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CRS Explains International Tax Provisions in Senate ETI Repeal Bill

FEB. 18, 2004

CRS Explains International Tax Provisions in Senate ETI Repeal Bill

DATED FEB. 18, 2004
DOCUMENT ATTRIBUTES
  • Authors
    Brumbaugh, David L.
  • Institutional Authors
    Congressional Research Service
  • Cross-Reference
    For the text of an unofficial version of S. 1637 as reported by the

    Senate Finance Committee, see Doc 2003-24262 (378 original pages)

    or 2003 TNT 218-19.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2004-4346 (11 original pages)
  • Tax Analysts Electronic Citation
    2004 TNT 41-36

 

Memorandum

 

February 18, 2004

 

 

TO:

 

Senate Committee on Commerce, Science, and Transportation

 

Attention: Gregg Elias

 

 

FROM:

 

David L. Brumbaugh

 

Specialist in Public Finance

 

Government and Finance Division

 

 

SUBJECT:

 

International Tax Provisions of S. 1637

 

 

[1] This memorandum responds to your request for an explanation of the international tax provisions of S. 1637, approved by the Senate Finance Committee on October 1, 2003 (S. Rpt. 108-92). The bill is designed to resolve the controversy between the United States and the European Union (EU) over the extraterritorial income exemption (ETI) tax benefit for exports that is provided by the U.S. Internal Revenue Code. The EU has complained to the World Trade Organization (WTO) that ETI is an export subsidy that is impermissible under the WTO agreements, and a succession of WTO rulings has essentially supported the EU's position. The EU has received authority to impose retaliatory tariffs on imports from the United States, and has indicated it will phase in the tariffs beginning March 1 of the current year unless the United States repeals ETI.

[2] In broad terms, S. 1637 would repeal ETI and would enact in its stead a range of tax cuts for investment that would include both benefits for domestic U.S. investment and provisions benefitting overseas investment. The measure also contains several revenue- raising measures in addition to its repeal of ETI. These are principally in the area of tax shelters, but also include international provisions in areas such as expatriation. The discussion here, however, is confined to S. 1637 and to those of its provisions applying to foreign source income and overseas investment and to the U.S. income and investment of foreign persons and firms. In addition to provisions applying to U.S. individuals and firms, S. 1637 contains several tax changes for foreign investors in the United States. These provisions, however, are quite narrow and small in their revenue impact and are not discussed here.

[3] The contents of the discussion and explanations is as follows:

Basic Structure of U.S. International Taxation

Deferral, Subpart F, and Related Provisions

Temporary Tax Cut for Repatriated Dividends

"Look Through" Treatment of Dividends and Other Subpart F Income

Subpart F Exception for Aircraft- and Vessel-Leasing Income

Expansion of Subpart F's De Minimus Rule

Other Deferral and Subpart F Provisions

Foreign Tax Credit Proposals

Interest Allocation Rules

Carryover and Carryback Rules

Recharacterization of Domestic Losses

Foreign Tax Credit's Applicability to the Alternative Minimum Tax

Other Foreign Tax Credit Provisions

Expatriation Provisions

Corporate Inversions: Provisions for Corporations

Corporate Inversions: Stock Options

Expatriation by Individuals

 

Basic Structure of U.S. International Taxation

 

 

[4] In broad terms, most of S. 1637's international proposals can be separated into three general categories. The first two apply to the foreign activities of U.S. individuals and firms and consist of modifications to: 1) the U.S. foreign tax credit and its associated rules; and 2) the so-called "deferral" benefit and its limitations under the tax code's Subpart F rules. The third category of proposals applies to the U.S. income and investment of foreign individuals and firms. However, before explaining the proposals in more detail, it is useful to take a brief look at the current U.S. system for taxing international income and investment and how provisions such as the foreign tax credit, deferral, and Subpart F work.

[5] First, tax jurisdiction. The United States applies its tax system on the basis of residence -- that is, it looks to the domicile of a corporation or individual in determining whether it applies its taxes. In broad terms, the United States taxes U.S. residents and citizens on their worldwide income, including both U.S.- and foreign-source income. For firms, the United States applies its residence system by taxing corporations chartered in the United States on their worldwide income.

