The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Herman B. Bouma
Buchanan Ingersoll & Rooney PC, Washington, D.C.
There follows a true/false quiz about the purpose of the foreign tax credit under §901. To review the basics: the foreign tax credit under §901 is a credit that a U.S. person is allowed for a particular taxable year based on the amount of foreign income taxes (which, for this purpose, include "in-lieu-of" taxes under §903) that the U.S. person has accrued (or paid) for that year. The credit is applied, with certain limitations, against the preliminary U.S. income tax on the person's worldwide taxable income for the year.
If you score less than 70% on this quiz, you should probably bone up on the legislative history of §901 (and its predecessors).
1. True/False: The purpose of the foreign tax credit is to eliminate double taxation.
In determining the truth or falsity of this proposition, it is first necessary to ask: double taxation of what? — U.S. persons, activities, or income? With respect to income, it is critical to note that rarely do the income tax systems of two countries determine income in the same way. There are differences with respect to: (1) realization; (2) valuation; (3) expensing, depreciation, and amortization; (4) exclusions; and (5) deductions. It is best to think of two income tax systems as parallel universes — they are simply different systems with different rules and they hardly ever tax the "same" income. From time to time, two systems might determine gross income in the same way in a particular case, but then one system might allow some deductions whereas the other system does not, or both systems might allow different types of deductions. Therefore, they end up taxing different amounts. Thus, it really does not make sense to talk about the double taxation of income.
Moreover, even if two income tax systems did determine income in exactly the same way (and so were taxing exactly "the same amount"), it still is not the case that the purpose of the foreign tax credit is to eliminate that double taxation. Where the foreign effective tax rate is lower than the U.S. effective tax rate, clearly the foreign tax credit does not eliminate double taxation — the U.S. person will be paying both the foreign income tax and residual U.S. income tax. In that situation the foreign tax credit is working exactly as intended even though the double taxation is not eliminated. Consequently, one cannot say that the purpose of the foreign tax credit is to eliminate double taxation.
To talk of double taxation of an activity or of a U.S. person does make sense because both the United States and a foreign country may be taxing the same activity or the same person (although foreign countries may differ from the United States as to what is a "person"). However, here again, the purpose of the foreign tax credit is not to eliminate the double taxation since, as pointed out above, where the foreign effective tax rate is lower than the U.S. effective tax rate, there will still be taxation of the activity or the person by two different income tax systems. Thus, the purpose of the foreign tax credit is not to eliminate double taxation, but to relieve it.1
2. True/False: Double taxation could be relieved by giving U.S. persons a deduction for foreign income taxes.
In fact, that's how double taxation was relieved from the time the income tax was enacted (in 1913)2 until the Revenue Act of 1918. It's also the way in which the United States relieves double taxation by state and local governments.3
3. True/False: The foreign tax credit was instituted in order to relieve double taxation in a way that makes U.S. persons, particularly U.S. companies, more competitive in the global marketplace.
As indicated above, initially U.S. persons were only given a deduction for foreign income taxes. In 1918 Congress enacted the foreign tax credit4 because it was very difficult for U.S. companies to compete against foreign competitors when U.S. companies were only given a deduction for foreign income taxes. (Foreign companies were generally exempt from home country tax on their income earned abroad or given a generous foreign tax credit.) Ever since the foreign tax credit was enacted in 1918, there have been attempts from time to time to repeal it on the grounds that it's a "tax break or loophole for shipping U.S. jobs offshore." These attempts, however, have always been rebuffed on the grounds that the foreign tax credit is vital to ensuring the global competitiveness of U.S. companies.
