MEASURING A COMPANY’S 

FOREIGN TAX CREDIT POSITION 

by 

Henry Louie and Gerald Silverstein 

Office of Tax Analysis, U.S. Department of Treasury 

and 

Donald J. Rousslang 

Hawaii State Department of Taxation 

OTA Paper 97 October 2006 

OTA Papers is an occasional series of reports on the research, models, and data sets 

developed to inform and improve Treasury’s tax policy analysis. The papers are works in 

progress and subject to revision. Views and opinions expressed are those of the authors 

and do not necessarily represent official Treasury positions or policy. OTA Papers are 

distributed in order to document OTA analytic methods and data and invite discussion 

and suggestions for revision and improvement. Comments are welcome and should be 

directed to the authors. 

Office of Tax Analysis 

Department of the Treasury 

Washington, DC 20220 

The authors thank Charles Boynton, Harry Grubert, Don Kiefer and William Randolph 

for helpful comments and discussion. The views expressed in this paper are those of the 

authors and do not necessarily reflect the views of the Treasury Department. 
MEASURING A COMPANY’S 

FOREIGN TAX CREDIT POSITION 

by 

Henry Louie and Gerald Silverstein 

Office of Tax Analysis, U.S. Department of Treasury 

and 

Donald J. Rousslang 

Hawaii State Department of Taxation 

OTA Paper 97 October 2006 

OTA Papers is an occasional series of reports on the research, models, and data sets 

developed to inform and improve Treasury’s tax policy analysis. The papers are works in 

progress and subject to revision. Views and opinions expressed are those of the authors 

and do not necessarily represent official Treasury positions or policy. OTA Papers are 

distributed in order to document OTA analytic methods and data and invite discussion 

and suggestions for revision and improvement. Comments are welcome and should be 

directed to the authors. 

Office of Tax Analysis 

Department of the Treasury 

Washington, DC 20220 

The authors thank Charles Boynton, Harry Grubert, Don Kiefer and William Randolph 

for helpful comments and discussion. The views expressed in this paper are those of the 

authors and do not necessarily reflect the views of the Treasury Department. 
 Abstract 

A number of authors have tried to discover how the residual U.S. tax on foreign 

corporate earnings (the U.S. tax after the foreign tax credit) affects business decisions. 

Some of them inferred the residual tax from data in the company’s financial statement, 

whereas others used the residual tax reported in the company's income tax return. In the 

present study, we point out problems with both approaches. For instance, we show that 

in many cases, the two approaches yield different results for the same firm. We then 

compare the generally accepted measures of the residual tax with a third measure that, at 

least conceptually, should reliably reveal whether the company anticipates owing a 

residual tax for the year, after accounting for its ability to carry unused foreign tax credits 

over to prior or future years. We find that this third measure does not accord well with 

the commonly used measures of the company’s foreign tax credit position. We believe 

that our results, therefore, draw into question the conclusions of the earlier studies that 

tried to capture the incentives imparted by the residual U.S. tax. 

2
 
Table of Contents 

Introduction................................................................................................................................... 4
 

The U.S. Rules for Taxing Foreign Earnings ............................................................................. 6
 

Problems Encountered When Inferring the Company’s Foreign Tax Credit Position 
 

from Its Financial Statement ....................................................................................................... 9
 

Differences Between FSI and Foreign Income as Reported in the Financial Statement............ 9 
 

Differences between Creditable Foreign Taxes Reported on Tax Returns and Foreign 
 

Income Taxes Reported in Financial Statements...................................................................... 12 
 

Other Problems in Inferring Foreign Tax Credit Positions from Financial Statement 
 

Data........................................................................................................................................... 13 
 

Measuring the Final Foreign Tax Credit Position and Inferring the Anticipated
 

Final Position............................................................................................................................... 14
 

The Data....................................................................................................................................... 17
 

Foreign Income and Foreign Taxes as Reported in Financial Statements .............................. 17 
 

Foreign Tax Credits and FSI Reported for the General Basket on the Tax Returns................ 17 
 

The Results .................................................................................................................................. 18
 

Constructing the Samples of Companies .................................................................................. 18 
 

Comparing the Average Effective Tax Rates Calculated from the Financial Statements 
 

With Those Calculated From the Tax Returns for the General Basket .................................... 18 
 

Using Discreet Variables to Predict the Anticipated Final Foreign Tax Credit 
 

Positions.................................................................................................................................... 21 
 

Summary and Conclusions......................................................................................................... 23 
 

References.................................................................................................................................... 25
 

Table of Figures 

Table 1: Average Effective Tax Rates for Various Samples of U.S. Manufacturers .................. 27 
 

Table 2: Reconciling Income and Taxes as Reported on Tax Returns and in Financial 
 

Statements for the Companies in Sample 3 .......................................................................... 28 
 

Table 3: The Frequency of Agreement Between the Foreign Tax Credit Position as 
 

Reported on Tax Returns and as Inferred from Financial Statements .................................. 29 
 

Table 4: The Requency with which Companies Switch Foreign Tax Credit Positions: 
 

1992 to 1997 ......................................................................................................................... 30 
 

Table 5: Frequency of an Agreement Between the Anticipated Final Foreign Tax Credit 
 

Position as Inferred from the Use of Export Tax Breaks and Various other 
 

Candidates that Might be Used to Infer the Anticipated Final Position ............................... 31 
 

Table 6: Continuous Variable Candidates for Determining the Anticipated Final Position........ 32 
 

3
 
1 

Introduction 

A number of authors have tried to discover how the residual U.S. tax on foreign 

earnings of U.S. corporations – the U.S. tax after the credit for foreign income taxes – 

influences business decisions (Mutti, 1981; Hines and Hubbard, 1990; Altshuler and 

Newlon, 1993; Altshuler, Newlon and Randolph, 1995; Froot and Hines, 1995; Hines, 

1996; Collins, Kemsley and Lang, 1998; and Kemsley, 1998, among others).1

 Some of 

them relied on information reported in financial statements to infer the residual tax, while 

others looked at the actual corporate income tax returns.2

 All of them used a dummy 

variable to represent the foreign tax credit position (i.e., whether or not the company 

owed a residual tax). In the present paper we show how the residual taxes that are 

inferred from the financial statements differ from those taken from the tax returns. We 

also show that the dummy variables used in the earlier studies differ systematically from 

a variable that should, logically, best represent the incentives imparted by the residual 

tax. To make clear the limitations of the study from the outset, we do not try to 

determine the biases that might be present in the earlier studies. 