[6] Next, the deferral benefit mentioned above and its restrictions under Subpart F. While the United States taxes U.S.- chartered corporations on their worldwide income, it generally taxes foreign-chartered corporations only on their U.S.-source income. Thus, a U.S. firm can indefinitely defer U.S. tax on its foreign-source income if it operates abroad through a foreign- chartered subsidiary rather than through a branch of the U.S.- chartered parent corporation. The subsidiary's earnings are not subject to U.S. tax until they are remitted to the U.S. parent as dividends or other income. This ability to postpone (defer) U.S. tax constitutes a tax benefit because of the time value of money -- while the tax liability is postponed, the firm can invest the funds that would otherwise be paid in taxes and earn a return.

[7] The deferral benefit is subject to a restriction under the terms of the tax code's Subpart F. Subpart F applies to foreign-chartered corporations classified by the tax code as controlled foreign corporations (CFCs) -- a classification that applies to a foreign corporation if more than 50% of its stock is owned by U.S. shareholders (including shareholding U.S. corporations), each of whom own at least 10% of the subsidiary's stock. Once a foreign subsidiary qualifies as a CFC, the deferral benefit is denied to certain categories of income -- categories that generally consist of income from passive investment (i.e., interest, dividends, rents, and royalties) and certain other types of income whose allocation among related firms is thought to be easily manipulated. Subpart F denies the deferral benefit by taxing 10% U.S. shareholders of CFCs on their share of the CFC's Subpart F income even if the income is not repatriated.

[8] Finally, the foreign tax credit. If a U.S.-chartered corporation earns foreign income directly rather than through a subsidiary, it is subject to U.S. tax on a current rather than deferred basis. And even under deferral, foreign income may ultimately be subject to U.S. tax when it is repatriated as dividends. Absent special provision, this presents the possibility of double-taxation: because foreign host-countries usually apply at least some tax to foreign (in this case, U.S.) investors, two layers of tax apply when U.S. taxes apply to foreign income. Like many countries, the United States addresses double taxation by providing a foreign tax credit. Under its terms, U.S. taxpayers may credit on a dollar-for-dollar basis the foreign taxes they pay against the U.S. taxes they would otherwise owe.

[9] Importantly, the foreign tax credit is subject to a limitation that generally provides that foreign taxes can only be credited against that portion of a firm's pre-credit U.S. tax liability that applies to foreign-rather than domestic-source income. In effect, a U.S. firm or other taxpayer can use foreign tax credits to offset U.S. tax on its foreign earnings up to the point where the foreign taxes equal the U.S. pre-credit tax on foreign income. At this point, all U.S. tax on the firm's foreign income is eliminated and additional foreign taxes cannot be credited in the current year.

[10] For individuals and firms with U.S.-source income, U.S. tax treatment generally depends on the nature of the income. First, income foreign firms or individuals earn from the conduct of a trade or business in the United States is generally subject to the same tax rules that apply to U.S. individuals and businesses. Second, income from portfolio investment in the United States depends on the type of income and the home country of the investor. Interest income is generally not subject to U.S. tax, nor are capital gains from the sale of portfolio investments. Dividends, rents, and royalties are generally subject to a 30% flat "withholding tax" withheld by the U.S. payor, but the tax is frequently reduced or eliminated by a tax treaty with the investor's home country.

[11] The rules relating to international transactions are among the most complex and elaborate in the U.S. tax code, and the discussion here sets forth the only basic building blocks of the system. However, we turn now to the particular proposals in S. 1637 and provide additional details on the current system as needed.

Deferral, Subpart F, and Related Provisions

[12] The bill's proposed modifications to deferral, Subpart F, and related provisions are all incremental in nature rather than structural reforms of the system. The proposals are also in the same direction: they are tax cuts that apply to foreign source income. In most cases the proposals generally expand the scope of deferral, generally by scaling-back the application of Subpart F. In terms of revenue impact, the largest of the provisions is a temporary reduction in the rate of tax that applies to dividends repatriated to U.S. parent firms from their foreign subsidiaries. Other large items include an increase in Subpart F's de minimus exception and a relaxation of the "look-through" rules.

