[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
FIRST IN SERIES ON THE EXTRATERRITORIAL INCOME REGIME
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SELECT REVENUE MEASURES
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
APRIL 10, 2002
__________
Serial No. 107-63
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
79-486 WASHINGTON : 2002
________________________________________________________________________
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COMMITTEE ON WAYS AND MEANS
BILL THOMAS, California, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
E. CLAY SHAW, Jr., Florida FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut ROBERT T. MATSUI, California
AMO HOUGHTON, New York WILLIAM J. COYNE, Pennsylvania
WALLY HERGER, California SANDER M. LEVIN, Michigan
JIM McCRERY, Louisiana BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan JIM McDERMOTT, Washington
JIM RAMSTAD, Minnesota GERALD D. KLECZKA, Wisconsin
JIM NUSSLE, Iowa JOHN LEWIS, Georgia
SAM JOHNSON, Texas RICHARD E. NEAL, Massachusetts
JENNIFER DUNN, Washington MICHAEL R. McNULTY, New York
MAC COLLINS, Georgia WILLIAM J. JEFFERSON, Louisiana
ROB PORTMAN, Ohio JOHN S. TANNER, Tennessee
PHIL ENGLISH, Pennsylvania XAVIER BECERRA, California
WES WATKINS, Oklahoma KAREN L. THURMAN, Florida
J.D. HAYWORTH, Arizona LLOYD DOGGETT, Texas
JERRY WELLER, Illinois EARL POMEROY, North Dakota
KENNY C. HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
Allison Giles, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Select Revenue Measures
JIM McCRERY, Louisiana, Chairman
J.D. HAYWORTH, Arizona MICHAEL R. McNULTY, New York
JERRY WELLER, Illinois RICHARD E. NEAL, Massachusetts
RON LEWIS, Kentucky WILLIAM J. JEFFERSON, Louisiana
MARK FOLEY, Florida JOHN S. TANNER, Tennessee
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
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
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C O N T E N T S
__________
Page
Advisory of March 27, 2002, announcing the hearing............... 2
WITNESSES
U.S. Department of the Treasury, Barbara Angus, International Tax
Counsel........................................................ 25
Archer, Hon. Bill, PricewaterhouseCoopers LLP.................... 7
Chorvat, Terrence R., George Mason University School of Law...... 35
Garrett-Nelson, LaBrenda, Washington Council Ernst & Young....... 28
Gibbons and Company, Hon. Samuel M. Gibbons...................... 13
McIntyre, Michael J., Wayne State University..................... 40
SUBMISSIONS FOR THE RECORD
Cifrulak, Stephen D., Jr., Sewickley, PA, statement.............. 53
McNulty, Hon. Michael, a Representative in Congress from the
State of New York, statement................................... 42
MTI Services Limited, Princeton, NJ, and Western Growers
Association, Irvine, CA, joint statement....................... 57
FIRST IN SERIES ON THE EXTRATERRITORIAL INCOME REGIME
----------
WEDNESDAY, APRIL 10, 2002
House of Representatives,
Committee on Ways and Means,
Subcommittee on Select Revenue Measures,
Washington, DC.
The Subcommittee met, pursuant to notice, at 2:05 p.m., in
room 1100 Longworth House Office Building, Hon. Jim McCrery,
(Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 226-5911
FOR IMMEDIATE RELEASE
March 27, 2002
No. SRM-4
McCrery Announces First in a Series of
Hearings on the Extraterritorial Income Regime
Congressman Jim McCrery (R-LA), Chairman, Subcommittee on Select
Revenue Measures of the Committee on Ways and Means, today announced
that the Subcommittee will hold its first hearing on the
extraterritorial income (ETI) regime. The hearing will take place on
Wednesday, April 10, 2002, in the main Committee hearing room, 1100
Longworth House Office Building, beginning at 2:00 p.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. 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:
On January 14, 2002, the World Trade Organization (WTO) Appellate
Panel issued its report finding the United States' ETI rules to be a
prohibited export subsidy. This marks the fourth time in the past two
and one-half years that the United States has lost this issue, twice in
the Foreign Sales Corporation case and now twice in the ETI case. There
is no opportunity for the United States to appeal this latest
determination.
On January 29, 2002, a WTO Arbitration Panel began proceedings to
determine the amount of retaliatory trade sanctions that the European
Union (EU) can impose against U.S. exports to the EU. The EU has
requested $4.043 billion in sanctions. The United States has asserted
that the proper measure of sanctions is no more than $1.1 billion. The
Arbitration Panel will issue its determination by April 29, 2002.
In announcing the hearing, Chairman McCrery stated: ``With the
arbitration panel poised to rule on the level of sanctions which can be
imposed by the EU, it is critical that we make a prompt, yet thorough
inquiry into possible changes to the ETI system which are both WTO-
compliant and foster the competitiveness of American companies.
Witnesses at the hearing will help us explore the possibility of one
approach--leaving ETI in place but making modifications to it that
address the objections raised by the EU.''
FOCUS OF THE HEARING:
The focus of the hearing will be to examine whether adjustments can
be made to the existing ETI regime to bring it into compliance with WTO
rules without undermining the competitiveness of U.S. businesses in the
global marketplace.
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Those filing written statements who wish to have their statements
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Chairman McCrery. The Subcommittee will come to order.
We are told we are going to have a vote on the floor in
about 10 or 15 minutes, so if we can get Members to take their
seats as well as our guests, we will proceed and try to get
through the first panel before that vote.
Good afternoon, everyone. Today the Select Revenue Measures
Subcommittee begins its examination of the Extraterritorial
Income (ETI) Exclusion Act which replaced the Foreign Sales
Corp. (FSC) regime. I am glad that Chairman Thomas has asked
our Subcommittee to delve into this difficult issue and hope
that we are up to the task of finding a way to untie this
Gordian knot.
As Members of this panel are well aware, the United States
has a world-wide tax regime, meaning U.S. companies pay tax on
all of their income regardless of where it is earned. Some of
the U.S.'s major competitors have territorial tax systems.
Under such systems only income earned within the home country
is taxed. Income earned outside of the home country generally
is not.
Our international tax rules that provide for deferral for
certain types of income earned abroad and which provide tax
credits for income taxes paid to foreign countries are an
endless source of complexity. Members of this Committee are
interested in simplifying these rules to improve the
competitiveness of U.S. multinational companies. I note that
just last month Oversight Subcommittee Chairman Houghton
introduced legislation on this difficult subject.
The ETI FSC rules are an attempt to address a slightly
different issue impacting the ability of the U.S. companies to
compete abroad. For reasons buried deep in the past, the
agreement establishing the World Trade Organization (WTO)
expressly permits countries to border adjust indirect taxes but
not direct taxes, and upon this distinction lies the prospect
of a trade war with Europe.
Many European countries have relied on value-added taxes,
or VATs, for a significant share of their tax base. Under the
terms of the WTO, the embedded VAT may be rebated when products
are exported. By contrast, the United States raises most of its
revenue from income taxes which are considered direct taxes and
are not similarly rebatable on exported products.
In order to level the playingfield, the United States has
provided a tax benefit to our exporters in an attempt to
replicate the benefits of border adjustability. But what was
offered in incentives to U.S. exporters lacked compliance with
world trading rules.
Domestic sales corporations were replaced by foreign sales
corporations in 1984. In 2000, the WTO ruled the FSC rules, the
Foreign Sales Corporation rules, constituted an impermissible
export subsidy. Working with the Clinton Administration, the
Congress repealed FSC and replaced it with the extraterritorial
income regime, which itself has been found to be in violation
of those same WTO rules.
The case is now before an arbitration panel. That body
will, by the 29th of April, set the amount of retaliation that
the Europeans may impose to mitigate the impact of our Tax
Code's impermissible export subsidy. We fervently hope the
Europeans will not immediately exercise their right to impose
sanctions and recognize the strong commitment of this Congress
and the President to make the necessary changes to the Tax Code
as soon as practicable.
Today's hearing explores one way to bring our Tax Code into
compliance with the WTO ruling. Some observers have suggested
that the WTO Appellate decision provides a road map for how the
ETI regime could be narrowly modified to come into technical
compliance with the WTO's rules while still providing the same
benefits to the same set of taxpayers. Others, however, suggest
the latest Appellate decision provides little wiggle room for
cosmetic solution and believe the WTO will be very skeptical of
supposed solutions that do not fundamentally revamp our Tax
Code.
We have a distinguished group of witnesses to help us
examine these difficult questions, and I am particularly
pleased to welcome back to 1100 Longworth two good friends and
long-time leaders of the Committee on Ways and Means, Chairman
Bill Archer and Chairman Sam Gibbons.
Before I introduce them more fully, though, I would like to
yield to my good friend from Massachusetts who is substituting
for my good friend from New York today as acting Ranking
Member, Mr. Neal.
[The opening statement of Chairman McCrery follows:]
Opening Statement of the Hon. Jim McCrery, a Representative in Congress
from the State of Louisiana, and Chairman, Subcommittee on Select
Revenue Measures
Good afternoon. Today, the Select Revenue Measures Subcommittee
begins its examination of the Extra-Territorial Income Exclusion Act,
which replaced the Foreign Sales Corporation regime.
I am glad Chairman Thomas has asked our Subcommittee to delve into
this difficult issue and hope we are up to the task of finding a way to
untie this Gordian Knot.
As Members of this panel are well-aware, the United States has a
worldwide tax regime, meaning U.S. companies pay tax on all of their
income, regardless of where it is earned. Some of the United States'
major competitors have territorial tax systems. Under such systems,
only income earned within the home country is taxed; income earned
outside of the home country generally is not.
Our international tax rules that provide deferral for certain types
of income earned abroad and which provide tax credits for income taxes
paid to foreign countries are an endless source of complexity. Members
of this Committee are interested in simplifying these rules to improve
the competitiveness of U.S. multi-national companies. I note that just
last month, Oversight Subcommittee Chairman Houghton introduced
legislation on this difficult subject.
The ETI/FSC rules are an attempt to address a slightly different
issue impacting the ability of U.S. companies to compete abroad.
For reasons buried deep in the past, the agreement establishing the
World Trade Organization expressly permits countries to border adjust
indirect taxes but not direct taxes. And upon this distinction lies the
prospect of a trade war with Europe.
Many European countries have relied on Value Added Taxes, or VATs,
for a significant share of their tax base. Under the terms of the WTO,
the embedded VAT may be rebated when products are exported. By
contrast, the United States raises most of its revenue from income
taxes, which are considered direct taxes and are not similarly
rebatable on exported products.
In order to level the playing field, the United States has provided
a tax benefit to our exporters in an attempt to replicate the benefits
of border adjustability.
But what was offered in incentives to U.S. exporters lacked
compliance with world trading rules. Domestic Sales Corporations were
replaced by Foreign Sales Corporations in 1984. In 2000, the WTO ruled
the FSC rules constituted an impermissible export subsidy. Working with
the Clinton Administration, the Congress repealed FSC and replaced it
with the Extra-Territorial Income Regime, which itself has been found
to be in violation of those same rules.
The case is now before an arbitration panel. That body will, by the
29th of April, set the amount of retaliation that the Europeans may
impose to mitigate the impact of our tax code's impermissible export
subsidy.
We fervently hope the Europeans will not immediately exercise their
right to impose sanctions and recognize the strong commitment of the
Congress and the President to making the necessary changes to the tax
code as soon as practicable.
Today's hearing explores one way to bring our tax code into
compliance with the WTO ruling. Some observers have suggested that the
WTO appellate decision provides a road map for how the ETI regime could
be narrowly modified to come into technical compliance with the WTO's
rules while still providing the same benefits to the same set of
taxpayers.
Others, however, suggest the latest appellate decision provides
little wiggle room for a cosmetic solution and believe the WTO will be
very skeptical of supposed solutions that do not fundamentally revamp
the tax code.
We have a distinguished group of witnesses to help us examine these
difficult questions. I am particularly pleased to welcome back to 1100
Longworth two good friends and long-time leaders of the Ways and Means
Committee, Bill Archer and Sam Gibbons.
Before I introduce them, however, I would like to yield to the
gentleman from New York for an opening statement.
Mr. Neal. Thank you, Mr. Chairman.
I agree with you. You couldn't have met two finer people or
two better Chairmen. It is a great opportunity for Members of
this Committee to finally question two Chairmen of this
Committee. It is a rare opportunity we get, finally.
I do want to thank you, Mr. Chairman, for holding this
important hearing today on ensuring the competitiveness of U.S.
multinational businesses.
I also want to thank you and your staff in working in
earnest on another topic of interest to me, the corporate
expatriate problem. I understand a hearing will be held perhaps
as early as the end of this month when a U.S. Department of the
Treasury report on the issue is expected to be released. Either
way, if that report is not available, I think our hearing would
certainly be instructive for the Treasury officials doing the
report since there really has been no public debate on this
issue thus far.
I do want to get to the question-and-answer period with our
respective guests today. But I do also want to thank you Mr.
Chairman publicly for agreeing to proceed with hearings on that
expatriate issue.
Chairman McCrery. I thank the gentleman for his comments
and look forward to working with him and other Members of the
Subcommittee on that issue.
Our first two witnesses today are well known to this
Committee and undoubtedly to our audience and our guests today.
This week is Masters week, as some of you know, some of you
golf addicts like me know. I am looking forward to it. It is my
favorite tournament of the year. It is in the opinion of a
great many people the best-running golf tournament in the
world, and one of the great things about the Masters is the
chance for past champions to come back and mingle with younger
golfers, give them the benefit of their experience and their
knowledge of the Masters Tournament and the game.
Certainly today we have two past masters with us to share
with us their experiences and their knowledge of the game, so
to speak; and we couldn't have chosen two finer examples of the
greatness embodied in the Members of the Committee on Ways and
Means which I think and most people believe is the greatest
Committee in Congress. I don't get any disagreement with our
panel or from the dais.
So, welcome, gentlemen. We very much welcome you back. We
hope you won't make this your last visit to the Committee on
Ways and Means. We hope to see much more of you. Certainly
appreciate your taking time out of your schedules to join us
today and try to help us with this issue.
We do have a vote on the floor--if it is just one vote. We
could find out if it is just one vote. It is just one vote. So
why don't I suggest that the Members of the Subcommittee run
over and cast this one vote. Then we will be right back, and
that way we can go full on.
Thank you. The Subcommittee will be in recess.
[Recess.]
Chairman McCrery. The Subcommittee will come to order.
Welcome back, everyone.
Our first two witnesses today are the Honorable Bill Archer
and the Honorable Sam Gibbons. Mr. Archer is presently Senior
Policy Advisor, Washington National Tax Services for
PricewaterhouseCoopers. Mr. Gibbons is Chairman of Gibbons and
Company. Gentlemen, once again, thanks for coming.
Today we will begin with Chairman Archer. Mr. Archer.
STATEMENT OF THE HON. BILL ARCHER, SENIOR POLICY ADVISOR,
PRICEWATERHOUSECOOPERS LLP (FORMER MEMBER OF CONGRESS)
Mr. Archer. Mr. Chairman, thank you so much. Congressman
Neal and other Members of the Subcommittee, I think this is a
extremely important hearing today; and I am honored to be a
part of it. Thank you for inviting me.
I have a longer written statement, Mr. Chairman, which I
would like to have inserted in the record; and I will shorten
for my verbal presentation.
Chairman McCrery. Without objection.
Mr. Archer. Today I will discuss briefly our current
international tax system and the role of the ETI, and I will
also offer for the Committee's consideration four fundamental
principles for international tax reform that I hope you will
find useful during the course of your work.
For the record, let me note that, as you mentioned, Mr.
Chairman, I am currently serving as Senior Policy Advisor to
the firm of PricewaterhouseCoopers, but today I testify on my
own behalf and not as the representative of any organization.
I am extremely pleased to have the chance to discuss with
my former beloved colleagues--and I mean that genuinely--in
this auspicious environment of the Committee on Ways and Means
hearing room the critical issue of ensuring that U.S.
international tax rules provide a level playing field for U.S.
businesses to compete globally; and I think that is what this
issue basically is all about. As President Bush stated early in
his Administration, and I quote, ``Open trade fuels the engine
of economic growth that creates new jobs and new income in the
United States and around the world.'' I believe we must have a
tax system that frees American workers and businesses to
participate fully and fairly in the benefits of an open global
trading system.
Achieving that goal in a manner that honors our
international trade commitments is a fundamental imperative for
our country and for the world. I am confident that the
Committee on Ways and Means will address this challenge by once
again demonstrating its longstanding bipartisan commitment to
putting first the interests of American workers, farmers and
businesses.
As we all know, the World Trade Organization ruled on
January the 14th, for the fourth time, that the U.S. Tax Code
is inconsistent with our obligations to the WTO. I share the
disappointment that you must have that Congress must once again
confront this issue.
I had the distinct honor of chairing the Committee when we
all worked together in a totally bipartisan manner to pass
legislation in November 2000 that responded to an earlier WTO
ruling when we repealed the FSC and enacted the ETI provisions.
Unfortunately, the WTO ruled against the ETI; and by April 29th
it will rule on sanctions. The amount and timing of any
European Union (EU) retaliation remains unclear. What is clear
are the serious risks posed by sanctions to our recovering U.S.
economy and the orderly operation of the global trading system.
Chairman McCrery, when you announced this hearing you
stated that it is critical that we make a prompt yet thorough
inquiry into possible changes into the ETI system which are
both WTO compliant and foster the competitiveness of American
companies. I could not agree more. You asked for help in
exploring the possibility of leaving the ETI in place but
making modifications to it that address the objections raised
by the European Union.
I have looked very carefully at the WTO decision, and let
me state emphatically today that the Committee should not in my
opinion consider another interim response to the WTO ruling. In
my opinion, the ETI cannot be modified to preserve effectively
its essential benefits and still be in compliance with the WTO.
I suppose that is really the guts of my comments today. I
believe the Committee needs to consider fundamental reform of
the ways that U.S.-based businesses are taxed. On this point I
concur with Chairman Thomas, although I would add a note of
caution that there will be winners and losers when you change
the existing rules.
I believe that it is important to balance the needs of
various affected industries and implement any proposed
legislation in a manner that avoids disruption of current
business plans and activities.
In my view, we force U.S.-based businesses to enter the
global trading arena with one hand tied behind their backs
relative to the Tax Codes of the countries where corporations
are competing against us. The existing ETI provisions serve
only in part to offset some of the anti-competitive features of
U.S. international tax rules.
Under current law, a U.S.-based business operating
internationally almost always pays a greater share of its
income in foreign and U.S. tax than does a competing
multinational corporation headquartered outside the United
States.
In addition, the complexity and high compliance costs
associated with U.S. international tax rules represent
essentially an additional hidden tax on American businesses
that operate abroad. It was most recently noted in a report
that roughly 47 percent of the compliance costs under our Tax
Code are a result of the way we tax foreign source income, and
that should never be ignored. Because even though it is an
administrative cost, it adds to the burden of our corporations
that have to compete overseas.
You can witness the impact of an overly burdensome and
complex tax regime on the U.S. economy in the area of corporate
mergers and reorganizations. As this Committee knows from past
hearings right in this room on international tax
simplification, U.S. international tax rules can play a key
role in determining the location of a corporate headquarters.
This was clearly the situation in the case of Chrysler when
it became, as a result of our Tax Code, DaimlerChrysler instead
of ChryslerDaimler, a German corporation, with the result that
the culture that now permeates that organization is directed
out of Germany, not out of the United States of America.
I do not believe that is in the best long-term interests of
our country. In fact, recent studies have shown that between 73
and 86 percent of large cross-border acquisitions involving
U.S. companies have resulted in a merged company being
headquartered abroad. Of the world's 20 largest corporations,
the number headquartered in the United States has declined from
18 in 1960, the period of time when our current code was put on
the books in the early sixties, to just 8 in 1996. So from
1960, 18 of the largest--of the 20 largest corporations in the
world were in the United States. Today, only six. And that
tells a story in itself.
In conclusion, let me say that we must consider the bigger
picture when discussing the current U.S. international tax
system. Achieving a high standard of living for American
workers and their families ultimately rests on the productivity
of U.S. investments. The challenge is to design a tax system
that raises revenue with the least damage to investment and
growth in productivity.
With these larger issues in mind, I would like to offer
four fundamental principles that I hope you would consider
during your deliberations. I believe that these bedrock
guidelines should be a part of the core criteria by which any
proposal is judged.
First, if and to the extent that the ETI regime is
repealed, any scored positive revenues such action generates
should be reserved for measures to improve the competitiveness
of U.S. corporations operating in the world marketplace.
Second, in designing international tax reform measures, the
Committee should balance the needs of various affected
industries. All industries are not alike in the way they are
impacted.
Thirdly, also, the Committee should seize every opportunity
presented during this process to fashion international tax
rules that U.S. businesses can understand and the government
can administer.
Finally, any repeal of the ETI should be accompanied by an
adequate transition period to avoid disruption of current plans
and business activities.
A successful U.S. response to the WTO's ruling against the
ETI has the potential to address two key priorities for our
country. First, we must make the United States more competitive
internationally; and, second, we must address the underlying
problems with the U.S. international tax rules that are
resulting in fewer and fewer global business headquarters being
located in our country.
Finally, although Ambassador Zoellick is making efforts to
have the European Union defer any retaliatory action while the
United States works to comply with our WTO commitments, there
remains the real possibility that some action may be required
this year. Because of the potential magnitude of this issue, it
would be highly desirable for the Congress to work with the
White House to put in place a joint bipartisan task force to
make formal recommendations to the Congress on a solution. That
task force should, in my opinion, include representatives of
the White House, select Members of Congress from both parties,
representatives of business, farmers and organized labor. I
don't think it can come too soon to lay the groundwork for an
ultimate solution to this problem.
For my part, I offer my assistance and the assistance of
PricewaterhouseCoopers as the Committee considers any
replacement of the ETI regime. I played a very big role, as you
may remember, in the development of the ETI, working very
closely with the Clinton Treasury and with both sides of the
aisle. We did our best, but it was not upheld by the WTO. Now
again it must be on the basis of full consideration on both
sides of the aisle and the White House.
I thank you again for letting me come and testify, and I
will be happy to answer any of your questions.
Chairman McCrery. Thank you, Chairman Archer.
[The prepared statement of Mr. Archer follows:]
Statement of the Hon. Bill Archer, Senior Policy Advisor,
PricewaterhouseCoopers LLP (former Member of Congress)
Mr. Chairman, Congressman McNulty, and distinguished members of the
Subcommittee, I appreciate the opportunity to appear at this hearing to
discuss the future of the extraterritorial income tax regime. Today,
after exploring the current state of our country's international tax
regime, I would like to offer for your consideration four fundamental
principles for international tax reform that I hope you will find
useful during the course of the Committee's work.
For the record, let me note that while I am currently serving as
Senior Policy Advisor to PricewaterhouseCoopers, I am testifying today
on my own behalf and not as the representative of any organization.
First, I am extremely pleased to have this chance to discuss with
my former colleagues the critical issue of ensuring that U.S.
international tax rules provide a level playing field for U.S.
businesses to compete globally. As President Bush stated early in his
Administration, ``Open trade fuels the engine of economic growth that
creates new jobs and new income in the United States and around the
world.'' We must have a tax system that frees American workers and
businesses to participate fully and fairly in the benefits of an open
global trading system.
Achieving this goal in a manner that honors our international trade
commitments is a fundamental imperative for our country. I am confident
that the House Committee on Ways and Means will address this challenge
by once again demonstrating its longstanding bipartisan commitment to
putting first the interests of American workers and businesses.
The Subcommittee has been charged with the responsibility for
exploring options that respond to the January 14th World Trade
Organization appellate ruling that the U.S. tax code is inconsistent
with our obligations under the WTO. This decision marks the fourth time
the WTO has ruled this way, twice in the Foreign Sales Corporation
(FSC) case and now twice in the extraterritorial income (ETI) case.
