THE IMPACT OF INTERNATIONAL TAX REFORM: 

BACKGROUND AND SELECTED ISSUES RELATING 

TO U.S. INTERNATIONAL TAX RULES AND THE 

COMPETITIVENESS OF U.S. BUSINESSES 

Scheduled for a Public Hearing 

Before the 

SUBCOMMITTEE ON SELECT REVENUE MEASURES 

of the 

HOUSE COMMITTEE ON WAYS AND MEANS 

on June 22, 2006 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

June 21, 2006 

JCX-22-06
i

CONTENTS 

Page

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

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

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

B. General Rationales for a Worldwide Tax System......................................................... 3 

C. General Rationales for a Territorial Tax System .......................................................... 5 

D. Methods of Implementing a Territorial Tax System..................................................... 8 

E. Other Issues Raised by a Shift to a Territorial System ............................................... 10 

II. THE U.S. INTERNATIONAL TAX SYSTEM ............................................................... 13 

A. Tax Treatment of Foreign Activities of U.S. Persons................................................. 13 

B. Tax Treatment of U.S. Activities of Foreign Persons................................................. 29 

C. Transfer Pricing .......................................................................................................... 30

D. Treaties........................................................................................................................ 31 

III. BRIEF DESCRIPTIONS OF SELECTED TERRITORIAL AND OTHER SYSTEMS. 32 

A. Selected Territorial Systems ....................................................................................... 32 

1. France.................................................................................................................... 32

2. Germany................................................................................................................ 36 

3. Netherlands ........................................................................................................... 39 

4. Singapore .............................................................................................................. 43 

B. Selected Nonterritorial Systems.................................................................................. 47 

1. China..................................................................................................................... 47

2. Ireland ................................................................................................................... 50

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

UNITED STATES IN THE GLOBAL ECONOMY........................................................ 55 

A. Is U.S. Business Competitive in the Global Economy?.............................................. 55 

B. Taxation and Investment in the Global Economy....................................................... 57 

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

and Investments .......................................................................................................... 64 

V. BACKGROUND AND DATA RELATING TO INTERNATIONAL TRADE AND 

INVESTMENT................................................................................................................. 68 

A. Trade Deficits and Cross-Border Capital Flows......................................................... 68 

B. Trends in the U.S. Balance of Payments..................................................................... 74 

C. Trends in the U.S. Financial Account......................................................................... 78 
1

INTRODUCTION 

The Subcommittee on Select Revenue Measures of the House Ways and Means 

Committee has scheduled a public hearing for June 22, 2006, on the impact of international tax 

reform on U.S. competitiveness. This document,1

 prepared by the staff of the Joint Committee 

on Taxation, provides general background on the U.S. international tax rules and certain other 

countries’ tax systems, and discusses selected issues relating to international tax reform and U.S. 

competitiveness. 

 1

 This document may be cited as follows: Joint Committee on Taxation, The Impact of 

International Tax Reform: Background and Selected Issues Relating to U.S. International Tax Rules and 

the Competitiveness of U.S Businesses (JCX-22-06), June 21, 2006. 
2 

I. 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 taxpayer’s country of legal residence (the “residence 

country”) preserves its right to tax income derived within the residence country. Because 

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. This 

mechanism is known as “deferral.” In the United States, 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. It is also possible for a worldwide tax 

system not to offer deferral. As in the case of a “classic” worldwide system, double taxation 

would be mitigated through the allowance of a foreign tax credit. 

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 residence-country 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 foreignsource 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 principle 

of territoriality for certain cases deemed to be abusive, using mechanisms 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 currently in use share at 

least some features of both worldwide and territorial approaches. 
3 

B. General Rationales for a Worldwide Tax System 

Economic efficiency 

Proponents of a worldwide tax system argue that it promotes economic efficiency better 

than a territorial system, because it does not distort the decision of whether to locate investment 

at home or abroad. A resident has no tax incentive under a worldwide system either to move 

activities abroad or to keep them within the residence country − 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 and deferral, reduce this 

neutrality.2

Equity

In general

Proponents of a worldwide tax system argue that it promotes equity in a number of ways. 

Horizontal equity 

First, it is argued that a worldwide system furthers the policy objective 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. 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 than the taxpayer earning 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. Thus, a worldwide system provides a framework for 

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

Vertical equity

The U.S. Federal income tax system is progressive. Resident individuals earning higher 

levels of income are taxed at progressively higher marginal rates, on the theory that it is fair to 

require them to shoulder a greater proportionate share of the tax burden based on their greater 

ability to pay. If ability to pay is regarded as important, then income earned abroad should also 

be included in the tax base and subjected to progressive rates. Otherwise, the overall 

progressivity of the tax system may be eroded, as higher-earning taxpayers might shift activities 

and income abroad. Thus, a worldwide system helps to promote the policy that higher income-

 2

 By contrast, as discussed in section I.C., proponents of a territorial system argue that it better 

promotes a different form of neutrality. See section IV.B. for a fuller discussion the different measures of 

neutrality. 
4 

earners should bear a larger proportionate share of the tax burden − a concept known as vertical 

equity. 

Benefits of U.S. citizenship and residency

Taxing U.S. citizens and residents on their worldwide income may also reflect the notion 

that U.S. citizenship and residency bestow important benefits that are unavailable to non-citizens 

and non-residents (e.g., a highly developed legal and technical business infrastructure, military 

protection, and passport and embassy services) for which U.S. citizens and residents should pay, 

regardless of where they might earn their income.3

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 lower-tax jurisdictions, 

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

predominantly territorial systems (e.g., France)4 typically provide for current taxation of certain 

types of foreign-source income that may easily be earned in tax havens − a significant departure 

from “pure” territorial taxation.5

 3

 Consistent with this notion, the United States taxes its citizens on their worldwide income, even 

if they reside outside the country. Reflecting the mixed nature of the U.S. system, however, the United 

States provides to qualifying individuals living abroad a partial exclusion for certain foreign source 

service income and housing expenses. Sec. 911. 

4

 See the descriptions of certain countries’ territorial systems in section III.A. 

5

 Likewise, both worldwide and territorial tax systems may employ various rules to limit the 

improper shifting of income from high-tax to low-tax countries (such as transfer pricing and expense 

allocation rules). 
5 

C. General Rationales for a Territorial Tax System 

Economic efficiency 

Proponents of a territorial system argue that it promotes economic efficiency better than a 

worldwide tax system, because a territorial system treats all investment within a particular 

country (the “source country”) the same, regardless of the residence of the investor. This 

efficiency norm is referred to as “capital import neutrality” (referred to by some as 

“competitiveness”6). Thus, if a residence country adopts a pure territorial system, residents of 

that country, when investing abroad in a particular source country, are not 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 generally impossible to fully achieve both capital import 

neutrality and capital export neutrality at the same time.7

 Thus, difficult balancing decisions are 

unavoidable, and there is no consensus as to which of the two goals should take precedence.8

Simplicity in compliance and administration 

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

compliance standpoint than worldwide tax systems. It is 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 because 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, a set of rules similar to an anti-deferral regime (e.g., for 

passive income shifted to tax havens) is probably necessary to protect the tax base, but once 

adopted, such a regime would add substantial complexity to the system, both in terms of the antideferral regime itself and as a result of 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, because source of income is the fundamental basis for taxation 

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

 6

 See discussion of the various meanings of the term “competitiveness” in section IV.A. See 

section IV.B. for a fuller discussion of the concepts of capital export neutrality and capital import 

neutrality. 

7

 It is possible to satisfy both principles at the same time if effective tax rates on capital income 

are the same in all countries. See discussion in section IV.B. 

8

 It has 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. 
6 

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. 

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, because 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.9 Because of this, 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. 

Territoriality as a response to global economic developments

How the world has changed

As noted above, large corporations are increasingly performing their activities on a global 

scale. This is occurring in part because the capital markets constantly demand growth and 

growth may not be available in the corporation’s home country, and in part because such 

corporations have the means to do so, due to their size and access to capital markets. Factors 

such as improvements in communications and other information technologies, more efficient 

transportation of goods (e.g., by containers) and people (e.g., by air), and the lowering of 

economic-political barriers such as tariffs and currency restrictions have created larger regional 

markets such as the European Union and the Association of Southeast Asian Nations 

(“ASEAN”). The rise of relatively low-cost manufacturing and service jurisdictions such as 

China and India and the regionalization of markets have created a large potential for large 

corporations to lower their cross-border transaction costs. 

How business has changed

International businesses have adapted to these developments by altering their practices. 

Improved transportation of goods and logistics minimize the potentially negative effects of costsaving practices such as “just-in-time” manufacturing (i.e., manufacturing on order rather than 

for inventory) and multiple manufacturing sites. Improved communications and transportation 

of people facilitate the provision of cross-border services and the creation of large cross-border 

service organizations to fill the service needs of multinational corporations. As a result of these 

 9

 There have been proposals to adapt the definition of “residence” to the “nationless” 

multinational corporation. See, e.g., Joint Committee on Taxation, Options to Improve Tax Compliance 

and Reform Tax Expenditures (JCS-02-05), January 27, 2005, at 178-181 (a foreign-incorporated entity is 

resident in the United States if its primary place of management and control is in the United States). 
7 

developments, businesses in many cases are efficiently producing goods or performing services 

in lower-cost jurisdictions for customers in regionalized markets. 

Implications for territoriality

Some proponents of capital import neutrality argue that the changes in the global 

economy and international business described above require the adoption of a territorial tax 

system. These proponents argue that the growing volume and importance of cross-border trade 

have critically heightened the need for the economic efficiency and simplicity gains that they 

claim a territorial tax system would provide. 
8 

D. Methods of Implementing a Territorial Tax System 

In general

Some have advocated changing the U.S. tax rules to move towards a territorial system. 

There are many possible variations of territoriality. Some basic approaches are described below, 

but others could be developed that contain a mixture of elements described below. 

Exempt all foreign-source income

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

residence-country tax. The primary question with regard to the U.S. system, if it were converted 

to a pure territorial system, would be whether the current source rules are adequate to fairly and 

efficiently define the exemption. 

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. A key question to be addressed 

under this method would be whether to exempt all active income, or to limit the exemption to 

active income that is not highly mobile. In any case, defining the operative concepts, such as 

“active income,” “passive income,” or “highly mobile income,” would be critical to such an 

approach. 

Exempt only high-taxed foreign-source income 

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

certain minimum effective (or nominal) 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. Alternatively, such an exemption could be limited in 

amount. For example, the American Jobs Creation Act of 2004 (“AJCA”) provided for a lower 

rate of tax on certain international shipping income earned by U.S. corporate taxpayers, based 

upon the net tonnage of the corporation’s qualifying vessels.10

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 

 10 Secs. 1352-1359, added by sec. 248 of Pub. L. No. 108-357. The Tax Increase Prevention and 

Reconciliation Act of 2005 (“TIPRA”), Pub. L. No. 109-222 (2006), expanded the definition of 

qualifying vessels subject to these rules. 
9 

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 

identified tax haven jurisdictions could be excepted from the system (a “blacklist” approach). 

Exemption with progression 

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

consideration is whether 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 localsource 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 low-tax jurisdictions. 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. An example of this type of system might entail enacting, on a 

permanent basis, the dividends-received deduction of 85 percent of the cash dividends received 

from controlled foreign corporations (“CFCs”) which AJCA provided on a temporary basis.11

 11 Sec. 965, added by sec. 422 of Pub. L. No. 108-357. 
10 

E. Issues Raised by a Shift to a Territorial System 

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. The treatment of pre-exemption-system losses 

would raise similar issues. 

Rules accommodating residual tax on certain foreign-source income

As discussed in section I.D. above, most variations of a territorial tax system would 

continue to tax certain kinds of foreign-source income (e.g., passive, highly mobile, or low-taxed 

foreign-source income). In order to prevent double taxation of such non-exempt foreign-source 

income, certain rules similar or identical to those under the present-law U.S. worldwide tax 

system (but limited in scope to cover only such non-exempt foreign-source income) would be 

necessary. So, for example, foreign taxes paid with respect to non-exempt foreign-source 

income would presumably be creditable against the U.S. income tax on such income. Further 

policy issues implicated in designing such a system include, for instance, whether all non-exempt 

foreign-source income would be immediately subject to current U.S. income tax or whether 

certain income (e.g., income earned by foreign subsidiaries of the U.S. taxpayer) would qualify 

for deferral, and the extent to which foreign tax credits on non-exempt foreign-source income 

would be subject to limitation rules similar to those under the present-law U.S. worldwide tax 

system. 

Expense disallowance

Under a territorial system, exempt foreign earnings constitute a tax-exempt stream of 

income. If the United States adopted a territorial system, then the question would arise whether 

deductions for interest and certain other expenses that would otherwise be deductible for U.S. 

income tax purposes should be disallowed to the extent allocable to these exempt earnings.12 

The concept behind the disallowance is one of matching − that expenses should not reduce the 

tax base to the extent incurred to produce income that will never increase the tax base. 

The principal deduction that would be affected by such a rule would likely be interest 

expense. One method for disallowing these interest deductions is to allocate interest expense 

between U.S. and foreign-source income under rules similar to those of present law. The amount 

of interest expense allocated to foreign-source income under these rules then would be further 

allocated between exempt earnings and other foreign-source income on a pro rata basis, based on 

assets. Interest expense deductions allocated to the foreign-source exempt earnings would be 

 12 These allocations would be made as the earnings are generated, as opposed to when they are 

distributed (e.g., under a participation exemption system). 
11 

disallowed. Different classes of expenses13 would likely have different allocation rules, as under 

present law. 

U.S. employment and “runaway plants”

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

overseas, would encourage U.S. companies to move their manufacturing and service operations 

(and thus jobs) abroad. Others respond that, as the present worldwide system allows deferral of 

certain income earned abroad through a foreign corporation, these incentives already exist, 

particularly when coupled with favorable source-country tax regimes for various types of 

manufacturing income. Nevertheless, critics argue, the adoption of a territorial system would not 

alleviate and would likely exacerbate this problem. On the other hand, it is argued that the 

adoption of a territorial system would also 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. Thus, it is argued, adoption of a 

territorial system could help to halt or reverse the recent trend toward “corporate expatriation” 

from the United States, via cross-border mergers or otherwise. 

Tax competition

Critics 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, it is argued, a major 

barrier to tax competition would be removed and a “race to the bottom” would ensue.14 Some 

would find this state of affairs intolerable, and might advocate a concerted international effort, 

such as through the Organisation for Economic Co-operation and Development (“OECD”), to 

ensure an adequate level of tax revenues to finance necessary government operations throughout 

the world. Others 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. For example, the disallowance of interest 

 13 For example, interest expenses, research and experimentation expenses, general and 

administrative expenses, and stewardship expenses. 

14 Even under a worldwide tax system, there are many competitive pressures. For example, 

many foreign countries tax income from international shipping activities on a territorial basis, at a 

relatively lower rate than other types of income, or not at all. AJCA repealed the anti-deferral rule 

applicable to shipping activities conducted by CFCs and reduced the rate of tax on international shipping 

activities of U.S.-flag vessels. The legislative history points specifically to lower foreign taxation of 

shipping income as the rationale for the provisions. H.R. Rep. No. 108-548, Part 1, at 177, 209 (2004). 
12 

deductions allocated to exempt income might give rise to double taxation and tax disputes if the 

relevant treaty partner does not allow the deduction. In addition, switching to a territorial system 

might weaken the rationale for U.S. arguments to treaty partners for the enforcement or 

renegotiation of information-sharing treaty provisions or stand-alone agreements. 

Transfer pricing

Multinational corporations engage in many cross-border transactions. Transfer pricing 

rules, in particular the “arm’s length standard,” govern the determination of the amounts of 

income attributed to U.S. and foreign legal entities in these transactions. Under a territorial 

system, the tax stakes involved would be increased: immediate income inclusion versus 

permanent exemption, as contrasted with the present-law stakes of current taxation versus 

deferral. This would place additional pressure on the transfer pricing rules. It is possible that 

there would be a need to increase resources to enforce these rules. In addition, some argue that 

the current transfer pricing rules or the arm’s length standard would not adapt to the pressures of 

a territorial system. 

