U.S. Taxation of Overseas Investment and Income: Background and Issues in 2005
U.S. Taxation of Overseas Investment and
Income: Background and Issues
Updated May 21, 2008
Donald J. Marples
Specialist in Public Finance
Government and Finance Division
U.S. Taxation of Overseas Investment and Income:
Background and Issues
Summary
Investment abroad by U.S. individuals and firms is substantial and growing —
an important aspect of the increased integration of the U.S. economy with the rest of
the world. At the end of 2006, the overall stock of private U.S. investment abroad
was 38.4% of the total U.S. stock of private capital; the proportion has more than
doubled over the past two decades. Because investment outflows have grown, it is
not surprising that U.S. taxation of overseas investment has been and is likely to
remain a prominent issue before Congress. First, because investment abroad is an
increasingly important part of the economy, the effects of taxation on foreign
investment are potentially more important. Second, the increased mobility of capital
has changed the environment in which taxes apply; some have suggested that
capital’s mobility may call for a change in U.S. tax policy.
Current U.S. tax policy towards investment abroad poses a patchwork of
incentives, disincentives, and neutrality, and different features of the system have
different effects. The foreign tax credit generally promotes tax neutrality; the credit
is limited, however, and the limitation can pose either a disincentive or incentive to
invest abroad. The system’s deferral principle in some cases permits U.S. firms to
postpone U.S. tax on foreign income; it poses an incentive to invest abroad where
foreign tax rates are low. Deferral is restricted, however, by the tax code’s Subpart
F, which nudges the system back in the direction of tax neutrality.
Whether these various effects are considered beneficial depends, in part, on the
perspective a policymaker takes. Traditional economic theory suggests that a tax
policy that promotes neutrality between investment at home and abroad best
promotes world economic welfare. Economic theory also indicates, however, that
U.S. economic welfare is maximized when overseas investment is to a degree
discouraged. Different components of the U.S. tax system are consistent with
different perspectives; which perspective the U.S. tax system best exemplifies is not
clear.
The varied effects of the U.S. tax system suggest an ambivalence towards
overseas investment on the part of policymakers and the public. In the 110th
Congress, H.R. 3970 proposes to implement changes that vary in their likely effect
on foreign investment — echoing the underlying tax system. This implied
ambivalence — along with foreign investment’s growing importance — suggests that
debate over U.S. international taxation will continue in Congress in 2008 and
beyond. Some possible issues include the place of international taxation in a possible
movement towards fundamental tax reform; and whether the United States should
move towards a “territorial” tax system or — alternatively — adopt provisions
designed to either promote tax neutrality or limit “offshore outsourcing.”
This report was originally written by David L. Brumbaugh, Specialist in Public
Finance, who has retired from CRS. It will be updated as legislative events occur.
Contents
The United States in the World Economy...............................1
How Taxes Affect International Investment.............................3
Investment and the Distribution of Income..........................3
Taxes and Economic Welfare: Capital Export Neutrality, National
Neutrality, and Capital Import Neutrality.......................3
U.S. Taxation of Foreign Income: The General Framework.................6
Basic Jurisdictional Principles and the Foreign Tax Credit..............6
The Foreign Tax Credit Limitation and Cross-Crediting................7
Deferral .....................................................8
Subpart F’s Restriction of Deferral................................9
The System’s Overall Mix of Incentives............................9
Domestic Provisions and International Investment...................10
Possible Issues in 2008 and Beyond..................................11
Fundamental Tax Reform and International Taxation.................11
Territorial Taxation...........................................12
Taxes and Offshore “Outsourcing”...............................13
Proposed Legislation in the 110th Congress.............................13
H.R. 3970: Tax Reduction and Reform Act of 2007..................13
List of Tables
Table 1. Incentives Towards Foreign Investment Under
the U.S. Tax System...........................................10
U.S. Taxation of Overseas Investment and
Income: Background and Issues
One of the chief manifestations of the increased openness of the U.S. economy
is an increase in U.S. investment abroad. U.S.-based multinational firms are
increasing their overseas operations and U.S. investors are increasing the foreign
assets in their portfolios. This report analyzes how the current U.S. tax system
applies to foreign investment undertaken by U.S. firms abroad, and how that
application was changed by recent legislation. It also assesses the impact of the tax
system and legislation, and concludes by discussing a variety of issues in
international taxation that Congress may face in 2008 and beyond. It begins with a
brief examination of the data on international investment.
The United States in the World Economy
The most basic economic data clearly show that the U.S. economy is
increasingly involved in the world economy. In the language of economics, the U.S.
economy is growing more “open.” For example, the data show that the total volume
of trade in goods and services, that is, exports plus imports, has increased
substantially and steadily over the past 30 years. In 1977, exports plus imports were
16.8% of U.S. gross domestic product (GDP); by 2007 trade was a full 28.8% of
GDP . 1
But the focus here is on capital investment, and if trade has increased
substantially, investment has grown dramatically. Rough estimates indicate that in
owned capital stock; by year end 2006, assets abroad were 38.4% of the total U.S.
private capital stock. In 1976, the stock of foreign private assets in the United States
was 3.7% of the U.S. capital stock; at year end 2006 it was 38.8% of private U.S.
capital.2
1 Data on trade is from Table 4.1. Foreign Transactions in the National Income and Product
Accounts, Bureau of Economic Analysis, downloaded on February 29, 2008, and data on
Gross Domestic Product is from Table 1.1.5 Gross Domestic Product, Bureau of Economic
Analysis, downloaded on February 29, 2008.
