# Presentation: 411745

## Presentation to President’s Advisory Panel on Federal Tax Reform

**International Provisions of the Internal Revenue Code**March 31, 2005

- Willard Taylor

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## Outward and Inward Investment 

**In teaching international tax, it is common to deal separately with “outward” and “inward” investment – that is, investment *****from***** and investment *****into***** the US**
**Export income (*****e.g.,***** the DISC, FSC, ETI and domestic production rules) is generally thought of as a third category**
**Most of the debate – and complaints – relate to outward investment**

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## What’s different?

**Witnesses on other subjects have spoken about the complexity and other problems of the Code**
**What’s different in the case of “outward” investment from the US?**

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## What’s different? – cont’d

**First, the growth of international trade and investment have made the US tax rules much more important than when they took shape in 1962**
**A creditor nation and a modest exporter of capital in 1962, the US is now a large capital exporter and importer and also the world’s largest debtor nation**

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## What’s different? – cont’d

**Second, the different rhetoric and values that drive the debate on the taxation of foreign income **
**Not about fairness to US individuals and domestic economic efficiency, but**
**rightly or wrongly, framed as a choice between “capital export” and “capital import” neutrality* (and sometimes “national neutrality”**)**
*******	****Essentially, which country (residence or source) has the first claim to tax**
********	****Foreign taxes treated as an operating expense, not a tax credit**

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## What’s different? – cont’d

**Third, ****the probable inability to achieve the goal of any system for taxing foreign income without some international con-sensus on the choice and on rates of tax, at least among major trading partners**

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## What’s different? – cont’d

**The capital export/import neutrality debate**
**Invokes issues of national competitiveness and world economic welfare **
**There are other systems in the world for taxing foreign income ******** such as a “territorial” (or exemption) system**
**In a pure territorial or exemption system, foreign income of domestic taxpayers is simply not taxed and no foreign tax credit is allowed **

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## What’s different? – cont’d

**But choosing a different system would not**
**solve the complexity and other problems discussed hereafter or **
**significantly change the terms of the debate**

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## Where are we today?

**General agreement that the inability to resolve competing arguments has resulted in a system for taxing the foreign income of US taxpayers that is***** **
**not “effective” or “administrable”**** **
**“****complex, easily avoided by the well advised and a trap for the poorly advised”**
**“****schizophrenia in the tax system” with “rules that lack coherence and often work at cross purposes”**
**“****absurd [in its] level of complexity” **
**a “jerry-rigged system”, and/or**
**“****a cumbersome creation of stupefying complexity”**
***In the words of practitioners and academics**

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## Where are we today? – cont’d

**Remarkably, no consensus on the economic consequences of what we now have –**** **
**Does it or does it not make***** *****US-owned businesses less competitive than foreign-owned businesses?**
**Hard to believe that the present complexity does not make US business less competitive than it could be in the absence of the complexity**

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## Evolution of Code provisions on “outward” investment

**How did we get to where we are?**
**Started in 1954 with a system that, broadly**
**deferred taxing earnings of US-owned foreign subsidiaries until repatriated  **
**allowed a foreign tax credit for foreign income taxes on foreign income, but not in excess of the US tax on that income**
**A progression, from 1962 through 2004, of ever more complicated limitations on**** **
**the deferral of tax, and**
**the foreign tax credit**

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## Evolution of Code provisions on “outward” investment – cont’d

**Because of a concern that the 1954 Code unfairly favored foreign investment by US persons over domestic investment, **
**The 1962 Act limited the deferral of US tax on un-repatriated earnings of foreign subsidiaries**
**These limitations were expanded in the 1975, 1976 and 1986 Acts**

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## Evolution of Code provisions on “outward” investment – cont’d

**Because of a concern that the foreign tax credit permitted the use of foreign taxes on one class of income against US tax on another, **
**The 1962 Act created a separate foreign tax credit “basket” for passive interest income – taxes on income in that basket could not be used against US tax on other income**
**More “baskets” were added in the 1975, 1976, 1984 and 1986 Acts**

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## Evolution of Code provisions on “outward” investment – cont’d

