[Congressional Record Volume 145, Number 96 (Thursday, July 1, 1999)]
[Extensions of Remarks]
[Pages E1488-E1489]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




                     INTEREST ALLOCATION REFORM ACT

                                 ______
                                 

                            HON. ROB PORTMAN

                                of ohio

                    in the house of representatives

                         Thursday, July 1, 1999

  Mr. PORTMAN. Mr. Speaker, on June 17, 1999, joined by Mr. Matsui of 
California, I introduced H.R. 2270, a bill to correct a fundamental 
distortion in the U.S. tax law that results in double taxation of U.S. 
taxpayers that have operations abroad.
  The United States taxes U.S. persons on their worldwide income, but 
allows a foreign tax credit against the U.S. tax on foreign-source 
income. The foreign tax credit limitation applies so that foreign tax 
credits may be used to offset only the U.S. tax on foreign-source 
income and not the U.S. tax on U.S.-source income. In order to compute 
the foreign tax credit limitation, the taxpayer must determine its 
taxable income from foreign sources. This determination requires the 
allocation of deductions between U.S.-source gross income and foreign-
source gross income.
  Special rules enacted as part of the Tax Reform Act of 1986 apply for 
purposes of the allocation of interest expense. These rules generally 
require that interest expense incurred by the U.S. members of an 
affiliated group of corporations must be allocated based on the 
aggregate of all the U.S. and foreign assets of the U.S. members of the 
group.
  The interest allocation rules purport to reflect a principle of 
fungibility of money, with interest expense treated as attributable to 
all the activities and property of the U.S. members of a group 
regardless of the specific purpose for which the debt is incurred. 
However, the present-law rules enacted with the 1986 Act do not 
accurately reflect the fungibility principle because they apply 
fungibility only in one direction. Accordingly, the interest expense 
incurred by the U.S. members of an affiliated group is treated as 
funding all the activities and assets of such group, including the 
activities and assets of the foreign members of the group. However, in 
this calculation, the interest expense actually incurred by the foreign 
members of the group is ignored and thus is not recognized as funding 
either their own activities and assets or any of the activities and 
assets of other group members. This ``one-way-street'' approach to 
fungibility is a gross economic distortion.
  By disregarding the interest expense of the foreign members of a 
group, the approach reflected in the present-law interest allocation 
rules causes a disproportionate amount of U.S. interest expense to be 
allocated to the foreign assets of the group. This over-allocation of 
U.S. interest expense to foreign assets has the effect of reducing the 
amount of the group's income that is treated as foreign-source income 
for U.S. tax purposes, which in turn reduces the group's foreign tax 
credit limitation. The present-law interest allocation rules thus 
prevent the group from fully utilizing its available foreign tax 
credits, and lead to double taxation of the foreign income earned by 
the U.S. multinational group.
  This double taxation of the income that U.S. multinational 
corporations earn abroad is contrary to fundamental principles of 
international taxation and imposes on U.S. multinational corporations a 
significant cost that is not borne by their foreign competitors. The 
present-law interest allocation rules thus impose a burden on U.S.-
based multinationals that hinders their ability to compete against 
their foreign counterparts. Indeed, the distortions caused by the 
interest allocation rules impose a substantial cost that affects the 
ability of U.S.-based multinationals to compete against their foreign 
counterparts both with respect to foreign operations and with respect 
to their operations in the United States.
  H.R. 2270 will reform the interest allocation rules to eliminate the 
distortions caused by the present-law approach. The elimination of 
these distortions will reflect the fundamental tax policy goal of 
avoiding double taxation and will eliminate the competitive 
disadvantage at which the present-law interest allocation rules place 
U.S.-based multinationals. A detailed technical explanation of the 
provisions of H.R. 2270 follows.