The obvious problem with using data from financial statements to infer the 

 Mutti (1981), Hines and Hubbard (1990), Altshuler and Newlon (1993), and Altshuler, Newlon and 

Randolph (1995) sought to explain dividend repatriation behavior. Froot and Hines (1995) estimated the 

effect of U.S. interest allocation rules on borrowing and new investment of U.S. companies. Hines (1996) 

estimated how after-tax foreign earnings affect the company’s dividend payout rate. Collins, Kemsley and 

Lang (1998) sought to explain how U.S. companies respond to tax incentives to shift income between 

affiliates in different countries. Kemsley (1998) sought to explain how the U.S. sales source rules affect a 

company’s decision whether to locate new production in the United States or abroad. All of the studies 

used a variable for the residual U.S. tax in their regressions. 

2 Mutti (1981), Hines and Hubbard (1990), Altshuler and Newlon (1993), and Altshuler, Newlon and 

Randolph (1995) used tax return data, whereas Froot and Hines (1995), Hines (1996), Collins, Kemsley and 

Lang (1998), and Kemsley (1998) used data from financial statements. 

4
 
residual tax is that the foreign income and taxes on the financial statement are not the 

same, even conceptually, as the foreign income and taxes that determine the company’s 

residual U.S. tax. But even the foreign tax credit position actually reported on the tax 

return may be a poor guide to the incentives being imparted by the residual tax. This is 

true, because excess foreign tax credits can be carried forward or back to other years.3 To 

the extent that the residual tax influences business decisions, it is the final foreign tax 

credit position for the year that matters, not the current-year position. But this final 

position is not known until carry-overs are exhausted.4 

If one is trying to discover the effect of the residual tax on a business decision 

such as a repatriation of income from a foreign subsidiary, the best variable to use is one 

that reflects the final position as it is anticipated by the company when the decision is 

made. In this paper, we devise a variable that logically should reveal the final foreign tax 

credit position the company anticipates having for the year. The variable is gleaned from 

the company’s tax planning behavior; namely, how the company chooses between two 

tax provisions for U.S. export profits, the sales source rules (sections 863(b) and 

862(a)(6) of the Internal Revenue Code) and Foreign Sales Corporations (FSCs). Of 

course, this variable is available only for companies that export goods from the United 

States and only for those few years that data on FSC operations are available,5

 so it is not 

3

 The American Jobs Creation Act of 2004 changed the rules for credit carryovers. Under the new rules, 

excess foreign tax credits can be carried back one year and carried forward for ten years. Our data predate 

the new rules. During the period of our analysis, excess foreign tax credits could be carried forward for 

only five years or back for two years. 

4

 As will be explained later, the final position for the year may not be known, even well after the period in 

which excess foreign tax credits from the year can be carried forward. 

5

 Data on FSC operations are available for the fiscal years 1985 through 1987, 1992, 1996, and 2000. The 

5
 
always a viable alternative for researchers studying the effects of the residual tax. 

Nevertheless, it is a useful tool to assess the other variables as measures of the company’s 

foreign tax credit position. 

This paper is organized as follows: the next section summarizes briefly the U.S. 

rules for taxing foreign earnings of U.S. companies. The third section describes the 

financial statement data on foreign earnings and foreign taxes and shows how they differ 

from foreign income and creditable foreign taxes that the company reports on its tax 

return. The fourth section describes our method for inferring the company's final 

anticipated position. The fifth section describes the data and presents our results. The 

last section contains a summary and conclusions. 

The U.S. Rules for Taxing Foreign Earnings 

The United States taxes the worldwide income of U.S. multinational companies, 

but allows them to defer the tax on earnings of their foreign subsidiaries until the 

earnings are repatriated. Income from a company’s foreign operations that is subject to 

U.S. tax in the current year is called foreign-source income (FSI) and is reported on Form 

1118 (Foreign Tax Credit – Corporations) of the U.S. parent’s tax return. FSI consists 

mainly of the following items: dividends received from foreign subsidiaries, measured 

gross of foreign withholding taxes; foreign income taxes deemed paid on the earnings 

FSC program has been eliminated, so no new data on its operations are forthcoming. The corporate income 

tax return (Form 1120) contained an entry for dividends from a FSC or former FSC, but the FSC income 

did not always show up as dividends to the parent company in the year it was earned. The corporate form 

filed to claim a foreign tax credit (Form 1118) has a category for income from a FSC or prior FSC, but the 

basket contains only a special kind of FSC income. 

6 
that underlie these dividends, or the “gross-up” for foreign income taxes;6

 foreign-source 

interest income; rents and royalties received for exports of technology and other services; 

income earned by foreign branches; and profits from U.S. goods exports that are treated 

as foreign source income under the sales source rules (described in more detail below). 

The U.S. parent must also pay current U.S. tax on certain income of controlled foreign 

corporations (CFCs)7 under subpart F of the Internal Revenue Code, whether or not the 

income is actually repatriated. For the most part, subpart F prevents companies from 

deferring the U.S. tax on income from investments that are highly mobile and therefore 

easy to locate in low-tax jurisdictions, such as investments in financial assets and 

international shipping. Finally, taxpayers must deduct certain domestic expenses from 

FSI including some of their domestic interest expenses, some of their domestic research 

and development expenses, and some of their home-office overhead expenses. 

As part of its system of worldwide taxation, the United States allows a credit for 

foreign taxes, which can be subtracted from the latent U.S. tax. The foreign tax credit 

equals the foreign income taxes paid on the foreign earnings underlying the FSI plus 

foreign withholding taxes, or the U.S. tax rate times the FSI, whichever is less. FSI is 

assigned to a “basket,” based on the type of income. The U.S. tax liability and foreign tax 

6 When the U.S. parent owns 10 percent or more of the stock of a foreign subsidiary, it grosses up the 

dividends it receives from the subsidiary to get the underlying foreign earnings before foreign income 

taxes. The foreign earnings are defined according to U.S. tax principles and may bear little resemblance to 

the taxable income as defined by the host country. The foreign earnings generally are close to the standard 

accounting definition of income (“book” income), especially when the foreign activity is manufacturing. 

