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US tax policy toward international firms is one of the most unfavorable forces undermining US leadership of the global economy. The current US tax system creates unintended incentives for multinational enterprises to locate high- technology production abroad and to shift their headquarters activities overseas and facilitates tax evasion on foreign portfolio income paid or accrued to US residents. To encourage multinational enterprises to locate both headquarters activities and high-technology production in the United States, Hufbauer and Assa propose that the US tax regime be shifted toward a territorial system, coupled with favorable expense allocation rules. They suggest a new approach for taxing royalty and fee income earned abroad so that high-technology produc- tion in the United States is not penalized by comparison with production abroad. They urge the United States to take the lead in creating a cooperative interna- tional system that would discourage underreporting of foreign portfolio income, including by US residents. These proposed reforms, the authors calculate, might collect more tax revenue than the present system, paving the way for a lower corporate tax rate or other forms of business tax relief. GARY CLYDE HUFBAUER, Reginald Jones Senior Fellow since 1992, was the Marcus Wallenberg Professor of International Finance Diplomacy at Georgetown University (1985–92), senior fellow at the Peterson Institute (1981–85), deputy director of the International Law Institute at Georgetown University (1979–81), deputy assistant secretary for international trade and investment policy of the US Treasury (1977–79), and director of the International Tax Staff at the US Treasury (1974–76). He has written extensively on international trade, investment, and tax issues. He is the author of Fundamental Tax Reform and Border Tax Adjustments (1996) and US Taxation of International Income: Blueprint for Reform (1992) and coauthor of Reforming the US Corporate Tax (2005). ARIEL ASSA is a tax counsel for JP Morgan Chase & Co. in New York City. He was a tax attorney at the law firms of Willkie, Farr & Gallagher LLP in New York City (2003–07) and Herzog, Fox & Neeman in Tel Aviv (1999–2001). He also served as a tax agent in Israel's Income Tax Authority (1994–99) and an assistant professor in several tax courses at Tel Aviv University (1996–2001). He earned his law, accounting, and MBA degrees from Tel Aviv University and is a graduate of the LLM program in taxation at Georgetown University Law Center (2002). US Taxation of Foreign Income of Foreign Income TAXATION Gary Clyde Hufbauer & Ariel Assa PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS US   1750 Massachusetts Avenue, NW Washington, DC 20036-1903 Tel: (202) 328-9000 Fax: (202) 659-3225 www.petersoninstitute.org US Taxation of Foreign Income Hufbauer & Assa TAXATION  US  of Foreign Income Gary Clyde Huauer & Ariel Assa TAXATION of Foreign Income U.S. Washington, DC October 2007 Peterson Institute for International Economics Gary Clyde Hufbauer, Reginald Jones Senior Fellow since 1992, was the Marcus Wallenberg Professor of International Finance Diplomacy at Georgetown Univer- sity (1985–92), senior fellow at the Peterson Institute (1981–85), deputy director of the International Law Institute at Georgetown University (1979–81), deputy assistant secretary for international trade and invest- ment policy of the US Treasury (1977–79), and director of the International Tax Staff at the US Treasury (1974–76). He has written extensively on international trade, invest- ment, and tax issues. He is the author of Fundamental Tax Reform and Border Tax Adjustments (1996) and US Taxation of International Income: Blueprint for Reform (1992) and coauthor or coeditor of Reforming the US Corporate Tax (2005), US-China Trade Disputes: Rising Tide, Rising Stakes (2006), NAFTA Revisited: Achievements and Chal- lenges (2005), and World Capital Markets: Challenge to the G-10 (2001). Ariel Assa is a tax counsel for JP Morgan Chase & Co. in New York City. He was a tax attorney at the law firms of Willkie, Farr & Gallagher LLP in New York City (2003–07) and Herzog, Fox & Neeman in Tel Aviv (1999–2001). He also served as a tax agent in Israel’s Income Tax Authority (1994–99) and an assistant professor in several tax courses at Tel Aviv University (1996–2001). He earned his law, accounting, and MBA degrees from Tel Aviv University and is a graduate of the LLM program in taxation at Georgetown University Law Center (2002). PETER G. PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS 1750 Massachusetts Avenue, NW Washington, DC 20036-1903 (202) 328-9000 FAX: (202) 659-3225 www.petersoninstitute.org C. Fred Bergsten, Director Edward Tureen, Director of Publications, Marketing, and