Winners and losers

A shift to a territorial system would affect taxpayers in different ways and to different 

degrees. Some taxpayers would benefit, some would be hurt, and others would be relatively 

unaffected.15 The effects on a particular taxpayer of implementing a territorial system would 

depend on the details of such system, the nature and mix of the taxpayer’s activities, and the 

corporate structure of the taxpayer’s legal entities. For example, implementation of a 

participation exemption system might have little or no effect on a U.S. company whose sole 

activity is exportation. Under a territorial system, taxpayers that receive much of their exempt 

income from CFCs located in jurisdictions with relatively low taxes would generally see their 

situation improve. Taxpayers that receive much of their exempt income from CFCs located in 

jurisdictions with relatively high taxes would generally see their situation worsen if they are 

currently able to fully credit such taxes. That would be the case if the taxpayer has excess 

foreign tax credit limitation.16

 15 However, it should be noted that “unaffected” taxpayers might bear the weight of any future 

increases in the tax rate. 

16 For example, many companies in the technology, pharmaceutical, and financial services 

industries, and other companies whose income is derived from intangibles, may fall into this category. In 

addition, a taxpayer that exports goods from the United States but also has a large amount of income from 

high-tax foreign jurisdictions may also fall into this category. 
13

II. THE U.S. INTERNATIONAL TAX SYSTEM 

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

In general

The United States employs a worldwide tax system, under which 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 parent corporation. Until that repatriation, the U.S. tax on the 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 on certain categories of passive or highly mobile 

income earned by its foreign corporate 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 F17 and the passive foreign 

investment company rules.18 A foreign tax credit generally is available to offset, in whole or in 

part, the U.S. tax owed on foreign-source income, whether the income is earned directly by the 

domestic corporation, repatriated as an actual dividend, or included in the domestic parent 

corporation’s income under one of the anti-deferral regimes.19

Foreign tax credit

The United States generally provides a credit for foreign income taxes paid or accrued.20 

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

corporation is generally entitled to an indirect (also referred to as a deemed paid) credit for those 

taxes when it receives an actual or deemed distribution of the underlying earnings from the 

foreign subsidiary.21 The foreign tax credit generally is limited to the U.S. tax liability on a 

taxpayer’s foreign-source income. This limit is intended 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.22 

To determine the amount of allowable foreign tax credits after taking into account the 

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

and foreign sources. Under present law, interest expense that a U.S.-based multinational 

 17 Secs. 951-964. 

18 Secs. 1291-1298. 

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

20 Sec. 901. 

21 Secs. 902, 960. 

22 Secs. 901, 904. 
14

corporate group incurs in the United States is allocated between 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).23 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 foreignsource income. This allocation has the effect of reducing the foreign tax credit limitation and 

thus reducing the credits allowable (even though the interest expense incurred in the United 

States is generally not deductible in computing the actual tax liability under applicable foreign 

law).24 

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, the 

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

For example, suppose 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. In the absence of the separate limitation rules 

described below, earning untaxed (or low-taxed) passive income could permit the taxpayer 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.25 Thus, in the example above, the 

rules would place the passive income and the active income into separate limitation categories 

(or “baskets”), and the low-taxed passive income would not be allowed to increase the foreign 

tax credit limitation applicable to the credits arising from the high-taxed active income. For 

taxable years beginning prior to January 1, 2007, section 904(d) provides eight separate baskets 

as a general matter, and effectively many more in situations in which various special rules 

apply.26 

Special rules govern the ability of a taxpayer with excess foreign tax credits (that is, an 

amount of foreign tax credits which exceeds the foreign tax credit limitation for the taxable year) 

to offset such excess credits against tax liability arising in a prior year (credits so utilized are said 

to be carried back) or in a subsequent year (carried forward).27 Excess credits generated in a 

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

24 AJCA made certain changes to the interest expense allocation rules, effective for taxable years 

beginning after December 31, 2008, intended to mitigate this effect. AJCA sec. 401. These changes are 

described in “Recent Legislative Changes” below. 

25 Sec. 904(d). 

26 As discussed in “Recent Legislative Changes” below, AJCA reduced the number of baskets 

from nine to eight (eliminating the 10/50 basket) for taxable years beginning after December 31, 2002, 

and further reduced the number of baskets to two for taxable years beginning after December 31, 2006. 

AJCA sec. 404. 

27 Sec. 904(c). 
15

taxable year are permitted to be carried back to the immediately preceding taxable year and 

carried forward ten taxable years (in chronological order), and are usable only as a credit (not as 

a deduction), and only to the extent that there is excess foreign tax credit limitation in the 

carryover or carryback year. Consequently, foreign tax credits arising in a taxable year are used 

before excess credits from another taxable year are carried forward or backward and applied to 

that year. 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 basket for a taxable year, those 

excess credits may be carried back and forward only as taxes allocable to that basket, 

notwithstanding the fact that the taxpayer may have excess foreign tax credit limitation in 

another basket for that year. If credits cannot be utilized within the one-year carryback and tenyear carryforward period, they expire and are permanently disallowed. 

If a taxpayer generates an overall foreign loss (“OFL”) for the year − that is, the amount 

of its foreign-source income is lower than the amount of expenses allocable to that income 

(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 that income will be “recaptured,” or 

recharacterized as U.S.-source, thus reducing the foreign tax credit limitation in those later 

years.28 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 on U.S.-source income. 

The U.S. treasury would not be made whole when the taxpayer subsequently earns foreignsource income if, in the absence of such a recapture provision, the U.S. taxes on such income 

were completely offset by foreign tax credits.29

Anti-deferral regimes

In general

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

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

parent 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. These antideferral rules are intended 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, for most types of active business income earned abroad. 

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

29 As discussed in “Recent Legislative Changes” below, AJCA added a parallel provision that 

allows a taxpayer that generates an overall domestic loss in a taxable year beginning after December 31, 

2006, to recharacterize a portion of its U.S.-source income in succeeding years as foreign-source to the 

extent of such overall domestic loss. AJCA sec. 402. 
16

Subpart F

Subpart F,30 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).31 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.32 

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,33 insurance income,34 and certain income relating to international boycotts and 

other violations of public policy.35 Foreign base company income consists of foreign personal 

holding company income, which includes passive income such as dividends, interest, rents, and 

royalties, and a number of categories of income from business operations, including foreign base 

company sales income, foreign base company services income, and foreign base company oilrelated income.36 

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. 

The U.S. 10-percent shareholders of a controlled foreign corporation also are required to 

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

earnings invested in certain items of U.S. property.37 This U.S. property generally includes 

tangible property located in the United States, stock of a U.S. corporation, an obligation of a U.S. 

person, and certain intangible assets, such as patents and copyrights, acquired or developed by 

the controlled foreign corporation for use in the United States.38 There are specific exceptions to 

 30 Secs. 951-964. 

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

32 Sec. 951(a). 

33 Sec. 954. 

34 Sec. 953. 

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

36 Sec. 954. AJCA eliminated the category of foreign base company shipping income. 

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

38 Sec. 956(c)(1). 
17

the general definition of U.S. property, including for bank deposits, certain export property, and 

certain trade or business obligations.39

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.40 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.41 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.42 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.”43

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 under section 951(b). Thus, subpart F is allowed to trump 

the passive foreign investment company rules. 

 39 Sec. 956(c)(2). 

40 Sec. 1297. 

41 Secs. 1293-1295. 

42 Sec. 1291. 

43 Sec. 1296. 
18

Recent Legislative Changes

The 108th Congress and the 109th Congress have enacted a number of important changes 

affecting the taxation of foreign (and, in certain circumstances, domestic) activities of U.S. 

persons. AJCA and TIPRA included rules intended to simplify and rationalize the application of 

the anti-deferral and foreign tax credit rules, and to exempt from current U.S. taxation certain 

items of income that previously had been considered subpart F income. AJCA also included two 

other important sets of rules: (1) a temporary provision intended to encourage the repatriation of 

foreign earnings, and (2) the phasing out of certain export-related tax benefits and their 

replacement with a new deduction for certain domestic manufacturing activities. Preferential 

rules for activities in U.S. possessions expired at the end of last year. These various changes, 

and background relevant to the changes, are described below. 

Foreign tax credit rules

Interest expense allocation rules

In order to compute the foreign tax credit limitation, a taxpayer must determine the 

amount of its taxable income from foreign sources by allocating and apportioning deductions 

between items of U.S.-source gross income, on the one hand, and items of foreign-source gross 

income, on the other. In the case of interest expense, the rules generally are based on the 

premise that money is fungible and that interest expense is properly attributable to all business 

activities and property of a taxpayer, regardless of any specific purpose for incurring an 

obligation on which interest is paid.44 For interest allocation purposes, the Code provides that all 

members of an affiliated group of corporations generally are treated as a single corporation (the 

so-called “one-taxpayer rule”) and allocation must be made on the basis of assets rather than 

gross income.45 

The term “affiliated group” in this context generally is defined by reference to the rules 

for determining whether corporations are eligible to file consolidated returns.46 These rules 

generally exclude all foreign corporations from an affiliated group.47 Thus, while debt generally 

is considered fungible among the assets of a group of domestic affiliated corporations, the same 

rules do not apply as between the domestic and foreign members of a group with the same 

degree of common control as the domestic affiliated group. 

AJCA modified the interest expense allocation rules by providing a one-time permanent 

election, generally available in a taxpayer’s first taxable year beginning after December 31, 

2008, to determine the taxable income of the domestic members of an affiliated group from 

 44 Sec. 864(e). 

45 Sec. 864(e)(1). 

46 Sec. 864(e)(5); sec. 1504. 

47 Sec. 1504(b)(3). 
19

sources outside the United States generally by allocating and apportioning interest expense of the 

domestic members of a worldwide affiliated group on a worldwide-group basis (i.e., as if all 

members of the worldwide group were a single corporation).48 If a group makes this election, 

the taxable income of the domestic members of a worldwide affiliated group49 from sources 

outside the United States is determined by allocating and apportioning the third-party interest 

expense of those domestic members to foreign-source income in an amount equal to the excess 

(if any) of (1) the worldwide affiliated group’s worldwide third-party interest expense multiplied 

by the ratio which the foreign assets of the worldwide affiliated group bears to the total assets of 

the worldwide affiliated group, over (2) the third-party interest expense incurred by foreign 

members of the group to the extent such interest would be allocated to foreign sources if the 

provision’s principles were applied separately to the foreign members of the group.50

Overall domestic loss

AJCA added a provision, mirroring the long-standing OFL re-sourcing rules, which 

applies a re-sourcing rule to U.S.-source income in cases in which a taxpayer’s foreign tax credit 

limitation has been reduced as a result of an overall domestic loss (“ODL”).51 An ODL is any 

domestic loss to the extent it offsets foreign-source taxable income for the current taxable year or 

 48 AJCA sec. 401. 

49 The worldwide affiliated group consists of all corporations in an affiliated group plus, 

generally, all controlled foreign corporations that would be members of that affiliated group but for the 

fact that they are foreign corporations. Sec. 864(f)(1)(C) (as in effect for taxable years beginning after 

December 31, 2008). Thus, if an affiliated group makes this election, the foreign-source income of 

domestic group members generally is determined by allocating and apportioning interest expense of the 

domestic members of the worldwide affiliated group as if all of the interest expense and assets of 80-

percent or greater owned domestic corporations and certain controlled foreign corporations were 

attributable to a single corporation. 

50 Such an election may be made only by the common parent of the domestic affiliated group, 

and may be made only for the first taxable year beginning after December 31, 2008, in which a worldwide 

affiliated group exists which includes such affiliated group and at least one foreign corporation. Once 

made, such an election applies to the common parent and all other corporations that are members of the 

worldwide affiliated group for such taxable year and all subsequent taxable years, and cannot be revoked 

without consent of the IRS Commissioner. Sec. 864(f)(6) (as in effect for taxable years beginning after 

December 31, 2008). 

51 AJCA sec. 402. While the OFL rules are intended to prevent taxpayers from claiming an 

improper double benefit (that is, reducing U.S. tax by means of expenses properly allocable to foreign 

source income in the OFL year, and subsequently receiving the full benefit of unrecaptured foreign source 

income in calculating the foreign tax credit limitation for future years), the ODL rules are intended to 

protect taxpayers from improper double taxation (that is, losing the ability to claim any foreign tax credits 

in the ODL year, with no opportunity to benefit from the positive ODL-year foreign-source income in 

calculating the foreign tax credit limitation for future years). 
20

for any preceding taxable year by reason of a loss carryback.52 Under the provision, which 

applies to losses incurred in taxable years beginning after December 31, 2006, a portion of the 

taxpayer’s U.S.-source income for each succeeding taxable year will be recharacterized as 

foreign-source income in an amount equal to the lesser of: (1) the amount of the 

unrecharacterized ODLs for years prior to such succeeding taxable year, and (2) 50 percent of 

the taxpayer’s U.S.-source income for such succeeding taxable year.53

Look-through rules for dividends from noncontrolled section 902 corporations

Prior to AJCA, special foreign tax credit limitations applied in the case of dividends 

received from a foreign corporation in which the taxpayer owned at least 10 percent of the stock 

by vote and which was not a controlled foreign corporation (a so-called “10/50 company”).54 

Effective for taxable years beginning after December 31, 2002, AJCA eliminated the separate 

limitation basket for dividends paid by 10/50 companies, and instead provides a look-through 

approach to such dividends regardless of the year in which the earnings and profits out of which 

the dividend is paid were accumulated.55

 52 For this purpose, a domestic loss means the amount by which the U.S.-source gross income for 

the taxable year is exceeded by the sum of the deductions properly apportioned or allocated thereto, 

determined without regard to any loss carried back from a subsequent taxable year. However, an ODL 

does not include any loss for any taxable year unless the taxpayer elected the use of the foreign tax credit 

for such taxable year. Sec. 904(g) (as in effect for taxable years beginning after December 31, 2006). 

53 Any U.S.-source income recharacterized under the ODL rules is allocated among and increases 

the various foreign tax credit separate limitation categories in the same proportion that those categories 

were reduced by the prior overall domestic losses, in a manner similar to the recharacterization rules for 

separate limitation losses. 

54 For example, all dividends paid by a 10/50 company in taxable years beginning before January 

1, 2003, as well as dividends paid in taxable years beginning after December 31, 2002 by a 10/50 

company that was a passive foreign investment company out of earnings and profits accumulated in 

taxable years beginning before January 1, 2003, were subject to a separate foreign tax credit limitation for 

each 10/50 company. Dividends paid after December 31, 2002, by a 10/50 company that was not a 

passive foreign investment company out of earnings and profits accumulated in taxable years beginning 

before January 1, 2003, were subject to a single foreign tax credit limitation for all 10/50 companies 

(other than passive foreign investment companies). Dividends paid by a 10/50 company out of earnings 

and profits accumulated in taxable years after December 31, 2002, were treated as income in a foreign tax 

credit limitation category in proportion to the ratio of the 10/50 company’s earnings and profits 

attributable to income in such foreign tax credit limitation category to its total earnings and profits (a 

“look-through” approach). Sec. 904(d). 

55 AJCA sec. 403. A technical correction made by the Gulf Opportunity Zone Act of 2005, Pub. 

L. No. 109-135, added a transition rule allowing taxpayers to elect not to apply the look-through rules to 

taxable years beginning before January 1, 2005. 
21

Foreign tax credit baskets

Prior to AJCA, the foreign tax credit limitation was applied separately to the following 

categories of income: (1) passive income, (2) high withholding tax interest, (3) financial services 

income, (4) shipping income, (5) certain dividends received from noncontrolled section 902 

foreign corporations (“10/50 companies”), (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).56 In addition, a number of other provisions 

of the Code and U.S. tax treaties effectively create additional separate limitations in certain 

circumstances.57

Effective for taxable years beginning after December 31, 2006, AJCA generally reduced 

the number of foreign tax credit limitation categories to two: passive category income and 

general category income.58 Other income is included in one of the two categories, as 

appropriate.59 Taxes paid or accrued in a taxable year beginning before January 1, 2007, and 

carried to any subsequent taxable year are treated as if this provision were in effect on the date 

such taxes were paid or accrued. Thus, such taxes are assigned to one of the two foreign tax 

credit limitation categories.60

Ten-year foreign tax credit carryforward; one-year foreign tax credit carryback

Prior to AJCA, the amount of creditable taxes paid or accrued (or deemed paid) in any 

taxable year which exceeded the foreign tax credit limitation was 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 (not deducted) to the extent that the taxpayer 

 56 Sec. 904(d)(1) (as in effect prior to AJCA). 

57 See, e.g., sec. 245(a)(10) (relating to certain dividends treated as foreign source under treaties); 

sec. 865(h)(1)(B) (relating to certain gains from stock and intangibles treated as foreign source under 

treaties); sec. 901(j)(1)(B) (relating to income from certain specified countries); and sec. 904(g)(10)(A) 

(relating to interest, dividends, and certain other amounts derived from U.S.-owned foreign corporations 

and treated as foreign source under treaties). 

