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1972, were probably related to unsettled conditions in the exchange markets and speculation about the future value of the dollar. The sharp increase in foreign purchases in 1975 owes much to purchases by the oil producing countries as already mentioned, but net purchases by the rest of the world also rose sharply from the depressed 1974 levels.

Of further interest as a measure of the importance of foreigners in our market might be the net foreign purchases of U.S. stocks in relation to the net change in outstanding corporate stocks, that is, new issues less retirements. Transactions in outstanding securities do not, of course, bring additional funds to issuers of securities: the latter can be accomplished only by net new issues. Directly or indirectly, net foreign purchases provide funds which can be used to purchase new issues. A comparison of the two series in recent years follows (dollar amounts in millions):

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These figures are consistent with the turnover ratios cited above: that is, it seems quite likely that the percentage of foreign transactions on the New York Stock Exchange is greater than the percentage of foreign holdings of all New York Stock Exchange issues. In any event, foreign transactions in any volume must add to the depth and resiliency of the market; whether foreign transactions also add to its volatility is a more difficult question to answer.

Foreign investors would add to the volatility of the market if they were net purchasers in a rising market and net sellers in a falling market. Data showing variations in foreign net purchases of U.S. stocks together with the course of the Standard and Poor's price index of 500 common stocks5 are shown in Chart 3.

During the entire 15 year period, there have been few periods when foreigners were net sellers of U.S. equities; on the whole, therefore, they did help to provide a stabilizing influence on the downside of the market. However, the patterns of the two lines on the chart are roughly similar, indicating that foreigners were usually increasing their purchases when prices were rising and vice versa. Two noteworthy exceptions, the periods from late 1970 to late 1971 and again more briefly in early

Potential Influence on Market Stability

Any large investor, or group of investors similarly motivated, has the potential ability to cause short-term instability in financial markets by changing the composi

of his portfolio abruptly. In addition, foreign investors, acting simultaneously, could not only create perturbations in the securities market, but in the foreign exchange markets as well. The latter could occur, for instance, if foreign holders on a large scale attempted to liquidate their U.S. portfolios and to convert the proceeds into foreign currencies, either their own or those of other countries. The potential for foreign portfolio investors to generate instability in U.S. financial marketsparticularly the stock market—is severely limited, however, by several factors.

In the first place, such holdings comprise a relatively small part of all outstanding securities in U.S. markets less than 4 per cent of all companies reporting in the survey in which foreigners held voting shares.

Secondly, foreign holdings seem to be well distributed among individual issues and by industry, as just indicated. However, there are a few issues in which foreign holdings are relatively strong-over 10 percent in 327 companies. In such cases a sudden liquidation of foreign holdings—like similar action by any specified group of shareholders, say mutual funds—could have a marked temporary effect on the price of a particular issue, or seg. ment of the market.

But, most importantly, foreign holdings of U.S. securities are widely scattered among many thousands of investors in numerous countries. There seems to be far less likelihood that they might be subject to similar motivations at any given time than important groups of domestic shareholders, such as mutual funds, bank trust departments or institutional investors as a group. Thus there seems to be little reason for regarding foreign shareholders in total as a special group likely to affect the market, or as being subject to any special influences

4In fact, of course, some may have been effected on the over-thecounter market; however, it seems likely that the volume so effected would have been small.

5The Standard and Poor's index includes a few foreign stocks. The foreign transactions data for January 1967-March 1969 have been adjusted to eliminate the estimated amount of sales by the U.K. authorities of stocks vested by them during World War II. The amplitude of the swings in foreign purchases would be less if they were adjusted for price changes but the pattern of the relationship indicated by the chart would not be affected.

not affecting domestic investors of similar types. Only in the case of severe international crises, such as the outbreak of war, might foreigners or at least a large number of foreigners have a motivation for acting in concert. In this connection, it should be remembered that at least 9 percent of total “foreign" holdings are held by U.S. citizens residing abroad.

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* 3 month moving averages. Note: Net foreign purchases exclude estimated sales in 1967 - March 1969 by the

U.K. authorities of stocks vested during World War II.

