INTERNATIONAL ASPECTS OF CORPORATE-SHAREHOLDER 

TAX INTEGRATION 

George N. Carlson 

U.S. Treasury Department 

OTA Paper 40 July 1980 

OTA Papers are circulated so that the preliminary findings

of tax research conducted by staff members and others 

associated with the Office of Tax Analysis may reach a wider 

audience. The views expressed are those of the author, and 

do not reflect Treasury policy. Comments are invited, but 

OTA Papers should not be quoted without permission from the 

authors. Managing editors are Michael Kaufman and Gary

Robbins. 

Office of Tax Analysis 

U.S. Treasury Department, Room 1116 

Washington, D.C. 20220 

Issued: July 1980 
TABLE OF CONTENTS 

Page 

I. INTRODUCTION ................................... 1 

I1. PRESENT LAW .................................... 3 

I11 . PRINCIPLES OF U.S. INTERNATIONAL TAX POLICY .... 7 

IV. ANALYSIS ....................................... 10 

V . CONCLUSION ..................................... 22 

REFERENCES ..................................... 25 
ABSTRACT 

INTERNATIONAL ASPECTS OF CORPORATE-SHAREHOLDER 

TAX INTEGRATION* 

,George N. Carlson 

The integration of corporate and shareholder taxes has 

received considerable attention in recent years. Several major

trading partners of the United States, including Canada, France, 

Germany, Japan, and the United Kingdom, have integrated their tax 

structures by giving individual shareholders a credit for taxes 

paid at the corporate level on distributed corporate earnings.

Periodically, in response to a perceived inadequacy of capital

formation, integration also has aroused the interest of policy

makers in the United States. 

Most of the countries that have integrated their tax systems

allow individual shareholders a credit for taxes paid at the 

corporate level on distributed earnings. In effect, some of the 

taxes paid by the corporation are "imputed to," or treated as 

paid by, the shareholder. 

This form of integration, coupled with the flow of capital 

across international borders, gives rise to two important

international taxation issues: 

1. Whether nonresident shareholders are entitled to the 

credit far carparate taxes. 

2. Whether a resident taxpayer is entitled to the credit 

for foreign corporate taxes paid. 

The first issue pertains to whether the country adopting the 

integrated system will extend the credit to nonresident shareholders in domestic corporations. The second relates to whether 

a foreign corporate tax will be creditable against the domestic 

income tax in the shareholder's country of residence. 

This paper analyzes these issues with respect to three of the 

basic objectives of U.S. international tax policy: "capital export neutrality," nondiscrimination in the taxation of residents 

and nonresidents, and an equitable division of tax revenues 

between the source and residence jurisdictions. It suggests a 

mechanism for simultaneously achieving these objectives within 

the context of an integrated system. 

* I am indebted to Emil Sunley and James Rauch for their helpful comments and to Carole Garland for her efficient typing

of the manuscript. 
INTERNATIONAL ASPECTS OF CORPORATE-SHAREHOLDER 

TAX INTEGRATION * 

George N. Carlson ** 

I. INTRODUCTION 

The integration of corporate and shareholder taxes has 

received considerable attention in recent years. Several major

trading partners of the United States, including Canada, France, 

Germany, Japan, and the United Kingdom, have integrated their tax 

structures by giving individual shareholders a credit for taxes 

paid at the corporate level on distributed corporate earnings.

In response to a perceived inadequacy of capital formation, 

integration also has aroused the interest of policy makers in the 

United States. 

The Ford administration, for example, proposed dividend integration as part of its 1975 tax reform recommendations. 1/ The 

Task Force on Capital Formation of the House Committee Ways

and Means examined integration as part of its 1976 study of 

investment needs and incentives. 2/ The Treasury Department, in 

response to one of President Carter I s campaign pledges, looked 

closely at several methods for integrating the corporate and 

individual income taxes in developing the Administration's 1978 

L1/ Tax Reform, statement of William E. Simon, Secretary of the 

Treasury, Public Hearings before the Committee on Ways and 

Means, House of Representatives, 94th Congress, 1st Session, 

Part 5, pp. 3843-3863. 

2/ Tax Policy and Capital Formation, committee print, prepared

for Task Force on Capital Formation of the Committee on Ways

and Means by the Joint Committee on Taxation, April 4, 1977, 

pp. 9-17. 

* This article appeared in substantially the same form in the 

Case Western Reserve Journal of International Law, Vol. 11, 

no. 3, Summer 1979. 