I believe that I share the disappointment of each of you that
Congress once again must confront this issue. I had the distinct honor
of chairing the House Committee on Ways and Means when we all worked
together in a bipartisan manner to pass legislation in November 2000
that responded to an earlier WTO ruling by repealing the FSC and
enacting the ETI provisions.
Unfortunately, the most recent WTO rulings find that the current
ETI, like the FSC provisions that preceded them, are inconsistent with
our international trade commitments. A WTO Arbitration Panel is
expected to rule by April 29 on the amount of sanctions the European
Union can impose against U.S. exports to EU countries. The amount and
timing of any retaliation remains unclear. What is clear are the
serious risks posed by sanctions to our recovering U.S. economy and the
orderly operation of a global trading system.
Chairman McCrery, in announcing this hearing, you stated that ``it
is critical that we make a prompt, yet thorough inquiry into possible
changes to the ETI system which are both WTO-compliant and foster the
competitiveness of American companies.'' You asked for help in
exploring the possibility of leaving the ETI in place but making
modifications to it that address the objections raised by the European
Union.
I do not think it is possible to design a replacement that will
replicate the same benefits to the same taxpayers and still satisfy the
WTO rules. On this point, I concur with Chairman Thomas. Thus, the
Committee will need to recognize that there will be winners and losers
with respect to any change to the existing rules. However, I believe
that it is important to balance the needs of various affected
industries and implement any proposed legislation in a manner that
avoids disruption of current business plans and activities.
Let me state emphatically that the Committee should not consider
another interim response to the WTO ruling. In my opinion, the ETI
cannot be modified to preserve effectively its essential benefits and
still be in compliance with the WTO. I believe the Committee needs to
consider fundamental reform of the ways that U.S.-based businesses are
taxed. As you all know, I have been a long-time advocate of fundamental
tax reform. While reform of our overall tax system remains an issue for
another day, it is vital that the Congress begin to consider
comprehensive overhaul of U.S. international tax rules.
The current ETI provisions, like the earlier FSC provisions, are
integral parts of a larger system of international tax rules under
which U.S.-based businesses must compete internationally. The ETI and
FSC provisions were designed to level the playing field at least
partially for those U.S.-based businesses that are subject to those
rules.
In my view, we force U.S.-based businesses to enter the global
trading arena with one hand tied behind their backs relative to the tax
codes of the countries where corporations are competing against us. The
existing ETI provisions serve only in part to offset some of the anti-
competitive features of U.S. international tax rules. It is important
that we examine just how complex and burdensome those rules are.
First, current international tax rules are grossly outdated. The
basic Subpart F rules, for example, were enacted in 1962. These rules
reflect the economic climate of that time. In 1962, the United States
was a net exporter of capital and ran a trade surplus. Imports and
exports were only one-half of the percentage of GDP that they are
today. As we all know, the world has changed. Our tax laws need to
change too.
The impact of U.S. tax rules on the international competitiveness
of U.S. multinationals is much more significant an issue than it was
forty years ago. Today, foreign markets provide an increasing amount of
the growth opportunities for U.S. businesses. At the same time,
competition from multinationals headquartered outside of the United
States is becoming greater. Of the world's 20 largest corporations, the
number headquartered in the United States has declined from 18 in 1960
to just 8 in 1996. Around the world, 21,000 foreign affiliates of U.S.
multinationals compete with about 260,000 foreign affiliates of foreign
multinationals.
If U.S. rules for taxing foreign source income are more burdensome
than those of other countries, U.S.-based businesses will be less
successful in global markets, with negative consequences for exports
and jobs at home. I think a fair comparison of U.S. international tax
rules and those of other nations shows that American businesses are
increasingly put at a competitive disadvantage in the world
marketplace.
First, about half of OECD countries have a territorial tax system
under which a company generally is not subject to tax on the active
income earned by a foreign subsidiary. By contrast, the United States
taxes income of a U.S.-controlled foreign corporation either when
repatriated or when earned in cases where income is subject to U.S.
anti-deferral rules.
Second, the scope of U.S. anti-deferral rules under subpart F is
unusually broad compared to those of other countries. While most
countries tax passive income earned by controlled foreign subsidiaries,
the United States stands out for taxing as a deemed dividend a wide
range of active income under various subpart F provisions.
Third, the U.S. foreign tax credit, which is intended to prevent
double taxation of foreign source income, has a number of deficiencies
that increase complexity and prevent full double tax relief.
Taken all together, you find that a U.S.-based business operating
internationally frequently pays a greater share of its income in
foreign and U.S. tax than does a competing multinational company
headquartered outside of the United States.
In addition to a comparatively higher effective tax rate, the U.S.-
based business is burdened by tax rules that are among the most complex
in the entire U.S. tax code. Economists who surveyed Fortune 500
companies found that 43.7 percent of U.S. income tax compliance costs
were attributable to foreign source income even though foreign
operations represented only 26-30 percent of worldwide employment,
assets, and sales. The complexity and high compliance costs associated
with U.S. international tax rules represent essentially an additional
hidden tax on American businesses that operate abroad.
One indication of the impact of an overly burdensome and complex
tax regime on the U.S. economy is in the area of corporate mergers and
reorganizations. As this Committee knows from past hearings on
international tax simplification, U.S. international tax rules can play
a key role in determining the location of a corporate headquarter. This
was clearly the situation in the case of DaimlerChrysler. In fact,
recent studies have shown that between 73 and 86 percent of large
cross-border transactions involving U.S. companies have resulted in the
merged company being headquartered abroad.
How we tax foreign source income will influence what kind of
economy we have in the long run--specifically, whether we have a strong
and vibrant economy with competitive workers and companies, and whether
we can create more export-related jobs which pay on average 17 percent
more to the workers of this country.
In conclusion, let me say that we must consider the bigger picture
when discussing the current U.S. international tax system. Achieving a
high standard of living for American workers and their families
ultimately rests on the productivity of U.S. investments. Growing
productivity in turn requires investment in plant and equipment and in
the further development of knowledge through research and education.
The challenge is to design a tax system that raises revenue with
the least damage. An overly complex and burdensome tax system can
impose unnecessarily high costs to the economy by discouraging savings
and investment, by causing investment to be allocated inefficiently, or
by requiring excessive resources to be devoted to complying with and
administering the tax rules.
With these larger issues in mind, I would like to offer four
fundamental principles that I hope you would consider during your
deliberations. I believe that the following bedrock guidelines should
be part of the core criteria by which any proposal is judged:
Four fundamental principles to guide WTO response
1. If and to the extent that the ETI regime is repealed, any
scored positive revenues such action generates should be
reserved for measures to improve the competitiveness of U.S.
corporations operating in the world marketplace;
2. In designing international tax reform measures, the
Committee should balance the needs of various affected
industries;
3. The Committee should seize every opportunity presented
during this process to fashion simplified international tax
rules that U.S. businesses can understand and the government
can administer; and
4. If the ETI regime is repealed or substantially changed,
there should be an adequate transition period to avoid
disruption of current plans and business activities.
A successful U.S. response to the WTO's ruling against the ETI has
the potential to address two key priorities for our country. First, we
must make the United States more competitive internationally, and,
second, we must address the underlying problems with the U.S.
international tax rules that are resulting in fewer and fewer global
business headquarters being located in our country.
As Chairman Thomas noted to the full Committee at the February 27th
hearing, the task before you is not an easy one. It will require the
collective effort of all Members from both parties to build a consensus
on an approach that will meet U.S. international commitments while
maintaining the competitiveness of American businesses and workers in
the global marketplace. I am confident that the Members of the House
Committee on Ways and Means, with the active leadership of the Bush
Administration and the collaboration of Senate colleagues, will rise to
the occasion once again.
Finally, I would note Ambassador Zoellick's efforts to have the
European Union defer any retaliatory action while the United States
works to comply with our WTO commitments. There remains the likelihood
that some action may be required this year. Because of the huge
potential magnitude of this issue, it would be highly desirable for the
Congress to work with the White House to put in place a joint
bipartisan task force to make formal recommendations to the Congress on
a solution. That task force should include: (1) the Administration; (2)
select Members of Congress from both parties; and (3) representatives
of both business and organized labor.
For my part, I would like to offer my assistance, and the
assistance of PricewaterhouseCoopers, as the committee considers any
replacement of the ETI regime.
Thank you again for the opportunity to testify today. I will be
happy to answer any questions you may have.
Chairman McCrery. Now another gentleman with a long track
record of examining this Nation's tax laws and regulations and
one who has put, I know, a lot of thought into our tax system,
Mr. Gibbons. We are very thankful to have you also with us.
You might notice that we allowed Mr. Archer to go over the
5 minutes. We will extend that same courtesy to you. The panels
that are following, don't get any bright ideas. We are doing
this for two former distinguished Chairmen of this Committee.
We certainly will allow you to speak for however long you
wish, Mr. Gibbons. Please address the Committee.
STATEMENT OF THE HON. SAMUEL M. GIBBONS, CHAIRMAN, GIBBONS AND
COMPANY (FORMER MEMBER OF CONGRESS)
Mr. Gibbons. Mr. Chairman and Members of the Committee, let
me thank you for allowing me to come back here in this position
as a witness before the Committee. It is a high honor for me. I
will try to do my best.
Like I think Mr. Archer and I both feel, we would prefer to
have a dialogue with you which we hope our direct testimony
will stimulate so that we can really pure out the knowledge
that we have and the thoughts that we have in that dialogue. So
I will try to keep my remarks brief; and, Mr. Chairman, just
slam me with the gavel when you think I have gone too far.
Mr. Chairman, I don't disagree with a thing that Mr. Archer
has said. We talked about this when he and I were both on the
Committee. We fundamentally understand the subject matter, and
I feel that it is our job and I am sure he feels it is our job
to try and impart some of that knowledge that we accumulated on
our years here so that you all can take some affirmative action
on it.
Let me go back to the beginning. How did we get in this
predicament? Well, it is certainly not your fault. It is not
our fault. It is the fault of a long time ago, an innocent
decision that was made at that time. And there were no villains
in the whole process at all. Let me paint the picture.
In 1947, I was a young lawyer down in Tampa, Florida. I had
just graduated from law school, spent 5 years in the Army, and
was not focused upon Washington at all. But the world was in
shambles. Europe looked like it was--we knew it was prostate
because we had destroyed it during World War II. We thought it
was going Communist, because that was the emerging philosophy
there. And Japan was in terrible shape, China. Every place on
Earth except the United States of America was in terrible
shape.
The leaders at that time decided to convene here in
Washington in 1947 a conference on what to do about rebuilding
the world. Everybody came to Washington from all over the
world, knowing that America was the number one economic engine
of not only the United States but of the world; and they had
been defeated or had worked with us in defeating the rest of
the world in the war. So they convened here in Washington in
1947, and they eventually came out with something called the
General Agreement on Tariffs and Trades (GATT) with its rules.
That graduated over a period of time into the World Trade
Organization. But essentially the rules are the same as they
started in 1947. They were rules that the United States of
America imposed upon the rest of the world. Let's have no doubt
about it. We are the ones that invented these rules that have
us entrapped today.
The Europeans who had the strongest economy, such as it
was, and it was in terrible shape, came along and in that 1947
agreement this distinction between indirect and direct taxes
was made. And why was it made? Why did the United States impose
that kind of rule? Well, that is the same kind of rule that we
had developed in the United States in how we handle our sales
tax. Today, and even then, if you buy something in New York
with a high sales tax and you have it shipped to here in
Washington, you don't pay any New York sales tax, and vice
versa. If you buy something here in Washington with its
relatively high sales tax and have it shipped to you in New
York, you don't end up paying any Washington sales tax.
That is the same dilemma we are in this--the world rules
today. We imposed that rule on the rest of the world in 1947,
and it hasn't changed.
Now, why did we do it? Well, we were trying to get rid of
subsidies. We realized that the Tax Code could be used to
subsidize businesses. So we got rid of them in the direct
subsidies; and when we got to the subsidies that are embedded
in the tax law we said, well, we will adopt the same rule that
we have for our own domestic sales tax. That is how we got
where we are today, and that is the same rule that comes back
to haunt us.
Now the Europeans weren't plotting against us when they
agreed to do that. They had the same kind of tax system in
Europe, such as it was, as we had in this country--high
dependence upon excise taxes and a heavy dependence upon income
taxes and various other nuisance taxes like alcohol and tobacco
and excise taxes on fuel and things of that sort. So the tax
systems were roughly the same.
In 1965, the French had had so much trouble with their own
income tax system that they started experimenting, and they
came up with something called a tax value added, TVA.
I first ran into it when I found myself without an overcoat
in Paris with Martha, oh, sometime in the late 1960s or early
1970s. I had to go buy an overcoat. The embassy didn't want me
shivering to death over there in that French weather, and I
bought an overcoat.
Well, the fellow from the embassy who was with me jabbered
off in French to the clerk there something about TVA. I didn't
know what the heck they were talking about. Well, 2 months
later I was sitting in my office in the Rayburn Building and in
comes a check from a bank in New York for about 200 bucks. No
letter going with it or anything else.
So I called the bank. I said, why did you send me $200?
They said, well, that is the rebate on the French TVA tax that
I had paid on the overcoat.
I called the colonel in who had been my escort. I said, how
did we get into this? He said, I turned in all those papers
that you gave me at the border when we left France and you got
the tax back that had been collected on your overcoat.
Well, that got me to scratching my head. Attending
conferences in Europe, I would meet with the European
Commission and the European Council, and I would complain about
this rebate, this unfair advantage that they had against
Americans. They would say, it is a sales tax, just you all have
got in the United States, State level. You rebate that same
thing when you make the sales.
So it dawned upon me that we are up against something that
was a little different, and the severity of it didn't dawn on
me until American businesses kept coming to me saying,
complaining, well, we are at a disadvantage. The Europeans can
rebate their cost of government at the border on their products
when they export them into the world market, and we Americans
can't.
Well, about the early 1970s, I think it was, the Treasury
Department came in. There were only 25 of us on the Committee.
There was no lower level down here. They took us over to H-208
and explained to us what the problem was. We came up with this
way to get around it, we thought. It was highly controversial
within H-208, but there were no newspaper reporters around,
nobody else. The doors were all closed, and we were just
plotting up a solution ourselves behind those closed doors.
After a few hours of arguing back and forth, we finally
adopted this monster that you all are dealing with right now.
It has had to be changed over the years as one time after
another that the monster got chopped down, and we had to fess
up that, yeah, we have committed a tax subsidy under the Income
Tax Code. There isn't any way out of it. We imposed the rule on
the world. It has come back to haunt us.
Everybody on Earth has gone to a value-added tax. Instead
of a TVA, it is a VAT; and only our country and Australia have
not gone that route. So it is us against the world. We are
eventually going to have to conform to their set of rules or
suffer the consequences. That means that they can levy
offsetting duties against our products if we continue to be the
scofflaw in the international situation, so there is no way out
of it.
Maybe some kind of temporary something can be negotiated
with the rest of the world. I doubt it, but you can try. It
will be very frustrating, and you are not going to get very
far. The rest of the world is going to say, you know,
Americans, if you don't like the rules, you join the club. You
change your rules, you change your tax laws, and you can join
the same club we are all in.
Now, what is that club? That club is--let me take off these
glasses, because they impede my ability to think.
If you manufacture these glasses in the United States and
sell them abroad--and nobody does that, but if you did, when
they went abroad, they would go with the full cost of the U.S.
Government in here, the full tax cost of the U.S. government.
It is a pretty substantial burden to have to carry and go
overseas.
When you hit their border you would not only have your cost
of government there, these glasses, but these glasses, when
they pass that border, would pick up under their value-added
tax, their cost of government. So these glasses would be
burdened with two costs of government going from our country to
their country. But coming from their country to our country, it
is just the opposite. They take off the value-added tax, their
cost of government, at their border. We have got nothing that
effectively intercepts it on our side.
So what are we doing? We are exporting American jobs. Let
me repeat that. What are we doing? We are exporting American
jobs, good American jobs, because of the way we collect taxes.
Now, there is no solution through the income tax. We have
tried it for 20--almost 26, 27 years. Every time we have tried
it, the World Trade Organization says, you know, that is a
subsidy. And honestly it is, under the current rules. But--so,
I don't know of anybody on this Committee that wants to
continue to export American jobs, but that is what we are
doing. That is what we have been doing for quite some time.
That is what we are going to be doing at a greater rate unless
we change our system.
So, men and women of the Committee on Ways and Means, the
burden comes back to you. You can't judge it. You can't fix it.
You can't flinch it. You got to do it. You have got to adopt
some kind of tax system that will work in the world system.
We are a world power, but we are a limited world power. We
are only 4 percent of the Earth's population, something that
never dawns upon most Americans. We are only 4 percent of its
population, but we possess and control about 30 percent of its
wealth. We are bleeding that away, and we are bleeding it away
primarily not because we are not a productive nation, but
because of our tax system.
I don't know what it costs to collect taxes in the United
States at the Federal level, but it is horrible. It is far
greater than what we pay the Internal Revenue Service (IRS).
Because also out there is tax deductible--are all of the tax
firms that do tax law, all of the people that write books and
write electronic programs and everything else. It is a huge,
huge industry.
All of you, like Mr. Archer, who fill out your tax return--
I did it for years until I finally got audited and wised up and
found out it was better for me to hire an accountant rather
than explain to the IRS why I didn't fill out a tax return
properly----
Chairman McCrery. You are going into areas now that this
Committee is not prepared to discuss.
Mr. Gibbons. They audited my tax return when I was first a
Member of this Committee; and, believe me, that is an exquisite
feeling if you have never been through it. I don't recommend it
for anybody.
I want to say right now I didn't get caught, and I was
clean, and Martha didn't have to pay anything, and I didn't
have to pay anything. But it is an exquisite feeling to have
the people walk in from the IRS and say, we are from the
government. We are here to help you, and we are going to audit
your tax return. We want all your books and records. And a cold
sweat, even if you are a Congressman, breaks out all over you
when that happens.
So that, you know, I do know something about what the cost
of collecting taxes is. It is a huge drag upon the American
economy, one that we insist on imposing on our economy; and we
are going to reduce ourselves to a third-world nation if we
continue down this path. That is how critical this issue is.
I have talked longer than Bill Archer, and I have talked
longer than most of you care to listen to me. But thank you
very much. If I can ever come back and spend time with you or
go on a retreat with you, Bill and I will be glad to go. There
is a lot there that we won't be able to say because you just
haven't got the time to listen. But we are here to help you. We
are here to work with you.
Chairman McCrery. Thank you very much, both of you. And
quite the contrary, Mr. Gibbons, I think it is helpful for
particularly the younger Members of the Committee to hear the
history of how we got to where we are. It is very helpful for
us to hear from the two of you who were intimately involved in
various efforts through the years to make our tax system work
within the confines of the rules of the World Trading
Organization, whether it was GATT or WTO.
I want to begin the questions by exploring a little bit
those efforts that you went through. Just to use the most
recent example, back in 2000, when Chairman Archer worked with
Charlie Rangel and Members on both sides of the aisle and with
the Clinton Administration to try to figure out a way to
replace the FSC with something that was workable and
permissible under the rules and they came up with ETI, that
process took nearly a year. It would have taken a lot longer
except for the fact that everybody involved agreed where we
wanted to go and everybody was in agreement that something had
to be done. Everybody was in agreement that we wanted to keep
American workers and farmers and businesses competitive and to
keep Americans working. So we all worked together very
expeditiously to go from FSC to ETI.
My question to you, though, relates to where we are today
vis-a-vis the sanctions that may be imposed upon us in the not-
too-distant future. Do you believe that a similar--first of
all, do you believe that a similar bipartisan effort is
necessary to come up with any solution that we arrive at?
Mr. Archer. As I stated in my testimony, I believe that.
Chairman McCrery. Mr. Gibbons.
Mr. Archer. But I do not believe that it can be done in a
rapid fashion. That is why I think you need to get started with
the process by exploring the alternatives.
Chairman McCrery. That is my next question. Do you think we
can get the parties together--not just political parties but
all the parties that have to be involved in such a tremendous
effort and get something done before the end of this month when
retaliation is due to come from the WTO, from the Europeans?
Mr. Archer. I doubt it. But it is my understanding of the
signals that we have been getting from the Europeans, as
particularly articulated by Lamy, that if there is a process
under way which shows good faith for us to reform our tax
system that they will not immediately retaliate.
Chairman McCrery. Mr. Gibbons, do you have an opinion on
how long it is going to take us?
Mr. Gibbons. I think you could work out the bipartisan part
in the Congress and with the President. I don't think that is
the big problem. I think the problem is, what are you going to
do with the rest of the world? When I say the rest of the
world, you know there are almost 160 members of the WTO.
Everybody on Earth that we have allowed in is in the WTO, and
you have got--and all of them have got a value-added type of
system that they are working from, and we have got--we depend
heavily upon the income tax. They are just--unless there is
something within the psyche of those 157 other nations out
there, I don't think you got much negotiating grounds.
Now, they want some things and we want some things, and
maybe I think with a wink and a nod and a handshake you could
work out something that would delay the impending execution of
those dates if you could show good-faith effort that you were
moving ahead. It isn't going to be easy. And the biggest part
of the problem is not the technical problem but the political
problem within the United States of moving from an income-based
tax and a payroll tax to an indirect tax. That is the problem.
And it is not an easy problem.
But, friends, they have got the goods on us. We have got to
show some good-faith effort that we are ready to move and are
willing to move. I don't know of any other short-term thing
that could have happened. We have got to go to the WTO and tell
them we would like to sit down and work this thing out and show
some good-faith effort that we are willing to work it out. I
don't think we can pass any more changes in the income tax law
that will stand up more than to take the time to file a case in
the WTO.
Chairman McCrery. Thank you. Mr. Neal.
Mr. Neal. That was fine testimony, Mr. Chairman. I do not
have any questions at this time.
Chairman McCrery. Mr. Hayworth.
Mr. Hayworth. Thank you, Mr. Chairman.
Mr. Chairman, thank you for returning; and we appreciate
your insight.
Chairman Archer, as you laid out the four principal ideas
and guidelines for us in responding to the WTO, I was
wondering, sir, if you could elaborate a bit more on principle
number two: In designing international tax reform measures the
Committee should balance the needs of various affected
industries. For purposes of illustration only, could you
elaborate a little bit on that?
Mr. Archer. That becomes the very difficult part of this
process. I think politically, as you begin to move in to
restructuring the Tax Code, you are going to find domestic
winners and losers. You cannot duplicate as we did with ETI the
benefits so that everybody was a winner. That was a big
advantage that we had with the ETI. I don't think as you begin
to move into a WTO-compatible system that you are going to be
able to do that.
But I think you need to give very strong consideration to
businesses where the differences are great, for example,
between an extractive industry and a manufacturing industry.
The differences are great between an industry that has to go
overseas for most of its business because that is where the
markets are and one that depends more upon the U.S. markets.
That is going to make your job very difficult. But I think
you have to look at it, and you have to carefully assess it and
reach the best possible result that you can.
Now, there are any number of options that you can use to
address this problem. Again, the only thing that I don't think
you can do, as I mentioned, is replicate the benefits for all
of the people who are exporting from this country who benefit
under the ETI and do it with a WTO-compatible result. I don't
think that is possible. Today we don't have time to try to
brainstorm all of the alternatives, and that is where both Mr.
Gibbons and I--and, by the way, I associate myself with his
remarks, which I think were beautifully stated--are available
to the Committee in any way we can help.
Then I would add also that all of the technical expertise
of PricewaterhouseCoopers is also available to you should you
wish to draw on it.
