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7 Federal Tax Policy Memo 1 (1983)

handle is hein.tera/fetxcyemo0007 and id is 1 raw text is: TAX FOUNDAT!ON, INCORPORATED 1875 CONNECTICUT AVENUE NW WASHINGTON, DC 20009 TELEPHONE (202) 328-4500 V - __ 41 M rr, ERAL TAX POLICY MEMO - -A U.S. Tax Treatment of Foreign Source Income By Douglas N. Beck Staff Economist Recently there has been increasing talk of modifying the various provisions contained in the U.S. Tax Code pertaining to the treatment of domestic corporations involved in inter- national trade. Motivated by numerous, often conflicting goals, several proposals have been made that would either curtail or eliminate the foreign tax credit, deferral, and the law establishing Domestic International Sales Corporations (DISC)-the three provisions that form the basis of U.S. tax policy relating to international trade. The foreign tax credit and deferral, which have been part of the Tax Code since 1918, serve to neutralize tax considerations in worldwide in- vestment decisions. On the other hand, DISC, enacted only twelve years ago, was designed to encourage exports of U.S. products. Although the basic nature of the foreign tax credit and deferral are dissimilar to DISC, they will be considered together for ease of presentation. The renewed movement to alter these provisions is largely a response to two conditions currently plaguing the American economy. First is the prospect of big budget deficits contin- uing for many years and the consequent search for new sources of income to narrow this gap. Opponents of the provisions see them as loopholes that can be closed to raise large sums of additional revenue. Second is the claim that current U.S. tax law, in particular the foreign tax credit and deferral, is in part responsible for the high level of unemployment that plagues the American economy. Critics claim that these provisions permit more favorable tax treatment for foreign source income than for income earned domestically and thereby provide an incentive for U.S. businesses to invest in foreign countries rather than in the United States. This substitution of foreign for do- mestic investment causes jobs to be exported overseas. Tightening the tax treatment of U.S. firms investing abroad would reduce foreign operations and increase domestic in- vestment, thereby increasing U.S. employment. Another important consideration is the claim by several European countries that DISC violates the General Agree- ment on Tariffs and Trade (GATT), ratified in 1947 to establish an international code on tariffs and trade rules. GATT's goal was to reduce impediments to international trade created by high tariffs, import quotas, and other discriminatory trade practices. This agreement is widely believed to have been responsible for the dramatic increase in world trade over the last forty years and the accompanying rise in the standard of living in signatory countries. U.S. TAX LAW Tax law in the United States recognizes the importance of the principle of international tax neutrality, also known as capital export neutrality, which holds that the tax laws of a given country should neither favor nor discourage foreign over domestic investment. In practice, neutrality requires that the overall level of taxation on foreign source income of a firm or individual be the same as for domestic source income. Investment decisions can thus be made based on economic variables rather than tax considerations, promoting inter- national specialization in production with a resultant increase in worldwide income. Deviations from tax neutrality can cre- ate distortions causing resources to be misallocated and in- come reduced. FOREIGN TAX CREDIT Under U.S. law, American citizens are taxed on their world- wide income. In order to prevent the double taxation of in- come earned abroad, a dollar-for-dollar credit is allowed for taxes paid by U.S. citizens to foreign governments. This credit mechanism also concedes to the host government the initial share of taxation on income generated within its borders. To see how the foreign tax credit works, suppose an Amer- ican firm earns $100,000 within a foreign country that imposes a 20 percent income tax. The U.S. tax liability on this income is $46,000 based on a statutory corporate income tax rate of 46 percent. Against this amount the taxpayer is allowed a credit of $20,000 for taxes paid to the host country. The re- maining S26,000 is paid to the U.S. Treasury. If the tax rate imposed by the host country was equal to or greater than 46 percent, the U.S. tax liability on that foreign source income is zero. U.S. law also allows a credit for foreign taxes paid through foreign corporations, provided that the U.S. corporation owns at least 10 percent of the voting stock of the foreign corpo- ration. This deem paid credit provision allows the U.S. corporations to claim a credit for foreign taxes paid on the earnings of a foreign subsidiary out of which dividends are paid to the U.S. corporation. For example, suppose that a domestic corporation receives a dividend of 580 from a foreign corporation. This S80 dividend represents $100 in income earned by the foreign corporation from which $20 in taxes is paid to the host government. For purposes of calculating the U.S. tax liability, the S20 in foreign taxes paid is added to the $80 dividend, making the taxable foreign source income of the domestic corporation equal to $100. This is known as grossing-up the dividend. The U.S. tax liability is 546 (5100 x46%) against which a credit of S20 is granted, and the balance of $26 is collected by the U.S. Treasury. In actual practice the foreign tax credit becomes somewhat more complicated. In order to be creditable, a foreign tax must be of the predominant character of the U.S. income tax. Copyright 1983 by Tax Foundation, Incorporated, 1875 Connecticut Avenue, N.W., Washington, D.C. 20009 (202) 328-4500 MAY 1983 VOL. 7, NO. I

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