** International Economist, Office of International Tax Affairs, 

U.S. Treasury Department. The opinions expressed are those 

of the author and not necessarily the views af the Treasury 

Department . 
tax reform proposals. Because of the complexity of the issues 

and the need for an immediate economic stimulus, the 

Administration decided not to propose an integration plan, but to 

rely on other forms of tax relief for business. 3/ Chairman 

Ullman of the Committee on Ways and Means proposed a partial

integration plan as an "important start toward making corporate 

finance more efficient and more responsive to the country's need 

for increased capital formation." 4/ The Congress, however, in 

passing the Revenue Act of 1978, opted for lower corporate rates 

and z more generous investment tax credit as the vehicle for J 

reduced taxation of capital. 

While there are a variety of methods (see, for example, Ault, 

1976; Chown, 1971; McLure, 1979) most of the countries that have 

integrated their tax systems allow individual shareholders a 

credit for taxes paid at the corporate level on distributed 

earnings. In effect, some of the taxes paid by the corporation 

are "imputed to", or treated as paid by, the shareholder. 

This form of integration, coupled with the flow of capital 

across international borders, gives rise to two important 

inter national taxation issues: 

1. Whether nonresident shareholders are entitled to the 

credit for corporate taxes. 

2. Whether a resident taxpayer is entitled to the credit 

for foreign corporate taxes paid. 

The first issue pertains to whether the country adopting the 

integrated system will extend the credit to nonresident shareholders in domestic corporations. The second relates to whether 

a foreign corporate tax will be creditable against the domestic 

income tax in the shareholder's country of residence. 

In Section IV of this paper these issues are analyzed with 

respect to three of the basic principles of U.S. international 

tax policy: "capital export neutrality," nondiscrimination in the 

-3/ See statement of Donald C. Lubick, Acting Assistant Secretary

of the Treasury for Tax Policy, "Integration of the Corporate

and Individual Income Tax," before the Committee on Ways and 

Means of the House of Representatives, April 7, 1978, 

'Treasury Department News Release, B-818. 

-4/ Congressional Record, February 2, 1978, pp. H640-H642. 
-3-

taxation of residents and nonresidents, and an equitable division 

of tax revenues between the source and residence jurisdictions.

Section I11 describes these principles. Section I1 reviews the 

taxation of corporations and shareholders under separate entity

and integrated tax systems. Conclusions are presented in 

Section V. 

11. PRESENT LAW 

Separate Entity System. With limited exceptions, the United 

States has a "classical" or separate entity system of taxation. -5/ A corporation is taxed an its earnings (as a separate entity)

and its shareholders are taxed again on distributed earnings.

Double taxation is reduced at the corporate level by allowing a 

U.S. corporation to deduct 85 percent or 100 percent, depending 

on the degree of affiliation, af dividends received from other 

U.S. corporations. 6/ Generally, earnings distributed to 

individual shareholaers are fully taxable. c7/ 

The present U.S. corporate tax rates are 17 percent on the 

first $25,000 of taxable income, 20 percent on all income in 

excess of $25,000 up to $50,000, 30 percent on all income in 

excess of $50,000 up to $75,000, 40 percent on all income in 

excess of $75,000 up to $100,000, and 46 percent on all income in 

excess of SlU0,OOO. 8/ Resident individuals are subject to tax 

on dividends at rates ranging from 14 percent to 70 percent. -9/ 

-S/ Subchapter S of the Internal Revenue Code is a notable exception. It permits a corporation with 15 or fewer shareholders 

to elect not to pay corporate tax on its income and instead 

have the shareholders pay taxes on the income, whether 

distributed or not. 

-

6/ Internal Revenue Code, Section 243.

-7/ Under the Internal Revenue Code Section 116, a shareholder is 

allowed to exclude $100 of dividends from taxable domestic 

corporations from his taxable income. Prior to 1964, the law 

provided for an exclusion from income of the first $50 of 

dividends received from domestic corporations as well as a 4 

percent credit against tax of dividends in excess of $50. 

-8/ Internal Revenue Code, Section 11. 

-!4/ Internal Revenue Code, Section 1. 
-4-

Nonresident alien individuals and foreign corporations are subject to a statutory withholding tax of 30 percent on dividend income not effectively connected with a U.S. trade or business. -

10/

The separate entity principle extends to U.S. shareholders in 

a foreign corporation. U.S. citizens, residents, and corporations are subject to U.S. taxation on their worldwide income. - U.S. shareholders in a 'foreign corporation, however, generally 

are taxable only on income received as dividends, not on income

retained by the foreign Corporation. Because the U.S. tax is 

deferred until the earnings of a foreign corporation are distributed to the U.S. shareholders, this consequence of a separate 

entity system is known as "deferral". 

