[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]



 
                 CURRENT U.S. INTERNATIONAL TAX REGIME

=======================================================================

                                HEARING

                               before the

                       SUBCOMMITTEE ON OVERSIGHT

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             FIRST SESSION

                               __________

                             JUNE 22, 1999

                               __________

                             Serial 106-53

                               __________

         Printed for the use of the Committee on Ways and Means


                    U.S. GOVERNMENT PRINTING OFFICE
65-844 CC                    WASHINGTON : 2000

_______________________________________________________________________
            For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 
                                 20402



                      COMMITTEE ON WAYS AND MEANS

                      BILL ARCHER, Texas, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
BILL THOMAS, California              FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida           ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut        WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York               SANDER M. LEVIN, Michigan
WALLY HERGER, California             BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana               JIM McDERMOTT, Washington
DAVE CAMP, Michigan                  GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington            WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia                 JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio                    XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania      KAREN L. THURMAN, Florida
WES WATKINS, Oklahoma                LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida

                     A.L. Singleton, Chief of Staff

                  Janice Mays, Minority Chief Counsel

                                 ______

                       Subcommittee on Oversight

                    AMO HOUGHTON, New York, Chairman

ROB PORTMAN, Ohio                    WILLIAM J. COYNE, Pennsylvania
JENNIFER DUNN, Washington            MICHAEL R. McNULTY, New York
WES WATKINS, Oklahoma                JIM McDERMOTT, Washington
JERRY WELLER, Illinois               JOHN LEWIS, Georgia
KENNY HULSHOF, Missouri              RICHARD E. NEAL, Massachusetts
J.D. HAYWORTH, Arizona
SCOTT McINNIS, Colorado

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.



                            C O N T E N T S

                               __________

                                                                   Page

Advisory of June 14, 1999, announcing the hearing................     2

                               WITNESSES

BMC Software, Inc., John W. Cox..................................    34
Citigroup, Denise Strain.........................................    41
Deere & Company, Thomas K. Jarrett...............................    48
National Foreign Trade Council, Inc., and Exxon Corporation, Joe 
  O. Luby, Jr....................................................     7
Northrop Grumman Corporation, Gary McKenzie......................    51
Tax Executives Institute, Inc., and Hewlett-Packard Company, 
  Lester D. Ezrati...............................................    20
Warner-Lambert Company, Stan Kelly...............................    56

                       SUBMISSIONS FOR THE RECORD

European-American Business Council, William W. Chip, statement 
  and attachment.................................................    71
Financial Executives Institute, statement........................    74
General Motors Corporation, Detroit, MI, statement...............    77
International Air Transport Association, Montreal, Quebec, 
  Canada, Howard P. Goldberg, statement..........................    79
Investment Company Institute, statement..........................    80
Munitions Industrial Base Task Force, Arlington, VA, et al, 
  Richard G. Palaschak, joint statement..........................    81
National Defense Industrial Association, Arlington, VA, Lawrence 
  F. Skibbie, statement..........................................    83
Tropical Shipping, Riviera Beach, FL, Richard Murrell, letter....    84
Washington Counsel, P.C.:
    LaBrenda Garrett-Nelson and Robert J. Leonard, statement.....    85
    LaBrenda Garrett-Nelson, statement...........................    86



                 CURRENT U.S. INTERNATIONAL TAX REGIME

                              ----------                              


                         TUESDAY, JUNE 22, 1999

                  House of Representatives,
                       Committee on Ways and Means,
                                 Subcommittee on Oversight,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 1:03 p.m., in 
room 1100, Longworth House Office Building, Hon. Amo Houghton 
(Chairman of the Subcommittee), presiding.
    [The advisory announcing the hearing follows:]

ADVISORY

FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                       SUBCOMMITTEE ON OVERSIGHT

                                                CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE

June 14, 1999

No. OV-8

                     Houghton Announces Hearing on

                 Current U.S. International Tax Regime

    Congressman Amo Houghton (R-NY), Chairman, Subcommittee on 
Oversight of the Committee on Ways and Means, today announced that the 
Subcommittee will hold a hearing on the complexity of the current U.S. 
international tax regime. The hearing will take place on Tuesday, June 
22, 1999, in the main Committee hearing room, 1100 Longworth House 
Office Building, beginning at 1:00 p.m.
      
    Oral testimony at this hearing will be from invited witnesses only. 
Invited witnesses include representatives from the U.S. Department of 
the Treasury, Tax Executives Institute, National Foreign Trade Council, 
financial services industry, software industry, heavy equipment 
manufacturing industry, pharmaceutical industry, and high-technology 
manufacturing industry. However, any individual or organization not 
scheduled for an oral appearance may submit a written statement for 
consideration by the Committee and for inclusion in the printed record 
of the hearing.
      

BACKGROUND:

      
    The United States employs a ``worldwide'' system of taxation on 
income of U.S. corporations and its foreign affiliates. A U.S.-parent 
corporation incurs income taxes on the income of its affiliates earned 
abroad to the extent that the affiliates repatriate that income either 
through dividends or deemed dividends. This worldwide-tax system has 
become a maze of complex rules for sourcing and timing foreign income 
and expenses.
      
    The laws enacted by Congress and regulations promulgated by the 
Internal Revenue Service over the past 40 years have introduced an 
amount of complexity which some believe has made the international tax 
regime unworkable and has resulted in an increasing amount of double 
taxation of U.S. corporations' foreign income. According to this 
viewpoint, the competitiveness of U.S. corporations vis-a-vis their 
international competitors thus is disadvantaged.
      
    United States corporations remain the most competitive in the world 
as a result of superior technology and access to skilled labor. 
However, the current international tax regime may adversely affect the 
competitive advantages that such corporations now hold.
      
    On June 7, 1999, Chairman Houghton and Rep. Sander Levin introduced 
H.R. 2018, the ``International Tax Simplification for American 
Competitiveness Act of 1999.''
      
    In announcing the hearing, Chairman Houghton stated: ``In an 
increasingly competitive global market, Congress must examine whether 
the complexity of the U.S. international tax regime puts U.S. 
corporations and their employees at a competitive disadvantage. 
Congressman Levin and I have introduced legislation to address several 
of these concerns.''
      

FOCUS OF THE HEARING:

      
    The Subcommittee will review problems faced by domestic 
corporations in complying with the complexity of the current U.S. 
international tax regime as well as proposals to change the law.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch 
diskette in WordPerfect 5.1 format, with their name, address, and 
hearing date noted on a label, by the close of business, Tuesday, July 
6, 1999, to A.L. Singleton, Chief of Staff, Committee on Ways and 
Means, U.S. House of Representatives, 1102 Longworth House Office 
Building, Washington, D.C. 20515. If those filing written statements 
wish to have their statements distributed to the press and interested 
public at the hearing, they may deliver 200 additional copies for this 
purpose to the Subcommittee on Oversight office, room 1136 Longworth 
House Office Building, by close of business the day before the hearing.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be on an IBM compatible 3.5-inch diskette in WordPerfect 5.1 format, 
typed in single space and may not exceed a total of 10 pages including 
attachments. Witnesses are advised that the Committee will rely on 
electronic submissions for printing the official record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, company, address, telephone and fax numbers where the witness or 
the designated representative may be reached. This supplemental sheet 
will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press 
and the public during the course of a public hearing may be submitted 
in other forms.

      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at `HTTP://WWW.HOUSE.GOV/WAYS__MEANS/'.
      

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.
      

                                


    Chairman Houghton. The hearing will come to order.
    Good afternoon, ladies and gentleman; delighted to have you 
here. The Ways and Means Committee holds a unique position, as 
you know, in forming policies that will drive economic growth 
in the next century. The committee has jurisdiction over tax 
and trade matters, and each are intricately intertwined with 
the other.
    Since I have been on this Committee, Congress has passed a 
variety of trade laws, including the Omnibus Trade and 
Competitiveness Act of 1988, the implementing bills for NAFTA, 
and the Uruguay Rounds Agreements. Each year, the committee 
leads the effort in Congress to preserve normal trade relations 
with China. Within the last month, the committee has passed the 
African Growth and Opportunities Act and the Caribbean Basin 
Initiative. The policy behind each of these bills has been to 
break down trade barriers, so that we can expand export 
opportunities for U.S. firms and workers. The U.S. market, as 
you know, is the most open in the world; yet, more than 96 
percent of the world's population lives outside our borders. 
So, it is important that we secure market access beyond our 50 
States in order to sustain our record of economic growth and 
job creation, as we look out at a new millennium within 6 
months.
    Unfortunately, over the last 40 years, since the inception 
of Subpart F, the disconnect between trade and tax policy has 
widened. With one hand, Congress passes laws to help U.S. 
business expand and become competitive around the globe. With 
the other, Congress hobbles these same businesses through 
double taxation and a variety of obstacles to capital formation 
in markets abroad. These mixed messages to U.S. businesses are 
not helpful.
    So, as I looked over the prepared testimony, I noticed a 
couple of things. First of all, the diversity of industries 
that are represented here today--banking, pharmaceutical, 
software, high-tech, heavy manufacturing, and oil and gas. We 
have to be very proud as these U.S. companies are world leaders 
in their fields. We also have to keep an eye on the future to 
make sure that these companies and the industries they 
represent remain world leaders. And, so that means that we need 
to build a coherent link between trade and tax policy. We need 
to understand the correlation between the two and work to pass 
laws with that understanding in mind, our goal is to help 
expand jobs, not throw boulders in their path.
    The second thing that I noticed was despite the impressive 
brain power of these men and women and the tax professionals 
that support them, each witness speaks of the incredible 
complexity of the tax code and the burden it places on their 
companies. How did we get where we are today with such a 
hodgepodge of tax laws that put the U.S. businesses at such a 
disadvantage in the global marketplace? Isn't it time to rework 
that system so it helps U.S. businesses? A strong economy in 
the United States is driven mainly by how competitive our 
companies are around the globe. Today, the international tax 
laws stand in their way.
    The tax code should be designed to tax income fairly and 
uniformly. With these goals in mind, Mr. Levin--who is sitting 
over here to my left--and I have introduced H.R. 2018, the 
International Tax Simplification for American Competitiveness 
Act of 1999. We believe that this bill takes important steps to 
help ensure that U.S.-owned businesses will not be subject to 
double or premature taxation. Only when these concerns are 
addressed will our tax and trade laws be in line.
    I am pleased now to yield to our Ranking Democrat, Mr. 
Coyne.
    Mr. Coyne. Thank you, Mr. Chairman, and I want to thank you 
for having these hearings. I have a written statement I would 
like to submit for the record, and I yield the balance of my 
time to the gentleman from Michigan, Mr. Levin.
    [The opening statement follows:]

Opening Statement of Hon. William J. Coyne, a Representative in 
Congress from the State of Pennsylvania

    Our hearing today will focus on problems faced by domestic 
corporations in complying with the complexity of the current 
U.S. international tax system. I want to commend Chairman 
Houghton and Congressman Levin for their leadership in this 
area and for the introduction of H.R. 2018, the ``International 
Tax Simplification for American Competitiveness Act of 1999.'' 
This bill is sponsored, on a bipartisan basis, by many Members 
of the Ways and Means Committee. H.R. 2018 proposes changes to 
various aspects of our international tax rules.
    I share Chairman Houghton's concern that, given an 
increasingly competitive global market, the Congress must 
examine whether the complexity of the U.S. international tax 
regime puts U.S. corporations and their employees at a 
competitive disadvantage. Consequently, I believe that it is 
timely that the Oversight Subcommittee review our international 
tax rules to see how they might be reformed and simplified. 
Consideration of H.R. 2018 is a good first step toward 
understanding the problems of international taxation and 
industries' proposals for reform.
    Also, our hearing today will serve as an excellent 
introduction to the full Committee's hearing, next week, to 
review the impact of U.S. tax rules on the international 
competitiveness of U.S. workers and businesses. I look forward 
to hearing the testimony of the witnesses who support H.R. 
2018, including the Tax Executives Institute, the National 
Foreign Trade Council, and representatives of the financial 
services, software, heavy equipment manufacturing, 
pharmaceutical, and high-technology industries.
    Finally, international tax systems are typically evaluated 
in terms of efficiency (whether tax considerations are 
sufficiently neutral to investment and employment decisions); 
equity (whether domestic businesses are treated fairly in 
comparison to foreign-based firms); growth (whether the tax 
system promotes economic growth); simplicity (whether the tax 
system imposes unnecessary complexity and administrative 
burdens on taxpayers; and, harmonization (whether the tax 
system conforms with international norms and promotes dealings 
with foreign countries). I have a particular interest in the 
effect U.S. international tax law has on workers and the 
retention of jobs in the U.S. I hope that the witnesses today 
will address that issue as well in their testimony.
    Thank you.

                                


    Chairman Houghton. Mr. Levin.
    Mr. Levin. Thank you very much, Mr. Coyne, and to you, Mr. 
Chairman, thank you for your holding this hearing and also for 
your leadership. It is a pleasure to collaborate with you on 
this and other matters.
    I have a statement. Let me, if I might, just go through it, 
because I think it may help us to frame the issue. This bill 
that you and I have introduced is an effort to rationalize and 
simplify further the international tax provisions of U.S. tax 
laws by streamlining foreign tax credits, encouraging exports, 
providing incentives for the performance of research and 
development in the United States, enhancing overall U.S. 
competitiveness, and minimizing revenue loss.
    International tax policies were created at a time when the 
focus was on preventing tax avoidance, not promoting 
international competitiveness. In the early sixties, for 
example, U.S. companies focused their manufacturing and market 
strategies in the United States, which at the time was, by far, 
the largest consumer market in the world. U.S. companies 
generally could achieve economies of scale and rapid growth, 
selling exclusively or almost so into the domestic market. In 
the early 1960's, foreign competition in U.S. markets 
generally, therefore, was inconsequential.
    Yet, increasingly, it has become vital for American 
businesses and workers to compete beyond our borders. In 
response, the United States generally tries to raise revenue in 
a neutral manner; that is, one that does not discriminate in 
favor of one investment over another. In the international 
arena, this means the United States seeks to apply the same tax 
burden on income from both domestic and foreign investment. 
Accordingly, the United States generally taxes U.S. companies 
on their worldwide income with a credit for taxes paid to 
foreign jurisdiction.
    There is one important exception, and this applies to 
foreign subsidiaries of U.S. companies. Because these 
subsidiaries would face substantially higher tax rates than 
their local competitors if worldwide taxation were strictly 
enforced, U.S. law defers tax on the subsidiary's income until 
it is repatriated. But with that, there is one problem, and 
that is that the deferral of a foreign subsidiary's tax until 
repatriation can create an incentive for U.S. companies to keep 
their profits abroad even when the profits are not plowed back 
to an active business operation. To counteract this incentive 
to keep profits abroad for non-business reasons, Congress, over 
the years, has eliminated deferral and imposed current taxation 
on various forms of passive investment income. Thus, active 
foreign operations are exempt from tax until repatriation so 
that U.S. companies are taxed at the same level as their 
foreign competitors in a given market, but passive income 
earned abroad generally is taxed currently. However, this 
structure, as we all know so well, has developed increasing 
complexities.
    So, over the last few years, a number of us have tried to 
achieve greater simplification and equity. This is, I think, 
our fourth bill on this issue and the third with our Senator 
counterparts, Orrin Hatch and Max Baucus. We made some progress 
in the 1977 act; most importantly, giving foreign sales 
corporations treatment to software, simplifying reporting rules 
for 10/50 companies, and eliminating overlap in passive foreign 
investment companies, PFIC--you have to know the acronyms in 
this field, and controlled foreign corporation, CFC, rules. 
Last year, we were able to include a 1-year change in the rules 
for active financing income. We are now trying to get that 
provision to extend its 1-year life.
    These are important reforms--technical but important--which 
have enabled American businesses and workers to be more 
competitive abroad. I am pleased by how far we have come, but 
there is still more work to be done, and then I would lay out a 
bit of where we have to go, Mr. Chairman.
    And I conclude with you and I and others believe that by 
saying simplifying our existing rules, we can achieve our goals 
of increasing competitiveness and fairness for our American 
companies in the global marketplace.
    Thank you, Mr. Chairman.
    Chairman Houghton. Thank you very much, Mr. Levin.
    So, you understand the thrust of this meeting. We 
appreciate your being here.
    I would like to introduce the first panel--Mr. Joe Luby, 
Assistant General Tax Counsel of Exxon and Chair of the Tax 
Committee of the National Foreign Trade Council, and, also, Mr. 
Lester Ezrati, General Tax Counsel of Hewlett-Packard in Palo 
Alto on behalf of The Tax Executives Institute.
    Mr. Luby, would you give your testimony?

 STATEMENT OF JOE O. LUBY, JR., ASSISTANT GENERAL TAX COUNSEL, 
  EXXON CORPORATION, IRVING, TEXAS, AND CHAIR, TAX COMMITTEE, 
              NATIONAL FOREIGN TRADE COUNCIL, INC.

    Mr. Luby. As you said, I am here on behalf of the National 
Foreign Trade Council. I am accompanied by Fred Murray who is 
our vice president of Tax with NFTC. I will concentrate my 
remarks on the impact of the U.S. tax system on the ability of 
U.S. multinationals to compete with foreign-based competition. 
While I cannot state that the U.S. system is solely responsible 
for the decline in rank of U.S. multinationals, I submit it had 
a major role in the United States going from 18 of the world's 
20 largest corporations in 1960 to just 8 by the mid-1990's. I 
do not have new statistics, but recent events will probably 
result in an even lower number now that Amoco is a British 
company; Chrysler, a German company, and Bankers Trust, a 
German bank.
    I will concentrate on how two of the provisions you have 
included in your bill impact competitiveness. Your bill would 
accelerate and grant look-through treatment for 10/50 
companies. An example will show you the adverse impact of 10/50 
on competitiveness. Assume a U.S. company's 10/50 affiliate is 
competing with a French company for an investment in Singapore. 
The project calls for a $1 billion investment, and it is 
projected to earn $150 million before tax or a 15 percent 
return. Singapore grants tax holidays, so there is no foreign 
tax. Our French competitor would project a 15 percent after-tax 
return, because France does not tax active business income from 
foreign sources. In contrast, the U.S. company would have 
projected a 9.8 percent return because of the 10/50 provisions 
imposing a U.S. tax of $52.5 million. The return advantage of 
5.2 percent enjoyed by the French competitor may allow it to 
preempt the U.S. bid. In any event, the 5.2 percent detriment 
may drive the return below the level that would allow the U.S. 
company to even entertain the project.
    The granting of full look-through and acceleration of 
repeal will enhance U.S. competitiveness by eliminating the 
kind of adverse impact on project returns I have just 
illustrated. Our members are still walking away from 
investments, deferring investments, or taking less than optimal 
ownership positions in foreign ventures due to the 10/50 rules. 
Thus, we welcome your acceleration in look-through treatment 
for 10/50.
    Section 907 came into the code in 1975 in reaction to the 
first oil crisis and to the suspicion that some U.S. oil 
companies might be taking foreign tax credits at rates so high 
that they may be inclusive of royalties. In 1983, this concern 
was addressed in IRS regulations to provide a formula for 
splitting the amount paid the foreign government into a tax 
component and a royalty component. These regulations have never 
been controversial and have worked well. Despite that fact, 
section 907 remains in the code requiring that taxpayers 
determine the amount of their extracted income versus their 
oil-related income and the foreign taxes associated with each 
category. This requires determining the point at which income 
changes from extracted to oil-related, also determining the 
associated cost for every oil well in every foreign country. No 
foreign country where we operate has these kinds of rules.
    It also requires that the IRS audit such determinations. 
This is a complete waste of shareholder and taxpayer money 
since from its inception, section 907 has raised little if any 
tax revenue for the U.S. fisc. An API study indicated that no 
major U.S. company in our industry has paid tax under 907 from 
its inception in 1975 through the tax year 1997. Spending money 
to comply with a provision that has essentially been useless 
and has been superseded by subsequent law changes does not make 
sense or enhance U.S. competitiveness.
    Do compliance costs make a difference? Let us give you a 
couple of examples based on my own company's experience. We 
have 121 people in tax departments all over the world doing 
nothing but trying to comply with U.S. international tax rules; 
25 of them do section 907. This does not include people who are 
comptrollers and other departments that also much assist. We 
have an average of 30 IRS auditors in our office every business 
day of the year. The information document requests have ranged 
from 944 for the 1980 to 1982 audit to 2,232 in our most recent 
audit. In contrast, our affiliates in Japan file a tax return 
at the end of March, are visited by five auditors, and within 2 
months the audit is completed. In the Netherlands, an audit for 
our 1991 to 1994 tax years was handled by one auditor and took 
6 months. Finally, in the U.K., most audits are handled by two 
auditors, and we have had an issue raised that required 
litigation in over 20 years.
    So, that you will know the size of those audits and that 
they are about substantial companies when you compare, our 
sales in Japan total $16.5 billion and $3.5 billion in tax; the 
Netherlands, $9.5 billion in sales and $1.9 billion in tax, and 
the U.K., sales of $16.4 billion and $6 billion in tax.
    NFTC thanks you for the opportunity to present its views 
and especially for your efforts to bring to the international 
tax rules some semblance of common sense in regard for the 
ability of U.S. companies to compete abroad.
    [The prepared statement follows:]

Statement of Joe O. Luby, Jr., Assistant General Tax Counsel, Exxon 
Corporation, Irving, Texas, and Chair, Tax Committee, National Foreign 
Trade Council, Inc.

    Mr. Chairman, and distinguished Members of the 
Subcommittee:
    My name is Joe Luby. I am Assistant General Tax Counsel of 
Exxon Corporation. As Chairman of its Tax Committee, I am 
appearing today as a witness for the National Foreign Trade 
Council, Inc.
    The National Foreign Trade Council, Inc. (the ``NFTC'' or 
the ``Council'') is appreciative of the opportunity to present 
its views on simplification of the international tax system of 
the United States. The NFTC also wishes to congratulate you, 
Mr. Chairman, and Mr. Levin, and Mr. Sam Johnson, as well as 
the other Members who have joined you--Mr. Crane, Mr. Herger, 
Mr. English, and Mr. Matsui--in the introduction of H.R. 2018, 
the International Tax Simplification for American 
Competitiveness Act of 1999. As I will further elaborate below, 
the provisions of the bill, if enacted, will do much to affect 
the concerns we express in this testimony and would 
significantly lower the cost of capital, the cost of 
administration, and therefore the cost of doing business in the 
global marketplace for U.S.-based firms.
    The NFTC is an association of businesses with some 550 
members, originally founded in 1914 with the support of 
President Woodrow Wilson and 341 business leaders from across 
the U.S. Its membership now consists primarily of U.S. firms 
engaged in all aspects of international business, trade, and 
investment. Most of the largest U.S. manufacturing companies 
and most of the 50 largest U.S. banks are Council members. 
Council members account for at least 70% of all U.S. non-
agricultural exports and 70% of U.S. private foreign 
investment. The NFTC's emphasis is to encourage policies that 
will expand U.S. exports and enhance the competitiveness of 
U.S. companies by eliminating major tax inequities and 
anomalies. International tax reform is of substantial interest 
to NFTC's membership.
    The founding of the Council was in recognition of the 
growing importance of foreign trade and investment to the 
health of the national economy. Since that time, expanding U.S. 
foreign trade and investment, and incorporating the United 
States into an increasingly integrated world economy, has 
become an even more vital concern of our nation's leaders. The 
share of U.S. corporate earnings attributable to foreign 
operations among many of our largest corporations now exceeds 
50 percent of their total earnings. Even this fact in and of 
itself does not convey the full importance of exports to our 
economy and to American-based jobs, because it does not address 
the additional fact that many of our smaller and medium-sized 
businesses do not consider themselves to be exporters although 
much of their product is supplied as inventory or components to 
other U.S.-based companies who do export. Foreign trade is 
fundamental to our economic growth and our future standard of 
living. Although the U.S. economy is still the largest economy 
in the world, its growth rate represents a mature market for 
many of our companies. As such, U.S. employers must export in 
order to expand the U.S. economy by taking full advantage of 
the opportunities in overseas markets.
    United States policy in regard to trade matters has been 
broadly expansionist for many years, but its tax policy has not 
followed suit.
    There is general agreement that the U.S. rules for taxing 
international income are unduly complex, and in many cases, 
quite unfair. Even before this hearing was announced, a 
consensus had emerged among our members conducting business 
abroad that legislation is required to rationalize and simplify 
the international tax provisions of the U.S. tax laws. For that 
reason alone, if not for others, this effort by the 
Subcommittee, which focuses the spotlight on U.S. international 
tax policy, is valuable and should be applauded.
    The NFTC is concerned that the current and previous 
Administrations, as well as previous Congresses, have often 
turned to the international provisions of the Internal Revenue 
Code to find revenues to fund domestic priorities, in spite of 
the pernicious effects of such changes on the competitiveness 
of United States businesses in world markets. The Council is 
further concerned that such initiatives may have resulted in 
satisfaction of other short-term goals to the serious detriment 
of longer-term growth of the U.S. economy and U.S. jobs through 
foreign trade policies long consistent in both Republican and 
Democratic Administrations, including the present one.
    The provisions of Subchapter N of the Internal Revenue Code 
of 1986 (Title 26 of the United States Code is hereafter 
referred to as the ``Code'') impose rules on the operations of 
American business operating in the international context that 
are much different in important respects than those imposed by 
many other nations upon their companies. Some of these 
differences, noted in the sections that follow, make American 
business interests less competitive in foreign markets when 
compared to those from our most significant trading partners:
     The United States taxes worldwide income of its 
citizens and corporations who do business and derive income 
outside the territorial limits of the United States. Although 
other important trading countries also tax the worldwide income 
of their nationals and companies doing business outside their 
territories, such systems generally are less complex and 
provide for ``deferral'' \1\ subject to less significant 
limitations under their tax statutes or treaties than their 
U.S. counterparts. Importantly, many of our trading partners 
have systems that more closely approximate ``territorial'' 
systems of taxation, in which generally only income sourced in 
the jurisdiction is taxed.
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    \1\ The foreign income of a foreign corporation is not ordinarily 
subject to U.S. taxation, since the United States has neither a 
residence nor a source basis for imposing tax. This applies generally 
to any foreign corporation, whether it is foreign-owned or U.S.-owned. 
This means that in the case of a U.S.-controlled foreign corporation 
(CFC), U.S. tax is normally imposed only when the CFC's foreign 
earnings are repatriated to the U.S. owners, typically in the form of a 
dividend. However, subpart F of the Code alters these general rules to 
accelerate the imposition of U.S. tax with respect to various 
categories of income earned by CFCs.
    It is common usage in international tax circles to refer to the 
normal treatment of CFC income as ``deferral'' of U.S. tax, and to 
refer to the operation of subpart F as ``denying the benefit of 
deferral.'' However, given the general jurisdictional principles that 
underlie the operation of the U.S. rules, we view that usage as 
somewhat inaccurate, since it could be read to imply that U.S. tax 
``should'' have been imposed currently in some normative sense. Given 
that the normative rule imposes no U.S. tax on the foreign income of a 
foreign person, we believe that subpart F can more accurately be 
referred to as ``accelerating'' a tax that would not be imposed until a 
later date under normal rules.
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     The United States has more complex rules for the 
limitation of ``deferral'' than any other major industrialized 
country. In particular, we have determined that: (1) the 
economic policy justification for the current structure of 
subpart F has been substantially eroded by the growth of a 
global economy; (2) the breadth of subpart F exceeds the 
international norms for such rules, adversely affecting the 
competitiveness of U.S.-based companies; and (3) the 
application of subpart F to various categories of income that 
arise in the course of active foreign business operations 
should be substantially narrowed.
     The U.S. foreign tax credit system is very 
complex, particularly in the computation of limitations under 
the provisions of section 904 of the Code. While the theoretic 
purity of the computations may be debatable, the significant 
administrative costs of applying and enforcing the rules by 
taxpayers and the government is not. Systems imposed by other 
countries are in all cases less complex.
     The United States has more complex rules for the 
determination of U.S. and foreign source net income than any 
other major industrialized country. In particular, this is true 
with respect to the detailed rules for the allocation and 
apportionment of deductions and expenses. In many cases, these 
rules are in conflict with those of other countries, and where 
this conflict occurs, there is significant risk of double 
taxation. We further address one of the more significant 
anomalies, that of the allocation and apportionment of interest 
expense, later in this testimony.
     The current U.S. Alternative Minimum Tax (AMT) 
system imposes numerous rules on U.S. taxpayers that seriously 
impede the competitiveness of U.S. based companies. For 
example, the U.S. AMT provides a cost recovery system that is 
inferior to that enjoyed by companies investing in our major 
competitor countries; additionally, the current AMT 90-percent 
limitation on foreign tax credit utilization imposes an unfair 
double tax on profits earned by U.S. multinational companies--
in some cases resulting in a U.S. tax on income that has been 
taxed in a foreign jurisdiction at a higher rate than the U.S. 
tax.
    As noted above, the United States system for the taxation 
of the foreign business of its citizens and companies is more 
complex than that of any of our trading partners, and perhaps 
more complex than that of any other country.
    That result is not without some merit. The United States 
has long believed in the rule of law and the self-assessment of 
taxes, and some of the complexity of its income tax results 
from efforts to more clearly define the law in order for its 
citizens and companies to apply it. Other countries may rely to 
a greater degree on government assessment and negotiation 
between taxpayer and government--traits which may lead to more 
government intervention in the affairs of its citizens, less 
even and fair application of the law among all affected 
citizens and companies, and less certainty and predictability 
of results in a given transaction. In some other cases, the 
complexity of the U.S. system may simply be ahead of 
development along similar lines in other countries--many other 
countries have adopted an income tax similar to that of the 
United States, and a number of these systems have eventually 
adopted one or more of the significant features of the U.S. 
system of taxing transnational transactions: taxation of 
foreign income, anti-deferral regimes, foreign tax credits, and 
so on. However, after careful inspection and study, we have 
concluded that the United States system for taxation of foreign 
income of its citizens and corporations is far more complex and 
burdensome than that of all other significant trading nations, 
and far more complex and burdensome than what is necessitated 
by appropriate tax policy.
    U.S. government officials have increasingly criticized 
suggestions that U.S. taxation of international business be 
ameliorated and infused with common sense consideration of the 
ability of U.S. firms to compete abroad. Their criticism either 
directly or implicitly accuses proponents of such policies of 
advocating an unwarranted reaction to ``harmful tax 
competition,'' by joining a ``race to the bottom.'' The idea, 
of course, is that any deviation from the U.S. model indicates 
that the government concerned has yielded to powerful business 
interests and has enacted tax laws that are intended to provide 
its home-country based multinationals a competitive advantage. 
It is seldom, if ever, acknowledged that the less stringent 
rules of other countries might reflect a more reasonable 
balance of the rival policy concerns of neutrality and 
competitiveness. U.S. officials seem to infer from the 
comparisons that what is being advocated is that the United 
States should adopt the lowest common denominator so as to 
provide U.S. businesses a competitive advantage. Officials 
contend this is a ``slippery slope'' since foreign governments 
will respond with further relaxations until each jurisdiction 
has reached the ``bottom.''
    The inference is unwarranted. Let us look at our subpart F 
regime, for example. The regimes enacted by other countries 
that we have studied all were enacted in response to, and after 
several years of, scrutiny of the United States' regimes. They 
reflect a careful study of the impact of our rules in subpart 
F, and, in every case, embody some substantial refinements of 
the U.S. rules. Each regime has been in place for a number of 
years, giving the government concerned time to study its 
operation and conclude whether the regime is either too harsh 
or too liberal. While each jurisdiction has approached CFC 
issues somewhat differently, as noted, each has adopted a 
regime that, in at least some important respects, is less harsh 
than the United States' subpart F rules. The proper inference 
to draw from the comparison is that the United States has tried 
to lead and, while many have followed, none has followed as far 
as the United States has gone. A relaxation of subpart F to 
even the highest common denominator among other countries' CFC 
regimes would help redress the competitive imbalance created by 
subpart F without contributing to a race to the bottom.
    The reluctance of others to follow the U.S. may in part 
also be attributable to recognition that the U.S. system has 
required very significant compliance costs of both taxpayer and 
the Internal Revenue Service, particularly in the international 
area where the costs of compliance burdens are 
disproportionately higher relative to U.S. taxation of domestic 
income and to the taxation of international income by other 
countries.

          There is ample anecdotal evidence that the United States' 
        system of taxing the foreign-source income of its resident 
        multinationals is extraordinarily complex, causing the 
        companies considerable cost to comply with the system, 
        complicating long-range planning decisions, reducing the 
        accuracy of the information transmitted to the Internal Revenue 
        Service (IRS), and even endangering the competitive position of 
        U.S.-based multinational enterprises.\2\
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    \2\ See Marsha Blumenthal and Joel B. Slemrod, ``The Compliance 
Cost of Taxing Foreign-Source Income: Its Magnitude, Determinants, and 
Policy Implications,'' in National Tax Policy in an International 
Economy: Summary of Conference Papers, (International Tax Policy Forum: 
Washington, D.C., 1994).

    Many foreign companies do not appear to face the same level 
of costs in their operations. The European Community Ruding 
Committee survey of 965 European firms found no evidence that 
compliance costs were higher for foreign source income than for 
domestic source income.\3\ Lower compliance costs and simpler 
systems that often produce a more favorable result in a given 
situation are competitive advantages afforded these foreign 
firms relative to their U.S.-based counterparts.
---------------------------------------------------------------------------
    \3\ Id.
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    In the 1960s, the United States completely dominated the 
global economy, accounting for over 50% of worldwide cross-
border investment and 40% of worldwide GDP. As of the mid-
1990s, the U.S. economy accounted for about 25% of the world's 
foreign direct investment and GDP.
    The current picture is very different. U.S. companies now 
face strong competition at home. Since 1980, the stock of 
foreign direct investment in the United States has increased by 
a factor of 6, and $20 of every $100 of direct cross-border 
investment flows into the United States. Foreign companies own 
approximately 14% of all U.S. non-bank corporate assets, and 
over 27% of the U.S. chemical industry alone. Moreover, imports 
have tripled as a share of GDP in the 1960s to an average of 
over 9.6% over the 1990-1997 period.
    That the world economy has grown more rapidly that the U.S. 
economy over the last 3 decades represents an opportunity for 
U.S. companies and workers that are able to participate in 
these markets. Foreign markets now frequently offer greater 
growth opportunities to U.S. companies than the domestic 
market. In the 1960s, foreign operations averaged just 7.5% of 
U.S. corporate net income; by contrast, over the 1990-1997 
period, foreign earnings represented 17.7 percent of all U.S. 
corporate income. A recent study of the 500 largest publicly-
traded U.S. corporations finds that sales by foreign 
subsidiaries increased from 25 % of worldwide sales in 1985 to 
34% in 1997. From 1986 to 1997, foreign sales of these 
companies grew 10% a year, compared to domestic growth of just 
3% annually. In fact, many of our members tell us that foreign 
sales now account for more than 50% of their revenue and their 
profits.
    However, this growth in foreign markets is much more 
competitive that in earlier decades. The 21,000 foreign 
affiliates of U.S. multinationals now compete with about 
260,000 foreign affiliates of multinationals headquartered in 
other nations. Over the last three decades, the U.S. share of 
the world's export market has declined. In 1960, one of every 
$6 of world exports originated from the United States. By 1996, 
the United States supplied only one of every $9 of world export 
sales. Despite a 30% loss in world export market share, the 
U.S. economy depends on exports to a much greater degree. The 
share of our national income attributable to exports has more 
than doubled since the 1960s.
    Foreign subsidiaries of U.S. companies play a critical role 
in boosting U.S. exports--by marketing, distributing, and 
finishing U.S. products in foreign markets. In 1996, U.S. 
multinational companies were involved in 65% of all U.S. 
merchandise export sales. U.S. industries with a high 
percentage of investment abroad are the same industries that 
export a large percentage of domestic production. And studies 
have shown that these exports support higher wages in exporting 
companies in the United States.\4\
---------------------------------------------------------------------------
    \4\ See, Ch. 6, The NFTC Foreign Income Project: International Tax 
Policy for the 21st Century, March 25, 1999.
---------------------------------------------------------------------------
    Taking into account individual as well as corporate-level 
taxes, a report by the Organization for Economic Cooperation 
and Development (OECD) finds that the cost of capital for both 
domestic (8.0 percent) and foreign investment (8.8 percent) by 
U.S.-based companies is significantly higher than the averages 
for the other G-7 countries (7.2 percent domestic and 8.0 
percent foreign). The United States and Japan are tied as the 
least competitive G-7 countries for a multinational company to 
locate its headquarters, taking into account taxation at both 
the individual and corporate levels.\5\ These findings have an 
ominous quality, given the recent spate of acquisitions of 
large U.S.-based companies by their foreign competitors.\6\ In 
fact, of the world's 20 largest companies (ranked by sales) in 
1960, 18 were headquarter- ed in the United States. By the mid-
1990s, that number had dropped to 8.
---------------------------------------------------------------------------
    \5\ OECD, Taxing Profits in a Global Economy: Domestic and 
International Issues (1991).
    \6\ See, e.g., testimony before the Committee on Finance, U.S. 
Senate, March 11, 1999.
---------------------------------------------------------------------------
    Short of fundamental reform--a reform in which the United 
States federal income tax system is eliminated in favor of some 
other sort of system--there are many aspects of the current 
system that could be reformed and greatly improved. These 
reforms could significantly lower the cost of capital, the cost 
of administration, and therefore the cost of doing business for 
U.S.-based firms.
    In this regard, for example, the NFTC strongly supports the 
International Tax Simplification for American Competitiveness 
Act of 1999, H.R. 2018, recently introduced by you Mr. 
Chairman, and Mr. Levin, and Mr. Sam Johnson, and joined by 
four other Members: Mr. Crane, Mr. Herger, Mr. English, and Mr. 
Matsui. We congratulate you on your efforts to make these 
amendments. They address important concerns of our companies in 
their efforts to export American products and create jobs for 
American workers.
    Against this background, the NFTC would also like to 
elaborate on some of the provisions in H.R. 2018 in areas that 
illustrate problems with significant impact on our members, as 
well as others that are under consideration in pending 
legislation yet to be introduced.

