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Wednesday, March 3, 2010

The Foreign Tax Credit’s Interest Allocation Rules

Jane G. Gravelle
Senior Specialist in Economic Policy

Donald J. Marples
Specialist in Public Finance

The foreign tax credit alleviates the double-taxation that would result if U.S. investors' overseas income were to be taxed by both the United States and a foreign country. U.S. taxpayers credit foreign taxes paid against U.S. taxes they would otherwise owe, and in doing so concede that the country where income is earned has the primary right to tax that income. But the United States retains the primary right to tax U.S.-source income, placing a limit on the foreign tax credit: foreign taxes can only offset the part of a U.S. taxpayer's U.S. tax that falls on foreign source income. It is this limit to which the American Jobs Creation Act of 2004 (P.L. 108-357, Jobs Act) applied. To calculate the limit, a firm separates its revenue and costs, for tax purposes, into those having a foreign source and those having a U.S. source. Foreign taxes can offset U.S. tax on revenue "sourced" abroad; in effect, foreign-source income is exempt from U.S. tax for firms whose foreign tax credits exceed the limit (firms with "excess credits"). But because deductions allocated abroad reduce U.S. tax, the effect is the same as if deductions allocated to foreign sources cannot be claimed for U.S. tax purposes. 

If a U.S. firm has foreign investments, current law requires at least part of the U.S. interest to be allocated to foreign sources based on the theory that debt is fungible—that regardless of where funds are borrowed, they support a firm's worldwide investment. But multinational firms have argued that if part of domestic interest is allocated abroad, part of foreign interest should be allocated to the United States, which would reduce U.S. tax. (Some critics have suggested, however, that granting multinationals tax benefits through interest allocation revisions should be accompanied by restrictions on the benefit of deferral, which allows taxes.) 

This worldwide allocation rule was adopted in the Jobs Act, but has not yet been implemented. The Jobs Act called for implementation starting in 2009, while P.L. 110-289 subsequently delayed implementation until 2011. 

In the 111th Congress, the Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92, further delayed implementation of the worldwide allocation rules to 2018. Further proposals in the 111th Congress, the America's Affordable Health Choices Act of 2009, H.R. 3200, and S.Amdt. 3310 to the Jobs for Main Street Act, 2010, H.R. 2847, would delay the implementation of worldwide interest allocation to 2020, while the Affordable Healthcare for America Act of 2009, H.R. 3962, would repeal the worldwide allocation rule. 

The analysis here suggests that current law's interest allocation rules are likely imperfectly structured to achieve the objective of the foreign tax credit limit and that worldwide allocation of interest as enacted by the Jobs Act, while losing revenue, would probably be more consistent with the basic objective of the foreign tax credit limit. Tax planning techniques, however, could undermine this objective and cause further revenue loss. And, like the foreign tax credit limit itself, allocation rules contribute to tax distortions which may be heightened with worldwide allocation. Further, an expansion of the bank "subgroup" elections contained in the Jobs Act may not be consistent with the general objective of worldwide allocation of interest. Although the Jobs Act contains anti-abuse rules, these subgroup elections may permit firms to avoid the impact of the interest allocation rules.

Date of Report: February 19, 2010
Number of Pages: 17
Order Number: RL34494
Price: $29.95

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