CRS Analyzes FTC Interest Allocation Rules in Tax Relief Bill

September 17, 1999

David L. Brumbaugh Specialist in Public Finance Government and Finance Division and Jane G. Gravelle Senior Specialist in Economic Policy

ABSTRACT

[1] On August 5, 1999, Congress passed H.R. 2488, the Taxpayer Refund and Relief Act, a bill that provided tax cuts for individuals and business. The largest tax cut for businesses was adoption of so- called "worldwide allocation" rules for treating interest expense for purposes of the U.S. foreign tax credit. The proposed rules probably would make the foreign tax credit rules function more nearly as they were intended. However, other proposed changes -- specifically, the bill's "subgroup elections" -- might reduce the accurate functioning of foreign tax credit. While President Clinton vetoed the bill on September 23, the interest allocation issue may surface in future legislation. This report will be updated as legislative developments occur.

The Taxpayer Refund and Relief of 1999 and the Foreign Tax Credit's Interest Allocation Rules

Summary

[2] On August 5, Congress approved H.R. 2488, the Taxpayer Refund and Relief Act of 1999 (TRRA). Along with tax cuts for individuals, the bill contained business tax reductions, including the topic of this report: more generous rules for the treatment of interest expense when multinational firms calculate foreign tax credits (costing $24 billion over 10 years). While President Clinton vetoed the bill on September 23, the interest allocation issue may surface again in future legislation.

[3] The foreign tax credit alleviates the double-taxation that would result if U.S. investors' overseas income is 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 concedes 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 TRRA 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 neither can deductions allocated abroad reduce U.S. tax; the effect is the same as if deductions allocated to foreign sources cannot be claimed for U.S. tax purposes.

[4] If a U.S. firm has foreign investments, current law requires at least part of the its 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, however, suggested that granting multinationals tax benefits through interest allocation revisions should be accompanied by restrictions on the benefit of deferral, which allows taxes to be deferred on profits that are not repatriated). Under the TRRA, firms could indeed do this; part of a foreign subsidiary's interest expense could reduce U.S. rather than foreign income, thus increasing creditable foreign taxes while reducing U.S. tax.

[5] The analysis here indicates that current law's interest allocation rules are likely imperfectly structured and that worldwide allocation of interest as proposed in H.R. 2488, while losing revenue, would probably be more consistent with the basic objective of the foreign tax credit limit. Tax planning techniques could, however, 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, certain "subgroup" elections contained in H.R. 2488 do not appear consistent with the general objective of worldwide allocation of interest. Although the bill 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 developments occur.

                              CONTENTS

[6] The Taxpayer Refund and Relief Act of 1999 (H.R. 2488; the TRRA) was passed by both the House and the Senate on August 5, 1999. President Clinton vetoed the bill on September 23 because of the size of the tax cut it delivered; it would reduce taxes by an estimated $792 billion over 10 years. Beyond its general outlines, a number of the bill's specific provisions have also been the focus of debate. Among these is the topic of this report and the largest business tax cut in the bill: more generous rules for multinationals to use in allocating interest expense for purposes of the U.S. foreign tax credit, also called the "worldwide" allocation of interest. According to the Joint Committee on Taxation, the provision would reduce tax revenues by an estimated $24 billion over 10 years. ¹

[7] The TRRA's interest allocation provision was designed to correct what multinationals argue is an imperfection in the design of current law's foreign tax credit rules. In general, the tax code places a limitation on the foreign tax credit. To calculate it, firms are required to separate interest and other expenses into those with domestic sources and those with foreign sources. Because of effects that are 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 liabilities. Firms have argued that current law requires excessive interest to be allocated to foreign rather than U.S. sources, thereby improperly reducing creditable foreign taxes and increasing U.S. tax. The TRRA would address this perceived flaw.

[8] The analysis here indicates that current law's interest allocation rules are probably imperfectly structured and that worldwide allocation of interest, while losing revenue, would probably be more consistent with the basic objective of the foreign tax credit limit. Tax planning techniques could, however, 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.

