NFTC1a Volume1_part2Chap1-5.qxd 12/17/01 4:23 PM Page 147 The NFTC Foreign Income Project: International Tax Policy for the 21st Century Part Two Relief of International Double Taxation NFTC1a Volume1_part2Chap1-5.qxd 12/17/01 4:23 PM Page 148 NFTC1a Volume1_part2Chap1-5.qxd 12/17/01 4:23 PM Page 149 Origins of the Foreign Tax Credit Chapter 1 Origins of the Foreign Tax Credit I. Introduction The United States’ current system for taxing international income was creat- ed during the period from 1918 through 1928.1 From the introduction of 149 the income tax (in 1913 for individuals and in 1909 for corporations) until 1918, foreign taxes were deducted in the same way as any other business expense.2 In 1918, the United States enacted the foreign tax credit,3 a unilat- eral step taken fundamentally to redress the unfairness of “double taxation” of foreign-source income. By way of contrast, until the 1940s, the United Kingdom allowed a credit only for foreign taxes paid within the British 1 For further description and analysis of this formative period of U.S. international income tax policy, see Michael J. Graetz & Michael M. O’Hear, The ‘Original Intent’ of U.S. International Taxation, 46 DUKE L.J. 1021, 1026 (1997) [hereinafter “Graetz & O’Hear”]. The material in this chapter is largely taken from this source. 2 The reasoning behind the international tax aspects of the 1913 Act is difficult to discern from the historical sources. One scholar has concluded “it is quite likely that Congress gave little or no thought to the effect of the Revenue Act of 1913 on the foreign income of U.S. persons or the U.S. income of foreign persons.” Alan G. Choate et al., Federal Tax Policy for Foreign Income and Foreign Taxpayers— History, Analysis and Prospects, 44 TEMPLE L.Q. 441 (1971). The decision made in 1913 to tax the world- wide income of taxpayers may have simply followed the earlier, 1909, decision to make worldwide income subject to the 1909 federal excise tax on corporate income. See Corporation Excise Tax of 1909, ch. 6, § 38, 36 Stat. 11, 112-17. 3 Revenue Act of 1918, ch. 18, 40 Stat. 1057, §§ 222(a)(1) (individuals), 238(a) (corporations), 240(c) (describing creditable taxes). The Revenue Act of 1918 also adopted the indirect foreign tax credit, which allows U.S. companies a tax credit for foreign taxes paid by their controlled foreign sub- sidiaries. Revenue Act of 1918, § 240 (c). The Revenue Act of 1918 is misleadingly named as it was actually enacted in 1919. Originally drafted in a special session of Congress during the summer of 1918, the Act was passed by the House in late September 1918; however, the Senate could not complete its deliberations until after the Armistice of November 11, 1918. Peace necessitated a certain amount of redrafting, which prevented final Senate action until February 1919. JOHN F. W ITTE, THE POLITICS AND DEVELOPMENT OF THE FEDERAL INCOME TAX 85 (1995) [hereinafter “Witte”]. NFTC1a Volume1_part2Chap1-5.qxd 12/17/01 4:23 PM Page 150 The NFTC Foreign Income Project: International Tax Policy for the 21st Century Empire and limited the credit to a maximum of one-half of the U.K. tax on the foreign income.4 A few countries at that time protected residents from double taxation by taxing only domestic-source income.5 The Revenue Act of 1921, the first major tax act after World War I, introduced a limitation on the foreign tax credit to ensure that a taxpayer’s total foreign tax credits could not exceed the amount of the U.S. tax liability on the taxpayer’s foreign-source income.6 This limitation was enacted to pre- vent taxes from countries with income tax rates higher than those of the United States from reducing U.S. tax liability on U.S.-source income.7 While the details of the foreign tax credit have changed substantially since its intro- duction in 1918, these provisions still constitute the basis of U.S. law for taxing income earned abroad by U.S. citizens and residents. In 1928, the League of Nations issued draft model bilateral income tax treaties for the reciprocal relief of double taxation of international income. Those League of Nations models still serve as the basis for the model income tax treaties of the Organisation for Economic Cooperation and Development (OECD), the United Nations and the United States.8 Although, like U.S. tax law, treaty articles have become more complex, commentaries have become 150 more detailed and some apparent loopholes have been closed, the 1928 4 See Graetz & O’Hear, supra note 1, 1045-1048. The United Kingdom had previously allowed foreign tax credits for taxes paid within the British Commonwealth. Thomas S. Adams, Interstate and International Double Taxation, LECTURES ON TAXATION 101, 102 (Roswell Magill ed., 1932). 