International Tax Provisions of the American Competitiveness and Corporate Accountability Act (H.R. 5095)

Congressional research reportSep 20, 2002

Ask Donna

What actually matters in this document.

Text

Order Code RL31574

Report for Congress

Received through the CRS Web

International Tax Provisions of the

American Competitiveness and

Corporate Accountability Act (H.R. 5095)

September 20, 2002

David L. Brumbaugh

Specialist in Public Finance

Government and Finance Division

Congressional Research Service ˜ The Library of Congress

International Tax Provisions of the American

Competitiveness and Corporate Accountability Act

(H.R. 5095)

Summary

On July 11, 2002, House Ways and Means Committee Chairman William

Thomas introduced H.R. 5095, the American Competitiveness and Corporate

Accountability Act. The focus of this report is the bill’s proposed changes in U.S.

taxation of income from international transactions. The bill also contains provisions

designed to restrict corporate tax shelters; the report does not discuss these.

The bill’s international proposals are in three general areas. First, the bill would

repeal the extraterritorial income (ETI) tax benefit for exporting, thereby attempting

to end a long-running dispute between the United States and the European Union

(EU) over whether the U.S. tax benefit is an export subsidy prohibited by the World

Trade Organization agreements. Second, the bill contains proposals aimed at

offshore corporations with subsidiaries in the United States. In part, these proposals

are aimed at corporate “inversions” where some U.S.-owned firms have reorganized

to include paper parent corporations chartered in “tax haven” countries. In part, these

proposals also address “earnings stripping,” or the shifting of U.S. profits abroad by

means of intra-firm transactions. Third, H.R. 5095 contains proposals altering the

tax treatment of U.S. firms with foreign operations and investment. The bill terms

these changes international tax “simplification;” the bulk of the provisions would

have the effect of reducing U.S. tax on foreign-source income. The chief areas that

would be affected are rules related to the foreign tax credit and provisions affecting

the “deferral” tax benefit for overseas business operations.

This report does not attempt a comprehensive economic analysis of H.R. 5095.

Several likely broad effects, however, can be identified. First, taken alone, repeal of

the ETI export benefit would likely not increase the U.S. trade deficit, but would

reduce the overall level of U.S. trade – exports and imports alike – by a small

amount. Because export subsidies generally reduce the aggregate economic welfare

of the subsidizing country, repeal of the ETI provisions would likely increase U.S.

economic welfare, while leading to a small contraction of the export sector and a

small expansion of import competing sectors. Second, tax-motivated inversions are

apparently events that chiefly occur on paper, involving little alteration of the

location of economic activity. Their chief economic impact is probably a reduction

in U.S. tax revenues. Thus, the chief impact of H.R. 5095’s inversion provisions

would probably be to reduce the extent to which inversions erode U.S. corporate tax

collections. The bill’s earnings stripping provisions may likewise reduce erosions

in U.S. tax collections but an assessment of whether these provisions would reduce

foreign investment in the United States is not attempted here. Third, the bill’s

foreign source income provisions would likely reduce the tax burden on foreignsource income. As a result, their impact would probably be to increase the level of

U.S. investment abroad beyond what would otherwise occur. Preliminary estimates

by the Joint Committee on Taxation indicate the bill would increase tax revenue by

a net of $6.4 billion over five years and a net of $1.1 billion over 10 years.

This report will be updated as legislative developments occur.

Contents

Basic Features of the U.S. International Tax System . . . . . . . . . . . . . . . . . . . . . . . 2

Overseas Investment: Foreign Tax Credit Proposals . . . . . . . . . . . . . . . . . . . . . . 3

Interest Allocation Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Consolidation of Tax Credit Limitations (“Baskets”) . . . . . . . . . . . . . . . . . . 6

“Look Through” Treatment for Dividends from Section 902

Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Recharacterization of Overall Domestic Losses . . . . . . . . . . . . . . . . . . . . . 8

Extension of Foreign Tax Credit Carryforward Period . . . . . . . . . . . . . . . . . 9

Repeal of Foreign Tax Credit Restrictions under the Alternative

Minimum Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Overseas Investment: Deferral and Subpart F . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Sales and Services Income Subject to Subpart F . . . . . . . . . . . . . . . . . . . . 11

“Look through” Treatment for Dividends Flowing Between

Related Foreign Subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Other Provisions for U.S. Investment in Foreign Corporations . . . . . . . . . . 12

Provisions Directed at “Earnings Stripping” and Corporate

“Inversions” or “Expatriation” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Repeal of the Extraterritorial Income Tax Benefit for Exports . . . . . . . . . . . . . . 15

Other Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Economic Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Impact on Investment and Economic Welfare . . . . . . . . . . . . . . . . . . . . . . 17

Impact on U.S. Tax Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Affected Industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

List of Tables

Table 1. Estimated Revenue Effects of H.R. 5095 . . . . . . . . . . . . . . . . . . . . . . . 20

Table 2. Foreign Sales Corporations, 1996: Gross Receipts,

by Major Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

Table 3. Foreign Sales Corporations, 1996: Net Exempt Income,

by Major Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Table 4. 1997 Foreign Tax Credits Claimed, by Industry . . . . . . . . . . . . . . . . . . 26

Table 5. 1996 Subpart F Income of Controlled Foreign Corporations,

by Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

International Tax Provisions of the American

Competitiveness and Corporate

Accountability Act (H.R. 5095)

The American Competitiveness and Corporate Accountability Act (ACCAA;

H.R. 5095) was introduced on July 11, 2002, by Chairman William Thomas of the

House Committee on Ways and Means. The first title of the bill contains several

provisions designed to restrict corporate tax shelters – provisions beyond the scope

of this report. The balance of the bill, however, contains a broad range of proposals

for taxation of income from international transactions and is the report’s focus. The

international proposals are in three general areas: taxation of income from foreign

business operations and investment; export tax benefits; and the tax treatment of

offshore corporations that have U.S. subsidiaries, including foreign “inversions” or

“expatriation.” Compared to changes enacted in international taxation in recent

years, the bill’s changes are important and broad in scope. At the same time,

however, the proposals are incremental rather than a broad structural revision of the

U.S. international tax system.

The likely impacts of the proposals on business tax burdens vary: its foreignsource income provisions would likely reduce the tax burden on the overseas

operations of U.S.-owned firms while the export provisions probably will increase

the tax burden on U.S. export firms. The inversions provisions may restrict the

viability of the restructuring transactions as tax-saving devices and thus reduce U.S.

revenue losses from the transactions, although the proposed provisions are

temporary. The bill’s earnings stripping provisions would probably reduce revenue

losses from the shifting of otherwise-taxable profits abroad and may increase the tax

burden on foreign business investment in the United States. According to

preliminary estimates by the Joint Committee on Taxation, H.R. 5095’s proposals –

including both its international and tax shelter provisions – would increase U.S. tax

revenue on a net basis by $6.4 billion over five years and $1.1 billion over 10 years.1

The scope of H.R. 5095 is broad, touching almost every area of U.S.

international taxation, from export profits to overseas subsidiary firms, to the foreign

tax credit, to foreign parent corporations chartered in tax havens. Accordingly, this

report begins by describing the basic structural features of the U.S. international tax

system.

U.S. Congress, Joint Committee on Taxation, “Estimated Revenue Effects of H.R. 5095,”

reprinted in BNA Daily Tax Report, July 17, 2002, pp. L-1 - L-3. The estimates are

reproduced below, on pages 20-21.

CRS-2

Basic Features of the U.S. International Tax System

In the international setting, countries base their tax jurisdiction on either the

source of income or the residence of the taxpayer. That is, in determining whether

it has jurisdiction to tax income, a tax system can look either to the geographic or

territorial source of the income or to the residence of the entity or person earning the

income. Under a “territorial” system, a country taxes only income earned within its

borders. However, under a “residence system” a country taxes the worldwide income

of its resident individuals or firms.

In applying its tax jurisdiction to the overseas income of its own citizens and

firms, the United States generally – with some exceptions – operates a residencebased system. It looks to the nationality of the taxpayer, taxing U.S. citizens and

residence on their worldwide income and, in the case of businesses, taxing

corporations chartered or organized in the United States on their worldwide income.

Thus, if a U.S. corporation earns dividends whose source is, say, Ireland or Germany,

the U.S. firm will generally be subject to U.S. tax on the dividends – at least in

principle. In applying its tax system to foreign investors in the United States, the

United States operates a source-based system, taxing the U.S. branches of foreign

corporations only on their U.S.-source income.

But there are exceptions to this general structure. First, the United States grants

foreign tax credits. While the United States taxes its residents’ worldwide income,

it concedes that the country of source has the primary right to tax that income and

permits its corporate and non-corporate taxpayers to credit foreign income taxes they

pay against U.S. taxes they would otherwise owe. In so doing, the United States –

in effect – accepts the responsibility for alleviating the double-taxation that would

result when the U.S. worldwide tax jurisdiction overlaps the normal practice of host

countries in taxing income earned within their borders.

