[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
HEARING ON THE IMPACT OF INTERNATIONAL
TAX REFORM ON U.S. COMPETITIVENESS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SELECT REVENUE MEASURES
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
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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
ERIC CANTOR, Virginia
JOHN LINDER, Georgia
BOB BEAUPREZ, Colorado
MELISSA A. HART, Pennsylvania
CHRIS CHOCOLA, Indiana
DEVIN NUNES, California
Allison H. Giles, Chief of Staff
Janice Mays, Minority Chief Counsel
______
SUBCOMMITTEE ON SELECT REVENUE MEASURES
DAVE CAMP, Michigan, Chairman
JERRY WELLER, Illinois MICHAEL R. MCNULTY, New York
MARK FOLEY, Florida LLOYD DOGGETT, Texas
THOMAS M. REYNOLDS, New York STEPHANIE TUBBS JONES, Ohio
ERIC CANTOR, Virginia MIKE THOMPSON, California
JOHN LINDER, Georgia JOHN B. LARSON, Connecticut
MELISSA A. HART, Pennsylvania
CHRIS CHOCOLA, Indiana
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
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C O N T E N T S
__________
Page
Advisories announcing the hearing................................ 2
WITNESSES
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
HEARING ON THE IMPACT OF INTERNATIONAL
TAX REFORM ON U.S. COMPETITIVENESS
----------
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
follow:]
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 226-5911
FOR IMMEDIATE RELEASE
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.
m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. However,
any individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Subcommittee and
for inclusion in the printed record of the hearing.
BACKGROUND:
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.''
FOCUS OF THE HEARING:
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.
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* * * CHANGE IN DATE AND TIME * * *
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 226-5911
FOR IMMEDIATE RELEASE
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 * * *
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 226-5911
FOR IMMEDIATE RELEASE
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
time.
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.
STATEMENT OF R. GLENN HUBBARD, DEAN AND RUSSELL L. CARSON
PROFESSOR OF FINANCE AND ECONOMICS, COLUMBIA BUSINESS SCHOOL,
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
globalization.
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
growth.
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
competitiveness.
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.
THE UNITED STATES IN THE GLOBAL ECONOMY
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
quadrupled.
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
`home.'
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
country.
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
operations.
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
paid.
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
base.''
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.
multinationals.
TAX POLICY AND U.S. INTERNATIONAL COMPETITIVENESS
The increasing globalization of economic competition has centered
attention on the impact of U.S. tax rules. Foreign markets represent an
increasing fraction of the growth opportunities for U.S. businesses. At
the same time, competition from multinationals headquartered outside of
the United States is becoming greater. An example of this phenomenon is
the sharp decline over the past 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
reforms.
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
system.
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
firms.
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.
CONCLUSIONS
Multinational corporations are an integral part of the U.S.
economy, and their foreign activities are part of their domestic
success. Accordingly, we must ensure that U.S. tax rules do not impact
the ability of U.S. multinationals to compete successfully around the
world. 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
reform.
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.
STATEMENT OF JAMES R. HINES, JR., PH.D., PROFESSOR OF BUSINESS
ECONOMICS AND PUBLIC POLICY, UNIVERSITY OF MICHIGAN, ANN ARBOR,
MICHIGAN
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
distinct.
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
investments.
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
competitiveness.
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
employment.
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,
alternative.
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
efficiency.
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
differences.
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
(CON).
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
countries.
______
References
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.
STATEMENT OF CRAIG R. BARRETT, PH.D., CHAIRMAN OF THE BOARD,
INTEL CORPORATION, SANTA CLARA, CALIFORNIA
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
questions.
[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
Measures:
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
world.
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:
[GRAPHIC] [TIFF OMITTED] T0706A.001
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
factor.
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
expenditures.
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
imposed.
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
industry.
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
infrastructure.
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
schedules.
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
competitiveness?
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
States.
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
automatically.
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
firms.
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
environment.
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
citizens.
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
States?
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
appeal.
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
home.
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
appearance.
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
States.
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
zero.
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.
STATEMENT OF PAUL W. OOSTERHUIS, PARTNER, SKADDEN, ARPS, SLATE,
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
deductions.
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
country
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
multinationals.
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
world.
---------------------------------------------------------------------------
\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
marketplace.\7\
---------------------------------------------------------------------------
\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
Japan.
---------------------------------------------------------------------------
\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.
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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.
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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
perspective.
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).
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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
countries.
---------------------------------------------------------------------------
\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\
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\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
considered.
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\
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\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
costs.
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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.
STATEMENT OF MICHAEL J. GRAETZ, JUSTUS S. HOTCHKISS PROFESSOR
OF LAW, YALE LAW SCHOOL, NEW HAVEN, CONNECTICUT
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
capital.
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
him.
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
America.
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
services.
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
observations.
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.
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\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
offsets.
