D. Adopt a Dividend Exemption System for Foreign Business Income

Present Law

"Worldwide" vs. "territorial" taxation of business income

The tax systems of the world generally reflect two basic approaches to the taxation of cross-border business income, often referred to as "worldwide" and "territorial" approaches. Under a pure worldwide tax system, resident corporations are taxable on their worldwide income, regardless of source, and the potential double taxation arising from overlapping sourcecountry and residence-country taxing jurisdiction is mitigated by allowing a foreign tax credit. In contrast, under a pure territorial tax system, a country taxes only income derived within its borders, irrespective of the residence of the taxpayer. Thus, foreign-source income earned by a resident corporation is exempt from tax under a pure territorial tax system.

Each type of system may be said to promote a particular conception of economic efficiency. A pure worldwide tax system promotes capital export neutrality, a norm that holds that tax considerations should not influence a taxpayer's decision of whether to invest at home or abroad. Under a pure worldwide tax system, the after-tax return to an otherwise equivalent investment does not depend on whether the investment is made at home or abroad, since in either case the income from the investment generally will be subject to tax at the residence-country rate. Thus, investment-location decisions are governed by business considerations, instead of by tax law. A pure territorial system, on the other hand, promotes capital import neutrality, a norm that holds that all investment within a particular source country should be treated the same, regardless of the residence of the investor. Thus, if a residence country adopts a pure territorial system, residents of that country, when investing abroad in a particular source jurisdiction, will not receive a lower after-tax return than other investors by virtue of their country of residence.

In a world with diverse tax systems and rates, it is impossible fully to achieve both capital import neutrality and capital export neutrality at the same time. For example, suppose a source country offers a lower tax rate on a particular investment than the U.S. rate on a similar investment in the United States. Capital export neutrality would dictate that the United States impose a residual residence-based tax on the foreign investment at a level sufficient to make a U.S. investor indifferent on an after-tax basis between the two investment locations; however, doing so would violate capital import neutrality, as a U.S. investor in the source country would earn a lower after-tax rate of return compared to non-U.S. investors in the same source country, to the extent that such investors' residence countries did not assert a similar residual tax on the income. As long as different countries maintain different tax systems and rates, the two goals will remain in tension with each other.

The tax systems of all large, industrialized countries may be said to reflect varying compromises between these competing goals. Accordingly, no large, industrialized country employs a pure worldwide or pure territorial system. Existing systems may be accurately characterized as predominantly worldwide or territorial, but all systems share at least some features of both the worldwide and territorial approaches. Thus, systems commonly described as "worldwide" in fact include many territorial-type elements that promote capital import neutrality, such as indefinite deferral of tax on most types of foreign business income earned through

foreign subsidiaries in the case of the United States. Similarly, systems commonly described as "territorial" include many worldwide-type features that promote capital export neutrality, such as residence-country taxation of passive income earned through foreign subsidiaries in lower-tax countries.

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Many countries tax resident corporations on a predominantly territorial basis by exempting dividends received from foreign subsidiaries from residence-country tax. This exemption typically applies only where the parent company's ownership in the subsidiary exceeds a certain threshold (commonly five to 10 percent), and the exemption may be total or partial (e.g., only 95 percent, or 60 percent, of qualifying dividends might be exempted, as a proxy for disallowing expenses allocable to exempt income). A number of restrictions generally apply, in order to limit the exemption to certain categories of income (e.g., active business income) and to address concerns about shifting income to lower-tax countries in order to avoid tax. These exemption systems generally do impose tax on foreign-source royalties and portfoliotype income.

The U.S. system: worldwide, deferral-based taxation of foreign business income

The United States employs a "worldwide" tax system, under which domestic corporations generally are taxed on all income, whether derived in the United States or abroad. Income earned by a domestic parent corporation from foreign operations conducted by foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income generally is deferred, and U.S. tax is imposed on such income when repatriated.

