Statement of the
Investment Company Institute

On the International Tax System
Submitted to the Committee on Finance,
United States Senate

March 19, 1999

Summary
1. 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.

2. 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.

3. 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 U.S. 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.

4. 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 "investment competitiveness" legislation that 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.

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.

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.

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.

Congress Should Enact Legislation Eliminating U.S. Tax Barriers to Foreign Investment in U.S. Funds
Investment competitiveness" legislation introduced in both the Senate and the House in every Congress since 1991, and most recently in 1997,⁴ effectively would modify the "designation" rules applicable to U.S. funds. The Institute has supported fully these "investment competitiveness" bills, which would permit all U.S. funds to preserve, for withholding tax purposes, the character of interest income and short-term gains distributed to foreign investors, provided the interest income and gains would be exempt from U.S. withholding tax if received directly or through a foreign fund.⁵

The Institute urges the Committee to support the enactment of this "investment competitiveness" legislation. Following enactment of such legislation, the full panoply of U.S. funds-equity, balanced and bond funds-would be available to foreign investors without this adverse U.S. tax treatment. Absent this change, foreign investors seeking to enter the U.S. capital markets will continue to have a significant U.S. tax incentive not to invest in U.S. funds.

An important first step toward improving the investment competitiveness of U.S. funds is contained in the President's Fiscal Year 2000 budget proposal. Under the President's proposal, distributions to foreign investors by a U.S. fund that invests substantially all of its assets in U.S. debt securities or cash generally would be treated as interest exempt from U.S. withholding tax. A fund's distributions would remain eligible for this withholding tax exemption if the fund invests some of its assets in foreign debt instruments that are free from foreign tax pursuant to the domestic laws of the relevant foreign countries.

Should the Committee determine to accept the Administration's narrower bond fund proposal, the Institute recommends that such legislation draw a distinction between (1) a foreign bond that is exempt from foreign tax in the hands of a U.S. investor pursuant to the domestic law of the relevant foreign country (a "tax-exempt" foreign bond) and (2) a foreign bond that would be subject to foreign tax in the hands of a U.S. investor but for an income tax treaty with the United States (a "taxable" foreign bond). This approach, which would ensure that foreign investors could not avoid otherwise-applicable foreign tax by investing in U.S. funds that qualify for treaty benefits under the U.S. tax treaty network, was contained in legislation introduced in both the Senate and the House in 1998.⁶

U.S. mutual funds cannot compete effectively in the rapidly-expanding global economy so long as U.S. tax law encourages foreign portfolio investors to make their investments either directly or through a foreign fund, rather than through a U.S. fund. The Institute urges the enactment of legislation to remove this inadvertent U.S. tax barrier to foreign investment in U.S. funds.

¹The Investment Company Institute is the national association of the American investment company industry. Its membership includes 7,446 open-end investment companies ("mutual funds"), 456 closed-end investment companies, and 8 sponsors of unit investment trusts. Its mutual fund members have assets of about $5.662 trillion, accounting for approximately 95% of total industry assets, and have over 73 million individual shareholders.

²The U.S. statutory withholding tax rate imposed on non-exempt income paid to foreign investors is 30 percent. U.S. income tax treaties typically reduce the withholding tax rate to 15 percent.

³"Portfolio investment" typically refers to a less than 10 percent interest in the debt or equity securities of an issuer, which interest is not "effectively" connected to a U.S. trade or business of the investor.

⁴The "Investment Competitiveness Act of 1997" was introduced by Senators Baucus, Gorton and Murray (as S. 815) and by Representatives Crane, Dunn and McDermott (as H.R. 707).

⁵The taxation of U.S. investors in U.S. funds would not be affected by these proposals.

⁶The "International Tax Simplification for American Competitiveness Act of 1998" was introduced by Senators Hatch and Baucus (as S. 2331) and by Representatives Houghton, Levin and Crane (as H.R. 4173). Under this legislation, no limit would have been placed on the ability of U.S. funds to invest in "tax-exempt" foreign securities, such as Eurobonds. Investments in "taxable" foreign bonds, however, would have been subject to very strict investment restrictions.