investment. It does not support a territorial tax, and most proposals in the past were to move closer to an effective worldwide tax (see Appendix ). At the same time, if such a change is not feasible, another question becomes whether moving to an explicit territorial tax would be better or worse than the present system. The fundamental issues are the effects on disincentives to repatriate income, to what extent the revision will divert investment from the United States, the effects on artificial profit shifting, transition issues, administrative and compliance considerations, and the revenue consequences. There is no single blueprint for a territorial tax and the answers to these questions depend, to some extent, on specific design choices. This report first explains how the international tax system works and describes the magnitude and distribution of foreign source income and taxes. The report then focuses on alternative features of a territorial tax and their consequences. It also contains, in a final section, a brief discussion of options that move in the opposite direction and other alternatives that do not fit into either the territorial or worldwide approach (such as current taxation of foreign source income but at a lower rate). The current U.S. tax system is a hybrid. It has some elements of a residence-based or worldwide tax, where income of a country's firms is taxed regardless of its location. It also has some elements of a source based or territorial tax, where all income earned within a country is taxed only by that country regardless of the nationality of the firms. The provisions that introduce territorial features are deferral and cross-crediting. There are a number of complex interactions that will affect both the design of a territorial or other tax revision and the consequences of those changes. Deferral allows a firm to delay taxation of its earnings in foreign subsidiaries until the income is paid as a dividend to the U.S. parent company. Although a territorial tax is often focused on exempting foreign source income that under current law is taxed when repatriated, there are four basic categories of foreign source income, three of which are not eligible for deferral. They are profits of foreign incorporated subsidiaries; current payment income, such as royalties and interest payments; branch income; and Subpart F income. U.S. multinationals are not currently taxed on the profits of their subsidiaries incorporated abroad (except for " Subpart F Income " discussed below). Rather they defer payment of taxes until the income is received by the parent as a dividend (repatriated). U.S. tax is then due on the dividend and, because the dividend is after foreign tax, an additional amount (called a gross-up) is added to taxable income to reflect the foreign taxes paid and place the income on a pre-tax basis. A foreign tax credit is then allowed against this U.S. tax. Current payment income is income that is received as a direct payment, such as royalties and interest. It is taxed currently. This income is usually deductible as an expense in the foreign country and, indeed, may not constitute true foreign source income, at least in the case of royalties that could be viewed as more like export income. Branch income is income from operations that are carried out without a separately incorporated foreign subsidiary. Income of operations organized as foreign branches rather than as separately incorporated subsidiaries is also taxed currently. For tax purposes, branch gross income and deductions are combined with parent income just as if the operation were taking place in the United States. Although branch income is not eligible for deferral, it can be a beneficial form of organization in some cases. If a firm is experiencing a loss, which may be the case with start-ups or mineral or exploration companies, the losses can only reduce U.S. income if the operation is in branch form. In some cases, dividends may attract an additional withholding tax, although for most trading partners these taxes are eliminated or minimized through tax treaties. Non-tax reasons may also cause a firm to choose the branch form; this form, for example, may be particularly beneficial for financial firms in which the branch operation is backed by the assets of the worldwide firm. Subpart F income, named after the section of the Internal Revenue Code that imposes the rules, is income that can easily be shifted to low tax jurisdictions. Subpart F income includes passive income, such as interest and dividends, and certain sales and service income flowing between related parties (called foreign base company income). This income is taxed currently. Subpart F has been made less effective in recent years because of check-the-box rules that allow flexibility in choosing whether to recognize related firms as separate entities. There are also specific exceptions to Subpart F rules that allow for income from active financing and insurance operations that might otherwise fall under Subpart F to be deferred. These provisions are currently part of the "extenders," provisions that are enacted with an expiration date but that are generally extended periodically. The extenders have currently expired after 2011, although some or all of them they may be extended retroactively. Also among the extenders is a look-through rule that has a similar effect to check-the-box through legislative rather than regulatory rules. Cross-crediting is a phenomenon that occurs when credits for taxes paid to one country can be used to offset U.S. tax due on income earned in a second country. Cross-crediting occurs because countries generally tax all income arising within their borders from both foreign and domestic firms. The U.S. system allows a credit against U.S. tax due on foreign source income currently taxed for foreign income taxes. This foreign tax credit is designed to prevent double taxation of income earned by foreign subsidiaries of U.S. corporations from facing a combined U.S. and foreign tax in excess of the U.S. tax due if the income was earned in the United States. In addition to cross-crediting across countries, cross-crediting can occur within a country if some income is subject to high tax rates and some is subject to lower tax rates. If the foreign tax credit had no limit, a worldwide system with current taxation and a foreign tax credit would produce the same result, for firms, as a residence based tax, because the tax effectively applying would be the tax of the country of residence. Firms in countries with a higher rate than the U.S. rate would get a refund for the excess tax, and firms in countries with a lower rate than the U.S. rate would pay the difference. To protect the nation's treasury from excessively high foreign taxes causing excessive revenue losses, however, the credit is limited to the U.S. tax that would be due on the foreign source income. If applied on a country-by-country and income-by-income basis, this rule would result in higher taxes paid on incomes and/or in countries where foreign taxes are higher than U.S. taxes. The rule would also result in total taxes paid equal to the U.S. tax when foreign taxes are lower. If applied overall or in a way that can combine income subject to high taxes with income subject to low taxes, unused credits in high-tax countries (or associated with highly taxed income) can be used to offset U.S. tax due in low-tax countries or income subject to low taxes. This mechanism is called cross-crediting.