1. 1 OVERVIEW OF U.S. INTERNATIONAL TAX POLICY Presented by: Carol Dunahoo and Peter Merrill PricewaterhouseCoopers LLP with Members of the International Tax Policy Forum July 17, 1998

2. 2 Policy Goals U.S. international tax policy is a balance between capital export neutrality (CEN) and competitiveness.

3. 3 Capital Export Neutrality l The aim of CEN is to make sure U.S. companies bear the same tax burden whether they operate at home or abroad. l This could be achieved by taxing worldwide income when earned and allowing an unlimited credit for foreign taxes paid.

4. 4 Capital Export Neutrality l The U.S. tax system follows CEN principles in that it taxes worldwide income, including income earned abroad by U.S.-owned foreign corporations.

5. 5 Competitiveness l Another goal of U.S. international tax policy is competitiveness. This requires that U.S.- controlled companies operating abroad pay no more tax than their foreign competitors.

6. 6 Competitiveness (cont.) l This could be achieved by exempting income earned abroad from tax so that it would bear tax only at the foreign rate. Such a system is called a “territorial” tax system.

7. 7 Foreign Income Taxation, OECD Countries, 1990 1 For nontreaty countries, worldwide tax with credit. 2 For nontreaty countries, worldwide tax with deduction. 3 Exemption of 90% of gross dividend. 4 Treaty countries with tax system similar to Australia's. 5 25% ownership requirement and tax system similar to Denmark's. 6 Credit for Swiss tax on foreign dividends effectively exempts these dividends from Swiss tax. Source: OECD, Taxing Profits in a Global Economy: Domestic and International Issues, 1991, pp. 63-64.

8. 8 Competitiveness (cont.) l The U.S. strikes a balance between CEN and competitiveness. l It taxes the worldwide income of U.S. companies, but promotes competitiveness by generally deferring U.S. tax on the foreign income earned by U.S. companies doing business abroad.

9. 9 Fundamental Concepts l The United States taxes the worldwide income of U.S. persons –U.S. corporations –U.S. citizens –U.S. residents

10. 10 Choice of Structure l Two Possibilities: –U.S. person may conduct foreign activities: u directly (through a branch or partnership) u indirectly (through a foreign corporation) l Both direct and indirect activities may be conducted through a “hybrid entity” l Business considerations for choice of structure

11. 11 International Double Taxation l If there were no mechanism for avoiding double taxation, U.S. persons could be subject to double taxation, both by the foreign country in which they do business and by the United States. l Foreign taxes include: –income taxes –withholding taxes

12. Foreign Tax Credit: Law and Policy 12

13. 13 Purpose of Foreign Tax Credit l Alleviates double taxation of foreign source income. l The foreign tax credit (FTC) is a dollar-for- dollar offset of the foreign tax against U.S. tax on foreign source income (subject to numerous limitations). l Only certain types of foreign taxes qualify for FTC.

14. 14 Foreign Tax Credit Limitation l The credit is limited to the amount of tax the U.S. would have imposed on the foreign income (and is subject to many other restrictions). l For each “basket,” FTC is lesser of: –Actual foreign taxes paid or accrued, and –Amount computed under FTC formula: Foreign source taxable income Worldwide taxable income U.S. tax on worldwide taxable income X

15. 15 Foreign Tax Credit Baskets l A "basket" is a separate category of foreign source income for which a separate FTC limitation calculation must be made. l Purpose: to prevent averaging of taxes among different types of income.

16. 16 Foreign Tax Credit Baskets l General Limitation Income l Passive Income l Financial Services Income l 10-50 Dividends (until 2002) l High Withholding Tax Income l Shipping Income l DISC Dividends l FSC Distributions l Foreign Trade Income

17. 17 Steps to Compute Foreign Tax Credit Limitation 1.Determine U.S. and Foreign Source Taxable Income: –Gross receipts (minus cost of goods sold) –Other gross income 2.Determine Deductions Allocable to U.S. and Foreign Income. 3.Determine Net U.S. and Foreign Source Income.

18. 18 Steps to Compute Foreign Tax Credit Limitation 4.Determine FTC Category (“Basket”) –Characterize Gross Income –Source Gross Income 5.Allocate and Apportion Deductions among FTC Categories of Gross Income. 6.Determine Amount of Creditable Foreign Taxes Within Each Category.