IntegrLtion Systems. There are a variety of methods for 

integrating corporate and individual income taxes. Under full 

integration, which no country has adopted, all of a corporation's

income, whether distributed or not, would be taxable only to the 

shareholders. The corporation would be taxable as a partnership.

P'o guard against the shareholder being unable to pay the tax, the 

corporztion tax would probably be kept as a withholding device to 

be creditable against the shareholders' individual tax 

li&biiity. -11/ 

The countries that have integrated their tax structures have 

done so only with respect to distributed earnings. This is known 

as partial integration and can be accomplished by either (1) the 

split-rate or dividend deduction method or (2) an imputation or 

shareholder credit system. The former provides relief at the 

corporate level by taxing dividends at either a reduced or zero 

rate. Prior to 1976, for example, the German split-rate system

provided for a 51 percent tax on retained earnings and a 15 

percent tax on distributed earnings. 

The imputation or shareholder credit method of integration

has been adopted by Canada, France, and the United Kingdom. In 

contrast to the split-rate system, tax relief is provided at the 

-iu/ Internal Revenue Code, Sections 871 and 881. An income tax 

treaty between the United States and another country usually

provides a withholding rate on dividends reduced to 15 

percent or less. 

-11/ This was one of the recommendations of the Canadian Royal

Commission on Taxation, also known as the Carter Commission. 

See Canadian Royal Commission (1965) and Bucovetsky and Bird 

(1972). 

3 
-5-

shareholder level by allowing the shareholder a credit for part

(partial imputation) or all (full imputation) of the corporate 

taxes paid on distributed earnings. Some countries, such as 

Germany and Japan, have adopted a "hybrid" system with both a 

split-rate and shareholder credit. -12/ 

The dividend deduction and imputation systems are illustrated 

in examples 1 and 2. 

Example 1 

Dividend Deduction System 

Corporation Individual shareholder 

Tax rate 

Income $100 '20% 60 % 

Dividend 40 

Dividend deduction (50%) 20 Cash dividend $40 $40 

Taxable income $ 80 Tax 8 24 

Tax (50%) 40 After-tax cash flow 32 16 

After-tax income 60 Total (corporate plus

Retained earnings $20 shareholder) tax 48 64 

Dividend 40 

In example 1, the corporation is allowed to deduct 50 percent 

of dividends paid. Assuming a tax rate of 50 percent, it has a 

tax liability. of $40 and retained earnings of $20 after paying a 

dividend of $40. The shareholder's after-tax cash flow is $32 

and $16, assuming individual income tax rates of 20 percent and 

60 percent, respectively. 

-12/ For a detailed description of foreign integration systems see 

Ault and Radler (1976) , Chown (1971) , Gourevitch (1977) , NTA-TIA Symposium (1975), and Sato and Bird (1974). 
-6 -

Example 2 

Shareholder Imputation System 

Corporation Individual 

Income $100 Cash dividend 

Corporate tax 50 Gross up (1/3) 

After-tax income $ 50 Gross dividend 

Retained earnings $20 

Dividend 30 

This system allows the 

third of the dividend, for 

Tax 

Tax credit 

shareholder 

Tax rate 

20% 60% 

$30 $30 

10 10 

$40 $40 

8 24 

10 10 

paid corporate level. 

The shareholder ''grosses up" or increases the $30 cash dividend 

by the $10 in corporate tax claimed as a credit at the shareholder level. 13/ The shareholder is taxed on the "grossed up"

dividend, but is entitled to a credit of $10 for corporate taxes 

paid. The corporation's retained earnings and the individual 

shareholder's cash flow are the same as in Example 1. 

Thus, while the split-rate system nominally provides relief 

at the corporate level and the imputation system at the shareholder level, the two systems can be made equivalent, provided

the cash dividend is reduced under the imputation system. The 

lower cash dividend leaves the shareholder in the same after-tax 

position because he receives a tax credit with the dividend. 

After-tax corporate profits (dividends plus retained earnings) 

are higher under the dividend deduction system. 

