[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
THIRD IN SERIES ON THE
EXTRATERRITORIAL INCOME REGIME
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SELECT REVENUE MEASURES
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
JUNE 13, 2002
__________
Serial No. 107-90
__________
Printed for the use of the Committee on Ways and Means
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84-168 WASHINGTON : 2002
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COMMITTEE ON WAYS AND MEANS
BILL THOMAS, California, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
E. CLAY SHAW, Jr., Florida FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut ROBERT T. MATSUI, California
AMO HOUGHTON, New York WILLIAM J. COYNE, Pennsylvania
WALLY HERGER, California SANDER M. LEVIN, Michigan
JIM McCRERY, Louisiana BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan JIM McDERMOTT, Washington
JIM RAMSTAD, Minnesota GERALD D. KLECZKA, Wisconsin
JIM NUSSLE, Iowa JOHN LEWIS, Georgia
SAM JOHNSON, Texas RICHARD E. NEAL, Massachusetts
JENNIFER DUNN, Washington MICHAEL R. McNULTY, New York
MAC COLLINS, Georgia WILLIAM J. JEFFERSON, Louisiana
ROB PORTMAN, Ohio JOHN S. TANNER, Tennessee
PHIL ENGLISH, Pennsylvania XAVIER BECERRA, California
WES WATKINS, Oklahoma KAREN L. THURMAN, Florida
J.D. HAYWORTH, Arizona LLOYD DOGGETT, Texas
JERRY WELLER, Illinois EARL POMEROY, North Dakota
KENNY C. HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
Allison Giles, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Select Revenue Measures
JIM McCRERY, Louisiana, Chairman
J.D. HAYWORTH, Arizona MICHAEL R. McNULTY, New York
JERRY WELLER, Illinois RICHARD E. NEAL, Massachusetts
RON LEWIS, Kentucky WILLIAM J. JEFFERSON, Louisiana
MARK FOLEY, Florida JOHN S. TANNER, Tennessee
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
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C O N T E N T S
__________
Page
Advisory of June 6, 2002, announcing the hearing................. 2
WITNESSES
Council of Economic Advisers, Hon. R. Glenn Hubbard, Chairman.... 7
U.S. Department of the Treasury, Barbara Angus, International Tax
Counsel........................................................ 13
______
AeA, and Hewlett-Packard Company, Daniel Kostenbauder............ 41
International Mass Retail Association, and Wal-Mart Stores, Inc.,
Gary L. McLaughlin............................................. 47
International Shipholding Corporation, and Overseas Shipholding
Group, Inc., Robert Cowen...................................... 54
National Association of Manufacturers, and Excel Foundry and
Machine, Inc., Doug M. Parsons................................. 61
National Foreign Trade Council, Hon. William A. Reinsch,
accompanied by LaBrenda Garrett-Nelson, Washington Council
Ernst & Young.................................................. 35
Newlon, T. Scott, Horst Frisch Incorporated...................... 63
Software Industry Coalition for Subpart F Equality, and Baker &
McKenzie, Gary D. Sprague...................................... 48
SUBMISSIONS FOR THE RECORD
Coalition of Service Industries, statement....................... 79
Equipment Leasing Association, Arlington, VA, statement.......... 82
Leasing Coalition, statement..................................... 82
Patton Boggs LLP, Donald V. Moorehead, and Aubrey A. Rothrock
III, statement................................................. 84
THIRD IN SERIES ON THE EXTRATERRITORIAL INCOME REGIME
----------
THURSDAY, JUNE 13, 2002
House of Representatives,
Committee on Ways and Means,
Subcommittee on Select Revenue Measures,
Washington, DC.
The Subcommittee met, pursuant to notice, at 10:05 a.m., in
room 1100 Longworth House Office Building, Hon. Jim McCrery,
(Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 226-5911
FOR IMMEDIATE RELEASE
June 6, 2002
No. SRM-7
McCrery Announces Third in a Series of Hearings
on the Extraterritorial Income Regime
Congressman Jim McCrery (R-LA), Chairman, Subcommittee on Select
Revenue Measures of the Committee on Ways and Means, today announced
that the Subcommittee will hold its third hearing on the
extraterritorial income (ETI) regime. The hearing will take place on
Thursday, June 13, 2002, in the main Committee hearing room, 1100
Longworth House Office Building, beginning at 10:00 a.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. However,
any individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committee and for
inclusion in the printed record of the hearing.
BACKGROUND:
On January 14, 2002, the World Trade Organization (WTO) Appellate
Panel issued its report finding the United States' ETI rules to be a
prohibited export subsidy. This marks the fourth time in the past two
and one-half years that the United States has lost this issue, twice in
the Foreign Sales Corporation case and now twice in the ETI case. There
is no opportunity for the United States to appeal this latest
determination.
On January 29, 2002, a WTO Arbitration Panel began proceedings to
determine the amount of retaliatory trade sanctions that the European
Union (EU) can impose against U.S. exports to the EU. The EU has
requested $4.043 billion in sanctions. The United States has asserted
that the proper measure of sanctions is no more than $1.1 billion.
Originally expected on April 29, 2002, a decision by the panel is now
expected by June 17, 2002.
The Subcommittee held its first two hearings on the issue on April
10 and May 9 of this year. The full Committee held a hearing on
February 27, 2002.
In announcing the hearing, Chairman McCrery stated: ``It was clear
from our first hearing that we cannot replicate the benefits of FSC/
ETI. Our second hearing examined whether this dispute presents an
opportunity to fundamentally reform the Tax Code. This hearing will
explore a third possible response to the WTO's ruling, namely making
changes to the Tax Code to promote the international competitiveness of
U.S. companies.''
FOCUS OF THE HEARING:
The focus of the hearing will be to consider proposals to modify
the Tax Code in ways which promote the competitiveness of U.S.
companies while respecting our international obligations under the WTO.
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Chairman MCCRERY. The hearing will come to order.
Today's hearing continues the work of this Subcommittee to
examine possible responses to the World Trade Organization
(WTO) finding that the Extraterritorial Income (ETI) regime is
an export subsidy in violation of our international trade
obligations.
Four days from today, an arbitration panel of the WTO will
issue its decision on the level of remedies which the European
Union (EU) may impose on products exported from the United
States. While there is no requirement that the EU impose these
sanctions, the decision of the arbitration panel will give them
a fairly heavy club, and cast a shadow over American exports
and the high paying jobs they support.
Given this situation, it is clear to me and others that it
would be unacceptable for the Congress to do nothing and just
hope the Europeans decide against the use of authorized
sanctions. We must show the world that our commitment to
meeting our obligations under the WTO is not just lip service.
These hearings are exploring possible solutions. I hope
they will help the Committee as it contemplates possible
responses to the WTO's decisions. Our first hearing held in
April examined whether the ETI regime could be fixed so as to
provide the same benefits to the same companies while
responding to the objections of our trading partners. The
unanimous conclusion of the witnesses was that the WTO decision
in the ETI case makes it clear any modification which
constitutes a mere repackaging of the existing benefits will
not survive the inevitable challenge.
Our second hearing held a month later reviewed proposals
which would fundamentally reform the Tax Code. Witnesses
advocated a number of alternatives, including variations of a
national sales tax or a value-added tax (VAT). The hearings
showed the potential benefits of such wholesale reform as well
as the difficult transition issues which any rewrite of the Tax
Code would present.
Today's hearing explores another possible response to the
WTO decision. Instead of either tinkering with ETI or
fundamentally reforming the Tax Code, a third option would be
to repeal the ETI regime and use the revenue raised to address
some of the shortcomings of our international tax rules, which
hinder the competitiveness of U.S. companies.
The worldwide tax system employed by the United States and
the resulting international tax rules are complex and often
place U.S. business at a competitive disadvantage relative to
their foreign counterparts. Moreover, in some instances the
system actually encourages American companies to invest abroad,
rather than here in the United States.
Instead of investing profits in the United States to
generate more economic growth and more jobs, our Tax Code
actually encourages American companies with overseas operations
to keep those funds abroad. The international Tax Code's
complexities and shortcomings have hindered the competitiveness
of American companies, and has therefore made them excellent
takeover targets by their international competitors.
In the sixties, the United States served as the world's
dominant market. As we enter the new millennium, there is a
real danger that U.S. businesses will be less competitive in
the global marketplace. We cannot afford to sit idly by while
economic growth and high paying jobs are forced overseas by a
Tax Code cobbled together largely when America was the
unchallenged economic leader of the world.
Today's hearings will provide the Committee with a wealth
of ideas for possible reforms of the international Tax Code. In
particular, Glenn Hubbard and Barbara Angus will give us
insights into the thoughts of the Administration on this issue.
Our second panel will provide us with input from several
industry sectors, including large exporters, small
manufacturers, large retailers, shippers, software
manufacturers, and the electronics industry. Their suggestions
on ways to make American companies more competitive will be
helpful to us in determining whether changes to the Tax Code
should accompany repeal of the ETI regime.
[The opening statement of Chairman McCrery follows:]
Opening Statement of the Hon. Jim McCrery, a Representative in Congress
from the State of Louisiana, and Chairman, Subcommittee on Select
Revenue Measures
Today's hearing continues the work of this Subcommittee to examine
possible responses to the WTO's finding that the ETI regime is an
export subsidy in violation of our international trade obligations.
Four days from today, an Arbitration Panel of the WTO will issue
its decision on the level of remedies which the European Union may
impose on products exported from the United States.
While there is no requirement that the EU impose those sanctions,
the decision of the Arbitration Panel will give them a fairly heavy
club and casts a shadow over American exports and the high-paying jobs
they support.
Given the situation, it is clear to me and others that it would be
unacceptable for the Congress to do nothing and hope the Europeans
decide against the use of authorized sanctions.
We must show the world that our commitment to meeting our
obligations under the WTO is not just lip service. These hearings are
exploring possible solutions; I hope they will help the Committee as it
contemplates possible responses to the WTO's decisions.
Our first hearing, held in early April, examined whether the ETI
regime could be ``fixed'' so as to provide the same benefits to the
same companies while responding to the objections of our trading
partners. The unanimous conclusion of the witnesses was that the WTO
decision in the ETI case makes it clear any modification which
constitutes a mere repackaging of the existing benefits will not
survive the inevitable challenge.
Our second hearing, held a month later, reviewed proposals which
would fundamentally reform the Tax Code. Witnesses advocated a number
of alternatives, including variations of a national sales tax or a VAT.
The hearing showed the potential benefits of such wholesale reform as
well as the difficult transition issues which any re-write of the Tax
Code would present.
Today's hearing explores another possible response to the WTO
decision. Instead of either tinkering with ETI or fundamentally
reforming the Tax Code, a third option would be to repeal the ETI
regime and use the revenue raised to address some of the shortcomings
of our international tax rules which hinder the competitiveness of U.S.
companies
The worldwide tax system employed by the United States and the
resulting international tax rules are complex and often place U.S.
businesses at a competitive disadvantage relative to their foreign
counterparts. Moreover, in some instances, the system actually
encourages American companies to invest abroad, rather than here in the
U.S. Instead of investing profits in the U.S. to generate more economic
growth and more jobs, our Tax Code actually encourages American
companies with overseas operations to keep those funds abroad.
The international Tax Code's complexities and shortcomings have
hindered the competitiveness of American companies and has therefore
made them excellent takeover targets by their international
competitors. In the 1960's, the U.S. served as the world's dominant
market, but as we enter the next millennium, there is a real danger
that U.S. businesses will be less competitive in the global
marketplace. We cannot afford to sit idly by while economic growth and
high-paying jobs are forced overseas by a Tax Code cobbled together
largely when America was the unchallenged economic leader of the world.
Today's hearing will provide the Committee with a wealth of ideas
for possible reforms of the international Tax Code. In particular,
Glenn Hubbard and Barbara Angus will give us insights into the thoughts
of the Administration.
Our second panel will provide us with input from several industry
sectors, including large exporters, small manufacturers, large
retailers, shippers, software manufacturers, and the electronics
industry. Their suggestions on ways to make American companies more
competitive will be helpful to us in determining whether changes to the
Tax Code should accompany repeal of the ETI regime.
I yield to my friend from New York, Mr. McNulty, for any opening
statement he might wish to make. . . .
Chairman MCCRERY. Now I would like to yield to my friend
and Ranking Member of the Subcommittee, Mr. McNulty.
Mr. MCNULTY. Thank you, Mr. Chairman. I welcome our guests
today. I am pleased to join with the Select Revenue Measures
Subcommittee in its third hearing on the replacement of the ETI
regime, which the World Trade Organization ruled to be
prohibited export subsidy.
Our hearing today will focus on the three issues raised
during our earlier Subcommittee hearings: Number one, how the
United States should respond to the WTO ruling on the ETI;
number two, whether fundamental corporate tax reform is a
viable option for replacing the ETI; and number three, why
there are concerns about the international competitiveness of
U.S. companies.
The Administration's response to the WTO ruling must be
done in a way that does not harm the overall competitiveness of
American businesses in the global marketplace. There must be a
bipartisan approach for handling the ETI, and our actions must
be taken in a timely manner. Earlier testimony confirmed that
overhaul of our current system of international taxation would
be a major undertaking and something that must not be done in
haste.
The competitiveness of our multi-national companies is at
stake and the issues merit full analysis and discussion.
Finally, it is important that this Subcommittee continue its
review of international tax issues and move the discussion from
theoretical approaches to realistic alternatives.
As always, the devil is in the details. Until specifics of
a proposal are put on the table, it is unclear how the
Committee should proceed, and who the winners and losers will
be. Today's testimony from experts in the area of international
taxation and multinational corporate associations will be of
assistance to us in each of these areas.
I thank Chairman McCrery for scheduling this important
hearing. Again, I thank our guests for taking the time to come
before us and to share their expertise.
[The opening statement of Mr. McNulty follows:]
Opening Statement of the Hon. Michael R. McNulty, a Representative of
Congress from the State of New York
I am pleased to join the Select Revenue Measures Subcommittee in
its third hearing on replacement of the ``Extraterritorial Income''
(ETI) regime which the World Trade Organization (WTO) ruled to be a
prohibited export subsidy.
Our hearing focus today will focus on the three issues raised
during our earlier Subcommittee hearings:
how the U.S. should respond to the WTO ruling on the
ETI;
whether ``fundamental corporate tax reform'' is a
viable option for replacing the ETI; and,
why there are concerns about the international
competitiveness of U.S. companies.
The Administration's response to the WTO ruling must be done in a
way that does not harm the overall competitiveness of American
businesses in the global marketplace. There must be a bipartisan
approach for handling the ETI and our action must be taken in a timely
manner.
Earlier testimony confirmed that overhaul of our current system of
international taxation would be a major undertaking and something that
must not be done ``in haste.'' The competitiveness of our multinational
companies is at stake, and the issues merit full analysis and
discussion.
Finally, it is important that this Subcommittee continue its review
of international tax issues and move the discussion from theoretical
approaches to realistic alternatives. As always, the ``devil is in the
details.'' Until the specifics of a proposal are put on the table, it
is unclear how the Committee should proceed and who the ``winners and
losers'' will be.
Today's testimony--from experts in the area of international
taxation and multinational corporate associations--will be of
assistance to us in each of these areas. I thank Chairman McCrery for
scheduling this important hearing and I thank our guests for coming
before us to testify.
Chairman MCCRERY. Thank you, Mr. McNulty. Our first panel
today is from the Administration. We have the Honorable Glenn
Hubbard, Chairman of the Council of Economic Advisers, and Ms.
Barbara Angus, International Tax Counsel with the U.S.
Department of the Treasury.
Mr. Hubbard, we welcome your testimony. Your written
testimony will be in the record in full. We would like for you
to try to summarize that within about 5 minutes. Thank you.
STATEMENT OF THE HON. R. GLENN HUBBARD, CHAIRMAN, COUNCIL OF
ECONOMIC ADVISERS
Mr. HUBBARD. Okay. Thank you very much. Mr. Chairman, I
will be brief. I think your own introduction covered a great
many of the important issues. What I really wanted to do was
three things: One, give you a sense of the charge from the
President to his staff and to the Treasury Department about
principles to use; second, to describe briefly the importance
of the issue, that is, the important role multinationals play
in our economy; and third, to tee up, as you did, Mr. Chairman,
the idea that tax reform in this area is very, very important.
The proximate reason that you called the hearing has to do
with the Foreign Sales Corporation (FSC) ETI dispute. In light
of the WTO finding, the President gave us two principles, one
that he wanted the United States to honor quite explicitly its
international commitments, and to be candid, not walk close to
the line, that is, to have a genuine response to the finding.
Second, to work with you in the Congress to come up with a
policy instead which could, if possible, enhance, and certainly
not diminish, the competitiveness of U.S. firms.
To go to the issue of why this is so important for the
economy, just put a fact out that you, of course, are familiar
with on the Subcommittee, that multinationals account for quite
a large chunk of American economic activity. About a quarter of
our Nation's gross national product is produced by nonfinancial
multinationals.
An economist would note that the primary motivation for
being a multinational is to compete more effectively in foreign
markets, not domestic markets. This is sometimes portrayed as
an issue of domestic versus foreign in jobs. That is simply not
the case.
Multinationals' activities generate substantial additional
jobs at home, and more to the point, the kind of jobs that we
all want, high-wage technical jobs in the United States.
On the issue of tax policy in international
competitiveness, I think it is quite clear that globalization
has taken place faster than we have been able to reform our Tax
Code. An example of this is the sharp decline over the past 40
years in American companies' shares in the world's largest
multinationals.
Tax policy matters a lot, and U.S. policy differs from that
of our major trading partners in at least four important ways.
First, about half of the Organization of Economic
Cooperation and Development (OECD), about half of the
industrial countries have territorial tax systems, so that a
U.S. firm in such a case wouldn't be subject to tax on active
income earned abroad under such a system.
Second, even among the countries that do tax worldwide
income on a worldwide basis, as do we in the United States,
active business income is generally not taxed until it is
remitted to a parent. In some circumstances, for example,
income that would arise from base companies' sales or service,
that is, business income that would be earned abroad, one
foreign-controlled corporation to another, would not be deemed
to be repatriated in alternative systems.
Third, the United States tends to place greater
restrictions on the use of foreign tax credits which, of
course, were intended to avoid double taxation. This is beyond
the issue you are very familiar with on multiple baskets, but
allocation rules for interest and other expenses sometimes will
preclude full offset. This is double taxation; it is not good
tax policy.
Fourth, the United States is one of only a handful of
countries that fails to provide some integration of the
corporate and individual tax systems, that is, again, double
taxation of equity income. This absence of integration is a
general problem; it extends far beyond international tax, but I
would urge you to think of it in your discussion. Economists
have been less helpful than we might in this debate over the
years. You know, there are principles for neutrality that have
been suggested: Both capital export neutrality which would say
that an investor should face the same tax irrespective of where
it places the investment, and capital import neutrality, which
is focused more on competitiveness, that is equal taxation in
the host country.
Despite 40 years of debate, (and I promise you, I won't go
through the entrails of that debate) to cut to the chase, these
notions have proven not to be terribly useful in practice. In
part, that is because the debate among economists has been a
bit simplistic. That is, we all know, of course, that capital
can flow through multinationals making allocations; it can also
flow through portfolio investors. Many ideas justifying capital
export neutrality are based on a world that simply doesn't
exist.
A perhaps larger weakness with traditional notions of
capital export neutrality it is designed under the benchmark of
perfect competition. Now, perfect competition is an exciting
concept, and it is most exciting in economic textbooks. It,
however, does not describe the world in which multinationals
work. Indeed, it would be very hard to imagine why you would
want to be a multinational if you were in a world of perfect
competition. To cut to the chase, there is abundant work that
suggests among economists that the theories of why a
multinational exists point very strongly in the direction of
something closer to capital import neutrality.
Now, what does all of this have to do with implications for
multinationals and what you are doing? It is very important for
the Nation, from an economic perspective to maintain the
viability of U.S. multinationals and the headquartering of U.S.
multinationals in the United States.
Tax policy matters for this, and frankly has played a role
in the relocation for headquarters purposes of some
multinationals.
To conclude, Mr. Chairman, I agree with you in your
introduction. This is a very important topic. I think the clear
guidance from the President is that this topic be taken to try
to improve the competitiveness of U.S. firms. There is quite
specific guidance there in the sense of trying to avoid double
taxation, and trying to promote competitiveness that translates
into many of the proposals that you have been actively looking
at on the Committee. I salute you for doing so. Thank you very
much, sir.
[The prepared statement of Mr. Hubbard follows:]
Statement of the Hon. R. Glenn Hubbard, Chairman, Council of Economic
Advisers
Chairman McCrery, Mr. McNulty, and Members of the Subcommittee,
thank you for the opportunity to testify today on the effect of U.S.
tax rules on the international competitiveness of U.S. companies.
Increasingly, the markets for U.S. companies have become global, and
foreign-based competitor companies operate under tax rules that are
often more favorable than our own. The existing U.S. tax law governing
the activities of multinational companies has been developed in a
patchwork fashion, with the result that current law can result in
circumstances that harm the competitiveness of U.S. companies. In
addition to their economic implications, the international tax rules
are among the most complex in the Code, with the result that they are
both costly and difficult for companies to comply with and challenging
for the Internal Revenue Service to administer. That is why I salute
your interest, Mr. Chairman, in reviewing the current U.S.
international tax rules with a view to reducing complexity and removing
impediments to U.S. international competitiveness.
The proximate cause of this hearing is the finding by the Appellate
Panel of the World Trade Organization (WTO) that the United States'
Foreign Sales Corporation/Extraterritorial Income (FSC/ETI) regime does
not comply with our international agreements. In light of this finding,
the President has emphasized that two principles will guide our
response. First, the United States will honor its international
commitments and come into compliance by modifying it tax laws. Second,
in doing so, we should work with Congress to enhance if possible, but
certainly not diminish, the competitiveness of our tax rules. This
guidance raises the larger question of tax policy and international
competitiveness, to which I will now turn.
Multinational Corporations and the United States Economy
Multinational corporations are an important part of the United
States economy. Approximately one quarter of the 1999 U.S. Gross
National Product of $9.3 trillion was produced by U.S. non-bank
multinationals. These corporations had a gross product of $2.4
trillion.\1\ In the manufacturing sector, the contribution is even
higher, with U.S. parent firms producing 54 percent of all U.S. gross
manufactured product. In the conduct of these operations, U.S.
multinational firms provide a large number of jobs to American workers.
In 1998, parent firms employed over 21 million people in the United
States, compared to a national workforce of 130 million.\2\
---------------------------------------------------------------------------
\1\ Department of Commerce, Survey of Current Business, March 2002.
\2\ Department of Commerce, Survey of Current Business, March 2002.
---------------------------------------------------------------------------
The primary motivation for U.S. multinationals to operate abroad is
to compete more effectively in foreign, not domestic, markets. Thus
their overseas investment activities are largely aimed at providing
services that cannot be exported, obtaining access to natural resources
abroad, and to selling goods that are costly to export due to
transportation costs, tariffs, and local content requirements. As one
piece of evidence in this regard, the Department of Commerce notes that
two-thirds of sales from U.S.-owned foreign affiliates were local
(i.e., to their host country). Only 11 percent of sales from these
firms were made back to the United States, and less than 10 percent of
U.S. plants abroad exported goods back to the U.S. market.\3\ Thus the
primary market for foreign operations of U.S. companies is the host
country, followed by other foreign countries. Indeed, more than one-
half of all foreign affiliates of U.S. multinationals are in the
service sector, including distribution, marketing, and servicing U.S.
exports.
---------------------------------------------------------------------------
\3\ National Foreign Trade Council, International Tax Policy for
the 21st Century, 2001.
---------------------------------------------------------------------------
Sales. By definition, multinationals operate and sell their
products in more than one country. However, research indicates that
U.S. operations abroad do not serve to displace exports. Indeed, in
part because foreign affiliates of U.S. companies rely heavily on
exports from the United States, the activities of multinationals
generate a net trade surplus. A recent study by the Organization for
Economic Cooperation and Development (OECD) complements other academic
research in finding that each dollar of outward foreign direct
investment is associated with $2.00 of additional exports and an
increase in the bilateral trade surplus of $1.70.\4\
---------------------------------------------------------------------------
\4\ Organization for Economic Cooperation and Development, Open
Markets Matter: The Benefits of Trade and Investment Liberalization,
1998.
---------------------------------------------------------------------------
How important are multinationals in international transactions? In
1999 (the most recent year for which data are available), foreign
affiliates of U.S. companies purchased $203 billion of goods from U.S.
sources. At the same time, domestic operations of U.S. multinationals
exported $267 billion to other foreign customers. Drawing these
together, U.S. multinationals contributed roughly $440 billion of
merchandise exports in 1999, or about two-thirds of overall U.S.
merchandise exports.\5\
---------------------------------------------------------------------------
\5\ Department of Commerce, Survey of Current Business, March 2002.
---------------------------------------------------------------------------
U.S. multinationals are also an important part of import behavior.
Many are familiar with the notion that imported goods give domestic
businesses and consumers access to a wider variety of goods at lower
prices and competition that forces domestic firms to operate more
efficiently. However, imports also provide specialized equipment that
helps American businesses to compete and improve their productivity.
The United States imported $377.1 billion of goods that involved
multinationals, 37 percent of the share of U.S. total imports (down
from 42 percent in 1989). In total, U.S.-owned multinationals exported
$64 more than they imported.\6\
---------------------------------------------------------------------------
\6\ Department of Commerce, Survey of Current Business, March 2002.
---------------------------------------------------------------------------
Intangible Capital Assets. Physical capital assets often dominate
the discussion of multinational investment decisions. However, among
the assets of U.S. companies is their scientific expertise. Foreign
physical capital investments are one avenue to increase their use of
this expertise, thereby raising the rate of return on firm-specific
assets such as patents, skills, and technologies. Not surprisingly,
raising the rate of return provides enhanced incentives for investment
in research and development. In 1999, non-financial U.S. multinationals
performed $142 billion of research and development. 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. In addition, this activity tends
to be located in the United States--$123.5 billion, or nearly 90
percent, was done in a domestic operation. Thus, in this area as well,
the foreign and domestic operations of multinationals tend to be
complements, and not substitutes, for one another.
Employment. A common concern is that the overseas activities of
U.S. multinationals come at the expense of domestic employment. There
are reasons, however, for the opposite to be true. The need for labor
by any firm is related to its overall success. In the case of
multinational corporations, this is no different. Foreign investments
can lead to more domestic employment because the need for employees by
a multinational is linked to its entire international, firm-level
success at trade in intermediate and final goods.\7\ This link
generates a complementary, as opposed to competitive, relationship
between employment in industrialized and developing countries.
---------------------------------------------------------------------------
\7\ David Riker and Lael Brainard, ``U.S. Multinationals and
Competition from Low Wage Countries,'' National Bureau of Economic
Research Working Paper No. 5959, 1997.
---------------------------------------------------------------------------
Put differently, international investment by U.S. multinationals
generates sales in foreign markets that could not be achieved by
producing goods entirely at home and exporting them. U.S.
multinationals use foreign affiliates in coordination with domestic
operations to produce goods that allows them to compete effectively
around the world, generating overall success evidenced by employment in
the United States and significant exports. As evidence of their
success, employment in these export-related activities yields higher-
than-average wage rates.
Put differently, suppose that a U.S. multinational chose to forego
opening a foreign affiliate and relied exclusively on exports from
domestic production. Without the benefit of local marketing and
distribution support, it might be less successful in its sales. Or the
sheer cost of transport may make it non-competitive. In either event,
it would lose out to competitors that either pursued a presence in the
country or had lower transportation costs. The end result may be a
company with lower profits, slower growth, and fewer employment
opportunities.\8\
---------------------------------------------------------------------------
\8\ See the Council of Economic Advisers, Economic Report of the
President 1991, p. 259.
---------------------------------------------------------------------------
For these reasons, it is unlikely that U.S. direct investment
abroad displaces U.S. jobs or reduces U.S. exports on a net or overall
basis.
Summary. U.S. multinationals provide significant contributions to
the U.S. economy through a strong reliance on U.S.-provided goods in
both domestic and foreign operations. These activities generate
additional domestic jobs at above average wages and domestic
investments in equipment, technology, and research and development. As
a result, the United States has a significant interest in insuring that
its tax rules do not bias against the competitiveness of U.S.
multinationals.
TAX POLICY AND U.S. INTERNATIONAL COMPETITIVENESS
The increasing globalization of economic competition has centered
attention on the impact of U.S. tax rules. 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. An example of this phenomenon is
the sharp decline over the past 40 years in the United States share of
the world's largest multinational corporations.
Why Tax Policy Matters. If U.S. businesses are to succeed in the
global economy, the U.S. tax system must not generate a bias against
their ability to compete effectively against foreign-based companies--
especially in foreign markets. Viewed from the narrow perspective of
income taxation, however, there is concern that the United States has
become a less attractive location for the headquarters of a
multinational corporation. This concern arises from several major
respects in which U.S. tax law differs from that of most of our trading
partners.
First, about half of the OECD countries have a territorial tax
system (either by statute or treaty), under which a parent company is
not subject to tax on the active income earned by a foreign subsidiary.
By contrast, the United States taxes income earned through a foreign
corporation, either when the income is repatriated or deemed to be
repatriated under the rules of the Tax Code.
Second, even among countries that tax income on a worldwide basis,
the active business income of a foreign subsidiary is generally not
subject to tax before it is remitted to the parent. In some
circumstances, for example income arising from ``base country sales or
service'' sources, the active business income is deemed to be
repatriated and taxed immediately. Indeed, one reading of tax history
is that the FSC regime originally developed at least in part in
response to the pressures generated by the absence of deferral on these
income sources. I will defer the details of the mechanics of these tax
rules, and any potential routes to modification, to the testimony of my
colleague Treasury International Tax Counsel Barbara Angus.
Third, the United States places greater restrictions on the use of
foreign tax credits than do other countries with worldwide tax systems.
For example, there are multiple ``baskets'' of tax credits which serve
to limit the flexibility of firms in obtaining credits against foreign
taxes paid. In some circumstances, allocation rules for interest and
other expenses also preclude full offset of foreign tax payments,
raising the chances of double-taxation of international income. Again,
I will leave the details for further discussion by my colleague.
Fourth, the United States (along with Switzerland and the
Netherlands) is one of only a handful of industrialized countries to
fail to provide some form of integration of the corporate and
individual income tax systems. The absence of integration results in
double taxation of corporate income, making it more difficult for U.S.
companies to compete against foreign imports at home, or in foreign
markets through exports from the United States, or through foreign
direct investment.
Principles of Neutrality. A strict concern for the competitiveness
of a U.S. multinational operating in a foreign country would dictate an
approach to taxation that results in the same tax as a foreign-based
multinational operating in that country. This competitiveness principle
is also known as Capital Import Neutrality (CIN), as it results in the
same rate of return for all capital flowing into a country. An
alternative notion of efficiency is that a U.S. investor should be
taxed equally whether the investment is made at home or abroad. This
latter notion is referred to as Capital Export Neutrality (CEN).
The debate regarding the principles of competitiveness and capital
export neutrality dates back at least to the early 1960s and the
proposal of the Kennedy Administration to tax immediately all foreign
source income earned by subsidiaries of U.S. companies (except in
developing countries). Despite 40 years of debate, however, CEN and CIN
have not proven to be very useful principles in practice. The theories
supporting the principles have been overly simplified and have not
advanced much in the intervening time. In many instances, analysis
fails to account for the existence of a corporate tax, the ability of
portfolio investors to buy foreign corporate shares, and the utter
complexity with which actual tax systems involve mixtures of residence-
based and source-based taxation.
The conventional economic analysis supporting CEN assumes that all
foreign investment is in the form of direct equity and that there are
no international flows of portfolio equity or debt investments. Under
these assumptions, any decrease in foreign investment by U.S. companies
would result in increased corporate investment in the United States.
However, capital can flow out of the United States because portfolio
investors can reinvest their shareholdings, selling U.S. in favor of
foreign companies. Such investment can also flow into the U.S. non-
corporate sector. Currently, portfolio investment accounts for about
two-thirds of U.S. investments abroad and about two-thirds of foreign
investment in the United States, casting doubt on any heavy reliance on
a theory that excludes portfolio investment.
