International Taxation
Study Countries That Exempt Foreign-Source Income Face Compliance Risks and Burdens Similar to Those in the United States Gao ID: GAO-09-934 September 15, 2009A debate is underway about how the United States should tax foreign-source, corporate income. Currently, the United States allows domestic corporations to defer tax on the earnings of their foreign subsidiaries and also gives credits for foreign taxes paid, while most other developed countries exempt the active earnings of their multinational corporations' foreign subsidiaries from domestic tax. The debate has focused on economic issues with little attention to tax administration. GAO was asked to describe for a group of study countries with exemption systems: (1) the rules for exempting foreign-source income, and (2) the compliance risk and taxpayer compliance burden, such as recordkeeping, of the rules. The study countries, selected to provide a range of exemption systems, are Australia, Canada, France, Germany, and the Netherlands. For these countries GAO reviewed documents; interviewed government officials, academic experts, and business representatives; and compared tax policies, compliance activities and taxpayer reporting requirements.
The study countries exempt some corporate income, such as dividends received from foreign subsidiaries, from domestic tax. However, the study countries tax other types of foreign-source income such as royalties. Multinational corporations present a compliance risk because they can use subsidiaries to convert taxable income into tax-exempt or lower taxed income, eroding the domestic tax base. Although quantitative estimates of noncompliance do not exist, tax experts interviewed by GAO identified sources of compliance risk and taxpayer burden in each of the study countries. These issues, particularly the ones below, have also been identified as sources of compliance risk and burden in the United States. Transfer prices--the prices for transactions between related parties--can be manipulated to shift profits. Tax experts in the study countries said the growing importance of intangible property such as trademarks and patents is making international transactions more susceptible to transfer pricing abuse. In response, the study countries have all increased their scrutiny of transfer prices, including increased demands for documentation and more audits, resulting in increased compliance burden for taxpayers. Cooperative efforts between taxpayers and tax agencies to reduce audits, such as Advanced Pricing Agreements, received mixed reviews in the study countries. Anti-avoidance rules prevent taxpayers from moving passive income (interest and royalties are often passive income) to a foreign subsidiary in order to avoid domestic tax. Generally, the rules make such passive income, even if moved, taxable. Tax agencies and taxpayers reported difficulties in obtaining information from other countries to make complex determinations about whether the anti-avoidance rules apply or not. The United States does not report taxes paid on foreign-source income. Treasury officials said it would be feasible to do so. Such reporting would make more explicit the role international tax rules play in raising revenues and protecting the domestic tax base. All experts we spoke with on this topic agreed.
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Director: Team: Phone:GAO-09-934, International Taxation: Study Countries That Exempt Foreign-Source Income Face Compliance Risks and Burdens Similar to Those in the United States
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
September 2009:
International Taxation:
Study Countries That Exempt Foreign-Source Income Face Compliance Risks
and Burdens Similar to Those in the United States:
GAO-09-934:
GAO Highlights:
Highlights of GAO-09-934, a report to The Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
A debate is underway about how the United States should tax foreign-
source, corporate income. Currently, the United States allows domestic
corporations to defer tax on the earnings of their foreign subsidiaries
and also gives credits for foreign taxes paid, while most other
developed countries exempt the active earnings of their multinational
corporations‘ foreign subsidiaries from domestic tax. The debate has
focused on economic issues with little attention to tax administration.
GAO was asked to describe for a group of study countries with exemption
systems: (1) the rules for exempting foreign-source income, and (2) the
compliance risk and taxpayer compliance burden, such as recordkeeping,
of the rules. The study countries, selected to provide a range of
exemption systems, are Australia, Canada, France, Germany, and the
Netherlands. For these countries GAO reviewed documents; interviewed
government officials, academic experts, and business representatives;
and compared tax policies, compliance activities and taxpayer reporting
requirements.
What GAO Found:
The study countries exempt some corporate income, such as dividends
received from foreign subsidiaries, from domestic tax. However, the
study countries tax other types of foreign-source income such as
royalties.
Multinational corporations present a compliance risk because they can
use subsidiaries to convert taxable income into tax-exempt or lower
taxed income, eroding the domestic tax base. Although quantitative
estimates of noncompliance do not exist, tax experts interviewed by GAO
identified sources of compliance risk and taxpayer burden in each of
the study countries. These issues, particularly the ones below, have
also been identified as sources of compliance risk and burden in the
United States.
Transfer prices: the prices for transactions between related parties”
can be manipulated to shift profits. Tax experts in the study countries
said the growing importance of intangible property such as trademarks
and patents is making international transactions more susceptible to
transfer pricing abuse. In response, the study countries have all
increased their scrutiny of transfer prices, including increased
demands for documentation and more audits, resulting in increased
compliance burden for taxpayers. Cooperative efforts between taxpayers
and tax agencies to reduce audits, such as Advanced Pricing Agreements,
received mixed reviews in the study countries.
Anti-avoidance rules prevent taxpayers from moving passive income
(interest and royalties are often passive income) to a foreign
subsidiary in order to avoid domestic tax. Generally, the rules make
such passive income, even if moved, taxable. Tax agencies and taxpayers
reported difficulties in obtaining information from other countries to
make complex determinations about whether the anti-avoidance rules
apply or not.
The United States does not report taxes paid on foreign-source income.
Treasury officials said it would be feasible to do so. Such reporting
would make more explicit the role international tax rules play in
raising revenues and protecting the domestic tax base. All experts we
spoke with on this topic agreed.
Figure: Simple Example of Dividend Exemption:
[Refer to PDF for image: illustration]
Foreign subsidiary:
Net income: $100;
Taxes paid: $20;
After-tax profit: $80.
Dividend $80:
Domestic parent corporation:
Dividend income: $80.
Income tax $20:
Foreign government:
20% corporate income tax.
Source: GAO.
[End of figure]
What GAO Recommends:
Because changing the United States system of taxing foreign-source
income is a policy decision, GAO is not making recommendations related
to tax reform. GAO does recommend that the Secretary of Treasury
annually report, using already available data, the revenue generated by
taxing foreign-source corporate income. The Secretary agreed with our
recommendation.
View [hyperlink, http://www.gao.gov/products/GAO-09-934] or key
components. For more information, contact Jim White at (202) 512-9110
or whitej@gao.gov.
[End of section]
Contents:
Letter:
Background:
Study Countries Vary in the Types of Foreign-Source Income Exempted
from Domestic Tax and in the Rules Governing Those Exemptions:
Study Countries Face Areas of Compliance Risk and Burden Known to Exist
in the United States:
Conclusion:
Recommendation for Executive Action:
Agency Comments:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Transfer Pricing Documentation Requirements in the Study
Countries:
Appendix III: Example from Australia of the Process for Obtaining an
Advanced Pricing Agreement:
Appendix IV: Examples of Other Anti-avoidance Rules in the Study
Countries and the United States:
Appendix V: Description of Dividend Exemption Systems in Japan and the
United Kingdom:
Appendix VI: Comments from the Department of the Treasury:
Appendix VII: GAO Contact and Staff Acknowledgments:
Related GAO Products:
Tables:
Table 1: Select Examples of Types of Income That Can Be Generated from
Foreign Sources:
Table 2: General Domestic Tax Treatment of Different Types of Foreign-
Source Income:
Table 3: Dividend Qualification Criteria--Required Domestic Ownership
Type and Level of Foreign Subsidiary to Qualify for Tax Exemption of
Foreign-Source Dividend Income:
Table 4: Dividend Qualification Criteria--Domestic Tax Treatment of
Foreign-source Dividend Income Distributed from Active and Passive
Income:
Table 5: General Overview of CFC and Other Anti-avoidance Rules:
Table 6: Overview of Rules Governing FTCs in the Study Countries and
the United States:
Table 7: Examples of Additional Anti-avoidance Rules by Country:
Table 8: Required Domestic Ownership Type and Level of Foreign
Subsidiary to Qualify for Tax Exemption of Foreign-Source Dividend
Income:
Figures:
Figure 1: Continuum of Tax Systems of Foreign-Source Corporate Income:
Figure 2: Simple Example of Deferral:
Figure 3: Simple Example of Dividend Exemption:
Figure 4: Simple Depiction of CFC Rules:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
September 15, 2009:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
One hallmark of the global economy is greater mobility of income and
economic transactions. As technology advances and globalization
continues to eliminate barriers to conducting business across
countries, companies routinely earn income in several countries. For
example, U.S. corporations reported $205 billion in foreign-source
income for tax year 2003, the latest year currently available.[Footnote
1] This is about half of the $425 billion of total worldwide income
(foreign plus domestic) earned by U.S. corporations in that
year.[Footnote 2] Often income is not earned directly by a domestic
corporation, but rather through wholly or partially owned subsidiaries
incorporated in other countries.
Foreign-source income, especially when earned by multinational
corporations (MNC), presents challenges for income tax design and
administration. These challenges include ensuring tax law compliance,
minimizing tax induced distortions of businesses decisions about where
to locate investment, avoiding the double taxation of income earned in
one country by companies located in another country, and minimizing
unnecessary taxpayer compliance burden, such as recordkeeping.
There are two general approaches to taxing foreign-source corporate
income. Under both approaches, a corporation pays any tax due in the
foreign country where the income is earned. The approaches differ in
how the corporation is taxed domestically, that is, in the
corporation's home country. One approach--called worldwide taxation--
taxes all income earned by a corporation regardless of where the income
is derived. Under this approach, double taxation is addressed through
foreign tax credits (FTC). The FTC is a credit, usually subject to
limits, against domestic tax for foreign taxes paid. A corporation
would pay domestic tax on foreign-source income only to the extent that
the domestic tax on that income exceeds the foreign tax credit.
The other approach--called territorial taxation--only taxes the
corporation's income derived within the taxing country's borders,
irrespective of the residence of the taxpayer. Thus, unlike worldwide
taxation, foreign-source income earned by a domestic corporation is
exempt from residence-country tax. The exemption generally eliminates
the possibility of double taxation.[Footnote 3]
In practice, large developed countries do not use a pure worldwide or
pure territorial approach when taxing foreign-source corporate income.
Instead, they use hybrid approaches. Most developed countries,
especially after recent policy changes in Japan and the United Kingdom,
now lean toward a territorial approach but are not purely territorial-
-in part, because they place significant limitations on what types of
income are eligible for exempt treatment.[Footnote 4] The United States
and a few other countries, on the other hand, lean toward a more
worldwide approach but are not purely worldwide--in part, because
taxation can be deferred on certain qualifying income until it is
actually paid to the domestic corporation by subsidiaries as dividends.