 A CFC is a foreign corporation in which U.S. shareholders, each of whom owns 10 percent or more of 

the corporation’s stock, collectively own more than 50 percent of the corporation’s stock. 

7
 

7 
credit are calculated separately for each basket. The baskets have been modified by 

recent legislation,8

 but for the period covered by our data, the main baskets were for 

passive income (portfolio dividends, interest, rents and royalties from unrelated parties 

abroad or from non-controlled foreign corporations), financial services income, 

international shipping income, and general limitation income (income from a foreign 

affiliate in an active trade or business that is not included in one of the other baskets). 

Other baskets were for dividends from so-called “section 902” corporations (foreign 

subsidiaries in which the U.S. parent owns between 10 percent and 50 percent of the 

equity), for income from foreign subsidiaries engaged in international shipping, for 

interest income on which foreign withholding tax has been paid at a rate of 5 percent or 

more, for dividends from a FSC or former FSC, for income from foreign trading 

companies, and for dividends from a Domestic International Sales Corporation (DISC) or 

former DISC.9

 There was a separate basket for each section 902 corporation, but all of 

the company’s FSI from majority-owned foreign subsidiaries, and the attendant foreign 

taxes, were lumped together within each of the other baskets. 

If the interest, rents or royalties were received from a CFC, the U.S. parent was 

allowed to “look through” to the activity that generates the income, so these payments 

were put into the same basket as the dividends the parent received from the CFC. For 

example, if the U.S. parent financed a CFC’s operations partly with an equity investment 

and partly with a loan, and if the CFC earned income only from manufacturing activities, 

 The American Jobs Creation Act of 2004 reduced the number of baskets from nine to two. Under the 

new law, all FSI, except for passive income which retains its own basket, is placed into the general basket. 

9 The DISC, a special tax provision for U.S. export profits, was replaced by the FSC program in 1985. 

8 

8 
then both the dividends and the interest that the parent receives from the CFC went into 

the basket for general limitation income (the “general” basket). The general basket 

accounts for the lion’s share of the FSI earned by U.S. manufacturing companies; for 

example, in 1992 and 1996 (the sample years for the quantitative analysis that follows), 

this basket contained on average 94 percent of the FSI of these companies. Under 

the old rules, it was possible for a company to have many foreign tax credit baskets, and 

to have a different credit position in each basket. For example, a U.S. parent with foreign 

subsidiaries in manufacturing and financial services could have had excess foreign tax 

credits in the general basket and at the same time owe a residual U.S. tax on FSI in the 

financial services basket. 

Since 1987, the U.S. parent has had to pool earnings and income taxes across 

years for each foreign subsidiary. When dividends are paid from the pool to the U.S. 

parent, the foreign taxes attached to the dividends are calculated by taking the ratio of the 

dividends to the pooled earnings and multiplying it times the foreign income taxes in the 

pool. 

Problems Encountered When Inferring the Company’s Foreign Tax Credit Position 

from Its Financial Statement 

Differences between FSI and Foreign Income as Reported in the Financial Statement 

Foreign income reported in the company’s financial statement consists of pre-tax 

foreign earnings of its majority-owned affiliates with a deduction for minority interest, 

plus after-tax income from its minority-owned foreign subsidiaries. There are several 

major differences between foreign income and FSI. One is that interest, rents and 

9
 
royalties from a foreign subsidiary are part of the U.S. parent company’s FSI, but they are 

expenses of the subsidiary so they are not reported as income in the parent’s consolidated 

financial statement. A second major difference is that the sales source rules for U.S. 

exports allow the U.S. parent to include some of the income from U.S. exports in FSI, 

whereas little, if any, of this income is included in foreign income in financial statements. 

A third major difference arises from differences in timing between when foreign income 

is earned and when it is included in FSI: The financial statement includes all foreign 

earnings, whether or not they are repatriated to the U.S. parent, whereas FSI includes the 

earnings of foreign subsidiaries only when they are repatriated by the U.S. parent, or are 

deemed to have been repatriated under subpart F (although FSI does include income of 

foreign branches). Also, FSI can include dividends paid from income earned by its 

foreign subsidiaries in a prior year and retained abroad. A fourth major difference is that 

FSI excludes losses of foreign subsidiaries, whereas such losses automatically reduce net 

foreign earnings reported in financial statements. A fifth major difference is that the 

domestic expenses allocated to FSI are not deducted from foreign income in financial 

statements. 

The above-listed differences are potentially important. For example, in 1992 and 

1996 interest, rents and royalties, and gross export income included in FSI under the sales 

source rules accounted, on average, for 35 percent of gross FSI of all U.S. manufacturing 

companies. In those years, profitable CFCs of U.S. manufacturing parents averaged more 

than $71.6 billion per year in earnings after foreign taxes, but the unprofitable CFCs of 

these same parents averaged annual losses of $12.8 billion and the dividends from the 

10
 
CFCs averaged only $27.1 billion per year, including deemed dividends under subpart F. 

Domestic expenses allocated to FSI averaged $43.6 billion, or 36 percent of gross FSI. 

There are also a number of other (less important) differences between FSI and 

foreign income as reported in financial statements. In the period of our data, income 

from U.S. exports deemed earned by a FSC was included in FSI if the FSC paid a 

dividend to the U.S. parent, but the FSC income usually did not appear as part of foreign 

income in financial statements. FSI in the passive income basket includes rents or 

royalties, or interest on loans that comes from unrelated parties or from minority-owned 

foreign subsidiaries, but such income is not included in foreign income reported in 

financial statements. FSI in the section 902 baskets includes the gross-up for foreign 

corporate income taxes attached to the dividends from minority-owned foreign 

subsidiaries, but excludes the earnings that were not repatriated, whereas the foreign 

income reported in financial statements includes the parent’s share of all after-tax 

earnings of the minority-owned foreign subsidiaries. 

Another potential source of difference between foreign earnings and FSI may lie 

in the divergent consolidation rules under Generally Accepted Accounting Principles 

(GAAP) and U.S. tax rules. In general terms, the GAAP consolidation rules are 

significantly more inclusive than their tax equivalent. For instance, the consolidated 

financial group encompasses all of the company’s greater-than-50-percent-owned 

subsidiaries, both domestic and foreign, with a deduction for minority interests. For 

subsidiaries that are 20-50 percent controlled, a pro-rata share is included under the 

11
 
equity method of accounting. If the company owns less than 20 percent of the subsidiary, 

only dividends from that subsidiary are included in the consolidated group’s income. 

