THE U.S. INTERNATIONAL TAX RULES:

BACKGROUND AND SELECTED ISSUES RELATING TO THE 

COMPETITIVENESS OF U.S. BUSINESSES ABROAD

Scheduled for a Public Hearing

Before the

SENATE COMMITTEE ON FINANCE

on July 15, 2003

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

July 14, 2003

JCX-68-03
i

CONTENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. BACKGROUND: WORLDWIDE VS. TERRITORIAL TAX SYSTEMS ............................... 2

A. In General............................................................................................................................ 2

B. Rationale for a Worldwide Tax System.............................................................................. 2

C. Rationale for a Territorial Tax System............................................................................... 4

D. Methods of Implementing a Territorial Tax System........................................................... 5

E. Other Issues Raised by a Shift to a Territorial System....................................................... 6

F. Relationship of Territorial-vs.-Worldwide Debate to WTO Dispute over FSC/ETI.......... 7

II. OVERVIEW OF THE U.S. INTERNATIONAL TAX SYSTEM.......................................... 10

A. Tax Treatment of Foreign Activities of U.S. Persons....................................................... 10

B. Tax Treatment of U.S. Activities of Foreign Persons....................................................... 14

C. Transfer Pricing................................................................................................................. 14

D. Treaties.............................................................................................................................. 14

III. DISCUSSION OF ECONOMIC ISSUES RELATED TO THE POSITION OF THE 

UNITED STATES IN THE GLOBAL ECONOMY.................................................................... 16

A. Is U.S. Business Competitive in the Global Economy?.................................................... 16

B. Taxation and Investment in the Global Economy............................................................. 17

C. Characterization of the U.S. System of Taxation of Cross-Border Transactions

and Investments................................................................................................................. 24

IV. RECENT COMPETITIVENESS AND SIMPLIFICATION PROPOSALS ......................... 29

A. Proposals Relating to the Foreign Tax Credit................................................................... 29

B. Proposals Relating to the Subpart F Anti-Deferral Rules................................................. 33

C. Joint Committee Staff Simplification Recommendations................................................. 35

V. TEMPORARY RATE REDUCTION FOR CERTAIN DIVIDEND REPATRIATIONS...... 38

A. Background ....................................................................................................................... 38

B. Recent Proposals............................................................................................................... 38

C. Analysis............................................................................................................................. 40

VI. EXCLUSION FOR FOREIGN EARNED INCOME............................................................. 43

A. Background ....................................................................................................................... 43

B. Proposed Repeal................................................................................................................ 44

C. Analysis............................................................................................................................. 44
1

INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing for July 15, 2003, on 

the effects of the U.S. international tax rules on the competitiveness of U.S. businesses abroad. 

This document, 1 prepared by the staff of the Joint Committee on Taxation, provides general 

background on these rules and discusses selected issues relating to the tax treatment of the 

foreign activities of U.S. businesses.

 

1

 This document may be cited as follows: Joint Committee on Taxation, The U.S. 

International Tax Rules: Background and Selected Issues Relating to the Competitiveness of U.S 

Businesses Abroad (JCX-68-03), July 14, 2003.
2

I. BACKGROUND: WORLDWIDE VS. TERRITORIAL TAX SYSTEMS

A. In General

Worldwide tax system 

In a pure worldwide tax system, resident individuals and entities are taxable on their 

worldwide income, regardless of where the income is derived. Double taxation of foreign 

income is mitigated through the allowance of a foreign tax credit. However, the credit is 

generally limited to ensure that the residence country preserves its right to tax income derived 

within the residence country. Since corporations are generally respected as separate entities, 

foreign-source income earned by a resident through a foreign corporation generally is not subject 

to tax until repatriated. In the United States, several complex anti-deferral regimes apply as 

exceptions to this general rule and tax U.S. shareholders currently on certain mobile or passive 

income derived through certain foreign corporations.

Territorial tax system 

In a pure territorial tax system, the country taxes only income derived within its borders, 

irrespective of the residence of the taxpayer. Thus, unlike in a worldwide tax system, foreignsource income earned by a resident is exempt from tax. There is no need for a foreign tax credit, 

because exemption generally eliminates the possibility of double taxation of foreign income. 

There also is no need for complicated anti-deferral rules, because foreign-source income is 

exempt from tax in the first place. As a practical matter, however, countries that have adopted 

territorial-type tax systems generally have included exceptions to the territorial principle for 

certain cases deemed to be abusive, using regimes similar to the U.S. anti-deferral rules and 

foreign tax credit.

Mixed systems 

No country uses a pure worldwide or territorial system. Systems may be accurately 

characterized as predominantly worldwide or territorial, but all systems share at least some 

features of both worldwide and territorial approaches. 

B. Rationale for a Worldwide Tax System

Economic efficiency 

A pure worldwide tax system arguably promotes economic efficiency, in that it does not 

distort the decision of whether to locate investment at home or abroad. A resident has no tax 

incentive either to move activities abroad or to keep them within the residence country, since in 

either case the income generally will be subject to tax at the residence-country rate. Thus, 

investment-location decisions are governed by business considerations, instead of by tax law. 

This efficiency norm is referred to as capital export neutrality. Common deviations from the 

“pure” form of the worldwide tax system, such as the foreign tax credit limitation, reduce this 

neutrality.
3

Equity

A worldwide tax system arguably promotes equity in a number of ways. 

Horizontal equity 

First, a worldwide system arguably furthers the policy that taxpayers earning similar 

levels of income should be subject to tax at similar overall effective rates. Thus, a resident 

taxpayer earning income abroad should be subject to tax at the same effective rate as a taxpayer 

earning the same amount of income domestically. Providing a foreign tax credit mitigates the 

possibility that the taxpayer earning income abroad will be subject to a higher overall effective 

rate than the taxpayer earning income domestically; subjecting foreign-source income to 

residence-country tax mitigates the possibility that the taxpayer earning income abroad will be 

subject to a lower overall effective rate. Thus, a worldwide system provides a framework for 

treating similarly situated individuals similarly -- a concept known as horizontal equity.

Vertical equity

The U.S. income tax system is progressive. Resident taxpayers earning higher levels of 

income are taxed at progressively higher marginal rates, on the theory that their greater ability to 

pay renders it fair to require them to shoulder a greater proportionate share of the tax burden. If 

ability to pay is regarded as important, then income earned abroad should be included in the tax 

base and subjected to progressive rates. Otherwise, the overall progressivity of the tax system 

may be eroded, as wealthier taxpayers might shift activities and income abroad. Thus, a 

worldwide system helps to promote the policy that higher income-earners should bear a larger 

proportionate share of the tax burden -- a concept known as vertical equity.

Citizenship and residency as values 

Taxing U.S. citizens and residents on their worldwide income arguably also reflects the 

notion that U.S. citizenship and residency bestow important benefits (e.g., legal and technical 

business infrastructure, military protection, passport and embassy services) that U.S. citizens and 

residents should be made to pay for, regardless of where they might earn their income. 

Consistent with this notion, the United States is the only industrialized country in the world that 

taxes its citizens on their worldwide income, even if they reside outside the country.

Preservation of the U.S. tax base 

A worldwide tax system arguably preserves the residence-country tax base more 

effectively than a pure territorial system. If foreign-source income is entirely exempt from 

taxation, then resident taxpayers will shift investment and income into tax havens, thus eroding 

the residence-country tax base. For this reason, even those countries that employ predominantly 

territorial systems (e.g., France) typically provide for current taxation of certain types of foreignsource income that may easily be earned in tax havens -- a significant departure from “pure” 

territorial taxation.
4

C. Rationale for a Territorial Tax System

Economic efficiency 

A territorial system arguably promotes economic efficiency better than a worldwide tax 

system, because a territorial system treats all investment within a particular source country the 

same, regardless of the residence of the investor. This efficiency norm is referred to as capital 

import neutrality (or, in the business community, as “competitiveness”). Thus, if a residence 

country adopts a pure territorial system, residents of that country, when investing abroad in a 

particular source jurisdiction, will not be disadvantaged relative to other investors by virtue of 

their country of residence. For example, if a source country provides low effective tax rates on 

manufacturing income, a taxpayer resident in a country with a territorial tax system will fully 

enjoy the benefits of the lower source-country rate, while a taxpayer resident in a country with a 

worldwide tax system generally will not. In a world with diverse tax systems and rates, it is 

impossible to fully achieve both capital import neutrality and capital export neutrality at the same 

time. Thus, difficult balancing decisions are unavoidable, and there is no consensus as to which 

of the two goals should take precedence. The weight of academic opinion generally favors 

capital export neutrality, while the business community generally leans toward capital import 

neutrality. (It has also been argued that these concepts are inadequate, and too indeterminate to 

be of any use in formulating policy in the first place, but this is a minority view in the relevant 

literature.) 

Simplicity in compliance and administration 

Some argue that territorial tax systems are less complex from an administrative and 

compliance standpoint than worldwide tax systems. It is certainly true that many complicated 

features of a worldwide system are not necessary in a pure territorial system. For example, the 

foreign tax credit and anti-deferral regimes, two of the most complex features of a worldwide tax 

system, are not necessary in a pure territorial system. However, as noted above, a pure territorial 

system is probably not workable, since the country’s tax base would be significantly eroded as 

residents shifted investments and activities abroad to low-tax jurisdictions. Thus, in order to 

make a territorial system work as a practical matter, various features of a worldwide system 

probably must be incorporated, which in turn adds back much of the complexity that a pure 

territorial system would avoid. For example, some set of rules similar to an anti-deferral regime 

(e.g., for passive income shifted to tax havens) would probably be necessary to protect the tax 

base, but once adopted, such a regime would add substantial complexity to the system, both in 

the complexity of the regime itself and in the collateral consequences of having such a regime, 

such as the need for a foreign tax credit or other mechanism to mitigate double taxation of the 

“tainted” income. In addition, since source of income would be the fundamental basis for 

taxation under a territorial system, the rules for sourcing income and expenses (e.g., interest 

expense), as well as the transfer pricing rules, would bear considerably more weight than they do 

under a worldwide system, and thus might need to become more complex to serve their 

expanded role. 
5

Source vs. residence as basis for taxation 

The concept of residence is the fundamental basis of taxation under a worldwide tax 

system, whereas a pure territorial system, by relying on source, renders the concept of residence 

generally irrelevant. Several commentators have argued that, as applied to corporations, the 

concept of residence is becoming meaningless as a practical matter, since large multinational 

corporations are becoming “nationless” in the sense that their shareholders, employees, business 

activities, and income are increasingly spread throughout the world, rather than concentrated 

predominantly in any one country. Since concepts that are meaningless in the real world 

probably should not dictate tax consequences, the de-emphasis of residence is arguably one 

advantage of a territorial system. Of course, in a territorial system that incorporates some 

attributes of a worldwide system, the concept of residence would become important again, 

although probably less so than under a predominantly worldwide system. 

D. Methods of Implementing a Territorial Tax System

Exempt all foreign-source income 

A pure territorial tax system would simply exempt all foreign-source income from 

residence-country tax.

Exempt only active foreign-source income 

A modified territorial tax system might exempt only active foreign-source income, but 

tax passive (or other highly mobile) foreign-source income.

Exempt only high-taxed foreign-source income 

Another approach could be to exempt only foreign-source income that is subject to a 

certain minimum effective foreign tax rate, and to tax foreign-source income that is subject to 

foreign tax below that rate.

Exempt only certain kinds of foreign-source income 

Another approach would be to exempt limited categories of foreign-source income, such 

as income from e-commerce transactions.

Exempt only income derived from certain countries 

Yet another approach might be to exempt only income earned in a country with which the 

United States has a tax treaty, or simply to extend more favorable treatment to such income if a 

broader exemption system were adopted (e.g., by not subjecting the exemption to a high-tax test 

in the case of income derived in a treaty country, if the high-tax variation described above were 

adopted). Alternatively, a broad exemption system could be adopted, but income derived in tax 

havens could be excepted from the system (a “blacklist” approach).
6

Exemption with progression 

No matter how broadly or narrowly the class of exempt income is defined, a further 

possibility is to employ an exemption system in which the exempt foreign-source income, while 

not taxed, is nevertheless considered in determining the taxpayer’s position on a progressive 

marginal rate schedule, thus affecting the rate that applies to the taxpayer’s local-source income. 

The rationale for this approach would be to preserve as much progressivity as is possible under a 

territorial tax system.

“Participation exemption” systems 

Many countries (including several in Europe) tax resident multinational enterprises on a 

predominantly territorial basis by exempting dividends received from certain foreign subsidiaries 

from residence-country tax. The exemption typically applies only where the parent company’s 

ownership (“participation”) in the subsidiary exceeds a certain threshold (commonly 5-10 

percent), reflecting an intent not to extend territorial principles to portfolio-type investments. 

The exemption may be total or partial (e.g., only 95 percent, or 60 percent, of qualifying 

dividends might be exempted), and other restrictions generally apply, in order to limit the 

exemption to certain categories of income (e.g., active income) and to address concerns about 

shifting income to tax havens. The exemption also may or may not be extended to gains on the 

sale of a participation interest. A participation exemption system generally provides a significant 

degree of territoriality with respect to parent companies that receive mainly dividend income 

from their foreign subsidiaries; much less territoriality is achieved with respect to parent 

companies that receive large volumes of other types of income (e.g., royalties) from their foreign 

subsidiaries, and indeed these latter companies may even be better off under the present-law 

credit system than under a participation exemption system. 

