[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
IMPACT OF U.S. TAX RULES ON INTERNATIONAL COMPETITIVENESS
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
FIRST SESSION
__________
JUNE 30, 1999
__________
Serial 106-92
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
66-775 CC WASHINGTON : 2001
_______________________________________________________________________
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC
20402
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
WES WATKINS, Oklahoma LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
hearing records of the Committee on Ways and Means are also published
in electronic form. The printed hearing record remains the official
version. Because electronic submissions are used to prepare both
printed and electronic versions of the hearing record, the process of
converting between various electronic formats may introduce
unintentional errors or omissions. Such occurrences are inherent in the
current publication process and should diminish as the process is
further refined.
C O N T E N T S
__________
Page
Advisory of June 15, 1999, announcing the hearing................ 2
WITNESSES
American Express Company, Alan J. Lipner......................... 20
Bouma, Hermann B., H.B. Bouma.................................... 93
Caterpillar Inc., Sally A. Stiles................................ 24
Chip, William W., European-American Business Council, and
Deloitte & Touche LLP.......................................... 111
Coalition of Service Industries, Harvey B. Mogenson.............. 106
Conway, Kevin, National Association of Manufacturers, and United
Technologies Corporation....................................... 100
CSX Corporation, Peter J. Finnerty............................... 27
DaimlerChrysler Corporation, John L. Loffredo.................... 16
Dean, Warren L., Jr., Subpart F Shipping Coalition, and Thompson
Coburn LLP..................................................... 140
Deloitte & Touche LLP:
Philip D. Morrison........................................... 69
William W. Chip.............................................. 111
European-American Business Council, William W. Chip.............. 111
Finnerty, Peter J., CSX Corporation, and Sea-Land Service, Inc... 27
General Motors Corporation, William H. Laitinen.................. 116
Green, Richard C., Jr., UtiliCorp United......................... 12
Hamond, David, Section 911 Coalition............................. 124
H.B. Bouma, Hermann B. Bouma..................................... 93
Houghton, Hon. Amo, a Representative in Congress from the State
of New York.................................................... 9
International Tax Policy Forum, and Columbia University, R. Glenn
Hubbard........................................................ 47
Laitinen, William H., General Motors Corporation................. 116
Levin, Hon. Sander M., a Representative in Congress from the
State of Michigan.............................................. 5
Lipner, Alan J., American Express Company........................ 20
Loffredo, John L., DaimlerChrysler Corporation................... 16
Merrill, Peter R., PricewaterhouseCoopers LLP, and National
Foreign Trade Council, Inc..................................... 78
Morgan Stanley Dean Witter & Co., Harvey B. Mogenson............. 106
Morrison, Philip D., Deloitte & Touche LLP, and National Foreign
Trade Council, Inc............................................. 69
Murray, Fred F., National Foreign Trade Council, Inc............. 55
National Association of Manufacturers, Kevin Conway.............. 100
National Foreign Trade Council, Inc.:
Fred F. Murray............................................... 55
Philip D. Morrison........................................... 69
Peter R. Merrill............................................. 78
PricewaterhouseCoopers LLP, Peter R. Merrill..................... 78
Sea-Land Service, Inc., Peter J. Finnerty........................ 27
Section 911 Coalition, David Hamod............................... 124
Stiles, Sally A., Caterpillar Inc................................ 24
Subpart F Shipping Coalition, Warren L. Dean, Jr................. 140
Thompson Coburn LLP, Warren L. Dean, Jr.......................... 140
United Technologies Corporation, Kevin Conway.................... 100
UtiliCorp United, Richard C. Green, Jr........................... 12
SUBMISSIONS FOR THE RECORD
Ad Hoc Coalition of Finance and Credit Companies, LaBrenda
Garrett-Nelson, joint statement................................ 152
Alexander, Hon. Bill, American Citizens Abroad, Geneva,
Switzerland, statement and attachment.......................... 161
AlliedSignal, Larry Bossidy, joint statement and attachment...... 157
American Bankers Association, statement.......................... 159
American Citizens Abroad, Geneva, Switzerland, Hon. Bill
Alexander, statement and attachment............................ 161
American Petroleum Institute, statement.......................... 165
Blecher, M. David, Hewitt Associates, LLC, statement............. 189
Bossidy, Larry, Business Roundtable, and AlliedSignal, joint
statement and attachment....................................... 157
Brown, Timothy A., International Organization of Masters, Mates &
Pilots, Linthicum Heights, MD, Marine Engineers' Beneficial
Association, joint statement................................... 193
Business Roundtable, Larry Bossidy, joint statement and
attachment..................................................... 157
Council of Great City Schools, Rod Paige, joint statement........ 174
Crowley Maritime Corporation, Michael G. Roberts, letter and
attachments.................................................... 176
Ernst & Young LLP, Peter Kloet, Michael F. Patton, and John
Wills, letter.................................................. 179
Decker, Jane, Joint Venture: Silicon Valley Network, San Jose,
CA, letter..................................................... 201
Financial Executives Institute, Morristown, NJ, statement........ 183
Frank Russell Company, Tacoma, WA, Warren Thompson, statement.... 186
Garrett-Nelson, LaBrenda:
Ad Hoc Coalition of Finance and Credit Companies, and
Washington Counsel, P.C., joint statement.................. 152
Washington Counsel, P.C., statement.......................... 213
Gould, Jeffrey L., Youngstein & Gould, London, England, letter
and attachment................................................. 214
Hewitt Associates, LLC, M. David Blecher, statement.............. 189
Houston Public Schools, Rod Paige, joint statement............... 174
International Organization of Masters, Mates & Pilots, Linthicum
Heights, MD, Timothy A. Brown, joint statement................. 193
Interstate Natural Gas Association of America, statement......... 194
Investment Company Institute, statement.......................... 199
Joint Venture: Silicon Valley Network, San Jose, CA, Larry
Langdon, and Jane Decker, letter............................... 201
Kloet, Peter, Ernst & Young LLP, letter.......................... 179
Langdon, Larry, Joint Venture: Silicon Valley Network, San Jose,
CA, letter..................................................... 201
LeMaster, Roger J., Tax Council, letter.......................... 212
Leonard, Robert J., Washington Counsel, P.C., statement.......... 213
Marine Engineers' Beneficial Association, Lawrence H. O'Toole,
joint statement................................................ 193
Moss, Ralph L., Seaboard Corporation, letter..................... 206
Murrell, Richard, Tropical Shipping, Riviera Beach, FL, letter... 212
NEU Holdings Corporation, Whippany, NJ, Richard W. Neu, letter
and attachment................................................. 205
O'Toole, Lawrence H., Marine Engineers' Beneficial Association,
joint statement................................................ 193
Paige, Rod, Council of Great City Schools, and Houston Public
Schools, joint statement....................................... 174
Patton, Michael F., Ernst & Young LLP, letter.................... 179
Roberts, Michael G., Crowley Maritime Corporation, letter and
attachments.................................................... 176
Seaboard Corporation, Ralph L. Moss, letter...................... 206
Section 904(g) Coalition, statement and attachment............... 208
Tax Council, Roger J. LeMaster, letter........................... 212
Thompson, Warren, Frank Russell Company, Tacoma, WA, statement... 186
Tropical Shipping, Riviera Beach, FL, Richard Murrell, letter.... 212
Washington Counsel, P.C.:
LaBrenda Garret-Nelson, joint statement...................... 152
LaBrenda Garret-Nelson, and Robert J. Leonard, statement..... 213
Wills, John, Ernst & Young LLP, letter........................... 179
Youngstein & Gould, Jeffrey L. Gould, London, England, letter and
attachment..................................................... 214
IMPACT OF U.S. TAX RULES ON INTERNATIONAL COMPETITIVENESS
----------
WEDNESDAY, JUNE 30, 1999
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:02 p.m., in
room 1100, Longworth House Office Building, Hon. Bill Archer
(Chairman of the Committee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
June 15, 1999
No. FC-12
Archer Announces Hearing on
Impact of U.S. Tax Rules on International
Competitiveness
Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
and Means, today announced that the Committee will hold a hearing on
the impact of U.S. tax rules on the international competitiveness of
U.S. workers and businesses. The hearing will take place on Wednesday,
June 30, 1999, in the main Committee hearing room, 1100 Longworth House
Office Building, beginning at 10:00 a.m.
Oral testimony at this hearing will be from both invited and public
witnesses. Also, any individual or organization not scheduled for an
oral appearance may submit a written statement for consideration by the
Committee or for inclusion in the printed record of the hearing.
BACKGROUND:
The tax rules that apply to individuals and businesses with
international operations are among the most complex in the Internal
Revenue Code. These international tax rules often cause U.S. taxpayers
to structure their domestic and international activities in particular
ways. For instance, the current rules may effectively prevent a
taxpayer from undertaking a particular activity in a specific location,
business entity, or manner otherwise consistent with the taxpayer's
business interests. Similarly, the current rules may create incentives
to structure business activities in a particular location, entity, or
manner. Some of the consequences of these U.S. international tax rules
are intended; many, however, are either unintended or result from
competing tax, economic, or social policies in the international tax
rules.
In announcing the hearing, Chairman Archer stated: ``I have long
been interested in reform of our international tax rules. I strongly
believe that our tax rules must help, rather than hinder, the
competitiveness of American workers and businesses. People in too many
businesses, large and small, have described to me how our tax law has
affected their decisions regarding place of incorporation, choice of
business entity, and location of business assets and operations. Having
the tax system-rather than business, economic, or family
considerations-drive these decisions is troubling.
I am truly concerned by what I see happening to our economy. Are
the current rules arbitrary or unfair? Is the U.S. tax system
contributing to the de-Americanization of U.S. industry? Do our tax
laws force U.S. companies to be domiciled in foreign countries? Are we
making it a foregone conclusion that mergers of U.S. companies with
foreign companies will always leave the resulting new company
headquartered overseas? I want the Committee to examine (1) the effect
that our current international tax rules have on U.S. workers and
businesses, and (2) the policies (tax or otherwise) our international
tax rules ought to reflect and implement.''
FOCUS OF THE HEARING:
The hearing will focus on the impact of current U.S. tax rules on
international competitiveness including that on cross-border
transactions, international operations of U.S.-based companies, and the
treatment of U.S. citizens working in foreign countries. The hearing
will examine some of the problems caused by the current rules and
proposed solutions to these problems.
DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:
Requests to be heard at the hearing must be made by telephone to
Traci Altman or Pete Davila at (202) 225-1721 no later than the close
of business, Tuesday, June 22, 1999. The telephone request should be
followed by a formal written request to A.L. Singleton, Chief of Staff,
Committee on Ways and Means, U.S. House of Representatives, 1102
Longworth House Office Building, Washington, D.C. 20515. The staff of
the Committee will notify by telephone those scheduled to appear as
soon as possible after the filing deadline. Any questions concerning a
scheduled appearance should be directed to the Committee staff at (202)
225-1721.
In view of the limited time available to hear witnesses, the
Committee may not be able to accommodate all requests to be heard.
Those persons and organizations not scheduled for an oral appearance
are encouraged to submit written statements for the record of the
hearing. All persons requesting to be heard, whether they are scheduled
for oral testimony or not, will be notified as soon as possible after
the filing deadline.
Witnesses scheduled to present oral testimony are required to
summarize briefly their written statements in no more than five
minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full
written statement of each witness will be included in the printed
record, in accordance with House Rules.
In order to assure the most productive use of the limited amount of
time available to question witnesses, all witnesses scheduled to appear
before the Committee are required to submit 300 copies, along with an
IBM compatible 3.5-inch diskette in WordPerfect 5.1 format, of their
prepared statement for review by Members prior to the hearing.
Testimony should arrive at the Committee office, room 1102 Longworth
House Office Building, no later than, Monday, June 28, 1999. Failure to
do so may result in the witness being denied the opportunity to testify
in person.
WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:
Any person or organization wishing to submit a written statement
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch
diskette in WordPerfect 5.1 format, with their name, address, and
hearing date noted on a label, by the close of business, Wednesday,
July 7, 1999, to A.L. Singleton, Chief of Staff, Committee on Ways and
Means, U.S. House of Representatives, 1102 Longworth House Office
Building, Washington, D.C. 20515. If those filing written statements
wish to have their statements distributed to the press and interested
public at the hearing, they may deliver 200 additional copies for this
purpose to the Committee office, room 1102 Longworth House Office
Building, by close of business the day before the hearing.
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1. All statements and any accompanying exhibits for printing must
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2. Copies of whole documents submitted as exhibit material will not
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3. A witness appearing at a public hearing, or submitting a
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The above restrictions and limitations apply only to material being
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Note: All Committee advisories and news releases are available on
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The Committee seeks to make its facilities accessible to persons
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business days notice is requested). Questions with regard to special
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materials in alternative formats) may be directed to the Committee as
noted above.
Chairman Archer. Good morning. Today, the Committee is
holding what the Chair believes to be one of the most important
hearings that we will conduct for the entire year and that is
the effect of U.S. tax rules on our country's global
competitiveness.
As you all know, I have been a long-time advocate of
fundamental tax reform. In short, I do not believe we will ever
fix the income tax. That is perhaps an issue for another day. I
will continue to push to completely eliminate income as the
base of taxation because rather than this negative way to tax,
we could adopt a border adjustable consumption tax and one that
gets the IRS completely out of our everyday lives. In my view,
the notion of taxing the foreign earnings of American
corporations and not having a border adjustable Tax Code are
absurd in a competitive global economy. We force our businesses
to enter this arena with one hand tied behind their backs
relative to the Tax Codes of the countries where corporations
are competing against us.
However, those of you who still need convincing that we
should throw out our current income tax, I suggest you look
closely at the rules that apply to international transactions.
These rules are unbelievably complex and often at odds with our
economic goals. Professionals spend a lifetime trying to
understand the complexities of how we tax foreign source income
and, yet, there is massive disagreement among the experts
because of the complexities.
Our current tax rules are grossly outdated. The basic
Subpart F rules, for example, were enacted in 1962. These rules
reflect the economic climate of that time. In 1962, the United
States was a net exporter of capital and ran a trade surplus.
Imports and exports were only one-half of the percentage of GDP
that they are today. U.S. companies focused on the domestic
market and international trade had relatively little effect on
our economy. My how things have changed since 1962.
To put things in perspective, in 1962, the cost of college
was described by President Kennedy has skyrocketing to
astronomical levels of $1,600 a year. In 1962, a Japanese
motorcycle company called Honda decided to start making cars
for the first time. In 1962, Bill Gates was probably more
concerned about his second grade teacher than computer
software. The world has changed and our tax laws need to change
to.
In particular, I have been troubled by some aspects of the
recent acquisitions of U.S. companies. I do not have anything
against foreign investment in the United States. It is part of
a healthy, open economic system. I am very concerned that our
tax law increasingly puts American companies at a disadvantage
in the world marketplace. How we tax foreign source income will
influence what kind of economy we have in the long-run,
specifically, whether we have a strong and vibrant economy with
competitive workers and companies, whether we can create more
jobs for export which pay on average 17 percent more to the
workers of this country.
As a growing consensus develops behind the need to re-
examine and modify our international tax rules, there have been
some significant studies and reports in this area, and we will
hear about them from several witnesses today.
The Treasury Department is also undertaking a study of the
Subpart F rules. I do not know whether I will agree with
anything in the Treasury's study, but I do know that we need to
have an open-minded debate. I urge us all, Congress, the
administration, and the private sector, to get involved in this
debate. Our long-term economic well-being is at stake.
If there is anyone here on the minority, I would be happy
to recognize them for a statement. Mr. Levin, would you like to
make a statement on behalf of the minority or do you want to
wait until you make your statement from the witness stand?
Mr. Levin. I think I will wait for the latter. I think once
will be enough.
Chairman Archer. All right.
Mr. Levin. Thank you.
Chairman Archer. Well, we are fortunate to start off today
with two respected Members of the Ways and Means Committee. I
hope that this augurs that there is bipartisanship on this
entire issue. We are happy to recognize first Mr. Levin of
Michigan?
STATEMENT OF HON. SANDER M. LEVIN, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF MICHIGAN
Mr. Levin. Thank you, Mr. Chairman, and my colleagues on
the Ways and Means Committee and especially hello to the
gentleman next to me. We have been working together in the
international tax area for a number of years. And I fully
concur with your discussion, with your suggestion, Mr.
Chairman, that we very much need to debate the international
tax field. Wherever one comes from, I think it is vital that we
continue to do that. And Mr. Houghton and I are pleased to
report to you on our further package of proposals.
This is the fourth bill that we have put together and the
third on a bipartisan basis with Senators Hatch and Baucus.
This bill contains a long list of proposals unified by a
common theme. The way we tax the income of U.S. companies doing
business abroad should reflect the economic realities of doing
business abroad and should facilitate the efficient allocation
of resources. Guided by that principle, our bill seeks to
further amend the U.S. international tax regime in a way that
will simplify the reporting burden, enhance the competitiveness
of U.S. businesses and their workers, and promote exports.
This bill seeks to further update the U.S. international
tax regime by bringing it into further sync with the realities
and demands of the modern business environment. We made
substantial progress though there are no doubt continuing
problems in the 1997 legislation, and let me just review them
very quickly so we have that background.
As you know, one of the changes related to active
financing. Our Tax Code generally defers taxation of
manufacturing income of U.S. controlled foreign corporations,
CFCs, until that income is repatriated. In enacting the 1997
legislation, we recognized that the time has come to apply the
same common sense policy to financial services companies,
banks, brokers, insurance companies, auto financing companies,
that we apply to manufacturers.
Second, reporting by so-called 10/50 companies. A number of
American companies engage in business abroad through joint
ventures in which they hold more than 10 percent but less than
50 percent of the equity. Prior to 1997, each so-called 10/50
venture was treated separately for purposes of determining
foreign tax credit limitations. This rule resulted in
tremendous reporting burdens for U.S. companies doing business
through multiple 10/50 ventures with little impact, little
impact on their ultimate tax liability. Thanks to reforms
enacted in the 1997 act, a look-through rule will kick in
beginning in the year 2003 that will allow U.S. companies to
group income from 10/50 ventures, greatly reducing their
reporting burden. Another change related to the overlap between
P-FIC and CFC rules.
So there has been some progress, but much work remains to
be done. And let me highlight, if I might, just a few of the
key provisions in H.R. 2018. And my colleague and friend, Mr.
Houghton, will give a more general overview.
One of the changes is to make the deferral of active
financing income permanent. The last change, the change I
mentioned, is due to expire at the end of the year.
Mr. Chairman and my colleagues, I hope as we look at
expiring provisions, we will take a hard look at this provision
because, as with other expiring provisions of the Tax Code,
such as the R&D credit, expiration of this provision and
uncertainty as to whether it will be extended impairs
businesses' ability to plan ahead, and I don't think I need to
elaborate on that view, Mr. Chairman and my colleagues.
The second proposed change, and I referred earlier to the
treatment of 10/50 companies, that would not go into effect
until the year 2003 and this bill proposes would make it
effective at the beginning of next year.
Let me just spend a little more time on a provision
relating to section 202 to make domestic loss recapture rules
mirror foreign loss recapture rules. Currently, if a U.S.
company experiences a loss in its foreign operations in a given
year, it may deduct that loss against U.S. source income. If
the foreign operations turn a profit in a subsequent year, the
loss is recaptured, i.e., the U.S. company is required to
characterize a portion of that profit as U.S. source income,
thus, effectively reducing its ability to use foreign tax
credit. This ensures that the company will not receive a double
benefit. But a similar rule does not apply when a U.S. company
experiences a loss in U.S. operations in 1 year and a profit in
a second subsequent year.
Our bill proposes to correct this asymmetry and I elaborate
on this on my statement to Mr. Chairman, which I know you will
place in the record.
Let me finish by referring to two issues that will be
discussed by further panels where----
Chairman Archer. Mr. Levin, let me make a general
observation that without objection, all written statements of
every witness will be inserted in full into the record.
Mr. Levin. Thank you. And I shall finish, Mr. Chairman, by
reference to two studies that this bill of Mr. Houghton and
others of our colleagues and mine proposes. A study, first of
all, of treating the European Union as a single country for tax
purposes. And perhaps we will want to go into this further. Mr.
Houghton had an oversight hearing where this issue was
discussed at great length. It is not a simple issue. We clearly
need to study it to prepare to be able to act on it. The second
study, our bill would direct Treasury to study current rules
for allocating interest expense between domestic and foreign
operations and the effect that those rules have on different
industries.
We have made some progress but we need to continue this
effort. We can help bring our Tax Code further up-to-date in a
way that will make U.S. companies and U.S. goods produced by
American workers more competitive. These are goals on which I
am sure we can all agree, and I am committed to continue to
work with Members of this Committee and with Mr. Houghton and
the Senate to advance those goals.
Thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Hon. Sander M. Levin, a Representative in Congress from
the State of Michigan
Thank you Mr. Chairman for giving me the opportunity to
testify before this Committee. I am pleased to report to you on
the package of international tax simplification proposals that
Mr. Houghton and I, along with a number of our colleagues, have
put together in this session.
This is the fourth such bill on which I have had the
privilege to work with Mr. Houghton, and our third with
Senators Hatch and Baucus.
The bill, H.R. 2018, contains a long list of proposals
unified by a common theme: The way we tax the income of U.S.
companies doing business abroad should reflect the economic
realities of doing business abroad and should facilitate the
efficient allocation of resources. Guided by that principle,
our bill seeks to amend the U.S. international tax regime in a
way that will simplify the reporting burden, enhance the
competitiveness of U.S. businesses and their workers, and
promote exports.
There has not been a major review of our international tax
regime since 1986. The commercial landscape has changed
significantly since then. Increasingly, as international
business transactions have become the norm, it has been
necessary to re-assess when rules designed to rein in tax
avoidance have the effect of deterring or severely burdening
transactions undertaken for legitimate and, from the point of
view of American competitiveness, desirable, economic reasons.
Today, companies regularly take advantage of the gains in
efficiency that come from locating strategically in multiple
points around the globe. It is not uncommon for a U.S. company
to rely on a support network based in several different
countries. This is how companies operate in today's business
environment. Not only does strategic location around the globe
make U.S. companies more competitive, it also can increase
demand for U.S. exports, since U.S. companies operating
overseas are very likely to purchase U.S. goods and services.
Our International Tax Simplification bill seeks to update
the U.S. international tax regime by bringing it in to sync
with the realities and demands of the modern business
environment.
We made substantial progress towards that end in the
Taxpayer Relief Act of 1997 and in international tax
simplification measures enacted last year. Some of our changes
were in the following areas:
Active Financing: Our Tax Code generally defers taxation of
manufacturing income of U.S. controlled foreign corporations
(CFCs) until that income is repatriated. This rule ensures that
a German subsidiary of a U.S. company will be taxed in the same
way as other German-based companies with which it competes. It
will not be handicapped by current U.S. taxation of its income
in addition to German taxation of the same income. In enacting
the Taxpayer Relief Act of 1997, we recognized that the time
has come to apply the same common-sense policy to financial
services companies--banks, brokers, insurance companies, auto
financing companies--that we apply to manufacturers.
Reporting by 10/50 Companies: A number of U.S. companies
engage in business abroad through joint ventures in which they
hold more than 10% but less than 50% of the equity. Prior to
1997, each so-called 10/50 venture was treated separately for
purposes of determining foreign tax credit limitations. This
rule resulted in tremendous reporting burdens for U.S.
companies doing business through multiple 10/50 ventures with
little impact on their ultimate tax liability. Thanks to
reforms enacted in the Taxpayer Relief Act, a ``look-through''
rule will kick in beginning in 2003 that will allow U.S.
companies to group income from 10/50 ventures, greatly reducing
their reporting burden.
Overlap Between P-FIC and CFC Rules: Prior to 1997, confusing
and sometimes conflicting regimes applied when a controlled
foreign corporation (CFC) engaged in active business
accumulated enough income from passive investments to trigger
rules regarding passive foreign investment companies (P-FIC).
The 1997 Act eliminated this problem by providing that under
most circumstances the P-FIC rules will not apply to CFCs
engaged primarily in active business.
I am pleased by the progress we made in the last Congress.
But much work remains to be done. Our goal in this Congress is
to build on the accomplishments of the last Congress. Let me
highlight a few of the key provisions in H.R. 2018:
Make Deferral of Active Financing Income Permanent (Sec.
101): The rule that makes active financing income exempt from
current taxation (like manufacturing income) is due to expire
at the end of this year. As with other expiring provisions of
the Tax Code (such as the R&D credit), expiration of this
provision and uncertainty as to whether it will be extended
impairs businesses' ability to plan ahead. The lack of
predictability is an unnecessary cost that reduces
competitiveness.
Accelerate Look-Through Treatment for 10/50 Companies (Sec.
204): As I mentioned earlier, the ``look-through'' rule that
will simplify reporting for U.S. companies engaged in 10/50
joint ventures will not kick in until January 1, 2003. Our bill
proposes acceleration of this much-needed element of
simplification to January 1, 2000.
Make Domestic Loss Recapture Rule Mirror Foreign Loss
Recapture Rule (Sec. 202): Currently, if a U.S. company
experiences a loss in its foreign operations in a given year,
it may deduct that loss against U.S.-source income. If the
foreign operations turn a profit in a subsequent year, the loss
is ``recaptured''--i.e., the U.S. company is required to
characterize a portion of that profit as U.S.-source income
(thus, effectively reducing its ability to use foreign tax
credits). This ensures that the company will not receive a
double benefit--first, the benefit of applying a foreign loss
against U.S. income, and second, the benefit of a foreign tax
credit on the subsequent foreign-source income. A similar rule
does not currently apply when a U.S. company experiences a loss
in U.S. operations in one year and a profit in a subsequent
year. Thus, a loss attributable to domestic operations in a
given year must be spread over worldwide income. This reduces
the loss carryover the company would have but for its foreign
income, and it reduces the limit against which the company may
apply foreign tax credits.
Our bill proposes to correct this asymmetry by allowing a
U.S. company in the latter situation to characterize U.S.
income in a subsequent year as foreign-source income. Instead
of suffering a double detriment as a result of a loss
attributable to U.S. operations, the detriment would be offset
by an increase in the company's foreign tax limitation in a
subsequent year when U.S. operations are profitable.
In addition to the foregoing examples, and a list of other
proposals, our bill calls for the study of issues that are
becoming increasingly important as the commercial environment
in which U.S. companies operate evolves. These include:
Treating the European Union as a Single Country for Tax
Purposes (Sec. 102): The anti-deferral regime in Subpart F is
subject to certain exceptions for transactions that take place
within a single country. Our bill would require the Department
of Treasury to study whether the European Union should be
treated as a single country for such purposes.
Interest Allocation (Sec. 309): Our bill would direct
Treasury to study current rules for allocating interest expense
between domestic and foreign operations and the effect that
those rules have on different industries.
I am very encouraged by the progress we have made to date
in the area of international tax simplification. By continuing
this effort, we can bring our Tax Code up to date in a way that
will make U.S. companies and U.S. goods produced by American
workers more competitive. Those are goals on which I am sure we
can all agree, and I am committed to working with the Members
of this Committee to advance those goals.
Thank you, Mr. Chairman.
Chairman Archer. Mr. Houghton, we are pleased to have you
as a witness before the Committee and welcome. You may proceed.
STATEMENT OF HON. AMO HOUGHTON, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF NEW YORK
Mr. Houghton. Thank you very much. Thank you, Mr. Chairman.
Well, Mr. Chairman, I appreciate the opportunity to be here,
not only to testify here with people who I am sure have the
feelings about our tax system, but also with Mr. Levin, who I
have got tremendous respect for. Mr. Levin has spelled out a
lot of the things. I am not going to go into the details. The
testimony will be submitted for the record. I just want to hit
some of the high spots.
Really because of your concerns, a number of the provisions
in our prior bills have been enacted. For example, simplifying
the translation of foreign taxes using average exchange rates,
an extension of tiers for the indirect foreign tax credit.
Those things were all a result of what you did and reaction to
some of the pieces of legislation that Mr. Levin and I have put
forward.
As Mr. Levin has said, we had a hearing of the Oversight
Committee last week on the bill and other international tax
simplification issues. In our bill, 2018, it contains about 26
provisions to change the tax law affecting multinational
corporations. And I am not going to go into the details at this
time. They are all spelled out. Be glad to talk about them
whenever you would like.
But I do want to mention a concern I expressed last week
and that is the disconnect between our tax laws and our trade
laws. On the one hand, we pass trade laws to encourage exports
by U.S. companies, then we retain or impose restrictive tax
laws relating to the multinationals themselves. So many times
these tax laws place U.S. companies at a disadvantage vis-a-vis
their competitors overseas.
Since I have been on this Committee, we have passed a
variety of trade laws: NAFTA, GATT, African Growth, CBI, NTR
for China each year. Why? The reason being to break down,
obviously, the trade barriers to increase opportunities for
American workers and American companies to trade overseas.
Now are markets are open. I don't think there is a more
open economic system in this world. So we need to continue to
push for markets to be open abroad and it is a constant,
constant push. It is important we update U.S. international tax
laws now, and we need to re-work the system so that it helps
U.S. businesses become more competitive. Today, the tax laws I
believe stand in the way, and I think that Mr. Levin would
agree with that.
And our bill, we hope, will help. But beyond that, we need
to take a hard look at Subpart F, as well as the foreign tax
credit provisions of the Code.
So, Mr. Chairman, I appreciate being here. I applaud your
efforts of holding this hearing and the goals and objectives
you spelled out and it is important that we address these now.
