Reform of U.S. International Taxation:
Alternatives
Jane G. Gravelle
Senior Specialist in Economic Policy
December 27, 2012
Congressional Research Service
7-5700
www.crs.gov
RL34115
CRS Report for Congress
Pr
epared for Members and Committees of Congress
Reform of U.S. International Taxation: Alternatives
Summary
A striking feature of the modern U.S. economy is its growing openness—its increased integration
with the rest of the world. The attention of tax policymakers has recently been focused on the
growing participation of U.S. firms in the international economy and the increased pressure that
engagement places on the U.S. system for taxing overseas business. Is the current U.S. tax system
for taxing U.S. international business the appropriate one for the modern era of globalized
business operations, or should its basic structure be reformed?
The current U.S. system for taxing international business is a hybrid. In part the system is based
on a residence principle, applying U.S. taxes on a worldwide basis to U.S. firms while granting
foreign tax credits to alleviate double taxation. The system, however, also permits U.S. firms to
defer foreign-source income indefinitely—a feature that approaches a territorial tax jurisdiction.
In keeping with its mixed structure, the system produces a patchwork of economic effects that
depend on the location of foreign investment and the circumstances of the firm. Broadly, the
system poses a tax incentive to invest in countries with low-tax rates of their own and a
disincentive to invest in high-tax countries. In theory, U.S. investment should be skewed towards
low-tax countries and away from high-tax locations.
Evaluations of the current tax system vary, and so do prescriptions for reform. According to
traditional economic analysis, world economic welfare is maximized by a system that applies the
same tax burden to prospective (marginal) foreign and domestic investment so that taxes do not
distort investment decisions. Such a system possesses “capital export neutrality,” and could be
accomplished by worldwide taxation applied to all foreign operations along with an unlimited
foreign tax credit. In contrast, a system that maximizes national welfare—a system possessing
“national neutrality”—would impose a higher tax burden on foreign investment, thus permitting
an overall disincentive for foreign investment. Such a system would impose worldwide taxation,
but would permit only a deduction, and not a credit, for foreign taxes.
A tax system based on territorial taxation would exempt overseas business investment from U.S.
tax. In recent years, several proponents of territorial taxation have argued that changes in the
world economy have rendered traditional prescriptions for international taxation obsolete, and
instead prescribe territorial taxation as a means of maximizing both world and national economic
welfare. For such a system to be neutral, however, capital would have to be completely immobile
across locations. A case might be made that such a system is superior to the current hybrid
system, but it is not clear that it is superior to other reforms, including not only a movement
toward worldwide taxation by ending deferral, but also restricting deductions for costs associated
with deferred income or restricting deferral and foreign tax credits for tax havens.
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Reform of U.S. International Taxation: Alternatives
Contents
The Current System and Possible Revisions ................................................................................... 2
The System’s Structure .............................................................................................................. 2
Possible Revisions ..................................................................................................................... 4
Neutrality, Efficiency, and Competitiveness .................................................................................... 4
Understanding Capital Export Neutrality, Capital Import Neutrality, and National
Neutrality ................................................................................................................................ 5
Capital Ownership Neutrality .................................................................................................... 7
Assessing the Existing Tax System ................................................................................................ 10
Territorial Taxation: The Dividend Exemption Proposal ............................................................... 12
A Residence-Based System in Practice.......................................................................................... 15
President Obama’s Proposals to Restrict Deferral and Cross-Crediting ........................................ 16
Tax Havens: Issues and Policy Options ......................................................................................... 18
General Reforms of the Corporate Tax and Implications for International Tax Treatment ........... 20
Tables
Table 1. Illustration of the Effects of Residence- and Source-Based Taxation ................................ 6
Contacts
Author Contact Information........................................................................................................... 22
Acknowledgments ......................................................................................................................... 22
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Reform of U.S. International Taxation: Alternatives
he increasingly global scope of U.S. business has a variety of dimensions. In trade, the
overall level of exports plus imports has risen steadily and substantially in recent decades,
Tincreasing from 16% of U.S. gross domestic product (GDP) in 1976 to a 25% of GDP in
2009. Cross-border investment is growing even more dramatically. In 1976, the ratio of U.S.
private assets to GDP was 0.20; by year end 2009 the ratio was 1.01.1
The bulk of the increase in “outbound” investment has been portfolio investment—investment in
financial assets such as stocks and bonds without the active conduct of overseas business
operations. But foreign direct investment by U.S. firms—actual foreign production by U.S.-
owned companies—has increased too, rising from a ratio of 0.12 to 0.28 of GDP between 1976
and 2009. It is the taxation of U.S. business operations that has been the recent focus of
policymakers, and that has raised the question of basic tax reform in the international sector: is
the current U.S. tax system for taxing U.S. international business appropriate in this age of
globalized business operations, or is reform needed?2 Moreover, along with the increasing scope
of international investment activities, there is an increasing opportunity for tax shelters that take
advantage of low-tax foreign jurisdictions. How might revisions in the tax system exacerbate or
address these tax shelter issues?
The current U.S. system is a “hybrid” construct, embodying a mix of opposing jurisdictional
principles. Not surprisingly, the mixed system—in conjunction with foreign host-country taxes—
poses a patchwork of incentive effects for U.S. firms and their global operations, in some cases
taxing foreign operations favorably and posing an incentive to invest abroad, and in other cases
imposing high tax burdens and posing a disincentive to overseas investment. In some cases, the
system presents a rough tax neutrality towards overseas investment. It is perhaps the hybrid
nature of the system that has led to calls for reform. Prescriptions for a “good” tax system vary,
and the hybrid system satisfies none of them fully.
The report describes and assesses the principal prescriptions that have been offered for broad
reform of the international system. The report begins with an overview of current law and of
possible revisions. It then sets the framework for considering economic efficiency as well as tax
shelter activities. Finally, it reviews alternative approaches to revision in light of those issues.
1 Data on trade, U.S. assets abroad, and foreign assets in the United States are from the website of the U.S. Department
of Commerce, Bureau of Economic Analysis, at http://www.bea.gov. The fixed assets data were adjusted to include
estimated stocks of inventory and intangible capital.
2 Interest in international reform comes from a variety of sources. For example, the President’s executive order (E.O.
13369) establishing his advisory panel on tax reform cited international competitiveness concerns as one principal
reason for considering tax reform; the panel’s final report included a fundamental change in the structure of the U.S.
international system as part of one of its reform options. See President’s Advisory Panel on Federal Tax Reform,
Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System (Washington, November 2005). In Congress, in
June 2006, the House Ways and Means Committee’s Subcommittee on Select Revenue Measures held a hearing on
international tax reform. The topic is also receiving attention in the academic and professional world: the National Tax
Journal published a four-article forum on international tax reform in its December 2001 issue.
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The Current System and Possible Revisions
The System’s Structure
There are two alternative, conceptually “pure,” principles on which countries base their tax in the
international setting: residence and territory. Under a residence system, a country taxes its own
residents (or domestically chartered “resident” corporations) on their worldwide income,
regardless of its geographic source. Under a territorial or source-based system, a country taxes
only income that is earned within its own borders.
In practice, no country uses a pure residence-based tax; historically, virtually all countries tax
income foreign investors earn within their borders (although they may grant tax holidays in some
cases as an inducement to investment). Some countries, however, do have an exclusively
territorial or source-based tax.3 The United States uses a system that taxes both income of foreign
firms earned within its borders as well as the worldwide income of its U.S.-chartered firms.
Despite these nominal “residence” features, however, U.S. taxes do not apply to the foreign
income of U.S.-owned corporations chartered abroad. As a result, a U.S. firm can indefinitely
defer U.S. tax on its foreign income if it conducts its foreign operations through a foreign-
chartered subsidiary corporation; U.S. taxes do not apply as long as the foreign subsidiary’s
income is reinvested overseas. With some exceptions, U.S. taxes apply only when the income is
remitted to the U.S.-resident parent as dividends or other intra-firm payments such as interest and
royalties. The deferral feature reduces the effective U.S. tax burden on foreign income and
imparts an element of territoriality to the system; it also results in a dichotomous structure for
taxing overseas business income: deferral in the case of foreign-subsidiary income and current
taxation in the case of branches of U.S. chartered corporations. The bulk of active business
investment by U.S. firms is through foreign-chartered subsidiaries.4
Along with deferral, another basic feature of the U.S. system is the foreign tax credit. While the
United States taxes worldwide income on either a current or deferred basis, it also allows credits
for foreign taxes paid on a dollar-for-dollar basis against U.S. taxes otherwise owed.5 This
treatment avoids the double-taxation that would otherwise apply and concedes the first right of
taxation to the country of source. In effect, the United States gives the foreign host country the
3 President Bush’s Advisory Panel on Tax Reform published a list of countries that use a territorial system either by
statute or treaty. The territorial countries are: Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Germany, Greece, Hungary, Iceland, Italy, Luxembourg, Netherlands, Norway, Portugal, Slovak Republic, Spain,
Sweden, Switzerland, and Turkey. The following countries tax foreign-source income at some point and rely on foreign
tax credits to relieve double taxation: Czech Republic, Iceland, Japan, Korea, Mexico, New Zealand, Poland, the
United Kingdom, and the United States. President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-
Growth: Proposals to Fix America’s Tax System (Washington, November 2005), p. 243. Japan and the United
Kingdom, however, have recently moved to a territorial system.
