US INTERNATIONAL TAX POLICY OVERVIEW International Tax Policy

US INTERNATIONAL TAX POLICY: OVERVIEW International Tax Policy Forum Briefing for Congressional Staff March 5, 1999

US International Tax Policy Contents l Economic perspective – Global economic change: 1962 -1999 – US investment abroad: help or hurt US economy? – US international competitiveness: does it matter? l US law and policy – – Overview Foreign tax credit Deferral regime Policy 2

Economic Perspective Topics l Global economic change: 1962 -1999 l US investment abroad: help or hurt US economy? l US international competitiveness: does it matter? 3

Global economic change Technological drivers l Cost of info processing, $/instruction/second: – Reduced by 10, 000 times in 20 years (1975 -1995) l Cost of communications, 3 minute telephone call from NYC to London – In 1960 = $50 (1996 $), $1 today l Electronic commerce -- the next wave 4

Global economic change Deregulation, privatization l Transportation sector l Communications sector Electric power sector Pipeline sector l l 5

Global economic change US Foreign direct investment (FDI) l Declining US share of world FDI Direct investment stock 1967 1996 US share of world 50. 4% 25% l Declining US share of corp. headquarters World’s 20 largest corps. 1960 1996 Number US corps. 18 8 6

Global economic change Foreign direct investment l In 1996, 21, 000 foreign affiliates of US companies compete with 260, 000 affiliates of foreign MNCs l Rising competition. . . ROR on assets (bef. int. & tax) 1985 1995 Nonfinancial foreign subs 11. 8% 9. 8% 7

Global economic change US economy is far more dependent on FDI US corporate profits 1960 -69 1990 -97 Share from foreign source 7. 5% 17. 7% Sales of S&P 500 co’s Foreign subs’ share 1985 1997 25% 34% 8

Global economic change US Market in the 1960’s. . . l In 1962, US companies focused on US market – – US economy was 40% of world GDP Scale economies achieved w/o foreign operations Little import competition Little foreign activity within US borders 9

Global economic change US investment abroad (as % of GDP) trails behind average for G-7 countries. Source: World Investment Report 1997, United Nations. 10

Global economic change US market today. . . l Increased competition with US borders – 14% of US nonbank corp assets foreign owned – US imports have tripled to 9. 6% of GDP l Foreign markets key to growth and profits – Foreign sales of S&P 500 companies are growing at 10%/yr vs 3%/yr domestically (1986 -1997) – 75% of world GDP is now outside US 11

Global economic change Portfolio share of U. S. investment abroad has increased. In 1997, 58% of US investment abroad was portfolio investment, compared to 13% in 1962. 12

Global economic change Market integration l GATT, WTO and global reductions in tariff walls l Regional trade agreements – Euro Econ Area, NAFTA, ASEAN, Mercosur, etc. l l Half of the 153 FTAs notified to GATT/WTO since 1990 MNCs view their business regionally 13

US FDI: help or hurt US economy? The issue. . . l l Some argue US investment abroad comes at the expense of domestic economy. Under this view, Subpart F needed to protect US workers. By contrast, the OECD finds: “domestic firms and their employees generally gain from the freedom of businesses to invest overseas. As with trade, FDI generally creates net benefits for host and source countries alike. ” 1 1 OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, 1998. 14

US FDI: help or hurt US economy? Why US companies invest abroad l FDI primarily attracted by consumer markets abroad, not low wages – 81% of FDI in high wage/income countries (1996) – Only 9% of foreign sub sales are back to US (1995) – Foreign sub employment has declined as a share of domestic employment: 5. 0% in 1982 to 4. 9% in 1996 l According to the UN. . . “accessing markets will remain the principal motive for investing abroad” 1 1 UNCTAD, World Investment Report, 1997 15

US Companies Operate Abroad to Sell Into Foreign, Not US, Markets 9% 68% 23% The overwhelming majority of goods and services produced by UScontrolled foreign corporations are sold into foreign markets. In 1995, less than 10 percent of US-controlled foreign corporation sales were exported to the US. (Source: Pricewaterhouse. Coopers 16 analysis based on US Department of Commerce data. )

US FDI: help or hurt US economy? Why US companies invest abroad l Transportation costs l Tariffs Local content requirements Control vs. license valuable intangibles l l 17

