FOREIGN SOURCE INCOME-ITS RELATIONSHIP TO THE

TAX BASE AND RATES

Donald H. Gleason, assistant treasurer, Corn Products Co., New York Certainly no one will quarrel with the announced objectives of this inquiry. However, one might conclude from the press release of May 18, 1959, that there is no practical possibility of significant rate reductions without the elimination of a considerable number of exemptions, exclusions, and deductions now provided for in the Internal Revenue Code. To this conclusion I do not subscribe for two reasons. First, I believe a great deal more can be done than has been done in the area of controlling expenditures, and, second, the tax base under the present statute is significantly broadening, year by year, through increases in dollar income at all levels, partly because of the increase in the gross national product, and partly because of inflation. To me the arguments in favor of the Herlong-Baker approach to rate reduction are very persuasive. I presume that the arguments-pro and con-of this approach to equitable rate reduction will be thoroughly explored by other panelists whose assignments are more closely related thereto and will leave that discussion to them.

The merits of the various deductions, exemptions, and exclusions should, of course, be reviewed, giving full consideration to economic factors, equity, and practical considerations. Each should stand or fall on these considerations. It is in this light that I would discuss the taxation of foreign source income, the tax credit system, and the various exclusions and exemptions.

BACKGROUND

Many people seriously contend that foreign source income should not be subject to U.S. tax at all. It seems abvious that the extent of U.S. economic activities in the foreign field would be far less than they are today were it not for foreign tax credits, and the exclusions and preferential rates that have been and are now embodied in our Revenue Code. Nor is it seriously contended by anyone that these foreign economic activities are not only desirable but even essential.

The arguments used in favor of exemption have changed in substance and emphasis from time to time as the political and economic climate both here and abroad have changed. For example, economic arguments in favor of exemption during periods of comparatively low tax rates at home and abroad such as were in effect during the 1920's and the 1930's seemed somewhat less persuasive than they do today. Much the same thing can be said of the arguments in favor of all other special purpose provisions in the statute, such as those in respect of capital transactions, accelerated depreciation, and the like. As a generalization it has been said that the need of all of them is the product of high rates. It has, of course, been put conversely: high rates are their product and without their elimination rates cannot be reduced.

As in the case of all generalizations, they are only generally accurate, and to some degree they are inaccurate, and it seems to me that they are particularly inaccurate when applied to the special provisions in respect of foreign source income.

ARGUMENTS IN FAVOR OF EXEMPTION

The traditional arguments in support of exemption and inferentially in favor of the present preferential treatment of foreign source income may be summarized as follows:

(1) Business conducted in foreign lands are subject to greater hazards than are those conducted at home;

(2) Double taxation places a foreign operation at a competitive disadvantage;

(3) Businesses conducted abroad do not enjoy as many of the benefits provided by our Government which the tax collected supports.

I would add another which appears at the beginning of the discussion, setting it apart for special emphasis:

(4) Unquestionably there would be far less U.S. economic activity abroad were it not for preferential tax treatment. The real question, perhaps, then is, Should not present preferential provisions be broadened?

This should be emphasized for several reasons:

(1) First, the economic benefits of U.S. international operations cannot be overemphasized;

(2) Second, competition between nations to reach and hold expanding markets throughout the world is becoming more and more intense; and, finally,

(3) The major arguments not only against broadening the present provisions but in favor of their restriction do not, when viewed in proper perspective, stand up.

ARGUMENTS AGAINST PREFERENTIAL TREATMENT

(1) Equity requires that similar classes of income bear equal rates of tax. The source of income, so the argument goes, is not relevant in determining the taxpayer's capacity to meet his tax obligations. If policy requires special inducements to overcome special risks, these should not take the form of tax preferences.