Chapter 5

Legal Aspects of Foreign Portfolio Investment

perceived by persons in the banking, legal, or brokerage communities in the United States and abroad.

Tax Laws

The material in this chapter was drawn from a survey of the legal aspects of foreign portfolio investment in the United States and in eight major foreign countries conducted for the Treasury Department by R. Shriver Associates, 1 The survey was conducted in response to the tasks assigned to the Treasury by Section 6 of P.L. 93-479, quoted in full as follows (the numbers refer to subsections of Section 6):

(6) study the effect of Federal securities laws, rules,

regulations, and policies on foreign portfolio in

vestment activities in the United States; (7) compare the purpose and effect of United States,

State, and local laws, rules, regulations, programs, and policies on foreign portfolio investment in the United States with laws, rules, regulations, programs, and policies of selected nations and areas where such comparison may be informative.

Withholding tax. U.S. Federal tax law specifies that a foreign person (either a nonresident alien individual or a foreign corporation) will be taxed at a statutory withholding rate of 30 percent on his passive investment income other than capital gains. If the foreign person is a resident of a country that has a tax treaty with the United States, the tax on such passive investment income is normally lower, e.g., 15 percent on dividends, 0 percent on interest. Capital gains classified as passive investment income accruing to foreigners are not taxed by the United States.

The law, however, does provide that the income foreign governments receive from passive investments in the United States is exempt from the Federal income tax. This exemption extends to organizations created by the foreign government if the organization does not engage in commercial activities in the United States on more than a de minimus basis and also meets the following requirements: 1. it is wholly owned and controlled by a foreign

Although taxation was not specifically mentioned in either of these subsections, it is obviously the single most important aspect of the legal framework surrounding international investment, and therefore receives primary attention in the material which follows. The chapter is divided into two parts: the first deals with U.S. legislation and the second with foreign legislation. The second part opens with a brief comparison of U.S. and foreign laws so far as their effect on foreign portfolio investment in the country in question is concerned.

Effects of U.S. Laws

While there is very little in the way of U.S. legislation designed to affect the volume or type of foreign portfolio investments in the United States, these investments are affected by various laws drawn up for other purposes. In some cases these laws undoubtedly deter some foreigners from investing in the United States; in other cases, the law may be viewed as a positive factor. It is not possible, however, to judge objectively the extent of these effects; in this section only the likely effects of certain laws are discussed (i.e., to increase or decrease investment), as

government; 2. its assets and income are derived solely from its

activities and investments and from the

foreign government; 3. its net income is credited either to itself or to the

foreign government, with no portion of its income inuring to the benefit of any private per

son; and

4. its investments in the United States, if any, in

clude only those which produce passive income, such as currencies, fixed interest deposits, stocks, bonds, and notes or other

securities evidencing loans. The withholding tax is considered a substantial deterrent to foreign portfolio investors (other than foreign governments) considering investments in incomeoriented equities and debt issues. The U.S. banking and brokerage communities feel strongly that they are at a distinct competitive disadvantage in offering management and brokerage services in these areas. There has

Reprinted as Appendix G.

been so little foreign investor interest in such investments that many brokers have discontinued sending investment information on fixed income securities to their foreign offices. Rumors of the United States' terminating the withholding tax have stimulated inquiries as to U.S. brokerage capabilities on fixed income securities orders.

In the case of growth-oriented, low-yielding, equity issues, foreign investors view the withholding tax as a cost of doing business or as a sales tax item which must be paid in order to participate in the U.S. growth equity market. The main objectives of investors in making commitments in growth equities are capital preservation and appreciation. Accordingly, the withholding tax reducing the investors' yield is considered an acceptable price to pay to achieve these objectives.

