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entitled 'International Taxation: Study Countries That Exempt Foreign-
Source Income Face Compliance Risks and Burdens Similar to Those in the 
United States' which was released on October 16, 2009. 

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Report to the Committee on Finance, U.S. Senate: 

United States Government Accountability Office: 
GAO: 

September 2009: 

International Taxation: 

Study Countries That Exempt Foreign-Source Income Face Compliance Risks 
and Burdens Similar to Those in the United States: 

GAO-09-934: 

GAO Highlights: 

Highlights of GAO-09-934, a report to The Committee on Finance, U.S. 
Senate. 

Why GAO Did This Study: 

A debate is underway about how the United States should tax foreign-
source, corporate income. Currently, the United States allows domestic 
corporations to defer tax on the earnings of their foreign subsidiaries 
and also gives credits for foreign taxes paid, while most other 
developed countries exempt the active earnings of their multinational 
corporationsí foreign subsidiaries from domestic tax. The debate has 
focused on economic issues with little attention to tax administration. 
GAO was asked to describe for a group of study countries with exemption 
systems: (1) the rules for exempting foreign-source income, and (2) the 
compliance risk and taxpayer compliance burden, such as recordkeeping, 
of the rules. The study countries, selected to provide a range of 
exemption systems, are Australia, Canada, France, Germany, and the 
Netherlands. For these countries GAO reviewed documents; interviewed 
government officials, academic experts, and business representatives; 
and compared tax policies, compliance activities and taxpayer reporting 
requirements. 

What GAO Found: 

The study countries exempt some corporate income, such as dividends 
received from foreign subsidiaries, from domestic tax. However, the 
study countries tax other types of foreign-source income such as 
royalties. 

Multinational corporations present a compliance risk because they can 
use subsidiaries to convert taxable income into tax-exempt or lower 
taxed income, eroding the domestic tax base. Although quantitative 
estimates of noncompliance do not exist, tax experts interviewed by GAO 
identified sources of compliance risk and taxpayer burden in each of 
the study countries. These issues, particularly the ones below, have 
also been identified as sources of compliance risk and burden in the 
United States. 

Transfer prices: the prices for transactions between related partiesó
can be manipulated to shift profits. Tax experts in the study countries 
said the growing importance of intangible property such as trademarks 
and patents is making international transactions more susceptible to 
transfer pricing abuse. In response, the study countries have all 
increased their scrutiny of transfer prices, including increased 
demands for documentation and more audits, resulting in increased 
compliance burden for taxpayers. Cooperative efforts between taxpayers 
and tax agencies to reduce audits, such as Advanced Pricing Agreements, 
received mixed reviews in the study countries. 

Anti-avoidance rules prevent taxpayers from moving passive income 
(interest and royalties are often passive income) to a foreign 
subsidiary in order to avoid domestic tax. Generally, the rules make 
such passive income, even if moved, taxable. Tax agencies and taxpayers 
reported difficulties in obtaining information from other countries to 
make complex determinations about whether the anti-avoidance rules 
apply or not. 

The United States does not report taxes paid on foreign-source income. 
Treasury officials said it would be feasible to do so. Such reporting 
would make more explicit the role international tax rules play in 
raising revenues and protecting the domestic tax base. All experts we 
spoke with on this topic agreed. 

Figure: Simple Example of Dividend Exemption: 

[Refer to PDF for image: illustration] 

Foreign subsidiary: 
Net income: $100; 
Taxes paid: $20; 
After-tax profit: $80. 

Dividend $80: 
Domestic parent corporation: 
Dividend income: $80. 

Income tax $20: 
Foreign government: 
20% corporate income tax. 

Source: GAO. 

[End of figure] 

What GAO Recommends: 

Because changing the United States system of taxing foreign-source 
income is a policy decision, GAO is not making recommendations related 
to tax reform. GAO does recommend that the Secretary of Treasury 
annually report, using already available data, the revenue generated by 
taxing foreign-source corporate income. The Secretary agreed with our 
recommendation. 

View [hyperlink, http://www.gao.gov/products/GAO-09-934] or key 
components. For more information, contact Jim White at (202) 512-9110 
or whitej@gao.gov. 

[End of section] 

Contents: 

Letter: 

Background: 

Study Countries Vary in the Types of Foreign-Source Income Exempted 
from Domestic Tax and in the Rules Governing Those Exemptions: 

Study Countries Face Areas of Compliance Risk and Burden Known to Exist 
in the United States: 

Conclusion: 

Recommendation for Executive Action: 

Agency Comments: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Transfer Pricing Documentation Requirements in the Study 
Countries: 

Appendix III: Example from Australia of the Process for Obtaining an 
Advanced Pricing Agreement: 

Appendix IV: Examples of Other Anti-avoidance Rules in the Study 
Countries and the United States: 

Appendix V: Description of Dividend Exemption Systems in Japan and the 
United Kingdom: 

Appendix VI: Comments from the Department of the Treasury: 

Appendix VII: GAO Contact and Staff Acknowledgments: 

Related GAO Products: 

Tables: 

Table 1: Select Examples of Types of Income That Can Be Generated from 
Foreign Sources: 

Table 2: General Domestic Tax Treatment of Different Types of Foreign- 
Source Income: 

Table 3: Dividend Qualification Criteria--Required Domestic Ownership 
Type and Level of Foreign Subsidiary to Qualify for Tax Exemption of 
Foreign-Source Dividend Income: 

Table 4: Dividend Qualification Criteria--Domestic Tax Treatment of 
Foreign-source Dividend Income Distributed from Active and Passive 
Income: 

Table 5: General Overview of CFC and Other Anti-avoidance Rules: 

Table 6: Overview of Rules Governing FTCs in the Study Countries and 
the United States: 

Table 7: Examples of Additional Anti-avoidance Rules by Country: 

Table 8: Required Domestic Ownership Type and Level of Foreign 
Subsidiary to Qualify for Tax Exemption of Foreign-Source Dividend 
Income: 

Figures: 

Figure 1: Continuum of Tax Systems of Foreign-Source Corporate Income: 

Figure 2: Simple Example of Deferral: 

Figure 3: Simple Example of Dividend Exemption: 

Figure 4: Simple Depiction of CFC Rules: 

[End of section] 

United States Government Accountability Office: 
Washington, DC 20548: 

September 15, 2009: 

The Honorable Max Baucus: 
Chairman: 
The Honorable Charles E. Grassley: 
Ranking Member: 
Committee on Finance: 
United States Senate: 

One hallmark of the global economy is greater mobility of income and 
economic transactions. As technology advances and globalization 
continues to eliminate barriers to conducting business across 
countries, companies routinely earn income in several countries. For 
example, U.S. corporations reported $205 billion in foreign-source 
income for tax year 2003, the latest year currently available.[Footnote 
1] This is about half of the $425 billion of total worldwide income 
(foreign plus domestic) earned by U.S. corporations in that 
year.[Footnote 2] Often income is not earned directly by a domestic 
corporation, but rather through wholly or partially owned subsidiaries 
incorporated in other countries. 

Foreign-source income, especially when earned by multinational 
corporations (MNC), presents challenges for income tax design and 
administration. These challenges include ensuring tax law compliance, 
minimizing tax induced distortions of businesses decisions about where 
to locate investment, avoiding the double taxation of income earned in 
one country by companies located in another country, and minimizing 
unnecessary taxpayer compliance burden, such as recordkeeping. 

There are two general approaches to taxing foreign-source corporate 
income. Under both approaches, a corporation pays any tax due in the 
foreign country where the income is earned. The approaches differ in 
how the corporation is taxed domestically, that is, in the 
corporation's home country. One approach--called worldwide taxation-- 
taxes all income earned by a corporation regardless of where the income 
is derived. Under this approach, double taxation is addressed through 
foreign tax credits (FTC). The FTC is a credit, usually subject to 
limits, against domestic tax for foreign taxes paid. A corporation 
would pay domestic tax on foreign-source income only to the extent that 
the domestic tax on that income exceeds the foreign tax credit. 

The other approach--called territorial taxation--only taxes the 
corporation's income derived within the taxing country's borders, 
irrespective of the residence of the taxpayer. Thus, unlike worldwide 
taxation, foreign-source income earned by a domestic corporation is 
exempt from residence-country tax. The exemption generally eliminates 
the possibility of double taxation.[Footnote 3] 

In practice, large developed countries do not use a pure worldwide or 
pure territorial approach when taxing foreign-source corporate income. 
Instead, they use hybrid approaches. Most developed countries, 
especially after recent policy changes in Japan and the United Kingdom, 
now lean toward a territorial approach but are not purely territorial-
-in part, because they place significant limitations on what types of 
income are eligible for exempt treatment.[Footnote 4] The United States 
and a few other countries, on the other hand, lean toward a more 
worldwide approach but are not purely worldwide--in part, because 
taxation can be deferred on certain qualifying income until it is 
actually paid to the domestic corporation by subsidiaries as dividends. 
Basic features of the U.S. tax system result in the ability of some 
MNCs to defer domestic taxation until it is actually paid to a domestic 
part of the MNC.[Footnote 5] 

In the United States, proposals have been developed to reform the 
taxation of foreign-source income.[Footnote 6] The proposals differ, 
with some designed to move the United States toward more territoriality 
and others intended to maintain a more worldwide approach. An extensive 
body of literature debates the economic merits of these proposals, 
including the effects of taxes on competitiveness and the location 
decisions of firms. While some research shows that taxes change 
location incentives, the existing research does not reach definitive 
conclusions about important economic effects such as the impact of 
foreign investment by U.S. corporations on U.S. employment. 

Compared to the extensive examination of economic effects, little has 
been done to study whether there are important differences between 
worldwide and territorial systems in terms of tax administration and, 
more specifically, in terms of compliance by taxpayers and taxpayers' 
compliance burden (recordkeeping, reporting, and other costs). In the 
context of foreign-source income, at least two broad compliance issues 
exist. One is ensuring that domestic corporations pay the tax due on 
foreign-source income. The other is ensuring corporations do not erode 
the domestic tax base by illegally shifting domestic income abroad. 

Because of the ongoing debate about the taxation of foreign-source 
income and because of the limited information available on 
administering a worldwide system versus a territorial system, you asked 
us to report on other countries' experience administering territorial 
systems. Based on your request, our objectives are to (1) describe, for 
select case study countries that take a territorial approach, what 
types of foreign-source income the countries exempt and the rules 
governing those exemptions; and (2) describe, to the extent information 
is available, the compliance risks and taxpayer compliance burdens that 
the taxation of foreign-source corporate income presents for each of 
these countries. 