**Since the foreign tax credit is limited to the US tax on foreign source *****taxable***** income, the foreign tax credit rules require an allocation of expenses**
**Including, with modifications in 2004, interest expense incurred by US corporations**

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## Evolution of Code provisions on “outward” investment – Sources of complexity

**What were the sources of complexity resulting from the limitation on deferral? **
**Income of foreign subsidiaries that was not eligible for deferral had to be put in categories**
**Foreign personal holding company income – 1962 **
**Foreign base company sales and services income – 1962**
**Income from insurance – 1962, 1986 and 1988**
**Oil related income – 1975**
**Shipping and aircraft income – 1975 **
**Sales of property that did not produce active income – 1986**
**Income from commodities transactions – 1986**
**Income from foreign currency transactions – 1986**
**Income from a banking or similar business – 1986**

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## Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d

**What were the sources of complexity resulting from the limitation on deferral?**
**Host of special rules for **
**Business rents and royalties**
**Income from sales or services outside of the foreign subsidiary’s country of incorporation**
**In-country related party dividends, interest,  rents and royalties**
**Income from notional principal contracts**

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## Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d

**What were the sources of complexity in the foreign tax credit changes? **
**Growth in separate “baskets”**
**Passive interest income – 1962**
**Some dividend income – 1984**
**Foreign oil related income – 1975**
**All passive income – 1986**
**High withholding tax interest – 1986**
**Financial services income – 1986**
**Shipping and aircraft income – 1986**
**Dividends from certain non-controlled foreign corporations – 1986 **

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## Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d

**What were the sources of complexity in the foreign tax credit changes?**** **
**In the “basket” system **
**The need to identify taxes on specific types of income**
**To separately allocate expenses to that income**
**To do this for taxes paid and expenses incurred through tiers of entities **
**To relate these calculations to income eligible/not eligible for deferral**

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## Evolution of Code provisions on “outward” investment – Other provisions

**Focusing on the foreign tax credit and the anti-deferral rules should not diminish the importance of other legislative changes in the last 50-plus years – rules for**
**International boycotts – 1976**
**Cross-border mergers and acquisitions – principally, 1976**
**“****Stapled” entities – 1984**
**Related party factoring income – 1984**
**“****Passive foreign investment companies” – 1986**
**“****Functional currency” and foreign exchange gain or loss – 1986**
**Related party transfers of intangibles –  1986**
**“****Dual consolidated losses” – 1986**

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## Evolution of Code provisions on “outward” investment – Regulations, etc.

**In evaluating what has happened since 1962, need also to grasp that  **
**Many statutory changes have since enact-ment been further amended – in some cases, reversing the original legislative solution**
**Many of the statutory changes were followed by pages and pages of explanatory IRS regulations**
**The IRS on its own has issued significant regulations affecting outward investment**

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## Other developments – the check-the-box regulations

**One specific set of regulations deserves a comment  -- the check-the-box regulations**
**Provided the ability, for 1997 and later years, to choose whether an entity would for tax purposes be a corporation, a branch or a partnership **
**A  revolution for foreign operations of US taxpayers**
**Simplified the task of reporting foreign income, but**
**Allowed the use of “hybrid”* branches to undercut the anti-deferral rules**
*******	****An entity treated as a corporation for purposes of the foreign country’s tax law but not for US tax purposes**

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## Evolution of Code provisions on “outward” American investment – Jobs Creation Act of 2004

**What ultimately became the American Jobs Creation Act of 2004 had the articulated objectives of simplification and rolling back some of the anti-deferral rules**
**Some simplification but more than offset by the complexity of other newly-enacted rules**
**Did not even begin the process of addressing broad simplification or the development of coherent rules **
**Dropped the ball on **
**corporate expatriations**
**“****earnings stripping” --- the deductibility of interest paid to related foreign persons**

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## “Inward” Investment

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## Evolution of Code provisions on “inward” investment

**Rules on “inward” investment – *****i.e., *****US invest-ment by foreign persons**
**Big change in US position since 1954 – now a major importer of capital and the world’s largest debtor nation**
**Inward investment rules **
**Do not reflect the debate on capital import/export neutrality**
**Generally, lack a political constituency for reform**
**Have remained more constant than the outward investment rules, taking (again) the 1954 Code as a starting point**