(2) The principal economic argument against preferential tax treatment of foreign source income is that taxes should not influence the direction or location of economic activities and the placement of capital. The factors of the marketplace should govern. (3) Finally it is suggested by some who would resist expanding the present preferential treatment, or perhaps narrow it, that those in favor of expanding preferential treatment obscure the very favorable treatment now provided by the statute. It is argued that the present treatment amounts to a subsidy for foreign investment. It is further argued that the deferral mechanism inherent in the use of the foreign subsidiary form amounts to a tax-free loan to the taxpayers using it.

In addition to the above, the impact on the revenue should be considered. Further, practicalities such as the administrative cost of the

taxpayer and the Revenue Service alike are important. And there is the problem of loopholes.

Tax preferences for foreign source income and indeed their extension seem to enjoy the distinct advantage in the arguments. In support of this conclusion I would merely direct consideration to where we would be now if it had not been for the foreign tax credit system and the other exclusions and exemptions. Our foreign economic activities, although not entirely nonexistent, would be comparatively minor. The stimulation that these have had on our domestic economy would have been virtually nonexistent and the revenue would have suffered on two counts, one foreign and the other domestic.

Arguments such as deferral of U.S. tax through the use of foreign corporations amount to tax-free loans by the Treasury with the taxpayers controlling the maturity dates are not very persuasive for, without the tax credit system and the deferral mechanism, much of the income and thus the tax on it which is deferred would never have existed. The same criticism can be reasonably made of terming the present preferential provisions a subsidy, for without them much of the foreign source income that now exists would not be there to tax. Incentive certainly would be a more appropriate term for each.

Further, I would like to comment here on the frequently made assertion that taxation doesn't play a very important role in business thinking in the location of economic activities and the placement of capital in the foreign field. My own experience has been that it does play a very important role. Under present circumstances it is all important insofar as form is concerned. I will refer to this latter point in more detail below.

THE TAX CREDIT SYSTEM

The primary jurisdiction in respect of the taxation of income is the country of source. The jurisdiction over the person of the taxpayer is thus secondary.

World War I emphasized the importance of American operations abroad from an economic and international political standpoint. The restrictive effects of multiple taxation on such operations became apparent, and the tax credit system was introduced to meet the problem.i

These tax credit provisions concerned only foreign taxes assessed directly on the foreign source income of U.S. persons and entities. The tax position of U.S. businesses conducted through the foreign corporations continued to be disadvantageous. In order to correct this, the so-called deemed credit system was introduced in 1921.2 Its substance has remained in our tax laws ever since.

The tax credit system is a compromise between full exemption from U.S. taxation of foreign source income and its full taxation with foreign taxes merely permitted as deductions just like any other costs, for under it the United States doesn't forgo its secondary tax jurisdiction over foreign source income. It is a compromise in that while the United States doesn't collect the same amount of tax on each class of income from foreign sources that it collects on such

1 Secs. 222 (a), (2) and 238 (a) of the 1918 Revenue Act.

2 Sec. 238 (e) of the Revenue Act of 1921.

classes from domestic sources, each class theoretically bears the same amount of overall tax, both foreign and domestic.

The broad effect of the foreign tax credit system is to limit overall income taxes (foreign and domestic) to whichever of the two rates is the higher. Thus, when the foreign tax rate is lower than the U.S. rate, the U.S. taxpayer pays full foreign tax on his foreign source income plus the difference between the foreign and the U.S. rates in U.S. tax. When the foreign rate equals or exceeds the U.S. rate, the U.S. taxpayer pays only foreign tax on his foreign income.

The equality sought by the tax credit system is only approximately reached for a number of reasons. Were the revenue, for example, of all foreign countries derived in the same proportion from income taxes and other taxes as they are in the United States, and their income tax laws and accounting principles more closely parallel in design and administration to ours, equality would be more nearly approached. A step toward achieving the theoretical objective was the enactment of the "in lieu of provision" in 1942.3 However, because of very strict administration by the Revenue Service, the provision has to a great extent failed to serve its purpose.*

The deemed credit and its alleged loophole

Recently there has been a great deal of discussion concerning an alleged loophole in the way in which the "deemed credit" works. It stems from the fact that under the present rules where dividends carrying deemed credits are paid from foreign subsidiaries and where the foreign tax rate is less than the U.S. rate, the combined U.S. and foreign tax expressed as a percentage of net income before foreign tax is less than the applicable U.S. rate. This effect may be illustrated by the following schedule: 5

Total tax paid as a percentage of foreign earnings before tax...

