The US: Tax Deferral on Retained Foreign Earnings

However, the test of central management and control has not yet been replaced, and could therefore still be applied to British­controlled companies registered abroad. This residual provision modified for treaty countries, as mentioned above, as well as the requirement of approval for the issue of debentures by foreign subsidiaries, remain as a fall­back for the Revenue: thus, for example, foreign companies formed for investment in UK real estate may be treated as UK resident Yerbury 1991, p. 33. However, taxation of unrepatriated earnings from foreign investment is now dealt with primarily under the CFC provisions discussed in Chapter 7 below.

2. The US: Tax Deferral on Retained Foreign Earnings

The US income tax applied from the start both to all income from US sources, and also to the income of US citizens from all sources worldwide. Although this was based on a similar principle of tax equity to Britains, it differed significantly, in that taxation of income from all sources applied not to residents but to US citizens. This became crucial in the case of companies, since it covered only corporations formed under US law; companies formed under foreign law were not regarded as subject to US tax, even if they were wholly­owned subsidiaries of US corporations. 2.a Individuals Taxation of US citizens on their worldwide income has given the American authorities a wide personal jurisdiction over US citizens wherever they may be resident. Thus, the IRS officers who are attached to many American embassies are importantly concerned with the tax returns of US citizens living abroad as well as dealing administratively with the allocation of income of international businesses: see Chapter 10 below. Liability to US tax on worldwide income is mitigated by allowing foreign tax paid to be credited, so that in effect US citizens and corporations are expected to pay the higher of the US or the foreign tax. In addition, individuals resident abroad have since 1926 been allowed an exemption for foreign earned income. 1 2.b Foreign Corporations US taxation of a corporation formed abroad is limited to income `effectively connected with the conduct of a trade or business within the United States ¶ Although a foreign corporation doing business in the US through a branch is subject to corporate tax on its `effectively connected ¶income, distributions of after­tax profits 1 Apart from an experiment between 1978­81 with a system of deductions for foreign `excess living FRVWV¶WKLVKDVFRQWLQXHGLQIRUFHZLWKYDULRXVFRPSOH[VDIHJXDUGV2ZHQV3W,,,VHF9, to its head office are normally free of tax. However, if the `effectively connected ¶ income averages more than 50 over a 3­year period, the US has applied a withholding tax on the dividends paid by the company, and on interest paid to its foreign creditors, either at the full 30 rate or at the treaty rate applicable under any treaty with the companys country of residence. But it is easy to see that this tax is difficult to collect, since it is levied on payments made abroad by foreign companies. Thus, it became convenient in some circumstances for foreign companies to do business in the US through a branch, especially if the company could be formed in a convenient jurisdiction. This led to the provisions in the 1986 Tax Reform Act for the US branch tax, a withholding tax on the `dividend equivalent amount ¶ of after­tax profits of a US branch of a foreign company. Since this was specific to foreign companies it could be said to conflict with the non­discrimination provisions of tax treaties, so this `treaty override ¶ entailed negotiation of specific protocols with US treaty partners see Chapter 11 below. Since foreign corporations are not subject to US tax on their foreign income, wealthy Americans appreciated, from an early date, that they could limit US taxation on their foreign investment income if their foreign assets could be transferred to companies formed abroad. Legislation against such `foreign personal holding companies ¶ was enacted in 1934, to apply the highest rate of US tax of 70 on undistributed passive investment income of a foreign corporation qualifying as the personal holding company of a US citizen. In 1937, new provisions taxed the US shareholder in a foreign personal holding company directly on the undistributed income. To justify these measures, evidence was given by the Treasury to a joint Congressional committee on Tax Evasion and Avoidance, set up at the request of President Roosevelt, which showed a growth in holding companies set up by Americans in the Bahamas 64 companies set up in 1935­6, Panama, Newfoundland, and other low tax jurisdictions. 