This contrasts with the rules for tax consolidation, which allow only those 

domestic subsidiaries of which the U.S. parent owns at least 80 percent to be consolidated 

onto the parent’s tax return. No deductions are permitted to account for minority 

interests. These disparities will necessarily create differences between foreign income 

and FSI for any group other than a U.S. parent and its wholly-owned domestic subsidiary 

with no foreign operations or holdings, or a U.S. parent with only portfolio holdings in a 

foreign company10. 

The divergent definitions of the consolidated group result in asymmetrical 

computations of foreign earnings. First, the tax consolidated group omits all FSI and 

foreign losses of 50-80-percent owned domestic subsidiaries, whereas these are reflected 

in the foreign earnings of the financial consolidated group. Second, the U.S. parent is 

never allowed to use losses in a foreign subsidiary to offset income on its U.S. tax return, 

whereas the foreign subsidiary losses are included on the consolidated financial 

statement. It follows that foreign loss-subsidiaries will in all cases drive book FSI down 

relative to taxable FSI. 

Differences between Creditable Foreign Taxes Reported on Tax Returns and Foreign 

Income Taxes Reported in Financial Statements 

Foreign income taxes associated with foreign earnings retained abroad are not 

reported on the company’s U.S. tax return, but they are part of foreign taxes included in 

In the second hypothetical structure, both the tax- and book-consolidated groups would include only 

dividends (without a gross-up) and no losses from the foreign company. 

12
 

10 
its financial statement. However, the foreign income taxes reported on the tax return may 

differ from those in the financial statement, even if the company repatriates exactly the 

same amount as its foreign earnings for the year. One reason is that the foreign income 

taxes that accompany dividends from a subsidiary on the tax return are calculated using 

the average rate of foreign tax on the subsidiary’s pool of post-1986 earnings from which 

the dividends were drawn, so the associated creditable taxes may not be the same as the 

foreign income tax paid in the current year. Another reason is that income taxes paid by 

minority-owned foreign subsidiaries are not included in the foreign taxes in financial 

statements, but the creditable foreign taxes associated with dividends in the 902 baskets 

are included on tax returns. Finally, there may be discrepancies between the definition of 

income taxes used for the financial statements and creditable foreign taxes (defined in 

section 901 of the IRC). 

Other Problems in Inferring Foreign Tax Credit Positions from Financial Statement 

Data 

An important problem in determining foreign tax credit positions from financial 

statements is that the financial statements do not break down the foreign income and 

foreign taxes according to the separate limitation baskets. The lack of basket detail in the 

financial statements reduces their usefulness for inferring foreign tax credit positions. 

For example, although the bulk of FSI for U.S. parent companies in manufacturing goes 

into the general basket, some of these companies have sizable FSI in the financial 

services basket. Also, the financial statements do not show excess foreign tax credits 

carried forward or back, nor do they show whether the company was subject to the 

13
 
Alternative Minimum Tax (AMT). Under the laws in effect during the years covered by 

our data, the AMT often reduced the amount of foreign tax credits the company may 

claim.11 

Measuring the Final Foreign Tax Credit Position and Inferring the Anticipated 

Final Position 

We consider the company’s final foreign tax credit position for the year to be one 

of excess credit if the company would not have benefited from being given an extra 

dollar of foreign tax credits that year, after accounting for its ability to carry excess 

foreign tax credits over to prior or future years. This final position cannot be measured in 

all cases, even with a complete time series of data that covers the carry-over years. For 

example, suppose that in 1997 a company finally would have been able to absorb an extra 

dollar of foreign tax credits given to it in 1992 (just before they expired), but that this 

would have reduced the amount of foreign tax credits that it would otherwise have carried 

back from 1998. Whether or not the company would suffer from the reduction in carrybacks depends on whether or not it would be able to absorb the excess credits it held in 

1998 before they expired in 2003, which, in turn, may depend on its carry-backs from 

2004, and so forth into the indefinite future. 

Despite the problems in measuring the final foreign tax credit position, if the 

company exports goods from the United States, we can, in some years, infer from its tax 

return whether it anticipated having excess foreign tax credits for the year after carry-

 This rule was repealed as part of The American Jobs Creation Act of 2004. For an explanation of how 

the AMT affected a company’s foreign tax credit position, see Lyon and Silverstein (1995). 

14
 

11 
overs. This opportunity arises owing to the interaction of the sales source rules for U.S. 

export income and the Foreign Sales Corporation (FSC) program.12 The sales source 

rules allow a company with excess foreign tax credits to reduce by 50 percent the 

effective rate of U.S. tax on its export income by deeming up to 50 percent of its export 

profits as being FSI. Companies with excess credits have an incentive to increase their 

ratio of FSI to worldwide income in this way, because doing so raises the amount of 

foreign tax credits they may utilize that year. 

The FSC program typically allowed the company to exempt 15 percent of its 

export income from U.S. tax. If the company used a FSC for the exports, however, then 

it could use the sales source rules to apply foreign tax credits to only 25 percent of the 

export income. Used together, the FSC and the sales source rules typically reduced the 

U.S. tax on a company’s U.S. export profits by about 40 percent, whereas if the company 

applied the sales source rules without using a FSC for the exports, it could reduce the tax 

on the export profits by 50 percent if it had sufficient excess foreign tax credits. 

Stated another way, if the company had excess foreign tax credits that it expected 

to expire unused, the tax on its export profits would have been 10 percent higher if it had 

used a FSC for the exports instead of relying exclusively on the sales source rules. On 

the other hand, if the company anticipated having no unused foreign tax credits, it would 

have saved 15 percent in taxes on the export profits by using a FSC. Thus, we can infer 

whether the company anticipated having excess foreign tax credits, after carry-overs, 

 For a more detailed explanation of the FSC program, see U.S. Department of the Treasury (1997). A 

detailed description of the operation of the sales source rules is provided in U.S. Department of the 

Treasury (1992). Rousslang (1994) describes the interaction between these programs. 