I 

13/ It may seem odd to require the shareholder to include corporate taxes in his taxable income. This is necessary because 

the imputation system treats taxes paid at the corporate

level as paid by the shareholder, i.e., imputes them to the 

shareholder. This part of the corporate tax can be thought - of as a withholding tax, similar to wage withholding, against 

the shareholder's individual tax liability. It is included 

in the Shareholder's income, just as is the withholding tax 

on wages. # 

After-tax cash flow 32 16 

Total (corporate plus

shareholder) tax 48 64 

shareholder a credit, equal to onetaxes at the 

I 
-7-

111. PRINCIPLES OF U.S. INTERNATIONAL TAX POLICY 

. 

I 

Under either a separate entity or integrated tax system, the 

movement of capital across national boundaries gives rise to competing tax claims. The two basic jurisdictional standards for 

asserting tax liability are source and residence. E/ Under the 

source standard, a country asserts tax jurisdiction over income 

earned within its geographical area. It makes no difference who 

receives the income; residents and nonresidents are both taxed an 

income derived from within the source jurisdiction. %/ 

The residence of the taxpayer, rather than the source of 

income, is the relevant criterion under the residence principle.

Residence is usually defined in terms of domicile for individuals 

and place of incorporation or management for corporations.

Worldwide taxation is closely related to the residence principle

since a resident may be subject to taxation on income from all 

sources, foreign as well as domestic. 

Most countries have a combination of source and residence 

rules. U.S. citizens and residents, for example, are subject to 

U.S. taxation on their worldwide income, while nonresident 

foreign taxpayers are generally subject to U.S. taxation only on 

their U.S.-source income. 16/ The same income may be taxed twice 

if it is subject to taxation in both the source and residence 

jurisdictions. A foreign subsidiary of a U.S. corporation, for 

-14/ The United States also taxes on the basis of citizenship. 

-15/ Residents and nonresidents are not necessarily taxed the 

same. Sections 871 and 881 of the Internal Revenue Code, for 

example, impose a flat-rate tax of 30 percent on U.S.-source 

dividends, not effectively connected with a U.S. trade or 

business, received by nonresident alien individuals and 

foreign corporations. Although known as a "withholding" tax, 

the 30 percent tax does not represent a prepayment of domestic income tax, but a final tax payment that is a substitute 

for being taxed at the regular rates applied to resident 

individuals and corporations. 

-16/ Nonresident foreign taxpayers are subject to U.S. taxation 

at the normal rates on income "effectively connected" with 

a U.S. trade or business and to the basic 30 percent withholding tax on U.S.-source investment income, such as dividends, interest, and royalties. The 30 percent rate 

frequently is reduced by a tax treaty. 
-8-

example, normally will be subject to foreign tax on its earnings

in the source jurisdiction, and the subsidiary's dividends will 

be subject to U.S. taxation when received by the U.S. parent. 

The need to resolve this "international double taxation" has 

given rise to the following basic principles of U.S. international tax policy: capital export neutrality, nondiscrimination 

between residents and nonresidents, and a reasonable division of 

revenue between the source and residence countries. 

Capital Export Neutrality. This principle requires that an 

enterprise pay the same total taxation on its foreign as on its 

domestic profits. If, for example, a foreign subsidiary of a 

U.S. corporation is taxed in the foreign country at 40 percent,

capital export neutrality would require a current U.S. tax of 6 

percent on those profits. 17/ Capital export neutrality tends to 

maximize world output or efficiency by permitting investment 

decisions to be made independent of tax considerations on the 

basis of the most favorable before-tax rates of return. 18/ 

Capital is allocated optimally in that it is invested where, 

adjusted for risk, its return is greatest. 

The foreign tax credit is the cornerstone of the U.S. policy

of capital export neutrality. 19/ Foreign and domestic profits

of a U.S. corporation tend to taxed the same because taxes 

paid to a foreign country can be subtracted from the taxpayer's 

U.S. tax liability. The credit is available for income taxes paid 

on foreign branch earnings, withholding taxes on dividends from a 

-17/ This assumes a U.S. corporate tax rate of 46 percent. The 

effective U.S. rate on domestic profits is, however, less 

than this because of the investment tax credit and asset depreciation range, which are not available for foreign investment. Equal investment incentives relate, of course, to 

effective, not nominal, rates. 

An alternative criterion is the maximization of national, 

rather than world, income. This would be accomplished by

allowing a deduction, rather than a credit, for foreign 

taxes. Still another concept is captial import neutrality,

achieved when both foreign and domestic firms pay the same 

ultimate tax in the country in which they are operating. For 

a discussion and evaluation of these concepts, see Hufbauer 

(1975, pp. 1-6), and Musgrave (1972, pp. 176-219). 