However, under anti-deferral rules, the domestic parent corporation may be taxed on a current basis in the United States with respect to certain categories of passive or highly mobile income earned by its foreign subsidiaries, regardless of whether the income has been distributed as a dividend to the domestic parent corporation. The main anti-deferral provisions in this context are the controlled foreign corporation ("CFC") rules of subpart F416 and the passive foreign investment company ("PFIC") rules.417

A foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed on foreign-source income, whether earned directly by the domestic corporation, repatriated as a dividend from a foreign subsidiary, or included in income under the anti-deferral rules.418 The foreign tax credit generally is limited to the U.S. tax liability on a taxpayer's foreign-source

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These systems are often referred to as "participation exemption" systems.

income, in order to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting the U.S. tax on U.S.-source income."

The foreign tax credit limitation is applied separately to different types of foreign-source income, in order to reduce the extent to which excess foreign taxes paid in a high-tax foreign jurisdiction can be "cross-credited" against the residual U.S. tax on low-taxed foreign-source income. For example, if a taxpayer pays foreign tax at an effective rate of 40 percent on certain active income earned in a high-tax jurisdiction, and pays little or no foreign tax on certain passive income earned in a low-tax jurisdiction, then the earning of the untaxed (or low-tax) passive income could expand the taxpayer's ability to claim a credit for the otherwise uncreditable excess foreign taxes paid to the high-tax jurisdiction, by increasing the foreign tax credit limitation without increasing the amount of foreign taxes paid. This sort of cross-crediting is constrained by rules that require the computation of the foreign tax credit limitation on a category-by-category basis. Thus, in the example above, the rules would place the passive income and the active income into separate limitation categories, and the low-tax passive income would not be allowed to increase the foreign tax credit limitation applicable to the credits arising from the high-tax active income. A significant degree of cross-crediting may be achieved within a single limitation category, however. For example, a high-tax dividend from a CFC and a lowtax royalty from another CFC may both fall into the general limitation category, with the result that potential excess credits associated with the dividend effectively may reduce the residual U.S. tax owed with respect to the royalty.

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Reasons for Change

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It has long been recognized that the worldwide, deferral-based system of present law distorts business decisions in a number of ways. By establishing repatriation as the system's principal taxable event, the worldwide, deferral-based system creates incentives in many cases to redeploy foreign earnings abroad instead of in the United States, thereby distorting corporate cash-management and financing decisions. At the same time, basing the system on repatriation renders the payment of U.S. tax on foreign-source business income substantially elective in many cases, because repatriation itself is elective. By maintaining deferral indefinitely, a taxpayer may achieve a result that is economically equivalent to 100-percent exemption of income, with no corresponding disallowance of expenses allocable to the exempt income, provided that the taxpayer does not repatriate the earnings or run afoul of subpart F or other anti

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Secs. 901 and 904.

Sec. 904(d). The American Jobs Creation Act of 2004 (“AJCA") generally reduced the number of these categories from nine to two, effective in 2007. A number of other provisions of the Code and treaties have the effect of creating additional separate limitation categories in specific circumstances.

421 See sec. 904(d)(3) (providing for look-through treatment of dividends, interest, rents, and royalties received from CFCs).

deferral rules. 422 In addition, taxpayers that repatriate high-tax earnings may be able to use excess foreign tax credits arising from these repatriations to offset the U.S. tax on lower-tax items of foreign-source income, such as royalties received for the use of intangible property in a low-tax country.

For these reasons, in many cases, the present-law "worldwide" system actually may yield results that are more favorable to the taxpayer than the results available in similar circumstances under the "territorial" exemption systems used by many U.S. trading partners, as these systems generally fully tax foreign-source royalties and portfolio-type income, and often exempt less than 100 percent of a dividend received from a subsidiary, as a proxy for disallowing expenses allocable to the exempt income. At the same time, however, the potential for taxation under the U.S. system by reason of either repatriation or application of the highly complex U.S. antideferral rules arguably forces U.S.-based multinationals to contend with a greater degree of complexity, and to engage in a greater degree of tax-distorted business planning, than many of their foreign-based counterparts resident in countries with exemption systems.