                   Technical Explanation of H.R. 2270


                               IN GENERAL

       The bill would modify the present-law interest allocation 
     rules of section 864(c) that were enacted by the Tax Reform 
     Act of 1986. The bill embodies the provisions that were 
     passed by the Senate in connection with the 1986 Act. Under 
     the bill's modifications, interest expense generally would be 
     allocated

[[Page E1489]]

     by applying the principle of fungibility to the taxpayer's 
     worldwide affiliated group (rather than to just the U.S. 
     affiliated group). In addition, under special rules, interest 
     expense incurred by a lower-tier U.S. member of an affiliated 
     group could be allocated by applying the principle of 
     fungibility to the subgroup consisting of the borrower and 
     its direct and indirect subsidiaries. The bill also allows 
     members engaged in the active conduct of a financial services 
     business to be treated as a separate group; this provision 
     reflects an expansion of the present-law bank group rule to 
     other financial services firms which is similar to the 
     expansion that was proposed in the Foreign Income Tax 
     Rationalization and Simplification bill introduced in 1992 by 
     Representatives Rostenkowski and Gradison. Finally, the bill 
     would provide specific regulatory authority for the direct 
     allocation of interest expense in other circumstances where 
     such tracing is appropriate.
       Under the bill, a taxpayer would be able to make a one-time 
     election to apply either the interest allocation rules 
     currently contained in section 864(e) or the modified rules 
     reflected in the bill. Such election would be required to the 
     made for the taxpayer's first taxable year to which the bill 
     is applicable and for which it is a member of an affiliated 
     group, and could be revoked only with IRS consent. Such 
     election, if made, would apply to all the members of the 
     affiliated group.
       The bill generally is not intended to modify the 
     interpretive guidance contained in the regulations under the 
     present-law interest allocation rules that is relevant to the 
     rules reflected in the bill, and such guidance is intended to 
     continue to be applicable.


                         WORLDWIDE FUNGIBILITY

       Under the bill, the taxable income of an affiliated group 
     from sources outside the United States generally would be 
     determined by allocating and apportioning all interest 
     expense of the worldwide affiliated group on a group-wide 
     basis. For this purpose, the worldwide affiliated group would 
     include not only the U.S. members of the affiliated group, 
     but also the foreign corporations that would be eligible to 
     be included in a consolidated return if they were not 
     foreign. Both the interest expense and the assets of all 
     members of the worldwide affiliated group would be taken into 
     account for purposes of the allocation and apportionment of 
     interest expense. Accordingly, interest expense incurred by a 
     foreign subsidiary would be taken into account in determining 
     the initial allocation and apportionment of interest expense 
     to foreign-source income. The interest expense incurred by 
     the foreign subsidiaries would not be deductible on the U.S. 
     consolidated return. Accordingly, the amount of interest 
     expense allocated to foreign-source income on the U.S. 
     consolidated return would then be reduced (but not below 
     zero) by the amount of interest expense incurred by the 
     foreign members of the worldwide group, to the extent that 
     such interest would be allocated to foreign sources if 
     these rules were applied separately to a group consisting 
     of just the foreign members of the worldwide affiliated 
     group. As under the present-law rules for affiliated 
     groups, debt between members of the worldwide affiliated 
     group, and stockholdings in group members, would be 
     eliminated for purposes of determining total interest 
     expense of the worldwide affiliated group, computing asset 
     ratios, and computing the reduction in the allocation to 
     foreign-source income for interest expense incurred by a 
     foreign member.
       As under the present-law rules, taxpayers would be required 
     to allocate and apportion interest expense on the basis of 
     assets (rather than gross income). Because foreign members 
     would be included in the worldwide affiliated group, the 
     computation would take into account the assets of such 
     foreign members (rather than the stock in such foreign 
     members). For purposes of applying this asset method, as 
     under the present-law rules, if members of the worldwide 
     affiliated group hold at least 10 percent (by vote) of the 
     stock of a corporation (U.S. or foreign) that is not a member 
     of such group, the adjusted basis in such stock would be 
     increased by the earnings and profits that are attributable 
     to such stock and that are accumulated during the period that 
     the members hold such stock. Similarly, the adjusted basis in 
     such stock would be reduced by any deficit in earnings and 
     profits that is attributable to such stock and that arose 
     during such period. However, unlike under the present-law 
     rules, these basis adjustment rules would not be applicable 
     to the stock of the foreign members of the expanded 
     affiliated group (because such members would be included in 
     the group for interest allocation purposes).
       Under the bill, interest expense would be allocated and 
     apportioned based on the assets of the expanded affiliated 
     group. For interest allocation purposes, the affiliated group 
     would be determined under section 1504 but would include life 
     insurance companies without regard to whether such companies 
     are covered by an election under section 1504(c)(2) to 
     include them in the affiliated group under section 1504. This 
     definition of affiliated group would be the starting point 
     for the expanded affiliated group. In addition, the expanded 
     affiliated group would include section 936 companies (which 
     are included in the group for interest allocation purposes 
     under present law). The expanded affiliated group also would 
     include foreign corporations that would be included in the 
     affiliated group under section 1504 if they were domestic 
     corporations; consistent with the present-law exclusion of 
     DISCs from the affiliated groups, FSCs would not be included 
     in the expanded affiliated group.