If I could really sort of sum up, I think that there are
three or four big things. Every so often, you need to open the
file and take a look at what you have got and judge is this
what we intended in the first place? And as far as our tax laws
now, I have got to believe there is a lot of correction to be
made. Second, tax laws should be compatible with our trade
laws. Third, there should be no double taxation, that was the
whole concept initially. And the fourth thing is to simplify
it, to simplify because as these things go and corrode and get
more complicated, they obliterate the real reason for the law
in the first place.
Thank you very much.
[The prepared statement follows:]
Statement of Hon. Amo Houghton, a Representative in Congress from the
State of New York
I wish to thank Chairman Archer and Representative Rangel
for the opportunity to appear before the Committee to discuss
the issue of the U.S. international tax laws and how that
affects the competitiveness of our multinational companies vis-
a-vis their foreign counterparts. I am appearing here today
with my colleague, Sander Levin from Michigan, a Member of this
Committee.
Mr. Levin and I have introduced a bill, H.R. 2018,
``International Tax Simplification for American Competitiveness
Act of 1999.'' The bill contains twenty-six (26) provisions to
change tax law affecting multinational companies. Most are
simplification proposals. Some are included in separate tax
bills before this Committee. This is the third international
tax simplification bill we have introduced in as many
Congresses. Because of your concerns regarding the negative
effect of the international tax system on U.S. multinationals,
a number of our proposals in the earlier bills have been
enacted, and I thank you for that.
I do not intend to dwell on the detailed provisions in our
bill. The Oversight Subcommittee had a hearing last week. There
was a good discussion of the various provisions in the bill, as
well as other international tax issues. We will hear more on
those from today's witnesses.
I would to like to take a minute to emphasize a concern
which I mentioned the other day at the Oversight hearing. This
is the disconnect between our tax laws and trade laws. On the
one hand we pass trade laws to encourage exports by U.S.
companies, then we retain or impose restrictive tax laws
relating to multinationals which not only are complex, but in
many cases place our companies at a disadvantage vis-a-vis
their foreign competitors. As a result, we hear horror stories
about complexity, mountains of paperwork, legions of talented
people gathering tax information, ``name'' companies moving
abroad, etc.
Since I have been on this Committee, Congress has passed a
variety of trade laws, including implementation of NAFTA,
Uruguay Round of GATT, normal trade relations for China on an
annual basis, and recently the African Growth and Opportunities
Act and the Caribbean Basin Initiative. The policy behind each
of these bills has been to break down trade barriers and expand
export opportunities for U.S. firms and workers. Our markets
are open. It is important that we push for open markets abroad.
It is important that we update U.S. international tax laws
now. I believe it is time to rework the system so that it helps
U.S. businesses become more competitive. A strong economy in
the U.S. is driven by how competitive our companies are around
the globe. Today the international tax laws stand in the way.
Our bill will help. Beyond that we need to take a hard look at
Subpart F as well as the foreign tax credit provisions of the
Code.. Many of the complexities of the Code spring from these
provisions. The provisions can lead to double taxation. They
can throw up roadblocks to capital formation.
In the 1960s, the U.S. accounted for more than 50% of
cross-border direct investment. By the mid-1990s, that had
dropped to 25%. In the 1960s, 18 of the world's largest
corporations, ranked by sales, were headquartered in the U.S.
By the mid-1990s that number had dropped to 8. Despite the
decline of U.S. dominance of world markets, the U.S. economy is
far more dependent on foreign direct investment than ever
before. In the 1960s, foreign operations averaged just 7.5% of
U.S. corporate net income. By contrast, over the 1990-1997
period, foreign earnings represented 17.7% of all U.S.
corporate net income. The same story is true regarding exports.
They have gone from 3.2% of national income to 7.5% in a
comparable period.
Mr. Chairman, I applaud you for holding this hearing. It is
a most important subject. The law as now constituted frustrates
the legitimate goals and objectives of American business and
erects artificial and unnecessary barriers to U.S.
competitiveness. Neither the large U.S. multinationals nor the
Internal Revenue Service are in position to administer and
interpret the web of complexity that makes up the foreign tax
provisions in our Code. It is important that we address these
issues as we are doing today. It is also important that we take
action. Thank you, Mr. Chairman.
Chairman Archer. The Chair is grateful to both of you
because I do not think there is enough interest on the part of
either members or the general public in this issue, which is
going to loom as more vital to the welfare of every working
American in the next century. That is why I said I think this
may be one of the most important hearings that we will have
this year. I wish it could be beamed into the homes of every
single American so that Americans would have an understanding
of how they are not really insulated from this, but they
ultimately are directly connected with it. I, of course, agree
with everything that both of you have said, and I thank you for
your work on your legislation.
Does any other member wish to inquire?
[No response.]
If not, thank you very much.
Mr. Levin. Thank you.
Mr. Houghton. Thank you.
Chairman Archer. We will be pleased to welcome our next
panel: Mr. Green, Mr. Loffredo, Mr. Lipner, Ms. Stiles, and Mr.
Finnerty. If you will come to the witness table, please?
Good morning and welcome. Mr. Green, if you would lead off,
the Chair would be pleased to hear your testimony. If you will
identify yourself first for the record and that would be true
for each of you. You may proceed. Under the rules of the
Committee, we would ask you to try to stay within the 5 minute
on your oral testimony and your entire written statement will
be inserted in the record.
Mr. Green, you may proceed.
STATEMENT OF RICHARD C. GREEN, JR., CHAIRMAN AND CHIEF
EXECUTIVE OFFICER, UTILICORP UNITED, KANSAS CITY, MISSOURI
Mr. Green. Thank you, Mr. Chairman. I have submitted a
written statement and these oral comments are a summary of
that. My name is Rick Green. I am chief executive officer of
UtiliCorp United, an international energy company headquartered
in Kansas City, Missouri.
Let me first acknowledge that much of the business
community is grateful for the efforts of this Committee to
improve our Nation's ability to compete in the global economy.
And I do welcome this opportunity to address what I think is a
very serious problem that unfairly constrains international
growth aspirations of American companies. The inequity that I
am talking about is that of the interest allocation rules of
the U.S. Tax Code. This problem looms large over many American
companies doing business abroad. And we at UtiliCorp support an
economy-wide solution.
However, I can best describe the inequity that poses the
problem to our competitiveness by looking at the industry I
know best: regulated utilities. This industry offers an
especially poignant example of the problem. The global needs of
energy are poised for explosive growth. To meet the growing
needs, companies, markets, governments need to dramatically
alter the way we do business. The vigorous demands of this
marketplace are pointing to the fault lines in our tax rules.
This impairs what otherwise would be a strong competitive
instinct of our American companies. Huge amounts of capital are
going to be required to take advantage of these emerging
opportunities. Unfortunately, outdated interest allocation
rules act as a strong disincentive, literally trapping American
corporate funds in foreign countries where they cannot be
efficiently utilized.
When U.S. companies doing business overseas prepare their
returns under present law, tax on foreign income is paid in the
foreign country and again in the United States, but without
full credit. That is double taxation, pure and simple. Many of
the foreign competitors have no such burden. Their profits from
the United States are free to go home, strengthen their
operations on their own turf and fund other international
ventures, possibly even including additional U.S. acquisitions.
As an American chief executive officer, I would love to have
that choice. But as it is, I only have one choice, that is to
leave such funds overseas or take a double tax hit.
In some respects, the concerns I have raised would apply to
many U.S. corporations doing business internationally. But my
operating arena, the utility industry, is especially hurt by
existing interest allocation rules. The current interest
apportionment formula harms an industry such as mine because a
disproportionate amount of U.S. interest is allocated to
foreign source income thereby reducing and sometimes
eliminating the foreign tax credit and creating a double tax.
Some of the contributing factors to this are the facts that
utilities are capital intensive businesses, holding long-lived
assets that are among the more highly leveraged U.S. companies.
The greater the leverage, the greater the interest expense, the
greater the interest to be allocated, therefore decreasing the
foreign tax credit.
Also, because of our inability to transport electricity or
gas over long distances, particularly over an ocean, U.S.
utilities must establish a taxable presence where the utility
customer resides. This means the U.S. utilities generally do
not have the ability to generate low tax foreign income to
offset the disadvantage caused by the interest allocation
rules.
Foreign utility companies generally are not subject to the
same regulatory restrictions as U.S. utility companies in
making foreign investments. This is a serious competitive
disadvantage. U.S. tax law should not further compound this
problem.
The proposed solution we would like you to consider
eliminates double taxation, changing the allocation rules to
take into account foreign interest in the interest allocation
formula. As I have stated, we believe the solution should be
available to all U.S. companies eligible for foreign tax
credit. However, Mr. Chairman, we understand there may be
revenue constraints and if it is not possible to enact this
with an immediate effective date, we hope you will consider a
phased in approach, phased in across all American industry with
an initial focus on those most negatively impacted.
Mr. Chairman, American know-how, muscle, capital have built
an energy system that is the envy of the world. In fact, it is
clear to foreign corporations that they cannot be successful in
the emerging global energy market unless they are a player in
our U.S. markets. U.S. tax policy should not unduly
disadvantage U.S. companies in their efforts to expand
internationally. We, therefore, respectfully request relief
from double taxation we presently face under the existing
interest allocation rules.
Thank you, Mr. Chairman, for the opportunity to appear
here.
[The prepared statement follows:]
Statement of Richard C. Green, Jr., Chairman and Chief Executive
Officer, UtiliCorp United
Mr. Chairman . . . Members of the Committee, my name is
Rick Green and I am the Chief Executive Officer of UtiliCorp
United, an international energy company based in Kansas City,
Missouri. Much of the business community is already grateful
for the efforts of this Committee to resolve some of the more
critical issues facing our country in dealing with increasingly
sophisticated and vigorous international competition.
Therefore, I welcome this opportunity to address a very
serious problem that unfairly constrains the international
growth aspirations of American companies--the inequity of
interest allocation rules in the U.S. Tax Code that limit the
ability of American businesses to compete.
Let me emphasize that this problem looms large over many
American companies doing business abroad. I can best describe
the nature and extent of this threat to our competitiveness by
reference to the industry that I know best--regulated energy
suppliers. And as will become evident, this industry offers an
especially poignant example of the problem.
Although my comments have a utility industry focus, at
UtiliCorp we've identified a possible remedy to this inequity
for your consideration which we think would apply to all U.S.
businesses. I'll discuss that more later, but I must emphasize
that the problem is particularly onerous for the U.S. regulated
utility industry.
The current tax law does not give companies the ability to
efficiently bring cash generated from foreign investments back
to the U.S.--therefore, when UtiliCorp makes a foreign
investment, it is evaluated as a ``cash invested offshore''
strategy. This obviously does not provide the best answer to
the U.S. economy, or to our shareholders.
I thought it also might be helpful if I could provide some
context by offering a closer look at how one U.S. utility
company views the emerging reality of the global energy
marketplace. For it is the rigorous demands of this marketplace
that are pointing to the fault lines in our tax rules which
impair the otherwise strong competitive instincts of American
companies.
UtiliCorp has been pursuing investments overseas since 1987
first in Canada, and later in Great Britain, New Zealand and
Australia. To date we have invested $1.4 billion in
international projects and plan to seek additional
opportunities. We're currently taking steps to participate on
the European Continent as the markets in those countries open
to competition.
Driving all this is the creation of a new global energy
industry that is creating immense global opportunities for
American companies willing to change the way they think and do
business.
It's very clear to us at UtiliCorp that if we and the U.S.
economy are going to continue to be successful competitors, all
of our people, policies, systems, processes and tools will have
to adapt to reflect the best-of-class global standards that are
shaping this new industry. Global markets are developing,
customers are becoming available, and the competitive instincts
of American business are creating a sense of urgency to capture
those customers.
In fact, in an industry not typified in the past by
venturing much beyond the monopoly-protected confines of highly
regulated U.S. turf, we were one of the first--if not the
first--to begin more than a decade ago to prepare for this new
reality by exploring overseas markets as pathways to growth and
greater opportunities for our shareholders and employees.
Achievement of these goals means UtiliCorp has to reinvent
itself nearly every day, changing those things under our
control to meet the demands of a constantly churning global
marketplace, or coming here to Washington as I am today, to
point to changes needed on matters beyond the control of the
private sector.
The global need for energy is poised for explosive growth.
Throughout the world, one third of humanity does not even have
access to energy as we know it. As many as two billion people
still meet their daily energy requirements by burning wood or
cow dung. Some 80% of energy used around the world is not
renewable.
So, the challenge that needs to be recognized by companies,
governments and markets is that in order to meet these growing
energy needs they must dramatically alter the way they do
business. In the U.S., we need to adopt a philosophy of growth
based on rational tax policies that enhance rather than impede
the deployment of capital in order to create competition and
develop emerging markets.
We must also continue to develop energy supply and
efficient delivery system while pushing the boundaries to make
renewable energy sources more economical and commercially
viable as American companies move forward.
There are, of course, many places around the globe that
don't have anything near the kind of energy infrastructure that
would support a thriving competitive market, and American
companies can capitalize on that. On the other end of the
spectrum, there are a number of ``gold plated'' infrastructures
out there, constructed when cost-plus regulation was a reality,
that need to be simplified to take advantage of today's market.
Huge amounts of capital will be required to take advantage
of these emerging opportunities. Unfortunately, outdated U.S.
tax laws act as a strong disincentive, literally trapping
American corporate funds in foreign countries where they cannot
be efficiently utilized.
When U.S. companies doing business overseas prepare their
returns under present law, tax on foreign income is paid in the
foreign country and again in the U.S. but without full credit.
That's double taxation, pure and simple.
Many of our foreign competitors have no such burden. Their
profits from U.S. investments are free to go home to strengthen
operations on their own turf, or to fund other international
ventures, possibly even including additional U.S. acquisitions.
As an American CEO, I'd love to have that choice. As it is, we
have but one choice--to leave such funds overseas or take the
double tax hit.
UtiliCorp has closely examined a number of investment
opportunities in Portugal, the United Kingdom, South America,
Canada and other parts of the world. In cases where we were
competing against foreign buyers with tax laws more favorable
than our own, it has been impossible to compete.
In some respects, the concerns I've raised would apply to
many U.S. corporations doing business internationally, but my
operating arena the utility industry is especially hurt by
existing interest allocation rules. The current interest
apportionment formula harms an industry such as mine because a
disproportionate amount of U.S. interest is allocated to
foreign source income, thereby reducing or eliminating the
foreign tax credit and creating the double tax.
Contributing factors include:
U.S. utility assets are older and more fully
depreciated than our foreign assets. Since interest is
allocated based on the ratio of foreign assets to total assets,
and foreign assets would be newer and less depreciated, an
increased amount of interest is allocated to foreign source
income which reduces the foreign tax credit and creates the
double tax situation.
U.S. utility assets are amortized using
accelerated depreciation rules, while foreign assets are
amortized using slower straight-line depreciation rules which
again creates a disproportionately higher foreign asset base.
This increases the amount of interest allocated to foreign
income and further compounds the problem.
Utilities are capital-intensive businesses holding
long-lived assets and they tend to be more highly leveraged
than companies in other industries. The greater the leverage,
the greater the interest expense, thus creating a larger pool
of interest to be allocated. This factor, coupled with the
preceding points, causes an increased amount of interest to be
allocated to foreign source income, thereby decreasing the
foreign tax credit.
Foreign utility companies generally are not
subject to the same regulatory restrictions as U.S. utility
companies in making foreign investments, thus creating a
serious competitive disadvantage. U.S. tax law should not
further compound this problem.
Because the era of opportunity for U.S. investment
in foreign utilities is relatively new, a federal tax stumbling
block to exploitation of investment opportunities by U.S.
utilities today will have long-lasting effects on our future
competitiveness in foreign markets.
Because of the inability to transport electricity
or gas over long distances, particularly over the ocean, U.S.
utilities must establish a taxable presence where the utility
customers reside. This means that U.S. utilities generally do
not have the ability to generate a low-tax foreign income to
offset the disadvantage caused by the interest allocation
rules. By contrast manufacturing, transportation, and
communications industries generally can make cross-border sales
and thereby generate low tax foreign source income.
U.S. utility companies generally are not able to
generate low-tax foreign source income through licensing of
intangibles offshore, such as intellectual property. For
example, utilities generally own little or no intellectual
property, trademarks, trade names, and so on.
The proposed solution we'd like you to consider eliminates
double taxation by changing the allocation rules to take into
account foreign interest in the interest allocations formula.
As I have stated, we believe the solution should be available
to all U.S. companies eligible for the foreign tax credit.
However, Mr. Chairman we understand there may be revenue
constraints and if it is not possible to enact this with an
immediate effective date, we hope you will consider a phased-in
approach, a phase-in across all American industries with an
initial focus on those most negatively impacted.
To sum up, Mr. Chairman, for our industry the market's
expectations are a lot tougher today. In times past, in that
earlier model in which we operated, we would just deliver safe,
reliable, energy in our local monopoly territories--that was
it. We could go home. Job done. Not so any more. That's just
entry-level performance, and a far cry from global best-of-
class.
To achieve that distinction we must consistently, each and
every day, strive for the opportunity to reach and serve the
global customer and make that customer more comfortable at home
and more efficient in the workplace. That means we have to go
beyond just delivering the energy. We have to understand our
customers far deeper and better than we ever have before and
make significant investments overseas and in the improved
products and services the global customer base needs, expects
and deserves.
If American companies don't do it, our foreign counterparts
will. That's what competition is all about. The companies--and
countries--that make this fundamental shift will thrive and
grow at the leading edge of these global changes. The ones that
do not will be swept aside to tumble in the wake of the
leaders.
The people who run utilities and other companies overseas
are savvy international business people. They realize that to
be effective players on the global energy stage they've got to
have a solid presence in the U.S. marketplace, the most
advanced and lucrative in the world.
And one of the reasons our market is so attractive is that
perhaps its most valuable asset is the skills and knowledge
embedded in the experience of the Americans we employ. We don't
export jobs, Mr. Chairman--but we do export that knowledge.
It's a tremendously valuable commodity.
Mr. Chairman, American know-how, capital and muscle have
built a truly ``First Tier'' energy system that's the envy of
the world. That's why foreign investors already are moving
aggressively to buy U.S. utilities, such as the acquisition of
PacifiCorp by Scottish Power and the U.K.'s National Grid
acquisition of New England Electric System.
Earlier this month when approving the Scottish Power and
National Grid acquisitions, FERC Chairman James Hoecker said
the deals, and I quote, ``illustrate(s) how attractive U.S.
utility assets are to international markets.''
But I hope you understand that I am not advocating
protectionism. I am not asking for a bailout or special breaks
or loop-holes. All I am seeking are straightforward tax rules
that recognize this new global marketplace and help to provide
an equitable solution for American companies and the U.S.
economy.
There should be no question that U.S. enterprise knows how
to compete, but it is absolutely vital that our government act
to let us play to our strengths. If you don't, then the U.S.
utility industry, which presently occupies the First Tier among
the world's utilities, could quickly be relegated to a position
on the second or third tier behind our foreign competitors.
U.S. tax policy should not unduly disadvantage U.S.
companies in their efforts to expand internationally. We
respectfully request relief from the double taxation we
presently face under the existing interest allocation rules,
which create an impediment to the ability of American
enterprise to compete.
Acting now to sweep these tax impediments aside before a
crisis develops is vastly preferable to coming back later to
shore things up after the damage to the U.S. economy and U.S.
companies is done.
Thank you for this opportunity to appear before you, Mr.
Chairman. Now, I'd be pleased to address whatever questions you
or the Committee may have.
Chairman Archer. Mr. Green, thank you.
Our next witness is Mr. John Loffredo. Mr. Loffredo, we are
happy to have you with us. If you will identify yourself for
the record, you may proceed.
STATEMENT OF JOHN L. LOFFREDO, VICE PRESIDENT AND CHIEF TAX
COUNSEL, DAIMLERCHRYSLER CORP.
Mr. Loffredo. Thank you. My name is John Loffredo, and I am
vice president and chief tax counsel for DaimlerChrysler Corp.,
the U.S. arm of DaimlerChrysler A.G. The merger of Chrysler
Corp. and Mercedes Benz was a marriage of two global
manufacturing companies, one with its core operations in North
America and the other headquartered in Europe with operations
around the world. I thought I would share with you today some
of the tax considerations, just some of them, that went into
determining whether the new company should be a U.S. company or
a foreign company.
Both companies, Chrysler and Daimler Benz, knew that after
the merger, these companies would continue to pay their fair
share of taxes to the countries in which they operated.
Therefore, the merger would not reduce or eliminate the
company's taxes in the United States or Germany on operations
in those countries. However, the new company was concerned that
it only pay tax to the country where the income was earned and
not a second time on dividends repatriated from its foreign
operations. And, second, it would be subject to immediate
taxation on normal, active business income earned outside the
country of incorporation.
There was a clear, distinct choice to be made between the
U.S. tax laws and those of most acceptable foreign countries.
Management chose a company organized under the laws of Germany.
The German tax system is based on the territorial theory. By
contrast, the U.S. tax system follows a philosophy of taxing
the worldwide income of a U.S. company while allowing tax
credits for taxes paid to foreign governments.
At the time of the merger, the German Territorial Tax
System allowed qualified dividends received from foreign
subsidiaries to be tax-free in Germany. Recent tax law changes
in Germany now tax 15 percent of the dividends received from
these companies. When DaimlerChrysler Corporation earns income
in the United States and it elects to dividend some of its
aftertax earnings from the United States to Germany, less a 5
percent withholding tax, these dividends are now taxed in
Germany at 3.5 percent. Therefore, we have a degree of
certainty as to the amount of tax that will be paid on the U.S.
operations of DaimlerChrysler.
However, under the U.S. worldwide tax system, a U.S. parent
company receiving dividends from its foreign affiliates does
not have this certainty. The U.S. company must include the
dividends and correspondent foreign taxes paid in its U.S.
taxable income. Under certain restrictions put into the U.S.
tax law over the past several decades, the U.S. taxpayer may
never know beforehand whether these dividends will or will not
be taxed by the United States. The result could be taxation of
at least a portion of the earnings twice by two different
countries.
Why does a U.S. company have a problem utilizing all its
foreign tax credits so that foreign source income is only taxed
once? The main reason for this problem is that the U.S. company
has to apportion many of its domestic business expenses,
especially interest, against its foreign source income, thus,
reducing the amount of foreign income that may be taken into
account in meeting the limitation. This would create unused
foreign tax credits.
In DaimlerChrysler Corporation's case, if it were the
parent of the new company, more than 50 percent of its interest
expense incurred in the United States to finance a sale or
lease of a vehicle in the United States would have been
apportioned to foreign source income. This would have certainly
resulted in double taxation of significant amounts of
repatriated foreign earnings. Just for an example, if we sold a
Dodge pick-up in Texas and incurred $1,000 of interest expense
in our finance company, $500 of that interest would have been
allocated to foreign source income.
There are other U.S. tax rules that also came into our
decision. The treatment of foreign finance subsidiaries, which
was corrected on a year to year basis, would not be a problem
under German tax laws. Investment income earned by foreign
subsidiaries would not be taxed by the German company. And
foreign-based company sales where we manufacture in one
company, sell it to a distribution company in a second country
and then sell on to a third company, that had the potential of
being taxed in the United States.
Finally, by becoming a subsidiary of a German company,
DaimlerChrysler Corporation has minimized the possibility of
paying additional tax--not taxes--on our foreign operation.
This should help the U.S. operation of the company to continue
to compete on a global scale. However, there are many U.S.
companies which have foreign operations and they are put at a
competitive disadvantage in the global economy because of the
U.S. tax rules on their foreign operation.
Thank you.
[The prepared statement follows:]
Statement of John L. Loffredo, Vice President and Chief Tax Counsel,
DaimlerChrysler Corporation
My name is John Loffredo, and I am Vice President and Chief
Tax Counsel for DaimlerChrysler Corporation, the U.S. arm of
DaimlerChrysler. The merger of Chrysler Corporation and Daimler
Benz A.G. was a marriage of two global manufacturing companies,
one with its core operations in North America and the other
headquartered in Europe, with operations around the world.
However, the U.S. tax system puts global companies at a
decisive disadvantage. This issue became a major concern and
when the time came to choose whether the new company should be
a U.S. company or a foreign company, Management chose a company
organized under the laws of Germany.
Generally, the German tax system is based on a
``Territorial'' theory. By contrast, the U.S. tax system
follows the philosophy of taxing the worldwide income of a U.S.
company while allowing tax credits for taxes paid to foreign
governments. In theory, it is possible for both systems to
result in the same tax being imposed on a company whether they
are U.S. or German. However, in practice this does NOT happen.
Before I go further, I want to make it clear that the
former Daimler Benz has been a good corporate citizen in the
U.S. and has paid all taxes believed legally due on its U.S.
operations. The same is true for the former Chrysler
Corporation. In addition, Daimler and Chrysler will continue to
be subject to the U.S. tax laws on their U.S. operations and
will continue to pay their fair share of U.S. taxes. However,
what we did not want to happen as part of this merger was to
increase the company's tax burden by subjecting to U.S. tax
Daimler Benz's non-U.S. operations that were NEVER subject to
U.S. tax laws in the past.
As mentioned, the main reason that Germany's tax system on
global corporations is preferable to the U.S. is the
``Territorial'' nature of their tax system. What does this mean
from a practical standpoint?
1. Worldwide vs. Territorial Tax System
As of the date of our merger, the German Territorial Tax
System exempted qualified dividends received from foreign
subsidiaries from taxation . (Recent German law changes now tax
15% of such dividends). When DaimlerChrysler Corporation earns
income in the U.S. it may elect to dividend some of its after-
tax earnings from the U.S. to Germany, (less a 5% withholding
tax). Before 1999 these dividends were not subject to German
income tax but now 15% of the dividend is taxed (resulting in a
3.5% German tax on the gross dividend before U.S. tax).
However, under the U.S.'s worldwide tax system a U.S.
parent company receiving dividends from its foreign affiliates
must include the dividends and corresponding foreign taxes paid
in its U.S. taxable income. Then it must determine the U.S. tax
on those dividends. The U.S. company may be able to offset the
U.S. tax on that income if it can meet certain limitations and
utilize the foreign tax credits generated by these foreign
subsidiaries. If the foreign tax rate is the same or higher
than the U.S. tax rate, the foreign tax credits should, in
theory, offset the U.S. tax on those dividends. If this
occurred, the result would be the same in the U.S. as it is
under the German Territorial System. That is, no further U.S.
corporate tax would be imposed and the earnings will have been
taxed by only one country. However, under restrictions put in
the U.S. tax laws over the past several decades, this
theoretical result is typically NOT achieved and, in many
cases, the U.S. taxpayer can NEVER fully utilize all of the
foreign taxes paid by its subsidiaries to offset the U.S. tax
on foreign earnings. The result is taxation of at least a
portion of the earnings twice, by two countries.
Under these circumstances, the German Territorial Tax
System provides a greater degree of certainty for the new
DaimlerChrysler company that corporate income earned outside of
the country of incorporation for the parent will only be taxed
once. (Although as of January 1, 1999 dividends remitted to
Germany will be subject to the new tax equivalent of 3.5% of
the gross dividend before U.S. tax).
Why does a U.S. company have a problem utilizing all its
foreign tax credits so that foreign source income is only taxed
once? The main reason for this problem is that a U.S. company
has to apportion many of its domestic business expenses
(especially interest expense) against its foreign source
income, thus reducing the amount of foreign income that may be
taken into account in meeting the limitation. This would create
unused foreign tax credits.
2. Apportionment of Business Expenses
The U.S. tax system requires certain domestic company's
business expenses to be apportioned to foreign source income
for purposes of determining the amount of foreign tax credits
that may be claimed. This apportionment of expenses has the
effect of reducing the amount of a taxpayer's foreign source
income. The result is a taxpayer does not have sufficient
foreign source income to utilize all of its foreign tax
credits. In effect, this apportionment of expenses to foreign
source income results in an amount of foreign income equal to
the apportioned expenses being taxed in the U.S. with NO credit
offset. This amount of income is thus subjected to tax twice,
once by the foreign country and again by the U.S.
The expense apportioned to foreign source income that
creates the most difficulty to a company like DaimlerChrysler,
and to many other U.S. companies, is interest expense, which
must be apportioned on the basis of the location of an
affiliated group's assets. Since interest is apportioned on an
asset basis, it is apportioned to foreign source income
categories whether or not the foreign affiliates have current
income subject to U.S. taxation (e.g., dividends that are paid
from a foreign subsidiary).
DaimlerChrysler has a large affiliated finance company in
the U.S. whose primary business purpose is to provide financing
to Chrysler dealers and customers who buy Chrysler products in
the U.S. However, under the U.S. tax laws, DaimlerChrysler must
apportion its U.S. affiliated group's interest expense between
its U.S. income and its worldwide income. Had the former
Chrysler Corporation become the parent company of the merged
group, substantially over 50% of the value of the assets of the
combined companies would have been located outside of the
United States. This would have meant that more than 50% of the
U.S. affiliated group's interest would have been apportioned to
foreign source income. This would have decreased the amount of
foreign source income that was eligible for offset by the
foreign tax credit. In effect, U.S. tax would have to be paid
on the amount of foreign source income equal to the expenses
allocated to that income, and that would have been quite a
large number.
For example, let's examine what would happen where the
German company is a subsidiary of the U.S. Company. Assume
DaimlerChrysler Corporation sold one vehicle in the U.S. and
made $1,000 of net taxable income on the sale.
DaimlerChrysler's finance subsidiary financed the sale of the
vehicle and that company incurred $100 of interest expense.
Also, in that year, the former Daimler Benz AG earned $100,
paid $50 in tax to the German tax authorities, and remitted a
$50 dividend to the DaimlerChrysler parent company in the U.S.
