In applying tax deferral, care should be taken to make sure that only income actually earned from foreign operations is given the relief. With respect to exports, this would mean limiting deferral to profits earned over and above the wholesale selling price-not the cost of the exported commodities alongside ship in U.S. ports. If provision is made for a foreign business corporation, the presently used type of tax-haven corporation should be made so unattractive that it would be abandoned in favor of the foreign business corporation. There may be several methods of discouraging the use of tax-haven corporations. For example, it would perhaps be feasible to require the use of consolidated joint returns in case the taxpayer using a tax-haven corporation wished to avail itself of the foreign tax credit. There may be other appropriate special incentives for investment in underdeveloped countries, such as the proposals made by the Straus committee to the State Department. In case the committee is interested in any of these, I would be glad to discuss them at the hearings, but will not go into them in this paper. SPECIAL PROBLEMS IN CORPORATE TAXATION FOREIGN INCOME Raphael Sherfy* Over the past years, many proposals have been made for changes in the U.S. tax treatment of individuals and corporations carrying on business abroad or deriving income from foreign sources. These proposals have gone from the one extreme of recommending that foreign income be taxed in full without the allowance of any foreign tax credit to the other extreme of proposing complete tax exemption from tax of all kinds and types of foreign income. During this period, I have not seen any willingness on the part of the Congress or on the part of the executive branch of the U.S. Government to adopt either extreme position. Either extreme position is difficult to justify. The elimination of the foreign tax credit would result in very inequitable and harsh double taxation. Its elimination, generally, would result in a total tax burden in execss of the rates in either country. In my opinion, the foreign tax credit is essential to fair and equitable taxation of foreign income. On the other hand, the adoption of a sweeping exemption of all foreign income would grant unjustifiable benefits to some taxpayers as compared to others in similar circumstances. For example, it would seem difficult to support an exemption for dividends received from a foreign corporation by a citizen living in the United States while his next door neighbor is receiving dividends from a U.S. corporation which are taxable. This year the attention of taxpayers, the Congress, and the executive branch has been focused on international tax policy. The studies carried on by the administration, the examination of the foreign trade policy of the United States by the Subcommittee on Foreign Trade Policy, and the public hearings held by the Ways and Means Committee are indicative of the current importance given to the subject. As a background to consideration and analysis of the policies to be followed in this area, it might be helpful if I reviewed the legislative history leading up to the present tax pattern for the taxation of American business abroad. 1. Foreign tax credit A. LEGISLATIVE HISTORY From the first Revenue Act in 1913, whether by design or by accident, U.S. corporations have been taxed on their foreign income and have been allowed to deduct their foreign losses. Until 1918, gross *Parnter in the law firm of Turney and Turney, Washington, D.C., Associate Head of the Legal Advisory Staff and the Tax Legislative Counsels Office, Treasury Department, 1952 to March 1959. 1 Secs. 222 and 238 of the Revenue Act of 1918. income included income from all sources, and foreign income taxes were only allowed as a deduction. In the 1918 act, Congress for the first time permitted American taxpayers to credit against their U.S. tax liability all foreign income taxes, and this credit has been the basic method by which the United States has ever since eliminated international double taxation. Thus, the U.S. tax can be offset, dollar for dollar, by foreign income taxes. The purpose of this action was explained in the committee report of the Ways and Means Committee as being the need to alleviate the severe burden caused by high foreign taxes. On the floor of the House, it was pointed out that unless this provision was put in foreign commerce would be discouraged. 3 The 1918 act also extended the application of the foreign tax credit provisions to the situation where a domestic corporation receives dividends from a foreign corporation, the majority of whose voting stock is owned by such domestic corporation. Under those circumstances, a domestic corporation was permitted to credit a portion of the foreign income taxes paid by the foreign corporation. It is interesting to note that this credit for foreign taxes paid by foreign corporations was adopted in the conference between the House and the Senate in substitution for a Senate proposal which would have permitted the consolidation of the incomes of foreign corporations with that of domestic corporations and the allowance of a foreign tax credit for foreign taxes paid by such foreign corporations.