US Investment and Jobs Abroad Have Not Increased Relative to Domestic Investment and Jobs Foreign share of investment 6. 9% 5. 0% 6. 4% 4. 8% Foreign share of employment Employment in US CFCs dropped from 5. 0% of US civilian employment in 1982 to 4. 8% in 1995. Similarly, gross output of UScontrolled foreign corporations has declined from 6. 9 percent of US GDP in 1982 to 6. 4 percent in 1995. (Source: Pricewaterhouse. Coopers calculations based on US Department of Commerce data. ) 18

US FDI -- help or hurt US economy? Impact on US employment l Foreign and domestic employment of US MNCs are complements not substitutes: “labor demand of US multinationals is linked internationally at the firm level, presumably through trade in intermediate and final goods, and this link results in complementarity rather than competition between employers in industrialized and developing countries. ” 1 1 Riker and L. Brainard, US Multinationals and Competition from Low Wage Countries, NBER WP No. 5959, March 1997. 19

US FDI -- help or hurt US economy? Impact on US employment l US parents pay higher wages than purely domestic companies 1 – low paid production workers benefit more than higher paid workers (in % terms) l According to the Council on Economic Advisers, “On a net basis, it is highly doubtful that US direct investment abroad reduces US exports or displaces US jobs. Indeed, US direct investment abroad stimulates US companies to be more competitive internationally. . . [and] to allocate their resources more efficiently, thus creating a healthier domestic operations, which, in turn, tend to create jobs. ” 2 1 Doms and B. Jensen, Comparing wages, skills, and productivity between domestic and foreign owned manufacturing establishments in the United States, mimeo, October 1996. 2 US CEA, Economic Report of the President, 1991, p. 259. 20

US FDI -- help or hurt US economy? Impact on national income l l l Rate of return on foreign sub assets is about 30% higher than on domestic corporate investment (1995) Foreign profits were $150 billion in 1997, accounting for almost 18% of all US corp. profits The most recent IRS data shows that foreign subs of US parents distributed $50 billion or 67% of earnings and profits (1994 tax returns) 21

US FDI -- help or hurt US economy? Impact on exports l 1996 data: – Foreign subs purchase $194 billion of merchandise exports from US – US MNCs export $213 billion to unaffiliated co’s – In total, US MNCs account for $407 billion of exports, 65% of US merchandise exports l According to the OECD, “Each dollar of outward FDI is associated with $2 of additional exports and with a bilateral trade surplus of $1. 7” 1 1 OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, 1998, p. 50 22

US Companies Finance Foreign Subs Primarily with Foreign Capital $ 24% $ 62% $ 14% 76% of the financing of US-controlled foreign corporations comes from foreign sources -- not US parents. Debt and equity from US parents financed less than 24% of total assets in 1995. Source: Pricewaterhouse. Coopers calculations based on US Dept. of Commerce data. 23

US FDI -- help or hurt US economy? In conclusion, US FDI. . . l is complementary with US employment l sells over 90% into foreign (not US) markets is overwhelmingly in high wage countries expands exports increases shareholder returns is associated with better wages in US benefits foreign economies, too l l l 24

International competitiveness: does it matter? US MNCs. . . l locate over 70% of assets & jobs in US l Invest and pay more per job at home than abroad (including in developed countries) perform 88% of R&D in US (vs. 67% of sales) overwhelmingly have US leadership supply foreign subs much more heavily from US sources l l l 1 Source: L. D’Andrea Tyson, They are not us: why American ownership still matters, The American Prospect, Winter 1991, pp. 37 -49 25

International competitiveness: does it matter? If US taxes foreign source income of its MNCs more heavily than other countries …. . . then market share of US MNCs will drop – US portfolio investment will go to foreign MNCs – Foreign acquisitions of US companies (Chrysler, Amoco, Bankers Trust, Trans. America, etc. ) New foreign investment will be under foreign parent u Foreign hdqtrs. necessary for corp. integration relief u – Foreign (vs. US) acquisitions of foreign companies u Foreign MNCs can pay more foreign earnings 26

US Double Taxes Corp. Income IRS $26. 00 Shareholder Tax (40% Rate x $65) Shareholders $35 Corporate Tax (35% Rate x $100) $65 Dividend $100 of Operating Income Company 61% Tax Rate on Corporate Income 27

