Foreign governments investing in U.S. companies currently enjoy a tax advantage over foreign private investors seeking to invest in those same companies -- so long as the investment does not constitute a controlling stake in a firm.
"The U.S. income tax treatment afforded U.S. investments by foreign governments is generally similar to, but somewhat better than, the tax treatment afforded similar investments by foreign corporations," according to a lengthy report [PDF] released this week by the Joint Committee on Taxation. Governments receive better treatment than overseas corporations in terms of the dividends they receive from equity investments in U.S. firms and the interest they receive from U.S. affiliates, a committee staffer explained. The reason for this exemption dates back to U.S. income tax laws from 1917; these laws were created long before the first sovereign wealth funds emerged.
Todd Malan, executive director at the Organization for International Investment, provided a basic example of how SWFs might be treated differently than a private corporation. He said that if another country makes an investment in the U.S. and sells the investment for profit, that government doesn't have to pay a gains tax as a private company would.
"The policy rationale for why we don't tax SWFs like private companies is because they are similar to our own tax-advantaged state pension funds," contended Malan.
The amount of money circulating around the world via sovereign wealth funds has been growing exponentially; the firm Global Insight predicts that the funds will exceed the U.S.'s current economic output by 2015. Combined sovereign wealth reached $3.5 trillion in 2007 -- the largest generator being China, according to the firm. Russia and Kuwait are next.
Because of the sheer magnitude of these funds and the potential national security concerns they raise, U.S. policymakers have been closely following the issue in recent months, and the International Monetary Fund has taken steps to establish guidelines for countries regarding these funds.
The joint committee report argues that "unencumbered trade in goods and services and cross border investment creates the greatest opportunity for growth both in the United States and abroad," while "policies that impede cross border investment can lead to inefficient decisions and potentially reduce aggregate investment." Putting greater restrictions on SWFs "may be interpreted by other potential investors as an indication that the United States is inhospitable to foreign investors," according to the committee.
Not all observers take such a positive view of sovereign investment, however. Victor Fleischer, who teaches tax law at the University of Illinois, said that, "at a minimum, we should treat sovereign investment no better than we do private foreign investment." Fleischer suggested another approach would be to raise the tax rate for all SWFs but offer a tax exemption condition for funds that comply with best practices, such as those operated by professionals with no political managers.
Despite the questions raised by SWFs, the Bush administration has made plain its intention to continue promoting investment from foreign governments. "America will keep our markets open at home to investment from private firms and from sovereign wealth funds," Treasury Secretary Henry Paulson said earlier this month.
The joint committee's report is a response to a request in March by Senate Finance Chairman Max Baucus, D-Mont., and Ranking Member Charles Grassley, R-Iowa, for the committee to examine the tax rules regarding U.S. investments by foreign governments.
"The U.S. has long exempted passive investment income of foreign governments on sovereign immunity grounds. ... This rule is consistent with the important goal of keeping the U.S. economy open to foreign investment," Baucus and Grassley wrote in March. "In light of the rapid increase in the size and number of SWFs, their U.S. investments, and their expected continued growth, it is appropriate to examine the tax regime applicable to their U.S investments and its policy underpinnings."
The joint committee report said it does not see a reason to justify changing existing tax rules to treat sovereign wealth funds less favorably than foreign corporations.