**DESCRIPTION AND ANALYSIS OFPRESENT-LAW RULESRELATING TO INTERNATIONAL TAXATION
Scheduled for a Hearing 

Before the

HOUSE COMMITTEE ON WAYS AND MEANS

on June 30, 1999

Prepared by the Staff

of the

June 28, 1999

JCX-40-99

**CONTENTS**

**INTRODUCTION**

**I.  SUMMARY**

**II.  PRESENT LAW**

A.  U.S. Taxation of U.S. Persons with Foreign Income     1.	Overview     2.	Foreign operations conducted directly     3.	Foreign operations conducted through a foreign corporation        a.	In general        b.	Controlled foreign corporations        c.	Passive foreign investment companies        d.	Foreign personal holding companies        e.	Personal holding companies        f.	Accumulated earnings tax        g.	Foreign investment companies     4.	Transfer pricing rules     5.	Foreign tax credit rules        a.	In general        b.	Deemed-paid foriegn tax credit        c.	Foreign tax credit limitation     6.	Foreign sales corporations

B.  U.S. Taxation of Foreign Persons with U.S. Income     1.	Overview     2.	Source of income rules     3.	Net-basis taxation        a.	Income from a U.S. business        b.	Investments in U.S. real property     4.	Gross-basis taxation        a.	Withholding tax        b.	Excise tax on insurance premiums paid to foreign insurers        c.	Branch level taxes

C.  Income Tax Treaties     1.	In general     2.	Model income tax treaty provisions

D.  Tax Treatment of U.S. Persons Living Abroad     1.	General exclusion     2.	Income from sources within U.S. possessions

**III. BACKGROUND AND DATA RELATING TO INTERNATIONAL TRADE AND INVESTMENT**

A.  Trade Deficits and Cross Border Capital Flows

B.  Trends in the United States' Balance of Payments

C.  Trends in the United States' Capital Account

**IV.  ANALYSIS OF ISSUES RELATING TO INTERNATIONAL INVESTMENT**

A.  Capital Export Neutrality, Capital Import Neutrality, and National Neutrality

B.  Departures From Capital Export Neutrality in Current U.S. Tax Rules     1.	Deferral of tax on foreign income     2.	Foreign tax credit limitation     3.	Cross-crediting of foreign taxes     4.	Creditability of subnational foreign taxes     5.	Export incentives

C.  Tax Treaties     1.	In general     2.	Tax sparing     3.	Integration of corporate/shareholder taxation

**V.  SUMMARY OF TAXATION OF FOREIGN INCOME IN THE UNITED KINGDOM, GERMANY, AND JAPAN**

A.  Treatment of Foreign Income in the United Kingdom     1.	Foreign tax credit     2.	Income earned through foreign subsidiaries     3.	Incentives for outbound investment

B.  Treatment of Foreign Income in Germany     1.	Foreign tax credit     2.	Treatment of foreign income in treaties     3.	Income earned through foreign subsidiaries
C.  Treatment of Foreign Income in Japan     1.	General rule of deferral     2.	Foreign tax credit     3.	Tax sparing

**APPENDIX:  DATA ON U.S. INTERNATIONAL TRANSACTIONS**

	Appendix Table A.1--U.S. International Transactions, 1962-1998

	Appendix Table A.2--U.S. Gross Domestic Product, Gross Saving, Gross Investment, and Net Foreign Investment, 1959-1998

	Appendix Table A.3--Increase in U.S. Assets Abroad and Foreign Assets in the United States, 1962-1998

	Appendix Table A.4-Selected Nongovernmental Foreign Holdings of U.S. Assets, Both Portfolio and Direct Investments, 1982-1997

**INTRODUCTION**

	The House Committee on Ways and Means has scheduled a public hearing on June 30,1999, on international tax issues. This document,(1) prepared by the staff of the Joint Committeeon Taxation, provides a description of certain aspects of present law and issues relating tointernational taxation.

	Part I of this document is a summary. Part II provides a description of certain present-lawincome tax rules that apply to U.S. persons doing business abroad and foreign persons doingbusiness in the United States. Part III contains background and data relating to international tradeand investment. Part IV is an analysis of issues relating to international investment. Part V is asummary of the taxation of foreign income in the United Kingdom, Germany, and Japan. TheAppendix presents data used in Figures 1-7 and 10.

**I.  SUMMARY**

**Present law**

	Under the present-law Federal income tax system, U.S. persons are subject to U.S.income tax on all income, whether derived in the United States or abroad.  However, the UnitedStates generally allows a credit against the U.S. tax imposed on income derived from foreignsources for foreign income taxes imposed on such income. Foreign persons are subject to U.S.tax only on income that has a sufficient connection to the United States.

	Within this basic framework, there are a variety of rules that affect the U.S. taxation ofinternational transactions.  Detailed rules govern the determination of the source of income andthe allocation and apportionment of expenses between foreign-source and U.S.-source income.Such rules are relevant not only for purposes of determining the U.S. taxation of foreign persons(because foreign persons are subject to U.S. tax only on income that is from U.S. sources orotherwise has sufficient U.S. nexus), but also for purposes of determining the U.S. taxation ofU.S. persons (because the U.S. tax on a U.S. person's foreign-source income may be reduced oreliminated by foreign tax credits).  Authority is provided for the reallocation of items of incomeand deduction between related persons in order to ensure the clear reflection of the income ofeach person and to prevent the evasion of tax.  Although U.S. tax generally is not imposed on aforeign corporation that operates abroad, several anti-deferral regimes apply to impose currentU.S. tax on certain income from foreign operations of a U.S.-owned foreign corporation.

	An international transaction potentially gives rise to tax consequences in two (or more)countries.  The tax treatment in each country generally is determined under the tax laws of therespective country.  However, an income tax treaty between the two countries may operate tocoordinate the two tax regimes and minimize the double taxation of the transaction.  In thisregard, the United States' network of bilateral income tax treaties includes provisions affectingboth U.S. and foreign taxation of both U.S. persons with foreign income and foreign personswith U.S. income.

**Trends in U.S. international trade and investment**

	Foreign trade has become increasingly important to the United States economy.  Exportsand imports each have risen from less than 6 percent of GDP in 1962 to more than 13.5 percentin 1998.  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.

	Trade deficits, capital inflows, investment, savings, and income are all connected in theeconomy.  The value of an economy's total output must be either consumed domestically (byprivate individuals and government), invested domestically, or exported abroad.  If an economyconsumes and invests more than it produces, it must be a net importer of goods and services.  Ifthe imports were all consumption goods, in order to pay for those imports, the country musteither 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 alsoexperience foreign capital inflows as foreign persons purchase domestic assets, make equityinvestments, or lend funds (purchase debt instruments).

	Net foreign investment has become a larger proportion of the economy and a moresignificant proportion of total domestic investment than in the past.  In 1982, the United Stateschanged from being a modest exporter of capital in relation to GDP to being a large importer ofcapital.  In 1998, gross investment in the United States was $1,392 billion and net foreigninvestment was $213 billion, or 15.3 percent of gross domestic investment.  The value of foreignassets owned by private U.S. persons has grown from $295.1 billion in 1980 to $4,237 billion in1997.  This growth in value has not been as rapid as the growth in the value of assets in theUnited States owned by foreign persons.

**Issues relating to international investment**

	International investment plays an important role in determining the total amount ofworldwide income as well as the distribution of income across nations.  In addition, internationalinvestment flows can substantially influence the distribution of capital and labor income withinnations.  Because each government levies taxes by its own method and at its own rates, theresulting system of international taxation can distort investment and contribute to reductions inworldwide economic welfare.

	If a system of residence taxation is the worldwide norm, enterprises resident in low-taxcountries might be able to attract more investment capital or perhaps increase their market sharethrough lower prices to the detriment of enterprises resident in high-tax jurisdictions, eventhough the latter are more efficient.  In either case, capital is diverted from its more productiveuses, and worldwide income and efficiency suffer.  The most straightforward solution to thisproblem is equalization of effective tax rates, but this may not be a practical solution givendifferences in national preferences for the amount and method of taxation.  There is no consensuson what method of taxing international investment income minimizes distortions in the allocationof capital when nations tax income at different effective rates, but the alternatives of capitalexport neutrality and capital import neutrality are the most cited guiding principles.  These twostandards are each desirable goals of international tax policy.  The problem is that, satisfyingboth principles at the same time is possible only if effective tax rates on capital income are thesame in all countries.

Capital export neutrality.--Capital export neutrality refers to a system where an investorresiding in a particular locality can locate investment anywhere in the world and pay the sametax. 

Capital import neutrality.--Capital import neutrality refers to a system of internationaltaxation where income from investment located in each country is taxed at the same rateregardless of the residence of the investor.

	Some commentators refer to the principle of capital import neutrality as promoting"competitiveness."  This notion of competitiveness refers to the ability of U.S. multinationals(firms headquartered in the United States that operate abroad) that locate production facilitiesoverseas to compete in foreign markets.  Overseas production facilities owned by U.S. interestsmay compete with firms owned by residents of the host country or with multinational firmsbased in other countries.  The notion of capital import neutrality promoting the competitivenessof such businesses focuses on the after-tax returns to investments in production facilities abroad.

	As a whole, the U.S. system of taxation is a hybrid containing elements consistent withboth capital import neutrality and capital export neutrality. With regard to the relative treatmentof domestic and outbound investment, many provisions work at cross purposes.  Someprovisions of current law favor outbound investment, while others discourage it.

**II.  PRESENT LAW**

**A.  U.S. Taxation of U.S. Persons with Foreign Income**

**1.  Overview**

	The United States taxes U.S. citizens, residents, and corporations (collectively, U.S.persons) on all income, whether derived in the United States or elsewhere. By contrast, theUnited States taxes nonresident alien individuals and foreign corporations only on income with asufficient nexus to the United States.

	The United States generally cedes the primary right to tax income derived from sourcesoutside the United States to the foreign country where such income is derived. Thus, a creditagainst the U.S. income tax imposed on foreign-source taxable income is provided for foreigntaxes paid on that income. In order to implement the rules for computing the foreign tax credit,the Code and the regulations thereunder set forth an extensive set of rules governing thedetermination of the source, either U.S. or foreign, of items of income and the allocation andapportionment of items of expense against such categories of income.

	The tax rules of foreign countries that apply to foreign income of U.S. persons varywidely. For example, some foreign countries impose income tax at higher effective rates thanthose of the United States. In such cases, the foreign tax credit allowed by the United States islikely to eliminate any U.S. tax on income from a U.S. person's operations in the foreign country.On the other hand, operations in countries that have low statutory tax rates or generous deductionallowances or that offer tax incentives (e.g., tax holidays) to foreign investors are apt to be taxedat effective tax rates lower than the U.S. rates. In such cases, after application of the foreign taxcredit, a residual U.S. tax generally is imposed on income from a U.S. person's operations in theforeign country.

	Under income tax treaties, the tax that otherwise would be imposed under applicableforeign law on certain foreign-source income earned by U.S. persons may be reduced oreliminated. Moreover, U.S. tax on foreign-source income may be reduced or eliminated by treatyprovisions that treat certain foreign taxes as creditable for purposes of computing U.S. taxliability.

**2.  Foreign operations conducted directly**

	The tax rules applicable to U.S. persons that control business operations in foreigncountries depend on whether the business operations are conducted directly (through a foreignbranch, for example) or indirectly (through a separate foreign corporation). A U.S. person thatconducts foreign operations directly includes the income and losses from such operations on theperson's U.S. tax return for the year the income is earned or the loss is incurred. Detailed rulesare provided for the translation into U.S. currency of amounts with respect to such foreignoperations. The income from the U.S. person's foreign operations thus is subject to current U.S.tax. However, the foreign tax credit may reduce or eliminate the U.S. tax on such income.

**3.  Foreign operations conducted through a foreign corporation**

     **a.  In general**

	Income earned by a foreign corporation from its foreign operations generally is subject toU.S. tax only when such income is distributed to any U.S. persons that hold stock in suchcorporation. Accordingly, a U.S. person that conducts foreign operations through a foreigncorporation generally is subject to U.S. tax on the income from those operations when theincome is repatriated to the United States through a dividend distribution to the U.S. person. Theincome is reported on the U.S. person's tax return for the year the distribution is received, and theUnited States imposes tax on such income at that time. The foreign tax credit may reduce theU.S. tax imposed on such income.

	A variety of complex anti-deferral regimes impose current U.S. tax on income earned bya U.S. person through a foreign corporation. Detailed rules for coordination among theanti-deferral regimes are provided to prevent the U.S. person from being subject to U.S. tax onthe same item of income under multiple regimes.

	The Code sets forth the following anti-deferral regimes: the controlled foreigncorporation rules of subpart F (secs. 951-964); the passive foreign investment company rules(secs. 1291-1298); the foreign personal holding company rules (secs. 551-558); the personalholding company rules (secs. 541-547); the accumulated earnings tax rules (secs. 531-537); andthe foreign investment company rules (sec. 1246). The operation and application of theseregimes are briefly described in the following sections.

     **b.  Controlled foreign corporations**

**General rules**

	U.S. 10-percent shareholders of a controlled foreign corporation (a "CFC") are requiredto include in income for U.S. tax purposes currently certain income of the CFC (referred to as"subpart F income"), without regard to whether the income is distributed to the shareholders (sec.951(a)(1)(A)). In effect, the Code treats the U.S. 10-percent shareholders of a CFC as havingreceived a current distribution of their pro rata shares of the CFC's subpart F income. In addition,the U.S. 10-percent shareholders of a CFC are required to include in income for U.S. taxpurposes their pro rata shares of the CFC's earnings to the extent invested by the CFC in U.S.property (sec. 951(a)(1)(B)). The amounts included in income by the CFC's U.S. 10-percentshareholders under these rules are subject to U.S. tax currently. The U.S. tax on such amountsmay be reduced through foreign tax credits.

	For this purpose, a U.S. 10-percent shareholder is a U.S. person that owns 10 percent ormore of the corporation's stock (measured by vote) (sec. 951(b)). A foreign corporation is a CFCif U.S. 10-percent shareholders own more than 50 percent of such corporation's stock (measuredby vote or by value) (sec. 957).(2)

	In determining stock ownership for purposes of the subpart F rules, a U.S. persongenerally is considered to own a proportionate share of stock owned, directly or indirectly, by orfor a foreign corporation, foreign partnership, or foreign trust or estate of which the U.S. personis a shareholder, partner, or beneficiary (sec. 958(a)). In addition, constructive ownership rulesapply for purposes of determining whether a U.S. person is a U.S. 10-percent shareholder,whether a foreign corporation is a CFC, and whether two persons are related, but not forpurposes of requiring the inclusion of amounts with respect to the CFC in a U.S. shareholder'sgross income (secs. 958(b) and 318(a)).

	Earnings and profits of a CFC that have been included in income by the U.S. 10-percentshareholders are not taxed again when such earnings are actually distributed to such shareholders(sec. 959(a)(1)). Similarly, previously-taxed earnings are not included in income by the U.S.10-percent shareholders in the event that such earnings are invested by the CFC in U.S. property(sec. 959(a)(2)). In the event that stock in the CFC is transferred subsequent to an incomeinclusion by a U.S. 10-percent shareholder but prior to the actual distribution of previously taxedincome, the transferee shareholder generally is similarly exempt from U.S. tax on thedistribution.

**Subpart F income**

          In general

	Subpart F income typically is passive income or income that is relatively movable fromone taxing jurisdiction to another. Subpart F income consists of foreign base company income(defined in sec. 954), insurance income (defined in sec. 953), and certain income relating tointernational boycotts and other violations of public policy (defined in sec. 952(a)(3)-(5)).Subpart F income does not include income of the CFC that is effectively connected with theconduct of a trade or business within the United States (on which income the CFC is subject tocurrent U.S. tax) (sec. 952(b)).

	The subpart F income of a CFC is limited to its current earnings and profits (sec. 952(c)).Under this rule, current deficits in earnings and profits in any income category reduce the CFC'ssubpart F income. In addition, accumulated deficits in a CFC's earnings and profits generated bycertain activities in prior years may be used to reduce the CFC's subpart F income generated bysimilar activities in the current year.

	Pursuant to a de minimis rule, generally none of a CFC's income for a taxable year istreated as foreign base company income or subpart F insurance income if the CFC's gross foreignbase company income and gross subpart F insurance income total less than the lesser of 5 percentof the CFC's gross income or $1 million (sec. 954(b)(3)(A)). Pursuant to a full inclusion rule, ifmore than 70 percent of a CFC's gross income is foreign base company income and/or subpart Finsurance income, generally all of the CFC's income is treated as foreign base company incomeor subpart F insurance income (whichever is appropriate) (sec. 954(b)(3)(B)). Under an electiveexception for income that is subject to high foreign taxes, foreign base company income andsubpart F insurance income generally do not include items of income received by the CFC thatthe taxpayer establishes were subject to an effective foreign tax rate greater than 90 percent of themaximum U.S. corporate tax rate (sec. 954(b)(4)).

          Foreign base company income

	Foreign base company income includes five categories of income: foreign personalholding company income, foreign base company sales income, foreign base company servicesincome, foreign base company shipping income, and foreign base company oil related income(sec. 954(a)). In computing foreign base company income, income in these five categories isreduced by allowable deductions properly allocable to such income (sec. 954(b)(5)).

          Foreign personal holding company income

	One major category of foreign base company income is foreign personal holdingcompany income (sec. 954(c)). For subpart F purposes, foreign personal holding companyincome generally consists of the following: (1) dividends, interest, royalties, rents and annuities;(2) net gains from the sale or exchange of (a) property that gives rise to the preceding types ofincome, (b) property that does not give rise to income, and (c) interests in trusts, partnerships,and REMICS; (3) net gains from commodities transactions; (4) net gains from foreign currencytransactions; (5) income that is equivalent to interest; (6) income from notional principalcontracts; and (7) payments in lieu of dividends.

	Subpart F foreign personal holding company income generally includes the excess ofgains over losses from sales and exchanges of non-income producing property and property thatgives rise to certain passive income (sec. 954(c)(1)(B)). However, an exclusion is provided forgains and losses from the sale or exchange of property that is inventory property in the hands ofthe CFC. Also excluded are gains and losses from the sale or exchange of property (includinggains or losses arising out of bona fide hedging transactions) by a CFC that is a regular dealer insuch property. A temporary exclusion also applies to gains and losses from the sale or exchangeof property that gives rise to dividends, interest, rents, royalties, or annuities if such propertygives rise to certain active financing income (secs. 954(c)(1)(B) and 954(h) and (i)).

	Subpart F foreign personal holding company income generally includes the excess ofgains over losses from transactions (including futures, forward, and similar transactions) in anycommodities (sec. 954(c)(1)(C)). However, exceptions are provided for gains and losses fromcertain bona fide hedging transactions and certain active business transactions.

	Subpart F foreign personal holding company income generally includes the excess offoreign currency gains over foreign currency losses attributable to section 988 transactions (sec.954(c)(1)(D)). An exception is provided for hedging and other transactions directly related to thebusiness needs of the CFC.

	Subpart F foreign personal holding income generally includes net income from notionalprincipal contracts (sec. 954(c)(1)(F)). However, income, gain, deduction or loss from a notionalprincipal contract entered into to hedge an item of income in another category of foreign personalholding company income is included in that other category.

	Subpart F foreign personal holding company income does not include rents and royaltiesreceived by the CFC in the active conduct of a trade or business from unrelated persons (sec.954(c)(2)(A)). Also generally excluded are dividends and interest received by the CFC from arelated corporation organized and operating in the same foreign country in which the CFC wasorganized, and rents and royalties received by the CFC from a related corporation for the use ofproperty within the country in which the CFC was organized (sec. 954(c)(3)). However, interest,rent, and royalty payments do not qualify for this exclusion to the extent that such paymentsreduce subpart F income of the payor.

	Temporary exceptions from foreign personal holding company income (as well as foreignbase company services income) apply for subpart F purposes for certain income that is derived inthe active conduct of a banking, financing, or similar business, or in the conduct of an insurancebusiness (so-called "active financing income") (sec. 954(h) and (i)). These exceptions for activefinancing income are applicable only for taxable years beginning in 1999.(3)

	The 1999 exceptions from subpart F foreign personal holding company income apply toincome derived in the active conduct of a banking, financing, or similar business by a CFC that ispredominantly engaged in such business and that conducts substantial activity with respect tosuch business. Detailed rules apply in determining whether the predominantly engaged andsubstantial activity requirements are satisfied, as well as whether income is treated as derived inthe active conduct of a banking, financing, or similar business. In addition, certain nexusrequirements apply, which provide that income derived by a CFC or a qualified business unit("QBU") of a CFC from transactions with customers is eligible for the exceptions if, among otherthings, substantially all of the activities in connection with such transactions are conducteddirectly by the CFC or QBU in its home country, and such income is treated as earned by theCFC or QBU in its home country for purposes of such country's tax laws. Moreover, the 1999exceptions apply to income derived from certain cross border transactions, provided that certainadditional requirements are met. Additional temporary exceptions from foreign personal holdingcompany income apply for certain income derived by a securities dealer within the meaning ofsection 475 and for gain from the sale of active financing assets.

	The 1999 provision also provides a temporary exception from foreign personal holdingcompany income for certain investment income derived by a qualifying insurance company andby certain qualifying insurance company branches.  The exception applies to income (receivedfrom a person other than a related person) from investments made by a qualifying insurancecompany or qualifying insurance company branch of its reserves allocable to exempt contracts or80 percent of its unearned premiums from exempt contracts.(4)

	In addition, temporary and proposed regulations treat certain payments under certainhybrid arrangements as subpart F foreign personal holding company income. The regulationswere issued under Notice 98-11. That Notice, issued on January 16, 1998, stated that theTreasury Department and the Internal Revenue Service have concluded that the use of certainarrangements involving hybrid branches is contrary to the policy and rules of subpart F. Thehybrid branch arrangements identified in Notice 98-11 involve structures that are characterizedfor U.S. tax purposes as branches of a CFC but are characterized for purposes of the tax law ofthe country in which the CFC is incorporated as a separate entity.  Notice 98-11 stated thatregulations would provide that the branch and the CFC would be treated as separate corporationsfor subpart F purposes, with the result that the regulations would treat certain payments madebetween a hybrid branch and a CFC as subpart F income taxable to the CFC's U.S. 10-percentshareholders.

	Under the Notice 98-11 regulations, issued on March 23, 1998, certain payments betweena CFC and its hybrid branch or between hybrid branches of the CFC (so-called "hybrid branchpayments") are treated as giving rise to subpart F income. The regulations generally provide thatnon-subpart F income of the CFC, in the amount of the hybrid branch payment, isrecharacterized as subpart F income of the CFC if: (1) the hybrid branch payment reduces theforeign tax of the payor, (2) the hybrid branch payment would have been foreign personalholding company income if made between separate CFCs, and (3) there is a disparity betweenthe effective tax rate on the payment in the hands of the payee and the effective tax rate thatwould have applied if the income had been taxed in the hands of the payor. The regulations alsoapply to other hybrid branch arrangements involving a partnership, including a CFC'sproportionate share of any hybrid branch payment made between a partnership in which the CFCis a partner and a hybrid branch of the partnership or between hybrid branches of such apartnership. Under the regulations, if a partnership is treated as fiscally transparent by the CFC'staxing jurisdiction, the recharacterization rules are applied by treating the hybrid branch paymentas if it had been made directly between the CFC and the hybrid branch, or as if the hybridbranches of the partnership were hybrid branches of the CFC, as applicable. If the partnership istreated as a separate entity by the CFC's taxing jurisdiction, the recharacterization rules areapplied to treat the partnership as if it were a CFC.