Temporary Tax Cut for Repatriated Dividends

[13] The deferral tax benefit applies as long as a subsidiary's earnings are reinvested abroad. However, U.S. taxes apply in full -- on a pre-credit basis -- once those earnings are remitted as dividends or other income. Under a provision known as the "indirect" credit, U.S. parent firms can claim foreign tax credits for foreign taxes paid by a subsidiary on the income out of which repatriated income is paid. In general, S. 1637 reduces the pre-credit tax rate applicable to repatriations to 5.25%.1 For a firm subject to the top U.S. corporate rate of 35%, the reduction is the equivalent of an 85% deduction. The reduced rate would only apply for one year, and would only apply to repatriations in excess of a firm's average repatriations occurring in three of the five preceding years. To qualify, repatriations would also be required to be subject to an investment plan approved by the parent firm, under which the repatriated funds would generally be invested in the United States. Eighty-five percent of foreign taxes attributable to the qualified repatriations would not be creditable.

[14] The Joint Committee on Taxation (JCT) has estimated that the rate reduction proposal would increase tax revenues in the first two years after enactment -- presumably because firms are expected to increase their repatriations, and thus pay more tax in the near term, albeit at a reduced rate. However, the provision is expected to lose revenue thereafter, with an estimated revenue loss of $1,931 million over five years (fiscal years 2004-2008, and net of the initial revenue gains) and $3,769 million over 10 years.2

"Look Through" Treatment of Dividends and Other Subpart F Income

[15] Subpart F was enacted in 1962 as a means of discouraging firms from augmenting the benefits of deferral by artificially shifting income to foreign subsidiaries located in low-tax ("tax haven") countries. As described above, a principal class of income within the scope of Subpart F is income from passive investment -- including dividends, interest, rents, royalties, and certain similar types of income received by a CFC. Subpart F makes a "look through" exception, however, and does not apply current taxation to dividends and interest a CFC receives from a related foreign corporation chartered in the same country as the CFC -- presumably because the possibility of cross-border income-shifting does not exist in such cases. S. 1637 expands the look-through exception to Subpart F by including qualified payments received from related corporations whether or not the related firms are organized in the same country as the CFC, and by including rents and royalties as well as dividends and interest as income that qualifies for the exception. The JCT has estimated that this provision would reduce tax revenue by $733 million over five years and $2,193 million over 10 years.

Subpart F Exception for Aircraft- and Vessel-Leasing Income

[16] Along with passive investment income such as dividends, interest, rents, and royalties (income Subpart F terms "foreign personal holding company income"), Subpart F applies to certain other types of income whose source is thought to be relatively easy to manipulate. One such category of other income is what Subpart F terms "foreign base company shipping income," which is generally income from international air or sea transportation. It includes within its scope not only income a CFC earns from its own provision of transportation services, but also income from the leasing of aircraft or vessels for use in foreign commerce. (Note that even if foreign base company shipping income were not a category of Subpart F income, a firm's transportation-related leasing income might be within the scope of Subpart F as rent.) S. 1637 would exempt income from the active conduct of an aircraft- or vessel-leasing business from Subpart F under both the foreign base company shipping income rules and the foreign personal holding company rules. The JCT has estimated that the proposal would reduce tax revenue by $233 million over five years and $1,914 million over 10 years.

Expansion of Subpart F's De Minimus Rule

[17] Subpart F contains a de minimus rule that essentially provides that if a CFC's Subpart F income is less than the smaller of 5% of its gross income or $1 million, then no part of the CFC's income is subject to Subpart F. S. 1637 expands the de minimus level to the lesser of 5% of gross income or $5 million. The JCT has estimated that the proposal would reduce tax revenue by $488 million over five years and $1,649 million over 10 years.