As a mechanical matter, a participation exemption system might be implemented via a 

dividends-received deduction. For example, existing dividends-received deduction rules in the 

United States could be modified to extend to certain dividends received by U.S. corporations 

from their foreign subsidiaries.

Transition issues 

A shift from a predominantly worldwide to a predominantly territorial tax system would 

raise a number of transition issues. For example, it is not clear how the pre-exemption-system 

deferred income of controlled foreign corporations would be treated. Options would include 

exempting such income entirely, taxing it upon repatriation, or taxing it immediately as a “toll 

charge” into the new exemption-based system. Pre-exemption-system losses would raise similar 

issues.

E. Other Issues Raised by a Shift to a Territorial System

U.S. employment and “runaway plants”

Some would argue that a shift to a territorial system, by exempting income earned 

overseas, would encourage U.S. companies to move plants (and thus jobs) abroad. Others would 

respond that, under the present worldwide system that allows deferral of income earned abroad 
7

through a foreign corporate entity, these incentives already exist, particularly in the case of 

favorable source-country tax regimes for various types of manufacturing income. Nevertheless, 

it seems likely that the adoption of a territorial system would not alleviate, and could very well 

exacerbate, this problem. On the other hand, the adoption of a territorial system also would 

arguably make the United States a more attractive place in which to incorporate, which may help 

to create or preserve various “headquarters” jobs, such as R&D, financial, corporate, and other 

administrative services. This could arguably help to halt or reverse the recent trend toward 

“corporate expatriation” from the United States, via cross-border mergers or otherwise.

Tax competition 

Some argue that if the United States and other major home countries of multinational 

enterprises were to adopt territorial tax systems, tax competition would intensify. Without the 

constraint of some residence-based taxation of foreign-source income, a major barrier to tax 

competition would be removed, and a “race to the bottom” would arguably ensue. Some would 

argue that this state of affairs would be intolerable, and that some sort of concerted effort, 

through the OECD or otherwise, would be necessary to ensure an adequate level of tax revenues 

to finance necessary government operations throughout the world. Others would find nothing 

objectionable in the prospect of increased tax competition, and would reject any effort to prevent 

a country from determining its own tax rules and rates.

Tax treaties 

The United States has an extensive network of bilateral tax treaties. These treaties are 

based on the fundamental premise that the United States has a worldwide tax system. A switch 

to a territorial system would require existing tax treaties to be renegotiated, at significant expense 

both to the country and to our trading partners.

F. Relationship of Territorial-vs.-Worldwide Debate

to WTO Dispute over FSC/ETI 

Exports under a territorial system 

Many countries, including several EU countries, base their tax systems on territorial 

principles to a greater extent than the United States does. By exempting foreign-source income 

to varying degrees, such countries’ tax systems arguably provide an incentive for their exports 

(as well as other foreign-related business activities of their residents). The extent of this arguable 

export benefit depends on both the definition of exports and the sourcing rules applicable to 

them. 

Exports under a worldwide system 

The United States, on the other hand, bases its tax system on the worldwide principle to a 

greater extent. Thus, the basic U.S. tax system does not include an inherent export incentive like 

the more territorial-based systems arguably do. In part for this reason, the United States has in 

the past provided special tax regimes designed to encourage U.S. exports -- specifically the 

domestic international sales corporation (“DISC”) and foreign sales corporation (“FSC”) 

regimes.
8

FSC/ETI disputes 

The FSC regime was enacted in 1984 in response to concerns that the DISC regime 

violated the General Agreement on Tariffs and Trade (“GATT”). In 1999, the World Trade 

Organization (“WTO”), in response to EU complaints, held that the FSC regime constituted an 

illegal export subsidy under the relevant WTO agreements. In 2000, the United States repealed 

the FSC regime and enacted an exclusion for “extraterritorial income” (“ETI”). The EU 

immediately challenged the ETI regime in the WTO, and in January of 2002 a WTO Appellate 

Body held that the ETI regime also constituted a prohibited export subsidy under the relevant 

trade agreements.2

Implications of WTO rulings 

The United States has consistently taken the view that these regimes (DISC, FSC, ETI) 

were designed merely to approximate in a worldwide system the benefits inherent in a more 

territorial-based system, and thus to allow U.S. companies to compete on an equal footing with 

companies resident in the more territorial-based countries. Indeed, on a technical level, the ETI 

system was structured as a partial territorial system for certain kinds of income. The WTO, 

however, found this difference unpersuasive in determining whether the ETI regime complied 

with U.S. obligations under international trade law. As a result of the WTO decision, countries 

with predominantly worldwide tax systems are arguably placed at a disadvantage relative to 

countries with more territorial-based tax systems. In other words, the more territorial-based 

systems are arguably allowed to provide an inherent export incentive without violating 

international trade law, while attempts to replicate this benefit under a more worldwide-based 

system have been found to violate this law. Moreover, countries that impose a value-added tax 

(“VAT”) commonly provide for “zero-rating” of export sales, pursuant to which exporters 

receive a VAT rebate. This practice arguably also constitutes an export subsidy, but as an 

“indirect” tax, the VAT lies beyond the reach of existing WTO agreements, which address only 

“direct” taxes such as an income tax.

Relevance of WTO rulings to U.S. choice of overall tax framework 

Some would argue that, given the current state of international trade law as reflected by 

the WTO’s report on the ETI regime, it might make sense for the United States to consider 

shifting to a more territorial-based system (or, for that matter, to a VAT-based system), in order 

to allow U.S. companies to compete on an equal footing with other companies without running 

afoul of international trade law. However, others would argue that the benefits provided by the 

FSC and ETI regimes, and potentially provided under a more heavily territorial system, represent 

only one consideration among many in evaluating a fundamental shift in the country’s entire tax 

framework. In dollar terms, the principal companies and activities that have benefited from the 

FSC and ETI regimes represent a relatively small portion of overall U.S. trade flows. Thus, 

 

2

 For a more detailed discussion of the FSC/ETI dispute, see Joint Committee on 

Taxation, The U.S. International Tax Rules: Background, Data, and Selected Issues Relating to 

the Competitiveness of U.S.-Based Business Operations (JCX-67-03), July 3, 2003.
9

some would argue that it would not be prudent to make a fundamental change to the entire tax 

system on the basis of this narrower set of concerns.

Some would argue that the competitiveness, complexity, and other concerns raised by 

U.S.-based multinational enterprises could be adequately addressed within the framework of the 

present system through a number of incremental changes. Indeed, some may even regard such 

incremental changes as constituting an appropriate and adequate response to the loss of the FSC 

and ETI regimes. In this regard, many different incremental changes have been proposed in 

recent years, mostly affecting two key areas of the U.S. international tax system: the foreign tax 

credit and the anti-deferral regime. Some of the major proposals in this regard are described in 

part IV, below.
10

II. OVERVIEW OF THE U.S. INTERNATIONAL TAX SYSTEM

A. Tax Treatment of Foreign Activities of U.S. Persons

In general

Under the U.S. worldwide tax system, domestic corporations generally are taxed on all 

income, whether derived in the United States or abroad. Income earned by a domestic parent 

corporation from foreign operations conducted by foreign corporate subsidiaries generally is 

subject to U.S. tax when the income is distributed as a dividend to the domestic corporation. 

Until such repatriation, the U.S. tax on such income generally is deferred. However, certain 

anti-deferral regimes may cause the domestic parent corporation to be taxed on a current basis in 

the United States with respect to certain categories of passive or highly mobile income earned by 

its foreign subsidiaries, regardless of whether the income has been distributed as a dividend to 

the domestic parent corporation. The main anti-deferral regimes in this context are the 

controlled foreign corporation rules of subpart F3

 and the passive foreign investment company 

rules.4 A foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed 

on foreign-source income, whether earned directly by the domestic corporation, repatriated as an 

actual dividend, or included under one of the anti-deferral regimes.5

Foreign tax credit

The United States generally provides a credit for foreign income taxes paid or accrued.6 

In the case of foreign income taxes paid or accrued by a foreign subsidiary, a U.S. parent 

corporation is generally entitled to a “deemed paid” credit for such taxes when it receives an 

actual or deemed distribution of the underlying earnings from the foreign subsidiary.7 The 

foreign tax credit generally is limited to the U.S. tax liability on a taxpayer’s foreign-source 

income, in order to ensure that the credit serves its purpose of mitigating double taxation of 

foreign-source income without offsetting the U.S. tax on U.S.-source income.8 

Due to this limitation, a taxpayer must allocate gross income and expenses between U.S. 

and foreign sources in order to determine the amount of allowable foreign tax credits. Under 

present law, interest expense that a U.S.-based multinational corporate group incurs in the United 

States is allocated to U.S. and foreign sources based on the gross assets located in the United 

States relative to those located abroad (measured either by basis or by fair market value), without 

 

3

 Secs. 951-964.

4

 Secs. 1291-1298.

5

 Secs. 901, 902, 960, 1291(g).

6

 Sec. 901.

7

 Secs. 902, 960.

8

 Secs. 901, 904. 
11

regard to any interest that the group incurs abroad.9 Thus, a U.S.-based multinational with a 

significant portion of its assets overseas must allocate a significant portion of its U.S. interest 

expense to foreign-source income, which reduces the foreign tax credit limitation and thus the 

credits allowable (even though the interest expense incurred in the United States is not deductible 

in computing the actual tax liability under applicable foreign law).

The foreign tax credit limitation is applied separately to different types of foreign-source 

income, in order to reduce the extent to which excess foreign taxes paid in a high-tax foreign 

jurisdiction can be “cross-credited” against the residual U.S. tax on low-taxed foreign-source 

income. For example, if a taxpayer pays foreign tax at an effective rate of 45 percent on certain 

active income earned in a high-tax jurisdiction, and pays little or no foreign tax on certain 

passive income earned in a low-tax jurisdiction, then the earning of the untaxed (or low-taxed) 

passive income could expand the taxpayer’s ability to claim a credit for the otherwise 

uncreditable excess foreign taxes paid to the high-tax jurisdiction, by increasing the foreign tax 

credit limitation without increasing the amount of foreign taxes paid. This sort of cross-crediting 

is constrained by rules that require the computation of the foreign tax credit limitation on a 

category-by-category basis.10 Thus, in the example above, the rules would place the passive 

income and the active income into separate limitation categories (or “baskets”), and the lowtaxed passive income would not be allowed to increase the foreign tax credit limitation 

applicable to the credits arising from the high-taxed active income. Present law provides nine 

separate baskets as a general matter, and effectively many more in situations in which various 

special rules apply.11

If a taxpayer generates an overall foreign loss (“OFL”) for the year -- whether as the 

result of business losses or expense allocations under U.S. tax rules -- it will not be able to claim 

foreign tax credits for that year, since it will have no foreign-source income and thus will have a 

foreign tax credit limitation of zero. Moreover, if the taxpayer does generate foreign-source 

income in later years, some portion of such income will be “recaptured,” or recharacterized as 

U.S.-source, thus reducing the foreign tax credit limitation in later years.12 The rationale for 

OFL recapture is that the foreign-source losses offset U.S.-source income in the year generated, 

thereby reducing the U.S. tax collected with respect to U.S.-source income. The U.S. fisc would

not be made whole when the taxpayer subsequently earns foreign-source income if the U.S. taxes 

on such income were completely offset by foreign tax credits.

 

9

 Sec. 864(e); Temp. Reg. sec. 1.861-11T.

10 Sec. 904(d).

11

 Id.

12 Sec. 904(f). These rules also operate on a category-by-category basis.
12

Anti-deferral regimes

In general

Generally, income earned indirectly by a domestic corporation through a foreign 

corporation is subject to U.S. tax only when the income is distributed to the domestic 

corporation, because corporations generally are treated as separate taxable persons for Federal 

tax purposes. However, this deferral of U.S. tax is limited by anti-deferral regimes that impose 

current U.S. tax on certain types of income earned by certain corporations, in order to prevent 

taxpayers from avoiding U.S. tax by shifting passive or other highly mobile income into low-tax 

jurisdictions. Deferral of U.S. tax is considered appropriate, on the other hand, with respect to 

most types of active business income earned abroad.

Subpart F

Subpart F,13 applicable to controlled foreign corporations and their shareholders, is the 

main anti-deferral regime of relevance to a U.S.-based multinational corporate group. A 

controlled foreign corporation generally is defined as any foreign corporation if U.S. persons 

own (directly, indirectly, or constructively) more than 50 percent of the corporation’s stock 

(measured by vote or value), taking into account only those U.S. persons that own at least 10 

percent of the stock (measured by vote only).14 Under the subpart F rules, the United States 

generally taxes the U.S. 10-percent shareholders of a controlled foreign corporation on their pro 

rata shares of certain income of the controlled foreign corporation (referred to as “subpart F 

income”), without regard to whether the income is distributed to the shareholders.15 

Subpart F income generally includes passive income and other income that is readily 

movable from one taxing jurisdiction to another. Subpart F income consists of foreign base 

company income,16 insurance income,17 and certain income relating to international boycotts and 

other violations of public policy.18 Foreign base company income consists of foreign personal 

holding company income, which includes passive income (e.g., dividends, interest, rents, and 

royalties), as well as a number of categories of non-passive income, including foreign base 

company sales income, foreign base company services income, foreign base company shipping 

income and foreign base company oil-related income.19 

 

13 Secs. 951-964.

14 Secs. 951(b), 957, 958.

15 Sec. 951(a).

16 Sec. 954.

17 Sec. 953.

18 Sec. 952(a)(3)-(5).

19 Sec. 954.
13

In effect, the United States treats the U.S. 10-percent shareholders of a controlled foreign 

corporation as having received a current distribution out of the corporation's subpart F income. 