4 According to IRS data for 2008, before-tax earnings and profits of foreign subsidiaries was $661 billion while branch
gross income was $178 billion. The data are posted on the IRS website at http://www.irs.gov/uac/SOI-Tax-Stats—
International-Business-Tax-Statistics.
5 U.S. parent firms are permitted to claim foreign tax credits for foreign taxes paid by their foreign-chartered
subsidiaries. Such “indirect” credits can be claimed by the parent when the foreign-source income is remitted as
dividends.
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Reform of U.S. International Taxation: Alternatives
first opportunity to tax the income, and collects only what tax is left (up to its own rate) after the
foreign host country collects its share.
When the foreign tax is higher than the U.S. tax, the credit is limited to the U.S. tax that would be
due on the foreign income. The purpose of the limit is to protect the U.S. domestic tax base:
without it, foreign countries could impose very high taxes without discouraging inbound U.S.
investment, because the cost of the higher taxes would be shifted to the U.S. treasury. With the
limitation, if foreign taxes exceed the U.S. tax that would be due, the excess foreign taxes cannot
be credited. Foreign tax credits that exceed this limitation are termed “excess credits.” Currently
foreign tax credits are allowed on what is sometimes termed an “overall” basis, so that income
and tax credits from all countries are combined. This treatment allows for “cross-crediting,”
where credits paid in excess of U.S. tax in one country may be used to offset U.S. tax in a country
where the foreign tax is lower than the U.S. tax. To prevent abuse, tax credits are divided into
“baskets” which separate passive income easily shifted to low-tax countries. Currently, there are
two baskets, one for active income and one for passive income. Over half of foreign-source active
business income is earned by firms with overall excess credits.6
To address tax avoidance by shifting passive income into low-tax jurisdictions, Subpart F restricts
the applicability of deferral in some situations. Subpart F provides that U.S. stockholders (e.g.,
parent firms) of foreign corporations are subject to current U.S. tax on certain types of subsidiary
income, whether or not the income is repatriated. Only stockholders owning at least 10% of
subsidiary stock and only subsidiaries that are at least 50% owned by 10% U.S. stockholders are
subject to Subpart F. Countries that have territorial tax systems generally also have some type of
anti-abuse provision to protect their tax base.
Tax deferral results in heightened importance for the system’s rules for dividing income between
related firms; the more income a firm can assign, for tax purposes, to a foreign subsidiary in a
low-tax country, the lower its overall tax burden. The current system generally requires firms to
set hypothetical “transfer prices,” which are required to approximate the prices two firms would
agree on if they conducted their transactions at arm’s length. The system is complex and difficult
to administer.
The foreign tax credit’s limitation also places pressure on the system’s rules for determining the
source of income (“sourcing” rules). Because firms can only credit foreign taxes against the
portion of taxable income attributable to foreign sources, taxpayers must assign both revenue and
costs to either domestic or foreign sources. While the tax code contains rules for making such
allocations, they are likewise complex and difficult to administer.
In sum, the United States taxes its resident corporations on their worldwide income, but permits
indefinite deferral of active business income earned through foreign subsidiaries. Where U.S.
taxes apply, foreign tax credits alleviate double taxation but are limited to offsetting U.S. tax on
foreign income. Subpart F is designed to deny deferral to what is generally passive income.
6 Jennifer Gravelle reports 62% of income in 2008 was earned by firms with excess credits in at least one basket;
Presentation at National Tax Association Meetings, Providence, Rhode Island, November 2012. Similar shares were
found in the past. See Rosanne Altshuler and Harry Grubert, ‘Corporate Taxes in the World Economy: Reforming the
Taxation of Cross-Border Income,” In Fundamental Tax Reform: Issues, Choices and Implications, Ed. John W.
Diamond and George R. Zodrow, The MIT Press, Cambridge, MA, 2008.
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Possible Revisions
Because the current U.S. tax system is a mix of a worldwide system and a territorial system, the
fundamental tax reform issue is whether moving toward either “pure” system—a territorial or
worldwide residence-based regime—would be an improvement. Moving toward a territorial
system would involve permanently exempting most foreign-source active business income. (Most
territorial proposals, however, would continue taxing passive income, as under current law’s
Subpart F.) Moving toward a worldwide tax would eliminate the deferral benefit and might also
entail further restricting cross-crediting by increasing the number of baskets for the foreign tax
credit limit. Some revisions that maintain the current system but tighten the rules for deductions
include proposals to disallow certain deductions of the parent company (such as interest) that
reflect the share of income that is deferred.
The report defers the discussion of the precise changes fundamental reform would entail. First,
however, the report explains the tools economists have developed for evaluating the various
international tax systems.
Neutrality, Efficiency, and Competitiveness
The term competitiveness has often been invoked in the debate about U.S. policy in a global
economy, including discussions of U.S. tax policy.7 In economic analysis, however, it is not
countries that are competitive, it is companies that are. A company generally thinks of itself as
competitive if it can produce at the same cost as, or a lower cost than, other firms. But a country’s
firms cannot be competitive in all areas. Indeed, even if firms in a country are more productive
than firms in all other countries in every respect, a country would still tend to produce those
goods in which its relative advantage is greatest. The other countries need to produce goods with
their resources as well. This notion is called comparative advantage, and it is an important
concept in economic theory.8
When discussing national policy, including tax policy and its effect on the international allocation
of capital, the issues are generally framed around issues of efficiency, neutrality, and optimal
policies rather than notions of competitiveness. These terms can mean the same thing, or they can
be slightly different. Neutrality generally refers to provisions that do not alter the allocation of
investment from that which would occur without taxes. When markets are operating efficiently, a
neutral tax policy will also be an efficient policy, since it will maintain the efficient allocation that
would occur without taxes. Moreover, even when there are market imperfections, neutrality may
still be the policy most likely to be efficient, given the difficulty in identifying and measuring
market imperfections.
7 For a more detailed discussion of this concept see CRS Report RS22445, Taxes and International Competitiveness, by
Donald J. Marples. See also Jane G. Gravelle, “Does the Concept of Competitiveness Have Meaning in Formulating
Corporate Tax Policy?” Tax Law Review, vol. 65, no. 3, 2012, p. 323-348.
8 Comparative advantage is not a technical or unfamiliar concept; it is a common, everyday occurrence. A lawyer may
be able to do his or her paralegal employee’s work more efficiently, but that activity is not the best use of his or her
time. A lawyer has an absolute advantage in both law practice and paralegal work, but a comparative advantage in
practicing law.
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Optimal policy differs from efficiency in that it usually refers to a particular agent or actor
choosing a policy that maximizes his or her own welfare. A country can also choose a policy that
leads to the greatest welfare for its own citizens, even if that policy distorts the allocation of
capital (is not neutral) and leads to less efficient worldwide production. The optimal policy from
the perspective of a country, in other words, may not be the most efficient in terms of the
worldwide allocation of capital, and may not be the optimal policy from the perspective of world
economic welfare.
Economists have traditionally used three concepts to evaluate tax rules that apply to outbound
investment. These concepts are referred to as neutrality concepts, although, as shown below, they
are not always neutral in the sense of not distorting the allocation of investment. The concepts are
capital export neutrality, capital import neutrality, and national neutrality. In order to evaluate the
consequences of any multinational tax reform, it is crucial to understand these concepts, whether
they are valid, and what they imply for policy. The concepts were developed when virtually all
foreign investment took place as direct investment of multinational companies; virtually no
foreign portfolio investment (ownership of foreign stock by U.S. citizens) existed. The growth in
this portfolio investment has led to a new neutrality concept, referred to as capital ownership
neutrality. We address these traditional and new concepts in turn.
Understanding Capital Export Neutrality, Capital Import
Neutrality, and National Neutrality
Capital export neutrality requires a country to apply the same tax rate to its firms’ investments,
regardless of where they are located, and is embodied in a residence-based tax system. Capital
import neutrality requires the same tax on firms with different nationalities that invest in a given
location and is embodied in a territorial or source-based tax. National neutrality requires that the
nation’s total return on investment, including both that nation’s taxes and its firms’ profits, is
equal in each jurisdiction, foreign and domestic. This form of neutrality is obtained by taxing
foreign-source income and allowing a deduction for foreign taxes.
