TAX ASPECTS OF U.S. FOREIGN DIRECT INVESTMENT By Nathan N. Gordon I. BASIC PRINCIPLES OF THE SYSTEM. II. DEFERRAL OF TAX ON SIONS AND CHINA TRADE ACT CORPORATIONS. I. BASIC PRINCIPLES OF SYSTEM The focus of this paper is how the United States taxes the multinational corporation. By "multinational corporation" we mean a U.S. corporation which engages in business in several countries through foreign branches and subsidiaries. To date most U.S.-based multinational corporations are predominantly owned by U.S. shareholders; but in any event this paper deals with the taxation of the corporate entity and not the ultimate shareholders. The fundamental principle of U.S. income tax policy is ability to pay based on aggregate income without regard to sources. Ever since the Federal income tax was introduced in 1913, all income, whether from domestic or foreign sources, has been subject to tax. It is, of course, also true that deriving benefits from more than one government may give rise to being a taxpayer in more than one jurisliction. The United States has acknowledged this situation and has djusted its tax unilaterally to compensate for double taxation, at first by treating foreign taxes on foreign source income as deductible business Expenses and, since 1918, by allowing foreign income taxes as credits gainst U.S. tax up to the amount of U.S. tax on that income. Complementary efforts to reduce taxation of the same income by he United States and another country have been incorporated in a etwork of bilateral income tax treaties developed since 1939 and now overing some thirty countries. These treaties seek to reduce or eliminate axes at source on investment income and income derived from minimal Nathan N. Gordon is Director for International Tax Affairs, Department of the reasury. The views expressed are not necessarily those of the Department. Mr. ordon wishes to acknowledge the assistance of Mrs. Marcia Fields in the preparation this paper. or temporary activities and to establish agreement on source rules, the respective methods for eliminating double taxation, and procedures for resolving differences. An increasingly important aspect of treaty relationships is agreement to seek a mutually acceptable resolution of the allocation of costs, deductions and income between related companies in the two states and to make the necessary adjustments of tax liability. Thus, the U.S. system essentially taxes income from both domestic and foreign investments, granting a tax credit for income taxes paid to a foreign country on income from foreign sources and buttressing the system with a network of bilateral treaties to iron out discrepancies between other tax systems and our own. However, the simplicity and neutrality of this system "in essence" are often obscured in practice; it seems to be a truism that tax laws are complex, and that is no less true of the international aspects of our income tax. While it is not the purpose of this summary to make specific policy recommendations, the repeated evidence of complexity and lack of adequate rational justification of many of the existing provisions indicate some general guidelines for future changes. In some cases the original reasons for distinctions in treatment have been outlived, in others the reasons have simply become lost as time goes on. The guidelines for future changes should involve a clear decision on what the policy objective is, investigation of how the present tax system affects that objective, and analysis of whether use of the tax system to actively encourage that objective is justifiable. Tax changes to remove obstacles or to simplify procedures are more readily defensible than tax changes to provide incentives (ie., subsidies); tax incentives may be an efficient means of accomplishing an objective, but careful analysis of the estimated costs and benefits of alternative methods is needed to assure that the price is reasonable for those who will have to pay it. Of primary importance in any proposed change is the desirability of simplifying the law, for both taxpayers and administrators. Elusive as that goal has proven to be in the past, it continues to be worth pursuing. II. DEFERRAL OF TAX ON THE INCOME OF FOREIGN SUBSIDIARIES Income from foreign branches Investments made abroad through foreign branches are treated like domestic investments. Foreign branch profits are regarded as pertaining to the home office as they accrue and are subject to U.S. tax currently. This treatment offers the advantage of offsetting foreign losses against domestic income and of taking favorable deductions, such as mineral depletion allowances, from foreign as well as domestic income. The branch form of organization for foreign direct investment is used predominantly by the minerals industry. It is also commonly used by banks which are often subject to foreign legal restrictions on incorpora tion abroad. But by far the larger share of foreign direct investment is made through foreign subsidiary corporations which enjoy the advantage of the deferral of U.S. tax until the foreign profits are remitted. Almost $5 billion of the total $7 billion of profits after foreign tax attributed to U.S. foreign direct investors in 1968 was earned by foreign subsidiaries. Income from Foreign Subsidiaries In general, the U.S. tax on profits earned through foreign corporations is postponed until the profits are distributed to the U.S. taxpayer as dividends. In the interim profits generated abroad may be used by the foreign corporation as a source of financing without incurring U.S. tax. If the foreign country's corporate tax rate is less than the U.S. corporate rate, deferral provides a tax incentive to reinvest profits in the foreign corporation. It is cheaper in those cases to finance expansion abroad through local self-financing than by remitting profits to the parent corporation and having the latter make a capital contribution to the subsidiary. Where the foreign and U.S. corporate taxes are about the same there may still be such an incentive to self-financing since most countries typically impose a withholding tax on the distribution of dividends. Pros and Cons of Deferral Elimination of deferral was proposed in 1961 with respect to income from developed country subsidiaries, on the grounds that it was no longer necessary or desirable to encourage investment in developed countries, but that the incentive should be retained for investments in less developed countries. The opposing arguments stressed that taxing U.S. shareholders on the undistributed profits of a foreign corporation would have an adverse effect on the competitive position of U.S.