                    Look Through for 10/50 Companies

    The 1997 Tax Act no longer requires U.S. companies operating joint 
ventures (``JVs'') in foreign countries to calculate separate foreign 
tax credit (``FTC'') limitations for income earned from each JV in 
which the U.S. owner holds at least 10 percent, but no more than 50 
percent, of the JV ownership. The 1997 Tax Act now allows U.S. owners 
to compute FTCs with respect to dividends from such entities based on 
the underlying character of the entities' income (i.e., ``look-
through'' treatment). However, the change is only effective for 
dividends received after the year 2002. A separate ``Super'' FTC basket 
is still required to be maintained for dividends received after 2002 
but attributable to earnings and profits of the JV from years before 
2003.
    As stated by the Clinton Administration in its budget proposals 
issued earlier this year, the concurrent application of both a single 
basket approach for pre-2003 earnings and a look-through approach for 
post-2002 earnings would result in significant complexity to taxpayers. 
Thus, Section 208 of your bill would offer much needed simplicity for 
foreign JVs by eliminating the ``Super'' FTC basket and accelerating 
the effective date for application of the ``look-through'' rules to all 
dividends received after 1999, regardless of when the earnings and 
profits underlying those dividends were generated. As stated earlier by 
Treasury, this reduction in complexity and compliance burdens will 
reduce the bias against U.S. participation in foreign JVs, and help 
U.S.-based companies to compete more effectively with foreign-based JV 
partners.

       Look-Through Treatment for Interest, Rents, and Royalties

    As just mentioned, the 1997 Tax Act extended look-through treatment 
to certain dividends received from 10/50 Companies after the year 2002, 
but it failed to extend look-through treatment to interest, rents, and 
royalties from these same foreign JVs. U.S. shareholders of foreign JVs 
are often unable (due either to government restrictions or business 
practices) to acquire controlling interests, especially in cases where 
the foreign JV partner is a foreign government, or the activity 
involved in is a government regulated industry. It is patently unfair 
to penalize such non-controlling JV partners. Thus, Section 205 of your 
bill extends look-through treatment to interest, rents, and royalties 
received from foreign JVs after this year.
    Current tax rules also require that payments of interest, rents, 
and royalties from noncontrolled foreign partnerships (i.e., foreign 
partnerships owned between 10 and 50 percent by U.S. owners) must be 
treated as separate basket income to the JV partners. Again, this 
result is not good tax policy. Thus, your bill extends look-through 
treatment to these entities as well. Such legislative action would 
bring much needed consistency and fairness to this area of the tax law, 
by allowing look-through treatment to all forms of income streams, and 
to all forms of business enterprises.

       Look-Through Treatment for Sales of Partnership Interests

    Currently, gains from sales of partnership interests are also 
treated as separate basket passive income, even though U.S. partners 
owning 10 percent or more of the value of foreign partnerships can 
apply look-through treatment for their distributive shares of such 
partnership income (although not interest, rents or royalties as stated 
before). Consistent with our earlier comments concerning look-through 
treatment in general, we support your provision in Section 107, which 
treats gains or losses associated with the disposition of a partnership 
interest as a disposition of the partner's proportionate share of each 
of the assets of the partnership.

                 Amend the Domestic Loss Recapture Rule

    Currently, when a taxpayer has taxable income from U.S. sources but 
an overall loss from foreign sources, the foreign source loss reduces 
the U.S. source taxable income and U.S. tax liability by decreasing the 
taxpayer's worldwide taxable income on which the U.S. tax is based. 
When the taxpayer subsequently generates foreign source income, the 
prior tax benefit is recaptured by treating a portion of that foreign 
income as domestic source for purposes of determining the FTC 
limitation. Current law also provides that an overall domestic loss 
reduces a taxpayer's foreign source income. The U.S. loss reduces the 
taxpayer's U.S. tax liability and, through application of the loss 
against foreign income, the FTC limitation is correspondingly reduced. 
There is no symmetry in these rules, however, in the case where it is a 
domestic loss that is incurred. In contrast to the foreign provisions, 
taxpayers are not allowed to recover or recapture foreign source income 
that was lost due to a domestic loss. To prevent this inequity and 
remove this anomaly, Section 202 of your bill would recharacterize such 
subsequent domestic income as foreign source to the extent of the prior 
domestic loss, and therefore allow the FTC that was disallowed because 
of the domestic loss.

            Subpart F Exemption for Active Financing Income

    We also applaud Section 101 of your bill, which extends the one-
year provision enacted last year providing deferral of U.S. tax on non-
U.S. income earned in the active conduct of a banking, financial, or 
similar business. This provision, particularly if made permanent, would 
significantly assist U.S. based financial service companies to compete 
successfully in the international marketplace against foreign based 
companies. It would also bring some consistency in the U.S. tax rules 
by treating active income earned by financial service companies 
similarly to active income earned by U.S. companies in other 
industries.
    Let us underscore the importance of this provision--U.S. banks and 
financial companies have historically expanded abroad hand-in-hand with 
U.S. industrial and service companies. They have, however, become an 
endangered species, as now only two (2) are ranked in the top twenty-
five (25) financial services companies in the world, ranked by asset 
size (Citigroup and Chase Manhattan Corporation). Recent acquisitions 
of U.S.-based companies, such as Bankers Trust and Republic Bank, as 
well as growth in foreign-based companies have changed the global 
landscape beyond recognition.

  Repeal the Alternative Minimum Tax 90 Percent Limitation on Foreign 
                              Tax Credits

    Current law limits the ability of taxpayers to offset their 
corporate AMT liability by only allowing FTCs to offset up to 90 
percent of such AMT. This has the likely result of taxing certain U.S. 
multinationals more heavily on their foreign income than their foreign 
competitors, or other domestic companies that have no foreign 
operations. Section 207 of your bill repeals this limitation and merely 
permits foreign taxes actually paid to be offset up to the amount of 
AMT liability on foreign source income, without affecting any U.S. 
source tax liability. As a result, the likelihood of double and 
sometimes triple taxation of foreign source income would be lessened, 
making U.S. multinationals more competitive internationally.

      Restrict Application of Excise Tax to Airline Mileage Awards

    The 1997 Tax Act imposed a 7.5 percent aviation excise tax on 
amounts paid to air carriers for the right to provide mileage awards 
(or other cost reductions) for air transportation. However, that 
legislation failed to specify the geographical or transactional scope 
of the excise tax, and has caused significant problems in the tourism 
industry and complaints from other governments. Your Section 307 would 
clarify that the excise tax does not apply to certain payments for the 
right to provide mileage awards predominantly to foreign persons (who 
are outside the taxing arm of the U.S. government).

 Remove Pipeline Transportation Income and Income from Transmission of 
           High Voltage Electricity from Subpart F Treatment

    In 1982, Congress expanded subpart F income to include certain 
types of oil related income, such as income from operating an oil or 
gas pipeline in a country other than where the oil or gas was extracted 
or sold. The expansion of subpart F was due to a concern that petroleum 
companies had been paying too little U.S. tax on their foreign 
subsidiaries' operations relative to their high revenue. Specifically, 
Congress thought that U.S. tax could be avoided on the downstream 
activities of a foreign subsidiary because the income of the subsidiary 
was not subject to U.S. tax until that income was paid to its 
shareholders. The argument was that because of the fungible nature of 
oil and because of the complex structures involved, oil income was 
particularly suited to tax haven type operations.
    However, this treatment is contrary to the original intent of 
subpart F, which primarily was aimed at passive and other easily 
movable income, rather than active income. Pipeline income, on the 
other hand, is neither passive nor easily movable. Moreover, no other 
major industrial country has special rules that sweep pipeline income 
into its anti-deferral regime. Consequently, U.S. companies find it 
difficult to compete with foreign-based multinationals for pipeline 
projects that would generate income subject to subpart F. Therefore, we 
applaud Section 105 of your bill, which would no longer treat as 
subpart F income, any income derived from the pipeline transportation 
of oil or gas within a foreign country.
    Similarly, Section 106 of your bill would allow U.S.-based utility 
companies to enter foreign markets for electricity. These complex 
projects often involve the construction of costly fixed transmission 
systems that in some cases cross national boundaries. This income is 
also neither passive nor easily movable. Imposition of subpart F 
treatment on them is not justifiable, and is counterproductive to the 
interests of the United States.

  Extension of Carryforward Period and Ordering Rules for Foreign Tax 
                           Credit Carryovers

    When companies invest overseas, they often receive favorable local 
tax treatment from foreign governments, at least in the early years of 
operation. For example, companies are sometimes granted rapid 
depreciation write-offs, and/or low or even zero tax rates, for a 
period of years until the new venture is up and running. This results 
in a low effective tax rate in those foreign countries for those early 
years of operation. For U.S. tax purposes, however, those foreign 
operations must utilize much slower capital recovery methods and rates, 
and are still subject to residual U.S. tax at 35 percent. Thus, even 
though those foreign operations may show very little profit from a 
local standpoint, they may owe high incremental taxes to the U.S. 
government on repatriations or deemed distributions to the U.S. parent. 
However, once such operations are ongoing for some length of time, this 
tax disparity often turns around, with local tax obligations exceeding 
residual U.S. taxes. At that point, the foreign operations generate 
excess FTCs but, without an adequate carryback and carryforward period, 
those excess FTCs will expire.
    The U.S. tax system is based on the premise that FTCs help 
alleviate double taxation of foreign source income. By granting 
taxpayers a dollar-for-dollar credit against their U.S. liability for 
taxes paid to local foreign governments, the U.S. government allows its 
taxpayers to compete more fairly and effectively in the international 
arena. However, by imposing limits on carryovers of excess FTCs, the 
value of these FTCs diminish considerably (if not entirely in many 
situations). Thus, the threat of double taxation of foreign earnings 
becomes much more likely.
    Sections 201 and 206 of your bill extend the carryover period, and 
useful life, respectively, of FTCs. Section 201 extends the carryover 
period from 5 to 10 years, while Section 206 allows old carryovers to 
be utilized first, which results in a ``freshening'' of unexpired FTCs. 
Both of these provisions would help reduce the costs of doing business 
overseas for U.S. multinationals, and help eliminate competitive 
disadvantages suffered by U.S.-based companies versus foreign-based 
companies. Please keep in mind that higher business taxes for U.S. 
companies may result in higher prices for goods and services sold to 
U.S. consumers, stagnant or lower wages paid to American workers in 
those businesses, reduced capital investment leading, perhaps, to work 
force reductions or decreased benefits, and smaller returns to 
shareholders. Those shareholders may be the company's employees, or the 
pension plans of other middle class workers.
    We also note that the President's Fiscal Year 1998 Budget contained 
a proposal to reduce the carryback period for excess foreign tax 
credits from two years to one year. This proposal has been and is 
currently being considered in the Senate as a revenue raiser for one or 
more pending bills. The NFTC strongly opposes this proposal. Like the 
carryforward period, the carryback of foreign tax credits helps to 
ensure that foreign taxes will be available to offset U.S. taxes on the 
income in the year in which the income is recognized for U.S. purposes. 
Shortening the carryback period also could have the effect of reducing 
the present value of foreign tax credits and therefore increasing the 
effective tax rate on foreign source income.

                       Repeal of Code Section 907

    Under current law, in additional to having to calculate separate 
foreign tax credit (``FTC'') limitations for income earned from each 
separate category or ``basket'' under section 904(d) (e.g., the passive 
income basket, shipping income basket, etc.), multinational oil 
companies are also required to calculate a separate limitation on their 
foreign oil and gas extraction income (``FOGEI'') under Code Section 
907. Section 208 of your bill would repeal Code Section 907 and, thus, 
eliminate the additional separate limitation on FOGEI.
    As background, Section 907 was originally enacted in response to a 
Congressional concern that oil industry taxpayers were paying amounts 
to foreign governments that were ostensibly ``taxes'' but were in 
reality ``disguised royalties.'' The issue arose from the fact that in 
foreign countries, the sovereign usually retains the right to its 
natural resources in the ground. Thus, a major concern was whether 
payments made to foreign governments were for grants of specific 
economic benefits or general taxes. Congress wanted to limit the FTC to 
that amount of the ``government take'' which was perceived to be a tax 
payment, and not a royalty. Moreover, once the tax component was 
identified, Congress wanted to prevent oil companies from using excess 
FOGEI credits to shield U.S. tax on certain low-taxed ``other'' income, 
such as passive income or shipping income.
    However, both concerns have already been adequately addressed in 
subsequent legislation or rulemaking. First, under Treasury Decision 
7918, so-called ``dual capacity taxpayer'' regulations were issued 
which help taxpayers to determine how to separate payments to foreign 
governments into their income tax element and ``specific economic 
benefit'' element. Second, the 1986 Tax Act fragmented foreign source 
income into various FTC ``baskets,'' restricting taxpayers from 
offsetting excess FTCs from high-taxed income, including FOGEI, against 
taxes due on low-taxed categories of income, such as passive or 
shipping income.
    We emphasize that compliance with the rules under Code Sec.  907 is 
extremely complicated and time consuming for both taxpayers and the 
IRS. Distinctions must be made as to various items of income and 
expense to determine whether they properly fall under the FOGEI 
category, or the FORI (or other) category. Painstaking efforts are 
often needed to categorize and properly account for thousands of income 
and expense items, which must then be explained to IRS agents upon 
audit. Ironically, such efforts typically result in no or little net 
tax liability changes, since U.S.-based oil companies have, since the 
inception of section 907, had excess FTCs in their FORI income 
category. As a result, oil industry taxpayers, which already must deal 
with depressed world oil prices, also must incur large administrative 
costs to comply with a section of the Income Tax Code that results in 
little or no revenue to the Federal Treasury.
    Current Section 907 clearly increases the cost for U.S. companies 
of participating in foreign oil and gas development. Ultimately, this 
will adversely affect U.S. employment by hindering U.S. companies in 
their competition with foreign concerns. Although the host country 
resource will be developed, it will be done so by foreign competition, 
with the adverse ripple effect of U.S. job losses and the loss of 
continuing evolution of U.S. technology. The loss of any major foreign 
project to a U.S. company will mean less employment in the U.S. by 
suppliers, and by the U.S. parent, in addition to fewer U.S. 
expatriates at foreign locations. By contrast, foreign oil and gas 
development by U.S. companies assures utilization of U.S. supplies of 
hardware and technology, ultimately resulting in increased U.S. job 
opportunities.

        Extension of FSC Benefits to Exports of Defense Products

    Code Section 923(a)(5) reduces the tax exemption available to 
companies that sell defense products abroad to 50 percent of the 
benefits available to other exporters. This provision prevents defense 
companies from competing as effectively as they could in increasingly 
challenging foreign markets.
    Any U.S. exporter may establish Foreign Sales Corporations (FSCs) 
under which a portion of their earnings from foreign sales is exempt 
from U.S. taxation. This provision is designed to achieve tax parity 
with the territorial tax systems of our trading partners, i.e., it 
mirrors the economic effects of European Union tax systems on their 
exported products, for example.
    For exporters of defense products, however, the FSC tax incentive 
is reduced by 50 percent, compared to the full benefit for all other 
products. That limitation, enacted in 1976, was based on the premise 
that military products were not sold in a competitive market 
environment and the FSC benefit was therefore not necessary for defense 
exporters.
    Whatever the veracity of that premise 20 years ago, today military 
exports are subject to fierce international competition in every area. 
Moreover, with the sharp decline in the defense budget over the past 
decade, exports of defense products have become ever more critical to 
maintaining a viable U.S. defense industrial base. The aerospace 
industry alone provides over 800,000 jobs for U.S. workers. Roughly 
one-third of these jobs are tied directly to export sales. In 1996, for 
example, total industry sales were $112 billion, $37 billion of which 
was for exports.
    Maintaining exports of defense products is today more difficult 
than ever before. First, the U.S. government prohibits the sale of 
defense products to certain countries and must approve all others in 
advance. Second, European and other states are developing export 
promotion projects to counter the industrial impact of their own 
declining defense budgets by being more competitive internationally. 
Finally, a number of Western purchasers of defense equipment now view 
Russia and other formerly communist countries as acceptable suppliers, 
further intensifying the global competition.
    No valid economic or policy reason exists for continuing a tax 
policy that discriminates against a particular class of manufactured 
products. Furthermore, repealing this section will not impact the 
foreign policy of the United States. Military sales will continue to be 
subject to the license requirements of the Arms Export Control Act.
    An egregious example of how these rules discriminate against 
certain products involves commercial communications satellites. U.S. 
manufacturers are the world's leaders in the production and deployment 
of communications satellites. Until this year, commercial 
communications satellites manufactured in the United States qualified 
for full FSC benefits. For export control purposes, the Strom Thurmond 
National Defense Authorization Act for Fiscal Year 1999 transferred 
jurisdiction over commercial satellite exports from the Commerce 
Department Commerce Control List (CCL) to the State Department U.S. 
Munitions List (USML), effective March 15, 1999. An unintended result 
of this jurisdictional change is that commercial communications 
satellites and related items are now ``military property'' for purposes 
of the FSC rules. This unintended result should be corrected and the 
full FSC benefit for commercial communications satellites should be 
restored. In fact, the House of Representatives Select Committee on 
Technology Transfers to the Peoples Republic of China, chaired by 
Representative Christopher Cox, recommended that satellite 
manufacturers should not suffer a tax increase because of the transfer 
from CCL to USML.
    Improvement of the U.S. trade imbalance is fundamental to the 
health of our economy. The benefits provided by the FSC provisions 
contribute significantly to the ability of U.S. exporters to compete 
effectively in foreign markets. The FSC limitation on the exemption for 
defense exports hampers the ability of U.S. companies, many of whom 
already have access to large foreign markets, to compete effectively 
abroad with many of their products. Section 923(a)(5) should be 
repealed immediately to remove this impediment to the international 
competitiveness and to the future health of our defense industry.
    Section 303 of your bill, Mr. Chairman, and an identical provision 
included in a stand-alone bill, H.R. 796, would remedy this situation. 
H.R. 796 currently has 54 cosponsors, including 28 of the 39 members of 
the Committee.
    In addition to these areas of concern that have been addressed in 
your bill, as noted above we have significant concerns in another area 
that we would like to address.

                     Allocation of Interest Expense

    Prior to January 3, 1977, when Treasury issued its final Regulation 
Sec. 1.861-8, there essentially was no requirement to allocate and 
apportion U.S. interest expense to foreign-sourced income. Moreover, 
even under these 1977 regulations, opportunities were available to 
minimize the impact of interest allocation. For example, interest could 
be allocated on a separate company basis. Thus, corporate structures 
could be organized so that U.S. debt could be carried only by companies 
in an affiliated group that had domestic source income, eliminating any 
allocation of interest to foreign sourced income.
    The 1986 Tax Reform Act required that allocation of interest now be 
made on a consolidated group basis. It also eliminated the optional 
gross income method for allocating interest, and required that earnings 
and profits of more than ten percent owned subsidiaries be added to 
their stock bases for purposes of allocating interest under the asset-
tax basis method. Also in 1986, while advancing the concept of 
``fungibility,'' Congress nevertheless failed to allow an offset for 
interest expense incurred by foreign affiliates. Although such a 
``worldwide fungibility'' provision was included in the Senate-passed 
version of the bill in 1986, it was dropped in Conference. Similarly, a 
subgroup/tracing exception approved by the Senate was also dropped from 
the final 1986 Act. While these fungibility and subgroup/tracing 
provisions have appeared in later tax bills (see e.g., H.R. 2948 
(``Gradison Bill'') introduced in 1991 and H.R. 5270 (``Rostenkowski 
Bill'') introduced in 1992), they have never been enacted.
    The NFTC strongly suggests that Congress fix the inequitable 
interest allocation rules currently existing in the law. They are 
extremely costly and particularly anti-competitive for multinational 
corporations. By failing to take into account borrowings of foreign 
affiliates, the law results in a double allocation of interest expense. 
Moreover, these rules operate to impede a U.S. multinational 
corporation's ability to utilize the foreign tax credit for purposes of 
mitigating double taxation. It is simply unfair that U.S. 
multinationals with U.S. subsidiaries operating solely in the U.S. 
market, where the subsidiary incurs its debt on the basis of its own 
credit, must nevertheless allocate part of that interest expense 
against wholly unrelated foreign generated income.
    One solution, of course, is simply to reinstate and codify the pre-
1986 Act interest allocation rules permitting interest expense to be 
allocated on a separate company basis. However, due to the strong 
criticism of the rules in 1986, this approach is unlikely to succeed. 
We, therefore, suggest an alternative approach of advancing the 
provisions that were passed by the Senate in connection with the 1986 
Act. Recall that under the earlier Senate version, interest expense of 
foreign affiliates would be added to the total interest expense ``pot'' 
to be allocated among all affiliates. Thus, this approach allows 
adoption of the ``worldwide fungibility'' concept of allocating 
interest, as opposed to the ``water's edge'' approach of current law. 
We also suggest the inclusion of an elective ``subgroup'' or tracing 
rule that allows interest expense to be allocated based on a subgroup 
consisting of only the borrower and its direct and indirect 
subsidiaries. This approach allows interest that should be specifically 
allocated to a particular domestic operation to remain identified with 
such operation, a much more equitable approach than under current law.

                             In Conclusion

    In particular, our study of the international tax system of the 
United States has led us so far to four broad conclusions:
     U.S.-based companies are now far less dominant in global 
markets, and hence more adversely affected by the competitive 
disadvantage of incurring current home-country taxes with respect to 
income that, in the hands of a non-U.S. based competitor, is subject 
only to local taxation; and
     U.S.-based companies are more dependent on global markets 
for a significant share of their sales and profits, and hence have 
plentiful non-tax reasons for establishing foreign operations.
     Changes in U.S. tax law in recent decades have on balance 
increased the taxation of foreign income.
     United States policy in regard to trade matters has been 
broadly expansionist for many years, but its tax policy has not 
followed suit.
    These two incompatible trends--decreasing U.S. dominance in global 
markets set against increasing U.S. taxation of foreign income--are not 
claimed by us to have any necessary causal relation. However, they 
strongly suggest that we must re-evaluate the balance of policies that 
underlie our international tax system.
    Again, the Council applauds the Chairman and the Members of the 
Subcommittee for beginning the process of reexamining the international 
tax system of the United States. These tax provisions significantly 
affect the national welfare, and we believe the Congress should 
undertake careful modification of them in ways that will enhance the 
participation of the United States in the global economy of the 21st 
Century. We would enjoy the opportunity to work with you and the 
Committee in further defining both the problems and potential 
solutions. The NFTC would hope to make a contribution to this important 
business of the Subcommittee. The NFTC is prepared to make 
recommendations for broader reforms of the Code to address the 
anomalies and problems noted in our review of the U.S. international 
tax system, and would enjoy the opportunity to do so.
[GRAPHIC] [TIFF OMITTED] T5844.001

                                


    Chairman Houghton. Thanks very much, Mr. Luby.
    Before we go on, I want to introduce Mr. Wes Watkins, 
Congressman from Oklahoma. We are delighted you are here, Mr. 
Watkins.
    And, then, Mr. Lester Ezrati, would you please testify?

  STATEMENT OF LESTER D. EZRATI, GENERAL TAX COUNSEL, HEWLETT-
  PACKARD COMPANY, PALO ALTO, CALIFORNIA, AND PRESIDENT, TAX 
                   EXECUTIVES INSTITUTE, INC.

    Mr. Ezrati. Thank you, Mr. Chairman. I am general tax 
counsel for Hewlett-Packard Company in Palo Alto, California. I 
am here today as president of Tax Executives Institute, the 
preeminent group of in-house tax professionals in North 
America. Our 5,000 members represent the 2,700 largest 
corporations in the United States and Canada, most of which 
have significant operations overseas.
    TEI believes that the Code's foreign provisions need 
fundamental reform and simplification, and for this reason, we 
support H.R. 2018. Enactment of this bill will generally reduce 
the cost of complying with the laws without any material 
diminution in tax dollars flowing to the Treasury. The bill 
will not only reduce administrative burdens, thereby enhancing 
the country's competitiveness, but will also signal Congress's 
commitment to the simplification of the tax law generally. In 
addition, the bill will bring overdue reform to the foreign tax 
credit area where taxpayers have been especially burdened.
    Mr. Chairman, the proposals in H.R. 2018 have been 
described as modest. It marks a beginning, not an end. For 
example, in the more than three decades since their enactment, 
the Subpart F rules have been distended to capture more and 
more active operating income. Reform is needed here. One 
solution is to remove Subpart F's artificial barriers to 
competitiveness by excluding foreign-based companies' sales and 
services income from current taxation and allowing U.S. 
corporations to compete more effectively. Other areas to be 
addressed are the translation of the deemed-paid foreign tax 
credit rule under section 906 and the elimination of the 
current interest allocation rules. These comments 
notwithstanding, we agree with you, Mr. Chairman, that the bill 
represents a significant downpayment on further reform.
    I would now like to highlight two provisions in H.R. 2018 
that we believe are particularly important for the reform of 
international tax laws.
    First, TEI believes that taxpayers should be permitted to 
use generally accepted accounting principles to calculate the 
earnings and profits of controlled foreign corporations under 
Subpart F. Current law provides that a foreign corporation's 
earnings and profits is to be computed in accordance with rules 
substantially similar to those for domestic corporations. As a 
practical matter, however, a foreign corporation is frequently 
unable to compute E&P in the same manner as a domestic 
corporation. Although a domestic corporation generally 
calculates E&P by making adjustments to U.S. taxable income, a 
foreign corporation necessarily uses foreign book income as its 
starting point. This bill will provide significant 
simplification by permitting taxpayers to reduce their 
administrative burdens by using United States' generally 
accepted accounting principles (GAAP) to compute E&P. In our 
view, however, the provision should be elective, not mandatory.
    Second, TEI applauds section 207, which would eliminate the 
90-percent limitation on the use of the foreign tax credit to 
offset any alternative minimum tax liability. Giving taxpayers 
the ability to offset their entire liability with their foreign 
taxes will not frustrate the policy underlying the AMT and will 
further the goal of eliminating double taxation. A taxpayer 
with an AMT liability and sufficient foreign tax credits to 
offset that liability, has already paid a significant amount of 
tax. Clearly, that the tax has not been paid to the United 
States has no bearing on the economic cost it represents to the 
taxpayer. We therefore support the enactment of this provision.
    H.R. 2018 would also mandate two Treasury Department 
studies: one on the treatment of the European Union as a single 
country for purposes of the same-country exception to Subpart F 
and a second on the interest allocation rules. We commend the 
Chairman for recognizing that the European Community's 
elimination of barriers to cross-borders payments places U.S. 
corporations at a disadvantage. We suggest, however, that 
companies need relief now in order to remain competitive and 
urge Congress to consider the immediate adoption of this 
proposal.
    As for the interest allocation rules, we agree that they 
desperately need reform. In our view, the rules are not 
justified on economic grounds.
    Finally, I would like to address an issue not included in 
H.R. 2018--confidentiality of advance pricing agreements. Mr. 
Chairman, you recently voiced support for legislation to 
protect APAs from disclosure. As businesses become more global, 
it will become increasingly important for governments and 
taxpayers to work together to resolve disputes in creative, 
cost-effective ways, such as the APA Program. TEI strongly 
believes that any compromise of taxpayer confidentiality will 
have a negative effect on the future of this important program.
    Information set forth in an APA is highly fact-specific and 
involves sensitive financial and commercial information. 
Taxpayers submitted the pricing information to the IRS with the 
understanding that it would be kept confidential. That the IRS 
is preparing to disclose APAs threatens these companies' 
legitimate privacy interests and has already begun to undermine 
our relations with treaty partners and the future of the APA 
Program. For these reasons, TEI strongly supports enactment of 
legislation to protect APAs and supporting documents from 
disclosure.
    Mr. Chairman, we commend you for recognizing that the 
international provisions are among the most complex provisions 
of the Internal Revenue Code, and we pledge our support for 
your efforts to effect meaningful simplification and reform.
    Thank you for giving us the opportunity to testify, and I 
would be pleased to respond to your questions.
    [The prepared statement follows:]

Statement of Lester D. Ezrati, General Tax Council, Hewlett-Packard 
Company, Palo Alto, California, and President, Tax Executives 
Institute, Inc.

    Good afternoon. I am Lester D. Ezrati, General Tax Counsel 
for Hewlett-Packard Company in Palo Alto, California. I appear 
before you today as the president of Tax Executives Institute, 
the preeminent group of corporate tax professionals in North 
America. The Institute is pleased to provide the following 
comments on international complexity and simplification.

                               Background

    Tax Executives Institute is the preeminent association of corporate 
tax executives in North America. Our 5,000 members are accountants, 
attorneys, and other business professionals who work for the largest 
2,800 companies in the United States and Canada; they are responsible 
for conducting the tax affairs of their companies and ensuring their 
compliance with the tax laws. Hence, TEI members deal with the tax code 
in all its complexity, as well as with the Internal Revenue Service, on 
almost a daily basis. Most of the companies represented by our members 
are part of the IRS's Coordinated Examination Program, pursuant to 
which they are audited on an ongoing basis. TEI is dedicated to the 
development and effective implementation of sound tax policy, to 
promoting the uniform and equitable enforcement of the tax laws, and to 
reducing the cost and burden of administration and compliance to the 
benefit of taxpayers and government alike. Our background and 
experience enable us to bring a unique and, we believe, balanced 
perspective to the subject of international complexity and 
simplification.
    The international provisions of the Internal Revenue Code are among 
the most complicated provisions in the tax law. The last several years 
have seen several small steps taken to reduce tax law complexity for 
multinational corporations. For example, three years ago, Congress 
repealed section 956A of the Internal Revenue Code, which in our view 
was ill-conceived when it was enacted in 1993. And in 1997, Congress 
rectified an inequity that has existed for the past decade when it 
eliminated the overlap between the controlled foreign corporation and 
passive foreign investment company rules. Although laudable, these 
actions represent only a small step on the journey of simplifying the 
international tax provisions of the Internal Revenue Code.
    TEI believes that the Code's foreign provisions need fundamental 
reform and simplification, and for this reason we support H.R. 2018, 
the International Tax Simplification for American Competitiveness Act 
of 1999, which was introduced on June 7, 1999, by Oversight 
Subcommittee Chairman Amo Houghton and several other representatives. 
Enactment of this bill will generally reduce the costs of preparing 
U.S. corporate tax returns for American companies engaged in 
international trade without any material diminution in tax dollars 
flowing to the treasury. The bill will not only reduce compliance 
costs--thereby enhancing the country's competitiveness--but it will 
also signal Congress's continued commitment to the simplification of 
the tax law generally. In addition, the bill will bring long overdue, 
albeit partial, reform to the foreign tax credit area.
    Any simplification efforts will need to comprehend the changing 
face of the business environment, owing, among other things, to the 
growth of electronic commerce and business technologies. As businesses 
become more global and as companies strive to manage their supply 
chains digitally, the need for meaningful tax reform will become more 
and more manifest. In addition, it will become increasingly important 
for governments and taxpayers to work together to resolve--or 
forestall--disputes in creative, cost-effective ways, such as advanced 
pricing agreements (APAs). Accordingly, TEI is very pleased that 
Congressman Houghton and other members have voiced support for 
preserving the confidentiality of APAs. TEI strongly believes that any 
compromise of taxpayer confidentiality will have a negative effect on 
the future of the APA program.
    As Congressman Houghton noted in his introductory statement, H.R. 
2018 seeks reform ``in modest but important ways.'' We agree that, 
although a major leap forward, enactment of the bill will not obviate 
additional reform of the Code's international tax provisions--for 
example, in respect of Subpart F, which Chairman Houghton himself has 
singled out as an extremely complex area of the law. Subpart F was 
initially enacted as an exception to the deferral principle in order to 
tax the types of income considered relatively ``movable'' from one 
taxing jurisdiction to another and therefore able to take advantage of 
low rates of tax. In the three decades since its enactment, however, 
Subpart F has been distended to capture active operating income. One 
solution to removing Subpart F's artificial barrier to competitiveness 
would be to exclude foreign base sales and services income from current 
taxation, allowing U.S. corporations to compete more effectively on a 
level international playing field.\1\ Other areas that should be 
considered for simplification include the translation of the deemed 
paid tax credit under section 986, the aggregation of dividends from 
noncontrolled section 902 corporations in one basket, and the 
elimination of the interest allocation rules. These comments 
notwithstanding, we agree with Congressman Houghton and the other 
sponsors of H.R. 2018 that the bill represents a ``down payment on 
further reform.''
---------------------------------------------------------------------------
    \1\ The proposal in H.R. 2018 to treat the countries in the 
European Community as a single country for purposes of the ``same-
country'' exception to Subpart F would also effect some relief. See the 
discussion of this provision at pages 7-8.
---------------------------------------------------------------------------

                        H.R. 2018: A Good Start

I. Treatment of Controlled Foreign Corporations

    A. Use of GAAP for E&P Calculations. The concept of 
``earnings and profits'' (E&P) has relevance in the foreign tax 
area for several reasons. For example, E&P is used in measuring 
the amount of Subpart F inclusions, the portion of a 
distribution from a foreign corporation that is taxable as a 
dividend, the amount of foreign taxes deemed paid for purposes 
of the deemed-paid foreign tax credit, and the amount of 
section 1248 gain taxable as a dividend.
    The Code currently provides that the E&P of a foreign 
corporation is to be computed in accordance with rules 
substantially similar to those applicable to domestic 
corporations. As a practical matter, however, a foreign 
corporation is frequently unable to compute E&P in the same 
manner as a domestic corporation. Although a domestic 
corporation generally calculates E&P by making adjustments to 
U.S. taxable income, a foreign corporation necessarily uses 
foreign book income as its starting point. The ensuing 
adjustments become especially difficult in the case of 
noncontrolled foreign corporations since the U.S. shareholder 
of such companies may be unable to obtain all the information 
required to compute E&P.
    Although foreign corporations do not compute U.S. taxable 
income, they frequently do adjust foreign book income to 
conform with U.S. generally accepted accounting principles 
(GAAP) for financial reporting purposes. There are numerous 
differences between GAAP and E&P, but most relate to timing 
differences and have at most a transitory and nominal effect on 
a company's U.S. tax liability, especially in light of the 
requirement of the Tax Reform Act of 1986 that taxpayers 
compute their deemed-paid credit on the basis of a ``pool'' of 
post-1986 undistributed earnings.
    Because we believe that taxpayers should generally be 
permitted to elect to use U.S. GAAP in computing the E&P of 
foreign corporations, we endorse section 104 of H.R. 2018, 
which would clarify the Treasury Department and IRS's authority 
to provide such an election.\2\ Enactment of this provision is 
needed to simplify calculations of E&P in the foreign area.
---------------------------------------------------------------------------
    \2\ Regulations proposed in 1992 would eliminate the need to adjust 
financial statements prepared in accordance with GAAP, but only with 
respect to uniform capitalization and depreciation for purposes of 
computing a foreign corporation's E&P. The proposed regulations do not 
address the computation of E&P for Subpart F purposes because the IRS 
and Treasury question whether they have the authority to effect such a 
change by regulation.
---------------------------------------------------------------------------
    B. De Minimis Rule for Subpart F Income. Section 954(b)(3) 
of the Code provides that no part of a CFC's gross income is 
treated as foreign-based company income (FBCI) if its FBCI and 
insurance income for the year is less than the smaller of (i) 
five percent of its gross income for the year or (ii) $1 
million. Section 103 of H.R. 2018 would increase the FBCI de 
minimis income from five to ten percent of gross income, 
thereby reducing the reporting requirements for many companies. 
The bill would also increase the $1 million ceiling to $2 
million, a provision that would assist companies with 
relatively small overseas operations.
    TEI endorses this provision, which would simplify the 
computation of FBCI. We suggest, however, that consideration be 
given to eliminating the dollar threshold altogether (or 
increasing it to $5 million). These changes would restore the 
de minimis rule that was in effect before 1987.
    C. Treatment of the European Union Under the Same-Country 
Exception. In 1992, the European Community created a single 
market now comprised of 15 countries that led to the 
consolidation of many European business opportunities. The 
resulting reduction of operating costs enhanced the 
competitiveness of EC-based corporations, often to the 
detriment of U.S.-based companies that are subject to Subpart 
F. The conversion of 11 currencies to the euro can only 
exacerbate the problem.
    Under the current Subpart F rules, certain sales and 
services income that is earned outside a CFC's home country is 
taxable, while income earned inside the home country is exempt 
from current taxation under the ``same-country exception.'' 
Computing Subpart F income significantly increases the 
administrative costs for U.S.-based companies; because of the 
generally high European tax rates, there is most often no 
increase in revenues for the United States. Thus, U.S. 
multinationals may be forced to choose between the potential 
for cost-efficient consolidation of operations in Europe and 
higher administrative costs.
    Section 102 of H.R. 2018 would provide for a Treasury 
Department study on the feasibility of treating all countries 
included in the European Community as one country for purposes 
of applying the same-country exception under Subpart F of the 
Code.\3\ The European Community is eliminating barriers to 
cross-border payments--an initiative that places U.S. 
corporations at a disadvantage. Accordingly, TEI believes that 
companies need relief now in order to remain competitive, and 
we regret that a study will only further delay the proper 
economic result: treatment of the EC countries as one country. 
Such a solution would permit the efficient consolidation of 
U.S. multinationals' European operations, thereby enhancing 
their ability to compete in the European Union. TEI strongly 
urges Congress to consider the outright adoption of this 
proposal.
---------------------------------------------------------------------------
    \3\ Prior iterations of this bill provided for the treatment of EC 
countries as a single country for purposes of the same-country 
exception. See, e.g., H.R. 1690, 104th Cong., 2d Sess. (introduced on 
May 24, 1995).