Let's assume that 50% of DaimlerChrysler Corporation's
assets were foreign. Therefore, 50% of the interest expense or
$50 is allocated to foreign source income. Of DaimlerChrysler
Corporation's total income subject to U.S. tax of $1,100 only
$100 is foreign source income ($50 dividend plus $50 gross-up
for German taxes). Under the method used to calculate foreign
tax credits in the U.S., the $100 in foreign source income is
reduced by the $50 U.S. interest expense apportioned to foreign
source income. This results in net foreign source income of
$50. The U.S. tax on that amount is $17.50 which is the maximum
amount of credit that may be claimed on the $100 of German
income. Therefore on the $100 earnings in Germany, 67.5% would
be paid in taxes (50 in Germany; 17.5 in the U.S.). That is, a
portion of the German income will have been taxed twice.
With DaimlerChrysler A.G. as the parent company, if its
U.S. subsidiary earned $100 of income from U.S. sources, that
income would have been subject to a tax at the 35% U.S. rate. A
subsequent dividend to Germany would be subject to an
additional 5% U.S. withholding tax and then the new German tax
(equivalent to 3.5% of the $100 earned from U.S. sources) for a
total effective tax of around 44%, rather than 67.5%.
In addition to the apportionment of expenses problem, there
were three other areas of concern to DaimlerChrysler under the
laws in the U.S. for taxation of foreign subsidiaries of U.S.
companies:
(A) foreign finance subsidiaries;
(B) incidental investment income earned by foreign operating
subsidiaries; and
(C) foreign base company sales income.
A. Foreign Finance Subsidiaries--Prior to 1997, foreign
subsidiaries of U.S. companies who were carrying on an active
finance business (borrowing and lending) in a foreign location
had to be concerned that these operations were subject to U.S.
tax on their earnings even though not distributed to the U.S.
parent. The problem has been alleviated by recent legislation
that has given taxpayers temporary relief to exclude such
active business income from U.S. taxation. The German tax
system would NOT tax such an active business. DaimlerChrysler
Corporation, which continues to own active finance companies in
Canada and Mexico, strongly supports this rule which allows
active foreign finance company income to be exempt from U.S.
taxation until remitted to the U.S. and urges that it be made
permanent.
B. Incidental Investment Income Earned by Foreign Operating
Subsidiaries--The U.S. will tax in the year earned passive
foreign income (interest) if the tax rate in the foreign
country is less than 90% of the U.S. tax rate or less than
31.5%. The Germans, on the other hand, will not tax incidental
income (interest on working capital) earned at an active
operating company. However, both the German's and the U.S. have
similar rules when it comes to taxing foreign sourced passive
income where such income is in a tax haven country. In Germany,
the income is taxed immediately if it is not subject to a 30%
tax rate in the country where it is earned and, as mentioned
before, the U.S. rule is that such income must be taxed at a
31.5% tax rate to avoid immediate U.S. taxation.
C. Foreign Base Company Sales Income--DaimlerChrysler is in
the business of selling vehicles worldwide. Let us assume
DaimlerChrysler A.G., a German company, establishes a regional
distribution center in the United Kingdom as a staging area for
the sale of right-hand drive vehicles worldwide. Vehicles
manufactured in Germany are sold to the distribution center in
the U.K., and then on to a third country. The income earned by
the U.K. distribution center would be taxed in the U.K. (and
not Germany until a dividend was eventually paid to Germany in
which case the new tax on 15% of the dividend would apply).
Now assume that DaimlerChrysler, a U.S. company, sent
vehicles manufactured by its German subsidiary to the U.K.
center. The vehicles in the U.K. will be sold throughout the
world. Under U.S. tax laws the income earned by the U.K.
distribution center on vehicles shipped to other countries
would be taxed immediately in the U.S. The reason for this is
because the new U.K. tax rate of 30% is less than 90% of the
U.S. tax rate. In the above two scenarios there is no
difference in operation for the DaimlerChrysler group, only a
difference in tax results. The only change in facts is the
country of incorporation of the parent company. The U.S.
company is placed at a decisive disadvantage.
In the above three circumstances, the foreign source income
included in U.S. taxable income is reportable in the year the
income is earned by the foreign company. This is the case
whether or not the income is repatriated to the U.S. or whether
or not the U.S. taxpayer is in a net U.S. taxable income or
loss position for the year. Because of the ``basket'' rules
adopted in 1986, many taxpayers with losses may be in a
position of including this income in their tax base but they
cannot offset the tax on this income with current foreign tax
credits. In these cases, the chance for double taxation on the
foreign source income increases.
As can be seen from above, DaimlerChrysler Corporation, now
a subsidiary of a German company, has minimized the possibility
of paying ADDITIONAL tax (NOT TAXES) on its foreign operations.
This should help the operations of the company to continue to
compete on a global scale. However, there are many U.S.
companies which have foreign operations and they are put at a
competitive disadvantage in the global economy, just because
they are competing against companies who do not have to follow
the way the U.S. tax system taxes foreign operations.
[The Report, Entitled ``THE NFTC FOREIGN INCOME PROJECT:
INTERNATIONAL TAX POLICY FOR THE 21ST CENTURY,'' dated March
25, 1999, is being retained in the Committee files.]
Chairman Archer. Thank you, Mr. Loffredo.
Our next witness is Mr. Lipner. Mr. Lipner, if you will
identify yourself for the record, you may proceed.
STATEMENT OF ALAN J. LIPNER, SENIOR VICE PRESIDENT, TAXES,
AMERICAN EXPRESS COMPANY, NEW YORK, NEW YORK
Mr. Lipner. Good morning, Mr. Chairman and Members of the
Committee. My name is Al Lipner. I am the senior vice president
and chief tax officer of American Express Co. I am pleased to
have this opportunity to testify on the effect the U.S. tax
rules have on the international competitiveness of our
business.
American Express has had a strong international business
presence for more than a century and well before the Sixteenth
amendment to the Constitution was ratified and the Federal
income tax was first enacted. American Express offers products
and services in some 200 countries and territories around the
world. We offer American Express cards issued in 45 different
currencies throughout the world. Our major competitors are
overseas banks and other financial institutions that are
incorporated and have headquarters outside the United States.
Before 1987, the Subpart F rules permitted U.S. tax to be
deferred on income derived in the active conduct of banking or
financing business until that income was distributed to a U.S.
shareholder. In repealing deferral for active financing income,
Congress focused on U.S.-controlled firms operating in tax
havens. What Congress ignored was that the majority of U.S.-
controlled banks, finance companies, and insurance companies
operate overseas through a substantial presence in key markets
rather than as tax haven paper companies.
While U.S. taxes might appear to be imposed at a relatively
moderate nominal rate compared to the rates imposed by foreign
countries, in practice U.S. taxes frequently exceed the
effective tax rate due to more generous foreign country tax
rules. When U.S.-owned firms are subject to a higher tax burden
than their foreign competitors, this can significantly affect
how much to invest in business development, how products are
priced, and even whether or not to continue an investment or
continue a business in a foreign market. Such factors have
influenced some of my company's business decisions.
American Express purchased a Swiss bank in 1983. Its
business operations were exclusively outside the United States
and its customers were not U.S. persons. Its effective tax rate
was 9 percent but was increased to 40 percent in 1987 when the
U.S. Subpart F rules made its earnings subject to U.S. tax. Our
subsidiaries thus became subject to a much higher tax rate than
our foreign competitors solely because of U.S. ownership. We
disposed of our controlling interest in the Swiss bank in 1990.
We considered purchasing a United Kingdom life insurance
company. Although its nominal tax rate was about 34 percent, we
were faced with the prospect of a tax rate of over 200 percent
because of the inability to defer U.S. tax on profits and the
disparities between the tax base under U.S. and foreign tax
rules. We did not go forward with the purchase.
Congress has recently made significant progress in
addressing some of these concerns by restoring deferral on
certain active foreign financial services income. These new tax
rules have significantly recognized that finance companies,
other than banks, are eligible for deferral in appropriate
cases. Unfortunately, the new tax rules expire at the end of
this year. We hope Congress will enact a longer-term solution,
rather than a 1-year extension of the current rules, since our
business planning and investment decisions require a stable set
of rules without the uncertainty presented by year-to-year
changes.
Turning to the foreign tax credit, the present basket rules
often make arbitrary distinctions between certain types of
income earned in an integrated business. For American Express,
a noteworthy example concerns our travel business, which the
regulations consider to be separate from and not incidental to
our card and Travelers Cheque activities. As a result, a
typical transaction with a single customer handled by a single
American Express employee in an American Express Travel office
overseas is considered to give rise to income and related taxes
in two separate foreign credit baskets.
We appreciate the introduction earlier this month of H.R.
2018, the international tax simplification bill, presented by
Representatives Houghton and Levin.
In conclusion, I would like to thank the Chairman and the
Committee for their interest in addressing the impact of U.S.
tax rules on international competitiveness. The business
activities of American Express in key locations of the United
States, including New York, Minneapolis, Phoenix, and Fort
Lauderdale, serve our global operations and not just the U.S.
market. Assuring a strong competitive position of our business
overseas has a clear and positive effect on U.S. business and
the U.S. employment base of American Express.
Thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Alan J. Lipner, Senior Vice President, Taxes, American
Express Company, New York, New York
Good morning, Mr. Chairman and Members of the Committee. My
name is Alan J. Lipner, Senior Vice President--Taxes of
American Express Company. I am pleased to have this opportunity
to testify on the effect U.S. tax rules have on the
international competitiveness of our business. In addition to
my oral remarks today, I have prepared a written statement
that, with your permission, I would like to have entered into
the official record of today's hearing.
As the chief tax officer of one of the world's leading
financial services companies, I am well aware of the profound
impact tax issues have on our business. In my role as Chairman
of the Board of The Tax Council and through other groups such
as the National Foreign Trade Council, I have discussed tax
issues of this nature with several of my counterparts at other
major U.S. companies. My testimony today will not focus in
detail on the technical tax rules. Instead, I will try to
illustrate how those tax rules can have an impact upon how our
business and other U.S. businesses compete against those whose
headquarters are outside the United States.
American Express has a long history of doing business
outside the United States. This is well known by anyone who has
traveled overseas and bought or cashed an American Express
Travelers Cheque or used an American Express Card to charge a
purchase. In fact, American Express has had a strong
international business presence for more than a century--or
well before the 16th Amendment to the Constitution was ratified
and the Federal income tax was first enacted.
American Express began in 1850 as a shipping company that
transported currency and other valuable items swiftly and
safely to their destinations. A sizeable foreign exchange and
foreign remittance business developed in the late 19th century
as a service for new Americans and laid the groundwork for the
Company's eventual major role in the international financial
arena.
A great step in the company's international expansion came
with the introduction in 1891 of the American Express Travelers
Cheque. This revolutionary financial instrument, with its now
familiar signature and countersignature, allowed travelers to
obtain access to funds without the inconvenience of letters of
credit that could be honored only within normal banking hours
at specified correspondent banks in a very time consuming
process. The international business expansion that followed led
to the establishment of a chain of American Express offices--or
``homes away from home''--in key cities throughout the world
around the turn of the century.
Today, American Express offers its products and services in
some 200 countries and territories around the world. As in the
early days of its international business, the company continues
to serve U.S. customers whose personal or business affairs
require our financial services to be available wherever they
need them. Over the years, our business has expanded to focus
also upon non-U.S. customers. This is illustrated by the fact
that American Express Cards are now issued in 45 different
currencies around the world. Our major competitors overseas are
banks and other financial institutions that are incorporated
and have their headquarters outside the United States.
The two major features of U.S tax rules that affect our
international operations are the Subpart F rules and the
foreign tax credit. Both these areas were modified
substantially in 1986 in ways that adversely affected both the
burdens of tax compliance and our competitive position vis-a-
vis non-U.S. financial services firms.
Before 1987, the Subpart F rules permitted U.S. tax to be
deferred on income derived in the active conduct of a banking
or financing business until that income was distributed to a
U.S. shareholder. In repealing deferral for active financing
income, Congress focused on U.S.-controlled firms operating in
tax havens and earnings that were manipulated for tax reasons.
What Congress ignored was that the majority of U.S.-controlled
banks, finance and insurance companies operate overseas through
a substantial presence in key markets rather than as tax haven
``paper'' companies. These firms compete head-to-head with
foreign-controlled companies whose home countries do not impose
tax on unremitted, reinvested earnings. Also ignored was the
impact of foreign banking or insurance regulations that often
require these businesses to be operated by a locally
incorporated subsidiary subject to local regulatory control.
While U.S taxes might appear to be imposed at a relatively
moderate nominal rate compared to the rates imposed by foreign
countries, in practice U.S. taxes frequently exceed the
effective foreign tax rate due to more generous foreign rules
for such items as bad debt deductions or certain preferential
income. When U.S-owned firms are subject to a higher tax burden
than their foreign competitors, this can obviously affect such
factors as how much to invest in business development, how
products are priced and even whether or not to invest or
continue to do business in a foreign market. Such tax factors
have influenced some of my company's business decisions:
American Express purchased a Swiss bank in 1983. Its business
operations were exclusively outside the U.S. and its customers
were not U.S. persons. Its effective tax rate of about 9%
increased to 40% in 1987 when the changes in the Subpart F
rules made its earnings subject to U.S. tax. Our subsidiary
thus became subject to a much higher tax rate than our foreign
competitors solely because of its U.S. ownership. We disposed
of our controlling interest in the Swiss bank in 1990.
We considered purchasing a U.K. life insurance company.
Although its nominal local tax rate was about 34%, we were
faced with the prospect of an effective tax rate of over 200%
because of our inability to defer U.S. tax on its profits and
disparities between the tax base under U.S. and foreign tax
rules. We did not go forward with the purchase.
Congress has recently made significant progress in
addressing some of these concerns by restoring deferral of U.S.
tax on certain active foreign financial services income. These
new rules have specifically recognized that finance companies
other than banks are eligible for deferral in appropriate
cases. Unfortunately, the new rules expire at the end of this
year. We hope Congress will enact a longer-term solution rather
than a mere one-year extension of the current rules since our
business planning and investment decisions require a stable set
of rules without the uncertainty presented by year-to-year
changes. We appreciate that a substantial number of the members
of this committee have co-sponsored H.R. 681, legislation
introduced by Representatives McCrery and Neal to provide
greater certainty.
Turning to the foreign tax credit, the present separate
limitation or ``basket'' rules often make arbitrary
distinctions between certain types of income earned in an
integrated business. For American Express, a noteworthy example
concerns our Travel business, which the tax regulations
consider to be separate from and not incidental to our Card and
Travelers Cheque activities. As a result, a typical transaction
with a single customer handled by a single employee in an
American Express Travel office overseas is considered to give
rise to income (and related taxes) in two separate foreign tax
credit baskets. Another example is the so-called ``high
withholding tax interest'' basket, which was intended to curb
cross-border loans that were not economically sound on a pre-
tax basis. By discouraging cross-border lending by U.S.
financial institutions, the tax rules have given foreign-
controlled lenders a tax-based competitive advantage in
financing developing economies around the world. A third
example is the separate basket for ``joint ventures'' or
foreign corporations with between 10% and 50% ownership by U.S.
firms. We support proposals to accelerate a repeal of these
rules that inhibit U.S. firms from expanding business overseas
by investing in strategic alliances with foreign partners.
Another area of concern to American Express is the excise
tax on the purchase of frequent flyer mileage awards from
airlines. Some have interpreted this tax to apply not only to
frequent flyer points to be awarded to U.S. customers, but also
to any points purchased anywhere in the world, from any
airline, and for any customer, if there is a mere possibility
that the points could be used to obtain an airline ticket to or
from the U.S. Since foreign governments and companies have
objected to this extraterritorial reach of the U.S. excise tax,
the practical effect is that, absent rigorous global
enforcement, the tax burden will fall only upon U.S. companies
doing business overseas and the customers of U.S.-based
airlines.
We appreciate the introduction earlier this month of H.R.
2018, the international tax simplification bill, by
Representatives Houghton and Levin. This bill would address
several of the problems I have highlighted above and would help
simplify our complicated international tax rules and encourage
competitiveness.
In conclusion, I would like to thank the Chairman and the
Committee for their interest in addressing the impact of U.S.
tax rules on international competitiveness. The business
activities American Express conducts at its key locations in
the United States, including New York, Minneapolis, Phoenix and
Fort Lauderdale, serve our global operations and not just the
U.S. market. Assuring a strong competitive position for our
business overseas has a clear positive effect on our U.S.
business and employment base. In addition, ensuring a strong
position for the financial services sector reinforces a
competitive strength for the U.S. economy as a whole, as
indicated by the positive contribution the service sector makes
to our overall balance of payments situation.
I would be pleased to respond to any questions the Chairman
or Members of the Committee may have.
Chairman Archer. Thank you, Mr. Lipner.
Our next witness is Ms. Stiles. We are happy to have you
here and welcome. You may proceed.
STATEMENT OF SALLY A. STILES, INTERNATIONAL TAX MANAGER,
CATERPILLAR INC., PEORIA, ILLINOIS
Ms. Stiles. Good morning, Mr. Chairman, Members of the
Committee. I am Sally Stiles. I am an international tax manager
for Caterpillar. It is a pleasure to be here this morning and
to have the opportunity to talk with you about international
taxation.
For those of you not entirely familiar with Caterpillar,
let me begin with a few facts about the company. We are the
world's largest manufacturer of constructing and mining
equipment, natural gas and diesel engines, and industrial
turbines.
We also own and operate subsidiaries that handle financing,
insurance, leasing, and logistics services. We employ more than
40,000 employees in the United States and more than 65,000
employees worldwide. We posted sales last year of nearly $21
billion, including $6 billion in exports from the United
States. These export sales directly support 15,000 U.S. jobs at
our CAT facilities and an additional 30,000 jobs with our U.S.
suppliers.
Mr. Chairman, Caterpillar applauds your efforts to reduce
trade and tax barriers that U.S. companies face on a daily
basis. We wholeheartedly agree with you that many of our tax
policies don't reflect the current competitive environment
facing companies like Caterpillar. International tax policies
implemented in the sixties, and continually expanded in the
years since, have not kept pace with the global marketplace.
The cross border emphasis embodied in the U.S. anti-
deferral rules is rapidly becoming obsolete in a world where
the marketplace is no longer defined by country borders. The
dramatic events unfolding in Europe are certainly the most
convincing evidence of the changing marketplace. As the world
recognizes the European Union as a single marketplace, so, too,
should the U.S. tax law.
Mr. Chairman, we support your efforts to preserve two very
important provisions in the current Tax Code. The Export Source
Rule and the Foreign Sales Corporation provisions are
critically important to U.S. exporters. These provisions and
the recent decision to include active finance company income in
the deferral rules have helped place U.S. companies on a more
level playingfield with their foreign competitors. We strongly
support permanent extension of the active finance provision.
Let me briefly explain to you why this provision is so
important to Caterpillar.
Purchasing high value goods, like Caterpillar equipment,
generally entails more than simply writing a check. Mr.
Chairman, you have in front of you a model which represents the
little brother to our largest mining shovels that are
manufactured exclusively in our Joliet, Illinois facility. This
mammoth equipment generally costs in excess of $1 million per
unit. And let's bear in mind, many of our customers buy in
fleets.
Caterpillar Financial Services Corporation and its
subsidiaries offer competitive leasing and purchasing programs
to all our customers, including the nearly 50 percent who are
not in the United States.
Until the recent change in the U.S. tax law providing
deferral for active finance income, the foreign source income
generated from our foreign financing business was taxable in
the United States on a current basis. Many of our foreign
competitors are able to offer flexible financing programs to
assist in the purchase of their competitive equipment without
this additional home-country tax burden. The active finance
exception has allowed us to remain competitive in these
programs, but we run the risk of losing what we gained if we
backtrack now.
If we are to maintain our primary philosophy of build it
here and sell it there, we need a modern tax policy that is
consistent with our global focus. U.S. tax rules must allow us
to be competitive bidders when opportunities arise rather than
placing us at an immediate disadvantage.
Several Members of this Committee have been instrumental in
proposing and helping to enact simplification measures to our
international tax system. We encourage those efforts to
continue. The compliance cost associated with the incredibly
complex U.S. international tax rules are enormous.
Let's keep our eye on the long-term benefits to the U.S.
economy, ensuring U.S. companies remain globally competitive,
recognizing and responding to the tax-related challenges of new
technologies and new markets. By working together, we can
assure our future generations an opportunity to participate in
world markets, instead of apologizing for lost opportunities.
I will be happy to answer any questions at the appropriate
time. Thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Sally A. Stiles, International Tax Manager, Caterpiller
Inc., Peoria, Illinois
Good morning Mr. Chairman and members of the Committee, I
am Sally Stiles, International Tax Manager for Caterpillar Inc.
It's a pleasure to be here and to have the opportunity to talk
with you about international taxation.
For those of you not entirely familiar with Caterpillar,
let me begin with some facts about the company. We are the
world's largest manufacturer of construction and mining
equipment, natural gas and diesel engines, and industrial
turbines.
We also own and operate subsidiaries that handle financing,
insurance, leasing programs, countertrade and logistics
services. We employ 65,000 employees worldwide and posted sales
last year of nearly $21 billion, including $6 billion in
exports from the United States. These export sales directly
support 15,000 U.S. jobs and an additional 30,000 jobs with our
U.S. suppliers.
Mr. Chairman, Caterpillar applauds your efforts to reduce
trade and tax barriers that U.S. companies face on a daily
basis. We wholeheartedly agree with you that many of our tax
policies don't reflect the current competitive environment
facing companies like Caterpillar. Tax policies implemented in
the 1960's and continually expanded in the years since have not
kept pace with the global marketplace.
The cross border emphasis embodied in the U.S. anti-
deferral rules is rapidly becoming obsolete in a world where
the marketplace is no longer defined by country borders. The
dramatic events unfolding in Europe are certainly the most
convincing evidence of the changing marketplace. As the world
recognizes the European Union as a single marketplace so too
should the U.S. tax laws.
Mr. Chairman we support your efforts to preserve two very
important features of the current tax code. The Export Source
Rule and the Foreign Sales Corporation provisions are
critically important to U.S. exporters. These provisions and
the recent decision to include active finance company income in
the deferral rules have helped place U.S. companies on a more
level playing field with their foreign competitors. We strongly
support permanent extension of the active finance provision.
Let me briefly explain why this provision is so important
to Caterpillar.
Purchasing high value goods like Caterpillar equipment
generally entails more than simply writing a check. The model
you have in front of you represents the little brother of our
largest mining shovels that are manufactured exclusively in our
Joliet Illinois facility. This mammoth equipment generally
costs in excess of one million dollars per unit ... and let's
bear in mind many customers buy in fleets.
Caterpillar Financial Services Corporation and its
subsidiaries offer competitive leasing and purchasing programs
to all our customers--including the nearly fifty percent who
are not in the United States.
Until the recent change to U.S. tax law providing deferral
for active finance income, the foreign source income generated
from our foreign financing business was taxable in the United
States on a current basis. Many of our foreign competitors are
able to offer flexible financing programs to assist in the
purchase of their competitive equipment without this additional
home-country tax burden. The active finance exception has
allowed us to remain competitive in these programs, but we run
the risk of losing what we've gained if we backtrack now.
If we are to maintain our primary philosophy of ``build it
here and sell it there,'' we need a modern tax policy that is
consistent with our global focus. U.S. tax rules must allow us
to be competitive bidders when opportunities arise rather than
placing us at an immediate disadvantage.
Several members of this Committee have been instrumental in
proposing and helping to enact simplification measures to our
international tax system. We encourage those efforts to
continue. The compliance costs associated with the incredibly
complex U.S. international tax rules are enormous.
Let's keep our eyes on the long-term benefits to the U.S.
economy, ensuring U.S. companies remain globally competitive,
recognizing and responding to the tax-related challenges of new
technologies and new markets. By working together, we can
assure future generations of Americans an opportunity to
participate in world markets--instead of apologizing for lost
possibilities.
As stated in the discussion above, the U.S. anti-deferral
rules must be reformed if U.S. companies are to fully
participate in world markets. The Foreign Base Company Income
rules and the Foreign Personal Holding Company Income rules
make it impossible for U.S. companies to enjoy the same
economies of centralized operations that are available to their
foreign competitors. Under current U.S. rules, the cross border
transactions that are inherent in centralized operations such
as treasury centers, distribution operations, marketing and
``back office'' service centers are all currently taxable in
the United States. Income associated with these centralized
operations is clearly active business income and should not be
subject to current U.S. taxation.
The Foreign Tax Credit Limitation calculation is another
area of the international tax law that is very much in need of
reform. The rules dictating the segregation of income into the
various baskets have become so overly complicated that
compliance efforts are not only costly but also error prone.
Acceleration of the provisions allowing look-thru treatment for
dividends of Non-controlled Section 902 Corporations and
extension of the allowable period for foreign tax credit
carryforwards are measures that, if adopted, would provide some
relief in this area.
The expense allocation and apportionment rules are no less
complicated and burdensome than the income sourcing rules. In
particular, the interest expense apportionment rules are not
only a complex administrative burden but also unfairly penalize
U.S. multinational companies with U.S. financial subsidiaries.
Under current rules interest expense may not be netted against
interest income and must be apportioned on the asset method.
For U.S. companies with foreign subsidiaries a significant
portion of this interest expense will be apportioned to foreign
source income in spite of the fact that the expense was
incurred solely to fund U.S. financial transactions.
The volume of information that must be collected from
foreign locations to comply with the U.S. informational
reporting requirements has become a tremendous burden on U.S.
multinational companies. Adopting US GAAP accounting for the
determination of Earnings and Profits for both informational
and Subpart F calculations would greatly simplify this process.
Chairman Archer. Thank you, Ms. Stiles.
Our last witness on this panel is Mr. Finnerty, welcome.
You may proceed.
STATEMENT OF PETER J. FINNERTY, VICE PRESIDENT, PUBLIC AFFAIRS,
SEA-LAND SERVICE, INC., AND VICE PRESIDENT, MARITIME AFFAIRS,
CSX CORPORATION, RICHMOND, VIRGINIA
Mr. Finnerty. Thank you very much, Mr. Chairman and Members
of the Committee. I am Peter Finnerty, Vice President, Public
Affairs, Sea-Land Service. And I am very appreciative of the
opportunity to testify today on the significant adverse impact
of U.S. tax rules on the international competitiveness of the
United States Merchant Marine and some proposed solutions.
Sea-Land is the largest ocean carrier in the United States,
with a global fleet of about 100 container ships serving 120
ports in 80 countries. Thirty-five of our ships are registered
in the United States. Our inter-modal network operates with
about 220,000 freight containers, port terminals, extensive
computer and communications technology on five continents. It
is a highly capital intensive business.
As set forth in my full statement, U.S.-flag carriers are
proud of our record of innovation. Sea-Land invented
containerization in 1956 when the initial voyage sailed from
New York to Houston, Texas. In the years since, however, the
U.S.-flag fleet has been struggling under a heavy tax burden
whereas foreign nations purposely do not tax their
international shipping activities so they will be more
competitive on the high seas.
The U.S. tax burden takes many forms. In addition to income
tax and various fees, there is the alternative minimum tax and
the very onerous 50 percent duty on U.S.-flag vessel
maintenance and repair.
The administration now proposes to impose an added $1
billion a year in harbor dredging taxes. U.S. ocean carriers
have testified, seeking relief from the heavy tax burden in the
past. I testified before this Committee in 1980 on this same
point. John Snow, our chairman of CSX Corp., our parent
company, and John Lillie, then chairman of American President
Companies, testified in 1993 before the Senate. And again in
1995, U.S.-flag carriers stressed that the tax gap between us
and our foreign-flag competitors is large.
H.R. 2159, introduced June 10, 1999, by Congressman McCrery
and cosponsored by Congressmen Herger, Jefferson, and
Abercrombie, proposes a number of beneficial changes to the
Capital Construction Fund to increase its effectiveness in
helping U.S.-flag vessel operators to generate private
investment capital for new U.S.-flag ships and operating
equipment. The U.S.-flag maritime industry strongly supports
this measure, and we urge its early approval by the Committee.
And I would like to submit a letter to that extent for the
record.
[The information had not been received at the time of
printing.]
Mr. Finnerty. The Capital Construction Fund changes would
include a broadening of the scope of U.S.-flag vessels
``eligible'' to make deposits into a CCF. U.S.-flag vessels
operated in the ocean-going domestic trade and in trade between
foreign ports would be included as qualified vessels. And
containers and trailers which are part of the complement of an
``eligible'' vessel could be purchased with CCF funds.
Qualified withdrawals from a CCF account for vessels would
continue to be limited to U.S.-flag vessels built in the United
States. A very important change would allow a CCF fund-holder
the right to elect a deposit into a CCF of all or a portion of
the amount that would otherwise be payable to the Secretary of
the Treasury as a duty on foreign repairs to U.S.-flag vessels
imposed by section 466 of the Tariff Act of 1930.
These tax improvements would benefit the same U.S.-flag
ships that the Department of Defense relies upon for support of
the Armed Forces in such contingencies as Vietnam and Desert
Storm.
The economic and national security of our country depend on
this Nation's ability to guarantee the flow of goods in
international commerce through U.S. ports. It is critical that
the Committee approve H.R. 2159 to ensure future
competitiveness of the U.S. Flag Merchant Marine.
Thank you.
[The prepared statement follows:]
Statement of Peter J. Finnerty, Vice President, Public Affairs, Sea-
Land Service, Inc., and Vice President, Maritime Affairs, CSX
Corporation, Richmond, Virginia
Key Points
By increasing the economic cost of new vessels for
U.S. shipowners, U.S. tax rules have hindered the development
of a United States-flag commercial merchant fleet in the
foreign trades of sufficient size and capacity to maintain its
share of U.S. international oceanborne trade over the last half
of the 20th Century. As U.S. waterborne imports and exports
increased five-fold, the share of that trade carried on United
States-flag ships dropped from 60 percent (in 1947) to less
than 3 percent (1997).