Web Development Printing by Kirby Lithographic Company, Inc. Typesetting by ATLIS Copyright © 2007 by the Peter G. Peterson Institute for International Economics. All rights reserved. No part of this book may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by information storage or retrieval system, without permission from the Institute. For reprints/permission to photocopy please contact the APS customer service department at Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923; or email requests to: info@copyright.com Printed in the United States of America 100908 54321 Library of Congress Cataloging-in- Publication Data Hufbauer, Gary Clyde. U.S. taxation of foreign income / Gary Clyde Hufbauer and Ariel Assa. p. cm. Includes bibliographical references and index. ISBN 978-0-88132-405-1 (alk. paper) 1. Income tax—United States—Foreign income. 2. Income tax—Law and legisla- tion—United States. 3. Aliens— Taxation—Law and legislation—United States. 4. Corporations, Foreign— Taxation—Law and legislation—United States. I. Assa, Ariel. II. Title. KF6419.H84 2007 343.7305Ј248—dc22 2007029580 The views expressed in this publication are those of the authors. This publication is part of the overall program of the Institute, as endorsed by its Board of Directors, but does not necessarily reflect the views of individual members of the Board or the Advisory Committee. 1393.chfm.qxd 9/18/07 11:23 AM Page iv For Congressman Bill Archer, Chairman House Ways and Means Committee (1995–2001) Champion of tax reform 1393.chfm.qxd 9/18/07 11:23 AM Page v 1393.chfm.qxd 9/18/07 11:23 AM Page vi vii Contents Preface xiii Acknowledgments xvii 1 Introduction 1 The US Role in the World Economy: Five Decades of Change 2 Foreign-Owned Assets in the United States 6 Internationalization of the US Economy 10 The Rise of High Technology 13 Headquarters for MNEs 21 2 Corporate Taxation 25 Historical Background 26 Incidence of the Corporate Income Tax 28 Relevance to International Tax Issues 41 3 Traditional Tax Doctrine for Foreign Income 51 Capital Export Neutrality 54 National Neutrality 63 Capital Import Neutrality 65 Capital Export Neutrality and Capital Import Neutrality Theories in Tax Reality 69 Capital Ownership Neutrality 72 Revenue Considerations 73 The Futur e Debate 77 1393.chfm.qxd 9/18/07 11:23 AM Page vii 4 Residence Taxation for Portfolio Investment Income 79 The Rise of Portfolio Capital 79 Applying Capital Export Neutrality Logic to Portfolio Income 81 Residence-Only Taxation of Portfolio Income 83 Cooperation Against Tax Avoidance 86 OECD Project on Harmful Tax Competition 88 The USA Patriot Act and Anti-Money Laundering Initiatives 92 Recommendations 94 5 Multinational Firms in the World Economy 99 Strategic Arguments 101 A Model of Operating Profits and Headquarters Costs 109 Restrictive Policies and National Prosperity 114 Tax Policy Implications 119 6 Agenda for Modest Reform: A Territorial System 123 The Territorial System 133 Antiabuse Measures 152 Tax Treaty Policy 163 Revenue Implications 166 Appendix A1 175 History of US Taxation of Foreign Income of US Corporations (Excluding Merchandise Export Income) Appendix A2 191 History of US Foreign Tax Credit Limitations Appendix A3 197 History of US Deferral of Current Taxation of Controlled Foreign Corporations Appendix A4 203 History of US Taxation of Merchandise Export Income Appendix A5 211 History of US Taxation of Foreign Corporations Doing Business in the United States Appendix A6 223 History of Source-of-Income Rules Prior to the Tax Reform Act of 1986 Appendix A7 227 Comparison of Source-of-Income Rules Before and After the Tax Reform Act of 1986 viii 1393.chfm.qxd 9/18/07 11:23 AM Page viii Appendix A8 233 Allocation-of-Expenses Rules Appendix A9 243 History of Rules for Intercompany Pricing Between US and Affiliated Foreign Corporations Appendix B 255 Methods for Reducing Corporate Income Taxes Appendix C1 261 A Simple Model of World Portfolio Capital Flows Appendix C2 265 Temporary Taxes on Portfolio Capital Appendix C3 267 Conditions for Reimbursement of the Backup Withholding Tax Appendix D 269 The Simple Economics of Imperfect Competition Appendix E 275 Electronic Commerce Appendix F 295 Revenue on Foreign Investment in the United States References 297 Index 309 Tables Table 1.1 US, Japanese, and EC/EU shares of world GDP, exports, and foreign direct investment, 1960–2005 3 Table 1.2 United States: Foreign direct investment position, 1960–2005 5 Table 1.3 Headquarter locations of top 100 industrial firms and top 50 commercial banks worldwide, 1960–2005 6 Table 1.4 Foreign-owned assets in the United States, 1985–2005 8 Table 1.5 US-owned assets abroad, 1985–2005 9 Table 1.6 United States: Selected measures of openness to international trade and investment, 1960–2005 1 1 Table 1.7 US merchandise trade associated with US multinational enterprises, selected years 12 ix 1393.chfm.qxd 9/18/07 11:23 AM Page ix [...]