[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
WTO'S EXTRATERRITORIAL INCOME DECISION
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
FEBRUARY 27, 2002
__________
Serial No. 107-67
__________
Printed for the use of the Committee on Ways and Means
79-971 U.S. GOVERNMENT PRINTING OFFICE
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
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
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unintentional errors or omissions. Such occurrences are inherent in the
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C O N T E N T S
Page______
Advisories announcing the hearing................................ 2, 3
WITNESSES
U.S. Department of the Treasury, Barbara Angus, International Tax
Counsel........................................................ 7
Office of the United States Trade Representative, Peter Davidson,
General Counsel................................................ 12
______
Institute for International Economics, Gary Hufbauer............. 45
Merrill, Peter R., Pricewaterhousecoopers LLP, and International
Tax Policy Forum............................................... 51
Shay, Stephen E., Ropes & Gray, and Harvard Law School........... 62
SUBMISSIONS FOR THE RECORD
MTI Services Limited, Princeton, NJ, and Western Growers
Association, Irvine, CA, joint statement....................... 87
National Foreign Trade Council, William A. Reinsch, statement.... 89
WTO'S EXTRATERRITORIAL INCOME DECISION
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WEDNESDAY, FEBRUARY 27, 2002
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:45 a.m., in
room 1100 Longworth House Office Building, Hon. Bill Thomas
(Chairman of the Committee) presiding.
[The advisory and revised advisory announcing the hearing
follow:]
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
February 19, 2002
No. FC-16
Thomas Announces a Hearing on
WTO's Extraterritorial Income Decision
Congressman Bill Thomas (R-CA), Chairman of the Committee on Ways
and Means, today announced that the Committee will hold a hearing on
the World Trade Organization's (WTO's) decision that the United States'
Extraterritorial Income Exclusion Act (ETI) is a prohibited export
subsidy. The hearing will take place on Wednesday, February 27, 2002,
in the main Committee hearing room, 1100 Longworth House Office
Building, beginning at 10:00 a.m.
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 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 (FSC) 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 $956 million. The
Arbitration Panel will issue its determination by the end of April
2002.
In announcing the hearing, Chairman Thomas stated: ``Although the
most recent decision comes as no surprise, it illustrates the need to
fundamentally reform our tax system so that U.S. workers, farmers and
businesses are not disadvantaged in international trade. This will be
the first of several hearings to consider the WTO Appellate Panel
decision and to examine ways to maintain the international
competitiveness of the United States.''
FOCUS OF THE HEARING:
The hearing is expected to (1) outline the history of the FSC-ETI
dispute, (2) analyze the January 14, 2002, WTO Appellate Panel
Decision, and (3) discuss the potential trade ramifications of the
decision.
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, March 13, 2002.
Those filing written statements who wish to have their statements
distributed to the press and interested public at the hearing should
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may result in the witness being denied the opportunity to testify in
person.
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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
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* * * NOTICE--CHANGE IN TIME * * *
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
February 26, 2002
No. FC-16 Revised
Change in Time for Committee Hearing on
WTO's Extraterritorial Income Decision
Congressman Bill Thomas (R-CA), Chairman of the Committee on Ways
and Means, today announced that the Committee hearing on the World
Trade Organization's decision that the United States' Extraterritorial
Income Exclusion Act is a prohibited export subsidy, scheduled for
Wednesday, February 27, 2002, at 10:00 a.m., in the main Committee
hearing room, 1100 Longworth House Office Building, will now be held at
10:30 a.m.
All other details for the hearing remain the same. (See Committee
Advisory No. FC-16, dated February 19, 2002.)
Chairman Thomas. If our guests will find their seats,
please. Good morning. As the world's largest importer and the
world's largest exporter, an orderly international trading
system is crucial to the economic success of the United States.
Given our global leadership, it is important that America
complies with the established rules of engagement that the
World Trade Organization (WTO) referees. It is in our interest
that others follow the rules and therefore, it is imperative
that we follow the rules as well.
To that end, we must carefully and thoroughly address the
problems created at the intersection of our Tax Code, and our
international trade obligations. On January 14 of this year,
the WTO issued an appellate ruling that the U.S. Tax Code
provides an export subsidy. This decision marks the fourth time
that the WTO has ruled this way, twice in the foreign sales
corporation (FSC) case and now twice in the extraterritorial
income (ETI) case. Four times the WTO has sent the United
States this same clear message. Our tax system, as it is
currently constituted, violates international trade rules. In
the opinion of the Chairman of this Committee, the time has
come for us to listen.
Our corporate tax structure is in need of major
restructuring, not another attempt at a short-term fix. More
fundamental reform is required. In an economy struggling to
recover, the United States cannot afford to dismiss the
Europeans' proposed 4 billion, 3 billion, 2 billion, 1 billion,
pick-a-number retaliation as an empty threat. Many people said
the Europeans would never challenge us on this portion of the
Code because they would be damaged as well. It has even been
called a nuclear weapon. Well, it has been triggered. It is not
an empty threat.
U.S. Trade Representative (USTR) Robert Zoellick is
forcefully challenging the European Union's (EUs) assessment of
harm, but if we do nothing, trade sanctions against our country
remain a distinct possibility. The European Union has
graciously indicated that it will be reasonably patient and
that it does recognize the difficulty of changing our corporate
Tax Code. The Congress and I believe this Administration must
also demonstrate its commitment to address the problem. It is
not an easy task. It will require collaboration from all
Members of this Committee, Republican and Democrat. We must
build a consensus on a new approach that will meet our
international obligations while maintaining the competitiveness
of American businesses and workers in the global marketplace.
It will be impossible to recreate a system which duplicates
the current winners. But we must act in good faith. And we must
begin this difficult process now. Today's hearing, where we
will discuss the history of the foreign sales corporation
dispute, the January 14 appellate body decision and the threat
of retaliation, marks the beginning of this process. Yet no
discussion of history, no attempt to justify the correctness of
the U.S. position can be a beginning, a beginning begins with
the realization that the previous attempts have failed.
One chapter has been closed. We need to open a new one.
Following the full Committee hearing, the Subcommittee on
Select Revenue will hold a series of hearings to examine
options in reforming America's corporate tax structure. To give
you an idea of how difficult that will be, we have a second
panel today in which there are some suggested options, and my
assumption is there will be an examination of the viability of
some of those options. This is never pleasant. It is always
difficult. The United States believes that we should set our
own course, but we are a partner among partners and we have to
start with the recognition that we have to change. And with
that, does the gentleman from New York wish to make any opening
remarks.
[The opening statement of Chairman Thomas follows:]
OPENING STATEMENT OF THE HON. BILL THOMAS, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF CALIFORNIA, AND CHAIRMAN, COMMITTEE ON WAYS AND MEANS
Good morning. As the world's largest importer and exporter, an
orderly international trading system is crucial to the economic success
of the United States. Given our global leadership, it is important that
America complies with the established rules of engagement that the
World Trade Organization (WTO) referees. It is in our interest that
others follow the rules and therefore it is imperative that we follow
the rules as well.
To that end, we must carefully and thoroughly address the problems
created at the intersection of our tax code and our international trade
obligations.
On January 14th of this year, the WTO issued an appellate ruling
that the U.S. tax code prohibits an export subsidy.
This decision marks the fourth time that the WTO has ruled this
way, twice in the Foreign Sales Corporation (FSC) case and now twice in
the Extraterritorial Income (ETI) case.
Four times the WTO has sent the United States this same clear
message--our tax system as it is currently constituted violates
international trade rules. In the opinion of the Chairman of this
committee, the time has come for us to listen. Our corporate tax
structure is in need of major restructuring, not another attempt at a
short-term fix. More fundamental reform is required.
In an economy struggling to recover, the United States cannot
afford to dismiss the European's proposed $4 billion, $3 billion, $2
billion, $1 billion, pick a number--retaliation as an empty threat.
Many people said the Europeans would never challenge us on this portion
of the code because they would be damaged as well. It has even been
called a nuclear weapon. Well, it's been triggered. It is not an empty
threat. The United States Trade Representative Robert Zoellick is
forcefully challenging the EU's assessment of harm, but if we do
nothing trade sanctions against our country still remain a distinct
possibility.
The EU has graciously indicated that it will be reasonably patient
and that it does recognize the difficulty of changing our corporate tax
code, but Congress and, I believe, this Administration must also
demonstrate its commitment to address the problem.
It's not an easy task--it will require collaboration from all
Members of this Committee, Republican and Democrat. We must build
consensus on a new approach that will meet our international
obligations while maintaining the competitiveness of American
businesses and workers in the global marketplace.
It will be impossible to recreate a system, which duplicates the
current winners, but we must act in good faith, and we must begin this
difficult process now.
Today's hearing, during which we will discuss the history of the
Foreign Sales Corporation dispute, the January 14th Appellate Body
Decision, and the threat of retaliation, marks the beginning of this
process. But no discussion of history, no attempt to justify the
correctness of the U.S. position can be a beginning.
A beginning begins with the realization that previous attempts have
failed. One chapter has been closed and we need to open a new one.
Following this full committee hearing, the Subcommittee on Select
Revenue will hold a series of hearings to examine options in reforming
America's corporate tax structure.
To give you an idea how difficult that will be we have a second
panel today in which there will be some suggested options. My
assumption is there will be an examination of the viability of several
of those options. This is never pleasant and it is always difficult.
The United States believes we should set our own course, but we are a
partner among partners and we have to start with the recognition that
we have to change.
I now recognize the ranking member from New York for his opening
statement.
Mr. Rangel. Thank you, Mr. Chairman. This Congress, and
more particularly this Committee, has taken a lot of pride in
the bipartisanship in which we have handled trade and issues
before the World Trade Organization. This dispute has gone on
for decades, but we as a Committee have stood solidly behind
this and previous Administrations in letting the World Trade
Organization understand our unanimity of thought in trying to
get a fair and flat playing field. Now it appears as though we
may have reached an impasse. And I would hope that this
Administration would come to this Committee with strong
recommendations as to how we could maintain the integrity of
our tax system, and at the same time, fulfill our international
obligations.
I am fearful, however, that this crisis that we face with
the WTO may be used as a political vehicle to bring back the
days when rhetorically we talked about pulling up the Tax Code
by its roots and getting on buses going into communities and
saying that we are going to simplify the system. That is a
very, very political road, and I would hate to see our European
friends think that our division in thought as to what the Tax
Code should or should not be would give them an opportunity to
go into these sanctions that they are threatening us with.
I do hope we can continue the spirit of bipartisanship on
this issue that historically we found ourselves. But having
heard the Secretary of Treasury talk about proposals to repeal
the corporate tax, knowing the rhetoric about substituting
consumption taxes for our tax system, realizing the lack of
progressivity on some of these things, the Chairman said it
would be difficult. I say these are very explosive political
issues. I don't want the crisis that we face as a nation and
certainly the responsibilities that we have as a--as the tax
writing Committee for the entire Congress--to allow our
political preferences to interfere with obligations to attempt
to resolve this problem. The Administration--the Administration
can avoid a train wreck on this. The Administration should be
giving us guidelines on this.
If you let us get started on this before the election, you
can bet your life you are going to have a political problem.
If, on the other hand, you give us direction as to what we can
do legislatively, well, you do the best you can diplomatically,
I think we can maintain our tradition and move forward as a
bipartisan Committee. Thank you, Mr. Chairman.
[The opening statements of Mr. Crane and Mr. Ramstad
follow:]
OPENING STATEMENT OF THE HON. PHILLIP M. CRANE, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF ILLINOIS
Mr. Chairman, I want to thank you for holding this very important
hearing. As you know, I have been a longtime advocate for the repeal of
the corporate income tax. Corporations don't pay taxes, instead, they
pass along this cost of doing business to consumers through higher
prices. The ruling by the WTO that makes illegal the FSC/ETI is the
perfect hook for us to finally repeal this insidious tax scheme.
Unfortunately, there are those that will advocate for a new
iteration of the FSC. I believe that this would be a major mistake. We
have already made three attempts to write an export subsidy law that is
WTO compliant and each time we have failed. Clearly, the WTO
discriminates against our tax system, which is income based, as opposed
to favoring those tax systems that are consumption based. It's not
secret that the Europeans provide similar subsidies to their domestic
corporations. Yet, there can be no successful challenge to those
schemes because of the underlying assumption that a consumption based
system is de facto WTO compliant.
That leaves us in the position to advocate for either a total
repeal of the corporate tax or, in the alternative, fundamentally
reforming the system with a territorial or border-adjustable VAT tax.
If we are unable to repeal the corporate tax, then I'll support a
territorial system. But I still believe the repeal of the corporate tax
is the best alternative. No corporate tax means that foreign
corporations will race to set up shop in the United States. That means
more jobs for American workers, less people on welfare, and more tax
revenues for the Treasury. I challenge anyone to argue with those
outcomes.
OPENING STATEMENT OF THE HON. JIM RAMSTAD, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF MINNESOTA
Mr. Chairman, thank you for holding this important hearing on the
WTO's decision that the United States' Extraterritorial Income
Exclusion Act (ETI) rules amount to an illegal export subsidy.
The ETI structure, and its predecessors the Foreign Sales
Corporation (FSC) and the Domestic International Sales Corporation
(DISC), were attempts to level the tax playing field for American
companies doing business overseas.
Our international competitors have territorial tax systems and many
allow Value-Added Tax (VAT) rebates for their companies' exports. This
structure is acceptable to the WTO, while the U.S. system of worldwide
taxation, which taxes the income of American businesses regardless of
where they are doing business, combined with an ETI-like structure is
unacceptable to the WTO.
While our U.S. trade team deals with the fallout from the WTO
decision, we must begin to examine whether the foundations of our
worldwide tax system are sustainable if American businesses are to
remain competitive in our global economy. We already have too many
examples of former U.S. companies that now are headquartered overseas
because of our burdensome international tax system. The WTO's most
recent decision and the resulting sanctions facing our businesses is
another wake-up call for reform.
I look forward to hearing from our witnesses today about possible
short-term and long-term solutions to the massive trade challenge we
are now facing following the WTO's ruling.
Thank you, Mr. Chairman.
Chairman Thomas. Thank you very much, Mr. Rangel. And to
hear the first word from the Administration on this issue, the
two departments that are clearly focused on this issue is
Barbara Angus, the International Tax Counsel, Office of Tax
Policy, U.S. Department of the Treasury; and Peter Davidson,
the General Counsel of the U.S. Trade Representative. I want to
thank you both for appearing. Your written testimony will be
made a part of the record and you may address us as any way you
see fit during the time you have available. The microphones
need to be turned on and they are very uni-directional, so you
need to be right in front of it so we can hear you. So with
that, Ms. Angus.
STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX COUNSEL, U.S.
DEPARTMENT OF THE TREASURY
Ms. Angus. Mr. Chairman, Congressman Rangel and
distinguished Members of the Committee. I appreciate the
opportunity to appear today at this hearing on the World Trade
Organization's recent decision regarding the extraterritorial
income exclusion provisions of the U.S. tax law.
On January 29, the WTO dispute settlement body adopted a
final report finding that the ETI provisions of the U.S. tax
law are inconsistent with U.S. obligations under the WTO. We
are all disappointed with this outcome.
This decision is the culmination of a challenge brought by
the European Union in late 1997 against the FSC provisions then
contained in the U.S. tax law. However the origins of this
dispute go back almost 30 years, predating the WTO itself. The
United States has consistently and vigorously pursued this
matter and defended its laws through 3 decades because of the
importance of the provisions and principles at stake. At its
core, this case raises fundamental questions regarding a level
playing field with respect to tax policy. The ETI provisions,
like the FSC provisions that preceded them, represent an
integral part of our larger system of international tax rules.
These provisions were designed to help level the playing field
for U.S.-based businesses that are subject to those
international tax rules. As we contemplate our next steps and
address this decision, we should not lose sight of that
objective.
The Congress has demonstrated its commitment to the U.S.
businesses, both large and small, that operate in the global
marketplace and to the U.S. workers that produce the output
that is sold in markets around the world. The Congress took
decisive action on a bipartisan basis under significant time
pressure in passing legislation in November, 2000, to respond
to the first WTO decision in this dispute by repealing the FSC
provisions and enacting the ETI provisions. That legislation
represented a good faith effort to bring the United States into
compliance with its WTO obligations, while at the same time
protecting the level playing field for U.S. businesses.
To be facing this same issue again so soon is certainly a
disappointment. Nevertheless, we must look forward and pursue
all options to resolve this matter so that American workers and
the businesses that employ them will not be disadvantaged. We
have a serious problem, and we need to develop a serious
solution. Mr. Chairman, the Administration looks forward to
working closely with the Congress to find a solution that will
protect America's interest and honor our obligations in the
WTO. Given the focus of this hearing, our written testimony
today focuses on the particular provisions of our tax law at
issue, the history of the dispute in the WTO over these
provisions and the findings and analysis of the WTO dispute
settlement body. I would be happy to answer any questions.
Thank you very much.
Chairman Thomas. Thank you, Ms. Angus. Mr. Davidson.
[The prepared statement of Ms. Angus follows:]
STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX COUNSEL, U.S. DEPARTMENT
OF THE TREASURY
Mr. Chairman, Congressman Rangel, and distinguished Members of the
Committee, we appreciate the opportunity to appear today at this
hearing on the World Trade Organization's recent decision regarding the
extraterritorial income exclusion (ETI) provisions of the U.S. tax law.
On January 29th, the WTO Dispute Settlement Body adopted a final
report finding that the ETI provisions of the U.S. tax law are
inconsistent with the United States' obligations under the WTO. We all
are very disappointed with this outcome. This decision is the
culmination of a challenge brought by the European Union in late 1997
against the foreign sales corporation (FSC) provisions then contained
in the U.S. tax law. However, the origins of this dispute go back
almost 30 years, predating the WTO itself. The United States has
vigorously pursued this matter and defended its laws because of the
importance of the provisions and principles at stake.
At its core, this case raises fundamental questions regarding a
level playing field with respect to tax policy. Few things are as
central to a country's sovereignty as the right to choose its own tax
system. The ETI provisions, like the FSC provisions that preceded them,
represent an integral part of our larger system of international tax
rules. These provisions were designed to help level the playing field
for U.S.-based businesses that are subject to those international tax
rules. As we contemplate our next steps, we should not lose sight of
that.
The Congress has demonstrated its commitment to the U.S.
businesses, both large and small, that operate in the global
marketplace and to the U.S. workers that produce the output that is
sold in markets around the world. The Congress took decisive action,
under significant time pressure, in passing legislation in November
2000 to respond to the first WTO decision in this dispute by repealing
the FSC provisions and enacting the ETI provisions. That legislation
represented a good faith effort to bring the United States into
compliance with its WTO obligations while protecting the level playing
field for U.S. businesses.
To be facing the same issue again so soon certainly is a
disappointment. Nevertheless, we must look forward and pursue all
options to resolve this matter so that American workers and the
businesses that employ them will not be disadvantaged.
Mr. Chairman, the Administration looks forward to working closely
with the Congress, on a bipartisan basis, to find a solution that will
protect America's interests and honor our obligations in the WTO.
Our testimony today will focus on the particular provisions of our
tax law at issue, the history of the dispute in the WTO over these
provisions, and the findings and analysis of the WTO Dispute Settlement
Body with respect to these provisions.
The Foreign Sales Corporation Provisions
The FSC provisions were enacted in 1984. They provided an exemption
from U.S. tax for a portion of the income earned from export
transactions. This partial exemption from tax was intended to provide
U.S. exporters with tax treatment that was more comparable to the
treatment provided to exporters under the tax systems common in other
countries.
A FSC that elected to be subject to these provisions generally was
a foreign subsidiary of a U.S. manufacturer. The U.S. manufacturer sold
its products to the FSC for resale abroad or paid the FSC a commission
in connection with its sales of products abroad. In order to qualify
for these provisions, the FSC was required to be managed outside the
United States and was required to conduct certain economic processes
outside the United States with respect to these export transactions.
These economic processes related to the solicitation, negotiation, and
making of contracts with respect to such transactions.
The sales or commission income of the FSC on these transactions was
determined under specified pricing rules. The exemption from tax
applied to a portion of the FSC's income from sales and leases of
export property and from related services. The FSC was subject to
current U.S. tax on the remainder of its income from these
transactions.
The FSC provisions were enacted to resolve a General Agreement on
Tariffs and Trade (GATT) dispute involving a prior U.S. tax regime--the
domestic international sales corporation (DISC) provisions enacted in
1971. Following a challenge to the DISC provisions brought by the
European Union and a counter-challenge to several European tax regimes
brought by the United States, a GATT panel in 1976 ruled against all
the contested tax measures. This decision led to a stalemate that was
resolved with a GATT Council Understanding adopted in 1981 (the ``1981
Understanding''). Pursuant to this 1981 Understanding regarding the
treatment of tax measures under the trade agreements, the United States
repealed the DISC provisions and enacted the FSC provisions.
The WTO Decision Regarding the FSC Provisions
The European Union formally challenged the FSC provisions in the
WTO in November 1997, thirteen years after their enactment.
Consultations to resolve the matter were unsuccessful, and the EU
challenge was referred to a WTO dispute resolution panel. In October
1999, the WTO panel issued a report finding that the FSC provisions
constituted a violation of WTO rules. The United States appealed the
panel report; the European Union also appealed the report. In February
2000, the WTO Appellate Body issued its report substantially upholding
the findings of the panel.
Although the United States believed that the FSC provisions were
blessed by the 1981 Understanding, the WTO panel completely dismissed
this argument, concluding that the 1981 Understanding had no continuing
relevance in the interpretation of current WTO rules. The panel's
analysis focused mainly on the application of the WTO Agreement on
Subsidies and Countervailing Measures. The panel found that the FSC
provisions constituted a prohibited export subsidy under the Subsidies
Agreement.
Under the Subsidies Agreement, a subsidy exists if (1) government
revenue otherwise due is foregone and (2) a benefit is thereby
conferred. The Subsidies Agreement prohibits subsidies that are
contingent, in law or in fact, on export performance. Looking first at
the subsidy issue, the panel concluded that three specific aspects of
the FSC provisions, taken together, resulted in an exception from
taxation for income that otherwise would be subject to U.S. tax; the
panel therefore concluded that the FSC provisions resulted in foregone
government revenue through which a benefit was conferred. The panel
then concluded that this subsidy provided by the FSC provisions was
export-contingent, and therefore prohibited, because the tax treatment
under the FSC provisions depended upon the exportation of U.S. goods.
The panel further found that the FSC provisions constituted an export
subsidy in violation of the WTO Agreement on Agriculture. The panel
declined to rule on the European Union's additional arguments that the
pricing rules and ``domestic content'' rules contained in the FSC
provisions constituted separate violations of the WTO rules. The panel
recommended that the subsidy provided by the FSC provisions be
withdrawn with effect from October 1, 2000 (which date was later
extended to November 1, 2000, under a procedural agreement between the
parties).
The Extraterritorial Income Exclusion Provisions
In response to the WTO decision against the FSC provisions, the FSC
Repeal and Extraterritorial Income Exclusion Act was enacted on
November 15, 2000. This legislation had been voted out of this
Committee with a vote of 34 to 1, and was passed by the House with a
vote of 316 to 72. The legislation repealed the FSC provisions and
adopted in their place the ETI provisions. The legislation was intended
to bring the United States into compliance with WTO rules by addressing
the analysis reflected in the WTO decision. The new regime addressed
the subsidy issue by establishing a new general rule of taxation under
which extraterritorial income is excluded from gross income; the new
regime addressed the export-contingency issue by applying to income
from all foreign sales and leases of property, without regard to where
the property is manufactured. At the same time, the legislation also
was intended to ensure that U.S. businesses not be foreclosed from
opportunities abroad because of differences in the U.S. tax laws as
compared to the laws of other countries.
The ETI provisions provide an exclusion from U.S. tax for certain
extraterritorial income. This exclusion applies to a portion of the
taxpayer's income from foreign sales and leases and certain related
services. The ETI provisions apply to foreign sales and leases of
property manufactured in the United States and also to foreign sales
and leases of property manufactured outside the United States. In the
case of property manufactured outside the United States, the
manufacturer either must be subject to the taxing jurisdiction of the
United States or must elect to subject itself to such jurisdiction.
Thus, the income from transactions to which the ETI provisions apply is
subject to consistent U.S. tax treatment.
Unlike the FSC provisions, the ETI provisions do not require the
filing of an election or the formation of a special entity to which
sales are made or commissions are paid. Also unlike the FSC provisions,
the ETI provisions apply to both corporations and individuals in the
same manner.
The exclusion provided under the ETI provisions generally is
available only if certain economic processes are conducted outside the
United States. As under the FSC provisions, these economic processes
relate to the solicitation, negotiation, and making of contracts. A
portion of the income from foreign transactions covered by the ETI
provisions is exempt from U.S. tax. Because this exclusion is an
alternative approach to addressing potential double taxation, foreign
tax credits are not allowed with respect to the excluded income.
The WTO Decision Regarding the ETI Provisions
Immediately following the enactment of the ETI Act, the European
Union brought a challenge in the WTO. In August 2001, a WTO panel
issued a report finding that the ETI provisions also violate WTO rules.
The panel report contained sweeping language and conclusory statements
that had broad implications beyond the case at hand. Because of the
importance of the issues involved and the troubling implications of the
panel's analysis, the United States appealed the panel report.
The WTO Appellate Body generally affirmed the panel's findings.
However, significantly, the Appellate Body modified and narrowed the
panel's analysis. The Dispute Settlement Body adopted the report as
modified by the Appellate Body on January 29, 2002.
The Appellate Body report makes four main findings with respect to
the ETI provisions: (1) the ETI provisions constitute a prohibited
export subsidy under the WTO Subsidies Agreement; (2) the ETI
provisions constitute a prohibited export subsidy under the WTO
Agriculture Agreement; (3) the limitation on foreign content contained
in the ETI provisions violate the national treatment provisions of
Article III:4 of GATT; and (4) the transition rules contained in the
ETI Act violate the WTO's prior recommendation that the FSC subsidy be
withdrawn with effect from November 1, 2000.
Prohibited Export Subsidy Under the Subsidies Agreement
The analysis of the prohibited export subsidy under the Subsidies
Agreement involved three separate issues.
First, the Appellate Body found that the ETI provisions constitute
a subsidy under Article 1.1(a)(ii) of the Subsidies Agreement. The
Appellate Body compared the ETI exclusion to the tax rules that
otherwise would have applied to income from this type of transaction.
Based on that analysis, the Appellate Body found that the ETI exclusion
constitutes the ``foregoing of revenue which is `otherwise due','' that
it confers a benefit, and that it is therefore a subsidy.
Second, the Appellate Body found that the ETI provisions are export
contingent because of the provisions' application only to income from
transactions involving property that is sold, leased, or rented for
direct use, consumption, or disposition outside the United States. As
did the lower panel, the Appellate Body bifurcated the ETI provisions,
separating the application to transactions involving property produced
within the United States from the application to transactions involving
property produced abroad. For property produced within the United
States, the foreign use requirement could be met only by exporting the
property. Based on this bifurcation, the Appellate Body found that the
ETI provisions are export contingent with respect to domestically
produced products. This conclusion was not affected by the fact that
the ETI provisions apply in circumstances that are plainly not export
contingent (i.e., with respect to property produced outside the United
States and sold for use outside the United States).
Third, the Appellate Body rejected the U.S. argument that the ETI
provisions constitute a permitted measure for avoidance of double
taxation. The United States believed that the ETI provisions fell
within the fifth sentence of footnote 59 of the Subsidies Agreement
which effectively permits a country to ``tak[e] measures to avoid the
double taxation of foreign-source income,'' even if the measures
constitute export subsidies. The Appellate Body found that footnote 59
applies only to ``foreign-source income'' and that, to be considered
``foreign-source income,'' the income must have sufficient links to
another country that the income could be taxed by that other country.
The Appellate Body further viewed the ETI provisions as potentially
applying to income that would not fall within the reach of this rule as
so interpreted. Therefore, the Appellate Body found that the ETI
provisions do not constitute a measure to avoid double taxation under
footnote 59.
Export Subsidy Under the Agriculture Agreement
Because the Appellate Body held that the ETI provisions constitute
a prohibited export subsidy under the Subsidies Agreement, it followed
that the ETI provisions also violate the export subsidy provisions of
the WTO Agriculture Agreement.
National Treatment Under GATT Article III:4
The Appellate Body affirmed the panel's finding that the 50 percent
limitation on foreign articles and direct labor costs contained in the
ETI provisions violates GATT Article III:4. The Appellate Body
dismissed the U.S. factual point that taxpayers may meet this
requirement without using any U.S. content whatsoever. The Appellate
Body found that this limitation in the ETI provisions represents an
encouragement of domestic manufacturers to use domestic over imported
components, thereby providing less favorable treatment to imported
products than to like domestic products.
Withdrawal of FSC Benefits
The Appellate Body also rejected the transition rules included in
the ETI Act, finding no basis for permitting the continuance of the
application of the FSC provisions beyond the November 1, 2000 date
specified for withdrawal of the subsidy found to have been provided by
the FSC provisions. The Appellate Body rejected the U.S. position that
efficient and fair administration of the tax laws frequently requires
tax legislation to include transition rules and binding contract relief
for taxpayers that acted in reliance on the prior law provisions.
Current Arbitration Proceeding
When it challenged the ETI Act in November 2000, the European Union
simultaneously requested authority from the WTO to impose trade
sanctions on $4.043 billion worth of U.S. exports. The United States
responded by initiating a WTO arbitration proceeding on the grounds
that the amount of trade sanctions requested by the European Union was
excessive under WTO standards. This arbitration was suspended pending
the outcome of the European Union's challenge to the WTO-consistency of
the ETI Act, and resumed on January 29th with the Dispute Settlement
Body's adoption of its final report. The parties are filing written
submissions and will meet with the arbitration panel, which will issue
its report on the appropriate level of trade sanctions on April 29th.
Following adoption of that report, the European Union will be
authorized to begin imposing trade sanctions on U.S. exports up to the
level set by the arbitrators.
STATEMENT OF PETER DAVIDSON, GENERAL COUNSEL, OFFICE OF THE
UNITED STATES TRADE REPRESENTATIVE
Mr. Davidson. Thank you, Mr. Chairman, Representative
Rangel, and Members of the Committee. It is a pleasure to be
here today. I do apologize in advance for my voice. I am
working on a little cold here, so I will try to speak as loudly
as I can or put it in my mouth here. But I do appreciate the
opportunity to be here to talk about this issue, a dispute
between the United States and the EU on the FSC and then the
ETI case. As my detailed statement does go into somewhat more
length on the historical record, I will try to be brief here in
my remarks about where we are going to be going and be happy to
answer any questions.
Ambassador Zoellick has said on a number of occasions in
the past year, noting the seriousness of the dispute with its
potentially large financial implications for U.S. companies, as
the Chairman noted last May, he likened the issue to a trade
nuclear bomb which, if not treated with the utmost care, could
cause enormous damage to the U.S.-EU relationship, and perhaps
the trading system more generally.
Mr. Chairman, I agree with you we cannot treat the threat
of retaliation as an empty threat. Ambassador Zoellick stated
in his joint press conference with Trade Commissioner Lamy of
the EU last month that the United States intends to seek to
resolve this dispute in a spirit of good faith, and that we
intend to respect our WTO obligations.
Mr. Chairman, as you noted, you can forcefully challenge
the amount at issue. And the arbitration phase will also work
cooperatively to show the progress necessary to prevent
retaliation. I hope we can work through our differences with
the EU in a way that will result in a true level playing field
with respect to taxation, but it will be a difficult road and
one that will require patience on all sides. The solution will
be found in an appreciation of the need to move the global
trading system forward to advance the U.S.-EU trading
relationship overall, and at the same time, to find a solution
to this dispute within which all parties can prosper.