2.c US Corporations: Foreign Branches and Subsidiaries The exclusion from US taxation of subsidiaries formed abroad, combined with the foreign tax credit, offered US corporations some choice in the forms through which their foreign business could take place. A foreign branch is not treated as a separate entity for tax purposes; its income therefore forms part of the taxable income of the US corporation and it may claim the same allowances and deductions. This made foreign branch operations useful for a period in extractive industries, especially oil, to take advantage of the generous percentage depletion allowances permitted under US law. The foreign branch may credit its allowable foreign income taxes directly against the US taxes due from the corporation as a whole. A major problem has been to decide when a foreign tax is an `income tax ¶allowable for credit. This can lead to complex interactions and negotiations, as shown in the international political and economic manoeuvres in the postwar period when oil­producing countries moved from a royalty to a profits­tax system discussed in Chapter 2 section 1.b above. Even greater complexities arose in the 1970s and 1980s under some of the production­ sharing arrangements for oil then introduced, in deciding which of the producer country levies should be regarded as deductible costs and which as income taxes eligible for credit Gifford and Owens 1982 III, pp.37­41. Numerous other types of tax levied, especially by developing countries, on foreign­owned companies have also raised this problem. In economic terms, it is difficult to establish any adequate rationale for distinguishing between foreign sales taxes or royalties, which at most may be allowable as an expense in computing profit, and taxes on profits which can be credited dollar for dollar against US taxes due Surrey 1956, pp.819­25, Tillinghast 1979, pp.264­70. For most purposes, US corporations have organized foreign business through subsidiaries formed abroad, since companies formed abroad are not liable to US taxes at all on business profits earned abroad. The rule that taxes apply to the entire income of US citizens and entities formed under US law, which was apparently enacted from basic principle or political instinct in 1913, became an increasingly important policy decision as US foreign investment grew Surrey 1956, p.827. Dividends remitted to the US parent are subject to US taxes, but the parent may credit against them the foreign income tax paid on the underlying income, i.e. the proportion of foreign income taxes paid which the dividend represents of the total profits before tax. Thus, earnings retained abroad in a foreign subsidiary are not liable to US tax, until repatriated as dividends: in that sense, the US tax is `deferred ¶ These tax considerations have helped to encourage the characteristic form of US foreign investment: direct investment by US corporations through a network of foreign subsidiaries. The foreign subsidiary has been preferred even over tax privileged status offered for certain types of corporation. In particular, the status of a Western Hemisphere Trade Corporation, enacted in 1942, gave an entitlement to a lower corporation tax rate of 38 for a US corporation doing 95 of its business outside the US, in the western hemisphere. This had a curious history. The intention was to exempt from wartime excess profits taxes and surtax US firms operating abroad, on the grounds that these high taxes were aimed at domestic industries profiteering from wartime conditions. Also, complaints had been made about the high US wartime tax rates by several US corporations with operations in Bolivia, Argentina and Central America. It was apparently not realized that the formula used in drafting, referring to income derived from the active conduct of a trade or business outside the US, could also include export sales Surrey 1956 832­8. In practice, the WHTC form was less advantageous for foreign operations than using a foreign subsidiary UN 1953 p.24; on the other hand, it became widely used for US exports. By 1954, a Congressional Committee proposing other revisions in the tax code stated that `although the [WHTC] ... provisions produce some anomalous results, it has retained the provisions in order to avoid any disturbances at the present time to established channels of trade ¶Surrey 1956, p.838. Indeed, in 1971, President Nixon and the Congress went further, and granted special tax status for US corporations qualifying as Domestic International Sales Corporations DISCs. This allowed deferral of US taxes for approximately half of the profits channelled to a DISC. However, specially generous inter­affiliate pricing rules allowed transfer of a higher proportion of profits from manufacturing to export, so that in practice a high proportion of the income of corporations with exports was freed from US tax, even if returned for reinvestment in the USA. Critics pointed out that the DISC was merely a tax subsidy to some of the largest US corporations, having at best a small incremental effect on exports. The subsidy was costing 1.5 billion by 1976, and only 59 corporations accounted for over half of the total net income of all DISCs Surrey, Pechman McDaniel, in Gifford Owens 1982 III, p. 516. The DISC provisions were condemned as an export subsidy by the GATT, but not repealed until the Tax Reform Act of 