58 AJCA sec. 404. 

59 AJCA did not affect the separate computation of foreign tax credit limitations under special 

provisions of the Code relating to, for example, treaty-based sourcing rules or specified countries under 

section 901(j). 

60 Sec. 904(d)(2)(K) (as in effect for taxable years beginning after December 31, 2006). 
22

otherwise had excess foreign tax credit limitation for those years.61 AJCA extended the excess 

foreign tax credit carryforward period to ten years and limited the carryback period to one year.62

Foreign tax credit under alternative minimum tax

Taxpayers are subject to an alternative minimum tax (“AMT”), which is payable, in 

addition to all other tax liabilities, to the extent that it exceeds the taxpayer’s regular income tax 

liability.63 The tax is imposed at a flat rate of 20 percent, in the case of corporate taxpayers, on 

alternative minimum taxable income (“AMTI”) in excess of an exemption amount.64 AMTI is 

the taxpayer’s taxable income increased for certain tax preferences and adjusted by determining 

the tax treatment of certain items in a manner that limits the tax benefits resulting from the 

regular tax treatment of such items.65

Taxpayers are permitted to reduce their AMT liability by an AMT foreign tax credit.66

The AMT foreign tax credit for a taxable year is determined under principles similar to those 

used in computing the regular tax foreign tax credit, except that (1) the numerator of the AMT 

foreign tax credit limitation fraction is foreign source AMTI and (2) the denominator of that 

fraction is total AMTI.67 Prior to AJCA, the AMT foreign tax credit for any taxable year 

generally could not offset a taxpayer’s entire pre-credit AMT. Rather, the AMT foreign tax 

credit was limited to 90 percent of AMT computed without any AMT net operating loss 

deduction and the AMT foreign tax credit.68 AJCA repealed this 90-percent limitation on the 

utilization of the AMT foreign tax credit, effective for taxable years beginning after 

December 31, 2004; thus, a taxpayer with sufficient AMT foreign tax credit limitation is now 

permitted to offset up to 100 percent of its pre-credit AMT with AMT foreign tax credits.69

 61 Sec. 904(c) (as in effect prior to AJCA). 

62 AJCA sec. 417. 

63 Sec. 55. 

64 Sec. 55(b)(1)(B). 

65 Sec. 55(b)(2). 

66 Sec. 59(a). 

67 Sec. 59(a)(1). Alternatively, a taxpayer may elect to calculate its AMT foreign tax credit as 

the ratio of foreign source regular taxable income to total AMTI. Such an election must be made in the 

taxpayer’s first taxable year which begins after December 31, 1997, and for which the taxpayer claims an 

AMT foreign tax credit. Sec. 59(a)(4)(A). Once made, such an election applies to the taxable year for 

which made and all subsequent taxable years, and cannot be revoked without consent. Sec. 59(a)(4)(B). 

68 Sec. 59(a)(2) (as in effect prior to AJCA). 

69 AJCA sec. 421. 
23

Anti-deferral rules

CFC look-through

As described above, one category of subpart F income is foreign personal holding 

company income. This category includes passive income such as dividends, interest, rents, and 

royalties. Foreign personal holding income does not, however, include dividends and interest 

received by a CFC from a related corporation organized and operating in the same foreign 

country in which the CFC is organized. It also does not include rents and royalties received by a 

CFC from a related corporation for the use of property within the country in which the CFC is 

organized. The exclusions from foreign personal holding company income for these interest, 

dividend, rent, and royalty payments do not apply to the extent the payments reduce the subpart 

F income of the payor. 

TIPRA added a new exclusion from foreign personal holding company income for 

dividends, interest, rents, and royalties received by one CFC from a related CFC (with relation 

based on control) to the extent attributable or properly allocable to non-subpart-F income of the 

payor.70 The exclusion applies for taxable years beginning after 2005 and before 2009. 

Section 956

As described above, under section 956 the U.S. 10-percent shareholders of a controlled 

foreign corporation are required to include currently in income their pro rata shares of the 

corporation’s earnings invested in certain kinds of U.S. property. AJCA created two new 

exceptions to U.S. property under section 956, one for securities acquired and held by a 

controlled foreign corporation in the ordinary course of its trade or business as a securities 

dealer, and the other for obligations issued by a U.S. person that is not a domestic corporation 

and is not (1) a U.S. 10-percent shareholder of the controlled foreign corporation or (2) a 

partnership, estate, or trust in which the controlled foreign corporation or any related person is a 

partner, beneficiary, or trustee immediately after the controlled foreign corporation’s acquisition 

of the obligation.71

Partnership sales

Subpart F income generally includes gain from the sale of an interest in a partnership.72 

Under AJCA section 412, however, if a controlled foreign corporation owns at least a 25-percent 

capital or profits interest in a partnership and sells an interest in that partnership, the controlled 

foreign corporation is treated under subpart F as selling the proportionate share of the assets of 

the partnership attributable to that interest.73 Consequently, the sale gives rise to subpart F 

 70 TIPRA sec. 103(b). 

71 AJCA sec. 407; Code sec. 956(c)(2)(L) and (M). 

72 Secs. 952(a)(2), 954(a)(1) and (c)(1)(B)(ii). 

73 Sec. 954(c)(4). 
24

income only to the extent that a proportionate sale of the underlying assets would give rise to 

subpart F income. 

Other anti-deferral rules

The subpart F and PFIC rules are not the only anti-deferral regimes. Other rules that 

impose current U.S. taxation on income earned by a U.S. person through a foreign corporation 

include the accumulated earnings tax rules74 and the personal holding company rules.75 Until the 

enactment of AJCA, the Code included two other sets of anti-deferral rules, those applicable to 

foreign personal holding companies and those for foreign investment companies.76 Because the 

overlap among the various anti-deferral regimes was seen as creating complexity with no 

ultimate tax consequences, AJCA repealed the foreign personal holding company and foreign 

investment company rules.77

Active financing income

Under a provision enacted in 1997 and originally applicable only for one taxable year,78

there is an exclusion from subpart F income for certain income of a controlled foreign 

corporation that is derived in the active conduct of a banking or financing business (“active 

financing income”).79 Congress has extended the application of section 954(h) several times, 

most recently in TIPRA.80 The exception from subpart F for active financing income now 

applies to taxable years of foreign corporations starting before January 1, 2009 (and to taxable 

years of U.S. shareholders with or within which those corporate taxable years end).81

AJCA expanded the scope of the active financing income exclusion from subpart F. 

Income is treated as active financing income (and was so treated before AJCA) only if, among 

other requirements, it is derived by a controlled foreign corporation or by a qualified business 

unit of that controlled foreign corporation. After the enactment of AJCA, certain activities 

conducted by persons related to the controlled foreign corporation or its qualified business unit 

are treated as conducted directly by the controlled foreign corporation or qualified business 

 74 Secs. 531-537. 

75 Secs. 541-547. 

76 Secs. 551-558 and 1246-1247. 

77 AJCA sec. 413. 

78 Pub. L. No. 105-34, sec. 1175. 

79 Sec. 954(h). 

80 TIPRA sec. 103(a)(2); Pub. L. No. 107-147, sec. 614 (2002); Pub. L. No. 106-170, sec. 503 

(1999); Pub. L. No. 105-277 (1998). 

81 TIPRA sec. 103(a)(2); Code sec. 954(h)(9). 
25

unit.82 An activity qualifies under this rule if the activity is performed by employees of the 

related person and if the related person is an eligible controlled foreign corporation the home 

country of which is the same as the home country of the related controlled foreign corporation or 

qualified business unit; the activity is performed in the home country of the related person; and 

the related person receives arm’s-length compensation that is treated as earned in the home 

country. Income from an activity qualifying under this rule is excepted from subpart F income 

so long as the other active financing requirements are satisfied. 

Aircraft and vessel leasing

In general, rents are considered subpart F income.83 Rents (and royalties) are not treated 

as subpart F income, however, if they are derived in the active conduct of a trade or business and 

are received from an unrelated person.84 In AJCA, Congress added to this exception for active 

rental income a safe harbor for rents derived from aircraft or vessel leasing.85 Rents derived 

from leasing an aircraft or vessel in foreign commerce will not fail to be treated as derived in the 

active conduct of a trade or business if, under Treasury regulations, the active leasing expenses 

are at least 10 percent of the profit on the lease.86

Other recent changes

Temporary dividends received deduction for repatriated foreign earnings

Section 421 of AJCA added to the Code section 965, a temporary provision intended to 

encourage the repatriation of certain low-taxed foreign earnings. As discussed above, the U.S. 

tax rules generally allow a U.S. corporation to defer U.S. income tax on the active foreign-source 

income earned abroad by its CFCs until such income is returned to the United States. By 

providing a present-value benefit to U.S. taxpayers who keep low-taxed CFC earnings offshore, 

these rules operate as a disincentive to repatriate such earnings. In addition, U.S. generally 

accepted accounting principles (“U.S. GAAP”) may provide a further (and related) disincentive 

for publicly traded companies to repatriate low-taxed CFC earnings.87

 82 AJCA sec. 416; Code sec. 954(h)(3)(E). 

83 Secs. 952(a)(2), 954(a)(1) and (c)(1)(A). 

84 Sec. 954(c)(2)(A). 

85 AJCA sec. 415(b). 

86 Sec. 954(c)(2)(A). 

87 In particular, Accounting Principles Board Opinion 23 (“APB 23”) provides an exception to 

the general rule of comprehensive recognition of deferred taxes for temporary book-tax differences. (For 

a general overview of the financial accounting rules relating to book-tax differences, see Joint Committee 

on Taxation, Present Law and Background Relating to Corporate Tax Reform: Issues of Conforming 

Book and Tax Income and Capital Cost Recovery (JCX-16-06), May 8, 2006.) The exception applies to 

temporary differences related to undistributed earnings of foreign subsidiaries and foreign corporate joint 
26

Under section 965, certain dividends received by a U.S. corporation from its controlled 

foreign corporations are eligible for an 85-percent dividends-received deduction.88 The 

deduction is subject to a number of general limitations. First, it applies only to cash repatriations 

generally in excess of the taxpayer’s average repatriation level calculated for recent taxable 

years. Second, the amount of dividends eligible for the deduction is generally limited to the 

amount of earnings shown as permanently invested outside the United States on the taxpayer’s 

recent audited financial statements.89 Third, in order to qualify for the deduction, dividends must 

be described in a domestic reinvestment plan approved by the taxpayer’s senior management and 

board of directors.90 

Under section 965(d), no foreign tax credit (or deduction) is allowed for foreign taxes 

attributable to the deductible portion of any dividend. For this purpose, the taxpayer may 

specifically identify which dividends are treated as carrying the deduction and which dividends 

are not. In other words, the taxpayer is allowed to choose which of its dividends are treated as 

meeting the base-period repatriation level (and thus carry foreign tax credits, to the extent 

otherwise allowable), and which of its dividends are treated as comprising the excess eligible for 

the deduction (and thus entail proportional disallowance of any associated foreign tax credits).91 

 

ventures that meet the indefinite reversal criterion in APB 23 (such earnings are said to be “permanently 

reinvested”). Under U.S. GAAP, a U.S. multinational company generally includes the pre-tax income of 

its CFCs in the U.S. parent’s consolidated financial statements (thereby increasing its reported earnings to 

reflect the foreign income of its CFCs); however, if the APB 23 exception applies, the company is not 

required to make an accrual for the residual U.S. tax that will be imposed when the earnings are 

repatriated (thereby avoiding a reduction of its reported earnings to take into account the U.S. tax liability 

which would be due upon repatriation). The rationale for this exception is that, when management of the 

company asserts that certain low-taxed foreign earnings will never be repatriated, it would be inconsistent 

with the objectives of U.S. GAAP (including the objective of providing investors with accurate 

information) to require a current accrual for future U.S. taxes that management, according to such 

assertion, expects that the company will never be required to pay. Instead, under APB 23, the company 

will reduce its reported consolidated income to account for the residual U.S. tax on the CFC’s earnings 

only at the time such earnings are repatriated (or when such earnings no longer qualify as “permanently 

reinvested,” if earlier). Thus, just as taxpayers can often defer the cash payment of U.S. tax until foreign 

income is repatriated, so too publicly-traded U.S. multinational companies can often defer accounting for 

and reflecting this tax cost in their public financial statements until the foreign income is repatriated. 

88 At the taxpayer’s election, this deduction is available for dividends received either during the 

taxpayer’s first taxable year beginning on or after October 22, 2004, or during the taxpayer’s last taxable 

year beginning before such date. 

89 This rule refers to elements of APB 23 as described above. 

90 The plan must 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, and the financial stabilization of the corporation for the purposes of job 

retention or creation. 

91 Accordingly, taxpayers generally would be expected to pay regular dividends out of high-taxed 

CFC earnings (thereby generating deemed-paid credits available to offset foreign-source income) and 
27

The deduction itself will have the effect of appropriately reducing the taxpayer’s foreign tax 

credit limitation. In addition, deductions are disallowed for expenses that are directly allocable 

to the deductible portion of any dividend. 

In enacting section 421 of AJCA, the Congress emphasized that this tax reduction is a 

temporary economic stimulus measure, and that there is no intent to make the measure 

permanent, or to “extend” or enact it again in the future.92

FSC/ETI and section 199

Until recently, the United States provided export-related benefits under various Code 

rules. For most of the last two decades, these benefits were provided under the foreign sales 

corporation regime. In 2000, the foreign sales corporation regime was declared a prohibited 

export subsidy by the World Trade Organization. In response to this ruling, the United States 

repealed the foreign sales corporation rules and replaced them with a new set of rules, the 

extraterritorial income regime. This new regime also was found to be a prohibited export 

subsidy. In AJCA, Congress repealed the extraterritorial income regime, subject to certain 

transition and grandfather rules.93 At the same time as it repealed the extraterritorial income 

rules, Congress enacted a new tax incentive for certain domestic manufacturing activities.94 

When fully phased in, the tax benefit from this manufacturing incentive will be equivalent to a 

three-percent tax rate reduction. 

Expiration of section 936 and 30A credits

Under prior U.S. law, certain domestic corporations with business operations in U.S. 

possessions could elect under Code section 936 to generally eliminate the U.S. tax (including the 

alternative minimum tax) on certain foreign source income which was related to their operations 

in the possessions. The benefit conferred to companies under section 936 is commonly referred 

to as the possessions tax credit. A majority of the corporations that benefited from the 

possessions tax credit established operations in Puerto Rico. Companies with significant 

operations in Puerto Rico operated through a Puerto Rico branch of a domestic U.S. corporation. 

Such corporations were commonly referred to as “section 936 companies.” Income that was not 

subject to U.S. tax under this provision included income that was derived either from the active 

conduct of a trade or business within a U.S. possession or from certain investments in the 

possessions or in certain Caribbean Basin countries which generated qualified possession source 

 

section 965 dividends out of low-taxed CFC earnings (thereby availing themselves of the 85-percent 

deduction). 

92 H.R. Rep. No. 108-548, at 43 (2004); S. Rep. No. 108-192, at 50 (2003). 

93 Rules grandfathering certain arrangements under binding contracts subsequently were repealed 

in TIPRA. Transition period rules were left in place. TIPRA sec. 513. 

94 Sec. 199. 
28

investment income (“QPSII”). The benefit of the possessions tax credit was that it spared the 

electing corporation U.S. tax whether or not it paid income tax to the possession. 

