[House Hearing, 109 Congress]
[From the U.S. Government Printing Office]




                               before the


                                 of the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION


                             JUNE 22, 2006


                           Serial No. 109-82


         Printed for the use of the Committee on Ways and Means

30-706                      WASHINGTON : 2007
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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

E. CLAY SHAW, JR., Florida           CHARLES B. RANGEL, New York
NANCY L. JOHNSON, Connecticut        FORTNEY PETE STARK, California
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM MCCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM MCDERMOTT, Washington
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. MCNULTY, New York
PHIL ENGLISH, Pennsylvania           JOHN S. TANNER, Tennessee
J.D. HAYWORTH, Arizona               XAVIER BECERRA, California
JERRY WELLER, Illinois               LLOYD DOGGETT, Texas
KENNY C. HULSHOF, Missouri           EARL POMEROY, North Dakota
RON LEWIS, Kentucky                  STEPHANIE TUBBS JONES, Ohio
MARK FOLEY, Florida                  MIKE THOMPSON, California
KEVIN BRADY, Texas                   JOHN B. LARSON, Connecticut
THOMAS M. REYNOLDS, New York         RAHM EMANUEL, Illinois
PAUL RYAN, Wisconsin
MELISSA A. HART, Pennsylvania
DEVIN NUNES, California

                    Allison H. Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel



                     DAVE CAMP, Michigan, Chairman

JERRY WELLER, Illinois               MICHAEL R. MCNULTY, New York
MARK FOLEY, Florida                  LLOYD DOGGETT, Texas
ERIC CANTOR, Virginia                MIKE THOMPSON, California
JOHN LINDER, Georgia                 JOHN B. LARSON, Connecticut
MELISSA A. HART, Pennsylvania

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



Advisories announcing the hearing................................     2


R. Glenn Hubbard, Ph.D., Dean and Russell L. Carson Professor of 
  Finance and Economics, Columbia Business School, New York, New 
  York...........................................................     5
James R. Hines, Jr., Ph.D., Professor of Business Economics and 
  Public Policy, University of Michigan, Ann Arbor, Michigan.....    13
Craig R. Barrett, Ph.D., Chairman of the Board, Intel 
  Corporation, Santa Clara, California...........................    20


Paul W. Oosterhuis, Partner, Skadden, Arps, Slate, Meagher & 
  Flom, LLP......................................................    32
Michael J. Graetz, Justus S. Hotchkiss Professor of Law, Yale Law 
  School, New Haven, Connecticut.................................    42
Stephen E. Shay, Partner, Ropes & Gray, LLP., Boston, 
  Massachusetts..................................................    51

                       SUBMISSIONS FOR THE RECORD

Alliance for Competitive Taxation, statement.....................    71
Citigroup, Inc., New York, NY, statement.........................    74
Dow Chemical Company, Midland, MI, statement.....................    78
Linbeck, Leo, Americans For Fair Taxation, Houston, TX, statement    84
Nye, Perry, Tuscaloosa, AL, letter...............................    92
Petrini, Kenneth, The Tax Council, letter........................    92
Rees, Bradley S., Americans For Fair Taxation, Houston, TX, 
  letter.........................................................    94
Tittle, Martin B., Law Office of Martin B. Tittle, statement.....    95
United States Council for International Business, statement......   100
Yomtov, Adam, Elmsford, NY, letter...............................   106



                        THURSDAY, JUNE 22, 2006

             U.S. House of Representatives,
                       Committee on Ways and Means,
                   Subcommittee on Select Revenue Measures,
                                                    Washington, DC.

    The Subcommittee met, pursuant to notice, at 10:00 a.m., in 
room B-318, Rayburn House Office Building, Hon. David Camp 
(Chairman of the Subcommittee) presiding.
    [The advisory and revised advisories announcing the hearing 



                                                CONTACT: (202) 226-5911
March 15, 2006
No. SRM-7

                Camp Announces Hearing on the Impact of

            International Tax Reform on U.S. Competitiveness

    Congressman Dave Camp (R-MI), Chairman, Subcommittee on Select 
Revenue Measures of the Committee on Ways and Means, today announced 
that the Subcommittee will hold a hearing on the impact of 
international tax reform on U.S. competitiveness. This hearing will be 
part of a series of hearings on tax reform. The hearing will take place 
on Tuesday, May 23, 2006, in the main Committee 
hearing room, 1100 Longworth House Office Building, beginning at 2:00 p.
    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 Subcommittee and 
for inclusion in the printed record of the hearing.


    In its November 2005 report, the President's Advisory Panel on 
Federal Tax Reform (the Panel) criticized the current U.S. 
international tax system as one that ``distorts business decisions, 
treats different multinationals differently, and encourages wasteful 
tax planning.'' As a result, the Panel's report contained a number of 
international tax reform proposals that are intended ``to reduce 
economic distortions and improve the fairness of the U.S. international 
tax regime by creating a more level playing field that supports U.S. 
competitiveness.'' Lawmakers, taxpayers, practitioners and academics 
have similarly criticized the U.S. international tax system and have 
also proposed reforms.
    In announcing the hearing, Chairman Camp stated, ``This hearing 
will provide us the opportunity to understand how the current U.S. 
international tax system impacts the competitiveness of U.S. 
multinational corporations and to evaluate how this system can be 
reformed to enhance our competitiveness abroad and stimulate job 
creation at home.''


    The purpose of this hearing is to understand how the current U.S. 
international tax system impacts the competitiveness of U.S. 
multinational corporations and to evaluate how this system can be 
reformed to enhance our competitiveness abroad and stimulate job 
creation at home.


    Please Note: Any person(s) and/or organization(s) wishing to submit 
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                  * * * CHANGE IN DATE AND TIME * * *



                                                CONTACT: (202) 226-5911
April 24, 2006
SRM-7 Revised

                      Change in Date and Time for

                 Hearing on the Impact of International

                   Tax Reform on U.S. Competitiveness

    Congressman Dave Camp (R-MI), Chairman, Subcommittee on Select 
Revenue Measures of the Committee on Ways and Means, today announced 
that the Subcommittee hearing on the Impact of International Tax Reform 
on U.S. Competitiveness, previously scheduled for Tuesday, May 23, 
2006, at 10:00 a.m., in the main Committee hearing room, 1100 Longworth 
House Office Building, will now be held on Thursday, June 22, 2006, at 
10:30 a.m.
    The deadline to provide a submission for the record will now be 
close of business, Friday, July 7, 2006. All other details for the 
hearing remain the same.
    (See Subcommittee Advisory No. SRM-7, dated March 15, 2006).


                * * * CHANGE IN TIME AND LOCATION * * *



                                                CONTACT: (202) 226-5911
June 20, 2006
SRM-7 Revised #2

                    Change in Time and Location for

                 Hearing on the Impact of International

                   Tax Reform on U.S. Competitiveness

    Congressman Dave Camp (R-MI), Chairman, Subcommittee on Select 
Revenue Measures of the Committee on Ways and Means, today announced 
that the Subcommittee hearing on the Impact of International Tax Reform 
on U.S. Competitiveness, previously scheduled for Thursday, June 22, 
2006, at 10:30 a.m., in the main Committee hearing room, 1100 Longworth 
House Office Building, will now be held at 10:00 a.m. in B-318, Rayburn 
House Office Building.
    All other details for the hearing remain the same. (See 
Subcommittee Advisories No. SRM-7 and SRM-7 Revised, dated March 15, 
2006 and April 24, 2006, respectively.)


    Chairman CAMP. Good morning. The Select Revenue 
Subcommittee of the Committee on Ways and Means hearing on the 
impact of the international tax reform on U.S. competitiveness 
will begin.
    Everyone has found their seats. Good morning. At our recent 
hearing on corporate tax reform, a number of witnesses 
testified on the importance of international tax reform. The 
current U.S. international tax system has been characterized as 
one that distorts business decisions and inhibits the 
competitiveness of U.S. business abroad. This hearing will 
provide us the opportunity to understand how the current 
international tax system impacts the competitiveness of U.S. 
companies operating abroad and to evaluate how this system can 
be reformed and to stimulate job creation at home.
    International tax reform will be an important consideration 
in the full Committee's evaluation of the many options to 
reform the Federal Tax Code, and I want to welcome our visitors 
and witnesses, and I look forward to hearing your views on 
these important issues.
    I now recognize the Ranking Member, Mr. McNulty of New 
York, for his statement.
    Mr. MCNULTY. Thank you, Mr. Chairman.
    I recognize our witnesses, and thank you, Mr. Chairman.
    In 2002, this Subcommittee held a series of hearings 
specifically on international corporate tax reform. In 2004, 
the American Jobs Creation Act was enacted into law and 
substantially revised our international tax system.
    Even with those changes, few believe our international tax 
rules have been perfected and have reached the proper balance. 
There is no question that our current international tax 
structure remains very complex and in need of reform. It is 
clear that our tax system often carries incentives for U.S. 
companies to locate or move their operations overseas. 
Hopefully, our discussion today will focus on realistic options 
to simplify and restructure our international tax system.
    Our country's economic growth requires that U.S. companies 
be competitive both at home and in the expanding markets of the 
world. I must emphasize that our country continues to face 
record Federal deficits: The national debt has ballooned to 
more than $8.3 trillion. The goal of any future international 
tax reform measures should not be to merely provide additional 
corporate tax breaks to U.S. multinationals nor should it 
result in the shifting of U.S. jobs overseas. Our goal must be 
to modernize our tax system in a way that ensures economic 
growth in the United States and provides long-term financial 
stability for our children and grandchildren.
    Thank you, Mr. Chairman. I yield back the balance of my 
    Chairman CAMP. Thank you very much.
    Again, I want to welcome our panel. We have with us Dr. 
Glenn Hubbard, Dean and Russell R. Carson Professor of Finance 
and Economics at Columbia Business School in New York; Dr. 
James R. Hines, Professor of Business Economics and Public 
Policy at the University of Michigan in Ann Arbor; and Dr. 
Craig Barrett, Director of the Intel Corporation in Santa 
Clara, California.
    Each of you will have 5 minutes to summarize your 
testimony, and after each of you gives your testimony, we will 
have time for questioning.
    I will begin with Dr. Hubbard. Again, welcome. Thank you 
for coming. You have 5 minutes.

                       NEW YORK, NEW YORK

    Dr. HUBBARD. Thank you, Mr. Chairman and Mr. McNulty. I 
think that this is an incredibly important subject that you 
have chosen for this hearing. As a way of putting it in 
context, I think the subject today touches on the vital issue 
of competitiveness. Our economy's success absolutely and 
relative to our trading partners over the past decade has 
depended on flexibility and productivity, and growth of 
multinational companies. I think it is imperative that we not 
tie the hands behind the backs of these successful businesses. 
Today I wanted to note two points, one, that multinationals 
play a very large role in the American economy. Second, the tax 
policy toward multinationals matters, and reform is needed--or 
reform is needed and overall corporate tax reforms should 
remain a priority for your consideration.
    On the issue of multinationals, recent research among 
economists suggests that in a highly open economy, highly 
successful multinationals can boost both brand value of our 
companies and productivity. This is driven by multinationals 
who capture for all of us, essentially, the benefits of 
    Interestingly, in thinking about where these multinationals 
are, most overseas investment by American multinationals is for 
market access and remains in higher-wage, higher-tax countries.
    On the issue of tax policy, this matters a lot. Empirical 
work by myself and many other people over many years suggests 
that the way we tax multinationals importantly affects their 
investment decisions, their location decisions, and how they 
finance themselves. Our overall norms that we have 
traditionally used in this country for judging tax policies 
toward multinationals strike me as outdated. They are based on 
models of perfectly competitive firms which are not the way 
multinationals operate. They are based on norms of looking at 
worldwide well-being, which is not something we do in the rest 
of policy. In any event, the usual norm of capital export 
neutrality is not even applied in practice.
    I think more contemporary treatment of multinationals would 
suggest that, at a minimum, cash flow taxation deferral in this 
case or an exemption system of territorial taxation is far more 
defensible. As an economy, we have a strong incentive to get 
this right to maintain the productivity advantage that we have. 
A territorial tax proposal, in my view, deserves very serious 
considerations and will not affect investment or jobs.
    The corporate tax, though, remains the elephant in the 
room. This morning's Wall Street Journal referred to the action 
that has been proposed in Germany for a corporate rate cut. The 
United States has the second highest rate in the Organization 
for Economic Co-operation and Development (OECD). The corporate 
tax discourages capital formation. More recent work suggests it 
actually discourages innovation, risk-taking and, in fact, wage 
    But, importantly, to close, fundamental tax reform, whether 
you choose to examine it as an income tax or a consumption tax, 
would remove investor level taxes on corporate income. This 
necessarily implies a territorial tax. Almost any version of 
tax reform gets you there.
    Thank you again, Mr. Chairman. I look forward to your 
questions later.

    [The prepared statement of Dr. Hubbard follows:]

   Statement of R. Glenn Hubbard, Ph.D., Dean and Russell L. Carson 
Professor of Finance and Economics, Columbia Business School, New York, 
                                New York

    Mr. Chairman, Ranking Member McNulty, and members, it is a pleasure 
to have the opportunity to discuss with you the role of tax policy in 
improving the international competitiveness of the United States.
    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. Current U.S. 
international tax rules should be reviewed with an eye to reducing 
their complexity and removing impediments to U.S. international 
    The U.S. economy is increasingly linked to the world economy 
through trade and investment. U.S.-based multinationals and their 
foreign investment help bring the benefits of global markets back to 
the United States by providing jobs and income. The profitability and 
long-term viability of U.S.-based multinationals is influenced by U.S. 
tax policy.
    Like all firms, multinationals are faced with a number of business 
decisions, including how much to invest and where. Because 
multinationals by definition operate in a number of countries, they 
also have to decide in which country to locate their headquarters which 
in turn affects which countries reap the majority of benefits from the 
multinational's operations. Each of these business decisions is 
influenced by tax policy, particularly how countries tax income from 
foreign investment.
    The U.S. tax system, in the past, has chosen to tax income from 
foreign investment at the same rate as it taxes domestic income under a 
principle called capital-export neutrality. The principle is based on 
the idea that investment abroad is a substitute for investment (and 
jobs) at home, and is founded on the assumption that global markets are 
perfectly competitive. As I describe later, capital-export neutrality 
was seen as a laudable objective in the 1960s, when the United States 
was the primary source of capital investment, and dominated world 
markets. Both the global economic setting and the accepted view of 
global markets have changed dramatically since the 1960s. In the past 
few decades, other countries have come to challenge the United States' 
preeminent position in the global market, and the United States has 
become a net recipient of foreign investment as opposed to the largest 
source. There is mounting evidence that foreign affiliates are in fact 
complements to domestic investment and employment, and therefore 
should, if anything be encouraged.
    The U.S. system of taxing income from foreign investment should be 
reconsidered in the light of the new global setting. The tax system 
should enhance the competitiveness of the U.S. position in global 
markets, and ensure that Americans reap the full benefits of increasing 
trade and investment flows.

    Over the past few decades, the global economy has become 
increasingly integrated. For the United States, this integration is 
reflected by the fact that more than ten percent of the U.S. gross 
domestic product (GDP) in 2005 about $1.2 trillion was derived from 
U.S. exports of goods and services. Roughly eight percent of American 
workers produce goods and services that will be sold in foreign 
markets. In addition, imports of foreign raw materials and capital 
goods help the U.S. economy run smoothly and efficiently.
    The mirror image of increased trade in goods and services is the 
enormous rise in international capital flows over the past thirty 
years. These flows represent funds channeled from savers in one country 
to borrowers in another. The International Monetary Fund estimates that 
since 1970, gross capital flows capital flows into and out of a country 
as a percentage of GDP have risen more than tenfold for developed 
countries and fivefold for developing countries. In the last decade 
alone, estimated capital flows in developed countries have more than 
    Americans have benefited from liberalized of trade and capital 
flows. Trade enhances productivity, which is reflected in the fact that 
workers in exporting firms and industries typically earn about 10 to 15 
percent more than the average U.S. worker. More generally, enhanced 
global trade by further reducing world barriers to trade by one-third 
would be equivalent to a $2,500 per-year increase in the annual income 
of the average family of four. It is in our economic interest to 
enhance market forces and capture the benefits of international 
movements of goods and capital.
Multinational Corporations and the U.S. Economy
    Multinationals are an intrinsic part of globalization. To begin, 
they represent a substantial portion of cross-border economic activity. 
Almost two-thirds of U.S. exports take place through U.S. 
multinationals. And the involvement of the United States in global 
trade has impacts on income and employment in the U.S. economy. 
Multinationals are an intrinsic part of global integration because they 
represent an alternative means by which nations conduct cross-border 
transactions. That is, the economic costs of production, 
transportation, distribution, and final sale may be lower of conducted 
within a single firm than via a series of market transactions. 
Accordingly, the rise in global integration carries along with an 
increased volume of transactions for which multinationals have a 
particular advantage.
    To pursue their market opportunities, multinationals must make a 
number of business decisions. Like all firms, they must determine the 
scale and character of their capital expenditures, the size and skill 
composition of their labor force, and which technologies are the most 
promising. However, in each case, multinationals' decisions have a 
locational dimension as well. That is, they must determine not only the 
amount of each of these activities, but also where they will take 
place. Indeed, in the extreme, they must choose where they will call 

Why Do Multinationals Invest Abroad?
    The starting point for multinationals' investment in foreign 
countries is the same as domestic investment: profitability. As in 
other circumstances, firms will seek out profit opportunities as a 
means to provide firm growth in output, employment, revenues, and 
shareholder returns. Indeed, the research literature suggests that 
there are significant profit opportunities in this area--an additional 
dollar of foreign direct investment by U.S. corporations, in present 
value, leads to 70 percent more interest and dividend receipts and U.S. 
tax payments than an additional dollar of domestic investment.
    What opportunities are provided by foreign investment? Foreign 
investment by multinationals is often classified into two types, each 
type associated with a different motivation. In horizontal investment a 
firm invests in a similar production process in various countries. 
Building a facility abroad that is similar to domestic operations is 
one way to access foreign markets in the face of barriers (tariff or 
nontariff barriers) to trade in goods. If a market is protected by 
trade barriers, one way for a firm to get access to the market is to 
set up a subsidiary in the country, and produce the product locally 
(perhaps with foreign technology, inputs, brand names etc). Or, it may 
simply be too expensive to transport domestically-produced goods and 
remain competitive. Economic research has highlighted that trade and 
capital movements can be substitutes, and horizontal investment has 
this character. Alternatively, in vertical investment, a firm invests 
in different input processes in different countries. This kind of 
investment is often driven by different costs of operation (including 
different taxation levels). And trade flow data generally support the 
horizontal theory: The primary market for foreign plants is their host 
    The distinction between horizontal and vertical incentives for 
investment informs the concern that multinationals will move production 
to the location with the lowest cost of production. To the extent that 
simple versions of vertical investment dominate, this concern has 
greater significance.
    Empirical research by economists has also concluded that foreign 
direct investment is more often horizontal than vertical. A number of 
recent empirical papers support this theory. As noted above, most 
foreign investment flows from large, rich countries to other large, 
rich countries. Thus investment is not flowing to the lowest-cost (or 
at least lowest-wage) countries. Second, sales by foreign affiliates of 
U.S. multinationals are higher in countries with higher tariffs and 
transport costs on U.S. goods. Third, U.S. firms serve foreign markets 
more through foreign investment and less through exports the larger is 
the scale of corporate operations relative to the scale of production. 
This fact is consistent with the idea that multinationals arise when 
there are economies of scale in headquarters (or parent) activities 
relative to scale economies in production.
    Even when foreign investment is vertical, there is little evidence 
that it affects wages in the home country. For example, a number of 
empirical studies show that increased capital mobility, including the 
``outsourcing'' of production to low-wage countries, as well as 
immigration from developing countries to the advanced economies, have 
only a small effects on wages in OECD countries. And the vast majority 
of U.S. multinational foreign investment is in other developed, high-
wage countries.
    A particularly important location decision is the location of the 
headquarters of the multinational. Although multinationals, by 
definition, operate in a number of countries, the Department of 
Commerce reports that the bulk of the revenue, investment, and 
employment of U.S.-based multinationals are located in the United 
States, and this has not changed over time. At the beginning of this 
decade, 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. 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 
    The foreign operations of U.S. multinationals also benefit the U.S. 
economy because they increase the demands for services from the firm's 
headquarters. A recent OECD study based on 14 developed countries found 
that ``each dollar of outward foreign investment is associated with $2 
of additional exports and with a bilateral trade surplus of $1.70.'' In 
addition, U.S. multinationals perform the overwhelming majority of 
their research and development at home. Physical capital assets often 
dominate the discussion of multinationals' investment decisions. 
However, among the assets of U. S. companies are their scientific 
expertise. Foreign physical capital investments are 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. Foreign and domestic 
operations of multinationals appear to be complements, not substitutes.
International Tax Policy

Looking Back: Capital-Export Neutrality
    The U.S. approach to international taxation dates to the 1960s, a 
time in which the U.S. was the source of one half of all multinational 
investment in the world, produced about 40 percent of the world's 
output, and was the largest capital exporter in the world.
    In this circumstance, it was appealing to construct a tax system 
that was ``neutral'' with respect to the location of foreign investment 
by taxing income from all foreign investments at the same overall rate. 
This approach to taxing income from foreign sources is known as 
capital-export neutrality. Capital-export neutrality carries with it 
the appealing notion that taxes will not distort location decisions and 
that a company will invest wherever the return is greatest, maximizing 
efficiency. Thus a firm would be taxed at the same marginal rate on 
income from foreign or domestic investments. In one example of a fully 
capital export neutral system, domestic corporations have their 
foreign-source income taxed as if earned in the United States, but with 
an unlimited credit for foreign income taxes. Under such a system, 
domestic corporations presumably would locate investments where they 
are most productive.
    As an example of the mechanics of such a system, with a U.S. 
corporate tax rate of 35 percent, firms earning $100 abroad would owe 
$35 on the income. To offset foreign taxes, American multinationals can 
claim foreign tax credits for income taxes (and related taxes) paid to 
foreign governments. If the U.S.-based firm paid $25 in tax to the 
foreign government, the firm would be given a tax credit of $25 against 
its $35 owing to the U.S. government. The United States would receive 
net taxes of $10, and the overall tax of $35 would be the same for both 
domestic and any foreign investment.
    Capital-export neutrality as a tax policy objective received 
intellectual support from the ``perfect'' competition paradigm that 
dominated economics at the time. In this characterization of market 
competition, aggressive pricing and ease of entry, and multitudes of 
competitors yielded no brand-name loyalty, economies of scale, or other 
sources of extra profits.

Looking Forward: Capital-Export Neutrality Reconsidered
    A variety of considerations suggest a reconsideration of capital 
export neutrality as a tax policy objective. To begin, it is useful to 
note that the United States never fully adhered to the principle in 
practice, suggesting the presence of alternative incentives. Two 
features of the U.S. system deferral and incomplete crediting serve to 
place an important gap between the principle of capital-export 
neutrality and tax practice.
    To understand the impact of deferral, consider an example. Assume a 
foreign subsidiary of a firm makes a profit of $100 which is taxed by 
the foreign country at a rate of 25 percent. The firm then reinvests 
$55 of the profit into its operations and pays the other $20 as 
dividends to its shareholders in the United States. Therefore, the firm 
has to pay U.S. tax on that $20, but gets a credit for the 25 percent 
tax on the $20 (amounting to $5). If the firm pulls the $55 out of the 
firm the following year and repatriates it to the United States, it 
will have to pay U.S. taxes on that profit at that time.
    The rules surrounding deferral are the source of considerable 
complexity. Deferral is only available on the active business profits 
of American-owned foreign subsidiaries, and the profits of 
unincorporated foreign businesses such as American owned branch banks, 
are immediately taxed by the United States. As well, under ``Subpart 
F'' of U.S. tax law, certain income (called Subpart F income) from 
foreign investments is ``deemed distributed'' and is therefore 
immediately taxable by the United States.
    In other ways, the current tax system departs from capital-export 
neutrality by making foreign investment less attractive than domestic 
investment. For example, a firm that faces higher taxes in its host 
country than at home will receive excess foreign tax credits, which it 
may or may not be able to use. The firm can either apply its excess to 
foreign tax credits against taxes paid in the previous two years, or in 
future years. However, if the host country consistently has a higher 
tax than the United States, it will end up paying the higher of the two 
tax rates on its foreign income, and pay the lower U.S. tax on its 
domestic income, counter to the principle of capital-export neutrality. 
A second example in which the tax system acts to discourage foreign 
investment is one in which activities are carried out in a foreign 
corporation; the U.S. tax rules will accelerate any income, but defer 
any losses. If those activities were instead placed in a U.S. 
corporation, both income and loses would be recognized for U.S. tax 
purposes. Therefore, given the uncertainty of any initial investment, 
the current system actually biases investment toward the domestic 
market and away from foreign ventures.
    In addition to some trepidation with fully implementing capital-
export neutrality, the underpinnings of the international tax regime 
have shifted on both the theoretical front and the economic landscape. 
On the theoretical front, it is now recognized that most multinationals 
produce differentiated products and compete in industries where there 
are some economies of scale. Indeed, in the absence of economies of 
scale, it would not make sense to have the foreign plants affiliated 
with the parent firm at all. Therefore, the model of perfect 
competition that drives the principle of capital-export neutrality 
merits reconsideration.
    The traditional theory supporting capital-export neutrality is 
based on a stylized view of multinational companies. Under this view, 
foreign direct investment is indistinguishable from portfolio 
investment and there are no economic rents that is, there is perfect 
competition. Michael Devereux of the University of Warwick and I 
reexamined the theory of optimal tax policy taking into account that 
foreign investment is different from portfolio investment in that the 
returns that exceed the cost of capital (that is, there are economic 
rents) due to factors such as intangibles (for example, brands, or 
patents) and company-specific cost advantages.
    As noted above, the returns on foreign investment are higher than 
those on domestic investment, implying that there are rents. Also noted 
above, there are economies of scale associated with headquarter 
activities, further putting the assumption of perfect competition in 
question. Devereux and I note that research in industrial organization 
on multinational corporations in fact emphasizes the presence of 
economic rents and that empirical studies of foreign direct investment 
find that investment location decisions are more closely related to 
average rather than marginal tax rates. These empirical observations 
support the view that foreign direct investment differs fundamentally 
from portfolio investment.
    When Devereux and I take into account more realistic assumptions 
about the economic characteristics of foreign direct investment, we 
predict that the residence-based tax system fails to achieve domestic 
welfare maximization. Deferral of taxation of foreign income generally 
results in higher national welfare than current taxation (ignoring 
foreign country taxation). At low rates of foreign income tax, a 
limited foreign tax credit with deferral of foreign income generally 
dominates current taxation with a deduction for foreign income taxes 
    In terms of the economic setting, the United States is now the 
world's largest importer of capital. This observation highlights the 
fact that capital export neutrality ignores that the firm can decide 
where to call ``home.'' Unless the domestic tax rate is the same in 
both countries, under a scheme of capital-export neutrality, the 
decision of where to place the firm's headquarters will be affected by 
the countries' tax systems.
    Effects of home-country tax policy on location of economic activity 
and investment have been investigated by economists, with the basic 
insight that a move toward a more territorial system will be unlikely 
to generate a large shift in investment locations. Other analysis has 
examined positive externalities created for a country by being the home 
of multinational headquarters, implying that economic activity of 
foreign affiliates is complementary to the economy of the ``home 
    To summarize, 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 wage rates 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. 

    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 forty years in the U.S. 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. The United States should 
examine closely the merits of a more territorial approach, a move that 
would be consistent with most commonly discussed fundamental tax 
    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 former FSC regime originally developed at least in part in 
response to the pressures generated by the absence of deferral on these 
income sources.
    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.
    Fourth, the United States only recently departed from the handful 
of industrialized countries that fail to provide some form of 
integration of the corporate and individual income tax systems. Partial 
integration since 2003 has reduced double taxation of corporate income, 
but the lack of permanent integration makes 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.

Revisiting Principles of Neutrality
    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, as it results in the same rate of return for 
all capital flowing into a country.
    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 
corporation abroad must compete in several ways for capital and 
customers. It might have to compete with foreign-based companies for a 
foreign market. It 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 
    A direct application of the simple capital-export neutrality notion 
can actually make efficiency worse, even from the perspective of its 
objectives. A well known economic theorem shows that when there are 
multiple departures 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, 
capital-import neutrality, 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. However, it is interesting to note that this recent research 
tends to support the tax strategies of competitive nations. 
Nevertheless, concerns have been raised over the possibility that using 
capital-import neutrality to guide tax policy will result in a narrower 
tax base and a shift in the structure of production for multinational 
    One concern with moving to a more territorial approach to taxing 
foreign income is that U.S.-based firms will relocate domestic 
operations to the country with the lowest taxes. This concern stems 
from the same assumption noted above that investment abroad and 
investment domestically is substitutes. Although firms take the cost of 
production of their affiliates into account, there is little reason to 
believe that increased investment abroad necessarily implies less 
economic activity at home.
    As noted earlier, the vast majority of U.S. foreign investment is 
located in other industrialized countries, with taxes not out of line 
from those in the United States. Because taxes typically are only a 
small part of total costs of production, the change in taxation level 
alone is unlikely to induce a plant to move from the United States. The 
OECD found that where tax policy is identified as a major issue, 
transparency in the tax law and administration will often be ranked by 
investors ahead of special tax relief. Uncertainty over tax 
consequences of foreign direct investment increases the perception of 
risk and discourages capital flows, a fact particularly important for 
long-term, capital--intensive direct investment that most host 
countries are eager to attract.
    A related concern is the loss of the tax base. The argument goes 
that if the United States does not tax income from foreign investment, 
it will lose substantial revenue. However, this argument presupposes 
two facts: (1) foreign tax credits received by foreign subsidiaries are 
less than the tax owing to the U.S. government; and (2) there is not 
another way to tax that same profit. Although the U.S. corporate tax 
rate is one of the highest among industrial economies, a number of 
firms have excess foreign tax credits. There is also evidence that the 
United States can capture taxes from foreign subsidiaries from personal 
income taxation. Because foreign subsidiaries tend to pay out more 
dividends (due perhaps to the greater need to signal profitability), 
profits can be taxed. In a recent study, James Hines estimates that, 
among American firms, one dollar of reported foreign profitability is 
associated with the same level of dividend payments to common 
shareholders as is three dollars of reported domestic profitability. In 
fact, the United States receives greater tax revenue from the foreign 
operations of American companies by taxing individual dividend income 
that it does by taxing corporate income. For example, Hines finds that 
for $100 of after-tax foreign profits generates $50 more dividends to 
domestic shareholders than does $100 of after-tax domestic profits.
    While fears of runaway plants or a runaway tax base are overblown, 
runaway headquarters is a real concern. Measured by deal value, over 
the 1998 to 2000 period, 73 to 86 percent of large cross-border mergers 
and acquisitions involving U.S. companies have been structured so that 
the merged company has its headquarters abroad. In the case of Daimler-
Chrysler, U.S. taxes were specifically identified as a significant 
factor in determining the location of the new parent firm. U.S.-based 
multinationals have most of their jobs and funds invested in their 
parent firms, losing the parents becomes more of a concern than simply 
increasing the amount of investment in foreign-owned affiliates.
    And Reform Likely Requires Corporate Tax Reform While reform of the 
tax treatment of U.S. multinationals remains important for tax 
policymakers, real reform almost surely leads to a consideration of the 
corporate income tax. The United States has the second highest 
corporate tax rate among OECD economies, and many large OECD economies 
have been cutting corporate tax rates, while broadening the tax base. 
For the United States to remain competitive, we should consider 
reducing corporate tax rates substantially. While some of the lost 
revenue could be made up through corporate base broadening, a better 
approach would be to address corporate tax changes (and international 
tax changes) in the context of fundamental tax reform. Recent research 
by economists suggests that such changes could improve economic 
efficiency, improve the climate for innovation, and raise wages.

    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. Policymakers should continue to review carefully the U.S. 
international tax system (and the corporate tax generally), including 
fundamental reforms like a territorial 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. These 
gains should contribute to the growing interest in fundamental tax 
    Thank you, Mr. Chairman, and I look forward to your questions.


    Chairman CAMP. Thank you very much, Dr. Hubbard. Dr. Hines, 
you have 5 minutes.


    Dr. HINES. Thank you. There are two primary channels by 
which residence-based international taxation as practiced 
currently by the United States affects the competitiveness of 
American business operations. The first channel is that 
residence taxation creates incentives that distort the behavior 
of American firms.
    The second channel is that residence taxation affects the 
total tax burdens of companies that are residents in the United 
States. Both of these channels are important, but they are 
    U.S. residence-based taxation influences after-tax returns 
by imposing home-country taxation that is a function of actions 
undertaken at home and abroad. The incentive problem is that 
the actions that the system encourages are often inconsistent 
with maximizing investment returns net of foreign taxes, in 
that what American firms are encouraged instead to do is 
maximize returns net of foreign plus domestic taxes. These 
incentives impair the competitiveness of American firms 
operating abroad, specifically, the U.S. tax system encourages 
American firms with deficit foreign tax credits to discount the 
cost of foreign taxes since the payment of foreign taxes 
produces an off-setting foreign tax credit that can be used to 
reduce U.S. tax liability. For American firms with excess 
foreign tax credits, the U.S. expense allocation rules 
discourage profitable investments in the United States that can 
trigger additional tax liabilities by reducing the foreign tax 
credit limit and may thereby also discourage profitable foreign 
    In both cases, the system sacrifices the competitiveness of 
American firms, doing so in pursuit of an unclear objective.
    Taxation on the basis of residence not only creates 
inefficient incentives for American firms with foreign 
operations but imposes a pattern of tax liabilities that 
separately impairs competitiveness. The most obvious feature of 
this residence-based taxation is that a firm that is an 
American resident owes tax to the United States on its 
worldwide income whereas a firm that is a resident in another 
country does not. This system effectively imposes what can be a 
very large tax on U.S. residents, thereby discouraging 
multinational firms from establishing U.S. residency and 
encouraging firms that are already residents in the United 
States to relocate elsewhere.
    The wave of corporate inversions from 1996 to 2002 reflects 
these incentives as a number of American firms thought it 
worthwhile to incur the tax and other costs associated with 
relocating to foreign residence in order to avoid U.S. taxation 
of their worldwide incomes.
    The corporate inversion phenomenon is not quantitatively 
huge in and of itself. Only 25 large firms inverted. It is 
instead a signal of the magnitude of incentives created by the 
U.S. residence taxation. For every firm that changes its 
nationality by inverting, there were several others whose U.S. 
tax liabilities or potential tax liabilities on foreign income 
were significant enough to make them contemplate inverting or 
else never establishing U.S. residency in the first place.
    Taxation on the basis of residence makes most sense when 
residence is an immutable characteristic of a person or a firm. 
In the global economy, residence is a matter of choice not only 
because people and companies can move but also because the 
weight of economic activity is itself responsive to tax 
burdens, even in circumstances in which people in firms never 
change their tax residences.
    If the United States imposes a heavy tax on the foreign 
incomes of firms resident in the United States, then over time, 
American firms will not flourish to the same extent as firms 
resident in other countries. The after-tax incomes of American 
firms will be depressed by heavy tax-burdens and investors will 
not commit the funds they would to an otherwise equivalent firm 
that was not subject to the same tax-burdens. United States 
adoption of territorial taxation offers the prospect of 
addressing these problems, providing incentives and tax burdens 
for global businesses that would enhance the competitiveness of 
American firms.
    Even if the goal of American policy were to enhance World 
and not U.S. welfare, this is achieved by reducing U.S. 
taxation of foreign income to bring it better into line with 
world norms. One might ask why it matters to the United States, 
or for that matter the world, that a company's residence to the 
United States operates under a tax system that maintains their 
    If the goal of U.S. policy is to advance the living 
standards of Americans, then policies should be designed to 
promote the efficiency of businesses located in the United 
States. This most definitely includes their international 
competitiveness. In a market system, the wages of American 
workers are determined by the productivity of labor in the 
United States. In maximizing the efficiency of business 
operations, sound policy also maximizes the productivity of 
American labor and capital. Since labor represents most of the 
United States' economy, labor receives most of the benefits of 
productive efficiency in the United States with these benefits 
coming in the form of higher compensation and greater 
    Viewed through a modern lens, residence-based taxation as 
practiced by the United States appears very curious in that it 
serves neither the interests of the United States nor of the 
world as a whole.
    Thank you.

    [The prepared statement of Dr. Hines follows:]

Statement of James R. Hines Jr., Ph.D., Professor of Business Economics 
     and Public Policy, University of Michigan, Ann Arbor, Michigan

    Mr. Chairman and Members of this distinguished Subcommittee, it is 
an honor to participate in these hearings on the impact of 
international tax reform on U.S. competitiveness. I am a Professor of 
Economics at the University of Michigan, where I am also Research 
Director of the Office of Tax Policy Research. I am a Research 
Associate of the National Bureau of Economic Research, and Research 
Director of the International Tax Policy Forum.
    There can be little doubt that the United States would benefit from 
international tax reform. Advocates of all stripes urge reform, many of 
them stressing the need for reform as a matter of some urgency. As so 
often happens with such complex issues, however, the advocates are not 
of a single mind. I hope to clarify the sources of differences of 
opinion, and to sketch a sensible way to think about the impact of U.S. 
tax reform on the international competitiveness of the American 
economy. This exercise serves the double function of assisting in the 
evaluation of what are by now familiar arguments, and suggesting 
directions of beneficial reform.

The Residence Principle
    The residence principle has long been the basis of U.S. 
international tax policy. Its concept is that income earned by American 
persons anywhere in the world should be taxed by the United States at 
the same rate as other income. In practice, U.S. tax policy deviates 
significantly from the residence principle in several ways, most 
notably in permitting taxpayers to claim credits for certain taxes paid 
to foreign governments, and in deferring U.S. taxation of certain types 
of foreign income. Despite these deviations, the residence principle 
remains the cornerstone of U.S. international tax policy, and the 
primary way in which U.S. tax policy influences the competitiveness of 
American-owned operations abroad.
    There are two primary channels by which residence-based taxation, 
as practiced by the United States, affects the competitiveness of 
American business operations. The first channel is that residence 
taxation creates incentives that distort the behavior of American 
firms. The second channel is that residence taxation affects the total 
tax burdens of companies that are resident in the United States. Both 
of these channels are important, but they are distinct, and there is 
considerable confusion about their roles and relative importance.

Incentives Created by Residence Taxation
    The first way in which residence taxation impairs the 
competitiveness of American firms is by creating incentives that are 
inconsistent with maximizing economic value as judged from the 
standpoint of the United States. This is not to say that the system 
fails to create incentives. The market system in the international 
setting, as in every other setting, encourages taxpayers to allocate 
resources in a way that maximizes after-tax returns. Importantly, from 
the standpoint of American businesses operating abroad, U.S. residence-
based taxation influences after-tax returns by imposing home-country 
taxation that is a function of actions undertaken at home and abroad. 
The incentive problem is that the actions that the system encourages 
are often inconsistent with competitiveness and efficiency.
    Consider a very simple example in which an American firm operates 
abroad in two countries, one that taxes corporate income at a 15% rate, 
and another that taxes corporate income at a 30% rate. Let us assume 
that the firm does not have excess foreign tax credits from other 
foreign operations, and is unable to find sufficiently attractive 
foreign investment opportunities that would permit it to benefit from 
deferring repatriation of foreign profits. Then if the firm earns 
income of $100 in the first country, it owes $15 in taxes to the 
foreign government and $20 of residual taxes to the United States, 
since its U.S. tax liability of $35 (35% of $100) is reduced to $20 by 
virtue of the $15 foreign tax credit that it receives for taxes paid to 
the foreign government. If the firm earns income of $100 in the second 
country, then by the same reasoning it owes $30 in taxes to the foreign 
government and $5 of residual taxes to the United States.
    What is wrong with this picture? The problem, from the standpoint 
of the United States, is that taxpayers seeking to maximize after-tax 
profits will be indifferent between earning $100 in the first country 
and earning $100 in the second country. In either case the taxpayer 
walks away with $65 of after-tax profits; the only difference between 
the two cases is the allocation of tax payments between the foreign 
government and the U.S. government. From the standpoint of the United 
States, however, these two outcomes are far from equivalent, since in 
the first case Americans (the taxpayer and the U.S. government 
together) earn $85 after payment of foreign taxes, whereas in the 
second case Americans earn $70 after foreign taxes.
    To modify the example slightly, an American who maximizes after-tax 
income would prefer to earn $100 before tax in a foreign jurisdiction 
with a 30% tax rate than to earn $90 before tax in a foreign 
jurisdiction with a 15% tax rate, since in the first case the taxpayer 
receives $65 (65% of $100), whereas in the second case the taxpayer 
receives $58.50 (65% of $90). Yet from the standpoint of the U.S. 
government and the American taxpayer taken together, the first 
investment produces a return of $70 (70% of $100), and the second 
investment produces a return of $76.50 (85% of $90). Hence the U.S. tax 
system encourages exactly the wrong choice between these two foreign 
investment opportunities.
    As the examples illustrate, residence taxation interferes with 
incentives to maximize investment returns net of foreign taxes. Since 
maximizing such returns is the essence of competitiveness, U.S. 
residence taxation impairs the competitiveness of American firms 
operating abroad.
    In fact, the problems created by U.S. residence-based taxation are 
considerably worse than those suggested by the example, since the 
detailed aspects of the foreign tax credit limit calculation and the 
operation of deferral contribute to reducing the competitiveness of 
American firms operating abroad. The foreign tax credit is limited to 
(roughly) the U.S. tax that would have been due on foreign source 
income. The previous example suggests that U.S. residence taxation 
creates anticompetitive incentives only for firms with deficit foreign 
tax credits, that is, for firms whose average foreign tax rates fall 
below the U.S. rate--but that conclusion is incorrect. Instead, the 
practical operation of the U.S. foreign tax credit limit implies that 
firms with excess foreign tax credits--those whose average foreign tax 
rates exceed the U.S. tax rate--also have incentives not to maximize 
profits net of foreign taxes.
    Consider the case of a firm with excess foreign tax credits. This 
taxpayer may face serious problems that stem from U.S. expense 
allocation rules that apportion domestic expenses between U.S. and 
foreign source. Any domestic expenses allocated to foreign source 
reduce the foreign tax credit limit and thereby increase the taxpayer's 
U.S. tax liability on foreign-source income. This allocation method 
thereby affects incentives for both foreign and domestic activities, 
doing so in a way that is inconsistent with the goal of maximizing 
returns net of foreign taxes.
    Consider, for example, a firm that earns $100 in foreign location 
with a 40% tax rate. The firm pays $40 of taxes to the foreign 
government, and, in the absence of domestic expense allocation, would 
have no U.S. tax liability on its foreign income, since it would be 
entitled to claim a $35 foreign tax credit with which to offset its 
U.S. taxes on the $100 of foreign profits. Suppose that the same firm 
spends $50 on domestic administration designed to improve domestic 
efficiency and thereby generate $55 of additional domestic output. From 
an efficiency standpoint this is clearly a worthwhile expenditure, 
since it produces more value ($55) than it costs ($50). If, however, 
the allocation rules require the firm to allocate $20 of this 
expenditure to foreign source, then the firm's foreign tax credit limit 
will be reduced by $7 (35% of $20), and the firm will be obliged to pay 
$7 of additional U.S. tax on its foreign source income. As a result, 
the firm will have an incentive to forego the economically beneficial 
domestic efficiency improvement, since doing so triggers additional tax 
due on foreign income.
    There is a second possibility, of course, which is that the 
American firm might maintain its domestic operations and simply forego 
its foreign operations altogether. With this option there is clearly no 
problem with the foreign tax credit limit, since the firm would have no 
foreign income. But this is hardly an efficient, or competitive, 
    The general problem with the expense allocation rules is that they 
make U.S. tax liabilities complex functions of domestic and foreign 
activities, and do so in a manner that is inconsistent with maximizing 
profits. Under normal circumstances taxpayers have incentives to spend 
$100 to earn $110, even though the $10 profit is taxed, and the same 
taxpayers will prefer investments that return $110 to investments that 
return $105. The system of residence taxation together with foreign tax 
credit limits and expense allocation rules interferes with these 
incentives, and can create situations in which economically inefficient 
transactions are preferred.
    The current international tax system is designed to defend the U.S. 
tax base by preventing taxpayers from reducing their U.S. tax 
liabilities on domestic income with credits for taxes paid to foreign 
governments, and to prevent taxpayers from incurring deductible 
expenses in the United States that produce foreign income that is taxed 
lightly, or taxed not at all, by the United States. These are 
reasonable motivations. A major difficulty with the current solution is 
that, as we have seen, the methods used to defend the tax base 
themselves create incentives that are inconsistent with economic 
efficiency. A second difficulty, to which I will turn shortly, is that 
the absence of similar provisions in the tax laws of other nations 
raises the possibility that U.S. policy needlessly impairs the 
competitiveness of American business and thereby actually reduces the 
size of the total U.S. tax base.
    The deferral of U.S. taxation of unrepatriated income earned by 
foreign subsidiaries is designed to attenuate some of the costs of U.S. 
residence taxation. Unfortunately, deferral itself creates incentives 
to delay returning investment proceeds to the United States, 
encouraging firms to retain funds in foreign investments, even though 
the same firms might better deploy their money in the United States 
than they do abroad. Mihir Desai, Fritz Foley and I have estimated 
(Desai, Foley, and Hines, 2001) that, in an average year, the existence 
of U.S. repatriation taxes reduces total repatriations by 12.8%. Of 
course for some firms, and particular foreign operations, the effect is 
much larger than that. We estimate the efficiency loss associated with 
merely the incentives to time dividend repatriations around tax 
considerations is equal to approximately 2.5% of the dividends 
received, a figure that grows greatly once financing and investment 
effects are included.