I understand that the primary purpose of today's hearing is
to review the history of this important case, and therefore I
hope my comments will provide the Committee with a bit of
context, both historical and WTO procedural, to help establish
a framework for future discussions.
As we approach April 15, I am also reminded to provide
another caveat that I am very far from a tax expert on any of
these issues, and so I will defer most of those questions to
the Treasury. But I will try to clarify some of the highlights
if I can.
Barbara Angus just went through the history of the dispute.
It is a long history. As the Chairman noted, it is history. And
so I will not go through that about each of those stages at
this point. A detailed account is in my written testimony. But
to summarize, essentially since 1997, the FSC, and later the
ETI, with both twice judged by the WTO, found to be an illegal
export subsidy under WTO rules. The latest chapter began with
the WTO panel finding against the ETI Act in August of 2001.
After consulting extensively with Congress and the private
sector last November, we proceeded to appeal the latest panel
result challenging all of the panels' ultimate findings with
respect to the ETI Act.
We chose to appeal even though we are not optimistic of
achieving a reversal of all the panels' findings, we thought we
could perhaps obtain greater clarity from the appellate body.
The appellate bodies' report was formally adopted on January
29. At that point, the arbitration proceeding which had been
suspended by mutual agreement with the EU in November of 2000
for purposes of determining the level of countermeasures to
which the EU is entitled, resumed.
A WTO arbitration proceeding normally takes no more than 60
days. In this case, the arbitrators have informed us that they
expect to take until April 29 to finish their work and issue
their determination on the authorized maximum level of
countermeasures. The EU and United States have, in recent days,
submitted to the arbitrators our respective arguments on the
appropriate maximum level for authorized countermeasures in
this case. The EU is expected, and has argued, should be
allowed to adopt countermeasures with a value of up to $4.043
billion. The EU essentially claims that this amount is
reasonable because it estimates the actual effects of the ETI
to be far greater than this amount.
In contrast, the United States holds that the EU should
only be entitled to countermeasures totaling from $1 billion to
$1.1 billion, depending on the base year chosen. This
represents appropriately, in our view, the proportion of the
FSC ETI subsidy that applies to the EU based on the EU's share
of total nongoods production worldwide. If the arbitrators find
that the EU is entitled to countermeasures in some amount, the
EU would be in the same position to ask for WTO authority to
impose countermeasures sometime in May.
However, there is no deadline by which the EU must request
this nor is there any deadline by which the EU must impose
countermeasures once the authority is received. The European
Commission (EC) in the fall of 2000 notified the WTO that it
would seek authorization, when appropriate, to increase tariffs
on U.S. exports to be selected from a very broad potential
list. To date, we are unaware of any further-refined list of
potential targets by the Commission.
Throughout the WTO dispute settlement process, we have
maintained our contacts with EU counterparts with a view toward
managing the dispute in a manner that does not disrupt the
general progress being made in international trade
liberalization. Ambassador Zoellick and Commissioner Lamy have
met numerous times and with other counterparts in the European
Commission Member States.
Mr. Chairman, I hope that this thumbnail sketch of our
origin and current status of the dispute will prove useful in
forming the Committee's future consideration of these issues.
Given our understanding of the Committee's objectives for this
hearing, I have refrained from going too far into thinking on
how to move the topic forward in the coming weeks and months,
but we look forward to working closely with Congress, the
private sector, and in particular, this Committee, in
developing ideas on how to respond to the WTO ruling and other
aspects of this important issue. Thank you. And I would be
happy to take any questions that the Committee would have.
[The prepared statement of Mr. Davidson follows:]
STATEMENT OF PETER DAVIDSON, GENERAL COUNSEL, OFFICE OF THE UNITED
STATES TRADE REPRESENTATIVE
Mr. Chairman, Representative Rangel, and Members of the Committee:
I would like to thank you for the opportunity to testify before the
Committee today on the dispute between the United States and the
European Union (EU) in the World Trade Organization, first over the
Foreign Sales Corporation (FSC) rules of the U.S. tax code, and most
recently over the FSC Repeal and Extraterritorial Income Exclusion Act
of 2000 (ETI Act).
Ambassador Zoellick has on a number of occasions in the past year
noted the seriousness of this dispute and its potentially large
financial implications for U.S. companies. In Strasbourg, France, last
May, Ambassador Zoellick likened the issue to a trade ``nuclear bomb,''
which, if not treated with the utmost care, could cause enormous damage
to the U.S.-EU relationship and perhaps the trading system more
generally. There has certainly been no lack of expressions of concern
coming in recent months to USTR from the private sector, other
agencies, and of course the Congress emphasizing the need to find a way
through the dispute that avoids EU retaliation.
As Ambassador Zoellick stated in his joint press conference with EU
Trade Commissioner Lamy last month, the United States intends to seek
to resolve this dispute in a spirit of good faith. He also said that we
intend to respect our WTO obligations and seek to come into compliance
with the WTO ruling.
I am hopeful that we will work through our differences with the EU
in a way that will result in a true level playing field with respect to
taxation. But it will be a difficult road, and one that will require
patience on all sides. The solution will be found in an appreciation of
the need to move the global trading system forward, to advance the
U.S.-EU trading relationship overall, and at the same time, to find a
solution to this dispute within which all parties can prosper.
All this being said, I understand that the primary purpose of
today's hearing is to review the history of this important case.
Therefore I hope my comments will provide the Committee with a bit of
context, both historical and WTO/procedural, to help establish a
framework for future discussions. The approach of April 15th reminds me
that I need to underscore to you my lack of credentials as an expert on
tax questions. However, I will do my best to make clear a rather
complicated story.
History
The U.S.-EU disagreement over FSC/ETI in fact has been simmering
for a long time. Indeed, the case began with a challenge in 1972 under
the General Agreement on Tariffs and Trade (GATT) by the then European
Economic Community (EC) to the Domestic International Sales Corporation
(DISC) provisions of U.S. tax law, forerunner to the FSC. The EC's
challenge alleged that the DISC rules constituted an export subsidy
that was prohibited under the GATT. In its defense, the United States
contended that the DISC in essence operated no differently from methods
of exempting foreign-source income used by the tax regimes of EC Member
States Belgium, France and the Netherlands. In the U.S. view, the DISC
simply ``looked different'' from European approaches because it
operated within the U.S. worldwide (or residence-based) system of
income taxation as opposed to European-style territorial tax systems.
The United States proceeded to bring its own GATT disputes against the
three EC Member States.
In 1976, a GATT dispute settlement panel ruled against the DISC and
the three European tax regimes, finding that each allowed exports to be
taxed more favorably than comparable domestic transactions. In 1981,
the panel's findings were adopted by the GATT Contracting Parties,
together with an Understanding which essentially overturned the legal
conclusions of the panel with respect to the European systems. In 1984,
the United States enacted the FSC legislation, claiming in the GATT
that the new U.S. tax rules conformed to the principles elaborated in
the 1981 Understanding. Though the EC and Canada promptly requested
GATT dispute settlement consultations on the new FSC, and joint
consultations were held with these trading partners in 1985, neither
Canada nor the EC thereafter chose to pursue the matter further in the
GATT.
Ten years later, in 1995, the WTO came into existence, along with a
new Subsidies Agreement. In 1997, the EC, now the EU, requested WTO
dispute settlement consultations with respect to the FSC. In 1998, a
WTO dispute settlement panel was established to consider the EU's
complaint. In developing the U.S. defense in the case, USTR worked
closely with the Treasury Department and private sector representatives
of FSC users. The U.S. brief covered a range of technical areas, but
the key U.S. arguments were:
The FSC exempted income attributable to foreign economic
activities, as expressly permitted by the 1981 Understanding; and
In substance, if not form, the FSC was no different from
the territorial exemption method used by many European countries. Like
the DISC, it simply ``looked different'' due to the different nature of
the U.S. tax system.
In 1999, the WTO panel issued its report, finding the FSC to be a
prohibited export subsidy under both the WTO Subsidies and Agriculture
Agreements. Essentially, the panel found that the FSC was an export-
specific exemption from otherwise applicable U.S. tax rules. The panel
also found that because the 1981 Understanding did not form part of the
WTO rules on subsidies, there was no exception for tax measures that
exempted income attributable to foreign economic activities. As a
result, the panel did not make findings as to whether the FSC actually
did exempt foreign-source, as opposed to domestic-source, income. Also
on grounds of judicial economy, the panel did not address the EU's
challenges to the FSC administrative pricing rules, which were alleged
to be inconsistent with the arm's length principle; and to the FSC
definition of ``export property,'' which was alleged to violate the WTO
prohibition against subsidies contingent upon the use of domestic over
imported goods. The panel said that the United States should withdraw
the FSC subsidy effective October 1, 2000.
The United States appealed the panel decision, but in February
2000, the WTO Appellate Body affirmed the panel's findings, although it
modified its reasoning somewhat. Through the summer of 2000, Congress
and the former Administration worked on replacement legislation. The
parameters for this legislation were: (1) no significant revenue
consequences; (2) no significant diminution of existing FSC benefits;
and (3) WTO-consistency.
During this time the former Administration also attempted to engage
the EU in discussions on what could go into the replacement legislation
that would alleviate EU WTO concerns. Former Deputy Secretary of the
Treasury Eizenstat visited Brussels in May 2000 and met with EU Trade
Commissioner Pascal Lamy. Unfortunately, the European Commission
declined to enter into substantive discussions of what the new
legislation should look like, claiming that the EU was not in a
position to advise the United States on how to write its tax laws and
insisting that compliance with WTO rules was the only criterion that
mattered to the EU.
After an intense several months of consultations between Congress,
the Administration and the private sector, Congress in November 2000
enacted the FSC Repeal and Extraterritorial Income Exclusion Act of
2000 (ETI Act). The EU promptly challenged the ETI Act as an inadequate
response to the earlier panel findings. At the same time, it requested
authority from the WTO to withdraw WTO concessions to the United States
(i.e., impose countermeasures) in the amount of over $4 billion, in
line with the EU's calculation of the amount of the subsidy provided by
the FSC rules. However, under a procedural agreement the Administration
had negotiated with the EU in September 2000, a WTO arbitration
proceeding to determine the amount of countermeasures to which the EU
actually was entitled was suspended pending the outcome of the EU's
challenge to the WTO-consistency of the ETI Act.
In August 2001, the WTO panel issued its report, finding against
the ETI Act. Specifically, the panel found that:
The ETI Act's exclusion from taxation of certain
extraterritorial income constitutes a prohibited export subsidy under
the Subsidies Agreement.
The tax exclusion is not protected as a measure to avoid
double taxation of foreign-source income within the meaning of footnote
59 to the Subsidies Agreement.
The tax exclusion constitutes an export subsidy in
violation of U.S. obligations under the Agreement on Agriculture.
The ETI Act's 50 percent rule regarding certain foreign
value violates the national treatment provisions of Article III:4 of
GATT 1994.
The ETI Act's transition rules resulted in a failure to
withdraw the FSC subsidies by the recommended date.
On grounds of judicial economy, the panel did not address
the EU's claims that the 50 percent rule rendered the tax exclusion a
prohibited import substitution subsidy under the Subsidies Agreement.
Where We Are Today
After consulting extensively with the Congress and the private
sector, on October 15, 2001, we filed a notice of appeal, challenging
all of the panel's ultimate findings with respect to the ETI Act. We
decided to appeal because, even though we were not optimistic about
achieving a reversal of all of the panel's findings, we thought we
could perhaps obtain greater clarity from the Appellate Body, which
would be of assistance in making any further modifications to U.S. tax
law. On November 1, we filed our appellant submission. As you will
recall, the Appellate Body on January 14 of this year rejected our
appeal on all counts. The Appellate Body's report was formally adopted
on January 29, at which point the arbitration proceeding for purposes
of determining the level of countermeasures to which the EU is
entitled, which we had been suspended by mutual agreement with the EU
in November of 2000, resumed. One would normally expect a WTO
arbitration proceeding to take no more than 60 days. In this case, the
arbitrators have informed us that they expect to take until April 29 to
finish their work and issue their determination on the authorized
maximum level of countermeasures.
The EU and the United States have in recent days submitted to the
arbitrators our respective arguments on the appropriate maximum level
for authorized countermeasures in this case. The EU, as expected,
argued that they should be allowed to adopt countermeasures with a
value up to $4.043 billion. The EU essentially claims that this amount
is reasonable because it estimates the actual effects of the ETI to be
far greater than this amount. In contrast, the United States holds that
the EU should only be entitled to countermeasures totaling from 1.0
billion to 1.1 billion, depending on the base year chosen. Our
reasoning is that WTO principles require that countermeasures be
proportionate to the trade impact on the complaining WTO Member of a
WTO-inconsistent measure adopted by the defending Member. To measure
the trade impact of the ETI Act on the EU, we used the amount of the
subsidy as a proxy for the actual trade impact, and assigned to the EU
a portion of this amount based on the EU's share of total non-U.S.
goods production worldwide.
If the arbitrators find that the EU is entitled to countermeasures
in some amount, the EU would be in position to ask for WTO authority to
impose countermeasures sometime in May. However, there is no deadline
by which the EU must request authority to impose countermeasures, nor
is there any deadline by which the EU must impose countermeasures once
the authority is received. If the European Commission decides to
utilize whatever authority it receives from the WTO to impose
countermeasures, we expect it would then move to seek approval from the
EU Council of Ministers, representing the EU Member States, to impose
increased tariffs on selected imports from the United States. How long
such a process would take is not clear at present. The Commission in
the fall of 2000 notified the WTO Dispute Settlement Body that it would
intend to seek authorization, when appropriate, to increase tariffs on
U.S. exports to be selected from a very broad potential list. To date,
we are unaware of any further-refined lists of potential targets
produced by the Commission.
I should add that, throughout the WTO dispute settlement process,
we have maintained our contacts with our EU counterparts with a view
toward managing the dispute in a manner that does not disrupt the
general progress being made in international trade liberalization.
Future Work
Mr. Chairman, I hope this thumbnail sketch of the origin and
current status of the FSC/ETI dispute will prove useful in informing
the Committee's future consideration. Given our understanding of the
Committee's objectives for this hearing, I have refrained from going
into too much detail today with respect to our thinking on how to move
this topic forward in coming weeks and months. We at USTR look forward
to working with the Congress and the private sector to develop further
our ideas on how to respond to the WTO ruling and other aspects of this
important issue.
Thank you and I will be happy to answer any questions you may have.
Chairman Thomas. Thank you very much both of you.
As I said in my opening statement, reinforced by my
colleague, the Ranking Member, working a solution to this will
be difficult, one, because it is hard, and two, because anyone
who wants to--may or may not be true--but anyone who wants to
can twist this in terms of a partisan reason for trying to
change the Tax Code. I guess the first question that I need to
ask to reinforce where we ultimately need to go is, do you
believe there is any response that will have a lasting result
short of changing the Tax Code?
Ms. Angus, can we do something other than changing the Tax
Code to respond to this. It probably is a yes or no question.
Ms. Angus. In terms of the issue of tax changes, given the
WTO's analysis of the WTO rules, we do think that significant
change in the system would be necessary and that legislation
that simply replicates the FSC or ETI provisions would be
unlikely to pass muster.
Chairman Thomas. Or is anywhere in the ball park of
replicating or looks anything like it? Do you agree with that?
Ms. Angus. We need to look at this much more fundamentally
and examine the whole range of possible ways to address the
decision while ensuring that we continue to help maintain that
level playingfield for U.S.-based businesses.
Chairman Thomas. In your oral testimony, you used the term
``disappointed'' twice--we were disappointed. Well, all of us
were disappointed that the Europeans didn't continue to honor
the gentleman's agreement. Were you surprised?
Ms. Angus. I certainly was disappointed.
Chairman Thomas. The point is that there is a legal
argument to be made, but some of us who are not attorneys or
legal or constitutional scholars have lived this. We were on
the Committee when we marched through the alphabet with the
Domestic International Sales Corp. (DISC), FSC, and up the hill
on ETI. Has the Administration, or at least that portion of the
Administration which this Committee has to work closely with in
dealing with our laws, come to the conclusion, and I believe
you said it, but I just want to underscore it, that we can't
continue down the same similar trail and expect the Europeans
to honor what, at one time, had been a gentleman's agreement,
not to probe?
Ms. Angus. Again, in light of the decision of both
appellate bodies and their fairly compelling statements
rejecting that gentleman's agreement, taking the position that
it had no continuing relevance under the WTO rules, we are
faced with a situation with the appellate body's analysis of
those rules, that legislation that takes a similar approach is
not likely to pass muster at all.
Chairman Thomas. I don't need to get more out of an
attorney than that. I would appreciate more, but I will accept
that. Not likely. I think that is an understatement. Can we get
away with doing nothing?
Mr. Davidson. Mr. Chairman----
Chairman Thomas. And what are the consequences of doing
nothing?
Mr. Davidson. I think doing nothing and this comes from the
conversations that Ambassador Zoellick has had with
Commissioner Lamy and that we have had with a number of Member
States and other Europeans. I think the comments you made in
your opening remarks that retaliation is not an empty threat is
accurate. I think that the United States taking a position that
we need to do nothing to comply with the appellate body's
decision would invite retaliation.
And I applaud the Committee for taking the step of having
the hearing today and talking about the positive steps that we
are going to make because Commissioner Lamy has made it clear,
both in private and in public, most explicitly in the press
conference, in meetings that he had with Ambassador Zoellick
last month, that the EU will be looking for solid steps of
progress in terms of what the Administration and Congress are
going to do working together to move forward on this issue. And
if we are doing that and it appears to the Europeans that we
are taking our obligations seriously, that he believes it is
possible to hold off retaliation. It is yet to be seen what
level of retaliation will be authorized. Whatever level is
authorized, it will be one of the largest, if not the largest
amount in the history of the--short history of the WTO. So I
think it is something that needs to be taken very seriously.
Chairman Thomas. Well, if we agree that we can't stay where
we are, which is the now and we have to go somewhere which is
the then, between now and then, we will be looking to
diplomatic initiatives to get people to understand that getting
between now and then is difficult. It just so happens that I
had a very interesting conversation with Mr. Superchi in the
World Economic Forum up in New York and I found it ironic as he
was talking about taking over the leadership of the WTO and
some of the sensitive issues that they were going to have to
face, he immediately presented to me two dates around which he
needed to work, August and September, involving the
parliamentary elections in France and the ministerial or the
executive elections in Germany.
The Europeans have been very successful in selling how
difficult it is to make change during the season of elections.
I think you just heard from the Ranking Member that we will
move forward on this, but it is very difficult for us to make
change during the season of our elections as well. So I would
hope that the Ambassador conveys to Mr. Lamy that there are
other elections that people should be sensitive to and they are
in November of this year and that we will be moving forward on
statutory changes to the Tax Code to comply with the WTO
ruling.
But if we are not successful by the time of the election,
it is in great part due to the fact that we do have elections
and that we will address this issue and we will resolve it. But
to expect us to resolve these difficult fundamental issues in
an election season when everyone else gets an automatic pass
from difficult decisions, because it is an electoral decision
is a point I think that this Administration needs to stress
with our friends as we look at the calendar that you outlined
in terms of potential pitfalls along the way to a resolution of
this concern.
We will be holding hearings on ways in which we can resolve
this problem. But I also want to underscore what my colleague
from New York said about the role that this Administration
needs to play. You cannot follow and expect Congress to lead in
this difficult issue. We have to be full working partners. And
to a very great extent, given the brilliance and the talent and
the expertise in both the USTR and in the Treasury, if you
could come up with some potential resolutions that you could
present to us, it would be a very great help in us moving
forward. I believe we understand our responsibilities. I am not
comfortable with the timeframe. It is going to be very
difficult. To the degree you can buy us some time on our way to
resolving the issue, it would be greatly appreciated, and to
the degree you can present some potential solutions to the
problem, that would also be greatly appreciated.
Mr. Davidson. Mr. Chairman, could I respond to that
briefly? I do think Commissioner Lamy and many in the EU
understand the complexity of our system, and particularly, I
think they understand the difficulty of dealing with tax
legislation. Mr. Rangel referenced the complexity and
difficulty of that issue in his statement as well.
So I think that there is a sound understanding. At the same
time he has been very clear that he needs to see signs of
progress throughout that--in the near future and very quickly.
That doesn't mean--I take that as meaning that the end of the
process he understands is a long time, but there are a number
of steps in the interim that progress needs to be shown.
Your point about the elections in the EU I think is a very
good point. This issue must also be seen in the context of the
overall trading relationship and there are a number of
controversial issues we have with the EU. When we have things
that we are concerned about they make the point to us about we
have political problems in some of our Member States, we have
elections, this is going to be a difficult issue to resolve for
awhile, have patience with us. I think your point is entirely
accurate as well to be able to make the same point to them
here. It is not a process that can be created quickly. And
particularly when you are talking about the kinds of
fundamental reforms that you are talking about.
In terms of the Administration presenting alternatives and
interaction with the Congress, we have every intention of being
full working partners and engaging proactively in putting
forward some ideas of what we can move forward on, but we are
going to need some help and interaction as well so that we can
share some of these ideas and get a feel for whether they are
moving in the right direction.
In that vein, I know that Secretary O'Neill, Ambassador
Zoellick, Secretary Evans, and others are looking forward to
creating a more formalized consultation process which I am sure
they will be talking with you about so that we can put that
full working partnership into effect in a way that moves
expeditiously, at least in the interim steps toward moving
toward some consensus solution. Thank you.
Chairman Thomas. Thank you. Just so you clearly understand,
the statements of my friend from New York were not taken by the
Chairman as a threat or a promise. They were understood to be
factual statements about the reality of the situation that we
are in. The Congress--and Europeans are sophisticated enough to
clearly understand our system--that clearly Congress needs to
forward. But to the degree they don't see the cooperation and
more importantly the understanding of the need to move forward
from the Administration, they can rightly believe that we are
not presenting as broad and honest an approach in trying to
resolve the issue as we could. So it is going to take a full
partnership. And we cannot be Alphonse and Gastone asking
someone else to go through the door first. You don't wait for
us, we don't wait for you. Both of us need to move forward. And
the argument that somehow you have to have a formal invitation
to help us address an international problem is not what I
really want to hear.
What I want to hear is, you folks get it, we have got to
change, notwithstanding the difficulty of the change, we are
beginning with this hearing and we will move forward. Now is
behind us and then is in front of us. Between now and then, our
diplomatic and legislative and executive efforts, all of us
have to be part of this team pulling together. I know we will.
And I appreciate your testimony.
Gentleman from New York.
Mr. Rangel. Well, I feel a little awkward in agreeing with
almost everything the Chairman has said. And I don't really
like the idea of foreign governments making the determination
as to how quickly we are making progress. You see Mr. Davidson,
your office has a very responsible diplomatic role to play. But
it is the Secretary of the Treasury that has a real realistic
role to play in giving us a road map as to what the
Administration would like to see the objectives to be. It is
never easy making dramatic changes in the Tax Code, and when
the Chair asked the question, do we have to change the Tax
Code, that is all we do is change the Tax Code. We change it,
it doesn't mean we reached the results that we would want.
So that you could be disappointed, but you had a series of
disappointments because we never really reached a point that we
found an international legislative resolution of this problem
that has been hanging over our heads for decades. Now I think
it is safe to say that the Chairman and I have not built up a
reservoir of bipartisanship that the Administration can rely
on. And that means that no matter how much of us have love for
our country, that we just can't wave the flag and move forward
and say we want to accommodate USTR and our friends in the
European Union.
We have to find out just what changes--how these changes
are going to impact on American taxpayers, on American
industry, whether they would be a flight of American industry
if we changed the tax system so there is no corporate taxes. It
is very complicated, but a very political decision--very
political decisions have to be reached.
So I think what the Chairman is saying is, you can't--you
should not rely on us in coming up with the answers alone. We
will do what we have done in the past and we have supported
each Administration, Democrat and Republican, to let our
foreign friends know that we intend to be treated fairly on
this issue. But if you leave it up to us to come up with
solutions that tear us apart without having your help in
bringing us together, then whether or not progress has been
made, it will just be a moot issue.
So I cannot think of an issue more than the war that should
bring us together in a bipartisan way to try to work out before
we go public, and so I am glad that the Chairman has restricted
the testimony this morning to the history of what got us to
where we are.
And I don't know what the Oversight Subcommittee is going
to do, Mr. Chairman, but I hope that the fireworks are kept
down to a minimum over there until we can get a handle as to
which road we can walk down to comfortably, and then just try
to work out the details to it. But if we are going to have a
dramatic change in our tax law, we can just hope that the
Administration helps us to progress quickly toward resolution
of this long time problem we face.
Thank you, Mr. Chairman.
Chairman Thomas. Thank you very much. As the gentleman from
New York can see, there are no TV cameras at the full
Committee, and the chances of a TV camera getting to a
Subcommittee are even less. So our purpose of moving the issues
of resolution to a Subcommittee is clearly to pursue options
that not only seem to be viable but acceptable. And it will be
a difficult road.
Mr. Rangel. If I may, I think the Administration had
suggested, or at least Mr. Davidson, that we might have some
informal meetings between Mr. Evans, O'Neill, and USTR and
Members of the Committee.
Chairman Thomas. Let me suggest that what the
Administration has proposed, my understanding is that they are
going to put together a working team among the Administration
and that they will bring outsiders and academians, laypeople
and others in looking at options that they have. My
encouragement is that they move fairly quickly through that
process. We can meet informally or formally. I think work
product is the most important thing, and that if they are able
to come up with some suggestions as the gentleman has indicated
repeatedly, we need them as soon as possible.
Mr. Davidson. Mr. Chairman and Mr. Rangel, if I could just
clarify my statements, I completely agree with your assessment
that we need to move together on this and work closely and work
quickly. I did not mean to imply in any way that we should hold
back on either of the fronts before one of the other front was
moving forward. I applaud the Committee for having the hearing
today, beginning the process of looking at where we need to go
in the formal setting of a hearing room. I think that the
informal process and consultation needs to move forward
simultaneously. But I don't think we can wait on any one stage
to move forward on all of them. And that is our position.
Chairman Thomas. Gentleman from Illinois, the Chairman of
the Trade Subcommittee, wish to inquire?
Mr. Crane. Thank you, Mr. Chairman. Ms. Angus, what types
of fiscal alternative proposals are being considered to keep
U.S. businesses competitive in the global marketplace?
Ms. Angus. We believe that we need to consider the full
range of options, all possible alternatives that will address
this issue, but as you say, ensure that we maintain the
competitiveness of U.S. businesses and their workers. We need
to thoroughly examine the U.S. international tax rules. Those
rules were first developed 40 years ago when the global economy
and the U.S. place in that global economy were very different
than they are today. We need to look at all of those rules from
the beginning in order to find a way to address this issue that
doesn't disadvantage U.S. businesses.
Mr. Crane. Well, I would hope that you would incorporate in
your considerations a total repeal of any tax on business
whatsoever. I pushed for that for the entire time I have been
in Congress, but before that, when I was teaching. And the
thing that is so disturbing about taxing business is that they
don't pay taxes. They gather taxes. That is a cost, like,
planned equipment and labor, and you have got to pass it
through and get a fair return or you are out of business.
And there are countries that are providing that kind of
window of opportunity, and there are American businesses
running to places like Bermuda because of it. And I would hope
that we might consider something wholesome and healthy like
elimination of that stupid tax all together. And I yield back
the balance of my time.
Chairman Thomas. Now that oil has been poured on troubled
waters, gentleman from Michigan wish to inquire?
Mr. Levin. I am going to try to take back some of that oil,
Mr. Chairman.
Chairman Thomas. As long as you don't light it.
Mr. Levin. No. Indeed, within the bipartisan spirit the two
of you preceded the Chairman and Ranking Member, I want to try
to cast this in a somewhat different light, not only for those
of us in this country, but for those in Europe and the WTO.
First of all, we have gone over the background and I hope that
there is not only a sense of disappointment in this country,
but really a sense of outrage.
This was more than a gentleman's agreement. After the
General Agreement on Tariffs and Trade (GATT) decision in the
early 1980s, this thing was worked out through the GATT council
with an official understanding. And we, as a result, passed
legislation in 1984 as we all know. That legislation was an
effort to fulfill the understanding that we had on this issue.
And for the next--1984.
And for the next decade plus, that approach prevailed. It
wasn't seriously challenged. It wasn't raised in the Uruguay
round when the Europeans could have raised it and it was only
after the Europeans lost a series of cases really that they
raised this issue. And I think everybody should understand
that--this background, so that is point one. It was more than a
gentleman's agreement. It was a--it was a structure that was
enacted pursuant to discussions within the GATT, and it was the
structure that prevailed without any serious challenge until
the Europeans lost a series of cases. Number two, I don't think
we should act as if this is a dagger at the United States. What
this is is a dagger at the U.S. and European economic
relationship. I don't like the nuclear trade bomb description
very well.
Mr. Zoellick said trade nuclear bomb, not nuclear bomb. But
if it is a trade nuclear bomb, that means that both sides
better be weary about its use. And I think the same is true if
you call it a dagger. In this respect, Mr. Davidson, I want to
read back to you your testimony which I assume has been cleared
by USTR and I think the Europeans should listen to this, and I
am not saying anything that I haven't said to Mr. Zoellick and
this is on page one. The solution will be found in an
appreciation of the need to move the global trading system
forward to advance the U.S.-European trading relationship
overall, and at the same time, to find a solution to this
dispute within which all parties can prosper.
Now we should embrace that language and make it clear to
the Europeans and everybody else that this dispute is a threat
to the global trading system. And if anybody tries to grab it
to their advantage, they are, I think threatening the global
trading system.
And so, we are not the only ones who should have a concern
about this. So should the Europeans, and for them to think
there is a major tactical advantage here I think is, for them,
a serious mistake. And therefore, I want to make one last
point. The Chairman talked about the difficulty of moving this
in an election season. That is part of it, Mr. Chairman, but it
is not only because this is an election year. These are
exceptionally difficult issues. Mr. Crane says he has been
advocating the change of all of his years here. That is what,
Mr. Crane, 3 decades?
Now maybe that says something about the substantive
difficulties. Mr. Davidson, when you talk about signs of
progress, let the Europeans not misunderstand that there is an
easy solution to this in terms of American policy because there
is not. There are deep differences and they cannot expect to
use a temporary tactical advantage to expect that there will be
major tax changes in this country in any foreseeable future. We
can work on it and I am glad we are going to do it, but there
should not be false expectations here. And I don't want to make
it difficult by saying zero will happen because if Mr. Lamy
wants something to point to, we should give it to him.
But--and we will work on this issue but this is not mainly
an election year issue. And their advantage is, I think
something that can come back to haunt them. I told Mr. Lamy, he
is like the dog that caught the bus, and I hope he takes it
seriously. We didn't raise this at Doha. We didn't raise it
before Doha, and we need to raise it now.
And Mr. Davidson, I will finish by saying I think the words
here about where the solution will lie is surely something that
should be taken seriously. We will work hard on legislation but
the Europeans should understand the ramifications of action on
their part challenging a structure that they lived with for
more than a decade without challenge and did not really
challenge until they lost a series of cases in the WTO.
Chairman Thomas. Thank the gentleman. I want to underscore
the point that he made. I did start out in my statement by
saying that this is going to be very hard to do. I pointed out
the elections and I stand corrected. The French elections are
on April 21, and Germans in September, because that is what
they always use as an excuse. And I wanted to lay the
groundwork that, in fact, we have a pretty darn good one as
well. But clearly, the gentleman from Michigan's point is well
taken. The primary reason we may not be able to resolve this in
several months is underscored. This is going to be a hard thing
to do. Gentlewoman from Connecticut wish to inquire?