-19/ The policy is more properly characterized as "modified" capital export neutrality, in that foreign taxes are creditable 

only up to the U.S. level and earnings of a foreign 

subsidiary are not taxed until repatriated as dividends. 
-9-

foreign corporation, 20/ and the corporate tax on the underlying

earnings out of whichthe dividends are paid, provided the U.S. 

taxpayer is a corporation that owns at least 10 percent of the 

foreign corporation. -21/ 

The credit is limited to the U.S. tax liability on the taxpayer's foreign source income. 22/ A taxpayer therefore pays the 

higher of the U.S. or foreign rate. If, for example, the U.S. 

rate is 46 percent and the foreign rate is 44 percent, the U.S. 

Treasury will collect 2 percent from the U.S. taxpayer. If, however, the foreign rate is 52 percent, the U.S. Treasury will 

neither collect revenue nor refund the 6 percent excess to the 

U.S. taxpayer. 23/ The purpose of the limit is to prevent

foreign taxes from reducing U.S. taxation of domestic source 

income. 

Nondiscrimination. This principle, which requires equal treahent for residents and nonresidents, is another tenet of 

U.S. international tax policy. A foreign branch or subsidiary of 

a U.S. corporation, for example, should not be subject to heavier 

taxation in the foreign country than a branch or subsidiary of a 

domestic corporation is taxed in that country. U.S. treaty

policy is aimed at assuring that U.S. investors are not subject 

to discriminatory tax treatment by a foreign country. U.S. 

statutory policy aims at nondiscriminatory U.S. taxation of 

-20/ Unlike a withholding tax on the wages of a resident, a dividend withholding tax is levied at a flat rate and is a final 

rather than provisional tax payment. Withholding taxes on 

dividends paid to nonresidents frequently are reduced to 10 

to 15 percent by treaty. 

-21/ Internal Revenue Code, Sections 901 and 902. 

-22/ Internal Revenue Code, Section 904. 

-23/ Prior to the Tax Reform Act of 1976, the foreign tax credit 

limitation could be determined on either a per-country or 

overall basis. The Act repealed the per-country limitation 

and requires all taxpayers to use the overall method. This 

method combines income from various sources, effectively

enabling an "averaging" of high and low foreign tax rates. 

If a taxpayer has foreign income that has been subject to a 

relatively low tax, it is possible the entire the 52 percent

foreign tax in the example would be creditable against the 

U.S. tax liability. 
-10 -

foreigners. While dividends from a foreign subsidiary are 

usually subject to a withholding tax in the foreign country, this 

is acknowledged to be an acceptable alternative to the inability

of the source country to subject a nonresident's entire income to 

its individual income tax system. 

Tax Revenue Division. The United States is also interested in 

an "equitable" or reasonable division of tax revenue between the 

source and residence countries. The foreign tax credit cedes the 

first slice of tax revenue to the source jurisdiction, leaving 

the residence jurisdiction with only residual taxing rights. The 

United States feels this is reasonable in that it is appropriate 

for the source jurisdiction to receive the major share of the 

revenue. 

IV. ANALYSIS 

Most of the countries that have integrated their tax systems

have chosen the shareholder imputation rather than the dividend 

deduction system. This reflects a desire to explicitly exclude 

nonresident shareholders from the benefits of integration by not 

extending the imputation credit to them. These countries are 

aware that the split-rate or dividend deduction system automatically extends the benefits of integration to nonresident shareholders through the reduced or zero rate applied to all dividend 

distributions. It would be possible to effectively deny the 

benefits of integration by levying an increased withholding tax 

on distributions to nonresidents, but existing treaties with 

provisions for reciprocal withholding rates generally would 

prohibit this. 

Imputation Credit to Nonresidents: Portfolio Investment. 

Larselv because of revenue considerations, imputation countries 

are-reiuctant to extend the integration tax credit to nonresident 

shareholders in domestic corporations. 24/ Separate entity countries, like the United States, argue that the principle of nondiscrimination demands its extension. Table 1, which assumes a 

separate entity system in the United States and a shareholder 

imputation or gross up and credit system in the foreign country, 

I24/ It has been extended by treaty. Under the January 1, 1970, 

protocol to the United States - France income tax treaty,

France extends the same shareholder credit to U.S. individuals and corporate portfolio investors in a French corporation that it provides French investors. A U.S. corporation 

that owns 10 percent or more of the shares of a French corporation, and is thus a direct, rather than portfolio, 

investor, is excluded from the scope of the protocol. 
U[.. .. , " P 

.. " 

01 I I mcOm W 

01 I I mrld W 

rl 0 

w 

LI 

a,

ccl 

5 

c 

5 

C 

ccl 

fn. 

