Foreign-owned companies must pay tax on the income they earn from business activities within the United States. Treaties with other countries generally stipulate that the United States will not tax the income of foreign-owned businesses more heavily than the income of U.S.-owned businesses.

When foreign multinational corporations operating in the United States import materials and services from affiliated companies abroad, the "transfer price" of imports affects the amount of income that is subject to U.S. tax. (The transfer price is the price charged for goods sold between affiliated companies.) By raising the transfer price of imports, foreign-owned companies can shift income out of the United States to their foreign affiliates and reduce their U.S. tax liability. U.S. tax law requires companies to base the transfer prices of many goods and most services on comparable transactions between unaffiliated companies. But such prices are often difficult for companies to determine and even more difficult for the Internal Revenue Service to enforce, especially when comparable goods and services are not routinely traded between unaffiliated companies.

Foreign-owned multinational corporations may be manipulating transfer prices to shift income overseas and avoid U.S. tax. Circumstantial evidence has indicated that this kind of tax avoidance has occurred. For example, studies have found that the reported profit rates (as a percentage of assets and as a percentage of sales) of foreign-owned multinational corporations operating in the United States are generally lower than the profit rates of U.S.-owned corporations in the same industry.

However, other plausible explanations exist for the low profit rates. For example, foreign-owned companies may have newer plants and equipment than U.S.-owned companies in the same industry. Because accelerated depreciation methods allow companies to claim larger annual deductions on newer equipment than on older equipment, foreignowned companies would have higher reported depreciation costs and lower reported profit rates as a percentage of sales. Moreover, the lack of an inflation adjustment for the book value of plant and equipment undervalues older assets relative to newer assets. As a result, U.S.-owned companies with older assets would tend to have higher profit rates as a percentage of reported book value than foreign-owned companies with newer assets. When foreign-owned companies are the result of recent acquisitions, they would tend to have lower than average rates of profit. Newly acquired companies tend to have more debt, larger depreciation deductions, and higher book value from assets that are revalued on acquisition.

To discourage foreign companies from manipulating transfer prices to avoid U.S. tax, a minimum tax could be levied on foreign-owned businesses that have a sizable amount of trade with affiliated companies overseas. One legislative provision, introduced in 1992, would have imposed a minimum tax on all companies that are at least 25 percent foreign owned and have transactions with foreign affiliates in excess of either 10 percent of their gross income or $2 million annually. Under the proposal, the foreign-owned company would compute its taxable income under the current income tax rules, but its taxable income would be subject to a floor. The floor would equal

75 percent of its gross business receipts multiplied by the average profit margin on gross receipts for U.S. companies in the same industry. If the foreignowned company's operations spanned several industries, the floor would be based on the profit margins in each industry weighted by the share of the company's gross receipts in that industry. The Internal Revenue Service could waive the minimum tax after examining a company's method of computing transfer prices and finding it acceptable.

The formula approach under the minimum tax provides a simple way to ensure that foreign-owned companies conducting business in the United States pay an acceptable amount of U.S. tax. The simplicity of the approach may offer some advantage over the cumbersome rules for arm's-length pricing, which are extremely difficult to enforce. The formula approach, however, provides a very crude estimate of taxable profit.

The minimum tax would discriminate against foreign-owned companies, possibly in violation of U.S. treaties, by taxing their income more heavily than the income of their domestic competitors. The minimum tax would be especially onerous on foreign-owned companies starting new businesses in the United States because new businesses are seldom profitable initially. Under the minimum tax, such businesses would still owe a sizable amount of income tax based on their gross receipts.

Other countries would be likely to treat the minimum tax as a protectionist measure and retaliate with similar taxes on U.S.-owned companies conducting business within their borders. If so, the minimum tax would stifle international trade and reduce economic welfare throughout the world. Imposing the minimum tax on foreign-owned companies, which is one of many possible formulary approaches, would raise $2.4 billion from 1997 through 2002.