[9] The TRRA contained another important modification of the interest allocation rule provisions that would increase a firm's creditable foreign taxes. Specifically, it would have permitted firms to maintain subsidiaries and groups of subsidiaries for whom the interest allocation rules can be calculated separately. This particular provision could insulate firms from a large part of the code's interest allocation rules, and would be at odds with the theoretical model underlying the TRRA's other provisions.

[10] The rest of the report begins with a more detailed explanation of the foreign tax credit and the principles underlying it. It continues with an analysis of H.R. 2488's proposed changes: first, its change in the allocation formula; then the "subgroup election" provisions.

FUNCTION AND MECHANICS OF THE U.S. FOREIGN TAX CREDIT

[11] The U.S. tax code's 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. The credit is one of the principal structural pieces in the U.S. system of taxing foreign-source income. It fits in as follows: the United States -- at least in principle -- taxes its resident corporations and individuals on their worldwide income, regardless of where it is earned. A U.S. corporation chartered in Delaware, for example, is potentially subject to U.S. tax on income it earns in, say, Germany or France. At the same time, however, the foreign country where income is earned frequently asserts the right to tax that income, even if it is earned by a foreign (in this case, U.S.) investor. This raises the possibility of double-taxation of the foreign-source income by both the United States and the source country. Absent some provision, much foreign-source income would be subject to very high rates of tax.

[12] But the foreign tax credit alleviates the possibility of double-taxation of foreign income. With the credit, the United States implicitly concedes that the country where income is earned has the primary right to tax that income and collect the tax revenue it generates. In a sense, the United States gives to the foreign source country the first opportunity to collect tax revenue from foreign income, and itself collects any remaining tax revenue. In contrast to a number of other tax credits and special exclusions contained in the U.S. tax code, the foreign tax credit in general is not a tax benefit or tax expenditure favoring selected groups, but one aspect of the way the United States defines its tax jurisdiction.

[13] What may seem initially like a straightforward mechanism for dealing with overlapping tax jurisdictions has numerous complications and specialized provisions. To understand the rules changed by the 1999 Act, it is useful to take a quick look at two of these: the deferral principle and the foreign tax credit limitation.

Deferral

[14] As noted above, the United States asserts the right to tax its resident corporations and individuals on their world wide income. But U.S.-owned firms can easily arrange to conduct their foreign operations through subsidiary corporations that are chartered abroad and that do not, therefore, qualify as U.S. "residents" for tax purposes. Indeed, foreign-chartered corporations are not subject to U.S. tax on their foreign income. Thus, if U.S. firms earn their foreign income through foreign-chartered subsidiaries, U.S. tax is deferred on the foreign income as long as it is reinvested abroad, and until such time as it is repatriated to the U.S. parent firm as intra-firm dividends. ²

[15] Foreign tax credits can be claimed with respect to U.S. tax on dividends received from foreign subsidiaries. Not only can foreign taxes levied directly on the dividends be credited (so-called "withholding" taxes imposed as dividends flow out of a country), but "indirect" foreign tax credits can be claimed by a U.S. parent firm for foreign taxes paid by the subsidiary during the period of time the income was tax-deferred. ³ As discussed below, it is these indirect foreign tax credits on dividends paid by a subsidiary that are partly at issue in H.R. 2488.

[16] Some have argued that a revision in multinational taxation to grant tax reductions to multinational firms, as in H.R. 2488, should be accompanied by a repeal or restriction of the benefits of deferral (which would raise revenues) in order to provide a more consistent system of taxation of U.S. taxation of foreign source income.

Foreign Tax Credit Limitation

[17] As noted above, the United States concedes to foreign countries where income is earned the primary right to tax foreign- source income. It retains, however, the primary right to tax U.S. source-income. The United States thus imposes a limitation on the foreign tax credit that provides that foreign taxes can be credited only against the portion of a taxpayer's U.S. tax liability that falls on foreign, and not U.S., income. Foreign taxes that exceed the limitation cannot be credited in the year they are paid, although they can be carried back two years and carried forward five years. Foreign taxes that exceed the limit and that cannot be credited are sometimes termed "excess credits;" firms whose foreign taxes exceed the limit are said to be in an "excess credit" position.