---------------------------------------------------------------------------
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
law.
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.
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\3\ Michael J. Graetz, ``Taxing International Income: Inadequate
Principles, Outdated Concepts, and Unsatisfactory Policy,'' Tax Law
Review, Vol. 54, pp. 261-336 (2001).
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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.
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\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.
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\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
dividends.
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.
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Chairman CAMP. Thank you. Mr. Shay.
STATEMENT OF STEPHEN E. SHAY, PARTNER, ROPES & GRAY, LLP,
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.
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.
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\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.
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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\
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\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.
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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\
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\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.
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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
objectives.
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
individuals.\6\
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\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
budget.
\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.
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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
undesirable.
Our current rules fail these criteria of fairness, efficiency and
administrability.
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.
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\7\ Staff of Joint Comm. On Tax'n, Options to Improve Tax
Compliance and Reform Tax Expenditures, JCS-02-05, 189 (Jan. 27, 2005).
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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
taxation.
The President's Advisory Panel's Proposed Exemption of Foreign Business
Income
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.
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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
earnings.
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\
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\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).
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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.
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\13\ Staff of Joint Comm. On Tax'n, Options to Improve Tax
Compliance and Reform Tax Expenditures, JCS-02-05, 191 (Jan. 27, 2005).
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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\
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\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.
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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
Deferral
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.
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\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).
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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
adopted.
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
have.
______
Mr. Shay is not appearing on behalf of any client or organization.
Practice
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
Treasury.
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.
Memberships
American Bar Association, Tax Section
American Law Institute
International Bar Association
International Fiscal Association
Bar Admissions
New York
Massachusetts
Education
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-
beneficial?
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
coming.
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.
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
generous?
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
competitive?
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
somewhere.
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
thinking.
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.
Chairman CAMP. The gentleman from Illinois, Mr. Weller, may
inquire.
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
ahead.
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
cetera.
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
world.
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
hearing.
At this time the Select Revenue Measures Subcommittee is
adjourned.
[Whereupon, at 1:39 p.m., the Subcommittee was adjourned.]
[Submissions for the record follow:]
Statement of Alliance for Competitive Taxation
INTRODUCTION
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\
\1\ All ACT research papers are available at
www.competitivetaxation.org.
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.
SUMMARY OF RESEARCH
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
(federal)
------------------------------------------------------------------------
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).
[GRAPHIC] [TIFF OMITTED] T0706A.008
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,
2005).
\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
2000.\12\
---------------------------------------------------------------------------
\12\ Martin A. Sullivan, ``A New Era in Corporate Taxation,'' Tax
Notes, (January 30, 2006), pp. 440-442.
---------------------------------------------------------------------------
CONCLUSION
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
realized.
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
2006.
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.
Conclusion
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.
APPENDIX
Worldwide Interest Allocation Example
Assumptions:
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:
Interest
Income Expense
New York 6% 5%
Tokyo 1% --
London 3% 2%
Calculations:
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
Conclusion:
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
Introduction
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
countries.
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.
exports.
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
customer.
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
country.
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-
deductible.
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.
Conclusion
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
Measures:
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
message.
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.
[GRAPHIC] [TIFF OMITTED] T0706A.009
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.''
[GRAPHIC] [TIFF OMITTED] T0706A.010
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
System
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
FairTax.
---------------------------------------------------------------------------
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
VAT.
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
priority.
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
rule.
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
soil.
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
spending.
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
today.
---------------------------------------------------------------------------
\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.
Conclusion
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.
Sincerely,
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.
Sincerely,
Kenneth Petrini
Chairman
______
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
compete.
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
jurisdictions.
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
mobile.
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
law.
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
matter.
Sincerely,
Bradley S. Rees
Chief Correspondence Coordinator
Statement of Martin B. Tittle, Law Office of Martin B. Tittle
Introduction
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
subsidy).
\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
46.
---------------------------------------------------------------------------
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
legislation.\14\
---------------------------------------------------------------------------
\13\ See Revenue Act of 1918, ch. 18, section 222(a), 40 Stat.
1057.
\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://
europa.eu.int/eur-lex/lex/LexUriServ/site/en/com/2005/
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
taxing]'').
---------------------------------------------------------------------------
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
wages.\29\
---------------------------------------------------------------------------
\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
(1997).
\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
creditability.\39\
---------------------------------------------------------------------------
\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''
proposal).
\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
liability).
---------------------------------------------------------------------------
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.
Conclusion
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\
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\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/
VAT_credit.pdf.
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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]'').
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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.
Conclusions
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
goals.
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
foreign.
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
disease.
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
solution.
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
community.
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\
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\1\ TAX CODE SIMPLIFICATION--FRED T. GOLDBERG, JR. 15 June 2004,
Congressional Testimony by Federal Document (c) 2004 FDCH / eMedia,
Inc. All Rights Reserved.
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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
1986.
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