Order Code RL30848
CRS Report for Congress
Received through the CRS Web
U.S. Taxation of Overseas Investment & Income:
Background and Issues in 2002
Updated March 8, 2002
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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U.S. Taxation of Overseas Investment and Income:
Background and Issues in 2002
Summary
Investment abroad by U.S. individuals and firms is substantial and growing – an
important aspect of the increased integration of the U.S. economy with the rest of the
world. At the end of 2000, the stock of private U.S. investment abroad was a full
26.4% of the total U.S. stock of private capital; the proportion has more than doubled
over the past two decades. And because investment outflows have grown, it is not
surprising that U.S. taxation of overseas investment is a prominent issue before
policymakers in Congress and elsewhere. First, because investment abroad is an
increasingly important part of the economy, more pressure is placed on the U.S.
system of taxing that aspect of the economy – the effects of taxation on foreign
investment are potentially more important. Second, the increased mobility of capital
has changed the environment in which taxes apply; some have suggested that the
mobility of capital may call for a change in how U.S. taxes apply.
As it currently exists, U.S. tax policy towards investment abroad poses a
patchwork of incentives, disincentives, and neutrality. Different features of the
system, in isolation, have different effects. The foreign tax credit, for example,
generally promotes tax neutrality; the credit is limited, however, and the limitation can
pose either a disincentive or incentive to invest abroad. The system’s deferral
principle in some cases permits U.S. firms to postpone U.S. tax on foreign income
indefinitely; it poses an incentive to invest overseas in countries that impose low tax
rates of their own. Deferral is restricted, however, by the tax code’s subpart F
provisions which nudge the system back in the direction of tax neutrality.
Whether these various tax effects are beneficial depends, in part, on the
perspective a policymaker takes. Traditional economic theory suggests that a tax
policy that promotes neutrality between investment at home and abroad – a policy
termed “capital export neutrality” – best promotes world economic welfare.
Economic theory also indicates, however, that U.S. economic welfare is maximized
by a policy (“national neutrality”) where overseas investment is, to some extent,
discouraged. Yet a third policy standard – sometimes termed “capital import
neutrality” – is supported by many investors and multinational firms, who emphasize
the importance of the competitive position of U.S. firms in the world market place.
A complete tax exemption for overseas income – a “territorial” system of taxation –
would be consistent with capital import neutrality. Clearly, the different components
of the U.S. system are consistent with different ones of the three policies; which one
the current U.S. system best approximates, on the average, is not clear.
Should U.S. tax policy towards investment abroad be changed? It might be
argued that the increased level of foreign investment makes any flaws that might exist
in the U.S. system more serious. Yet given the various policy standards that have
been recommended for U.S. taxation and given the varied impact of the current
system, it is not surprising that proposals for change have varied.

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Contents
The United States in the World Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
U.S. Taxation of Foreign Income: The General Framework . . . . . . . . . . . . . . . . 2
Deferral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Subpart F and Other Exceptions to Deferral . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Foreign Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
The Foreign Tax Credit and the Tax Rate on Foreign Income . . . . . . . . . . . 5
The Foreign Tax Credit and Incentives to Invest or Work Abroad . . . . . . . 6
Income with Separate Limitations or “Baskets” . . . . . . . . . . . . . . . . . . . . . 7
Source of Income Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Domestic Investment Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Policy Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Capital Export Neutrality: Maximizing World Economic Welfare . . . . . . . 10
National Neutrality: Maximizing U.S. Economic Welfare . . . . . . . . . . . . . 11
Competitiveness as a Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Current and Recent Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Proposals Supporting Capital Export Neutrality . . . . . . . . . . . . . . . . . . . . 13
Territorial Taxation and Proposals Supporting Capital Import Neutrality . 15
Proposals Supporting National Neutrality . . . . . . . . . . . . . . . . . . . . . . . . . 16
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

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U.S. Taxation of Overseas Investment and
Income: Background and Issues in 2002
One of the chief manifestations of the increased openness of the U.S. economy
is an increase in U.S. investment abroad. U.S.-based multinational firms are
increasing their overseas operations; U.S. investors are increasing the foreign assets
in their portfolios. This report looks at how the U.S. tax system applies to that
investment, and the policy issues it presents to Congress in 2002. It begins with a
brief look at the data; it next describes the basic statutory features of the tax system
and their effects on economic incentives. Next, it outlines the traditional economic
framework for evaluating the system’s economic effects. It concludes by describing
policy proposals prescribed by the different perspectives on taxing international
investment.
The United States in the World Economy
Even the most basic data clearly show that the U.S. economy is increasingly a
part of the world economy. For example, the data show that the total volume of trade
in goods and services – that is, exports plus imports – has increased substantially and
steadily over the past 25 years. In 1976, exports plus imports were 16.8% of gross
domestic product (GDP); by 2000 trade was a full 25.4% of GDP.1
But the focus here is on capital investment, and if trade has increased
substantially, investment has grown dramatically. In 1976, the stock of U.S. private
assets abroad was 8.2% of the total U.S. private capital stock; by year end 2000,
assets abroad were 26.4% of the total U.S. capital stock In 1976, the stock of foreign
private assets in the United States was 4.2% of the U.S. capital stock; at year-end
2000 it was 31.5% of the U.S. capital stock.2
We now take a closer look at the components of outbound investment.
Traditionally, economists have identified two types of overseas investment: portfolio
investment and direct investment. With portfolio investment, the underlying assets
are not actively managed by the investor; direct investment entails the active
management of overseas assets and operations by the investor. Portfolio investment
1Data on trade are from U.S. Executive Office of the President, Council of Economic
Advisors, Economic Report of the President, (Washington: GPO, February 2002), p. 442.
2The source for data on U.S. assets abroad and foreign assets in the United States is Russell
B. Scholl, “The International Investment Position of the United States at Yearend 2000,”
Survey of Current Business, vol. 80, July 2001, p. 7-15. Data on the U.S. capital stock are
from Shelby W. Herman, “Fixed Assets and Consumer Durable Goods for 1925-2000,”
Survey of Current Business, vol. 80, Sept. 2001, pp. 27-38.