[18] The function of the limitation in protecting the U.S. tax base can be demonstrated by imagining a possible scenario if there were no limitation. A foreign government needing additional tax revenues, but also not wishing to discourage U.S. investment could increase its tax on U.S. investment that it hosts far beyond the U.S. tax rate on foreign income. The U.S. firm -- assuming it has sufficient U.S. tax liability -- could simply credit all the foreign government's taxes against its U.S. tax liability on U.S. income, and would not be dissuaded from continuing its foreign operations.

[19] 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 limitation, a U.S. investor pays total taxes (that is, U.S. plus foreign taxes) on foreign income at an average rate equal to the U.S. pre-credit tax rate or the foreign tax rate, which ever is higher. 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 percentage points of foreign tax plus the 25 percentage points of U.S. tax that remain after 10 percentage points has been offset by foreign tax credits. The total rate would be (10% + 25% = 35%). Or, if the foreign tax rate is 50%, the firm could offset all its U.S. tax on foreign income with the foreign tax, and would pay total tax at a 50% rate, consisting only of foreign taxes. ⁴

[20] If a firm is in an excess credit position -- that is, if its foreign taxes exceed U.S. tax on foreign-source income and the foreign tax credit limit becomes a binding constraint -- how the tax code requires income and deductions to be sourced matters. To see why, note again that 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 maximum foreign tax credits are increased because foreign income and the share of U.S. pre-credit tax falling on foreign income are 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 thus increases after-credit U.S. tax.

[21] We turn in a moment to a closer look at the rules for assigning a source to income and deductions and how the TRRA proposed to change them. First, however, it is useful to recap the U.S. international tax system so as to understand the implications of the TRRA's proposal and its place in the system. The principal characteristic of the U.S. method of taxing foreign income is that it has a patchwork of effects. For example, the deferral principle produces an incentive to invest abroad. In general, however, in alleviating double-taxation, the foreign tax credit promotes even taxation of foreign and domestic income and investment. Such evenness has several salubrious effects, promoting both economic efficiency (because taxes do not distort the decision of where to invest in such cases) as well as tax equity. A price the United States is implicitly not willing to pay to promote such evenness, however, is its own primary tax base -- income earned within the United States. This is the intended function of the foreign tax credit limit -- to protect the U.S. tax base.

INTEREST ALLOCATION RULES IN H.R. 2488

"Worldwide" Allocation Provisions

[22] Again, whether an expense is deducted from foreign or U.S. income matters for tax purposes. The tax code accordingly contains rules for allocating deductions between U.S. and foreign sources. Current law provides for the allocation of interest expense by combining that of the parent firm and its domestic subsidiaries. A portion of the interest is then allocated to foreign source income (and affects the foreign tax credit limit) even if the funds are borrowed in the United States. The allocation is based on the share of the group's assets located in the United States or abroad.

[23] The allocation of part of domestic borrowing to foreign sources is based on the notion that borrowing is "fungible": that borrowed funds are interchangeable and that borrowing in one location supports a firm's investment in all locations. Thus, for example, a U.S. parent company might borrow in the United States, use its borrowed funds to increase its equity stake in a foreign subsidiary, which in turn uses the transfer from its parent to undertake its own investments. Or suppose a firm borrows in the United States and uses the funds to finance domestic investment -- investment that might otherwise be financed with earnings repatriated from a foreign subsidiary. If, however, the domestically borrowed funds permit the subsidiary to retain its earnings which it then uses to finance investment abroad, the domestic borrowing has, in effect, helped support that foreign investment as well as domestic investment. (Of course, this implies that equity is fungible too; that the subsidiary's retained earnings support investment at home and abroad.)