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## Evolution of Code provisions on “inward” investment – cont’d

**In 1954, and for many years prior thereto, the rules for taxing inward investment consisted of **
**A flat 30% tax, collected by withholding at source, on US “source” dividends, interest, royalties and like income of a foreign person that did not otherwise carry on business in the US**
**Tax at the regular individual or corporate rate on the US business income of foreign persons – that is, on income that was “effectively connected” with a US business**

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## Evolution of Code provisions on “inward” investment – cont’d

**There was (and is) the rule that requires taxable income from transactions between commonly-controlled corporations to reflect arm’s length dealings***
**Of great importance, because “inward” invest-ment typically is through foreign-owned US  subsidiaries**
**Apart from the statutory “earnings stripping” rules, arm’s length pricing is the main rule that protects the US tax base from mispricing between US subsidiaries and their foreign affiliates**
*******	****Section 482 of the Code**

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## “Inward” investment – What are the problems? – cont’d

**What are the problems in the US taxation of inward investment?**
**Complexity – although possibly not to the same extent as for outward investment**
**Specific rules that are neither administrable nor, as a practical matter, are in fact administered**
**Other rules that are out of date – *****e.g*****., they turn on physical presence in the US and the “source” of income**

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## Conclusions

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## Are there solutions? 

**What are the issues with the way the Code and regulations have evolved?**
**General agreement that the subpart F and foreign tax credit rules are “stupefying” in their complexity and not administrable – the same could be said about some of the inward investment rules**
**No easy solution**
**Changing to a territorial or exemption system would neither simplify nor fundamentally change the terms of the debate**
**Nor are all of the 1962-2004 changes, however complex, “bad” and it would therefore be a mistake to simply go back to the 1954 Code **

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## Are there solutions? – cont’d

**Like the system we now have, a territorial (or exemption) system would have to **
**Classify income as foreign or domestic**
**Distinguish between passive and active business income**
**Address how passive (or non-exempt) income will be treated (*****e.g*****., no deferral and a foreign tax credit?)**
**Distinguish between partially and wholly-US owned foreign corporations**
**Allocate expenses between foreign and domestic, and passive and active business, income**
**Enforce arm’s length pricing among affiliates**

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## Are there solutions? – cont’d

**A territorial system would also have to**
**Address foreign branches of US corporations **
**Possibly distinguish between “good” and bad” foreign tax systems (and systems that are someplace in between) **
**Deal with the transition from the existing to the new system (*****e.g*****., what happens to untaxed retained earnings?)**

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## Are there solutions? – cont’d

**Simplification is not possible without **
**In the case of outward investment, a serious compromise between proponents of capital export and capital import neutrality **
**In the case of inward and outward investment, a serious intent to simplify for that reason alone**
**Need also to consider tax treaties and the desirability of  international consensus**

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## Appendix 1

**Evolution of Code provisions on “outward” investment**

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## Evolution of Code provisions on “outward” investment

**How did we get to where we are?**
**Historically, the US has**
**been a foreign tax credit country, **
**that deferred taxing foreign earnings of foreign subsidiaries until repatriated, and **
**classified corporations as foreign or not on the basis of where incorporated, not where managed or controlled**
**Not the only model in the world, but neither was the US model uncommon at the time**

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## 1954 Code

**The 1954 Code rules on outward investment allowed a foreign tax credit for direct and “indirect”* foreign income taxes**
**Limited to the US tax on foreign source income, calculated on a country-by-country basis**
*******	****Generally, a credit for foreign taxes paid by a foreign corporation on earnings distributed to a 10% or greater US corporate shareholder **

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## 1954 Code – cont’d

**Earnings of US-owned foreign corporations were not taxed until repatriated***
**Further, certain branches of US corporations could elect to be treated as foreign corporations**
**There was (and is) a general rule  that taxable income from transactions between commonly controlled corporations, whether US or foreign, must reflect arm’s length terms****** **
*******	****Other than passive income of foreign personal holding companies**
********	****In Section 482 of the Code**