Some of these neutrality rules may also be rules for optimization. National neutrality is often
described as optimal, but that outcome is only the case with perfectly mobile capital and no
retaliation by foreign countries. There is also an optimizing rule for choosing the tax rate on
inbound investment, which depends on how responsive that investment inflow is to the return.
Evaluating policy, discussed subsequently, is complicated because while some countries have
territorial or source-based taxes, no country imposes a pure residence-based tax. While worldwide
taxation as practiced in the United States and other countries has some attributes of a residence-
based tax, it is a mixture of residence- and source-based tax. Tax is imposed on foreign firms
operating within the United States, a source-based attribute. On outbound investment, the
application of tax to repatriated income creates some resemblance to residence tax, but the
foreign tax credit limitations cause it to depart from such a tax, and deferral provisions introduce
an element of a source-based tax.
Because these concepts are so frequently misunderstood, it is useful to employ a simple
illustrative example to explain them with the pure tax systems that are consistent with capital
export neutrality and capital import neutrality. In these simple systems, national neutrality is the
same as capital export neutrality, and its nuances will be discussed in the following section where
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more realistic tax systems are discussed. In this instance, it may be helpful to demonstrate the
difference between residence-based and source-based taxes in achieving economic neutrality.
Consider a world beginning with no taxes, and assume that capital is perfectly substitutable
across countries, implying that a firm will earn the same after-tax return in each location. The
return is 10%. There are three countries: a high-tax country that imposes a 50% tax rate, a low-tax
country that imposes a 25% tax rate, and a zero-tax country. All investment is made through the
companies’ direct operations, hence, there is no substitution of capital across firms and the capital
owned by each country is fixed. The high and low-tax rate countries have capital which can be
used to invest in their own country, or in the other two countries. To simplify, the zero-tax country
is assumed to have only labor and no capital.
Table 1 shows the return to firms in the absence of any tax and with the two tax systems in place
but before investment has shifted (which would alter the pre-tax return). Residence taxation,
which produces capital export neutrality, has no effect on the allocation of investment by either
country’s firms because each firm still earns the same return in each location. Source-based
taxation, however, will result in higher returns in the zero- and, to a lesser extent, low-tax
countries. As a result, capital will flow out of the high-tax country, raising its return and lowering
the wages of the workers in that country and into the zero-tax country, lowering its return and
raising the wages of the workers in that country. The effect on the low-tax country depends on the
size of that country and its labor force relative to the rest of the world. In addition to the effects
on the return to capital and wages, output is produced inefficiently, which reduces world welfare.
Table 1. Illustration of the Effects of Residence- and Source-Based Taxation
Return by Location of Investment (%)
Nationality of Firm
High-Tax
Low-Tax
Zero-Tax
Country
Country
Country
No Taxes
High-Tax
Country
10% 10% 10%
Low-Tax
Country
10% 10% 10%
Residence Tax
High-Tax
Country
5% 5% 5%
Low-Tax
Country
7.5% 7.5% 7.5%
Source-Based (Territorial) Tax
High-Tax
Country
5%
7.5%
10%
Low-Tax
Country
5%
7.5%
10%
Note: The high-tax country has a 50% tax rate, while the low-tax country has a 25% tax rate.
Table 1 can also be used to show that the residence-based system is also consistent with national
neutrality, but the source-based system is not. For the high-tax country, in each location it earns
5% in tax revenue and 5% in profits (for a total of 10%). Thus the total return to the nation is
equated in each jurisdiction. The same is true of the low-tax country, although the total return is
split into 2.5% taxes and 7.5% profits. The source-based system does not meet that standard.
Even before investment shifts, the high-tax country, while earning 10% domestically and in the
zero tax haven country, is earning only 7.5% in the low-tax country, since that country’s
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government is collecting the tax. The same is true of the low-tax country with respect to
investment taxed by the high-tax country.
National neutrality departs from capital export neutrality in the more complex, real world
circumstances. It, in fact, requires that foreign-source income be taxed, and that any taxes
imposed by the country of location be deducted (rather than the current rule of some countries,
including the United States, that allow taxes to be credited). If foreign countries impose taxes,
national neutrality does not lead to worldwide neutrality, since foreign investment is discouraged
in countries that impose taxes.
National neutrality is really about optimal policy, which maximizes the welfare of the country’s
residents. It is an optimal policy if all capital is perfectly mobile; if not, it is actually optimal for a
country to impose even more tax on outbound investment than is suggested by the neutrality
standard.
In sum, according to these longstanding measures of neutrality and efficiency, capital export
neutrality is appropriate for maximizing world output, national neutrality is appropriate for
maximizing a nation’s welfare, and capital import “neutrality” is not neutral at all.
Capital Ownership Neutrality
A new concept of neutrality has appeared in recent years. The term capital ownership neutrality
(CON) is closely associated with Desai and Hines, professors, respectively, of business at
Harvard and economics at the University of Michigan.9 The term itself, however, appears to have
been coined by Michael Devereaux,10 a British economist. The underlying justification for the
new standard’s development, the growth of portfolio investment, was also discussed
independently about the same time in a paper by Frisch.11 Essentially, capital ownership neutrality
is the same as capital import neutrality in that, under certain very restrictive assumptions, it is
achieved by source-based taxation, and some of the earlier discussions viewed it as a resurrection
of capital import neutrality.12
The issue of ownership neutrality developed because international investment markets changed.
At the time the previous notions of neutral international tax systems were first developed—
generally, the early 1960s—virtually all U.S. investment abroad was carried out through foreign
direct investment by U.S. firms.13 U.S. portfolio investors held almost no stock in foreign firms.
Until the mid-1980s, the share of foreign stocks in U.S. residents’ stock portfolios was less than
9 Mihir Desai and James Hines, Evaluating International Tax Reform, National Tax Journal, vol. 56, September 2003.
10 Michael P. Devereux, “Capital Export Neutrality, Capital Import Neutrality, Capital Ownership Neutrality, and All
That,” Unpublished Paper, June 11, 1990.
11 Daniel J. Frisch, “The Economics of International Tax Policy: Some Old and New Approaches,” Tax Notes, April 30,
1990.
12 Frisch, in “The Economics of International Tax Policy: Some Old and New Approaches,” states, “In short, a major
element of the CIN view would seem to possess a grain of truth,” (p. 590) referring to the capital import neutrality
framework. Devereux, in “Capital Export Neutrality, Capital Import Neutrality, Capital Ownership Neutrality, and All
That,” indicated that he originally attempted to redefine capital import neutrality to cover the capital ownership
neutrality concept.
13 The concepts were first developed by Peggy Musgrave. See, for example, her United States Taxation of Foreign
Investment Income: Issues and Arguments (Cambridge MA: Harvard Law School, 1969), pp. 108-121.
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1%. Thus, it was reasonable to assume, as in the discussion above, that there was no substitution
across the nationality of firms, but rather only across locations—that is, U.S. investors could not
substitute investment abroad through foreign firms for investment in U.S. firms with foreign
operations. Over time, however, the share of foreign stock owned by U.S. investors increased,
and by the end of 2006, it was 22% of corporate equity owned by U.S. investors.14 This increase
did not occur smoothly: it increased in the latter part of the mid-1980s to about 6%, leveled out
for a number of years, then again rose around 1993 and 1994 to about 11%, where it stayed until
around 2001, and then rose again.
A closer look at the CON concept indicates that, to make the argument that capital ownership
neutrality (and therefore source-based taxation) should be the guiding principle for an efficient
and neutral tax system, three requirements are needed. First, firms are assumed not to substitute
operations in one location for those in another—capital is completely immobile across locations.
Second, firms must differ in their productivity—that is, some firms are more efficient than
others—and there must be substitution across portfolios that results in firms being shut out of
lines-of-business that they could run more efficiently. Third, there must be no mechanisms
available to obtain the benefits of productive efficiency—short of owning the productive capital
assets. For example, relatively inefficient firms cannot rent efficient technologies or hire efficient
managers away from efficient firms.