Importantly, however, to protect the U.S. tax base, the U.S. foreign tax credit

is limited to offsetting U.S. tax on foreign income; foreign taxes cannot be credited

against U.S. tax on U.S. income. The tax credit’s limitation and associated rules give

rise to some of the most complex parts of the tax code, as described further in the

section below on H.R. 5095’s foreign tax credit provisions. In general terms, H.R.

5095 would ease restrictions on the foreign tax credit embedded in a number of

foreign tax credit rules.

Along with the foreign tax credit, another exception to U.S. worldwide taxation

is the so-called “deferral” principle. While the United States taxes foreign income

earned directly by branches of U.S. corporations – branches that are not separately

incorporated abroad – the United States does not tax foreign-chartered corporations

on their foreign-source income. Thus, if a U.S. firm conducts foreign operations

through a subsidiary firm chartered abroad, the foreign income is not subject to U.S.

tax until the income is remitted to the U.S. parent as dividends or other income (at

which point it enters the U.S. tax jurisdiction as income of a U.S.-resident

corporation). U.S. tax on the subsidiary’s income is thus tax-deferred as long as the

income is reinvested abroad.

CRS-3

Deferral poses a tax incentive for U.S. firms to invest abroad in countries with

relatively low tax rates and reduces U.S. tax revenues, but since 1962 the tax code’s

Subpart F provisions have denied deferral’s benefit to certain types of income –

generally income from passive investment and other income whose source is thought

to be easy to manipulate in order to reduce taxes. Subpart F and deferral are

described in more detail below in the section on H.R. 5095’s proposals for U.S.controlled foreign corporations. In broad terms, H.R. 5095 reduces the scope of

Subpart F and expands potential areas where deferral can apply.

U.S. tax treatment of foreign corporations has also been a focus of attention in

the recent controversy over corporate “inversions” or “expatriation.” Since foreign

corporations are not taxed on foreign-source income, a number of U.S. firms with

U.S.-incorporated parent segments have reorganized so that the parent segment or

holding company is a foreign corporation chartered in low-tax country or “tax

haven.” The tax savings on foreign-source income is apparently supplemented in

many cases by “earnings stripping” – the use of related-company debt – to shift U.S.

income from U.S. subsidiaries into the hands of a foreign-chartered parent. H.R.

5095 contains a number of provisions designed to limit inversions and earnings

stripping.

Under the United States residence-based tax system, U.S. taxes would normally

apply to export income in full. If a U.S. corporation were to sell exports directly,

U.S. worldwide taxation would ordinarily ensure full U.S. taxation; if a U.S. firm

were to sell exports through a related foreign subsidiary outside the U.S. tax

jurisdiction, U.S. “transfer pricing” rules – rules governing the allocation of income

among related firms – would restrict the extent to which export income could be

allocated abroad to a foreign subsidiary outside the U.S. tax jurisdiction. To the

extent flexibility in the application of transfer pricing permits the allocation of

income to foreign subsidiaries, Subpart F apparently rules out much of the potential

for deferral to apply. Notwithstanding these rules, however, several provisions of the

U.S. tax code provide tax benefits for U.S. exports. One of these – the extraterritorial

income (ETI) benefit – has been the focus of a controversy between the United States

and the European Union (EU), with the EU complaining to the World Trade

Organization (WTO) that ETI constitutes an illegal export subsidy. Several WTO

rulings have supported the EU, and unless the United States brings its tax code into

compliance, the WTO may permit the EU to levy tariffs on EU imports of U.S.

products. The controversy is described more fully below; H.R. 5095 would repeal

the ETI provisions. At the same time, however, the bill would relax the Subpart F

rules applicable to sales to related subsidiaries.

We turn now to the specific provisions of H.R. 5095.

Overseas Investment:

Foreign Tax Credit Proposals

While the foreign tax credit generally concedes to foreign host countries the

primary right to tax foreign income, the limitation of the credit to offsetting U.S. tax

on foreign and not U.S. income is designed to protect the part of the U.S. tax base

CRS-4

consisting of U.S. income. If not for the limitation, foreign governments could

conceivably impose extremely high tax rates on the U.S. investors they host without

fear of discouraging inbound investment. With an unlimited credit, investors would

be impervious to the high foreign taxes; they could simply credit their foreign taxes

against U.S. taxes on their U.S. earnings.

While the foreign tax credit’s limitation protects the U.S. tax base, it is also

responsible for some of the most complex and difficult-to-administer rules in the tax

code. H.R. 5095’s foreign tax credit proposals generally simplify and ease

restrictions on the tax credit rules in a number of areas related to the limitation. In

addition, it increases the extent to which the credit can reduce a firm’s alternative

minimum tax.

Interest Allocation Rules

In calculating its foreign tax credit limitation, whether a firm can assign an item

of income or deductible expense to foreign or domestic sources can have a

substantial impact on the company’s maximum creditable foreign taxes and thus on

its U.S. tax liability, after credits. Among H.R. 5095’s foreign tax credit proposals,

that which is likely to have the largest impact may well be a proposed change in rules

governing the allocation of interest expense between foreign and U.S. sources. To

illustrate, the provision is estimated to reduce tax revenue by $23.4 billion over 10

years – approximately half the revenue loss from all the bill’s foreign tax credit

proposals and about one quarter of the revenue loss of all the bill’s revenue-losing

items.

Firms with foreign earnings have long argued that current law’s rules for interest

allocation work improperly and are unfair, and in 1999 Congress included a revision

of the rules as part of the more general tax cut it passed with the Taxpayer Refund

and Relief Act (H.R. 2488, 106th Congress).2 However, President Clinton vetoed the

Act. H.R. 5095 would essentially implement the changes passed in 1999.

How income and expenses are allocated matters to a firm only if the foreign tax

credit limitation is a binding constraint and the firm has excess foreign tax credits.

To see why, note that under the foreign tax limitation, maximum creditable foreign

taxes are limited to the share of U.S. pre-credit tax falling on foreign source rather

than domestic income. It follows that if, for example, an item of revenue is

determined to have a foreign rather than U.S. source, the share of U.S. pre-credit tax

falling on foreign income is increased and maximum creditable foreign taxes are

therefore 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,

thereby reducing creditable foreign taxes and increasing after-credit U.S. tax. For

interest expense specifically, the important point is this: interest deductions allocated

For a more comprehensive explanation of the interest allocation rules, see: CRS Report

RL30321, The Taxpayer Refund and Relief Act of 1999 and the Foreign Tax Credit’s

Interest Allocation Rules, by David L. Brumbaugh and Jane G. Gravelle.

CRS-5

to foreign rather than U.S. sources reduce foreign tax credits and increase U.S. taxes.

Or, looking at it another way, a firm in an excess credit position has no remaining

U.S. tax liability on foreign-source income; it has all been eliminated by foreign tax

credits. Thus, a deductible cost allocated to foreign rather than U.S. sources can

produce no further tax savings and the deduction is, in effect, lost.

Given the importance of allocating income and expenses, the tax code contains

detailed rules for making the allocations, including the rules governing interest

expense. Current law provides for the allocation of interest expense by combining

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) based on the

proportion of the group’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.

The controversy over the rules is based on the particular way in which this

allocation is applied under current law – a method of allocation sometimes referred

to as a “water’s edge” allocation. Under this method, the borrowing of foreign

subsidiaries is not explicitly included in the allocation. Specifically, debt-financed

assets of subsidiaries are not included in the calculation; 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. Second, while some parent interest expense

is allocated to foreign sources, no subsidiary interest is allocated to domestic sources.

In isolation, this second omission reduces foreign income and 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.

In a manner similar to the vetoed 1999 Act, section 311 of H.R. 5095 would

substitute a “worldwide” allocation regime for current law’s water’s edge rule.3

Under this method, the interest costs of foreign subsidiaries would be 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 H.R. 5095’s worldwide allocation

regime would increase firms’ foreign tax credits and reduce their after-credit U.S.

taxes.

H.R. 5095 leaves out part of a set of “subgroup election” rules included in the 1999

legislation. Under current law, firms can elect to apply the interest allocation rules

separately for those parts of a corporate group that are financial institutions. The 1999 bill

would have expanded this election to include finance companies and insurance firms; it also

would have permitted a second election to allocate interest separately for any group of

subsidiaries, subject to certain anti-abuse rules. H.R. 5095 includes the expansion for

financial firms but not the second, broader election. For a more detailed discussion, see

Ibid., pp. 9-11.

CRS-6

Consolidation of Tax Credit Limitations (“Baskets”)

One feature of the foreign tax credit’s limit that has occupied the attention of

policymakers on a number of occasions is the ability of investors to “cross credit”

high foreign taxes on one stream of income or high foreign taxes paid to one country

against residual U.S. taxes that might be due on other, more lightly taxed foreign

income. Cross crediting works like this: if a U.S. firm’s only foreign-source income

is subject to low foreign taxes, the firm will not have sufficient foreign tax credits to

offset all U.S. taxes on the income and will owe some residual U.S. tax. Or, if a

corporation’s only foreign income is subject to rates that are high compared to the

U.S. tax rate, it will be able to eliminate its entire U.S. tax on foreign income but will

have excess credits left over. But if a firm has both heavily-taxed and lightly-taxed

foreign income, it can “cross credit” the excess credits from the heavily-taxed income

against U.S. tax due on the lightly-taxed income.