This competitive handicap can be directly
attributed to U.S. tax rules--not the competitiveness of the
U.S. industry itself. During this period, technology and
logistics innovations developed by the U.S. industry virtually
revolutionized international shipping, and in every segment of
the fleet today's U.S.-flag vessels are highly efficient and
fully competitive with their foreign counterparts. For example,
the U.S. liner industry today carries 25 percent more cargo
than 30 years ago with 70 percent fewer ships.
Nor is this a question of U.S. ship acquisition--
United States-flag ships in the international trades can be
purchased on the same international shipbuilding market as
ships of our foreign competitors. The key difference is that
because of U.S. tax rules, American shipowners must purchase
those ships with after-tax dollars whereas foreign operators
generally can do so with pre-tax funds. As a result, American
shipowners face a 35 percent economic disadvantage before a
ship even hits the water.
Other aspects of U.S. tax rules have a similar
impact on the availability of operating revenues for investment
in new ships. On average, our new ships would pay about $1
million a year more in taxes, per ship, than our foreign
competitors. Moreover, even in our unprofitable years, we
remain subject to the Alternative Minimum Tax. If a United
States-flag carrier and a foreign carrier each earns $10
million in operating revenues, after national taxes are
applied, the foreign carrier still has $10 million available to
reinvest, while the American carrier has only $6.5 million.
H.R. 2159, the ``United States-Flag Merchant
Marine Revitalization Act of 1999,'' now before this Committee,
proposes key changes to U.S.-flag tax rules to increase the
international competitiveness of U.S.-flag shipping companies
in international oceanborne trade. If enacted, these changes
would make the existing Capital Construction Fund program a
much more effective means of generating private investment
capital for new ships and equipments for the United States-Flag
Merchant Fleet.
Statement
Mr. Chairman and Members of the Committee: Good morning my
name is Peter Finnerty, Vice President of Public Affairs for
Sea-Land Service, Inc. and of Maritime Affairs for CSX
Corporation, Sea-Land's corporate parent.\1\ I am pleased to
appear before the Committee today to discuss the impact of U.S.
tax rules on the international competitiveness of the United
States maritime industry and to stress the importance of
proposed changes to those rules as embodied in H.R. 2159, the
United States-Flag Merchant Marine Act of 1999, now pending
before this Committee.
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\1\ Disclosure required under Truth in Testimony Rule: Sea-Land
Service, Inc. contracts with the United States Government under the
Maritime Security Act of 1996, 46 U.S.C. 652 et seq., and for
oceanborne transportation services under 10 U.S.C. 2631 and 46 U.S.C.
901.
---------------------------------------------------------------------------
I. Introduction
The ability of the American shipowner competing in
international shipping markets to build and operate ships on a
comparable economic basis as our foreign competitors is vital
to the competitiveness of the U.S.-flag industry. And tax rules
are key to that equation. The U.S. tax environment under which
we must compete--but from which our foreign competitors are
largely exempt--impacts both our day to day operating
competitiveness and our ability to acquire new or replacement
tonnage for our fleets.
The problem is not that these rules make it impossible for
us to compete in international shipping. Make no mistake about
it--today's United States-flag commercial fleet operating in
the foreign trades is highly competitive and more than capable
of out-performing our foreign-flag rivals in head-to-head
competition on a level competitive playing field. For example,
we carry as much cargo today as 40 years ago, but with fewer
ships than at any point in our history.
The problem with U.S. tax rules, however, is that they
force us to play catch-up from the very day we first contract
to build a new ship. Even though we can build our ships in the
same shipyards as our foreign competitors, for roughly the same
delivered contract price, by and large our foreign competitors
can purchase those ships with pre-tax dollars whereas under
U.S. tax law the majority of our investment must come from
post-tax dollars. Thus, we have to out-perform our competitors
on the operating side just to catch-up economically.
Moreover, those same U.S. tax rules make it more difficult
for us to compete economically in daily operations. For
example, many of our competitors are based in countries whose
tax regimes exempt earnings of national flag ships operated in
international commerce from taxation altogether, whereas United
States-flag operators are subject to U.S. tax law for all such
revenues. Thus, not only can our foreign competitors invest
pre-tax dollars in new ships, but the tax rules under which
they operate leave them more of such revenues with which to
make those purchases. Similarly, if one of our ships and one of
their ships go into the same foreign shipyard to receive the
same repairs at the same contract cost, our repairs end up
costing us 50 percent more due to U.S. tax rules that impose a
50 percent ad valorem duty on such repairs.
The cumulative effect of the economic penalties imposed on
United States-flag shipping companies by U.S. tax rules over
the last 50 years is clear. Immediately following the end of
WWII, United States-flag ships carried almost 60 percent of
U.S. oceanborne commerce moving in international trade (by
tonnage). Today that figure is less than 3 percent.\2\ Yet
today's American ships are more efficient than ever--in the
liner trades, for example, compared to 25 years ago, United
States-flag ships carry 25-35 percent more cargo with 70-80
percent fewer vessels.
---------------------------------------------------------------------------
\2\ U.S. Department of Transportation, Maritime Administration,
MARAD 98, at 49. The range in numbers results from variations in the
categories of vessels counted for those trades across this period of
time.
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Why then has the percentage of cargoes carried by U.S.-flag
ships in foreign trades declined so precipitously? Why are more
than 97 out of every 100 tons of cargo entering or leaving a
U.S. port in international commerce moving on foreign-flag
ships? The answer is not that the U.S. fleet is inefficient--it
is not--or that American companies simply cannot compete in
international shipping. The answer is that even though the
amount of cargo carried by American ships has remained
unchanged for virtually the last 40 years, U.S. trade has
increased almost five-fold over that same period--and virtually
all of the increase is being carried by foreign-flag ships.
Operating under U.S. tax rules, the U.S.-flag fleet
modernized and led the world in the introduction of new
technologies that revolutionized international shipping. But at
the same time, it failed to grow. Conversely, encouraged by
their own, more favorable tax regimes, foreign shipping
companies adopted the American companies' new technologies,
invested in increasing numbers of modern, well-built ships
(using tax-exempt dollars), grew in both vessel and total fleet
capacity, and now dominate U.S. international waterborne
commerce.
Following a brief introduction to Sea-Land and to the
present state of the U.S.-flag industry, my testimony today
will focus on two points:
The impact of existing tax rules on the economic
competitiveness of U.S.-flag ships and shipping companies in the
foreign trades; and
Proposed solutions to two aspects of that impact:
Investment in new ships; and
Repairs in non-U.S. shipyards.
In closing, I will also briefly address the role a portion
of these proposed changes would play in the future
modernization of the U.S.-flag fleet operating in the non-
contiguous trades with the U.S. mainland, trades in which Sea-
Land also operates. While not in direct competition with
foreign shipping, the ability of U.S. carriers in those trades
to replace existing tonnage with new ships as we enter the 21st
Century in as cost-efficient a manner as possible will play an
important role in our ability to continue to provide American
shippers in those trades with the same safe, reliable and cost
effective service as today.
II. Introduction to Sea-Land Service
Sea-Land Service, Inc., headquartered in Charlotte, NC, is
a worldwide leader in container shipping transportation and
related trade services. Sea-Land operates a fleet of about 100
containerships under both United States and foreign flags and
approximately 220,000 containers. Placed end-to-end, this
equates to a solid line of containers stretching from
Washington, DC to somewhere between St. Louis, MO and Denver,
CO (depending on whether they are 20- or 40-foot units). Sea-
Land's ships serve 120 ports in 80 countries and territories.
III. The U.S.-Flag Fleet Today
In recent years, there has been much debate over the
declining numbers of oceangoing U.S.-flag ships operating in
the foreign trades. Those numbers, however, tell only a part of
the story. It is important to look beyond the declining number
of vessels in this part of the U.S.-flag fleet to assess its
present state.\3\ For example, between 1965 and 1995, the U.S.-
flag oceangoing fleet decreased by 62 percent based on the
numbers of vessels, but increased its total cargo carrying
capacity by 15 percent. Moreover, productivity in that fleet--
as measured by output (tons carried) per seagoing employee--
increased at an annual rate (16 percent) that was 8 times the
productivity gains being achieved by American business as a
whole during the same period! Clearly American ships and crews
can be competitive in international shipping markets.
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\3\ Indeed, on the domestic side, where all vessels operate under
the same tax rules, the United States-flag fleet has more than doubled
in size (based on the same size vessel as discussed in the text) and
tripled in productivity. Today, that fleet includes almost 1,900 such
large commercial vessels (compared to only 861 in 1965) and carries
over 1 billion tons cargo annually.
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The U.S.-flag dry cargo liner fleet provides a textbook
example of increased productivity during this period. The
Shipping Act of 1984 affirmed the longstanding U.S. policy of
permitting U.S. carriers to participate in liner conferences on
the same basis as foreign carriers that was first enacted in
the Shipping Act, 1916. Under the stable investment climate
created by those Acts, U.S. liner carriers became world leaders
in the industry through technological development and marketing
innovation. As containerships replaced breakbulks in the liner
trades, the number of U.S.-flag vessels in the international
liner trades declined, but the cargo carrying capacity of the
U.S. liner fleet actually grew substantially. When non-liner
vessels are excluded from the analysis of the U.S.-flag foreign
trade fleet shown above and only the U.S.-flag liner fleet is
considered--which is the portion of the fleet most affected by
the Shipping Act--it becomes clear that to a great extent the
changes in the size and composition of that fleet over the past
20 years represent a continuing process of downsizing and
modernizing.
In 1975, for example, the total U.S. liner fleet (foreign
and domestic trades) numbered 278 ships (compared to its
current size of roughly 138 ships), but the 1975 fleet included
142 older, general cargo (or ``breakbulk'') vessels that were
rapidly becoming commercially obsolete as a result of the
general shift to containers for non-bulk dry cargo shipments.
By 1995, the general cargo side of the liner fleet had dropped
from 142 to just 16 ships--simply because that type of ship was
no longer commercially viable. In contrast, although the number
of intermodal vessels \4\ (primarily containerships) in the
U.S. liner fleet declined slightly between 1975 and 1995 (from
136 to 122 ships or by roughly 10 percent), the total
deadweight tonnage, or cargo carrying capacity, of that part of
the fleet actually increased by 35 percent as new, larger,
faster vessels replaced the early, smaller classes of
containerships.
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\4\ The term intermodal refers to transportation in the course of
which the goods or passengers being carried transfer from one mode to
another (e.g., from truck to railcar to oceangoing vessel). While this
term can be used to describe virtually all modern transportation except
trips in private automobiles, its use here is limited to referring to
the movement of containerized goods or of wheeled vehicles (e.g., truck
trailers) employing either containerships, roll-on/roll-off ships, or
barges designed for those purposes whether operating separately or when
carried on specially designed larger ``LASH'' ships. The remaining
categories of waterborne freight transportation are bulk (cargo loaded
``without mark or count'') employing ships or barges described same
term and general or breakbulk, which refers to cargoes loaded as
individual items on board a ship or barge also described using that
term, a practice generally no longer employed in much of the maritime
industry.
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This modernization process continued throughout the decade
following the 1984 Shipping Act. Between 1984 and 1994, the
number of intermodal ships in the U.S.-flag foreign trading
liner fleet declined slightly (down 7 percent from 74 to 69
ships), but the deadweight tonnage of that same fleet increased
by 19 percent over the same decade. The 69 ships in 1994
carried 25 percent more total cargo tonnage in international
trade than did all 218 ships in the U.S. foreign trading fleet
in 1975. Put simply, today's U.S.-flag foreign trade liner
fleet carries 25 percent more cargoes in a year with almost 70
percent fewer ships. Thus, as these figures show, while its
numbers may be less, the U.S.-flag liner fleet in the foreign
trades today is substantially stronger and more productive than
it was in 1975.
IV. Impact of U.S. Tax Rules on Competitiveness
If United States-flag ships and their American crews
individually have been able to successfully compete in
international trade for cargoes up to the amounts carried by
U.S. ships historically over the last 30-40 years, why have
U.S. shipping companies, or the United States-flag fleet
overall, been largely unable to compete effectively for cargoes
beyond that amount? The answer simply is in large part due to
the impact of U.S. tax rules on the competitiveness of those
American companies in international commerce.
A. Impact of U.S. Tax Rules
In recent years, American shipping companies have testified
before Congress on numerous occasions detailing challenges
faced by then in the international shipping market. And
Congress has responded over the years, most recently with the
Ocean Shipping Reform Act of 1998, which entered into effect
this last May 1st. Indeed, the heightened competition in
international liner shipping services that will occur as a
result of that Act further highlight the need for Congress to
address the tax rules applicable to the U.S.-flag shipping
industry.
In 1993, for example, John Snow, the Chairman of CSX
Corporation, and John Lillie, then Chairman of American
President Companies, testified before the Merchant Marine
Subcommittee of the Senate Committee on Commerce, Science and
Transportation, that the tax difference between a U.S.-flag and
a foreign-flag vessel amounted to an estimated $1 million
annually for their companies per vessel.\5\
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\5\ Hearing before the Merchant Marine Subcommittee of the U.S.
Senate Committee on Commerce, Science and Transportation, on the
``Implications of the U.S. Government's Decision Not to Support a U.S.-
Flag Fleet,'' August 5, 1993.
---------------------------------------------------------------------------
Two years later, in a Joint Statement submitted to the same
committee, a group of U.S.-flag carriers again addressed the
tax issue in the following manner:
The Tax Gap Between Us and Our Competitors Is Large. U.S.-
based liner companies are subject to significantly higher taxes
than their foreign-based counterparts. In testimony two years
ago before this Committee, APL and Sea-Land submitted data
showing that, as a result of shipping income tax exemptions,
deferral devices, and accelerated depreciation, many of our
foreign competitors pay virtually no income taxes (neither do
their crews under many foreign tax regimes). Yet here at home,
even in our unprofitable years, we are subject to the
Alternative Minimum Tax. Consequently, U.S.-flag operators must
earn more in the marketplace than their competitors in order to
earn the same amount for reinvestment or distribution to
shareholders. For example, if a U.S.-flag carrier and a
foreign-flag carrier each earn $10 million, the foreign-flag
carrier generally has $10 million left after applying national
income taxes. The U.S.-flag carrier has only $6.5 million
(applying a 35 percent Federal corporate rate and ignoring any
State income tax considerations.\6\
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\6\ Hearing before the Merchant Marine Subcommittee of the U.S.
Senate Committee on Commerce, Science and Transportation, supporting
``Prompt Enactment of Authorizing and Appropriations Legislation to
Revitalize the United States-Flag Liner Fleet,'' July 26, 1995.
At that time, the carriers stated they were not before the
committee to seek maritime tax reform legislation, but
acknowledged that such legislation ``would be a great help.''
Also in 1993, the General Accounting Office (``GAO'')
conducted a study that found the commercial maritime industry
had been assessed $11.9 billion in taxes during fiscal year
1991. GAO identified 12 federal agencies as levying a total of
117 diverse assessments on the industry, 92 of which are
specific to and paid only by the maritime industry. Such taxes
included the Harbor Maintenance Tax (since repealed for exports
only), vessel entry processing fees, the vessel tonnage tax,
and an inland waterways fuel tax. These agencies included:
Animal and Plant Health Inspection Service
Coast Guard
Customs Service
Federal Communications Commission
Internal Revenue Service
Surface Transportation Board
Maritime Administration
National Oceanic and Atmospheric Administration
Panama Canal Commission
St. Lawrence Seaway Development Corporation
Since the 1993 study, additional taxes have been imposed.
For example, the U.S. Coast Guard is now charging fees for a
number of services it provides, including fees for vessel
inspections (which it requires to be made), licensing and
documentation of vessels, as well as fees charged to mariners
for individual licenses and documentation. Moreover, the 105th
Congress rejected an effort by the Office of Management and
Budget to tax only commercial vessel operators for navigational
assistance services, such as buoy placement and maintenance,
vessel traffic services, and radio and satellite navigation
systems.
B. Cumulative Impact on Competitiveness
The following graph illustrates the cumulative effect of
these disparate economic conditions over the last 50 years. As
noted above, immediately following the end of WWII, United
States-flag ships carried almost 60 percent of U.S. oceanborne
commerce moving in international trade (by tonnage). Today that
figure is less than 3 percent.\7\ As U.S. trade grew, U.S.-flag
shipping companies continued to compete effectively for
generally the same amounts of cargo as over the last 40 years.
Foreign-flag shipping companies, on the other hand, were able
to take advantage of the favorable investment climates created
by their national tax regimes to purchase large numbers of new
ships, capturing virtually all of the growth in the U.S.
market.
---------------------------------------------------------------------------
\7\ U.S. Department of Transportation, Maritime Administration,
MARAD 98, at 49. The range in numbers results from variations in the
categories of vessels counted for those trades across this period of
time.
[GRAPHIC] [TIFF OMITTED] T6775.001
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C. Opportunity Cost on Competitiveness
The preceding graph also illustrates the opportunity cost
of U.S. tax rules on the United States-flag merchant fleet,
particularly as those rules have limited the ability of
American shipowners to purchase on a competitive basis the new
vessels needed to expand the U.S.-flag fleet as required to
capture ongoing growth in U.S. oceanborne trade, or, indeed, to
even maintain existing market shares. This is amply
demonstrated by the following example.
In 1965, the overall share of U.S. international trade
moving on U.S.-flag ships on a tonnage basis was 7.5 percent
(compared to 3.0 percent today). As the following table
illustrates, had U.S. shipowners been able to invest in new
tonnage as U.S. trade grew over the last 30 years--as did the
foreign shipowners whose ships now carry those cargoes--today's
United States-flag foreign-trading fleet could be almost 3
times its present size.
Impact of Lost Opportunity on U.S.-Flag Foreign Trading Fleet
----------------------------------------------------------------------------------------------------------------
Notional
Projected Ships Based
Segment 1965 U.S.- 1997 No. Ships on
Flag Share Tonnage (1997) Projected
Tonnage
----------------------------------------------------------------------------------------------------------------
Dry Bulk.................................................... 4.8% 19.6 M 8 20
Liner....................................................... 22.8% 29.2 M 59 157
Tanker...................................................... 5.5% 24.1 M 13 33
Total Ships............................................... 80 210
----------------------------------------------------------------------------------------------------------------
V. Proposed Changes to U.S. Tax Rules
Today, the Capital Construction Fund (``;CCF'') provides
the primary means under the U.S. Tax Code for a U.S.-flag
shipowner to accumulate capital to invest in new ships on a
basis that even remotely approaches the economic benefits
available to our foreign competitors under their national tax
regimes. As illustrated above, while the U.S. system has
enabled the U.S. fleet overall to stay even with its foreign
competition in terms of the amount of cargo historically
carried by U.S. ships in international commerce, it has failed
to provide a basis for growth. As a result, the U.S.-flag fleet
continues to lose market share to foreign ships and operators.
H.R. 2159, the ``United States-Flag Merchant Marine
Revitalization Act of 1999,'' introduced June 10, 1999, by
Representative McCrery and co-sponsored by Representatives
Herger, Jefferson, and Abercrombie, and referred to this
Committee, proposes a number of changes to the CCF and the tax
treatment accorded funds deposited therein to increase its
effectiveness in helping to generate private investment capital
for new United States-flag ships and operating equipment. We
strongly support this measure and urge its prompt consideration
by the Committee and its early enactment.
A. Capital Construction Fund
The Capital Construction Fund (or ``CCF'') Program set
forth is section 607 of the Merchant Marine Act of 1936 and
Section 7518 of the Internal Revenue Code of 1986 is designed
to provide competitive tax treatment to U.S.-flag vessel
operators and to encourage construction, reconstruction and
acquisition in United States shipyards of new vessels for the
U.S.-flag foreign, domestic non-contiguous, Great Lakes, and
fisheries fleets. Under the CCF, maritime and fisheries
operators enter into binding contracts with the federal
government which allow them to defer U.S. income tax on certain
funds to be used for an approved shipbuilding program. The
deferred tax is then recouped by the U.S. Treasury through
reduced depreciation as the tax basis of a vessel purchased
with CCF funds is reduced to compensate for the tax deferral.
Under CCF, an operator is permitted to deposit into a CCF
account revenues derived from the operation in the covered
trades of an ``eligible'' vessel and to use those deposits for
purchase of a new ``qualified'' vessel built in a U.S.
shipyard. While the proposed changes will not alter this basic
equation, they will reduce the competitive handicap of these
U.S. tax rules by expanding the definitions of such vessels and
how CCF funds are treated under the Code.
B. Proposed Changes
The purpose of the proposed changes is to revitalize the
international competitiveness of the United States-flag
merchant marine. This is accomplished by providing a tax
environment which, as compared with current U.S. tax rules,
more closely approximates the favorable tax environments
provided by other maritime nations to their national flag
merchant fleets. Absent the proposed tax reforms, U.S.-flag
carriers will continue to face a formidable tax cost
disadvantage against foreign flag carriers who pay little or no
tax in their home countries. Moreover, U.S. operators in the
domestic oceangoing coastwise and noncontiguous trades would be
encouraged to invest in construction of new or replacement
vessels for those trades in U.S. shipyards, with increased
benefits to the American shippers served by those trades and
the U.S. economy generally.
The proposed changes to the CCF and how CCF funds are
treated under existing U.S. tax rules include the following:
Modernize the scope of vessels covered by the CCF
regime by including foreign-built, U.S.-flag vessels as
eligible vessels for purposes of CCF deposits. Additionally,
U.S.-flag vessels operated in the oceangoing domestic trade and
in trade between foreign ports are to be included within the
definition of qualified vessels for purposes of purchases using
CCF. Moreover, containers and trailers that are part of the
complement of a qualified vessel would become eligible for CCF
purchase. Qualified withdrawals from a CCF account for vessels,
however, would continue to be limited to U.S.-flag ships built
in U.S. shipyards.
Allow CCF withdrawals to be used to fund the
principal amount of a lease of qualified vessels or containers
if the lease is for a period of at least five years. This
recognizes the widespread use of leasing as a modern financing
technique for vessel acquisition, a change that has occurred
since the original enactment of CCF.
Allow fundholders the right to elect deposit into
a CCF all or a portion of the amount that would otherwise be
payable to the Secretary of the Treasury as a duty on foreign
repairs to U.S.-flag vessels imposed by section 466 of the
Tariff Act of 1930 (19 U.S.C. 1466)(``ad valorem duty'').
Allow fundholders the flexibility to exceed the
normal cap for deposits into the CCF during a taxable year
where such excess results from an audit adjustment for a prior
tax year which increases the deposit cap for that year. The
excess that may be deposited equals only the amount which could
have been deposited under the cap for that year, less the
amount actually deposited.
Broadens the category of investments into which
CCF account funds can be invested. Thus, a CCF could invest not
only in ``interest bearing securities'' but also in ``other
income producing assets (including accounts receivable)'' so
long as the Secretary of Transportation approves the
investment.
As applicable, would make conforming changes to
the Merchant Marine Act of 1936, the Internal Revenue Code, and
other provisions of U.S. law needed to accomplish the foregoing
changes.
VI. Benefit for Coastwise/Non-Contiguous Trades
As noted, the proposed changes would affect not only United
States-flag ships operated in the foreign trades, but would
provide similar benefits to ships in the oceangoing domestic
coastwise, the non-contiguous, and the Great Lakes trades of
the United States. In these latter cases, the issue is not so
much the impact of U.S. tax rules on the international
competitiveness of those ships themselves--inasmuch as they do
not compete directly with foreign ships--but rather on the
competitiveness of the American industries and local U.S.
economies dependent on such shipping in domestic commerce.
The greater the efficiency and cost effectiveness of those
segments of the U.S.-flag fleet in transporting domestic goods
to market or to loading ports for foreign trade, the more
competitive those industries can be in the global marketplace.
The ability to build new, more modern ships for those trades--
as provided under the proposed changes--will be an important
factor in ensuring continued improvements in service and
lowered costs for American shippers.
VII. Summary & Closing
For the last half-century, U.S. tax rules have hindered the
international competitiveness of the United States-flag
commercial merchant fleet in the foreign trades. Faced with
competition from foreign-flag ships granted favorable tax
treatment by their national states, U.S. ships and shipping
companies have seen the share of U.S. international oceanborne
commerce carried by U.S.-flag ships decline steadily over this
period, despite a five-fold increase in such trade. As U.S.
trade grew, foreign shipping companies were able to invest in
newer, more numerous ships, using tax-free funds, while U.S.
shipowners were generally limited to using primarily after-tax
dollars for such investments.
Even where U.S. programs like CCF existed, their limited
scope made it possible for U.S. companies to replace existing
ships with newer ships, but not to expand their fleets to
compete for new cargoes. As a result, foreign ships now
dominate U.S. international trade. The economic and national
security of the United States depend on this Nation's continued
ability to guarantee the flow of goods in international
commerce through U.S. ports. Where, as here, U.S. tax rules
have hindered the competitiveness of the U.S.-flag shipping
industry, it is critical for Congress to act to ensure future
competitiveness.
Chairman Archer. The Chair is grateful to each of you
because you are the epitome of what we are trying to focus on
today. I am, as I mentioned in my preliminary remarks,
extremely concerned about what our Tax Code does to reduce our
competitiveness in the global marketplace, which is going to be
absolutely vital to every working American in the next century,
perhaps one of the most vital things facing the future of every
working American in the next century. Particularly as we look
at the extra burden on workers as a result of the demographic
changes that are looming with the baby-boomer retirement and
two workers for every retiree instead of three. We are going to
have to increase productivity. We are going to have to increase
savings. We are going to have to increase competitiveness in
the global marketplace.
Frankly, I do not think we can stop in simply improving
competitiveness. I think we need to give you, each of you, an
advantage. I happened to be strongly enough American to where I
do not think a level playingfield is what we should shoot for.
I think we should shoot for giving you an advantage to overcome
and replace the disadvantage that you have all spoken to that
we have under the current law. Now whether we can achieve it
ultimately is going to be a very, very long, difficult journey.
In the meantime, we need to think about how we can immediately
improve the current law, at least to some degree that will
significantly help you in the near-term.
I was very interested, Mr. Loffredo, in your comments
because what we are seeing, it seems to me, is the advent of a
new chemistry that is beginning to develop in the world and
that is the merger of larger corporations across country
boundaries. That again is part of what we have got to expect
more and more of in an inter-related world marketplace. Your
company, Chrysler, has merged with Daimler, and I notice that
it is not ChryslerDaimler, it is DaimlerChrysler. I wonder if
our Tax Code were changed whether it would perhaps not be
ChryslerDaimler or if perhaps the headquarters, the home
office, the controlling corporation would be U.S. instead of
German. Can you tell us what role, what impact the different
Tax Codes had on the ultimate decision of the boards of
directors in determining whether the resulting corporation
would be German or whether it would be U.S.?
Mr. Loffredo. Taxes were one of several issues that
determined the location and corporation--the country of
incorporation. The point that should be made is the fact the
United States never had a chance. There is no major foreign
operation that would voluntarily submit itself to the U.S.
international tax system. The way the structure is now, whether
taxes was a controlling factor or just one of many, we never
had the opportunity to broach the question because the tax
system kept us from having any arguments to say it should be a
U.S. company. So, basically, I can't tell you taxes was the
reason. There were a lot of legal reasons, a lot of political
reasons in Germany. But I can tell you the U.S. tax system did
not give me any weapons to fight to make it a U.S. company.
Chairman Archer. What sort of advice did the boards of
directors receive from their tax experts on both sides of the
Atlantic relative to what the resulting corporation should be?
Mr. Loffredo. Once it was determined that the U.S. laws
were not the proper place from a tax standpoint, and this means
a lot because one of the major disadvantages of not being a
U.S. company is that you are not treated the same way on the
New York Stock Exchange and Standard & Poors. So you don't take
such a decision lightly here. By giving up the U.S. corporate
format, we were taken out of the Standard & Poors 500 and our
stock suffered greatly.
But there were many reasons, there were legal, there were
political, there were tax. But after we got through the point
as to whether or not that we knew we could not be a U.S.
company, we looked around Europe or the rest of the world as to
what type of company we should be. We looked to The Netherlands
and we looked to some of the tax havens. And then the German
tax laws came in strongly to support the fact that it should be
a German company because if you look at the German tax laws,
even though they at that time they probably had an effective
tax rate of 52 percent, which is significantly higher than
ours, 45 of that being a Federal tax rate, when a German
company pays a dividend to a German shareholder, they receive
15 percent of those 45 percent points back. And then the
integrated tax system in Germany comes to play. So, in effect,
a German company is not a taxpayer when it has a German
shareholder because the shareholder would get the credit for
the corporate tax. So the integrated system favored a German
company.
And, as you can see over the past year or so since the
merger, we started out with 44 percent U.S. shareholders and we
are down to around 25 percent shareholders. The attractiveness
of this investment in Europe is growing. I can't say taxes was
the major decisionmaker, but definitely I had no arguments from
a U.S. standpoint to fight for it.
Chairman Archer. Well, you testified that by becoming a
German company, your corporation was able to save 23.5 percent.
Mr. Loffredo. That is an example of--if we were comparing
being a U.S. parent company and a German company on dividends
coming into the parent. If the dividends came from Germany to
the United States----
Chairman Archer. Sure.
Mr. Loffredo [continuing]. We would be unable to use the
credits, our rate would have been significantly higher. Going
into Germany, we know that the tax on U.S. dividends will be
about 40, 41 percent. But, again, in any decision you make in
business, taxes is just one of many that you do. It is not the
controlling decision.