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## 1954 Code – cont’d

**“****Special” provisions were essentially limited to Western Hemisphere Trade, China Trade Act and “possessions” corporations**
**In effect, subsidies for operations in specific geographic areas **
**The basic rules had been unchanged for many years  **
**In origin, the rules did not respond to any stated theoretical view – *****i.e*****., were not in response to any capital export/import neutrality debate**

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## Evolution of Code provisions on “outward” investment – the 1962 Act

**The Kennedy Administration thought that these rules unfairly favored foreign over US investment **
**Sought in 1962 to end deferral for all of the income of US-owned foreign corporations**
**Not pure “capital export neutrality” because of exceptions – would have retained deferral for earnings from less developed countries and also in part for income of export trade corporations**

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## Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

**Got instead an end to deferral for so-called “subpart F” income with back-up rules which treated  **
**untaxed earnings of a controlled foreign corporation as repatriated if used to make “investments in United States property”, and**
**gain from the sale of stock of a controlled foreign corporation as a dividend to the extent attributable to retained earnings**

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## Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

**Thus, a combination of capital export and capital import neutrality**
**Set the framework for the debate in the next 50-plus years about which system was the “better” one**
**Also put the Code distinctly on the path to complexity**

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## Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

**What were the sources of complexity resulting from the limitation on deferral? **
**Income of foreign subsidiaries that was not eligible for deferral had to be put in categories – **
**Foreign personal holding company income **
**Foreign base company sales and services income**
**Income from insurance **
**Oil related income**
**Shipping and aircraft income**
**A host of special rules for **
**business rents and royalties**
**income from sales or services outside of the foreign subsidiary’s country of incorporation**
**income from a banking, financing or similar business**

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## The 1962 Act also introduced a separate foreign tax credit “basket” for foreign taxes on passive interest income
Idea was that the foreign tax credit limitation – which limits the credit to the US tax on foreign source taxable income – ought to be applied separately to each “basket” of income 
so that taxes on one basket of income could not be used to offset US tax on another basket of income
or, colloquially, no “cross-crediting”

**Idea was that the foreign tax credit limitation – which limits the credit to the US tax on foreign source taxable income – ought to be applied separately to each “basket” of income**** **
**so that taxes on one basket of income could not be used to offset US tax on another basket of income**
**or, colloquially, no “cross-crediting”**

**Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d**

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## What were the sources of complexity in the 1975-1986 tax legislation?
In the “basket” system, 
the need to identify taxes on specific types of income
to separately allocate expenses to that income
to do this for taxes paid and expenses incurred through tiers of entities 
to relate these calculations to income eligible/not eligible for deferral

**In the “basket” system, **
**the need to identify taxes on specific types of income**
**to separately allocate expenses to that income**
**to do this for taxes paid and expenses incurred through tiers of entities **
**to relate these calculations to income eligible/not eligible for deferral**

**Evolution of Code provisions on “outward” investment – the 1986 Act **

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## Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d

**What were the sources of complexity in the 1975-1986 tax legislation?**
**The further expansion of the categories of subpart F income to include, *****e.g.,***
**A much broader class of insurance income**
**Banking, financing and similar income**
**Foreign oil related income**
**Commodities income**
**Shipping income**
**Foreign exchange gain**

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## Evolution of Code provisions on “outward” investment – the 1975 Act

**In 1975, special foreign tax credit rules were enacted for foreign oil and gas income – ultimately**
**Credits for taxes on “foreign oil and gas exploration income” were limited to the US tax rate**
**Credits for taxes on “foreign oil related income” were subject to a limitation that was comparable in intent but different**
**“****Recapture” if foreign oil and gas extraction losses offset domestic income**
**Subpart F income expanded in 1975 to include **
**foreign base company oil related income **
**foreign base company shipping (including aircraft) income**

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## Evolution of Code provisions on “outward” investment – the 1976 Act 

**The 1976 Act further tightened up what had been started in 1962 – in 1976**
**No more deferral for earnings from less developed countries**
**Recapture of foreign losses used to offset domestic income **
**Capital gains rate differential taken into account in the foreign tax credit limitation**
**Repeal of the per country calculation of the limitation on foreign tax credit – henceforth, a worldwide calculation**

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## Evolution of Code provisions on “outward” investment – the 1984 Act