1984. Their replacement, the Foreign Sales Corporation FSC allowed exemption from tax at corporate level for foreign trade income derived from foreign presence and economic activity of a foreign subsidiary organized in a qualifying foreign country. Qualifying countries were essentially those willing to provide information exchange satisfactory to the IRS. 1 2.d The Deferral Debate After 1945, the US definitively surpassed Britain as the dominant world economic power and source of international investment. This led to considerable debate in the postwar period about the US role and responsibility in stimulating foreign investment for economic development. Hence, pressures were renewed for the liberalization of the foreign tax credit, or the extension of total exemption to foreign earned income. From 1945 to 1959 a series of official and semiofficial reports and studies examined the foreign investment policy question, including the issue of tax incentives or disincentives. Although some, such as the IDABs Rockefeller Report `Partners in Progress ¶of 1951, went as far as to recommend US tax exemption of income from new foreign investments, other studies did not favour exemption. Proposals for exemption put to Congress by the Eisenhower administration in various forms in 1953­4 were rejected. On close examination, little grounds could be found in principle or policy for tax incentives for US foreign investment. Data collected by the Department of Commerce and the IRS showed that US foreign investment was highly concentrated in relatively 1 The UK has not qualified for FSC status: see Chapter 10 below. few firms. Of the more than half a million corporations making tax returns in 1949, only 2,200 or 0.4 had foreign investments; 442 of these controlled 93 of the foreign investment stock, 62 of which had 71, and the ten biggest had 40 Barlow Wender 1955, ch.2. Encouragement of foreign investment by a wider group of the largest corporations did not require exemption from US tax liability. The corporations cautious attitude to foreign investment risk meant that, especially in manufacturing, foreign subsidiaries were set up with a low initial dollar investment from the parent: working capital was provided often from loans raised abroad, while further expansion was financed from retained earnings. Equity capital was often minimal, and the book value of foreign subsidiaries low in comparison to their earnings, since parent companies preferred to make loans, because interest payments were tax­deductible at source, and less likely to be blocked by foreign exchange controls. Given this pattern, US tax liability was no real disincentive to the expansion of foreign direct investment. Tax deferral already gave a great incentive, not only to retain earnings in the firm rather than distribute them as dividends, but also to reinvest foreign earnings abroad, since reinvestment in the US e.g. by loans to the parent might make the returns on such investment liable to US taxes. Thus, deferral of US taxation on retained foreign earnings reinforced the separation practised by US corporations between the financing of domestic and foreign investment. Paradoxically, a move towards full exemption of foreign business income would have had most effect on profits from exports rather than investment. The profit on foreign sales of goods manufactured in the US is divided between manufacturing and export profits, and export profits are considered to be earned abroad if title to the goods passes abroad. The inclusion of such export profits earned abroad in an exemption for foreign earnings would have greatly added to the revenue loss from exemption to the Treasury, as well as creating difficulties of definition, and posing starkly the problem of inequity to the US taxpayer. This created a significant obstacle to the exemption proposals see Barlow Wender 1955, ch.16. The debate therefore became centred on the extent to which tax deferral itself was legitimate or desirable. Proposals to give explicit legitimacy to deferral were made by academic analysts Barlow Wender 1955 ch.19, as well as in a Bill placed before Congress by Congressman Boggs HR 5 of 1959­60: see Tax Institute 1960. These provided for a special class of `foreign business corporations ¶ whose income from foreign operations would not be subject to US tax until distributed in the US. The extension of explicit legitimacy for tax deferral would have extended its scope both explicitly and, more importantly, by implication. For example, an anti­avoidance provision enacted in 1932 required IRS approval for a transfer of assets to a foreign corporation if such transfer might be considered part of a plan for avoidance of US taxes. The Treasury and the Revenue had taken the position that setting up foreign business in such a way as to enable tax deferral could come within this section; but the legitimation of deferral via a `foreign business corporation ¶would prevent such administrative rulings endangering the systematization of tax deferral. 