The Small Business Job Protection Act of 199695 (“Small Business Act”) repealed the 

possession tax credit for tax years beginning after December 31, 1995. In doing so, the Small 

Business Act provided grandfather rules that allowed for a 10-year transition period. However, 

for tax years beginning after December 31, 1995, the Small Business Act stated that QPSII 

earned after July 1, 1996 no longer qualified for the possession tax credit. The Small Business 

Act also added an additional income limitation to the calculation of the possession tax credit. 96

The Small Business Act added a new section 30A to the Code with respect to qualified 

income earned in Puerto Rico. This section allowed an economic activity credit that was 

applicable for tax years beginning after December 31, 1995 and before January 1, 2006. While 

in a separate section of the Code, the economic activity credit (section 30A) was calculated under 

the rules set forth for the possession tax credit (section 936). The possession tax credit applied 

generally to taxpayers operating in any U.S. possession. The economic activity credit was a 

special case of the possession tax credit, applicable only to taxpayers in Puerto Rico. 

The possession tax credit and the economic activity credit were subject to either an 

economic activity limitation or an income limitation. A corporation subject to the economic 

activity limitation with respect to income earned in Puerto Rico claimed a credit under section 

30A rather than under section 936. All other corporations claimed a possession tax credit under 

section 936. 

For the past ten years, domestic corporations with business operations in the U.S. 

possessions could claim the possession tax credit or the economic activity credit to reduce their 

U.S. tax on certain income related to operations in the possessions97 Both credits expired for 

taxable years beginning after December 31, 2005.98

 95 Pub. L. No. 104-188, August 20, 1988. 

96 A special rule applied to Guam, American Samoa, and the Commonwealth of the Northern 

Mariana Islands. This rule allowed such applicable possessions to continue to get the full benefit of the 

possession tax credit, as in effect prior to repeal, until December 31, 2005. See sec. 936(j)(8). 

97 Dividends paid by a section 936 corporation to its U.S. shareholder could qualify for a 

dividends-received deduction. In cases where at least 80 percent of the stock of the electing corporation 

was owned by a single domestic corporation, the electing corporation’s possession source income 

generally could be distributed without incurring any regular U.S. income tax. However, such a dividend 

constituted adjusted current earnings of the shareholder for purposes of computing the alternative 

minimum tax. 

98 Some companies may still qualify for tax benefits for some period of time under section 936 or 

section 30A after December 31, 2005 if their taxable year began sometime before December 31, 2005. 
29

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 net-basis 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.99

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.100 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.101 The tax generally is collected by 

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

income.102

The Code includes certain rules, known as “thin capitalization” rules, intended to prevent 

foreign corporations from eliminating or inappropriately reducing the income of their U.S. 

subsidiaries through excessive interest deductions. Those rules provide, in part, that the interest 

paid or accrued by a domestic corporation is nondeductible if it is paid or accrued to a related 

party, no tax is imposed on the payment, and the domestic corporation has a debt-equity ratio 

exceeding 1.5 to one. The amount that is nondeductible generally is limited to the excess of the 

domestic corporation’s net interest expense − that is, interest expense less interest income − over 

its taxable income (with certain adjustments).103

 99 Secs. 871(b) and 882. 

100 Secs. 871 and 881. 

101 Secs. 871(h)-(i), 881(c)-(d). 

102 Secs. 1441, 1442. 

103 Sec. 163(j). 
30

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; it establishes 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.104 These transactions present particular challenges to the administration of the arm’s 

length standard because intangibles and services may be unique. This uniqueness renders a 

comparison with third-party market transactions difficult or impossible. Cost-sharing rules thus 

take a different approach. These rules generally permit related parties to share profits from the 

use of self-developed intangibles in the same proportion as they share the costs of developing the 

intangibles. 

 104 The income with respect to a transfer or license of intangible property must be commensurate 

with the income attributable to the intangible. 
31

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, such as dividends, interest and royalties, paid to residents of the other 

treaty country. For another example, treaties set the standard for the taxation by a treaty country 

of the business activities of a resident of the other treaty country (known as a “permanent 

establishment”). Treaties also include provisions governing the creditability of taxes imposed by 

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

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

which inconsistent positions taken by the treaty countries on a single item of income or 

deduction may be mutually resolved by the two countries. 

The United States has a network of 57 bilateral income tax treaties covering 65 countries. 

This network includes all other 29 OECD member countries. It also covers the vast majority of 

foreign trade and investment of U.S. businesses. 

Recently, the United States has entered into a series of bilateral tax treaties that eliminate 

withholding tax on dividends paid by one corporation to another corporation that owns at least 

80 percent of the stock of the dividend-paying corporation (often referred to as “direct 

dividends”), provided that certain conditions are met. The elimination of withholding tax under 

these circumstances is intended to reduce further the tax barriers to direct investment between the 

two treaty countries. Many bilateral tax treaties to which the United States is not a party 

eliminate withholding taxes in similar circumstances. The European Union has eliminated 

withholding taxes in cases of at least 25-percent ownership under its “Parent Subsidiary 

Directive.”105

Over the last three years, the Senate has given advice and consent to ratification of U.S. 

treaties and protocols containing zero-rate provisions with the United Kingdom, Australia, 

Mexico, Japan, the Netherlands, and Sweden. In addition, the United States has recently signed 

protocols with Denmark, Finland, and Germany which all include zero-rate provisions. These 

provisions are all similar in nature, although the treaty with Japan allows a lower ownership 

threshold (i.e., more than 50 percent, as opposed to at least 80 percent) than do the other 

provisions. 

 105 The European Union is in the process of decreasing this ownership threshold to 10 percent. 
32 

III. BRIEF DESRIPTIONS OF SELECTED TERRITORIAL 

AND OTHER SYSTEMS106

A. Selected Territorial Systems 

1. France107

In general

Individuals resident in France are taxed on their worldwide income. Corporations, 

wherever resident, are subject to tax only on income derived from French sources. France 

imposes four major categories of income taxes: corporation income taxes, individual income 

taxes, social levies, and payroll taxes. French tax law, like that of the United States, generally 

takes an expansive view of income including most economic benefits and capital gains. Timing 

and amounts of taxable income are generally determined by reference to commercial accounting 

rules. Although individuals resident in France are subject to tax on their worldwide income, 

corporations, wherever resident, are only subject to tax on income arising in France. 

France also imposes a number of indirect taxes, including a value-added tax (“VAT”) 

based on the European Community Directive. The French VAT differs from some “cascade” tax 

systems, which are applied at each stage of the manufacturing and distribution process. 

Although collected from and, to a certain extent, funded by the manufacturer or distributor, the 

VAT is considered to be an indirect tax because it is borne by the final consumer. The amount of 

tax due on the “added value,” is determined by deducting the “input” VAT from the “output” 

VAT. The VAT covers all economic, commercial, industrial, and professional activities. 

Figure 1, below, provides a comparison of tax receipts, as a percentage of GDP, in 

France, the United States, and the average of the member countries of the OECD.108

 106 The following descriptions of the tax laws of selected foreign jurisdictions were prepared with 

the assistance of the staff of the Directorate of Legal Research, Law Library, Library of Congress. 

107 Unless otherwise noted, the following discussion is drawn from Bernard Chesnais, Francois 

Froment-Meurice and Sandra Hazan, Foreign Income: Business Operations in France, BNA Tax 

Management Portfolio 961-3rd (2005); Ernst & Young, Worldwide Corporate Tax Guide, pp. 254-264 

(2005); and the National Foreign Trade Council, International Tax Policy for the 21st Century (2001). 

108 OECD, Revenue Statistics, 1965-2004 (OECD: Paris, 2005). 
33 

Figure 1 

Comparative Revenue Profile of France - Major Taxes

as a Percentage of GDP, 2003

43.4

7.6

2.5

16.4

7.3

25.6

9.0

2.1

6.7

2.1

36.3

9.4

3.4

9.5

6.9

0

5

10

15

20

25

30

35

40

45

50

Total Tax Revenue Individual Income Corporate Income Social Security General Consumption

Percentage

France U.S.A. OECD

Source: OECD. 

Taxation of corporations

Domestic corporations

Income from domestic activities

France has a territorial system of corporate income taxation. Thus, corporations, 

wherever resident, are subject to tax only on income derived from French sources. Certain 

partnerships may elect entity-level taxation as corporations in lieu of current attribution of their 

income to partners. Business income is subject to tax at the standard rate of 33.33 percent and 

long-term capital gains are subject to tax at a rate of 15 percent. A parent company and its at 

least 95-percent owned subsidiaries may elect taxation as a single corporate entity. Certain 

special-purpose “headquarters companies” and “logistics center companies” are subject to a 

simplified tax regime wherein corporate tax at the normal rates is imposed upon an income 

corresponding to at least six to 10 percent of their annual operating expenses, with exemptions 

for certain employee allowances. At the election of the companies involved, corporate 

reorganizations may be accomplished without current tax effect. 
34 

Income from foreign activities

As a general rule, foreign income earned directly by a French company is exempt from 

French taxation. Foreign subsidiary income of a French multinational is also generally exempt 

from French tax. Such income is not taxed when it is earned by the foreign subsidiaries and 95 

percent of it is exempt on repatriation to France. The exemption applies provided the French 

recipient owns 5 percent of the equity capital of the paying company and provided the recipient 

either subscribed for the original shares or purchased the shares with the intention of holding 

them for at least two years. 

In order to be exempt from French taxation, income generated abroad must be 

attributable to a foreign permanent establishment or other independent establishment that 

regularly conducts business activities. Where there is no applicable treaty, case law is used to 

provide a definition of what is a “business conducted abroad.” In accordance with case law, 

French corporations are not subject to tax on: (1) profits realized by a foreign establishment; (2) 

profits from transactions habitually conducted abroad involving the participation of 

intermediaries who are not professionally independent; or (3) profits from transactions that 

constitute a “complete commercial cycle” carried out abroad, distinct from the entity’s other 

operations. A complete commercial cycle means the resale of purchased or manufactured goods. 

The corporate income tax applies to transactions conducted abroad by means of an independent 

agent or intermediary, and to profits resulting from foreign transactions if: (1) neither their nature 

nor their mode of execution distinguish them from the company’s other business; and (2) they do 

not represent a commercial activity habitually conducted abroad. 

The rules governing foreign source income are subject to an important exception, 

described below. 

Special rules for income from foreign activities

Under the controlled foreign company (“CFC”) rules, an exemption is not allowed for 

specifically defined types of low-taxed, non-business income. A French company is required to 

pay French tax on its pro rata share of foreign source income received or deemed received from a 

CFC established in a low-tax jurisdiction. Only certain categories of non-business income are 

targeted, such as securities or royalty income and intra-group services income. The CFC rules 

were substantially amended in December 2004. The new legislation is effective starting January 

1, 2006. 

The French CFC regime is jurisdiction-based, applying to CFCs in countries with a 

“privileged tax system.” Generally, a foreign country is considered to have a privileged tax 

system when the foreign tax actually borne by the CFC is at least 50 percent lower than that of 

France. In addition, the resident company must directly or indirectly hold a participation of more 

than 50 percent in the foreign company. A country is also considered to have a privileged tax 

system if it does not impose tax on foreign-source income of corporations established there. 

There is an unofficial list of the countries that are considered tax havens under the French 

regime. 
35 

The new CFC rules do not apply if the company is established within the European 

Union unless the French tax administration can demonstrate that it is part of “an artificial 

arrangement aimed at circumventing the French tax legislation.” Outside the European Union, 

the rules do not apply if the foreign company is principally engaged in active commercial or 

industrial activities. However, even in this case, the French company must prove that the 

operation of the foreign company is not an artificial arrangement to circumvent French tax when: 

(1) more than 20 percent of its income is derived from the management of shares, participations, 

or assets for its own account or for the account of companies belonging to a group controlled by 

the French company, or more than 20 percent of its income is derived from the sale or 

concessions of intangible rights related to industrial or intellectual property; or (2) more than 50 

percent of its income is derived from operations listed in (1) and from intra-group services. 

Foreign corporations

Nonresident corporations are generally subject to withholding taxes at the following 

rates, in lieu of the progressive income tax to which residents are subject: 25 percent on 

dividends; 16 percent on interest; and 33.33 percent on royalties from patents and know-how. 

Furthermore, repatriation of profits from a French branch of a foreign corporation is generally 

subject to a 25-percent withholding tax. 

Avoidance or relief of double taxation

France does not have detailed statutory rules dealing with the allocation of expenses to 

exempt foreign-source income. Expenses that are directly related to exempt foreign-source 

income are non-deductible. Expenses that are not directly related must be apportioned between 

taxable and exempt income and are likewise non-deductible. 

Since France fully excludes foreign income from French taxable income, foreign losses 

never enter into French taxable income. Thus, resourcing provisions like the U.S. overall foreign 

loss rules are not necessary. 

France has entered into a large number of tax treaties whose main objective is the 

elimination of double taxation of income and capital. These tax treaties are aimed at eliminating 

conflict between the tax rules of two taxing jurisdictions that, if the national rules alone were 

applied, would result in the same items being taxed twice in the hands of the same taxpayer by 

two separate taxing authorities. 

Recently, France has entered into a bilateral tax treaty with the United States that 

eliminates withholding tax on dividends paid by one corporation to another corporation that 

owns at least 80 percent of the stock of the dividend-paying corporation (often referred to as 

“direct dividends”), provided that certain conditions are met. The elimination of withholding tax 

under these circumstances is intended to reduce further the tax barriers to direct investment 

between the two treaty countries. In addition, under the European Union “Parent Subsidiary 

Directive,” withholding taxes are eliminated on intra-group dividend payments between 
36 

European Union countries in the case of shareholdings of at least twenty-five percent.109 Under 

the Parent Subsidiary Directive, France generally does not impose withholding tax on such 

dividends paid by French companies to other European Union companies (e.g., Germany) and 

other European Union companies generally do not impose a withholding tax on such dividends 

paid to French companies. 

In the absence of a treaty, France generally provides double tax relief to resident 

individuals by way of a deduction from taxable income. Since corporations are not generally 

subject to French tax on income from sources outside France, they are not provided double tax 

relief. 

2. Germany110

In general

Germany imposes income tax on resident and nonresident individuals at progressive 

rates. In January 2001, Germany replaced the imputation system111 of corporate income taxation 

with a classical system and instituted a flat 25 percent corporate tax rate. To prevent the 

corporate income tax from having a cascading effect, dividends received by a corporate taxpayer 

can now be excluded from the taxable income of the recipient corporation. German law 

generally provides that German resident corporations are subject to tax on their worldwide 

income. Nevertheless, Germany accomplishes most of its double tax relief through exemption. 

Germany also applies a VAT system based on the European Community directive. The 

German VAT differs from some “cascade” tax systems, which applied at each stage of the 

manufacturing and distribution process. Although collected from and, to a certain extent, funded 

by the manufacturer or distributor, the VAT is considered to be an indirect tax because it is borne 

by the final consumer. The amount of tax due on the “added value,” is determined by deducting 

the “input” VAT from the “output” VAT. The VAT covers all economic, commercial, industrial, 

and professional activities. 

Figure 2, below, provides a comparison of tax receipts, as a percentage of GDP, in 

Germany, the United States, and the average of the member countries of the OECD.112

 109 The European Union is in the process of decreasing this ownership threshold to 10 percent. 

110 Unless otherwise noted, the following discussion is drawn from Dr. Juergen Killius, Foreign 

Income: Business Operations in Germany, BNA Tax Management Portfolio 962-2nd (2006); Ernst & 

Young, Worldwide Corporate Tax Guide, pp. 291-301 (2005); and the National Foreign Trade Council, 

International Tax Policy for the 21st Century (2001). 

111 Under the German imputation system, the were generally split rates for retained earnings and 

distributed profits, and there was institutionalized integration of the corporate income tax paid at the 

company level and the individual or corporate tax paid at the shareholder level. 

112 OECD, Revenue Statistics, 1965-2004 (OECD: Paris, 2005). 
37 

Figure 2 

Comparative Revenue Profile of Germany - Major Taxes

as a Percentage of GDP, 2003

35.5

8.5

1.3

14.4

6.4

25.6

9.0

2.1

6.7

2.1

36.3

9.4

3.4

9.5

6.9

0

5

10

15

20

25

30

35

40

Total Tax Revenue Individual Income Corporate Income Social Security General Consumption

Percentage

Germany U.S.A. OECD

Source: OECD. 