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II. Foreign Tax Credit Rules

    A. Creditability against Alternative Minimum Tax. Under 
section 59(a)(2) of the Code, a taxpayer's foreign tax credit 
(FTC) may offset no more than 90 percent of the taxpayer's 
alternative minimum tax (AMT) liability.\4\ In contrast, a 
taxpayer that is subject to a regular income tax liability is 
not subject to the 90-percent restriction. The 90-percent 
limitation is presumably the result of Congress's efforts to 
reconcile the arguably conflicting policies underlying the FTC 
and AMT.
---------------------------------------------------------------------------
    \4\ This limitation is imposed in addition to the foreign source 
income limitations of section 904 as it applies to both AMT and regular 
taxpayers.
---------------------------------------------------------------------------
    Because the United States taxes the worldwide income of its 
citizens and residents, the FTC was introduced to limit the 
incidence of double taxation--the taxation of the same income 
by two jurisdictions. The policy underlying the FTC has not 
changed over the years, though certain limitations have been 
imposed to prevent what has been deemed to be the improper 
averaging of high- and low-tax foreign source income. Thus, 
under the regular income tax provisions, a U.S. taxpayer may 
offset fully 100 percent of its U.S. tax liability on foreign-
source income with its FTC. This does not mean that the 
taxpayer is not paying any tax, but rather simply acknowledges 
that the taxpayer has already paid a tax (to the jurisdiction 
where the income was derived) at the rate equal to or greater 
than the amount the United States would assess on that income.
    When the AMT was enacted as part of the Tax Reform Act of 
1986, Congress had ``one overriding objective: to ensure that 
no taxpayer with substantial economic income can avoid 
significant tax liability by using exclusions, deductions, and 
credits.'' S. Rep. No. 99-313, 99th Cong., 2d Sess. 518-19 
(1986). Thus, the AMT was deemed necessary to address public 
perceptions about the fairness of the tax system.
    TEI has serious reservations about the policy basis for the 
AMT generally, but we recognize that calls for its outright 
repeal are beyond the scope of this hearing. Accordingly, we 
applaud section 207 of H.R. 2018, which proceeds from the 
premise that, even if the AMT remains in effect, it makes no 
sense to retain the 90-percent FTC limitation. According a 
taxpayer the ability to offset its entire liability with its 
foreign taxes would not frustrate the legitimate policy 
underlying the AMT. Unlike the other items that may serve to 
reduce a taxpayer's regular tax liability (which taxpayers are 
not permitted to take fully into account for AMT purposes), the 
foreign tax credit represents precisely what its name suggests: 
a tax. A taxpayer with an AMT liability and sufficient FTC to 
offset that liability has already paid a significant tax. 
Clearly, that the tax has not been paid to the United States 
has no bearing on the economic cost it represents to the 
taxpayer. Moreover, to the extent the FTC and AMT regimes do 
conflict, TEI submits that the policy supporting the FTC (and 
complementary provisions in U.S. tax treaties)--which is based 
upon sound economic reasoning and comports with longstanding 
international norms--should prevail. We therefore support the 
enactment of this provision.\5\
---------------------------------------------------------------------------
    \5\ This provision mirrors the relief provided in H.R. 1633, which 
was introduced by Chairman Houghton in April.
---------------------------------------------------------------------------
    B. Expansion of FTC Carryforward and Ordering Rules. 
Section 904(c) of the Code currently provides that any foreign 
tax credits (FTCs) not used against U.S. tax in the current 
year may be carried back two years and forward five. In 
contrast, the rules for the general business tax credit 
(section 39) and net operating losses (section 172(b)) provide 
for a three-year carryback and a fifteen-year carryforward.
    In addition, the ordering rules set forth in section 904(c) 
for FTCs require that the current year's credits be utilized 
before any carryovers are taken into account. By contrast, in 
respect of the general business tax credit, a carryover is to 
be used first, before the current year's credits, to afford the 
taxpayer the maximum opportunity for using the credit. See 
I.R.C. Sec. 38(a).
    The inconsistency in carryback/carryforward periods is not 
only inequitable, but also complicates the tax laws. The 
current rules create administrative burdens for the government 
and taxpayers alike. More fundamentally, the rules effectively 
penalize taxpayers that experience operating losses, thereby 
creating a windfall for the federal government that may 
``collect'' a substantial portion (if not all) of the FTCs 
previously earned and claimed because of the unduly short 
carryback/carryforward period. Current law effects an 
especially harsh result in respect of taxpayers in cyclical 
industries whose ability to utilize FTCs is limited because of 
income fluctuations and start-up companies with initial losses.
    Section 201 of H.R. 2018 would expand the FTC carryforward 
rules to 10 years, bringing them more in line with the rules 
for net operating losses and general business tax credits. 
Although the Institute believes that the rules for the three 
credits should be the same, we recognize that the proposal 
would limit the situations where the purpose of the FTC--the 
elimination of double taxation--is frustrated by 
unrealistically short carryover periods. We also endorse 
section 206, which would change the ordering rules whereby any 
carryover FTC would be taken into account before the current 
year's credit. Permitting the oldest credits to be used first 
would mitigate the problem of expiring credits.\6\
---------------------------------------------------------------------------
    \6\ We recognize that legislation has been proposed (e.g., S. 1134, 
the Affordable Education Act of 1999, and S. 331, the Workers 
Incentives Improvement Act) to shorten the FTC carryback from two years 
to one and expand the carryforward from five years to seven. Enactment 
of this revenue raiser would exacerbate the double taxation caused by 
expiring FTCs, particularly for companies in cyclical industries.
---------------------------------------------------------------------------
    C. Treatment of Overall Domestic Loss. Section 904(f) of 
the Code provides for the ``recapture'' of ``overall foreign 
losses'' where the taxpayer sustains a foreign-source loss in 
one year and there is foreign-source income in a subsequent 
year; the recapture is accomplished by treating income in the 
later years as domestic-source income. The law does not, 
however, provide for similar recapture treatment when there is 
an overall domestic loss that is offset against foreign income 
in one year and in a subsequent year there is sufficient 
domestic income to otherwise absorb the domestic loss.
    Section 202 of H.R. 2018 would apply a resourcing rule to 
U.S. income where the taxpayer has suffered a reduction in the 
amount of its FTC limitation due to a domestic loss. The bill 
would recharacterize into foreign-source income U.S.-source 
income (up to 50 percent of taxable income) earned in a year 
subsequent to a year in which an overall domestic loss offset 
foreign-source income. Adoption of this provision not only 
would provide parallel treatment for foreign and domestic 
losses, but would also foster U.S. competitiveness. TEI 
recommends enactment of the provision.\7\
---------------------------------------------------------------------------
    \7\ The bill's introduction of an overall domestic loss provision 
would remedy an inequity faced by taxpayers attempting to claim FTCs. 
This reform would not eliminate the need to address current section 
904(f) (relating to overall foreign losses), which limits a taxpayer's 
ability to claim FTCs. Consideration should be given to either 
repealing or modifying both the overall foreign loss rules and section 
864(e)'s interest expense allocation provisions, because these rules 
place U.S. corporations at a competitive disadvantage.
---------------------------------------------------------------------------
    D. ``Look-Through'' Rules for Dividends, Interest, Rents, 
and Royalties from 10/50 Companies. The 1986 Act categorized 
foreign affiliates that are owned between 10 and 50 percent by 
a U.S. shareholder as a ``noncontrolled section 902 company'' 
and created a separate FTC limitation for each such company. 
The requirement that dividends from each noncontrolled section 
902 company be placed in a separate ``basket'' was generally 
recognized as among the most maddeningly, mind-numbingly 
complex rules of the 1986 Act's provisions. Last year, Congress 
acted to remedy this problem by permitting taxpayers to elect a 
``look-through'' rule for dividends similar to the one provided 
for CFCs under section 904(d)(3). The use of this rule was 
delayed, however, until 2002.
    Section 204 of H.R. 2018 would advance the effective date 
of the 1998 provision to taxable years beginning after December 
31, 1999; section 205 would expand look-through treatment to 
include interest, rents, and royalties. TEI agrees that 
enactment of these provisions would alleviate some of the 
complexity in current law and for sophisticated taxpayers might 
be especially beneficial. From an administrative perspective, 
however, we suggest that a better approach would be to permit 
dividends from noncontrolled corporations to be aggregated into 
a single basket.

III. Other Provisions

    A. Limitation on UNICAP Rules. As enacted in 1986, section 
263A of the Code requires the uniform capitalization of certain 
direct and indirect costs, including interest, incurred with 
respect to property produced by the taxpayer or acquired for 
resale (the ``UNICAP rules''). Although section 263A applies in 
the foreign context, the revenue raised by application of the 
UNICAP rules to foreign subsidiaries is small compared with the 
administrative burden they impose on taxpayers.
    Section 302 of H.R. 2018 would provide that the UNICAP 
rules of section 263A apply to a non-U.S. person only to the 
extent necessary for purposes of determining the amount of tax 
imposed on Subpart F income or on U.S. effectively connected 
income. It is a simplifying provision that should be 
adopted.\8\
---------------------------------------------------------------------------
    \8\ The adoption of the GAAP E&P rules discussed on pages 5-6 of 
this submission would render this change unnecessary.
---------------------------------------------------------------------------
    B. Study of Interest Allocation Rules. H.R. 2018 requires 
the Treasury Department to conduct a study of the rules under 
section 864(e) of the Code relating to the allocation of 
interest expense among members of an affiliated group.
    TEI commends the Chairman for recognizing that the interest 
allocation rules are in desperate need of reform. In our view, 
the interest allocation rules were enacted as a revenue raiser 
in 1986 and are not justified on economic grounds. The rules 
have spawned not revenue so much as a series of complex 
transactions to minimize their effect. Hence, TEI believes that 
section 864(e) should be repealed. We are confident that the 
Treasury study will confirm that view and urge that action be 
taken as soon as possible.
    C. Reporting Requirements for Foreign-Owned Corporations. 
Section 6038A of the Code sets forth reporting requirements for 
any corporation engaged in a trade or business in the United 
States that is at least 25 percent owned by a foreign person. 
Substantial penalties are imposed for noncompliance. The 
statute contains no de minimis reporting rule. In addition, 
Treas. Reg. Sec. 1.6038A-3(f)(2) provides that documents 
maintained outside of the United States must be produced within 
60 days of a request by the IRS and must be translated within 
30 days of a request for translation.
    Section 311 of H.R. 2018 would provide that a reporting 
corporation will not be required to report any information with 
respect to any foreign-related person if the aggregate value of 
the transactions between the corporation and the related person 
during the taxable year does not exceed $5 million. In 
addition, the provision would expand the time in which a 
taxpayer may produce translations of documents from 30 days to 
at least 60 days. The subsection also provides that nothing 
shall limit the right of the taxpayer to request additional 
time to comply with the request for translation.
    TEI supports enactment of the de minimis rule, which will 
ease the reporting burdens on taxpayers. In addition, we agree 
that an expansion of time in which to produce translated 
documents recognizes the practical difficulties inherent in a 
global marketplace where documents may be kept in various 
languages and at various locations. We suggest, however, that 
the proposed language--``nothing shall limit the right of the 
taxpayer to request additional time''--be revised to read ``the 
Internal Revenue Service shall have the authority to grant all 
reasonable requests for additional time to furnish the 
requested translations.''

                      Safeguarding the APA Process

    Congressman Houghton has voiced support for legislation 
that would amend section 6103(b)(2)(A) of the Code to provide 
protection from disclosure for negotiated agreements between 
taxpayers and the IRS. Included in the proposal's protection 
are advanced pricing agreements (APAs), as well as closing 
agreements and competent authority agreements.\9\ The bill 
responds to recent litigation to seeking disclosure of APAs and 
closing agreements.
---------------------------------------------------------------------------
    \9\ The bill would also amend section 6110(b)(1) to exclude these 
agreements from the definition of ``written determinations'' subject to 
disclosure.
---------------------------------------------------------------------------
    The APA program is designed to forestall contentious and 
expensive transfer pricing disputes between taxpayers and the 
IRS. A voluntary venture, it is one of the IRS's success 
stories of the 1990s and furthers the goal of eliminating 
unnecessary complexity in the tax law. Each APA specifies a 
methodology negotiated between the specific taxpayer and the 
IRS (and, at times, a foreign country) for the taxpayer to use 
in determining its intercompany pricing and thereby assure 
compliance with section 482 of the Code. The information set 
forth in an APA--the method by which a company determines its 
profit margins--is highly fact specific and involves sensitive 
financial and commercial information. Almost 200 APAs have been 
negotiated since the program began in 1991 and the program has 
been used as a model by the international community as a means 
of minimizing double taxation of income and settling costly 
transfer pricing disputes.
    Since the inception of the APA program until January 8, 
1999, the IRS treated the APAs and their supporting 
documentation as tax return information that was not subject to 
disclosure. On that date--in conjunction with a suit to compel 
release of the APAs under the Freedom of Information Act--the 
IRS said it now takes the position that APAs constitute 
``written determinations'' under section 6110 of the Code and 
therefore may be publicly released in a redacted form. TEI 
believes that the IRS's position is wrong and we have filed a 
brief amicus curiae in the case.
    As a professional association dedicated to the development 
and implementation of sound tax policy, TEI is concerned that 
the release of the APAs--even in redacted form--will adversely 
affect the APA program. Taxpayers submitted the pricing 
information to the IRS with the understanding that the 
information would be subject to the same confidentiality 
restrictions as tax returns. Companies' legitimate privacy 
interests--as well as the privacy interest of our treaty 
partners in respect of bilateral APAs--will be compromised by 
the release of the APA background documents and their ability 
to compete effectively in the marketplace could be harmed. 
Moreover, the very redaction process that accompanies release 
of the information would be extremely difficult, burdensome, 
and time-consuming.
    More important, the knowledge that such information will be 
released in the future will discourage taxpayers from seeking 
APAs. TEI believes that the APA program represents the best way 
for companies to resolve transfer pricing controversies and 
avoid costly and time-consuming audits and litigation. At a 
time when the IRS is seeking more taxpayer-friendly ways of 
doing business, programs such as the APA program should 
actively be encouraged, rather than jeopardized by a mistaken 
interpretation of the law.
    For these reasons, TEI strongly supports enactment of 
legislation to protect APAs and supporting documents from 
disclosure.

                               Conclusion

    Tax Executives Institute appreciates this opportunity to 
present its views on international complexity and 
simplification. Any questions about the Institute's views 
should be directed to either Michael J. Murphy, TEI's Executive 
Director, or Timothy J. McCormally, the Institute's General 
Counsel and Director of Tax Affairs. Both individuals may be 
contacted at (202) 638-5601.

                                


    Chairman Houghton. Thank you very much, Mr. Ezrati.
    I am going to forego my questions until the end. I would 
like to pass the questioning over to Mr. Coyne.
    Mr. Coyne. Thank you, Mr. Chairman, and thank you for your 
testimony.
    I would just like to ask, in considering the various 
provisions of H.R. 2018, I wonder if each of you would be able 
to tell us how the provisions would affect each of your 
individual firms, and I know, Mr. Ezrati, you are representing 
the TEI, but if you could tell us about Hewlett-Packard?
    Mr. Ezrati. Certainly. If I can focus on just a few of 
them. The adoption of the elective GAAP E&P provisions will be 
a major simplification. Hewlett-Packard has about 65 foreign 
subsidiaries in which we employ a similar number of people like 
Mr. Luby does to help HP comply with these provisions. This 
would allow us to employ them in other active pursuits rather 
than complying with the tax law.
    The treatment of the European Union as a single country 
would be key for our business in Europe. The trade barriers are 
coming down in Europe for our competitors, but, right now, we 
are obligated to create a separate subsidiary in each one of 
those countries. Our businesses don't want to do business that 
way. They want a central spot in Europe where they can 
distribute all over the continent, and, right now, the U.S. tax 
rules make that difficult.
    Mr. Coyne. Mr. Luby.
    Mr. Luby. As I mentioned, 907, of course, would save us a 
lot of compliance costs. The GAAP rules for Subpart F would be 
important. Another important provision is pipeline 
transportation income provision. That makes pipeline 
transportation income Subpart F, currently deemed up should it 
cross the border. That is active business income. It is very 
difficult to ship pipelines around, as you might expect, so 
that would be important to our industry. And look-through 
treatment for the sales of partnership interests would be a 
major improvement for our industry. As you know, our 
investments are so large, we have to do joint ventures that 
result in partnerships, and we think that the treatment of the 
sale, the partnership interests, should be the same as the 
underlying income.
    Mr. Coyne. Could each of you give just a brief description 
about how your international operations would change as a 
result if these changes were to be implemented?
    Mr. Ezrati. Again, I will focus on the European Union. I 
think we would see a smaller infrastructure in Europe and a 
greater ability to distribute products all over Europe. That 
would be key. Right now, customers in Europe don't want to deal 
with salespeople and service operations and markets in each of 
their countries; they want to deal with one European-wide 
operation, and that is what our businesses want to move to. As 
we move to more electronic commerce, we just want one central 
focal point in Europe, and we will be able to achieve that.
    Similarly, operations in China would improve dramatically 
if there were improvements in the Subpart F arrangements, 
because it is very difficult to do business in China with 
currency controls and similar restrictions. Improvements in 
Subpart F would help us dramatically in that major market.
    Mr. Luby. The 10/50 provisions have hurt us enormously in 
various joint ventures. You have situations such as in Malaysia 
where they don't really want to hear about a partnership; they 
don't want to hear about ``check the box;'' they want their own 
kind of corporation. Therefore, we have to forego investments 
because of the return detriment. I used an example. We have had 
situations in the North Sea where we have actually had to pay 
our partner's share of the gross receipts tax in order to get 
them to agree to a partnership so that we could avoid the 
earnings hit of 10/50, and we have had situations in China 
where we have actually deferred investments because of this 
provision.
    Mr. Coyne. Thank you.
    Chairman Houghton. Thank you, Mr. Coyne. Mr. Watkins.
    Mr. Watkins. Thank you, Mr. Chairman. I am delighted you 
are having these oversight hearings on the international tax 
simplification.
    I was in Congress for 14 years before being out about 6 
years, and as I worked on a number of things--in fact, in the 
early 1980's, I put an international trade center in the State 
of Oklahoma, because I realized that we were not prepared, I 
think, in the global competitive world that we were going to be 
entering in. I was out about 6 years and decided I would try to 
come back for two reasons: No. 1, I felt like a balanced 
budget, that I had kind of been unfair to my children and 
grandchildren for not in those 14 years being able to achieve 
that, and the other reason was I wanted to try to do my darnest 
to prepare this country for a global competitive economy, a 
21st century global competitive economy. You and I might be 
able to escape being personally involved as much as a lot, but 
the young people--our children and grandchildren--have no 
choice; they are thrust into that. And by a 21st century global 
competitive economy, I mean one that has got less taxation, a 
more simplified or fair way to work things through on taxation. 
No. 2, less regulation that we have to try to uncomplicate that 
situation as much as we can, and, third, less litigation. I 
just read something, Mr. Chairman, coming up here that in 
Japan, they have got about 16,000 lawyers and we have got over 
900 and some odd thousand, nearly a million, and lots of times 
that is dealing with a lot of liability
    But I guess what I am concerned about is--or I would say 
that I know the Chairman here and also our Ranking Members want 
to make sure we have a less complicated and more workable 
allowing us to be competitive overseas, and I kind of mentioned 
those three things, because I think that gives us, within that 
structure, we have got an overburden--what I call an overburden 
in the oil patch--an overburden of being able to do business 
overseas.
    So, are you involved in pipeline construction, 
multinational pipeline construction, overseas, Mr. Luby, at 
your company?
    Mr. Luby. Yes, we are, and we are also users of pipelines 
owned by others, so that the change in the bill, for example, 
would, hopefully, either lower our investment costs or lower 
the costs of renting space in the pipeline.
    Mr. Watkins. I think that this question is asked kind of 
indirectly, but probably the three most general changes that we 
could look at, I mean, that would affect all businesses and 
industry, so to speak, allowing us to be more competitive in 
that global economy, what would your thoughts be? What three?
    Mr. Luby. I would substantially reform the Subpart F rules 
to a major extent. I believe that since pay-go became the watch 
word here that policy flew out the window and basically the 
foreign area didn't have a constituency, and, therefore, a lot 
of the pay-fors for domestic initiatives, be they child care 
credits or what--and I am not criticizing child care credit; I 
am just using that as an example--have been paid for out of our 
international rules with no policy justification. That is why 
we have 10/50; that is why we have the PFIC overlap; that is 
why we have 956A that you repealed in 1997 due to these 
gentlemen's efforts. So, that is one area that I think needs to 
really be reworked.
    And the other area in international is the various foreign 
tax credit baskets. There is a chart right here; we have got 
nine of them. There is no reason on Earth that we need to have 
nine separate foreign tax credit baskets in order to determine 
whether we owe a residual U.S. tax on foreign source income. It 
is just nonsense, and it wastes money on compliance. Those are 
the major things.
    Mr. Watkins. We appreciate those. Any quick thoughts you 
might have on----
    Mr. Ezrati. Absolutely. The only thing I would add is that 
the adoption of the elective GAAP E&P would greatly simplify 
things, and removal of the 90-percent limitation on using the 
foreign tax credits to offset U.S. alternative minimum tax 
would remove all double taxation in that area.
    Mr. Watkins. I appreciate those comments on that, and, 
again, I want to thank the Chairman for having these, because 
we truly are in this global competitive world, and we have got 
to streamline some things, and I think it has got to begin with 
taxes and then regulatory policies we have and also the 
litigation situation we are confronted in trying to do that and 
conduct that business. So, Mr. Chairman, thank you so much.
    Chairman Houghton. Thanks, Mr. Watkins.
    Mr. Levin.
    Mr. Levin. Mr. Chairman, should I defer to Ms. Dunn, if she 
would like. I am not on the Subcommittee, so maybe I should--I 
don't want to be chivalrous but also abide by protocol.
    Chairman Houghton. Sure. Ms. Dunn has joined us. Would you 
like to inquire?
    Ms Dunn. I simply want to thank you gentleman for coming 
over. I had lunch, Mr. Luby, with one of the folks who works 
for your company today at a speech that I gave, and, so 
greetings from her, and thank you for coming and testifying on 
something that is critically important as we look at the rules 
we set up to become more competitive through industry.
    Chairman Houghton. Mr. Levin.
    Mr. Levin. Thank you, Mr. Chairman.
    If I might just make a couple of comments, because this is 
really interesting testimony, and I believe it relates to my 
first comment. There is a lot of skepticism here on this level 
and the next level about simplification that it can ever occur. 
In this field, it does seem feasible. Some steps you can take, 
but further steps can be taken that are sound tax policy. They 
simply can be made much less complex.
    Second, I would hope that you could help us inspire some 
discussion of this. I think the Chairman of the Full Committee 
is interested in international tax issues. I think that is true 
on both sides of the aisle. It is unclear what is going to be 
the life of the tax bill here, and I do think that we need to 
foster some further discussion to ensure that the international 
tax area is part of the next.
    So, if you could continue to raise these issues. It is not 
easy, because these are detailed provisions, but you have been 
able to give a few concrete examples in response to Mr. Coyne's 
excellent questions as to what it would mean for your company 
within the 
parameters of sound tax policy, and, Mr. Chairman, I would 
guess you would share my sentiments that we need all the help 
we can get to try to boil these issues down so that they are 
understandable, and we avoid having people choose up sides as 
happens too much around here kind of an automatic or 
stereotypical basis. These provisions are good for basic 
economic operations in this country, and therefore can have a 
positive impact on both business and workers, the business 
community and workers.
    So, your testimony has been very salient, and I hope you 
will help us spread the word.
    Mr. Ezrati. Absolutely.
    Chairman Houghton. Thank you, Mr. Levin.
    We have been joined by Mr. Neal. Mr. Neal, would you like 
to----
    Mr. Neal. I don't have any questions.
    Chairman Houghton. No questions. OK, well, I have some 
questions. They are really sort of generic questions.
    You know, Mr. Levin and I have got a bill out there, and I 
would really like you to sort of coalesce your ideas into what 
are the two or three things in that bill that really are going 
to help you. And then, also, secondly, where do we go from 
here? What other things--what more should we be doing? So, I 
throw those questions to both you gentleman for an answer.
    Mr. Ezrati. I don't want to repeat myself too much, but 
here are three things: adoption of the GAAP E&P provisions, 
removal of the 90-percent limitation on the foreign tax credit 
for the alternative minimum tax, and go beyond studying to 
treat the European Union as a single country for purposes of 
Subpart F. Not just for my company, but I think for the 
majority of the 5,000 members of TEI and the 2,700 companies 
they represent, it will make a huge difference.
    And let me echo Mr. Luby. If you want to know where to go 
from there, it's to those nine foreign tax credit baskets that 
we enacted in 1986 and that are the worst complexities we face 
today. Repeal those nine baskets, and the world would be a lot 
easier, and U.S. business would be more competitive.
    Chairman Houghton. Do you feel the same about the Far East 
as you do about the European Union?
    Mr. Ezrati. I think it is a little more difficult in the 
Far East; it is not one economic trade block. I could see it 
actually happening in Latin America more quickly than in the 
Far East. As the Mercisol countries move together to form one 
trade block, we are finding that U.S. companies will be less 
competitive in Latin America, and so I could see the same thing 
happening there, especially after NAFTA where you removed those 
trade barriers, only to erect, as Mr. Levin said, tax barriers. 
It is going to be a little more difficult in Asia, because they 
haven't come together as one trade block. So, as I said, 
substantially reforming Subpart F will make things lots easier 
in China to do business there.
    Chairman Houghton. All right. Mr. Luby.
    Mr. Luby. In addition to the items I have already 
mentioned--which I won't bore you with going over again--I 
would mention that for our membership doing something again on 
active financing income would be very helpful, and I know that 
you have a witness in another panel that will address that much 
more eloquently than I ever could. Extending the foreign tax 
credit carryover provision would be of great assistance. 
Because of the mismatch between 
foreign law and U.S. law, we sometimes end up under the current 
system with credits expiring. That is not the purpose of the 
credit system. The purpose is to eliminate double taxation. And 
we appreciate your including a call for an interest allocation 
study. That is definitely needed. Something needs to be done 
there. The way that works today, it rigs the system so that we 
are in effect double taxed. So, those would be the items that I 
would mention in addition to the earlier items in response to 
other questions.
    Chairman Houghton. OK, thanks very much.
    We have been joined by Mr. Weller. Would you like to ask 
questions?
    Mr. Weller. Thank you, Mr. Chairman.
    I guess as we look this year at what type of tax cut we are 
going to provide--and, of course, we have opportunity in this 
year's budget for almost a $770 billion tax cut over 10 years--
I am one of those who advocates that as we put together those 
tax provisions in this year's budget, we should focus on 
simplifying and bringing fairness to the code, and many in the 
business community have said,

    Well, you know, when you have these temporary extenders 
that every year have to reauthorize, that is really an issue of 
fairness, because it is hard to make a decision on how to move 
forward.

    And, of course, the Subpart F treatment of financial 
services with overseas income, I was wondering can you give 
some examples of whether or not it is fair to annually extend 
that provision for 
financial services?
    Mr. Luby. We don't have--my company, personally, doesn't 
have a problem in that area, because we are not in that 
particular business, but I would say that based on the way we 
do our corporate plans, we look beyond the next quarter, 
obviously; we look 3 to 5 years out in planning our business 
and in planning where we may want to budget our investments. If 
I have a provision that hurts me competitively, that is 
renewable annually, then that is going to definitely crimp my 
plans beyond that one-year outlook, and when I am looking at 
projects or investments that are very substantial in the 
context of what I have available--the shareholders' money at 
risk--it can cause me to make wrong or less than optimum 
decisions, so that is about as much detail as I could give you 
on that point.
    Mr. Weller. Mr. Ezrati.
    Mr. Ezrati. We have looked at that financial services 
provision, and the company has thought about adjusting the way 
we finance products, and we do a lot of financing, though the 
provision does nothing for us at the moment, because it is so 
narrowly crafted and so complex. But we have asked, ``Should we 
adjust the way we do business to take advantage of that 
provision? Will that make us more competitive in financing our 
products versus our competitors?'' And you say, ``But is it 
worth it? It will take us 6 months to gear up for it, and it is 
a year provision.'' Thus, I do think it is terribly unfair that 
those provisions are enacted year-by-year, and you need to 
guess whether they will be there next year. In fact, this 
provision itself, when it was originally enacted, was different 
from the one you extended last year. It is even more difficult 
when it is different each year.
    Mr. Weller. I am one who believes that we should, of 
course, make that provision permanent; same with the R&D tax 
credit or opportunity tax credit, because businesses are making 
decisions, having to invest large amounts of money, trying to 
make decisions, and, of course, the consequence in not knowing 
if that provision in the tax code is going to be there long-
term. If we are unable to make Subpart F permanent, what is the 
minimum number of years you feel is necessary, really, from a 
management standpoint when you are considering how to invest 
millions of dollars?
    Mr. Luby. In the context of our company, I would say a 
minimum of 3 years.
    Mr. Weller. A minimum of 3? Would you agree, Mr. Ezrati?
    Mr. Ezrati. I think I would like to go even longer. You 
mentioned the research and experimentation tax credit, and I 
think that has never been longer than about 5 years. I now hear 
that 5 is now considered permanent, but that is what I would 
like to see, because that is the time horizon for making large 
investments. Three might work, but five would certainly be 
preferable.
    Mr. Weller. Mr. Chairman, I certainly believe from a 
fairness standpoint, if we are asking these employers to invest 
for the long-term, we should certainly ensure that the tax 
provision they are basing decisions on is for the long-term, as 
well, and that is why I hope we can work together not only for 
permanency but, at a minimum, for a long multiyear extension so 
they can make some long-term decisions.
    Chairman Houghton. I agree with you, Mr. Weller.
    I have just one more question, The National Foreign Trade 
Council came out with a report on anti-deferral rules. Can you 
sort of spell out a few of those things--how they compare with 
other countries, and where we end up if we proceed with those 
rules?
    Mr. Luby. Well, an example is the one I used earlier in the 
testimony. The French exempt back these incomes from foreign 
taxation that comes from foreign sources, whereas, we do not. 
In many cases, active financing is a good example. That is 
active business income to our banking companies, and they have 
to pay current U.S. tax on that income. That puts them at a 
definite disadvantage vis-a-vis a French banking competitor, if 
they are looking at investments in Europe or elsewhere around 
the globe.
    Other countries are very similarly situated. You hear about 
territorial versus our type of system, and you find that 
although very few have a territorial system, well, they really 
have a territorial system, but it is with a wink and a nod so 
that they can say that they followed our lead and have 
controlled foreign corporation rules. Great Britain has 
tightened their rules quite a bit, but they still allow a 
Bermuda headquartered company to put in low-taxed financing 
income and high-taxed other income and mix it all up, and guess 
what? You average it out, and there is no residual for you to 
pay for tax. We have a competitor--who I am sure you can 
guess--that is headquartered both there and in the Netherlands 
that happens to use that to their advantage when they are 
competing with us on projects.
    So, our report shows that Subpart F needs to be reexamined; 
that it is a drag on the competitiveness of U.S. companies. We 
have now formulated recommendations that are coming out of that 
report, and we hope to release them in the very short term, 
and, as Les said a few minutes ago, echoing my earlier comment 
on the baskets, we have now begun the second phase of that 
project, which is a study of the foreign tax credit, and we 
will have recommendations come out of that, as well. So, we 
will, at least at the NFTC, heed Mr. Levin's suggestion and 
continue to bring attention to the area of international tax.
    Chairman Houghton. OK, well, thank you very much. We look 
forward to working with you, and, gentleman, I really 
appreciate your testimony. Thank you.
    Mr. Ezrati. Thank you.
    Chairman Houghton. Now, I will call the panel composed of 
Mr. Cox, who is Vice President of Tax at BMC Software in 
Houston, Texas; Denise Strain, General Tax Counsel at Citicorp 
in New York; Thomas Jarrett, Director of Taxes at the Deere 
Company in Moline, Illinois; Gary McKenzie, Vice President of 
Tax for the Northrop Grumman Corporation in Los Angeles, 
California; and Stan Kelly, Vice President of Tax for Warner-
Lambert in Morris Plains, New Jersey.
    If you would come forward.
    Mr. Cox, good to have you here. Would you proceed?

STATEMENT OF JOHN W. COX, VICE PRESIDENT OF TAX, BMC SOFTWARE, 
                      INC., HOUSTON, TEXAS

    Mr. Cox. Thank you, Mr. Chairman. Good afternoon. I am John 
Cox, vice president, Tax, for BMC Software. BMC is 
headquartered in Houston, Texas and is a worldwide developer 
and vendor of software solutions for automating application and 
database management across host-based and distributed systems 
environments. I thank the committee for giving me this 
opportunity to present my views on international tax 
simplification.
    The U.S. software industry currently leads the 
international marketplace for developing new technologies used 
to create new products. This technology is the product of U.S.-
based research and development which produces market leading 
patents and copyrights. The ability to efficiently use these 
intangible assets throughout the world is a key component in 
the operations of U.S. software businesses.
    Currently, U.S. tax policy hinders U.S. competitiveness 
when compared with the tax regimes of other countries. Not only 
is our worldwide system of taxation more burdensome than 
systems of many of our trading partners, but also our 
incentives to encourage R&D in the United States are less 
beneficial than the incentives offered by many of our trading 
partners. In addition, U.S. rules for taxing foreign income are 
extraordinarily complex. As a result, an inordinate amount of 
resources are devoted to structuring transactions that will 
accomplish the business goals of U.S. companies without 
incurring a heavy tax burden. BMC applauds the efforts of 
Chairman Houghton and Congressman Levin to bring simplicity to 
the international tax rules of the Internal Revenue Code.
    Although I favor many, if not most, of the proposals in 
H.R. 2018, my testimony today will highlight two provisions 
that I believe will particularly helpful to the software 
industry. In addition, my testimony will include two issues 
that are not addressed in the current legislation.
    I support the bill's alternative minimum tax proposal. 
Under the current law, U.S. taxpayers subject to the AMT regime 
may claim a foreign tax credit against their alternative 
minimum tax only to the extent of 90 percent of the actual tax 
paid or accrued in foreign countries. Thus, foreign tax credits 
can never entirely extinguish U.S. tax liability under the AMT 
regime.
    This rule has been widely criticized on several grounds. 
First, foreign tax credit is not a tax preference but simply a 
means of reducing unfair and unavoidable double taxation that 
would otherwise fall on U.S. taxpayers earning income abroad. 
Second, the AMT limitation is fundamentally inconsistent with 
international tax treaty norms. U.S. treaty partners have 
frequently expressed dissatisfaction with this feature of U.S. 
law. Finally, the 90-percent limitation adds complexity to the 
AMT regime, which is notoriously complicated even without the 
provision.
    I also support the effort to move towards treating the EU 
as one country for Subpart F purposes. Under current law, the 
member countries of the EU are treated as separate countries 
for purposes of the various ``same-country exceptions'' to 
Subpart F income. Treating the EU as a single country for these 
purposes would help U.S. corporations operating in the EU take 
full advantage in that market, and it would also help the U.S. 
corporations compete more effectively against EU corporations 
that are already able to enjoy the benefits of these 
initiatives.
    I now turn to two international tax matters that are not 
covered by the bill but that deserve the Committee's attention. 
The first is the inconsistent characterization of cross-border 
transactions by the United States and its trading partners. For 
example, income from the sale of a disk containing a computer 
program might be treated as business profits by the United 
States but as a royalty by the customer's country of residence. 
Double taxation can therefore arise. These problems have in 
fact cropped up repeatedly in cross-border activities for 
software companies. Treaty mutual agreement procedures can be 
effective, but they are costly, time-consuming, and uncertain. 
We recognize that this problem is not resolvable by unilateral 
U.S. action; however, we do encourage Congress and the 
administration to pursue all available opportunities for 
resolving these issues, both treaty-by-treaty and 
multilaterally.
    The last point I wish to discuss is the challenge to the 
Foreign Sales Corporation regime now pending before the World 
Trade Organization. The FSC rules are extremely important to 
U.S. software companies, which derive 30 percent of their 
revenue from exports, and the industry is grateful that 
Congress clarified this application of these rules to software 
licenses as part of the 1997 Tax Act. The FSC rules were 
enacted to offset a competitive disadvantage faced by U.S. 
exporters, because the U.S. tax system is not as generous to 
exports as are the tax systems of our trading partners. These 
concerns still exist today. As we await a final decision from 
the WTO panel on the FSC issue, I wanted to make you aware of 
the importance of this issue to the software industry.
    In conclusion, Mr. Chairman, thank you again for this 
opportunity to present my views on these important issues. I am 
happy to answer any questions you might have.
    [The prepared statement follows:]

Statement of John W. Cox, Vice President of Tax, BMC Software, Inc., 
Houston, Texas

                              Introduction

    I am John W. Cox, Vice President of Tax for BMC Software, 
Inc. BMC, headquartered in Houston, is a worldwide developer 
and vendor of software solutions for automating application and 
data management across host-based and open system environments. 
The software industry is growing at an extremely rapid pace. 
Since 1994, software sales have been growing at a constant rate 
of 15.4% annually, which is three times the growth rate of the 
GDP. Much of the growth in the industry is due to expansion in 
overseas markets. BMC operates in approximately 30 different 
foreign markets. Our fiscal year 1999 revenue was $1.3 billion, 
of which approximately 40% is from foreign sales.
    The U.S. software industry currently leads the 
international marketplace in developing new technologies used 
to create new products. This technology is the product of U.S.-
based research and development, which produces market leading 
patents and copyrights. The ability to efficiently use these 
intangible assets throughout the world is a key component in 
the operations of a U.S. software business.
    In recent years the Congress and the Administration have 
made noteworthy improvements in the international tax rules 
affecting software companies. First, in 1997 Congress passed 
legislation clarifying that software exports qualify for FSC 
benefits. Then in 1998 the Treasury finalized regulations 
providing clear guidance on the proper characterization of 
software revenue that is generally consistent with industry 
business practice and will help reduce the potential for 
burdensome taxation by our trading partners. We thank you for 
these improvements. However, current U.S. tax policy still 
hinders U.S. competitiveness, when compared with the tax 
regimes of other countries. Not only is our worldwide system of 
taxation more burdensome than the systems of many of our 
trading partners, but also our incentives to encourage R&D in 
the United States are less beneficial than the incentives 
offered by many of our trading partners.
    In addition, U.S. rules for taxing foreign income are 
extraordinarily complex. As a result, an inordinate amount of 
resources are devoted to structuring transactions that will 
accomplish the business goal of U.S. companies, without 
incurring a heavy tax burden. BMC applauds the efforts of 
Chairman Houghton and Congressman Levin to bring simplicity to 
the international tax rules in the Internal Revenue Code. My 
testimony today will highlight provisions in H.R. 2018, the 
``International Tax Simplification for American Competitiveness 
Act of 1999,'' that we believe will be particularly helpful to 
the software industry. In addition, my testimony will include 
two issues that are not addressed in the legislation--(1) 
inconsistent characterization of income by the United States 
and other countries, and (2) the WTO controversy between the 
United States and the EU over the U.S. foreign sales 
corporation (FSC) rules.