... diminished outward FDI stocks Hence, part of the loss of competitiveness of US firms in the 1960 and 1970s reflects non -US global firms’ reestablishment of their prewar positions 4 US TAXATION OF FOREIGN INCOME 1393.ch01.qxd 9/7/07 12:53 PM Page 3 Table 1.1 US, Japanese, and EC/EU shares of world GDP, exports, and foreign direct investment, 1960–2005 (percent of total) Indicator 1960 1970 1980 1990 2000... fiscal deficit causes the trade balance to deteriorate by $20 billion 6 US TAXATION OF FOREIGN INCOME 1393.ch01.qxd 9/7/07 12:53 PM Page 7 That said, certain second-order effects of business taxation are worth noting The inevitable counterpart of a current account deficit is a capital account surplus, meaning foreign acquisition of US assets, such as shares, bonds, real estate, and firms When foreign owners... considerably across industries The share of the domestic market in total revenues for industries producing highly tradable products (e.g., pharmaceuticals, 12 US TAXATION OF FOREIGN INCOME 1393.ch01.qxd 9/7/07 12:53 PM Page 13 top 100 European MNEs, the EU-wide bias is similar to the US home bias of US firms in terms of revenues and employment (Véron 2006) However, the rising importance of global markets... reflection of foreign eagerness to buy American assets Passive debt assets, including foreign official assets, remain at nearly 70 percent of the total The United States would almost certainly benefit if a greater share of inward foreign investment were in corporate equities rather than debt, and in direct rather than portfolio investment The burden of US business taxation clearly favors the foreign acquisition... growing internationalization of the US economy In 2004 merchandise exports associated with US MNEs accounted for 52 percent of US merchandise exports and 34 percent of US merchandise imports Much of the commerce was conducted among affiliates of the same corporate group In 2004 intrafirm merchandise exports of US multinationals accounted for 20 percent of total US merchandise exports, and intrafirm... Table F.1 11:23 AM Page xi Illustrative US corporate tax rates at the federal level (after foreign tax credits) by type of foreignsource income APA applications filed and executed, 1991–2005 Withholding rates applied by the United States, 1990 and 2005 Hypothetical US income from foreign sources, foreign tax credits, and US tax revenue under territorial system, 2002 Summary of expense apportionment before... trade of EU members is counted in calculating these estimates 16 US TAXATION OF FOREIGN INCOME 1393.ch01.qxd 9/7/07 12:53 PM Page 17 high-technology goods, with exports of $54 billion against imports of $27 billion By 2003 the United States faced a high-technology trade deficit of about $35 billion, out of a total trade deficit of $437 billion in harmonized system (HS) chapters 28–97.24 In that year, US. .. the context of the US system for taxing corporate and individual income Since 1990, US- based multinational enterprises (MNEs)— especially in high-technology industries—have dramatically expanded their business operations abroad and now generate a large portion of their income from activities outside the United States In fact, household name corporations often earn more than half their profits from overseas... the US economy than are purely financial investments.6 Second, US federal tax collections are far larger on a billion dollars of equity holdings or direct investment than a billion dollars of US Treasury securities or other debt As chapter 4 emphasizes, US tax collections average less than 2 percent of interest payments to foreign persons By contrast, US tax collections average nearly 30 percent of US. .. very rapid ascent of China, India, and other emerging powers Second, the United States has now become a prime destination for foreign asset holders—a sharp reversal from its post–World War II status as creditor to the world At the end of 2005, US ownership of assets abroad amounted to about $10 trillion, compared with foreign ownership of US assets of about $12.7 trillion The stock of inward investment . 659-3225 www.petersoninstitute.org US Taxation of Foreign Income Hufbauer & Assa TAXATION  US  of Foreign Income Gary Clyde Huauer & Ariel Assa TAXATION of Foreign Income U.S. Washington,. 191 History of US Foreign Tax Credit Limitations Appendix A3 197 History of US Deferral of Current Taxation of Controlled Foreign Corporations Appendix A4 203 History of US Taxation of Merchandise. Center (2002). US Taxation of Foreign Income of Foreign Income TAXATION Gary Clyde Hufbauer & Ariel Assa PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS US   1750 Massachusetts Avenue,