Mrs. Johnson of Connecticut. I thank the Chairman, and I
too join the gentleman from Michigan in expressing my very
strong concerns that after living with a regimen that was
agreed to by both sides for over a decade, that they should
have raised this. On the other hand, it is extremely important
to us as a Nation that we have a rule based enforceable trade
structure and that issue of abiding by decisions is just
extremely important to America.
If we can't enforce the intellectual property provisions of
the World Trade agreements, we will be the ones to pay over and
over again, and it will, in the end, have a serious effect on
our economy. So we depend on a rules-based system. This has
gone against us. We do have to find a way to deal with it. It
will take time.
But I want my colleagues on this Committee to--I want to
just express to them and to you that I hope that we will deal
with this issue at the same time we look at what is causing the
American Tax Code to drive international mergers to be
controlled by foreign entities.
We had testimony before this Committee that DaimlerChrysler
is DaimlerChrysler because of our Tax Code. It could have been
Chrysler Daimler. And we see now that they are downsizing.
Where is the power when the tough decisions are made? They are
being made out of Germany. They are not being made out of
America. We had testimony behind closed doors, and we had
statements behind closed doors in some of the big international
bank mergers that they are going to be foreign-owned, primarily
because of our Tax Code. Last year or year before we saw
insurance companies organizing in Bermuda.
Now we are seeing tool makers organizing in Bermuda because
it saves them millions and millions of dollars without laying
anyone off or other consequences. So we do have to look at how
our Tax Code is driving control over major actors in our
economy offshore, and often into foreign arms. And I just think
we need to look closely at that and maybe from looking at that,
we will find things that also might solve this other problem or
move us in a direction that will make us somewhat more
harmonious with the world, because I think our tax structure is
beginning to drive jobs abroad just like a few decades ago,
some of our environmental regulations drove the cost of
production so high that jobs went abroad. Now those things are
beginning to even out at least in some parts of the world. But
our Tax Code is now showing evidence of driving jobs abroad,
the movie industry and all across the front. So we have our
work cut out for us and we need you and the Secretary of the
Treasury to begin to put a strong shoulder to the wheel.
Thanks.
Chairman Thomas. Gentleman from Washington, Mr. McDermott
wish to inquire?
Mr. McDermott. Thank you, Mr. Chairman. Seems to me like
you walked into a lecture hall here today and hearing lectures.
And I just would make a discussion that when you put that panel
or working panel together, you try and make it an open one so
that we don't have any trouble with people deciding decisions
being made behind closed doors. But one of the things that
strikes me as I listen to this whole thing--and I think Mr.
Crane is the most honest man on the Committee. At least he will
put a plan on the table. Nobody else. But I have been sitting
here listening to this baloney for 8 years now and nobody will
put a plan on the table. Everybody says, well, we will figure
it out, we will go back and we will challenge them and we keep
losing.
We have done it a couple of times and you ought to learn
after the second one that this isn't going to work. But I think
you can count on this Committee for doing nothing. We are not
going to do anything until you do something.
I think that the record in the course of last 8 years has
been actually we have done very little. Now, I used to
represent one of the major exporters of this country. I still
represent some pieces of it, but the major piece went to
Chicago. And I don't know--I used to worry about this FSC
thing, but I don't worry about it anymore because it looks to
me like it is permanent employment for tax lawyers and trade
lawyers because nobody seems very worried about this thing.
Can you give me a cutoff date when we are really going to
get slammed, or is this thing just going to go on forever, we
will be looking at this when I retire in 25 years, and we will
still be thinking we are going to deal with FSC one of these
days? Is this just passive-aggressive on our part?
Mr. Davidson. Mr. McDermott, I can't give you a specific
date by which there will be retaliation and I can't tell you,
regardless of the retaliation--that is actually given to the EU
by the panel--what amount they may choose to proceed with. All
I can say is that in conversations with Commissioner Lamy and
others and Member States, that I don't think--they will not be
hesitant to retaliate if they believe that we are going to go
through another what you said, 8 years of doing nothing. So I
don't know when the cutoff date is.
It seems to us from all the indications that we have seen--
I was in Europe a couple months ago meeting with some Member
States, and I received the same message from them. So I think
that it is a question of looking at what--what our government
is doing, how serious an effort they are taking toward--steps
toward reforming the system, and I think that if we don't take
those steps----
Mr. McDermott. What steps did you suggest--I mean, I heard
there was some progress. What steps did you tell the Europeans
that we were taking toward a resolution of this? We are going
to form a Committee? Is that what the progress was?
Mr. Davidson. No. We didn't give a specific list of things
that we were doing, procedures we are going to be taking, other
than to say that we are going to be working closely with you,
with Congress, in terms of moving forward on the issue. Now, I
am sure their response is well, you know, we will believe it
when we see it; the jury is out and so----
Mr. McDermott. But there is nothing in the rules of the WTO
that gives them a date where they can say, look, March 1, you
either do something or here comes the penalty?
Mr. Davidson. Once they get the--on April 29 or thereabout,
there is a perfunctory procedure----
Mr. McDermott. Perfunctory?
Mr. Davidson. Well, there is one more--once they get the
number from the panel, there is one more stage which they have
to go through but that is perfunctory----
Mr. McDermott. The panel has to decide how much to
finance----
Mr. Davidson. Find how much, and then for all practical
purposes essentially they can retaliate to that amount in a WTO
legal manner. They don't have to wait. There are some--
hopefully some consultations that go on, but----
Mr. McDermott. So Boeing airplanes could go up in price, 10
percent or 5 percent or something else, on that day.
Mr. Davidson. That is right. That is right. And there is
no----
Mr. McDermott. The 29th of April, when we have just laid
off 30,000 people.
Mr. Davidson. But there is--there is no deadline by which
they have to exercise that authority; so there is an
opportunity for us to continue to work through the issue to--we
have established quite an arsenal of weapons here, from daggers
and nuclear bombs and things like that and----
Mr. McDermott. I am more worried about price increases.
Mr. Davidson. An effort to prevent that from happening I
think is what we are here talking about; what is the process
that prevents that from happening? And to answer your question,
there is simply no set date. They can delay as long as they
would like to delay before imposing retaliation, but retain the
ability to do so.
Mr. McDermott. Are you betting that they will just let it
ride a while?
Mr. Davidson. No. I think, Mr. McDermott, our belief is
that if the EU does not see what they consider to be credible
progress in terms of us moving forward, that we face a high
likelihood of some type of retaliation.
Mr. McDermott. So you think--if they see a Committee, do
you think they would think that was credible progress?
Mr. Davidson. Mr. McDermott, I can't speak to what they
would see, but I think--I think what they are looking for is a
credible process and that is--that is, you know, actually
making some progress toward talking about the kinds of things
that the Chairman was talking about and Mr. Rangel was talking
about earlier.
So I don't think--if your question is can we hold a series
of meetings and hearings and things like that and hope to hold
off retaliation if there is no substance there, I don't think
that that is going to be sufficient.
Mr. McDermott. And the substance would be a proposal on the
table that we were considering--or what would the substance--I
would like to know what the substance is that I need----
Mr. Davidson. The substance would be a substantive
discussion of options.
Mr. McDermott. Thank you. That sounds pretty clear to me.
Mr. Crane. If the gentleman could yield for just a moment,
he made a reference, and I expressed appreciation for his nice
compliment, but we lost this distinguished gentleman from
Chicago. He moved out to Seattle, and Seattle graciously traded
off by giving us Boeing. And what we both want to guarantee is
that Boeing doesn't become Lufthansa-Boeing.
Chairman Thomas. The Chair would now like to recognize the
gentleman from New York, Mr. Houghton, if he has a question or
two.
Mr. Houghton. Yeah. Thanks very much. I would like to make
a couple of statements and then have you challenge them. First
of all, I see no way in order to help a business to solve this
thing in a hurry, because if something else has to happen to
our tax structure it is going to take a long time. You know how
the process works around here. We don't even have the ideas.
Take a long time.
So something in the meantime, in the interim, has to come
into play. And frankly, the only thing that I can think of, and
challenge me on this, is that we--we say to the Europeans we
are going to have more time on this thing. We are working on
it, we are doing whatever we can, we are not going to be put on
the defensive, and frankly if that is not good for you, then we
are going to start challenging you.
I mean, we have just been over in--Mr. English and I have
just been over at a meeting in Germany, and they are
complaining about some of the steel cases, the 201 situation,
forgetting entirely that they upheld--they invested in the
steel industry from the government. I mean, that is something
which we can challenge.
I don't know what happened as far as the foreign source
income used by the tax regimes of Belgium, France and
Netherlands, whether that was resolved or not. But they are not
lily white clean on this thing, and frankly the only thing we
can do--and, again, challenge me--is to say we have got to have
time on this thing.
Now, as far as the--as far as the taxes are concerned
overall, I am not convinced that--that ChryslerDaimler would
have been ChryslerDaimler if we had had a different tax
situation. The fact is that Daimler had more of the stock, and
that is pretty clear to me, and therefore they call the shots
on this. There are always going to be places you can go.
I know there was a wonderful suggestion at one time that
the ideal situation would be for a business to own an island,
and then have the domicile of that business on that island and
establish its own tax rules. Well, that may happen in the
future and they are going to be trading back and forth, and the
question of where you can get the best price and the best cost
structure, but those are big, big, big issues; and at the
moment, it seems to that we must bide for time, and if we
don't, then the people that we are trying to help are going to
go under. Four billion dollars is not an inconsequential price
tag. Maybe you can comment on that.
Mr. Davidson. Mr. Houghton, I concur with you completely
and we have made the case strongly to the Europeans that we
need time to comply. And in fact, you know, we have been
working with them throughout my entire tenure at USTR for the
last year or so on pushing hard on that area, and I think they
do understand the complexity of this area. So we have made that
case forcefully.
In terms of talking about if you were heading in the
direction of filing other cases to provide leverage or
something like that, for strategy like that to--I think there
are some concerns about a strategy like that. You have to
have--you actually have to have some arrows in your quiver that
are of commensurate value, and second I think such a strategy
runs the risk of a never-ending cycle of litigation that
doesn't actually help you solve the underlying problem.
I think if you look at--the bananas dispute that we have
been working on is a good example. You know, counter cases to
the bananas dispute I am not sure would have helped us reach a
resolution. Instead we rolled up our sleeves, got down to work,
and we actually worked out a resolution on that case and it
took some time--it took some time to do it.
I think what is going to drive the resolution of--and this
is my own opinion, but I think what will ultimately drive the
resolution of this will be both sides looking at it seriously,
working hard, and looking at it in the context of the overall
U.S.-EU relationship. We have got a lot at stake in terms of
the positive trade liberalizing agenda and we can't allow
disputes like this to throw those important initiatives off
track.
We have the launch of the new round in Doha recently. Both
the United States and the EU were instrumental in moving that
forward. Both sides have a real interest in moving the broader
context forward, and so I think that is the positive incentive
to work through this issue and come up with a result that will
actually get us there as opposed to more negative incentives.
That is my own personal opinion.
Chairman Thomas. Thank you. The gentleman from
Massachusetts----
Mr. Neal. Mr. Chairman, could you come back to me after we
vote?
Chairman Thomas. Well, I think everyone would like to do
that, and, if in fact, we are not going to be able to carry on
the hearing, do we have just--the Chair understands it is a
vote on the rule, and so there are other Members who wish to
inquire, the Chair assumes. Let us then say that we will
reconvene at 20 minutes after 12, and if you will allow us to
do that and remain, because there are further questions by
Members of the Committee, the Committee will stand in recess
until 12:20.
[Recess.]
Chairman Thomas. The Chair wants to thank the
representatives of the Administration. Holding hearings during
voting clearly means we have to do two things at once
sometimes, and we are not able. The gentleman from Louisiana
wish to inquire?
Mr. McCrery. Yes, Mr. Chairman. First of all I want to
thank Chairman Thomas. I and the other Members of the Select
Revenue Measures Subcommittee appreciate the opportunity to
move this process forward and to seek a legislative solution to
this matter. So we will be working on that at your direction,
Mr. Chairman, and look forward to working with you to
accomplish that goal.
I would like to pose this question to either of you or both
of you, and it concerns the question of jobs in the United
States. Can you tell us how the FSC or ETI rules affect jobs
here in the United States, or does it have any effect on job
creation or job retention here in the United States?
Ms. Angus. The ETI provisions, as a part of our
international tax rules, help to allow U.S. companies to
compete better in the international marketplace, and that in
turn allows them to expand their production, investment and
employment here in the United States. So these provisions, by
allowing them to be more competitive in the international
marketplace, in the markets where the customers are and where
they need to compete, allow them to produce more here in the
United States and employ more workers here in the United
States.
Mr. McCrery. That is the right answer. Mr. Davidson, I
guess you don't have anything to add to that.
Mr. Davidson. Yeah. Mr. McCrery, I don't really have any
economic data to back up any different opinions, so I defer to
Treasury on that analysis.
Mr. McCrery. It sounds like she was well prepared for that.
Now I would like for you to talk about this distinction between
direct and indirect taxes and what difference that makes in
terms of the WTO and the rules allowing indirect taxes to be
rebated at the border. Can you give us a little background on
that, explain that a little bit?
Ms. Angus. The United States imposes an income tax which is
considered a direct tax. Under the trade rules as I understand
them, direct taxes are not border-adjustable. So under the
trade rules the U.S. income tax isn't--isn't and cannot be--
rebatable on exports. An indirect tax is a tax on transactions,
goods or consumption; in other words, a tax that isn't on
income. The definition seems to be that indirect tax is
anything that isn't a tax on income. Value added taxes and
sales taxes are considered indirect taxes.
As I understand the trade rules, a tax is considered a
border-adjustable indirect tax if it is levied on the
destination principle. Under the trade rules, a tax is not
border-adjustable if it is levied on the origin principle.
There are some indirect taxes that are levied on the origin
principle. Direct taxes, like income taxes, are levied on the
origin principle. I think on the next panel, Mr. Hufbauer in
his testimony traces this distinction in the trade rules
between the treatment of direct and indirect taxes all the way
back to a 1960 GATT, General Agreement on Tariffs and Trade,
working party.
Mr. McCrery. And what difference does it make if indirect
taxes are rebated at the border? What practical effect does
that have?
Ms. Angus. Well, I think that the real issue is one of
consistent treatment; the treatment on the way in, and the
treatment on the way out. This distinction under the trade
rules on how they allow income taxes or direct taxes to be
treated versus how the rules allow indirect taxes to be treated
is one that has long historical roots. I think the economists
will tell us that the distinctions in incidence between direct
and indirect taxes really shouldn't be relevant for purposes of
determining whether one or the other should be border-
adjustable.
Mr. McCrery. But the practical effect of allowing indirect
taxes to be rebated at the border, and not direct taxes as they
are defined by the WTO, is that a product coming from, say,
France, which has a price attached to it, part of which is the
value-added tax, the indirect tax, when you subtract that part
of the price, what happens to the price that we pay in the
United States for that product? It is reduced, isn't it?
Whereas the same product emanating from the United States,
going to France, and the tax component is an income tax, that
can't be rebated at the border so you don't get that reduction
of the price, right?
Ms. Angus. Yes. And another aspect of this difference in
treatment between income and non-income taxes, direct and
indirect taxes, is that should be looked at in the context of
the fact that the United States has a tax system that is
heavily reliant on an income tax, whereas while other countries
do have income taxes, a larger portion of their tax is made up
of consumption taxes for which these border adjustments are
permitted.
Mr. McCrery. Thank you.
Chairman Thomas. I thank the gentleman. I guess that was a
discussion with a lawyer about what goes on in terms of
rebatable taxes at the border. I noticed during that discussion
the long-time Trade Subcommittee Chair of this Committee and
the interim Chairman of this Committee, the gentleman from
Florida, Mr. Gibbons, came in, and I know he followed the
lawyerly argument there; but I think probably if you will allow
me for just a moment, a perhaps more English answer would be
that the Europeans have a tax structure which allows them when
they export products to rebate a tax, and when products are
brought into the country, to impose it.
Let me put it another way. Since we use an income tax, and
we have taxes and some of the taxes that are the largest part
of our tax system are social welfare costs, the Medicare and
the Social Security Trust Fund moneys, that those costs are
embedded in our products, whether they are in this country or
whether they go oversees. So we have social welfare costs
embedded in our products domestically or internationally.
When the Germans or the Japanese or any other major
industrial country with which we trade--as I said in my opening
statement, we are the world's largest importer and the world's
largest exporter. When their products remain in their country,
it is true their social welfare costs remain, because those
taxes have been added to their product domestically, whether it
is Germany, Japan, or another country. But when they export
those products, they get those taxes rebated, so the social
welfare costs are lifted from the foreign products going into
the United States. But when the U.S. exports into the EU,
Japan, or any other major industrial country, those taxes are
added. So we carry the embedded social welfare costs for the
United States, and we carry the additional social welfare costs
of every other country we export products into. But the
Europeans coming to the United States have had that tax lifted.
So they come into the U.S. market, the world's largest trading
market, unencumbered to a very great extent by those taxes.
They go on the shelf in direct competition with U.S. products
that have those taxes embedded in them.
So in one of the most fundamental ways, we are at a
disadvantage by our unwillingness to change our Tax Code, and
every other country with which we trade is advantaged by their
Tax Code on social welfare costs.
Let me put it a bit more practical way. The United States
pays the world's social welfare costs along with ours, and we
don't have any other country sharing the paying of our social
welfare costs because of our tax system, and we have tried to
modify that slightly. That is why we are here. We have to
address the fundamentals. And it seems to me--this is an
editorial comment. We are not supposed to look at the future at
this hearing, but it seems to me that if we come up with a
solution to our current dilemma and don't deal with the
rebatable tax question, we have not really taken advantage of
an opportunity to make a change that puts us on a level playing
field in terms of those rebatable taxes. That does narrow our
options. But for us to go back into the tranche of income is to
continue to pay the world's social welfare costs, and the world
doesn't help us with ours. And that is an undercurrent that
will continue throughout all of the discussions as to what our
response will be in dealing with the ETI, Foreign Sales Corp.,
DISC, or any other attempt to take away the advantage the
Europeans have because of their tax systems.
And I thank the Committee for allowing me to lay that out,
because it is an issue that we are going to have to face. The
gentleman from New York.
Mr. Rangel. Mr. Chairman, I hope that my silence is not
interpreted as being supportive of what you said.
Chairman Thomas. Whether the gentleman is silent or voices
his opinion, I have never assumed it is supportive of what I
say.
The gentleman from Massachusetts wish to inquire?
Mr. Neal. Thank you, Mr. Chairman. Just one--since you
editorialized, let me do the same for just a couple of seconds.
Mr. Chairman, despite the talk that we heard around here, for a
considerable period of time beginning in 1992, 1993, 1994, we
are no closer to a flat tax today or no closer to a consumption
tax. I mean, it sounded great in terms of campaign sloganeering
and all those things, but a fundamental discussion of
simplification is a good starting point for all of us, and I am
convinced we can find some middle ground.
But, more to the subject at hand. Ms. Angus, we have heard
some comments today, and I expect we are going to hear a few
more about some U.S. corporations becoming fed up with our U.S.
tax system and leaving the country. Some have advocated
fundamental tax reform, which will certainly take a lot of time
to implement. But in the meantime, how might you respond if
individuals decided that they, too, were fed up with the tax
system and they decided to decamp to the Caribbean?
Is the Treasury Department disturbed about this trend? Do
you have any proposals to stop these departures, either
corporate or individual?
And we have also heard that some of these corporations must
decide between layoffs and paying their share of U.S. income
taxes. Tough decisions indeed. What if a company shuts down the
factories and moves offshore to avoid U.S. tax, and does the
Treasury Department have a concern about this?
There is this great aura of patriotism that surrounds the
country, and then there are those who in the next breath argue
that somehow paying their share puts them at an anticompetitive
position. We have read some disturbing news accounts. I assume
that there are some discussions taking place within Treasury
about what has been happening. And what is the long view of
Treasury in this instance?
Ms. Angus. Thank you. We need to look carefully at these
transactions that have been reported recently to understand
exactly what is being done from a transactional perspective and
also from a tax treatment perspective. We need to understand
the impact at the corporate level. We need to understand the
impact at the shareholder level. We need to make sure that the
transactions are properly reported and that our laws are
complied with.
We also need to examine why U.S. companies are entering
into these transactions. We need to look at all the factors,
tax and nontax, that may be encouraging a U.S. company to
undertake this type of reorganization. An examination of the
U.S. tax rules that affect international business certainly
needs to be a part of that exercise.
Many parts of our international tax rules were developed 30
to 40 years ago. As I noted earlier, it was a time when the
global economy looked very different and the U.S. place in that
global economy was very different. We need to make sure that
our international tax rules operate efficiently and
appropriately in light of the current global environment. We
need to make sure and address any ways in which our
international tax rules may be impeding the ability of U.S.
companies to compete internationally, and if there are aspects
of our U.S. tax rules that are driving companies to consider
this type of transaction, we need to understand that and
understand why it is happening.
Mr. Neal. Based upon preliminary discussions that you have
had, would you be prepared to characterize any of what you have
witnessed as tax avoidance?
Ms. Angus. It is very difficult to characterize anything.
We certainly need to look at all of these transactions
carefully. We certainly do need to make sure that our tax laws
are complied with and that everyone is bearing their fair share
of tax liability, and there are a number of things that we are
doing in that area in a whole range of areas.
Just one particular project for which the Secretary,
Secretary O'Neill, has made a major commitment, looking at
internationally, is the need for us to be able to have the
information about cross-border transactions so that we can
enforce our tax laws.
We do everything we can to enforce our tax laws, but there
are sometimes situations, particularly when you are looking at
a transaction that crosses a border, where we need information
from another country to ensure that our tax laws have been
properly complied with. The Secretary earlier this year made a
commitment that he was going to expand our network of
arrangements that would allow us to have the appropriate
information exchange with other countries to get the
information we need when we suspect that someone may not be
complying with our tax laws and may be using the institutions
of another country to avoid our tax laws.
We think it is more important than ever not to allow the
financial institutions of any country to be used for any
illicit purpose, including cheating on taxes. And so we are
very pleased that we recently signed three new information
exchange agreements with significant financial centers, and we
are working to continue that, all to the end of having the
information that we need to ensure that our laws are complied
with.
Mr. Neal. Mr. Chairman, can I just finish for 30 seconds?
Thank you. I think I totally agree with the second half of your
answer. I thought it was very good. But might I point out that
when we talk about competition, that the people that are
visiting my office, the corporate representatives that are
coming to my office that are upset about this, they are arguing
that their competitive position is being compromised by this
occurrence, and I think we have to keep light of that as well.
Some of my best employers think this is outrageous that
this is happening, so I am not driven here by some notion of
wealth redistribution as much as hearing from those who do
abide by the rules, who do pay their fair share. They are great
employers and they feel very strongly that they are being put
at a disadvantage by what they are witnessing.
Thank you. Thanks, Mr. Chairman.
Chairman Thomas. Thank the gentleman. The gentleman from
California, Mr. Herger, wish to inquire?
Mr. Herger. Yes. Thank you very much, Mr. Chairman. And,
Mr. Chairman, I want to thank you for the comments that you
just previously made. I feel that you very accurately described
and outlined the situation that the United States is both the
largest importer and exporter of goods of any nation in the
world.
My question, beginning question, one of a couple to you,
Ms. Angus, comes from someone who has the privilege of
representing one of the richest, most fertile, and productive
agricultural areas in the world, the northern Sacramento Valley
of California. We produce a major percentage of the world's
peaches, walnuts, almonds, dried plums, all of which we in
California and the United States cannot consume; we are
dependent on exporting.
And today's hearing feels a little bit like, as Yogi Berra
used to say, ``deja vu all over again.'' This Committee and
Congress have spent years attempting to fine-tune our tax
system to provide American exporters a level playing field with
their international competitors in a WTO-consistent manner.
Unfortunately, we do not have much time given the WTO's
most recent decision. My questions today deal with the short
term and how we manage this issue until a final resolution can
be worked out. And, Ms. Angus, given the impending April
retaliation determination, what specific effort is the
Administration making to lessen trade tensions with the EU and
to prevent the imposition of trade sanctions against U.S. goods
exported to the EU?
Ms. Angus. I think, really, I ought to turn that question
over to Peter on the trade side of things to talk about exactly
what we are doing, as we face that deadline at the same time
that we are looking at some of these more fundamental changes
to our tax system and other changes, to address this in a more
long-term way.
Mr. Davidson. Mr. Herger, I think--to summarize some of my
earlier comments as well, I think if I get the gist of your
question, Commissioner Lamy has laid out some of the criteria
that he believes will be--will allow the Europeans to put off
retaliation, and those are efforts on behalf of the United
States to come to terms with the appellate body decision and
make progress in terms of what he sees as compliance.
We had a discussion a little bit earlier with Mr. McDermott
about precisely what steps need to be taken. I think it is more
difficult; I think it is more art than science. But I think it
is a question of managing the relationship between the United
States and the EU, which gets back to the question of the close
working relationship between the Administration and Congress.
So, in a nutshell, clear steps, looking at satisfying our
international obligations which are credible and move us closer
to a final result that is acceptable to all parties,
recognizing that this is a very complex process and a topic we
have talked about at length; and so it is going to take some
time. Within that amount of time, a demonstration of concrete
steps toward the end point, I think is the best formula that I
can articulate at this point.
Mr. Herger. So, then, would you say that the USTR is
working on agreement with the EU to provide Congress the time--
possibly 2 to 3 years--it may take to craft new legislation to
keep U.S. businesses competitive in agriculture?
Mr. Davidson. Mr. Herger, I am not sure that I would
characterize it as an agreement as such. What I would
characterize it as is a working understanding that, as long as
we are making credible progress, EU will hold off retaliation.
And again I don't know that it is possible to put down on paper
precisely what the terms of such an agreement or working
understanding might be, so I think it is closer to a working
agreement or a working understanding than an agreement as such.
Mr. Herger. Thank you. Thank you, Mr. Chairman.
Chairman Thomas. Thank the gentleman. Gentlewoman from
Washington wish to inquire?
Ms. Dunn. Thank you very much, Mr. Chairman. I feel the
same concern that everybody else on this Committee does when it
comes to FSC or ETI. I am from the same State as Congressman
McDermott is from, and I represent 25,000 workers in the
company that he showed concern about.
For me, it is an easy story. Airbus gets a rebate and
Boeing does not, and it creates huge competitiveness problems
with this. And yet the catch 22 is who is the sore thumb
sticking in the air when the EU decides to retaliate? And it is
going to be Boeing and it is going to be Mr. Herger's
agricultural constituents. That is where it is going go, so it
is going to hurt us over and over again unless we do something.
So I am eager to see a solution to this problem as everybody
else is eager to see a solution.
I am amazed more companies have not moved their production
out of this country. Between the burden of our tax system and
the huge costs of labor, particularly in a State like mine, I
don't see how shareholders are going to allow companies to
continue to operate in this environment.
My interest is in a trade war. I don't want to see a trade
war. I don't want to see my companies penalized because of the
amount of exporting they do, because it is a very simple ratio.
The more you export, the more jobs you have. So I am wondering
if you have garnered data over the last years on the
relationship between the number of jobs and our use of the FSC
provisions or the ETI provisions. Are there data out there we
ought to be using in some way to further our case?
Ms. Angus. I don't have data in front of me. We will
certainly look into it and look for those studies. But it is
absolutely clear that the ETI provisions are designed as a part
of our current tax system to allow U.S. companies to compete
better in the international marketplace and those marketplaces
where it is absolutely essential that they be able to compete;
and that ensuring their ability to compete is key to allowing
them to continue to expand and grow their production and
investment and employment here in the United States.
So we see a clear link between the role of these provisions
and the importance of a level playing field from a tax
perspective and jobs here in the United States.
Mr. Davidson. Ms. Dunn, can I respond quickly to your
question, or your statement, on not wanting to see a trade war?
I think that is also precisely where we are coming from,
and when I was speaking earlier--before about the larger
context of the U.S.-EU relationship, I think it is moving in a
very positive direction overall right now. I think the launch
of the round in Doha, other sectoral initiatives going on,
there are some very positive directions in the relationship.
There are a number--as there are with any trading partners
that have a huge volume, a trillion dollars of trade volume
that we have with the EU, there are going to be cases like this
which are major cases and other cases as well; and we have to
manage each of those. And so what I think I have been trying to
say here this morning is, it is our attempt to manage this
issue with the EU in a way that moves us forward and allows us
to move forward on a broader context.
But that is precisely where we are coming from, as well,
because it would be very destructive for the EU to retaliate
and then have this issue degenerate further.
Ms. Dunn. I appreciate that, obviously being hurtful to
everybody.
As you meet with companies who come in to assist you--as we
know, ETI was important to have the input of the companies, as
well as tax authorities and trade authorities--are you seeing
the development of--what I have heard you say so far is, the
relationship is strong enough that we may be able to be allowed
a little more time to solve the problem, and that we are
negotiating with the EU. Are you seeing any particular
direction that these discussions are going--what sort of a
solution it will be, combination of tax policy and trade
policy?
Mr. Davidson. I can start, and then Barbara may want to
answer that as well.
I think it is too early to say exactly what the ultimate
proposals will be, and I think that is precisely what we want
to work both with the private sector and with Congress on. We
are working closely with the private sector, and as we have
historically, throughout this process consulting on the stages
of the litigation.
And I think it is going to be very important also to have
import from the private sector in terms of where we go from
here.
Barbara, do you have anything else to add?
Ms. Angus. I would just add and echo certain remarks that,
given the importance of this matter, it is essential that we
pursue all options and all possible routes to resolving this in
a way that does protect American interests and, at the same
time, honors our WTO obligations.
Chairman Thomas. Thank you. Gentleman from Tennessee wish
to inquire?
Mr. Tanner. Thank you very much, Mr. Chairman.
I appreciate you all being here today. I just returned from
a NATO, North Atlantic Treaty Organization, trip to Brussels,
and while there went by the Organization of Economic
Cooperation and Development (OECD) and wound up in London. This
is a very, very contentious and serious issue for the
Europeans, as you know. And I was sitting here thinking as I
was listening to your comments, perhaps this is the debate on
the trade bill.
Because in some ways what we are talking about goes far
beyond the momentary disagreement we have with the Europeans
and with WTO. Because if one looks at it in context and in
total, it may be that our system of taxation is doing as much,
or more, to export jobs than any sort of trade agreement we
could possibly enter into. And so I want to premise my remarks
by saying that in my judgment, there may be no more important
issue coming before this Committee any time than the subject
matter at hand.
I heard you talking about origin-based taxes, territorial-
based taxes versus consumption taxes. And would you explain
again to the Committee the WTO rules and the way they treat--
however one wishes to characterize it--consumption taxes versus
territorial or direct or indirect? Could you go over that one
more time, please.
Ms. Angus. Certainly. And perhaps Peter has something that
he would like to add to this.
The WTO rules treat differently direct taxes and income--
indirect taxes. The U.S. income tax is a direct tax, and under
the trade rules, direct taxes are not border adjustable.
An indirect tax, a tax on transactions, goods or
consumption, such as a value-added tax or a sales tax, is
treated differently under the trade rules. Under the trade
rules, an indirect tax that is levied on the destination
principle is border adjustable. And this distinction in the
trade rules or the history of the trade rules distinction
between these two types of taxes dates back, all the way back
to 1960.