                        Provisions in H.R. 2018

A. AMT Foreign Tax Credit Rules

    Under current law, taxpayers are required to pay an income 
tax that is the greater of their tax computed under the normal 
rules of the Internal Revenue Code (the ``Code'') or the 
special ``alternative minimum tax'' (``AMT'') rules. The AMT 
regime is intended to ensure that high-income taxpayers making 
extensive use of so-called ``tax preference items'' pay at 
least a minimum level of tax. The recapture of the tax benefit 
afforded by the tax preference items is generally achieved by 
adding back to income the ``excessive'' portion of the 
deduction or exclusion granted by the preference.
    The AMT regime also limits the ability of AMT taxpayers to 
use otherwise allowable credits against their overall U.S. tax 
liability. In the case of the credit allowed for income taxes 
paid to foreign governments (the foreign tax credit or 
``FTC''), the regime essentially limits the credit to 90% of 
the U.S. tax owed. This rule ensures that FTCs can never 
entirely extinguish U.S. tax liability under the AMT regime.
    This rule has been widely criticized on several grounds. 
First, the FTC is unlike most other credits, which are 
essentially intended to act as incentives to modify taxpayer 
behavior (such as the low-income housing credit or the alcohol 
fuels credit). The FTC is remedial in nature in that it seeks 
to avoid double taxation of income. Far from being a tax 
preference intended to reward taxpayers that take certain 
affirmative action, the FTC alleviates the unfair and 
unavoidable double taxation that would otherwise fall on U.S. 
taxpayers earning income abroad. It is illogical to treat this 
relief provision as a ``tax preference'' subject to overuse or 
abuse.
    Second, the AMT limitation is fundamentally inconsistent 
with international tax treaty norms. Relief from double 
taxation is the primary purpose of income tax treaties, and the 
credit provision is widely recognized as an acceptable method 
of complying with the treaty obligation. The majority of the 
over 1200 bilateral income tax treaties in force throughout the 
world provides for double taxation relief through a credit 
mechanism.
    Limiting the FTC to 90% of the U.S. tax due prevents tax 
treaties from achieving their full objective of eliminating 
double taxation. While most U.S. treaties are drafted in a way 
that prevents the limitation from technically violating the 
treaty, U.S. treaty partners have frequently expressed 
dissatisfaction with this feature of U.S. law, which 
contravenes internationally accepted principles.
    Finally, the FTC limitation adds complexity to the AMT 
regime, which is notoriously complicated even without the 
provision. Because the FTC is applied separately with respect 
to separate categories or ``baskets'' of income, the AMT 
limitation is not a single computation, but requires a series 
of computations that must be undertaken in addition to the 
normal FTC calculations.
    Section 207 of the Bill would repeal the FTC limitation now 
found in the AMT provisions. For all of the reasons detailed 
above, we endorse this proposal.

B. Treatment of the European Union

    The controlled foreign corporation (``CFC'') provisions of 
the Code impose current U.S. taxation on the U.S. shareholders 
of foreign corporations that they control. This taxation is 
limited to so-called ``subpart F income'' earned by the CFC. 
Among the various categories of subpart F income is passive 
income such as dividends, interest, rents, and royalties. The 
policy underlying the current taxation of such income is that 
it is inherently mobile, so that a worldwide group of 
corporations can route the income to a low-tax jurisdiction and 
avoid both U.S. and foreign taxes. Similarly, income from 
sales, services, and insurance outside the CFC's country of 
incorporation is subpart F income if related party transactions 
are involved, on the theory that taxpayers could transfer 
profits from these activities to a low-tax jurisdiction.
    The Code provides an exception for certain dividends, 
interest, rents, and royalties paid to a CFC by a related party 
located in the same country as the CFC's country of 
organization. Subpart F income also does not include sales, 
services, and insurance income earned in that country. The 
policy underlying these exceptions is that transactions 
occurring in the same country will rarely, if ever, result in 
inappropriate avoidance of local tax, and taxpayers should 
therefore be free to adopt in each country corporate structures 
and business operations that are not artificially affected by 
tax considerations.
    Under current law, the member countries of the European 
Union (``EU'') are treated as separate countries for purposes 
of the ``same country'' exception. Thus, payments of dividends, 
interest, and similar amounts from an entity organized in one 
EU country to a related entity in a different EU country are 
treated for U.S. tax purposes as subpart F income. Sales, 
service, and insurance income earned in another EU country may 
also be subpart F income.
    Section 102 of the Bill would direct the Treasury 
Department to study the feasibility of treating the EU as a 
single country for purposes of the same-country exception. 
Under this approach, sales, service, and insurance income 
earned anywhere within the EU by an EU country entity, as well 
as passive income received from an EU affiliate by a controlled 
foreign corporation in an EU member state would not generally 
be treated as subpart F income.
    We fully support the effort to move towards treating the EU 
as one country for subpart F purposes. This approach would help 
U.S. corporations operating in the EU take full advantage of 
the EU initiatives to create a single market with the free flow 
of goods, services, labor, and capital across national borders. 
It would also help U.S. corporations compete more effectively 
against EU corporations that are, by virtue of their countries 
of residence, already able to enjoy the benefit of these 
initiatives.
    We understand that the Bill proposes only a study of the 
issue because of concerns that the EU member countries have 
different tax systems and rates. While we do not oppose a 
Treasury study, we submit that Congress should consider more 
immediate and direct action. The possibility of applying same-
country status to the EU has been under consideration by 
Congress for several years.\1\ We question whether a Treasury 
study, which would further delay direct Congressional 
consideration of this important issue, would shed a great deal 
of additional light on the area, particularly as the EU 
countries continue to move toward integrating their tax 
systems.
---------------------------------------------------------------------------
    \1\ See section 601 of H.R. 5270, the Foreign Income Tax 
Rationalization and Simplification Act of 1992 (introduced on May 27, 
1992) 102nd Cong., 2nd Sess.; H.R. 1401 (introduced on March 18, 1993), 
103rd Cong., 1st Sess.; section 8 of H.R. 1690, the International Tax 
Simplification and Reform Act of 1995 (introduced on May 24, 1995), 
104th Cong., 1st Sess.; section 206 of S. 2086, the International Tax 
Simplification for American Competitiveness Act (introduced on 
September 17, 1996), 104th Cong., 2nd Sess.

---------------------------------------------------------------------------
C. Expansion of subpart F de minimis rule

    Under current law, a de minimis rule excludes all gross 
income of a CFC from subpart F income if what would otherwise 
be the CFC's gross subpart F income \2\ is less than the lesser 
of (1) 5% of the CFC's gross income or (2) $1 million. Thus, 
the maximum exclusion per CFC is $1 million, which will be 
available only if the CFC's gross income equals or exceeds $20 
million.
---------------------------------------------------------------------------
    \2\ Technically, the test applies to the sum of gross foreign-based 
company income and gross insurance income, but for most CFCs these are 
the only categories of subpart F income that commonly arise.
---------------------------------------------------------------------------
    The exclusion is an acknowledgement that it is difficult 
for corporations to avoid earning some subpart F income--
interest on bank deposits, gain on the sale of unproductive 
assets, small royalties, and similar items. If the bulk of the 
CFC's income is active, however, it is administratively 
burdensome to keep track of relatively minor amounts of subpart 
F income, and there is little revenue to be gained by 
attempting to tax such income currently.
    The Code has contained the de minimis rule in its current 
form since 1986. Before that year, the exclusion was available 
if 10% or less of the CFC's gross income would otherwise be 
subpart F income, with no dollar limitation. Section 103 of the 
Bill would return to this 10% limitation and increase the 
dollar threshold to $2 million.
    We support this proposal. The return to the percentage 
threshold under pre-1986 law leads to increased administrative 
convenience and efficiency at a low revenue cost. The increase 
in the dollar threshold is an appropriate adjustment to reflect 
inflation, and CFCs with at least 90% active income should not 
be burdened with the need to keep careful track of small 
amounts of other income.

D. Extension of foreign tax credit carryforward

    Under current law, unused foreign tax credits may be 
carried back to the two previous taxable years and forward for 
five taxable years. If not usable within that time period, they 
expire, and the foreign taxes become a simple cost of doing 
business. These unused taxes may not be deducted for Federal 
income tax purposes, because they relate to a year in which the 
taxpayer elected credit treatment.
    Expiring credits are a problem for many companies in our 
industry. Although it is often possible to control the timing 
and amount of foreign taxes to some extent, thereby maximizing 
the ability of the U.S. taxpayer to benefit from the credit, 
five years may not be enough time in all cases to fully enjoy 
this benefit. The result is that the U.S. taxpayer's overall 
costs rise, and its ability to compete globally decreases, even 
in cases where, taking a longer view, the overall worldwide tax 
rate is no higher than the U.S. rate.
    From the taxpayer's point of view, an unlimited carryover 
of unused credits would of course be ideal. We recognize, 
however, that from the government's point of view an unlimited 
credit might pose an administrative and recordkeeping problem. 
Section 201 of the Bill would extend the current carryforward 
period to ten years. We believe that this period represents a 
reasonable--and more realistic--compromise that accommodates 
the concerns of both taxpayers and the government.

E. Recharacterization of overall domestic loss

    U.S. taxpayers with foreign branch operations may deduct 
losses generated by the branch against U.S. source income in 
the same taxable year. This deduction reduces U.S. source 
income subject to U.S. tax. When in a subsequent year the 
branch generates income subject to foreign tax, the taxpayer 
may be able to claim a foreign tax credit to offset the U.S. 
tax on the income. This arguably creates a ``double benefit'' 
for the taxpayer arising solely from the timing of foreign 
income and loss.
    In 1976, Congress enacted an overall foreign loss (``OFL'') 
recapture rule to prevent this result. The Code provides that a 
taxpayer must create a special OFL account whenever a foreign 
source loss reduces U.S. source income. If positive foreign 
source income is generated in a later year, the income is re-
sourced to the United States, effectively preventing foreign 
taxes on that income from being credited against the U.S. tax 
due.
    In the reciprocal situation, however, where timing rules 
could operate to the taxpayer's detriment, there is no 
corresponding recapture rule. For example, if a taxpayer has a 
U.S. source loss that offsets foreign source income in the same 
year, the taxpayer's available foreign tax credit may be 
reduced because the foreign tax credit limitation is computed 
on the basis of net foreign source income. In a later year, 
U.S. source income is not re-sourced to foreign, so that the 
available foreign tax credit in that year is not increased.
    This lack of parallelism has often been criticized as 
illogical, because it corrects the mismatch when favorable to 
the government but not when favorable to the taxpayer.\3\ In 
addition, taxpayers lose the value of their foreign tax credits 
as an offset against double taxation of income at a time when 
they are already losing money in the United States. Section 202 
of the Bill would remedy this defect and provide for equitable 
treatment of taxpayers by applying the same rules to both 
foreign and domestic losses. We support this provision as a way 
of adding fairness and neutrality to the international 
provisions of the Code.
---------------------------------------------------------------------------
    \3\ See, for example, Isenbergh, International Taxation: U.S. 
Taxation of Foreign Taxpayers and Foreign Income (1990), at para. 
21.3.3, which notes that the subsequent U.S. source income ``will 
effectively be overtaxed.''

---------------------------------------------------------------------------
F. Ordering rules for FTC carryovers

    Under current law, a taxpayer with FTC carryovers in a 
taxable year must first claim credits for taxes paid or accrued 
in that year before crediting taxes carried over from other 
periods. This rule suffers from the same problems as the five-
year carryforward provision discussed above. The ability of 
taxpayers to obtain credit for taxes paid in prior years is 
circumscribed.
    Section 206 of the Bill would reverse this rule, and give 
credit for taxes carried over from prior years before current 
year taxes were credited. The current year taxes would 
themselves be eligible for carryover if the taxpayer remained 
with excess credits after the credit computation.
    We support this change. Like the extension of the carryover 
from five years to ten, it will smooth out year-to-year 
fluctuations in levels of foreign income and taxes and allow a 
more efficient operation of the foreign tax credit regime.

G. Application of UNICAP rules to foreign persons

    The uniform capitalization (``UNICAP'') rules of the Code 
generally require taxpayers to capitalize both direct costs and 
a properly allocable portion of indirect costs attributable to 
property produced or acquired for resale. These rules require a 
detailed allocation of costs to various activities and then to 
the products themselves. Almost 100 pages of regulations 
prescribe the specific accounting procedures and computations 
that must be made.
    The UNICAP rules are not currently limited to U.S. persons. 
Foreign taxpayers are also subject to the rules to the extent 
that their income, deductions, credits, and other tax 
attributes are relevant to U.S. tax. For example, a CFC must 
use the UNICAP rules in computing its earnings and profits for 
purposes of determining the subpart F inclusions of its U.S. 
shareholders.
    The application of UNICAP to foreign taxpayers is a 
substantial increase in complexity and administrative burden. 
These rules apply only for U.S. tax purposes, and a foreign 
corporation with no U.S. connection other than its owners would 
ordinarily not have to make the detailed allocations called for 
by the rules. Full compliance with these rules is costly for 
taxpayers, and often makes no revenue difference because there 
is usually a cushion of undistributed and untaxed CFC earnings 
to absorb any adjustments attributable to UNICAP allocations.
    Section 302 of the Bill would provide that the UNICAP rules 
would apply to foreign persons only for purposes of computing 
the tax on income effectively connected with the conduct of a 
U.S. trade or business. We endorse this proposal, which will 
significantly simplify tax compliance for U.S. taxpayers with 
foreign subsidiaries. The proposal is also sound on tax policy 
grounds. Activities to which the rules apply are typically 
those of an active business, which when conducted by a CFC 
outside the United States are not normally subject to current 
U.S. tax.

 Inconsistent Characterization of Income from Cross-Border Transactions

    In connection with the Committee's consideration of 
international tax rules, we wish to draw attention to a 
significant problem that is not addressed by the Bill but that 
has cost our industry needless time and money--and may 
ultimately reduce tax revenue to the U.S. Treasury. This 
problem is the characterization of income for a foreign 
country's tax purposes in a way that is inconsistent with the 
U.S. tax characterization of the same income.
    For example, assume that a U.S. taxpayer sells a disk 
containing a copyrighted computer program to a foreign buyer. 
Under the U.S. regulations governing transactions in computer 
software, this transaction is characterized as the sale of a 
copyrighted article. Under U.S. income tax treaties, sales 
income is taxable under the Business Profits article. Under 
this interpretation, if the U.S. taxpayer does not have a 
permanent establishment in the country of sale, the foreign 
country is prohibited from imposing tax.
    However, the foreign tax authorities may not agree that the 
transaction gives rise to business profits. Because the 
transaction involves copyrighted software, the payment may be 
viewed as a royalty, which the source country may be permitted 
to tax (usually at reduced rates) under the treaty. This tax 
may not be creditable against U.S. tax because the U.S. does 
not view the foreign country as having tax jurisdiction over 
the payment.
    These problems have arisen repeatedly in the cross-border 
activities of software companies. Some of these companies have 
sought relief under the mutual agreement procedures available 
under tax treaties. While these avenues can be effective, they 
are costly, time-consuming, and uncertain. Furthermore, the 
problem is a recurring one, and taxpayers would prefer not to 
resort to the mutual agreement procedure on a regular basis.
    We recognize that this problem is not resolvable by 
unilateral U.S. action, short of deferring in all cases to 
another country's characterization of income--a step that the 
government is understandably unwilling to take. However, we 
encourage the Congress and the Administration to pursue all 
available opportunities for resolving these issues on a 
bilateral or multilateral basis.
    Bilaterally, the tax treaty process--in which the Senate 
plays a significant role--can be used to forge country-by-
country agreements on specific points that have arisen with 
particular countries. Multilaterally, work with international 
organizations such as the Organizations for Economic 
Cooperation and Development can often lead to fruitful common 
understandings in key areas of international taxation. Congress 
should support the participation of the United States in these 
efforts, and be willing to participate fully in implementing 
points on which agreement is reached.

                    Foreign Sales Corporation Rules

    The U.S. Foreign Sales Corporation (FSC) rules have 
recently been challenged by the E.U. and a decision with 
respect to the legality of the FSC under multilateral trade 
agreements is currently pending before a WTO panel. The FSC 
rules are extremely important to the U.S. software industry, 
which derive 30% of their revenue from exports, and the 
industry is grateful that Congress clarified the application of 
these rules to software licenses as part of the 1997 Tax Act. 
The current FSC rules, and the DISC rules that they replaced, 
were enacted to offset a competitive disadvantage faced by U.S. 
exporters because the U.S. tax system is not as generous to 
exports as are the tax systems of our trading partners. These 
concerns still exist today. As we await a final decision from 
the WTO panel on the FSC issue, I wanted to make you aware of 
the importance of this issue to the software industry.

                               Conclusion

    We appreciate the opportunity to present our views on 
international tax simplification. We appreciate the Chairman's 
efforts to provide some much-needed simplification to this 
highly complicated area of the law. In addition, we look 
forward to continued Congressional attention to U.S. tax rules 
that hinder competition. In particular, we need a permanent R&D 
credit that compares favorably to the incentives offered by 
other countries. We also need to assure that the United States 
does not impose higher levels of tax on exports than do our 
trading partners. Finally, U.S. tax rules should not hinder 
efficient utilization of technology around the world. We look 
forward to working with the Subcommittee on these important 
issues.

                                


    Chairman Houghton. Ms. Strain, please.

  STATEMENT OF DENISE STRAIN, GENERAL TAX COUNSEL, CITICORP, 
                 CITIGROUP, NEW YORK, NEW YORK

    Ms. Strain. My name is Denise Strain, and I am the general 
tax counsel for Citicorp, a wholly-owned subsidiary of 
Citigroup. I want to thank the Chairman and the Subcommittee 
Members for their invitation to testify today on the topic of 
international tax simplification and for the Chairman's 
leadership in this area.
    Over the last several years, the Houghton-Levin legislation 
has provided an approach for Congress to simplify and 
rationalize the U.S. tax rules that apply to the global 
operations of U.S.-based, multinational companies. The U.S. 
international tax rules are important to Citigroup because of 
the global reach of the company. Citigroup is a diversified 
financial services company which offers banking, insurance, 
credit cards, asset management, and investment banking to our 
customers throughout the world. Citigroup has 170,000 employees 
located in 100 countries, including 112,000 employees in the 
United States. This global business requires us to prepare a 
complicated and time-consuming tax return.
    To give you some idea of the compliance burden these rules 
impose on Citigroup, let me describe our tax filings. In 
September of 1999, Citigroup will file its 1998 tax return. It 
will exceed 30,000 pages in length, including computations for 
more than 2,000 companies located in 50 States and 100 
countries. More than 200 tax professionals, both here and 
overseas, will be involved in this process. To say the least, 
it is a formidable task.
    My company understands first-hand that the global economy 
has become increasingly integrated; financial transactions have 
become more complex; financial decisions are made more quickly, 
and the tax implications, both here in the United States and in 
foreign jurisdictions, have become more difficult to resolve. 
It is not an easy task to structure a tax system that addresses 
both the evolving world of financial globalization in a manner 
that is fair and neutral while maintaining competitiveness for 
U.S. businesses.
    H.R. 2018, the legislation introduced earlier this month by 
Chairman Houghton and Congressman Levin, will go a long way 
toward simplifying our rules and encouraging competitiveness. I 
would like to highlight a couple of proposals in the bill. 
First, the proposal to make permanent, or at least extend, the 
deferral from Subpart F income for the active income of 
financial services companies is of critical importance to the 
U.S. financial services industry and is one of the key 
provisions in your bill. The provisions that permit the active 
business income of U.S. banks, securities firms, insurance 
companies, finance companies, and other financial services 
firms to be subject to U.S. tax only when that income is 
distributed back to the United States will expire at the end of 
this year. Active financial services income is universally 
recognized as active trade or business income. Thus, if the 
current law provisions were permitted to expire at the end of 
this year, U.S. financial services companies would find 
themselves at a significant competitive disadvantage vis-a-vis 
their major foreign competitors.
    Not only should the current rules be extended, but we hope 
very much that Congress will refrain from making another round 
of major changes to these rules. In order to comply with the 
deferral rules, over the past 2 years, U.S. companies have 
implemented numerous systems changes to accurately follow two 
very different versions of the active financing law. Further 
changes at this time would create excruciating complexity and 
compliance burdens with no commensurate benefits to the U.S. 
Treasury.
    Another proposal in your bill would greatly simplify the 
foreign tax credit rules. As a regulated industry in many 
countries, U.S.-based financial services companies operating 
outside the United States are often required by local laws to 
operate in joint ventures with local banks and other financial 
services companies. For this reason, it is so important for my 
industry that the tax rules be simplified for income from 
foreign joint ventures and other business operations in which 
U.S. companies own at least 10 percent but not more than 50 
percent of the stock in a foreign company. The so-called ``10/
50'' foreign tax credit limitation is bad tax policy and 
increases the cost of doing business for U.S. companies 
operating abroad.
    The 1997 Tax Relief Act sought to correct these problems by 
eliminating separate foreign tax credit baskets for 10/50 
companies. However, this important change will not take effect 
until after 2002, and it is accomplished in a rather 
complicated manner. Your bill, Mr. Chairman, will fix this 
problem. The proposal, which is also included in President 
Clinton's fiscal year 2000 budget, would accelerate from 2003 
to 2000 the repeal of the separate foreign tax credit basket 
for such ``10/50 companies,'' and would make this change for 
all dividends received in tax years after 1999.
    My written testimony, submitted for the hearing record, 
details a number of other important proposals included in H.R. 
2018 that we support and we believe will go a long way toward 
making our international tax regime less complex and more 
rational.
    On behalf of Citigroup, I want to thank you, Mr. Chairman, 
and the members of the Ways and Means Committee for your 
interest in international tax simplification. As a 
representative of a U.S.-based financial services company with 
operations throughout the world, I believe your efforts to 
simplify and rationalize the U.S. international tax rules are 
vitally important.
    Thank you.
    [The prepared statement follows:]

Statement of Denise Strain, General Tax Counsel, Citicorp, Citigroup, 
New York, New York

                              Introduction

    My name is Denise Strain, and I am the General Tax Counsel 
for Citicorp, a wholly-owned subsidiary of Citigroup. 
Citigroup, the product of last year's merger of Citicorp and 
the Travelers Group, is a diversified financial services 
holding company whose businesses provide a broad range of 
financial services to consumers and corporate customers around 
the world.
    On behalf of Citigroup, I want to thank the Chairman and 
the Subcommittee for their invitation to testify today on the 
topic of international tax simplification. I also want to 
express my appreciation, and the appreciation of Citigroup, to 
Chairman Houghton, Chairman Archer, Congressman Levin, and 
other members of the House Ways and Means Committee for your 
efforts in this area. Over the last several years, the 
Houghton-Levin legislation has provided a road map for Congress 
in seeking to simplify and rationalize the U.S. tax rules that 
apply to the global operations of U.S.-based multinational 
companies.
    Citigroup understands first hand that as the global economy 
has become increasingly more integrated, financial transactions 
have become more complex, financial decisions are being made 
more quickly, and the tax implications both here in the United 
States and in foreign jurisdictions have become more difficult 
to resolve. It is not an easy task to structure a tax system 
that addresses this evolving world of financial globalization 
in a manner that is fair and neutral while maintaining the 
competitiveness of U.S. business. The simple fact that you are 
conducting this hearing today sends a strong signal that we are 
making progress. The legislation introduced earlier this month 
by Chairman Houghton and Congressman Levin, which is aimed at 
further simplifying key aspects of the U.S. international tax 
rules, includes a number of important proposals. If enacted, 
these proposals will go a long way towards achieving a simpler 
and fairer tax regime for U.S. companies operating overseas.
    Mr. Chairman, in my testimony today, I would like to 
discuss why we believe the goal of maintaining a tax system 
that keeps pace with global competition and economic 
integration is important. Specifically, I will discuss a number 
of provisions in H.R. 2018, the International Tax 
Simplification for American Competitiveness Act of 1999, that 
are of significance to the financial services industry, 
including Citigroup.
         The Importance of International Tax Rules to Citigroup
    To understand why U.S. international tax rules are so 
important to Citigroup, I think it will be helpful to the 
Committee if I explain a little bit about my company. As I 
mentioned in my introduction, Citigroup is a diverse company. 
We offer our customers a broad range of financial services, 
including banking, insurance, credit cards, asset management, 
securities brokerage, and investment banking. The principal 
subsidiaries of Citigroup include Citibank, Travelers 
Insurance, Salomon Smith Barney, and Commercial Credit. 
Citigroup has 170,900 employees located in 100 countries, 
including 111,640 employees in the United States.
    Historically, U.S. financial services companies expanded 
abroad to support the global expansion of U.S. commercial 
businesses. As companies such as Caterpillar, General Motors, 
Exxon, and IBM have become global powerhouses and household 
names outside the United States, Citicorp and Citigroup have 
been there to provide capital for their expansions, and to 
provide banking and other investment services and advice to 
their employees. This is still the case as a new generation of 
American companies, including Microsoft, Intel, and Hewlett-
Packard, have launched and expanded their foreign operations.
    Unfortunately, U.S.-based multinational financial services 
companies could soon become an endangered species. Most of the 
world's large financial services players are foreign-based 
companies. Only three U.S.-based companies--Citigroup, 
BankAmerica, and Chase--are among the top 25 financial services 
companies in the world, as measured by asset size. Citigroup's 
foreign-based competitors are competing with us not only on 
foreign soil, but also on U.S. soil. These include such 
companies as Deutsche Bank, which recently completed its 
acquisition of Bankers Trust, and HSBC Holding, which is in the 
process of acquiring Republic Bank. Our foreign-based 
competitors in insurance are also increasingly making inroads 
into U.S. markets. For example, just recently, German-based 
Allianz AG acquired Fireman's Fund Insurance and the 
acquisition of Transamerica Corp. by Dutch-based insurance 
company Aegon NV is currently pending.
    It is no coincidence that, for the most part, the home-
country tax systems of these companies are simpler and more 
neutral when it comes to taxing home-country and international 
investment than the U.S. system, according to a National 
Foreign Trade Council (NFTC) study of foreign tax regimes and 
subpart F released earlier this year.
    This level of increased competition from non-U.S.-based 
financial services entities results from the fact that national 
economies are becoming increasingly global. Globalization is 
being fueled by rapid technological changes and a worldwide 
reduction in tax and regulatory barriers to the free 
international flow of goods and capital. These changes are all 
for the good. However, these changes are also putting 
tremendous pressure on our tax rules, which have become 
increasingly antiquated over the last 30 years.
    We can not afford a tax system that fails to keep pace with 
fundamental changes in the global economy, or that creates 
barriers that place U.S. financial services companies, as well 
as other U.S.-based multinationals, at a competitive 
disadvantage. Some have questioned whether the globalization of 
U.S.-based companies does much for U.S. economic growth and 
employment. In my company, the answer is easy. As Citigroup has 
grown internationally, our domestic support for those 
international activities has grown accordingly. For example, 
Citibank's U.S.-based credit card manufacturing and processing 
facilities produce credit card statements, inserts, and actual 
credit cards for Citibank customers in Europe, Latin America, 
and the Caribbean. Other Citigroup service centers in the 
United States process all the bills and payments for outside 
vendors the corporation utilizes around the globe, along with 
employee expense reports and reimbursements. We've found that 
consolidating many of these back-office functions in the United 
States achieves a maximum level of efficiency, just as the 
centralization of credit card manufacturing and processing 
takes advantage of economies of scale and R&E performed in this 
country.
    U.S. trade policy has clearly recognized that breaking down 
barriers to international trade is a key factor in spurring 
U.S. economic growth and jobs, and this committee has played a 
leading role in that regard. It is ironic, therefore, that our 
international tax policy at times seems to go in a different 
direction. For example, we continue to face double taxation 
because our foreign tax credit rules are antiquated. In 
addition, the question still remains among some whether the 
active income of financial services companies should continue 
to be subject to the anti-deferral regime of subpart F. These 
two factors--the incidence of double taxation and the premature 
imposition of U.S. tax on our foreign earnings--together hinder 
our ability to compete against foreign-based companies that 
face less hostile home-country tax regimes, according to the 
NFTC international tax study.
                     The Complexities in Our System
    Moreover, our international tax regime imposes layer upon 
layer of needless complexity, creating an environment where 
taxpayers and the IRS are in a constant tug-of-war over rules 
that were not designed to apply in the context of many modern 
cross-border financial transactions.
    From the standpoint of one of the largest financial 
services companies in the world based in the United States, we 
see the evidence of this first hand, every day. The labyrinth 
of rules and regulations we face are almost beyond 
comprehension. More often than not, applying these rules to 
increasingly complex transactions produces more questions than 
answers.
    To give just one example of the complexities we face, at a 
time when American corporations are trying to concentrate on 
competitiveness and pare down nonessential costs, determining 
the earnings and profits of our foreign subsidiaries for 
subpart F purposes requires our staff to go through a five-step 
procedure. This process starts with the local books of account 
and then continues with a series of complicated accounting and 
tax adjustments. On audit, each of these steps must be 
explained and justified to IRS agents. Yet, equally reliable 
figures could be provided, at a fraction of the time and cost, 
by simply using GAAP to determine earnings and profits. I am 
glad to say that H.R. 2018 includes just such a rule, and we 
would recommend that this GAAP provision be extended to apply 
to calculations of earnings and profits of all foreign 
corporations for all purposes.
    More generally, one of the biggest problems we face 
involves the coordination of U.S. rules with those of the 
countries in which we do business. It is a fact of life for 
Citigroup that our U.S. tax filing deadlines and requirements 
generally bear no relationship to those of other countries. 
This means that we generally do not have all the foreign 
information we need when our U.S. tax return is due, so our 
return contains tentative information, and we are forced to 
adjust our returns during the IRS audit process.
    Mr. Chairman, I ask you to think about this: when you and I 
and tens of millions of other Americans finish our individual 
tax returns by April 15 every year, we breathe a long sigh of 
relief that an annoying, stressful, and time consuming process 
has been completed--until next year. For Citigroup, however, 
this task of filing our annual tax return is an ongoing process 
that often takes years to complete. This situation is 
ameliorated somewhat by a network of bilateral tax treaties 
intended to limit double taxation and coordinate information 
and other requirements between two countries' tax regimes. 
However, this network does not extend to many countries in 
which Citigroup does business, including such emerging market 
countries as Brazil and Argentina.
    To give you some idea of the scope of the compliance burden 
for Citigroup, let me describe our tax filings. In September, 
Citigroup will file its 1998 tax return. It will exceed 30,000 
pages in length, including computations for more than 2,000 
companies located in 50 states and 100 countries. More than 200 
tax professionals, both here and overseas, will be involved in 
this process. The end of this process is the examination of 
this return by IRS auditors, generally years from now. To say 
the least, it's a formidable process.
                      Tax Simplification Proposals
    Mr. Chairman, we do believe that enactment of a modest 
number of changes to the current system will go a long way to 
help simplify some rules that are unnecessarily complex and 
time consuming to deal with. Moreover, I believe these changes 
will help us be more competitive.

Active Financing Exception to Subpart F

    The rules that permit the active business income of U.S. 
banks, securities firms, insurance companies, finance companies 
and other financial services firms to be subject to U.S. tax 
only when that income is distributed back to the United States, 
expire at the end of this year. The proposal to make permanent 
or, at the very least extend, the exception to the anti-
deferral regime of subpart F for the active income of financial 
services companies is of crucial importance to the U.S. 
financial services industry and is one of the key provisions in 
your bill.
    By way of background, when subpart F was first enacted in 
1962, the basic intent was to require current U.S. taxation of 
foreign income of U.S. multinational corporations that was 
passive in nature. The 1962 law was careful not to subject 
active financial services business income to current taxation, 
through a series of detailed carve-outs. In particular, 
dividends, interest and certain gains derived in the active 
conduct of a banking, financing, or similar business, or 
derived by an insurance company on investments of unearned 
premiums or certain reserves received from unrelated persons, 
were specifically excluded from current taxation. In 1986, 
however, the provisions that were put in place to ensure that a 
controlled foreign corporation's active financial services 
business income would not be subject to current tax were 
repealed in response to concerns about the potential for 
taxpayers to route passive or mobile income through tax havens.
    In 1997, the 1986 rules were revisited for several reasons. 
A key reason was the fact that many U.S. financial services 
companies found that the existing rules imposed a competitive 
barrier in comparison to home-country rules of many foreign-
based financial services companies. Moreover, the logic of the 
subpart F regime made no sense, given that most other U.S. 
businesses were not subject to similar subpart F restrictions 
on their active trade or business income. The 1997 Tax Act 
created an exception to the subpart F rules for the active 
income of U.S.-based financial services companies, along with 
rules to address concerns that the provision would be available 
to shelter passive operations from U.S. tax. At the time, the 
exception was included for only one year primarily for revenue 
reasons, as you yourself pointed out, Mr. Chairman, in remarks 
in support of the provision made on the House floor.
    The active financing income provision was reconsidered 
again in 1998, in the context of extending the provision for 
the 1999 tax year, and considerable changes were made in 
response to Congressional and Administration concerns.
    Active financial services income is generally recognized as 
active trade or business income. Thus, if the current-law 
provision were permitted to expire at the end of this year, 
U.S. financial services companies would find themselves at a 
significant competitive disadvantage vis-a-vis major foreign 
competitors when operating outside the United States. In 
addition, because the U.S. active financing exception is 
currently temporary, it denies U.S. companies the certainty 
their foreign competitors have. The need for certainty in this 
area cannot be overstated. U.S. companies need to know the tax 
consequences of their business operations, which are generally 
evaluated on a multi-year basis.
    Not only should the current rules be extended, but we hope 
very much that Congress will refrain from making another round 
of major changes to these rules. In order to comply with the 
deferral rules, over the last two years U.S. companies have 
implemented numerous system changes to accurately follow two 
significantly different versions of the active financing law. 
While some in government have indicated problems still exist, 
we all need to remember that many U.S. companies, including 
Citigroup, have yet to file their first U.S. tax returns 
incorporating the 1997 Tax Act rules in this area. It will be 
another 15 months before tax returns are filed incorporating 
the rules that were enacted last year to apply to the 1999 tax 
year. Further changes at this time would create excruciating 
complexity and compliance burdens with no commensurate benefits 
for the U.S. Treasury.
    Despite any real evidence that the current rules are not 
working, I understand that the Treasury Department has 
suggested that Congress hold off extending the active financing 
exception until Congress has had the time to review the 
Treasury's suggestions. However, the international growth of 
American finance and credit companies, banks, securities firms, 
and insurance companies would be impaired by an ``on-again, 
off-again'' system of annual extensions that does not allow for 
certainty. Failing to extend the active financing exception 
this year would be the antithesis of tax simplification. In 
contrast, making this provision a permanent part of the law, or 
at least extending the provision, would greatly simplify U.S. 
international tax rules and enhance the global position of the 
U.S. financial services industry.

The 10/50 Foreign Tax Credit Basket

    As a regulated industry in many countries, U.S.-based 
financial services companies operating outside the United 
States are often required by local laws to operate in joint 
ventures with local banks and other financial services 
companies. That is why it is so important for my industry that 
the tax rules be simplified for income from foreign joint 
ventures and other business operations in which U.S. companies 
own at least 10 percent but not more than 50 percent of the 
stock in the foreign company.
    In particular, the so-called 10/50 foreign tax credit rules 
impose a separate foreign tax credit limitation for each 
corporate joint venture in which a U.S. company owns at least 
10 percent but not more than 50 percent of the stock of the 
foreign entity. The 10/50 regime is bad tax policy. The current 
rules increase the cost of doing business for U.S. companies 
operating abroad by singling out income earned through a 
specific type of corporate business form for separate foreign 
tax credit ``basket'' treatment. Moreover, the current rules 
impose an unreasonable level of complexity, especially for 
companies with many foreign corporate joint ventures.
    The 1997 Tax Relief Act sought to correct these problems by 
eliminating separate foreign tax credit baskets for 10/50 
companies. However, this important change will not take effect 
until after 2002, and it is accomplished in a rather 
complicated manner. Under the new rules, dividends from 
earnings accumulated after 2002 will get so-called look-through 
treatment, effectively repealing the 10/50 rules, while 
dividends from pre-2003 earnings will all be part of a single 
``super'' 10/50 foreign tax credit basket.
    Your bill, Mr. Chairman, would fix this problem. The 
proposal, which is also included in President Clinton's FY 2000 
budget, would accelerate from 2003 to 2000 the repeal of the 
separate foreign tax credit basket for such ``10/50 
companies.'' In doing so, so-called look-through treatment 
would apply in order to categorize income from all such 
ventures according to the type of earnings from which the 
dividends are paid. The proposal would apply the look-through 
rules to all dividends received in tax years after 1999, 
regardless of when the earnings constituting the makeup of the 
dividend were accumulated.
    We very much support this approach and hope it can be 
enacted this year. In particular, the requirement of current 
law that we use two sets of rules on dividends beginning with 
the year 2003 has been a concern of taxpayers, members of 
Congress, and the Administration. That is why it is so 
important that the effective date of the 1997 Tax Act changes 
be accelerated and that the ``super'' 10/50 basket be repealed.