Residence Taxation and Tax Burdens
    Taxation on the basis of residence not only creates inefficient 
incentives for American firms with foreign operations, but also imposes 
a pattern of tax liabilities that separately impairs competitiveness.
    The most obvious feature of U.S. residence based taxation is that a 
firm that is an American resident owes tax to the United States on its 
worldwide income, whereas a firm that is resident in another country 
does not. This system effectively imposes what can be a very large tax 
on U.S. residence, thereby discouraging multinational firms from 
establishing U.S. residency, and encouraging firms that are already 
resident in the United States to relocate elsewhere. The wave of 
corporate inversions from 1996-2002 (documented in Desai and Hines, 
2002) reflects these incentives, as a number of American firms found it 
worthwhile to incur the tax and other costs associated with relocating 
to foreign residence in order to avoid U.S. taxation of their worldwide 
incomes. The corporate inversion phenomenon is not quantitatively huge 
in and of itself--only 25 large firms inverted--but is instead a signal 
of the magnitude of the incentives created by U.S. residence based 
taxation. For every firm that changed its nationality by inverting, 
there were several whose U.S. tax liabilities, or potential U.S. tax 
liabilities, on foreign income were significant enough to make them 
contemplate inverting or else never establishing U.S. residency in the 
first place.
    Taxation on the basis of residence makes the most sense when 
residence is an immutable characteristic of a person or a firm. In the 
global economy residence is a matter of choice, not only because people 
and companies can move, but also because the weight of economic 
activity is itself responsive to tax burdens, even in circumstances in 
which people and firms never change their tax residences. If the United 
States imposes a heavy tax on the foreign incomes of firms resident in 
the United States, then over time American firms will not flourish to 
the same extent as firms resident in other countries. The after-tax 
incomes of American firms will be depressed by heavy tax burdens, and 
investors will not commit the funds that they would to an otherwise 
equivalent firm that was not subject to the same tax burdens.
    How large a burden does the U.S. tax system impose on the foreign 
incomes of American firms? In addressing this issue it is important to 
distinguish the taxes that American firms pay from the burdens they 
incur, since taxpayers can, and do, avoid paying taxes by foregoing 
valuable investments. These foregone opportunities are very real 
burdens, which taxpayers would not face if the tax system were 
redesigned to promote efficiency. Mihir Desai and I have estimated 
(Desai and Hines, 2004) that U.S. taxation of foreign income prior to 
2005 imposed burdens of approximately $50 billion a year on American 
firms. Certainly the subsequent legislative reforms have reduced this 
burden, but it remains substantial both as a fraction of foreign income 
and when compared to the home country tax burdens of firms with which 
Americans compete.

Who Taxes on the Basis of Residence?
    Most countries do not attempt to tax substantially any of the 
active foreign incomes of their resident companies. Of the 30 high-
income countries that are members of the OECD, only nine, the Czech 
Republic, Iceland, Japan, Korea, Mexico, New Zealand, Poland, the 
United Kingdom, and the United States, impose taxes on any significant 
fraction of active foreign income. Non-OECD countries are even less 
likely than OECD countries to tax the foreign incomes of resident 
companies. Among the countries that tax foreign incomes, the United 
States has a particularly complex system of income determination and a 
very advanced method of ensuring compliance, all designed to prevent 
income from escaping the U.S. tax net.
    Should it matter to the United States that other countries use tax 
systems that differ from the American system? This matters not only 
because firms can choose their locations of residence, but also because 
Americans compete in global product markets, and the market for 
corporate control, with firms located in other countries. If the U.S. 
tax system fails to promote efficiency, then the burden is borne by 
American firms in the form of reduced international competitiveness. 
The significance of the resulting cost to American firms, and the U.S. 
economy, is apparent from consideration of the welfare economics of 
taxing foreign income.

Should Taxation be Based on Residence?
    Until relatively recently, there was a commonplace belief that the 
U.S. policy of taxing foreign income while granting foreign tax credits 
was if anything too generous from the standpoint of advancing American 
interests, and could be justified only as a gesture that advances well-
being around the world. This belief persisted in spite of the differing 
practices of so many other countries, and the evident impact of 
American tax policy on the foreign business activity of U.S.-owned 
firms. In recent years those who think about these questions have come 
to some very different conclusions, but in order to understand the 
latest thinking on these issues, it is helpful to appreciate what we 
used to believe, and where it has gone wrong.
    Capital export neutrality (CEN) is the doctrine that the return to 
capital should be taxed at the same total rate regardless of the 
location in which it is earned. If a home country tax system satisfies 
CEN, then a firm seeking to maximize after-tax returns has an incentive 
to locate investments in a way that maximizes pre-tax returns. This 
allocation of investment is thought to correspond to global economic 
efficiency under certain circumstances. The CEN concept is frequently 
invoked as a normative justification for the design of tax systems 
similar to that used by the United States, since the taxation of 
worldwide income with provision of unlimited foreign tax credits would 
satisfy CEN.
    The standard analysis further implies that governments acting on 
their own, without regard to world welfare, should tax the foreign 
incomes of their resident companies while permitting only a deduction 
for foreign taxes paid. Such taxation satisfies what is known as 
national neutrality (NN), discouraging foreign investment by imposing a 
form of double taxation, but doing so in the interest of the home 
country that disregards the value of tax revenue collected by foreign 
governments. From the standpoint of the home country, foreign taxes are 
simply costs of doing business abroad, and therefore warrant the same 
treatment as other costs. The home country's desired allocation of 
capital is one in which its firms equate marginal after-tax foreign 
returns with marginal pretax domestic returns, a condition that is 
satisfied by full taxation of foreign income after deduction of foreign 
taxes. This line of thinking suggests that the American policy of 
taxing foreign income while granting foreign tax credits fails to 
advance American interests because it treats foreign income too 
generously. In this view there is a tension between tax policies that 
advance national welfare (NN) by taxing after-tax foreign income, and 
those that advance global welfare (CEN) by taxing foreign income while 
permitting taxpayers to claim foreign tax credits. The practice of much 
of the world, including Germany, France, Canada, and the Netherlands, 
that effectively exempts foreign income from taxation, is, by this 
reasoning, difficult to understand, since it is inconsistent with 
either national or global interests.
    It is important to clarify that there are important assumptions 
built into the standard normative framework that delivers CEN and NN as 
global and national welfare criteria, and in particular, it is critical 
that foreign firms are assumed not to respond to changes induced by 
home-country taxation. Realistically, however, investment by domestic 
firms at home and abroad may very well influence investment by foreign 
firms, a scenario that is inconsistent with the logic underlying CEN 
and NN. If greater investment abroad by home-country firms triggers 
greater investment by foreign firms in the home country, then it no 
longer follows that the home country maximizes its welfare by taxing 
foreign income while permitting only a deduction for foreign taxes 
paid. From the standpoint of global welfare, if home and foreign firms 
compete for the ownership of capital around the world, and the 
productivity of an investment depends on its ownership, then it is no 
longer the case that the taxation of foreign income together with the 
provision of foreign tax credits necessarily contributes to productive 
    Modern analysis of international tax systems tend to focus much 
more on tax-induced ownership changes than do the older views on the 
subject. Tax systems satisfy what is known as capital ownership 
neutrality (CON) if they do not distort ownership patterns. It is 
easiest to understand the welfare properties of CON by considering the 
extreme case in which the total stock of physical capital in each 
country is unaffected by international tax rules. In this setting, the 
function of foreign direct investment is simply to reassign asset 
ownership among domestic and foreign investors. If the productivity of 
capital depends on the identities of its owners (and there is 
considerable reason to think that it does), then the efficient 
allocation of capital is one that maximizes output given the stocks of 
capital in each country. It follows that tax systems promote efficiency 
if they encourage the most productive ownership of assets within the 
set of feasible investors.
    Consider the case in which all countries exempt foreign income from 
taxation. Then the tax treatment of foreign investment income is the 
same for all investors, and competition between potential buyers 
allocates assets to their most productive owners. Note that what 
matters for asset ownership is comparative advantage rather than 
absolute advantage: if French firms are always the most productive 
owners of capital, but they do not have the resources necessary to own 
everything, then efficiency requires that French firms own the capital 
for which their rate of return difference with the rest of the world is 
the greatest. The United States would reduce world welfare by taxing 
foreign income while permitting taxpayers to claim foreign tax credits, 
since such a system encourages American firms to purchase assets in 
high-tax countries and foreign firms to purchase assets in low-tax 
countries. These tax incentives distort the allocation of ownership 
away from one that is strictly associated with underlying productivity 
    In order for the allocation of capital ownership to be efficient it 
must be the case that it is impossible to increase output by trading 
capital ownership among investors. This efficiency condition requires 
not necessarily that capital be equally productive in the hands of each 
investor, but that the potential gain of reallocating ownership to a 
higher-productivity owner be exactly equal to the cost of such a 
reallocation by offsetting ownership changes elsewhere. Since taxpayers 
allocate their investments to maximize after-tax returns, the marginal 
dollar spent on new investments by any given investor must yield the 
same (expected, risk-adjusted) after-tax return everywhere. It follows 
that, if net (host country plus home country) tax rates differ between 
investments located in different countries, marginal investments in 
high-tax locations must generate higher pre-tax returns than do 
marginal investments in low-tax locations. Selling an asset in a low-
tax location and purchasing an investment in a high-tax location 
increases output by the firm engaging in the transaction, but 
(generally) reduces output by the firm on the other side of this 
transaction. If both parties face the same tax rates, or face taxes 
that differ in fixed proportions from each other, then CON is 
satisfied, ownership reallocation would have no effect on total 
productivity, and the outcome is therefore efficient. If some countries 
tax foreign income while others do not, then it is impossible to 
restore CON without bringing them all into alignment, though individual 
countries have the potential to improve global welfare by moving their 
taxation of foreign income into conformity with an average global norm.
    The same circumstances that make CON desirable from the standpoint 
of world welfare also imply that countries acting on their own, without 
regard to world welfare, have incentives to exempt foreign income from 
taxation no matter what other countries do. The reason is that 
additional outbound foreign investment does not reduce domestic tax 
revenue, since any reduction in home-country investment by domestic 
firms is offset by greater investment by foreign firms. With unchanging 
domestic tax revenue, home-country welfare increases in the after-tax 
profitability of domestic companies, which is maximized if foreign 
profits are exempt from taxation. Tax systems that exempt foreign 
income from taxation can therefore be said to satisfy ``national 
ownership neutrality'' (NON). Hence it is possible to understand why so 
many countries exempt foreign income from taxation, and it follows 
that, if every country did so, capital ownership would be allocated 
efficiently and global output thereby maximized.

Competitiveness and American Affluence
    One might ask why it matters to the United States--or for that 
matter, the world--that companies resident in the United States operate 
under a tax system that maintains their competitiveness in a global 
environment. If the goal of U.S. policy is to maintain and advance the 
living standards of Americans, then policies should be designed to 
promote the efficiency of businesses located in the United States, and 
this most definitely includes their international competitiveness. In a 
market system, the wages of American workers are determined by the 
productivity of labor in the United States. In maximizing the 
efficiency of business operations, sound policy also maximizes the 
productivity of American labor and capital. Since labor represents most 
of the U.S. economy, labor receives most of the benefits of productive 
efficiency in the United States, with these benefits coming in the form 
of higher compensation and greater employment.
    There is extensive evidence that tax systems influence the 
magnitude and composition of international economic activity, and there 
is good reason to believe that improved tax design has the potential to 
enhance the performance of national economies. The welfare principles 
that underlie current U.S. taxation of foreign income rely on the 
premise that direct investment abroad by American firms reduces the 
level of investment in the United States, since foreign competitors are 
assumed not to react to new investments by Americans. It follows from 
this premise that the opportunity cost of investment abroad includes 
foregone domestic economic activity and tax revenue, so national 
welfare is maximized by taxing the foreign incomes of American 
companies, whereas global welfare is maximized by providing foreign tax 
credits. If, instead, direct investment abroad by American companies 
triggers additional investment in the United States by foreign 
companies, which is likely in a globally competitive market, then 
entirely different prescriptions follow. The national welfare of the 
United States is then maximized by exempting foreign income from 
taxation (NON), and global welfare is maximized by conformity in the 
systems of taxing foreign income among capital-exporting countries 
    The contribution of the U.S. tax system to the competitiveness of 
American multinational firms and the performance of the U.S. economy 
has been the subject of extensive analysis and rethinking in recent 
years. What we have learned can be summarized in two points. The first 
is that the ownership and activities of multinational corporations are 
highly sensitive to taxation, much more so than what was previously 
believed to be the case. The second is that the competitiveness of the 
world economy has the potential to change everything we think about the 
features that characterize tax systems that promote economic 
efficiency. Together, these two findings carry dramatic implications 
for the kinds of tax policies that advance the competitiveness of U.S.-
owned firms, the well-being of Americans, and the productivity of the 
world economy. Viewed through a modern lens, residence based taxation, 
as practiced by the United States, appears very curious, in that it 
serves the interests neither of the United States nor of other 
    Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr., 
Repatriation taxes and dividend distortions, National Tax Journal, 
September 2001, 54 (4), 829-851.
    Desai, Mihir A., and James R. Hines Jr., Expectations and 
expatriations: Tracing the causes and consequences of corporate 
inversions, National Tax Journal, September 2002, 55 (3), 409-440.
    Desai, Mihir A., and James R. Hines Jr., Old rules and new 
realities: Corporate tax policy in a global setting, National Tax 
Journal, September 2004, 57 (3), 937-960.


    Chairman CAMP. Thank you very much, Dr. Hines. Dr. Barrett.


    Dr. BARRETT. Chairman Camp, Members of the Subcommittee, 
thank you for this opportunity.
    My name is Craig Barrett. I am Chairman of Intel, and just 
to give you a few pertinent facts about Intel, we are the 
world's largest semiconductor company. Revenues last year were 
approximately $38 billion; 80-plus percent of that revenue came 
from outside of the United States. We are mainly an export-
oriented company. We spend over $5 billion a year in research 
and development (R&D), and last year, we spent over $6 billion 
dollars on capital investment for manufacturing.
    There has been a lot of discussion recently about 
competitiveness and our company, and others have spoken on this 
topic. Competitiveness, in my definition, is really the ability 
to have a highly educated workforce, the investment in research 
and development to generate ideas for the next generation of 
products, and the role of the government is in establishing an 
environment for investment and innovation.
    With regard to my own company and my own industry, it is 
not really an issue of whether tax policy will cause us to 
invest or not invest in R&D and capital. We will invest. The 
only question is where we will invest and where the jobs will 
be created by our investment.
    I would like to address briefly two topics. One, investment 
in manufacturing, the sort of manufacturing facilities that we 
have which are very capital intensive. They are roughly $3 
billion facilities. They are probably the poster child for the 
sort of manufacturing the United States should have. They are 
capital intensive. They are high tech. They have a highly 
educated workforce. They are profitable.
    The other area that I would like to address is research and 
development. We currently do most of our research and 
development in the United States, but there are forces tending 
to pull that way to other countries.
    Let me address the manufacturing issue first and the impact 
of tax policy.
    The $3 billion facilities that we have, if you do a net 
present value or net present cost of those facilities over a 
10-year period and you compare them to being located in the 
United States or being located in certain foreign environments 
where tax policies are different, you see that the range in net 
present value is approximately a billion dollars plus or minus 
a few hundred million over a 10-year period, so roughly one 
hundred million dollar-per-year, penalty to put those 
facilities in the United States because of our tax policy. That 
hundred million dollar a year deficit or penalty comes about 
from our high corporate tax rate, which as mentioned earlier, 
is the highest in the OECD. It is also the lack of investment 
tax credits and the lack of what I would call competitive 
depreciation schedules for our facilities.
    Interestingly, labor plays a very, very small role in that 
penalty. Cost of materials and capital are about the same 
everywhere in the world. So, of the billion dollar over 10-year 
penalty, roughly 70 percent of it is tax-related, 20 percent of 
it is investment credit or investment incentive related. So 
roughly, 90 percent of it is, then, tax-related.
    To briefly compare that to a few other countries and their 
attitudes. In Malaysia, for example, for similar investments, 
that might make in the United States, would give a 10-year tax 
holiday. That is 10 years of zero percent tax; accelerated 
depreciation schedules; and depreciation schedules of well over 
a hundred percent of the actual capital costs.
    In Israel, you will see a 20 percent capital grant and 
basically a 10 percent corporate tax rate. In Ireland, you 
would see a 12.5 percent tax rate, and a 20 percent R&D tax 
credit. The list would go on and on. Other countries are using 
their tax policy as an incentive to promote investments in 
their countries, whereas the United States is not.
    The solution to this I think is complicated, obviously, but 
it embodies corporate tax rates. It embodies depreciation 
schedules. It involves investment tax credit. It is as my first 
Chief Financial Officer that I worked with at Intel told me, a 
buck is a buck no matter how it gets to the bottom line. Not 
being a tax expert, I can't tell you how to get that dollar to 
the bottom line, but getting it there is incredibly important.
    Just a few comments on R&D tax credit.
    The R&D tax credits started in 1981. It has not been 
uniformly applied during that period. There have been lapses in 
it. The tax rate that it gets is approved for a short period of 
time. When our horizon for R&D spending is much longer than the 
approval period for that R&D tax credit, it makes it less of an 
incentive in the United States than it could be.
    A brief example in conclusion, France, which is not known 
for its progressive tax policy in promoting investments, has a 
50 percent incremental R&D tax credit which applies not only to 
salaries but also to capital investments in R&D.
    Thank you for the chance to testify, and I look forward to 

    [The prepared statement of Dr. Barrett follows:]

  Statement of Craig R. Barrett, Ph.D., Chairman of the Board, Intel 
                  Corporation, Santa Clara, California

    Chairman Camp and members of the Subcommittee on Select Revenue 
    My name is Craig Barrett and I am the Chairman of the Board of 
Intel Corporation.
    Intel, since its founding in 1968, has become the world's largest 
semiconductor chip maker. We employ over 100,000 people worldwide (54% 
of whom are in the U.S.). For 2005, Intel's revenue was over $38 
billion dollars. Also, in 2005, Intel spent nearly $6 billion dollars 
on capital facilities and equipment, and over $5 billion on research 
and development. Intel consistently delivers architectural innovation 
along with world-class, high-volume manufacturing.
    Intel is a global company--over 80% of Intel's consolidated sales 
revenue in 2005 was from non-U.S. sources--clearly, we are an export-
intensive company. The marketplace is global, and so is our 
competition. Intel must compete with companies based all over the 
    I've spoken out frequently over the last few years about U.S. 
competitiveness and its many facets, such as the state of the U.S. K-12 
education system, government research funding, and increases in the 
number of U.S. visas for highly talented high-tech employees. These are 
all important areas that need to be addressed in a comprehensive and 
effective U.S. competitiveness policy. However, the subject of today's 
hearing is tax policy, tax reform, and the United States' international 
tax rules. U.S. tax policy is, and should be, another important element 
in keeping the U.S. economy and U.S. multinational companies as 
competitive as possible.
    To be competitive in the global marketplace, U.S. tax policy needs 
to focus on offering tax treatment that is comparable, if not more 
favorable, than that which is offered by other nations competing for 
the investments and operations of U.S. multinationals. Taxes are a cost 
of doing business, but not a consistent one across jurisdictions.
    My colleague, Paul Otellini, Intel's CEO, testified last year 
before the President's Tax Advisory Panel. He was invited to consider, 
and address, how the U.S. Tax Code affects business decision-making, 
and in turn, affects our competitiveness. Intel's intensive spending on 
capital, labor, and R&D, as well as its focus on exports, has 
significant tax implications. Decisions by U.S. companies as to the 
location of their production facilities and the location and extent of 
their R&D are critical to U.S. competitiveness--especially as the U.S. 
economy becomes increasingly knowledge-based in nature. The impact of 
the Tax Code on business decision-making was the focus of Paul's 
presentation; my testimony today will have a similar focus.
    I am aware that it has been said before (most recently during your 
tax reform hearing last month) that the Tax Code should not include tax 
preferences to reward a behavior that would happen anyway. That 
statement raises a valid point, but it misses a more critical question: 
you should not only ask yourselves whether the behavior would happen 
anyway; you should also ask yourselves where it would happen. In our 
case, Intel will continue to spend on production facilities and R&D as 
our business grows and prospers, but the relevant question for Intel 
is, as it should be for U.S. policy-makers, not whether we would spend 
as we grow in the future, but instead where that spending and growth 
will occur.
    Semiconductor manufacturing is extremely capital intensive. The 
cost to build and equip a new wafer fabrication facility today is $3 
billion or more. Where, and when, to build a fabrication plant is the 
largest ongoing financial decision a semiconductor CEO must make. 
However, the initial cost of a factory is just the beginning. Intel 
introduces a new generation of more advanced chip-making technology as 
frequently as every 18 months--and to make the more advanced products 
in one of our existing factories, we have to again invest very 
substantial sums in advanced production equipment.
    Historically, about 70% of Intel's capital expenditures have been 
in the U.S. because that is where most of our advanced factories have 
been located. Currently, we have wafer fabrication plants in six U.S. 
states (Arizona, California, Colorado, Massachusetts, Oregon, and New 
Mexico), and in two other countries (Israel and Ireland). Five of our 
seven most sophisticated (300 millimeter) wafer facilities now 
completed or under construction are located in the U.S.
    The impact of these facilities is considerable. For example, in 
Arizona where we have multiple facilities, we employ almost 11,000, 
with an annual payroll exceeding a billion dollars. Taking into account 
our effect on other businesses in Arizona, Intel's impact translates 
into over 27,000 jobs, and the overall impact of Intel's Arizona 
operations on the gross state product is estimated to be $2.6 billion. 
As a point of reference, about 228,000
    Americans work directly in the semiconductor industry. 
Additionally, many more work for companies supplying the industry with 
materials and equipment. Gartner recently forecast that the market for 
semiconductor chips will reach $259.5 billion in 2006, and in recent 
years U.S semiconductor companies have had slightly less than half of 
the industry's total sales.
    As I mentioned before, many countries compete intensely to attract 
Intel's facilities, although this has also changed in recent years. 
More nations very intent on attracting high-tech state-of-the-art 
factories, such as Intel's, now also have the requisite infrastructure 
and well-trained workforce they lacked in years past. Many countries 
offer very significant incentive packages and have highly favorable tax 
systems. While in the past we focused on comparing Europe to the U.S., 
we now increasingly focus on comparing Asia to the U.S.
    As a result of this change in the competitive environment, a 
critical issue we must now consider when deciding where to locate a new 
wafer fabrication plant is that it costs $1 billion dollars more to 
build, equip, and operate a factory in the U.S. than it does outside 
the U.S. The largest portion of this cost difference is attributable to 
taxes. The billion dollars is the difference between the net present 
cost over ten years of building and operating the wafer fabrication 
facility in the U.S., estimated to be as much as $6.8 billion, compared 
to the net present cost over ten years of building and operating the 
same facility outside the U.S., estimated to be as little as $5.6 
billion. The following chart illustrates this cost difference:


    The chart shows that costs can be lower internationally due, in 
part, to capital grants from foreign governments. These grants can be 
very sizable, and may also be received up-front, thereby suffering no 
decline in their nominal value due to the time value of money. Labor 
can be somewhat less costly internationally, but labor cost is not a 
large relative difference in Intel's case because advanced chip 
factories are highly automated and the employees are well--trained and 
well-paid in all locations. Materials and operating costs are 
essentially the same worldwide.
    Consequently, most of the $1 billion cost difference (about 70%) is 
the result of lower taxes; also, if taxes are combined with capital 
grants, then as much as 90% of the cost difference occurs.
    Among the taxes and incentives in foreign countries we have 
observed are:

      Malaysia--providing a 10-year tax holiday, and tax 
depreciation for capital building and equipment costs equal to 160% of 
their cost;
      Ireland--with a 12.5% corporate tax rate, and a 20% 
research tax credit;
      Israel--paying up to a 20% capital grant, with a 10% tax 
rate and a two-year tax holiday; and
      China--granting a 5-year tax holiday, followed by 50% of 
the normal tax rate for 5 more years.

    These are in comparison to the U.S., with its 35% corporate tax 
rate, lack of investment incentives, and relatively uneconomic and 
uncompetitive depreciation treatment.
    Although state tax policies and incentives can be relevant and 
important in site decisions among potential domestic sites, they do not 
typically significantly decrease the billion dollar cost difference. 
However, recently, certain states are attempting to help address the 
U.S. competitive cost disadvantage through state capital grants, and 
these hold the potential to become a more significant cost reduction 
    To help put the magnitude of a $1 billion cost difference into 
perspective, it equals about one-third of the cost of a wafer 
fabrication facility or about 20% of Intel's yearly U.S. R&D 
    From just this sample of tax systems and incentives available in 
other countries, you can see that the U.S. compares relatively poorly, 
and effectively an economic penalty on investment in the U.S. is 
    With the global nature of Intel's business, a preference to locate 
production facilities near markets, and the increasing number of 
countries capable of meeting Intel's operating needs, considerable 
business reasons exist for locating a number of our wafer fabrication 
facilities in foreign locations. However, the $1 billion cost penalty 
serves as encouragement to do so even for those factories that may for 
good business reasons otherwise be preferably located in the U.S. In 
the semiconductor industry generally, most of the newest generation of 
factories are being built outside the U.S.; two-thirds of the new 300 
millimeter wafer fabrication facilities under construction, being 
equipped, or in production are located in Asia, and if all types of 
plants (not only 300 millimeter) are considered, China leads with 
eighteen semiconductor plants.
    What can be done through U.S. tax policy to address this serious 
competitive challenge?
    Potential solutions to close the gap include a corporate rate 
reduction, an investment tax credit (ITC), full expensing of a factory 
in year one (or expensing plus a write-off of an additional percentage 
above and beyond the facility's cost), or a combination of these items. 
The solution could be broad-based or targeted (perhaps to capital-
intensive industries, state-of-the-art technology, high growth 
potential, or some other criteria).
    The U.S. statutory rate for corporations is clearly uncompetitive 
when compared with other nations, and a rate reduction would be helpful 
(depending upon its size). A recent comparison among OECD corporate 
income tax rates finds that the U.S. is tied for the highest federal 
rate among thirty OECD countries. A recent ad in the Harvard Business 
Review noted the favorable Irish 12.5% corporate tax rate, and its 
attractiveness to companies in the bio-tech and pharmaceutical sectors 
(specifically naming seven such world-class companies), so the 
relatively high rate in the U.S. and favorable rate in Ireland have 
been noted, and acted upon, by more than just the semiconductor 
    The responsiveness of the business community to tax rates can also 
be seen from the recent measure in the American Jobs Creation Act that 
provided a temporary reduced tax rate on foreign dividends brought into 
the U.S. for investment in productive activities, including capital 
facilities and research. It has been estimated that as much as $300 
billion entered the U.S. economy during the reduced rate period. 
Intel's $6 billion of ``homeland investment'' dividends helped in our 
decision to invest over $3 billion in a new wafer fabrication facility 
in Arizona.
    An investment tax credit would help reduce the cost of productive 
assets, through its partial offset of income tax liability. Full 
expensing could be another option. Semiconductor manufacturing 
equipment becomes outmoded quickly, and its current 5-year 
``accelerated'' tax depreciation no longer reflects its current 
economic usefulness or even its 4-year financial book life. Expensing, 
however, would only produce a timing difference; it simply accelerates 
the depreciation of the equipment to an earlier year. In contrast, a 
rate reduction, ITC, or expensing of the equipment beyond its original 
cost would generate greater value, producing permanent differences 
impacting the effective tax rate and bottom-line.
    Another important aspect of competitiveness and U.S. tax policy 
should also be noted. Once a wafer fabrication facility is located at a 
foreign site, it is highly likely that earnings in the foreign country 
will be invested in additional plant expansions overseas, rather than 
being invested in the U.S. If brought back to the U.S., after the U.S. 
35% corporate income tax, only 65 cents of each dollar of earnings 
would be available to be invested here, while in contrast as much as a 
full dollar (or 87.5 cents in Ireland, for example) would remain for 
investment in a foreign location after local tax. Having more money 
left to invest in production facilities is a competitive advantage. 
Consequently, an initial decision to invest in a foreign location, 
prompted by the $1 billion cost penalty, will then further disadvantage 
the U.S. when earnings from the overseas location are also invested 
outside the U.S. The homeland investment provision of the American Jobs 
Creation, previously mentioned, addressed this detrimental aspect of 
our current tax system, but only as a temporary solution, not a 
sustaining one.
    Research & development in the semiconductor business requires 
sustained and heavy commitments as well. In 2001 and 2002, during the 
sharpest downturn from a revenue standpoint in the history of the 
semiconductor industry, Intel nonetheless continued investing virtually 
the same amount in R&D (around $4 billion) as in the immediately 
preceding years, in order to ensure that new products would be ready 
when the downturn ended. About 80% of Intel's R&D has typically been 
performed in the U.S. (over $4 billion dollars, for example, in 2004)--
and the balance of our research is performed in design centers located 
around the world, including in Israel, Russia, China, and India. Other 
countries greatly value research performed in their countries, and they 
offer very generous tax credits and incentives to attract research. 
U.S. research and U. S competitiveness are inextricably linked, as the 
President noted in his State of the Union competitiveness initiative. 
The U.S. should be encouraging as much U.S. private sector research as 
possible, as well as increasing government funding of basic research.
    A Tax Credit for increased U.S. research was first enacted in 1981, 
but, despite its long history, the Credit thereafter has been subject 
to only limited extensions. The Credit also suffered a year-long gap in 
its history. Most recently, the Credit once again expired at the end of 
last year and is now awaiting another extension (but, as proposed, only 
for yet another limited period). A permanent Credit is long overdue. A 
recent Congressional Research Service study identified inadequacies in 
the Credit, and specifically noted its lack of permanence as a key 
detriment. The expiration of the Credit, the possibility of another 
gap, and repetitive short-term extensions dilute its potential impact. 
Research planning demands a long-term view, and project planning 
through implementation frequently spans several years. In addition, in 
order to maximize the Credit's impact, it should be made more effective 
by its extension to as many companies as possible performing U.S. 
research; to do so, the Credit must contemplate more varied factual 
circumstances, and pending proposals to further enhance the Credit to 
extend its reach also merit enactment.
    I appreciate this opportunity to share Intel's views on tax policy 
and tax reform, specifically from the perspective of a business 
decision-maker, and with a focus on U.S. competitiveness. I welcome any 
questions you may have.


    Chairman CAMP. Thank you very much. I want to thank all of 
the panel Members for being here.
    Dr. Barrett, the question I wanted to ask you was, how does 
the U.S. international tax system impact business investment 
decisions, but after hearing your testimony, I think I should 
ask you how do other countries' tax systems affect or impact 
business investment decisions. In deciding to locate a 
facility, what are the considerations that are most important 
to you?
    Dr. BARRETT. Historically, the considerations were in the 
ability to do business. That is the presence of the 
infrastructure, and this is infrastructure of everything from 
transportation to power to educated workforce to the physical 
    Over the last 10 or 20 years, that limited the choices 
basically to countries in Western Europe and Japan and the 
United States, the only countries with really significant 
infrastructure. More recently, we have seen a dramatic switch 
as more and more countries come on line with strong educational 
infrastructure and also physical infrastructure.
    So, Asia now is probably the most competitive environment. 
If you look at the sort of facilities I was describing, about 
70 percent of all of facilities currently under construction 
are in Asia, and I don't mean Japan. I mean Asia proper. So, 
increasingly, it is a very, very competitive environment, and 
increasingly, those countries are using their tax policy and 
their other government investment policies to promote 
investments, to promote high-paying jobs and looking at that as 
an investment for the future. We have seen Western Europe, 
Japan and the United States more or less hold firm, with a few 
exceptions, on relatively high corporate tax rates, lack of 
investment tax credits and lack of competitive depreciation 
    Ireland might be the Western European exception when, 
approximately 15 years ago, they changed their corporate tax 
rate from 40 percent to its current 12.5 percent. You have seen 
what happened in Ireland in terms of investment and growth of 
their economy as they went from the bottom of the European 
Union in 1989 to currently the highest per capita income in the 
EU, driven primarily by strong educational infrastructure but 
more importantly by a very low corporate tax rate.
    Chairman CAMP. Thank you.
    Dr. Hubbard, this lower corporate tax rate, what effect--
obviously, recent studies in the United States have shown we 
have one of the highest rates, as several of you have testified 
comparing us to our trading partners.
    What effect does our U.S. tax rate have on the 
competitiveness of U.S. firms operating abroad?
    Dr. HUBBARD. The U.S. tax rate affects U.S. firms in two 
ways. At home, it certainly affects investment decisions. In 
terms of their multinational firms' operations abroad, it 
affects their overall tax burden. The corporate tax also 
affects workers in our economy, whether it is from overseas 
operations or domestic operations, because much of the burden 
of the corporate tax is borne by workers so a rate cut would be 
good for labor.
    Chairman CAMP. Dr. Hines, we had a lot of discussions over 
time about whether we should replace our worldwide U.S. 
taxation system with a territorial system, and if we did 
convert to a territorial tax system, again, on U.S. companies 
operating abroad, what effect would that have on their 
    Dr. HINES. Adoption of territorial taxation would 
immediately make U.S. firms more competitive in foreign markets 
and make them more efficient in the United States as well. The 
reason is that the current system, in which the United States 
is such an outliner compared to other countries, other rich 
countries and other countries that aren't rich, leads to an 
outcome where the tax system gives the American firms the wrong 
incentives to organize their production around the world. If we 
were to adopt a territorial system thereby becoming like most 
of the countries in the world, we would go back to having a tax 
system that doesn't distort ownership of assets the way that 
the current system does, and once you don't distort the 
ownership of assets, you will make business more productive, 
and that includes in the United States.
    So, I agreed with Dr. Hubbard that the impact of that 
system would be to rationalize production and thereby increase 
the productivity of labor and other factors in the United 
    Chairman CAMP. Are there any incremental steps that you 
would suggest in the event that a comprehensive addressing of 
the issue is not done?
    Dr. HINES. You mean, it won't be done? Just in case, it 
isn't, then there are partial steps. There are big steps in 
that direction. France exempts 95 percent of foreign source 
dividends. For thecalendar year 2005 the United States exempted 
85 percent of foreign source dividends from taxation, but that 
was a purely temporary gesture which is different from what we 
are talking about now.
    But one could choose a number--currently, the number is 
zero, and you could exempt maybe 50 percent or more.
    Chairman CAMP. So, you think the exemption of foreign 
source dividends would be one area that we have done in the 
past at least partially and for a short period of time would be 
something that we could do as an incremental step.
    Dr. HINES. Yes, the concept being not as a temporary 
adjuster this time but instead permanently.
    Chairman CAMP. Thank you.
    Mr. McNulty.
    Mr. MCNULTY. Thank you, Mr. Chairman. Since I came here in 
the late eighties, I have been increasingly concerned about the 
increasing Federal budget deficits. The growing national debt, 
which I mentioned in my opening statement, is now in excess of 
$8.3 trillion, and as someone who has four children and five 
grandchildren, I worry about that more and more with each 
passing day.
    I was just wondering if you could state for the Committee 
how you believe your proposals today would positively impact 
that situation, or the bottom line as you would have it, for 
the United States of America?
    Dr. HUBBARD. If I could begin, the U.S. fiscal picture over 
the medium to long run is almost entirely a story about our 
entitlement programs. In fact, the implicit debt in those 
programs is far larger than the numbers that you mentioned, by 
an order of magnitude, perhaps. The question is how we meet our 
obligations. We have to have the most efficient possible tax 
system to do this. The sorts of changes that are being talked 
about to make firms more productive I think will go in the 
right direction. We can't meet those obligations down the road 
by raising taxes on capital. We would be killing ourselves to 
do that. So, I think you have mentioned probably the big 
question, and I think it is another big reason for favoring tax 
reform along the lines that have been discussed this morning.
    Dr. HINES. I share your concern with the deficit. I think 
it is not a sound way to run the economic policy to have huge 
debts and persistent government deficits, and it is simply a 
matter of the United States has to pay its bills, and the 
United States will pay its bills. The question is, how we are 
going to do that and whether we will do it in a sensible, I 
believe, a better manner or a less sensible manner.
    You are much better positioned to be able to pay your bills 
if you have an efficient tax system, and the reason is, you 
collect money more effectively, and you will have a stronger 
economy to tax. So, the more efficient you can set up the 
system, the easier it will be to pay your bills.
    Now, of course, this isn't going to be the whole solution 
because in order to--for the country to pay its bills, we are 
going to either cut spending or raise taxes. Those are the only 
two things you can do.
    But in the processes----
    Mr. MCNULTY. Or grow the economy.
    Dr. HINES. Yes, absolutely. If you can grow the economy, 
that is a way of collecting more taxes because it would happen 
    But all of those things are going to happen most easily if 
you have an efficient system, and that is what we are 
describing this morning, I think, is that the current system is 
not efficient from the standpoint of taxing of multinational 
    Dr. BARRETT. I only have four grandkids that I am worried 
about. The oldest one is a sophomore going into her junior year 
at Stanford. So, she's getting perilously close to the work 
    This is a conundrum as far as a head of a major corporation 
is concerned in the United States My company, for example, 
could be very successful if it never hired another person in 
the United States. Most of our business is done out of the 
United States As a U.S. citizen, that is not an acceptable 
vision to me. So, I would like to see United States be as 
competitive as possible.
    Using tax policy to promote investment and to promote the 
creation of high-paying jobs, I think, is the most critical 
thing the government can do. As I look around the world at 
these other countries that we are involved with that have 
progressive tax policies who promote investments they see a net 
positive flow into their country. Ireland perhaps is the 
classic example where with a corporate tax rate--and they did 
not rob the Treasury in Ireland, created the most prosperous, 
most dynamic economy in Western Europe and added to the growth 
of their economy and the growth of opportunity for their 
    So, my comments are targeted toward opportunity for 
citizens in the United States by tax policy which promotes 
investment in the United States in the creation of jobs in the 
United States.
    The current policy, the numbers that I mentioned, are in 
fact exactly the opposite. They are promoting companies of the 
sort that Intel is to invest in R&D and to invest in 
manufacturing facilities out of the United States. They can't 
possibly be good for the budget deficit, but more importantly, 
they can't possibly be good for our children or grandchildren.
    Mr. MCNULTY. Thank you.
    Chairman CAMP. Thank you.
    Mr. Chocola may inquire.
    Mr. CHOCOLA. Thank you, Mr. Chairman.
    Thank you all for being here this morning.
    Dr. Hubbard, I appreciate your comments about the unfunded 
liabilities we face, which I think the Government 
Accountability Office puts at, at least at $36 trillion today.
    I guess my first question would be for Dr. Hubbard, but all 
of you are more than welcome to respond. If the United States 
ended our tax deferral on overseas income, do you think the 
result would be more or less companies investing in the United 
    Dr. HUBBARD. If the United States repealed deferral, we 
would be raising tax on capital in the our country. Investment 
would become less attractive for American companies and, by 
weakening the economy, less attractive for companies generally.
    Mr. CHOCOLA. Dr. Hines, do you have any comment?
    Dr. HINES. Yes. I think there be would be less investment 
in the United States. Repealing deferral has a superficial 
appeal because it seems that you would remove the tax liability 
associated with repatriation and therefore trigger flows of 
funds from abroad to the United States. So, at first blush, it 
is easy to think of repealing deferral as a gesture that will 
create more investment funds for the United States.
    However, in the medium run, after maybe a couple of months, 
repealing deferral would make the United States even more 
unusual compared to all other countries that are capital 
exporters. We would become unique in the sense of imposing such 
a heavy tax on outbound investments from the United States.
    What that would do is weaken American companies, first of 
all, and second, make it much less attractive for foreigners to 
invest in the United States, which is another source of job 
creation and investment.
    So, repealing deferral is not an adjustment which one would 
want to undertake, even though, it does have this apparent 
    Mr. CHOCOLA. Intel took advantage of the temporary low 
rates of repatriating earnings?
    Dr. BARRETT. We did. Income, to the best of my knowledge, 
that temporary repeal in rates brought about $300 billion back 
to the United States. Intel contributed about $6 billion of 
that repatriation, and $3 billion of that went to build a new 
facility which is under construction in Arizona at this point 
in time.
    In response to your question, I would reiterate that over 
80 percent of our business is export business. Our competitors 
are international competitors. If you repeal the deferral of 
tax on foreign income, it would make Intel and companies like 
Intel less competitive in the international marketplace. Our 
competitors would prosper, and we would decline.
    Mr. CHOCOLA. Yesterday I had a group of steelworkers in my 
office, and we had a spirited discussion about global trade 
issues. I used to run a public company, but we had some of the 
same issues. We had to make decisions about where we invested 
and not only on tax policy but on market forces, obviously. 
However, Dr. Hubbard, you said in your written testimony that 
although firms take the cost of production of their affiliates 
into account, there is little reason to believe that increased 
investment abroad necessarily implies less economic activity at 
    Would you like to explain or expound on that?
    Dr. HUBBARD. Certainly. There is often a common view that 
if a multinational invests abroad, that investment displaces 
whatever it would have done in the United States. In fact, most 
multinational investment abroad has to do with market access, 
accessing lower costs of production as well, so it really is 
that the capital abroad and capital in the United States for 
many industries that are complementary. Certainly, 
multinational employment abroad can tend to raise high-wage 
employment here in the United States. So, this is something 
that isn't a matter of just theory. There have been a number of 
empirical studies by Martin Feldstein and others to suggest 
this very strong complementary relationship despite the facial 
    Mr. CHOCOLA. Dr. Barrett, in your written testimony, I 
think you said you agree with not giving companies incentives 
to do--to engage in behavior they were going to behave in 
anyway; it is just a question of where they are going to engage 
in the behavior.
    In an earlier hearing, we had people say, don't give us tax 
incentives, give us a low rate. Has there been any research 
done on what an optimal rate would be here for corporate tax in 
the United States to make us as competitive as possible, and to 
be revenue appropriate? Have there been any studies of that?
    Dr. BARRETT. I don't have an absolute number. I can only 
point you to countries that are aggressively attracting 
investment in the sort of innovative assessment that we would 
like to have more of in the United States. They are using 
either tax holidays or tax rates in the 10 percent range, so 
the 0 to 10 percent range compared to the United States 35 
percent from the Federal standpoint and not adding state and 
other taxes on top of that. However, I certainly would not 
argue with a 10 percent corporate tax rate in the United 
    Mr. CHOCOLA. Do either of you have--are aware of any 
research done----
    Chairman CAMP. The gentleman's time has expired. So, if you 
could answer briefly.
    Dr. HUBBARD. The optimal tax on capital is zero, but I 
think more interestingly, the recent work suggests a revenue 
maximizing corporate rate would be only in the mid 20 percent 
for the United States
    Chairman CAMP. All right. Thank you.
    The gentleman from Texas, Mr. Doggett may inquire.
    Mr. DOGGETT. Thank you, Mr. Chairman.
    Picking up on Dr. Hubbard's comments, Dr. Hines, isn't that 
optimum tax rate of zero what you are advocating for all 
foreign source income?
    Dr. HINES. No, because foreign source income is taxed by 
foreign governments.
    Mr. DOGGETT. I am about talking about U.S. tax being be 
    Dr. HINES. Yes.
    Mr. DOGGETT. Do you agree with that? That we should apply 
the zero rate on all foreign source income of U.S. companies as 
far as the U.S. tax system is concerned?
    Dr. HUBBARD. Yes, sir.
    Mr. DOGGETT. Dr. Barrett, is that your position also?
    Dr. BARRETT. My position is merely the United States should 
have a competitive policy on tax such that it doesn't inhibit 
companies like Intel from investing in the United States as 
well as investing in foreign countries.
    Mr. DOGGETT. If we make--going right to that point then, if 
we make the rate zero on all foreign source income, don't we 
need to at the same time lower toward zero the rate on 
corporate income in this country in order to avoid an incentive 
for people to do all their investments where they pay no taxes, 
no U.S. taxes at all?
    Dr. HUBBARD. Not quite, Congressman. The argument for the 
zero tax on foreign-source income is simply that it is in the 
interests of the United States; because of the well-being of 
multinationals and the effect that has on wages and capital 
formation in the United States. There is a separate and bigger 
question that I mentioned in my opening remarks about the 
corporate tax generally, and yes, we should be lowering the 
corporate tax rate. However those are two different questions.
    Mr. DOGGETT. Dr. Barrett has told us that there are 
countries like Malaysia that practically pay Intel to come. 
They are not paying any tax, perhaps at least for some period 
of a tax holiday, and are being given various and other 
incentives to be there to get the competition between the 
states and localities here to attract an Intel.
    So, if there is no U.S. tax and, in some cases, for 
extended periods of tax holidays, there is no foreign tax 
there--if the U.S. corporate tax stays even in the twenties and 
it is--and there is no tax that you face to build new plants in 
Malaysia or some other country, then unless you lower the U.S. 
tax significantly, there will be a strong incentive to export 
jobs and plant equipment abroad.
    Dr. HUBBARD. Be careful about generalizing that example 
because the bulk of multinational investment really is for 
market access. It is not to be in the Malaysias of the world 
but the high-tax, high-wage countries.
    Dr. HINES. If the question is what effect would that have 
on business activity in the United States, and employment in 
the United States, the way to--exempting foreign income from 
taxation, there is a lot of theory and a lot of evidence now 
that that would improve business activity and increase 
employment in the United States. It seems paradoxical, but the 
way that it works is foreign governments have the opportunity 
to tax businesses located wherever they are, and they can 
choose to tax it wherever they are at whatever rate they want 
and some of them offer very low tax rates.
    Mr. DOGGETT. Let me ask what I think is the converse of the 
question I posed. That is, if the rate for building a new plant 
and equipment is effectively 35 percent in Maryland and is zero 
in Malaysia under your plan, you don't think we need to make 
any adjustments in the rate for domestic income generation just 
because it is zero abroad?
    Dr. HINES. Not on that question.
    Mr. DOGGETT. Let me ask you as we move under your 
recommendations to a zero tax rate on foreign source income--we 
have heard comments from Dr. Barrett that we need to make 
adjustments, which I agree with in depreciation schedules for--
certainly people who are in semiconductor and other kinds of 
new information technology production that we need to have more 
dependable research and development tax credit All of those 
things of course, take money from the treasury as would a zero 
tax rate on foreign source income. How do each of you propose 
that we make up that revenue? Or do you believe that the 
answer, as I thought Dr. Hubbard was saying, is that the 
deficit is all about entitlements, which is another way of 
saying, make it up by changes in Medicare and Social Security.
    Dr. HUBBARD. To answer your question, we actually do not 
raise that much revenue from the taxation of foreign-source 
income. However such tax generates a lot of distortions. 
Happily, this is one that is not that costly to fix. It is, 
however, expensive to cut the domestic corporate rate, though 
that should be part of an exercise of overall tax reform where 
I think most economists would recommend.
    Mr. DOGGETT. Do either of you have any specific places that 
you would generate more revenue in order to compensate for any 
changes in the level of corporate taxation at home or abroad 
that you recommend?
    Dr. HUBBARD. You should broaden the corporate tax base.
    Dr. HINES. Might want to think about a value-added tax.
    Chairman CAMP. All right. Thank you.
    Dr. BARRETT. I was going to suggest that other countries 
look at this, as opposed to taxation, as to creating 
opportunity and creating jobs which then create a tax base on 
their own. When we look at different states in the U.S. where 
corporate tax rates are not an issue, but local taxes are, 
every analysis that has been done shows that creating the local 
jobs more than accommodates the decrease in property tax rates 
or whatever incentives states can provide.
    As I travel around the world, I see countries investing for 
the future by creating jobs and creating the tax base and not 
worrying about taxing the corporation that creates the jobs.
    Chairman CAMP. All right. Thank you.
    I want to thank the panel Members for your excellent 
testimony and for your time for being here.
    Thank you very much.
    Our second panel I would ask to come forward is composed of 
Michael J. Graetz, who is the Justus S. Hotchkiss Professor of 
Law, Yale Law School in New Haven, Connecticut; Paul 
Oosterhuis, who is a partner in Skadden, Arps, Slate, Meagher & 
Flom; and Stephen Shay, who is a partner in Ropes & Gray in 
Boston, Massachusetts.
    Thank you all for being here. You each have 5 minutes to 
summarize your testimony. Your written statements we have and 
will be made a full part of the record. We will begin with Mr. 
Oosterhuis. Thank you for being here.