2 The source for data on U.S. assets abroad and foreign assets is in “Table 2: International
Investment Position of the United States at Yearend, 1976-2006,” Bureau of Economic
Analysis, downloaded on February 29, 2008. Data on the U.S. capital stock are from “Table
“Fixed Assets and Consumer Durable Goods for 1925-2001,” Survey of Current Business,
vol. 81, Sept. 2002, pp. 23-37, and David B. Wasshausen, “Fixed Assets and Consumer
(continued...)
It is informative to examine the components of outbound investment.
Traditionally, economists have identified two types of overseas investment: portfolio
investment and direct investment. With portfolio investment, the underlying assets
are not actively managed by the investor; direct investment entails the active
management of overseas assets and operations by the investor. Portfolio investment
can be thought of as a U.S. person or firm who has foreign stocks, bonds, or other
assets in his investment portfolio; direct investment can be thought of as the overseas
business operations of a U.S. firm. The data suggest that the rapid growth in U.S.
assets abroad has consisted almost entirely of portfolio investment rather than direct
investment in overseas business operations. At year-end 1976, portfolio investment
abroad was 2.7% of the total U.S. capital stock; at the end of 2006, it was 29.4% of
the total stock. In contrast, foreign direct investment was 4.1% of the total in 1976
and 9% at the end of 2006.
Taxes potentially affect investment by altering the allocation of capital between
domestic and foreign locations; hence, the focus thus far on stocks rather than flows.
However, another concern of international taxation is tax revenue. To obtain a rough
idea of how important overseas investment potentially is to the U.S. tax base, it is
useful to examine income flowing from international investment. Here, the growth
in importance, while it has occurred, is somewhat less imposing. In 1976, receipts
by private U.S. investors of earnings on overseas assets were 1.5% of U.S. GDP; by
2003, they were 2.6% of GDP. As with the stock of investment, most of the growth
was in portfolio investment rather than direct investment. Over the same period,
receipts from portfolio investment grew from 0.5% of GDP to 1.0% of GDP; receipts
from foreign direct investment grew from 1.0% of GDP to 1.7% of GDP. Another
way of gauging the importance of overseas investment income is to compare it with
total U.S. income from capital. In 1976, private receipts from overseas investment
were 7.1% of U.S. capital income; by 2003 they had grown to 8.5%.3
What is the import of these various numbers? First, they substantiate the notion
that overseas investment has grown rapidly both in absolute terms and relative to the
rest of the U.S. economy. Accordingly, U.S. tax treatment of that investment is
potentially more important than previously; its various effects are increasingly
important to the economy. The next section examines how taxes can affect the
allocation of investment between the domestic economy and foreign locations and
the implications of those effects for several important dimensions of economic
performance. Given portfolio investment’s magnitude, U.S. tax policy towards
investment in foreign stocks, bonds, and other portfolio assets is clearly important.
The remainder of this report, however, focuses on overseas direct investment by U.S.
firms — a topic that is frequently a focus of attention by Congress.
2 (...continued)
Durable Goods for 1997-2006,” Survey of Current Business, vol 87, Sept. 2007, pp 31-32.
The fixed assets data were adjusted to include estimated stocks of inventory and intangible
capital.
3 Data on receipts from foreign investment are from Douglas B. Weinberg and Kelly K.
Pierce, “U.S. International Transactions, Third Quarter 2007,” Survey of Current Business,
vol. 88, Jan. 2008, p. 22. U.S. capital income data are from “BEA Current and Historical
Data,” Survey of Current Business, vol. 84, Nov. 2004, p. D-16.
How Taxes Affect International Investment
This section of the report sets forth the basic economic analysis of how taxes in
the abstract affect international investment. First, economic theory stipulates that a
firm’s fundamental goal is to maximize its profits — after taxes. When a firm
considers where to employ its investment, it implicitly weighs the relative rate of
return on investment in its various locations — again, after taxes. Taxes can
therefore pose an incentive for firms to invest overseas if the tax burden abroad is
lower than the burden on identical investment in the United States. Alternatively,
taxes can pose a disincentive towards foreign investment compared to investment in
the domestic economy if taxes are relatively high in overseas locations. Or, taxes can
be “neutral” towards the investment decision; if the tax burden is the same on foreign
investment as on identical domestic projects, then taxes have no impact on where
firms invest. The implication of this framework is clear: if U.S. and foreign tax
systems as a whole were to favor either location over the other, then U.S. investment
in the favored location would be higher than would otherwise occur. The discussion
of the impact of particular features of the U.S. system is deferred until the next
section, but note here that the overall thrust of the system is mixed in its incentive
effects, with no clear net impact.