	The regulations also address the application of the same-country exception to the foreignpersonal holding company income rules under subpart F in the case of certain hybrid brancharrangements. Under the regulations, the same-country exception applies to payments by a CFCto a hybrid branch of a related CFC only if the payment would have qualified for the exception ifthe hybrid branch had been a separate CFC incorporated in the jurisdiction in which the paymentis subject to tax (other than a withholding tax). The regulations provide additional rules regardingthe application of the same-country exception in the case of certain hybrid arrangementsinvolving a partnership.

	In Notice 98-35, issued on June 19, 1998, the Treasury Department and the InternalRevenue Service withdrew Notice 98-11 and announced their intention to withdraw the relatedtemporary and proposed regulations under Notice 98-11, and to reissue proposed regulations onhybrid transactions to be finalized no earlier than January 1, 2000. To date, the temporary andproposed regulations issued under Notice 98-11 have not been withdrawn.

	Under Notice 98-35, future proposed regulations will treat certain payments under hybridtransactions as giving rise to subpart F income under circumstances similar to those in thetemporary and proposed regulations under Notice 98-11, with certain modifications includingcertain grandfathering and transition rules. In this regard, Notice 98-35 states that proposedregulations on hybrid transactions (whether through branches or partnerships) will not befinalized before January 1, 2000, and when finalized, generally will be effective for paymentsmade on or after June 19, 1998, under hybrid arrangements.(5) However, the Notice states that theproposed regulations will not be effective for payments made under hybrid arrangements enteredinto before June 19, 1998, so long as the arrangement is not substantially modified on or afterthat date.

	In addition, Notice 98-35 provides transitional relief for certain qualifying hybrid branchpayments made under hybrid arrangements entered into on or after June 19, 1998, and before thedate the regulations are finalized. In this regard, Notice 98-35 states that proposed regulationswill not apply to such payments earlier than the first taxable year of the U.S. shareholderbeginning on or after the expiration of five calendar years from the date the regulations arefinalized (i.e., no earlier than taxable years beginning on January 1, 2005). The Notice states thatthis transition rule applies for so long as the arrangement is not substantially modified after thedate the regulations are finalized. For purposes of the transition relief, the Notice provides that aqualifying hybrid branch payment is a payment that is attributable to a U.S. shareholder thatwould otherwise generally be recharacterized as subpart F income under the proposedregulations, but that when aggregated with all other such payments attributable to such U.S.shareholder for a particular country in a taxable year, does not exceed a maximum payment limitattributable to the U.S. shareholder. The Notice states that the maximum payment limitattributable to the U.S. shareholder for a country is 50 percent of the total non-subpart F earningsand profits amount of CFCs or qualified business units in that country and that is owned by suchshareholder on June 19, 1998 (the "non-subpart F earnings and profits amount"). The non-subpart F earnings and profits amount generally is defined as the highest of the CFC's orqualified business unit's non-subpart F earnings and profits for any of its last seven taxable yearsending before June 19, 1998. In the case of certain newly established businesses, the Noticeprovides that the U.S. shareholder may elect to treat its non-subpart F earnings and profitsamount as equal to 20 percent of the net active equity of the business on June 19, 1998. TheNotice also provides special rules relating to qualifying hybrid branch payments in the case of aCFC that is not wholly-owned by a U.S. shareholder.

          Foreign base company sales and services income

	Foreign base company income also includes foreign base company sales and servicesincome. Foreign base company sales income generally consists of sales income of a CFC locatedin a country that is neither the origin nor the destination of the goods with respect to sales ofproperty purchased from or sold to a related person (sec. 954(d)). Foreign base company servicesincome consists of income from services performed outside the CFC's country of incorporationfor or on behalf of a related party (sec. 954(e)).

	A special branch rule applies only for purposes of determining a CFC's foreign basecompany sales income. Under this rule, a branch of a CFC is treated as a separate corporationwhere the activities of the CFC through the branch outside the CFC's country of incorporationhave substantially the same effect as if such branch were a subsidiary (sec. 954(d)(2)).

	For purposes of the subpart F rules, a related person is defined as any individual,corporation, trust, or estate that controls or is controlled by the CFC, or any individual,corporation, trust, or estate that is controlled by the same person or persons that control the CFC(sec. 954(d)(3)). Control with respect to a corporation means ownership of more than 50 percentof the corporation's stock (by vote or value). Control with respect to a partnership, trust, or estatemeans ownership of more than 50 percent of the value of the beneficial interests of thepartnership, trust, or estate. Indirect and constructive ownership rules apply.

          Foreign base company shipping income

	Foreign base company income includes foreign base company shipping income. Foreignbase company shipping income consists of income derived from (1) the use (or hiring or leasingfor use) of any aircraft or vessel in foreign commerce, (2) the performance of services directlyrelated to the use of any such aircraft or vessel, or (3) the sale, exchange or other disposition ofany such aircraft or vessel (sec. 954(f)). Foreign base company shipping income also includesany income derived from certain space or ocean activities.

          Foreign base company oil related income

	Foreign base company income includes foreign base company oil related income (i.e.,income other than extraction income). Foreign base company oil related income generallyincludes all oil related income, other than income derived from a source within a foreign countryin connection with either (1) oil or gas that was extracted from a well located in that foreigncountry, or (2) oil, gas, or a primary product of oil or gas that is sold by the CFC or a relatedperson for use or consumption within that foreign country, or is loaded in that country on avessel or aircraft as fuel for such vessel or aircraft (sec. 954(g)). An exception is available for anyCFC that, together with related persons, does not constitute a large oil producer.

          Insurance income

	Insurance income subject to current inclusion under the subpart F rules generally includesany income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contractin connection with risks located in a country other than the CFC's country of organization (sec.953(a)). Subpart F insurance income also includes income attributable to an insurance contract inconnection with risks located within the CFC's country of organization, as the result of anarrangement under which another corporation receives a substantially equal amount ofconsideration for insurance of other-country risks. Investment income of a CFC that is allocableto any insurance or annuity contract related to risks located outside the CFC's country oforganization is taxable as subpart F insurance income (Prop. Treas. Reg. sec. 1.953-1(a)).

	Subpart F insurance income that is related person insurance income generally is taxableunder subpart F to an expanded category of U.S. persons (sec. 953(c)).  For purposes of takinginto account such income under the subpart F provisions, the U.S. ownership threshold for CFCstatus is 25 percent or more.  Any U.S. person who owns (directly or indirectly) stock in theforeign corporation, whatever the degree of ownership, is taken into account in applying thisthreshold and is subject to current U.S. tax on the CFC's related person insurance income. Certain exceptions apply to these special subpart F rules with respect to related person insurance. For this purpose, related person insurance income is insurance income attributable to a policy ofinsurance or reinsurance where the insured is a U.S. shareholder of the CFC (or related to suchshareholder).

	A special exception from insurance income applies for the first taxable year beginning in1999.(6)  The 1999 exception from insurance income applies for income derived by a qualifyinginsurance company that is attributable to the issuing (or reinsuring) of an exempt contract by thequalifying insurance company or a qualifying insurance company branch of such a company, andthat is treated as earned by the company or branch in that company's, or branch's, home countryfor purposes of that country's tax laws.  An exempt contract is an insurance or annuity contractissued or reinsured by a qualifying insurance company or qualified insurance company branch inconnection with property in, liability arising out of activity in, or the lives or health of residentsof, a country other than the United States.  No contract is treated as an exempt contract unless thequalifying insurance company or branch derives more than 30 percent of its net writtenpremiums from exempt contracts (determined without regard to this sentence) coveringapplicable home country risks, and with respect to which no policyholder, insured, annuitant, orbeneficiary is a related person (within the meaning of sec. 954(d)(3)).

	Under the 1999 exception, a qualifying insurance company is a CFC that meets threerequirements that are intended to distinguish firms that have a real business nexus with a foreigncountry or countries from firms that do not.  The first requirement is that the CFC be subject toregulation as an insurance (or reinsurance) company by its home country, and that the CFC belicensed, authorized, or regulated by the applicable insurance regulatory body for its homecountry to sell insurance, reinsurance, or annuity contracts to persons other than related persons(within the meaning of sec. 954(d)(3)) in its home country.  The second requirement is that theCFC derive more than 50 percent of its aggregate net written premiums from the insurance orreinsurance by the CFC (on an aggregate basis, including qualifying insurance companybranches) covering applicable home country risks (as described above) of the CFC or branch, asthe case may be.  The third requirement is that the CFC be engaged in the insurance business andthat it would be subject to tax under subchapter L if it were a domestic corporation.

	The 1999 exception imposes additional requirements with respect to any contract thatcovers cross border risks (that is, risks other than applicable home country risks), due to theincreased concern about mobility of income in cross border business. A contract issued by aqualifying insurance company or qualifying insurance company branch that covers risks otherthan applicable home country risks is not treated as an exempt contract unless such company orbranch, as the case may be, (1) conducts substantial activity in its home country with respect tothe insurance business, and (2) performs in its home country substantially all of the activitiesnecessary to give rise to the income generated by the contract.

          Other subpart F income

	Subpart F income also includes three categories of income relating to internationalboycotts and other violations of public policy. The first category consists of the portion of theCFC's current income, other than amounts otherwise subject to current U.S. taxation, that istreated as attributable to participation in an international boycott (sec. 952(a)(3)). The secondcategory consists of any illegal bribes, kickbacks, or other payments by or on behalf of thecorporation directly or indirectly to an official, employee, or agent in fact of a government (sec.952(a)(4)). The third category consists of income derived from any foreign country during aperiod in which the taxes imposed by that country are denied eligibility for the foreign tax creditpursuant to the implementation of U.S. foreign policy (sec. 952(a)(5)).

**Treatment of investments in U.S. property**

	As discussed above, the U.S. 10-percent shareholders of a CFC generally are subject toU.S. tax currently on their pro rata shares of the CFC's subpart F income. In addition, the U.S.10-percent shareholders of a CFC are subject to U.S. tax currently on their pro rata shares of theCFC's earnings to the extent invested by the CFC in U.S. property.

	A shareholder's current income inclusion with respect to a CFC's investment in U.S.property for a taxable year is the shareholder's pro rata share of an amount equal to the lesser of(1) the CFC's average investment in U.S. property for such year, to the extent that suchinvestment exceeds the foreign corporation's earnings and profits that were previously taxed onthat basis, or (2) the CFC's current or accumulated earnings and profits, reduced by distributionsduring the year and by earnings that have been taxed previously as earnings invested in U.S.property (secs. 956 and 959). An income inclusion is required only to the extent that the amountso calculated exceeds the amount of the CFC's earnings that have been previously taxed assubpart F income (secs. 951(a)(1)(B) and 959).

	The U.S. property held (directly or indirectly) by a CFC must be measured as of the closeof each quarter in the taxable year (sec. 956(a)). The amount taken into account with respect toany property is the property's adjusted basis as determined for purposes of reporting the CFC'searnings and profits, reduced by any liability to which the property is subject.

	For purposes of section 956, U.S. property generally is defined to include tangibleproperty located in the United States, stock of a U.S. corporation, an obligation of a U.S. person,and the right to use certain intellectual property in the United States (sec. 956(c)(1)). Specifiedexceptions are provided for, among other things, obligations of the United States, U.S. bankdeposits, certain export property, certain trade or business obligations, stock or debt of certainunrelated U.S. corporations, and certain deposits or receipts of collateral or margin by, andcertain repurchase or reverse repurchase agreement transactions entered into by or with, asecurities or commodities dealer in the ordinary course of the dealer's business (sec. 956(c)(2)).

**Gain from sales or exchanges of stock of certain foreign corporations**

	If a U.S. person sells or exchanges stock in a foreign corporation, or receives adistribution from a foreign corporation that is treated as an exchange of stock, and, at any timeduring the five-year period ending on the date of the sale or exchange, the foreign corporationwas a CFC and the U.S. person was a U.S. 10-percent shareholder, any gain recognized on thesale or exchange generally is recharacterized as dividend income, to the extent of the earningsand profits of the foreign corporation accumulated during the period that the shareholder heldstock while the corporation was a CFC (sec. 1248). In addition, if a CFC is treated as having gainfrom the sale or exchange of stock in a foreign corporation, the gain is treated as a dividend tothe same extent that it would have been so treated under section 1248 if the CFC were a U.S.person.

	For this purpose, earnings and profits of the foreign corporation do not include amountsthat already were subject to U.S. tax (whether imposed on the foreign corporation itself or on theU.S. 10-percent shareholders) (sec. 1248(d)). Detailed rules govern the application of section1248 in the case of (1) sales or exchanges of certain U.S. stock, (2) certain nonrecognitiontransactions involving a foreign corporation, and (3) certain indirect transfers of stock of aforeign corporation.

     **c.  Passive foreign investment companies**

**General rules**

	The Tax Reform Act of 1986 established an anti-deferral regime applicable to U.S.persons that hold stock in a passive foreign investment company (a "PFIC"). A U.S. shareholderof a PFIC generally is subject to U.S. tax, plus an interest charge that reflects the value of thedeferral of tax, upon receipt of a distribution from the PFIC or upon a disposition of PFIC stock.However, if a "qualified electing fund" election is made, the U.S. shareholder is subject to U.S.tax currently on the shareholder's pro rata share of the PFIC's total earnings; a separate electionmay be made to defer payment of such tax, subject to an interest charge, on income not currentlyreceived by the shareholder. In addition, with respect to PFIC stock that is marketable, electingshareholders currently take into account as income (or loss) the difference between the fairmarket value of their PFIC stock as of the close of the taxable year and their adjusted basis insuch stock (subject to certain restrictions).

	Constructive ownership rules apply in determining whether a U.S. person owns stock in aPFIC (sec. 1298(a)). Under these rules, a U.S. person generally is treated as owning such person'sproportionate share of PFIC stock (1) owned by a partnership, trust or estate of which the personis a partner or beneficiary, (2) owned by a corporation of which the person is a 50-percent orgreater shareholder (measured by value), or (3) owned by another PFIC of which the person is ashareholder.

**Qualification as a PFIC**

	A foreign corporation is a PFIC if (1) 75 percent or more of its gross income for thetaxable year consists of passive income, or (2) 50 percent or more of the average assets of thecorporation consists of assets that produce, or are held for the production of, passive income (sec.1297(a)). The 50-percent PFIC asset test generally is applied using fair market value for purposesof measuring the PFIC's assets  (sec. 1297(f)). For this purpose, fair market value is used for aforeign corporation that is publicly traded. A foreign corporation is treated as publicly traded ifstock in such corporation is regularly traded on a national securities exchange that is registeredwith the Securities Exchange Commission, the national market system established pursuant toapplicable securities laws, or any other exchange or market that the Treasury Secretarydetermines has rules that adequately ensure a sound fair market value for the market price of thestock. However, in the case of a foreign corporation that is a CFC that is not publicly traded (orany other foreign corporation that so elects), the asset test for PFIC status is applied using theadjusted bases of the corporation's assets rather than their fair market value (sec. 1297(f)(2)).

	For this purpose, passive income generally means income that satisfies the definition offoreign personal holding company income under the subpart F provisions (sec. 1297(b)).However, except as provided in regulations, passive income does not include certainactive-business banking or insurance income. Also excluded from the definition of passiveincome is certain active-business securities income.

	Special exceptions from PFIC classification apply to start-up companies (sec. 1298(b)(2))and corporations changing businesses during the taxable year (sec. 1298(b)(3)). In both suchcases, the corporation may have a substantially higher proportion of passive assets (and passiveincome, in some cases) than at other times in its history.

	In determining whether a foreign corporation that owns a subsidiary is a PFIC,look-through treatment is provided in certain cases. A foreign corporation that owns, directly orindirectly, at least 25 percent of the value of the stock of another corporation is treated as owninga proportionate part of the other corporation's assets and income. Thus, amounts such as interestand dividends received from foreign or domestic subsidiaries are eliminated from the parent'sincome in applying the income test, and the stock or debt investment is eliminated from theparent's assets in applying the asset test. A special rule treats as active assets certain U.S. stockinvestments of a 25-percent owned U.S. corporation (sec. 1298(b)(8)). In addition to the rulesapplicable to 25-percent-owned subsidiaries, interest, dividends, rents, and royalties receivedfrom related persons are excepted from treatment as passive income to the extent that suchamounts are allocable to income of the payor that is not passive income (sec. 1297(b)(2)(C)).

**Treatment of nonqualified funds**

	In the absence of a qualified electing fund election, a U.S. shareholder of a PFIC issubject to U.S. tax and an interest charge at the time the shareholder receives an "excess"distribution from the PFIC or disposes of stock in the PFIC (sec. 1291). Under this rule, gainrecognized on receipt of an "excess" distribution or on disposition of PFIC stock generally istreated as ordinary income earned pro rata over the shareholder's holding period with respect tothe PFIC stock, and is taxed at the highest applicable tax rate in effect for each respective year.Interest is imposed at the underpayment rate on the tax liability with respect to amounts allocatedto prior taxable years. Special rules apply for purposes of computing foreign tax credits withrespect to such distributions (sec. 1291(g)).

	An "excess" distribution is any distribution during the current taxable year that exceeds125 percent of the average amount of distributions received during the three preceding years (or,if shorter, the taxpayer's holding period prior to the current taxable year) (sec. 1291(b)). Thedetermination of an excess distribution excludes from the three-year average distribution basethat part of a prior-year excess distribution that is considered attributable to deferred earnings.There are no excess distributions for the first year in the U.S. shareholder's holding period.

**Treatment of qualified electing funds**

	A U.S. person that owns stock in a PFIC may elect that the PFIC be treated as a"qualified electing fund" with respect to that shareholder (sec. 1295). Under such election, theU.S. shareholder must include currently in gross income the shareholder's pro rata share of thePFIC's total earnings and profits (sec. 1293). This inclusion rule generally requires currentpayment of tax, absent a separate election to defer payment of the tax (sec. 1294).

	The amount currently included in the income of an electing shareholder is dividedbetween the shareholder's pro rata share of the ordinary earnings of the PFIC and theshareholder's pro rata share of the net capital gain of the PFIC (sec. 1293(a)(1)). Thecharacterization of income, and the determination of earnings and profits, generally is madepursuant to general Code rules (sec. 1293(e)).

	A U.S. shareholder's pro rata share of income generally is determined by attributing thePFIC's income for the taxable year ratably over the days in such year (sec. 1293(b)). Electingshareholders include in income for the period in which they held stock in the PFIC an amountequal to the sum of their daily ownership interest in the PFIC multiplied by the income attributedto such day. If it is established that a PFIC maintains records determining its shareholders' prorata shares of income more accurately than by allocating a year's income ratably on a daily basis,the shareholders' pro rata shares of income may be determined on that basis.

	The distribution of earnings and profits that were previously included in the income of anelecting U.S. shareholder under these rules is not taxed as a dividend to the shareholder (sec.1293(c)). The basis of an electing U.S. shareholder's stock in a PFIC is increased by amountscurrently included in income under these rules, and is decreased by any amount that is actuallydistributed but treated as previously taxed (sec. 1293(d)).

	Special rules apply in cases where a U.S. shareholder makes the qualified electing fundelection with respect to the PFIC after the beginning of the shareholder's holding period withrespect to the PFIC (i.e., where the PFIC is a nonqualified fund with respect to the shareholderfor some period before the shareholder makes the election) (sec. 1291(d)).

	Foreign tax credits are allowed against U.S. tax on amounts included in income from aqualified electing fund to the same extent, and under the same rules, as in the case of incomeinclusions from a CFC (sec. 1293(f)). Special rules apply in characterizing such incomeinclusions from qualified electing funds for foreign tax credit purposes.

	U.S. shareholders generally may elect to defer the payment of U.S. tax on amounts thatare included currently in income but for which no current distribution has been received (sec.1294). An election to defer tax is treated as an extension of time to pay tax for which a U.S.shareholder is liable for interest. The disposition of stock in a PFIC terminates all previousextensions of time to pay tax with respect to the earnings attributable to that stock. Any transferof ownership generally is treated as a disposition for this purpose, regardless of whether thetransfer constitutes a realization or recognition event under general Code rules.

**Elimination of overlap between subpart F and the PFIC provisions**

	A 10-percent U.S. shareholder that is subject to current inclusion under the subpart Frules with respect to stock of a PFIC that is also a CFC generally is not subject also to the PFICprovisions with respect to the same stock (sec. 1297(e)).  In this regard, a corporation is nottreated as a PFIC with respect to a shareholder during the qualified portion of the shareholder'sholding period for the stock of such corporation. The qualified portion of the shareholder'sholding period generally is the portion of such period which is after December 31, 1997, andduring which the shareholder is a U.S. shareholder (withing the meaning of sec. 951(b)) and thecorporation is a CFC (within the meaning of sec. 957). The PFIC provisions continue to apply inthe case of a PFIC that is also a CFC to shareholders that are not subject to subpart F (i.e., toshareholders that are U.S. persons that own (directly, indirectly, or constructively) less than 10percent of the corporation's stock by vote).(7)

	The elimination of the overlap between the PFIC and CFC provisions does not apply to ashareholder of a corporation that was a PFIC with respect to such shareholder and that was anonqualified fund, unless the shareholder makes an election to pay tax and an interest chargewith respect to the unrealized appreciation in the stock or the accumulated earnings of thecorporation (sec. 1298(b)(1)). If a shareholder is not subject to the PFIC provisions because theshareholder is subject to subpart F and the shareholder subsequently ceases to be subject tosubpart F with respect to the corporation, the shareholder's holding period for such stock istreated as beginning immediately after such cessation for purposes of applying the PFIC rules(sec. 1297(e)).

	For purposes of the PFIC provisions, attribution rules apply to the extent that the effect isto treat stock of a PFIC as owned by a U.S. person. In general, if 50 percent or more in value ofthe stock of a corporation is owned (directly or indirectly) by or for any person, such person isconsidered as owning a proportionate part of the stock owned directly or indirectly by or for suchcorporation, determined based on the person's proportionate interest in the value of suchcorporation's stock. However, this 50-percent limitation does not apply in the case of acorporation that is a PFIC; a person that is a shareholder of a PFIC is considered as owning aproportionate part of the stock owned directly or indirectly by or for such PFIC, without regardto whether such shareholder owns at least 50 percent of the PFIC's stock by value. Theseattribution rules apply without regard to the provision that treats a corporation as a non-PFICwith respect to a shareholder for the qualified portion of the shareholder's holding period.Accordingly, stock owned directly or indirectly by or for a corporation that is not treated as aPFIC for the qualified portion of the shareholder's holding period nevertheless will be attributedto such shareholder, regardless of the shareholder's ownership percentage of such corporation.