(u

P 

m 

00 0 0 010 (3

om m m I 0 m 

* 

d rl rl 

C 

LI 

4-1 

rl . 

3 

a, m 

rl * 

H 

5 

a 

eel I. I. .I I. . a

-4 

U 

C 

" I- a, 

mm W LI e * I U 

0 1 3 I 

"I W 

* 

rl 

01 3 I 

"I LO 0 ri 

nJ 

0 

3 

rl 

a,

m 

3 

'A 

N 

. . .. .. .. .# 

G 

4-1 

a, c 

c 

m 

U 

(3

x 

c 

c 

C 

1 

-0 

.d 
-12-

provides a basis for evaluating these claims with respect to an 

individual shareholder's portfolio, or less than 10 percent

ownership, investment. 

Column 1 shows that a resident individual shareholder 

receiving a $100 dividend from a U.S. corporation and subject to 

an individual tax rate of one-third would have an after-tax cash 

flow of $66.67. A similarly situated resident individual in the 

imputation country would receive $100 according to column 2. The 

integration of the corporate and shareholder taxes in the foreign 

country accounts for the difference. 

Column 3 shows that a nonresident shareholder who does not 

receive the imputation credit also would receive an after-tax 

payment of $66.67. This would appear to fulfill the criterion of 

capital export neutrality and the revenue split (roughly $18 U.S. 

and $15 foreign) would seem to be reasonable. Denying the credit 

to a nonresident shareholder, however, violates the principle of 

nondiscrimination. The nonresident shareholder is subject to 

heavier taxation in the foreign country than is the resident 

shareholder because he receives a net dividend of only $85 ($100

cash less $15 withholding tax) whereas the resident shareholder 

receives a net dividend of $100. An important practical consequence is that the switch from a classical to an integrated 

system will probably mean a reduced after-tax cash flow for the 

foreign investor. In order to share in the benefits of integration, most corporations would probably reduce their cash 

dividends in response to the imputation system. Resident shareholders would still be likely to have an increased after-tax cash 

flow because of their entitlement to a tax credit. The nonresident shareholders, however, will be left with only the smaller 

cash d iv idend. 

Extending the credit to the nonresident shareholder, as shown 

in column 4, eliminates this discrimination. Both residents and 

nonresidents are taxable on a cash dividend of $100 plus a $50 

shareholder credit. -25/ This may, however, be inconsistent with

-25/ It is true that the nonresident shareholder is taxed at only 

a 15 percent withholding rate on a grossed-up dividend of . SlSU while the resident shareholder is taxed at an individual 

tax rate of 33-1/3 percent. A withholding tax on nonresidents, however, is the internationally accepted alternative 

to the taxation of resident individuals at the regular rates. 

It is not intended as a full or final tax, since only the 

country of residence can determine the "appropriate" tax burden by giving consideration to the taxpayer's total income, 

deductions, and exemptions. The withholding tax concept is 

-

not considered a departure from the nondiscrimination

principle. 
-13-

capital export neutrality, since the nonresident shareholder in a 

foreign corporation now receives an after-tax payment of $100, 

while the resident shareholder in a U.S. corporation receives 

only $66.67. One might respond that foreign and domestic profits

bear the same total individual tax rate (one-third) , but the 

total foreign dividend (cash plus tax credit) is larger because 

of the reduction in corporate tax inherent in the imputation 

system. Still, for a given cash dividend ($100) , the investor in 

the foreign corporation receives a larger after-tax cash flow 

than the investor in a U.S. corporation. 

The revenue division is altered greatly if the source country

extends the imputation credit to nonresidents, since it will be 

giving up all of the integrated portion of its corporate income 

tax with respect to dividends paid to non-residents. The source 

country is left with only the revenue from the unintegrated

portion of its corporate income tax. A country, such as Germany,

that has integrated its entire corporate tax on distributed 

earnings (full imputation, but not full integration) would, 

except for a withholding tax, collect no tax on dividends paid to 

nonresidents. This result might be reasonable if one views the 

German system, which gives a resident shareholder full credit 

against his individual tax liability for corporate taxes paid on 

dividend income, as totally eliminating the corporate tax on 

distributed earnings. 

