The taxation of foreign profits


This paper synthesizes and extends the literature on the taxation of foreign source income in a framework that covers both greenfield and acquisition investment, and a general constraint linking investment at home and abroad for the multinational by introducing a cost of adjustment for the mobile factor. Unless the cost of adjustment is zero, the domestic tax on foreign-source income should always be set to ensure the optimal allocation of the mobile factor between domestic and foreign assets and should follow the classical rules in the literature; national optimality requires the deduction rule, and global optimality requires the credit rule. Only in the zero-cost case does exemption become optimal. Allowances can be set so as to ensure that domestic and foreign asset purchases are undistorted by the tax system: this requires a cash-flow tax on domestic investment in the greenfield case, and a cross-border cash flow tax on foreign investment in both cases. These basic results extend to various extensions of the model, notably: (i) when a profit-shifting motive is present; and (ii) to some extent, when a corporate income tax is in place. The introduction of tax administration costs into the model can explain the empirical trend towards the use of the exemption regime.

Research Highlights

How should foreign profits be taxed?


This research reviews the recent debate on the taxation of foreign source income of multinational firms. For a long time the optimality of the tax credit system, referred to as the ‘old view’, was widely accepted, and served as an important benchmark in the policy debate. Recently, however, a ‘new view’ has emerged, which argues that rules for taxing foreign profits might be in need of reform. However, the direction of reform is controversial. Some authors view exemption as the best option on the grounds that domestic and outbound investment are not substitutes. Others argue for exemption on the grounds that, if corporation tax is a tax on domestic economic activity, justified as firms benefit from public services, then corporate income earned abroad should not be taxed domestically. A third, more pragmatic view, places less emphasis on the impact of taxation on the international capital allocation and focuses on the implications of taxes on foreign profits for administration and compliance costs.

Clemens Fuest


The UK debate over the exemption of foreign source dividends raises issues about the appropriate treatment of such income from an economic perspective. This project develops economic principles for the appropriate treatment of the taxation of international profit, from both a global and national perspective. It argues that the optimal treatment from a national perspective is difficult to  identify, but is most likely to imply source-based taxation: this supports the UK decision to exempt foreign source dividends from UK tax. However, the new system is far from perfect. The allocation of the profits of multinational companies to individual jurisdictions – which is particularly difficult with source-based taxation – is in many cases without any conceptual foundation. Further the taxation of interest income on a residence basis is also hard to justify if the aim of the tax system is to tax only the income arising from economic activity in a given country.

Michael Devereux