[24] Is fungibility of debt a reasonable assumption on which to base interest allocation rules? For it to be a perfect representation of the real world, firms would have to be able to shift borrowed funds costlessly from one member of the corporate group to another. And to a certain extent, it seems reasonable to suppose they can. Corporations are, after all, only legal entities, not economic ones, and corporate boundaries can frequently be manipulated with ease. On the other hand, the existence of different interest rates in different locations may be evidence that fungibility does not hold in all locations. It is beyond the scope of this report to examine the reasonableness of fungibility, except to note that it underlies the current allocation of interest rules (as well as those in H.R. 2488). ⁵

[25] Current law applies the fungibility principle in a particular way that is sometimes referred to as a "water's edge" allocation. Under this system, foreign subsidiaries are not explicitly included in the allocation, which has two implications for the allocation formula. First, only a domestic parent's equity stake in its foreign subsidiary is counted as a foreign asset; the share of the subsidiary's assets financed by debt is not included in the calculation. At the same time, the parents assets are all included in the calculation, whether financed by debt or equity. The second implication of the current water's edge allocation rule is that the subsidiary's own interest expense is automatically allocated only to foreign sources -- none is allocated to domestic sources. This second effect occurs because the subsidiary's interest expense reduces dividend payments to the parent which are all allocated to foreign sources.

[26] An alternative to water's edge allocation is a "worldwide" allocation regime, which was proposed as an election in H.R. 2488. Under worldwide allocation, the borrowing of the 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, effectively allocating part of foreign debt to domestic uses, reducing foreign source deductions, increasing foreign source income, increasing the foreign tax credit limit (and the credit) and reducing U.S. tax liability. The second effect is to measure foreign subsidiary assets on a gross basis rather than a net-of-debt basis, which increases the foreign share of assets. This change, taken in isolation, would allocate more interest to foreign sources and raise U.S. tax liability. However, mathematically, the first effect dominates, so that tax liability falls.

[27] There is one restriction on worldwide allocation as proposed by H.R. 2488: the allocation formula cannot be used to make a negative allocation. That is, the amount of foreign interest reallocated to domestic uses cannot exceed the amount of domestic interest allocated to foreign uses. There are reasons for applying this restriction, as discussed under the section on the problems and limitations of the worldwide allocation.

The Advantages of Worldwide Allocation

[28] Does water's edge or worldwide allocation more nearly accomplish the intended purpose of the foreign tax credit limitation? As demonstrated in the appendix, if borrowed funds are assumed to be fungible, the worldwide allocation more accurately limits the foreign tax credit to income that is attributable to a foreign source. Even if the parent company borrows and uses part of that borrowing to fund foreign operations, if the foreign subsidiary itself borrows, that borrowing should also be taken into account.

[29] Briefly, this conclusion results as follows: if it is assumed that economic reality is best represented by the fungibility of borrowing -- that is, if it is true that borrowing in one location finances investment in all locations equally -- then it is also true that whether a firm borrows at home or abroad should not change the share of income earned in respective locations. It also follows, then, that if the foreign tax credit limitation is functioning properly, a taxpayer should not be able to affect maximum creditable foreign taxes -- and after-credit U.S. taxes -- by shifting the location of borrowing. Under current law, the limitation can be affected if borrowing is shifted; under worldwide allocation, foreign tax credits are not changed by shifting. (As described subsequently, there may be actions companies can take to benefit from the worldwide allocation formula as well as explicit provisions of H.R. 2488, that diminish the accuracy of the foreign tax credit limit if fungibility of borrowing is assumed.)

Disadvantages and Complications of Worldwide Allocation

[30] While worldwide allocation would achieve a more accurate foreign tax credit limitation, there are also some complications and disadvantages to such an approach: administrative complications, possible tax planning techniques that permit companies to further lower their U.S. tax, and some potential increases in investment distortions (even though U.S. tax revenue is lost rather than gained). And again, if interest rates vary across localities, it is not clear whether fungibility of borrowing is pervasive and that worldwide allocation of interest is completely appropriate.

Administrative Complications.

[31] 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 tax administration and compliance.

Tax Planning Possibilities.