Chairman Archer. Well, certainly, that would be the case.
You examine government regulation, you examine all types of
things, but so many of the other things, we do not have much
opportunity to change.
Mr. Loffredo. Right. No, I agree.
Chairman Archer. If the United States had no income tax and
derived all of its revenue from a border adjustable consumption
tax, would you have been able to make a strong recommendation
to the board that they should emerge as a U.S. corporation?
Mr. Loffredo. I think my position would have been greatly
enhanced because then I would have had the argument that any
dividends coming into the United States would have been free of
tax because we would have basically then been a similar
territorial system like the German system is now. Plus, as you
know, I have spent a lot of time over the last 15 years looking
at border adjustable type taxes and with the advent--well, with
the sale of close to 2 million Chrysler vehicles in the United
States, Chrysler Jeeps and Dodges and Plymouths, and the sale
of 200,000 Mercedes Benz in the United States, a third of those
coming now from Alabama, I think it would have given me a
strong argument for the United States being the seat of the
corporation. Whether that would have changed the minds of the
Daimler people, I can't say.
Chairman Archer. Well, I understand that you are to some
degree limited in your position with the corporation today in
what you can say publicly before the Committee, and I do
appreciate what testimony you have given to us. Let me simply
say to all of you that Princeton Economics did a survey of
major foreign corporations in Europe and Japan and asked them
this question: If the United States abolished its income tax
and raised its revenue in the form of a sales tax, what impact
would that have on your decisions? The responses were that 80
percent said they would build their new factories in the United
States and export from the United States. Twenty percent said
they would move their international headquarters to the United
States.
What we are seeing in reverse, as a result of our Tax Code,
is DaimlerChrysler headquartered in Germany. I am not opposed
to all of this inter-relationship, but in the long-term, it is
certainly going to push ideas, concepts, purchases and the
operation of the company more toward a consideration of the
Germans than the United States. We have seen that happen with
Bankers Trust, which is now Deutsche Bank of Germany because of
our Tax Code. We have seen it happen with Amoco and now with
Arco, which are now British corporations. If our Tax Code were
different, there is no doubt in my mind that all of them would
be U.S. corporations. Even though it is not the total factor in
decisions, it is a massive factor in decisions.
So I am delighted to hear the testimony from you today that
conveys to this Committee the need to do something about the
way that we prejudicially tax foreign source income and to get
American moving again, not just to compete but to win the
battle of the global marketplace in the next century.
So I thank you very much. I am sure other members would
like to inquire.
Mr. McCrery.
Mr. McCrery. Thank you, Mr. Chairman. You spoke about
competitiveness and there is one item that was brought up by
this panel that to me just sticks out, not in the Tax Code but
in our duty structure, as being uncompetitive or putting our
American ocean carriers in a very uncompetitive position and
that is the duty on foreign repairs. This Committee repealed
that duty 2 years ago only to lose it in conference because of
some other considerations.
But, Mr. Finnerty, so that the Members of this Committee
will fully understand what happens, let me just describe a
situation and you tell me if this is correct. If there is an
American vessel leaving port in the United States carrying
goods for export and it sails across the Atlantic, goes over to
Europe, dumps its goods--not dumps, puts its goods into port
for export, and then it has a mechanical problem, something
goes wrong with the ship. And you got to have it fixed at a
repair facility in Europe. Tell us what happens duty-wise when
you have to make that repair overseas?
Mr. Finnerty. Mr. McCrery, the law provides that after we
pay the bill overseas, whether it be in Asia or Europe, when we
call at the first port in the United States with that U.S.-flag
vessel, we then owe the U.S. Government 50 percent of that
bill. This does not apply to the foreign-flag vessels that we
operate. And it does not apply to the foreign-flag vessels that
are operated by all of our other competitors overseas. It only
applies to U.S.-flag ships.
Mr. McCrery. So that repair costs you 50 percent more than
it otherwise would because of the duty imposed by the U.S.
Government?
Mr. Finnerty. That is correct.
Mr. McCrery. Mr. Chairman, that, to me, is one of the more
ridiculous provisions of our law that I have ever heard. And I
hope this Committee once again will repeal that. But in lieu of
repealing, the American-flag vessels have come up with an
innovative way to turn that duty to the advantage of American
shipyards. They are willing to allow that duty to continue to
be imposed if they have the option of putting that 50 percent
duty, rather than into the Treasury, into something that is
already set up, the Capital Construction Fund, which would
enable them to use that money at some point to build new ships
in American shipyards. So it kind of creates at least a partial
win-win for the industry. They still have to pay the 50 percent
penalty, but at least the money would go into a ship
construction fund that would have to be spent at shipyards here
in the United States.
So, Mr. Chairman, I hope this Committee will give
consideration to that approach if we do not just repeal that
duty altogether.
Thank you.
Chairman Archer. Does any other member have any questions?
Mr. Rangel?
Mr. Rangel. Thank you. Mr. Loffredo, you had indicated that
tax liability was one of the major factors in determining where
you would have your headquarters, but the chairman was
suggesting the abolishment of the entire Tax Code and
substituting it with a national sales tax. What impact would
that have had on the decision that your company made?
Mr. Loffredo. It would have at least given me the
opportunity to present the case that a U.S. quarters should
be--or a U.S. corporation should be the parent of the Daimler
Group because one of the concerns of double taxation in the
United States would have gone away, and we would be certain
that the only tax we would pay would be on the products sold in
the United States. And so at least I would have had an argument
to go forward. Under the current system, I had no way--I mean
as a tax director, it was very good to be able to give advice
saying, ``Don't be a U.S. company.'' But as an American, that
was very difficult advice to give our management that you don't
want to end up being an American company. All kinds of
companies are trying to flip out of the United States, and we
have an opportunity to do it. And so from a tax standpoint,
this advice is being given everyday. But it shouldn't be the
advice that a U.S. citizen should give.
Mr. Rangel. But tax relief or simplification or abolishment
of the double taxation, any of these things could have provided
you with a more favorable tax climate in the United States. The
chairman read parts of a report from Princeton, which sounds so
exciting. It suggests that if we just ``abolished the Tax Code
as we know it,'' then you wouldn't have any decision to make.
You would just bounce your firm right over here.
Mr. Loffredo. As you know, our partner was Daimler Benz,
which is the largest manufacturer in Germany. So political
decisions could have outweighed any tax decisions as to where
the location of that facility would be. I can say from a tax
standpoint, I could defend a U.S. corporation very well and
probably from an investment standpoint because it would have
been still in the Standard & Poors and still a normal stock on
the New York Stock Exchange. But the political aspects of that,
as you know are sometimes beyond my control.
Mr. Rangel. What you are saying is that if we make it more
favorable, it's a factor and----
Mr. Loffredo. Right.
Mr. Rangel. And you have to weigh everything. Then you make
a decision. But you certainly are not prepared to say that if
we abolished the Tax Code you would be here.
How about the rest of you in terms of this approach that
the chairman has suggested just wipe the Tax Code out, pull it
up by the roots, start all over, go into a universal sales tax
system, and get all you guys back here in the United States? Is
there anyone who believes that this would really bring you all
back home where you belong? Do you think it would be a
tremendous advantage to be able to say that you are a U.S.
firm, you are tax-free, you will be more productive, and if it
is possible, you will help the economy improve to an even
higher standard than the President's gotten it? You don't seem
as nearly as excited about this as my chairman. How about you,
Mr. Finnerty?
Mr. Finnerty. Well, Mr. Rangel, I will defer to my
colleagues on the specifics, but I can tell you of what I know
of that proposal, it would have a very dramatic and beneficial
impact on the U.S. economy. My own company does business
primarily outside the United States with our ships, so it would
not have as immediate an impact on us. But in terms of our
customers that would be producing the exports from the United
States, it would be a very powerful engine.
Mr. Rangel. Let me ask this before the red light goes on.
We know that taxes play an important role in deciding where you
are going to set up your headquarters. What about the
competency of your staff and the education of our workers and
the transfer of technology? Do you find that United States
workers are competitive with workers in other parts of the
country with regards to your company needs? Are we in pretty
good shape?
Mr. Loffredo. I would just make a point. Whether you are a
U.S. company or a German company, it really doesn't dictate
where you have to set up your physical location for your
headquarters. At the current time, we have two headquarters
within the DaimlerChrysler Group. We have a headquarters in
Auburn Hills and we have a headquarters in Stuttgart. And it
doesn't mean that eventually we may not have a headquarters in
London or in New York to really be more of a holding company.
So the country of incorporation doesn't have to dictate where
you put your headquarters.
Mr. Rangel. No, I am asking though whether the
sophistication or the training of the employees, would that not
be a factor too as to where you would place yourselves?
Mr. Loffredo. But it may not be a factor as to what country
of incorporation you are in. It just may be where you have your
offices.
Mr. Green. I can tell you in the emerging global energy
industry that with the American workers and the skill of
knowledge that we have in this country is unquestionably in the
top-tier around the world. And that is really where we are
coming from and having that capability to transfer that
knowledge and skills. And I say knowledge and skills because we
are an industry that cannot export jobs. We have to have a
taxable presence with the other customers. So it is teaching
that knowledge and that skill that we have learned in this
country around the world. And to have that opportunity is what
we are after. This has only been going on since about 1987. So
it is a new situation in the global energy industry. And what
we are talking about is foreign companies owning energy
infrastructures, the very key driver to economies around the
world. And for Americans to have the chance to be a part of
that vital piece of other economies is very important. At the
same time, we want to be able to protect our own economy and
who owns our energy infrastructure here. So it is a very
serious, important situation for us.
Mr. Rangel. Thank you, Mr. Chairman.
Chairman Archer. Does any other Member have questions?
Mr. Levin.
Mr. Levin. Just briefly, a couple of comments. Mr.
Chairman, I think the discussion about the impact of our tax
system on our competitiveness needs to be undertaken seriously
and openly and with open-mindedness. I hope we will bring the
same spirit when we talk about trade legislation and be willing
to look at new ideas and also have the same sensitivity to the
impact on U.S.--on American productiveness and production.
I take it the answer on the sales tax would be affected to
some extent by the amount of the sales tax. I would think that
my friend from Chrysler would be the first to acknowledge that
that has some impact.
Let me just say, Mr. Chairman, it is important that we talk
about the basic system, and I think you will agree, we also
need to continue to focus on changes that we might make in the
present system. For example, the discussion of active finance
income. I hope we will continue to think about that because
that is one item that has some cost to it in our bill. And
unless there is substantial support for it, it isn't likely to
be continued on a long-term basis.
I also want to join with Mr. McCrery in urging we do take a
look at 2159 to try to solve that dilemma.
Thank you, Mr. Chairman.
Chairman Archer. Thank you, Mr. Levin. The Chair recognizes
Mr. Weller and then Mr. McDermott.
Mr. Weller. Thank you, Mr. Chairman. And I would like to
direct my question to Ms. Stiles of Caterpillar. And, of
course, in my conversations with your company, you employ
almost 8,000 workers in the district that I represent in the
south suburbs and rural areas that I represent. And you folks
make a lot of these. And this is a fraction of the size of the
actual equipment that is produced. But very clearly,
Caterpillar has always indicated how important global trade is
in our conversations. And I just wonder can you tell me what
percent of the product you produce is sold overseas today?
Ms. Stiles. I believe we are at 49 percent of our sales are
overseas.
Mr. Weller. And that area, is it growing?
Ms. Stiles. It has grown in the past years. I think we are
actually down a percent maybe last year from 50 percent.
Mr. Weller. Is your chief competitor a U.S. company?
Ms. Stiles. We do not regard our chief competitor as a U.S.
company. I would say more that it is a Japanese Co., Kamutzu,
would be I believe one of--it is spread a bit between Japanese,
Korean, and, of course, we do have competitors in the United
States. But especially on that large equipment, like you have
sitting there, it would not be a U.S. company, no.
Mr. Weller. You mention that the deferral for finance,
active finance income helps you provide a more level
playingfield when you are competing with the Japanese and the
Koreans and the others in the global market. Can you elaborate
on why this is the case? Why that deferral for active finance
income helps put you on a more level playingfield?
Ms. Stiles. Certainly. As I discussed earlier, given the
average price of Caterpillar equipment, the majority of our
sales are very closely tied to the ability to provide an
attractive financing package to our customers. We have found at
Caterpillar, we maintain a very close relationship with our
customers, not only for the machine and the servicing and sale
of the machine but also for the financing.
In order to do this in international settings, we have to
compete with our foreign competitors based on the local tax law
because most of our foreign competitors will not be subject to
an additional incremental tax in their home country. Now when
we absorb those costs, which we must if we are going to offer
the same type of financing packages that they do, over the
course of billions and billions of sales transactions, this
becomes a very significant cost for Caterpillar. If, on the
other hand, we find that we simply cannot offer the same type
of package, due to the incremental tax costs facing our
companies, we risk not only losing the finance transaction, but
we risk losing the sale of the equipment, which is basically
the reason we have a finance company is to sell CAT equipment.
Mr. Weller. So the loss of your ability to offer finance
income would severely hamper your ability to compete with the
foreign competition?
Ms. Stiles. That is correct.
Mr. Weller. The last two hearings on international
simplification, including the one this past week, they have
disclosed there are major problems with the United States
treatment of foreign tax credits. And I was wondering what you
would recommend to remedy this problem?
Ms. Stiles. Well, there are several things, two of which we
would recommend highly are included in the current legislation,
the extension of the carry-forward period for foreign tax
credits and the acceleration of the provisions related to the
902 non-controlled foreign corporations. But in addition to
that, there are several places where it is noted we need a
study of allocation of interest expense and apportionment.
I would go a little further than that in that I don't know
of a company that the interest expense apportionment rules are
not having a very detrimental effect on them for a variety of
different reasons. In our case, we have a U.S.-captive
financial company. And because of the interest expense that is
incurred by that company, we feel we are unfairly penalized
with that expense because a very large portion of that is
apportioned to foreign assets under the current rules. This
expense is incurred solely to fund U.S. transactions. It should
be consolidated within that financial company.
Also, the basket rules have become so complex that they are
not only costly procedures but error prone. We have to devote
an entire staff of people for 8 to 10 weeks to calculate one
number on our tax return, the foreign tax credit limitation.
And while I am on the simplification, the use of U.S. gap
earnings and profits, I think would go very far in the eyes of
most companies to simplifying this process, and I believe
making it a more accurate process than what we have now.
Mr. Weller. OK, thank you. I see my time has expired. Thank
you, Mr. Chairman.
Chairman Archer. The Chair recognizes Mr. McDermott.
Mr. McDermott. Thank you, Mr. Chairman. As one of the non-
tax lawyers on this Committee, I have a question. Mr. Loffredo,
you talk about the Germans are territorial. Are they talking
Germany or they talking the common market?
Mr. Loffredo. No, worldwide. Prior to this recent law
change, any dividends received by a German company from a
foreign subsidiary would not have been taxed in Germany. It is
not only the common market.
Mr. McDermott. It is the whole world?
Mr. Loffredo. Our dividends from the United States to them
would have also gone in tax free.
Mr. McDermott. And explain to me, just trying to understand
historically why this happened, why are we in the position that
we are that makes an American company say, ``Gee, we would be
better to be registered in Germany.'' Explain what are the--how
did that happen?
Mr. Loffredo. I think it began, as the chairman started the
hearings with in 1962, with the beginning of Subpart F and the
evolution of that over the last 35 or 37 years making it more
and more difficult for U.S. companies to utilize their foreign
tax credits. And once you make it more difficult to utilize
foreign tax credits, which are taxes paid by our foreign
subsidiaries, you are then subjecting to yourself to a double
taxation in the United States when you bring the funds home.
Mr. McDermott. But in other words, the Congress kind of
used a sledge hammer to deal with the Cayman Islands, or
wherever the tax havens were, and they hit the rest of you?
Mr. Loffredo. Right, the abuses were out there and there
were definitely abuses out there. But when they went after the
abuses, they brought in the normal business transactions also.
Mr. McDermott. Do you think it is possible to divide the
baby here and deal with legitimate foreign operations and the
kind of tax haven operations of the Caymans?
Mr. Loffredo. I question whether whatever law comes up, I
think someone would be able to find a way around it.
Mr. McDermott. Guys as smart as you could find a way around
it, right?
Mr. Loffredo. Yes, a decision has to be made whether or not
you are going to maybe set a rule, you are going to tax all
foreign income at 35 percent. If you proved you paid it
someplace else, then you don't pay any more into the United
States. If you didn't pay it someplace else, then you pay it to
the United States. I mean something that arbitrary may have to
be the only way to do it. But any rule you try to create will
just create a 1,000 tax lawyers getting around it.
Mr. McDermott. In other words, trying to devise a rule that
defines a paper corporation?
Mr. Loffredo. Right.
Mr. McDermott. Is pretty difficult?
Mr. Loffredo. Pretty difficult.
Mr. McDermott. I have a second question for Mr. Finnerty.
My understanding that your taxation, when you say when you tie
up in an American port, you have to pay 50 percent of the cost
of the repair. That is a trade law. That is not an income tax
law, is that correct?
Mr. Finnerty. It is a customs duty, Mr. McDermott. It is
not an income tax, it is a customs duty.
Mr. McDermott. So the chairman's idea of taking out the
income tax, that really wouldn't do anything for what you are
talking about because you are not taxed?
Mr. Finnerty. No, not on that particular piece. But the
balance of my discussion about the Capital Construction Fund,
which is a tax deferral account, does relate to income.
Mr. McDermott. OK, thank you. The other question I have for
the panel really is a question of what you are saying here
today is the tax laws are slanted the wrong way and we want to
slant them the other way. There must be some reason why your
companies stay here or don't--for instance, Caterpillar, why
don't you go find some small equipment manufacturer somewhere
overseas and do what DaimlerChrysler did? Why don't you do
that? What makes you stay here?
Ms. Stiles. Well, in the first place, for Caterpillar to
move would be a very expensive proposition. Our plants are not
easily moveable. We have to sink three stories into the ground
just to lift our equipment, and we have a manufacturing base
right now whereby 70 percent of our assets are in the United
States. We would like to keep it that way.
Mr. McDermott. But that is true for Chrysler, too? They did
that. They didn't move any of their plants. They just simply
moved the headquarters people and the tax people and changed
the line on the door that said a German company?
Mr. Loffredo. There is a rule in the tax law currently that
says if you basically flip out to a foreign jurisdiction and
re-incorporate, unless you meet certain tests, which we met in
our merger, your shareholders are subject to tax on the gain.
So there is some control on becoming a non-U.S. company
currently in the tax law. If Chrysler were larger than Daimler,
we would have had the potential of a U.S. tax problem if we
became a German company. But in our tax situation, Daimler was
larger than Chrysler.
Mr. McDermott. So Caterpillar's real problem is that they
are too big?
Mr. Loffredo. Right.
Mr. McDermott. They can't find anybody bigger than them to
join with?
Mr. Loffredo. But one of the things I have noticed is you
can start doing a pyramid scheme because we have come from $60
billion, well, let's say they were $80 billion when they
acquired us, and we were $60. And now we are maybe $140 billion
company. And now we can look at a Caterpillar where you could
almost pyramid your way out.
Mr. McDermott. Thank you, Mr. Chairman. I don't think I
understand everything yet.
Chairman Archer. Does any other member wish to inquire? The
Chair would like to comment briefly to your inquiry, Mr.
McDermott. If we went to the simplified 35 percent of foreign
source income tax, you would still have to define foreign
source income. You can not avoid that. You can not simplify it
because you are inevitably coming back and having to change
what is and what is not income and no two economists agree on
what is or is not income. That is the problem. Your testimony
today for the most part, if we could get this change in the
Code, we would not be at this great disadvantage. Then you
start to examine how you make these changes and it is the most
complex part of the Tax Code that we have.
I would like to ask each one of you what disadvantages are
present in deciding between remaining a U.S. corporation
compared to being a foreign corporation other than the Tax
Code?
Mr. Green. I will speak for the utility industry. That
really is the primary disadvantage, quite frankly. Here we have
the energy system that is the envy of the world, the skill and
knowledge and the workers, and what we are seeing is the
globalization of an industry that has only been going on for 10
or 12 years. So really getting Americans competitive in this
industry is to preempt the event that we simply can't be
competitive.
Chairman Archer. Does any one want to cite other aspects of
being in the United States where you are at a disadvantage
other than the Tax Code?
Mr. Loffredo. May I just--two things I have noticed is that
first of all, the reaction to Wall Street has been negative,
the fact that we are not a U.S. company any longer, which is
really critical in a lot of respects. Second, from a personal
standpoint, the morale of U.S. employees I think has been a
negative.
Chairman Archer. You think there is higher morale of
employees in other countries than there is in the United
States?
Mr. Loffredo. No, I think there was higher morale at
Chrysler when we were a U.S. company.
Chairman Archer. OK. So you have not cited any other
inherent disadvantage to being in the United States other than
the Tax Code?
Mr. Loffredo. And Wall Street.
Chairman Archer. And Wall Street. Let me make sure I
understand this. In other words, U.S. corporations are at a
disadvantage to foreign corporations because of Wall Street?
Mr. Loffredo. No, no, I'm sorry. Tax Code, but a
disadvantage of being a foreign corporation is that you are no
longer allowed certain rights on Wall Street.
Chairman Archer. OK. So that is an advantage to being in
the U.S.?
Mr. Loffredo. Yes.
Chairman Archer. OK. I am asking you to cite any other
disadvantage to being in the U.S. other than the Tax Code? The
reason I do that is because of the inference in other questions
that the Tax Code is only a small factor and all these other
factors are things that have to be considered. If the Tax Code
is the only negative factor in being a U.S. corporation, then
clearly it is of major significance because all of these
decisions are made at the margin. We could not see, for
example, up until the last five to 10 years, what is happening
now with DaimlerChrysler, Banker's Trust, Deutsche, Case,
foreign corporation, Amoco, Arco, foreign corporations taking
over. This is a new phenomenon in an inter-related world
marketplace. It is clear that it is driven by the Tax Code. It
is clear that it will continue into the next century when the
conditions are at the margin where the Tax Code will make that
determination.
That is not in the best interest of the United States of
America. God help us if we do not do something about this. It
is the single biggest thing we can do to help in this regard
unless you think of something else, it is a disadvantage in the
United States where we ought to help on that.
Mr. Watkins. Mr. Chairman?
Chairman Archer.
Mr. Watkins.
Mr. Watkins. I think the point is well-taken that you are
making. And I think we are, in all respect, we are dealing with
tax individuals here and I would like them to broaden their
thinking just a little because you are right on the tax policy.
And one of the reasons why I came back to Congress was we need
to have a 21st century globally competitive economy in the
United States allowing us to be competitive around the world.
In all respects, tax policy is on your mind. That is a major
problem, and we have got to address that.
But there are three areas that I have studied, and tax
policy, yes. Second, regulatory. And I guarantee you talk to
other people in your company and the regulator policies are
affecting big time. Third, litigation, product liability, other
things we put right here in this country. Those are some of the
things that also have to be addressed if we are going to be
competitive companies around the world. But tax policy I know
is the issue right today. But I think we need to talk to other
people in our corporations because those two things are putting
an overburden of about 15 percent on a lot of our products.
Chairman Archer. Thank you very much for testifying today,
and I hope that all of you realize that I am not coming down on
any of you in my enthusiasm for trying to do something to help
you to be more competitive in the world marketplace in the next
century. If we do not change the Tax Code, we are driving jobs
out of this country. We are reducing our capability to compete.
We are reducing our ability to export. We are undermining the
ability of workers in this country to earn more in the next
century. Those are major items I think we need to attend to.
I do want to ask one specific question, relative to
interest allocation, which has come up a couple of times. Would
the Senate 86 proposal basically remedy this problem if we were
to adopt it in the tax bill this year?
Mr. Green. That wouldn't take care of our problems. I think
that that is a very good bill, and we need to work with that.
But there are two issues with that, one the 80 percent
ownership requirement. In the energy industry and the
privatization going on around the world, many times the
privatization is less than 50 percent. So we would fall out of
that qualification. The second piece of it that we would like
to work with them on deals with changing the measuring of the
assets to a fair market value or a tax book value. That, again,
becomes misleading for a utility that has depreciated long-
lived assets and really exacerbates the problem we have with
the interest allocation formula. But on the whole, it is a bill
that we think is a good one, and we would like to work with it
to see if we can get our solution inside that.
Chairman Archer. Do you think from your expert counsel on
this very complicated issue, that we can improve the Senate 86
approach without losing significant additional revenue, which
may make it prohibitive in the Tax Code?
Mr. Green. That certainly is our intent, understanding that
we are very sensitive to that revenue estimate. At the same
time, I would also like to encourage looking at this at a
phased-in approach perhaps, to maybe spread that a little bit
more and at least start the action to change in this area.
Chairman Archer. Well, we most definitely will need to do
that. Whatever tax relief bill that we propose will have very
little revenue to use in the first couple of years. So whatever
we establish as tax policy for the future, all of it is will be
phased in with a few exceptions. Then expanded as the wedge
grows out. That is a generic format that we will need to
follow.
Again, thank you very much. We appreciate your testimony.
You are excused, and we will get ready to hear our next panel.
The Chair announces that, at the conclusion of the next
panel, we will recess today for lunch. I hope we can do that no
later than 12:15 and come back at 1.
Gentlemen, welcome. We are ready to hear your testimony.
Dr. Hubbard, if you would lead off, we would appreciate it.
Again, if you will keep your oral testimony to within 5
minutes, we would appreciate it. Your entire written statement
will be printed in the record. Identify yourself before you
proceed.
STATEMENT OF R. GLENN HUBBARD, PH.D., RUSSELL L.
CARSON PROFESSOR OF ECONOMICS AND FINANCE, GRADUATE SCHOOL OF
BUSINESS, COLUMBIA UNIVERSITY, NEW YORK, NEW YORK, AND RESEARCH
DIRECTOR, INTERNATIONAL TAX POLICY FORUM
Mr. Hubbard. Thank you, Mr. Chairman, Mr. Rangel, Members
of the Committee. I am Glenn Hubbard, a professor of economics
at Columbia and research director of the International Tax
Policy Forum. The Forum is a diverse group of U.S.-based
multinationals that sponsors economic research and policy
education about international tax policy.
Racing against the red light, I only want to make three
points and focus on the last two of those. First, U.S.
multinationals make quite significant contributions to the U.S.
economy. Second, following up on the points raised by the last
panel, tax policy matters a lot for a range of investment
decisions of multinationals. And, third, the current anti-
competitive U.S. tax policy toward multinationals can lead to
runaway headquarters with significant potential losses in
national well-being.
I will not dwell on the role that U.S. multinationals play
in our economy. It is in my written testimony, and I am sure
other members of the panel will emphasize it. But I think it is
important to note that the United States has a significant
interest in ensuring that its tax rules do not hinder the
competitiveness of U.S. multinationals.
Tax policy matters a lot. Unfortunately, the discussion
here often centers on an academic debate between economic
efficiency and competitiveness. On the one hand, the United
States has traditionally advocated so-called capital export
neutrality, which is a long economic-sounding phrase simply
stating that a resident should pay the same rate of tax whether
an investment is made at home or abroad. This sounds simple.
The idea is not to bias the location of investment, and the
hope is to promote worldwide economic efficiency.
From a competitiveness perspective, on the other hand, the
United States has actually become one of the least attractive
countries in which to locate the headquarters of a
multinational. This reflects restrictions on the use of foreign
tax credits, strong anti-deferral rules, and the lack of
integration of the corporate individual income tax systems.
Why should we care? U.S. companies can compete successfully
against foreign firms only if they are adequately efficient to
overcome this artificially imposed tax disadvantage.
More important, this academic debate about efficiency
versus competitiveness is actually based on a false choice.
First, the United States has not, and probably will not, follow
the capital export neutrality doctrine that it espouses.
Implementation of capital export neutrality requires not just
eliminating deferral, which is often talked about before you,
but the granting of an unlimited foreign tax credit. Moreover,
worldwide efficiency, economists' holy grail, emerges only if
all countries simultaneously embrace the doctrine, a rather
unlikely outcome. It is an old lesson in economics that going
only part of a way toward an efficient outcome seldom makes us
better off.
Second, the models used to support the conclusion of
capital export neutrality abstract from many important features
of the real world, including imperfect competition. Economists
who study multinationals outside of the tax area stress those
features as absolutely critical for understanding
multinationals.
In a recent paper, Michael Devereux and I find that using
realistic assumptions about strategic competition, deferral of
U.S. taxation on foreign-source income can actually increase
the well-being of U.S. residents.
What are the bottom lines of U.S. multinationals? A
continuation of the current emphasis of U.S. tax policy could
lead to a decline in the share of multinational income earned
by companies headquartered here. It is not just academic. We
have been hearing it all morning. In several recent high-
profile mergers among United States and European
multinationals, including BP-Amoco, Daimler-
Chrysler, and Deutsche Bank Bankers' Trust, a merged entity is
chosen to be a foreign headquartered company.
More important, looking down the road, future investments
made by these companies outside the United States are not
likely to be made through U.S. subsidiaries since tax on those
operations could be removed from the U.S. corporate tax system
by simply making them through the foreign parent. To be blunt,
while some have suggested that reductions in the U.S. tax on
foreign-source income could lead to the movement of
manufacturing operations outside the U.S., so-called runaway
plants, the far more likely scenario for you to consider is
that a non-competitive U.S. tax system might lead to runaway
headquarters, an increase in the foreign control of U.S.
assets. Bottom line: U.S. tax rules can significantly alter the
ability of U.S. multinationals to compete successfully around
the world and ultimately at home.