15
 

12 
13 

merely by looking to see whether it used a FSC for its exports. In fact, if the company 

used a FSC for any of its exports, we can infer that it anticipated paying a residual U.S. 

tax and therefore its anticipated final position for the year was one of excess limit. For 

example, a company with excess foreign tax credits in a given year would have used a 

FSC for some of its exports only if, after applying the sales source rules and after 

allowing for carry-overs and for the interaction of the FSC and sales source rules, it 

anticipated being in final excess limit for the year. Also, a company in excess limit in a 

given year would have chosen to forgo using a FSC, and therefore to rely exclusively on 

the sales source rules for its export tax saving, only if it had expected to be able to carry 

back sufficient excess foreign tax credits from the ensuing two years.13 

It seems safe to presume that if companies respond to tax incentives at all, they 

would have efficiently utilized the two special tax provisions for profits from U.S. 

exports, because doing so requires little effort beyond making the appropriate accounting 

entries. 14 

It is possible that the current foreign tax credit position will be artificially perversely correlated with our 

measure of the anticipated final position. This is true, because booking exports through a FSC reduces the 

amount of foreign tax credits that the company can claim by using the sales source rules. For instance, if 

the company anticipated having excess limit positions in future years, it may have used a FSC for some of 

its exports in the current year, even if this created more excess foreign tax credits in the year. To account 

for this effect, we constructed an alternative measure for the company’s foreign tax credit position before 

the increase in FSI created with the sales source rules. This alternative measure is unaltered by the 

company’s FSC usage. 

14 The cost of establishing and operating a FSC was minimal, but use of a FSC required that the title to 

goods be passed abroad. The exporter could arrange to pass title abroad using nothing more than 

bookkeeping entries. There seldom were adverse U.S. tax consequences of passing title abroad, and 

companies could decide whether to book exports through a FSC at the end of the accounting period 

16
 
The Data 

Foreign Income and Foreign Taxes as Reported in Financial Statements 

The foreign income reported in the company’s financial statement is given by the 

Compustat variable “Pre-Tax Income – Foreign” (PIFO, or annual data item A273) and 

the foreign corporate income taxes are given by the Compustat variable “Income Taxes – 

Foreign” (TXFO, or annual data item A64). To infer the company’s foreign tax credit 

position, we followed the standard procedure that was adopted in previous studies,15 

namely, we compared the rate of foreign taxes (foreign taxes divided by foreign earnings) 

to the U.S. statutory tax rate on corporate income. The company was deemed to be in 

excess credit if the rate of foreign taxes was higher than the statutory U.S. rate, and if it 

was lower the company was deemed to be in excess limit. 

Foreign Tax Credits and FSI Reported for the General Basket on the Tax Returns 

Because the general basket contains almost all (94 percent) of the FSI for 

manufacturing companies, we use only information from that basket for our analysis. 

The manufacturing company’s FSI and the associated creditable foreign taxes in the 

general basket are given on lines 6 and 5, respectively, of Schedule B, Part II, Form 1118. 

Line 5 gives the total of creditable foreign taxes, including tax credits carried over from 

prior years. The carry-overs are given separately on line 4. The company has excess 

foreign tax credits in the current year if the creditable foreign taxes exceeded the latent 

U.S. tax on the foreign-source income, which is usually the statutory U.S. corporate 

income tax rate multiplied by the FSI. Otherwise the company would have a residual 

U.S. tax. 

17 
For a company with U.S. exports, the anticipated final credit position for the 

general basket was inferred by whether the company used a FSC for any of its exports, 

that is, if it reported exempt foreign trade income on line 10, Schedule B of Form 1120 – 

FSC (U.S. Income Tax Return of a Foreign Sales Corporation), the form for reporting 

FSC income. U.S. export income that the company includes in FSI under the sales source 

rules appears on Part I, Schedule F of Form 1118. 

The Results 

Constructing the Samples of Companies 

We constructed several samples of U.S. companies for 1992 and 1996. To be 

included in a sample, the company had to be classified as a manufacturer and have 

positive pre-tax foreign earnings, and it had to pay creditable foreign taxes in the current 

year at a positive rate below 100 percent of FSI. To be included in Sample 1, the 

company had to have its financial statement included in the Compustat PC Plus file, and 

the statement had to identify separately the company's foreign earnings and foreign taxes. 

To be included in Sample 2, the company had to have its Form 1118 included in 

Treasury’s sample of tax returns. Sample 3, the “matched sample” is the primary sample 

for our analysis. To be included in Sample 3, the company had to be in Samples 1 and 2, 

and it had to have used a FSC or the sales source rules for exports. 

Comparing the Average Effective Tax Rates Calculated from the Financial Statements 

With Those Calculated From the Tax Returns for the General Basket 

Table 1 shows the dollar-weighted and the un-weighted averages of the foreign 

effective tax rates on foreign income as measured from financial statement data and on 

15 See the studies cited in footnote 2. 18 
FSI as reported on tax returns for the various samples. For both of our sample years 

(1992 and 1996), we find no statistically significant difference between the mean of the 

average effective tax rates as calculated from the financial statements in Sample 1 and 

that of the matched sample, or between the mean of the average effective tax rates as 

calculated from the tax returns in Sample 2 and that of the matched sample. 

For each sample, the mean of the average effective tax rates calculated from the 

financial statements is higher than the corresponding mean calculated from the tax 

returns. This is true for both 1992 and 1996. Also, all of the differences are statistically 

significant at the 95 percent level using a one-tailed test. The difference in tax rates 

could have gone either way. For example, the income reported in the financial statement 

includes foreign losses, whereas these losses are excluded from FSI. Thus, the difference 

in the treatment of losses tends to cause the average foreign tax rate as calculated from 

the financial statement to exceed the foreign tax rate as calculated from FSI. On the other 

hand, FSI excludes non-repatriated foreign earnings, and the US parent is less likely to 

repatriate low-tax foreign earnings, because they may be exposed to a residual U.S. tax. 

The foreign earnings reported in financial statements include the non-repatriated 

earnings. Thus, the difference in the treatment of non-repatriated foreign earnings tends 

to cause the foreign tax rate as calculated from the FSI to exceed the one calculated from 

data in the financial statement. 