Taxation of corporations

Domestic corporations

Companies resident in Germany are subject to the corporate income tax with respect to 

their worldwide income. Taxable income is gross income, less business expenses and other 

statutory allowances incurred by the taxpayer during the fiscal year as determined by the accrual 

method of accounting for the taxable year. The recent German tax reform abolished the former 

corporate imputation system and under the new regime, dividends received by German 

companies and branches of nonresident companies from their German and foreign subsidiaries 

are exempt from tax. This results from the introduction of a participation exemption 

(comparable to a full dividend-received deduction) for all intracorporate domestic or foreign 

dividends. The law imposes neither a minimum shareholding requirement nor a minimum 

holding period requirement for the participation exemption. 

Five percent of the tax-exempt dividend income received from foreign subsidiaries is 

treated as a nondeductible expense, while expenses actually accrued are deductible. For 

dividend income received in tax years ending after December 31, 2003, the 95 percent exemption 

rule applies to dividends received from both resident and nonresident companies. Expenses 
38 

related to such income are fully deductible for corporate tax purposes, but interest is deductible 

only if certain thin-capitalization requirements are met. 

Dividends received from corporations in which the parent holds less than 10 percent at 

the beginning of the fiscal year are subject to trade tax. The same rule applies to dividends 

received from non-EU corporations, regardless of the percentage of ownership, if passive income 

accounts for more than 10 percent of the foreign corporation’s gross income. 

Special rules for income from foreign activities

Special CFC rules apply to specifically defined types of passive investment income. 

Dividends and branch profits of this nature that are derived in low-tax jurisdictions are not 

permitted an exemption. Germany, like the United States, has a transaction-based system, but it 

is modified by jurisdiction-based exemptions. The regime only attributes certain tainted income 

to the shareholders of a CFC. All income that is not on an enumerated list of exempt types of 

income is treated as tainted when the income of the CFC is not subject to income taxation at the 

rate of at least 30 percent. Germany has an unofficial list of the countries whose effective rate is 

less than 30 percent and a list of countries whose effective rate is more than 30 percent. 

However, the presumption that a rate is less than or more than 30 percent may be overcome by 

the tax authorities or the taxpayer. The income excluded by the enumerated list of types of 

exempt income is generally income from active business. 

Foreign corporations

A nonresident corporation, whose corporate seat and place of management are located 

outside Germany, is subject to corporate income tax only on income derived from German 

sources. German source income includes, among other items, business income from operations 

in the country through a branch, office or other permanent establishment, including a permanent 

representative, and income derived from the leasing and disposal of real estate located in 

Germany. 

Avoidance or relief of double taxation

Germany’s expense allocation laws are relatively generous. For instance, interest 

expense related to the acquisition and financing of a foreign holding generating exempt 

dividends is fully deductible by a German parent corporation. 

Germany’s provisions on foreign losses are not very favorable. Foreign branch losses are 

not deductible. As a result, loss recapture rules are not necessary. However, in situations where 

the credit regime applies, branch losses can be carried forward for offset against future income of 

the respective branch. Thus, a benefit for the branch loss, although deferred, is ultimately 

obtained. 

Germany has entered into a large number of tax treaties whose main objective is the 

elimination of double taxation of income and capital. These tax treaties are aimed at eliminating 

conflict between the tax rules of two taxing jurisdictions that, if the national rules alone were 

applied, would result in the same items being taxed twice in the hands of the same taxpayer by 

two separate taxing authorities. 
39 

Recently, Germany has entered into a bilateral tax treaty with the United States that 

eliminates withholding tax on dividends paid by one corporation to another corporation that 

owns at least 80 percent of the stock of the dividend-paying corporation (often referred to as 

“direct dividends”), provided that certain conditions are met.113 The elimination of withholding 

tax under these circumstances is intended to reduce further the tax barriers to direct investment 

between the two treaty countries. In addition, under the European Union “Parent Subsidiary 

Directive,” withholding taxes are eliminated on intra-group dividend payments between 

European Union countries in the case of shareholdings of at least twenty-five percent.114 Under 

the Parent Subsidiary Directive, Germany generally does not impose withholding tax on such 

dividends paid by German companies to other European Union companies (e.g., France) and 

other European Union companies generally do not impose a withholding tax on such dividends 

paid to German companies. 

Under German domestic law, foreign-source income, except for foreign intracompany 

dividends (mentioned above), is usually taxable, with a credit for foreign income taxes paid, up 

to the amount of German tax payable on the foreign-source income, subject to per-country and 

per-item limitations. Excess foreign tax credits cannot be carried back or forward. Instead of a 

foreign tax credit, a deduction may be claimed for foreign income tax. This may be beneficial in 

loss years and in certain other instances. 

3. Netherlands115

In general

Individuals resident in the Netherlands are taxed on their worldwide income. The income 

tax takes into account the origin of the income and distinguishes between three categories known 

as “boxes.” The income in each of the boxes is taxed at a different rate. The sum of the tax 

owed in each of the three boxes is the total income tax payable. Corporations are subject to tax 

on their worldwide income, but the Netherlands employs an exemption system that is applicable 

to both domestic and foreign shareholdings and such exemption allows for the avoidance of 

double taxation when the profits of a subsidiary are distributed to its parent company. 

Netherlands tax law uses a source-of-income model. Only income derived from a source 

is subject to taxation. Source income arises only in cases where a taxpayer undertakes an 

economic activity with the intent of deriving a benefit that can objectively be expected to 

 113 In June 2006, the United States and Germany signed a protocol that includes a zero-rate 

dividends provision, but such protocol has not been ratified by the U.S. Senate. 

114 The European Union is in the process of decreasing this ownership threshold to 10 percent. 

115 Unless otherwise noted, the following discussion is drawn from Kees van Raad, Foreign 

Income: Business Operations in The Netherlands, BNA Tax Management Portfolio 973-2nd (2005); 

Ernst & Young, Worldwide Corporate Tax Guide, pp. 625-642 (2005); and the National Foreign Trade 

Council, International Tax Policy for the 21st Century (2001). 
40 

materialize. As a result, activities that are unlikely to produce any positive amount of income 

(e.g., hobby farms, inventing) will not be deemed a source of income. 

The Netherlands also applies a VAT system based on the European Community directive. 

The Netherlands VAT differs from some “cascade” tax systems, which applied at each stage of 

the manufacturing and distribution process. Although collected from and, to a certain extent, 

funded by the manufacturer or distributor, the VAT is considered to be an indirect tax because it 

is borne by the final consumer. The amount of tax due on the “added value,” is determined by 

deducting the “input” VAT from the “output” VAT. The VAT covers all economic, commercial, 

industrial, and professional activities. 

Figure 3, below, provides a comparison of tax receipts, as a percentage of GDP, in the 

Netherlands, the United States, and the average of the member countries of the OECD.116

Figure 3 

Comparative Revenue Profile of the Netherlands - Major Taxes

as a Percentage of GDP, 2003

38.8

6.9

2.9

14.1

7.7

25.6

9.0

2.1

6.7

2.1

36.3

9.4

3.4

9.5

6.9

0

5

10

15

20

25

30

35

40

45

Total Tax Revenue Individual Income Corporate Income Social Security General Consumption

Percentage

Netherlands U.S.A. OECD

Source: OECD. 

 116 OECD, Revenue Statistics, 1965-2004 (OECD: Paris, 2005). 
41 

Taxation of corporations

Domestic corporations

Entities resident in the Netherlands are subject to corporate income tax on their 

worldwide income. All income earned by companies is deemed to be business income. 

Corporate income tax is levied at a rate of 29 percent on the first €22,689 of taxable profits and 

at 31.5 percent on the excess. Losses may be carried forward and deducted from profits in a 

subsequent year. Profits distributed to shareholders are not deductible from taxable profits for 

purposes of the corporate income tax. 

The Companies Income Tax Act provides for a participation exemption, which is 

applicable to both domestic and foreign shareholdings. Corporate tax need not be paid on the 

profits generated by the participation. The exemption allows for the avoidance of double 

taxation when the profits of a subsidiary are distributed to its parent company. A participation 

exists if the taxpayer (1) holds at least five percent of the nominal paid-up capital of a company, 

or (2) holds less than five percent, but ownership of the shares is necessary for the conduct of 

normal business, or the acquisition of the shares serves a general interest. All profits gained 

from shareholdings are exempt from taxation unless shares in a foreign corporation are held as 

an investment or the foreign company in which the shares are held is not subject to tax on its 

profits in the foreign country (the rate of tax is unimportant). A 25 percent withholding tax is 

imposed on dividends from corporations resident in the Netherlands, unless the participation 

exemption applies. Dividends received from a qualifying subsidiary company are exempt from 

tax in the hands of the parent company. Similarly, capital gains realized on the disposition of 

shares of such a subsidiary company are exempt. 

Under certain conditions a parent corporation may be taxed as a group together with one 

or more of its subsidiaries. Group taxation allows losses of one company to be set off against 

profits of another company, and fixed assets may be transferred tax-free from one company to 

another. Group taxation is allowed only if all the companies involved are based in the 

Netherlands for tax purposes and the parent company holds at least 95 percent of the shares in 

the subsidiary. 

Special rules for income from foreign activities

As mentioned above, the Netherlands provides for a participation exemption that 

generally exempts all dividend income received from foreign subsidiaries from taxation in the 

Netherlands. Because the Netherlands exempts dividends from a foreign subsidiary from 

income, there is no domestic income on which to defer tax (and thus no need for an extensive 

anti-deferral regime). However, the Netherlands denies the benefit of the participation 

exemption to income derived from certain passive investments. One consideration in 

determining whether an investment is passive is the level of ownership associated with such 

investment. The greater the ownership, the less likely the investment will be considered passive. 

In the case of a holding company, there is a look-through to the companies that the holding 

company owns to determine whether ownership is passive. If the participation exemption does 

not apply, the annual increase in the value of the subsidiary is fully taxable at the level of the 

Netherlands parent company, whether or not profits were distributed. 
42 

Because multinationals that are resident in the Netherlands are not taxed on current 

income of a foreign subsidiary under an anti-deferral regime or on the dividends from foreign 

subsidiaries when remitted, they enjoy a relative advantage over other multinationals that are 

subject to an extensive anti-deferral regime with CFC rules. 

Foreign corporations

Nonresident corporations are subject to tax in the Netherlands on business income 

derived through a permanent establishment in the Netherlands, real property income and gains, 

dividends and interest received from a resident country at least five percent of the shares of 

which are held by the entity as portfolio investment, and certain other categories of income. 

Avoidance or relief of double taxation

The Netherlands has entered into a large number of tax treaties whose main objective is 

the elimination of double taxation of income and capital. These tax treaties are aimed at 

eliminating conflict between the tax rules of two taxing jurisdictions that, if the national rules 

alone were applied, would result in the same items being taxed twice in the hands of the same 

taxpayer by two separate taxing authorities. 

Recently, the Netherlands has entered into a bilateral tax treaty with the United States 

that eliminates withholding tax on dividends paid by one corporation to another corporation that 

owns at least 80 percent of the stock of the dividend-paying corporation (often referred to as 

“direct dividends”), provided that certain conditions are met. The elimination of withholding tax 

under these circumstances is intended to reduce further the tax barriers to direct investment 

between the two treaty countries. In addition, under the European Union “Parent Subsidiary 

Directive,” withholding taxes are eliminated on intra-group dividend payments between 

European Union countries in the case of shareholdings of at least twenty-five percent.117 Under 

the Parent Subsidiary Directive, the Netherlands generally does not impose withholding tax on 

such dividends paid by Dutch companies to other European Union companies (e.g., Germany) 

and other European Union companies generally do not impose a withholding tax on such 

dividends paid to Dutch companies. 

In the absence of a treaty, the Netherlands generally provides double tax relief under the 

2001 Unilateral Decree on the Avoidance of Double Taxation (“the Decree”). The Decree 

relieves international double taxation either by way of a proportional tax reduction (sometimes 

referred to as “exemption with progression”) or by way of a foreign tax credit. The major 

income elements to which the proportional tax reduction applies are business income, income 

from foreign real property, and income from employment exercised abroad. Double taxation 

relief by way of the foreign tax credit applies to dividends, interest and royalties received from 

sources in developing countries (dividends received by a corporate shareholder generally qualify 

for double tax relief under the participation exemption). 

 117 The European Union is in the process of decreasing this ownership threshold to 10 percent. 
43 

4. Singapore118

In general

The Singapore tax system includes corporate and individual income taxes; an estate tax; 

property taxes for residential and commercial property; customs and excise duties on a limited 

range of items; a goods and services tax (“GST,” a form of a value added tax); stamp duties on 

legal instruments related to real property and securities; and social security taxes. 

The GST is imposed at either a five-percent or a zero-percent rate on all goods and 

services unless a specific exemption applies. GST is collected by sellers from customers and is 

remitted to the government. Sellers of goods and services collect and remit GST on their sales 

and can claim a credit for GST charged on their purchases. GST generally is charged on 

imports, and exports from Singapore are zero rated. 

The corporate income tax is discussed next. 

Taxation of corporations

In general

Singapore’s corporate income tax regime is territorial. A corporation, whether 

incorporated or registered in Singapore or elsewhere, generally is subject to Singapore tax on all 

income derived from Singapore sources or received in Singapore. Companies resident in 

Singapore may be subject to tax by Singapore on non-Singapore source income only when that 

income is remitted to Singapore. There generally are no special rules for the taxation of nonresident companies. Like resident companies, nonresident companies are taxed in Singapore on 

income derived from Singapore sources or received in Singapore. In practice, under this rule 

nonresident companies are taxed in Singapore on income from business operations in Singapore. 

Certain payments to a nonresident company of Singapore-source income not connected with 

Singapore business operations of the nonresident may be subject to Singapore withholding tax. 

Singapore maintains a variety of preferential tax rules for targeted industries and 

activities. These rules are briefly summarized below. 

Taxation of resident companies

Income from domestic activities

As described above, under Singapore’s territorial taxing regime, resident companies are 

subject to tax on their income derived from Singapore sources or received in Singapore. The 

 118 Unless otherwise noted, the following discussion is drawn from Brij S. Soin, Foreign Income: 

Business Operations in Singapore, BNA Tax Management Portfolio 983-3rd (2005); Ernst & Young, 

Worldwide Corporate Tax Guide, pp. 811-21 (2005); and Angela Tan & Tan How Teck, Singapore 

Master Tax Guide Handbook 2005, 24th ed., CCH Asia Pte Ltd. (2005). 
44 

place of residence of a company is determined by where the management and control of the 

company is exercised. Income from Singapore sources encompasses most sorts of profits from 

business activities but does not include capital gains. 

The rate of corporate tax generally is 21 percent in 2006 and is scheduled to be reduced 

to 20 percent in 2007. 

Dividends received by a resident corporation (or by an individual shareholder) from 

another resident corporation, whether paid out of fully-taxed corporate income or out of income 

exempt from tax or subject to a reduced rate of tax, are exempt from income tax.119

Special tax rules apply in a variety of circumstances. Examples include the following: 

• Under rules intended to help small and medium size businesses, companies 

generally are eligible for a partial exemption from income tax for the first 

S$100,000 (about $63,000) of taxable income. 

• New companies may be exempted from paying income tax on the first S$100,000 

of taxable business income − dividend income does not qualify for the exclusion 

− for each of their first three years of tax assessment. 

• Under a headquarters program, entities incorporated or registered in Singapore 

that provide headquarters services to affiliated companies regionally or worldwide 

and that satisfy certain other conditions are subject to tax rates of zero to 15 

percent for a specified period on certain qualifying income. 

• Other tax incentives and preferences exist for, among other things, certain capital 

expenditures; payments of certain royalties, technical assistance fees, and research 

and development costs; payments to nonresidents for software and other 

technological goods and services; remittances of foreign-source royalties and 

interest income when used for research and development purposes; financial 

institutions’ income from qualifying activities; and income from global trading 

operations involving commodities and certain other products. 

Income from foreign activities

As described previously, resident companies may be subject to tax by Singapore on nonSingapore source income (earned, for example, through foreign branch operations) only when 

that income is remitted to Singapore. Dividends received from nonresident companies are 

exempt from Singapore tax so long as the income underlying the dividends has been earned in a 

country with a headline tax rate of at least 15 percent. 