On behalf of the International Tax Policy Forum, I urge
you, Mr. Chairman and Members of the Committee, to review
carefully the U.S. international tax system in order to root
out the major impediments limiting U.S. multinationals' ability
to compete globally with foreign-based multinationals.
[The prepared statement follows:]
Statement of R. Glenn Hubbard, Ph.D., Russell L. Carson Professor of
Economics and Finance, Graduate School of Business, Columbia
University, New York, New York, and Research Director, International
Tax Policy Forum
I. Introduction
I am R. Glenn Hubbard, Russell L. Carson, Professor of
Economics and Finance, Graduate School of Business, Columbia
University. I am testifying today on behalf of the
International Tax Policy Forum, of which I am the research
director. Founded in 1992, the International Tax Policy Forum
is a diverse group of U.S.-based multinationals, including
manufacturing, service, energy, financial service, and
technology companies. The Forum sponsors research and education
regarding the U.S. taxation of income from cross-border
investments. As a matter of policy, the Forum refrains from
taking positions on legislative proposals. John M. Samuels,
Vice President and Senior Counsel for Tax Policy and Planning
of General Electric, is chairman of the Forum.
PricewaterhouseCoopers LLP acts as consultant to the Forum. A
list of member companies is attached as Appendix A of this
testimony.
The Forum welcomes the opportunity to testify today on the
effect of U.S. tax rules on the international competitiveness
of U.S. companies. Increasingly, the markets for our companies
have become global, and our competitors are foreign-based
companies operating under tax rules that are often much more
favorable than our own.
The existing U.S. tax law governing the activities of
multinational companies has been developed in a patchwork
fashion over many years. In many instances, current law creates
barriers that harm the competitiveness of U.S. companies. These
rules also are horribly complex both for U.S. multinational
companies to comply with and for the Internal Revenue Service
to administer. That is why the Forum believes it is important
for this Committee to review the current U.S. international tax
rules with a view to reducing complexity and removing
impediments to U.S. international competitiveness.
II. The Role of U.S. Multinational Corporations in the U.S. Economy
The primary motivation for U.S. multinationals to operate
abroad is to compete better in foreign markets, not domestic
markets. Investment abroad is required to provide services that
cannot be exported, to obtain access to natural resources, and
to provide goods that are costly to export due to
transportation costs, tariffs, and local content requirements.
More than one-half of all foreign affiliates of U.S.
multinationals are in the service sector, including
distribution, marketing, and servicing U.S. exports.\1\ Foreign
investment allows U.S. multinationals to compete more
effectively around the world, ultimately increasing employment
and wages of U.S. workers.
---------------------------------------------------------------------------
\1\ Matthew Slaughter, Global Investments, American Returns.
Mainstay III: A Report on the Domestic Contributions of American
Companies with Global Operations, Emergency Committee for American
Trade (1998).
---------------------------------------------------------------------------
A. Exports
Much research has shown that U.S. operations abroad produce
a net trade surplus for the United States. Foreign affiliates
of U.S. companies rely heavily on exports from the United
States. Foreign affiliates of U.S. multinationals purchased
just under $200 billion of merchandise exports from the United
States in 1996. Additional exports by U.S. multinationals to
unaffiliated foreign customers accounted for an additional $213
billion in merchandise exports. Altogether, exports by U.S.
multinationals were $407 billion in 1996--or 65 percent of all
U.S. merchandise exports.\2\
---------------------------------------------------------------------------
\2\ National Foreign Trade Council, The NFTC Foreign Income
Project: International Tax Policy for the 21st Century, chapter 6
(1999).
---------------------------------------------------------------------------
A recent study by the Organization for Economic Cooperation
and Development complements other academic research in finding
that each dollar of outward foreign direct investment is
associated with $2.00 of additional exports and an increase in
the bilateral trade surplus of $1.70.\3\
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\3\ OECD, Open Markets Matter: The Benefits of Trade and Investment
Liberalization, p. 50 (1998).
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B. U.S. Employment
Foreign investment by U.S. multinationals generates sales
in foreign markets that generally could not be achieved by
producing goods entirely at home and exporting them. The
strategy used by U.S multinationals of using foreign affiliates
in coordination with domestic operations to produce goods
allows U.S. multinationals to compete effectively around the
world while still generating significant U.S. exports. These
U.S. exports result in additional employment of U.S. workers at
higher than average wage rates.\4\
---------------------------------------------------------------------------
\4\ Mark Doms and Bradford Jensen, Comparing Wages, Skills, and
Productivity between Domestic and Foreign-Owned Manufacturing
Establishments in the United States, mimeo. (October 1996).
---------------------------------------------------------------------------
A number of studies find investment abroad generates
additional employment at home through an increase in the
domestic operations of U.S. multinationals. As noted by
Professors David Riker and Lael Brainard:
The fundamental empirical result is that the labor demand of
U.S. multinationals is linked internationally at the firm
level, presumably through trade in intermediate and final
goods, and this link results in complementarity rather than
competition between employers in industrialized and developing
countries.\5\
---------------------------------------------------------------------------
\5\ David Riker and Lael Brainard, U.S. Multinationals and
Competition from Low Wage Countries, National Bureau of Economic
Research Working Paper no. 5959 (1997).
This relationship between foreign operations and domestic
employment was also noted by the Council of Economic Advisers
---------------------------------------------------------------------------
in the 1991 Economic Report of the President:
In most cases, if U.S. multinationals did not establish
affiliates abroad to produce for the local market, they would
be too distant to have an effective presence in that market. In
addition, companies from other countries would either establish
such facilities or increase exports to that market. In effect,
it is not really possible to sustain exports to such markets in
the long run. On a net basis, it is highly doubtful that U.S.
direct investment abroad reduces U.S. exports or displaces U.S.
jobs. Indeed, U.S. direct investment abroad stimulates U.S.
companies to be more competitive internationally, which can
generate U.S. exports and jobs. Equally important, U.S. direct
investment abroad allows U.S. firms to allocate their resources
more efficiently, thus creating healthier domestic operations,
which, in turn, tend to create jobs.\6\
---------------------------------------------------------------------------
\6\ Council of Economic Advisers, Economic Report of the President,
p. 259 (1991).
---------------------------------------------------------------------------
C. U.S. Research and Development
Foreign direct investment allows U.S. companies to take advantage
of their scientific expertise, increasing their return on firm-specific
assets, including patents, skills, and technologies. Professor Robert
Lipsey notes that the ability to make use of these firm-specific assets
through foreign direct investment provides an incentive to increase
investment in activities that generate this know-how, such as research
and development.\7\
---------------------------------------------------------------------------
\7\ Robert Lipsey, ``Outward Direct Investment and the U.S.
Economy,'' in The Effects of Taxation on Multinational Corporations, p.
30 (1995).
---------------------------------------------------------------------------
Among U.S. multinationals, total research and development in 1996
amounted to $113 billion, of which $99 billion (88 percent) was
performed in the United States.\8\ Such research and development allows
the United States to maintain its competitive advantage in business and
be unrivaled as the world leader in scientific and technological know-
how.
---------------------------------------------------------------------------
\8\ U.S. Department of Commerce, Survey of Current Business
(September 1998).
---------------------------------------------------------------------------
D. Summary
U.S. multinationals provide significant contributions to the U.S.
economy through:
A strong reliance on U.S.-provided goods in both domestic
and foreign operations;
Additional domestic employment of employees at above
average wages; and
Critical 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 hinder the competitiveness of U.S.
multinationals.
III. Tax Policy and U.S. International Competitiveness
The increasing integration of the world economies has
magnified the impact of U.S. tax rules on the international
competitiveness of U.S. multinationals. 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. As an example of this heightened worldwide
competition, between 1960 and 1996 the number of the world's 20
largest corporations headquartered in the United States
declined from 18 to just 8.
A. Why Tax Policy Matters
With the increasing globalization of the world economies,
it has become critical for U.S. businesses to compete
internationally if they wish to remain competitive at home. If
U.S. businesses are to succeed in the global economy, they will
need a U.S. tax system that permits them to compete effectively
against foreign-based companies. This requires that U.S.
international tax rules not place U.S.-headquartered
multinationals at a competitive disadvantage in foreign
markets.
From an income tax perspective, the United States has
become one of the least attractive industrial countries in
which to locate the headquarters of a multinational
corporation. This is because there are 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.\9\ By contrast, the United States taxes
income earned through a foreign corporation when it is
repatriated or deemed to be repatriated under various ``anti-
deferral'' rules in the tax code.
---------------------------------------------------------------------------
\9\ Organization for Economic Cooperation and Development, Taxing
Profits in a Global Economy (1991).
---------------------------------------------------------------------------
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.\10\ This differs from the U.S treatment of foreign base
company sales and service income, and certain other types of
active business income, which are subject to current U.S. tax
even if such income is reinvested abroad.\11\
---------------------------------------------------------------------------
\10\ Organization for Economic Cooperation and Development,
Controlled Foreign Company Legislation (1996).
\11\ Foreign source income relating to active financing income was
taxed on a current basis until the 1997 Act. Such income presently is
exempted from current taxation, although this exemption is slated to
expire on December 31, 1999.
---------------------------------------------------------------------------
Third, other countries with worldwide tax systems have
fewer restrictions on the use of foreign tax credits than does
the United States. The United States, on the other hand, has a
variety of rules that limit the crediting of foreign taxes.
Such rules include: the use of multiple ``baskets,''
restrictions imposed by the alternative minimum tax, the
apportionment of interest and certain other deductions against
foreign source income, and the attribution to a foreign
subsidiary of a larger measure of income for U.S. purposes
(``earnings and profits'') than is used by other countries.\12\
These rules can result in the incomplete crediting of foreign
taxes and, as a result, the double taxation of foreign source
income earned by U.S. multinational corporations.
---------------------------------------------------------------------------
\12\ Price Waterhouse LLP, Taxation of U.S. Corporations Doing
Business Abroad: U.S. Rules and Competitiveness Issues, Financial
Executives Research Foundation (1996).
---------------------------------------------------------------------------
Fourth, among the OECD countries, the United States, the
Netherlands, and Switzerland are the only countries that fail
to provide some form of integration of the corporate and
individual income tax systems.\13\ This integration is provided
by the major trading partners of the United States in order to
reduce or eliminate the extent to which corporate income is
double taxed by recognizing that dividends are paid to
shareholders from income previously taxed at the corporate
level.
---------------------------------------------------------------------------
\13\ Sijbren Cnossen, Reform and Harmonization of Company Tax
Systems in the European Union, mimeo., Erasmus University (1996).
---------------------------------------------------------------------------
The net effect of these tax differences is that a U.S.
multinational operating through a foreign subsidiary frequently
pays a greater share of its income in foreign and U.S. tax than
does a similar foreign subsidiary owned by a competing
multinational company headquartered outside of the United
States.\14\ This makes it more expensive for U.S. companies to
operate abroad than their foreign-based competitors. In such
circumstances, U.S. companies can only successfully compete
against foreign-based multinationals if they are sufficiently
more efficient than the competition to overcome this
artificially imposed tax disadvantage.
---------------------------------------------------------------------------
\14\ Organization for Economic Cooperation and Development, Taxing
Profits in a Global Economy (1991).
---------------------------------------------------------------------------
B. Capital Export Neutrality
While concerns for competitiveness require a U.S.
multinational operating in a foreign country to pay the same
tax as a foreign-based multinational operating in that country,
another efficiency concern is frequently proffered to support
taxing a U.S. investor equally whether the investment is made
at home or abroad. This latter notion is referred to as
``capital export neutrality.'' Capital export neutrality seeks
to ensure that a resident of a given country pays the same rate
of tax whether the investment is made at home or abroad. In
general terms, capital export neutrality is thought to not bias
the location of investment from the investor's perspective.
Capital export neutrality requires that all foreign source
income be taxed on a current basis by the home country and that
the home country provides an unlimited foreign tax credit for
all taxes paid.
The principles of competitiveness and capital export
neutrality necessarily conflict whenever effective tax rates
differ across countries. U.S. international tax policy has
frequently wrestled with the tradeoffs between these two
principles. In a recent speech, Treasury Assistant Secretary of
Tax Policy, Donald Lubick, noted the tradeoff between these
principles.\15\
---------------------------------------------------------------------------
\15\ Donald C. Lubick, Treasury Assistant Secretary of Tax Policy,
Speech before the George Washington University/IRS Institute (December
11, 1998).
---------------------------------------------------------------------------
The Internal Revenue Service issuance last year of Notice
98-11, in which the IRS announced that Treasury would issue
regulations to prevent the use of certain ``hybrid branch''
arrangements deemed contrary to the policies and rules of
Subpart F, demonstrated the Treasury's concern for capital
export neutrality.\16\ The hybrid branch arrangements targeted
by this Notice reduced foreign taxes, not U.S. taxes. Indeed,
the use of these arrangements can only serve to increase total
U.S. tax paid by U.S. multinationals since aggregate foreign
tax credits would be reduced.
---------------------------------------------------------------------------
\16\ Regulations that would have created subpart F income with
respect to such transactions were proposed in March 1998, but their
withdrawal was subsequently announced by Notice 98-35. Notice 98-35
expresses the intention to re-issue similar rules.
---------------------------------------------------------------------------
The debate regarding the principles of competitiveness and
capital export neutrality dates back at least to 1961, when
President Kennedy proposed the current taxation of all foreign
source income earned by foreign subsidiaries of U.S. companies
(except in developing countries). The legislation ultimately
enacted in 1962, however, put traditional concerns of
competitiveness ahead of the Kennedy Administration's concerns
for capital export neutrality.\17\
---------------------------------------------------------------------------
\17\ See National Foreign Trade Council, The NFTC Foreign Income
Project: International Tax Policy for the 21st Century, chapter 2
(1999).
---------------------------------------------------------------------------
C. Does Capital Export Neutrality Promote Efficiency?
The theoretical model in which capital export neutrality
results in worldwide efficiency in the allocation of capital
resources is a fairly simple model. In its simplest form,
savings in every country is in fixed supply and is not
responsive to market opportunities. As a result, each dollar of
foreign direct investment by a domestic resident results in one
less dollar of domestic investment. The model makes a number of
simplifications, but, even so, capital export neutrality leads
to worldwide efficiency only if all countries follow a tax
system imposing capital export neutrality. As noted earlier, in
practice a substantial number of the major trading partners of
the United States--half of the OECD--exempt active foreign
source income from taxation. In such a case, an attempt by the
United States to maintain capital export neutrality does not
necessarily improve either worldwide efficiency or U.S. well-
being. A well-known economic theorem shows that when there is
more than one departure from economic efficiency, correcting
only one of them may not be an improvement.18 Unilateral
imposition of capital export neutrality by the United States
may fail to advance both worldwide efficiency and U.S. national
well-being.
---------------------------------------------------------------------------
\18\ R.G. Lipsey and K. Lancaster, ``The General Theory of the
Second Best,'' Review of Economic Studies, pp. 11-32 (1956-57).
---------------------------------------------------------------------------
The simple model supporting capital export neutrality fails
to consider a number of real-world features that significantly
affect the tax policy conclusions one should draw regarding the
tax principles that promote worldwide efficiency and U.S. well-
being. For example, the model fails to consider that
competition among multinational corporations takes place in a
strategic environment where companies can increase their income
by achieving economies of scale. In work co-authored with
Michael Devereux, we show that, when these assumptions are
relaxed, deferral of home-country taxation on foreign source
income can increase the well-being of domestic residents
relative to a system of current inclusion of foreign
earnings.\19\
---------------------------------------------------------------------------
\19\ Michael P. Devereux and R. Glenn Hubbard, ``Taxing
Multinationals,'' mimeo. (January 1999).
---------------------------------------------------------------------------
The simple model supporting capital export neutrality also
fails to consider the possibility that foreign direct
investment is complementary to domestic investment--rather than
a substitute for domestic investment. As discussed earlier, a
number of economic studies find that, at the firm level,
foreign direct investment results in an increase in exports
from the home country to foreign subsidiaries.
Another important example of the simple model's failings is
that it ignores the possibility that domestic residents can
transfer their savings abroad through portfolio investment as
an alternative to foreign direct investment. As recently as
1980, portfolio investment abroad by U.S. investors was only
about one-sixth the size of U.S. direct investment abroad. By
1997, however, portfolio investment abroad was 40 percent
larger than U.S. direct investment abroad.\20\ If U.S. tax law
disadvantages U.S. multinationals, U.S. investors today have
the opportunity to direct their savings to portfolio investment
in foreign multinationals, the foreign investments of which are
not subject to U.S. corporate income tax.
---------------------------------------------------------------------------
\20\ U.S. Department of Commerce, Survey of Current Business (July
1998).
---------------------------------------------------------------------------
For these reasons, contemporary economic analysis offers
little reason to believe that unilateral adoption of the
principle of capital export neutrality can improve either
worldwide efficiency or U.S. well-being.
D. Implications for U.S. Multinationals
As noted earlier, from a tax perspective the United States
is one of the least favorable industrial countries in which a
multinational corporation can locate. Over time, these U.S. tax
rules could lead to a reduction in the share of multinational
income earned by companies headquartered in the United States.
This decline in the importance of U.S. multinationals should be
a concern for the very real loss in economic opportunities such
a decline would bring about for American workers and their
families.
Professor Laura Tyson, former Chair of the Council of
Economic Advisers and former Director of the National Economic
Council, points out a number of political, strategic, and
economic reasons why maintaining a high share of U.S. control
over global assets remains in the national interest.\21\ These
include:
---------------------------------------------------------------------------
\21\ Laura D'Andrea Tyson, ``They Are Not Us: Why American
Ownership Still Matters,'' American Prospect (Winter 1991).
---------------------------------------------------------------------------
U.S. multinationals locate over 70 percent of
their assets and employment in the United States;
U.S. multinationals invest more per employee and
pay more per employee at home than abroad in both developed and
developing countries; and
U.S. multinationals perform the overwhelming
majority of their research and development at home.
If the United States wishes to attract and retain high-end
jobs, the U.S. tax system must not discourage multinationals
from establishing their headquarters here.
In several recent high-profile mergers among U.S. and
European multinational corporations (including AEGON-
Transamerica, BP-Amoco, Daimler-Chrysler, Deutsche Bank-Bankers
Trust, and Vodafone-AirTouch) the merged entity has chosen to
be a foreign-headquartered company. In recent testimony before
the Senate Finance Committee, DaimlerChrysler's vice president
and chief tax counsel specifically implicated the overly
burdensome U.S. international tax regime as a key factor in the
merged firm's decision to be a German-headquartered
company.\22\ Future investments made by these companies outside
of the United States are unlikely to be made through the U.S.
subsidiary since tax on these operations can be permanently
removed from the U.S. corporate income tax system by instead
making them through the foreign parent.
---------------------------------------------------------------------------
\22\ John L. Loffredo, ``Testimony before the Senate Finance
Committee'' (March 11, 1999).
---------------------------------------------------------------------------
As I pointed out earlier, portfolio investment offers still
another, perhaps less visible, route by which foreign-owned
multinationals can expand at the expense of U.S.
multinationals. If U.S. multinationals cannot profitably expand
abroad due to unfavorable U.S. tax rules, foreign-owned
multinationals will attract the investment dollars of U.S.
investors. Individuals purchasing shares of foreign companies--
either through mutual funds or directly through shares listed
on U.S. and foreign exchanges--can generally ensure that their
investments escape the U.S. corporate income tax on foreign
subsidiary earnings.
While some have suggested that reductions in the U.S. tax
on foreign source income could lead to a movement of
manufacturing operations out of the United States (``runaway
plants''), a far more likely scenario is that a noncompetitive
U.S. tax system will lead to ``runaway headquarters''--a
migration of multinational headquarters outside the United
States and an increase in the foreign control of corporate
assets.
The decline in the market share of multinationals
headquartered in the United States has important implications
for the well-being of the U.S. economy. High-paying
manufacturing jobs and high-paying executive jobs are lost with
the movement of these headquarters. Research and development
may be shifted abroad, in addition to jobs in high-paying
service industries, such as finance, associated with
headquarters' activities. Further, foreign-based multinationals
operating in the United States rely significantly more on
inputs and supplies produced offshore than do U.S.-owned
companies. At the same time, the channeling of new investment
outside of the United States through foreign subsidiaries owned
by the foreign parent results in the generation of income
completely outside of the U.S. tax system. A desire to tax
foreign source income at rates higher than those of our
competitors may ultimately insure that that there is little
income left to tax.
IV. Conclusions
In summary, U.S. tax rules can have a significant impact on
the ability of U.S. multinationals to compete successfully
around the world and, ultimately, at home. On behalf of the
International Tax Policy Forum, I urge that this Committee
carefully review the U.S. international tax system with a view
to removing impediments that limit the ability of U.S.
multinationals to compete globally on the same terms as
foreign-based multinationals. Such reforms would enhance the
well-being of American families and allow the United States to
retain its world economic leadership position into the 21st
century.
Appendix International Tax Policy Forum Member Companies.
American Express Company
America Online, Inc.
Associates First Capital Corporation
Bank of America
Bristol-Myers Squibb Company
Caterpillar Inc.
CIGNA Corporation
Cisco Systems, Inc.
Citigroup
Dow Chemical Company
Eastman Kodak Company
Emerson Electric Co.
Enron Corporation
Exxon Corporation
Ford Motor Company
General Electric Co.
General Motors Corporation
Georgia-Pacific Corporation
Goodyear Tire & Rubber Company
Hewlett-Packard Company
Honeywell, Inc.
IBM Corporation
ITT Industries, Inc.
Johnson & Johnson, Inc.
Merrill Lynch & Co., Inc.
Microsoft Corporation
Morgan Stanley, Dean Witter & Co.
PepsiCo, Inc.
Philip Morris Companies, Inc.
Premark International, Inc.
The Procter & Gamble Company
The Prudential Insurance Company
Tenneco, Inc.
Tupperware Corporation
United Technologies Corporation
Warner-Lambert Company
Chairman Archer. Thank you, Dr. Hubbard.
The next witness is Mr. Murray. Welcome, and you may
proceed.
STATEMENT OF FRED F. MURRAY, VICE PRESIDENT FOR TAX POLICY,
NATIONAL FOREIGN TRADE COUNCIL, INC.
Mr. Murray. Thank you, Mr. Chairman. Good morning and good
morning to the distinguished Members of the Committee. My name
is Fred Murray. I am Vice President for Tax Policy for the
National Foreign Trade Council. With me today are Mr. Phil
Morrison, director of the International Tax Services Group in
the Washington national office of Deloitte & Touche and
formerly International Tax Counsel at the Treasury. And also,
Mr. Peter Merrill, director of the National Economic Consulting
practice at Pricewaterhouse-
Coopers in their Washington national office, and who was
formerly chief economist for the Joint Committee on Taxation.
Our testimony relates to the Foreign Income Project of the
National Foreign Trade Council. My written statement and a copy
of our report is before you in your packets.
In addition to the three of us, the Project has been
drafted and reviewed by more than 50 distinguished
professionals, former Treasury and IRS officials, including
Assistant Secretaries and Deputy Assistant Secretaries for Tax
Policy, International Tax Counsels, a Commissioner of Internal
Revenue, and other distinguished lawyers and economists,
corresponding professionals from Hill offices, and, finally,
distinguished lawyers, accountants, and economists from some of
America's most prominent companies, professional firms, and
universities.
The NFTC is an association of businesses with some 550
members founded in 1914. Most of the largest U.S. manufacturing
companies and most of the 50 largest U.S. banks are Council
members, accounting for at least 70 percent of all U.S. non-
agricultural exports and 70 percent of U.S. private foreign
investment.
In 1997, the NFTC launched this project in response to
growing concerns about the disparity between U.S. trade policy
and U.S. tax policy. Foreign competition faced by U.S.-based
businesses has greatly intensified in recent years. The
globalization of business has also greatly accelerated. We
believe it is important to pause to look at these changes and
at their implications.
We focus our study on the last 40 or so years because in
1962, Congress made major changes in our international tax
system in enacting Subpart F. Subpart F was shaped in a global
economic environment that has changed almost beyond recognition
as the 20th century comes to a close. The gold standard has
been abandoned. The exchange rate of the dollar is no longer
fixed. The United States is now the largest importer of
capital, with foreign investment in U.S. assets exceeding U.S.
investment in foreign assets by over $100 billion per year.
Our current rules, to the extent they were enacted for more
than revenue considerations, are often based on economic
underpinnings that no longer apply. Mr. Merrill will elaborate
on these issues in his remarks.
Our study today leads us to several broad conclusions:
United States-based companies are much more dependent on
global markets for a significant share of their sales and
profits, and, hence, have plentiful non-tax reasons for
establishing foreign operations.
United States-based companies are now far less dominant in
global markets, and, hence, more adversely affected by the
competitive disadvantage of incurring current home country
taxes with respect to income that in the hands of a non-U.S.-
based competitor is subject only to local taxation.
Changes in U.S. tax law in recent decades have on balance
increased the taxation of foreign income. And, as Mr. Morrison
will discuss in a greater detail, we have also concluded that
U.S. taxation of foreign income is far more complex and
burdensome than that of other significant trading nations and
far more complex and burdensome than what is required by
appropriate tax policy. We have tried to lead other countries
to our position, but none have followed us to where we are.
United States tax laws impose rules that are different in
important respects than those imposed by many other nations
upon their companies. Other countries also tax the worldwide
income of their nationals and companies doing business outside
their territories. But such systems are generally less complex,
and provide for deferral subject to less significant
limitations. Importantly, many have territorial systems of
taxation and/or border adjustable VAT systems.
The U.S. foreign tax credit system is very complex,
particularly in the computation of applicable limitations under
section 904. Systems imposed by other countries are in all
cases less punitive. The current U.S. international tax system
contains many anomalies that make little sense when considered
in the context of the matters we discussed today, and that
create many ``heads, I win, tails, you lose,'' scenarios that
are difficult to justify on a principled basis. One of those
that has been noted a number of times today is the allocation
of interest expense between domestic and foreign subsidiaries
for the purpose of determining the foreign tax credit
limitation.
Finally, in a 1991 OECD study, the United States and Japan
are tied as the least competitive G-7 countries for a
multinational company to locate its headquarters, taking into
account taxation at both the individual and corporate levels.
These findings have an ominous quality, given the recent spate
of acquisitions of large U.S.-based companies by their foreign
competitors. In fact, of the world's 20 largest companies,
ranked by sales in 1960, 18 were headquartered in the United
States. By the mid-nineties, that number had dropped to eight
and is probably less today. That trend is starkly reflected in
the banking sector. After recent acquisitions, only two,
CitiCorp and Chase Manhattan, of the world's largest 25
financial services companies are headquartered in the United
States.
In closing, Mr. Chairman, the NFTC strongly supports H.R.
2018, introduced by Mr. Houghton, Mr. Levin, and Mr. Johnson,
and joined by Mr. Crane, Mr. Herger, Mr. English, and Mr.
Matsui. We congratulate them on their efforts to make these
amendments. They address important concerns of our companies in
their efforts to export American products and to create jobs
for American workers.
And we congratulate you on holding this hearing this
morning. That concludes my oral remarks. I will be pleased to
answer questions.
[The prepared statement follows:]
Statement of Fred F. Murray, Vice President for Tax Policy, National
Foreign Trade Council, Inc.
Mr. Chairman, and Distinguished Members of the Committee:
My name is Fred Murray. I am Vice President for Tax Policy
for the National Foreign Trade Council, Inc. I was formerly
Special Counsel (Legislation) for the Internal Revenue Service,
and before that represented taxpayers for seventeen years in
private practice before joining the Treasury. With me today are
Mr. Phil Morrison, Director of the International Tax Services
Group in the Washington National Office of Deloitte & Touche
LLP and formerly International Tax Counsel at the U.S.
Treasury, and Mr. Peter Merrill, Director of the National
Economic Consulting Practice at Pricewaterhouse Coopers in
their Washington National Tax Services Office and formerly
Chief Economist for the Joint Committee on Taxation. We intend
to summarize for you the analysis and conclusions that have
been reached in the ongoing National Foreign Trade Council
Foreign Income Project. In addition to the two gentlemen here
with me today, the project has been drafted and reviewed by
more than fifty distinguished professionals: former Treasury
and IRS officials including Assistant Secretaries and Deputy
Assistant Secretaries for Tax Policy, International Tax
Counsels, a Commissioner of Internal Revenue, and other
distinguished lawyers and economists, corresponding
professionals from Hill offices, and finally distinguished
lawyers, accountants, and economists from some of America's
most prominent companies, professional firms, and universities.
The National Foreign Trade Council, Inc. (the ``NFTC'' or
the ``Council'') is appreciative of the opportunity to present
its views on the impact on international competitiveness of
certain of the foreign provisions of the Internal Revenue Code
of the United States.
The NFTC is an association of businesses with some 550
members, originally founded in 1914 with the support of
President Woodrow Wilson and 341 business leaders from across
the U.S. Its membership now consists primarily of U.S. firms
engaged in all aspects of international business, trade, and
investment. Most of the largest U.S. manufacturing companies
and most of the 50 largest U.S. banks are Council members.
Council members account for at least 70% of all U.S. non-
agricultural exports and 70% of U.S. private foreign
investment. The NFTC's emphasis is to encourage policies that
will expand U.S. exports and enhance the competitiveness of
U.S. companies by eliminating major tax inequities and
anomalies. International tax reform is of substantial interest
to NFTC's membership.