Corporate Taxation in OECD Member Countries, 1990 */ Hybrid tax system (relief from double taxation at both corporate and shareholder levels). #/ Deduction for dividends paid may offset fully the corporate and personal income tax for dividends up to 15% of capital value. Dividends in excess of this limit are fully taxed at both levels. Sources: Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, Research Memorandum 9604. Erasmus University, Rotterdam. OECD, Taxing Profits in a Global Economy: Domestic and International Issues, 1991, p. 57. 28

The US International Tax System: Law and Policy l l Overview Foreign Tax Credit Deferral Policy

The US International Tax System: Overview

International Tax: Overview l l International tax rules are needed to prevent double taxation of cross-border operations— taxation by two countries of the same income. Countries use various mechanisms to avoid double tax: – “Territorial” systems exempt foreign source income – “Worldwide” systems allow a credit (or, in some cases, a deduction) foreign taxes 31

International Income Taxation, OECD Countries, 1990 1 2 3 4 5 6 For nontreaty countries, worldwide tax with credit. For nontreaty countries, worldwide tax with deduction. Exemption of 90% of gross dividend. Treaty countries with tax system similar to Australia's. 25% ownership requirement and tax system similar to Denmark's. Credit for Swiss tax on foreign dividends effectively exempts these dividends from Swiss tax. Source: OECD, Taxing Profits in a Global Economy: Domestic and International Issues, 1991, pp. 63 -64. 32

The US System: Worldwide Taxation l The US has a “worldwide” tax system – The US taxes all income of US persons (citizens, corporations, and “residents”), whether earned here or abroad. – The other country also often taxes amounts earned by US persons there. – This requires a mechanism to avoid double taxation by both the US and the other country of the same earnings. 33

The US System: Foreign Tax Credit and Deferral l The US relieves international double taxation by allowing a credit foreign taxes. l As in the case of US subs, tax generally is imposed on the foreign earnings of foreign subs only when they are paid as a dividend (or otherwise “repatriated” to the US) 34

The US International Tax System: The Foreign Tax Credit

The Foreign Tax Credit: Background l The US was the first country to provide a foreign tax credit, which we did by statute in 1918. l A foreign tax credit has been allowed in some form under US law ever since. 36

The Foreign Tax Credit: Background l The purpose of the US foreign tax credit is to eliminate double tax on foreign income. l The foreign tax credit is a dollar-for-dollar offset of the foreign tax against the US tax on foreign income--not US income. l Numerous limitations apply. 37

The Foreign Tax Credit: Computation l A formula is used to determine the tax the US would have imposed on the foreign income: Foreign source taxable income Worldwide taxable income l X US tax on worldwide taxable income A foreign tax credit is allowed for the lesser of this “limitation” amount and the amount of foreign tax actually paid or accrued. 38

The Foreign Tax Credit: Computation l This computation must be done separately for each “basket” of foreign source income. l The purpose of the “basket” rules is to prevent averaging of taxes among different types of income. 39

Foreign Tax Credit Baskets l General Limitation Income l High Withholding Tax Income l Passive Income l Shipping Income l Financial Services Income l DISC Dividends l FSC Distributions l Foreign Trade Income l 10 -50 Dividends (until 2002) 40

Steps to Compute Foreign Tax Credit Limitation 1. Determine US and Foreign Source Taxable Income: – Gross Receipts (minus cost of goods sold) – Other Gross Income 2. Determine Deductions Allocable to US and Foreign Income. 3. Determine Net US and Foreign Source Income. 41

Steps to Compute Foreign Tax Credit Limitation 4. Determine FTC Category (“Basket”) – Characterize Gross Income – Source Gross Income 5. Allocate and Apportion Deductions among FTC Categories of Gross Income. 6. Determine Amount of Creditable Foreign Taxes Within Each Category. 42

Source of Income Rules Different Source Rules for Different Types of Income: l l Income from the Sale of Purchased Inventory Income from the Sale of Manufactured Inventory Dividends Interest l Rents l Royalties l Sale of Stock Sale of Intangibles Other l l 43

Expense Allocation Rules Different Allocation Rules for Different Expenses: l Interest l Research & Development l General & Administrative l Other 44

Example 1 l l USCO has a foreign subsidiary in Country X that performs services in Country X. The subsidiary earns $1, 000, on which it pays Country X income tax at a rate of 35% ($350). If all the Country X earnings are distributed as a $650 dividend to USCO, USCO would be allowed a foreign tax credit of $350. Foreign tax credit limit = $350 $1, 000 Foreign Income $1, 000 Taxable Income X $350 (US tax before FTC) 45