The present-law system thus creates a sort of paradox of defects: on the one hand, the system allows tax results so favorable to taxpayers in many instances as to call into question whether it adequately serves the purposes of promoting capital export neutrality or raising revenue; on the other hand, even as it allows these results, the system arguably imposes on taxpayers a greater degree of complexity and distortion of economic decision making than that faced by taxpayers based in countries with exemption systems, arguably impairing capital import neutrality in some cases.

The Congress recognized and addressed some of these problems in AJCA, but significant problems remain. Replacing the worldwide, deferral-based system with a dividend exemption system arguably would mitigate many of these remaining problems, while generally moving the system further in the direction charted by the Congress in 2004.

Description of Proposal

Overview

Under the proposed dividend exemption system, income earned abroad by foreign subsidiaries of U.S. parent corporations would fall into one of two categories: (1) passive and other highly mobile income, which would be taxed to the U.S. parent on a current basis under subpart F; or (2) all other income--i.e., active, less-mobile income not subject to subpart F-which would be exempt from U.S. tax and thus could be repatriated free of any tax impediment. The deferral and repatriation tax at the heart of the present-law system would be eliminated, and the foreign tax credit system would serve a more limited function than it does under present law.

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In addition, in some cases taxpayers may enter into transactions that are substantially equivalent to repatriations economically, but that are intended to escape taxation as such. Section 956 imposes limits on this practice with respect to many of the nearest repatriation equivalents.

CFC-parent dividends exempt from tax

A U.S. corporation that holds 10 percent or more of the stock of a CFC would exclude from income 100 percent of the dividends received from the CFC. This exclusion would be mandatory, and no foreign tax credits would arise with respect to foreign taxes attributable to the excluded dividend income (including both corporate-level income taxes and dividend withholding taxes). In addition, a special rule would provide that no subpart F inclusions would be created as a dividend moves up a chain of CFCs, to the extent that the dividend is attributable to a 10 percent or greater direct or indirect interest in the dividend-paying CFC owned by the U.S. parent. This rule would ensure that dividends could be repatriated from lower-tier CFCs without losing the benefit of dividend exemption, and it also would make it easier to redeploy CFC earnings in different foreign jurisdictions without triggering subpart F, thus promoting neutrality as to the decision of how to dispose of CFC earnings.

Under the dividend exemption system, CFC earnings would constitute a predominantly tax-exempt stream of income for the U.S. parent corporation. Accordingly, deductions for interest and certain other expenses incurred by the U.S. corporation would be disallowed to the extent allocable to exempt (non-subpart-F) CFC earnings. These allocations would be made as the earnings are generated, as opposed to when they are distributed. Thus, for expense allocation purposes, CFC earnings would be treated as giving rise to foreign-source income as they are earned.

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Interest expense would first be allocated between U.S. and foreign-source income under rules similar to those of present law, including the interest allocation changes made by AJCA. The amount of interest expense allocated to foreign-source income under these rules then would be further allocated between exempt CFC earnings and other foreign-source income on a pro rata basis, based on assets. Research and experimentation expenses would first be allocated between U.S. and foreign-source income under rules similar to those of present law." The amount of research and experimentation expenses allocated to foreign-source income then would be further allocated first to taxable royalties and similar payments (e.g., cost-sharing or royalty-like sale payments) to the extent thereof, then to CFC earnings to the extent thereof (with this amount divided on a pro rata basis between exempt CFC earnings and non-exempt CFC earnings), and then finally to other foreign-source income. General and administrative expenses would be allocated to exempt CFC earnings in the same proportion that exempt CFC earnings of the group bears to overall earnings of the group. Other expenses, such as stewardship expenses, may be directly allocable to exempt CFC earnings in some cases. With respect to all of these categories of expenses, as under present law, it will be necessary for the Treasury Department to provide detailed expense allocation rules by regulation.