                      MEAGHER & FLOM, LLP

    Mr. OOSTERHUIS. Thank you. It is my pleasure to be here. I 
received my first experience as a tax lawyer on the Joint 
Committee Staff beginning in 1973, and I spent a wonderful five 
and a half years working on international tax rules.
    Since then, I have been working in private practice 
advising U.S.-based and foreign-based multinationals on the 
subject that we are talking about today. So, I am going to 
speak to you from the perspective of a practitioner.
    I would like to focus my attention on the territorial 
proposal like that Jim Hines and Glen Hubbard discussed on the 
prior panel.
    The first thing to make sure everybody understands is that 
a territorial system, a dividend exemption system as it has 
been proposed recently would raise revenues, not lose revenues. 
That is important for you to understand. That is because it is 
important to understand how it raises revenue when you are 
thinking about it, and whether the implications of those 
revenue-raising aspects cause problems that need resolution 
before deciding whether territoriality is a good direction that 
we should move in or not.
    Moving from our current deferral and foreign tax credit 
system to a territorial system raises revenues essentially for 
three reasons. The first, in our foreign tax credit system as 
it exists today, companies can use foreign taxes that they pay 
to high-tax countries and use those credits to reduce their 
U.S. tax on other items of income that are not heavily taxed. 
That, first of all, applies to exports. That is because our 
rules, going back to the 1986 Act, allow some portion of export 
income to be foreign source income whether or not the company 
has any presence abroad. If a company has substantial high-
taxed earnings in foreign countries and also exports, it can 
reduce its rate of U.S. tax on exports by using its credits 
against its export income.
    If we move to a territorial exemption system, excess 
credits go away. Because foreign income is exempt from a tax, 
no foreign tax credits are allowed, and therefore, for some 
companies, territoriality is going to raise the taxes on their 
export transactions.
    You need to understand that and you need to evaluate 
whether increased taxes on exports is acceptable or whether 
there are serious issues involved in such an increase.
    Second, companies that have high-tax foreign earnings can 
use those high foreign taxes to reduce the U.S. tax on their 
foreign royalty income given the way our rules work today. The 
royalties are principally from technology. It is also royalties 
from trademarks and consumer and marketing intangibles, but 
principally royalties from technology development activities 
that occur in the United States. So, if we switch to a 
territorial system, we are increasing the taxation of those 
technology companies that rely on high taxes in various foreign 
countries to reduce the tax on their royalties. You need to 
think about that. I think you could think about that in the 
context of the R&D tax credit legislation because one solution 
there might be to use some of the money that territorial would 
raise to expand and make permanent the R&D tax credit.
    The third results because in the territorial exemption 
system, foreign dividends are exempting, and thus most people 
believe there are some expenses that also need to be disallowed 
as a deduction because they are expenses that relate to the 
generation of exempt income. In our foreign tax credit world, 
we don't need to disallow any deduction. We just treat those 
expenses as being foreign source expenses, and then give a 
foreign tax credit on net foreign source income, that is 
foreign income net of foreign source. In a territorial system, 
the logical analog is to disallow foreign source as deductions 
in the United States. That can have a very negative impact on 
the location of jobs in the United States to the extent the 
expenses of paying salaries, for example, are disallowed as 
    The Joint Committee suggested a territorial proposal over a 
year ago. They proposed that some R&D expenses might be 
disallowed as deductions. I think that is wrong. It is wrong as 
a technical matter, and I think it would be bad as a policy 
matter. Second, general and administrative (G&A) expenses are a 
big category of expenses potentially disallowed as deductions. 
Those are headquarters-type expenses of people who are managing 
international businesses of U.S. based multinationals. There is 
an argument that some of those expenses should be disallowed, 
but I think you should consider whether or not that is 
necessary given the importance of these types of jobs in our 
    So, these are some of the issues that you need to think 
about as you consider a territorial system. On balance, there 
is a lot to be said for territoriality, as Dr. Hubbard and Dr. 
Hines indicated in the prior panel, but there are some problems 
as well. It does raise revenue rather than lose revenue, so you 
need to be very careful as you analyze it.

    [The prepared statement of Mr. Oosterhuis follows:]

    Statement of Paul W. Oosterhuis, Partner, Skadden, Arps, Slate,
                           Meagher & Flom LLP

    Thank you for the invitation to testify today. It is a pleasure to 
appear before you to discuss the topic of reform of the U.S. 
international tax regime. I am appearing on my own behalf, and not on 
behalf of any client or organization. As such, the views I express here 
today are solely my own.
I. Introduction
    The foundations for much of the current U.S. international tax 
regime were passed into law in 1962. Without belaboring the point, much 
has changed economically since the 1960s and 1970s. Our world is much 
more global. U.S. multinationals are much less dominant in the global 
economy. In 1960, 18 of the world's 20 largest companies ranked by 
sales were U.S. multinationals. By the mid-1990s, that number had 
fallen to 8.\1\ In the early 1960s, the U.S. accounted for over forty 
percent of worldwide gross domestic product.\2\ Today, the U.S. 
accounts for only approximately 28% \3\ of worldwide output. Instead of 
being the world's largest exporter, of capital, the United States is 
now the world's largest importer of capital.
    \1\ SeeEconomic Report of the President 210 (2003).
    \2\ Fred F. Murray, ed., The NFTC Foreign Income Project: 
International Tax Policy for the 21st Century 95 (Dec. 15, 2001).
    \3\ The World Bank reported that for 2004, U.S. GDP was $11,712 
billion and world GDP was $41,290 billion. See World Bank Data Query, 
http://devdata.worldbank.org/data-query/ (last visited June 16, 2006).
    At the same time, the prosperity of the United States is 
increasingly tied to the global economy. Falling tax and regulatory 
barriers to the free flow of goods, services, and capital have created 
an integrated worldwide marketplace. Reductions in the cost of 
international transportation and communication, as well as 
technological advances, make it not only possible but essential for 
companies to operate efficiently across national boundaries. Half a 
century ago, multinational firms invested abroad to overcome tariff and 
transport costs. Today, global supply chains have gone from being the 
exception to being the norm. Foreign direct investment by U.S. 
multinationals is now part of an integrated production process that 
must be highly efficient to compete with other U.S. and foreign 
    Adapting U.S. international tax policies to these business 
realities is a subject of considerable discussion. Most of that 
discussion over the last few years has revolved around establishing a 
territorial international tax regime or eliminating the deferral of 
taxation on certain foreign income that represents the heart of our 
current worldwide system of international taxation. In particular, both 
the Joint Committee on Taxation and the President's Advisory Panel on 
Federal Tax Reform have studied territorial approaches and produced 
outlines of the rules that might be used to implement such a system.
    Of course both territorial and deferral systems require 
consideration of taxing currently some of the income earned by 
controlled foreign corporations. I believe there are important 
interactions between the nature of the rules that determine which 
foreign income will be taxed currently \4\ in either a deferral system 
or a territorial system and the desirability or necessity of a 
territorial tax system. The competitive advantages of a territorial 
system could be thwarted by casting the remaining subpart F rules too 
wide, so that substantial active business income would be taxed 
currently, or by casting that net too narrowly, so that substantial 
passive income of U.S. taxpayers would go untaxed anywhere in the 
    \4\ Or, alternatively, which foreign income qualifies for deferral 
or exemption.
    Subpart F of the Code contains the rules governing the current 
taxation of CFC income under our Code today. Thus, it would seem useful 
first to discuss issues relating to the scope of our current subpart F 
rules and then to discuss issues relating to the merits of moving to a 
territorial system.

II. Issues Under Subpart F
A. Historical Rationale for Subpart F
    To understand the structure and rationale underlying the provisions 
of subpart F, it is helpful to return to the circumstances that led to 
its adoption during the Kennedy Administration. The country faced a 
large deficit and the Administration worried that U.S. economic growth 
was slowing relative to other industrialized countries. At the time, 
deferral was available for all foreign income earned by foreign 
affiliates, and administration policymakers became concerned that U.S. 
multinationals were shifting their operations offshore in response to 
the tax incentive provided thereby.\5\ The Kennedy Administration 
proposed to impose current taxation on the foreign source income of 
foreign subsidiaries of U.S. multinationals operating in developed 
countries and simultaneously to provide investment tax credits and 
accelerated depreciation allowances intended to encourage investment 
and production in the United States.\6\ The Kennedy Administration's 
intent was to make investment in U.S. facilities relatively more 
attractive in comparison to investment in foreign facilities.
    \5\ John F. Kennedy, President of the U. S., Annual Message to 
Congress on the State of the Union (Jan. 11, 1962), in 1 Pub. Papers at 
13-14 (1963).
    \6\ Id.
    Businesses and many in Congress believed, however, that ending 
deferral would unfairly disadvantage U.S. companies competing in 
foreign markets first by taxing them at a higher rate than their 
locally-owned competitors and second by eliminating their flexibility 
to utilize deferral to average their foreign tax credits over time to 
avoid double taxation. These concerns were understandably widespread 
despite the fact that at the time the United States was the source of 
half of all multinational investment worldwide, was the world's largest 
capital exporter, and basically dominated the nascent global 
    \7\ Fred F. Murray, ed., The NFTC Foreign Income Project: 
International Tax Policy for the 21st Century 95 (Dec. 15, 2001).
    It soon became clear that the Kennedy Administration's proposal to 
end deferral entirely in developed countries could not pass the 
Congress. The compromise that emerged is what we all now know as 
subpart F. As one of its core concepts, subpart F attempts to eliminate 
deferral for third-party passive investment income. The 1962 version of 
subpart F retained deferral for most truly active businesses.\8\
    \8\ I.R.C.  951-960 (1962).
    Subpart F as enacted in 1962 was a classic example of a practical 
legislative solution to a perceived problem, as opposed to an attempt 
to achieve a theoretically perfect result. At the turn of the 1960s 
most developed countries had corporate income tax rates equal to or 
higher than the United States. Thus, over the long run deferral of 
income earned in those countries was not that valuable and did not 
provide that much of an incentive for U.S. companies to make 
investments abroad instead of in the United States. U.S. 
multinationals, however, had set up structures in which a foreign 
affiliate company located in a low-tax jurisdiction would lend, license 
or otherwise do business with operating company affiliates in high-tax 
foreign jurisdictions. Interest, royalties or other deductible 
intercompany payments were made by the high-taxed foreign affiliates, 
reducing income tax liability in those foreign jurisdictions and 
creating income for the low-taxed foreign affiliate. Due to deferral, 
that income could generally avoid U.S. tax until repatriation. Prior to 
subpart F, these simple ``earnings stripping'' arrangements represented 
the heart of U.S. corporate international tax planning.
    Subpart F was designed in substantial part to address these 
earnings stripping transactions. It identifies specific categories of 
income, not principally their location or tax burden. At least in 
theory, subpart F attempts to identify the tax planning activities that 
can give U.S. multinationals an incentive to invest abroad independent 
of local tax rates. As enacted, it reduced any such incentive for U.S. 
multinationals to invest abroad without affecting their ability to 
compete with local foreign companies, which were unlikely to be able to 
engage in similar earnings stripping-transactions. In concept, subpart 
F could thus make it much more difficult for a U.S. multinational to 
lower its effective tax rate below the U.S. tax rate over time.\9\ 
Doing so required locating profitable manufacturing facilities in low-
taxed jurisdictions, which for non-tax reasons was often more difficult 
to do.
    \9\ In the early years subpart F had a variety of exceptions and 
special rules which substantially reduced the scope of its application, 
but by 1976 it was reasonably effective in accomplishing its goals.
    But in its creation and particularly as it was expanded in the 
1980s, subpart F applied to more than third-party passive income and 
earnings stripping transactions. It always applied to some active 
businesses, including in particular services businesses to the extent 
of services performed outside of a company's jurisdiction of 
incorporation, a topic to which I will return.\10\ In the 1970s and 
1980s other categories of active business income were added to subpart 
F, including shipping and active finance income.\11\ Our experience 
with attempts to eliminate deferral on shipping income and active 
finance income indicates that eliminating deferral on active business 
income, even if it is low-taxed, may not strike the right balance 
between competitiveness and minimizing foreign investment incentives. 
In both cases after enactment the perceived impact on competitiveness 
was sufficient that Congress rethought its handiwork, enacting 
successive extensions of the temporary active finance exception since 
1997\12\ and eliminating the shipping income category in 2004.\13\
    \10\ I.R.C. Sec. 954 (1962).
    \11\ Pub. L. No. 99-14 (1986); Pub. L. No. 94-12, Sec. 602 (1975).
    \12\ See, e.g., Pub. L. No. 106-170, Sec. 503(a)(1)-(3) (1999); 
Pub. L. No. 107-147, Sec. 614(a)(2) (2002).
    \13\ Pub. L. No. 108-357,  415(C)(2)(a) (2004).
B. Subpart F in the Global Economy of the 21st Century
    Economic globalization in the forty-plus years since the 1962 Act 
greatly changed both the business model of multinationals and the way 
economists think about why multinationals invest across national 
borders. Today much U.S. multinational activity inevitably must take 
place abroad, and direct investment decisions may more often center on 
whether a U.S. or foreign-based multinational will own a pre-existing 
foreign operating facility or business than on where any new direct 
investment will be made. In 2001 over 96% of' foreign direct investment 
into the United States represented the acquisition of preexisting 
entities.\14\ Although data for outbound investment is not as readily 
available, it is also likely that most current outbound direct 
investment by U.S. multinationals similarly represents transfers of' 
ownership rights rather than development of' new assets.\15\ To many, 
this data suggests that often the question is no longer whether a U.S. 
company will build and operate a manufacturing plant in Des Moines, 
Stuttgart, or Kyoto. Instead, the question is whether a U.S.-based 
multinational, a European multinational, or a Japanese multinational 
will own a manufacturing plant in a location such as Shanghai, and as a 
result whether the headquarters and research and development jobs 
associated with that plant will be predominantly in the U.S., Europe or 
    \14\ See Mihir A. Desai & James R. Hines Jr., Economic Foundations 
of International Tax Rules 16 (2003) (citing Thomas Anderson, Foreign 
Direct Investment in the United States: New Investment in 2001, Surv. 
of Current Bus., June 1, 2002, p. 28-35.).
    \15\ Id.
    As the competitive pressures associated with global product and 
services markets increase, the flaws embedded in various provisions of 
subpart F have become correspondingly more important. In that regard, I 
would direct the Congress' attention to perspectives like that 
articulated in an excellent 2001 National Foreign Trade Council 
(``NFTC'') report on deferral issues.\16\ That report concluded that 
more than forty years after its creation, the basic structure of the 
U.S. international tax system (including the general deferral 
principle) remains workable. The report articulated the principle that 
our subpart F rules should generally be in line with comparable rules 
of other major countries that serve as home to multinational 
competitors. It then benchmarked U.S. international tax rules against 
the rules imposed by many of our major trading partners and OECD 
counterparts, including Canada, France, Germany, Japan, and the United 
Kingdom.\17\ The Report suggested that relative to the rules major 
foreign competitors of the U.S. impose on their multinationals, subpart 
F imposes a harsh regime with respect to certain types of active 
business income. To maintain our subpart F comparability, the report 
proposed liberalizing those parts of subpart F that accelerate tax on 
active business income of foreign affiliates of American companies.\18\
    \16\ Fred F. Murray, ed., The NFTC Foreign Income Project: 
International Tax Policy for the 21st Century (Dec. 15, 2001).
    \17\ Id. at 67-88.
    \18\ Id. at 3.
    The principle that our CFC rules should be reasonably in line with 
those of other major countries makes considerable sense; it is a useful 
exercise to focus on elements of our current subpart F rules from that 

1. Subpart F Services Income
    CFC income from services performed for, or on behalf of, a related 
person outside the country under the laws of which the CFC is organized 
is taxed currently under subpart F.\19\ Treasury regulations have 
secured a broad scope for this provision by deeming services performed 
by a CFC with ``substantial assistance'' from a related party--defined 
by the regulations to include certain types of direction, supervision, 
services, know-how, financial assistance, equipment, material, or 
supplies--to be subpart F services income.\20\
    \19\ I.R.C.  954(e).
    \20\ Treas. Reg.  1.954-4(b)(1)(iv).
    With their considerable breadth, the subpart F services income 
rules have always encroached on active business income. Today, however, 
those rules are pervasively troublesome given the declining importance 
of physical location in the performance of services. As a result of the 
rules' reach, multinational corporations face the prospect of immediate 
taxation for otherwise deferrable active business income as the result 
of routine and otherwise efficient global staffing and resource 
allocation decisions. By contrast, the OECD countries surveyed in the 
NFTC report give their CFCs considerable flexibility to provide or 
receive services with assistance from a related CFC without losing 
deferral or exemption for the affected income (at least so long as the 
services are not provided from the parent's home country or by a CFC 
that is subject to tax in that country). The subpart F services rules 
thus represent a deviation from the general principle favoring deferral 
for active business income and a serious departure from consistency 
with the regimes of our major trading partners. They are also 
fundamentally antiquated (and frankly unenforced) in the modern 
business environment, where cross-border services projects using 
resources from multiple countries and affiliates are ubiquitous. For 
all these reasons, they would best be repealed.\21\
    \21\ It also seems particularly anomalous that a U.S. CFC is taxed 
currently when it provides services to a related CFC, but is not taxed 
when it makes an intercompany loan to that same related CFC. That 
contrast results because the subpart F rules now allow foreign-to-
foreign earnings stripping transactions, but continue to tax active 
business provision of services to related parties.
2. Active Financing
    In 1986 subpart F was expanded to capture certain gains derived in 
the active conduct of a banking, financing, or similar business. A 
temporary exception to this provision was first passed by the Congress 
in 1997 (with certain rules to prevent the routing of income through 
foreign countries to maximize tax benefits). Currently, financial 
services firms enjoy an exception from subpart F for active financing 
income of their CFCs provided the CFC (or its qualified business unit) 
is both ``predominantly engaged'' and ``conducts substantial activity'' 
in an active banking, financing, or similar business.\22\
    \22\ I.R.C.  954(h).
    Allowing U.S. multinationals to face only the local tax rate until 
income is repatriated is clearly appropriate for financial services, 
which is in many respects the most globalized of all the service 
industries. Outside the United States, active financing income is 
almost universally recognized as active trade or business income and is 
consequently entitled to either deferral or exemption (depending on 
whether the home jurisdiction has a deferral-based or territorial tax 
system). To promote certainty and stability for U.S. financial 
corporations as well as to provide a level playing field, Congress 
should permanently extend a generous active financing exception.
    Moreover, the active finance exception as it has existed since 1997 
has a number of detailed requirements. For example, to qualify for the 
exception, substantially all of the activities in connection with which 
a relevant item of income is earned must be conducted directly by the 
eligible CFC in its home country.\23\ In addition, a qualifying CFC 
that is not licensed to do business as a bank in the United States (and 
most are not so licensed) must derive more than 70 percent of its 
income from transactions with unrelated customers outside the United 
States.\24\ Such CFCs must also derive more than 30% of their gross 
income from the active and regular conduct of a lending or finance 
business in transactions with unrelated customers that are located in 
the CFC's home country.\25\ These requirements can intrude on sound 
business practices in an industry that is as globalized and multi-
jurisdictional as financial services. Our financial institutions 
operate in a global, not local, business world. Limitations on cross-
border lending and other active finance-type activities between foreign 
countries make little sense in today's world. To my knowledge, no other 
major foreign country imposes similar limitations on their resident 
banks under comparable CFC rules. Thus, a strong case can be made for 
liberalizing these rules as well as making them permanent.
    \23\ Section 954(h)(3)(A)(ii).
    \24\ Section 954(h)(2)(B)(ii).
    \25\ Section 954(h)(3)(B).
3. Subpart F Sales Income
    The U.S. subpart F sales income rules attempt to strike a balance 
between promoting competitiveness and preventing earnings stripping 
but, because they can apply to very real and substantial companies, can 
be less favorable than those of our OECD counterparts. Sales income 
subject to subpart F encompasses income earned in a variety of 
transactions--including (1) the purchase of personal property from a 
related person and sale to another person, (2) the sale of personal 
property to any person on behalf of a related person, (3) the purchase 
of personal property from any person and its sale to a related person, 
or (4) the purchase of personal property from any person on behalf of a 
related person--where the property purchased or sold is both produced 
outside and sold for use outside of the country under the laws of which 
the CFC is organized.\26\ These rules apply very mechanically. 
Historically, they were intended to prevent multinationals from routing 
income through ``re-invoicing'' companies with little substance and 
strategically located in low-tax countries. However, as business models 
have adapted to the globalized economy and manufacturing and marketing 
of products is conducted across multiple national boundaries for 
legitimate business reasons, the mechanical nature of the rules results 
in many transactions creating subpart F sales income even though they 
involve very real and substantial business operations.
    \26\ Section 954(d).
    OECD countries surveyed by the NFTC impose deferral limitations 
with a similar goal to our subpart F sales rules, but in general--and 
particularly in the cases of Canada, German, and Japan--impose more 
flexible limits on dealing with related parties and operating outside 
the CFC country. The persuasive rationale for such flexibility rests on 
the recognition that in a world of multinational firms, many legitimate 
sales businesses may entail substantial sales to or purchases from 
related parties.
    Thus, Congress should consider liberalizing the subpart F sales 
rules. As part of that effort, consideration should be given to 
clarifying those circumstances where contract manufacturing activities 
should be taken into account in determining the applicability of 
subpart F to sales income.\27\
    \27\ See Rev. Rul. 97-43, 1997-2 C.B. 59; Rev. Rul. 75-7, 1975-1 
C.B. 244.
4. Application of Subpart F to Related Party Passive Income
    With relatively little debate Congress recently enacted on a 
temporary basis look-through rules to except from subpart F related 
party dividends, interest, royalties and rents.\28\ This legislation 
effectively codifies the result that since 1998 most taxpayers had been 
able to achieve on their own through check-the-box planning techniques.
    \28\ Section 103 of the Tax Increase Prevention and Reconciliation 
Act of 2005 amended section 954 of the Code to provide that for a three 
year period dividends, interest, rents, and royalties received from a 
related CFC will not be treated as subpart F income to the extent 
attributable to income of the related CFC that is not itself subpart F 
income. Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. 
No. 109-222,  103, 120 Stat. 345 (2006). This provision represents the 
logical extension of the application of the check-the-box rules.
    Applying a look-through rule for dividends may well be good policy. 
Taxing such dividends under subpart F raised little revenue but 
distorted multinational behavior by discouraging the payment of 
dividends from CFCs with low taxed income. Excluding from subpart F, 
however, related party payments that are deductible in foreign 
countries raises completely different policy issues. The exclusion 
allows U.S. multinationals to incur deductible expenses in a high-tax 
foreign jurisdiction payable to a related entity in a low-tax 
jurisdiction without generating subpart F income in the United States. 
It thus repeals one of the core concepts of subpart F. The result 
clearly improves the competitiveness of U.S. multinationals by reducing 
their foreign tax on foreign income. But it is not clear that the 
result strikes the right balance between that competitiveness and 
minimizing foreign investment incentives.
    The implication of the principle articulated in the NFTC report 
that our CFC rules should be in line with those in major foreign 
countries is that we need not have our CFC rules be more lenient than 
the comparable rules found in these major foreign countries.
    In my experience at least, the kinds of earnings stripping 
transactions that check-the-box planning and the newly enacted related 
party look-through rules permit are substantially more difficult to 
accomplish, and are thus less frequently undertaken, by French, German, 
Japanese and U.K. multinationals because the CFC rules in those 
countries tax such transactions in most cases. (Canada has a look-
through rule for related party interest payments under its FAPI regime, 
and so is an exception).
    Moreover, if similar look-through exclusions to their CFC rules 
were adopted by major foreign countries, the long-run result would 
arguably be unfortunate from a global tax policy perspective; the only 
limitation on earnings stripping transactions would be imposed by the 
country of source. Yet countries have great difficulties in limiting 
earnings stripping transactions solely on a source basis. Many 
countries in Europe, for example, have recently reexamined their thin 
capitalization rules, but substantial taxpayer flexibility remains.
    The United States last attempted to further limit earnings 
stripping on a source basis in 2003, when the Treasury Department 
proposed to tighten section 163(j) by, among other things, abandoning 
the existing uniform 1.5 to 1 debt-to-equity ratio safe harbor approach 
in favor of an approach that would divide the assets owned by a 
taxpayer into identified classes and allow a safe harbor based on the 
degree of leverage typically associated with such types of assets.\29\ 
A worldwide leverage test would also have been added that could apply 
in addition to the adjusted taxable income test to disqualify interest 
deductions for interest in excess of safe harbor amounts.\30\ The 
foreign investment community and others complained that neither the 
asset categories nor the worldwide leverage test would be sufficiently 
reflective of commercial realities for any specific multinational, 
while also raising a host of technical issues with the proposal.\31\ 
While some of the criticisms of the Treasury proposal may have been 
exaggerated, they did highlight the difficulties with designing 
tailored earnings stripping rules to be administered by source 
    \29\ Office of Mgmt. & Budget, Exec. Office of the President, 
Analytical Perspectives: Budget of the United States Government, Fiscal 
Year 2004 (2003).
    \30\ Id.
    \31\ See, e.g., Andrew Berg, NYSBA Comments on Proposals to Modify 
Earnings Stripping Rules, Tax Notes Today, Sept. 12, 2003.
    These source country limitations leave the U.S. and other 
jurisdictions with two alternatives in dealing with earnings stripping 
transactions: they can permit the transactions and thereby implicitly 
accept as a fact that cross-border investments are generally taxed at a 
lower global tax rate than are purely domestic investments; or they can 
attempt to minimize the rate reductions on cross border investments in 
large part through CFC rules that tax earnings stripping transactions.
    In other areas of international tax policy, the U.S. has been a 
leader in encouraging foreign countries to adopt reasonably consistent 
regimes. For example, the United States was largely responsible for the 
adoption of the arm's length standard for evaluating transfer pricing 
arrangements. Maintaining CFC rules that reasonably align with those of 
other major countries at least with respect to earnings stripping 
transactions, and avoiding any ``race to the bottom'' competition, does 
require a longer run perspective. Nevertheless, such consistency would 
seem to be potentially achievable U.S. policy. Thus, in the related 
party passive income area of subpart F, it may be appropriate for 
Congress to reconsider whether the balance between maintaining 
competitiveness and minimizing tax incentives for foreign investment 
has been struck appropriately.
    In doing so, Congress should recognize that it would also be 
possible to adjust the check-the-box regime (with all of its attendant 
simplification benefits) to avoid the self-help repeal of the earnings 
stripping provisions of subpart F. For example, a regime that respected 
transparent entities with one member as a separate partnership-type 
flow-through entity could be adopted for purposes of subpart F. It is 
the check-the-box regulation's treatment of single member entities as 
disregarded, leading to the disregarding of actual transactions, that 
effectively repealed the earnings stripping provisions of subpart F.

III. The Connection Between Related Party Passive Income Rules and a 
        Territorial Tax System
    Since check-the-box became effective in 1998, U.S. multinationals 
have understandably migrated to check-the-box tax planning structures 
that incorporate the types of earnings stripping transactions subpart F 
was originally intended to prevent. Over that time the amount of income 
deferred by U.S. taxpayers has grown substantially. In 2003, for 
example, U.S. corporations retained $169 billion dollars of foreign 
earnings abroad, representing 67% of total foreign profits.\32\ That is 
a 122 percent increase over the $76 billion of retained foreign 
earnings in 1997 (which represented 48% of foreign profits). A 
selective survey showed that among 38 of the largest U.S.-based 
multinationals the amount of annual foreign earnings retained abroad 
grew from $9 billion in 1997 to $46.3 billion in 2003.\33\
    \32\ Martin A. Sullivan, Presentation at the Tax Council Policy 
Institute 2005 Symposium (Feb. 10-11, 2005) (materials available from 
The Tax Council Policy Institute).
    \33\ John Almond & Martin Sullivan, While Congress Dawdles, Trapped 
Foreign Profits Surge, Tax Notes Today, June 28, 2004 at 1586.
    Clearly, not all of this increase can be attributed to check-the-
box planning for earnings stripping transactions. Over this same period 
section 936 of the Code was capped, leading many section 936 companies 
to convert to foreign companies and take advantage of deferral on their 
manufacturing income in Puerto Rico. Moreover, during this period many 
companies' foreign affiliates adopted cost sharing of R&D. Nonetheless, 
the impact of check-the-box planning should not be underestimated. One 
recent estimate suggests that check-the-box planning saved the U.S. $7 
billion in local country tax in 2002.\34\
    \34\ Rosanne Altshuler & Harry Grubert, Special Reports: 
Governments and Multinational Corporations in the Race to the Bottom, 
Tax Notes Int'l, at 459 (February 6, 2006).
    In large part in response to the build-up of earnings resulting 
from check-the-box and other deferral planning, over the past couple of 
years increased interest has been given to proposals to move to a 
territorial system. By permitting tax-free repatriation of earnings 
that benefit from deferral today, a territorial system would eliminate 
the distortions that result from the requirement under deferral that 
offshore earnings remain offshore, and invested in foreign assets, in 
order to avoid U.S. tax. The deferral system together with provisions 
in subpart F that attempt to deem repatriation when profits are no 
longer needed in a foreign business lead not to increased repatriation 
but to increased distortion in the productive use of the funds in order 
to avoid repatriation. Thus, if properly structured, a territorial 
system can lead to a more efficient use of funds earned abroad without 
materially encouraging investment abroad.
    Drafted properly, a territorial system would also allow for some 
significant simplification, including the repeal of section 956 and 
section 367(b), the elimination of dividends as a category of subpart F 
income (whether or not subpart F were to continue to permit other 
check-the-box planning) and a much more limited application of complex 
foreign currency translation rules. If the concept of territoriality 
were also applied to exempt gain on the sale of foreign affiliate 
stock, which would be consistent with most foreign country systems, 
U.S. multinationals could restructure their foreign operations (as is 
often required for business reasons) without worrying about whether 
each transaction meets the requirements of the Internal Revenue Code 
reorganization provisions. The simplification benefits from this change 
would in practice be very substantial.
    Further, territoriality seems preferable to a periodic enactment of 
a Homeland Investment Act as a response to the continual build-up of 
foreign earnings. As a practical matter, the U.S. simply will not--and 
should not--repeal deferral on active business income generally any 
time soon for competitiveness reasons (unless perhaps our corporate tax 
rates were reduced below the 20 to 25 percent range). Thus, under 
deferral it is almost inevitable that over time foreign earnings will 
build to the point that another HIA will be necessary. Finally, even if 
one takes the view that our tax rules often do affect where 
``greenfield'' foreign investment in plants, property, and equipment 
takes place, incentives to undertake foreign investment do not 
significantly increase if deferral is replaced with territoriality.
    But in considering a territorial system, Congress will need to 
confront several important issues. First, the export source rule, 
embedded in IRS regulations under Code sections 861 and 863, currently 
treats all of the income from the export of products purchased by U.S. 
persons and essentially one-half of the income from the export of 
products manufactured by U.S. persons as foreign source income in the 
general limitation basket.\35\ Moving to a territorial system would 
eliminate the excess foreign tax credits that can shelter that foreign 
source income from exports from U.S. tax. Congress retained the export 
source rule in the 1986 Act (even when a U.S. exporter had no taxable 
presence abroad) because it believed that the rule helped encourage 
exports and therefore was sound economic policy; the impact of fully 
taxing exports should therefore be carefully examined.
    \35\ See generally Treas. Reg.  1.861-7, 1.863-3.
    Second, excess foreign tax credits also are used today to shelter 
royalty income from U.S. tax. These royalty payments are deductible in 
the foreign subsidiaries' country of residence. However, because the 
foreign tax credit look-through rules for categorizing income apply to 
royalty payments by foreign subsidiaries and the subpart F income that 
reflects such payments, excess foreign tax credits can reduce U.S. tax 
on these royalty payments. The impact on the conduct of intangible 
development activities in the U.S. of fully taxing royalty payments 
arising out of such development activities must be carefully examined, 
and alternative proposals for mitigating that impact should be 
    Ironically, particularly if earnings stripping transactions remain 
eligible for deferral, the export and royalty issues are likely to be 
less important to many U.S. multinationals today than they were in the 
late-1980's and 1990's. Foreign tax rates have continued to come down 
in many high tax rate countries since that time. Moreover, in many 
instances U.S. multinationals have given up their excess credit shelter 
by initiating deferral strategies through check-the-box planning to 
push local tax rates significantly below the U.S. 35 percent rate. The 
look-through rules for foreign personal holding company purposes will 
further encourage such planning, especially if Congress chooses to make 
those rules permanent. Nonetheless, the impact of territoriality on 
U.S. exports and U.S. intangible development activities must be 
carefully reviewed.
    Another important issue involves the disallowance of expenses. The 
territoriality proposal suggested by the President's Advisory Panel 
sensibly avoids any disallowance of R&D expense and appropriately 
limits interest expense disallowance to interest apportioned under a 
scheme like the worldwide interest allocation provision enacted as part 
of the 2004 Act.\36\ But that proposal leaves open the question of 
disallowing general and administrative (``G&A'') expenses.\37\ That is 
troublesome. The principle underlying a territorial system of taxation 
is that all income should be taxable in one and only one jurisdiction. 
In a parallel manner, all expenses should be deductible in one 
jurisdiction either directly or indirectly through charge out payments. 
It is no doubt true that some G&A (including stewardship) factually 
relates to exempt foreign affiliate income and that in many cases that 
G&A expense cannot be charged out under Section 482 (in which case it 
should be fully deductible). Yet disallowing a deduction for G&A 
expenses that cannot be charged out means that such expenses are not 
deductible anywhere in the world even where all income is taxable 
somewhere in the world. The relevant G&A expenses moreover are 
typically for management services that reflect jobs the Congress should 
not want to discourage locating in the United States. Thus, a strong 
argument exists for permitting a full deduction of G&A expenses or at 
least for expanding cost-sharing to apply to G&A expenses.\38\
    \36\ President's Advisory Panel on Fed. Tax Reform, Simple, Fair, 
and Pro-Growth: Proposals to Fix America's Tax System 239-242 (2005).
    \37\ The Advisory Panel proposal would disallow that portion of G&A 
expenses that are not charged out to foreign subsidiaries allocable to 
exempt foreign affiliate income using an allocation scheme generally 
analogous to the worldwide interest allocation provision enacted as 
part of the 2004 Act. Id. at 241.
    \38\ Today our section 482 cost-sharing regulations only apply to 
intangible development costs. See Treas. Reg.  1.482-7. Expanding it 
to include G&A expenses more generally would make sense, but only if 
other major foreign jurisdictions also accepted cost-sharing of these 
IV. Conclusion
    So where does this leave us? In the end I think there are three key 
lessons. First, Congress should act to eliminate those parts of subpart 
F that lead to the current taxation of active foreign business income. 
Second, Congress should examine further whether exempting earnings 
stripping transactions from subpart F is necessary in the context of 
maintaining a subpart F regime that balances competitiveness concerns 
with minimizing tax incentives to invest abroad and that is reasonably 
consistent with those of other major countries. Finally, assuming 
substantial deferral planning is continued to be permitted, Congress 
should seriously consider moving to a territorial system to avoid 
substantial imbalances of funds abroad but should fully consider its 
impact on U.S. R&D activities, on U.S. exports, and on the tax 
treatment of G&A-type expenses in the United States. Because adopting 
such a territorial system would raise significant revenues, the costs 
of liberalizing subpart F as it applies to active businesses should be 
manageable and should leave additional revenues to consider other 
matters, including increased incentives for U.S. R&D. Properly done, 
the overall package could eliminate the distortions of the current 
deferral system and establish a system that from the perspective of the 
competitiveness of U.S. multinationals would not be more burdensome 
than the systems of most major foreign countries.
    Thank you for your attention and I look forward to taking any 
questions you may have.


    Chairman CAMP. Thank you very much. Professor Graetz.


    Mr. GRAETZ. Thank you very much. I want to begin where the 
last panel left off, which is with the notion that it is no 
longer possible given the integration of the world economy to 
think about domestic tax reform and international tax reform as 
if they are two different subjects. Corporate income tax in the 
United States affects not only the competitiveness of U.S. 
companies abroad but also the attractiveness of the United 
States as a place for investment of both domestic and foreign 
    When John Castellani, the president of the Business 
Roundtable, testified before this Subcommittee a month ago, he 
made the point that the U.S. corporate tax rate was the most 
important issue facing American companies, and I agree with 
    In my view, the most important corporate change that the 
Congress could make both to stimulate our own domestic economy 
and to increase the competitiveness of U.S. companies 
throughout the world would be to lower our corporate tax rate 
substantially. A 25-percent rate would put us in line where the 
OECD countries are now, but I think our goals should be lower 
than that. We should try to get the corporate rate down to 15 
percent, the rate that is now applicable to capital gains and 
dividends. It would be good for the U.S. economy. It would 
diminish the payoff from corporate tax shelters and 
intercompany transfer pricing, and it would be good for 
    The $64 question I think is the one that Congressman 
Doggett put earlier, which is, given the financial shape of the 
U.S. Treasury, how do we replace the revenues that would cost? 
Given the fact that corporate tax receipts were about $300 
billion last year, cutting the rate would be expensive. My 
answer to that is that we really ought to take seriously 
enacting a value-added tax or a similar tax on goods and 
    If we enacted such a tax, for example, at a 14--10 to 14 
percent rate, that would allow us to pay for the corporate rate 
reduction. It would allow us to eliminate 150 million Americans 
from paying income taxes. It would allow us to get our 
individual tax rate down in the neighborhood of 20 and 25 
percent, and it would keep the distribution of the tax burden 
about where it is today.
    Compared to other OECD Nations, the United States is a low-
tax country. However it is not a low-income tax country, so 
when people like the earlier panel talk about Singapore and 
Ireland, they talk about the low income tax rates, but all of 
those countries make up the revenue by a consumption tax, 
typically in the form of value-added tax. So, that kind of 
value-added tax reform would enhance our economic growth, 
basically simplify our tax system and maintain the same 
distribution of burdens that we now have.
    The second point I want to make is that any domestic tax 
reform that we are going to undertake must fit well with 
international tax practices. While I found much to admire in 
the report of the President's panel on tax reform, their 
alternative to the income tax--what they call a growth and 
investment tax--is completely out of sync with international 
practices and, as they recognize, would require complete 
renegotiation of all of our income tax treaties and the General 
Agreement on Tariffs and Trade (GATT).
    The idea that we are going to get a tax reform not only 
through this Congress and signed by the President but also 
through the World Trade Organization (WTO) seems to me 
hopelessly optimistic.
    I don't mean to suggest that we can't make incremental 
improvements of the sort we have been talking about earlier to 
our international tax system without fundamental tax reform. My 
point is that the benefits to the U.S. economy will be quite 
small compared to the benefits of a fundamental restructuring 
of the U.S. tax system.
    The third point I want to make, and this one seems obvious, 
but apparently, it is not. In evaluating either domestic U.S. 
tax or international tax reforms, the goal ought to be what is 
in the best interests, the well-being--the long term well-
being--of the American people. That is the goal that we apply 
everywhere else in domestic and international policy, and we 
ought to apply it to international tax reform as well.
    The Joint Committee pamphlet today describes that as a 
minority view. So, I think it is worth reconsidering.
    On the question of territoriality in the few seconds 
remaining to me, let me say one thing. I believe the reason to 
go to territoriality instead of what we now have, which can be 
done on a revenue-neutral basis as has just been suggested, is 
that it eliminates the barrier to repatriation of earnings to 
the United States; and the current system now makes that 
expensive or--requires huge amounts of tax planning in order to 
make that possible.
    As we have seen with the Homeland Investment Act (HIA) and 
the temporary exclusion of dividends, there is a major amount 
of earnings of U.S. companies that get trapped abroad that 
might repatriate to the United States if we did not have a 
residual tax on repatriations, and I think that is the reason 
to do it; that it would lower the cost of capital to U.S. 
businesses and improve our situation.
    Thank you, Mr. Chairman.