To address our objectives, we selected five countries--Australia, 
Canada, France, Germany, and the Netherlands--to study based on several 
criteria, including range of rules governing the taxation of foreign- 
source income, unique tax system features, and Organization of Economic 
Cooperation and Development (OECD) membership. To provide assurance 
that all of the information used in this report is sufficiently 
reliable, we used data from commonly used and cited sources of 
statistical data, such as the OECD, and other publicly available 
reports from international government agencies. Additionally, we 
performed an in-depth literature review on all of the study countries, 
including government documents, private sector studies, and academic 
publications. We collected and analyzed data on the countries and their 
systems for taxing foreign-source corporate income, including tax 
policies, administrative mechanisms, compliance activities, and 
taxpayer reporting and documentation requirements. We interviewed 
knowledgeable government officials from the study countries, including 
officials from the tax agencies. We also interviewed U.S. tax agency 
officials, international tax experts, including academic and private- 
sector experts, and members of a number of professional services 
organizations that represent and serve MNCs that have large numbers of 
foreign subsidiaries under their control. We provided the tax agencies 
of our study countries a copy of our report to verify data and specific 
factual and legal statements about the tax treatment of foreign-source 
income in those countries. We did not conduct a formal legal review of 
the tax laws and rules in other countries, but relied on the 
information supplied by tax agency officials in those countries. We 
made technical corrections to our report based on these reviews. A more 
detailed discussion of our methodology is in appendix I. 

We conducted our work from June 2008 to September 2009 in accordance 
with all sections of GAO's Quality Assurance Framework that are 
relevant to our objectives. The framework requires that we plan and 
perform the engagement to obtain sufficient and appropriate evidence to 
meet our stated objectives and to discuss any limitations in our work. 
We believe that the information and data obtained, and the analysis 
conducted, provide a reasonable basis for any findings and conclusions 
in this product. 

Background: 

Multinational Corporations and Foreign-Source Income: 

Corporate income tax is levied on business entities that organize and 
operate as corporations, as defined by each individual country's tax 
rules and laws. Generally, corporations are individual business 
entities that issue shares and can make distributions to shareholders, 
such as dividend payments. 

Corporations can be shareholders in other corporations, both domestic 
and foreign. The amount of control the corporate shareholder has over 
the other corporation can vary depending on the percentage of shares 
owned and other factors. At the low range of corporate ownership, 
portfolio shareholding allows a corporate shareholder to invest in a 
business but does not involve maintaining a controlling stake in the 
firm. At greater levels of ownership, corporations can own a sufficient 
percentage of shares to gain partial or total control of major business 
decisions, such as the level and timing of dividend distributions and 
investment and pricing strategies. For this report, we will call the 
controlling firm a parent corporation and the controlled firm a 
subsidiary.[Footnote 7] Parent-subsidiary relationships can be 
complicated, involving a corporation owning multiple subsidiaries, 
subsidiaries being controlled by multiple parents, or tiered 
arrangements with subsidiaries owning subsidiaries of their own. When 
these relationships involve entities in more than one country, these 
corporations are referred to as multinational corporations (MNC). 

MNCs are groups of separate legal entities, which can include 
corporations, partnerships, trusts, and other legal entities, that 
operate and generate income in multiple countries, and different parts 
of an MNC may have different domestic jurisdictions. MNCs may also have 
branches--domestic, foreign, or both--as part of a corporation's 
internal organizational structure.[Footnote 8] In general, each 
corporate entity that is part of the MNC is taxed as an individual 
taxable entity by the relevant governments, unless the corporation is 
allowed to and chooses to file a consolidated return. 

Different Types of Foreign-Source Income: 

Corporations can earn a variety of different types of income from 
foreign sources. This income can be generated from transactions with 
either unrelated parties, such as retail customers located abroad, or 
related parties, such as foreign subsidiaries or other parts of the 
same MNC. Corporations can earn foreign-source income from active and 
passive activities with foreign parties. While countries vary somewhat 
in their definitions of active and passive income, generally speaking, 
active income is considered to be the income generated through the 
primary business activities of the corporation. Passive income, in 
contrast, is income that is not earned through primary business 
activities. Interest earned, rental income, and royalty payments from 
foreign sources are generally considered passive income. However, for 
some companies, such as financial services companies, these types of 
income may constitute the primary business and be considered active 
income under the tax laws of some countries. Additionally, corporations 
can purchase shares of foreign companies and receive dividend 
distributions based on the earnings of those companies. Table 1 below 
lists some general examples of different types of income that can be 
generated from foreign-sources. 

Table 1: Select Examples of Types of Income That Can Be Generated from 
Foreign Sources[A]: 

Type of income: Capital gains; 
General definition: The gain realized from the appreciated value 
between the purchase and sales price of an asset, such as shares in a 
corporation. Investments that have not yet been sold, but would yield a 
profit if they were sold have unrealized capital gains; 
Example of foreign-source income in a parent-subsidiary relationship: A 
domestic parent sells shares it held in a foreign subsidiary for $50. 
The domestic parent had bought the shares for $20. The realized capital 
gain is the $30 difference. 

Type of income: Dividends; 
General definition: A payment distributed by a company to its 
shareholders. Dividends are usually given out in the form of cash, but 
can also be given out as stock or other property; 
Example of foreign-source income in a parent-subsidiary relationship: A 
domestic parent company owns 10,000 shares of a foreign subsidiary. The 
foreign subsidiary makes a dividend payment of $1 per share to all 
shareholders, including $10,000 to the parent. 

Type of income: Interest; 
General definition: Payments received as compensation for lending 
money; 
Example of foreign-source income in a parent-subsidiary relationship: A 
domestic parent makes a 10-year, 5 percent loan for $1 million to a 
foreign subsidiary. The subsidiary makes semi-annual interest payments 
of $25,000 to the domestic parent. 

Type of income: Rent; 
General definition: Compensation for the use or occupation of property; 
Example of foreign-source income in a parent-subsidiary relationship: A 
domestic parent owns a factory in a foreign country. A foreign 
subsidiary makes monthly payments to the domestic parent for occupation 
and use of the factory. 

Type of income: Royalty; 
General definition: Income generated from licensing the use of 
property, such as intellectual property; 
Example of foreign-source income in a parent-subsidiary relationship: A 
foreign subsidiary pays a domestic parent firm for the right to use 
trademark logos on goods produced and sold. 

Source: GAO: 

[A] The definitions in this chart reflect how we use these terms for 
the purposes of this report. Other definitions exist for these terms 
but are outside the scope of this report. 

[End of table] 

Most Countries Take a Hybrid Approach to Taxing Foreign-Source Income: 

In practice, countries combine elements of worldwide and territorial 
approaches to taxing foreign-source income. One approach, generally 
referred to as deferral, deviates from the worldwide model and taxes 
the domestic corporation on all of its income, including income and 
dividends received from foreign subsidiaries, but defers taxation until 
the income is repatriated. Another approach, generally referred to as 
dividend exemption, is closer to the territorial model and permits the 
tax-exempt repatriation of the dividends distributed by foreign 
subsidiaries, but may limit the extent to which some income is exempt. 
In either system, foreign-source income is taxed first in the source 
country; under a deferral system, a residual tax is then imposed only 
when the income is repatriated. Figure 1 shows a continuum of tax 
treatments for foreign-source corporate income with hybrid systems 
ranging between the pure worldwide and territorial models. 

Figure 1: Continuum of Tax Systems of Foreign-Source Corporate Income: 

[Refer to PDF for image: illustration] 

Hybrid systems: 

Moving toward Pure worldwide: 
All income, regardless of type, production source, or country source is 
taxed currently. Foreign taxes offset by deduction or credit. 

Moving toward Pure territorial: 
Foreign-source income is exempt. Domestic source income is taxed. 

Source: GAO. 

[End of figure] 

Worldwide System with Deferral: 

The current tax system in the United States is an example of a 
worldwide system with deferral, which taxes domestic corporations on 
their worldwide income, regardless of where the income is earned and 
gives credits for foreign income taxes paid. Income unrelated to a U.S. 
trade or business earned by foreign corporations is not taxed 
domestically until it is distributed to a domestic shareholder, such as 
a domestic parent corporation, which allows deferral of taxation on 
income of foreign subsidiaries. Special rules may exist that tax 
certain shareholders, such as a parent corporation, currently on the 
income of certain subsidiaries in order to protect the domestic tax 
base. To reduce the double taxation of income, corporate taxpayers can 
offset, in whole or in part, the domestic tax owed on the foreign- 
source income through a FTC. In certain circumstances, a parent 
corporation may claim FTCs for foreign taxes paid by a subsidiary. 
Figure 2 shows how a dividend payment is generally taxed under a 
worldwide tax approach that permits deferral. 

Figure 2: Simple Example of Deferral: 

[Refer to PDF for image: illustration] 

Step 1: 
Foreign subsidiary earns $100 profit from active business activities in 
the foreign country. 

Step 2: 
Foreign subsidiary is subject to a 20% income tax in the foreign 
country. Foreign subsidiary pays $20 in taxes leaving an after-tax 
profit of $80. 

Step 3: 
At some point in time, foreign subsidiary distributes its after-tax 
profits of $80 as a dividend to its sole shareholder, domestic parent 
corporation (reports foreign taxes paid $20). 

Step 4: 
Domestic parent corporation calculates taxable income on the grossed-up 
amount of dividend received. Dividend income $80; Reported foreign 
taxes paid $20; Taxable income = $100[A]. 

Step 5: 
Domestic parent corporation is assessed a 35% income tax by domestic 
country. Domestic parent corporation pays the tax through a combination 
of $15 in cash and $20 in imputed FTCs. $35 tax liability; Foreign tax 
credit claimed $20. 

Step 6: 
Domestic parent corporationís after-tax net income is $65. 

Source: GAO. 

[A] Domestic tax liability is based on the grossed-up value of the 
dividend plus the amount of foreign income tax paid on the associated 
earnings. 

[End of figure] 

Exemption Systems: 

Many OECD countries exempt some types of foreign-source corporate 
income from domestic tax. Exemptions are commonly granted in these 
countries for dividends paid by a foreign subsidiary. As shown in 
figure 3, which is a simplified example of an exemption system, the 
domestic corporation does not incur a tax liability by receiving the 
dividend income from its foreign subsidiary. However, similar to the 
worldwide systems with deferral that were described earlier, exemption 
systems may disallow the tax advantages of foreign-source income under 
certain circumstances to protect the domestic tax base. 

Figure 3: Simple Example of Dividend Exemption: 

[Refer to PDF for image: illustration] 

Step 1: 
Foreign subsidiary earns $100 profit from active business activities in 
the foreign country. 

Step 2: 
Foreign subsidiary is subject to a 20% income tax in the foreign 
country. Foreign subsidiary pays $20 in taxes leaving an after-tax 
profit of $80. 

Step 3: 
Foreign subsidiary distributes its after-tax profits of $80 as a 
dividend to its sole shareholder, domestic parent corporation. 

Step 4: 
Domestic parent corporation receives $80 dividend from foreign 
subsidiary. The domestic country exempts from taxation foreign-source 
dividends. Domestic parentís net income is $80. 

Source: GAO. 