A second weakness of the typical economic analysis underpinning CEN
is the presumption of ``perfect'' competition. Perfect competition is a
useful analytic benchmark for economists. However, strictly
interpreted, it requires that firms produce the same products, cannot
take advantage of scale economies, and do not ever earn above-market
profits. In practice, multinationals produce differentiated products,
and compete in industries where there are some economies of scale--
which is one explanation why foreign plants are affiliated with a
parent firm at all. A reevaluation of tax principles in a more
realistic setting casts doubt on the traditional analysis, including my
own research with Michael Devereux. We reexamined the theory of
international tax policy, noting that foreign investment is different
from portfolio investment. In particular, foreign investment offers the
possibility of exploiting intangible factors such as brands or patents
and company-specific cost advantages. This research calls into question
the basic findings that support CEN. Interestingly, in this setting it
is often the case that average tax rates--not just marginal tax rates--
have a large influence on investment decisions.
One implication of the accumulation of research is that there is no
simple general abstract principle that applies to all international tax
policy issues. The best policy in each case depends on the facts of the
matter and how the tax system really works. A U.S.-controlled operation
abroad must compete in several ways for capital and customers. They
might have to compete with foreign based companies for a foreign
market. They might have to compete with U.S. exporters or domestic
import-competing companies. Each of these competing businesses can be
controlled either by U.S.-based or foreign-based parents. It is a
challenge for policy to determine the best path to a competitive tax
system.
A direct application of the simple CEN notion can actually make
efficiency worse, even from the perspective of its objectives. A well-
known economic theorem shows that when there is more than one departure
from economic efficiency, correcting only one of them may not be an
improvement. Unilateral imposition of capital export neutrality by the
United States may fail to advance either worldwide efficiency or U.S.
national well-being.
A direct application of the alternative notion of neutrality, CIN
can be equivalent to a territorial tax system. As noted above, it is
unlikely that any single, pure theory of international tax rules will
provide direct and universal policy guidance. Nevertheless, concerns
have been raised over the possibility that using CIN to guide tax
policy will result in a narrower tax base and a shift in the structure
of production for multinational firms. In this light, it is interesting
to note that recent analyses of territorial tax systems by Harry
Grubert and Rosanne Altshuler depart from traditional conceptions of
the implications of a territorial tax system, arguing that revenue may
rise when moving to a territorial system and there may be little impact
on plant location decisions by multinationals.\9\
---------------------------------------------------------------------------
\9\ See Harry Grubert, ``Dividend Exemption and Tax Revenue,'' and
Rosanne Altshuler, and Harry Grubert, ``Where Will They Go if We Go
Territorial? Dividend Exemption and the Location Decisions of U.S.
Multinational Corporations,'' papers presented at the Conference on
Territorial Income Taxation, The Brookings Institution, April 30, 2001.
---------------------------------------------------------------------------
Implications for U.S. Multinationals. As noted earlier, from a tax
perspective the United States is now less favorably viewed as an
industrial country in which a multinational corporation should locate.
Over time, any such bias from U.S. tax rules could lead to a reduction
in the share of multinational income earned by companies headquartered
in the United States. Incentives supporting a decline in the importance
of U.S. multinationals should be a concern, not out of any narrow
concern over particular companies, but because of the potential loss in
economic opportunities such a decline would bring about for American
workers and their families. Professor Laura Tyson, one of my
predecessors as Chair of the Council of Economic Advisers, points out a
number of political, strategic, and economic reasons why maintaining a
high share of U.S. control over global assets remains in the national
interest.\10\ These include the fact that U.S. multinationals locate
over 70 percent of their employment and capital assets in the United
States. Also, they have higher pay and investment per employee in the
United States than in either developed or developing countries.
Finally, as noted earlier, U.S. multinationals conduct a very large
percentage of their research and development domestically.
---------------------------------------------------------------------------
\10\ Laura D'Andrea Tyson, ``They Are Not Us: Why American
Ownership Still Matters,'' American Prospect, Winter 1991.
---------------------------------------------------------------------------
The Department of Commerce data support the view that the vast
majority of the revenue, investment and employment of U.S-based
multinationals is located in the United States. This has not changed
over time. In 1999, U.S. parents accounted for about three-fourths of
the multinationals' sales, capital expenditures and employment. These
shares have been relatively stable for the last decade.\11\ Therefore
where a firm chooses to place its headquarters will have a large
influence on how much that country benefits from its domestic and
international operations.
---------------------------------------------------------------------------
\11\ Department of Commerce, Survey of Current Business, March
2002.
---------------------------------------------------------------------------
The decline in the market share of multinationals headquartered in
the United States has important implications for the well-being of the
U.S. economy. To the extent that tax rules are the source of this
shift, higher-paying manufacturing jobs and management functions may
move along with these headquarters. Research and development may be
shifted abroad, in addition to jobs in high-paying service industries,
such as finance, associated with headquarters' activities. Future
investments made by these companies outside of the United States are
unlikely to be made through the U.S. subsidiary since tax on these
operations can be permanently removed from the U.S. corporate income
tax system by instead making them through the foreign parent. As I
pointed out earlier, portfolio investment offers still another, perhaps
less visible, route by which foreign-owned multinationals can expand at
the expense of U.S. multinationals. If U.S. multinationals cannot
profitably expand abroad due to unfavorable U.S. tax rules, foreign-
owned multinationals will attract the investment dollars of U.S.
investors. Individuals purchasing shares of foreign companies--either
through mutual funds or directly through shares listed on U.S. and
foreign exchanges--can generally ensure that their investments escape
the U.S. corporate income tax on foreign subsidiary earnings.
Conclusions
Multinational corporations are an integral part of the U.S.
economy, and their foreign activities are part of their domestic
success. Accordingly, we must ensure that U.S. tax rules do not impact
the ability of U.S. multinationals to compete successfully around the
world. I urge that this Committee continue to review carefully the U.S.
international tax system with a view to removing biases against the
ability of U.S. multinationals to compete globally. Such reforms would
enhance the well-being of American families and allow the United States
to retain its world economic leadership.
Chairman MCCRERY. Thank you, Mr. Hubbard. Ms. Angus.
STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX COUNSEL, U.S.
DEPARTMENT OF THE TREASURY
Ms. ANGUS. Mr. Chairman, Congressman McNulty, and
distinguished Members of the Subcommittee. I appreciate the
opportunity to appear today at this hearing focusing on
international tax policy and competitiveness issues. The issues
that the Subcommittee has explored in this series of hearings
on the recent WTO decision are critically important as we work
toward meaningful changes in our tax rules that will protect
the competitive position of American businesses and workers and
honor our WTO obligations.
The concern facing the Subcommittee today is that our Tax
Code has not kept pace with the changes in our real economy.
International tax policy remains rooted in tax principles
developed in the fifties and sixties. That was a time when
America's foreign direct investment was preeminent abroad and
competition from imports to the United States was
insignificant.
Today we have a truly global economy in terms of both trade
and investment. The principles that guided tax policy
adequately in the past must be reconsidered in today's highly
competitive knowledge-driven economy. It is significant that
the U.S. tax system differs in fundamental ways from those of
our major trading partners. In considering these
competitiveness issues, it is important to understand the major
features of the U.S. tax system and to how they differ from
those of our major trading partners.
First, the United States has a worldwide tax system, while
many of our trading partners do not tax on the basis of
worldwide income. U.S. citizens and residents and corporations
are taxed on all of their income regardless of where it is
earned. Income earned from foreign sources is subject to tax
both by the country where the income is earned and by the
United States.
To provide relief from this potential double taxation, the
United States allows taxpayers a foreign tax credit. However,
detailed rules apply to limit the foreign tax credit. A U.S.
corporation generally is subject to U.S. tax on the active
earnings of a foreign subsidiary once such income is
repatriated as a dividend. However, the U.S. parent is subject
to current U.S. tax on certain income earned by a foreign
subsidiary without regard to whether the income is distributed.
The U.S. worldwide system of taxation is in contrast to the
territorial systems operated by half of the OECD countries.
Under these systems, domestic residents and corporations
generally are subject to tax only on their incomes from
domestic sources. A domestic business is not subject to
domestic tax on the active income earned abroad by a foreign
branch or on dividends paid from active income earned by a
foreign subsidiary.
Differences between a worldwide tax systems and a
territorial system can affect the ability of U.S.-based
multinationals to compete for sales in foreign markets against
foreign based multinationals. Under a worldwide tax system,
repatriated income is taxed at the higher of the source country
rate or the resident's country rate. In contrast, foreign
income under a territorial system is subject to tax at the
source country rate. The use by the United States of a
worldwide tax system may disadvantage the competitiveness of
U.S. foreign direct investment in countries with effective
corporate tax rates below those of the United States. The use
of a worldwide tax system does not disadvantage in countries
with effective corporate rates above those of the United
States. In instances where the taxpayer has lower-taxed foreign
income, that may actually result in favorable treatment for
incremental U.S. investment relative to investment from
companies established in territorial countries.
Second, the U.S. worldwide tax system differs in
significant ways from the worldwide systems of our major
trading partners. About half of the OECD countries employ
worldwide systems. Looking at competition among multinationals
established in these countries, U.S. multinationals still may
be disadvantaged when competing abroad. This is because the
United States employs a worldwide system that, unlike other
systems, may tax active forms of business income earned abroad
before it has been repatriated and may more strictly limit the
use of foreign tax credits to prevent double taxation.
Income earned abroad by a foreign subsidiary generally is
subject to U.S. tax at the U.S. parent level only when such
income is distributed by the foreign subsidiary to the U.S.
parent in the form of a dividend. An exception to this general
rule is provided with the rules of subpart F, under which a
U.S. parent is subject to current U.S. tax on certain income of
its foreign subsidiaries. The focus of the subpart F rules is
on passive investment type income that is earned abroad through
a foreign subsidiary. However, the reach of the subpart F rules
extends well beyond passive income to encompass forms of income
from active foreign business operations. No other country has
rules for the immediate taxation of foreign income that are
comparable to the U.S. rules in terms of breadth and
complexity.
Under the worldwide system of taxation, U.S. income earned
abroad potentially is subject to tax in two countries: The
taxpayer's country of residence and the country where the
income was earned. Relief from this potential double taxation
is provided through the foreign tax credit. The United States
allows U.S. taxpayers a foreign tax credit for taxes paid on
income earned outside of the United States. However, complex
rules apply to limit the availability of the foreign tax
credits by requiring the categorization of income into multiple
baskets to which the foreign tax credit rules are applied
separately. Detailed rules also require the reduction of income
for which foreign tax credits may be claimed to reflect a broad
allocation of U.S.-incurred expenses without regard to locally
incurred expenses. These rules can have the effect of denying
U.S.-based companies the full ability to credit foreign taxes
paid on incomes earned abroad against the U.S. tax liability
with respect to that income, and therefore can result in the
imposition of the double taxation that the foreign tax credit
rules are intended to eliminate.
Finally, the U.S. domestic tax rules also differ
significantly from those of our major trading partners. While
concern about the effects of the U.S. tax system on
international competitiveness may focus on the treatment of
foreign income, competitiveness issues arise in very much the
same way in terms of the general manner in which corporate
income is subject to tax in the United States.
One aspect of the U.S. system is that income from an
equity-financed investment in the corporate sector is taxed
twice: First, under the corporate income tax and again, under
the individual income tax when received by the shareholder as a
dividend or as a capital gain on the appreciation of corporate
shares. In contrast, most other OECD countries offer some form
of integration under which corporate tax payments are either
partially or fully taken into consideration when assessing
shareholder taxes. Whether competing at home or abroad, the
U.S. double tax makes it harder for the U.S. company to compete
successfully against a foreign competitor.
Both the increase in foreign acquisitions of U.S.
multinationals and the recent corporate inversion activity are
evidence that the potential competitive disadvantages created
by our international tax rules is a serious issue with
significant consequences for U.S. businesses and the U.S.
economy. The urgency of this issue is further heightened by the
recent WTO decision against our ETI provisions and the need to
respond promptly to that decision to come into compliance with
the WTO rules. We must undertake a reexamination of the U.S.
international tax rules and the fundamental assumptions
underlying them. Given the global economy in which we live,
that reexamination must consider the experiences and choices of
our major trading partners in designing their international tax
systems. These competitiveness issues should form the basis for
the beginning of that reexamination.
I would be happy to answer any questions. Thank you.
[The prepared statement of Ms. Angus follows:]
Statement of Barbara Angus, International Tax Counsel, U.S. Department
of the Treasury
Mr. Chairman, Congressman McNulty, and distinguished Members of the
Subcommittee, I appreciate the opportunity to appear today at this
hearing focusing on international tax policy and competitiveness
issues. The issues that the Subcommittee has explored in this series of
hearings on the recent WTO decision regarding the U.S. extraterritorial
income exclusion provisions are critically important as we work toward
meaningful changes in our tax rules that will protect the competitive
position of American businesses and workers and honor our WTO
obligations.
Introduction
The pace of technological advancement around the world is awe
inspiring. Computer processing abilities are expanding at exponential
rates, roughly doubling every year or two. Innovations in
pharmaceuticals and biotechnology are providing breakthroughs in
treating disease, permitting dramatic improvements in the quality of
life. Today, the keys to production in even basic commodity industries
like oil, paper, and steel are found in better knowledge and
innovation: the ability to produce more with less waste.
The concern facing this Subcommittee today is that our Tax Code has
not kept pace with the changes in our real economy. International tax
policy remains rooted in tax principles developed in the 1950s and
1960s. That was a time when America's foreign direct investment was
preeminent abroad and competition from imports to the United States was
scant. Today, we have a truly global economy, in terms of both trade
and investment. The value of goods traded to and from the United States
increased more than three times faster than GDP between 1960 and 2000,
rising to more than 20 percent of GDP. The flow of cross-border
investment, both inflows and outflows, rose from a scant 1.1 percent of
GDP in 1960 to 15.9 percent of GDP in 2000.
The globalization of the world economy has provided tremendous
benefits to consumers and workers. Those who can build a better
mousetrap now can sell it to the world. The potential for a world
market encourages companies to invest in research that leads to
continuous innovation. At one time, the strength of America's economy
was thought to be tied to its abundant natural resources. Today,
America's strength is its ability to innovate: to create new
technologies and to react faster and smarter to the commercialization
of these technologies. America's preeminent resource today is its
knowledge base.
A feature of a knowledge-driven economy is that unlike physical
capital, technological know-how can be applied across the world without
reducing the productive capacity of the United States. For example,
computer software designed to enhance the efficiency of a manufacturing
process may require substantial investment, but once developed it can
be employed around the world without diminishing the benefits of the
know-how within the United States. Foreign direct investment by
companies in a knowledge-driven economy provides opportunities to
export this know-how at low cost and incentives to undertake greater
domestic investment in developing these sources of competitive
advantage.
There are many reasons to believe that the principles that guided
tax policy adequately in the past should be reconsidered in today's
highly competitive, knowledge-driven economy. In this regard, it is
significant that the U.S. tax system differs in fundamental ways from
those of our major trading partners. In order to ensure the ability of
U.S. workers to achieve higher living standards, we must ensure that
the U.S. tax law does not operate to hinder the ability of the U.S.
businesses that employ those workers to compete on a global scale.
Competitiveness and U.S. Tax Policy
There are several different ways in which tax policy can affect the
ability of firms to compete. It may be helpful to consider the ways in
which commercial operations based in different countries compete in the
global marketplace.
Competition may be among:
U.S.-managed firms that produce within the United
States;
U.S.-managed firms that produce abroad;
Foreign-managed firms that produce within the United
States;
Foreign-managed firms that produce abroad within the
foreign country in which they are headquartered; and
Foreign-managed firms that produce abroad within a
foreign country different from the one in which they are
headquartered.
These entities may be simultaneously competing for sales within the
United States, within a foreign country against local foreign
production (either U.S., local, or other foreign managed), or within a
foreign country against non-local production. Globalization requires
that U.S. companies be competitive both in foreign markets and at home.
Other elements of competition among firms exist at the investor
level: U.S.-managed firms may have foreign investors and foreign-
managed firms may have U.S. investors. Portfolio investment accounts
for approximately two-thirds of U.S. investment abroad and a similar
fraction of foreign investment in the United States. Firms compete in
global capital markets as well as global consumer markets.
In a world without taxes, competition among these different firms
and different markets would be determined by production costs. In a
world with taxes, however, where countries make different
determinations with respect to tax rates and tax bases, these
competitive decisions inevitably are affected by taxes. Assuming other
countries make sovereign decisions on how to establish their own tax
systems and tax rates, it simply is not possible for the United States
to establish a tax system that restores the same competitive decisions
that would have existed in a world without taxes.
The United States can, for example, attempt to equalize the
taxation of income earned by U.S. companies from their U.S. exports to
that of U.S. companies producing abroad for the same foreign market.
However, in equalizing this tax burden, it may be the case that the
U.S. tax imposed results in neither type of U.S. company being
competitive against a foreign-based multinational producing for sale in
this foreign market.
The manner in which balance is achieved among these competitive
concerns changes over time as circumstances change. For example, as
foreign multinationals have increased in their worldwide position, the
likelihood of a U.S. multinational company competing against a foreign
multinational in a foreign market has increased relative to the
likelihood of U.S. export sales competing against sales from a U.S.
multinational producing abroad. The desire to restore competitive
decisions to those that would occur in the absence of taxation
therefore may place greater weight today on U.S. taxes not impeding the
competitive position of U.S. multinationals vis-a-vis foreign
multinationals in the global marketplace. Similarly, while at one time
U.S. foreign production may have been thought to be largely
substitutable with U.S. domestic production for export, today it is
understood that foreign production may provide the opportunity for the
export of firm-specific know-how and domestic exports may be enhanced
by the establishment of foreign production facilities through supply
linkages and service arrangements.
Given the significance today of competitiveness concerns, it is
important to understand the major features of the U.S. tax system and
how they differ from those of our major trading partners. The primary
features of the U.S. tax system considered here are: (i) the taxation
of worldwide income; (ii) the current taxation of certain types of
active foreign-source income; (iii) the limitations placed on the use
of foreign tax credits; and (iv) the unintegrated taxation of corporate
income at both the entity level and the individual level.
Taxation of Worldwide Income
The United States, like about half of the OECD countries, including
the United Kingdom and Japan, operates a worldwide system of income
taxation. Under this worldwide approach, U.S. citizens and residents,
including U.S. corporations, are taxed on all their income, regardless
of where it is earned. Income earned from foreign sources potentially
is subject to taxation both by the country where the income is earned,
the country of source, and by the United States, the country of
residence. To provide relief from this potential double taxation, the
United States allows taxpayers a foreign tax credit that reduces the
U.S. tax on foreign-source income by the amount of foreign income and
withholding taxes paid on such income. As discussed below, detailed
rules apply to limit the foreign tax credit. A U.S. corporation
generally is subject to U.S. tax on the active earnings of a foreign
subsidiary if and when such income is repatriated as a dividend.
However, the U.S. parent is subject to current U.S. tax on certain
income earned by a foreign subsidiary, without regard to whether that
income is distributed to the U.S. parent. As discussed further below,
while these current taxation rules are focused on passive, investment-
type income earned by a foreign subsidiary, their reach extends to
active business income in certain cases.
The U.S. worldwide system of taxation is in contrast to the
territorial tax systems operated by the other half of the OECD
countries, including Canada, Germany, France, and the Netherlands.
Under these territorial tax systems, domestic residents and
corporations generally are subject to tax only on their income from
domestic sources. A domestic business is not subject to domestic
taxation on the active income earned abroad by a foreign branch or on
dividends paid from active income earned by a foreign subsidiary. A
domestic corporation generally is subject to tax on other investment-
type income, such as royalties, rent, interest, and portfolio
dividends, without regard to where such income is earned; because this
passive income is taxed on a worldwide basis, relief from double
taxation generally is provided through either a foreign tax credit or a
deduction allowed for foreign taxes imposed on such income. This type
of territorial tax system sometimes is referred to as a ``dividend
exemption'' system because active foreign business income repatriated
in the form of a dividend is exempt from taxation. By contrast, a pure
territorial system would provide an exemption for all income received
from foreign sources, including passive income such as royalties, rent,
interest, and portfolio dividends. Such pure territorial systems have
existed only in a few developing countries.
Differences between a worldwide tax system and a territorial system
can affect the ability of U.S.-based multinationals to compete for
sales in foreign markets against foreign-based multinationals. Under a
worldwide tax system, repatriated foreign income is taxed at the higher
of the source country rate or the residence country rate. In contrast,
foreign income under a territorial tax system is subject to tax at the
source country rate.
Consider a U.S.-based company and a foreign-based company
established in a country with a territorial tax system. Each company is
considering investment in a new foreign subsidiary to establish a
manufacturing operation for the local foreign market. The effect of the
worldwide system on this form of competition depends on the
relationship of the foreign rate of tax on corporate income to that of
the United States.
Let us first assume that the effective tax rate on corporate income
of this foreign country is lower than the effective U.S.-tax rate on
corporate income (because the foreign country has a lower statutory
rate on corporate income or because it has investment incentives such
as accelerated depreciation). If the foreign subsidiary of the U.S.-
based company repatriates on a current basis its economic profits to
its U.S. parent, it will effectively be subject to the higher U.S. tax
rate on its income. The foreign subsidiary of the company established
in the territorial country, however, will be subject to the lower
foreign rate of tax. If the U.S. company cannot garner sufficient
efficiency advantages relative to its foreign competitor, it will be
unable to compete since it must sell its product in this market at
prices competitive with that of its foreign competition.
An alternative outcome results if the foreign country in which the
foreign investment is being considered has a higher effective corporate
tax rate than the United States. In this case, the U.S. parent is not
disadvantaged relative to the company established in a country with a
territorial tax system. Income earned by the U.S.-owned foreign
subsidiary will be subject to tax at only the source country tax rate,
the same result as under a territorial system.
The foregoing examples assumed that the U.S. parent company had no
other foreign-source income. The presence of other foreign-source
income can affect the rate of tax paid on additional foreign-source
income under U.S. tax rules because credits for taxes paid to one
foreign country can effectively be pooled with credits for taxes paid
to another foreign country.
Consider for example the case of a U.S. parent that has other
foreign-source income that is taxed at foreign rates higher than the
U.S. tax rate. In this case, the U.S. parent will have excess foreign
tax credits before considering its decision to invest in a new foreign
subsidiary. If the U.S. parent is considering establishing its new
foreign subsidiary in a country with a tax rate lower than the U.S.
rate, these excess credits generally may be used to offset the
additional U.S. tax that would be levied on the income of this new
investment. The presence of excess foreign tax credits thus reduces the
tax burden imposed by the United States on income from the new lower-
taxed foreign location. As a result, a U.S. parent in this position
will be relatively less disadvantaged by the U.S. tax system. If it has
sufficient excess foreign tax credits, the U.S. parent can offset all
of its U.S. corporate tax on the income from the new investment and its
tax burden will be just the taxes paid in the foreign country--the same
result as under a territorial system.
A different competitive result occurs when the U.S. parent has
other foreign-source income that is taxed at foreign rates lower than
the U.S. tax rate. In such a case the U.S. tax rate is the effective
tax rate on such foreign income. If the U.S. parent is now considering
establishing its new foreign subsidiary in a country with a tax rate
higher than the U.S. rate, the income earned from this new investment
will generate excess foreign tax credits that can offset the additional
U.S. tax paid on its preexisting foreign-source income. As a result, in
this case the U.S. parent receives a tax advantage from making the new
investment in the high-tax country relative to the treatment of such
investment under a territorial system.
These examples illustrate that the use by the United States of a
worldwide tax system may disadvantage the competitiveness of U.S.
foreign direct investment in countries with effective corporate tax
rates below those of the United States. The use of a worldwide tax
system does not disadvantage investment in countries with effective
corporate tax rates above those of the United States, and in some
instances may actually result in more favorable treatment for
incremental U.S. investment relative to investment from companies
headquartered in territorial countries. Of course, these results are
based just on the distinction between a territorial and worldwide tax
system, and ignore other key features of the U.S. tax system.
The complexities present in taxing income generally are heightened
in determining the taxation of income from multinational activities,
where in addition to measuring the income one must determine its source
(foreign or domestic). This complexity affects both tax administrators
and taxpayers. Indeed, the U.S. international tax rules have been
identified as one of the largest sources of complexity facing U.S.
corporate taxpayers.
The distinction in the treatment under a territorial tax system of
foreign-source income relative to domestic-source income puts
particular pressure on the determination of the source of items of
income and expense. While classification of income as foreign source is
important under a worldwide tax system because it determines
availability of foreign tax credits, in a territorial system
classification as foreign-source income gives rise to an exemption from
tax. Similarly, under a territorial tax system, expenses allocable to
foreign-source income would not be deductible for tax purposes while
expenses so allocated in a worldwide tax system would reduce the
availability of foreign tax credits.
Under most territorial systems, certain investment-type income is
subject to tax without regard to where that income is earned. This
raises the further issue of classification of income as subject to tax
under this exception from the generally applicable territorial
principles. Moreover, to the extent that this income is eligible for a
foreign tax credit, the computational steps that are required to
determine the amount of foreign-source income for purposes of applying
foreign tax credit rules in a worldwide tax system would be built into
the territorial system as well.
Given the complexity of the task of taxing multinational income
under a worldwide or territorial system on top of the general
complexity of the income tax system, some consideration might be given
to alternative tax bases other than income. Other OECD countries
typically rely on taxes on goods and services, such as under a value
added tax, for a substantial share of tax revenues. In the European
OECD countries, for example, these taxes raise nearly five times the
amount of revenue as does the U.S. corporate income tax as a share of
GDP.
Differences in Worldwide Tax Systems
As described above, about half of the OECD countries employ a
worldwide tax system as does the United States. However, even limiting
comparison of competition among multinational companies established in
countries using a worldwide tax system, U.S. multinationals may be
disadvantaged when competing abroad. This is because the United States
employs a worldwide tax system that, unlike other worldwide systems,
may tax active forms of business income earned abroad before it has
been repatriated and may more strictly limit the use of the foreign tax
credits that prevent double taxation of income earned abroad.
Limitations on Deferral
Under the U.S. international tax rules, income earned abroad by a
foreign subsidiary generally is subject to U.S. tax at the U.S. parent
corporation level only when such income is distributed by the foreign
subsidiary to the U.S. parent in the form of a dividend. An exception
to this general rule is provided with the rules of subpart F of the
Code, under which a U.S. parent is subject to current U.S. tax on
certain income of its foreign subsidiaries, without regard to whether
that income is actually distributed to the U.S. parent. The focus of
the subpart F rules is on passive, investment-type income that is
earned abroad through a foreign subsidiary. However, the reach of the
subpart F rules extends well beyond passive income to encompass some
forms of income from active foreign business operations. No other
country has rules for the immediate taxation of foreign-source income
that are comparable to the U.S. rules in terms of breadth and
complexity.
Several categories of active business income are covered by the
subpart F rules. Under subpart F, a U.S. parent company is subject to
current U.S. tax on income earned by a foreign subsidiary from certain
sales transactions. Accordingly, a U.S. company that uses a centralized
foreign distribution company to handle sales of its products in foreign
markets is subject to current U.S. tax on the income earned abroad by
that foreign distribution subsidiary. In contrast, a local competitor
making sales in that market is subject only to the tax imposed by that
country. Moreover, a foreign competitor that similarly uses a
centralized distribution company to make sales into the same markets
also generally will be subject only to the tax imposed by the local
country. While this subpart F rule may operate in part as a
``backstop'' to the transfer pricing rules that require arms' length
prices for intercompany sales, this rule has the effect of imposing
current U.S. tax on income from active marketing operations abroad.
U.S. companies that centralize their foreign distribution facilities
therefore face a tax penalty not imposed on their foreign competitors.
The subpart F rules also impose current U.S. taxation on income
from certain services transactions performed abroad. In addition, a
U.S. company with a foreign subsidiary engaged in shipping activities
or in certain oil-related activities, such as transportation of oil
from the source to the consumer, will be subject to current U.S. tax on
the income earned abroad from such activities. In contrast, a foreign
competitor engaged in the same activities generally will not be subject
to current home-country tax on its income from these activities. While
the purpose of these rules is to differentiate passive or mobile income
from active business income, they operate to subject to current tax
some classes of income arising from active business operations
structured and located in a particular country for business reasons
wholly unrelated to tax considerations.
Limitations on Foreign Tax Credits
Under the worldwide system of taxation, income earned abroad
potentially is subject to tax in two countries--the taxpayer's country
of residence and the country where the income was earned. Relief from
this potential double taxation is provided through the mechanism of a
foreign tax credit, under which the tax that otherwise would be imposed
by the country of residence may be offset by tax imposed by the source
country. The United States allows U.S. taxpayers a foreign tax credit
for taxes paid on income earned outside the United States.
The foreign tax credit may be used only to offset U.S. tax on
foreign-source income and not to offset U.S. tax on U.S.-source income.
The rules for determining and applying this limitation are detailed and
complex and can have the effect of subjecting U.S.-based companies to
double taxation on their income earned abroad. The current U.S. foreign
tax credit regime also requires that the rules be applied separately to
separate categories or ``baskets'' of income. Foreign taxes paid with
respect to income in a particular category may be used only to offset
the U.S. tax on income from that same category. Computations of foreign
and domestic source income, allocable expenses, and foreign taxes paid
must be made separately for each of these separate foreign tax credit
baskets, further adding to the complexity of the system.
The application of the foreign tax credit limitation to ensure that
foreign taxes paid offset only the U.S. tax on foreign-source income
requires a determination of net foreign-source income for U.S. tax
purposes. For this purpose, foreign-source income is reduced by U.S.
expenses that are allocated to such income. Under the current rules,
interest expense of a U.S. affiliated group is allocated between U.S.
and foreign-source income based on the group's total U.S. and foreign
assets. The stock of foreign subsidiaries is taken into account for
this purpose as a foreign asset (without regard to the debt and
interest expense of the foreign subsidiary). These rules thus treat
interest expense of a U.S. parent as relating to its foreign
subsidiaries even where those subsidiaries are equally or more
leveraged than the U.S. parent. This over-allocation of interest
expense to foreign income inappropriately reduces the foreign tax
credit limitation because it understates foreign income. The effect can
be to subject U.S. companies to double taxation. Other countries do not
have expense allocation rules that are nearly as extensive as ours.
Under the current U.S. rules, if a U.S. company has an overall
foreign loss in a particular taxable year, that loss reduces the
company's total income and therefore reduces its U.S. tax liability for
the year. Special overall foreign loss rules apply to recharacterize
foreign-source income earned in subsequent years as U.S.-source income
until the entire overall foreign loss from the prior year is
recaptured. This recharacterization has the effect of limiting the U.S.
company's ability to claim foreign tax credits in those subsequent
years. No comparable recharacterization rules apply in the case of an
overall domestic loss. However, a net loss in the United States would
offset income earned from foreign operations, income on which foreign
taxes have been paid. The net U.S. loss thus would reduce the U.S.
company's ability to claim foreign tax credits for those foreign taxes
paid. This gives rise to the potential for double taxation when the
U.S. company's business cycle for its U.S. operations does not match
the business cycle for its foreign operations.
These rules can have the effect of denying U.S.-based companies the
full ability to credit foreign taxes paid on income earned abroad
against the U.S. tax liability with respect to that income and
therefore can result in the imposition of the double taxation that the
foreign tax credit rules are intended to eliminate.
U.S. Corporate Taxation
While concern about the effects of the U.S. tax system on
international competitiveness may focus on the tax treatment of
foreign-source income, competitiveness issues arise in very much the
same way in terms of the general manner in which corporate income is
subject to tax in the United States.
One aspect of the U.S. tax system is that the income from an
equity-financed investment in the corporate sector is taxed twice.
Equity income, or profit, is taxed first under the corporate income
tax. Profit is taxed again under the individual income tax when
received by the shareholder as a dividend or as a capital gain on the
appreciation of corporate shares. In contrast, most other OECD
countries offer some form of integration, under which corporate tax
payments are either partially or fully taken into consideration when
assessing shareholder taxes on this income, eliminating or reducing the
double tax on corporate profits.