In effect, cross crediting shields investment in low-tax countries from U.S. tax,

leaving the low foreign taxes as the only tax burden the investment faces and posing

an incentive to invest abroad in low tax countries while reducing U.S. tax revenue.

At the same time, cross-crediting reduces the effective tax burden where foreign

taxes are high, thereby reducing what would otherwise be a tax disincentive to invest

abroad in high-tax countries. Because of these incentive and revenue effects,

legislation has been enacted on a number of occasions that is intended to limit the

ability of firms to cross credit by requiring the foreign tax credit limit to be calculated

separately for different types or “baskets” of income, in effect segregating different

streams of foreign income and prohibiting cross-crediting between different baskets.

In some periods in the past, separate limits have applied on a country-by-country

basis, thereby prohibiting taxes paid in “high tax” countries from being cross credited

against income earned in “low tax” countries. Under current law, however, separate

limits apply to several different categories of income rather than to separate

countries; much of their structure was implemented by the Tax Reform Act of 1986

(Public Law 99-514).

Under current law, there are nine separate foreign tax credit baskets, as follows:

1. dividends from Domestic International Sales Corporations (DISCs);

2. income attributable to “foreign trade income;”

3. distributions from Foreign Sales Corporations (FSCs);

4. financial services income;

5. shipping income;

6. dividends from each “section 902” corporation;

7. high withholding tax interest;

8. passive income;

9. all other income.

In addition, section 907 of the tax code limits the amount of taxes on foreign oil and

gas extraction income that can be credited, albeit under a somewhat different

mechanism.

The first three of the baskets in the above list are of limited importance,

applying to export income that is typically not subject to high foreign taxes and to

CRS-7

income related to export tax benefits – FSCs and DISCs – that have been repealed.4

The next two baskets are relatively narrow, applying to specific industries: income

from financial services and shipping income. (Note, however, that IRS data show

that the financial services basket is the second largest in terms of the amount of

taxable income it contains.5 ) The geographic source of this income is thought to be

relatively flexible, and thus relatively easy to locate in low-tax foreign countries,

making cross-crediting with heavily-taxed income particularly useful to the taxpayer.

The next three baskets apply to different types of income from passive

investment. One is dividends a taxpayer receives from each foreign subsidiary

corporation that is not controlled by U.S. stockholders but in which the dividend’s

recipient owns at least 10% of the stock. (These are known as “section 902”

corporations. As described more fully below, however, this basket is scheduled for

elimination in 2003.) Under this basket’s rules, a separate limitation must be

calculated for dividends from each subsidiary, thus restricting cross-crediting among

income from different foreign corporations. The remaining passive income baskets

are a basket for passive income in general – for example, interest, rents, and royalties

– and interest income that is subject to a high foreign withholding tax.6 As with the

transportation and banking limitations, the separate basket for general passive income

was implemented because passive income is thought to be geographically flexible.7

The high-withholding-tax basket was created because even low foreign withholding

taxes on a U.S. lender’s gross interest received from abroad could amount to a high

effective tax rate on the investor’s net interest from a loan, thereby generating large

amounts of excess credits.8

The last remaining basket is a residual category into which any remaining type

of income is placed. It is thus a general, “overall” basket into which income from

most active business operations is placed.

Section 313 of H.R. 5095 would consolidate current law’s nine baskets into

three: a general passive income basket; a basket for financial services income; and

a general, “overall” basket. In doing so, the bill eliminates the separate baskets

related to export income, the basket for shipping income, the basket for highwithholding-tax interest, and the basket for section 902 corporations. The general

effect of the proposal would be to increase cross crediting. What data are available

Pointed out by Richard Doernberg in his International Taxation in a Nutshell, 5th ed. (St.

Paul, MN: West Group, 2001), p. 215. Our explanation of baskets relies heavily on

Professor Doernberg’s book.

See Kathryn A. Green and Scott Luttrell, “Corporate Foreign Tax Credit, 1977,” Statistics

of Income Bulletin, vol. 21, Winter 2001-2002, p. 143.

A high withholding tax is defined for purposes of the limitation as a withholding tax with

a rate of at least 5%.

U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act

of 1986, joint committee print, 100th Cong., 1st sess. (Washington: GPO, 1987), p. 863.

Ibid., p. 864. See also the explanation in Doernberg, International Taxation in a Nutshell,

p. 220.

CRS-8

suggest that the most important consolidations would be eliminating the highwithholding-tax basket (whose contents would most likely be placed in the passiveincome basket) and eliminating the basket for section 902 corporations.

“Look Through” Treatment for Dividends from Section 902

Corporations

As noted above, the tax code currently requires a separate foreign tax credit

limitation to be calculated for dividends received from each section 902 corporation

– noncontrolled corporations where the recipient owns at least 10% of the stock. The

purpose of the separate limitations is to prevent cross-crediting between dividends

from a 902 corporation and other streams of income; the provision was first enacted

with the Tax Reform Act of 1986.

In 1997, Congress concluded that the separate limitations for section 902

dividends were overly complex and discouraged participation by U.S. firms in joint

ventures overseas.9 The Taxpayer Relief Act of 1997 scheduled the limitation for a

manner of phaseout by applying “look through” rules for section 902 dividends paid

out of earnings generated after 2002. Under the look through rules, the dividend is

apportioned among the tax credit baskets in proportion to the types of income

comprising the section 902 corporation’s earnings and profits. The 1997 Act also

changed the treatment of section 902 dividends paid out of earnings and profits

generated prior to 2003; effective beginning in 2003, the Act places dividends from

all section 902 corporations in a single basket.

As described in the preceding section, H.R. 5095 would remove the separate

limitation for section 902 dividends. H.R. 5095 would also apply a look through rule

to all section 902 dividends, allocating the dividend among the bill’s three baskets

in proportion to the amount of passive, financial services, and general active-business

income comprising the firm’s earnings and profits.

Recharacterization of Overall Domestic Losses

An additional foreign tax credit proposal in H.R. 5095 changes the way the tax

code’s loss rules and foreign tax credit rules interact. Under current law, if a

taxpayer incurs a loss for tax purposes – that is, if it has negative taxable income –

the loss (termed a “net operating loss,” or NOL, in tax parlance) can be “carried

back” up to two years and used to offset taxable income in those years, potentially

generating a tax refund.10 If some or all of the NOL remains after applying it to

carryback years, the loss can be saved and carried forward up to 20 years in the

future.

U.S. Congress, Joint Committee on Taxation, General Explanation of Tax Legislation

Enacted in 1997, joint committee print, 105th Cong., 1st sess. (Washington: GPO, 1997), p.

302.

In March, 2002, Congress enacted as part of P.L. 107-147 a provision that extended the

carryback period to five years in the case of NOLs incurred in 2001 and 2002.

CRS-9

In calculating the foreign tax credit limitation, a taxpayer who incurs a loss with

respect to domestic operations can use the loss to reduce foreign income. If a firm

has some residual U.S. tax liability on foreign income – that is, if it does not have

excess credits – the loss can generate tax savings by reducing U.S. tax on foreignsource income. However, H.R. 5095’s loss provision is aimed at taxpayers in a

different situation: firms that have a domestic loss and excess foreign tax credits.

Here, while the loss does reduce foreign-source income, it produces no tax saving in

the loss year because there is no U.S. tax liability on foreign-source income. Further,

the potential NOL carryforward embodied by the loss – and the resulting future tax

savings – is reduced to the extent the loss is deducted from foreign income. Excess

foreign tax credits can be carried forward up to five years, and deducting the NOL

from foreign income in this case generally increases foreign tax credit carryforwards

in a manner that potentially offsets the loss in tax savings from the reduced NOL

carryforward. However, if a firm expects to be in an excess credit position

indefinitely, this offsetting mechanism does not work and the taxpayer will, in effect,

have lost some or all of its NOL carryforward – an important loss if the firm

anticipates returning to having positive taxable income in the near future.

H.R. 5095 would give firms with domestic losses the option of recharacterizing

a certain amount of U.S.-source income as foreign-source income in a subsequent

year. For firms in an excess credit position in the year the recharacterization occurs,

the recharacterization would increase the amount of foreign tax credits that can be

claimed, thereby compensating for the reduced NOL. The amount of income that can

be recharacterized would be equal to the firm’s previously-incurred domestic loss,

subject to a cap equal to 50% of the firm’s U.S.-source taxable income.

H.R. 5095’s recharacterization proposal has been proposed previously – first in

1983 and again in 1992 – but was not adopted. In part, this was because of concern

over whether firms without excess credits in a loss year, but with excess credits in a

subsequent year, could obtain both the benefit of deducting the loss in the loss year

and recharacterizing income in the later, excess credit year. Treasury Department

testimony in 1992 indicated that “certain objections” to the proposal had been

rendered moot, but did not elaborate. Thus, it is not certain whether the doublebenefit exists with the current proposal.11

Extension of Foreign Tax Credit Carryforward Period

Excess foreign tax credits that accrue in one year can be carried back to the two

preceding years and any credits that remain after the carryback can be carried forward

up to five years. The carryback and carryforward provisions were instituted as a

means of compensating for the possibility that income and deductions may be

For a description of the double benefit, see U.S. Congress, Senate, Committee on Finance,

1983-84 Miscellaneous Tax Bills– VII: S. 120, S. 1397, S. 1584, S. 1814, S. 1815, and S.