**Mark-to-market election**

	A shareholder of a PFIC may make a mark-to-market election with respect to the stock ofa PFIC, provided that such stock is marketable (sec. 1296). Under such an election, theshareholder includes in income each year an amount equal to the excess, if any, of the fair marketvalue of the PFIC stock as of the close of the taxable year over the shareholder's adjusted basis insuch stock. The shareholder is allowed a deduction for the excess, if any, of the adjusted basis ofthe PFIC stock over its fair market value as of the close of the taxable year. However, deductionsgenerally are allowable under this rule to the extent of any net mark-to-market gains with respectto the stock included by the shareholder for prior taxable years.(8)

	For purposes of this election, PFIC stock is considered marketable if it is regularly tradedon a national securities exchange that is registered with the Securities Exchange Commission, oron the national market system established pursuant to applicable securities laws, or any otherexchange or market that the Treasury Secretary determines has rules which adequately ensure asound fair market value for the market price of the stock (sec. 1296(e)). PFIC stock also is treatedas marketable, to the extent provided in regulations, if the PFIC offers for sale (or hasoutstanding) stock of which it is the issuer and which is redeemable at its net asset value in amanner comparable to a U.S. regulated investment company ("RIC").

	In addition, PFIC stock owned by a RIC is treated as marketable for purposes of theelection if the RIC offers for sale (or has outstanding) any stock of which it is the issuer andwhich is redeemable at its net asset value (sec. 1296(e)(2)). PFIC stock held by any other RIC is treated as marketable if the RIC otherwise publishes net asset valuations at least annually, exceptto the extent provided in regulations.

	The shareholder's adjusted basis in marketable PFIC stock is adjusted to reflect theamounts included or deducted under this election (sec. 1296(b)). Amounts included in incomepursuant to the election, as well as gain on the actual sale or other disposition of the PFIC stock,are treated as ordinary income (sec. 1296(c)). Ordinary loss treatment also applies to thedeductible portion of any mark-to-market loss on the PFIC stock, as well as to any loss realizedon the actual sale or other disposition of PFIC stock to the extent that the amount of such lossdoes not exceed the net mark-to-market gains previously included with respect to such stock. Thesource of amounts with respect to a mark-to-market election generally is determined in the samemanner as if such amounts were gain or loss from the sale of stock in the PFIC (sec. 1296(c)).

	A mark-to-market election applies to the taxable year for which made and all subsequenttaxable years, unless the PFIC stock ceases to be marketable or the Treasury Secretary consentsto the revocation of such election.

	The PFIC rules for nonqualified funds generally do not apply to a shareholder of a PFICif a mark-to-market election is in effect for the shareholder's taxable year.(9) However, in the caseof a taxpayer that makes the mark-to-market election with respect to stock of a PFIC that is anonqualified fund after the beginning of the taxpayer's holding period with respect to such stock,a coordination rule applies to ensure that the taxpayer does not avoid the interest charge withrespect to amounts attributable to periods before the election (sec. 1296(j)). Similar coordinationrules apply in the case of a taxpayer that marks to market PFIC stock under section 475 or anyother provision after the beginning of the taxpayer's holding period for the PFIC stock.  Asimilar rule applies to RICs that make the mark-to-market election after the beginning of theirholding period with respect to PFIC stock, to the extent the RIC had not previously marked tomarket the stock of the PFIC.

     **d.  Foreign personal holding companies**

	The foreign personal holding company rules are aimed at preventing U.S. persons fromaccumulating income tax-free in foreign "incorporated pocketbooks." If a foreign corporationqualifies as a foreign personal holding company, all the U.S. shareholders of the corporation aresubject to U.S. tax currently on their pro rata share of the corporation's undistributed foreignpersonal holding company income.

	A foreign corporation is a foreign personal holding company if it satisfies both a stockownership requirement and a gross income requirement (sec. 552(a)). The stock ownershiprequirement is satisfied if, at any time during the taxable year, more than 50 percent (measuredby vote or by value) of the stock of the corporation is owned by or for five or fewer individualcitizens or residents of the United States. Indirect and constructive ownership rules apply forpurposes of the stock ownership requirement (sec. 554). The gross income requirement issatisfied initially if at least 60 percent of the corporation's gross income is foreign personalholding company income. Once the corporation qualifies as a foreign personal holding company,however, the gross income threshold for each subsequent year is only 50 percent, until theexpiration of either one full taxable year during which the stock ownership requirement is notsatisfied or three consecutive taxable years for which the gross income requirement is notsatisfied at the 50-percent threshold (sec. 552(a)(1)).

	Foreign personal holding company income generally includes passive income such asdividends, interest, certain royalties, and certain rents (sec. 553(a)). It also includes, among otherthings, gains (other than gains of dealers) from stock and securities transactions, gains (other thangains from bona fide hedging transactions) from commodities transactions, and amounts receivedwith respect to certain personal services contracts. Look-through rules apply for purposes ofcharacterizing certain dividends and interest received from related persons (sec. 552(c)).

	If a foreign corporation is a foreign personal holding company, its undistributed foreignpersonal holding company income is treated as distributed as a dividend on a pro-rata basis to allof its U.S. shareholders (sec. 551(b)). The undistributed foreign personal holding companyincome that is deemed distributed is treated as recontributed by the shareholders to the foreignpersonal holding company as a contribution to capital. Accordingly, the earnings and profits ofthe corporation are reduced by the amount of the deemed distribution (sec. 551(d)), and eachshareholder's basis in his or her stock in the foreign personal holding company is increased bythe shareholder's pro rata portion of the deemed distribution (sec. 551(e)). If an item of income ofa foreign corporation would be includible in the gross income of a U.S. shareholder under boththe subpart F rules and the foreign personal holding company rules, that item of income isrequired to be included only under the subpart F rules (sec. 951(d)).

     **e.  Personal holding companies**

	In addition to the corporate income tax, a tax is imposed at the rate of 39.6 percent on theundistributed personal holding company income of a personal holding company (sec. 541). Thistax substitutes for the tax that would have been incurred by the shareholders on dividendsactually distributed by the personal holding company.

	A corporation generally is a personal holding company if (1) at least 60 percent of itsadjusted gross income for the taxable year is personal holding company income, and (2) at anytime during the last half of the taxable year more than 50 percent (by value) of its outstandingstock is owned, directly or indirectly, by or for not more than five individuals (sec. 542(a)). Thedefinition of a personal holding company is very similar to that of a foreign personal holdingcompany, discussed above, but does not depend on the U.S. citizenship or residence status of theshareholders. However, specified exceptions to the definition of a personal holding companypreclude the application of the personal holding company tax to, among others, any foreignpersonal holding company, most foreign corporations owned solely by nonresident alienindividuals, and any PFIC (sec. 542(c)(5), (7), and (10)). Notwithstanding these exceptions, thepersonal holding company tax is potentially applicable to a small class of closely-held foreigncorporations.

     **f.  Accumulated earnings tax**

	In addition to the corporate income tax, a tax is imposed at the rate of 39.6 percent on theaccumulated taxable income of a corporation formed or availed of for the purpose of avoidingincome tax with respect to its shareholders (or the shareholders of any other corporation), bypermitting its earnings and profits to accumulate instead of being distributed (secs. 531, 532(a)).The fact that the earnings and profits of the corporation are allowed to accumulate beyond thereasonable needs of the business generally is determinative of the required tax-avoidance motive(sec. 533). Like the personal holding company tax, the accumulated earnings tax acts as asubstitute for the tax that would have been incurred by the shareholders on dividends actuallydistributed by the corporation.

	The accumulated earnings tax does not apply to any personal holding company, foreignpersonal holding company, or PFIC (sec. 532(b)). These exceptions, along with the currentinclusion of subpart F income in the gross incomes of the U.S. 10-percent shareholders of a CFC,result in only a very limited application of the accumulated earnings tax to foreign corporations.

     **g.  Foreign investment companies**

	A foreign corporation generally is a foreign investment company if (1) the corporation isregistered as a management company or as a unit investment trust, or is engaged primarily in thebusiness of investing, reinvesting, or trading in securities or commodities or any interest insecurities or commodities and (2) 50 percent or more (measured by vote or by value) of the stockof the corporation is held (directly or indirectly) by U.S. persons (sec. 1246(b)). Gain on a sale orexchange (or a distribution that is treated as an exchange) of stock in a foreign investmentcompany generally is treated as ordinary income to the extent of the taxpayer's ratable share ofthe undistributed earnings and profits of the foreign investment company (sec. 1246(a)). Thisrule operates not to prevent deferral of U.S. tax, as do the foregoing sets of rules, but rather toprevent the use of a foreign corporation to convert ordinary income into capital gain.

**4.  Transfer pricing rules**

	In the case of a multinational enterprise that includes at least one U.S. corporation and atleast one foreign corporation, the United States taxes all of the income of the U.S. corporation,but only so much of the income of the foreign corporation as is determined to have sufficientnexus to the United States. The determination of the amount that properly is the income of theU.S. member of a multinational enterprise and the amount that properly is the income of aforeign member of the same multinational enterprise thus is critical to determining the amount ofincome the United States may tax (as well as the amount of income other countries may tax).

	Due to the variance in tax rates and tax systems among countries, a multinationalenterprise may have a strong incentive to shift income, deductions, or tax credits amongcommonly controlled entities in order to arrive at a reduced overall tax burden. Such a shifting ofitems between commonly controlled entities could be accomplished by setting artificial transferprices for transactions between group members.

	As a simple illustration of how transfer pricing could be used to reduce taxes, assume thata U.S. corporation has a wholly-owned foreign subsidiary. The U.S. corporation manufactures aproduct domestically and sells it to the foreign subsidiary. The foreign subsidiary, in turn, sellsthe product to unrelated third parties. Due to the U.S. parent's control of its subsidiary, the pricewhich is charged by the parent to the subsidiary theoretically could be set independently ofordinary market forces. If the foreign subsidiary is established in a jurisdiction that subjects itsprofits from the sale of the product to an effective rate of tax lower than the effective U.S. taxrate, then the U.S. corporation may be inclined to undercharge the foreign subsidiary for theproduct. By doing so, a portion of the combined profits of the group from the manufacture andsale of the product would be shifted out of a high-tax jurisdiction (the United States) and into alower-tax jurisdiction (the foreign corporation's home country).(10) The ultimate result of thisprocess would be a reduced worldwide tax liability of the multinational enterprise.

	Under section 482, the Secretary of the Treasury is authorized to redetermine the incomeof an entity subject to U.S. taxation, when it appears that an improper shifting of income betweenthat entity and a commonly controlled entity in another country has occurred. This authority isnot limited to reallocations of income between different taxing jurisdictions; it permitsreallocations in any common control situation, including reallocations between two U.S. entities.However, it has significant application to multinational enterprises due to the incentives fortaxpayers to shift income to obtain the benefits of significantly different effective tax rates.

	Section 482 grants the Secretary of the Treasury broad authority to allocate income,deductions, credits, or allowances between any commonly controlled organizations, trades, orbusinesses in order to prevent evasion of taxes or clearly to reflect income. The statute generallydoes not prescribe any specific reallocation rules that must be followed, other than establishingthe general standards of preventing tax evasion and clearly reflecting income. Treasuryregulations adopt the concept of an arm's length standard as the method for determining whetherreallocations are appropriate. Thus, the regulations attempt to identify the respective amounts oftaxable income of the related parties that would have resulted if the parties had been uncontrolledparties dealing at arm's length. The regulations contain complex rules governing thedetermination of an arm's-length charge for various types of transactions. The regulationsgenerally attempt to prescribe methods for identifying the relevant comparable unrelated partytransactions and for providing adjustments for differences between such transactions and therelated party transactions in question. In some instances, the regulations also provide safeharbors.

	Determinations under section 482 that result in the allocation of additional income to theUnited States might theoretically subject a taxpayer to double taxation, if both the United Statesand another country imposed tax on the same income and the other country did not agree that theincome should be reallocated to the United States. Tax treaties generally provide mechanisms toattempt to resolve such disputes in a manner that may avoid double taxation if both countriesagree. Such mechanisms include the designation of a "competent authority" by each country, toact as that country's representative in the negotiation attempting to resolve such disputes.However, such competent authority procedures do not guarantee that double tax may not beimposed in a particular case.

	One method for addressing the issue of double taxation is through the advance pricingagreement ("APA") procedure.(11) An APA is an advance agreement establishing an approvedtransfer pricing methodology entered into between the taxpayer, the Internal Revenue Service,and a foreign tax authority. The taxpayer generally is required to use the approved transferpricing methodology for the duration of the APA. The IRS and the foreign tax authoritygenerally agree to accept the results of such approved methodology. An APA also may benegotiated between just the taxpayer and the IRS; such an APA establishes an approved transferpricing methodology for U.S. tax purposes. The APA process may prove to be particularly usefulin cases involving industries such as financial products and services for which transfer pricingdeterminations are especially difficult.

**5.  Foreign tax credit rules**

     **a.  In general**

	Because the United States taxes U.S. persons on their worldwide income, Congressenacted the foreign tax credit in 1918 to prevent U.S. taxpayers from being taxed twice on theirforeign source income: once by the foreign country where the income is earned and again by theUnited States. The foreign tax credit generally allows U.S. taxpayers to reduce the U.S. incometax on their foreign income by the foreign income taxes they pay on that income. The foreign taxcredit does not operate to offset U.S. income tax on U.S.-source income.

	A credit against U.S. tax on foreign income is allowed for foreign taxes paid or accruedby a U.S. person (sec. 901). In addition, a credit is allowed to a U.S. corporation for foreign taxespaid by certain foreign subsidiary corporations and deemed paid by the U.S. corporation upon adividend received by, or certain other income inclusions of, the U.S. corporation with respect toearnings of the foreign subsidiary (the "deemed-paid" or "indirect" foreign tax credit) (sec. 902).

	The foreign tax credit provisions of the Code are elective on a year-by-year basis. In lieuof electing the foreign tax credit, U.S. persons generally are permitted to deduct foreign taxes(sec. 164(a)(3)). For purposes of the alternative minimum tax, foreign tax credits generallycannot be used to offset more than 90 percent of the U.S. person's pre-foreign tax credit tentativeminimum tax (sec. 59(a)).(12)

	A foreign tax credit limitation, which is calculated separately for various categories ofincome, is imposed to prevent the use of foreign tax credits to offset U.S. tax on U.S.-sourceincome. Detailed rules are provided for the allocation of expenses against U.S.-source andforeign-source income. Special rules apply to require the allocation of foreign losses in onecategory of income for a taxable year to offset foreign income in the other categories for suchyear and to require the recharacterization of foreign income for a year subsequent to a foreignloss year from one income category to another or from foreign source to U.S. source (sec.904(f)).

	The amount of creditable taxes paid or accrued (or deemed paid) in any taxable yearwhich exceeds the foreign tax credit limitation is permitted to be carried back to the twoimmediately preceding taxable years and carried forward to the first five succeeding taxableyears, and credited in such years to the extent that the taxpayer otherwise has excess foreign taxcredit limitation for those years (sec. 904(c)). For purposes of determining excess foreign taxcredit limitation amounts, the foreign tax credit separate limitation rules apply.

	Foreign tax credits are denied for withholding taxes paid with respect to certain dividendsreceived by a corporation or a regulated investment company, if the shareholder has not held thestock for a minimum period of time during which it is not protected from risk of loss (sec.901(k)). An exception from this treatment is provided for foreign tax credits with respect tocertain dividends received on stock by active dealers in securities (sec. 901(k)(4)).

     **b.  Deemed-paid foreign tax credit**

	U.S. corporations owning at least 10 percent of the voting stock of a foreign corporationare treated as if they had paid a share of the foreign income taxes paid by the foreign corporationin the year in which that corporation's earnings and profits become subject to U.S. tax asdividend income of the U.S. shareholder (sec. 902(a)). This is the "deemed-paid" or "indirect"foreign tax credit. A U.S. corporation may also be deemed to have paid taxes paid by a second,third, fourth, fifth, or sixth tier foreign corporation, if certain requirements are satisfied (sec.902(b)). Foreign taxes paid below the third tier are eligible for the deemed credit only withrespect to taxes paid in taxable years during which the payor is a CFC. Foreign taxes paid belowthe sixth tier are not eligible for the deemed-paid credit. In addition, a deemed-paid creditgenerally is available with respect to subpart F inclusions (sec. 960(a)). Moreover, a deemed-paidcredit generally is available with respect to inclusions under the PFIC provisions by U.S.corporations meeting the requisite ownership threshold (secs. 1291(g) and 1293(f)).

	The amount of foreign tax eligible for the indirect credit is added to the actual dividend orinclusion (the dividend or inclusion is said to be "grossed-up") and is included in the U.S.corporate shareholder's income; accordingly, the shareholder is treated as if it had received itsproportionate share of pre-tax profits of the foreign corporation and paid its proportionate shareof the foreign tax paid by the foreign corporation (sec. 78)).

	For purposes of computing the deemed-paid foreign tax credit, dividends (or otherinclusions) are considered made first from the post-1986 pool of all the distributing foreigncorporation's accumulated earnings and profits (sec. 902(c)(6)(B)).(13)Accumulated earnings andprofits for this purpose include the earnings and profits of the current year undiminished by thecurrent distribution (or other inclusion) (sec. 902(c)(1)). Dividends in excess of the accumulatedpool of post-1986 undistributed earnings and profits are treated as paid out of pre-1987accumulated profits and are subject to the ordering principles of pre-1986 Act law (sec.902(c)(6)).

     **c.  Foreign tax credit limitation**

	A premise of the foreign tax credit is that it should not reduce the U.S. tax on a taxpayer'sU.S.-source income but should only reduce the U.S. tax on the taxpayer's foreign-source income.Permitting the foreign tax credit to reduce U.S. tax on U.S. income would in effect cede toforeign countries the primary right to tax income earned from U.S. sources.

	In order to prevent foreign taxes from reducing U.S. tax on U.S.-source income, theforeign tax credit is subject to an overall limitation and a series of separate limitations. Under theoverall limitation, the total amount of the credit may not exceed the same proportion of thetaxpayer's U.S. tax which the taxpayer's foreign-source taxable income bears to the taxpayer'sworldwide taxable income for the taxable year (sec. 904(a)). In addition, the foreign tax creditlimitation is calculated separately for various categories of income (sec. 904(d)). Under theseseparate limitations, the total amount of the credit for foreign taxes on income in each categorymay not exceed the same proportion of the taxpayer's U.S. tax which the taxpayer's foreign-source taxable income in that category bears to the taxpayer's worldwide taxable income for thetaxable year.

	The separate limitation categories are passive income; high withholding tax interestincome; financial services income; shipping income; certain dividends received by a corporationfrom noncontrolled section 902 corporations(14); dividends from a domestic international salescorporation (DISC) or former DISC; certain distributions from a foreign sales corporation (FSC)or former FSC; and taxable income of a FSC attributable to foreign trade income (sec. 904(d)).Income not in a separate limitation category is referred to in the regulations as "general limitationincome." A special limitation applies to the credit for taxes imposed on foreign oil and gasextraction income (sec. 907(a)).

	Dividends, interest, rents, royalties, and subpart F income inclusions received (or deemedreceived) from CFCs by their U.S. 10-percent shareholders generally are subject to the generallimitation or to the various separate limitations (as the case may be) in accordance withlook-through rules that take into account the extent to which the income of the payor is itselfsubject to one or more of these limitations (sec. 904(d)(3)).

**6.  Foreign sales corporations**

	Under special tax provisions that provide an export incentive, a portion of the exportincome of an eligible foreign sales corporation ("FSC") is exempt from U.S.income tax. Inaddition, a U.S. corporation is not subject to U.S. tax on dividends distributed from the FSC outof earnings attributable to certain export income. Thus, there generally is no corporate level taximposed on a portion of the income from exports of a FSC.(15)

	Typically, a FSC is owned by a U.S. corporation that produces goods in the UnitedStates. The U.S. corporation either supplies goods to the FSC for resale abroad to unrelatedpersons or pays the FSC a commission in connection with its sales to unrelated persons.Therefore, the income of the FSC, a portion of which is exempt from U.S. tax under the FSCrules, equals the FSC's gross markup or gross commission income, less the expenses incurred bythe FSC.

	A FSC must have a foreign presence, it must have economic substance, and activities thatrelate to its export income must be performed by the FSC outside the U.S. customs territory.Furthermore, the income of the FSC is determined according to specified transfer pricing rules.

	A FSC generally is not subject to U.S. tax on its exempt foreign trade income. To achievethis result, the exempt foreign trade income of a FSC is treated as foreign-source income whichis not effectively connected with the conduct of a trade or business within the United States (sec.921(a)).

	Foreign trade income other than exempt foreign trade income, as well as investmentincome, generally is treated as U.S.-source income effectively connected with the conduct of atrade or business conducted through a permanent establishment within the United States (sec.921(d)). Thus, income other than exempt foreign trade income generally is subject to U.S. taxcurrently and is treated as U.S.-source income for purposes of the foreign tax credit limitation.

	Foreign trade income of a FSC is defined as the FSC's gross income attributable toforeign trading gross receipts (sec. 923(b)). Foreign trading gross receipts generally are the grossreceipts of any FSC that are attributable to the following types of transactions: the sale of exportproperty; the lease or rental of export property; services related and subsidiary to such a sale orlease of export property; engineering and architectural services for projects outside the UnitedStates; and export management services (sec. 924(a)). Investment income and carrying chargesare excluded from the definition of foreign trading gross receipts (sec. 924(f)(2)).

	The term "export property" generally means property (1) which is manufactured,produced, grown or extracted in the United States by a person other than a FSC, (2) which is heldprimarily for sale, lease, or rental in the ordinary course of a trade or business for direct use orconsumption outside the United States, and (3) not more than 50 percent of the fair market valueof which is attributable to articles imported into the United States (sec. 927(a)). The term "exportproperty" does not include property leased or rented by a FSC for use by any member of acontrolled group of which the FSC is a member; patents, copyrights (other than films, tapes,records, similar reproductions, and other than computer software, whether or not patented), andother intangibles; oil or gas (or any primary product thereof); or products the export of which isprohibited. Export property also excludes property designated by the President as being in shortsupply.

	If export property is sold to a FSC by a related person (or a commission is paid by arelated person to a FSC with respect to export property), the income with respect to the exporttransactions must be allocated between the FSC and the related person. The taxable income ofthe FSC and the taxable income of the related person are computed based upon a transfer pricedetermined under an arm's-length pricing approach or under one of two formulae which areintended to approximate arm's-length pricing.

	The portion of a FSC's foreign trade income that is treated as exempt foreign tradeincome depends on the pricing rule used to determine the income of the FSC. If the amount ofincome earned by the FSC is based on arm's-length pricing between unrelated parties, or betweenrelated parties under the rules of section 482, the exempt foreign trade income generally is 30percent of the foreign trade income the FSC derives from a transaction (secs. 923(a)(2) and (6)and 291(a)(4)). If the income earned by the FSC is determined under one of the special formulaespecified in the FSC provisions, the exempt foreign trade income generally is 15/23 of theforeign trade income the FSC derives from the transaction (secs. 923(a)(3) and (6) and291(a)(4)).