**The 1984 Act added**
**A new foreign tax credit “basket” for certain dividend income **
**A rule to prevent US source income from becoming foreign source when it was received by a US-owned foreign corporation and paid out to (or included in income by) US persons**

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## Evolution of Code provisions on “outward” investment – the 1986 Act

**To the separate “baskets” for interest, dividend and foreign oil and gas income, the 1986 Act added 4 new baskets, in addition to an expanded “passive income” basket**
**High withholding tax interest, financial services income, shipping income and dividends from non-controlled Section 902 corporations**
**In many cases with sub-baskets – *****e.g*****., export financing income was excluded from high withholding tax interest and high-taxed income from passive income**
**The baskets were applied on a look-through basis to dividends, interest and other income from foreign subsidiaries**

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## The 1986 Act also rewrote the rules for determining foreign source taxable income, and thus the allowable foreign tax credit
Required an allocation of domestically-incurred interest expense to determine foreign source taxable income
Dramatically affected the foreign tax credit limitation
The allocation reduced foreign source income by an expense that was not deductible in the foreign country
Provided statutory rules (replacing 1977 regulations) for the apportionment of R & D expenses

**Required an allocation of domestically-incurred interest expense to determine foreign source taxable income**
**Dramatically affected the foreign tax credit limitation**
**The allocation reduced foreign source income by an expense that was not deductible in the foreign country**
**Provided statutory rules (replacing 1977 regulations) for the apportionment of R & D expenses**

**Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d**

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## Evolution of Code provisions on “outward” investment – 1986 Act – cont’d

**1986 Act expanded Subpart F to include income from**
**insurance outside of the foreign corporation’s country of incorporation **
**sales of property that did not produce active income **
**commodities transactions **
**foreign currency transactions**
**a banking or similar business**
**shipping, even though reinvested**
**In 1988, the insurance rules were amended again to apply subpart F to “related party insurance income” of a foreign insurance company owned to the extent of 25% or more by US shareholders**

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## Evolution of Code provisions on “outward” investment – Regulations

**In evaluating what happened between 1962 and 1986, need to grasp that  **
**Many of the statutory changes were followed by pages and pages of explanatory IRS regulations**
**Most of the statutory changes have since enactment been further amended (with exceptions, special rules and complex definitions), in some cases on a regular basis**
**A number of the statutory changes (*****e.g*****., the treatment for subpart F purposes of income from the conduct of a banking or similar business) reversed, then reversed again, the original legislative solution**

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## Evolution of Code provisions on “outward” investment – Regulations – cont’d

**Apart from the statutory changes, the IRS independently issued extensive regulations on a number of major international subjects, including, e.g., **
**In 1991, the definition of a creditable foreign income tax**
**The standards for arm’s length pricing – in the ‘90s, the IRS embarked on a major and on-going effort to cover specific situations, such as transfers of tangible and intangible property**

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## Other developments – the check-the-box regulations

**For 1997 and later years, the classification of an entity as a corporation, a branch or a partnership became (under the check-the-box regulations) largely elective**
**The check-the-box regulations **
**Were a simplification for domestic entities, but a  revolution for foreign operations of US taxpayers**
**The ability to elect to treat foreign entities as branches or as partnerships has vastly simplified the task of reporting foreign income, but**
**IRS had not thought through the implications of the check-the-box regulations on foreign operations**

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## Other developments – the check-the-box regulations – cont’d

**Elective classification permits **
**the use of “hybrid”* branches to eliminate foreign tax **
**and thus replicate the low-taxed foreign income that subpart F was directed at**
**The IRS sought to address “hybrid” entities in the so-called hybrid branch payment rules, but Congress objected and these have not been adopted**
***An entity treated as a corporation for purposes of the foreign country’s tax law but not for US tax purposes**

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## Other developments – the check-the-box regulations – cont’d

**The check-the-box regulations also permit the separation of foreign taxes from the underlying foreign income, either through**
**partnership allocations (which has been addressed) and  **
**the use of reverse “hybrid” entities* **
*******	****An entity treated as a corporation for US tax purposes but as transparent for purposes of the foreign country’s tax law**

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## Evolution of Code provisions on “outward” investment – cont’d

