The Foreign Tax Credit's Interest Allocation Rules
The Foreign Tax Credit’s Interest Allocation Rules
Updated September 29, 2008
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Donald J. Marples
Specialist in Public Finance
Government and Finance Division
The Foreign Tax Credit’s Interest Allocation Rules
The foreign tax credit alleviates the double-taxation that would result if U.S.
investors’ overseas income were to be taxed by both the United States and a foreign
country. U.S. taxpayers credit foreign taxes paid against U.S. taxes they would
otherwise owe, and in doing so concede that the country where income is earned has
the primary right to tax that income. But the United States retains the primary right
to tax U.S.-source income, placing a limit on the foreign tax credit: foreign taxes can
only offset the part of a U.S. taxpayer’s U.S. tax that falls on foreign source income.
It is this limit to which the American Jobs Creation Act of 2004 (P.L. 108-357, Jobs
Act) applied. To calculate the limit, a firm separates its revenue and costs, for tax
purposes, into those having a foreign source and those having a U.S. source. Foreign
taxes can offset U.S. tax on revenue “sourced” abroad; in effect, foreign-source
income is exempt from U.S. tax for firms whose foreign tax credits exceed the limit
(firms with “excess credits”). But because deductions allocated abroad reduce U.S.
tax, the effect is the same as if deductions allocated to foreign sources can not be
claimed for U.S. tax purposes.
If a U.S. firm has foreign investments, current law requires at least part of the
U.S. interest to be allocated to foreign sources based on the theory that debt is
fungible — that regardless of where funds are borrowed, they support a firm’s
worldwide investment. But multinational firms have argued that if part of domestic
interest is allocated abroad, part of foreign interest should be allocated to the United
States, which would reduce U.S. tax. (Some critics have suggested, however, that
granting multinationals tax benefits through interest allocation revisions should be
accompanied by restrictions on the benefit of deferral, which allows taxes.)
This worldwide allocation rule was adopted in the Jobs Act, but has not yet been
implemented. The Jobs Act called for implementation starting in 2009, while P.L.
110-289 has subsequently delayed implementation until 2011. Other bills before the
110th Congress, including H.R. 3920, H.R. 5720, H.R. 6049, and H.R. 7060, would
also delay or repeal the implementation of the worldwide interest allocation rule.
The analysis here suggests that current law’s interest allocation rules are likely
imperfectly structured to achieve the objective of the foreign tax credit limit and that
worldwide allocation of interest as enacted by the Jobs Act, while losing revenue,
would probably be more consistent with the basic objective of the foreign tax credit
limit. Tax planning techniques however, could undermine this objective and cause
further revenue loss. And, like the foreign tax credit limit itself, allocation rules
contribute to tax distortions which may be heightened with worldwide allocation.
Further, an expansion of the bank “subgroup” elections contained in the Jobs Act
may not be consistent with the general objective of worldwide allocation of interest.
Although the Jobs Act contains anti-abuse rules, these subgroup elections may permit
firms to avoid the impact of the interest allocation rules. This report will be updated
as legislative events warrant.
Function and Mechanisms of the U.S. Foreign Tax Credit..................2
Foreign Tax Credit Limitation....................................3
Interest Allocation Rules............................................4
The Advantages of Worldwide Allocation..........................5
Disadvantages of Worldwide Allocation............................5
Interest Rate Differentials...................................7
Appendix. Effects of Alternative Allocation Rules........................9
Deriving Accurate Allocation Rules...............................9
The Basic Limitation without Allocation of Interest...............9
Adjusting for the Fungibility of Borrowing: The Ideal............10
Adjusting for the Fungibility of Borrowing: Current Law
and the Jobs Act......................................10
Effects on Borrowing Location..................................11
Effects on Equity Investment....................................12
Effects on Investment Financed by Debt and Equity..................13
The Foreign Tax Credit’s Interest
The American Jobs Creation Act of 2004 (P.L. 108-357; the Jobs Act) contained
a number of provisions related to the taxation of multi-national corporations. Among
these provisions were more generous rules for multinationals to use in allocating
interest expense for purposes of the U.S. foreign tax credit. This rule is referred to
as the “worldwide” allocation of interest and it is the subject of this report. The act’s
changes are due to take effect for tax years beginning after December 31, 2008. The
implementation was, subsequently, delayed until tax years beginning after December
5720, H.R. 6049, H.R. 3920, and H.R. 7060, would also delay or repeal the
worldwide interest allocation rule.