Basic features of the U.S. tax system result in the ability of some
MNCs to defer domestic taxation until it is actually paid to a domestic
part of the MNC.[Footnote 5]
In the United States, proposals have been developed to reform the
taxation of foreign-source income.[Footnote 6] The proposals differ,
with some designed to move the United States toward more territoriality
and others intended to maintain a more worldwide approach. An extensive
body of literature debates the economic merits of these proposals,
including the effects of taxes on competitiveness and the location
decisions of firms. While some research shows that taxes change
location incentives, the existing research does not reach definitive
conclusions about important economic effects such as the impact of
foreign investment by U.S. corporations on U.S. employment.
Compared to the extensive examination of economic effects, little has
been done to study whether there are important differences between
worldwide and territorial systems in terms of tax administration and,
more specifically, in terms of compliance by taxpayers and taxpayers'
compliance burden (recordkeeping, reporting, and other costs). In the
context of foreign-source income, at least two broad compliance issues
exist. One is ensuring that domestic corporations pay the tax due on
foreign-source income. The other is ensuring corporations do not erode
the domestic tax base by illegally shifting domestic income abroad.
Because of the ongoing debate about the taxation of foreign-source
income and because of the limited information available on
administering a worldwide system versus a territorial system, you asked
us to report on other countries' experience administering territorial
systems. Based on your request, our objectives are to (1) describe, for
select case study countries that take a territorial approach, what
types of foreign-source income the countries exempt and the rules
governing those exemptions; and (2) describe, to the extent information
is available, the compliance risks and taxpayer compliance burdens that
the taxation of foreign-source corporate income presents for each of
these countries.
To address our objectives, we selected five countries--Australia,
Canada, France, Germany, and the Netherlands--to study based on several
criteria, including range of rules governing the taxation of foreign-
source income, unique tax system features, and Organization of Economic
Cooperation and Development (OECD) membership. To provide assurance
that all of the information used in this report is sufficiently
reliable, we used data from commonly used and cited sources of
statistical data, such as the OECD, and other publicly available
reports from international government agencies. Additionally, we
performed an in-depth literature review on all of the study countries,
including government documents, private sector studies, and academic
publications. We collected and analyzed data on the countries and their
systems for taxing foreign-source corporate income, including tax
policies, administrative mechanisms, compliance activities, and
taxpayer reporting and documentation requirements. We interviewed
knowledgeable government officials from the study countries, including
officials from the tax agencies. We also interviewed U.S. tax agency
officials, international tax experts, including academic and private-
sector experts, and members of a number of professional services
organizations that represent and serve MNCs that have large numbers of
foreign subsidiaries under their control. We provided the tax agencies
of our study countries a copy of our report to verify data and specific
factual and legal statements about the tax treatment of foreign-source
income in those countries. We did not conduct a formal legal review of
the tax laws and rules in other countries, but relied on the
information supplied by tax agency officials in those countries. We
made technical corrections to our report based on these reviews. A more
detailed discussion of our methodology is in appendix I.
We conducted our work from June 2008 to September 2009 in accordance
with all sections of GAO's Quality Assurance Framework that are
relevant to our objectives. The framework requires that we plan and
perform the engagement to obtain sufficient and appropriate evidence to
meet our stated objectives and to discuss any limitations in our work.
We believe that the information and data obtained, and the analysis
conducted, provide a reasonable basis for any findings and conclusions
in this product.
Background:
Multinational Corporations and Foreign-Source Income:
Corporate income tax is levied on business entities that organize and
operate as corporations, as defined by each individual country's tax
rules and laws. Generally, corporations are individual business
entities that issue shares and can make distributions to shareholders,
such as dividend payments.
Corporations can be shareholders in other corporations, both domestic
and foreign. The amount of control the corporate shareholder has over
the other corporation can vary depending on the percentage of shares
owned and other factors. At the low range of corporate ownership,
portfolio shareholding allows a corporate shareholder to invest in a
business but does not involve maintaining a controlling stake in the
firm. At greater levels of ownership, corporations can own a sufficient
percentage of shares to gain partial or total control of major business
decisions, such as the level and timing of dividend distributions and
investment and pricing strategies. For this report, we will call the
controlling firm a parent corporation and the controlled firm a
subsidiary.[Footnote 7] Parent-subsidiary relationships can be
complicated, involving a corporation owning multiple subsidiaries,
subsidiaries being controlled by multiple parents, or tiered
arrangements with subsidiaries owning subsidiaries of their own. When
these relationships involve entities in more than one country, these
corporations are referred to as multinational corporations (MNC).
MNCs are groups of separate legal entities, which can include
corporations, partnerships, trusts, and other legal entities, that
operate and generate income in multiple countries, and different parts
of an MNC may have different domestic jurisdictions. MNCs may also have
branches--domestic, foreign, or both--as part of a corporation's
internal organizational structure.[Footnote 8] In general, each
corporate entity that is part of the MNC is taxed as an individual
taxable entity by the relevant governments, unless the corporation is
allowed to and chooses to file a consolidated return.
Different Types of Foreign-Source Income:
Corporations can earn a variety of different types of income from
foreign sources. This income can be generated from transactions with
either unrelated parties, such as retail customers located abroad, or
related parties, such as foreign subsidiaries or other parts of the
same MNC. Corporations can earn foreign-source income from active and
passive activities with foreign parties. While countries vary somewhat
in their definitions of active and passive income, generally speaking,
active income is considered to be the income generated through the
primary business activities of the corporation. Passive income, in
contrast, is income that is not earned through primary business
activities. Interest earned, rental income, and royalty payments from
foreign sources are generally considered passive income. However, for
some companies, such as financial services companies, these types of
income may constitute the primary business and be considered active
income under the tax laws of some countries. Additionally, corporations
can purchase shares of foreign companies and receive dividend
distributions based on the earnings of those companies. Table 1 below
lists some general examples of different types of income that can be
generated from foreign-sources.
Table 1: Select Examples of Types of Income That Can Be Generated from
Foreign Sources[A]:
Type of income: Capital gains;
General definition: The gain realized from the appreciated value
between the purchase and sales price of an asset, such as shares in a
corporation. Investments that have not yet been sold, but would yield a
profit if they were sold have unrealized capital gains;
Example of foreign-source income in a parent-subsidiary relationship: A
domestic parent sells shares it held in a foreign subsidiary for $50.
The domestic parent had bought the shares for $20. The realized capital
gain is the $30 difference.
Type of income: Dividends;
General definition: A payment distributed by a company to its
shareholders. Dividends are usually given out in the form of cash, but
can also be given out as stock or other property;
Example of foreign-source income in a parent-subsidiary relationship: A
domestic parent company owns 10,000 shares of a foreign subsidiary. The
foreign subsidiary makes a dividend payment of $1 per share to all
shareholders, including $10,000 to the parent.
Type of income: Interest;
General definition: Payments received as compensation for lending
money;
Example of foreign-source income in a parent-subsidiary relationship: A
domestic parent makes a 10-year, 5 percent loan for $1 million to a
foreign subsidiary. The subsidiary makes semi-annual interest payments
of $25,000 to the domestic parent.
Type of income: Rent;
General definition: Compensation for the use or occupation of property;
Example of foreign-source income in a parent-subsidiary relationship: A
domestic parent owns a factory in a foreign country. A foreign
subsidiary makes monthly payments to the domestic parent for occupation
and use of the factory.
Type of income: Royalty;
General definition: Income generated from licensing the use of
property, such as intellectual property;
Example of foreign-source income in a parent-subsidiary relationship: A
foreign subsidiary pays a domestic parent firm for the right to use
trademark logos on goods produced and sold.
Source: GAO:
[A] The definitions in this chart reflect how we use these terms for
the purposes of this report. Other definitions exist for these terms
but are outside the scope of this report.
[End of table]
Most Countries Take a Hybrid Approach to Taxing Foreign-Source Income:
In practice, countries combine elements of worldwide and territorial
approaches to taxing foreign-source income. One approach, generally
referred to as deferral, deviates from the worldwide model and taxes
the domestic corporation on all of its income, including income and
dividends received from foreign subsidiaries, but defers taxation until
the income is repatriated. Another approach, generally referred to as
dividend exemption, is closer to the territorial model and permits the
tax-exempt repatriation of the dividends distributed by foreign
subsidiaries, but may limit the extent to which some income is exempt.
In either system, foreign-source income is taxed first in the source
country; under a deferral system, a residual tax is then imposed only
when the income is repatriated. Figure 1 shows a continuum of tax
treatments for foreign-source corporate income with hybrid systems
ranging between the pure worldwide and territorial models.
Figure 1: Continuum of Tax Systems of Foreign-Source Corporate Income:
[Refer to PDF for image: illustration]
Hybrid systems:
Moving toward Pure worldwide:
All income, regardless of type, production source, or country source is
taxed currently. Foreign taxes offset by deduction or credit.
Moving toward Pure territorial:
Foreign-source income is exempt. Domestic source income is taxed.
Source: GAO.
[End of figure]
Worldwide System with Deferral:
The current tax system in the United States is an example of a
worldwide system with deferral, which taxes domestic corporations on
their worldwide income, regardless of where the income is earned and
gives credits for foreign income taxes paid. Income unrelated to a U.S.
trade or business earned by foreign corporations is not taxed
domestically until it is distributed to a domestic shareholder, such as
a domestic parent corporation, which allows deferral of taxation on
income of foreign subsidiaries. Special rules may exist that tax
certain shareholders, such as a parent corporation, currently on the
income of certain subsidiaries in order to protect the domestic tax
base. To reduce the double taxation of income, corporate taxpayers can
offset, in whole or in part, the domestic tax owed on the foreign-
source income through a FTC. In certain circumstances, a parent
corporation may claim FTCs for foreign taxes paid by a subsidiary.
Figure 2 shows how a dividend payment is generally taxed under a
worldwide tax approach that permits deferral.
Figure 2: Simple Example of Deferral:
[Refer to PDF for image: illustration]
Step 1:
Foreign subsidiary earns $100 profit from active business activities in
the foreign country.
Step 2:
Foreign subsidiary is subject to a 20% income tax in the foreign
country. Foreign subsidiary pays $20 in taxes leaving an after-tax
profit of $80.
Step 3:
At some point in time, foreign subsidiary distributes its after-tax
profits of $80 as a dividend to its sole shareholder, domestic parent
corporation (reports foreign taxes paid $20).