And I think, actually, Mr. Hufbauer's testimony will cover
some of the roots of that. That was before my time.
Mr. Tanner. Thank you very much. I wanted that again on the
record because in looking at this issue--and I have been for
the last 10 days--I am not sure that there is a fix as long as
there is this difference in our system of taxation that would
be WTO compliant and would be capable of being passed and
signed by the President.
And, Mr. Chairman, my observation was, given the
distinction, I am not sure there is a legislative fix that is
both WTO compliant and capable of being passed by this Congress
and signed by the President, given our two extremely different
philosophies with respect to taxation on this issue of border
adjustability.
Do you have any ideas as to how those two could be married,
as it were?
Ms. Angus. I think it is certainly a difficult issue. At
this hearing today there has been a lot of acknowledgment about
how difficult it will be to find a solution that addresses all
of the needs here and something that we need to look at very
carefully.
We need to keep focused on some of the objectives of the
provisions that the WTO has looked at, the provisions in our
tax law, their objective in ensuring a level playingfield. We
need to look at the WTO rules and their treatment of taxes.
And, again, we think that it is very important that we look at
all aspects of this, and that our solution looks at all options
and takes into account all of the things that need to be done
to address this.
Mr. Tanner. I appreciate your time.
Mr. Chairman, I think that this is a question for Harry
Houdini, if you can find him, to try to match these two
differing philosophies together. Maybe we can get him to come
testify next time. But I want to thank you for this hearing.
This is the trade hearing.
Chairman Thomas. Thank the gentleman for his comments. And
his observation is a real one, and what I would offer now,
prior to listening to the hearings and the comments, is that if
we cannot fundamentally change the Tax Code to allow us to have
the same relative advantages as the Europeans, because there is
an ideological, philosophical problem associated with it,
perhaps an alternative way of looking at it--and I only suggest
this now, and I don't want to enter into a debate about it--is
that although it is true that corporations are fictitious,
people designed them originally to create an ability to
accumulate capital in multiple ways, if you would view
corporations as the victims in this, we might be able to deal
with resolving some of the problems around the victims.
If you choose to view it as a victimless crime, then, yeah,
we are back to the fundamentals of dealing with underlying Tax
Code changes.
But if the corporations are the victims in this, we might
be able to deal with the victims and provide a solution for the
victims. And I will simply leave it at that now.
Gentleman from Georgia wish to inquire?
Mr. Collins. Mr. Chairman, the gentleman from Georgia is a
victim. You know, Yogi was brought up awhile ago, and I believe
old Yogi also said, ``When you come to a fork in the road, take
it.'' That is about where we are today. We are at the fork in
the road, so we are going to take it.
You know, the Foreign Sales Corp., as I understand it, was
put in place for competitive purposes, is that right, to allow
our businesses to be more competitive in a global market? Is
that true?
Ms. Angus. Yes, it was aimed in addressing differences
between our tax system and other tax systems that had the
effect of impeding the competitiveness. So the provisions in
the context of our system were aimed at addressing exactly that
issue.
Mr. Collins. And that provision of Tax Codes is
noncompliance with the WTO rules, right?
Ms. Angus. Yes.
Mr. Collins. Based on what I hear coming from this hearing
and what I read about the European Union, their only solution
is repeal of that provision, basically.
Mr. Davidson. You are right, Mr. Collins.
Mr. Collins. That is enough. Stop while you are ahead.
So we have a choice, status quo or repeal. What is the
difference cost-wise? Status quo, do we not then continue to
allow the business to use the Foreign Sales, and we have to pay
compensation or higher tariffs on products we export? Is that
the choice?
Mr. Davidson. Yes, Mr. Collins. I think the costs of status
quo would be most likely, probably inevitably, paying the cost
of retaliation, which means putting--basically, American
products being exported at a higher cost overseas, harming our
ability to export, or paying compensation back here in the
United States, which would be lowering the cost of European
goods.
Mr. Collins. So it is a higher cost--reduces the advantage
of being, or reduces the competitiveness of the world markets.
That is the end result whether you repeal or don't repeal the
status quo.
Well, back then, it relates to consumers and the cost to
consumers because if you repeal or if you don't repeal, either
way, the cost is going to be passed on to the consumers,
domestic or foreign.
The only thing that I can see in the interim is the fact
that Congress imposes a lot of cost on business. We impose cost
through either rules, regulations, taxation. There are a
multiple number of ways that the Congress imposes costs on
business. That is where we hear a lot of discussion about tax
reform.
And then the gentleman from Tennessee made a very good
observation of where we are with this. Reform will come from a
mandate from the people or it will not come from this Congress
because it is too political. That mandate is not there yet.
Further discussion of reform may lead to such a mandate.
But here we need some simplification, and that goes back to
the one provision that the EU has problems with. If we were to
repeal that or if we leave it in place, we need to look at the
Codes themselves and see how we can change the codes that will
lessen the cost to business for both domestic and foreign sales
that will leave us to be in a competitive state.
Well, that is going to disrupt somewhere the cash flow in
this town. I mean, the focus here in this town is the cash flow
of the Treasury, because we get our cash flow from people and
business and such. So that is the cash flow we ought to be
focused on. This Congress, particularly this Committee, should
focus on substance, substance of simplification of tax law that
we have jurisdiction over that will focus on the reduction of
cost of goods both domestically or exported.
As I say, there will be a disruption in cash flow. The only
way you deal with the disruption in cash flow is one of two:
You raise another tax to offset that disruption or you look at
your spending habits. Folks at home tell me, look at spending
first, because we ain't spending a lot of money in this town.
And I see the red light is on, and I am going to close with
this; and this is probably going to blow somebody's skirt up. I
hear constantly that I am left out. This is just an effort on
the part of some people that I am left out. You know, phone
lines in my office run both ways. You can receive a call or you
can make a call. When I walk down one of these halls, both
ways, I meet people coming and going.
There has to be an effort on both sides to reach
something--an agreement that has substance to it. And that is
what we need to do here.
I appreciate your patience and your indulgence. Come back
to us with something of substance, and hopefully, by the time
you get back, we will have something of substance.
Thank you, Mr. Chairman.
Chairman Thomas. Thank the gentleman.
I also would like to have heard the panel's response to you
that since we are the world's largest importer and the world's
largest exporter, our failure to abide by the rules is not just
the direct loss of any financial transaction, but it is a
fundamental erosion of the rules by which the world trades; and
that we cannot afford any erosion of those rules because we
will be the losers in that, not others. That is why we have
fought so hard for another round to perfect, even beyond
current rules, the rules of world trade.
Mr. Collins. Well, that is true; and it could, far beyond
just the European Union.
Chairman Thomas. It is trying to get the world to comply
with the trading rules.
We are focused on America's failure to comply. The real
problem is the world in general tries to fail to comply. Our
job is to set the example of how we ought to operate.
Gentleman from Pennsylvania wish to inquire?
Mr. English. Thank you, Mr. Chairman. I think this hearing
has explored this issue very thoroughly, and I simply want to
say that examining the WTO decision in this area leads me to
associate myself with those who have said today that they are
disappointed.
It is fairly clear the WTO decision overlooked existing
past practices within this jurisdiction. It created a precedent
for a massive intrusion into the design of individual States'
tax practices. It has--by ``individual States,'' I mean
countries. It has, I think, created the specter of future
intrusion into legitimate tax design and tax policy decisions
that are made by sovereign States. And I am particularly
concerned about the long-term impact on the world trading
system.
I do have one question for the panel, and that is, looking
at this decision and having analyzed it, do you see any
jurisdictions within the European Union where their tax system
would be equally subject to challenge, based on the principles
that the WTO has announced?
Mr. Davidson. Thank you, Mr. English.
I think that one of the reasons is that we decided--and
there was a discussion about the process of appeal. We worked
with the private sector and worked closely with Congress. And
one of the most important factors in terms of deciding to take
the appeal, knowing as we did ultimately where it was likely to
head, was obtaining some kind of clarity in the ultimate rules,
which would both guide us in terms of our efforts to comply
with the decision, but also give us some indication about where
other systems might be in terms of the new appellate body
standard.
I think it is unclear right now as to whether there might
be EU Member-States that would be vulnerable under the current
criteria. It is something that we are looking at, and we will
continue to look at that as we move through the process. We
will inform you further if we find any provisions there that we
think need to be acted on. But for now, I think that is an
interesting question and something we are going to be pursuing,
but I am not sure that is an answer to our current situation of
where we go from here.
Mr. English. I recognize that. And may I say, I would
welcome correspondence with you in the future as you look at
other tax systems. I think it is fair game for us to assess
whether we can appropriately challenge some of our trading
partners' tax systems if that is the path they have chosen to
pursue.
My final comment, Mr. Chairman, Mr. McDermott earlier, and
I think with some justification, expressed a gloomy view of the
likelihood of our coming up with a solution. I am not quite as
gloomy.
I think, as you do, Mr. Chairman, that we need to have
fundamental reform of the business Tax Code with the objective
of creating a system which is simpler, which accommodates our
exports and the capital investments that are necessary for some
of our companies to compete globally. With that in mind, I
would encourage Mr. McDermott and others to consider the
business side of a bill that I have reintroduced in this
Congress, the Simplified USA Tax, which would establish a WTO
consistent business consumption tax similar to that that was
included in Nunn-Domenici, but which would provide for full
expensing of capital investments.
I believe that this approach to reform is certainly one of
the options that needs to be considered, and I salute you, Mr.
Chairman, for being willing to raise the banner of business tax
reform; and I hope you receive support for that.
And I yield back the balance of my time.
Chairman Thomas. Thank the gentleman. The gentleman from
Texas, Mr. Doggett, wish to inquire?
Mr. Doggett. Thank you, Mr. Chairman. And thanks to both of
you for your testimony this morning.
Ms. Angus, is it correct that the law at issue before us
today represents legislation for which, prior to your coming to
your current job, you were a principal advocate and lobbyist on
behalf of the FSC 2000 coalition?
Ms. Angus. In my prior job, before I came to the U.S.
Department of the Treasury, I did represent companies that were
very interested in the issue of the FSC.
Mr. Doggett. That is what I wanted to ask you about.
This 2000 Coalition, in which you filed a disclosure form
that you were the principal of, who are the principal
individual members of that coalition?
Ms. Angus. I don't think that I can give--I could recite to
you right now----
Mr. Doggett. Just tell me three or four that you remember.
Ms. Angus. They were--the members of that coalition were--
there were several companies involved in that group, all very
interested in this issue.
Mr. Doggett. Any of the names that you recall today? You
were lobbying for them this time last year.
Ms. Angus. I am a little bit uncomfortable with not being
able to give a complete list. I did give a complete list in
disclosure forms that I filed and am certainly happy to provide
that to you.
Mr. Doggett. You gave a complete list of all the companies
that were members of the FSC 2000 Coalition?
Ms. Angus. In disclosure forms that I filed in connection
with my current position, releasing information regarding
companies----
Mr. Doggett. Where did you file that?
Ms. Angus. The financial disclosure forms.
Mr. Doggett. Listed the names of all the individuals?
Ms. Angus. Information regarding all companies with whom I
worked previously.
Mr. Doggett. If you don't want to single out some of them
today, can you provide me that information this week, the names
of the individual companies that comprised the FSC 2000
Coalition?
Chairman Thomas. If the gentleman would yield briefly.
Mr. Doggett. As soon as I finish with her.
Chairman Thomas. It is on this. I want to know if there is
a legal question.
Mr. Doggett. It is not a legal question.
Chairman Thomas. You indicated you filed this information
somewhere. Is that public information?
Ms. Angus. I am not certain about that. Obviously there are
a variety of disclosure forms that are filed. We will
certainly----
Mr. Doggett. I am just asking for the names of the
companies that composed the FSC 2000 Coalition for which you
were lobbying last year, the year before and perhaps longer
before that.
Ms. Angus. We will certainly look into this and get you the
information that----
Mr. Doggett. And that information will contain the names of
the members of the FSC 2000 Coalition?
Ms. Angus. We will certainly go back and look at this and
get you----
Mr. Doggett. What is there to look at? Can you not tell me
the names of any member of the FSC 2000 Coalition that lobbied,
with you as their principal, for the very bill that we have up
for consideration today?
Chairman Thomas. Will the gentleman yield? There is no bill
up for consideration today.
Mr. Doggett. It is the law we have. The bill you lobbied
for is the one that the WTO found noncompliant. And I am asking
the names of any of the companies that composed the FSC 2000
Coalition for which you were working as principal.
Chairman Thomas. I think if the witness understands the
question, and I believe the concern is whether or not there is
any legal concern about answering the question----
Mr. Doggett. To identify whom she was lobbying for?
Chairman Thomas. If the gentleman believes that is not a
problem, then my assumption is he has resources and either
knows the answer----
Mr. Doggett. I am sure she is about to give it.
Chairman Thomas. I am sure she is about to tell you that
she will make sure that there is no legal violation to her
answer and that she will provide it. But let us hear what her
answer is.
Mr. Rangel. Mr. Chairman.
Chairman Thomas. I tell the gentleman from New York, I am
trying to move away from what is getting very close to
badgering the witness.
Mr. Doggett. It is simply asking for information from a
witness.
Mr. Rangel. I am not saying that you are wrong in that
pursuit, but you could be a little more sophisticated in
planting an answer in the witness' mouth.
Mr. Doggett. And if I may ask----
Ms. Angus. As I indicated earlier, I would like the
opportunity to go back and determine what is appropriate
information to provide, and will certainly provide all of that
information that is appropriate and required.
[The information is being retained in the Committee files.]
Chairman Thomas. Gentleman's time has expired.
Mr. Doggett. Mr. Chairman, I haven't been given 5 minutes.
Chairman Thomas. You had 5 minutes.
Mr. Doggett. May I have just another 30 seconds?
Chairman Thomas. Gentleman can have 30 seconds.
Mr. Doggett. I would extend that answer to the 877
Coalition for which you were lobbying. People that renounced
their American citizenship, just like what Mr. Neal was asking
about for corporations, but for individuals; and also the
coalition of corporate taxpayers--taxpayers that were also
involved in international tax issues.
I want to know the names of the individual companies that
are part of that coalition, those three together, according to
the records that are public----
Chairman Thomas. Gentleman's extension of time has expired.
Mr. Doggett. Over the last 18 months, and I would like to
know who did that.
Chairman Thomas. Gentleman from Oklahoma wish to inquire?
Mr. Watkins. Yes, sir. Thank you Mr. Chairman. And I have
something that might be worthwhile. Probably a little bit of an
editorial comment, but I hope it is helpful with the Committee,
maybe our panel.
First, let me say I think the gentleman from Tennessee--Mr.
Tanner, I think you are right on the button. This is very
crucial and very important, and I think we have to work on it.
I don't have all the disagreement that Mr. Doggett has because
I hope we do have some people who are knowledgeable sitting at
this table. And I hope we do have people that have a background
in FSC and some things that are going on, because we don't want
people who are totally inept sitting out here trying to resolve
our problems.
And let me say to Ms. Angus here, the FSC provisions were
enacted to resolve---and I would like the panel to know this,
enacted to resolve a GATT dispute involving a prior U.S. tax
regime that DISC enacted back in 1971. Remember that date,
1971.
Now, nearly a generation later, in 1998, WTO came along and
said the dispute settlement--that this was not kosher. And the
European Union challenged that along the way, and in 1999 a WTO
panel was set up.
The point I would like to make here is, FSC came into being
because we are trying to resolve differences and it was
accepted then. But, Mr. Chairman, 25, 30 years later, they say,
Whoa, you've got to change that. It is not a level playing
field.
Well, you know, let us go back to Ground Zero. We have to
level some other things in with them.
Now, Mr. Davidson, let me say that I read your statement
too, and I think we have some arrows in the quivers, so to
speak, that we can work with because this deals also with
agriculture; and I think you indicated, I think your testimony
indicated, this is about a $4 billion problem.
Mr. Davidson. The EU claims that their retaliation is a $4
billion retaliation.
Mr. Watkins. And I would like that to be considered, $4
billion against business, industry as in agriculture. I don't
know what percentage of that is agriculture. Do you know?
Mr. Davidson. What percentage of FSC users in the United
States are agricultural?
Mr. Watkins. Could that be provided, a real short answer?
Mr. Davidson. We can certainly get back to you on that.
Mr. Watkins. If you don't mind. But agriculture is affected
with that.
Now, Mr. Chairman, also we do have some arrows in the
quiver, because I would like the panel to talk about it. And
you mentioned bananas, and I have led the fight about the beef
industry because the EC, in an unscientific way, has blocked
our beef from being sold in Europe. That is a blatant trade
barrier, maybe not a big number, but maybe 250 million or more
and sometimes larger than that.
But the point is, we also settled in the Uruguay talks for
a peace clause, and when you get to the peace clause, it lets
the ECU have $7 billion worth of agricultural subsidies, I
think we have an arrow; I think we have got a big-time one. We
only have about 200 million export subsidies that were
accepted. They got $7 billion, and they come to us with $4
billion in FSC.
We should not consider only taxation, by itself. We should
bring the subsidies to the table at the same time. And we need
to have someone looking at the big picture, not just simply a
tax deal. And we are talking about--because we are being hurt,
Mr. Rangel. We have been sold down the drain, and we should not
let them escape this time sequence and say, Oh, now today we
come back 30 years later and say, Let me have that, because it
was accepted then.
So I am very concerned. And, you know, I don't want to get
concerned about it very much, and that is why I want you to get
me the figures later.
But it is not just a fly-by-night thing for me. I end up
building a Center for International Trade in Oklahoma, trying
to move us forward in trade, and I find all these problems.
So an editorial comment, Mr. Chairman, I hope the comments
of the gentleman from Tennessee and I hope something I said
might be of help, but we need to use the arrow that we have,
and we have $7 billion, and we need to take it to the table to
solve this problem.
Thank you so much. I appreciate your being here, and I am
glad you are knowledgeable about the FSC.
Mr. Davidson. Thank you.
I think you know how important agriculture is in terms of
the President's trade agenda. And Ambassador Zoellick has
appeared here several times to make that point; I think it is
our number one priority in terms of the new round of trade
negotiations.
And we want to make sure we are continuing to make
progress, as I said before, on the broader trade agenda because
it is so important to keep that on track to make sure that
American agricultural products are being able to be treated
fairly overseas. And we have a number of issues we are engaging
people on, on the GMOs, genetically modified organisms, and
other issues.
Mr. Watkins. Are we putting agriculture on the table for
discussions or leaving them off? Are we resolving that at the
same time?
Mr. Davidson. In terms of the round, I mean, agriculture is
front and center in terms of the issues we want to address.
Mr. Watkins. Thank you.
Chairman Thomas. Mr. Ryan, wish to inquire?
Mr. Ryan. We are in this situation because we are in this
situation. It is important to note that this is the fourth
time, so I think that we are in agreement here between the
Administration and most members of this Committee that we need
to come up with a fundamental solution.
We can't pass something that is similar to what we just had
struck down by the WTO. So it is going to require this
Committee and the Administration to think fundamentally how we
restructure corporate taxes to respond to this, and to do so in
a way that we can continue to send our businesses overseas with
confidence and on a level playing field so they can compete in
the global marketplace. That means jobs here in America, and
that is what this is all about.
The reason I decided to comment, Ms. Angus, is there is an
old trick in Washington, and I am a relatively new guy, but the
oldest trick here is, if you don't want to debate somebody on
the merits of an argument, impugn their motives. And I think
you are seeing a little bit of that here; and it is unfortunate
because it soils the tone of the debate we have here, which is
a very important and time-sensitive issue.
We need to have experienced people in government. We need
to have people who have experience in dealing with these types
of tax issues, who know what corporations face when they run
into these tax regimes and who know the consequences of this
FSC ruling. So I think it is important in our executive branch
that we have people who know what they are talking about, who
know how these policies affect real people in our economy and
how they affect corporations.
It is not an issue that we should be ashamed of in any way,
and it is a shame that we have to go down the road of impugning
someone's motives when we are trying to find a solution on a
bipartisan basis to an issue that we are forced to deal with.
Hopefully, we will rise above that in the future.
Our next panel have some interesting ideas that we need to
look at, and I just encourage you to work with us very quickly
to come up with a fundamental answer to this problem. With
that, I just yield.
Chairman Thomas. I thank the gentleman.
And I want to thank the panel. Obviously we will be
pursuing more specific concerns in Subcommittee, and clearly
the full Committee needs to revisit it. Thank you very much.
Chair would ask the second panel to come forward. And,
first of all, thank you for bearing with us.
The second panel consists of Gary Hufbauer, Senior Fellow
for the Institute for International Economics; Mr. Peter
Merrill, who is a Partner and Director of the Economic
International Consulting Group from PricewaterhouseCoopers; and
Mr. Stephen Shay, who is a Tax Partner at Ropes & Gray in
Boston, Massachusetts.
We have written testimony from each of you and make it a
part of the record without objection. You may address us in the
time you have in any way you see fit to enlighten us from your
perspective.
And if we can start with Mr. Hufbauer and move across the
panel. Welcome and we look forward to your testimony. And you
are going to need to turn the microphones on and they are very
uni-directional.
STATEMENT OF GARY HUFBAUER, SENIOR FELLOW, INSTITUTE FOR
INTERNATIONAL ECONOMICS
Mr. Hufbauer. Thank you very much, Mr. Chairman.
As was mentioned in the earlier panel and reinforced, this
case seems to date back to 1971 and these core issues have been
both negotiated and litigated for more than 30 years in the
GATT and WTO. I subscribe to the view that the time has come
for Congress to settle this dispute once and for all; and I
think it should settle the dispute by eliminating the
competitive disadvantage to the U.S. economy arising from the
ancient practice of taxing foreign income generated when
American firms export their goods and services to world markets
and when they produce abroad.
In the outline that accompanies my remarks, I traced the
history. The most recent appellate body decision, while an
improvement on the second panel report, contains a good deal of
mischief. The second panel report stretched to declare the ETI
Act was a prohibited export subsidy. The way it stretched was
to create a new test which was not found in the first panel
report, namely this concept of a normative benchmark for
judging national tax systems.
The second appellate body used a less sweeping, ``but for''
rule to invalidate the ETI. In terms of legal rationale, that
counts as an improvement. In addition, the second appellate
body actually reaffirmed most but not all of the elements of
that 1981 Council Decision that was spoken of and what had been
dismissed by the first appellate body. So you had kind of a
circular process. They tossed the Decision out in the first
round; and in the second round, at the appellate body level,
they reinstated many of the provisions. So I guess I have to
say that is another improvement.
But these improvements came at a cost by comparison with
the first panel report and first appellate body report. And
even under the second panel report, it would have been
relatively easy for the United States to mount an attack on
European corporate tax systems. But the easy shots were
foreclosed in the second appellate body report.
There is a lot of tax detail there, and I know people don't
really want to go into that here. I am not saying that the
European systems are immune to attack under the second
appellate body report, but I am saying that the area of attack
was substantially circumscribed.
Apart from that, there is other mischief in the second
appellate body report. These WTO judicial mechanisms will
become the world arbiter of what is, and what is not, foreign-
source income if they go down the path they have set. And they
will decide what mixture of exemptions and credit systems do
and do not create prohibited export subsidies.
If this judicial activism is pursued by future appellate
body judges and not curbed by WTO Members in their Doha Round
negotiations, I think we will be traveling down the road of
more intrusive WTO examination of national tax systems that
differentiate between export oriented and domestically oriented
sectors of national economies.
I believe in the virtues of uniform taxation, but I don't
think those virtues should be imposed from Geneva. The
challenge for Congress is to reform the U.S. tax laws so as to
accomplish two goals. First, eliminate the huge bargaining chip
that the WTO Appellate body has handed the European Union. I
think it is a far larger chip than the EU ever contemplated in
the beginning. To paraphrase Senator Dirksen, after a billion
dollars, who is counting, but the FSC decision is a huge chip
for the EU and Congress has to remove the chip from the table
or the United States will pay for it throughout the Doha Round.
Second, I hope the Congress will remove the competitive tax
disadvantage that U.S. firms face when they export to world
markets and produce abroad. In his statement, Peter Merrill
goes into some length on these disadvantages. Let me just say
here that I totally disagree with the suggestion that Mr. Shay
will be offering later in this panel to eliminate deferral.
If the United States actually eliminated the practice known
as ``deferral,'' the whole U.S. economy, including all
exporters, would be placed at an extremely serious competitive
disadvantage in the global marketplace, and we would see far
more examples of inverted ownership. In fact, U.S. companies
would become easy pickings for foreign purchasers, just based
on tax differences, if we eliminate deferral.
Well, a final word on the ETI case. As a supplement to
congressional action taken in consultation with the Treasury
Department, the Administration should renegotiate the WTO Code
on Subsidies and Countervailing Measures, both to achieve
greater parity in rules that are applied to direct and indirect
taxation and to curb judicial activism in the WTO. But I want
to emphasize those negotiations are a supplement and not a
substitute for congressional action.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Hufbauer follows:]
STATEMENT OF GARY HUFBAUER, SENIOR FELLOW, INSTITUTE FOR INTERNATIONAL
ECONOMICS
Chairman Thomas and members of the Committee, thank you for
inviting me to testify on the second WTO Appellate Body decision in the
FSC/ETI case (United States--Tax Treatment for ``Foreign Sales
Corporations'' Recourse to Article 21.5 of the DSU by the European
Communities. AB-2001-8, decided 14 January 2002.) In a sense, this case
is three decades old: its antecedents date to the Domestic
International Sales Corporation legislation enacted in 1971. The core
issues have been repeatedly negotiated and litigated for nearly thirty
years in the GATT and now the WTO.
The time has come for Congress to settle the dispute once and for
all. It should settle the dispute by eliminating the competitive
disadvantage to the U.S. economy arising from our ancient practice of
taxing foreign income generated when American firms export their goods
and services to world markets, and when they produce abroad.
In the outline that follows, I trace the history of the current FSC
dispute back to the 1960 GATT Working Party. The most recent Appellate
Body decision, while an improvement on the second Panel Report contains
a good deal of mischief. The second Panel Report, stretching to declare
the ETI Act an export subsidy, created a new test not found in the
first Panel Report--namely the concept of a ``normative benchmark'' for
judging national tax systems. The Appellate Body used a less sweeping
``but for'' rule to invalidate the ETI. In terms of legal rationale,
that counts as an improvement. Moreover, the Appellate Body, in its
second decision, reaffirmed most (but not all) the elements of the 1981
Council Decision--a decision that had been tossed aside (not a ``legal
instrument'') in the first Panel Report and Appellate Body decision.
Again, this is an improvement.
But mischief remains. Under the second Appellate Body decision, the
WTO's judicial mechanisms will become the world arbiter of what is, and
what is not, foreign source income. These same mechanisms will decide
what mixture of exemption and credit systems do and do not create
prohibited export subsidies. This judicial activism, if pursued by
future Appellate Body judges, and not curbed by the WTO members in
their Doha Round negotiations, points to more intrusive WTO examination
of domestic tax systems that differentiate between export-oriented and
domestically-oriented sectors of national economies. Like most
economists, I believe in the virtues of uniform taxation. But I do not
believe these virtues should be imposed from Geneva.
The challenge for Congress is to reform U.S. tax laws so as to
accomplish two goals. First, eliminate the huge bargaining chip that
the WTO Appellate Body has handed to the European Union. Second, remove
the competitive tax disadvantage that U.S. firms face when they export
to world markets and produce abroad.
Supplementary to Congressional action, the Administration should
renegotiate the WTO code on Subsidies and Countervailing Measures both
to achieve greater parity in rules applied to ``direct'' and
``indirect'' taxation, and to curb judicial activism in the WTO. But
negotiations in the Doha Round should be a supplement, not a
substitute, for Congressional action.
Thank you.
__________
THE FSC CASE: BACKGROUND AND IMPLICATIONS
A. Quick background
A 1960 GATT Working Party codified the ancient
distinction between permissible border adjustments for direct and
indirect taxes: origin principle for direct (no adjustments at the
border); destination principle for indirect (adjustments permitted at
the border--i.e., impose the tax on imports, exempt the tax on
exports). Hence destination principle adjustments for corporate profits
taxes on export earnings (classified as a direct tax) are both an
impermissible export subsidy and a violation of national treatment. But
destination principle adjustments for VAT taxes on export and import
sales are permitted. This distinction persists, despite the obvious
economic point that a VAT amounts to a combination of a direct tax on
profits, a direct tax on interest and rent paid by the corporation, and
a direct tax on wages. In other words, by GATT alchemy, direct taxes
can be transformed into indirect taxes and adjusted at the border. But
without this magical transformation, direct taxes cannot be adjusted at
the border.
In 1962, the United States enacted Subpart F of the
Internal Revenue Code. Subpart F eliminated deferral for ``foreign base
company income'' earned by controlled foreign corporations in tax haven
countries. Base company income includes profits from handling the sales
of U.S. exports to third countries. This ``anti-abuse'' provision put
U.S. exporters at a tax disadvantage compared to other industrial
country exporters.
In 1971, faced with a growing trade deficit, the U.S.
introduced the Domestic International Sales Corporation (DISC)--tax
deferral for the export earnings of a U.S. corporation. In tax terms,
the DISC softened the impact of Subpart F, which subjected foreign base
company income to U.S. tax. The United States argued that tax deferral
under the DISC was not the same as tax exemption. The EC challenged the
DISC in 1974. In turn, the U.S. challenged the European ``territorial
approach'' to taxing export earnings. Specifically, the U.S. challenged
tax exemption for the portion of export earnings attributed to a sales
subsidiary located in a tax haven country. (None of the European
countries then or now has an effective equivalent of Subpart F for
current taxation of ``foreign base company income''.)
A GATT panel decided the four ``tax cases'' in 1976: all
defendants lost. Retaliation was held in abeyance during the Tokyo
Round negotiations.
The Tokyo Round Code on Subsidies & Countervailing Duties
settled the four tax cases, based on four principles: (a) the
distinction between direct and indirect taxes was preserved; (b) U.S.
agreed to repeal DISC (tax deferral was conceded to be an export
subsidy, like tax exemption); (c) however, methods of avoiding double
taxation--both the exemption method associated with territorial systems
of taxation and the foreign tax credit method associated with worldwide
systems of taxation--are defined not to be subsidies; (d) the arm's
length pricing standard is to be observed in transactions between
parent exporting companies and their foreign sales subsidiaries.
Following the conclusion of the Tokyo Round, in 1981 a
GATT Council Decision disposed of the four tax cases, with a Chairman's
note that reiterated the bargain struck in the Tokyo Round Code. In
particular the Chairman's note stated: ``The Council adopts these
reports on the understanding that with respect to these cases, and in
general, economic processes (including transactions involving exported
goods) located outside the territorial limits of the exporting country
and should not be regarded as export activities in terms of Article
XVI:4. It is further understood that Article XVI:4 requires that arm's-
length pricing be observed--Furthermore, Article XVI:4 does not
prohibit the adoption of measures to avoid double taxation of foreign
source income.''
Based on this note, in 1984 the United States repealed
the DISC, and enacted the Foreign Sales Corporation (FSC). The FSC
allowed partial tax exemption for the income of a foreign corporate
subsidiary derived from handling U.S. export sales. The amount of
income exempted was calculated by a formula designed to approximate
arm's length pricing (dividing export profits between domestic and
foreign sources).
B. First Round of FSC Litigation
In 1999, the EU challenged the FSC as a violation of the
Uruguay Round Code on Subsidies & Countervailing Measures (SCM). This
was a surprise to the United States, since the FSC had not been
challenged during the course of the Uruguay Round negotiations. The EU
motivation was to create bargaining chips to resolve other WTO disputes
(e.g., bananas, beef hormones), potential disputes (e.g., Airbus and
steel), and pending disputes at the expiration of the agricultural
peace clause (December 2003).