Table 2 compares the foreign earnings and foreign taxes in the financial 

statements with FSI and foreign taxes eligible for the tax credit as reported in the general 

basket on the tax returns. After accounting for the differences that could be measured, 

19
 
the foreign earnings reported in financial statements accounted for about 86 percent of 

the FSI of the manufacturing companies in our sample in 1992 and for about 88 percent 

in 1996. The differences are smaller between foreign taxes taken from the two sources. 

Foreign taxes reported in financial statements accounted for 103 percent of the creditable 

foreign taxes reported on tax returns in 1992 and for 95 percent in 1996. 

Table 3 shows the frequency of agreement within Sample 3 (for 1992 and 1996 

combined) between a dummy variable indicating the current foreign tax credit positions 

as inferred from the financial statement (DFS) and a dummy variable indicating the 

position shown on the tax return, either with (DTW) or without (DTWO) excess foreign 

tax credits carried over from prior years. Each dummy takes a value of one if the 

company had (or was deemed to have had) excess foreign tax credits and a value of zero 

otherwise. 

A χ

2 test is used to determine whether the dummy variables are statistically 

independent of each other. The results of the test are reported in the last column of table 

3. The table also shows the simple correlation between each pair of dummies. Since 

observations for the same company for 1992 and 1996 may not be independent of each 

other (in which case the χ

2 statistic would be biased), the test is done for two separate 

pooled samples for 1992 and 1996. The first pooled sample (pooled sample a) omits the 

observations for a company in 1996 if the company is included in the 1992 sample, and 

the second pooled sample (pooled sample b) omits observations for a company in 1992 if 

the company is included in the 1996 sample. The results from the two samples are 

reported as χ

2 (a) and χ2 (b). For sample a, DFS and DTW were found to be statistically 

20
 
independent. DFS and DTWO were not statistically different in either sample, but DFS 

is a very poor predictor for DTWO: The simple correlation between the two variables is 

extremely low (0.01).16 

These results do not preclude DFS from being a good, unbiased proxy for the 

final tax credit position or for the anticipated final position. This is true, because the 

company's current position often switches from one year to the next, so both DTW and 

DTWO may be poor predictors for the final position. To demonstrate the fickle nature of 

the current foreign tax credit positions, we constructed a panel of data for 1992 through 

1997, which contains 139 companies. Table 4 shows the frequency with which the 

companies switched positions (from excess credit to excess limit, or vice-versa) over this 

period when the positions were measured both with and without carry-forwards. Even 

after carry-forwards, less than a quarter of the firms never switched positions during the 

period, whereas 38 percent switched positions at least twice. The table also shows that 

the positions as inferred from the financial statements are also fickle and switched about 

as often as the positions reported on the tax returns. 

Using Discreet Variables to Predict the Anticipated Final Foreign Tax Credit Positions 

The dummy variable for the anticipated final position (DRA) takes a value of 

unity if the company did not use a FSC for any of its exports (the final anticipated 

position is one of excess credit). Table 5 shows how well DTW, DTWO and DFS do at 

16 We also compared the averages of the tax rates as calculated from the financial statement for the 

companies that were in excess credit before and after carry-forwards. Neither average differed significantly 

from the overall average at the 95 percent level. 

21
 
17 

predicting DRA.17 The simple correlation and the χ

2

 test for independence is reported in 

the final column of the table. The correlations are all low, and DTW, DTWO and DFS 

are all statistically independent of DRA at the five percent level of significance in at least 

one of the pooled samples.18 

Positions 

Separate results are presented for 1992 and 1996. 

In regression 3, 

None 

Using Continuous Variables to Predict the Anticipated Final Foreign Tax Credit 

Table 6 provides the results of Probit regressions that use continuous variables to 

explain the anticipated final position. 

The dependent variable in each regression is DRA. In regression 1, the independent 

variable is the tax rate on foreign earnings calculated from data in the company’s 

financial statement. In regression 2, the independent variable is the rate of potentially 

creditable foreign taxes on FSI as reported on the company’s tax return. 

the independent variable is the rate of potentially creditable foreign taxes on FSI, where 

FSI is measured before application of the sales source rules for U.S. export profits. 

of the coefficients of the tax rates was statistically significant at the 90 percent level, 

indicating that neither the rate of tax on foreign income nor the extent to which the 

In addition to these three dummy variables, we also compared how well three other candidates would 

predict DRA. One candidate is a dummy variable that predicts a final position of excess credit only if the 

company generates excess foreign tax credits in the current year and also carries excess credits forward 

from a prior year. This candidate is less likely than DTW or DTWO to falsely predict that the final position 

is excess credit when it is actually excess limit. The two other candidates are DTW and DTWO, measured 

to account for the effect of the export tax breaks on the company’s current foreign tax credit position, as 

explained in note 13. All of these other candidates were statistically independent from DRA at the 95% 

level. We also used a panel of data for 1992 to 1997 to try to measure the final position for 1992, but the 

resultant variable was not significantly correlated with DRA, DFS, DTW or DTWO at the usually accepted 

levels. 

18 The weakest result is for the relation between DTWO and DRA. However, DTWO is also more poorly 

correlated with DRA than are DTW or DFS. 

22
 
company is in excess credit or excess limit in a particular year provides much information 

about its final anticipated position for the year. 

Summary and Conclusions 

A company’s foreign tax credit position often is volatile, switching from excess 

credit to excess limit from one year to the next. Since the company can carry unused 

foreign tax credits forward or backward in time, it is hard to predict its final foreign tax 

credit position for a given year. We have found that the measures commonly used to 

gauge the company’s foreign tax credit position (the position as actually reported on the 

company's tax return or the position imputed from data in the financial statement) can in 

many cases provide inconsistent results. 

As part of our examination of these two measures of the residual tax used in 

earlier studies, we devised a variable that logically should reveal the final foreign tax 

credit position the company anticipates having for the year. The variable was constructed 

using information gleaned from the company’s tax planning behavior, namely how it 

chose between two tax provisions for U.S. export profits, the sales source rules and the 

FSC provisions. In many cases, our method does not provide a viable alternative to 

researchers studying the effects of the residual tax, because it can be applied only for 

companies that export goods from the United States, and only for the handful of years 

during which data on operations of the FSCs were collected. Nevertheless, it is a useful 

tool to assess the other variables as measures of the company’s foreign tax credit 

position. 