[End of figure] 

Study Countries Vary in the Types of Foreign-Source Income Exempted 
from Domestic Tax and in the Rules Governing Those Exemptions: 

Our study countries--Australia, Canada, France, Germany, and the 
Netherlands--have hybrid tax systems that exempt some types of foreign- 
source income and tax others. All of the study countries tax domestic 
corporations on income earned through rental payments and royalties. 
Such payments may be made by unrelated parties or by subsidiaries and 
are generally expenses of the payee in the foreign country but are 
received as income by the domestic corporation. Subject to an extensive 
list of exceptions, the study countries generally exempt, but to 
varying extents, income of domestic corporations received as foreign- 
source dividends from foreign subsidiaries, sales by foreign branches, 
and the gains from the sale of shares in foreign subsidiaries. For 
example, all of the study countries permit domestic corporations to 
receive dividends that meet certain qualifications as tax-exempt 
income, but differ in the rules they use in determining which dividends 
are qualified. In addition, Canada does not allow domestic corporations 
to earn tax-exempt, foreign-source income through foreign branches and 
taxes up to half of the capital gains on the sale of foreign subsidiary 
shares while the other study countries generally exempt income from 
these sources.[Footnote 9] 

In addition to the rules above covering income payments received by 
domestic corporations, all study countries also have rules that tax 
domestic corporations on some income at the time it is earned by 
foreign subsidiaries, regardless of when or if the foreign subsidiary 
distributes a dividend. These rules, generally referred to as anti- 
avoidance rules, attribute certain earnings of related foreign entities 
to domestic corporations in order to limit the tax benefits of holding 
certain types of income offshore. 

Table 2 presents a brief overview of the tax treatment for different 
types of foreign-source income in our study countries. All rows except 
the last show the tax treatment of income payments received by a 
domestic corporation. The last row shows the tax treatment of income at 
the time it is earned by a foreign subsidiary that is subject to 
certain anti-avoidance rules regardless of whether the income was 
distributed as a dividend. 

While data was not available for most of our study countries, in 
Canada, at least 76 percent of foreign-source dividends received by 
Canadian taxpayers from foreign affiliates from 2000 to 2005 were 
qualified foreign-source dividends and, therefore, were tax exempt. 
[Footnote 10] 

Table 2: General Domestic Tax Treatment of Different Types of Foreign- 
Source Income: 

Rent, royalty, and interest income paid by Foreign subsidiaries: 
Australia: Taxable; 
Canada: Taxable; 
France: Taxable; 
Germany: Taxable; 
Netherlands: Taxable. 

Rent, royalty, and interest income paid by unrelated third parties: 
Australia: Taxable; 
Canada: Taxable; 
France: Taxable; 
Germany: Taxable; 
Netherlands: Taxable. 

Nonqualifying foreign-source dividends: 
Australia: Taxable; 
Canada: Taxable; 
France: Taxable; 
Germany: Taxable; 
Netherlands: Taxable. 

Qualified foreign-source dividends: 
Australia: Exempt; 
Canada: Exempt; 
France: Effectively 95% exempt[A]; 
Germany: Effectively 95% exempt[A]; 
Netherlands: Exempt. 

Active foreign branch income: 
Australia: Exempt; 
Canada: Taxable with FTC; 
France: Exempt; 
Germany: Taxable with FTC under domestic law but generally exempt 
through tax treaty; 
Netherlands: Generally exempt. 

Capital gains from the sale of foreign subsidiary shares: 
Australia: Generally exempt; 
Canada: 50% to 100% Exempt; 
France: Effectively 95% exempt[A]; 
Germany: Effectively 95% exempt[A]; 
Netherlands: Exempt. 

Attributable foreign earnings subject to anti-avoidance rules: 
Australia: Taxable with FTC; 
Canada: Taxable with FTC; 
France: Taxable with FTC; 
Germany: Taxable with FTC; 
Netherlands: Taxable. 

Source: GAO analysis of country information. 

Note: This table shows general treatments. It does not present all of 
the details, exceptions, or rules that govern the tax treatment of 
foreign-source income for our study countries. 

[A] For France and Germany, the exempt amount of qualified foreign- 
source gross dividends and capital gains is effectively 95 percent due 
to rules that tax 5 percent of the income as nondeductible expenses. 
This is discussed in more detail later in this report. 

[End of table] 

Study Countries Use Different Criteria to Qualify Foreign-Source 
Dividends for Domestic Tax Exemption: 

Our study countries all have certain criteria that, when met, allow 
domestic corporations to receive tax-exempt income in the form of 
dividend payments, called qualified foreign-source dividends in table 
2. In each of the countries, all of the criteria must be met for the 
domestic corporation to receive the foreign-source dividend tax-exempt. 
If any of the conditions are not met, then the dividend does not 
qualify for the tax exemption and is, therefore, taxable. Our study 
countries applied up to three criteria when determining which income is 
tax-exempt: domestic ownership type and level of foreign subsidiaries; 
the type of income (active versus passive) distributed as a dividend; 
and the presence of a tax treaty or similar agreement between the 
domestic and foreign government where the subsidiary is located and 
income is earned. 

All of our study countries except Germany require the domestic 
corporation to have a minimum ownership stake in a foreign subsidiary 
in order to qualify for the benefits of exemption. In general, these 
minimum ownership level stakes mean that income from portfolio or 
portfolio-like investment is not exempt. Each country takes a different 
approach in determining the type of shares that qualify dividend income 
for exemption with distinctions made on the type of shares and the 
length of time the shares are held. For example, while Canada requires 
domestic corporations to own 10 percent or more of any class of shares 
in the foreign subsidiary, France requires its corporations to own at 
least 5 percent of a foreign subsidiary's shares.[Footnote 11] The 
requirements for each country are summarized in table 3. 

Table 3: Dividend Qualification Criteria--Required Domestic Ownership 
Type and Level of Foreign Subsidiary to Qualify for Tax Exemption of 
Foreign-Source Dividend Income: 

Domestic ownership of foreign company: 
Australia: Direct shareholding of at least 10%; 
Canada: Direct ownership of 1% and direct or indirect ownership of at 
least 10%; 
France: At least 5% ownership; 
Germany: None; 
Netherlands: In principle a shareholding of at least 5%. 

Foreign company share type: 
Australia: Shares must have a voting interest; 
Canada: Any type; 
France: Ownership or participating shares; 
Germany: Any type; 
Netherlands: Any type. 

Ownership duration: 
Australia: None; 
Canada: None; 
France: 2 years; 
Germany: None; 
Netherlands: None. 

Source: GAO analysis of country information. 

Note: This table shows general treatments. It does not present all of 
the details, exceptions, or rules that govern the tax treatment of 
foreign-source income for our study countries. 

[End of table] 

In addition to the criteria above, Canada also makes a distinction 
between dividends distributed from active and passive income, while the 
other study countries do not, as shown in table 4. 

Table 4: Dividend Qualification Criteria--Domestic Tax Treatment of 
Foreign-source Dividend Income Distributed from Active and Passive 
Income: 

Dividends distributed from active income: 
Australia: Exempt; 
Canada: Exempt; 
France: Effectively 95% exempt[A]; 
Germany: Effectively 95% exempt[A]; 
Netherlands: Exempt. 

Dividends distributed from passive income: 
Australia: Exempt; 
Canada: Taxable with FTC eligibility[B]; 
France: Effectively 95% exempt[A]; 
Germany: Effectively 95% exempt[A]; 
Netherlands: Exempt. 

Source: GAO analysis of country information. 

Note: This table shows general treatments. It does not present all of 
the details, exceptions, or rules that govern the tax treatment of 
foreign-source income for our study countries. 

[A] In France and Germany, the gross dividend amount exempt from 
domestic tax is effectively 95 percent due to rules that tax 5 percent 
of the gross dividend amount as nondeductible expenses. This is 
discussed in more detail later in this report. 

[B] Income that was previously taxed under anti-avoidance rules may be 
tax exempt upon repatriation. 

[End of table] 

Of all our study countries, currently only Canada requires that the 
foreign subsidiary be located and earn active income in a designated 
treaty country in order to qualify for the dividend tax exemption that 
was shown in table 2. For Canada, a designated treaty country is a 
country with which Canada either has a tax treaty or a tax information 
exchange agreement (TIEA). As was noted earlier, at least 76 percent of 
dividends received by Canadian taxpayers from foreign affiliates 
between 2000 and 2005 were tax exempt. 

Study Countries Limit Tax Advantages of Earning Foreign-Source Income 
under Certain Conditions: 

As was shown in the last row of table 2, all study countries have anti- 
avoidance rules that limit the tax advantages of earning certain types 
of income abroad. In general, these rules are intended to protect the 
domestic tax base by preventing taxpayers from avoiding domestic tax on 
passive or other specific types of income by moving to or holding these 
types of income in a foreign country. When triggered, these rules 
require a domestic shareholder to be taxed currently on its pro rata 
share of certain types of income earned by certain foreign 
subsidiaries, regardless of when or if that income is distributed to 
the shareholder.[Footnote 12] Anti-avoidance rules exist in both 
worldwide and territorial tax systems, and are in effect in each of our 
study countries and the United States (commonly known as Subpart F in 
the United States). 

A prominent anti-avoidance rule used by all study countries except the 
Netherlands applies to controlled foreign corporations (CFC).[Footnote 
13] Each country's CFC rules vary, but they generally tax domestic 
shareholders, including shareholding corporations, currently on certain 
types of income earned by foreign corporations that qualify as 
controlled by domestic shareholders. This is illustrated in figure 4. 
This means that the domestic corporation may be taxed on income that it 
has not received from the foreign corporation (called a deemed dividend 
in figure 4). This income is taxable when earned by the subsidiary, 
although CFC rules generally permit the domestic taxpayer to offset 
some or all of their domestic tax liability through credits on the 
foreign taxes paid on the income. 

Figure 4: Simple Depiction of CFC Rules: 

[Refer to PDF for image: illustration] 

Step 1: 
Foreign subsidiary, a wholly owned subsidiary of domestic parent 
corporation, earns $100 in interest income earned from a loan provided 
to another foreign corporation. Interest income is considered passive 
income in the domestic country. 

Step 2: 
Foreign subsidiary is subject to a 5% corporate income tax in the 
foreign country. Foreign subsidiary pays $5 in tax, leaving it with $95 
in after-tax profit on passive income. 

Step 3: Foreign subsidiary does not make any profit or earnings 
distribution to the domestic parent corporation. Domestic parent 
corporation must recognize $100 as a deemed dividend for passive income 
earned by the foreign subsidiary. 

Step 4: 
Because foreign subsidiary is a controlled foreign corporation of 
domestic parent corporation, domestic parent corporation pays taxes on 
the $100 undistributed passive income of the foreign subsidiary. 
Domestic parent corporation receives $5 in foreign tax credits to off-
set taxes paid to foreign government on the deemed dividend and pays a 
net tax of $30 to domestic government. 

Source: GAO. 