In 1934, the Ways and Means Committee proposed allowing a foreign tax credit with respect to only one-half of a taxpayer's foreign-source income, but the Senate rejected the proposal and it was dropped in conference.5 Senator Pat Harrison (D-MS), Chairman of the Finance Committee, pointed out that without the foreign tax credit, an American corporation doing business abroad would be placed at a serious disadvantage as compared to a foreign corporation conducting the same kind of business in the same foreign country.6
In the early 1970s, momentum began gathering for a drastic cutback in the foreign tax credit and the deferral provisions of the Code. This effort was pushed most forcefully by Senator Vance Hartke (D-IN). In 1971 and again in 1973 the famous Burke-Hartke bills were introduced, which would have repealed the foreign tax credit (and deferral) for corporations.7 In 1973, the Ways and Means Committee held a series of hearings on the subject of tax reform (beginning a process that ultimately culminated in the Tax Reform Act of 19768). During these hearings there was substantial public opposition to repealing the foreign tax credit,9 and also strong opposition by the Chairman of the Ways and Means Committee, Representative Wilbur Mills (D-AR). A number of experts, including Jay Glasmann of Ivins, Phillips & Barker, Stanford Ross of Caplin & Drysdale, and Professor Robert Stobaugh of Harvard Business School, testified that repeal of the foreign tax credit would prove disastrous for U.S. companies operating abroad. 10 The Tax Reform Act of 1976 did not repeal the foreign tax credit but provided a "recapture" rule for situations in which foreign losses offset U.S.-source income.
During consideration of the Tax Reform Act of 1976, a task force of the Ways and Means Committee was formed for the purpose of reviewing U.S. policy towards the taxation of foreign-source income. In its report, which was issued after the 1976 Act was enacted, the task force stated, "Certain changes which might otherwise have been appropriate were found not to be acceptable if unilaterally adopted by the United States because they would subject U.S. businesses operating abroad to tax while their foreign competitors would not be similarly taxed, thus placing the U.S. businesses at a competitive disadvantage." 11
On June 19, 1986, during consideration on the Senate floor of the Finance Committee's version of the Tax Reform Act of 1986, 12 Senator DeConcini (D-AZ) proposed an amendment that would have eliminated the foreign tax credit (and deferral) in order to "curtail the outflow of U.S. investment capital." 13 Senators Packwood (R-OR) and Bradley (D-NJ) strongly opposed this proposal on the grounds that, if enacted, U.S. companies would be unable to compete effectively in foreign countries. 14 The proposed amendment was tabled by a vote of 92 to 7.
4. True/False: Cross-crediting is inherently evil.
A limitation on the foreign tax credit was first enacted by the Revenue Act of 1921. 15 The basic purpose of the limitation was to prevent the foreign tax credit from offsetting preliminary U.S. tax on U.S.-source income. 16 This limitation allowed for broad "cross-crediting," i.e., the crediting of foreign income taxes incurred with respect to one foreign activity against preliminary U.S. income tax imposed on income from another foreign activity (whether in the same country or another country). For many years a limitation on the foreign tax credit that allows for broad cross-crediting (with respect to foreign-source income but not with respect to U.S.-source income) has been favorably viewed by Congress as helping U.S. companies compete in the global marketplace, particularly with respect to foreign companies that are generally exempt from home country tax on income earned abroad.
