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Present Law and Issues in U.S. Taxation of Cross-Border Income

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Present Law and Issues in U.S. Taxation of Cross-Border Income PRESENT LAW AND ISSUES IN U.S. TAXATION OF CROSS-BORDER INCOME Scheduled for a Public Hearing Before the SENATE COMMITTEE ON FINANCE on September 8, 2011 Prepared by the Staff of the JOINT COMMITTEE ON TAXATION September 6, 2011 JCX-42-11 CONTENTS Page INTRODUCTION .......................................................................................................................... 1 I. U.S. CROSS-BORDER TRANSACTIONS AND INVESTMENTS ................................... 2 A. Trade Deficits and Cross-Border Capital Flows .............................................................. 2 1. National income accounting ...................................................................................... 2 2. Economic implications of trade deficits .................................................................... 5 B. Trends in the U.S. Balance of Payments .......................................................................... 9 1. Overview of U.S. balance of payments (current account) ......................................... 9 2. Components of the current account ......................................................................... 11 C. Trends in the U.S. Financial Account ............................................................................ 12 1. Overview of the U.S. financial account ................................................................... 12 2. Growth in foreign-owned assets in the United States and U.S.-owned assets abroad ....................................................................................................................... 13 D. Summary and Implications for Tax Reform .................................................................. 19 II. PRESENT LAW .................................................................................................................. 20 A. General Overview .......................................................................................................... 20 1. International tax principles ...................................................................................... 20 2. International principles as applied in the U.S. system ............................................. 20 3. Principles common to inbound and outbound taxation............................................ 22 B. U.S. Tax Rules Applicable to U.S. Activities of Non-U.S. Persons (Inbound) ............. 28 1. In general ................................................................................................................. 28 2. Gross-basis taxation of U.S.-source income ............................................................ 28 3. Net-basis taxation..................................................................................................... 35 4. Special rules ............................................................................................................. 39 C. U.S. Tax Rules Applicable to Foreign Activities of U.S. Persons (Outbound) ............. 43 1. In general ................................................................................................................. 43 2. Foreign tax credit ..................................................................................................... 43 3. Anti-deferral regimes ............................................................................................... 46 4. Other special rules .................................................................................................... 50 5. Foreign earned income exclusion ............................................................................ 52 III. ISSUES RELATED TO PRESENT LAW .......................................................................... 54 A. Issues Applicable to U.S. Activities of Non-U.S. Persons ............................................ 54 1. Earnings stripping .................................................................................................... 54 2. Effect of inbound foreign direct investment on U.S. employment, research and development, and trade ..................................................................................... 62 3. Effect of withholding taxes and reporting on cross-border investment ................... 63 B. Issues Applicable to Foreign Activities of U.S. Persons ............................................... 69 1. Background .............................................................................................................. 69 2. Effect of deferral on investment decisions ............................................................... 69 3. Multiple distortions .................................................................................................. 73 4. Empirical studies ...................................................................................................... 76 i 5. U.S. foreign direct investment and domestic investment ........................................ 77 6. Effect of deferral on residence choice ..................................................................... 79 IV. FUNDAMENTAL INTERNATIONAL TAX REFORM ................................................... 80 A. Territorial System .......................................................................................................... 80 1. Principal features ..................................................................................................... 80 2. Economic analysis ................................................................................................... 84 3. Structural issues presented by territoriality .............................................................. 88 B. Full Inclusion System .................................................................................................... 99 1. Mechanisms for implementing a full inclusion system ........................................... 99 2. Economic analysis ................................................................................................. 103 3. Structural issues presented by full inclusion .......................................................... 105 ii INTRODUCTION The Senate Committee on Finance has scheduled a public hearing on September 8, 2011, entitled “Tax Reform Options: International Issues.” This document,1 prepared by the staff of the Joint Committee on Taxation (“Joint Committee staff”), provides general background on economic data relating to international trade and U.S. international tax rules applicable to cross- border income both those rules applicable to foreign persons earning income in the United States and those rules applicable to U.S. persons earning income abroad. The document also provides a discussion of issues related to the present-law U.S. tax system and describes aspects of a territorial and full inclusion tax system. 1 This document may be cited as follows: Joint Committee on Taxation, Present Law and Issues in U.S. Taxation of Cross-Border Income (JCX-42-11), September 6, 2011. This document can be found on our website at www.jct.gov. 1 I. U.S. CROSS-BORDER TRANSACTIONS AND INVESTMENTS This section discusses the economic relationship between trade deficits and cross-border investment. In doing so, it also presents background data relating to the scope of the international trade sector in the United States economy, and briefly reviews trends in both the current account (the trade surplus or deficit) and the financial account (U.S. investment abroad and foreign investment in the United States).2 In short, among other things, the data show increased trade in goods and services (exports and imports). Increased levels of exports increase income that U.S. persons must allocate between U.S.-source and foreign-source income for income tax purposes. Likewise, increased levels of imports increase income that foreign persons must allocate between U.S.-source and foreign-source income. The tax rules generally applicable to such income are described in part II.A.3. below. The data also document increasing levels of direct investments and portfolio investments abroad by U.S. persons (called “outbound” investment) and increasing levels of direct investments and portfolio investments in the United States by foreign persons (called “inbound” investments). The income earned by such investments is subject to U.S. taxation as described in Part II.B., below, in the case of inbound investment and in part II.C., below, in the case of outbound investment. A. Trade Deficits and Cross-Border Capital Flows 1. National income accounting In popular discussion of trade issues, much attention is given to the trade deficit or surplus, that is, the difference between the economy’s exports and imports. In the late 1980s, just as at present, there was also attention given to inflows of capital from abroad. Capital inflows can take the form of foreign purchases of domestic physical (or “real”) assets, or of domestic financial assets, such as equity interests or debt instruments. 2 Prior to 1999, the U.S. Department of Commerce, Bureau of Economic Analysis reported and described international transactions by reference to the “current account” and the “capital account.” Beginning in June 1999 the Bureau of Economic Analysis adopted a three-group classification to make U.S. data reporting more closely aligned with international guidelines. The three groups are labeled: current account; capital account; and financial account. Under this regrouping, the “financial account” encompasses all transactions that used to fall into the old “capital account,” that
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