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Financial Times

Friday May 24 2002

A beautiful exception: Why close a tax loophole that
underpins America's status as a magnet for foreign capital?

by Amity Shlaes

 Everybody's worried about America's current account deficit. All's fine and dandy so long as foreigners keep pouring more capital into the US than the US spends abroad. But what happens when the foreigners stop sending their cash to America? And if you share the deficit concern, so the argument goes, shouldn't you be doing all that you can to keep America attractive for investors?

Perhaps not, to judge by the actions of the US Treasury and its Internal Revenue Service. For the pair have not so far withdrawn plans dating back to the Clinton administration that would undermine some of America's great power as a capital magnet. The plans apply directly to the foreigners who have deposited some trillion-odd in cash, bonds, and investments with US banks.

The issue here is a little-known rule known as the portfolio interest exception. It was written in the 1980s, when the US was in a panic over foreign investment. (Some things never change).

So Congress passed the exception and some other related rules. Taken together, they allow foreigners to both collect interest on US bank deposits and invest in US government paper and commercial bonds, all without owing tax to the US government on the interest they earn. So long as the foreign nationality of the investor is established, there is not even a requirement to report that income to Washington, since the interest earned is not taxed.What these investors tell their national governments is their own affair. In other words, a beautiful loophole.

Attracting capital was one of the explicit goals of this step. If people were going to be investing in dollar instruments, why not let them do it directly in the US instead of, as was the custom at the time, via complicated ten-step manoevres involving the Netherland Antilles? As the authorities wrote, the change would "would benefit the US economy by stimulating investment in plant and equipment…" There are a number of exceptions to the exception. Canadians, for example, do not enjoy this privilege, due to a treaty with tax-loving Ottawa that targets them.

But you get the picture: though few Americans know it, many foreigners enjoy a pleasure they cannot, unless they buy municipal bonds or have access the shelter of America's tax haven for the middle class, the Roth IRA. That pleasure is tax-free interest. And although it's hard to quantify the degree to which the tax advantage drives capital to the US, one thing is clear: foreigners do own a good share of US Treasuries - the UK government and its citizens held $203bn in February, for example, Germany and its people $83b, Japan $333b, and so on.

The Clinton administration put out draft regulations to try to halt this practice, largely, one suspects, as a favour to the revenue-hungry high tax regimes of Europe. The draft noted explicitly that it "several countries" had "requested information concerning bank deposits of individual residents of their countries". The proposed regulations would require banks and other financial institutions to report interest earned by foreigners.

Since September 11, the proposal, which the O'Neill Treasury is reviewing, has found a second justification - security. Giving Europe or Asia the chance to track the investments of their nationals might also give them a chance to snare some terrorists, or their friends. Right now, as I say, these regulations have not become law, but they are part of the general horsetrading going on among nations post-September 11.

But for fans of the strong dollar and a strong US economy at least, such regulations are problematic. In effect, says Dan Mitchell of the Heritage Foundation, they amount to "putting the interests of foreign tax collectors ahead of those of the US economy". Readers wishing to know more about such intrusions should have a look at a new report published by the private sector Task Force on Information Exchange and Financial Privacy (www.prosperity-institute.org) The report does an especially good job in pointing out the pitfalls of the European Union's Savings Tax Directive and the United Nations' proposed International Tax Organization, which would share information around the globe.

The main point is simple. Foreign capital funded a lot of job creation in the US of the 1990s. Is it really in the nation's interest to dam the inflow?

 

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