19. 19 Source of Income Rules l Income from the Sale of Purchased Inventory l Income from the Sale of Manufactured Inventory l Dividends l Interest l Rents l Royalties l Sale of Stock l Sale of Intangibles l Other Different Source Rules for Different Types of Income:

20. 20 Expense Allocation Rules l Interest l Research & Development l General & Administrative l Other Different Allocation Rules for Different Expenses:

21. 21 Example 1 l USCO has a foreign subsidiary in Country X that performs services in Country X. l The subsidiary earns $1,000, on which it pays Country X income tax at a rate of 35% ($350). l If all the Country X earnings are distributed as a $650 dividend to USCO, USCO would be allowed a foreign tax credit of $350. l Foreign tax credit limit = $350 (U.S. tax before FTC) $1,000 Foreign Income $1,000 Taxable Income X = $350

22. 22 Example 1 (cont.) l Therefore, USCO would have no net U.S. tax liability on those earnings. l Deferral would not change this result because there would be no U.S. tax to defer.

23. 23 Example 2 l Same as Example 1, except: –The foreign subsidiary has $200 of allocable expenses against foreign income which are not deductible in calculating foreign-country tax. Allocating and apportioning expenses reduces the maximum amount of foreign tax credit a U.S. company may receive.

24. 24 Example 2 (cont.) –If all the Country X earnings are distributed as a $650 dividend to USCO, USCO would be allowed a foreign tax credit of $280, leaving $70 of foreign taxes paid for which USCO would receive no credit. Foreign tax credit limitation = = $280 $350 (U.S. tax before FTC) ($1,000 Foreign Income - $200 Allocable Expenses) $1,000 Taxable Income X

25. 25 Other Rules l FTC is Elective l When FTC allowed -- either when paid or when accrued l Holding period l Carryover/Carryback Rules --2 Back and 5 Forward l Overall Foreign Losses/Recapture l Currency Exchange Rules l Look-thru Rules l Alternative Minimum Tax--90% Limitation l No FTC allowed for taxes paid/accrued to certain foreign countries

26. 26 Typical Obstacles to FTC Utilization l Foreign tax rates higher than U.S. tax rate l Separate basket limitations l Required allocation and apportionment of deductions l OFL recapture

27. Deferral: Law and Policy 27

28. 28 Deferral l U.S. generally imposes tax on worldwide income, regardless of whether it is earned here or abroad. l However, U.S. generally defers its tax on foreign earnings until they are remitted.

29. 29 Deferral l Fundamental TIMING principle of U.S. tax law. l Issue under this system is not WHETHER, but WHEN, U.S. person will be taxed on foreign earnings.

30. 30 Basic Terminology l If U.S. tax is imposed as foreign earnings are earned, the earnings are said to be subject to "current" U.S. tax. l If U.S. tax is imposed at a later time (e.g., when earnings are paid out to the U.S. shareholders as dividends), U.S. tax is said to be "deferred."

31. 31 General Rule l U.S. tax is imposed on foreign earnings when they are earned (or deemed earned) by a U.S. person (i.e., U.S. corporation, citizen or resident individual). l Timing of U.S. tax thus depends on how foreign activities are conducted.

32. 32 If U.S. Person Conducts Foreign Activities Directly: Current Taxation l U.S. person is earning the amounts. l Earnings are subject to current U.S. tax.

33. 33 If Foreign Corporation Conducts the Foreign Activities: Deferral l Foreign person, not U.S. person, is earning the amounts. l The U.S. cannot tax a foreign person on foreign earnings.

34. 34 If Foreign Corporation Conducts the Foreign Activities (cont.) l Instead, the U.S. generally taxes U.S. owners of the foreign entity only as earnings are remitted to the U.S. (e.g., as dividends). l U.S. tax is deferred in this case, because it is imposed when earnings are remitted to the U.S. and not as they are earned by the foreign entity.

35. 35 Exceptions to Deferral l The general rule always has been to defer U.S. tax on foreign earnings. l However, various exceptions to this general rule have been enacted over the years. –Subpart F income u Foreign personal holding company income u Foreign base company sales income u Foreign base company services income

36. 36 Exceptions to Deferral (cont.) –Subpart F income (cont.) u Subpart F insurance income u Subpart F shipping income u Foreign oil and gas extraction income u Foreign oil related income u Illegal payments –Section 956 Income (investment in U.S. property)

37. 37 Exceptions to Deferral (cont.) –PFIC Income –Personal Holding Company Income –Foreign Personal Holding Company Income –Foreign Investment Company Income l Where an exception applies, a U.S. person may be subject to current U.S. tax (or an interest charge) on foreign source income, even though it has not received the income.