The non-integration of corporate and individual tax payments on
corporate income applies equally to domestically earned income or
foreign-source income of a U.S. company. This double tax increases the
``hurdle'' rate, or the minimum rate of return required on a
prospective investment. In order to yield a given after-tax return to
an individual investor, the pre-tax return must be sufficiently high to
offset both the corporate level and individual level taxes paid on this
return.
Whether competing at home against foreign imports or competing
abroad through exports from the United States or through foreign
production, the double tax makes it less likely that the U.S. company
can compete successfully against a foreign competitor.
An example may help to clarify matters. Suppose that a corporation
earns $100 of pre-tax profit. Consider the tax burden imposed by the
present U.S. tax system. On its $100 profit, the corporation must pay
corporate income tax of $35 assuming a 35 percent corporate tax rate,
leaving $65 to be distributed to shareholders or reinvested in the
firm. If the money is distributed as a dividend, shareholders also must
pay tax under the individual income tax. If shareholders are subject to
an average tax rate of 20 percent, they pay tax of $13, leaving them
$52 of after-tax income. In this example, the $100 profit is taxed
twice--$35 in tax payments are collected under the corporate income tax
and an additional $13 are collected under the individual income tax. In
total, the tax system collects $48 in tax and so imposes a 48 percent
``effective'' tax rate on corporate profits distributed as dividends.
Now consider how integration reduces the tax burden on income from
corporate equity. Full integration of the partnership type eliminates
the corporate income tax and imputes the $100 of pre-tax profit
directly to the shareholders, where it is taxed at the shareholders' 20
percent tax rate under the individual income tax. Full integration
reduces the total tax on $100 in profits from $48 under present law to
$20. A simple form of partial integration is a dividend exclusion,
which exempts dividends from the shareholders' taxable income. A
dividend exclusion reduces the total tax burden to $35, entirely paid
under the corporation income tax.
Because the unintegrated tax system results in a higher effective
tax rate on income earned in the corporate sector, it is more difficult
for a given investment to achieve a desired after-tax return (after
both corporate and individual taxes are paid) than in an integrated tax
system. As a result, projects that could attract equity capital in an
integrated tax system may not be sufficiently profitable to attract
equity capital in the present unintegrated system. In the context of
competitiveness, this may mean that a project that would otherwise be
undertaken by a U.S. company, either at home or abroad, is instead
undertaken by a foreign competitor.
As noted above, most OECD countries offer some form of tax relief
for corporate profits. This integration typically is provided by
reducing personal income tax payments on corporate distributions rather
than by reducing corporate level tax payments. International
comparisons of corporate tax burdens, however, sometimes fail to
account for differences in integration across countries and consider
only corporate level tax payments. To be meaningful, comparisons
between the total tax burden faced on corporate investments by U.S.
companies and those of foreign multinational companies must take into
account the total tax burden on corporate profits at both the corporate
and individual levels.
______
Both the increase in foreign acquisitions of U.S. multinationals
and the recent corporate inversion activity are evidence that the
potential competitive disadvantage created by our international tax
rules is a serious issue with significant consequences for U.S.
businesses and the U.S. economy. The urgency of this issue is further
heightened by the recent WTO decision against our extraterritorial
income exclusion provisions and the need to respond promptly to that
decision to come into compliance with the WTO rules.
A reexamination of the U.S. international tax rules is needed. It
is appropriate to question the fundamental assumptions underlying the
current system. We should look to the experiences of other countries
and the choices that they have been made in designing their
international tax systems. Consideration should be given to fundamental
reform of the U.S. international tax rules. Consideration also should
be given to significant reforms within the context of our current
system.
The many layers of rules in our current system arise in large
measure because of the difficulties inherent in satisfactorily defining
and capturing income for tax purposes, particularly in the case of
activities and investments that cross jurisdictional boundaries.
However, the complexity of our tax law itself imposes a significant
burden on U.S. companies. Therefore, we also must work to simplify our
international tax rules.
Chairman MCCRERY. Thank you, Ms. Angus.
Well, if the opening testimony in today's hearing has done
nothing else, it has made all of us want to be tax lawyers. It
is pretty exciting stuff.
I am a lawyer, but I didn't get into international tax
issues back in Leesville, Louisiana, or even Shreveport. I have
had to delve into them at length as our Subcommittee has
studied this problem of the ETI regime, and before that, FSC,
and before that Domestic International Sales Corporation
(DISC). So, we all on this Subcommittee have had to become
somewhat familiar with international tax rules and the
complexity of international tax provisions in our Tax Code. I
think it is safe to say that the DSC and FSC and ETI came about
because of the complexities and the disadvantages that are
apparent when one looks at treatment of foreign income by U.S.
companies.
So that is why we are here.
First of all, I have three questions by Mr. Crane, who is
not a Member of the Subcommittee, but a Member of the full
Committee, and wanted me to ask. If it is okay with the
witnesses from the Administration, I will submit these in
writing and would ask that you return a response to Mr. Crane's
questions. They are regarding the 30 percent withholding tax on
incomes from U.S. mutual funds.
[The questions submitted from Mr. Crane to Ms. Angus, and
her responses follow:]
U.S. Department of the Treasury
Washington, DC 20220
Questions:
1. LWould you agree that the current 30% withholding tax on the
``dividend income'' received by offshore investors in U.S.
mutual funds acts as a punitive export tax? Does this force
U.S. mutual funds to set up offshore ``mirror'' funds in order
to be competitive with foreign investment funds?
2. LI understand that the investment management industry pays
some of the highest average wages in the U.S. Should we be
concerned that American mutual fund companies are forced to
send these jobs overseas to respond to the investment needs of
non-citizens?
3. LIn light of the economic devastation from 9/11 that hit the
financial services industry particularly hard, would correcting
U.S. tax policy to remove the 30% withholding of dividend
income earned by foreign investors help restore this industry
and the jobs they support?
Response:
Distributions to shareholders from a U.S. regulated investment
company, or mutual fund, are characterized as dividends. Under current
law, such dividend distributions from a U.S. mutual fund to a foreign
investor generally are subject to the U.S. 30-percent withholding tax.
The U.S. withholding tax applies without regard to the character of the
underlying earnings of the U.S. mutual fund out of which the
distributions are made. Therefore, distributions from a U.S. mutual
fund made out of earnings that are interest income or short-term
capital gains are subject to the U.S. withholding tax, even though
interest income and short-term capital gains generally would not be
subject to the withholding tax if paid directly to a foreign investor.
Characterization of all distributions from U.S. mutual funds as
dividends which are subject to the U.S. withholding tax does not
reflect the economic character of the underlying investment income. In
addition, the imposition of the U.S. withholding tax in the case of
investments made through a U.S. mutual fund, when none is imposed on
comparable investments through a foreign mutual fund, inhibits the
ability of U.S. mutual funds to attract foreign investors. Current law
thus encourages the establishment of ``mirror'' funds outside the
United States for foreign investors that wish to invest in U.S.
securities.
These economic distortions could be addressed by modifying the
current-law rules so that the application of the U.S. withholding tax
to distributions from a U.S. mutual fund to its foreign investors
depended upon the character of the underlying earnings out of which the
distribution was made. Under this approach, distributions to a foreign
investor of interest income earned by a mutual fund would not be
subject to the U.S. withholding tax, just as the interest income would
not be subject to the U.S. withholding tax if paid directly to the
foreign investor. Under this approach, foreign investors would not be
subject to U.S. withholding tax on distributions of investment income
from a U.S. mutual fund in situations where such investors would not be
subject to withholding tax on such investment income if it were earned
directly or if it were earned through a foreign mutual fund.
Obviously, we wanted to overcome some of the problems that
the witnesses described by giving some special tax advantages
to exporters, to companies in this country who wanted to sell
their products overseas.
The WTO has ruled that the method we chose was contrary to
the rules of the WTO. I think we have decided that we can't
fight that any longer, and we must do something different to
try to overcome these problems in our Tax Code.
Those companies who are advantaged by ETI and who now face
repeal of that and replacement with some other tax provisions
tell me, and I am sure others on this Subcommittee that if we
do that, it will cost jobs in their companies, in their
industries that are directly benefited by the ETI, but will
only perhaps be generally benefited, and not as much, by
changes to the Tax Code, some of which we have talked about.
So, Mr. Hubbard, I would like to ask you your opinion as to
the impact on jobs generally in the country if we repeal ETI,
but use the revenue raised from that repeal to give other tax
breaks generally to the business community along the lines
that--some of the lines that the Treasury Department has
suggested.
Mr. HUBBARD. Well, certainly. Mr. Chairman, I think it
largely depends on what you decide to do. When you think about
business tax reform, you could think generally about tax policy
generally for corporations or you could think in the
international area. Even in the international area, moving to
better tax policy is likely for the economy as a whole to
generate more jobs and income than was possible under the FSC
ETI regime. There will be winners and losers. As you know,
whenever you change tax policy, that is so. We can't wish that
away.
For the economy as a whole, I think there are many options
you could take which would make us generally better off.
Chairman MCCRERY. You are saying that if we use that
revenue to provide tax changes to industry and maybe
particularly to industries that compete in the global
marketplace, that it could result in more jobs, not just keep
us even, but you think it could result in more economic
activity here and more jobs here?
Mr. HUBBARD. I think that is possible, Mr. Chairman. It
depends on what you do. There are some very good tax policy
options that are just good tax policy in the international area
that you might wish to consider and no doubt are considering.
So, I think that is possible, yes.
Chairman MCCRERY. Now, let's talk about the quality of
those jobs. We are told over and over that jobs that are tied
to exports are generally higher paying jobs. Some say 10 to 15
percent more, that those jobs pay 10 to 15 percent more than
the average U.S. job. If all of that is true, and we think it
is, then are we risking those higher paying jobs by changing,
by doing away with ETI and not directing those revenues at the
targets of the ETI?
Mr. HUBBARD. Well, again, going back to the President's
principles, it is likely not possible for you to make whole the
exact distribution. If it were, we wouldn't be in this box. I
think that there are also very high paying jobs associated with
headquarters of multinationals, and there are tax policy
changes that can be taken to make it attractive for
multinationals to be in the United States.
So, I think that those are also high paying jobs. So, on
average, I think that there are things you can do that are very
positive for the economy. No matter what you do, you are likely
to create winners and losers.
Chairman MCCRERY. Should we look, as much as possible, at
directing this revenue to companies that export?
Mr. HUBBARD. Well, I would urge you to look as much as
possible for the best possible tax policy, because that is what
is going to generate the highest gains for the economy as a
whole. You identify, I think very aptly and more succinctly
than Barbara and I did, the complex problems in the
international area. This is an area that is really ripe for
reform. I think there are some great things that you can do
there that would be very positive for the economy.
Chairman MCCRERY. So bottom line, you are confident that we
can make this transition from ETI to maybe a simpler
international Tax Code without doing damage, and in fact, we
might even improve the Nation's economy?
Mr. HUBBARD. Well, I guess, first, I would suggest humbly
to you that we must make the transition. It would be my
judgment as an economist that you could find a package of
policies that would make the economy as a whole as well off or
better off.
Chairman MCCRERY. Thank you. Ms. Angus, Mr. Newlon, who
will testify later, states in his testimony that
competitiveness is a particular concern for financial services
income because integration of the international financial
markets leads to direct competition among foreign financial
institutions.
While that is certainly true, is that the only arena where
there is integration of world markets?
Ms. ANGUS. No. It is certainly clear that there is
integration of world markets in all industries. The
globalization that is facing the financial services industry
may be somewhat more recent than the globalization that has
faced and is facing other industries equally.
Chairman MCCRERY. In fact, we have pretty healthy
integration in manufacturing, software, and other services as
well as financial services, don't we?
Ms. ANGUS. Yes. Yes. The integration of markets is
happening both with respect to goods and products and also
increasingly in the service sectors of our economy.
Chairman MCCRERY. So, competitiveness is an issue pretty
much across the board with respect to our domestic corporations
and multinationals residing here?
Ms. ANGUS. Yes, it is.
Chairman MCCRERY. Thank you. I would say to the Members of
the Subcommittee we have a 15-minute vote followed by one 5-
minute vote. So, we will recess at this time and go vote.
Please, as soon as possible, return to the hearing room and we
will resume the hearing. The Subcommittee is in recess.
[Recess.]
Chairman MCCRERY. The Subcommittee will come to order. I
appreciate the witnesses understanding of our need to go vote
occasionally. I am told that we won't have another vote for a
couple of hours. So, maybe we can get the rest of the hearing
in before we are interrupted again.
I would like to now recognize my colleague, Mr. McNulty,
for any questions that he may have of the panel.
Mr. MCNULTY. Thank you, Mr. Chairman. Again, I thank both
of our witnesses for testifying. Ms. Angus, does the
Administration believe it will take major or minor changes to
fix the ETI regime?
Ms. ANGUS. Yes. In looking at the WTO opinion, we don't
believe that it is possible to tinker with the current
provisions or make minor fixes. We will need to make more
meaningful changes to our tax law. It won't be possible simply
to tweak around the edges and replicate the benefits. This is
an exercise that will require that we look more fundamentally
at our tax law and make more meaningful changes.
Mr. MCNULTY. What are we looking at? What is on the table?
Ms. ANGUS. Well, as Mr. Hubbard indicated, we think it is a
priority that whatever we do must honor our WTO obligations and
be compatible with the WTO rules.
Mr. MCNULTY. What specifically do you think we would
propose? What would the outline be of a solution, in the
opinion of the Administration?
Ms. ANGUS. I don't----
Mr. HUBBARD. If I might, Mr. McNulty. You wanted to think
of international tax reform. There are a whole variety of
issues that the Subcommittee and the Committee has looked at in
the past. I referred to two in my testimony that related to the
President's principles trying to emphasize competitiveness by
looking at base company rules, avoiding double taxation in the
interest allocation. There are many, many areas as the Chairman
said in his remarks. This is both mindlessly inefficient and
mindlessly complex, but there are many such policies that you
could put together.
Mr. MCNULTY. Can you give me some examples? Could you be
any more specific than that?
Mr. HUBBARD. Well, I just gave two that are probably on an
economist's list as among the areas needing greatest reform, if
that were your objective.
Mr. MCNULTY. Do you think those would do it?
Mr. HUBBARD. It depends upon what you mean by ``do it,''
sir. Terms of improving tax policy in the international area--
--
Mr. MCNULTY. Fix it so we would be in compliance.
Mr. HUBBARD. It would certainly be WTO compliant. The other
part of the President's charge had to do with improving
competitiveness. It would accomplish that as well, but there
are also other policies that would do the same thing. We would
certainly look forward to working with you on that.
Mr. MCNULTY. Would either of you have an idea of what a
timeframe would be for getting an administrative proposal, a
legislative proposal to us?
Mr. HUBBARD. I think that from the President's charge, we
look forward to working with Congress. The President had asked
us to work first with the Committee on Ways and Means. We have
been doing so and continue to be at your service.
Mr. MCNULTY. What do you think the timetable would be in
order to avoid the imposition of penalties by the WTO?
Ms. ANGUS. I think that that is certainly a difficult
question. We believe that it is critically important that we
address these issues promptly, that it is essential that we
start making real progress toward a solution. Certainly the
issues that are facing us, all of us, are complicated ones.
It is important, particularly with the WTO arbitration
decision expected very shortly, that we begin to show real
progress. Obviously that has begun with the work of this
Subcommittee, the three hearings in this Subcommittee as well
as the full Committee hearing earlier this year.
Mr. MCNULTY. I thank both of the witnesses. Thank you, Mr.
Chairman.
Chairman MCCRERY. Thank you, Mr. McNulty. Mr. Ryan.
Mr. RYAN. Thank you, Mr. Chairman. Well, Mr. Hubbard, you
were saying in your testimony that putting to the categories of
different tax reform proposals into the capital import neutral
system and the capital export neutral system is not really a
good way to measure those things.
Then, I think you went on in your testimony to talk about
how capital import neutrality is basically a territorial
system. What are your thoughts on a territorial system? What do
you think are the benefits and the pros and the cons of a
territorial system?
Mr. HUBBARD. Well, of course, a territorial system is one
example of a capital import neutral system. There might be
others. I think a territorial system properly designed is
consistent with a number of fundamental tax reform objectives.
Remember, fundamental tax reform would not have you tax income
multiple times. Since we are talking about dividends from
foreign subsidiaries back to the parents, that is the same
issue.
So arguably, a territorial tax system could be consistent
with both fundamental income tax reform or fundamental
consumption tax reform, but here the devil really lies in the
details. When people say territorial, they can mean very many
different things. I think that a territorial tax discussion
would be part of any fundamental tax reform discussion that you
might decide to have.
Mr. RYAN. Well, the third hearing that we are having here
today is talking about sort of a rifle shot fix to ETI, FSC.
Ultimately do you believe that even if we do a narrow fix to
FSC or ETI that that will have to be changed later in place of
ultimate tax reform? Do you believe that the incompatibility of
the U.S. business tax regime internationally with respect to
our competitors is ultimately going to have to force the hand
of our country to fundamentally reform our tax system? If that
is the case, where do you think we should head? Which direction
should we go?
Mr. HUBBARD. To the first part of your question, I would
hope that what you would do would buildupon, in other words,
have fundamental tax reform be a logical follow on. There are
many steps you could take that would be consistent, ultimately,
with tax reform. I share your belief that ultimately we have to
discuss fundamental tax reform in the United States. The
Treasury Department, of course, is engaged in such an exercise.
Mr. RYAN. Do you think that what we do right now to respond
to FSC is going to set up the direction of tax reform with
respect to whether we go territorial or whether we go to
something like a subtraction method VAT or something like that?
Do you think that it matters with respect to where we want to
go on tax reform at the end of the day, based upon what we are
going to do to respond this year, if we do this year, to this
current problem?
Mr. HUBBARD. Well, what I would say is, do you want to take
an answer on the FSC ETI that doesn't diminish the chance of
fundamental tax reform? There are many things you could do as a
replacement for FSC ETI that would be on the path toward tax
reform.
I am not sure that you could roll in a fundamental tax
reform discussion into this and accomplish it in a short period
of time. I think you do want to be consistent.
Mr. RYAN. Ms. Angus, I know the Administration hasn't come
up with a specific proposal. I am not going to press you for
one right now. We are trying to learn more about this ourselves
to come up with a suitable response to the WTO problems we
have, along the lines that the President mentioned, make sure
that we don't do harm to the economy, to jobs, and make sure
that we improve our competitiveness, but time is ticking. We
will have to put a response out there fairly soon. We at least
have to show progress.
When do you expect to bring a proposal to the Committee?
Are you going to wait for the Committee to come up with
something that you will then respond to, or are you actually
planning on bringing a proposal to us this year?
Mr. HUBBARD. Our current plan, Mr. Ryan, is to work with
the Committee, and this work has already been going on at the
technical level. We also, of course, in the Administration,
plan to raise the issue of direct versus indirect taxes general
in the WTO round. We will be doing that independent of the work
of the work here, but we do look forward to working with the
Committee. That work is already going on.
Mr. RYAN. You don't agree with their definition of direct
taxes, correct?
Mr. HUBBARD. I do not. I think that we will be working
within the next round on that.
Mr. RYAN. Okay. Thanks.
Chairman MCCRERY. Mr. Neal.
Mr. NEAL. Thank you, Mr. Chairman. Mr. Hubbard, regarding
the corporate inversion problem, some have suggested that we
move forward with a temporary fix. While reading both of your
testimonies, I don't see a consensus conclusion about what we
should do. In fact, I don't even see agreement on whether we
should do fundamental reform within our system or fundamental
reform within a whole new system of taxation.
With no clear recommendation from the Administration, do
you think Congress can overhaul our corporate tax system within
the next 3 months? How about with an election coming up? Do you
think this is doable within a year?
Mr. HUBBARD. Sure. Why not? No. Going to your question in
two parts. On corporate inversions. Inversions, of course, are
an important question, slightly different question than was the
subject of the hearing today. Inversions raise the important
topic that the Tax Code itself has sufficient problems that
lead to tax strategies that we would all wish were not there. I
think solution there is to fix the Tax Code. The Treasury
Department has made a very concrete suggestion there.
As to the issue of overhauling the Tax Code within the next
3 months, as I was suggesting to Mr. Ryan earlier, I think that
having a very short-term discussion on fundamental tax reform
is not likely to produce a quick answer for you on FSC ETI.
What you might want to do is consider reforms that are
consistent with a variety of fundamental tax reforms, but also
help in the FSC ETI. There are several roads you could take; I
know that the Committee is exploring.
Mr. NEAL. In your previous presentation, you used the term
``best tax policy,'' and you spoke about winners and losers.
Would you agree that those who are currently winning think that
is the current system is the best tax policy?
Mr. HUBBARD. Well, I was speaking from the point of view of
the national interests. In other words, if one's objective in
tax policy were to have the most efficient tax system so our
economy as a whole is doing the best, that is what, from an
economic perspective, would be the best tax policy? There are
any of a number of winners in any particular tax policy, but
overall for the country, what is best is what is in the
national interest.
Mr. NEAL. You think that is going to happen?
Mr. HUBBARD. Well, of course, what we would look for is the
best possible tax policy, as I am sure you would on the
Committee.
Mr. NEAL. Let me just refresh your memory, if I can, for a
second here. The Majority Leader, upon taking office in 1994
said that we were going to change the tax system,
fundamentally. The former Chairman of our Committee here, a
good friend of mine, and if I can just give you the rhetoric of
the time, because we listen to it here patiently, said, ``We
were going to pull the Tax Code up by its roots, we were going
to drive a stake into the heart of the tax system.''
He said we were all going to a long funeral procession for
the tax system. Now, I ask you, Mr. Hubbard, what evidence do
you have during the last 8 years that supports the suggestion
today that we are about to radically reform the tax system at
the same time allowing an opportunity for these companies to
continue to move to Bermuda? While we have this academic
discussion, here they are sneaking out of town in the dark of
night?
Does the Administration support these companies moving to
Bermuda?
Mr. HUBBARD. Well, first again, let me cut to the premise
of your question. We have suggested a very concrete way to go
at that. It does not require fundamental tax reform. It exposes
the need for fundamental tax reform. There are certainly ways
to deal with corporate inversions. I just remind you of the
issue of tax reform generally; 1986, which was a landmark tax
reform, was many, many years in the making. There was part of
my earlier answer to you. Tax reform doesn't happen overnight,
you are quite right.
There is much that we can do, both for inversions and in
FSC ETI area that is consistent with tax reform and doable by
you very quickly.
Mr. NEAL. With the exception of what Mr. McCrery has done
here to help us out in this discussion, I don't recall the
Committee having done a heck of a lot over the last 6 years
about structural tax questions.
Let me just ask. Does the Administration support those
companies, agree with these companies sneaking out of town in
the dark of night and moving to Bermuda?
Mr. HUBBARD. The question from the perspective of the
Administration and what the Treasury Department has helpfully
suggested, is that we want to make sure that we fix the
problems in the Internal Revenue Code that lead to this kind of
behavior.
We do believe that headquartering in the United States is a
plus for the economy, and we want to make sure that we don't
have a Tax Code that is biasing companies from wanting to do
business in the United States.
Mr. NEAL. Mr. Hubbard, let me give you a third opportunity.
Does the Administration support these companies moving to
Bermuda--and I will use my previous suggestion--in the dark of
night?
Mr. HUBBARD. Rather than wishing the problem away,
Congressman, what the Administration wants to do is to suggest
a concrete proposal, and did, to remove the economic incentive
for such transactions.
Mr. NEAL. Mr. Hubbard, I understand the talk of economists,
vague as it can be. Yes or no?
Mr. HUBBARD. The Administration supports the fixes in the
Internal Revenue Code that would not provide the incentive for
the behavior you want. You simply can't wish away activities.
Mr. NEAL. I guess, then, in terms of economic nomenclature,
yes and no don't exist. Thank you, Mr. Chairman.
Chairman MCCRERY. You are welcome. I will say to my good
friend from Massachusetts that I don't think we should condone
that.
Mr. NEAL. Mr. Chairman, I know you don't.
Chairman MCCRERY. I don't think the Administration does.
Mr. NEAL. Well, they could have said that.
Chairman MCCRERY. They have.
Mr. NEAL. Mr. Hubbard, do you want to say that?
Chairman MCCRERY. They have said that.
Mr. HUBBARD. I believe we actually put out a specific and
concrete proposal.
Mr. NEAL. Do you want to say no, Mr. Hubbard?
Mr. HUBBARD. We put out a specific----
Mr. NEAL. You don't agree with this. Do you want to say
that?
Chairman MCCRERY. Mr. Neal, I am reclaiming my time.
Mr. NEAL. Thank you, Mr. Chairman.
Chairman MCCRERY. The Administration has been very helpful,
the Treasury Department has been very helpful in coming up with
a very specific list of suggestions which would not prevent but
certainly discourage companies from doing that. I think it is
very constructive, and I think we will find, you and I and
others, when we get further along into this that we might be
able to put together a nice little package on inversions and on
ETI that would make a lot of sense in terms of restructuring
our international tax provisions, It would solve the problem
that you are concerned about, that I am concerned about and
would, I think, not make everybody happy that is getting ETI
now, but get us a long way down the road to having a system
that makes a lot more sense for our multinational companies.
Mr. NEAL. Mr. Chairman, would you yield for a brief
question?
Chairman MCCRERY. Sure.
Mr. NEAL. Would it be possible for you to ask Mr. Hubbard
if the answer is yes or no to the question I raised?
Chairman MCCRERY. Well, I will say that in my discussions
with the Administration and based on their cooperation and
suggestions through the Treasury Department, it is clear to me
that the Administration thinks that the practice of companies
moving offshore to reduce their tax burden is not a desirable
outcome for the U.S. economy. They are trying very hard to work
with us to restructure our tax provisions so that those things
don't happen. That is the best answer you are likely to get out
of them.
Mr. NEAL. Mr. Chairman, would you yield for one quick
comment? Now, I understand why the framers of our Constitution
decided to separate the executive branch from the legislative
branch. You have really cleared that up. Thank you.
Chairman MCCRERY. Let me say for the record, I do
appreciate the cooperation we are getting from the Treasury
Department and the expertise we are getting from the Treasury
Department on the question of inversions and on this very
complex question of the ETI and approaches to solving that.
Now I would like to turn to Mr. Lewis.
Mr. LEWIS. Thank you, Mr. Chairman. Ms. Angus, has the
Treasury Department studied the effects of the Tax Code on the
international shipping industry?
Ms. ANGUS. We have not studied, those effects, although
certainly I think that is something that we ought to be looking
at as we talk about some of the aspects of our subpart F rules
and the ways that the U.S. subpart F rules operate to impose
current taxation on active business income earned abroad when
the aim of the provisions is at passive income. That is
something that is a real concern, and one of those areas is the
treatment of shipping.
We have talked a little bit about the need to look to the
tax approaches of our major trading partners. When we look to
other countries, none of our major trading partners treat
shipping income in the same way that the U.S. tax rules treat
shipping income. Certainly the evidence that has been presented
about the changes in the U.S. shipping industry recently are
dramatic and that is something that we ought to look at very
carefully.
Mr. LEWIS. What has actually happened to the U.S.
controlled shipping interests?
Ms. ANGUS. Well, I am not an expert on the shipping
industry. I believe you actually have a witness that will be
talking about that. Certainly from reading that testimony in
preparation for this hearing, there has been a significant
change in the shipping industry over the last decade or so, and
that is something that we ought to look at very carefully.
Mr. LEWIS. Well, it is evident it has had a very
devastating effect to the shipping industry. So, I hope that
will be something that you will look at. Thank you.
Chairman MCCRERY. Thank you, Mr. Lewis. Mr. Foley.
Mr. FOLEY. Thank you very much, Mr. Chairman. I feel
somewhat compelled to at least respond to the gentleman from
Massachusetts relative to this Committee's endeavor on tax
relief. There is no question since I have been in Congress in
1994 and joined this Committee in 1998, we have endeavored to
try and straighten out the complexities of the Tax Code. We
have tried to eliminate estate taxes, we have reduced capital
gains taxes. We are on the Floor debating marriage penalty
elimination.
Almost every one of these measures has been universally met
with opposition from the minority. Virtually every trade
agreement we try to enunciate with world partners is met with a
stunning rejection of the minority party. So when there are
companies leaving, which I do not agree or support, they may be
leaving because this Committee and the minority have obstructed
the ability to give clear signals to the business community
that we are, in fact, serious about trying to retain the best
and brightest corporations in this country. The Senate rejected
yesterday the ability to provide estate tax relief.
Now, I know the Administration does not support the exodus
of corporations offshore. I can answer that question for the
Treasury Department, and I will for the President.
Mr. NEAL. Gentleman yield?
Mr. FOLEY. Absolutely.
Mr. NEAL. If you can answer it for them, why can't they
answer it for them?
Mr. FOLEY. They may not be here to answer that specific
question. But let me speak----
Mr. NEAL. That was clearly----
Mr. FOLEY. I reclaim my time. The Treasury Department--many
times when we were sitting here listening to Mr. Rubin they
wouldn't answer direct questions posed by this Committee
either. Mr. Rubin is probably one of the most talented men I
have met in my time in this process, but we were met with
stone-faced silence when we asked him about capital gains. In
fact, he said to this Committee they not only didn't support
it, didn't think it was appropriate, were going to cause
deficits to soar and, to the contrary, we saw economic
stimulus. So, even when they did answer on occasion their
answers proved to be false.
I think what we need to do is look at the problems we place
before domestic companies, and I think this is systemic of the
problems and the complexities of the Tax Code. I would work
tirelessly with the Democratic leadership if they choose in
fact to show a welcome attitude toward our domestic corporate
partners on some of these global issues that we face because we
are in a global world.
There is an issue, Ms. Angus, I would like to inquire about
relative to software. Their rents and royalties from software
transactions should be considered active income and exempt from
subpart F. Do you share that thought?
Ms. ANGUS. I think it is fair to say that the treatment of
software under our subpart F rules in particular raises a
number of difficult issues, and some of them arise from the
fact that our subpart F rules do date back to the sixties. So,
we have got rules that are now covering transactions and a
technology that wasn't contemplated at the time that they were
written.
Over recent years Congress has been grappling with the
application of the subpart F rules to the financial services
industry and making some changes to modernize those rules as
the financial services industry became more global, and I think
those same issues need to be addressed in this industry as
well. It is an industry that is obviously new relative to when
the rules were written and also an industry that has become
increasingly global. So we do need to take a hard look at our
rules, subpart F in particular, but also other aspects of
international rules to make sure that they are properly
characterizing these transactions.
Some of these transactions in the software area are fairly
complex and there may be several different forms in which a
transaction can be done and the subpart F may give a different
answer depending on which form is done. That doesn't make sense
when the transactions are all economically equivalent. So, it
is an area that needs a careful look.
Mr. FOLEY. It seems though we are very late in coming to
the table on some of these more complex issues. The dynamics of
those business models seem to be thriving and yet we are slow
to catch up with their technology.
Ms. ANGUS. I would agree that it is fair to say that the
U.S. tax rules and the international rules in particular have
not kept up with the changes in our economy, and that is why we
do need to take a careful relook at these rules so that they
aren't out of step with the way that business is done in
today's global economy.
Mr. FOLEY. Thank you very much. I yield back.
Chairman MCCRERY. Thank you, Mr. Foley. Mr. Doggett is not
a Member of the Subcommittee, but he is a Member of the full
Committee, and he is with us this morning.
Mr. DOGGETT. Thank you very much.
Chairman MCCRERY. If you would like to inquire of the
witnesses, please proceed.
Mr. DOGGETT. Appreciate it, Mr. Chairman. Ms. Angus, I know
that in the Treasury Department report there was a
recommendation to take a look at section 163(j) of the Tax
Code. Is it your belief that section 163(j) should be amended?
Ms. ANGUS. Yes, and in fact at the hearing last week we
proposed some very specific amendments to revise those rules in
order to address concerns about the ability for foreign based
companies to use debt as a form of shifting income out of the
United States and reducing their tax on income that would
otherwise be subject to U.S. taxes.