In addition, the U.S. 10-percent shareholders of a controlled foreign corporation are required to 

include currently in income for U.S. tax purposes their pro rata shares of the corporation's 

earnings invested in U.S. property. 20

Passive foreign investment companies

The Tax Reform Act of 1986 established an anti-deferral regime for passive foreign 

investment companies. A passive foreign investment company generally is defined as any 

foreign corporation if 75 percent or more of its gross income for the taxable year consists of 

passive income, or 50 percent or more of its assets consists of assets that produce, or are held for 

the production of, passive income.21 Alternative sets of income inclusion rules apply to U.S. 

persons that are shareholders in a passive foreign investment company, regardless of their 

percentage ownership in the company. One set of rules applies to passive foreign investment 

companies that are “qualified electing funds,” under which electing U.S. shareholders currently 

include in gross income their respective shares of the company’s earnings, with a separate 

election to defer payment of tax, subject to an interest charge, on income not currently 

received.22 A second set of rules applies to passive foreign investment companies that are not 

qualified electing funds, under which U.S. shareholders pay tax on certain income or gain 

realized through the company, plus an interest charge that is attributable to the value of 

deferral.23 A third set of rules applies to passive foreign investment company stock that is 

marketable, under which electing U.S. shareholders currently take into account as income (or 

loss) the difference between the fair market value of the stock as of the close of the taxable year 

and their adjusted basis in such stock (subject to certain limitations), often referred to as 

“marking to market.”24

Coordination

Detailed rules for coordination among the anti-deferral regimes are provided to prevent 

U.S. persons from being subject to U.S. tax on the same item of income under multiple regimes. 

For example, a corporation generally is not treated as a passive foreign investment company with 

respect to a particular shareholder if the corporation is also a controlled foreign corporation, and 

the shareholder is a “U.S. shareholder” as defined in section 951(b). Thus, subpart F is allowed 

to trump the passive foreign investment company rules. 

 

20 Secs. 951(a)(1)(B), 956.

21 Sec. 1297.

22 Sec. 1293-1295.

23 Sec. 1291.

24 Sec. 1296.
14

B. Tax Treatment of U.S. Activities of Foreign Persons

The United States asserts taxing jurisdiction over nonresident alien individuals and 

foreign corporations (“foreign persons”) only with respect to income that has a sufficient nexus 

to the United States. Foreign persons are subject to U.S. tax on income that is “effectively 

connected” with the conduct of a trade or business in the United States. Effectively connected 

income generally is taxed in the same manner and at the same rates as the income of a U.S. 

person.

Foreign persons are also subject to a gross-basis U.S. tax at a 30-percent rate on certain 

categories of non-effectively-connected income derived from U.S. sources (interest, dividends, 

rents, royalties, and other similar types of income), subject to a few exceptions. One major 

exception is that certain types of interest (for example, interest from certain bank deposits and 

from certain portfolio obligations) are not subject to the tax. The tax generally is collected by 

means of withholding by the person making the payment to the foreign person receiving the 

income.

C. Transfer Pricing

Due to the variation in tax rates and tax systems among countries, a multinational 

enterprise, whether U.S.-based or foreign-based, may have an incentive to shift income, 

deductions, or tax credits among commonly controlled entities in order to arrive at a reduced 

overall tax burden. Such a shifting of items between commonly controlled entities could be 

accomplished by establishing artificial, non-arm’s-length (i.e., non-market) prices for 

transactions between group members.

Under section 482, the Secretary of the Treasury is authorized to redetermine the income 

of an entity subject to U.S. taxation when necessary to prevent an improper shifting of income 

between that entity and a commonly controlled entity. The statute generally does not prescribe 

any specific reallocation rules that must be followed, other than establishing the general 

standards of preventing tax evasion and clearly reflecting income. Treasury regulations adopt 

the concept of an arm's length standard as the method for determining whether reallocations are 

appropriate. Thus, the regulations generally attempt to identify the respective amounts of taxable 

income of the related parties that would have resulted if the parties had been uncontrolled parties 

dealing at arm's length. Special transfer pricing rules apply to transactions involving intangible 

property and services. These transactions present particular challenges to the administration of 

the arm’s length standard, since intangibles and services may be unique, thus rendering a 

comparison with third-party market transactions difficult or impossible. 

D. Treaties

In addition to the U.S. and foreign statutory rules for the taxation of foreign income of 

U.S. persons and U.S. income of foreign persons, bilateral income tax treaties limit the amount 

of income tax that may be imposed by one treaty partner on residents of the other treaty partner. 

For example, treaties often reduce or eliminate withholding taxes imposed by a treaty country on 

certain types of income (e.g., dividends, interest and royalties) paid to residents of the other 

treaty country. Treaties also contain provisions governing the creditability of taxes imposed by 
15

the treaty country in which income was earned in computing the amount of tax owed to the other 

country by its residents with respect to such income. Treaties further provide procedures under 

which inconsistent positions taken by the treaty countries with respect to a single item of income 

or deduction may be mutually resolved by the two countries.
16

III. DISCUSSION OF ECONOMIC ISSUES RELATED

TO THE POSITION OF THE UNITED STATES IN THE GLOBAL ECONOMY

A. Is U.S. Business Competitive in the Global Economy?

For a number of years policymakers, business groups, and economists have argued that 

improving the international competitiveness of the economy of the United States should be a 

major policy goal. This focus on competitiveness is certainly related to some of the economic 

trends of the past two decades: large U.S. trade deficits; large inflows of foreign investment in

the Unites States; and low national saving rates.25 Cross-border mergers of recent years and 

cases of corporate inversions to re-incorporate outside the United States have heightened interest 

regarding the position of the United States in the global economy. Although the term 

“competitiveness” is used frequently, it does not have a consistent definition. The term 

“competitiveness” encompasses different concepts. This section briefly explores various 

meanings commonly given to the term “competitiveness” in writings on U.S. economic policy.

Trade competitiveness

One definition of competitiveness is the ability of firms located in the United States to 

sell their output in foreign markets and to compete in domestic markets with output produced in 

foreign countries. Trade competitiveness often is measured by the U.S. trade deficit. 

A trade deficit is not necessarily undesirable. For example, if a country uncovers 

profitable investment opportunities, then it will be in that country’s interest to obtain funds from 

abroad to invest in these profitable projects. In this situation, investment will exceed saving, and 

the initial effect of the foreign capital inflow will be a trade deficit. The investment, however, 

will lead to increased income and an increased standard of living in the future. If foreign 

borrowing finances consumption instead of investment, there are no new assets created to 

generate a return which can support the borrowing; when the debt is eventually repaid, the 

repayments will come at the expense of future consumption.

Standard of living competitiveness 

A second definition of competitiveness does not focus specifically on international trade 

and investment. Instead, this measure of competitiveness compares the current U.S. living 

standard and the prospects for future U.S. living standard with those of other countries. This 

measure focuses on the productivity growth of U.S. labor and the savings rate of the United 

States, because both of these factors affect future living standards. According to this concept of 

competitiveness, policy goals should not focus primarily on either the trade surplus or deficit, or 

on capital flows between nations, though both of these may be useful as indicators of the success 

of more fundamental policies. 

 

25 Joint Committee on Taxation, The U.S. International Tax Rules: Background, Data, 

and Selected Issues Relating to the Competitiveness of U.S.-Based Business Operations (JCX67-03), July 3, 2003, reviews the trends in trade deficits and cross-border investment flows.
17

There are a number of situations in which standard of living competitiveness is increased, 

but trade competitiveness may not be. Increases in natural resources, advances in technology, 

increases in worker efficiency, and other wealth-enhancing innovations have ambiguous effects 

on the trade deficit in the short and medium run. Because these innovations increase the 

productivity of U.S. workers and lower production costs, they increase the attractiveness of U.S. 

goods, and may result in increased exports. To the extent these innovations increase the demand 

for investment, however, they can have the opposite effect on the trade deficit. Nonetheless, 

each of these innovations increases the standard of living competitiveness of the United States, 

because each of these increases the output of the economy, and hence the incomes of U.S. 

residents. On the other hand, current standards of living do not provide a sufficient measure of 

competitiveness because a nation can maintain high standards of living for a fairly long time by 

running large trade deficits. Eventually, large trade deficits that finance consumption will reduce 

a nation’s standard of living.

Multinational competitiveness

A third definition of U.S. competitiveness is the ability of U.S. multinational businesses 

(businesses headquartered in the United States that operate abroad) that locate production 

facilities overseas to compete in foreign markets. Overseas production facilities owned by U.S. 

interests may compete with firms owned by residents of the host country or with multinational 

firms based in other countries. This definition of competitiveness focuses on the after-tax returns 

to investment in production facilities abroad. Some also apply this notion of “competitiveness” 

to the ability of U.S.-based multinational businesses to compete in the United States with firms 

owned by multinational businesses headquartered abroad. Unlike the two previous notions of 

competitiveness, this notion does not appeal to macroeconomic measures, but relies on an 

industry-by-industry assessment. The United States could dominate world markets in one 

industry and be seen as very “competitive” while in another industry U.S. businesses could be 

losing market share everywhere.

B. Taxation and Investment in the Global Economy

International investment plays an important role in determining the total amount of 

worldwide income as well as the distribution of income across nations. In addition, international 

investment flows can substantially influence the distribution of capital and labor income within 

nations. Because each government levies taxes by its own method and at its own rates, the 

resulting system of international taxation can distort investment and contribute to reductions in 

worldwide economic welfare. A government's tax policies affect the distribution of income 

directly, by collecting tax from foreigners earning income within its borders and from residents 

earning income overseas, and indirectly by inducing capital movements across national borders.

The concepts of capital export neutrality and capital import neutrality

Capital movements across national borders in response to tax policy, rather than 

investment in response to pure economic fundamentals, reduce worldwide economic welfare. 

The nature of these economic distortions depends on the method of taxing income from 

international investment. If investment income is taxed only at the source, substantial amounts 

of capital could be diverted to jurisdictions with the lowest tax rates instead of flowing to 
18

investment projects with the highest pre-tax rate of return. If a system of residence taxation is 

the worldwide norm, 26 enterprises resident in low-tax countries might be able to attract more 

investment capital or perhaps increase their market share through lower prices to the detriment of 

enterprises resident in high-tax jurisdictions, even though the latter are more efficient. In either 

case, capital is diverted from its more productive uses, and worldwide income and efficiency 

suffer. The most straightforward solution to this problem is equalization of effective tax rates, 

but this may not be a practical solution given differences in national preferences for the amount 

and method of taxation. There is no consensus on what method of taxing international 

investment income minimizes distortions in the allocation of capital when nations tax income at 

different effective rates, but the alternatives of capital export neutrality and capital import 

neutrality are the most cited guiding principles. These two standards are each desirable goals of 

international tax policy. The problem is that, with unequal tax rates, these two goals are not 

mutually attainable. Satisfying both principles at the same time is possible only if effective tax 

rates on capital income are the same in all countries.

Capital export neutrality.–Capital export neutrality refers to a system under which an 

investor residing in a particular locality can locate investment anywhere in the world and pay the 

same tax. 

Capital import neutrality.–Capital import neutrality refers to a system under which 

income from investment located in each country is taxed at the same rate regardless of the 

residence of the investor.

Chart 1 below, compares capital export neutrality with capital import neutrality. The 

chart provides a taxonomy of the tax that would apply to income from an investment by location 

of the investment and by residence of the investor under the principle of capital export neutrality 

(panel a) and capital import neutrality (panel b). Tax rates are always equal for investors 

residing in the same country under capital export neutrality. Tax rates are always equal for 

investments located in the same country under capital import neutrality.

 

26

 The text envisions a system of residence taxation applied to enterprises. A pure 

residence system would fully integrate corporate and individual income taxes and tax individuals 

based upon their residence.
19

Chart 1.–The Principles of Capital Export Neutrality

and Capital Import Neutrality

a. Capital Export Neutrality

Domestic investor faces domestic tax rate no matter where investment is located. Foreign 

investor faces foreign tax rate no matter where investment is located. Foreign investment 

income is subject to foreign tax rate regardless of the residence of the taxpayer.

Location of Investment

Domestic Foreign

Domestic Tax income at 

domestic rate

Tax income at 

domestic rate Residence

of

Investor Foreign Tax income at

foreign rate

Tax income at

foreign rate

b. Capital Import Neutrality

Domestic investment income is subject to the domestic tax rate regardless of the 

residence of the taxpayer. Foreign investment income is subject to foreign tax rate regardless of 

the residence of the taxpayer.