The founding of the Council was in recognition of the
growing importance of foreign trade and investment to the
health of the national economy. Since that time, expanding U.S.
foreign trade and investment, and incorporating the United
States into an increasingly integrated world economy, has
become an even more vital concern of our nation's leaders. The
share of U.S. corporate earnings attributable to foreign
operations among many of our largest corporations now exceeds
50 percent of their total earnings. Even this fact in and of
itself does not convey the full importance of exports to our
economy and to American-based jobs, because it does not address
the additional fact that many of our smaller and medium-sized
businesses do not consider themselves to be exporters although
much of their product is supplied as inventory or components to
other U.S.-based companies who do export. Foreign trade is
fundamental to our economic growth and our future standard of
living. Although the U.S. economy is still the largest economy
in the world, its growth rate represents a mature market for
many of our companies. As such, U.S. employers must export in
order to expand the U.S. economy by taking full advantage of
the opportunities in overseas markets.
The Council Believes That We Must Re-evaluate Current International
Tax Policies
United States policy in regard to trade matters has been
broadly expansionist for many years, but its tax policy has not
followed suit.
The foreign competition faced by U.S.-based companies has
intensified as the globalization of business has accelerated.
At the same time, U.S.-based multinationals increasingly voice
their conviction that the Internal Revenue Code places them at
a competitive disadvantage in relation to multinationals based
in other countries. In 1997, the NFTC launched an international
tax policy review project, at least partly in response to this
growing chorus of concern. The project is presently divided
into two parts, the first dealing with the United States' anti-
deferral regime, subpart F, the second dealing with the foreign
tax credit. The two parts are in turn divided into two phases.
In both, an analytical report examining the legal, economic and
tax policy aspects of the U.S. rules will be followed by
legislative and policy recommendations based on the analytical
report.
On March 25, 1999, the NFTC published a report analyzing
the competitive impact on U.S.-based companies of the rules
under subpart F of the tax code, which accelerate the U.S.
taxation of income earned by foreign affiliates.\1\ The data
and analysis presented in Part One support several significant
conclusions:
---------------------------------------------------------------------------
\1\ The NFTC Foreign Income Project: International Tax Policy for
the 21st Century; Part One: A Reconsideration of Subpart F (hereinafter
referred to as ``Part One'' or ``the Report'').
---------------------------------------------------------------------------
Since the enactment of subpart F more than 35
years ago, the development of a global economy has
substantially eroded the rules' economic policy rationale.
The breadth of subpart F exceeds the international
norms for such rules, adversely affecting the competitiveness
of U.S.-based companies by subjecting their cross-border
operations to a heavier tax burden than that borne by their
principal foreign-based competitors.
Most importantly, subpart F applies too broadly to
various categories of income that arise in the course of active
foreign business operations, and should thus be substantially
narrowed.
Our present testimony is in part based upon the findings
described in the Report.
Fundamental Changes in the Economic Underpinnings of Our International
Tax System
The compromise embodied in a significant portion of our
present international tax system was shaped in the global
economic environment of the early 1960s--a world economy that
has changed almost beyond recognition as the 20th century draws
to a close.
In the decades since subpart F was enacted in 1962, the
global economy has grown more rapidly than the U.S. economy. By
almost every measure--income, exports, or cross-border
investment--U.S.-based companies today represent a smaller
share of the global market. At the same time, U.S.-based
companies have become increasingly dependent on foreign markets
for continued growth and prosperity. Over the last three
decades, sales and income from foreign subsidiaries have
increased much more rapidly than sales and income from domestic
operations. To compete successfully both at home and abroad,
U.S.-based companies have adopted global sourcing and
distribution channels, as have their competitors.
Changes introduced since 1962 in subpart F and other
important rules in our international tax system have imposed
current U.S. taxation on ever-larger categories of active
foreign income. These two incompatible trends -decreasing U.S.
dominance in global markets set against increasing U.S.
taxation of CFC income--are not claimed to have any necessary
causal relation. However, they strongly suggest that re-
evaluation of the balance of policies that underlie our rules
is long overdue.
Because economic arguments advanced against the backdrop of
the 1962 economy are the foundation upon which subpart F was
erected, the balance that was struck in 1962 may no longer be
appropriate. The same is true for other provisions of our
international tax system that were constructed with far
different bases in mind.
Accordingly, with U.S.-based companies less dominant in
foreign markets, but at the same time more dependent on those
markets, U.S. international tax rules that are out of step with
those of other major industrial countries are more likely to
hamper the competitiveness of U.S. multinationals than was the
case in the 1960s. The growing economic integration among
nations -especially the formation of common markets and free
trade areas -raises questions about the appropriateness of U.S.
tax rules regarding ``base'' companies that transact business
across national borders with affiliates. Finally, the eclipsing
of foreign direct investment by portfolio investment calls into
question the importance of tax policy focused on foreign direct
investment for purposes of achieving an efficient global
allocation of capital.
We will discuss these issues in greater detail in the
balance of my testimony and in that of my colleagues.
Where We Came From and Where We Are Today
In 1962, the Kennedy Administration proposed to subject the
earnings of U.S. controlled foreign corporations (CFCs) to
current U.S. taxation. At this time, the dollar was tied to the
gold standard, and the United States was the world's largest
capital exporter. These capital exports drained Treasury's gold
reserves, and made it more difficult for the Administration to
stimulate the economy. Thus, the proposed repeal of deferral of
tax on the foreign income of U.S. multinationals was intended
by Treasury Secretary Douglas Dillon to serve as a form of
capital control, reducing the outflow of U.S. investment
abroad.
The 1962 Legislation
Some commentators have taken the view that subpart F as
enacted in 1962 reflected a compromise between two competing
tax policy goals. Treasury itself has recently described
subpart F as enforcing a balance between the goal of
maintaining the competitiveness of U.S. business, on the one
hand, and on the other of maintaining neutrality as between the
taxation of domestic and foreign business (capital export
neutrality \2\). The compromise between competitiveness and
neutrality that was struck in 1962 has been seriously disrupted
by the legal and economic changes of nearly four decades.
---------------------------------------------------------------------------
\2\ ``Capital export neutrality'' is a term used to describe a
situation in which tax considerations will play no part in influencing
a decision to invest in another country.
---------------------------------------------------------------------------
The United States has never enacted an international tax
regime that makes capital export neutrality its principal goal
with respect to the taxation of business income. Indeed, during
the period 1918-1928, the formative era for U.S. tax policy
regarding international business income, the United States
ceded primary taxing jurisdiction over active business income
to the country of source.\3\ Rules were formulated to protect
the ability of the United States to collect tax on U.S.-source
income, and the foreign tax credit was introduced allowing U.S.
income tax to be imposed whenever the foreign country where the
income was sourced failed to tax the income. The dominant
purpose of the U.S. international tax system put in place
then--a system that still governs U.S. taxation of
international income--was to eliminate the double taxation of
business income earned abroad by U.S. taxpayers, which had been
imposed under the taxing regime enacted at the inception of the
income tax.\4\
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\3\ See Michael J. Graetz & Michael O'Hear, The Original Intent of
U.S. International Taxation, 46 Duke L.J. 1021 (1997).
\4\ Id. The original system had allowed only a deduction for
foreign income taxes.
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When the foreign tax credit was first enacted in 1918, the
United States taxed income earned abroad by foreign
corporations only when that income was repatriated to the
United States. In addition to implementing the basic policy
decision to grant source countries the principal claim to the
taxation of business income, this ``deferral of income'' \5\
reflected concerns both about whether the United States had the
legal power to tax income of foreign corporations (even if
owned by U.S. persons) and about the practical ability of the
United States to measure and collect tax on income earned
abroad by a foreign corporation.\6\ Deferral of tax on active
business income remained essentially unchanged for the next 44
years--until 1962. The only exception to this rule was the
result of ``foreign personal holding company'' legislation
enacted in 1937 to curb the use of foreign corporations to hold
income-producing assets and to sell assets with unrealized (and
untaxed) appreciation. The foreign personal holding company
rules tax currently certain kinds of ``passive'' income of a
narrow class of corporations in the hands of their owners.\7\
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\5\ The foreign income of a foreign corporation is not ordinarily
subject to U.S. taxation, since the United States has neither a
residence nor a source basis for imposing tax. This applies generally
to any foreign corporation, whether it is foreign-owned or U.S.-owned.
This means that in the case of a U.S.-controlled foreign corporation
(CFC), U.S. tax is normally imposed only when the CFC's foreign
earnings are repatriated to the U.S. owners, typically in the form of a
dividend. However, subpart F of the Code alters these general rules to
accelerate the imposition of U.S. tax with respect to various
categories of income earned by CFCs.
It is common usage in international tax circles to refer to the
normal treatment of CFC income as ``deferral'' of U.S. tax, and to
refer to the operation of subpart F as ``denying the benefit of
deferral.'' However, given the general jurisdictional principles that
underlie the operation of the U.S. rules, we view that usage as
somewhat inaccurate, since it could be read to imply that U.S. tax
``should'' have been imposed currently in some normative sense. Given
that the normative rule imposes no U.S. tax on the foreign income of a
foreign person, we believe that subpart F can more accurately be
referred to as ``accelerating'' a tax that would not be imposed until a
later date under normal rules.
\6\ See supra note 3.
\7\ See I.R.C. Sec. Sec. 552 and 553.
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However, President Kennedy urged a reversal of this
longstanding U.S. tax policy in 1961. The President called for
the ``elimination of tax deferral privileges in developed
countries and `tax haven' privileges in all countries.'' \8\
President Kennedy's 1961 State of the Union Address, elaborated
on in his tax message of April 20, 1961, prompted Congressional
consideration during 1961 and 1962 of changes in the U.S.
taxation of controlled foreign corporations. In addressing
broad balance of payments concerns, Kennedy announced in his
State of the Union Address that his administration would ask
Congress to reassess the tax provisions that favored investment
in foreign countries over investment in the United States. The
President, in his April tax message, urged five goals for
revising U.S. tax policy: (1) to alleviate the U.S. balance of
payments deficit; (2) to help modernize U.S. industry; (3) to
stimulate growth of the economy; (4) to eliminate to the extent
possible economic injustice; and (5) to maintain the level of
revenues requested by President Eisenhower in his last budget.
---------------------------------------------------------------------------
\8\ Message of the President's Tax Recommendations, April 20, 1961,
reprinted in H.R. Doc. No. 87-140, at 6 (1961).
---------------------------------------------------------------------------
In addition to changes in foreign income tax provisions,
President Kennedy, in both his State of the Union Address and
tax message, called for the introduction of an 8 percent
investment tax credit on purchases of machinery and equipment
to ``spur our modernization, our growth and our ability to
compete abroad.'' \9\ Kennedy urged that this credit be limited
to expenditures on new machinery and equipment ``located in the
United States.'' \10\ [Emphasis added.]
---------------------------------------------------------------------------
\9\ See H.R. Rep. No. 87-2508, at 2 (1962)(Conference Report).
\10\ See Message of the President's Tax Recommendations (April 20,
1961), reprinted in H.R. Doc. No. 87-140, at 4 (1961).
---------------------------------------------------------------------------
Specifically, with regard to the taxation of foreign
income, the President stated that ``changing conditions'' made
continuation of the ``deferral privilege undesirable,'' and
proposed the elimination of tax deferral in developed countries
and in tax havens everywhere. The President stated:
To the extent that these tax havens and other tax deferral
privileges result in U.S. firms investing or locating abroad
largely for tax reasons, the efficient allocation of
international resources is upset, the initial drain on our
already adverse balance of payments is never fully compensated,
and profits are retained and reinvested abroad which would
otherwise be invested in the United States. Certainly since the
post-war reconstruction of Europe and Japan has been completed,
there are no longer foreign policy reasons for providing tax
incentives for foreign investment in the economically advanced
countries.'' \11\
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\11\ Id., at 6-7.
The Kennedy Administration's recommendations with respect
to deferral and the investment tax credit were not neutral
toward the location of capital.
It is clear that neither the House nor the Senate embraced
the Kennedy Administration's call. The President's proposal was
rejected by the Congress, and the legislation that eventually
passed as the Revenue Act of 1962 provided for much narrower
constraints on deferral of the taxation of active business
income. Congress aimed to curb tax haven abuses rather than to
end the deferral of U.S. income tax on active business income
in developed countries. The 1962 legislation, as ultimately
enacted, was targeted at eliminating certain ``abuses''
permitted under prior law, although, the historical record is
far from clear about exactly what the ``abuses'' were that
Congress intended to curb.
The abuses that the Revenue Act of 1962 sought to rectify
changed substantially as the legislation made its way through
the legislative process. Under President Kennedy's original
proposal contained in his tax message of April 1961, and urged
throughout the Congressional process by Treasury Secretary
Dillon, any deferral of U.S. taxation constituted an abuse. An
exception to current taxation would have been provided for (and
limited to) investments in less developed countries, but this
exception was explicitly grounded in foreign policy, not tax
policy, considerations.
Treasury's proposal of July 20, 1961, implicitly treated as
abusive the deferral of tax on income from transactions between
a foreign corporation and a related party outside the country
in which the foreign corporation was organized.\12\ In the
Senate Finance Committee hearings, Secretary Dillon singled out
as abusive the use of foreign corporations that market their
goods or services in third countries with the subjective intent
of ``reducing taxes.'' \13\ The potential of transfer pricing
abuses between related companies were a concern.
---------------------------------------------------------------------------
\12\ Staff of the Joint Comm. on Internal Revenue Taxation, 87th
Cong., General Explanation of Comm. Discussion Draft of Revenue Bill of
1961, at 5 (Comm. Print 1961).
\13\ Id.
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In the legislation sent to the House by the Committee on
Ways and Means and adopted by the House, the abuse appeared to
be the avoidance of ``taxation by the United States on what
could ordinarily be expected to be U.S. source income.'' \14\
As stated above, this concern was consistent with U.S. tax
policy dating back to the formative period of 1918-1928, and
can be viewed, not as a change in policy, but rather as an
application of longstanding policies to new circumstances.
---------------------------------------------------------------------------
\14\ H.R. Rep. No. 87-1447, at 58 (1962)(Committee on Ways and
Means, Revenue Act of 1962).
---------------------------------------------------------------------------
It is clear, however, that Congress did not intend to
reverse the policy of generally permitting deferral of active
business income earned abroad. Ultimately, no clear
Congressional understanding of exactly what constituted an
abuse can be determined from the history of the 1962 Revenue
Act. Indeed, the Act left determinations of abuse--at least to
some extent--up to the Treasury on a case-by-case basis. What
these provisions seek to do is still mysterious even today.
The Importance of Transfer Pricing Developments
In reviewing Secretary Dillon's concerns, and the
subsequent enactment of the base company rules, it is clear
that the subpart F provisions were intended to be a
``backstop'' to the then existing transfer pricing regime of
the Code. Very significant changes have taken place in the
field of transfer pricing administration since the 1962
legislation, as Treasury itself has testified in recent years.
When subpart F was enacted, the use of improper transfer
pricing to shift income into tax haven jurisdictions was a
major concern of Treasury and Congress. Although
contemporaneous efforts were being made to address transfer
pricing concerns via regulations under section 482, significant
aspects of subpart F were specifically intended to backstop
transfer pricing enforcement by imposing current U.S. tax on
various forms of tax haven income, thus reducing U.S.
taxpayers' incentives to shift income into tax havens. In
particular, this was one of the stated reasons for the rules
relating to foreign base company sales and services. By
limiting the benefit of maximizing sales or services profits in
a tax haven, these rules were intended to relieve some of the
pressure on the still-nascent transfer pricing regime's ability
to police the pricing of cross-border transactions.\15\
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\15\ Transfer pricing was not, of course, the sole or even the
principal rationale for these rules; they were also said to be
justified by ``anti-abuse'' notions that related to protection of the
U.S. tax base and, in the views of some, capital export neutrality.
---------------------------------------------------------------------------
Nearly four decades later, transfer pricing law and
administration have undergone profound changes that call into
serious question the continued relevance of subpart F to
transfer pricing enforcement. Most conspicuously, based on
legislative changes in the 1986 and 1993 tax acts, Treasury has
promulgated detailed regulations that have drastically altered
the transfer pricing enforcement landscape.\16\ These
regulations clarify many areas of substantive transfer pricing
controversy, but perhaps more importantly they implement a
structure of reporting and penalty rules that have had a
considerable impact on taxpayer behavior. Further, although
audit experience with the new rules is still limited, it is
anticipated that the widespread availability of contemporaneous
transfer pricing documentation will markedly enhance the
Internal Revenue Service's ability to perform effective
transfer pricing examinations.
---------------------------------------------------------------------------
\16\ I.R.C. Sec. Sec. 482 (last sentence) and 6662(e); Treas. Reg.
Sec. Sec. 1.482-1 through -8 and 1.6662-6.
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Almost as important is the globalization of transfer
pricing enforcement efforts; partly in response to U.S.
initiatives in the area, and partly because of compliance
concerns of their own, many of the United States' major trading
partners have recently stepped up their own transfer pricing
enforcement efforts, enhancing reporting and penalty regimes
and increasing audit activity. As a result, the role of the
Organisation for Economic Cooperation and Development (OECD) as
a forum for the development of international consensus on
transfer pricing matters has attained new prominence, with the
United States making notable efforts to ensure that its own
transfer pricing initiatives win international acceptance via
the OECD.
Accordingly, the ability of U.S. taxpayers to shift income
into a sales base company by manipulating the pricing of
transactions is far more circumscribed than it was when
transfer pricing as a discipline was in its infancy. This basic
change in the landscape, in combination with the general
development of a global economy, suggests that transfer pricing
considerations no longer provide much support for the base
company sales and services rules. Indeed, treating
international transactions through centralized sales or
services companies as per se tax abusive ignores the current
realities of both transfer pricing enforcement and the globally
integrated business models demanded by the global marketplace.
Development of Subpart F
A lack of clarity in the historical record of the 1962 Act
about what constituted an abuse of tax deferral in
international transactions has resulted in ongoing debates
about the proper scope of subpart F that continue to this day.
Legislation since 1962 has changed the rules for when current
taxation is required, but has not resolved the basic debate
that raged in 1962. Interpretations of the 1962 Act subsequent
to its enactment have sometimes described as abusive any
transaction where a foreign government imposes lower tax than
would be imposed by the United States on the same transaction
or income.\17\ This cannot be right. In 1962, Congress clearly
rejected making capital export neutrality the linchpin of U.S.
international tax policy. Attempting to force a strained
interpretation of the legislation it did enact into an
endorsement of capital export neutrality by defining anything
that departs from capital export neutrality as an abuse
flagrantly disregards the historical record.
---------------------------------------------------------------------------
\17\ See Stanford G. Ross, Report on the United States Jurisdiction
to Tax Foreign Income, 49b Stud. on Int'l Fiscal L. 184, 212 (1964).
---------------------------------------------------------------------------
Nevertheless, in the years since 1962, subpart F has been
the subject of numerous revisions, including substantial
overhauls in 1975 and 1986: by the addition of new categories
of subpart F income; by the narrowing of exceptions to subpart
F income; and by the creation of additional anti-deferral
regimes (i.e., the Passive Foreign Investment Company
provisions). This constant tinkering has created both
instability and a forbiddingly arcane web of general rules,
exceptions, exceptions to exceptions, interactions, cross
references, and effective dates, generating a level of
complexity that cannot be defended. Further, while Congress has
over the years modified the rules in ways that both tightened
and relaxed the anti-deferral rules, it is clear that the
overall trend has been to expand the scope of those rules.
Particularly with the changes made in 1975 and 1986, Congress
has brought more and more income within the net of current
taxation, to the point where Treasury now feels justified in
positing that current taxation is the general rule, with
deferral permitted only as an exception.
A review of this legislative activity makes it clear that
U.S. international tax policy has remained largely unchanged
for more than three decades. Legislative activity has continued
to focus on perceived abuses of deferral (as well as the
foreign tax credit), with relatively little consideration given
to the changing relationship between the U.S. economy and the
rest of the world.
1999 Is Not 1962
The compromise embodied in subpart F was shaped in the
global economic environment of the early 1960s--a world economy
that has changed almost beyond recognition as the 20th century
draws to a close. The gold standard was abandoned during the
Nixon Administration, and the exchange rate of the dollar is no
longer fixed. The United States is now the world's largest
importer of capital, with foreign investment in U.S. assets
exceeding U.S. investment in foreign assets by over $100
billion per year.
With the completion of the post-World War II economic
recovery in Europe and Japan, the growth of an industrial
economy in many countries in Asia and elsewhere, and the
overall development of a global economy, U.S. dominance of
international markets is only a memory. The competition from
foreign-based companies in U.S. and international markets is
far more intense today than it was in 1962.\18\ While
competition in international markets has grown stiffer, those
markets have simultaneously become more important to the
prosperity of U.S.-based companies, as foreign income has come
to constitute an increasing percentage of U.S. corporate
earnings.
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\18\ Some Treasury officials have suggested that the loss of U.S.
dominance is simply a function of the rest of the world ``catching up''
after the devastation of World War II. This may well be true, but it is
also irrelevant: whatever the reasons for the loss of U.S. dominance,
the point is that the competitive landscape is completely different
today, so that it is high time to reconsider the competitive impact of
legislative provisions enacted when the world was a very different
place.
---------------------------------------------------------------------------
The relentless tightening of the subpart F and foreign tax
credit rules since 1962, plus the enactment of additional anti-
deferral regimes, has steadily increased the tension between
U.S. international tax policy and the competitive demands of a
global economy. A comparison between the policy goals of our
international tax system and changes in the global economy is
thus long overdue.
Relevant Tax Policy Considerations
Without foreclosing the consideration of other factors, it
should be noted that Treasury officials in recent months have
suggested that five tax policy considerations will need to be
taken into account in the process of reforming subpart F:
Capital export neutrality
Competitiveness
Conformity with international norms
Minimizing compliance and administrative burdens
Meeting revenue needs in a fair manner
Capital Export Neutrality
As explained in detail in the Report, and as further explained by
my colleagues with me on the panel this morning, the NFTC believes that
the historical significance of capital export neutrality (``CEN'') in
the enactment of subpart F has come to be exaggerated by subsequent
commentators. More importantly, the Report finds numerous reasons to
reject CEN as a foundation of U.S. international tax policy. Briefly
summarized, these reasons include:
The futility of attempting to achieve globally efficient
capital allocation by unilateral action.
The similar futility of attempting to advance investment
neutrality by focusing solely on direct investment, particularly in
light of the fact that international portfolio investment now
significantly exceeds direct investment.
The failure of the United States itself to take CEN
seriously as a matter of tax policy, other than in the one relatively
narrow area of subpart F, where it appears to operate largely as a
rationale of convenience.
Growing criticism of CEN in current economic literature.
The anomalousness of adopting a tax policy that encourages
the payment of higher taxes to foreign governments.
The fact that CEN is the wrong starting point for our international
tax policy is particularly well illustrated by the last item. Several
provisions of subpart F have the effect of penalizing a taxpayer that
reduces its foreign tax burden, apparently based on the CEN principles.
Presumably the idea is that preventing U.S. taxpayers from reducing
foreign taxes will ensure that they do not make investment decisions
based on the prospect of garnering a reduced rate of foreign taxation
(while deferring U.S. taxation until repatriation). However, insisting
that U.S. taxpayers pay full foreign tax rates when market forces
require that they do business in another jurisdiction is a flawed
policy from at least three perspectives. First, from the standpoint of
the tax system, insisting on higher foreign tax payments obviously
increases the amount of foreign taxes available to be credited against
U.S. tax liability, thus decreasing U.S. tax collections in the long
run. Second, from the standpoint of competitiveness, it leaves U.S.-
based companies in a worse position than their foreign-based
competitors: the U.S. company must either pay the high local rate, or
if it attempts to reduce that tax it will instead trigger subpart F
taxes at the U.S. rate, while the foreign competition will reduce their
local taxes through perfectly normal transactions such as paying
interest on a loan from an affiliate, and trigger no home country taxes
by doing so.\19\ Third, the belief that the level of foreign investment
by U.S. companies will be significantly increased by the ability to
reduce foreign taxes (while deferring U.S. taxation) is seriously
antiquated in the context of the global economy. Such a belief may have
been justified in the early 1960's, when the business reasons for U.S.
companies to invest offshore were more limited. But today, when the
principal opportunities for expansion are offered by foreign markets,
so that U.S.-based companies derive an ever-greater proportion of their
earnings from offshore activities, a presumption that foreign tax
reduction will generate tax-motivated foreign investment is not merely
out of touch with economic reality, but seriously harmful to the
competitiveness of U.S.-based companies (as further discussed below).
We submit that the at best highly theoretical global capital allocation
benefits that may be achieved by subpart F's haphazard pursuit of CEN
principles do not even come close to justifying the fiscal and
competitive damage caused by denying U.S. companies the ability to
reduce local taxes on the foreign businesses that are critical to their
future prosperity and that of their workers.
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\19\ Local tax authorities may well scrutinize the amount of
outbound deductible payments under transfer pricing and thin-
capitalization principles, but subject to that discipline there is
nothing inherently objectionable about an allocation of functions and
risks among affiliates that gives rise to a deductible payment in a
high-tax jurisdiction. Treasury has not made a case that protection of
the foreign tax base should in any event be a concern of the U.S. tax
system.
---------------------------------------------------------------------------
Accordingly, the NFTC believes that CEN is not a sound basis on
which to build U.S. international tax policy for the coming century,
and recommends that in redesigning subpart F it be given no greater
weight than it has been given in the case of other major international
provisions such as the foreign tax credit.
Competitiveness
Accelerating the U.S. taxation of overseas operations (while
permitting a foreign tax credit) means that a U.S.-based company will
pay tax at the higher of the U.S. or foreign tax rate. If the local tax
rate in the company of operation is less than the U.S. rate, this means
that locally-based competitors will be more lightly taxed than their
U.S.-based competition. Moreover, companies based in other countries
will also enjoy a lighter tax burden, unless their home countries
impose a regime that is as broad as subpart F, and none have to date
done so. While the competitive impact of a heavier corporate tax burden
is difficult to quantify, it is clear that a company that pays higher
taxes suffers a disadvantage vis-a-vis its more lightly taxed
competitors. That disadvantage may ultimately take the form of a
decreased ability to engage in price competition, or to invest funds in
the research and capital investment needed to build future
profitability, or in the ability to attract capital by offering an
attractive after-tax rate of return on investment. Whatever its
ultimate form, however, it cannot be seriously questioned that a
heavier corporate tax burden will harm a company's ability to
compete.\20\
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\20\ Congress has previously acknowledged the connection between
corporate tax burden and competitiveness. For example, in connection
with the enactment of the dual consolidated loss rules under Code
section 1503(d) as part of the Tax Reform Act of 1986 (the ``'86
Act''), Congress observed that the ability of a foreign corporation to
reduce its worldwide corporate tax burden through the use of a dual
resident company enabled such corporations ``to gain an advantage in
competing in the U.S. economy against U.S. corporations.'' Joint
Committee on Taxation, General Explanation of the Tax Reform Act of
1986 (the ``'86 Act General Explanation''), at 1065.
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Competitiveness concerns were central to the debate when subpart F
was enacted, even at a time when U.S.-based companies dominated the
international marketplace. This apparent dominance did not convince
Congress that the competitive position of U.S. companies in
international markets could be ignored. Thus, although the
Administration originally proposed the acceleration of U.S. taxation of
most foreign-affiliate income, that proposal was firmly rejected by
Congress based largely on concerns about its competitive impact.\21\
---------------------------------------------------------------------------
\21\ See Part One, Chapter 2.
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If competitiveness was a consideration when subpart F was enacted,
there are compelling reasons to treat it as a far more serious concern
today.
Conformity with International Norms
As will be further developed by my colleagues on the panel
this morning, conformity with international norms is important
from a competitiveness standpoint, but it bears further
emphasis here that our principal trading partners have
consistently adopted rules that are less burdensome than
subpart F. We do not dispute the fact that subpart F
established a model for the taxation of offshore affiliates
that has been imitated to a greater or lesser degree in the CFC
legislation of many countries. But looking beyond the
superficial observation that other countries have also enacted
CFC rules, the detailed analysis in the Part One Report showed
that in virtually every scenario relating to the taxation of
active offshore operations, the United States imposes the most
burdensome regime. Looking at any given category of income, it
is sometimes possible to point to one or two countries whose
rules approach the U.S. regime, but the overall trend is
overwhelmingly clear: U.S.-based multinationals with active
foreign business operations suffer much greater home-country
tax burdens than their foreign-based competitors.
The observation that the U.S. rules are out of step with
international norms, as reflected in the consistent practices
of our major trading partners, supports the conclusion that
U.S.-based companies suffer a competitive detriment vis-a-vis
their multinational competitors based in such countries as
Germany and the United Kingdom, and that the appropriate reform
is to limit the reach of subpart F in a manner that is more
consistent with the international norm.
Some commentators have suggested that the competitive
imbalance created by dissimilar international tax rules should
be redressed not through any amelioration of the U.S. rules,
but rather through a broadening of comparable foreign regimes.
As a purely logical matter the point is valid--a see-saw can be
balanced either by pushing down the high end or pulling up the
low one. However, the suggestion is completely impractical for
several reasons--conformity and competitive balance are far
more likely to be achieved through a modernization of the U.S.
rules. For one thing, since the U.S. rules are out of step with
the majority, from the standpoint of legislative logistics
alone it would be far easier to achieve conforming legislation
in the United States alone, rather than in more than a dozen
other countries. More fundamentally, there is no particular
reason to believe that numerous foreign sovereigns, having
previously declined to adopt subpart F's broad taxation of
active foreign businesses, will now suddenly have a change of
heart and decide to follow the U.S. model.
Further, recent OECD activities relating to ``unfair tax
competition'' do not increase the likelihood of foreign
conformity with subpart F's treatment of active foreign
businesses. It is important to recognize that those activities
relate to efforts by OECD member countries to limit the
availability and usage of ``tax haven'' countries and regimes.