1826, hearings, 98th Cong., 1st sess., Sept. 26, 1983 (Washington: GPO, 1984), pp. 79-80.

For subsequent testimony, see U.S. Congress, House, Committee on Ways and Means,

Foreign Income Tax Rationalization and Simplification Act of 1992, hearings, 102nd Cong.,

2nd sess., July 21 and 22, 1992 (Washington: GPO, 1992), p. 235.

CRS-10

recognized at different times under foreign tax systems than under the U.S. system.

H.R. 5095 would extend the carryforward period to 10 years.

Repeal of Foreign Tax Credit Restrictions under the

Alternative Minimum Tax

Under current law, taxpayers pay either their regular tax or their alternative

minimum tax (AMT), whichever is larger. The two amounts ordinarily differ

because taxable income is defined more strictly under the AMT while tax rates under

the AMT are lower than under the regular tax. The purpose of the AMT is to ensure

that every firm or individual who registers positive economic income pays at least

some tax and is not able to use various tax benefits to eliminate their tax completely.

The foreign tax credit is generally not considered a tax “benefit,” but is instead a

mechanism for alleviating double taxation of foreign-source income; the credit is

therefore generally allowed to offset a taxpayer’s AMT. Nonetheless, as part of a

broad revision of the AMT in 1986, Congress concluded that every taxpayer with

positive income should make at least a “nominal” contribution to the U.S. tax base,

even when it is foreign tax credits that eliminate U.S. taxes.12 Accordingly, foreign

tax credits are permitted to offset only 90% of a taxpayer’s AMT.

H.R. 5095 would repeal the 90% limitation.

Overseas Investment: Deferral and Subpart F

As described above, the tax deferral available to income earned through foreign

subsidiary corporations is restricted in some cases by the tax code’s Subpart F

provisions – provisions that were first enacted in 1962 and that were designed to

restrict firms’ ability to augment the deferral tax benefit by concentrating income in

tax havens or other countries with low tax rates. Subpart F denies the deferral benefit

to certain types of income whose geographic source is thought to be easily

manipulated. The tax code contains several other “anti-deferral” regimes in addition

to Subpart F. Most prominent of the other anti-deferral regimes is the passive foreign

investment company (PFIC) rules.

The tax code applies Subpart F to those U.S. stockholders who own at least 10%

of a “controlled foreign corporation (CFC),” as defined by the tax code. A CFC, in

turn, is a foreign corporation that is more 50% owned by those U.S. stockholders

owning at least 10% of the corporation’s stock. One component of income covered

by Subpart F is income the tax code terms “foreign personal holding company

income,” which is generally income from passive investment (e.g., interest,

dividends, and royalties). Subpart F income also includes income from international

air or sea transportation, certain oil-related income, certain insurance income, and

certain sales and services income from transactions with related firms. H.R. 5095

U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act

of 1986, joint committee print, 100th Cong., 1st sess. (Washington: GPO, 1987), p. 436.

CRS-11

would generally reduce the scope of Subpart F, thus expanding the applicability of

deferral.

Sales and Services Income Subject to Subpart F

H.R. 5095’s most important change to Subpart F is likely its proposal to remove

sales and services income from the provision’s coverage. As defined under current

law these categories of income – termed “foreign base company sales income” and

“foreign base company services income”– consist (respectively) of income from sales

to a related corporation where the property is both produced and used outside the

related corporation’s country of incorporation, and income from the provision of

services to a related corporation, outside the CFC’s country of incorporation. H.R.

5095 would retain Subpart F coverage for sales of U.S. products back to the United

States, thus apparently restricting the ability of firms to apply the deferral benefit to

what might be U.S.-source income.

Given the elimination of the extraterritorial income (ETI) tax benefit for

exporting by other parts of H.R. 5095, the question of whether or not the bill’s repeal

of foreign base company sales and services income could pose a replacement export

benefit is relevant.13 Suppose, for example, a U.S. exporting corporation sells its

exports to a subsidiary foreign corporation chartered in a low-tax country, and the

foreign subsidiary, in turn, sells the exports in various foreign markets. To the extent

export income is allocated for tax purposes to the foreign subsidiary rather than the

U.S. parent, an export tax benefit results. Further, it is not clear whether continuing

to apply Subpart F coverage to sales of products back to the United States while

exempting exports would run afoul of the WTO agreements.

Absent stringent regulations governing the allocation of income, a firm might

be able to achieve such an export benefit by, for example, charging an unrealistically

low price for exports sold to its foreign subsidiary; such a technique would make the

foreign subsidiary’s income unrealistically high and the U.S. parent’s income

unrealistically low. However, the internationally-accepted norm for allocating

income between related entities for tax purposes is a method known as “arm’s length

pricing” – a method that approximates the division that would occur if the different

parts of the firm were, in fact, unrelated. And where “arm’s length pricing” rules are

followed in allocating income between a U.S. parent and its foreign sales subsidiary,

little or no export income can be allocated to a foreign sales subsidiary. IRS

regulations issued under section 482 of the Internal Revenue Code generally require

arm’s length pricing to be used in allocating income.14 Some observers, however,

The possibility of solving the dispute in this manner was raised as early as 1988. See:

Robert E. Hudec, “Reforming GATT Adjudication Procedures: The Lessons of the DISC

Case,” Minnesota Law Review, vol. 72, June 1988, p. 1449. However, the writer ignores the

obstacle to this solution posed by application of arm’s length pricing.

Doernberg, International Taxation in a Nutshell, p. 237.

CRS-12

have expressed concern over potential manipulation of transfer prices so as to shift

export income abroad.15

“Look through” Treatment for Dividends Flowing Between

Related Foreign Subsidiaries

As noted above, one broad type of income subject to Subpart F is income from

passive investment, which is defined to include dividends. Current law makes an

exception, however, for dividends and interest a CFC receives from a related

corporation that is incorporated in the same foreign country as the CFC itself, and

that conducts business in that country. Subpart F income also does not include rents

and royalties received for the use of property in the CFC’s own country. H.R. 5095

would add to these exceptions dividend, interest, and other passive income a CFC

receives from a related CFC to the extent the payments are not attributable to what

would be Subpart F income in the hands of the related corporation. The proposed

look through rule contrasts with current law’s exceptions in that the country where

the excepted income originates would be immaterial, but would not include all

dividend or other income received from the related CFC.

Other Provisions for U.S. Investment in Foreign Corporations

As described above, one type of Subpart F income is “foreign personal holding

company (FPHC) income,” which is generally income from passive investment,

generally including dividends, interest, rents, royalties, and annuities. FPHC income

also includes gains from the sale of assets that produce the identified types of passive

income, gains from the sale of interests in partnerships or trusts, and gains from

certain commodities transactions. H.R. 5095 would repeal Subpart F’s inclusion of

gain from the sale of partnership interests and would ease its applicability to gains

from commodities transactions. It would also provide more generous treatment

under Subpart F’s oil-income rules to income from transportation of oil.

As noted above, Subpart F is not the only anti-deferral regime contained in the

U.S. tax code, although it likely is the most broadly applicable. Next to Subpart F,

the most widely applicable set of rules limiting deferral are the passive foreign

investment company (PFIC) rules, enacted with the Tax Reform Act of 1986. In

contrast to Subpart F, the PFIC rules deny the deferral benefit to all income of

defined corporations (PFICs) and to all stockholders, not just 10% stockholders. A

PFIC is defined differently than a CFC, however. Rather than criteria based on

control by U.S. stockholders, a PFIC is a foreign corporation that is intensively

engaged in passive investment, according to several tests set forth in the PFIC rules.

Beyond the Subpart F and PFIC rules, deferral of tax on foreign income can

potentially be restricted under four additional sets of rules: the foreign personal

holding company provisions; the foreign investment company rules; the

personal holding company provisions; and the accumulated earnings tax rules.

(The last two of these can apply to domestic as well as foreign corporations.) The

Samuel C. Thompson, Jr. “A Critical Perspective on the Thomas Bill,” Tax Notes, Jul. 22,

2002, pp. 581-584.

CRS-13

scope and applicability of the regimes differ and can overlap in some cases. The tax

code contains rules coordinating the various regimes.

H.R. 5095 would repeal the foreign personal holding company rules and the

foreign investment company rules. It would exclude foreign-chartered corporations

from coverage under the personal holding company provisions.

Provisions Directed at “Earnings Stripping” and

Corporate “Inversions” or “Expatriation”

Recent news reports and articles in professional tax journals have drawn the

attention of policymakers and the public to a phenomenon sometimes called

corporate “inversions” or “expatriation” – instances where firms that consist of

multiple corporations reorganize their structure so that the “parent” element of the

group is a foreign corporation rather than a corporation chartered in the United

States. Firms engaged in the inversions cite a number of reasons for undertaking

them, including creating greater “operational flexibility,” improved cash

management, and an enhanced ability to access international capital markets.16

Prominent, if not primary, however, is the role of taxes: firms that undertake

inversion have indicated they expect significant tax savings from the

reorganizations.