The Jobs Act’s interest allocation provision was designed to correct what some
argue was an imperfection in the design of the foreign tax credit rules. In general, the
tax code places a limit on the foreign tax credit. To calculate the limit, firms are
required to separate interest and other expenses according to source — foreign or
domestic. Because of effects detailed below, the more interest that is assigned to
domestic sources, the more foreign tax credits a firm can claim and the lower its U.S.
tax liability. Some believed that the prior law’s approach unduly left taxpayers
exposed to double taxation of foreign-source income.1 The Jobs Act addressed this
The analysis here indicates that worldwide allocation rules, while losing
revenue, would likely be better aligned with the objective of the foreign tax credit.
Tax planning techniques could undermine this objective — and lead to increased
revenue loss and efficiency costs.
The act contained another relevant modification to the interest allocation rules,
that would increase a firm’s creditable taxes. Specifically, the provision expands the
subgroup election for banks to include other financial intermediaries, including
insurance companies — which allows for the separate calculation of interest
allocation. This provision could insulate some firms from a portion of the interest
allocation rules, and it is at odds with the theory underlying the act’s other
1 U.S. Congress, Joint Committee on Taxation, General Explanation of Tax Legislation
Enacted in the 108th Congress, JCS-5-05, May 2005 (Washington: GPO, 2005).
Function and Mechanisms of the
U.S. Foreign Tax Credit
The United States — in principle — taxes its resident corporations and
individuals on their worldwide income, regardless of where it is earned, under the
residence rule. The foreign tax credit and deferral, are the key structural pieces of the
U.S. taxation of foreign-source income. The foreign tax credit provisions generally
permit U.S. taxpayers to credit foreign taxes they pay against U.S. taxes they would
otherwise owe — on a dollar-for-dollar basis. For example, a U.S. corporation
chartered in North Dakota is potentially subject to U.S. tax on income it earns outside
the United States. Concurrently, however, the foreign countries where the income
is earned generally tax that income, even if it is earned by a foreign (U.S. in this case)
investor, under the source principle. In the absence of the foreign tax credit, this
income would potentially face double-taxation and possibly very high tax rates.
The foreign tax credit, however, generally alleviates the possibility of double-
taxation of foreign-source income. With the credit, the U.S. concedes that the
country where income is earned has the primary right to tax that income and collect
the tax revenue that it generates.2 This results in the U.S. collecting only the U.S. tax
due after paying foreign taxes — if positive. As such, the foreign tax credit helps to
define the U.S. tax jurisdiction and it is not a tax expenditure favoring selected
groups. While theoretically straight-forward, overlapping jurisdictions introduce
numerous complications. To better understand interest allocation rules, it is useful
to first examine two key structural pieces: deferral and the foreign tax credit
As noted above, deferral is one of the key structural pieces of the U.S. taxation
of foreign-source income. U.S.-owned firms can conduct their foreign operations
through foreign chartered subsidiaries. Unlike U.S. chartered firms, these foreign-
chartered corporations are generally taxed only on income earned in the United
States. Thus, where a U.S. parent firm invests abroad through a foreign chartered
subsidiary, U.S. taxes do not apply to its foreign income, as long as the income is
reinvested abroad.3 U.S. taxes are, in other words, deferred or postponed. Because
of discounting, firms view the cost of taxes paid in the future as less than an identical
amount paid in the present. U.S. taxes do apply when the income is repatriated to the
U.S. parent firm as intra-firm dividends.
Foreign tax credits can be claimed with respect to U.S. tax on dividends
received from foreign subsidiaries. In addition to the direct credit, “indirect” foreign
2 That is, the resident principle is subordinate to the source principle when the two are
asserted by different jurisdictions.
3 Income received under Subpart F rules, which are aimed at sheltering activities, is not
eligible for deferral.
tax credits can be claimed by a U.S. parent firm for foreign taxes paid by the
subsidiary during the time the income was tax-deferred.4
Foreign Tax Credit Limitation
As noted above, the U.S. concedes that the country where income is earned has
the primary right to tax that income and collect the tax revenue that it generates. The
U.S. retains, however, the primary right to tax U.S. source-income. In order to
protect its domestic tax base, the U.S. imposes a limitation on the foreign tax credit.5
In effect, the tax code only allows foreign tax credits to offset the U.S. tax on foreign
source-income. Any foreign taxes paid in excess of the limit become “excess
credits” and can be carried back one year and carried forward up to 10 years.6
The foreign tax credit and its mechanics can be understood clearly by looking
at the tax rate on foreign income that is produced by the foreign tax credit. With the
foreign tax credit and its limitations, a U.S. investor pays total taxes (U.S. plus
foreign taxes) on foreign income at an average rate equal to the higher of the U.S.