Identifying the likely impact of taxes on the allocation of investment is only an
intermediate answer. According to economic theory, various important effects result
from the allocation of investment between domestic and foreign sources, and it is
these effects that are ultimately of concern to policymakers.
Investment and the Distribution of Income
Changes in the distribution of income both within the United States and abroad
is one result of the allocation of investment capital. Thus, when taxes affect the
allocation of investment between foreign and domestic uses, they also affect the
income distribution. Capital flows affect the distribution of income as follows: a
basic principle of economic theory holds that in smoothly operating markets, labor
compensation is commensurate with labor productivity; the more productive labor
is, the higher wages are. Because labor productivity is higher the more capital it has
to work with (the higher the capital/labor ratio), domestic labor income generally
declines if capital income is diverted abroad. At the same time, income of domestic
capital is increased if investors are free to seek higher returns abroad. In short, tax
policy that increases or diminishes investment abroad has implications for the
distribution of domestic income between capital and labor. This result likely
underlies the contrasting policy recommendations for international taxes that tend to
be supported by domestic labor, on the one hand, and multinational firms, on the
other. In broad terms, labor tends to oppose tax measures that pose incentives to
invest abroad; businesses tend to support them.
Taxes and Economic Welfare: Capital Export Neutrality,
National Neutrality, and Capital Import Neutrality
Along with their impact on how income is distributed, taxes on capital flows
have broad effects on economic efficiency or how much income is available for
distribution in the first place. Economic theory has developed two standards for
evaluating the efficiency of international taxation, each with a different perspective:
“capital export neutrality” (CEN), which considers the impact of taxes on world
economic welfare; and “national neutrality” (NN), which considers only the
economic welfare of the capital exporting country (in this case, the United States).
Discussions of international taxes also frequently evaluate them for their impact on
the competitive position of U.S. firms abroad, a standard sometimes called “capital
import neutrality” (CIN).
Capital export neutrality (CEN) is based on the idea that the economy’s supply
of capital is employed most efficiently when each increment of capital is used where
it earns the highest return, before taxes. In economic terms, this occurs when the pre-
tax return on an additional increment of investment (“marginal” investment) abroad
is equal to the pre-tax return on identical new domestic investment.
Generally, economic theory states that in the absence of taxes, profit-
maximizing investors will accomplish this allocation on their own, simply in
response to market forces; they maximize their investment profits by ensuring that
the return on additional investment abroad is just equal to the return on additional
domestic investment. It follows that the most efficient tax system is that which least
distorts investors’ decisions on how capital is employed. A tax system is thus most
efficient when it is neutral towards the decision to invest at home or abroad, and
when the tax burden on identical investments is the same in either location. CEN is
a policy that establishes such conditions: a policy where taxes do not distort an
investor’s decision of where to invest and the world’s capital resources are employed
where they are most productive. Under CEN, the world’s economy is getting the
most from its capital resources and world economic welfare is maximized.
A tax policy that maximizes world economic welfare by establishing identical
tax burdens on foreign and domestic investment is not necessarily one that
maximizes U.S. economic welfare. CEN, in other words, is not necessarily optimal
from the perspective of the United States, and the United States alone. There are two
reasons for this. First, a unit of capital that is employed in the United States increases
both U.S. labor income and U.S. capital income: the labor component accrues
because the unit of capital makes labor more productive and increases wages. In
contrast, a unit of U.S. capital that is employed abroad produces a return for the
investor but not for U.S. labor; the increase in wages accrues to foreign rather than
domestic labor. As a result, national welfare is not maximized by equating the return
to a marginal unit of capital abroad with a marginal investment in the United States.
Instead, national welfare is maximized if overseas investment is discouraged by some
incremental amount.
Even if U.S. labor were not directly disadvantaged by the shifting of investment
abroad, neutral taxation would still not maximize U.S. economic welfare in cases
where foreign host governments impose their own tax on U.S. investors. This result
occurs because the benefit to the United States of an additional unit of overseas
investment is the return on that investment, less foreign taxes. The return on that
same investment made in the United States, however, is the return on the investment
plus any tax collected by the United States.
National neutrality (NN) is the term applied by economists to a tax policy that
maximizes U.S. national welfare. In general, NN prescribes a tax burden on foreign
investment that is higher than the burden on identical domestic investment so that
investment abroad is discouraged. More specifically, NN at least prescribes a policy
of allowing only a deduction for investors’ foreign taxes and not a credit. Indeed,
NN may well require an even more onerous tax rate on foreign investment. In
general, the greater the demand for U.S. capital abroad, the higher the optimal tax
rate under national neutrality. However, while NN maximizes U.S. welfare, it is a
“beggar thy neighbor” policy that increases U.S. welfare by less than it reduces
foreign welfare. Further, such a policy could redound to the disadvantage of the
United States if foreign governments retaliated by restricting capital exports.