The lower treaty tax rates imposed on investment income of foreign investors of various treaty countries have encouraged foreign portfolio investment in the United States for two reasons. First, they generally mitigate the effect of the withholding tax on securities yields by reducing or, in some cases, eliminating the tax on various classes of income. In addition, the treaties generally provide that the tax paid to the United States on dividends or interest can be offset as a credit against the tax payable by the foreign investor to his home country. Second, treaties providing for reduced withholding rates induce foreign investors of countries without treaties with the United States to form either personal holding companies or trusts in the foreign treaty jurisdiction in order to have their investments in the United States receive favorable withholding tax treatment. These entities are then afforded the benefit of treaty tax rates applicable to the jurisdictions in which they are operating.

On the other hand, treaties negotiated between the United States and other countries have provisions requiring both countries to exchange information necessary to carry out the tax law of each country, and these provisions have deterred foreign investors who are sensitive to information on their financial assets being given to their home governments. Accordingly, these investors have either been deterred from investing in the United States entirely or have employed indirect devices or foreign institutions to make their investments in the United States, such as foreign trusts and personal holding companies, formed in tax haven jurisdictions. In certain cases, it is alleged that the fear of disclosure is so strong that foreign investors who are suspected of being residents of treaty countries claim to be residents of nontreaty countries, thus incurring a higher rate of tax, but avoiding disclosure to their home governments.

The effect of the withholding tax on foreign portfolio investment, as seen in the brokerage community, is the encouraging of speculation rather than sound investment analyses. The reduction of yields due to the withholding tax encourages the foreign investor who is exempt from capital gains taxes to look to short swing profits in both the equity and debt securities markets. The result is rapid turnover of foreign portfolios.

The banking community has observed that the foreign investor portfolios are deprived of full servicing in the

American securities market due to the withholding tax. The portfolio manager is limited to certificates of deposit or foreign dollar securities to achieve the required yields on dollar securities for accounts for which income is a primary investment objective. Accordingly, the account is deprived of participating in U.S. Government and U.S. corporate debt issues to achieve its objectives.

The withholding tax collection burden imposed on U.S. institutions and foreign institutions in cases of treaty obligations is regarded as a deterrent in soliciting foreign portfolio accounts. Specifically, the cost of collection and payment of the tax is a factor in establishing fees for foreign accounts and acts as a deterrent in evaluating whether this line of business should be sought after by U.S. institutions. Similarly, foreign institutions which must act as collection agents for the United States under a treaty obligation for accounts where their foreign investor client is not entitled to the treaty rate applicable to the country where the financial institution is resident (e.g., Colombian client of a Swiss bank) are deterred by the cost of collection and recordkeeping from recommending more investment in U.S. securities.

Estate and gift tax. Federal tax law imposes an estate tax on a foreign investor's property situated or deemed to be situated in the United States. For estate tax purposes, United States corporate securities, no matter where the certificates are located, are deemed to be part of a nonresident alien's gross estate. Foreign corporate securities are, of course, excluded from a foreign investor's U.S. estate. The law provides for a $30,000 exemption and a 5 percent tax on the first $100,000 of an estate. The highest rate of tax is 25 percent applied to that part of an estate that exceeds $2,000,000.

Estate tax treaties modify the estate tax rules (e.g., for purposes of determining the status of certain kinds of securities and bank deposits). There is statutory authority for the President to impose a more burdensome estate tax on citizens of countries whose governments impose burdensome estate taxes on U.S. citizens who have property in those countries. Shares of a foreign personal holding company that is completely owned by foreign persons and which in turn holds U.S. securities, are not subject to U.S. estate taxes.

The United States exempts gifts of intangible personal property by nonresident aliens from the gift tax. Gifts of real estate and tangible personal property located within the United States are subject to the U.S. gift tax. These rules, however, may be modified by treaty.

Imposition of an estate tax on estates of nonresident aliens has deterred portfolio investors with $100,000 to $400,000 from investing directly in the United States by opening accounts with U.S. financial institutions. The U.S. institutions receive many inquiries from investors of this size who are deterred from opening accounts once they learn of the existence of the U.S. estate tax and the U.S. institutions' obligation to act as statutory executor and comply with the payment of the tax. It is believed this type of capital is either deterred completely from investment in U.S. securities or is channeled to foreign intermediary institutions which do not comply with payment of the U.S. estate tax.

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