Step 4:
Domestic parent corporation calculates taxable income on the grossed-up
amount of dividend received. Dividend income $80; Reported foreign
taxes paid $20; Taxable income = $100[A].
Step 5:
Domestic parent corporation is assessed a 35% income tax by domestic
country. Domestic parent corporation pays the tax through a combination
of $15 in cash and $20 in imputed FTCs. $35 tax liability; Foreign tax
credit claimed $20.
Step 6:
Domestic parent corporation‘s after-tax net income is $65.
Source: GAO.
[A] Domestic tax liability is based on the grossed-up value of the
dividend plus the amount of foreign income tax paid on the associated
earnings.
[End of figure]
Exemption Systems:
Many OECD countries exempt some types of foreign-source corporate
income from domestic tax. Exemptions are commonly granted in these
countries for dividends paid by a foreign subsidiary. As shown in
figure 3, which is a simplified example of an exemption system, the
domestic corporation does not incur a tax liability by receiving the
dividend income from its foreign subsidiary. However, similar to the
worldwide systems with deferral that were described earlier, exemption
systems may disallow the tax advantages of foreign-source income under
certain circumstances to protect the domestic tax base.
Figure 3: Simple Example of Dividend Exemption:
[Refer to PDF for image: illustration]
Step 1:
Foreign subsidiary earns $100 profit from active business activities in
the foreign country.
Step 2:
Foreign subsidiary is subject to a 20% income tax in the foreign
country. Foreign subsidiary pays $20 in taxes leaving an after-tax
profit of $80.
Step 3:
Foreign subsidiary distributes its after-tax profits of $80 as a
dividend to its sole shareholder, domestic parent corporation.
Step 4:
Domestic parent corporation receives $80 dividend from foreign
subsidiary. The domestic country exempts from taxation foreign-source
dividends. Domestic parent‘s net income is $80.
Source: GAO.
[End of figure]
Study Countries Vary in the Types of Foreign-Source Income Exempted
from Domestic Tax and in the Rules Governing Those Exemptions:
Our study countries--Australia, Canada, France, Germany, and the
Netherlands--have hybrid tax systems that exempt some types of foreign-
source income and tax others. All of the study countries tax domestic
corporations on income earned through rental payments and royalties.
Such payments may be made by unrelated parties or by subsidiaries and
are generally expenses of the payee in the foreign country but are
received as income by the domestic corporation. Subject to an extensive
list of exceptions, the study countries generally exempt, but to
varying extents, income of domestic corporations received as foreign-
source dividends from foreign subsidiaries, sales by foreign branches,
and the gains from the sale of shares in foreign subsidiaries. For
example, all of the study countries permit domestic corporations to
receive dividends that meet certain qualifications as tax-exempt
income, but differ in the rules they use in determining which dividends
are qualified. In addition, Canada does not allow domestic corporations
to earn tax-exempt, foreign-source income through foreign branches and
taxes up to half of the capital gains on the sale of foreign subsidiary
shares while the other study countries generally exempt income from
these sources.[Footnote 9]
In addition to the rules above covering income payments received by
domestic corporations, all study countries also have rules that tax
domestic corporations on some income at the time it is earned by
foreign subsidiaries, regardless of when or if the foreign subsidiary
distributes a dividend. These rules, generally referred to as anti-
avoidance rules, attribute certain earnings of related foreign entities
to domestic corporations in order to limit the tax benefits of holding
certain types of income offshore.
Table 2 presents a brief overview of the tax treatment for different
types of foreign-source income in our study countries. All rows except
the last show the tax treatment of income payments received by a
domestic corporation. The last row shows the tax treatment of income at
the time it is earned by a foreign subsidiary that is subject to
certain anti-avoidance rules regardless of whether the income was
distributed as a dividend.
While data was not available for most of our study countries, in
Canada, at least 76 percent of foreign-source dividends received by
Canadian taxpayers from foreign affiliates from 2000 to 2005 were
qualified foreign-source dividends and, therefore, were tax exempt.
[Footnote 10]
Table 2: General Domestic Tax Treatment of Different Types of Foreign-
Source Income:
Rent, royalty, and interest income paid by Foreign subsidiaries:
Australia: Taxable;
Canada: Taxable;
France: Taxable;
Germany: Taxable;
Netherlands: Taxable.
Rent, royalty, and interest income paid by unrelated third parties:
Australia: Taxable;
Canada: Taxable;
France: Taxable;
Germany: Taxable;
Netherlands: Taxable.
Nonqualifying foreign-source dividends:
Australia: Taxable;
Canada: Taxable;
France: Taxable;
Germany: Taxable;
Netherlands: Taxable.
Qualified foreign-source dividends:
Australia: Exempt;
Canada: Exempt;
France: Effectively 95% exempt[A];
Germany: Effectively 95% exempt[A];
Netherlands: Exempt.
Active foreign branch income:
Australia: Exempt;
Canada: Taxable with FTC;
France: Exempt;
Germany: Taxable with FTC under domestic law but generally exempt
through tax treaty;
Netherlands: Generally exempt.
Capital gains from the sale of foreign subsidiary shares:
Australia: Generally exempt;
Canada: 50% to 100% Exempt;
France: Effectively 95% exempt[A];
Germany: Effectively 95% exempt[A];
Netherlands: Exempt.
Attributable foreign earnings subject to anti-avoidance rules:
Australia: Taxable with FTC;
Canada: Taxable with FTC;
France: Taxable with FTC;
Germany: Taxable with FTC;
Netherlands: Taxable.
Source: GAO analysis of country information.
Note: This table shows general treatments. It does not present all of
the details, exceptions, or rules that govern the tax treatment of
foreign-source income for our study countries.
[A] For France and Germany, the exempt amount of qualified foreign-
source gross dividends and capital gains is effectively 95 percent due
to rules that tax 5 percent of the income as nondeductible expenses.
This is discussed in more detail later in this report.
[End of table]
Study Countries Use Different Criteria to Qualify Foreign-Source
Dividends for Domestic Tax Exemption:
Our study countries all have certain criteria that, when met, allow
domestic corporations to receive tax-exempt income in the form of
dividend payments, called qualified foreign-source dividends in table
2. In each of the countries, all of the criteria must be met for the
domestic corporation to receive the foreign-source dividend tax-exempt.
If any of the conditions are not met, then the dividend does not
qualify for the tax exemption and is, therefore, taxable. Our study
countries applied up to three criteria when determining which income is
tax-exempt: domestic ownership type and level of foreign subsidiaries;
the type of income (active versus passive) distributed as a dividend;
and the presence of a tax treaty or similar agreement between the
domestic and foreign government where the subsidiary is located and
income is earned.
All of our study countries except Germany require the domestic
corporation to have a minimum ownership stake in a foreign subsidiary
in order to qualify for the benefits of exemption. In general, these
minimum ownership level stakes mean that income from portfolio or
portfolio-like investment is not exempt. Each country takes a different
approach in determining the type of shares that qualify dividend income
for exemption with distinctions made on the type of shares and the
length of time the shares are held. For example, while Canada requires
domestic corporations to own 10 percent or more of any class of shares
in the foreign subsidiary, France requires its corporations to own at
least 5 percent of a foreign subsidiary's shares.[Footnote 11] The
requirements for each country are summarized in table 3.
Table 3: Dividend Qualification Criteria--Required Domestic Ownership
Type and Level of Foreign Subsidiary to Qualify for Tax Exemption of
Foreign-Source Dividend Income:
Domestic ownership of foreign company:
Australia: Direct shareholding of at least 10%;
Canada: Direct ownership of 1% and direct or indirect ownership of at
least 10%;
France: At least 5% ownership;
Germany: None;
Netherlands: In principle a shareholding of at least 5%.
Foreign company share type:
Australia: Shares must have a voting interest;
Canada: Any type;
France: Ownership or participating shares;
Germany: Any type;
Netherlands: Any type.
Ownership duration:
Australia: None;
Canada: None;
France: 2 years;
Germany: None;
Netherlands: None.
Source: GAO analysis of country information.
Note: This table shows general treatments. It does not present all of
the details, exceptions, or rules that govern the tax treatment of
foreign-source income for our study countries.
[End of table]
In addition to the criteria above, Canada also makes a distinction
between dividends distributed from active and passive income, while the
other study countries do not, as shown in table 4.
Table 4: Dividend Qualification Criteria--Domestic Tax Treatment of
Foreign-source Dividend Income Distributed from Active and Passive
Income:
Dividends distributed from active income:
Australia: Exempt;
Canada: Exempt;
France: Effectively 95% exempt[A];
Germany: Effectively 95% exempt[A];
Netherlands: Exempt.
Dividends distributed from passive income:
Australia: Exempt;
Canada: Taxable with FTC eligibility[B];
France: Effectively 95% exempt[A];
Germany: Effectively 95% exempt[A];
Netherlands: Exempt.
Source: GAO analysis of country information.
Note: This table shows general treatments. It does not present all of
the details, exceptions, or rules that govern the tax treatment of
foreign-source income for our study countries.
[A] In France and Germany, the gross dividend amount exempt from
domestic tax is effectively 95 percent due to rules that tax 5 percent
of the gross dividend amount as nondeductible expenses. This is
discussed in more detail later in this report.
[B] Income that was previously taxed under anti-avoidance rules may be
tax exempt upon repatriation.
[End of table]
Of all our study countries, currently only Canada requires that the
foreign subsidiary be located and earn active income in a designated
treaty country in order to qualify for the dividend tax exemption that
was shown in table 2. For Canada, a designated treaty country is a
country with which Canada either has a tax treaty or a tax information
exchange agreement (TIEA). As was noted earlier, at least 76 percent of
dividends received by Canadian taxpayers from foreign affiliates
between 2000 and 2005 were tax exempt.
Study Countries Limit Tax Advantages of Earning Foreign-Source Income
under Certain Conditions:
As was shown in the last row of table 2, all study countries have anti-
avoidance rules that limit the tax advantages of earning certain types
of income abroad. In general, these rules are intended to protect the
domestic tax base by preventing taxpayers from avoiding domestic tax on
passive or other specific types of income by moving to or holding these
types of income in a foreign country. When triggered, these rules
require a domestic shareholder to be taxed currently on its pro rata
share of certain types of income earned by certain foreign
subsidiaries, regardless of when or if that income is distributed to
the shareholder.[Footnote 12] Anti-avoidance rules exist in both
worldwide and territorial tax systems, and are in effect in each of our
study countries and the United States (commonly known as Subpart F in
the United States).