If only the first requirement is met (immobility across locations), any system of taxing investment
abroad would be neutral because the particular distortion—allocation of investment across
locations—is simply assumed away. It doesn’t matter if overseas operations are taxed higher or
lower than domestic investment, because investment has no reason to move. Residence taxation
would be efficient as well as source-based taxation, because the national affiliation of firms
would not matter to productivity (although residence taxation would not be optimal for the high-
tax country which would have no revenues).15
If the two remaining assumptions also apply—productivity differs and no mechanisms exist to
boost efficiency—it can be shown that residence-based taxation is inefficient while source-based
taxation produces efficiency. For example, returning to Table 1, suppose some firms in each
country are particularly productive and can earn 12% before tax rather than 10%. With residence-
based taxation, the after-tax return of the high-tax country’s productive firms, which would yield
an after-tax return of 6%, would not be enough for these firms to operate and, if the only way to
realize the higher return is to own the capital, the higher pre-tax yields of these more efficient
firms would not be realized. With source-based taxation, the efficient firms in each country would
operate and displace the less efficient ones.
In the more realistic tax systems where countries also tax capital income in their own location, the
high-tax country’s especially productive firms would still operate in their own country. That is, by
taxing income within its borders, a high-tax country that is attempting to practice capital export
neutrality with a worldwide tax still faces neutral ground in its home country. Thus, any distortion
14 Calculated by reducing U.S. corporate equity issues by foreign stock holdings in the United States determining U.S.
holdings of foreign stocks as a share. Data on corporate equities can be found in the Board of Governors of the Federal
Reserve Flow of Funds Accounts, Table L213, which can be found at http://www.federalreserve.gov/releases/Z1/
Current/. Historical series can also be found in the National Income and Product Accounts at http://www.bea.gov/
national/nipaweb/Ni_FedBeaSna/TableView.asp?SelectedTable=5&FirstYear=1998&LastYear=2005&Freq=Year.
15 This optimality issue has also been addressed with the notion of National Ownership Neutrality, which indicates that
it is both efficient and optimal to have source-based taxation.
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arising in practice from the current system would involve foreign firms and the solution of
exempting foreign-source income from tax is the solution consistent with capital ownership
neutrality.
Consider each of the restrictions in turn. The first is the assumption that capital is immobile
across locations; as noted above, there is considerable evidence that it is not and, indeed, that it is
quite elastic. So at best, it would be a question of picking which type of distortion is worse. As
long as capital is mobile across jurisdictions, “capital ownership neutrality” is not neutral. At
most, the model shows that there is no way to achieve neutrality and that one is in a second-best
world.
The second restriction requires a high, perhaps perfect, degree of substitution in portfolios of
different types of stocks that would lead to the exclusion of stock of high-tax countries. There is
considerable evidence to suggest that such perfect substitution is not the case. It has long been
known that there is a significant home bias in the holding of both portfolio and direct assets.
Despite global securities markets, American residents continue to hold 80% of their stock
portfolios in stock of U.S. firms. If portfolio investment were perfectly substitutable, the U.S.
share would be expected to be closer to the share of total assets. The U.S. accounts for about a
third of total fixed investment of the OECD countries.16
The fact that the portfolio share has grown does not in itself provide evidence of a significant
elasticity; rather, it may reflect a variety of technical and institutional changes that make holding
foreign stocks more feasible. Moreover, the portfolio shares are consistent with the notion that the
holdings that do exist are not so much due to tax differences but to a general desire to diversify
assets across countries to reduce cyclical risk. Two-thirds of investment is in other countries with
similar tax rates. At the end of 2005, the two largest shares were for the U.K. (16%) and Japan
(15%). While the U.K., with a 30% corporate rate, has a lower statutory rate than the U.S. (39%
including state taxes), Japan has a rate of 41%. The next two largest claimants with 7% and 6%
have rates of 35% and 35%.17 There are significant shares in two tax havens, Bermuda (5%) and
the Cayman Islands (3%). According to the Department of Treasury, however, the Bermuda
investments are largely former U.S. firms that have moved their location to avoid U.S. tax (a
phenomenon called inversion, which was subsequently addressed with legislative restrictions),
and the Cayman Islands investments are in offshore financial centers (again likely a tax avoidance
issue rather than direct production issue).18
An imperfect portfolio substitution elasticity also suggests that the phenomenon of eliminating
efficient firms is less likely to happen. Firms that are especially productive and efficient will earn
higher returns than other firms in similar circumstances of nationality and location, and they
would be expected to be retained in both domestic and foreign investors’ portfolios. Any firms
whose size is contracted by portfolio shifts due to tax rates are more likely to be the marginal
firms that have a normal level of productivity.
16 Congressional Budget Office, Corporate Tax Rates: International Comparisons, November, 2005.
17 Data are from tax rates cited in Congressional Budget Office. Corporate Tax Rates: International Comparisons,
November, 2005, and portfolio share data are from U.S. Department of Treasury Report on U.S. Portfolio Holdings of
Foreign Securities.
18 U.S. Department of Treasury, Report on U.S. Portfolio Holdings of Foreign Securities.
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Finally, this model assumes that there are no other ways to enjoy the additional productivity of
more efficient firms. In effect, the model begins with the assumption of productive advantages
without defining in formal terms—so that the effects can be modeled—the source of the
productivity.
For example, if the greater productivity of the firm is due to the employment of managers with
greater skills, then that productivity arises at a cost, and these management skills embodied in the
individuals resident in a given country should be free to move to their highest use, and allocated
efficiently. Since they add a surplus value, they would not be driven out of the market, and
worldwide efficiency requires a capital export neutrality approach to labor resources as well as
capital.
If the asset is uniquely tied to the firm—such as a value through a trademark, intangible R&D, or
even a management set-up—the model does not allow for the fact that ownership of the
productive assets and ownership of the intangible asset can, in most cases, be separated.
Trademarks and patents can be franchised and sold. Or, if the intangible cannot be separately sold
(for example, if the R&D could be easily copied and thus is not patented but kept secret), there
are ways for the firm to operate without ownership of the capital assets, such as factories,
machinery, and equipment, that give rise to normal products. These assets could be leased by the
firm with the intangible asset. Moreover, if the asset is not closely tied to management, the firm
could arrange for contract manufacturing, a technique commonly used to shift profits. These
techniques may be less than perfect if there are principal-agent costs,19 but this effect is of
questionable importance.
In light of the many ways in which the efficiency costs of capital ownership non-neutrality are
unlikely to be significant compared to location distortions, it seems questionable to use meeting
this standard of neutrality to evaluate tax reform changes and questionable to see source-based
taxation as an efficient international tax regime.
Assessing the Existing Tax System
The above examples illustrate the various traditional concepts of neutrality and how they are
embodied in basic tax structures. However, as described at the report’s outset, the U.S. tax system
is a hybrid—neither a pure territorial or residence-based system. Accordingly, it presents a
patchwork of incentive effects, sometimes posing an incentive to invest abroad and, in other
situations, presenting either a disincentive or tax neutrality. We look in this section at the existing
system’s principal incentive effects.
First, in some cases the U.S. system resembles residence-based taxation—it taxes foreign branch
income on a current basis while allowing a foreign tax credit. Even where current taxation
applies, however, the U.S. system departs from pure residence taxation by placing a limit on its
foreign tax credit. If pure residence-based means taxing income of residents at the same rate,
regardless of where it is earned, an unlimited foreign tax credit would be required. Under such a
credit, when the foreign tax is lower than the home country tax, the home country would collect a
19 Principal-agent costs occur when the objectives of the two parties are not identical. For example, the contract
manufacturer (the agent) may want to increase the scale of the operation rather than maximizing profits for the firm
authorizing the manufacturing (the principal).
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residual, equating the total tax imposed to that on its domestic investment. When the foreign
country’s tax is higher, the home country would have to refund the excess so that, again, the tax
on the foreign investment would be the same as the tax on domestic investment. In practice,
however, an unlimited foreign tax credit is not feasible because of its potential threat to the home
country tax base (here, that of the United States). Without a limit, countries host to foreign
investment could simply raise their taxes on inbound investment without limit and without fear of
driving foreign investors away. The foreign investors could simply credit their high foreign taxes
against their home-country tax bill. The U.S. thus limits its foreign tax credit to offsetting U.S.
taxes on foreign (and not domestic) income.
The incentive effects of a worldwide system with a limited credit depend on exactly how the
credit is limited. If the limit applies separately for each country (a “per-country” limit), the system
would achieve neutrality on outbound investment with respect to low tax-rate countries, but not
high tax-rate countries. If taxes can be averaged across countries—that is, if a firm calculates a
single limit aggregated across countries, the neutrality consequences are less clear. In that case,
the excess credits from the investment in a high-tax country can be used to offset tax due on
investments in the low-tax country (can be “cross credited”). For example, assume profits were
$100 in a high-tax location with a 50% rate and $100 in the no-tax location, with the home
country tax rate 25%. With no cross crediting, a firm from the 25% tax rate country uses the
foreign tax of $50 to wipe out the home country tax of $25, with only the tax of $50 applying,
while the firm would pay a home country tax of $25 on the income earned in the zero tax
jurisdiction. The total tax is $75. With cross crediting, the total foreign-source income is $200, the
total foreign tax paid is $50 (in the high-tax country, on $100 of profit), and the total home-
country tax due is also $50 (25% of $200 of income in both countries). All foreign tax is credited
and the total tax is $50.