Example 1 (cont. ) l Therefore, USCO would have no net US tax liability on those earnings. l It does not matter when the US taxes the earnings in this case. 46

Example 2 Allocating and apportioning expenses reduces the maximum amount of foreign tax credit a US company may receive. l Same as Example 1, except: – The foreign subsidiary has $200 of allocable expenses against foreign income which are not deductible in calculating foreign-country tax. 47

Example 2 (cont. ) – If all the Country X earnings are distributed as a $650 dividend to USCO, USCO would be allowed a foreign tax credit of $280, leaving $70 of foreign taxes paid for which USCO would receive no credit. Foreign tax credit limitation = $280 ($1, 000 Foreign Income - $200 Allocable Expenses) $1, 000 Taxable Income X $350 (US tax before FTC) 48

Other Rules l FTC is Elective l When FTC allowed -either when paid or when accrued Holding period Carryover/Carryback Rules --2 Back and 5 Forward l l l Overall Foreign Losses/Recapture l Currency Exchange Rules Look-thru Rules Alternative Minimum Tax--90% Limitation No FTC allowed for taxes paid/accrued to certain foreign countries l l l 49

Typical Obstacles to FTC Utilization l Foreign tax rates higher than US tax rate l Separate basket limitations l Required allocation and apportionment of deductions l “Overall foreign loss” recapture 50

The US International Tax System: “Deferral” Regime

Deferral l US generally defers its tax on foreign earnings of foreign subs until they are remitted. l US tax is imposed on foreign earnings when they are earned (or deemed earned) by a US person (i. e. , US corporation, citizen or resident individual). 52

Deferral (cont. ) l Fundamental TIMING principle of US tax law. l Issue under this system is not WHETHER, but WHEN, US person will be taxed on foreign earnings. 53

Exceptions l The general rule always has been to defer US tax on foreign earnings of foreign subs. l However, various exceptions to this general rule have been enacted over the years. – Subpart F income u Foreign personal holding company income u Foreign base company sales income u Foreign base company service income 54

Exceptions to Deferral (cont. ) – Subpart F income (cont. ) u Subpart F insurance income u Subpart F shipping income u Foreign oil and gas extraction income u Foreign oil related income u Illegal payments – Section 956 Income (investment in US property) 55

Exceptions to Deferral (cont. ) – PFIC – Personal Holding Company Income – Foreign Investment Company Income l Where an exception applies, a US person may be subject to current US tax (or an interest charge) on foreign source income, even though it has not received the income. 56

Exceptions to Deferral (cont. ) l Present law is complex because there are many sets of potentially overlapping exceptions. l Application of exceptions to deferral typically has depended on two factors: – Level of US ownership – Type of income involved 57

Policy Issues

Policy issues US policy reflects a balance between different goals: l l CEN. Foreign investment should bear same tax burden as domestic investment (so-called “capital export neutrality” or CEN). Competitiveness. US companies should not bear higher tax burden on foreign income than foreign competitors. Harmonization. Follow international tax norms. Protect US tax base. Foreign activities of US companies should not jeopardize US tax base. 59

Policy issues l CEN could be achieved by – Taxing foreign source income when earned – With unlimited foreign tax credit l Competitiveness could be achieved by – Exempting from US tax income from FDI l US System more closely follows CEN by taxing worldwide income, but – Limits foreign tax credit (to project US tax base) – Generally defers tax until income remitted (for competitiveness) 60

Policy issues l l Some argue that US policy should move closer to CEN by further limiting deferral. Others view the increasingly competitive global marketplace as justification for limiting anti-deferral rules. – More level playing field vis-à-vis foreign MNCs – Allows reinvestment of foreign earnings before tax – Offsets other problems in US system Numerous foreign tax credit limits (causing international double taxation) u Lack of corp. integration (domestic double taxation) u 61

Policy issues CEN reconsidered: l No country (incl. US) has a CEN system l Half of OECD countries exempt income from FDI Imposing CEN at corporate level may cause individuals to invest in foreign MNCs Theoretical case for CEN assumes “perfect competition” e. g. , NO intangibles, NO strategic competition, etc. 1 l l 1 Michael Devereux and Glenn Hubbard, Taxing Multinationals, ITPF, 1999. 62