    [The prepared statement of Mr. Graetz follows:]

 Statement of Michael J. Graetz, Justus S. Hotchkiss Professor of Law,
                Yale Law School, New Haven, Connecticut

    Mr. Chairman and Members of the Committee----
    Thank you for inviting me to testify today on the subject of 
international tax reform. I want to begin my testimony with three basic 
    First, it is no longer possible--given the integration of the world 
economy--to regard domestic tax reform and international tax reform as 
if they are two different subjects. When Congress last enacted 
fundamental tax reform--in 1986--the stock of cross boarder investment 
was less than 10% of the world's output. Today it equals about one 
quarter of the world's output. The U.S. corporate tax affects U.S. 
companies doing business domestically, U.S.-headquartered firms doing 
business abroad and foreign-headquartered firms doing business here. 
It, therefore, affects the competitiveness of U.S. companies and the 
attractiveness of the United States as a place for investment of 
domestic and foreign capital.
    When John Castellani, President of the Business Roundtable, 
testified here last month on the topic of tax reform generally, he said 
that the priority for U.S. corporations is to lower significantly the 
U.S. corporate tax rate. I agree that the U.S. corporate rate is a 
crucial issue for our nation's economy. After the 1986 tax reform, our 
corporate tax rate was one of the lowest in the world; today it is one 
of the highest. [See Figures 1 and 2.\1\ In my view, the most important 
corporate tax change Congress could enact--both to stimulate our 
domestic economy and to increase the competitiveness of U.S. companies 
throughout the world--would be to lower our corporate tax rate 
substantially. Although a 25% rate would put us in line with most OECD 
nations, it is worth trying to get that rate down to 15%--the rate now 
applicable to dividends and capital gains--or to no more than 20%. Such 
a rate reduction would be very good for the U.S. economy. It also would 
allow much simplification of our rules for taxing international 
business income; for example, a 15% rate would greatly diminish the 
payoff from both corporate tax shelters--which frequently have 
international aspects--and intercompany transfer pricing that shifts 
U.S. income abroad while consuming great resources of the IRS and 
taxpayers alike.
    \1\ Figure 2 illustrates only statutory corporate rates; other 
measures generally show similar patterns.
    But given the current financial condition of the federal 
government--with deficits as far as the eye can see--and the inevitable 
future demands for spending on retirement income, health care, and 
long-term care for an aging population, it is not possible to achieve 
this kind of corporate rate reduction without a major restructuring of 
our domestic tax system. Corporate tax receipts were $279 billion in 
FY2005, $303 billion in FY 2006, about 2.3% of our GDP. While some 
corporate base broadening is surely feasible, base broadening alone 
will not produce enough revenue to pay for the kind of rate reduction I 
am urging here. My first point, therefore, is simple but challenging: 
Lowering the corporate tax rate significantly--the priority for 
international competitiveness of the U.S. economy and for international 
tax reform--cannot happen without domestic tax reform.
    In my view, the goal of such a tax reform should be to reduce our 
nation's reliance on the income tax and increase our reliance on 
consumption taxation. I have detailed elsewhere how enacting a value 
added tax (or a similar tax on goods and services) at a 10-14% rate 
would allow us to eliminate 150 million Americans from the income tax 
altogether by enacting an exemption of $100,000 (for married couples) 
and to lower the income tax rate for income above that level to 20-
25%.\2\ It would also permit the kind of corporate rate reduction, I am 
advocating here.
    \2\ See Michael J. Graetz, ``100 Million Unnecessary Returns: A 
Fresh Start for the U.S. Tax System,'' Yale Law Journal, Vol. 112 pp. 
261-310; Michael J. Graetz ``A Fair and Balanced Tax Reform for the 
Twenty-first Century. Toward Fundamental Tax Reform (edited by Alan J. 
Auerbach and Kevin A. Hassett) (AEI Press, 2005). Low- and middle-
income workers would be protected a tax increase by payroll tax 
    Compared to other OECD countries, the United States is a low tax 
country. As a percentage of GDP, our taxes are as low as Japan's and 
much lower than most European nations. [See Figure 3] But we are not a 
low income tax country. Our income taxes as a share of GDP are not 
lower than the average elsewhere. [See Figure 4.] The critical 
difference is that we rely much less than other OECD nations on 
consumption taxes. [See Figure 5.] The tax reform proposal I am 
advocating would shift that balance dramatically, making our 
consumption taxes comparable to those elsewhere and our income taxes 
much lower. [See Figures 5 and 6.] This would enhance our nation's 
economic growth and dramatically simplify our tax system while 
maintaining roughly the same distribution of tax burdens as current 
    Second, any major domestic tax reform must fit well with 
international tax practices. For example, while I found much to admire 
in the Report of the President's Panel on Tax Reform issued last 
November, a crucial weakness of its proposal for a consumption tax 
alternative to the income tax--its so-called ``Growth and Investment 
Tax''--is that it does not mesh well with longstanding international 
practices. Indeed, adopting that proposal would require not only the 
votes of the Congress and the signature of the President, but also 
would require the U.S. to renegotiate all 86 of our bilateral Income 
Tax Treaties as well as the General Agreement on Trade and Tariffs 
(GATT). If the proposal had no other major shortcomings (which it 
does), it is so out of sync with our international tax and trade 
arrangements that it is unrealistic as a practical matter. The panel, 
in my view, also failed to take into account the potential responses of 
other nations to the kind of major tax reform it was suggesting.
    I do not mean to suggest that incremental improvements in our 
system for taxing international income cannot occur in the absence of 
fundamental tax reform. Some international tax reforms--such as moving 
to a territorial system--can be done independently of domestic tax 
reform on a revenue neutral basis. But in my view, the benefits for the 
American people of such changes will be quite small relative to the 
potential benefits achievable through a fundamental restructuring of 
our nation's domestic and international tax system.
    Third, in evaluating either domestic or international tax reforms 
it is important to have the same goal in mind: improving the wellbeing 
of American citizens and residents. For too long, international tax 
reform has occurred in the context of a debate between two normative 
ideas--capital export neutrality and capital import neutrality--that 
both fail to ask the fundamental question: What will be the effects of 
the changes on the wellbeing of Americans?
    Unfortunately and importantly, many policymakers longstanding 
understanding of the normative underpinnings of international tax 
policy is thoroughly unsatisfactory. I have made this point in detail 
elsewhere.\3\ The essential problem is that at least since 1962, when 
Subpart F was enacted, the Treasury Department, the Joint Committee on 
Taxation, and most other policymakers have looked to capital export 
neutrality (CEN) and capital import neutrality (CIN or 
``competitiveness'') as their guide to U.S. international tax policy. 
It is now well known that we cannot have both CEN and CIN 
simultaneously when there are differences in the tax base or tax rates 
between two countries. If our policy guideline is to compromise 
somewhere between CEN and CIN, that is no guideline at all. Such 
compromises make setting international tax policy free play; you can 
compromise anywhere. The fundamental questions we should be asking are 
``What policy is in the U.S.'s national interest?'' What rules will 
best serve the long-term interests of the American people? These are 
the questions we normally ask about domestic tax policies and about 
other non-tax international policies, and these are the basic questions 
for international tax policy as well. There is no reason to depart 
here, as so many analysts do, by substituting worldwide economic 
efficiency norms.
    \3\ Michael J. Graetz, ``Taxing International Income: Inadequate 
Principles, Outdated Concepts, and Unsatisfactory Policy,'' Tax Law 
Review, Vol. 54, pp. 261-336 (2001).
    The great difficulty, of course, is knowing what to do to improve 
the wellbeing of our citizens and residents. The essential problem is 
empirical uncertainty. As is so often the case with tax policies, it is 
very difficult to know with certainty the consequences of alternative 
policy decisions. Contested facts inevitably will play an important 
role. For example, does foreign expansion by U.S. multinationals reduce 
or expand American jobs? Although there is much concern about 
outsourcing U.S. jobs, the best evidence at the moment seems to be that 
foreign expansion by U.S. multinationals usually increases U.S. jobs. 
Nor do we know with certainty the extent to which capital used abroad 
replaces capital that would otherwise be deployed in the U.S. or, 
instead, is complementary to capital used in the U.S. Again, the best 
evidence seems to be that foreign investment is most often 
complementary to domestic investment. Nevertheless, we need to seek 
better information about these kinds of questions in order to make firm 
judgments about the effects of alternative policies on the welfare of 
the American people.
    I should emphasize that seeking to advance the wellbeing of the 
American people does not, mean abandoning this nation's leading role in 
multinational organizations such as the OECD and WTO. Nor does it mean 
that we should always adopt policies advancing the competitiveness of 
U.S. multinationals. Advancing the competitive position of U.S. 
multinationals may or may not be the best course depending on the 
particular issue and circumstances.
    In sum, my three basic points are these: (1) International tax 
reform and domestic tax reform are now inextricably linked, and the 
best way to improve the international competiveness of the U.S. economy 
is through a fundamental restructuring of our nation's tax system. (2) 
It would be a serious mistake to undertake a domestic tax reform that 
ignores international tax and trade arrangements. (3) The test for both 
domestic and international tax reforms should be whether they will 
improve the wellbeing of the American people. Let me know turn to 
discuss a few specific issues relating to the international taxation of 
business income.

Taxing International Business Income
    Currently, the big debate in international tax policy is whether we 
should substitute for our foreign tax credit system--often referred to 
as a worldwide system--a system that exempts active business income 
earned abroad. More than half of OECD countries now exempt dividends 
paid from foreign subsidiaries. The origins of U.S. international tax 
policy demonstrate that our foreign tax credit was not put into the tax 
code to promote capital export neutrality. It was enacted in 1918 for 
mercantilist reasons. The policy of the U.S. then was to encourage U.S. 
companies to go abroad and trade. The limitation on the foreign tax 
credit, which was put into the law a few years later in 1921, was 
intended to protect U.S. taxation of U.S. source income.\4\ An 
unlimited foreign tax credit would allow taxpayers to escape U.S. tax 
on U.S source income.
    \4\ See Michael J. Graetz and Michal O'Hear, ``The `Original 
Intent' of U.S. International Income Taxation,'' Duke Law Journal, Vol. 
46, pp 1022-1109, (1997).
    The key difficulty in international tax policy is that we have two 
national governments with legitimate claims to tax the same income: The 
country where the capital originates (the residence country) and the 
country where the income is earned (the source country). They must 
decide how to split the tax dollars between the two nations. The goal 
of multinational corporations, of course, is to pay taxes to neither.
    It has long been the tax policy of the U.S. and of other 
industrialized nations to treat the prime claim between the two nations 
as the claim of the country where the income is earned--the source 
country--when the taxation of active business income is at issue. The 
primacy of source-based claims to income taxes on active business 
income has been a feature not only of the U.S. system, but of all OECD 
tax systems since the 1920's. The fundamental goal has been to avoid 
double taxation. If the source country taxes the business income, the 
residence country should not tax it again.
    It is more difficult, however, to know how much to worry about low 
or even zero taxation by the source country. Should the United States, 
for example, be concerned if U.S. multinationals are avoiding taxes by 
stripping income out of source countries in Europe and elsewhere? This, 
of course, is the basic goal of much recent international tax planning 
involving the use of hybrid entities and the so-called check-the-box 
rules and the foreseeable effect of the new CFC look-through rules. 
Analysts who are predominately concerned with the potential for tax-
induced capital flight abroad--those who urge policy based on capital 
export neutrality--will argue that the U.S. should act unilaterally to 
shore up the ability of foreign governments to prevent such tax 
reductions, for example, by tightening our Subpart F rules or even by 
eliminating the ability of U.S. multinationals to defer foreign-source 
income reinvested abroad.
    My approach to this issue would take a different tack. My concern 
is that if U.S. policy encourages or readily facilitates the ability of 
U.S. companies to strip earnings without paying taxes to the country 
where the income is earned, foreign countries will respond by enacting 
rules that will allow their companies to strip earnings from the U.S. 
without paying tax. Our own experience with transfer pricing and our 
recent experience with efforts to restrict such earnings strippings 
demonstrates the difficulty of effective unilateral action by the 
source country. European nations will have even greater difficulties in 
protecting their corporate tax bases due to limitations imposed by the 
European treaties as interpreted by the European Court of Justice. The 
potential for an ongoing ``race to the bottom'' as each nation assesses 
the international ``competitiveness'' of its own multinationals and 
aids their avoidance of taxes abroad suggests great caution in enacting 
rules that facilitate tax avoidance abroad by U.S. multinationals.
    However, given our system for taxing active business income, which 
concedes the primacy of source-based taxation, an exemption system and 
our foreign tax credit system with deferral generally available for 
active business income, are not terribly far apart. The two methods are 
very close, although they differ in certain important respects.\5\ In 
my view, the major difference is that with an exemption system there 
would be little or no cost to U.S. multinationals in bringing earnings 
back to the United States. Under our foreign tax credit system, much 
tax planning occurs to avoid incremental U.S. income tax when money is 
brought back into the United States.
    \5\ See Michael J. Graetz & Paul W. Oosterhuis, ``Structuring an 
Exemption System for Foreign Income of U.S. Corporations,'' National 
Tax Journal, Vol. 44, pp 771-786 (2001).
    Thus, the crucial advantage of an exemption system is to eliminate 
the burden on the repatriation of foreign earnings to the United States 
and remove the tax barrier to investing here. As experience with the 
Homeland Investment Act has well demonstrated, there are substantial 
earnings of U.S. companies that have been trapped abroad which will 
return to the United States for either a small U.S. income tax or none 
at all. The key reason to move to an exemption system is to remove the 
tax barrier to repatriation, not simplification or international 
competitiveness. Removing this tax barrier would lower the cost of 
capital for U.S. companies and could do so without any substantial 
revenue loss. In my view, this would be a worthwhile improvement in 
U.S. tax policy, although, I have said, the key issue for the 
competitiveness of the U.S. economy both domestically and for U.S. 
multinationals operating throughout the world is a significantly lower 
corporate tax rate.
    There are a number of important questions, however, that must be 
answered before moving to an exemption system. As is typically the case 
in tax policy, the devil is in the details. For example, there is the 
question to what extent expenses should be allocated between taxable 
U.S. income and non-taxable foreign income. A worldwide allocation of 
interest as under the 2004 legislation seems appropriate as the 
President's Panel suggested. The Joint Committee on Taxation has 
suggested that research and development expenses should also be 
allocated between domestic and foreign income. The President's Panel 
disagreed. I would support the President's Panel in this regard. 
Royalties will be taxed when paid to a U.S. parent under a dividend 
exemption system, and this should make the allocation of R & D to 
foreign income unnecessary. The Joint Committee on Taxation and the 
President's Panel also diverged on the treatment of general and 
administrative expenses. Again, I am inclined to think that the 
President's Panel came closer to the best answer. One option used 
abroad, which should be considered here, is not to allocate such 
expenses but to allow an exemption of only 90 or 95 percent of 
    There is also a question about how to treat exports. Should the 
current sales source rules for domestically manufactured products be 
retained? In my view, shifting from our current system to an exemption 
system does not itself demand revision of this rule, although such a 
shift would provide a good occasion to reassess its effectiveness.
    Third, it is important to note that interest, rents, royalties, and 
other payments deductible abroad are not usually excluded in an 
exemption system. Exempting them from taxation here would mean that 
such payments are subject to tax nowhere, which clearly seems the wrong 
answer. On the other hand, under current law, foreign tax credit 
planning most often makes royalty income from abroad nontaxable. Many 
multinationals will no doubt push for continued exemption of royalty 
income. If we were to take that path, it would re-open the question 
whether to allocate research and development expenses. With both of 
these issues in play, assessing the impact of alternative rules on the 
level and types of research and development activities in the United 
States seems essential before reaching a final conclusion.
    Fourth, with exemption, we would clearly have to maintain an 
equivalent to our current Subpart F for passive income. This means that 
there will be at least two categories of income: exempt income and 
income currently taxable subject to foreign tax credits. Congress 
should resist creating a third category of income that can be deferred 
and allowed foreign tax credits. With income either exempt or taxed 
currently subject to foreign tax credits, the question will inevitably 
occur regarding the proper scope of Subpart F, particularly with 
respect to ``base company'' income and other types of active business 
income, such as the income of financial services businesses.
    Thus, moving to an exemption system for active business income does 
not allow the complete elimination of foreign tax credits. We will, for 
example, still have to maintain a foreign tax credit for taxes withheld 
abroad on payments of royalties and other income. An exemption system, 
however, should allow a single foreign tax credit limitation.
    Finally, the question will arise whether dividend exemption should 
apply to pre-effective date income. Since the main reason for adopting 
an exemption system is to permit repatriations of income without 
imposing a U.S. tax burden, I am inclined to believe that the best 
answer to this question is yes, the exemption should apply to income 
earned before the date when the law changes. If Congress concludes 
otherwise, however, it would be much simpler to limit the exclusion to 
a specified percentage of dividends rather than attempt to determine 
whether dividends were from pre- or post-enactment earnings.
    Before I conclude, I would like to illustrate once again the 
linkage between the level of corporate tax rates and fundamental issues 
of international taxation. In a recent paper, Harry Grubert of the 
Treasury Department and Rosanne Altshuler, who served as the staff 
economist for the President's Tax Reform Panel, have estimated that 
repealing deferral of all CFC business income would allow the corporate 
tax rate to be reduced to 28% on a revenue neutral basis. Personally, I 
do not think--given the rates of corporate tax around the world--that a 
28% rate is low enough to permit the repeal of deferral without harming 
both the competitiveness of U.S. companies and the U.S. economy. But, 
if the corporate tax rate were lowered to 15%, as I have suggested 
should be our goal, repealing deferral would look very different. 
Current U.S. taxation of all foreign source business income at a 15% 
rate, offset by appropriately limited credits for foreign taxes, would 
become a reasonable alternative worthy of careful consideration. And, 
as the Grubert-Altshuler paper suggests, repealing deferral might be 
one element to help finance the rate reduction. Current taxation of all 
income earned abroad, with a foreign tax credit up to the new U.S. 15% 
rate, would allow great simplification of our international income tax 
system in a context providing the economic advantages from 
restructuring our domestic tax system that I described earlier.
    As I indicated at the beginning of this testimony, I do not believe 
that such a substantial rate reduction can be accomplished in the 
absence of a major restructuring of the U.S. tax system. Therefore, 
this option will no doubt have to wait until the Congress undertakes 
the broader task. Given the ongoing expansion of the individual AMT and 
the coming expiration in 2010 of the tax reductions enacted in the past 
several years, however, serious Congressional consideration of a major 
restructuring of our nation's tax system in the years ahead does not 
seem unrealistic.
    Thank you for allowing me to make these observations here today. I 
will be happy to answer any questions.








    Chairman CAMP. Thank you. Mr. Shay.


                     BOSTON, MASSACHUSETTS

    Mr. SHAY. Thank you, Mr. Chairman.
    Our international tax rules are only one element of our 
overall system for taxing business income. As has been said by 
others on this panel, broader tax system design issues are more 
significant than the choice of whether you tax foreign income 
at a full rate or with exemption.
    I agree that the primary focus of U.S. income tax policy 
should be how to raise revenue in a manner that improves the 
lives and living standards of our citizens and residents.
    The manner in which we apply our rules should be guided by 
our traditional tax policy criteria of fairness, efficiency and 
administrability. There is a lack of consensus among the 
economists regarding what promotes efficiency in the home and 
global economy. I would take a commonsense practical approach 
which is to reduce the incentives to shift economic activity in 
response to differences in effective tax rates that exist under 
our current international tax rules.
    Foreign income generally is treated more favorably than 
domestic income. Income earned through a foreign corporation 
may be deferred from U.S. tax without regard to whether it is 
subject to a foreign tax. Taxpayers that operate in high-tax 
jurisdictions can use foreign tax credits against other foreign 
income, which provides an incentive to earn low foreign taxed 
    Income from export sales is treated as foreign source 
income for our tax credit limitation purposes, though almost no 
country in the world will tax that income at source. Yet U.S. 
tax on this export income is being allowed to be offset by 
excess foreign tax credits. Cross-crediting effectively allows 
the burdens of other foreign countries high foreign taxes to be 
offset against U.S. tax. The 2004 Act, referred to as a reform 
act, expanded the scope for cross-crediting.
    Our current international tax rules distort economic 
decisions, create incentives to structure business activity in 
a manner that takes advantage of lower foreign effective tax 
rates, and, the most disturbing in my view, is to undermine the 
confidence of U.S. citizens and residents that the American tax 
system is fair.
    I did say at the outset that I am an international tax 
practitioner, and I have been doing it for 25 years.
    The President's Advisory Panel on Tax Reform has suggested 
possible reforms. We have been speaking about exemption. The 
President's Advisory Panel on Tax Reform's Simplified Income 
Tax Proposal would exempt foreign business income as part of 
its reform plan. The proposal would not require any minimum 
level of foreign tax or even a subject-to-tax requirement, 
which is commonly found in other territorial systems as a 
condition for the exemption. I would contrast this with the 
proposal made in 1993 of the outgoing Department of the 
Treasury by the first Bush Administration.
    Under the President's Advisory Panel's exemption proposal, 
any kind of non-Subpart F income that can be earned outside the 
United States at a lower rate would benefit from exemption, and 
the amounts could be repatriated. That would expand the scope 
of people who would be interested in creating a foreign 
operation. In my experience today, if a client comes in asking 
if they can set up in a foreign operation, I say, if you can't 
reinvest your money usefully outside the United States, 
deferral is not for you. Exemption would expand the scope for 
deferral of U.S. tax.
    I am going to skip over some other technical problems with 
the Advisory Pale exemption proposal, but expense allocation is 
by far the most important. The rules in there have defects that 
need to be addressed.
    Based on the foregoing, I do not believe that the benefits 
from an exemption system, even if redesigned, are likely to be 
superior to a reform that is based on full taxation of foreign 
income with an appropriately limited tax credit.
    One approach would be to tax United States shareholders and 
U.S.-controlled foreign corporations currently on their share 
of the income. There would be a number of technical changes 
that would be necessary to make this workable, but these rules 
have a history of use since 1962 and could be implemented 
without substantial redesign. The current foreign tax credit 
mechanism should be improved by repeal of the sales-source rule 
and other rationalizations of source rules that today permit 
foreign taxes to offset U.S. tax and U.S. economic activity.
    Full taxation of foreign income would eliminate the lock-
in-effect of a separate tax on repatriation as would exemption. 
They are the same in that regard. In addition, full taxation 
would reduce the scope of effective tax rate differentials.
    Finally, full current taxation of a foreign income is a 
fairer system. United States persons would be taxed on their 
income more equally and the advantages would not fall to those 
who operate principally outside the United States.
    I respectfully encourage the Subcommittee to consider 
international reform proposals that would take in this broader 
perspective. This perspective has been characterized today as a 
minority view of fairness and a superficial view on full 
taxation, but I beg to differ with Dr. Hubbard on these points. 
Thank you.

    [The prepared statement of Mr. Shay follows:]

        Statement of Stephen E. Shay, Partner, Ropes & Gray LLP,
                         Boston, Massachusetts

    Mr. Chairman and Members of the Committee:
    My name is Stephen Shay. I am a partner in the law firm Ropes & 
Gray in Boston. I specialize in U.S. international income taxation and 
was formerly an International Tax Counsel for the Department of the 
Treasury.\1\ With the Chairman's permission, I would like to submit my 
testimony for the record and summarize my principal observations in 
oral remarks.
    \1\ I have attached a copy of my biography to this testimony. The 
views I am expressing are my personal views and do not represent the 
views of either my clients or my law firm.
    The subject of today's hearing is the impact of international tax 
reform on U.S. competitiveness. I will direct my testimony and remarks 
at the U.S. tax rules relating to the taxation of foreign business 
income earned by U.S. persons.
The Context of International Tax Reform
    I respectfully submit that the formulation of the topic for today's 
hearing may be too narrow. Indeed, it almost suggests that U.S. 
international tax rules, as opposed, for example, to overall 
governmental fiscal policies, are a major factor in U.S. 
competitiveness. While some tax practitioners and teachers may believe 
that differences in systems for taxing foreign business income have 
great economic significance, it is clear that the effect of these rules 
on economic growth is vastly less important than sound overall fiscal 
and monetary policies.\2\
    \2\ In recent years there generally has been a vast overstatement 
in public policy debates of the role of tax rule design in our economic 
affairs. Recent academic work has questioned whether ideally designed 
income and consumption tax bases are materially different in what they 
tax. See Reuven S. Avi-Yonah, Risk, Rents, and Regressivity: Why the 
United States Needs Both an Income Tax and a VAT, 105 Tax Notes 
(TA)1651 (Dec. 20, 2004). The revenue estimates for shifting to a 
dividend exemption system also suggest that the revenue gain or loss 
from such a switch would be modest.
    Our international tax rules are only one element of our overall 
system for taxing business income. The international rules govern how 
the United States taxes income earned by a resident in one country from 
economic activity in another country. The principal design decisions 
made with respect to our overall tax rules affect the design of our 
international rules. Thus, decisions to tax income and to impose a 
separate tax on corporate income are key design elements of the tax 
base on which our international tax rules are constructed. These 
overall tax system design decisions are far more significant than the 
choice between full taxation of foreign business income and exemption 
of foreign business income.
    In this testimony, I will limit my remarks to possible reforms of 
our current system for taxing foreign business income. I will assume 
for purposes of this discussion that the income tax will be retained as 
a material element of the U.S. tax system and that the United States 
will continue to impose tax on corporate income.\3\
    \3\ The President's Advisory Panel on Federal Tax Reform has 
proposed two tax reform plans; the ``Simplified Income Tax Plan'' and 
the ``Growth and Investment Tax Plan.'' President's Advisory Panel on 
Federal Tax Reform, Simple, Fair & Pro-Growth: Proposals to Fix 
America's Tax System, Report of the President's Advisory Panel on 
Federal Tax Reform (Nov. 2005), available at http://
www.taxreformpanel.gov/final-report/ [hereinafter the ``President's 
Advisory Panel Report'']. The Growth and Investment Tax Plan would move 
the federal tax system much closer to a consumption tax system,. 
However, it retains some taxation of capital income. The plan would 
permit business to expense most new investments with the consequence 
that the tax on business income would be very limited. I will not 
discuss the Growth and Investment Tax Plan in my testimony.
    While there have been proposals to ``scrap'' the income tax and 
replace it with a consumption tax, these proposals are impractical. The 
problems of transition and the rates that would be required to achieve 
revenue neutrality, as well as other problems, are extremely daunting. 
See A.B.A. Tax Sec. Tax Systems Task Force, A Comprehensive Analysis of 
Current Consumption Tax Proposals (1997). The international 
implications of eliminating the income tax could be substantial. See 
Stephen E. Shay and Victoria Summers, Selected International Aspects of 
Fundamental Tax Reform Proposals, 51 University of Miami Law Review 
1029 (1997).
    Professor Michael Graetz has proposed enactinga broad federal 
consumption tax in addition to the existing income tax. See Michael J. 
Graetz, 100 Million Unnecessary Returns: A Fresh Start for the U.S. 
Income Tax System, 112 Yale L.J. 261 (2002); see also Reuven S. Avi-
Yonah, Risk, Rents, and Regressivity: Why the United States Needs Both 
an Income Tax and a VAT, 105 Tax Notes (TA)1651 (Dec. 20, 2004). While 
proposals to reduce the U.S. reliance on the income tax by adopting 
some form of value-added tax may have some merit, I do not comment on 
them in this testimony.
    The specialized nature of the international tax rules and the 
importance of these rules to a concentrated and important business 
constituency, our multinational business community, has resulted in an 
emphasis on our international tax rules that obscures the fact that 
foreign business income is as much a part of the U.S. tax base as 
domestic income. Taxing foreign business income differently from 
domestic income should be justified under the same criteria that we 
apply to justify more or less favorable taxation of income from any 
other activity.

Objectives of International Tax Reform
    As observed above, international tax policy is but a subset of a 
country's overall tax policy. The objectives of U.S. international tax 
policies must be understood in the framework of overall U.S. tax policy 
    The principal function of the U.S. income tax system is to collect 
revenue.\4\ The manner in which the system serves this role is guided 
by traditional policy criteria of fairness, efficiency and 
administrability.\5\ In applying the criteria, we start with the 
understanding that the correct measure of U.S. welfare is the well 
being of individual U.S. citizens and residents. Accordingly, the 
primary focus of U.S. income tax policy should be how to raise revenue 
in a manner that improves the lives and living standards of those 
    \4\ A secondary role of the U.S. income tax system is to serve as a 
means for appropriating public funds. While I will not discuss the 
topic of ``tax expenditures'' as such, the deferral of income earned 
through controlled foreign corporations is the largest international 
item in the President's 2005 ``normal tax method'' tax expenditure 
    \5\ U.S. Treas. Dep't, Tax Reform for Fairness, Simplicity and 
Economic Growth 13-19 (1984).
    \6\ See Michael J. Graetz, The David Tillinghast Lecture: Taxing 
International Income: Inadequate Principles, Outdated Concepts, and 
Unsatisfactory Policies, 54 Tax Law Rev. 261, 284 (2001). The fact that 
a policy may advance global welfare on the one hand, or the interests 
of U.S. corporations or other U.S. business entities over foreign 
business entities on the other hand, should not be determinative unless 
there is a reasonable basis to conclude that individual U.S. citizens 
and residents will realize a benefit in relation to overall costs. The 
President's Advisory Panel on Federal Tax Reform articulated a standard 
for evaluating proposals that favor one activity over another that 
should be applied to evaluate proposals to tax foreign income more or 
less favorably than domestic income:
    Tax provisions favoring one activity over another or providing 
targeted tax benefits to a limited number of taxpayers create 
complexity and instability, impose large compliance costs, and can lead 
to an inefficient use of resources. A rational system would favor a 
broad tax base, providing special tax treatment only where it can be 
persuasively demonstrated that the effect of a deduction, exclusion, or 
credit justifies higher taxes paid by all taxpayers.
    President's Advisory Panel Report, at xiii.
    The policy criteria of fairness, efficiency, and administrability 
conflict to some degree. The fairness criterion is based on the 
accepted notion that a fair tax should take account of taxpayers 
ability to pay. There is no a priori reason for excluding foreign 
income from the analysis of a person's ability to pay, whether the 
income is earned directly by individuals or indirectly through foreign 
activities of U.S. or foreign corporations. If U.S. taxation of foreign 
business income is lower than on domestic business income, U.S. persons 
who do not earn foreign business income will be subject to heavier 
taxation solely because of where their business is located. This would 
violate the ability-to-pay norm. To justify relief from U.S. tax on 
foreign business income, there should be an identifiable benefit to 
individual U.S. citizens and residents.
    Allowing a credit for foreign income taxes, or exempting active 
foreign business income, is not fully consistent with the ability to 
pay criterion. Such relief from double taxation may be justified, 
however, by the expectation that the benefits of international trade 
will accrue to individual U.S. citizens and residents. This 
justification does not extend, however, to treating foreign income more 
favorably than necessary to eliminate double taxation.
    Generally, the efficiency criterion supports rules that distort 
economic decisions as little as possible. There is a lack of consensus 
among economists regarding what tax rules are ``efficient'' in an open 
economy setting. A common sense approach is to seek to reduce the tax 
incentives to shift economic activity in response to differences in 
effective tax rates. In other words, from an overall U.S. perspective, 
the effective tax rate on an item of foreign income, taking into 
account foreign taxes, should not be materially lower than the 
effective rate on domestic income. Relief should not be given to higher 
foreign effective tax rates.
    There is a general consensus that while taxpayers with 
international income are generally sophisticated and able to deal with 
complex provisions, a system whose complexity fosters wasteful tax 
planning and which is difficult to administer by tax authorities is 
    Our current rules fail these criteria of fairness, efficiency and 

Current U.S. International Tax Rules
    The current U.S. tax rules allow the U.S. taxation of active 
foreign business income earned through a foreign corporation to be 
deferred until repatriated as a dividend. While arguably a measure to 
mitigate double taxation, the deferral privilege is allowed without 
regard to whether a foreign tax is imposed on the income. Accordingly, 
if low-taxed foreign income may be earned in a foreign corporation and 
reinvested in foreign businesses, U.S. tax may be postponed and a 
taxpayer may achieve low overall effective rates of taxation. The 2002 
effective tax rate on net income of U.S. companies' foreign 
manufacturing subsidiaries was approximately 16%.
    Taxpayers that earn high-tax foreign income can use excess foreign 
tax credits against other low-taxed foreign income. The effect of this 
cross-crediting is to provide an incentive to a taxpayer with excess 
foreign tax credits to earn low-taxed foreign income and to credit the 
foreign tax against U.S. tax on this income. This effectively shifts 
the burden of a foreign country's high taxes to the United States. 
Excess foreign tax credits even can be used to offset U.S. tax on 
income from export sales that is treated as foreign-source income for 
U.S. tax purposes (though in most countries income from such sales 
would be considered domestic income).
    With proper planning, U.S. income tax rules may be applied to 
achieve, with respect to low-taxed foreign income, effective tax rates 
comparable to those possible under a territorial tax system that 
exempts foreign income. However, high foreign income taxes also may be 
cross-credited against U.S. tax on other ``foreign'' income in the same 
foreign tax credit limitation category. The latter benefit may be 
contrasted with an exemption system that generally does not allow a 
benefit for high foreign taxes. The current U.S. rules, while complex, 
represent the best of all worlds for U.S. multinational taxpayers. It 
is difficult to conclude that the U.S. rules for taxing international 
business income unfairly disadvantage U.S. multinational taxpayers.
    The current U.S. tax rules encourage the following tax planning:

      Reducing foreign taxes below the U.S. effective rate,
      Using transfer pricing to shift additional income to 
foreign corporations subject to low effective foreign tax rates,
      Deferring U.S. tax on foreign income subject to a low 
effective foreign income tax rate,
      Accelerating repatriation of foreign taxes to cross-
credit excess foreign taxes against U.S. tax on low-taxed foreign 
income in the same foreign tax credit limitation category, and
      Repatriating low-taxed income when excess foreign taxes 
are available to offset U.S. tax (or when homeland dividend effective 
tax rates of 5.25% are available).

    In practice, the current U.S. system of worldwide taxation with 
deferral of U.S. tax on foreign corporate business income, while 
complex, can be managed to achieve low effective rates of tax on 
foreign income. If U.S. multinationals earn income through active 
business operations carried on by foreign corporations through low-
effective-tax rate structures, the U.S. multinationals generally pay no 
residual U.S. tax until they either receive dividends or sell their 
shares. When this effective tax reduction is combined with other 
features of the U.S. international tax regime (i.e., the ability to 
cross-credit excess foreign taxes against royalty income and export 
sales income), the overall effect can be more generous than an 
exemption system.
    To summarize, our current international tax rules (i) are complex, 
(ii) do not raise revenue (indeed, they permit erosion of the U.S. tax 
base), and (iii) provide incentives to locate business activity outside 
the United States. They offer substantially unfettered planning 
opportunities to aggressively reduce foreign taxes and to shift income 
to entities with low-effective tax rates. This is a ``paradox of 
defects.''\7\ The immediate effect is to distort economic decisions and 
create incentives to structure business activity in a manner that takes 
advantage of low or reduced effective tax rates. The more disturbing 
longer term effect is to undermine confidence of U.S. citizens and 
residents that the American tax system is fair.
    \7\ Staff of Joint Comm. On Tax'n, Options to Improve Tax 
Compliance and Reform Tax Expenditures, JCS-02-05, 189 (Jan. 27, 2005).
    There are two major reform alternatives for taxing foreign income: 
some form of exemption of foreign income and an expansion of current 
taxation of foreign income. While in theory it is possible to design an 
exemption system that would be an improvement over the current U.S. 
system, exemption is a second best alternative to full current 

The President's Advisory Panel's Proposed Exemption of Foreign Business 
    The major approaches by which the tax system of a country (the 
``residence country'') taxes income earned by its residents in a 
foreign country (``foreign-source income'') are a worldwide system and 
an exemption, or territorial, system. The President's Advisory Panel on 
Federal Tax Reform's Simplified Income Tax Proposal would exempt 
foreign business income as part of its reform plan.
    The President's Advisory Panel's exemption proposal would exempt a 
domestic corporation from tax on dividends from a foreign corporation 
attributable to certain active business income.\8\ The proposal also 
would exempt gains on the sale of stock of a foreign subsidiary.\9\ The 
proposal would not require any minimum level of foreign tax (or even a 
subject-to-tax requirement), as a condition for exemption. In other 
words, the proposal would extend exemption to foreign earnings of a 
controlled foreign corporation so long as they are not subject to 
current taxation under the anti-deferral rules of Subpart F of the 
Code, even if the foreign earnings were subject to no foreign tax on 
the income.
    \8\ President's Advisory Panel Report at 124-25.
    \9\ Id. at 240.
    The President's Advisory Panel exemption proposal would tax foreign 
royalties (and interest), would tax export income and would retain 
current taxation and allowance of a foreign tax credit for Subpart F 
income. Significantly, the proposal would exempt pre-effective date 
    The principal attraction of a foreign exemption proposal is that it 
eliminates the tax on repatriation of earnings under a deferral regime. 
It nevertheless leaves other problems of current law unsolved. 
Significantly, the incentive for shifting activity to low-tax locations 
would increase.
    One consequence of not having any subject to tax requirement would 
be that income earned in low-effective tax entities would be eligible 
for exemption without being includible in U.S. income under Subpart 
F.\10\ While it also is possible today to defer U.S. tax on such 
income, the benefit of deferral is limited if the U.S. parent 
corporation needs to use the CFC's earnings in the United States 
because the earnings will be taxed upon repatriation as a dividend. 
Consequently, deferral is of the most benefit to U.S. multinational 
corporations that have other non-U.S. businesses in which to invest the 
deferred earnings. Under the President's Advisory Panel's exemption 
proposal, however, any kind of non-Subpart F income that can be earned 
at a lower tax rate outside the United States could benefit from 
exemption and repatriation.\11\ An exemption regime like that in the 
President's Advisory Panel proposal would materially expand the U.S. 
businesses that could realize tax benefits from earning low-taxed 
foreign business income.\12\
    \10\ Under Subpart F, income from manufacturing products, income 
from performing services in the CFC's country of incorporation, active 
financing and active insurance income are not included in Subpart F 
income without regard to the level of foreign tax. In addition, there 
are a variety of techniques that may be used under current law to avoid 
the reach of the Subpart F rules.
    \11\ For example, a U.S. manufacturer only sells products to U.S. 
customers could benefit from manufacturing the product abroad in a 
foreign low-effective tax rate structure, selling the product to 
unrelated customers in the United States and repatriating the exempt 
profits to the U.S. parent as exempt earnings. This would not trigger 
Subpart F and would qualify for exemption under the proposal.
    \12\ The 1993 Treasury Department Interim Report on International 
Tax Reform proposed a modified exemption system that either would apply 
an effective rate test, so that only foreign income that bears a 
certain level of foreign tax would be exempt, or alternatively, and 
arguably more simply, only would exempt income from certain designated 
countries. U.S. Treas. Dep't,International Tax Reform: An Interim 
Report, 1993 Tax Notes Today 15-30 (Jan. 22, 1993).
    Under an exemption system without a subject to tax test, expenses 
must be allocated between exempt income and income not eligible for 
exemption. The stakes of such allocation for taxpayers and the 
Government would be higher than under present law and the likelihood of 
controversies in this difficult area would materially increase. Under 
the present system of deferral, the allocation of deductions to foreign 
income adversely affects a taxpayer only if the expenses allocated to 
foreign income reduce the taxpayer's foreign tax credit limitation to 
the point that foreign taxes are not allowed as a credit. In other 
words, the issue has practical significance for taxpayers with excess 
foreign tax credits. In contrast, under an exemption system, every 
dollar of expense allocated to exempt earnings is a lost deduction. 
Thus, the issue will affect every taxpayer with exempt foreign income. 
It may be predicted that there will be increased controversies between 
taxpayers and the Service over the allocation of expenses.
    If, however, expense allocation rules are adopted that do not 
properly allocate expense to foreign income, there is substantial 
potential for revenue loss. Thus, for example, the President's Advisory 
Panel's proposal would allocate R&D expense entirely to taxable income. 
This apparently is based on the theory that all returns to intangibles 
are in the form of royalties, which would be fully taxed under the 
President's Advisory Panel's proposal. The premise, however, may not be 
correct. If a U.S. company holding a valuable intangible sets up a 
sales branch in a low-effective rate location and the sale is made 
through the branch, under U.S. principles, no royalty is charged back 
to the United States. The income embedded in the sales price that is 
attributable to the intangible developed in the United States would be 
exempted without the loss of any associated expense deductions.
    The Joint Committee on Taxation's exemption proposal is more 
detailed than the President's proposal and anticipates this issue by 
requiring that the full range of rules dealing with inter-company 
transactions be applied to transactions between a foreign branch and 
the domestic corporation of which it is a part.\13\] While not 
specified in the proposal, this implies that an intra-company royalty 
would be charged to the branch by the domestic corporation's home 
office. This would achieve the correct result. A second best 
alternative to the Joint Committee Proposal would be to allocate the 
R&D expense to the foreign income. These approaches would involve 
transfer pricing or expense allocation determinations and illustrate 
the difficult issues involved in designing an exemption system that 
does not expose the United States to a loss of its domestic tax base. 
The dollars in the R&D allocation issue alone are very substantial and 
will be (indeed, I suspect have been) the subject of intense behind the 
scenes lobbying.
    \13\ Staff of Joint Comm. On Tax'n, Options to Improve Tax 
Compliance and Reform Tax Expenditures, JCS-02-05, 191 (Jan. 27, 2005).
    The potential for U.S. tax base erosion is materially reduced if 
the exemption is restricted to foreign business income that is subject 
to an effective rate of foreign tax that is at or reasonably close to 
the U.S. tax rate. Of course, if this approach were adopted, one should 
ask why a more effective reform proposal could not be adopted, namely 
current taxation of foreign business income.
    Although an exemption system provides no direct benefit for foreign 
operations in countries with effective tax rates equal to or higher 
than the U.S. rate, absent a ``subject to tax'' condition, it offers 
greater opportunities for reducing high foreign taxes through tax 
planning techniques that shift income from a high tax to a lower-tax 
foreign country. If there is lower taxation of foreign income, 
taxpayers with foreign operations have an incentive to shift higher 
taxed U.S. (and foreign) income to lower taxed foreign operations.\14\ 
While one of the advantages of an exemption system is that it permits 
repatriation of future exempted foreign business earnings without 
further U.S. tax, thereby avoiding the inefficiencies of the ``lock-
in'' affect of a deferral regime, exemption also places pressure on 
transfer pricing rules that they are not designed to sustain.\15\ The 
only way to limit tax avoidance through transfer pricing is to minimize 
effective tax rate differentials.\16\
    \14\ The principal objection to a territorial system is that it 
creates a bias in favor of investment in foreign operations. In the 
worst case, this bias causes a foreign investment to be preferred even 
though the U.S. investment has a higher before-tax rate of return and 
is, therefore, economically superior.
    \15\ None of the current international proposals (including 
Chairman Thomas's) would provide for tax-free repatriation of future 
earnings eligible for deferral. The Homeland Reinvestment Act would 
allow a reduced tax on currently deferred income--much in the nature of 
a tax amnesty.
    \16\ It may be anticipated that the proponents will argue that 
benefits for operations in lower tax foreign countries will generate 
greater purchases of U.S. goods because U.S. multinationals will buy 
from their U.S. affiliates and suppliers. Although this is a claim that 
deserves some scrutiny, at best this is an assertion that reduced 
taxation of the operations of U.S. multinationals in low-taxed foreign 
countries indirectly encourages U.S. exports and economic activity. It 
is unclear how much support there is for this claim, but no proposal to 
expand deferral would limit its scope to businesses with foreign 
operations that purchase goods from the United States.
    An exemption proposal that does not have a material subject to tax 
condition requires continued application of the Subpart F rules as an 
anti-avoidance device. Moreover, as proposed, by the President's 
Advisory Panel, the foreign tax credit would continue to be allowed 
with respect to income currently taxed under Subpart F. The foreign tax 
credit would continue to be subject to a limitation. This structure in 
essence creates two taxing regimes for foreign income, one for Subpart 
F income and another for income eligible for exemption. These rules are 
complicated and this approach would substantially undermine any 
simplicity gains from the proposal.
    Based on the foregoing analysis, I do not believe that the benefits 
from an exemption system, even if re-designed, are likely to be 
superior to a reform that is based on full taxation of foreign income 
with an appropriately limited foreign tax credit.