Cross crediting, as allowed in the U.S. tax system, can therefore reduce the disincentive to invest
in high-tax countries if the firm already has investment in the zero tax country, because the excess
credits have a value. Similarly, it can increase the incentive to invest in the zero tax country if the
country already has investment in the high-tax country, since excess credits can effectively
remove any residual tax in the zero tax country. In either case, foreign investment is encouraged
relative to domestic investment. In practice, the U.S. tax system permits extensive cross crediting;
it does not require a per-country limitation, although it does require firms to calculate separate
limits for passive and active business income.
Second, the U.S. tax system departs from residence-based taxation in its use of deferral. As
described above, U.S. taxes generally do not apply to the foreign business income of foreign-
chartered subsidiaries. This feature of the tax system introduces elements of a territorial or
source-based taxation into the system, and also introduces a distortion in firms’ decisions of
whether to return profits to the United States or reinvest them abroad. Moreover the interaction of
deferral with cross crediting provides some scope for firms to choose the times and places of
repatriation to minimize tax liability. In general, the availability of deferral—like the territorial
taxation it at least approaches—poses an incentive for U.S. firms to invest in low-tax countries.
Also, once capital has been invested abroad, the provision encourages firms to retain their
earnings overseas rather than returning them to the United States.
This mixture of treatments also provides methods for avoiding tax apart from the direct effects on
investment allocation. Deferral provides an incentive to artificially shift profits to low-tax
jurisdictions. Since firms can choose between branch operations and investment via foreign-
chartered subsidiaries, they can use a branch form when operations are starting up and typically
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lose money to allow losses to be deducted from the U.S. worldwide income tax, and then shift to
a subsidiary form when the operation becomes profitable.
In sum, the current system poses a patchwork of incentive effects that is in keeping with its
hybrid nature. Where current taxation applies—for example, to branch income—there is a
disincentive to invest in high-tax countries, and either an incentive or neutrality towards
investment in low-tax countries, depending on whether the investing firm can use cross-crediting
of foreign taxes. Where deferral is available, the system poses an incentive to invest in low-tax
countries. The system also provides mechanisms for artificially sheltering income from tax.
Territorial Taxation: The Dividend Exemption
Proposal
The preceding sections showed why the theoretical argument that territorial taxation is optimal is
difficult to defend. Some have argued, however, that while territorial taxation may not be the
most efficient system in a perfect world, it is nonetheless superior to the hybrid, patchwork
system that is the current U.S. system—a “second best” argument. A territorial tax was recently
proposed by the National Commission on Fiscal Responsibility and Reform, although the specific
details were not provided.20 To best understand this argument for territorial taxation, it is helpful
to examine the specific version proposed in a 2001 American Enterprise Institute monograph by
economists Harry Grubert and John Mutti. A similar plan was set forth in 2005 by President
Bush’s advisory commission on tax reform.21 While the Grubert-Mutti proposal had been the
focus of attention for many years, more recent proposals, described subsequently, are quite
different.
Grubert and Mutti described their proposal as a “dividend exemption” system, thus focusing on
the chief modification their plan would make to the current regime: it would exempt from U.S.
taxes dividends repatriated to U.S. parents from foreign subsidiary corporations, thus moving
from current law’s deferral for foreign income to a permanent exemption. More generally, an
exemption system can be viewed as a territorial tax system whose application is restricted to
active business investment abroad, but that continues to tax portfolio investment of firms (such as
interest, royalties, and similar income) on a current basis.
Several additional features of the plan are important to the advantages it might have over the
current system. First, the plan would not permit foreign tax credits to be claimed for foreign taxes
paid with respect to repatriated earnings. The repatriations, after all, would be exempt from U.S.
tax, thus obviating the need for relief from double taxation. Second, deductions allocable to tax-
exempt foreign-source income would be disallowed. Here, the reasoning is that the purpose of
deductions is to remove items of cost from the tax base; since overseas income would no longer
be in the U.S. tax base, removal of associated costs would not be necessary. Importantly, this
20 National Commission on Fiscal Responsibility and Reform, The Moment of Truth., Washington, D.C., The White
House, December 2010.
21 Harry Grubert and John Mutti, Taxing International Business Income: Dividend Exemption versus the Current
System (Washington: American Enterprise Institute, 2001), 67 pp; President’s Advisory Panel on Tax Reform, Simple,
Fair, and Pro-Growth: Proposals to Fix America’s Tax System (Washington, 1985), pp. 239-244.
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would mean that a portion of debt incurred by a U.S. parent corporation would not be
deductible—the portion assumed to be used in financing tax-exempt foreign subsidiaries.
As described in the preceding sections, the capital import neutrality and capital ownership
neutrality standards both recommend adoption of territorial taxation, but traditional economic
theory is skeptical of the theoretical justification of the two standards. Grubert and Mutti argue,
however, that even if CIN and CON are rejected on theoretical grounds, an exemption system is
superior to the current hybrid system in terms of several important factors: efficiency, simplicity,
and the raising of tax revenue.
First, efficiency: Grubert and Mutti argue that current law’s application of tax to repatriated
foreign earnings encourages wasteful and inefficient behavior on the part of corporations in
devising methods of repatriating foreign earnings without paying U.S. tax. Under an exemption
system, such wasteful planning would be unnecessary. Also, since foreign tax credits would no
longer be applicable, cross-crediting of excess foreign tax credits would no longer shield
investment in low-tax foreign locations from U.S. tax, and the artificial diversion of technology-
exploiting investment to low-tax locations would no longer occur.22
Nevertheless, elimination of these sources of inefficiency alone would not be sufficient to make
an exemption system less wasteful than current law. If elimination of tax on repatriations were the
only feature of an exemption system, the system would likely increase inefficiency by
encouraging added investment in low-tax countries. Rather, the crucial element to an exemption
system’s purported superiority is its elimination of interest deductions for overseas investment.
The inclusion of this provision would actually result in an increase in the average tax burden for
overseas investment, thus generating an efficiency gain from an improved allocation of
investment away from low-tax overseas locations and into the domestic economy.23
An exemption system may also increase tax revenue. The Grubert and Mutti analysis concludes
that the system would generate $7.7 billion annually in added U.S. revenue.24 (Their estimate is
based on 1994 data, so it would likely be larger in the current economy.) More recently, the Joint
Committee on Taxation has estimated the revenue gain at about $6 billion per year.25 As with the
efficiency gains, however, the increase in tax revenues is crucially dependent on denial of
deductions for costs allocated to tax-exempt foreign income. Without the new restrictions, an
exemption system would likely reduce tax revenue. The Joint Committee on Taxation has
estimated that current law’s deferral reduces revenues by approximately $6 billion.26 By the same
22 Ibid., p. 11. Note, however, that cross-crediting also reduces current law’s inefficient disincentive to invest in high-
tax countries on the part of firms without excess credits, a feature not considered by the Grubert/Mutti analysis.
Because income earned by firms with a deficit of credits outweighs that of firms with excess credits, it is plausible that
an exemption system’s loss of this easing of inefficiency would outweigh the gains from reduced investment in low-tax
countries.
23 Writing more recently, Grubert and his co-author Rosanne Altshuler note that if an exemption system is actively
considered by policymakers, its adoption with its full panoply of deduction restrictions intact would be problematic.
Rosanne Altshuler and Harry Grubert, Corporate Taxes in the World Economy: Reforming the Taxation of Cross-
Border Income, unpublished paper presented at the James A. Baker II Inst. for Public Policy conference on tax reform,
April 27-28, 2006, p. 4.
24 Harry Grubert and John Mutti, Taxing International Business Income, p. 38.
25 Report in U.S. Congressional Budget Office, Budget Options (Washington, February 2007), p. 319.
26 Joint Committee on Taxation, Estimates of Federal Tax Expenditures 2006-2010, JCS-2-06, April 25, 2006.
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token, an exemption system would lose tax revenue compared to the current system if the current
system were to deny deductions to deferred income.
In the area of simplicity, proponents of an exemption system emphasize its reduction in the need
for tax planning. It should be noted, however, that tax complexity—and its accompanying
difficulties for tax administration—exist when entities or activities are taxed according to
different rules. Under an exemption system, foreign subsidiary corporations would be tax exempt
as under current law, and since the exemption would be permanent rather than temporary, its
import for firms’ tax planners would be magnified. Accordingly, the tax system’s transfer pricing
rules for allocating income among U.S. parent firms and their foreign subsidiaries would become
more important; more pressure would apply to rules that are inherently difficult to enforce. The
same would be true for the distinction between active and passive income, since active income
would be permanently exempt and passive-investment income would be taxed on a current basis.