5 For a discussion of other limited relief measures that were in existence prior to the U.S. foreign tax credit, see JOHN G. HERNDON, JR., RELIEF FROM INTERNATIONAL DOUBLE TAXATION: THE DEVELOPMENT OF INTERNATIONAL RECIPROCITY FOR THE RELIEF OF DOUBLE INCOME TAXATION 10-14 (Callahan & Company, Chicago 1932) [hereinafter “Herndon”] (describing legislation in the Netherlands, Belgium, Norway, and Switzerland). The Netherlands was the other large capital exporter of the time. See also T.C. JEN, DOUBLE TAXATION 4 (1924) (unpublished manuscript, available in T. S. Adams Papers, Yale University, Box 29, folder covering May-August 1924) (describing the income taxes of Australia, New South Wales, and South Africa). Among the U.S. states, New York would soon introduce an income tax that provided a credit to resi- dents for taxes paid to another state, but only if the other state also had an income tax and provided a similar credit or exception for New Yorkers. Edwin R.A. Seligman, The New York Income Tax, 34 POL. SCI. Q. 521, 534 n.1 (1919). Wisconsin also provided a tax credit to prevent double taxation, though double taxation of a different kind: Wisconsin permitted taxpayers to offset their personal property taxes against income taxes. ELLIOTT BROWNLEE, PROGRESSIVISM AND ECONOMIC GROWTH: THE WISCONSIN INCOME TAX, 1911-1929, at 62 (1974). 6 Revenue Act of 1921, ch. 136, 42 Stat. 227, §§ 222(a)(5) (individuals), 238(a) (corporations). This limitation was intended to ensure that U.S. companies and individuals could not use foreign taxes to reduce or eliminate U.S. taxes on U.S.-source income. See the discussion of the 1921 Act in Graetz & O’Hear, supra note 1, and Chapter 1.III of this Report. 7 See Graetz & O’Hear, supra note 1,1054-1056. 8 Some early 19th century double taxation agreements are on record, including a Dutch measure dat- ing from 1819 exempting foreign ships from the Dutch business-license tax on condition of reciprocity. See Mitchell B. Carroll, Double Taxation Relief, Discussion of Conventions Drafted at the International Conference of Experts, 1927 and Other Measures, DEPARTMENT OF COMMERCE TRADE INFORMATION BULLETIN NO. 523, 1 (1927) [hereinafter “Carroll”]. The modern treaty era began with the Prussia-Austria double taxation agreement of 1899. NFTC1a Volume1_part2Chap1-5.qxd 12/17/01 4:23 PM Page 151 Origins of the Foreign Tax Credit League of Nations model, formulated more than seven decades ago, remains the common source of the roughly 2,000 bilateral tax treaties now in force throughout the world. Despite massive changes in the world economy, the United States’ inter- national tax regime formulated in the 1920s has survived largely intact. The complexities of current U.S. tax law governing international transactions undoubtedly would shock a tax practitioner of the 1920s. Nor could those who fashioned the League of Nations’ model income tax treaty of 1928 have foreseen the current integration of the world economy, or the expansion and sophistication of international capital flows. Nevertheless, the basic princi- ples of both the 1920s United States’ international tax law and the 1928 model treaty still govern the income tax consequences of international trans- actions. Nothing comparable to the multilateral restructurings of interna- tional monetary and trade relationships that followed World War II occurred in the context of international income taxation.9 The international tax dilemmas that confronted the Congress in the early days of the income tax remain essentially unchanged today. When income is earned in one country by a citizen or resident of another country, both the country where the income is earned (the source country) and the 151 country where the investor or earner resides (the residence country) have legitimate claims to tax the income. The basic task of international income tax rules is to resolve the competing claims of residence and source coun- tries to avoid the double taxation that will result when both fully exercise their taxing powers. Capital-importing countries have the most to gain from taxation at source, capital-exporting countries from the taxation of residents. In the absence of bilateral or multilateral agreements, residence countries are unable to limit the unilateral actions of source countries. 9 Professor Richard Vann of Australia has described this circumstance as follows: Although it is possible to refine the actual terms of the OECD Model and to elaborate the commentary so as to cover new cases as they arise, the time has passed for radical revision within the current bilateral framework. In a sense the opportunity to go in another direc- tion was lost before the 1963 draft appeared. The failure to adopt any new approach to international tax after the Second World War (compared to trade law and the international monetary system) meant that effectively the solution adopted after the First World War continued by default.