pre-credit tax rate or the foreign tax rate. For example, if a firm pays U.S. tax at a
35% rate and the foreign tax rate is 10%, its total tax on foreign income would
consist of the 10% foreign tax plus the 25% of U.S. tax that remains after the 10%
offset by the foreign tax credit.7 If, instead, the foreign tax rate is 50%, the firm
could offset all of its U.S. tax on foreign income with the foreign tax credit, and
would pay only foreign taxes — at a 50% rate.8
If a firm is in an excess credit position — its foreign taxes exceed U.S. tax on
foreign-source income — the sourcing of income and deductions matters. Under the
foreign tax credit limitation, maximum creditable foreign taxes are limited to the
amount of U.S. pre-credit tax falling on foreign source income rather than domestic-
source income. It follows that if, for example, an item of revenue is determined to
have a foreign rather than U.S. source, then the maximum foreign tax credit is
increased because foreign income and the share of U.S. pre-credit tax falling on
foreign income is increased. The reverse is true with deductions; a deduction
allocated to foreign rather than U.S. sources reduces foreign income and U.S. pre-
credit tax on foreign income; it reduces creditable foreign taxes and increases after-
credit U.S. tax.
4 While the U.S. parent can claim indirect foreign tax credits with respect to dividends, the
dividends are also “grossed up” by the amount of the foreign tax before they are included
in the parent’s taxable income. Thus, a parent’s taxable dividend from foreign sources is
5 In the absence of a limit, foreign countries could, in theory, divert tax revenue from the
U.S. by simply raising their taxes on U.S. investors — without fear of placing additional
burdens on the U.S. firms themselves.
6 Firms whose foreign taxes exceed the limit are said to be in an excess credit position.
7 Thus, the total tax rate is 35% — 10% plus 25%.
8 These relationships assume a uniform definition of taxable income in the U.S. and foreign
Interest Allocation Rules
Whether an expense is deducted from foreign or U.S. income matters for tax
purposes. The tax code, therefore, contains rules for allocating deductions between
foreign and U.S. sources. In the case of interest expense, the rules generally are
based on the approach that money is fungible and that interest expense is properly
attributable to all business activities and property of a taxpayer, regardless of any
specific purpose for incurring an obligation on which interest is paid. For example,
a U.S. parent company might borrow in the U.S. and use the funds to increase its
equity stake in a foreign subsidiary, which uses those borrowed funds to make its
own investments. Conversely, a U.S. firm could borrow domestically to finance
domestic investment — investment that might otherwise have been financed through
repatriated earnings. In this case, domestic borrowing may support both domestic9
and foreign investment.
While it is beyond the scope of this report to determine if the fungibility of debt
is a reasonable assumption, except to recognize that it underlies both the current
interest allocation rules and those enacted by the Jobs Act, some facts on each side
are worth noting. First, in favor of fungibility, corporations are legal entities, and not
economic ones. As a result corporate boundaries can be easily manipulated for
financial gain. Conversely, the existence of cross-jurisdictional interest rate
differentials suggest that fungibility may not hold between all jurisdictions.
Current law applies the fungibility principle in a manner sometimes referred to
as “waters edge” allocation. Under this system, foreign subsidiaries are not explicitly
included in the allocation. This has two implications for the allocation formula.
First, only a domestic parent’s equity stake in its foreign subsidiary is counted as an
asset — excluding the foreign subsidiary’s assets financed by debt. The parent’s
assets, in contrast, are all included in the calculation — whether financed by equity
or debt. Secondly, the subsidiary’s interest expense is automatically allocated to
foreign sources. This occurs since the subsidiary’s interest expense reduces dividend
payments to the parent, which are all allocated to foreign sources.
An alternative to the “waters edge” allocation is a “worldwide” allocation
regime, such as enacted by the Jobs Act.10 Under a “worldwide” allocation, the
borrowing of foreign subsidiaries would be taken into account. This change would
have two effects, which combined, increase the foreign tax credit limit of
multinationals and therefore decrease after-credit U.S. taxes. The first effect involves
including interest of the foreign subsidiary. By allocating a portion of foreign debt
to domestic use, this reduces foreign source deductions, increases foreign source
income, increases the foreign tax credit limit and reduces U.S. tax liability. The
9 This implies a fungibility of equity, i.e. the subsidiary’s retained earnings support
investment at home and abroad.
10 The interest allocation provisions of the Jobs Act become effective for taxable years
beginning after December 31, 2008.
second effect involves counting foreign subsidiary, debt financed assets as part of the
worldwide asset base of the parent company. Taken in isolation, this would allocate
more interest to foreign sources and raise U.S. tax liability. Mathematically,
however, the first effect dominates — so tax liability is reduced under worldwide
The Advantages of Worldwide Allocation
One can argue that worldwide allocation more accurately limits the foreign tax
credit to income that is attributable to a foreign source, as long as borrowed funds are
fungible. Briefly, this perspective results as follows: if it is true that borrowing in
one location finances investment in all locations equally; then it is true that
borrowing domestically or abroad should not alter the share of income earned
domestically or abroad. Remembering that the purpose of the foreign tax credit
limitation is to protect the U.S. tax base, while minimizing double-taxation of
foreign-source income, it then follows that location of borrowing should not affect
the maximum creditable foreign taxes. Under current law, the limitation can be
affected by shifting the borrowing location.
