Exempt Active Foreign Dividends from U.S. Taxation and Change the Tax Treatment of Overhead Expenses

The federal government taxes the income that U.S. businesses earn both at home and abroad. Most of the income that U.S. corporations earn from their foreign subsidiaries' business activities is not subject to taxation in the United States until it is repatriated in the form of dividends that the subsidiaries pay to their parent company. Other forms of foreign income, such as royalties, interest, and "passive" income--that is, income derived from business assets by investors with little or no personal participation in the business--are subject to U.S. tax as that income is earned.

To prevent income earned abroad from being subject to both foreign and U.S. taxation, the tax code gives U.S. corporations a credit that reduces their domestic tax liability by the amount of income and withholding taxes they have paid to foreign governments. The foreign tax credit is subject to limits that are designed to ensure that the value of the credits taken does not exceed the amount of U.S. tax that otherwise would have been due. Those limits also are intended to prevent corporations from using foreign tax credits as a way to reduce taxes on income earned in the United States. For computing those credit limits, the overhead expenses (such as interest costs) that a U.S. parent company incurs for its operations must be allocated between domestic and foreign activities. (When computing taxable income, however, firms can deduct total overhead expenses, regardless of the source.)

This option would exempt from U.S. taxation "active" dividends--those that U.S. corporations earn from the business operations of their foreign subsidiaries or foreign branches. All other foreign income (including royalties, interest, and income from passive activities) would be taxed in the current manner--as it is earned. Foreign tax credits would be allowed so that companies could offset any foreign income taxes or withholding taxes paid on foreign income that was still subject to U.S. taxation. Overhead costs, such as interest expenses, of a U.S. parent company would be allocated between the company's

U.S. and foreign activities, as is the case under current law for purposes of computing the foreign tax credit. In a departure from current law, however, overhead expenses allocated to foreign income would no longer be deductible from U.S. income. Those changes would increase revenues by a total of $32 billion from 2012 through 2016 and by $76 billion over the 2012-2021 period. The revenue lost by exempting active dividends from U.S. taxation would be more than offset by increases in taxes on other sources of income. Specifically, taxes on U.S. income would rise because overhead expenses allocated to exempt foreign income could no longer be deducted from U.S. income. In addition, companies that paid high foreign income taxes could no longer use the foreign tax credits associated with repatriated dividends to shield other low-tax foreign income, such as royalties and export income, from U.S. taxes. An argument in favor of this option is that such a change would reduce the complexity of the tax system. Current rules allow U.S. multinational corporations to reduce their worldwide taxes by carefully planning how and when to repatriate dividend income from their foreign subsidiaries. Researchers have estimated the total costs of such planning to be more than $1 billion per year. This option would eliminate those planning costs. It is also argued that this option would allow foreign tax-credit rules to be simplified because many of those rules would no longer apply to active dividend income.

An argument against such a policy change is that it over U.S. investment and thus reducing the amount would have the same effect as the current tax system, of capital available for production in the United States. causing U.S. corporations to favor foreign investment RELATED OPTIONS: Revenues, Options 24 and 25