38. 38 Exceptions to Deferral (cont.) l Present law is complex because there are many sets of potentially overlapping exceptions. l Application of exceptions to deferral typically has depended on two factors: –Level of U.S. ownership –Type of income involved

39. 39 Policy Issues Regarding Deferral Arguments against deferral: l “Capital export neutrality”

40. 40 Policy Issues Regarding Deferral l Promotes global competitiveness of U.S. business by providing more level playing field vis-a-vis foreign competitors. l Does not impose tax until earnings are actually received and taxpayer has funds to pay tax. Arguments for deferral for active foreign income earned through foreign corporations:

41. 41 Policy Issues Regarding Deferral (cont.) l Deferral offsets other problems in Code -- –Foreign tax credit limitations –Inability to consolidate profits and losses of U.S. and foreign affiliates –Less favorable depreciation and credits for foreign activities –Less favorable treatment of foreign losses

42. Domestic Double Taxation of Corporate Income in the U.S. 42

43. 43 U.S. Imposes a Double Tax on Corporate Income l U.S. shareholders in U.S. corporations are potentially exposed to four levels of taxation: –foreign income tax –foreign withholding tax –U.S. corporate tax –U.S. individual tax

44. U.S. Imposes a Double Tax on Corporate Income $26.00 Shareholder Tax (40% Rate x $65) $100 of Operating Income $35 Corporate Tax (35% Rate x $100) $65 Dividend 61% Tax Rate on Corporate Income Shareholders 44 IRS Company

45. 45 Corporate Taxation in OECD Member Countries, 1990 */ Hybrid tax system (relief from double taxation at both corporate and shareholder levels). #/ Deduction for dividends paid may offset fully the corporate and personal income tax for dividends up to 15% of capital value. Dividends in excess of this limit are fully taxed at both levels. Sources: Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, Research Memorandum 9604. Erasmus University, Rotterdam. OECD, Taxing Profits in a Global Economy: Domestic and International Issues, 1991, p. 57.

46. U.S. Investment Abroad: Facts & Figures 46

47. Business Globalization is a Worldwide Phenomenon U.S. investment abroad (as a percentage of GDP) trails behind the average investment rate of the Group of Seven industrialized countries. (Source: World Investment Report 1997, United Nations.) 47

48. The U.S. Share of Worldwide Foreign Direct Investment Has Declined Sharply In 1980, U.S. companies accounted for over 42% of foreign direct investment by international businesses. By 1996, U.S. multinational companies’ share of foreign direct investment had dropped to just 25%. (Source: Price Waterhouse calculations based on United Nations data.) 48

49. U.S. Investment and Jobs Abroad Have Not Increased Relative to Domestic Investment and Jobs Employment in U.S.-controlled foreign corporations dropped from 5.0 percent of U.S. civilian employment in 1982 to 4.8 percent in 1995. Similarly, gross output of U.S.-controlled foreign corporations has declined from 6.9 percent of U.S. GDP in 1982 to 6.4 percent in 1995. (Source: Price Waterhouse calculations based on U.S Department of Commerce data.) 49 5.0%4.8% 6.9%6.4% Foreign share of investment Foreign share of employment

50. 50 U.S. Companies Operate Abroad to Sell Into Foreign, Not U.S., Markets The overwhelming majority of goods and services produced by U.S.-controlled foreign corporations are sold into foreign markets. In 1995, less than 10 percent of U.S. controlled foreign corporation sales were exported to the U.S. (Source: PW analysis based on U.S. Department of Commerce data.) 68% 23% 9%

51. 51 U.S. Companies Operate Abroad to Sell Into Foreign, Not U.S., Markets Three-quarters of the financing of U.S.-controlled foreign corporations comes from foreign sources and not U.S. parents. Debt and equity from U.S. parents financed less than 24 percent of the total assets of U.S.-controlled foreign corporations in 1995. The rest came from foreign equity and debt, and reinvestment. (Source: Price Waterhouse calculations based on U.S. Department of Commerce data.) $ 62% $ 24% $ 14%

52. 52 U.S. Companies Boost Return on Capital By Investing Abroad Over the last 10 years, U.S. companies have earned a 30% to 70% higher return on foreign assets as compared to domestic investment. (Source: PW calculations based on U.S. Dept. of Commerce data.) U.S. companies are able to use their advanced technology and efficiency to earn high profits in foreign markets. 11.80% 10.30% 9.80% 198519901995 6.70% 7.60% 199019851995

53. 53 THE INTERNATIONAL TAX POLICY FORUM Founded in 1992, the International Tax Policy Forum is an independent group of 30 major U.S. multinationals with a diverse industry representation. The primary purpose of the Forum is to promote research and education on U.S. taxation of income from cross-border investment. To this end, the Forum sponsors research and conferences on international tax issues and meets periodically with academic and government experts to promote a dialogue on these issues. Mr. John M. Samuels, Vice President and Senior Counsel for Tax Policy and Planning with General Electric Company, serves as Chairman of the Forum. PricewaterhouseCoopers’ Washington National Tax Services office serves as consultant to the Forum.