Firms would have an even greater incentive to move from branch to subsidiary operations for
start-up firms.
In a recent article critical of territorial tax proposals, Kleinbard pointed out analyses by Grubert
and others that emphasized the growth in the importance of royalties as a share of repatriated
earnings for multinationals, suggesting that the exploitation of intangible assets by multinationals
in foreign locations is increasing. However, where the Grubert and Mutti analysis sees this as an
important reason to adopt an exemption system—cross-crediting of foreign taxes would no longer
pose an incentive to low-tax investment under an exemption system—Kleinbard sees it as a
liability. The growth of intangibles, argues Kleinbard, would place enormous pressure on the
administration of transfer prices.27
Proponents of an exemption system concede that it is not perfect, but argue that it is at least
superior to the highly imperfect system now in existence. Even this defense, however, has its
shortcomings: the most economically attractive aspects of the exemption proposals could, in
principle, be adopted piecemeal, and its most distortionary aspects could be left behind.
Specifically, more restrictive rules for deducting interest and other costs could be adopted without
exempting dividend repatriations from U.S. tax. Such plans could enhance economic efficiency
more than would the full-blown exemption systems.
More recent proposals, such as those proposed by the Ways and Means Committee and in a bill
by Senator Enzi (S. 2091), differ in substantial ways from the Mutti-Grubert proposal. They do
not include the allocation of deductions and propose, or consider, some relief for royalties. These
proposals also contain anti-base erosion provisions or options for limiting profit shifting whose
adoption and effectiveness is uncertain. Finally, they propose to be revenue neutral in the budget
horizon but this neutrality relies on a one time taxation of existing accumulated earnings and thus
would lose revenue in the long run. On the whole, therefore, these proposals would likely
encourage more investment abroad. The fleshing out of a detailed territorial tax provision that
might be considered legislatively has also served to highlight one of the major concerns about
moving to a territorial tax: the possible increase in international profit shifting and tax
avoidance.28
27 Edward D. Kleinbard, “Throw Territorial Taxation from the Train,” Tax Notes, February 5, 2007, pp. 552-553.
28 For a discussion of international tax avoidance, see CRS Report R40623, Tax Havens: International Tax Avoidance
and Evasion, by Jane G. Gravelle. For a more detailed discussion of territorial tax proposals, see CRS Report R42624,
Moving to a Territorial Income Tax: Options and Challenges, by Jane G. Gravelle.
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Even with these criticisms and even when considering the Mutti-Grubert version of the
exemption, another question is this: why accept second best? The report next examines what
moving towards a residence-based system would look like, in practice.
A Residence-Based System in Practice
The capital export neutrality standard recommends a system that would be based on residence—
that is, a system that taxes the income of home-country firms, regardless of where it is earned.
The present section looks at the shape a residence-based system would likely take.
Current law’s deferral system would be repealed under a residence-based system, and U.S.
taxation would apply on a current basis to the income of foreign subsidiaries, whether or not the
income is repatriated. If it were not for foreign taxes, deferral’s repeal would move the system to
the brink of capital export neutrality (except for the portfolio investment concern): the tax burden
on foreign investment would roughly equal the tax rate on domestic investment. Foreign taxes,
however, complicate matters and make pure capital export neutrality difficult to achieve, in
practice. The problem arises when a foreign host country’s tax rate exceeds the U.S. domestic tax
rate. In such cases, pure capital export neutrality would require an unlimited foreign tax credit.
Foreign taxes would offset U.S. taxes on domestic as well as foreign income—only by this
mechanism could the high foreign tax burden be brought into line with taxes on domestic
investment. Yet, as noted in the preceding section on the existing tax system, an unlimited foreign
tax credit is impractical: foreign governments could, in effect, draw on the U.S. Treasury by
raising taxes on U.S. investors, ad infinitum.
Advocates of a residence-based system have in some cases advocated a more restrictive form of
the foreign tax credit limitation that would place more limits on “cross crediting” than does
current law’s two-part limit. For example, at various times in the past, the United States has
required firms to calculate their limitation on a country-by-country basis (a so-called “per-
country” limitation), under which taxes paid to one country could not be credited against U.S. tax
on income from another country.29 The Wyden-Gregg Tax Reform Act , S. 3018, introduced in the
111th Congress would, in the context of a general corporate reform that would broaden the base
and reduce the rate, eliminate deferral and institute a per country foreign tax credit limit. An
alternative or additional approach to restricting cross crediting was implemented by the Tax
Reform Act of 1986 (P.L. 99-514), which, instead of requiring separate limits for each country,
specified a variety of different types of income for which separate limits ( “baskets”) were
required. The American Jobs Creation Act of 2004 (AJCA; P.L. 108-357), however, reduced the
number of separate limits to current law’s two.30 Note, however, that a more restrictive foreign tax
credit limitation would not necessarily move a residence-based system closer to pure capital
29 From 1954 to 1961, taxpayers were required to use a per-country limitation. For a synopsis of changes in limitation
policy, see Thomas Horst, “The Overall vs. the Per-Country Limitation on the U.S. Foreign Tax Credit,” in U.S.
Department of the Treasury, Office of Tax Analysis, 1978 Compendium of Tax Research (Washington: GPO, 1978),
pp. 213-214.
30 The purest form of a separate limitation would require a separate limitation to be calculated for each investment a
firm makes. Clearly, however, such a policy would present considerable administrative difficulties.
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export neutrality. As noted above, while cross crediting may pose an incentive to invest in low-tax
countries, it also mitigates the disincentive to invest in high-tax countries.
Capital export neutrality requires equal tax burdens on foreign and domestic investment. There
are several features of the current system that favor domestic over foreign investment, and whose
modification would move the current system in the direction of capital export neutrality. The most
important of these is the 9% tax deduction for domestic production enacted in 2004 by AJCA.
Other tax benefits that are restricted to domestic investment are the Section 179 “expensing”
allowance for machines and equipment and the research and experimentation tax credit.
As noted above, Grubert and Altshuler revisited the topic of international tax reform in 2006. In
their analysis, they compared the exemption system with what they termed a “burden neutral”
worldwide taxation system. In constructing this latter system, they couple elimination of deferral
with a reduction in the statutory U.S. tax rate that applies to foreign earnings—thus using the
added tax revenue from deferral’s repeal to, in effect, “purchase” a cut in the tax rate. The goal of
the exchange is to not damage what they term the “competitive position” of U.S. multinationals.
As a consequence of the countervailing changes, the burden on investment in a range of low-tax
countries would increase; the burden of a range of income that is repatriated under current law
would fall, but the overall burden on overseas investment would be unchanged.
Grubert and Altshuler note that the overall advantage of their burden-neutral worldwide proposal
over current law depends on outcomes which are, as yet, unknown: how many firms would be in
an excess credit position under the plan and what the burden-neutral tax rate would be. They also
caution that the plan would have another weakness: foreign countries would have an incentive to
raise their tax rates in the face of current U.S. taxation because inbound U.S. investment would be
less sensitive to the foreign rates.31 They further note that their plan’s reduction of tax rates at the
corporate level would shift more of the overall U.S. tax burden on corporations from the
corporate to the shareholder level—a virtue in the modern world where capital is increasingly
mobile since shareholder-level taxes are generally imposed on a residence basis and thus achieve
allocative efficiency.
President Obama’s Proposals to Restrict Deferral
and Cross-Crediting
It is also possible to move toward further restrictions on deferral without eliminating it entirely.
One such proposal, contained in H.R. 3970, the tax reform proposal introduced by Chairman
Rangel of the Ways and Means Committee, would disallow certain deductions of parent company
costs (the most important being interest) that reflect the share of income that is deferred. This
provisions, projected to raise revenue of $106 billion over 10 years, would make investment in
low-tax countries much less attractive.32 The revenue from this provision and other changes were
to be used to lower the corporate statutory tax rate.
31 Rosanne Altshuler and Harry Grubert, Corporate Taxes in the World Economy: Reforming the Taxation of Cross-
Border Income, p. 17.
32 The provisions of H.R. 3970 are discussed in CRS Report RL34249, The Tax Reduction and Reform Act of 2007: An
Overview, by Jane G. Gravelle. The bill also contains a provision that repeals a planned liberalization of interest
allocation rules for purposes of the foreign tax credit limit. This provision is discussed in CRS Report RL34494, The
(continued...)
