CRS Offers Overview of U.S. Taxation of Overseas Investment

                       CRS Report for Congress

[1] Investment abroad by U.S. individuals and firms is substantial, and is growing. At the end of 1997, the stock of private U.S. investment abroad was a full 18% of the total U.S. stock of private capital; the proportion has more than doubled over the past two decades. ¹ Given the large and growing role of foreign investment, how it is taxed can have important economic effects, either encouraging or discouraging the investment and helping or hindering U.S. and world economic efficiency and international economic performance. Under current law, however, the effect of U.S. tax policy towards overseas investment varies widely, depending on its location, form, and the investor's circumstances. It presents a patchwork of incentives, in some cases encouraging foreign investment, in others discouraging it, and in still others remaining neutral. As a consequence, the current system has no single, general economic effect on economic performance and economic welfare. Some of the features of the U.S. system are consistent with maximizing of world economic welfare while others more narrowly support U.S. economic welfare, and yet others are not optimal from either standpoint. This report will be updated only when major changes occur in U.S. international tax policy.

The Basic Structure

[2] Much of the structure of U.S. international taxation is based on the manner in which the United States asserts its tax jurisdiction in the international economy. In general, the United States defines its tax jurisdiction on the basis of residence. That is, if an investor is a U.S. "resident" for tax purposes, the United States asserts the right to tax the resident's worldwide income, regardless of its geographic source. For example, if a U.S. citizen possesses a portfolio of foreign securities, he is generally subject to U.S. federal tax on the interest, dividends, and capital gains it generates. In the case of corporate investors, a corporation is a U.S. resident if it is chartered in the one of the 50 U.S. states or the District of Columbia. A Delaware corporation, for example, is -- in principle -- subject to U.S. federal tax on its overseas income as well as its domestic income.

[3] But if the U.S. international tax structure begins with worldwide taxation, there are important provisions that modify it substantially. One is the U.S. foreign tax credit, which is designed to alleviate double taxation. In many cases foreign countries that are host to multinational investment assert the right to tax U.S. and other foreign investors on the basis of source -- that is, foreign host countries often assert the right to tax income earned within their own borders, regardless of the residence of the investor. As a result, if special provision were not made, U.S. residents would pay both U.S. and foreign tax on their foreign-source income. In many cases, the combined tax burden would be high enough to pose a severe impediment to the free flow of investment. Like many other capital exporting countries, the United States assumes the responsibility for relieving double taxation of its residents by granting its residents (subject to certain limits) a dollar-for-dollar credit for foreign income taxes they have paid on their overseas income.

[4] If the foreign tax credit is one important feature modifying worldwide taxation, another is a provision known as the "deferral principle," or simply "deferral." Deferral works like this: while the United States taxes corporations chartered in the United States on their worldwide income, it only taxes foreign-chartered corporations (i.e., non-resident corporations) on their U.S.-source income; foreign-source income of foreign corporations is generally exempt from U.S. tax. Thus, if a U.S. firm conducts its foreign operations through a foreign-chartered subsidiary, it can defer (postpone) U.S. tax on its foreign income as long as the income is reinvested abroad and remains in the hands of the foreign subsidiary. U.S. taxes are payable only when the foreign income is repatriated to the U.S. parent firm as dividends or other income.

[5] But deferral itself has important exceptions that limit its scope. The most important of these is the tax code's Subpart F provisions. Under its terms, U.S. stockholders of certain foreign corporate subsidiaries are subject to U.S. tax on certain of the subsidiaries' income, whether it is distributed or not. The particular type of subsidiaries subject to Subpart F are Controlled Foreign Corporations (CFCs), as defined by the tax code: corporations that are more than 50-percent owned by U.S. stockholders, each of whom own at least 10% shares of the CFC in question. The particular type of CFC income subject to Subpart F is generally income from strictly financial or passive investment ² and income whose source is thought to be relatively easy to manipulate.

