Impact of U.S. Tax Rules on
International Competitiveness

Submitted to the 
Committee on Ways and Means
U.S. House of Representatives

Statement of the 
Investment Company Institute

July 7, 1999

Summary

I. The U.S. Fund Industry is the Global Leader.

Individuals around the world increasingly are turning to mutual funds to meet their diverse investment needs. As the global leader, the U.S. mutual fund industry offers professional portfolio management, diversification, liquidity, significant shareholder safeguards, and convenient shareholder services. Nevertheless, foreign investment in U.S. funds is low.

II. U.S. Tax Policy Encourages Foreign Investment in the U.S. Capital Markets.

Pursuant to U.S. tax policy designed to encourage foreign portfolio investment in the U.S. capital markets, foreign investors generally are exempt from U.S. withholding tax on the capital gains and interest income arising from their portfolio investments in U.S. equity and debt securities.

III. U.S. Tax Law, However, Inadvertently Encourages Foreigners to Prefer Foreign Funds Over U.S. Funds.

Regrettably, these incentives to encourage foreign portfolio investment are of only limited applicability when investments in securities are made through a U.S. fund. In particular, interest income and short-term capital gains, which otherwise would be exempt from U.S. withholding tax when received by foreign investors directly or through a foreign fund, are subject to U.S. withholding tax when distributed by a U.S. fund to its investors. This inadvertent result occurs because U.S. tax law treats fund distributions of these types of income as "dividends" subject to U.S. withholding tax.

IV. Congress Should Enact Legislation Eliminating U.S. Tax Barriers to Foreign Investment In U.S. Funds.

The Institute encourages the Committee to support the enactment of H.R. 2430, the "Investment Competitiveness Act of 1999," which would permit all U.S. funds to preserve, for U.S. withholding tax purposes, the character of interest income and short-term gains distributed to foreign investors, provided that the income and gains would be exempt from U.S. withholding tax if received directly or through a foreign fund.

Statement

The Investment Company Institute (the "Institute")¹ urges the Committee to enhance the international competitiveness of U.S. mutual funds, treated for federal tax purposes as "regulated investment companies" or "RICs," by enacting legislation that would treat certain interest income and short-term capital gains as exempt from U.S. withholding tax when distributed by U.S. funds to foreign investors.² The proposed change merely would provide foreign investors in U.S. funds with the same treatment available today when comparable investments are made either directly or through foreign funds.

I. The U.S. Fund Industry is the Global Leader.

Individuals around the world increasingly are turning to mutual funds to meet their diverse investment needs. Worldwide mutual fund assets have increased from $2.4 trillion at the end of 1990 to $7.6 trillion as of September 30, 1998. This growth in mutual fund assets is expected to continue as the middle class continues to expand around the world and baby boomers enter their peak savings years.

U.S. mutual funds offer numerous advantages. Foreign investors may buy U.S. funds for professional portfolio management, diversification, and liquidity. Investor confidence in our funds is strong because of the significant shareholder safeguards provided by the U.S. securities laws. Investors also value the convenient shareholder services provided by U.S. funds.

Nevertheless, while the U.S. fund industry is the global leader, foreign investment in U.S. funds is low. Today, less than one percent of all U.S. fund assets are held by non-U.S. investors.

II. U.S. Tax Policy Encourages Foreign Investment in the U.S. Capital Markets.

Pursuant to U.S. tax policy designed to encourage foreign portfolio investment³ in the U.S. capital markets, U.S. tax law provides foreign investors with several U.S. withholding tax exemptions. U.S. withholding tax generally does not apply, for example, to capital gains realized by foreign investors on their portfolio investments in U.S. debt and equity securities. Likewise, U.S. withholding tax generally does not apply to U.S. source interest paid to foreign investors with respect to "portfolio interest obligations" and certain other debt instruments. Consequently, foreign portfolio investment in U.S. debt instruments generally is exempt from U.S. withholding tax; with respect to portfolio investment in U.S. equity securities, U.S. withholding tax generally is imposed only on dividends.

III. U.S. Tax Law, However, Inadvertently Encourages Foreigners to Prefer Foreign Funds Over U.S. Funds.

Regrettably, the incentives to encourage foreign portfolio investment are of only limited applicability when investments in U.S. securities are made through a U.S. fund. Under U.S. tax law, a U.S. fund’s distributions are treated as "dividends" subject to U.S. withholding tax unless a special "designation" provision allows the fund to "flow through" the character of its income to investors. Of importance to foreign investors, a U.S. fund may designate a distribution of long-term gain to its shareholders as a "capital gain dividend" exempt from U.S. withholding tax.

For certain other types of distributions, however, foreign investors are placed at a U.S. tax disadvantage. In particular, interest income and short-term capital gains, which otherwise would be exempt from U.S. withholding tax when received by foreign investors either directly or through a foreign fund, are subject to U.S. withholding tax when distributed by a U.S. fund to these investors.

IV. Congress Should Enact Legislation Eliminating U.S. Tax Barriers to Foreign Investment in U.S. Funds.

The Institute urges the Committee to support the enactment of H.R. 2430,⁴ which generally would permit all U.S. funds to preserve, for withholding tax purposes, the character of short-term gains and interest income distributed to foreign investors.⁵ For these purposes, U.S.-source interest and foreign-source interest that is free from foreign withholding tax under the domestic tax laws of the source country (such as interest from "Eurobonds"⁶ ) would be eligible for flow-through treatment. The legislation, however, would deny flow-through treatment for interest from any foreign bond on which the source-country tax rate is reduced pursuant to a tax treaty with the United States.

The Institute fully supports H.R. 2430 because it would eliminate the U.S. withholding tax barrier to foreign investment in U.S. funds, while containing appropriate safeguards to ensure that (1) flow-through treatment applies only to interest income and gains that would be exempt from U.S. withholding tax if received by a foreign investor directly or through a foreign fund and (2) foreign investors cannot avoid otherwise-applicable foreign tax by investing in U.S. funds that qualify for treaty benefits under the U.S. income tax treaty network.

* * * * * * *

The Institute urges the enactment of legislation to make the full panoply of U.S. funds—equity, balanced, and bond funds—available to foreign investors without adverse U.S. withholding tax treatment. Absent this change, foreign investors seeking to enter the U.S. capital markets or obtain access to U.S. professional portfolio management will continue to have a significant U.S. tax incentive not to invest in U.S. funds.

ENDNOTES