Disadvantages of Worldwide Allocation
While worldwide allocation would achieve a more accurate foreign tax credit
limitation, there are also some complications and disadvantages to such an approach,
including administrative complications, tax planning complications, and increases
in investment distortions (even though U.S. revenue is lost). Also, if interest rates
vary across jurisdictions, it isn’t clear whether fungibility of borrowing is pervasive
and that worldwide allocation of interest is completely appropriate to achieving the
goal of limiting the foreign tax credit to income that is attributable to a foreign
Administrative Complications. One obvious disadvantage of worldwide
allocation is that it would require foreign subsidiaries, which are not always wholly
owned by U.S. firms, to classify their assets and borrowing for U.S. tax purposes as
having a U.S. or foreign location. This change would complicate both IRS tax
administration and firm compliance.
Tax Planning. A second issue with worldwide allocation is the possibility that
firms could artificially increase their gross foreign assets to eliminate any interest
allocation. Under worldwide allocation, there are no decreases in the foreign tax
credit limit if the foreign subsidiary has a debt to asset ratio as high or higher than the
parent company. However, if firms could borrow and redeposit funds, they could
increase their debt to gross asset ratios. For example, suppose a parent company has
$100 million in assets and its subsidiary also has $100 million in assets, with only
$50 million in debt attributable to the parent company. Under both current and
pending law, half of the debt ($25 million) would be allocated to the subsidiary. This
allocation is consistent with the worldwide fungibility of debt. Suppose, however,
that the subsidiary could borrow $100 million and redeposit the $100 million in a
bank account, then no allocation would occur. The subsidiary would now have $200
million in gross assets, two-thirds of the total, gross debt would be $150 million and
$50 million would be allocated to domestic uses.
The possibility of borrowing is one reason to restrain the allocation to a non-
negative one; otherwise this technique could be used, at the extreme, to further
reduce U.S. tax liability and to render the foreign tax credit limit meaningless.
While this discussion outlines a possible tax planning technique; firms may not
choose to use it and that transaction costs could reduce the value of the technique.
It does illustrate that at an extreme, tax planning could eliminate the allocation rules
entirely. It is possible that other methods could be used to prevent such abuses, but
they would likely be complex and add to the administrative complications, mentioned
Economic Efficiency. Another worldwide allocation issue concerns
economic efficiency. As noted above, the purpose of the foreign tax credit limit is
not to ensure the efficient allocation of resources; rather, it is concerned with
protecting the U.S. tax base. The impact of worldwide allocation on the ability of the
economy to efficiently allocate investment and borrowing among different locations,
however, can be viewed as one cost of fine-tuning the foreign tax credit limitation.
In some respects, worldwide allocation might create greater distortions in the
allocation of debt and equity capital, relative to the non-tax allocation.
First, worldwide allocation magnifies tax-based incentives to borrow abroad —
an important consideration if debt is not fungible, as assumed. Allocating interest on
the worldwide basis of aggregate capital stock, for purposes of the foreign tax credit
limit, effectively reduces borrowing in the U.S. and increases it abroad. In effect, any
savings can be calculated by multiplying the foreign tax rate times the interest shifted
abroad. For example, if the interest rate were 10 percent and the foreign tax rate 40
percent, a $100 dollar shift in debt from the U.S. to a foreign locale would save the
company $4. If there were no allocation rules, however, then the shift in debt abroad
would lead to a larger interest deduction abroad, but a smaller foreign tax credit limit,
because the flow of dividends is net of interest costs. In this case, the benefit of
shifting is the difference in the tax rates. Continuing our example, the foreign tax
rate is 40 percent and the U.S. tax rate is 35 percent, so that the savings is only $0.50
(0.05 times the interest). The current system is in between these two cases; the
allocation of domestic interest does mean that a shift in the debt abroad has an effect
in reducing the foreign tax credit limitation, but not the effect that would occur with
no allocation rules.
Similarly, the degree to which equity investment is discouraged in the high tax
countries (a general efficiency problem with international taxation), while minimized
when there is no allocation rule at all, is likely to be larger with the worldwide
allocation system than with the current allocation system.
The efficiency effects of shifting both debt and equity abroad simultaneously
would be more complex and depend upon the level of debt by the parent firm and
other factors. In some cases, the current allocation rules cause more distortions and
in some cases they reduce distortions.
