AN ANALYSIS OF SOME OF THE LIMITATIONS ON THE BASE FOR U.S. TAXATION OF FOREIGN INCOME AND FOREIGN CORPORATIONS

Ira T. Wender, attorney, Baker, McKenzie & Hightower, Chicago, Ill.

The purpose of this paper is to analyze three of the assumptions upon which U.S. taxation of foreign income and foreign corporations is premised. These are: first, the definition of foreign entities and particularly foreign corporations for U.S. income tax purposes; second, the source of income rules; and third, the source of income on export and import transactions. Each constitutes an important limitation on the tax base, the justification for which has generally received little attention. In each of these areas we shall here examine the existing approach, consider the major problems raised by it, and compare some of the available alternatives.

FOREIGN ENTITIES

As a general jurisdictional principle, the United States taxes all of the income of domestic entities no matter from what source derived, but taxes only domestic source income of foreign entities. Thus, if an entity is foreign for tax purposes, the base upon which U.S. taxes are computed is immediately limited to U.S. source income.

Individuals, corporations, and trusts and estates are recognized as taxable entities by the code. The rules with respect to the categorization of these entities as foreign or domestic are as follows: A corporation is domestic if organized under the laws of the United States or of any State or territory.1 Conversely, a foreign corporation is one created or organized under the laws of any jurisdiction other than the United States, or any State or territory of the United States.2 A domestic individual for tax purposes is a citizen or resident of the United States, so that only a nonresident alien of the United States is recognized as a foreign entity for tax purposes.3

The rules with respect to the status of trusts and estates are somewhat unclear. The existence of a foreign trust subject to limited U.S. tax jurisdiction is recognized by the code. Apparently, jurisdiction to tax a trust may require an analysis both of the alienage or citizenship of the trust and its residence. A trust would appear to be foreign if created under the laws of a foreign country.5 A foreign trust or

1 Secs. 7701(a) (3) and (4).

2 Secs. 7701(a) (3) and (5). 3 Secs. 872(a) and 871.

In sec. 1493 a foreign trust is defined as one which would not be subject to U.S. tax on a sale of appreciated property outside the United States because the source of that income would be foreign. However, the definition is limited to ch. 5 and does not, therefore, have any effect for ch. 1 which imposes normal tax and surtax. Similarly, sec. 402(c) recognizes foreign situs employee's trusts.

I.T. 1885, II-2 Cum. Bull. 164 (1923); B. W. Jones Trust v. Commissioner, 132 F. 2d 914 (4th Cir., 1943), affirming 46 BTA 531 (1942); but cf. Estate of A. F. T. Cooper, 9 BTA 21 (Acq.) (1927), in which the Board stated that the citizenship and residence of the fiduciary determined the status of an estate.

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estate is presumably nonresident if managed and administered outside the United States by a nonresident trustee.

A foreign entity is taxable only on U.S. source of income. The form of U.S. tax, however, depends upon whether the foreign entity is engaged in trade or business in the United States and in the case of individuals, trusts, and estates may also depend upon the amount of the U.S. source of income. If a foreign corporation or a nonresident alien is not engaged in trade or business in the United States, withholding tax is imposed on "fixed or determinable annual or periodical" income from U.S. sources in lieu of regular income taxes on all U.S. source income. Generally, "fixed or determinable annual or periodical" income includes such items as interest, dividends, rent, premiums, annuities, compensations, and other similar items as well as the following items which are specially treated as capital gains under the code: lump-sum distributions of pension trusts, timber and coal royalties, and gain from sales of patents under section 1255. Ordinarily gain from sale of personal property is not fixed or determinable annual or periodical income. Although not engaged in trade or business in the United States, a nonresident alien is taxable at regular rates if his gross income for any taxable year from sources within the United States exceeds $15,400. This latter provision has generally been abnegated in income tax treaties.

Here we shall consider in detail only the rules with respect to foreign corporations. A foreign corporation is taxable only on its U.S. source income. The propriety of this insulation from U.S. taxation by the mere act of foreign incorporation can be questioned in a number of situations. Problems arise under this doctrine because unequal tax burdens may be imposed upon similar economic activities and because of the possibilities of tax avoidance inherent in the use of foreign corporations.