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CRS-2
can be thought of as a U.S. person or firm who has foreign stocks, bonds, or other
assets in his investment portfolio; direct investment can be thought of as the overseas
business operations of a U.S. firm. A striking conclusion emerges from the data: the
rapid growth in U.S. assets abroad has consisted almost entirely of portfolio
investment rather than direct investment in overseas business operations. At year-end
1976, portfolio investment was 3.2% of the total U.S. capital stock; at the end of
2000, it was 20.0% of the total stock. In contrast, foreign direct investment was
5.0% of the total in 1976 and 6.4% at the end of 2000.
Taxes potentially affect investment by altering the allocation of capital between
domestic and foreign locations; hence, our focus thus far on stocks rather than flows.
However, another concern of international taxation is tax revenue. To obtain a rough
idea of how important overseas investment potentially is to the U.S. tax base, it is
useful to look at income flowing from international investment. Here, the growth in
importance, while it has occurred, is somewhat less imposing. In 1976, receipts by
private U.S. investors of earnings on overseas assets were 1.5% of U.S. GDP; by
2000, they were 3.6% of GDP. As with the stock of investment, most of the growth
was in portfolio investment rather than direct investment. Over the same period,
receipts from portfolio investment grew from 0.5% of GDP to 1.9% of GDP; receipts
from foreign direct investment grew from 1.0% of GDP to 1.5% of GDP. Another
way of gauging the importance of overseas investment income is to compare it with
total U.S. income from capital. In 1976, private receipts from overseas investment
were 7.1% of U.S. capital income; by 1999 they had grown to 15.3%.3

What is the import of these various numbers? First, they substantiate the notion
that overseas investment has grown rapidly both in absolute terms and relative to the
rest of the U.S. economy. Accordingly, U.S. tax treatment of that investment is
potentially more important than previously; its various effects are increasingly
important to the economy. We look now at the tax system that applies to the
investment and its various incentive effects.
U.S. Taxation of Foreign Income:
The General Framework
A good place to begin an overview of the U.S. international tax system is a look
at broad jurisdictional principle. The United States generally bases its tax jurisdiction
on an individual’s or firm’s residence, and much of the structure of U.S. international
taxation follows from this principle. For example, the United States asserts the right
to tax its residents and citizens on their worldwide income, regardless of where the
income is earned. If, for example, a U.S. citizen lives in Germany and earns income
in Germany, the United States, at least in principle, asserts the right to tax that
income. In a parallel way, the United States also asserts the right to tax corporations
chartered in the United States (i.e., its resident corporations) on their worldwide
3Data on receipts from foreign investment are from Douglas B. Weinberg, “U.S. International
Transactions, Third Quarter 2001,” Survey of Current Business, vol. 81, Jan. 2002, pp. 29-
57. U.S. capital income data are from Economic Report of the President, p. 306.

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CRS-3
income. Thus, if a corporation chartered in, say, Delaware, earns income directly
through a branch in Britain, the United States — again, in principle — asserts the
right to tax that income.
But this just a general principle; actual U.S. practice departs from it frequently.
One important departure, as we shall see, is the foreign tax credit, under whose
provisions the United States permits its residents and corporations to credit foreign
income taxes they pay against the U.S. taxes they would otherwise owe on foreign-
source income. Although the United States asserts the right to tax income earned
abroad, its foreign tax credit concedes that the country of source – that is, the country
where the income is earned – has the primary jurisdiction to tax and is first in line to
tax the foreign income. Another important exception to U.S. worldwide taxation is
the “deferral principle,” under which U.S. firms can indefinitely postpone income from
foreign operations if they are structured in a particular way – that is, if the income is
earned by a foreign chartered subsidiary corporation.
But U.S. international taxation is exceedingly complex; even its exceptions have
exceptions, as we see by next turning to a more detailed look at the system.
Deferral
The deferral principle, or simply “deferral,” is one of the chief features of the tax
code for U.S. firms with foreign operations. As noted above, it allows U.S. firms that
structure their foreign operations with subsidiaries rather than branches to indefinitely
postpone U.S. taxes on their foreign-source income. Deferral’s economic substance
is thus a departure from the general principle of worldwide taxation on the basis of
residence.
Deferral’s place in the tax system actually results, however, from a literal,
legalistic application of the residence principle, as follows: under the residence
principle, a U.S.-chartered corporation is taxed on its worldwide income. In contrast,
a corporation chartered abroad is taxed only by the United States on its U.S.-source
income, and is exempt from U.S. tax on its foreign-source income.4 But in substance
if not legal form, firms can transcend mere corporate boundaries; for example, a U.S.
firm can conduct its foreign operations through a subsidiary corporation chartered
abroad. If it does so, the income the foreign corporation earns is exempt from U.S.
taxation as long as it remains in the subsidiary’s hands; the subsidiary’s income is
generally subject to U.S. tax only when it is remitted to the U.S. parent corporation
as intra-firm dividends, interest payments, royalties, or other income.
For a firm, taxes matter less the longer payment can be postponed; this is the
heart of deferral. In essence, a dollar of taxes paid today is more costly than a dollar
paid next year because the firm can invest next year’s dollar over the interim period
and earn a return. Thus, as a general matter, the tax burden on investment abroad is
lower than on identical investment in the United States in any case where the tax rate
imposed by the foreign host government is lower than the U.S. tax rate on identical
4It is, however, generally taxed by the United States on its U.S.-source income.