23
 
We found that the two measures used in the earlier studies to gauge the 

company’s foreign tax credit position do not correlate well with our new measure of the 

revealed anticipated final foreign tax credit position. We believe the lack of correlation 

among the three measures of credit position draws into question the conclusions of the 

earlier studies. 

24
 
References 

Adler, Michael. “U.S. Taxation of U.S. Multinational Corporations: A Manual of 

Computational Techniques and Managerial Decision Rules.” In International Finance 

and Trade, Vol. 2, eds. M. Salant, G. Szego. Cambridge Mass.: Ballinger, 1979. 

Altshuler, Rosanne and Harry Grubert. “Balance Sheets, Multinational Financial Policy, and the 

Cost of Capital at Home and Abroad.” NBER Working Paper No. 5810. Cambridge, 

Mass.: National Bureau of Economic Research, October, 1996. 

Altshuler, Rosanne and T. Scott Newlon. “The Effects of U.S. tax Policy on the Income 

Repatriation of U.S. Multinational Corporations.” In Studies in International Taxation, 

eds. A. Giovannini, R.G. Hubbard and J. Slemrod. Chicago: University of Chicago 

Press, 1993. 

Altshuler, Rosanne, T. Scott Newlon and William C. Randolph. “Do Repatriation Taxes Matter? 

Evidence from the Tax Returns of U.S. Multinationals.” In M. Feldstein, J.R. Hines and 

R.G. Hubbard, eds. The Effects of Taxation on Multinational Corporations. Chicago: 

National Bureau of Economic Research, 1995. 

Collins, Julie, Deen Kemsley and Mark Lang. “Cross-Jurisdictional Income Shifting and 

Earnings Valuation.” Journal of Accounting Research Vol. 36 (Autumn 1998): 209-230. 

Dworin, Lowell. “On Estimating Corporate Tax Liabilities From Financial Statements.” Tax 

Notes (December 2, 1985): 965-971. 

Froot, Kenneth A. and James R. Hines. “Interest Allocation Rules, Financing Patterns, and the 

Operations of Multinationals.” In M Feldstein, J.R. Hines and R.G. Hubbard, eds. The 

Effects of Taxation on Multinational Corporations, Chicago: National Bureau of 

Economic Research, 1995. 

Grubert, Harry. “Taxes and the Division of Foreign Operating Income Among Royalties, 

Interest, Dividends and Retained Earnings.” Journal of Public Economics, Vol 68 (May 

1998): 269-290. 

Hartman, David. “Tax Policy and Foreign Direct Investment.” Journal of Public Economics 

(February 1985): 107-121. 

Hines, James R. “Dividends and Profits: Some Unsubtle Foreign Influences.” Journal of 

Finance Vol. 51 (June 1996): 661-689. 

25
 
Hines, James R., Jr. and R. Glenn Hubbard. “Coming Home to America: Dividend 

Repatriations by U.S. Multinationals.” In Taxation in the Global Economy, ed. A. Razin 

and J. Slemrod. Chicago: University of Chicago Press, 1990. 

Internal Revenue Service, “Corporate Foreign Tax Credit, 1992: An industry and Geographic 

Focus,” Statistics of Income Bulletin, Winter 1995-1996, Washington D.C., 1996. 

Kemsley, Deen. “The Effect of Taxes on Production Location.” Journal of Accounting

 Research Vol. 36 (Autumn 1998): 321-342. 

Lyon, Andrew B. and Gerald Silverstein. “The Alternative Minimum Tax and the Behavior of 

Multinational Corporations.” In M. Feldstein, J.R. Hines and R.G. Hubbard, eds. The 

Effects of Taxation on Multinational Corporations. Chicago: National Bureau of 

Economic Research, 1995. 

Mutti, John. “Tax Incentives and the Repatriation Decisions of U.S. Multinational 

Corporations.” National Tax Journal Vol. 34 (June 1981): 241-248. 

Rousslang, Donald J. “The Sales Source Rules for U.S. Exports: How Much Do They Cost?” 

Tax Notes International (February 21, 1994): 527-535, and Tax Notes (February 21, 

1994): 1047-1054. 

The Mc-Graw Hill Companies. Data Guide, Compustat (North America), 1998. 

U.S. Department of the Treasury. The Operation and Effect of the Foreign Sales Corporation 

 Legislation. Washington, D.C.: U.S. Department of the Treasury, November 

1997. 

U.S. Department of the Treasury. Report on the Sales Source Rules. Washington, D.C.: U.S. 

Department of the Treasury, 1992. 

26
 
 Table 1: Average Effective Tax Rates for Various Samples of U.S. Manufacturers 

Samples 1 and 2 

 U.S. manufacturers that had positive FSI 

and paid foreign tax on the FSI at a positive rate less than 100 percent 

Tax rate calculated from Rate of creditable 

 financial statement data foreign taxes on FSI 

 (from sample 1) (from sample 2) 

1992 1996 1992 1996 

Number of 

companies 

Assets (in $billions) 

Average tax rate: 

Dollar-weighted 

Un-weighted 

Median tax rate 

that paid foreign tax on the FSI at a positive rate less than 100 percent, 

that used the sales source rules or a FSC for their exports, 

and for which tax return and financial statement data are available 

Tax rate calculated from Rate of creditable 

 financial statement data foreign taxes on FSI 

1992 1996 1992 1996 

261 449 453 

1,016 1,989 1,669 2,824 

0.353 0.334 0.302 0.297 

(0.169) (0.166) (0.175) 

0.366 0.339 0.232 0.238 

(0.168) (0.166) (0.139) 

0.353 0.327 0.243 0.243 

624 

(0.181) 

(0.161) 

 Sample 3 

U.S. manufacturers that had positive FSI, 

Number of 

companies 168 299 168 299 

Assets (in $billions) 874 1,753 874 1,753 

Average tax rate: 

Dollar-weighted 0.349 0.330 0.285 0.289 

(0.166) (0.154) (0.135) (0.164) 

Un-weighted 0.383 0.335 0.264 0.255 

(0.162) (0.154) (0.129) (0.155) 

Median tax rate 0.359 0.330 0.283 0.273 

Note: The figures in parentheses are standard deviations. 