Although capital gains on most assets are taxable when the assets are sold, capital gains on home sales generally escape taxation. A taxpayer can defer the capital gain from the sale of a principal residence if she or he purchases another home of at least equal value within two years. When a homeowner dies, the accrued gain on the current home plus any gain on previous homes escapes tax permanently. Further, the tax law allows taxpayers age 55 and older to exclude up to $125,000 of gain from one home sale even if they do not purchase another home of equal or greater value within two years. Replacing the above provisions with a rule that includes 30 percent of capital gains from home sales in taxable income would raise $30.4 billion in 1997 through 2002. Alternatively, including all lifetime gains in excess of $125,000 in taxable income when realized would raise $4.5 billion over the same period.

The preferential treatment of capital gains from home sales is only one of the ways in which the tax code strongly favors owner-occupied homes over other investments (for a discussion of other ways, see REV-04). All of those tax preferences divert savings from business investment to housing. One way to make the tax treatment of housing more like that of other assets would be to replace the capital gains deferral and exclusion provisions with a low tax rate on gains from home sales. Including 30 percent of the

gain from home sales in taxable income would make the tax rate on such gains range from 4.5 percent for taxpayers facing a 15 percent marginal tax rate to 11.9 percent for those in the 39.6 percent tax bracket.

A tax on gains from home sales would discourage home sales in the same way that current law discourages taxpayers from selling other capital assets. In the case of home sales, such a tax might discourage workers from relocating to take advantage of better job opportunities. The tax might also deter some homeowners (especially older taxpayers with large accrued gains) from changing homes as family requirements change.

Another option would allow all taxpayers to exempt the first $125,000 of gains on all home sales from tax, but would fully tax the excess over that amount at the time of sale. That option would protect the mobility of most homeowners. Taxpayers who realize a gain of less than $125,000 on their first home could apply the unused portion to future home sales. That exclusion would increase the mobility of homeowners under age 55 relative to current law because they could move to homes of lesser value without incurring a tax as long as the gain on the home they sold was less than $125,000. Although this proposal would increase mobility for most homeowners, it would reduce it for those under age 55 whose gains from home sales exceed $125,000. Those taxpayers could no longer defer additional gain by purchasing a more expensive home.

Taxing gains on home sales without the rollover and exclusion that current law allows would increase

A capital gain or loss is the difference between the current value of an asset and the owner's basis. The owner's basis is the initial cost of the asset plus the cost of any subsequent improvements and minus any deductions for depreciation. When an asset is sold, tax law normally requires that the owner include any realized gain in taxable income. The owner can deduct any realized losses against realized gains, and when the owner does not have gains in excess of losses, he or she can deduct up to $3,000 of the loss against other income.

An exception occurs when an owner holds an asset until death. In that case, tax law allows the inheritor to "step up" the basis to the asset's value as of the date of the decedent's death. When the inheritor subsequently sells the asset, he or she pays tax on the gain that accrued after the decedent's death. The gain that accrued before the decedent's death is permanently excluded from taxable income. The estate of the decedent may pay taxes under the separate estate tax, but that tax applies equally to assets on which the decedent previously paid income tax and to assets with accrued capital gains that had escaped income taxation.

There are three ways to tax gains held at death: the law could require that gains held at death be included as income on the final income tax return of

the decedent, the estate of the decedent could be subject to a supplemental tax rate on accrued gains, or the law could require that inheritors assume the decedent's basis in the asset they inherit. Under the last method of carryover basis, the inheritors would include the decedent's unrealized gain in their taxable income when they sold the asset.

Tax Gains on Final Return of the Decedent. Taxing accrued but unrealized gains on the final income tax return of the decedent would raise about $58 billion from 1997 through 2002. This option would exclude gains on assets that a spouse inherits. Instead, the spouse would assume the basis of the decedent and pay tax on the full gain only if he or she sold the asset. Any gains on assets that the decedent left to charity would also be exempt. The option would include gains on other assets in taxable income. It would also allow three additional modifications. First, to ease the problem of documenting the basis, the option would allow the estate to use an alternative basis equal to one-half of the asset's current value in computing the gain to be included on the final tax return. Second, the estate could claim the existing $125,000 exclusion on the gain from the sale of a principal residence if the decedent had not already claimed it. Third, the estate could exclude an additional $75,000 of any remaining gains. With all of those provisions, about 10 percent of decedents