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CRS-4
investment. As a consequence deferral poses an incentive for U.S. firms to invest
abroad in low-tax countries.
But as noted above, the tax code has exceptions to exceptions. In the case of
deferral, the Subpart F provisions and several other anti-deferral regimes restrict
deferral, especially in the case of portfolio investment. Nonetheless, deferral is still
potentially available to most manufacturing operations abroad in low-tax foreign
countries. We turn next to the exceptions to deferral.
Subpart F and Other Exceptions to Deferral
Like most tax benefits, deferral has both critics and champions; the debate over
its merits goes back three decades and further. The most significant curtailment of
the provision, Subpart F, was enacted in 1962 as a compromise, after the Kennedy
Administration initially proposed repealing deferral altogether.5 Subpart F singles out
certain types of income and certain types of ownership arrangements, and in those
cases taxes the income on a current rather than deferred basis.
Subpart F only applies to foreign corporations that the tax code classifies as
Controlled Foreign Corporations (CFCs): foreign corporations that are more than
50% owned by U.S. stockholders. Further, it applies only to those U.S. shareholders
whose stake in the CFC is 10% or greater. Subpart F applies its current taxation by
requiring each 10% shareholder to include their share of a CFC’s Subpart F income
in their taxable income, even if it has not actually been distributed.
The types of income subject to current tax under Subpart F are generally those
that are thought to be easily located in tax havens and low-tax countries: income
from passive investment — that is, investment that is primarily financial in nature and
that does not involve the active management of a business operation — and certain
other types of income whose source is thought to be easily manipulated so as to locate
it in countries with low tax rates. Passive investment income generally includes items
such as dividends from small blocks of stock as well as interest and royalties. The
other types of income in Subpart F include income from sales transactions with related
firms, income from services provided to related firms, petroleum-related income other
than that derived from extraction, and income from international shipping.
The second most significant exception to deferral is the Passive Foreign
Investment Company (PFIC) provisions, which were enacted by the Tax Reform Act
of 1986. If, roughly speaking, Subpart F applies only to large (10%) U.S.
shareholders, and only to certain types of income earned through CFCs, the PFIC
rules deny deferral to all U.S. shareholders on all income earned by any foreign
corporation, controlled or not, that is intensively engaged in passive investment, as
measured by the PFIC rules.
5For a discussion of the circumstances of Subpart F’s enactment, see CRS Report 95-1143,
Anti-Tax Deferral Measures in the United States and Other Countries, by Harry G.
Gourevitch.

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CRS-5
More specifically, the PFIC rules deny deferral to U.S. stockholders of a foreign
corporation that the tax code classifies as a PFIC. A foreign corporation is classified
as a PFIC if 75% or more of its gross income is income from passive investment, or
if 50% or more of its assets are passive investments. The deferral benefit is generally
denied by requiring PFIC shareholders to include their share of the PFIC’s income in
their own taxable income whether it is distributed or not, or, alternatively, by
requiring payment of interest on the deferred tax liability.
The Foreign Tax Credit
The U.S. foreign tax credit is a central feature of the system for both individuals
and firms. Its provisions generally permit U.S. taxpayers, both corporations and
individuals alike, to credit foreign income taxes they pay against U.S. income taxes
they would otherwise owe. The credit’s function in the system is to alleviate double-
taxation where the U.S. residence-based tax jurisdiction overlaps with a foreign host-
country’s source-based jurisdiction. Double-taxation could potentially result in
prohibitively high tax rates on foreign investment and could pose a severe impediment
to international capital flows. As noted above, by shouldering the responsibility for
alleviating double-taxation the United States effectively concedes that the country of
source has the primary jurisdiction to tax that income.
The tax code places a limit on the foreign tax credit that is designed to protect
the U.S. tax base, and the United States’ own primary jurisdiction to tax U.S.-source
income. The limitation works by effectively placing a barrier between U.S.-source
income and foreign-source income; if an investor’s foreign taxes on foreign-source
income exceed U.S. taxes on the income, they cannot be credited and become so-
called “excess credits.” If not for the limitation, foreign governments could
conceivably impose extremely high tax rates on the U.S. investors they host. With an
unlimited credit, investors would be impervious to the high foreign tax rates; they
could simply credit their foreign taxes against U.S. taxes. At the same time, while the
foreign government would be collecting plentiful revenues it would not be damaging
its own attractiveness as an investment location.
The foreign tax credit and its associated rules account for some of the most
complex sections of the Internal Revenue Code, much of them stemming from the
credit’s limitation. And unlike the deferral principle, whose incentive effect is
straightforward, the foreign tax credit’s effects vary. We turn now to these incentive
effects.
The Foreign Tax Credit and the Tax Rate on Foreign Income
Basic arithmetic and the foreign tax credit limitation dictate that total taxes paid
by a U.S. investor may consist of both U.S. and foreign taxes, but they are paid at a
combined rate equal to either the average foreign tax rate or the U.S. tax rate,
whichever is higher. For example, suppose a person has foreign income exclusively
from a country with low tax rates compared to the United States. He could credit all
of his foreign taxes against his U.S. tax liability without exhausting his U.S. tax
liability on foreign income and reaching the credit’s limitation. He would pay foreign