**To focus on the foreign tax credit and subpart F is not to diminish the importance of other changes in the last 50-plus years**
**The enactment in 1976 of the international boycott rules **
**Apart from reporting, disallow credits and end deferral and other benefits for income from boycott operations**
**The repeated changes, beginning largely in 1976, to the rules in Section 367**
**These govern the extent to which reorganizations and exchanges that are tax-free if purely domestic will be tax-free if a foreign corporation is involved**
**The 1984 enactment of Section 269B, relating to foreign corporations whose ownership is “stapled” to the ownership of a US corporation**

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## Evolution of Code provisions on “outward” investment – cont’d

**The 1984 rules that treat income from related party factoring as interest received from a related party for subpart F and specified other purposes  **
**The enactment in 1986 of the “passive foreign investment company” rules **
** ****impose penalty taxes on US shareholders of broadly-defined “passive foreign investment companies”**
**Co-existed until 2004 with foreign personal holding company and foreign investment company rules **

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## Evolution of Code provisions on “outward” investment – cont’d

**The 1986 enactment of rules that establish a “functional currency” and thus foreign exchange gain or loss for non-functional currency transactions**
**The 1986 amendment which specified that the income from a related-party transfer of an intangible had to be “commensurate with” the income from the intangible **
**The 1986 prohibition on the use of a “dual consolidated loss” of a “dual resident corporation” to reduce the income of other members of a US consolidated group**

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## Evolution of Code provisions on “outward”investment – American Jobs Creation Act of 2004

**What ultimately became the American Jobs Creation Act of 2004 had the articulated objective of “reforming” subpart F and foreign tax credit rules – essentially targeting what had happened in 1986 and rolling back some capital export neutrality rules**
**There was some simplification**
***E.g., *****the elimination of some “baskets”, of the foreign personal holding company and foreign investment company rules**
**But that simplification was more than offset by the complexity of other newly-enacted rules, such as the new elective interest allocation rules**

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## Evolution of Code provisions on “outward” invest-ment – American Jobs Creation Act of 2004 – cont’d

**The Act lacked balance and perspective – did not comprehensively address, or even begin the process of addressing, broad simplification or the development of coherent rules **
**The provisions of the Act**
**were mostly borrowed from industry-inspired wish lists, and  **
**what was ultimately included or not, and its effective dates, responded to revenue projections and the lobbies’ influence**

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## Evolution of Code provisions on “outward” invest-ment – American Jobs Creation Act of 2004 – cont’d

**Dropped the ball on **
**the treatment of corporate inversions,  and **
**whether the earnings stripping rules needed revisions in order to achieve a different balance between the treatment of foreign and US-owned US corporations **

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## Appendix 2

**Inward Investment**

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## Evolution of Code provisions on “inward” investment

**Rules on “inward” investment – *****i.e., *****US investment by foreign persons**
**Do not involve the capital export/import neutrality debate**
**Do not, with exceptions, have a political constituency for reform**
**Have remained more constant than the inward investment rules, taking (again) the 1954 Code as a starting point**

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## Evolution of Code provisions on “inward” investment – cont’d

**In 1954, and for many years prior thereto, the rules for taxing “inward” investment consisted of **
**A flat 30% tax, collected by withholding at source, on US “source” dividends, interest, royalties and like income of a foreign person that did not otherwise carry on business in the US**
**Tax at the regular individual or corporate rate on the US business income of foreign persons – that is, on income that was “effectively connected” with a US business**

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## Evolution of Code provisions on “inward” investment – cont’d

**There was (and is) the rule that requires taxable income from transactions between commonly-controlled corporations to reflect arm’s length dealings***
**Of great importance, because “inward” investment typically is through foreign-owned US  subsidiaries**
**Apart from the statutory “earnings stripping” rules, arm’s length pricing is the main rule that protects the US tax base from mispricing between US subsidiaries and their foreign affiliates**
*******	****Section 482 of the Code**

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## Evolution of Code provisions on “inward” investment – cont’d

**The principal changes in the treatment of “inward” investment since 1954 have been**
**The 1966 enactment of rules which eliminated uncertainties about the tax consequences of, and thus encouraged, investment in US stocks, securities and commodities **
**The 1980 imposition of tax at regular rates on gain from a sale of an interest in US real estate**
**including an interest in a US corporation predominantly invested in such assets – the so-called “FIRPTA” tax**