A prototypical inversion begins with a firm with operations in both the United

States and abroad, but whose parent corporation – the component of the firm whose

stock is traded on the stock exchange – is chartered in the United States. Thus, the

firm may use the deferral tax benefit for its foreign operations, but its foreign income

is ultimately subject to U.S. tax when it is repatriated to the United States. The firm

in question inverts by creating a foreign corporation chartered in a low tax country

– Bermuda and the Cayman Islands have been cited as popular destinations. The

firm reorganizes so the new foreign corporation becomes the parent of the U.S.

corporation that was formerly the parent firm; the former U.S. parent transfers its

foreign subsidiary corporations to the new foreign parent. The stockholders of the

erstwhile U.S. parent firm automatically become stockholders of the new foreign

parent.

Inversions need not involve the shift of economic activity from the United States

abroad, and those that have been prominently featured in the recent controversy have

apparently been accomplished entirely on paper. The transaction does, however,

produce tax savings from two general sources. First, as described above, although

the United States does not tax the foreign-source income of foreign subsidiaries

immediately, it does tax their income when it is ultimately remitted to the United

These reasons were cited by Stanley Works in a Feb. 8, 2002 press release. The release

is available at the firm’s website at [http://www.stanleyworks.com/index.htm]. See also the

Nov. 2, 2001 proxy statement by Ingersoll-Rand, which cited “a variety of potential

business, financial and strategic benefits.” The statement is available on the IR website at:

[http://www.ingersoll-rand.com/proxy.pdf]. Note that on Aug. 1, Stanley Works announced

that it was cancelling its planned reorganization.

CRS-14

States. An inversion eliminates this deferred tax liability by placing the ownership

of foreign subsidiaries in the hands of the new foreign parent.17

A second source of tax saving from an inversion – known as “earnings

stripping” – actually applies to U.S. rather than foreign-source income. The practice

of earnings stripping involves a U.S. subsidiary corporation essentially shifting U.S.source income out of the U.S. tax jurisdiction, from the hands of a taxable U.S.

corporation into the hands of a foreign corporation. In general, the U.S. subsidiary

of a foreign corporation makes tax-deductible payments (e.g., interest or royalties)

to its foreign parent firm in compensation for intrafirm loans or the use of patents or

copyrights. The tax deduction reduces the taxable income of the U.S. subsidiary,

while increasing the income of the foreign subsidiary. Given that foreign

corporations are subject only to U.S. corporate income tax on the active conduct of

a U.S. trade or business, the interest or royalty income is removed from the U.S. tax

base.18 Note that earnings stripping is not unique to inverted U.S.-owned firms, but

can be practiced by foreign-owned firms that invest in the United States through

U.S.-chartered subsidiaries. Indeed, in 1989 provisions designed to curtail earnings

stripping were enacted with section 163(j) of the Internal Revenue Code.

H.R. 5095 contains provisions that would curtail each of these sources of tax

savings. First, it would revamp existing restrictions on earnings stripping contained

in section 163(j). Under current law, deductions are denied for interest paid to

related entities if the payor’s debt-to-equity ratio exceeds 1.5 to 1; the deduction is

generally denied for interest exceeding 50% of its taxable income, after certain

adjustments. Denied deductions are permitted to be carried forward indefinitely, and

used to reduce taxable income in the future. H.R. 5095 would redesign the

restrictions by removing the debt-to-equity test and reducing the percentage threshold

to 35% from 50%. The bill would also limit the carryforward of interest to five

years.

In addition to these changes, H.R. 5095 would disallow a portion of interest

deductions if a domestic subsidiary’s indebtedness is out of proportion to the entire

corporate group’s indebtedness, and the indebtedness consists of debt to related

entities. More specifically, the deductibility of interest on related party debt would

be disallowed to the extent the subsidiary’s total debt (to both related and unrelated

entities) exceeds a share of the entire group’s external debt equal to the subsidiary’s

share of the group’s assets.

At the same time, however, an inversion may trigger U.S. capital gains tax for U.S.

individual stockholders of inverting firms. Some have suggested this provides a clue as to

the reason for the recent apparent upsurge in inversions – the declines in the stock market

have made the individual-level capital gains tax consequences of inversions less onerous.

For further information, see CRS Report RL31444, Firms That Incorporate Abroad for Tax

Purposes: Corporate “Inversions” and “Expatriation,” by David L. Brumbaugh.

Note that aside from the corporate income tax, the United States in some cases applies a

withholding tax on interest or royalty payments to non-residents. However, the withholding

tax is frequently reduced or eliminated by treaty provisions.

CRS-15

H.R. 5095 addresses inversions’ savings on foreign-source income with a

temporary measure that would treat the new foreign parent firms created in an

inversion transaction as U.S. firms. The foreign parents’ foreign-source income

would thus be subject to U.S. taxation upon its receipt. The provision would apply

to transactions where the shareholders of the former U.S. parent corporation own

80% or more of the new foreign-chartered parent, and the foreign parent does not

have substantial business activity in its country of incorporation. The provision

would apply for inversions occurring during the three-year period spanning March

20, 2002 to March 20, 2005.19

An additional inversion provision under the bill would apply to transfers of

foreign stock by a U.S. corporation (e.g., a former parent corporation) to a new

foreign parent firm. Under current law, such transfers are in principle subject to U.S.

tax, but U.S. tax can be offset by foreign tax credits or net operating losses. H.R.

5095 would prohibit such “toll taxes” from being offset by tax credits and other tax

attributes. This provision would apply to transactions where 60% or more of the

foreign parent company is owned by stockholders of the former U.S. parent. The

provision would be permanent rather than limited to three years.

In contrast to the tax savings inversions can generate at the corporate level,

individual stockholders of an inverting firm are generally required to recognize any

gain embedded in their stock at the time of inversion. In contrast, current law

provides that persons holding stock options are not subject to U.S. tax until the

option is exercised. Accordingly, persons holding stock options in inverting firms

– for example, corporate officers – could avoid the capital gains tax that would

ordinarily apply when an inversion occurs. H.R. 5095 would impose a 20% excise

tax on certain holders of an inverting firm’s stock options, including officers,

directors, and persons owning 10% or more of the firm’s stock. The tax would be

imposed on gain determined by reference to an option-pricing model specified by the

Treasury Department.

Repeal of the Extraterritorial Income Tax

Benefit for Exports

Under the U.S. residence-based tax system, the United States would ordinarily

tax income its exporters earn from sales of U.S. goods abroad. However, prior to

2001, the U.S. tax code’s Foreign Sales Corporation (FSC) rules provided an explicit

tax benefit for exporting.20 The FSC provisions were the statutory descendant of the

This provision is similar to anti-inversion provisions of several other bills introduced in

the 107th Congress, although those proposals would generally not be temporary. For a

discussion of those bills, see: CRS Report RL31444, Firms that Incorporate Abroad for Tax

Purposes: Corporate “Inversions” and “Expatriation”, by David L. Brumbaugh.

An alternative, implicit tax benefit for exporting is provided by the so-called “export

source rule,” under whose terms an exporter can allocate as much as 50% of export income

to foreign sources for purposes of calculating its foreign tax credit limitation. This has the

effect of providing a 50% tax exemption for firms in an excess credit position. The EU has

(continued...)

CRS-16

an earlier tax benefit – the Domestic International Sales Corporation (DISC)

provisions, first enacted in 1971. However, European countries charged that DISC

was an export subsidy, and so violated the General Agreement on Tariffs and Trade

(GATT). Although a GATT panel supported the European charge, the United States

never conceded that DISC violated GATT. The FSC provisions were enacted in

1984 in an attempt to defuse the controversy.

In 1997, the countries of the European Union (EU) complained to the World

Trade Organization (WTO; successor to GATT) that FSC also was an export subsidy

and contravened the WTO. A WTO panel ruling upheld the EU complaint, and to

avoid WTO-sanctioned retaliatory tariffs, the United States in November 2000

replaced FSC with the ETI provisions, which deliver a tax benefit of similar size but

that was redesigned in an attempt to achieve WTO-compliance. The United States

maintained that the ETI provisions were WTO-compliant, but the EU disagreed and

asked the WTO to rule against them and approve $4 billion in tariffs. A WTO panel

ruled against the ETI provisions in August, 2001, and in January, 2002, a WTO

appellate body denied an appeal by the United States. On August 30, 2002, a WTO

arbitration panel issued a report approving the level of tariffs requested by the EU.

Some EU officials have suggested that the EU is not anxious to impose

sanctions and will delay their implementation as long as it believes the United States

is making progress in becoming WTO-compliant. Unlike the previous legislative

responses to GATT and WTO rulings, H.R. 5095 does not attempt to construct a

WTO-compliant export tax benefit. Rather, it would simply repeal the provision.21

Other Provisions

As noted at the outset of the report, H.R. 5095 contains a set of provisions

designed to restrict the use of tax shelters by corporations; these provisions are not

discussed in this report. In addition, the bill contains several other proposals not

related to taxation of income from international transactions.