[End of figure] 

Generally, study countries establish criteria in three areas that, when 
met, define a domestic shareholder's tax liability for certain types of 
income earned by a foreign corporation under the CFC rules. First, 
countries define when a foreign corporation is controlled by domestic 
shareholders. For example, Australia defines a controlled foreign 
corporation as any foreign corporation that meets either of the 
following definitions: (1) where five or fewer Australian residents 
effectively control the foreign corporation or own more than 50 percent 
of the foreign corporation; or (2) where one Australian entity has an 
individual ownership of 40 percent or more of the foreign corporation 
not controlled by another corporation. Second, countries generally set 
a minimum level of ownership in the foreign corporation that domestic 
shareholders must meet before being taxed on the foreign corporation's 
earnings. For example, under Canada's CFC rules, a Canadian shareholder 
must own at least 10 percent of the foreign corporation to be taxed on 
certain types of income earned by the foreign corporation. Third, the 
controlled foreign corporation generally must earn certain types of 
income that are specified in each country's CFC rules. For example, 
Germany requires that a CFC earn passive income that is taxed at an 
effective rate of 25 percent or less by the foreign country before a 
domestic corporation is required to pay tax on the CFC's earnings. 

Once the criteria above are met, domestic shareholders are taxed 
currently on certain types of attributed income earned by the CFC. Some 
countries, like Canada, generally limit the taxable foreign earnings to 
the domestic corporation's pro rata share of passive income.[Footnote 
14] Other countries, like France, tax domestic corporations on their 
pro rata share of all earnings by the foreign corporation. Table 5 
presents a simplified overview of the CFC rules used by our study 
countries. Additional details on other types of anti-avoidance rules 
can be found in appendix IV. 

Table 5: General Overview of CFC and Other Anti-avoidance Rules: 

Criteria a foreign entity must meet to be considered a CFC: 
Australia: Either: (1) five or fewer Australian residents control or 
own more than 50% of the foreign entity; or; (2) When one Australian 
resident owns 40% or more of the foreign entity; 
Canada: Five or fewer Canadian residents, including parties that do not 
deal at arm's length with them, own greater than 50% of the foreign 
entity; 
France: (1) The foreign entity is located in a country with an 
effective tax rate that is 50% or less than that of France; (2) French 
residents own 50% or more; (3) Intragroup income is greater than 20%, 
or passive income and intra-group services income is greater than 50%; 
Germany: (1) German residents own 50% or more;; (2) The foreign entity 
earns passive income; (3) Passive income is taxed at an effective rate 
less than 25%; 
Netherlands: N/A. 

Domestic shareholder ownership level necessary: 
Australia: 10% or greater; 
Canada: 10% or greater; 
France: Directly or indirectly hold 50% or greater; 
Germany: Any level of ownership; 
Netherlands: N/A. 

Foreign earnings subject to current taxation: 
Australia: Pro-rata share of passive earnings in most countries; 
Canada: Pro-rata share of passive earnings; 
France: Pro-rata share of all earnings; 
Germany: Pro-rata share of passive earnings; 
Netherlands: N/A. 

Additional features of CFC rules; Australia: 
CFCs resident in "listed" countries--those with similar tax systems to 
Australia--have fewer types of income that may be attributed to 
domestic corporations; 
Canada: [Empty]; 
France: CFC rules do not apply if the foreign subsidiary is located in 
another EU country and does not exist solely to avoid French taxation; 
Germany: CFC rules do not apply if the foreign subsidiary exists in 
another EU or European Economic Area country and conducts genuine 
economic activities; 
Netherlands: [Empty]. 

Additional Anti-avoidance Rules: 
Australia: Foreign investment fund rules; 
Canada: Offshore investment fund rules; 
France: Abuse of law doctrine; 
Germany: General anti-avoidance rule; 
Netherlands: Low-taxed passive shareholding rules. 

Source: GAO analysis of country information. 

Note: This table shows general treatments. It does not present all of 
the details, exceptions, or rules that govern the tax treatment of 
foreign-source income for our study countries. 

[A] The percentage ownership by the domestic shareholder corresponds to 
the type of shares that were presented in table 2. 

[End of table] 

Study Countries Face Areas of Compliance Risk and Burden Known to Exist 
in the United States: 

Differences in tax rates across countries and differences in the 
taxation of different types of income may create incentives to avoid 
tax by shifting income from a high tax jurisdiction to a lower taxed 
jurisdiction or by converting income from a taxable type to tax-exempt 
type. Such efforts to reduce taxes may sometimes be legal tax 
avoidance, but may also be illegal noncompliance. 

Tax experts identified four areas as sources of compliance risk or 
taxpayer compliance burden in our study countries. None of our study 
countries were able to provide quantitative estimates of the extent of 
noncompliance with their tax laws governing foreign-source income or 
the amount of compliance burden placed on taxpayers. Furthermore, an 
exhaustive list of all sources of compliance risk and burden does not 
exist. However, four areas that tax experts, including tax agency 
officials, tax practitioners, and academics identified were: 

* transfer pricing, 

* anti-avoidance rules, 

* foreign tax credits, and: 

* domestic expense deductions. 

These areas are also viewed by the Internal Revenue Service (IRS) or 
other tax experts as sources of compliance risk or compliance burden in 
the United States. 

While countries establish rules in these four areas to serve a variety 
of policy goals, including maintaining economic competitiveness and 
avoiding double taxation, one important consideration is protecting the 
domestic tax base. One unique tax administration challenge that MNCs 
present is that they can shift income and assets among related entities 
in different countries to convert taxable income, either foreign or 
domestic, to tax-exempt or lower-taxed foreign-source income. The laws 
and regulations in these four areas are intended, in part, to protect 
the domestic tax base by preventing MNCs from mispricing transactions, 
relocating domestic passive income, misusing foreign tax credits, or 
reallocating expenses in ways that inappropriately reduce domestic 
taxes. These laws also create compliance burden, often requiring 
taxpayers to maintain detailed records and conduct complex analyses of 
international transactions. 

Transfer Pricing, Particularly for Intangible Property, Is a Major 
Compliance Risk and Source of Compliance Burden in all of the Study 
Countries: 

Many tax agency officials we met with stated that transfer pricing was 
the most significant compliance risk they face in the area of 
international taxation. Similarly, many business representatives said 
complying with transfer pricing rules was often the most burdensome 
aspect of international taxation. Transfer prices are the prices of 
goods and services transferred among related entities within an MNC. 
These prices create compliance risks because MNCs can sometimes 
deliberately manipulate them to shift income from one related entity to 
another in order to reduce tax liability. For example, a parent 
corporation that charges a foreign subsidiary a below-market price for 
a good or service lowers the parent corporation's taxable income and 
raises the subsidiary's taxable income. Depending on tax rates and 
rules governing exemption and deferral, shifting income in this way may 
reduce an MNC's overall tax liability. An above-market price would 
shift taxable profits from the subsidiary to the parent. 

Because transfer prices can shift taxable income from one country to 
another, all of our study countries have focused attention on transfer 
pricing with emphasis on stringent documentation requirements and 
audits. Generally, the study countries require taxpayers to provide 
evidence that transfer prices meet an arms-length standard, which means 
pricing transactions as if they occurred between unrelated parties. 
Establishing an arms-length price can be difficult when there is no 
comparable market price, such as for a unique good, service, or 
intangible property. 

Although comprehensive data were not available, several experts, 
including the OECD, have noted that a significant amount of trade 
occurs between related parties.[Footnote 15] Trade in services in the 
United States, while not a measure of overall U.S. trade, provides an 
example. According to the U.S. Bureau of Economic Analysis, trade in 
services between CFCs and related parties increased (in nominal 
dollars) from approximately $38.4 billion in 1999 to approximately 
$178.7 billion in 2006.[Footnote 16] 

The changing nature of international trade, particularly the growing 
trade in intangibles, is making international transactions more 
susceptible to transfer pricing abuse.[Footnote 17] Tax experts 
repeatedly identified intangible property as a particular challenge 
when attempting to establish a transfer price that meets the arm's 
length standard. The unique nature of many intangible assets, such as 
patents, trademarks, copyrights, and brand recognition, means that it 
is difficult or impossible to identify comparable transactions for 
transfer pricing purposes. The revenue risk posed by mispricing 
intangibles can be significant because it can result in a company 
converting taxable income into tax-exempt or lower taxed income. For 
example, a parent corporation can license a patented computer 
technology to a foreign subsidiary and charge a below-market royalty, 
which is taxed in the domestic country. The subsidiary, which is in a 
low-tax country, uses the technology to generate a profit. The 
subsidiary then pays a tax-exempt dividend to the parent corporation. 
The parent corporation's country loses tax revenues because the tax- 
exempt dividend received is inflated and the taxable royalty is 
reduced. Conversely, the subsidiary's country receives additional tax 
revenues because the subsidiary's income is higher than it should be, 
as the smaller royalty payment is a deductible expense. In the 
aggregate, however, the MNC reduces its tax liability because the tax 
rate in the subsidiary's country is lower than the tax rate in the 
parent corporation's country. 

Because identifying comparable prices for intangibles is often 
difficult, tax agencies and taxpayers often rely on a profit-split 
approach. The goal is to determine the percentage of profit 
attributable to buyers and sellers in different countries. Company 
officials consistently reported that making these determinations often 
requires costly special studies done by outside technical experts. In 
Australia, for example, to help protect against penalties, it is 
recommended that companies document that they followed a four-step 
process including selecting and justifying a transfer pricing 
methodology and then conducting an analysis based on that methodology 
to determine an arm's-length price. Appendix II provides details on the 
transfer pricing documentation and filing requirements for all of our 
study countries. One company official further said that even after 
making these investments, tax authorities may disagree with the results 
because of differences in opinion about the assumptions that had to be 
made. A number complained about transfer pricing reviews turning into 
disputes between countries over the distribution of tax liabilities. 
This can occur because, in many transfer pricing disputes, there are at 
least three interested parties, the taxpayers and two tax agencies. 
When a taxpayer reaches an agreement with one government on a price it 
can result in a lower tax payment for the other government. 

On the other hand, tax agency officials repeatedly told us that they 
needed detailed information on the pricing methodologies used in order 
to verify that companies' prices satisfy the arm's-length standard. Tax 
agency officials said documentation of the data used and analysis 
conducted are critical to conducting independent determinations of the 
appropriateness of transfer prices. As one example of the importance 
tax agencies place on this documentation, the Australian Tax Office 
(ATO) has a system for rating the documentation quality. Under this 
system, poorly documented transfer pricing decisions are more 
systematically identified, allowing better targeting of audits. 

Transfer pricing abuse is also known to be a significant problem in the 
United States. For example, IRS lists transfer pricing abuse as a high- 
risk compliance area because of the large number of taxpayers and 
significant dollar risk. 