The inequality of tax burdens can be simply illustrated. A number of industries in the United States today derive approximately half their income from foreign operations. This group includes, for example, the international oil companies, drug manufacturers, and motion picture distributors. If corporations in these fields were foreign, rather than domestic, they would pay no U.S. taxes on their profits earned outside the United States. They would, as a result, have more income available after tax should any of their foreign income be taxed abroad at rates lower than U.S. rates. U.S. companies competing with firms such as Unilever, Royal Dutch Shell, Philips, and Olivetti face a competitive disadvantage as a result of the broad sweep of U.S. tax jurisdiction (a disability which they, incidentally, share with United Kingdom companies). Until recently this disadvantage was perhaps fully compensated by the financing advantages inherent in domestic incorporation. However, the successful experience with the listing of foreign corporations on U.S. exchanges and the flow of U.S. capital to foreign exchanges reduces these advantages. Not only do U.S. corporations bear a higher tax burden than their foreign controlled competitors, but they also bear a higher burden than enterprises financed and controlled in the United States but organized as foreign corporations.

GCM 11221, XI-2 Cum. Bull. 123 (1932); UD 743, 3 Cum. Bull. 203 (1921). 'Secs. 1441 and 1442.

Treas. Reg. sec. 1.1441-2(a)(3).

In this perspective U.S. tax jurisdiction may be criticized for its breadth; in others it can be argued that tax avoidance is encouraged by the U.S. approach. To illustrate two extremes, let us consider the Canadian investment companies and the handling of export activities. Canadian investment companies operate in the following fashion: A Canadian corporation is formed and its shares are distributed publicly to U.S. investors. The capital thus raised is invested in Canadian securities. Under Canadian law, dividends from Canadian corporations and capital gains are tax-exempt to the investment company. The investment company accumulates its profits without distributing dividends. The shareholders realize the tax-exempt surplus subject only to capital gains taxes by selling their shares. For high-bracket taxpayers investment in such companies may be even more advantageous than in tax-exempt State and municipal bonds. Personal income taxes on dividends are thus avoided, and capital gains can be reinvested free of tax until the ultimate liquidation of the shareholders' interest in the investment company. The personal holding company surtax and the penalty tax on unreasonable accumulation are inapplicable since the income is from foreign sources. Nor do the foreign personal holding company provisions apply, since no group of five or fewer sharehold ers holds more than 50 percent in value of the outstanding stock of these Canadian companies.

A second example lies in the taxation of export income. If a U.S. corporation exports directly, it pays full corporate taxes on its export profits. If, on the other hand, it organizes a foreign corporation to which it sells for resale to purchasers outside the United States, the profit on the export sales will be foreign income under present law provided title to the goods passes from the seller to the buyer outside the United States. Accordingly, it would appear that the foreign corporation could operate entirely within the United States from a domestic office in the same manner as the U.S. corporation had previously operated and, nevertheless, pay no U.S. tax on its profits. If these results seem inequitable, what alternative rules-other than a change in source of income rules which will be discussed later-are available upon which to base tax jurisdiction? The principal alternatives are the English rule, the Australian rule, or the foreign personal holding company approach.

(1) The United Kingdom rule

Under United Kingdom tax concepts which are followed by Canada, a corporation is domestic to the country where its central management and control is located. 10 Generally, that place is where the board of directors meets. This alternative rule has not proved more successful in practice than the U.S. rule. In fact, England was forced to adopt a law imposing a criminal penalty on transferring the central management and control of British corporations outside England without prior governmental approval. If adopted by the United States, most domestic corporations with substantial foreign income would be forced to move their central management and control out

This aspect of U.S. taxation is discussed in greater detail in the third section of this paper.

10 Technically the United Kingdom and Canada talk in terms of a resident corporation. The term "resident" has the same tax consequences as our term "domestic"; that is, a resident corporation is subject to taxation on all its income from whatever source derived.

side the United States. While this might equalize the competitive position of some domestic firms, it would not broaden the tax base or prevent tax avoidance through utilization of foreign corporations. (2) The Australian rule

The Australian rule is perhaps the most successful in preventing tax avoidance through use of foreign corporations. Australia treats as domestic and, hence, subject to full Australian tax, the following categories of corporations:

1. A corporation organized under Australian law;

2. A corporation organized under foreign (non-Australian) law, the central management and control of which is located in Australia; and

3. A corporation organized under foreign (non-Australian) law which carries on business in Australia and the voting control of which is held by Australian residents.