Other Deferral and Subpart F Provisions

[18] S. 1637 contains a number of additional provisions that would modify Subpart F or deferral, but that are estimated to have a smaller impact on tax revenues than the provisions described thus far. These additional provisions are thus likely to be more limited in their applicability. They include:

  • a modification of the rules governing the circumstances under which income from commodities transactions is included in Subpart F (revenue loss of $34 million over fiscal years (FY) 2004-2008 and $88 million over 2004-2013);

  • elimination of the tax code's foreign personal holding company and foreign investment company rules. These sets of rules, like Subpart F, can restrict deferral in some cases, although their applicability is likely considerably narrower (revenue loss of $244 million over FY2004-FY2008 and $822 million over FY2004-FY2013);

  • exemption of gain from the sale of partnership interests from Subpart F (revenue loss of $327 million over FY2004-FY2008 and $911 million over FY2004-FY2013);

  • provides more flexible rules under which a firm that conducts an active financing business can qualify for the current law's temporary exception from Subpart F (revenue loss of $9 million over FY2004-FY2008 and $21 million over FY2004-2013);

  • adds exceptions to the rules that include CFC investments in U.S. property in Subpart F (revenue loss of $66 million over FY2004-FY2008 and $194 million over FY2004-2008).

Foreign Tax Credit Proposals

 

 

[19] As with its deferral and Subpart F proposals, S. 1637's foreign tax credit proposals are incremental in nature rather than a wholesale reform of the foreign tax credit's basic structure. This is not to say, however, that the bill proposes no important changes. The bill's largest change would be in the rules for allocating interest expense, which would reduce revenue by $11.5 billion over the first five years it is in effect. (The change would not apply until 2009.) As with deferral, the foreign tax credit proposals are generally tax reductions, providing more generous rules for the foreign tax credit and its associated limitations and income allocation rules.

Interest Allocation Rules

[20] As described above, the tax code provides that foreign tax credits can only offset that portion of a firm's U.S. pre-credit tax liability that applies to foreign rather domestic income. To calculate the limitation, then, taxpayers must separate their taxable income into that with a foreign source and that with a domestic source. Because taxable income consists of gross income (generally, revenue) minus deductible costs, the "sourcing" of taxable income requires, in turn, that a taxpayer assign both its items of income and deductible costs to either domestic or foreign sources.

[21] Whether a particular item of revenue or cost is assigned to a U.S. or foreign source can have an important impact on a firm's after-credit tax liability. To illustrate, if a deduction is assigned to a foreign rather than domestic source, it is subtracted from foreign rather than U.S. gross income and reduces foreign taxable income rather than U.S. taxable income. As a consequence, the portion of a firm's pre-credit U.S. tax liability that applies to foreign income is reduced rather than the portion that applies to U.S. income. Since foreign tax credits can only offset U.S. tax on foreign income, assignment of a cost to foreign sources therefore reduces the maximum foreign tax credits a firm can claim. And if a firm has paid a large volume of foreign taxes, the foreign tax credit's limitation is a binding constraint and the assignment of the cost to foreign sources can increase the firm's after-credit U.S. tax liability.

[22] Given the potential importance of income and cost allocations to firms with large volumes of foreign tax credits, the tax code and associated Internal Revenue Service regulations contain elaborate rules governing the allocation of income and costs -- including rules governing the allocation of interest expense. Current law provides for the allocation of interest expense based on the proportion of the firm's assets that are located abroad. Thus, even if all of a domestic firm's borrowing is done in the United States, part of its interest expense may be allocated abroad. This is based on the notion that debt is fungible -- that regardless of where borrowing occurs, it funds the totality of a firm's investment.

[23] U.S. firms have long complained about the operation of current law's interest allocation rules. Current law's particular allocation method is sometimes referred to as a "water's edge" allocation because of its treatment of foreign subsidiaries: under current law's water's edge method, the borrowing of a firm's foreign subsidiaries is not explicitly included in the allocation. Specifically, debt-financed assets of subsidiaries are not included when a firm calculates the share of its assets located abroad; subsidiary assets are included only to the extent of parent ownership of subsidiary stock. In isolation, this omission has the effect of reducing the amount of interest allocated to foreign sources and increases creditable foreign taxes. But a second feature of current allocation rules works in the opposite way: none of a foreign subsidiary's interest expense is included in the calculation or allocated to domestic sources -- such an inclusion could reduce domestic income and increase creditable foreign taxes. Mathematically, the impact of omitting foreign interest is larger than omitting foreign assets so that, on balance, omitting foreign debt from the formula reduces creditable foreign taxes.