Location of Investment

Domestic Foreign

Domestic Tax income at 

domestic rate

Tax income at 

foreign rate Residence

of

Investor Foreign Tax income at

domestic rate

Tax income at

foreign rate

Capital export neutrality and location of investment

Under capital export neutrality, decisions on the location of investment are not distorted 

by taxes. That is, all else being equal, the investor’s after-tax return would be equal regardless of 

location. Proponents of the capital export neutrality principle observe that this implies 

investments would be made only on the basis of pre-tax profit potential. Capital export 

neutrality is a principle describing how investors pay tax, not to whom they pay. Capital export 

neutrality primarily is a framework for discussing the efficiency and incentives faced by private 

investors, and not the distribution of the revenues and benefits of international investment. 
20

Tax systems may adhere to the principle of capital export neutrality by taxing worldwide 

income and granting credits for income and profits taxes paid to foreign governments. As an 

alternative to the system of foreign tax credits, capital export neutrality could be achieved with 

the source country relinquishing its jurisdiction to tax income derived from investments within 

its borders and allowing the country of residence the exclusive right to tax this income.

Capital import neutrality and location of investment

Under capital import neutrality, capital income from all businesses operating in any one 

locality is subject to uniform taxation. The nationality of investors in a particular locality will 

not affect the rate of tax. Capital import neutrality may be achieved by the residence country 

exempting income earned from foreign jurisdictions entirely from tax and allowing the source 

country's taxation to be the only taxation on the income of international investors. This is 

commonly referred to as a “territorial” or an “exemption” system of international taxation.

Commentators who address competitiveness in terms of multinational competitiveness 

state that the principle of capital import neutrality promotes the competitiveness of U.S.-based 

multinational businesses. Overseas production facilities owned by U.S. interests may compete 

with firms owned by residents of the host country or with multinational firms based in other 

countries. The notion of capital import neutrality promoting the competitiveness of such 

businesses focuses on the after-tax returns to investments in production facilities abroad. As 

described above, under the principle of capital import neutrality, any business would see the 

return from its investment in any given foreign country taxed only by that foreign country. 

Under present law, residual U.S. taxation in the case of a U.S. multinational may apply 

differently than residual taxation by another capital-exporting country. The result may be that 

the after-tax return to an investment by a U.S. multinational in a given foreign country may be 

less than the after-tax return earned by another investor, even if that investor makes an identical 

investment to that of the U.S. multinational. Some argue that this puts the U.S. multinational at a 

competitive disadvantage.

The concept of national neutrality

Because countries typically tax income arising within their borders, a nation can increase 

its income through policies that reduce outbound investment by its residents and encourage 

inbound investment by foreigners. This is the case even if net outbound investment is driven 

below the level that would prevail in a free and efficient international capital market. Promoting 

national economic interest may not coincide with promoting worldwide economic income.

In a world of source taxation, the national interest and the interests of outbound investors 

do not coincide. Outbound investment is only in the national interest if the return after foreign 

tax (but before domestic tax) equals or exceeds the before-tax return on domestic investment. To 

further its national interest, a government can reduce outbound investment by reducing the aftertax rate of return on outbound investment and driving its before-tax return above that on 

domestic investment. A government can penalize outbound investment by imposing a layer of 

taxation in addition to foreign taxation at source. This result can be achieved when a capitalexporting nation, in response to foreign source taxation, does not cede taxing jurisdiction over 
21

foreign source income (for example, through a foreign tax credit) and allows only a deduction for 

foreign taxes.27

The policy of allowing only deductions for foreign taxes is sometimes known as 

“national neutrality.” A deduction penalizes outbound investment and aligns the interests of the 

taxpayer with the interests of its home country, but only at the expense of reduced worldwide 

economic welfare. Despite the potential to maximize national welfare, self-interested nations 

generally do not adopt tax systems designed to achieve national neutrality. There are at least 

three possible explanations for this. First, there is reason to expect that one nation's unilateral 

attempt to improve its own welfare through a policy of national neutrality would meet with 

retaliation by other nations with similar policies. Such tax competition would reduce worldwide 

income even further.28 If, on the other hand, nations can coordinate their tax policies, a tax 

system can be designed to increase worldwide income above the inefficient level produced by 

national neutrality. With international coordination, there is potential for adopting a system in 

which worldwide income could be maximized (and, if necessary, redistributed) so all nations 

could be better off.

Second, the disincentives to outbound investment embodied in the concept of national 

neutrality only increase national welfare if outbound investment increases at the expense of 

domestic investment. If the economy responds to increased outbound investment with increased 

domestic saving instead of reduced domestic investment, policies to discourage outbound 

investment may have little positive effect on domestic labor and, furthermore, may reduce 

national welfare in addition to worldwide welfare.

Third, even if the first two rebuttals to national neutrality do not hold, there is some 

evidence that outbound investment increases exports by more than it increases imports.29 This 

increase in net exports may provide benefits to domestic labor and increase overall domestic 

income. If this is the case, policies discouraging outbound investment could increase the

merchandise trade deficit and reduce national output. 

The concept of capital ownership neutrality

Recently, some analysts have suggested that analysis of cross-border investment and tax 

policy should not be analyzed solely in terms of the location of investments, but rather by the 

 

27 Several authors provide a description of how deductions for foreign taxes maximize 

domestic welfare of a capital-exporting country. See Richard E. Caves, Multinational 

Enterprises and Economic Analysis, (Cambridge, England: Cambridge University Press), 1982, 

pp. 229-231; and Peggy B. Musgrave, United States Taxation of Foreign Investment Income: 

Issues and Arguments, (Cambridge, Massachusetts: International Tax Program, Harvard Law 

School), 1969, p. 134.

28 In the context of international trade, policies that attempt to promote domestic 

economic welfare at the expense of the rest of the world are referred to as “beggar-thy-neighbor” 

policies.

29 See discussion below of foreign direct investment and domestic investment.
22

ownership of investments in addition to the location of those investments.30 They argue that 

economic efficiency would be promoted if the tax system does not distort the ownership pattern 

of investments, that is, an efficient system would promote capital ownership neutrality. The 

underlying premise of this notion of neutrality is that the same units of physical capital (plant and 

equipment) will have different levels of productivity and profitability, depending upon who owns 

that capital and manages its operation. The differences in productivity from a given production 

facility may result from proprietary intangible assets of the owners.31 If the productivity and 

profitability, of physical assets depends upon the intangible assets of those who own and manage 

the assets, efficiency is improved if those who possess the proper intangible assets that will 

permit the greatest productivity from the physical assets own the physical assets. If the tax 

system dissuaded the potentially most productive owners from owning any particular physical 

assets, wherever located, then economic efficiency would be diminished. Capital ownership 

neutrality would be sustained if all countries were to tax foreign income, but permit a full foreign 

tax credit. Likewise, if all countries were to exempt foreign income from their tax base, capital 

ownership neutrality would be sustained. In each circumstance, ownership would be determined 

by productivity differences and not tax differences.32 In either circumstance, if any country’s tax 

policy deviated from conformity, ownership neutrality could not be achieved. 

 

30 Mihir A. Desai and James R. Hines, Jr., “Evaluating International Tax Reform,” 

National Tax Journal, forthcoming, September 2003. 

31 Some argue that much cross border investment by multinational businesses is 

motivated because these businesses possess intangible assets such as patents, trade names, and 

proprietary production skills. The purchase of an under-performing existing business’s physical 

plant allows the owner of these intangible assets the ability to quickly earn returns on these 

intangible assets and know-how in foreign markets. For example, see Richard E. Caves, 

Multinational Enterprise and Economic Analysis, (Cambridge, U.K.: Cambridge University 

Press), 1996. 

32 Desai and Hines, “Evaluating International Tax Reform.” In the first case, involving 

taxation of foreign source income and a full tax credit, the tax systems of all countries would be 

consistent with the principle of capital export neutrality. In the second case, involving the 

exemption of foreign source income, the tax systems of all countries would be consistent with 

the principle of capital import neutrality. Each case would result in the multinational enterprise 

being subject to only the tax imposed by the residence country. In either case the rates of tax 

imposed by different countries could be different and ownership neutrality would be sustained. 

This could lead to distortions in the geographic location of physical investment, but not in the 

ownership of the physical investment. Desai and Hines write, “Whether the [efficiency] cost of 

having too many factories in the Bahamas is larger or smaller than the cost of discouraging 

value-enhancing corporate acquisitions is ultimately an empirical question, though the 

importance of ownership to FDI [foreign direct investment] suggest that its welfare impact may 

also be substantial.”
23

Foreign direct investment and domestic investment

Some argue that if U.S. multinationals were exempted from the U.S. corporate tax on 

their foreign-source income, the after-tax return to establishing facilities overseas would be 

increased and U.S. multinational corporations would substitute investment in foreign facilities 

for investment in domestic facilities. For example, instead of manufacturing products in the 

United States and selling the products domestically and exporting products abroad, a firm might 

choose to locate production facilities abroad and import some products back to the United States 

and serve overseas markets from the foreign location. 33

Others argue that foreign direct investment undertaken by U.S. persons is not a substitute 

for U.S. domestic investment, but rather is a complement to U.S. domestic investment. They 

note that a foreign production facility can be a major source of demand for components from its 

U.S. affiliate and that the foreign production affiliate relies on U.S.-based research facilities and 

headquarters operations. If a foreign production facility fosters overall demand for the firm’s 

products, then investment in the U.S.-based component facilities, research facilities, and 

headquarters operations will be required to sustain the increased worldwide demand.

Empirical studies have attempted to examine whether foreign direct investment is a 

substitute for or complement of domestic investment. A decade ago the President’s Council of 

Economic Advisors concluded, “On a net basis, it is highly doubtful that U.S. direct investment 

abroad reduces U.S. exports or displaces U.S. jobs.”34 Generally, empirical studies find either 

no effect or a positive effect of overseas production in a host-county market on home-country 

exports to that market. One survey of the empirical literature reports that, on average, studies 

find one dollar of overseas production by U.S. affiliates generates $0.16 of exports from the 

United States.35 The evidence suggests that overseas production does displace certain types of 

domestic production as the parent firm shifts to more capital intensive and skill intensive 

domestic production. 36 

There is no definitive conclusion about the effect of outbound investment on U.S. 

employment. The same survey concludes, “[T]he evidence suggests that the effect of overseas 

production on the home-country labor market involves the composition of a firm’s home 

employment rather than the total amount. That change in composition is mainly a shift toward 

 

33 This possibility is often referred to as a “run-away plant.”

34 Council of Economic Advisers, Economic Report of the President, (Washington, D.C.: 

U.S. Government Printing Office), February 1991, p. 259. The report also surveys some of the 

evidence on the economic effects of outbound investment.

35 Robert E. Lipsey, “Outward Direct Investment and the U.S. Economy,” in Martin 

Feldstein, James R. Hines, Jr., and R. Glenn Hubbard (eds.), The Effects of Taxation on 

Multinational Corporations, (Chicago: University of Chicago Press), 1995. In a more recent 

survey, Lipsey reaches similar conclusions. Robert E. Lipsey, “Home and Host Country Effects 

of FDI,” National Bureau of Economic Research Working Paper No. 9293, October 2002.

36 Lipsey, “Home and Host Country Effects of FDI.”
24

more managerial and technical employment....”37 However, most of the evidence on this subject 

examines individual industries rather than aggregate economic effects. In aggregate, it is clear 

that U.S. manufacturing employment has fallen among U.S.-owned manufacturing enterprises, 

but the decline has been largely offset by employment at foreign-owned manufacturing facilities 

located in the United States.38

Summary

A government can implement capital export neutrality by taxing worldwide income of its 

residents but also allowing credits for taxes paid to foreign governments. Alternatively, a 

government can implement national neutrality by replacing credits with deductions for foreign 

taxes. Finally, a government can implement capital import neutrality by exempting all foreign 

source income from tax. Coordinated tax policies across capital exporting and importing 

countries would be necessary to attempt to achieve capital ownership neutrality. Because 

national neutrality is less generous to taxpayers than capital export neutrality, deviations from 

capital export neutrality that increase taxes on foreign income move the U.S. system closer to a 

system of national neutrality. Conversely, since capital import neutrality is often more generous 

to taxpayers than capital export neutrality, deviations from capital export neutrality that decrease 

tax on foreign income move the U.S. system closer to a system of capital import neutrality.

C. Characterization of the U.S. System of Taxation of Cross-Border

Transactions and Investments

As a whole, the U.S. system of taxation is a hybrid containing elements consistent with 

both capital import neutrality and capital export neutrality. With regard to the relative treatment 

of domestic and outbound investment, some provisions work at cross-purposes. Some provisions 

of current law favor outbound investment, while others discourage it.

Deferral of tax on foreign income

Income from outbound investments earned by the separately incorporated foreign 

subsidiaries of U.S. corporations generally is not subject to tax until that income is repatriated. 

However, income from foreign branches of U.S. corporations must be included in current taxable 

income. The majority of foreign business activity controlled by U.S. corporations is conducted 

by separate foreign corporations as opposed to branches. In 1998, the largest 7,500 CFCs of 

U.S. multinationals reported $143.8 billion of earnings and profits from gross receipts of $1.7 

 

37 Lipsey, “Outward Direct Investment and the U.S. Economy,” p. 31. One recent study 

does find some substitution of foreign labor for U.S. labor but characterizes the degree of 

employment substitution as low between domestic and foreign affiliates, finding greater labor 

substitution between employees in different developing countries. See, S. Lael Brainard and 

David A. Riker, “Are U.S. Multinationals Exporting U.S. Jobs?” National Bureau of Economic 

Research Working Paper No. 5958, March 1997.