But if you see ultimately fit--and I am not recommending
that you abolish the ETI, but if you come to the point where
you have to do that, then whatever revenues result in the
estimates that you will get from the Joint Committee on
Taxation, you should put back as best you can into the system
to reduce the barriers in our Tax Code to our corporations that
are operating overseas.
Now, just to reach out and talk about one or two things,
the way our subpart F operates, for example, can be changed to
be very, very helpful. The way we require interest allocations
can be changed. That will be very helpful. These will not
duplicate the current benefits under the ETI, but they will
move in the right direction. So there are things that can be
done within the current system.
I must say that I agree completely with Chairman Gibbons
that in the long term you are going to have to throw out the
income tax system that we currently use in the corporate level
and replace it. Because, to me, we must in a competitive global
marketplace, have a Tax Code that at least gives us a level
playingfield against our foreign competitors.
What I have ascertained by looking at a number of different
corporate structures is that, on average, our corporations pay
an effective tax rate of around 39 percent. Now that is both
Federal and State taxes. There are foreign competitors who, on
average, pay a tax rate of about 24 percent. Now, that is a 15
percent margin of difference, and that goes against the bottom
line.
If our corporations are faced with this type of competition
over a long period of time, one of two things is going to
happen: They are either going to go out of business because
they can't sell their goods and services competitively in the
world marketplace with this extra cost--and I am not yet
including what Mr. Gibbons and I referred to as the compliance
cost, which are somewhere around $250 billion a year in this
country. Now, not all of that is corporate, but that is an
overall figure. But either they will decline and be defeated by
their foreign competition or, what is more likely, is they will
be taken over by foreign corporations like Chrysler was, like
Amoco and Arco were, like Bankers Trust was by Deutsch Bank.
Then the entire culture of that corporation is going to be
removed into a foreign country, and I think that is the worst
of all worlds for the United States of America.
Mr. Gibbons. May I add it would not only be their
headquarters, it will be American jobs that are removed----
Mr. Archer. Yes.
Mr. Gibbons. And members. They are flowing out of this
country like a flood right now. There is not a day that you
pick up the news media that you don't see American jobs flying
overseas. We have got to stem the flood. It is not the
productivity of American labor that is at fault, it is not the
productivity of our other systems, it is the tax system that is
at fault, and there is no way we can escape that. The tax
system has got to be changed.
Mr. Hayworth. Thank you both.
Chairman Gibbons, when you come to Arizona, chances are you
won't have to buy an overcoat. We look forward to your visit.
Mr. Gibbons. I spent some very happy hours in Arizona as a
soldier. I kept all the Japanese out and not a single one of
them penetrated our defense line.
Mr. Hayworth. We are very grateful for that; and, on a more
serious note, we are very grateful for your service on June 6,
1944, and, subsequently, in the European theater, too, sir.
Mr. Gibbons. I was adequately paid for it. And thank you,
sir.
Chairman McCrery. Mr. Lewis.
Mr. Lewis. Chairman Archer and Chairman Gibbons, it really
is good to see you back here. I think we are hearing you loud
and clear that there is not a Band-aid approach to this, to
solving the problem. The ultimate answer is a change in the Tax
Code.
I know, Chairman Archer, you have been a big advocate of a
national sales tax and in doing away with the income tax. But
that is what I am hearing you say. The only way we are going to
solve this and solve it for good is to change the Tax Code. Is
that what you are saying?
Mr. Archer. Well, first, let me say that I have been for
replacing the income tax with another system that makes better
sense for this country. I have not spoken out in favor of a
vehicle that is a retail sales tax, but that is one way to do
it.
In this instance, though, it seems to me that you have a
great opportunity because you can address this problem in a
limited way to the corporate Tax Code without having to get
into all of the more difficult ramifications of the individual
income tax; and, hopefully, you make a decision that will help
this country and the workers, as Mr. Gibbons said, the standard
of living of the workers and the jobs in this country for the
next several generations.
Mr. Gibbons. You see when all this first started the way
you measured America's wealth was through the gross domestic
product. Foreign trade or foreign commerce was an insignificant
part of America's gross domestic product in the 1940s. Today,
it is a huge amount of America's gross domestic product; and it
is growing all the time. Like it or not, stop it or not, you
can't stop it. We are internationalizing. We have got to be in
the world system or we are going to suffer if we are not.
Let me say--I will do a little advertising here--when I
could see the beginning of the end of my career here in
Congress, I left you a heritage. I wrote it all out. It is all
in the 1996 Congressional Record, complete with legislation and
an explanation of what ought to be done. Now, I won't take up
your time today because it is not the purpose of this hearing
to explain how it could be done. But it can be done, and it
will be done. It is a question as to how much longer we are
going to bleed before we do it.
Mr. Lewis. Thank you, sir. Thank you.
Chairman McCrery. In fact, Mr. Gibbons, another way of
saying, your previous statement, that we represent only 4
percent of the world's population is 96 percent of the world's
customers live outside the United States.
Mr. Gibbons. Correct. That is it.
Chairman McCrery. Mr. Brady.
Mr. Brady. Thank you, Mr. Chairman. And I want to welcome
my fellow Texan, and Houston area Member of Congress, Bill
Archer to the hearing.
To let you know how strong his heritage is, Mr. Chairman,
in our part of the area I have the good fortune to represent a
good part of the former part of Mr. Chairman Archer's district.
And when you ask people there who your Congressman is, they
will say, well our representative is Kevin Brady, but my
Congressman is Bill Archer. That will continue for decades to
come.
Two questions. Chairman Archer, a task force you recommend.
How soon could a group meet, really thoroughly, examine the
issue and report back a good substantive change to Congress?
How long do you imagine that would take to really do a good job
but move quickly?
Mr. Archer. I think that will depend on how rapidly there
is the decision to put in place that task force.
I don't think it is too early, for example, for leaders of
the Congress to talk to people in the White House as a first
step and see about how this should be structured and how it
should be moved forward. And by leaders, I mean, both Democrats
and Republicans in the Congress.
What obviously will make it more unwieldy is to be able to
take into consideration the views of organized labor, the views
of the business community and the views of farmers. But I think
that needs to be done before any final decision is made.
Mr. Brady. Sort of a follow-up to that, that second
question. How do we both stress the importance of
bipartisanship and move in a timely way? How do we educate
Members of both parties and leaders of both parties that not
only is this a problem, but this is an opportunity to help make
American companies more competitive and an opportunity to slow
the merge than move overseas trend that is occurring?
How, in a period that can get pretty tense up here in
Washington? How do we make sure that message gets heard and
accepted by both parties?
Mr. Archer. Well, one method obviously is your intention to
hold hearings on this issue. Well, actually there is a hearing
right now. But the Chairman of the full Committee, I
understand, plans on holding hearings on how is our foreign--
how do we tax foreign source income? What can we do about it,
and so forth?
And I think at those hearings, obviously you are going to
have witnesses who are going to be testifying. And hopefully
the media will cover those events and that information will be
made available to the American public. But, as so often is the
case in Washington, that both Mr. Gibbons and I found over the
years, and which you find today, is it is very, very difficult
to let light overcome heat on issues. And the light is the
information that is presented as objectively as possible for
people to understand.
But, Mr. Gibbons is absolutely right. When all of this
started, particularly back in the early sixties, we were the
receptacle of investment capital, here in the United States.
And we had just come through the Marshall Plan period, and we
had extended our capital to the rest of the world. We had
massive trade surpluses. And we didn't need to be so concerned
about the negative aspects of our Tax Code. We weren't really
looking overseas. We didn't have a global marketplace as we do
today. And today it is very different.
And if our corporations again have to compete with one hand
tied behind their back, and their net is reduced by the extra
operating cost that is represented both by taxes and
compliance, then their cost of capital is going to go up.
As their net revenues and net profits go down, their cost
of capital goes up and it just becomes a compounding problem
over time. And I think this is a great window of opportunity.
It will not be easy.
Mr. Brady. Thank you, Mr. Chairman. Chairman Gibbons,
anything to add?
Mr. Gibbons. You know, excuse me. We often think of this as
just a problem of the export industries in the United States
who manufacture here. It is far beyond that. It is every
American who works and sweats in the system. High-tech
industry, low-tech industry, any kind of job that is at a
competitive disadvantage because of the way our tax system
works in the international marketplace.
Whether you are a person who is trying to fight against a
losing a market overseas because your product is overtaxed when
it goes to consumption overseas, or whether you are working in
an industry, it might be the same industry who is competing
against an import, you are affected by this.
Everybody that works is affected by this. It is not just an
isolated problem that affects only the export industries. It is
everybody that is involved in it.
That is what they have got to understand. I am talking
about the great electorate out there. This is not a brandnew
problem. The Reagan Administration attempted to phase this in
early in President Reagan's Administration. If you go back, you
will find that they did a deep study into all of this. And they
started to recommend to the Congress that we go to some kind of
value-added tax system then.
But the Congress was in control of the Democrats. The White
House was in control of the Republicans. They just didn't feel
like that they could take that kind of political risk at this
time. I don't know when we are ever going to get out of that
political risk situation. But, you know, something has got to
be done about it unless we are content to allow our system to
continue to bleed, and us to become a third-rate economic power
in the world. It is the tax system.
Mr. Brady. That message is getting through loud and clear
today. I hope we can replicate it. Thank you, Mr. Chairman.
Chairman McCrery. Thank you, Mr. Brady. And now a
representative from one of our other greats, represented by the
panel today, Mr. Foley from Florida.
Mr. Foley. Thank you very much, Mr. Chairman. I am trying
to focus on FSC. But I can't get my mind off this coat you
bought in 1960 where you got a $200 refund. I hope you still
have that coat.
Mr. Gibbons. That was a good French overcoat. I wore it for
years.
Mr. Foley. Because I am a consumer, I want to see that
coat.
Mr. Gibbons. That was just the rebate. They kept most of
the money over in France. But it was--you know, prices have
changed a lot since the late sixties.
Mr. Foley. I am still remembering Dick Nixon's Pat analogy
of the plain cloth coat. So I just want to see this coat, Sam.
Chairman McCrery. Mr. Foley, let's try to restrict our
questions to the matter at hand.
Mr. Foley. The Chairman and I get along well. We are both
Floridians. And I just wanted to enjoy a moment.
But you just mentioned something, Sam, that is very, very
important. And I think it underscores the complexities here.
Because a bipartisan group, after the WTO's refusal of FSC,
when to the ETI, spent a lot of time on it.
I think the Europeans would like us to change our Tax Code,
and they may help us do it. It seems like the only thing
acceptable to them is a VAT concept.
It seems like everything else we create or try and put our
hands around fails. So I would like both of the participants,
Mr. Archer particularly, good to see you, both of your answers
on, is the VAT system the only acceptable mechanism by which
the WTO will give us a final resolution?
Mr. Archer. I think they would love for us to keep our
system with the income tax system so they have an advantage on
us. I don't think they want to force us into any other form of
taxation.
They are sitting smiling like a Cheshire cat now, because
as Sam mentioned, we created a system many, many years ago to
which we didn't give adequate thought. And then we exacerbated
it in 1986 in tax reform and made an absolute disaster out of
the way that we tax foreign source income. I am not going to go
back into all of that history.
But, we created this odium taxing our own corporations. And
then the only way out for us was to create an export subsidy.
And there is no doubt about it. We thought we were Okay because
we had an informal agreement with the Europeans back in the
early eighties that we weren't going to attack each other's tax
systems and all of that. But that was before the WTO was
created.
And we put ourselves in the position that in order to have
a level playing field, we had to put into our code an export
tax subsidy. And we have got to remove that in some way or
another and we have got to replace it with something that gives
us a better chance to compete.
A VAT is not the only way to do it. And we can, you know--
if you want me to continue to work with you personally, I will
be glad to do it. There are a lot of options that can be
considered. But, in the long term, and you have heard me say
this on this Committee, and I say it because I personally
believe it and have believed it. I am not like one of our
colleagues who told me one day I am a very fair individual, all
I want is a fair advantage.
I want a fair advantage for the United States of America. I
wished we would not stop at a level playing field. I wish we
would adopt a system that would give us a fair advantage under
the WTO rules. And that can be constructed. But again, we don't
have the time today to go into all of the details.
Mr. Foley. I would welcome that engagement because I think
it is important. And I respect your expertise.
Chairman McCrery. If the gentleman will yield. We are going
to have a hearing later at which we will explore some of those
alternatives.
Mr. Foley. Thank you, Mr. Chairman. Mr. Gibbons.
Mr. Gibbons. Well, sitting here trying to respond to your
first observation. At that time, the French had a number of
different rates at which they taxed under their TVA system,
which is really a VAT system. But the French called it a TVA
system. And I would imagine they classified my French overcoat
bought somewhere near the embassy as a luxury item. And the tax
on it may have been 50 or 60 percent.
Mr. Neal. Mr. Chairman. Would you yield for 1 second, Mr.
Foley? Mr. Gibbons, can I ask you a question? It is on
everybody's mind in this hearing room. What did you pay for the
coat?
Mr. Foley. That was the crux of my earlier observation.
Mr. Gibbons. Damn if I know.
I remember Martha and I didn't have much spending money for
the rest of the trip. And, you know, I--at that time, the TVA
might have been 50 or 60 percent. Because, they--the French at
the time were administering their code under--they were taxing
various items at different rates.
Mr. Foley. Well, it continues today because when you
travel----
Chairman McCrery. Mr. Foley, your time is up. Thank you
very much.
Mr. Gibbons. The final voice has spoken.
Chairman McCrery. Thank you very much for your testimony.
We appreciate again your willingness to work with us to try to
get through this problem that we have got with our Tax Code.
And we welcome you back any time.
Mr. Archer. Mr. Chairman, if can I have one last quick
thing. I know you have got other witnesses coming. I don't
think that Mr. Gibbons and certainly I mean to imply that the
European credit invoice value-added tax system would ever be
right for the United States. I do not believe it would be. And
I want to make that very clear. That is an option that I do not
think is a realistic one for this country.
Chairman McCrery. Thank you very much. And we look forward
to seeing you again soon.
Our next witness is Ms. Barbara Angus, International Tax
Counsel for the U.S. Department of the Treasury. Ms. Angus.
Ms. Angus, we will certainly put in the record any written
testimony that you have for us. But if you would try to
summarize that within 5 minutes. You may proceed.
STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX COUNSEL, U.S.
DEPARTMENT OF THE TREASURY
Ms. Angus. Thank you, Mr. Chairman, Congressman Neal, and
distinguished Members of the Subcommittee. I appreciate the
opportunity to appear today at this hearing on whether the
existing ETI regime can be modified in a manner that brings it
into compliance with WTO rules without undermining the internal
competitiveness of U.S. businesses and their employees.
Mr. Chairman, I would like to request your permission to
read a letter that Assistant Secretary Weinberger sent to you
yesterday regarding the matter that is before the Subcommittee
today and that states the administration's views.
Chairman McCrery. You certainly may do that.
Ms. Angus. To read the letter:
``Dear Chairman McCrery:
``Thank you for the opportunity to have a representative of the
Treasury Department appear before the Select Revenue Measures
Subcommittee on April 10, 2002, as your panel begins examining possible
legislative solutions to the current FSC/ETI dispute. As representative
of the administration have said repeatedly, this is a very serious
matter requiring immediate attention and we must pursue all available
avenues to achieve an appropriate final resolution, a resolution that
protects America's interests and satisfies our obligations under the
WTO. We must continue to seek every opportunity to address the
underlying issues in the ongoing trade dialog. At the same time, we
must begin work toward meaningful changes to our tax rules to respond
to the decision in the FSC/ETI case.
``We want to applaud you for the work your Subcommittee is doing.
With the possibility that the European Union could move to impose trade
sanctions against exports from the United States as early as May, the
urgency of the situation is clear. At the same time, we must not lose
sight of the objective served by the ETI provisions and the FSC
provisions that preceded them, which is to help level the playingfield
for U.S.-based businesses that are subject to the U.S. system of
international tax rules.
``We understand your hearing will explore whether minor changes can
be made to bring the current ETI regime into compliance with WTO rules.
Given the analysis of the current WTO rules reflected in the decisions
in the FSC/ETI case, we do not believe legislation that simply
replicates FSC or ETI benefits will pass muster in the WTO.
``We must pursue all routes to resolving this matter promptly and
fairly so that American workers and the businesses that employ them
will not be disadvantaged. Addressing the decisions through the tax law
without adversely affecting the competitive position of U.S.-based
businesses in the global marketplace will require consideration of
meaningful changes to our current international tax laws. We need to
explore a whole range of possible tax legislative options. This
includes consideration of changes that will help rationalize key
components of our international tax rules within the existing
framework. It also includes consideration of comprehensive and
fundamental reforms of our international tax system.
``While we work toward the needed changes to our international tax
rules, we also must continue to maintain a dialog with the European
Union. Given the importance of this matter, we must pursue a
multifaceted approach to resolving it, including both tax and trade
approaches. It is essential that we achieve a resolution of this matter
that is clear, fair and final. We must take every step needed to ensure
that this does not further escalate to the detriment of the global
trading environment.
``Mr. Chairman, thank you again for this opportunity to discuss
this matter and for the work your Subcommittee is doing. We look
forward to working closely with Congress and all interested parties to
develop and implement a solution that will protect America's interests
and honor our obligations in the WTO.
Sincerely,
Mark A. Weinberger,
Assistant Secretary (Tax Policy).''
Given the particular focus of this hearing, let me
reiterate that we believe legislation that simply replicates
FSC or ETI benefits will not pass muster in the WTO. We need to
work together toward meaningful changes in our international
tax rules in order to protect the competitive position of
American businesses and workers and meet our WTO obligations.
I would be happy to answer any questions. Thank you.
Chairman McCrery. Thank you, Ms. Angus. And I gather from
the letter that you read from Mr. Weinberger and from your own
statements that the administration is spending some time now
looking at possible solutions to this matter on both the
legislative front and the trade front, and you are actively
pursuing within the Administration some recommendations that
could be forthcoming sometime in the future on this matter?
Ms. Angus. Yes, Mr. Chairman. The Administration and all of
the agencies are working together to explore all options for
resolving this critically important matter. It is a complex
matter that cuts across areas of expertise and we need to bring
together all of that expertise to contribute to finding a
solution now.
We believe the administration, Congress and all interested
parties must work together to resolve this matter. We intend to
consult closely with Congress on consideration of the types of
meaningful changes to our international tax rules that will be
needed to address the decisions. We applaud you and Chairman
Thomas for holding those hearings on this matter at this
critical time.
Chairman McCrery. Thank you. Mr. Neal.
Mr. Neal. Thank you very much, Mr. Chairman.
Ms. Angus, at a recent mark-up of this Committee where your
colleague from Treasury, Pam Olson was in the witness chair,
the Chairman of the full Committee stated his desire to have
this Subcommittee investigate the expatriate issue and to
report back fairly quickly on why and how these companies are
leaving the United States, and why they are avoiding U.S.
income taxes.
Your colleague, Ms. Olson, said at that time that the
Treasury study would be a preliminary report with
recommendations coming later. Is that still the expectation of
your report on the corporate expatriate problem?
Ms. Angus. Yes. We intend to release our preliminary views
by the end of April. This is a matter of priority for the
Treasury Department. We believe that a detailed technical study
can help to inform the debate over the appropriate response to
these developments and will ensure that the government can act
promptly and effectively.
Mr. Neal. Thank you. When we last met, it was, I believe,
the day before Treasury announced the study of the corporate
expatriate issue. Since then, my staff has performed some
research on a handful of these expatriate companies. And it has
come to my attention that these expatriate companies enjoy in
excess of $2 billion a year in Federal government contract
money.
In fact, one of these expatriates has a $40 million
contract to help the IRS collect more tax revenue. Now, I find
that more than a little ironic that we are awarding Federal tax
revenues to companies who have decided they are exempt from
paying it. I wonder if you can comment on whether the Treasury
Department has considered a review of these particular
contracts or the policy of awarding these Treasury contracts to
expatriate companies?
Ms. Angus. Congressman, that is certainly something that I
can look into and we can provide you a response. It is not
something that is within my area of expertise. From my
perspective, the work that we are doing within my group
involves looking at these transactions from a technical
perspective to understand the implications for our tax law, the
implications for our economy, and to work to develop an
appropriate response.
Mr. Neal. I tried to be very precise in my questioning so
as to not appear irresponsible. But with April 15th looming,
and September 11th just behind us, it seems to me that there is
an ideal opportunity to examine this question. Mr. McCrery has
said he is going to hold hearings on it. The Chairman of the
full Committee has indicated he is going to hold hearings on
it. But this is a large issue that looms for the American
people. The President, in the end, is going to get most of the
defense buildup that he desires, rightly so. It is also, I
think, understandable that the American people would ask: Who
is going to help to pay for all of this?
So we have companies that are winning large contracts, and
at the same time setting up foreign addresses so that they
don't have to pay corporate income tax.
Ms. Angus. As I indicated earlier, we are studying this
issue. We expect to have preliminary views by the end of this
month. We do believe that we need to determine whether there
are any inadequacies in our tax law that companies can take
advantage of or exploit through those transactions. If those
inadequacies exist, we need to know about that. And we
certainly intend to work with the IRS and Congress to address
those.
At the same time, we also believe we need to look at
whether there are aspects of our international tax rules that
are driving companies to feel they need to consider these
transactions for competitiveness reasons. If that is the case,
we also need to understand that and consider our approach to
that issue as well.
Mr. Neal. Thank you.
Chairman McCrery. Mr. Lewis.
Mr. Lewis. Thanks, Mr. Chairman. Ms. Angus, last week an EU
spokesman stated what we urgently need is a road map of what
kind of measures the American Government plans to take to
comply with the WTO ruling.
What does the--what kind of road map can you give us today
about what the Administration plans to do in moving forward on
this?
Ms. Angus. Well, as Ambassador Zoellick has said,
Commissioner Lamy wants to see us making progress toward
resolving this matter. It is critically important that the
administration and the Congress work together with all
interested parties to address this matter now.
This is an urgent matter requiring immediate attention.
These hearings represent a very important first step. We must
work together toward consideration of meaningful changes to our
international tax rules. We need to do so as soon as possible
in order to demonstrate real progress toward meeting our WTO
obligations.
And as we do that, we believe it is important that we keep
in mind the objective of ensuring that we don't adversely
affect the competitiveness of American-based businesses.
Mr. Lewis. Okay. Thank you.
Chairman McCrery. Thank you very much, Ms. Angus. And we
look forward to working with you and others in the
Administration as we wrestle with this problem.
Ms. Angus. Thank you.
Chairman McCrery. And now the third panel. LaBrenda
Garrett-Nelson, Terrence Chorvat, and Michael McIntyre. If you
would come to the front. Welcome. Our first witness on the
third panel is LaBrenda Garrett-Nelson. She is a Partner with
Washington Council, Ernst & Young.
And then Terrence Chorvat, Assistant Professor of Law at
George Mason University. And Mr. Michael McIntyre, Professor of
Law at Wayne State University, School of Law.
Ms. Garrett-Nelson, we will begin with you. You may
proceed. Please summarize your testimony for us within about 5
minutes.
STATEMENT OF LABRENDA GARRETT-NELSON, PARTNER, WASHINGTON
COUNCIL ERNST & YOUNG
Ms. Garrett-Nelson. Thank you, Mr. Chairman and Members of
the Committee.
I am LaBrenda Garrett-Nelson. And I am appearing today on
my own behalf and not as a representative of any organization.
The testimony that I offer relates to the legislative drafting
implications of the WTO Appellate panel's report on ETI. I do
not offer any specific legislative proposals. Rather, my
testimony highlights three aspects of the Appellate body report
that will become relevant if the decision is made to pursue a
legislative solution to the FSC/ETI dispute.
First, that the legal analysis in the Appellate body report
would prevent the United States from coming into compliance
simply by making cosmetic changes to ETI.
Second, but significantly, for the first time, the
Appellate body has provided guidance regarding the extent to
which an export tax subsidy could be provided for foreign
source income.
And last, but importantly, it should be kept in mind that
there is nothing in the Appellate body report that would
prevent the United States from amending its tax laws in a
manner that could provide a benefit to the same general class
of taxpayers that utilize the ETI regime. And that is relevant
to the decision whether to pursue a legislative solution.
The Congress clearly retains the ability to develop
legislation that would preserve the competitiveness of American
companies.
Turning first to the basis for my conclusion that it will
not be possible to simply make adjustments to ETI. Two of the
principal legal issues before the Appellate body were, is there
a subsidy? If so, is the subsidy export contingent? The
Appellate body broke new ground, and in doing so, invalidated
legal conclusions that had been formed as the basis of drafting
decisions in developing the ETI statutory provisions.
On the threshold issue of whether a subsidy exists. When
the Appellate body reviewed the FSC case, it applied a but-for
test. It looked to see whether the FSC was an exception to a
general rule with the result that more tax would been paid but-
for the FSC.
In light of that but-for test, the ETI regime was drafted
as a general rule with taxation cast as the exception. But when
the Appellate body reviewed ETI, it decided that the but-for
test should be limited to cases where the measure at issue is
an exception and instead applied a new test, a test that
compared the treatment of income under the ETI regime to
comparable foreign source income.
And particularly because the ETI regime is elective, on
that basis the Appellate body held that the ETI regime confers
a subsidy.
On the question of export contingency. Before the Appellate
body report on the ETI regime, it was unclear whether export
contingencies could be cured by expanding the universe of
beneficiaries. And in that regard, the ETI Act was drafted to
apply to nonexport foreign sales of certain property produced
abroad.
So the ETI regime is legally not contingent on exportation
because the operative rule could apply to nonexport sales.
Well, the Appellate body also decided against the United States
on this issue on the grounds that for property produced within
the U.S. exportation was required.
So, apparently to avoid a finding of export contingency, it
would be necessary to apply a single operative rule without
regard to whether property is produced within or without the
United States. Now, there was the one instance in which the
Appellate body did agree with an interpretation offered by the
United States. That was on the ruling that there is an
exception to the prohibition on export subsidies for a measure
to avoid double taxation of foreign source income. And that is
the exception based on what you may hear referred to as
Footnote 59 in the relevant trade agreement.
I would point out with respect to Footnote 59, that it
remains to be seen to what extent Footnote 59 would allow
anything that looks like a replication of ETI. I say that for
two reasons: First, because of the Appellate body's definition
of foreign source income that could be treated under such an
exception, and also because of the related requirement that
with respect to export sales, arms-length pricing methods would
be required to allocate income between foreign and domestic
sources.
So in addition to the drafting possibilities presented by
Footnote 59, I would remind the Committee again, that nothing
in either the Appellate body report or the applicable trade
agreements would prevent the United States from considering
options for amending general tax rules that affect the
competitiveness of American exporters.
It is clear, however, that either of these possible
drafting approaches would take time to implement and develop.
This ends my prepared statement. I would be happy to respond to
questions you may have.
[The prepared statement of Ms. Garrett-Nelson follows:]
Statement of LaBrenda Garrett-Nelson, Partner, Washington Council Ernst
& Young
My name is LaBrenda Garrett-Nelson and I am a partner in Washington
Council Ernst & Young, a division of the National Tax Practice of Ernst
& Young. I am also a consultant to the National Foreign Trade Council's
FSC-ETI Coalition; however, I am testifying today on my own behalf and
not as a representative of any organization.
Introduction
The January 14, 2002, WTO Appellate Body Report in United States--
Tax Treatment for ``Foreign Sales Corporations''--Recourse to Article
21.5 of the DSU by the European Communities (the ``AB Report'') upheld
the decision of the WTO panel that the FSC Replacement and
Extraterritorial Income Exclusion (``ETI'') Act confers prohibited
export subsidies in violation of the international trade obligations of
the United States. Consistent with the focus of today's hearing, my
statement is based on my analysis of the legislative drafting
implications of the AB Report. My statement does not presuppose that a
legislative response is the only response to the FSC-ETI dispute, nor
does it offer any specific legislative proposals. Rather, my testimony
highlights three aspects of the AB Report that will become relevant if
the decision is made to pursue a legislative solution to the FSC-ETI
dispute (either alone or in combination with trade initiatives). These
three aspects are as follows:
(1) By providing definitive interpretations of the
substantive provisions that impose the prohibition on export
subsidies, the AB Report precludes a drafting approach that
merely ``tinkers'' with the ETI regime;
(2) Significantly, however, the AB Report also allows for the
consideration of an alternative legislative response that
targets exports in the context of a measure to avoid double
taxation of foreign-source income; and
(3) Nothing in the AB Report would prevent the United States
from amending rules of general application in a manner that
could benefit exporters, among other taxpayers.
Discussion
The FSC-ETI case--brought under the 1995 World Trade Agreement--is
the latest chapter in a long-running dispute between the United States
and the European Commission over the legality of export tax incentives.
This, however, was a case of first impression, as there were no WTO
precedents involving export subsidies delivered through an income tax
system.\1\ As in the original FSC dispute, three legal issues were
presented under the Agreement on Subsidies and Countervailing Measures
(the ``SCM Agreement'') and the Agreement on Agriculture: \2\ (1)
whether the ETI Act provides a subsidy; (2) whether the subsidy confers
a benefit; and (3) whether the subsidy is contingent on export
performance.
---------------------------------------------------------------------------
\1\ The European Community's challenge of the 1971 DISC legislation
and the United States' counter-claims based on the tax exemptions for
foreign-source income provided by Belgium, France, and the Netherlands
were brought under GATT 1947.
\2\ Because the Appellate Body's treatment of the three, principal
issues under the SCM Agreement also determined the outcome under the
Agreement on Agriculture, the following discussion focuses on the
drafting implications of the SCM Agreement.
---------------------------------------------------------------------------
Article 1.1(a)(1)(ii) of the SCM Agreement provides that a
``subsidy'' exists if ``government revenue that is otherwise due is
forgone or not collected.'' In turn, Article 3.1(a) prohibits
``subsidies contingent in law or in fact, whether solely or as one of
several conditions, upon export performance, including those
illustrated in Annex I'' (the Illustrative List of Export Subsidies
that appears at the end of the SCM Agreement). Paragraph (e) of Annex I
lists as an export subsidy ``the full or partial exemption remission,
or deferral specifically related to exports, of direct taxes . . . paid
or payable by industrial or commercial enterprises.'' Importantly,
however, the fifth sentence of ``Footnote 59'' to Paragraph (e)
provides that ``Paragraph (e) is not intended to limit a Member from
taking measures to avoid the double taxation of foreign-source income
earned by its enterprises or the enterprises of another Member.
Additionally, the AB Report addressed the issue whether the ETI Act
is inconsistent with the General Agreement on Tariffs and Trade 1994
(``GATT 1994'') by reason of the limitation on the use of foreign
articles and labor. Note that the Appellate Body upheld the adverse
``findings,'' as opposed to the rationale, of the WTO panel that
considered the validity of the ETI Act. Thus, it is the AB Report that
provides dispositive guidance on the drafting parameters of any
replacement legislation.
While the basic legal issues addressed in the AB Report were
identical to those presented by the original FSC dispute,\3\ the
Appellate Body broke new ground by fleshing out the analytical
framework that was used to draft the ETI Act. In clarifying the
application of the applicable trade agreements, the AB Report
invalidated legal conclusions that supported drafting decisions
reflected in various provisions of the ETI Act. Moreover, these new
pronouncements ``fixed'' the parameters of any legislative response
that the United States might consider.
---------------------------------------------------------------------------
\3\ See United States--Tax Treatment for ``Foreign Sales
Corporations'' (``US--FSC''), WT/DS108/AB/R, adopted 20 March 2000 (the
``FSC Case'').
I. LThe analysis underlying the AB Report precludes a drafting apporach
---------------------------------------------------------------------------
that merely ``tinkers'' with the ETI regime.
The AB Report altered the legal landscape by clarifying the extent
to which a Member state can refrain from taxing foreign-source income
without creating a subsidy, and providing substantive interpretations
of provisions in the SCM Agreement.
A. LFirst, in the context of defining a ``subsidy,'' the Appellate Body
rejected the notion that there might be a general category of foreign-
source income that WTO Member states are free not to tax.
In the original FSC dispute, the Appellate Body indicated that ``in
principle, a Member is free not to tax any particular category of
income it wishes, even if this results in the grant of a ``subsidy''
under Article 1.1 of the SCM Agreement, provided that the Member
respects its WTO obligations with respect to the subsidy.'' \4\ In the
AB Report, however, this statement was ``explained away'' as follows:
``Article 1.1 of the SCM Agreement does not prohibit a Member from
foregoing revenue that is otherwise due under its rules of taxation,
even if this also confers a benefit under Article 1.1(b) of the SCM
Agreement. However, if a Member's rules of taxation constitute or
provide a subsidy under Article 1.1, and this subsidy is specific under
Article 2, the Member must abide by the obligations set out in the SCM
Agreement with respect to that subsidy, including the obligation not to
`grant [] or maintain' any subsidy that is prohibited under Article 3
of the Agreement.'' \5\
---------------------------------------------------------------------------
\4\ Appellate Body Report. WT/DS70/AB/RW, adopted August 4, 2000,
para. 90 (hereafter, the ``FSC Case'').
\5\ The AB Report at para. 86.
B. LAdditionally, the AB Report includes adverse interpretations of
---------------------------------------------------------------------------
relevant provisions in the SCM Agreement
1. LRegarding the threshold issue of whether a subsidy exists, the
Appellate Body limited use of the ``but for'' test to the facts of the
FSC case.
As in the original FSC dispute, the Appellate Body interpreted the
phrase ``otherwise due'' (in Article 1.1(a)(1)(ii) of the SCM
Agreement) as implying a comparison with a ``defined, normative
benchmark.\6\ '' In the FSC proceeding, the Appellate Body approved the
use of a ``but for'' test formulated by the WTO panel.\7\ Under the
``but for'' test, whether revenue forgone is ``otherwise due'' was
determined by examining the tax liability that would exist under a
Member's tax regime in the absence of the measures at issue. In light
of this ``but for'' test, the ETI Act was drafted as a general rule of
U.S. taxation whereby the income excluded from taxation was outside
U.S. taxing jurisdiction.\8\
---------------------------------------------------------------------------
\6\ AB Report at para. 89.
\7\ Note that, in the original FSC case, the Appellate Body did
express a reservation about applying the ``but for'' test in all cases
(although it acknowledged that the test worked in that case); and none
of the parties raised this issue. (FSC Case at page 31)
\8\ United States' appellant's submission, para. 71.
---------------------------------------------------------------------------
In the AB Report, however, the Appellate Body indicated that the
``but for'' test is limited to situations where the measure at issue is
an ``exception'' to a general rule of taxation, adding that ``Article
1.1(a)(1)(ii) does not always require panels to identify, with respect
to any particular income, the `general' rule of taxation prevailing in
a Member.'' \9\ Instead, the Appellate Body concluded, ``panels should
seek to compare the fiscal treatment of legitimately comparable income
to determine whether the contested measure involves the foregoing of
revenue which is `otherwise due,' in relation to the income in
question.'' \10\ Under this standard, the Appellate Body compared the
treatment of income excluded under the ETI Act with the taxation of
other foreign-source income, and upheld the finding that the United
States through the ETI regime ``foregoes revenue that is otherwise
due'' and thus grants a subsidy within the meaning of under Article
1.1(a)(1)(ii) of the SCM Agreement.\11\ Also, the Appellate Body opined
that a taxpayer's ability to ``elect'' application of the ETI regime
``confirms that the United States will forgo revenue . . . that would
be `otherwise due,' '' \12\ (assuming that a taxpayer will elect the
rules of taxation that result in the payment of the lowest amount of
tax).
---------------------------------------------------------------------------
\9\ AB Report at para. 91.
\10\ Id.
\11\ AB Report at para. 106.
\12\ AB Report at para. 104.
---------------------------------------------------------------------------
Thus, under the AB Report's interpretation of the phrase
``otherwise due,'' any elective, replacement regime that departs from
an otherwise applicable general rule would be viewed as granting a
subsidy.
2. LThe AB Report also makes clear that ``export contingency'' can be
found if exporting is required of any beneficiary.
Although ETI involves a general rule that excludes a category of
income that is broader than exports, it clearly defines U.S. exports as
covered transactions. In this regard, prior to the AB Report, it was
unclear whether expanding the universe of taxpayers eligible for a
subsidy could cure ``export contingency.''
The ETI Act was drafted to apply to income earned from certain non-
export foreign sales of property produced outside the United States.
Thus, the ETI regime is not legally contingent on exportation because
exportation is not mandatory. Notwithstanding the existence of a single
operative rule, the Appellate Body bifurcated the provisions of the ETI
Act, on the grounds that the ``conditions for the grant of subsidy with
respect to property produced outside the United States are distinct
from those governing the grant of subsidy in respect of property
produced within the United States.'' \13\ Viewing the two situations
separately, the Appellate Body upheld the finding--but only with
respect to property ``manufactured, produced, grown, or extracted''
within the United States--that the ETI regime grants subsidies
contingent in law upon export performance within the meaning of Article
3.1(a) of the SCM Agreement (without opining on the alleged export
contingency of the subsidy in relation to property ``manufactured,
produced, grown, or extracted'' outside the United States).\14\
---------------------------------------------------------------------------
\13\ AB Report at para. 114-115.
\14\ AB Report at para. 120.
---------------------------------------------------------------------------
Apparently, to avoid a finding of export contingency, it would be
necessary to devise an operative rule that applies a single set of
conditions to property produced within and without the United
States.\15\
---------------------------------------------------------------------------
\15\ Trade lawyers caution, however, that export contingency could
be found in any event if beneficiaries under a replacement regime are
``predominantly exporters.''
II. LSignificantly, however, the Appellate Body ruled that Footnote 59
provides an exception to the prohibition on export subsidies for a
---------------------------------------------------------------------------
measure to avoid double taxation of foreign-source income.
The Appellate Body ruled that Footnote 59 permits a WTO Member
state to adopt a measure taken to avoid the double taxation of foreign-
source income. In the present case, however, ``even though parts of the
ETI measure may be regarded as granting a tax exemption for foreign-
source income, . . . the United States [did not meet] its burden of
proving that the ETI measure, viewed as a whole, falls within the
justification available under the fifth sentence of footnote 59 of the
SCM Agreement.'' \16\ Nevertheless, the AB Report is instructive
because it provides guidance regarding the extent to which foreign-
source income from exports could be exempted in a WTO-compliant manner.
---------------------------------------------------------------------------
\16\ AB Report at para. 186.
---------------------------------------------------------------------------
A Footnote 59 approach could be used in the context of legislation
that explicitly confers an (otherwise prohibited) export subsidy, or in
combination with amendments to rules of general application. In either
case, however, the ability to replicate the benefits of the ETI regime
would be circumscribed by the AB Report's definition of ``foreign-
source income'' and the related requirement that arm's length pricing
be used to allocate income between foreign and domestic sources.
Moreover, a Footnote 59 approach would not permit the Unites States to
grant an exemption to small exporters without demonstrating that the
income is foreign-source, or exempt income from services that may be
performed within the United States (as discussed below).
A. LFor purposes of Footnote 59, the AB Report requires that foreign-
source income be defined by reference to ``widely recognized principles
of taxation.''
The term foreign-source income, as used in footnote 59, ``cannot be
interpreted by reference solely to the rules of the Member taking the
measure to avoid double taxation of foreign-source income.'' \17\
Rather, the Appellate Body deemed ``it appropriate . . . to derive
assistance from . . . widely recognized principles'' from bilateral tax
treaties and multilaterally developed model tax conventions dealing
with double taxation--noting that the majority of bilateral treaties
adopt the principles of the OECD and U.N. Model tax treaties.\18\
---------------------------------------------------------------------------
\17\ AB Report at para. 140.
\18\ AB Report at para. 142.
---------------------------------------------------------------------------
A taxpayer need not be required to maintain a permanent
establishment in a foreign country to establish a sufficient link,\19\
although the Appellate Body did identify one common element that would
be required of any definition of foreign-source income:
---------------------------------------------------------------------------
\19\ Footnote 122 in the AB Report.
---------------------------------------------------------------------------
``Although there is no universally agreed meaning for the term
``foreign-source income'' in international tax law, . . . there seems
to us to be a widely accepted common element to these rules. . . . The
common element is that a `foreign' State will tax a non-resident on
income which is generated by activities of the non-resident that have
some link with that State.'' \20\
---------------------------------------------------------------------------
\20\ AB Report at para. 141 and 143.
---------------------------------------------------------------------------
There are, however, other statements of the Appellate Body's views
that suggest other, possible meanings, including the statements that
``the word ``source'', in the context of the fifth sentence of footnote
59, has a meaning akin to ``origin'' and refers to the place where the
income is earned,'' \21\ and ``the term `foreign-source income' in
footnote 59 refers to income which is susceptible of being taxed in two
States.'' \22\
---------------------------------------------------------------------------
\21\ AB Report at para. 137.
\22\ AB Report at para. 138.
B. LNevertheless, Footnote 59 would allow a degree of flexibility in
---------------------------------------------------------------------------
targeting the income to be exempted.
There is no need to show that income is actually taxed in another
jurisdiction. The Appellate Body recognized that ``the avoidance of
double taxation is not an exact science. Indeed, the income exempted
from taxation in the State of residence of the taxpayer might not be
subject to a corresponding, or any, tax in a `foreign' State.'' \23\
The AB Report also makes clear that a partial exemption would pass
muster: ``[W]e do not believe that measures falling under footnote 59
must grant relief from all double tax burdens. Rather, Members retain
the sovereign authority to determine for themselves whether, and to
what extent, they will grant such relief.'' \24\
---------------------------------------------------------------------------
\23\ AB Report at para. 146.
\24\ AB Report at para. 148.
C. LOn the other hand, an allocation between domestic and foreign
---------------------------------------------------------------------------
sources would be required for income from export transactions.
``[U]nder footnote 59 . . . the `foreign-source income' arising in
such a transaction is only that portion of the total income which is
generated by and properly attributable to activities that do occur in a
`foreign state.' '' \25\ In the case of a sale of goods, the Appellate
Body suggested that arm's length pricing rules would be an acceptable
basis for distinguishing between domestic and foreign-source income.
The manufacturer would be treated as if it had sold the goods to an
independent distributor at arm's length prices, who in turn resold the
goods. This would ``dissect'' the transaction on the basis of the place
where the different activities occurred.\26\ In the case of ``a sale or
lease transaction,'' however, the AB Report indicates that income may
be attributable to activities such as research and development,
manufacturing, advertising, selling, transport, and administration,''
\27\ suggesting the possible need to allocate beyond manufacturing
versus sale and distribution income.
---------------------------------------------------------------------------
\25\ AB Report at para. 154.
\26\ See Footnote 133.
\27\ AB Report at para. 154.
---------------------------------------------------------------------------
In allocating income to a foreign source, exportation would not be
a sufficient basis: ``[S]ales income cannot be regarded as `foreign-
source income', under footnote 59, for the sole reason that the
property, subject-matter of the sale, is exported to another State, for
use there. The mere fact that the buyer uses property outside the
United States does not mean that the seller undertook activities in a
`foreign' State generating income.'' \28\
---------------------------------------------------------------------------
\28\ AB Report at para. 176.
---------------------------------------------------------------------------
Similarly, the ``foreign economic process requirements'' utilized
under the ETI regime would not suffice.\29\ In the view of the
Appellate Body, the ETI regime falls short of adequately identifying
foreign-source income, to the extent that the ETI allocation rules
apply fixed percentages to amounts that may include domestic-source
income, with the result that taxpayers can obtain a tax exemption for
income that is domestic-source income.\30\ The only aspect of ETI that
passes muster is the general rule for Foreign Sale and Leasing Income
(``FSLI''). For independent distributors that sell to unrelated parties
using arm's length pricing, FSLI is limited to the ``foreign trade
income properly allocable to activities'' that are performed . . .
outside the United States in satisfaction of the foreign economic
process requirement described in sections 942(b)(2)(A)(i) and
942(b)(3).\31\ With respect to this category of income, the Appellate
Body opined as follows:
---------------------------------------------------------------------------
\29\ Regarding the ETI measure, the AB Report notes that, ``the
foreign economic process requirement establishes a link between some
part of the qualifying transactions covered by the ETI measure and a
`foreign' state.' This does not necessarily mean that all of the income
generated by such a transaction will be `foreign-source income.' At
para. 153-4.
\30\ AB Report at para. 183.
\31\ All references to ``sections'' are to the Internal Revenue
Code of 1986, as amended.
---------------------------------------------------------------------------
``By requiring such a process of separating domestic- and foreign-
source income, on the basis of the locus of the activities generating
the income, Section 941(a)(1)(A) IRC includes in the calculation of
FSLI only income which may properly be regarded as ``foreign-source
income'' under footnote 59 of the SCM Agreement. In other words,
Section 941(c)(1)(A) IRC separates out, or unbundles, the domestic- and
foreign-source income that are combined in foreign trade income.'' \32\
---------------------------------------------------------------------------
\32\ AB Report at para. 170.
---------------------------------------------------------------------------
The Appellate Body did not, however, approve of the treatment of
FSLI that is lease or rental income, as a ``proper'' allocation is not
required of that type of FSLI.\33\
---------------------------------------------------------------------------
\33\ AB Report at para. 171.
D. LFootnote 59 would not, however, permit any special provisions for
---------------------------------------------------------------------------
small exporters or services performed within the United States.
The Appellate Body made clear that Footnote 59 would not allow an
exemption, such as the $5 million exception for small exporters in
section 942(c)(1), unless the income is demonstrated to be foreign-
source income under the principles outlined above.\34\ Similarly, where
the ETI Act does not state expressly that subsidiary and related
service activities need to be performed outside the United States, the
AB Report indicates that this would be a requirement of a regime based
on Footnote 59.\35\
---------------------------------------------------------------------------
\34\ AB Report at para. 177. Thus, section 942(c)(1) was viewed as
defective because it dispenses entirely with the foreign economic
process requirement, treating ``a portion of the taxpayers' income--as
exempt foreign-source income even though it--need not be established--
that the taxpayer undertook any activities outside the United States.''
AB Report at para. 175.
\35\ AB Report at para. 179-80.
---------------------------------------------------------------------------
E. Other issues that were decided against the United States.
However flexible Footnote 59 proves to be, it is not at all clear
that the United States would be able to address every identified issue
through legislative amendments.
1. LThe Appellate Body upheld the finding ``that, by virtue of the fair
market value rule, the measure accords less favourable treatment within
the meaning of Article III:4 of the GATT 1994 to imported products than
to like products of United States origin.'' \36\
---------------------------------------------------------------------------
\36\ AB Report at para. 222.
The GATT 1994 was not at issue in the original FSC dispute; rather,
a claim was made that the prior-law limitation on the use of foreign
articles rendered the ``subsidy'' contingent on the use of U.S. goods
over imported goods, contrary to Article 3.1(b) of the SCM Agreement. A
claim that the foreign articles/labor limitation violates Article
3.1(b) of the SCM Agreement was also made with respect to the ETI Act,
as a conditional appeal, but the Appellate Body declined to consider
any conditional appeals (leaving this issue open).
The Appellate Body's analysis of the ``national treatment''
principle under Article III:4 of GATT 1994 indicates that any similar
provision might fail if it provides an impetus for manufacturers to use
domestic products, rather than like imported ones: ``[T]he . . .
conclusion is not nullified by the fact that the fair market value rule
will not give rise to less favourable treatment for like imported
products in each and every case.'' \37\ Note also that there is no
indication that Footnote 59 provides an exception to this trade
agreement.
---------------------------------------------------------------------------
\37\ AB Report at para. 221.
2. LThe Appellate Body flatly rejected the inclusion of transition
---------------------------------------------------------------------------
rules in any replacement legislation.
In the view of the Appellate Body, the inclusion of transition
rules covering FSC users means that the United States has not fully
withdrawn the FSC subsidies found to be prohibited export
subsidies.\38\ The AB Report includes the statements that ``a Member's
obligation under . . . the SCM Agreementto withdraw prohibited
subsidies `without delay' is unaffected by contractual obligations that
the Member itself may have assumed under municipal law. Likewise, a
Member's obligation to withdraw prohibited export subsidies, . . .
cannot be affected by contractual obligations which private parties may
have assumed inter se in reliance on laws conferring prohibited export
subsidies. Accordingly, we see no legal basis for extending the time-
period for the United States to withdraw fully the prohibited FSC
subsidies.'' \39\
---------------------------------------------------------------------------
\38\ AB Report at para. 231.
\39\ AP Report at para. 230.
III. LNothing in the applicable trade agreements would prevent the
United States from responding to the AB Report by replacing ETI with
---------------------------------------------------------------------------
rules of general application.
There is nothing in the AB Report that would preclude a direct
response to the Appellate Body's findings. As noted by the Appellate
Body, ``each Member is free to determine the rules it will use to
identify the source of income and the fiscal consequences--to tax or
not to tax the income--flowing from the identification of source.''
\40\ By way of example, and quite apart from the Footnote 59 exception
for foreign-source income, the United States remains free to amend any
of its general rules for the taxation of income earned abroad.
---------------------------------------------------------------------------
\40\ AB Report at para. 139.
---------------------------------------------------------------------------
Similarly, consideration could be given to the development of
legislation that might benefit classes of taxpayers that currently
utilize the ETI regime (e.g., small exporters) without requiring
exportation. Alternatively, some have argued that it is possible to
model a replacement regime on the footnote in the SCM Agreement on
which the EU relies in concluding that rebates of indirect taxes (such
as Value Added Taxes) do not violate WTO rules--which footnote is based
on the rationale that indirect taxes are passed on to consumers, but
direct taxes (such as income taxes) are not. It seems clear, however,
that any of these possible, legislative responses would take time to
develop and implement.
Conclusion
To summarize the principal drafting implications of the AB Report,
it will not be possible to draft a single replacement regime that
complies with the trade obligations of the United States and replicates
the tax benefits of the ETI statute. It is now clear, however, that a
WTO Member can provide an export subsidy in the form of a tax exemption
if it is a measure to avoid double taxation of foreign-source income.
Moreover, there is no prohibition on a Member State's ability to
liberalize rules of general application that have the incidental effect
of benefiting exporters. Thus, relevant to the decision whether to
pursue a legislative resolution of the FSC-ETI dispute, the Congress
retains the ability to develop legislation that preserves the
competitiveness of American companies.
Chairman McCrery. Thank you. Mr. Chorvat.
STATEMENT OF TERRENCE R. CHORVAT, ASSISTANT PROFESSOR OF LAW,
GEORGE MASON UNIVERSITY SCHOOL OF LAW, FAIRFAX, VIRGINIA
Mr. Chorvat. First of all, I would like to thank Chairman
McCrery and the Members of the Subcommittee for inviting me
here to talk about the extraterritorial income regime and
possible modifications to it.
My name is Terrence Chorvat, and I am Assistant Professor
of Law at George Mason University. And for the record, I am
testifying today on my own behalf and not as a representative
of any organization.
As all prior witnesses have testified, the WTO panel has
held that the FSC and the ETI regime violate the GATT Treaties.
If the ETI and FSC regimes are not permitted under the GATT
Treaties, what types of rules that promote exports are
permitted? As described below, there are quite a number of ways
the country can promote exports and not, at least as of yet, be
held to violate free trade agreements.
As a number of commentators have pointed out, there have
not been many decisions by the WTO with respect to income tax
rules. And, therefore, we do not know how this jurisprudence
will develop. Consequently any conclusions we express today are
dependent upon how this body of law will develop in the future.
In the last 10 to 15 years the European countries have been
reducing their corporate taxes and their place relying more
heavily on consumption taxes, like the value added taxes or
VATs.
Under European VATs, when the product leaves the country or
taxing jurisdiction then the VAT is refunded. This is because
such taxes are intended to tax consumption that occurs within
the country. If such consumption does not occur in the
jurisdiction, it is not taxed there.
One can argue that this has the effect of encouraging
exports, because exported products are not subject to the VAT.
Importantly, because these taxes are indirect taxes, such
export adjustment are permitted under the GATT Treaties. Such
indirect taxes are viewed as being imposed on the ultimate
consumer rather than on the producer, therefore, they are not
viewed as export subsidies.
In addition, it appears that having an income tax system
which exempts all foreign source income is also permissible.
Such a system would impose lower taxes on exports than on
domestically sold goods because income earned abroad would not
be subject to tax. Many European countries have adopted
territorial tax systems.
One of the key arguments for a regime like the ETI is that
it would merely level the playing field for U.S. corporations
selling abroad. Because European producers are able to receive
tax deductions on some of the products they export, it seems
U.S. producers should also receive tax concessions on exports
to prevent distortions in the market.
Another set of rules which seems immune to challenge are
the source rules found in section 863(b) of the Internal
Revenue Code. These rules define the source of income for the
sale of property which is manufactured in the United States and
sold abroad. They are often said to be export subsidies,
because they allow U.S. taxpayers to increase their use of
foreign tax credits, which can decrease the tax paid to the
United States.
However, because those rules are fundamental source rules
which apply both to imports and exports, they do not constitute
a special regime. These are the only source rules that apply to
these products manufactured in one country and sold in another.
Hence, these rules should not fun afoul of the GATT Treaties as
interpreted by the WTO.
The fundamental purpose of the deferral regimes found in
the Tax Code, such as subpart F, is to eliminate a taxpayer's
ability to avoid U.S. tax by shifting income to low-tax
jurisdictions.
Generally, the United States allows income earned by
foreign subsidiaries to be deferred until the income is
repatriated to the United States. The exception to deferral are
primarily related to passive income and other types of income
that are easily manipulated. Active business income of a
controlled foreign corporation or CFC is generally only subject
to U.S. tax where there is an insufficient economic connection
with the jurisdiction in which the CFC is organized.
On the other hand, the FSC and the ETI regimes were
intended to exempt from U.S. taxation income from good
manufactured in, or extracted from, the United States and sold
abroad. Under the FSC regime, this required an exception to the
subpart F rules. These two important portions of the U.S.
system are in conflict.
Conflicts like this allow the Europeans to argue that the
ETI and the FSC provisions are exceptions to the general
patterns of taxation.
While then, what are our alternatives? There are four basic
ones. First, repeal the ETI provisions and use the revenue to
reduce other taxes. While this is the simplest response, it
does not address the concerns that created the Domestic
International Sales Corporation (DISC), the FSC, and the ETI
regimes in the first place.
The second would be to adopt a territorial system. This
would seem to be allowed under the GATT Treaties. However, it
seems that as such a small portion of it, like the FSC or the
ETI regimes changing our entire system of taxing foreign source
income, just based on this seems a little bit extreme, although
there might be good reasons for doing that.
The third is to adopt a system that involves significant
reliance on indirect taxes such as VATs. That has also been
discussed. But again moving to that system merely because of
the ETI holding again seems a bit extreme, although there may
be good reasons for doing that.
And the fourth is to repeal or to significantly alter
subpart F. There are a number of provisions which one could
either change within subpart F or get rid of entirely, that
would--probably be viewed as not an export subsidy, because
they are, instead of adding something additional, they are
paring away from what we already have.
However, again, we are not confident as to how the WTO
panel would view that because there has not been much
jurisprudence in that area.
None of these alternatives are simple replacements for the
ETI regime. They all involve a change in rules as they apply to
all taxpayers and not simply U.S. manufacturers.
And I would be happy to answer any questions on this.
[The prepared statement of Mr. Chorvat follows:]
Statement of Terrence R. Chorvat, Assistant Professor of Law, George
Mason University School of Law, Fairfax, Virginia
I would like to thank Chairman McCrery, Ranking Member McNulty, and
the members of the Subcommittee for inviting me here to talk about the
Extraterritorial Income Regime and the possible modifications to it.
I. Introduction
My name is Terrence R. Chorvat, and I am an assistant professor of
law at George Mason University. For the record, I am testifying today
on my own behalf and not as a representative of any organization.
II. Background of the FSC and ETI Cases
The dispute over whether the United States gives impermissible
export subsidies through the income tax code has been going on for
thirty years. It began in 1972 with a challenge by what was then called
the European Economic Community (EC) to the Domestic International
Sales Corporation (DISC) regime then in place. The GATT Dispute
Settlement Panel ruled that the DISC regime was a prohibited export
subsidy. In 1984, after negotiations with various members of the EC,
the United States enacted the Foreign Sales Corporation (FSC) regime.
This was thought to overcome the problems with the DISC rules because
it required significant foreign activity.
In 1995, the World Trade Organization (WTO) came into existence. In
1997, the European Union (EU), the successor of the EC, requested WTO
dispute settlement consultations with respect to the FSC rules. In
1999, the WTO panel found that the FSC was a prohibited export subsidy.
On November 15, 2000, Congress enacted the FSC Repeal and
Extraterritorial Income Exclusion Act of 2000 which repealed the FSC
regime and put in its place the Extraterritorial Income Regime (ETI).
The ETI allowed for the exemption of income from products which had a
higher level of foreign produced content than did the FSC. In addition,
the number of persons eligible for the new regime was greatly expanded.
It was thought that these and other changes would overcome the problems
the WTO had with the FSC regime.
However, on August 20, 2002, WTO panel issued a report that held
the ETI regime violated the GATT Code on Subsidies and Countervailing
Measures (SCM). The United States appealed this decision. On January
14, 2002, the WTO Dispute Settlement Unit issued a report which found
against the United States. On January 29, 2002 the WTO Dispute
Settlement Body (DSB) adopted the two earlier reports. There are no
further avenues of appeal for the United States. Currently, the WTO
panel is determining the damages they will assess against the United
States. The damages will be somewhere between about a $1 billion to $4
billion in potential trade sanctions against the United States by the
EU. This does not include the amounts that might have to be paid to
Australia, Canada, Japan and India who had all filed briefs against the
ETI regime in this case, and who will be able to petition the WTO for
relief from damages that they arguably suffered from the ETI regime.
III. Analysis of the WTO Ruling and the Current U.S. Tax Rules
A. The Report Issued by the WTO
The report issued on January 14, 2002 was based an the
interpretation of the DSM that tax provisions must not ``forego
revenue'' otherwise due and this ``reduction in taxes must not be
contingent. . . . upon export performance.'' The report held that
because the exemption in section 114 of the Internal Revenue Code was
conditioned both upon the ``use [of the products] outside of the United
States'' and upon at least 50% of the value of the product being
generated by economic processes that occurred within the United States,
the ETI provision was a prohibited export subsidy. Furthermore, it held
that the exception to the general rules that allows for tax provisions
that attempt to avoid double-taxation, did not apply and so nothing
prevented the ETI regime from being held a prohibited subsidy.
While many have criticized these decisions, both that their
interpretation of the term ``subsidy'' is incorrect and that the policy
of allowing income tax decisions to be determined by international
organizations is troubling, the interpretation of the treaty provisions
adopted by the WTO is clearly a defensible reading of the GATT
treaties. There is little question that the ETI regime does reduce tax
revenue (at least on a short-term basis) and that this reduction is to
some degree based upon property being exported from the United States.
Hence, the decision of the WTO in this matter is far from arbitrary or
capricious.
B. Permitted Export Favorable Rules
If the ETI and FSC regimes are not permitted under the GATT
treaties, what types of rules that promote exports are permitted? It
cannot be the case that the GATT treaties require countries to adopt
rules which are exclusively neutral or discourage exports. As described
below, there are quite a number of ways a country can promote exports
and not (at least as of yet) be held to violate free-trade agreements.
As a number of commentators have pointed out, there have not been
many decisions by the WTO with respect to income tax rules. Therefore,
we do not know how this jurisprudence will develop. Consequently, the
conclusions expressed below are dependent upon how this body of law
will develop in the future.
In the last ten to fifteen years, the European countries have been
reducing their corporate taxes and in their place relying more heavily
on consumption taxes like the value added taxes (VATs). Under European
VATs, when the product leaves the country or taxing jurisdiction, then
the VAT is refunded. This is because such taxes are intended to tax
consumption that occurs within the country. If such consumption does
not occur in the jurisdiction, it is not taxed there. One can argue
that this has the effect of encouraging exports because exported
products are not subject to the VAT. Importantly, because these taxes
are indirect taxes such export adjustments are permitted under the GATT
treaties. Such indirect taxes are viewed as being imposed on the
ultimate consumer, rather than on the producer. Therefore, they are not
viewed as export subsidies.
In addition, it appears that having an income tax system which
exempts all foreign source income is also permissible. Such a system
would impose lower taxes on exports than on domestically sold goods
because income earned abroad would not be subject to tax. Many European
countries have adopted territorial tax systems.
One of the key arguments for a regime like the ETI is that it would
merely level the playing field for U.S. corporations selling abroad.
Because European producers are able to receive tax reductions on some
of the products they export, it seems U.S. producers should also
receive tax concessions on exports to prevent distortions in the
market.
Another set of rules which seems immune to challenge are the source
rules found in Section 863(b) of the Internal Revenue Code. These rules
define the source of income for the sale of property which is
manufactured in the United States and sold abroad. They are often said
to be export subsidies because they allow U.S. taxpayers to increase
their use of the foreign tax credits, which can decrease the tax paid
to the United States. However, because these rules are fundamental
source rules which apply both to imports and exports, they do not
constitute a special regime. These are the only source rules that apply
to products manufactured in one country and sold in another. Clearly,
it is necessary to define what the source of the income is in this
situation, and the approach the rules take, which generally results in
a half of the income being treated as foreign source income and half
U.S. source, is easily defensible. Hence, these rules should not run
afoul of the GATT treaties as interpreted by the WTO.
C. Inherent Conflict between ETI and Subpart F
The fundamental purpose of the anti-deferral regimes in the U.S.
tax code, such as subpart F, is to eliminate a taxpayer's ability to
avoid U.S. tax by shifting income to low tax-jurisdictions. Generally,
the U.S. allows income earned by foreign subsidiaries to be deferred
until the income is repatriated to the United States. The exceptions to
deferral are primarily limited to passive income and other types of
income that are easily manipulated. Active business income of a
controlled foreign corporation (CFC) is generally only subject to U.S.
tax where there is an insufficient economic connection with the
jurisdiction in which the CFC is organized.
On the other hand, the FSC and ETI regimes were intended to exempt
from U.S. taxation income from goods manufactured in or extracted from
the United States and sold abroad. Under the FSC regime, this required
an exception to the subpart F rules. These two important portions of
the U.S. system (Subpart F and the ETI) are in conflict. Conflicts like
this allow the Europeans to argue that the ETI and FSC provisions are
exception to our general patterns of taxation.
IV. Alternatives to the ETI Regime
The structure of the U.S. tax system makes it more difficult to
encourage exports than other systems. By basing our tax system on
income taxes which have, at least in principle, a worldwide reach, it
is difficult to draft provisions which do not run afoul of the GATT
treaties and which give our multinationals benefits comparable to those
enjoyed by European multinationals.
While, as discussed below, a number of possible solutions exist,
there are some approaches that clearly will not be approved by the WTO.
Merely increasing the amount of foreign content allowable for the
exemption, or any other proposal which only slightly alters the
provisions in the ETI rules, is unlikely to be ruled upon favorably.
Any attempt to replace the ETI regime will require a fundamental re-
thinking of the approach taken. The replacement cannot be something
which can be thought of as a special exemption or a ``loophole.'' It
needs to be something which is an integral part of the system. It will
have to apply to foreign corporations and other non-U.S. taxpayers with
the same force it applies to U.S. manufacturers.
The following are the basic alternatives:
A. Repeal of the ETI Provisions and Use the Revenue to Reduce Other
Taxes. The additional revenue raised by the repeal of the ETI could be
used for other purposes like repealing the Corporate AMT etc. While
this is the simplest response, it does not address the concerns which
created the DISC, FSC and ETI regimes, in the first place.
B. Adopt a Territorial System. This would seem to be allowed under
the GATT treaties. Furthermore, by defining U.S. source income as
products that are sold here, (i.e. retaining the 863(b) source rule or
something like it), this would reduce the tax on products which are
exported and would likely not run afoul of the GATT provisions as
interpreted by the WTO. I myself have argued for a territorial system
in the past.\1\
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\1\ Terrence R. Chorvat Ending the Taxation of Foreign Business
Income 42 Ariz. L. Rev. 835 (2000)
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C. Adopt a System that Involves a Significant Reliance on Indirect
Taxes (such as VATs). If we adopted a VAT that only applied to
consumption within the United States, (sometimes referred to as a
destination-based VAT) we would be able to exempt exported property
from these taxes. Such a change would involve a large restructuring of
the current federal tax system. While the response to the WTO ruling on
the ETI regime is very important, it seems that an issue which involves
between four or five billion dollars annually should not be the chief
reason for making a change as large as this.
D. Repeal or Significantly Alter Subpart F. If the Foreign Base
Company Sales and Services rules were repealed, much of the profit from
products produced in the United States and sold abroad could be
deferred (which amounts to a tax cut if the foreign subsidiary is
incorporated in a low-tax jurisdiction). U.S. businesses could sell the
products produced in the United States through foreign subsidiaries and
the profits allocated to the subsidiaries would not be taxed in the
United States until they are repatriated to the United States.
Currently, relatively little money is raised from the Foreign Base
Company Sales and Services provisions. As discussed above, these
provisions are fundamentally in conflict with the ETI provisions.
Repealing these rules is unlikely to run afoul of the GATT provisions
because it would apply to all transactions by U.S. subsidiaries whether
the products had a direct U.S. connection or not. If this alternative
is chosen, we could still retain the Foreign Personal Holding Company
provisions which tax passive income earned by controlled foreign
corporations. This approach would not have quite the same effect as ETI
because it would give tax benefits to U.S. multinationals to produce in
any of the high tax jurisdictions in which they operate.
E. Retain Subpart F, but Loosen the Manufacturing Exception to
Subpart F. One alternative would involve allowing foreign subsidiaries
of U.S. corporations to manufacture in the United States without being
treated as being engaged in a U.S. trade or business and without being
subject to the Foreign Base Company Sale and Services Income rules,
which would in either case result in the income being taxable in the
United States in the year in which it is earned. Products produced in
this fashion would not be subject to U.S. tax and would only be taxed
in the jurisdictions where the company is organized or a resident and
where the products are ultimately sold. In order to not violate the
GATT provisions, such a regime would have to apply to subsidiaries of
corporations headquartered in other countries with the same force as it
applies to subsidiaries of U.S. corporations. In conjunction with this
or in the alternative we could allow foreign corporations to use
contract manufacturers in the United States and allow such activities
to not be treated as a U.S. trade or business and to be treated as
manufacturing for purposes of the subpart F definitions. This would
imply overturning the ruling position of the I.R.S. announced in
Revenue Ruling 97-48.
None of these alternatives have are simple replacement for the ETI
regime. They all involve a change to the rules as they apply to all
taxpayers, not simply U.S. manufacturers.
Chairman McCrery. Thank you. Mr. McIntyre.
STATEMENT OF MICHAEL J. McINTYRE, PROFESSOR OF LAW, WAYNE STATE
UNIVERSITY, DETROIT, MICHIGAN
Mr. McIntyre. Thank you. I have a prepared statement that I
would like to submit for the record.
Chairman McCrery. Without objection. Is your microphone on,
Mr. McIntyre?
Mr. McIntyre. I believe it now is. Thank you.
I am here in part to make a plea for free trade. I was
invited to a panel back in 1975 when DISC legislation was being
considered. I said at that time that the DISC legislation was
inconsistent with free trade, that it would be so found by
GATT, and that even if it weren't, it would not be in the
interests of the United States to be promoting an export
subsidy. All theorists on free trade believe that tax subsidies
for exports and tax impediments to imports make countries
poorer.
If we want our country to be competitive in world markets,
we need to embrace free trade. I have heard a lot of rhetoric
today about free trade. But, when we get down to it, we have
people telling us that the United States should want a ``fair
advantage,'' or at least some advantage, over our competitors.
The implicit message we are getting is that we need to do
something special in violation of free trade to help our
economy and to help our businesses or we are going to end up as
a third world country.
I don't think we are at risk of being a third world
country. And if we were actually facing such a risk, there is
nothing we could do with a small subsidy of this nature that
would change that fate.
This is the strongest economy in the world. If people in
other countries were listening to the kind of worry about
competitiveness that we are hearing today they would be quite
shocked. They think we are formidable competitors.
All over the world, countries are wanting to emulate the
American success. We have just come out of a decade of enormous
growth, enormous vigor. And to have us be considering this
free-trade issue as if we were at the bottom of the heap or
just about to tumble off the top of the heap strikes me as
missing the mark entirely.
I am very pleased, however, to see that everyone who has
been involved in this discussion agrees that we cannot simply
let the situation with ETI stand. Everyone seems to agree that
this legislation, which was found to be in violation of our
international agreements, has to be repealed. So that is the
number one task, I believe, of the Congress--to get rid of this
legislation and to get rid of it as quickly as possible before
it sours our relationships with our trading partners.
There are other options, of course, that one might consider
in addition to the repeal of ETI. All of those options are more
complex, they take a lot of time, they involve tradeoffs, they
involve political battles over who pays the tax and who gets
the benefits.
Those battles are necessarily prolonged. All of the
proposals that I have heard in this discussion, both today and
in previous periods, have enormous effects on our State
governments. And I am sure that our 27 Republican Governors and
our 21 Democratic Governors and our independent Governors would
like to be heard on these issues.
These complex measures cannot be done quickly. We should
take this opportunity to immediately repeal a subsidy that is
in violation of our WTO agreement, and then in our leisure, we
can examine the range of options that are before us.
In considering options, I think that we have to put the
full set of options on the table, not simply that small set of
options that are particularly appealing to a few of our
multinational companies that have the ear of some people.
I think that we need to look at options that protect the
American economy, not simply American business. American
business is not synonymous with America. It is merely an
important part of America. We need to have tax rules that are
fair and reasonable and enforceable for our business interests.
But, we don't want to have taxes that are driven only by the
interests of business.
Our tax rules need to be driven by our concerns for the
well-being of Americans generally. And I think that when we
look at the full plate of options, what we would be looking for
is some simplification in our system and for more coordination
with our trade partners. When we look at trade issues, we
always look at them as a cooperative matter. When we look at
our income tax issues that related to trade, we also should
look at them in a cooperative manner. Thank you very much.
[The prepared statement of Mr. McIntyre follows:]
Statement of Michael J. McIntyre, Professor of Law, Wayne State
University, Detroit, Michigan
My name is Michael J. McIntyre, and I teach international tax and
various other tax courses at Wayne State University in Detroit,
Michigan. I thank the subcommittee for inviting me to participate in
this hearing. In the time allotted to me, I will explain why I believe
the United States should promptly repeal what the World Trade
Organization has found to be an illegal export subsidy. I also will
explain why I believe it best serves the interests of the American
people and the American economy for Congress to support free trade by
refraining from adopting any type of replacement for that subsidy.
History of U.S. Export Subsidies
The United States has provided a tax subsidy for exports since
1971. The subsidy was initially provided by granting tax deferral for
export income earned through a U.S. corporation that qualified as a
Domestic International Sales Corporation (DISC). In 1984, Congress
largely replaced the DISC subsidy with an subsidy for export income
channeled through a foreign corporation that qualifies as a Foreign
Sales Corporation (FSC). The FSC legislation was adopted in an attempt
to avoid conflicts with U.S. trading partners under the General
Agreement on Tariffs and Trade (GATT).
In 1997, the European Communities, with support from Canada and
Japan, challenged the FSC legislation before the World Trade
Organization (WTO), asserting that it constituted an impermissible
export subsidy. That FSC was an export subsidy was beyond debate. The
issue was whether the United States would be able to get the WTO to
accept certain technical arguments that the particular type of subsidy
was not inconsistent with the language of the GATT. A final decision
against the FSC subsidy was issued on February 24, 2000.
Congress responded in 2000 to the WTO decision against the FSC
legislation by repealing FSC and enacting a new export subsidy called
the Extraterritorial Income Exclusion Act of 2000 (ETI). ETI borrowed
many features of FSC, but it avoided those features of FSC that the WTO
had specifically cited as objectionable. Not surprisingly, the ETI
legislation was again challenged by the European Communities, this time
with support from Australia, Canada, India and Japan. The WTO again
rejected the U.S. attempt at subsidizing exports in a broad-gauged
opinion that evaluated the legality of ETI by reference to its
substance rather than its form.
Congressional Options
The Congress of the United States must now decide how it should
respond to the decision of the WTO. I suggest that Congress has the
following four options:
(1) Do Nothing. Congress can do nothing and simply allow the United
States to remain in violation of its international trade agreements.
This option would open the United States to sanctions by our trading
partners. More fundamentally, it would undermine the movement towards
free trade that the United States has championed for over half a
century.
(2) Support Free Trade. The most attractive option, from a public
policy perspective, would be to support free trade by repealing the ETI
provisions without any replacement. The virtues of free trade have been
well known at least since the publication of Wealth of Nations by Adam
Smith in 1776. Free trade--the removal of export subsidies and import
barriers--strengthens a nation's economy and lifts the living standards
of its workers. These benefits of free trade have been touted by
politicians from both of our major parties in every election I can
remember. As an added bonus, support for free trade and honoring our
international agreements will foster improved relations with U.S.
allies. Avoiding needless conflicts with our trading partners is
particularly important at a time when we must rely on them for support
in our efforts at combating international terrorism.
(3) Grandson of FSC. A third option, which is not really a
practical option at all, would be to develop some revised version of
ETI that would subsidize exports without violating the WTO agreements.
The game of disguising a trade subsidy as a normal part of the tax
code, however, is no longer winnable. The ETI legislation is skillfully
drafted. It adopts a mechanism for delivering a subsidy to exporters
that is export-neutral in form. It might even have been approved by
adjudicators in some forums. It had little chance of approval, however,
in a forum that is dedicated to upholding the substance of free trade
against the inevitable pressures from governments to obtain an unfair
trade advantage over their trading partners. It should now be clear
that the WTO is not prepared to uphold a U.S. export subsidy, however
well disguised it may be. Further legislative efforts at hiding the
subsidy will simply antagonize our trading partners.
(4) Radical Reform. The fourth option is to repeal ETI as part of a
plan to repeal or radically modify the corporate income tax. One
radical reform plan floated by some commentators is to adopt what they
characterize as a ``territorial'' tax as a replacement for the
corporate income tax. Another plan would substitute a broad-based
consumption tax for the corporate income tax. The United States would
not have a problem with the WTO if it repealed the corporate tax
completely, and the territorial system also would be acceptable to the
WTO as long as it was clear that it was not intended as a disguised
export subsidy. These radical proposals, nevertheless, are
disproportionate and inappropriate responses to the ETI problem, for
reasons discussed in detail below. They also would not be helpful in
dealing with the ETI problem unless they could be enacted quickly,
before the ETI problem provokes a trade conflict that would be harmful
to the U.S. economy and to U.S. interests abroad.\1\
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\1\ I have two reasons for believing that radical reform of the
corporate tax is unlikely in the near term. First, the radical reform
proposals are likely to attract serious opposition from one or both
political parties as their economic and political implications become
better understood by Congress. Second, the radical proposals, if
enacted in a revenue-neutral way, would shift tax burdens
significantly--increasing taxes on some taxpayers and lowering them on
others. I believe that Congress would find some difficulty in acting
swiftly to raises taxes on a large segment of the voting public.
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Option 2 is the free-trade option, and options 1 and 3 are the
anti-free-trade options. The case for adopting option 2 depends,
therefore, on the strength of the case for free trade. I set forth that
case below. I argue that the United States policy over the past half-
century of fostering free trade has enriched Americans and strengthened
the U.S. economy. I also argue that under the widely accepted theory of
free trade, export subsidies distort trade patterns, resulting in a
decline in worldwide welfare. Export subsidies do not produce, however,
a net increase in jobs or economic activity in the exporting country
even ignoring the likelihood that they would provoke retaliatory
measures. In brief, free trade makes America richer, and export
subsidies make us poorer.
The radical reform proposals that I have labeled Option 4 should
not be evaluated only or even primarily with respect to their potential
for dealing with the ETI issue. Those proposals should be accepted or
rejected--and I would hope rejected--based on their substantial impact
on the distribution of U.S. tax burdens generally, with the trade issue
being a relatively minor consideration.\2\
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\2\ In my view, these radical proposals have nothing to do with
genuine tax reform. As the Enron debacle illustrates, the starting
point for genuine corporate tax reform is to close off opportunities
for offshore tax avoidance and evasion. The effect of both radical
reform proposals, however, would be to enhance and legitimize those
opportunities.
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The only reason for considering the radical reform proposals in the
context of a discussion of ETI is the claim of their proponents that
enactment of one or the other proposal would stimulate U.S. exports. If
the radical reform proposals would stimulate exports, they become
variants of option 3. As a result, they are not an appropriate response
to the ETI issue because, according to the theory of free trade, they
would make America poorer rather than richer.
The radical reform proposals are also an inappropriate response to
the ETI issue for another reason, namely that they are unlikely to
actually stimulate U.S. exports. The impact on exports of income tax
concessions is a complex issue, which I address in some detail below. I
conclude that the impact of the radical reform proposals on exports is
likely to be negligible. I reach a similar conclusion with respect to
ETI itself. That is, I believe that income tax concessions directed at
profits derived from exports or from foreign activities are likely to
have little or no impact on the overall level of exports. Lobbyists
seeking to retain or replace ETI apparently agree, for it seems
unlikely that they would be working so diligently to preserve a tax
subsidy if most or all of the benefits of the subsidy were being passed
on to foreign consumers.
The Virtues of Free Trade
The primary purpose of the WTO is to promote and safeguard free
trade. In playing a major role in the establishment of the WTO, the
United States showed its commitment to free trade. It recognized that
some international institution is needed to get national governments to
give up their predilection to manage trade for the benefit of the few
and to allow the free market to operate as Adam Smith envisioned.
In the ETI case, the WTO has operated exactly as it was designed to
operate. It correctly labeled ETI as an export subsidy and determined
that the continued operation of ETI was inconsistent with U.S. treaty
obligations. Any other decision would have struck a blow for
protectionism and undermined the credibility of a major international
institution that serves America's long-term economic and political
interests and the long-term interests of its trading partners.
Some advocates of managed trade contend that ETI is necessary to
allow American companies to compete against foreign firms that are
obtaining export subsidies in their home country. They become vague to
the point of incoherence, however, when they are asked to identify
these foreign subsidies. If there are identifiable foreign subsidies,
the proper U.S. response is to point them out and bring an action for
relief to the WTO. The United States should not ignore the rule of law
and take unilateral actions contrary to our international agreements.
The precedent set by the WTO's decision in the ETI case should make it
quite easy for any member of the WTO to challenge successfully any
export subsidy that it is able to identify.
According to free-trade theory, export subsidies benefit the
recipients of the subsidies at the expense of the general population
and the national economy. If that theory is correct--and most
commentators believe it is--then the WTO decision against the U.S.
government will actually advance the best interests of the American
public and the American economy if it leads to the demise of ETI. That
is, the WTO decision can be a major victory for free trade and
therefore a victory for America if Congress simply repeals ETI.
As a simplified illustration of the case for free trade, assume
that Country A decides it wants to stimulate exports by providing a
subsidy of $25 per spool for each spool of copper wire that is
exported, provided that the exporter demonstrates that it lowered the
price of copper wire in the foreign market by the full amount of the
subsidy. XCo manufactures wire in Country A. It takes advantage of the
subsidy to lower the unit price of its wire in foreign markets by $25,
resulting in an increase in its exports. To meet the new demand, it
hires some additional employees in Country A. So far, the subsidy seems
to be working.
A trade subsidy, however, is unlikely to have just one effect.
Assume that YCo is a domestic company that manufactures electric motors
in Country A and sells them domestically and abroad. Copper wire is a
major component of an electric motor. YCo's price for wire, which it
buys from XCo, is not changed by the export subsidy. Its foreign
competitors, however, can now buy copper wire at the subsidized price.
As a result, they are able to reduce their price for electric motors in
Country A and in foreign markets, creating competitive problems for
YCo. As a result of the new competition, YCo experiences a reduction in
its domestic and foreign sales of motors and is forced to reduce the
number of employees at its production plant in Country A. Whatever jobs
were gained from the expansion of XCo's business might be lost from the
contraction of YCo's business. In addition, Country A is now paying the
bill for an export subsidy that probably has added no new jobs and
certainly has distorted normal trade patterns.
The above example may appear to be something of a special case. In
a world of floating exchange rates, however, an export subsidy is
likely to have negative effects on domestic production of unsubsidized
products. The reason is that an export subsidy is likely to cause an
increase in the relative value of a country's currency when currency
exchange rates are set by the market. That increase obviously would
affect trade flows. In general, the changes in trades flows would tend
to wash out any economic benefits that a country would hope to obtain
from pursuing a beggar-thy-neighbor trade policy.\3\
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\3\ When the DISC legislation was first under consideration in
1969, the value of the dollar was fixed as $32 per ounce of gold. When
DISC was adopted in 1971, however, the United States had replaced the
gold standard with a floating rate system. This change to floating
rates made DISC obsolete just as it was going into effect. See Michael
J. McIntyre, ``DISC After Four Years: Reassessment Needed,'' 3 Tax
Notes 9-14 (September 29, 1975) (Based on testimony as invited witness
before Ways and Means Committee, July 23, 1975).
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To illustrate the above point, assume that no companies in Country
A manufacture electrical motors or anything else using copper wire. In
that case, Country A would not have to be concerned that the export
subsidy for wire would harm its domestic industries directly. Because
of the currency-exchange effect, however, Country A almost certainly
would be harmed by the export subsidy. The subsidy, by increasing the
demand for the products of Country A in foreign markets, almost
certainly would increase the value of Country A's currency relative to
other currencies. As the following example illustrates, the expected
result of the higher exchange rate would be an increase in imports into
Country A and a loss of jobs in the businesses in Country A that make
products in competition with the new imports.
The facts of this example are similar to the facts in the example
above, with the additional facts that Country A uses the dollar as its
currency, and Country B uses the franc. The exchange rate before the
export subsidy for copper wire was one dollar for two francs. After the
subsidy was granted and exports of wire increased, the value of a
Country A dollar rose so that it now commands three francs. Country B
produces apples, which it sells for 30 francs a crate. The price of
apples in Country A is 14 dollars (28 francs at the pre-subsidy
exchange rate). Before the export subsidy caused the exchange rate to
change, apples produced in Country B were not competitive with apples
produced in Country A. After the exchange rate adjustment, however, a
producer in Country B that sold apples in Country A for 10 dollars a
crate could convert the proceeds into 30 francs. As a result, apples
produced in Country B are now competitive in Country A, and exports of
apples from Country B should be expected to go up. Producers of apples
in Country A would lose sales, and jobs in the apple business in
Country A would be lost.
In the above examples, the violation of free trade by Country A
produced a bad result, for it and the rest of the world, even without
any retaliation by Country A's trading partners. The worldwide economic
costs of Country A's conduct would be magnified many times if other
countries responded by erecting barriers to trade or by adopting their
own export subsidies. One of the major purposes of the United States in
helping to establish the WTO was to keep countries from making
themselves poorer by behaving like Country A. Another major purpose was
to prevent the almost inevitable disputes over trade practices from
escalating out of control.
Why the Radical Proposals Do Not Solve ETI Problem
There are two major proposals for radical reform of the corporate
income tax currently being floated. One is to convert the corporate
income tax into a ``territorial'' system. The basic idea is that U.S.
corporations would be exempt from tax on dividends, rents, royalties,
interest, and other receipts from their foreign affiliates, and they
would be able to more fully utilize foreign tax havens to avoid both
U.S. taxes and the income taxes imposed by our trading partners. I call
the territorial system ``Enron on stilts'' because of its clear
potential for promoting unbridled tax avoidance and evasion.\4\
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\4\ Some proponents of a territorial system assert, contrary to
fact, that Canada operates a territorial system. For a discussion of
the Canadian international tax system by a leading Canadian commentator
and a clear refutation of the arguments being advanced for a
territorial system, see Brian J. Arnold, ``Comments on the Proposed
Adoption of a Territorial Tax System in the United States,'' 25 Tax
Notes Int'l 1091-94 (March 11, 2002).
---------------------------------------------------------------------------
The tax revenue cost of moving to a territorial system would be
many, many times the tax savings from the repeal of ETI.\5\ As a
result, its adoption would require a sharp increase in other taxes or a
sharp increase in the budget deficit.
---------------------------------------------------------------------------
\5\ A detailed revenue estimate of adopting a territorial system is
not possible at this point, due in part to the lack of specificity
about the intended features of the system. Some idea of the costs can
be gotten by realizing that Enron enjoyed the benefits of a self-help
territorial system through mechanisms that would become perfectly legal
under a territorial system.
---------------------------------------------------------------------------
The other proposal for radical reform is to adopt some form of
consumption tax as a replacement for the corporate income tax. One
variant of this proposal is a European-style value-added tax (VAT). The
European VAT is a tax on domestic retail sales collected in stages from
manufacturers, wholesalers and retailers.\6\ Another variant is a
business activity tax (BAT), similar to the business-tax component of
the Hall-Rabuska flat tax.\7\ Both the VAT and the BAT have economic
effects similar to a retail sale tax. That is, the burden of a VAT or a
BAT would be passed on to consumers in the form of higher prices.
---------------------------------------------------------------------------
\6\ In Europe, the VAT is imposed in addition to a corporate income
tax.
\7\ This business activity tax was promoted by the Kemp Commission
in its 1996 report. Its appeal is due in part to the fact that it is
likely to be a hidden tax on consumers. Quite comically, the particular
form of value-added tax proposed by the Kemp Commission called for the
imposition of the tax on exports and the exemption of imports from the
tax. See Michael J. McIntyre, ``International Aspects of the Kemp
Commission Report,'' 70 Tax Notes 607-609 (Jan. 29, 1996), reprinted in
12 Tax Notes Int'l 417-420 (Feb. 5, 1996).
---------------------------------------------------------------------------
Advocates for these radical reform proposals obviously have agendas
that extend well beyond ETI. They attempt to link their proposals to
ETI by claiming that elimination of the corporate income tax on profits
earned abroad would stimulate foreign sales of goods and services
produced in the United States by making those goods and services
cheaper in foreign markets. This claim is unsupportable. The U.S.
corporate tax on foreign profits is not currently being paid by foreign
consumers, so its elimination would not lower the price of goods and
services in foreign markets.
To be sure, in some quarters it seems to be an article of faith
that the corporate income tax is passed on to consumers through higher
prices.\8\ There is little in the tax literature, however, to support
that belief. According to standard economic theory, the price of goods
and services in a market is set by supply and demand in that market.
The U.S. corporate tax paid by a U.S. corporation is highly unlikely to
affect significantly either the supply or the demand for goods and
services in foreign markets. Consequently, the tax would not affect the
price of those goods and services significantly.
---------------------------------------------------------------------------
\8\ In allowing U.S. corporations to claim a credit for foreign
income taxes, Congress has implicitly treated those corporations as
having paid the tax. If the tax is passed on to consumers, no credit
should be allowed. See Michael J. McIntyre, The International Income
Tax Rules of the United States, Lexis Publishing (2000) at ch. 5/G.2.
---------------------------------------------------------------------------
Consider, for example, PCo, a U.S. manufacture of children's
clothing that manufactures dresses in the United States for $10 and
sells them in France for $20. French, German, Dutch and Italian
companies are selling similar dresses for $20. Their cost of producing
a dress is also $10. Now suppose the U.S. Congress adopts a corporate
income tax that requires PCo to pay a tax of $3.50 (35% of $10) on the
profits it earns on each dress sold in France. The officers and
shareholders of PCo are unhappy with the tax and would like to pass
some or all of the tax on to consumers. PCo can attempt to do so by
advertising its dresses for a price above $20.\9\ If it refuses to sell
the dresses for the market price of $20, however, it will end up making
no sales at all in the French market because it cannot control the
supply or demand for dresses in that market. Because it is still making
a good profit on its sales of dresses in France at $20, it has no
incentive to forgo those sales.\10\
---------------------------------------------------------------------------
\9\ To fully pass on a 35% corporate income tax, PCo would need to
sell its dresses for $25.39 each. That amount is determined as follows:
If N equals the pre-tax profit on a dress and $10 is the after-tax
profit, then N--(35% of N) = $10. Thus N = $10/0.65 = $15.3846, and the
price necessary for PCo to bear no net tax burden would be $15.39 pre-
tax profit + $10 cost = $25.39.
\10\ The example is intended as a counter to the claim made by some
supporters of export subsidies that U.S. corporate taxes paid with
respect to profits on export sales are routinely passed on to foreign
customers. The incidence of the corporate income tax is a complex and
controversial issue. My own view is that the tax generally is paid by
equity investors, although some portion of the tax may be shifted to
workers and even to consumers under some circumstances.
---------------------------------------------------------------------------
An argument I have heard on occasion in support of the proposition
that an income tax cut on export profits would result in lower prices
for exports is that business executives set their prices so as to
obtain a target after-tax profit. According to that argument, if the
tax rate is cut, then business executives would cut their prices so as
to maintain the same after-tax rate of return. I have not seen any
empirical support for the argument. Its implausibility is illustrated
by the following example.
Assume that Country A has an income tax with a top marginal rate of
39.6 percent. Among those paying at this rate are some wealthy doctors
and lawyers. The legislature of Country A cuts the top marginal rate to
30 percent, resulting in a big tax reduction for the doctors and
lawyers. How likely is it that the doctors and lawyers will respond to
the tax rate cut by lowering their prices for medical and legal
services in the hope of attracting more customers? I expect that few
people would anticipate that the price for medical and legal services
would be dropped. There is little reason to believe, moreover, that
corporate executives seeking to maximize their profits would be more
inclined than the doctors and lawyers to share their new-found tax
benefits with their customers.
Conclusion
Of the four options available to Congress, only the second option--
repeal of ETI without any replacement--is consistent with free trade
and offers Congress an honorable and effective solution to its ETI
problem. It is mistaken to think that some drafting wizard can come up
with a new export subsidy that will reward the current beneficiaries of
ETI and still pass muster with the WTO. It is equally mistaken to think
that some embryonic plan for radical tax reform will suddenly solve the
problem. The clear reality is that ETI must go if the United States is
to satisfy its obligations under international law and maintain its
position as a leader of the free-trade movement. It is equally clear
that any alternative mechanism for stimulating exports, even one that
is acceptable to the WTO, will simply distort trade patterns without
increasing U.S. jobs or strengthening the U.S. economy. The best course
of action for Congress is to stay the free-trade course that the United
States chartered more than a half-century ago.
Although free trade can provide many economic benefits, it is not a
free lunch. It can bring dislocations to communities and to workers
when established businesses are unable to compete with foreign-based
competitors. Many proponents of free trade, myself included, support
the use of government authority to ameliorate hardships resulting from
robust international competition. Programs that provide job retraining,
unemployment benefits and community support are all consistent with a
commitment to free trade. Free trade provides major economic benefits
to the U.S. economy, and those benefits should be shared equitably.
Fortunately, the revenue generated from repeal of ETI is fully adequate
to deal with the short-term dislocations of American workers that may
result from that repeal.
A repeal of ETI presents Congress with a political dilemma. The
costs to U.S. consumers and U.S. companies from the ETI export subsidy
are substantially greater in aggregate than the benefits to the users
of ETI. Those costs, however, are often hidden and diffused. In
contrast, the benefits to the companies that use ETI are palpable and
large. For example, a handful of U.S. airplane manufacturers garnered
hundreds of millions of dollars in tax savings from FSC and presumably
are benefiting similarly from ETI. I do not pretend to have a solution
to this political dilemma. The best that those of us in the academic
community can do is to make the case for repeal of ETI as forcefully
and clearly as we can, with the hope that our defense of free trade
will be helpful to Congress in resisting the inevitable political
pressures for protectionism.
Chairman McCrery. Thank you, Mr. McIntyre.
Well, I think what I have heard from all three of you is
that in your opinion, it is impossible to exactly replicate the
FSC or the ETI in terms of those American companies that will
be advantaged under the current system; is that correct?
Ms. Garrett-Nelson. I think that is correct, Mr. Chairman.
It would be impossible to replicate the essential features of
ETI, the targeted prescribed tax rate reduction for U.S.
exports is clearly not permissible under the Appellate Panel
opinion.
Mr. McIntyre. I agree with that fully. I would also say
that it not be in the interests of the United States and the
U.S. economy to try to replicate it, even if it were possible.
But, I certainly agree it cannot be done consistent with our
international obligations.
Mr. Chorvat. I also second that. Any real attempt to try
and replicate it I think is only going to irritate the WTO,
because they will see through what we are trying to do. And
they will rule against us and maybe even give us greater
sanctions.
Chairman McCrery. Mr. McIntyre, I agree with your favor of
free trade. And I admire your saying so.
Mr. McIntyre. Thank you.
Chairman McCrery. However, I don't think I agree with your
conclusion that the ETI or FSC has nothing to do or should have
nothing to do with our trade situation. And giving our domestic
companies a level playingfield in the arena of free trade.
Mr. McIntyre. It was not my intention to suggest that ETI
or its equivalents had no effect on the particular companies
that were trying to export. In large measure, I think that the
tax benefits were not passed on to foreign consumers by way of
lower prices, and, therefore, they had very little effect on
total production in the United States.
I certainly agree that ETI and FCS were of assistance to
U.S. exporters, probably reduced their capital costs to some
degree. But, the problem is that if you provide a stimulus for
exports and it actually works in increasing exports, there is a
currency exchange affect. That always happens.
What that means is that imports now become cheaper. So if
we have a business in the United States that is absolutely
competitive right now making bread, and suddenly we have
changed the exchange rate so that Canadian bread can come over
here at a lower price, we have helped, perhaps, our aircraft
industry with the export subsidy, but we have also hurt our
bread industry.
The point about free trade is that there are all of those
tradeoffs. Any benefit that you get for one industry you are
almost certainly going to lose in another industry.
Chairman McCrery. I don't disagree with that. And we all
know that there are great many things that affect exchange
rates, and we can't control all of those things. But what we
can control is our own tax system. If we know that our domestic
manufacturers who want to take advantage of foreign markets by
selling in those markets are having to imbed in the cost of the
product to the ultimate consumer a tax that we impose that
their foreign competitors are not having to bear because of
their nation's tax system, it seems to me we would want to
address that.
Mr. McIntyre. That is a very clear statement of the issue,
Congressman, and I appreciate that. Let me give you a couple of
points on that. First, Australia was cited a little bit earlier
as a country without a value-added tax. They very recently
adopted one. No one thinks this has helped their exports. We
should look at that. I think the Committee ought to have
someone on the staff talk to some people involved in Australian
government on that issue. I think that you will see that it is
not the view of the Australians that adding this tax changed
their export position at all. That is one part of the answer.
The second point is, I don't think I agree with the
economic theory that you implied--that was embedded in your
comment--that the corporate tax is passed on to consumers in
the way of higher prices.
I think that the price of goods in foreign markets is
determined by supply and demand. The U.S. corporate tax
generally has no effect either on the supply or the demand in
foreign markets, and, therefore, it has very little to do with
foreign prices. For the most part, the corporate tax is
absorbed in lower profits which is the intent, of course, of a
profits tax.
Chairman McCrery. Well, we will have just have to disagree
on that. There is no question in my mind that the level of
taxation that a corporation has to pay is reflected, to some
extent, in the price that they have to charge for the product.
You are right, there are a great many other factors that
determine the price that the market will bear.
But, it just may be that because of the price that the
market will bear, our producers are unable to compete because
they can't sell their product at a profit at the price that the
market will bear there.
Mr. McIntyre. It is not my place, of course, to ask you a
question. But, rhetorically, we just cut taxes on some high
income people and some middle income people as well. But let's
look just at the high income people. Some doctors received a
substantial tax reduction. Is it your expectation that this tax
cut has been reflected in lower fees that doctors are now
charging?
Chairman McCrery. That could happen. But it could also
happen that they would consume more and create more jobs. So
there could be a good result in any number of ways by that tax
cut. I thank you for asking that question.
Mr. Chorvat or Ms. Garrett-Nelson, do you have any comment
on this discussion, before I go to Mr. Neal?
Ms. Garrett-Nelson. Well, I don't know. Should I comment on
the Australian VAT tax system? I would agree with you on that.
I would take issue with you and I think--I am not an economist
and never want to be one. But I think some economists would
also disagree with you, though, on the correlation or the
degree to which there is a correlation between exchange rates
and exports.
And I read something recently, I think by Huffbauer
suggesting that that view has been somewhat discredited. But I
think your point, though, that we can agree on was that all
options, legislative options should be viewed and reviewed at
this time. I would strongly disagree that the ETI provisions
should be repealed before the Congress determines that there is
an appropriate legislative solution to replace it.
Chairman McCrery. Mr. Chorvat.
Mr. Chorvat. Just one comment on essentially the incidence
of the corporate tax. In other words, who is really paying the
tax. That is one of the most knotty empirical problems that--
the odds are that it is probably allocated amongst consumers
and labor and capital. Some of it--we don't really know how
much, but they probably think some of it.
Chairman McCrery. Thank you. Fortunately we don't have an
economist on this panel who would take the time to explain that
to us.
Mr. Neal.
Mr. Neal. Thanks, Mr. Chairman.
Mr. McIntyre just three easy questions for you. Isn't it
true that no major developed nation has a pure territorial tax
system?
Mr. McIntyre. No country that I know of has a territorial
system, as I have heard it described today. Certainly some of
the discussion I have heard has suggested that Canada, for
example, has a territorial system. That is a substantial
misstatement of the Canadian system. It has some elements that
some might properly be described as territorial, but it is
essentially a global income tax system.
And an income tax by its very nature is a global tax--an
origin tax and not a territorial tax.
Mr. Neal. Let me follow up on that. Isn't it true that a
territorial system is of no benefit to the U.S. companies with
only domestic operations?
Mr. McIntyre. Yes. Well, I would have to give a qualified
yes to that. A territorial system, as I have seen it described,
and I am not being cute on that, it is just that there is a
variety of territorial systems out there, does create a lot of
opportunities for tax advance. So I think even a purely
domestic company would almost certainly set up offshore leasing
arrangements and the like to substantially reduce its U.S.
source income when a territorial system.
So I would say that a domestic company, a purely domestic
one, might engage in some forms of tax avoidance that we would
find inappropriate and would cost the government some revenue,
but the territorial system would certainly not improve its
economic performance.
Mr. Neal. Is it possible that under a territorial tax
system that some companies actually might have a higher tax
burden than they do now?
Mr. McIntyre. Again, that would depend on the territorial
system. If we were having a territorial system that was very
strict on not allowing deductions that related to foreign
source income, some companies would pay higher taxes. There are
lots of ways that one could design a territorial system that,
for some taxpayers, would result in substantially a higher tax
burden.
But, again, the impact would depend on the technical rules
that were designed. In a paper that my colleague here, Mr.
Chorvat, wrote sometime ago looking at a territorial system, he
tried to keep some elements of anti-avoidance rules in the
system. And that is a commendable thing if you are going to
adopt such a system.
On the other hand, I see from the testimony today Professor
Chorvat was suggesting that Congress might manipulate the
source rules so that some U.S. source income--what we would
generally think of as U.S. source income--would not be taxed.
So if you are going to manipulate the source rules so that a
manufacturer in the United States doesn't produce U.S. income
for us to tax, then, of course, the territorial system would be
a very substantial drain on revenue and wouldn't raise taxes on
people.
So you have to look to see the details of the particular
proposal. But, a genuine effort at fully taxing territorial or
U.S. source income would very likely raise taxes on some
taxpayers.
Mr. Neal. In fairness, let me ask the other panelists if
you would like to comment.
Ms. Garrett-Nelson. I am sorry. I was trying to follow your
questions. And when Professor McIntyre started talking about
tax avoidance I thought I perhaps didn't hear the question
correctly. But he is correct that no two countries have the
same type of territorial system. And it would depend entirely
on how it is structured.
I would point out that the issues that would determine
results like whether tax liability would be higher would depend
entirely on the kinds of choices that are made, including the
level of anti-deferral rules that might be employed in the
context of such a system.
And those are the very same decisions that could be made
within our current system. The underlying issues are the same.
The source of income would be very important, for example. And
you would face the same issues whether we have a territorial
system or our current worldwide system.
Mr. Neal. Okay. Mr. Chorvat.
Mr. Chorvat. Actually in the article that Professor
McIntyre was referring to, I basically argued that the
difference between a territorial system and the system that we
have now effectively for most U.S. multinational corporations
isn't all that great for most of them. And that we would still
have to have rules essentially like what we have now to get rid
of the antiabuse--to prevent abuse so that a pure territorial
system--very few, if any, countries have, and I don't think we
would have a pure territorial system.
Mr. Neal. Thank you all very much.
Chairman McCrery. Mr. Brady.
Mr. Brady. Thank you, Mr. Chairman. Actually I agree with
Professor McIntyre. There are a number of companies that don't
pass their corporate taxes down to the consumers. I think we
call them failed businesses. Overhead is overhead.
I hear consensus about the fact that it is not possible to
replicate the ETI regime in a way that is WTO compliant. So it
is important not only to know what to do, which is to bring
about real change, but what not to do. I know that each of you
have looked at and rejected a number of proposals that we are
going to hear about for just tinkering. Can you share some of
the proposals that you think will come to Congress to be
considered as a tinkering and what you find objectionable to
them?
Ms. Garrett-Nelson. Well, I am not prepared to share
conclusions about particular proposals. But, I can say that
under the legal analysis in the Appellate body report, it is
clear that whatever is put in place of ETI, assuming that that
is the route the Committee goes down, much more economic
substance will be required, or I should say, more substance
would be required than has been required under the DISC or the
FSC or ETI.
Even under a Footnote 59 approach, for example, it is clear
that a requirement for export transactions that arms-lengths
pricing be used, would mean that something would actually have
to occur overseas. Some value would have to be maintained
overseas in a way that is not required under current law.
And for that reason, we are clearly talking about going
beyond what current law requires pure exporters to do.
Mr. Brady. Great. Thank you. Mr. Chorvat.
Mr. Chorvat. Yeah, just to sort of amplify that a little
bit, if something is done it is going to have to be something
that would also permit tax advantages, I guess in the most
broad sense, to products which are entirely produced overseas
and have nothing to do with what occurred here, I think that is
part of what is going on is that we were giving tax advantages
for things that were, to some degree, produced here and were
used overseas.
Whatever happens, if it is going try to be compliant with
the WTO, is not going to have to be focused on exports per se,
but on something else, possibly in connection with the United
States or being foreign sourced or something like that. But it
cannot be something which has the word ``export'' in it or
anything that could arguably be exports.
Mr. McIntyre. I would agree with that assessment that
anything that was seen as providing a benefit primarily to U.S.
businesses engaging in export activities would have some issues
with the WTO. That is, anything that I would think that this
Committee would be interested in doing in this area as a
replacement for ETI would create a problem. But as was noted
earlier, we have only had a few opinions from the WTO. I think
we have got one clue, and that is that if the WTO thinks that
this latest legislation is a runaround, we will lose. I thought
we would lose with ETI, even though I admire the drafting skill
of its authors. I was very confident that we would lose, and so
told my students, because it seemed to me that the WTO's
message was not that it had this little technical problem with
FSC, it was that the WTO would not permit free trade to be
undermined. That is, the WTO did not want to be the body that
undermined free trade.
The Appellate body was saying that free trade is important
to us, and we will make decisions based on whether we think
they further free trade. I think that there was no doubt that
they felt, and many others felt, and virtually everyone outside
the United States felt, that the prior FSC legislation was
inconsistent with free trade.
Mr. Brady. I see my time is up. Thank you, Mr. Chairman.
Thank you, members of the panel.
Chairman McCrery. Thank you Mr. Brady. And I want to thank
all of the members of the panel for your excellent testimony
and responses to our questions and for your excellent questions
also.
Mr. McIntyre. Thank you very much.
Chairman McCrery. We hope you will continue to work with us
as we try to get through this.
Mr. McIntyre. I am sure I will, and I am sure other
panelists will be happy to do that.
Chairman McCrery. Thank you very much. Before the Committee
adjourns, I would like to, without objection, introduce for the
record the statement of my colleague from New York, Mr.
McNulty, who unfortunately was ill today and had to miss the
Subcommittee hearing. And with that, the hearing is adjourned.
[The statement of Mr. McNulty follows:]
Statement of the Hon. Michael McNulty, a Representative in Congress
from the State of New York
Historically, there has been a broad bipartisan commitment to
preserve the Foreign Sales Corp. (FSC) tax code provision and later the
extraterritorial income (ETI) regime. We have worked together on the
FSC-ETI issue in the past and I hope that we will continue to do so in
the future.
I believe that the Administration should take the lead on this
important issue just as prior Administrations have done. We had the
opportunity to hear from officials from the Treasury Department and
U.S. Trade Representative Office on this issue during a full Committee
hearing on February 28, 2002. It is now the time for the Administration
to develop a strategy for resolving this issue.
It is clear that we must respond to the World Trade Organization
(WTO) ruling. However, the right solution is not an obvious one. As is
often the situation, generalized or theoretical solutions may sound
good, but the ``devil is in the details.'' I look forward to the
witnesses' discussion of the direction this Committee may take in the
coming weeks.
Finally, I would suggest that the Committee Chairman and others not
use the FSC-ETI controversy as an opportunity to quickly push-through
proposals that would fundamentally alter our corporate income tax
system. There is no consensus on a proposal to repeal the corporate
income tax and substitute in a consumption tax, nor is there a
consensus to limit our corporate income tax only to activities in the
United States.
Such alternatives merit thorough evaluation of the potential impact
on U.S. competitiveness worldwide and whether this action might result
in creating unintended incentives for U.S. companies to move operations
overseas. As time has proven, it is unlikely that the Congress could
act on such proposals any time soon and the World Trade Organization is
poised to issue its determination of sanctions at the end of this
month.
I look forward to the expert testimony we will hear today on these
and related issues. And, of course, I want to thank Subcommittee
Chairman McCrery for setting up this important series of hearings.
[Whereupon, at 11:45 a.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of Stephen D. Cifrulak, Jr., Sewickley, Pennsylvania
I. EXECUTIVE SUMMARY:
On January 14, 2002, an Appeals Panel of the World Trade
Organization (WTO) held that the Foreign Sales Corporation (FSC) Repeal
and Extraterritorial Income Exclusion Act of 2000 (P.L. 106-519) is
inconsistent with international trade agreements. As a result, it is
expected that, on or around June 17, WTO arbitrators will impose
sanctions against the US in an amount less than $4 billion, but
probably more than $1 billion. The EU, however, is not expected to
immediately impose sanctions because to do so might negatively impact
EU businesses (and possibly initiate a US-EU trade war.) Thus, the EU
may agree to a 2 to 3 year ``cease-fire'' . . . provided that the US
works in ``good faith'' to resolve the issue on a long-term basis. For
that reason, on April 8, the EU requested a ``road map'' from the US
detailing how it plans comply with the WTO ruling. The House Ways and
Means Committee then held a public hearing on April 10 to discuss
various options for changing America's extraterritorial income (ETI)
regime. In that hearing, virtually every commentator agreed that ``it
will not be possible to draft a single replacement regime that complies
with the trade obligations of the United States and replicates the tax
benefits of the ETI statute.'' I respectfully disagree with such
commentary. Indeed, the purpose of this paper is to provide a ``road
map'' of at least one ``good faith'' measure that the US can pursue in
order to preserve its export benefits.
In short, this paper will hopefully demonstrate that, while the
WTO's interpretation of footnote 59 may effectively preclude ETI
reform, it nonetheless seems to re-open the door for continued FSC use.
After all, everyone seems to have forgotten that the WTO has never
specifically interpreted footnote 59 in a FSC-only context. Rather, the
WTO actually ``decline[d] to examine the US argument that the FSC
measure is a measure to avoid double taxation within the meaning of
footnote 59'' because the WTO said that the US had ultimately failed to
properly raise the matter as an affirmative defense in the original
suit. As such, it may be premature for commentators to proclaim that
``it will not be possible to draft a single replacement regime that
complies with the trade obligations of the United States and replicates
the tax benefits of the ETI statute.'' An alternate solution might be
for the US to now apply the WTO's interpretation of footnote 59 back to
the old FSC regime in order to see if any conforming modifications can
be made. If this is done, then this paper suggests that the US may find
additional innovative ways to solve some of its other international tax
problems (such as deferral, corporate inversions, Subpart F abuse, and
various tax avoidance schemes.)
II. FOOTNOTE 59
(1) Background/Explanation
Footnote 59 of the SCM Agreement provides an exemption for measures
taken to avoid the double taxation of foreign-sourced income. This is
true even if the measure is determined to be an ``export-contingent
subsidy'' (such as was determined for both FSC and ETI benefits).
The standard of analysis for determining if a Member State might
prevail with a footnote 59 argument is that, the WTO must determine
that: \1\
---------------------------------------------------------------------------
\1\ See Sec. 8.80 of the WTO Panel report entitled ``United
States--Tax Treatment for ``Foreign Sales Corporations''--Recourse to
Article 21.5 of the DSU by the European Communities.'' 20 August 2001.
Document # WT/DS108/RW.
1. The Act is a measure to avoid the double taxation of
foreign-source income within the meaning of the [last] sentence
of footnote 59 of the SCM Agreement as an exception to Article
3.1(a); and that,
2. the [last] sentence of footnote 59 falls within the scope
of footnote 5 of the SCM Agreement.
In relation to requirement 2, the WTO ``found that [since] the
[ETI] Act does not fall within the scope of the fifth sentence of
footnote 59, [it did] not believe that it [was] necessary to reach the
issue of whether the fifth sentence of footnote 59 also falls within
the scope of footnote 5 of the SCM Agreement.'' \2\ In any case, the EU
ultimately stipulated that it saw ``no reason to contest that the last
sentence of footnote 59 may be an exception to Article 3.1(a).'' \3\ As
such, requirement 2 seems to be a moot point.
---------------------------------------------------------------------------
\2\ Id. at Sec. 8.108.
\3\ Id. at Sec. 8.77.
---------------------------------------------------------------------------
Conversely, in interpreting requirement 1, the WTO focused on three
main terms in both its initial ETI-Panel Report,\4\ and in its
subsequent ETI-Appeals Report \5\--``Avoid'', ``Double Taxation'', and
``Foreign Source Income''--which were defined as follows:
---------------------------------------------------------------------------
\4\ The original WTO Panel report versus ETI. Entitled ``United
States-Tax Treatment for ``Foreign Sales Corporations''--Recourse to
Article 21.5 of the DSU by the European Communities. Report of the
Panel.'' 20 August 2001. Document # WT/DS108/RW.
\5\ The subsequent WTO Appeals Panel report versus ETI. Entitled
``United States-Tax Treatment for ``Foreign Sales Corporations''--
Recourse to Article 21.5 of the DSU by the European Communities. Report
of the Appellate Body.'' 14 January 2001. Document # WT/DS108/RW (AB-
2001-8).
------------------------------------------------------------------------
``ETI-Panel ``ETI-Appeals
Term Report'' Comments Report'' Comments
------------------------------------------------------------------------
``Avoid''....................... The The
purpose of the avoidance of
measure (or at double taxation
least one of its is not an exact
purposes) must be science. Indeed,
to avoid (i.e. the income
``prevent'' or exempted from
``obviate'') the taxation in the
double taxation State of
of foreign-source residence of the
income. (Sec. taxpayer might
8.94). not be subject to
We do not a corresponding,
view footnote 59 or any, tax in a
as requiring that ``foreign''
a measure ``to State. Yet, this
avoid'' the does not
double taxation necessarily mean
of foreign-source that the measure
income must avoid is not taken to
double taxation avoid double
entirely, taxation of
exclusively or foreign-source
precisely. income. Thus, we
However, we agree with the
consider that the panel, and the
relationship United States,
between the that measures
measure and its falling under
asserted purpose-- footnote 59 are
i.e. ``to avoid not required to
the double be perfectly
taxation of tailored to the
foreign-source actual double tax
income . . .''-- burden. (Para.
must be 146)
discernable . . .
[in relation to]
the overall
structure,
design, and
operation of the
Act in the
broader context
of the US tax
system. (Sec.
8.95).
``Double Taxation''............. The term ``double
``double taxation'' occurs
taxation'' refers when the same
to the situation income, in the
where the same hands of the same
income is taxed taxpayer, is
in more than one liable to tax in
jurisdiction. different States
(Sec. 8.92). (Para. 137)
``Foreign Source Income''....... . . . it In our
is not clear to view, ``foreign
us that the term source income''
has obtained a in footnote 59 to
universally the SCM Agreement
agreed upon refers to income
special meaning . generated by
. [and] no such activities of a
definition or non-resident
meaning has been taxpayer in
included in the ``foreign'' State
SCM Agreement as which have such
a common links with that
understanding State so that the
among WTO income could
Members. properly be
Therefore . . . subject to tax in
we do not impose that State.
a single rigid (Para. 137)
definition or
interpretation of
the term
``foreign-source
income'' nor do
we import into
the WTO Agreement
any definition of
the term that may
exist in other
international
instruments or
fora. Nor are we
of the view that
the meaning of
the term
``foreign-
source'' as used
in footnote 59
need necessarily
be determined
purely by
reference to the
domestic laws of
the Member
invoking the
footnote. . . .
We understand the
term ``foreign
source income''
as used in
footnote 59 to
refer to certain
income
susceptible to
``double
taxation''. (Sec.
8.93).
------------------------------------------------------------------------
Based on the above interpretations, the WTO expressly stated that
its test for analyzing compliance with footnote 59 will ultimately
hinge on ``whether legislators concerned with avoiding the double
taxation of foreign-source income might reasonably have been expected
to draft legislation such as the Act.'' \6\ This test is important
because, as the recent House Ways and Means Committee hearing revealed,
many commentators seem to agree that:
---------------------------------------------------------------------------
\6\ ETI-Panel Report. Id. at Sec. 8.106.
A footnote 59 approach could be used in the context of
legislation that explicitly confers an (otherwise prohibited)
export subsidy, or in combination with amendments to rules of
general application. In either case, however, the ability to
replicate the benefits of the ETI regime would be circumscribed
by the AB Report's definition of ``foreign source income'' and
the related requirement that arm's length pricing be used to
allocate income between foreign and domestic sources.'' \7\
(Emphasis added.)
---------------------------------------------------------------------------
\7\ Statement of LaBrenda Garrett-Nelson. Partner, Washington
Council Ernst & Young On the Extraterritorial Income Regime. Hearing
before the Subcommittee on Select Revenue Measures. Committee on Ways
and Means. On April 10, 2002. Page 5.
As highlighted above, the relevant question now seems to be whether
``the ability to replicate the benefits of the FSC regime would be
circumscribed by the AB Report's definition of ``foreign source
income'' and the related requirement that arm's length pricing be used
to allocate income between foreign and domestic sources.'' After all,
the WTO has never specifically interpreted footnote 59 in a FSC-only
context. Instead, the WTO actually ``decline[d] to examine the US
argument that the FSC measure is a measure to avoid double taxation
within the meaning of footnote 59'' \8\ because the WTO said that the
US had ultimately failed to properly raise the matter as an affirmative
defense in the original suit.
---------------------------------------------------------------------------
\8\ See Para. 103 of the subsequent WTO Appeals Panel report versus
FSC. Entitled ``United States--Tax Treatment for ``Foreign Sales
Corporations''--Report of the Appellate Body.'' AB-1999-9. (24 Feb
2000).
---------------------------------------------------------------------------
It therefore seems to be premature for commentators to proclaim
that ``it will not be possible to draft a single replacement regime
that complies with the trade obligations of the United States and
replicates the tax benefits of the ETI statute.'' \9\ After all, now
that the WTO has more clearly interpreted footnote 59, a better course
of action might be to apply this interpretation back to the old FSC
regime in order to see if any conforming modifications are necessary
concerning (1) the definition of ``foreign source income''; and/or (2)
the requirement for arm's length pricing.
---------------------------------------------------------------------------
\9\ Id. at Page 10.
---------------------------------------------------------------------------
(2) Criteria for Determining Footnote 59 Compliance in a FSC-only
context
As previously noted, the WTO Appeals Panel Report for ETI states
that:
In our view, ``foreign source income'', in footnote 59 to the
SCM Agreement, refers to income generated by activities of a
non-resident taxpayer in a ``foreign'' State which have such
links with that State so that the income could properly be
subject to tax in that State.\10\
---------------------------------------------------------------------------
\10\ ETI-Appeals Panel report. Id. at Para. 137.
This statement is significant because, under the old FSC regime,
there was in fact a ``link with a foreign State'' via a separate entity
(i.e., the FSC). In addition, these links were such ``so that the
[FSC's] income could properly be subject to tax in that [foreign]
State.'' In practice, however, most foreign states did not ultimately
choose to tax FSC income. Instead, they levied an annual registration
fee of a fixed amount against the FSC. The more important point,
however, is that these foreign states clearly could have taxed FSC
income if they had so desired and therein lies the first hurdle
concerning FSC compliance with footnote 59. For example, if a given
foreign State did choose to tax FSC income, then the FSC rules are
clearly deficient in that they do not allow for a corresponding US
foreign tax credit. As a result, the FSC rules may not be viewed by the
WTO as a means of preventing ``double taxation.'' (After all, as
previously noted, the WTO's test for determining footnote 59 compliance
is ``whether legislators concerned with avoiding the double taxation of
foreign-source income might reasonably have been expected to draft
legislation such as the Act.'') \11\
---------------------------------------------------------------------------
\11\ ETI-Panel Report. Id. at Sec. 8.106.
---------------------------------------------------------------------------
As for the second problem cited by commentators--``that arm's
length pricing be used to allocate income between foreign and domestic
sources''--the FSC regime, once again, seems to be guilty as charged.
For example, in the original FSC-only Appeal, the WTO noted that:
There is no limitation on the amount of exempt foreign trade
income that may be earned by a FSC. Therefore, the legal
entitlement that the FSC measure establishes is unqualified as
to the amount of export subsidies that may be claimed by FSCs.
There is, in other words, no mechanism in the measure for
stemming, or otherwise controlling, the flow of FSC subsidies
that may be claimed.\12\
---------------------------------------------------------------------------
\12\ Summarized from the subsequent WTO Appeals Panel report versus
FSC.
In the light of footnote 59, this original FSC-only argument now
seems to be a moot point. After all, as previously noted, footnote 59
of the SCM Agreement provides an exemption for measures taken to avoid
the double taxation of foreign-sourced income. This is true, for
example, even if the measure is determined to be an ``export-contingent
subsidy. Seemingly then, the actual amount of the subsidy is probably
irrelevant . . . provided, of course, that the measure is otherwise in
compliance with footnote 59.
Nonetheless, in its ETI-Appeals Report, the WTO further refined its
argument concerning the need for arm's length pricing in a footnote 59
context by specifically noting that:
Related parties are able to ``sweep into'' the calculation of
QFTI income from purely domestic transactions, involving in
that example domestic-source manufacturing income. In the
absence of this provision, the separate transactions between
the manufacturer and related distributor, and between the
distributor and unrelated foreign buyer, would have operated as
a means of separating out some domestic-source and foreign-
source income in those separate transactions. In other words,
the domestic source income in the first transaction would not
be included in the calculation of QFTI.\13\
---------------------------------------------------------------------------
\13\ ETI--Appeals Panel report. Id. at Para. 167.
If the US therefore attempts to revive FSC use, it is clear that
certain modifications will be required, but unlike ETI (which does not
utilize a separate entity), these modifications will not necessarily be
``deal killers''. Rather, they might actually provide the US with
creative alternatives for solving some of its other international tax
problems (such as deferral, corporate inversions, Subpart F abuse, and
various tax avoidance schemes.)
III. CONCLUSION: A ``ROAD MAP'' FOR FSC COMPLIANCE
Based on the above analysis, I therefore suggest that the US
immediately provide the EU with the following ``road map'' that
outlines at least one ``good faith'' measure that the US can pursue to
preserve export benefits:
1. The ETI Statutes will be repealed as soon as possible; at
the same time, however,
2. The FSC Statutes will be re-instated, but with the
following modifications . . .
a. All restrictions prohibiting the application of US
foreign tax credits to FSC income will be removed.
(Indeed, the stated goal of this new FSC regime will be
``to facilitate the repatriation of certain US-related
income by implementing measures designed to avoid (and/
or significantly reduce) the double taxation of
foreign-source income.'')
b. The US will also immediately begin to research
ways in which it can make its FSC administrative
pricing rules conform to the ``arm's length'' concerns
outlined in the WTO's recent ETI-Appeals decision. The
US will keep the EU informed concerning the status of
this research. Moreover, the US will pledge to complete
this research in a reasonable amount of time, and to
ultimately bring its pricing rules in compliance with
WTO standards.
3. In exchange for a reasonable amount of time to implement
the above changes, the US will also agree not to bring future
WTO suits which characterize the various EU VAT regimes as
``prohibited export subsidies regimes not in compliance with
WTO rules.''
If the EU agrees to the above ``road map'', then from a ``policy''
standpoint, the benefits of the suggested changes would be as follows:
A trade war could be averted (both now and in the
future);
The US and the EU will both preserve certain export
benefits on a long-term basis;
The existing tenets of US international tax policy--
such as the foreign tax credit, subpart F, and section 863(b)--
could all remain in place;
Treasury could continue its commitment to the
doctrine of capital export neutrality;
The dual issues of anti-deferral and hybrid use
would, most likely, become less of a problem. (Indeed, the
current focus on the precise details of Subpart F reform could
probably be somewhat avoided. After all, if FSCs are allowed to
utilize US foreign tax credits, then presumably, US taxpayers
would have a legitimate means of repatriating certain qualified
income at rates that are more in line with worldwide standards,
e.g., 12.17% to 29.75%.); and finally,
US businesses could continue in their pursuit of
``globalization.'' (Moreover, they would now have less of an
incentive to renounce US incorporation status.)
At any rate, I hope the analysis contained herein will re-energize
the current FSC/ETI debate. More importantly, I hope that it
demonstrates that there is at least one as-of-yet unexplored solution
for resolving this seemingly complex problem; and that this solution
may actually allow all parties involved to save face in this matter.
As for more specific details concerning other aspects of FSC
reform, I have some thoughts concerning these matters as well . . . but
alas, that is a battle best saved for another day.
Statement of MTI Services Limited, Princeton, New Jersey, and Western
Growers Association, Irvine, California
MTI Services Limited, acting through its Tax Committee, and the
Western Growers Association submit the following written testimony to
the Subcommittee for its consideration. MTI Services Limited's Tax
Committee is represented by Ms. Deborah Fehr-Niswanger (Military Truck
Parts, Inc., Many, Louisiana), Brian Ward (Cortland Line Company, Inc.,
Cortland, New York), and John Andrews (QSC Audio Products, Inc., Costa
Mesa, California).
We appreciate this opportunity to make our views known, and we
would be pleased to work with Congress, the Treasury Department and the
Internal Revenue Service over the coming weeks and months to overcome
the current problem posed by the WTO's decisions.\1\
---------------------------------------------------------------------------
\1\ We have previously commented to the full Committee on the World
Trade Organization's decision that the United States' Extraterritorial
Income Exclusion Act is a prohibited export subsidy, at the Committee's
hearing on Wednesday, February 27, 2002. On that occasion we addressed
the History of the FSC-ETI Dispute--The Role of Decisions Made in the
1960s; The WTO Appellate Body's Decision--A Misconception of the Nature
of U.S. Tax Rules; Impact of Changes in the FSC-ETI Rules--Effects on
Medium-Size and Smaller Taxpayers; The EU's Request for Sanctions--A
Proposal for Attacking the Numbers; and Multiple Ownership--Need for
Continued Support. During the development of the FSC Repeal and
Extraterritorial Income Exclusion Act of 2000, we were active in
contributing proposals and comments to the tax-writing committees, the
Joint Committee on Taxation and the Treasury Department.
---------------------------------------------------------------------------
THE POSITION OF SMALL AND MEDIUM-SIZE EXPORTERS
We support the proposition put forward by some large multinational
corporations that Congress and the Administration should carefully
consider changing from a ``worldwide tax system'' to a ``territorial
tax system'' and amending the Subpart F and related rules. It must be
emphasized, however, that NONE OF THE STEPS BEING DISCUSSED WOULD
BENEFIT SMALL AND MEDIUM-SIZE EXPORTERS. Smaller companies, unlike many
large corporations, do not have plants outside the U.S., and they have
no incentive or desire to move any part of their operations to a
foreign jurisdiction. They typically ``sell out the back of the
plant,'' and the plant is here in this country. Agricultural businesses
grow, pack and sell from their farms, again here in this country.
Realistically, we think it should be acknowledged that wide-ranging
changes in the way the United States taxes international business,
including exporting, will not come quickly. Also, these changes may not
come by themselves but as part of a very broad reform of the Internal
Revenue Code, which, frankly, has not changed to reflect today's
business practices and life styles.
Our point is simple and straightforward: Small and medium-size
exporters do not want Congress to ``trade off'' the ETI provisions for
enactment of these or any other new rules. The tax treatment of export
income under DISC, FSC and ETI was and is important, and we want to
keep ETI or something like it in one form or another.
As explained briefly below and in greater detail in memoranda
prepared for the Congressional and Treasury Department staffs, we
believe that the tax treatment afforded under FSC and ETI can be
replicated under existing non-FSC, non-ETI law without violating trade
obligations and without doing injury to generally-accepted tax
principles. This approach to the problem is not for small and medium-
size companies only; large companies can join in. Also, since it relies
upon rulings, in the form of Pre-Filing Agreements (``PFAs'') or
Private Letter Rulings (``PLRs''), it is a simple matter, in effect, to
``sunset'' them when more comprehensive changes are enacted.
We would add that our Representatives in Congress, we believe,
should be as attentive to the views of small and medium-size exporters
as they are to large exporters. Smaller exporters, including
agricultural exporters, represent a disproportionate number of
``users'' of the subject tax provisions. Of the 4,363 FSC returns filed
in 1996, for example, the largest 40% of the exporter population, by
size of total assets, filed 1,659 returns, while the remaining 60%--the
smaller companies--filed 2,704 returns. Smaller exporters employ a
large number of people. And the tax savings, frankly, can be critical
to the company's efforts to export.
As the owner of one of our companies recently wrote to the Chairman
of this Subcommittee:
Our company does a good deal of export business, and the FSC/
ETI program has assisted us in being competitive in
international markets where the negotiations for contracts can
be intensely challenging. In a new venture outside basic truck
parts, I have just completed a two-year negotiation for
American-made ambulances, fully equipped with American-made
medical equipment for Egypt. This negotiation was successfully
completed with direct low-margin profits, but it should be kept
in mind that the advantage with the FSC/ETI program made it
possible to compete and win. These provisions have helped us
grow our export market and increase the number of employees as
we have grown.
Letter from Deborah L. Fehr-Niswanger, President, Military Truck
Parts, Inc. to Congressman Jim McCrery dated April 8, 2002.
To our fellow taxpayers that are larger companies, we point out
that the exporting community has only succeeded in making their case to
Congress and the Executive Branch when as a group we have been able
correctly to say that the provisions in question do not merely help the
largest 10-20% of exporters. Otherwise, the approach is too lopsided
and takes on the appearance of corporate welfare. Keeping smaller
exporters in the game is the rationale behind numerous provisions in
the statute, such as the exemption from the foreign economic processes
requirements and the shared provisions, and in the Treasury Department
regulations.
LEAVING ETI IN PLACE BUT MAKING MODIFICATIONS
The Chairman's announcement asks that persons submitting testimony
help the Subcommittee ``explore the possibility of one approach--
leaving ETI in place but making modifications to it that address the
objections raised by the EU. * * * The focus of the hearing will be to
examine whether adjustments can be made to the existing ETI regime to
bring it into compliance with WTO rules without undermining the
competitiveness of U.S. businesses in the global marketplace.''
In summary, our suggestion is that ETI be kept in place and, at the
same time, exporters be encouraged to set up operations under existing
non-ETI law so as to dramatically reduce the revenue cost of the ETI
provisions. It is this figure that the European Union has fixed on in
its request for authorization to impose sanctions. Put differently, we
need to focus on reducing the ETI revenue cost figure, not making
amendments to the ETI provisions.
LThe United States, As A Matter Of Technical Tax And Trade Law,
Probably Cannot Enact Yet Another Version Of Exporter Tax Rules That
Will Be WTO-Compliant
Having worked with the FSC and ETI provisions in great detail since
as far back as 1984 and studied the various WTO reports and decisions,
we believe that it would be extremely difficult if not impossible to
solve the current problem by enacting yet another version of the
exporter tax rules. This is because the World Trade Organization's FSC
and ETI reports and decisions have been written quite purposefully to
make this as difficult as possible.
Without reviewing each of the numerous problem areas in what runs
to over 500 pages of writing, including the original FSC report and
decision, and over twice this amount taking into account the various
submissions, questions and comments, we will look at two by way of
example.
First, in finding that the ETI provisions constitute a subsidy, the
Appellate Body found that the ETI exclusion amounted to a forgoing of
revenue that is ``otherwise due.'' In doing so, it opined that the
normal or ``benchmark'' rule under U.S. law is that U.S. persons are
taxable on their foreign source income and, therefore, ETI operates as
an exception. By characterizing the U.S. tax system in these terms and
labeling as a subsidy anything that diverges from the proclaimed norm,
the WTO has made it very difficult to do anything that does not tax the
foreign source income of exporters.\2\
---------------------------------------------------------------------------
\2\ United States--Tax Treatment For ``Foreign Sales Corporations''
Recourse to Article 21.5 of the DSU by the European Communities, WT/
DS108/AB/RW dated Jan. 14, 2002, Report of the Appellate Body, pp. 26-
33.
---------------------------------------------------------------------------
It is odd that the United States should be constrained by
competitors' characterization of its own laws. This is especially true
where the characterization is overly broad to the point of being
simplistic. As Congress and the Treasury Department are well aware, the
U.S. tax system is not that sheer or pristine. To take just one
example, Americans residing abroad are exempt from U.S. tax, up to the
level of $80,000, on their foreign earned income.\3\ Also, should
Congress wish to rethink anti-exporting measures that it put in place
in the past, must it be barred from acting? \4\
---------------------------------------------------------------------------
\3\ Section 911.
\4\ For example, the exception for export property to the rule that
taxes foreign controlled corporations on amounts reinvested in U.S.
property looks a little anemic, and Congress may wish at some time to
broaden it. Section 956(c)(2) (United States Property Defined;
Exceptions).
---------------------------------------------------------------------------
Secondly, in finding that the ETI provisions did not qualify for
the exception in Footnote 59 of the Agreement on Subsidies and
Countermeasures for measures to avoid double taxation, the Appellate
Body characterized income falling within the purview of the ETI rules
as not solely foreign-source income but also U.S. source income. Here
it opines on the definition of foreign source income, what degree of
foreign presence must exist for the exception to come into play, and
whether formulae can be employed to allocate income.\5\ This treatment
makes it difficult to construct simple, easily administered rules and,
instead, pushes tax writers toward the arm's-length, case-by-case
standard. Incidentally, it also ignores qualitative factors and the
existence of electronic commerce, which was almost nonexistent when the
foreign economic processes were first drafted in the early to mid-
1980s.
---------------------------------------------------------------------------
\5\ Id. at pp. 41-59.
---------------------------------------------------------------------------
We note that the Appellate Body seems to have a great deal of
difficulty dealing with the 30% of foreign sale and leasing income
method in section 941(a)(1). With FSC, there was the possibility using
the sale price actually charged, subject to section 482 pricing. Also,
with FSC, there was the possibility of arm's length pricing between the
related supplier and the FSC. These possibilities, in effect, fell away
with ETI. While with hindsight one is tempted to say that it might have
been better to move farther away from formulaic approaches, we doubt
that it would have made a difference.\6\
---------------------------------------------------------------------------
\6\ In fact, while only a small percentage of companies used, with
FSC, a method other than one of the administrative pricing methods,
significant amounts of income travelled through these
``nonadministrative'' routes, that is, the section 482 method and the
arm's length method. C. Belmonte, ``Foreign Sales Corporations, 1996,''
SOI Bulletin (Spring 2000).
---------------------------------------------------------------------------
Looking at the Appellate Body's work as a whole, it is safe to say
that in addition to making it very difficult for the United States to
comply, the authors very much wanted also to avoid creating a
``roadmap'' for that compliance.
The United States Should Not Even Try To Enact New Legislation
We think that having changed our rules twice--once from DISC to FSC
in 1984 and again from FSC to ETI in 2000--and done so in good faith in
order to try to comply with the views of our trade competitors,
``enough is enough.'' It is simply inappropriate for this country--
Congress, the Administration, the export community--to go through that
process again, especially since it can be predicted that those who will
sit in judgment of the work product are strongly inclined against its
success.
It is far preferable for exporters to fall back upon existing law
that does not tie to the ETI provisions. Congress and the
Administration can facilitate this course of action by urging Treasury
Department and the IRS to act expeditiously.
At the same time, the U.S. Trade Representative can pursue one or
more avenues to ameliorate the problem, negotiating an acceptable
approach to sanctions and/or compensation, trading off some items in
the mix of trade issues, and, most importantly, taking tax issues out
of the disputes settlement process. When dealing with the question of
sanctions, it needs to be made clear that since the European Union is
tying its figures to the ETI tax cost figure, as this number drops, the
authorized sanctions number drops as well.
Congress Should Not Repeal ETI
The U.S. has never wanted simply unilaterally--without the
Europeans and others dropping their subsidization of their exporters--
to drop its tax rules favoring exporters. President Nixon and Congress
helped exporters in 1971 with DISC; President Reagan and Congress
helped in 1984 with FSC; President Clinton and Congress, with
remarkable unanimity, helped exporters in 2000 with ETI.\7\ President
Bush and this Congress should not be the ones to preside over defeat.
---------------------------------------------------------------------------
\7\ ETI was adopted by the Senate by Unanimous Consent and by the
House on a vote of 316 to 72. The House Ways and Means Committee, led
by Chairman Archer and ranking Democrat Congressman Rangel, adopted it
with only one member, Congressman Stark, voting against. Two other
Members, Congressman Doggett and Congressman Lewis, expressed concerns
about benefiting some types of exporters.
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Some might say that encouraging exporters to proceed under existing
non-ETI is an unusual step under these circumstances. But one should
recall that DISC was a highly unusual step in 1971, on the heels of
enactment of Subpart F and the changes in the section 482 regulations.
The conversion of DISC to FSC in 1984 was probably the most remarkable
of all the steps because it necessitated constructing from whole cloth
a unique set of statutory rules, followed by hundreds of pages of
regulations. Enactment of ETI and the effort that went into
accommodating the concerns of our competitors was, as we all know,
truly extraordinary. In this light, avoiding the current problem, which
is pressed on us by our competitors, and reducing tensions among the
parties by fostering a set of rulings or Pre-Filing Agreements is not
very remarkable. It is relatively simple. It does not require a great
deal of time and effort; indeed, very little effort on the part of
Congress is called for. And in a very appropriate way it ``buys time''
for the development of more comprehensive measures.
LExporters Should Be Encouraged To Solve The Problem Under Existing,
Non-ETI Law
Treasury and the IRS should work with groups of exporters, such as
trade associations and groups sponsored by State Development Offices,
to conclude Pre-Filing Agreements or Private Letter Rulings with the
IRS. These PFAs or PLRs would determine how exporters that operate
through a multiple ownership or ``shared'' foreign corporation will be
taxed. The resulting business structure is similar to that used with
Shared FSCs, under the FSC provisions, and Shared Partnerships, under
the new ETI rules. Companies successfully used Shared FSCs over a 14-
year period. The two tax-writing committees, the House Ways and Means
Committee and the Senate Finance Committee, together with the
Administration, should encourage this approach.
By joining in groups, the companies can best deal with the pricing
and allocation rules and the rules in section 245(a) for a 70%
dividends-received deduction. The details can be worked out in the
context of the PFA or PLR.\8\
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\8\ There may well be more than one way of achieving this end.
Also, there doubtless will need to be modifications for different
situations, including ones involving leasing and cooperatives.
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Foreign countries, including Barbados, have expressed a willingness
to work with these groups in order to arrive at a practical solution.
This approach springs from the fact that the United States has
repeatedly argued that FSC, and now ETI, is not a radical departure
from our ``normal'' international tax rules. These provisions made it
easier for U.S. companies to comply, but they are not the only avenues
available.
LSince Exporters Would Not Be Relying Upon The ETI Provisions And No
New Special Tax Rules Would Be Needed, There Is No Subsidy For Our
Trade Competitors To Complain About; Nor Would There Be Any Special
Treatment Afforded In The Form Of A Ruling Or Audit Practice
Under the proposed approach, the U.S. would be in a position to
demonstrate, using actual tax numbers taken from taxpayers' returns,
that the amount of tax benefits claimed under ETI (section 114 of the
Code) has dropped dramatically. It will have dropped because exporters
will have gone through the PFA or PLR process.
If the EU wishes to continue to raise objections, we strongly
recommend that the U.S. attack the notorious rulings practices of The
Netherlands, France and other countries, which help their exporters.
This Approach Is Not For Smaller And Medium-Size Companies Only
While only a handful of large companies in the past participated in
any form of shared entity, the approach being suggested certainly
applies to large companies as well as smaller companies. Large
companies can form their own groups based on any number of factors,
joining with unrelated companies near their geographic location or in
their industry. If they wish, they can help with the day-to-day
operations of the entity; in fact, this can be a significant
contribution to the effort.
When this approach was first ``floated'' in 2000, companies thought
that the ETI changes would provide the solution. This has turned out,
unfortunately, not to be the case. Now a number of large exporters have
indicated a willingness to travel down this road.
MULTIPLE OWNERSHIP; THE NEED FOR CONTINUED SUPPORT
It needs to be reiterated that whatever approaches are contemplated
in the future, these approaches should accommodate U.S. exporters that
wish to band together in a shared entity of some sort. These provisions
have always existed--with DISCs, FSCs and the ETI regime. They should
continue to exist. They help medium size and smaller companies that
cannot afford the time and expense of ``going it alone.'' It is a way
of ``outsourcing,'' in a fashion, some of the international aspects of
their business. Also, these provisions are used by trade associations
and state trade development offices to help their members and
constituents.
Shared FSCs and Shared Partnerships under the ETI rules, by their
nature, perform greater services for the exporters and have a greater
presence in the foreign jurisdiction.
It is interesting that neither the ETI Panel Report nor the
ETI Appellate Body decision makes any mention of shared
partnerships or shared FSCs. The FSC Panel Reports simply
states: In addition many US States, regional authorities, trade
associations, or private businesses sponsor ``shared FSCs'' for
their companies, members or customers. A ``shared FSC'' is a
FSC which is ``shared'' by 25 or fewer unrelated exporter
``shareholders'', so as to reduce the costs while obtaining the
full tax benefit of a FSC. Each exporter-shareholder owns a
separate class of stock and each runs its own business as
usual. The US Department of Commerce grants written Export
Trade Certificates to shared FSCs that allow US exporters to
engage in joint export conduct with other US companies.
Certified exporters are virtually immune from all federal and
state government antitrust action.
The FSC Appellate Body report pays the subject even less attention:
``We note here that special rules apply inter alia in the case of
agricultural cooperatives, small FSCs, shared FSCs, FSCs owned by
individual rather than corporate shareholders, and transactions
involving military property.''
The WTO appears not to be aware of the potential for shared or
grouped entities to perform the operations of a true trading company,
much like a trading company acting on behalf of Dutch, French or
Japanese companies.
______
MTIS is a FSC-ETI management company that manages solo and shared
entities, some of which are ``sponsored'' by organizations, such as the
Delaware Economic Development Office, the Pennsylvania Office of
International Trade and the National Association of Manufacturers. Over
the last 16 years, MTIS and its subsidiary have helped approximately
500 exporters utilize the relevant benefits. Annually its companies
export around $500 million in total. These companies represent a broad
spectrum of exporters from small (a couple of million dollars of gross
receipts from exports) to medium size (approximately $50 million gross
receipts from exports). The items of export range from automobile parts
to fishing line, and they include agricultural and forest products.
The Tax Committee of MTIS is represented by Ms. Deborah Fehr-
Niswanger (Military Truck Parts, Inc., Many, Louisiana), Brian Ward
(Cortland Line Company, Inc., Cortland, New York), and John Andrews
(QSC Audio Products, Inc., Costa Mesa, California). Military Truck
Parts, Inc. sells and services specialty vehicles including trucks and
Hummers. Cortland Line Company, Inc. manufactures and sells fishing
line and related equipment. QSC Audio Products, Inc. manufactures,
sells and installs professional audio equipment including fully
integrated audio systems.
WGA, which is headquartered in Irvine, California, is the largest
and most active regional fresh produce trade association in the United
States. Its members grow, pack and ship over 90% of the fresh
vegetables and 60% of the fresh fruit grown in California and Arizona.
The actual items (carrots, tomatoes, broccoli, citrus, lettuce, etc.)
number in excess of 250; and they constitute over 50% of the fresh
produce grown in the United States. They are shipped throughout Europe
and Asia, as well as Canada and Mexico. WGA began creating shared FSCs
for its members in 1992. Since that time, it estimates that its members
have shipped over $1.5 billion through its shared entities.
Approximately 95 companies participate in the WGA export program. The
smallest of these has exports of around $400,000.
Questions concerning this testimony can be directed to Charles M.
Bruce (1-202-965-5300)