Mr. DOGGETT. So whatever else, this Committee does on a
short-term or a long-term basis, one thing it most certainly
should do is to amend section 163(j), and do it now.
Ms. ANGUS. We certainly do believe that it is important to
address the section 163(j) issue immediately.
Mr. DOGGETT. Isn't it true that section 163(j) would only
capture interest payments and not royalty fees?
Ms. ANGUS. Section 163(j) is focused on interest payments.
In the proposals that we made last week and in the issues that
were discussed in our study from last month, we also talked
about the need to take a careful look at our transfer pricing
rules and in particular----
Mr. DOGGETT. I hope we have time to get into that because I
am very interested in that issue also. Closing the--you don't
really close it, but changing section 163(j) will get to
interest payments. It does not get to royalty payments,
correct?
Ms. ANGUS. No. We need to look at the transfer pricing
rules to address the royalty payments. There are very difficult
issues that arise there and something that----
Mr. DOGGETT. Section 163(j) won't address transfer pricing
or royalty payments, correct?
Ms. ANGUS. Right, which is why we have----
Mr. DOGGETT. Have your other recommendations----
Ms. ANGUS. Need to work in that area.
Mr. DOGGETT. Your recommendation on those matters relates
more to study than changing a statute now?
Ms. ANGUS. No, I wouldn't describe it that way because we
indicated that we were going to work immediately to look at our
transfer pricing rules. The transfer pricing rules are based on
an arm's-length standard. We do believe that that is the
standard that is an appropriate economic standard. There are
very difficult issues that arise in applying that, particularly
in the case of transfer of intangibles. So, we need to take an
immediate look at our rules and to work with the Internal
Revenue Service (IRS) on enforcement practices to make sure
that those rules are operating correctly.
Mr. DOGGETT. I believe the other area that Ms. Olson
actually mentioned in her testimony before the full Committee
are our tax treaties because there has been exploitation of our
tax treaties, has there not, in this area?
Ms. ANGUS. There have been some issues that have arisen
under some of our tax treaties and, as Ms. Olson indicated in
her testimony last week, we intend to take a comprehensive look
at our tax treaties. The purpose of our network of tax treaties
is to eliminate double taxation. We need to make sure that that
is what our treaties do and that they don't serve to eliminate
all taxation together. If there are instances where they
operate that way, we need to address that.
Mr. DOGGETT. That would be a--when you say address it, it
would be through renegotiation, which could take several years
with the dozens of tax treaties that we have.
Ms. ANGUS. Well, I think we need to identify the treaties
where there are particular problem areas and address those
immediately and obviously focusing on the places where these
issues arise.
Mr. DOGGETT. There is no doubt, as indicated in the
prospectus for Stanley Works and the claims of reduced tax
savings, that it was concerned not only about reducing any
double taxation that may occur on its international operations
but to reduce taxes on its American-based operations also.
Isn't that correct?
Ms. ANGUS. That is exactly the issue that we think needs to
be addressed through changes to section 163(j). The
transactions that you can do through creation of debt that
allow you to reduce the U.S. tax on income earned in the United
States that would otherwise be subject to U.S. tax is something
that we need to deal with.
Mr. DOGGETT. Let me just ask then in closing, so it will be
in the record, that I want to renew my request from February
27, when you testified, and asked you for the names of the
members of the 877 Coalition and the Coalition of Corporate
Taxpayers which you represented to preserve tax shelters. I
would renew that request. I know it is pending in the--before
you and the Treasury Department, but would ask you to supply
that information.
I thank you for your testimony.
Chairman MCCRERY. Thank you, Mr. Doggett. That was very
nice. Excellent questions, and I want to thank all the Members
of the Subcommittee for your excellent questions. I do think we
share a common goal here to get something done in the
international field, and again I appreciate the cooperation of
the Administration and thank you for your excellent testimony
and responses to questions. We will welcome you back, I am
sure, at a later date. Thank you.
Now I would call up our final panel, the Honorable William
A. Reinsch, the President of National Foreign Trade Council;
Dan Kostenbauder, General Tax Counsel for Hewlett-Packard, Palo
Alto, California, on behalf of AeA; Gary McLaughlin, Senior
Director, International Tax, Wal-Mart Stores, Inc.,
Bentonville, Arkansas, on behalf of the International Mass
Retail Association; Gary D. Sprague, Partner, Baker & McKenzie,
from Palo Alto, California, on behalf of the Software Industry
Coalition for Subpart F Equality; Robert Cowen, Senior Vice
President and Chief Operating Officer for Overseas Shipholding
Group, New York; Doug Parsons, President, Excel Foundry and
Machine, Inc., Pekin, Illinois, on behalf of the National
Association of Manufacturers; and Scott Newlon, Managing
Director of Horst Frisch.
I am sorry if I mangled any of those names. I hope I got
close. Welcome, everybody. Thank you for coming today to try to
help us sort through this quagmire of international tax
complexity.
Mr. Reinsch. Is that how you pronounce your name?
Mr. REINSCH. Yes, it is. Well done, Mr. Chairman.
Chairman MCCRERY. Thank you. We will begin with you. Your
full written testimony will be entered into the record, but we
would ask you to summarize that if you could in about 5
minutes. You may begin.
STATEMENT OF THE HON. WILLIAM A. REINSCH, PRESIDENT, NATIONAL
FOREIGN TRADE COUNCIL, AND FORMER UNDERSECRETARY FOR EXPORT
ADMINISTRATION, U.S. DEPARTMENT OF COMMERCE; ACCOMPANIED BY
LABRENDA GARRETT-NELSON, PARTNER, WASHINGTON COUNCIL ERNST &
YOUNG
Mr. REINSCH. Thank you, Mr. Chairman. This is the first
time I have been able to testify before this Subcommittee, and
it is an honor to be with you. I am Bill Reinsch. I am
President of the National Foreign Trade Council (NFTC), founded
in 1914. The NFTC is an association of businesses with some 400
members. It is the oldest and largest U.S. association of
businesses in support of open rules based trade.
The NFTC FSC/ETI Coalition, which is composed of many of
the companies currently using FSC/ETI, has developed a
conceptual draft of a proposal of modifications to the Tax Code
that combined with the repeal of the ETI regime we believe will
bring the United States into compliance with its international
trade obligation as well as ensuring that U.S. exporters are
not disproportionately disadvantaged. I would like to describe
those concepts underlying the proposal briefly, and I would
ask, Mr. Chairman, that a copy of the Coalition's entire draft
proposal be inserted into the record.
Chairman MCCRERY. Without objection.
Mr. REINSCH. Thank you very much. The Coalition does not
believe that an appropriate response to the WTO decision would
be to simply repeal ETI, which we believe would have an adverse
impact on the international competitiveness of domestic
exporters and threaten thousands of American jobs.
Our proposal is a conceptual draft. It is not a finished
legislative document. We have already begun to meet with
Members of the Committee, and we are ready to work with all of
you on further improvements in it. We have worked very hard on
it, and we believe that it comes close to ensuring that as many
companies as possible approach the level of their current ETI
tax benefits. No company, however, would obtain a greater
benefit than under current law because our proposal includes an
overall cap.
We also believe that our proposal meets the stringent test
of WTO compliance, although we expect that whatever resolution
Congress comes to will ultimately be subject to discussions or
negotiations with the European Commission. We believe our
proposal would be a good basis for those discussions.
Our proposal has four parts. First, it would permit
taxpayers to exclude from U.S. tax foreign source income earned
by U.S. taxpayers in export transactions. We believe that this
concept complies with the appellate body rulings in the FSC/ETI
case that the fifth sentence of Footnote 59 of the Agreement on
Subsidies and Countervailing Measures permits a WTO member
state to adopt the measure taken to avoid the double taxation
of foreign source income. The exclusion would apply to foreign
source income from property sold, leased, or licensed for
direct use outside the United States and income from services
as a commissioned agent in connection with the sale, lease, or
license of property for export. The proposal would have--the
property would have to be manufactured or produced in the
States for final disposition outside the United States.
The second part of our proposal would restrict the scope of
subpart F in a manner that would partially conform to the less
stringent anti-deferral rules adopted by the countries,
including member states of the Commission, which countries
generally apply anti-deferral regimes only to passive
investment income earned by foreign subsidiaries. This proposal
would eliminate the provisions that define subpart F income to
include foreign based company sales income.
The proposal also would exempt a portion of the Foreign
Base Company Source Income from U.S. tax as permitted by
Footnote 59 and permit the tax free transfer of a limited
category of associated marketing intangibles to control foreign
corporations under section 367(d). No foreign tax credits would
be allowed for taxes associated with income exempted under this
proposal.
The third part of our proposal, Mr. Chairman, retains ETI-
like benefits for a limited category of qualifying
international transportation property such as aircraft, rolling
railroad stock, vessels, motor vehicles, containers, orbiting
satellites, and other property used for international
transportation purposes. Although these transactions qualified
for ETI treatment under the predominant use test of existing
law, they are not considered exports under trade law and
therefore should not be considered, in our judgment, to be
contingent on export performance within the meaning of the
agreement on subsidies.
Finally, in our proposal, in order to provide some level of
tax benefits for direct exporters, we have developed a wage tax
credit for manufacturers of qualifying property based on the
wages paid to employees producing the qualifying property. The
credit would be 1 percent of qualifying wages.
In closing, Mr. Chairman, I would like to reiterate that
our proposal is conceptual and not a finished legislative
package. We continue to review it and work on it, and we
welcome the opportunity to work with you and the other Members
of the Committee as you decide how you want to proceed. Thank
you.
[The prepared statement of Mr. Reinsch follows:]
Statement of the Hon. William A. Reinsch, President, National Foreign
Trade Council, and former Undersecretary for Export Administration,
U.S. Department of Commerce
Chairman McCrery, Ranking Member McNulty and distinguished Members
of the Subcommittee.
My name is Bill Reinsch and I am the President of the National
Foreign Trade Council (NFTC). The 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.
Thank you for holding this important hearing on the WTO Appellate
Body (AB) ruling, United States--Tax Treatment for ``Foreign Sales
Corporations''--Recourse to Article 21.5 of the DSU by the European
Communities. According to the Hearing Advisory, the focus of the
Subcommittee hearing is to ``consider proposals to modify the Tax Code
in ways which promote the competitiveness of U.S. companies while
respecting our intentional obligations under the WTO.'' \1\
---------------------------------------------------------------------------
\1\ Ways and Means Committee Advisory Number SRM-7.
---------------------------------------------------------------------------
The NFTC FSC/ETI Coalition \2\ (the Coalition) has developed a
conceptual draft of a unitary proposal of modifications to the Tax Code
that, combined with a repeal of the ETI regime, we believe will bring
the United States into compliance with its international trade
obligations as well as ensuring that U.S. exporters are not
disproportionately disadvantaged. I would like to focus my testimony on
describing the concepts underlying the proposal and the need to take a
holistic approach to any legislative changes to promote the
competitiveness of U.S. exporters, as illustrated by the NFTC's unitary
proposal. With your permission, I would ask that a copy of the
Coalition's conceptual draft of a unitary proposal be inserted into the
record.
---------------------------------------------------------------------------
\2\ The NFTC FSC/ETI Coalition is a broad-based group of companies
with varying business models representative of typical FSC/ETI users.
Companies in the Coalition employ thousands of Americans in high-paying
export related jobs.
---------------------------------------------------------------------------
Introduction
I. Historical Background
The Tax Code has provided explicit tax incentives for U.S.
exporters since 1971 with the enactment of the Domestic International
Sales Corporation (DISC) regime. The DISC provisions were designed to
restore the competitiveness of U.S. exporters hampered by the 1962
enactment of the Subpart F rules. The DISC was successfully challenged
by the Europeans at the General Agreement on Tariffs and Trade (GATT),
the predecessor organization of the WTO. Relying on a 1981
``Understanding'' reached in the DISC case, the United States enacted
the Foreign Sales Corporation (FSC) tax provisions in 1984. After a
string of WTO losses, the European Commission (``Commission'') filed a
WTO challenge against the FSC in 1997; both the WTO Panel and Appellate
Body ruled that the FSC was a prohibited export subsidy.
Accordingly, the United States enacted the FSC Repeal and
Extraterritorial Income Exclusion Act of 2000 (P.L. 106-519) (the
``ETI'' regime). The ETI regime, while enacting a new general rule that
excluded extraterritorial income, closely tracked the tax benefits
available to American exporters through the FSC. The Commission
immediately brought a WTO challenge against ETI. In August of last
year, a WTO Panel upheld the Commission's claim and, after the United
States appealed this decision, the WTO Appellate Body affirmed the
panel decision (while substantially refining the legal reasoning
underlying the ruling). In essence, the case turned on the fact that
WTO rules prohibit the rebate of direct taxes on export transactions,
although rebates of indirect taxes on exports are permitted.
The United States and the Commission are currently awaiting an
arbitration panel's decision regarding the appropriate level of
sanctions the Commission will be authorized to charge U.S. exports,
with the Commission having argued for a $4.043 billion figure and the
United States maintaining that the appropriate amount is in the
neighborhood of $1.1 billion. The WTO arbitration panel's ruling giving
the Commission the legal authority to impose sanctions on U.S. exports
is expected on June 17.
II. The NFTC Conceptual Unitary Proposal
Having briefly considered the historical background and policy
underpinnings of the FSC/ETI issue, it is clear that this Committee has
long been cognizant of the need to ensure that our tax system does not
unfairly penalize U.S. businesses, especially vis-a-vis our foreign
competitors. The Coalition does not believe that an appropriate
response to the WTO ETI decision would be to simply repeal ETI--in
effect, a tax increase on American exporters. Such a result would have
an adverse impact on the international competitiveness of domestic
exporters, threatening thousands of American jobs.
The Coalition supports compliance with America's international
trade obligations. We stand ready to work with the Administration and
the Congress, on a bipartisan basis, to find a solution that brings the
United States into compliance with the WTO ruling. The unitary proposal
I will describe, supported by a broad array of America's leading
exporters, provides a set of legislative recommendations that would
preserve U.S. jobs, promote the international competitiveness of U.S.
corporations, and enable the United States to fulfill its WTO
obligations.
As indicated previously, the Coalition's proposal is a conceptual
draft--we do not view our package as a finished legislative document.
We stand ready to work with the Members of this Committee to improve
the ideas contained in our document and assist in the development of
legislation.
I also would like to stress that the Coalition views this package
as a unitary proposal. Since our coalition runs the gamut from pure
exporters to broad-based multinational corporations, not all of the
provisions benefit every company. In fact, some companies may only
benefit from one of the provisions. We have worked very hard on the
proposal and believe that it comes very close to ensuring that as many
companies as possible get close to their ETI tax benefits. No company,
however, would obtain a greater benefit under our proposal than under
current law because our proposal contemplates the adoption of an
overall cap on the tax benefits provided by any combination of the
proposals.
The Coalition developed these provisions with a careful eye on the
WTO case law and with the understanding that any legislative package
must be WTO-compliant. We believe that the unitary proposal meets that
stringent test. As Ways and Means Committee Members, you have had this
issue you before you several times and, understandably, will want
assurances that the legislative package you adopt will put this matter
to rest, once and for all. This level of confidence in the WTO-legality
of a replacement package can be achieved through discussions or
negotiations with the Commission. The Coalition believes that our
unitary proposal would serve as a good basis for these discussions with
the Commission.
Discussion
Recognizing the diverse nature of American exporters, the NFTC's
conceptual draft of a unitary proposal takes a four-pronged approach:
(1) implement the exception to the prohibition on export subsidies for
measures to avoid double taxation, in the case of income derived from
certain sales, leases, and licenses of property; (2) repeal certain
exceptions to the general rule of deferral for active business income
derived by U.S.-controlled foreign corporations (``CFCs'') from foreign
sources; (3) enact an exemption for a limited category of transactions
that are WTO-permissible; and (4) provide a new wage-based tax credit
of general application.
I. A Measure to Avoid Double Taxation
LConceptually, a legislative response could target exports in
the context of a measure to avoid double taxation of foreign-
source income.
This proposal would permit taxpayers to exclude from U.S. tax (up
to prescribed limits) all foreign-source income earned by U.S.
taxpayers in export transactions. We believe that this concept complies
with WTO rules, as interpreted by the January 14, 2002 Appellate Body
ruling in the FSC-ETI case. The Appellate Body ruled that the fifth
sentence of Footnote 59 of the Agreement on Subsidies and
Countervailing Measures (the ``SCM Agreement'') permits a WTO member
state to adopt a measure taken to avoid the double taxation of foreign-
source income (the ``Footnote 59 exception'').\3\
---------------------------------------------------------------------------
\3\ United States--Tax Treatment for ``Foreign Sales
Corporations''--Recourse to Article 21.5 of the DSU by the European
Communities, at para. 132.
---------------------------------------------------------------------------
The exclusion would apply to foreign-source income from property
sold, leased, or licensed for direct use outside the United States, and
income from services as a commission agent in connection with the sale,
lease or license of property for export. The property would be required
to be manufactured or produced in the United States for final
disposition outside the United States.
The foreign-source income eligible for exclusion would be
calculated using arm's length pricing methods (ensuring that only was
foreign-source--and no U.S.-sourced--income is excluded). In addition,
the provision would require that the definition of foreign-source
income qualify under widely recognized international norms of taxation,
as prescribed by the WTO Appellate Body.
Finally, the proposal would allow taxpayers to treat excluded
foreign-source income as previously taxed income (``PTI'') when
received from a controlled foreign corporation (CFC).
II. Subpart F Modifications
LConceptually, the United States remains free to amend any of
its general rules for the taxation of income earned abroad; the
applicable WTO agreements would not prevent the United States
from amending rules of general application in a manner that
could benefit exporters, among other taxpayers.
The general rule under U.S. tax law provides for unlimited deferral
of U.S. tax on business profits earned abroad through CFCs. Such income
is subject to tax when it is distributed to the U.S. in the form of
dividends or other transactions. The ``subpart F'' anti-deferral regime
is an exception to the general rule of deferral and results in the
imposition of a current U.S. tax. The proposal would restrict the scope
of subpart F in a manner that would partially conform to the less
stringent anti-deferral rules adopted by other countries (including
member states of the Commission), which countries generally apply anti-
deferral regimes only to passive investment income earned by foreign
subsidiaries.\4\
---------------------------------------------------------------------------
\4\ See National Foreign Trade Council, Inc., International Tax
Policy for the 21st Century, Part One: A Reconsideration of
Subpart F (December 15, 2001), for a discussion of the subpart F rules
and a summary of several other CFC-like regimes.
---------------------------------------------------------------------------
The Congress defined subpart F income to include ``foreign base
company sales income'' and ``foreign base company services income''
(collectively, ``FBCSI''), in part to stop domestic corporations from
shifting income to foreign subsidiaries through ``artificial
arrangements between parent and subsidiary regarding intercompany
pricing.'' \5\ The precursor of ETI, the DISC, was designed to restore
the competitiveness of U.S. exporters hampered by the enactment of the
FBCSI rules. The current state of U.S. transfer-pricing law and
administration (including the globalization of transfer pricing
enforcement) calls into question the continued need for subpart F to
serve as a backstop to the transfer-pricing rules.\6\
---------------------------------------------------------------------------
\5\ See S. Rep. No. 1881, 87th Cong., 2d Sess. 78 (1962) (quoting a
message from the President).
\6\ See the discussion of this issue beginning on page 65 of the
NFTC Foreign Income Project: International Tax Policy for the
21st Century, Conclusions and Recommendations (December 15,
2001).
---------------------------------------------------------------------------
This proposal would eliminate the provisions that define subpart F
income to include FBCSI. Very generally, FBCSI refers to related-party
transactions in which income is earned by a CFC outside of its country
of incorporation. Unlike most other definitions of Subpart F, FBCSI
constitutes active business income (not passive income).
The proposal also would exempt a portion of income that would be
defined as FBCSI from U.S. tax (as permitted by Footnote 59), and
permit the tax-free transfer of a limited category of associated
marketing intangibles to CFCs under Section 367(d). No foreign tax
credits would be allowed for taxes associated with income exempted
under this proposal. In conforming amendments, the proposal would
clarify the extent to which royalty and rental income qualifies for the
``active rents and royalties exception'' to subpart F.
III. International Transportation Property
LConceptually, property that qualifies for ETI tax treatment
under the ``predominant use'' test of current, but that is not
a Trade-Law Export, should not be considered to be contingent
on export performance within the meaning of the applicable WTO
agreements.
This proposal envisions retaining ETI-like benefits for a limited
category of qualifying ``international transportation property.'' Sales
and leases of qualifying property to U.S. companies for predominant use
outside the United States are not considered exports under
international trade law norms. International transportation property
includes aircraft, railroad rolling stock, vessels, motor vehicles,
containers, orbiting satellites and other property used for
international transportation purposes (including engines, components
and spare parts).
Although these transactions qualify for ETI tax treatment under the
``predominant use'' test of existing law, they are not considered
exports under trade law and, therefore, should not be considered to be
contingent on export performance within the meaning of the Agreement on
Subsidies.
IV. Wage Tax Credit
LConceptually, consideration could be given to the development
of legislation that might benefit broad classes of taxpayers of
a type that currently utilize the ETI regime (e.g., small
exporters) without requiring exportation.
As indicated previously, the Coalition is comprised of a broad
cross-section of U.S. companies, including ``direct exporters,'' U.S.
taxpayers that sell to unrelated foreign businesses but whose
activities are (for the most part) located in the United States.
Similarly, many farmers receive ETI benefits for the agricultural
products they export overseas. They currently qualify for ETI benefits
but would not obtain any tax benefits from modifications to U.S.
international tax rules if they have no overseas operations.
In order to provide some level of tax benefits for direct
exporters, the Coalition has developed the concept of a wage tax
credit. The proposal envisions the creation of a tax credit for
manufacturers of qualifying property based on the wages paid to
employees producing the qualifying property. The credit would be 1% of
qualifying wages. As mentioned previously, the credit proposal (as well
as all of the other provisions of the unitary proposal) would be
subject to an overall combined cap on benefits to ensure that a
taxpayer did not receive greater benefits under the wage credit than
under current ETI benefits.
Conclusion
In closing, I would like to again thank the Subcommittee for the
opportunity to testify on behalf of the NFTC FSC/ETI Coalition and
explain the concepts underlying our unitary proposal. As I indicated
earlier, our proposal is a conceptual paper and should not be
considered a finished legislative package. Crafting legislation that
replaces the ETI regime and complies with our WTO obligations while
ensuring the competitiveness of American exporters is a very
challenging task. The Coalition would like to assist you in that
endeavor and believes that our conceptual draft of a unitary proposal
could serve as a useful starting point as the Committee begins this
legislative process. I would be happy to answer any questions you may
have.
______
APPENDIX
April 30, 2002
NFTC FSC-ETI COALITION
DRAFTING SPECIFICATIONS FOR UNITARY PROPOSAL
EXECUTIVE SUMMARY
The Appellate Body Report in United States--Tax Treatment for
``Foreign Sales Corporations''--Recourse to Article 21.5 of the DSU by
the European Communities upheld the decision of the WTO panel that the
FSC Replacement and Extraterritorial Income Exclusion (``ETI'') Act
confers prohibited export subsidies in violation of the international
trade obligations of the United States.
It will take a considerable amount of time to develop
and implement an appropriate response to the WTO decision in
the FSC-ETI case, one that is likely to require some
combination of negotiations with the European Commission and
legislation.
Accordingly, the NFTC FSC-ETI Coalition has developed
preliminary drafting concepts, to facilitate the discussion of
legislative options for addressing the resolution of the FSC-
ETI dispute in a manner that brings the United States into
compliance with its international trade obligations while
maintaining the international competitiveness of U.S. exporters
and workers.
Drafting Parameters. The WTO decision AB Report
precludes a legislative response that merely ``tinkers'' with
the ETI regime, and thus, it will not be possible to replicate
present law.
There is, however, a limited category of
transactions for which ETI-like treatment should be maintained.
Also, and significantly, the WTO decision confirms
the availability of an exception for legislation that targets
exports in the context of a measure to avoid double taxation of
foreign-source income.
Moreover, nothing in the WTO decision would prevent
the United States from amending rules of general application in
a manner that could benefit exporters, among other taxpayers.
Summary of Unitary Proposal. The unitary proposal is
premised on the repeal of the ETI provisions, and includes all
of the following elements:
Footnote 59 Exception.--Implementing the recognized
exception to the prohibition on export subsidies for measures
to avoid double taxation, by excluding from U.S. tax (up to
prescribed limits) foreign-source income earned by U.S.
taxpayers in export transactions. The exclusion would apply to
income from property manufactured within the United States and
sold, leased, or licensed for direct use, consumption or
disposition outside the United States, and income from services
as a commission agent in connection with a sale or license of
property for export or otherwise related and subsidiary to a
sale, lease, or license of property for export.
Subpart F Modification.--Repealing certain
exceptions to the general rule of deferral for active business
income derived by U.S.-controlled foreign corporations
(``CFC(s)'') from foreign-sources sales and services in a
manner that would partially conform to the less stringent anti-
deferral rules adopted by other countries (including EC member
states). The general rule under U.S. tax law provides unlimited
deferral of U.S. income tax on business profits earned abroad
through CFCs. Deferral results from a basic structural feature
of the U.S. system, namely, the treatment of a corporation and
its shareholders as separate taxpayers. The anti-deferral
regime of ``Subpart F'' is an exception to the general rule of
deferral. The proposal would restrict the scope of Subpart F by
repealing the provisions that define subpart F income to
include ``foreign base company sales income'' and ``foreign
base company services income.'' The proposal would also exempt
a portion of such foreign-source earnings from U.S. tax (as
permitted by the recognized exception for foreign-source
income).
WTO-permissible Transactions.--Enacting an
exemption for a limited category of transactions that are WTO-
permissible because they are not exports under international
norms.
Wage-based Tax Credit.--Providing a new wage-based
tax credit of general application, for taxpayers engaged in
businesses in specified North American Industrial
Classification System (NAICS) industry codes.
To constrain the revenue effect to the current law
cost of ETI, the unitary proposal contemplates that an overall
cap would be imposed on the benefits that could be obtained by
use of any combination of the individual proposals.
Chairman MCCRERY. Thank you, Mr. Reinsch. Mr. Kostenbauder,
is that close?
Mr. KOSTENBAUDER. Yes, very good.
Chairman MCCRERY. Very good. Thank you. I think your
microphone needs to be turned on.
Mr. KOSTENBAUDER. There we go. Thank you.
Chairman MCCRERY. Thank you.
STATEMENT OF DANIEL KOSTENBAUDER, GENERAL TAX COUNSEL, HEWLETT-
PACKARD COMPANY, PALO ALTO, CALIFORNIA, ON BEHALF OF AeA
Mr. KOSTENBAUDER. Thank you, Mr. Chairman. I appreciate the
opportunity to be here today on behalf of Hewlett-Packard (HP)
Company. HP is based in Palo Alto, California. We have over
half of our revenue from outside of the United States, so that
means that we are both an exporter, and we care greatly about
the treatment of U.S. companies by the international provisions
of the Tax Code. I am also appearing on behalf of AeA, formerly
the American Electronics Association, which has about 3,500
members, and a great number of these companies have global
markets for their high tech electronics products. So again,
they are both exporters and care deeply about the treatment of
U.S. companies with respect to their international activities.
We appreciate very much your having these hearings, looking
at both the big picture of international reform and possible
approaches to improving the U.S. tax system as well as more
specific, focused possibilities, and we have some thoughts
today on those. We think that the provisions and the
legislation you are about to work on should help exporters and
should also help the competitiveness of U.S. companies in
international markets.
The AeA has four specific proposals that we would recommend
to your attention. One is to repeal the foreign base company
services income and foreign base company sales income
provisions. Another would be to remove active software rents
and royalties from the subpart F provisions. In the foreign tax
credit area, we recommend extending the foreign tax credit
carryforward period from 5 to 10 years, and eliminating the
restriction on using foreign tax credits to offset the
alternative minimum tax (AMT). Today they are limited to
offsetting only 90 percent of the AMT, and we would propose
that in pursuit of the principle of avoiding double taxation,
that corporations should be permitted to offset 100 percent of
the AMT with foreign tax credits.
Let me make just a very quick review of the international
tax system for the United States. We, as you all know, tax on a
worldwide basis. The tax on active income earned by controlled
foreign corporation (CFC) subsidiaries of U.S. companies is
generally deferred until there is a distribution of those
earnings. Subpart F, a very complex provision, provides
exceptions to that deferral, which means immediate U.S.
taxation of some aspect of international activity. Certainly
the passive income rules are well accepted and very standard in
most countries' international tax systems. The United States,
however, has a far more robust subpart F, and that is one of
the reasons we are suggesting the repeal of these base company
rules.
Let me briefly describe what these base company rules are.
Foreign base company income generally includes sales income
that is earned by a controlled foreign corporation in a country
that neither manufactures or sells property and which it
purchases from or sells to a related party. The service company
rules are similar. When I think of these base company rules,
and nobody in the world uses the word ``base company'' except
in the context of subpart F, I think of the words ``trading
company.'' The key things you look for are a transaction with a
related party and a transaction outside the country of its
incorporation. If you have both of those, generally that is
what we are talking about. Is this a tax dodge or does this
make sense? Let me give you an example.
If you had a company with 10 factories and 10 sales
companies all outside the United States and if all the
factories were going to sell to all the sales companies, you
have right there a hundred different sets of transactions, a
hundred value-added tax registrations to comply with, lots of
data processing systems, and lots of logistical challenges. The
way companies short circuit all that extra work is to put a
trading company, or a ``base company,'' in the middle. Then all
of the factories sell to one company and one company sells to
all of the sales companies. Voila, you have 20 transactions,
you have a lot better management, and that is what base
companies are all about, whether it is sale of goods or sale of
services. Notice, this is all related to normal active
business.
One of the concerns and one of the reasons these base
company rules have been in the subpart F for the last 40 years
has been the concern about transfer pricing. Since 1962, the
transfer pricing rules and their enforcement have been
dramatically improved both in the United States and elsewhere.
Also, repealing these base company rules would encourage
exports to the extent that the United States is the factory
that is manufacturing and selling to one of these trading
companies that would have some subpart F imposed. Quite
clearly, those transactions have an extra U.S. tax that would
not otherwise exist with the repeal of the base company rules.
So, there is a very direct relief from their repeal and then
more broadly, to the extent that U.S. companies can organize
themselves to compete better internationally, they will be more
competitive. It is important to note that most exports of U.S.
companies are actually to their foreign subsidiaries and
probably to foreign trading companies that then distribute into
foreign markets.
I will make one final comment, which is that removing those
rules will greatly simplify the Tax Code and the operation of
the Tax Code for taxpayers. So, the repeal of the base company
rules will have that additional benefit.
Thank you.
[The prepared statement of Mr. Kostenbauder follows:]
Statement of Daniel Kostenbauder, General Tax Counsel, Hewlett-Packard
Company, Palo Alto, California, on behalf of AeA
My name is Dan Kostenbauder, General Tax Counsel at Hewlett-Packard
Company in Palo Alto, California. HP was founded in 1939. With our
recent merger with Compaq Computer Corporation, the new HP is a leading
technology solutions provider for consumers and businesses with market
leadership in fault-tolerant servers, UNIX servers, Linux
servers, Windows servers, storage solutions, management
software, imaging and printing and PCs. Furthermore, 65,000
professionals worldwide lead our IT services team. Our $4 billion
annual R&D investment fuels the invention of products, solutions and
new technologies, so that we can better serve customers and enter new
markets. HP invents, engineers and delivers technology solutions that
drive business value, create social value and improve the lives of our
customers.
I am appearing today on behalf of the AeA, formerly the American
Electronics Association. Advancing the business of technology, AeA is
the nation's largest high-tech trade association. AeA represents more
than 3,500 member companies that span the high-technology spectrum,
from software, semiconductors and computers to Internet technology,
advanced electronics and telecommunications systems and services. With
18 regional U.S. councils and offices in Brussels and Beijing, AeA
offers a unique global policy grassroots capability and a wide
portfolio of valuable business services and products for the high-tech
industry. AeA has been the accepted voice of the U.S. technology
community since 1943.
