Case Overview, Change How Companies Treat Foreign Earnings and Interest Expenses for U.S. Tax Purposes


This document provides background information and summarizes the debate over corporate taxes on foreign and interest earnings. The links to the left will lead you to public documents that we have found.

 

          In general, a foreign tax credit can be used to offset the U.S. tax owed by an American company that has some operations in other countries. Since American companies pay taxes to the country where the foreign income is generated, the idea is to avoid or minimize the extent to which American multinational companies are "doubly taxed" for foreign-source income. The 1986 Tax Reform Act established the current interest allocation rules, which limit the amount of foreign tax credits an American company may claim. Currently, interest expenses incurred by foreign subsidiaries of an American company are not counted toward the foreign tax credit. In effect, this reduces the amount of income counted as foreign-source income and reduces the amount of foreign tax credit that companies may claim when paying U.S. taxes.

           A number of American companies with foreign subsidiaries have been working for years to change this provision of the tax code. For example, since electric utilities began investing in foreign countries in the mid-1990s (as a result of the 1992 Energy Policy Act), they became interested in changing the tax treatment of foreign interest expenses to lower their tax bill in the United States.

           In the 106th Congress, this effort continued as several companies tried to persuade Congress to change the tax rules relating to foreign interest expenses. They argued that the current law amounts to "double taxation" on American companies with operations in foreign countries (as they are taxed by the foreign country but then are not able to fully deduct that amount when calculating their tax bill in the United States). Proponents also argue that the current system gives foreign companies a tax advantage over American companies, even when they compete in the United States. For example, advocates argue that because of the interest expense tax rules, GM paid a higher tax than Nissan when both companies built car-making plants in Tennessee.

           While there is no organized opposition to the proposed change in interest expense tax rules, there are some significant barriers to its passage. One is the large cost in lost government revenues. The Joint Committee on Taxation estimates that the provision would cost $25 billion over ten years. Second, proponents observe that "election year uncertainty" is another barrier. As one advocate stated, "No one knows what tax bill can be passed by Congress and signed by the president." While proponents believe that the Clinton administration is sympathetic to their arguments, this provision has been caught in partisan disputes over other tax provisions. The Clinton administration would like to enact changes in interest expense rules along with other changes in international tax provisions that are opposed by many Republicans in Congress. Republicans in Congress passed the requested changes in interest expense rules in 1999 as part of broader tax cut legislation. However, President Clinton vetoed the bill because of objections to other parts of the legislation.

           The stalemate continued for the rest of the Clinton presidency. However, advocates finally succeeded in the 108th Congress, after the election of George W. Bush as president. Changes in interest expense tax rules were passed along with several other business and manufacturing tax breaks in October of 2004.