 119 Before 2003, Singapore maintained a full imputation system under which dividends paid by a 

resident company out of profits subject to the normal corporate tax rate generally were treated as paid net 

of a 20-percent tax. Shareholders then could claim a credit for this tax as an offset against their income 

tax liability. Any excess of the credit over the shareholder’s tax liability was refundable. 
45 

Special rules for income from foreign activities

Singapore has no rules analogous to the U.S. controlled foreign corporation rules. 

Various anti-avoidance rules, however, including a general anti-avoidance provision, grant the 

Singapore tax authorities the power to combat tax avoidance schemes, including schemes 

involving elements outside Singapore.120

Nonresident companies

As described above, nonresident companies are subject to Singapore tax on income 

derived from business operations in Singapore. No additional branch profits tax is imposed 

when income is remitted by a Singapore branch of a nonresident company to its foreign base.121

Certain payments to nonresident companies of Singapore-source income not derived by 

the nonresident from Singapore business operations may be subject to Singapore withholding 

tax. These payments include interest, commissions, fees, and other payments in relation to loans 

or indebtedness; royalties for the use of moveable property; fees for technical assistance or 

management; directors remuneration; and gains from real property transactions. Royalty 

payments for the use of intellectual property in Singapore generally are subject to withholding at 

a 10-percent rate (reduced from the 15-percent rate in effect before 2005). Singapore-source 

interest payments generally are subject to withholding tax at a 15-percent rate. Dividend 

payments are not subject to withholding tax. 

Avoidance or relief of double taxation

In general, because foreign-source income of Singapore resident companies is exempt 

from Singapore tax, no possibility of double taxation arises until income is remitted to 

Singapore. As described above, moreover, dividend payments to Singapore resident companies 

are exempt from Singapore taxation so long as the income out of which the dividends are paid is 

earned in a country with a headline tax rate of 15 percent. To the extent any non-Singapore 

source income may be subject to tax by both Singapore and another country, a foreign tax credit 

generally is available to offset the foreign tax imposed on that income. 

Singapore has a network of at least 50 bilateral tax treaties. These treaties largely are 

based on the OECD model income tax treaty. Singapore’s tax treaties generally have three chief 

purposes: the avoidance of double taxation through provisions allocating taxing power between 

the treaty countries; the promotion of bilateral trade and investment; and, through information 

exchange provisions, the prevention of tax avoidance and evasion by treaty residents. Many 

Singapore tax treaties include tax sparing provisions under which each treaty country agrees to 

provide a credit for taxes forgone by the other treaty country under an incentive measure. Where 

 120 International Bureau of Fiscal Documentation, Asia-Pacific Taxation Analysis, Singapore, 

Country Survey, at ¶28.2 (2006) (accessed through RIA Checkpoint internet-based research service). 

121 International Bureau of Fiscal Documentation, Asia-Pacific Taxation Analysis, Singapore, 

Country Survey, at ¶26.1 (2006) (accessed through RIA Checkpoint internet-based research service). 
46 

tax treaties permit a Singapore resident to be taxed by Singapore on an item of income that also 

may be taxed by the other treaty country, the treaties typically provide a credit against Singapore 

tax for the foreign tax imposed on the income.
47 

B. Selected Nonterritorial Systems 

1. China122

In general

The Chinese tax system includes a wide variety of taxes. The most significant taxes 

include the foreign enterprise tax; an individual income tax; turnover taxes (including a valueadded tax, a business tax applicable to most service industries, and a consumption tax applicable 

to goods such as tobacco, alcohol, jewelry, and motor vehicles); and miscellaneous taxes such as 

stamp duties, real property taxes, a natural resource tax, and a land appreciation tax. 

The value-added tax is a credit-invoice style VAT. Taxpayers are required in each period 

to pay VAT on the difference in that period between (1) the VAT applicable to revenue from the 

sale or provision of goods or labor services and (2) the VAT applicable to purchases of goods or 

labor services. VAT generally is imposed on the customs value of imported goods, and exported 

goods generally are zero rated (with the result that input VAT paid on exported goods may be 

refunded to the exporter). Simplified rules apply to a defined category of small taxpayers. Small 

taxpayers are taxed on the basis of revenue derived from sales of goods or the provision of 

taxable services.123 The VAT rates for small taxpayers are four percent for the commercial 

sector and six percent for other sectors. The general VAT rate on other taxpayers is 17 percent, 

but the VAT rules include a preferential 13-percent rate for, among other products, agricultural 

supplies. 

Business income taxes are described next. 

Taxation of businesses

In general

Since the 1980s, China has undertaken a series of tax reform efforts. Business income 

taxation in China now is generally carried out through two sets of rules. 

State-owned enterprises and other domestic enterprises are subject to the enterprise 

income tax regulations. Under these regulations, enterprises are subject to tax in China on 

Chinese and non-Chinese source income at a rate of 33 percent, a significantly lower rate than 

the 55-percent rate that was applicable to Chinese enterprises before 1994. 

 122 Unless otherwise noted, the following discussion is drawn from Owen D. Nee, Jr. and 

Deborah J. Goldstein, Foreign Income: Business Operations in the People’s Republic of China, BNA 

Tax Management Portfolio 957-2d (2003), and Ernst & Young, Worldwide Corporate Tax Guide, pp. 

147-56 (2005). 

123 Beijing Local Taxation Bureau, http://english.tax861.gov.cn/zgszky/zgszky04.htm (last 

visited Jun. 19, 2006). 
48 

Chinese-foreign joint ventures and cooperative enterprises and foreign-owned businesses 

with Chinese business operations or Chinese-source income are subject to tax in China under the 

Income Tax Law of the People’s Republic of China Concerning Foreign Investment Enterprises 

and Foreign Enterprises (“FEITL”). The FEITL generally imposes a 33-percent tax on income 

from foreign business activity in China. 

State-owned and other domestic enterprises

As mentioned above, under the enterprise income tax regulations, state-owned enterprises 

and other domestic businesses are liable for tax in China on their worldwide income at a 33-

percent rate. Income under the enterprise income tax regulations includes income from business 

operations, income from the sale of property, and portfolio income such as interest, leases, 

royalties, and dividends. 

Foreign income tax paid on income derived from non-Chinese sources may be offset by a 

credit against Chinese income tax. The credit may not exceed the amount of the Chinese income 

tax imposed on the foreign-source income. 

Chinese tax law applicable to domestic enterprises does not included controlled foreign 

corporation rules or other anti-avoidance rules, other than transfer pricing rules, for income 

earned through foreign subsidiaries.124

FEITL

In general

The FEITL is, as described above, applicable to Chinese-foreign joint ventures and 

cooperative enterprises and to foreign-owned businesses with operations in China. Foreign 

investment enterprises with headquarters in China are subject to tax under the FEITL on their 

worldwide income; other foreign enterprises are liable for tax only on Chinese-source income. 

The generally applicable FEITL net-basis tax rate on Chinese business operations is, as 

stated above, 33 percent. This 33-percent rate is comprised of a 30-percent central tax and a 3-

percent local tax. The 33-percent rate is reduced or eliminated in certain circumstances 

described below. Taxable income under the net basis tax generally includes all income from 

business operations. Capital gains generally are treated the same as other income except that 

foreign investors are subject to a 10-percent withholding tax on gain from the sale of ownership 

interests in a foreign owned enterprise in China. 

Payments to nonresidents of Chinese-source amounts that are not connected with 

business operations in China generally are subject to gross-basis withholding tax. The stated 

 124 International Bureau of Fiscal Documentation, Asia-Pacific Taxation Analysis, China, 

Country Survey, at ¶ 47 (2006) (accessed through RIA Checkpoint internet-based research service). 
49 

withholding rate on interest and royalties under the FEITL is 20 percent, but this rate has been 

reduced to 10 percent by a notice issued in 2000.125

Dividend payments to a nonresident owner of a foreign investment enterprise are not 

subject to Chinese withholding tax. 

Preferential rules

The FEITL offers preferential net-basis tax regimes in many circumstances. A 15-

percent rate is available for foreign enterprises operating in Special Economic Zones or in 

designated zones of various Chinese cities. The 15-percent rate also is available for enterprises 

in particular sectors, including manufacturing and high technology, provided the enterprises 

satisfy various other criteria. A 24-percent rate is available for foreign investment enterprises 

engaged in production and manufacturing activities in certain specified coastal and urban areas. 

China also grants tax holidays and significant rate reductions for certain favored activities and 

projects. 

If profits are reinvested for at least five years in China in the same enterprise or in 

another foreign investment enterprise, a 40-percent refund of taxes paid on those profits may be 

available. A full tax refund may be available if the reinvestment is in a technologically advanced 

business or an export enterprise. 

A foreign investment enterprise that purchases certain domestically-made equipment may 

be eligible for a credit against their income tax liability under the FEITL. The maximum credit 

amount is, subject to additional income-based limitations, 40 percent of the amount of the 

purchase. 

Foreign tax credit

A credit against Chinese tax liability under the FEITL generally is available for foreign 

taxes paid by foreign investment enterprises. The maximum foreign tax credit is the amount of 

Chinese tax imposed on the income. 

Tax treaties126

China has entered into bilateral tax treaties with more than 80 countries, including the 

United States. These tax treaties generally follow the OECD model treaty. Treaties generally 

provide for reduced rates of withholding tax on cross-border payments. Most treaties also 

provide for tax sparing and for credits against foreign tax where double taxation otherwise is not 

eliminated. 

 125 International Bureau of Fiscal Documentation, Asia-Pacific Taxation Analysis, China, 

Country Survey, at ¶ 23.4 (2006) (accessed through RIA Checkpoint internet-based research service). 

126 International Bureau of Fiscal Documentation, Asia-Pacific Taxation Analysis, China, 

Country Survey, at ¶ 45.2 (2006) (accessed through RIA Checkpoint internet-based research service). 
50 

2. Ireland127

In general

The Irish tax system includes a corporate income tax, an individual income tax, a valueadded tax, a capital gain tax (which, in the case of corporations, is part of the income tax), a gift 

and inheritance tax, and stamp duties on certain legal documents executed in Ireland and related 

to transactions such as the sale of land in Ireland or of securities in an Irish company. 

The value-added tax is a credit-invoice style tax, with tax charged on sales of goods and 

services and credits available for purchases. The general rate under the VAT is 21 percent; a 

small number of items are subject to a 13.5-percent rate. VAT generally is imposed on imports 

from countries outside the EU and is not charged on exports. 

Figure 4, below, provides a comparison of tax receipts, as a percentage of GDP, in 

Ireland, the United States, and the average of the member countries of the OECD.128

Figure 4 

Comparative Revenue Profile of Ireland - Major Taxes

as a Percentage of GDP, 2003

29.7

7.9

3.8 4.4

7.3

25.6

9.0

2.1

6.7

2.1

36.3

9.4

3.4

9.5

6.9

0

5

10

15

20

25

30

35

40

Total Tax Revenue Individual Income Corporate Income Social Security General Consumption

Percentage

Ireland U.S.A. OECD

Source: OECD. 

 127 Unless otherwise noted, the following discussion is drawn from John Ryan, Foreign Income: 

Business Operations in Ireland, BNA Tax Management Portfolio 965-3rd (2004), and Ernst & Young, 

Worldwide Corporate Tax Guide, pp. 391-410 (2005). 

128 OECD, Revenue Statistics, 1965-2004 (OECD: Paris, 2005). 
51 

Taxation of corporations

In general

Under the Irish corporation tax, Irish resident corporations generally are subject to tax on 

all profits (income and gains) regardless of source. A credit for foreign taxes imposed on foreign 

source income may be available under a tax treaty, and if a tax treaty does not apply, limited 

relief may be provided under Irish domestic law. Nonresident companies generally are taxed by 

Ireland only on income derived from and attributable to a trade or business carried on in Ireland. 

Domestic corporations

In general

As described above, Irish resident corporations are subject to tax on their worldwide 

income. Gross income is determined under a comprehensive schedular system. Items that would 

be included in calculating income or loss from operations under generally accepted accounting 

principles are included in gross income for tax purposes. 

Tax residence is determined under two tests. First, a corporation is considered a tax 

resident of Ireland if it is managed and controlled in Ireland. Second, if a company is 

incorporated in Ireland, it also is considered a resident unless (1) the company or a related 

company carries on a trade in Ireland and either (a) it is under the control of persons who are 

resident in a tax treaty country or another EU jurisdiction, provided those persons are not 

controlled by persons not resident in those countries, or (b) the principal class of shares in the 

company or a related company are regularly traded on an exchange in another EU country or a 

treaty country; or (2) the company is treated under a tax treaty country as being a resident in a 

treaty country and not resident in Ireland. 

The general rate of corporate tax is 12.5 percent. Certain items of passive income and 

income from certain industries such as mining and petroleum are taxed at a rate of 25 percent. 

Capital gains generally are subject to tax at a 20 percent rate. Until recently, the tax rate on 

income from manufacturing activities in Ireland was 10 percent, but this preferential rate was 

considered a harmful tax measure under European Union (“EU”) rules. After negotiations with 

the European Commission, the Irish government enacted phase-out rules for this preferential 

manufacturing rate. The preferential rate is due to expire completely in 2010. 

Special rules for capital gains and dividends

In 2004 the Irish government enacted an exemption from capital gains taxation for gains 

from certain sales by a corporation of stock in another corporation (the “investee corporation”). 

The exemption is available if: (1) at the time of the sale, the investee corporation is a resident for 

tax purposes in Ireland, in another EU member state, or in a country with which Ireland has a tax 

treaty; (2) the Irish company has owned (directly or indirectly) for at least 12 of the 24 months 

preceding the sale at least five percent of the shares of the investee company; and (3) the investee 

company is wholly or principally engaged in a trade or, taken together, the holding company, its 

five-percent group, and the investee company are wholly or principally engaged in a trade. 
52 

Dividend distributions received by an Irish resident company from another Irish resident 

company generally are excluded from income. Consequently, the 20-percent dividend 

withholding tax applicable to distributions by an Irish company generally does not apply to 

distributions made to another Irish resident company provided the recipient owns at least a fivepercent interest in the paying corporation. 

Special rules for income from foreign activities

In general, as described above, Irish resident corporations are subject to Irish corporate 

tax on their income from foreign sources, including income earned in a foreign country through a 

branch (but not through a nonresident subsidiary). This tax applies regardless of whether the 

income is remitted to Ireland. 

Ireland does not have rules analogous to the U.S. controlled foreign corporation rules. 

Irish taxing authorities instead may argue that a nominally nonresident company in fact is 

managed and controlled in Ireland and thus should be taxed as an Irish resident company.129

Special rules for relief of double taxation with respect to dividends received from foreign 

subsidiaries are discussed below. 

Nonresident companies

As described previously, nonresident companies (including nonresident subsidiaries of 

Irish resident companies) generally are taxed by Ireland on a net basis only on income derived 

from and attributable to a trade or business carried on in Ireland through a branch or an agency 

and on gains from the sale of Irish assets used or held for use by the branch or agency. 

Irish-source income of nonresident companies that is not attributable to an Irish trade or 

business may be subject to Irish withholding tax. A 20-percent withholding tax generally applies 

to payments of dividends, interest, and royalties, but payments to nonresident companies may be 

exempt from withholding tax in the circumstances described below. 

Dividend distributions to nonresident companies are exempt from the 20-percent 

dividend withholding tax in certain circumstances, including when the nonresident recipient of 

the dividend is regularly traded on a recognized stock exchange or is a resident in an EU member 

country or a treaty country and is not controlled by Irish residents. 

Interest and royalties paid by Irish resident companies to nonresident companies also are 

exempt from Irish withholding tax in certain circumstances. These circumstances include (1) 

when interest is paid to a company that is a resident of a tax treaty or an EU jurisdiction unless 

the interest is paid to that company in connection with a trade or business of that company in 

Ireland; and (2) based on the EU Interest and Royalties Directive, when payments of interest or 

 129 International Bureau of Fiscal Documentation, European Taxation Analysis, Ireland, 

Corporate Taxation (detailed) at ¶ 13.4 (2006) (accessed through RIA Checkpoint internet-based research 

service). 
53 

royalties are made by an Irish company to an associated company of another EU member state, 

with association for this purpose requiring at least 25-percent common ownership. 