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CRS-6
taxes at the foreign rate, and after applying credits he would pay U.S. taxes at the
U.S. rate minus the foreign rate. Total taxes on foreign income would thus be paid
at the U.S. rate, but would consist of both foreign and U.S. taxes.6
Suppose a person pays foreign taxes at an average rate greater than the U.S.
rate. He would have sufficient foreign tax credits to eliminate his entire U.S. tax
liability on foreign source income. But because of the limitation, he would not be able
to credit the excess of his foreign taxes over the U.S. foreign-source liability; to do
so would require crediting foreign taxes against U.S. taxes on U.S. income. Thus, his
taxes on foreign income would consist exclusively of foreign taxes; they would be
paid, of course, at the foreign tax rate.
The Foreign Tax Credit and Incentives to
Invest or Work Abroad
The tax credit limitation and the tax rates it produces create a particular incentive
structure for investing or working abroad. As we noted above, a person pays total
taxes on foreign income at either the U.S. tax rate or the foreign tax rate, whichever
is higher. It follows that if a person has no other foreign income and thus has no
excess foreign tax credits to complicate matters, the foreign tax credit limitation is
“neutral” towards (has no effect on) the incentive to invest or work in a country with
low taxes, since taxes are the same as in the United States. On the other hand, the
limitation permits a disincentive to exist with respect to investing or working in a
high-tax country; taxes on the prospective foreign activity stand to be higher than on
the same activity in the United States.
But this assumes that the U.S. person or firm has no other existing foreign
income; if there is other foreign income, the foreign tax credit situation with respect
to the income can change the incentives. First, suppose the existing foreign income
is taxed at such a high foreign rate that the taxpayer has excess foreign tax credits that
cannot be used because of the limitation. In such a case, while there is still a
disincentive towards high-tax countries, there is an incentive to invest or work in a
low tax country. This is why: a person with excess credits can generally use them to
offset some or all of the new U.S. taxes that would otherwise be due on the new
income earned in the low-tax country. In effect, the excess credits shield the new
income from U.S. taxes. The new income investment or activity thus faces only the
low foreign tax rate while an identical activity in the United States would face the
relatively higher U.S. tax rate.
An investor’s existing income can also alter the situation facing prospective
activity that is subject to high foreign taxes. Suppose, for example, the existing
income is subject to low foreign taxes so that the investor has a residual U.S. tax
liability, after credits, that is equal (as we have seen) to the pre-credit U.S. rate minus
the foreign rate. If the investor obtains new income subject to high foreign taxes, an
6If we represent the U.S. tax rate as “u” and the foreign tax rate as “f”, before credits the total
tax rate on foreign income would be: u + f. After credits, the total rate would be the before
credit rate minus credits, or: ( u + f ) - f, which is equal to u, the U.S. tax rate. As used here,
“rate” is the average rate: total taxes as a percent of total taxable income.

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CRS-7
amount equal to the U.S. tax rate on the new income must be devoted to offsetting
the U.S. taxes on the new income itself. However, any additional foreign taxes on the
new income can be used to reduce the residual U.S. taxes owned on existing income
from low-tax foreign activities. Thus, the tax rate on the new, heavily taxed
investment is reduced, in effect, to a rate equal to the U.S. tax rate. In short, the
disincentive that would otherwise exist with respect to the high tax activity is
converted to neutrality when an investor has existing income from a low tax country.
The following chart shows the various incentives posed by the foreign tax credit
schematically.
Incentives Towards Foreign Investment Facing Firms in
Different Foreign Tax Credit Situations
Investor’s Foreign Tax
Investment in High-Tax
Investment in Low-Tax
Credit Position
Countries
Countries
No Previous Foreign
Disincentive
Neutrality (If deferral is
Investment
not used)
Incentive (if deferral is
used)
Excess Credits
Disincentive
Incentive
Deficit of Credits
Neutrality
Neutrality (if deferral is
not used)
Incentive (if deferral is
used)

The rows show incentives faced by firms in various foreign tax credit positions:
those with no previous, existing foreign investment (and thus with neither an existing
U.S. tax liability on foreign income nor excess credits); those with excess credits; and
those with a “deficit” of credits (a residual U.S. tax liability on existing overseas
investment). The columns show incentives with respect to investment in countries
with tax rates of their own that are higher than the United States (“high-tax”
countries) and countries with relatively low tax rates (“low-tax” foreign countries).
Income with Separate Limitations or “Baskets”
The particular incentive structure we have described applies in cases where
investors are free to credit taxes paid on one stream of income against U.S. taxes
owed on another stream of foreign income that is taxed at a different foreign rate. In
1986, the Tax Reform Act sought to reduce (but not eliminate) instances where this
effect could occur by requiring that the foreign tax credit limitation be applied
separately for several different types of income. In tax parlance, the 1986 Act created
a number of different foreign tax credit “baskets” into which different types of income
were required to be placed. The segregated types of income were generally of a sort