While there is agreement that transfer pricing is a major compliance 
risk in both our study countries and the United States, there is no 
consensus among the tax experts we met with about whether the 
compliance risks are greater in our study countries' exemption systems 
or in the United States' deferral system. Some argued that the tax 
benefits for an MNC from manipulating transfer prices are potentially 
larger under an exemption system than a deferral system. They argue 
that gains from transfer pricing abuse are larger if income can be made 
tax-exempt rather than tax-deferred. However, other experts pointed out 
that transfer pricing abuse is already a significant problem in the 
United States. Some of these experts noted that the incentives to avoid 
or evade tax under a deferral system can be quite large because tax can 
be deferred indefinitely. One of these experts also pointed out that 
there is no empirical evidence supporting the claim that countries with 
exemption systems face greater noncompliance with transfer pricing 
rules. 

Study Countries Have Placed Greater Emphasis on Enforcing Transfer 
Pricing Rules: 

According to tax agency officials and outside tax experts, all study 
countries are placing greater emphasis on transfer pricing when 
auditing MNCs. For example, a tax practitioner in France said that the 
overwhelming majority of the audit issues he faces are transfer-pricing 
related. Another tax practitioner made the same observation about 
Germany, saying that there is a general perception that the burden for 
complying with transfer pricing has increased in recent years. These 
and other company representatives we spoke with said that time spent 
determining and documenting transfer prices in accordance with country 
requirements is a primary source of burden. These findings are echoed 
in the research of others. For example, according to a survey of 850 
MNCs, 65 percent of respondents believe that transfer pricing 
documentation is more important now than it was 2 years ago.[Footnote 
18] Similarly, two-thirds of those respondents said they increased 
their resources on transfer pricing experts and studies in the last 3 
years. 

All Study Countries Use Advanced Pricing Agreements to Address 
Compliance Risks: 

All of the study countries have developed advanced pricing agreement 
(APA) programs that allow taxpayers and tax agencies to resolve 
transfer pricing issues before tax returns are filed and without the 
need for time consuming and expensive audits. Tax experts' opinions on 
APA participation varied, but often these experts did not consider them 
an efficient use of resources for addressing transfer pricing issues. 
Due to the time and resources required to obtain an APA, some taxpayers 
only pursue them for high-value transactions. Guidance provided by the 
Australian Tax Office illustrates the time and extensive documentation 
that can be required for an APA. The document, included in appendix 
III, lists requirements such as numerous meetings with agency 
officials, details of the transfer pricing methodology, and data 
supporting that methodology. The amount of time needed to complete an 
APA can be greater when it involves multiple countries. According to 
statistics from some of our study countries, APAs may take a year, or 
multiple years, to finalize. Between 1992 and the end of 2007, Canada 
finalized 153 APAs. 

Some tax practitioners said that the decision to use APAs can also 
depend on the perceived risk that a transaction is likely to be subject 
to audit. Some taxpayers determine that APAs are less burdensome than 
going through an audit. 

Complying with and Enforcing Anti-avoidance Rules, both CFC and Other 
Rules, Presents Challenges in All of Our Study Countries: 

According to taxpayers and tax officials we spoke with from the study 
countries, rules limiting the tax advantages of earning certain types 
of income offshore can serve as a source of taxpayer compliance burden 
and can be subject to compliance risk. As shown earlier in table 5, all 
of our study countries with the exception of the Netherlands use CFC 
rules as a primary method to limit the exemption or tax-deferral of 
certain income held offshore.[Footnote 19] In addition, all of our 
study countries, including the Netherlands, have additional anti- 
avoidance rules that may apply and disallow tax advantages on specific 
types of income earned offshore. See appendix IV for details of other 
anti-avoidance rules in our study countries and in the United States. 
The study countries were not able to provide us with statistics on the 
number of subsidiaries subject to these anti-avoidance rules, the 
amount of income earned by them, or the residual tax revenue they 
generated.[Footnote 20] Government officials we spoke with in several 
countries estimated the revenue generated from these rules to be low. 
However, some tax experts we spoke with stated that these rules played 
an important role in preventing MNCs from avoiding domestic taxes by 
earning income through CFCs. 

When CFC rules are triggered, it can result in an increase in the MNC's 
tax liability. As a result, some of the tax practitioners we talked to 
said that structuring subsidiaries to avoid CFC rules requires careful 
planning and continuous monitoring. It is even possible that the 
actions of others could change a foreign subsidiary's CFC status. For 
example, as shown in table 5, one way a subsidiary of an Australian MNC 
can be a CFC is if five or fewer Australian investors own more than 50 
percent of its shares. Consequently, a subsidiary that is not currently 
a CFC could become one if other Australian investors increase their 
ownership share. 

Some tax practitioners told us that the complexity of the requirements 
for determining whether CFC rules applied and the amount of information 
needed to support a determination created considerable burden. For 
example, a French tax professional said that France's CFC rules are 
burdensome because they require the taxpayer to make a series of 
complex determinations (these were summarized in table 5)--such as 
whether the foreign tax liability of a subsidiary is greater or less 
than 50 percent of what it would be had the income been earned in 
France--in order to decide whether the subsidiary is a CFC. Given 
differences in accounting and tax rules between France and a foreign 
subsidiary's home country, these calculations can become complicated. 
German CFC rules require similar comparisons of actual taxes paid to 
theoretical taxes owed in determining whether the subsidiary will be 
taxed as a CFC. Australia takes a different approach, providing a list 
of countries where CFCs can be located and have fewer types of income 
that may be attributed to domestic corporations. It is not clear the 
extent to which this reduces burden in comparison to the other study 
countries. 

Tax experts in Canada also said that acquiring information for 
documentation requirements related to CFC rules is particularly 
burdensome. For example, a Canadian firm with a 10 percent holding in a 
foreign subsidiary is required to provide the Canada Revenue Agency 
(CRA) with detailed tax and operations information from the foreign 
subsidiary. With only a 10 percent ownership stake, the Canadian firm 
may find it challenging to obtain such information in a timely manner, 
or at all. 

Generally, CFC rules intend to limit an MNC's ability to shift income, 
especially passive income, to foreign jurisdictions to avoid or 
postpone domestic tax. Enforcing these rules could be difficult if the 
tax agency is not present in the foreign jurisdictions. For example, 
some officials in France and Canada said they may not be able to obtain 
and validate information needed to enforce these rules. One French 
official stated that it is difficult to see if a foreign subsidiary 
located in a low-tax jurisdiction thousands of miles away was an active 
business or being used to shelter income. 

While the Netherlands does not have specific CFC rules, taxpayers and 
tax officials stated that the compliance burden associated with other 
anti-avoidance rules can be significant. According to tax professionals 
we spoke with, the Netherlands has low-taxed passive shareholding 
rules, another type of anti-avoidance rule. Overall, the tax 
practitioners and experts we spoke with agreed that the compliance 
burden related to anti-avoidance rules in the Netherlands could be 
significant. 

Exemption of Foreign-Source Income Reduces the Need for Foreign Tax 
Credits, but They Can Still Serve as a Compliance Risk: 

The study countries all have FTC systems; however, according to both 
tax agency officials and tax practitioners FTCs play less of a role in 
these countries than in the United States because of the extent to 
which foreign-source income is exempt. For exempt income, taxpayers do 
not have to track and report foreign taxes paid. However, FTCs still 
exist as the study countries use them to avoid double taxation on 
foreign-source income that is not exempt, such as income subject to 
anti-avoidance rules. Most study countries were not able to supply data 
on the amount of FTCs that are claimed by domestic parent corporations 
in their countries. However, some tax experts said that the extent to 
which FTCs are generated varies by country, the type of industry in 
which the MNC conducts business, and the overall structure and location 
of the MNC's subsidiaries. For example, according to one German tax 
practitioner we spoke with, FTCs in that country tend to be generated 
mainly by businesses in the financial and insurance industries or where 
CFCs are involved. 

As shown in table 6, the study countries vary in the rules they apply 
to FTCs. Many of these rules address the extent to which companies are 
allowed to accumulate FTCs and use them to offset other types of 
income. For example, Australia requires that all FTCs must be used in 
the taxable period in which they are recognized by the taxpayer on 
their tax filing. Any FTCs that a company has accumulated that are in 
excess of the amount of domestic tax actually paid on that income are 
lost. Canada, on the other hand, allows companies to carry excess FTCs 
back into the previous 3 years or forward up to 10 years. The United 
States allows companies to apply accumulated FTCs across different 
types of foreign-source incomes, across multiple countries, and over 
multiple years. For example, FTCs accumulated for foreign taxes paid on 
royalty income can be combined with FTCs accumulated on dividend 
income. 

Table 6: Overview of Rules Governing FTCs in the Study Countries and 
the United States: 

Country: Australia; 
FTC allowed: Yes; 
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income; 
FTC carryover: Back: None; 
FTC carryover: Forward: None. 

Country: Canada; 
FTC allowed: Yes; 
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income by country; 
FTC carryover: Back: 3 years; 
FTC carryover: Forward: 10 years. 

Country: France; 
FTC allowed: Yes[A]; 
Some limits on the use of FTCs: Generally only allowed for withholding 
taxes paid to eligible tax treaty countries; 
FTC carryover: Back: None; 
FTC carryover: Forward: None. 

Country: Germany; 
FTC allowed: Yes; 
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income by country; 
FTC carryover: Back: None; 
FTC carryover: Forward: None. 

Country: Netherlands; 
FTC allowed: Yes; 
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income; 
FTC carryover: Back: None; 
FTC carryover: Forward: None. 

Country: United States; 
FTC allowed: Yes; 
Some limits on the use of FTCs: Domestic tax liability on the foreign-
source income by broad category of income (general or passive); 
FTC carryover: Back: 1 year; 
FTC carryover: Forward: 10 years. 

Source: GAO analysis of country information. 

Note: This table shows general treatments. It does not present all of 
the details, exceptions, or rules that govern the tax treatment of FTCs 
for our study countries. 

[A] French domestic law, generally, does not allow FTCs; income subject 
to foreign tax and not exempt from French tax is taxable net of foreign 
tax paid. However, most French tax treaties provide for a tax credit 
that generally corresponds to withholding taxes on passive income. 

[End of table] 

Some practitioners said there was some burden in tracking FTCs, but 
generally these rules were much less burdensome than complying with 
transfer pricing and anti-avoidance rules. One tax practitioner from 
Germany pointed out that in instances where MNCs have numerous 
subsidiaries subject to anti-avoidance rules it generally results in 
more instances where income is subject to tax in two countries, thus 
creating additional burden to identify and track FTCs. 