A prominent anti-avoidance rule used by all study countries except the
Netherlands applies to controlled foreign corporations (CFC).[Footnote
13] Each country's CFC rules vary, but they generally tax domestic
shareholders, including shareholding corporations, currently on certain
types of income earned by foreign corporations that qualify as
controlled by domestic shareholders. This is illustrated in figure 4.
This means that the domestic corporation may be taxed on income that it
has not received from the foreign corporation (called a deemed dividend
in figure 4). This income is taxable when earned by the subsidiary,
although CFC rules generally permit the domestic taxpayer to offset
some or all of their domestic tax liability through credits on the
foreign taxes paid on the income.
Figure 4: Simple Depiction of CFC Rules:
[Refer to PDF for image: illustration]
Step 1:
Foreign subsidiary, a wholly owned subsidiary of domestic parent
corporation, earns $100 in interest income earned from a loan provided
to another foreign corporation. Interest income is considered passive
income in the domestic country.
Step 2:
Foreign subsidiary is subject to a 5% corporate income tax in the
foreign country. Foreign subsidiary pays $5 in tax, leaving it with $95
in after-tax profit on passive income.
Step 3: Foreign subsidiary does not make any profit or earnings
distribution to the domestic parent corporation. Domestic parent
corporation must recognize $100 as a deemed dividend for passive income
earned by the foreign subsidiary.
Step 4:
Because foreign subsidiary is a controlled foreign corporation of
domestic parent corporation, domestic parent corporation pays taxes on
the $100 undistributed passive income of the foreign subsidiary.
Domestic parent corporation receives $5 in foreign tax credits to off-
set taxes paid to foreign government on the deemed dividend and pays a
net tax of $30 to domestic government.
Source: GAO.
[End of figure]
Generally, study countries establish criteria in three areas that, when
met, define a domestic shareholder's tax liability for certain types of
income earned by a foreign corporation under the CFC rules. First,
countries define when a foreign corporation is controlled by domestic
shareholders. For example, Australia defines a controlled foreign
corporation as any foreign corporation that meets either of the
following definitions: (1) where five or fewer Australian residents
effectively control the foreign corporation or own more than 50 percent
of the foreign corporation; or (2) where one Australian entity has an
individual ownership of 40 percent or more of the foreign corporation
not controlled by another corporation. Second, countries generally set
a minimum level of ownership in the foreign corporation that domestic
shareholders must meet before being taxed on the foreign corporation's
earnings. For example, under Canada's CFC rules, a Canadian shareholder
must own at least 10 percent of the foreign corporation to be taxed on
certain types of income earned by the foreign corporation. Third, the
controlled foreign corporation generally must earn certain types of
income that are specified in each country's CFC rules. For example,
Germany requires that a CFC earn passive income that is taxed at an
effective rate of 25 percent or less by the foreign country before a
domestic corporation is required to pay tax on the CFC's earnings.
Once the criteria above are met, domestic shareholders are taxed
currently on certain types of attributed income earned by the CFC. Some
countries, like Canada, generally limit the taxable foreign earnings to
the domestic corporation's pro rata share of passive income.[Footnote
14] Other countries, like France, tax domestic corporations on their
pro rata share of all earnings by the foreign corporation. Table 5
presents a simplified overview of the CFC rules used by our study
countries. Additional details on other types of anti-avoidance rules
can be found in appendix IV.
Table 5: General Overview of CFC and Other Anti-avoidance Rules:
Criteria a foreign entity must meet to be considered a CFC:
Australia: Either: (1) five or fewer Australian residents control or
own more than 50% of the foreign entity; or; (2) When one Australian
resident owns 40% or more of the foreign entity;
Canada: Five or fewer Canadian residents, including parties that do not
deal at arm's length with them, own greater than 50% of the foreign
entity;
France: (1) The foreign entity is located in a country with an
effective tax rate that is 50% or less than that of France; (2) French
residents own 50% or more; (3) Intragroup income is greater than 20%,
or passive income and intra-group services income is greater than 50%;
Germany: (1) German residents own 50% or more;; (2) The foreign entity
earns passive income; (3) Passive income is taxed at an effective rate
less than 25%;
Netherlands: N/A.
Domestic shareholder ownership level necessary:
Australia: 10% or greater;
Canada: 10% or greater;
France: Directly or indirectly hold 50% or greater;
Germany: Any level of ownership;
Netherlands: N/A.
Foreign earnings subject to current taxation:
Australia: Pro-rata share of passive earnings in most countries;
Canada: Pro-rata share of passive earnings;
France: Pro-rata share of all earnings;
Germany: Pro-rata share of passive earnings;
Netherlands: N/A.
Additional features of CFC rules; Australia:
CFCs resident in "listed" countries--those with similar tax systems to
Australia--have fewer types of income that may be attributed to
domestic corporations;
Canada: [Empty];
France: CFC rules do not apply if the foreign subsidiary is located in
another EU country and does not exist solely to avoid French taxation;
Germany: CFC rules do not apply if the foreign subsidiary exists in
another EU or European Economic Area country and conducts genuine
economic activities;
Netherlands: [Empty].
Additional Anti-avoidance Rules:
Australia: Foreign investment fund rules;
Canada: Offshore investment fund rules;
France: Abuse of law doctrine;
Germany: General anti-avoidance rule;
Netherlands: Low-taxed passive shareholding rules.
Source: GAO analysis of country information.
Note: This table shows general treatments. It does not present all of
the details, exceptions, or rules that govern the tax treatment of
foreign-source income for our study countries.
[A] The percentage ownership by the domestic shareholder corresponds to
the type of shares that were presented in table 2.
[End of table]
Study Countries Face Areas of Compliance Risk and Burden Known to Exist
in the United States:
Differences in tax rates across countries and differences in the
taxation of different types of income may create incentives to avoid
tax by shifting income from a high tax jurisdiction to a lower taxed
jurisdiction or by converting income from a taxable type to tax-exempt
type. Such efforts to reduce taxes may sometimes be legal tax
avoidance, but may also be illegal noncompliance.
Tax experts identified four areas as sources of compliance risk or
taxpayer compliance burden in our study countries. None of our study
countries were able to provide quantitative estimates of the extent of
noncompliance with their tax laws governing foreign-source income or
the amount of compliance burden placed on taxpayers. Furthermore, an
exhaustive list of all sources of compliance risk and burden does not
exist. However, four areas that tax experts, including tax agency
officials, tax practitioners, and academics identified were:
* transfer pricing,
* anti-avoidance rules,
* foreign tax credits, and:
* domestic expense deductions.
These areas are also viewed by the Internal Revenue Service (IRS) or
other tax experts as sources of compliance risk or compliance burden in
the United States.
While countries establish rules in these four areas to serve a variety
of policy goals, including maintaining economic competitiveness and
avoiding double taxation, one important consideration is protecting the
domestic tax base. One unique tax administration challenge that MNCs
present is that they can shift income and assets among related entities
in different countries to convert taxable income, either foreign or
domestic, to tax-exempt or lower-taxed foreign-source income. The laws
and regulations in these four areas are intended, in part, to protect
the domestic tax base by preventing MNCs from mispricing transactions,
relocating domestic passive income, misusing foreign tax credits, or
reallocating expenses in ways that inappropriately reduce domestic
taxes. These laws also create compliance burden, often requiring
taxpayers to maintain detailed records and conduct complex analyses of
international transactions.
Transfer Pricing, Particularly for Intangible Property, Is a Major
Compliance Risk and Source of Compliance Burden in all of the Study
Countries:
Many tax agency officials we met with stated that transfer pricing was
the most significant compliance risk they face in the area of
international taxation. Similarly, many business representatives said
complying with transfer pricing rules was often the most burdensome
aspect of international taxation. Transfer prices are the prices of
goods and services transferred among related entities within an MNC.
These prices create compliance risks because MNCs can sometimes
deliberately manipulate them to shift income from one related entity to
another in order to reduce tax liability. For example, a parent
corporation that charges a foreign subsidiary a below-market price for
a good or service lowers the parent corporation's taxable income and
raises the subsidiary's taxable income. Depending on tax rates and
rules governing exemption and deferral, shifting income in this way may
reduce an MNC's overall tax liability. An above-market price would
shift taxable profits from the subsidiary to the parent.
Because transfer prices can shift taxable income from one country to
another, all of our study countries have focused attention on transfer
pricing with emphasis on stringent documentation requirements and
audits. Generally, the study countries require taxpayers to provide
evidence that transfer prices meet an arms-length standard, which means
pricing transactions as if they occurred between unrelated parties.
Establishing an arms-length price can be difficult when there is no
comparable market price, such as for a unique good, service, or
intangible property.
Although comprehensive data were not available, several experts,
including the OECD, have noted that a significant amount of trade
occurs between related parties.[Footnote 15] Trade in services in the
United States, while not a measure of overall U.S. trade, provides an
example. According to the U.S. Bureau of Economic Analysis, trade in
services between CFCs and related parties increased (in nominal
dollars) from approximately $38.4 billion in 1999 to approximately
$178.7 billion in 2006.[Footnote 16]
The changing nature of international trade, particularly the growing
trade in intangibles, is making international transactions more
susceptible to transfer pricing abuse.[Footnote 17] Tax experts
repeatedly identified intangible property as a particular challenge
when attempting to establish a transfer price that meets the arm's
length standard. The unique nature of many intangible assets, such as
patents, trademarks, copyrights, and brand recognition, means that it
is difficult or impossible to identify comparable transactions for
transfer pricing purposes. The revenue risk posed by mispricing
intangibles can be significant because it can result in a company
converting taxable income into tax-exempt or lower taxed income. For
example, a parent corporation can license a patented computer
technology to a foreign subsidiary and charge a below-market royalty,
which is taxed in the domestic country. The subsidiary, which is in a
low-tax country, uses the technology to generate a profit. The
subsidiary then pays a tax-exempt dividend to the parent corporation.
The parent corporation's country loses tax revenues because the tax-
exempt dividend received is inflated and the taxable royalty is
reduced. Conversely, the subsidiary's country receives additional tax
revenues because the subsidiary's income is higher than it should be,
as the smaller royalty payment is a deductible expense. In the
aggregate, however, the MNC reduces its tax liability because the tax
rate in the subsidiary's country is lower than the tax rate in the
parent corporation's country.