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whose source is thought to be easily manipulated as well as income that is
characteristically subject to either a high foreign tax rate or a low foreign tax rate.
The baskets, in short, were meant to separate income that lends itself particularly well
to the cross-crediting of foreign taxes. A partial list of the specific separate baskets
includes: income from passive investment; income subject to high foreign withholding
taxes;7 financial services income; and shipping income.
Source of Income Rules
The foreign tax credit limitation results in great importance for the tax code’s
rules for determining the source of income. And since the limitation is in terms of net,
taxable income, rules governing the source of deductions are just as important as rules
governing the allocation of items of gross income. For example, suppose a U.S.
investor with extensive foreign investments sells stock in a U.S. company, but in a
foreign stock market. Is the profit from the sale U.S. source income or foreign source
income? If a taxpayer is above the foreign tax credit limitation — that is, if they pay
foreign taxes at a high rate so that they have excess credits — and the profit is
classified as foreign-source income, the investor will owe no U.S. taxes on the gain;
if it has a U.S. source, the investor will.8 The tax code’s rules governing the source
of income and the associated Treasury regulations are numerous, complex and varied;
they are not summarized here. It is important to note, however, that much of the
legislative activity in the international area is devoted to adjusting the source rules.
In general, a change in law that shifts the source of an item’s income abroad reduces
taxes; a change that shifts an item of income to U.S. sources increases them.
Conversely, legislation that shifts an item of deduction from U.S. to foreign sources
raises taxes, while shifting it to U.S. sources reduces them.
Domestic Investment Incentives
The tax treatment of overseas investment does not work its incentive effects in
isolation; it is the relative tax burden on foreign and domestic investment that matters
to investors and that potentially changes the allocation of investment capital between
the United States and abroad. Accordingly, investment tax incentives that are
available for domestic but not overseas investment are at the same time disincentives
to foreign investment. And prior to the Tax Reform Act of 1986, several broad
investment incentives were available for domestic but not foreign investment, and thus
posed such a disincentive. These provisions included the investment tax credit, which
was available for domestic investment in plant and equipment and the Accelerated
7A “withholding tax,” as used in this context, is a tax a country that is host to an investment
by a non-resident generally applies to the interest, dividends, royalties, and similar income
generated by the investment. The tax is generally levied at a flat rate, is applied on a gross
basis (i.e., without allowing for deductions), and is required to be withheld by the payer.
8In general, section 865 of the Internal Revenue Code allocates (“sources”) income from the
sale of personal property (e.g., stock) in an investor’s country of residence. In this example,
then, the income would have a U.S. source and — in principle — would be subject to U.S.
tax.

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CRS-9
Cost Recovery System of generous depreciation deductions. The 1986 Act, however,
repealed the investment credit and scaled back depreciation, leaving only a scattering
of more narrow domestic incentives in place.
Notable among the still-existing incentives for domestic investment are the
research and development (R&D) tax credit and two separate tax incentives for
exporting. The R&D credit provides a tax benefit for firms that increase their
qualified research expenditures; “qualified research,” however, explicitly excludes
research conducted abroad. The two export incentives are the “inventory source rule”
and the extraterritorial exemption rules for exporters; they provide an incentive for
domestic investment simply because exports – by definition – cannot be produced
abroad. The inventory source rule provides an export incentive by allowing firms to
allocate part of their export income abroad for foreign tax credit limitation purposes;
the consequence of the allocation is potentially an effective exemption for a part of
export income. The extraterritorial exemption likewise provides a partial exemption
for export income; it is discussed in more detail below in the section on
“competitiveness.”
Other incentives for domestic investment are export tax benefits. There are two
of these: the “inventory source” rule, and the extraterritorial income (ETI) exemption
that replaced prior law’s Foreign Sales Corporation (FSC) provisions. In these cases,
exports, by definition, can only be produced by domestic investment, and so an export
tax benefit is necessarily an incentive for domestic rather than foreign investment.
Indeed, the FSC provisions’ statutory predecessor, the Domestic International Sales
Corporation (DISC) provisions, were in part enacted in order to provide a tax
incentive for domestic investment that would counter deferral.9
Thus far we have confined our economic analysis to identifying the international
system’s various incentive effects. We look next at the broader economic
consequences of these incentives and the different policy perspectives on those
effects.
Policy Perspectives
According to economic theory, the various incentive effects that the tax system
has on investment flows can affect both the U.S. and world economies by changing
the allocation of capital resources between the United States and abroad. Various
effects flow from that allocation of investment, including impacts on both capital and
labor income, on tax revenue, and ultimately on the economic welfare of the United
States and the world at large.
One broad effect of the capital flows to and from the United States is the
distribution of income within the United States and abroad. Thus, taxes on foreign
9In response to complaints by the European Union, World Trade Organization (WTO) panels
have ruled that both FSC and the ETI provisions are export subsidies and so violate the
agreements on which the WTO is based. For further information, see CRS Report RS21143,
Policy Options for U.S. Export Taxation, by David L. Brumbaugh.

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investment affect the distribution of income. Capital flows affect the distribution of
income as follows: a basic principle of economic theory holds that in smoothly
operating markets, labor compensation is commensurate with its productivity.
Because labor productivity is higher the more capital it has to work with – the higher
the capital/labor ratio – domestic labor income generally declines if capital income is
diverted abroad. At the same time, income of domestic capital is increased if
investors are free to seek higher returns abroad. In short, tax policy that increases or
diminishes investment abroad has implications for the distribution of domestic income
between capital and labor. This result likely underlies the contrasting policy
recommendations for international taxes that tend to be supported by domestic labor,
on the one hand, and multinational firms, on the other. In broad terms, labor tends
to oppose tax measures that pose incentives to invest abroad; firms tend to support
them.
Taxes on capital flows also have broad effects on economic efficiency, or the
level of economic benefit produced by capital and other resources. Economic theory
has developed two standards for evaluating the efficiency of international taxation,
each with a different perspective: “capital export neutrality,” which considers the
impact of taxes on world economic welfare; and “national neutrality,” which
considers only the economic welfare of the capital exporting country (in this case, the
United States). Discussions of international taxes also frequently evaluate them for
their impact on the competitive position of U.S. firms abroad, a standard sometimes
called “capital import neutrality.” Having described the U.S. tax system and its
incentive effects, we now look at how the system measures up to these different
standards and identify the particular issues each standard presents.
Capital Export Neutrality:
Maximizing World Economic Welfare
Capital export neutrality (CXN) is based on the idea that the economy’s supply
of capital is employed most efficiently when each increment of capital is used where
it earns the highest return, before taxes. In economic terms, this occurs when the pre-
tax return on an additional increment of investment (“marginal” investment) abroad
is equal to the pre-tax return on identical new domestic investment.
Generally, economics holds that in the absence of taxes, profit-maximizing
investors will accomplish this allocation on their own, simply in response to market
forces; they maximize their investment profits by ensuring that the return on additional
investment abroad is just equal to the return on additional domestic investment. It
follows that the most efficient tax system is that which is least distorting of investors’
decisions and of how capital is employed. CXN is a policy that is “neutral” towards
the decision whether to invest at home or abroad – a policy where taxes do not affect
or distort an investor’s decision of where to invest and the world’s capital resources
are employed where they are most productive. The world’s economic welfare is
therefore maximized. In short, under CXN, the world’s economy is getting the most
from its capital resources.
The U.S. system is consistent with capital export neutrality in some cases, but
not others – an outcome that is not surprising, given the varied incentive effects