-owned foreign subsidiaries vis-à-vis their foreign-owned counterparts in the same market. In 1962 Congress decided to retain deferral generally, except for what it regarded as tax haven abuse of controlled foreign corporations. The present Administration has not advocated changing. the deferral provision which it feels performs satisfactory in putting U.S.-owned and foreign-owned corporations on a competitive footing in foreign economies.1 A change in the opposite direction would be to shift to a territorial tax basis, exempting foreign source profits from U.S. tax in lieu of crediting the foreign income tax thereon. But to do so would be to abandon the ultimate neutrality of the U.S. tax in favor of a system under which the income tax paid by U.S. taxpayers would vary according to the source of their income and would be determined by countries 1 An Administration proposal before Congress would extend deferral to domestic exporting (DISC) corporations. other than the United States. The one evident advantage would be a simplification by the elimination of the present procedure for claiming the foreign tax credit; although it would still be necessary to have rules distinguishing between foreign source and domestic income. One possibility under consideration designed to simplify the present procedure without entailing the inequities of exempting all foreign source income would permit direct investors to exempt income from trade or business activities in a country where the combination of profits tax and withholding tax on dividends approximates the US. tax liability on that income. That is, on profits from specified countries where the foreign tax credit would virtually eliminate any net US. revenue, the taxpayer would be excused from the paperwork of reporting that income and filing for the credit. The per-country limitation on the foreign tax credit would apply on other foreign source income. Passive income such as interest and royalties, which is typically taxed at low rates in the country of source, would not be entitled to the exemption. One potential problem with this approach is that the effec tive rate of tax paid by different taxpayers in the same country may vary widely due to different treatment such as accelerated depreciation or tax holiday incentives; yet requiring documentation of the effective rate actually paid would reduce the simplification value of the proposal. The solution might lie in a limited list of special tax measures that would be taken into account in determining whether the exemption could be applied. Tax Haven Operations The United States does depart from deferral in two situations where its advantages are used for tax avoidance. Where a foreign corporation is owned more than 50 percent by U.S. shareholders (in such a case the foreign corporation is considered a controlled foreign corporation), the U.S. shareholders which own at least 10 percent of the voting stock of the corporation are taxed on its undistributed earnings as well as on the distributed earnings, to the extent that the undistributed earnings are considered tax haven income ("subpart F income"). Tax haven income includes foreign base com pany sales income, foreign base company services income and foreign personal holding company income (Code sections 951-956). Such income is, however, not taxed to U.S. corporate shareholders if the controlled foreign corporation makes certain minimum distributions, which vary depending on the applicable foreign tax rate. As a result of the minimum distribution election, corporations with extensive manufacturing activi ties in high tax countries can achieve deferral on substantial amounts of tax haven income. The second situation in which deferral is inapplicable relates to foreign personal holding companies. A foreign personal holding company is generally a foreign corporation which derives most of its income (60 percent the first year, 50 thereafter) from dividends, interest, rents, royalties, personal service contracts and other specified items of “passive" income and which is owned 50 percent or more by not more than five U.S. shareholders. The U.S. shareholders of such a holding company are taxed on its undistributed profits as if they had been distributed as dividends. While the foreign personal holding company provision has been in the law a number of years, the current taxation of tax haven income of controlled foreign corporations was introduced in 1962 to curb the use of low tax countries as havens in which to accumulate income generated elsewhere. This purpose remains valid, but the benefits of the experience gained during the intervening years are now being reviewed to identify aspects which might be improved and simplified. III. THE FOREIGN TAX CREDIT The credit for foreign taxes is limited to the U.S. tax liability on foreign source income either from each country taken separately or on all foreign source income taken together at the election of taxpayer.2 An excess of foreign tax credits over U.S. tax liability may be carried backward two years and forward five. There is a direct credit for taxes paid by the U.S. taxpayer and, in the case of dividends from a foreign corporation owned 10 percent or more by the U.S. taxpayer, an indirect credit for taxes paid by the foreign corporation and its 50 percent owned subsidiary on the profits out of which distributions were made to the U.S. taxpayer. The computation varies according to whether the income originates in a developing or developed country. Limitations on the Credit The creditable amount of foreign tax is equal to the lower of the taxes actually paid or the proportion of U.S. tax attributable to the foreign taxable income. Since 1960 the taxpayer has been able to choose between defining foreign taxes and foreign income on a country-bycountry basis or in the aggregate, but this has not always been the case. The history of the limitations on the tax credit can be summarized briefly as follows: 1918-1821 1921-1932 1932-1954 1954-1960 1960-present -up to the total U.S. tax liability on all income, including U.S. source income -overall limitation; all foreign source income and taxes aggregated -lesser of overall or per-country limitation -per-country limitation -overall or per-country limitation at taxpayer's election Under the per-country limitation there is no averaging of foreign ax rates. On the other hand, neither is there averaging of foreign 2 Alternatively, the taxpayer may elect to deduct foreign taxes. In most cases it ill only be to his advantage to do so, however, if he has a worldwide loss, in which se the foreign taxes paid increase the operating loss carry-over. |