The first WTO FSC Panel, in its October 1999 decision,
stated that the 1981 Council Decision was not ``a legal instrument'' of
the GATT-1947 that had been adopted by the GATT-1994, by virtue of the
Annex 1A of the Uruguay Round (the grandfather or savings clause).
Surprise! The Panel then went on to hold that the FSC is a prohibited
export subsidy because: (a) revenue is foregone; (b) exports are taxed
more favorably than production abroad. The Panel did not rule on the EC
claim that FSC violates the SCM because exports are taxed more
favorably than production for the home U.S. market. However, the Panel
did rule that the FSC is not a permissible application of the
territorial approach--i.e., the exemption approach--to avoiding
taxation of foreign source income because the FSC invokes the
territorial principle for only the export segment of foreign source
income. In February 2000, the WTO Appellate Body affirmed the Panel
Report in all essential respects.
C. The Extraterritorial Income Exclusion (ETI) Act
In November 2000, the U.S. Congress passed the ETI Act in
response to the WTO Appellate Body decision. The ETI Act excluded from
the U.S. definition of gross income certain foreign source income--
namely a portion of export earnings, and a portion of earnings from
production abroad--with the condition that this territorial method of
avoiding double tax relief could only be used if the taxpayer did not
claim foreign tax credits with respect to the same earnings. The
benefits of the ETI Act were also conditioned on the sale of the goods
outside the United States, and the use of less than 50% non-U.S. (i.e.,
imported) inputs. Under the ETI Act, FSC benefits are phased out.
In the U.S. view, the ETI Act conformed to the Appellate
Body decision because: (a) revenue was no longer foregone--ETI income
was no longer part of gross income subject to corporate tax; (b) export
earnings and foreign production earnings were similarly taxed under the
ETI Act.
D. Second Round of FSC/ETI Litigation
The EU brought a second case to the WTO, claiming: (a)
notwithstanding the ETI Act, revenue was still foregone; (b) the export
contingency remained, even if foreign production was, in some
circumstances, covered; (c) the U.S. content requirements for export
earnings under ETI violate Article III (national treatment); (d) the
FSC phase-out does not respect the first Appellate Body deadline
(October 2000).
In August 2001, the WTO FSC/ETI Panel endorsed the EU
arguments in all essential respects. In reaching its decision, the
Panel, like its predecessor, continued to disdain any deference to
established tax practices. Instead:
The Panel arrogated the power to decide when a
mixed system of double tax relief (territorial exemption plus
foreign tax credits) amounts to a prohibited export subsidy.
The ETI exclusion flunked, according to the Panel, partly
because it was too broadly drawn (it could exempt income not
taxed by another country) and partly because it was too
narrowly drawn (only exports and selected foreign production
are covered).
On the way to creating this power, the Panel
claimed the power to say that any deduction or exclusion from
gross income could amount to a departure from the ``normative
benchmark'' of the offending nation's tax system, and thus
could amount to a relief from tax ``otherwise due'' (SCM
1.1(ii)), and thus could amount to a subsidy.
The Panel did not bother to examine actual U.S. tax
practice, developed since 1913, which has long allowed deferred
taxation of the income of controlled foreign corporations
(CFCs). In economic terms, deferral amounts to a partial or
near-total exemption. The ETI provision allows an explicit
exemption where prior and current law allow for its first
cousin, deferral.
The Panel decided that the ETI exemption was
``contingent on'' exports--in other words, that exporting is a
necessary condition for receiving the subsidy--even though the
ETI exclusion also applies to foreign production in designated
circumstances. This, despite footnote 4 to the SCM which
states: ``The mere fact that a subsidy is granted to
enterprises which export shall not for that reason alone be
considered to be an export subsidy . . .
Not surprising, the Panel found that the U.S.
content rule violated Article III.
The Appellate Body affirmed the Panel decision, but
narrowed the rationale with two important twists. (a) The Appellate
Body walked away from the Panel's ``normative benchmark'' concept and
instead defined ``revenue otherwise due'' by referring to the taxation
of ETI income when the taxpayer elects to claim a foreign tax credit
rather than the exemption. Since the taxpayer will only elect the
exemption method when his bottom line U.S. taxes are less under the
credit method, it follows that the U.S. Treasury has foregone ``revenue
otherwise due''. (b) The Appellate Body delved into ETI Act rules for
determining the division of export income between domestic and foreign
sources. Using simple-minded examples, the Appellate Body found
circumstances where the rules could improperly characterize domestic
source income as foreign source income.
In important ways, the Appellate Body returned to the
main outlines of the bargain struck in the 1981 GATT Council Decision.
The Appellate Body reaffirmed the arm's length principle for
distinguishing between domestic source and foreign source income earned
on export sales. The Appellate Body confirmed that foreign source
income, properly computed, could be exempt from tax and the exemption
does not automatically amount to an export subsidy prohibited by the
SCM.
E. Questions Raised
First question: how big is the bargaining chip that the
WTO has created for the WTO? Under the SCM, the Arbitral Panel decides
the permitted level of retaliation--i.e. ``appropriate
countermeasures'' (Article 4.11 of the SCM)--in the event that the
subsidizing member does not ``withdraw the subsidy without delay''. The
Arbitral Panel has said it will reach a decision at the end of April
2002. Once decided, the Arbitral Panel's ruling cannot be appealed.
There is little case guidance on ``appropriate countermeasures''--only
the Brazil-Aircraft arbitration. In that case, the Arbitral Panel
decided that ``appropriate countermeasures'' means the ``the full
amount of the subsidy to be withdrawn''--not the level of trade
impairment to Canada (as Brazil had argued). Following this precedent,
the U.S. argues that the bargaining chip is $956 million, calculated
with reference to the tax benefits on FSC/ETI exports to the EU
directly, and to third country markets where U.S. and EU exports
compete. The EU says the bargaining chip is $4,043 million, based on
total FSC tax benefits on exports to the world. Both submissions avoid
an explicit calculation of the trade impact of the FSC/ETI benefit.
However, their implicit calculations assume that the size of trade
impact equals the size of tax benefit (i.e., an export demand
elasticity of--1.0). The Arbitral Panel's decision will set an
important precedent for calculating ``appropriate countermeasures''.
Second question: what is in the EU shopping bag? The EU
claims that it only wants the U.S. to amend or repeal the ETI law in a
WTO-consistent manner. This oft-repeated EU statement is only a ploy to
force the U.S. into opening negotiations, offering ``compensation'' in
the form of concessions on other trade issues. Plausible candidates for
the EU shopping bag: (a) beef hormones and potential biotechnology
claims; (b) Section 201 restrictions on steel imports (but there the EU
can retaliate directly); (c) agricultural subsidies. The logic from
Pascal Lamy's standpoint is to hold the bargaining chip in his pocket,
and threaten but not invoke retaliation. Possible outcome: a standstill
on all retaliation that lasts until the end of the Doha Work Programme
in 2005.
Third question: will other WTO members use the decision
to create their own bargaining chips for negotiations and dispute
resolution with the United States? They would have to mount new cases
against the FSC/ETI to get permission to retaliate, but the precedent
seems straightforward. If this scenario unfolds, how will future
Arbitral Panels go about allocating the rights to ``appropriate
countermeasures'' among WTO complainants?
Fourth question: will the U.S. (and possibly other
members) use the logic of the WTO's decision to launch their own tax
cases against their trading partners? Export processing zones, widely
used by developing countries, are vulnerable. So is the U.S. export
source rule. The EU countries may have arbitrary formulas for
calculating exempt foreign source income tucked away in their tax laws
and regulations. The Appellate Body decision is an invitation to tax
litigation--member A can respond to a non-tax WTO case brought against
it by launching its own tax case against member B. This danger
underscores the standstill option mentioned earlier.
Fifth question: will WTO members renegotiate the SCM in
the Doha Work Programme? Two possible objectives: (a) Stop the DSM from
turning itself into a World Tax Court. For example, the SCM could
instruct the DSM to defer to jurisprudence established in bilateral tax
treaties and the OECD for defining foreign source income. (b) Eliminate
the artificial distinction between border adjustment rules for direct
and indirect business taxes. For example, the SCM rules could allow
members to exempt 50% of export earnings from corporate profits tax.
(c) As a matter of transparency, require WTO members to publish their
schedules of border tax adjustments applied on a product basis,
following the Harmonized Tariff System.
Sixth question: how will the U.S. Congress change the tax
law? Congressional action is clearly necessary, both to take away
bargaining chips from the EU and to avert ``piling on'' by other WTO
members. There are three broad options: (a) The ``minimal'' fix--repeal
the ETI Act, and exclude export income from ``foreign base company''
income under Subpart F. (b) Abandon export tax relief--repeal the ETI
and use the revenue for other business tax reform, for example phasing
out the AMT. (c) Use the WTO decision as a springboard for fundamental
reform, through a territorial system of taxing corporate profits. This
is clearly the best answer. Politically, it may be the most difficult.
Chairman Thomas. Thank you Mr. Hufbauer.
Mr. Merrill.
STATEMENT OF PETER R. MERRILL, PRINCIPAL AND DIRECTOR, NATIONAL
ECONOMIC CONSULTING GROUP, PRICEWATERHOUSECOOPERS LLP, AND
CONSULTANT, INTERNATIONAL TAX POLICY FORUM
Mr. Merrill. Thank you, Mr. Chairman, Mr. Rangel, Members
of the Committee. I am Peter Merrill, Director of the National
Economic Consulting Group at PricewaterhouseCoopers. I am also
a consultant to the International Tax Policy Forum (ITPF) and
co-author of a book published recently by the National Foreign
Trade Council on international tax policy.
For the record, I am testifying today on my own behalf. The
focus of my testimony is the relationship between U.S. tax
policy and international competitiveness.
Current rules regarding the taxation of both domestic and
foreign income create barriers that harm the competitiveness of
U.S. companies. These rules are also horribly complex to comply
with and to administer. Regardless of how the ETI dispute is
ultimately resolved, I believe it is important for this
Committee to review the current U.S. tax rules with a view to
reducing complexities and removing impediments to U.S.
competitiveness.
In a global market the competitiveness of the country
depends on the ability of its enterprises to produce goods and
services that are successful both at home and in foreign
markets. Today, almost 80 percent of world income and
purchasing power lies outside the United States. Foreign
affiliate sales are growing three times as fast as domestic
sales within Standard and Poor's, S&P, 500 companies.
It is a common perception that the investment abroad by
U.S. multinationals comes at the expense of the domestic
economy. This is an incorrect view. According to the U.S.
Department of Commerce, less than 11 percent of sales by U.S.-
controlled foreign corporations were made back to the United
States.
In 1998, U.S. multinationals were directly responsible for
almost two-thirds of all U.S. exports. A recent study by the
OECD found each dollar of outward foreign direct investment is
associated with $2 of additional exports. A number of studies
have found U.S. investment abroad generates additional
employment at home through an increase in the domestic
operations of U.S. multinationals. Moreover, research has shown
that workers at domestic plants owned by U.S. multinationals
earn higher wages than workers at domestic plants owned by
companies with only domestic operations.
In summary, U.S. multinationals provide significant
contributions to the U.S. economy through sales of U.S. goods
and services abroad and employment at above average wages at
home.
With the reduction of the U.S. corporate income tax rate
from 46 to 34 percent in 1986, it is commonly thought that the
United States is a low-tax jurisdiction for corporations. While
this was true immediately after the 1986 tax, it is no longer
true today. The United States increased the corporate income
tax rate to 35 percent in 1991. Meanwhile, the average OECD
corporate tax rate has fallen to 4.5 percentage points less
than the U.S. rate.
In addition to a relatively high corporate income tax rate,
the United States is one of only three OECD Member Countries
that does not provide some form of relief from the double
taxation of corporate dividends. For a shareholder in the top
individual income tax bracket, the combination of corporate and
individual income tax is over 60 percent of distributed
corporate income in the United States. And while the total U.S.
tax burden as a percentage of GDP is relatively light compared
to other OECD countries, reliance on income and profits tax is
unusually high.
In 1999, the U.S. relied on income and property taxes for
almost half of all revenues, compared to slightly over a third
in the average OECD country. Indeed, the United States is the
only one of the 30 OECD Member Countries that does not have a
national value-added tax.
A study published by the European Commission last year
found that, on average, U.S. multinationals bear a higher
effective tax rate when investing into the European Union than
do EU multinationals. This is a European Commission study. The
additional tax burden ranged from 3 to 5 percentage points
depending on the type of finance.
There are a number of reasons why the United States has
become an unattractive jurisdiction in which to locate the
headquarters of a multinational company, aside from our
relatively high corporate tax rate.
First, unlike the United States, about half of the OECD
countries have a dividend exemption, also called a
``territorial'' tax system under which a parent company
generally is not subject to tax on the active income earned by
foreign subsidiaries.
Second, the foreign tax credit, which is intended to
prevent double taxation of foreign-source income, has a number
of deficiencies that increase the complexity and prevent full
double tax relief.
Third, the scope of the U.S. anti-deferral rules under
subpart F is unusually broad. While most countries tax passive
income earned by controlled foreign subs, the United States is
unusual in taxing a wide range of active foreign income that is
reinvested abroad.
In conclusion, short of adopting a territorial tax system,
there are significant opportunities to increase the
competitiveness and reduce the complexity of U.S. tax rules
applicable to foreign source income.
One opportunity that is worth special attention within the
context of these hearings is the foreign base company sales
rules adopted by Congress in 1962. Part of the benefit of the
FSC regime that was rejected by the WTO was the fact that it
created an exception to the base company rules. If the foreign
base company rules were to be repealed, U.S. companies would be
put in a position more comparable to their foreign competitors.
Moreover, the original policy rationale for the base
company rules was thrown into doubt by the Treasury
Department's study of subpart F.
In conclusion, U.S. rules for taxing domestic and foreign
source income are out of step with other major industrial
countries in a number of ways. Regardless of the ultimate
resolution of the ETI case, Congress should consider changes to
the U.S. system that promote economic growth and reduce the
costs of complying with the tax system.
Thank you.
Chairman Thomas. Thank you, Mr. Merrill.
Mr. Shay?
[The prepared statement of Mr. Merrill follows:]
STATEMENT OF PETER R. MERRILL, PRINCIPAL AND DIRECTOR, NATIONAL
ECONOMIC CONSULTING GROUP, PRICEWATERHOUSECOOPERS LLP, AND CONSULTANT,
INTERNATIONAL TAX POLICY FORUM
U.S. TAX POLICY AND INTERNATIONAL COMPETITIVENESS
I. INTRODUCTION
I am Peter Merrill, a Principal and Director of the National
Economic Consulting group at PricewaterhouseCoopers LLP. I am also a
consultant to the International Tax Policy Forum, a group of U.S.-based
multinational companies from a broad range of industries, and co-author
of a recent book published by the National Foreign Trade Council on
International Tax Policy for the 21st Century. For the
record, I am testifying today on my own behalf and not as a
representative of any organization.
The focus of my testimony is the relationship between U.S. tax
policy and international competitiveness. In many instances, current
rules regarding the taxation of both domestic and foreign income create
barriers that harm the competitiveness of U.S. companies. These rules
also are horribly complex both for taxpayers to comply with and for the
Internal Revenue Service to administer.
The existing extraterritorial income (ETI) tax regime serves in
part to offset some of the anti-competitive features of U.S. tax
policy. Thus, the WTO's adverse decision in the ETI case raises the
question how Congress can strengthen the competitive position of the
U.S. tax system. Regardless of how the ETI dispute is resolved, I
believe it is important for this Committee to review the current U.S
tax rules with a view to reducing complexity and removing impediments
to U.S. competitiveness.
II. TAX POLICY AND INTERNATIONAL COMPETITIVENESS
While there are a variety of ways to define competitiveness, in
this testimony I focus on the standard of living of U.S. residents as
the measure of economic performance. Achieving a high standard of
living ultimately rests on the productivity of U.S. investments.
Growing productivity in turn requires investment--in plant and
equipment and in the development and dissemination of knowledge through
research and education.
The challenge for tax policy is to design a tax system that raises
revenue with the least damage to the growth of productivity and
national income. A poorly designed tax system can impose unnecessarily
high costs to the economy--so-called dead-weight loss--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.
III. U.S. MULTINATIONALS AND INTERNATIONAL COMPETITIVENESS
In a global market, the competitiveness of a country depends on the
ability of its enterprises to produce goods and services that are
successful both at home and in foreign markets. Today, almost 80
percent of world income and purchasing power lies outside of U.S.
borders. Opportunities for U.S. companies to grow their businesses
increasingly lie overseas. From 1986 to 1997, foreign sales of S&P 500
companies grew 10 percent a year, compared to domestic sales growth of
just 3 percent annually.\1\
---------------------------------------------------------------------------
\1\ Wall Street Journal, ``U.S. Firms Global Progress is Two-
Edged,'' August 17, 1998.
---------------------------------------------------------------------------
A. U.S. Investment Abroad and Exports
It is a common perception that investment abroad by U.S.
multinationals comes at the expense of the domestic economy. This is an
incorrect view. The primary motivation for U.S. multinationals to
operate abroad is to compete better in foreign markets, not domestic
markets. According to the Commerce Department, less than 11 percent of
sales by U.S.-controlled foreign corporations were made to U.S.
customers.\2\
---------------------------------------------------------------------------
\2\ U.S. Department of Commerce, Survey of Current Business (July
2000). Note that 40 percent of the sales back to the United States were
from Canadian subsidiaries.
---------------------------------------------------------------------------
Investment abroad is required to provide services that cannot be
exported, to obtain access to natural resources, and to provide goods
that are costly to export due to transportation costs, tariffs, and
local content requirements. Foreign investment allows U.S.
multinationals to compete more effectively around the world, ultimately
increasing employment and wages of U.S. workers.
While about one-fourth of U.S. multinational parent companies are
in the services sector, 56 percent of all foreign affiliates are this
sector, which includes distribution, marketing, and product support
services.\3\ Without these sales and services subsidiaries, it would be
impossible to sustain current export volumes.
---------------------------------------------------------------------------
\3\ Matthew Slaughter, Global Investments, American Returns.
Mainstay III: A Report on the Domestic Contributions of American
Companies with Global Operations, Emergency Committee for American
Trade (1998).
---------------------------------------------------------------------------
According to the U.S. Commerce Department, in 1998, U.S.
multinationals were directly responsible, through their domestic and
foreign affiliates, for $438 billion of U.S. merchandise exports--
almost two-thirds of all merchandise exports.\4\
---------------------------------------------------------------------------
\4\ National Foreign Trade Council, The NFTC Foreign Income
Project: International Tax Policy for the 21st Century, chapter 6
(1999).
---------------------------------------------------------------------------
A recent study by the Organization for Economic Cooperation and
Development (OECD) found that each dollar of outward foreign direct
investment is associated with $2.00 of additional exports.\5\
---------------------------------------------------------------------------
\5\ OECD, Open Markets Matter: The Benefits of Trade and Investment
Liberalization, p. 50 (1998).
---------------------------------------------------------------------------
B. U.S. Employment
Foreign investment by U.S. multinationals generates sales in
foreign markets that generally could not be achieved by producing goods
entirely at home and exporting them.
A number of studies find U.S. investment abroad generates
additional employment at home through an increase in the domestic
operations of U.S. multinationals. As noted by Professors David Riker
and Lael Brainard:
``Specialization in complementary stages of production implies that
affiliate employees in industrialized countries need not fear the
multinationals' search for ever-cheaper assembly sites; rather, they
benefit from an increase in employment in developing country
affiliates.'' \6\
---------------------------------------------------------------------------
\6\ David Riker and Lael Brainard, U.S. Multinationals and
Competition from Low Wage Countries, National Bureau of Economic
Research Working Paper no. 5959 (1997) p. 19.
---------------------------------------------------------------------------
Moreover, workers at domestic plants owned by U.S. multinational
companies earn higher wages than workers at domestic plants owned by
companies without foreign operations, controlling for industry, size of
company, and state where the plant is located.\7\
---------------------------------------------------------------------------
\7\ Mark Doms and Bradford Jensen, Comparing Wages, Skills, and
Productivity between Domestic and Foreign-Owned Manufacturing
Establishments in the United States, mimeo. (October 1996).
---------------------------------------------------------------------------
C. U.S. Research and Development
Foreign direct investment allows U.S. companies to take advantage
of their scientific expertise, increasing their return on firm-specific
assets, including patents, skills, and technologies. Professor Robert
Lipsey notes that the ability to make use of these firm-specific assets
through foreign direct investment provides an incentive to increase
investment in activities that generate this know-how, such as research
and development.\8\
---------------------------------------------------------------------------
\8\ Robert Lipsey, ``Outward Direct Investment and the U.S.
Economy,'' in The Effects of Taxation on Multinational Corporations, p.
30 (1995).
---------------------------------------------------------------------------
Among U.S. multinationals, total research and development in 1996
amounted to $113 billion, of which $99 billion (88 percent) was
performed in the United States.\9\ Such research and development allows
the United States to maintain its competitive advantage in business and
be unrivaled as the world leader in scientific and technological know-
how.
---------------------------------------------------------------------------
\9\ U.S. Department of Commerce, Survey of Current Business
(September 1998).
---------------------------------------------------------------------------
D. Summary
U.S. multinationals provide significant contributions to the U.S.
economy through:
Sales of U.S. goods and services abroad;
Domestic employment at above average wages; and
Critical domestic investments in equipment, technology,
and research and development.
As a result, the United States has an important interest in
insuring that its tax rules do not hinder the competitiveness of U.S.
multinationals.
IV. DOMESTIC TAX COMPETITIVENESS
A. Corporate Income Tax Rate
With the reduction in the U.S. corporate income tax rate from 46 to
34 percent, as a result of the Tax Reform Act of 1986, it is commonly
thought that the United States is a low-tax jurisdiction for
corporations. While true immediately after the 1986 Act, it is no
longer true today. The United States increased the corporate income tax
rate to 35 percent in 1991. Meanwhile, the average central government
corporate tax rate in OECD member states has fallen since 1986 to 30.5
percent in 2001--4.5 percentage points less than the U.S. rate (see
Exhibit 1). This disparity in corporate tax rates would be even larger
if corporate income taxes imposed by subnational levels of government
were taken into account.
B. Double Taxation of Corporate Dividends
In addition to a relatively high corporate income tax rate, the
United States is one of only three OECD member countries that does not
provide some form of relief from the double taxation of corporate
dividends (see Exhibit 2). Most OECD countries relieve double taxation
of corporate dividends at the shareholder level through some form of
credit, exemption, or special tax rate for dividend income. For a
shareholder in the top individual income tax bracket (38.6 percent
\10\), the combination of corporate and individual income tax is over
60 percent of distributed corporate income (see Exhibit 3). The
combined income tax rate on distributed corporate income is even higher
if state and local tax on corporate and individual income are taken
into account.
---------------------------------------------------------------------------
\10\ Under the Economic Growth and Tax Relief Reconciliation Act of
2001, the top individual income tax rate is scheduled to be reduced to
35 percent in 2006.
---------------------------------------------------------------------------
C. Reliance on Income and Profit Taxation
While the total tax burden as a percent of Gross Domestic Product
(GDP) is relatively light in the United States compared to other OECD
countries, reliance on income taxes to fund spending at all levels of
government is unusually high. In 1999, the United States relied on
income and profits taxes for almost half of all revenues (49.1 percent)
while the average OECD country raised slightly over one-third of
revenues (35.3 percent) from this source (see Exhibit 4). The U.S. data
include sales taxes imposed by state and local governments; the federal
government is even more heavily reliant on income and profits taxes as
there is no broad-base consumption tax at the federal level. Indeed,
the United States is the only one of the 30 OECD member countries that
does not have a national value-added tax.
D. Conclusion
When compared to other OECD and EU member countries, the United
States relies relatively heavily on income taxes to fund government
operations, has a comparatively high corporate income tax rate, and is
unusual in not providing a mechanism for relieving the double taxation
of corporate income.
From a trade standpoint, heavy reliance on income taxes relative to
consumption taxes may be viewed as disadvantageous because the WTO
Agreement on Subsidies and Countervailing Measures permits border tax
adjustments for indirect taxes such as consumption taxes, but prohibits
such adjustments for income and profits taxes. However, from the
standpoint of U.S. economic growth, the main reason to avoid over-
reliance on income and profit taxes is that they discourage savings and
investment, which are closely linked to growth in national income.
V. INTERNATIONAL TAX COMPETITIVENESS
A. Rising Level of International Competition
In 1962, when the controlled foreign corporation rules in Subpart F
were adopted, the U.S. multinationals overwhelmingly dominated global
markets. In this environment, the consequences of adopting tax rules
that were out-of-step with other countries were of less concern to many
policymakers.
Today, the increasing integration of the world economies has
magnified the impact of U.S. tax rules on the international
competitiveness of U.S. multinationals. Foreign markets represent an
increasing fraction of the growth opportunities for U.S. businesses. At
the same time, competition from multinationals headquartered outside of
the United States is becoming greater.\11\
---------------------------------------------------------------------------
\11\ See, National Foreign Trade Council, International Tax Policy
for the 21st Century, vol. 1, 2001, pp 95-96.
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.
U.S. multinational companies' share of global cross-
border investment has declined from 50 percent in 1967 to 25 percent in
1996.
The 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. multinationals will be less
successful in global markets, with adverse consequences for exports and
employment at home.
B. International Comparison of U.S. Rules for Taxing Multinational
Companies
A study published by the European Commission last year found that,
on average, U.S. multinational companies bear a higher effective tax
rate when investing into the European Union than do EU multinationals.
The additional tax burden borne by U.S. multinationals ranges from 3 to
5 percentage points depending on the type of finance used (see Exhibit
5).
In addition to the relatively high U.S. corporate income tax rate,
there are a number of other reasons why United States has become a
relatively unattractive jurisdiction in which to locate the
headquarters of a multinational corporation.
First, about half of the OECD countries have a dividend exemption
(``territorial'') tax system under which a parent company generally is
not subject to tax on the active income earned by a foreign subsidiary
(see Exhibit 6). By contrast, the United States taxes income earned
through a foreign corporation when repatriated (or when earned if
subject to U.S. anti-deferral rules).
Second, 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, including:
\12\
---------------------------------------------------------------------------
\12\ See, National Foreign Trade Council, U.S. International Tax
Policy for the 21st Century, vol. 1, Part II, 2001
Over allocation of U.S. interest expense against foreign
source income due to failure to take into account foreign debt. This
reduces the foreign tax credit limitation and can cause income that has
been subject to foreign tax at a rate of 35 percent or more to be
subject to additional U.S. tax;
Asymmetric loss recapture rules that have the effect of
restoring U.S. but not foreign income, thereby reducing the foreign tax
credit limitation;
The limitation on foreign tax credits to 90 percent of
alternative minimum tax liability;
The limited carryover period for foreign tax credits (two
years back and five years forward); and
The complexity associated with the numerous separate
foreign tax credit limitations and the ``high-tax kick out'' rules that
move certain income out of the passive basket.
A third difference from the multinational tax rules of other
countries is the unusually broad scope the U.S. anti-deferral rules
under subpart F. While most countries tax passive income earned by
controlled foreign subsidiaries, the United States is unusual in taxing
a wide range of unrepatriated active income as a deemed dividend to the
U.S. parent, including: \13\
---------------------------------------------------------------------------
\13\ Ibid., vol. 1, Part I.
Foreign base company sales income;
Foreign base company services income; and
Active financial services income (an exclusion of this
income from Subpart F expired last year).
The net effect of these tax differences is that a U.S.
multinational 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.
Complexity. The U.S. rules for taxing foreign source income are
among the most complex in the Internal Revenue Code. A survey of
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.\14\ These data show that U.S. tax
compliance costs related to foreign source income are grossly
disproportionate. These high compliance costs are a hidden form of
taxation that discourages small U.S. companies from operating abroad
and makes it more difficult for larger companies to compete
successfully with foreign multinationals.
---------------------------------------------------------------------------
\14\ Marsha Blumenthal and Joel Slemrod, ``The Compliance Costs of
Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy
Implications, International Tax and Public Finance, vol. 2, no. 1, 37-
54 (1995).
---------------------------------------------------------------------------
The international tax recommendations in the Joint Committee on
Taxation's simplification study are a good start to begin addressing
the high compliance burden imposed by U.S. international tax rules.\15\
It should also be noted that the Treasury Department's tax
simplification project, described in the Administrations FY 2003
Budget, identifies the international tax rules as an area singled out
by taxpayers as one of the biggest sources of compliance burden.\16\
---------------------------------------------------------------------------
\15\ Joint Committee on Taxation, Study of the Overall State of the
Federal Tax System and Recommendations for Simplification, Pursuant to
Section 8022(3)(B) of the Internal Revenue Code of 1986, JCS-3-01
(April 2001).
\16\ Office of Management and Budget, Budget of the United States
Government, Fiscal Year 2002, Analytical Perspectives, p. 79
---------------------------------------------------------------------------
C. Conclusion
Short of adopting a territorial tax system, there are significant
opportunities to increase the competitiveness and reduce the complexity
of the U.S. tax rules applicable to foreign source income. Indeed,
there are a number of reasons to think very carefully before adopting a
territorial income tax system.
First, foreign experience suggests that adopting a territorial
income tax system does not guarantee a simple tax regime. OECD
Countries with territorial income tax systems also have parallel
foreign tax credit rules for foreign income that is not exempt.
Moreover, many OECD countries with territorial income tax systems also
have anti-deferral rules that tax certain income earned by foreign
subsidiaries on a current basis.
Second, depending on how a territorial tax system is designed, it
could cause a substantial tax increase for companies that currently
repatriate dividends from high-tax jurisdictions. Present law allows
excess foreign tax credits on high-taxed foreign income to be used to
reduce U.S. tax on low-taxed foreign income within the same limitation
category. Under a dividend exemption system, cross crediting between
dividends and other types of foreign income generally is not possible.
Third, allocation of U.S. interest and other domestic expenses
against foreign source income causes these expenses to be nondeductible
under a territorial income tax system. Double taxation will result
unless foreign governments allow a deduction for these allocated
expenses.
One opportunity for international tax reform is worth special
mention within the context of these hearings, i.e., the foreign base
company sales rules adopted by Congress in 1962 as part of Subpart F of
the Internal Revenue Code. Absent these rules, U.S. companies would be
able to set up sales companies in low-tax jurisdictions and reinvest
their active foreign earnings without current U.S. tax. In fact, part
of the benefits of the FSC regime were attributable to the fact that it
created an exception to the foreign base company sales rules.\17\
Repeal of the foreign base company sales rules would put U.S. companies
in a more comparable position to their foreign competitors who
generally can use these structures with being subject to home country
tax. Moreover, the original policy rationale for these rules was thrown
into doubt by the Treasury Department's policy study on Subpart F,
released in December 2000, which concluded that the economic efficiency
effects of the base company rules were ``ambiguous.'' \18\
---------------------------------------------------------------------------
\17\ This exception was one of the reasons that the FSC regime was
determined by the WTO to violate the Agreement on Subsidies and
Countervailing Measures under the ``but for'' test.]
\18\ U.S. Department of the Treasury, Office of Tax Policy, The
Deferral of Income Earned through U.S. Controlled Corporations: A
Policy Study (December 2000) p. 47. The report reached similar
conclusions regarding the other foreign-to-foreign related party rules
of Subpart F such as the foreign base company services income rules.
---------------------------------------------------------------------------
VI. SUMMARY
U.S. rules for taxing both domestic and foreign source income are
out of step with other major industrial countries in a number of ways.