[32] A second problem 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 jurisdiction has a debt to asset ratio as high as 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 the only debt a $50 million one of the parent company. Under both current and proposed rules, half of the debt ($25 million) would be allocated to the subsidiary, and this allocation is consistent with the concept of worldwide fungibility of debt as well. If the subsidiary could, however, borrow $100 million and redeposit that $100 million in a bank account, then no allocation would occur. The subsidiary would now have $200 million of gross assets, two-thirds of the total, gross debt would be $150 million and $50 million would be allocated to domestic uses.

[33] Indeed, this 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.

[34] This discussion merely outlines a possible tax planning technique; firms may not engage in it and there are some potential transactions costs involved. But, at the extreme, such rules would be tantamount to eliminating the allocation rules entirely. It is possible that there are methods that could be used to prevent such practices, but they would be complex and perhaps difficult to enforce. At any rate, such methods were not contained in H.R. 2488.

Economic Efficiency.

[35] Another disadvantage of worldwide allocation concerns economic efficiency. As noted above, the foreign tax credit is not concerned principally with efficient allocation of resources; it is concerned with protecting the principal U.S. tax base. Nonetheless, the impact of worldwide allocation on the ability of the economy to efficiently allocate investment and borrowing among different locations can be viewed as a cost of fine-tuning the foreign tax credit limitation. Perhaps surprisingly, the worldwide allocation approach would actually be less efficient in some respects in bringing about an allocation of debt and equity capital that would be more likely to occur in a non-tax environment; it would add to tax distortions in the allocation of capital.

[36] First, worldwide allocation magnifies tax-based incentives to borrow abroad -- a consideration that is potentially important if debt is, in fact, not fungible. When worldwide interest is allocated for purposes of the foreign tax credit limit on the basis of aggregate capital stock, the effect of reducing borrowing in the United States and increasing it abroad is a saving in the amount of the foreign tax rate times the interest on the debt that is shifted abroad. For example, if the interest rate were ten percent, and the foreign tax rate were 40 percent, $100 dollar of debt shifted from the U.S. to the foreign locale would save the company $4 (40 percent of the ten dollars of interest). If there were no allocation rules at all, however, then a shift of debt abroad would lead to larger interest deductions 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. In our example, the foreign tax rate is 40 percent and the U.S. rate is 35 percent, so that the savings is only $0.50 (.05 times interest). The current system is in between these two cases; the allocation of domestic interest does mean that a shift of debt abroad has an effect in reducing the foreign tax credit limitation, but not the full effect that would occur with no allocation rules. (These reductions would be greater with a larger domestic capital stock relative to the foreign capital stock, and larger the more equity finance is used initially).

[37] Similarly, the degree to which equity investment is discouraged in the high tax countries (a general, but inevitable, efficiency problem with international taxation), while minimized when there is no allocation rule at all, is likely to be larger with a worldwide allocation system than with the current allocation system. (This conclusion would hold if domestic borrowing is large relative to foreign borrowing).

[38] The efficiency effects of shifting both debt and equity abroad simultaneously would be more complex and depend on 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.

[39] Overall, the best system for minimizing the distortions in both the allocation of borrowing and the allocation of equity investment is to have no allocation rules at all. Nevertheless, if the parent tends to do most of the borrowing (which might occur for a variety of non-tax reasons), having no allocation rules could cause a significant loss of U.S. revenue compared both to the current system and to the worldwide allocation approach. That is, some efficiency cost is necessary to protect U.S. revenue. But, in both cases, partial allocation rules are less distorting that full allocation rules. The rules are less clear with respect to investment shifts that occur simultaneously with debt shift.

[40] These issues also 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 country with high tax rates -- 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 judgments about economic efficiency when the tax system is not efficient in other ways, such as with the deferral principle. Nevertheless it is interesting that there are cases where a change in the allocation rules that lowers taxes of multinational corporations can nevertheless magnify distortions.

Interest Rate Differentials.

[41] 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 domestic savers prefer investing in particular locations or there are differences in risk across locations, such differentials will arise. In particular, if foreign interest rates are higher than U.S. rates, worldwide allocation rules will have a larger effect in increasing the foreign tax credit limit than would be the case if interest rates were identical.

[42] 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- equity ratios) may not be appropriate. This is an area that may need further exploration.

