[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


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















                            C O N T E N T S

                               __________
                                                                   Page
Advisory of June 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.

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

    Please Note: Due to the change in House mail policy, any person or 
organization wishing to submit a written statement for the printed 
record of the hearing should send it electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, by the close of business, Thursday, June 27, 2002. 
Those filing written statements that wish to have their statements 
distributed to the press and interested public at the hearing should 
deliver their 200 copies to the Subcommittee on Select Revenue Measures 
in room 1135 Longworth House Office Building, in an open and searchable 
package 48 hours before the hearing. The U.S. Capitol Police will 
refuse sealed-packaged deliveries to all House Office Buildings.

FORMATTING REQUIREMENTS:

    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
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    1. Due to the change in House mail policy, all statements and any 
accompanying exhibits for printing must be submitted electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, in Word Perfect or MS Word format and MUST NOT exceed a 
total of 10 pages including attachments. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.

    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
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these specifications will be maintained in the Committee files for 
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    3. Any statements must include a list of all clients, persons, or 
organizations on whose behalf the witness appears. A supplemental sheet 
must accompany each statement listing the name, company, address, 
telephone and fax numbers of each witness.

    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://waysandmeans.house.gov.

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

                               

    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
                  Business Software Alliance (BSA) \7\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
                  Software Finance & Tax Executives Council (SoFTEC) 
        \8\
---------------------------------------------------------------------------
    \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.

---------------------------------------------------------------------------
                               

    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \3\ National Security Directive 28, October 5, 1989.
---------------------------------------------------------------------------
    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.''
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \7\ ``The Restore Access to Foreign Trade Act,'' (H.R. 3312).

---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    \1\ As discussed further below, this ignores taxes on deductible 
payments back to the United States, such as intercompany royalties, 
fees and interest.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \5\ See Harry Grubert, ``Enacting Dividend Exemption and Tax 
Revenue,'' National Tax Journal, 44, No. 4, December 2001, pp. 811-28.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \3\ United States--Tax Treatment for ``Foreign Sales Corporations, 
Appellant Submission of the United States, (November 1, 2002) 
paragraph. 262.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \4\ United States--Tax Treatment for ``Foreign Sales Corporations, 
Appellant Submission of the United States, (November 1, 2002) 
paragraph. 265.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \1\ U.S. Department of Commerce.
    \2\ Equipment Leasing Association.
    \3\ Equipment Leasing Association.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \4\ I.R.C. section 168(g).
    \5\ I.R.C. section 168(h).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \6\ ``Long Live le Leveraged Lease,'' Asset Finance, July/August 
2001.
---------------------------------------------------------------------------
    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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