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The big exception to the U.S. regime of worldwide taxation for residents (with a foreign tax credit to avoid double taxation) is the rule of non-taxation of the foreign source active business income (as opposed to passive or tax-avoidance type income) of foreign subsidiaries of U.S. parents. This system operates as a disincentive, rather than as an incentive, for investment in developing countries by U.S. companies, in part because repatriated profits of the subsidiary are subject to U.S. tax. More importantly, however, with the advent of tax-rate competition by developed countries, such as Ireland, U.S. companies are able to achieve lower rates without moving to developing countries and can rely on a well-developed treaty network (with countries such as the Netherlands) to further reduce the ultimate tax on earnings by stripping them out to entities in countries that do not tax certain types of income, such as royalties. The combination of low rates, potential tax base erosion, and the stable, sophisticated infrastructure and labor force offered by low-tax developed countries virtually eliminates a foreign investment role for developing countries unless they possess natural resources or other unique on site advantages.
The United States taxes all U.S. persons, including domestic corporations, on worldwide income, but provides a credit against U.S. tax liability for taxes paid on foreign source income. A corporation is domestic if organized under the laws of the United States or one of the states. As a result, a domestic corporation hoping to shelter income from U.S. taxation may simply organize a subsidiary under the laws of a foreign jurisdiction. The income of the foreign subsidiary is free of U.S. tax unless under controlled foreign corporation (CFC) provisions it earns certain tax-avoidance income (generally passive income, certain sales and services income derived on behalf of the parent, insurance income and foreign oil and gas income). This income, known as subpart F income, results from transactions suggesting that the parent is using a foreign subsidiary to shift income offshore and is deemed distributed to the domestic corporation even if no amount is actually received.
While non-subpart F income may be safely shifted outside of the U.S. taxing jurisdiction through use of a foreign affiliate, the tax deferral ends when profits are returned to the U.S. parent in the form of dividends, interest, or royalties, etc., because, unlike many of the other countries featured in this volume, the U.S. has no participation exemption or other similar relief for repatriated profits. Thus, in order to minimize tax, U.S. companies have organized subsidiaries in low-tax regimes and kept the profits offshore to the extent possible. In recent years, some have expatriated, becoming domestic subsidiaries of a foreign parent in what has become known as “inversion” transactions. These inversions insulate most of the affiliated groups’ profits from U.S. taxation and, in some cases, allow the new foreign parent to strip earnings from the new U.S. subsidiary through transfer pricing and other tax-minimizing strategies.
Counterintuitively, this system operates as a disincentive, rather than as an incentive, for U.S. companies to invest in developing countries. With the advent of tax-rate competition by developed countries, such as Ireland, U.S. companies can achieve lower rates without moving to developing countries and can rely on a well-developed treaty network (with countries such as the Netherlands) to further reduce the amount ultimately subject to tax by stripping out earnings to subsidiaries organized in countries that do not tax certain types of income, such as royalties. The combination of low rates, potential tax base erosion, and the stable, sophisticated infrastructure and labor force offered by low-tax developed countries virtually eliminates a foreign investment role for developing countries unless they possess unique attractions, such as natural resources, that must be exploited on site. Moreover, the promise of an additional tax holiday like the one enacted by the U.S. Congress in 2004, enabling U.S. parents to bring home as much as $500 million in offshore profits at a 5.25 % tax rate, provides a strong incentive for multinationals to maintain the status quo.
The United States provides no tax incentives for investment in developing countries. Although some countries offer (or offered) tax sparing provisions in treaties that allow their multinationals to benefit from tax incentives offered by developing countries, the United States has never done so. Tax sparing provisions were negotiated with certain countries, including India, Israel, Pakistan, and the United Arab Republic, however, the U.S. Senate has never ratified them.
No incentives are currently offered for investment in countries with low incomes or high poverty rates. A provision that afforded relief from the subpart F rules for investment in “less developed” countries was repealed in 1975.
The United States does provide some tax advantages for its territories. In general, corporations organized under the laws of the territories are treated as foreign corporations, subject to tax only on U.S. source income and income effectively connected to a U.S. trade or business and not on worldwide income. Dividends received from U.S. sources by specified corporations organized under the laws of one of the territories are either exempt or subject to a reduced withholding tax. An important tax break, exempting from U.S. taxation as foreign source income profits derived by domestic corporations operating (and generating employment) in Puerto Rico, was repealed in 1996. While the U.S. continues to look for ways to support economic development in Puerto Rico, the repealed regime was found not to generate benefits commensurate with the cost of the incentive to the U.S. Treasury.
The U.S. has taken measures to encourage economic activity within its own jurisdiction. The Foreign Sales Corporation (FSC) rules, exempting a portion of a U.S. exporter’s profits from sales through a U.S. subsidiary, were repealed after a successful challenge by the EU caused the WTO to declare the regime an illegal export subsidy. A replacement regime, the extraterritorial income exclusion (ETI), was also repealed after the WTO found it provided the same prohibited subsidy. In order to compensate for the loss of ETI and stimulate domestic manufacturers to create jobs, Congress enacted the deduction for domestic production activities. It provides for a deduction equal to 9 % of specified domestic production activities which effectively amounts to a tax rate reduction.
While the federal government provides a limited array of tax incentives to attract economic activity, the various state governments rely heavily on them to attract investment. Economic studies indicate that the U.S. state and local subsidies outweigh those provided by the EU states. While nearly every state has offered some type of investment incentive, there is concern that the costs in the form of foregone revenue may outweigh the benefits to the locality.
The U.S. corporate tax system is partially integrated. The domestic corporation is separately taxed on its profits and the shareholders who are individuals are taxed on dividend distributions but at a preferential rate. For dividends received by domestic corporations (and some foreign corporations with U.S. trade or business income) there is a deduction ranging from 70 to 100 %. The taxable income of a corporation is taxed at the rates of 15 %, 25 %, and 35 %. A corporation with taxable income in excess of $18,333,333 pays tax at a flat 35 % rate. States may also impose tax on corporate income.
The United States is a party to numerous bilateral and multilateral trade and investment treaties.
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