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## The imposition in 1984 of withholding by a purchaser of US real property as a means of collecting the FIRPTA tax
The 1984 repeal of the 30% withholding tax on “portfolio” interest paid to unrelated foreign investors, 
reflects the importance of permitting US borrowers to access foreign capital
The 1984 enactment of a statutory rule for determining when a non-citizen is a US resident and therefore subject to full US tax 

**The 1984 repeal of the 30% withholding tax on “portfolio” interest paid to unrelated foreign investors, **
**reflects the importance of permitting US borrowers to access foreign capital**
**The 1984 enactment of a statutory rule for determining when a non-citizen is a US resident and therefore subject to full US tax **

**Evolution of Code provisions on “inward” investment – cont’d**

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## Evolution of Code provisions on “inward” investment – cont’d

**The 1986 imposition of withholding tax on a foreign partner’s share of partnership income attributable to a US business**
**The 1986 enactment of “source” rules for international communications and space and ocean activity income**
**The 1987 enactment of a statutorily mandated minimum rate of investment return for foreign insurance companies doing business in the US**

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## Evolution of Code provisions on “inward” investment – cont’d

**The 1986 enactment of branch taxes**
**Repatriation of profits of a US branch treated substantially as a dividend from a US subsidiary**
**Interest paid by a branch treated substantially as a payment of interest by a US subsidiary**

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## Evolution of Code provisions on “inward” investment – cont’d

**Limited the historical “equivalent exemption” rule to publicly traded companies or companies locally owned**
**Imposed a 4% excise tax on the gross US source transportation income of a company not eligible for the exemption to the extent the income is not taxable as income from a US business **

**Evolution of Code provisions on “inward” investment – cont’d**

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## Evolution of Code provisions on “inward” investment – cont’d

**The 1989 enactment, and 1993 extension to guaranteed debt, of the “earnings stripping rules”**
**Disallow a current deduction for interest paid to, or on debt guaranteed by, a related foreign person that would otherwise reduce taxable income by more than 50% **
**The 1993  enactment of anti-conduit rules directed at avoidance of US withholding tax through the use of tax treaty provisions**

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## Evolution of Code provisions on “inward” investment – cont’d

**The 1996 enactment of rules on the expatriation of individual taxpayers**
**The 1997 enactment to deal with withholding on interest, dividend and like payments to “hybrid” entities**

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## What are the problems in the US taxation of inward investment?
Complexity -- although possibly not to the same extent as for outward investment
As in the case of outward investment, many of the statutory amendments have been followed by pages and pages of IRS regulations
Other complex regulations have been initiated without legislative prompting -- e.g., those dealing with
withholding at source on interest and dividends, and 
with the taxation of US branches of foreign banks 

**Complexity -- although possibly not to the same extent as for outward investment**
**As in the case of outward investment, many of the statutory amendments have been followed by pages and pages of IRS regulations**
**Other complex regulations have been initiated without legislative prompting -- *****e.g*****., those dealing with**
**withholding at source on interest and dividends, and **
**with the taxation of US branches of foreign banks **

** “****Inward” investment – What are the problems? – cont’d**

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##  “Inward” investment – What are the problems? – cont’d

**What are the problems?**
**Many of the rules are neither administrable nor, as a practical matter, are in fact administered**
**E.g., the PFIC or FIRPTA rules**
**The rules for determining the taxability of increasingly important items of income are out of date – they turn on physical presence and “source”**
**For example, income from e-commerce and in some cases from derivatives**
**Residence-based sourcing does not work in a world with abundant tax havens**

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##  “Inward” investment – What are the problems? – cont’d

**Rules for determining arm’s length pricing for services, intangibles and other items are not working well **
**the so-called advance pricing agreement program is not an answer**

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## Appendix 3

**DISCs, FSCs and Domestic Production**

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## The DISC regime was enacted in 1971 to permit deferral of export-related income