[24] S. 1637 would substitute a "worldwide" allocation regime for current law's water's edge rule. Under this method, the interest costs of foreign subsidiaries would be explicitly included in the allocation formula and subsidiary assets would be included in the allocation formula on a gross basis rather than a net-of-debt basis. In isolation, the first of these changes would increase firms' foreign tax credits and reduce taxes while the second would have the reverse effect. On balance, switching to S. 1637's worldwide allocation regime would increase firms' foreign tax credits and reduce their after-credit U.S. taxes.

[25] As noted above, the new rules would not apply until 2009 under S. 1637. The JCT has estimated that the interest allocation proposal would reduce tax revenue by $11,467 million over fiscal years 2009 -- 2013.

Carryover and Carryback Rules

[26] Because the foreign tax credit limitation provides that foreign taxes can only offset U.S. tax on foreign income, a firm that pays foreign taxes at high rates may have a certain amount of foreign taxes that are not creditable -- termed "excess credits" in tax parlance.3 While excess credits cannot be used in the current year, they can be "carried back" and used to offset pre- credit U.S. tax (if any) on foreign income from the two preceding years. If the carryback does not exhaust a firm's excess credits, they can be "carried forward" and used to offset pre-credit U.S. tax in the five succeeding years. S. 1637 shortens the carryback period to one year but lengthens the carryforward period to 20 years. The JCT has estimated that the net result will be a reduction in tax revenues of $1,488 million over five years and $6,556 over 10 years.

Recharacterization of Domestic Losses

[27] The U.S. tax code contains special loss carryforward rules that interact with the foreign tax credit rules in a way that can increase the tax liability of a firm with domestic losses. The loss rules work as follows: if a firm's allowable deductions in a particular year exceed its gross revenue, it registers a negative amount of taxable income, or a loss for tax purposes (termed a net operating loss, or NOL). NOLs can be carried back and deducted from positive taxable income (if any) in the preceding two years; NOLs not used as carrybacks can be carried forward up to 20 years. Deductible carrybacks generate tax refunds; carryforwards generate tax savings in the future year to which they are carried.

[28] If a firm incurs a tax loss with respect to its domestic operations, the loss is deducted from foreign-source taxable income, thus reducing the firm's pre-credit U.S. tax on foreign income. If a firm pays sufficient foreign taxes in such a situation, the deduction of the loss may generate no tax savings: if there are sufficient foreign tax credits to offset any U.S. tax to begin with, the deduction makes no difference. At the same time, deduction of the loss uses an equal amount of the firm's potential NOL carryforward, and thus reduces the tax savings the firm would ultimately realize in the future year to which the NOL would be carried. In effect, the foreign tax credit rules deny the use of some or all of the firm's NOL carryforward. S. 1637 would permit taxpayers that incur a domestic NOL in a particular year to recharacterize a portion of U.S.-source income earned in future years as foreignsource income. For a firm with excess foreign tax credits, the recharacterization would increase its maximum creditable foreign taxes and thus reduce its U.S. tax liability to compensate for the loss of the NOL. The maximum amount that could be recharacterized would generally be 50% of the firm's domestic income. The JCT has estimated that the provision would reduce tax revenue by $737 million over fiscal years 2004-2008 and $4,690 million over 2004-2013. The provision would not come into effect, however, until 2007. The average annual revenue loss after the provision is effective would thus be between $700 and $800 million per year.

Foreign Tax Credit's Applicability to the Alternative Minimum Tax

[29] In effect, the U.S. corporate income tax consists of two parallel taxes: the regular corporate income tax and the alternative minimum tax (AMT). In general, a firm calculates both amounts and pays whichever is higher. The two amounts ordinarily differ, because the AMT tax rates are lower than those of the regular tax, but fewer special tax benefits and deductions are permitted to reduce taxable income under the AMT. Because the AMT permits fewer tax benefits, its measurement of income more closely approximates a firm's true economic income. Thus, the function of the AMT is to ensure that no truly profitable firm can escape paying at least some tax, regardless of the volume of tax benefits it is permitted to use under the regular tax.