Multinational firms and others sometimes argue that tax policy towards foreign
investment should be set so as to place U.S. firms on an even tax footing with foreign
competitors — a standard sometimes referred to as “capital import neutrality” (CIN).
Supporters of CIN generally argue that the standard could be achieved and U.S.
competitiveness would be maximized if U.S. taxes did not apply to foreign-source
income. Economic theory suggests that such a policy distorts the geographic
allocation of capital and maximizes the economic welfare of neither the United States
nor the world. Thus, even though it establishes even taxes when certain comparisons
are made (i.e., U.S. firms compared to foreign firms), CIN is not a “neutral” policy
in the same sense as CEN or NN.
Notwithstanding economic theory, a number of arguments are sometimes made
in support of CIN. For example, it has been argued that given increasingly open and
integrated world capital markets, U.S. savers desirous of investing in foreign equity
can escape any U.S. corporate-level tax on overseas direct investment by means of
portfolio investment, that is, by purchasing stock in foreign firms directly rather than
relying on a U.S. multinational to make foreign investments for them.4 For this to
be true requires portfolio investment to be a perfect substitute, in savers’ eyes, for
direct investment, which may not be the case. Beyond this, however, simply because
savers can in some cases circumvent the U.S. corporate income tax on foreign direct
investment is not a strong case against taxing foreign direct investment.
Another argument supporting CIN holds that overseas investment produces a
higher return for research and certain other activities multinationals undertake; these
activities carry with them “external” benefits to the economy as a whole that make
the return to research greater than the private return to the firm conducting the
research.5 While it can be argued that external benefits from research suggest a
subsidy is warranted, such a subsidy seems likely to be more accurately targeted if
it were to apply only to research rather than foreign income. Further, the tax code
already provides such a subsidy in the form of a tax credit and deductions for
research.
4 Daniel J. Frisch, “The Economics of International Tax Policy: Some Old and New
Approaches,” Tax Notes, Apr. 30, 1990, pp. 590-591.
5 Gary Clyde Hufbauer, U.S. Taxation of International Income: Blueprint for Reform
(Washington: Institute for International Economics, 1992), pp. 77-94.
Finally, it has been argued that if the supply of saving in the United States
expands with reductions in tax on investment, then world welfare and U.S. welfare
would be increased by cutting taxes on overseas investment as in CIN.6 This
analysis, however, leaves unanswered the following question: if taxes on investment
are to be cut, why reduce them in a manner that distorts the allocation of capital
between the domestic economy and abroad?7
U.S. Taxation of Foreign Income:
The General Framework
Relative tax burdens on foreign and domestic investment affect the allocation
of investment between U.S. and foreign locations by posing incentives or
disincentives to invest in either location. The allocation of investment, in turn,
affects the distribution of income within the domestic economy and affects economic
efficiency and economic welfare on international investment. Capital export
neutrality, national neutrality, and capital import neutrality are frequently used to
gauge the nature of these effects in the case of a particular tax system or particular
tax provisions. The next section examines the basic features of the U.S. tax system
and their effects.
Basic Jurisdictional Principles and the Foreign Tax Credit
Capital export neutrality prescribes equal tax burdens for identical new
investment at home and abroad, and two basic jurisdictional elements of the U.S.
system are (taken alone) consistent with CEN: taxation based on residence; and
provision of a tax credit for foreign taxes paid. First the residence principle:
conceptually, a home country can base its income tax jurisdiction either on who earns
income or on the source of income. Under the latter, a country would confine its
application of taxes to income earned within its own borders, operating a “territorial”
tax system. Under the former, a country generally taxes the worldwide income of its
citizens and residents, regardless of where the income is earned. Under its residence
principle, the United States asserts the right to tax both the foreign and domestic
income of its citizens and resident individuals and of corporations chartered in the
United States (i.e., resident corporations).
Absent special provision, residence-based taxation would result in double-
taxation of foreign income in any case where a foreign country imposes its own
taxes. Like most countries in their role as a capital exporters, the United States
accepts the responsibility for relieving double-taxation. In its case, the United States
provides a foreign tax credit for foreign income taxes its residents pay on foreign-
source income. In doing so, it concedes that the country that is host to overseas
6 Thomas Horst, “A Note on the Optimal Taxation of International Investment Income,”
Quarterly Journal of Economics, vol. 94, June 1980, pp. 793-795.
7 For an up-to-date and thorough review of economics literature on optimal taxation of
foreign investment, see Donald J. Rousslang, “Deferral and the Optimal Taxation of
International Investment Income,” National Tax Journal, vol. 53, Sept. 2000, pp. 589-600.
investment has first claim to tax that investment and first claim on the tax revenue
it potentially produces.
Additional features of the U.S. system prevent its achievement of full CEN.