Because identifying comparable prices for intangibles is often
difficult, tax agencies and taxpayers often rely on a profit-split
approach. The goal is to determine the percentage of profit
attributable to buyers and sellers in different countries. Company
officials consistently reported that making these determinations often
requires costly special studies done by outside technical experts. In
Australia, for example, to help protect against penalties, it is
recommended that companies document that they followed a four-step
process including selecting and justifying a transfer pricing
methodology and then conducting an analysis based on that methodology
to determine an arm's-length price. Appendix II provides details on the
transfer pricing documentation and filing requirements for all of our
study countries. One company official further said that even after
making these investments, tax authorities may disagree with the results
because of differences in opinion about the assumptions that had to be
made. A number complained about transfer pricing reviews turning into
disputes between countries over the distribution of tax liabilities.
This can occur because, in many transfer pricing disputes, there are at
least three interested parties, the taxpayers and two tax agencies.
When a taxpayer reaches an agreement with one government on a price it
can result in a lower tax payment for the other government.
On the other hand, tax agency officials repeatedly told us that they
needed detailed information on the pricing methodologies used in order
to verify that companies' prices satisfy the arm's-length standard. Tax
agency officials said documentation of the data used and analysis
conducted are critical to conducting independent determinations of the
appropriateness of transfer prices. As one example of the importance
tax agencies place on this documentation, the Australian Tax Office
(ATO) has a system for rating the documentation quality. Under this
system, poorly documented transfer pricing decisions are more
systematically identified, allowing better targeting of audits.
Transfer pricing abuse is also known to be a significant problem in the
United States. For example, IRS lists transfer pricing abuse as a high-
risk compliance area because of the large number of taxpayers and
significant dollar risk.
While there is agreement that transfer pricing is a major compliance
risk in both our study countries and the United States, there is no
consensus among the tax experts we met with about whether the
compliance risks are greater in our study countries' exemption systems
or in the United States' deferral system. Some argued that the tax
benefits for an MNC from manipulating transfer prices are potentially
larger under an exemption system than a deferral system. They argue
that gains from transfer pricing abuse are larger if income can be made
tax-exempt rather than tax-deferred. However, other experts pointed out
that transfer pricing abuse is already a significant problem in the
United States. Some of these experts noted that the incentives to avoid
or evade tax under a deferral system can be quite large because tax can
be deferred indefinitely. One of these experts also pointed out that
there is no empirical evidence supporting the claim that countries with
exemption systems face greater noncompliance with transfer pricing
rules.
Study Countries Have Placed Greater Emphasis on Enforcing Transfer
Pricing Rules:
According to tax agency officials and outside tax experts, all study
countries are placing greater emphasis on transfer pricing when
auditing MNCs. For example, a tax practitioner in France said that the
overwhelming majority of the audit issues he faces are transfer-pricing
related. Another tax practitioner made the same observation about
Germany, saying that there is a general perception that the burden for
complying with transfer pricing has increased in recent years. These
and other company representatives we spoke with said that time spent
determining and documenting transfer prices in accordance with country
requirements is a primary source of burden. These findings are echoed
in the research of others. For example, according to a survey of 850
MNCs, 65 percent of respondents believe that transfer pricing
documentation is more important now than it was 2 years ago.[Footnote
18] Similarly, two-thirds of those respondents said they increased
their resources on transfer pricing experts and studies in the last 3
years.
All Study Countries Use Advanced Pricing Agreements to Address
Compliance Risks:
All of the study countries have developed advanced pricing agreement
(APA) programs that allow taxpayers and tax agencies to resolve
transfer pricing issues before tax returns are filed and without the
need for time consuming and expensive audits. Tax experts' opinions on
APA participation varied, but often these experts did not consider them
an efficient use of resources for addressing transfer pricing issues.
Due to the time and resources required to obtain an APA, some taxpayers
only pursue them for high-value transactions. Guidance provided by the
Australian Tax Office illustrates the time and extensive documentation
that can be required for an APA. The document, included in appendix
III, lists requirements such as numerous meetings with agency
officials, details of the transfer pricing methodology, and data
supporting that methodology. The amount of time needed to complete an
APA can be greater when it involves multiple countries. According to
statistics from some of our study countries, APAs may take a year, or
multiple years, to finalize. Between 1992 and the end of 2007, Canada
finalized 153 APAs.
Some tax practitioners said that the decision to use APAs can also
depend on the perceived risk that a transaction is likely to be subject
to audit. Some taxpayers determine that APAs are less burdensome than
going through an audit.
Complying with and Enforcing Anti-avoidance Rules, both CFC and Other
Rules, Presents Challenges in All of Our Study Countries:
According to taxpayers and tax officials we spoke with from the study
countries, rules limiting the tax advantages of earning certain types
of income offshore can serve as a source of taxpayer compliance burden
and can be subject to compliance risk. As shown earlier in table 5, all
of our study countries with the exception of the Netherlands use CFC
rules as a primary method to limit the exemption or tax-deferral of
certain income held offshore.[Footnote 19] In addition, all of our
study countries, including the Netherlands, have additional anti-
avoidance rules that may apply and disallow tax advantages on specific
types of income earned offshore. See appendix IV for details of other
anti-avoidance rules in our study countries and in the United States.
The study countries were not able to provide us with statistics on the
number of subsidiaries subject to these anti-avoidance rules, the
amount of income earned by them, or the residual tax revenue they
generated.[Footnote 20] Government officials we spoke with in several
countries estimated the revenue generated from these rules to be low.
However, some tax experts we spoke with stated that these rules played
an important role in preventing MNCs from avoiding domestic taxes by
earning income through CFCs.
When CFC rules are triggered, it can result in an increase in the MNC's
tax liability. As a result, some of the tax practitioners we talked to
said that structuring subsidiaries to avoid CFC rules requires careful
planning and continuous monitoring. It is even possible that the
actions of others could change a foreign subsidiary's CFC status. For
example, as shown in table 5, one way a subsidiary of an Australian MNC
can be a CFC is if five or fewer Australian investors own more than 50
percent of its shares. Consequently, a subsidiary that is not currently
a CFC could become one if other Australian investors increase their
ownership share.
Some tax practitioners told us that the complexity of the requirements
for determining whether CFC rules applied and the amount of information
needed to support a determination created considerable burden. For
example, a French tax professional said that France's CFC rules are
burdensome because they require the taxpayer to make a series of
complex determinations (these were summarized in table 5)--such as
whether the foreign tax liability of a subsidiary is greater or less
than 50 percent of what it would be had the income been earned in
France--in order to decide whether the subsidiary is a CFC. Given
differences in accounting and tax rules between France and a foreign
subsidiary's home country, these calculations can become complicated.
German CFC rules require similar comparisons of actual taxes paid to
theoretical taxes owed in determining whether the subsidiary will be
taxed as a CFC. Australia takes a different approach, providing a list
of countries where CFCs can be located and have fewer types of income
that may be attributed to domestic corporations. It is not clear the
extent to which this reduces burden in comparison to the other study
countries.
Tax experts in Canada also said that acquiring information for
documentation requirements related to CFC rules is particularly
burdensome. For example, a Canadian firm with a 10 percent holding in a
foreign subsidiary is required to provide the Canada Revenue Agency
(CRA) with detailed tax and operations information from the foreign
subsidiary. With only a 10 percent ownership stake, the Canadian firm
may find it challenging to obtain such information in a timely manner,
or at all.
Generally, CFC rules intend to limit an MNC's ability to shift income,
especially passive income, to foreign jurisdictions to avoid or
postpone domestic tax. Enforcing these rules could be difficult if the
tax agency is not present in the foreign jurisdictions. For example,
some officials in France and Canada said they may not be able to obtain
and validate information needed to enforce these rules. One French
official stated that it is difficult to see if a foreign subsidiary
located in a low-tax jurisdiction thousands of miles away was an active
business or being used to shelter income.
While the Netherlands does not have specific CFC rules, taxpayers and
tax officials stated that the compliance burden associated with other
anti-avoidance rules can be significant. According to tax professionals
we spoke with, the Netherlands has low-taxed passive shareholding
rules, another type of anti-avoidance rule. Overall, the tax
practitioners and experts we spoke with agreed that the compliance
burden related to anti-avoidance rules in the Netherlands could be
significant.
Exemption of Foreign-Source Income Reduces the Need for Foreign Tax
Credits, but They Can Still Serve as a Compliance Risk:
The study countries all have FTC systems; however, according to both
tax agency officials and tax practitioners FTCs play less of a role in
these countries than in the United States because of the extent to
which foreign-source income is exempt. For exempt income, taxpayers do
not have to track and report foreign taxes paid. However, FTCs still
exist as the study countries use them to avoid double taxation on
foreign-source income that is not exempt, such as income subject to
anti-avoidance rules. Most study countries were not able to supply data
on the amount of FTCs that are claimed by domestic parent corporations
in their countries. However, some tax experts said that the extent to
which FTCs are generated varies by country, the type of industry in
which the MNC conducts business, and the overall structure and location
of the MNC's subsidiaries. For example, according to one German tax
practitioner we spoke with, FTCs in that country tend to be generated
mainly by businesses in the financial and insurance industries or where
CFCs are involved.
As shown in table 6, the study countries vary in the rules they apply
to FTCs. Many of these rules address the extent to which companies are
allowed to accumulate FTCs and use them to offset other types of
income. For example, Australia requires that all FTCs must be used in
the taxable period in which they are recognized by the taxpayer on
their tax filing. Any FTCs that a company has accumulated that are in
excess of the amount of domestic tax actually paid on that income are
lost. Canada, on the other hand, allows companies to carry excess FTCs
back into the previous 3 years or forward up to 10 years. The United
States allows companies to apply accumulated FTCs across different
types of foreign-source incomes, across multiple countries, and over
multiple years. For example, FTCs accumulated for foreign taxes paid on
royalty income can be combined with FTCs accumulated on dividend
income.
Table 6: Overview of Rules Governing FTCs in the Study Countries and
the United States:
Country: Australia;
FTC allowed: Yes;
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income;
FTC carryover: Back: None;
FTC carryover: Forward: None.
Country: Canada;
FTC allowed: Yes;
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income by country;
FTC carryover: Back: 3 years;
FTC carryover: Forward: 10 years.
Country: France;
FTC allowed: Yes[A];
Some limits on the use of FTCs: Generally only allowed for withholding
taxes paid to eligible tax treaty countries;
FTC carryover: Back: None;
FTC carryover: Forward: None.
Country: Germany;
FTC allowed: Yes;
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income by country;
FTC carryover: Back: None;
FTC carryover: Forward: None.
Country: Netherlands;
FTC allowed: Yes;
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income;
FTC carryover: Back: None;
FTC carryover: Forward: None.
Country: United States;
FTC allowed: Yes;
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income by broad category of income (general or passive);
FTC carryover: Back: 1 year;
FTC carryover: Forward: 10 years.
