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433

Economists who have studied how moving to a dividend exemption system might affect the location incentives of U.S. corporations find no definitive evidence that incentives would be significantly changed. Two recent studies examine how the incentive to invest in low-tax locations abroad would be affected if the United States were to move to a dividend exemption system similar to the one described here. In both studies, the authors consider dividend exemption systems that impose allocation rules similar to those of present law so that some portion of deductions for interest and overhead expenses incurred by the U.S. parent company and allocated to exempt foreign income are disallowed as deductions from U.S. taxable income. One study concludes that under dividend exemption, the effective tax rate on U.S. investment in low-tax locations would actually increase relative to the system in place prior to AJCA. Although active foreign business income would avoid U.S. residual taxation, the loss of the ability to shield U.S. tax on foreign royalties through cross-crediting and to claim deductions for overhead and interest expense at home (or in other high-tax locations) results in higher tax burdens in low-tax locations. The second study presents hypothetical effective tax rates for incremental investment by a U.S. taxpayer in a low-tax subsidiary abroad under the U.S. tax system in place prior to AJCA and under dividend exemption with expense allocation rules. This study also finds that the tax burden of investing in low-tax countries may increase under dividend exemption. In addition, the study uses two other approaches to investigate how location decisions may change under dividend exemption: a comparison of foreign direct investment patterns for the United States and for two countries which exempt dividends received from foreign affiliates resident in countries with which they have tax treaties (Germany and Canada) and an empirical analysis of the extent to which residual U.S. taxes on low-tax foreign earnings impact the location decisions of U.S. corporations. Neither approach yielded results that would suggest that location decisions would be significantly altered if the United States were to exempt dividends from residence country taxation."

435

432 Harry Grubert and John Mutti, Taxing International Business Income: Dividend Exemption versus the Current System, Washington, D.C., American Enterprise Institute (2001) ("Grubert and Mutti"); and Rosanne Altshuler and Harry Grubert, "Where Will They Go if We Go Territorial? Dividend Exemption and the Location Decisions of U.S. Multinational Corporations," National Tax Journal, Vol. LIV, No. 4 (December 2001) ("Altshuler and Grubert").

435

Some economic research has focused on the impact of home country tax systems on foreign direct investment in the United States. The conclusions from this literature are mixed. Joel Slemrod uses time-series data to compare the responsiveness to U.S. corporate tax rates of foreign direct investment from exemption and "worldwide" countries. Joel Slemrod, "Tax Effects on Foreign Direct Investment: Evidence from a Cross-Country Comparison," in Taxation in the Global Economy, edited by Assaf Razin and Joel Slemrod, Chicago, University of Chicago Press, 1990. The study does not uncover a difference between the two groups of countries. James R. Hines, Jr. examines whether the sensitivity of manufacturing foreign direct investment to State income tax rates varies across exemption and "worldwide" countries. James R. Hines,

Jr., "Altered States: Taxes and the Location of Foreign Direct Investment in America,” American Economic Review, 86, No. 5, December, 1996. The study finds that foreign direct investment from exemption countries is more responsive to differences in State income tax rates. Although relevant, these papers do not examine the experience of U.S. corporations and how location incentives may change under the dividend exemption proposal described here and the current system.

VII. OTHER BUSINESS PROVISIONS

A. Disallow Deduction for Interest on Indebtedness

Allocable to Tax-Exempt Obligations

(sec. 265)

Present Law

In general

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437

Present law disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from tax (tax-exempt obligations). This rule applies to tax-exempt obligations held by individual and corporate taxpayers. The rule also applies to certain cases in which a taxpayer incurs or carries indebtedness and a related person acquires or holds tax-exempt obligations. There are two methods for determining the amount of the disallowance. One method, which applies to all taxpayers other than financial corporations or dealers in tax-exempt obligations, asks whether a taxpayer's borrowing can be traced to its holding of exempt obligations. A second method, which applies to financial corporations and dealers in exempt obligations, disallows interest deductions based on the percentage of a taxpayer's assets comprised of exempt obligations.

The interest expense disallowance rules are intended to prevent taxpayers from engaging in tax arbitrage by deducting interest on indebtedness that is used to purchase tax-exempt obligations.

Rules for nonfinancial corporations

General rules

Under IRS rules,438 for every taxpayer other than a financial corporation or a dealer in tax-exempt obligations, an interest deduction generally is disallowed only if the taxpayer has a purpose of using borrowed funds to purchase or carry tax-exempt obligations (the "tracing rule"). This purpose may be established by direct or circumstantial evidence.

436 Sec. 265.

437 Section 7701(f) provides that the Secretary of the Treasury will prescribe regulations necessary or appropriate to prevent the avoidance of any income tax rules that deal with the use of related persons, pass-through entities, or other intermediaries in (1) the linking of borrowing to investment or (2) diminishing risks. See H Enterprises Int'l, Inc. v. Commissioner, T.C.M. 1998-97, aff'd. 183 F.3d 907 (8th Cir. 1999) (Code section 265(a)(2) applied where a subsidiary borrowed funds on behalf of a parent and the parent used the funds to buy, among other investments, tax-exempt securities).