If the United States were to follow the Australian rule, a domestically controlled foreign corporation operating an export business in the United States would be taxable in the same manner as a domestic corporation.

On the other hand, the Australian rule tends to discriminate against small corporations. Were the Australian rule followed by the United States, large domestic corporations with substantial foreign operations could afford to maintain an office outside the United States from which to conduct their export operations. Small U.S. corporations frequently would not have the personnel or resources to operate from such an establishment. The Australian rule would have no effect on the operation of Canadian investment companies and other relatively widely held foreign investment corporations.

(3) The foreign personal holding company approach

Theoretically, the foreign personal holding company provisions could be applied to all foreign corporations. Under those provisions, the undistributed income of a foreign corporation is deemed to be distributed as a dividend to its shareholders on the last day of the corporation's taxable year. A foreign corporation is a foreign personal holding company if. (1) 60 percent or more of its gross income is derived from personal holding company sources such as dividends, rent, interest, capital gains on securities and royalties, and (2) more than 50 percent in value of its stock is owned, directly or indirectly, by 5 or fewer individuals who are residents of the United States. Presumably, there would be no constitutional bar to taxing the undistributed income of foreign corporations controlled by U.S. residents. While this approach might eliminate the Canadian investment companies, it would also tend to impede the flow of U.S. private corporate capital abroad. It would, furthermore, encourage U.S. corporations to take minority positions in foreign corporations. The advisability of a tax-oriented limitation on participation in foreign enterprises might well be questioned on policy grounds.

If this approach were limited to foreign corporations accumulating investment income, so that the flow of direct investment is not discouraged, the consequences might still be excessively harsh. Minority U.S. shareholders who did not have control over the dividend policies of a foreign corporation deriving its income from investments would

nevertheless be taxed on income they did not receive and could not choose to receive. At present the foreign personal holding company provisions affect only closely held companies. As a result, the shareholders taxed under these provisions usually have control of the payment of dividends and can, hence, choose to receive in cash the constructive dividends upon which they will be taxed.

(4) Summary

Of the alternative approaches, seemingly only the Australian and the foreign personal holding company (limited to foreign investment companies) would broaden the tax base along lines which would increase the equity of our present system and would not adversely affect the flow of U.S. foreign investment. Yet these approaches also create problems of equity. The Australian rule clearly favors the large corporation. Adoption of the foreign personal holding company provisions would tend to eliminate the tax avoidance inherent in foreign investment companies. The success of such companies is, however, a result of excessively high U.S. surtaxes. Unless that basic problem is solved, it is doubtful that legislation would eliminate the abuses. Investment companies controlled by non-U.S. interests undoubtedly would be formed to accommodate the desire of high-bracket U.S. taxpayers for a medium by which to avoid surtaxes.

THE SOURCE OF INCOME RULES

Basic to the U.S. taxation of foreign income and foreigners is the nature of the income and its source. The approach is schedular. To each type of income such as interest, dividends, compensation, royalties, and gains on the sales of property, special rules are applied to determine whether the source be domestic or foreign and, if foreign, the country to which the income is to be assigned. For example, the source of interest is determined by the residence of the debtor, the source of dividends by the country of incorporation of the payer, rent and royalties by the place the property is used, and gains from the sale of personal property by the situs of the property when title passes. The importance of the source rules stems from the fact that a foreign corporation is taxable only on U.S. source income and that the amount of foreign tax credit allowed for foreign income taxes paid by a domestic corporation will depend on the amount and source of its foreign income.

An illustration of the effect of this schedular approach on the base of U.S. taxation is the fact that a corporation created under the laws. of a foreign country may conduct any of the following income producing activities free of U.S. tax from an office in the United States:

(1) Exportation of U.S. manufactured goods, retaining title until arrival of the goods in the foreign country of the buyer; (2) Exportation of foreign goods to buyers in other foreign countries;

(3) Importation of goods produced abroad passing title to the goods at the foreign port of shipment;

(4) Control of the operation of ships registered under foreign flags;

(5) Ownership and trading in non-U.S. securities or trading in U.S. securities on foreign stock exchanges;