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reviewed in the preceding section. It is clear, for example, that the United States’
deferral principle violates capital export neutrality with respect to investment in
countries with low tax rates – deferral distorts investment by favoring investment in
low-tax countries and by diverting investment from the United States to those
locations. Subpart F and the other anti-deferral regimes nudge the system
incrementally back in the direction of CXN.
If the foreign tax credit had no limitation, it would establish CXN in cases where
deferral is not a factor. As we have seen, however, the limitation results in varied
effects, but the limitation moves the system away from capital export neutrality by (on
the average) discouraging foreign investment. The ability of investors to cross-credit
foreign taxes paid to high-tax countries mitigates the limitation’s disincentive effects;
at the same time, however, cross crediting distorts the allocation of U.S. investment
among foreign countries, favoring investment in countries with low tax rates over
high-tax countries.
National Neutrality: Maximizing U.S. Economic Welfare
The tax policy that maximizes world economic is not necessarily that which
maximizes U.S. economic welfare. CXN, in other words, is not necessarily optimal
from the narrow perspective of the United States. There are two reasons for this.
First, a unit of capital that is employed in the United States increases both U.S. labor
income and U.S. capital income: the labor component accrues because the unit of
capital makes labor more productive and increases wages. In contrast, a unit of U.S.
capital that is employed abroad produces a return for the investor but not for U.S.
labor; the increase in wages accrues to foreign rather than domestic labor. As a result,
national welfare is not maximized by equating the return to a marginal unit of capital
abroad with a marginal investment in the United States. Instead, national welfare is
maximized if overseas investment is discouraged by some incremental amount.
But even if U.S. labor were not directly disadvantaged by the shifting of
investment abroad, neutral taxation would still not maximize U.S. economic welfare
in cases where foreign host governments impose their own tax on U.S. investors.
This result occurs because the benefit to the United States of an additional unit of
overseas investment is the return on that investment, less foreign taxes. The return
on that same investment made in the United States, however, is the return on the
investment plus any tax collected by the United States.
National neutrality (NN) is the term applied by economists to a tax policy that
maximizes U.S. national welfare. In general, NN prescribes a tax burden on foreign
investment that is higher than the burden on identical domestic investment so that
investment abroad is discouraged. More specifically, NN at least prescribes a policy
of allowing only a deduction for investors’ foreign taxes and not a credit. Indeed, NN
may well require an even more onerous tax rate on foreign investment. In general,
the greater the demand for U.S. capital abroad, the higher the optimal tax rate under
national neutrality. However, while NN maximizes U.S. welfare, it is a “beggar thy
neighbor” policy that increases U.S. welfare by less than it reduces foreign welfare.
Further, such a policy could redound to the disadvantage of the United States if
foreign governments retaliated by restricting capital exports.

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The current United States tax system contains elements that are consistent with
the NN standard. In cases where the foreign tax credit’s limitation poses a
disincentive to investment abroad, the optimal tax rate on foreign investment may be
approached or even surpassed. But in cases where the foreign tax credit establishes
neutrality or provides an incentive towards overseas investment, U.S. economic
welfare is not maximized. The deferral principle, in other words, along with the
foreign tax credit, are inconsistent with national neutrality. The position of the
system, on the average, is ambiguous.
Competitiveness as a Standard
Multinational firms and others sometimes argue that tax policy towards foreign
investment should be set so as to place U.S. firms on an even tax footing with foreign
competitors – a standard sometimes referred to as “capital import neutrality (CMN).”
Economic theory suggests that such a policy distorts the geographic allocation of
capital and maximizes the economic welfare of neither the United States nor the
world. Thus, even though it establishes even taxes when certain comparisons are
made (i.e., U.S. firms compared to foreign firms), CMN is not a “neutral” policy in
the same sense as CXN or NN.
Notwithstanding economic theory, a number of arguments are sometimes made
in support of CMN. For example, it has been argued that given increasingly open and
integrated world capital markets, U.S. savers desirous of investing in foreign equity
can escape any U.S. corporate-level tax on overseas direct investment by means of
portfolio investment – that is, by purchasing stock in foreign firms directly rather than
relying on a U.S. multinational to make foreign investments for them.10 For this to
be true requires portfolio investment to be a perfect substitute, in savers’ eyes, for
direct investment, which may not be the case. Beyond this, however, simply because
savers can in some cases circumvent the U.S. corporate income tax on foreign direct
investment is not a strong case against taxing foreign direct investment.
Another argument supporting CMN holds that overseas investment produces a
higher return for research and certain other activities multinationals undertake; these
activities carry with them “external” benefits to the economy as a whole that make the
return to research greater than the private return to the firm conducting the research.11
But while it is true that the external benefits from research suggest a subsidy is
warranted, such a subsidy seems likely to be more accurately targeted if it were to
applied only to research rather than foreign income. Further, the tax code already
provides such a subsidy in the form of a tax credit and generous treatment of
deductions for research.
Finally, it has been argued that if the supply of saving in the United States
expands with reductions in tax on investment, then world welfare and U.S. welfare
10Daniel J. Frisch, “The Economics of International Tax Policy: Some Old and New
Approaches,” Tax Notes, April 30, 1990, pp. 590-1.
11Gary Clyde Hufbauer, U.S. Taxation of International Income: Blueprint for Reform
(Washington: Institute for International Economics, 1992), pp. 77-94.