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This proposal also included a foreign tax credit pooling proposal, which would allow a share of
foreign tax credits equal to the share of income repatriated. This provision limits the ability of
firms to repatriate income from high tax countries and use excess foreign tax credits to shield
income from low tax countries from the foreign tax credit. President Obama proposed these
changes, along with others, in his various budget proposals.33 (The allocation of deductions,
however, excluded research and development expenditures). The deferral provision was projected
to raise $5.9 billion in FY2014 and $37.2 billion over 10 years and the foreign credit and the
foreign tax credit pooling provision was projected to raise $5.5 billion in FY2013 and $60.8
billion over 10 years.
Another provision (contained in the FY2010 proposals, but not in later outlines) would eliminate
“check-the-box,” a provision that allows firms to elect to treat subsidiaries as separate entities or
disregarded entities. These regulations permit firms to avoid current taxation on certain income
that would be subject to Subpart F anti-abuse rules (such as interest on loans from a subsidiary in
a low tax country to a related subsidiary in a high tax country). This provision was originally
projected to raise $86 billion over 10 years.34
A provision in the FY2013 proposal would treat excess income from intangibles as Subpart F
income and assigns them to a separate foreign tax credit basket. This provision is projected to
raise $2.7 billion in FY2014, and $23.0 billion over 10 years. It may have been a substitute for
“check-the-box” revisions.
The proposals also included a provision that would disallow foreign tax credits when the
associated income is not received, as can occur with an arrangement termed a “reverse hybrids.”
This provision was adopted in 2010 (P.L. 111-226). P.L. 111-226 contained a number of
provisions that were directed at perceived abuses of the foreign tax credit. Several other more
limited proposals were included in the President’s budget proposals.35 In the FY2013 proposal,
these international proposals are projected to raise $16.2 billion in FY2014 and $147.5 over 10
years.
The Administration also presented a framework for tax reform that mentioned five elements: the
allocation of interest for deferred income (first bullet point above), a tax on excess intangibles
(third bullet point), a minimum tax on foreign source income in low tax countries, disallowing a
deduction for the cost of moving abroad, and providing a 20% credit for costs of moving an
operation from abroad to the United States.36
(...continued)
Foreign Tax Credit’s Interest Allocation Rules, by Jane G. Gravelle and Donald J. Marples.
33 U.S. Department of Treasury,. General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals
(Green Book), Washington, DC, February, 2012. http://www.treasury.gov/resource-center/tax-policy/Documents/
General-Explanations-FY2013-Tables.pdf.
34 U.S. Department of Treasury. General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals
(Green Book), Washington, DC, May 2009. http://www.treasury.gov/resource-center/tax-policy/Documents/General-
Explanations-FY2010.pdf.
35 See CRS Report R40623, Tax Havens: International Tax Avoidance and Evasion, by Jane G. Gravelle, for a
summary of these enacted and proposed revisions.
36 The President’s Framework for Business Tax Reform: A Joint Report by the White House and the Department of the
Treasury, February 2012, http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Framework-
for-Business-Tax-Reform-02-22-2012.pdf.
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A minimum tax on foreign source income might be a compromise between moving to a territorial
system and eliminating deferral. Another form of compromise might be requiring a percentage of
income to be paid out.
Tax Havens: Issues and Policy Options
The topic of “tax havens” has been a focus of recent international tax policy discussions. (This
topic is treated in more detail in another CRS report.)37Tax havens do not fit neatly into the
traditional CEN/CMN/NN evaluation framework outlined above—perhaps because the tax haven
issue involves as much artificial shifting of income and investment as it does questions about how
investment is actually allocated. To the extent tax havens abet the shifting of income from its true
geographic source to low-tax jurisdictions (the havens themselves), they raise questions about
protecting the U.S. Treasury from revenue losses. They also raise questions about tax fairness
(not all taxpayers are in position to reduce their U.S. taxes by using tax havens). And to the extent
tax havens reduce the tax burden on investment that truly occurs overseas, they also raise the
same questions about economic efficiency and neutrality addressed by the traditional framework
outlined above.
“Tax haven” is not a precisely defined term, but in most usages it refers to a country—in many
cases small ones—where non-residents can save taxes by conducting various investments,
transactions, and activities. Attributes that make a country a successful tax haven include low or
non-existent tax rates applicable to foreigners; strict bank and financial secrecy laws; and a highly
developed communications, financial, and legal infrastructure.
At the heart of the tax haven issue is the discrepancy between real economic activity and what is
only apparent. Much of the economic activity that appears to occur in tax havens actually occurs
elsewhere, and is only associated with particular tax haven countries because of sometimes
spurious relationships between the person or firm conducting the activity and the tax-haven
country. Thus, for example, much (or even most) of the income reported by U.S.-controlled
subsidiaries chartered in tax havens may well have its true economic location either in some other
foreign country or even in the United States itself. In several small tax haven locations, income of
U.S.-controlled foreign subsidiaries are many times larger than GDP. In Bermuda and the
Cayman Islands, this income was respectively, over six times and over five times.38
In part, U.S. firms may find tax havens useful tax-saving mechanisms because of particular
aspects of the U.S. tax structure. Here, no illegal tax evasion or even transfer-price manipulation
may be necessary to obtain tax savings. An example is the technique sometimes termed a
corporate “inversion” reorganization, under which the overall parent of a corporate group shifts
from a U.S.-chartered entity to a foreign corporation organized in an offshore tax haven. The
rearrangement can potentially reduce or eliminate U.S. tax that would otherwise be due when
foreign income is repatriated.39
37 CRS Report R40623, Tax Havens: International Tax Avoidance and Evasion, by Jane G. Gravelle.
38 Ibid., see Table 4.
39 For more information, see CRS Report RL31444, Firms That Incorporate Abroad for Tax Purposes: Corporate
“Inversions” and “Expatriation”, by Donald J. Marples.
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U.S. firms can also use tax havens to shift income out of foreign countries where there are
corporate income taxes to the zero-tax environment many tax havens offer. Short of outright tax
evasion, techniques for shifting income include manipulation of transfer prices affixed to
intrafirm sales and other transfers, and the structuring of intrafirm lending and interest charges so
as to shift income out of high-tax countries to tax havens (sometimes called “earnings stripping”).
Transfer price manipulation can also theoretically be used to shift what is actually U.S.-source
income to offshore tax-haven subsidiary corporations.
Along with income shifting and expatriation by corporations, tax havens in some cases apparently
abet the outright evasion of taxes, in some cases by U.S. citizens. For example, income from
illegal activity in the United States can be shielded from U.S. authorities if a tax haven offers
sufficient bank secrecy. Or, taxes on legally generated U.S. income are apparently evaded in some
cases by depositing the income in secrecy-protected foreign bank accounts.40 The focus of this
report, however, is the activities of multinational firms, so its concern with tax havens is more
with legal (albeit what some might term “abusive”) income shifting rather than outright tax
evasion.
In part, the ability of firms to divert income from other foreign locations to tax havens has
implications for the real location of investment: just because a tax haven is not the true source of
income does not make the associated tax savings any less real for the underlying investment,
wherever it may be located. We can interpret the effect of tax havens on actual investment in
terms of the efficiency framework outlined in previous sections of the report. First, regarding the
allocation of investment between the United States and foreign locations, existing data indicate
that the United States is a relatively “high tax” country, even if tax havens are omitted from the
calculation.41 Thus, much of the income shifted to tax havens is likely shifted from countries
whose taxes are lower than U.S. taxes to begin with. As a result, it is likely that tax havens on
balance magnify the distorting effects of deferral, thus further diverting U.S. investment to
foreign locations and, in turn, reducing economic efficiency and U.S. national welfare. This
efficiency effect, however, may be mitigated by a reduction in the tax-induced distortion of
location decisions across foreign countries.42
Along with efficiency effects, tax havens reduce tax revenue collections by capital-exporting
countries. In the case of U.S. firms’ use of tax havens, the revenue loss can accrue both to the
United States (in the case of income shifted from domestic sources) and other countries (in the
case of income shifted from other countries with higher taxes). Tax havens likewise have the
potential of damaging perceptions of tax fairness when public reports appear of large firms and
wealthy individuals using tax havens to avoid or evade substantial taxes.43 Accordingly, a policy
40 For a discussion of tax havens and illegal activities, see Martin A. Sullivan, “Sex, Drugs, and Tax Evasion,” Tax
Notes, June 18, 2007, pp. 1098-1100.
41 2002 Internal Revenue Service data on U.S.-controlled foreign subsidiaries show that subsidiaries pay, on average, a
lower percentage of their pre-tax earnings in tax than do firms in the United States. This is true even for developed
countries such as the United Kingdom and Canada.