In 1960, as part of H.R. 10087, 17 Congress reinstituted a broad general limitation on the foreign tax credit (as an alternative to the per-country limitation, which had been enacted with the 1954 Code) because Congress believed that the averaging of high and low foreign tax rates under a general (or overall) method was proper since most taxpayers viewed their foreign operations as a unitary enterprise. 18 Many tax scholars and commentators observed that the per-country limitation was not appropriate for a global marketplace where goods are designed, built, assembled, and marketed in many different countries. In testimony before the Ways and Means Committee in 1958, Professor Roy Blough of Columbia University defended the overall limitation on the basis that the principles of neutrality and fairness among taxpayers are served by the "lumping together of income derived from and taxes paid to all foreign countries…." 19 In 1961, Professor Elisabeth Owens of Harvard Law School, in her book The Foreign Tax Credit,the leading text on the subject, agreed that whether foreign income taxes are paid to one country or divided up among several foreign countries should be immaterial to the function of the foreign tax credit. She concluded that the problem with double taxation ought to be solved by "treating the world apart from the United States as one taxing jurisdiction." 20
Following enactment of the Tax Reduction Act of 1975, 21 the Ways and Means Committee resumed its efforts to formulate a comprehensive tax reform bill. During the summer of 1975, the committee held a series of hearings and invited experts to give advice and information with respect to the foreign tax credit and other foreign issues. 22 The strongest argument in favor of a broad general limitation was made by William J. Nolan, Jr., Chairman of the Committee on Taxation of the U.S. Council of the International Chamber of Commerce. He stated the following:
[T]he overall method puts an integrated U.S. international company in a better position to compete with foreign-owned worldwide competitors whose home countries grant incentives to encourage foreign investment or do not tax foreign-source income in any event. This result is obtained because the taxpayer which [has] an economically interrelated and integrated business spread out over a number of countries is allowed to recognize the homogenous nature of all the foreign income by combining it and all the foreign income taxes paid in connection therewith and treat it as a whole[,] which has the effect of leveling out the foreign income tax rates by averaging. This is the same position which a foreign owned competitor is in where its home country does not tax foreign-source income. 23
The essence of this statement is that the overall limitation is preferable to the per-country limitation because the overall limitation comes closer to achieving a de factoterritorial approach. A territorial approach, which would simply exempt foreign operating income from U.S. tax, would remove all U.S. tax impediments to the international competitiveness of U.S. companies. If territoriality cannot be obtained, the cross-crediting of foreign income taxes allowed under the overall limitation constitutes the best surrogate for territoriality. 24
The importance of promoting international competitiveness was emphasized by Timothy W. Stanley, President, International Economic Policy Association:
When considering changes in the tax treatment of foreign-source income, it is vital to examine the policies of other industrialized countries, for the long-term future of the U.S. economy will depend on its competitive position in the international marketplace. [Adverse changes] in the U.S. tax treatment of foreign-source income will have the effect of increasing U.S.-owned companies' costs vis-a-vis German, British, and Japanese competitors. It is the economies of our competitors that will benefit, not the United States. 25
Stanford Ross of Caplin & Drysdale stated, "From the standpoint of fairness, the overall limitation, to my mind, realistically recognizes that modern business enterprises spill across national boundaries and that allowing an averaging of high and low foreign tax rates is appropriate United States policy. 26 As mentioned earlier, the Tax Reform Act of 1976 retained the foreign tax credit and a broad general limitation but instituted a "recapture" rule for foreign losses.
Unfortunately, the Tax Reform Act of 1986 27 instituted a number of new separate limitations on the foreign tax credit. However, the American Jobs Creation Act of 2004 28 reinstituted a broad general limitation because "Congress believed that simplifying these rules would reduce double taxation, make U.S. businesses more competitive, and create jobs in the United States." 29
5. True/False: An item-by-item foreign tax credit limitation is the "conceptually correct" foreign tax credit limitation.
The notion that an item-by-item limitation is the conceptually correct limitation ignores the basic reason the foreign tax credit was enacted, i.e., to enhance the international competitiveness of U.S. companies. (See discussion in 3 and 4 above.) It also ignores the fact that it is extremely rare for a foreign country and the United States to be taxing "the same amount" of income.
6. True/False: A broad general limitation on the foreign tax credit achieves the purpose of the foreign tax credit and keeps complexity to a minimum.
As mentioned above, a broad general limitation on the foreign tax credit, which permits the cross-crediting of foreign income taxes imposed on different types of income earned in different foreign countries, constitutes a surrogate for territoriality 30 and thus reduces the extent to which worldwide taxation of U.S. companies otherwise impedes their international competitiveness. The international competitiveness of foreign operations of U.S. companies is critical to the economic well-being of the United States and should be the single most important consideration guiding our system of taxing foreign income.