Rev. Proc. 72-18, 1972-1 C.B. 740.

Direct evidence of a purpose to purchase tax-exempt obligations exists if the proceeds of indebtedness are used for and are directly traceable to the purchase of tax-exempt obligations. Direct evidence of a purpose to carry tax-exempt obligations exists if tax-exempt obligations are used as collateral for indebtedness. In the absence of direct evidence, the interest disallowance rule applies only if the totality of facts and circumstances supports a reasonable inference that the purpose to purchase or carry tax-exempt obligations exists. In general terms, the tracing rule applies only if the facts and circumstances establish a sufficiently direct relationship between the borrowing and the investment in tax-exempt obligations.

Two-percent de minimis exception

Under IRS rules, an interest deduction generally is not disallowed to an individual if during the taxable year the average adjusted basis of the individual's tax-exempt obligations is two percent or less of the average adjusted basis of the individual's portfolio investments and trade or business assets. For a corporation an interest deduction generally is not disallowed if the average adjusted basis of the corporation's tax-exempt obligations is two percent or less of the average adjusted basis of all assets held in the active conduct of the corporation's trade or business. These two-percent safe harbors do not apply to dealers in tax-exempt obligations or to financial institutions.

Interest on installment sales to State and local governments

If a corporation holds tax-exempt obligations (installment obligations, for example) acquired in the ordinary course of its business in payment for services performed for, or goods supplied to, State or local governments, and if those obligations are nonsalable, the interest deduction disallowance rule generally does not apply." 439 The theory underlying this rule is that a corporation holding tax-exempt obligations in these circumstances has not incurred or carried indebtedness for the purpose of acquiring those obligations.

Rules for financial corporations and dealers in tax-exempt obligations

440

A financial institution generally is denied a deduction for that portion of its interest expense (not otherwise allocable to tax-exempt obligations) that equals the ratio of the financial institution's average adjusted basis of tax-exempt obligations acquired after August 7, 1986 to the average adjusted basis of all the taxpayer's assets (the "pro-rata rule"). In the case of an obligation of an issuer that reasonably expects not to issue more than $10 million in tax-exempt obligations within a calendar year (a “qualified small issuer"), the general pro-rata rule does not apply. Instead, only 20 percent of the interest allocable to the tax-exempt obligations of a qualified small issuer is disallowed." The special rule for qualified small issuers also applies to

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439

Rev. Proc. 72-18, as modified by Rev. Proc. 87-53, 1987-2 C.B. 669.

certain aggregated issuances of tax-exempt obligations in which more than one governmental entity receives benefits."

443

A rule similar to the pro-rata rule applies to dealers in tax-exempt obligations, but there is no exception for qualified small issuers, and the 20-percent disallowance rule does not apply.“

Reasons for Change

The tracing rule requires an inquiry into a taxpayer's intent in borrowing. A taxpayer's deduction for the interest expense of borrowing is subject to the tracing rule only if the taxpayer intends to use the proceeds of the borrowing to buy or carry tax-exempt obligations. Because intent is difficult to determine, and because a firm's funds are fungible, the tracing rule has proven difficult to administer and easy to avoid. In particular, related corporations have avoided the tracing rule by engaging in borrowing through one corporation and the holding of exempt obligations by another corporation. Moreover, the two-percent de minimis exception provides a safe harbor for a certain amount of tax arbitrage.

Description of Proposal

The proposal extends to all corporations (other than insurance companies) the pro-rata rule applicable to financial institutions under present law. Accordingly, except in limited circumstances (described below), the proposal repeals the tracing rule, and it repeals the twopercent de minimis exception provided by IRS guidance. The proposal retains the present-law scope of the qualified small issuer exception. The proposal retains the present-law exception for interest on installment sales to State and local governments and extends the exception to taxpayers that become subject to the pro-rata rule under this proposal.

445

The proposal applies the pro-rata rule to related persons by treating (1) all members of the same affiliated group as one taxpayer444 and (2) any interest in a partnership held by the taxpayer as a direct ownership interest by the taxpayer in its allocable share of partnership assets and liabilities. In addition, the proposal applies the present-law tracing rule to all other related persons by treating those persons and the taxpayer as a single entity." For example, if one taxpayer borrows with the purpose that a related person will hold tax-exempt obligations (and the taxpayer and related person are not members of an affiliated group), the tracing rule applies to the taxpayer's borrowing.

1563(a).

446

444 The proposal adopts the definition of affiliated group found in present law section

445

446

The proposal defines related persons by reference to section 267(f)(1).

If the taxpayer and the related person are members of an affiliated group, they are treated as a single taxpayer under the proposal, and the pro-rata rule applies.