Suppose dividend payments were made tax deductible in calculating corporate taxable income in the United States. Assume that if dividends are received from foreign subsidiaries and the U. S. parent in turn distributes the dividends to its shareholders, the shareholders are permitted to take foreign tax credits for the foreign taxes they have paid indirectly. Foreign tax credits are limited, however, to an amount equal to shareholders’ U.S. tax rate multiplied by the foreign source income they have received. For example, suppose a wholly owned subsidiary in a foreign country earns $ 1 of pretax income, pays local tax of $. 20, and declares a dividend of $. 80 to its U.S. parent.
The U. S. parent in turn declares an $. 80 dividend to its shareholders, thereby avoiding taxable income on the receipt of the dividend. Shareholders must recognize $ 1.00 of taxable income ($. 80 in dividends plus $. 20 of indirect foreign taxes paid) and are eligible for a foreign tax credit of up to $. 20. The tax credit is equal to exactly $. 20 if their U. S. tax rate is 20% or more. How might the preceding set of rules, relative to current U. S. taxation, affect the propensity of tax- exempt investors to invest in purely domestic versus multinational businesses?