A broad general limitation on the foreign tax credit also has the advantage of keeping complexity to a minimum. When this author was an Attorney-Advisor in the International Branch of the Legislation and Regulations Division of the IRS Office of Chief Counsel, he was asked to review a legislative proposal (from the IRS field) to deny the foreign tax credit for foreign income taxes that were not imposed on income that was also subject to U.S. income tax. He wrote a rather lengthy memorandum on the subject, explaining how extremely complicated such a provision would be. Fortunately, the IRS never recommended the proposal to Congress (or to Treasury).
In 2004, Congress reinstituted a broad general limitation on the foreign tax credit because it "believed that reducing the number of foreign tax credit baskets to two would greatly simplify the Code and undo much of the complexity created by the Tax Reform Act of 1986," and would make U.S. companies more competitive. 31 With the enactment on August 10, 2010, of P.L. 111-226 (commonly referred to as the "Education Jobs and Medicaid Assistance Act of 2010"), and in particular with the addition of §§909, 901(m), and 960(c) to the Code, "complexity creep" with respect to the foreign tax credit has begun again. Absurd complexity that makes compliance by taxpayers extremely difficult and enforcement by revenue agents virtually impossible serves no useful purpose and leads to disrespect for the system. Moreover, the provisions cited are at odds with the basic purpose of the foreign tax credit, i.e., to promote the global competitiveness of U.S. companies. Perhaps if the tax-writing committees had been permitted to hold hearings on the proposals, this might have been avoided.
This commentary also will appear in the January 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes -- General Issues, and Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904, and in Tax Practice Series, see ¶7150, U.S. Persons—Worldwide Taxation, and ¶7160, U.S. Income Tax Treaties.
1 The Organisation for Economic Co-operation and Development (OECD) often talks about the need to eliminate double taxation. Where a person is taxed by its residence country on a worldwide basis, the OECD has in mind eliminating double taxation by properly sourcing income and applying a foreign tax credit. Where a person is taxed by its residence country on a territorial basis, the OECD has in mind eliminating double taxation by properly allocating income between two jurisdictions. As explained above, talk about eliminating double taxation through the use of a foreign tax credit does not make sense. Although such talk might appear to make some sense when focusing on two countries that have territorial systems, even in that context it does not make sense because the OECD's focus is primarily on allocating gross income and not also deductions (e.g., the OECD is not necessarily concerned with the use of different apportionment methods by two jurisdictions in determining the profits of a PE). Thus, in that context also the focus is on relieving double taxation, not eliminating it.
2 Section II(A)(1) of the Income Tax Act of 1913 imposed a 1% tax upon "the entire net income arising or accruing from all sources in the preceding calendar year to every citizen of the United States, whether residing at home or abroad…." Section II(G)(b)(fourth) provided that in determining the net income for U.S. corporations all sums paid for taxes imposed by the government of any foreign country were deductible from gross income.
19 House Hearings Before the Committee on Ways and Means on General Revision of the Internal Revenue Code, 85th Cong., 2d Sess. 1177 (1958). Donald Gleason of Corn Products Company, Ira Wender of Baker, McKenzie & Hightower, and Raphael Sherfy also testified in favor of the overall limitation. SeeHouse Panel Discussion Before the Committee on Ways and Means on Income Tax Revision, 86th Cong., 1st Sess. 1150-1, 1174, 1189 (1959).
24 It is noteworthy that The Moment of Truth,the proposal released on Dec. 1, 2010, by the Co-Chairmen of the President's bipartisan National Commission on Fiscal Responsibility and Reform, recommended moving to a "competitive territorial tax system." Recommendation 2.2.3 at p. 33.
27 P.L. 99-514 (10/22/86). Further discussion of the legislative history of the foreign tax credit until 1989 may be found in McClure and Bouma, "The Taxation of Foreign Income from 1909 to 1989: How a Tilted Playing Field Developed," Tax Notes 1379 (6/12/89).
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