[30] Calculation of the foreign tax credit limitation for AMT purposes is similar to its calculation under the regular tax. Credits are limited to the portion of a firm's AMT that applies to foreign income, with the foreign AMT tax liability based on AMT definitions of income. In addition, however, current law provides that foreign tax credits may offset no more than 90% of a firm's pre-credit AMT tax liability. S. 1637 would repeal the additional 90% limitation. The JCT has estimated that the provision would reduce revenues by $1,263 million over five years and $2,964 million over 10 years.

Other Foreign Tax Credit Provisions

[31] S. 1637 contains a number of additional foreign tax credit provisions that are likely to be more limited in their scope than the provisions described thus far. These narrower provisions include:

  • more generous "look through" rules for calculating the foreign tax credit limitation with respect to dividends received from partially-owned subsidiary corporations (revenue loss of $742 million over FY2004-FY2008 and $743 million over FY2004- FY2013);

  • more flexible rules for claiming indirect foreign tax credits for taxes paid by foreign subsidiaries owned indirectly through partnerships (revenue loss of $10 million over FY2004- FY2008 and $25 million over FY2004-2013);

  • more flexible rules for claiming foreign tax credits in connection with tax base differences -- that is, foreign tax credits generated by amounts that are income under foreign tax laws, but not under U.S. tax principles (revenue loss of $69 million over FY2004-FY2008 and $205 million over FY2004-2013);

  • more generous rules for calculating the foreign tax credit limitation in the case of "deemed" royalty payments arising from the transfer of intangible assets to foreign subsidiaries (revenue loss of $41 million over FY2004-FY2008 and $66 million over FY2004-FY2013).

 

Expatriation Provisions

[32] As noted at the outset, S. 1637 contains a number of revenue raising provisions in addition to its repeal of ETI. The largest single item among these is in the area of tax shelters, and is not confined to international taxation -- a proposed clarification of the "economic substance" doctrine and related penalty provisions. In addition, however, the bill contains several significant revenue raisers that are in the international area -- a set of proposals that would impose more stringent tax rules on both individual and corporate expatriations. The latter are sometimes also referred to as corporate "inversions."

Corporate Inversions: Provisions for Corporations 4

[33] As described above, the United States does not tax the foreign source income of foreign-chartered corporations; it taxes U.S.-chartered corporations on their foreign subsidiaries' income only when it is repatriated or if it is subject to the provisions of Subpart F. In recent years, apparently growing numbers of U.S. firms have undertaken corporate reorganizations ("inversions") designed to increase their tax savings under this structure. A typical inversion begins with a firm consisting of a group of affiliated corporations whose corporate parent is chartered in the United States. The firm reorganizes so that ownership of the group is vested in the hands of a new corporate parent located in a low-tax foreign country. The stockholders of the U.S. parent corporation become stockholders of the new foreign parent. A typical inversion does not involve any significant movement of real resources or investment and occurs only on paper. Its principal result is in the area of taxes. Because dividends of the foreign subsidiaries are now paid to the new foreign parent, the firm is no longer subject to U.S. tax on repatriations or Subpart F.5

[34] S. 1637 would impose two new tax regimes on inversions, depending on ownership thresholds and on when the inversions occur. Under the first regime, S. 1637 would tax a foreign parent corporation like a domestic corporation if it passes an ownership threshold, thus nullifying much of the tax benefit an inversion can generate. The test would be met if at least 80% of the foreign corporation is owned by the former shareholders of a domestic corporation or partnership that had transferred substantially all of its property to the foreign parent. The threshold also requires the foreign parent and its affiliates not to have "substantial business activities" in the country of incorporation, and applies only to inversions that occur after March 20, 2002.

[35] S. 1637's second regime is based on a 50% ownership test and would potentially apply whether the inversion occurs before or after March 20, 2002. (The second set of rules would not apply, however, to post-March 20 inversions subject to the bill's first regime.) The second regime would act as a type of toll tax on the shifting of the firm's foreign subsidiaries from the former U.S. parent to the new foreign parent. The tax would apply the highest corporate tax rate (or the highest individual tax rate, in the case of partnerships) to stock received by the former domestic parent from the new foreign parent in exchange for ownership of the firm's foreign subsidiary corporations. Neither foreign tax credits nor net operating losses would be permitted to offset the tax.