Canada's Rules for Determining if Dividend Income Is Taxable, with FTCs 
Allowed, or Exempt Is a Compliance Challenge and Imposes Significant 
Taxpayer Burden: 

Tax agency officials, taxpayers, and tax experts agreed that Canada's 
rules for tracking foreign-source income and determining whether the 
income qualifies for tax exemption are complex and challenging for 
taxpayers and tax officials. As discussed earlier in this report, 
Canada's rules for determining whether or not dividend income received 
from foreign subsidiaries is exempt from domestic taxation include 
ownership requirements, location and business activities in a treaty 
country, and evaluating what type of earnings (e.g., capital gains, 
passive income, or active income) the subsidiary is distributing as a 
dividend. Canadian corporations receiving dividend income that does not 
qualify for exemption are taxed on that income, although FTCs may be 
applied to offset domestic tax. Canadian corporations are responsible 
for tracking all foreign earnings to ensure appropriate taxation once 
the income is received by the Canadian corporation. Taxpayers said 
these rules are burdensome, in part, because they require information 
only available from foreign subsidiaries, complex calculations and 
adjustments to income based on Canadian rules, and monitoring ownership 
changes for the foreign subsidiary. Tax agency officials said the rules 
are a compliance risk because of their complexity and difficulty of 
validating adherence. 

The Generation of Inappropriate Foreign Tax Credits Was Identified as a 
Compliance Risk in Canada but the Risk Was Uncertain for the Other 
Study Countries: 

One area identified by tax officials as a source of compliance risk in 
Canada is the generation of abusive FTCs to offset overall tax 
liability. Often termed FTC generators, these activities, for example, 
allow taxpayers to take advantage of definitions of debt and equity in 
two countries by setting up a subsidiary for the purpose of holding 
assets and generating an income stream in such a way that the income 
stream is subject to foreign tax but also receives an offsetting 
deduction so that there is no net foreign tax. The taxpayer then tries 
to claim a domestic tax credit against this foreign tax paid while 
ignoring the offset. 

Tax agency officials in Canada told us that FTC generators are 
considered a significant compliance risk in their country. CRA 
officials said they were currently auditing a number of domestic 
corporations to determine the extent to which Canadian companies are 
participating in these types of schemes. Because there is often no 
economic purpose to such a transaction, one company generally pays the 
other a fee for participating in the transaction. CRA officials said, 
so far, they have identified a substantial amount in avoided Canadian 
tax from 2001 to 2005. 

Several experts we spoke to with knowledge of the other study countries 
said they did not think FTC generators were a significant issue in 
those countries. For example, a tax practitioner in Germany told us 
that since the majority of repatriated income to Germany is tax exempt 
FTCs are not produced in many instances. Similarly, Australian tax 
agency officials said that since Australian rules require FTCs to be 
used immediately in the year they are recognized, it reduces the 
ability to exploit the FTC generator scheme. However, some experts also 
pointed out that there is always a possibility that taxpayers could 
structure specific transactions to produce improper FTCs. 

FTC generators are also known to be a significant problem in the United 
States. For example, IRS lists them as a high-risk compliance area 
because of the large number of taxpayers and significant dollar risk 
that these types of schemes present. 

Study Countries Differ in How They Limit Domestic Deductions for 
Expenses in Order to Prevent Erosion of the Domestic Tax Base: 

Using sometimes indirect methods, all study countries limit the 
domestic deductibility of some expenses associated with earning foreign-
source income. Tax experts said that methods resulted in fewer 
compliance risks and burdens as compared to more direct methods. The 
deductibility of expenses incurred to earn foreign-source income is an 
issue because of the effect on revenue. If domestic deductibility is 
allowed under an exemption system, then MNCs are able to deduct 
expenses even though the resulting income is not subject to domestic 
tax. 

France and Germany provide an example of an indirect approach to 
limiting expense deductions. As shown in table 2, they require 
corporations to add 5 percent of their gross tax-exempt dividends to 
their domestic taxable income (making dividends effectively 95 percent 
exempt) as an offset for deductible expenses incurred to earn the 
dividends. In our interviews with tax officials and members of the 
business community, this approach was cited as being less burdensome 
than tracing or allocating domestic expenses to tax-exempt income. 
Tracing would involve matching specific expenses to actual income 
generated. Some tax experts that we spoke to generally agreed that 
tracing would be ineffective. Many of the domestic expenses incurred by 
domestic corporations to invest or maintain an investment in a foreign 
subsidiary are general to the domestic corporation. These expenses 
include general management expenses, interest expense on borrowed 
money, and other administrative expenses. Because these expenses are 
general to the corporation, they are difficult to trace to the income 
items. 

One alternative to tracing, mentioned by several experts we talked to, 
is allocating overhead expenses to income sources according to 
formulas. Rather than tracing expenses to actual income items, this 
alternative would allocate expenses according to a rule. Although not 
used in our study countries, allocating overhead expenses in this way 
could be made less burdensome than tracing. However, some experts 
stated that this approach would create compliance risks and burdens 
that do not currently exist. Several experts pointed to the United 
States as an example of this. In general, the United States requires 
U.S. corporations to allocate their expenses to a class of gross income 
and then, if a statutory provision requires, apportion deductions 
between the statutory grouping and the residual grouping. IRS officials 
stated that these rules were a compliance risk because corporations 
sometimes do not apply them appropriately. Some tax experts said these 
rules were a significant compliance burden because they are complex, 
requiring considerable time to conduct detailed calculations. 

Another approach taken by all of our study countries is to limit the 
amount of interest expense that domestic corporations may deduct. 
Without limits on interest rates and amounts, corporations could shift 
income offshore and artificially increase domestic interest expenses, 
eroding the domestic tax base. The rules vary by country and in many 
cases apply to all corporations, not just multinationals. For example, 
Germany and France require that interest rates be equivalent to arm's- 
length terms; the amount of expense that exceeds those terms is 
generally nondeductible.[Footnote 21] Germany also has a rule 
disallowing interest expenses that exceed 30 percent of the 
corporation's adjusted earnings. Canada has a rule that targets 
interest paid to a foreign related-entity with a limit based on debt- 
to-equity ratios. With a few exceptions, tax professionals generally 
stated that the general types of interest expense rules described above 
did not pose much of a compliance burden. 

The approaches taken by the study countries do not disallow all 
domestic deductions for expenses incurred with respect to foreign- 
source dividend income. However, some experts thought that the indirect 
approaches for limiting the deductibility of overhead expenses were 
more administrable and less burdensome than more targeted alternatives. 

Australia, France, and Germany exempt active foreign-source income 
earned through foreign branches, but generally disallow domestic 
deductions for direct expenses attributable to earning the tax-exempt 
income. Direct expenses, like the cost of inventory, can be traced more 
easily to the income generated than more general expenses, like 
interest or other overhead costs. 

Study Countries and the United States Do Not Regularly Report Basic 
Information about the Revenues Generated by Taxing Foreign-Source 
Corporate Income: 

In addition to lacking data about compliance and compliance burden for 
their foreign tax rules, our study countries lack data on the amount of 
tax revenues generated from the foreign activities of domestic 
corporations. This is also the case for the United States. Several 
federal agencies consistently report on the business activities of U.S. 
MNCs, but tax revenues are not included in these reports. For example, 
the Bureau of Economic Analysis reports on the foreign direct 
investment activities of U.S. MNCs and IRS reports data on the amount 
of income U.S. MNCs earn through CFCs. 

U.S. international tax experts, including noted academics with multiple 
publications who we spoke to on this topic all agreed that regularly 
and consistently reporting U.S. tax revenue from foreign-source 
corporate income would be useful. They said that this information would 
help inform the debate about how to tax foreign-source income and 
potentially improve understanding of the role international tax rules 
play in the U.S. tax system. For example, one of these experts pointed 
out that it was not widely understood how little domestic revenue is 
actually raised from taxing foreign-source income and that the tax 
regime governing foreign-source income plays a role in protecting the 
domestic tax base. 

Treasury officials and the experts we talked to noted that producing 
regular revenue reports is feasible. A few academic papers and a recent 
release from the Secretary of the Treasury on international tax issues 
have reported estimates.[Footnote 22] However, the experts said that 
these reports from different sources are not as useful as they could be 
because they are irregular, incomplete, and lack transparency. The 
experts felt that consistent and transparent reporting by a reputable 
government source that clearly describes the methodology used to 
produce the numbers and any limitations would be superior to the 
current occasional reports that sometimes lack much explanation. IRS 
and Treasury officials said IRS already collects the necessary data 
through corporate income tax returns to make the necessary 
calculations. Therefore, the tax experts said there should not be 
significant additional cost to the government to provide this 
information. 

Conclusion: 

The United States, like our study countries, does not report the taxes 
collected by the United States on foreign-source income. Such basic 
information about the U.S. system would not be costly to provide and 
could contribute to the ongoing debate about the direction of U.S. 
policy. Such reporting would make explicit to policy makers, and 
perhaps to the general public as well, how little residual revenue is 
received by the United States from taxing foreign-source corporate 
income. Doing so could help highlight the important role that 
international corporate tax rules play in protecting the domestic tax 
base. 

Recommendation for Executive Action: 

We recommend that the Secretary of the Treasury use currently collected 
information to report annually on the revenue to the United States 
Treasury from taxing foreign-source corporate income. To enhance 
usefulness, such reports should describe the methodology and important 
limitations. 

Agency Comments: 

We requested comments on a draft of this report from the Secretary of 
the Treasury. Treasury agreed with our recommendation. The Acting 
Assistant Secretary (Tax Policy)'s letter is reprinted in Appendix VI. 
Treasury and IRS staff also provided technical comments, which we have 
incorporated as appropriate. 

As agreed with your offices, unless you publicly announce its contents 
earlier, we plan no further distribution of this report until 30 days 
after its date. At that time, we will send copies to the Secretary of 
the Treasury, the Commissioner of Internal Revenue, and other 
interested parties. This report will also be available at no charge on 
GAO's Web site at [hyperlink, http://www.gao.gov]. 

If you or your staff has any questions, please contact me at (202) 512- 
9110 or whitej@gao.gov. Contact points for our Offices of Congressional 
Relations and Public Affairs may be found on the last page of this 
report. Key contributors to this report are listed in Appendix VII. 

Signed by: 

James R. White: 
Director, Tax Issues Strategic Issues Team: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology: 

The objectives of this report were to (1) describe, for select case 
study countries that take a territorial approach, what types of foreign-
source income the countries exempt and the rules governing those 
exemptions; and (2) describe, to the extent information is available, 
the compliance risks and taxpayer compliance burdens that the taxation 
of foreign-source corporate income presents for each of these 
countries. 

To address our objectives, we selected five countries--Australia, 
Canada, France, Germany, and the Netherlands--to study based on several 
criteria, including range of tax treatments for foreign-source 
corporate income, unique tax system features, and Organization for 
Economic Cooperation and Development (OECD) membership. To gather 
information related to our selection criteria, we interviewed a number 
of corporate income tax experts, including academics, corporate tax 
practitioners, corporate taxpayers, officials at the OECD, and 
government officials. We contacted those experts that we identified 
through our literature review, which is described immediately below, 
along with experts that were recommended by other experts. Our 
literature review consisted of academic articles and books, national 
government publications, OECD and other multinational-organization 
publications on worldwide and territorial tax systems, and private 
sector research pertaining to various international aspects of 
corporate income tax systems and administration. 