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would be increased by cutting taxes on overseas investment as in CMN.12 This
analysis, however, leaves unanswered the following question: if taxes on investment
are to be cut, why reduce them in a manner that distorts the allocation of capital
between the domestic economy and abroad?13
We next examine several prominent policy proposals for U.S. international
taxation, and show how each relates to CXN, NN, and CMN.
Current and Recent Proposals

Proposals Supporting Capital Export Neutrality
A system of pure CXN would be established by a policy of worldwide taxation
of residents, (implying repeal of deferral) and an unlimited foreign tax credit.
However, few proposals have been made in recent years that are designed to establish
broad CXN by the U.S. system. Proposals to restrict deferral tend to gather
momentum during periods of domestic recession or high unemployment; as we have
seen, deferral tends to reduce domestic labor earnings by encouraging capital to move
abroad. Given the unprecedented length of the recent U.S. economic expansion, the
lack of numerous recent proposals to repeal deferral is not surprising.
A prominent past proposal to repeal deferral was the Burke-Hartke measure that
was introduced in Congress in 1971 and again in 1973. The bill was strongly
supported by organized labor, and a primary concern of its supporters was the
perception that deferral led to the “export” of U.S. jobs. Another prominent proposal
for deferral’s repeal was made in 1978 by the Carter Administration. But neither
Burke-Hartke nor the Carter proposal were adopted. Further, even the Tax Reform
Act of 1986, with its sweeping changes to promote efficiency and tax neutrality
generally confined its international tax changes to an incremental expansion of
Subpart F and refinements in the foreign tax credit limitation and related source-of-
income rules.
More recently in December, 2000, the United States Treasury Department issued
a report on taxation of U.S. controlled foreign corporations and subpart F. The
report concluded that if the goal of tax policy is to maximize global economic welfare,
the CXN is the best policy.14 Further, the report stated that ending the deferral
principle would be the specific policy that would have the “most positive long-term
12Thomas Horst, “A Note on the Optimal Taxation of International Investment Income,”
Quarterly Journal of Economics, vol. 94, June 1980, pp. 793-5.
13For an up-to-date and thorough review of economics literature on optimal taxation of foreign
investment, see Donald J. Rousslang, “Deferral and the Optimal Taxation of International
Investment Income,” National Tax Journal, vol. 53, Sept. 2000, pp. 589-600.
14U.S. Treasury Department, The Deferral of Income Earned Through U.S. Controlled
Foreign Corporations (Washington: 2000), p. 97.

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effect on economic efficiency and welfare.”15 Yet even with these conclusions, the
report made no specific policy recommendations.
Recent congressional proposals supportive of CXN have tended to be
incremental in nature. For example, H.R. 4133 in 106th Congress (proposed by
Representative Evans) would have repealed deferral for income from oil extraction.
Also, bills that would repeal deferral for “runaway plants” have been proposed at
various times in the past. (See, for example, S. 1597 and H.R. 3252 in the 104th
Congress, proposed by Senator Dorgan and Representative McKinney.) The
proposals attempted to identify firms that shut down domestic production, open
factories abroad, and export goods back to the United States; the firms’ income
would be taxed on a current basis.
One of the most prominent of recent congressional proposals that would move
the U.S. system in the direction of CXN actually would reduce rather than increase
multinationals’ taxes by reforming source rules related to the foreign tax credit
limitation. (The limitation, as we have seen, inhibits CXN by allowing a disincentive
to exist in high-tax countries.) The proposal was aimed at rules governing the
allocation of interest expense between foreign and domestic sources. In broad terms,
current law’s rules work like this: if a U.S. firm has foreign investments, at least part
of its U.S. interest expense must be allocated to foreign rather than domestic sources
based on the theory that debt is fungible – that regardless of where funds are
borrowed, they support a firm’s worldwide domestic investment. For firms that have
excess foreign tax credits and for whom the foreign tax credit limitation is a binding
constraint, allocation of interest expense abroad has the effect of reducing creditable
foreign taxes – in effect, such firms lose the benefit of the interest deduction for any
interest allocated abroad.
In contrast to these “sourcing” rules for U.S. interest, current law does not
permit any part of the interest expense of foreign subsidiaries to be allocated to U.S.
sources. The Taxpayer Refund and Relief Act of 1999 would have permitted firms
to use a part of a foreign subsidiary’s interest expense to reduce U.S. rather than
foreign income, thus increasing creditable foreign taxes while reducing U.S. tax. The
change would have mitigated the disincentive posed by the foreign tax credit
limitation and would have nudged the system incrementally in the direction of CXN.
The Act was vetoed, however, by President Clinton for reasons not directly related
to its interest allocation provisions.16
15Ibid., p. 90.
16For background and analysis of the provision, 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.