38 Lipsey, “Home and Host Country Effects of FDI.”
25

trillion and paid $34.7 billion of foreign income taxes.39 Foreign branches of U.S. multinationals 

reported $87.3 billion of gross branch income and paid $4.9 billion of foreign income taxes.40 

If, for a particular taxpayer, the effective rate of foreign tax can be expected to be 

consistently above the U.S. rate, deferral of U.S. taxes would not provide any tax benefit. 

However, if the effective rate of foreign tax is at any time or in any jurisdiction below the U.S. 

rate, U.S. multinationals may enjoy two substantial benefits from deferral. First, deferral may 

delay the payment of U.S. taxes on foreign source income until earnings are repatriated. Second, 

because excess foreign tax credits cannot be carried forward indefinitely, deferral expands the 

opportunity for cross-crediting (if effective foreign tax rates vary across years or across 

jurisdictions) by not deeming high foreign taxes to be paid until a year when the U.S. taxpayer 

chooses also to repatriate low-taxed foreign source income.41 The benefit from the deferral of 

tax until foreign earnings are repatriated may be viewed as similar to the benefit enjoyed from 

delaying realizations of capital gains. As with capital gains, one method of eliminating the tax 

benefit of deferral is the payment of taxes on income as it is earned, rather than when payment is 

received. This is achieved, in limited circumstances, by the various anti-deferral regimes in the 

Code.

Deferral does, however, impose costs on taxpayers. For example, subpart F, and its 

interactions with the credit rules and the other anti-deferral rules, are considered highly 

complex. 42 In addition, the interest allocation rules, by precluding full worldwide fungibility of 

interest among commonly controlled domestic and foreign subsidiaries, may impose costs on a 

U.S. corporation that operates through foreign subsidiaries, which costs might be avoided by 

operating through foreign branches of a U.S. corporation.

To the extent that deferral continues to provide an advantage to outbound investment, this 

advantage provides an incentive for outbound investment and therefore moves the U.S. system of 

 

39 John Comiskey, “Controlled Foreign Corporations, 1998,” Statistics of Income 

Bulletin, 22, Winter 2002-2003, pp. 47-86.

40 Rob Singmaster and Andrea Heilbroner, “Corporate Foreign Tax Credit, 1998,” 

Statistics of Income Bulletin, 22, Fall 2002, pp. 177-247.

41 This second benefit is in some degree limited by the less generous foreign tax credit 

carryover periods (back two years and forward five years) as compared to the net operating loss 

carryover periods (back two years and forward 20 years). For example, when a U.S. source loss 

for a year in which foreign source income is earned renders the crediting of foreign tax paid or 

deemed paid in that year unnecessary, the effect of the foreign income and taxes is to convert a

loss, usable over the next 20 years, into a credit carry forward, usable only over the next five 

years. Thus, while deferral makes it possible for the taxpayer to choose the year in which the tax 

will be deemed paid, the reduced carry forward period prevents the taxpayer from also enjoying 

the flexibility to use its excess credits over the full 20 years accorded to losses.

42

 E.g., David Tillinghast, "International Tax Simplification," 8 American Journal of Tax 

Policy, 8, 1990, pp. 187-190.
26

taxation of foreign income closer to capital import neutrality and away from capital export 

neutrality. Deferral provides an incentive for outbound investment, but restrictions on deferral 

negate this incentive.

Foreign tax credit limitation

For taxpayers in an excess foreign tax credit position (that is, taxpayers with creditable 

foreign taxes in excess of the foreign tax credit limitation), tightening limitations on the foreign 

tax credit may, when foreign laws are taken into account and are assumed not to change as a 

result of the tightening, result in discouraging outbound investment and encouraging domestic 

investment. In order for a credit system of foreign taxation to be fully consistent with capital 

export neutrality where it is assumed that no changes in source country law are possible, 

unlimited credits for foreign tax payments against residence country tax liability would have to 

be available to taxpayers in their country of residence. This would include a grant by the 

residence country to the taxpayer of the amount, if any, by which such source country tax 

exceeds residence country tax. In other words, for a credit system of outbound taxation to be 

fully capital-export neutral, the residence country must be willing to relinquish tax jurisdiction 

over domestic income.

It is important to recognize that when the foreign tax credit limitation is binding, the 

disincentive to outbound investment results primarily from foreign effective rates of tax in 

excess of the domestic rate. The only “fault” of the foreign tax credit limitation in the context of 

capital export neutrality is that subsidies are not provided in the form of foreign tax credits in 

excess of domestic tax liability. The reduced availability of foreign tax credits may, however, be 

accompanied by reductions in effective foreign tax rates.

In 1921, three years after the foreign tax credit was first made available to U.S. taxpayers, 

the credit was limited to the amount of tax that would be paid at domestic rates on foreign source 

income computed under U.S. tax rules. Taxpayers in an “excess limit”: position (that is, 

taxpayers with foreign tax credit limitation in excess of creditable taxes) have no incentive to 

reduce their foreign taxes, and foreign governments have no inducement to lower their income 

taxes on income earned by those U.S. taxpayers. Without the credit limitation, there would be no 

reasonable bound on the potential transfer of funds from the U.S. Treasury to foreign 

governments. To the extent of U.S. tax liability (before foreign tax credits), the level of foreign 

taxation would be a matter of indifference to the U.S. investor since increased foreign taxes 

effectively would be paid by the U.S. Treasury. 43 The foreign tax credit limitation is thus among 

the most important of a variety of revenue protection features of the U.S. system of international 

taxation. To the extent that U.S. tax rates fall relative to foreign tax rates, the importance of the 

foreign tax credit limitation increases.

 

43 In this case, the only limitation would be that foreign tax credits cannot exceed U.S. 

tax liability.
27

Cross-crediting of foreign taxes

In its 1984 tax reform proposals, the Treasury Department proposed a per-country foreign 

tax credit limitation to replace the overall limitation which provided “many taxpayers a tax 

motivated incentive to invest abroad rather than in the United States.”44 This tax reform proposal 

addressed the use of high foreign taxes imposed by one country (i.e., taxes in excess of the U.S. 

rate) to offset U.S. tax on income earned by the same U.S. taxpayer in a low-tax country. This is 

sometimes referred to as “averaging” or “cross-crediting.”

The creation of new separate foreign tax credit baskets in the final version of the 1986 

Act reduced in a different way the ability of U.S. taxpayers to average foreign tax liability on 

highly taxed foreign income against the foreign tax liability on lightly taxed foreign income. For 

example, the passive income basket included in the 1986 Act reduced the incentive for U.S. 

taxpayers with excess foreign tax credits to reallocate funds from domestic uses to portfolio 

investments in low-tax countries. With an ability to “cross-credit” between taxes on active and 

passive income, a corporate taxpayer paying, for example, 45-percent tax on $100 of active 

income from one country would be able to make investments yielding $100 in another 

jurisdiction with a tax rate as high as 25 percent on investment income, and be subject only to 

foreign tax. The taxpayer in this instance has a tax incentive to invest abroad since his marginal 

rate of tax is 25 percent on outbound investment compared to 35 percent on domestic investment. 

Separate basketing requires an additional 10 percent of U.S. tax to be paid on this outbound 

investment.

In terms of the principles discussed above, limiting the ability to cross-credit moves the 

tax treatment of the marginal outbound investment by a U.S. investor away from capital import 

neutrality and toward capital export neutrality. On the other hand, under current U.S. law, 

taxpayers may cross-credit high foreign taxes paid to one country against U.S. tax on similar 

types of income earned in other low-tax foreign countries. Complete elimination of crosscrediting may be undesirable for administrative reasons, quite apart from issues of capital import 

and export neutrality. For example, substantial administrative issues could arise in the allocation 

and apportionment of foreign income of an integrated multinational business among separate 

foreign countries in which operations take place. Some of the separate foreign tax credit 

limitation rules of current law already create what may be regarded as undue complexity.

Creditability of subnational foreign taxes

Under present law, taxes paid by U.S. businesses to foreign governments that are by their 

nature taxes on income or profits, such as a corporate income tax, are fully creditable (within the 

foreign tax credit limitation) against Federal income taxes. This applies whether the tax is 

imposed by the national government or by a subnational government of that foreign country. 

However, income taxes paid by U.S. businesses to the States or to other subnational governments 

within the United States are only deductible against Federal income tax. Depending upon the 

rates of U.S. and foreign national and subnational taxes, this disparity in treatment of subnational 

 

44 U.S. Treasury Department, Tax Reform for Fairness, Simplicity, and Economic 

Growth, Vol. 2, 1984, p. 361.
28

taxes can create an incentive to invest overseas. This is the case when the foreign tax credit 

limitation is not binding and the overall (i.e., national and subnational combined) level of foreign 

income tax is lower than the level of U.S. Federal and local income tax.

To illustrate this point, assume that an investor can earn $100 before both national and 

local taxes from either a domestic or outbound investment, and that the rate of U.S. Federal 

income tax is 35 percent and the foreign national rate is 20 percent. Before taking into account 

other, subnational taxes, the U.S. taxpayer would earn $65 after-tax from either domestic or 

outbound investment. In the case of outbound investment, the investor pays $20 of tax to the 

foreign government and $15 (after foreign tax credits) to the U.S. government. Now assume that 

subnational governments in both the United States and the foreign jurisdiction impose a 10-

percent income tax. On domestic investment, the investor pays $31.50 of Federal tax (0.35 times 

$90) and $10 of subnational income tax, resulting in an effective rate of tax of 41.5 percent and 

leaving the investor with $58.50 after tax. On outbound investment, the investor pays $18 of tax 

to the foreign national government and $10 to the foreign subnational government. Because the 

total foreign tax paid does not exceed the foreign tax credit limitation, all the foreign taxes are 

creditable. The taxpayer owes $7 to the U.S. government and is left with $65 after tax.
29

IV. RECENT COMPETITIVENESS AND SIMPLIFICATION PROPOSALS

A. Proposals Relating to the Foreign Tax Credit

Background

Since the United States taxes its citizens and residents on their worldwide income, and 

the countries in which such income is earned generally also assert their jurisdiction to tax the 

same income on the basis of source, cross-border income earned by U.S. persons may be subject 

to double taxation. In order to mitigate this possibility, the United States provides a credit 

against U.S. tax liability for foreign income taxes paid, subject to a number of limitations. Most 

recent incremental reform proposals in this area relate to these limitations. 

Allocation of interest expense using “worldwide fungibility” approach45

The foreign tax credit generally is limited to the U.S. tax liability on a taxpayer’s foreignsource income, in order to ensure that the credit serves its purpose of mitigating double taxation 

of cross-border income without offsetting the U.S. tax on U.S.-source income. In light of this 

limitation, a taxpayer must allocate gross income and expenses between U.S. and foreign sources 

in order to determine the amount of foreign tax credits allowable. Under present law, interest 

expense that a U.S.-based multinational enterprise incurs in the United States is allocated to U.S. 

and foreign sources based on the gross assets located in the United States and abroad, without 

regard to any interest that the enterprise incurs abroad. Thus, a U.S.-based multinational with a 

significant portion of its assets overseas must allocate a significant portion of its interest expense 

to foreign-source income, which reduces the foreign tax credit limitation and thus the credits 

allowable (even though the interest expense incurred in the United States is not deductible in 

computing the actual tax liability under the relevant foreign law). Many companies complain 

that this approach unduly limits their ability to claim foreign tax credits and leaves them 

excessively exposed to double taxation of their foreign-source income. They propose that 

interest expense instead be allocated using an elective “worldwide fungibility” approach, under 

which interest expense incurred in the United States would be allocated against foreign-source 

income only if the debt-to-asset ratio was higher for U.S. than for foreign investments. This 

measure would significantly expand the ability of many U.S.-based multinational enterprises to 

claim foreign tax credits.

Reduction of the number of foreign tax credit limitation categories (or “baskets”)46

Present law applies the foreign tax credit limitation separately to different types of 

foreign-source income, in order to reduce the extent to which excess foreign taxes paid in a hightax foreign jurisdiction can be “cross-credited” against the residual U.S. tax on low-taxed 

 

45 A version of this proposal was in H.R. 285 (108th Congress), H.R. 5095 (107th

Congress), and H.R. 2488 (106th Congress). 

46 A version of this proposal was in H.R. 285 (108th Congress) and H.R. 5095 (107th

Congress).
30

foreign-source income. For example, if a taxpayer pays foreign tax at an effective rate of 45 

percent on certain active income earned in a high-tax jurisdiction, and pays little or no foreign 

tax on certain passive income earned in a low-tax jurisdiction, then the earning of the untaxed (or 

low-taxed) passive income could expand the taxpayer’s ability to claim a credit for the otherwise 

uncreditable excess foreign taxes paid to the high-tax jurisdiction, by increasing the foreign tax 

credit limitation without increasing the amount of foreign taxes paid. This sort of cross-crediting 

is constrained by rules that require the computation of the foreign tax credit limitation on a 

category-by-category basis. Thus, in the example above, the rules would place the passive 

income and the active income into separate limitation categories (or “baskets”), and the lowtaxed passive income would not be allowed to increase the foreign tax credit limitation 

applicable to the credits arising from the high-taxed active income. 