Regardless of the ultimate resolution of the ETI case, Congress should
consider changes to the U.S. system that promote economic growth and
reduce costs of complying, with and administering the tax system.
If the United States is an unattractive location--from a tax
standpoint--to headquarter a multinational corporation, then U.S.
multinationals will lose global market share. This can happen in a
variety of ways.
First, U.S. individual and institutional investors can choose to
invest in foreign rather than U.S. headquartered companies. Indeed, as
of 1999, almost two-thirds (66 percent) of all U.S. private investment
abroad was in the form of portfolio rather than foreign direct
investment. This allows U.S. investors to invest in multinational
companies whose foreign operations generally are outside the scope of
U.S. tax rules.
Second, in a cross-border merger, the transaction may be structured
as a foreign acquisition of a U.S. company rather than the reverse.
Measured by deal value, over the 1998-2000 period, between 73 and 86
percent of large cross-border transactions involving U.S. companies
have been structured so that the merged company is headquartered
abroad.\19\ Clearly taxes are only one of many considerations in the
structuring of these transactions, but it is notable that in one large
transaction, taxes were specifically identified as a significant
factor.\20\ By choosing to be headquartered abroad, the merged entity
can invest outside the United States without being subject to the
complex and onerous U.S. rules that apply to the foreign source income
of U.S.-headquartered companies.\21\
---------------------------------------------------------------------------
\19\ Recent examples include: AEGON-Transamerica, BP-Amoco,
Daimler-Chrysler, Deutsche Bank-Bankers Trust, and Vodafone-AirTouch.
\20\ See, John L. Loffredo, ``Testimony before the Senate Finance
Committee'' (March 11, 1999) regarding the Daimler-Chrysler
transaction.
\21\ Where business reasons dictate the form of a transaction,
there generally is no cause for concern. The concern we are raising is
that non-competitive U.S. tax rules may be influencing the form of
transactions.
---------------------------------------------------------------------------
Third, and most starkly, a growing number of U.S. companies have
structured transactions in which their U.S. parents are acquired by
their own foreign subsidiaries. Such ``inversion'' transactions, like
foreign acquisitions of U.S. companies, allow new foreign investments
to be structured as subsidiaries of a foreign parent corporation and
thus not subject to U.S. rules relating to the taxation of foreign
source income.
Fourth, an increasing number of new ventures are being incorporated
at inception as foreign corporations.
While some have suggested that reducing the U.S. tax burden on
foreign source income could lead to a movement of manufacturing
operations out of the United States (``runaway plants''), an
alternative scenario is that a noncompetitive U.S. tax system will lead
to a migration of multinational headquarters outside the United States.
A decline in the market share of U.S. multinationals may affect the
well being of the U.S. economy because, as noted above, U.S.
multinationals play an important role in promoting U.S. exports and
creating high-wage jobs.
EXHIBIT 1--CENTRAL GOVERNMENT CORPORATE INCOME TAX RATES, 1986-2001
----------------------------------------------------------------------------------------------------------------
Country 1986 1991 1995 2001
----------------------------------------------------------------------------------------------------------------
Australia................................................... 49.0 39.0 33.0 34.0
Austria..................................................... 30.0 30.0 34.0 34.0
Belgium..................................................... 45.0 39.0 39.0 40.2
Canada...................................................... 36.0 29.0 29.0 27.0
Denmark..................................................... 50.0 38.0 34.0 30.0
Finland..................................................... 33.0 23.0 25.0 29.0
France...................................................... 45.0 34/42 33.0 33.3
Germany..................................................... 56.0 50/36 45/30 25.0
Greece...................................................... 49.0 46.0 35/40 37.5
Iceland..................................................... 51.0 45.0 33.0 Na
Ireland..................................................... 50.0 43.0 40.0 20.0
Italy....................................................... 36.0 36.0 36.0 36.0
Japan....................................................... 43.0 38.0 38.0 30.0
Luxembourg.................................................. 40.0 33.0 33.0 30.0
Netherlands................................................. 42.0 35.0 35.0 35.0
New Zealand................................................. 45.0 33.0 33.0 33.0
Norway...................................................... 28.0 27.0 19.0 28.0
Portugal.................................................... 42/47 36.0 36.0 34.0
Spain....................................................... 35.0 35.0 35.0 35.0
Sweden...................................................... 52.0 30.0 28.0 28.0
Switzerland................................................. 4-10 4-10 4-10 8.5
Turkey...................................................... 46.0 49.0 25.0 30.0
United Kingdom.............................................. 35.0 34.0 33.0 30.0
United States............................................... 46.0 34.0 35.0 35.0
Unweighted averages: \1\
EU.......................................................... 42.8 35.9 34.4 31.8
OECD........................................................ 41.4 35.0 32.0 30.5
----------------------------------------------------------------------------------------------------------------
1Midpoint tax rate used for countries with multiple rates.
Sources: Jeffrey Owens, Tax Reform for the 21st Century, Tax Notes International. 2001 data from American
Council for Capital Formation, ``The Role of Federal Tax Policy and Regulatory Reform in Promoting Economic
Recovery and Long-Term Growth,'' November 28, 2001.
______
EXHIBIT 2--TAXATION OF CORPORATE DIVIDENDS IN OECD COUNTRIES, 1999
----------------------------------------------------------------------------------------------------------------
Method of relieving double taxation of corporate dividends
------------------------------------------------------------------------------------------
No relief from double Shareholder level
taxation of corporate ---------------------------------------------------------------------
dividends Imputation system Special personal tax Corporate level
(partial or complete) Tax credit method rate
----------------------------------------------------------------------------------------------------------------
Netherlands Australia Canada Austria Iceland \2\
Switzerland Finland \5\ Rep. of Korea Belgium \5\
United States France Spain Czech Republic
Ireland \3\ Denmark
Mexico Germany \1\
New Zealand Greece \5\
Norway Hungary
Portugal Italy
United Kingdom Japan
Luxembourg \4\
Poland
Sweden
Turkey
United Kingdom
----------------------------------------------------------------------------------------------------------------
1 Germany recently has adopted a 50 percent dividend exclusion.
2 Deduction for dividends paid may offset fully the corporate and personal income tax for dividends up to 15
percent of capital value. Dividends in excess of this limit are fully taxed at both levels.
3 Ireland eliminated its imputation credit effective April 6, 1999.
4 Luxembourg has a 50 percent dividend exclusion.
5 Information as of 1996 based on S. Cnossen.
Sources: PricewaterhouseCoopers, Individual Taxes 1999-2000: Worldwide Summaries (John Wiley & Sons, 1999) and
Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, Research Memorandum
9604, Erasmus University, Rotterdam (1996).
______
EXHIBIT 3--COMBINED U.S. INDIVIDUAL AND CORPORATE STATUTORY TAX RATE IN
2002: CORPORATE INCOME DISTRIBUTED AS DIVIDEND TO INDIVIDUAL SHAREHOLDER
IN TOP BRACKET
------------------------------------------------------------------------
Corporate income........................................... $100.00
Less corporate income tax at 35% (federal)............... $35.00
Net income................................................. $65.00
Dividend assuming 100% distribution........................ $65.00
Less individual income tax at 38.6% (federal)............ $25.09
Net income after federal and individual income tax......... $39.91
Combined corporate and individual income tax rate.......... 60.09%
------------------------------------------------------------------------
______
EXHIBIT 4--INCOME AND PROFITS TAXATION, 1999
------------------------------------------------------------------------
Percent of Total Taxation in OECD Countries
-------------------------------------------------------------------------
Rank Country Percent
------------------------------------------------------------------------
1 Australia 59%
------------------------------------------------------------------------
2 Denmark 58.9%
------------------------------------------------------------------------
3 New Zealand 57.2%
------------------------------------------------------------------------
4 United States 49.1%
------------------------------------------------------------------------
5 Canada 48.9%
------------------------------------------------------------------------
6 Ireland 42.2%
------------------------------------------------------------------------
7 Sweden 41.6%
------------------------------------------------------------------------
8 Finland 41.1%
------------------------------------------------------------------------
9 United Kingdom 39.2%
------------------------------------------------------------------------
10 Iceland 39.1%
------------------------------------------------------------------------
11 Belgium 38.6%
------------------------------------------------------------------------
12 Luxembourg 36.2
------------------------------------------------------------------------
13 Switzerland 36.2%
------------------------------------------------------------------------
14 Norway 35.8%
------------------------------------------------------------------------
15 Italy 34.0%
------------------------------------------------------------------------
16 Japan 31.4%
------------------------------------------------------------------------
17 Turkey 31.4%
------------------------------------------------------------------------
18 Mexico 30.0%
------------------------------------------------------------------------
19 Germany 29.8%
------------------------------------------------------------------------
20 Portugal 28.8%
------------------------------------------------------------------------
21 Austria 28.7
------------------------------------------------------------------------
22 Spain 28.1
------------------------------------------------------------------------
23 Greece 26.4%
------------------------------------------------------------------------
24 Netherlands 25.3%
------------------------------------------------------------------------
25 Korea 24.8%
------------------------------------------------------------------------
26 France 24.0%
------------------------------------------------------------------------
27 Slovak Republic 24.0%
------------------------------------------------------------------------
28 Hungary 23/2%
------------------------------------------------------------------------
29 Poland 22.6%
------------------------------------------------------------------------
30 Czech Republic 22.3%
------------------------------------------------------------------------
Unweighted averages
------------------------------------------------------------------------
OECD 35.3%
------------------------------------------------------------------------
EU 34.9%
------------------------------------------------------------------------
Source: OECD, Revenue Statistics, 1965-2000 (2001)
______
EXHIBIT 5--EFFECTIVE AVERAGE TAX RATE FOR INVESTMENT INTO EU
----------------------------------------------------------------------------------------------------------------
Financing of foreign subsidiary
-------------------------------------------------------
Investment from MNC based in: Retained
earnings New equity Debt Average
----------------------------------------------------------------------------------------------------------------
EU...................................................... 30.1% 30.4% 30.2% 30.2%
US...................................................... 33.2% 35.7% 34.7% 34.5%
----------------------------------------------------------------------------------------------------------------
Source: Commission of the European Communities, ``Towards an Internal Market without Obstacles,'' Com(2001)582,
Brussels, October 23, 2001.
______
EXHIBIT 6--TAXATION OF FOREIGN SUBSIDIARY DIVIDENDS IN OECD COUNTRIES,
1999
------------------------------------------------------------------------
Dividend exemption (territorial) system
(Either by statute, by treaty or for Worldwide taxation system
listed countries)
------------------------------------------------------------------------
1. Australia 1. Czech Republic
------------------------------------------------------------------------
2. Austria 2. Greece
------------------------------------------------------------------------
3. Belgium 3. Iceland\2\
------------------------------------------------------------------------
4. Canada 4. Italy
------------------------------------------------------------------------
5. Denmark 5. Japan
------------------------------------------------------------------------
6. Finland\2\ 6. Rep. of Korea
------------------------------------------------------------------------
7. France 7. Mexico
------------------------------------------------------------------------
8. Germany 8. New Zealand
------------------------------------------------------------------------
9. Hungary 9. Norway
------------------------------------------------------------------------
10. Ireland\1\ 10. Poland
------------------------------------------------------------------------
11. Luxembourg 11. Portugal
------------------------------------------------------------------------
12. Netherlands 12. Spain\3\
------------------------------------------------------------------------
13. Sweden 13. Turkey
------------------------------------------------------------------------
14. Switzerland 14. United Kingdom
------------------------------------------------------------------------
15. United States
------------------------------------------------------------------------
1 Although Ireland nominally has a worldwide tax system, under the
Finance Act of 1988, foreign subsidiary dividends generally are exempt
if re-invested in employment-generating activities within Ireland.
2 Information as of 1990 based on OECD.
3 Some treaties provide for the exemption method.
Sources: (1) PricewaterhouseCoopers, Individual Taxes 1999-2000:
Worldwide Summaries (John Wiley & Sons, 1999). (2) OECD, Taxing
Profits in a Global Economy: Domestic and International Issues (1991).
______
Exhibit 7
[GRAPHIC] [TIFF OMITTED] T9971A.001
STATEMENT OF STEPHEN E. SHAY, PARTNER, ROPES & GRAY, BOSTON,
MASSACHUSETTS, AND LECTURER IN LAW, HARVARD LAW SCHOOL
Mr. Shay. Thank you, Mr. Chairman, Mr. Rangel and Members
of the Committee. My name is Stephen Shay. My testimony is in
the record along with my biography.
I want to emphasize the views I am expressing are my
personal views and do not represent the views of either my
clients or my law firm. I just want to touch on four points.
The unspoken premise of everything that has been discussed
so far relies on a definition of competitiveness that aligns
U.S. competitiveness with benefits to U.S. multinationals. I
think the Committee should adopt a view of competitiveness that
is implicit in the Chairman's statement. Does any proposal
ultimately improve the welfare of American citizens and
residents, that is, individual citizens, individual residents?
That is what all of this is ultimately about.
So when we talk about a proposal that will improve the
profitability of a multinational, the task for it should be,
will it meet that test, will it ultimately improve the welfare
of the individual citizens and residents of this country?
Second, the ETI. What the ETI does, at the bottom line, is
reduce the effective tax rate on income from exports by roughly
5.25 percent. So your effective rate, instead of 35 percent for
a corporate taxpayer, is 29.75 or thereabouts.
Who benefits from the ETI? Because of other rules, we have
in our code, particularly something called the ``sales source
rule,'' companies that operate abroad and have excess foreign
tax credits normally will elect to take advantage of the sales
source rule and not the ETI. So the ETI benefits, principally,
two categories of taxpayers, those that export exclusively from
the United States don't pay foreign taxes, and those that do
operate abroad, that manage their foreign taxes to remain below
the U.S. tax rate. That is who benefits.
The third point I would like to make relates to adoption of
a territorial system, the exemption of U.S. tax on foreign
business income. Is that relevant? Is that responsive to the
taxpayers who are affected by a repeal or demise of the ETI? I
submit that it is not.
If you adopt a territorial system, it generally has three
key elements. First and most relevant, it provides that
business income earned by a U.S. person outside the United
States from operations outside the United States would be
exempted from U.S. tax under a territorial system.
Second, losses from operations outside the United States
normally would be disallowed. In other words, you have exempt
income, you don't get to take deductions against exempt income.
Third, most countries--in fact, I think almost all
countries that have adopted a territorial system--tax fully
foreign-source interest and royalties, including royalties from
the license of U.S. intellectual property abroad. Thus, the
benefit of a territorial system applies where there is foreign-
located economic activity and there is a lower tax rate than
the U.S. tax rate.
This is not a substitute, in terms of impact, for a
replacement of the ETI. There are other problems with a
territorial system. First, it does create a bias if you can
find a place to locate activity that is subject to a lower tax
rate than the United States. If it is otherwise something you
were doing in your business and you were indifferent at the
margin you would place the activity where there is lower tax.
For that reason, a territorial system needs very
significant safeguards, more than what we have today. You need
to be sure that expenses are not allocated to foreign income.
You need to be sure that pricing does not shift income to the
exempt area. You need to be sure that there are anti-abuse
rules, so that inappropriate transfers of businesses aren't
occurring.
A territorial system is not a simplification panacea. So if
this Committee chooses to look at it, you need to look at it
very carefully with those in mind.
As Mr. Hufbauer has suggested, I encourage the Committee to
look at other alternatives that, frankly, go the other way,
that would increase the taxation of foreign income to equalize
it with what it would be on U.S. income.
My time has expired. I would be happy to take any questions
from the Committee.
[The prepared statement of Mr. Shay follows:]
Statement of Stephen E. Shay,* Tax Partner, Ropes & Gray, Boston,
Massachusetts, and Lecturer in Law, Harvard Law School
---------------------------------------------------------------------------
*Mr. Shay is not appearing on behalf of any client or organization.
---------------------------------------------------------------------------
Mr. Chairman and Members of the Committee:
My name is Stephen Shay. I am a partner in the law firm Ropes &
Gray in Boston and a Lecturer in Law at Harvard Law School. I
specialize in U.S. international income taxation and was formerly an
International Tax Counsel for the Department of the Treasury in the
Reagan Administration. I was invited last Friday by the Committee to be
a witness to discuss some of the potential fundamental tax reform
alternatives that the Committee might consider in response to the WTO
decision.\1\
---------------------------------------------------------------------------
\1\ I have attached a copy of my biography to this testimony. The
views I am expressing are my personal views and do not represent the
views of either my clients or my law firm.
---------------------------------------------------------------------------
With the Chairman's permission, I would like to submit my testimony
for the record and summarize my principal observations in oral remarks.
Overview
In the announcement for the Hearing, Chairman Thomas stated the
purpose for the Hearing as follows:
Although the most recent [WTO] decision comes as no surprise,
it illustrates the need to fundamentally reform our tax system
so that U.S. workers, farmers and businesses are not
disadvantaged in international trade. This will be the first of
several hearings to consider the WTO Appellate Panel decision
and to examine ways to maintain the international
competitiveness of the United States.
The purpose of my testimony is to describe certain fundamental
international tax reform alternatives and observe how they do or do not
relate to the possible elimination of the Extraterritorial Income
exclusion (``ETI'').
I will first briefly review the ETI and the activity it benefits. I
next describe a territorial tax system, how it creates an incentive to
locate investment in lower-taxed foreign countries, and how the
activity it benefits differs from the activity benefited by the ETI. I
then consider other approaches to international tax reform, including
modifying the current U.S. system of worldwide taxation (with deferral
of tax on business income earned through foreign corporations) to
reduce rather than increase the incentive under current law to locate
investment outside the United States in a low-taxed foreign country.
The ETI Regime
The ETI was enacted in November, 2000. Under the ETI, a taxpayer
may exclude a percentage of income attributable to foreign trading
gross receipts (``FTGR'') or net income from FTGR.\2\ The bottom line
effect of the ETI is to reduce the tax rate on this income by
approximately 15%. Thus, a domestic corporation subject to a 35%
Federal corporate tax rate will pay a 29.75% rate on its net income
subject to the ETI regime.
---------------------------------------------------------------------------
\2\ FTGR generally are receipts from sales of qualified foreign
trade property, leasing of qualified foreign trade property for use
outside the United States, certain services in connection with foreign
construction projects. Certain foreign economic processes have to be
met in connection with earning FTGR. Qualifying foreign trade property
is defined substantially in the same manner as ``export property''
under the FSC, including that no more than 50% of the property may be
attributable to foreign content. The principal difference in
definition, apparently thought by this Committee to be sufficient to
satisfy the WTO rules, was that qualifying foreign trade property need
not be manufactured in the United States.
---------------------------------------------------------------------------
The ETI is designed, like the FSC, to prevent a taxpayer electing
the ETI from also obtaining the full benefit of the sales source rule
for exporters under the Internal Revenue Code. The sales source rule
permits taxpayers that manufacture in the United States and sell
outside the United States to treat 50% of the income from the sale as
foreign income. In most cases, this foreign income is in the general
foreign tax credit limitation category and, for firms that have enough
excess foreign tax credits (i.e., have paid foreign taxes at a rate
higher than the effective U.S. rate on the same general limitation
category of foreign income), permits this income to be exempt from U.S.
tax. The marginal rate of U.S. Federal tax on these export sales is
17.50%.\3\ For taxpayers with excess foreign tax credits, the benefit
of the sales source rule is generally larger than the ETI benefit.
Thus, the sales source rule causes the ETI to benefit taxpayers that do
not have excess foreign tax credits, that is, taxpayers that either
exclusively export from the United States or, if they also conduct
foreign operations, have managed their foreign taxes to remain below
the effective U.S. tax rate on the same income.
---------------------------------------------------------------------------
\3\ If the sales source rule applies to income of $100, the U.S.
tax on $50 allocated to foreign income is $17.50 and is offset by
foreign tax credits, the U.S. tax on the remaining 50 would be $17.50.
Thus, the effective tax rate would be 17.50%.
---------------------------------------------------------------------------
Alternatives to the ETI
As noted in the Hearing announcement, on January 14, 2002, the WTO
Appellate Body issued a report upholding a dispute resolution panel
finding that the ETI is a prohibited export subsidy.\4\ The stated
objective of the Committee's Hearing is to ``examine ways to maintain
the international competitiveness of the United States.''
---------------------------------------------------------------------------
\4\ The ETI was the successor to the Foreign Sales Corporation
(``FSC''), enacted by the Congress in 1984 and found by a WTO Appellate
Body in February, 2000, to be a prohibited export subsidy. The FSC was
the successor to the Domestic International Sales Corporation
(``DISC'') enacted in 1971, and found to be an export subsidy in a
panel report adopted by the GATT Council in 1981. The 1981 GATT Council
decision was subject to an understanding that a country need not tax
export income attributable to economic processes outside their
territory. This understanding was the source of the U.S. approaches in
the FSC and the ETI to characterize the benefited income as being taxed
in a manner comparable to the taxation under a territorial system. I do
not discuss here the substance of the U.S. position nor its merits as a
matter of trade law. Suffice it to say, the WTO has twice rejected the
U.S. efforts in this regard.
---------------------------------------------------------------------------
As an initial matter, it may be questioned whether the ETI (and its
predecessors the FSC and DISC) did in fact improve the international
competitiveness of the United States by comparison with alternative
ways that the foregone revenues (or tax benefits) could have been
spent. There appears to be support for the position that the impact of
the ETI on net exports (the increase in exports reduced by the
corresponding increase in demand for imports) was modest.\5\
---------------------------------------------------------------------------
\5\ A 2000 Report on the FSC by the Congressional Research Service
cites a 1992 Treasury Department analysis that repealing the FSC would
have reduced net exports by 140 million. If the impact of the ETI on
net exports was in fact less than the tax expenditure, it would be
ironic that the United States now is faced with having to arbitrate EU
claims for compensatory damages that are based on U.S. tax expenditure
estimates. The CRS Report also observed that under traditional economic
analysis the FSC by definition reduces U.S. economic welfare (as
opposed to the welfare of the firms benefited by the subsidy and their
shareholders) because at least some portion of the benefit is presumed
to be passed on to foreign consumers in the form of lower prices.
---------------------------------------------------------------------------
In the following portions of my testimony, I assume for purposes of
discussion that the Committee will not adopt a fourth proposal along
the lines of DISC/FSC/ETI, but instead will consider other changes to
the U.S. international tax rules. As described in the next section, the
alternative to the ETI most frequently discussed in recent days, a
territorial tax system, creates an incentive to locate investment
outside the United States and does not benefit the exporter that
carries on its manufacturing and/or selling operations entirely from
within the United States. A territorial system also is often heralded
as a simplification panacea, but as discussed in the next section, its
simplification potential generally is overstated. I urge the Committee
to also consider fundamental tax reform alternatives that would have
the effect of decreasing U.S. tax benefits for foreign income and
directing those revenues toward alternative uses, such as investment in
domestic human capital or broader reductions in the level of taxation
on all business income.
Changing from A Worldwide Tax System with Deferral to A Territorial Tax
System
The major approaches by which the tax system of a country (the
``residence country'') accounts for income earned by its residents in a
foreign country (``foreign-source income'') are a worldwide system and
an exemption, or territorial, system. If the United States were to
adopt a territorial system comparable to the systems adopted in other
countries, the United States (i) would not tax its own residents'
foreign-source business income that is subject to taxation in another
country,\6\ (ii) would disallow the deduction of foreign business
losses,\7\ and (iii) would tax currently portfolio dividends and all
foreign source interest and royalties. In other words, only foreign-
source business income would be exempt from U.S. tax and this income
would bear the tax only in the foreign country where the income was
produced (the ``source country'').
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\6\ For this purpose, foreign business income includes foreign
dividends or gains from substantial shareholdings.
\7\ In some cases, foreign losses are allowed, but are recaptured
as domestic income when the taxpayer next realizes positive foreign net
income.
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The principal objection to a territorial system is that it creates
a bias, not in favor of investment in domestic production for export,
but in favor of investment in foreign operations. In the worst case,
this bias causes a foreign investment to be preferred even though the
U.S. investment has a higher before-tax rate of return and is,
therefore, economically superior.\8\
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\8\ For example, assume that USCo is a U.S. corporation considering
a new business that will produce a 10 percent return, before U.S.
income taxation, if the business is located in the United States, and
an 8 percent return, before U.S. income taxation, if the business is
established in a foreign country. Assume further that the United States
will tax USCo at a flat 35 percent rate and that the foreign country
will impose a 10 percent rate of tax. If USCo is exempt from U.S. tax
on profits from the foreign investment under a territorial system, USCo
will be choosing between after-tax returns of 6.5 percent (.10 x
[1-.35]) in the U.S. location and 7.2 percent (.08 x [1-.10]) in the
foreign location. In this example, the pre-tax rate of return of the
U.S. investment is 20% higher than the foreign investment, but the
after-tax rate of return under a territorial system is 10.77% lower
than the foreign investment. Thus, the effect of a territorial system
is to create a strong incentive for USCo to make the economically
inferior foreign investment.
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The justification for exempting U.S. multinationals' foreign-source
business income is based principally on a competitiveness argument that
is usually stated as follows: foreign corporations operating businesses
in low-tax foreign countries owned by residents of countries with a
territorial tax system, as well as local businesses in the low-tax
foreign countries, pay only the low local income tax on their in-
country profits. Without exemption, U.S. multinationals are unduly
disadvantaged when competing against these foreigners in low-tax
foreign countries because in addition to the foreign tax, a U.S.
multinational will pay a U.S. residual tax on its foreign profits,
while the foreigners would pay only the low foreign tax. Therefore a
U.S. multinational should be given a countervailing exemption from the
U.S. residual tax.\9\
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\9\ Although a territorial system provides no direct benefit for
foreign operations in countries with effective tax rates equal to or
higher than the U.S. rate, it does offer greater potential for a U.S.
multinational to reduce high foreign taxes through tax planning
techniques that shift income from a high tax to a lower-tax foreign
country. Although often effective today, these planning techniques
would be frustrated by expansion of the high tax countries' CFC regimes
which is the general trend in these countries.
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This argument is not a request for the United States to give U.S.
multinationals relief from international double taxation. The foreign
tax credit already addresses that issue. Instead, this is a request for
tax system assistance that is not available to pure exporters or other
earners of U.S.-source income.
Relieving U.S. multinationals' foreign-source income from U.S. tax
would be a poorly structured tax assistance measure because the
assistance would not be targeted at U.S. corporations that face tax-
related competition. To be specific, a U.S. multinational facing little
tax-related foreign competition in low-tax foreign countries, whether
because (i) it is selling paten--or copyright-protected goods, (ii) its
principal competitor is from a foreign country that does not have a
territorial system, or (iii) its competitor is another U.S.
corporation, would benefit as extensively from a territorial system as
a U.S. multinational facing the tax-based competition.
In the current context of the possible repeal of the ETI,
proponents of a territorial system should be required to go further
than making generalized competitiveness arguments, and should link the
tax benefits of an exemption system to promotion of U.S. exports. It is
anticipated that the proponents will argue that these benefits for
operations in lower tax foreign countries will generate greater
purchases of U.S. goods because U.S. multinationals will buy from their
U.S. affiliates and suppliers. Although this is a claim that deserves
some scrutiny, at best this is an assertion that tax assistance to the
operations of U.S. multinationals in low-taxed foreign countries
indirectly encourages U.S. exports. This is a remote and somewhat
speculative support for U.S. exporters and is heavily weighted for
businesses with foreign operations that already are advantaged by
deferral. There is no direct relationship between adoption of a
territorial system and benefiting domestic U.S. exporters that do not
carry on foreign operations.
Adoption of a territorial system also is not a simplification
panacea. The allocation of expenses between U.S. and foreign source
income would be critical to determining which expenses are allocable to
exempt foreign income under a territorial system and therefore
disallowed as deductions. Today, the allocation of expenses to foreign
income is a potential audit issue primarily for taxpayers that have
excess foreign tax credits. Under an exemption system, there would be
pressure for all taxpayers that earn exempt foreign income to allocate
expenses, such as interest and research and development costs, to
domestic income and away from exempt foreign income. Thus, the IRS
would have to increase its scrutiny of this difficult area.
Similar to the transfer pricing pressures existing today, taxpayers
with foreign operations would have an incentive to shift U.S. income to
exempt lower taxed foreign operations. Under a territorial system,
however, the benefit is permanent (and not a deferral of tax until
repatriation) and transfer pricing would take on commensurately greater
significance.
Adoption of a territorial system would not eliminate the need for
anti-abuse measures that are comparable in effect to our current highly
complex anti-deferral regimes. Major developed countries that have
territorial systems also have adopted controlled foreign corporation
(``CFC'') regimes or other legislation to prevent tax-motivated
offshore investment. France, for example, provides for exemption of, or
a reduced tax on, foreign income, but has adopted expansive CFC
legislation. Germany, which exempts foreign business income earned in
treaty partner countries, has adopted foreign investment fund
legislation that denies favorable tax treatment to certain diversified
foreign investment funds that are not listed in Germany or do not have
a tax representative in Germany. These sophisticated territorial
countries recognize the need to protect the domestic tax base by
reducing the incentive to shift income-producing activity abroad.
Indeed, the need to protect the domestic tax base is more pronounced
for a country that does not tax foreign income than for a country that
taxes foreign income and employs a foreign tax credit system.
The Committee should take these considerations into account if it
considers a territorial tax system.
Reform of the Current U.S. Tax System of Worldwide Taxation with
Deferral
In practice the current U.S. system of worldwide taxation with
deferral of U.S. tax on foreign corporate business income operates in
much the same manner as a territorial system. If U.S. multinationals
earn income through active business operations carried on by foreign
corporations in low-tax source countries, the U.S. multinationals
generally pay no residual U.S. tax until they either receive dividends
or sell their shares. This phenomenon is referred to as ``deferral.''
Deferral obviously decreases the present value of the U.S. residual
tax. When this value reduction is combined with certain other features
of the U.S. international tax regime (i.e., cross-crediting foreign
taxes and certain source rules that overstate foreign-source income),
well-advised U.S. multinationals can frequently reduce the U.S.
residual tax on their repatriated foreign-source income to zero. Stated
differently, the U.S. worldwide system, with deferral, frequently
provides the same result as a territorial system (exemption from U.S.
tax on foreign-source income).
The current U.S. system therefore is subject to many of the same
criticisms as a territorial system. An appropriate response to those
criticisms, however, only may be achieved through a reform of the
current worldwide tax system. Adoption of a territorial system would be
a second best solution to a reasoned reform of the current rules.
The original proponents of the DISC argued for the export subsidy
in part on the grounds that exporters were disadvantaged relative to
taxpayers that could locate their operations abroad and take advantage
of deferral. In other words, an original rationale for the DISC
predecessor of the ETI was to equalize for exporters the advantages
realized by U.S. multinationals from deferral.\10\ If the ETI is
repealed and a third DISC successor is precluded by the WTO rules, as a
logical matter the Committee could consider decreasing the tax
advantages to earning low-taxed foreign income through foreign
corporations.
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\10\ See generally Cohen and Hankin, ``A Decade of DISC: Genesis,
and Analysis,'' 2 Va. Tax Rev. 7 (1982).
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Does decreasing the tax benefits for foreign income improve
competitiveness? An initial question is how to define competitiveness.
It is questionable whether U.S. competitiveness should be defined in
terms of U.S. multinationals' profitability. A more meaningful measure
of competitiveness is whether any proposal will advance the welfare of
individual U.S. citizens and residents.\11\ The proponents of tax
assistance to enhance the returns of U.S. multinationals, and their
shareholders, from foreign operations should be expected to carry the
burden of demonstrating the value of the assistance will exceed both
the revenue cost and the opportunity cost of alternative uses for that
revenue. For example, would investment of a given amount of revenue in
education grants to localities improve the living standard for
Americans more than the same amount of tax relief for foreign income of
U.S. multinational businesses?