[36] The provisions are estimated by the JCT to increase revenue by $819 million over five years and $2,610 million over 10 years.

Corporate Inversions: Stock Options

[37] An additional provision of S. 1637 would impose an excise tax on stock options related to inversions. Under the provision, officers, directors, and 10% owners of inverted firms would be subject to a 20% excise tax on compensation that is directly linked to the value of an inverting corporation's stock. Such compensation would include stock, certain stock options (generally non-qualified stock options), and other stock-based compensation. For stock options, the tax would apply to the value of the option at the time of the inversion, determined by an option-pricing model specified by the Treasury Department. The excise tax would apply, however, only when the inversion in question triggers recognition of shareholder- level capital gains. The JCT has estimated that the stock option provisions related to inversions would increase tax revenue by $32 million over five years and $68 million over 10 years.

Expatriation by Individuals

[38] The tax treatment of individuals rather than firms is the focus of a second set of expatriation provisions in S. 1637. In a manner parallel to corporations, the United States taxes U.S. citizens and foreigners resident in the United States on their worldwide income.

[39] In contrast, U.S. taxes do not apply to the foreign income of non-resident foreign individuals ("nonresident aliens," in tax parlance). Further, as described above, the U.S. taxation of the U.S.-source income of nonresident aliens depends on the type income. While a withholding tax applies to some income, other income -- most capital gains and interest -- is exempt from U.S. tax.

[40] Given this structure -- and absent special provisions -- a U.S. citizen not averse to living abroad could reduce or eliminate his or her U.S. taxes by relinquishing U.S. citizenship and moving abroad. The erstwhile U.S. person -- now a nonresident alien -- could then collect U.S. capital gains and interest income without paying U.S. tax. Further, any foreign-source income would be exempt from U.S. tax. Special provisions do exist, however, that are designed to at least restrict such tax-saving strategies. Section 877 of the tax code generally provides that individuals who relinquish their U.S. citizenship or terminate their U.S. residency and whose income exceeds certain thresholds are subject to full U.S. taxation for the 10 years following their expatriation. S. 1637 would provide more stringent treatment by taxing expatriates on accrued but unrealized U.S. capital gains. The bill would treat expatriates as having sold their U.S. capital assets for their fair market value at the time of expatriation; the tax would only apply to gain exceeding $600,000. The JCT has estimated that the provision would increase revenue by $410 million over five years and $700 million over 10 years.

 

FOOTNOTES

 

 

1 The bill actually imposes what it terms a 5.25% "toll tax" on qualified dividends in lieu of the regular corporate income tax. The effect, however, is the same as that of a rate reduction.

2 The revenue estimates are from U.S. Congress, Senate Committee on Finance, Jumpstart our Business Strength (JOBS) Act, report to accompany S. 1637, 108th Cong., 1st sess., S. Rpt. 108-192, (Washington: GPO, 2003) p. 227. The intent of the proposal is to encourage U.S. firms to undertake additional repatriations so as to increase U.S. investment. For an economic analysis, see CRS Report RL32125, Tax Exemption for Repatriated Foreign Earnings: Proposals and Analysis,, by David L. Brumbaugh.

3 The concept of excess credits applies to the preceding discussion of the interest allocation rules as follows: the interest allocation rules only matter for those firms for whom the foreign tax credit limitation is a binding constraint -- that is, those firms with excess credits.

4 For additional information on inversions, CRS Report RL31444, Firms That Incorporate Abroad for Tax Purposes: Corporate "Inversions" and "Expatriation," by David L. Brumbaugh.

5 In some cases, an inversion may trigger capital gains tax at the individual stockholder level. It is generally thought, however, that downturn of the stockmarket in past years -- along with extensive stock ownership by tax-exempt entities -- reduced the applicability of such taxes and helped stimulate inversions.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Brumbaugh, David L.
  • Institutional Authors
    Congressional Research Service
  • Cross-Reference
    For the text of an unofficial version of S. 1637 as reported by the

    Senate Finance Committee, see Doc 2003-24262 (378 original pages)

    or 2003 TNT 218-19.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2004-4346 (11 original pages)
  • Tax Analysts Electronic Citation
    2004 TNT 41-36
Copy RID