(Indeed, some would argue that the system falls substantially short of CEN.) But if
residence taxation always applied under the tax system and all foreign income taxes
were creditable, CEN would result. To see how, suppose first that the foreign tax
rate on a U.S.-chartered corporation were low relative to the U.S. tax rate — using
a hypothetical foreign rate of 10% and assuming the U.S. firm pays the maximum
U.S. corporate rate of 35%. In this case, the firm would pay its foreign taxes at the
10% rate and use foreign tax credits to offset 10 percentage points of its pre-credit
U.S. tax. The firm’s total (U.S. plus foreign) tax on its foreign investment would
consist of foreign taxes paid at the 10% rate plus 25 percentage points of U.S. tax
(35% minus 10%) for a total of 35% — exactly the rate applicable to the firm’s U.S.
investment.
However, what if foreign taxes are higher than U.S. taxes? With an unlimited
foreign tax credit, tax burdens on foreign and domestic investment would still be the
same — foreign taxes not needed to offset U.S. tax on a foreign investment’s own
income could still be credited against U.S. tax on income from U.S. sources. The
U.S. tax system, however, does contain a limitation that prevents this outcome.
The Foreign Tax Credit Limitation and Cross-Crediting
Under the U.S. tax code’s foreign tax credit limitation, foreign taxes can only
offset U.S. tax on the portion of a taxpayer’s pre-credit U.S. tax liability that applies
to foreign rather than domestic income. In effect, the tax code places a wall between
foreign and domestic income, and once foreign tax credits have offset all U.S. tax on
the foreign side of the barrier, any remaining foreign taxes cannot be credited. The
extra foreign taxes become “excess credits” in tax parlance, and can be carried back
up to one year and carried forward up to 10 years. (In contrast, a firm that has
insufficient foreign taxes to offset its entire U.S. tax liability is said to have a
“deficit” of foreign tax credits.) The purpose of the limitation is protect the U.S. tax
base. Absent the limit, foreign host countries could in theory divert tax revenue from
the U.S. Treasury by simply raising their own taxes on U.S. investors without fear of
placing an onerous burden on the U.S. firms themselves.
Suppose, then, that a firm has no existing overseas investment and is
contemplating a new project in a country with a high tax rate — say, a 50% foreign
tax rate compared to the 35% U.S. tax rate. In this case, foreign tax credits could be
counted on to eliminate all 35 percentage points of U.S. tax on the new investment’s
income, but the remaining foreign tax — 50% minus 35%, or 15% of the
investment’s income — would not be creditable. The total tax on the foreign
investment would consist of only the 50% foreign tax, but would be high relative to
taxes on identical U.S. investment and would pose a disincentive to invest in the
high-tax country.
As described above, NN is a policy perspective that recommends a disincentive
to invest abroad, and so, in a sense, the limitation on the foreign tax credit introduces
an element of NN into the U.S. system. The actual incentive situation, however, is
complicated by the particular way in which the limitation is applied and by a practice
known as “cross crediting.” Again, if a firm has no existing foreign investments, the
foreign tax credit limit would result in a disincentive for high-tax foreign
investments. But the tax code does not require the foreign tax credit’s limitation to
be calculated on an investment-by-investment basis or (similarly) on a per-country
basis. Thus, if a firm is planning a new high-tax investment and has existing foreign
investment that is lightly taxed (and thus subject to a residual after-credit U.S. tax
liability), it can possibly cross-credit the excess foreign tax credits generated by the
new, heavily taxed foreign against the existing, lightly taxed foreign investment. At
the extreme, all excess credits produced by the new investment could be absorbed,
reducing the tax burden on the heavily taxed foreign investment to a rate equal to the
U.S. tax rate. Neutrality, in other words, can result, even for investment in high-tax
foreign countries.
Cross crediting can also work where the new investment is in a low-tax rather
than high-tax location, but in this case it produces a tax incentive for overseas
investment. Here, a firm with existing heavily-taxed investment that produces excess
credits can use the credits to offset the residual U.S. tax that would otherwise be due
on new investment in a low-tax country. The excess credits, in effect, shield new
investment in low- tax countries from new U.S. taxes, thus preserving the relatively
low tax burden for investment in the low-tax country.
The ability of firms to cross-credit foreign taxes has been restricted and relaxed
at various times by the U.S. tax code in various ways.
Deferral
An additional fundamental feature of the U.S. tax system is the so-called
“deferral principle,” or simply deferral. If the U.S. tax jurisdiction is based on
residence in a technical or legal sense, deferral is a substantial departure from
residence (and towards territoriality) in economic substance. Deferral’s impact is to
shift the average impact of the tax system away from neutrality and in the direction
of a general tax incentive for overseas investment.
Deferral works as follows: under the U.S. residence-based tax regime,
corporations chartered in the United States are taxed on their foreign as well as
domestic income. In contrast, the United States generally taxes foreign-chartered
corporations only on income earned in the United States. Thus, where a U.S. parent
firm invests abroad through a separately incorporated subsidiary firm chartered in a
foreign country, U.S. taxes do not apply to its foreign income as long as the income
is reinvested abroad. U.S. taxes apply only when the income is repatriated to the
U.S. parent firm as income or other income. U.S. taxes are, in other words, deferred
or postponed. Because of discounting, taxes paid in the future do not matter as much
to a firm as an identical amount paid in the present. Because of discounting, deferral
results in a lower overall tax burden for foreign investment compared to domestic
investment in cases where foreign taxes are relatively low. The low tax burden under
deferral occurs regardless of whether a firm has excess credits available for cross
crediting.