* Later, the language of this provision was changed to its present-day form, so as to permit a credit for the portion of the foreign income taxes paid by the foreign corporation with respect to the year from which the earnings and profits were distributed. However, in order to prevent the amount of the credit from overlapping the U.S. tax otherwise due on other income, a further limitation was imposed in this casenamely, the credit for taxes paid by a foreign corporation could not exceed the amount of the U.S. tax allocable to the dividends from that corporation. Under the 1918 act, the foreign tax credit was unlimited in amount, and where the foreign tax exceeded the U.S. tax allocable to foreign income, foreign taxes could offset U.S. tax liability on U.S. income. Because of this possibility, the Congress in 1921 limited the amount of the credit which was allowable so that it could never exceed the amount of U.S. tax attributable to foreign income. This limitation has become known as the "overall" limitation, and the net effect of it is that foreign profits are taxed at an effective rate no higher than that of either the U.S. tax or the foreign tax allocable to such profits, whichever is the greater. The provisions relating to the foreign tax credit remained unchanged until 1932. As I have noted, under the law prior to the Revenue Act of 1932, a credit was allowed for all foreign income taxes subject only to the "overall" limitation adopted in 1921. Thus, a corporation receiving income from two foreign countries—one which 2 Report of Committee on Ways and Means on revenue bill of 1918, H. Rept. 767, 65th Cong., 2d sess. 3 Sec. 240 (c) of the Revenue Act of 1918. Statement of the managers on the part of the House, H. Rept. 1037, 65th Cong., 3d sess. Sec. 238 (e) of the Revenue Act of 1921. * Sec. 238 (a) of the Revenue Act of 1921. imposed little or no tax on the income and the other which imposed a rate of tax higher than the effective U.S. rate on the income-was able to utilize the income from the former country to secure a higher credit than was available to the taxpayer who derived income solely from the latter country. Thus, assume A's total taxable income was $10,000 and his U.S. tax before allowance of a credit was $2,500. If he derived $3,000 from the X country subject to tax of $1,200 and $2,000 from the Y country, subject to no foreign tax, he was entitled to the full credit of the entire $1,200, because the "overall" limitation permitted a total credit of $1,250. However, if taxpayer B had a total taxable income of $10,000, but his sole foreign source of foreign income was $3,000, derived from X country, and if he was subject to tax on this income, just as was A, in the amount of $1,200, his credit was only $750, not $1,200. Yet, in both instances, the foreign income subject to the tax was the same in each case. Although the Senate Finance Committee did not agree that the result just described was undesirable? the Congress in the Revenue Act of 1932 eliminated this difference in result by providing for separate computations for each country. Thus, the $2,000 derived by A from Y country was no longer permitted to be utilized in the computation of limitations on the amount of the credit with respect to the $1,200 paid by A to the X country. 8 It is interesting to note here that while the Congress saw fit to prevent the use of tax-exempt income from one country, to increase the credit allowed for taxes paid to another foreign country, it ignored the fact that somewhat the same effect is produced under the "per country" limitation where a taxpayer derives two items of income from the same foreign country, one subject to tax and the other exempt from tax by that country. In such case, the taxpayer takes advantage of the fact that both items are derived from the source within one foreign country in computing the limitation with respect to that country, even though one item is not subject to tax in that country. For example, assume that there are two taxpayers each deriving income from M country, and that taxpayer X derives two items of income equal in amount, item 1 being subject to tax by M country at the rate of 50 percent and item 2 completely exempt from foreign tax. Assume taxpayer Y derives taxable income in the same amount as taxpayer X did, but does not derive any exempt income. Assume further that the U.S. effective rate (before credit) is 25 percent. In such cases, taxpayer X gets a credit for his entire foreign tax paid to the M country, but taxpayer Y gets a credit for only one-half of such tax. Thus, the advantage which the Congress thought desirable to remove where the income was derived by the taxpayer from different countries is still enjoyed by the taxpayer who derives two kinds of income, one of which is not taxed or is taxed at a relatively low rate, from the same foreign country. A further amendment was made in the Revenue Act of 1932, which prevented the tax ultimately payable to the United States from being less than the portion of the U.S. tax allocable to net income from sources sources within the United States. Under the then existing 7 S. Rept. No. 665, 77th Cong., 1st sess. 8 Sec. 131 (b) (1) of the Revenue Act of 1932. Sec. 23 (c) (2) of the Revenue Act of 1932. |