Source: GAO analysis of country information.
Note: This table shows general treatments. It does not present all of
the details, exceptions, or rules that govern the tax treatment of FTCs
for our study countries.
[A] French domestic law, generally, does not allow FTCs; income subject
to foreign tax and not exempt from French tax is taxable net of foreign
tax paid. However, most French tax treaties provide for a tax credit
that generally corresponds to withholding taxes on passive income.
[End of table]
Some practitioners said there was some burden in tracking FTCs, but
generally these rules were much less burdensome than complying with
transfer pricing and anti-avoidance rules. One tax practitioner from
Germany pointed out that in instances where MNCs have numerous
subsidiaries subject to anti-avoidance rules it generally results in
more instances where income is subject to tax in two countries, thus
creating additional burden to identify and track FTCs.
Canada's Rules for Determining if Dividend Income Is Taxable, with FTCs
Allowed, or Exempt Is a Compliance Challenge and Imposes Significant
Taxpayer Burden:
Tax agency officials, taxpayers, and tax experts agreed that Canada's
rules for tracking foreign-source income and determining whether the
income qualifies for tax exemption are complex and challenging for
taxpayers and tax officials. As discussed earlier in this report,
Canada's rules for determining whether or not dividend income received
from foreign subsidiaries is exempt from domestic taxation include
ownership requirements, location and business activities in a treaty
country, and evaluating what type of earnings (e.g., capital gains,
passive income, or active income) the subsidiary is distributing as a
dividend. Canadian corporations receiving dividend income that does not
qualify for exemption are taxed on that income, although FTCs may be
applied to offset domestic tax. Canadian corporations are responsible
for tracking all foreign earnings to ensure appropriate taxation once
the income is received by the Canadian corporation. Taxpayers said
these rules are burdensome, in part, because they require information
only available from foreign subsidiaries, complex calculations and
adjustments to income based on Canadian rules, and monitoring ownership
changes for the foreign subsidiary. Tax agency officials said the rules
are a compliance risk because of their complexity and difficulty of
validating adherence.
The Generation of Inappropriate Foreign Tax Credits Was Identified as a
Compliance Risk in Canada but the Risk Was Uncertain for the Other
Study Countries:
One area identified by tax officials as a source of compliance risk in
Canada is the generation of abusive FTCs to offset overall tax
liability. Often termed FTC generators, these activities, for example,
allow taxpayers to take advantage of definitions of debt and equity in
two countries by setting up a subsidiary for the purpose of holding
assets and generating an income stream in such a way that the income
stream is subject to foreign tax but also receives an offsetting
deduction so that there is no net foreign tax. The taxpayer then tries
to claim a domestic tax credit against this foreign tax paid while
ignoring the offset.
Tax agency officials in Canada told us that FTC generators are
considered a significant compliance risk in their country. CRA
officials said they were currently auditing a number of domestic
corporations to determine the extent to which Canadian companies are
participating in these types of schemes. Because there is often no
economic purpose to such a transaction, one company generally pays the
other a fee for participating in the transaction. CRA officials said,
so far, they have identified a substantial amount in avoided Canadian
tax from 2001 to 2005.
Several experts we spoke to with knowledge of the other study countries
said they did not think FTC generators were a significant issue in
those countries. For example, a tax practitioner in Germany told us
that since the majority of repatriated income to Germany is tax exempt
FTCs are not produced in many instances. Similarly, Australian tax
agency officials said that since Australian rules require FTCs to be
used immediately in the year they are recognized, it reduces the
ability to exploit the FTC generator scheme. However, some experts also
pointed out that there is always a possibility that taxpayers could
structure specific transactions to produce improper FTCs.
FTC generators are also known to be a significant problem in the United
States. For example, IRS lists them as a high-risk compliance area
because of the large number of taxpayers and significant dollar risk
that these types of schemes present.
Study Countries Differ in How They Limit Domestic Deductions for
Expenses in Order to Prevent Erosion of the Domestic Tax Base:
Using sometimes indirect methods, all study countries limit the
domestic deductibility of some expenses associated with earning foreign-
source income. Tax experts said that methods resulted in fewer
compliance risks and burdens as compared to more direct methods. The
deductibility of expenses incurred to earn foreign-source income is an
issue because of the effect on revenue. If domestic deductibility is
allowed under an exemption system, then MNCs are able to deduct
expenses even though the resulting income is not subject to domestic
tax.
France and Germany provide an example of an indirect approach to
limiting expense deductions. As shown in table 2, they require
corporations to add 5 percent of their gross tax-exempt dividends to
their domestic taxable income (making dividends effectively 95 percent
exempt) as an offset for deductible expenses incurred to earn the
dividends. In our interviews with tax officials and members of the
business community, this approach was cited as being less burdensome
than tracing or allocating domestic expenses to tax-exempt income.
Tracing would involve matching specific expenses to actual income
generated. Some tax experts that we spoke to generally agreed that
tracing would be ineffective. Many of the domestic expenses incurred by
domestic corporations to invest or maintain an investment in a foreign
subsidiary are general to the domestic corporation. These expenses
include general management expenses, interest expense on borrowed
money, and other administrative expenses. Because these expenses are
general to the corporation, they are difficult to trace to the income
items.
One alternative to tracing, mentioned by several experts we talked to,
is allocating overhead expenses to income sources according to
formulas. Rather than tracing expenses to actual income items, this
alternative would allocate expenses according to a rule. Although not
used in our study countries, allocating overhead expenses in this way
could be made less burdensome than tracing. However, some experts
stated that this approach would create compliance risks and burdens
that do not currently exist. Several experts pointed to the United
States as an example of this. In general, the United States requires
U.S. corporations to allocate their expenses to a class of gross income
and then, if a statutory provision requires, apportion deductions
between the statutory grouping and the residual grouping. IRS officials
stated that these rules were a compliance risk because corporations
sometimes do not apply them appropriately. Some tax experts said these
rules were a significant compliance burden because they are complex,
requiring considerable time to conduct detailed calculations.
Another approach taken by all of our study countries is to limit the
amount of interest expense that domestic corporations may deduct.
Without limits on interest rates and amounts, corporations could shift
income offshore and artificially increase domestic interest expenses,
eroding the domestic tax base. The rules vary by country and in many
cases apply to all corporations, not just multinationals. For example,
Germany and France require that interest rates be equivalent to arm's-
length terms; the amount of expense that exceeds those terms is
generally nondeductible.[Footnote 21] Germany also has a rule
disallowing interest expenses that exceed 30 percent of the
corporation's adjusted earnings. Canada has a rule that targets
interest paid to a foreign related-entity with a limit based on debt-
to-equity ratios. With a few exceptions, tax professionals generally
stated that the general types of interest expense rules described above
did not pose much of a compliance burden.
The approaches taken by the study countries do not disallow all
domestic deductions for expenses incurred with respect to foreign-
source dividend income. However, some experts thought that the indirect
approaches for limiting the deductibility of overhead expenses were
more administrable and less burdensome than more targeted alternatives.
Australia, France, and Germany exempt active foreign-source income
earned through foreign branches, but generally disallow domestic
deductions for direct expenses attributable to earning the tax-exempt
income. Direct expenses, like the cost of inventory, can be traced more
easily to the income generated than more general expenses, like
interest or other overhead costs.
Study Countries and the United States Do Not Regularly Report Basic
Information about the Revenues Generated by Taxing Foreign-Source
Corporate Income:
In addition to lacking data about compliance and compliance burden for
their foreign tax rules, our study countries lack data on the amount of
tax revenues generated from the foreign activities of domestic
corporations. This is also the case for the United States. Several
federal agencies consistently report on the business activities of U.S.
MNCs, but tax revenues are not included in these reports. For example,
the Bureau of Economic Analysis reports on the foreign direct
investment activities of U.S. MNCs and IRS reports data on the amount
of income U.S. MNCs earn through CFCs.
U.S. international tax experts, including noted academics with multiple
publications who we spoke to on this topic all agreed that regularly
and consistently reporting U.S. tax revenue from foreign-source
corporate income would be useful. They said that this information would
help inform the debate about how to tax foreign-source income and
potentially improve understanding of the role international tax rules
play in the U.S. tax system. For example, one of these experts pointed
out that it was not widely understood how little domestic revenue is
actually raised from taxing foreign-source income and that the tax
regime governing foreign-source income plays a role in protecting the
domestic tax base.
Treasury officials and the experts we talked to noted that producing
regular revenue reports is feasible. A few academic papers and a recent
release from the Secretary of the Treasury on international tax issues
have reported estimates.[Footnote 22] However, the experts said that
these reports from different sources are not as useful as they could be
because they are irregular, incomplete, and lack transparency. The
experts felt that consistent and transparent reporting by a reputable
government source that clearly describes the methodology used to
produce the numbers and any limitations would be superior to the
current occasional reports that sometimes lack much explanation. IRS
and Treasury officials said IRS already collects the necessary data
through corporate income tax returns to make the necessary
calculations. Therefore, the tax experts said there should not be
significant additional cost to the government to provide this
information.
Conclusion:
The United States, like our study countries, does not report the taxes
collected by the United States on foreign-source income. Such basic
information about the U.S. system would not be costly to provide and
could contribute to the ongoing debate about the direction of U.S.
policy. Such reporting would make explicit to policy makers, and
perhaps to the general public as well, how little residual revenue is
received by the United States from taxing foreign-source corporate
income. Doing so could help highlight the important role that
international corporate tax rules play in protecting the domestic tax
base.
Recommendation for Executive Action:
We recommend that the Secretary of the Treasury use currently collected
information to report annually on the revenue to the United States
Treasury from taxing foreign-source corporate income. To enhance
usefulness, such reports should describe the methodology and important
limitations.
Agency Comments:
We requested comments on a draft of this report from the Secretary of
the Treasury. Treasury agreed with our recommendation. The Acting
Assistant Secretary (Tax Policy)'s letter is reprinted in Appendix VI.
Treasury and IRS staff also provided technical comments, which we have
incorporated as appropriate.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after its date. At that time, we will send copies to the Secretary of
the Treasury, the Commissioner of Internal Revenue, and other
interested parties. This report will also be available at no charge on
GAO's Web site at [hyperlink, http://www.gao.gov].
If you or your staff has any questions, please contact me at (202) 512-
9110 or whitej@gao.gov. Contact points for our Offices of Congressional
Relations and Public Affairs may be found on the last page of this
report. Key contributors to this report are listed in Appendix VII.