**US has a history of providing tax benefits for exports**
**1962 Act included special rules for “export trade corporations” – whose qualification as such depended on US manufacture or production**
**In 1971, went further and enacted the DISC (“Domestic International Sales Corporation”)  rules – a partial roll back of the anti-deferral measures in the 1962 Act**
**A DISC is a U.S. corporation which devotes 95% of its activities to exports, and**
**Usually a “paper” corporation through which its US parent channels exports**
**Earnings not taxed until distributed**
**GATT countries objected to DISCs because the deferral of domestic tax had the effect of an export subsidiary**

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## In response to GATT objections, the US enacted the FSC provisions in 1984

**In 1984, deferral benefits of DISCS were ended – an interest charge on deferred income**
**Enacted FSC (“Foreign Sales Corporation”) provisions to respond to GATT rulings which approved of tax exemptions for activities “abroad”**
**A foreign corporation owned by a U.S. exporter**
**Allowed to contract with a related U.S. entity to produce all of its products, thus substantially skirting the “abroad” requirement**
**”****Rule of origin” required imported components to contribute no more than 50% of the exports’ fair market value**
**The WTO found the FSC regime to be an illegal export subsidiary**

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## ETI was U.S.’s response to the WTO ruling

**In 2000, the ETI (“Extraterritorial Income”) legislation repealed the FSC provisions and exempted from tax qualifying foreign trade income, which included**
**30% of foreign sales and leasing income**
**1.2% of foreign trading gross receipts**
**15% of foreign trade income**
**Like the FSC provision, ETI**
**Only exempted export income**
**Retained the 50% rule of origin**
**The WTO ruled the ETI regime to be illegal in 2002**

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## American Jobs Creation Act of 2004

**The American Jobs Creation Act of 2004 responded by phasing-out the ETI system and phasing-in a reduced rate of tax for income from qualified domestic production**

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## Appendix 4

**US income tax treaties**

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## US income tax treaties	

**Treaties cut back on the reach of the Code by, among other things**
**reducing the rates of US withholding tax on dividends, interest, royalties and like items**
**using a more restrictive “permanent establishment” test before business income is taxed**
**limiting the US tax on service income of individuals**
**providing rules for foreign taxes eligible for credit**
**Treaties also provide a process for resolving conflicting tax claims between taxing authorities**

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## US income tax treaties – cont’d

**In 1954, the US had some 18 income tax treaties**
**There are now more than 60, and US negotiations now generally begin with a “model” treaty**
**The spread of treaties can only be good, but US treaties have also become a separate body of knowledge**
**The terms differ materially, in part because entered into at different times**
**Limitation-on-benefit articles, which vary from treaty to treaty, are as complicated as any provision of the Code**

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## Appendix 5

**Some possible simplifications**

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## Simplifications? 

**Eliminate provisions which are out-of-date or whose complexity cannot be justified, such as  **
**Are foreign tax credit limitations on FOGEI and FORI needed, given the subsequent regulatory definition of creditable foreign taxes?**
**Would it be simpler to treat related party factoring income as interest for all tax purposes?**
**Are the “anti-conduit” regulations needed now that most US tax treaties have limitation on benefit articles?**
**Can the reach of the PFIC rules be justified?**
**If “hybrid” entities erode subpart F, shouldn’t the subpart F rules be revised to accept that? Or, if not, the check-the-box regulations changed?**

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## Simplifications – cont’d

**Eliminate provisions which are out-of-date or whose complexity cannot be justified, including **
**In light of the repeal of the withholding tax on “portfolio” interest, do the compliance rules imposed on banks and other intermediary holders of debt make sense?**
**If dividend flows can be replicated by derivatives, is there any point in imposing withholding tax on “portfolio” dividends?**
**In the case of a foreign and domestic corporation, do we need the stapled entities rule in Section 269B?**
**Can the Section 367 regulations on corporate “inversions” be eliminated now that Congress has addressed the subject in Section 7874?**
**With changes in securities markets, is the bank loan exception to the portfolio interest exemption still relevant?**

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## Simplifications? – cont’d

**Eliminate (or move elsewhere) provisions whose purpose seems more driven by ideology than sound tax policy**
**The FIRPTA tax on sales and dispositions of US real property (and the related withholding tax)**
**The international boycott participation and related “bad” country rules**
**The rules relating to dual consolidated losses of dual resident entities**

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