One of these provisions is indexation and expansion of the “expensing”

allowance contained in section 179 of the tax code. Under current law, firms are

permitted to deduct immediately (expense) rather than deduct gradually (depreciate)

up to $24,000 of equipment investment each year. The allowance is scheduled to

increased to $25,000 in 2003 and thereafter. The amount that can be expensed is

reduced and gradually eliminated for a firm’s investment above $200,000. The effect

of the expensing allowance is to confer a tax benefit in the form of a tax deferral

because the expensed investment is deducted more rapidly than the asset in question

actually declines in value.

(...continued)

not lodged a complaint against the export source rules.

For further information on the ETI/FSC/WTO controversy, see CRS Report RS20746,

Export Tax Benefits and the WTO: Foreign Sales Corporations and the Extraterritorial

Replacement Provisions, by David L. Brumbaugh.

CRS-17

H.R. 5095 would index for inflation both the basic allowance and the $200,000

threshold above which the allowance is phased out. Indexing would begin in 2005.

In addition, the bill would increase the base allowance to $40,000 and the phase-out

threshold to $325,000 beginning in 2013.

H.R. 5095 also contains a set of relatively narrow revenue-raising items apart

from its tax shelter, ETI, and inversion proposals. The largest item is extension of

a set of user fees applied by the U.S. Customs Service that are scheduled to expire

at the end of FY2003.

Economic Effects

Impact on Investment and Economic Welfare

The range of provisions contained in H.R. 5095 is broad, and a comprehensive

analysis of its likely economic effects is not undertaken here. Nonetheless, several

general preliminary assessments are possible. First, the bill’s proposals relating to

the foreign tax credit, controlled foreign corporations, and repeal of the ETI

provisions will each probably increase the share of U.S.-owned capital that is

employed abroad rather than in the United States beyond what would otherwise

occur. Second, in isolation, repeal of the ETI provisions is likely to reduce the level

of U.S. trade, reducing both exports and imports. At the same time, however, the

increased flow of U.S. capital abroad that would occur in the near term is likely to

reduce the U.S. trade deficit in the near term below what would otherwise occur. The

bill’s net impact on U.S. economic welfare is uncertain, with repeal of the ETI

benefit probably increasing U.S. welfare (in isolation) and the foreign tax credit and

CFC provisions reducing it. According to “very preliminary” estimates by the Joint

Committee on Taxation, the bill would increase revenues by a net $6.4 billion over

five years and by $1.1 billion over 10 years.

Business taxes apply to corporate profits – the return from capital investment.

Accordingly, the most direct impact of changes in international business taxes is on

the level, location, and type of investment firms undertake, and it is here H.R. 5095

would likely have its most immediate impact. As we have seen, the bill proposes

changes in two broad areas affecting the income from overseas operations – changes

to the foreign tax credit and related source-of-income rules and changes for the

deferral principle and Subpart F. In applying to income from overseas operations,

the proposals affect the aftertax rate of return on overseas investment; the changes

would generally reduce the tax burden on investment abroad and thus increase its

attractiveness for U.S. firms. Accordingly, one broad impact of the bill’s foreign tax

credit and CFC proposals would be to increase the share of U.S.-owned capital

consisting of foreign rather than domestic U.S. investment compared to what would

otherwise occur.

In contrast, two other broad areas of the bill – its earnings stripping and ETI

exporting provisions – would both likely affect the rate of return on investment in the

United States. Export production, by definition, involves investment and production

in the United States and sales abroad. Repeal of the ETI provisions would therefore

CRS-18

probably reduce the aftertax rate of return on investment in the United States export

sector and in isolation may increase the flow of U.S. investment abroad by a small

amount. At the same time, a portion of investment released from the U.S. export

sector would likely stay in the United States, flowing to the import-competing sector

and other parts of the economy. For their part, the earnings stripping rules would

likely increase the tax burden on foreign investment in the United States by making

it harder to shift U.S.-source income abroad for tax purposes. Accordingly, the

earnings-stripping provisions would probably reduce the stock of foreign investment

to the United States below what would otherwise occur.

Each of these effects works in the same direction, working to increase the share

of U.S.-owned capital employed abroad. The lone exception of the bill’s proposals

appears to be the increase in the expensing allowance for domestic U.S. investment.

This provision, in isolation, would probably reduce the level of investment abroad

compared to what would otherwise occur. Nonetheless, because the great bulk of the

bill’s proposals would increase the flow of U.S. investment abroad, the bill’s net

impact would probably be in that direction.

The bill’s likely impact on U.S. exports is harder to discern. In isolation, repeal

of the ETI provisions would probably reduce the level of U.S. exports, although

exchange rate adjustments that would reduce the price of the U.S. dollar would

probably also reduce U.S. imports. In isolation, repeal of the ETI provisions would

probably not alter the U.S. balance of trade. But the provisions of the bill that would

alter the level of U.S. capital employed abroad – the foreign tax credit and CFC

provisions – would likely alter the balance of trade at least in the near term, triggering

exchange rate adjustments that would also reduce the price of U.S. currency in world

markets. In isolation, U.S. exports would increase and imports would fall, reducing

the U.S. trade deficit. It is likely that the net impact of the bill would be to reduce

U.S. imports, but whether the bill would increase exports, on balance, is uncertain.

These effects may actually reverse in the long run, as capital stocks abroad adjust to

the new levels induced by the bill’s foreign investment provisions.

Economic theory suggests, however, that a country’s ultimate economic welfare

– in this case, that of the United States – does not depend, for example, on exporting

as much as it possibly can or even on maximizing the competitiveness of its firms’

operations abroad. Rather, it depends heavily on whether investment locations are

distorted in inefficient ways or on whether the benefit of subsidies accrues to U.S.

individuals or firms or flows out of the United States. In the case of an export

subsidy such as the ETI provisions, economic theory suggests that its repeal would,

in isolation, increase the economic welfare of the United States on both counts. An

export subsidy distorts the allocation of investment, drawing an inefficient amount

of capital to the export sector and encouraging the subsidizing country (here, the

United States) to export more than is economically efficient. At the same time, a part

of the export benefit flows to foreign consumers, as U.S. producers pass on part of

their tax reduction in the form of lower prices for U.S. goods.

The net impact of the remaining parts of the bill on U.S. economic welfare are

harder to discern, and a definite conclusion is not possible at this point. For

example, the deferral tax benefit poses an incentive for U.S. firms to invest in lowtax countries more than they otherwise would, and traditional economic theory

CRS-19

suggests that such a distortion of investment reduces U.S. economic welfare.

Accordingly, the parts of the bill that relax Subpart F and expand deferral – for

example, the provisions relating to section 902 firms and the repeal of foreign base

company sales income – probably, in isolation, reduce U.S. economic welfare.

In contrast, the bill’s interest allocation rules may reduce distortions in

investment. As noted above, the rules are designed to correct an imperfection in the

design of existing rules that affect the operation of the foreign tax credit limitation,

and, in any case, one general impact of the foreign tax credit limitation is to distort

investment by posing a tax disincentive to invest abroad. Accordingly, the revised

interest allocation rules, by providing more generous foreign tax credit limitation

rules, may ease the limitation’s distortion and increase economic welfare.

The impact of other foreign tax credit proposals is more ambiguous. The

practice of “cross-crediting” foreign tax credits between different streams of foreign

income probably poses an incentive to invest in low-tax countries by shielding such

investment from U.S. tax. Expansion of cross-crediting would likely result from

H.R. 5095’s consolidation of the foreign tax credit’s separate baskets. On the other

hand, however, cross-crediting probably also reduces a disincentive to invest in hightax countries, thereby reducing a distortion posed by the U.S. foreign tax credit.

But even if both the interest allocation rules and reduction of foreign tax credit

baskets were to reduce investment distortions on balance, we could not automatically

conclude that the provisions enhance U.S. economic welfare. The reason is tax

revenue: to the extent the provisions reduce U.S. tax revenue collected from foreign

sources, the provisions may reduce U.S. welfare, and whether that reduction would

be sufficient to offset efficiency gains from allocation of investment is not clear.

Impact on U.S. Tax Revenue

As noted above, the Joint Committee on Taxation’s preliminary estimates are

that H.R. 5095 would, on balance, increase tax revenue over $6.4 billion over its first

five years and by $1.1 billion over its first 10 years. These figures are modest

compared to other tax bills enacted in recent years. For example, the Economic

Growth and Tax Relief Reconciliation Act of 2001 (Public Law 107-16) was

estimated to reduce tax revenue by $552.5 billion over five years and by $1,348.5

billion over 10 years. The estimates we cite for H.R. 5095, however, are net amounts

equal to the revenue gain from the bill’s revenue-raising items minus the revenue loss

from its revenue-losing provisions, and the net amounts mask larger swings in

revenue that are estimated to occur. Taken alone, the revenue-raising items would

increase revenue by an estimated $43.1 billion over five years and $94.7 billion over

10 years; the revenue -losing items would reduce revenue by an estimated $36.6

billion over five years and by $93.6 billion over 10 years. These revenue changes are

still small, however, compared to those projected to result from the 2001 tax cut.