To describe the corporate income tax systems of our study countries, we 
consulted with corporate taxpayers, business representatives, 
government tax officials, and academic experts. We performed an in- 
depth literature review on each country's corporate income tax system, 
focusing on the rules governing international taxation. We also 
reviewed research-based publications produced by professional services 
organizations, academic experts, and international organizations. In 
general, we relied on information provided by tax officials from the 
study countries as well as published documents to summarize and 
characterize the corporate income tax systems for each country. We 
collected and analyzed data on the countries and their systems for 
taxing foreign-source corporate income, including tax policies, 
administrative mechanisms, compliance activities, and taxpayer 
reporting and documentation requirements. We did not conduct a formal 
legal review of the tax laws and rules in other countries, but relied 
on the information supplied by tax agency officials in those countries. 
We also provided the tax agency officials in our study countries a copy 
of our report to verify data and specific factual and legal statements 
about the tax laws in their country. 

To address our second objective, we searched for publicly available 
data that quantified taxpayer compliance risk and burden for each of 
our study countries. In addition, we interviewed tax practitioners, 
taxpayers, government tax officials, business representatives, and 
officials from the OECD. We analyzed the information gathered through 
interviews as well as published documents to identify and describe the 
common sources of taxpayer compliance risk and compliance burden across 
the study countries. When available, we used publicly available data 
obtained from governments, private sector research, and academics to 
support evidence provided in the interviews. In addition, we provided 
tax agency officials from each of the study countries with a statement 
of facts that were presented in the report for their review and 
comment. Technical corrections were made to this report based upon 
country responses. This report shows general tax treatments and does 
not present all of the details, exceptions, or rules that govern the 
tax treatment of foreign-source income in our study countries and the 
United States. 

We conducted our work from June 2008 to September 2009 in accordance 
with all sections of GAO's Quality Assurance Framework that are 
relevant to our objectives. The framework requires that we plan and 
perform the engagement to obtain sufficient and appropriate evidence to 
meet our stated objectives and to discuss any limitations in our work. 
We believe that the information and data obtained, and the analysis 
conducted, provide a reasonable basis for any findings and conclusions 
in this product. 

[End of section] 

Appendix II: Transfer Pricing Documentation Requirements in the Study 
Countries: 

Country: Australia; 
Documentation requirements: Documentation should evidence that the 
taxpayer has followed the following four-step process in setting and 
reviewing its transfer prices: Step 1: Accurately characterize the 
international dealings between the associated enterprises in the 
context of the taxpayer's business and document that characterization; 
Step 2: Select the most appropriate transfer pricing methods and 
document the choice; Step 3: Apply the most appropriate method, 
determine the arm's length outcome and document the process; and; Step 
4: Implement support processes. Install review process to ensure 
adjustment for material changes and document these processes; 
Time at which documentation should be prepared: Contemporaneous. 
However, generally only required to be submitted to the revenue 
authority following a specific notification, such as through an audit; 
Time to fulfill formal requests made during an audit: 28 days. 

Country: Canada; 
Documentation requirements: Contemporaneous documentation required for 
cross border, related party transactions. Form T-106 required to be 
filed annually asks for reporting of non-arms-length transactions; Time 
at which documentation should be prepared: Must exist at the time of 
tax filing; 
Time to fulfill formal requests made during an audit: 3 months. 

Country: France; 
Documentation requirements: Taxpayers are not required to keep any 
transfer pricing documentation but are expected to cooperate with the 
tax agency in transfer pricing audits; 
Time at which documentation should be prepared: No formal 
contemporaneous documentation requirement; 
Time to fulfill formal requests made during an audit: 60 days, but 
could be extended an additional 30 days. 

Country: Germany; 
Documentation requirements: Documentation that shows the type and 
content of business transaction to related parties, including general 
information about (1) the group and ownership structure, (2) business 
relations to related parties, (3) analysis of functions and risks, and 
(4) transfer pricing analysis; 
Time at which documentation should be prepared: Contemporaneous for 
exceptional business transactions only; 
Time to fulfill formal requests made during an audit: 60 days. 

Country: Netherlands; 
Documentation requirements: Documentation must show the arm's length 
nature of the transfer price that was applied; 
Time at which documentation should be prepared: Generally expected to 
be available at the time when the transaction occurs; 
Time to fulfill formal requests made during an audit: 4 weeks, but up 
to 3 months for certain complex transactions. 

Source: Organization for Economic Cooperation and Development and Ernst 
& Young. 

[End of section] 

[End of table] 

Appendix III: Example from Australia of the Process for Obtaining an 
Advanced Pricing Agreement: 

Step 1: Pre-lodgment meetings: 
The purpose of pre-lodgment meetings is to: 

* discuss the suitability of an APA; 
* allow a business to provide a broad outline of the proposed transfer 
pricing methodology; 
* discuss whether the APA will be unilateral or bilateral; 
* discuss the required documentation and analysis; 
* determine whether independent expert advice is required; 
* discuss Tax Office audit activity (if an APA is to flow on from 
audit); 
* agree on a date for lodging a formal application; 
* agree on the APA timetable, and; 
* discuss the process for evaluating the application. 

Pre-lodgment meetings do not bind either party to the APA program. 

Step 2: Lodgment of formal application: 
If proceeding with the APA, a business will be required to lodge a 
formal application. The APA application should include: 
* details of the proposed transfer pricing methodology, supported by 
relevant information; 
* terms and conditions governing the application of the transfer 
pricing methodology; 
* data showing that the transfer pricing methodology will produce armís 
length results; 
* a discussion and analysis of the critical assumptions, and; 
* a suggested period of time for which the APA will apply. 

For bilateral APAs we normally advise the treaty partnerís tax 
authority once the application has been accepted. 

Step 3: Analysis/evaluation: 
We evaluate the data submitted and other relevant information, and seek 
additional information where necessary. We normally have numerous 
meetings with a business. 

Step 4: Negotiation and agreement: 
For a bilateral APA, the relevant tax administrations exchange position 
papers outlining the acceptability of the proposed transfer pricing 
methodology. A written confirmation of the concluded agreement is 
provided to the business. 

For a unilateral APA, we provide written confirmation of the agreement 
we reach with the business. 

Step 5: 
Concluded APAA concluded APA contains at least the following 
information: 
* the transactions, agreements or arrangements covered by the APA; 
* the period and tax years covered by the APA; 
* the agreed transfer pricing methodology and the critical assumptions 
on which it is based; 
* the definition of key terms that form the basis of the methodology 
(for example, sales, operating profit); 
* if applicable, a range of armís length results, and; 
* the businessís obligations as a result of the APA. 

Source: Australian Tax Office. 

[End of section] 

Appendix IV: Examples of Other Anti-avoidance Rules in the Study 
Countries and the United States: 

Table 7 provides some examples of non-controlled-foreign-corporation 
(CFC) anti-avoidance rules. This is not a complete list of the anti- 
avoidance rules in these countries. The consequences of falling under 
these rules are not necessarily the same as the CFC rules, but those 
consequences are beyond the scope of this table. 

Table 7: Examples of Additional Anti-avoidance Rules by Country: 

Country: Australia; 
Regime: Foreign Investment Fund (FIF) rules; 
General definition of anti-avoidance rules: Certain Australian 
shareholders are subject to annual taxation on a deemed return on their 
pro rata shares of foreign investment funds if: 
(a) the foreign company or trust is not controlled by Australian 
residents; and; 
(b) the taxpayer's shareholding is more than 10% of the total value of 
the taxpayer's interest in foreign companies and trusts; and; 
(c) the foreign company or trust engages in "blacklisted" activities, 
such as certain financial intermediary, insurance, and banking 
transactions; and; 
(d) the taxpayer holds the interest at the end of the taxable year. 

Country: Canada[A]; 
Regime: Offshore Investment Fund (OIF); 
General definition of anti-avoidance rules: Canadian shareholders of an 
OIF are taxed currently on an imputed return basis where the investment 
in the OIF is established to be motivated by tax avoidance. 

Country: France; 
Regime: Abuse of Law doctrine; 
General definition of anti-avoidance rules: General anti-avoidance law 
that permits the tax authorities to take action against legal 
arrangements or particular transactions when those arrangements and 
transactions were fictitious or undertaken for solely tax reasons. 

Country: Germany; 
Regime: General Anti-Avoidance Rule; 
General definition of anti-avoidance rules: General anti-avoidance 
rule, re-written in 2007, that prevents taxpayers from establishing 
legal forms or structures for the sole purpose of obtaining a tax 
advantage. Tax authorities may disregard structures for tax purposes in 
these situations. 

Country: Netherlands; 
Regime: Low-Taxed Passive (LTP) Shareholding; 
General definition of anti-avoidance rules: The Dutch shareholder that 
holds 25% or more, alone or together with an affiliate, of the shares 
in a (foreign) entity has to value its shareholding at market value in 
case the following conditions are met: 
(a) At least 90 percent of the assets of the subsidiary are, directly 
or indirectly, of a portfolio nature; 
(b) The foreign tax paid on profits is less than 10 percent of tax on 
profits if calculated under Dutch tax law; and; 
(c) more than 50 percent of the carrying value of its property is not 
investment property. 

Country: United States; 
Regime: Passive Foreign Income Companies (PFIC); 
General definition of anti-avoidance rules: A foreign corporation is a 
PFIC if: 
(a) 75 percent of the corporation's income is passive income; or; 
(b) 50 percent of the corporation's assets (by value) are held for 
production of passive income. 
Unlike a CFC, a PFIC does not have any minimum stock ownership 
requirement. Each U.S. shareholder of a PFIC can choose to be taxed in 
one of two ways (or, in the case of marketable stock, one of three) 
ways. 

Source: GAO analysis of country information. 

[A] A more comprehensive 'foreign investment entity' (FIE) regime is 
proposed but not yet enacted. Under these proposed rules, Canadian 
investors in a FIE would be taxed currently on an imputed return basis, 
except where qualifying investors elect for accrual or mark-to-market 
treatment instead. 

[End of table] 

[End of section] 

Appendix V: Description of Dividend Exemption Systems in Japan and the 
United Kingdom: 

Japan and the United Kingdom both adopted dividend exemption systems in 
2009. These countries previously taxed dividends received from foreign 
subsidiaries but allowed for foreign tax credits (FTC) for foreign 
taxes paid. Like our study countries, Japan and the United Kingdom have 
specific rules used to determine whether a dividend qualifies for 
exemption. Table 8 describes these rules. 

Table 8: Required Domestic Ownership Type and Level of Foreign 
Subsidiary to Qualify for Tax Exemption of Foreign-Source Dividend 
Income: 

Domestic ownership of foreign company: 
Japan: Direct shareholding of at least 25%[A]; 
United Kingdom: Direct or indirect. 

Foreign company share type: 
Japan: Any type; 
United Kingdom: Most types. 

Ownership duration: 
Japan: 6 months; 
United Kingdom: None. 

Source: GAO analysis of country information. 

Note: This table shows general treatments. It does not present all of 
the details, exceptions, or rules that govern the tax treatment of 
foreign-source income in these countries. 