Reform of the Current U.S. Tax System of Worldwide Taxation with 
    There are two basic approaches to taxing the income of a controlled 
foreign corporation currently in the hands of a U.S. shareholder. One 
approach would be to adopt pass-through treatment for earnings.\17\ 
This would have the benefit of maintaining the character and source of 
the income and subjecting the income to the applicable tax rate of the 
shareholder. It would permit current pass-through of losses. While 
conduit taxation may be optimal as a theoretical matter, it would 
constitute a dramatic and difficult change from current law.
    \17\ I and my co-authors, Professors Robert J. Peroni and J. 
Clifton Fleming, Jr., have outlined a proposal for a broad repeal of 
deferral. Essentially, our proposal would apply mandatory pass-through 
treatment to 10% or greater shareholders in foreign corporations. 
Robert J. Peroni, J. Clifton Fleming, Jr. & Stephen E. Shay, Getting 
Serious About Curtailing Deferral of U.S. Tax on Foreign Source Income, 
52 SMU L. Rev. 455 (1999); J. Clifton Fleming, Jr., Robert J. Peroni & 
Stephen E. Shay, Deferral: Consider Ending It Instead of Expanding It, 
86 Tax Notes 837 (2000).
    Current taxation of U.S. shareholders under an expansion of Subpart 
F, while second best to a conduit approach, would be a substantial 
improvement over current law and probably would enjoy broader support. 
One approach would be to tax 10% or greater U.S. shareholders by vote 
in a controlled foreign corporation (more than 50% owned, by vote or 
value, directly or indirectly, under constructive ownership rules, by 
10% U.S. shareholders by vote), to be currently taxed on their share of 
the controlled foreign corporation's income. There are a number of 
changes that should be considered to the specifics of these rules, but 
they have a history of use since 1962 and could be implemented without 
substantial re-design.
    Less than 10% U.S. shareholders and 10% U.S. shareholders in 
foreign corporations that did not have a controlling U.S. shareholder 
group would be taxed under current law rules on distributions when 
received. The passive foreign investment company (PFIC) rules would 
continue to apply, however, the PFIC asset test should be eliminated 
and the passive income threshold should be reduced to 50% from 75%. The 
PFIC taxing rules, a deferred tax with an interest charge, qualified 
electing fund pass-through taxation, or mark-to-market taxation, would 
apply to a U.S. shareholder in a PFIC.
    The current foreign tax credit mechanism should be improved by 
repeal of the sales source rule and other rationalization of source 
rules combined with improvements to the expense allocation rules. 
Changes to limit cross-crediting of foreign taxes also should be 
    In the context of other base broadening reforms, the changes just 
described would move toward equalizing the taxation of foreign and 
domestic income. This approach would assist U.S. businesses that export 
from the United States or compete against foreign imports as well as 
businesses that operate abroad.
    Full taxation of foreign income would eliminate the lock-in effect 
of a separate tax on repatriation of earnings. In addition, it would 
reduce scope for transfer pricing income shifting induced by effective 
tax rate differentials. While expense allocations would be necessary 
for purposes of the foreign tax credit limitation, the stakes would 
depend on whether U.S. business tax rates are reduced below foreign tax 
rates--which today generally are in the range of 30% in major trading 
partner countries.
    Finally, full current taxation is a fairer system. U.S. persons 
would be taxed on their income more equally and the advantage would not 
fall to those who operate outside the United States. I respectfully 
encourage the Subcommittee to consider international tax reform 
proposals that will improve the well-being of all U.S. citizens and 
residents, including workers, farmers and small business men and women, 
and not just those who work or invest in the multinational sector.
    I would be pleased to answer any questions the Committee might 
    Mr. Shay is not appearing on behalf of any client or organization.

    Stephen E. Shay is a tax partner with Ropes & Gray in Boston, 
Massachusetts. Stephen has extensive experience in the international 
tax area, advising clients that include large and medium-sized 
multinational companies, financial institutions, and global investors 
on issues such as foreign tax credits, deferral of U.S. taxation, 
foreign currency gains and losses, withholding taxes and financial 
product issues. Stephen regularly advises clients on transfer pricing 
issues and has successfully resolved numerous transfer pricing 
controversies with the IRS. Stephen also works with Ropes & Gray's 
Private Client Group advising high net worth clients on cross-border 
income tax planning. Before joining Ropes & Gray in 1987, Stephen was 
the International Tax Counsel for the United States Department of the 

Honors and Awards
      Chambers Global: The World's Leading Lawyers
      Chambers USA, Leading Individuals (Tax)
      Best Lawyers in America
      Euromoney Legal Media, Expert Guide to the Best of the 
Best 2004
      Euromoney's Guide to The World's Leading Tax Advisers
Professional & Civic Activities
    Stephen is a Lecturer in Law at the Harvard Law School teaching a 
course on international aspects of U.S. income taxation. Stephen was 
the Jacquin D. Bierman Visiting Lecturer in Taxation at Yale Law School 
in 2004. Stephen has served as Associate Reporter for the American Law 
Institute's Federal Income Tax Project on Income Tax Treaties with 
Reporters David R. Tillinghast and Professor Hugh Ault. He also has 
served as Chairman of the Tax Section's Committee on Foreign Activities 
of U.S. Taxpayers of the American Bar Association.
    Stephen authored Revisiting U.S. Anti-Deferral Rules, 74 Taxes 1042 
(1996), and has co-authored Selected International Aspects of 
Fundamental Tax Reform Proposals, 51 University of Miami Law Review 
1029 (1997) (with Victoria P. Summers), Getting Serious About 
Curtailing Deferral of U.S. Tax on Foreign Source Income, 52 SMU Law 
Review 455 (1999) (with Robert J. Peroni and J. Clifton Fleming, Jr.), 
Fairness in International Taxation: The Ability-to-Pay Case for Taxing 
Worldwide Income, 5 Florida Tax Review 299 (2001) (with J. Clifton 
Fleming, Jr. and Robert J. Peroni), and The David R. Tillinghast 
Lecture ``What's Source Got to Do With It?'' Source Rules and U.S. 
International Taxation, 56 Tax Law Review 81 (2003) (with Robert J. 
Peroni and J. Clifton Fleming, Jr.). Stephen also has testified before 
Congress on international tax policy issues.
    Stephen is a member of the Board of Directors of Outdoor 
Explorations, a community-based not-for-profit organization that 
promotes inclusion for people with and without disabilities through 
shared outdoor adventure and service.
      American Bar Association, Tax Section
      American Law Institute
      International Bar Association
      International Fiscal Association
Bar Admissions
      New York
      1976, J.D., Columbia Law School
      1972, B.A., Wesleyan University


    Chairman CAMP. Thank you. I appreciate all of your 
testimony. Thank you for coming before the Subcommittee. I 
think the main thing that we are trying to get at is this 
dramatically changing world that we are in, and the fact that 
other countries are changing their tax systems. I guess I would 
like to, if you could--each of you, summarize briefly what best 
could we do immediately to address our international 
competitiveness and our ability to continue to have U.S. 
companies compete abroad?
    Mr. OOSTERHUIS. I would say, considering a territorial 
exemption system would be the best thing you could do. I do not 
think it would take that long to put together a package, but 
you do need to consider some of the things I talked about 
earlier in terms of its impact on technology companies and on 
exporters. Assuming you put together an appropriate package, 
you may well be able to be able to improve the competitiveness 
of U.S. companies.
    I agree with Michael that our current system with deferral 
does not discourage people from investing abroad, in my 
experience. My experience may be a little different than 
Steve's in practice, but companies do invest abroad taking full 
advantage of the fact that we do not currently tax their 
earnings, even if they are not taxed abroad. So, moving to an 
exemption system with territoriality isn't, in my judgment, 
going to significantly increase the incentives to move 
investment from the United States to abroad.
    Rather, what it is going to do is what Michael was saying, 
which is free up those moneys abroad to be invested efficiently 
rather than distort it.
    There was a survey that Marty Sullivan did for Tax Notes, 
and it indicated the amount of deferred income by 38 major 
multinationals in 1997 was $9 billion. By 2003, it was $46 
billion a year. I would imagine by now, it is substantially 
higher than that. That is a lot of distortion. That is the 
reason why HIA was an important priority of the 2004 Congress 
and it will come back again in a few years if you do not think 
about it.
    Chairman CAMP. Professor Graetz.
    Mr. GRAETZ. On a purely incremental basis, I want to agree 
with Paul. I think that one should take seriously the idea of 
eliminating the barrier to repatriations by going to some form 
of territorial system. However, as I said, I really think that 
to be serious about the competitiveness of our economy, what we 
really need to do is find a way to get our rates down and move 
to a consumption tax. That is not an incremental change, but it 
is, I think, where we need to go.
    Chairman CAMP. Thank you.
    Mr. Shay.
    Mr. SHAY. Mr. Chairman, I was at the Treasury Department 
and was international tax counsel in 1986. My views haven't 
changed, and some people would say that is a problem, but I 
think we should broaden the base, lower rates and not treat 
income differently.
    Chairman CAMP. Thank you. Mr. McNulty may inquire.
    Mr. MCNULTY. Thank you, Mr. Chairman. Some of you may have 
heard the question I posed to the first panel, and I think 
Professor Graetz said it better than I could. That was that 
whatever we do with regard to tax policy ought to be based upon 
what is in the best interest of the American people. Certainly, 
hundreds of billions of dollars in deficits every year and 
exploding national debt that has exceeded $8.3 trillion is not 
in the best interest of the people of the United States of 
America. So, my question would be, how would the proposals 
which you are making today make that situation better.
    Mr. GRAETZ. Mr. McNulty, if I could start, I think that tax 
reform ought to be proceeding on at least a revenue neutral 
basis in a way that will increase economic growth, and 
therefore will, in fact, increase revenues. So, I think, to the 
extent that we can move away from relying on corporate taxes, 
relying as heavily as we do on income taxes, taking advantage 
of our status as a low-tax Nation and taxing more consumption 
and less income, but doing it in a way that is consistent with 
international practices that would help. Trying to invent some 
new tax, as the President's panel did, taking American 
exceptionalism as the norm, seems to me the wrong way to go.
    So, I think what we ought to do is look at a tax system 
like Ireland's where they have substantial value-added taxes, 
which could help close the deficit and at the same time be used 
to reduce income taxes on companies and eliminate income taxes 
on most Americans--the vast majority of Americans.
    I think in our current fiscal situation and looking as you 
and Dr. Hubbard did, forward to an aging society and the 
demands for retirement income, long term care and health 
insurance, we are going to have to think seriously about a 
restructuring of our tax system. I know that it is a difficult 
thing to do, but I really think that is where we have to go.
    Mr. OOSTERHUIS. I could not agree more. Heavily relying on 
the income tax in a global economy is a very difficult thing to 
do. There are just too many ways that income and activity can 
be moved to maximize competitiveness and it is necessary that 
companies do that because their foreign competitors are doing 
that. So, the more weight you put solely on the income tax, the 
more pressure you put on trying to capture that revenue with 
proposals like Steve's, to tax our multinationals on their 
global income, even though our foreign competitors do not do 
that with their multinationals.
    The way to take the pressure off that is to get rates down, 
and the way to get rates down is to move to some sort of 
consumption tax to make up the difference.
    Mr. SHAY. It seems to be clear that there is an advantage 
to achieving lower income tax rates, but, the only way I can 
see to get there consistent with the direction of your question 
is to broaden the base. In the event that you do not find 
additional sources of revenue in the value-added tax, if you 
are going to put the kind of reliance we do on the income tax, 
there is going to be a greater, not lesser, premium on not 
having holes in the bathtub.
    What I do for a living is plan to take advantage of 
effective tax rate differences. You can see the fruits of that 
in the financial footnotes of companies. Further, nonpublic 
companies also do that by organizing themselves to take 
advantage of tax rate differences. It just seems to me common 
sense that you want to move in a direction that is going to 
reduce those rate differentials. Full taxation of foreign 
income moves in that direction.
    Now it is different from other countries, so if you are 
going to do that, I do think you need to try to broaden the 
base and lower the tax rate. If you can keep rates within the 
range of other major countries, that is where we want to be; I 
think it is where we have to be.
    Mr. MCNULTY. Thank you all. Thank you, Mr. Chairman.
    Chairman CAMP. Thank you. Mr. Chocola, may inquire.
    Mr. CHOCOLA. Thank you, Mr. Chairman. Thank you all for 
being here. There has been a lot of talk today about moving 
from a world wide to a territorial system. Mr. Linder is not 
here unfortunately, but as you know, he likes the fair tax, and 
I think it is great in theory but it seems to me a lot of 
transitional issues we would have to work through. What kind of 
transitional issues would there be from going from a worldwide 
to a territorial system that would be beneficial or non-
    Mr. GRAETZ. The key question is whether you would apply an 
exemption for dividends back to the United States with respect 
to earnings that have been accumulated under current law or 
whether you would limit the dividend exclusion to earnings 
after the date of enactment.
    I would argue that one should apply it to all dividends, 
and if that creates too big a hole, then exempt only a 
percentage of the payments. Trying to trace whether dividends 
are out of post-enactment or preenactment earnings, is simply 
going to create opportunities for planning and complexities and 
undermine what I believe is the major goal of going to a 
territorial system, which is to allow the tax free movement of 
capital that is now trapped offshore back to the United States.
    Mr. OOSTERHUIS. If I could add two other transitional 
issues; one is, there are companies that have excess foreign 
tax credits which would lose their value once you move to a 
territorial system, in all likelihood. I think you need to 
provide some transitional measure for them to obtain value from 
those foreign tax credits through during a transition period, 
or else you unfairly, in effect, tax companies who just happen 
to be in a circumstance where they have excess credits in the 
years leading up to the switch.
    The other are companies that have had losses outside the 
United States and thus have what we call overall foreign 
losses, which normally would be recaptured out of exempt income 
in the future under territoriality. A lot of those losses were 
created by our overreaching interest allocation rules that you 
addressed prospectively starting in 2009, I believe, in the 
2004 Act, but that still apply. So, requiring recapture in 
effect as a result of those overreaching rules is something I 
think ought to be addressed in the transition.
    Mr. CHOCOLA. We haven't had a lot of discussion this 
morning about a value-added tax. Would you guys like to discuss 
how that would impact competitiveness of U.S. companies, 
especially a border adjustable value-added tax?
    Mr. GRAETZ. I will begin. I have been advocating a value-
added tax for a number of years now as a way to reduce income 
taxes in the United States. I know that my economist friends on 
the prior panel would tell you that border adjustability does 
not matter because currency rates will adjust--I think, 
instantaneously is their position, so that it does not matter 
whether you tax production here or consumption here.
    I really disagree with that. Border adjustability is the 
rule throughout the world with one or two very small exceptions 
in some of the former Soviet states. I think, as I have said 
earlier, what we ought to be seeking to do is to get to a tax 
system that meshes well with other tax systems. If you have to 
distort either consumption or the place of production, which is 
the choice between having border adjustability or not, all of 
the evidence I have seen suggest that you are much safer in 
distorting consumption rather than distorting the location of 
production and keeping these questions of competitiveness 
    So, in my view, I think we ought to move to a tax which is 
border adjustable. Just to complete the point, that means that 
under the current WTO, that a standard credit method value-
added tax will work. Mr. Linder's national sales tax will work 
on that ground, whatever it's other problems might or might not 
be. So, I think border adjustability is the way to go. A tax 
that is sometimes known as the X tax, sometimes known as the 
flat tax, sometimes known in the President's panel as the 
growth and investment tax, which give a deduction for wages is 
not allowed to be border adjustable under our current trade 
agreements. So, I think those are not terribly practical ideas.
    Mr. CHOCOLA. Would anybody else like to? Thank you, Mr. 
    Chairman CAMP. Thank you. The gentleman from Texas, Mr. 
Doggett, may inquire.
    Mr. DOGGETT. Professor, do you believe that it is possible 
or wise to eliminate all taxes, all U.S. taxes on corporate 
foreign source income without substantially reducing the 
corporate tax on domestic corporate income?
    Mr. GRAETZ. Well, I think the way you put the question I do 
not think that would be wise. That is why I am arguing that 
what we ought to do is lower the corporate tax rate generally. 
I do want to come back to Paul's earlier point, which is that 
moving to an exemption system compared to our current system 
where we defer earning abroad and give tax credits is not a 
system that lowers the overall rate of tax. It can be done in a 
revenue neutral way, and would not lower the overall rate of 
tax on foreign earnings. It would keep the overall tax the 
same. It changes, to a large extent, some of the rules about 
how and who would pay those taxes. However, it would not lower 
those taxes.
    By talking about an exemption system compared to the 
current system, we are not necessarily talking about a 
reduction of tax on foreign earnings abroad. We are talking 
about a different system that would raise roughly the same 
amount of revenue. At least that is what Paul and I have been 
talking about.
    Mr. DOGGETT. To have revenue neutrality on the corporate 
tax changes you would make at home and abroad, you recommend a 
value-added tax.
    Mr. GRAETZ. I do. I would like to say that I think that the 
value-added tax not only allows you to do tremendous good in 
terms of our international competitiveness, in terms of our 
domestic investment and investment abroad, but it also allows 
you to eliminate from the tax rolls 150 million people at a 
reasonable rate. I have a chart at the end of my paper that 
shows you that the rate would be no higher than that around the 
rest of the world. It creates a huge amount of revenue to lower 
income tax on individuals as well as on corporations.
    Mr. DOGGETT. Mr. Shay, lower rates was one of the three 
things that you talked about as objectives, but you also said 
that if rates were to be lowered, we need to broaden the base, 
and we need to not treat different kinds of income differently. 
What steps would you take to broaden the base and to ensure 
that different types of income are not treated differently?
    Mr. SHAY. Well, the focus of this hearing has been on 
foreign income, and so the proposal I would make in that 
context is to include foreign income currently with a foreign 
tax credit. After foreign tax credit, taking into account what 
the effective rate would be, the objective is to keep effective 
rates the same to minimize tax motivated decisionmaking.
    Mr. DOGGETT. You discussed cross crediting. Do you feel 
that way the laws on tax credits are currently written is too 
    Mr. SHAY. I think the most problematic aspect of our 
current foreign tax credit rules are source rules that 
effectively treat as foreign income, income that is never going 
to be taxed by a foreign jurisdiction. Therefore, you are not 
really serving the purpose of the foreign tax credit, which is 
to avoid or relieve double taxation, but what you are doing, in 
essence, is allowing high foreign taxes to offset what should 
be viewed as a U.S. tax base, so yes, that would be a reform.
    Mr. DOGGETT. Like me, you have heard five witnesses say 
that the only way we can be competitive is to eliminate taxes 
on foreign source income. I note that in passing that the 
Congressional Budget Office has found that our effective 
corporate tax rate is at about the median of the Group of seven 
(G-7) versus the statutory rate on something like equity 
financed investments in machinery. Do you believe, Mr. Shay, we 
can have taxation of foreign source income and still be 
    Mr. SHAY. Well, I think we are using a very fair narrow 
definition of competitive. That is, what is the tax on a 
multinational, or a taxpayer who has international income. I 
really think that earlier in this hearing, we have heard a more 
appropriate and broader view. What is going to make us 
competitive as a country, is not what the particular tax rate 
is. We are not Ireland. We have to educate our people. We have 
a retirement crisis. That retirement crisis, by the way, is 
shared in Europe. It troubles me a little bit to not look out 
ahead and see they have already maxed out on value-added tax. 
Where is their future revenue going to come from? It is going 
to come from the income tax or it is going to come from 
    So, the notion that this is all static and we should not be 
building a system for the future that is stable, that can 
sustain, if necessary, higher rates, strikes me as risky.
    Mr. DOGGETT. Thank you.
    Chairman CAMP. Thank you. The gentleman from Florida, Mr. 
Foley, may inquire.
    Mr. FOLEY. Thank you. I would like you to expound on that 
thought, because it seems like we frustrate both the American 
economy and the consumer with our tax policy. It is confusing, 
complicated; we are getting ready to adjust rates on estates 
taxes, capital gains taxes, and incentives for various 
activities. When I look at what Mr. Linder is proposing which 
really becomes a consumption tax, it seems to me those who want 
to spend more pay more. There is an embedded cost, I would 
assume, in this Blackberry. When you purchase one, isn't there 
on the price tag the tax consequence?
    So, given that fact a consumption tax, give me an idea what 
you think would be the most logical progression from the 
complication we have today to a tax that not only frees the 
economy but increases competitiveness.
    Mr. SHAY. I think you broaden the base in as many ways as 
you can. It may be heresy, but it is not clear to me why we 
need to have a differential tax rate on capital gains. It is 
not clear to me why we need to have favorable taxation of 
foreign income. We have major tax expenditures that have been 
viewed as sacred cows. As long as they are there, we are going 
to have difficulty achieving the objectives we need.
    To be competitive, we need to broaden the base, and lower 
rates. If we need to go to the value-added tax, the one thing 
the panel needs to recognize is that the value-added tax is a 
tax on consumers. While it is possible to make it progressive, 
there are not great models for doing that. So, we need to think 
about how we integrate it with the State retail sales taxes.
    It is not clear to me that it is efficient to have a retail 
sales tax in the State and a Federal value-added tax. I think 
there would be pressure to try to integrate those and there 
should be if we go in that direction. The core decision that I 
think Mike was alluding to is we have to decide what is the 
balance. Europe has achieved a balance of a much higher value-
added taxation in relation to income taxation. We have the 
other end of that balance. If we are going to shift, we need to 
understand that it reduces our ability to achieve progressive 
objectives. We need to incorporate that into our overall 
    As I say in my testimony, there is tension between 
fairness, which is what progressivity is aimed at, and 
efficiency, which would imply broadening and possibly 
increasing the ratio of consumption taxation to income taxation 
and get masterability. I think there is a way to meld all of 
those, but it involves difficult choices. I do not see the 
difficult choice being made with respect to foreign income. I 
do not think exemption is the best way to get there.
    Mr. FOLEY. Your thoughts.
    Mr. GRAETZ. I really am interested in Steve's comments, 
because he said he was there in 1986. I guess everybody is 
claiming their prior experience. I was at the Treasury in 1990 
to 1992 and in 1969 to 1972, so I was there twice. However, the 
world has changed since 1986. In 1986, international 
transactions were less than 10 percent of the global economy. 
Today they are more than a quarter of the global economy. We 
really do have to change our thinking. I think we have to 
change it in fundamental ways, and I think that we should 
moving toward a sales tax, a tax on consumption, which is what 
a value-added tax is, all it is there a lot of misunderstanding 
about it. People think it is French. In fact, it was invented 
by Thomas Adams in 1929 in the United States in New Haven, 
Connecticut, I might add; but it is a U.S. idea and all it is 
is a sales tax with withholding. Instead of relying on the 
retailer to pay the whole amount, we require the wholesaler to 
withhold some of that sales tax and the manufacturer to 
withhold some of it, but it is not a multiple tax on different 
levels. So, I think that is what we ought to be thinking about.
    Mr. FOLEY. Well, it also seems like you capture more of the 
economy. Right now, the underground economy is never captured. 
If they do not pay income taxes or capital gains taxes, then 
they are not going to be paying any tax. Whereas consumption 
does, in fact, capture every level of the economy.
    Mr. GRAETZ. I think there are many advantages to it. The 
advantage of compliance of relying on more than one tax, that 
is the ability to collect at low rates on multiple tax bases is 
a great advantage in terms of making sure that you collect the 
tax. The more eggs you put in one basket in this economy, the 
less you are going to collect.
    Chairman CAMP. Thank you. The gentlewoman from 
Pennsylvania, Ms. Hart, may inquire.
    Ms. HART. Thank you, Mr. Chairman. I want to follow up on 
some of Mr. Chocola's line of questioning. As he was asking his 
question, I was reading my notes from a meeting we had back 
home. I am from Pittsburgh, and I had the opportunity to meet 
with a number of the senior tax people in my larger 
manufacturing companies about this issue. They sent me out of 
the room with a whole lot of questions and some suggestions. 
One was that they all announced to me that they do prefer the 
territorial tax structure because they do want to be able to 
make their decisions about where they locate their 
manufacturing facilities based on what is better for their 
company and what is better for their customers. In some cases, 
they are going to want to locate the manufacturing facility in 
the Far East because that is where their customers are.
    But in a significant number of the cases, they would prefer 
to locate their facilities here in the United States, but when 
they look at their balance sheet, it is not making a lot of 
sense to them.
    What I would like you to do for me, and I am not sure if 
any of you are very heavily schooled in the difference as far 
as the tax decisions for a manufacturer. I expect that you are, 
I would guess, especially.
    Mr. Oosterhuis, I want to start with you. Can you help me 
as far as the analysis of a territorial tax, if that is going 
to make a big difference as far as some of these decision these 
folks make, they tell me it will. What is your experience?
    Mr. OOSTERHUIS. To be honest my, experience is that it will 
make a marginal difference, not a big difference, because today 
manufacturing income--if you have a plant, whether it is in 
Germany or Singapore or Ireland, the income from that is not 
subject to current U.S. tax. It is only subject to U.S. tax if 
you bring those earnings back to the United States in the form 
of a dividend.
    Ms. HART. Before you go on, I am presuming that they are 
going to want to repatriate.
    Mr. OOSTERHUIS. Right. Well, that is where the rub is 
because for years, the inability to bring money back was not a 
problem for most multi-nationals. The amount of income relative 
to the growth outside of the United States was modest, and so 
the funds could be reinvested. What has happened over the past 
10 years is the amount of earnings that people--that companies 
have from their facilities outside the United States, has grown 
very substantially. That puts a lot more pressure on the 
utilization of those funds and therefore, a lot more pressure 
on being able to put those funds back to use them efficiently 
in the United States.
    So, I do think that is one of the main reasons why we 
should consider territorial. Not that it will necessarily lead 
people in the future to make decisions to invest abroad that 
they otherwise would not have made, but rather, that it will 
free them up with respect to their existing investment to 
utilize the funds most efficiently, which may actually 
discourage them from investing in the newest plant abroad and 
build it back in the United States, because they can get the 
money back here to build it.
    Ms. HART. That is obviously what a lot of them expressed as 
far as a concern. Mr. Shay.
    Mr. SHAY. Look, the companies are going to want the 
flexibility that territoriality offers. That just makes sense. 
Implicit in your question was what would increase the 
likelihood that they would invest in the United States. It 
presumably would be greater depreciation, exactly what Dr. 
Barrett was saying earlier, more benefits for investment in the 
United States.
    Well, how do you fund those benefits, and do you fund them 
by exempting foreign income? There is a circle here that needs 
to be completed. Part of the premise that I have is, look, I 
think the companies are very important productive part of our 
economy. They are my clients. However, the perspective that you 
have to have to take is what is in the best interest of the 
United States and what is going to maximize economic activity 
here in relation to the world? That is the question. The 
question is does exemption get you there?
    Ms. HART. Thank you. Did you have a comment?
    Mr. GRAETZ. I would just like to comment on something that 
Mr. Shay said earlier that is related to these questions, and 
that is, the suggestion that we would somehow be better off by 
taxing all foreign income currently. If you go back, we have 
never taxed foreign active business income currently in the 
United States, nor has any other OECD country ever taxed all 
foreign income currently when it is active business income. The 
idea that if, in 1918, when the foreign tax credit came into 
the Code, we had taxed income currently, that looking backward 
we would be better off if we had not had all the U.S. 
investment abroad that we have had during the interval, just 
seems incorrect to me.
    It seems to me that one has to be careful when one talks 
about base broadening, not to talk about base broadening in a 
way that will make things worse in terms of the economic 
benefits to the U.S. people.
    Ms. HART. I see my time has expired. Thank you, Mr. 
    Chairman CAMP. The gentleman from Illinois, Mr. Weller, may 
    Mr. WELLER. Thank you, Mr. Chairman. I commend you for 
conducting this hearing today. I am sorry I missed part of it. 
I would like to ask our panelists here, the folks I represent 
back home, when they look at the Tax Code, they think it is 
complicated, they all hear the stories about jobs going 
offshore. They believe that the Tax Code has something to do 
with it. As many business decisionmakers have shared with me, 
the Tax Code does influence business decisionmaking, 
particularly in the area of investment. One of the areas they 
raise, of course, is how we depreciate assets, as we look at 
the capital purchases and how they impact investment in the 
United States.
    Ninety-six percent of the globe's population is outside our 
borders, 4 percent is inside our borders. Obviously, we want to 
produce products over here in the United States and sell them 
outside our own territories and serve that market.
    I was wondering, could each of you share your perspective 
on how our current corporate Tax Code as we treat capital 
assets from the standpoint of depreciation--how do you believe 
that affects business decisionmaking on investing particularly 
in production from manufacturing and other capabilities to 
serve the international market, producing the product here, how 
that behavior is influenced.
    Mr. Oosterhuis, do you want to go first?
    Mr. OOSTERHUIS. I will go first. It is very dependent on 
which kind of industry, which kind of company you are talking 
about. The semiconductor manufacturers that Dr. Barrett 
represents are very capital intensive and make investments in 
physical assets, tangible property assets, so for them 
depreciation is very important in their location decisions. I 
have no doubt about that. There are other industries, the 
software industry, for example, where there are a lot of high 
paying jobs, but where depreciation is not particularly 
relevant at all because other than the computers that their 
employees use, their tangible assets are not that substantial. 
Most of their investments are in intangible development costs, 
software development type activities.
    So, I think you are absolutely right that focussing on our 
depreciation rules can be very important to selected sectors of 
the economy, but to industries like pharmaceuticals and 
software, it is not all that important.
    Mr. WELLER. How about those who make cars and bulldozers?
    Mr. OOSTERHUIS. Certainly for cars and bulldozers it would 
be, sure, absolutely.
    Mr. GRAETZ. While I do not disagree with anything Paul has 
said, I just want to make an additional observation, and that 
is throughout the history of the United States, going back 
actually to the Depression, we have changed depreciation laws 
to stimulate investment and had investment tax credits to 
stimulate investment in 1954, 1962, 1971 and on and on.
    We could go through a list. The best evidence that I have 
seen is that those changes have affected mostly the timing of 
investment rather than the overall level of investment. To my 
mind, there is a trade off. We saw it in the 1986 Act. We have 
seen it over a long period of time between whether you have low 
rates and relatively higher depreciation, or whether you have 
faster depreciation and higher tax rates. I think in the 
current economy, we really ought to focus on getting the rates 
down, and then the depreciation allowances won't matter nearly 
so much as they do with high rates. Rather than singling out, 
as this earlier conversation suggests those capital intensive 
industries for a tax break, we should spread the tax break more 
evenly throughout the economy through low rates.
    Mr. WELLER. Was part of the reason, though, if people move 
the timing of their purchase--if they fast forward it, is it 
because those, whether it was bonus depreciation that was in 
the Bush tax cut, or some of the various investment tax 
credits, was it because of the temporary nature of that. Had 
they been permanent provisions of the Tax Code would the 
behavior been different?
    Mr. GRAETZ. Well, Mr. Weller, as you know well, the fat 
lady never sings in tax policy. I do not know what the meaning 
of ``permanent'' is in tax policy. We have tax legislation 
constantly. The investment tax credit is a great example. It 
was put in on a permanent basis, then it was repealed 
permanently, then it was put back in and then it was taken back 
off. So, I think that companies are well aware, especially in a 
climate like the current fiscal climate, where we really do 
have to believe that we are going to be looking for revenues 
ahead, that a depreciation break today may well be gone 
tomorrow even if it is labeled permanent.
    Chairman CAMP. Mr. Shays, if you could answer briefly, 
because the time has expired.
    Mr. SHAY. The whole thrust of the 1986 Act was to try and 
equalize the taxation of capital and non-capital intensive 
businesses by pushing rates down. That is the advantage. 
Depreciation always turns. That is why once it is gone, you are 
paying full tax on it. So, lower tax rates tends to be a better 
long-term answer.
    Chairman CAMP. All right. Thank you. The gentlewoman from 
Ohio, Ms. Tubbs-Jones may inquire.
    Ms. JONES. Thank you, Mr. Chairman. Gentlemen, good 
morning. I want to start with Mr. Shay. Mr. Shay, you were 
talking about the 1986 tax changes. If you had a looking glass 
looking forward, what would you have done differently, what 
would you have suggested that we would have done differently 
with regard to taxes?
    Mr. SHAY. Preserve the base broadening better. It really 
has been largely eroded since then. Maybe this isn't fully 
responsive to your question, but I think every time----
    Ms. JONES. My feelings will not be hurt. It happens.
    Mr. SHAY. I think every time we have tried to put in 
benefits and preferences, whether it is capital gains 
preferences, whether it is accelerated depreciation, it is the 
government trying to guess right. I think the whole thrust of 
the approach I would propose is let's try and get as close to 
economic depreciation, as broad a base as we can, lower tax 
rates, and not have the government policy be the one that is 
dictating where the investment is made.
    I beg to differ slightly with my colleague, Professor 
Graetz. The U.S. financial industry was subject to full current 
taxation from 1986 to 1997. They persuaded this Congress to 
change that with the advent of the active finance exception to 
Subpart F. I am not aware that there is really strong data that 
they became a second rate citizen during that period.
    Ms. JONES. Okay. I am giving you time. What else would you 
suggest that we should be doing. It is still your time.
    Mr. SHAY. Well, I think actually I would just stop there.
    Ms. JONES. He is so stunned that I am giving him this much 
time. He is at a loss of words. I am kidding, Mr. Shay. Go 
    Mr. SHAY. No, really, that is the way I would respond.
    Ms. JONES. In the State of Ohio since 2001, we have lost 
186,000 jobs, in the city of Cleveland alone, we lost 60,000 
jobs. I want to come off of you for a moment, Mr. Shay. 
Professor Graetz, what would you suggest we might do in terms 
of taxing authority to help return some of those jobs to the 
United States, because, of course, most of those went overseas 
somewhere for lower labor rates, and so forth, and so forth, et 
    Mr. GRAETZ. It is true that we do lose some jobs to 
overseas competition, especially where lower----
    Ms. JONES. Some jobs, Professor Graetz, come on now.
    Mr. GRAETZ. The best evidence about overseas investment 
that I have seen is that in the aggregate overseas investment 
increases U.S. jobs because it creates jobs at home in order to 
supply the growth abroad. I do however understand what you are 
saying about Ohio, and I think it is an important question and 
it is certainly true that this is very important for certain 
localities. I would say that I think the best thing we could do 
is to try and get the rates on investment in Ohio down. One way 
to do that is to lower our corporate tax rates and our tax 
rates on capital investments.
    The difficulty--which is the difficulty we keep bumping 
back into, is that we are going to have to tax something else 
if we are not going to tax that kind of income, unless we 
believe that the economic growth will be enough to pay for it, 
which I am skeptical of.
    So, I think that this relates to your earlier question to 
Mr. Shay, I think the big difference looking backward 20 years 
is that in 1986, we decided to continue the sole reliance of 
the United States Federal Government on income taxes rather 
than consumption taxes. We broadened the base and lowered the 
rates. What happened in the 20 years since is the rate has gone 
up and the base has gotten narrower, and that will happen 
again. I think we just have to spread out our way of raising 
taxes and include a consumption tax in the mix.
    Ms. JONES. So, you will not accuse Democrats of raising 
taxes and doubling taxes in order to reach this outcome that 
you are proposing?
    Mr. GRAETZ. I have to say I think there are occasions in 
which taxes have to be raised. I am not a person who has ever 
accused anybody of anything.
    Ms. JONES. Say it again so my colleagues on the other side 
can hear.
    Mr. GRAETZ. There are occasions when taxes need to go up. I 
am clear about that.
    I think there are those occasions, but the question is in 
order to raise the revenue you need to finance the government, 
you are going to have--how can you do that in a way that is 
fair and most conducive to economic growth and less burdensome 
to U.S. citizens? There, I think, we are in the wrong place in 
relying as heavily as we do on the income tax and on taxes on 
capital investments, both domestically and throughout the 
    Ms. JONES. Thank you, Mr. Chairman.
    Chairman CAMP. Thank you. I want to thank this panel for 
your testimony, and I appreciate the Members for attending this 
    At this time the Select Revenue Measures Subcommittee is 

    [Whereupon, at 1:39 p.m., the Subcommittee was adjourned.]

    [Submissions for the record follow:]

             Statement of Alliance for Competitive Taxation

    The Alliance for Competitive Taxation (``ACT'') is a group of 
companies with diverse industry representation organized to promote 
independent academic research on the economic effects of U.S. corporate 
income taxation and to disseminate the findings to policymakers and the 
public. ACT member companies are listed at the end of this statement.
    The Alliance's Research Director is Dr. Glenn Hubbard, Dean of 
Columbia Business School and former Chairman of the President's Council 
of Economic Advisers. Under Dr. Hubbard's direction, the Alliance has 
commissioned a program of research by highly respected economists. To 
date, ACT has sponsored five research papers on the following topics: 

    \1\ All ACT research papers are available at 

      A history of corporate income taxation in European Union 
and G-7 countries over the last two decades and an analysis of the 
relationship between corporate tax rates and tax revenues, by Michael 
Devereux at the University of Warwick.
      A simulation of the economic effects of federal corporate 
income tax reform proposals using a dynamic, general equilibrium model 
of the U.S. economy, by Dale Jorgenson at Harvard University.
      The effect of corporate tax rates on wages across OECD 
countries, by Kevin Hassett and Aparna Mathur at the American 
Enterprise Institute.
      An assessment of the cost of complying with the U.S. 
corporate income tax and how tax reform may affect those costs, by Joel 
Slemrod of the University of Michigan.
      An examination of how corporate taxation affects 
investment, economic growth, risk-taking, and innovation, by Kenneth 
Judd at Stanford University.

    The results of ACT's research program are summarized in the 
following section of this statement.
    Corporate income is subject to double taxation. Investments made by 
corporations are subject to tax at both the corporate and the 
individual shareholder level. By contrast, investments made through 
other forms of jointly-owned businesses--partnerships, limited 
liability companies, and small business ``S'' corporations--are taxed 
just once on the individual income tax returns of the owners on a flow-
through basis. As a result, $100 of corporate income distributed to 
shareholders bears a maximum federal income tax of $44.75 while $100 of 
income earned by a partnership bears a maximum tax of $35.
U.S. Taxation of Business income, 2006: Corporation versus Partnership
    [Corporation and business owner in top federal income tax brackets; 
100% dividend payout]

               Item                    Corporation        Partnership
Business income                     $100.00            $100.00
  Corporate income tax at 35%       $35.00             $0
Net business income                 $65.00             $100.00
Owner's income tax
  Individual income tax on          $9.75              $0
 dividend at 15%
  Individual tax on business        $0                 $35.00
 income at 35%
Combined corporate and individual   $44.75             $35.00
 income tax rate
Net income after federal and        $55.25             $65.00
 individual income tax

    Non-corporate business income has increased rapidly and has 
exceeded corporate income since 1998. To avoid double taxation, many 
businesses that can operate without access to public capital markets 
organize as a legal entity taxed on a flow-through basis (e.g., a 
partnership or small business ``S'' corporation). According to the most 
recent available data, business income earned by flow-through entities 
has exceeded that earned by regular corporations since 1998. In 2002, 
the most recent year for which IRS data is available, regular 
corporations accounted for less than one-third of business income.
    Once competitive, today's combined corporate income tax rate in the 
United States is over 10 percentage points higher than the OECD 
average. The combined top federal, state and local corporate tax rate 
(39.3%) is second highest (after Japan) among the 30 OECD countries, 
and 10.7 percentage points greater than the OECD average.\2\ Even in 
the high social spending Scandinavian countries--Sweden, Denmark and 
Norway--the combined corporate income tax rate (28%) is more than 11 
percentage points below the U.S. rate.
    \2\ Organization for Economic Cooperation and Development, http://
www.oecd.org/dataoecd/26/56/33717459.xls (data accessed May 22, 2006).