Application of the U.S. Aviation Ticket Tax to Foreign 
Frequent-Flyer Programs

    Significant administrative and compliance problems have 
arisen due to the interpretation that the aviation ticket tax 
rules as modified in 1997 may apply to certain frequent-flyer 
``affinity'' programs that operate outside the United States 
but involve carriers with flights to the United States. Your 
bill contains a modest change to the statute, giving the IRS 
and Treasury authority to address this issue in regulations 
that would adequately address this problem at very little cost 
to the Treasury.
    This is important to my industry, Mr. Chairman, because 
credit card companies are among the largest providers of such 
affinity programs. Citibank and Diners Club, for example, 
compete throughout the world with locally-based banks and 
credit card companies. Under these affinity programs, these 
banks permit their customers to earn miles on air carriers when 
they make credit card purchases. We provide these miles to our 
customers by purchasing the mileage award points from the 
carriers.
    Specifically, the problem relates to the extension of the 
7.5 percent ticket tax to these purchases from air carriers of 
frequent-flyer miles by credit card companies, hotels, 
telephone companies and other consumer businesses for the 
benefit of their customers. The statute has been interpreted to 
apply this tax to the purchase of all mileage awards on a 
worldwide basis, including miles that could be redeemed for 
transportation that has no relationship to the United States. 
This interpretation has led to numerous diplomatic protests and 
has created competitive and administrative issues for the U.S. 
travel and tourism industry.
    We also understand that the only parties actually paying 
the tax at this time are U.S.-based taxpayers, including U.S. 
purchasers of mileage awards and U.S.-based carriers. Because 
foreign-based carriers and purchasers of miles apparently take 
the position that the tax should not apply to transactions 
outside our borders, they are not paying the tax. This pattern 
of compliance is creating an unfair playing field for U.S. 
companies doing business in foreign markets.
    The application of the aviation ticket tax to these foreign 
programs is a prime example of the need for simplification and 
rationalization in our tax rules. A simple solution to this 
problem would be to provide the IRS and Treasury with 
regulatory authority to exclude payments for mileage awards 
from the tax as long as the awards relate to individuals with 
non-U.S. addresses.

Withholding Tax Exemption for Certain Mutual Fund Distributions

    We very much support the proposal included in the Houghton/
Levin bill to exempt from U.S. withholding tax all 
distributions of interest and short-term capital gains to 
foreign investors by a U.S. mutual fund, including equity, 
balanced, and bond funds. Under the proposal, mutual fund 
distributions would be exempt from U.S. withholding tax if they 
were received by a foreign investor either directly or through 
a foreign fund. Similar legislation has been introduced in 
prior Congresses by Representatives Crane, Dunn, and McDermott.
    Mr. Chairman, while the U.S. mutual 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. The current withholding tax that applies to all 
dividends distributed from a U.S. fund to foreign investors is 
a clear disincentive to foreign investment in U.S. funds. This 
is the case because distributions of interest income and short-
term capital gains received directly, rather than from a fund 
investment, are not subject to withholding tax.
    The proposed legislation would enhance the competitive 
position of U.S. fund managers and their U.S.-based workforce 
and simplify the administration of these funds.
                     Other Simplification Proposals
    H.R. 2018 includes a number of other international 
simplification proposals that we would like to highlight.

Provide an Ordinary Course Exception to the Income Re-sourcing 
Rule for U.S.-Owned Foreign Securities Dealers

    Current law provides that income received by a U.S. parent 
from its CFC will be re-sourced from foreign source to U.S. 
source to the extent the CFC is treated as having earned U.S. 
source income (for example, if the CFC derives interest income 
from a Eurobond). Recognizing that the existing rule is 
inequitable when applied to securities dealers, the bill would 
create an exception to the existing re-sourcing rule by 
providing that income earned by a securities dealer from 
securities held in the ordinary course of conducting its 
customer business will not be re-sourced.

Treat a Foreign Securities Firm's Market-Making Activities in 
its Parent Company's Issuances Consistently with its Market-
Making Activities in Other U.S. Companies' Securities

    U.S.-owned foreign securities firms, as part of their 
ordinary course market-making activities, will hold in 
inventory securities of U.S. corporations. Thus, for example, a 
foreign securities firm may hold in inventory a Eurobond issued 
by General Motors. However, Citigroup's foreign securities 
dealers are effectively prohibited from holding Citigroup 
issuances in inventory over quarter-end because the holding of 
that security would give rise to a subpart F deemed dividend. 
The bill would eliminate this rule for parent and affiliate 
securities held by a U.S.-owned foreign securities dealer in 
the ordinary course of its market making activity.

                               Conclusion

    On behalf of Citigroup, we want to thank you, Mr. Chairman, 
and Members of the Ways and Means Committee for your interest 
in international tax simplification and the impact of current 
rules on my company. As a representative of a U.S.-based 
financial services company with operations throughout the 
world, I believe your efforts to simplify and rationalize the 
U.S. international tax rules are vitally important. Thank you 
again for the opportunity to testify today.

                                


    Chairman Houghton. Thanks very much, Ms. Strain.
    Mr. Jarrett.

  STATEMENT OF THOMAS K. JARRETT, DIRECTOR OF TAXES, DEERE & 
                   COMPANY, MOLINE, ILLINOIS

    Mr. Jarrett. Good afternoon, Mr. Chairman, Members of the 
Committee. My name is Tom Jarrett, director of Taxes for Deere 
& Company. In this position, I am responsible for Deere's 
worldwide tax and compliance measures.
    Deere is the world's largest producer and distributor of 
agricultural equipment and a leading producer and distributor 
of construction and grounds care equipment. It also finances 
and leases equipment and has insurance and health care 
operations. We employ 26,000 people in the United States, 
37,000 worldwide.
    Mr. Chairman, we want to thank you for your efforts to make 
the U.S. Tax Code not only simpler and fairer but also one that 
helps American corporations compete abroad. In my written 
testimony, I have focused on the details of three specific 
areas of interest to Deere and other manufacturers: foreign 
interest expense allocation, active financing income exemption, 
and foreign tax credit ordering rules. The reason this 
Committee's attention to these issues is critical is something 
you understand well. Deere and other U.S. manufacturers are in 
a global race with our foreign competitors. Many of these 
foreign companies are provided tax policy advantages that 
support their operations around the world. The U.S. Tax Code 
should level the playing field for American companies so that 
they may compete successfully for international business.
    The issue here is cost. Bad tax policy adds cost. For 
instance, the allocation of our U.S. credit subsidiaries' 
interest expense to foreign operations doubles the allocation 
of interest to foreign operations, yet our U.S. credit 
operation has basically no foreign assets. Regarding the active 
financing exemption, retaining this measure will permit Deere 
and others to compete on equal terms with U.S. banks and 
foreign finance competitors. It is extremely important for us 
to expand our markets and export our U.S. goods.
    The John Deere brand is sought around the world as a result 
of our reputation for quality and genuine value. Our customers 
are willing to pay a premium for our products, innovative 
technology, superior engineering, and overall quality. The 
company's costs for research and development and quality 
improvement may be reflected in the price the customer pays, 
but there are limits to what the market will bear. The world 
market won't allow costs associated with outdated and 
disproportionate tax obligations to be passed to our customers. 
These costs simply slow us down in our global race.
    John Deere is a global enterprise. About one-third of 
Deere's total equipment sales in 1998 took place outside the 
United States. While the U.S. farmer remains our number one 
customer, Deere's growth opportunities are increasingly tied to 
our ability to compete in the global marketplace. We have 
aggressive growth objectives, both in this country and abroad. 
Our experience is that growth here and abroad is complimentary. 
Our presence abroad helps our U.S. exports and helps to provide 
product volumes that keep U.S. products less expensive for our 
customers. Sometimes products produced for markets outside the 
United States also have a use in the United States. Our balance 
of payments from a U.S. perspective is clearly positive.
    In summary, Deere & Company must be able to compete 
effectively overseas in order to continue to provide jobs to 
its employees, expand its business, and provide genuine value 
to shareholders. The three recommendations we are making today 
will favorably affect all U.S. equipment manufacturers. 
Moreover, they will strengthen our ability to compete favorably 
overseas and provide more jobs in and exports from this 
country.
    Thank you.
    [The prepared statement follows:]

Statement of Thomas K. Jarrett, Director of Taxes, Deere & Company, 
Moline, Illinois

    Good afternoon Mr. Chairman and Members of the Committee. I 
am Tom Jarrett, Director of Taxes for Deere & Company. In this 
position I am responsible for Deere's worldwide tax planning 
and compliance.
    Deere & Company is the world's largest producer and 
distributor of agricultural equipment and a leading producer 
and distributor of construction and grounds care equipment. It 
also finances and leases equipment and has insurance and health 
care operations. Deere employs approximately 26,000 people in 
the United States and 37,000 worldwide.
    The company has factories in nine states and eleven 
countries. Our products are distributed and serviced worldwide 
by a large number of independent John Deere dealers.
    We have aggressive growth objectives both in this country 
and abroad. Our experience is that growth here and abroad is 
complimentary. Our presence abroad helps our U.S. exports and 
helps provide product volumes that keep U.S. products less 
expensive for our customers. Sometimes products produced for 
markets abroad also have a use in the U.S. Our balance of 
payments--from a U.S. perspective--is clearly positive.
    For Deere to continue expanding our businesses at a level 
acceptable to our shareholders, Deere clearly must continue to 
expand and be competitive overseas.
    One of the greatest challenges faced by Deere and other 
multinational companies is the complexity of U.S. international 
tax rules. Many provisions of the U.S. tax code not only result 
in a paperwork burden unmatched anywhere in the world, but also 
hinder the ability of American companies to compete in the 
international arena. Mr. Chairman, we appreciate your 
leadership in examining this issue. Your legislation (H.R. 
2018) addresses many areas where the U.S. Code could be 
improved. I would like to focus on a few specific areas of 
interest to Deere and other manufacturers.
    Three key tax issues that affect our competitiveness 
overseas are: the foreign interest expense allocation; the 
active financing income exemption; and, the foreign tax credit 
ordering rules. The way these issues are currently handled 
causes U.S. manufacturers to be less competitive with overseas 
manufacturers and, as a result, reduces U.S. manufacturers' 
ability to sell U.S. products overseas. For this reason, we 
have advocated for several years that U.S. international tax 
laws must be addressed in these areas.

                (1) Foreign Interest Expense Allocation

    The maximum foreign tax credit a U.S. company can receive is equal 
to the U.S. tax rate times the foreign taxable earnings less the U.S. 
expenses incurred to generate those earnings. In determining the U.S. 
expense incurred, Regulation 
1.861-11T requires that the total U.S. affiliated company interest 
expense be allocated between domestic and foreign source income based 
on assets.
    The Deere U.S. credit and leasing companies only finance equipment 
sold or leased within the U.S. The Deere U.S. credit and leasing 
company assets represent over 50 percent of the total asset allocation 
base. By comparison, foreign assets are less than 13 percent of total 
assets. The credit and leasing companies account for 80 percent of the 
U.S. consolidated income tax return interest expense. The tax 
regulations force a disproportionate allocation of interest expense to 
foreign assets. The arbitrary interest expense allocation has reduced 
Deere's foreign tax credit by 11 to 20 percent in recent years. The 
resulting double taxation of foreign earnings makes Deere and other 
manufacturers less competitive in foreign markets.
    Currently, the interest expense allocation regulation exempts 
certain financial institutions, including chartered banks and thrifts, 
from the 861-11 allocation. However, other active domestic finance 
companies that are defined in Section 
1.904-4(e)(3) of the Regulations are actually performing the same 
functions as chartered banks and thrifts (such as Deere's credit and 
leasing operations), but are not included in the exemption.
    We recommend that the exemption to the interest allocation 
regulation be expanded to include all active domestic financial 
institutions. In this manner, our foreign income will be more 
accurately reflected and our eligibility for an appropriate level of 
foreign tax credit will be restored. This issue must be addressed to 
ensure that U.S. companies' international tax burden approximates that 
of our competitors.

                 (2) Active Financing Income Exemption

    Another important foreign tax issue to equipment manufacturers is 
the exemption for active financing income. In 1997 Congress adopted an 
exception to subpart F of the Code for foreign finance companies that 
comply with the significant active business tests in Section 
954(h)(2)(A) of the Code. Prior to its adoption, subpart F taxed all 
income on foreign loans and leases as the income was earned, rather 
than permit such income to be deferred until foreign dividends were 
paid. The law viewed all finance activity as passive investment 
activity.
    However, Section 954(h)(2)(A) established an exception to the 
subpart F rules for foreign finance companies where their principal 
business activity is to provide financing to unrelated parties located 
in the country in which the foreign finance company was organized. This 
exception strengthens the business carried on by the foreign finance 
companies.
    Moreover, the exception was, and continues to be, extremely 
important to equipment manufacturers such as Deere as we expand our 
markets overseas and as we expand financing activities abroad to South 
America, Eastern Europe and Asia. All of these markets have a high 
demand for our products, but the customers have had difficulty in 
securing adequate financing for their purchases of equipment. With the 
expansion of our financing operations overseas during the period of the 
exemption, this problem has been minimized and Deere, like other 
equipment manufacturers, is able to compete successfully in the foreign 
marketplace.
    The exemption for active financing income is scheduled to expire on 
December 30, 2000. Deere recommends that the active financing income 
exemption be made permanent. A permanent exemption would enable Deere 
and other manufacturers to continue to expand our financing operations 
overseas, export more equipment abroad and expand our U.S. workforce.

                 (3) Foreign Tax Credit Ordering Rules

    The third area of concern to Deere and other manufacturers is the 
manner in which corporations must use unused foreign tax credits. 
Currently, unused foreign tax credits that are earned in a given year 
must be used before any carryover credits can be used in that year. As 
a result, equipment manufacturers that are experiencing a downturn find 
it very difficult to claim any carryover foreign tax credit in years of 
reduced profits.
    Many companies often find that in a downturn (1) lower 
manufacturing activity reduces foreign royalty income; (2) foreign 
source export sales income is greatly reduced as the demand for 
equipment softens overseas; (3) foreign dividends are withheld to 
finance the buildup of inventory and trade receivables abroad; (4) U.S. 
interest expense allocated to foreign source income increases as U.S. 
borrowings increase to finance the buildup of similar U.S. inventory 
and receivables; and (5) the combination of lower foreign source income 
and rising 861 interest expense allocations reduces a company's ability 
to claim a foreign tax credit. And without the benefit of a foreign tax 
credit, that company's foreign earnings are being double taxed.
    Accordingly, we recommend that the Committee establish ``ordering 
rules'' for foreign tax credits similar to the rules governing net 
operating losses. These rules would permit the ``earliest-to-expire'' 
carryover credit to be used before any credit that is earned in the 
current year--just as currently is the case with NOL carryovers. In 
this manner, a company would be able to maximize its foreign tax credit 
carryovers without losing them during a downturn. This would enable 
equipment manufacturers to maximize their foreign tax credits and 
remain competitive in their overseas markets following a downturn.
    In summary, Deere & Company must be able to compete effectively 
overseas in order to continue to provide jobs to its employees, expand 
its business and provide genuine value to its shareholders. The three 
recommendations that we are making today will favorably affect all U.S. 
equipment manufacturers. Moreover, they will strengthen our ability to 
compete favorably overseas and therefore provide more jobs in and 
exports from this country.
    Thank you.

                                

    Chairman Houghton. Thank you very much. You are a very 
efficient man. You did it well within the time limit.
    Now, I would like to turn to Mr. McKenzie.

  STATEMENT OF GARY MCKENZIE, VICE PRESIDENT OF TAX, NORTHROP 
          GRUMMAN CORPORATION, LOS ANGELES, CALIFORNIA

    Mr. McKenzie. Thank you, Mr. Chairman and Members of the 
Subcommittee for the opportunity to appear before you today.
    Northrop Grumman Corporation is a leading designer and 
manufacturer of defense products, and our most widely known 
products are the B-2 and the Joint STARS aircraft----
    Chairman Houghton. Do you want to bring that mike just a 
little closer to you? Bring the mike a little closer to you.
    Mr. McKenzie. I am sorry. Would you like me to start over?
    Chairman Houghton. No, that is fine.
    Mr. McKenzie. OK. First, I want to commend Chairman 
Houghton and Congressman Levin for the many constructive 
changes included in H.R. 2018. In my view, Subpart F of the 
Internal Revenue Code has become overly complex and restrictive 
to the point that it actually interferes with the conduct of 
international business. The reevaluation of the policy goals of 
Subpart F and the entire scheme of international taxation is 
overdue, and I applaud your efforts to begin that process, and 
I would be happy to share more of my thoughts on that once we 
have reached the end of this.
    However, I will now focus my comments specifically on the 
benefits of section 303 of H.R. 2018, which repeals section 
923(a)(5) of the code that severely discriminates against U.S. 
exporters of products on the United States munitions list. 
Specifically, current law reduces Foreign Sales Corporation 
benefits available to companies that sell military products 
abroad to 50 percent of the benefits available to all other 
exporters. The provision is essentially a penalty tax imposed 
only on U.S. exporters with military property and should be 
repealed; its time has passed. Today, military exports, like 
commercial exports, are subject to fierce international 
competition in every area from companies such as British 
Aerospace, Aerospacio, Daimler-Benz, and others.
    Since fiscal 1985, the United States defense budget has 
shrunk from 27.9 percent of the Federal budget, now, to 14.8 
percent in fiscal 1999; that is almost a half decrease. And in 
facing such dramatic cuts in U.S. defense spending, the 
international market has become increasingly important to U.S. 
defense contractors and to maintaining the defense industrial 
base. For example, of the three fighter aircraft programs under 
production in this country currently, two are largely dependent 
on foreign customers. The same is true for the manufacturer of 
the M-1A1 tank. Repeal will not only benefit the large 
manufacturers of military hardware, but also smaller munitions 
manufacturers whose products are particularly sensitive to 
price fluctuations.
    One of Northrop Grumman's main export product lines is 
ground radars. In this market, we compete against companies 
from France, Germany, Italy, and Great Britain, which are often 
government subsidized, and price is often a key factor as to 
who wins the foreign sale. The restoration of the full FSC 
benefit has the potential to strengthen the U.S. defense 
industry base by leveling the playing field with our 
international competition.
    I now want to talk about Northrop Grumman's real-time FSC 
analysis. The FSC tax benefits have a real impact on our 
international sales and pricing. As an example, Northrop 
Grumman performs the FSC benefit analysis on a real-time basis. 
Under our internal procedures, the tax department is 
responsible for reviewing the company's foreign bids, 
proposals, contracts, and joint ventures. Our program managers 
and contracts negotiators are generally aware of the FSC 
benefits, and we often consult with them about it at the time 
the bids are prepared and the contract prices with foreign 
customers are being negotiated. So, my point here is that the 
FSC benefits are cranked into pricing and considered at the 
time that the prices are being negotiated with foreign 
customers, and if we can roll down the price, that gives us a 
competitive advantage against foreigners.
    Now, I would like to point out that the provision is 
support by the Department of Defense. For example, in a letter 
dated August 26, 1998, Deputy Secretary of Defense, John Hamre, 
wrote Treasury Secretary Rubin about the FSC. And Mr. Hamre 
wrote--and here I am quoting: ``The Department of Defense 
supports extending the full benefits of the FSC exemption to 
the defense exporters. I believe, however, that putting defense 
and non-defense companies on the same footing, would encourage 
defense exports that would promote standardization and 
interoperability of equipment among our allies. It could also 
result in a decrease in the cost of defense products to the 
defense products to the Department of Defense.''
    Continued export license reviews: I would now like to 
emphasize that the repeal of section 923(a)(5) of the tax code, 
the discriminatory provision against defense contractors, does 
not alter U.S. export licensing policy. Military sales will 
continue to be subject to the license requirements of the Arms 
Export Control Act. As under current law, exporters of military 
property will only be able to take advantage of the FSC after 
the U.S. Government has to determined that a sale is in the 
national interest. However, once a decision has been made that 
the military export is consistent with the national interest, 
our Government should encourage such sales to go to U.S. 
companies and workers, not to our foreign competitors.
    As you probably know, Congressman Sam Johnson's bill, the 
Defense Jobs and Trades Promotion Act of 1999, includes 
language identical to section 303 of H.R. 2018. This bill 
enjoys broad bipartisan support. Currently, 54 Members of 
Congress are co-sponsors of the bill, including 9 of the 12 
members of this Subcommittee and 28 of 39 members of the full 
Ways and Means Committee. In addition, Senators Mack and 
Feinstein have introduced identical legislation in the Senate, 
which also enjoys broad bipartisan support.
    In conclusion, I urge the Congress to enact H.R. 2018. The 
enactment of section 303 of H.R. 2018, in particular, will 
provide fair and equal treatment to our defense industry and 
its workers and enable American defense companies to compete 
more successfully in the increasingly challenging international 
market.
    Thank you for your time, and I will be pleased to answer 
any questions that you may have.
    [The prepared statement follows:]

Statement of Gary McKenzie, Vice President of Tax, Northrop Grumman 
Corporation, Los Angeles, California

    Mr. Chairman and Members of the Subcommittee, thank you for 
providing me the opportunity to appear before you today. My 
name is Gary McKenzie and I am Vice President of Tax for 
Northrop Grumman Corporation. Northrop Grumman, headquartered 
in Los Angeles, is a leading designer, systems integrator and 
manufacturer of military surveillance and combat aircraft, 
defense electronics and systems, airspace management systems, 
information systems, marine systems, precision weapons, space 
systems, and commercial and military aerostructures. We employ 
about 49,000 people based almost entirely in the United States. 
In 1998 we had sales of $8.9 billion. Many of our products, 
including the B-2 bomber and the Joint STARS surveillance 
aircraft, were used extensively during the recent conflict in 
Kosovo.
    I am pleased to provide testimony on the myriad problems 
facing U.S. corporations in complying with the complexity of 
the current U.S. international tax regime. I also want to 
commend Chairman Houghton and Congressman Levin for the many 
constructive changes included in H.R. 2018, the ``International 
Tax Simplification for American Competitiveness Act of 1999.'' 
My specific comments on the bill will concentrate, in 
particular, on Section 303, the ``Treatment of Military 
Property of Foreign Sales Corporations.''
    Before I discuss the Foreign Sales Corporation provision, 
however, I would like to say why the time has come (and, 
indeed, is long overdue) to reform the entire U.S. 
international tax system. Particularly needing reform is our 
system for taxing the foreign income of U.S. corporations under 
the so-called ``subpart F'' regime. The complexity of the 
subpart F rules and the pressing need for a fresh look at, and 
complete reevaluation of, subpart F was presented in a recent 
report prepared by the National Foreign Trade Council, 
``International Tax Policy for the 21st Century: A 
Reconsideration of Subpart F.'' I strongly agree with the 
report's recommendations, and I would like to highlight some of 
the issues discussed in the report.
    As I am sure many of you know, subpart F was initially 
added to the Internal Revenue Code (IRC) almost 40 years ago, 
during the Kennedy Administration. Before the enactment of the 
subpart F rules, U.S. tax generally was imposed on earnings of 
a U.S.-controlled foreign corporation (a ``CFC'') only when the 
CFC's foreign earnings were actually repatriated to the U.S. 
owners, usually in the form of a dividend. Subpart F is 
referred to by many tax professionals as an ``anti-deferral'' 
regime. That is, its intended purpose, which has been achieved 
quite effectively during the course of numerous legislative 
changes since 1962, is to prevent U.S. companies from deferring 
the payment of U.S. tax on income earned abroad by CFCs in 
their foreign operations, including various categories of 
``active'' business income. Put another way, the anti-deferral 
rules under subpart F frequently accelerate the imposition of 
U.S. tax on various types of income earned by CFCs, even though 
the income has not been repatriated to the U.S. This regime 
places U.S. companies at a clear disadvantage to foreign 
companies, which frequently do not operate under these kinds of 
harsh and complex taxing rules. The simple fact is that the 
application of subpart F to various categories of active 
foreign business income should be substantially narrowed as a 
first step to reforming the current anti-deferral regime.
    A certain irony underlies this entire discussion. The 
subpart F rules were originally intended to achieve capital 
export ``neutrality'' when they were enacted in 1962. That is, 
it was intended that the subpart F rules would play no part in 
influencing the decision of whether to invest in the U.S. or a 
foreign country. Unfortunately, subpart F has developed over 
the last 40 years into an arcane set of rules that not only are 
enormously complex, but also clearly place U.S. companies at a 
competitive disadvantage in the global marketplace. It is my 
view, which I believe is shared by many others, that tax rules 
play a key role in America's continuing prosperity, 
particularly in the context of an increasingly global 
marketplace. A reevaluation of the policy goals of subpart F 
and, indeed, the entire scheme of international taxation is 
long overdue; and I applaud your efforts to begin that process.
    I will now discuss Section 303 of H.R. 2018, which 
eliminates a provision of the tax code that severely 
discriminates against United States exporters of products on 
the U.S. Munitions List. Specifically, Section 303 repeals IRC 
Section 923(a)(5), which reduces the Foreign Sales Corporation 
(FSC) benefits available to companies that sell military goods 
abroad to 50 percent of the benefits available to other 
exporters.
    Congressman Sam Johnson's bill, H.R. 796, the ``Defense 
Jobs and Trade Promotion Act of 1999,'' includes language 
identical to Section 303. This bill enjoys broad bipartisan 
support. Currently 54 members of Congress are cosponsors of the 
bill, including 10 of the 13 members of this subcommittee and 
28 of the 39 members of the full Ways and Means Committee, as 
well as a number of members from the defense oversight and 
appropriations committees. Senators Mack and Feinstein have 
introduced S. 1165, a companion bill in the Senate, which also 
enjoys broad bipartisan support.
    Repeal of Section 923(a)(5) will help protect our defense 
industrial base and insure that American defense workers--who 
have already had to endure sharply declining defense budgets--
do not see their jobs lost to foreign competitors because of 
detrimental U.S. tax policy.
    The Internal Revenue Code allows U.S. companies to 
establish FSC's, under which they can exempt from U.S. taxation 
a portion of their earnings from foreign sales. This provision 
is designed to help U.S. firms compete against foreign 
companies relying more on value-added taxes (VAT's) than on 
corporate income taxes. When products are exported from such 
countries, the VAT is rebated, effectively lowering their 
prices. U.S. companies, in contrast, must charge relatively 
higher prices in order to obtain a reasonable net profit after 
taxes have been paid. By permitting a share of the profits 
derived from exports to be excluded from corporate income 
taxes, the FSC in effect allows companies to compete with 
foreign firms who pay less tax.
    In 1976 the Congress reduced the Domestic International 
Sales Corporation (DISC) tax benefits for defense products to 
50 percent, while retaining the full benefits for all other 
products. The limitation on military sales, currently IRC 
Section 923(a)(5), was continued when Congress enacted the FSC 
in 1984. The rationale for this discriminatory treatment--that 
U.S. defense exporters faced little competition--no longer 
exists. Whatever the veracity of that premise 25 years ago, 
today military exports are subject to fierce international 
competition in every area. In the mid-1970's, roughly half of 
all the nations purchasing defense products benefited from U.S. 
military assistance. Today U.S. military assistance has been 
sharply curtailed and is essentially limited to two countries. 
European and other countries are developing export promotion 
projects to counter the industrial impact of their own 
declining domestic defense budgets and are becoming more 
competitive internationally. In addition, a number of Western 
purchasers of defense equipment now view Russia and other 
former Soviet Union countries as acceptable suppliers, further 
increasing the global competition.
    Circumstances have changed dramatically since the tax 
limitation for defense exports was enacted in 1976. Total U.S. 
defense exports and worldwide defense sales have both decreased 
significantly. Over the past fifteen years, the U.S. defense 
industry has experienced reductions unlike any other sector of 
the economy. During the Cold War defense spending averaged 
around 10 percent of U.S. Gross Domestic Product, hitting a 
peak of 14 percent with the Korean War in the early 1950's and 
gradually dropping to 6-7 percent in the late 1980's. That 
figure has now sunk to 3 percent of GDP and is planned to go 
even lower, to 2.8 percent by Fiscal Year (FY) 2001.
    Since FY85 the defense budget has shrunk from 27.9 percent 
of the federal budget to 14.8 percent in FY99. As a percentage 
of the discretionary portion of the U.S. Government budget, 
defense has slid from 63.9 percent to 45.8 percent over the 
same time. Moreover, the share of the defense budget spent on 
the development and purchase of equipment--Research, 
Development, Test and Evaluation (RDT&E) and procurement--has 
contracted. Whereas procurement was 32.2 percent and RDT&E 10.7 
percent of the defense budget in FY85--for a total of 42.9 
percent; those proportions are now 18.5 percent and 13.9 
percent, respectively--for a total of 32.4 percent.
    Obviously, statistics such as these are indicative that the 
U.S. defense industry has lost much of its economic robustness. 
I know members of Congress are well aware of the massive 
consolidation and job loss in the defense industry. Out of the 
top 20 defense contractors in 1990, two-thirds of the companies 
have merged, been sold off or spun off; hundreds of thousands 
of jobs have been eliminated in the industry. To put this in 
perspective, consider, for instance, the fact that in 1998 
WalMart had $138 billion in revenues; in comparison, the 
combined revenues of the top five defense contractors totaled 
$61 billion--less than half the WalMart results for the 
year.\1\
---------------------------------------------------------------------------
    \1\ ``The Post-Deconstruction Defense Industry,'' 1999 Revised 
Edition, Dr. Loren B. Thompson, Lexington Institute, April 1, 1999.
---------------------------------------------------------------------------
    Budget issues are always a concern to lawmakers. The Joint 
Tax Committee estimates that extending the full FSC benefit to 
defense exports will likely cost about $340 million over five 
years. Overriding policy concerns justify this expense. With 
the sharp decline in the defense budget over the past fifteen 
years, exports of defense products have become ever more 
critical to maintaining a viable U.S. defense industrial base. 
Several key U.S. defense programs rely on international sales 
to keep production lines open and to reduce unit costs. For 
example, of the three fighter aircraft under production in this 
country, two are largely dependent on foreign customers. The 
same is true for the manufacturer of the M-1A1 tank, which must 
compete with several foreign tank companies. Repeal will not 
only benefit the large manufacturers of military hardware, but 
also the smaller munitions manufacturers, whose products are 
particularly sensitive to price fluctuations.
    One of Northrop Grumman's main product lines is ground 
radars. In this market we compete against companies from 
France, Germany, Italy and Great Britain, and these companies 
are often government subsidized. Price is frequently a key 
factor as to who wins the sale. The restoration of the full FSC 
benefit has the potential to improve the defense industrial 
base and our ability to compete on a more level playing field 
with foreign firms.
    The recent conflict in Kosovo demonstrated the importance 
of interoperability of equipment among NATO allies. 
Unfortunately, when our foreign competitors win a sale, not 
only does a U.S. business lose a contract, the U.S. military 
must then conduct operations with a military using different 
equipment. For example, Northrop Grumman and Lockheed Martin 
recently competed against a Swedish company, Ericsson, for a 
contract to supply an Airborne Early Warning System (AEW) to 
the Greek Government. Despite the fact that both U.S. companies 
were offering proven, state-of-the-art technology at a fair 
price, the Greek Government selected the Ericcson proposal, 
which had never been tested and will lack commonality with the 
NATO AEW system when built.
    This is one reason why the Department of Defense supports 
repeal of Section 923(a)(5). In an August 26, 1998, letter, to 
Treasury Secretary Rubin, Deputy Secretary of Defense John 
Hamre wrote:

          The Department of Defense (DoD) supports extending the full 
        benefits of the FSC exemption to defense exportersI believe, 
        however, that putting defense and non-defense companies on the 
        same footing would encourage defense exports that would promote 
        standardization and interoperability of equipment among our 
        allies. It also could result in a decrease in the cost of 
        defense products to the Department of Defense.

    Section 303 implements the DoD recommendation and calls for 
the repeal of this outdated tax provision.
    The recent decision to transfer jurisdiction of commercial 
satellites from the Commerce Department to the State Department 
illustrates the fickleness of Section 923(a)(5). When the 
Commerce Department regulated the export of commercial 
satellites, the satellite manufacturers received the full FSC 
benefit. When the Congress transferred export control 
jurisdiction to the State Department, the identical satellites, 
manufactured in the same facility, by the same hard working 
employees, no longer receive the same tax benefit. Why? Since 
these satellites are now classified as munitions, they receive 
50 percent less of a FSC benefit than before. This result 
demonstrates the inequity of singling out one class of products 
for different tax treatment than every other product 
manufactured in America.
    The Cox Committee, recognizing the absurdity of the 
situation, recommended that the Congress take action to correct 
this inequity as it applies to satellites. The 
administration has agreed with this recommendation. Section 303 
would not only correct the satellite problem, but would also 
change the law so that all U.S. exports are treated in the same 
manner under the FSC. The Department of Defense and the Cox 
Committee are not the only entities that have commented 
publicly about this provision. Several major trade associations 
including the National Association of Manufacturers, the U.S. 
Chamber of Commerce, and the Electronics Industry 
Alliance, to name just a few, have stated that Section 
923(a)(5) is bad tax policy and should be repealed.
    A joint project of the Lexington Institute and the 
Institute for Policy Innovation, entitled ``Out of Control: Ten 
Case Studies in Regulatory Abuse,'' highlighted the FSC. The 
December 1998 article, fittingly titled ``26 U.S.C. 923(a)(5): 
Bad for Trade, Bad for Security, and Fundamentally Unfair,'' 
because it reveals the many problems with this provision. In 
the paper, Dr. Thompson argues that Congress' decision to limit 
the FSC benefit for military exports was not based on sound 
analysis of tax law, but on the general anti-military climate 
that pervaded this country in the mid-1970's. Congress enacted 
Section 923(a)(5), and I quote: ``to punish weapons makers. 
Section 923(a)(5) was simply one of many manifestations of 
congressional anti-
militarism during that period.''
    I want to emphasize that the repeal of Section 923(a)(5) of 
the tax code does not alter U.S. export licensing policy. 
Military sales will continue to be subject to the license 
requirements of the Arms Export Control Act. Exporters will 
only be able to take advantage of the FSC after the U.S. 
Government has determined that a sale is in the national 
interest.
    Decisions on whether or not to allow a defense export 
should continue to be made on foreign policy grounds. However, 
once a decision has been made that an export is consistent with 
those interests, surely our government should encourage such 
sales to go to U.S. companies and workers, not to our foreign 
competitors. Discriminating against these sales in the tax code 
puts our defense industry at great disadvantage and makes no 
sense in today's environment. Removing this provision of the 
tax code will further our foreign policy objectives by making 
defense products more competitive in the international market.
    I urge the Congress to repeal this provision in order to 
provide fair and equal treatment to our defense industry and 
its workers and to enable American defense companies to compete 
more successfully in the increasingly challenging international 
market.
    I thank you for your time and will be pleased to answer any 
questions that you have.

                                


    Chairman Houghton. Thank you, Mr. McKenzie.
    Now, Mr. Kelly.

  STATEMENT OF STAN KELLY, VICE PRESIDENT-TAX, WARNER-LAMBERT 
               COMPANY, MORRIS PLAINS, NEW JERSEY

    Mr. Kelly. Good afternoon. I am honored to appear before 
the Ways and Means Committee. I am Stan Kelly, Vice President 
of Tax for Warner-Lambert Company, a $10 billion U.S. 
multinational headquartered in Morris Plains, New Jersey.
    Warner-Lambert employs 41,000 people in 150 countries and 
operates 78 manufacturing facilities worldwide. Warner-Lambert 
has three principal product lines: confections, consumer health 
products, and pharmaceuticals. Well known Warner-Lambert brands 
include Listerine, Benadryl, Sinutab, Trident gums, and Halls 
lozenges. Warner-Lambert's pharmaceutical line includes 
Lipitor, the world's leading cholesterol reducing agent, and 
Viracept, the world's leading AIDS treatment.
    The pharmaceutical industry is on the brink of a scientific 
revolution that will be sparked by the decoding of the human 
genome during the next few years. This revolution will be 
global. Drug targets will jump from 500 to 15,000, triggering a 
tidal wave of competition. Warner-Lambert's competition will 
come primarily from Japan and Europe whose tax policies support 
their multinationals better than U.S. policies support our 
multinationals. U.S. international tax policy must change in 
order to improve the competitive position of U.S. companies.
    Mr. Chairman, your bill and this hearing are important 
steps that can help to move U.S. international tax policy in 
the right direction. Warner-Lambert strongly supports H.R. 2018 
because it promotes three sound, international tax policies 
that would help to improve American competitiveness. First, 
your bill would begin to reverse the anti-deferral rules in our 
tax system. I refer to section 107 of the bill, which provides 
for look-through treatment for sales with partnership interest. 
In addition, although it does not affect Warner-Lambert, I 
refer to section 101 of the bill, which provides for permanent 
Subpart F exemption for active financing income.
    Second, your bill would improve the operation of the 
foreign tax credit system by reducing double taxation that is 
inherent in the system today. Eliminating double taxation is a 
fundamental objective of U.S. international tax policy. I refer 
to section 207 of the bill, which provides for the repeal of 
the 90 percent foreign tax credit limitation under the 
alternative minimum tax.
    Third, your bill would simplify the administration of our 
international tax rules. I refer to section 306 of the bill 
instructing the Treasury to issue regulations stating that 
agreements which are not legally enforceable are not intangible 
property for various purposes. Warner-Lambert supports this 
provision, which mandates a bright-line test in an area where 
Treasury has not exercised the regulatory authority given to it 
more than 15 years ago.
    I would now like to direct your attention to two provisions 
of the bill that may need further clarification. First, section 
102 of the bill authorizes Treasury to conduct a study of the 
feasibility of treating the European Union as one country for 
purposes of the same-country exceptions under Subpart F. 
Warner-Lambert supports this concept, but section 102(a) also 
provides,

    Such studies shall include consideration of methods of 
ensuring that taxpayers are subject to a substantial effective 
rate of foreign tax in such countries if such treatment is 
adopted.