[6] In sum, the United States taxes its resident investors on their worldwide income, while granting tax credits for foreign taxes paid on overseas income. Accordingly, a U.S. firm that invests abroad through a branch of the U.S. parent corporation is subject to U.S. tax on the branch's foreign income on a current basis. Under the deferral principle, however, U.S. firms that conduct their foreign operations through foreign-chartered subsidiaries can indefinitely defer U.S. tax on their foreign income. However, certain passive and other types of income are denied the benefit from deferral under the provisions of Subpart F.

[7] We look next at the basic incentive effects of the system and its features.

HOW TAXES AFFECT THE DECISION TO INVEST ABROAD

[8] Taxes can affect the location of investment by affecting how the after tax profitability of different locations compare. Suppose, for example, a firm is considering whether to add to a plant in the United States or open a new plant abroad. If taxes on the U.S. factory are lower than taxes on the prospective foreign operation, taxes pose a disincentive to make the foreign investment; if taxes on the foreign operation are lower, then a tax incentive exists to investment overseas. And if taxes are the same in either location, the tax system has no effect on (is neutral towards) the location decision.

Incentive Effects of the Foreign Tax Credit

[9] In relieving double-taxation, the foreign tax credit generally does not provide a tax benefit. Instead, it alleviates what would otherwise be a tax penalty posed by U.S. tax being superimposed on any applicable foreign taxes. The total tax burden on foreign source income would consist of the foreign tax rate plus the U.S. tax rate. The foreign tax credit in some cases replaces the tax penalty for overseas investment with even taxation of foreign and domestic income and tax neutrality. However, the U.S. tax code also places a limit on the credit that leaves a tax penalty for foreign investment intact in some situations. In still other situations, limit's particular rules result in a tax incentive to invest abroad.

[10] We look first at how the foreign tax credit can create tax neutrality towards foreign investment, neither encouraging nor discouraging investment abroad rather than in the United States. To see how this occurs, suppose a U.S. firm is considering whether to open a foreign branch or to invest in a new plant in the United States. Suppose also that the foreign country where the prospective branch would be located imposes a 10% tax rate; the firm pays U.S. taxes at the statutory U.S. corporate rate of 35%. If the firm were to open the foreign branch, the deferral principle would not apply and its income would be subject to a combined foreign and U.S. tax rate, before foreign tax credits, of 45 percent (35% plus 10%). Under the foreign tax credit rules, however, the company can credit the 10% foreign tax against the 35% U.S. tax. As a result, the firm would pay U.S. taxes after credits at a 25% rate on the branch income (the 35% U.S. pre-credit rate minus the 10% foreign tax used as foreign tax credits). After credits, the combined tax rate on the prospective branch would be 35% (the 25% U.S. rate, after credits, plus the 10% foreign rate) -- a rate exactly equal to that which would apply to investment in the United States. In this situation, taxes will therefore be neutral and generally not interfere with the firm's decision of where to invest.

[11] As mentioned above, the tax code does not permit foreign taxes to be credited without limit. The limitation's purpose is to protect U.S. tax revenues. If foreign taxes could be credited without limit, foreign governments -- in theory -- could raise their own taxes on U.S. investors to extremely high rates. As long as the U.S. investors had U.S. operations with a concomitant U.S. tax liability, the foreign government could collect a large volume of tax revenue from U.S. investors while not making their country an unattractive location to U.S. investors who could simply credit the foreign government's taxes against their U.S. tax on U.S. income. The tax code's limitation, however, provides that foreign taxes can only offset the portion of a taxpayer's U.S. tax liability that applies to foreign source income. Foreign tax credits, in other words, cannot offset U.S. taxes on U.S. income, and to the extent an investors foreign taxes exceed U.S. tax on foreign income, they are not creditable and become what are sometimes called "excess credits."