	A FSC is not required or deemed to make distributions to its shareholders. Actualdistributions are treated as being made first out of earnings and profits attributable to foreigntrade income, and then out of any other earnings and profits (sec. 926(a)). Any distribution madeby a FSC out of earnings and profits attributable to foreign trade income to a foreign shareholderis treated as U.S.-source income that is effectively connected with a business conducted througha permanent establishment of the shareholder within the United States (sec. 926(b)). Thus, theforeign shareholder is subject to U.S. tax on such a distribution.

	A U.S. corporation generally is allowed a 100 percent dividends-received deduction foramounts distributed from a FSC out of earnings and profits attributable to foreign trade income(sec. 245(c)(1)(A)). Thus, there generally is no corporate level U.S. tax on exempt foreign tradeincome and only a single level of U.S. corporate tax (at the FSC level) on non exempt foreigntrade income. However, the 100 percent dividends-received deduction is not allowed fornonexempt foreign trade income determined under arm's-length principles (sec. 245(c)(2)).

**B.  U.S. Taxation of Foreign Persons with U.S. Income**

**1.  Overview**

	The United States imposes tax on nonresident alien individuals and foreign corporations(collectively, foreign persons) only on income that has a sufficient nexus to the United States. Incontrast, the United States imposes tax on U.S. persons on all income, whether derived in theUnited States or in a foreign country.

	Foreign persons are subject to U.S. tax on income that is "effectively connected" with theconduct of a trade or business in the United States, without regard to whether such income isderived from U.S. sources or foreign sources. Such income generally is taxed in the same mannerand at the same rates as income of a U.S. person. In addition, foreign persons generally aresubject to U.S. tax at a 30-percent rate on certain gross income derived from U.S. sources.

	Pursuant to an applicable tax treaty, the 30-percent gross-basis tax imposed on foreignpersons may be reduced or eliminated. In addition, an applicable tax treaty may limit theimposition of U.S. tax on business operations of a foreign person to cases where the business isconducted through a permanent establishment in the United States.

**2.  Source of income rules**

	The source of income for U.S. tax purposes is determined based on various factors. Therelevant factors include the location or nationality of the payor, the location or nationality of therecipient, the location of the recipient's activities that generate the income, and the location of theassets that generate the income. The rules for determining the source of specific types of incomeare described briefly below.

          Interest

	Interest income generally is treated as U.S.-source income if it is from obligations of theUnited States or the District of Columbia or from interest-bearing obligations of U.S. residents orU.S. corporations (sec. 861(a)(1)). Under a special rule, interest paid by certain U.S. persons thatconduct active foreign businesses is treated as foreign-source income in whole or in part (sec.861(c)). Other exceptions from the general rule treating interest paid by U.S. persons asU.S.-source income apply to interest on deposits with foreign commercial banking branches ofU.S. corporations or partnerships and certain other amounts paid by foreign branches of domesticfinancial institutions (sec. 861(a)(1)(B)).

          Dividends

	Dividends from U.S. corporations generally are treated as U.S.-source income (sec.861(a)(2)(A)). Under a special rule, dividends from certain foreign corporations that conductU.S. businesses are treated in part as U.S.-source income (sec. 861(a)(2)(B)).

          Rents and royalties

	Rents or royalties from property located in the United States, and rents or royalties for theuse of or privilege of using intangible property in the United States, generally are treated as U.S.-source income (sec. 861(a)(4)).

          Income from sales of personal property

	Subject to significant exceptions, income from the sale of personal property is sourced onthe basis of the residence of the seller (sec. 865(a)). For this purpose, the term "nonresident" isdefined to include any foreign corporation (sec. 865(g)). The term "nonresident" also is definedto include any nonresident alien who does not have a "tax home" in the United States.

	Several exceptions to the general rule result in income from sales of property bynonresidents being treated as U.S.-source income. Gain of a nonresident on the sale of inventoryproperty may be treated as U.S.-source income if title to the property passes in the United Statesor if the sale is attributable to an office or other fixed place of business maintained by thenonresident in the United States (secs. 865(b) and (e) and 861(a)(6)). If the inventory property ismanufactured in the United States by the person that sells the property, a portion of the incomefrom the sale of such property in all events is treated as U.S.-source income (sec. 863(b)). Gainof a nonresident on the sale of depreciable property is treated as U.S.-source income to the extentof prior U.S. depreciation deductions (sec. 865(c)). Payments received on sales of intangibleproperty are sourced in the same manner as royalties to the extent the payments are contingent onthe productivity, use, or disposition of the intangible (sec. 865(d)).

          Personal services income

	Compensation for labor or personal services performed in the United States generally istreated as U.S.-source income, subject to an exception for amounts that meet certain de minimiscriteria (sec. 861(a)(3)).(16)

          Insurance income

	Underwriting income from issuing insurance or annuity contracts generally is treated asU.S.-source income if the contract involves property in, liability arising out of an activity in, orthe lives or health of residents of, the United States (sec. 861(a)(7)).

          Transportation income

	Generally, 50 percent of income attributable to transportation which begins or ends in theUnited States is treated as U.S.-source income (sec. 863(c)).

          Income from space or ocean activities or international communications

	In the case of a foreign person, generally no income from a space or ocean activity istreated as U.S.-source income (sec. 863(d)). The same holds true for internationalcommunications income unless the foreign person maintains an office or other fixed place ofbusiness in the United States, in which case the income attributable to such fixed place ofbusiness is treated as U.S.-source income (sec. 863(e)).

**3.  Net-basis taxation**

     **a.  Income from a U.S. business**

	The United States taxes on a net basis the income of foreign persons that is "effectivelyconnected" with the conduct of a trade or business in the United States (secs. 871(b) and 882).Any gross income earned by the foreign person that is not effectively connected with the person'sU.S. business is not taken into account in determining the rates of U.S. tax applicable to theperson's income from such business (secs. 871(b)(2) and 882(a)(2)).

**U.S. trade or business**

	A foreign person is subject to U.S. tax on a net basis if the person is engaged in a U.S.trade or business. In this regard, partners in a partnership and beneficiaries of an estate or trustare treated as engaged in the conduct of a trade or business within the United States if thepartnership, estate, or trust is so engaged (sec. 875).

	The question of whether a foreign person is engaged in a U.S. trade or business hasgenerated a significant body of case law. Basic issues involved in the determination includewhether the activity constitutes business rather than investing, whether sufficient activities inconnection with the business are conducted in the United States, and whether the relationshipbetween the foreign person and persons performing functions in the United States with respect tothe business is sufficient to attribute those functions to the foreign person.

	The Code contains specific rules with respect to the application of the trade or businessstandard to certain activities. Pursuant to section 864(b), the term "trade or business within theUnited States" expressly includes the performance of personal services within the United States.However, an exception is provided in the case of a nonresident alien individual's performance ofservices for a foreign employer, where both the total compensation received for such servicesduring the year and the period in which the individual is present in the United States are deminimis (sec. 864(b)(1)). In addition, detailed rules govern the determination of whether tradingin stocks or securities or commodities constitutes the conduct of a U.S. trade or business (sec.864(b)(2)). Under these rules, trading in stock or securities or commodities by a foreign personthrough an independent agent generally is not treated as the conduct of a U.S. trade or business,if the foreign person does not have an office or other fixed place of business in the United Statesthrough which such transactions are effected. Trading in stock or securities or commodities forthe foreign person's own account also generally is not treated as the conduct of a U.S. business,provided that the foreign person is not a dealer in stock or securities or commodities, as the casemay be.

**Effectively-connected income**

	A foreign person that is engaged in the conduct of a trade or business within the UnitedStates is subject to U.S. net-basis taxation on the income that is "effectively connected" withsuch business. Specific statutory rules govern the determination of whether income is soeffectively connected (sec. 864(c)).

	In the case of U.S.-source capital gain or loss and U.S.-source income of a type thatwould be subject to gross basis U.S. taxation, the factors taken into account in determiningwhether the income, gain, deduction, or loss is effectively connected with a U.S. trade orbusiness include whether the amount is derived from assets used in or held for use in the conductof the U.S. trade or business and whether the activities of the trade or business were a materialfactor in the realization of the amount (sec. 864(c)(2)). In making this determination, due regardis given to whether the asset or income, gain, deduction, or loss was accounted for through theU.S. trade or business. In the case of any other U.S.-source income, gain, deduction, or loss, suchamounts are all treated as effectively connected with the conduct of the trade or business in theUnited States (sec. 864(c)(3)).

	Foreign-source income of a foreign person that is effectively connected with the conductof a trade or business in the United States may also be taxed by the United States, subject to acredit for any foreign income taxes (secs. 864(c)(4) and 906). However, only specific types offoreign-source income are considered to be effectively connected with a U.S. trade or business(sec. 864(c)(4)(A)). Foreign-source income of a type not specified generally is exempt from U.S.tax.

	Foreign-source income, gain, deduction, or loss generally is considered to be effectivelyconnected with a U.S. business only if the person has an office or other fixed place of businesswithin the United States to which such income, gain, deduction, or loss is attributable and suchincome falls into one of the three categories described below (sec. 864(c)(4)(B)). The firstcategory consists of rents or royalties for the use of patents, copyrights, secret processes orformulas, good will, trade-marks, trade brands, franchises, or other like intangible propertiesderived in the active conduct of the U.S. trade or business (sec. 864(c)(4)(B)(i)). The secondcategory consists of interest or dividends derived in the active conduct of a banking, financing, orsimilar business within the United States or received by a corporation the principal business ofwhich is trading in stocks or securities for its own account (sec. 864(c)(4)(B)(ii)).Notwithstanding the foregoing, foreign-source income consisting of dividends, interest, orroyalties is not treated as effectively connected if the items are paid by a foreign corporation inwhich the recipient owns, directly, indirectly, or constructively, more than 50 percent of the totalcombined voting power of the stock (sec. 864(c)(4)(D)(i)). The third category consists of income,gain, deduction, or loss derived from the sale or exchange of inventory or property held by thetaxpayer primarily for sale to customers in the ordinary course of the trade or business where theproperty is sold or exchanged outside the United States through the foreign person's U.S. officeor other fixed place of business (sec. 864(c)(4)(B)(iii)). Such amounts are not treated aseffectively connected if the property is sold or exchanged for use, consumption, or dispositionoutside the United States and an office or other fixed place of business of the taxpayer in aforeign country participated materially in the sale or exchange.

	In determining whether a foreign person has a U.S. office or other fixed place of business,the office or other fixed place of business of an agent generally is disregarded. The place ofbusiness of an agent other than an independent agent acting in the ordinary course of business isnot disregarded, however, if either the agent has the authority (regularly exercised) to negotiateand conclude contracts in the name of the foreign person or the agent has a stock of merchandisefrom which he regularly fills orders on behalf of the foreign person (sec. 864(c)(5)(A)).Assuming that an office or other fixed place of business does exist, income, gain, deduction, orloss is not considered attributable to such office unless the office was a material factor in theproduction of the income, gain, deduction, or loss and the office regularly carries on activities ofthe type from which the income, gain, deduction, or loss was derived (sec. 864(c)(5)(B)). Finally,in the case of any inventory property sales that are foreign-source income effectively connectedwith a U.S. business, the income, gain, deduction, or loss treated as attributable to the U.S. officecannot be more than the amount of U.S.-source income that would have been produced had thesale or exchange been made in the United States (sec. 864(c)(5)(C)).

	Special rules apply for purposes of determining the effectively-connected income of aninsurance company. The foreign-source income of a foreign corporation that is subject to taxunder the insurance company provisions of the Code is treated as effectively connected, providedthat such income is attributable to its United States business (sec. 864(c)(4)(C)).

	Income, gain, deduction, or loss for a particular year generally is not treated as effectivelyconnected if the foreign person is not engaged in a U.S. trade or business in that year (sec.864(c)(1)(B)). However, if income or gain taken into account for a taxable year is attributable tothe sale or exchange of property, the performance of services, or any other transaction whichoccurred in a prior taxable year, the determination whether such income or gain is taxable on anet basis is required to be made as if the income were taken into account in the earlier year andwithout regard to the requirement that the taxpayer be engaged in a trade or business within theUnited States during the later taxable year (sec. 864(c)(6)). Also, if any property ceases to beused or held for use in connection with the conduct of a trade or business within the UnitedStates and the property is disposed of within 10 years after the cessation, the determination ofwhether any income or gain attributable to the disposition of the property is taxable on a net basisis required to be made as if the disposition occurred immediately before the property ceased to beused or held for use in connection with the conduct of a trade or business in the United States andwithout regard to the requirement that the taxpayer be engaged in a trade or business within theUnited States during the taxable year for which the income or gain is taken into account (sec.864(c)(7)).

**Allowance of deductions**

	Effectively connected taxable income is computed taking into account deductions to theextent that they are associated with income that is effectively connected with the conduct of aU.S. trade or business. For this purpose, the issue of the proper apportionment and allocation ofdeductions generally is addressed in detailed regulations. The regulations applicable todeductions other than interest expense set forth general guidelines for allocating deductionsamong classes of income and apportioning deductions between effectively-connected andnon-effectively-connected income, providing that, in appropriate cases, deductions may beallocated on the basis of units sold, gross sales or receipts, costs of goods sold, profitscontributed, expenses incurred, assets used, salaries paid, space utilized, time spent, or grossincome received. More specific guidelines are provided for the allocation of research andexperimental expenditures, legal and accounting fees, income taxes, losses on dispositions ofproperty, and net operating losses. Interest deductions are subject to a detailed regulatory regimefor the allocation and apportionment to effectively-connected income.

     **b.  Investments in U.S. real property**

	Special U.S. tax rules apply to gains of foreign persons attributable to dispositions ofinterests in U.S. real property. The rules governing the imposition and collection of tax on suchdispositions are contained in a series of provisions that were enacted in 1980 and that arecollectively referred to as the Foreign Investment in Real Property Tax Act ("FIRPTA") (secs.897, 1445, 6039C, and 6652(f)). Prior to the enactment of the FIRPTA provisions, foreignpersons could invest in U.S. real property without being subject to U.S. tax upon the eventualdisposition of such property.

**Imposition of tax**

	Section 897(a) provides that gain or loss of a foreign person from the disposition of aU.S. real property interest is taken into account for U.S. tax purposes as if such gain or loss wereeffectively connected with a trade or business within the United States during the taxable year.Accordingly, foreign persons generally are subject to U.S. tax on any gain from a disposition of aU.S. real property interest at the same rates that apply to similar income received by U.S.persons.

	In the case of nonresident alien individuals, the alternative minimum tax applies to thelesser of the individual's alternative minimum taxable income or the individual's net real propertygains (sec. 897(a)(2)(A)). Losses of nonresident alien individuals are taken into account underthe FIRPTA provisions only to the extent that such losses would be taken into account undersection 165(c), which limits loss deductions to business losses, losses on transactions enteredinto for profit, and certain casualty or theft losses (sec. 897(b)).

	In the case of foreign corporations, the gain from a disposition of a U.S. real propertyinterest may also be subject to the branch profits tax at a 30-percent rate (or a lower treaty rate).If a foreign corporation that holds a U.S. real property interest is entitled to nondiscriminatorytreatment with respect to such interest under an applicable treaty, the foreign corporation mayelect to be treated as a U.S. corporation for purposes of the FIRPTA provisions (sec. 897(i)). Thiselection may be made only if all shareholders of the corporation consent to the election andspecifically agree that any gain upon the disposition of the interest that would be taken intoaccount under the FIRPTA provisions will be taxable even if such taxation would be contrary toa treaty. This election to be treated as a domestic corporation is the exclusive remedy for anyperson claiming treaty protection against discriminatory treatment as a result of the FIRPTAprovisions.

**Definition of U.S. real property interest**

	Under the FIRPTA provisions, U.S. tax is imposed on gains from the disposition of aninterest in real property (including an interest in a mine, well, or other natural deposit) located inthe United States or the U.S. Virgin Islands. The term "interest in real property" includes, withrespect to both land and improvements thereon, (1) fee ownership and co-ownership, (2)leaseholds, (3) options to acquire, and (4) options to acquire leaseholds (sec. 897(c)(6)(A)).Moreover, the term includes partial interests in real property, such as life estates, remainders, andreversions. In addition, the term includes any direct or indirect right to share in the appreciationin the value of, or in the gross or net proceeds or profits generated by, U.S. real property.

	Also included in the definition of a U.S. real property interest is any interest (other thanan interest solely as a creditor) in any domestic corporation, unless the taxpayer establishes thatthe corporation was not a U.S. real property holding corporation ("USRPHC") at any time duringthe five-year period ending on the date of the disposition of the interest (sec. 897(c)(1)(A)(ii)).This general rule does not apply to investments in a publicly-traded USRPHC. Under a specialrule, USRPHC stock of a class that is regularly traded on an established securities market istreated as a U.S. real property interest only in the case of a foreign person that, at some timeduring the five-year period described above, held more than 5 percent of that class of stock (sec.897(c)(3)). Rules similar to this special rule apply to treat an interest in a publicly-tradedpartnership as a U.S. real property interest.

	A corporation is a USRPHC if the fair market value of such corporation's U.S. realproperty interests equals or exceeds 50 percent of the sum of the fair market values of (1) its U.S.real property interests, (2) its interests in foreign real property, plus (3) any other of its assetswhich are used or held for use in a trade or business (sec. 897(c)(2)). For purposes of this assettest, a corporation that is a partner in a partnership or a beneficiary of an estate or trust generallytakes into account its proportionate share of all assets of such partnership, estate, or trust (sec.897(c)(4)(B)). Look-through rules also apply to a controlling interest (50 percent or more of thefair market value of all classes of stock) held by a corporation in another corporation, whetherforeign or domestic (sec. 897(c)(5)).

**Special rules applicable to certain transactions**

	Gain recognized by a foreign person on the disposition of an interest in a partnership,trust, or estate generally is subject to tax under the FIRPTA provisions to the extent that the gainis attributable to any appreciation in the value of any U.S. real property interests of the entity(sec. 897(g)).

	As a general rule, nonrecognition provisions apply under the FIRPTA provisions only inthe case of an exchange of a U.S. real property interest for an interest the sale of which would betaxable under the Code (sec. 897(e)). This rule is designed to prevent a foreign person fromescaping U.S. tax by exchanging a taxable asset for a nontaxable asset in an exchange whichwould otherwise qualify for nonrecognition treatment under the Code. Specific rules apply torequire gain recognition in certain cases. In this regard, foreign corporations are required incertain circumstances to recognize gain upon the distribution (including a distribution inliquidation or redemption) to their shareholders of appreciated U.S. real property interests (sec.897(d)(1)). Moreover, gain generally is recognized by a foreign person under the FIRPTAprovisions on the transfer of a U.S. real property interest to a foreign corporation if the transfer ismade as paid-in surplus or as a contribution to capital.

**Withholding on dispositions by foreign persons of U.S. real property interests**

	The Code generally imposes a withholding obligation when a U.S. real property interestis acquired from a foreign person (sec. 1445). The withholding obligation generally is imposedon the transferee; however, in certain limited circumstances, an agent of the transferor ortransferee is required to withhold. Any tax imposed on a foreign person under the FIRPTAprovisions in excess of the amount withheld remains the liability of the foreign person.

	The amount required to be withheld on the sale by a foreign person of a U.S. realproperty interest generally is 10 percent of the amount realized on the transaction (i.e., the grosssales price) (sec. 1445(a)). However, a certificate for reduced withholding may be issued by theIRS such that the amount required to be withheld will not exceed the transferor's maximum taxliability (sec. 1445(c)(1)).

	There are several exemptions from the obligation to withhold on a disposition of a U.S.real property interest. First, withholding by the transferee generally is not required if thetransferor furnishes to the transferee an affidavit stating, under penalty of perjury, that thetransferor is not a foreign person and providing the transferor's taxpayer identification number(sec. 1445(b)(2)). Second, withholding is not required on the disposition of an interest in adomestic corporation if the corporation furnishes an affidavit to the transferee stating, underpenalty of perjury, that the corporation is not a USRPHC and has not been a USRPHC during thefive-year period ending on the date of disposition (sec. 1445(b)(3)). Third, withholding may bereduced or eliminated if the transferee receives a qualifying statement issued by the IRS that thetransferor is exempt from tax or either the transferor or the transferee has provided adequatesecurity (or has made other arrangements for payment of the tax) (sec. 1445(b)(4)). Fourth,withholding is not required if the transferee intends to use the transferred real property as aresidence, and the amount realized by the transferor on the disposition of the property is$300,000 or less (sec. 1445(b)(5)). Fifth, withholding is not required on a disposition of stock ofa class that is regularly traded on an established securities market (sec. 1445(b)(6)).

	Special withholding rules apply in the case of certain dispositions of U.S. real propertyinterests by partnerships, trusts, and estates; certain distributions by foreign or domesticcorporations, partnerships, trusts, and estates; and certain dispositions of interests in partnerships,trusts, and estates.

**4.  Gross-basis taxation**

     **a.  Withholding tax**

	In the case of U.S.-source interest, dividends, rents, royalties, or other similar types ofincome (known as fixed or determinable, annual or periodical gains, profits and income), theUnited States generally imposes a flat 30-percent tax on the gross amount paid to a foreignperson if such income or gain is not effectively connected with the conduct of a U.S. trade orbusiness (secs. 871(a) and 881). This tax generally is collected by means of withholding by theperson making the payment to the foreign person receiving the income (secs. 1441 and 1442).Accordingly, the 30-percent gross-basis tax generally is referred to as a withholding tax. In mostinstances, the amount withheld by the U.S. payor is the final tax liability of the foreign recipientand, thus, the foreign recipient files no U.S. tax return with respect to this income.

	The United States generally does not tax capital gains of a foreign corporation that are notconnected with a U.S. trade or business. Capital gains of a nonresident alien individual that arenot connected with a U.S. business generally are subject to the 30-percent gross-basis tax only ifthe individual was present in the United States for 183 days or more during the year (sec.871(a)(2)). Also subject to tax at a flat rate of 30 percent are any foreign person's gains from thesale or exchange of patents, copyrights, trademarks, and other like property, or of any interest insuch property, to the extent the gains are from payments that are contingent on the productivity,use, or disposition of the property or interest sold or exchanged (secs. 871(a)(1)(D) and881(a)(4)).

	Gains of a foreign individual or corporation on the disposition of U.S. real propertyinterests are taxed on a net basis under FIRPTA, even if they are not otherwise effectivelyconnected with a U.S. trade or business. Similarly, rental and other income from U.S. realproperty may be taxed, at the election of the taxpayer, on a net basis at graduated rates (secs.871(d) and 882(d)).

	Although payments of U.S.-source interest that is not effectively connected with a U.S.trade or business generally are subject to the 30-percent withholding tax, there are significantexceptions to that rule. For example, interest from certain deposits with banks and other financialinstitutions is exempt from tax (secs. 871(i)(2)(A) and 881(d)). Original issue discount onobligations maturing in six months or less is also exempt from tax (sec. 871(g)(1)(B)(i)). Anadditional exception is provided for certain interest paid on portfolio obligations (secs. 871(h)and 881(c)). Portfolio interest generally is defined as any U.S.-source interest (including originalissue discount), not effectively connected with the conduct of a U.S. trade or business, (1) on anobligation that satisfies certain registration requirements or specified exceptions thereto, and (2)that is not received by a 10-percent shareholder (sec. 871(h)). This exception is not available forany interest received either by a bank on a loan extended in the ordinary course of its business(except in the case of interest paid on an obligation of the United States), or by a controlledforeign corporation from a related person (sec. 881(c)(3)). Moreover, this exception is notavailable for certain contingent interest payments (sec. 871(h)(4)).