Overall, the best system for minimizing the distortions in both the allocation of
borrowing and equity investment is to have no allocation rules at all. Nevertheless,
if the parent tends to do most of the borrowing (which may occur for a variety of non-
tax reasons), having no allocation rules could cause a significant loss of U.S. revenue
compared to both the current system and to the worldwide approach. That is, some
efficiency cost is necessary to protect the U.S. tax base. In both cases, however,
partial allocation rules are less distortionary than full allocation rules. The rules are
less clear with respect to investment shifts that occur simultaneously with debt shift.
These issues become more complicated when considering multiple country
investments. Since firms are generally not required to calculate separate foreign tax
credit limits for different countries, firms can use excess credits from one country —
a high tax country — to shelter income from a low tax country from U.S. tax.
Accordingly, even if a firm is in an excess credit position and makes interest
allocations, it will still be faced with an incentive to invest in low-tax countries.
Moreover, it is difficult to make precise judgements about economic efficiency when
the tax system is not efficient in other ways, such as with deferral. Nevertheless it
is interesting that there are cases where a change in the allocation rules that lowers
taxes of multinational corporations can magnify distortions.
Interest Rate Differentials. A final complication relating to interest
allocation rules is the possibility of interest rate differentials. In a perfect world with
completely mobile capital, such interest rate differentials would not occur. However,
if the domestic savers prefer investing in particular locations or there are differences
in risk across locations, such differentials may arise. In particular, if foreign interest
rates are higher than U.S. rates, worldwide allocation rules will have a larger effect
increasing the foreign tax credit limit than would be the case where interest rates are
It is difficult to ascertain how these interest rate differentials should influence
the allocation process. Certainly, the presence of interest rate differentials suggests
that the very presumption of fungibility is in question, and also suggests that the
presumed standard that justifies worldwide allocation — equal debt-to-equity ratios
— may not be the case. While beyond the scope of this paper, this area may need
Along with allowing firms to allocate interest expense on the basis of worldwide
groups, the Jobs Act contained an additional related change. Current law contains
a subgroup election for firms that are banks. The act expands this election to a wider
range of financial intermediaries, including finance companies and insurance firms.
Such an election could, potentially, reduce the amount of interest a worldwide group
is required to allocate to foreign sources. For example, a firm that has a financial
subsidiary which conducts genuine financial intermediation could arrange to have a
portion of the non-financial part of the firms’ borrowing undertaken by the
subsidiary. If the financial subsidiary’s assets are principally located in the U.S.,
borrowing through the subsidiary could be insulated from allocation rules. More
directly stated, firms could distribute their borrowing among related subsidiaries to
minimize foreign allocations of interest. The act does contain anti-abuse provisions
whose apparent intent is to limit such arrangements. Nonetheless, it remains to be
seen if the anti-abuse provisions will be effective in limiting such arrangements.
As mentioned above, the Jobs Act contains a number of rules intended to limit
the extent to which the expansion of the bank group election can be used to avoid
interest allocation. For example, the act would limit the extent to which a subgroup
member can increase the portion of its earnings it pays to the parent as dividends.
This rule is, presumably, designed to limit the means by which a subgroup can
borrow and subsequently transmit debt to its parent. If the subgroup is new,
however, the rules for calculating average dividends are confined to the subgroups’
years in existence, which may provide a mechanism for avoiding the limitation.
In short, the act’s subgroup election provision appears to present potential
opportunities for firms to avoid the allocation of interest according to the fungibility
principle. Unlike the act’s other changes in the allocation rules (discussed above),
this feature of the bill appears to move the system away from the “theoretically pure”
foreign tax credit limitation under the assumption of fungibility.
The analysis in this report suggests that there are benefits and disadvantages to
worldwide allocation of interest enacted by the Jobs Act. If debt is fungible,
worldwide allocation is the most accurate method of ensuring that the U.S. foreign
tax credit is used for its intended purpose: allowing the foreign tax credit to offset the
full share of U.S. pre-credit tax that falls on foreign source income. Absent
additional rules, however, opportunities for tax planning may limit the achievement
of this objective. Also, like the foreign tax credit limit itself, allocation rules tend to
contribute to the distortions that discourage equity investment abroad. Adopting
worldwide allocation rules could, in several ways, increase these distortions relative
to current law. While the distortions created by current law can be viewed as a cost
of collecting taxes — since they increase U.S. revenue — and potential increased
distortion associated with worldwide rules cannot since they decrease U.S. revenue.