No branch profits tax or branch remittance tax is imposed on a nonresident corporation’s 

withdrawals from an Irish branch.130

Avoidance or relief of double taxation

Foreign tax credit

Irish internal law does not include a general mechanism by which corporations are 

entitled to a credit against the Irish corporate tax for foreign taxes paid. Under various rules, 

however, Irish resident companies may be eligible for relief from Irish corporate taxes in respect 

of foreign taxes paid. 

Tax treaties provide relief from double taxation. Those treaties are described below. In 

the absence of a tax treaty, a deduction for foreign tax paid generally is allowed against the 

income in respect of which the tax was assessed. 

A foreign tax credit is allowed in certain circumstances. A foreign tax credit is available 

to offset Irish corporate tax on income from certain activities such as sales of computer software 

and the provision of computer services. Irish internal law also provides for credit for foreign tax 

imposed in relation to dividends received from nonresident companies. These credit rules for 

dividends implement the EU Parent-Subsidiary Directive as amended in 2004. Under the rules, 

an Irish resident company receiving a dividend from a five-percent owned (by voting rights) 

subsidiary that is a resident of a country with which Ireland does not have a tax treaty is allowed 

a credit against Irish tax on the dividend for any direct or withholding tax imposed on the 

dividend and for the portion of any foreign tax imposed on the income out of which the dividend 

is paid.131 This credit against Irish tax for foreign tax imposed with respect to dividend payments 

also is allowed to Irish branches of companies resident in the EU or in European Economic Area 

states with which Ireland has a tax treaty. An Irish company receiving a dividend from a fivepercent subsidiary that has lower-tier subsidiaries is allowed a credit for the portion of any 

foreign taxes imposed on the lower-tier subsidiaries with respect to the dividend so long as the 

parent and the lower-tier subsidiaries are connected in a chain of ownership through at least fivepercent indirect shareholding (based on vote). 

Irish internal law allows cross-crediting (or “onshore pooling”) for taxes on different 

dividend streams and permits unused credits to be carried forward indefinitely. 

 130 International Bureau of Fiscal Documentation, European Taxation Analysis, Ireland, 

Corporate Taxation (detailed) at ¶ 8.4.3 (2006) (accessed through RIA Checkpoint internet-based 

research service). 

131 This relief also is allowed even if treaty benefits are available for a dividend payment. The 

internal law credit mechanism in some cases could be more beneficial than the treaty benefits. 
54 

Tax treaties

Ireland has a network of more than 40 bilateral tax treaties. Under these tax treaties, any 

foreign tax on income and gains of an Irish resident company that is not otherwise eliminated by 

the treaty (for example, foreign tax on income attributable to an Irish company’s permanent 

establishment in the other treaty country) generally can be credited against Irish tax imposed on 

that income or gain. The foreign tax credit may not exceed Irish corporate tax attributable to that 

income or gain. With limited exceptions, no cross-crediting is allowed under tax treaties. 
55 

IV. 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.132 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 the 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. 

 132 Part V of this publication reviews the trends in trade deficits and cross-border investment 

flows. More detailed data are presented in 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. 
56 

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. 
57 

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 

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

the worldwide norm,133 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. 

 133 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. 
58 

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. 

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. 
59 

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 
60 

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

foreign taxes.134 

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.135 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. 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 

ownership of investments in addition to the location of those investments.136 They argue that 

 134 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. 

135 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. 

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

Journal, 56, September 2003, pp. 487-502. Also, Mihir Desai and James R. Hines, Jr., “Old Rules and 
61 

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.137 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.138 In either circumstance, if any country’s 

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

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 

 

New Realities: Corporate Tax Policy in a Global Setting,” National Tax Journal; 57, December 2004, pp. 

937-60. 

137 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 knowhow in foreign markets. For example, see Richard E. Caves, Multinational Enterprise and Economic 

Analysis, (Cambridge, U.K.: Cambridge University Press), 1996. 

138 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.” 
62 

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

and serve overseas markets from the foreign location.139

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 to 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.”140 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.141 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.142 

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 

more managerial and technical employment....”143 However, most of the evidence on this subject 

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

140 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. 

141 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. 

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

143 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. S. Lael Brainard and David A. Riker, “Are U.S. 

Multinationals Exporting U.S. Jobs?” in David Greenway and Douglas Nelson, eds., Globalization and 

Labour Markets, Elgar, 2001. 
63 

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.144

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. 

 144 Lipsey, “Home and Host Country Effects of FDI.” 
64 

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 

trillion and paid $34.7 billion of foreign income taxes.145 Foreign branches of U.S. 

multinationals reported $87.3 billion of gross branch income and paid $4.9 billion of foreign 

income taxes.146 

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.147 The benefit from the deferral of 

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

 145 John Comiskey, “Controlled Foreign Corporations, 1998,” Statistics of Income Bulletin, 22, 

Winter 2002-2003, pp. 47-86. 

146 Rob Singmaster and Andrea Heilbroner, “Corporate Foreign Tax Credit, 1998,” Statistics of 

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

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

periods (back one year and forward ten 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 ten 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. 
65 

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 

(subpart F and PFIC rules) 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.148 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 

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 

 148 E.g., David Tillinghast, “International Tax Simplification,” 8, American Journal of Tax 

Policy, 1990, pp. 187-190. 
66 

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.149 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. 

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.”150 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 Tax 

Reform Act of 1986 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 

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

liability. 

150 U.S. Treasury Department, Tax Reform for Fairness, Simplicity, and Economic Growth, Vol. 

2, 1984, p. 361. 
67 

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 

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. 
68 

V. BACKGROUND AND DATA RELATING TO INTERNATIONAL 

TRADE AND INVESTMENT 

This part presents background data relating to the scope of the international trade sector 

in the United States economy. This part discusses the economic relationship between trade 

deficits, capital inflows, investment, and savings in the economy. It briefly reviews trends in 

both the current account (the trade surplus or deficit) and the financial account (U.S. investment 

abroad and foreign investment in the United States).151 

A. Trade Deficits and Cross-Border Capital Flows 

National income accounting

In popular discussion of trade issues, much attention is given to the trade deficit or 

surplus, that is, the difference between the exports and imports of the economy. In the late 

1980s, there was also attention given to inflows of capital from abroad. Capital inflows can take 

the form of foreign purchases of domestic physical assets, of equity interests, or of debt 

instruments. These two phenomena, trade balances and capital inflows, are not independent, but 

are related to each other. Trade deficits, capital inflows, investment, savings, and income are all 

connected in the economy. The connection among these economic variables can be examined 

through the national income and product accounts, which measure the flow of goods and services 

and income in the economy.152

 151 Prior to 1999, the U.S. Department of Commerce, Bureau of Economic Analysis reported and 

described international transactions by reference to the “current account” and the “capital account.” 

Beginning in June 1999 the Bureau of Economic Analysis adopted a three-group classification to make 

U.S. data reporting more closely aligned with international guidelines. The three groups are labeled: 

current account; capital account; and financial account. Under this regrouping, the “financial account” 

encompasses all transactions that used to fall into the old “capital account,” that is, the financial account 

measures U.S. investment abroad and foreign investment in the United States. Under the new system, the 

“current account” is redefined by removing a small part of the old measure of unilateral transfers and 

including it in the newly defined “capital account.” The newly defined capital account consists of capital 

transfers and the acquisition and disposal of non-produced, non-financial assets. For example, the newly 

defined capital account includes such transactions as forgiveness of foreign debt, migrants’ transfers of 

goods and financial assets when entering or leaving the country, transfers of title to fixed assets, and the 

acquisition and disposal of non-produced assets such as natural resource rights, patents, copyrights, and 

leases. In practice, the Bureau of Economic Analysis believes that newly defined “capital account” 

transactions will be small in comparison to the current account and financial account. 

152 The national income and product accounts measure the flow of goods and services (product) 

and income in the economy. The most commonly reported measure of national economic income is gross 

domestic product (GDP). Related to GDP is gross national product (GNP). GNP is GDP plus the net 

factor income received by residents of United States from abroad. Thus, wages earned by a U.S. resident 

from temporary work abroad constitutes part of GNP but not GDP. Similarly, the returns from 

investment abroad constitute part of GNP but not GDP. To help understand the connection between trade 

deficits and cross border capital flows, in the following it is useful to use GNP, which includes cross 

border returns to investment, rather than the more commonly reported GDP concept. The GNP of the 
69 

The value of an economy’s total output must be either consumed domestically (by private 

individuals and government), invested domestically, or exported abroad. If an economy 

consumes and invests more than it produces, it must be a net importer of goods and services. If 

the imports were all consumption goods, in order to pay for those imports, the country must 

either sell some of its assets or borrow from foreigners. If the imports were investment goods, 

foreign persons would own the investments. Thus, an economy that runs a trade deficit will also 

experience foreign capital inflows as foreign persons purchase domestic assets, make equity 

investments, or lend funds (purchase debt instruments). 

For example, when the United States imports more than it exports, the United States pays 

for the imports with dollars. If foreigners are not buying goods with the dollars, then they will 

use the dollars to purchase U.S. assets. (An alternate way of viewing these relationships is that 

dollars flowing out of the U.S. economy in order to purchase goods or to service foreign debt 

must ultimately return to the economy as payment for exports or as capital inflows.) 

The previous discussion focuses on the disposition of the economy’s output. If the 

economy is a net importer, it must attract capital inflows to pay for those imports. If the 

economy is a net exporter, it must have capital outflows to dispose of the payments it receives 

 

economy is the total annual value of goods and services produced by the economy and may be measured 

in several ways. One way to measure GNP is by expenditures on final product. By this measure, 

(1) GNP = C + I + G + (X-M) + NI. 

Equation (1) is an accounting identity which states that gross national product equals the sum of 

private consumption expenditures (C), private investment expenditures on plant, equipment, inventory, 

and residential construction (I), government purchases of goods and services (G), net exports (exports less 

imports of goods and services and net interest payments to foreigners, or X-M), plus net investment 

income (the excess of investment income received from abroad over investment income sent abroad or 

NI). 

An alternative is to measure GNP by the manner in which income is spent. By this measure, 

(2) GNP = C + S + T. 

Equation (2) is another accounting identity which states that gross national product equals the 

sum of private consumption expenditures (C), saving by consumers and businesses (S), and net tax 

payments to the government (T) (net tax payments are total tax receipts less transfer, interest, and subsidy 

payments made by all levels of government). 

Because both measures of GNP are simple accounting identities, the right hand side of equation 

(1) must equal the right hand side of equation (2). From this observation can be derived an additional 

national income accounting identity: 

(3) I = S + (T - G) + (M - X) - NI 

Equation (3) states that private investment equals private saving (S), plus public saving (T-G) and 

net imports (M - X), less net investment income. 
70 

for its exports. Another way of looking at the connection between capital flows and the goods 

and services in the economy is to concentrate on the sources of funds for investment. Because 

domestic investment must be financed either through saving or foreign borrowing, net capital 

inflows must also equal the difference between domestic investment and saving. 

These relationships can be summarized as follows (the equation ignores relatively small 

unilateral transfers such as foreign aid and assumes, without loss of generality, that the 

government budget is balanced): 

Net Foreign Borrowing = Investment - Saving 

= (Imports - Exports) - Net Investment Income 

For this purpose, imports and exports include both goods and services, and net 

investment income is equal to the excess of investment income received from abroad over 

investment income sent abroad.153 The excess of imports over exports is called the trade deficit 

in goods and services. Net investment income can be viewed as payments received on 

previously-acquired foreign assets (foreign investments) less payments made to service foreign 

debt. 

If the investment in an economy is larger than that country’s saving, the country must 

either be running a trade deficit or the economy is increasing its foreign borrowing. Similarly, a 

country cannot run a trade surplus without also exporting capital, either by increasing its foreign 

investments, or by servicing previously-acquired foreign debt. Because the level of net 

investment income in any year is fixed by the level of previous foreign investment (except for 

changes in interest rates), changes in investment or saving that are associated with capital 

inflows will have a negative impact on a country’s trade balance. 

Economic implications of trade deficits

A trade deficit is not necessarily undesirable. What is important is the present and future 

consumption possibilities of the economy. That will depend in part on whether the trade deficit 

is financing consumption or investment. 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.154 If the economy currently does not have enough domestic 

savings to invest in these projects, it could reduce its consumption (generating more domestic 

saving) or look to foreign sources of funds (thus allowing investment without reducing current 

consumption). For example, suppose new oil reserves that could be profitably recovered through 

 153 This equation in the text can be derived from equation (3) in footnote 152 above if the 

government budget is assumed to be balanced, that is, if G = T. It follows that if the government runs a 

deficit, that is, if G>T, for a given level of investment, saving, and net investment income, net foreign 

borrowing must be greater. 

154 This scenario describes the experience of the United States in the mid to late 1800s, when 

foreign capital inflows financed much of the investment in railroads and other assets. 
71 

increased investment are discovered in the United States. The investment may be financed by 

foreigners. In order to invest in U.S. assets, foreigners will have to buy dollars, thus increasing 

the value of the dollar. This dollar appreciation makes U.S. goods more expensive to foreigners, 

thereby reducing their demand for U.S. exports. At the same time, the dollar appreciation makes 

foreign goods cheaper for U.S. residents, increasing the demand for imports and resulting in a 

trade deficit. Eventually, the flow of capital will be reversed, as the U.S. demand for new 

investment falls, and foreigners receive interest and dividend payments on their previous 

investments. 

The foreign borrowing in the above example was used to finance investment. This 

borrowing did not reduce the living standards of current or future U.S. residents, because the 

interest and dividends that were paid to foreigners came from the return from the new 

investment. If foreign borrowing finances consumption instead of investment, there are no new 

assets created to generate a return that can support the borrowing. When the debt eventually is 

repaid, the repayments will come at the expense of future consumption. For instance, consider a 

situation in which the domestic supply of funds for investment decreases because domestic 

saving rates fall. Foreign borrowing in this case is not associated with increased investment, but 

instead is devoted to investment that was previously financed with domestic savings. Because 

the foreign borrowing is not associated with increased investment, future output does not 

increase, and interest and dividends on the investment will be paid to foreign persons at the 

expense of future domestic consumption. In this case, there may be an increase in the standard 

of living for current U.S. residents at the expense of a decrease in the standard of living of future 

residents. 

During the period that foreign borrowing finances U.S. consumption, the United States 

runs a trade deficit. Although the United States could service its growing foreign debt by 

increased borrowing, and hence larger trade deficits, in the long run trade deficits cannot keep 

growing. In fact, the United States must eventually run a trade surplus. If the United States 

imported more goods than it exported every year, there also would be an inflow of foreign 

capital every year. This capital inflow would be growing with the increasing costs of servicing 

the foreign debt. Eventually, foreigners would be unwilling to continue lending to the United 

States, and the value of the dollar would fall. The fall in the dollar would eliminate the trade 

deficit, and the United States would eventually run a trade surplus, so that the current account 

deficit (the sum of the trade deficit in goods and services and the net interest on foreign 

obligations) would be small enough for foreigners to be willing to lend again to the United 

States. 

Even when foreign investment finances domestic consumption, trade deficits and capital 

inflows themselves should not necessarily be viewed as undesirable, because the foreign capital 

inflows help to keep domestic investment, and hence labor productivity, from falling. For 

instance, the large inflow of foreign capital to the United States in the 1980s is widely viewed to 

be a result of low U.S. saving rates. If the mobility of foreign capital had been restricted 

(through capital or import controls, for example), then the low saving rate could have led to 

higher domestic interest rates and lower rates of investment. That decreased investment would 

have led to decreases in future living standards because the lower growth rate of the capital stock 

would have resulted in lower growth rates of U.S. labor productivity. The fact that foreign 
72 

capital was not restricted and did finance U.S. investment helped mitigate the negative effects on 

economic growth of low domestic saving. 

The above observations support the argument that the trade deficit does not in itself 

provide a useful measure of international competitiveness, since trade deficits and trade 

surpluses can be either good or bad for the United States. The example of oil discovery 

discussed above shows that even increases in a country’s stock of exportable goods can have 

ambiguous effects on the trade deficit. If the discovery of oil also increases the demand for 

investment, then the trade deficit may actually increase in the short run. 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 output of the 

economy, and hence the incomes of U.S. residents. 

