ECONOMIC AND U.S. INCOME TAX ISSUES RAISED BY SOVEREIGN WEALTH FUND INVESTMENT IN THE UNITED STATES Prepared by the Staff of the JOINT COMMITTEE ON TAXATION June 17, 2008 JCX-49-08 CONTENTS Page INTRODUCTION ....................................................................................................................... 1 I. U.S. CROSS-BORDER TRANSACTIONS AND INVESTMENTS ................................ 3 A. Trade Deficits and Cross-Border Capital Flows......................................................... 3 B. Trends in the U.S. Balance of Payments................................................................... 10 C. Trends in the U.S. Financial Account....................................................................... 13 D. Summary and Implications for Discussion of SWFs................................................ 19 II. SOVEREIGN WEALTH FUNDS.................................................................................... 21 A. Background Information........................................................................................... 21 B. Recent Prominent SWF Investments in the United States........................................ 27 C. Non-Tax Policy Concerns Raised by SWFs ............................................................. 30 D. Non-Tax Policy Responses....................................................................................... 33 III. CURRENT U.S. INCOME TAX RULES ........................................................................ 37 A. U.S. Income Taxation of Foreign Persons................................................................ 37 B. U.S. Income Taxation of Foreign Governments....................................................... 41 C. Application of Income Tax Treaties to Foreign Governments and SWFs................ 56 IV. TECHNIQUES USED BY SWFs TO INVEST IN UNITED STATES .......................... 63 A. Mandatory Convertible Securities ............................................................................ 63 B. Common and Convertible Preferred Stock............................................................... 69 C. Other Investment Strategies...................................................................................... 71 V. POLICY CONSIDERATIONS REGARDING THE CURRENT TAX TREATMENT OF U.S. INVESTMENT BY FOREIGN GOVERNMENTS .......................................... 73 A. Economic Policy Considerations .............................................................................. 73 B. Tax Policy Considerations........................................................................................ 73 VI. COMPARISON WITH FOREIGN LAW ........................................................................ 77 APPENDIX ONE: FOREIGN LAW TAX TREATMENT OF GOVERNMENT INVESTMENT........................................................................................................................... A-1 i INTRODUCTION This document,1 prepared by the Staff of the Joint Committee on Taxation, describes the economic and U.S. income tax issues raised by sovereign wealth fund (“SWF”) investment in the United States. The United States has been a net importer of goods and services since 1982. Whenever a country imports more than it exports, the currency that its residents use to purchase those imports must ultimately return to that country, either as payment for that country’s exports or to purchase that country’s assets. Because the United States has been a net importer of goods and services for the last quarter century, this economic principle means that U.S. dollars that are used to purchase foreign goods and services (net of payments received for exports) must return to the United States to purchase U.S. assets. In fact, the relative share of U.S. assets owned by foreign investors has steadily increased during the last 25 years, indicating not only that dollars paid for net imports have been recycled into purchases of U.S. assets, but also that the rate of investment in the U.S. economy by foreign investors has grown in relation to the rate of investment by domestic investors. Recently, attention has focused on a particular source of cross-border investment in the United States—SWFs. In general, SWFs are actively managed, government-owned pools of capital originating in foreign exchange assets. SWFs are currently estimated to manage total assets of $3 trillion or more, with significant growth anticipated in the next five to 10 years. The largest SWFs are controlled by countries with substantial commodity exports or large current account surpluses. The increasing prominence of SWFs in global finance has raised some policy concerns, such as their perceived lack of transparency and the possibility that they may have political objectives. At the same time, SWFs are generally recognized as playing a useful role in the world economy. International organizations in which the United States participates are developing “best practices” guidelines for both SWFs and countries that are the recipients of SWF investments. In the United States, SWFs may benefit from a long-standing exemption from U.S. income tax that applies to certain passive income received by foreign governments. This exemption does not apply to income related to commercial activity. The exemption is not specifically directed at SWFs, and, in fact, first became part of the U.S. income tax laws in 1917, long before the first SWFs were created. In addition to existing law’s statutory (and, in respect of some sovereigns, treaty) exemption for passive income earned by foreign governments, the United States also exempts from income tax, or taxes at reduced rates, many important types of income earned by nongovernmental foreign investors. To the extent that a foreign government recognizes income 1 This document may be cited as follows: Joint Committee on Taxation, Economic and U.S. Income Tax Issues Raised by Sovereign Wealth Fund Investment in the United States (JCX-49-08), June 17, 2008. This document can also be found on the internet at www.jct.gov. 1 that is not exempt from U.S. income tax under the exception for passive income received by foreign sovereigns, the foreign government is treated as a corporate resident of its own country. As a result, the U.S. income tax treatment of foreign governments in many cases is similar to the U.S. income tax treatment of foreign persons generally. In each case, for example, portfolio interest income paid by U.S. obligors generally is exempt from U.S. income tax. Both foreign sovereigns and foreign private investors are subject to U.S. net income tax on commercial activities conducted directly in the United States. Moreover, the exception for passive income earned by foreign sovereigns is not available to a foreign government with respect to income that it derives from a controlled subsidiary conducting a commercial business in the United States. In that case, the foreign government must rely on the same statutory and treaty rules as would apply to a private foreign investor holding the same investment. In practice, some of the most important statutory U.S. income tax advantages that a foreign sovereign investor enjoys over a foreign private investor are: exemption from U.S. withholding tax on all U.S. source dividends paid by noncontrolled corporations; exemption from U.S. withholding tax on interest paid by a corporation where the foreign sovereign owns at least 10 percent (so the general “portfolio interest” exemption is not available) but less than 50 percent (so the payor is not “controlled” by the foreign sovereign) of the payor; and exemption from U.S. tax on certain gains from real estate transactions. The economic analysis presented here suggests that investment in the United States by foreign sovereigns, like that of investment by foreign private investors, is a necessary and desirable consequence of the long-term trade deficit position of the United States. As noted earlier, investments by SWFs or foreign governments more generally raise nontax policy concerns, but these fall largely outside the expertise of the Staff of the Joint Committee on Taxation. Tax policy considerations addressed in this document include consistency between a foreign government’s exemption from U.S. income tax and a foreign country’s immunity from the jurisdiction of U.S. courts, the scope of the difference in the U.S. income tax treatment between foreign governments and other investors in the United States, and certain issues specific to the technical terms of the U.S. income tax exemption for foreign governments. 2 I. U.S. CROSS-BORDER TRANSACTIONS AND INVESTMENTS SWFs purchase U.S. assets (including stock of U.S. corporations) and make loans to U.S. owners of assets. They also may purchase U.S. government bonds. Each of these activities is a form of foreign investment in the United States. Such cross-border investment cannot be examined without also examining cross-border trade in goods and services and the domestic savings rate, as these economic activities are all interrelated. This section discusses the economic relationship between trade deficits, capital inflows, investment, and savings in the economy. 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 A. Trade Deficits and Cross-Border Capital