    The policy goals represented by this sentence are unclear. 
Does the United States have a tax or trade policy requiring 
U.S. multinationals to pay substantial amounts of foreign tax 
on profits made outside the U.S.? Wouldn't such a policy make 
it easier for other developed countries to fund the support of 
their own multinationals? Mr. Chairman, I strongly urge you to 
reconsider the language in section 102 of your bill.
    The second provision that may need clarification is section 
310 of your bill, which would amend the earning stripping rule 
in section 163(j) of the code. I believe that this provision 
could actually facilitate stripping of U.S. earnings by our 
foreign competitors, and Warner-Lambert could not identify any 
benefit to U.S. multinationals in section 310. I am concerned 
that section 310 may inadvertently impose a competitive tax 
disadvantage on U.S. multinational corporations.
    Overall, H.R. 2018 is a good step in the right direction 
for U.S. international tax policy, but more can be done to 
improve the competitiveness of U.S. multinationals. I encourage 
this committee to continue its efforts. Warner-Lambert is ready 
to offer its assistance.
    I want to thank you all for your time today and commend and 
thank you, Mr. Chairman, for introducing H.R. 2018 and for 
holding this hearing.
    [The prepared statement follows:]

Statement of Stan Kelly, Vice President-Tax, Warner-Lambert Company, 
Morris Plains, New Jersey

    Good afternoon, Chairman Houghton and members of the 
Committee, I am pleased to testify today about the impact of 
the current U.S. tax system on the competitiveness of U.S. 
multinationals. I will also comment on your effort to improve 
and simplify the U.S. tax system, specifically H.R. 2018, the 
``International Tax Simplification for American Competitiveness 
Act of 1999.''
         Warner-Lambert: A Global Leader Building Global Brands
    I am Stan Kelly, Vice President of Tax for Warner-Lambert 
Company. Warner-Lambert is a U.S. multinational company 
headquartered in Morris Plains, New Jersey, which employs 
approximately 41,000 people devoted to developing, 
manufacturing and marketing quality health care and consumer 
products worldwide. The members of the Subcommittee may be 
familiar with some of Warner-Lambert's brand name products, 
such as Listerine, Sudafed, Benadryl, Schick and Wilkinson 
Sword shaving products, Tetra, Rolaids, Halls, Trident, Dentyne 
and Certs. Our Pharmaceutical sector is comprised of three 
parts: Parke-Davis, which has been engaged in the 
pharmaceutical business for 127 years; Agouron, a wholly-owned 
subsidiary of Warner-Lambert, an integrated pharmaceutical 
company engaged in the discovery, development and 
commercialization of drugs for treatment of cancer, viral 
diseases, and diseases of the eye; and Capsugel, the world 
leader in manufacturing empty, hard gelatin capsules. Warner-
Lambert's leading pharmaceutical products, Lipitor, Rezulin, 
Neurotin, Accupril, and Agouron's Viracept were developed to 
treat patients suffering from high cholesterol, diabetes, 
epilepsy, heart failure, and AIDS.
    It is an honor to appear before the Ways and Means 
Committee and to continue our company's participation in the 
trade and tax policy-making process. Our Chairman and CEO, 
Lodewijk de Vink, testified two years ago before the 
Subcommittee on Trade. Warner-Lambert is proud to be a leader 
in promoting free trade policies and my remarks today regarding 
the U.S.'s international tax regime are closely intertwined 
with those same policies.
    In 1998, Warner-Lambert had total revenues of approximately 
$10.2 billion ($4.3 billion, or 40% from international sales) 
and sold product in over 150 countries. Warner-Lambert has 
approximately 78 production plants in its six lines of business 
worldwide.
                         The Biomedical Century
    Senator Daniel Patrick Moynihan (D-NY) recently said that the 21st 
century would be the ``Biomedical Century.'' At the heart of this 
statement are the significant potential biomedical advances that 
Warner-Lambert and other companies in the pharmaceutical industry will 
make in the next decade. Scientists will soon complete a project 
started in 1990, to map the code of life itself, the Human Genome. 
Within five years, the number of targets for drug therapy will increase 
from 500 today, to more than 15,000, as scientists apply the findings 
of this project. That is a thirty-fold increase at a time when even 500 
drug targets keeps the global pharmaceutical industry going at full 
bore. So, for this reason and others, we agree with Senator Moynihan's 
statement. We are on the brink of a revolution in research and 
development that will lead to new forms of prevention, new cures, and 
new treatments. This revolution is global and U.S. companies need to 
compete aggressively in product discovery, development, manufacturing, 
marketing, and delivery with equally talented and driven foreign 
competitors primarily from Europe and Japan. U.S. trade policy and U.S. 
international tax policy must keep pace with these changes in order to 
mitigate competitive disadvantages facing U.S.-based companies.
    Let me emphasize this last part: the global pharmaceutical industry 
is highly competitive, with many of the world's largest pharmaceutical 
corporations headquartered outside the United States. These competitors 
such as Glaxo-Wellcome, Novartis, Astra Zeneca, Roche, Hoechst Marion 
Roussel, and SmithKline Beecham are not subject to the worldwide tax 
system similar to that used by the United States.
    The U.S. has long recognized the importance of open global markets 
in the continued growth of the U.S. economy. The U.S. trade policy is 
evolving to ensure that U.S. companies are able to remain competitive 
in a global economy. Conversely, U.S. tax policy, particularly as it 
relates to the taxation of international activities, has not kept pace 
with changes in the global market place in helping to promote U.S. 
competitiveness. Simply stated, U.S. tax policy is out of step with the 
broader objectives of our country's evolving trade policy. Mr. 
Chairman, your bill and this hearing are important steps towards 
harmonizing these two important and related policy areas.
    Before I turn to my specific comments on your bill, let me give you 
an example of how well the system can work when U.S. businesses and the 
Government work together toward a common objective. Last year Warner-
Lambert and others had the opportunity to work with the U.S. Treasury 
Department and foreign revenue officials in coordinating the tax 
consequences of the conversion to the Euro. The policy asserted by U.S. 
business was tax neutrality, i.e., the U.S. tax cost of converting to 
the Euro should be the same to a U.S. multinational corporation 
operating in Europe as the foreign tax cost to a foreign multinational 
corporation operating in Europe. By maintaining tax neutrality, the 
competitiveness of U.S. multinational corporations operating in Europe 
was maintained. The U.S. Treasury should be complimented for quickly 
developing a practical policy that enabled a smooth transition to the 
Euro.
    Turning now to your bill.
               Warner-Lambert Strongly Supports H.R. 2018
    Warner-Lambert strongly supports H.R. 2018 because it 
promotes three sound overall international tax policies: (i) 
reversing the growth of anti-deferral rules in our tax system 
by narrowing the scope of subpart F; (ii) improving the 
operation of the foreign tax credit system by reducing double 
taxation; and (iii) simplifying tax compliance.
     Reversing Anti-Deferral rules: The proposed changes would 
restore aspects of deferral that have been eliminated since the 
enactment of subpart F in 1962. This is an important contribution to 
the continued effort to improve the competitiveness of American 
industry. I refer to Sections 103 (expansion of the de minimis rule 
under subpart F) and 107 (look-through treatment for sales of 
partnership interests) of the bill as examples of this policy. In 
addition, even though not of direct interest to Warner-Lambert, I also 
refer to Section 101 of the bill (permanent subpart F exemption for 
active financing income) as an example of this policy.
     Improving the Operation of the Foreign Tax Credit System 
By Reducing Double Taxation: The foreign tax credit system is the 
United States' attempt at fairness to U.S. multinationals (as compared 
to the exemption system used by many countries), with the intention of 
eliminating double taxation of income earned outside the United States. 
Eliminating double taxation through the foreign tax credit system is a 
fundamental objective of U.S. international tax policy. Accomplishing 
this objective is critical to the competitiveness of American industry. 
I refer to Sections 201 (extension of period to which excess foreign 
taxes may be carried) and 207 (repeal of limitation of foreign tax 
credit under alternative minimum tax) of the bill as examples of this 
policy.\1\
---------------------------------------------------------------------------
    \1\ Section 207 of H.R. 2018 is identical to H.R. 1633 (introduced 
on April 29, 1999 by Chairman Houghton and 25 other members of the Ways 
and Means Committee) and S. 216 (introduced on January 19, 1999 by 
Sens. Moynihan and Jeffords (R-VT)).
---------------------------------------------------------------------------
     Simplifying Tax Compliance: Simplifying the administration 
of tax compliance is another important element in improving the 
competitiveness of American industry. U.S. tax compliance is generally 
considered much more burdensome than tax compliance under the laws of 
many of our principal trading partners. I refer to Section 306 of the 
bill (instructing the Treasury to issue regulations to the effect that 
agreements which are not legally enforceable are not intangible 
property for various purposes) as an example of this policy. Warner-
Lambert supports this provision, which mandates a bright-line test in 
an area where Treasury has not exercised regulatory authority given to 
it more than 15 years ago.
    I would like to direct your attention to one section of 
H.R. 2018 that is of particular interest to Warner-Lambert. 
Section 107(a) would amend Section 954(c) of the Internal 
Revenue Code (the ``Code'') to provide a look-through rule for 
the sale of a partnership interest by a controlled foreign 
corporation (``CFC''). If a CFC disposes of an interest in a 
partnership, the CFC would be deemed to have sold its pro rata 
share of the underlying assets of the partnership. This look-
through rule only applies if the CFC has a 10% or greater 
interest in the partnership. This rule makes sense for three 
reasons. First, with the proliferation of international joint 
ventures there are instances where a transfer of a partnership 
interest is deemed to be a sale and gain recognized for U.S. 
tax purposes. Thus, the U.S. tax treatment of gain from the 
sale of a partnership interest by a CFC is becoming a more 
common issue.
    Second, under the present law the gain on the sale of a 
partnership interest is treated as passive subpart F income. 
That is the case even if 100% of the income generated by the 
partnership in its business is otherwise treated as active non-
subpart F income. Thus, under this amendment gain from a 
partnership interest is treated in a manner similar to the 
income earned from the partnership, which is a rational tax 
policy.
    Third, under current law the transfer of a partnership 
interest is frequently treated as a deemed transfer of a pro 
rata share of the partnership's underlying assets, such as 
under Code Section 367(a)(4). Thus, this change enhances 
consistency in the treatment of a sale of a partnership 
interest in the international tax area.
    Overall H.R. 2018 is clearly a step in the right direction. 
It should be noted, however, that there are confusing signals 
from Congress. For example, Section 201 of H.R. 2018 expands 
the carryover period for foreign tax credits, but, in contrast, 
the Senate Finance Committee earlier this year once again 
approved a proposal to reduce the carryback period.\2\
---------------------------------------------------------------------------
    \2\ A reduction in the carryback period from two years to one year 
was most recently approved by the Senate Finance Committee on May 19, 
1999 as Section 401 of S. 1134, the Affordable Education Act of 1999.
---------------------------------------------------------------------------
                       Request for Clarification
    There are two provisions of your bill, Mr. Chairman, that 
need further clarification. Section 102(a) of the bill 
authorizes the Secretary of the Treasury to conduct a study on 
the feasibility of treating all countries included in the 
European Union as one country for purposes of applying the same 
country exceptions under subpart F. That aspect of Section 102 
represents a positive step, which Warner-Lambert strongly 
supports. That provision is attractive to us because it would 
lessen the gap between ourselves and our European based 
pharmaceutical competitors in that market. But then Section 
102(a) provides as follows:

          Such study shall include consideration of methods of ensuring 
        that taxpayers are subject to a substantial effective rate of 
        foreign tax in such countries if such treatment is adopted.

    The policy represented by this sentence is unclear. Should 
the policy of the United States be that non-U.S. business 
activities of a U.S. multinational corporation must be subject 
to ``substantial'' foreign tax? If so, how did we reach this 
point? Mr. Chairman, I strongly urge you to reconsider the 
language in Section 102(a) of your bill and in particular ask 
that you do so in light of the recent National Foreign Trade 
Council's (the ``NFTC'') report on international tax policy for 
the 21st century.
    Also Section 310 in H.R. 2018 appears to be inconsistent 
with the notion of ``International Tax Simplification for 
American Competitiveness.'' Section 310 would amend the so-
called ``earnings stripping'' rule in Section 163(j) of the 
Code. The earnings stripping rule imposes a limitation on the 
amount of interest expense that may be deducted by a foreign-
owned domestic corporation. This subsection was enacted to stop 
the practice by foreign multinationals of ``stripping'' the 
earnings out of their domestic subsidiaries through related-
party loans. Many other developed countries have similar 
restrictions, frequently in the form of debt/equity ratio 
requirements.
    I believe that this provision might potentially facilitate 
earnings stripping by our foreign competitors. Warner-Lambert 
could not identify a benefit to U.S. multinationals of Section 
310. Let us make certain that Section 310 is not an instance 
where by unilateral action the United States indirectly imposes 
a competitive tax disadvantage on its own multinational 
corporations.
    Although this amendment to Code Section 163(j) may have 
merit, I ask this Committee to take into account the treatment 
accorded U.S. multinationals in the reverse situation before 
proceeding with this subsection. I would also point out that 
Section 310 incorporates what may be considered a subjective 
test, i.e., satisfying the Secretary that a loan would have 
been made without a parent guarantee. A number of years ago the 
subjective test in the high-tax exception of Code Section 
954(b)(4) (no tax avoidance intention) was repealed because of 
alleged administrative difficulties in applying the test.
                            The NFTC Report
    Before I conclude, I would like to comment on a recent 
report issued by the NFTC, an organization of which I am 
pleased to be a member of the Board of Directors. This report, 
The NFTC Foreign Income Project: International Tax Policy for 
the 21st Century (the ``Report''), is the first of a series of 
studies commissioned by the NFTC to evaluate our international 
tax policies in light of the globalization of the world's 
economy. The first report focused on the subpart F rules of the 
Code, which provide a number of exceptions to the principal 
U.S. international tax policy of deferral of U.S. taxation on 
foreign earnings until distributed. The Report highlights the 
slow breakdown of deferral. Your bill focuses on and addresses 
this trend.
    The Report concludes that (1) the economic policy 
justification for the current structure of subpart F has been 
substantially eroded by the growth of a global economy; (2) the 
breadth of subpart F exceeds the international norms for such 
rules, adversely affecting the competitiveness of U.S.-based 
companies; and (3) the application of subpart F to various 
categories of income that arise in the course of active foreign 
business operations should be substantially narrowed.
    When subpart F was enacted in 1962, 18 of the 20 largest 
corporations in the world (ranked by sales) were headquartered 
in the U.S. Now there are eight. In 1962 over 50% of worldwide 
cross-border direct investment was made by U.S. businesses. Now 
that number is 25%. U.S. gross domestic product as a percentage 
of the world total has gone from 40% to 26%. As these figures 
suggest, the competitive environment in 1962 and the 
competitive environment today are completely different. Thus, 
international tax policy should reflect this change to a global 
economy.
    In 1962 subpart F included a de minimis test where a CFC 
was deemed to have no subpart F income if certain designated 
categories of income constituted 30% or less of total gross 
income. That test over time has been reduced to the lesser of 
5% of gross income or $1,000,000. As a result, we have reached 
the point where incidental interest income earned on normal 
levels of working capital used in an active business 
constitutes subpart F income. In 1962, the ``high-tax 
exception'' referred to the alternative of a specified 
effective tax rate or establishment of no tax avoidance intent. 
Now a mechanical effective tax rate test creates anomalous 
situations in which, for example, a CFC organized in Italy 
(with a statutory tax rate in excess of the U.S. rate) may fail 
the high-tax exception because U.S. and Italian capital 
recovery rules are not identical. Also, the U.K. now 
constitutes a low-tax jurisdiction under our subpart F rules 
and, therefore, a CFC doing business in the U.K may no longer 
qualify for the high-tax exception of Code Section 954(b)(4).
    A subsequent NFTC report will focus on the functioning of 
the second principal U.S. international tax policy--avoidance 
of double taxation through the foreign tax credit system.
                               Conclusion
    In conclusion, I commend and thank you Mr. Chairman for 
introducing H.R. 2018 and holding a hearing on what is a highly 
technical but extremely important area of our tax laws. Warner-
Lambert supports the bill but more can be done in the 
international tax area to improve the competitiveness of U.S. 
multinationals. I encourage this Committee to continue its 
efforts in this regard. Warner-Lambert is ready to offer its 
assistance in your efforts. Finally, I urge you to include the 
important provisions in H.R. 2018 in the tax bill the Committee 
will be marking up early next month.
    Mr. Chairman, I am pleased to answer any questions.

                                


    Chairman Houghton. Well, thank you very much.
    I am going to ask one question, and then I am going to pass 
it over to Mr. Coyne.
    Tell me, gentlemen, how do we treat the European Union as 
one tax entity when there are so many different tax laws in the 
various countries? Help us on that.
    That is a question, and I hear no answers.
    Mr. Kelly. Maybe I will try.
    Chairman Houghton. Well, yes, because--I mean, it is very 
easy to say that there are too many baskets and a lot of bows 
being thrown the way of U.S. corporations that make us 
uncompetitive with other parts of the world and other European 
countries, but to move from the principle to the practical, how 
does it get done?
    Mr. Kelly. Mr. Chairman, just to make sure I understand the 
question, are we talking about the provision related to the 
European Union?
    Chairman Houghton. Yes.
    Mr. Kelly. OK. The way I understand that provision is that 
it is really addressing the treatment of Subpart F income in 
the European Union so that it is dealing with movements of 
funds across borders. It is not trying to say that all of the 
rules and all of those countries should be treated the same. It 
is only saying that if you move cash back and forth with 
royalty payments or interest payments, et cetera, that we not 
treat those movements of cash as taxable in the United States.
    Mr. Cox. I think that is right, Mr. Chairman, and I think 
also, to give you an example in our industry, Germany is our 
biggest market; Switzerland is a small market, so I actually 
had a discussion with our German country manager one time that 
said he wanted to service the Swiss market by having men and 
women sales representatives just either fly in or drive into 
the Swiss market. I told him he couldn't do that. He looked at 
me like I was cross-eyed, and I said, ``Well, you can't do it 
because of U.S. Subpart F,'' and then he really went cross-eyed 
on me. But the importance of that--and the gentleman is exactly 
correct--the issue is not how much tax we would pay in 
Switzerland or how much tax we would pay in Germany, the issue 
is, absent setting up--and I believe Mr. Jarrett pointed it out 
correctly--adding additional costs, administrative costs, 
setting up a new subsidiary in Switzerland, all that cost, why 
do I have to do that as a corporation? Why do I need to make 
that decision? I am going to pay tax, and the foreign taxes I 
pay and I credit will simply be determined based on whichever 
country I do business in, irrespective of and knowing full well 
that all those countries will have different rates. So, I think 
we are maybe trying to make that a little more complicated than 
it should be.
    Chairman Houghton. Well, we will get back to this in a 
minute.
    I want to call on Mr. Coyne.
    Mr. Coyne. Thank you, Mr. Chairman.
    One would hope that our international tax policies would 
lend themselves to domestic firms having incentives to retain 
operations and workers here in the United States. Which 
provisions of the proposed bill, 2018, would do that? They 
would lend themselves to retain jobs in the United States. 
Anyone can answer.
    Mr. McKenzie. I think, if I could speak, that section 303 
of the bill clearly would aid in doing that by making us more 
competitive on international bids and for selling military 
property overseas. That would tend to strengthen the industrial 
base for defense companies, keep workers employed here to the 
extent that we could win those contracts, and, as a byproduct, 
even though we get somewhat of a tax break on the FSC rules, 
overall, we pay more U.S. tax if we are able to generate 
additional U.S. profits overseas. So, as I see it, it is a win-
win situation for everybody.
    Mr. Coyne. Anyone else care to comment?
    Ms. Strain. I would agree with that. If one assumes that, 
for example, the active financing provision helps us U.S. 
companies be more competitive in the overseas marketplace and 
therefore be able to expand our businesses there. We see, 
today, in my company that we have a number of locations in the 
United States which originally started out servicing just a 
domestic customer base which now service our global customers. 
It is the credit card business, our payables, some of our cash 
management functions--all are done in the United States for 
overseas markets. Similarly, our R&D, is developed primarily 
first for the American market, and then we export. It, 
therefore, becomes cheaper for us to develop if we have a 
larger customer base.
    Mr. Coyne. Can you cite what types of industries, however, 
would be more likely to move operations overseas and why that 
would be an advantage to them? Just by type of industry.
    Mr. Cox. Congressman, specifically related to provisions in 
this bill?
    Mr. Coyne. Right.
    Mr. Cox. I cannot.
    Mr. Coyne. All right, thank you.
    Chairman Houghton. All right. Mr. Watkins.
    Mr. Watkins. Let me ask the question a little differently 
in something that might be in the real practical phase of it. 
By the way, I have used a lot of that green and yellow.
    Each of you see some of these provisions were enacted to 
take place. How many more jobs--let me say it right now--what 
percentage of exports do you do now, so to speak, from this 
country? What additional increases and exports would you think 
your company would achieve by these provisions? And then we 
were talking about, probably, economic growth here, jobs over 
here in this country, too, and you tried to give us a little 
bit of insight on that. A lot of companies do not do a very 
good job educating their employees that their job depends on 
export trade. Now, I have talked to some of my businesses, 
because we can't pass Fast Track, we can't do other things, and 
people are voting actually against their jobs, in many cases, 
with some of these industries. Now, what kind of increase do 
you think you would have with jobs in this country if some of 
these provisions would be passed?
    Mr. McKenzie. Well, Congressman, if I may answer that the 
way I understand your question, I think it cuts two ways. If a 
company forms a ``maquiladora'' in Mexico to attain cheaper 
wages in Mexico, that may, in fact, have some effect of 
transferring jobs overseas to obtain the cheaper labor. 
However, the case that we are after--if I could just point out 
a couple of statistics. In 1998, for example, Northrop Grumman 
had export sales qualifying for the FSC treatment of 
approximately $1 billion. That is up 128 percent over 1997, and 
it is up 278 percent over 1994. So, that created U.S. jobs, OK? 
Because the manufacturing that took place on those qualifying 
sales took place in the United States by definition, in order 
to meet the requirements to qualify for a foreign export sale. 
That is what we mean by strengthening the U.S. defense base in 
the workplace.
    Mr. Watkins. Right. You see where I am coming from. I think 
this is going to be the compelling argument on how this is 
going to be helping over here and sharing with us.
    How about you, Mr. Jarrett and John Deere?
    Mr. Jarrett. As I mentioned in my statement, I think about 
one-third of Deere's sales today are export sales. Deere serves 
an agricultural market for half of its income, basically. It is 
a very mature market in the United States. The growth in our 
agricultural products, many of our construction products is 
going to be overseas. The markets in South America, the markets 
in Asia are growing, and that is where the farmers, the 
customers need equipment. Much of that equipment comes from the 
United States. It is going to be our ability to not only 
produce equipment in the United States but also to produce 
equipment in the countries that need it. The technology, the 
competitiveness, the research and development all comes from 
the United States, and that is what we want to retain from our 
perspective or from a manufacturers perspective. I need to 
control that technology; I need to control that patent and the 
ability to make that equipment worldwide. That is where we will 
gain from having an even playing field from a tax structure.
    Mr. Watkins. Well, I know your company has done a good job. 
I am product of using the old Pop and Johnny, what we called it 
years ago, the old Pop and Johnny, and it has changed a whole 
lot since that day when I used to crank them a little bit. I am 
not that old, but, you know, just back where you couldn't get 
them to me. Any other comment on some of the other companies?
    I think we have done a poor job of educating the American 
people--if I can just say this--and part of it--I am 
challenging the companies that I know of and I have worked with 
to get off their duffs and help, because they expect a lot of 
things from us, and I am a believer. I am willing to get into 
the trenches and try to make sure we don't have certain 
barriers out there that make it difficult to burst into those 
markets overseas and be able to do business. But I know the 
chairman of Boeing is leading an effort and realizes that--a go 
trade effort and hope that your companies are involved in that, 
because we have got to do a lot in those areas, including, as I 
said, not only the taxation policy but the regulatory and 
litigation policies that you are confronted with and many 
companies are, and what little work I have done outside the 
Congress in the international field, I found it very 
complicated.
    Mr. Chairman, thank you very, very much, and I appreciate 
the insight in your companies; something is happening there.
    Chairman Houghton. Is that it? OK. Mr. Neal.
    Mr. Neal. Thank you, Mr. Chairman.
    Ms. Strain, the Treasury Department has urged Congress to 
delay any extension of the active financing exception to the 
Subpart F rules until after it completes a thorough study of 
the Subpart F regime later this year. Do you believe that we 
should agree to that proposal from Treasury?
    Ms. Strain. I would urge you to continue with the provision 
that you have. I think that the Treasury study that is being 
undertaken is very worthwhile. I think it needs to be done. We 
need simplification and reform, and perhaps, answers, to Mr. 
Levin's question earlier of what more needs to be done. We 
probably need to have that discussion, but I think that we also 
need to get on with business and continue to maintain a 
competitive posture. The Treasury study, I believe, will spark 
a lot of conversation, a lot of study, and a lot of analysis, 
and that is not going to be a short-term effort. It will be a 
longer-term effort. But in the shorter-term, now, we need to 
have the provision renewed and extended.
    Mr. Neal. Thank you. Mr. McKenzie, thank you for your 
statement on the Foreign Sales Corporation rules for military 
property. From a tax perspective, can you think of any 
legitimate policy reason why defense projects should be singled 
out from receiving the full FSC benefit?
    Mr. McKenzie. No, sir. As a matter of fact, we view in the 
industry as a penalty tax against U.S. defense contractors. In 
other words, we are the only ones who are not permitted to 
claim the full FSC benefit, and we were singled out and 
discriminated against and allowed only half the benefit that 
was allowed to everyone else. Now, in my view--and I am 
speaking strictly for myself here--this provision came into law 
back in 1975 at the height of the global arms race between the 
United States and Russia, at a time when Vietnam was the hot 
issue, and there were those on both sides of the aisle who, on 
the one hand, wanted to disallow all benefits for FSC for 
military contractors and those on the other side that wanted to 
allow full benefits, seeing no difference whatsoever between 
exporting military sales approved by DOD and all other 
products. And I think what happened in the end was the baby was 
cut in half as a compromise, and that is where we have been so 
far. I see no logic, really, to allowing half if there are 
sound arguments for repeal. It seems to me, it should either 
come out one way or the other, and now that the environment has 
totally changed, it seems to me that we should allow and treat 
military product exports that are approved by DOD as being in 
the national interest as no different from any other export 
product.
    Mr. Neal. Fair enough.
    Thank you, Mr. Chairman.
    Chairman Houghton. Thanks very much.
    Mr. Portman.
    Mr. Portman. Thank you, Mr. Chairman, and I want to commend 
Mr. Levin and the Chairman, Mr. Houghton, for doggedly pursuing 
this issue over the years since I have been on the Ways and 
Means Committee. It is a simplification issue and a 
competitiveness issue, the two being related, and I think it is 
great that we are rolling up our sleeves and getting into some 
of these issues, and I hope on this tax bill we will be able at 
least to make the downpayment.
    I have an interest in the territorial tax system. I am told 
that this didn't come up today--and I apologize that I am 
late--but if we could talk a little about the territorial tax 
system and its impact on your companies as compared to some of 
your competitors. Maybe if I could just ask a couple of 
questions, Mr. Chairman, the first being, do you have any 
competitors in developed countries, industrialized countries 
like the United States, that use other than a territorial tax 
system for their employees, their foreign employees? Are there 
any other competitors of yours that are based in a foreign 
country that have a tax situation that is similar to the one 
you face being a U.S. company? Are you aware of any?
    Mr. Cox. With few exceptions, Congressman. In the software 
industry, most of the companies are U.S.-based multinationals. 
There are some exceptions, but most of them are similar to us.
    Mr. Portman. Ms. Strain.
    Ms. Strain. In the financial services industry, I would say 
that most of our foreign competitors are not U.S.-based 
multinationals. Deutsche Bank, HSBC, Standard Charter, are our 
major competitors in a number of different jurisdictions. If 
you look at their published effective tax rates compared to the 
effective tax rates of U.S. financial institutions, they are 
generally lower.
    Mr. Portman. And that is because they have territorial tax 
system, correct?
    Ms. Strain. You are crossing a number of different 
jurisdictions, but that is a factor, also probably, more 
liberal controlled foreign corporation rules. Integration 
systems, as well. So there will be a number of different 
factors, but the data shows that they are generally facing 
lower effective tax rates.
    Mr. Portman. Mr. Jarrett.
    Mr. Jarrett. That is very true with manufacturing. We face 
local competitors in those countries, and U.S. tax law today 
for international operations forces us at a significant 
disadvantage. As I mentioned earlier, in just looking at my 
interest allocation rules, over half of the interest expense 
that Deere incurs this year relates to our credit operation. 
Our credit operation has no foreign assets; it basically 
operates within the United States to provide credit to the 
Deere customers here, but we have to allocate almost 60 percent 
of that interest expense overseas. That causes us to lose about 
20 percent of our foreign tax credit, raising our price to our 
customers.
    Mr. Portman. The interest allocation issue is one that is 
near and dear to my heart, and I understand it is not a subject 
of this hearing, particularly. We are addressing it during a 
competitiveness hearing that is coming up, but getting back to 
the territorial issue, the territorial system versus a 
worldwide system, does that put you at a competitive 
disadvantage?
    Mr. Jarrett. Yes, it does.
    Mr. Portman. Mr. McKenzie.
    Mr. McKenzie. Yes, I couldn't agree more. One of the 
biggest problems I see is being able to move excess cash in one 
country to another country where it's needed to enhance the 
overall conduct of the business. That gets very difficult under 
current subpart F rules. Of course there's tremendous U.S. 
taxes. If you simply loan excess capital from a subsidiary in 
Germany to a subsidiary in Switzerland, that is considered to 
be a deemed dividend back to the United States, taxable in the 
United States, and then back to Switzerland. That seems to me 
totally unfair. That is why I say it interferes with the 
conduct of good U.S. business practices. That is just one 
example.
    All of the other examples come under section 367(d). When 
you want to transfer products overseas, section 482 for inter-
company pricing allocations. Foreign tax credits when you do 
want to bring income back to the United States. You have to be 
extremely careful about what you invest or U.S. foreign 
earnings in. When you liquidate a company, it gets very 
complicated, but when you want to reorganize foreign 
subsidiaries, that also gets extremely complicated to avoid 
U.S. taxes.
    Mr. Portman. And many of these are not problems that a 
foreign competitor of Northrop Grumman would experience?
    Mr. McKenzie. In my experience, the foreign competition we 
face have much more lax rules in that area. It is much easier 
for them to move working capital around to where they need it. 
As a matter of fact, I would be in favor actually of going back 
to the 1962 proposals that the Kennedy Administration came up 
with to tax U.S. companies currently on their U.S. worldwide 
operations, and in exchange for that, allow foreign tax credits 
for foreign taxes actually paid overseas. If that is too much 
to put through all at once, perhaps establish some arbitrary 
limit on the foreign tax credit of 80 to 85 percent. That would 
dramatically simplify the rules in this area, it seems to me, 
and do away with a lot of the bells and whistles that we have 
hung onto the system. I would not--however, support a change in 
current law that would lead to a higher tax burden for U.S. 
taxpayers.
    I don't mean to castigate the system. I think that the 
principles and fundamentals that we have in the Internal 
Revenue Code are sound. It is just a matter that we tried to 
hand too many bells and whistles on it that we need to scale it 
back.
    Mr. Portman. Mr. Kelly, do you have anything to add?
    Mr. Kelly. Yes. In the case of the pharmaceutical industry, 
we have obviously some U.S. competitors and some foreign 
competitors. With respect to the foreign competitors, some are 
located in countries which use territorial systems. For 
example, the German pharmaceutical companies, Hoechst Marion 
Roussel and Scherig AG operate under a territorial system.
    With respect to the other competitors, foreign competitors 
who are not located in territorial systems, if you were to look 
at the NFTC study I think you would see that although they 
appear to be systems like ours, in fact there is substantially 
less taxing of off-shore operations by countries such as Japan, 
the UK, France, et cetera.
    Mr. Portman. Thank you, Mr. Kelly.
    Thank you, Mr. Chairman.
    Chairman Houghton. Thanks very much.
    Mr. Levin.
    Mr. Levin. Thank you, Mr. Chairman. This is becoming an 
increasingly interesting hearing. There are some policy bases 
or maybe irrational policy bases for all these provisions. I 
appreciate the questions of our colleagues, Mr. Chairman; Mr. 
Coyne, and Mr. Neal's questions I think helped to bring out 
issues like the impact on jobs in this country. I appreciate 
Mr. Portman's kind words.
    His question raises the most basic issue about our system. 
I think we should always be ready to look at the assumptions in 
our system, always though careful to avoid the conclusion that 
there is an easy alternative. Radical reform is often more 
easily said than done. We have essentially proceeded I hope 
importantly, but somewhat incrementally. That has been the 
assumption. We hope it has made a difference and there is more 
ground to cover.
    In that regard, Mr. Kelly, we will take another look at the 
language about the study. I think actually one of your 
colleagues, panelists, kind of answered it. The question 
relates not to--it doesn't really I think reflect the fact that 
there are different tax rates and structures in the country, in 
the various European countries, but the notion that we could 
for the purposes of this provision, treat all those systems, 
the countries the same. Whether that is really an appropriate 
assumption, I don't know. We will take another look at it.
    Mr. Kelly. Thank you.
    Mr. Levin. It was to look at tax havens within the European 
Community and the impact of them on these provisions.
    Let me say, Mr. McKenzie, I asked some of the staff who 
have been around here I think longer than I have, but who are 
younger than I, whether they remembered the rationale for the 
50 percent. Their explanation was the same as yours, if you can 
call it a rationale.
    Mr. McKenzie. Yes.
    Mr. Levin. I think that may have been a case where you 
split the baby in half and it clearly doesn't make any sense.
    Mr. McKenzie. I believe so, yes.
    Mr. Levin. But we need to take a look at that as we're 
doing in this provision. I hope we can have some rational 
discussions.
    Just quickly, the question about active financing and the 
Treasury. Were we talking about two different things? I think 
maybe we were. The Treasury study about the entire structure 
and the Treasury response to extension of this provision. I am 
not sure they are one in the same, maybe they are. I would hope 
Treasury could give us their suggestions about extending the 
active financing provision in time for us to act, even if they 
are looking at the broader picture.
    Let me close, Mr. Chairman, and just ask Mr. Cox, because I 
think you stated correctly that it is hard for us I think to 
adopt a policy that simply says that we'll accept the 
characterization of other countries in your field. So I think 
you need to help us come up with how we resolve that riddle, 
because I am not sure what we do about it. It seems to me if we 
allowed the characterization of other countries to determine 
our tax treatment, it would be subject to manipulation on their 
part. Correct?
    Mr. Cox. I agree, Congressman Levin. One of the things that 
Congress can do is play an active role in treaty negotiations. 
Obviously that is usually done on the Senate side, but in 
following recognized bodies like OECD, OECD has now come with 
models that they are coming to a position that has agreed upon 
with regard to characterization of a lot of things, one of 
which is software income. So I think by supporting those types 
of efforts, that is one thing that Congress can do.
    Mr. Levin. OK. But let's talk further about it because I 
would believe--and this relates to Mr. Coyne's good question 
about the impact on businesses and jobs here. I think your 
answer was a very responsive one. The jobs are basically here, 
not entirely, but substantially, which we want to be able to 
continue. I think we would like to find ways to be helpful 
without adopting a statutory provision that really would not be 
workable. So let us know. Give us some further ideas.
    Mr. Cox. That is correct. I mean whether it's changes in 
subpart F, which allow us, as Mr. Jarrett said, those are cost 
issues. Cost issues means do I spend money on tax issues or do 
I spend money hiring people to do jobs which can create a new 
product in my particular industry. In my particular company, 
the average wage of the U.S.-based workforce exceeds $75,000 
per annum. So these are extremely good jobs that we would like 
to keep in the United States. So whether it's issues like 
extending the research credit on a more permanent basis, you 
had a discussion about that earlier, all of these things are 
important as we look at where do we place jobs. We would like 
to place them here, whether it's in the United States.
    Mr. Levin. We surely agree with that.
    Mr. Cox. I didn't think you would have any objection.
    Mr. Levin. No.
    Mr. Cox. We're on the same page there.
    Mr. Levin. Absolutely.
    Mr. Cox. But realize as we make business decisions, those 
are factors, maybe not the only factor, maybe not even the most 
important factor, but those are factors that business men and 
women look at every day in terms of where to----
    Mr. Levin. Right. That is the gist of this legislation. 
Thanks.
    Thanks, Mr. Chairman.
    Chairman Houghton. Thanks. I just have a few questions.
    Mr. Jarrett, you talk about controlling technology, it's 
important that you control technology. Tell me how the 
treatment of international tax laws affects the control of 
technology.
    Mr. Jarrett. The treatment of international tax policy will 
affect that because if your U.S. tax policy forces me or other 
companies overseas, we get into regimes that we have to develop 
technology in those countries. Those countries will own that 
technology from the standpoint of the sub that's there. The 
United States loses some of its effectiveness to control where 
that technology goes from there. All countries don't have the 
same laws to protect trademarks, patents. If we have some of 
those in our overseas subsidiaries, we have to follow their 
country rules. I like to keep that technology at home where it 
is controlled, where we can dole it out as it needs to be, make 
the investment in it in U.S. property and export the product.
    Chairman Houghton. Still--you have to help me. I am a 
little slow on this. What you are saying is that if you move 
basic weight of industry abroad--jobs, investment, and, 
technology will be there. The reason that's its moved abroad is 
because of the tax laws. Therefore, less of our technology can 
be produced in this country. Is that right?
    Mr. Jarrett. If that technology is developed overseas, that 
belongs to that overseas subsidiary. It doesn't belong to our 
U.S. subsidiary. There is a cost to bring that back home. We 
are trying to keep that technology home where I believe we 
should keep that technology at home.
    Chairman Houghton. Yes. But as you look way out, I mean, 
you can take a look at the past 30 years of your company and 
you take it and look at another 30 years, won't you be doing a 
great deal more sort of spot manufacturing and spot development 
in the areas where you have got to serve that market? So, you 
still will have that problem in terms of controlling 
technology. It doesn't have anything to do with the tax laws.
    Mr. Jarrett. We would have that problem, except we license 
that technology overseas rather than develop it overseas. We 
want our U.S. parent to own that technology.
    Chairman Houghton. OK. Thank you.
    I would like to ask Ms. Strain the question about the 
active financing exception to subpart F. Tell me a little bit 
about this. How does this help you?
    Ms. Strain. In a couple of different ways. From my 
perspective, I worry about the computation of our ultimate U.S. 
tax liability. It is a complicated procedure. We have had two 
different tax laws that we have had to deal with in the last 2 
years. In terms of gathering information, calculating it for 
our tax return, I am sending requests out to personnel in 100 
different countries. English is not necessarily their first 
language. I am asking them to interpret U.S. tax law and give 
information back. So in that regard, I would hope that we don't 
have a change for a third year in a row in terms of the law, 
considering the compliance aspect to it.
    Without active financing we are required to provide for 
U.S. taxes whether we distribute income or not. In terms of our 
acquisition activity, which as you might guess, has been 
increasing over the last couple of years of the financial 
services industry worldwide consolidates, when we are bidding 
for a company overseas, we are using a U.S. tax rate rather 
than the local tax rate. We find that many of our competitors 
obviously are operating in lower tax jurisdictions or have 
lower effective rates. Again, not 100 percent of the time is 
the tax reason why we may not win a bid, but it is certainly an 
important factor in terms of our ability to expand overseas.
    Last, it helps in normal planning. The subpart F 
requirements in terms of recognizing income on a current basis 
require us to calculate income as if it was distributed back to 
the United States. It does not obviously reflect a reality. It 
is more complicated. It affects our foreign tax credit 
computations. It makes the whole management of our overseas 
operations more difficult.
    Chairman Houghton. OK. That is very helpful. Thanks a lot.
    Now let me just come back to the basic question which I had 
posed earlier. I have a report here from the Joint Committee on 
Taxation. Again, I have got to go back to the concept of the 
European Union as being considered one tax entity. Our bill, as 
you probably have read, will direct the Secretary of the 
Treasury to study this feasibility, and I know the European 
Union has taken great steps to integrate their economies and so 
on and so forth, but they do have different tax rules. I just 
wondered how you feel about whether these tax rules are 
sufficiently harmonized to allow sort of a single treatment. 
Anyone?
    Ms. Strain. I think the answer is that the tax rules are 
probably not harmonized at this point in time, but I believe 
that the answer to that question was that it relates to the 
treatment of subpart F income and how it should be calculated.
    One of the factors though I think we should point out is 
that if we are looking at the European Union, the OECD is also 
concerned about this issue in terms of tax haven activity. They 
are trying to exclude from the definition of the European Union 
so-called ``tax havens,'' which I think they are working to 
develop. So I think in one sense there is a certain amount of 
pressure off the notion that the European Union contains within 
it, tax havens that will draw more and more business activity 
to that location. But the answer I think was that the subpart F 
rules have to be reviewed in the context of whether they still 
make sense.
    Chairman Houghton. Does anybody have any other comments on 
that?
    Mr. Kelly. I hope this is helpful. If a member of the E.U. 
makes a dividend distribution back to its U.S. parent, we are 
going to look at the tax structure in that country to determine 
the U.S. tax consequences. So that actual distributions and 
actual pavements back to the United States, as far as I 
understand the provision, wouldn't be affected by our using the 
single country exception for all the E.U. That is just for 
Subpart F. So in effect, you kind of split the system. The 
advantage of doing that is really to facilitate our handling of 
cash off shore and to simplify our compliance here in the 
United States.
    Mr. Cox. I think Mr. Kelly is exactly correct on that. It 
eliminates that need to worry about common everyday business 
issues, movement of funds. You know, one subsidiary needs 
money, one does not, irrespective of the differing rules which 
is when you actually do have a distribution from one of those 
foreign corporations.
    Chairman Houghton. OK. That is very helpful. Any other 
questions? All right. Well, ladies and gentlemen, thank you 
very much for being with us. I look forward to working with 
you.
    The hearing is adjourned.
    [Whereupon, at 2:49 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]