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\11\ See Michael J. Graetz, The David Tillinghast Lecture: Taxing
International Income: Inadequate Principles, Outdated Concepts, and
Unsatisfactory Policies, 54 Tax Law Rev. 261, 284 (2001).
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I respectfully submit that the Committee should consider proposals
that would cut back on the deferral benefit for foreign income as an
alternative to the ETI or a territorial system. I and my co-authors,
Professors Robert J. Peroni and J. Clifton Fleming, Jr., have outlined
a proposal for a broad repeal of deferral.\12\ Essentially, our
proposal would apply mandatory pass-through treatment to 10% or greater
shareholders in foreign corporations.
---------------------------------------------------------------------------
\12\ Robert J. Peroni, J. Clifton Fleming, Jr. & Stephen E. Shay,
Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source
Income, 52 SMU L. Rev. 455 (1999); J. Clifton Fleming, Jr., Robert J.
Peroni & Stephen E. Shay, Deferral: Consider Ending It Instead of
Expanding It, 86 Tax Notes 837 (2000).
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One would not have to go so far as our proposal to make substantial
improvements in the current international tax rules without increasing
the current incentives to locate investment outside the United States.
There would be substantial improvements to the controlled foreign
corporation rules if the current foreign base company sales and
services rules applied without exception whenever the CFC's income,
determined separately for each foreign legal entity and qualified
business unit of the CFC, was not taxed at a effective foreign tax rate
of some minimum amount. Under current law, a safe harbor exists for
income taxed at 90% of the U.S. rate; the Committee could choose to
employ a lower percentage of the U.S. rate.\13\ Although this is a
second best approach to the mandatory pass-through approach, it would
be a substantial improvement over today's rules.\14\
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\13\ The current foreign tax credit mechanism could be improved by
repeal of the sales source rule combined with improvements to the
interest allocation rules and allowance of foreign as well as domestic
loss recapture. Finally, some simplification may be achieved in the
U.S. international rules by consolidating anti-deferral rules and
rationalizing the source rules.
\14\ It might be argued that these changes would pressure U.S.
companies to become foreign companies. If this is perceived as a
significant problem, the Committee could consider a range of
alternatives. For example, the Committee adapt existing U.S. tax
provisions to require U.S. investors to take account at the time of
sale whether a publicly-traded foreign corporation's earnings during
the investor's ownership have borne a level of foreign tax equal to or
greater than the U.S. corporate tax rate. If not, the investor could be
taxed on the gain to make up the difference in the same manner as
currently applies under Section 1248(b) of the Code. An alternative
approach would be to re-examine the circumstances in which a foreign
corporation should be taxed as a domestic corporation.
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The kinds of changes just described could be combined with revenue
neutral reductions in tax for business income generally. This approach
would assist U.S. businesses that export from the United States or
compete against foreign imports as well as those that operate abroad.
Alternatively, any revenue increase from these changes could pay for
more favorable depreciation and amortization for investment in
productive property, used to improve U.S. education or fund anti-
terrorism initiatives. Whatever the choice, I respectfully urge the
Committee to consider international tax reform proposals that will
improve the well-being of all U.S. citizens, workers, farmers and
businesses and not just those in the multinational sector.
I would be pleased to work with the Committee to analyze and
develop alternative fundamental international tax reform proposals.
Chairman Thomas. I want to thank all of you, especially for
your written testimony, which gives us at least a disembarking
point on looking at some options that are inevitable as we are
going to, as they say, round up the usual suspects. We want as
much help as we can get in fully understanding what those
suspects look like and clear the territorial taxes often
offered as a potential.
Mr. Hufbauer, let me understand your oral statement,
because I would like to ask the question this way.
We had a first appeal of the decision. We modified our
position slightly, obviously, and certainly not enough; and we
got a second decision. Are you saying by the fact that there
was a change in the substance and manner of the second appeal
that perhaps the United States would have been relatively
advantaged in how many hostages we could take under the first
appeal, that on balance we probably should not have taken the
second appeal?
Mr. Hufbauer. I guess it is always easy to do
quarterbacking on these difficult legal decisions. But the
rationale changed very dramatically between WTO reports. I know
you did read, Mr. Chairman, and I know everybody here did read,
that first appellate body report. What the WTO focused on in
the first report was the difference in taxation between
production abroad and exports. And, as you know, the ETI was an
attempt--and I think a good-faith attempt at the time--to come
up to the letter of the first set of decisions, because foreign
production and export taxation was harmonized.
The goal post moved in the second round, and in the second
round the WTO said, well, what we have got to do is look at the
normative benchmark. That was at the panel level, and at the
appellate level--and really I am condensing a lot--they came to
this ``but for'' test, but for ETI, the export income would be
taxed with a foreign tax credit. And the only reason a company
would choose ETI is because the tax was less. So, the WTO
reasoned, ETI is a goner. But they moved the goal post.
Now, I suppose with a good crystal ball you could have
said, if the WTO doesn't like the FSC, it is going to move the
goal post to catch ETI; with this crystal ball, you wouldn't
have enacted the ETI, or you would have done it differently.
But that is all rewriting history. But, I want to emphasize,
the goal post moved. And it moved further between the panel
report and the appellate body report in the second round.
In the first round, the appellate body said, ``Panel, you
are in good shape.'' In the second round, the appellate body
said, ``This is a bombshell.'' We are going to get rid of the
normative benchmark idea and instead we are going to go for a,
``but for'' test. Under the normative benchmark, the United
States could have looked at whatever the normative benchmark--
whatever that means--was for each and--every tax system, and
then pointed out exceptions and 25 possible subsidies. And we
could have said, ``You (Country X) are not following your own
normative benchmark; you (Country Y) are not following yours.''
We could have brought a boatload of cases.
But under the ``but for'' test, it will not be a boatload
of potential cases. There will be some--but I don't have the
expertise that Peter Merrill does or Steve Shay does to say how
many. I am sure there are ``but for'' problems out there, but
they are not as big as with the normative benchmark.
I am sorry to be so long on that.
Chairman Thomas. I think very few, if anyone, agrees with
your conclusion that they moved the goal posts. But in our
pursuit of solutions, it might be at least helpful for us to
understand the relationship that we are now in with the
Europeans. And then the question goes not to what the goal
posts did, but the why.
In your opinion, was it because we were pretty good on the
ETI in terms of the first appellate decision, and it may have
fit, had they remained consistent; or was it that there was too
much collateral damage to the Europeans, based upon that first
decision, and since we decided to try again instead of going in
a different direction, that decision couldn't stand and that
they needed some cover?
Clearly, it is probably a little bit of each, but do you
have any insight for the Committee in helping us understand the
shifting of the goal posts?
Mr. Hufbauer. I don't have any inside information in from
talking to the judges or the panelists, but I think the
direction which you are seeing is absolutely right. They
reflected and--they saw all the comments from here and around
the world, and those judges and panelists reflected and said,
``Look, we are becoming a World Tax Code Court too fast, too
soon, and we are going to create just too much of a backlash.''
There is a big issue on the balance between the judicial
role of the WTO and its legislative (negotiating) role, I won't
go into that, but the judges probably saw they were really over
the hill on this one and thought, ``Yeah, we don't like the
FSC, we don't like the ETI, we think it is just a continuation
of the DISC, and we are going to try to nail it more
specifically.''
Chairman Thomas. Mr. Merrill, in your presentation, you
talked about making some adjustments going back to some
decisions that were made in 1962, and certainly the world has
changed.
Do you have any indication of what the revenue forgone
would be if we made some of those adjustments? Whether we look
at it or not--as I discussed briefly with the gentleman from
Tennessee, if we are going to look at victims here, there are
people who are going to be looking for compensation and
adjustments whether it merits it or not.
Could you give us some idea of the level of dollars we are
talking about in the disruption in the Tax Code if we make some
of the changes you suggested?
Mr. Merrill. I have not done revenue estimates for these
provisions, and certainly the official scorekeepers for these
provisions are the Joint Committee on Taxation. And I am not
aware--I have not seen any published estimates they have done
on any of these provisions. It may well be that some of these
provisions would be scored as relatively expensive.
Chairman Thomas. And I think that our Joint Tax Committee
does an excellent job, but it seems this is very difficult to
mark, and as they are having difficulty determining what the
compensation is, the actual dollar values, this Committee is
going to need as bright a light as we can get on the decisions
that we make relative to revenue shifts and winners and losers.
Whether we like it or not, that has to be part of the decision
process.
If you know of any, it would be very helpful; and we may
rely on some of you in at least providing an alternative set of
numbers, because in all likelihood it is going to be somewhere
in between. No one is going to get this one right.
Mr. Shay, you began your testimony a little bit
defensively, because Mr. Hufbauer said he disagreed with you
before you started; and you identified pretty much where it was
that he may have disagreed with you without his indicating any
particulars. So did you guys talk ahead of time about what is
obvious about the presentation Mr. Shay, that others would
react negatively to or at least not agree?
Mr. Shay. Are you asking me to point out where in my
presentation----
Chairman Thomas. I am asking you to defend the part that
you felt sensitive about. I think some people maybe didn't
follow.
Mr. Shay. Well, the thrust of my testimony, which I think
Gary was referring to, which I did not really spend time at
length in my oral comments on, was that much of the discussion
has been about how to potentially reduce U.S. taxation on
foreign income by creating an exemption from U.S. tax on
business income earned abroad. And indeed I think this may have
come up earlier in today's hearing.
In fact, one of the original reasons for the DISC back in
1971, at least as reported in an article by somebody who was
there cited in my testimony, was to equalize the treatment of
exporters with those companies who could earn foreign income
through foreign corporations and not pay current U.S. tax on
that income. And part of what I was pointing out in my
testimony is that if you go further, as some have suggested,
and not just defer U.S. tax on foreign income earned through
foreign corporations, but exempt from U.S. tax all foreign
income, whether earned through a foreign operation directly or
through a corporation, then you further exacerbate the
distinction between the exporter who is operating exclusively
in the United States--perhaps in Washington, perhaps in
Chicago--from the multinational that is conducting part of
their operations outside the United States.
So, as a matter of logic, there is an alternative approach
to exempting foreign business income. It is to tax it and tax
it equally so that that exporter in Washington or Chicago that
may not have foreign operations is bearing the same U.S. tax
burden as is the multinational, basically, that is performing
aboard.
Now, then, to answer your question, the objection is made
that some other countries do adopt a territorial system and do
not tax that income earned in that other country when our
company is in that other country. And that comes back to the
first part of my testimony, Mr. Chairman, how significant is
that element, the taxation element in that competitive mix;
because if that is Pepsi and Coke, it is not relevant. If that
is a company that is operating there under the protection of
intellectual property laws that are respected in that country,
so that they effectively have a monopoly on that product, the
tax is not relevant.
So some of the solutions that are being proposed do not
meet my criterion that I set out at the beginning of the
testimony: Do they enhance overall U.S. competitiveness, not
defining it in terms of the profitability of the multinational?
I am a private, practicing tax lawyer. If you give me the
opportunity to advise my clients to enhance their profitability
through the rules you will pass, I guarantee you I will take
it, and I have taken it for 25 years.
I am here today before the Committee in a private capacity,
not representing my clients, but representing what I perceive
to be the best tax policy for the United States. And that is
the standard I am asking the Committee to adopt, and for that
reason, I am asking the Committee to include in its range of
options that it is considering options that do not lower income
U.S. taxation on foreign income, but increase it.
Mr. Hufbauer has extensively criticized that position, and
I respect his arguments and I respect his position, but it
seems to me that is what the debate should be about.
Chairman Thomas. And I want to underscore that the reason I
asked you to make those comments is that this Committee is
certainly not going to arbitrarily or artificially cut off any
avenue of investigation.
I do think, as you said, logic leads you to a particular
position. We have to approach this with a somewhat scientific
method which--more often than not, our hypotheses will be
disproven. But in being disproven, it allows us then to move on
to other areas.
The thrust of a fundamental change in the Tax Code is so
difficult that we may have to look at some of these
alternatives, and I can assure you that while we will not
dismiss any alternative without having gone through the process
to the best of our ability, looking at the pros and cons, and
especially if we are going to add several different components
together to get a full impact of exactly who the winners and
losers are, our goal is not to try to respond to a WTO panel's
attempt to determine our internal taxes and wind up punishing
ourselves even more. Our goal is, to the best of our ability,
change our system; and to the degree we can't do it,
fundamentally to offset some of the negatives caused by this
decision.
Gentleman from New York?
Mr. Rangel. I thank all of you witnesses. You have been
very, very helpful.
Mr. Hufbauer, do you believe there was justification for
the WTO's decision to reject the way we handle our exports?
Mr. Hufbauer. Not based on their first report. If you read
the letter of the first report, I thought that the ETI--and I
said so at the time, and I was obviously mistaken, but I
thought it was consistent with the first panel report and the
first appellate body report on the theory that we are a very
contract-driven system in the WTO, and it is not a common law
system.
It is becoming a common law system, and therefore, you
could look at the letter, you could respect the letter and----
Mr. Rangel. I was really referring to our last legislative
response to their rejection. The last case that we lost, do you
believe that was justification for the decision by the WTO to
disregard what we thought was a remedial solution to our
problem?
Mr. Hufbauer. Mr. Rangel, I have read the decision. I see
where they are making the arguments. I totally disagree with
the second appellate body decision and the second panel report.
They are the judges, not me, obviously.
Mr. Rangel. While you disagree with their decision, you do
believe under existing law that United States firms suffer a
competitive disadvantage.
Mr. Hufbauer. Yes, I do.
Mr. Rangel. So that the WTO decision really gives us an
opportunity to even better our position, even though their
decision was that it put our friends at an advantage.
Mr. Hufbauer. Absolutely. It can be changed in a way that
we could be better off than we were before the FSC or before
the DISC. It is up to the Congress and Treasury Department and
people of America.
Mr. Rangel. And are you suggesting that we should adopt a
territorial system in terms of part of the solution to the
problem that we face?
Mr. Hufbauer. The word ``territorial'' is one of these
plastic words that means different things to different people.
And with my own nuances--and everybody would have their
nuances--the fundamental answer is ``yes.'' And I co-authored a
book 10 years ago, U.S. Taxation of International Income, where
we advanced this position, and while I would certainly have
changes to whatever I said 10 years ago on this or any other
subject, the basic answer remains ``yes.''
Mr. Rangel. Would you support the suggestion made by Mr.
Shay, that would create a large incentive for U.S. companies to
move to countries that have low corporate taxes?
Mr. Hufbauer. Absolutely not. I fundamentally disagree with
that. Now I have to talk about one of the nuances. I go for a
territorial system which is territorial with respect to
countries which have normal tax systems. And I realize,
``normal tax system'' is a plastic term. But all these kind of
``run away'' arguments are talking about running away from the
United States to the Bahamas or running away from the United
States to I don't know where. Our whole international tax
system is focused on a handful of little countries where nobody
is running to except maybe some insurance companies. And that
is where I would put my nuances. But our big competitors--you
know the countries. U.S. companies are not going to run away to
tax havens countries, but instead to Canada, to Mexico, to
Germany, to Japan, to China. Under a territorial system, our
companies are in fact going to be much more competitive doing
business here, exporting directly, and especially exporting to
their operations abroad, which Peter Merrill emphasized. This
is terribly important in a global economy.
Mr. Rangel. Mr. Shay, would you care to respond to Mr.
Hufbauer?
Mr. Shay. I guess there are two comments. One is that there
are very legitimate taxing countries that have chosen to adopt
a low rate of tax. A country I have enormous admiration for is
Ireland, and they have chosen to adopt a corporate income tax
rate which I think is now 12 percent. That is substantially
below 35 percent. And I could in very good conscience counsel a
client, if we had a tax-exempt system, to say if from a
business perspective you could ship your product to your
customers from the United States to Ireland and the customer
would be equally satisfied--well, I don't think anybody here
would make a different decision as to where they would locate
the operation.
Second, I have been engaged in numerous planning exercises
involving some of the countries that Mr. Hufbauer named that
have what he calls normal tax systems, where we are able to
bring the effective rate down not quite to 10 percent but
substantially below 35 percent. And, in fact, I have worked
with some at least former colleagues of people on the panel. So
it is a complicated question.
I think the short answer is that most businesses run their
businesses for business objectives first. There is a point
where they come to their tax lawyers and they say, Okay, I have
got two choices; does tax make a difference? Sometimes they
come to the tax lawyer earlier, but the fact is taxes at the
margin make a difference or else we wouldn't have been having
this discussion.
Mr. Rangel. Mr. Merrill, you are very cautious about the
territorial system yourself.
Mr. Merrill. That is correct. In my written statement, I
raise a number of practical problems. I should say that in
April of last year, the International Tax Policy Forum and the
Brookings Institute and had a conference on territorial income
taxation. All the papers for that are available on the ITPF Web
site. There were a number of papers that described how
territorial systems worked in Canada, Netherlands, and so
forth. And what those detailed descriptions showed is that a
territorial system is not necessarily a simpler tax system. So
I think that is one concern.
There is also a concern that there could be a number of
taxpayers that would have a substantial tax increase under a
territorial tax system depending on how it was structured. And
I think you would want to think carefully about redistributing
the tax burdens in that way. And, frankly, one concern is that
actually some exporters could face some very large tax
increases under a territorial tax system, which again I think
is something you would want to look at pretty carefully.
A third issue is the allocation of expenses, which under a
territorial system means those expenses are nondeductible if
allocated abroad. That is an issue we face today with interest
allocation and the foreign tax credit. It affects so-called
excess credit taxpayers. It is a much bigger problem under a
territorial tax system.
So I think you have to look at it really carefully and, as
Gary said, there are many different ways to do it and not all
of them are particularly attractive.
Mr. Crane. [Presiding.] I would like to throw a
hypothetical question out at you, and it gets back to the
proposal that I pushed for all the years that I have been here,
and that is the total elimination of any tax whatsoever on
business. And my argument has always been that they don't pay
taxes in the first place, they gather taxes. And that is the
cost of doing business just like plant and equipment and labor,
and you got to pass it through and get a fair return or you are
out of business.
So, given the hypothetical, let me ask you the question, if
we eliminated any tax on business whatsoever in this country,
what would be your assessment as to the impact on our exports?
Mr. Hufbauer. Let me just make a distinction, Mr. Crane,
between eliminating a tax on business and who actually writes
the check. It is much easier for any tax authority to collect
taxes from, let's say, 100,000 business firms than 100 million
households. And so you do have the issue of who writes the
check, if I can put it that way, who has the legal liability,
which I think is quite distinct from the tax on business the
way you are framing it in the question.
Now let me come to the question itself. The estimates that
I have seen on responsiveness of investment to tax differences
between countries, between States, between provinces, show a
tremendous response. When I was young and going to university,
in formal terms this responsiveness or elasticity was thought
to be either zero or one half, 0.5. In other words, if you
change your tax by 10 percent, at most you would get a 5
percent change in investment. Maybe you would get zero.
Recent studies are going to much higher numbers. The recent
studies are more sophisticated, in their econometrics, but they
are also capturing something that is happening in the real
economy, which is that our firms, advised by Steve Shay and
other bright people like Peter Merrill--are comparing taxes as
well as everything else to a much greater extent than they once
did, and probably the elasticity now internationally is three.
That is to say, change your tax by 1 percentage point, and you
get a 3 percentage change in investment, which is a big impact.
So--Within the United States, the elasticity may be as high as
10 between States. I think if we got rid of the corporate
income tax as we know it today, and replaced it with something
else on a revenue-neutral basis, there would be----
Mr. Crane. Not replace it; eliminate it entirely, and no
offset. Don't come up with----
Mr. Hufbauer. Well, then cut the spending. You would have
to cut the spending side, and I am trying to deal with the
fiscal balance--but keeping the fiscal balance the same by
cutting spending or replacing the tax. But I think it would be
a tremendous stimulus to investment and the competitiveness of
the American economy in exports worldwide.
Mr. Crane. Let me ask you one other follow-up question. To
what degree do you think that provides an attraction to foreign
companies to locate here in the United States?
Mr. Hufbauer. That would be a big part of it. If we had a
lower tax rate on business----
Mr. Crane. Not lower; eliminate.
Mr. Hufbauer. If we had elimination, you know we already
have a lot of foreign direct investment in the United States.
Mr. Crane. I have got a small steel company in my district
that has just moved down to Bermuda because they don't have to
pay taxes in Bermuda. What I am thinking about is the dynamics
of the attraction of business here and job creation. And I
don't think anyone could even begin to speculate on what that
might translate into as far as increased revenues here in D.C.
Mr. Hufbauer. I agree.
Mr. Crane. Could you other folks comment on that, Mr.
Merrill?
Mr. Merrill. If I understand your proposal, you would
dramatically reduce the tax burden on capital. That would have
the effect of lowering the costs for U.S. companies that are
capital intensive in producing their goods. It would make their
goods more competitive in world markets. There is no doubt
about that.
Your proposal, as I understand it, would make the United
States a very attractive place to locate your operations,
because income earned within the United States would be subject
to only one level of tax for U.S. shareholders and that should
attract investment into the United States.
Mr. Crane. Mr. Shay.
Mr. Shay. I think you would have to be careful about what
you actually mean. If you mean by eliminating tax on business,
as Peter just assumed, eliminating a tax on capital and only
taxing wages that is one thing. But you suggested before that
you didn't mean that; that what you meant was eliminating tax
on business and reducing spending and leaving the income tax on
individuals.
Mr. Crane. Well, wait. I didn't say reducing spending,
because I think the dynamics of it would not necessarily
dictate reducing spending.
Mr. Shay. Then I think we are getting back to where Peter
was. You would be eliminating tax on business, and all of that
tax revenue would be made up at the individual level, correct?
Mr. Crane. Well, not necessarily made up. We passed a tax
cut last year, $1.3 trillion over 10 years. And I have seen
projections that if you eliminated any tax whatsoever on
business it would amount, I think, like $25 to $30 billion a
year over 10 years.
Mr. Shay. Implicitly what you are assuming then is that,
because what you anticipate to be the enhanced economic growth,
there will be----
Mr. Crane. That would be an offset that would neuter that
revenue loss.
Mr. Shay. Then I think you are assuming the answer to your
question, which is there would be economic growth, which I
think does incorporate Peter's response. I am not sure--where I
would have difficulty with that is, I am not persuaded by the
evidence I have seen that you are going to have that degree of
economic growth that you make up the revenue. If you don't make
up the revenue and your spending decreases, if it decreases in
productivity to the United States, I am not sure where they
come out.
Mr. Crane. Do you agree or disagree that it would attract
businesses here and increase jobs?
Mr. Shay. If you define it as Peter was defining it. If you
define it as eliminating the tax on capital and you apply only
taxes to wages--I in fact cited an article that I co-authored,
which agrees would have a great tendency to attracting foreign
capital. But I think you would find it would be difficult to
maintain another principle which is essential to our system,
and that is taxing people on the ability to pay, because it
would levy that tax burden on workers and they would have to
make up for it. And the foreign investors, the reason they
would be attracted here is because they would not be paying
that tax.
Mr. Crane. You are assuming you would have to have an
offset for this.
Mr. Shay. I am assuming that either you are going to reduce
spending--and you are saying no to that.
Mr. Crane. I am in favor of reducing spending, but my point
is the projected budget surpluses--when we passed the $1.3
trillion tax cut last year over 10 years, there was no pass-
through to put that burden on anybody in the Tax Code. The
assumption was that we were producing surpluses because of
record high taxes, and the taxpayers needed relief and we gave
them relief with that tax measure.
Mr. Shay. I think the facts are that the assumption was
there would be economic growth that has not materialized, and
that with the declining economic growth----
Mr. Crane. That was historic economic growth.
Mr. Shay. The future surpluses, which are no longer
projected, were projected as a result of an anticipated
economic growth that we are now scaling back. So in fact there
would have to be a tax makeup on the current assumptions, it
seems to me, to get to what you are driving at.
Mr. Crane. But getting back to my question, if you
eliminated that tax, would it not provide an incentive for
businesses to locate here and we wouldn't have DaimlerChrysler,
we would have ChryslerDaimler.
Mr. Shay. I agree with the following. If you eliminated the
tax on capital you would indeed attract capital to this
market--and let me hasten to say, I am not an economist, but I
agree with that proposition. I will not tell you, as Mr.
Houghton said earlier, there are not other dynamics as to what
was Chrysler and what was Daimler. But what you would see are
other collateral effects that are very dramatic socially. You
would have taxes on wages that would be bearing the burden of
the cost of the U.S. government, including the cost of
supporting that foreign investment which is in our market. And
I think that is part of the equation that the Committee as a
whole would have to take into account.
Mr. Crane. Well, I think Mr. Greenspan was testifying
today, and I think there are some good turnaround events,
information that was coming in today that suggests the economy
may be doing better. Well let me--Mr. Levin?
Mr. Levin. Thank you. We kind of dipped our toes in the
water--maybe more than our toes. So thank you very much.
I won't get into the last exchange, though it was
interesting to hear Mr. Shay's response. So let me just suggest
that what I think your testimony shows, Mr. Hufbauer, I think
your analysis of the WTO decisions is a cogent one and I hope
that the Europeans and others will listen to it, that if they
thought that tactical advantage could be gained from dipping
into this area, it is very problematic. I don't think any more
murkier subject could be used to try to gain a trade advantage
in this one. And I also think they should listen to the three
of you as you discuss and sometimes argue about what other
solutions might be undertaken by us, because if anyone thinks
that that can happen in a short period of time, I think they
are being misled.
And I think today, really, we didn't want to get into the
substance, but you helped us do that, and it showed that we
have a long journey ahead. So your testimony has been
especially helpful, and I hope we will circulate it to all the
Members who were unable to get here so that they realize that
there is a difficult journey ahead here.
So thank you to you all very, very much.
Mr. Crane. Mr. McCrery.
Mr. McCrery. Yes. Thank you, Mr. Chairman. Mr. Shay, I came
in after your testimony and got in just on the tail end of your
discussion with Mr. Thomas. So I heard you talking about
raising taxes on foreign operations, I guess, of multinational
corporations and how that would level the playingfield. And
while that may be true vis-a-vis, say, Boeing and some other
domestic corporation, the problem at least as I appreciate it
is not a relative tax burden between American multinationals
and American corporations that just do business here. The
problem is the relative taxation of American companies, whether
they are multinational or not, and foreign companies that are
exporting into the United States. And that part of your--maybe
there is much more to your solution than that, but that part of
your solution doesn't seem to address what I perceive to be the
principal problem here. Did I miss something here? And I
apologize if I did.
Mr. Shay. What I pointed out was that in arguing that tax
differences are the key to competitive differences, when two
companies from different countries, let's assume, are competing
in a third market, and the U.S. company is going to pay tax at
the U.S. rate and the other company is from a country that is
going to let the foreign country rate apply, even if it is
lower than their home rate, my first observation is that there
is no competitive issue if the local country rate is higher
than the U.S. rate, because we give a credit for that, Okay. So
the only circumstance that we are talking about----
Mr. McCrery. That is correct insofar as income is
concerned.
Mr. Shay. We will come back to indirect taxes in a moment.
On direct taxes, the only circumstance, then, that your concern
arises is A, the foreign country is at a lower rate than the
U.S. rate; B, the other company is not taxed at the same rate
as the U.S. rate back in its home country; and C, the premise
is that the difference in taxation is the driver of a
competitive difference. So when we talk about income tax, one
of the problems that befuddles, I think it is fair to say, some
economists--I am not an economist---is what is the incidence of
that tax, who ends up bearing it? Does it reflect in price?
Does it reflect in lower shareholder profit and so on?
Before you give U.S. tax relief in that case, my experience
is that there are very great advantages coming from the United
States. We have a market that supports those companies a way
that the other countries' own company market may not. There are
many other factors. And so the only observation I was making
is--and I left out a piece.
The other piece I observed in my testimony is there may
not, in fact, be that competitive difference as a business
matter if the U.S. company owns intangibles or has other
benefits that effectively preclude the competitor from selling
the same quality product in the market. And that may come from
our R&D, research and development in the United States. It is a
rich and complex picture.
So the test I was asking the Committee to apply before
reducing the U.S. tax on all foreign income of a U.S. company,
which is going to affect a lot of cases where we are going to
be reducing our revenue not really for the immediate
competitive issue addressed, we need to ask ourselves are we
getting the bang for the buck? Is that a better use of our
money? Because if it is going to the profitability of two U.S.
companies competing in that market, then there may have been a
better use for it. It may be that we could have reduced all
corporate rates in this country, and that would not help the
company that is not in that market but the exporter. That is
the argument I was making.
Mr. McCrery. So you weren't making a blanket statement. You
are just saying in those isolated instances, we ought to look
at that in terms of relative taxation. Any of you, Mr. Merrill
or Mr. Hufbauer, want to comment on what Mr. Shay just said?
Mr. Merrill. As I understand one of the options that Steve
has put forward, it would be to eliminate deferral, which would
tax U.S. companies operating abroad currently on their income,
active and passive. That is something that this Committee
considered 40 years ago and was proposed by the Kennedy
Administration, and your Committee decided not to do that. No
other country in the world has repealed deferral. The
implication would be that a U.S. company doing business abroad
would be taxed in a very different way than multinationals
anywhere else in the world.
The consequence of that would be that it would be extremely
unattractive to headquarter your company in the United States
because if you were a U.S.-headquartered company, you would pay
U.S. tax everywhere you operated in the world, where your
foreign competitors would only pay local country tax, in most
cases, where they operated.
In that sort of a world you would see an explosion of the
phenomenon that we are already seeing, which is not only
companies deciding to invert, which is not very common yet--
only about 28 transactions--but also acquisitions of U.S.
companies by foreign companies, because that allows the
acquired company to operate abroad essentially free of U.S. tax
where they invest outside the United States. We are not talking
about income earned in the United States. We are talking about
income earned outside of the United States and if the United
States imposes current tax on that, the U.S. companies will
very logically find ways to headquarter outside the United
States.
We will also see increased portfolio investment. Two-thirds
of all our investment outside the United States is not
multinationals, it is pension funds, it is institutional
investors, it is portfolio capital investing in foreign-
headquartered companies.
So I think it would be pretty clear, Stephen, in your
capacity as advisor to companies, if they had a choice to set
up an operation in the United States or abroad and if they set
up the operation in the United States, their entire foreign
operations would be subject to current U.S. tax. If they set up
abroad, only their U.S.-source income would be subject to tax;
it is obviously what you would advise your companies to do. So
that type of activity, setting up headquarters abroad, would
skyrocket.
Mr. McCrery. [Presiding.] Thank you. Very quickly, Mr.
Hufbauer.
Mr. Hufbauer. I obviously affiliate myself with what Peter
Merrill has just said. And the way I see it is, without making
a lot of complication, if you tried to make taxation of U.S.
companies working abroad equivalent to what taxation is in the
United States and try to achieve that parity, (``capital export
neutrality'' in the lingo of the tax world), you have the
competitive problem all of these other different companies used
in different places. It is not 1950, when 80 percent of
multinationals were U.S.-based; it is 2002, and it is down to a
quarter or something like that.
Anyway, you have a lot of companies based in other
countries who can do business in those low-tax countries and
not face this disadvantage that we are suddenly going to impose
on U.S. companies doing business there.
And then the point you made, Mr. McCrery, was that they
will produce in those countries and ship back into the United
States. So you have got the third country competition coming
back into the United States.