SUBGROUP ELECTIONS UNDER TRRA

[43] Along with allowing firms to allocate interest expense on the basis of worldwide groups, the TRRA contained an additional important change: it permits firms to calculate the interest allocation separately for different subgroups of the worldwide affiliated group of corporations. Potentially, such elections could substantially reduce the amount of interest a group of related corporations is required to allocate to foreign sources; firms could possibly distribute their borrowings among related subsidiaries so as to minimize foreign allocations of interest. The bill does contain an equalization rule and anti-abuse provisions that are apparently aimed at limiting such arrangements. Nonetheless, it appears that tax- minimizing borrowing arrangements could still be made under the bill. ⁶

[44] The antecedents of the TRRA's subgroup elections can be traced to rules that applied prior to the Tax Reform Act of 1986 (Public Law 99-514). Even before the 1986 Act, Treasury regulations were based on the fungibility of debt principle and required firms potentially to allocate at least some domestic interest expense to foreign sources. But prior to 1986, firms were allowed to make the allocation calculation separately for different members of their affiliated group of corporations. Thus, for example, a firm could arrange to have a large portion of its borrowing conducted by a subsidiary corporation possessing little or no foreign assets, thus minimizing the portion of the group's interest expense allocated abroad. With certain exceptions, the Tax Reform Act required a single interest allocation calculation to be made for the consolidated group as a whole. ⁷

[45] The TRRA's subgroup elections apparently would have restored at least part of the flexibility foreclosed by the 1986 Act's consolidated group requirement. The 1999 bill contained two subgroup elections a firm can make: a financial institution election, and a subsidiary group election. Under the first of these, a firm consisting of an affiliated group of corporations can elect for a subgroup consisting only of financial institutions to allocate its interest expense separately. Subsidiaries qualifying under this provision generally would be firms that earn at least 80% of their gross income from the active conduct of a banking, financing, or insurance business and that is derived from transactions with unrelated entities. An anti-abuse rule would provide that in qualifying as a financial institution, a firm's income is disregarded if the principal purpose of the underlying transaction is, in fact, to qualify the firm as a financial institution.

[46] Current law already contains a subgroup election for firms that are banks. The TRRA would have expanded eligible firms to include a wider range of financial intermediaries, including finance companies and insurance firms. Notwithstanding the bill's anti-abuse rules, it is conceivable that firms whose principal business is not financial intermediation could avoid at least part of the impact of the allocation rules using this subgroup election. For example, a firm that has a finance subsidiary that conducts genuine financial intermediation could arrange to have a portion of the non-financial part of the firm's borrowing undertaken by the subsidiary. If the finance subsidiary's assets are principally located in the United States, borrowing through the subsidiary could be insulated from the allocation rules.

[47] The second, "subsidiary group," election, is more general, and may also permit substantial avoidance of the interest allocation rules by a wide range of firms. Under its terms, the common parent of an affiliated group of corporations can elect for a domestic subsidiary to calculate its interest allocation separately, together with any of the subsidiary's own subsidiaries. Again, a firm might be able to concentrate its borrowing and interest payments in a subsidiary (or group of subsidiaries) having little or no foreign assets. The interest allocation formula for that subgroup would thus result in little or no allocation of interest to foreign sources.

[48] The TRRA contained a number of rules that, it has been argued, may limit the extent to which firms can use subgroup elections to avoid interest allocation. For example, the bill contained what it terms an "equalization rule" that allocates to foreign sources any interest of the worldwide group's members who are not in the subgroup that is necessary to achieve the same allocation that would be made if the subgroup did not exist. Absent any rearrangement of debt, this rule could defeat the tax-planning opportunities afforded by the subgroup election. But if a firm concentrates sufficient borrowing in the subgroup, the foreign interest allocation outside the subgroup would still apparently be minimal (and that of the subgroup, as well), and the equalization rule would have little effect. For example, if the members outside the subgroup had little interest expense, there would be little interest available with which to achieve equalization.