Statement of William W. Chip, Chairman, Tax Committee, European-
American Business Council

    My name is Bill Chip. I have been engaged in international 
tax practice for 20 years and am a principal in Deloitte & 
Touche LLP. I am testifying today as Chairman of the Tax 
Committee of the European-American Business Council (EABC). The 
EABC is an alliance of 85 multinational enterprises with 
headquarters in the United States and Europe. A list of EABC's 
members is attached. Because the EABC membership includes US 
companies with European operations and European companies with 
US operations, the EABC brings a unique but practical 
perspective to how the complexity of the US international tax 
regime may impede US companies from competing in the European 
Union (EU)--the world's largest marketplace.
    The EABC welcomes the efforts underway in this Subcommittee 
and elsewhere in Congress to reconsider the international tax 
rules that have accumulated in the Internal Revenue Code. The 
current regime imposes tax burdens on US-owned foreign 
enterprises that are not borne by the same foreign enterprises 
when owned by non-US companies. If US ownership of a foreign 
enterprise is not tax-efficient, that enterprise will not 
relocate to the US but will instead become foreign-owned. The 
foreign-owned enterprise may continue to ship its output to the 
US, but its profits will be forever exempt from US taxation.
    Nowhere is the anti-competitive burden imposed by US tax 
rules more evident and damaging than in the application of the 
US ``subpart F'' rules to US-owned enterprises in the EU. The 
subpart F rules were intended to prevent US companies from 
avoiding US taxes by sheltering mobile income in ``tax 
havens.'' The impact of these rules is exacerbated by the fact 
that since 1986 any country with an effective tax rate not more 
than 90% of the US rate is effectively treated as a tax haven. 
Even the United Kingdom, an industrialized welfare state with a 
modern tax system, is treated as a tax haven by subpart F 
because its 30% corporate rate is only 86% of the US corporate 
rate. If the US corporate tax rate when subpart F was enacted 
were the benchmark, the US today would itself be considered a 
tax haven.
    Subpart F focuses on economic activity that Congress 
perceived as ``mobile'' and therefore readily located in a tax 
haven. Manufacturing income was generally exempted from subpart 
F because manufacturing was perceived as geographically tied to 
transportation facilities and to sources of energy and 
materials and therefore unlikely to be artificially located in 
a tax haven. Because Congress perceived that selling and 
services were relatively mobile activities that could be 
separated from manufacturing and located in tax havens, the 
``foreign-base company'' rules of subpart F immediately tax 
income earned by US-controlled foreign corporations from sales 
or services to related companies in other jurisdictions.
    How do these rules impede the competitiveness of a US 
company seeking to do business in the EU? Consider a US company 
that already has operations in several EU countries but wishes 
to rationalize those operations in order to take advantage of 
the single market. Such a company may find it most efficient to 
locate personnel or facilities used in certain sales and 
service activities in a single location or at least to manage 
them from a single location. While a number of factors will 
affect the choice of location, all enterprises, whether US-
owned or EU-owned, will favor those locations that impose the 
lowest EU tax burden on the activities in question. However, if 
the enterprise is US-owned, the subpart F rules may eliminate 
any locational tax efficiency by immediately imposing an income 
tax effectively equal to the excess of the US tax rate over the 
local tax rate. Thus, US companies are penalized for setting up 
their EU operations in the manner that minimizes their EU tax 
burden (even though reduction of EU income taxes will increase 
the US taxes collected when the earnings are repatriated). It 
makes as little sense for the US to penalize its companies in 
this way as it would for the EU to impose a special tax on 
European companies that based their US sales and service 
activities in the US states that imposed the least taxes on 
those activities.
    The original rationale for the foreign-base company rules 
was twofold. The first was that companies with operations in 
low-tax jurisdictions might abuse transfer pricing to allocate 
unwarranted amounts of income to those operations. This concern 
is obsolete in light of the powerful tools acquired by the IRS 
in the past decade to enforce arm's length transfer pricing. 
The second was that, if a mobile sales or service activity did 
not need to be located in any particular location, there was 
generally no valid business purpose served by incorporating 
that activity in a tax haven company rather than a US company. 
This rationale has no application to US companies that locate 
their EU-wide sales and service functions in a single EU 
location, from which other EU subsidiaries are then served. The 
current subpart F rules would not tax the income of a UK 
subsidiary from serving another UK subsidiary, but they would 
tax such income if the UK company's personnel went to France to 
serve a French subsidiary. It should be self-evident that there 
are valid business reasons for not establishing a separate 
company in France, let alone a US company, to perform the 
latter services. Moreover, there is little likelihood of US 
companies achieving ``tax haven'' results through EU locational 
decisions, since the EU member states have ample reason 
themselves not to permit the formation of tax shelters within 
the EU, as evidenced by the emerging EU Code of Conduct against 
harmful tax competition.
    For the foregoing reasons, the EABC was pleased to see that 
section 102 of H.R. 2018 acknowledges the importance of this 
issue by requiring a Treasury study to be concluded within six 
months of enactment. However, the EABC believes that further 
study is unwarranted. The EU is unique--nowhere else in the 
world have so many important trading nations established a 
truly integrated market. Success in this fiercely competitive 
market is critical to success in the world at large. Almost 
since the inception of subpart F, US companies attempting to 
exploit the opportunities of the common European marketplace 
have pleaded for relief from the application of subpart F rules 
that treat the location of EU-wide activity in one EU member 
rather than in another as a form of tax avoidance that must be 
penalized. We respectfully observe that the time for correcting 
this most blatant of the unwarranted consequences of the US 
subpart F regime is long overdue.

Members of the European-American Business Council

    ABB
    ABN Amro Bank
    AgrEvo
    Airbus Industrie
    AirTouch Communications Inc.
    Akin, Gump, Strauss, Hauer & Feld
    Akzo Nobel Inc.
    Andersen Worldwide
    Astra Pharmaceutical Products Inc.
    AT&T
    BASF Corporation
    BAT Industries
    Bell Atlantic Inc.
    Bell South Corporation
    BMW (US) Holding Corporation
    BP America, Inc.
    BT North America, Inc.
    Cable & Wireless
    Chubb Corporation
    Citicorp/Citibank
    Cleary, Gottlieb, Steen & Hamilton
    Compagnie Financiere de CIC et de l'Union Europeenne
    Credit Suisse
    DaimlerChrysler
    Deloitte & Touche LLP
    DIHC
    Dun & Bradstreet Corporation
    Eastman Kodak Company
    ED&F Man Inc.
    EDS Corporation
    Ericsson Corporation
    Finmeccanica
    Ford Motor Company
    Gibson, Dunn & Crutcher
    Glaxo Inc.
    IBM Corporation
    ICI Americas Inc.
    ING Capital Holding Corporation
    Investor International
    Koninklijke Hoogovens NV
    Linklaters & Paines
    Lucent Technologies
    MCI Communications Corporation
    Merrill Lynch & Company, Inc.
    Michelin Tire Corporation
    Monsanto Company
    Morgan Stanley & Co.
    Nestle USA, Inc.
    Nokia Telecommunications Inc.
    Nortel Networks
    Novartis
    Novo Nordisk of North America
    Pechiney Corporation
    Pfizer International Inc.
    Philips Electronics North America
    Pirelli
    Powell, Goldstein, Frazer & Murphy
    Procter & Gamble
    Price Waterhouse LLP
    Rabobank Nederland
    Rolls-Royce North America Inc.
    SAAB AB
    Sara Lee Corporation
    SBC Communications Inc.
    Siegel & Gale
    Siemens Corporation
    Skandia
    Skanska AB
    SKF AB
    SmithKline Beecham
    Sulzer Inc.
    Tetra Laval Group
    Tractebel Energy Marketing
    Unilever United States, Inc.
    US Filter
    Veba Corporation
    VNU Business Information Svcs., Inc.
    Volkswagen
    Volvo Corporation
    White Consolidated, Inc.
    Xerox Corporation
    Zeneca Inc.

                                


Statement of the Financial Executives Institutes, Detroit, MI

    Chairman Amo Houghton and Members of the Subcommittee on 
Oversight of the House Ways and Means Committee:
    The Financial Executives Institute (``FEI'') Committee on 
Taxation appreciates this opportunity to present its views on 
the current U.S. international tax regime.
    FEI is a professional association comprising 14,000 senior 
financial executives for over 8,000 major companies throughout 
the United States. The Tax Committee represents the views of 
the senior tax officers from over 30 of the nation's largest 
corporations.
    At the outset, FEI would like to thank Chairman Houghton 
and Mr. Levin for introducing H.R. 2018, the International Tax 
Simplification for American Competitiveness Act of 1999. This 
legislation builds on your previous successful efforts to keep 
step with the rapid globalization of the economy by simplifying 
and rationalizing the international provisions of the Internal 
Revenue Code (the ``Code'').

                      Taxation in a Global Economy

    The U.S. international tax regime reflects a balance between two 
important, but sometimes conflicting, goals: neutrality and 
competitiveness. The U.S. generally tries to raise revenue in a neutral 
manner that does not discriminate in favor of one investment over 
another. At the same time, the U.S. seeks to raise revenue in a way 
that does not hinder, and where possible helps, the competitiveness of 
the American economy, its firms and its workers.
    The current balance between neutrality and competitiveness was 
struck almost four decades ago during the Kennedy Administration. At 
the time, the rest of the world was still in large measure trying to 
rebuild from the social, physical and political devastation of World 
War II. The United States was a comparative economic giant, accounting 
for 50 percent of worldwide foreign direct investment and 40 percent of 
worldwide GDP. Under these circumstances, policymakers were more 
concerned with the impact of tax law on the location decisions of U.S. 
firms--i.e., neutrality--than on the effect of tax law on the 
competitiveness of those firms.
    Accordingly, the Code taxes U.S. taxpayers on their worldwide 
income, with a tax credit for taxes paid to foreign jurisdictions. In 
theory, this approach ensures that a given investment by a U.S. firm 
will experience roughly the same level of taxation regardless of 
location. The Code takes competitiveness concerns into account by 
deferring tax on the active income of foreign subsidiaries of U.S. 
firms until the income is repatriated. This ensures that active 
subsidiaries are not more heavily taxed currently than their non-U.S. 
competitors down the street. Over the years, this deferral has been 
increasingly limited as competitiveness has taken a back seat to 
concerns about tax avoidance by U.S. taxpayers.
    Today, the global economic landscape looks very different than it 
did during the Kennedy Administration. Europe, Japan and a host of 
other nations have emerged as tough competitors. Revolutions in 
transportation, telecommunications and information technology mean that 
firms increasingly compete head-to-head on a global basis. As a result, 
the U.S. is fighting harder than ever to maintain its share, now down 
to about 25 percent, of the world's foreign direct investment and GDP, 
and many U.S. firms now focus as much or more on fast-growing overseas 
markets as on the mature U.S. market.
    The U.S. needs to adapt its international tax regime to this new 
reality. It is no longer acceptable merely to strive to treat U.S. 
taxpayers or their investments in a neutral manner. We must also 
consider how their competitors from other nations are taxed by their 
host governments. For example, while the United States continues to tax 
its taxpayers on a worldwide basis, many of our trading partners tend 
to tax their businesses on a ``territorial'' basis in which only income 
earned (``sourced'') in the home jurisdiction is subject to taxation. 
Even countries which tax on a worldwide basis do so with far fewer 
limitations and less complex rules on deferral, the foreign tax credit 
and the allocation and apportionment of income, deductions and expenses 
between domestic and foreign sources.

                    Making America More Competitive

    With your leadership, Mr. Chairman, Congress in recent years has 
taken some positive steps to reform the international tax rules and 
make America more competitive. Among the important changes: eliminating 
the PFIC/CFC overlap, simplifying the 10/50 basket, applying the FSC 
regime to software, repealing section 956A, and extending deferral to 
active financing income.
    H.R. 2018 includes many of the necessary next steps for reform. FEI 
strongly endorses this legislation and associates itself with the oral 
testimony of the National Foreign Trade Council with respect to 
specific provisions of the bill.
    For example, FEI strongly supports the provision in H.R. 2018 that 
seeks to treat the European Union as a single country. The European 
Union created a single market in 1992 and a single currency, the euro, 
in 1999. Yet U.S. international tax rules still treat the EU as 15 
separate countries. This has made it difficult for U.S. companies to 
consolidate their EU operations and take advantage of the new economies 
of scale. Over time, our European competitors, who do not face such 
obstacles to consolidation, will gain a competitive advantage.
    Another example is the provision that would accelerate the 
effective date for ``look-through'' treatment in applying the foreign 
tax credit baskets to dividends from 10/50 companies. The 1997 tax law 
allows such look-through treatment for dividends paid out of earnings 
and profits accumulated in taxable years beginning after December 31, 
2002. This means U.S. corporate taxpayers face an unnecessary tax cost 
until 2003.

                       Threats to Competitiveness

    Notwithstanding these positive developments, there have been some 
ominous clouds on the international tax horizon. The Treasury 
Department early last year issued guidance on so-called ``hybrid 
entities'' that would have substantially hindered the ability of U.S. 
companies to compete abroad (Notice 98-11). Although the original 
``hybrid'' rules were withdrawn and we understand that the subsequent 
notice (Notice 98-35) is being reconsidered, Treasury has given every 
indication that it will continue to push neutrality concerns over 
competitiveness. (e.g. seeking limits on deferral and promoting the 
OECD effort on ``harmful tax competition''). These and other proposals 
to amend the Code in ways that threaten U.S. competitiveness take us in 
precisely the opposite direction from where we need to go in the global 
economy. Consider the effort by some to further limit deferral.
    Under current law, ten percent or greater U.S. shareholders of a 
controlled foreign corporation (``CFC'') generally are not taxed on 
their proportionate share of the CFC's operating earnings until those 
earnings are actually paid in the form of a dividend. Thus, U.S. tax on 
the CFC's earnings generally is ``deferred'' until an actual dividend 
payment to the parent company, just as tax is ``deferred'' when an 
individual holds shares in a company until such time as the company 
actually pays a dividend to the individual. However, under Subpart F of 
the Code, deferral is denied--so that tax is accelerated--on certain 
types of income produced by CFCs.
    Subpart F was originally enacted in 1962 to curb the ability of 
U.S. companies to allocate income and/or assets to low-tax 
jurisdictions for tax avoidance purposes. Today, it is virtually 
impossible under the Section 482 transfer pricing and other rules to 
allocate income in this manner. Indeed, the acceleration of tax on 
shareholders of CFC operations has no counterpart in the tax laws of 
our foreign trading partners.\1\ Nevertheless, Subpart F remains in the 
Code, putting U.S. companies at a disadvantage. In many instances, 
Subpart F results in the taxation of income that may never be 
realized--perhaps because of the existence in a foreign country of 
exchange or other restrictions on profit distributions, reinvestment 
requirements of the business, devaluation of foreign currencies, 
subsequent operating losses, expropriation, and the like--by the U.S. 
shareholder.
---------------------------------------------------------------------------
    \1\ For example, according to a 1990 ``White Paper'' submitted by 
the International Competition Subcommittee of the American Bar 
Association Section of Taxation to congressional tax writing 
committees, countries such as France, Germany, Japan, and The 
Netherlands do not tax domestic parents on the earnings of their 
foreign marketing subsidiaries until such earnings are repatriated.
---------------------------------------------------------------------------
    Other problems posed by the acceleration of tax under Subpart F and 
similar proposals include:
     Acceleration of tax may lessen the likelihood or totally 
prevent U.S. companies from investing in developing countries by 
vitiating tax incentives offered by such countries to attract 
investment. This result would be counter to U.S. foreign policy 
objectives by opening the door to foreign competitors who would likely 
order components and other products from their own suppliers rather 
than from U.S. suppliers. Moreover, any reduced tax costs procured by 
these foreign competitors would likely be protected under tax sparing-
type provisions of tax treaties that are typically agreed to by other 
nations, although not by the U.S. Treasury.
     It may result in double taxation in those countries which 
permit more rapid recovery of investment than the U.S., because the 
U.S. tax would precede the foreign creditable income tax by several 
years and the carryback period may be inadequate. Moreover, even if a 
longer carryback period were enacted, the acceleration of the U.S. tax 
would be a serious competitive disadvantage vis-a-vis foreign-owned 
competition.
     It would discriminate against shareholders of U.S. 
companies with foreign operations, as contrasted with domestic 
companies doing business only in the U.S., by accelerating the tax on 
unrealized income. This is poor policy because U.S. multinational 
companies have been and continue to be responsible for significant 
employment in the U.S. economy, much of which is generated by their 
foreign investments.
     It could harm the U.S. balance of payments. Earnings 
remitted to the U.S. have exceeded U.S. foreign direct investment and 
have been the most important single positive contribution to the U.S. 
balance of payments. The ability to freely reinvest earnings in foreign 
operations results in strengthening those operations and assuring the 
future repatriation of earnings. Accelerating tax on CFCs would greatly 
erode this advantage.
    Acceleration of tax on CFCs is often justified by the 
belief that U.S. jobs will somehow be preserved if foreign 
subsidiaries are taxed currently. However, in reality, foreign 
operations of U.S. multinationals create rather than displace 
U.S. jobs, while also supporting our balance of payments and 
increasing U.S. exports. Foreign subsidiaries of U.S. companies 
play a critical role in boosting U.S. exports by marketing, 
distributing, and finishing American-made products in foreign 
markets. In 1996, U.S. multinational companies were involved in 
an astounding 65 percent of all U.S. merchandise export sales. 
And studies have show that these exports support higher wage 
jobs in the United States.
    U.S. firms establish operations abroad because of market 
requirements or marketing opportunities. For example, it is 
self-evident that those who seek natural resources must develop 
them in the geographical locations where they are found, or 
that those who provide time-sensitive information technology 
products and services must have a local presence. In addition, 
as a practical matter, local conditions normally dictate that 
U.S. corporations manufacture in the foreign country in order 
to enjoy foreign business opportunities. This process works in 
reverse: it has now become commonplace for foreign companies 
like BMW, Honda, Mercedes, and Toyota to set up manufacturing 
operations in the U.S. to serve the U.S. market. It is not just 
multinationals that benefit from trade. Many small- and medium-
sized businesses in the U.S. either export themselves or supply 
goods and services to other export companies.
    Moreover, CFCs generally are not in competition with U.S. 
manufacturing operations but rather with foreign-owned and 
foreign-based manufacturers. A very small percentage (less than 
10% in 1994) of the total sales of American-owned foreign 
manufacturing subsidiaries are made to the U.S. Most imports 
come from sources other than foreign affiliates of U.S. firms. 
In addition, a decrease in foreign investment by U.S. companies 
would not result in an increase in U.S. investment, primarily 
because foreign investments are undertaken not as an 
alternative to domestic investment, but to supplement such 
investment.
    There is a positive relationship between investment abroad 
and domestic expansion. Leading U.S. corporations operating 
both in the U.S. and abroad have expanded their U.S. 
employment, their domestic sales, their investments in the 
U.S., and their exports from the U.S. at substantially faster 
rates than industry generally. In a 1998 study entitled 
``Mainstay III: A Report on the Domestic Contributions of 
American Companies with Global Operations,'' and an earlier 
study from 1993 entitled ``Mainstay II: A New Account of the 
Critical Role of U.S. Multinational Companies in the U.S. 
Economy,'' the Emergency Committee for American Trade 
(``ECAT'') documented the importance to the U.S. economy of 
U.S. based multinational companies. The studies found that 
investments abroad by U.S. multinational companies provide a 
platform for the growth of exports and create jobs in the 
United States. (The full studies are available from The 
Emergency Committee for American Trade, 1211 Connecticut 
Avenue, Washington, DC 20036, phone (202) 659-5147).
    Proposals to accelerate tax through the repeal of 
``deferral'' are in marked contrast and conflict with over 50 
years of bipartisan trade policy. The U.S. has long been 
committed to the removal of trade barriers and the promotion of 
international investment, most recently through the NAFTA and 
WTO agreements. Moreover, because of their political and 
strategic importance, foreign investments by U.S. companies 
have often been supported by the U.S. government. For example, 
participation by U.S. oil companies in the development of the 
Tengiz oil field in Kazakhstan has been praised as fostering 
the political independence of that newly formed nation, as well 
as securing new sources of oil to Western nations, which are 
still heavily dependent on Middle Eastern imports.

                               Conclusion

    Current U.S. international tax rules create many impediments that 
cause severe competitive disadvantages for U.S.-based multinationals. 
By contrast, the tax systems of other countries actually encourage our 
foreign-based competitors to be more competitive. It is time for 
Congress to improve our system to allow U.S. companies to compete more 
effectively, and to reject proposals that would create new impediments 
making it even more difficult and in some cases impossible to succeed 
in today's global business environment.
    We thank you for the opportunity to provide our comments on this 
extremely important issue.

                                


Statement of General Motors Corporation

    General Motors is pleased to submit comments on 
simplification of the international tax system of the United 
States and how the system could be changed to make U.S. 
business more competitive in the global market place. We 
commend Chairman Houghton, Representative Levin and the other 
members who joined in the recent introduction of H.R. 2018, the 
International Simplification for American Competitiveness Act 
of 1999.
    We believe the U.S. rules for taxing international income 
are unduly complex and, in many cases, inequitable. We believe 
that legislation is required to rationalize and simplify the 
international provisions of the U.S. tax law. Thus, we are 
pleased with the recent introduction of H.R. 2018 and this 
hearing by the Subcommittee which focuses attention on this 
important area of U.S. tax law.
    The International Simplification Bill (H.R. 2018) contains 
important provisions which are a good start to making the tax 
rules more rational and workable and to remove some of the tax 
barriers currently faced by U.S.-based multinational companies. 
We would like to highlight three issues addressed in the bill 
that we at General Motors believe are particularly important.

         Allocation of Interest Expense (Sec. 309 of H.R. 2018)

    First, the bill includes a requirement that the Secretary of 
Treasury conduct a study of the rules for allocating U.S. interest 
expense of an affiliated group of companies between domestic and 
foreign-source income. We would like to see the bill go farther and 
actually include provisions that substantively fix the onerous interest 
allocation rules. In fact, GM strongly supports the Interest Allocation 
Reform Act, H.R. 2270, introduced recently by Congressmen Portman and 
Matsui which we believe is the right approach toward fixing the problem 
and should be included in any international tax reform legislation.
    By way of background, the U.S. tax system currently requires U.S. 
interest expense of U.S. multinational companies to be apportioned to 
foreign-source income for purposes of determining the amount of foreign 
tax credits that may be claimed. This apportionment of interest expense 
reduces the taxpayer's foreign-source income and thereby restricts its 
capacity to utilize foreign tax credits. This effectively results in an 
amount of income equal to the apportioned interest expense being taxed 
in the United States with no offsetting credit for foreign taxes. 
Another way of looking at it is that, in this circumstance, there is 
effectively no U.S. tax deduction for this apportioned interest 
expense. And, of course, there is no deduction for this amount in any 
foreign country. The result is double taxation.
    The interest allocation rules put U.S. companies at a competitive 
disadvantage in both foreign markets and in the United States. An 
investment by a U.S. company in a foreign market results in an 
additional allocation of U.S. interest expense with the consequent 
double taxation. However, foreign-based companies competing in that 
foreign market are not faced with losing any part of related interest 
expense deductions in their home country. We are not aware of any 
foreign competitor being subjected to as harsh a tax regime on its 
interest expense as a U.S.-based company.
    The interest allocation rules also discourage investments by U.S. 
businesses to enhance their domestic competitiveness vis-a-vis foreign 
competition in the United States. An expansion by a U.S.-based 
multinational of operations in the U.S. through the use of debt results 
in the apportioning of additional interest expense against foreign-
source income and an increased U.S. tax liability. GM itself 
experienced this in its creation of Saturn Corporation, (which, in a 
twist of irony, was conceived as an import-fighting line of small 
cars). GM incurred debt in the U.S. to finance the construction of 
Saturn facilities in Spring Hill, Tennessee. A portion of the interest 
on that debt was allocated to foreign-source income, and in effect a 
current deduction for some of that interest was lost. By contrast, 
foreign-owned competitors who were constructing new U.S. plants at 
about the same time could finance them with U.S. borrowings and get the 
full U.S. tax benefit from this interest expense, as they were unlikely 
to have any foreign-source income or foreign assets. Thus, under 
current interest allocation rules, U.S. companies can't even compete on 
a level playing field when they're the home team!
    Another problem with the interest allocation rules arises in the 
case of ``subgroups'' of U.S.-affiliated companies. By way of example, 
GM has a wholly-owned domestic subsidiary, GMAC, whose principal 
business is to provide financing to GM dealers and customers who buy or 
lease GM motor vehicles in the United States. GMAC borrows on the basis 
of its own credit and uses the proceeds in its own operations. Yet 
under current tax rules, GMAC's interest expense must be lumped 
together with all GM's U.S. affiliates in making the allocation. This 
has the effect of over-allocating U.S. interest expense to foreign-
source income.
    The Portman-Matsui bill (H.R. 2270) would substantially correct the 
adverse effect of these rules by taking into account as an offset the 
interest expense incurred by foreign affiliates, thus reducing the 
amount of U.S. interest expense allocated to foreign-source income. 
Also, it would allow an election to make a separate allocation 
computation in certain circumstances for subgroups of U.S. affiliates, 
including financial services subgroups, such as GMAC.

  Recharacterization of Overall Domestic Loss (Sec. 202 of H.R. 2018)

    The second provision in H.R. 2018 which we would like to mention is 
the one which would recharacterize an overall domestic loss in a year 
as foreign-source income in subsequent years to prevent permanent 
double taxation.
    Under current tax law, a U.S. taxpayer experiencing an overall loss 
on its domestic operations must offset that loss against its foreign-
source income. Today, this permanently reduces the capacity of the 
taxpayer to claim foreign tax credits and can result in double 
taxation. The proposal would in effect convert this to a timing 
difference by recharacterizing certain future domestic income as 
``foreign-source,'' and thus, restore the taxpayer's capacity to claim 
foreign tax credits in later years.
    The tax law already requires that when foreign loss exceeds 
domestic income the overall foreign loss amount is recaptured in 
subsequent years by recharacterizing similar amounts of foreign income 
as ``domestic income.'' Thus, the current proposal appropriately adds 
important and needed symmetry and fairness to present law. This would 
eliminate a ``trap'' in the current foreign tax credit rules for the 
unfortunate company that incurs domestic losses.
    With our current robust economy, people do not want to think these 
days about such problems as economic downturns or tax losses. But, for 
a company such as GM which is in an economically cyclical industry, and 
which in the past has been adversely impacted by such things as work 
stoppages and oil embargoes, the possibility of tax losses can never be 
totally dismissed. And with the economy now ``running on full,'' there 
couldn't be a better time to fix tax problems related to tax losses, 
i.e., when the revenue cost would be minimized.

Permanent Subpart F Exemption for Active Financing Income (Sec. 101 of 
                               H.R. 2018)

    Prior to 1998, the earnings of foreign subsidiaries which carried 
on an active financial services business in a foreign country were 
subject to U.S. tax even though the earnings were not distributed to 
the U.S. parent. That problem was alleviated temporarily through 
legislation which excludes such active business income from current 
U.S. taxation. However, that temporary relief expires at the end of 
this year and needs to be made permanent. This important provision 
allows U.S.-owned foreign finance companies, including foreign 
subsidiaries of GMAC, to compete on an equal footing with their 
foreign-based financing competitors. GM strongly supports making this 
rule permanent.
    In closing, General Motors again commends the Subcommittee for its 
consideration of the U.S. international tax provisions. We urge the 
Subcommittee in its review to give particular attention to remedying 
the interest allocation rules along the lines proposed in H.R. 2270. 
This is the single most important reform that's needed in the 
international area. In addition, permitting domestic loss 
recharacterization and extending the subpart F exception for active 
financing income are very badly needed provisions.

                                


Statement of Howard P. Goldberg, Assistant Director, Taxation, Mileage 
Award Tax Committee, International Air Transport Association, Montreal, 
Quebec, Canada

    Mr. Chairman, Members of the Committee, on behalf of the 
IATA Mileage Award Tax Committee, the International Air 
Transport Association (IATA) appreciates the opportunity to 
submit these written comments on the complexity of the current 
U.S. international tax regime.\1\ As part of the 1997 
amendments, section 4261(e)(3) imposed an excise tax on an 
airline's sale of frequent flyer miles to third party vendors 
like hotels, car rental agencies and credit card companies (the 
``mileage credit excise tax''). The tax is imposed on 
purchasers but is required to be collected by the selling 
airline.
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    \1\ The International Air Transport Association (IATA) is a 
worldwide association comprised of 263 member airlines. The members of 
IATA carry the bulk of the world's scheduled international and domestic 
air transportation under the flags of some 150 nations. The stated 
purposes of IATA include the promotion of safe, regular and economical 
air transport for the benefit of the peoples of the world and the 
fostering of international air commerce. All non-U.S. IATA member 
airlines have been established under the laws of their respective 
countries and many are duly designated and licensed to provide 
international transportation of passengers, cargo and mail to and from 
points in the United States. The IATA members who comprise the IATA 
Mileage Award Tax Committee are Aer Lingus, Aerolineas Argentina, Air 
Canada, Air France, Air New Zealand, Alitalia, British Airways, CSA 
Czech Airlines, Finnair, Iberia Airlines, Japan Airlines, KLM Royal 
Dutch Airlines, Lufthansa German Airlines, Qantas Airways, Sabena World 
Airlines, Swissair, Thai Airways, Turkish Airways, and Varig.
---------------------------------------------------------------------------
    Amendments made in 1997 to the aviation ticket tax rules of 
the Internal Revenue Code have increased both the complexity 
and the uncertainty regarding the application of excise taxes 
to international aviation. For example, it has been argued that 
the mileage credit tax might apply to a sale of miles from a 
foreign airline to a foreign hotel which provides those miles 
to its foreign hotel guests. Application of the tax in that 
situation, however, would be an infringement of the tax 
prerogatives of other sovereign nations. Such an infringement 
could lead to reciprocating tax regimes in foreign countries 
seeking to tax a U.S. carrier's sale of frequent flyer miles to 
U.S. hotels, credit card companies and car rental agencies.
    Diplomatic Notes. Some twenty foreign countries have 
submitted diplomatic notes to the Department of State and to 
Congress protesting any interpretation that would impose the 
mileage credit on an extraterritorial basis. The United States 
has been requested to confirm that such tax would not be 
imposed on non-U.S. commerce or in contravention of the U.S.'s 
obligations under its treaties, international agreements or 
international law.
    An Unfair User Fee. Section 4261(e)(3) cannot fairly be 
read to apply on an extraterritorial basis to sales of frequent 
flyer miles by foreign airlines. The aviation ticket taxes, 
including the mileage credit tax, are user fees which are 
dedicated to support the operation of the U.S. aviation 
infrastructure and are imposed based on a fair approximation of 
the use of U.S. aviation infrastructure. See, H.R. Rep. No. 91-
601, at 41 (1970); and S. Rep. No. 91-706, at 11 (1970) (both 
directing the Department of Transportation to prepare a report 
on the aviation user fees ``in order to insure an equitable 
distribution of future tax burdens among the various categories 
of airport and airway users as well as other persons deriving 
benefits from the aviation system''). The 1997 amendments to 
the aviation ticket tax, including section 4261(e)(3), were 
intended to improve the fairness of the aviation ticket taxes 
by expanding the taxation of currently untaxed payments to the 
extent that such payments benefit from the U.S. aviation 
infrastructure. H.R. Rep. No. 105-148, at 482-483.\2\ Payments 
by foreign vendors, for example, to participate in a foreign 
airline's frequent flyer program do not have an immediate or 
ascertainable impact on or derive a quantifiable benefit from 
the U.S. aviation infrastructure. Imposing the mileage credit 
tax on such payments would be an unfair application of the 
aviation ticket taxes and would not be based on or correlate to 
any benefit derived from the U.S. aviation infrastructure.
---------------------------------------------------------------------------
    \2\ The House Report states: ``the Committee determined that the 
perceived fairness of the passenger air transportation excise taxes 
will be improved if certain currently untaxed payments and passengers 
were required to contribute to the financing of the FAA programs from 
which they benefit. In furtherance of this goal, the bill extends the 
tax to internationally arriving passengers and clarifies that the tax 
applies applies to payments to airlines (and related parties) from 
credit card and other companies in exchange for the right to award 
frequent flyer or other reduced air travel rights.''
---------------------------------------------------------------------------
    Extraterritorial Application Would Violate U.S. 
Obligations. In addition, any extraterritorial application of 
the mileage credit excise tax would violate international 
agreements to which the United States is a party and would be 
inconsistent with principles of international law. The 
relationship of payments by vendors to foreign airlines for 
miles that ultimately might or might not be used for U.S. air 
transportation does not satisfy the just and reasonable 
requirements for user fees under international agreements to 
which the United States is party, or the norms of international 
law for excise taxation.
    The United States is party to numerous bilateral aviation 
agreements under which it has agreed that neither state may 
impose user fees on transactions that do not reasonably relate 
to a state's expenditures for the provision of aviation 
facilities. The United States has agreed under its bilateral 
aviation agreements that each state's airlines shall have fair 
and equal rights to compete in providing international air 
transportation. E.g., Air Transport Agreement of Jan. 17, 1966, 
as amended Feb. 24, 1995, U.S.-Can., arts. 4, 8.\3\ In order to 
respect the bilateral aviation agreements, the mileage credit 
excise ticket tax cannot apply on an extraterritorial basis to 
payments made by a vendor to participate in a foreign airline's 
frequent flyer program.
---------------------------------------------------------------------------
    \3\ Article 4(1) of the U.S.-Canada Air Transport Agreement states: 
``[e]ach Party shall allow a fair and equal opportunity for the 
designated airlines of both Parties to compete in providing the 
international air transportation governed by this Agreement.'' Articles 
8(A) and 8(B) require user charges to be ``just and reasonable'' and 
``just, reasonable, not unjustly discriminatory, and equitably 
apportioned among categories of users.''
---------------------------------------------------------------------------
    Under U.S. law, U.S. statutes are presumed and interpreted 
not to violate international law. Murray v. The Schooner 
Charming Betsy, 6 U.S. (2 Cranch) 64, 118 (1804). International 
law prohibits excise taxes on transactions that do not occur, 
originate or terminate in or have substantial relation to the 
state imposing the tax. Restatement (Third) of Foreign 
Relations Law of the United States, Sec. 412(4). Payments by a 
foreign vendor, for example, to participate in a foreign 
airline's frequent-flyer program do not have a substantial 
relationship to the United States and do not occur, originate 
or terminate in the United States. Application of the mileage 
credit tax on an extraterritorial basis to a foreign airline's 
sale of frequent flyer miles would be inconsistent with 
international law.
    As a matter of tax policy and international law, U.S. tax 
laws should not be applied on an extraterritorial basis to non-
U.S. commerce.
    Thank you very much for your consideration of this matter.