Imputation Credit to Nonresidents: Direct Investment. The 

imputation countries are even more reluctant to extend the 

shareholder credit to nonresident direct investors. 26/ In 

addition to the obvious revenue considerations, theypoint out 

that the theory of an imputation system is to provide relief for 

corporate taxes with respect to distributions taxed at the 

individual level. Since a direct investor (at least 10 percent

ownership) normally will be a corporation, these countries feel 

there is little reason for providing corporate tax relief for 

distributions still in corporate solution. Moreover, as 

explained below, because of the operation of the indirect or 

deemed paid foreign tax credit, 27/ the benefits of extending the 

credit to direct investors frequently will go to the treasury of 

the residence country rather than to the shareholder. 

-

26/ The recent U.S.4.K. income tax treaty is a notable exception. That treaty would extend one-half of the U.K. imputa­ tion credit to U.S. direct investors in U.K. corporations. 

-

27/ The credit for foreign taxes paid on the corporate earnings

out of which the distributions are paid. 
-14-

From the viewpoint of separate entity countries, such as the 

United States, it is discriminatory to deny the credit to nonresidents. They observe that the imputation country has decided to 

reduce its level of corporate taxation on distributed earnings. 

Whether this is done through an imputation credit or a reduced 

rate on distributed earnings is immaterial; to tax residents and 

nonresidents differently violates the principle of nondiscrimination. Suppose, to illustrate the point, that a corporation

wholly owned by residents paid no corporate tax, but a corporation wholly owned by nonresidents paid a 50 percent corporate 

tax. The separate entity countries argue that this clearly would 

be discriminatory and that denying the imputation credit to 

nonresidents is also discriminatory. 

Table 2 provides a basis for evaluating these views. It 

assumes that the United States has a separate entity system of 

taxation and that the foreign country has partially integrated

its taxes via the imputation method. 

Column 1 shows that a U.S. resident individual receiving a 

$1~0dividend from a U.S. corporation and subject to an individual tax rate of one-third would have an after-tax cash flow of 

$66.67. The United States, of course, would collect the entire 

$133.33 in tax on the $200 in income earned at the corporate

level. According to column 2, a foreign resident individual 

investing in a foreign corporation would receive after-tax income 

of $80. Although the corporate tax rate is assumed to be higher

in the foreign country, the individual shareholder receives a 

higher after-tax payment because of integration. 

Columns 3 through 5 illustrate the position of a nonresident 

shareholder in a foreign corporation under differing treatment of 

the imputation credit. Since the foreign direct investor is 

assumed to be a corporation, a U.S. corporation is interposed 

between the foreign corporation and the U.S. resident individual 

Shareholder. 

If the imputation country does not extend the credit, the 

U.S. corporate shareholder receives a dividend of $80. Since the 

corporation's U.S. tax liability is offset by its foreign tax 
3000 f> 

moo 

co 

a 

rl 

0 

UI 

ra 

*.-i3 

U 

.d 

C 

C 

aLl a 

C U 3u \ 5 

NI I .. a 

uu Y c

C C .rl gJ 22 

a

U 

.rl 

LI L1 .A G

a 

'3 

5, 

C 

,3

. .... ,rl rn

. -IN 9%=f 3 
U 

.d 

C 

I c 

I 

Lc 

u 

aJ 

3 

I 

I 

'T 

I 

I 

4 c 
-17-

.1 

credit, 28/ the individual shareholder receives a dividend of $80 

on whichhe pays tax of $26.67, leaving an after tax income of 

$53.33. This may appear inconsistent with capital export neutrality, since the U.S. resident individual investing in a U.S. 

corporation receives $66.67. The $13.34 difference, however,

is attributable to the fact that the foreign corporate tax in 

excess of the U.S. corporate tax is not creditable for U.S. tax 

purposes. Nevertheless, if the credit were extended to nonresidents, this would facilitate capital export neutrality by

effectively lowering the foreign corporate tax rate. 

Although the resident and nonresident individuals receive the 

same before-tax cash dividend of $80, the after-tax cash flow of 

$53.33 received by the nonresident individual appears to be 

-28/ The U.S. tax liability is more than offset. The indirect or 

deemed paid foreign tax credit is equal to: 

dividend received foreign tax paid 

net earnings 

or 

c 8o x 120 = $120

80 

Assuming a U.S. corporate tax rate 

tive U.S. tax liability on the $200 

earnings is $100. The foreign tax 

however, to: 