1 The delimitation of the extent to which deferral was legitimate had become important, since the rapid growth of US foreign direct investment during the 1950s had led to the development of foreign subsidiary structures to exploit the interaction of the US and foreign tax systems, as well as the tax treaty network. Essentially, these structures enabled earnings from foreign operating subsidiaries to be routed, often through a conduit company, to a holding company in a low­tax jurisdiction, or tax haven. This minimized tax at source on foreign retained earnings, and made them available for reinvestment in any new foreign operation see Chapter 6 below. It also enabled the marshalling and averaging of the tax credits available from the various operating subsidiaries, to be applied to that part of the profits eventually repatriated. Since the tax­paid credit could be carried forward, it acted as an interest­free loan to the US corporation. A few corporations had already established such holding companies before the war, but during the 1950s such structures became more widespread. Their relative merits were openly canvassed, often in terms not only of the technicalities involved, but also the degree of respectability. 2 In 1961 the Kennedy administration recommended the ending of the deferral privilege. Opponents of his proposal pointed out that it would make the US unique in taxing profits earned by US­owned companies abroad as they accrued. 3 However, the deferral debate was given a new impetus by a growing concern about the US balance of payments, which had registered significant deficits in 1958 and 1959. 2.e The Controlled Foreign Corporation and Subpart F The Kennedy administrations proposal faced a barrage of criticism in Congress, and business lobbyists and academics testified to its committees that foreign direct investment was an important factor in US exports, and that to end deferral would harm the competitive position of American TNCs in world markets US Congress 1962. Rather than end deferral, Congress concentrated on what was considered to be its abuse, the accumulation of earnings in tax haven holding companies. It therefore enacted Subpart F of the tax code, which taxes US shareholders of foreign companies 1 The nonrecognition of asset transfer provision became s.367 of the Tax Code; after 1976, in place of advanced decision that the IRS was satisfied that there was no tax avoidance purpose, Congress substituted a clearance procedure appealable to the Tax Court. 2 See Tax Institute 1960, pp 211­12 for a discussion comparing a Bahamas­Curacao [now Netherlands Antilles] set­up as more respectable than one based on Panama or Liberia. 3 The UK, the other major capital exporting country, had asserted a broad jurisdiction to tax any company controlled from the UK; as discussed in the previous section, it had from 1956 provided for exemption for the undistributed earnings of British­resident Overseas Trade Corporations, but this was ended in 1965. falling within the definition of a Controlled Foreign Corporation CFC, on their share of certain categories of undistributed profits. A CFC is defined as a foreign corporation over 50 of whose voting power is owned by US persons, each of whom owns directly or indirectly over 10. The income which is taxed on a current basis includes: i `foreign base company sales income ¶ essentially income from sales or purchases of personal property goods, either to or from a related person affiliate, if neither the manufacture nor the use of the goods take place in the country of incorporation of the CFC; ii `foreign base company service income ¶derived from rendering commercial, industrial or other services to a related person outside the country of incorporation of the CFC; iii `foreign personal holding company income ¶ which is passive investment income such as interest, dividends or royalties; but such income is excluded if produced from the conduct of a business, for example interest or fees from the conduct of a banking or financial business, or royalties earned from the conduct of a business by the CFC. Included, however, is income from the insurance of US risks. Originally, the 1962 Act excluded from Subpart F any income derived from international shipping and aircraft operations; and it also provided that some otherwise taxable Subpart F income could remain sheltered if reinvested in a developing country. In 1975, the developing country reinvestment provision was repealed, while the exclusion of shipping and aircraft profits was limited to those reinvested in such activities. Furthermore, in 1976, Congress added two new categories of income taxable as Subpart F income: income earned from participating or cooperating in an international boycott aimed at US corporations complying with the Arab boycott of Israel, and foreign bribe payments. The Subpart F provisions had a dual effect. On the one hand, they targeted some types of retained foreign earnings of American TNCs which should be immediately liable to US tax. Under the US approach, any CFC whose income