[49] Two other rules are also apparently aimed at the ability of firms to use the subgroup election to avoid allocation of interest. First, the bill would prohibit related parties outside the electing subgroup from guaranteeing the subgroup's debt. Second, the TRRA would limit the extent to which a subgroup member can increase the portion of its earnings it pays to its parent as dividends. Presumably, this rule is designed to limit the means by which a subgroup can borrow and subsequently transmit debt to its parent. Still, if a subgroup is new, the rules for calculating average dividends are confined to the years it has been in existence, which may provide a mechanism for avoiding the limitation.

[50] In short, the TRRA's subgroup election appears to present potential opportunities for firms to avoid the allocation of interest according to the fungibility principle. Unlike the bill's other changes in the allocation rules discussed above, this feature of the bill appears to move the system away from what might be termed a "theoretically pure" implementation of the foreign tax credit limitation under the assumption of fungibility.

[51] It is possible that the subgroup election provisions would increase the revenue cost of the interest allocation provision substantially. The Senate-passed version of H.R. 2488 did not contain the subgroup election included in the conference report (although the House bill did). The conference version would have an effective date earlier than the Senate bill would have, but both versions would be fully effective by 2005. Over the years 2005-2009, the annual revenue cost of the conference bill's interest allocation changes (including the subgroup election) was estimated by the Joint Committee on Taxation to average $3 billion per year; the Senate bill was estimated to cost an average of $2 billion per year over the same period. It is likely that the subgroup election explains much of the $1 billion difference.

CONCLUSION

[52] The analysis in this report suggests that there are benefits and disadvantages to worldwide allocation of interest as proposed in the conference report on H.R. 2488. If debt is assumed to be fungible, worldwide allocation of interest as provided by H.R. 2488 is the most accurate method of ensuring that the U.S. foreign tax credit is used for its intended purpose: allowing foreign tax credit to offset the full share of U.S. pre-credit tax that falls on foreign source income. It is not clear, however, that such a system would achieve its objective, absent some additional rules, given the opportunities for tax planning. Also, like the foreign tax credit limit itself, allocation rules tend to contribute to the distortions that discourage equity investment abroad, and worldwide allocation rules would, in a number of ways, magnify distortions. While the magnification of distortions due to current allocation rules (which act to increase U.S. revenue) can be viewed as a cost of collecting taxes, the further magnification due to worldwide allocation occurs with a loss in revenue.

[53] The subgroup elections contained in H.R. 2488 do not appear consistent with the general objective of the foreign tax credit limit or the bill's own worldwide allocation regime. The subgroup elections may permit firms to reduce the current domestic interest allocation costs while achieving foreign interest allocation benefits.

APPENDIX: COMPARING THE EFFECTS OF ALTERNATIVE ALLOCATION RULES

[Editor's Note: This document contains formulas not suited for online presentation. This document is available through our Access Service as Doc. 1999-32119.]

² Certain income is deemed to be received under Subpart F rules, which are aimed at tax sheltering activities.

³ 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 1/(1 - t), where t is the foreign tax rate.

⁴ Note that these relationships work out precisely only if the U.S. and foreign definitions of taxable income are identical.

⁵ See, for example, the discussion of interest allocation and its underlying principles in: U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986 Washington, U.S. Govt. Print. Off. 1987. P. 944.

⁶ See, however, the views attributed to Ken Kies, representative of a group supporting H.R. 2448, who believes the anti-abuse rules are sufficient and that exceptions to fungibility are warranted. Reported in: Sullivan, Martin A. Interest Allocation Reform: Time to Talk or Time to Act? Tax Notes International. Sept. 6, 1999. P. 875.

⁷ Prior to the 1986 Act, firms were also permitted to allocate interest expense on the basis of revenue rather than assets, thus opening tax-planning opportunities associated with foreign losses. For a summaries of the Act's provisions and their rationale, see: Altshuler, Roseanne, and Jack M. Mintz. US Interest-Allocation Rules: Effects and Policy. International Tax and Public Finance. V. 2. May, 1995. P. 7-35; and U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. Joint Committee Print, 100th Congress, 1st Sess. Washington, U.S. Govt. Print. Off. 1987. P. 941-56.