Summary of Testimony
Repeal of the Extraterritorial Income Exclusion regime (``ETI'') is
a possible response to the World Trade Organization (``WTO'') Appellate
Body decision that ETI is a prohibited export incentive. If the ETI is
repealed, then it should be replaced with tax legislation that clearly
will comply with WTO rules. Such legislation should be designed to help
those sectors of the U.S. economy that currently benefit from the ETI
and to improve the competitiveness of U.S. based companies. If the
timeframe for such legislation probably is too short to permit a
complete review and reform of the international provisions of the U.S.
tax system, AeA believes that a number of improvements can be made to
today's rules that will be consistent with future efforts toward more
comprehensive reform. AeA believes that reforms in the Subpart F and
foreign tax credit areas would be good tax policy and very
straightforward to adopt.
In particular, the AeA suggests that the following provisions
should be among those that should be adopted upon repeal of the ETI:
1. LRepeal the foreign base company sales income and the
foreign base company services income rules under Subpart F,
2. LRemove active rents and royalties from the passive income
rules under Subpart F,
3. LIncrease the foreign tax credit carryforward period to 10
years, and
4. LRepeal the limitation on use of foreign tax credits to
offset the corporate alternative minimum tax.
LBenefits of Current ETI Regime Should Be Preserved to the Extent
Possible
The WTO decision that the ETI regime enacted by Congress in 2000 is
a prohibited export subsidy violating U.S. international treaty
obligations could lead to significant sanctions against the United
States. There are other sources of trade friction between the United
States and many of our trading partners that should be resolved in a
manner that enhances international trade. The ``compliance work plan''
announced by Ambassador Zoellick and EU Commissioner Lamy, under which
the Administration and Congress will together to develop a proposal
that will allow the U.S. to comply with the Appellate Panel ruling, is
a good step forward.
AeA is pleased to contribute its ideas at this hearing, which is an
important step in the process of developing an alternative to the ETI.
We hope the process is both credible and rapid enough to forestall
retaliation by the EU, or at least to minimize the possibility of
sanctions and the attendant trade friction that would result.
As part of this process, AeA believes that the ETI regime should be
replaced with legislation that helps those sectors of the economy that
currently benefit from the ETI and that helps to improve the
international competitiveness of U.S. based companies.
Since it would be imprudent to enact provisions that once again
test the limits of what constitutes an export subsidy, Congress should
exercise its judgment to support sectors of the economy enjoying
benefits of ETI in a way that does not have a direct reliance upon
exports.
The AeA recommends that the foreign base company sales income and
foreign base company services income rules of Subpart F be repealed in
their entirety.
In general, U.S. tax is imposed under Subpart F not only on a
foreign subsidiary's passive income (interest, dividends, etc.) but
also on income earned from certain active business transactions with
related persons. For example, U.S. tax is imposed on the income of a
foreign subsidiary from purchasing goods from legal entities within the
multinational group and reselling them outside its country of
incorporation. By imposing U.S. tax on intercompany payments between
foreign subsidiaries, Subpart F of the Internal Revenue Code puts U.S.
multinationals at a competitive disadvantage in the global marketplace
by imposing current U.S. tax on ordinary foreign business transactions
that otherwise would not be subject to current U.S. taxation.
The Subpart F base company rules have been justified as measures
that counteract efforts by U.S. multinationals to shift foreign profits
to tax havens, in part by making payments to related companies located
in tax havens.
The 1962 legislative history to Subpart F reveals that the related
person provisions were targeted at transfer pricing abuses. Since 1962,
however, the ability of the IRS and foreign tax authorities to combat
transfer-pricing abuses has improved dramatically. The IRS has issued
increasingly detailed transfer pricing regulations to provide guidance,
and Congress has enacted stern penalties for non-compliance. As a
result, the profits of the various members of a U.S.-based
multinational group are much more likely today to be properly allocated
based on real economic factors (such as the functions performed,
investments made, and risks borne).
Subpart F generally does not apply to transactions within a single
``country'' under the rationale that, in such cases, artificial profit
shifting between tax jurisdictions does not occur. For example, the
provisions applicable to intercompany payments (the ``foreign personal
holding company income'' rules) exclude dividends and interest received
by a controlled foreign corporation (``CFC'') from a related person
that is (1) a corporation organized under the laws of the same country
in which the CFC was created; and (2) has a substantial part of its
assets used in a trade or business located in such same foreign
country.
Additionally, in the early 1960's, foreign subsidiaries of U.S.
multinationals typically operated only in their country of
incorporation, in part because each country presented a unique market.
With the rise of globalization, the falling of trade barriers (e.g.,
the economic integration of the EU countries), and improvements in
technology, foreign subsidiaries can now more efficiently and
effectively conduct business on a regional or even global basis. For
example, many multinational groups now seek to centralize functions in
regional hubs or service centers. However, Subpart F imposes a tax cost
on foreign subsidiaries that operate outside their country of
incorporation, and as a result, they are penalized for acting in the
most economically efficient manner (e.g., by operating on a regional
basis). Accordingly, U.S. multinationals are forced to either pay the
extra tax cost or to needlessly duplicate functions in multiple foreign
countries. The Subpart F related person provisions create unnecessary
complexity, which leads to excessive taxpayer compliance costs,
increased IRS audit costs, and additional burdens on the courts.
The revenue effects of the Subpart F base company rules are not
strictly revenue generating for the U.S. Treasury. In cases where
Subpart F income is generated by activities in high tax countries,
foreign tax credits can eliminate any residual U.S. tax liability.
As companies continue to adopt integrated business models dictated
by the global marketplace, such provisions act as a hindrance to U.S.
competitiveness.
An interesting proposal that was considered, but rejected, in 1962
when Subpart F was enacted would have treated the European Economic
Community (now the European Union) as a single country for purposes of
the Subpart F related persons provisions.
According to the legislative history, the basis for this decision
was the fact that, although the European countries had formed a common
market, they did not yet have a unified tax system.
Recent proposals introduced to simplify Subpart F include
provisions relating to the treatment of the EU as one country. For
example, in H.R. 2018 (106th Congress), the Secretary of the Treasury
would have been tasked with analyzing the impact of treating the EU as
one country for purposes of applying the same country exceptions under
Subpart F.
This treatment makes even more sense today than it did in 1962.
Greater political and economic integration among EU countries has been
achieved over the last forty years, including adoption of the euro as a
common currency by most member countries. Furthermore, the EU has been
working to achieve tax harmonization. For the past three years, the EU
members have been negotiating a ``code of conduct'' with respect to tax
matters, in order to eliminate harmful tax competition among member
states. More recently, the EU Commission has begun investigating
whether certain member state tax regimes constitute unlawful state
aids.
There are several ways that repeal of the base company rules would
encourage U.S. exports. First, if the base company rules apply to
purchases from the U.S. that are exported to foreign customers, then an
export transaction probably bears more U.S. tax as a result of the
Subpart F base company rules.
Second, if the foreign subsidiaries of U.S. multinational companies
are healthy and competitive, the U.S. parent company almost always
prospers as well. Since the U.S. foreign base company rules have not
been duplicated by other countries (unlike the passive income rules),
foreign subsidiaries of U.S. companies face greater complexity and
higher taxes than the foreign companies in whose home markets they are
trying to compete. Since such foreign subsidiaries of U.S. companies
are the conduit into foreign markets for most U.S. exports, the
healthier they are the greater the prospects for U.S. exports.
Exclude Active Software Royalties from Passive Income
An important policy goal of ETI replacement legislation should be
to provide benefits to those U.S.-based taxpayers that previously
qualified for FSC/ETI benefits. Since software rents and royalties
expressly qualify for ETI benefits today, any reform of Subpart F
should include relief for active business income from rents and
royalties.
The software industry is unique in that it delivers its products
and services to customers via delivery methods that, depending on the
facts of the transaction, produce either rents, royalties, sale of
goods income or services income. In all cases, the vendor company is
engaged in essentially the same business activity of developing,
marketing and supporting its products. The reason a software company
may have rent and royalty income therefore is due to its choice of
delivery methods, and does not imply that the company is not engaged in
an active trade or business.
Accordingly, to achieve parity with other industries which deliver
their products only by means of sales of goods, any Subpart F reform
should amend section 954(c)(2)(A) both to eliminate the current
complete prohibition on deferral for related party rents and royalties
and to rationalize the active trade or business test. These reforms
would place software companies on a tax parity with other U.S.
companies, and would allow Congress to meet the policy goal of matching
the beneficiaries of the proposed legislation as closely as possible
with the groups that historically benefited from FSC/ETI.
Two primary concerns have been expressed concerning whether this
proposal would be appropriate--that rents and royalties are somehow by
their very nature indicia of passive activity, and that even if some
reform is appropriate, the scope of qualifying rents and royalties
should be appropriately limited.
With respect to the concern that all rents and royalties are
inherently passive, it is important to emphasize that the
classification of income as active or passive based merely on whether
it is characterized as a sale of goods, rents or royalties is not
necessarily appropriate, at least in the software context. It would be
inconsistent and unfair from a policy perspective to treat transactions
that arise from the same business activity differently, based solely on
their nominal classification.
Also, it should be possible to create an active trade or business
test which appropriately distinguishes between rents and royalties
derived in the conduct of an active business, and income from more
passive, investment oriented activities. This test almost certainly
should refer to activities conducted by other members of the group to
characterize a revenue stream as active or passive, as is currently
provided for in certain other contexts. Perhaps the most
straightforward approach would be to limit the scope of any reform to
those industries that historically have derived rents and royalties
through active business operations, and retain current law for other
income such as real property rents. This approach would be consistent
with other statutory provisions reflecting the Congressional desire to
equalize the treatment of computer software royalties and other forms
of active business income. One possible means to narrowly limit the
scope of the proposal is to apply the proposal only to rents and
royalties which currently qualify for FSC/ETI benefits. Another
possible approach is to define a qualified recipient as an entity
engaged in an active software business based on some appropriate
measure, such as the presence in the affiliated group of substantial
development, marketing, and/or other business activities.
Increase Foreign Tax Credit Carryforward Period from 5 Years to 10
Years
Reform of the foreign tax credit (``FTC'') carryover rules is
needed to provide for an effective operation of U.S. tax laws intended
to protect against double taxation. The AeA further recommends that the
ordering rules be amended such that credits would be used first from
carryforwards to such taxable year, second from the current year, and
third from carrybacks.
U.S. taxpayers may claim FTCs against U.S. tax in order to avoid
double taxation of income. The amount of FTCs that may be claimed in a
year is subject to a limitation, so that the credit is allowed only to
offset U.S. tax on foreign source income. To the extent the amount of
creditable taxes of a given taxable year exceeds the limitation, the
excess may be carried back two years and forward five years.
Problems of double taxation often arise because the foreign tax
treatment of items of income and expense may differ from the U.S. tax
treatment. For example, the same income may arise in different taxable
years for foreign and U.S. tax purposes. As a result, the foreign taxes
may be imposed in a year during which little or no foreign income may
arise under U.S. tax principles. The rules for FTC carryovers seek to
address this problem by allowing the FTCs to be carried over from years
in which foreign taxes are imposed to years in which the foreign source
income arises under U.S. tax principles.
Extending the period of the FTC carryforwards would allow companies
to offset their U.S. tax liabilities in later years when they are
profitable without facing the pressure of expiring FTC carryovers.
This modification would allow U.S. taxpayers that had accrued or
paid foreign taxes additional time to utilize their FTC carryovers.
In addition, with the enactment of transfer pricing legislation in
many foreign jurisdictions, U.S. multinational corporations are
required to recognize income and pay foreign taxes in foreign
jurisdictions even when they have losses on a consolidated basis. The
vagaries of the economy and other business cycles are additional
factors that sometimes prevent utilization of FTCs before their
expiration.
LRemove 90% Limitation on Claiming Foreign Tax Credits from Alternative
Minimum Tax
The regular corporate income tax allows companies a credit of 100
percent of the foreign taxes on income earned abroad subject to various
limitations and restrictions. Only 90 percent of the alternative
minimum tax (``AMT'') may be offset by FTCs that would otherwise be
available. This rule causes double taxation of foreign income and
thwarts a fundamental and long-standing principle of U.S. tax policy.
The Joint Committee on Taxation April 2001 Study (JCX-27-01, 4/25/
01) recommended that the corporate AMT be eliminated. The report
concluded, ``The original purpose of the corporate AMT is no longer
served in any meaningful way.'' Furthermore, it has been estimated that
the cost of tax compliance alone for the complexities costs companies
many times the amount of AMT collected. Repeal of the entire AMT is an
issue for another day. In terms of overall international
competitiveness, however, eliminating the double taxation of
international income clearly is appropriate.
The AMT has a perverse effect of penalizing U.S. global companies
for distributing overseas earnings to U.S. parent companies to support
domestic operations. Because of the AMT's limit on FTCs, earnings
distributed from abroad are effectively taxed at a higher rate than
domestic earnings, and certainly at a higher rate than the earnings of
non-U.S. competitors operating in those same foreign markets. This puts
U.S. companies in this position at a competitive disadvantage vis-a-vis
their foreign competitors in overseas markets.
Chairman MCCRERY. Thank you, Mr. Kostenbauder. Mr.
McLaughlin.
STATEMENT OF GARY L. MCLAUGHLIN, SENIOR DIRECTOR, INTERNATIONAL
TAX, WAL-MART STORES, INC., BENTONVILLE, ARKANSAS, ON BEHALF OF
INTERNATIONAL MASS RETAIL ASSOCIATION
Mr. MCLAUGHLIN. Thank you, Mr. Chairman. I appear here
today on behalf of the International Mass Retail Association
(IMRA). The IMRA is the world's leading alliance of retailers
and their product and service suppliers. As IMRA retailers have
expanded into the EU, Mexico, China, and other international
markets, there has been an unleashing of pent-up demand for
affordable U.S. products. Most of our U.S. vendors that supply
the U.S. retail products we sell overseas export through and
realize the meaningful benefits of FSC/ETI. The U.S. tax that
vendors and retailers pay impacts the price we charge our
customers worldwide. Thus, IMRA has a vested interest in FSC,
FSC alternatives, or ETI and the solutions that Congress is
considering.
Retailers and our vendors are clearly the largest employers
in the United States and by being able to compete worldwide we
generate dollars to invest in the United States for job growth
and economic expansion.
In announcing these hearings, Mr. Chairman, you noted that
Congress cannot replicate the benefits of FSC and ETI and that
these hearings will focus on tax proposals which promote the
competitiveness of U.S. companies while respecting our
international obligations under WTO. The United States is not a
low-tax country for corporations. With U.S. taxation, of
worldwide income and the flaws in our deferral and foreign tax
credit mechanisms, the most meaningful action that Congress
could take to enhance the international competitiveness of U.S.
corporations would be to reduce the U.S. corporate income tax
rate.
However, I realize that such reduction may not be feasible
in today's environment, and I will therefore focus on various
changes that could and should be made to the subpart F and the
foreign tax credit provisions of the Tax Code. These changes
will both enhance American competitiveness and simplify the
operation of those provisions. There are four specific change
proposals in my written submission which are illustrative
rather than comprehensive, but do reflect the manner in which
the current foreign tax provisions of the Tax Code compromise
American international competitiveness. I will summarize the
two most important from the retailer perspective.
First, due to the cyclical nature of the retail business
and the associated large amounts of working capital required to
address such, the current de minimis exception of section 954
creates a situation where in many cases U.S. retailers' income
from working capital is taxed currently in the United States
even though such working capital is required for the active
conduct of our businesses in the international arena. For these
reasons, section 954 should be amended to preserve deferral for
working capital of a CFC attributable to active business
operations. This could be accomplished by either returning the
current threshold to its original 1962 level or Congress could
create a working capital exception from the section 954 foreign
base company income inclusion provisions.
Second, under subpart F certain intercompany sales and
services income of a CFC is classified as foreign base company
income and is thus not eligible for deferral even though the
income is generated in the active conduct of a trade or
business with the exception of transactions within the same
country. This same country exception which permits deferral
should be revised in the case of member countries within the EU
or within China, Hong Kong. The income encompassed by the
foreign base company sales and services income rules is active
business income of the type frequently not taxed on a current
basis by other countries that have enacted anti-deferral
regimes. Such income should not be subject to current U.S. tax.
The remaining points in my submission focus on the need to
revise the stacking rules for foreign tax credit utilization
and the interest allocation rules in order to assure double
taxation is avoided, as my colleagues have mentioned, and aid
in international competitiveness for all U.S. multinational
corporations. Additionally, the carryforward period for unused
foreign tax credits should be increased from 5 to 10 years.
Thank you, Mr. Chairman and Subcommittee Members.
Chairman MCCRERY. Thank you, Mr. McLaughlin. Mr. Sprague.
STATEMENT OF GARY D. SPRAGUE, PARTNER, BAKER & McKENZIE, PALO
ALTO, CALIFORNIA, ON BEHALF OF SOFTWARE INDUSTRY COALITION FOR
SUBPART F EQUALITY
Mr. SPRAGUE. Mr. Chairman and Members of the Subcommittee,
it is my pleasure to speak with you this morning about possible
subpart F reforms that will enhance the competitiveness of
American business internationally. I am a partner in the law
firm of Baker & McKenzie in Palo Alto, California, and as such
fully endorse the Chairman's remark that these are times when
one enjoys, actually enjoys being an international tax lawyer.
I am testifying today on behalf of the Software Industry
Coalition for Subpart F Equality, which includes many of the
country's, indeed the world's leading software companies. A
list of coalition members is attached to my written testimony.
One of the proposals before you is to exclude foreign base
company sales and services income from subpart F. This reform
would enhance the competitiveness of American business while
respecting our WTO obligations. Although we strongly support
these changes, it is essential that any modifications to
subpart F not be biased against computer software companies
solely because of the unique characteristics of the income
earned by these companies.
My testimony today will address those special features of
how software companies deliver their products to users which
demand revisions to our 40-year-old rules in subpart F. I
believe this is exactly the question raised by Mr. Foley a few
minutes ago. Computer software companies are engaged in active
businesses just like traditional manufacturing companies.
Unlike traditional manufacturers, however, computer software
companies generally deliver their products under license
agreements rather than contracts of sale. I am sure each Member
of this Subcommittee has carefully read and thoughtfully
considered the license agreements included with all of your
personal software.
This contractual form is necessary for reasons of
intellectual property law and other business considerations
completely unrelated to taxation. Because of this contractual
form, however, and due to the evolving business models of this
industry, income earned by a company from exactly the same
software program may be characterized as rents, royalties,
sales of goods, or services depending on the facts of the
particular transaction.
Let's take, for example, a word processing program. When
the program is sold through a retail distribution channel under
a shrink wrap license, the transaction, despite the form of
license, is nevertheless treated as a sale of goods for tax
purposes. At the same time, if the software company selects a
distribution channel for exactly the same software program
involving arrangements allowing the distributor to duplicate
the software, revenue from that transaction, from the same
program, is treated as a royalty. Furthermore, if the software
company chooses a model which requires a user to make periodic
payments for the continued right to use the program, that
revenue is characterized as a rent. Finally, software may be
made available to users in hosting arrangements, which
frequently gives rise to services income.
In all four cases, the software company is engaged in
essentially the same business activity of developing,
marketing, delivering, and supporting its products, but earns
four different types of revenue for tax purposes. Subpart F,
however, currently treats those four revenue streams in
dramatically different ways. The software company's sale of
goods and services income would fall within the purview of the
foreign base company sales and services income rules while the
rent and royalty income, in contrast, is within the scope of
the foreign personal holding company regime. Foreign personal
holding company income, however, is intended as a policy matter
to represent passive investment income. Therefore, it includes
interest, dividends, capital gains, and rents and royalties.
Subpart F, like many other parts of the Tax Code,
discriminates against rent and royalty income on the policy
basis that those income items presumably constitute passive
investment type income. One element of that discrimination is a
near complete ban on deferral for software rents and royalties
received from related parties, which is a rule that is not
mirrored in the sale of goods and services context. As a
result, different revenue streams of a single software company
can receive highly disparate treatment under subpart F despite
the fact that all revenues are derived in the context of a
company's single active business.
Accordingly, subpart F must be modernized to eliminate the
inconsistent and inequitable treatment of software income and
to achieve parity for the software industry relative to other
industries that deliver their products only by traditional
means. Congress can ensure that active business income earned
by software companies is treated in the same way regardless of
its nominal classification by doing two things: one, amending
the definition of foreign personal holding company income to
eliminate the current complete prohibition on deferral for
related party software rents and royalties, and two,
rationalizing the active trade or business test under the
foreign personal hold company rules.
I note that other speakers today have supported this reform
of the rent and royalty rules in their oral or written
testimony.
This reform also would allow Congress to meet the policy
goal of matching the beneficiaries of proposed reform as
closely as possible with those groups which have historically
benefited from ETI.
Thank you again for the opportunity to testify today. I
will be happy to answer any questions you may have and ask that
my written statement be made a part of the record of this
meeting.
[The prepared statement of Mr. Sprague follows:]
Statement of Gary D. Sprague, Partner, Baker & McKenzie, Palo Alto,
California, on behalf of Software Industry Coalition for Subpart F
Equality
Mr. Chairman and Members of the Committee, it is my pleasure to
appear before you today to discuss legislative alternatives to the FSC/
ETI regimes that will comply with international trade rules and enhance
the global competitiveness of U.S. companies.
I am testifying today on behalf of the Software Industry Coalition
for Subpart F Equality, which includes many of the world's leading
software companies. A list of the members of the Coalition is attached.
As other witnesses have testified today, it is imperative that the
U.S. tax system does not hinder United States companies from
effectively competing in the global markets. This was the primary
intent of the Foreign Sales Company (FSC) and Extraterritorial Income
(ETI) regimes; the competitiveness concerns that led to the enactment
of the FSC/ETI regime are no less pressing today. Therefore, FSC/ETI
replacement legislation should provide benefits to those U.S.
taxpayers, including computer software companies, which have previously
qualified for FSC/ETI benefits.
I. Importance of the Software Industry
The software industry is one of the fastest growing sectors of the
global economy, generating revenues of more than $150 billion every
year.\1\ Its importance to the U.S. economy's current health and future
prosperity is undisputed. In 1998, information technology contributed
8% to the U.S. gross domestic product (``GDP''),\2\ and it is estimated
that by 2006 industries that heavily utilize or produce information
technology will employ 49% of the U.S. private sector workforce.\3\
Today, nine of the world's ten biggest software companies are located
in the United States.\4\
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\1\ www.hoovers.com/industry/snapshot/profile, June 6, 2002.
\2\ Taylor, Paul, Financial Times, ``Reaping the Rewards of IT
Growth'' September 1, 1999.
\3\ Id.
\4\ www.hoovers.com/industry/snapshot, June 6, 2002.
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Congress demonstrated its commitment to supporting the
competitiveness of U.S. software companies in 1997 by clarifying that
FSC benefits specifically include income from software licenses as
qualifying income under the FSC/ETI regime. Although FSC/ETI benefits
are not generally available for income derived from transfers of
intellectual property, Congress recognized the importance of the
software industry to the U.S. economy by clarifying that the FSC rules
apply to ``computer software (whether or not patented).'' This
provision carried over to the ETI regime. Therefore, any replacement
for the FSC/ETI regime must include the computer software industry.
II. Subpart F Relief
Congress is considering various proposals for replacing FSC/ETI.
One set of proposals involves an amendment to Subpart F of the Internal
Revenue Code that excludes foreign base company sales income and
foreign base company services income from the definition of Subpart F
income. This would be a significant reform of U.S. tax laws that would
increase the international competitiveness of U.S. corporations and
respect the United States's obligations under the GATT. Subpart F
discriminates against U.S. companies that operate abroad in many ways
by, for example, currently taxing income earned by foreign subsidiaries
without giving equal treatment to losses. We support these changes.
Although we support the goal of reforming Subpart F, any
modification of the Subpart F provisions must take into account
taxpayers, such as computer software companies who derive income from
licensing intellectual property that can be classified as income
derived from the conduct of an active business rather than from passive
activities. My testimony will focus on the special features of the
computer software industry that must be taken into account when
considering Subpart F reform.
III. Unique Features of the Software Industry
Subpart F, which was enacted at a time when intellectual property
played a smaller role in the economy, uses heavy manufacturing as its
business model. Since that time, intellectual property has come to play
a major role in the economy as business models have changed. For
example, the computer software industry, which did not exist when
Subpart F was enacted, is now an important part of the economy and a
major U.S. exporter.
Computer software companies generally earn income by developing
computer programs, which are protected by copyrights and patents, and
delivering these programs to their customers. These delivery methods
may produce rents, royalties, sale of goods income, or services income,
depending on the facts of the transaction. The development process
frequently involves thousands of highly trained professionals and the
expenditure of many millions of dollars and years of effort to create
new software that may or may not be commercially successful. As one
commentator on the international provisions of the Code has observed,
in the context of distinguishing between taxpayers engaged in an active
trade or business from mere passive investors, ``we can readily sense a
difference between the activities of those who dig, plow, shape, make,
buy, sell, cajole, and those who merely glance at a market quotation in
the newspapers or perhaps merely remove a check from an envelope with
fingers left slender and pale from the absence of toil.'' \5\ By this
standard, the software industry is no less of an active business than
the heavy manufacturing that was Congress's paradigm when Subpart F was
enacted.
---------------------------------------------------------------------------
\5\ Joseph Isenbergh, International Taxation: U.S. Taxation of
Foreign Persons and Foreign Income Sec. 20.2 (3d ed. 2002).
---------------------------------------------------------------------------
The software industry is unique among active businesses, however,
in that that it delivers its products and services to customers via
delivery methods that produce rents, royalties, sale of goods income
and services income, depending on the facts of the transaction. In this
respect, software companies are unlike manufacturers, which only earn
income from the sale of goods. For example, computer software companies
frequently deliver their products under commercial arrangements
structured as licenses for reasons of intellectual property law and
other business reasons that are completely unrelated to taxation. Many
software companies deliver their products through time-limited
licenses, or through hosting arrangements, which may produce revenue
properly characterized under the tax law as rents and service fees,
respectively. In all cases, the company, be it a software company or a
steel mill, is engaged in essentially the same business activity of
developing, marketing and supporting its products. Thus, even if a
software company earns income that is characterized as rent or royalty
income, it does not imply that the company is not engaged in an active
trade or business. In addition, developments in communications
technology now allow multinational businesses to operate in an
integrated manner that would not have been possible when Subpart F was
enacted.
IV. Today Subpart F Discriminates Against the Software Industry
Subpart F of the Code requires a ``United States shareholder'' of a
``controlled foreign corporation'' (CFC) to include currently in its
gross income its pro rata portion of the CFC's ``subpart F income'' as
a deemed dividend. Subpart F income includes foreign personal holding
company income, foreign base company sales income, and foreign base
company services income. Foreign base company sales income includes
income derived from transactions in inventory property if the property
was purchased from, or sold to, a related party and the property was
neither manufactured, nor sold for use, in the CFC's country of
incorporation and certain other conditions are met. Foreign base
company services income includes income arising from services performed
outside the CFC's country of incorporation that are performed for or on
behalf of a related person, including under a regulatory interpretation
of the statute, services for which a related person provides
``substantial assistance.''
Foreign personal holding company income, which is intended to
represent passive income, includes interest, dividends, rents,
royalties, and capital gains. Subpart F, like many other areas of the
Code, discriminates against rent and royalty income by generally
treating them as a type of passive income. Subpart F attempts to limit
its discriminatory treatment of rent and royalty income by providing a
limited exception for certain active rents and royalties. This
provision excludes from foreign personal holding company income rents
and royalties that are both derived in the active conduct of a trade or
business and received from an unrelated person.
Although this active rent and royalty exception clearly shows
Congress' intent to distinguish income that is earned through active
business activity from passive income derived solely from the ownership
of intangible property, the regulations make this determination with
respect to each CFC on a stand-alone basis. This separate application
of Subpart F to each CFC was appropriate in the era when Subpart F was
enacted because foreign subsidiaries were likely to operate on a stand-
alone basis. However, computer software companies, like most knowledge-
based companies, operate in an integrated global manner, unlike the
manufacturing companies that were the norm when Subpart F was enacted.
Through the use of new communications technology and business models, a
software company's domestic and foreign subsidiaries work together in
developing new products, entering into global sales contracts with
multinational customers, and supporting their products around the
clock. This business model is far different from the country-specific
model that was the norm when Subpart F was enacted.
V. Software Income Should Be Kept on a Par with Other Active Industries
In order for the computer software industry to obtain parity with
other industries that deliver their products only by means of sales of
goods, subpart F reform must be modernized to eliminate the inequitable
treatment of software rent and royalty income. Congress can achieve
this result by amending Code section 954(c)(2)(A) to (i) eliminate the
current complete prohibition on deferral for related party software
rents and royalties, and (ii) rationalize the active trade or business
test by including the activities performed by members of the CFC's
group of corporations and activities performed by third parties on
behalf of the CFC.
These reforms would provide software companies with tax parity with
other U.S. companies, and would allow Congress to meet the policy goal
of matching the beneficiaries of the proposed legislation as closely as
possible with the groups that historically benefited from FSC/ETI.
VI. Our Proposal Will Not Lead to Inappropriate Tax Deferral
Some have expressed concern that this proposal would lead to
inappropriate tax deferral, namely (i) that rents and royalties are
somehow by their very nature indicia of passive activity and thus
should not enjoy deferral at all, and (ii) that even if some reform is
appropriate, the scope of qualifying rents and royalties should be
appropriately limited.
With respect to the concern that all rents and royalties are
inherently passive, it is important to emphasize that the
classification of income as active or passive based merely on whether
it is characterized as sale of goods income, rents or royalties is not
a valid assumption, at least in the software context. The income
derived by software companies normally is not passive income, but
rather is active income that is classified in a variety of ways,
including as sales, rents, royalties or services income, based on the
facts and circumstances of each transaction. It would be inconsistent
and unfair from a policy perspective to treat transactions that arise
from the same business activity differently, based solely on their
nominal classification.
The factors that cause an item of income arising from a computer
software transaction to be either sale of goods income, on one hand, or
rent or royalty income, on the other, have no bearing on whether the
income is active or passive. The characterization of an item of
software revenue can be affected by the period of time that the
customer can utilize the software without making an additional payment
or whether the customer is granted the right to make derivative works
based on the software. For example, a transfer of a copy of a computer
program will be classified as a sale of goods transaction if the
customer makes a single payment in exchange for the right to use the
software in perpetuity but will be classified as a rental transaction
if the customer is required to make periodic payments in order to
continue using the software. Alternatively, if the customer has the
right to use the software in perpetuity but obtains a significant right
to make a derivative work based on the original software, the
transaction will be classified as a license of copyright rights instead
of a sale of goods. These factors can cause an item of software income
to be treated as rents or royalties, instead of sale of goods income,
which are treated differently under current Subpart F rules. However,
these factors have no relationship to whether the income was earned in
an active business. Congress should eliminate these distinctions and
put the software industry on a level playing field with all other
active businesses.
We also note that the U.S. transfer pricing rules are entirely
adequate to prevent any inappropriate allocation of income to CFCs
earning software revenues. U.S. transfer pricing rules have become much
more sophisticated since Subpart F was enacted forty years ago. Modern
transfer pricing rules are based on the functions performed by each
entity and not the label assigned to that entity's income. These rules
take into account the need for multiple operating locations in an
integrated global business. In many cases, a CFC earning software
revenue also will be subject to transfer pricing scrutiny under the
various foreign laws of the market jurisdictions.
With respect to the second point, namely the desire to
appropriately limit the scope of this provision, we are confident that
it will be possible to create an active trade or business test which
appropriately distinguishes between rents and royalties derived in the
conduct of an active business, and income from more passive, investment
oriented activities. This test almost certainly should refer to
activities conducted by other members of the group for purposes of
characterizing a revenue stream as active or passive, as is currently
provided for in certain other contexts.