Finally, the subgroup election provision in the Jobs Act does not appear
consistent with the general objective of the foreign tax credit limit or the act’s own
worldwide allocation regime. This subgroup election may permit firms to reduce the
current domestic interest allocation costs, while achieving foreign interest allocation
Appendix. Effects of Alternative Allocation Rules
This appendix derives the allocation rules that most accurately support the
foreign tax credit limitation — the rules that most accurately limit creditable foreign
taxes to U.S. tax on foreign-source income. While this ideal rule is one under which
the location of borrowing does not affect the foreign tax credit limit for U.S. tax
purposes, taxpayers could still change their overall (that is, foreign and U.S.
combined) tax liability by switching the location of borrowing. The appendix
continues by showing how the incentive to borrow abroad is affected by allocation
rules. The discussion concludes with an analysis of how the allocation rules affect
Deriving Accurate Allocation Rules
The shape that accurate allocation rules take depends, crucially, upon the
assumption of debt fungibility. As noted in the text, it is unclear whether fungibility
accurately represents real world experiences. Since both current and enacted law
both make this assumption, however, fungibility will be assumed — that debt
supports investment in all locations, regardless of the borrowing locale.
With the assumption of fungibility, a shift in the location of borrowing should
not shift the location of investment. Further, since investment produces income, a
shift in the location of borrowing should not alter the proportion of income earned
at home or abroad. Thus, for the foreign tax credit limit to be accurate, a firm should
not be able to affect the limit by shifting its location of borrowing.
The Basic Limitation without Allocation of Interest. Assume a
multinational’s U.S. tax liability can be expressed as:
(1) U.S. Tax = t(Y + D/(1 - tf) - iBd) - tD/(1 - tf);
where t is the U.S. tax rate, Y is U.S.-source income before interest deductions, D is
dividends from a foreign subsidiary, tf is the foreign tax rate, i is the interest rate, and
Bd is domestic borrowing. The equation’s first term represents the tax on worldwide
income, with dividends grossed up to a pre-foreign tax basis, while the second term
is the foreign tax credit, which is limited to the U.S. tax on grossed up dividends.
The foreign tax credit is also limited to actual foreign taxes paid (or deemed paid, in
the case of dividends). As a result, changing the base of the foreign tax credit only
has an effect when a company is in an “excess credit” position — where the foreign
tax rate is greater than the U.S. rate.
For this analysis, foreign subsidiary dividends are defined in terms of foreign
earnings and other elements as:
(2) Yf = D + R + iBf + tf(Yf - iBf);
where Yf is foreign earnings before deducting interest, R is retained earnings, and Bf
is borrowing by the foreign subsidiary. In all cases, the amounts would be scaled
back for a subsidiary that isn’t wholly owned (e.g., if a subsidiary is 90 percent
owned, then all three values would be multiplied by 0.9). Foreign earnings are the
sum of dividends, retained earnings, interest payments, and foreign taxes. Therefore:
(3) D/(1 - tf) = Yf - R/(1 - tf) - iBf .
Thus, equation (1) can be rewritten:
(4) U.S. Tax - t(Y + Yf - R/(1 - tf) - iBf - iBd) - t(Yf - R/(1 - tf) - iBf).
For a firm in an excess credit position, the limitation, L, is the last term:
(5) L = t(Yf - R/(1 - tf) - iBf).
In this world, without allocation rules that require the allocation of domestic interest
to foreign sources, the taxpayer could increase the limitation — and reduce their
taxes — by shifting borrowing to their subsidiary (by reducing iBf and increasing
iBd by equal amounts). Clearly, if fungibility is assumed, requiring no allocation
rules does not result in an effective limitation.
Adjusting for the Fungibility of Borrowing: The Ideal. For the
limitation to be unaffected by the location of borrowing, geographic-specific
borrowing cannot be a parameter in equation (5). That is, neither Bf nor Bd can
appear in the equation. This condition is satisfied, incompletely, by replacing the
term iBf in the equation with iBT. In this formulation, the limitation could be
unaffected by the borrowing location with an allocation rule allocating all borrowing
costs to foreign income, or, alternatively, to domestic income. Clearly, this is at odds
with the assumption of fungibility. That is, if a firm has both foreign and domestic
investment supported by borrowing, some portion of the interest on total borrowing
must be allocated to foreign sources and that proportion must be independent of the
borrowing locale. Thus, assuming fungibility, an accurate limitation can be written
(6) L = t(Yf - R/(1 - tf) - iABT);
where A is the portion of interest allocated to foreign sources. Fungibility requires
that “A” cannot be an arbitrarily chosen fraction (50%, for example), and that only
the location of assets defines “A”. Thus:
(7) A = Kf/KT.
The ideal limitation can, therefore, be defined as:
(8) L* = t(Yf - R/(1 - tf) - i((Kf/KT)BT)).