    The double taxation of corporations hinders capital formation and 
economic efficiency. The corporate tax discourages investment in the 
corporate sector and distorts financial decisions--favoring high debt 
levels and low dividends. The economic drag of the corporate income tax 
is quite high relative to revenues raised. Harvard professor Martin 
Feldstein observes that ``the differential taxation of profits in the 
corporate sector--drives capital out of the corporate sector and into 
other activities, particularly into foreign investment and real estate 
(both owner-occupied and rental property).'' \3\ A recent study by the 
Joint Committee on Taxation found a cut in the corporate income tax 
rate would increase long-term economic growth by more than other equal 
revenue tax cut proposals examined (i.e., a cut in individual income 
tax rates and an increase in the personal exemption) due to increased 
capital formation at a lower corporate rate.\4\ According to new 
research by Harvard Prof. Dale Jorgenson, relieving the double taxation 
of corporate income by taxing corporate assets like non-corporate 
assets would result in a welfare gain of $1.1 trillion.\5\
    \3\ Martin A. Feldstein, ``The Effect of Taxes on Efficiency and 
Growth,'' Tax Notes (May 8, 2006), p. 684.
    \4\ Joint Committee on Taxation, Macroeconomic Analysis of Various 
Proposals to Provide $500 Billion in Tax Relief, JCX-4-05, (March 1, 
    \5\ Dale Jorgenson and Kun-Young Yun, ``Corporate Income Taxation 
and U.S. Economic Growth,'' (April 21, 2006).
    The costs to the economy of the corporate income tax are higher 
than commonly recognized. The economic efficiency costs of the 
corporate income tax are even larger than commonly recognized when the 
following three central features of the modern, technologically-
advanced economy are taken into account: (1) the role of patents, know-
how, and other sources of imperfect market competition; (2) risk; and 
(3) technological change. In a recent paper, Kenneth Judd at the Hoover 
Institution finds that, ``The case for reducing, if not eliminating, 
the corporate income tax is already strong, and made stronger when we 
include those features which make our economy a modern and 
technologically advanced one.'' \6\
    \6\ Kenneth Judd, ``Corporate Income Taxation in a Modern 
Economy,'' Hoover Institute, (May 10, 2006)
    International experience shows high corporate income tax rates do 
not translate into high corporate tax revenues. Using tax information 
from 20 OECD countries over the last 40 years, the University of 
Warwick's Michael Devereux finds that while the average corporate tax 
rate has fallen, the level of corporation tax revenues has risen as a 
proportion of GDP.\7\ Possible explanations are that high corporate tax 
rates make home country investment less attractive, push business 
formation into non-corporate legal entities (e.g., partnerships), and 
create an incentive for companies to report profits as earned abroad. 
The United States is a case in point--it has the second-highest 
combined (federal, state, and local) corporate tax rate among the 30 
OECD member countries and the fourth-lowest corporate revenue yield as 
a percentage of GDP (based on 2003 data).
    \7\ Michael Devereux, ``Developments in the Taxation of Corporate 
Profit in the OECD Since 1965: Rates, Bases and Revenues,'' (May 2006).
    In a global economy, the burden of the corporate income tax 
increasingly falls on workers. In the 1960s, the burden of the 
corporate income tax was thought to lower the return on capital and 
thus primarily burden investors. However, with fewer impediments to 
cross-border investment, shareholders can seek higher returns abroad, 
leaving the corporate tax burden on less mobile factors, such as labor. 
In 2005, U.S. investors put three times as much money into 
international mutual funds as domestic funds.\8\ Based on data for 70 
countries over 22 years, Kevin Hassett and Aparna Mathur at the 
American Enterprise Institute find that higher corporate tax rates lead 
to lower wages, with a one percent increase in corporate tax rates 
associated with a 0.7 to 0.9 percent drop in wage rates. In general, 
countries with high corporate tax rates tend to have lower wage rates, 
a finding that is stronger for the OECD countries.\9\
    \8\ Deborah Brewster, ``U.S. investors flock towards foreign 
funds,'' Financial Times, (25 April 2006) p. 27.
    \9\ Kevin Hassett and Aparna Mathur, ``Taxes and Wages,'' American 
Enterprise Institute, (March 6, 2006)
    Over the last three decades, countries with higher corporate income 
tax rates have grown more slowly, other things equal. Using cross-
country data over the 1970-1997 period, Roger Gordon and Young Lee find 
that increases in corporate tax rates lead to lower future growth rates 
within countries (after controlling for various other determinants of 
economic growth). The coefficient estimates suggest that a cut in the 
corporate tax rate by ten percentage points raises the annual growth 
rate by one to two percentage points.\10\
    \10\ Young Lee and Roger H. Gordon, ``Tax Structure and Economic 
Growth,'' Journal of Public Economics, Volume 89, Issues 5-6, June 
2005, Pages 1027-1043
    The complex corporate income tax imposes high compliance costs, 
diverting corporate resources from more productive activities. While 
corporate income tax revenues accounted for 23 percent of all federal 
income tax revenues in fiscal 2005, the Tax Foundation estimates that 
corporations accounted for 36 percent of federal income tax compliance 
costs. For every $100 in corporate income tax payments, the Tax 
Foundation estimates that it cost corporations an additional $34 in 
recordkeeping, research, return preparation, and form submission costs 
to comply with the income tax.\11\
    \11\ J. Scott Moody, Wendy P. Warcholik, and Scott A. Hodge, The 
Rising Cost of Complying with the Federal Income Tax, Tax Foundation, 
(December 2005).
    Internationally, support for corporate tax reductions abroad comes 
from across the political spectrum. While support for corporate tax 
rate reduction often is associated with conservative politicians, there 
are a number of recent examples where left-of-center governments have 
reduced corporate income tax rates. The socialist government in Spain 
adopted a corporate tax rate reduction from 35 to 30 percent earlier 
this year. Britain's Labour Party cut the corporate tax rate to 30 
percent in 1999, and Germany's Social Democrat-led government reduced 
the top federal corporate tax from 40 percent to 25 percent in 
    \12\ Martin A. Sullivan, ``A New Era in Corporate Taxation,'' Tax 
Notes, (January 30, 2006), pp. 440-442.
    In the technologically advanced and globally integrated economy in 
which companies now compete, the U.S. corporate income tax rate 
profoundly affect the competitiveness and performance of the U.S. 
economy. Traditional investment incentives, such as accelerated 
depreciation and investment tax credits, have diminished potency 
because the value of a company's intangible assets--such as patents, 
know-how, copyrights, and brands--frequently exceeds the value of its 
plant and equipment. Reductions in tariffs and transportation and 
communication costs, and market-oriented reforms in Central and Eastern 
Europe, China, and India, have removed many of the barriers that 
previously restrained cross-border investment. As a result, companies 
have far more flexibility in where to locate their value-generating 
activities, and corporate income tax rates can affect this decision at 
the margin. Moreover, U.S. companies must compete for capital globally, 
and high U.S. corporate income tax rates make this more difficult.
    Reducing the U.S. corporate income tax rate would: make the United 
States a more attractive location for locating physical investment and 
high-value headquarters activities and would reduce distortions in the 
current tax system that harm revenues and economic efficiency, such as 
the incentive to finance with debt, operate through pass-through 
entities, shift income generating activities to lower-tax foreign 
jurisdictions, and engage in sophisticated tax planning to achieve 
globally competitive tax rates. Recent cross-country economic studies 
find that, other things being equal, nations with lower corporate 
income tax rates have over time achieved both higher real wage levels 
and economic growth rates.
Alliance for Competitive Taxation
Member List
     1. Applied Materials, Inc.
     2. Boeing Company
     3. Caterpillar Inc.
     4. Cisco Systems, Inc.
     5. The Coca-Cola Company
     6. Electronic Data Systems Corp.
     7. Eli Lilly and Company
     8. General Electric Co.
     9. Intel Corporation
    10. Johnson & Johnson
    11. Lockheed Martin Corporation
    12. Microsoft Corporation
    13. Oracle Corporation
    14. PepsiCo, Inc.
    15. The Procter & Gamble Company
    16. Wal-Mart Stores, Inc.


            Statement of Citigroup, Inc., New York, New York
    Citigroup, Inc., is pleased to submit this testimony for the record 
to the House Ways and Means Subcommittee on Select Revenue Measures in 
regards to its June 22, 2006 hearing on the impact of international tax 
reform on U.S. competitiveness. In particular, Citigroup wishes to 
thank Subcommittee Chairman Dave Camp (R-MI), the ranking member, Rep. 
Mike McNulty (D-NY), and the other subcommittee members and staff for 
the opportunity to provide comments on proposals to move from the 
current worldwide system of taxing the foreign income of U.S.-based 
corporations to a territorial system.
    Citigroup is the world's largest financial institution. Citigroup's 
300,000 employees provide financial products and services to millions 
of customers through subsidiaries and branches in more than 100 
countries. Citigroup is truly a global company; nearly 50 percent of 
its earnings came from outside the United States in the first quarter 
of 2006. We expect that percentage will increase in the future as 
Citigroup views the marketplace for financial services outside the 
United States as a critical area of growth in the coming years. How our 
earnings are taxed by the United States and the other countries in 
which Citigroup does business is a critical ingredient in our ability 
to compete globally. Therefore, this hearing and the Subcommittee's 
work going forward in examining tax reform proposals and, specifically, 
proposals to transform the U.S. international tax regime address 
matters of significant concern to Citigroup.
    Although Citigroup at this time is not taking a position as to any 
of the specific tax reform regimes that have been proposed, we hope 
that this submission will help the Subcommittee and staff better 
understand how some of the choices they face may impact the 
effectiveness of the U.S. financial services industry to compete 
globally. In January 2005, the staff of the Joint Committee on Taxation 
released JCS-2-05, entitled Options to Improve Tax Compliance and 
Reform Tax Expenditures. That report included a proposal for the United 
States to move to a territorial tax system in which the active earnings 
of foreign subsidiaries and branches of U.S. corporations generally 
would be exempt from U.S. tax. In November 2005, the President's 
Advisory Panel on Federal Tax Reform produced a similar recommendation.
    Moving the U.S. tax system to a territorial regime could improve 
the competitiveness of U.S.-based financial services companies 
operating globally. However,adoption of a territorial tax system by the 
United States will only enhance the competitiveness of U.S. companies 
if it is constructed in a fair and effective manner. Further, 
concurrent with any adoption of a territorial system must be a 
reduction of the U.S. corporate rate. Without such a tax rate 
reduction, many of the benefits of a territorial system will not be 
    For the most part, our competitors are foreign-based companies 
resident in territorial-based taxing jurisdictions that price their 
products and services and analyze potential acquisitions based on the 
tax rate in the countries in which they are doing business, rather than 
in the countries in which they are headquartered. Often times, this 
divergent and usually more beneficial tax treatment can place U.S.-
based companies like Citigroup at a serous competitive disadvantage.
    However, the United States faces important challenges as it 
contemplates modernizing the U.S. tax rules, as is clear from the two 
territorial tax proposals now on the table--the proposal by the 
President's Advisory Panel on Federal Tax Reform, and the proposal 
presented by the staff of the Joint Committee on Taxation. The goal of 
a territorial tax system should be to ensure that no dollar of net 
income is subject to tax more than once. Unfortunately, both proposals, 
based on the somewhat limited descriptions that have been provided, 
appear to fail to achieve this goal. If adopted as described by their 
authors, they potentially would represent a tax increase for many U.S.-
based companies, and would place U.S. multinational companies in a 
worse off position competitively as compared to the current system.
Treatment of Financial Income
    As an initial matter, any territorial system should recognize that 
interest and other income earned by a financial institution (such as a 
bank, securities firm, finance company, or other financial services 
business) is active trade or business income that should be treated as 
exempt income if earned by a foreign subsidiary or foreign branch of a 
U.S.-based financial institution. Thus, for a U.S. financial 
institution, ``qualified banking and financing income'' of a foreign 
branch or of a foreign subsidiary as described in the active financing 
rules of section 954(h) of the Internal Revenue Code should be 
considered ``active income'' under any territorial system adopted by 
the United States, and those rules should be permanent.
    The President's Panel suggests the adoption of anti-abuse rules to 
ensure that passive income earned by financial institutions not be 
treated as exempt active business income. The existing rules under 
Section 954(h) include rigorous anti-abuse limitations that have been 
effective, and have been readopted on numerous occasions by Congress as 
it has extended the active financing provisions, most recently through 
2008 as part of the Tax Increase Prevention and Reconciliation Act of 

Taxing Income Once
    A central theme of a territorial tax system should be to have net 
income subject to tax only once and in the jurisdiction in which such 
income arises. In other words, a company's worldwide tax base should 
not exceed its worldwide income. To achieve this goal, all income must 
be subject to taxation by only one jurisdiction somewhere in the world. 
Under a territorial system, and unlike under the current U.S. system, 
if double taxation occurs, there would not be a foreign tax credit 
mechanism to offset the cost of double taxation.
    In order to ensure that under a territorial system the correct 
amount of income is taxed in the U.S. and in foreign jurisdictions, all 
expenses must be properly allocated between jurisdictions that 
recognize their deductibility, usually through charge outs to specific 
businesses and jurisdictions. We believe stewardship expenses should be 
deductible in the United States. Any expense that is not permitted to 
be deducted in any jurisdiction will cause the worldwide tax base of a 
U.S.-based global company to be greater than its worldwide net income, 
resulting in excessive taxation and a burden on the company's ability 
to compete against its foreign-based counterparts.
    Of particular concern are the rules for allocating worldwide 
interest expense. Financial institutions, such as Citigroup, borrow 
throughout the world and incur billions of dollars of interest expense 
annually. Both the JCT staff and Tax Reform panel proposals suggest 
that a U.S. territorial system should adopt the worldwide interest 
expense allocation rules that are currently in effect for computing net 
foreign source income for purposes of determining the foreign tax 
credit limitation. Specifically, the proposals provide that a 
taxpayer's worldwide interest expense is to be allocated fungibly to 
different jurisdictions based on the relative amount of assets located 
in those jurisdictions. This system may cause distortions because it 
ignores the differences in interest rates between the various 
currencies in which a taxpayer borrows. For example, interest expense 
incurred in the United States would, under the proposals, be disallowed 
as a deduction in the United States where interest rates outside of the 
United States are lower than those within the United States.
    While the worldwide interest expense allocation concept may work 
for purposes of a foreign tax credit regime, the adoption of the 
worldwide interest allocation provisions would be inconsistent with a 
territorial system, particularly for large financial institutions for 
which interest is the primary expense. The application of the worldwide 
interest allocation rules could distort the true economic net income 
arising in the United States by disallowing interest expense arising in 
the United States (due to allocating such interest expense to a foreign 
jurisdiction). This might not be the case if interest rates were the 
same throughout the world; however, interest rates can differ 
dramatically from one jurisdiction to another. The example in the 
Appendix illustrates this problem.
    We believe that a more reliable and realistic result would be 
produced with rules that determine the proper allocable U.S. interest 
expense based upon an attribution of capital to a branch or a 
subsidiary using a thin capitalization concept. In reviewing the 
territorial systems of several countries, we found that this approach, 
which was most recently adopted by Australia in 2003 as part of that 
country's conversion to a territorial system, provides a simple and 
fair method of allocating interest.

Treatment of Branches
    Like many banks, Citigroup may operate its businesses in some 
countries through a branch. Under current U.S. law, (a) the income of a 
foreign branch is taxed currently by the United States as if the income 
were earned in the United States, and (b) transactions between U.S. and 
foreign branches of the same entity, including loans between branches, 
are generally not recognized for U.S. tax purposes.
    Both the JCT staff and Tax Reform panel territorial proposals 
suggest that a U.S. territorial system should treat branches as if they 
are separate affiliates, so that their active income would be exempt 
from U.S. taxation. Unfortunately, both proposals provide no further 
details regarding the taxation of branches, allocation of expenses to 
branches, or the treatment of transactions between branches. Consistent 
with OECD principles, which generally recognize inter-branch 
transactions provided they satisfy arms-length principles, our 
recommendation is that a territorial system should recognize branch-to-
branch transactions as the most appropriate and accurate method of 
allocating income and expense between branches. We also recommend that 
consideration should be given to looking to the local books of the 
foreign branch to determine the exempt ``active'' income and expense of 
the foreign branch business operation.

Transfer Pricing and Tax Treaties
    The President's panel rightfully noted the critical role that 
transfer pricing enforcement will play if the United States adopts a 
territorial tax system. Under a territorial system, the U.S. tax 
authorities will need to combat efforts to artificially move U.S. 
taxable income to low tax jurisdictions.
    What also seems fairly evident to us, however, is the fact that 
U.S. businesses with significant foreign operations will find it quite 
difficult to realize the goal of having their income taxed only once 
without robust transfer pricing rules and enforcement combined with an 
expanded network of U.S. bilateral income tax treaties. Today, U.S. 
companies face enormous challenges in ensuring that 100 percent of 
expenses that are properly charged out to foreign operations are 
accepted as deductions in some of the countries in which those 
operations are based. For companies with excess foreign tax credit 
limitation, such expenses that ``fall through the cracks'' can be 
problematic but not incurable. This would not be the case under a 
territorial system. In recent years, the U.S. policy towards expanding 
the U.S. tax treaty network, reducing or eliminating withholding taxes 
on cross-border interest and dividends, and beginning to adopt 
mandatory arbitration to resolve competent authority disputes has been 
impressive. However, this network will need to be expanded further, 
particularly into Latin America and parts of Asia, and competent 
authority dispute resolution efforts will have to be enhanced further 
if a U.S. territorial tax system is to be implemented effectively from 
the standpoint of both U.S. tax administration and the competitiveness 
of U.S-based companies.

    Citigroup thanks the Subcommittee for the opportunity to provide 
its views on the topic of moving the United States to a territorial tax 
system, and looks forward to working with the Congress, the Treasury 
Department, and others as part of a thoughtful and productive debate 
over the future of U.S. international tax policy.

Worldwide Interest Allocation Example
      A business has its head office operations in New York, 
and branches in Tokyo and London. Each of the branches has the 
following assets (at the year-end U.S. dollar FX rates):

New York                            Tokyo              London
12,000                              500                500

      Each branch earns a 100 basis point spread on its assets 
with the following interest rates:

Income                               Expense
New York                             6%                  5%
Tokyo                                1%                  --
London                               3%                  2%


Local Books                          New York            Tokyo              London             Totals
Gross Interest                        120                5                   15                140
Interest Expense                     <100>               --                 <10>               110
Net Interest Income                    20                5                    5                 30

    Application of the worldwide interest allocation rules (interest 
expense allocated according to the relative assets of the branches and 
head office)

Gross Interest                        120                     5                15               140
Interest Expense                      <73>               <18.5>             <18.5>             <110>
Net Interest Income                    47                <13.5>              <3.5>               30

    The use of the worldwide interest allocation formula distorts the 
true $20 economic net income of the U.S. head office. Instead, the U.S. 
head office would be subject to tax on $47 of net income.


          Statement of Dow Chemical Company, Midland, Michigan

    I commend the Subcommittee on Select Revenue Measures for holding a 
hearing on the important subject of international tax reform and I am 
pleased to submit this statement for the record.
    The Dow Chemical Company today is a truly global company. We have 
customers around the world, and many of our customers are themselves 
global companies. Our largest competitors, both for business in foreign 
markets and for business in the U.S. market, are global companies. 
Given this globalization of the economy, it is critically important 
that the U.S. international tax rules do not disadvantage U.S.-based 
companies competing in the global marketplace. The optimal U.S. 
international tax system would enhance the global competitiveness of 
U.S. companies and allow American businesses and the workers that they 
employ to make the most of the tremendous opportunities that are 
available as markets around the world become even more open.

The Global Profile of The Dow Chemical Company
Dow Today
    Dow is a diversified, integrated science and technology company 
that develops and manufactures innovative chemicals, plastics, and 
agricultural products and services for industrial and consumer markets 
worldwide. Dow supplies more than 3,200 products, grouped within six 
operating segments: Basic Plastics, Performance Plastics, Performance 
Chemicals, Hydrocarbons and Energy, Basic Chemicals, and Agricultural 
Sciences. Dow serves customers in more than 175 countries in a wide 
range of markets, including food, transportation, health and medicine, 
personal and home care, and building and construction, among others.
    Dow's annual sales are $46 billion; of total sales, 38% is in the 
United States and 62% is international, divided between Canada, Europe, 
Latin America, and Asia. Dow has total fixed assets of over $13 
billion, with more than half located in the United States. Dow employs 
more than 42,000 people worldwide, including more than 21,000 employees 
in the United States.

Evolution of Dow
    Dow began business in the United States in 1897. By the middle of 
the 20th century, Dow had to become a global company in order to remain 
competitive. Dow's first international expansion was into Canada in the 
1940s. In the 1950s, with business growth after World War II, Dow began 
expanding into Europe and then Latin America. More recently, Dow's 
growth in the Middle East has been driven by high energy costs in the 
United States and the comparatively lower energy and feedstock costs in 
that region. Dow's expansion into China is driven by local market 
growth in that region. Dow now has 156 manufacturing sites in 37 
    The percentage of Dow's sales outside the United States has 
increased dramatically over the last fifty years. In 1955, Dow had $ 70 
million in sales outside the United States, representing 12% of total 
sales. By 1980, Dow had $ 5.2 billion in sales outside the United 
States, representing 50% of total sales. Today, Dow's sales outside the 
United States exceed 60% of total sales.
    The expansion of Dow's foreign operations has not only generated 
sales from those foreign operations but also has increased Dow's 
exports from the United States. Dow's foreign operations are 
significant customers for the output produced by Dow's facilities in 
the United States. Thus, foreign expansion creates expanded export 
markets for Dow's U.S. operations. The increase in Dow's total non-U.S. 
sales has been closely paralleled by an increase in Dow's U.S. exports, 
with exports from the United States consistently representing 
approximately 20% of Dow's total sales outside the United States and 
sales to foreign affiliates representing about 75% of Dow's total U.S. 
    Even with the expansion of Dow's foreign operations, the percentage 
of capital spending in the United States continues to remain fairly 
constant, reflecting the company's historic base and headquarters in 
the United States. Approximately 60% of Dow's capital expenditures each 
year is devoted to plants in the United States. The predominance of 
U.S. capital spending matches the company's aggregate fixed asset base 
which also is located predominately in the United States.

The Global Profile of Dow's Customers and Competitors
    Just as Dow has become increasingly globalized, so too have Dow's 
customers and Dow's competitors.

Dow's Customers
    Dow's customer base is very diversified, both by industry and by 
geography. Dow's customers represent a broad range of industries, 
including food and food packaging, personal and household care, 
hydrocarbons and energy, building maintenance and construction, home 
care and improvement, automotive and transportation, and paper and 
publishing. As noted above, Dow's customers today are located in more 
than 175 countries around the world.
    Increasingly, Dow's local customers are becoming global customers. 
They are themselves global businesses and they are looking for a global 
supplier. These customers want a supplier that can provide the same 
products at the same quality and the same price anywhere in the world. 
They are very well informed, are very sensitive to both price and 
quality, and are free to choose among multiple potential suppliers. In 
order to serve these customers, Dow must have production facilities in 
the many markets where the customers do business.

Dow's Competitors
    Dow's competitors also are very geographically diversified and have 
highly-efficient cost structures and world-class competitive 
technologies. Dow is the largest chemical company in the United States. 
It is the second largest chemical company in the world based on sales. 
Its two closest competitors, ranked first and third in the world based 
on sales, are BASF and Bayer, both of which are German companies. Of 
the top ten chemical companies in the world, only three are U.S.-based 
companies. The other seven companies are based in Germany, France, the 
United Kingdom, the Netherlands, China, and Saudi Arabia. Some of these 
competitors face very little home country tax. Unlike Dow, even those 
competitors from countries with significant tax systems generally are 
not subject to home-country tax on their foreign earnings.
    The competitive landscape is continuing to evolve. Focusing on the 
ethylene business for example, by 2010 four of the top ten global 
producers will be State-owned enterprises. These four government-
operated businesses are located in China, Iran, and Saudi Arabia. 
Moreover, several other State-owned businesses are expanding very 
quickly, including Saudi Aramco, Qatar Petroleum, Oman Oil, and 
Petrochemical Industries of Kuwait. These competitors all face little 
or no home country tax. These enterprises are all of global scale, have 
competitive technology, and similar general and administrative cost 
structures. The principal differentiators between these enterprises and 
Dow and other companies are raw material supply and tax position.
    Dow competes with these foreign companies not only in global 
markets but also in the United States. The U.S. market is open and 
accessible to foreign companies and its size and pricing makes it a 
very attractive market. Foreign production in the chemical industry is 
becoming increasingly competitive. Historically, the United States has 
been a consistent exporter of chemicals and related products. Now 
increasingly, these products are being imported into the United States 
by foreign companies.

The United States Needs a Competitive International Tax System
    In order to succeed in today's global economy, U.S.-based companies 
must be able to compete with a wide range of foreign competitors. They 
must compete in markets around the world to serve foreign customers. 
They must be prepared to serve multiple markets in order to meet the 
needs of global customers. In addition, they must be able to compete 
against foreign companies in order to serve the U.S. market. The 
structure of the U.S. international tax rules has a significant impact 
on the ability of U.S.-based companies to compete and succeed both 
abroad and here at home.

How U.S. and Foreign Taxes Affect Competition
    As the economy becomes increasingly globalized, customers are 
becoming increasingly sophisticated and are taking advantage of more 
freedom to choose the lowest cost, highest quality supplier. In the 
chemical industry in particular, there are many global suppliers, which 
heightens the competition in the industry. There are of course a whole 
range of factors that differentiate among suppliers and determine which 
company gets a customer's business. That said, the cost of taxes is one 
of the deciding factors in determining which company will build the 
next production facility and thus be in a position to supply the next 
    In the chemical industry, the location of a new plant is determined 
primarily by non-tax factors such as the location of customers and 
feedstock and energy costs. Because of the robust competition in the 
industry, these factors tend to be the same for all competitors, 
particularly in the basic chemicals sector. What often differentiates 
among the competitors is the tax cost they face.
    The cost of income taxes is an important factor in determining the 
rate of return on a project for a company. In the chemical industry's 
field of evenly-matched competitors, the tax burden does not often 
determine where a project will be built but rather determines which 
producer will build it. Dow measures the future tax costs associated 
with a project being contemplated by taking into account the expected 
tax on all cash flows from the project, including dividends, interest, 
royalties, and sales income. Where taxes reduce the rate of return on a 
project below an acceptable level, Dow will not undertake the project. 
One of Dow's foreign competitors, which operate in very different home 
country tax environments, may well undertake the project instead of 
Dow. Loss of business opportunities to foreign competitors affects not 
just foreign operations but also operations and jobs here at home.
    It is very rare that the local tax burden alone would be so high 
that none of the global competitors in the industry will undertake a 
project the underlying economics of which otherwise make sense on a 
pre-tax basis. However, variations in the combined local and home 
country tax burden with respect to a project across the range of global 
competitors in the industry will determine which company undertakes the 
project. Although there are a few exceptions in the Middle East (where 
some countries subject foreign investors to more onerous taxation than 
is imposed on local investors), typically the local taxes on the 
project will be the same for all competitors. What varies substantially 
is the tax treatment of the project by each competitor's home country. 
Thus, the home country taxation of income from international business 
activities is the key tax factor in determining which competitor will 
undertake a particular project and build a new plant to serve customers 
in a particular market.
    The current U.S. international tax rules, which impose current U.S. 
tax on many forms of foreign business income and subject repatriated 
foreign earnings to U.S. tax, can put U.S. companies at a significant 
competitive disadvantage. With the rise of State-affiliated enterprises 
as significant competitors for Dow, the sensitivity to home country 
taxes is becoming more pronounced because these competitors pay little 
or no home country tax. Even Dow's European competitors have a 
competitive advantage when it comes to taxes. Most of these companies 
are located in countries with territorial tax systems so that they are 
not subject to home country tax on their foreign earnings, even when 
they bring those earnings home.

Burdens of the Current U.S. International Tax System
    The current U.S. international tax system, which subjects U.S. 
companies to U.S. tax on all their income wherever earned, operates to 
disadvantage U.S.-based multinational companies relative to the foreign 
competition in a variety of ways. For Dow, the most burdensome aspects 
of the U.S. international tax rules are the overly restrictive foreign 
tax credit rules and the overreaching subpart F rules which impose 
immediate U.S. tax on foreign earnings.
    Under the U.S. worldwide tax system, foreign-source income of a 
U.S. company is subject to tax both in the country where it was earned 
and in the United States. In order to mitigate this double taxation, a 
foreign tax credit mechanism provides for foreign taxes to offset the 
U.S. taxes that would otherwise be imposed. The modifications made to 
the U.S. foreign tax credit rules in 2004 significantly improved this 
system, but the rules continue to include strict limitations that 
restrict the availability of credits for foreign taxes that have been 
paid. In this regard, complex expense allocation rules treat a portion 
of U.S.-incurred expenses as allocable to foreign-source income; this 
has the effect of reducing net foreign-source income and the allowable 
foreign tax credit, even though the allocation does not in any way 
reduce the company's foreign tax liability. The expense allocation 
approach in the current U.S. tax system is significantly more onerous 
than the approaches used by our trading partners. In addition, special 
rules regarding the treatment of losses further restrict a company's 
ability to use foreign tax credits. The economic effect of these 
restrictions is to cause U.S. companies to be subject to double 
taxation on income earned outside the United States. The 2004 changes 
extending the carryforward period and changing the domestic loss 
recapture rules help, but only to the extent that they help companies 
avoid losing use of their credits altogether. The strict limitations in 
current law continue to erode the value of the credits when their use 
is delayed for many years after the taxes were paid to the foreign 
    Under the current U.S. international tax rules, income earned 
abroad through foreign subsidiaries generally is not subject to U.S. 
tax until it is repatriated to the U.S. company through dividends. The 
subpart F rules which impose immediate U.S. tax on certain income of 
foreign subsidiaries are the exception to this general rule. The 
subpart F rules are intended to capture passive and other highly mobile 
income that is earned outside the United States. However, the subpart F 
rules operate to impose immediate U.S. tax on many forms of active 
business income earned abroad. In particular, U.S. companies can be 
subjected to immediate U.S. tax on services income and sales income 
earned through active business operations in foreign markets. This 
immediate U.S. tax is a significant cost that is not borne by foreign 
competitors operating in those markets. These rules also encourage the 
use of complicated business structures and transactions, impede the 
efficiencies of U.S. companies, and distract management from focusing 
on business concerns, all of which represent additional costs for U.S.-
based companies that are not borne by foreign competitors.

A U.S. Territorial Tax System
    Many of the countries that are major U.S. trading partners and that 
are home to Dow's principal competitors have territorial tax systems 
under which active foreign business income of their companies is not 
subject to home country tax. A move away from the existing worldwide 
approach and toward a territorial approach could bring the U.S. tax 
system more in line with those of other developed countries in Europe 
and elsewhere. Such a move could eliminate some of the costs and 
disadvantages of the current U.S. tax system for U.S. companies that 
have operations outside the United States. However, the benefits of 
such a system depend entirely on the details of how the system is 
structured. Great care would need to be taken to ensure that a new U.S. 
international tax system does not create further disadvantages for U.S. 
companies competing in the global marketplace.
    The Joint Committee on Taxation staff and the President's Advisory 
Panel on Federal Tax Reform have proposed possible territorial tax 
systems for the United States. Both of these proposals are largely 
conceptual, with many of the details unspecified. However, it is clear 
that a territorial system structured along the lines of these proposals 
would be very different than the territorial tax systems that exist 
today in Europe and elsewhere. These differences would make the 
proposed systems significantly more burdensome than the systems of our 
trading partners. These differences highlight some of the key features 
that must be carefully considered in designing a territorial tax system 
that would satisfy the objective of enhancing the competitiveness of 
U.S. businesses operating in the global marketplace.
    Treatment of foreign-source income: The territorial tax approaches 
that have been proposed would provide an exemption only for foreign-
source dividends and would impose full U.S. tax on other forms of 
income earned abroad by a U.S. company. This taxable foreign-source 
income includes royalty income, services income, and income from export 
sales. These categories of income could be taxed more heavily under the 
territorial tax proposals than they are under the current U.S. tax 
system. Such a tax increase would be very detrimental to the 
competitiveness of U.S.-based companies and to the U.S. economy, 
including the loss of U.S. jobs associated with exports of goods 
manufactured in the United States.
    Any increase in the U.S. tax on foreign-source royalty income would 
force U.S. companies to consider measures to reduce the royalties being 
paid back to the United States. This could be accomplished by shifting 
R&D activities outside the United States to foreign affiliates. Such a 
shift would mean that valuable new intangible property would be 
developed and owned outside the United States. Today, U.S. companies 
are net recipients of royalties paid by their foreign affiliates; if 
this sort of shift occurs, U.S. companies could become net payors of 
royalties to their foreign affiliates. The result would be a loss of 
high-paying U.S. R&D jobs, an erosion in the stock of valuable 
intangible property held in the United States, and a reduction in the 
U.S. tax base. This is a particularly inopportune time to drive 
companies to consider such a shift, as other countries (India and 
China, for example) are quickly increasing their talent pools to 
perform sophisticated R&D.
    An increase in the U.S. tax on service fees received from outside 
the United States similarly could cause a relocation of service 
operations away from the United States. This would reduce U.S. 
employment in these high-technology sectors. In addition, an increase 
in the U.S. tax on income from exports would increase the cost of 
export activity. This would reduce the incentive to export and increase 
the incentive to source contracts and supply customers from outside the 
United States. This would adversely affect U.S. employment in the 
manufacturing sector.
    In considering a territorial tax system for the United States, 
careful consideration must be given not just to the treatment of 
foreign-source dividend income but also to competitive treatment for 
other categories of foreign-source income. If a territorial system were 
designed in a manner that would lead to a tax increase on these 
important forms of foreign-source income, the adverse impact would harm 
the competitiveness of U.S. companies operating in the global 
marketplace and would create incentives to move activities outside the 
United States. Such results would be completely inconsistent with the 
reasons for considering adoption of a territorial tax system in the 
first place.
    Treatment of U.S. expenses: The territorial tax approaches that 
have been proposed by the JCT staff and the Tax Reform Panel include 
rules that would allocate a portion of U.S.-incurred expenses to income 
earned outside the United States. These proposals are out of line with 
the territorial systems of other countries. The proposed expense rules 
are based on the complex allocation rules currently used in the United 
States for purposes of the foreign tax credit limitation. However, the 
use of such allocations in a territorial tax system would have an even 
more dramatic effect by causing the denial of any deduction for 
expenses that are allocated to exempt foreign income.
    As noted above, no other country has expense allocation rules that 
are as rigorous and burdensome as the U.S. expense allocation rules. 
The impact of these rules is even more detrimental in the context of a 
territorial tax approach. Expenses that are treated under U.S. tax 
rules as allocated to income earned outside the United States would not 
be recognized by the country where the income is earned. They would not 
be allowed as a deduction for purposes of calculating the tax liability 
in that country. Therefore, such expenses would not be deductible 
anywhere. That result would be contrary to the basic principle that 
taxpayers should be entitled to deduct all ordinary and necessary 
business expenses.
    A denial of deductions for U.S.-incurred expenses also could 
trigger a behavioral response. If a portion of U.S.-incurred R&D 
expense were treated as non-deductible, the effect would be to increase 
the cost of conducting R&D in the United States. This would create a 
further incentive for U.S. companies to move their R&D operations 
outside the United States. Similarly, treating a portion of G&A costs 
incurred in the United States as non-deductible would create an 
incentive for companies to relocate these headquarters-type activities 
outside the United States. U.S. companies would be forced to consider 
these reductions in their U.S. activities and their U.S. employment 
simply in order to remain competitive.
    In considering a U.S. territorial tax system, careful consideration 
must also be given to ensuring appropriate treatment of expenses. 
Simply incorporating the expense allocation rules of current law into a 
new territorial system is not the answer. Appropriate rules must be 
crafted that ensure that ordinary business expenses are deductible and 
that do not drive companies to eliminate U.S. activities and lessen 
their connections to the United States.
    Application of subpart F rules: As noted above, the subpart F rules 
of the current U.S. international tax system subject U.S. companies to 
immediate U.S. tax on certain income earned by their foreign 
subsidiaries. The territorial tax approaches that have been proposed by 
the JCT staff and the Tax Reform Panel would continue to apply these 
rules. This would be significantly more burdensome than the approaches 
used by our trading partners.
    Many countries with territorial tax systems impose home-country tax 
on some income earned by foreign subsidiaries. However, the only 
foreign income that is covered by these rules is passive income. The 
U.S. subpart F rules are much broader than the passive income rules of 
other countries and impose immediate U.S. taxation on many forms of 
active business income earned by foreign subsidiaries of U.S. 
companies. For example, the U.S. rules impose immediate U.S. tax on 
income from the sales and services activities of foreign subsidiaries 
of U.S companies.
    Incorporating these rules into a territorial tax approach would 
result in a system that continues to impose substantial U.S. tax on the 
income of U.S.-based businesses operating in foreign markets, income 
that is not subject to home country tax when earned by their foreign 
competitors. Such a system would continue to put U.S. companies at a 
significant competitive disadvantage relative to their foreign 
counterparts. As part of a territorial tax system, substantial 
modifications to the subpart F rules would be needed in order to focus 
these rules on passive income.

Consideration of Other Countries' Territorial Tax Systems
    In considering the merits of a territorial tax system for the 
United States and the optimal design of such a system, it is useful to 
look to the international tax systems of our major trading partners. 
These are the tax systems faced by the global competitors of U.S.-based 
companies. It is the differences between these systems and the U.S. tax 
system that can determine whether a U.S. company or one of its foreign 
competitors wins the next project and builds the next plant to serve 
customers in markets around the world.
    Dow's principal foreign competitors are headquartered in Germany, 
the Netherlands, and the United Kingdom. Germany and the Netherlands 
both have territorial tax systems. The United Kingdom is actively 
considering a possible future move to a territorial tax system. The 
Dutch and German international tax systems both are significantly more 
competitive than the current U.S. international tax rules. Moreover, 
both countries are currently considering changes that will further 
enhance the international competitiveness of their tax systems.
    The Dutch international tax system: In many respects, the Dutch tax 
system is a model system, particularly with respect to the treatment of 
international activity.
    The Dutch tax system nominally subjects Dutch companies to tax on 
their worldwide income. However, virtually all income from foreign 
business operations is exempt from Dutch tax under one of two 
mechanisms. Under the participation exemption, dividends and capital 
gains from non-Dutch subsidiaries are exempt from Dutch tax. Under the 
double tax relief provisions of Dutch domestic law and tax treaties, 
income from foreign branch operations also is effectively exempt from 
Dutch tax.
    Under current law, foreign-source interest and royalties received 
by a Dutch company are subject to full Dutch tax at a rate of 29.6%. A 
foreign tax credit applies with respect to foreign withholding taxes 
imposed on this income. However, substantial tax reforms proposed in 
the Netherlands in May 2006 would reduce the top corporate income tax 
rate to 25.5%. Moreover, the proposed reforms provide for a special tax 
rate of 10% for certain royalties and other income related to research 
and development and a special tax rate of 5% for net interest income 
received from affiliated companies.
    Under the Dutch tax system, business expenses are fully deductible. 
The only limitations on expense deductions are relatively narrow. An 
anti-abuse rule applies to deny deductions for certain interest paid to 
related parties in situations involving excessive debt financing or 
thin capitalization. Interest paid to third parties is not affected by 
this rule. Expenses incurred to acquire a non-Dutch, non-EU company 
that is eligible for the participation exemption also can be non-
    The Dutch tax system does not include any rules comparable to the 
U.S. subpart F rules. The system includes one limited rule related to 
passive income earned abroad. Income earned by a foreign passive group 
finance company in a low-tax jurisdiction is not eligible for the 
participation exemption. Thus, dividends from this type of company are 
subject to Dutch tax.
    In sum, key features of the Dutch tax system serve to enhance the 
global competitiveness of Dutch companies: (1) Dutch companies 
operating in foreign markets are subject only to local tax and are not 
subject to Dutch tax on their foreign earnings; (2) expenses incurred 
by Dutch companies are not subject to any deduction disallowance, and 
(3) the Dutch rules for taxing foreign passive income are very narrowly 
targeted and do not capture active business income. In addition, 
proposed Dutch tax reforms would substantially reduce the tax imposed 
on foreign-source royalties and interest income of Dutch companies. 
Moreover, the Dutch tax system of advance rulings provides much-needed 
certainty regarding the tax treatment of international transactions.
    The German international tax system: Although Germany has 
traditionally been a relatively high tax country, recent reforms have 
made the German tax system more competitive and a substantial reduction 
in the corporate tax rate is currently being considered. Moreover, the 
German international tax rules are significantly more favorable to 
cross-border activity than the current U.S. international tax rules.
    Germany also operates under a participation exemption system 
pursuant to its network of tax treaties. Accordingly, German companies 
generally are eligible for exemption from German tax on dividends and 
capital gains from their foreign subsidiaries and on income earned 
through foreign branches. German companies are subject to German tax on 
foreign-source royalties and interest, with a foreign tax credit. In 
this regard, as noted above, reductions in the German corporate tax 
rate are under consideration currently.
    The German tax system does not include rules that require the 
allocation and deduction disallowance of expenses to exempt income. 
Instead, the participation exemption rules provide for a 95% exemption 
of foreign business income. This partial reduction in the exemption 
operates as a proxy for expense allocation rules.
    Germany has rules that are similar to the U.S. subpart F rules, but 
the reach of those rules is significantly narrower. Under the German 
rules, the participation exemption is denied and immediate tax is 
imposed only on income of a foreign subsidiary that both is passive and 
is subject to a low rate of tax.
    The territorial tax system in Germany provides a significant 
advantage to German companies operating internationally because their 
foreign operations effectively are subject only to local tax. German 
companies do not face the loss of deductions for business expenses or 
the risk of immediate tax on business income earned outside of Germany. 
The international competitiveness of the German system will be further 
enhanced if the substantial corporate rate cuts now being contemplated 
are enacted.

    Globalization means tremendous opportunities for U.S.-based 
businesses and American workers. It also means increasing competition 
from global businesses. The U.S. international tax rules subject U.S.-
based companies to costs that are not borne by their foreign 
competitors. The need for a more competitive international tax system 
for the United States is made all the more acute with the rise of 
foreign business entities, including State-owned businesses, that are 
subject to little or no tax in their home countries. The time is ripe 
for international tax reform in the United States. It is prudent, 
however, to proceed cautiously and deliberately, in order to ensure 
that any changes that are made accomplish the objective of enhancing 
the ability of U.S.-based business to compete and thrive in the modern 
global economy.


      Statement of Leo Linbeck, Jr., Americans For Fair Taxation,
                             Houston, Texas

Mr. Chairman and Members of the Subcommittee on Select Revenue 
    Witnesses before this Subcommittee today enumerate some key 
problems posed by our current system for America's international 
competitiveness. They criticize our corporate marginal tax rates as the 
highest in the developed world. They point out international reform 
must be integrated with comprehensive reform which does not punish 
savings and investment. They argue our extraterritorial tax system 
costs as much to comply with as it raises, even by the reckoning of the 
Joint Committee on Taxation staff.
    However, none addresses the leading problem domestic producers face 
when competing against foreign producers: Our failure to adopt a 
border-adjusted destination-based consumption tax. We submit this 
testimony for two reasons: (1) to offer badly needed perspective on the 
importance of ensuring that reform adopts a border-adjusted tax system; 
and (2) to help untangle the underbrush of competing proposals to 
better explain what competitiveness should mean and how to achieve it.
    Border-adjusted taxes are, quite simply, the most potent weapons 
foreign producers have against U.S. producers and workers. Border-
adjusted taxes are consumption taxes removed on export by the producing 
nation and assessed upon imports as ad valorem taxes. At this point in 
time, 29 of 30 OECD countries enjoy border-adjusted tax regimes. Only 
one--the U.S.--refuses to adopt a border-adjusted tax system in order 
to continue to rely upon an origin principle, direct, world-wide income 
tax system that taxes returns to capital multiple times. We do so at 
our peril.
    When two nations with border-adjusted tax regimes trade together, 
the effects negate themselves. Taxes one nation rebates on domestically 
produced exports are reimposed by the importing jurisdiction in what is 
effectively an economic wash. But the interaction of indirect border-
adjustable systems with the U.S.'s tax system is devastating. Border-
adjusted regimes effectively grant foreign producers an approximately 
18-percent price advantage over U.S. produced goods, whether competing 
here or abroad. Our failure to respond to these incentives amounts to a 
self-imposed handicap which stimulates outsourcing, encourages plant 
relocations, lowers the wages of the American workers, harms U.S. small 
businesses and farmers, and decimates our production capabilities to 
such an extent it raises national security concerns. A recent MIT 
report states that the U.S. failure to recognize and confront this 
problem costs us more than $100 billion in exports annually. In our 
judgment, this is a conservative estimate.
    Our unique failure to adopt a destination-based consumption tax 
combined with our uniquely high marginal corporate rates sends the 
wrong messages to American producers: ``Move your plants and facilities 
overseas, hire foreign workers, and then market your products back to 
the American consumers whose tax system favors consumption over 
investment and savings.'' To retailers: ``Stock foreign inventory.'' To 
consumers: ``Buy foreign products.'' The problem is American industry 
and consumers are taking Congress's advice. Market forces do work. The 
burgeoning trade deficit, the loss of American jobs, and stagnating 
blue collar wages are consequences of failing to send the right 
    At a time when U.S. companies are struggling to compete against 
foreign manufacturers, at a time of record trade deficits and 
manufacturing job losses, at a time when the tax-writing committees 
should finally realize that they cannot legally offer domestic 
producers export incentives like the Foreign Sales Corporation rules 
without violating WTO rules, the Congress is ignoring the root problem. 
And today, it is ignored again. If America wants to rebuild its 
manufacturing base and remain competitive, it must adopt a border-
adjusted tax system. And the best way to accomplish that is by enacting 
the most border-adjusted tax system that could be devised--the FairTax 
(H.R. 25).
    Second, we urge Members of this Subcommittee--before reaching for 
any particular solution to improve ``competitiveness''--to take the 
opportunity to better define the contours of that fuzzy concept. The 
true test of international competitiveness is not whether a tax system 
benefits multinationals which by definition know neither national 
boundaries nor allegiances. Rather, the true test ought to be whether 
or not the tax regime achieves the objective of raising the standard of 
living for the American people. We believe the FairTax addresses more 
effectively the problems raised by the witnesses than the very plans 
they promote, and more importantly, it offers solutions to other issues 
that should be more fully explicated. When examining whether various 
tax plans help America become more competitive, ask these questions:

      Do the plans create a better environment for domestic 
companies to produce in the U.S. and to hire American workers rather 
than to produce abroad and hire foreign workers? Only under the FairTax 
would domestic corporations enjoy a zero rate of tax for producing in 
the U.S.
      Do the plans make the U.S. a better environment from 
which to export? Only under the FairTax would exports be fully exempted 
from taxation.
      Do the plans tax foreign produced goods and U.S. produced 
goods alike in the U.S. market? Only under the FairTax's inherently 
border-adjusted scheme would foreign goods be taxed exactly the same as 
domestically produced goods consumed in the U.S.
      Do the plans encourage foreign establishment of plants 
and operations in the U.S. more than abroad? Only under the FairTax 
would foreign business enjoy a zero U.S. tax on earnings. A territorial 
income tax system, in contrast, would probably drive job-generating 
plants and facilities overseas so that only the shell corporation 
remains headquartered here.
      How well do the plans encourage tax competition (i.e., do 
they encourage global rates on savings and investment to fall or do 
they encourage a race to the top)? Only under the FairTax would foreign 
nations have such a clear choice: Reduce your taxes or lose investment 
to America. This would have a pronounced positive impact on world 
economic growth.
      How well do the plans reduce the costs of compliance with 
the international tax system? Only the FairTax eliminates the 
complexity of the foreign tax credit scheme, the personal foreign 
holding company rules, intercompany transfer pricing rules, Subpart F, 
income sourcing and expense allocation rules, and a host of other 
complex international tax rules that create high compliance costs 
today. It does so by eliminating any business-to-business taxation and 
by taxing only consumption in the U.S.
      Will the plans afford an easy transition from the current 
system to the alternative? Moving to a territorial income tax will 
raise many transition issues, including how to treat pre-enactment 
dividends and how to treat excess foreign tax credits.
      Will the plans allow businesses to make decisions 
entirely on economic grounds rather than for tax planning reasons? Only 
the FairTax would completely remove taxes from decision making by being 
vertically and horizontally equitable.
      Will the plan be sustainable or merely a temporary fix 
that will eventually devolve into the current morass? The FairTax is 
the only plan that can be guaranteed not to devolve into the current 
morass by repeal of the 16th Amendment.
      Will the interaction of the tax plan with foreign tax 
systems be favorable? Only the FairTax eliminates fully the need to 
coordinate juridical taxation because source income is not taxed.