27 
Table 2: Reconciling Income and Taxes as Reported on Tax Returns and in Financial Statements 

for the Companies in Sample 3 

(In millions of dollars) 

Income Reconciliation: 1992 1996

 General basket FSI.................................................................. 19,147 55,423 

 minus: 

 Distributions from prior years’ E&P..................................... 5,629 10,839 

Current year losses of CFCs.................................................. 2,814 5,122 

 Interest and royalties from related parties............................. 3,929 15,458 

 Net income included in FSI under the sales source rules...... 3,544 10,477 

plus: 

 Domestic expenses charged against FSI................................ 8,172 23,921 

Non-repatriated E&P†

............................................................16,053 43,589 

FSI in other baskets, except the FSC basket 

and the passive income basket, 

 less creditable foreign income taxes in the 

section 902 baskets................................................................... 772 2,509 

Total:........................................................................................ 28,228 83,546

 Foreign income as reported in 

 financial statements................................................................ 24,393 73,897 

Unreconciled difference in foreign income................................ 3,835 9,649 

Tax Reconciliation: 

 Creditable taxes in the general basket ....................................... 5,417 15,769 

plus 

Creditable taxes in other baskets, 

except the 902 basket............................................................... 267 1,172 

Foreign taxes on non-repatriated E&P 

 of majority-owned foreign subsidiaries†

.................................. 4,334 11,769 

 minus: 

 Creditable taxes attributable to distributions 

 from prior years’ E&P ........................................................... 1,730 3,040 

Total: .................................................................................. ...... 8,288 25,670

 Foreign taxes as reported in 

 financial statements ................................................................... 8,502 24,360 

Unreconciled difference in foreign taxes..................................... -214 1,310 

†

 Estimated using a tax calculator developed by the Office of Tax Analysis, U.S. Department of 

Treasury. 

†† Total FSI of the manufacturing companies in all baskets was 20,667 in 1992 and 60,060 in 

1996. The total of their foreign taxes in all baskets was 5,684 in 1992 and 16,941 in 1996. 

28
 
Table 3: The Frequency of Agreement Between the Foreign Tax Credit Position as Reported on 

r=0.11 

χ

2

(a)=9.70* 

χ

2

(b)=0.76 

DFS Total 

Excess Credit 103 124 227 

84 156 240 

Total 187 280 467 

r=0.01 

χ

2

(a)=2.34 

χ

2

(b)=0.70 

DFS Total 

Excess Credit 56 171 227 

57 183 240 

Total 113 354 467 

χ

2

 is significant at the 95% level or better. 

Tax Returns and as Inferred from Financial Statements 

Pooled observations from sample 6 for 1992 and 1996 

 DTW 

Excess Credit Excess Limit 

Excess Limit 

 DTWO 

Excess Credit Excess Limit 

Excess Limit 

Note: DTW is the position reported on the tax return after carry-forwards, DFS is the position 

inferred from the financial statement, and DTWO is the position reported on the tax return before 

carry-forwards. An asterisk (*) indicates that the 

29
 
Table 4: The Frequency with which Companies Switch Foreign Tax Credit Positions: 

1992 to 1997 

Foreign tax credit position after carry-forwards 

 Number Number Percent Cum.

 of switches of companies of total Percent 

0 33 23.7 23.7 

1 53 38.1 61.8 

2 30 21.6 83.4 

3 16 11.5 94.9 

4 6 4.3 99.2 

5 1 0.8 100.0 

Total: 139 100.0 

Foreign tax credit positions before carry-forwards 

 Number Number Percent Cum.

 of switches of companies of total Percent 

0 27 19.4 19.4 

1 42 30.2 49.6 

2 40 28.8 78.4 

3 20 14.4 92.8 

4 6 4.3 97.1 

5 4 2.9 100.0 

Total: 139 100.0 

Foreign tax credit positions based on COMPUSTAT data 

 Number Number Percent Cum.

 of switches of companies of total Percent 

0 39 26.5 26.5 

1 34 23.1 49.6 

2 47 32.0 81.6 

3 21 14.3 95.9 

4 5 3.4 99.3 

5 1 0.7 100.0 

Total: 147 100.0 

30
 
Table 5: Frequency of an Agreement between the Anticipated Final Foreign Tax Credit Position 

as Inferred from the Use of Export Tax Breaks and Various other Candidates that Might be Used 

to Infer the Anticipated Final Position 

 Non-overlapping Pooled observations for 1992 and 1996 

DRA 

r=0.12 

χ

2

(a)=7.26* 

χ

2

(b)=6.82* 

DTW Total 

Excess Credit 60 127 187 

59 221 280 

Total 119 348 467 

DRA 

r=0.09 

χ

2

(a)=5.24* 

χ

2

(b)=3.13 

DTWO Excess Credit Total 

Excess Credit 37 76 113 

82 272 354 

Total 119 348 467 

DRA 

r=0.11 

χ

2

(a)=7.75* 

χ

2

(b)=5.82* 

DFS Total 

Excess Credit 69 158 227 

50 190 240 

Total 119 348 467 

Excess Credit Excess Limit 

Excess Limit 

Excess Limit 

Excess Limit 

Excess Credit Excess Limit 

Excess Limit 

Note: Please see the note to table 3. DRA is a dummy variable representing the anticipated final 

tax credit position as inferred from the company’s use of the sales source rules and the FSC for 

its exports. 

31
 
Table 6: Continuous Variable Candidates for Determining the Anticipated Final Position 

Observations are for exporting manufacturing companies 

Probit regressions, Dependent variable: DRA 

Year 1992 1996 

Independent 

variable Coefficient (and P2

) 

Regression 1: n = 168 n = 299 

Constant 0.26 (1.33) 0.79 (23.92)* 

Rate of creditable 

foreign taxes on FSI 0.11 (0.02) 0.50 (0.81) 

(from tax returns) 

Regression 2: n = 168 n = 299 

Constant 0.36 (1.96) 1.21 (33.02)* 

Rate of tax 

on foreign earnings -0.18 (0.09) -0.86 (2.44) 

(from financial statements) 

Regression 3: n = 166 n = 298 

Constant 0.31 (9.54)* 0.91 (96.89)* 

Rate of creditable 

foreign taxes on FSI 

before application of the 

sales source rules -0.04 (1.06) 0.12 (0.02) 

(from tax returns) 

Note: An asterisk (*) indicates that the χ

2

 is significant at the 95 percent level or better. 

32