Since deferral results in a lower tax rate for investment in low-tax countries than
for identical investment in the United States, it poses an incentive for investment in
low-tax countries and nudges the U.S. system away from CEN. As noted above, CIN
calls for the exemption of foreign income from U.S. tax. Under deferral, U.S. taxes
ultimately apply when and if foreign earnings are repatriated, suggesting at least
some difference between deferral and CIN. Nonetheless, deferral moves the system
in that direction, and for income that is indefinitely reinvested abroad the difference
between exemption and deferral is negligible.
Subpart F’s Restriction of Deferral
Like most tax benefits, deferral has both critics and champions; the debate over
its merits goes back four decades. The most significant curtailment of the provision,
Subpart F, was enacted in 1962 as a compromise, after the Kennedy Administration
initially proposed repealing deferral altogether. Subpart F singles out certain types
of income and certain types of ownership arrangements, and in those cases taxes the
income on a current rather than deferred basis.
Subpart F applies only to foreign corporations that the tax code classifies as
Controlled Foreign Corporations (CFCs): foreign corporations that are more than
50% owned by U.S. stockholders. Further, it applies only to those U.S. shareholders
whose stake in the CFC is 10% or greater. Subpart F applies its current taxation by
requiring each 10% shareholder to include their share of a CFC’s Subpart F income
in their taxable income, even if it has not actually been distributed.
The types of income subject to current tax under Subpart F are generally those
that are thought to be easily located in tax havens and low-tax countries: income
from passive investment, that is, investment that is primarily financial in nature and
that does not involve the active management of a business operation, and certain
other types of income whose source is thought to be easily manipulated so as to
locate it in countries with low tax rates. Passive investment income generally
includes items such as dividends from small blocks of stock as well as interest and
royalties. The other types of income in Subpart F include income from sales
transactions with related firms, income from services provided to related firms,
petroleum-related income other than that derived from extraction, and income from
international shipping.
If deferral shifts the system towards CIN and away from neutrality and CEN,
Subpart F — where it applies — mitigates deferral’s effect.
The System’s Overall Mix of Incentives
The framework described presents a patchwork of effects on relative tax
burdens and a mix of incentives, disincentives, and neutrality. The tax system’s
overall, average impact on investment is not presented; the tax system is not
consistent with any one of the three policy perspectives of CEN, NN, and CIN. The
following chart, however, is useful in identifying the circumstances in which each of
the various incentive effects occur. As shown in the table, whether new overseas
investment faces an incentive, a disincentive, or neutrality depends on whether the
prospective investment is in a country with relatively high or low tax rates, and on
whether a firm has existing investment that has generated excess credits.
Table 1. Incentives Towards Foreign Investment Under
the U.S. Tax System
Investor’s foreign taxInvestment in high-taxInvestment in low-tax
credit positioncountriescountries
No Previous ForeignDisincentiveNeutrality (If deferral is not
Investmentused)
Incentive (if deferral is used)
Excess CreditsDisincentiveIncentive
Deficit of CreditsNeutralityNeutrality (if deferral is not
used)
Incentive (if deferral is used)
Domestic Provisions and International Investment
The tax treatment of overseas investment does not work its incentive effects in
isolation; it is the relative tax burden on foreign and domestic investment that is of
interest to investors and that potentially changes the allocation of investment capital
between the United States and abroad. Accordingly, investment tax incentives that
are available for domestic but not overseas investment are at the same time
disincentives to foreign investment. Prior to the Tax Reform Act of 1986 (P.L. 99-
514), several broad investment incentives were available for domestic but not foreign
investment, and thus posed such a disincentive. These provisions included the
investment tax credit, which was available for domestic investment in plant and
equipment and the Accelerated Cost Recovery System of generous depreciation
deductions. The 1986 Act, however, repealed the investment credit and scaled back
depreciation, leaving only a scattering of more narrow domestic incentives in place.
Notable among the incentives for domestic investment are the research and8
development (R&D) tax credit and two separate tax incentives for exporting. The
R&D credit provides a tax benefit for firms that increase their qualified research
expenditures; “qualified research,” however, explicitly excludes research conducted
abroad. The two export incentives are the “inventory source rule” and the
extraterritorial exemption rules for exporters; they provide an incentive for domestic
investment because exports — by definition — cannot be produced abroad. The
inventory source rule provides an export incentive by allowing firms to allocate part
of their export income abroad for foreign tax credit limitation purposes; the
8 The R&D tax credit expired on Dec. 31, 2007, but is one of a number of tax expenditures
commonly referred to as an “extender.” Like the R&E tax credit, extenders were originally
enacted with expiration dates that have subsequently been extended, in some cases
numerous times. For additional information on extenders, see CRS Report RL32367,
Certain Temporary Tax Provisions (“Extenders”) Expired in 2007, by Pamela J. Jackson
and Jennifer Teefy.
consequence of the allocation is potentially an effective exemption for a part of
export income.