[12] While the limitation protects the U.S. Treasury, the rules that implement it can disrupt the foreign tax credit's neutrality effects, and create incentives and disincentives to invest abroad. We look first at situations where the limitation permits a disincentive to exist. Suppose that in the example in the preceding section, the new overseas branch had been subject to a foreign tax rate of 50% rather than 10% -- a tax rate higher rather than lower than the U.S. tax rate. In that case, the firm would have been able to offset its entire U.S. tax liability on foreign source income. However, 15 percentage points of the foreign tax rate (the 50% foreign rate minus the 35% U.S. rate on foreign income) would have become excess foreign tax credits. The total tax rate on the new foreign investment -- consisting only of foreign taxes -- would have been 50% and would have posed a disincentive to make the foreign investment.

[13] In other situations, the foreign tax credit can help produce neutrality even for new investment that is subject to high foreign taxes. Suppose, for example, a new foreign investment is subject to a 50% foreign tax rate. By itself, we have seen that a heavily taxed investment such as this produces excess credits. But if the firm has other foreign investments that are subject to low foreign taxes, it may owe a residual U.S. tax liability on those investments, even after foreign tax credits. In such a case, the firm can generally "cross credit" the excess foreign tax credits its new investment produces, using them to reduce U.S. taxes on its existing investments. If a firm can cross credit all of the excess credits produced by its new investment, the effective tax rate on its new investment is reduced to the U.S. tax rate and neutrality exists.

[14] In some situations, cross-crediting can produce an incentive to invest in countries where taxes are low. Suppose, for example, a multinational firm has existing foreign source income that is subject to high foreign taxes -- so high that the firm has an ample stock of excess foreign tax credits. Suppose also that the company is contemplating a new investment that is subject to low foreign taxes. Ordinarily, the new investment would be subject to some level of U.S. taxes. (See the example in the preceding section where the foreign tax rate is only 10 percent.) But in this case, the multinational can use its existing excess credits to reduce or eliminate U.S. taxes due on its new investment. The only new taxes the new investment generates are the relatively low foreign taxes. An incentive thus exists to make the foreign investment.

[15] Cross-crediting of foreign taxes occurs when investors have income from various foreign activities that are subject to tax rates that differ one from another. One example is when a firm has operations in a high-tax country and a low-tax country. Another example is when a firm has several different types of foreign income that are typically subject to different tax rates. The foreign tax credit limitation contains a set of rules designed to limit cross- crediting in cases of this latter type; the tax code requires separate limitations to be calculated for several different types of income that are thought to be subject to especially high or low foreign tax rates, and that would thus otherwise lend themselves to cross-crediting. Examples of income subject to separate limitations (or "baskets") are income from passive investment, shipping income, and financial services income. However, most foreign income from active business operations is placed in a single, large basket and can thus benefit from cross-crediting. ³

[16] In sum, the incentive facing foreign investment that does not use deferral depends on whether a firm has existing investments that have produced excess credits and on whether the foreign tax rate on prospective investment is high or low. If an investor has excess credits, taxes pose an incentive to invest in low-tax countries and a disincentive to invest in high-tax countries. If an investor has existing investment abroad but no excess credits, taxes are neutral towards new investment in both low- and high-tax countries. If an investor has no existing foreign investment, taxes pose a disincentive to invest in high tax countries and are neutral towards new investment in low-tax countries.

Incentive Effects of Deferral

[17] Again, deferral permits U.S. firms that invest abroad through foreign-chartered subsidiaries to postpone paying U.S. tax on the subsidiaries' foreign income until it is repatriated. The basic economic principle of discounting holds that a given amount of funds matters less to an individual or firm if it is received or paid in the future rather than the present. Thus, while some residual U.S. tax may ultimately be paid even on a foreign subsidiary's income, its postponement until the future means its burden is diminished, and deferral poses a tax incentive for U.S. firms to invest abroad. Of course, even if a firm defers U.S. taxes, it may well be required to pay taxes to a foreign host government. Thus, deferral only poses a tax incentive to invest in countries with tax rates that are lower than those of the United States. ⁴

[18] Note that when a firm repatriates income from a foreign subsidiary, it is permitted to claim so-called "indirect" foreign tax credits for taxes the subsidiary paid during the period of time the income was retained abroad. The cross-crediting of foreign taxes can thus reduce U.S. taxes that are payable when heretofore tax-deferred income is repatriated and can add to deferral's tax benefit.