foreign taxable income 

worldwide taxable income X 

or 

X 

of 50 percent, the tentain grossed-up foreign

credit is limited, 

tentative U.S. tax on 

worldwide income 

100 = $100 

The purpose of this limit is to prevent foreign taxes from 

reducing the U.S. tax otherwise due on domestic source 

income. The $20 excess credit is available, however, to 

offset U.S. taxes on foreign income that has been subject to 

relatively low taxation in a foreign country. 
-18-

discriminatory. The difference is that one country has integrated its tax system and the other country has not. Those 

arguing discriminatory tax treatment contend that this misses the 

point. The resident shareholder, they say, receives an imputation credit of $40 in addition to an $80 cash dividend, while the 

nonresident receives only an $80 cash dividend. -

Finally, there is the issue of revenue division. Through the 

foreign tax credit, the United States cedes the first slice of 

tax revenue to the source jurisdiction. This slice becomes the 

entire pie when foreign rates equal or exceed U.S. rates. The 

United States is left with only the tax collected from individual 

shareholders. Denying the credit to nonresidents preserves this 

arrangement, but it does so arguably by taxing nonresidents more 

heavily than residents. In effect, nonresidents are asked to 

finance part of the revenue cost of integration by bearing a 

heavier corporate tax in the imputation country. 

Columns 4 and 5 illustrate cases in which the imputation 

country extends 50 percent and 60 percent, respectively, of the 

credit to nonresident direct investors. A rationale for this 

limited extension, in addition to source country revenue considerations, might be that roughly one-half of corporate earnings 

are distributed to individual shareholders. Since the "theory"

of integration is to provide relief for only those earnings that 

pass out of corporate solution, one can argue it is appropriate 

to extend about one-half the credit to nonresident direct 

investors. 

If one-half the credit is extended, the U.S. corporation 

receives an $80 cash dividend from the foreign corporation and a 

$2U imputation credit from the foreign treasury. The credit is 

equivalent to a reduction in foreign corporate tax. Accordingly, 

the U.S. corporation's tentative U.S. tax liability of $100 is 

exactly offset by the foreign tax credit, and it distributes $100 

to its individual shareholders. A shareholder taxed at an individual rate of one-third would have $66.67 in after-tax income. 

Capital export neutrality is achieved because all foreign 

taxes are now creditable. There is still room for debate as to 

whether the nonresident shareholder is taxed more heavily than . the resident shareholder in the imputation country. The arguments are the same as recited above and need not be reiterated 

except to note that since the position of the shareholder has 

improved, any discrimination has been reduced. Because of the 

effective reduction in foreign taxes, the revenue division is 

slightly more favorable to the United States. Still, the United 

States collects no corporate tax on foreign earnings. 
-19-

The case in which the nonresident's share of the credit is 

increased to 60 percent of the resident credit deserves special

mention. The effective foreign corporate rate, allowing for the 

imputation credit, now falls below the U.S. corporate rate. The 

dividend to the individual shareholder, however, cannot be more 

than $100 because the United States will always collect the 

residual corporate tax. 29/ The imputation countries tend to 

focus on this point. Thecombined impact in the residence

i country, they note, of residual corporate taxation and no relief 

at the shareholder level, means that a nonresident can never be 

made "whole" with a resident. 

Separate entity countries respond that how they tax their 

residents is not the proper concern of the source country. Nondiscrimination means equal tax treatment of residents and 

nonresidents in the source country. Accordingly, nonresidents 

should receive the same imputation credit as residents. The fact 

that it may end up in the coffers of the other country's 

treasury, rather than in the shareholder's pocket, is a choice 

properly left to the residence country. 

The 60 percent credit also allows all foreign taxes to be 

credited and thus comports with capital export neutrality. The 

full benefit of the larger credit, however, goes to the U.S. 

Treasury. The shareholder receives the same after-tax income. 

Under these conditions, it is understandable why imputation countries are reluctant to extend the credit to nonresidents. 

While a capital-importing country may be willing to extend the 

credit to nonresidents in anticipation of attracting more 

investment, that anticipation will be frustrated if the benefits 

of extending the credit go to the foreign treasury, rather than 

the foreign shareholder. 

Integration of Foreign Corporate and Domestic Individual 

-

Taxes. In addition to deciding whether nonresidents will

receive the shareholder credit, imputation countries must decide 

whether foreign corporate taxes wiil be integrated with the 

domestic individual income tax in the shareholder's country of 

residence. Will a resident portfolio shareholder in a foreign

corporation, for example, be entitled to a credit for foreign 

corporate taxes in the same way the individual investing in a 

domestic corporation receives a credit for domestic corporate

taxes? Or, will an individual receive a credit for domestic 

I 

-29/ The excess, if any, of the U.S. over the foreign rate.