Table 1 shows the Joint Committee’s estimates for the bill.

CRS-20

Table 1. Estimated Revenue Effects of H.R. 5095

(Prepared by the Joint Committee on Taxation)

(Millions of Dollars)

Fiscal Years

2002-2007

Fiscal Years

2002-2012

Tax Shelter Provisions

3,766

8,510

Economic substance doctrine

2,912

6,404

Reportable transactions

551

1,270

Partnership loss transfers

196

547

Substantial understatement penalty

188

Certain conduct related to tax shelters and

reportable transactions

Civil penalty on failure to report interest in foreign

accounts

Frivolous tax submissions

Regulation of individuals practicing before the

Treasury

Stripped interest

Minimum holding period on foreign tax credit

Consolidated return regulation

Tax Avoidance Through Earnings Stripping and

Expatriation

2,597

6,305

Earnings stripping

2,115

5,568

Expatriated entities (inversions)

405

595

Compensation of insiders in expatriated

corporations

115

Reporting of taxable mergers and acquisitions

U.S. Business Operations Abroad

-35,069

-88,516

Repeal of CFC rules on foreign base company

sales and service income

-13,727

-37,381

Look through treatment of payments between

related CFCs

-854

-2,216

Look through treatment for sales of partnership

interests

-392

-948

Repeal of foreign personal holding company rules

and foreign investment company rules

-269

-785

Treatment of pipeline transportation income

-26

-126

Foreign personal holding company income related

to commodities

-42

-95

CRS-21

Fiscal Years

2002-2007

Fiscal Years

2002-2012

Interest expense allocation rules

-9,882

-23,417

Recharacterization of overall domestic loss

-2,383

-6,041

Consolidation of foreign tax credit baskets

-2,785

-6,151

10-year foreign tax credit carryforward

-2,087

-6,725

Repeal of foreign tax credit limit under the

minimum tax

-1,873

-3,860

Look through rules for section 902 corporations

-736

-743

Stock ownership rules in apply section 902 and 960

credits

-13

-28

Repeal of export tax benefits

22,124

51,401

Repeal of ETI tax benefit for exporters

21,957

51,233

167

168

10,040

16,450

Application of uniform capitalization rules to

foreign persons

-488

-548

Assets acquired by dealers

-47

-113

Dividends of regulated investment companies

-445

-988

Average exchange rate rule

Withholding tax on dividends

-14

-29

Increase in section 179 expensing

-568

-3,422

Extension of IRS user fees

138

341

Extension of customs user fees

5,767

14,883

Nonqualified deferred compensation plans

4,226

5,214

Transfers of excess defined benefits pension plan

assets

287

Estimated taxes for deemed asset sales

120

145

1,108

527

Interest on potential underpayments

130

104

Installment agreements

Excise tax on bows and arrows

-7

-14

2,968

6,906

Repeal of FSC transitional rules

Other Provisions

Interest on tax overpayments

Interaction among provisions

Source: U.S. Congress, Joint Committee on Taxation, reprinted in BNA Daily Tax Report, July 17,

2002, pp. L1-L4.

CRS-22

Affected Industries

A general idea of the industries that would be primarily affected by H.R. 5095

can be gained by perusing Internal Revenue Service Statistics of Income data on

Foreign Sales Corporations, foreign tax credits, and controlled foreign corporations.

Tables 2 and 3 present FSC data, by type of product, and provide a glimpse of

the industries that would likely be most affected by repeal of FSC’s successor, the

ETI provisions. The tables show that manufactured products, by far, were the leading

exports of FSC-utilizing firms. Further, use of FSC was concentrated in just a few

manufacturing industries: together, nonelectrical machinery, motor vehicles and

aircraft, electrical machinery, and chemicals and drugs accounted for 63% – nearly

two-thirds – of FSC receipts and for 56% of exempt income of FSCs.

Table 2. Foreign Sales Corporations, 1996:

Gross Receipts, by Major Product

(money amounts in thousands)

Gross Receipts

Percent of Total

Gross Receipts

All Products

$285,902,491

100.0%

Nonmanufactured Products: Agricultural

$17,545,571

6.1%

Grains and Soybeans

9,138,533.00

3.2%

Livestock

3,742,374.00

1.3%

Crops, except cotton, grains and soybeans

2,935,908.00

1.0%

Cotton

1,100,600.00

0.4%

Fishery products

583,222.00

0.2%

Agricultural services

44,934.00

0.0%

Nonmanufactured Products: Nonagricultural

$16,965,476

5.9%

Computer software

8,985,985.00

3.1%

Motion picture distribution

4,312,768.00

1.5%

Engineering and Architectural Services

1,558,867.00

0.5%

Metal mining, except iron

917,219.00

0.3%

Coal mining

877,641.00

0.3%

Leasing services, other than aircraft

312,996.00

0.1%

Miscellaneous Nonmanufactured Products

2,740,361.00

1.0%

Manufactured Products

$246,480,712

86.2%

Nonelectrical machinery

52,290,199.00

18.3%

Motor vehicles, aircraft, and other transp. equipment

51,932,407.00

18.2%

Electrical machinery

43,665,146.00

15.3%

Chemicals, drugs, and allied products

31,952,356.00

11.2%

Professional instruments

13,205,941.00

4.6%

CRS-23

Gross Receipts

Percent of Total

Gross Receipts

Tobacco products

6,919,745.00

2.4%

Paper and allied products

6,574,620.00

2.3%

Fabricated metal products

5,082,249.00

1.8%

Primary metal products

3,901,103.00

1.4%

Miscellaneous manufactured products

2,773,969.00

1.0%

Rubber and miscellaneous plastics

2,192,314.00

0.8%

Lumber and wood products

2,119,700.00

0.7%

Textile mill products

1,271,260.00

0.4%

Stone, clay, glass, and concrete

930,767.00

0.3%

Apparel and other finshed goods

907,968.00

0.3%

Leather and leather products

884,299.00

0.3%

Printing, publishing, and allied products

770,966.00

0.3%

Furniture and fixtures

479,266.00

0.2%

Petroleum refinery products

392,570.00

0.1%

Food and kindred products

17,505.00

0.0%

Source: CARS calculations based on data in U.S. Internal Revenue Service Statistics of Income

Bulletin, Spring, 2000, pp. 99-102.

CRS-24

Table 3. Foreign Sales Corporations, 1996:

Net Exempt Income, by Major Product

(money amounts in thousands)

Net Exempt

Income

All Products

% of

Total Net

Exempt

Income

$8,496,280

100.0%

$220,350

2.6%

Grains and soybeans

110,594.00

1.3%

Crops, except cotton, grains, and soybeans

40,327.00

0.5%

Livestock

31,965.00

0.4%

Fishery products and services

19,311.00

0.2%

Cotton

12,450.00

0.1%

Agricultural services

5,703.00

0.1%

Nonmanufactured Products: Nonagricultural

763,309.00

9.0%

Computer software

482,913.00

5.7%

Motion picture distribution

167,425.00

2.0%

Engineering and architectural services

48,680.00

0.6%

Metal mining, except iron

35,502.00

0.4%

Leasing services, other than aircraft

16,788.00

0.2%

Coal mining

12,001.00

0.1%

Miscellaneous nonmanufactured products

94,380.00

1.1%

Manufactured products

$7,367,733

86.7%

Electrical machinery

1,693,099.00

19.9%

Machinery, other than electrical

1,377,157.00

16.2%

Chemicals, drugs, and allied products

1,354,662.00

15.9%

Professional instruments

472,533.00

5.6%

Transportation equipment

319,477.00

3.8%

Tobacco Products

285,205.00

3.4%

Food and kindred products

284,647.00

3.4%

Paper and allied products

138,272.00

1.6%

Fabricated metal products

111,174.00

1.3%

Miscellaneous nonmanufactured products

98,775.00

1.2%

Primary metal products

80,828.00

1.0%

Lumber and wood products

55,403.00

0.7%

Rubber and miscellaneous plastics

45,313.00

0.5%

Printing and publishing

36,618.00

0.4%

Textile mill products

35,826.00

0.4%

Nonmanufactured Products: Agricultural

CRS-25

Net Exempt

Income

% of

Total Net

Exempt

Income

Stone, clay, glass, and concrete

27,527.00

0.3%

Apparel and other finished products

18,389.00

0.2%

Leather and leather products

15,405.00

0.2%

Furniture and fixtures

12,956.00

0.2%

Petroleum refining

7,647.00

0.1%

Source: CARS calculations based on data in U.S. Internal Revenue Service Statistics of Income

Bulletin, Spring, 2000, pp. 99-102.