    These questions properly frame the debate over whether or not a 
plan is good for America.
    Mr. Chairman, as the nation's largest tax reform organization, we 
compliment this Subcommittee for focusing on the problem faced by U.S. 
producers. American producers struggle to compete in a global market 
where capital, technology, management, and increasingly labor are free 
to move to any venue offering the best opportunities for profit. 
However, American producers and the workers whose jobs depend on them 
are beyond mere rhetoric. They do not see increased outsourcing as a 
healthy correction in the economy, or a normal casualty of destructive 
capitalism like the obsolescence of the buggy whip manufacturers caused 
by automakers. They do not see America's manufacturing decline as a 
statistical abstraction relevant only to those nostalgic about 
America's industrial past. They do not see our tax system as 
repairable. Rather, they see destruction of America's manufacturing 
base as a harbinger of hardship ahead for future generations of 
Americans. This Subcommittee has a duty to understand how the tax laws 
they helped construct contribute to this problem, and what can be done 
to fix it.

I. America's Manufacturing Base is at Critically Low Mass
    For many decades, American manufacturing has been the nutrient of 
national prosperity and security; raising the standard of living for 
working Americans, fulfilling dreams of immigrants, enabling 
sustainable national security, building communities, and launching 
America on the global stage as a world leader. American industry has 
long been distinguished for its productivity and sustained innovation. 
The health of the U.S., the well-being of its citizenry, and our very 
survival are undeniably and inextricably bound to the health, well-
being, and survival of the American manufacturer. Without strong 
manufacturing, America's strength cannot endure.
    But U.S. manufacturing is rapidly eroding in the face of foreign 
competition. This erosion is visible in the dwindling contribution of 
manufacturing as a share of the U.S. economy.


    Until recent years, U.S. companies employed Americans to produce 
most of the goods that Americans consumed, employment supported sales, 
and sales supported employment. Today, manufacturing represents half of 
what its share of Gross Domestic Product (GDP) was in the 1950s. With 
each passing year, manufacturing has become an ever-decreasing part of 
the overall economy. Consider that the value of all goods manufactured 
in the U.S. was roughly 30 percent of the value of all goods and 
services in the economy in 1953, 25 percent in 1970, 20 percent in 
1982, and it fell below 15 percent in 2001. The share of the U.S. labor 
force working in the manufacturing sector fell over the same period 
from over 26 percent to about 10 percent.
    When manufacturing moves overseas, it takes the practical 
engineering know-how with it. Manufacturing has declined so severely in 
many communities that basic industrial skills and the small business 
suppliers and support industries are disappearing. Even the industrial 
base necessary to maintain a technological edge in military hardware 
and the ability to ramp up in the case of war is starting to vanish. 
The National Association of Manufacturers has warned, ``--the country 
may be dropping below critical mass in manufacturing.''


    The bad news does not stop there. The U.S. runs a sizable negative 
trade balance in goods with every principal nation and region in almost 
every category of goods; so large an imbalance that the U.S. trade 
deficit exceeded $700 billion in 2005, around 6 percent of GDP. Even 
the agricultural trade surplus is gone. In what is a demonstrably 
unsustainable pattern, we produce only two-thirds of the goods we 
consume.\1\ And the relentless growth of the trade deficit has 
converted the U.S., once the world's largest creditor, into the world's 
largest debtor, enabling foreigners to own an estimated $3.7 trillion 
in U.S. assets (an amount on scale with the total privately owned 
portion of the U.S. federal debt).
    \1\ This, of course, means that the U.S. is running a large capital 
surplus. But this capital is not being used to fund new investment. 
Business fixed investment is stable at 15 percent of GDP. Instead, the 
U.S. is selling its assets--and its economic future--to foreign 
investors to fund current consumption.
    High paying jobs are being destroyed. The effect of this decline is 
not a numerical abstraction. It can be felt in the shrinking share of 
U.S. income earned by blue-collar workers. The decimation of our 
domestic producer base results in job losses for America's middle 
class, lost opportunities for the young, suffering for the poor, and a 
widening wealth gap. This decline corresponds with the outsourcing of 
jobs and production overseas, and an increase in the number of 
manufacturing start-ups basing their operations on foreign soil.
    It means we must work harder for less. Indeed, the U.S., which led 
the world in adopting the 40-hour work week in the 20th century, enters 
the 21st century with a generally adopted 80-hour family work week 
simply to keep pace with costs. Today, it is becoming increasingly 
difficult for blue-collar families to achieve a middle-class standard 
of living.

II. The Central Problem Ignored: Failure to Adopt a Border-Adjusted Tax 
    The U.S. manufacturing decline and the ascendancy of foreign 
competition have been due in large part to the failure of the U.S. to 
adopt a border-adjusted tax base.
    We subsidize foreign producers and punish our exports. The U.S. 
should not target a particular trade deficit level, subsidize its 
exporters or impose tariffs on imports. By doing so, we would interfere 
with mutually beneficial transnational economic exchanges to the 
disadvantage of both countries' economies. That is the very purpose for 
seeking to achieve the objectives of capital export and import 
neutrality, which some witnesses believe are mutually unobtainable.\2\ 
By the same token, however, the U.S. government should not accord a 
huge advantage to foreign companies competing in the U.S. market or 
impose a huge disadvantage on American producers and workers selling 
their goods and services in the U.S. and foreign markets--as we now do 
as a matter of policy.
    \2\ Capital export neutrality is achieved when a taxpayer's choice 
to invest here or abroad is not effected by taxation. Capital important 
neutrality is achieved when all firms doing business in a market are 
taxed at the same rate. While conventional wisdom is that all forms of 
neutrality cannot coexist, these mutual goals are obtainable with the 
    We harm the competitiveness of domestic producers and workers. The 
U.S. tax system imposes heavy income and payroll taxes on U.S. workers 
and domestic producers whether their products are sold here or abroad. 
As noted, U.S. corporate taxes are the highest in the industrialized 
world, with a top corporate rate about nine percentage points higher 
than the OECD average.\3\ At the same time, the U.S. tax system imposes 
no corresponding tax burden on foreign goods sold in the U.S. market. 
Moreover, foreign VATs, which are a major component of the total 
revenue raised elsewhere, are rebated when foreign goods are exported 
to the U.S. market. This creates a large and artificial relative price 
advantage for foreign goods, in both the U.S. market and abroad.
    \3\ Edwards, Chris, ``The U.S. Corporate Tax and the Global 
Economy,'' Cato Institute, September 2003.

                     Advantage for Foreign Producers

                                        Sold in U.S.     Sold in foreign
               Origin                      market            markets

                                     Pays U.S. income   Pays U.S. income
                                      and                and
U.S. production                      payroll taxes.     payroll taxes
                                                         and foreign
                                     Pays no U.S.       Pays foreign
                                      income or          VAT.
Foreign production                   payroll tax and
                                      no foreign VAT.

    As the table above illustrates, American producers pay two sets of 
taxes when selling into foreign markets. Conversely, in U.S. markets, 
foreign goods bear no U.S. tax and the foreign VAT is forgiven. Thus, 
among the most manifest unfairness in the U.S. tax system is that it 
places U.S. producers--including businesses and workers in 
manufacturing, agriculture, mining, and forestry--at a large 
competitive disadvantage relative to their foreign competitors both in 
U.S. markets and in foreign markets. Our failure to counteract these 
border-adjusted taxes explicitly encourages consumption of foreign, 
rather than American, goods. And it converts many of our nation's 
retailers into what are effectively tax-free trade zones for foreign 
produced goods.
    Birth of the anomaly. The U.S. has adopted this self-flagellating 
policy partly because of our laudable commitment to free enterprise and 
rejection of mercantilism and colonialism. At least since World War II, 
American business and political leaders have viewed free trade as the 
basis for international peace and prosperity. As the dominant economic 
and military power, the U.S. led the movement to dismantle trade 
barriers and supported international trade liberalization (GATT and 
WTO), economic cooperation (OECD), and customs unions (such as the 
European Union and NAFTA). According to the OECD, its members have 
reduced their average tariff rates from 40 percent at the end of World 
War II to 4 percent today. The U.S.'s average import duty on goods is 
currently 1.7 percent. As tariffs declined, however, a trend emerged in 
Europe toward border-adjusted taxation in the form of VATs. These taxes 
were levied principally on manufactured goods. The alleged purpose was 
to ``level the playing field'' by offsetting the expense of government 
welfare through taxation of spending on consumption.
    The scope of the problem. Today, the European Union has an average 
standard VAT of 19 percent, while the average OECD standard VAT is 17.7 
percent. During the 1990s, Mexico and Canada increased composite rates 
to 15 percent from 10 percent and 7 percent, respectively. China 
adopted a 17-percent VAT in 1994. As foreign governments increased the 
VAT, they also reduced effective corporate income taxes. Meanwhile, 
high U.S. corporate tax rates today, coupled with U.S. taxation of the 
foreign income of corporations based in the U.S., caused the flight of 
corporations' headquarters to countries that exempt taxation of 
overseas income. In effect, the U.S. tax system is distorting the 
international marketplace and literally driving plants and good jobs 
out of this country at a devastating and unsustainable pace. There are, 
after all, only so many assets we can sell to foreigners before the 
entire financial system enters into a severe crisis.
    Counterarguments are usually self-serving. Some economists 
mistakenly argue that if America adopted a border-adjusted tax system, 
any relative price change would be eliminated by an offsetting 
appreciation in the dollar. This argument is normally advanced by 
supporters of tax plans that aren't or can't be made border adjustable. 
If the FairTax were implemented, for example, they hypothesize that the 
price change would be offset by a 23-percent immediate appreciation in 
the dollar. They contend such appreciation would be caused by a 
reduction in U.S. demand for foreign currency to acquire (the now more 
expensive) foreign goods and an increase in foreign demand for U.S. 
currency to acquire (the now less expensive) U.S. goods.
    Their arguments are specious. The fallacy is that the demand for 
U.S. dollars is not limited to the traded-goods market. Nearly $90 
trillion in U.S. assets owned by households and non-financial 
businesses are denominated in dollars. Financial institutions trade 
trillions of dollars in securities and currency each day based on 
expectations and guesses. Furthermore, the non-traded goods and 
services sector is much larger than the traded-goods sector and is also 
denominated in dollars.\4\
    \4\ If these economists are right and there is no increase in the 
competitiveness of U.S. goods because of a 23-percent increase in the 
price of the dollar (more or less precisely) relative to foreign 
currency, then that means the FairTax will have succeeded in increasing 
the wealth of the American people by something on the order of $20 
trillion (23 percent of $90 trillion) relative to the rest of the 
world, an instantaneous increase nearly equal to the value of all the 
goods and services produced in the U.S. over two years. Although that 
would be reason enough to enact the FairTax, it is impossible for the 
traded-goods sector to dominate the currency movements, since the 
dollar-asset markets are perhaps 100 times as large as the annual 
traded-goods market (net basis). See B. 100 and B. 102, Flow of Funds 
Accounts, U.S. of America, Fourth Quarter 2004, Federal Reserve System, 
for statistical information on asset markets.
    Prominent economists have recently begun to publicly disagree with 
their colleagues on the mitigating effects of exchange rates. A recent 
study by Professor Jim Hausman of M.I.T. found that:

      Existing disparities in treatment of corporate income 
taxes and VATs for purposes of border adjustment lead to extremely 
large economic distortions.
      U.S. exporters bear both domestic income taxes and 
foreign VATs when selling abroad.
      Foreign exporters in countries relying largely on VATs 
typically receive a full rebate of such taxes upon export to the U.S., 
and are not subject to U.S. corporate taxes.
      This situation creates a very significant tax and cost 
disadvantage for U.S. producers in international trade with significant 
impact on investment decisions--leading to the location of major 
manufacturing and other production facilities in countries that benefit 
from current rules on the border adjustment of taxes.
      The economic implications for the U.S. are very large.
      Elimination of the current disparity in WTO rules (by 
eliminating border adjustment for either direct or indirect taxes) 
would increase U.S. exports by 14 to 15 percent, or approximately $100 
billion based upon 2004 import levels.
      Eliminating such economic distortions should be a high 

    In sum, Professor Hausman agrees with FairTax.org that adjustments 
in exchange rates are not likely to counteract the relative price 
advantage of foreign produced goods.
III. How to Confront Border-Adjustable Tax Regimes
    There are two ways tax writers could defend U.S. industry against 
global border-adjusted taxes: (1) encourage our trade representatives 
and trading partners to allow income taxes to be border adjusted, or 
(2) adopt a destination-based consumption tax. In order for our trading 
partners to allow border-adjusted income taxes (direct taxes), they 
would need to eliminate the admittedly artificial distinction between 
direct taxes (income taxes) and indirect taxes (consumption taxes) 
alluded to earlier. Because GATT/WTO rules treat border tax adjustment 
of ``direct taxes'' as a prohibited export subsidy, border-adjusted 
taxes are permissible only in the case of indirect taxing regimes and 
then only insofar as the amount remitted doesn't exceed the amount of 
indirect tax ``levied in respect of the production.'' That rule was 
written so the U.S. income tax would not pass muster as a border-
adjustable tax, and as a direct tax it does not. Professors Hall and 
Rabushka's flat tax proposal would also probably fail to satisfy that 
    Were it politically expedient to eliminate the indirect/direct 
distinction in the Doha Round of WTO negotiations, such an action would 
warm the collective aortae of K Street lobbyists. They could 
immediately work to bring back FSCs, ETIs, DISCs, interest-charge 
DISCs, and other export subsidy vehicles which from time to time have 
been lobbied, enacted, and then quickly found violative of the WTO (and 
before that GATT). But negotiating away the indirect/direct distinction 
is not a sensible long-term policy response because convincing the 
WTO's 139 Member countries to abandon the indirect/direct distinction--
no matter how baseless that distinction--would take phenomenal 
diplomatic acumen. If we can't change our own system into one that 
stimulates economic growth, if this Subcommittee itself cannot 
appreciate the importance of granting foreign producers unchallenged 
subsidies to compete unfairly against domestic producers, if the 
Europeans were willing to sue for a relatively minor export incentive 
worth about $4 billion annually (the FSCs/ETIs), it may be naive to 
assume our negotiators could convince the Chinese, Japanese, Canadians, 
Mexicans, Koreans, Indians, and Europeans that they should abandon 
their unique bargaining leverage attributable to their border-adjusted 
taxes. After all, these nations adopted border-adjusted tax systems 
with the sole purpose of granting themselves a unilateral trade 
advantage against the U.S.
    Assuming arguendo such diplomacy were miraculously successful, 
eliminating the indirect/direct distinction would solve only a fraction 
of the economic problem, and then only for exporters. If the indirect/
direct distinction were fully eliminated, an export subsidy would only 
allow exporters to defer or exempt a portion of their income tax, even 
though payroll taxes constitute abut 36 percent of the gross 
collections by type of tax. And lest we forget about our record trade 
deficits, this does nothing to level the playing field on imports which 
continue to compete against domestic producers unfairly on our own 
    Finally, such a victory would be but one step in a process. The 
Ways and Means Committee is unlikely to have the appetite to pay for 
another major FSC provision given the current level of deficit 
    The best alternative is to enact a destination-principle tax system 
(also known as a border-adjusted tax system). U.S. manufacturers can 
compete effectively as the most productive and innovative workers in 
the world, but the U.S. must first remove this large and unjustified 
inequity against U.S. domestic producers. The removal of this tax 
advantage is nothing more than the promotion of neutrality, not the 
enactment of a special advantage. Replacing current U.S. income 
taxation with comparable border-adjusted taxation would tax all goods 
consumed in the U.S. alike, whether the goods are produced in the U.S. 
or abroad. We need to eliminate those aspects of the U.S. tax system 
that artificially place U.S. production at a competitive disadvantage 
compared to foreign production.
    And the best border-adjusted plan is the FairTax. The November 2005 
Report of the President's Advisory Panel on Federal Tax Reform 
recommends a border-adjusted tax system,\5\ but fails to honestly 
conclude none of its proposals would pass muster under the WTO/GATT 
rules. In fact, of the five candidates for true tax reform, only three 
are or could be made border-adjustable. These are: The FairTax (the 
most comprehensive, single-stage consumption tax), a business transfer 
tax (BTT) or a credit-invoice method value-added tax (which is called a 
Goods and Services Tax in Canada and Australia). Each is a destination 
principle consumption tax.
    \5\ See ``Simple, Fair, and Pro-Growth: Proposals to Fix America's 
Tax System,'' Report of the President's Advisory Panel on Federal Tax 
Reform, November 2005, pp. 171-172 and 283.
    Of these plans, only the FairTax is hard wired to make the entire 
system border adjusted. The FairTax would transform the entire U.S. tax 
system into a border-adjusted tax by:

      repealing all upstream federal taxes now embedded in the 
product price of U.S. goods and eliminating any business-to-business 
taxes, including payroll taxes,
      completely exempting exports from taxation, and
      imposing the FairTax on foreign goods entering our shores 
for final consumption.

    Only the FairTax can claim that under its regime, foreign 
manufactured goods and U.S. manufactured goods would bear the same tax 
burden when the goods are sold at retail. Only the FairTax can make the 
claim that U.S. businesses selling goods or services in foreign markets 
are fully relieved of federal tax (including payroll taxes).\6\ Only 
the FairTax addresses this preeminent issue ignored by the Subcommittee 
    \6\ The problem with other consumption tax plans--apart from the 
fact that they can quickly develop into income taxes--is that they only 
make non-payroll taxes border adjustable. For example, the BTT, which 
allows for complete expensing of business inputs, could be made border 
adjustable by not allowing a deduction for foreign business inputs and 
exempting export sales. The Flat Tax is not border adjusted.
IV. Other Criteria for Reform
    We can safely predict the issue of border adjustability will not be 
raised today because none of the plans the witnesses espouse can be 
made border adjusted. Instead, the witnesses are expected to support 
the combination of an origin-based territorial tax system and a 
reduction of marginal rates as the cornerstone of their competitiveness 
proposals. In touching upon the hundreds of pages of complexity that 
constitute our international tax system, from the income sourcing and 
expense allocation rules, to the foreign tax credit limitations, to 
CFCs, to Subpart F, to personal holding company rules, to the various 
``baskets'' of income which have made tax lawyers basket cases, the 
witnesses recommend simplification.
    If extraterritoriality, rates, and simplicity were the only factors 
the Subcommittee reviews to evaluate how various plans improve 
America's competitiveness, the FairTax would still be superior to every 
policy option presented.
    Begin by reviewing the three principal objectives sought to be 
achieved by territoriality.\7\ First, those that support territoriality 
argue that if an American company can enjoy low taxes and still be 
headquartered here, they are less likely to move their headquarters 
elsewhere. (Although they would certainly move their production.) 
Second, international tax laws are complex and often gamed, and 
companies spend billions complying with rules that yield little 
revenue. Third, by allowing U.S. production to move where the taxes are 
lowest we will force the U.S. to lower our own corporate tax rates. In 
other words, we will force the U.S. into tax competition. Advocates of 
a territorial taxing regime make some valid points. Add to the 
arguments the fact that the U.S. historically fell into an 
extraterritorial tax system, not by choice, but by default.
    \7\ Although today the U.S. taxes its citizens and residents on 
income no matter where is earned, under a territorial system the U.S. 
would exercise taxing jurisdiction only when income is earned in the 
U.S. Such a regime for example, would allow a U.S. multinational to 
escape U.S. corporate taxes on their foreign earnings.
    But before taking such a path, however, the Subcommittee should 
consider a past tax policy debate that offers valuable prologue on the 
merits of this course of action.
    Forty and one-half decades ago, during President John F. Kennedy's 
campaign, the same question arose in an almost identical context: 
Should the U.S. tax the foreign earned profits of U.S. multinationals 
(should U.S. companies doing business overseas escape U.S. taxes)? 
Quite predictably, the debate pitted management (who liked to keep 
white-collar jobs here at a U.S. headquarters) against unions (who 
argued it would also be a good idea to keep U.S. blue-collar jobs in 
the U.S.). It pitted Democrats against Republicans. Economist against 
economist. And the unions argued, quite understandably, that if 
American companies are able to take advantage of tax sparing (as some 
witnesses doubtless praise) they will establish themselves overseas to 
the detriment of the U.S. workforce. So 45 years later what does this 
mean for the territoriality debate? It is really a debate over 
legitimizing corporate inversions in fact. Companies can remain in the 
U.S. in name only, but the jobs will flock to nations that dole out the 
tax holidays.
    Tax writers may choose to stroll unwittingly into that political 
minefield, but history has shown that debate to be bloody and 
intractable. And more importantly, that course of action does not 
simplify the system. Determining whether or not activity takes place 
within or without the U.S., applying income sourcing and expense 
allocation rules, and figuring out how to treat older earnings that 
will be repatriated will equal or exceed the complexity posed by the 
arcane rules of current law because the stakes will not be merely 
deferral, but exoneration from tax. The witnesses no doubt will 
underestimate these effects or the necessary transition rules, but they 
are very, very significant because they retain almost all the cost 
drivers so despised by current law.
    There is a better answer that accomplishes all these objectives--
impose a zero rate of tax on productive activity with the FairTax. Only 
under the FairTax would the U.S. become the most attractive 
jurisdiction within which to invest. A zero rate of tax would give 
foreign jurisdictions two choices: Reduce their tax rate on savings and 
investment (which will stimulate global economic reform and growth) or 
lose investment to America. Companies now American in name only would 
repatriate investment and jobs back to our shores.
    As this Subcommittee holds its hearings, it misses the chance to 
discuss the issue of border adjustability and the chance to better 
elucidate those factors that bear upon the concept of competitiveness. 
As U.S. negotiators work to level the playing field in the Doha round 
of trade talks in the coming months, we urge this Subcommittee to focus 
a second competitiveness hearing solely on the issue of border-tax 
adjustments. And it might wish to take a step back and ask itself to 
establish the criteria on which reform should be based.
    Beyond any other plan, the FairTax solves the problem the 
Subcommittee ignored by converting the entire U.S. tax base into a 
border-adjusted system. Through WTO legal means, the FairTax exempts 
exports from taxation, while taxing imports the same as U.S. produced 
goods for the first time. And it solves the problems the Subcommittee 
should be considering. It is the simplest plan that could be devised, 
without the intercompany (and intracompany) transfer pricing problems 
present in an origin-principle income or consumption tax. It reduces 
U.S. corporate rates to zero, ensuring the U.S. is the most competitive 
environment in which to produce and from which to export. And it would 
stimulate economic growth by broadening the tax base and reducing 
marginal rates well beyond any other proposal and do so in a way that 
does not tax the poor, punish savings and investment or tax income more 
than once.
    Mr. Chairman: None of that would please K Street, but it will 
please Main Street.
    Sec. FairTax.org is the nation's largest nonpartisan, grassroots 
organization dedicated to replacing the current tax system. For more 
information visit the Web page: www.FairTax.org.


                                          Tuscaloosa, Alabama 35501
                                                     April 26, 2006
Committee on Ways and Means
House of Representatives
1102 Longworth House Office Building
Washington, DC 20515

Dear Committee on Ways and Means,

    The American people are ready for tax relief. Everywhere we go we 
are taxed from property, to income, to SSI and more. Corporations DO 
NOT pay taxes. We, the American people pay their taxes as they are in 
business to make a profit. Taxes are part of their cost of doing 
business. Eliminating the tax burden that corporations carry will make 
them more competitive internationally by lowering their overall cost of 
doing business and leveling the playing field.
    The American people are now working through June to pay our taxes. 
It is truly overwhelming.
    The FAIRTAX bill will not only provide tax relief for Americans, 
but generate additional revenue for our government. Through the 
collection of a national sales tax the average American can control 
some of the taxes he/she pays by making certain buying decisions. Those 
who pay no taxes, illegal aliens and drug dealers for example, will be 
paying into the system they benefit from.
    Personally, I want to see the money I earn in my checking account, 
savings account, and investments and not being controlled by the 
federal government.
    Please pass the FAIRTAX bill. America will prosper beyond our 
wildest imaginations.
                                                          Perry Nye


                                                    The Tax Council
                                                       July 5, 2006
The Honorable Dave Camp
Chairman, Subcommittee on Select Revenue Measures
Committee on Ways & Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington D.C. 20515

Dear Mr. Chairman:

    The Tax Council is grateful for the opportunity to submit a 
statement on the principles of international tax reform for the record 
of your hearing on the Impact of International Tax Reform on U.S. 
Competitiveness which was held on June 22, 2006.
    The Tax Council is an association of senior tax advisers 
representing over one hundred of the largest employers in the United 
States. The Tax Council's members include senior tax officers of 
companies involved in manufacturing, mining, energy, transportation, 
consumer products and services, retailing, and financial services.
    The Tax Council has adopted the enclosed principles on 
international tax reform and respectfully submits them to the 
Subcommittee. We urge that you consider these principles, as the 
subcommittee further examines the many complex and controversial 
aspects of international tax reform,
    We would be pleased to respond to your questions or comments on 
these principles.
                                                    Kenneth Petrini
The Tax Council
Principles of International Tax Reform
      A well-reasoned, pro-growth international tax policy will 
allow U.S. companies to remain strong at home while competing for and 
winning business globally.

            While there currently is no universal agreement on 
        the ``best'' way to reform international tax rules, ``reform'' 
        should enable U.S. companies to compete and thrive globally.
            U.S. international tax rules should focus on 
        enabling companies to invest capital based on market forces.
            U.S. multinationals must be able to compete for 
        business in worldwide markets, including the U.S. domestic 
        market, without an additional U.S. tax burden resulting from 
        our international tax rules.

      Tax policy must reflect the reality of doing business in 
the 21st century.

            It is critical that U.S. tax policy reflect the way 
        business currently is done and that it accommodate the business 
        models that are often required in a global economy. While many 
        U.S. companies have multinational operations, the markets are 
        often local; therefore business has to be located in these 
        markets to serve local customers and consumers.
            International tax policy cannot be based on 
        misplaced concerns of those who believe that investment by U.S. 
        firms in foreign locations substitutes for investment in the 
        United States. The decision is not to ``invest here or there.'' 
        In today's global economy, it is increasingly a question 
        whether U.S. companies will invest in growing markets around 
        the world or cede that investment to foreign competition. The 
        question is not investment in U.S. or foreign markets but 
        rather investment and growth by U.S. or foreign companies. The 
        U.S. economic health is not improved by foreign investment in 
        foreign markets.

      Active businesses investing scarce capital in market-
driven investments represent the real business model under which 
business operates. Taxes are a cost of capital and a key element in 
determining the ultimate return. On a close project, the difference 
between 35 percent and a 20 percent corporate tax rate can make or 
break the economic viability of a project and impact the identity of 
which investor develops the opportunity--the U.S. company or the tax-
advantaged foreign competitor.
      Low corporate income tax rates do make a difference in 
competitiveness, as reflected in the downward trend in corporate tax 
rates outside of the United States.
      Income should be taxed once and only once.

            Double taxation destroys the opportunity to 
            Governments acting rationally impose income taxes 
        that effectively tax or subject to tax income earned in each 
        jurisdiction once and only once.
            The ``arm's-length'' principle and the robust 
        development of appropriate transfer pricing rules in the U.S. 
        and most of our developed trading partners provide the best 
        tools to ensure that income is appropriately sourced to each 
        jurisdiction and subjected to the tax rules of those 

      A reformed tax system should be broad based and apply 
consistently across industry lines, so that no industry or group of 
taxpayers is favored or discriminated against.
      In order for U.S. companies to grow and thrive in the 
global marketplace, if the U.S. is to move to a territorial tax system, 
such a system must not be a tax increase disguised as reform.

            Misallocation of home country costs to foreign 
        operations, excessive taxation of revenue from the deployment 
        of intangibles in foreign markets, loss of cross crediting and 
        the denial of deductions for certain costs impose a double tax 
        on U.S. multinationals that distorts the economics of the 
        market place.
            Reasonable transition rules must be adopted to 
        protect those who have generated deferred tax assets under the 
        existing international system.
            Other elements of broader tax reform and 
        simplification must be analyzed and considered in the design of 
        a territorial tax system, all for the purpose of fully 
        realizing the practical advantages of territoriality as it 
        functions in many of our trading partners.

      Active business income is active income, no matter how 

            All income from invested capital is, more or less, 
        ``mobile.'' The appropriate policy distinction is between 
        active business income and passive income.
            International tax rules should incorporate suitable 
        and clear definitions of passive income that do not impinge on 
        the active conduct of business activities. In addition, any new 
        international tax rules should provide de minimis rules that 
        reflect conditions in the market place allowing businesses to 
        perform active economic and financial functions without the 
        fear of an additional layer of tax.


                                        Americans For Fair Taxation
                                               Houston, Texas 77227
                                                      June 22, 2006
    Dear Sir,

    At some point, we all have to admit that the current tax system is 
broken and beyond repair. Even the IRS doesn't understand the bulk of 
it. The staggering costs of compliance, the enormous burden placed 
squarely on the backs of the largest U.S. corporations, and the lack of 
incentive for small businesses and entrepreneurs have the cumulative 
effect of weakening the U.S. economy on the whole by increasing the 
trade deficit to horrifying levels.
    Between labor outsourcing and a tax system that punishes 
corporations for being profitable and creating jobs, it is hard to 
believe that this is the same country that was founded on 
individuality, personal responsibility, and a drive to succeed and 
excel. For years I have been wondering what we could do to stem the 
tide that threatens to wash over us all and leave in its wake a 
service-driven economy. I heard about a plan called the ``FairTax,'' 
introduced by a member of your subcommittee, John Linder, and was 
intrigued. I read the bill and the FairTax book, and was curious as to 
why this bill has not been passed through both houses and signed into 
    I realize that there are concerns about the minutia of the 
transition period for such a radical change, as I'm sure everyone must 
also realize that a switch to any of the proposed tax plans would 
involve such a transition period.
    The most important question is this: which of the proposals would 
be most beneficial to the country as a whole, thus making the 
transition period more tolerable? The answer, after rational discussion 
and consideration, is the FairTax.
    An informal study in 1996 concluded that out of the international 
corporations interviewed, 75% said their future plans would include 
building their next manufacturing facility in the U.S. if a proposal 
such as the FairTax were enacted. A full 20% of those corporations 
further suggested that their world headquarters would be moved to the 
U.S. as well.
    Based on all the research I've encountered, the FairTax will create 
the largest corporate tax haven in history, right here in our country. 
This will create the ``giant sucking sound'' Ross Perot predicted would 
follow the passage of NAFTA. The difference is, this sucking sound will 
not be jobs leaving the country (which has happened) but corporations, 
jobs, disposable income, and hence, more tax revenue, coming back to 
the U.S. where they belong.
    On behalf of millions of disgruntled American taxpayers, I would 
urge you, as the esteemed Chairman of the Subcommittee on Select 
Revenue Measures, to explore the FairTax plan with an open mind and 
intellectually honest discussion, I am sure that, given consideration, 
this committee will see, as so many Americans are beginning to, that 
this is the ``better way'' we have all been looking and, dare I say, 
praying for. Thank you for your time and attention in this important 
                                                    Bradley S. Rees
                                   Chief Correspondence Coordinator