                                


Statement of the Investment Company Institute

    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.
---------------------------------------------------------------------------
    \1\ The Investment Company Institute is the national association of 
the American investment company industry. Its membership includes 7,576 
open-end investment companies (``mutual funds''), 479 closed-end 
investment companies and 8 sponsors of unit investment trusts. Its 
mutual fund members have assets of about $5.860 trillion, accounting 
for approximately 95% of total industry assets, and have over 73 
million individual shareholders.
    \2\ The 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.
---------------------------------------------------------------------------
    I. 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.
    II. 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 \3\ 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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    III. 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.
    IV. Congress Should Enact Legislation Eliminating U.S. Tax Barriers 
to Foreign Investment In U.S. Funds. The Institute urges the Committee 
to support the enactment of H.R. 2430,\4\ which generally would permit 
all U.S. funds to preserve, for withholding tax purposes, the character 
of short-term gains and interest income distributed to foreign 
investors.\5\ For these purposes, U.S.-source interest and foreign-
source interest that is free from foreign withholding tax under the 
domestic tax laws of the source country (such as interest from 
``Eurobonds'') \6\ would be eligible for flow-through treatment. The 
legislation, however, would deny flow-through treatment for interest 
from any foreign bond on which the source-country tax rate is reduced 
pursuant to a tax treaty with the United States.
---------------------------------------------------------------------------
    \4\ Introduced by Representatives Crane, Dunn and McDermott as the 
``Investment Competitiveness Act of 1999.''
    \5\ The taxation of U.S. investors in U.S. funds would not be 
affected by these proposals.
    \6\ ``Eurobonds'' are corporate or government bonds denominated in 
a currency other than the national currency of the issuer, including 
U.S. dollars. Eurobonds are an important source of capital for 
multinational companies.
---------------------------------------------------------------------------
    The Institute fully supports H.R. 2430 because it would eliminate 
the U.S. withholding tax barrier to foreign investment in U.S. funds, 
while containing appropriate safeguards to ensure that (1) flow-through 
treatment applies only to interest income and gains that would be 
exempt from U.S. withholding tax if received by a foreign investor 
directly or through a foreign fund and (2) foreign investors cannot 
avoid otherwise-applicable foreign tax by investing in U.S. funds that 
qualify for treaty benefits under the U.S. income tax treaty network.
          * * * * *
    The Institute urges the enactment of legislation to make the full 
panoply of U.S. funds--equity, balanced and bond funds--available to 
foreign investors without adverse U.S. withholding tax treatment. 
Absent this change, foreign investors seeking to enter the U.S. capital 
markets or obtain access to U.S. professional portfolio management will 
continue to have a significant U.S. tax incentive not to invest in U.S. 
funds.

                                


Statement of Richard G. Palaschak, Director of Operations, Munitions 
Industrial Base Task Force, Arlington, VA

    Mr. Chairman and Members of the Subcommittee, thank you for 
providing this opportunity to submit a statement for 
consideration by the Committee. This statement is offered on 
behalf of the fourteen companies in the munitions business that 
are members of the Munitions Industrial Base Task Force 
(MIBTF). The member companies are: Aerojet General Corp.; 
Alliant Techsystems, Inc.; Armtec Defense Products Co.; Bulova 
Technologies, Inc.; Chamberlain Manufacturing; Day & 
Zimmermann, Inc.; General Dynamics Ordnance Systems, Inc.; KDI 
Precision Products, Inc.; Mason & Hanger Co., Inc.; Primex; 
Talley Defense Systems, Inc.; Textron Systems; Thiokol Corp.; 
Valentec International Corp.

    In May and June 1993, executives from a cross section of 
the nation's private munitions companies and its arsenal 
operators met and concluded that they were in the middle of an 
unplanned free-fall in munitions funding which would, if not 
reversed, cause the destruction of the United States munitions 
industrial base. This conclusion led to the formation of the 
Munitions Industrial Base Task Force, a non-profit organization 
representing the nation's munitions developers and producers, 
and to an intense effort to quantify the crisis and communicate 
its dimensions to decision-makers in the administration and the 
Congress. Task Force membership represents many of the major 
munitions prime contractors, as well as a cross section of 
subcontractors and suppliers. We manage both government-owned 
facilities as well as those owned solely by the private sector. 
The Task Force does not advocate specific programs on behalf of 
any of its members. Its sole purpose is to pursue a common 
goal:

          Adequate funding and policies to sustain a responsive, 
        capable U.S. munitions industrial base to develop, produce, and 
        support superior munitions for the U.S. and its allies.

    Throughout its existence our member companies have worked 
in cooperation with the DOD's Single Manager for Conventional 
Ammunition (SMCA) and other DOD and service ammunition oriented 
organizations to preserve threatened portions of the munitions 
production and design base. Let me emphasize that our purpose 
is not to ensure the survival of individual companies, but to 
ensure the survival of those threatened research, development, 
and production capabilities, and the associated skilled 
workforce, somewhere within the U.S. domestic industrial base. 
Mr. Chairman, our organization was formed because the munitions 
portion of the Department of Defense (DOD) budget declined by 
nearly 80% between fiscal year 1985 and fiscal year 1994. This 
precipitous funding decline seriously damaged the U.S. 
munitions industrial base and compromised its viability as well 
as its ability to support the national security strategy. The 
U.S. munitions base lost nearly 70% of its major munitions 
companies during this period. It is estimated that the base 
also lost thousands of second/third tier subcontractors. Thanks 
to actions taken by the DOD and the Congress, this decline has 
been stopped, but even the most recent assessment of the 
munitions industrial base by the Army Materiel Command (AMC) 
still characterizes the base as ``weak.''
    This situation is exacerbated by the unfair and 
discriminatory provision contained in Section 923(a)(5) of the 
Internal Revenue Code which reduces the Foreign Sales 
Corporation (FSC) benefits available to companies that sell 
defense materiel to foreign countries to 50 percent of that 
available to other exports. As the surviving companies struggle 
to remain viable, the international marketplace affords them an 
opportunity to supplement the U.S. domestic production needs 
and, thereby, sustain their workforce and maintain an available 
industrial capability to sustain our armed forces with 
ammunition or replenish expenditures of ammunition by our 
forces after a conflict. However, the sale of munitions 
overseas is one of this nation's most tightly regulated areas. 
In several instances, U.S. weapons have been provided or sold 
to friendly countries but the sale of the associated U.S. 
munitions has been disapproved. Even when regulators approve 
the sale of an item, U.S. munitions manufacturers are faced 
with a growing array of foreign competitors, many of whom are 
not only financially supported by their government, but also 
supported by their government's tax and procurement policies. 
Rare is the country that has no capability for munitions 
manufacturing, and many developed countries market, produce, 
and sell very competitive products. In fact, the U.S. itself 
has procured numerous foreign designed munitions that are in 
today's service inventories. These countries have sustained 
their indigenous munitions manufacturing capability, in the 
face of declining domestic defense budgets, by emphasizing 
exports. Many of them subsidize their munitions companies, 
restrict their own munitions procurements to domestic sources, 
help indigenous munitions companies market their products, and 
forgive Value Added Taxes for munitions exports. The current 
FSC provision places U.S. munitions companies at a serious 
disadvantage when they compete in this environment.
    In addition, the current FSC provision is a significant 
handicap to U.S. companies because of today's budget reality. 
In the past U.S. munitions companies could often overcome the 
FSC penalty imposed on munitions exports because of the large 
production requirements of the U.S. military. Economies of 
scale could sometimes offset that penalty as well as the 
advantages that foreign governments provided to their domestic 
manufacturers. That situation no longer exists.
    While the size of the U.S. military has been reduced by 
about a third, the munitions war reserve requirements of the 
U.S. military have plummeted by over 80% (in terms of tonnage) 
during the past decade. Concurrently, the requirements for 
training ammunition have been dramatically reduced by the 
innovative use of simulators and other changes instituted by 
the services. The net result has been smaller production runs 
or no production at all. Consequently, U.S. munitions companies 
lost one of the few offsets to the fierce foreign government 
supported competition that exists today for the international 
sale of munitions to countries approved by the U.S. government. 
Removal of the FSC tax penalty against the export of defense 
materiel will help level the international playing field and, 
in the process, help preserve a U.S. industrial capability that 
is absolutely essential to the conduct of successful warfare in 
support of the nation's national security strategy.
    We, the members of the Munitions Industrial Base Task 
Force, urge the Congress to repeal the FSC penalty on the 
export of defense products in order to provide a fair and 
equivalent treatment to our nation's defense industry and its 
workers, and to improve our industry's competitiveness in the 
international marketplace. The repeal of this provision is 
particularly vital to the U.S. munitions industrial base 
because of its unique circumstances as detailed above. This 
action is not only in the best interests of the U.S. defense 
industry and its workforce, but also in the best interests of 
the nation in ensuring a capable, viable, and enduring U.S. 
industrial base to support American armed forces in the future.

                                


Statement of Lawrence F. Skibbie, President, National Defense 
Industrial Association, Arlington, VA

    Mr. Chairman, Members of the Subcommittee, I am Larry 
Skibbie, president of the National Defense Industrial 
Association (NDIA). On behalf of NDIA, I want to compliment you 
for holding this important hearing and to express our 
appreciation for the opportunity to provide this statement.
    NDIA is the largest defense-related association dedicated 
to the viability of the technology and industrial base. Our 
24,000 individual Members and nearly 900 Member companies, 
which employ the preponderance of the two million men and women 
in the defense sector and represent the full spectrum of the 
base, are vitally interested in maintaining a strong, 
responsive national security infrastructure.
    A little background is in order so that the Subcommittee 
has the full appreciation of both NDIA'S position and the 
current U.S. International Tax Regime's adverse impact on the 
defense sector.
    Currently, the Internal Revenue Code allows U.S. exporters 
to establish Foreign Sales Corporations (FSC) under which they 
can exempt from U.S. taxation a portion of their earnings from 
foreign sales. Enacted in 1976, this provision was intended to 
help U.S. firms compete against companies in other countries 
which rely more on value-added taxes (VATS) than on corporate 
income taxes. Generally, VATS on products are rebated as they 
are exported.
    For U.S. exporters of defense products, however, the FSC 
tax incentive is reduced by 50 percent. Specifically, section 
923(A)(5) of the Internal Revenue Code reduces the tax 
exemption available to companies which export defense products 
to 50 percent of the benefits available to other exporters. 
Initially, the limitation of section 923 was based on the 
premise that military products are not sold in competitive 
market environments, therefore the FSC incentive is unnecessary 
for defense exporters.
    However, examination of today's market environment argues 
heavily against the original premise. Competition among defense 
exporting countries is intense and likely to intensify as 
budgets continue to be reduced. The United States faces 
increased European export promotion incentives, and Russia has 
become a major exporter in world markets. In addition, the U.S. 
Government prohibits the sale of defense products to certain 
countries and requires advanced approval of all sales.
    There is no valid economic or policy basis for continuing 
the discriminatory treatment that U.S. defense exporters face. 
NDIA is strongly opposed to such treatment and supports the 
repeal of section 923(A)(5), of the Internal Revenue Code. 
Moreover, repeal of section 923 will not impact foreign policy 
objectives of the United States. The same checks and balances 
will remain in place and sales of defense exports will continue 
to be subject to existing policy dictates and review processes.
    Therefore, NDIA strongly supports restoring Foreign Sales 
Corporation (FSC) tax benefits for defense products to full 
comparability with other U.S. exports. The FSC limitation for 
defense exports hampers the ability of U.S. companies to 
compete effectively abroad with many of their products. The FSC 
program was enacted to promote trade, which is fundamental to 
our economic health. Discriminating against the defense 
industry only contributes to our trade imbalance, reduces 
employment stability in the defense sector and allows 
competitors to capture business that would likely go to U.S. 
firms.
    Recently, Chairman Houghton and Representative Sander Levin 
introduced H.R. 2018, the international tax simplification for 
American competitiveness act of 1999. Section 303 of the bill 
represents a step toward rectifying a major tax inequity for 
U.S. defense exports. This Omnibus bill seeks to simplify 
certain international taxation rules for U.S. businesses 
operating abroad. Specifically, Section 303 repeals IRC Section 
923(a)(5), which reduces the FSC benefits available to 
companies that sell military goods abroad to 50 percent of the 
benefits available to other exporters.
    NDIA supports a strong, viable and competitive U.S. defense 
industrial base that contributes to our overall national and 
economic security. Unfortunately, the defense industry is 
hindered by the enactment and maintenance of tax laws based on 
outdated premises which represent serious barriers to our 
international competitiveness. These impediments, such as 
section 923(A)(5), should be dismantled as quickly as possible. 
Therefore, prompt repeal of section 923(A)(5) is in order.
    Mr. Chairman, Members of the Subcommittee, thank you again 
for permitting NDIA this opportunity to submit this statement.

                                


                                          Tropical Shipping
                                         Riviera Beach, FL,
                                                      July 6, 1999.
The Honorable A.L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
Washington, D.C.

Re: June 22, 1999 Oversight Subcommittee Hearing on Current U.S. 
International Tax Regime

    Dear Mr. Singleton:

    The U.S. international tax regime is forcing the U.S.-owned fleet 
to expatriate to remain competitive. An unintended result of the 1986 
and 1975 tax law changes has been the near complete removal of U.S. 
investment from the Ocean Shipping industry leaving the cargo trades of 
the United States almost entirely in the hands of foreign-owned and 
foreign-controlled shipping companies. Overall, U.S. ownership of the 
world fleet has declined from 25% of world tonnage in 1975 when 
Congress enacted the first tax code change affecting shipping, to less 
than 5% today!
    This unintended consequence has profound implications for the 
United States, as international trade and commerce of goods have 
historically been influenced by the national interests of the country 
of ultimate ship ownership.
    Tropical Shipping is a U.S.-owned container shipping company (CFC) 
with a business focus on serving the Caribbean, the only region in the 
world in which the United States has a balance of trade surplus. The 
exports to this region create numerous jobs throughout the U.S. 
agricultural and manufacturing sectors as well as our own company's 
employment of over 500 people in the U.S.
    The existence of the U.S. balance of trade surplus with the 
Caribbean is no coincidence. This region is the last area in the world 
where U.S.-owned shipping companies dominate the carriage of general 
cargo and this contributes to the success and promotion of U.S. 
exports. Our company, and our U.S.-owned competitors, are active every 
day, putting Caribbean buyers in touch with U.S. exporters as this is 
beneficial for Tropical Shipping's long term interests.
    Our tax laws force U.S. companies to become acquired by foreigners 
because these countries have adopted tax policies to ensure that their 
international shipping is competitive in world markets. The U.S. 
international tax system puts U.S. corporations and their employees at 
a competitive disadvantage. Our foreign-owned competitors have a great 
advantage in their accumulation of capital, as they are not taxed on a 
current basis and generally only pay tax when the dividends are 
repatriated. It is inevitable that sales of U.S. companies to 
foreigners or mergers of U.S. companies with foreign companies will 
leave the resulting entity headquartered overseas. Because of the 
adverse consequences resulting under the current foreign tax system, 
U.S. shipping companies are being forced out of the growing world 
market.
    Buying and operating ships is capital intensive. U.S. owners in 
this capital intensive and very competitive shipping industry, have 
sold out, gone out of business, and not invested in shipping because 
they just cannot compete due to the unintended consequences of the 
overly complex U.S. international tax regime. It is simply this regime 
that places U.S. owners at a distinct disadvantage in the global 
commerce of ocean transportation. U.S. owners can compete in all other 
respects.
    This tax system is contributing to the de-Americanization of U.S. 
industry because the U.S.-owned fleet is forced to expatriate to remain 
competitive. In the containerized shipping industry, U.S.-owned 
participation in the carriage of U.S. trade has steadily declined to an 
all time low of 14.2% of the container trade in 1988. The decline is 
not in the economic interest of the United States and weakens U.S. 
exports contributing to fewer U.S.-based jobs. It will be a sad day 
indeed if all the ocean commerce created in the growing market of the 
Americas as a result of NAFTA and the FTAA ends up benefiting foreign 
owners with no chance for U.S. investors to participate.
    Please correct the tax code, by reinstating the deferral of 
foreign-based company shipping income, so that the U.S. shipping 
industry is placed in a position of global competitiveness, rather than 
a competitive disadvantage. H.R. 265, introduced by Congressman Shaw 
and co-sponsored by Congressman Jefferson, is an important response to 
this problem.
            Sincerely yours,
                                            Richard Murrell
                                                  President and CEO

                                


Statement of LaBrenda Garrett-Nelson, and Robert J. Leonard, Washington 
Counsel, P.C.

    Washington Counsel, P.C. is a law firm based in the 
District of Columbia that represents a variety of clients on 
tax legislative and policy issues.

                              Introduction

    The provisions that make up the U.S. international tax 
regime rank among the most complex provisions in the Code. This 
statement discusses section 308 of the International Tax 
Simplification for American Competitiveness Act of 1999 (H.R. 
2018), a proposal to reduce complexity in this area by 
repealing the little used regime for export trade corporations 
(``ETCs''). The ETC rules were enacted in 1962 to provide a 
special export incentive in the form of deferral of U.S. tax on 
export trade income. The rationale for the proposed repeal is 
that the special regime for ETCs was, effectively, repealed by 
the 1986 enactment of the passive foreign investment company 
(``PFIC'') rules. At the same time, the proposal would provide 
appropriate (and prospective) transition relief for ETCs that 
were caught in a bind created by enactment of the PFIC regime.

I. The Overlap Between the ETC Regime and the PFIC Rules 
Effectively Nullified the ETC Rules For Many Corporations

    Although the PFIC rules were originally targeted at foreign 
mutual funds, the Congress has recognized that the scope of the 
PFIC statute was too broad. Thus, for example, the Taxpayer 
Relief Act of 1997 eliminated the overlap between the PFIC 
rules and the subpart F regime for controlled foreign 
corporations. Similarly, in the 1996 Small Business Jobs 
Protection Act, the Congress enacted a technical correction to 
clarify that an ETC is excluded from the definition of a PFIC.
    The 1996 technical correction came too late, however, for 
ETCs that took the reasonable step of making ``protective'' 
distributions during the ten-year period between the creation 
of the uncertainty caused by enactment of the PFIC regime and 
the passage of the 1996 technical correction. Although U.S. tax 
on distributed earnings would have been deferred but for the 
ETC/PFIC overlap, these ETCs made distributions out of 
necessity to protect against the accumulation of large 
potential tax liabilities under the PFIC rules. Thus, the PFIC 
rules, in effect, repealed the ETC regime.
II. Congressional Precedents for Providing Transition Relief 
for ETCs

    The proposal would simplify the foreign provisions of the 
tax code by repealing the ETC regime. When the Congress enacted 
the Domestic International Sales Company (``DISC'') rules in 
1971, and again when those rules were replaced with the Foreign 
Sales Corporation (``FSC'') rules in 1984, existing ETCs were 
authorized to remain in operation. Moreover, ETCs that chose to 
terminate pursuant to the 1984 enactment of the FSC regime were 
permitted to repatriate their undistributed export trade income 
as nontaxable previously taxed income (or ``PTI'').
    The Proposal also provides a mechanism for providing 
prospective relief to ETCs that were caught in the bind created 
by the PFIC rules. Consistent with the transition rule made 
available in the 1984 FSC legislation, the proposal would grant 
prospective relief to ETCs that made protective distributions 
after the 1986 enactment of the PFIC rules. Essentially, future 
(actual or deemed) distributions would be treated as derived 
from PTI, to the extent that pre-enactment distributions of 
export trade income were included in a U.S. shareholder's gross 
income as a dividend. Note that the proposed transition relief 
would provide only ``rough justice,'' because taxes have 
already been paid but the proposed relief will occur over time.

                               Conclusion

    Repeal of the ETC provisions would greatly simplify the 
international tax provisions of the Code, but such a repeal 
should be accompanied by relief for ETCs that were caught in 
the bind created by the PFIC rules.

                                


Statement of LaBrenda Garrett-Nelson, Washington Counsel, P.C., on 
behalf of the Ad Hoc Coalition of Finance and Credit Companies

    Section 101 of the International Tax Simplification for 
American Competitiveness Act of 1999 (H.R. 2018) highlights the 
need to extend the provision that grants active financial 
services companies an exception from subpart F. In light of the 
growing interdependence and integration of world financial 
markets, coupled with the international expansion of U.S.-based 
financial services entities, the foreign activities of the 
financial services industry should be eligible for deferral on 
terms comparable to that of manufacturing and other non-
financial businesses. This statement was prepared on behalf of 
an ad hoc coalition of leading finance and credit companies 
whose activities fall within the catch-all concept of a 
``financing or similar business.''
    The ad hoc coalition of finance and credit companies 
includes entities providing a full range of financing, leasing, 
and credit services to consumers and other unrelated 
businesses, including the financing of third-party purchases of 
products manufactured by affiliates (collectively referred to 
as ``Finance and Credit Companies''). This statement describes 
(1) the ordinary business transactions conducted by Finance and 
Credit Companies, including information regarding the unique 
role these companies play in expanding U.S. international 
trade, and (2) the importance of the active financing exception 
to subpart F to the international competitiveness of these 
companies.

   I. The International Operations of U.S.-Based Finance and Credit 
                               Companies

A. Finance and Credit Companies Conduct Active Financial 
Services Businesses

    Finance and Credit Companies are financial intermediaries 
that borrow to engage in all the activities in which banks 
customarily engage when issuing and servicing a loan or 
entering into other financial transactions. Indeed, many 
countries (e.g., Germany, Austria, and France) actually require 
that such a company be chartered as a regulated bank. For 
example, one member of the ad hoc group has a European Finance 
and Credit Company that is regulated by the Bank of England 
and, under the European Union (``EU'') Second Banking 
Coordination Directive, operates in branch form in Austria, 
France, and a number of other EU jurisdictions. The principal 
difference between a typical bank and a Finance and Credit 
Company is that banks normally borrow through retail or other 
forms of regulated deposits, while Finance and Credit Companies 
borrow from the public market through commercial paper or other 
publicly issued debt instruments. In some cases, Finance and 
Credit Companies operating as regulated banks are required to 
take deposits, although they may not rely on such deposits as a 
primary source of funding. In every important respect, Finance 
and Credit Companies compete directly with banks to provide 
loan and lease financing to retail and wholesale consumers.

B. A Finance and Credit Company's Activities Include A Full 
Range Of Financial Services.

    The active financial services income derived by a Finance 
and Credit Company includes income from financing purchases 
from third parties; making personal, mortgage, industrial or 
other loans; factoring; providing credit card services; and 
hedging interest rate and currency risks with respect to active 
financial services income. As an alternative to traditional 
lending, leasing has developed into a common means of financing 
acquisitions of fixed assets, and is growing at double digit 
rates in international markets. These activities include a full 
range of financial services across a broad customer base and 
can be summarized as follows:
     Specialized Financing: Loans and leases for major capital 
assets, including aircraft, industrial facilities and equipment and 
energy-related facilities; commercial and residential real estate loans 
and investments; loans to and investments in management buyouts and 
corporate recapitalizations.
     Consumer Services: Private label and bank credit card 
loans; merchant acquisition, card issuance, and financing of card 
receivables; time sales and revolving credit and inventory financing 
for retail merchants; auto leasing and lending and inventory financing; 
and mortgage servicing.
     Equipment Management: Leases, loans and asset management 
services for portfolios of commercial and transportation equipment, 
including aircraft, trailers, auto fleets, modular space units, 
railroad rolling stock, data processing equipment, telecommunications 
equipment, ocean-going containers, and satellites.
     Mid-Market Financing: Loans and financing and operating 
leases for middle-market customers, including manufacturers, vendors, 
distributors, and end-users, for a variety of equipment, such as 
computers, data processing equipment, medical and diagnostic equipment, 
and equipment used in construction, manufacturing, office applications, 
and telecommunications activities.
    Each of the financial services described above is widely 
and routinely offered by foreign-owned finance companies in 
direct competition with Finance and Credit Companies.

C. Finance and Credit Companies Are Located In The Major 
Markets In Which They Conduct Business And Compete Head-on 
Against ``Name Brand'' Local Competitors.

    Finance and Credit Companies provide services to foreign 
customers or U.S. customers conducting business in foreign 
markets. The customer base for Finance and Credit Companies is 
widely dispersed; indeed, a large Finance and Credit Company 
may have a single customer that itself operates in numerous 
jurisdictions. As explained more fully below, rather than 
operating out of regional, financial centers (such as London or 
Hong Kong), Finance and Credit Companies must operate in a 
large number of countries to compete effectively for 
international business and provide local financing support for 
foreign offices of U.S. multinational vendors. One Finance and 
Credit Company affiliated with a U.S auto maker, for example, 
provide services to customers in Australia, India, Korea, 
Germany, the U.K., France, Italy, Belgium, China, Japan, 
Indonesia, Mexico, and Brazil, among other countries. Another 
member of the ad hoc coalition conducts business through 
Finance and Credit Companies in virtually all the major 
European countries, in addition to maintaining headquarters in 
Hong Kong, Europe, India, Japan, and Mexico. Yet another member 
of the ad hoc coalition currently has offices that provide 
local leasing and financing products in 22 countries.
    Finance and Credit Companies are legally established, 
capitalized, operated, and managed locally, as either branches 
or separate entities, for the business, regulatory, and legal 
reasons outlined below:
    1. Marketing and supervising loans and leases generally require a 
local presence. The provision of financial services to foreign 
consumers requires a Finance and Credit Company to have a substantial 
local presence--to establish and maintain a ``brand name,'' develop a 
marketing network, and provide pre-market and after-market services to 
customers. A Finance and Credit Company must be close to its customers 
to keep abreast of local business conditions and competitive practices. 
Finance and Credit Companies analyze the creditworthiness of potential 
customers, administer and collect loans, process payments, and borrow 
money to fund loans. Inevitably, some customers have trouble meeting 
obligations. Such cases demand a local presence to work with customers 
to ensure payment and, where necessary, to terminate the contract and 
repossess the asset securing the obligation. These active functions 
require local employees to insure the proper execution of the Finance 
and Credit Company's core business activities--indeed, a single member 
of the ad hoc group has approximately 15,000 employees in Europe. From 
a business perspective, it would be almost impossible to perform these 
functions outside a country of operation and still generate a 
reasonable return on the investment. ``Paper companies'' acting through 
computer networks would not serve these local business requirements.
    In certain cases, a business operation and the employees whose 
efforts support that operation may be in separate, same-country 
affiliates for local business or regulatory reasons. For example, in 
some Latin American jurisdictions where profit sharing is mandatory, 
servicing operations and financing operations may be conducted through 
separate entities. Even in these situations, the active businesses of 
the Finance and Credit Companies are conducted by local employees.
    2. Like other financial services entities, a Finance and Credit 
Company requires access to the debt markets to finance its lending 
activities, and borrowing in local markets often affords a lower cost 
of funds. Small Finance and Credit Companies, in particular, may borrow 
a substantial percentage of their funding requirements from local 
banks. Funding in a local currency reduces the risk of economic loss 
due to exchange rate fluctuations, and often mitigates the imposition 
of foreign withholding taxes on interest paid across borders. 
Alternatively, a Finance and Credit Company may access a capital market 
in a third foreign country, because of limited available capital in the 
local market--Australian dollar borrowings are often done outside 
Australia for this reason. The latter mode of borrowing might also be 
used in a country whose government is running a large deficit, thus 
``soaking up'' available local investment. A Finance and Credit Company 
may also rely for funding on its U.S. parent company, which issues debt 
and on-lends to affiliates (with hedging to address foreign exchange 
risks).
    3. In many cases, consumer protection laws require a local 
presence. Finance and Credit Companies must have access to credit 
records that are maintained locally. Many countries, however, prohibit 
the transmission of consumer lending information across national 
borders. Additionally, under ``door-step selling directives,'' other 
countries preclude direct marketing of loans unless the lender has a 
legal presence.
    4. Banking or currency regulations may also dictate a local 
presence. Finance and Credit Companies must have the ability to process 
local payments and--where necessary--take appropriate action to collect 
a loan or repossess collateral. Foreign regulation or laws regarding 
secured transactions often require U.S. companies to conduct business 
through local companies with an active presence. For example, as noted 
above, French law generally compels entities extending credit to 
conduct their operations through a regulated ``banque'' approved by the 
French central bank. Other jurisdictions, such as Spain and Portugal, 
require retail lending to be performed by a regulated entity that need 
not be a full-fledged bank. In addition, various central banks preclude 
movements of their local currencies across borders. In such cases, a 
Finance and Credit Company's local presence (in the form of either a 
branch or a separate entity) is necessary for the execution of its core 
activities of lending, collecting, and funding.
    EU directives allow a regulated bank headquartered in one EU 
jurisdiction to have branch offices in another EU jurisdiction, with 
the ``home'' country exercising the majority of the bank regulation. 
Thus, for example, one Finance and Credit Company in Europe operates in 
branch form, engaging in cross-jurisdictional business in the 
economically integrated countries that comprise the EU. The purpose of 
this branch structure is to consolidate European assets into one 
corporation to achieve increased borrowing power within the EU, as well 
as limit the number of governmental agencies with primary regulatory 
authority over the business.

D. Finance and Credit Companies Play A Critical Role In Supporting 
International Trade Opportunities

    As U.S. manufacturers and distributors expand their sales 
activities and operations around the world, it is critical that U.S. 
tax policy be coordinated with U.S. trade objectives, to allow U.S. 
companies to operate on a level playing field with their foreign 
competitors. One of the important tools available to U.S. manufacturers 
and distributors in seeking to expand foreign sales is the support of 
Finance and Credit Companies providing international leasing and 
financing services. U.S. tax policy should not hamper efforts to 
provide financing support for product sales.
    U.S. manufacturers, in particular, include the availability of 
financing services offered by Finance and Credit Companies as an 
integral component of the manufacturer's sales promotion in foreign 
markets. For related manufacturing or other businesses to compete 
effectively, Finance and Credit Companies establish local country 
financial operations to support the business. As an example, the 
Finance and Credit Company affiliate of a U.S. auto maker establishes 
its operations where the parent company's sales operations are located, 
in order to provide marketing support.
    In supporting the international sales growth of U.S. manufacturers 
and distributors in developed markets, Finance and Credit Companies are 
themselves forced into competition with foreign-owned companies 
offering the same or similar leasing and financing services. To the 
extent Finance and Credit Companies are competitively disadvantaged by 
U.S. tax policy, U.S. manufacturers and distributors either are 
prevented from competing with their counterparts or must seek leasing 
and financing support from foreign-owned companies operating outside 
the United States.

      II. The Need to Continue the Subpart F Exception for Active 
                            Financing Income

A. Legislative Background

    When deferral for active financial services income was 
repealed in 1986, the Congress was concerned about the 
potential for abuse by taxpayers routing passive or mobile 
income through tax havens. At that time. the U.S. financial 
services industry was almost entirely domestic, and so little 
thought was given to the appropriateness of applying the 1986 
Act provisions to income earned by the conduct of an active 
business. The subsequent international expansion of the U.S. 
financial services industry created a need to modernize Subpart 
F by enacting corrective legislation.
    The Taxpayer Relief Act of 1997 introduced a temporary 
(one-year) Subpart F exception for active financing income, and 
1998 legislation revised and extended this provision for an 
additional year. The financial services industry continues to 
seek a more permanent Subpart F exception for active financing 
income.
    But for the Active financing exception, current law would 
discriminate against the U.S. financial services industry by 
imposing a current U.S. tax on interest, rentals, dividends 
etc., derived in the conduct of an active trade or business 
through a controlled foreign corporation. From a tax policy 
perspective, a financial services business should be eligible 
for the same U.S. tax treatment of worldwide income as that of 
manufacturing and other non-financial businesses.

B. The Active Financing Exception is Necessary To Allow U.S. 
Financial Services Companies To Compete Effectively In Foreign 
Markets

    U.S. financial services entities engaged in business in a 
foreign country would be disadvantaged if the active financing 
exception were allowed to expire (and the United States thereby 
accelerated the taxation of their active financing income).
    To take a simplified example, consider a case where a 
Finance and Credit Company establishes a U.K. subsidiary to 
compete for business in London. London is a major financial 
center, and U.S.-based companies compete not only against U.K. 
companies but also against financial services entities from 
other countries. For example, Deutsche Bank is a German 
financial institution that competes against U.S. Finance and 
Credit Companies. Like many other countries in which the parent 
companies of major financial institutions are organized, 
Germany generally refrains from taxing the active financing 
income earned by its foreign subsidiaries. Thus, a Deutsche 
Bank subsidiary established in London defers the German tax on 
its U.K. earnings, paying tax on a current basis only to the 
U.K.
    The application of Subpart F to the facts of the above 
example would place the U.S. company at a significant 
competitive disadvantage in any third country having a lower 
effective tax rate (or a narrower current tax base) than the 
United States (because the U.S. company would pay a residual 
U.S. tax in addition to the foreign income tax). The 
acceleration of U.S. tax under Subpart F would run counter to 
that of many other industrialized countries, including France, 
Germany, the United Kingdom, and Japan.\1\ All four of these 
countries, for example, impose current taxation on foreign-
source financial services income only when that income is 
earned in tax haven countries with unusually low rates of tax.
---------------------------------------------------------------------------
    \1\ For detailed analyses of other countries' approaches to anti-
deferral policy with respect to active financing income, see ``The NFTC 
Foreign Income Project: International Tax Policy for the 21st 
Century,'' Chapter 4 (March 25, 1999).
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    In view of the relatively low profit margins in the 
international financing markets, tax costs might have to be 
passed on to customers in the form of higher financing rates. 
Obviously, foreign customers could avoid higher financing costs 
by obtaining financing from a foreign-controlled finance 
company that is not burdened by current home-country taxation, 
or--in the case of Finance and Credit Companies financing 
third-party purchases of an affiliate's product--purchasing the 
product from a foreign manufacturer offering a lower all-in 
cost. The active financing exception advances international 
competitiveness by insuring that financial services companies 
are taxed in a manner that is consistent with their foreign 
competitors--consistent with the legislative history of Subpart 
F and the long-standing tax policy goal of striking a 
reasonable balance that preserves the ability of U.S. 
businesses to compete abroad.

  III. The Definition of a Finance Company Under the Active Financing 
 Exception to Subpart F was Carefully Crafted to Limit Application of 
                 the Exception to Bona Fide Businesses

    The 1998 legislation introduced a statutory definition of a 
``lending or finance business'' for purposes of the active 
financing exception to subpart F. A lending or finance business 
is defined to include very specific activities:
    (i) making loans;
    (ii) purchasing or discounting accounts receivable, notes, 
or installment obligations;
    (iii) engaging in leasing;
    (iv) issuing letters of credit or providing guarantees;
    (v) providing charge or credit services; or
    (vi) rendering related services to an affiliated 
corporation that is so engaged.

A. A Finance Company Must Satisfy a Two-pronged Test to be 
Eligible to Qualify any Income for the Active Financing 
Exception.

    1. Predominantly Engaged Test. Under a rule that applies to 
all financial services companies, a finance company must first 
satisfy the requirement that it be ``predominantly engaged'' in 
a banking, financing, or similar business. To satisfy the 
``predominantly engaged'' test, a finance company must derive 
more than 70 percent of its gross income from the active and 
regular conduct of a lending or finance business (as defined 
above) from transactions with unrelated ``customers.''
    2. Substantial Activity Test. Even if a finance company is 
``predominantly engaged,'' as in the case of all financial 
services companies, it will flunk the test of eligibility 
unless it conducts ``substantial activity with respect to its 
business. The ``substantial activity'' test, as fleshed out in 
the committee report, is a facts-and-circumstances test (e.g., 
overall size, the amount of revenues and expense, the number of 
employees, and the amount of property owned). In any event, 
however, the legislative history prescribes a ``substantially 
all'' test that requires a finance company to ``conduct 
substantially all of the activities necessary for the 
generation of income''--a test that cannot be met by the 
performance of back-office activities.

B. Once Eligibility is Established, Additional Requirements 
Must be Satisfied Before Income From Particular Transactions 
Can be Qualified Under the Active Financing Exception.

    As listed in the relevant committee report, there are only 
21 types of activities that generate income eligible for the 
active financing exception. In addition, an eligible Finance 
and Credit Company cannot qualify any income under the 
exception unless the income meets four, additional statutory 
requirements that apply to all financial services businesses:
    1. The Exception Is Limited to Active Business Income. 
First, the income must be ``derived by'' the finance company in 
the active conduct of a banking, financing or similar business. 
This test, alone, would preclude application of the active 
financing exception to the incorporated pocketbook of a high 
net worth individual or a pool of offshore passive assets.
    2. Prohibition on Transactions With U.S. Customers. 
Secondly, the income must be derived from one or more 
transactions with customers located in a country other than the 
United States.
    3. Substantial Activities. Substantially all of the 
activities'' in connection with a particular transaction must 
be conducted directly by the finance company in its home 
country.
    4. Activities Sufficient For a Foreign Country To Assert 
Taxing Jurisdiction. The income must be ``treated as earned'' 
by the Finance and Credit Company--i.e., subject to tax--for 
purposes of the tax laws of its home country.

C. In any Event, a Finance Company Cannot Qualify any Income 
Under the Active Financing Exception Unless it meets an 
Additional 30-Percent Home Country Test.

    Under a ``nexus'' test applicable to Finance and Credit 
Companies (but not banks or securities firms with respect to 
which government regulation satisfies the nexus requirement), a 
company must derive more than 30 percent of its separate gross 
income from transactions with unrelated customers in its home 
country. This rule makes it highly unlikely that taxpayers 
could locate a finance company in a tax haven and qualify for 
the active financing exception, because tax havens are unlikely 
to provide a customer base that would support the transactions 
required to meet the 30-percent home country test. Even if such 
a well-populated tax haven could be found, the ability to 
qualify income would be self-limiting (in terms of absolute 
dollars) by the dollar-value of transactions that could be 
derived from unrelated, home-country customers
                               Conclusion
    We urge the Congress to extend the provision that grants 
active financial services companies an exception from subpart 
F. Without this legislation, the current law provision that 
keeps the U.S. financial services industry on an equal footing 
with foreign-based competitors will expire at the end of this 
year. Moreover, this legislation will afford America's 
financial services industry parity with other segments of the 
U.S. economy.

                                
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