BONUS CONTENT: Foreign Tax Credits

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The League of Nations’ work in the 1920s creating the model for double tax treaties and hammering out what would become the arm’s-length standard is often seen as the birth of the global tax system.

But in a sense, it could be dated to earlier. Among other potential landmarks, the United States enactment of the first foreign tax credit in 1918 may have been the first big step towards a grand international tax system–although hardly anyone realized it at the time.

It was proposed by T.S. Adams, the Yale and Wisconsin professor who became the U.S. Treasury Department’s in-house expert on international taxes. Congress at the time had little interest (or ability) to grasp the details of the emerging issues, and was happy to defer to him, giving him an unusually strong role in setting U.S. tax policy. Which would ultimately characterize how the rest of the world coordinated their tax systems.

By guaranteeing that U.S. taxpayers could be reimbursed in full for foreign taxes paid–prior to 1918, those taxes were only deductible–the foreign tax credit was an unprecedented game-changer.

“The FTC represented what was an extraordinarily generous measure for its time: the United States was assuming sole responsibility for the costs of reducing the double taxation of its residents and citizens,” wrote Columbia Law School professor Michael Graetz in a 1997 paper, “The ‘Original Intent’ of U.S. International Taxation.”

It’s likely that Adams didn’t quite grasp how big a deal it was at the time. Congress certainly didn’t, including it in a revenue act with no discussion.

The measure was brought about due to the U.S. government’s desperate war-time need for revenue. Worldwide taxation of citizens had already been established, but rates were so low and the income tax was so targeted that double taxation wasn’t much of a concern. Those rates went up exponentially during the war, and many U.S. businesses faced potential effective tax rates of 100% or more abroad. To Adams, granting a full credit was the reasonable and fair solution, ensuring that U.S. companies weren’t taxed into bankruptcy at the very time they were needed.

As the headquarters for so many global companies, the U.S. has almost always been a proponent of residence-based taxation–but, ironically enough, Adams himself was committed to sourced-based measures. While all countries have a blend of the two, a residence-based system generally grants taxing supremacy to the country where taxpayers reside, whereas a source-based system looks to where the income was generated. (The arm’s-length standard was eventually created as a compromise between the two.)

Granting full credit for taxes paid abroad is in keeping with source principles, by essentially negating U.S. taxation when a foreign jurisdiction chooses to tax income first. But by giving companies this relief, it provided a firm ground for the strong worldwide system the U.S. would develop. While the ability for companies to defer collection of income would eventually erode U.S. worldwide taxation, for decades the U.S. could assert broad rights of taxation on its taxpayer’s foreign income, without those taxpayers facing confiscatory rates.

Not long after enacting the credit, Congress realized that it had been a little too generous. If companies paid enough in foreign taxes, the credit could reduce or even eliminate a taxpayer’s domestic tax payments. In 1921 lawmakers enacted a limit ensuring that the tax could only apply to foreign income. As the U.S. rate remained higher than most foreign tax rates after World War II, the limit was not a common issue for taxpayers, but after the 2017 Tax Cuts and Jobs Act it reared its ugly head again. The tax on global intangible low-taxed income can apply at rates much higher than its ostensible 10.5% rate, depending on how interest expense and other costs are calculated. That’s a disconnect in the TCJA framework that many hope to see addressed whenever Congress gets around to fine-tuning the law.

After the arm’s-length standard was established and double tax treaties became ubiquitous, the FTC may seem redundant. At least, that was my reaction when I first learned about it–why does the U.S. need such elaborate rules for allocating income, if there’s a credit for when two countries tax it anyways? (Indeed, many critics of the arm’s-length standard have questioned its need given this other tool for preventing double taxation.)

The short answer is that transfer pricing determines whether or not companies could defer income under the old system–or if that income can be fully exempted under the new U.S. quasi-territorial system. Foreign tax credits only apply after that determination has been made.

The longer answer is that transfer pricing and worldwide taxation operate on parallel tracks, often intersecting but ultimately based on different principles. Treaty-based transfer pricing is how nations have agreed to allocate income across borders. But countries have protected their right to tax their own taxpayers however they see fit–including by taxing the taxpayers’ foreign income. If a country wants to issue a credit to ensure that worldwide taxation doesn’t go too far, that’s their prerogative as well.

For countries like the U.S., with relatively high tax rates and a critical mass of global multinational companies, the foreign tax credit can also often seem like a giveaway. Countries can raise their tax rates without worrying that U.S. companies might relocate, since the U.S. companies will still pay the same overall rate of tax. It would just change where the taxes go.

This dynamic is why the U.S. Treasury has sought to tighten when those credits apply. Recently, it issued new proposed regulations to keep companies from claiming credits for digital services taxes, which the U.S. opposes and doesn’t view as a legitimate way to tax income. Those credits have become a firestorm, with many practitioners claiming they apply to much more than DSTs, and could ultimately nix credits for forms of income that have long been considered creditable.

Even more than a century after they were established, the application of foreign tax credits is still challenging.

Contact the author at amparkerdc@gmail.com.