Perhaps the most straightforward approach would be to limit the
scope of any reform to those business activities which historically
generated rents and royalties through active business operations, and
retain current law for other income such as real property rents. This
approach would be consistent with other statutory provisions reflecting
the Congressional desire to equalize the treatment of computer software
royalties with other forms of active business income. One possible
means of limiting the scope of the proposal is to define a qualified
recipient as an entity engaged in an active software business based on
some appropriate measure, such as the presence in the affiliated group
of substantial development, marketing, and/or other business
activities.
In closing, it is important to note that, if FSC/ETI is repealed,
these Subpart F reform proposals will not completely make up any lost
FSC/ETI benefit to the U.S. software industry. However, these reforms
will provide a portion of the lost benefit and will significantly
improve the international competitiveness of U.S. industry.
Thank you for the opportunity to testify today. I will be happy to
answer any questions you may have, and I ask that my written statement
be made a part of the record of this hearing.
The Software Industry Coalition for Subpart F Equality
Adobe Systems Incorporated
Amazon.com
Attachmate Corporation
BMC Software
Citrix Systems, Inc.
i2 Technologies, Inc.
IBM Corporation
J.D. Edwards & Company
Microsoft Corporation
Network Associates, Inc.
Novell, Inc.
Onyx Software Corporation
Oracle Corporation
Parametric Technology Corporation
Peregrine Systems, Inc.
Rational Software Corporation
Symantec Corporation
VERITAS Software Corporation
Information Technology Association of America (ITAA) \6\
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\6\ ITAA provides global public policy, business networking, and
national leadership to promote the continued rapid growth of the
information technology industry. ITAA consists of over 500 corporate
members throughout the U.S., and has a global network of 46 countries'
IT associations called the World Information Technology and Services
Alliance (WITSA).
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Business Software Alliance (BSA) \7\
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\7\ The Business Software Alliance (BSA) is a leading organization
dedicated to promoting a safe and legal online world. BSA educates
computer users on software copyrights and cyber security; advocates
public policy that fosters innovation and expands trade opportunities;
and fights software piracy. BSA members represent the fastest growing
industries in the world.
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Software Finance & Tax Executives Council (SoFTEC)
\8\
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\8\ The Software Finance and Tax Executives Council (SoFTEC) is a
trade association providing software industry focused public policy
advocacy in the areas of tax, finance and accounting.
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Chairman MCCRERY. Certainly will, Mr. Sprague. Thank you
for your testimony. Mr. Cowen?
STATEMENT OF ROBERT COWEN, SENIOR VICE PRESIDENT AND CHIEF
OPERATING OFFICER, OVERSEAS SHIPHOLDING GROUP, INC., NEW YORK,
NEW YORK, ON BEHALF OF INTERNATIONAL SHIPHOLDING CORPORATION,
NEW ORLEANS, LOUISIANA
Mr. COWEN. Thank you, Mr. Chairman, and thank you to all
the Members of the Subcommittee for affording us the
opportunity to testify today on these important issues. My name
is Bob Cowen. I am Senior Vice President and Chief Operating
Officer of Overseas Shipholding Group (OSG). My testimony today
focuses on the significant hardship created for U.S.-based
shipping companies by the present subpart F rules. My testimony
today is endorsed by International Shipholding Corporation,
headquartered in Louisiana, which also operates in our
business.
My company, OSG, is a major international shipping business
domiciled in Delaware and headquartered in New York. Through
our subsidiaries we own a diversified fleet of oceangoing oil
tankers and other bulk cargo vessels which operate in both the
U.S. flag and international flags markets. The OSG is the sixth
largest tanker owner in the world today.
Precisely because OSG is a U.S. company, we face an
overwhelming tax disadvantage as we compete in the global
shipping marketplace. As a result of legislation enacted in
1975 and 1986, the United States imposes tax currently on the
income earned abroad by OSG's subsidiaries. By contrast, our
foreign competitors typically are not taxed at all on their
shipping income.
The shipping industry is a prime example of the issues that
are the subject of this hearing and also of the debate over so-
called corporate inversion transactions. It is telling that the
treatment of shipping income was the first example of anti-
competitive U.S. tax law that was cited by the Treasury
Department in its report on inversion transactions. I note that
Barbara Angus this morning in her testimony also alluded to our
problem. As the Treasury Department noted, the disadvantages
under present law mean U.S.-based shipping companies have less
after tax income to reinvest in their business, which means
basically less growth. Put differently, OSG's ships would be
more valuable today if they were owned by a foreign company.
You might ask what does it matter if U.S.-based carriers
are taxed more heavily than their foreign competitors. There is
a simple and compelling answer. If the law is not changed,
there will be fewer and fewer U.S.-based carriers and fewer and
fewer U.S.-controlled ships to meet America's national security
and economic security needs. Indeed, U.S. participation in
international shipping is already in a state of dramatic
decline. In a world where almost all bulk seagoing
transportation is conducted on foreign flag vessels, the number
of U.S.-owned foreign flag vessels has declined by over 60
percent since 1974. From 1988 to 2000, the number of U.S.-owned
foreign flag tankers was cut nearly in half from 246 to only
126 ships. Today U.S.-owned foreign flag vessels constitute
barely 3 percent of the world merchant fleet, an astonishing
figure.
Because of the unfavorable tax treatment of U.S. companies
competing in foreign trade, we have seen the ownership of two
leading U.S. container operators, American President Lines
(APL) and Sea-Land move offshore. In 1997, APL was taken over
by Neptune Orient Lines of Singapore and in 1993 the A.P.
Moller group of Denmark acquired Sea-Land. In 1998, OMI, a
U.S.-domiciled tanker company, moved offshore to the Marshall
Islands in order to avoid the adverse competitive effects of
the subpart F rules.
Unless we change the subpart F rules a further decline in
U.S. ownership of international merchant fleets is inevitable.
The dramatic decline in U.S.-owned international fleets raises
significant national security and economic concerns for our
Nation. In times of emergency, the U.S. military relies on its
ability under law to requisition these U.S.-owned foreign flag
tankers, bulk carriers, and other vessels to carry oil,
gasoline, and other materials in defense of the U.S. interests
overseas.
The sharp decline in this fleet since the 1975 and 1986 tax
law changes and the adverse implications to U.S. strategic
interests are expected to be confirmed soon in a study
commissioned by the U.S. Navy.
Our national security also depends on America's ability to
maintain adequate domestic oil supplies in times of emergency.
One-half of every gallon of oil consumed in the United States
is imported on foreign-owned vessels. This growing dependence
on foreign parties who may not be sympathetic to American
interests and who have the ability to choke off our vital
supplies of oil in times of global crisis is cause for alarm
and must be addressed.
As Congress considers ways to make the U.S. international
tax system more competitive, whether in conjunction with the
FSC/ETI issue or the inversion debate, OSG would respectfully
submit that changes to the treatment of shipping income should
be at the top of list.
The OSG is encouraged that bipartisan legislation that
would seek to address the problems created by current law has
been introduced by Representative Weller and three other
Members of this Subcommittee, Mr. Lewis, Mr. Foley, and Mr.
Jefferson. We respectfully urge Congress to enact legislation
as soon as possible that will help level the playingfield for
U.S.-based carriers operating abroad. Such action will assure
the United States has an adequate available fleet in times of
global crisis, both to meet our military requirements and to
protect our economic security.
The OSG looks forward to working with all interested
parties to fashion a solution that will not only help U.S.
companies reclaim their share of the global shipping markets,
but will also help preserve and enhance U.S. flag shipping.
Thank you for your attention, and I would be glad to answer
any questions you might have.
[The prepared statement of Mr. Cowen follows:]
Statement of Robert Cowen, Senior Vice President and Chief Operating
Officer, Overseas Shipholding Group, Inc., New York, New York, on
behalf of International Shipholding Corporation, New Orleans, Louisiana
I. Introduction
On behalf of the Overseas Shipholding Group, Inc. (``OSG''), I
appreciate the opportunity to testify today before the Subcommittee on
Select Revenue Measures on international competitiveness issues raised
by the U.S. tax system. My testimony focuses on the significant
problems created by the present-law rules under subpart F of the
Internal Revenue Code applicable to shipping income. The views
expressed in this testimony are endorsed by the International
Shipholding Corporation, headquartered in Louisiana.
OSG, a Delaware corporation listed on the New York Stock Exchange
and headquartered in New York, is a major international shipping
enterprise owning and operating through its subsidiaries a diversified
fleet of oceangoing oil tankers and other bulk cargo vessels. Measured
by the carrying capacity of our fleet, OSG is the sixth largest tanker
owner in the world. OSG charters its ships to commercial carriers and
to U.S. and foreign governmental agencies for the carriage of petroleum
and related products to destinations around the world and in the United
States.
As a result of tax-law changes enacted in 1975 and 1986, U.S.
shipping companies are required to pay tax on income earned by
subsidiaries overseas immediately rather than when such income is later
brought back to the United States. This treatment represents a sharp
departure from the generally applicable income tax principle of
``deferral'' and, as the Treasury Department recently has noted,
operates to place U.S.-based owners of international fleets at a
distinct tax disadvantage compared to their foreign-based competitors.
The upshot is that the number of international tankers and vessels
owned by the U.S. companies has fallen to historically low levels, a
state of affairs that is raising dramatic national security and
economic security concerns. Congress can reverse this trend, and
strengthen U.S. security, by enacting legislation that restores
international parity for the U.S.-owned shipping industry.
II. OSG's Shipping Operations
OSG is engaged in the ocean transportation of crude oil petroleum
products and dry bulk cargoes in both the worldwide and self-contained
U.S. markets. It is one of the largest bulk shipping companies in the
world, owning and operating a fleet (including vessels on order)
currently numbering 50 vessels with an aggregate carrying capacity of
more than 7.4 million deadweight tons. Ownership of a diversified
fleet, with vessels of different flags, types, and sizes, provides
operating flexibility and permits maximum usefulness of its vessels.
For a variety of business reasons, each vessel is owned by a separate
corporate subsidiary, most of which are organized in foreign countries.
With respect to the domestic bulk shipping markets, OSG is one of
the largest independent owners of U.S.-flag bulk tonnage, with a fleet
that consists of 10 vessels aggregating approximately 665,000
deadweight tons. U.S. flag bulk vessels, which must be crewed by U.S.
seamen, cannot typically compete in foreign trades. The operating costs
of a U.S. flag tanker are significantly higher than those of a
comparable foreign flag tanker. Today, U.S. flag bulk vessels primarily
serve U.S. coastal trade and other niche domestic markets and
government programs.
International bulk shipping markets are primarily served by ``open
registry'' ships. To serve these worldwide markets, OSG employs a
modern fleet of 40 foreign flag vessels, amounting to almost 7 million
deadweight tons. These foreign flag vessels include 38 tankers that
range in size from the large double-hull crude carriers moving out of
the Middle East to product tankers serving U.S. ports on the Atlantic
and Pacific coasts. Competition in these markets is extremely keen, and
the markets served by OSG are highly dependent upon world oil
production and consumption. Charter rates are determined by market
forces and are highly sensitive to changes in supply or demand. Thus,
any change in labor or other operational costs--including taxes--or any
governmental regulations can have a direct and adverse impact if borne
by some but not all carriers.
The economic viability of OSG's foreign flag fleet has special
importance to the viability of its U.S. flag fleet. When markets served
by the U.S. flag fleet deteriorate, the revenues generated by the
foreign fleet can provide critical support for these domestic
operations.
III. Decline in U.S.-Owned International Shipping
The number of U.S.-owned foreign flag ships has dropped
precipitously in the aftermath of the 1975 and 1986 tax-law changes,
which are discussed further below. In 1976, there were 739 U.S.-owned
foreign flag ships. The U.S.-owned foreign flag fleet had shrunk to 429
ships by 1986 and to 273 ships by 2000. (See Exhibit A.) \1\
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\1\ Sources for data include Marcus, Henry et al, ``U.S. Owned
Merchant Fleet: The Last Wake-Up Call?'' M.I.T., 1991; Dean, Warren L.
and Michael G. Roberts, ``Shipping Income Reform Act of 1999:
Background Materials Regarding Proposal to Revitalize the U.S.
Controlled Fleet Through Increased Investment in International
Shipping,'' Thomas Coburn LLP, 1999; U.S. Maritime Administration;
Fearnleys World Bulk Fleet, July 1998, July 1993, July 1999; Fearnleys
Review, 1993, 1998, 1999; Fearnleys Oil & Tanker Market Quarterly, No.
1, 2000; Fearnleys Dry Bulk Market Quarterly No. 2, 2000.
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This decline is also pronounced in the tanker market, which is
particularly vital to U.S. security interests, as discussed further
below. From 1988 to 2000, the number of U.S.-owned foreign-flag tankers
fell by nearly 50 percent, from 246 ships to only 126 ships. (See
Exhibit B.)
As a result, U.S. companies now hold precious little share of the
world shipping marketplace. From 1988 to 1999, the number of U.S.-owned
foreign flag ships as a percentage of the world merchant fleet dropped
from 5.6 percent to 2.9 percent. (See Exhibit C.)
Part of this decline in recent years has been attributable to
corporate restructurings that had the effect of moving the headquarters
of global shipping companies outside the United States. Consider the
following three transactions:
In April 1997, American President Lines (``APL''),
then the largest U.S. shipper, announced that it was merging
with Neptune Orient Lines (``NOL'') of Singapore and that the
headquarters of the newly merged company would be in Singapore.
In 1998, OMI Corporation distributed to its
shareholders stock of a subsidiary in a transaction that
resulted in OMI's international shipping operations being owned
by a Marshall Islands corporation.
In December 1999, the A.P. Moller Group,
headquartered in Copenhagen, Denmark, acquired the
international liner business of Sea-Land Services, Inc., a
subsidiary of CSX Corporation, to form Maersk Sealand. Sea-Land
Services, Inc., was previously the largest U.S. shipper of
containers.
Absent a change to the subpart F rules, whose defects are discussed
further below, a continued loss of U.S. ownership of international
merchant fleets can be expected.
IV. Economic, National Security Issues
The decline in U.S.-owned international shipping is fundamentally
inconsistent with national security and economic objectives. The U.S.
military, in times of emergency, relies on the ability to requisition
U.S.-owned foreign-flagged tankers, bulk carriers, and other vessels to
carry oil, gasoline, and other materials in defense of U.S. interests
overseas. These vessels comprise the Effective United States Control
(``EUSC'') fleet.\2\ The sharp decline in the EUSC fleet since the 1975
and 1986 tax-law changes, and the resulting adverse strategic
consequences, are expected to be confirmed soon in a study that has
been commissioned by the U.S. Navy. This study is likely to conclude
that the current EUSC fleet is not large enough to satisfy U.S.
strategic needs.
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\2\ The EUSC fleet is comprised of merchant vessels, flagged in
``open registry'' countries (e.g., Liberia, Panama, Honduras, the
Bahamas, and the Marshall Islands), that are owned and operated
internationally (often through foreign subsidiaries) by American
companies, and which are available for requisition, use, or charter by
the United States in the event of war or national emergency.
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American security also depends in no small part on our ability to
maintain adequate domestic oil supplies in times of emergency. The
United States consumes approximately 19.6 million barrels of oil per
day, of which roughly 55 percent, mostly crude, is imported into the
United States. It is estimated that 95 percent of all oil imported into
the United States by sea is now imported on foreign-owned tankers. This
means that one half of every gallon of oil consumed in the United
States is carried on foreign-owned vessels. This growing dependence on
foreign parties--who may not be sympathetic to U.S. interests--to
deliver our oil in times of global crisis is cause for potential alarm.
The importance of a robust U.S.-owned international shipping fleet
was underscored in a 1989 National Security Directive on ``sealift''
sent by President George Bush to Cabinet officials (including the
Treasury Secretary) directing them to take steps to enhance the
competitiveness of the U.S. industry:
[A]ppropriate agencies shall ensure that international agreements
and Federal policies governing use of foreign flag carriers protect our
national security interests and do not place U.S. industry at an unfair
competitive disadvantage in world markets, During peacetime, Federal
agencies shall promote, through efficient application of laws and
regulations, the readiness of the U.S. merchant marine and supporting
industries to respond to critical national security requirements.\3\
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\3\ National Security Directive 28, October 5, 1989.
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In terms of U.S. tax policy affecting the shipping industry, it is
clear that this mandate has not been met.
V. The Problem with U.S. Tax Law
The dramatic reduction in U.S.-controlled international shipping,
and the EUSC fleet, over the last 25 years can be traced in no small
part to a succession of U.S. tax law changes that have placed U.S.-
based shipping companies at a significant disadvantage to their
competitors. Most foreign-based carriers pay no home-country taxes on
income they earn abroad from international shipping.
By way of background, the United States generally does not tax the
income earned abroad by separately incorporated controlled foreign
subsidiaries of U.S. corporations until the income is repatriated
(e.g., as a dividend by the foreign subsidiary to the U.S. parent
corporation). The so-called ``subpart F'' provisions enacted in 1962
are an exception to this general tax principle. Under the subpart F
regime, the principal U.S. shareholders of a U.S.-controlled foreign
corporation (``CFC'') are taxed on the ``Subpart F income'' of the CFC
in the year that income is earned by the CFC, even though the income
may not yet have been repatriated to the U.S. parent.
From 1962 until 1975, the subpart F regime specifically excluded
foreign shipping income from its operation.\4\ Accordingly, under the
general ``deferral'' principles applicable to subsidiaries of U.S.
corporations, the income attributable to foreign operations of the EUSC
fleet was, during that period, subject to U.S. tax only to the extent
it was actually (or constructively) repatriated to the United States.
---------------------------------------------------------------------------
\4\ According to the 1962 legislative history, this exclusion for
shipping income was provided ``primarily in the interests of national
defense.''
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In the Tax Reduction Act of 1975, Congress designated foreign
shipping income of a CFC as subpart F income, but provided that such
income would not be subject to the subpart F current taxation rule to
the extent the income was reinvested by the CFC in its foreign shipping
operations. When the 1975 legislation was enacted, the reinvestment
rule was acknowledged to be necessary given the capital-intensive
nature of the foreign shipping business and the importance to the
nation of a viable U.S.-owned maritime fleet.
In the Tax Reform Act of 1986, Congress repealed the reinvestment
exception and thereby eliminated the ability to defer tax on shipping
income generated by foreign subsidiaries of U.S. corporations. The
Joint Committee on Taxation staff noted, as a reason for eliminating
deferral, that ``shipping income is seldom taxed by foreign
countries.'' \5\ As an aside, one wonders what staff thought would be
the consequence of having the United States become the only country to
attempt to tax such income. Whatever may have been the ``tax policy''
rationale for subjecting shipping income to the subpart F taxing
regime, the change had but one effect: reducing the viability of EUSC
foreign shipping operations by imposing a tax burden not applicable to
competitors.
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\5\ General Explanation of the Tax Reform Act of 1986, at 970.
---------------------------------------------------------------------------
Because of the 1986 Act change, U.S. investors in international
shipping effectively now pay a ``premium'' because their investments
must be made with after-tax dollars, while most foreign-controlled
competitors invest with pre-tax dollars. Over time, these premiums on
U.S. investments require U.S.-owned vessels to command higher charter
rates than their competition in order to maintain overall rates of
return that are comparable to those earned by their foreign-based
competitors. To the extent such comparatively higher charter income
cannot be obtained--and it is clearly not possible to do so--the
overall economic picture of U.S.-owned shipping will continue to be
eroded.
The 1975 and 1986 tax-law changes trace closely to the decline in
U.S.-owned shipping highlighted above. Before subpart F was extended to
shipping income in 1975, the U.S.-owned share of the world's open-
registry shipping fleet stood at 26 percent. By 1986, when the
reinvestment exception was eliminated, the U.S. share had dropped to 14
percent. By 1996, the U.S. share had dropped to 5 percent.\6\
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\6\ Price Waterhouse, ``Decline in the U.S.-Controlled Share of the
Open-Registry Merchant Shipping Fleet Since 1975,'' June 6, 1997. The
U.S. share percentages discussed in the Price Waterhouse study relate
to the world's total open registry fleet, which is smaller than the
total world merchant fleet referenced in other statistics cited in this
testimony.
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In its recent preliminary report on corporate inversion
transactions, the Treasury Department clearly stated the problem with
present law applicable to U.S.-owned shipping:
. . . the U.S. tax system imposes current tax on the income earned
by a U.S.-owned foreign subsidiary from its shipping operations, while
that company's foreign-owned competitors are not subject to tax on
their shipping income. Consequently, the U.S.-based company's margin on
such operations is reduced by the amount of the tax, putting it at a
disadvantage relative to the foreign competitor that does not bear such
a tax. The U.S.-based company has less income to reinvest in its
business, which can mean less growth and reduced future opportunities
for that company.
Without prompt action by the Congress to reverse the misguided
application of subpart F rules to shipping income, in a short time
there are likely to be more ``runaway headquarters'' transactions like
those described above and therefore little or no remaining U.S.-
controlled international shipping. Treasury Secretary O'Neill put it
well when he released the corporate inversion report:
In addition, if the Tax Code disadvantages U.S. companies competing
in the global marketplace, then we should address the anti-competitive
provisions of the Code. I don't think anyone wants to wake up one
morning to find every U.S. company headquartered offshore because our
Tax Code drove them away and no one did anything about it. This is
about competitiveness and complications in the Tax Code that put U.S.-
based companies out of step with their foreign competitors.
OSG is encouraged that bipartisan legislation that would seek to
address the problems created by current law has been introduced in this
Congress by Rep. Jerry Weller (R-IL) and co-sponsored by
Representatives Charles Rangel (D-NY), Phil Crane (R-IL), Ron Lewis (R-
KY), Mark Foley (R-FL), William Jefferson (D-LA), John Shimkus (R-IL),
and Judy Biggert (R-IL).\7\ OSG appreciates that other Members of
Congress, including Rep. Clay Shaw (R-FL), have introduced similarly
oriented bills in the past.
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\7\ ``The Restore Access to Foreign Trade Act,'' (H.R. 3312).
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VI. Recommendation
OSG respectfully urges the Congress to enact legislation as soon as
possible that will help level the playing field for U.S.-based carriers
operating abroad. Such action will help provide the United States with
a robust available fleet in times of global crisis, which will restore
U.S. strategic capabilities and strengthen our economic security. OSG
looks forward to working with all affected parties to fashion a
solution, which not only will help U.S. companies reclaim their share
of the global shipping markets but also will help preserve and enhance
U.S.-flag shipping.
Exhibit A
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
Exhibit C
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
Sources for data include Marcus, Henry et al, ``U.S. Owned Merchant
Fleet: The Last Wake-Up Call?'' M.I.T., 1991; Dean, Warren L. and
Michael G. Roberts, ``Shipping Income Reform Act of 1999: Background
Materials Regarding Proposal to Revitalize the U.S. Controlled Fleet
Through Increased Investment in International Shipping,'' Thomas Coburn
LLP, 1999; U.S. Maritime Administration; Fearnleys World Bulk Fleet,
July 1998, July 1993, July 1999; Fearnleys Review, 1993, 1998, 1999;
Fearnleys Oil & Tanker Market Quarterly, No. 1, 2000; Fearnleys Dry
Bulk Market Quarterly No. 2, 2000.
Chairman MCCRERY. Thank you, Mr. Cowen. Mr. Parsons?
STATEMENT OF DOUG M. PARSONS, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, EXCEL FOUNDRY AND MACHINE, INC., PEKIN, ILLINOIS, ON
BEHALF OF NATIONAL ASSOCIATION OF MANUFACTURERS
Mr. PARSONS. Well, good afternoon now, Chairman McCrery and
Members of the Subcommittee, I want to thank you for the
opportunity to appear before you today and present the views of
Excel Foundry and Machine, and the National Association of
Manufacturers (NAM) on the way to promote the competitiveness
of U.S. companies while respecting international obligations
under the World Trade Organization agreement.
I am Doug Parsons, and I am President and Chief Executive
Officer of Excel Foundry and Machine, and before I go on with
that I just want to interject a few points, and that is I am a
pretty small fish in this room. I am a manufacturing company,
do about $12 million in revenue, and I just want you to know
that the elimination of the FSC/ETI benefit would greatly
impact my company. A third of my business is international and
a lot of those countries I try to get product into have tariffs
on my product and some very tough competition.
So, I just want to get that across in that this isn't all
about big huge multinational organizations. This is about small
manufacturing companies that are looking to international
markets not just to grow but to survive.
The National Association of Manufacturers is the Nation's
largest industrial trade organization, representing 14,000
member companies, including 10,000 small and mid-sized
companies and 350 member associations serving manufacturers and
employees in every industry sector in all 50 States.
Headquartered in Washington, D.C., the NAM has 10
additional offices across the country. Excel Foundry and
Machine supplies precision machines, bronze and steel parts for
heavy equipment-related industries, such as mining, crushing,
and mineral processing. Founded in 1929, the company had $12
million in sales in 2001 and projects $14 million in 2002.
Excel, which operates a subchapter S corporation, has 95
employees at its facility in Pekin, Illinois.
The current extraterritorial income regime as well as its
predecessors, the DISC and FSC, have been integral factors in
increasing export activities by U.S. manufacturers. According
to the IRS, of the roughly 4,300 FSCs in existence in 1996, 89
percent of them exported manufactured products. Congress first
created the DISC in 1971 to level the playingfield for U.S.
companies, large and small, selling their products overseas.
These three types of tax incentives created over the past three
decades were designed to neutralize some of the tax advantages
enjoyed by our foreign competitors located in countries with
territorial tax systems which generally exempt income earned
outside of the country from income tax and exports from value
added and other consumption taxes.
Traditionally, much of the attention in this area has been
focused on FSCs used by large companies. The FSC benefits also
are important to small and mid-sized manufacturers that export.
In fact, exporting goods overseas is more than a sideline for
many of these small companies, essentially it's a necessity of
staying in business. Smaller companies often turn to export tax
incentives to effectively compete in global marketplaces.
According to the NAM survey in 2000, small and mid-sized
manufacturers save on average about $124,000 annually by using
the FSC.
It is critically important to continue to encourage export
activity by these small companies. Of all the exporting
manufacturers in America, 93 percent are small and mid-sized
manufacturers. These firms, which individually employ anywhere
from 10 to 2000 employees, together employ roughly 9.5 million
people. Small and mid-sized manufacturers add jobs 20 percent
faster than firms that remain solely domestic and are 9 percent
less likely to go out of business.
For my company, Excel Foundry and Machine, selling products
in an international market means more than reaching a few
additional customers. International sales contribute to the
growth and health of the company, allowing us to expand by
adding new space, hiring more employees, and making capital
investment. International sales account for one-third of our
revenue and these sales are responsible for the tremendous
growth of the company, 30 percent over the last 4 years, and we
anticipate 20-percent growth this year. They have enabled the
company to begin building a 20,000 square foot expansion.
In the past Excel used a foreign sales corporation, and we
currently use the extraterritorial income regime. The benefit
provided by FSC/ETI justified the additional efforts to go into
these overseas markets to compete. For example, the tax system
in some South American countries heavily favor local suppliers.
The FSC/ETI have leveled the playingfield and you just can't
pull that incentive away from us.
Moreover, the loss of tax incentives like those provided by
FSC/ETI would have a tremendous impact on the company,
affecting revenues and employment. There are many hidden costs
in doing business internationally. In markets where margins are
already thin we would lose sales due to an uneven playingfield.
If these sales slump, Excel would likely have to cut between 3
and 5 percent of its workforce.
With the June 17, 2002, scheduled release date for the WTO
arbitration panel's sanctions report fast approaching, we are
pleased that the EU recognizes the difficulties of the
situation and has agreed to delay imposing sanctions until at
least 2003. However, 6 months is not enough time. It is clear
the international tax issues involved are complex and a
considerable amount of time will be required to develop and
implement appropriate legislative response.
Let me skip to the end here.
Really, no consensus has been found yet on an appropriate
solution, and the current proposals vary considerably, ranging
from substituting other changes in the international tax area
for the FSC/ETI to a legislative framework and timeline to
achieve compliance with WTO rulings.
As a small U.S.-based manufacturer, I am concerned that
some of the proposed solutions are targeted to multinational
corporations with subsidiary operations and employees outside
the United States. These changes will not benefit small
exporters like Excel with operations only in the United States
and thus will not serve as an adequate substitute for FSC/ETI.
I want to thank you for your time today and just for
providing the tools for American manufacturers, large and
small, to effectively compete with their foreign counterparts.
Chairman MCCRERY. Thank you, Mr. Parsons. Mr. Newlon?
STATEMENT OF T. SCOTT NEWLON, MANAGING DIRECTOR, HORST FRISCH
INCORPORATED
Mr. NEWLON. Thank you, Mr. Chairman and Members of the
Subcommittee, for giving me the opportunity to testify before
you today. My name is Scott Newlon. I am a Managing Director of
Horst Frisch Incorporated, an economics consulting firm. For
the record, I am testifying today on my own behalf and not as a
representative of any organization.
My testimony focuses on the international provisions of the
Tax Code, which is an area in which there is certainly great
scope for improvement and reform. There are of course worthy
policy options that should be considered in the context of a
broader reform of corporate taxation within the United States,
such as fixing the alternative minimum tax and integration of
the corporate and individual tax systems.
In considering policy options, we should not lose sight of
the fact that there are various valid objectives in developing
tax policy. Those include of course competitiveness, the
ability of U.S. firms to compete successfully with foreign
firms in domestic and international markets. There is economic
efficiency, which is generally understood to mean that the tax
system should affect as little as possible the allocation of
resources to the most productive investments. In other words,
to the greatest extent possible, the tax system should stay out
of the way of the decisions of individuals and businesses.
There is preservation of the tax base. The U.S.
international tax regime should not undermine our ability to
collect tax on the U.S. tax base, whatever we decide is the
appropriate U.S. tax base.
Finally there is simplicity. Complexity in tax provisions
can create substantial costs of compliance for taxpayers and
Administration for the IRS.
These objectives, while sometimes they go together, often
they are competing, and there have been tradeoffs made in the
development of tax policy. Over the years, in the development
of international tax policy, I think we have seen a lot of
focus on the first three of those objectives that I mentioned:
Competitiveness, economic efficiency, and preservation of the
tax base. The simplicity objective has received short shrift.
As a result, over the years we have ended up with a hodgepodge
of international tax rules that are complex and difficult to
administer.
Given the limited amount of time I have for my comments, I
wanted to summarize my principal conclusions. First, and maybe
I am a little bit alone here but I will state it, I think if
the WTO decision on FSC/ETI results in the repeal of those
provisions, I think we are ahead of the game in terms of the
welfare of the American people in general. These provisions are
an export subsidy that distorts trade. It may benefit
particular companies and to some extent their workers, but in
terms of the overall economy and the American people, it makes
us poorer than a free trade policy would.
Second, the current U.S. international tax regime
represents a mixed bag in terms of its effects on
competitiveness, economic efficiency, and protection of the tax
base. In general, there is actually relatively little U.S. tax
that is collected on foreign source income of U.S. companies
from active nonfinancial foreign investment. This suggests that
at least in this area the actual tax burden from payments of
tax is not so much the issue as other issues. At the same time,
in certain other areas our tax system does present more of a
burden in terms of direct tax payments. Those are areas in
which investment and activities have been thought to be more
mobile in the past and we have developed tax provisions that
maybe didn't give enough weight to competitiveness concerns,
particularly with the increasing integration of markets and
globalization of competition.
The U.S. international tax regime clearly fails on
simplicity grounds, and in many cases U.S. companies face
onerous burdens of compliance with exceedingly complex rules.
Changes that reflect a rebalancing of our objectives in favor
of simplicity could have beneficial effects in terms of
economic efficiency and competitiveness as well.
Finally, in considering the options, one of the options
would be a territorial tax regime. That could have some
attractive features, but we should keep in mind that its
impacts on U.S. multinationals would vary. For broad classes of
companies it would not necessarily lower their tax burden. In
addition, the prospects for simplification may not be
significantly better under such a system than they are under
the current system.
Thank you.
[The prepared statement of Mr. Newlon follows:]
Statement of T. Scott Newlon, Managing Director, Horst Frisch
Incorporated
Mr. Chairman and Members of the Committee:
Thank you for inviting me to testify today on changes to the Tax
Code to promote the international competitiveness of U.S. companies in
the light of the WTO ruling. My name is Scott Newlon. I am a managing
director of Horst Frisch Incorporated, an economics consulting firm.