	Pursuant to an applicable tax treaty, the 30-percent gross-basis tax imposed on foreignpersons may be reduced or eliminated. However, a foreign person is not entitled to a reduced rateof withholding tax under a treaty on an item of income derived through an entity that is treated asa partnership (or is otherwise fiscally transparent) for U.S. tax purposes if (1) such item is nottreated for purposes of the taxation laws of such foreign country as an item of income of suchperson, (2) the foreign country does not impose tax on an actual distribution of such item ofincome from such entity to such person, and (3) the treaty itself does not contain a provisionaddressing the applicability of the treaty in the case of income derived through a partnership orother fiscally transparent entity (sec. 894(c)). Temporary and proposed regulations address theapplication of reduced rates of withholding tax provided under a treaty in cases involving ahybrid entity (e.g., an entity that is treated as a partnership or is otherwise fiscally transparent forU.S. tax purposes but is treated as fiscally non-transparent for purposes of the tax laws of thejurisdiction of residence of the taxpayer) (Temp. Treas. Reg. sec. 1.894-1T).

     **b.  Excise tax on insurance premiums paid to foreign insurers**

	The United States imposes an excise tax on policies of insurance, indemnity bonds,annuity contracts, and policies of reinsurance issued by a foreign insurer or reinsurer (1) to or for(or in the name of) a domestic corporation or partnership or a U.S. resident individual withrespect to risks wholly or partly within the United States, or (2) to or for (or in the name of) anyforeign person engaged in business within the United States with respect to risks within theUnited States (secs. 4371 and 4372). The excise tax is 4 percent of the premiums paid on a policyof casualty insurance or an indemnity bond, and generally 1 percent on all other premiums (sec.4371). The excise tax does not apply to an amount effectively connected with the conduct of atrade or business in the United States (unless such amount is exempt from net basis U.S. taxunder a treaty) (sec. 4373). 

     **c.  Branch level taxes**

	A U.S. corporation owned by foreign persons is subject to U.S. income tax on its netincome. In addition, the earnings of the U.S. corporation are subject to a second tax, this time atthe shareholder level, when dividends are paid. As discussed above, when the shareholders areforeign, the second-level tax is imposed at a flat rate and collected by withholding. Similarly, asdiscussed above, interest payments made by a U.S. corporation to foreign creditors are subject toa U.S. withholding tax in certain circumstances. Pursuant to the branch tax provisions, the UnitedStates taxes foreign corporations engaged in a U.S. trade or business on amounts of U.S. earningsand profits that are shifted out of, or amounts of interest deducted by, the U.S. branch of theforeign corporation. The branch level taxes are comparable to these second-level taxes. Inaddition, where a foreign corporation is not subject to the branch profits tax as the result of atreaty, it may be liable for withholding tax on actual dividends it pays to foreign shareholders. 

	The United States imposes a tax of 30 percent on a foreign corporation's "dividendequivalent amount" (sec. 884(a)). The "dividend equivalent amount" generally is the earningsand profits of a U.S. branch of a foreign corporation attributable to its income effectivelyconnected with a U.S. trade or business (sec. 884(b)). The following earnings and profitsattributable to income effectively connected with a U.S. trade or business are excluded from theimposition of branch profits tax: (1) certain earnings derived by FSC; (2) certain foreigntransportation earnings; (3) earnings derived from the sale of any interest in U.S. real propertyholding corporations; (4) earnings derived by certain corporations organized in a U.S.possession; and (5) earnings derived by certain captive insurance companies (sec. 884(d)(2)).

	In arriving at the dividend equivalent amount, a branch's effectively connected earningsand profits are adjusted to reflect changes in a branch's U.S. net equity (i.e., the excess of thebranch's assets over its liabilities, taking into account only amounts treated as connected with itsU.S. trade or business) (sec. 884(b)). The first adjustment reduces the dividend equivalentamount to the extent the branch's earnings are reinvested in trade or business assets in the UnitedStates (or reduce U.S. trade or business liabilities). The second adjustment increases the dividendequivalent amount to the extent prior reinvested earnings are considered remitted to the homeoffice of the foreign corporation.

	Interest paid by a U.S. trade or business of a foreign corporation generally is treated as ifpaid by a U.S. corporation and therefore is subject to U.S. 30-percent withholding tax (if theinterest is paid to a foreign person) (sec. 884(f)(1)(A)). Certain "excess interest" of a U.S. tradeor business of a foreign corporation is treated as if paid by a U.S. corporation to a foreign parentand, therefore, is subject to U.S. 30-percent withholding tax (sec. 884(f)(1)(B)). For this purpose,excess interest is the excess of the interest deduction allowed with respect to the U.S. trade orbusiness over the amount of interest paid by such trade or business. 

**C.  Income Tax Treaties**

**1.  In general**

	In addition to the U.S. and foreign statutory rules for the taxation of foreign income ofU.S. persons and U.S. income of foreign persons, bilateral income tax treaties limit the amountof income tax that may be imposed by one treaty partner on residents of the other treaty partner.Treaties also contain provisions governing the creditability of taxes imposed by the treatycountry in which income was earned in computing the amount of tax owed to the other countryby its residents with respect to such income. Treaties further provide procedures under whichinconsistent positions taken by the treaty countries with respect to a single item of income ordeduction may be mutually resolved by the two countries.

	The preferred tax treaty policies of the United States have been expressed from time totime in model treaties and agreements. The Organization for Economic Cooperation andDevelopment (the "OECD") also has published model tax treaties. In addition, the UnitedNations has published a model treaty for use between developed and developing countries. TheTreasury Department, which together with the State Department is responsible for negotiatingtax treaties, last published a proposed model income tax treaty in September 1996 (the "U.S.model"). The OECD last published a model income tax treaty in 1992 ("the OECD model"). TheUnited Nations last published a model income tax treaty in 1980 ("the U.N. model").

	Many U.S. income tax treaties currently in effect diverge in one or more respects from theU.S. model. These divergences may reflect the age of a particular treaty or the particular balanceof interests between the United States and the treaty partner. Other countries' preferred tax treatypolicies may differ from those of the United States, depending on their internal tax laws anddepending upon the balance of investment and trade flows between those countries and theirpotential treaty partners. For example, certain capital importing countries may be interested inimposing relatively high tax rates on interest, royalties, and personal property rents paid toresidents of the other treaty country. Consequently, treaties with such countries may have higherwithholding rates on dividends, interest, royalties, and personal property rents. As anotherexample, the other country may demand other concessions in exchange for agreeing to requestedU.S. terms. Countries that impose income tax on certain local business operations at a relativelylow rate (or a zero rate) in order to attract manufacturing capital may seek to enter into"tax-sparing" treaties with capital exporting countries. In other words, the country may seek toenter into treaties under which the capital exporting country gives up its tax on the income of itsresidents derived from sources in the first country, regardless of the extent to which the firstcountry has imposed tax with respect to that income. While other capital exporting countrieshave agreed to such treaties, the United States has rejected proposals by certain foreign countriesto enter into such tax-sparing arrangements.

	The OECD, the U.N., and the U.S. models reflect a standardization of terms that serves asa useful starting point in treaty negotiations. However, issues may arise between the UnitedStates and a particular country that of necessity cannot be addressed with a model provision.Because a treaty functions as a bridge between two actual tax systems, one or both of the partiesto the negotiations may seek to diverge from the models to account for specific features of aparticular tax system.

**2.  Model income tax treaty provisions**

	Significant features of the model income tax treaties are described briefly below.

**Residence**

	The U.S. model generally treats as a resident of a treaty country any person who, underthe laws of that country, is liable to tax therein by reason of its domicile, residence, citizenship,place of management, place of incorporation, or any other similar criterion. However, theconcept of resident excludes any person who is liable to tax in a country solely in respect ofincome from sources in that country or of profits attributable to a permanent establishment in thatcountry.

**Business profits attributable to a permanent establishment**

	Under the U.S. model, one treaty country may not tax the business profits of an enterpriseof a qualified resident of the other treaty country, unless the enterprise carries on business in thefirst country through a permanent establishment situated there. In that case, the business profitsof the enterprise may be taxed in the first country on profits that are attributable to thatpermanent establishment. The U.S. model describes in detail the characteristics relevant todetermine whether a place of business is a permanent establishment. The term includes a place ofmanagement, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, orany other place of extraction of natural resources.

	The U.S. model provides that the business profits to be attributed to the permanentestablishment include only the profits derived from the assets or activities of the permanentestablishment. The U.N. model adds a limited "force of attraction rule" which would allow thecountry in which the permanent establishment is located to attribute to the permanentestablishment sales in that country of goods or merchandise of the same or similar kind as thosesold through the permanent establishment, and to attribute to the permanent establishment otherbusiness activities carried on in that country of the same or similar kind as those effected throughthe permanent establishment.

	The U.S., OECD, and U.N. models expressly provide for the allocation of worldwideexecutive and general administrative expenses in determining business profits attributable to apermanent establishment. The U.S. model also provides for the allocation of research anddevelopment expenses, interest, and other expenses incurred for the purposes of the enterprise asa whole (or the part of the enterprise that includes the permanent establishment).

**Dividends**

	The U.S. model permits taxation of dividends by the residence country of the payor, butlimits the rate of such tax in cases in which the dividends are beneficially owned by a resident ofthe other treaty country. In such cases, the U.S. model allows not more than a 5-percentgross-basis tax if the beneficial owner is a company that owns directly at least 10 percent of thepayor's voting stock, and not more than a 15-percent gross-basis tax in any other case. Under theOECD model, the 5-percent rate is not available unless the beneficial owner of the dividends is acompany other than a partnership that holds directly at least 25 percent of the capital of thedividend payor. The U.N. model expressly leaves to case-by-case bilateral negotiation theparticular percentage limit to be imposed on source-country taxation of dividends.

**Interest and royalties**

	The U.S. model generally allows no tax to be imposed by a treaty country on interest orroyalties arising in that country and beneficially owned by a resident of the other treaty country.By contrast, the OECD model would permit up to 10-percent gross-basis taxation of interest bythe treaty country in which the interest arises. The U.N. model expressly leaves to case-by-casebilateral negotiation the particular percentage limit to be imposed on source-country taxation ofinterest or royalties.

**Other income**

	The U.S. model provides that items of income beneficially owned by a resident of a treatycountry, wherever arising, that are not dealt with in the articles of the treaty are taxable only bythe recipient's country of residence. By contrast, the U.N. model states that items of income of aresident of a treaty country not dealt with in the other treaty articles and arising in the other treatycountry may also be taxed in that other country.

**Relief from double taxation**

	The U.S. model obligates the United States to allow its residents and citizens as a creditagainst U.S. income tax: (a) income taxes paid or accrued to the treaty country by the U.S.person, and (b) in the case of a U.S. company owning at least 10 percent of the voting stock of acompany resident in the treaty country, and from which the U.S. company receives dividends, thetreaty country income tax paid or accrued by or on behalf of the payor company with respect tothe profits out of which the dividends are paid. However, the U.S. model preserves U.S. internallaw by subjecting this right to the foreign tax credit to the provisions and limitations of U.S. lawas it may be amended from time to time without changing the general principle of the modelprovision.

	A standard article in treaties specifies the U.S. and foreign taxes covered by the treaty.The U.S. model provides that such covered taxes shall be considered income taxes for purposesof the credit article, and contemplates the possibility that such a tax might be creditable solely byreason of the treaty.

**Nondiscrimination**

	The U.S. model provides that nationals of a treaty country, wherever they may reside,shall not be subjected in the other country to any taxation (or any requirement connectedtherewith) that is more burdensome than the taxation and connected requirements to whichnationals of that other country in the same circumstances, particularly with respect to taxation onworldwide income, are or may be subjected. Similarly, the taxation of a permanent establishmentor fixed base that an enterprise or resident of a treaty country has in the other country generallyshall not be less favorably levied in the source country than the taxation levied on enterprises orresidents of the source country carrying on the same activities. Further, an enterprise of a sourcecountry, the capital of which is wholly or partly owned or controlled by one or more residents ofthe other country, shall not be subjected in the source country to any taxation (or any requirementconnected therewith) that is more burdensome than the taxation and connected requirements towhich other similar source-country enterprises are or may be subjected. Finally, the U.S. modelgenerally provides (subject to certain arm's length standards) that interest, royalties, and otherdisbursements paid by a treaty country resident to a resident of the other country shall, for thepurposes of determining the taxable profits of the payor, be deductible under the same conditionsas if they had been paid to a resident of the source country.

**Mutual agreement procedures**

	The U.S. model provides for a treaty country resident or national to obtain relief, from thecompetent authority of either treaty country, from actions of either or both countries that areconsidered to result in taxation in violation of the treaty. The U.S. model requires the competentauthorities to endeavor to resolve such a case by mutual agreement where the home countryauthority cannot do so unilaterally.

**D.  Tax Treatment of U.S. Persons Living Abroad**

**1.  General exclusion**

	A U.S. citizen or resident generally is taxed on his or her worldwide income, with theallowance of a foreign tax credit for foreign taxes paid on the foreign income. An individual whohas his or her tax home in a foreign country and who meets either of two eligibility requirements,however, generally can elect to exclude an amount of foreign earned income from gross income(sec. 911(a)). The maximum exclusion is $70,000 per year, increased in increments of $2,000 peryear beginning in 1998. The exclusion is $74,000 for 1999. The exclusion is indexed for inflationbeginning in 2008 (for inflation after 2006).

	An individual meeting the eligibility requirements generally may also elect to exclude (ordeduct, in certain cases) certain housing costs (sec. 911(a)(2)). Housing costs available forexclusion are the excess of the individual's housing expenses for the year over an amount equalto the product of 16 percent of the daily salary of an employee of the United States who iscompensated at a rate equal to the annual rate paid for step 1 of GS-14, multiplied by the numberof days during the taxable year that the person meets the exclusion's qualification requirements(sec. 911(c)(1)). For this purpose, housing expenses generally are the reasonable expenses, otherthan deductible interest or taxes, paid or incurred during the taxable year by (or on behalf of) theindividual for his or her housing (and housing of his spouse and dependents) in a foreign country(sec. 911(c)(2)).(17) Generally, the taxpayer is permitted an exclusion for the expenses of the abodethat bears the closest relationship to the tax home of the individual.(18)

	To qualify for the foreign earned income exclusion, an individual must satisfy either abona fide residence test or a physical presence test.(19) Under the bona fide residence test, a citizenof the United States must establish to the satisfaction of the Treasury Secretary that he or she hasbeen a bona fide resident of a foreign country for an uninterrupted period which includes anentire taxable year (sec. 911(d)(1)). In order to satisfy the physical presence test, the individualmust be present overseas for 330 days out of any 12 consecutive month period (sec. 911(d)(2)).In either case, the taxpayer must have a tax home in a foreign country.(20)

	The combined earned income exclusion and housing amount exclusion may not exceedthe taxpayer's total foreign earned income for the taxable year (sec. 911(d)(7)). Foreign earnedincome generally means income earned from sources outside the United States as compensationfor personal services actually rendered by the taxpayer (sec. 911(d)(2)).(21)

	The foreign earned income provision contains a denial of double benefits by reducingsuch items as the foreign tax credit by the amount attributable to excluded income (sec.911(d)(6)).

	Individuals who are present in a country with respect to which restrictions relating totravel or travel-related transactions are in effect lose certain tax benefits (sec. 911(d)(8)).(22) Anindividual who is present in such a country does not lose tax benefits unless that individual'sengaging in travel-related transactions is in violation of law. An individual is not treated as abona fide resident of, or as present in, a foreign country for any day during which the individualis present in a country in violation of law. Foreign earned income, otherwise eligible for theexclusion, does not include any income from sources within such a country attributable toservices performed therein. Housing expenses eligible for tax benefits do not include anyexpenses (allocable to a period in which presence was prohibited) for housing in such a countryor for housing of the spouse or dependents of the taxpayer in another country while the taxpayeris present in such a country.

**2.  Income from sources within U.S. possessions**

	The Code provides special rules for the taxation of certain persons residing in, andearning income from sources within, U.S. possessions.

**Guam, American Samoa, and the Northern Mariana Islands**

	As a general rule, section 931 provides that an individual who is a bona fide resident ofGuam, American Samoa, or the Northern Mariana Islands is permitted to exclude from his or hergross income any income derived from sources within those possessions, as well as any incomethat is effectively connected with the conduct of a trade or business by that individual withinthose possessions.(23) In order to eliminate such a person's ability to receive a double benefit fromthis provision, neither a deduction (other than the deduction for personal exemptions) nor a creditis permitted to be taken if it is properly allocable to amounts excluded from gross income.

	The rules of section 931 apply to bona fide residents of American Samoa, but do not yetapply to bona fide residents of Guam and the Northern Mariana Islands. In order for those rulesto apply to Guam and the Northern Mariana Islands, certain requirements must be satisfied,including, among other things, that the possession and the United States enter into animplementation agreement that provides for the elimination of double taxation by the possessionand the United States; the establishment of rules that prevent or inhibit U.S. income tax evasionor avoidance; exchange of information between the possession and the United States for taxadministration purposes; and resolution of other problems arising in connection with theadministration of the tax laws of the possession or the United States.(24) Guam and the UnitedStates entered into such an implementation agreement, intended to be effective January 1, 1991.However, the implementation agreement was indefinitely delayed, such that no agreementcurrently is in effect with Guam. The Northern Mariana Islands and the United States have notyet entered into an implementation agreement.(25) Until the applicable requirements are satisfied,the tax code of Guam and the Northern Mariana Islands is identical to that of the United States(i.e., a mirror code).

**U.S. Virgin Islands**

	The tax code of the Virgin Islands is identical to that of the United States (i.e., a mirrorcode). An individual who is a U.S. citizen or resident and has Virgin Island-source income orincome derived from the conduct of a trade or business in the Virgin Islands for the taxable yeargenerally is required to file income tax returns with both the United States and the Virgin Islands(sec. 932(a)). The individual's tax liability is pro-rated based on a specified formula. Under theformula, the amount of tax due to the Virgin Islands is equal to the total tax liability multipliedby the proportion of adjusted gross income from Virgin Islands sources to total adjusted grossincome (sec. 932(b)). The remainder of the tax is paid to the United States.

	The rule specified in the preceding paragraph does not apply to a person who is a bonafide resident of the Virgin Islands at the close of the taxable year. Such a person is required tofile an income tax return with the Virgin Islands. If the return so filed reports income from allsources and identifies the source of each item shown on the return, and the full tax liability onsuch income is remitted to the Virgin Island Government, then gross income shown on theVirgin Islands return is excluded from gross income for purposes of computing the person's U.S.income tax liability (i.e., the person will have no gross income for U.S. tax purposes) (sec.932(c)).

**Puerto Rico**

	A person born in Puerto Rico typically is a U.S. citizen and, thus, a U.S. person for U.S.tax purposes. However, income derived from sources within Puerto Rico by an individual who isa bona fide resident of Puerto Rico during the entire taxable year generally is excluded fromgross income and exempt from U.S. taxation, even if such resident is a U.S. citizen (sec. 933).(26)Such income generally is subject to taxation by Puerto Rico. In order to eliminate such a person'sability to receive a double benefit from this provision, neither a deduction (other than thededuction for personal exemptions) nor a credit is permitted to be taken if it is properly allocableto amounts excluded from gross income.

	Items of income earned from sources outside of Puerto Rico by U.S. persons who residein Puerto Rico generally are subject to U.S. taxation.

**III.  BACKGROUND AND DATA RELATING TO INTERNATIONAL TRADE AND INVESTMENT**

	This part presents background data relating to the scope of the international trade sectorin the United States economy.  This part discusses the economic relationship between tradedeficits, capital inflows, investment, and savings in the economy.  It briefly reviews trends inboth the current account (the trade surplus or deficit) and the capital account (U.S. investmentabroad and foreign investment in the United States).

**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 orsurplus, that is, the difference between the exports and imports of the economy.  In the late1980s, there was also attention given to inflows of capital from abroad.  Capital inflows can takethe form of foreign purchases of domestic physical assets, of equity interests, or of debtinstruments.  These two phenomena, trade balances and capital inflows, are not independent, butare related to each other. Trade deficits, capital inflows, investment, savings, and income are allconnected in the economy.  The connection among these economic variables can be examinedthrough the national income and product accounts, which measure the flow of goods and servicesand income in the economy.(27)

	The value of an economy's total output must be either consumed domestically (by privateindividuals and government), invested domestically, or exported abroad.  If an economyconsumes and invests more than it produces, it must be a net importer of goods and services.  Ifthe imports were all consumption goods, in order to pay for those imports, the country musteither 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 alsoexperience foreign capital inflows as foreign persons purchase domestic assets, make equityinvestments, or lend funds (purchase debt instruments).

	For example, when the United States imports more than it exports, the United States paysfor the imports with dollars.  If foreigners are not buying goods with the dollars, then they willuse the dollars to purchase U.S. assets.  An alternate way of viewing these relationships is thatdollars flowing out of the U.S. economy in order to purchase goods or to service foreign debtmust 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 theeconomy is a net importer, it must attract capital inflows to pay for those imports.  If theeconomy is a net exporter, it must have capital outflows to dispose of the payments it receives forits exports.  Another way of looking at the connection between capital flows and the goods andservices in the economy is to concentrate on the sources of funds for investment.  Becausedomestic investment must be financed either through saving or foreign borrowing, net capitalinflows must also equal the difference between domestic investment and saving.

	These relationships can be summarized as follows (the equation ignores relatively smallunilateral transfers such as foreign aid and assumes, without loss of generality, that thegovernment budget is balanced):

Net Foreign Borrowing   =   Investment - Saving

or,

Net Foreign Borrowing   =   (Imports - Exports) - Net Investment Income

For this purpose, imports and exports include both goods and services, and net investmentincome is equal to the excess of investment income received from abroad over investmentincome sent abroad.(28)  The excess of imports over exports is called the trade deficit in goods andservices.  Net investment income can be viewed as payments received on previously-acquiredforeign 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 musteither be running a trade deficit or the economy is increasing its foreign borrowing.  Similarly, acountry cannot run a trade surplus without also exporting capital, either by increasing its foreigninvestments, or by servicing previously-acquired foreign debt.  Because the level of netinvestment income in any year is fixed by the level of previous foreign investment (except forchanges in interest rates), changes in investment or saving that are associated with capital inflowswill 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 futureconsumption possibilities of the economy.  That will depend in part on whether the trade deficitis financing consumption or investment.  For example, if a country uncovers profitableinvestment opportunities, then it will be in that country's interest to obtain funds from abroad toinvest in these profitable projects.(29)  If the economy currently does not have enough domesticsavings to invest in these projects, it could reduce its consumption (generating more domesticsaving) or look to foreign sources of funds (thus allowing investment without reducing currentconsumption).  For example, suppose new oil reserves that could be profitably recovered throughincreased investment are discovered in the United States.  The investment may be financed byforeigners.  In order to invest in U.S. assets, foreigners will have to buy dollars, thus increasingthe 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 makesforeign goods cheaper for U.S. residents, increasing the demand for imports and resulting in atrade deficit.  Eventually, the flow of capital will be reversed, as the U.S. demand for newinvestment falls, and foreigners receive interest and dividend payments on their previousinvestments.