This "Doppler effect" in the mathematics of the calculation is caused by the fact that the net foreign income used to pay the foreign tax, for which U.S. tax credit is allowed, is not taxed at a rate equivalent to the full U.S. tax rate.

However, it should be observed that the total foreign and U.S. taxes paid in respect of the dividend received by the U.S. entity in each case is 52 percent of the dividend. The following schedule illustrates this point:

3 Sec. 131 (h) of the 1939 Revenue Code; sec. 903 of the 1954 Revenue Code. Permitting credit for payment of the "principal tax" of a foreign country was explored in the deliberation in connection with the 1954 Revenue Code. The idea was abandoned because of inherent practical difficulties.

5 The effects of the above factors have been shown graphically in a number of official documents in the past few years. See, for example, "Federal Tax Policy for Economic Growth and Stability" for Joint Committee on the Economic Report, pp. 717 and 718 (joint committee print dated Nov. 9, 1955).

These graphs are symmetrical curves showing that the comparative "advantage" increases from zero where the effective foreign and domestic rates are the same to a maximum where the foreign rate is exactly one-half of the domestic rate, and gradually decreases to zero as the foreign rate approaches zero.

Any correction of the alleged loophole would presumably reduce the allowable credit (and consequently increase the U.S. tax) on any foreign dividend to a point where the total U.S. and foreign taxes paid on, or with respect to, the dividend are equal not to 52 percent of the dividend itself but to 52 percent of the net income of the foreign subsidiary (computed before foreign taxes) out of which the dividend is paid.

The case for such an amendment rests on very uneasy theoretical and practical grounds.

Theoretical grounds.-As has been pointed out above the compromise inherent in the tax credit system between full U.S. taxation of foreign source income and its exemption requires that the U.S. taxpayer pay in respect of any income received a total tax (foreign and domestic) equivalent to the U.S. rate. This is precisely the result under the present provisions.

To compare the total U.S. and foreign taxes paid on or in respect of a dividend with anything other than the dividend itself is illogical. It implies the receipt of and the consequent exposure to U.S. tax of income that the U.S. taxpayer never gets nor can spend. This, in effect, extends the secondary tax jurisdiction of the United States to the income of foreign entities.

How, one might well ask, do the proponents of suggested amendment feel about the use of royalties and fees in a domestic parent and foreign subsidiary relationship? Almost always the income flowing up through such a route is subject to a very low overall tax if net income before foreign tax is the measure. In some situations, the overall tax is a negative figure. This happens because the royalty, although fully subject to U.S. tax, is a deduction to the foreign subsidiary in computing its foreign tax, and where the foreign tax rate exceeds the U.S. rate, the overall tax collected is a minus figure. Would the proponents of the amendments suggest a gross U.S. tax on royalties of upward of 100 percent? It was noted above that the philosophies behind the administrative and accounting practices governing many foreign tax laws are at considerable variance with ours." These variances create a considerable amount of imprecision, and the deemed credit mechanism, as a consequence, can only approximately reach its theoretical goal of equality.

Practical grounds

The present deemed credit rules are highly technical and vastly complicated. They are expensive and difficult for taxpayers and the Revenue Service alike to administrate. Such an amendment would pile complication on complication.

In view of the above, the suggested amendment seems undesirable.

EXCLUSIONS AND EXEMPTIONS

Several of the other special-purpose provisions can conveniently be classified together. None of these appear to be particularly controversial at the present time and in the context of this inquiry they are not very important, for the revenue implications are not large. These are as follows:

For example, compare our accelerated depreciation rule with the British initial and investment allowances in respect of depreciable property, and its effect on the deemed credit ratios. 47060 0-59-pt. 3-42