Throughout my career my work has focused on the economic analysis of
international tax issues in academic research, policy analysis while at
the Treasury Department, and in my consulting practice working with
multinational companies and tax authorities. For the record, I am
testifying today on my own behalf and not as a representative of any
organization.
I. Objectives and Principal Conclusions
In the announcement of this hearing, Chairman McCrery stated that
the purpose of the hearing was to ``explore a third possible response
to the WTO's ruling, namely making changes to the Tax Code to promote
the international competitiveness of U.S. companies.'' In my comments
today, I would like to focus on responses involving the international
provisions of the Tax Code, an area in which there is certainly room
for improvement. In considering such responses, we should not lose
sight of the fact that there are various objectives possible for U.S.
domestic and international tax policy:
Competitiveness: Which is generally understood to
mean the ability of U.S. firms to compete successfully with
foreign firms in domestic and international markets. This
includes competition by U.S. firms from operations in the U.S.
to serve domestic and foreign markets and competition by U.S.
firms through their foreign subsidiaries and branches.
Economic efficiency: Which is generally understood to
mean that the tax system should affect as little as possible
the allocation of resources to the most productive investments.
In the international context, this means that the tax system
ideally would not favor foreign investment over domestic
investment or vice versa.
Preservation of the tax base: The U.S. international
tax regime should not undermine our ability to collect tax on
the U.S. tax base.
Simplicity: Complexity can create substantial costs
of compliance for taxpayers and administration for the IRS.
These objectives cannot always (or, realistically, ever) be met
simultaneously, and the attempt to satisfy at least the first three of
these competing concerns, or at least to pay homage to them, has over
the years created the current hodgepodge of international tax rules.
The one objective that has received short shrift in this process is
certainly simplicity. Simplicity is related to, and can at times be
complementary with some of the other objectives. In particular,
simplicity can improve competitiveness and efficiency by reducing
burdensome compliance and planning costs.
With these objectives in mind, I will focus in the remainder of my
testimony on three areas. First, I will discuss briefly the effect the
WTO ruling and its implications for the objectives we discussed above.
Second, I will discuss the current tax system and how it measures up in
terms of competitiveness concerns and the other objectives discussed
above. Finally, I will discuss one of the principal alternatives to the
current system that is currently under discussion, some form of a
territorial tax system.
To summarize my principal conclusions:
If the WTO decision results in the repeal of the
extraterritorial income regime (ETI), we should be grateful to
the WTO for forcing us to do something that will benefit
Americans as a whole. The ETI represents an export subsidy,
which distorts trade. It may benefit particular companies and
possibly their workers, but overall it makes us poorer than a
free trade policy would.
The current U.S. international tax regime represents
a mixed bag in terms of its effects on competitiveness,
economic efficiency and protection of the tax base. In general,
relatively little U.S. tax is collected on foreign source
income of U.S. companies from active non-financial foreign
investment. This suggests that, in terms of the direct burden
of U.S. taxes, the competitiveness objective is most close to
being satisfied. At the same time, in specific areas in which
location of investment is often considered more mobile, such as
financial services, the rules emphasize efficiency and tax base
protection over competitiveness. However, given the increasing
global integration of these markets and the ease with which
companies operate across borders, it may be time to give
competitiveness concerns greater weight.
The current U.S. international tax regime clearly
fails on simplicity grounds. In many cases U.S. companies face
onerous burdens of compliance with exceedingly complex rules.
Changes that reflect a rebalancing of competing objectives in
favor of simplicity could result in net improvements in
competitiveness and economic efficiency, without substantially
undermining the U.S. tax base.
A realistic territorial tax regime could have some
attractive features, however, its impacts on U.S.
multinationals would vary, and for broad classes of companies,
it would not necessarily lower tax burdens. In addition, the
prospects for simplification may not be significantly better
than under the current system, if we continue to care about
preventing erosion of the U.S. tax base.
II. The WTO Decision
As I have stated, the WTO ruling should be considered a victory for
Americans, assuming that the extraterritorial income regime (ETI) is
repealed and the tax revenues thereby saved are used for some more
worthy policy objective. The ETI is in fact an export subsidy, which
distorts trade by subsidizing the consumption of U.S. products by
foreigners. If the subsidy increases exports at all, it has to be
because the price of U.S. exports falls relative to foreign imports.
Thus, at least a part of the benefit from this subsidy is passed
through to foreigners, and Americans as a whole are made poorer as a
result. The shareholders and workers of particular companies may get
some of the benefit from the subsidy if it increases company profits
and/or wages, but if exports are increased at all it has to be because
part of the benefit goes to foreigners.
Eliminating trade distortions like the ETI and following a policy
of free trade is likely to lead to a higher standard of living for
Americans as a whole.
III. Current U.S. Policy Towards Foreign Income
The United States taxes its resident corporations and individuals
on their worldwide income. For U.S. multinational corporations, this
system is complicated and sets up varying incentives for foreign
investment and income repatriation depending on the particular
circumstances of the U.S. parent corporation.
A. Key Elements of the System
The key elements of the system are deferral, the foreign tax
credit, the allocation of expenses to foreign income, and the income
source rules.
Deferral
The timing of the imposition of U.S. tax on the income of U.S.
companies from their foreign operations depends upon the way in which
the foreign operation is organized. If it is organized as a branch of
the U.S. corporation, then the income of the branch is taxed as it
accrues. If it is organized as a controlled foreign corporation (i.e.,
it is separately incorporated in the foreign country), then the income
(with some important exceptions) is not generally taxed until it is
remitted to the U.S. parent. This delay in the taxation of a
subsidiary's profits until they are actually remitted is known as
deferral.
Under the current tax rules deferral is limited by anti-deferral
rules that are targeted at certain types of income that are considered
to be particularly mobile or low-taxed. These anti-deferral rules
(largely the subpart F provisions) are the source of considerable
complexity.
Foreign Tax Credit
To avoid double taxation, a credit against U.S. tax is provided for
foreign taxes paid on foreign source income. The credit covers both
taxes incurred directly on payments of income from abroad, such as
withholding taxes on dividends, interest and royalties, and, for income
from a controlled foreign corporation (i.e., a separately incorporated
subsidiary of a U.S. company) the foreign taxes on income out of which
a dividend distribution is made to the U.S. parent company. The foreign
tax credit is limited to the amount of U.S. tax payable on the foreign
income. If the foreign tax exceeds the U.S. tax payable, excess credits
are created. These excess credits may be carried back two years or
forward five years to offset U.S. tax payable on foreign income in
another tax year.
The limitation on the foreign tax credit operates to a large extent
on an overall basis, that is, income from different sources can be
mixed together and excess credits from a source of income that faces a
high foreign tax rate may be used to offset U.S. tax from a source of
income that faces a low foreign tax rate. This ``cross-crediting'' is
limited by the placement of various different types of foreign source
income into nine different ``baskets'' that are each subject to a
separate foreign tax credit limitation. Most foreign source income
falls into the general limitation basket. The separate limitation
categories generally include types of income that are subject to low
foreign taxes or are considered to be particularly mobile and thus
easily located in low-tax locations.
The large number of separate limitation baskets creates a
substantial degree of complexity and imposes costly recordkeeping
burdens.
Expense Allocation
The allocation of expenses to foreign source income has the
objective of determining the appropriate amount of foreign source net
income, which feeds into the calculation of the foreign tax credit
limitation. In principle, only expenses that support the earning of the
foreign source income should be allocated to foreign source income.
Since the allocated expenses are typically not deductible in the
foreign jurisdiction, the effect of allocating expenses against foreign
source income is to reduce the foreign tax credit limitation. If the
taxpayer has excess foreign tax credits at the margin the allocation of
expenses to foreign source income in this case effectively represents a
denial of the deduction.
The rules regarding allocation of interest expense merit specific
discussion. These rules provide for what is referred to ``water's edge
fungibility.'' This means that U.S. interest expense is allocated
between domestic and foreign source income. The idea is that the U.S.
borrowing supports both the U.S. and foreign operations. However, as is
widely understood, this method ignores the fact that a foreign
subsidiary of a U.S. company may be supported by its own external
borrowing.
Source Rules
Any system that treats foreign source income differently from
domestic income (e.g., by allowing a foreign tax credit or exemption)
requires source rules to determine what income should be considered
foreign source. The only aspect of these rules which I will comment on
is the sales source rule. This rule permits U.S. companies that
manufacture in the United States and export their products to treat 50
percent of the income from those exports as foreign income. For those
companies that have excess foreign tax credits, this amounts to an
exemption of this income from U.S. tax.
This rule effectively amounts to an export subsidy similar to (and
more generous than) the ETI, but of benefit only to U.S. companies that
have excess foreign tax credits. The same analysis applies to this
subsidy as to the ETI: It may benefit particular firms, but it is a
distortion of trade that is likely to harm Americans as a whole.
B. Effects of the Current System
How does the current system measure up in terms of competitiveness
and the other objectives I listed above?
Standard economic analysis indicates that economic efficiency is
promoted if U.S. firms face the same tax on investment income, whether
that income is earned from a domestic investment or a foreign
investment. This is generally referred to as ``capital export
neutrality.'' On the other hand, competitiveness is promoted if U.S.
firms investing abroad face the same tax as local firms. This is
generally referred to as ``capital import neutrality.'' The current
rules regarding deferral and the foreign tax credit reflect a
compromise between the competitiveness and efficiency objectives and
the objective of preserving the U.S. tax base.
If we only cared about competitiveness, that objective could be
achieved by exempting foreign source income from U.S. tax. In that
case, the only tax that would apply would be the local tax.\1\ In many
cases, the current system in effect works like an exemption system. If
excess foreign tax credits are available for cross-crediting,
investment in a low-tax jurisdiction will in fact bear no additional
U.S. tax. Even if there are no excess foreign tax credits, if the U.S.
tax on low-tax foreign earnings can be deferred through reinvestment
abroad, its present value is reduced. If the deferral is for a
sufficiently long period of time, it is virtually equivalent to
exemption.
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\1\ As discussed further below, this ignores taxes on deductible
payments back to the United States, such as intercompany royalties,
fees and interest.
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In fact, studies indicate that non-financial U.S. companies do a
good job of avoiding substantial U.S. tax on their foreign earnings.
Using tax return data, Rosanne Altshuler and I found that non-financial
U.S. companies as a whole paid little in the way of U.S. taxes on their
foreign earnings.\2\ We found that the average U.S. tax rate on the
foreign source income of these companies was only 3.4 percent in 1986.
Harry Grubert and John Mutti performed similar, but more sophisticated
calculations using data from 1990 and found an effective U.S. tax rate
of only 2.7 percent on income paid back to the United States and 1.9
percent on total foreign income, both repatriated and unrepatriated.\3\
These data of course only deal with non-financial companies, and they
are bound to mask considerable variation across companies in terms of
their mix of business and tax position. However, they suggest that for
many U.S. companies the direct U.S. tax burden on their foreign source
income is small.
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\2\ See Rosanne Altshuler and T. Scott Newlon, ``The Effects of
U.S. Tax Policy on the Income Repatriation Patterns of U.S.
Multinational Corporations,'' in Studies in International Taxation, ed.
A. Giovannini, G. Hubbard, and J. Slemrod, pp. 77-115, Chicago:
University of Chicago Press, 1993.
\3\ See Harry Grubert and John Mutti, ``Taxing Multinationals in a
World with Portfolio Flows and R&D: Is Capital Export Neutrality
Obsolete?'' International Tax and Public Finance, 2, No. 3, November
1995, pp. 439-57.
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We have anti-deferral rules for two reasons. One is the concern
about potential erosion of the U.S. tax base if tax can be deferred
indefinitely on highly mobile types of income. If deferral were
available on passive income, for example, foreign subsidiaries could be
used essentially as mutual funds that could invest passively and avoid
U.S. tax on earnings indefinitely. There was also a concern that in the
case of business activities that were considered to be particularly
mobile, such as foreign base company sales and services operations and
financial services, deferral would provide too great an incentive to
shift activities to low-tax jurisdictions. This raised concerns in
regards both to tax base erosion and efficiency in the allocation of
investment between the United States and low-tax foreign locations.
However, competitiveness concerns may be particularly relevant in
respect of the taxation of financial services income. Integration of
international financial markets has placed U.S. financial institutions
in increasingly direct competition with foreign financial institutions.
The current U.S. taxation of foreign source financial services income
may disadvantage the U.S. firms relative to some of their foreign
competitors.
In any case, both the U.S. anti-deferral regime and the foreign tax
credit regime involve substantial complexity. Simplifying them could
bring benefits in terms of reduced compliance burdens. While there
would be some potential trade-off with competing objectives, given the
extreme complexity of the current rules, there are worthwhile trade-
offs to be made.
As noted above, the current interest expense allocation rules
generally amount to a partial disallowance of U.S. interest deductions
if the U.S. parent company has excess foreign tax credits. This raises
the cost of borrowing through the U.S. company and provides a strong
incentive to shift borrowing to foreign subsidiaries. This may harm the
firm if borrowing through foreign subsidiaries involves higher costs. A
better approach would be to allow the allocation of worldwide interest
expense for a multinational group.
IV. The Territorial Income Tax Alternative
About half of the OECD countries have a territorial system under
which dividends a company receives from foreign subsidiaries are exempt
from tax. If the United States were to adopt such a system, it is not
clear whether this would be beneficial it terms of the criteria we have
discussed: competitiveness, efficiency, preservation of the tax base or
and simplicity.
The typical territorial approach in other countries exempts only
dividend income from active businesses. Dividends from portfolio
investments and all interest and royalties are taxed when they are
paid, with a foreign tax credit provided for foreign taxes paid only on
these items of income. In addition, to varying degrees these countries
also may have their own anti-deferral regimes that tax certain income
earned by foreign subsidiaries as it accrues.
It is only natural that these countries limit the exemption in this
way. They are concerned about preservation of their tax base and do not
wish to provide their companies with inordinate incentives to invest
abroad. Exempting foreign source royalties from taxation would make it
enormously rewarding for companies to transfer intangible assets such
as patents, technology and know-how to a foreign subsidiary, since the
returning royalty could be largely untaxed. Similarly, exempting
interest receipts from foreign subsidiaries would make it enormously
rewarding for companies to push down the income of the subsidiary by
financing the subsidiary largely with debt, effectively avoiding any
tax.
Given that substantial categories of income would still be taxed on
a worldwide basis, with a foreign tax credit, and that anti-deferral
measures would remain necessary, it is unclear that an exemption system
would necessarily be any simpler than the current system.\4\
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\4\ For a complete discussion of issues in the implementation of an
exemption system, see Michael J. Graetz and Paul W. Oosterhuis,
``Structuring an Exemption System for Foreign Income of U.S.
Corporations,'' National Tax Journal, 44, No. 4, December 2001, pp.
771-86.
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Perhaps surprisingly, moving to a territorial system along these
lines would likely increase U.S. tax payments for many companies. This
would occur for three reasons. First, many companies currently use
excess foreign tax credits from highly taxed foreign source income to
offset U.S. tax on foreign source royalties. Under an exemption system,
these companies would continue to pay the same high foreign taxes on
their operations, but they would no longer be able to shelter their
foreign source royalties from U.S. tax with foreign tax credits.
Second, and similarly, many companies now benefit from the sales source
rule--but they only do so because they have excess foreign tax credits
to offset U.S. tax on the sales income that is treated as foreign
source under this rule. Under an exemption system there would be no
foreign tax credits, so this benefit would disappear. Finally,
currently allocations of U.S. interest and overhead expenses against
foreign source income result in an effective disallowance of these
deductions only when a company has overall excess foreign tax credits.
Under an exemption system, these allocations would virtually always
result in a disallowance of the deduction, since there is no tax on the
foreign source income and it would be difficult to get many foreign tax
authorities to accept a deduction against their own tax for expense
allocations of this nature. Together, these effects are so substantial
that Harry Grubert has estimated that substituting an exemption system
for the current system would actually raise tax revenue.\5\
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\5\ See Harry Grubert, ``Enacting Dividend Exemption and Tax
Revenue,'' National Tax Journal, 44, No. 4, December 2001, pp. 811-28.
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Companies that operate predominately in low-tax jurisdictions would
be more likely to benefit directly from a territorial system, since
they are not able under the current system to cross-credit to shield
their low-tax foreign income from U.S. tax. Because of this, there
would be increased incentives for companies to shift operations from
high-tax to low-tax locations. To the extent this reduces total foreign
taxes paid, it is a benefit to the United States. On the other hand, to
the extent that there is a substantial tax-induced shift of investment
out of the United States to low-tax locations, this would be harmful
both in terms of the economic efficiency of the allocation of our
capital stock and because of erosion of the U.S. tax base.
The ultimate effects of moving to a territorial system would depend
on the specific provisions of the system as adopted. Given that there
are competing valid policy objectives, and the impacts of moving to
such a system would likely vary across companies and industries, it is
unclear at this point what such a system might end up looking like if
it were actually implemented. Therefore we should be cautious about
comparing the current international tax system to an idealized
territorial system.
Chairman MCCRERY. Thank you, Mr. Newlon, and thank all of
the witnesses for your testimony. I have got a lot of
questions, but before I get to any of these specific concerns,
it just seems to me, listening to this array of witnesses, that
pretty well cuts across our industrial base, our manufacturing
base, and to some extent services, and, Mr. Newlon, it just
strikes me that we policymakers and those before us maybe, have
not done a good job in keeping our Tax Code modern, current. A
lot of these tax rules were written 30, 40 years ago when
things were a lot different in terms of how we make a living
and the kind of business we do, the kind of products we sell,
where we sell them.
So, I don't know about ripping the Tax Code out by its
roots, but it seems to me that there is a lot of spade work
that needs to be done.
We are the guys to do it.
So, Mr. Newlon, would you agree with that--that our Tax
Code is somewhat antiquated in view of the changes that have
taken place in the market over the last 10, 15, 20 years?
Mr. NEWLON. I think certainly over time that the Tax Code--
to some extent, I would say we started out with a base that we
have added to along the way. In adding to that, in some respect
we lose sight of the overall principles, and we end up with
sort of a camel that doesn't get to any of our objectives or
maybe doesn't have the appropriate tradeoffs we would want
moving forward into the future.
Chairman MCCRERY. The subpart F exceptions and--not the
exceptions; the subpart F rules were written at a time when we
manufactured widgets and sold widgets. Now, we have got
software. We have got all kinds of services that just don't
seem to fit very well under our current subpart F. That is just
one example where it seems to me we have been asleep at the
switch here.
Mr. REINSCH. That is a good example. I am going to say
something that fundamentally agrees with you, Mr. Chairman.
Globalization, which has been a long-term development,
really has changed the way that we do business in a lot of
significant ways. Free flow of capital, free flow of
technology, in particular, has made it possible for companies
to do many things now that they couldn't do before. We used to
think of trade as we export, which means the good is made here
and is shipped over there; or we import, vice versa. Now
companies have many different options, as you have seen by the
comments made here, and the subpart F rules, in particular,
haven't kept up.
At the same time, one of the things that I learned in
watching our coalition work--and I confess, as will be obvious
if you ask me any detailed questions, I am a trade person not a
tax person, and you know there is a big difference. What I
learned in watching this coalition develop is that there remain
in this country a number of very significant companies and
sectors that are still fundamentally exporters. For a variety
of reasons, they have not chosen or are not able to, or in the
case of defense-related companies are not allowed to, take
significant portions of their activities offshore.
One of the reasons we developed the proposal the way we did
is because of our realization that dealing only with subpart F
and the base rules accommodate the concerns of a number of
people who have adjusted to the changes reflected. There are a
significant number of sectors, primarily aerospace and
agriculture, that are simply not in a position to take
advantage of the trends that I have been talking about, and
those are sectors we ought to worry about too.
Chairman MCCRERY. Well, thank you. Let me get to your
proposal since you spoke up.
I have some concerns about some of the particulars with
regard to WTO compliance, and so I just want to throw a few of
these things out and give you a chance to respond. I am sure
our staff will be working with folks from your industry to
flesh out some of these concerns and get responses more in
detail.
Just to give you some idea of some of the things we are
looking at--let's see. Your list for wage credits, for example.
How did you pick the goods eligible for the wage credit? Why
didn't you include all products that are exported, like wood
products and so forth? How did you pick just that list of goods
eligible for the wage credit?
Mr. REINSCH. Well, I think there are probably two things to
say about that, Mr. Chairman. One, if we had attempted to focus
exclusively on industries that exported, or on exports, we
would probably have the same WTO problem that we have run into
with ETI. So we explicitly couldn't do that, and had to take a
different direction.
As to why we chose what we chose, I mean, to be quite frank
about it, we have a coalition, and the members of the coalition
put together the industry codes that were of interest to them.
If other people would like to join the coalition, we would be
happen to listen to them.
I would point out, there are revenue implications to that
one in particular. That is another reason why we put in an
overall cap.
Chairman MCCRERY. Thank you.
Also in your Footnote 59 proposal, there are a number of
things that you propose--expanded version of the ETI rules to
determine what is an export transaction, references to an ETI
cap, provisions permitting a tax-tree transfer of marketing
intangibles and election to use in the provision, a definition
of foreign source income including any goods susceptible to tax
and not actually subject to tax.
Did you all scrub all of these things individually and in
terms of WTO compliance? It just seems to me that some of those
might present a problem.
Mr. REINSCH. Well, if by ``scrub'' you mean, did we consult
with the European Commission, no. Did we--yes, in terms of
working with our own counsel, our trade counsel as well as our
tax counsel, yes, we did. We believe they are compliant.
With respect to just one of them, because I don't want to
use up all of your time, Mr. Chairman, but the cap that we
employ is not really related to--we don't think, in particular,
that presents a WTO problem. It is an effort to determine the
total amount of benefit that would accrue, but it is based on
the past amount of the tax benefit, not based on exports. It is
not based on current company activity, and so we think that it
wouldn't raise a compliance problem.
Our judgment at the end of the day on the Footnote 59
provision was that it would be compliant. If you would like, we
can present you in writing with a longer analysis of that
subject.
Chairman MCCRERY. Sure.
[The information is being retained in the Committee files.]
Mr. REINSCH. At the same time, I am constrained to say, Mr.
Chairman, it is my view from a trade policy standpoint that
whatever you ultimately do is likely to be challenged by the
European Commission regardless of what you or I think is
complaint.
Chairman MCCRERY. That may be the case. That is why I want
to make sure that we scrub all of these provisions and make
sure that we have the best possible case when it is, or when it
might be challenged. So, I appreciate your response.
We would like to see maybe a little more detailed
explanation of how you think these provisions would be in
compliance, and then we might take the opportunity later to
actually meet with some of your folks to go over all of that.
Mr. REINSCH. We would be glad to provide it. We would be
delighted to meet.
[The information is being retained in the Committee files.]
Chairman MCCRERY. Thank you. Mr. McNulty.
Mr. MCNULTY. Thank you, Mr. Chairman. I thank all of the
witnesses for their testimony.
Mr. Newlon, in your opinion, how competitive are U.S.
companies right now, today, internationally?
Mr. NEWLON. Well, I think obviously that varies from
company to company. Clearly the U.S. economy and U.S. companies
are some of the most competitive in the world. Obviously, the
U.S. economy has been the envy of most of the world, over the
last decade at least.
Mr. MCNULTY. Under a territorial system, who, in your
opinion, are the winners or the losers?
Mr. NEWLON. It is a little bit difficult to say until we
actually have a particular proposal for a specific territorial
system. If we went to the sort of territorial system that you
see in a lot of the other OECD countries that have territorial
systems, in which an exception was provided for active business
income, dividends effectively, or branch income, I think that
what you might see are companies that currently have excess
foreign tax credits from high-tax, foreign income, active--that
are in our active, the general limitation basket--I don't want
to get too technical here--but also have a lot of income coming
back in the same basket that doesn't face much foreign tax at
all, in particular, royalties, or intercompany interest that
might be in that basket.
Many of those companies are able to shelter that royalty
income, those deductible payments from abroad, from U.S. tax
using the excess foreign tax credits that they get from their
operations in high-tax foreign locations. That is a big benefit
to them.
There are also benefits in terms of the sales source rule,
where excess foreign tax credits may shelter U.S. income on
exports. Those benefits could be lost to those companies if we
move to a territorial system. A reasonable, logical territorial
system wouldn't exempt foreign royalties coming back, but you
would no longer have the excess foreign tax credits to shelter
that income from U.S. tax.
There would also be issues relating to allocations of U.S.
expenses against foreign income under a territorial system, and
how that gets sorted out could affect different companies
differently.
Mr. MCNULTY. Do you see any viable proposals on the table
right now to replace the ETI?
Mr. NEWLON. I would have to say, given my testimony that
what I would really be looking for myself in this area is a
broader perspective in terms of, if we are looking at the
international tax rules, going at them there is a lot of scope
for reforms that are clear winners in terms of good tax policy.
That is what I would look to if we want to use this opportunity
to improve our tax rules.
Mr. MCNULTY. Thank you, Mr. Chairman.
Chairman MCCRERY. Just following up quickly on the
competitiveness issue, you said that during the nineties the
U.S. economy was the envy of the world, and certainly our
manufacturers and so forth were very competitive.
Let's go back to the seventies. Was the picture the same
then, late seventies, early eighties?
Mr. NEWLON. No, it was not at that time.
Chairman MCCRERY. These things come and go. Some of it is
due to macroeconomic events that we can't control here. Some of
it is due to tax policy. In the early eighties, when we allowed
the manufacturing sector very liberal expensing rules, they
rebuilt, became much more efficient, became competitive with
the Japanese, and so forth.
I mean, there are a lot of things that go into this, but I
think it is incumbent upon us to continually review this and
make sure, or try to make sure, that the things we can control,
like tax policy, don't impede our domestic industries as they
try to stay competitive. We can't just rest on our laurels and
say we are good, so we will just say that way forever.
So, I just wanted to throw that in. Mr. Ryan.
Mr. RYAN. Thank you, Mr. Chairman.
Mr. Reinsch, I have a question on your subpart F proposal,
and I just want you to clear up something for me, if you could.
Your subpart F base company proposal permits base company
income from exports to be repatriated to the United States tax
free, but would not allow the same tax-free repatriation for
nonexport-based company income.
Why do you distinguish between the two? Don't you create a
WTO problem by doing that?
Mr. REINSCH. Well, as I mentioned to Mr. McCrery, Mr. Ryan,
I am a trade policy person.
I would like to ask Ms. LaBrenda Garrett-Nelson to comment
on that--she was the consultant that developed that piece of
our proposal--with your permission.
Ms. GARRETT-NELSON. That element of what is a conceptual
proposal is, based on the rationale of Footnote 59, that you
can permit an exemption for that type of income. That is why we
did not believe it would present a WTO compliance problem.
Mr. RYAN. It changes the tax treatment on exporters vs.
nonexporters. So, if a U.S. company is building it here and
selling it there, they can repatriate the income tax free, but
if they build it there, sell it there, they get taxed on it?
Ms. GARRETT-NELSON. That is the correct reading of it.
Mr. RYAN. You don't think that that appears to be----
Ms. GARRETT-NELSON. Well, part of the problem, this is why
Mr. Reinsch was suggesting that we would need to work with the
Committee and its staff. Part of the problem is that we are
dealing with language in a WTO opinion that really is dicta,
because what it had before it was a system that did not fit
within the exception, but they acknowledged that there is an
exception. So there is some uncertainty; short of the EC
blessing a package, there will be uncertainty.
Mr. RYAN. We are having these discussions because their
definition of indirect and direct taxes are different than our
definitions, and so we are going down this road. I guess we
will just talk about this later.
It doesn't seem to be WTO compliant to me, but maybe I am
wrong. I would love to learn more about the proposal.
Ms. GARRETT-NELSON. We would love to share more about it
with you.
Mr. RYAN. Thank you.
Mr. Newlon, I want to ask you a quick question. When you
summarized your testimony a minute ago, and correct me if I am
wrong, you said that it would be better for U.S.
competitiveness to simply eliminate the ETI, period, and that
we would need to go to, down the road, fundamental tax reform,
making our international rules more competitive.
Is that your testimony? Are you suggesting that ETI only
benefits a handful of companies and that if we eliminated ETI,
it would be make us more competitive, in and of itself?
Mr. NEWLON. What I would say, I don't think we need to go
to a necessarily--to fundamental tax reform to have
improvements that would help our competitiveness more generally
and just represent good tax policy.
In the international tax area there are lots of things that
can be done. Simplify the system to eliminate some
disadvantages potentially in some areas where we may have had a
lot of concerns about the location of investment that may have
now been overtaken by developments in the global economy.
In terms of the ETI/FSC, obviously it depends on what you
do with the money that comes out of that. You know, if the
money is thrown away or used for something that is bad tax
policy, we could end up worse off. My view is that FSC/ETI
isn't good tax policy in itself. So eliminating that, we have
the opportunity to do a lot better.
Mr. RYAN. Something needs to replace it to end the double
taxation on the income, correct?
Mr. NEWLON. I don't think that there is a double-taxation-
of-income issue necessarily there. I would say there is plenty
of opportunity here to replace--if we want to view it in that
way, use those revenues for things that will help the American
economy and help the American people, improve the productivity
of our economy.
Mr. RYAN. Okay. Well, I have many follow-ups, but I see my
time has run out, so I will yield.
Chairman MCCRERY. Thank you, Mr. Ryan.
I would tell the Members, if you desire a second round of
questioning, we certainly can do that. Mr. Neal.
Mr. NEAL. Can we get Mr. Hubbard to come back?
Thank you. I want to agree with Jim McCrery in his comments
a couple of moments ago about the changes that have taken place
and what it had done to promote the economic growth of the
nineties. I don't think we should discount deficit reduction
and debt reduction either; that had a huge impact on what
happened throughout the nineties.
Mr. Reinsch, in your June 11 report you say that you are
against the territorial tax system. I bet you were surprised at
the amount of attention given to this subject in the
Administration's testimony on the prior panel.
Is it your understanding that territoriality is one of the
options that the Treasury Department is seriously considering
to replace the current system of taxation?
Mr. REINSCH. We have not thus far believed that that was
the case. I think that the signals we have gotten from them in
our meetings with them, and that includes the witnesses that
you had, were primarily that they intend to work closely with
your Committee and would be guided in part by where you all
want to go.
We have not had the sense that they are dying to go down
that road.
Mr. NEAL. Fair enough.
I also noted that Ingersoll-Rand is a member of this study
group that issued the report. Is the National Foreign Trade
Council, representing U.S. multinational businesses, aware that
Ingersoll-Rand is a Bermuda company, having forsaken U.S.
citizenship to avoid taxes?
Mr. REINSCH. They are on our board. Yes, I am aware of it.
They are--well, let me just stop there.
Mr. NEAL. You don't have to.
Mr. REINSCH. Prudence would dictate. Let me just say they
are not a member of the FSC/ETI coalition. They did participate
in the territorial study.
Mr. NEAL. Thank you.
Mr. Cowen, the Chairman of the Subcommittee, Mr. McCrery,
and I, we have worked very hard, we have done it hand in glove
with the issue of trying to reform subpart F of the Tax Code.
So, we hear what you are saying.
In the past years, the industry does not always present, as
you know, a united front. So let me ask just three specific
questions.
Do you have an idea of the cost to the Treasury Department
of making a tax change to benefit your industry?
Mr. COWEN. My understanding is that there is no current
estimate available, and we are in the process of providing
information to the staff so that one can be obtained.
Mr. NEAL. How many jobs do you estimate would be created
for American citizens by that tax change?
Mr. COWEN. Well, of course I would have to make certain
assumptions as to the amount of increased activity there would
be in our business.
I would only say this. I believe that if we create an
opportunity for American companies to be competitive in the
foreign trades, we will see business created here, we will see
capital flow in, we will see companies based in the United
States with shore-side staffs and technical expertise.
We will also see, I believe, a U.S. flag component of that,
with U.S. jobs, because when the companies are here with that
expertise and those headquarters, they are going to actually be
looking at U.S. business the same way that we do today.