Signed by:
James R. White:
Director, Tax Issues Strategic Issues Team:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
The objectives of this report were to (1) describe, for select case
study countries that take a territorial approach, what types of foreign-
source income the countries exempt and the rules governing those
exemptions; and (2) describe, to the extent information is available,
the compliance risks and taxpayer compliance burdens that the taxation
of foreign-source corporate income presents for each of these
countries.
To address our objectives, we selected five countries--Australia,
Canada, France, Germany, and the Netherlands--to study based on several
criteria, including range of tax treatments for foreign-source
corporate income, unique tax system features, and Organization for
Economic Cooperation and Development (OECD) membership. To gather
information related to our selection criteria, we interviewed a number
of corporate income tax experts, including academics, corporate tax
practitioners, corporate taxpayers, officials at the OECD, and
government officials. We contacted those experts that we identified
through our literature review, which is described immediately below,
along with experts that were recommended by other experts. Our
literature review consisted of academic articles and books, national
government publications, OECD and other multinational-organization
publications on worldwide and territorial tax systems, and private
sector research pertaining to various international aspects of
corporate income tax systems and administration.
To describe the corporate income tax systems of our study countries, we
consulted with corporate taxpayers, business representatives,
government tax officials, and academic experts. We performed an in-
depth literature review on each country's corporate income tax system,
focusing on the rules governing international taxation. We also
reviewed research-based publications produced by professional services
organizations, academic experts, and international organizations. In
general, we relied on information provided by tax officials from the
study countries as well as published documents to summarize and
characterize the corporate income tax systems for each country. We
collected and analyzed data on the countries and their systems for
taxing foreign-source corporate income, including tax policies,
administrative mechanisms, compliance activities, and taxpayer
reporting and documentation requirements. We did not conduct a formal
legal review of the tax laws and rules in other countries, but relied
on the information supplied by tax agency officials in those countries.
We also provided the tax agency officials in our study countries a copy
of our report to verify data and specific factual and legal statements
about the tax laws in their country.
To address our second objective, we searched for publicly available
data that quantified taxpayer compliance risk and burden for each of
our study countries. In addition, we interviewed tax practitioners,
taxpayers, government tax officials, business representatives, and
officials from the OECD. We analyzed the information gathered through
interviews as well as published documents to identify and describe the
common sources of taxpayer compliance risk and compliance burden across
the study countries. When available, we used publicly available data
obtained from governments, private sector research, and academics to
support evidence provided in the interviews. In addition, we provided
tax agency officials from each of the study countries with a statement
of facts that were presented in the report for their review and
comment. Technical corrections were made to this report based upon
country responses. This report shows general tax treatments and does
not present all of the details, exceptions, or rules that govern the
tax treatment of foreign-source income in our study countries and the
United States.
We conducted our work from June 2008 to September 2009 in accordance
with all sections of GAO's Quality Assurance Framework that are
relevant to our objectives. The framework requires that we plan and
perform the engagement to obtain sufficient and appropriate evidence to
meet our stated objectives and to discuss any limitations in our work.
We believe that the information and data obtained, and the analysis
conducted, provide a reasonable basis for any findings and conclusions
in this product.
[End of section]
Appendix II: Transfer Pricing Documentation Requirements in the Study
Countries:
Country: Australia;
Documentation requirements: Documentation should evidence that the
taxpayer has followed the following four-step process in setting and
reviewing its transfer prices: Step 1: Accurately characterize the
international dealings between the associated enterprises in the
context of the taxpayer's business and document that characterization;
Step 2: Select the most appropriate transfer pricing methods and
document the choice; Step 3: Apply the most appropriate method,
determine the arm's length outcome and document the process; and; Step
4: Implement support processes. Install review process to ensure
adjustment for material changes and document these processes;
Time at which documentation should be prepared: Contemporaneous.
However, generally only required to be submitted to the revenue
authority following a specific notification, such as through an audit;
Time to fulfill formal requests made during an audit: 28 days.
Country: Canada;
Documentation requirements: Contemporaneous documentation required for
cross border, related party transactions. Form T-106 required to be
filed annually asks for reporting of non-arms-length transactions; Time
at which documentation should be prepared: Must exist at the time of
tax filing;
Time to fulfill formal requests made during an audit: 3 months.
Country: France;
Documentation requirements: Taxpayers are not required to keep any
transfer pricing documentation but are expected to cooperate with the
tax agency in transfer pricing audits;
Time at which documentation should be prepared: No formal
contemporaneous documentation requirement;
Time to fulfill formal requests made during an audit: 60 days, but
could be extended an additional 30 days.
Country: Germany;
Documentation requirements: Documentation that shows the type and
content of business transaction to related parties, including general
information about (1) the group and ownership structure, (2) business
relations to related parties, (3) analysis of functions and risks, and
(4) transfer pricing analysis;
Time at which documentation should be prepared: Contemporaneous for
exceptional business transactions only;
Time to fulfill formal requests made during an audit: 60 days.
Country: Netherlands;
Documentation requirements: Documentation must show the arm's length
nature of the transfer price that was applied;
Time at which documentation should be prepared: Generally expected to
be available at the time when the transaction occurs;
Time to fulfill formal requests made during an audit: 4 weeks, but up
to 3 months for certain complex transactions.
Source: Organization for Economic Cooperation and Development and Ernst
& Young.
[End of section]
[End of table]
Appendix III: Example from Australia of the Process for Obtaining an
Advanced Pricing Agreement:
Step 1: Pre-lodgment meetings:
The purpose of pre-lodgment meetings is to:
* discuss the suitability of an APA;
* allow a business to provide a broad outline of the proposed transfer
pricing methodology;
* discuss whether the APA will be unilateral or bilateral;
* discuss the required documentation and analysis;
* determine whether independent expert advice is required;
* discuss Tax Office audit activity (if an APA is to flow on from
audit);
* agree on a date for lodging a formal application;
* agree on the APA timetable, and;
* discuss the process for evaluating the application.
Pre-lodgment meetings do not bind either party to the APA program.
Step 2: Lodgment of formal application:
If proceeding with the APA, a business will be required to lodge a
formal application. The APA application should include:
* details of the proposed transfer pricing methodology, supported by
relevant information;
* terms and conditions governing the application of the transfer
pricing methodology;
* data showing that the transfer pricing methodology will produce arm‘s
length results;
* a discussion and analysis of the critical assumptions, and;
* a suggested period of time for which the APA will apply.
For bilateral APAs we normally advise the treaty partner‘s tax
authority once the application has been accepted.
Step 3: Analysis/evaluation:
We evaluate the data submitted and other relevant information, and seek
additional information where necessary. We normally have numerous
meetings with a business.
Step 4: Negotiation and agreement:
For a bilateral APA, the relevant tax administrations exchange position
papers outlining the acceptability of the proposed transfer pricing
methodology. A written confirmation of the concluded agreement is
provided to the business.
For a unilateral APA, we provide written confirmation of the agreement
we reach with the business.
Step 5:
Concluded APAA concluded APA contains at least the following
information:
* the transactions, agreements or arrangements covered by the APA;
* the period and tax years covered by the APA;
* the agreed transfer pricing methodology and the critical assumptions
on which it is based;
* the definition of key terms that form the basis of the methodology
(for example, sales, operating profit);
* if applicable, a range of arm‘s length results, and;
* the business‘s obligations as a result of the APA.
Source: Australian Tax Office.
[End of section]
Appendix IV: Examples of Other Anti-avoidance Rules in the Study
Countries and the United States:
Table 7 provides some examples of non-controlled-foreign-corporation
(CFC) anti-avoidance rules. This is not a complete list of the anti-
avoidance rules in these countries. The consequences of falling under
these rules are not necessarily the same as the CFC rules, but those
consequences are beyond the scope of this table.
Table 7: Examples of Additional Anti-avoidance Rules by Country:
Country: Australia;
Regime: Foreign Investment Fund (FIF) rules;
General definition of anti-avoidance rules: Certain Australian
shareholders are subject to annual taxation on a deemed return on their
pro rata shares of foreign investment funds if:
(a) the foreign company or trust is not controlled by Australian
residents; and;
(b) the taxpayer's shareholding is more than 10% of the total value of
the taxpayer's interest in foreign companies and trusts; and;
(c) the foreign company or trust engages in "blacklisted" activities,
such as certain financial intermediary, insurance, and banking
transactions; and;
(d) the taxpayer holds the interest at the end of the taxable year.
Country: Canada[A];
Regime: Offshore Investment Fund (OIF);
General definition of anti-avoidance rules: Canadian shareholders of an
OIF are taxed currently on an imputed return basis where the investment
in the OIF is established to be motivated by tax avoidance.
Country: France;
Regime: Abuse of Law doctrine;
General definition of anti-avoidance rules: General anti-avoidance law
that permits the tax authorities to take action against legal
arrangements or particular transactions when those arrangements and
transactions were fictitious or undertaken for solely tax reasons.
Country: Germany;
Regime: General Anti-Avoidance Rule;
General definition of anti-avoidance rules: General anti-avoidance
rule, re-written in 2007, that prevents taxpayers from establishing
legal forms or structures for the sole purpose of obtaining a tax
advantage. Tax authorities may disregard structures for tax purposes in
these situations.
Country: Netherlands;
Regime: Low-Taxed Passive (LTP) Shareholding;
General definition of anti-avoidance rules: The Dutch shareholder that
holds 25% or more, alone or together with an affiliate, of the shares
in a (foreign) entity has to value its shareholding at market value in
case the following conditions are met:
(a) At least 90 percent of the assets of the subsidiary are, directly
or indirectly, of a portfolio nature;
(b) The foreign tax paid on profits is less than 10 percent of tax on
profits if calculated under Dutch tax law; and;
(c) more than 50 percent of the carrying value of its property is not
investment property.
Country: United States;
Regime: Passive Foreign Income Companies (PFIC);
General definition of anti-avoidance rules: A foreign corporation is a
PFIC if:
(a) 75 percent of the corporation's income is passive income; or;
(b) 50 percent of the corporation's assets (by value) are held for
production of passive income.
Unlike a CFC, a PFIC does not have any minimum stock ownership
requirement. Each U.S. shareholder of a PFIC can choose to be taxed in
one of two ways (or, in the case of marketable stock, one of three)
ways.
Source: GAO analysis of country information.
[A] A more comprehensive 'foreign investment entity' (FIE) regime is
proposed but not yet enacted. Under these proposed rules, Canadian
investors in a FIE would be taxed currently on an imputed return basis,
except where qualifying investors elect for accrual or mark-to-market
treatment instead.
