The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries

Abstract

The purpose of this paper is to explore whether the U.S. should amend its international tax rules in ways that might encourage U.S. companies to invest in developing countries (DCs). Some scholars, notably Professor Karen Brown, have argued that the current U.S. international tax regime works against the interests of DCs and should be replaced by one that, she asserts, would benefit DCs in general and African nations in particular. She has proposed that the U.S. replace its foreign tax credit mechanism with an exemption system for DCs (at least for Africa). One of the reasons for the proposal is that the current U.S. system prevents DCs from offering tax incentives, such as tax holidays, to attract foreign direct investment (FDI) by U.S. multinational corporations (MNCs). Certainly it is the case that very little U.S. FDI finds its way to DCs. At the end of 2001, total U.S.-owned assets located abroad totaled $6.2 trillion (valued at cost), but little of these assets were in DCs. But, proposals such as that put forward by Professor Brown raise several questions. Is FDI an unqualified good for DCs? What are the determinants in the location of FDI? Are tax incentives offered by DCs effective in attracting FDI, even in situations where home country tax rules do not thwart them? Can tax incentives alone attract FDI or are there necessary preconditions a DC must satisfy before there is FDI at all? Are home country unilateral tax incentives effective in increasing FDI by its MNCs? Is it better for developed countries to assist DCs by offering tax subsidies to its MNCs or by providing direct financial assistance to DCs? This paper explores these questions. The paper first provides a broad overview of international tax systems that countries can adopt, i.e, the worldwide taxation of income with a foreign tax credit and exemption systems. The paper then demonstrates that the current U.S. foreign tax credit system defeats the objectives of DCs in offering tax holidays to U.S. MNCs only if the tax rate of the foreign country is lower than the U.S. and if the U.S. MNC is in an excess credit position. I propose a structural change in the U.S. foreign tax credit rules that would mitigate the impact of the U.S. international tax system on host country tax incentives to attract FDI. The proposal is not designed to be an incentive for greater FDI in developing countries by U.S. MNCs. Instead, it is intended to correct what I believe are defects in the current U.S. FTC rules. The factors and forces that adversely affect developing countries then are identified in order to lay the groundwork for an assessment of whether particular tax changes by the U.S. would impact these forces and factors positively. Recent work by the United Nations and the OECD regarding the level and means by which developed countries can aid DCs is also analyzed with particular attention paid to the role of foreign direct investment in these reports. The rather minimal economic evidence on the impact of tax policies on the level and location of FDI is then reviewed. Several different changes in the U.S. international tax system are assessed in terms of their efficiency and simplicity effects and in terms of their effectiveness in meeting the problems facing DCs: adopting an exemption system for DCs, reducing the corporate tax rate on DC income, adopting tax sparing for DC income, modifying Subpart F for DC income, and modifying transfer pricing rules to allow more profit to be allocated to DCs. The paper concludes that none of these proposals is likely to increase FDI by U.S. MNCs in DCs.