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Territorial Taxation and Proposals
Supporting Capital Import Neutrality
If CXN would be accomplished by worldwide taxation on the basis of residence
and an unlimited foreign tax credit, CMN would be accomplished by exempting
foreign-source income altogether. Such a regime would ,in effect, be a “territorial”
tax policy rather one based on “residence.” Under a territorial system, the capital
exporting country (in this context the United States) looks to the source of income
in determining its tax jurisdiction rather than the residence of the taxpayer. Among
major U.S. trading partners, France and the Netherlands have territorial systems.
Multinational firms and investors have frequently supported territorial taxation,
or at least a movement in that direction, if not for reasons that explicitly have CMN
in mind, then to promote U.S. “competitiveness.” Some have argued, for example,
that as the U.S. economy becomes increasingly open and U.S. firms increasingly
compete in the global marketplace, the tax system should be modified to promote
U.S. firms’ competitiveness.17 A prominent recent proposal for general adoption of
a territorial tax system was that made by the National Commission on Economic
Growth and Tax Reform (the “Kemp” commission on fundamental tax reform).18
Support of a CMN that would be more limited in scope has been based on
analyses that distinguish between portfolio investment and direct investment,
recommending CXN for the former and CMN for the latter. As noted above, for
example, some have argued that growth in international flows of portfolio investment
means that while portfolio investment plays an important role in the efficient
allocation of world capital, direct investment no longer does and performs alternative
economic functions. According to this view, while CXN is efficient for portfolio
investment, tax policy towards foreign direct investment should avoid placing
multinationals at a competitive disadvantage with respect to foreign firms.19 Again,
however, it can be pointed out that if multinationals conduct activities deserving
subsidization, those activities, such as research, might be more accurately targeted
than with a policy of exempting foreign investment income altogether. The Treasury
17See the statement submitted to the Senate Finance Committee by Fred F. Murray on behalf
of the National Foreign Trade Council, in U.S. Congress, Senate Committee on Foreign
Relations, International Tax Issues Relating to Globalization, hearing, 106th Cong., 1st sess.,
March 11, 1999 (Washington: GPO, 1999), p. 113.
18Notwithstanding support of CMN on the basis of competitiveness for U.S. firms, CMN
would reduce overseas investment if, on the average, foreign tax rates are relatively higher
than U.S. taxes on domestic investment (as noted above). In addition to a territorial tax
system, the Kemp commission recommended a complete tax exemption for all saving and
investment – domestic as well as foreign. CMN would exist under a system that exempts
capital income but would necessarily reduce the flow of investment abroad to countries that
still tax capital (assuming the U.S. capital stock is fixed). As a matter of terminology, note
also that such a system’s international tax system would not, strictly speaking, be “territorial,”
since the United States would not exercise jurisdiction to tax investment income on any basis.
19Daniel J. Frisch, “The Economics of International Tax Policy,” p. 590.

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Department’s recent report, however, cites subsequent studies that question Frisch’s
conclusions on several grounds: for example, that capital is limited in its mobility.20
Recent legislation supporting CMN that has been actively considered by
Congress has been incremental in nature. For example, the Job Creation and Worker
Assistance Act that Congress passed in March 2002, extended for 5 years (through
2006) a temporary exclusion from Subpart F of portfolio-type income derived from
the active conduct of a banking, finance, or insurance business.
The topic of “territorial” taxation also surfaced in legislation that Congress
adopted late in 2000 to replace the Foreign Sales Corporation (FSC) tax benefit for
exporting. In response to a complaint by the European Union, the World Trade
Organization (WTO) ruled in 1999 that the FSC provisions were an export subsidy
and were thus prohibited by the WTO agreements. H.R. 4986 in the 106th Congress,
the replacement legislation enacted in 2000, was designed to bring the export benefit
into WTO-compliance by adopting certain aspects of a territorial tax system, which
had been adjudged to be permissible under international agreements. H.R. 4986
grants a partial U.S. tax exemption to a limited amount of a U.S. exporter’s foreign-
source (“extraterritorial,” under the bill) income along with part of its export
income.21 In isolation, the foreign investment parts of the bill thus support CMN. At
the same time, however, export incentives such as those in the other parts of the bill
promote investment in the United States rather than abroad.
Proposals Supporting National Neutrality
Specific proposals consistent with national neutrality have tended to be
incremental in nature – perhaps even more so than with CXN or CMN proposals.
They have also been relatively rare, even in the past. In some cases “runaway plant”
proposals would not only restrict deferral but would impose a surtax on overseas
subsidiaries that export back to the United States. H.R. 4133 in the 106th Congress,
along with its repeal of deferral, would have restricted in certain ways the creditability
of foreign taxes on oil income. But even in this case, it could be argued that the oil
taxes that H.R. 4133 would restrict are actually in many cases royalty payments to
foreign governments who own the extracted oil, not taxes.
20U.S. Treasury Department, The Deferral of Income Earned Through U.S. Controlled
Foreign Corporations, p. 35.
21 CRS Report RS20746, Export Tax benefits and the WTO: Foreign Sales Corporations
(FSCs) and the Extraterritorial (ET) Replacement Provisions, by David L. Brumbaugh.

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Conclusions
A large part of this report has been devoted to pointing out that the economic
effects of various parts of the U.S. international tax system vary, and that the policy
perspectives on the merits of those effects vary also. Deferral poses an incentive to
invest abroad, the foreign tax credit limit a disincentive. To complicate matters
further, the merits of deferral and the foreign tax credit limit differ, depending on
whether one emphasizes world economic welfare and capital export neutrality or
U.S. economic welfare and national neutrality.
At the beginning of the report, we documented the growing U.S. involvement
in the world economy and growing stock of U.S. investment employed abroad.
Because U.S. involvement in the world economy is growing, any flaws in the U.S.
system are potentially becoming more important. And because each of the three
policy perspectives of CXN, NN, and CMN adjudge the present system to be
imperfect by their own standards, pressure to change the system is likely to increase.
International taxation is thus likely to continue to be an important policy issue before
Congress throughout 2001.

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