[End of table]
[End of section]
Appendix V: Description of Dividend Exemption Systems in Japan and the
United Kingdom:
Japan and the United Kingdom both adopted dividend exemption systems in
2009. These countries previously taxed dividends received from foreign
subsidiaries but allowed for foreign tax credits (FTC) for foreign
taxes paid. Like our study countries, Japan and the United Kingdom have
specific rules used to determine whether a dividend qualifies for
exemption. Table 8 describes these rules.
Table 8: Required Domestic Ownership Type and Level of Foreign
Subsidiary to Qualify for Tax Exemption of Foreign-Source Dividend
Income:
Domestic ownership of foreign company:
Japan: Direct shareholding of at least 25%[A];
United Kingdom: Direct or indirect.
Foreign company share type:
Japan: Any type;
United Kingdom: Most types.
Ownership duration:
Japan: 6 months;
United Kingdom: None.
Source: GAO analysis of country information.
Note: This table shows general treatments. It does not present all of
the details, exceptions, or rules that govern the tax treatment of
foreign-source income in these countries.
[A] If the foreign company is a resident in a country with which Japan
has concluded a tax treaty that provides for the allowance of an
indirect FTC on qualifying dividends for a shareholding percentage of
less than 25 percent, then the exemption can be applied in those cases.
[End of table]
Like the study countries, both Japan and the United Kingdom have anti-
avoidance rules, including controlled foreign corporation (CFC) rules,
which limit the tax advantages of earning or holding certain types of
income in relatively low-tax jurisdictions. Japan revised their rules
at the same time the dividend exemption system was implemented. The
United Kingdom plans to address reforms to their CFC rules in future
years. However, the United Kingdom did introduce a worldwide debt cap
rule that limits the extent to which debt expenses can be deducted by
corporations in the United Kingdom. One goal of this rule is to prevent
situations in which businesses in the United Kingdom borrow excessively
in order to invest internationally to produce exempt dividends. This is
similar to some of the interest expense limitation rules we identified
in the other study countries.
[End of section]
Appendix VI: Comments from the Department of the Treasury:
Department Of The Treasury:
Washington, D.C. 20220:
September 3, 2009:
Mr. James R. White:
Director, Strategic Issues:
U.S. Government Accounting Office:
Washington, DC 20548
Dear Mr. White:
Thank you for the opportunity to comment on GAO's draft report entitled
"International Taxation: Study Countries That Exempt Foreign-source
Income Face Compliance Risks and Burdens Similar to Those in the United
States" (GAO-09-934).
The draft report recommends that "the Secretary of [the] Treasury
annually report, using already available data, the revenue generated by
taxing foreign-source corporate income." As a result of our discussions
with GAO, we have asked the Statistics of Income Division of the
Internal Revenue Service to include additional data available from
corporate income tax returns in its annual article in the Statistics of
Income (SOI) Bulletin on the corporate foreign tax credit. We believe
that this additional reporting will provide public information
regarding the tax revenue attributable to foreign source income.
We also have technical comments on the draft report, which we will
discuss with your staff.
Thank you again.
Sincerely,
Signed by:
Michael F. Mundaca:
Acting Assistant Secretary (Tax Policy):
[End of section]
Appendix VII: GAO Contact and Staff Acknowledgments:
GAO Contact:
James R. White, (202) 512-9110 or whitej@gao.gov:
Staff Acknowledgments:
In addition to the contact named above, José Oyola, Assistant Director;
Brian James; Ed Nannenhorn; Danielle Novak; Chhandasi Pandya; Matthew
Reilly; A.J. Stephens; and Charles Veirs IV made significant
contributions to this report.
[End of section]
Related GAO Products:
Cayman Islands: Review of Cayman Islands and U.S. Laws Applicable to
U.S. Persons' Financial Activity in the Cayman Islands, an E-supplement
to [hyperlink, http://www.gao.gov/products/GAO-08-778], [hyperlink,
http://www.gao.gov/products/GAO-08-1028SP]. Washington, D.C.: July
2008.
U.S. Multinational Corporations: Effective Tax Rates Are Correlated
with Where Income Is Reported. [hyperlink,
http://www.gao.gov/products/GAO-08-950]. Washington, D.C.: August 12,
2008.
Tax Administration: Comparison of the Reported Tax Liabilities of
Foreign-and U.S.-Controlled Corporations, 1998-2005. [hyperlink,
http://www.gao.gov/products/GAO-08-957]. Washington, D.C.: July 24,
2008.
Business Tax Reform: Simplification and Increased Uniformity of
Taxation Would Yield Benefits. [hyperlink,
http://www.gao.gov/products/GAO-06-1113T]. Washington, D.C.: Sept. 20,
2006.
Understanding the Tax Reform Debate: Background, Criteria, and
Questions. [hyperlink, http://www.gao.gov/products/GAO-05-1009SP].
Washington, D.C.: September 2005.
Tax Administration: Comparison of the Reported Tax Liabilities of
Foreign-and U.S.-Controlled Corporations, 1996-2000. [hyperlink,
http://www.gao.gov/products/GAO-04-358]. Washington, D.C.: Feb. 27,
2004.
Tax Administration: IRS' Advanced Pricing Agreement Program.
[hyperlink, http://www.gao.gov/products/GAO/GGD-00-168]. Washington,
D.C.: Aug. 14, 2000.
Tax Administration: Foreign-and U.S.-Controlled Corporations That Did
Not Pay U.S. Income Taxes, 1989-95. [hyperlink,
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of Tax. [hyperlink, http://www.gao.gov/products/GAO/GGD-95-101].
Washington, D.C.: Apr. 13, 1995.
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[End of section]
Footnotes:
[1] These are U.S. corporations that claimed foreign tax credits on IRS
tax forms. This may not include all U.S. corporations.
[2] Internal Revenue Service, Corporate Foreign Tax Credit, 2003,
Statistics of Income Bulletin. Fall 2007.
[3] Under a worldwide approach, domestic corporations generally face
the same total income tax liability regardless of whether an investment
is located at home or abroad (assuming the foreign tax rate is the same
or lower than the domestic rate), so investment location decisions are
not distorted by the tax. However domestic corporations may not
necessarily pay the same tax on a foreign investment as a foreign
competitor. Under a territorial approach, domestic corporations earning
foreign income only pay foreign tax, ensuring that they do not face a
greater tax liability on that income than foreign competitors in the
same country. However, this means that a domestic corporation could
face different tax liabilities for foreign and domestic investments.
[4] See appendix V for additional details on the tax treatment of
foreign-source income in Japan and the United Kingdom.
[5] In general, the U.S. tax system does not tax income until it is
actually earned. The U.S. also generally imposes its corporate income
tax at the corporate entity level. Deferral is a result of these basic
features: anti-avoidance rules generally create exceptions to these
principles in specific circumstances.
[6] For examples see Department of the Treasury, Leveling the Playing
Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs
Overseas (TG-119) (May 4, 2009); and President's Advisory Panel on
Federal Tax Reform, Simple, Fair, and Pro-Growth: Proposals to Fix
America's Tax System (Washington, D.C, November 2005).
[7] There is no standard definition of a subsidiary. For the purposes
of our report, we use the term subsidiary loosely to refer to a chain
of ownership whereby a parent corporation exercises a degree of control
of another corporation. The level of ownership which determines control
differs by individual circumstances. We discuss these scenarios later
in the report.
[8] In general, branches of U.S. corporations are not regarded as
separate legal entities for tax purposes.
[9] As shown in table 2, France and Germany effectively exempt 95
percent of capital gains from the sale of foreign subsidiary stock from
domestic tax.
[10] As measured by the Canadian dollar value of total dividends
received from foreign affiliates. Advisory Panel on Canada's System of
International Taxation, Enhancing Canada's International Tax Advantage
(December 2008).
[11] To qualify for the tax exemption, the French corporation must hold
or intend to hold the shares for 2 years.
[12] Income taxed under anti-avoidance rules may, in some cases, be
distributed to the domestic parent corporation as tax-exempt dividends.
[13] We use the term controlled foreign corporation (CFC) to describe
foreign subsidiaries that are controlled by a domestic parent company
as defined by each country. Some of our study countries use similar
terms, such as controlled foreign company or controlled foreign
affiliate, which we include in our use of the term controlled foreign
corporation. Although this term has a specific technical meaning in
several jurisdictions, including in the United States, we do not use
this term in any of its technical senses, but as a generic description
of these types of rules in various countries.
[14] In Canada, this income taxed currently is known as foreign accrual
property income (FAPI). FAPI income includes categories of income that
may not meet all definitions of passive income.
[15] OECD Observer, Transfer Pricing: Keeping it at Arm's Length, July
3, 2008.
[16] U.S Bureau of Economic Analysis. U.S. International Services:
Cross-Border Trade 1986-2007, and Services Supplied Through Affiliates,
1986-2006.
[17] This is a significant issue for tax authorities because of the
growing significance intangibles play in the global economy. Although
there is currently no complete measure of the amount of income
generated globally, or even in the United States, from investment in
intangible assets, one indicator is the amount of income generated
through royalty payments. According to Treasury tax files, royalties
paid by the top 7500 CFCs of U.S. parent corporations increased 68
percent ($22.4 to $37.6 billion) from 1996 to 2002.
[18] Ernst & Young, Global Transfer Pricing Survey 2007-2008. We did
not validate the information reported in this study.
[19] As stated previously, we use the term CFC to generally describe
foreign subsidiaries that are controlled by a domestic company as
defined by each country. We do not use the term in any of its technical
senses, but as a generic description of these types of rules in our
study countries.
[20] Some of this data is available for U.S. MNCs based on corporate
tax returns. For example, for tax year 2004, IRS reported the existence
of 74,676 CFCs that earned $362.2 billion before income taxes. These
CFCs paid $69.3 billion in income taxes worldwide.
[21] These requirements are related to transfer pricing rules in that
they both aim to set the prices involved in certain related-party
transactions at arm's length.
[22] Altshuler and Grubert reported U.S. corporations paid $12.7
billion in U.S. taxes on foreign-source corporate income reported in
tax year 2000 in "Corporate Taxes in the World Economy: Reforming the
Taxation of Cross-border Income" in Fundamental Tax Reform: Issues,
Choices, and Implications, edited by John W. Diamond and George R.
Zodrow (2008). The Department of the Treasury reported about $16
billion in revenue for tax year 2004 in Leveling the Playing Field:
Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs
Overseas (TG-119) (May 4, 2009).
[End of section]
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