Table 4, below, presents data on foreign tax credits. In assessing the principal

industries that would be affected by the foreign tax credit provisions of the bill, we

note first that the bill’s main foreign tax credit proposals – its provisions for interest

allocation rules, recharacterization of domestic loss, consolidation of separate

baskets, and extended carryforward period – would only directly affect firms having

excess foreign tax credits. Unfortunately, excess credit data on an industry-byindustry basis have not been published, and we are therefore left with indirect

indicators of foreign tax credit position for the various industries. Table 4 offers one

such indirect measure, contained in the right-most column of the table: the percentage

of all un-credited foreign taxes accounted for by each industry, which can be viewed

as an approximation of the percentage of total excess credits in each industry. The

table shows that petroleum manufacturing by far accounts for the largest share of

“uncredited” foreign taxes, at 30.4%.22 Primary metal products is a distant second,

at 7.9%, motor vehicles is third at 6.1%, banking is fourth at 4.3%, and wholesale

trade is fifth, at 3.8%.

Table 5 presents data on Subpart F income. The right-hand column lists

Subpart F income by industry, as a percentage of total Subpart F income, and thus

gives an idea of which industries may be most affected by H.R. 5095’s relaxation of

Subpart F rules. According to the table, Subpart F income is concentrated in the

finance, insurance, and real estate industry (FIREA) – a phenomenon that likely

reflects the importance of passive income in the Subpart F rules. FIREA accounts

for 51.7% of all Subpart F income. Within FIREA, holding companies have the

largest portion of Subpart F income, followed by credit agencies, banks, and

insurance firms. Manufacturing accounts for only 28.39% of Subpart F income, with

drugs and electrical equipment manufacturers the leaders.

This high percentage may result from the exclusion of foreign taxes on oil extraction,

because oil firms tend to be vertically integrated and taxes on oil extraction tend to be high.

CRS-26

Table 4. 1997 Foreign Tax Credits Claimed, by Industry

(money amounts in thousands of dollars)

Foreign Taxes Foreign Tax

Available for

Credit

Claimed

Percentage of

Available

Aggregate

Foreign Taxes

less Credits Foreign Taxes

Not Credited

Claimed

$49,979,466

$42,222,743

$7,756,723

100.0%

38,313.00

34,696.00

3,617.00

0.0%

1,416,118.00

906,954.00

509,164.00

6.6%

Metal mining

417,581.00

166,282.00

251,299.00

3.2%

Oil and gas extraction

854,837.00

637,691.00

217,146.00

2.8%

Coal mining

134,825.00

94,155.00

40,670.00

0.5%

Nonmetallic minerals, except

fuels

8,875.00

8,826.00

49.00

0.0%

Construction

63,431.00

44,412.00

19,019.00

0.2%

Manufacturing

35,792,177.00 30,299,210.00

5,492,967.00

70.8%

Petroleum

9,102,941.00

6,748,403.00

2,354,538.00

30.4%

Drugs

2,815,266.00

2,202,041.00

613,225.00

7.9%

Electrical and electronic

equipment

3,437,298.00

2,962,524.00

474,774.00

6.1%

Primary metal products

701,061.00

421,868.00

279,193.00

3.6%

Motor vehicles and equipment

2,624,433.00

2,380,504.00

243,929.00

3.1%

Food and kindred products

3,042,404.00

2,801,304.00

241,100.00

3.1%

Office, computing, and

accounting

3,376,725.00

3,150,955.00

225,770.00

2.9%

Industrial plastics

1,861,492.00

1,647,569.00

213,923.00

2.8%

Other chemicals

1,471,640.00

1,321,594.00

150,046.00

1.9%

Fabricated metal products

844,557.00

694,974.00

149,583.00

1.9%

Other machinery, except

electrical

985,714.00

854,506.00

131,208.00

1.7%

Tobacco manufactures

1,379,627.00

1,302,880.00

76,747.00

1.0%

Instruments

1,344,804.00

1,292,349.00

52,455.00

0.7%

Paper and allied products

716,140.00

664,059.00

52,081.00

0.7%

Stone, clay, and glass

144,642.00

101,193.00

43,449.00

0.6%

Printing and publishing

331,423.00

288,130.00

43,293.00

0.6%

Miscellaneous manufacturing

217,384.00

177,199.00

40,185.00

0.5%

Rubber and misc. plastics

440,363.00

402,316.00

38,047.00

0.5%

Apparel and other textile

products

291,790.00

266,279.00

25,511.00

0.3%

Furniture and fixtures

41,940.00

22,761.00

19,179.00

0.2%

All Industries

Agriculture, forestry, and

fishing

Mining

CRS-27

Foreign Taxes Foreign Tax

Available for

Credit

Claimed

Available

Percentage of

Foreign Taxes

Aggregate

less Credits Foreign Taxes

Claimed

Not Credited

Lumber and wood products

52,370.00

40,342.00

12,028.00

0.2%

Transportation equipment,

except motor vehicles

527,783.00

517,204.00

10,579.00

0.1%

Textile mill products

28,485.00

26,532.00

1,953.00

0.0%

Leather and leather products

11,896.00

11,724.00

172.00

0.0%

Transportation and Public

Utilities

969,683.00

802,644.00

167,039.00

2.2%

Communication

539,130.00

451,925.00

87,205.00

1.1%

Electric, gas, and sanitary

services

216,693.00

163,078.00

53,615.00

0.7%

Transportation

213,860.00

187,641.00

26,219.00

0.3%

Wholesale trade

980,300.00

686,471.00

293,829.00

3.8%

Retail trade

913,847.00

696,776.00

217,071.00

2.8%

Finance, insurance, and real

estate

7,370,111.00

6,654,591.00

715,520.00

9.2%

Banking

3,672,822.00

3,337,311.00

335,511.00

4.3%

Insurance

1,703,013.00

1,552,984.00

150,029.00

1.9%

Holding companies

620,007.00

481,423.00

138,584.00

1.8%

Credit agencies

505,543.00

457,527.00

48,016.00

0.6%

Security, commodity brokers,

and services

801,877.00

765,424.00

36,453.00

0.5%

Real estate

16,188.00

9,759.00

6,429.00

0.1%

Insurance agents

50,660.00

50,162.00

498.00

0.0%

2,435,487.00

2,096,990.00

338,497.00

4.4%

Services

Source: U.S. Internal Revenue Service, Statistics of Income Bulletin, Winter 2001-2002, pp. 121-135; CRS

calculations.

CRS-28

Table 5. 1996 Subpart F Income of Controlled Foreign

Corporations, by Industry

(dollar amounts in thousands)

Subpart F

Income

Percent of

Total Subpart

F Income

22,943,983.00

100.00%

Agriculture, forestry, and fishing

18,099.00

0.08%

Mining

357,072.00

1.56%

Oil and gas extraction

323,957.00

1.41%

Nonmetallic minerals, except fuels

25,051.00

0.11%

Metal Mining

8,065.00

0.04%

Construction

119,762.00

0.52%

Special trade contractors

109,199.00

0.48%

Heavy construction contractors

10,551.00

0.05%

General bldg. contractors and

operative builders

12.00

0.00%

Manufacturing

6,512,757.00

28.39%

Drugs

1,386,119.00

6.04%

Electrical and electronic equipment

872,370.00

3.80%

Industrial, plastics, and synthetic

materials

562,158.00

2.45%

Office, computing, and accounting

machinery

534,811.00

2.33%

Petroleum and coal products

521,951.00

2.27%

Motor vehicles and equipment

486,697.00

2.12%

Food and kindred products

452,812.00

1.97%

Tobacco manufacturers

436,613.00

1.90%

Other chemicals

279,546.00

1.22%

Instruments and related products

269,941.00

1.18%

Miscellaneous manufacturing products

208,228.00

0.91%

Primary metals industries

141,864.00

0.62%

Other machinery, except electrical

126,859.00

0.55%

Fabricated metal products

110,018.00

0.48%

Paper and allied products

46,856.00

0.20%

Rubber and misc. plastic products

29,719.00

0.13%

All Industries

CRS-29

Subpart F

Income

Percent of

Total Subpart

F Income

Transportation equipment, except

motor vehicles

11,631.00

0.05%

Textile mill products

10,394.00

0.05%

Printing and publishing

9,394.00

0.04%

Stone, clay, and glass products

5,661.00

0.02%

Furniture and fixtures

4,662.00

0.02%

Apparel and other textile products

2,607.00

0.01%

Lumber and wood products

1,846.00

0.01%

Transportation and public utilities

388,157.00

1.69%

Water transportation

130,536.00

0.57%

Other transportation

119,321.00

0.52%

Communication

70,381.00

0.31%

Electric, gas, and sanitary services

67,919.00

0.30%

2,148,213.00

9.36%

241,478.00

1.05%

Finance, insurance, and real estate

11,862,803.00

51.70%

Holding and other investment

companies

4,859,873.00

21.18%

Credit agencies, other than banks

2,911,319.00

12.69%

Banking

1,653,523.00

7.21%

Insurance

1,597,589.00

6.96%

Security, commodity brokers, and

services

677,939.00

2.95%

Real estate

119,665.00

0.52%

Insurance agents, brokers, and services

42,896.00

0.19%

1,295,642.00

5.65%

Business services

791,333.00

3.45%

Other services

421,221.00

1.84%

Hotels and other lodging places

39,983.00

0.17%

Amusement and rec. services

15,559.00

0.07%

Wholesale trade

Retail trade

Services

Source: U.S. Internal Revenue Service, Statistics of Income Bulletin, Spring, 2001, pp.

146-7; CRS calculations.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.