And what kind of parity do you want to achieve? If you try
to achieve the parity that Steve is advocating, I think you are
just putting all U.S.-based companies at a horrendous
competitive disadvantage in a global market.
Mr. McCrery. Thank you.
Mr. McDermott?
Mr. McDermott. Thank you, Mr. Chairman. I am not sure I am
smart enough to ask any questions here, but I do have some
anyway.
Mr. Shay, I was reading your testimony, and in the first
paragraph, or the bottom paragraph on the first page, it says:
I next describe a territorial tax system, how it creates an
incentive to locate investment in lower tax forum countries and
how the activity it benefits differs from the activity
benefited by the ETI.
Unfortunately, coming from Seattle, one does think about
Boeing. You mentioned Chicago and Washington, and I suppose you
were talking about Boeing. They are the biggest exporter. And
what I am trying to figure out is, I watch these companies like
Stanley sort of go off to Bermuda, and I figure, well, I wonder
about Boeing.
How does this extraterritorial thing affect Boeing? Would
they have to move their headquarters or would they have to move
their production out of Seattle and Wichita to get the benefit?
Or tell me how they would construct it under this new
system or this extraterritorial system.
Mr. Shay. Let me start with today. What has been happening,
what you are referring to is a phenomenon where companies that
are U.S. corporations in their parent companies are engaging in
reorganizations, in most cases taxable, but because their stock
prices have been down, they are willing to take that hit,
although that is actually quite a difficult issue, for them to
transfer the parent company to another jurisdiction.
It does not necessarily mean at all that the group's
headquarters leave the United States. In fact, a well-known
example is Tyco, which took advantage of a merger a couple of
years ago, to merge into a company that is a Bermuda company
but the headquarters of Tyco, the executive headquarters, are
in New Hampshire. The U.S. operations remain in the United
States. They are in U.S. corporations.
What is going on, though, is their other non-U.S.
operations, by being under a foreign parent, are not being
subjected to rules that they would be subjected to if it were a
domestic corporation parent. It really is the phenomenon that
Peter was accusing me of permitting to happen under my
proposal, for which I have a response buried in the testimony
at footnote 14; that is what has been going on.
The ETI really has nothing to do with that at all. The
adoption of a territorial system does not answer that in any
sort of directly coherent way. It is a creature are of the fact
that today we honor the identification of a legal entity called
a corporation and treat it as a U.S. taxpayer if it is
organized under the laws of a State or the District of
Columbia. And if it is organized under the laws of the Cayman
Islands, we say it is a foreign corporation and we accord
enormous--quite substantial significance to that.
Now that significance does not apply if they are actually
operating in the United States; we will tax them. If that
Cayman Islands company is actually operating in the United
States, we will tax them. If they own a subsidiary in the
United States, we will tax that subsidiary. But what it does
mean is that our rules affecting the non-U.S. income are
basically cut out.
Part of my proposal that Peter was criticizing would be an
effort that would make that less relevant or not relevant. Now,
I did not describe my proposal in detail in testimony, and
indeed in the article I refer to, we have thought about
additional things that would have to be done basically to
address the concern that Peter has addressed, and indeed some
of that is in my testimony buried in the footnote.
This is a complicated area, but I think one thing that
should be clear about it is that you have a set of issues that
are raised by the inversion transactions. They are susceptible
to being dealt with by this Committee, but essentially the
options boil down to, adopt rules that make it irrelevant,
because basically you are not going to try to tax foreign
income at all; or try to fix what you currently have and try to
have more of an equalized taxation of all of your income, have
neutral taxation of U.S. and foreign income. And these are
difficult issues.
The comments that Gary made and Peter made, they are
legitimate comments, but they are not insoluble issues if there
is the will.
Mr. And what is the solution for Boeing, then, so that they
could keep jobs in the United States and not be at a
disadvantage with Airbus?
Mr. Shay. That is a unique situation because you
essentially have a two-competitor market. And the answer that I
frankly--I am not at all comfortable that that is a tax-driven
problem or that there is the problem--I don't know enough about
how they are disadvantaged vis-a-vis Airbus, I don't know
enough that it derives from the tax treatment of Airbus as
opposed to government purchasing approaches, other nontax
issues.
I am very reluctant, and I think we all should be, to
assume that there is a tax answer for everything. There is not.
They have to compete head to head with Airbus. They do it by
having the best educated workers and having good management
that prunes away all the excess costs and all the ABCs of good
business, and in my experience, tax comes at the end of the
dog.
Mr. McCrery. Before going to Mr. Watkins, that may be true,
but at least at margin the tax burden is relevant, and I think
that is what Mr. McDermott is getting at.
Mr. Watkins. Mr. Chairman and Members of the Committee, I
will say thanks for these two panels, the one earlier and
Messrs. Hufbauer, Merrill and Shay. I think this is probably
the most informative educational phase of this, and I
appreciate getting some meat around the bone, because I think
it is very good. Tax does affect that--there is no question
about it--in many ways.
Mr. Hufbauer, you said, in the fifties, 80 percent of the
corporations were U.S.-based. Was this multinationals?
Mr. Hufbauer. I am giving very loose figures, but if you
looked at multinational, or what was called ``foreign direct
investment,'' multinational corporations, and go back to those
years 40, 50 years ago, it was predominantly a U.S.-driven
phenomenon. But now, of course, a lot of other folks are in the
game.
Mr. Watkins. We are in a global economy, and it is not
really that way.
Mr. Merrill, you have an--I have read all of your
statements. All of you have some very good--I will take it home
and read it, and I will read it on the plane flying back and
forth. But I noticed, Mr. Merrill stated of the world's 20
largest corporations, the number headquartered in the United
States has declined from 18 in 1960 to just 8. I think everyone
who is wanting to tax corporations should look at that a little
bit. Declined from 18 out of the top 20, from 18 to down to
only 8. And the multinational companies' share of global cross-
border investment has declined from 50 percent in 1967; now it
is down to only 25 percent. We were talking about an economic
base out here, or our economic undergirding of our country;
some of it is gradually eroding in the United States.
I do not know about Boeing, Mr. Shay, but taxes do matter.
But I know--my friend, Mr. McDermott, just left, but I also
know that subsidies matter. And I also know that some of the
environmental and labor deals matter because there are some
variables, more than just taxes, as you say.
But I know I speak of ``taxes'' and ``Texas,'' I have two
colleagues here Mr. Brady and Mr. Doggett. I am from Oklahoma;
that is just above, geographically, Texas. The fact is, Texas
does not have a corporate tax or a personal income tax, though
it has a franchise. I know we lose businesses and industries
from Oklahoma to Texas because of that very reason.
Now, they could have the same environmental base that we
have because most of it is the United States. But it is tax
driven.
Let me assure you, I think what we are talking about is--
and today it is probably one of the most significant issues
facing the future of our country and its role if we are going
to remain the number one economic power in the world, which
also drives where we are as far as militarily, educationally or
anything else--we have got to have the base to do that.
I appreciate this, Mr. Chairman. Again, I think this is a
very, very important--to my friend from Tennessee, I hate that
he left because I know that he is also concerned about some of
these things we were just talking about. I will talk to him
personally.
I thank you so much for being here. I will probably have
some questions I may call some of you on or ask you to give me
more information on. Thank you.
Mr. McCrery. Mr. Hayworth.
Mr. Hayworth. Thank you, Mr. Chairman.
Gentlemen, thank you for coming down and for your testimony
today. And I listened with interest to my colleague from
Oklahoma talking about the environment he sees at home and the
analogy with what transpires internationally in terms of tax
law.
Mr. Merrill, you pointed out during your testimony, foreign
markets in today's global economy represent an ever-increasing
opportunity for the growth of U.S. companies. Furthermore,
competition for these markets is at an all-time high. And
echoes of what my friend from Oklahoma talked about, Mr.
Merrill, in your testimony you also point out that our U.S. tax
rules put our companies at a disadvantage when competing in
foreign markets.
To amplify this and get past theory and abstraction, can
you offer an example---I don't know if you would call it
``everyday'' or something that is so compelling and so notable
that it certainly bears amplification in this type of setting?
Mr. Merrill. I think one of the most graphic examples is
the U.S.-owned foreign shipping industry. That is an area where
Congress, in 1986, actually did what Steve recommends. It
terminated deferral for foreign shipping income. The result is
that the U.S.-owned foreign shipping income has been
eliminated. There are very, very few carriers left now that
operate a foreign flag fleet.
And this happened because they sold or they decontrolled.
They sold majority ownership so they would get out of these
rules. I think that is an example where it is crystal clear the
United States changed the law in 1986 and U.S. ownership of a
foreign flag fleet was almost eliminated.
Mr. Hayworth. Thank you, sir. Would anyone else care to
elaborate?
Mr. Shay, we do not have an equal-time provision, but do--
were there mitigating circumstances in your mind or would you
concur with Mr. Merrill's analysis?
Mr. Shay. Well, I can't speak to the shipping case, because
I have not studied it, but part of my caution is that you are
being asked by companies to reduce their tax burden.
I served 5 years in the Treasury. I had to use the word
``no'' more than any other word in the 5 years I was in the
Treasury, because when you are in your position in the
Treasury, you are always going to be asked to reduce the tax
burden.
The question is, is it in the overall best interest of the
United States? And the analogy I would make to my private
experience is, sometimes clients say, if I can just make that
investment, I will have a bigger market share.
That is not the only question. Will they make a profit?
There are some investments you should not make.
And that is the way you should analyze each of the
questions that come before you. Because my clients do not just
go for market share if they are not going to make a profit. And
the analogy here is, if the United States is going to invest in
our multinationals, which we do, we reap a huge benefit.
Let me summarize--first, tax does matter; I have been clear
about that in my testimony.
Two, these are very important issues. But part of the
importance is not only listening to the people who get the
benefit. If you ask my clients would they like the ETI, would
they like a territorial system, and you ask me, am I lobbying
for them, of course, I would say yes. How can you say no?
But that is not the issue before you. You folks have a
difficult task. You have got to sort out what is not just in
the best interest of the companies, but what is in the best
interest of the country.
And the first point I made in my oral testimony is that
there is not a perfect identity, notwithstanding the old
statement of Mr. Wilson from General Motors. We have limited
resources for the government. Tax is coercion, so when we
impose that coercion, if we are going to reduce it on the
multinationals and we are going to keep spending the same and
we do not have surpluses, it is going to come from somewhere
else. And that is just the burden we are under.
So I am not going to speak to the shipping example, but I
just want to say that it is not automatic that tax is causing--
you have to be skeptical and shine a light on the question of
whether in a particular case tax is creating a competitive
disadvantage.
I do not want to go further because it wasn't in your
question. But there has been a lot of discussion here today
about the advantage of countries that use indirect taxes to
give an export an advantage to their exports. I have not heard
any part of this discussion today getting into some of the
economics of the difference between an indirect tax or a direct
tax; and I encourage the Committee to find the people who can
inform them adequately on that issue, because it is not as
simple as today's discussion has suggested.
Mr. McCrery. Thank you. Mr. Doggett.
Mr. Doggett. Thank you very much, and thanks to all of you
for staying for an informative discussion.
Mr. Merrill, are you still lobbying for the contract
manufacturing coalition?
Mr. Merrill. Yes, sir. Well, as you may have read in the
Wall Street Journal today, our legislative practice at
PricewaterhouseCoopers has been sold to Clark/Bardes and that
project has gone with it.
Mr. Doggett. All right. Were you lobbying for them before
yesterday, or the sale?
Mr. Merrill. I was registered as a lobbyist because I did
some economic work for the coalition.
Mr. Doggett. And also for the FSC 2000 coalition?
Mr. Merrill. I was registered for them. I did some economic
work for that group.
Mr. Doggett. Is your former client, Enron, or any of its
subsidiaries, partnerships, or joint ventures a Member of
either of those coalitions or any of the other coalitions that
your firm has represented?
Mr. Merrill. Well, I can only tell you about the
International Tax Policy Forum. And there was a Wall Street
Journal article--incorrect, actually---but Enron was a Member
of the International Tax Policy Forum along with 30 other
companies. It withdrew when it became bankrupt.
Mr. Doggett. Do you know if it is a Member of the FSC 2000
coalition for which you lobbied?
Mr. Merrill. No. I would not know; my role there was to
provide economic research for Ken Kies.
Mr. Doggett. As to either of those coalitions, can you tell
us who some of the other Members are?
Mr. Merrill. I do not believe that would be appropriate for
me to disclose more than I disclosed in the lobby disclosure
form.
Mr. Doggett. The lobby disclosure form, of course,
discloses nothing, except for the name of the coalition. It
does not identify a single company, does it?
Mr. Merrill. As far as I know, it does not.
Mr. Doggett. Yes, sir. Are you declining to tell me and the
Committee today the names of any of the Members of the
coalitions for which you have been lobbying right up to this
past week?
Mr. Merrill. Well, one, I certainly do not know all the
names.
Mr. Doggett. No, I am not asking you for all of them. I am
asking if you can identify any of them for the Committee.
Mr. Merrill. I think it would be unfair for me to identify
a few and not all. And I actually want to find out about
disclosing all by asking whether it is possible to do that with
the clients involved, since that is not something they agreed
to.
Mr. Doggett. Just so the record will be clear as to the FSC
2000 coalition, you will not identify any of the Members of
that coalition to us today?
Mr. Merrill. Not today. I would be happy to find out from
the coalition whether they would be prepared----
Mr. Doggett. The coalition is something that is set up in
your office there at Pricewaterhouse isn't it?
Mr. Merrill. It is not there at the moment. It is at Clark/
Bardes.
Mr. Doggett. That was the case last week or last month?
Mr. Merrill. Right. Right.
Mr. Doggett. With reference to the Contract Manufacturing
Coalition, you decline to provide any of those names, though
that also is an entity set up there at Pricewaterhouse?
Mr. Merrill. Right. Again, it is no longer with
PricewaterhouseCoopers. At this point I would not be prepared
to disclose more than I was disclosing on the lobby disclosure
forms.
Mr. Doggett. And the Multinational Tax Coalition, its work
was directed at a regulation of the Treasury Department was it
not--9835, I believe?
Mr. Merrill. Actually, I am trying to recall. I think it
was originally 9811 and then 9835.
Mr. Doggett. I believe that is right. And that is where--
that coalition lobbied in an effort to try to bring change to
9811 and 9835 Treasury IRS proposals?
Mr. Merrill. That is correct.
Mr. Doggett. And can you tell the Committee the names of
any of the members of that coalition which was also formed
there at Pricewaterhouse?
Mr. Merrill. The same answer.
Mr. Doggett. Am I correct--since the caution light is on--
am I correct that if Enron or one of its subsidiaries or Global
Crossings or the ABC Corporation wants to hide its identity in
its lobbying efforts of Treasury or any other part of this
Congress or of our government, all they have to do is come to
firms like the one you have worked for and form a coalition
with them and hide their identity from the public? Is that the
way it works?
Mr. Merrill. I am not an expert on lobby disclosure rules.
All I can tell you is that we disclose everything we are
required to disclose.
Mr. Doggett. A coalition could consist of nothing but Enron
and itself, could it not?
Mr. Merrill. I don't know the answer to that.
Mr. Doggett. Thank you very much. And thank you, Mr.
Chairman.
Mr. McCrery. Mr. Brady.
Mr. Brady. I am confused. Mr. Merrill, are you complying
with all of the disclosure laws that Congress has asked you to
comply with?
Mr. Merrill. I certainly hope so. We have someone in our
office whose job it is to file the lobby disclosure forms, and
we have a regular canvassing of the entire Washington office.
We are very conservative in our disclosure. Even though I, for
example, haven't talked to any Member of Congress or staff
about any of the coalitions that were just mentioned, we still
disclose that I worked on it; and I feel that we ought to be
conservative and disclose everything that we might conceivably
be required to disclose. I hope that we are doing a complete
and thorough job on that.
Mr. Brady. I appreciate you for following the laws of the
land and engaging in legal activity the last time I checked.
Obviously, we have a big problem in front of us. This was a
great panel, by the way--extremely informative.
Sort of narrowing it back down to the end, Mr. Chairman,
with a simple question. We ought to be trying to find a
solution that is real and is not in your interest but in the
interest of America.
The question is, at this point, what would you recommend to
Congress, if our goal is a substantial solution that creates
American jobs or at least makes us more competitive to do so,
what approach would you recommend that we take at this point
for each of the panelists?
Mr. Hufbauer. Well, I would recommend going to a modified
territorial system. To spell out the modifications would take
more time than anybody wants today, but I would be happy to
talk about that later.
I believe the foreign tax credit system is hopelessly
complex and hard to administer. I appreciate what Stephen Shay
has said, that a territorial system is not easy. I am not
saying it is easy. I am saying it is an improvement over where
we are today. Instead of chasing these wills-of-the-wisp and so
forth. And in connection with that, I would provide for
equivalent taxation of U.S. export earnings exactly like--well,
not exactly, but very similar to what the Netherlands or France
does. That would be part of this general system that I would
urge.
Mr. Brady. Do you mind, at some point, could we get your
thought on the modifications?
Mr. Hufbauer. I would be delighted, Congressman.
Mr. Brady. Thank you, sir.
Mr. Merrill. I will take this as an opportunity to mention
a book done for the National Foreign Trade Council. It is
called ``U.S. International Tax Policy for the 21st century.''
It represents the work of four or five different authors; I was
one of them. And the purpose of this book is essentially a
blueprint for how to reform the U.S. taxation of multinational
companies. So I think that would provide a place to start.
It does not address territorial taxation. It takes as a
starting point our existing worldwide system and asks the
question, how can we make our existing worldwide tax system
simpler, more competitive, in many cases not inconsistent with
the capital export neutrality doctrine.
Mr. Brady. Would it address the WTO dispute?
Mr. Merrill. It does not directly address the WTO issues
that are at stake. It asks, how can we make our multinationals
more competitive. That would, I think indirectly address that
issue, because as I testified, multinationals are an extremely
important part of U.S. exports. They account for two-thirds of
U.S. exports. In many cases, the foreign operations of
multinationals are the sellers, distributors, the servicers of
U.S. exports. So I think the two go hand in hand.
Mr. Brady. Great.
Mr. McCrery. Mr. Brady, I am afraid I have to close this
hearing. We have a vote. They are holding the vote for you and
me.
Thank you, gentlemen, very much for your testimony. The
hearing is adjourned.
[Whereupon, at 3 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
STATEMENT OF MTI SERVICES LIMITED, PRINCETON, NEW JERSEY, AND THE
WESTERN GROWERS ASSOCIATION, IRVINE, CALIFORNIA
MTI Services Limited (MTIS) and the Western Growers Association
(WGA) submit the following written testimony to the Committee for its
consideration. We appreciate this opportunity to make our views known.
History of the FSC-ETI Dispute--The Role of Decisions Made in the 1960s
Regarding the history of the FSC-ETI dispute, the origins lie with
the enactment of Subpart F in 1962 and the tightening of the section
482 allocation regulations in 1968. These changes, taken together,
tightened the tax regime too much, with the result that exporters,
among others, were unfairly disadvantaged.\1\ At the beginning of the
1970s, the decision was made, in effect, to loosen the rules. However,
instead of amending Subpart F and the allocation regulations, it was
thought better to enact a new, separate set of rules--the DISC
provisions. These provisions and the subsequent FSC and ETI rules give
the appearance of special exceptions for exporters, when in fact they
are a modification in the treatment of international income.\2\ It is
submitted that Congress should reconsider the decision made in the
early 1970s not to amend the Subpart F and section 482 rules.
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\1\ We would emphasize that, in our view, the problem extends
beyond just Subpart F.
\2\ Cohen & Hankin, ``A Decade of DISC: Genesis and Analysis,'' 2
VA. TAX REV. 7, 225 (1982); Bruce, Lieberman & Hickey, 934 T.M.,
Foreign Sales Corporations.
---------------------------------------------------------------------------
The WTO Appellate Body's Decision--A Misconception of the Nature of
U.S. Tax Rules
The WTO Appellate Body's conclusions are based in part on the
notion that the normal or ``benchmark'' rule is that U.S. persons are
taxable on their foreign source income and, therefore, ETI operates as
an exception; thus, the United States foregoes revenue that otherwise
would be due. The U.S. tax system, however, is not this pristine. For
example, Americans residing abroad are exempt from U.S. tax, up to the
level of $80,000, on their foreign earned income.\3\ Moreover, the
United States has repeatedly argued that the FSC and ETI regimes are
not that distant from what could be achieved, albeit with a good deal
more trouble, under existing ``regular'' international tax rules.
Indeed, as noted below, exporters, with clarification by the Internal
Revenue Service of existing law, could obtain the same level of
benefits.
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\3\ Section 911.
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Impact of Changes in the FSC-ETI Rules--Effects on Medium Size and
Smaller Taxpayers
The FSC-ETI tax benefit, while not enormous, is significant for the
typical medium size and smaller exporter. The impact of changes in this
area of the tax law on these exporters is great. The changes create
confusion. Transitioning from one regime to another is costly and time-
consuming. They cause an air of uncertainty. Many smaller exporters are
simply falling by the wayside; how many will not be know for certain
until the tax return information for 2002 is captured, presumably in
late 2003 or early 2004.\4\
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\4\ Experience shows that it takes some time for taxpayers to
understand a new set of rules such as the ETI rules. With FSCs, the
``learning curve'' extended for 8-10 years. With ETI, we believe, it is
shorter but still considerable.
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The EU's Request for Sanctions--A Proposal for Attacking the Numbers
The European Union's estimate of the harm caused it by the ETI
provisions (approximately $4 billion per annum) is grossly overstated
for the reasons stated by the United States in its submissions and the
``fall off'' in use, especially among smaller exporters. The Treasury
Department and taxpayers, working together, can drive down the revenue
loss due to ETI by engineering a solution under existing ``regular''
U.S. international tax statutory and treaty provisions. One approach is
for the Internal Revenue Service to issue pre-filing agreements under
existing law, without regard to the ETI provisions, to shareholders and
their multiple ownership entities and to take such other steps as may
be necessary, including negotiate with treaty partners, to clarify the
tax treatment of these taxpayers under section 245(a) and sections 951-
964. \5\ There may be other approaches. The point is a simple one: It
is within the Treasury Department's and taxpayers' power to ``devalue''
the figure that underpins the EU's position on sanctions and, in so
doing, to promote a reasonable negotiated resolution. It would be
surprising if highly intelligent tax lawyers in the Service and
accounting and law firms could not map out a suitable plan. Then, the
more companies that ``buy into'' the solution, i.e., obtain an
agreement, the more effective it is.
---------------------------------------------------------------------------
\5\ For an explanation of how this might be achieved, see Bruce,
``The WTO's FSC Ruling: Let's All Relax,'' 86 Tax Notes 1927 (Mar. 27,
2000). It will be noted that this type of approach is WTO-legal. There
are no special provisions associated with it that benefit exporters;
therefore, there is nothing that can properly be characterized as a
subsidy.
---------------------------------------------------------------------------
Driving down the figure for sanctions and negotiating a resolution
buys time for a larger solution in the form of rethinking Subpart F and
the income allocation rules.
Multiple Ownership--Need for Continued Support
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.
* * * * *
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. It
is based Hamilton, Bermuda, with a subsidiary in Princeton, NJ. 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.
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.
STATEMENT OF WILLIAM A. REINSCH, PRESIDENT, NATIONAL FOREIGN TRADE
COUNCIL
The National Foreign Trade Council (NFTC), founded in 1914, is an
association of businesses with some 400 members. It is the oldest and
largest U.S. association of businesses devoted to international trade
matters. Its membership consists primarily of U.S. firms engaged in all
aspects of international business, trade, and investment. Most of the
largest U.S. manufacturing companies are NFTC members. The NFTC's
emphasis is to encourage policies that will expand open trade and U.S.
exports and enhance the competitiveness of U.S. companies by
eliminating major tax inequities and anomalies.
Introduction
The NFTC applauds Chairman Thomas's decision to hold a hearing on
the WTO Appellate Body ruling in United States--Tax Treatment for
``Foreign Sales Corporations''--Recourse to Article 21.5 of the DSU by
the European Communities. This statement follows the outline of the
matters identified in the announcement of the hearing: (1) outline the
history of the FSC-ETI dispute, (2) analyze the January 14, 2002, WTO
Appellate Panel Decision, and (3) discuss the potential trade
ramifications of the decision. Regarding the potential trade
ramifications, this statement highlights the importance of developing a
process for resolving the FSC-ETI dispute in a manner that preserves
the competitiveness of American companies while lessening trans-
Atlantic trade tensions. The NFTC appreciates the opportunity to submit
its views for the hearing record.
Background
The Domestic International Sales Corporation (``DISC'') provisions
were enacted to restore the competitiveness of U.S. exporters that were
adversely affected by the 1962 enactment of the Subpart F rules. The
WTO FSC-ETI case can be traced back to 1972 when the European Community
(``EC'') objected to the 1971 enactment of the DISC legislation, and
the United States counter-claimed that the tax exemptions for foreign-
source income provided by Belgium, France, and the Netherlands were
export subsidies. A 1976 GATT panel issued reports finding both that
the DISC had some characteristics of an illegal export subsidy and that
the three European territorial tax systems provided impermissible
export subsidies. It was not until 1981 that the parties agreed to the
adoption of the GATT panel's reports, based on an ``Understanding''
adopted by the GATT Council that provided the blueprint that was used
to develop the Foreign Sale Corporation (FSC) as a replacement for the
DISC. In particular, the 1981 Understanding made clear that a country
is not required to tax income from foreign economic processes.
The FSC provided a limited tax exemption for certain U.S. export
transactions. Income earned in these transactions from economic
activities occurring within the United States was fully taxed. Income
earned in FSC transactions from economic activities taking place
outside the United States was subject to an exemption. The FSC
replicated central aspects of territorial taxation as applied to export
transactions. The major difference between the FSC and territorial tax
systems was that the FSC applied specifically to exports while
territorial systems applied to exports as well as other international
transactions.
The 1981 Understanding laid the issue to rest for more than 15
years until the European Commission (``Commission'') challenged the FSC
in late 1997. Regrettably, both a WTO Panel and Appellate Body all but
ignored the 1981 Understanding in holding that the FSC was a prohibited
export subsidy. Accordingly, the United States repealed the FSC regime
and enacted a regime for ``extraterritorial income'' (``ETI'') in
November 2000. The ETI regime represented a fundamental change in U.S.
tax law, notably, a new, general exclusion of income earned in a broad
range of overseas transactions. Unlike the FSC, the ETI regime did not
require any exportation from the United States and was available to
(essentially) all U.S. taxpayers--treating foreign and domestic
businesses subject to U.S. taxation alike.
Nevertheless, the Commission brought a WTO challenge immediately
following enactment of the ETI regime. In August of last year, a WTO
Panel agreed with the Commission, and the Appellate Body affirmed the
Panel's decision on January 14, 2002. The matter is now before an
arbitration panel where the Commission is seeking authorization to
impose more than $4 billion in trade sanctions on U.S. exports. The
arbitration process likely will be completed by the end of April 2002,
at which time the Commission would be free to retaliate.
Brief Analysis of WTO Appellate Body Report
The January 14, 2002, Appellate Body Report upheld each of the
adverse ``findings'' (as opposed to the rationale) of the Panel that
considered the validity of the ETI regime. As in the original dispute,
the Appellate Body was required to determine whether the ETI regime
provides a subsidy before reaching the issues of whether the subsidy
confers a benefit and whether the subsidy is contingent on export
performance. The Appellate Body was also required to decide whether the
ETI is inconsistent with GATT 1994 by reason of the foreign articles/
labor limitation.
To summarize the principal conclusions in the Appellate Body's
report, any elective, replacement regime that departs from an otherwise
applicable general rule would be viewed as granting a subsidy. 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. In this regard, the foreign economic process
requirement under the ETI regime was viewed as sufficient to establish
the presence of ``some'' foreign-source income, but the ETI regime as a
whole fell short of adequately identifying ``foreign-source income''
(primarily because allocation rules apply fixed percentages to amounts
that may include domestic-source income).
The Appellate Body also upheld the Panel's finding that, by virtue
of the fair market value rule, the ETI regime accords less favorable
treatment to imported products than to like products of U.S. origin,
within the meaning of Article III:4 of the GATT 1994. Similarly, the
Appellate Body upheld the Panel's finding ``that the ETI measure
involves export subsidies inconsistent with the United States'
obligations under Articles 3.3, 8, and 10.1 of the Agreement on
Agriculture. Finally, the Appellate Body made clear that the United
States has no legal basis for providing transition rules that extend
the time-period for fully withdrawing the prohibited FSC subsidies.
Trade Ramifications
The dispute between the United States and the Commission over the
ETI provisions poses a grave danger to the future stability of the
trans-Atlantic economic relationship and, more broadly, the global
trading system. As an organization that represents companies keenly
interested in the future progress of both, the NFTC believes it is
imperative that this dispute be resolved equitably.
The European Union is one of our largest trading partners; in 2000
the two-way volume of U.S.-EU trade totaled roughly $385 billion. In
recent years, however, the relationship has been marred by a number of
contentious trade disputes, many of which have been litigated before
the WTO (hormone-fed beef, bananas, Havana Rum, and the 1916
Antidumping Act). Other potential trade cases may follow: the systemic
failure of the Commission to approve GMO products absent scientific
backing and the U.S. imposition of section 201 tariffs on steel
imports. If both parties do not pull back from the brink of this
seemingly ceaseless trade litigation, the NFTC fears they may be
risking long-term damage to the health of this vital economic
partnership.
This continued deterioration in U.S.-Commission relations will have
consequences for the broader trading system as well. The United States
and the Commission have traditionally played leading roles in charting
and driving the global trade agenda, as evidenced by the successful
creation and expansion of the GATT and then the WTO to cover an ever
broader array of trade disciplines (i.e. services, intellectual
property). A fractured U.S.-EU relationship will hamper the ability to
successfully complete the Doha Round and strengthen the hand of nations
inclined to retard progress.
The Resolution Process
The NFTC agrees with comments made by Chairman Thomas and other
Members of the Committee that it is important for the United States--as
the world's leading exporter--to comply with its international trade
obligations in a timely manner so as to set an example for other WTO
member countries. To achieve this end, the Administration must
demonstrate leadership by implementing a comprehensive process that
will lead to an acceptable resolution of the FSC-ETI dispute that does
not place U.S. businesses at a competitive disadvantage.
The Administration must make the resolution of this dispute a high
priority. In the end, some combination of trade and tax initiatives may
be necessary to resolve this dispute. It seems clear, however, that a
legislative response or a negotiated solution would take time to
develop and implement, and that this should be accomplished without
subjecting American businesses to a competitive disadvantage. Thus, the
NFTC urges the chairman and members of this Committee to press the
Administration to engage the Commission in serious, high-level
discussions, with the aim of avoiding retaliation before an accord is
reached. In addition to forcefully and consistently negotiating with
the Commission on the issue of the timetable for coming into
compliance, the Administration should seek assurances that the
Commission would be willing to consult with our government to obtain a
measure of certainty regarding any response that may be forthcoming.
In any event, the Administration and the Congressional tax-writing
committees should remain focused on leveling the playing field between
U.S. exporters and their foreign competitors. The NFTC looks forward to
working with the Committee and its staff in resolving this issue.
Conclusion
It is imperative that the United States and the Commission agree on
a mutually acceptable solution that ensures that U.S. businesses,
farmers, and workers are not placed at a disadvantage in relation to
their foreign competitors. Resolving this matter and avoiding the
destabilizing consequences it threatens are as important as any trade
issue currently facing our country. The NFTC stands ready to work with
this Committee and the Administration to achieve this result.