     Statement of Martin B. Tittle, Law Office of Martin B. Tittle
    Chairman Camp, Ranking Democratic Member McNulty, and other 
Distinguished Committee Members:
    Thank you for the opportunity to share my views with you. My name 
is Martin B. Tittle. I am an attorney with a practice centered on 
international aspects of U.S. taxation. This statement is submitted on 
my own behalf and not on behalf of any government or private entity.
    Several witnesses at the June 22 hearing suggested that it would be 
beneficial for the U.S. to consider exempting foreign-source income 
from U.S. income taxation. The mechanism suggested for such a change 
was a switch from the current worldwide system, which taxes U.S. 
residents on their worldwide incomes, to a territorial taxation system, 
which does not tax residents on most active foreign-source income.
    One witness, Paul W. Oosterhuis, cautioned the committee about 
several drawbacks of such a switch, including the disallowance of 
currently deductible expenses that, in a territorial system, would be 
properly allocated to exempt, foreign-source income. Mr. Oosterhuis and 
another witness, Prof. Michael J. Graetz, discussed these and other 
conversion issues in detail in a paper published in 2001.\1\
    \1\ See Michael J. Graetz and Paul W. Oosterhuis, ``Structuring an 
Exemption System for Foreign Income of U.S. Corporations,'' 44 Nat'l 
Tax J 771 (2001).
A Third Option: Extending Foreign Tax Credit to VATs
    The apparent ``either-or,'' ``worldwide-or-territorial'' choice 
presented in the hearing should be broadened to include a third option. 
We could alter our worldwide system to achieve a territorial result--
little or no taxation of offshore business income--without the upheaval 
and loss of current benefits involved in a change to territorialism.\2\ 
One alteration that could help achieve this result is a capped foreign 
tax credit for value added taxes (VATs).
    \2\ The various changes that the switch to territorialism might 
include are set forth in President's Advisory Panel on Federal Tax 
Reform, ``Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax 
System, Report of the President's Advisory Panel on Federal Tax 
Reform'' 132-135, 239-244 (November 2005) and Joint Comm. on Tax'n, 
``Options to Improve Tax Compliance and Reform Tax Expenditures,'' JCS-
2-05 186-197 (Jan. 27, 2005). Those proposed changes were recently 
analyzed and compared with the territorial systems of Canada, Germany, 
and the Netherlands in Peter Merrill et al., ``U.S. Territorial Tax 
Proposals and the International Experience,'' 42 Tax Notes Int'l 895 
(June 5, 2006).
    VATs are transaction taxes that businesses must pay on in-country 
sales. They differ from sales taxes in that they have an internal 
mechanism for giving businesses a credit for the VAT they pay on their 
purchases. VATs exist in more than 120 countries that cumulatively 
account for about 70% of the world's population.\3\ Therefore, many if 
not most U.S. companies doing business overseas owe and pay VAT to one 
or more foreign governments.
    \3\ Liam Ebrill et al., The Modern VAT xiv (2001).
    Allowing credit for VATs would tend to eliminate U.S. taxation of 
foreign-source business income \4\ because VAT is a tax on gross sales, 
while income tax is a tax on net income. For instance, sale of $100 
worth of widgets on which the profit margin is 10% would yield a profit 
of $10 and an income tax of only $3.50, assuming a tax rate of 35%. 
That same sale, however, would yield $15 of VAT in Luxembourg, where 
the standard VAT rate is 15%, and $25 in Denmark or Sweden, where the 
rate is 25%.
    \4\ See Gary Clyde Hufbauer, Email to Martin B. Tittle (May 11, 
2003) (``For the bulk of manufacturing and service establishments, my 
guess is that the bottom line of VAT creditability would be very 
similar to an exemption system, i.e., little or no U.S. tax collected 
on foreign business activity'').
    Credit for VATs need not be an all-or-nothing proposition; it 
could, and should be phased in. One option, which I do not favor, would 
limit the credit to a percentage of each VAT dollar paid directly to a 
foreign government and allow that percentage to increase over time. The 
problem with that approach is that the cost of VAT creditability would 
be difficult to forecast, even with accurate data on the past VAT 
liabilities of potential claimants.
    A better alternative would be to offer dollar-for-dollar credit 
with a fixed-dollar cap on the maximum reduction of any single year's 
tax bill, and then gradually raise the cap.\5\ If this alternative had 
been enacted in 2001, when 5,748 corporations claimed foreign tax 
credit,\6\ and if the cap had been set initially at $500, the lost-
revenue cost in the first year of VAT credit would have only been 
around $2.87 million.
    \5\ The current limitation of all foreign tax credits to the U.S. 
tax due on the foreign income would, of course, remain in place. See 
Internal Revenue Code Sec. 904.
    \6\ See Scott Luttrell, ``Corporate Foreign Tax Credit, 2001,'' 
available at http://www.irs.gov/pub/irs-soi/01cftcar.pdf (visited June 
9, 2006).
    In addition to serving as a surrogate for territorial taxation, 
foreign tax credit for VATs would throw a monkey wrench into the 
international trade law gears that maintain the distinction between 
direct and indirect taxes. Under both the General Agreement on Tariffs 
and Trade and the WTO Agreement on Subsidies and Countervailing 
Measures, the rebate of indirect taxes like VATs on exports is not an 
export subsidy, but the rebate of direct taxes like the income tax 
is.\7\ For years, U.S. politicians on both sides of the aisle as well 
as non-partisan commentators have argued that this distinction is 
outdated and should be discarded,\8\ but those countries that benefit 
from continuation of the distinction have refused to accept any change. 
VAT credit would blur the line between direct and indirect taxes and 
therefore might be helpful in future trade negotiations.
    \7\ See General Agreement on Tariffs and Trade 1947, Art. VI(4) 
(``No product of the territory of any contracting party imported into 
the territory of any other contracting party shall be subject to anti-
dumping or countervailing duty by reason of the exemption of such 
product from duties or taxes borne by the like product when destined 
for consumption in the country of origin or exportation, or by reason 
of the refund of such duties or taxes.''), Annex I, Ad Art. XVI (``The 
exemption of an exported product from duties or taxes borne by the like 
product when destined for domestic consumption, or the remission of 
such duties or taxes in amounts not in excess of those which have 
accrued, shall not be deemed to be a subsidy.''); Agreement on 
Subsidies and Countervailing Measures (SCM), Apr. 15, 1994, Marrakesh 
Agreement Establishing the World Trade Organization, Annex 1A, Uruguay 
Round of Multilateral Trade Negotiations[:] Legal Instruments Embodying 
the Results of the Uruguay Round of Multilateral Trade Negotiations 
Done at Marrakesh on 15 April 1994, vol. 27 (1994) Annex I(e) and n.58, 
available at http://www.wto.org/english/docs_e/legal_e/24-scm.doc 
(visited June 10, 2006) (identifying the ``full or partial exemption, 
remission, or deferral'' of direct taxes as a prohibited export 
    \8\ See, e.g., Chuck Gnaedinger and Natalia Radziejewska, ``U.S. 
Lawmakers Still Divided Over FSC-ETI Remedy,'' 2003 Worldwide Tax Daily 
(WTD) 31-1 (Feb. 14, 2003) (quoting House Ways and Means Committee 
Chair William M. Thomas, R-California, as saying, ``The difference 
between direct and indirect taxation . . . in today's world is a 
distinction without a difference.'' (ellipsis in original)); Chuck 
Gnaedinger and Natalia Radziejewska, ``Baucus Deems WTO Dispute 
Settlement System `Kangaroo Court' Against U.S.,'' 2002 WTD 188-1 
(Sept. 27, 2002) (quoting Senator Max Baucus, D-Montana, as saying, 
``The [WTO] appellate body's FSC decisions make an unworkable 
distinction between countries that rely primarily on direct taxes . . . 
and countries that rely primarily on indirect taxes. . . . Although the 
appellate body acknowledged countries' sovereign right to set their own 
tax systems, they interpret WTO rules in a way that heavily favors one 
particular system.''); Chuck Gnaedinger and Natalia Radziejewska, 
``White House Urges U.S. Senate Finance Committee To Repeal ETI Act,'' 
2002 WTD 147-5 (July 31, 2002) (quoting Senator Charles E. Grassley, R-
Iowa and Chair of the Senate Finance Committee, as saying, with respect 
to the distinction between direct and indirect taxes, ``How can we 
justify allowing this distinction to continue?''). See also infra note 
    Finally, VAT credit offers a distinct advantage over the two 
current proposals for territorialism \9\ in that it does not 
necessarily require the repeal, revocation, or elimination of any of 
the benefits of the current U.S. tax system. For instance, if VAT 
credit were enacted, the current characterizations of different types 
of income could stay the same.\10\ No deductible items would need to be 
disallowed because they were allocated to exempt income.\11\ No 
disregarded entities would need to become regarded.\12\
    \9\ See Joint Comm. on Tax'n, supra note 2, at 186-197 and 
President's Advisory Panel, supra note 2, at 132-135, 239-244.
    \10\ See President's Advisory Panel, supra note 2, at 240 (under 
territorialism, royalties would be imputed to foreign branches, and 
``mobile income,'' taxed when earned, would include the Sec. 863(d)/
954(f) ocean and space income that was just liberated from Subpart F by 
Sec. 415(a) of the American Jobs Creation Act of 2004, P.L. 108-357); 
Joint Comm. on Tax'n, supra note 2, at 191 (``Non-dividend payments 
from the CFC [and foreign branches; see note 12 infra] to the U.S. 
corporation (e.g., interest, royalties, service fees, income from 
intercompany sales) would be fully subject to tax [under 
territorialism], and this tax generally would not be offset by cross-
crediting as it often is under present law.'').
    \11\ See President's Advisory Panel, supra note 2, at 134 
(``Reasonable rules would be imposed to make sure that expenses 
incurred in the United States to generate exempt foreign income would 
not be deductible against taxable income in the United States.''); 
Joint Comm. on Tax'n, supra note 2, at 190 (``[D]eductions for interest 
and certain other expenses [including R&D] incurred by the U.S. 
corporation would be disallowed to the extent allocable to exempt (non-
subpart-F) CFC earnings.'').
    \12\ See President's Advisory Panel, supra note 2, at 240 (``Income 
of foreign branches would be treated like income of foreign affiliates 
[CFCs] under rules that would treat foreign trades or businesses 
conducted directly by a U.S. corporation as foreign affiliates.''); 
Joint Comm. on Tax'n, supra note 2, at 191 (foreign branches would be 
treated as CFCs ``for all Federal tax purposes'').
Theoretical Basis for Extending Credit to VATs
    Historically, U.S. foreign tax credit has been limited to income-
type taxes, but the reason for that limitation remains a mystery. No 
explanation was included in the 1918 act that introduced the 
credit,\13\ and, surprisingly, none has been enunciated in subsequent 
    \13\ See Revenue Act of 1918, ch. 18, section 222(a), 40 Stat. 
    \14\ See Karen Nelson Moore, ``The Foreign Tax Credit for Foreign 
Taxes Paid in Lieu of Income Taxes: An Evaluation of the Rationale and 
a Reform Proposal,'' 7 Am. J. Tax Pol'y 207, 213-215 (1988).
    In 1956, Professor Stanley Surrey speculated that the basis for the 
limitation might lie in the purported ``nonshiftability'' of income 
taxes.\15\ ``Shifting'' taxes, he explained, were those whose economic 
incidence was generally assumed to be passed on from the statutory or 
nominal payor to someone else. Examples included sales, turnover, and 
excise taxes. Income taxes, on the other hand, were generally assumed 
to be ``nonshiftable,'' and therefore actually borne, or suffered by 
the taxpayer.
    \15\ See Stanley S. Surrey, ``Current Issues in the Taxation of 
Corporate Foreign Investment,'' 56 Colum. L. Rev. 815, 820-821 (1956).
    Five years later, Elisabeth Owens came to same conclusion, saying 
``the chief determinative factor in deciding whether a tax qualifies 
for the credit should be whether or not the tax is shifted or passed on 
by the person paying the tax.'' \16\ Joseph Isenbergh repeated that 
theory of creditability in 1984, calling it the ``only plausible 
explanation that has ever appeared for limiting the foreign tax credit 
to income taxes.'' \17\
    \16\ Elisabeth Owens, The Foreign Tax Credit 83 (1961), quoted in 
Moore, supra note 14, at 217-218.
    \17\ Joseph Isenbergh, ``The Foreign Tax Credit: Royalties, 
Subsidies, and Creditable Taxes,'' 39 Tax L. Rev. 227, 288 (1984).
    The issue of shiftability is not merely a technical one. As Judge 
Karen Nelson Moore has correctly noted, ``the goal of achieving tax 
neutrality between foreign and domestic investment [sometimes called 
capital export neutrality, or CEN] is satisfied [only] if taxes do not 
alter the relative rates of return on investments; allowance of a tax 
credit limited to taxes that are not shifted to others is consistent 
with that goal, since taxes that can be shifted do not affect the 
taxpayer's rate of return.'' \18\
    \18\ Moore, supra note 14, at 217 (paraphrasing Owens, supra note 
16, at 84).
    Shiftability and nonshiftability are understood today, not as 
separate states that are fixed characteristics of different taxes, but 
as the opposite ends of a continuum across which all taxes move in 
response to market circumstances. In 1989, Judge Moore reviewed over 40 
sources before saying, ``The tax policy maker must conclude that a 
conclusive answer is not available today to the question whether the 
corporate income tax is shifted or whether it is in fact borne by the 
corporation and its owners.'' \19\ That question has not been resolved 
in the years between 1989 and the present.\20\
    \19\ Moore, supra note 14, at 222. Despite this statement, Judge 
Moore continued, in the same sentence as that quoted, ``however, it 
seems likely that a substantial part of the corporate income tax is 
indeed shifted.''
    \20\ See, e.g., Douglas A. Kahn and Jeffrey S. Lehman, Corporate 
Income Taxation 22-25 (5th ed. 2001) (noting ``substantial uncertainty 
about the incidence of the corporate income tax''); Cheryl D. Block, 
Corporate Taxation 14 (1998) (noting that the extent and direction of 
corporate tax shifting ``is the subject of much debate and the 
incidence question remains unresolved'').
    Similarly, Liam Ebrill and his co-authors freely admit in the 
International Monetary Fund's book The Modern VAT that ``[t]he 
effective incidence of a VAT, like that of any other tax, is determined 
not by the formal nature of the tax but by market circumstances, 
including the elasticity of demand for consumption and the nature of 
competition between suppliers. . . . The real burden of the VAT tax may 
not fall entirely on consumers but may in part be passed back to 
suppliers of factors through lower prices received by producers.'' \21\
    \21\ Ebrill et al., supra note 3, at 15, 76. See also Joint Comm. 
on Tax'n, ``Factors Affecting the International Competitiveness of the 
United States,'' JCS-6-91 298 (1991) (``It is not at all certain, 
however, that the entire VAT is actually borne by consumers in the form 
of higher prices.'').
    The VAT that U.S.-based e-tailers are now required to pay under the 
EU's e-commerce VAT Directive \22\ is likely nonshiftable either 
largely or completely because they face EU competition that can charge 
lower VAT and no VAT.\23\ In 2005, the European Commission proposed a 
``leveling of the playing field'' in which all e-sellers would 
calculate and pay applicable VAT on sales to individual consumers at 
the rate required by the buyer's place of residence.\24\ (The current 
rule allows EU e-tailers to use the VAT rate that applies where they 
are established, but requires non-EU e-tailers to use the rate in 
effect for the buyer's place of residence.) \25\ Unfortunately, the new 
proposal has still not been adopted as of the most recent, June 2006 
session of the EU Council of Economic and Financial Affairs.\26\
    \22\ Council Directive 2002/38/EC of 7 May 2002, 2002 O.J. (L 128) 
41 (hereinafter,''E-VAT Directive'').
    \23\ See Martin B. Tittle, ``U.S. Foreign Tax Creditability for 
VAT: Another Arrow in the ETI/E-VAT Quiver,'' 30 Tax Notes Int'l 809, 
813-815 (May 26, 2003), 2003 WTD 101-16, available at http://
www.martintittle.com/publications/FTC4VATs.pdf (visited July 3, 2006).
    \24\ See Amended Proposal for a Council Directive amending 
Directive 77/388/EEC as regards the place of supply of services, 
COM(2005) 334 final 12, 22 (July 20, 2005), available at http://
com2005_0334en01.pdf (visited June 8, 2006).
    \25\ See E-VAT Directive, supra note 22, at art. 1(1)(b) (adding 
subsection (f) to Council Directive 77/388/EEC of 17 May 1977 on the 
Common System of Value Added Tax, 1977 O.J. (L 145) 1, art. 9(2)).
    \26\ See Chuck Gnaedinger, ``ECOFIN Extends E-VAT Directive,'' 2006 
WTD 110-1 (June 8, 2006).
    Judge Moore's solution to the income tax's quasi-shiftable 
character was to suggest that the foreign tax credit be eliminated as a 
windfall, and that foreign income taxes be returned to their pre-1918, 
deductible-only status.\27\ However, an equally rational solution would 
be to continue the credit for income taxes, so as not to disadvantage 
businesses when income taxes cannot be shifted, and, with appropriate 
limitations, to expand the credit to VATs and other taxes that, like 
income taxes, are sometimes nonshiftable.\28\
    \27\ See Moore, supra note 14, at 226.
    \28\ See Isenbergh, supra note 17, at 294-295 (suggesting expansion 
of the foreign tax credit to include all foreign taxes and noting that, 
if the amount of the credit is capped, ``the Treasury has little reason 
to care about [the foreign government's] precise methods [of 
    The fact that the shiftability of both income taxes and VATs varies 
dynamically in step with market forces is indicative of a broader 
similarity. Direct taxes like income tax and indirect taxes like VAT 
are not opposites, but rather are alternate methods for allocating the 
same tax burdens. For example, it is widely acknowledged that VATs are 
essentially equivalent to a combination of several direct taxes, 
including a direct tax on business profits and a direct tax on 
    \29\ See Gary Clyde Hufbauer, ``Institute for International 
Economics Policy Brief on Foreign Sales Corporations,'' 2002 WTD 230-
18, para. 13 (Nov. 29, 2002); Ebrill et al., supra note 3, at 18-19, 
198 (a VAT ``levied at a uniform rate on all commodities'' is 
equivalent to ``a cash flow business tax and a tax on wage earnings''; 
if, in addition, ``the VAT rate is constant over time,'' it is 
equivalent to ``a tax on pure profits, a capital levy, and a tax on 
wage earnings''; if the VAT is applied to imports and remitted on 
exports, it is also a ``uniform export subsidy/import tax'').
    On the other hand, taxes that, under WTO rules, must be classified 
as direct are sometimes so similar to VATs that the difference is not 
substantive. For instance, the flat tax proposed by Congressman Richard 
Armey and Senator Richard Shelby in 1995 \30\ was essentially a flat-
rate subtraction VAT in which collection of the tax had been divided 
between business and individuals.\31\ That division of collection was 
not considered significant by knowledgeable observers including 
University of California, Berkeley economics and law professor Alan J. 
Auerbach.\32\ It was, however, enough to make the flat tax a direct, 
and not an indirect tax under existing WTO rules.\33\ As such, it could 
not have been remitted on exports and applied to imports, as VATs are, 
despite the fact that it was in essence a ``broad-based flat rate 
consumption tax.'' \34\
    \30\ See Freedom and Fairness Restoration Act of 1995, H.R. 2060, 
104th Cong. (1995); S. 1050, 104th Cong. (1995), cited in Stephen E. 
Shay and Victoria P. Summers, ``Selected International Aspects of 
Fundamental Tax Reform Proposals,'' 51 U. Miami L. Rev. 1029, 1030 n.4 
    \31\ See Michael J. Graetz, ``International Aspects of Fundamental 
Tax Restructuring: Practice Or Principle?,'' 51 U. Miami L. Rev. 1093, 
1095 (1997).
    \32\ Id. (citing Professor Auerbach's Congressional testimony).
    \33\ See SCM, supra note 7, Annex I(e) and n.58. See also Shay and 
Summers, supra note 30, at 1054.
    \34\ Graetz, supra note 31, at 1097; see Reuven S. Avi-Yonah, 
``From Income to Consumption Tax: Some International Implications,'' 3 
San Diego L. Rev. 1329, 1335 (1996).
    In the face of this virtual equivalence, it is no wonder that House 
Ways and Means Committee Chair William M. Thomas, R-California, has 
said that the distinction between direct and indirect taxes is, ``in 
today's world . . . a distinction without a difference.'' \35\ Senators 
Max Baucus, D-Montana, and Charles E. Grassley, R-Iowa, have voiced 
similar sentiments.\36\
    \35\ See Gnaedinger and Radziejewska, supra note 8.
    \36\ Id.
    Recognition of both the economic parity between income taxes and 
VATs and their equivalence in meeting the foreign tax credit criterion 
of nonshiftability strongly suggests that both income taxes and VATs 
should be creditable. Alternate bases for extending credit to VATs 
could include the competitive needs of U.S. businesses,\37\ or the fact 
that VAT is the ``principal tax'' of various foreign countries.\38\ The 
nonshiftability criterion has the advantage of being a classic theory 
and thus does not require ``breaking new ground'' to validate VAT 
    \37\ See Glenn E. Coven, ``International Comity and the Foreign Tax 
Credit: Crediting Nonconforming Taxes,'' 4 Fla. Tax Rev. 83, 86 (1999).
    \38\ See Surrey, supra note 15, at 820 (noting the need, in 1954, 
to exclude sales and turnover taxes from the ``principal tax'' 
    \39\ Cf. Robert F. Peroni, J. Clifton Fleming, Jr., and Stephen E. 
Shay, ``Reform and Simplification of the U.S. Foreign Tax Credit 
Rules,'' 31 Tax Notes Int'l 1177, 1204 (Sept. 29, 2003) (arguing for 
VAT credit but against any requirement of nonshiftability on the ground 
that ``[f]oreign taxes on corporate income also are shifted to others 
[as VATs are often thought to be] (and not necessarily completely to 
the shareholder-owners of the corporation) but are treated as 
creditable for U.S. purposes. That is rightly so because even if 
shifted, they are part of the cost and pricing structures of the 
corporations that nominally bear them and thus affect decisions on 
whether to invest at home or abroad.'').
Proposed Standards for VAT Creditability
    The standards for creditability of VATs may need to be slightly 
more stringent than the standards for income taxes. The three criteria 
for creditability of an income tax are: (1) the tax must be due from 
the taxpayer (the ``technical taxpayer'' rule), (2) there must be proof 
of payment, and (3) the tax must not have been refunded.\40\
    \40\ See Treas. Reg. Secs. 1.901-2(f) (the ``technical taxpayer'' 
rule); 1.905-2(a)(2) (taxpayer must present proof of payment); 1.905-
3T(d)(3) (refund of a foreign tax constitutes a change in foreign tax 
    The first and third of these should be applied to VATs without 
change. With respect to the second, however, the current rule allows 
credit for foreign taxes paid by others as long as the taxpayer 
claiming credit was liable for the tax.\41\ If that rule were applied 
to VAT creditability, then in theory everyone with an invoice showing a 
charge for VAT might claim a tax credit. Allowing credits on this basis 
would undermine the rationale for extending credit in the first place--
to prevent double taxation from discouraging business activity abroad--
because people who make a single purchase abroad are not necessarily 
attempting to engage in business activity there, even if the purchase 
is for business purposes.
    \41\ See Treas. Reg. Sec. 1.901-2(f)(1)-(2).
    It would be possible to bar such claims on the ground that the 
taxpayer could not demonstrate that the tax shown on the invoice had 
actually been paid by the party issuing the invoice (that is, that it 
had not been partially or totally offset by deductions). Alternatively, 
it could be argued that the claimant was not the ``technical 
taxpayer.'' That argument would be more tenuous because, according to 
the EU's Sixth Directive,\42\ all taxable persons must pay VAT, and the 
term ``taxable persons'' includes everyone ``who independently carries 
out in any place'' any of the economic activities of ``producers, 
traders, and persons supplying services.'' That category includes even 
those who, as members of special classes, are exempted from payment of 
VAT, and as a result, it might also include casual purchasers.
    \42\ Council Directive 77/388/EEC of 17 May 1977 on the Common 
System of Value Added Tax, 1977 O.J. (L 145) 1.
    Therefore, unless there is a clear advantage in keeping the 
criteria for income tax and VAT creditability identical and addressing 
this issue in an exception, VAT creditability should require that the 
taxpayer demonstrate direct payment of VAT to the foreign government. 
That proof could be a VAT return and payment authorization, or, if no 
VAT return has been or will be filed, it could be the receipt issued to 
the taxpayer or its representative by customs when VAT was paid at the 
time of importation. Either way, those with no more than an invoice 
showing a charge for VAT should not be able to claim the credit.
    Are there other issues that would need to be addressed before VAT 
credit could be implemented? Of course. For instance, there is the 
potential problem of abuse of VAT credit, which I have addressed 
briefly in a recent Tax Notes International article.\43\
    \43\ See Martin B. Tittle, ``Achieving a Territorial Result Without 
Switching to a Territorial System,'' 43 Tax Notes Int'l 41, 46-47 (July 
3, 2006), available at http://www.martintittle.com/publications/
    Should I address and try to resolve all implementation issues now? 
For two reasons, probably not. First, any person or group that decides 
to support VAT credit will likely want to put its own ``stamp'' on the 
idea, so it can receive appropriate credit when VAT credit is enacted. 
Leaving implementation issues unaddressed allows opportunity for this 
natural, political need to be met.
    Second, VAT credit is interesting only if we want to preserve our 
current, worldwide tax system and avoid the wholesale change that a 
switch to territorialism would entail.\44\ One counterargument to 
preservation is that a switch to territorialism is more dramatic, and 
success in achieving it might generate more political capital. Another 
counterargument is that switching to territorialism might come with a 
better ``playbook,'' in the form of the laws that other countries have 
generated in implementing it.\45\
    \44\ See supra note 2.
    \45\ See Merrill et al., supra note 2 (summarizing the territorial 
rules of Canada, Germany, and the Netherlands, comparing them to the 
territorial proposals in President's Advisory Panel, supra note 2, and 
Joint Comm. on Tax'n, supra note 2, but emphasizing the negative 
aspects of a change to territorialism).
    At the end of the day, VAT credit is just an option that has the 
potential to simulate territorialism while allowing the benefits of the 
current U.S. tax system to remain unchanged. Almost on a par with its 
territorial emulation, VAT credit also offers what I think is an 
enormous trade law ``kicker.'' That kicker, as noted, is that it could 
begin the process of erasing the distinction between direct and 
indirect taxes, a distinction that has plagued the U.S. for 
decades.\46\ Right now, the U.S. has only one trade law argument to 
use--``it's not fair anymore''--and that argument has been roundly 
ignored. Blending direct and indirect taxes by giving capped credit for 
the latter against the former would shake things up by putting a little 
of our money where our mouth is, and that could be just the edge our 
trade negotiators need the next time around.
    \46\ See, e.g., The WTO's Challenge to FSC/ETI Rules and the Effect 
on America's Small Business Owners: Hearing Before the House Comm. on 
Small Bus., 108th Cong., 1st Sess., 13 (2003) (testimony of Dr. Gary 
Clyde Hufbauer that ``[t]his [FSC-ETI] dispute originates in the 
ancient, and I think unjustified distinction between a direct and 
indirect taxes [sic]'').


     Statement of United States Council for International Business
    The United States Council for International Business (USCIB) is 
pleased to present its views to this Subcommittee on Select Revenue 
Measures (a Subcommittee of the Ways and Means Committee) with respect 
to this extremely important subject of the need to reform the 
international tax regime of the Internal Revenue Code (the Code) to 
enable U.S. multinational enterprises to enhance their international 
competitiveness vis-`-vis their foreign rivals. Although this hearing, 
and our statement, focus on the international aspects of the Code, many 
other, non-international provisions therein need re-examination and 
possible amendment, for the same reason.
    The USCIB advances the global interests of U.S. business, both here 
and abroad, including, in many instances, the U.S. operations of non-
U.S. enterprises. It is the U.S. affiliate of the International Chamber 
of Commerce (ICC), the Business and Industry Committee to the OECD 
(BIAC), and the International Organization of Employers (IOE). Thus, it 
clearly represents U.S. business in the preeminent intergovernmental 
bodies, where the many and complex issues that face the international 
business community are addressed, with the primary objective being to 
search for possible resolutions to these issues. The bottom line in all 
of this is to ensure the existence of an open and equitable system of 
world trade, finance and investment.
Introductory Background
    The U.S. income tax system was first enacted in 1913, following its 
authorization by a Constitutional amendment. The system evolved over 
the years, by way of annual income tax acts, three codifications 
culminating in the 1986 Code, which is the basis of the statute today 
(the earlier codifications occurred in 1939 and 1954). From the 
beginning, the Code subscribed to the so-called Classical system, 
applied on a Global basis (these terms and concepts will be described 
below). For many and varied reasons, the Code has become antiquated, 
reflecting an inability to deal effectively and efficiently with the 
modern day business models and practices. Therefore, most pundits in 
the area would agree that the Code is in dire need of a thorough 
overhaul at this time. In fact, this was corroborated by the Bush 
Administration, which gave a high priority to a fundamental tax reform 
project and appointed a blue ribbon panel (the Panel) to conduct such a 
study. (USCIB submitted a commentary to this Panel during its 
deliberations, which submission contained our thoughts and suggestions 
on this topic, many of which will be mentioned below.) Although this 
statement deals primarily with the international provisions of the 
Code, as mentioned above, the domestic provisions need a thorough, 
critical review as well.

    Before commencing with a detailed discussion, it would be useful to 
outline briefly the relevant goals that USCIB would envisage be 
accomplished by a major reform of the Code's international tax regime. 
These are set forth below.

      A reformed tax system should aim to depart completely 
from the old Classical model, which doubly taxes corporate income, and, 
in its place, shift to an integrated system, which avoids multiple 
levels of income tax on the same income.
      A reformed international tax regime should not result in 
an increase in the tax burden of U.S. multinational enterprises. Thus, 
nominal tax rates should be reduced, not increased, and the situation 
where U.S. multinationals encounter residual U.S. tax on foreign source 
income after application of the foreign tax credit provisions should be 
the exception rather than the rule.
      A reformed tax system should be broad based, and it 
should, thus, apply consistently across industry lines. In other words, 
it should not discriminate against certain industries or specified 
groups of taxpayers. In addition, the revised regime must offer 
consistency in tax treatment to all forms of business organization 
availed of by multinational taxpayers to conduct business operations 
abroad, whether it be a controlled foreign corporation, a branch, a 
partnership, a joint venture (e.g., a 10/50 company), etc., so as not 
to unfairly penalize any taxpayer for selecting one form of business 
organization over another, presumably, for valid business reasons.
      A reformed international tax regime should ideally 
eliminate, but, at the very least, substantially cut back the reach of, 
the Code's Subpart F provisions, so as to restore the sanctity of the 
principle of deferral with regard to U.S. taxation of foreign income 
earned through associated overseas entities. In other words, the 
acceleration of taxation of overseas non-repatriated earnings, 
including the active income of a foreign subsidiary of a U.S. based 
financial services enterprise, puts U.S. multinationals in a 
competitively more disadvantageous position than non-U.S. 
multinationals. Also, in this vein, an appropriate definition of 
``passive'' income should be carefully crafted so as not to subject to 
tax, in the guise of passive income, what is really active business 
income, prior to repatriation (e.g., royalties from intangibles and 
technology developed by a taxpayer for use in its trade or business).
      A reformed international tax regime should strive to 
minimize, if not totally eliminate, international double taxation by 
offering to U.S. multinational enterprises a true overall foreign tax 
credit limitation approach. In other words, the fracturing of the 
limitation into many different categories (baskets) defeats the goal of 
providing maximum relief from international double taxation, and 
adversely impacts the competitive position of U.S. enterprises. 
Moreover, for the same reason (i.e., competitiveness), the regime 
should simplify and ease the requirements and relevant rules in 
allocating and apportioning expenses to foreign source income. The 
alternative approach to providing double tax relief is the so-called 
territorial (i.e., exemption) approach, which is very popular among the 
European (and certain other) countries. The particular exemption system 
proposal currently under consideration in the USA is generally not 
favored by the USCIB membership; however, it is important to note that, 
if structured appropriately, territoriality could achieve the desired 
      A reformed international tax regime should fully support 
and encourage the enhancement of the U.S. tax treaty program, and 
strive to introduce into it innovative concepts which will serve the 
interest of minimizing double taxation for all taxpayers, U.S. and 
      A reformed international tax regime should retain the 
``place of incorporation'' standard as the sole standard for 
determining corporate residency; a ``place of management'' test, as an 
alternative or replacement, is undesirable.

    The discussion to follow will illuminate many of the above points.
Classical Model and Double Taxation of Corporate Earnings
    The United States has followed the Classical system model since the 
inception of the U.S. tax law. Under such model, net corporate income 
after corporation income tax is again subjected to income tax in the 
hands of shareholders, with the exception of dividends eligible for the 
inter-corporate dividend exemption. The ultimate individual 
shareholders are subject to tax on corporate dividends, which are 
almost always paid out of income already taxed at the corporate level.
    In contrast, many, if not most, of our trading partners, i.e., 
those nations in which the competitors of our U.S. multinational 
enterprises are domiciled, use some form of integrated tax system 
(there are several different methods of achieving an integrated system, 
but the imputation model has, over the years, been the most popular). 
Multinational enterprises which are resident in countries having 
integrated tax systems may well enjoy a competitive advantage over U.S. 
multinationals by reason of not being subject to the double taxation of 
corporate income as under the Classical model.
    Over the years, legislative efforts have been made, from time to 
time, to reduce the incidence of double taxation of corporate profits, 
through a combination of dividend credits and exemptions, most of which 
were repealed because of revenue concerns. The latest move to redress 
this flaw in our system took place in the 2003 tax legislation, i.e., 
the Jobs and Growth Tax Relief Reconciliation Act, which imposed a tax 
of 15% on portfolio dividends in lieu of a resident taxpayer's 
invariably higher marginal rate. This is indeed a step in the right 
direction of achieving a fully integrated system; but full integration, 
comparable to that in many of our trading partners, is still the 
ultimate goal in this area. In our view, it would be a simple matter, 
at this point, of completing the job that the 2003 legislation started, 
and to provide, legislatively, for a zero rate on portfolio dividend 
income. End of story!
    Although one might consider this issue more in the area of domestic 
tax policy, the elimination of the double tax on corporate income would 
make the Code more consistent with the approach of our trading partners 
and, thus, perhaps, tend to level the playing field for U.S. 
multinational enterprises.
Overall Tax Burden Concerns
    In devising a rational and user-friendly international tax regime 
for U.S. multinationals, one that will enhance their competitive 
standing in the world, there are two major overall themes that should 
be considered as guiding principles behind any proposed detailed 
technical legislative amendments. First of all, whatever shape reform 
in the international tax regime might take, the drafters of the 
statutory language must be sure that the changes do not impose higher 
tax burdens on U.S. multinational enterprises than now exist. This may 
seem like a simplistic statement, and it may be; but, in a proposal for 
reform in the international area developed by the Joint Committee on 
Taxation in 2005, in which the JCT recommended replacing the current 
system with a territorial system for mitigating international double 
taxation, the scheme so presented resulted in a tax increase of over 
$50 billion on the population of U.S. domiciled multinationals. This 
has to be carefully avoided, or the cure will be worse than the 
    Again, as a matter of domestic tax policy, if the rates of 
corporate tax must be tinkered with, they should not be raised so as to 
increase the tax burden. Ideally, they would be lowered, as the USA is 
today one of the higher tax countries in the world. (A tax decrease on 
multinational enterprises, in fact, could well have a salutary impact 
on the economic well being of the USA.) Moreover, we submit that U.S. 
multinationals should be in a position in which there is rarely any 
residual U.S. income tax on their foreign earnings. This can be 
achieved by way of a properly constructed foreign tax credit provision 
or a carefully tailored territorial system.
    The second guiding principle is that of consistency of treatment 
across the board. The tax system, as well as the international tax 
regime therein, should be broad based, and, in accord therewith, have 
equal application across industry lines. In other words, the regime 
should not single out specific industries or groups of taxpayers for 
special, usually discriminatory, treatment. Consider the current 
foreign tax credit provisions, which contain (in Section 907) punitive 
rules with respect to the petroleum industry, treating that industry 
more harshly in terms of additional limitations on their foreign income 
taxes which are available for the foreign tax credit. The standard of 
consistency also should apply to alternative forms of organization. 
Whatever form of organization a U.S. multinational enterprise elects 
for the conduct of its overseas business activities, be it a controlled 
subsidiary (a wholly-owned or majority-owned controlled foreign 
corporation), a branch, a partnership, or a joint venture (e.g., a 
minority-owned controlled foreign corporation or a non-controlled 
foreign corporation (a 10/50 company)), it should be subjected to 
similar tax treatment. The choice of form of organization is, in 
general, a business decision rather than a tax driven one.
Deferral/Controlled Foreign Corporation Rules
    The principle of deferral has been an underlying tenet of the tax 
statute virtually since inception of income taxation in the USA. 
Deferral is nowhere defined in the statutory language, but it is 
implicit in the structure of the law. Essentially, it stands for the 
proposition that earnings amassed by the overseas affiliates of a U.S. 
taxpayer are not includible in the income of such taxpayer as earned, 
but only as actually paid out, or otherwise made available to, the U.S. 
taxpayer. In other words, the income as earned by a foreign affiliate 
is deferred from U.S. tax as long as it remains in foreign corporate 
    In the United States, the principle of deferral was first violated 
by the introduction into the statute, under the 1939 Code (pre-1954), 
of the Foreign Personal Holding Company (FPHCo) provisions. This set of 
rules, together with its companion piece, the Personal Holding Company 
(PHC) provisions, targeted the incorporated pocketbooks of high net 
worth individuals who were attempting to reduce their personal tax 
burdens by shifting passive income-producing assets into corporate 
solution, either domestic (PHCo) or foreign (FPHCo). These provisions 
had no real effect upon publicly held U.S. multinational enterprises. 
It wasn't until 1963, courtesy of the Revenue Act of 1962, when the 
Controlled Foreign Corporation (CFC) provisions became effective that 
the large U.S. international corporations began to feel, to a degree, 
the impact from a partial ending of deferral. These CFC rules 
introduced into the Code a novel concept, that of taxing all U.S. 
taxpayers, including the large multinationals, on certain specified 
income earned by CFCs in which such shareholders held a greater than 10 
% voting interest. These new provisions went beyond the PHCo/FPHCo 
attack on passive income held by a closely-held corporation (i.e., the 
so-called corporate ``pocketbook''), although passive income was 
included as an item of income to be covered under the new regime.
    The main thrust of the CFC rules, in brief, was to treat low-taxed 
income earned by CFCs as dividends to the U.S. shareholders. It was 
aimed at preventing U.S. multinational enterprises from enjoying the 
tax deferral benefits arising from the use of tax havens or special tax 
incentive provisions in non tax haven jurisdictions to conduct bona 
fide business activities (e.g., product sales, services, etc). It is 
quite easy to see just how these changes adversely affected the 
competitiveness of U.S. business abroad, even at a time when the USA 
still dominated the world economy. Unfortunately, in the years since 
the Revenue Act of 1962, Congress has enacted a plethora of ill 
conceived, onerous amendments to Subpart F, having little relationship 
to the original purpose of the provisions, resulting in a further 
erosion of the competitiveness of U.S. business abroad. Although many 
other capital exporting nations have since enacted their versions of 
the CFC concept, the U.S. version is, by far, the most burdensome to 
its multinational community.
    The 2004 tax legislation did redress some of the issues and problem 
areas in the CFC rules. But what is really needed to shore up the 
competitive vigor of U.S. international enterprises is a complete 
repeal of the Subpart F provisions. The USCIB strongly supports this, 
which, in conjunction with the changes in the double taxation relief 
rules, to be discussed below, is just what the doctor ordered to cure 
the competitive ills of U.S. business abroad.
International Double Taxation Relief
Credit Approach
    Doubtlessly, the most important set of provisions in the Code with 
regard to restoring and enhancing the competitiveness of the U.S. 
multinational community is the set of provisions aimed at granting such 
enterprises relief from the scourge of double taxation (by two or more 
jurisdictions) on the same income streams. The provisions so designed 
to carry out this mandate encompasses the actual foreign tax credit 
mechanism (Sections 901-907 and 960) and the related expense allocation 
and apportionment principles (regulations under Section 861 and 862). 
The existence of a flexible and efficient system for the elimination of 
international double taxation is, in essence, the cornerstone upon 
which is built a suitable international tax regime for U.S. 
multinational enterprises.
    Initially, the foreign tax credit regime offered a country-by-
country limitation (referred to in the Code as the per-country 
limitation), under which a taxpayer would be limited in the amount of 
foreign tax credit allowable each year to the aggregate of the amounts 
of U.S. tax attributable to the taxable income from each foreign 
country in which the taxpayer incurred foreign income taxation. In 
1960, effective for calendar year 1961, the Congress enacted an overall 
limitation to replace, after a transitional period in which both 
limitations were in the law, the per-country limit. This mechanism, 
which allowed for the averaging of all foreign income taxes, 
irrespective of the source country or the nature of the activity giving 
rise to such income taxes, proved to be an a very effective shield for 
U.S. corporations against the burdens of double taxation, in terms of 
maximizing the foreign tax credit relief and, thereby, minimizing the 
tax burden (U.S. and foreign) on foreign source income. The ink was 
barely dry on the legislation enacting the overall approach when 
Congress took its first baby step toward diluting it by enacting a 
separate limitation on certain passive interest income. From then on, 
Congress kept chipping away at the effectiveness of the overall limit, 
culminating in the 1986 Code which established a series of separate 
limitations with the result that the overall limitation existed in name 
only, not in fact. Naturally, the competitive position of U.S. business 
was severely compromised by this development.
    Like in the deferral area, the 2004 tax legislation provided some 
relief by reversing some of the mischief created to the overall limit 
in the previous Congresses. But more needs to be done to truly re-
establish a level playing field for U.S. multinationals. This should be 
a two-pronged program. First, the overall limitation needs to be reborn 
in its original (1960) configuration, i.e., absolutely no separate 
limitations, not for passive income nor any type of operating income 
(e.g., oil and gas income covered now under Section 907). The second 
prong relates to expense allocation and apportionment which is 
discussed in the ensuing two paragraphs.
    Having a reasonable set of expense allocation and apportionment 
rules, for foreign tax credit purposes, is as important to U.S. 
multinationals in ensuring competitiveness abroad as having a 
monolithic (non-fractured) overall foreign tax credit limitation. If 
anything can dilute the efficiency of the overall foreign tax credit 
relief, it would be an arbitrary and unreasonable set of rules for 
allocating and apportioning expenses against foreign source income to 
arrive at foreign source taxable income, the numerator of the foreign 
tax credit limitation fraction. We were pleased to see the amendments 
enacted in the 2004 tax act introduced very sensible rules in the 
allocation and apportionment of interest expenses, which previously had 
been tilted unfairly against maximizing allowable foreign tax credits, 
as well as in the allocation and apportionment of general and 
administrative expenses. Such sensible rules should be retained and a 
similar approach should be utilized with respect to all other expense 
categories that require allocation and apportionment against foreign 
source income.
Exemption Approach
    An alternative to the credit approach is the exemption approach, 
often referred to as the territorial method. This method has been under 
intense scrutiny of late, having been the subject of a U.S. Treasury 
Department study as well as the recommended approach of the 
Presidential Advisory Panel on Tax Reform. In addition, a blueprint for 
such a system has evolved from a Joint Committee on Taxation (JCT) 
study thereof. In broad outline, the territorial system would operate 
to exempt U.S. enterprises from income tax on the business earnings of 
their overseas entities, including subsidiaries, branches, joint 
ventures, etc., while continuing to tax them on their so-called passive 
income where the foreign tax credit mechanism (probably on a per-item 
basis) would operate to eliminate the double tax on such income. The 
USCIB does not concur with a territorial system modeled along the lines 
of the JCT blueprint. If, however, a territorial system structured in 
the manner of those in use in certain of our trading partners (e.g., 
the Netherlands, France) were to be established, it could well achieve 
similar results, i.e., relieving double taxation as discussed in the 
immediately preceding section. Otherwise, retention of our present 
system will be more apt to enhance our nation's competitive position 
vis-`-vis these competitor nations.
    It is important to note that the territorial system is only about 
mitigation of the potential international double taxation burden that 
arises from engaging in cross border trade and investment, nothing 
more. The question is: does this system more effectively provide for 
U.S. multinational enterprises the maximization of double tax relief, 
and, therefore, the minimization of global tax burdens? The answer to 
this question depends upon the structure of the particular territorial 
model selected. We believe, however, that a territorial system 
installed in the Code for the purpose of raising additional tax revenue 
for the Government would be a very unfortunate development.
    Should a territorial system be adopted, a number of industry 
specific issues will emerge. For example, for the financial services 
industry, the most important international issue is the allocation of 
interest. Careful attention must be paid to developing rules that do 
not result in the loss of interest deductions to members of the 
financial services community. In particular, the tax systems of our 
major trading partners and OECD countries must be analyzed to 
understand how they treat interest expense so our financial 
institutions are not put at a serious competitive disadvantage.
    If one were to initially construct a tax system today, it would be 
a very close call as to whether to opt for a credit system or an 
exemption system. The answer would evolve about the design of the 
credit mechanism vs. the design of the territorial exemption and the 
comprehensiveness of the relief produced by each such approach. 
Although the territorial method would appear to enjoy the virtue of 
simplicity, this can be misleading. Simplicity may be desirable, but it 
is not the primary goal, which is the effectiveness of a system in 
minimizing the double taxation burden. It should be noted that the 
credit system, even if amended as we suggest above, is very familiar to 
the managements of U.S. multinationals, and, in particular, to the tax 
departments of these enterprises. Thus, taxpayers would be 
knowledgeable with all the nuances of the system and comfortable with 
its application. There would be no growing pains to suffer as there no 
doubt would be in implementing a whole new approach to double tax 
relief, which, although its proponents claim is simpler, does have its 
own complexities.
    In addition, the transition from the present system to a 
territorial system, involving an exemption from tax for business income 
and a foreign tax credit for other income, would, we estimate, be 
initially burdensome on the tax department resources of the U.S. 
multinational community, both financial and human. Also, there may have 
to be some very complex transition rules with regard to the phase-out, 
over a relatively long period of years, of the existing foreign tax 
credit rules so as to permit taxpayers the opportunity to somehow 
utilize credits accumulated in years in which the old system was in 
force. As a corollary, this would probably necessitate a gradual phase-
in of the new system. The change thus could be a long, drawn-out 
affair, replete with complications as the two systems operated in 
tandem. This factor alone, although not as significant as the 
comparative effectiveness of the two approaches, could be enough to 
substantially erode support for such a conversion at this time.
Importance of Tax Treaties
    Tax treaties have been with us since the 1930's. The number thereof 
and their importance has increased tremendously over the years. The 
foreign tax credit (as well as territoriality) is a unilateral approach 
to the elimination of international double taxation, while treaties 
present a bilateral approach for, inter alia, accomplishing this goal. 
All interested parties, government, business, investors, etc., support 
a vigorous, proactive and innovative treaty policy. In the context of 
these hearings, it should be said that any legislation addressing the 
reform of our international tax regime should be carefully structured 
to ensure consistency with this goal of enhancing our international 
treaty program.
Corporate Residence
    We noted that the Presidential Panel, in its report of November, 
2005, made a recommendation to alter the long standing definition in 
the Code of corporate residence. We do not concur with the Panel on 
this matter, and we wish to express that concern here in the event that 
this Subcommittee (or its parent, the W&M Committee) might decide to 
consider and recommend the Panel's position on this issue.
    Since inception of the U.S. income tax law, the test of corporate 
residence has been the place of incorporation. Accordingly, an entity 
organized under the laws of one of the fifty states of the USA (or 
under U.S. federal law) was a U.S. corporation, and, thus, resident, so 
to speak, in the USA. This is a straight-forward objective test, simple 
to apply. The Panel has recommended adding to the mix an additional, 
much more ambiguous, standard, i.e., the place at which the entity is 
managed and controlled. This so-called ``mind-and-management'' test is, 
admittedly, used in more countries than anything comparable to our 
standard, but that doesn't make it right. This mind-and-management 
standard was developed under the legal principles of the United 
Kingdom. Under it, one looks to various indicia in an effort to 
establish the place from which the entity is managed and controlled, 
and thus resident.
    The Presidential Panel recommended that the management and control 
test be included in the Code, in addition to the place of incorporation 
test. In other words, all U.S. incorporated entities would be U.S. 
residents by way of the long standing rule, while all non-U.S. 
incorporated enterprises would be tested under the new management and 
control standard, however that would be implemented, if enacted. 
Although it seems clear that the new standard would be aimed squarely 
at foreign controlled enterprises doing business in the USA, it could 
prove to be a pitfall for U.S. controlled enterprises as well, since it 
could easily be used by the IRS to assert a U.S. residence with respect 
to their CFCs. Accordingly, we see the potential for such a change in 
the corporate residence test to give rise to much controversy with the 
IRS, both with foreign controlled enterprises operating in the USA and 
U.S. controlled enterprises as to their CFCs. If this comes to pass, 
such additional controversy will no doubt lead to more, needless, 
costly (both to the IRS and taxpayers) litigation. The key 
consideration in this context is the possibility that a U.S. 
enterprise's CFCs could be treated as U.S. residents, for U.S. tax 
purposes, thus negating the benefit to U.S. competitiveness that will 
result if our recommendations on international tax reform discussed 
above with respect to deferral and controlled foreign corporations are 
taken seriously.
    An interesting observation to be noted, in the context of this 
discussion, is the distinct possibility that an amendment to the 
corporate residence rule along these lines would probably discourage 
decision-making executives of foreign enterprises engaging in U.S. 
business activities from residing in the U.S. Although such an 
eventuality might not have an adverse impact on the competitiveness of 
U.S. business, it could certainly have an adverse effect on inbound 
foreign investment in the U.S., which is not necessarily a good thing 
for the U.S. economy.
Conclusion_A Final Note
    In conclusion, we would urge the legislators to seriously consider 
the arguments and suggestions discussed above with respect to the 
Code's international tax regime in their effort to re-establish the 
strong competitive position internationally of the U.S. business 
    We would further suggest that, as part of this review, tax reform 
should also look at competitiveness of the U.S. economy. In other 
words, whatever reform legislation emerges from this current exercise, 
it should attempt to render, and retain, the U.S. economy as a user 
friendly jurisdiction in which to establish business operations. Over 
the years, our country has been a leader in attracting foreign 
investment. As the global economy, hopefully, continues to expand, we 
face increasing competition from other countries for this investment, 
which, of course, means that we should strive to eliminate tax policies 
and rules that discriminate against foreign investment. After all, 
foreign investment in the USA creates jobs for U.S. workers just as 
domestic investment does. It must also be said, in this vein, that tax 
legislation that discriminates against foreign investors tends to breed 
the enactment of similar measures by our trading partners which would 
act against the best interests of U.S. enterprises operating or 
investing internationally.
    We thank the members of this Subcommittee for the opportunity to 
present our views on this subject of utmost importance to our 
membership, to the U.S. multinational community and to the well being 
of the U.S. economy, in general.


                                           Elmsford, New York 10523
                                                     March 21, 2006
    An extremely important and delicate relationship exists between the 
citizens of this great country and its federal government. Putting it 
lightly, this relationship is very much aggravated by our current 
income tax system. Why must we have a tax system that causes so much 
friction? It need not be like this. As Mr. Goldberg so clearly stated, 
``What I find so discouraging is the gulf between what can be done and 
what's being done. It's not as though we are lacking for ways to 
simplify the system . . . there is no end to the good ideas; what's 
lacking is their enactment into law.'' \1\
Congressional Testimony by Federal Document (c) 2004 FDCH / eMedia, 
Inc. All Rights Reserved.
    We have created an environment that punishes hard work, savings, 
capital investment, and the entrepreneurial spirit. A tax system that 
has sliced and diced our country into a myriad of categories, groups, 
industries, races, classes, non-profit/profit, all clamoring and 
pleading with Washington for ``breaks,'' causing the very foundation of 
America to twist and bend with those who best promote their cause. The 
end result causing friction, lack of confidence, confusion, 
frustration, anger, in a nutshell, class warfare between all Americans.
    We spend over $200 billion dollars and 6 billion hours in complying 
with over 42,000 pages of code. At the end of it all it is estimated 
that some $300--$500 billion dollars escapes taxation and no tax 
preparer arrives at the same conclusion given a set of circumstances. 
Knowbody knows what the heck is going on!
    The Whole System is Unfair because it doesn't treat everybody 
equally. It has strayed from what should be the original intent of any 
taxing system, the Collection of Taxes. It has been warped into a tool 
for social change, (this is like trying to clean a window with a 
bulldozer), causing the environment which I have described above.
    The following must be recognized:

      The sole guiding principal is Collection with Simplicity 
and Fairness as the characteristics.
      Administered equally to all with one rate and with no 
exclusions. Note that I am a home owner and I donate to many causes.
      Any re-distribution of wealth should be in the form of 
specific targeted accountable programs. Of course we need to help those 
who are less fortunate, however, do not do it in the tax system.
      Only consumers pays taxes.
      Don't be too overly concerned with transitioning. Though 
we don't like having to do it, we have become quite resourceful and 
adept at doing it. How? With every modification that occurs with the 
current income tax code and there have been over 14,000 changes since 

    I am of the belief that we pull the income tax out by its roots so 
it will never grow back. I implore you to support the FairTax, H.R. 25 
& S.25.
    Realize, that we find ourselves in a wonderful moment in time where 
we have a leader in President Bush who recognizes that America has 
problems and is willing to confront those problems. I believe our 
income tax system is one of the largest and most pervasive problems 
that we face today and it isn't worthy of our United States of America.
    Thank you.
            Most Respectfully,
                                                     Adam S. Yomtov

    PS. Pregnancy is complicated. Paying our Federal taxes need not be!
    Statement of The Honorable Fred T. Goldberg, Jr. Commissioner, 
Internal Revenue Service, 1989-1992.
    Subcommittee on Oversight/Committee on House Ways and Means June 
15, 2004