Possible Issues in 2008 and Beyond
What does this context predict as international tax issues that may arise in 2008?
In abstract, general terms, the hybrid nature of the U.S. system suggests debate over
the appropriate course for U.S. policy may continue through 2008. In more specific
terms, a number of possible issues suggest themselves, and they are discussed in the
following sections.
Fundamental Tax Reform and International Taxation
The Bush Administration has been gathering information on fundamental tax
reform during the Administration’s second term. A variety of general arguments
have been advanced to support tax reform — for example, that it will simplify the tax
system, promote economic efficiency, and stimulate economic growth. In addition,
one type of broad tax reform — switching from the current hybrid tax system to a tax
on consumption — has been advocated in part because of its perceived favorable
effect on U.S. economic competitiveness. Economists are generally skeptical of such
claims (and even of the value of “competitiveness” as a concept), but it is nonetheless
likely that if tax reform is given serious consideration in Congress, its international
dimension is likely to be thoroughly debated.
First, if reform takes the form of a consumption tax, what might be its principal
effects in the international sector of the economy? Proponents of a national sales tax
or of a value-added tax (VAT) sometimes argue that U.S. exports will be increased
because — as with the VATs used by European and other foreign countries — the
tax will be rebated for exports and levied on imports. Yet while these so-called
“border tax adjustments” are part of several of the most fully-articulated reform
proposals, this is one area where economists doubt the impact of moving to a
consumption-based tax: economic theory indicates that because of adjustments in
exchange rates or other mechanisms, border tax adjustments ultimately do not alter
a country’s balance of trade.
But movement to a consumption tax could potentially implement large and
important changes in the U.S. tax system and could have important effects in the
international sector. For example, while taxes are an ineffective tool for changing the
trade balance, they can (and likely do) affect the composition of imports and exports.
Thus, if tax reform entails a shift in the way taxes apply across products, it could alter
what the U.S. economy imports and what it exports.
A shift to a consumption tax would likely alter the comparative tax burden on
domestic compared to foreign investment. Under a consumption tax, the return on
new domestic investment would be exempt from U.S. tax, while under the most
prominent proposals made in past years, foreign-source income would be outside the
U.S. tax jurisdiction. As a result, new U.S. investments would face a relatively low
tax burden compared to investment abroad, which would continue to face corporate
taxes imposed by foreign governments. Thus — except in jurisdictions with no taxes
of their own — U.S. firms would face a tax incentive to invest in the United States
rather than abroad.9 As a cautionary note, however, some analyses have concluded
that shifting to a consumption tax may reduce domestic real interest rates even if such
a tax were revenue neutral. In isolation, this would have an effect in the opposite
direction of the direct impact of relative domestic and foreign tax burdens.
While some have proposed that fundamental tax reform take the specific form
of a tax on consumption, that outcome is not a foregone conclusion. Alternatively,
tax reform could take the form of a comprehensive income tax — that is, a tax that
applies to all income from all sources and that does not contain the numerous
exemptions, deductions, and credits provided by current law. In the international
area, movement towards a comprehensive income tax would likely entail repeal of
deferral and implementation of separate foreign tax credit limitations for the various
types of foreign income or for income earned in each foreign country. With respect
to investment in low-tax countries, such a system would be consistent with CEN but
would be more in accord with NN with respect to investment in high-tax countries.
Territorial Taxation
In a legal sense, the current U.S. tax system bases its jurisdiction to tax on
residence — that is, the United States taxes U.S. resident corporations and
individuals on their worldwide income, regardless of its source. An alternative
jurisdictional concept is territoriality, in which jurisdiction to tax is based on the
source of the income in question rather than the nationality of the individual or firm
earning the income. Under a territorial tax system, a country taxes income earned
within its borders but exempts foreign-source income. Among major U.S. trading
partners, France and the Netherlands have territorial systems.
A territorial tax would be consistent with the principle of capital import
neutrality described above. Multinational firms and investors have frequently
supported territorial taxation, or at least a movement in that direction, if not for
reasons that explicitly have CIN in mind, then to promote U.S. “competitiveness.”
Some have argued, for example, that as the U.S. economy becomes increasingly open
and U.S. firms increasingly compete in the global marketplace, the tax system should
be modified to promote U.S. firms’ competitiveness. While the net, overall thrust
of the 2004 AJCA on incentives towards overseas investment was mixed, its
contraction of Subpart F and consolidation of foreign tax credit baskets can
nonetheless be viewed as incremental movements in the direction of territoriality.
It is thus possible that the 110th Congress will consider legislation that continues to
move the system in that direction.
9 Note that the CEN-NN-CIN framework has limited use as an analytical framework under
a consumption tax. In this way, the consumption tax is similar to the AJCA’s domestic
production deduction. While it poses an incentive for domestic investment, it is in contrast
to traditional prescriptions for NN in that the shift to domestic investment would occur
because of a tax cut for domestic investment rather than a tax increase for investment
abroad; the benefit of the shift would thus likely principally accrue to domestic capital rather
than labor.