	The foreign borrowing in the above example was used to finance investment. Thisborrowing did not reduce the living standards of current or future U.S. residents, because theinterest and dividends that were paid to foreigners came from the return from the newinvestment.  If foreign borrowing finances consumption instead of investment, there are no newassets created to generate a return that can support the borrowing. When the debt eventually isrepaid, the repayments will come at the expense of future consumption.  For instance, consider asituation in which the domestic supply of funds for investment decreases because domesticsaving 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.  Becausethe foreign borrowing is not associated with increased investment, future output does notincrease, and interest and dividends on the investment will be paid to foreign persons at theexpense of future domestic consumption.  In this case, there may be an increase in the standard ofliving for current U.S. residents at the expense of a decrease in the standard of living of futureresidents.

	During the period that foreign borrowing finances U.S. consumption, the United Statesruns a trade deficit.  Although the United States could service its growing foreign debt byincreased borrowing, and hence larger trade deficits, in the long run trade deficits cannot keepgrowing.  In fact, the United States must eventually run a trade surplus. If the United Statesimported more goods than it exported every year, there also would be an inflow of foreign capitalevery year. This capital inflow would be growing with the increasing costs of servicing theforeign 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, andthe United States would eventually run a trade surplus, so that the current account deficit (thesum of the trade deficit in goods and services and the net interest on foreign obligations) wouldbe small enough for foreigners to be willing to lend again to the United States.

	Even when foreign investment finances domestic consumption, trade deficits and capitalinflows themselves should not necessarily be viewed as undesirable, because the foreign capitalinflows help to keep domestic investment, and hence labor productivity, from falling.  Forinstance, the large inflow of foreign capital to the United States in the 1980s is widely viewed tobe 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 tohigher domestic interest rates and lower rates of investment.  That decreased investment wouldhave led to decreases in future living standards because the lower growth rate of the capital stockwould have resulted in lower growth rates of U.S. labor productivity.  The fact that foreigncapital was not restricted and did finance U.S. investment helped mitigate the negative effects oneconomic growth of low domestic saving.

	The above observations support the argument that the trade deficit does not in itselfprovide a useful measure of international competitiveness, since trade deficits and trade surplusescan be either good or bad for the United States.  The example of oil discovery discussed aboveshows that even increases in a country's stock of exportable goods can have ambiguous effects onthe trade deficit.  If the discovery of oil also increases the demand for investment, then the tradedeficit may actually increase in the short run.  Increases in natural resources, advances intechnology, increases in worker efficiency, and other wealth-enhancing innovations haveambiguous effects on the trade deficit in the short and medium run.  Because these innovationsincrease the productivity of U.S. workers and lower production costs, they increase theattractiveness of U.S. goods, and may result in increased exports.  To the extent theseinnovations increase the demand for investment, however, they can have the opposite effect onthe trade deficit.  Nonetheless, each of these innovations increases the output of the economy,and hence the incomes of U.S. residents.

**B.  Trends in the United States' Balance of Payments**

	Foreign trade has become increasingly important to the United States economy. Figure 1presents the value of exports from the United States and imports into the United States as apercentage of GDP for the period 1962-1998.(30)  As depicted in Figure 1, exports and importseach have risen from less than six percent of GDP in 1962 to more than 13.5 percent in 1998. Figure 1 also shows that the United States generally was a net exporter of goods and servicesprior to 1982.  Since that time, the United States has been a net importer of goods and services.

**FIGURE 1**

	The net trade position of a country is commonly summarized by its current account.  TheU.S. current account as a whole, which compares exports of goods and services and incomeearned by U.S. persons on foreign investments to imports of goods and services and incomeearned by foreign persons on their investments in the United States (plus unilateral remittances),was positive as recently as 1981, but generally has been in deficit by over $90 billion per yearnine times since 1984.  Figure 2 reports the current account balance of the United States for theperiod 1963 through 1998 in nominal (non-inflation-adjusted) dollars.(31) Figure 2, like Figure 1,shows the United States' change in status from net exporter to net importer since the early 1980s.Figure 2 reflects a substantial reduction in the current account deficit for 1992.  In that year, theUnited States received substantial payments from abroad related to the Persian Gulf war.

**FIGURE 2**

	The aggregate data reported in Figures 1 and 2 mask differences in the trade position ofvarious sectors of the economy.  As explained above, the current account compares exports ofgoods and services and payments of income earned by U.S. persons on foreign investments toimports of goods and services and payments of income earned by foreign persons on theirinvestments in the United States.  Figures 3, 4, and 5 separately chart the nominal dollar value ofexported and imported goods (Figure 3), exported and imported services (Figure 4), andinvestment income earned by U.S. and foreign persons (Figure 5).(32) The sum of the export curvesin Figures 3, 4, and 5 less the sum of the import curves (plus unilateral remittances) equals thecurrent account balance curve of Figure 2.

	Figures 3, 4, and 5 reveal different trends.  As has been widely reported, the merchandise(goods only) trade deficit has been over $100 billion per year since 1984.  On the other hand, theUnited States has been a net exporter of services since the mid-1970s (Figure 4).  Only since1994 have payments of income to foreign persons on their U.S. investments exceeded U.S.receipts of income on investments abroad (Figure 5).

**FIGURE 3**
**FIGURE 4**

**FIGURE 5
	These aggregate data also do not reveal the extent to which growing trade flows resultfrom trade between related parties.  For example, a domestic company might ship componentsmanufactured in the United States to its foreign subsidiary for final assembly and sale.  Suchshipments would be counted as exports from the United States.  A domestic company mightproduce components abroad and ship them to the United States for final assembly and sale.  Suchshipments would be counted as imports to the United States.  Likewise, a foreign parentcompany might ship components from abroad to its U.S. affiliate for final assembly and sale inthe United States.  Such shipments would be counted as imports into the United States.  Theforeign affiliate might ship components to another country for assembly and sale.  Suchshipments would be counted as exports from the United States.

	The preceding paragraph suggests that intra-firm trade involves the shipment ofcomponents across borders.  Other intra-firm trade may involve the shipment of raw materialsabroad for manufacture abroad or shipment of finished goods to a foreign sales affiliate.  Thedata do not permit such distinctions to be drawn.  Nevertheless, the extent of this intra-firmcross-border trade is large and growing.  In 1994, large foreign-owned domestic corporationsreported sales of tangible goods to related foreign persons (exports) of $70.5 billion, a figurerepresenting 14 percent of total U.S. merchandise exports in 1994.  Large foreign-owneddomestic corporations reported purchases of tangible goods from related foreign persons(imports) of $180.6 billion, a figure representing 27 percent of total U.S. merchandise imports in1994.(33)  Similarly, in 1994, U.S. multinational enterprises shipped $136.1 billion of goods totheir foreign affiliates, a figure representing 26 percent of U.S. merchandise exports in 1994. Foreign affiliates of U.S. multinational enterprises shipped $113.4 billion of goods to their U.S.parent enterprise, a figure representing 17 percent of U.S. merchandise imports in 1994.(34)  Thus,in total, in 1994 intra-firm trade accounted for at least 40 percent of U.S. merchandise exportsand 44 percent of U.S. merchandise imports.

	The balance of payments accounts, presented in Table 1, are analogous to a sources anduses of funds statement of the United States with the rest of the world.  As demonstrated in PartIII.A. above, the current account balance, which consists primarily of the trade balance, shouldbe exactly offset by the capital account balance, which measures the net inflow or outflow ofcapital to or from the United States.  The difference between the current account surplus ordeficit and the capital account deficit or surplus is recorded as a statistical discrepancy.  Seriousproblems of measurement cause the accounts to be somewhat mismatched in practice, but basicpatterns are unlikely to be significantly distorted by these problems. 

**Table 1.-International Transactions of the United States, Selected Years, 1975-1998($ Billions nominal)**
**1975****1980****1985****1990****1995****1998****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

       Unilateral Transfers**18.1**
157.9

107.1

25.5

25.4

132.7

98.2

22.0

12.6

7.1**2.3**
344.4

244.3

47.6

72.6

333.8

249.8

41.5

42.5

8.3**-124.2**
382.7

215.9

73.2

93.7

484.0

338.1

72.9

73.1

23.0**-92.7**
697.4

389.3

147.8

160.3

756.7

498.3

118.8

139.6

33.4**-152.9**
965.0

574.9

208.8

181.3

1,087.8

749.3

145.8

192.7

30.1**-233.4**
1,174.1

671.1

260.4

242.6

1,365.6

919.0

181.5

265.1

41.9**Capital Account Balance**
        Foreign Investment in the United States

              Direct Investment

              Private non-direct investment

             Official

       U.S. Investment Abroad

             Direct investment

             Private non-direct investment

            Increase in government assets

       Allocation of Special  Drawing Rights**-24.0**
15.7

2.6

6.0

7.0

39.7

14.2

21.1

4.3

----**-27.7**
58.1

16.9

25.7

15.5

87.0

19.2

54.4

13.3

1.2**101.3**
141.2

20.0

122.3

-1.1

39.9

14.1

19.1

6.7

----**48.2**
122.2

47.9

40.4

33.9

74.0

30.0

44.2

-0.1

----**146.2**
426.3

74.7

241.1

110.5

280.1

96.9

173.1

10.1

----**237.1**
542.5

196.2

368.4

-22.1

305.4

131.9

165.8

6.7

----**Statistical Discrepancy****5.9****25.4****23.0****44.5****6.7****-3.6**
Source:  Christopher L. Bach, "U.S. International Transactions, Fourth Quarter and Year 1998," *Survey of Current Business,* U.S. Department of Commerce,Bureau of Economic Analysis, April 1999, pp. 18-65, and selected earlier issues of the *Survey of Current Business*.  Data for 1998  are preliminary.
**C.  Trends in the United States' Capital Account**

**Overview of the United States' capital account**

	As explained in Part III.A., 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 Statesas payment for U.S. exports or to purchase U.S. assets.  As Figure 2 and Table 1 document theUnited States' current account has been in deficit since the early 1980s.  Figure 6 plots gross(before depreciation) U.S. investment and gross U.S. saving as a percentage of GDP for theperiod 1959-1998.(35)  Figure 6 also plots net foreign investment as a percentage of GDP.  InFigure 6, when the United States is a net exporter of capital, net foreign investment is measuredas a positive number and when the United States is a net importer of foreign capital net foreigninvestment is measured as a negative number.  Net foreign investment became a largerproportion of the economy since 1982.  At the same time, the United States changed from beinga modest exporter of capital in relation to GDP to being a large importer of capital.  Net foreigninvestment has become a larger proportion of the economy and a more significant proportion oftotal domestic investment than in the past.  In 1998, gross investment in the United States was$1,392 billion and net foreign investment was $213 billion, or 15.3 percent of gross domesticinvestment.  In 1993, net foreign investment comprised 8.9 percent of gross domestic investment.

**FIGURE 6**

	The net foreign investment in the United States is measured by the United States' capitalaccount.  The capital account measures the increase in U.S. assets abroad compared to theincrease in foreign assets in the United States.  Figure 7 plots the annual increase of U.S. assetsabroad and of foreign assets in the United States in nominal dollars for the period 1962-1998.(36)

**FIGURE 7**

**Growth in foreign-owned assets in the United States**(37)

	The amount of foreign-owned assets in the United States grew more than 700 percentbetween 1975 and 1988 and more than 300 percent between 1980 and 1988.(38)  The total amountof foreign-owned assets in the United States exceeded $5.4 trillion by the end of 1997.(39) Therecorded value of U.S.-owned assets abroad grew less rapidly during the same period.  TheDepartment of Commerce reports that in 1975 the amount of U.S.-owned assets abroad exceededforeign-owned assets in the United States by $74 billion.  By the end of 1988, however, thesituation had reversed, so that the amount of foreign-owned assets in the United States exceededU.S.-owned assets abroad by $162 billion. By 1997, the amount of foreign-owned assets in theUnited States exceeded U.S.-owned assets abroad by $1.22 trillion.(40)  These investments aremeasured by their book value.  Some argue that the market value of U.S.-owned assets abroad issimilar to, or greater than, the market value of foreign-owned assets in the United States, ifmarket values were measured accurately.(41)  Figures 8 and 9 display the value of U.S.-ownedassets abroad and foreign-owned assets in the United States for selected years measured underboth current (or book) cost and based on estimates of current market values.  Whether thisargument is correct with respect to the current net investment position, it is clear thatforeign-owned U.S. assets are growing more rapidly than U.S.-owned assets abroad as depictedin Figure 7.

**FIGURE 8**
**FIGURE 9
	Foreign assets in the United States (and U.S. assets abroad) can be categorized as directinvestment, non-direct investment, and official assets. Direct investment constitutes assets overwhich the owner has direct control.  The Department of Commerce defines an investment asdirect when a single person owns or controls, directly or indirectly, at least 10 percent of thevoting securities of a corporate enterprise or the equivalent interests in an unincorporatedbusiness.  Foreign persons held direct investments of $752 billion in the United States in 1997,having grown from $83 billion in 1980.(42)

	The largest category of investment is non-direct investment held by private(non-governmental) foreign investors, commonly referred to as portfolio investment. Thiscategory consists mostly of holdings of corporate equities, corporate and government bonds, andbank deposits. The portfolio investor generally does not have control over the assets that underliethe financial claims.  In 1997, portfolio assets of foreign persons in the United States were morethan five times the recorded value of direct investment, $3,875 billion compared to $752 billion,respectively.(43)  Bank deposits account for approximately one-fifth of this total, and reflect, inpart, the increasingly global nature of banking activities.  Figure 10 reports the dollar value offoreign holdings of selected U.S. assets, both portfolio investment and direct investment, for1984, 1990, and 1997.  Foreign investment in bonds, corporate equities, and bank deposits, likeother types of financial investment, provide a source of funds for investment in the United Statesbut 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 bygovernments, central banking systems, and certain international organizations. The foreigncurrency reserves of other governments and banking systems, for example, are treated as officialassets. Levels of foreign-held official assets have grown more slowly than foreign-held direct andportfolio investment of private investors.

	The value of investments by private U.S. persons abroad has grown from $295.1 billionin 1980 to $4,237 billion in 1997.(44)  This growth has not been as rapid as the growth in the valueof investments by foreign persons in the United States.

**FIGURE 10**

**IV.  ANALYSIS OF ISSUES RELATING TO INTERNATIONAL INVESTMENT**

**A.  Capital Export Neutrality, Capital Import Neutrality, and National Neutrality**

	International investment plays an important role in determining the total amount ofworldwide income as well as the distribution of income across nations.  In addition, internationalinvestment flows can substantially influence the distribution of capital and labor income withinnations.  Because each government levies taxes by its own method and at its own rates, theresulting system of international taxation can distort investment and contribute to reductions inworldwide economic welfare.  A government's tax policies affect the distribution of incomedirectly, by collecting tax from foreigners earning income within its borders and from residentsearning 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 thaninvestment in response to pure economic fundamentals, reduce worldwide economic welfare.The nature of these economic distortions depends on the method of taxing income frominternational investment.  If investment income is taxed only at the source, substantial amountsof capital could be diverted to jurisdictions with the lowest tax rates instead of flowing toinvestment projects with the highest pre-tax rate of return.  If a system of residence taxation isthe worldwide norm,(45) enterprises resident in low-tax countries might be able to attract moreinvestment capital or perhaps increase their market share through lower prices to the detriment ofenterprises resident in high-tax jurisdictions, even though the latter are more efficient.  In eithercase, capital is diverted from its more productive uses, and worldwide income and efficiencysuffer.  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 amountand method of taxation.  There is no consensus on what method of taxing internationalinvestment income minimizes distortions in the allocation of capital when nations tax income atdifferent effective rates, but the alternatives of capital export neutrality and capital importneutrality are the most cited guiding principles.  These two standards are each desirable goals ofinternational tax policy.  The problem is that, with unequal tax rates, these two goals are notmutually attainable.  Satisfying both principles at the same time is possible only if effective taxrates on capital income are the same in all countries.

Capital export neutrality.--Capital export neutrality refers to a system where an investorresiding in a particular locality can locate investment anywhere in the world and pay the sametax. 

Capital import neutrality.--Capital import neutrality refers to a system of internationaltaxation where income from investment located in each country is taxed at the same rateregardless of the residence of the investor.

	Chart 1 below, compares capital import neutrality with capital export neutrality.  Thechart provides a taxonomy of the tax that would apply to income from an investment by locationof the investment and by residence of the investor under the principle of capital export neutrality(panel a) and under capital import neutrality (panel b).  Tax rates are always equal for investorsresiding in the same country under capital export neutrality. Tax rates are always equal forinvestments located in the same country under capital import neutrality.

**Chart 1.-The Principles of Capital Export Neutralityand Capital Import Neutrality**

**a.  Capital Export Neutrality**

Domestic investor faces domestic tax rate no matter where investment is located.  Foreigninvestor faces foreign tax rate no matter where investment is located.  Foreign investment incomeis subject to foreign tax rate regardless of the residence of the taxpayer.

**Location of Investment**
Domestic
Foreign
**Residenceof Investor**
Domestic
Tax income atdomestic rate
Tax income atdomestic rate
Foreign
Tax income atforeign rate
Tax income atforeign rate

******b.  Capital Import Neutrality**

Domestic investment income subject to the domestic tax rate regardless of the residence of thetaxpayer.  Foreign investment income subject to foreign tax rate regardless of the residence of thetaxpayer.

**Location of Investment**
Domestic
Foreign
**Residenceof Investor**
Domestic
Tax income atdomestic rate
Tax income atforeign rate
Foreign
Tax income atdomestic rateTax income atforeign rate

	Under capital export neutrality, decisions on the location of investment are not distortedby taxes.  Capital export neutrality is a principle describing how investors pay tax, not to whomthey pay. Capital export neutrality primarily is a framework for discussing the efficiency andincentives faced by private investors, and not the distribution of the revenues and benefits ofinternational investment.  Tax systems may adhere to the principle of capital export neutrality bytaxing worldwide income and granting credits for income and profits taxes paid to foreigngovernments.  As an alternative to the system of foreign tax credits, capital export neutralitycould be achieved with the source country relinquishing its jurisdiction to tax income derivedfrom investments within its borders and allowing the country of residence the exclusive right totax this income.

	Under capital import neutrality, capital income from all businesses operating in any onelocality is subject to uniform taxation.  The nationality of investors in a particular locality willnot affect the rate of tax.  Capital import neutrality may be achieved by the residence countryexempting income earned from foreign jurisdictions entirely from tax and allowing the sourcecountry's taxation to be the only taxation on the income of international investors.  This iscommonly referred to as a "territorial" or an "exemption" system of international taxation.

	Some commentators refer to the principle of capital import neutrality as promoting"competitiveness."  This notion of competitiveness(46) refers to the ability of U.S. multinationals(firms headquartered in the United States that operate abroad) that locate production facilitiesoverseas to compete in foreign markets.  Overseas production facilities owned by U.S. interestsmay compete with firms owned by residents of the host country or with multinational firmsbased in other countries.  The notion of capital import neutrality promoting the competitivenessof such businesses focuses on the after-tax returns to investments in production facilities abroad. As described above, under the principle of capital export neutrality, any business would see thereturn 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 applydifferently than residual taxation by another capital-exporting country.  The result may be thatthe after-tax return to an investment by a U.S. multinational in a given foreign country may beless than the after-tax return earned by another investor, even if that investor makes an identicalinvestment to that of the U.S. multinational.  Some argue that this puts the U.S. multinational at acompetitive disadvantage.

**The concept of national neutrality**

	Because countries typically tax income arising within their borders, a nation can increaseits income through policies that reduce outbound investment by its residents and encourageinbound investment by foreigners.  This is the case even if net outbound investment is drivenbelow the level that would prevail in a free and efficient international capital market.  Promotingnational economic interest may not coincide with promoting worldwide economic income.

	In a world of source taxation, the national interest and the interests of outbound investorsdo not coincide.  Outbound investment is only in the national interest if the return after foreigntax (but before domestic tax) equals or exceeds the before-tax return on domestic investment.  Tofurther its national interest, a government can reduce outbound investment by reducing theafter-tax rate of return on outbound investment and driving its before-tax return above that ondomestic investment.  A government can penalize outbound investment by imposing a layer oftaxation 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 overforeign source income (for example, through a foreign tax credit) and allows only a deduction forforeign taxes.(47)

	The policy of allowing only deductions for foreign taxes is sometimes known as "nationalneutrality."  A deduction penalizes outbound investment and aligns the interests of the taxpayerwith the interests of its home country--but only at the expense of reduced worldwide economicwelfare.  Despite the potential to maximize national welfare, self-interested nations generally donot adopt tax systems designed to achieve national neutrality.  There are at least three possibleexplanations for this.  First, there is reason to expect that one nation's unilateral attempt toimprove its own welfare through a policy of national neutrality would meet with retaliation byother nations with similar policies.  Such tax competition would reduce worldwide income evenfurther.(48)  If, on the other hand nations can coordinate their tax policies, a tax system can bedesigned to increase worldwide income above the inefficient level produced by nationalneutrality.  With international coordination, there is potential for adopting a system in whichworldwide income could be maximized (and, if necessary, redistributed) so all nations could bebetter off.

	Second, the disincentives to outbound investment embodied in the concept of nationalneutrality only increase national welfare if outbound investment increases at the expense ofdomestic investment.  If the economy responds to increased outbound investment with increaseddomestic saving instead of reduced domestic investment, policies to discourage outboundinvestment may have little positive effect on domestic labor and, furthermore, may reducenational welfare in addition to worldwide welfare.

	Third, even if the first two rebuttals to national neutrality do not hold, there is someevidence that outbound investment increases exports by more than it increases imports.  Thisincrease in net exports may provide benefits to domestic labor and increase overall domesticincome.  If this is the case, policies discouraging outbound investment could increase themerchandise trade deficit and reduce national output.(49)

**Summary**

	A government can implement capital export neutrality by taxing worldwide income of itsresidents but also allowing credits for taxes paid to foreign governments.  Alternatively, agovernment can implement national neutrality by replacing credits with deductions for foreigntaxes.  Finally, a government can implement capital import neutrality by exempting all foreignsource income from tax.  Since national neutrality is less generous to taxpayers than capitalexport neutrality, deviations from capital export neutrality that increase tax on foreign incomemove the U.S. system closer to a system of national neutrality.  Conversely, since capital importneutrality is often more generous to taxpayers than capital export neutrality, deviations fromcapital export neutrality that decrease tax on foreign income move the U.S. system closer to asystem of capital import neutrality.