Present law provides nine separate baskets as a general matter, and effectively many 

more in situations in which various special rules apply. Separate foreign tax credit limitation 

categories are provided for the following items of income: (1) passive income; (2) high 

withholding tax interest; (3) financial services income; (4) shipping income; (5) certain dividends 

received from a noncontrolled section 902 foreign corporation (a “10/50 company”);47 (6) certain 

dividends from a domestic international sales corporation or former domestic international sales 

corporation; (7) taxable income attributable to certain foreign trade income; (8) certain 

distributions from a foreign sales corporation or former foreign sales corporation; and (9) any 

other income not described in items (1) through (8) (so-called “general basket” income). 

Many companies complain that the large number of different baskets creates unnecessary 

complexity and distorts business decisionmaking. They argue that the number of baskets should 

be greatly reduced, to three or even two. This proposal would reduce complexity and 

compliance costs for some companies, but at a risk of allowing more cross-crediting in these 

cases than may be considered appropriate. Many companies would not be significantly affected 

by this proposal, because the bulk of their income already falls into only one or two baskets.

Overall foreign loss and proposed overall domestic loss rules48

If a taxpayer generates an overall foreign loss (“OFL”) for the year -- whether as the 

result of business losses or expense allocations under U.S. tax rules -- it will not be able to claim 

foreign tax credits for that year, since it will have no foreign-source income and thus will have a 

foreign tax credit limitation of zero. Moreover, if the taxpayer does generate foreign-source 

 

47 Dividends paid by a 10/50 company in taxable years beginning before January 1, 

2003, are subject to a separate foreign tax credit limitation for each 10/50 company. Subject to 

certain exceptions, dividends paid by a 10/50 company in taxable years beginning after 

December 31, 2002, are subject to either a look-through approach in which the dividend is 

attributed to a particular limitation category based on the underlying earnings which gave rise to 

the dividend (for post-2002 earnings and profits), or a single-basket limitation approach for 

dividends from all 10/50 companies (for pre-2003 earnings and profits).

48 A version of this proposal was in H.R. 285 (108th Congress), H.R. 5095 (107th

Congress), S. 1164 (106th Congress) and H.R. 2488 (106th Congress). 
31

income in later years, some portion (generally no more than 50 percent) of such income will be 

“recaptured,” or recharacterized as U.S.-source, thus reducing the foreign tax credit limitation in 

later years.49 The rationale for OFL recapture is that the foreign-source losses offset U.S.-source 

income in the year generated, thereby reducing the U.S. tax collected with respect to U.S.-source 

income. The U.S. fisc would not be made whole when the taxpayer subsequently earns foreignsource income if the U.S. taxes on such income were completely offset by foreign tax credits.

Some argue that the OFL regime is unduly complicated and burdensome, and that the 

regime may result in some cases in overly strict limits on claiming the benefits of foreign tax 

credits. In some cases, as a result of the U.S. interest expense allocation rules, a company may 

build up an OFL so large as to impede its ability to claim foreign tax credits for the foreseeable 

future. Some have proposed mitigating these effects by slowing the OFL recapture rate. Others 

may argue that adoption of the worldwide fungibility interest allocation proposal would resolve 

the most significant issues involving the OFL regime, at least on a going-forward basis, 

rendering major changes to the OFL rules unnecessary.

Some also note that there is a lack of parity in the treatment of U.S. and foreign losses for 

foreign tax credit limitation purposes, and argue that a new resourcing rule in the taxpayer’s 

favor should apply to U.S. source income in situations in which the taxpayer’s foreign tax credit 

limitation has been reduced in a prior taxable year as a result of an overall domestic loss. 

Although the proposal would provide symmetry in the treatment of domestic and foreign losses, 

it would add significant complexity to Code. 

Extension of carryover period and “FIFO” reordering50

Under present law, the amount of creditable taxes paid or accrued (or deemed paid) in 

any taxable year which exceeds the foreign tax credit limitation is permitted to be carried back to 

the two immediately preceding taxable years (to the earliest year first) and carried forward five 

taxable years (in chronological order) and credited to the extent that the taxpayer otherwise has 

excess foreign tax credit limitation for those years. Excess credits that are carried back or 

forward are usable only to the extent that there is excess foreign tax credit limitation in such 

carryover or carryback year. Consequently, foreign tax credits arising in a taxable year are 

utilized before excess credits from another taxable year may be carried forward or backward. In 

addition, excess credits are carried forward or carried back on a separate limitation basis. Thus, 

if a taxpayer has excess foreign tax credits in one separate limitation category for a taxable year, 

those excess credits may be carried back and forward only as taxes allocable to that category, 

notwithstanding the fact that the taxpayer may have excess foreign tax credit limitation in 

another category for that year. If credits cannot be so utilized, they are permanently disallowed. 

Many companies complain that these carryover rules, especially in conjunction with the 

OFL and interest allocation rules discussed above, create a potential for the expiration of 

 

49 Sec. 904(f). These rules also operate on a category-by-category basis.

50 A version of this proposal was in H.R. 285 (108th Congress), H.R. 5095 (107th

Congress), and S. 1164 (106th Congress). 
32

significant levels of foreign tax credits. It has been proposed that: (1) the carryforward period 

for foreign tax credits be extended from five to ten years; and/or (2) the utilization of foreign tax 

credits be reordered, so that credits carried forward from prior years would be used before 

current-year credits, on a first-in-first-out (“FIFO”) basis. Some have argued that these 

proposals are inconsistent with a matching principle underlying the foreign tax credit rules (i.e., 

that foreign taxes should be creditable as near as possible to the time at which the earnings on 

which the foreign taxes are imposed are subject to U.S. tax). Others argue that the ma tching 

principle has already been largely abandoned in the foreign tax credit area, and that the 

prevention of credit expiration is a more important policy goal.

Elimination of special foreign oil and gas income rules51

Special foreign tax credit rules apply in the case of foreign oil and gas income. Under a 

special limitation, taxes on foreign oil and gas extraction income are creditable only to the extent 

that they do not exceed a specified amount (e.g., 35 percent of such income in the case of a 

corporation). For this purpose, foreign oil and gas extraction income is income derived from 

foreign sources from the extraction of minerals from oil or gas wells or the sale or exchange of 

assets used by the taxpayer in such extraction. A taxpayer must have excess limitation under the 

special rules applicable to foreign extraction taxes and excess limitation under the general 

foreign tax credit provisions in order to utilize excess foreign oil and gas extraction taxes in a 

carryback or carryforward year.

In the case of taxes paid or accrued to any foreign country with respect to certain foreign 

oil-related income, discriminatory foreign taxes (i.e., taxes found to subject oil-related income to 

a heavier burden than other income) are not treated as creditable foreign taxes. For this purpose, 

foreign oil-related income is income derived from foreign sources from: (1) the processing of 

minerals extracted by the taxpayer or any other person from oil or gas wells into their primary 

products; (2) the transportation of such minerals or primary products; (3) the distribution or sale 

of such minerals or primary products; (4) the disposition of assets used by the taxpayer in such 

processing, transportation, or distributions or sales; or (5) the performance of any other related 

service.

These special rules are designed to ensure that high-rate foreign taxes relating to foreign 

oil and gas activities are not used to offset the U.S. tax on other types of income. In addition, 

there is a concern that some countries and taxpayers may seek to disguise a royalty for the 

extraction of a resource as a tax, in an effort to obtain for the taxpayer a foreign tax credit for a 

payment that is not, in substance, a tax. Companies affected by these special rules argue that 

they are unduly burdensome, and that the concerns underlying the rules are adequately addressed 

under the general foreign tax credit rules (e.g., the rules under section 901 distinguishing taxes 

from other kinds of payments to foreign governments).

 

51 A version of this proposal was in H.R. 285 (108th Congress), S. 1164 (106th Congress) 

and H.R. 2488 (106th Congress). 
33

B. Proposals Relating to the Subpart F Anti-Deferral Rules 

Background

Generally, income earned indirectly by a U.S. person through a foreign corporation is 

subject to U.S. tax only when the income is distributed to the U.S. person. This deferral of U.S. 

tax is limited by a number of anti-deferral regimes (e.g., “subpart F”) that impose current U.S. 

tax on certain types of income earned by certain corporations, in order to prevent taxpayers from 

avoiding U.S. tax by shifting passive or highly mobile income into low-tax jurisdictions. 

Deferral of U.S. tax is considered appropriate, on the other hand, with respect to most types of 

active business income earned abroad. Drawing the line between “good” income and “tainted” 

income has proven contentious and has also engendered considerable complexity. 

Exclusion of active income from the scope of subpart F

Repeal of foreign base company sales and services income rules52

Present law places the income from many sales and services activities conducted abroad 

on the “tainted” side of the line, because such activities are thought to be highly mobile and thus 

prone to tax-motivated manipulation. For example, if a multinational enterprise directs its sales 

of products manufactured in one country to customers located in a second country through the 

use of related-party transactions with a sales company incorporated in a low-tax third country, 

there is a concern that the enterprise may be attempting to shift some of its income away from 

the United States (or another higher-tax country) into the low-tax third country. Accordingly, 

present law generally subjects the income from these and similar arrangements to current U.S. 

tax. Many U.S.-based multinationals complain that these rules are overbroad and penalize the 

use of common, non-tax-motivated business structures (e.g., centralizing sales and services 

functions for a number of different foreign markets within a single foreign entity), thus placing 

U.S.-headquartered businesses at a competitive disadvantage in the normal conduct of their 

active business activities around the world. They argue that the scope of subpart F should be 

limited to passive income (e.g., dividends and interest) earned abroad, and that other rules (e.g., 

the arm’s length transfer pricing rules of section 482) are sufficient to address any abuses 

involving the manipulation of active income streams. 

Others would note that the design and enforcement of the transfer pricing rules can never 

be airtight, and thus a backstop to these rules in situations prone to manipulation may still be 

useful. In addition, the present-law rules arguably serve a purpose of promoting capital export 

neutrality even in cases in which the U.S. transfer pricing rules are not relevant (e.g., cases in 

which a multinational seeks to “deflect” income from a higher-tax foreign country to a low-tax 

foreign country, thus enhancing the overall attractiveness of foreign investment as compared 

with domestic investment). Thus, some would argue that the present-law rules should be 

retained, and that U.S.-based multinationals should propose more narrowly tailored measures to 

 

52 A version of this proposal was in H.R. 285 (108th Congress) and H.R. 5095 (107th

Congress).
34

address their most compelling concerns, short of full repeal of the foreign base company sales 

and services income rules.

Repeal of foreign base company shipping income rules53

Another category of active income subject to the anti-deferral rules is foreign base 

company shipping income. Like foreign base company sales and services income, shipping 

income is thought to be prone to tax-motivated manipulation by reason of its high degree of 

mobility. Some argue that subjecting foreign shipping income to the anti-deferral regime places 

U.S.-based companies at a significant competitive disadvantage relative to competitors based in 

other countries, many of which have enacted special regimes under which shipping income is 

taxed lightly or not at all. Indeed, some argue that the present-law rules have caused a 

substantial decline in the overall number of ships under U.S.-based ownership, and that repeal of 

these rules would serve to reverse this trend.

Look-through treatment for payments of active earnings between CFCs 54

For subpart F purposes, foreign personal holding company income generally includes 

dividends, interest, rents and royalties, among other types of income. Thus, in many cases, a 

U.S.-based multinational may trigger a current U.S. tax under subpart F as it moves its foreign 

earnings among its CFCs by means of such payments. However, this result often can be avoided 

as a practical matter by using a “hybrid branch arrangement” (e.g., making an interest payment 

through an entity that is treated as a corporation under foreign law but as a branch of a CFC 

under U.S. law).55

Some have argued that there is nothing objectionable about moving active, non-subpart-F 

earnings from one CFC to another, and therefore that dividends, interest, rents, and royalties 

received by one controlled foreign corporation from a related controlled foreign corporation 

should not be treated as foreign personal holding company income to the extent attributable to 

non-subpart-F earnings of the payor. According to this view, this proposal would remove certain 

frictions that exist under present law in allocating foreign earnings among different foreign uses. 

Others argue that the proposal would significantly enhance the benefit of deferral, further 

deterring the repatriation of foreign earnings and increasing the overall attractiveness of foreign 

investment relative to domestic investment.

 

53 A version of this proposal was in H.R. 3312 (107th Congress) and H.R. 265 (106th

Congress). 

54 A version of this proposal was in H.R. 285 (108th Congress) and H.R. 5095 (107th

Congress).

55

 See, e.g., Notice 98-11, 1998-6 I.R.B. 18; Notice 98-35, 1998-27 I.R.B. 35.
35

C. Joint Committee Staff Simplification Recommendations

In general

In April 2001 the Joint Committee on Taxation released a study that included 

recommendations to simplify the Federal tax system (the “Study”).56 In developing these 

recommendations, the Joint Committee staff attempted not to alter the underlying policy 

articulated by the Congress in enacting the provisions at issue. Thus, the scope of the 

recommendations was generally limited to relatively uncontroversial proposals that eliminated 

unnecessary complexity without significantly altering the tax policy underlying the relevant 

provisions. The recommendations of the Study pertaining to the international tax rules are 

presented below. 

Elimination of certain overlapping anti-deferral regimes 

One proposal addresses the layering of anti-deferral regimes that are applicable or 

potentially applicable to U.S. persons who earn income through a foreign corporation. There are 

six such regimes: the accumulated earnings tax (1913), the personal holding company rules 

(1934); the foreign personal holding company rules (1937); the controlled foreign corporations 

rules (1962); the foreign investment company rules (1962); the passive foreign investment 

company rules (1986). To alleviate some of the complexity caused by the various overlapping 

regimes, the Joint Committee staff recommended:

• The foreign personal holding company and foreign investment company rules should 

be repealed, because they have little significance since the enactment of the subpart F and 

passive foreign investment company (“PFIC”) rules. 