Taxes and Offshore “Outsourcing”
A high-profile topic of debate was offshore outsourcing — generally, the real
or perceived movement of jobs from the United States overseas.10 A principal way
taxes are thought to abet what is sometimes described as the “export of jobs” is by
encouraging U.S. firms to invest abroad, and to establish foreign operations rather
than operations in the United States. As described above, deferral and in some cases
cross-crediting poses an incentive for overseas investment.
The policy prescription of those concerned with offshore outsourcing is to at
least eliminate the tax system’s extant incentives for investment abroad — a
prescription that is consistent with capital export neutrality. However, the focus of
outsourcing’s opponents on the movement of capital abroad and on outbound
investment’s employment effects also suggest sympathy with the principle of national
neutrality, which, as described above, would go beyond mere neutrality and would
implement a tax policy designed to dampen overseas investment.
Proposed Legislation in the 110th Congress
H.R. 3970: Tax Reduction and Reform Act of 2007
H.R. 3970 contains a number of provisions that would change the current law
concerning the tax treatment of overseas income and investment.11 Under current
law, income from foreign subsidiaries of U.S. firms is not taxed until it is repatriated
(in the form of dividends) to the parent firm. At the same time, the parent firm is
able to deduct costs, the most important of which is interest, even though some of
that cost is associated with income that is not immediately subject to U.S. tax. Such
treatment essentially allows firms to use foreign tax havens to effectively shift profit
out of the United States and its tax system. The allocation rule would deny the
portion of deductions associated with this income until the income is repatriated and
subject to tax. Companies investing in non-tax-haven countries could avoid the
allocation rule by repatriating income.
An additional allocation provision would repeal a rule that involves world wide
interest for the foreign tax credit. When income from abroad is subject to U.S. tax
(either as branch income or repatriated income), a foreign tax credit is allowed for
foreign taxes paid up to the U.S. tax due. For firms that have more foreign taxes paid
than allowable credits, increasing the amount of income allocated abroad increases
allowable foreign tax credits and reduces U.S. tax liability. Prior to 2004, U.S.
source interest was allocated between foreign and domestic incomes based on relative
magnitude of foreign and domestic assets. The 2004 provision included interest on
foreign borrowing as well as debt-financed investment in the calculation, which
10 For additional information on taxes and outsourcing, see CRS Report RL32587, Taxes and
Offshore Outsourcing, by Donald J. Marples.
11 For a complete description of the provisions in H.R. 3970, see CRS Report RL34249, The
Tax Reduction and Reform Act of 2007: An Overview, by Jane G. Gravelle.
would allocate more domestic interest to domestic source income, a reduction in
interest allocated to foreign income, and a resulting increase in the foreign tax credit
limit.
Another provision relating to international tax issues is intended to reduce
“treaty-shopping.”12 The United States imposes withholding taxes on interest,
royalties, and similar payments to foreigners, but also engages in a number of treaties
with other countries where these withholding rates are reduced. A firm in a country
without a treaty can benefit by setting up a subsidiary in a treaty country to avoid the
withholding tax, and this provision would eliminate that benefit.
Two provisions relate to inventory accounting. While inventories are most
important in the manufacturing and trade sectors of the economy, the economic
consequences of a change in the taxation of inventories are likely small — due to,
generally, short holding periods for inventory.13
Arguably the most significant proposed change contained in H.R. 3970 is the
repeal of a provision that allows last-in, first-out (LIFO) accounting for inventories.
In this form of inventory, the good being sold is assumed to be the last acquired and
since, in general, prices tend to rise over time, this method increases the cost of the
good sold and reduces profit (and therefore tax liability). The other inventory method
is first-in, first out (FIFO), where the good sold is assumed to be the first acquired,
and thus includes any price increases in income. Firms must use the same inventory
method for tax and book purposes; as a result, many firms that would find LIFO
advantageous nevertheless use FIFO because profits reported to shareholders would
be lower under LIFO. LIFO accounting may, on average, result in a more accurate
measure of income because it has the effect of indexing cost and not capturing
increases in value due to inflation. At the same time, when relative prices are
changing, such as oil prices, it allows firms to avoid tax on windfall gains. In
general, the economic consequences of taxing the return to inventories at a higher or
lower rate are probably not very important; because of the short holding period for
most inventories, the tax on the return is a very small part of the cost.
A second inventory provision eliminates the option to value inventories at
market value rather than at cost. Allowing this option permits the recognition of
losses in inventory even though the items have not been sold, a treatment inconsistent
with the general realization principle for gains and losses.
12 For additional information on “treaty-shopping,” see CRS Report RL34245, Tax Treaty
Legislation in the 110th Congress: Explanation and Economic Analysis, by Donald J.
Marples.
13 See Jane G. Gravelle, The Economic Effects of Taxing Capital Income, (Cambridge, MA,
The MIT Press), 1994, p. 300.