	As a whole, the U.S. system of taxation is a hybrid containing elements consistent withboth capital import neutrality and capital export neutrality.  With regard to the relative treatmentof domestic and outbound investment, many provisions work at cross purposes.  Someprovisions of current law favor outbound investment, while others discourage it.

**B.  Departures From Capital Export Neutrality in Current U.S. Tax Rules**

**1.  Deferral of tax on foreign income**

	Income from outbound investments earned by the separately incorporated foreignsubsidiaries 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 taxableincome.  The majority of foreign business activity controlled by U.S. corporations is conductedby separate foreign corporations as opposed to branches.  In 1994, the largest 7,500 CFCs of U.S.multinationals had $98.4 billion of earnings and profits and paid $23.3 billion of foreign incometaxes.(50)  Foreign branches of U.S. multinationals had $60.3 billion of branch income and paid$4.2 billion of foreign income taxes.(51)

	If for a particular taxpayer the effective rate of foreign tax can be expected to beconsistently 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 maydelay 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 theopportunity for cross-crediting (if effective foreign tax rates vary across years or acrossjurisdictions) by not deeming high foreign taxes to be paid until a year when the U.S. taxpayerchooses also to repatriate low-taxed foreign source income.(52)  The benefit from the deferral of taxuntil foreign earnings are repatriated may be viewed as similar to the benefit enjoyed fromdelaying realizations of capital gains.  As with capital gains, one method of eliminating the taxbenefit of deferral is the payment of taxes on income as it is earned, rather than when payment isreceived.  This is achieved, in limited circumstances, by the various anti-deferral regimes in theCode.

	Deferral does, however, impose costs on taxpayers.  For example, subpart F, and itsinteractions with the credit rules and the other anti-deferral rules, are considered highlycomplex.(53) In addition, the interest allocation rules, by precluding full worldwide fungibility ofinterest among commonly controlled domestic and foreign subsidiaries, may impose costs on aU.S. corporation that operates through foreign subsidiaries, which costs might be avoided byoperating through foreign branches of a U.S. corporation.

	To the extent that deferral continues to provide an advantage to outbound investment, thisadvantage provides an incentive for outbound investment and therefore moves the U.S. system oftaxation of foreign income closer to capital import neutrality and away from capital exportneutrality.  Deferral provides an incentive for outbound investment, but restrictions on deferralnegate this incentive.

**2.  Foreign tax credit limitation**

	For taxpayers in an excess foreign tax credit position (that is, taxpayers with creditableforeign taxes in excess of the foreign tax credit limitation), tightening limitations on the foreigntax credit may, when foreign laws are taken into account and are assumed not to change as aresult of the tightening, result in discouraging outbound investment and encouraging domesticinvestment. In order for a credit system of foreign taxation to be fully consistent with capitalexport 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 tobe available to taxpayers in their country of residence. This would include a grant by theresidence country to the taxpayer of the amount, if any, by which such source country taxexceeds residence country tax. In other words, for a credit system of outbound taxation to befully capital-export neutral, the residence country must be willing to relinquish tax jurisdictionover domestic income.

	It is important to recognize that when the foreign tax credit limitation is binding, thedisincentive to outbound investment results primarily from foreign effective rates of tax in excessof the domestic rate. The only "fault" of the foreign tax credit limitation in the context of capitalexport neutrality is that subsidies are not provided in the form of foreign tax credits in excess ofdomestic tax liability. The reduced availability of foreign tax credits may, however, beaccompanied 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 sourceincome computed under U.S. tax rules. Taxpayers in an "excess limit" position (that is, taxpayerswith foreign tax credit limitation in excess of creditable taxes) have no incentive to reduce theirforeign taxes, and foreign governments have no inducement to lower their income taxes onincome earned by those U.S. taxpayers. Without the credit limitation, there would be noreasonable bound on the potential transfer of funds from the U.S. Treasury to foreigngovernments. To the extent of U.S. tax liability (before foreign tax credits), the level of foreigntaxation would be a matter of indifference to the U.S. investor since increased foreign taxeseffectively would be paid by the U.S. Treasury.(54) The foreign tax credit limitation is thus amongthe most important of a variety of revenue protection features of the U.S. system of internationaltaxation. To the extent that U.S. tax rates fall relative to foreign tax rates, the importance of theforeign tax credit limitation increases.

**3.  Cross-crediting of foreign taxes**

	In its 1984 tax reform proposals, the Treasury Department proposed a per-country foreigntax credit limitation to replace the overall limitation which provided "many taxpayers a taxmotivated incentive to invest abroad rather than in the United States."(55) This tax reform proposaladdressed 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 issometimes referred to as "averaging" or "cross-crediting."

	The creation of new separate foreign tax credit baskets in the final version of the 1986Act reduced in a different way the ability on U.S. taxpayers to average foreign tax liability onhighly taxed foreign income against the foreign tax liability on lightly taxed income. Forexample, 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 portfolioinvestments in low-tax countries. With an ability to "cross-credit" between taxes on active andpassive income, a corporate taxpayer paying, for example, 45-percent tax on $100 of activeincome from one country would be able to make investments yielding $100 in anotherjurisdiction with a tax rate as high as 25 percent on investment income, and be subject only toforeign tax. The taxpayer in this instance has a tax incentive to invest abroad since his marginalrate 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 outboundinvestment.

	In terms of the principles discussed above, limiting the ability to cross-credit moves thetax treatment of the marginal outbound investment by a U.S. investor away from capital importneutrality 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 similartypes of income earned in other low-tax foreign countries. Complete elimination ofcross-crediting may be undesirable for administrative reasons, quite apart from issues of capitalimport and export neutrality. For example, substantial administrative issues could arise in theallocation and apportionment of foreign income of an integrated multinational business amongseparate foreign countries in which operations take place. Some of the separate foreign tax creditlimitation rules of current law already create what may be regarded as undue complexity.

**4.  Creditability of subnational foreign taxes**

	Under present law, taxes paid by U.S. businesses to foreign governments that are by theirnature taxes on income or profits, such as a corporate income tax, are fully creditable (within theforeign tax credit limitation) against Federal income taxes. This applies whether the tax isimposed 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 governmentswithin the United States are only deductible against Federal income tax. Depending upon therates of U.S. and foreign national and subnational taxes, this disparity in treatment of subnationaltaxes can create an incentive to invest overseas. This is the case when the foreign tax creditlimitation is not binding and the overall (i.e., national and subnational combined) level of foreignincome 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 andlocal taxes from either a domestic or outbound investment, and that the rate of U.S. Federalincome tax is 35 percent and the foreign national rate is 20 percent. Before taking into accountother, subnational taxes, the U.S. taxpayer would earn $65 after-tax from either domestic oroutbound investment. In the case of outbound investment, the investor pays $20 of tax to theforeign government and $15 (after foreign tax credits) to the U.S. government. Now assume thatsubnational governments in both the United States and the foreign jurisdiction impose a10-percent income tax. On domestic investment, the investor pays $31.50 of Federal tax (0.35times $90) and $10 of subnational income tax, resulting in an effective rate of tax of 41.5 percentand leaving the investor with $58.50 after tax. On outbound investment, the investor pays $18 oftax to the foreign national government and $10 to the foreign subnational government. Becausethe total foreign tax paid does not exceed the foreign tax credit limitation, all the foreign taxesare creditable. The taxpayer owes $7 to the U.S. government and is left with $65 after tax.

**5.  Export incentives**

	A fundamental decision facing any U.S. business is whether to locate some portion ofproduction overseas. In the case of a business that sells products overseas, the investmentlocation decision to invest abroad or domestically can be influenced by the availability of taxincentives for exports. Export incentives, like tariffs that penalize imports, reduce globaleconomic welfare. Furthermore, although they undoubtedly improve the lot of the favored exportsector, they generally can be expected to reduce the overall economic welfare of the nationproviding the subsidy. Nevertheless, tax and other export incentives may reduce the incentive ofU.S. businesses to locate production abroad. One of the tax incentives providing favorabletreatment to the taxation of income from exports is contained in the provisions available toexporters who make use of  FSCs.

**C.  Tax Treaties**

**1.  In general**

	Treaties involve trade-offs between the tax benefits they provide to inbound andoutbound investments. Policy issues are implicated by the trade-offs. For example, treaties mightbe seen as benefitting U.S. outbound investment at the cost of reducing U.S. revenues from taxon inbound investment.(56) Treaties might be seen as benefitting the United States by increasingthe inflow of investment at the cost of increasing investment outflows and reducing the U.S. taxtake from the inflow. Or treaties might be seen as benefitting the United States simply byreducing barriers to the free flow of resources at the cost of reducing U.S. tax revenues. In eachcase, treaties raise the issue of whether their perceived benefits are in fact benefits, whether theyare worth the costs, and whether more efficient approaches would be superior.

	The discussion that follows will concentrate on the policy issues arising from the taxbenefits achieved from applying treaty rules to outbound investment. It is worth remembering,however, that every such benefit is connected, to a greater or lesser degree, to benefits theresidents of the other treaty country achieve vis-a-vis their own U.S. tax liabilities.

	An overarching treaty issue regarding outbound investment is whether the reduction inforeign tax benefits the U.S. Treasury, U.S. taxpayers or the United States as a whole. Forexample, a U.S. taxpayer with excess foreign tax credit limitation generally will not benefit froma treaty reduction in foreign tax on income currently includable in U.S. taxable income. That is,U.S. tax liability will replace the reduced foreign tax liability. In this case, the treaty directlybenefits the U.S. Treasury. A taxpayer with excess foreign tax credits would find that a treatyreduction in foreign tax is not offset by an equal increase in U.S. tax. Thus, the treaty directlybenefits the taxpayer, not the Treasury.  The issue becomes whether this net tax savings of theU.S. taxpayer on its foreign income is also a net benefit to the United States. The conclusionreached becomes more significant to treaty policy the more U.S. taxpayers are likely to be in anexcess credit position.

	A related issue is the degree to which treaties are desirable from a U.S. policy perspectivesimply because foreign tax reductions of any amount are achieved, and the degree to which theamount of foreign tax reduction sought in negotiations should rightfully be measured by thedegree to which they eliminate aspects of foreign laws that discriminate against foreign investorsor foreign income of domestic investors.

**2.  Tax sparing**

	One treaty issue particularly affecting the treatment of outbound investment concerns theU.S. negotiating position with respect to tax sparing. Tax sparing would require the reduction orelimination of U.S. tax on income from activities in the source country, for example by allowinga credit for foreign taxes even though the taxes are not actually paid due to a tax holiday or otherlocal tax incentive program. Tax sparing generally is sought by countries seeking, for their ownpolicy reasons, to encourage inbound foreign investment through tax incentives.

	Proponents of tax sparing have argued that U.S. multinationals are prevented by theabsence of tax sparing from receiving the benefit of foreign tax incentives to investment in theforeign country. It is asserted, therefore, that if the United States spared the right to levy homecountry tax on foreign income, U.S.-based multinationals could tap low cost labor and rawmaterial markets in developing countries at an after-tax cost "far below" that currently availableto them. Thus, proponents of tax sparing argue that current U.S. policy not to enter intotax-sparing agreements hinders U.S. companies from access to the low cost labor and rawmaterials necessary to compete equally in world trade.(57)

	Opponents of tax sparing argue that if the goal of tax sparing were to relieve U.S. taxburdens that might otherwise deter active foreign investment, then under present law, tax sparingis actually unnecessary, given the deferral permitted on active foreign income earned by a U.S.person through a foreign subsidiary. Industries that historically have not taken advantage ofdeferral--i.e., that have operated abroad in branch form--include natural resources industrieswhich, it is argued, must base their operations where the resources are located, regardless of localtax incentives. It may also be argued that these industries paying sufficient amounts of foreigntax have found themselves to be exempt, in effect, from bearing any additional U.S. tax burdenon that income.

	It is further argued that tax sparing interacts with the foreign government's internal taxpolicy to the detriment of tax policy for all concerned. Given a certain level of governmentexpenditures and a certain level of debt-financing of those expenditures, a country choosing toimpose an income tax has a choice of imposing a relatively low income tax rate on a broadincome base, or of imposing a higher rate accompanied by tax incentives. It has been argued thatthe latter type of system is inefficient because of its "uneven playing field." In many cases, thegovernment concerned is also dependent on foreign loans or foreign aid to finance the shortfall inrevenues caused by the allowance of inefficient tax incentives. Thus, allowance of taxconcessions by countries seeking to further their economic development increases pressure oninternational financial markets and institutions, as well as on foreign aid budgets. It is argued thata treaty device which encourages U.S. investors abroad to bring pressure on foreign countries togrant tax concessions interferes with the development of foreign tax systems.(58) It is furtherargued that because in return for United States agreement to provide tax sparing, the treatycountry grants to U.S. residents reduced local taxes on payments such as interest, royalties, anddividends, the pressures on the treaty country government that are fostered by tax sparing areincreased further by reduced local revenues.

**3.  Integration of corporate/shareholder taxation**

	U.S. treaty policy toward integration benefits for cross-border dividends seems to bebased on a view that U.S. investors in corporations resident in countries with integratedcorporate/shareholder taxation systems should receive source country tax reductions on theirdividends from such corporations, and may fairly take a credit under U.S. law based on anamount of tax imposed by the foreign country not on the shareholders, but the corporations.

	The treaty issue is not only whether the United States will seek foreign tax reductions forthe benefit of U.S. investors in the treaty country, and will forgo some U.S. tax that mightotherwise take the place (under U.S. statutory law) of the reduced foreign taxes; the issue alsoinvolves arriving at a view as to what level of foreign tax reduction is to be sought and whatdegree of U.S. tax reduction is believed tolerable.

	For example, between the time Germany enacted its imputation system (1977) and thetime the 1989 treaty was signed, the Treasury Department expressed the view that the mostappropriate adjustment to German tax on U.S. investment in German companies would be forGermany to grant U.S. shareholders refunds of the full 36-percent German federal corporate taxon distributed profits.(59) The treaty that was actually signed generally provides U.S. directinvestors no imputation benefit, and provides U.S. portfolio investors in German residentcompanies with a 5-percent rate reduction relative to the generally applicable 15-percent sourcecountry treaty withholding rate for dividends paid by German resident companies. Germanshareholders, by contrast, receive a credit under internal German law for the full 36-percent"distribution burden" that German corporate earnings bear at the corporate level.  Thus, U.S.portfolio investors in German resident companies receive the benefit of the German split-ratesystem, but receive a smaller imputation-related benefit than German shareholders in Germanresident companies receive for dividends paid by the companies.

	Only under the U.K. treaty does the U.S. direct investor receive source country ratereductions to account for integration. The U.K. treaty does afford U.S. portfolio investorsintegration benefits analogous to those of domestic investors.(60)

	The issue is the degree of integration benefit that the United States will consideracceptable in its treaties. The outcome of the German treaty negotiation demonstrated that theUnited States was willing to accept less than full parity for its investors in Germany. Some mayargue that this bargain falls short of what is acceptable. Others may argue that the benefitsactually achieved in the German treaty constituted a reasonable compromise with Germaninternal policy.

	Moreover, it has been a well-established principle of international taxation that thecountry in which income-producing activity occurs is entitled to collect tax on the income fromthe activity. Therefore, any treaty system of dividend taxation would likely be designed to permitthe source country to retain an adequate percentage of the tax that would have been imposed hadthe shareholder been domestic.

**V.  SUMMARY OF TAXATION OF FOREIGN INCOME IN THE UNITED KINGDOM, GERMANY, AND JAPAN**

	This part provides for purposes of comparison a brief summary of the income taxtreatment of foreign-source income under the tax laws of the United Kingdom, Germany, andJapan. The summary is not intended as an authoritative representation of the laws of thesecountries. The staff of the Joint Committee on Taxation prepared this summary with theassistance of the staff of the Law Library of the Library of Congress.(61)

**A.  Treatment of Foreign Income in the United Kingdom**

**1.  Foreign tax credit**

	The worldwide income and gains of U.K. resident individuals and corporations generallyare subject to current U.K. tax.(62) In order to prevent an item of non-U.K. source income frombeing taxed by the source country and again by the United Kingdom, U.K. tax law provides aforeign tax credit (i.e., a credit against U.K. tax on that income to the extent of foreign taxesincurred on that income).

	Certain limitations are placed on the ability of taxpayers to utilize foreign tax credits. Theforeign tax credit is available only on a source-by-source (i.e., country-by-country) basis. Thus,excess foreign taxes attributable to one source generally may not offset the residual U.K. tax onuntaxed or low-taxed foreign income from a different source. However, taxpayers are able toachieve some degree of averaging of foreign taxes through the use of so-called "mixing"corporations. Finally, there is no allowance for a carryback or carryforward of unused foreign taxcredits. In cases where credits would go unused, taxpayers may elect to forgo the foreign taxcredit and instead claim a deduction for foreign taxes.

	U.K. law also provides for an indirect foreign tax credit in the case of certain dividendincome earned by a U.K. resident company. Where the dividend is from a non-resident company,the foreign tax credit applies to any tax directly withheld from the dividend, as well as to aportion of the foreign taxes incurred by the payor corporation with respect to the profits sodistributed. In order to qualify for the indirect foreign tax credit, the U.K. company (or its parentcompany) must directly or indirectly own at least 10 percent of the foreign company's votingstock.

	For dividends paid by such non-resident companies to U.K. companies after November25, 1996, the foreign tax credit may be denied if the companies have artificially increased theamount of the underlying foreign tax. The restriction applies when the underlying foreign taxpayable by the non-resident company is at a high rate, i.e., in excess of the rate of U.K.corporation tax, and the high rate is included because of an avoidance scheme that has theclaiming of double taxation relief as its only or main purpose.

	A 1998 law restricts the foreign tax credit when a bank or other lender receives interest ordividends and there is a related "financial expenditure" incurred either by the lender or anassociated company. The financial expenditure must be deducted from the interest or dividendsuch that the foreign tax credit is computed based upon the net amount of the interest ordividend. Further, the amount of foreign withholding tax that may be credited is limited to 15percent of the gross amount of the interest or dividends concerned.

**2.  Income earned through foreign subsidiaries**

	Income earned by non-U.K. subsidiaries (except to the extent they are connected tobusiness operations in the United Kingdom) is not subject to U.K. tax until it is repatriated in theform of dividends. In 1984, special legislation covering controlled foreign companies wasintroduced. This legislation eliminated the deferral of U.K. tax on certain earnings of foreignsubsidiaries.(63) It mainly applies to operations located in tax haven countries.

**3.  Incentives for outbound investment**

	Generally, the internal tax laws of the United Kingdom provide no tax incentives foroutbound investment other than the allowance of deferral on certain earnings of foreignsubsidiaries. However, in certain cases where foreign countries have provided "tax sparing" reliefto encourage inbound investment, the United Kingdom has agreed in tax treaties with thosecountries to allow a credit against U.K. tax for the foreign tax so spared. For foreign-sourceinterest or dividends paid after March 17, 1998, if the foreign tax includes spared tax, the excessof the spared tax over the amount qualifying for the credit is disallowed.

	The United Kingdom has an extensive network of tax treaties that include provisionsaddressing relief from double taxation. This treaty network does not extend to several countriesin Central and South America. In the absence of a treaty, as stated above, a U.K. resident maynonetheless obtain unilateral relief from double taxation through foreign tax credits.

	Relief for U.S. State taxes, as opposed to U.S. Federal taxes, also is given unilaterally(i.e., through foreign tax credits). Finally, unilateral relief is granted to dual resident companieswhich under the United States-United Kingdom income tax treaty are denied the benefit of mostof the provisions of that treaty.

**B.  Treatment of Foreign Income in Germany**

**1.  Foreign tax credit**

	Germany taxes the worldwide income of German resident individuals and corporations.This leads to potential double taxation of foreign income if the source country taxes such incomeas well.  Germany grants relief from this double taxation either through treaties on doubletaxation, or unilaterally through a credit or deduction for the foreign tax.

	A direct foreign tax credit is available to German resident taxpayers(64) for the foreignincome taxes paid on foreign-source income if the country imposing the tax does not have adouble taxation treaty with Germany.  In addition, the foreign tax credit of German law also isapplied if there is a double taxation treaty that calls for its application or if the treaty does notprovide relief.  For purposes of the foreign tax credit, German law defines taxable foreign-sourceincome according to the German tax rules for domestic income.  Under these rules, businessincome is taxable foreign-source income if realized through a foreign permanent establishment ofthe German resident taxpayer, or through his foreign permanent representative.

	The foreign tax credit can be claimed only for foreign taxes that correspond to theGerman income tax.  However, it can also be claimed for the income taxes of the States or localsubdivisions of a foreign country.  The foreign tax credit can only be used to reduce the Germanindividual or corporate income tax.  It cannot be credited against other taxes such as the Germantrade tax.

	The foreign tax credit is computed separately for each country that imposed foreign taxes. This per-country limitation benefits taxpayers who incur a loss in one country while obtaining aprofit elsewhere.  On the other hand, the limitation is disadvantageous where high and lowprofits are achieved in different countries.

	Foreign tax credits cannot be carried over to future tax years.  Credited foreign tax cannotexceed the amount of German tax attributable to the foreign-source net income.  In sum, theserules work to the effect that the taxpayer is burdened with the higher of the German or foreignincome tax.

	A deduction of foreign tax is available to the German resident taxpayer, as an option,instead of claiming of a credit. However, if the deduction is taken, it must be applied to allincome from one country.

	When German resident corporations receive dividends from their foreign subsidiaries,they are, under certain circumstances, entitled to apply for an indirect foreign tax credit for a pro-rata share of foreign income taxes paid by the foreign subsidiary.  This benefit is granted tomitigate the multiple taxation of corporate income.  The indirect foreign tax credit is available forGerman resident shareholders owning at least 10 percent of the stock of a first tier foreignsubsidiary, provided the subsidiary is engaged in an active business (and not in passiveinvestments).  In addition, an indirect foreign tax credit can be claimed under certaincircumstances for foreign income taxes paid by a second-tier foreign subsidiary.  Indirect foreigntax credits below the second tier are not allowed.

	For dividends distributed by subsidiaries in certain specified developing countries, a paidforeign tax credit is available.  The credit is granted for the total amount of the German incometax due on the dividends, regardless of the actual foreign taxes paid.  This credit, however, isavailable only for certain pre-existing investments.(65)

**2.  Treatment of foreign income in treaties**

	Germany has concluded double taxation treaties for income taxes with more than 70countries.  These countries use different methods to avoid double taxation.  Many of the treatiesfollow the Model Convention of the Organization for Economic Cooperation and Development. They primarily use the exemption method under which the income of a permanent businessestablishment is taxed only in the source country and exempted from taxation in the country ofresidence of the owner of the foreign establishment.  However, some treaties also use the foreigntax credit as the primary means of eliminating double taxation; yet others use the exemptionmethod for Germany and the foreign tax credit method for the other country (as is the case in theGermany-United States double taxation treaty).

	When the foreign tax credit method is used, Germany computes the foreign tax credit inaccordance with German domestic rules, as described above.  When the exemption method isused, losses resulting from a permanent establishment in a treaty country generally are notdeductible from the German income tax of the resident German taxpayer who owns theestablishment.