Next, we compare the current law’s allocation and the Jobs Act’s rules to this ideal
Adjusting for the Fungibility of Borrowing: Current Law and the
Jobs Act. As noted in the text, current law requires part of domestic borrowing to
be allocated to foreign sources. However, because the subsidiary’s own interest
payments reduce repatriated earnings and not domestic-source income, all the
subsidiary’s borrowing costs are automatically allocated to foreign sources. Thus the
parameter BT in the ideal limitation, equation (8), above, is replaced by Bd. In
addition, not all the subsidiaries’ assets are included in the allocation rule, A — only
the parent’s equity stake in the subsidiary is included. Thus,
(9) A = (Kf - Bf)/(KT - Bf) and
(10) L = t(Yf - R/(1 - tf) - iBf - i((Kf - Bf)/(KT - BF))Bd),
and since Bd = BT - Bf,
(11) L = t(Yf - R/(1 - tf) - iBf - i((Kf - Bf)/(KT - BF))(BT - Bf)).
Given that the limitation is, clearly, dependent on the location of borrowing —
i.e. the respective values of Bf and Bd, current law violates the principle of fungibility.
That is, a taxpayer can increase or decrease the limitation by shifting the borrowing
location. While a full discussion of this topic is in the following section, below, note
for now that dL/dBf > 0 and that a taxpayer can increase their limitation by shifting
borrowing from domestic to foreign locations.
Given current law violates the principle of fungibility, let’s turn to the JOBS
Act’s rules. As noted in the text, all assets of the subsidiary are included in the
allocation formula. Thus, equation (7) is unchanged. Additionally, the interest
expense of the subsidiary is also subject to allocation — both Bd, as in equation (9),
and Bf are multiplied by A. This can be accomplished by allocating part of domestic
interest to foreign sources and part of foreign interest to domestic sources — since
foreign borrowing has already been netted out of the dividend. Thus, the limitation
equation can be expressed as:
(12) L = t(Yf - R/(1 - tf) - iBf - iBd(Kf/KT) + iBf(Kd/KT)).
This simplifies to:
(13) L = L* = t(Yf - R/(1 - tf) - i((Kf/KT)BT)),
which is the ideal limitation formula, equation (8). As it is consistent with
fungibility, the value of the limitation is independent of the location of borrowing,
and it is proportional to the location of investment.
Effects on Borrowing Location
In order to examine the effects of tax regimes on borrowing locale, we depart
from the base model by adding foreign taxes. To simplify the analysis, we assume
a single tax rate applies to both dividends and retained earnings. This analysis
assumes that foreign tax authorities do not make allocation adjustments. Thus the
total tax paid by a company can be expressed as:
(14) Total Tax = t(Y + Yf - R/(1 - tf) - iBT) - t(Yf - R/((1-tf) -
iBf - i((BT - Bf)(Kf - Bf)/(KT - Bf)) + tf(Yf - iBf)
where tf is the foreign tax rate.
This rule can be contrasted with the circumstances where there is no allocation
rule in place:
(15) Total Tax = t(Y + Yf - R/(1 - tf) - iBT) - t(Yf - R/((1-tf) - iBf) + tf(Yf - iBf)
and the worldwide allocation rule, contained in the Jobs Act:
(16) Total Tax = t(Y + Yf - R/(1 - tf) - iBT) - t(Yf - R/((1-tf) - i(Kf/KT)BT) + tf(Yf - iBf).
Totally differentiating equation (14) gives us the effect of shifting a small
amount of debt from domestic to foreign use, under current law, as:
(17) Change in Tax = -tfi + ti(KT - Kf)* (KT - BT) * Change in Foreign Debt
(KT - Bf) (KT - Bf).
When there is no allocation rule, the result is:
(18) Change in Tax = (-tfi + ti) * Change in Foreign Debt,
and finally, with worldwide allocation:
(19) Change in Tax = -tfi * Change in Foreign Debt.