is 70 or more of the type defined by Subpart F is taxed on its entire income as if it were a US corporation. If its Subpart F income is 10 or less, it could be disregarded. Where the Subpart F income is between 10 and 70, only the actual Subpart F income is taxed on a current basis. At the same time, however, the enactment of Subpart F legitimized tax deferral on retained earnings which did not fall within or could be channelled outside those categories. Nevertheless, this was an implicit legitimacy, not an explicit one, as would have resulted from the proposals for deferral for US Foreign Business Corporations. Subpart F did not end the deferral debate, but had the effect of converting subsequent proposals to end deferral into bargaining over modifications of Subpart F, between the various factions and pressure groups active in the legislative process. As we have seen, initially in the 1950s, in the context of a generous approach to the US supply of investment for a capital­hungry world, the pressure was to exempt foreign income. This resulted instead in focussing attention on the non­taxation of US­owned foreign subsidiaries, especially with the emergence of US balance of payments problems in the late 1950s. By the 1970s, the dominant concern became the `export ¶ of US jobs by transfer of investments abroad, and the growing competitiveness of Japan and of export­oriented newly industrialising countries. Nevertheless, the principle of deferral, subject to Subpart F taxation of CFC income, survived. A Congressional vote to end deferral in 1975 resulted only in the modifications to Subpart F of 1975 and 1976 already mentioned. President Carter in 1978 expressed an intention to end deferral, but it came to nothing. Although the Treasury department again included ending deferral among the radical proposals for tax reform initially proposed under the Reagan presidency, it did not survive into the sweeping Tax Reform Act of 1986. This outcome resulted not simply from powerful lobbying, but from the recognition that the internationalization of capital had made it impossible for the US to achieve efficient taxation of TNCs unilaterally. Taxation of international capital was no longer merely a matter of equal treatment of inward or outward investment, but now concerned the cost of capital to and the allocation of investment by internationally­ integrated firms. US­based TNCs could structure and time the flows of payments from foreign affiliates so as to minimize their net post­foreign tax credit US tax liability on overseas earnings, although this entailed significant administrative costs. 1 More importantly, economic analysis of the effects on investment decisions and the cost of capital provided strong support for the ending of deferral Alworth 1988. Nevertheless, it was difficult to end deferral unilaterally and without related measures. Studies published by the Treasury argued that the ending of deferral could not be considered in isolation from the lower effective tax rates on domestic corporate investment, resulting from the various preferential provisions that narrowed the tax base. The ending of these preferences, coupled with the reduction of the nominal tax rate, provided an opportunity to increase effective US taxation of foreign investment. Nevertheless, to do so by unilaterally imposing US taxation on the consolidated worldwide operations of US TNCs, it was argued, would create an incentive for foreign countries to increase taxation of US­controlled subsidiaries, and 1 A detailed study of the repatriation of dividends, as well as interest, rent and royalties, in 1984 from over 12,000 US CFCs to 453 parents showed that 84 of CFCs paid no dividends at all, and concluded that `many firms are able to take advantage of intra­firm financial transactions and their abilities to time repatriations in order to reduce their US tax liabilities. That is, the combination of the credit system and deferral can diminish substantially the revenue raised by the United States from the taxation of overseas operations of U.S. multinationals. ... The present US system of taxing multinationals income may be raising little US tax revenue, while stimulating a host of tax­motivated ILQDQFLDOWUDQVDFWLRQV¶+LQHVDQG+XEEDUGSS­34. hence reduce the US revenue gains due to the foreign tax credit. At the same time, higher US taxes on CFCs would, it was predicted, lead to a cumulative loss of competitiveness which also would produce a net reduction rather than an increase in US tax revenue from foreign income Hufbauer Foster 1977. Hence, it was not surprising that the Reagan tax reforms did not involve ending deferral; but they did include a number of measures drawing back foreign income into the US tax net, such as the `super­royalty ¶ and generally increasing pressure for adequate policing of intra­firm payment flows see Chapters 3.2 above and 8 below. However, the necessity for a more international approach to the whole question had by now become increasingly obvious.

3. The Limits of Unilateral Measures