[A] If the foreign company is a resident in a country with which Japan 
has concluded a tax treaty that provides for the allowance of an 
indirect FTC on qualifying dividends for a shareholding percentage of 
less than 25 percent, then the exemption can be applied in those cases. 

[End of table] 

Like the study countries, both Japan and the United Kingdom have anti- 
avoidance rules, including controlled foreign corporation (CFC) rules, 
which limit the tax advantages of earning or holding certain types of 
income in relatively low-tax jurisdictions. Japan revised their rules 
at the same time the dividend exemption system was implemented. The 
United Kingdom plans to address reforms to their CFC rules in future 
years. However, the United Kingdom did introduce a worldwide debt cap 
rule that limits the extent to which debt expenses can be deducted by 
corporations in the United Kingdom. One goal of this rule is to prevent 
situations in which businesses in the United Kingdom borrow excessively 
in order to invest internationally to produce exempt dividends. This is 
similar to some of the interest expense limitation rules we identified 
in the other study countries. 

[End of section] 

Appendix VI: Comments from the Department of the Treasury: 

Department Of The Treasury: 
Washington, D.C. 20220: 

September 3, 2009: 

Mr. James R. White: 
Director, Strategic Issues: 
U.S. Government Accounting Office: 
Washington, DC 20548 

Dear Mr. White: 

Thank you for the opportunity to comment on GAO's draft report entitled 
"International Taxation: Study Countries That Exempt Foreign-source 
Income Face Compliance Risks and Burdens Similar to Those in the United 
States" (GAO-09-934). 

The draft report recommends that "the Secretary of [the] Treasury 
annually report, using already available data, the revenue generated by 
taxing foreign-source corporate income." As a result of our discussions 
with GAO, we have asked the Statistics of Income Division of the 
Internal Revenue Service to include additional data available from 
corporate income tax returns in its annual article in the Statistics of 
Income (SOI) Bulletin on the corporate foreign tax credit. We believe 
that this additional reporting will provide public information 
regarding the tax revenue attributable to foreign source income. 

We also have technical comments on the draft report, which we will 
discuss with your staff. 

Thank you again. 

Sincerely, 

Signed by: 

Michael F. Mundaca: 
Acting Assistant Secretary (Tax Policy): 

[End of section] 

Appendix VII: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

James R. White, (202) 512-9110 or whitej@gao.gov: 

Staff Acknowledgments: 

In addition to the contact named above, Josť Oyola, Assistant Director; 
Brian James; Ed Nannenhorn; Danielle Novak; Chhandasi Pandya; Matthew 
Reilly; A.J. Stephens; and Charles Veirs IV made significant 
contributions to this report. 

[End of section] 

Related GAO Products: 

Cayman Islands: Review of Cayman Islands and U.S. Laws Applicable to 
U.S. Persons' Financial Activity in the Cayman Islands, an E-supplement 
to [hyperlink, http://www.gao.gov/products/GAO-08-778], [hyperlink, 
http://www.gao.gov/products/GAO-08-1028SP]. Washington, D.C.: July 
2008. 

U.S. Multinational Corporations: Effective Tax Rates Are Correlated 
with Where Income Is Reported. [hyperlink, 
http://www.gao.gov/products/GAO-08-950]. Washington, D.C.: August 12, 
2008. 

Tax Administration: Comparison of the Reported Tax Liabilities of 
Foreign-and U.S.-Controlled Corporations, 1998-2005. [hyperlink, 
http://www.gao.gov/products/GAO-08-957]. Washington, D.C.: July 24, 
2008. 

Business Tax Reform: Simplification and Increased Uniformity of 
Taxation Would Yield Benefits. [hyperlink, 
http://www.gao.gov/products/GAO-06-1113T]. Washington, D.C.: Sept. 20, 
2006. 

Understanding the Tax Reform Debate: Background, Criteria, and 
Questions. [hyperlink, http://www.gao.gov/products/GAO-05-1009SP]. 
Washington, D.C.: September 2005. 

Tax Administration: Comparison of the Reported Tax Liabilities of 
Foreign-and U.S.-Controlled Corporations, 1996-2000. [hyperlink, 
http://www.gao.gov/products/GAO-04-358]. Washington, D.C.: Feb. 27, 
2004. 

Tax Administration: IRS' Advanced Pricing Agreement Program. 
[hyperlink, http://www.gao.gov/products/GAO/GGD-00-168]. Washington, 
D.C.: Aug. 14, 2000. 

Tax Administration: Foreign-and U.S.-Controlled Corporations That Did 
Not Pay U.S. Income Taxes, 1989-95. [hyperlink, 
http://www.gao.gov/products/GAO/GGD-99-39]. Washington, D.C.: Mar. 23, 
1999. 

International Taxation: Transfer Pricing and Information on Nonpayment 
of Tax. [hyperlink, http://www.gao.gov/products/GAO/GGD-95-101]. 
Washington, D.C.: Apr. 13, 1995. 

International Taxation: IRS' Administration of Tax-Customs Valuation 
Rules in Tax Code Section 1059A. [hyperlink, 
http://www.gao.gov/products/GAO/GGD-94-61]. Washington, D.C.: Feb. 4, 
1994. 

International Taxation: Taxes of Foreign-and U.S.-Controlled 
Corporations. [hyperlink, http://www.gao.gov/products/GAO/GGD-93-
112FS]. Washington, D.C.: June 11, 1993. 

International Taxation: Problems Persist in Determining Tax Effects of 
Intercompany Prices. [hyperlink, 
http://www.gao.gov/products/GAO/GGD-92-89]. Washington, D.C.: June 15, 
1992. 

[End of section] 

Footnotes: 

[1] These are U.S. corporations that claimed foreign tax credits on IRS 
tax forms. This may not include all U.S. corporations. 

[2] Internal Revenue Service, Corporate Foreign Tax Credit, 2003, 
Statistics of Income Bulletin. Fall 2007. 

[3] Under a worldwide approach, domestic corporations generally face 
the same total income tax liability regardless of whether an investment 
is located at home or abroad (assuming the foreign tax rate is the same 
or lower than the domestic rate), so investment location decisions are 
not distorted by the tax. However domestic corporations may not 
necessarily pay the same tax on a foreign investment as a foreign 
competitor. Under a territorial approach, domestic corporations earning 
foreign income only pay foreign tax, ensuring that they do not face a 
greater tax liability on that income than foreign competitors in the 
same country. However, this means that a domestic corporation could 
face different tax liabilities for foreign and domestic investments. 

[4] See appendix V for additional details on the tax treatment of 
foreign-source income in Japan and the United Kingdom. 

[5] In general, the U.S. tax system does not tax income until it is 
actually earned. The U.S. also generally imposes its corporate income 
tax at the corporate entity level. Deferral is a result of these basic 
features: anti-avoidance rules generally create exceptions to these 
principles in specific circumstances. 

[6] For examples see Department of the Treasury, Leveling the Playing 
Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs 
Overseas (TG-119) (May 4, 2009); and President's Advisory Panel on 
Federal Tax Reform, Simple, Fair, and Pro-Growth: Proposals to Fix 
America's Tax System (Washington, D.C, November 2005). 

[7] There is no standard definition of a subsidiary. For the purposes 
of our report, we use the term subsidiary loosely to refer to a chain 
of ownership whereby a parent corporation exercises a degree of control 
of another corporation. The level of ownership which determines control 
differs by individual circumstances. We discuss these scenarios later 
in the report. 

[8] In general, branches of U.S. corporations are not regarded as 
separate legal entities for tax purposes. 

[9] As shown in table 2, France and Germany effectively exempt 95 
percent of capital gains from the sale of foreign subsidiary stock from 
domestic tax. 

[10] As measured by the Canadian dollar value of total dividends 
received from foreign affiliates. Advisory Panel on Canada's System of 
International Taxation, Enhancing Canada's International Tax Advantage 
(December 2008). 

[11] To qualify for the tax exemption, the French corporation must hold 
or intend to hold the shares for 2 years. 

[12] Income taxed under anti-avoidance rules may, in some cases, be 
distributed to the domestic parent corporation as tax-exempt dividends. 

[13] We use the term controlled foreign corporation (CFC) to describe 
foreign subsidiaries that are controlled by a domestic parent company 
as defined by each country. Some of our study countries use similar 
terms, such as controlled foreign company or controlled foreign 
affiliate, which we include in our use of the term controlled foreign 
corporation. Although this term has a specific technical meaning in 
several jurisdictions, including in the United States, we do not use 
this term in any of its technical senses, but as a generic description 
of these types of rules in various countries. 

[14] In Canada, this income taxed currently is known as foreign accrual 
property income (FAPI). FAPI income includes categories of income that 
may not meet all definitions of passive income. 

[15] OECD Observer, Transfer Pricing: Keeping it at Arm's Length, July 
3, 2008. 

[16] U.S Bureau of Economic Analysis. U.S. International Services: 
Cross-Border Trade 1986-2007, and Services Supplied Through Affiliates, 
1986-2006. 

[17] This is a significant issue for tax authorities because of the 
growing significance intangibles play in the global economy. Although 
there is currently no complete measure of the amount of income 
generated globally, or even in the United States, from investment in 
intangible assets, one indicator is the amount of income generated 
through royalty payments. According to Treasury tax files, royalties 
paid by the top 7500 CFCs of U.S. parent corporations increased 68 
percent ($22.4 to $37.6 billion) from 1996 to 2002. 

[18] Ernst & Young, Global Transfer Pricing Survey 2007-2008. We did 
not validate the information reported in this study. 

[19] As stated previously, we use the term CFC to generally describe 
foreign subsidiaries that are controlled by a domestic company as 
defined by each country. We do not use the term in any of its technical 
senses, but as a generic description of these types of rules in our 
study countries. 

[20] Some of this data is available for U.S. MNCs based on corporate 
tax returns. For example, for tax year 2004, IRS reported the existence 
of 74,676 CFCs that earned $362.2 billion before income taxes. These 
CFCs paid $69.3 billion in income taxes worldwide. 

[21] These requirements are related to transfer pricing rules in that 
they both aim to set the prices involved in certain related-party 
transactions at arm's length. 

[22] Altshuler and Grubert reported U.S. corporations paid $12.7 
billion in U.S. taxes on foreign-source corporate income reported in 
tax year 2000 in "Corporate Taxes in the World Economy: Reforming the 
Taxation of Cross-border Income" in Fundamental Tax Reform: Issues, 
Choices, and Implications, edited by John W. Diamond and George R. 
Zodrow (2008). The Department of the Treasury reported about $16 
billion in revenue for tax year 2004 in Leveling the Playing Field: 
Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs 
Overseas (TG-119) (May 4, 2009). 

[End of section] 

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Automated answering system: (800) 424-5454 or (202) 512-7470: 

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Chuck Young, Managing Director, youngc1@gao.gov: 
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U.S. Government Accountability Office: 
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Washington, D.C. 20548: