[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 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.











                            C O N T E N T S

                               __________
                                                                   Page
Advisory of 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.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
      
    Please Note: Due to the change in House mail policy, any person or 
organization wishing to submit a written statement for the printed 
record of the hearing should send it electronically to 
[email protected], along with a fax copy to 
(202) 225-2610 by the close of business, Wednesday, April 24, 2002. 
Those filing written statements who wish to have their statements 
distributed to the press and interested public at the hearing should 
deliver their 200 copies to the Subcommittee on Select Revenue Measures 
in room 1135 Longworth House Office Building, in an open and searchable 
package 48 hours before the hearing. The U.S. Capitol Police will 
refuse unopened and unsearchable deliveries to all House Office 
Buildings.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. Due to the change in House mail policy, all statements and any 
accompanying exhibits for printing must be submitted electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, in Word Perfect or MS Word format and MUST NOT exceed a 
total of 10 pages including attachments. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. Any statements must include a list of all clients, persons, or 
organizations on whose behalf the witness appears. A supplemental sheet 
must accompany each statement listing the name, company, address, 
telephone and fax numbers of each witness.
      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://waysandmeans.house.gov.


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

                                


    Chairman 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\
---------------------------------------------------------------------------
    \1\ Terrence R. Chorvat Ending the Taxation of Foreign Business 
Income 42 Ariz. L. Rev. 835 (2000)
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
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    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\
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    \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).
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    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.
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    \5\ Id. at pp. 41-59.
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    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\
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    \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).
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    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.
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    \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)

                                
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