• Assuming such repeal, foreign personal holding company income for subpart F 

purposes should be expanded to include certain income currently covered only by the foreign 

personal holding company rules.

• The personal holding company regime should no longer apply to foreign 

corporations, because the PFIC rules should adequately police the routing of passive income 

through foreign corporations.

Expansion of subpart F de minimis rule

Due to the complexity and compliance burden of a U.S. taxpayer associated with 

accounting for income both under the general rules for income earned through a foreign 

corporation and under the anti-deferral regimes, the Joint Committee staff recommended that the 

subpart F de minimis rule should be increased from the current threshold of the lesser of 5 

percent of gross income or $1 million to the lesser of 5 percent of gross income or $5 million. 

 

56 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System 

and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal 

Revenue Code of 1986 (JCS-3-01), April 2001.
36

Acceleration of look-through rules for 10-50 companies

The Taxpayer Relief Act of 1997 modified the foreign tax credit limitation rules 

applicable to dividends received from a foreign corporation in which the taxpayer owns at least 

10 percent of the stock by vote but which is not a controlled foreign corporation (a so called “10-

50 company”) in favor of a simpler look-through approach. However, the look-through 

approach does not apply to earnings accumulated in taxable years beginning on or before 

December 31, 2002, which has created unnecessary complexity, as companies must apply both a 

separate basket approach and a look-through approach with respect to their 10-50 companies. 

Consequently, the Joint Committee staff recommended that the look-through rules with respect 

to 10-50 companies apply without regard to the year in which earnings were accumulated.

Foreign tax credits claimed through a partnership

There may be uncertainty in the law regarding the claiming of indirect foreign tax credits 

through a partnership. The Joint Committee staff proposed clarifying that a domestic corporation 

may claim deemed-paid foreign tax credits with respect to a foreign corporation that is held 

indirectly through a foreign or U.S. partnership, provided that the domestic corporation owns 

(indirectly through the partnership) ten percent or more of the foreign corporation’s voting stock. 

Conform possessions-related provisions (sections 30A and 936)

If Congress chooses to extend the credits under sections 30A and 936 after their 

expiration in 2005, the Joint Committee staff recommended that consideration be given to 

applying a single set of rules for credit claimants in all U.S. possessions and to combining these 

rules under one Code section.

Application of uniform capitalization rules for foreign persons

Under current law, costs incurred in producing property or acquiring property for resale 

are capitalized under the uniform capitalization rules. Given the complexity of the uniform 

capitalization rules, the Joint Committee staff recommended that these costs be capitalized using 

U.S. generally accepted accounting principles for purposes of determining a foreign person’s 

earnings and profits and subpart F income. 

Elimination of secondary withholding tax

The Joint Committee staff called for the repeal of the secondary withholding tax on 

certain U.S.-source dividends paid by certain foreign corporations, because this tax has largely 

been supplanted by the branch profits tax. 

Capital gains on certain nonresident individuals

Because the withholding tax on certain U.S.-source capital gains of nonresident alien 

individuals generally applies only in circumstances in which an individual would likely be

treated as a U.S. resident or, if the individual would not be treated as a U.S. resident, the capital 

gains would not likely be U.S. source, the Joint Committee staff advocated the repeal of this rule. 
37

Update U.S. model treaties

The Joint Committee staff recommended that the Treasury Department publish U.S. 

model treaties at least once every Congress. More frequent updates would provide useful 

information to taxpayers, the Congress, and to foreign governments as to the Administration’s 

evolving policy on often complicated treaty matters.

Report to Congress on older U.S. tax treaties

Older U.S. tax treaties may no longer reflect current U.S. tax treaty policy. Accordingly, 

the Joint Committee staff recommended that the Treasury Department report to the Congress on 

the status of older U.S. tax treaties once every Congress.
38

V. TEMPORARY RATE REDUCTION FOR CERTAIN

DIVIDEND REPATRIATIONS

A. Background

Income earned by a domestic parent corporation from the foreign operations of its foreign 

subsidiaries generally is subject to U.S. tax only when the income is distributed as a dividend to 

the domestic corporation. Until such repatriation, the U.S. tax on such income generally is 

deferred, subject to certain anti-deferral regimes. These regimes -- most significantly the subpart 

F regime -- may cause the domestic parent to be taxed on a current basis with respect to certain 

categories of passive or highly mobile income earned by its foreign subsidiaries. A foreign tax 

credit is available to offset, in whole or in part, the U.S. tax owed on the domestic corporation’s 

foreign-source income, whether earned directly by the domestic corporation, repatriated as a 

dividend, or included under one of the anti-deferral regimes.

The amount of U.S. tax owed as a result of a dividend repatriation thus depends on the 

U.S. parent’s ability to use foreign tax credits to offset some or all of the U.S. tax on the 

dividend. The foreign tax credit rules are highly complex, and the ability to use foreign tax 

credits depends on a number of different factors. As a general matter, however, earnings that are 

subject to higher rates of foreign tax often carry with them sufficient usable foreign tax credits to 

eliminate or substantially offset the U.S. tax on the repatriation, while earnings that are subject to 

lower rates of foreign tax are more likely to trigger substantial levels of residual U.S. tax at the 

time of repatriation.

It has long been recognized that this deferral system creates incentives in some cases for 

companies not to repatriate certain of their foreign earnings, and instead to accumulate and 

reinvest these earnings abroad, in order to maintain deferral of U.S. taxes. This distortion is of 

course more prevalent with respect to earnings generated in lower-tax jurisdictions, since, as 

explained above, it is often possible under present law to repatriate earnings generated in highertax jurisdictions with little or no residual U.S. tax. 

One recent provision of prior law attempted to address this distortion by imposing a tax 

on certain “excess passive assets” accumulated abroad, in an effort to decrease the tax incentive 

to retain earnings offshore.57 This provision generated considerable complexity, and it addressed 

only the incentive to redeploy earnings in passive, as opposed to active, foreign investments. It 

was repealed after only a few years of operation.

B. Recent Proposals

In general

Several recent proposals would reduce the disincentive for repatriating foreign earnings 

by effectively providing a partial amnesty for deferred U.S. taxes on earnings that a company 

repatriates within a certain temporary period. One such proposal was approved by the Senate in 

 

57 Sec. 956A, as in effect from 1993 through 1996.
39

its amendment of H.R. 2, the “Jobs and Growth Tax Relief Reconciliation Act of 2003,” and 

similar proposals were included in a number of bills introduced earlier in the 108th Congress.58 

Supporters of these proposals argue that this temporary tax relief would trigger the repatriation of 

funds that otherwise would remain offshore, and that these funds would be put to productive use 

in the United States, thereby stimulating the domestic economy. Others argue that the proposals 

would confer a large retroactive tax benefit on foreign earnings that have already benefited from 

the deferral of U.S. taxes, and that increased repatriations would not necessarily result in 

significant increases in productive activity in the United States.

Description of the repatriation provision in the Senate amendment to H.R. 2

Under the Senate amendment to H.R. 2, certain actual and deemed dividends received by 

a U.S. corporation from a controlled foreign corporation would be subject to tax at a reduced rate 

of 5.25 percent. For corporations taxed at the top corporate income tax rate of 35 percent, this 

rate reduction would be equivalent to an 85-percent dividends-received deduction. This rate 

reduction would be available only for the first taxable year of an electing taxpayer ending 120 

days or more after the date of enactment of the provision.

The reduced rate would apply only to repatriations in excess of the taxpayer’s average 

repatriation level over three of the five most recent taxable years ending on or before December 

31, 2002, determined by disregarding the highest-repatriation year and the lowest-repatriation 

year among such five years.59 The taxpayer would be allowed to designate which of its 

dividends are treated as meeting the base-period average level and which of its dividends are 

treated as comprising the excess.

In order to qualify for the reduced rate, dividends would have to be described in a 

“domestic reinvestment plan” approved by the taxpayer’s senior management and board of 

directors. This plan would have to provide for the reinvestment of the repatriated dividends in 

the United States, “including as a source for the funding of worker hiring and training; 

infrastructure; research and development; capital investments; or the financial stabilization of the 

corporation for the purposes of job retention or creation.”

The provision would disallow 85 percent of the foreign tax credits attributable to 

dividends subject to the reduced rate and would remove 85 percent of the underlying income 

from the taxpayer’s foreign tax credit limitation fraction under section 904.

In the case of an affiliated group, an election under the provision would be made by the 

common parent on a group-wide basis, and all members of the group would be treated as a single 

 

58

 See S. 596 (the “Invest in the USA Act of 2003”), H.R. 767 (the “Homeland 

Investment Act of 2003”), and H.R. 1162 (the “Invest in America Act of 2003”). Sec. 531 of the 

Senate Amendment to H.R. 2 (the “Jobs and Growth Tax Relief Reconciliation Act of 2003”) 

included the language of S. 596, but the provision was not included in the conference agreement 

for H.R. 2.

59 If the taxpayer has fewer than five taxable years ending on or before December 31, 

2002, then the base period consists of all such taxable years, with none disregarded.
40

taxpayer. The election would apply to all controlled foreign corporations with respect to which 

an electing taxpayer is a United States shareholder.

The provision would be effective for the first taxable year of an electing taxpayer ending 

120 days or more after the provision’s date of enactment.

C. Analysis

As explained above, the present-law deferral system creates incentives for U.S.-based 

multinational enterprises to reinvest certain of their foreign earnings offshore, instead of 

repatriating them. This creates an economic inefficiency, in that it may prove more profitable on 

an after-tax basis for a business to use these retained earnings to fund a new offshore investment 

instead of making an alternative investment in the United States, even if the pre-tax rate of return 

on the investment in the United States exceeds the pre-tax rate of return on the foreign 

investment.

A number of fundamentally different approaches might be considered to eliminate or 

reduce this inefficiency, including: (1) a permanent territorial-type exemption for repatriated 

foreign earnings; (2) a permanent reduced rate of tax for repatriated foreign earnings; (3) a tax 

penalty for excess accumulations of earnings offshore;60 (4) the elimination of deferral of U.S. 

taxes on the earnings of low-taxed foreign subsidiaries of U.S. parent corporations; and (5) the 

elimination of deferral of U.S. taxes on the earnings of all foreign subsidiaries of U.S. parent 

corporations. Any of these options would represent a fundamental change in U.S. tax policy and 

may warrant extensive deliberation.

The temporary tax-favored repatriation proposal, being temporary, would not resolve the 

underlying inefficiency that arises under the present-law deferral system. Instead, the proposal 

seeks only to encourage a one-time increase in dividend repatriations. The temporary proposal 

may “unlock” some monies held in investments offshore and redirect those funds to other uses, 

but after the temporary period, the underlying inefficiency discussed above would remain in 

place. Proponents of the proposal argue that the one-time “unlocking” would serve as a 

temporary economic stimulus measure, and thus that the proposal should be evaluated as such.

While the proposal may encourage the prompt repatriation of some earnings that would 

not otherwise be repatriated as quickly (or at all), proponents and opponents of the proposal 

differ as to the effects of these additional repatriations, as well as other implications of the 

proposal. Proponents of the proposal argue that the repatriated monies could be put to a number 

of beneficial domestic uses. First, proponents note that internally generated cash often is a 

corporation’s cheapest source of investment capital. They argue that the availability of the 

additional repatriated funds would enable U.S.-based multinational enterprises to make 

productive investments in the United States that they otherwise would not make, thereby 

stimulating the domestic economy. According to this view, by lowering a company’s cost of 

capital in the United States, the proposal would enable the company to make certain domestic 

investments that would be uneconomic under present law. 

 

60

 See, e.g., sec. 956A, as in effect from 1993 through 1996.
41

Others argue that a company’s investment decisions are normally made on an integrated, 

worldwide basis with a view to the expected performance of the various potential investments, 

and that the source of funds, whether foreign or domestic, external or internal, is unlikely to 

impact these investment decisions dramatically. For example, according to this view, a 

company’s decision of whether or not to build a factory in the United States would be unlikely to 

turn on the relative levels of earnings retained in the company’s U.S. and European treasury 

centers. Rather, if an investment is found to be attractive, the company should be able to find the 

financing for it (particularly at today’s low interest rates). Thus, according to this view, the 

temporary reduced rate for dividend repatriations would serve mainly to increase the after-tax 

profits of benefiting companies, rather than generate any additional domestic investment.

Proponents observe that another potential use of repatriated funds would be to pay down 

the domestic debt of the enterprise, improving the company’s balance sheet. They argue that this 

would produce two specific benefits. First, by reducing corporate leverage, the danger to the 

economy of bankruptcies in a future economic downtown would be diminished. Second, the 

reduction in any corporation’s leverage would better enable the corporation to take on additional 

debt to finance projects in the future. However, opponents of the proposal note that debt 

reduction does not provide much, if any, current-year economic stimulus. Further, they observe 

that the financial markets generally assess the creditworthiness of multinational enterprises on 

the basis of their consolidated, global operations. They question how reducing the equity held in 

foreign affiliates in order to reduce the debt incurred by domestic affiliates can benefit the 

consolidated balance sheet of the multinational enterprise. They may further note that many 

multinational enterprises that might avail themselves of the proposal already carry solid credit 

ratings.61

Proponents argue that another potential use of repatriated monies would be to fund 

pension shortfalls that have arisen in part as a result of the recent economic downturn. 