                           subgroup election

       The bill also provides a special method for the allocation 
     and apportionment of interest expense with respect to certain 
     debt incurred by members of an affiliated group below the top 
     tier. Under this method, interest expense attributable to 
     qualified debt incurred by a U.S. member of an affiliated 
     group could be allocated and apportioned by looking just to 
     the subgroup consisting of the borrower and its direct and 
     indirect subsidiaries (including foreign subsidiaries). Debt 
     would quality for this purpose if it is a borrowing from an 
     unrelated person that is not guaranteed or otherwise directly 
     supported by any other corporation within the worldwide 
     affiliated group (other than another member of such 
     subgroup). Debt that does not qualify because of such a 
     guarantee (or other direct supply) would be treated as debt 
     of the guarantor (or, if the guarantor is not in the same 
     chain of corporations as the borrower, as debt of the common 
     parent of the guarantor and the borrower). If this subgroup 
     method is elected by any member of an affiliated group, it 
     would be required to be applied to the interest expense 
     attributable to all qualified debt of all U.S. members of the 
     group.
       When this subgroup method is used, certain transfers from 
     one U.S. member of the affiliated group to another would be 
     treated as reducing the amount of qualified debt. If a U.S. 
     member with qualified debt makes dividend or other 
     distributions in a taxable year to another member of the 
     affiliated group that exceed the greater of its average 
     annual dividend (as a percentage of current earnings and 
     profits) during the five preceding years or 25 percent of its 
     average annual earnings and profits for such period, an 
     amount of its qualified debt equal to such excess would be 
     recharacterized as non-qualified. A similar rule would apply 
     to the extent that a U.S. member with qualified debt deals 
     with a related party on a basis that is not arm's length. 
     Interest attributable to any debt that is recharacterized as 
     non-qualified would be allocated and apportioned by looking 
     to the entire worldwide affiliated group (rather than to the 
     subgroup).
       If this subgroup method is used, an equalization rule would 
     apply to the allocation and apportionment of interest expense 
     of members of the affiliated group that is attributable to 
     non-qualified debt. Such interest expense would be allocated 
     and apportioned first to foreign sources to the extent 
     necessary to achieve (to the extent possible) the allocation 
     and apportionment that would have resulted had the subgroup 
     method not been applied.


                   FINANCIAL SERVICES GROUP ELECTION

       Under the bill, a modified and expanded version of the 
     special bank group rule of present law would apply. Under 
     this election, the allocation and apportionment of interest 
     expense could be determined separately for the subgroup of 
     the expanded affiliated group that consists solely of members 
     that are predominantly engaged in the active conduct of a 
     banking, insurance, financing or similar business. For this 
     purpose, the determination of whether a member is 
     predominantly so engaged would be made under rules similar to 
     the rules of section 904(d)(2)(C) and the regulations 
     thereunder (relating to the determination of income in the 
     financial services basket for foreign tax credit purposes). 
     Accordingly, a member would be considered to be predominantly 
     engaged in the active conduct of a banking, insurance, 
     financing, or similar business if at least 80 percent of its 
     gross income is active financing income as described in 
     Treas. Reg. sec. 1.904-4(e)(2). As under the subgroup rule, 
     certain transfers of funds from a U.S. member of the 
     financial services group to another member of the affiliated 
     group that is not a member of the financial services group 
     would reduce the interest expense that is allocated and 
     apportioned based on the financial services group. Also as 
     under the subgroup rule, if elected, this rule would apply to 
     all members that are considered to be predominantly engaged 
     in the active conduct of a banking, insurance, financing, or 
     similar business.


                             EFFECTIVE DATE

       The bill would be effective for taxable years ending after 
     December 31, 1999.

     

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