Mr. NEAL. Fair enough. The last part of it, number three,
does organized labor support the proposal?
Mr. COWEN. We are in discussions with our unions. I am
optimistic that they will come along with us, because in the
long run, OSG has demonstrated, and some of our competitors
have demonstrated too, that if you are strong on the foreign
side, you can also be there on the American side, to do the
Jones Act, to build the ships we need for the Jones Act trade
and the Alaska trade and other activities domestically.
Mr. NEAL. Thank you.
Chairman MCCRERY. Mr. Cowen, let me follow up. You pointed
out in your testimony that there have been a number of high-
profile transactions in which foreign shippers have bought
American shippers, and they have become foreign-owned
companies. You talk about the tax policy that contributes to
that.
Are there other reasons besides tax policy that we have
seen so many American shippers leave or be bought?
Mr. COWEN. I think in our case it is really that simple; it
is driven by tax policy. The normal flow of capital would
suggest that with the high level of interest in the United
States in the movement of oil and movement of bulk commodities
worldwide, you would expect there to be a flow of capital here
into unto that activity. It is simply the fact that the
incentives are turned upside down, and our foreign competitors
have different economics than we have, because of the tax law
that the United States has in place today under subpart F.
I think that really goes a long way in explaining why we
don't see the U.S. companies staying here, but we have seen a
lot of companies bought out or move.
Chairman MCCRERY. Thank you.
Mr. Kostenbauder, you talked a little bit about the
foreign-based company sales and services rules and how Hewlett-
Packard might be affected by those changes. Can you expand upon
that a little bit--how you might arrange your business
activities in Europe, for example, differently if those rules
were repealed?
Mr. KOSTENBAUDER. Sure. Let me make a point about the
general European environment.
Certainly it is a very big market. We have a lot of very
powerful competitors, and they are free to organize themselves
considering tax, as well as their normal business
considerations, in a way that optimizes their performance. The
way our competitors organize themselves might focus on lowering
taxes, but it could also focus on reducing other kinds of
costs, concentrating headquarters activities in a particular
location, or other considerations.
Our competitors there have the ability to do that as
European companies focusing on the European tax environment. A
company like Hewlett-Packard, which is subject to the subpart F
rules, can try to maximize its efficiency and organize itself
much like our European competitors. Our foreign competitors are
often organized in a way that the subpart F rules would be
applicable if they were subject to them, but they are not. So,
U.S. companies would never be able to achieve the same kind of
simplification and reduction of costs and tax expense because
subpart F puts a 35-percent automatic tax on most such cost
reductions.
I joined HP in 1980, so it is about half the lifetime ago
of subpart F, and one of the things that happened in my
experience with a company like HP--I think it was very typical
of most companies--was that activity used to be very country-
based.
So, we had a German subsidiary. It basically dealt with the
German marketplace, and a French subsidiary dealt with the
French marketplace.
Today, as a company, HP is trying to become much more
active in services. The whole electronics industry, instead of
selling people computers or software, is trying to sell
solutions. So if you think about solutions, there is not a
German or a British solution, but rather there is a solution
for the financial services sector, or the retail sector, or for
manufacturers. So increasingly, we have expertise related to
financial institutions that may be headquartered in London.
Well, everybody is using network software, computers, and
so forth. What is different? Well, the financial services
customers really need security. They really need encryption,
they need a lot of powerful fire walls.
There may be a concentration in France of employees who
have an expertise in retail. So you have some concern about
security in a retail context, but you really want to have all
of those cash registers out there collecting all of that point
of sale information, on a realtime basis putting that in a
database.
Well, our people that sell those things have expertise in
those different areas, and other kinds of expertise that might
relate to manufacturing. So today, and as I look at HP's
future, we are going to have a lot more of these kinds of
market focused activity that are going to be headquartered in
one country with people traveling to other countries. As I
mentioned earlier, when services are purchased from one
affiliate and delivered in another country, you have that
combination of a related party transaction and some activity
outside of the country of incorporation which triggers subpart
F foreign base company rules.
Our European competitors would not need to worry at all
about the subpart F rules. They also wouldn't have to worry one
little bit about the compliance and even the planning for it.
When we do some of these things, again that European companies
can do, based upon European considerations, our U.S. tax
department has to be involved to oversee that and to try to
make sure that we are, in fact, complying with the requirements
of U.S. laws as well.
Chairman MCCRERY. Mr. Sprague, how about the software
manufacturers? Would repeal of the base company sales and
service rules be beneficial to you?
Mr. SPRAGUE. Yes, very much so, essentially for the same
reasons that Dan mentioned with respect to HP. The software
industry also is heading toward business models that involve
regionalized locations--software development located in a
certain place, software support services being provided from a
different place, along with intangible property being licensed
between related entities in order to allow distribution of
products.
When you think about what subpart F addresses, it addresses
or it impacts any transaction that goes across country borders.
So, subpart F puts a real burden on any company that tries to
centralize functions in one place, but provides value, whether
it is goods, services, licensing, or whatever, across country
borders.
It is still the case that, from a local perspective, you
tend to want a separate German entity and a separate French
entity and a separate Japanese entity for labor law reasons and
all sorts of other things. When you overlay that separate
company or separate country entity regime on top of a
globalized and regionalized distribution system, you run into
subpart F complications every which way from Sunday.
So, the repeal of foreign base company sales income, and
services income also, would benefit the software industry.
The additional point about the need to also reform the rent
and royalty rules comes from the situation that we have a law
that was enacted 40 years ago when the software industry just
did not exist. Today, it is a $150 billion a year industry
around the world, with business models that just were not
within the contemplation of Congress when subpart F was
enacted. We need to do the right thing to bring the law into
the 21st century.
There is one other point I would like to make. The thought
was inspired by some of Mr. Neal's questions.
In subpart F today, there does exist an active trade or
business test, in the context of rents or royalties, that
attempts to distinguish between more active rent and royalty
income versus investment-type rent and royalty income. Today
that rule has real perverse incentives. It operates today to
give incentives to U.S. companies to locate value-added
activities overseas in foreign subsidiaries.
So, what I would like to see happen is that the active rent
or royalty rule be revised so that there is not an incentive
for U.S. software companies to locate development activity or
marketing activity in foreign countries.
Chairman MCCRERY. Thank you.
Mr. McLaughlin, you mentioned that Wal-Mart owns a 6-
percent share of a large Japanese retailer, and you have the
right to purchase up to 66 percent of that Japanese retailer.
To what extent would your decision about expanding your
Japanese holdings be affected by how the Congress responds to
the WTO ruling in the ETI case?
Mr. PARSONS. Of course, the retail industry does not
directly use FSC/ETI, as I mentioned in my testimony, but
rather it is our vendors and suppliers that take advantage of
these benefits. To the extent that they are not addressed, it
would drive up the costs of our suppliers, which means it makes
us more noncompetitive as we try to go in and work in that
Japanese market, as we try to introduce U.S. goods.
Chairman MCCRERY. What would that do to your decision to
expand your ownership share in the Japanese company?
Mr. PARSONS. We are in the process at the moment of looking
at that market and doing those economics to see whether or not
we will exercise those options to move up to two-thirds. I can
only say that it will be an economic decision considering all
of the factors, including taxes.
Chairman MCCRERY. Mr. Parsons, I understand where you are
coming from. It is a problem that we have talked about on the
Committee and among staff. We don't have a magic wand that we
can wave and solve problems of compliance with the WTO and
continue to provide the same benefits. So we are looking at
other ways to assist small manufacturers to try to help.
One way that we came up with earlier this year was in the
stimulus bill for the 30-percent expensing, and also we have
looked at section 179 expensing. Are you able to take advantage
of section 179 expenses?
Mr. PARSONS. Yes, we are.
Chairman MCCRERY. So any increase in that would help you?
Mr. PARSONS. Yes.
Chairman MCCRERY. Anything else that you can give us in a
general way, outside of the export realm, that can be helpful
to you?
Mr. PARSONS. Subchapter S tax relief would be greatly
appreciated. Even little things like--for a small company, I
don't have an international tax department. We depend a lot on
sources like the National Association of Manufacturers and
others.
Just to--even in collections there are currency risks that
I take in doing business in countries such as Australia and
doing business in South America. Just collections sometimes are
very difficult, and spending 2 years collecting on an account
in Peru is not exactly how I want to spend my time.
It is difficult for a small manufacturer to go out and be
competitive in areas where we are hit with tariffs going in,
and we have a higher cost of labor. Yet, we will continue to
pound on these doors and try to generate that business, because
that is where it is at.
Chairman MCCRERY. You mentioned tariffs, so another way
that we can be helpful is to work through trade agreements to
bring down those barriers to your products entering these
countries?
Mr. PARSONS. Absolutely. If we could extend the North
American Free Trade Agreement to Chile, for instance, that
would be a tremendous benefit for us.
Chairman MCCRERY. Okay. Well, thank you. Again, I want to
thank all of the witnesses today. I thank Mr. McNulty for his
participation today.
Gentlemen, we will, I am sure, be talking with you again as
we search for a solution to this problem and the inversion
problem. Thank you.
[Whereupon, at 12:55 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of the Coalition of Service Industries
The European Commission (``Commission'') filed a World Trade
Organization (``WTO'') challenge against the Foreign Sales Corporation
(``FSC'') regime in 1997. The United States replaced the FSC with the
extraterritorial income (or (``ETI'') regime) in 2000, after the WTO
Appellate Body ruled that the FSC was a prohibited export subsidy. On
January 14, 2002, the WTO Appellate Body issued a final report finding
that the ETI regime also violates WTO agreements to which the United
States is a party. The June 13, 2002 hearing was held to explore
``making changes to the Tax Code to promote the international
competitiveness of U.S. companies,'' as a possible response to the
WTO's ruling.
CSI welcomes the opportunity to submit its comments for the record
of the June 13, 2002 hearing. CSI's members represent a broad range of
service sectors, including financial services, transportation services,
accounting, legal, and other professional services as well as
telecommunications, energy, and information technology. CSI members
entered into cross-border leasing transactions that utilized the
foreign sales corporation (``FSC'') or the ETI tax rules.
Introduction
Before enactment of the ETI regime, a taxpayer could utilize a FSC
to facilitate exports by entering into leasing transactions,
particularly long-term leases of heavy equipment, U.S.-manufactured
airplanes, rolling stock, etc. Consistent with the general practice of
the Congress, the ETI Act included grandfather provisions to cover such
cases. Grave economic harm would result to U.S. exporters and U.S.
financing companies that entered into these transactions if the
grandfather provisions enacted in 2000 as part of ETI are not continued
in any future legislation. Taxpayers should be able to proceed on the
assumption that the transition rules for leasing transactions involving
a FSC will be continued.
Similarly, if the Congress determines that ETI should be replaced,
equivalent transition relief should be extended to leasing transactions
that qualified under ETI. The taxpayers in these ETI transactions
priced their leases in reliance on the assessment of the Congress--as
reflected in the legislative history--that the law in effect when the
transactions were closed complied with the WTO obligations of the
United States.\1\ A similar analysis applies to taxpayers who entered
into long-term FSC leases containing lessee options which, while not
binding on the lessor, were also priced in reliance on FSC benefits
should the options be exercised by the lessee and accepted by the
lessor--these FSC leases and options are today eligible for tax
benefits under the ETI regime. Similar to the applicable legislative
history, the Administration's ``Appellant Submission'' to the WTO
argued that the ETI regime was drafted to comply with the applicable
WTO agreements.\2\ The Congress should seek to ensure the provision of
transition relief that will fairly treat taxpayers who have
detrimentally relied on the U.S. Government's assessment regarding the
validity of current law.
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\1\ For example, the ``Reasons For Change'' in the Report of the
House Committee on Ways and Means, H.R. Rep. No. 106-845, 106th Cong.,
2d. Sess., includes the following statement: ``The Committee strongly
believes that the substantial modification to the U.S. tax law provided
in this bill is WTO compliant.'' See also S. Rep. No. 106-416, 106th
Cong., 2d Sess. page 5, regarding the statement that the ETI
``legislation addresses both the broader issue of U.S. taxation of
income derived from foreign sales, i.e., ``extraterritorial income,''
as well as complying with the WTO rulings.''
\2\ See United States--Tax Treatment for ``Foreign Sales
Corporations, Appellant Submission of the United States, (November 1,
2002) paragraph. 67.
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The Congress should make clear that the Administration would be
expected to negotiate with the Commission and insist on the
Commission's acceptance of prospective effective dates and reasonable
transition rules in any legislative response to the WTO FSC-ETI
dispute. This is particularly appropriate in view of the fact the
United States is in the position of considering amendments to its tax
law because of a ruling handed down by an international body--not
because U.S. lawmakers determined that a policy change was in order.
Indeed, as the Administration observed in its Appellant Submission to
the WTO, ``in requiring a sovereign country to subject its taxpayers to
such a shift, the WTO rules cannot have been intended to further
require that the country deny its taxpayers the right to an orderly
shift through transition relief consistent with it practice.'' \3\
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\3\ United States--Tax Treatment for ``Foreign Sales Corporations,
Appellant Submission of the United States, (November 1, 2002)
paragraph. 262.
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LThe FSC Transition Rules Honor Binding Contracts Entered into by FSCs
or Related Parties before the Enactment of ETI
The United States' repeal of the FSC was required to ``have effect
from October 1, 2000.'' Many affected leases are long-term in nature,
some with terms as long as 20 years. The repeal of the FSC transition
rules would wreck the economics of an existing lease that was priced by
taking into account the FSC benefit to the lessor or its affiliate
(resulting in lower rentals).
The repeal of the FSC provisions was a fundamental change in tax
policy, and--as such--should not apply on a mandatory basis to
contracts that were entered into before the date of enactment. Any
other treatment could result in an unwarranted retroactive tax increase
and be totally inconsistent with past Congressional practice.
LTransition Rules Included in the ETI Act Preserved the Benefits of the
FSC Regime for Leasing Transactions
In considering the transition from the FSC rules to the ETI regime,
the Congress recognized the need for a general transition rule that
took account of existing leasing contracts. For FSCs that were in
existence on September 30, 2000, and at all times thereafter, the
amendments made by the ETI Act did not apply to any transaction in the
ordinary course of trade or business involving the FSC that occurred--
(a) LBefore January 1, 2002, or
(b) LAfter December 31, 2001, pursuant to a binding contract
that--
(1) LIs between the FSC (or any related person) and any
person that is not a related person, and
(2) LIs in effect on September 30, 2000, and at all times
thereafter.
For purposes of this general transition rule, a binding contract
included a purchase option, renewal option, or replacement option that
was included in such contract and which was enforceable against the
seller or lessor. Thus, transition relief was provided to preserve the
benefits of the current FSC regime for: The remaining term of existing
leases; The term of a new lease entered into pursuant to a renewal
option; The term of a replacement lease entered into pursuant to a
replacement option; The sale of property pursuant to a purchase option;
and other lease options that would have been eligible for FSC benefits.
The WTO's View of the Transition Rules is Simply Unacceptable
The United States must weigh the WTO Appellate Body's ruling--that
``a member's obligation to withdraw prohibited export subsidies . . .
cannot be affected by contractual obligations which private parties may
have assumed inter se in reliance on laws conferring prohibited export
subsidies,'' (para. 230 of the AB Report)--against the fundamental
unfairness inherent in significant tax law changes that have an adverse
economic impact on taxpayers who relied on their government's
assessment of current law to their detriment.
As the Administration pointed out in its Appellant Submission to
the WTO, ``without such transition rules, taxpayers lose confidence
that the tax treatment they expect will in fact prevail. The absence of
such certainty affects the ability of taxpayers to plan for their
businesses, either in the long term or even in the short term. Failure
to maintain a consistent practice of transition relief would result in
significant and inefficient transaction costs as taxpayers are required
to factor in the risk of tax changes into their transactional
planning.'' \4\
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\4\ United States--Tax Treatment for ``Foreign Sales Corporations,
Appellant Submission of the United States, (November 1, 2002)
paragraph. 265.
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U.S. practice in the development of tax law changes is to
accommodate contracts that relied on the law as it existed when the
contract was made. Thus, while it probably will be necessary to seek
the Commission's agreement to continue the FSC transition rules and
provide similar rules for ETI transactions, we believe the
Administration should strive to respect congressional precedents and
the contractual obligations of the parties who entered into leasing
transactions. Any other treatment would result in an unwarranted
retroactive tax increase and be totally inconsistent with past
Congressional practice.
LIn the Interests of Fairness and Equity, The United States Should Not
Abandon It's Long-standing Practice of Promulgating Transition
Rules When Repealing Significant Tax Legislation
The United States rarely enacts retroactive tax provisions.
Generally, retroactivity is reserved for situations where affected
transactions are viewed as ``abusive'' and some significant
Congressional action has already occurred by the effective date.
The FSC transition rules were enacted because the ETI Act effected
a fundamental change in the treatment of foreign sales transactions.
The United States generally provides transition rules when taxpayers
can demonstrate that they had already taken steps in reliance on
existing law on or before the date on which a proposed change is
effective. There are numerous precedents for providing transition rules
on the basis of a binding contract, even if subject to a condition if
the condition is not within the control of the affected taxpayer. Note
that even tax treaties typically have one-year transition provisions
under which you can continue to apply the old treaty if you choose.
There is also ample precedent for providing specific grandfather
rules for leasing transactions, mainly in the context of legislation
affecting capital cost recovery provisions. For example, the effective
date of the 1984 Tax-exempt Leasing rules \5\ was for property ``placed
in service'' after the relevant date, thus excluding property already
under lease. Also under a provision in the 1984 legislation that
applied the effective date to property leased after the relevant date,
a lease was ``not treated as entered into or renewed . . . merely by
reason of the exercise of the lessee of a written option'' that was
enforceable against the lessor on the effective date and at all times
thereafter.
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\5\ See page 76 of the General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984, prepared by the staff
of the Joint Committee on Taxation (December 31, 1984).
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Conclusion
As noted above, U.S. financing companies and other parties to
leasing transactions fully acknowledge that the WTO decision found
fault with the FSC transition rules, and the WTO maintained that these
transition rules should be withdrawn. Nevertheless, we believe the
United States should protect U.S. taxpayers who relied on U.S. law and
regulations from retroactive changes in this area after the tax
benefits have already been irrevocably factored into the economics of
leases. We urge the Congress and the Administration to include
appropriate transition rules in any legislation that moves forward to
otherwise repeal the ETI statute. We also pledge to work vigorously
with this Committee and the Administration to help obtain the
Commission's support for continuing these transition rules as part of
any final resolution of the FSC/ETI matter.
Statement of the Equipment Leasing Association, Arlington, Virginia
The Equipment Leasing Association (ELA) is submitting this
statement for the record to express our views on the need for Congress
to retain the FSC leasing transition rules in any FSC/ETI legislation
enacted by Congress, and to protect lease transactions done pursuant to
the Extraterritorial Income Act. ELA has over 800 member companies
throughout the United States who provide financing for all types of
businesses in all types of markets. Large ticket leasing includes the
financing of transportation equipment such as aircraft, rail cars and
vessels. Middle market lessors finance high-tech equipment including
mainframe computers and PC networks, as well as medical equipment such
as MRIs (magnetic resonance imaging) and CT (computed tomography)
systems. Lessors in the small ticket arena provide financing for
equipment essential to virtually all businesses such as phone systems,
pagers, copiers, scanners and fax machines.
Prior to the enactment of the Extraterritorial Income Regime, U.S.
leasing companies were able to facilitate the financing of exports by
utilizing a foreign sales corporation (FSC). At the time a FSC
transaction was closed, both the lessor and lessee relied upon the law
in existence at the time of the transaction in pricing the lease. When
Congress enacted the ETI Act, it correctly included grandfather
provisions. It is imperative that leasing companies which entered into
FSC/ETI transactions be able to proceed on the assumption that the
transition rules for FSC leasing transactions will be continued in any
future legislation. The failure to grandfather FSC and ETI leasing
transactions will have grievous consequences for both U.S. exporters
and leasing companies which relied on the tax regimes in existence at
the time they entered into the transactions, as by their nature, these
types of leasing transactions are long-term and take numerous years to
complete.
Our position that existing FSC and ETI lease transactions be
grandfathered is consistent with the approach Congress took in
considering the original transition from the FSC rules to the ETI
regime, wherein Congress provided a general transition rule taking into
account existing lease contracts. Pursuant to the general transition
rule adopted by Congress, a binding contract included a purchase
option, renewal option, or replacement option that was included in such
contract and which was enforceable against the seller or lessor. Thus,
transition relief was provided to preserve the benefits of the current
FSC regime for: the remaining term of existing leases; the term of a
new lease entered into pursuant to a renewal option; the term of a
replacement lease entered into pursuant to a replacement option; the
sale of property pursuant to a purchase option; and other lease options
that would have been eligible for FSC benefits.
It is common practice for Congress to provide transition rules in
situations where taxpayers can show that they relied on existing law
when entering into a binding contract on or before the date on which a
proposed change may become effective. Therefore, we strongly urge the
U.S. Government to protect and defend U.S. taxpayers who entered into
binding contracts and priced those transactions based on existing U.S.
law as Congress moves forward in addressing the FSC/ETI replacement
issue.
Statement of the Leasing Coalition
I. INTRODUCTION
The Leasing Coalition, a group of U.S. businesses operating in the
global leasing marketplace, appreciates the opportunity to present this
written statement to the Select Revenue Measures Subcommittee in
conjunction with its June 13, 2002, hearing on proposals to modify the
Tax Code to promote the competitiveness of U.S. companies.
In these comments, the Leasing Coalition discusses the significant
competitive disadvantage created for the U.S. leasing industry by the
so-called ``Pickle'' rules under present law. We urge the Congress, as
part of its examination our international tax rules, to repeal the
limitations on depreciation under these rules for equipment leased by
U.S. taxpayers to foreign parties. These rules are a specific detriment
to U.S. exports. Repealing them is one of the few changes that Congress
can make in the tax area that would benefit U.S. exports and still
comply fully with our obligations under the World Trade Organization.
II. IMPORTANCE OF THE LEASING INDUSTRY
The leasing industry is important to the American economy. U.S.
manufacturers use leasing as a means to provide financing for exports
of their goods in overseas markets, and many have leasing subsidiaries
that arrange for such financing. Many U.S. financial companies also
arrange for lease financing as one of their core financial
intermediation services. Ultimately, the activities of these companies
support U.S. jobs and investment.
To put the size of the leasing industry into perspective, it has
been estimated that approximately 30 percent of all equipment
investment is financed through leasing rather than outright
acquisition.\1\ Approximately 80 percent of U.S. companies lease some
or all of their equipment.\2\ Currently, more than 2,000 companies act
as equipment lessors, and equipment leasing is estimated to be a $240-
280 billion industry.\3\
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\1\ U.S. Department of Commerce.
\2\ Equipment Leasing Association.
\3\ Equipment Leasing Association.
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Leasing also promotes exports of U.S. equipment, and thus helps
U.S. companies compete in the global economy. Many lease transactions
undertaken by U.S. lessors are cross-border leases, i.e., leases of
equipment to foreign users. These involve all types of equipment,
including tankers, railroad cars, machine tools, computers, copy
machines, printing presses, aircraft, mining and oil drilling
equipment, and turbines and generators. Many of these leases are
supported in one form or another by the Export-Import Bank of the
United States, which insures the credit of foreign lessees.
III. ADVERSE IMPACT OF THE ``PICKLE'' RULES
The Deficit Reduction Act of 1984 enacted the ``Pickle'' rules
(named after one of the sponsors of the provision, then-Representative
J.J. Pickle), which reduce the tax benefits of depreciation in the case
of property leased to a tax-exempt entity. The Pickle rules generally
provide that, in the case of any ``tax-exempt use property'' subject to
a lease, the lessor is entitled to depreciate the property using the
straight-line method and a recovery period of no less than 125 percent
of the lease term.\4\ Tax-exempt use property, for this purpose,
generally is tangible property leased to a tax-exempt entity, which is
defined to include any foreign person or entity.\5\
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\4\ I.R.C. section 168(g).
\5\ I.R.C. section 168(h).
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The present-law Pickle rules place the American leasing industry
and U.S. products at a severe competitive disadvantage in overseas
markets. Because of the adverse impact of the Pickle rules on cost
recovery, U.S. lessors are unable in many cases to offer U.S.-
manufactured equipment to overseas customers on terms that are
competitive with those offered by foreign counterparts. Many European
countries, for example, provide favorable lease rules for home-country
lessors leasing equipment manufactured in the home country. In France,
for example, government approval of leveraged leases is contingent on
the investment providing an economic and social benefit for France.\6\
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\6\ ``Long Live le Leveraged Lease,'' Asset Finance, July/August
2001.
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There is no compelling tax policy rationale for maintaining the
Pickle rules as they apply to export leases. The Pickle rules were
enacted in part to address situations where the economic benefit of
accelerated depreciation and the investment tax credit were indirectly
transferred to foreign entities not subject to U.S. tax through reduced
rentals under a lease. That rationale no longer applies. The investment
tax credit was repealed in 1986, and property used outside the United
States generally is no longer eligible for accelerated depreciation.
IV. REFORMS NEEDED TO STRENGTHEN COMPETITIVENESS OF U.S.
LEASING INDUSTRY
The global leasing markets have greatly expanded since 1984. The
competitive pressures on U.S. businesses from their foreign
counterparts also have increased dramatically. Repealing the Pickle
rules as they apply to leases to foreign parties, as has been proposed
by Subcommittee Chairman Jim McCrery (R-LA) in H.R. 1493 and by Ways
and Means Committee Member Bob Matsui (D-CA) in H.R. 1492, will
strengthen the competitiveness of the U.S. leasing industry and promote
U.S. jobs and investment.
The World Trade Organization's rulings against the foreign sales
corporation (``FSC'') and extraterritorial income (``ETI'') regimes
have only bolstered the rationale for repeal of the Pickle rules as
they apply to export leases. On balance, U.S. exports are likely to be
harmed by legislation that replaces the ETI rules with provisions that
do not confer a specific export subsidy. While the Pickle repeal bills
discussed above would benefit U.S. exports, they could not be read to
provide a prohibited subsidy. Rather, they simply would remove a
blatant disadvantage for export leases under U.S. law compared to
domestic leases. Surely, removing overt current-law tax burdens on U.S.
exports would be an advisable course of action in response to the WTO's
rulings.
Statement of Donald V. Moorehead, Partner, and
Aubrey A. Rothrock III, Partner, Patton Boggs LLP
This statement is submitted for inclusion in the record of the
hearings held by the Subcommittee on Select Revenue Measures on June
13, 2002 concerning possible changes to the Internal Revenue Code of
1986, as amended (the ``Code''), in light of the recent decision of the
World Trade Organization (the ``WTO'') with respect to the
extraterritorial income provisions of the Code. We understand that, in
fashioning a legislative response to the WTO decision, consideration
may be given to making numerous changes to the provisions of the Code
governing the taxation of income earned by U.S.-based businesses from
their international operations. In this statement, we describe two
proposals that should be included as part of such a legislative
package.
Passive Income Attributable to Assets Held to Match CFC Pension
Liabilities
In the United States and many foreign countries, employers may
establish pension plans for their employees and fund those plans
through annual contributions to a separate trust or its equivalent.
Employees and their beneficiaries generally are taxed only when the
benefits are paid to them. In some countries such as Germany, however,
the use of a trust or similar funding mechanism would result in the
imposition of tax on the employees prior to the commencement of
distributions to them upon retirement.
Under German law, if an employer creates a pension plan for its
employees, it is required by law to establish a reserve on its balance
sheet to reflect liabilities under the plan and to make annual
additions to the reserve to reflect the discounted present value of its
future obligations under the plan. Although the basic benefits provided
under the plan are insured, the insurance is payable only if the
employer is unable to pay the benefits as they fall due. Employers may
not formally fund these plans, through an irrevocable trust or similar
arrangement without adverse tax consequences to their employees.
In some instances, both as a matter of financial prudence and to
foster good working relationships with their employees, an employer may
seek to ``match'' its pension obligations (and offset its balance sheet
liability) through the purchase of investment assets. German law
implicitly encourages such practices by providing special tax treatment
for certain types of investments.
When the employer is a controlled foreign corporation (a ``CFC''),
the purchase of assets to match pension obligations can create adverse
U.S. tax consequences. Specifically, the passive income generated by
such investments will be treated as foreign base company income under
the subpart F provisions of the Code and thus, unless it is de minimis
in amount, will taxed to the U.S. shareholders of the CFC (e.g., the
U.S. parent corporation) in the year earned by the CFC. Moreover, that
income will be allocated to the ``passive'' basket for purposes of
computing the foreign tax credit limitation, even though it is
incidental to the active business operations of the CFC.
We believe this is an inappropriate result as a matter of policy.
The investment of earnings to fund retirement plans has long been
recognized as desirable from a public policy standpoint and Congress
itself has sought to provide relief in most instances through section
404A of the Code. Where, however, the host country does not permit the
use of a trust or other similar arrangement without adverse tax
consequences to employees, section 404A provides no relief if assets
are acquired to ``match'' the liability represented by the pension
reserve.
We recommend that, in the case of a CFC engaged in the active
conduct of a trade or business, income attributable to investment
assets purchased to match pension reserves should be placed in the same
foreign tax credit ``basket'' as the income attributable to the CFC's
active business operations. We also recommend that such income be
excluded from the definition of foreign base company income and thus
not taxed to the U.S. shareholders of the CFC unless and until
distributed to them as a dividend or invested in U.S. property.
Foreign Tax Credit ``Stacking'' Rules
Because U.S. businesses are taxed on their worldwide income, the
income they earn from international operations is potentially subject
to double taxation: once by the foreign country in which it is earned
and a second time by the U.S. Depending upon the character of such
income and whether it is earned directly by the U.S. business or
indirectly through a CFC, the U.S. tax on foreign source income will be
payable either in the year it is earned or deferred until the income is
distributed as a dividend to the U.S. shareholders or invested in U.S.
property.
The foreign tax credit provisions of the Code are intended to
reduce the actual incidence of such double taxation and the
effectiveness with which this objective is achieved is critical to the
competitive position of American businesses in the world's markets. By
reason of the operation of certain of these foreign tax credit
provisions, a U.S. corporation may in fact be unable to claim credits
on a current basis for all of the foreign taxes paid with respect to
the foreign source income included in its U.S. tax return. This is true
even where the applicable foreign tax rates are less than the U.S.
corporate rate of 35 percent.
In such situations, the excess credits may be carried back to the
two preceding taxable years and then forward to the succeeding five
taxable years. If they cannot be used during this carryover period,
they expire. Under current law, however, excess credits that are
carried over to another taxable year may in fact be used only after the
credits used in that taxable year have been fully utilized. This
stacking rule thus increases the likelihood that otherwise valid
credits for foreign taxes actually paid on foreign source income that
is subject to U.S. tax will not be used and expire.
We believe this is inappropriate as a matter of policy. Credits for
foreign taxes actually paid on income that is subject to U.S. tax
should in our view be permitted to be used at the earliest possible
date and the Code should be structured so that expiration is only a
remote possibility. This is particularly true since many U.S.
corporations are in ``excess credit'' positions largely because of
provisions of the Code that reduce foreign source income artificially
(e.g., the over allocation of interest expense to foreign source
income) or otherwise make it difficult to use credits in the first year
they are available (e.g., the allocation of types of foreign source
income to different ``baskets'' and the prohibition on the use of
credits earned with respect to income in one basket to offset the U.S.
tax on income in another basket).
For these reasons, we recommend that section 904(c) of the Code be
amended to provide that, with respect to any taxable year, foreign tax
credits would be applied in the following order: (1) credits carried
forward to that year; (2) credits earned in that year; and (3) credits
carried back to that taxable year. This approach was taken in prior
proposed bipartisan international tax simplification legislation and,
is we believe, a more direct solution to the problem than that
contained in H.R. 4541. The proposed change would enable the foreign
tax credit to achieve its objective more effectively and would reduce
the incentive now inherent in section 904(c) for taxpayers to engage in
transactions principally to enable them to use foreign tax credits that
might otherwise expire.
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