Proponents argue that, to the extent that the pension law requires companies to compensate for 

these shortfalls, funds may be diverted to this purpose away from other productive investments. 

If a company’s own accumulated foreign earnings could be applied more readily to this purpose, 

then this funding diversion need not occur, according to this view. Others would argue, as 

discussed above, that companies’ investment decisions, especially those of the larger companies 

that may have pension shortfalls, are generally not driven by cash-flow constraints. Rather, if an 

investment is worthwhile, funding for it generally can be found, especially in view of the larger 

companies’ sound bond ratings and current low interest rates. Opponents may further note that 

granting a partial tax holiday to help fund pension shortfalls would provide a subsidy from 

taxpayers at large to finance the promised retirement benefits of a relatively small number of 

 

61

 See Anne Swope, Bruce Kasman, and Robert Mellman, JP Morgan Securities Inc., 

Economic and Policy Research, Special Report, “Introducing the Homeland Investment Act,” 

April 30, 2002. The JP Morgan analysis of the audited financial statements of 237 S&P 500 

companies with reported cumulative amounts of foreign subsidiary earnings that could be 

repatriated found that more than 20 percent of potential repatriations were earnings of companies 

with AAA bond ratings, nearly 33 percent of potential repatriations were earnings of companies 

with AA or better bond ratings, and more than 77 percent of potential repatriations were earnings 

of companies with A- or better bond ratings.
42

U.S. based businesses. The company would get a double deduction of sorts, as it would be able 

to claim a deduction for pension contributions made from partially exempt income. This benefit 

would not be available to smaller, non-multinational companies facing pension shortfalls due to 

market conditions.

Another concern raised by opponents of the proposal is that, if enacted into law, pressure 

might then arise to “extend” the provision, thus rendering an ostensibly temporary stimulus 

provision the first step toward the adoption of a territorial-type tax system, without the degree of 

thorough examination and debate that would properly attend such a fundamental shift. Even if 

the provision is not extended immediately, taxpayers may view it as a precedent for this type of 

temporary tax relief as a response to future economic downturns. This could actually amplify 

present-law distortions, as taxpayers may refrain from repatriating earnings in the future, in the 

expectation that another partial amnesty may be implemented during the next economic 

downturn. Proponents of the proposal note that the proposal itself is indeed temporary and argue 

that it should be evaluated as such. They argue that the second-order effects predicted by 

opponents of the proposal are speculative and should be disregarded.

Proponents and opponents of the proposal also differ as to some of the specifics of 

implementing the proposal. For example, as described above, the proposal grants the benefit of 

the reduced rate only in connection with repatriations in excess of the average level of 

repatriations during a base period. Opponents of the proposal note that this feature has the effect 

of denying the benefit to companies that have been repatriating high levels of foreign earnings 

under present law, and rewarding companies that have repatriated little or no foreign earnings 

under present law. Proponents of the proposal argue that the tax incentive is intended only to 

encourage repatriations in excess of those observed under present law, and that the base period 

requirement tailors the proposal appropriately to that end. According to this view, to confer the 

benefit more broadly would be to give a windfall to those who face little or no impediment to 

repatriating earnings under present law. On the other hand, some companies that repatriate 

significant levels of earnings and pay residual taxes under present law may do so because they 

have less access to low-cost outside capital, compared to larger companies that have accumulated 

substantial earnings offshore, which may have readier access to low-cost external financing for 

domestic investment.

Another specific issue relates to the earmarking provision, which requires that a 

“domestic reinvestment plan” be adopted with respect to the repatriated earnings. This 

requirement would have little practical effect, in view of the fungibility of money. In other 

words, because the proposal does not require any increase in any particular type of U.S. 

investment on the part of a company, the earmarking requirement would have the effect of 

simply causing the company to declare that the repatriated funds are being used for a particular 

listed purpose, without necessarily altering the overall allocation of the company’s funds 

between listed and unlisted purposes. Proponents of the proposal argue that, regardless of the 

effect of the earmarking provision, it is unlikely that a company would decide to pay U.S. tax at 

a rate of 5.25 percent in order to repatriate foreign earnings unless it intended to use the funds in 

the United States, given the practical ease with which such earnings can be moved from one 

foreign country to another without triggering current U.S. tax.
43

VI. EXCLUSION FOR FOREIGN EARNED INCOME

A. Background

U.S. citizens generally are subject to U.S. income tax on all their income, whether 

derived in the United States or elsewhere. A U.S. citizen who earns income in a foreign country 

also may be taxed on such income by that foreign country. However, the United States generally 

cedes the primary right to tax income derived by a U.S. citizen from sources outside the United 

States to the foreign country where such income is derived. Accordingly, a credit against the 

U.S. income tax imposed on foreign source income is generally available for foreign taxes paid 

on that income, to the extent of the U.S. tax otherwise owed on such income. If the foreign 

income tax rate is lower than the U.S. income tax rate, then the United States generally provides 

a credit up to the amount of the foreign tax and imposes a residual tax to the extent of the 

difference.

Under section 911 of the Code, U.S. citizens living abroad may be eligible to exclude 

from their income for U.S. tax purposes certain foreign earned income and foreign housing costs, 

in which case no residual U.S. tax is imposed to the extent of such exclusion, regardless of the 

foreign tax rate. In order to qualify for these exclusions, an individual must be either: (1) a U.S. 

citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes 

an entire taxable year;62 or (2) a U.S. citizen or resident present overseas for 330 days out of any 

12-consecutive-month period. In addition, the taxpayer must have his or her tax home in a 

foreign country.

The exclusion for foreign earned income generally applies to income earned from sources 

outside the United States as compensation for personal services rendered by the taxpayer. The 

maximum exclusion for foreign earned income is $80,000 per taxable year for 2002 and 

thereafter. For taxable years beginning after 2007, the maximum exclusion amount is indexed 

for inflation.

The exclusion for housing costs applies to reasonable expenses, other than deductible 

interest and taxes, paid or incurred by or on behalf of the taxpayer for housing for the taxpayer 

and his or her spouse and dependents in a foreign country. The exclusion amount for housing 

costs for a taxable year is equal to the excess of such housing costs for the taxable year over an 

amount computed pursuant to a specified formula. In the case of housing costs that are not paid 

or reimbursed by the taxpayer's employer, the amount that would be excludible is treated instead 

as a deduction.

The combined earned income exclusion and housing cost exclusion may not exceed the 

taxpayer’s total foreign earned income. The taxpayer’s foreign tax credit is reduced by the 

amount of such credit that is attributable to excluded income.

 

62 Only U.S. citizens may qualify under the bona fide residence test. However, resident 

aliens of the United States who are citizens of foreign countries that have a treaty with the United 

States may qualify for Section 911 exclusions under the bona fide residence test by application 

of a nondiscrimination provision. 
44

Special exclusions apply in the case of taxpayers who reside in one of the U.S. 

possessions.

B. Proposed Repeal

The Senate amendment to H.R. 2, the “Jobs and Growth Tax Relief and Reconciliation 

Act of 2003,” included full repeal of the exclusion for foreign earned income and the exclusion 

and deduction for housing expenses. This provision was not adopted in the conference 

agreement for H.R. 2. 

C. Analysis

Proponents of repealing section 911 argue that repeal would create parity in the tax 

treatment of U.S. citizens living abroad and U.S. citizens living in the United States. Without 

section 911, U.S. citizens living abroad would be taxed on their worldwide income, and a foreign 

tax credit would be allowed for foreign taxes paid on their foreign source income. Thus, U.S. 

citizens living in countries with tax rates equal to or higher than those in the United States would 

generally still not owe U.S. tax on their foreign earned income, because such taxes would be 

covered by the foreign tax credit. U.S. citizens living in countries with tax rates lower than those 

in the United States would generally be worse off without section 911, because the United States 

would impose a residual tax attributable to the difference between the U.S. tax rate and the lower 

foreign tax rate, but this residual tax would serve only to promote parity between U.S. citizens 

living in the United States and U.S. citizens living overseas. 

Proponents of repealing section 911 argue that U.S. citizens with similar income levels 

should incur similar tax liabilities, regardless of where they live. They believe that present law 

provides an unwarranted benefit to U.S. citizens living in low-tax foreign countries, as well as to 

U.S. citizens exempt from income tax in a foreign country pursuant to a treaty or other 

agreement. The rules under section 911 prevent individuals from taking inconsistent positions 

with respect to residency in the United States and the foreign jurisdiction in order to avoid 

paying income tax in both countries, but in situations in which an individual is exempt from the 

income tax of a foreign country pursuant to a treaty or other agreement, such an exemption does 

not in itself prevent an individual for qualifying for the foreign earned income exclusion for U.S. 

tax purposes.63 Proponents of repeal believe that U.S. citizens living and working abroad benefit 

from their U.S. citizenship and should be treated the same as U.S. citizens living and working in 

the United States.

Opponents of repeal argue that section 911 was enacted to promote foreign trade and to 

put Americans working abroad on an equal footing with their foreign counterparts. They argue 

that the Congressional aim in passing and maintaining section 911 has been to aid and encourage 

U.S. enterprises abroad. They believe that section 911 makes it easier for U.S. multinational 

firms to find U.S. employees who are willing to work and live abroad, despite the additional 

costs that doing so may sometimes entail (e.g., maintaining two homes). They also believe that 

 

63

 Scott v. United States, 432 F.2d 1388 (Ct. Cl. 1970) and Rev. Rul. 72-497, 1972-2 

C.B. 448.
45

U.S. citizens living and working abroad do not receive the same benefits of U.S. citizenship as a 

U.S. citizen living and working in the United States and thus should not bear the same tax 

burden.

Others have recommended partial repeal as a compromise. Under this approach, 

Congress would leave section 911 in place, but significantly lower the amount of the foreign 

earned income exclusion. Lowering the foreign earned income exclusion to $35,000, for 

example, would allow the average U.S. citizen working abroad for a religious or charitable 

organization to continue to benefit from the foreign earned income exclusion, but would treat 

Americans working abroad earning more than that amount the same as U.S. citizens living and 

working in the United States.

Section 911 provides that the combined earned income exclusion and housing cost 

exclusion may not exceed the taxpayer’s total foreign earned income. Proponents of repeal 

argue that because the amount excludible from U.S. tax is tied to a U.S. citizen’s total foreign 

earned income, not the foreign earned income exclusion amount, the mechanics of this provision 

provide a greater benefit to highly compensated individuals. This is illustrated by the following 

example: Consider a U.S. citizen who earns foreign wages of $100,000 and is provided a 

housing allowance of $50,000. The foreign earned income exclusion for 2003 is $80,000, so the 

U.S. citizen would be allowed to exclude $80,000 under the foreign earned income exclusion and 

only $20,000 of the housing allowance, because the exclusion is limited to total foreign wages 

($80,000 + $20,000 = $100,000). In contrast, a U.S. citizen with the same $50,000 housing 

allowance, but instead earning $150,000 in foreign wages would be able to exclude the entire 

$50,000 housing allowance (and $80,000 of foreign wages).

Another criticism of retaining section 911 is that it operates as a subsidy to multinational 

companies that send employees overseas under “tax equalization” packages. Tax equalization 

packages are guarantees by an employer to the employee that the employee will not suffer a 

greater tax burden in accepting an assignment to work overseas. If an employee incurs a greater 

tax liability working overseas than the employee would have incurred if he or she had remained 

working in the United States, the employer guarantees to reimburse the employee for the 

difference. Many employers also provide housing allowances to their overseas employees to 

assist with cost of living expenses. In the United States, such housing benefits would normally 

be considered additional compensation to the employee and thus fully taxable. However, section 

911 generally allows overseas workers to exclude housing expenses, and thus the U.S. employer 

is relieved of reimb ursing the employee for U.S. tax attributable to such an allowance, which 

otherwise would have been owed to the employee pursuant to the employer’s tax equalization 

package.

Opponents of section 911 repeal argue that most U.S. multinational companies send 

employees on assignment to European countries, where individuals are subject to tax rates higher 

than the U.S. income tax rates. Thus, U.S. companies incur a great deal of expense reimbursing 

overseas employees for additional foreign taxes paid, and the subsidy provided to a U.S. 

company by section 911 merely facilitates a company’s ability to absorb these expenses. 

Opponents of repeal argue that, absent such a provision, U.S. companies would experience 

greater difficulty trying to compete in foreign markets, and U.S. citizens living overseas would 

be faced with additional compliance burdens because they would be required to calculate their 
46

foreign tax credit and comply with the rules and requirements related to such calculation. These 

additional compliance requirements, coupled with increased cost of living expenses and often the 

burden of maintaining two households, could discourage Americans from working abroad. 

Opponents of repeal maintain that section 911 removes obstacles to sending employees abroad, 

which helps a U.S. company grow by expanding into new markets, ultimately creating jobs in the 

United States. Opponents further argue that employing Americans instead of foreign individuals 

in positions overseas can translate into additional business for U.S. suppliers and service 

providers, because American employees are knowledgeable about and accustomed to working 

with such companies. Some also may argue that employing U.S. citizens abroad enhances social 

ties between the United States and other countries, which may produce broader social benefits.