1. Conference on Territorial Income Taxation
Brookings Institution and The International Tax Policy Forum
Washington DC, April 30, 2001

2. Primer on Exemption v. Credit: The US System
Hugh J. Ault, Boston College Law School and OECD

3. Primer on Exemption v. Credit: The US System
Non-technical and structural description
Basic elements
Worldwide assertion of taxing jurisdiction over US Persons
Deferral of taxation until distribution on income earned by through foreign corporations
Foreign tax credit for foreign income taxes paid on foreign source income

4. Taxing jurisdiction
US Persons taxed on all income regardless of its geographic “source”
Individuals are US persons if US resident or citizen
Corporations are US persons if incorporated in the US
Purely formal test of incorporation
Non-US Persons taxed only on US source income

5. Resulting patterns of taxation
US corporations with branch operations abroad subject to current tax
US corporations operating abroad through foreign-incorporated subsidiaries are not taxed currently (US tax is “deferred”until distributed)
In both cases, credit is given against the US liability for foreign income taxes paid

6. Limitations on Deferral
Foreign personal holding companies
Closely held investment vehicles with passive income or personal services income
US-controlled foreign corporations with certain classes of income (“Subpart F”)
Widely held foreign investment funds (Passive foreign investment companies, “PFIC”)

7. Subpart F: Basic principles
Certain categories of income of US-controlled foreign corporations are taxed directly to the US shareholders currently, thus eliminating the deferral of US tax until repatriation
Basic pattern of rules is to treat as equivalent to a current dividend distribution followed by a contribution to capital

8. Subpart F: Some technical issues
Definition of Controlled Foreign Corporation (“CFC”)
10% US shareholder
More than 50% controlled by 10% US shareholders
Attribution of ownership rules
Tiers of ownership

9. Subpart F Income Classes of income for which deferral is eliminated
Foreign personal holding company income
dividends, interest, rents and royalties, gains on passive assets
Exception for active rents and royalties
Temporary exception for active banking, financing and insurance income

10. Subpart F Income Foreign base company income Insurance income
related party sales income from sales outside of the CFC country of incorporation
related party services income from services performed outside the CFC country of incorporation
Shipping income
Oil related income
Insurance income
Bribery, boycott income
70% full inclusion rule

11. Subpart F: Some additional issues
Increased investment in US property as a deemed distribution
treatment of trade receivables
Foreign tax as a factor in determining base company income
Exclusion if foreign tax equal to 90% of US tax
Reduction of foreign tax involved in structure of base company income definitions
base company sales income
hybrid arrangements

12. Subpart F: Some additional issues
Gain on disposition of CFC shares
treated as ordinary income to extent of deferred profits not subject to Subpart F
credit for foreign taxes paid by qualified shareholder

13. Subpart F: Pattern of taxation
Current inclusion of income (limited to earnings and profits)
Indirect foreign tax credit for corporate shareholders
Upward basis adjustment in shares to reflect income inclusion; distribution of previously tax profits is tax free with downward basis adjustment

14. Foreign Tax Credit Principles
Credit for foreign income taxes on foreign source income
definition of income tax
determination source of income
Overall limit on current credit to US tax on foreign source income
“excess credit” and “excess limitation” situations
carryforward and carryback

15. “Averaging” and limitations on averaging
Basic “fractional” approach in lieu of per item tracing gives averaging possibilities
Foreign source taxable income/worldwide taxable income x US tax liability = limit on current credit
“ Basket” system to segregate classes of income and prevent averaging of, e.g. high tax business income and low tax passive income

16. Some technical aspects of foreign tax credit rules
“Deemed” foreign tax credit for taxes paid by foreign subsidiary on distributions of foreign profits
ownership requirements
lower tier credits
“Look through” for basket characterization purposes for dividends, interest and royalties from controlled foreign subsidiaries

17. Some technical aspects of foreign tax credit rules
“Source”rules and their impact on the credit
artificial rules of convention attempt to give geographic source to items of income
50-50 rule for income from manufacture in the US and sale abroad
Treatment of losses
impact on credit calculation

18. Some technical aspects of foreign tax credit rules
Allocation of deduction rules for determining foreign source taxable income
interest expense
fungibility theory
assets- based allocation
“water’s edge” approach
Research and development expenses
geographical and sales
General and administrative expense

19. Some technical aspects of foreign tax credit rules
For US companies in excess credit position, allocation to foreign source income is equivalent to denial of deduction

20. Overall Assessment
Exceedingly complex (function of system or of US mentality?)
BUT international transactions are inherently complex
Tension between competing policy goals with inevitable compromises