Note that the largest incentive to borrow abroad occurs with the worldwide
allocation, and the smallest incentive occurs with no allocation rules. Without
allocation rules, the savings from shifting debt abroad is the difference between the
tax savings from the foreign deduction and the tax savings from the domestic
deduction. With worldwide allocation, worldwide interest is allocated the same way
regardless of where it originates, so that the only effects that multiply the expression
ti, each one less than one, that dilute but do not eliminate the effect of the foreign tax
credit limit. The first term is the direct effect from allocating domestic interest and
the second is the effect of using net rather than gross foreign assets in the allocation
Effects on Equity Investment
Next, let us consider the effect of allocation rules on equity investment. To do
so, we change the notation slightly to reflect the idea that gross income is the return11
on capital multiplied by the capital stock. Under current law, the total tax of a firm
can be expressed as:
(20) Total Tax = t(rKd + rfKf - R/(1 - tf) - iBT) - t(rfKf - R/(1 - tf) - iBf
-i(BT - Bf)(Kf - Bf)/(KT - Bf)) + tf(rfKf - iBf)
where r is the return on U.S. capital and rf is the return to foreign capital, both on a
This rule can be contrasted with the circumstances where there is no allocation
rule at all:
(21) Total Tax = t(rKd + rfKf - R/(1 - tf) - iBT) - t(rfKf - R/(1 - tf) - iBf) + tf(rfKf - iBf)
and the Jobs Act rule, with worldwide allocation:
(22) Total Tax = t(rKd + rfKf - R/(1 - tf) - iBT) - t(rfKf - R/(1 - tf) - (iBTKf/KT))
+ tf(rfKf - iBf).
11 For completeness, one would need to make a similar adjustment to retained earnings. In
this analysis, however, retained earnings cancels out.
In order to isolate the tax effect, consider the case where the pretax returns are
equal — in practice they will not equal after the consideration of tax rules. Further,
consider the case where very small, but slightly, different taxes are added to this,
previously, case without taxes.
Next, we totally differentiating equations (20)-(22) with respect to Kf, which
holds the firm’s total capital stock fixed.
The change in the tax liability under current law with a reallocation of capital
(23) Change in Tax = ((tf - t)r + ti( Bd)) * Change in Foreign Capital
(KT - Bf*).
When there are no allocation rules:
(24) Change in Tax = (tf - t)r * Change in Foreign Capital,
and under worldwide allocation rules:
(25) Change in Tax = ((tf - t) + ti BT ) * Change in Foreign Capital.
In all three cases, the tax systems discourage investment abroad, due to the high
tax country. Allocation rules magnify this effect because the adjustment to the
foreign tax credit limit increases with larger shares of the capital stock located
abroad. In this case, however, the worldwide allocation rule will further discourage
investment abroad because of a more powerful effect on the allocation rule. As a
result, worldwide allocation is likely to be less efficient than domestic interest12
allocation with respect to disincentives for equity investment.
Effects on Investment Financed by Debt and Equity
Finally, we consider the effects on investment abroad that are financed by both
debt and equity. Assume that the debt to asset ratio of the subsidiary is fixed, and
that the total assets and debt of the parent and subsidiary are also fixed.
To consider the effects on equity investment, we again adjust our notation to
reflect idea that gross income is the return on capital multiplied by the capital stock.
The equations from the previous section are modified to allow borrowing to
change when the capital stock is altered. In examining the change in taxes for a
given change in foreign assets, the tax effects of the change in foreign debt are
incorporated. It is assumed that Bf bears a constant relationship of Kf. If the initial
ratio of foreign debt to foreign assets is defined as the constant a, then Bf - aKf, and
a change in Bf is equal to a times the change in Kf. That assumption, along with the
preceding assumption, allows the following derivations.
Under current law the effect of the change in tax can be expressed as:
12 This only holds true in the most likely case — when the foreign debt to asset ratio falls
below the domestic debt to asset ratio.
(26) Change in Tax = ((tf - t)® - iBf/Kf + ti [(BT - Bf)/(KT - Bf)][(-tiBf)/(Kf)]2
[((KT - Kf)/(KT - Bf)) + ((KT - Kf)(BT - Bf))/(KT - BF)]
* Change in Foreign Capital,
without an allocation rule:
(27) Change in Tax = (tf - t)® - iBf/Kf) * Change in Foreign Capital,
and with worldwide allocation:
(28) Change in Tax = (tf - t)® - iBf/Kf) + ti[(BT/KT) - (Bf/Kf)]
* Change in Foreign Capital.
Again, in all three cases, the tax systems discourage investment abroad, due to
the high tax country, although this effect is moderated by the deduction for debt
financed investment. The worldwide allocation rule — when debt to asset ratios are
lower abroad than in the United States — would discourage investment to a lesser
amount than equity investment. This moderation of effect results from a small
allocation being made as some of the U.S. interest is shifted abroad. Since the
worldwide allocation rule would not apply when foreign debt to equity ratios are
higher, the worldwide allocation rule would either further discourage investment
abroad or have no effect. In contrast, the current allocation rule may either encourage
or discourage investment abroad. The first term is unchanged from the previous
section, and reflects the effect of allocating more existing domestic interest abroad
as the capital stock increases. The second term reflects the fact that some interest has
shifted abroad and would not be allocated. If domestic debt is small relative to
foreign debt, then the current allocation rule would, simultaneously, raise U.S.
revenue and discourage foreign investment in high tax jurisdictions.