	When dividends of foreign corporations are distributed to a German resident shareholder,their tax treatment depends on a governing tax treaty or the absence thereof.  Under most Germantax treaties, shareholders who own at least 10 percent of the stock of a foreign corporation areexempt from German income taxation.  However, on the basis of domestic legislation, thisexemption is reduced to 85 percent of the income. The remaining 15 percent of such income issubject to German taxation because they are deemed to be non-deductible business expenses.

**3.  Income earned through foreign subsidiaries**

	In general, income of foreign corporations is taxed by Germany as foreign-source incomeonly if there is a distribution to a German resident shareholder.  Thus, generally, the corporateidentity of the foreign corporation is respected, particularly if the foreign corporation is engagedin an active business.

	However, there are certain instances under which the income of foreign subsidiaries ofGerman resident shareholders is taxed by Germany as foreign-source income. In this regard,certain undistributed income of foreign corporations is attributed to the German controllingshareholder as though it had been distributed and is taxed essentially as domestic income. Thisincludes undistributed income of a foreign corporation controlled at least 50 percent by one ormore German shareholders.  The income of such corporations is taxed in Germany as though itwas domestic income,(66) even if the corporation is an active foreign subsidiary (being engaged ina business other than investing). In addition, passive income (e.g., investment income) of aforeign corporation is attributed to a German shareholder who owns at least 10 percent of thestock of the corporation, if the corporation resides in a low tax country.(67)

**C.  Treatment of Foreign Income in Japan**

**1.  General rule of deferral**

	Japanese taxpayers are subject to income tax on their worldwide income, includingincome derived by foreign branch operations that is not remitted to Japan. Japanese taxpayersgenerally are not subject to taxation in Japan on the earnings of foreign corporations in whichthey own interests until the profits are repatriated to Japan (in the form of dividend or liquidatingdistributions, or upon sale of the interests). This general rule of deferral, however, does not applyto certain tax-haven subsidiaries.

	Certain Japanese taxpayers are taxable currently on their pro rata shares of theundistributed profits of Japanese-controlled corporations established in designated tax havens.Japanese taxpayers subject to this treatment are those owning (directly, indirectly, orconstructively) five percent(68) or more of the stock in a tax-haven subsidiary that is owned(directly, indirectly, or constructively) more than 50 percent by Japanese taxpayers. Tax-havencountries include any country where the effective rate of tax applicable to theJapanese-controlled corporation in question is "substantially low," which is defined in a Cabinetorder as 25 percent or less. The effective rate of tax generally is computed under principles ofJapanese law, and includes not only local taxes actually paid but also local taxes that areexempted or reduced to the extent that the exemption or reduction qualifies for a tax-sparingcredit under the local country's tax treaty with Japan.

	Actual distributions of previously taxed tax-haven profits are free of additional incometax if distributed within the next five years after the undistributed profits are taxed.

**2.  Foreign tax credit**

	Japanese corporations may credit certain foreign taxes against income taxes payable toJapan on foreign-source income. Both direct and deemed-paid taxes are eligible for the credit,with 25-percent ownership in the foreign corporation generally required for deemed-paid credits.Deemed-paid credits are allowed for only first-tier and second-tier foreign corporations.(69) Theownership threshold is waived for purposes of deemed-paid credits with respect to certainshareholders in designated tax-haven subsidiaries. The ownership threshold also is reduced incertain tax treaties. For example, under the United States-Japan tax treaty, Japanese shareholdersin U.S. corporations may claim deemed-paid credits with respect to as little as 10-percentownership.

	The foreign tax credit is subject to a limitation computed on an overall (as opposed to aper-country) basis. The limitation is computed on the basis of the national income tax only,although excess credits may be used, to a limited extent, against the corporation's localinhabitants income tax. Excess credits may be carried forward (but not back) for up to threeyears, and excess limitation may be carried forward three years (in effect, yielding a resultsimilar to a carryback).

	For purposes of determining the foreign tax credit limitation fraction, only one third of ataxpayer's foreign-source income that is not subject to any foreign tax may be included in thenumerator as foreign-source income (although all of such income is included in the denominatoras worldwide income), and the numerator (foreign-source income) may not exceed 90 percent ofthe denominator (worldwide income). In addition, export sales from Japan are treated as foreignsource-income only if they are sold through a fixed place of business in a foreign country, or ifthe income from the export sales is subject to tax in a foreign jurisdiction.

**3.  Tax sparing**

	Japan has entered into a number of tax treaties that provide "tax sparing" benefits withrespect to tax holidays or other incentives granted by developing countries to foreign investors.Under tax sparing, Japanese investors in business operations in the other treaty country mayclaim foreign tax credits against their Japanese tax liability as if they had actually paid theforeign taxes that were "spared" pursuant to the tax holidays. Japan currently offers tax sparing inits treaties with Bangladesh, Brazil, Bulgaria, China, India, Indonesia, Ireland, Korea, Malaysia,Mexico, Pakistan, the Philippines, Singapore, Spain, Sri Lanka, Thailand, Turkey, Vietnam, andZambia.

**APPENDIX:  DATA ON U.S. INTERNATIONAL TRANSACTIONS**

**Appendix Table A.1.**

**Appendix Table A.2.**

**Appendix Table A.3.**

**Appendix Table A.4.**
**FOOTNOTES**
1.   This document may be cited as follows: Joint Committee on Taxation,*Description andAnalysis of Present-Law Rules Relating to International Taxation* (JCX-40-99), June 28, 1999.
2.   A broader definition of a CFC applies in the case of a foreign corporation engaged incertain insurance activities (see secs. 953(c) and 957(b)).
3.   Temporary exceptions from foreign personal holding company income (as well asforeign base company services income) applied for subpart F purposes for certain income derivedin the active conduct of a banking, financing, insurance, or similar business, only for taxableyears beginning in 1998. Those exceptions were extended and modified as part of the present-lawprovision.
4.   A 1999 exception from insurance income also is provided, as described below.
5.   The temporary and proposed regulations under Notice 98-11 generally provide that therules apply to amounts paid or accrued pursuant to hybrid branch arrangements entered into orsubstantially modified on or after January 16, 1998. In the case of certain hybrid arrangementsinvolving partnerships, the Notice 98-11 regulations generally provide that the rules apply toamounts paid or accrued pursuant to such arrangements entered into or substantially modified onor after March 23, 1998.
6.   Investment income attributable to premiums that constitute same-country insuranceincome may be includable in the gross income of the U.S. shareholder of a CFC as foreignpersonal holding company income (Prop. Treas. Reg. sec. 1.953-1(a)).
7.   The elimination of the overlap between the PFIC and CFC provisions generally doesnot apply to a U.S. person with respect to PFIC stock that such person is treated as owning byreason of an option to acquire such stock. However, the elimination of the overlap does apply toa U.S. person that holds an option to acquire stock if such stock is held by a person that is subjectto the current inclusion rules of subpart F with respect to such stock and is not a tax-exemptperson.
8.   Deductions generally are allowable to the extent not only of prior mark-to-marketinclusions under section 1296 but also of prior mark-to-market inclusions under a prior proposedTreasury regulation applicable to a regulated investment company that holds stock in a PFIC(Prop. Treas. Reg. sec. 1.1291-8). That proposed regulation recently was withdrawn in light ofthe enactment of section 1296(e)(2) as part of the Taxpayer Relief Act of 1997, which permitscertain regulated investment companies to elect to mark-to-market their PFIC stock (See 64 Fed.Reg. 5015, February 2, 1999).
9.   The PFIC rules for nonqualified funds also generally do not apply to a shareholder of aPFIC that has marked-to-market such stock under section 475 or any other provision.
10.   By contrast, U.S. companies owning foreign subsidiaries that are located in countrieswith effective tax rates that are higher than the U.S. rates may have an incentive to overchargefor sales from the U.S. parent to the foreign subsidiary in order to shift profits, and the resultingtax, into the United States.
11.   There is ongoing litigation in the U.S. District Court between the Bureau of NationalAffairs, Inc. ("BNA"), a tax publisher, and the IRS involving the public release of APAs. TheIRS announced on January 11, 1999, that it was conceding that APAs are subject to disclosureunder section 6110. (See IR-1999-05). The continuing issues are, among other things, the processof redacting confidential information from the APAs and the schedule under which such APAswill be released.
12.   The alternative minimum tax foreign tax credit is determined under principles similarto those used in computing the regular foreign tax credit, except that (1) the numerator of thealternative minimum tax foreign tax credit limitation is foreign source alternative minimumtaxable income, and (2) the denominator of that fraction is total alternative minimum taxableincome. Taxpayers may elect to use as their alternative minimum tax foreign tax credit limitationfraction the ratio of foreign source regular taxable income to total alternative minimum taxableincome (sec. 59(a)(4).
13.   Earnings and profits computations for these purposes are to be made under U.S.concepts. Goodyear Tire & Rubber Co. v. United States, 493 U.S. 132 (1989). 
14.   Dividends paid by a noncontrolled foreign corporation in taxable years beginningbefore January 1, 2003, are subject to a separate foreign tax credit limitation for eachnoncontrolled corporation. In addition, dividends paid by a noncontrolled corporation that is nota passive foreign investment company in taxable years beginning after December 31, 2002, outof earnings and profits accumulated in taxable years beginning before January 1, 2003, aresubject to a single foreign tax credit limitation for all noncontrolled foreign corporations (otherthan passive foreign investment companies). Moreover, dividends paid by a noncontrolledforeign corporation that is a passive foreign investment company out of earnings and profitsaccumulated in taxable years beginning before January 1, 2003, are subject to a separate foreigntax credit limitation for each such noncontrolled foreign corporation. Finally, dividends paid by anoncontrolled foreign corporation in taxable years beginning after December 31, 2002, aresubject to the general limitation or to the various other separate limitations (as the case may be)in accordance with look-through rules that take into account the extent to which the income ofthe payor is itself subject to one or more of these limitations.
15.   Two export incentives preceded the enactment of the FSC provisions. Underprovisions enacted in 1962, CFCs that qualified as export trade corporations were permitted toreduce their subpart F income by the amount of certain export trade income (secs. 970 and 971).No CFC may qualify as an export trade corporation unless it so qualified as of 1971. Underprovisions enacted in 1971, domestic international sales corporations ("DISCs") were permittedto defer U.S. tax on certain export receipts (secs. 991-997). Upon enactment of the FSCprovisions in 1984, a special rule permitted any DISC to transfer its deferred earnings to a FSC.An interest charge is now imposed on the deferral of tax on the earnings of any remaining DISC(sec. 995(f)). In July 1998, the European Union requested that a World Trade Organization("WTO") dispute panel investigate the FSC regime and its compliance with WTO rules includingthe Agreement on Subsidies and Countervailing Measures. A WTO dispute panel wasestablished in September 1998 to address these issues.
16.   Gross income of a nonresident alien individual, who is present in the United States as amember of the regular crew of a foreign vessel, from the performance of personal services inconnection with the international operation of a ship generally is treated as foreign-sourceincome.
17.   Housing expenses are not considered reasonable to the extent they are lavish orextravagant under the individual's circumstances.
18.   Under a special rule, however, those expenses may also include the costs ofmaintaining a separate household outside of the United States for his or her spouse anddependents if that household is maintained due to dangerous, unhealthful, or otherwise adverseliving conditions in the location of the household where the taxpayer resides.
19.   Note that whereas the physical presence test applies to both U.S. citizens andnon-citizen U.S. residents (as defined under section 7701(b)), the statutory bona fide residencetest applies only to U.S. citizens.
20.   For this purpose, the term "tax home" means the taxpayer's home for purposes ofdetermining the deductibility of traveling expenses while away from home under section162(a)(2). A taxpayer is not treated as having a tax home in a foreign country for any periodduring which he has an abode in the United States (sec. 911(d)(3)).
21.   Foreign earned income does not include amounts (1) received as a pension or anannuity, (2) paid by the United States Government (or governmental agency to an employeethereof), (3) included in gross income by reason of section 402(b) (taxation of beneficiaries ofnonexempt trusts) or section  403(c) (taxation of beneficiaries of nonqualified annuities), or (4)received after the close of the taxable year following the taxable year in which the services towhich the amounts are attributable were performed (sec. 911(b)(1)(B)).
22.   For this purpose, the restrictions must have been adopted pursuant to the Trading Withthe Enemy Act (50 U.S.C. App. 1 et seq.), or the International Emergency Economic Powers Act(50 U.S.C. 1701 et seq.).
23.   No exclusion is permitted for amounts received for services rendered as an employeeof the United States Government.
24.   Tax Reform Act of 1986, section 1271.
25.   American Samoa and the United States entered into an implementation agreement,effective January 1, 1988.
26.   No exclusion is permitted for amounts received for services rendered as an employeeof the United States Government.
27.   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 nationaleconomic 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 fromabroad. Thus, wages earned by a U.S. resident from temporary work abroad constitutes part ofGNP but not GDP. Similarly, the returns from investment abroad constitute part of GNP but notGDP. To help understand the connection between trade deficits and cross border capital flows, inthe following it is useful to use GNP, which includes cross border returns to investment, ratherthan the more commonly reported GDP concept. The GNP of the economy is the total annualvalue 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 thesum of private consumption expenditures (C), private investment expenditures on plant,equipment, inventory, and residential construction (I), government purchases of goods andservices (G), net exports (exports less imports of goods and services and net interest payments toforeigners, or X-M), plus net investment income (the excess of investment income received fromabroad over investment income sent abroad or NI). 

	An alternative is to measure GNP by the manner in which income is spent. By thismeasure, 

	(2) GNP = C + S + T. 

	Equation (2) is another accounting identity which states that gross national product equalsthe sum of private consumption expenditures (C), saving by consumers and businesses (S), andnet 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 ofequation (1) must equal the right hand side of equation (2). From this observation can be derivedan 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.
28.   This equation in the text can be seen from equation (3) in footnote 27 above if thegovernment budget is assumed to be balanced, that is, if G = T. It follows that if the governmentruns a deficit, that is, if G>T, for a given level of investment, saving, and net investment income,then net foreign borrowing must be greater.  
29.   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.  
30.   Data for Figure 1 are from the U.S. Commerce Department, Bureau of EconomicAnalysis and are reprinted in Appendix Tables A.1. and A.2.
31.   Data for Figure 2 are from the U.S. Commerce Department, Bureau of EconomicAnalysis and are reprinted in Appendix Table A.1.  
32.   Data for Figures 3, 4, and 5 are from the U.S. Commerce Department, Bureau ofEconomic Analysis and are reprinted in Appendix Table A.1.
33.   Michael G. Seiders, "Transactions Between Large Foreign-Owned DomesticCorporations and Related-Foreign Persons, 1994," *SOI Bulletin*, 17, Winter 1997-1998, pp. 123-140.  The figures reported in the text are the sum of reported "sales of stock in trade" and "salesof other tangible property."  See Figure B.  In 1991, such inter-affiliate trade by large foreign-owned domestic corporations represented 11 percent of merchandise exports and 24 percent ofmerchandise exports. 
34.   Raymond J. Mataloni, Jr., "U.S. Multinational Companies: Operations in 1995,"*Survey of Current Business*, 77, October 1997, p. 50.
35.   Data for Figure 6 are from the U.S. Department of Commerce, Bureau of EconomicAnalysis and are reprinted in Appendix Table A.2.  
36.   Data for Figure 7 are from the U.S. Department of Commerce, Bureau of EconomicAnalysis and are reprinted in Appendix Table A.3.
37.   For a more complete discussion of issues relating to foreign investment in the UnitedStates, see Joint Committee on Taxation, *Background and Issues Relating to the Taxation ofForeign Investment in the United States* (JCS-1-90), January 23, 1990. 
38.   Russell B. Scholl, "The International Investment Position of the United States in1988," *Survey of Current Business*, U.S. Department of Commerce, Bureau of EconomicAnalysis, June 1989, p. 43. 
39.   Russell B. Scholl, "The International Investment Position of the United States in1997," *Survey of Current Business*, 78, U.S. Department of Commerce, Bureau of EconomicAnalysis, July 1998 pp. 24-34. 
40. *Ibid*. 
41.   Some commentators also have observed that the statistical discrepancies in the tradedata are becoming large enough to question any conclusions which might be drawn from suchdata. See "Statistical Discrepancy" in Table 1 above. The distinction between book valuation andmarket valuation is only relevant for the category of investment labeled "direct investment," notfor "portfolio investment." The distinction between direct and portfolio investment is explainedin the text below. 
42.   Russell B. Scholl, "The International Investment Position of the United States in1994," *Survey of Current Business*, U.S. Department of Commerce, Bureau of EconomicAnalysis, June 1995, pp. 52-60, and Scholl, "The International Investment Position of the UnitedStates in 1997."
43.   If direct investments are measured at market value, foreign persons' portfolio holdingsare approximately 2.4 times greater than foreign persons' direct investments.  Scholl, "TheInternational Investment Position of the United States in 1997."
44.   Scholl, "The International Investment Position of the United States in 1994," andScholl, "The International Investment Position of the United States in 1997."
45.   The text envisions a system of residence taxation applied to enterprizes.  A pureresidence system would fully integrate corporate and individual income taxes and tax individualsbased upon their residence.
46.   The term "competitiveness" encompasses different concepts.  In the present context itmight be better labeled "multinational competitiveness."  Multinational competitiveness refers tothe competitiveness of certain types of firms or industries relative to other types of firms orindustries.  The term "competitiveness" also is used in the context of measuring the ability offirms located in the United States to sell their output in foreign markets and to compete indomestic markets with output produced in foreign countries.  In that context, competitivenessmight be better labeled "trade competitiveness."  Trade competitiveness often is measured by theU.S. trade deficit.  Competitiveness also is used to describe comparisons of the current U.S.living standard and the prospects for future U.S. living standards with those of other countries. This notion of competitiveness focuses on the productivity growth of U.S. labor and the savingrate of the United States, because both of these factors affect future living standards.
47.   Several authors provide a description of how deductions for foreign taxes maximizedomestic welfare of a capital-exporting country. See Richard E. Caves, *Multinational Enterprisesand Economic Analysis,* Cambridge, England: Cambridge University Press, 1982, pp. 229-231;and Peggy B. Musgrave, *United States Taxation of Foreign Investment Income: Issues andArguments*, Cambridge, Massachusetts: International Tax Program, Harvard Law School, 1969,p. 134.
48.   In the context of international trade, policies that attempt to promote domesticeconomic welfare at the expense of the rest of the world are referred to as "beggar-thy-neighbor"policies.
49.   For a discussion of the positive effects of outbound U.S. investment, see Council ofEconomic Advisers, *Economic Report of the President*, Washington, D.C.: U.S. GovernmentPrinting Office, February 1991, pp. 258-261. The discussion on outbound investment concludes(p. 259): "On a net basis, it is highly doubtful that U.S. direct investment abroad reduces U.S.exports or displaces U.S. jobs."  Empirical studies find either no effect or a positive effect ofoverseas production in a host-county market on home-country exports to that market.  Robert E.Lipsey reports that, on average, studies find one dollar of overseas production by U.S. affiliatesgenerates $0.16 of exports from the United States.  Robert E. Lipsey, "Outward DirectInvestment 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 ChicagoPress), 1995.  There is no definitive conclusion about the effect of outbound investment on U.S.employment.  Lipsey concludes, "[T]he evidence suggests that the effect of overseas productionon the home-country labor market involves the composition of a firm's home employment ratherthan the total amount.  That change in composition is mainly a shift toward more managerial andtechnical employment...."  *Ibid*. p. 31.  However, most of the evidence Lipsey reviews examinesindividual industries rather than aggregate economic effects.
50.   Internal Revenue Service, "Controlled Foreign Corporations, 1994," *Statistics ofIncome**Bulletin,*18, Summer 1998, pp. 109-130. 
51.   Robin A. Robison and Sarah E. Nutter, "Corporate Foreign Tax Credit, 1994:*"Statistics of Income Bulletin*, 18, Fall 1998, pp. 172-230. 
52.   This second benefit is in some degree limited by the less generous foreign tax creditcarryover periods (back 2 years and forward 5 years) as compared to the net operating losscarryover periods (back 2 years and forward 20 years). For example, when a U.S. source loss fora year in which foreign source income is earned renders the crediting of foreign tax paid ordeemed paid in that year unnecessary, the effect of the foreign income and taxes is to convert aloss, usable over the next 20 years, into a credit carryforward, usable only over the next 5 years.Thus, while deferral makes it possible for the taxpayer to choose the year in which the tax will bedeemed paid, the reduced carryforward period prevents the taxpayer from also enjoying theflexibility to use its excess credits over the full 20 years accorded to losses. 
53.   E.g., Tillinghast, "International Tax Simplification," 8 *American Journal of Tax Policy*187, 190 (1990).
54.   In this case, the only limitation would be that foreign tax credits cannot exceed U.S.tax liability.
55.   U.S. Treasury Department, *Tax Reform for Simplicity, Fairness, and EconomicGrowth,* Vol. 2, 1984, p. 361.
56.   For a discussion of the impact of treaties on the taxation of inbound investments seeJoint Committee on Taxation, *Background and Issues Relating to the Taxation of ForeignInvestment in the United States*(JCS-1-90), January 23, 1990, pp. 43-54.
57.   Arthur Young & Co., *The Competitive Burden: Tax Treatment of U.S. Multinationals*(1988).
58. *Double Taxation Convention with Pakistan: Hearing before the Senate Comm. onForeign Relations*, 85th Cong., 1st Sess., 1-32 (1954) (testimony of Professor Stanley Surrey)*.*
59.   Treasury Department News Release B-1703 (July 2, 1979). 
60.   The U.K. recently has made changes which affect the taxation of distributions fromU.K. resident companies.  These changes may affect the treaty benefits of U.S. investors.
61.   The text summarizes the laws of the United Kingdom, Germany, and Japan as in effecton January 1, 1999.
62.   The income of a U.K. resident, not ordinarily resident or domiciled in the UnitedKingdom, that is derived from a trade or profession carried on wholly outside the UnitedKingdom, is subject to U.K. tax only if such income is remitted to the United Kingdom.However, if the earnings of a foreign branch cannot be remitted to the United Kingdom as aresult of foreign restrictions, deferral of payment of U.K. tax on that income is allowed.
63.   The loss of deferral is accomplished by the Inland Revenue's treatment of the relevantearnings of the controlled foreign corporation as having been deemed distributed to itsU.K.-resident corporate shareholders, who are in turn subject to U.K. tax on the deemeddistributions. Individual shareholders are not subject to this anti-deferral regime.
64.   The direct foreign tax credit is also available to certain non-resident taxpayers forforeign source income attributable to a permanent business establishment located in Germany.
65.   The credit is available for certain investments made before 1981 or based on contractsmade at that time.
66.   The taxation of controlled foreign companies was introduced in 1972, in the ForeignTransactions Tax Act, based on the subpart F provisions of the U.S. Internal Revenue Code.
67.   Such tainted foreign investment income is taxable for resident German shareholdersbeginning in 1992.
68.   Prior to the 1992 tax law amendments, this ownership threshold was 10 percent. 
69.   Deemed-paid credits for second-tier foreign corporations have been allowed only sinceJapan's 1992 tax amendments.******