The balance of payments accounts, presented in Table 1, are analogous to a sources and 

uses of funds statement of the United States with the rest of the world. As demonstrated above, 

the current account balance, which consists primarily of the trade balance, should be exactly 

offset by the capital account and financial account balances, which measure the net inflow or 

outflow of capital to or from the United States. The difference between the current account 

surplus or deficit and the capital and financial accounts deficit or surplus is recorded as a 

statistical discrepancy. Problems of measurement, which have been large in some years, cause 

the accounts to be somewhat mismatched in practice, but basic patterns are unlikely to be 

significantly distorted by these problems. The subsequent sections examine trends in the current 

account and financial account in more detail. 
73 

Table 1 – International Transactions of the United States, Selected Years, 

1975-2005 

($ Billions nominal) 

1975 1985 1995 2000 20051

Current Account Balance 

Exports of Goods and Services 

Merchandise 

Services 

Receipts from U.S. assets abroad 

Imports of Goods and Services 

Merchandise 

Services 

Payments on foreign-owned U.S. assets 

18.1 

157.9

107.1 

25.5 

25.4 

132.7

98.2 

22.0 

12.6 

-118.2 

387.6

215.9 

73.2 

98.5 

483.8

338.1 

72.9 

72.8 

-109.9 

1,005.9

575.2 

219.2 

211.5 

1,081.8

749.4 

141.4 

191.0 

-444.7 

1,418.6

772.2 

293.5 

352.9 

1,809.1

1,224.4 

217.0 

367.7 

-804.9 

1,740.9

892.6 

379.6 

468.7 

2,462.9

1,674.3 

321.6 

467.1

Unilateral Transfers 7.1 22.0 34.1 54.1 82.9 

Financial Account Balance 

Foreign Investment in the United States 

Direct Investment 

Private non-direct investment 

Official 

-22.5 

17.2

2.6 

7.5 

7.0 

101.3 

146.1

19.7 

127.5 

-1.1 

113.3 

465.7

57.8 

298.0 

109.9 

443.2 

1,024.2

287.7 

700.2 

37.6 

801.0 

1,292.7

128.6 

943.4 

220.7

U.S. Investment Abroad 

Direct Investment 

Private non-direct investment 

Increase in government assets 

39.7

14.2 

21.1 

4.3 

44.8

18.9 

19.1 

6.7 

352.4

98.8 

242.9 

10.7 

581.0

152.4 

427.3 

1.2 

491.7

21.5 

491.9 

-21.7 

Capital Account Transactions, net n.a. 0.3 0.4 0.7 5.6 

Statistical Discrepancy 4.4 16.5 3.8 0.7 9.6 

Source: Douglas B. Weinberg, “U.S. International Transactions, First Quarter 2001,” Survey of Current Business, 81, July 

2001, pp. 37-81, and Christopher L. Bach, “U.S. International Transactions in 2005,” Survey of Current Business, 86, April 

2006, pp. 22-68. 

n.a. - not applicable. 

1

 Preliminary figures for 2005. 
74 

B. Trends in the U.S. Balance of Payments 

Overview of U.S. balance of payments (current account)

Foreign trade has become increasingly important to the United States economy. Figure 5 

presents the value of exports from the United States and imports into the United States as a 

percentage of GDP for the period 1960-2005.155 As depicted in Figure 5, exports and imports 

each have risen from less than six percent of GDP in 1960 to more than 12 percent in 2005. 

Imports have consistently exceeded 15 percent of U.S. GDP since 1997. Figure 5 also shows 

that the United States generally was a net exporter of goods and services prior to 1982. Since 

that time, the United States has been a net importer of goods and services. 

Figure 5 

Exports and Imports as a Percentage of United States GDP,

1960-2005

0%

5%

10%

15%

20%

25%

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Year

Percentage of GDP

Exports

Imports

Source: Department of Commerce, Bureau of Economic Analysis. 

The net trade position of a country is commonly summarized by its current account. The 

U.S. current account as a whole, which compares exports of goods and services and income 

earned by U.S. persons on foreign investments to imports of goods and services and income 

earned by foreign persons on their investments in the United States (plus unilateral remittances), 

 155 Data for Figure 5 are from the U.S. Commerce Department, Bureau of Economic Analysis. 
75 

generally was positive from 1960 through 1981, but generally has been in deficit since 1982. 

Figure 6 reports the current account balance of the United States for the period 1960 through 

2005 as a percentage of GDP to eliminate the effect of inflation on reported nominal figures.156 

Figure 6 reflects a substantial reduction in the current account deficit for 1992. In that year, the 

United States received substantial payments from abroad related to the Persian Gulf War. 

Figure 6 

United Sates Current Account as a Percentage of GDP,

1960-2005

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Percentage of GDP

Source: Department of Commerce, Bureau of Economic Analysis. 

Components of the current account

Merchandise trade, trade in services, and income from investments

The aggregate data reported in Figure 5 and Figure 6 mask differences in the trade 

position of various sectors of the economy. As explained above, the current account compares 

exports of goods and services and payments of income earned by U.S. persons on foreign 

investments to imports of goods and services and payments of income earned by foreign persons 

on their investments in the United States. 

 156 Data for Figure 6 are from the U.S. Commerce Department, Bureau of Economic Analysis. 
76 

Several different trends are embedded within the data. Measuring the trade deficit in real, 

inflation adjusted year 2000 dollars, as has been widely reported, the merchandise (goods only) 

trade deficit has been over $200 billion per year since 1997 and over $500 billion per year the 

last three years. On the other hand, the United States has been a net exporter of services since 

the 1970s. This surplus in trade in services has averaged more than $50 billion per year (real, 

2000 dollars) since 2001. Also, throughout the entire period covered in Figure 6, U.S. receipts of 

income on investments abroad have exceeded payments of income to foreign persons on their 

U.S. investments (see Figure 7, below). 

Figure 7 

Receipts of Income from Investments Abroad and U.S. Payments

to Foreign Persons on Investments in the U.S., 1960-2005

(Billions of Real 2000 Dollars)

0

50

100

150

200

250

300

350

400

450

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Year

Dollars in Billions

U.S. receipts from abroad

U.S. payments to foreigners

Source: Department of Commerce, Bureau of Economic Analysis. 

Intra-firm trade

These aggregate data also do not reveal the extent to which growing trade flows result 

from trade between related parties. For example, a domestic company might ship components 

manufactured in the United States to its foreign subsidiary for final assembly and sale. Such 

shipments would be counted as exports from the United States. A domestic company might 

produce components abroad and ship them to the United States for final assembly and sale. Such 

shipments would be counted as imports to the United States. Likewise, a foreign parent 

company might ship components from abroad to its U.S. affiliate for final assembly and sale in 

the United States. Such shipments would be counted as imports into the United States. The 
77 

foreign affiliate might ship components to another country for assembly and sale. Such 

shipments would be counted as exports from the United States. 

For example, in 2003, U.S. multinational enterprises shipped $156.9 billion of goods to 

their foreign affiliates, a figure representing 22 percent of U.S. merchandise exports in 2003. 

Foreign affiliates of U.S. multinational enterprises shipped $191.9 billion of goods to their U.S. 

parent enterprise, a figure representing 15 percent of U.S. merchandise imports in 2003.157 

Similarly, in 2003, U.S. affiliates of foreign multinational enterprises exported $71.7 billion 

worth of goods to other enterprises in the foreign parent’s group (10 percent of U.S. merchandise 

exports). U.S. affiliates of foreign multinational enterprises imported $285.9 billion worth of 

goods from other enterprises in the foreign parent’s group (23 percent of U.S. merchandise 

imports).158 Thus, in total, in 2003 intra-firm trade accounted for approximately 32 percent of 

U.S. merchandise exports and 38 percent of U.S. merchandise imports. 

 157 Raymond J. Mataloni, Jr. “U.S. Multinational Companies: Operations in 2003,” Survey of 

Current Business, 85, July 2005, p. 13. 

158 William J. Zeile, “U.S. Affiliates of Foreign Companies: Operations in 2003,” Survey of 

Current Business, 85, August 2005, p. 208. 
78 

C. Trends in the U.S. Financial Account 

Overview of the United States' financial account

As explained above, when the United States imports more than it exports, the dollars the 

United States uses to buy the imports must ultimately return to the United States as payment for 

U.S. exports or to purchase U.S. assets. As Figure 6 and Table 1 document, the U.S. current 

account has been in deficit since the early 1980s. Net foreign investment became a larger 

proportion of the economy since 1982. At the same time, the United States changed from being 

a modest exporter of capital in relation to GDP to being a large importer of capital. Net foreign 

investment has become a larger proportion of the economy and a more significant proportion of 

total domestic investment than in the past. In 2004, gross investment in the United States was 

$2.30 trillion and net foreign investment was $653 billion, or 28.4 percent of gross domestic 

investment. In 1993, net foreign investment comprised 8.9 percent of gross domestic 

investment. 

The net foreign investment in the United States is measured by the U.S. financial 

account. The financial account measures the increase in U.S. assets abroad compared to the 

increase in foreign assets in the United States. Figure 8 plots the annual increase of U.S. assets 

abroad and of foreign assets in the United States in constant dollars for the period 1960-2005 in 

constant 2000 dollars. Foreign assets in the United States increased by $865 billion in 2003, 

$1.45 trillion in 2004, and $1.21 trillion in 2005 in nominal dollars. At the same time, foreign 

assets owned by U.S. persons increased by $326 billion in 2003, $868 billion in 2004, and $427 

billion in 2005 (nominal dollars). 

Figure 8 

Annual Increase in U.S. Assets Abroad and in Foreign Assets in U.S.,

1960-2005, in Constant 2000 Dollars

0

200

400

600

800

1,000

1,200

1,400

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Year

Dollars in Billions

U.S.-owned assets abroad

Foreign-owned assets in the U.S.

Source: Department of Commerce, Bureau of Economic Analysis. 
79 

Growth in foreign-owned assets in the United States and U.S.-owned assets abroad

Overview

Measured in nominal dollars, the amount of foreign-owned assets in the United States 

grew more than 700 percent between 1975 and 1988159 and by nearly 400 percent between 1980 

and 2000. The total amount of foreign-owned assets in the United States exceeded $8 trillion by 

the end of 2000.160 The recorded value of U.S.-owned assets abroad grew less rapidly during 

the same period. The Department of Commerce reports that in 1975 the amount of U.S.-owned 

assets abroad exceeded foreign-owned assets in the United States by $74 billion. By the end of 

1988, however, the situation had reversed, so that the amount of foreign-owned assets in the 

United States exceeded U.S.-owned assets abroad by $162 billion. By 2000, the amount of 

foreign-owned assets in the United States exceeded U.S.-owned assets abroad by $1.8 trillion.161 

These investments are measured at their so-called “current cost.”162 Some argue that the market 

value of U.S.-owned assets abroad is similar to, or greater than, the market value of foreignowned assets in the United States, if market values were measured accurately.163 Figure 9 and 

Figure 10 display the value of U.S.-owned assets abroad and foreign-owned assets in the United 

States for selected years measured under both current cost and based on estimates of current 

market values. Whether this argument is correct with respect to the current net investment 

position, it is clear that foreign-owned U.S. assets are growing more rapidly than U.S.-owned 

assets abroad, as depicted in Figure 10. 

 159 Russell B. Scholl, “The International Investment Position of the United States in 1988,” 

Survey of Current Business, U.S. Department of Commerce, Bureau of Economic Analysis, June 1989, p. 

43. 

160 Ibid. 

161 Ibid. 

162 The Bureau of Economic Analysis estimates the values of U.S. foreign direct investment 

abroad and foreign direct investment in the United States using three different bases: historical cost, 

current cost, and market value. Using the historical cost base, assets are measured according to values 

carried on taxpayers’ books. Thus, investments reflect the price level of the year in which the asset was 

acquired. Under the current cost measure, a parent’s share of its affiliates’ tangible assets (property, 

plant, and equipment and inventories) is revalued from historical cost to replacement cost. Under the 

market value measure, an owner’s equity in foreign assets is revalued to current market value using 

indexes of stock prices. 

163 The distinction between book valuation and market valuation is only relevant for the category 

of investment labeled “direct investment,” not for “portfolio investment.” The distinction between direct 

and portfolio investment is explained in the text below. 
80 

Figure 9 

International Investment Position of the United States,

1982, 1995, and 2004 in Constant 2000 Dollars

(Direct Investment at Current Cost)

0

2,000

4,000

6,000

8,000

10,000

12,000

1982 1995 2004

Year

Billions of Dollars

U.S. assets abroad Foreign assets in the U.S.

Figure 10 

International Investment Position of the United States,

1982, 1995, 2004 in Constant 2000 Dollars

(Direct Investment at Market Value)

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1982 1995 2004

Year

Billions of Dollars

U.S. assets abroad Foreign assets in the U.S.

Source: Department of Commerce, Bureau of Economic Analysis. 
81 

Direct investment, non-direct (portfolio) investment, and official investment

Foreign assets in the United States (and U.S. assets abroad) can be categorized as direct 

investment, non-direct investment, and official assets. Direct investment constitutes assets over 

which the owner has direct control. The Department of Commerce defines an investment as 

direct when a single person owns or controls, directly or indirectly, at least 10 percent of the 

voting securities of a corporate enterprise or the equivalent interests in an unincorporated 

business. Foreign persons held direct investments of $1.71 trillion in the United States in 2004, 

having grown from $127 billion in 1980.164

The largest category of investment is non-direct investment held by private (nongovernmental) foreign investors, commonly referred to as portfolio investment. For most of the 

past decade foreign portfolio investment annually has exceeded foreign direct investment, 

making portfolio investment responsible for the majority of growth in foreign ownership of U.S. 

assets. Foreign portfolio investment consists mostly of holdings of corporate equities, corporate 

and government bonds, and bank deposits. The portfolio investor generally does not have 

control over the assets that underlie the financial claims. In 2004, portfolio assets of foreign 

persons in the United States were more than four times the recorded value of direct investment, 

$7.85 trillion compared to $1.71 trillion, respectively. Bank deposits account for more than onequarter of this total ($2.3 trillion), and reflect, in part, the increasingly global nature of banking 

activities. Foreign investment in bonds, corporate equities, and bank deposits, like other types of 

financial investment, provide a source of funds for investment in the United States but also 

represent a claim on future U.S. resources. 

The final category of foreign-owned U.S. assets is official assets: U.S. assets held by 

governments, central banking systems, and certain international organizations. The foreign 

currency reserves of other governments and banking systems, for example, are treated as official 

assets. Levels of foreign-held official assets have grown more slowly than foreign-held direct 

and portfolio investment of private investors. 

The value of investments abroad by private U.S. persons has grown from $693 billion in 

1980 to $8.78 trillion in 2004.165 This growth has not been as rapid as the growth in the value of 

investments by foreign persons in the United States. As has been the case for foreign investors 

in U.S. assets, over the past decade U.S. investors’ portfolio holdings of foreign assets has 

increased more rapidly than U.S. foreign direct investment. At year-end 2004, U.S. foreign direct 

investment constituted approximately one-quarter of U.S. ownership of foreign assets, with 

foreign direct investment valued at $2.38 trillion and portfolio investment valued at $6.41 trillion 

(with direct investment measured at current cost). Measured at current cost, the value of U.S. 

direct investment abroad has remained above the value of foreign direct investment in the United 

States. (See Figure 11) Measured at market value, the value of foreign direct investment in the 

 164 This values the direct investment at current cost. The Bureau of Economic Analysis estimate 

for 2004 when valued at market value is $2.69 trillion. 

165 This figure values the direct investment at current cost. 
82 

United States and the value of U.S. direct investment abroad were estimated to have been 

comparable for 1998-2002, but recent preliminary estimates place the value of U.S. owned 

foreign direct investment in excess of foreign owned direct investments in the United States. 

(See Figure 12) 

Figure 11 

Year-End Value of Foreign Direct Investment in the United States

and U.S. Direct Investment Abroad, 1982-2004

(Billions of Real 2000 Dollars at Current Cost)

0

500

1,000

1,500

2,000

2,500

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Year

Billions of Dollars

U.S. Direct Investment Foreign Direct Investment
83 

Figure 12 

Year-End Value of Foreign Direct Investment in the United States

and U.S. Direct Investment Abroad, 1982-2004

(Billions of Real 2000 Dollars at Market Value)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Year

Billions of Dollars

U.S. Direct Investment Foreign Direct Investment

Source: Department of Commerce, Bureau of Economic Analysis.