42 That tax havens actually stimulate investment in nearby higher-tax countries is argued in Mihir A. Desai, C. Fritz
Foley, and James R. Hines, Jr., “Do Tax Havens Divert Economic Activity?” Economics Letters, vol. 90, 2006, pp.
219-224.
43 Senate Finance Committee Chairman Max Baucus, for example, has observed that when tax havens are used for tax
evasion “the honest American taxpayers who work hard, and do not have the ability to engage in offshore activity, are
left holding the bill.” Sen. Max Baucus, Hearing Statement Regarding Offshore Tax Evasion, May 3, 2007. Available
as Finance Committee news release on the committee’s website at
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question is how tax evasion, or what might be termed “abusive” tax avoidance through tax
havens, can be reduced.
One possible approach to tax havens is multilateral (that is, multi-country) action. The concept
here is that tax havens flourish in part because of a lack of coordination in tax-administration
between non-haven countries and that efforts to suppress tax-haven activities cannot be successful
without solidarity among non-haven countries.44 One prominent multilateral effort has been the
Organization for Economic Cooperation and Development’s (OECD’s) “harmful tax practices
project,” initiated in 1996. The focus of the OECD’s project has been to identify tax havens and
to induce them to increase their “transparency” (presumably reduce secrecy about financial
transactions) and to increase the number and scope of exchange of tax information agreements
with tax havens.45
A unilateral approach was proposed by the Clinton Administration with its FY2001 budget
proposal. The basis of the plan was to be a list of jurisdictions identified by the Treasury
Department as tax havens. Foreign tax credits and the deferral benefit would be restricted for
taxpayers using the identified tax havens.46 More narrow unilateral approaches proposed in the
past have primarily involved increasing information reporting requirements.
Several legislative proposals, including proposals in President Obama’s budget, have been made
to address evasion and avoidance. Some provisions were adopted in the Hire Act in 2010 (P.L.
111-147).47
General Reforms of the Corporate Tax and
Implications for International Tax Treatment
Despite increasing globalization of the U.S. economy, foreign direct investment remains a small
share of the U.S.-owned capital stock. For that reason, it would perhaps not be appropriate for
international concerns to dominate the formulation of corporate tax policy. Nevertheless, there are
specific forms of corporate tax revisions that might have important consequences for international
taxation.
44 To illustrate, imagine a situation where country A has exchange of information agreements both with country B and
tax haven H. Country B, however, has no exchange agreement with the tax haven. Conceivably, would-be taxpayers
from country A could channel tax-saving tax haven transactions through country B.
45 Jeffrey Owens, Director, OECD Centre for Tax Policy and Administration, “OECD’s Work in Counteracting the Use
of Tax Havens to Evade Taxes,” unpublished paper presented at the American Enterprise Institute, December 11, 2006.
Some U.S. critics of the OECD criticized what they saw as the initiative’s underlying premise that low taxes are
suspect. It was indeed partly on this basis that the Bush administration persuaded the OECD to focus on transparency
and exchange of information rather than efforts to persuade targeted countries to change their tax practices towards
non-residents. See Hon. Paul O’Neill, Secretary of the Treasury, testimony before the Senate Committee on
Governmental Affairs, Permanent Subcommittee on Investigations, July 18, 2001. Available at the committee’s
website, at http://hsgac.senate.gov/071801_psioneil.htm.
46 For a description of the proposal, see U.S. Congress, Joint Committee on Taxation, Description of Revenue
Proposals Contained in the President’s Fiscal Year 2001 Budget Proposals (Washington: GPO, 2000), pp. 500-509.
47 See CRS Report R40623, Tax Havens: International Tax Avoidance and Evasion, by Jane G. Gravelle for
descriptions.
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Under the current U.S. system, taxes on corporate profits at the individual level (dividends and
capital gains) tend to be collected (due to tax treaties) on a residence basis. If taxes at the
individual level could be increased and taxes at the corporate level decreased, the tax would shift
towards a residence-based system without any other changes and without any additional concerns
about portfolio substitution. In 2003, relief for double taxation was provided by reducing the tax
rate on corporate dividends from the ordinary tax rate to 15% for those in brackets above the 15%
rate, and to 5% for others. The 5% rate is now scheduled to fall to zero.
Using 2004 figures, where data on qualified dividends are available, the 35% corporate tax rate
could have been rolled back to a 31% rate, or even less, for the same revenue cost if a corporate
rate reduction rather than reductions in the individual level tax had occurred.48 There are many
other potential changes that could raise revenue to permit a further lowering of the corporate rate.
At the individual level, these might include higher capital gains tax rates, accrual taxation of
gains on corporate stock, and limits or modest taxes on retirement savings (which would benefit
from corporate rate reductions). At the corporate level, a number of base broadening provisions
might be considered. It could be feasible to lower the corporate tax rate to 25% with relatively
modest changes in tax rules.49
A lower U.S. corporate tax is desirable if one believes that the most serious distortion in the
international tax system is the tendency of capital to flow to low-tax foreign jurisdictions because
of deferral. Such a proposition is a reasonable one, as the United States is generally a high-tax
country. Lower corporate tax rates are also responsive to concerns that portfolio substitution
disfavors U.S. owned firms. Nevertheless, even significant reductions in the U.S. tax rate are
unlikely to have significant effects on overall U.S. output because the corporate tax is relatively
small compared to GDP. A recent estimate suggests that lowering the rate to 25% without making
any other changes would increase U.S. output by only 2/10 of 1% of GDP.50
48 In 2004, taxable qualified dividends for individual income taxes were $104 billion according to the Statistics of
Income data. Assuming a 15% rate differential, rolling back the provision for dividends would have raised revenues by
$15.6 billion. The gain from raising the capital gains tax rate back to 20% depends on the behavioral response—how
much individuals reduce their realizations, given tax increases. Based on the realization responses the Joint Tax
Committee used in the past, and the Congressional Budget Office baseline, the gain for capital gains would be $9.2
billion. If the realizations response were based on the response used by the Congressional Budget Office in projecting
the baseline, it would raise $12.7 billion. There is some evidence that even that response is too large as discussed in
CRS Report R41364, Capital Gains Tax Options: Behavioral Responses and Revenues, by Jane G. Gravelle If the
revenue gain is to be used to reduce the corporate tax and raise after-tax profits, they need to be grossed up by (1-t)
where t is the effective individual tax rate on an additional dollar of corporate after-tax profits. The estimate assumes an
average tax rate of 25% and that half of the income goes to non-taxable recipients such as pension funds, for an overall
rate of 12.5%. Corporate tax revenues were $189 billion in FY2004, but this value was unusually low because of bonus
depreciation. Adjusting for bonus depreciation brings the revenue to $236 billion. (For a discussion, see CRS Report
RL33672, Revenue Feedback from the 2001-2004 Tax Cuts, by Jane G. Gravelle.) The revenue gains divided by the
gross-up factor and then by corporate tax receipts indicate the percentage reduction in the corporate tax (12% and
13.5% respectively), which are then multiplied by the 35% rate to determine the percentage point reduction.
49 Taxing capital gains at full rates would have raised, for 2004, $7 billion to $20 billion, or even more, allowing a rate
decrease of one to three percentage points. Accrual taxation would yield dramatically larger revenues. Two examples of
corporate base broadeners include the production activities deduction for domestic manufacturing and certain
industries, and the title passage rule, which is a rule allowing an arbitrary allocation of income from U.S. exports to be
assigned to foreign-source income for purposes of the foreign tax credit limit (effectively an export subsidy).
According to tax expenditure estimates, the production activities deduction (which is being phased in) will reach a cost
of $10 billion by FY2010. The title passage rule costs about $6 billion. These two corporate provisions should permit a
three percentage point reduction, bringing the rate to between 27% and 28%.
50 CRS Report R41743, International Corporate Tax Rate Comparisons and Policy Implications, by Jane G. Gravelle.
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While international concerns should not necessarily dominate the issues surrounding corporate
tax policy,51 they do suggest the economic desirability of certain types of corporate tax reforms
that would improve economic efficiency in the international area.
Author Contact Information
Jane G. Gravelle
Senior Specialist in Economic Policy
jgravelle@crs.loc.gov, 7-7829
Acknowledgments
This report was originally written with David Brumbaugh.
51 Two reasons to provide relief at the individual level are (1) to focus tax cuts on marginal investment, which is more
likely to be taxable investment to individuals rather than investment in pension funds and retirement accounts; and (2)
to reduce the distortion that capital gains taxes impose on the willingness to realize gains and adjust assets. This latter
distortion, however, would be improved if an accrual basis capital gains tax on corporate stock were adopted. Such a
move would also raise a great deal of revenue that could be used to lower corporate tax rates. Doing so would also end
concerns about using corporations with lower tax rates to shelter income.
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