EVALUATING U.S. TAX POLICY

[19] Whether or not U.S. international tax policy is effective depends on the goal ascribed to it. Suppose, for example, that the goal of tax policy -- aside from raising revenue -- is to maximize the performance of the world economy, not just that of the United States. Here, economic theory suggests that the most effective tax policy is that which is neutral towards the decision to invest abroad and that does not interfere with the allocation of investment. Also, economic theory holds that in most cases, if left to their own devices, investors employ their investment funds in the most productive way possible. And if the world's scarce investment funds are being used in the most productive way possible, the world's economic welfare is maximized. Economists term a situation where taxes are neutral towards overseas investment "capital export neutrality." Worldwide taxation on the basis of residence coupled with a foreign tax credit -- albeit, an unlimited one -- are policies consistent with capital export neutrality.

[20] Some might argue that the goal of U.S. tax policy should be to maximize U.S. economic welfare rather than that of the world. And the tax policy that maximizes U.S. welfare is not necessarily that which maximizes world welfare. When U.S. investment is employed overseas, that location may indeed be the most productive possible. But part of the investment's benefit accrues to foreign workers and, if foreign governments tax the investment, part accrues to foreign governments as well. As a consequence, investments may in some cases produce a larger return for United States if they are made in the United States rather than abroad. Accordingly, the tax policy that maximizes U.S. economic welfare is one that poses a disincentive to invest abroad (although it is not one that shuts-off foreign investment altogether.) Such a policy is said to have "national neutrality." Some writers have suggested it might be achieved by replacing the U.S. foreign tax credit with a deduction for foreign taxes paid. Importantly, however, national neutrality is a "beggar- thy-neighbor" policy that increases national welfare at the expense of foreign countries', and may eventually backfire and reduce national economic welfare if foreign countries retaliate by raising their own taxes on their investors in the United States.

[21] A third standard of taxing international taxation that is sometimes supported by U.S. multinationals and others is termed "capital import neutrality." A policy of capital import neutrality would attempt to ensure that a home country's multinationals, when operating abroad, face the same tax burden as that faced by competing multinationals from third countries or from the host country. Under such a policy, the home country would completely exempt foreign- source income from taxation. In the current U.S. tax system, the deferral principle approaches capital import neutrality, but does not completely attain it due to the U.S. taxes that apply upon repatriation. In contrast to concepts of neutrality based on economic theory, this standard reduces global economic efficiency by distorting the allocation of capital towards countries with low tax rates.

[22] In sum, as outlined in the first sections of the report, the overall structure of the U.S. method of taxing overseas income is a patchwork of various provisions and principles. As a result, the incentive effects of the system are likewise varied, and depend on an investor's circumstances and the location of the investment. It also follows that the effect of the system on U.S. and world economic welfare is mixed. Some of its features maximize world economic welfare, some maximize U.S. economic welfare; and some do neither.

² Passive investment is generally investment in which the investor does not play an active role in managing the underlying business activity. For example, dividend income where an investor owns only a small part of a firm is income from passive investment, as is much of interest, royalty, and rental income.

³ Another approach to limiting cross-crediting is to impose a separate limitation for each country in which a taxpayer earns income. The United States has used such a per-country limitation in the past, but abandoned it.

⁴ Or, it might be said that deferral is moot in high-tax countries because of the U.S. tax credit. If foreign taxes on a new investment are higher than U.S. taxes, the entire U.S. tax liability would be offset, even without deferral.