By imposing abnormally low rates of taxation, such countries or
regimes may be viewed as improperly reducing other countries'
tax bases and distorting international investment decisions.
The failure of a country to impose any type of CFC legislation
can be viewed as offering a type of tax haven opportunity,
since it may permit the creation of investment structures that
avoid all taxation. Thus, the OECD has recommended that
countries without CFC regimes ``consider'' enacting them.
However, in encouraging countries that have no CFC rules to
enact them, the OECD has done nothing to advance the degree of
conformity among existing CFC regimes. Based on the materials
that are publicly available, it does not appear that the OECD
has sought to address the lack of conformity between the
highly-developed CFC rules of the United States and its major
trading partners, particularly as they affect active foreign
business operations.
In conclusion, the U.S. rules under subpart F are well
outside the international mainstream, and should be conformed
more closely to the practices of our principal trading
partners. We emphasize that, contrary to the suggestions of
some commentators, we advocate only that the U.S. rules be
brought back to the norm so as to achieve competitive parity--
not that they be loosened further in an effort to confer
competitive advantage.
Minimizing Compliance and Administrative Burdens
The NFTC applauds Treasury's inclusion of administrability
among the principal tax policy goals that will be considered in
reforming our international tax system. Subpart F includes some
of the most complex provisions in the Code, and it imposes
administrative burdens that in many cases appear to be
disproportionate to the amount of revenue at stake. There are
several sources of complexity within subpart F, including the
following:
The basic design and drafting of the subpart F
regime was complex;
That initial complexity has been exacerbated over
the years by numerous amendments, which have created an
increasingly arcane web of rules, exceptions, exceptions to
exceptions, etc.; and
The subpart F rule require coordination with
several other regimes that are themselves forbiddingly complex,
including in particular the foreign tax credit and its
limitations.
The complexity of the rules long ago reached the point that
the ability of taxpayers to comply, and the ability of the IRS
to verify compliance, were both placed in serious jeopardy. The
NFTC therefore urges that administrability concerns be given
serious weight in the process of modernizing the tax system. To
that end, we urge that the drafters of the Code and regulations
consider not only the legal operation of the rules, but also
their practical implementation in terms of forms and
recordkeeping requirements. In addition, we urge that fuller
consideration be given to the interaction of multiple complex
regimes; it may be possible to read section 904(d) and its
implementing regulations and conclude that the provision can be
understood, and it may likewise be possible to read section 954
and its implementing regulations and conclude that that
provision is also understandable, but when the two sets of
rules must be read and implemented together, we submit that the
limits of human understanding are rapidly exceeded.
Meeting Revenue Needs in a Fair Manner
The final policy criterion recently mentioned by Treasury
is fairness. While no one could quarrel with the notion of
fairness in tax policy, what fairness means in practice is
somewhat less clear. Our understanding is that Treasury is
concerned about preservation of the corporate tax base: it
would be unfair if U.S.-based multinationals could eliminate or
significantly reduce their U.S. tax burden through the use of
CFCs. This analysis presumably requires that a distinction be
drawn between those cases in which it is ``fair'' to accelerate
the U.S. taxation of foreign affiliates' income, and those in
which it is not.
There should be general agreement about two cases in which
accelerated U.S. taxation is appropriate: first, where passive
income is shifted into an offshore incorporated pocketbook, and
second, where income is inappropriately shifted offshore
through abusive transfer pricing. The first case is well-
addressed by the extensive subpart F rules concerning foreign
personal holding company (``FPHC'') income, while the second
case is addressed by extensive transfer pricing and related
penalty rules which give the IRS ample authority to curb
transfer pricing abuses. Thus, little needs to be done to
advance fairness in these regards.
Conversely, it should generally be agreed that it is not
fair to accelerate U.S. taxation when a foreign subsidiary
engages in genuine business activity in its foreign country.
Unless Treasury is considering a radical redefinition of the
scope of U.S. international taxing jurisdiction, the normal
U.S. rules that impose U.S. tax only when income is repatriated
should continue to be viewed as fair.
This leaves a relatively narrow band of potential
controversy: whether there are certain types of income that
should be taxed currently even though they are associated with
active foreign business operations. Subpart F currently
identifies a number of such categories, and imposes current tax
on them for reasons that are not always clear, but appear to be
generally bound up with the notion of capital export
neutrality, as advanced by Treasury at the time of the 1962
legislation. We have already stated our view that U.S.
international tax policy needs a firmer foundation than the
economic theorizing that underlies CEN, and would only add here
that CEN should be of no relevance to the definition of
fairness in international tax policy.
Finally, we conclude by noting that as a practical matter,
Treasury concerns for the preservation of the corporate tax
base and distributional equity in the U.S. tax system should
not be exaggerated in the context of the relatively modest
reforms that we advocate. We do not believe that the
rationalizations of subpart F and the foreign tax credit to be
proposed will alter historical patterns of offshore investment
and profit repatriation (although they will improve our
companies' ability to compete). Those patterns show that U.S.
companies invest and operate overseas in response to market
rather than tax considerations, that offshore operations do not
substitute for investments in U.S. operations, that offshore
investments in fact have a positive impact on U.S. employment,
and that a significant percentage of offshore profits will be
repatriated currently regardless of the applicable tax rules.
Accordingly, while the distributional equity of the U.S. tax
system is really not at stake here, the fairness of the system
will be meaningfully improved by rationalizing and modernizing
the taxation of U.S. companies that compete in the global
marketplace.
Conclusion
The NFTC believes that the tax policy criteria of
competitiveness, administrability, and international conformity
all support a significant modernization of our international
tax systemat this time, and that fairness considerations are at
worst a neutral factor. Finally, even if Congress and the
Administration are persuaded to given continued weight to the
policy of capital export neutrality (which we do not believe to
be justified), the countervailing considerations are
sufficiently powerful to justify meaningful reform.
Improvement of the U.S. International Tax System Is Necessary
There is general agreement that the U.S. rules for taxing
international income are unduly complex, and in many cases,
quite unfair. Even before this hearing was announced, a
consensus had emerged among our members conducting business
abroad that legislation is required to rationalize and simplify
the international tax provisions of the U.S. tax laws. For that
reason alone, if not for others, this effort by the Committee,
which focuses the spotlight on U.S. international tax policy,
is valuable and should be applauded.
The NFTC is concerned that this and previous
Administrations, as well as previous Congresses, have often
turned to the international provisions of the Internal Revenue
Code to find revenues to fund domestic priorities, in spite of
the pernicious effects of such changes on the competitiveness
of United States businesses in world markets. The Council is
further concerned that such initiatives may have resulted in
satisfaction of other short-term goals to the serious detriment
of longer-term growth of the U.S. economy and U.S. jobs through
foreign trade policies long consistent in both Republican and
Democratic Administrations, including the present one.
The provisions of Subchapter N of the Internal Revenue Code
of 1986 impose rules on the operations of American business
operating in the international context that are much different
in important respects than those imposed by many other nations
upon their companies. Some of these differences, noted in
previous sections of this testimony, make U.S.-based business
interests less competitive in foreign markets when compared to
those from our most significant trading partners:
The United States taxes worldwide income of its
citizens and corporations who do business and derive income
outside the territorial limits of the United States. Although
other important trading countries also tax the worldwide income
of their nationals and companies doing business outside their
territories, such systems generally are less complex and
provide for ``deferral'' subject to less significant
limitations under their tax statutes or treaties than their
U.S. counterparts. Importantly, many of our trading partners
have systems that more closely approximate ``territorial''
systems of taxation, in which generally only income sourced in
the jurisdiction is taxed.\22\
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\22\ We start from the fundamental assumption that the United
States taxes the income of its citizens and domestic corporations on a
worldwide basis. We do not attempt to address either the desirability
or the implications of the adoption of a territorial system of
taxation, an alternative that could itself be the subject of
substantial analysis and debate. Therefore, for this analysis the
question is stated not as whether but as when should foreign income be
taxed.
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The United States has more complex rules for the
limitation of ``deferral'' than any other major industrialized
country. In particular, we have determined that: (1) the
economic policy justification for the current structure of
subpart F has been substantially eroded by the growth of a
global economy; (2) the breadth of subpart F exceeds the
international norms for such rules, adversely affecting the
competitiveness of U.S.-based companies; and (3) the
application of subpart F to various categories of income that
arise in the course of active foreign business operations
should be substantially narrowed.
The U.S. foreign tax credit system is very
complex, particularly in the computation of limitations under
the provisions of section 904 of the Code. While the theoretic
purity of the computations may be debatable, the significant
administrative costs of applying and enforcing the rules by
taxpayers and the government is not. Systems imposed by other
countries are in all cases less complex.
The United States has more complex rules for the
determination of U.S. and foreign source net income than any
other major industrialized country. In particular, this is true
with respect to the detailed rules for the allocation and
apportionment of deductions and expenses. In many cases, these
rules are in conflict with those of other countries, and where
this conflict occurs, there is significant risk of double
taxation. In some cases, U.S. rules by themselves cause double
taxation, as for example, in one of the more significant
anomalies, that of the allocation and apportionment of interest
expense.
The current U.S. international tax system contains
many other anomalies that make little sense when considered in
the context of the matters we discuss today. Under present law,
the treatment of subpart F income and the treatment of losses
generated by subpart F-type activities are not symmetrical,
creating many ``heads-I-win-tails-you-lose'' scenarios that are
difficult to justify on a principled basis. Income from subpart
F activities is always recognized currently on the U.S. tax
return, but if those activities should instead generate losses
they will generally be given no current U.S. tax effect. (As a
threshold matter, we can't resist noting that this restrictive
treatment of losses realized by CFCs, as compared with the
treatment of losses realized by domestic affiliates, is a
distinct departure from CEN principles, since it creates a
genuine tax disincentive to carry out certain activities
abroad. If the activities targeted by subpart F are carried out
in a foreign corporation, subpart F will accelerate any income
but defer any losses. If those activities were instead placed
in a U.S. corporation, both income and losses would be
recognized for U.S. tax purposes. Since the likelihood of any
given activity's producing losses rather than income is not
generally known at the outset, the system creates a structural
bias in favor of U.S. investment, rather than anything
approaching neutrality. But as we noted elsewhere, U.S.
allegiance to CEN as a tax policy principle has been haphazard
at best.) The rules carry this bias not only in their basic
structure, but also in the way they apply to carryover
restrictions, consolidation of affiliate losses, and the
offsetting of losses among subpart F income categories.
Similarly, other provisions in the Code apply in an
asymmetrical way. This is true with respect to the rules
relating to overall foreign losses. Other rules determine the
composition of affiliated groups for the filing of consolidated
returns and do not allow the inclusion of foreign corporations,
except in very limited circumstances.
The current U.S. Alternative Minimum Tax (AMT)
system imposes numerous rules on U.S. taxpayers that seriously
impede the competitiveness of U.S. based companies. For
example, the U.S. AMT provides a cost recovery system that is
inferior to that enjoyed by companies investing in our major
competitor countries; additionally, the current AMT 90-percent
limitation on foreign tax credit utilization imposes an unfair
double tax on profits earned by U.S. multinational companies--
in some cases resulting in a U.S. tax on income that has been
taxed in a foreign jurisdiction at a higher rate than the U.S.
tax.
As noted above, the United States system for the taxation
of the foreign business of its citizens and companies is more
complex than that of any of our trading partners, and perhaps
more complex than that of any other country.
That result is not without some merit. The United States
has long believed in the rule of law and the self-assessment of
taxes, and some of the complexity of its income tax results
from efforts to more clearly define the law in order for its
citizens and companies to apply it. Other countries may rely to
a greater degree on government assessment and negotiation
between taxpayer and government--traits which may lead to more
government intervention in the affairs of its citizens, less
even and fair application of the law among all affected
citizens and companies, and less certainty and predictability
of results in a given transaction. In some other cases, the
complexity of the U.S. system may simply be ahead of
development along similar lines in other countries--many other
countries have adopted an income tax similar to that of the
United States, and a number of these systems have eventually
adopted one or more of the significant features of the U.S.
system of taxing transnational transactions: taxation of
foreign income, anti-deferral regimes, foreign tax credits, and
so on. However, after careful inspection and study, and as my
colleague will discuss in greater detail, we have concluded
that the United States system for taxation of foreign income of
its citizens and corporations is far more complex and
burdensome than that of all other significant trading nations,
and far more complex and burdensome than what is necessitated
by appropriate tax policy.
The reluctance of others to follow the U.S. may in part
also be attributable to recognition that the U.S. system has
required very significant compliance costs of both taxpayer and
the Internal Revenue Service, particularly in the international
area where the costs of compliance burdens are
disproportionately higher relative to U.S. taxation of domestic
income and to the taxation of international income by other
countries.
There is ample anecdotal evidence that the United States'
system of taxing the foreign-source income of its resident
multinationals is extraordinarily complex, causing the
companies considerable cost to comply with the system,
complicating long-range planning decisions, reducing the
accuracy of the information transmitted to the Internal Revenue
Service (IRS), and even endangering the competitive position of
U.S.-based multinational enterprises.\23\
---------------------------------------------------------------------------
\23\ See Marsha Blumenthal and Joel B. Slemrod, ``The Compliance
Cost of Taxing Foreign-Source Income: Its Magnitude, Determinants, and
Policy Implications,'' in National Tax Policy in an International
Economy: Summary of Conference Papers, (International Tax Policy Forum:
Washington, D.C., 1994).
Many foreign companies do not appear to face the same level
of costs in their operations. The European Community Ruding
Committee survey of 965 European firms found no evidence that
compliance costs were higher for foreign source income than for
domestic source income.\24\ Lower compliance costs and simpler
systems that often produce a more favorable result in a given
situation are competitive advantages afforded these foreign
firms relative to U.S. based companies.
---------------------------------------------------------------------------
\24\ Id.
---------------------------------------------------------------------------
Taking into account individual as well as corporate-level
taxes, a report by the Organization for Economic Cooperation
and Development (OECD) finds that the cost of capital for both
domestic (8.0 percent) and foreign investment (8.8 percent) by
U.S.-based companies is significantly higher than the averages
for the other G-7 countries (7.2 percent domestic and 8.0
percent foreign). The United States and Japan are tied as the
least competitive G-7 countries for a multinational company to
locate its headquarters, taking into account taxation at both
the individual and corporate levels.\25\ These findings have an
ominous quality, given the recent spate of acquisitions of
large U.S.-based companies by their foreign competitors.\26\ In
fact, of the world's 20 largest companies (ranked by sales) in
1960, 18 were headquartered in the United States. By the mid-
1990s, that number had dropped to 8.
---------------------------------------------------------------------------
\25\ OECD, Taxing Profits in a Global Economy: Domestic and
International Issues (1991).
\26\ See, e.g., testimony before the Committee on Finance, U.S.
Senate, March 11, 1999.
---------------------------------------------------------------------------
Short of fundamental reform--a reform in which the United
States federal income tax system is eliminated in favor of some
other sort of system--there are many aspects of the current
system that could be reformed and greatly improved. These
reforms could significantly lower the cost of capital, the cost
of administration, and therefore the cost of doing business for
U.S.-based firms.
In this regard, the NFTC strongly supports the
International Tax Simplification for American Competitiveness
Act of 1999, H.R. 2018, recently introduced by Mr. Houghton,
and Mr. Levin, and Mr. Sam Johnson, and joined by four other
members: Mr. Crane, Mr. Herger, Mr. English, and Mr. Matsui. We
congratulate them on their efforts to make these amendments.
They address important concerns of our companies in their
efforts to export American products and create jobs for
American workers.
The NFTC is preparing recommendations for broader reforms
of the Code to address the anomalies and problems noted in our
review of the U.S. international tax system, and would enjoy
the opportunity to do so.
Conclusion
In particular, our study of the international tax system of
the United States has led us so far to four broad conclusions:
U.S.-based companies are now far less dominant in global
markets, and hence more adversely affected by the competitive
disadvantage of incurring current home-country taxes with respect to
income that, in the hands of a non-U.S. based competitor, is subject
only to local taxation; and
U.S.-based companies are more dependent on global markets
for a significant share of their sales and profits, and hence have
plentiful non-tax reasons for establishing foreign operations.
Changes in U.S. tax law in recent decades have on balance
increased the taxation of foreign income.
The U.S. international tax system is much more complex and
burdensome than that of our trading partners.
United States policy in regard to trade matters has been
broadly expansionist for many years, but its tax policy has not
followed suit.
These two incompatible trends -decreasing U.S. dominance in
global markets set against increasing U.S. taxation of foreign
income -are not claimed by us to have any necessary causal
relation. However, they strongly suggest that we must re-
evaluate the balance of policies that underlie our
international tax system.
Again, the Council applauds the Chairman and the Members of
the Committee for beginning the process of reexamining of the
international tax system of the United States. These tax
provisions significantly affect the national welfare, and we
believe the Congress should undertake careful modification of
them in ways that will enhance the participation of the United
States in the global economy of the 21st Century. We would
enjoy the opportunity to work with you and the Committee in
further defining both the problems and potential solutions. The
NFTC would hope to make a contribution to this important
business of the Committee.
Chairman Archer. Thank you, Mr. Murray.
Mr. Morrison you may proceed.
STATEMENT OF PHILIP D. MORRISON, PRINCIPAL AND DIRECTOR,
WASHINGTON INTERNATIONAL TAX SERVICES GROUP, DELOITTE & TOUCHE
LLP.; ON BEHALF OF THE NATIONAL FOREIGN TRADE COUNCIL, INC.
Mr. Morrison. Thank you, Mr. Chairman, distinguished
Members of the Committee, and staff. My name is Phil Morrison.
I am a principal with Deloitte & Touche and the director of
Deloitte's Washington International Tax Services Group. I
appear today on behalf of the National Foreign Trade Council.
I am one of the co-authors of the NFTC's report on Subpart
F, and we are currently working on a second report, as Mr.
Murray said, on the foreign tax credit. My role with respect to
both of these reports is a comparative law one, to compare the
U.S. regime with the comparable regimes of our major trading
partners, specifically Canada, France, Germany, Japan, the
Netherlands, and the United Kingdom. It is the large
multinational corporations from these countries that form the
chief competition of U.S. companies when they operate abroad.
The Subpart F comparison that we completed illustrates
that, in many important respects, the U.S. CFC provisions in
Subpart F are much harsher than the rules of foreign countries'
comparable regimes. While the foreign tax credit comparison is
still a work in progress, preliminary results indicate that the
use of the credit, U.S. limitations on the use of the credit,
and expense allocation provisions, particularly interest
expense, as has been mentioned this morning several times, are
both more complex and more likely to result in double tax than
comparable regimes in the foreign countries surveyed. This is
particularly true with respect either to highly leveraged
industries or those that produce significant foreign losses
during the startup years abroad, such as telecommunications or
power generation.
The 1-page table that appears at the end of my written
testimony summarizes several of the practical examples that we
examined in the Subpart F report. As Example 1 shows, none of
the countries surveyed eliminates deferral for active financial
services income received by a CFC from unrelated persons. Such
income is universally recognized as active business income, and
except in the United States, is not subject to the anti-
defferal regime. Thus, if the temporary active financing
provision enacted for this year were permitted to expire at the
end of 1999, the United States would be clearly out of step
with international norms.
Examples 2, 3, and 4 in the table address the situations
where an active business CFC receives dividends, in Example 2;
interest, in Example 3; and royalties, in Example 4, from a
related active business CFC resident in a different country. In
each case, the United States is the only country that always
denies deferral.
Example 5 deals with foreign-based company oil-related
income, that is, income from downstream activities, such as
refining.
Under Subpart F, the income of the CFC always would be
attributed to U.S. shareholders. In the other countries, oil-
related income is subject to the same rules as other types of
active business income; only France would tax oil-related
income.
In Example 6, a CFC is engaged in buying and selling
property that it does not manufacture. The property is bought
from related parties outside the CFC's residence country and
sold to unrelated parties, also outside the CFC's country.
Again, because of tax disparities, Canadian, Dutch, German, and
Japanese multinationals all have a competitive advantage over
U.S. multinationals.
Example 7 demonstrates that none of the countries examined
have a section 956 surrogate. None require inclusion in income
by a CFC shareholder for an increase in earnings invested in
the home country of the CFC.
These comparisons demonstrate that, due to Subpart F, U.S.
multinationals operate at a competitive disadvantage abroad as
compared to multinationals from our major trading partners. By
pointing out this competitive disadvantage, and despite the
chairman's invitation earlier, we don't mean to imply that the
United States should inaugurate a ``race to the bottom,'' a
race to provide the most lenient tax rules in the United
States. The comparison does demonstrate, however, quite
clearly, that the rest of the developed world has not joined
the United States in a ``race to the top.'' In the 37 years
since the enactment of Subpart F, while each jurisdiction
studied has approached CFC issues somewhat differently, none
has adopted a regime as harsh as Subpart F.
The U.S. anti-deferral rules are out of step with
international norms. The relaxation of Subpart F, even to the
highest common denominator among other countries' regimes, let
alone to a more moderate middle ground, would help redress the
competitive imbalance created by Subpart F without contributing
to the feared race to the bottom.
While we have yet to complete our study that will be part
of the foreign tax credit report, our preliminary work reveals
that the U.S. credit system, again, particularly with respect
to interest allocation and the treatment of foreign losses, is
also out of step with international norms. It appears that this
too contributes to a competitive disadvantage for most U.S.
multinationals.
Thank you very much for your attention.
[The prepared statement follows:]
Statement of Phillip D. Morrison, Principal and Director, Washington
International Tax Services Group, Deloitte & Touche LLP; on behalf of
the National Foreign Trade Council, Inc.
Mr. Chairman, distinguished Members of the Committee, and
staff: My name is Phil Morrison. I am a Principal with Deloitte
& Touche LLP and the Director of Deloitte's Washington
International Tax Services Group. I appear today on behalf of
the National Foreign Trade Council (``NFTC'').
I. Introduction
I am co-author of the NFTC's report on subpart F \1\ and am
currently working with others on an NFTC-sponsored report on
the foreign tax credit. My role with respect to these reports
was to compare the United States subpart F and foreign tax
credit regimes to the comparable regimes of Canada, France,
Germany, Japan, the Netherlands, and the United Kingdom.
---------------------------------------------------------------------------
\1\ International Tax Policy for the 21st Century: A
Reconsideration of Subpart F, (March 25, 1999).
---------------------------------------------------------------------------
These countries were selected for comparison because they
constitute, together with the United States, the countries with
the most corporations that are among the world's largest 500
corporations. In the aggregate, these countries are home to 412
of the 500 largest corporations in the world,\2\ and it is
large multinational corporations from these countries that are
the competition for U.S. corporations that conduct business
abroad.
---------------------------------------------------------------------------
\2\ Based upon the Financial Times 500, The Financial Times,
January 22, 1998.
---------------------------------------------------------------------------
The subpart F comparison illustrates that, in many
important respects, the U.S. controlled foreign corporation
(CFC) provisions in subpart F are harsher than the rules in the
foreign countries' comparable regimes.\3\ While the foreign tax
credit comparison is still a work-in-progress, preliminary
results indicate that the U.S. limitations on the use of the
credit and expense allocation provisions are both more complex
and more likely to result in double taxation than the foreign
countries' comparable regimes. These comparisons demonstrate
that U.S. multinationals operate at a competitive disadvantage
abroad as compared to multinationals from these other major
jurisdictions.
---------------------------------------------------------------------------
\3\ For convenience, the anti-deferral regimes of all of the
countries will be referred to as ``CFC regimes.'' The actual names of
the particular regimes vary.
---------------------------------------------------------------------------
By pointing out this competitive disadvantage, we do not
mean to imply that the United States should inaugurate a ``race
to the bottom,'' a race to provide the most lenient tax rules.
The comparison does demonstrate, however, that the rest of the
developed world has not joined the United States in a ``race to
the top.'' If the rest of the developed world is not going to
join the United States and mimic the harshness of subpart F and
the complexity of our foreign tax credit rules, and history has
shown that it will not, then it is incumbent upon Congress to
carefully examine whether the resulting competitive imbalance
is warranted for other policy reasons. Since, as the NFTC
report demonstrates and as is summarized in the testimony of
Messrs. Murray and Merrill, it is not, it would be sensible to
relax the U.S. rules. This relaxation need not be a relaxation
to the lowest common denominator but only to a more reasonable
middle position among those adopted by our competitor
countries.
The unstated assumption of those who raise the spectre of a
race to the bottom, is that any significant deviation from the
U.S. model that exists in another country indicates that the
other government has yielded to powerful business interests and
has enacted tax laws that are intended to provide its home-
country based multinationals a distinct competitive advantage.
It is seldom, if ever, acknowledged that the less stringent
rules adopted in other countries might reflect a conscious but
different balance of the rival policy concerns of neutrality
and competitiveness.
The unstated assumption is incorrect. The CFC regimes
enacted by the countries studied, for example, all were enacted
in response to and after several years of scrutiny of the U.S.
subpart F regime. They reflect a careful study of the impact of
subpart F and, in every case, include some significant
refinements of the U.S. rules. Each regime has been in place
long enough for each respective government to study its
operation and to conclude whether it is either too harsh or too
liberal. While each jurisdiction has approached CFC issues
somewhat differently, each has adopted a regime that, in at
least some important respects, is materially less harsh than
subpart F.
The proper inference to draw from this comparison is that
the United States has tried to lead and, while many have
followed, none has followed as far as the United States has
gone. A relaxation of subpart F to even the highest common
denominator among other countries' CFC regimes, let alone to a
moderate middle ground, would help redress the competitive
imbalance created by subpart F without contributing to a race
to the bottom.
II. Anti-Deferral or CFC Regimes--Generally
Each of the countries examined in the NFTC study on subpart
F has enacted a regime aimed at preventing taxpayers from
obtaining deferral with respect to certain types of income of,
or income earned by certain types of, CFCs. At the same time,
however, each country has balanced its anti-deferral concerns
with the need not to interfere with the ability of domestic
taxpayers to compete in genuine business activities in
international markets. Resolution of the conflict between these
two policy objectives typically hinges on the definition of
what constitutes genuine foreign business activity. Genuine
business activity gains deferral; a lack of genuine business
activity triggers the anti-deferral regime. As might be
expected, the definition of genuine foreign business activity
varies widely.
There are two primary ways in which countries prevent what
they consider to be improper deferral of domestic taxation of
foreign-source income earned by CFC's. A country may end
deferral with respect to certain types of ``tainted'' income
that it believes should not receive deferral. This
transactional approach is the approach taken by the United
States, Canada, and Germany. The alternative is to deem all
income to be tainted when a CFC meets certain criteria (such as
having a significant amount of tainted income or being located
in certain jurisdictions). If the CFC does not meet the
criteria for application of the regime, deferral is allowed for
all of the income. This jurisdiction-based approach is taken by
France, Japan, and the United Kingdom. Both approaches provide
exemptions and modifications that tend to minimize the
differences between them, however. The Netherlands, through a
participation exemption, broadly exempts foreign income of
CFCs. While the participation exemption is denied for certain
passive investments, liberal safe harbors preserve the
exemption in most cases.
Deferral is ended (and current inclusion achieved) by
attributing either the tainted income or all income earned by
the CFC to certain shareholders (usually those holding a
minimum percentage ownership). Shareholders must include the
attributed income in their own income currently. CFC regimes
that attribute only tainted income provide for exclusions that
remove specific types of income from classes of income that
normally are considered to be tainted. CFC regimes that
attribute all income provide exemptions that remove all or
certain income from attribution under the regime.
III. Specific Comparison of CFC Regimes with Respect to Particular
Types
of Income \4\
A. Active Financial Services Income
Prior to 1986, a CFC's active financial services income was
treated much the same as other types of active income. From
1986 until 1998, however, most income earned by a CFC of a U.S.
financial services company was subject to tax when earned,
apparently because Congress believed that deferral of such
income provided excessive opportunities to route income through
foreign countries to maximize tax benefits.\5\ The pre-1986
treatment for active financial services income was temporarily
restored in 1997,\6\ with the addition of rules to address the
concerns that led to the repeal in 1986.
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\4\ In each of the examples below, it is assumed that a single
home-country shareholder (a parent company) owns 100% of the CFC.
Because of this, in each of the examples outlined below, the Dutch
anti-deferral regime (exceptions from the Dutch exemption system) will
not apply.
\5\ Joint Committee on Taxation, General Explanation of the Tax
Reform Act of 1986, at 966 (Comm. Print 1986).
\6\ Pub. L. No. 105-34, Sec. 1175(a); H.R. Rep. No. 105-220, at
639-645 (1997)(Taxpayer Relief Act of 1997, Conference Report to H.R.
2014).
---------------------------------------------------------------------------
The active financing income provision was revisited in
1998, in the context of extending the provision for the 1999
tax year. Considerable changes were again made to address
concerns relating to income mobility. The newly crafted
provision is narrowly drawn. Under the 1999 active financing
provision, a financial services business must have a
substantial number of employees carrying on substantial
managerial and operational activities in the foreign country.
The activities must be carried on almost exclusively with
unrelated parties, and the income from the activities must be
recorded on the books and records of the CFC in the country
where the income was earned and the activities were
performed.\7\ In addition, an active banking, financing,
securities, or insurance business is painstakingly defined by
statute and accompanying legislative history. The activities
that may be taken into account in determining whether a
business is active also are carefully delineated in the statute
and legislative history and substantially all of the CFC's
activities must be comprised of such activities as defined.
---------------------------------------------------------------------------
\7\ See H.R. Rep. No. 105-825, at 921 (1998)(Conference Report to
H.R. 4328, section 1005 of the Omnibus Consolidated and Emergency
Supplemental Appropriations Act of 1999).
---------------------------------------------------------------------------
As Example 1 on the attached table shows, none of the
countries surveyed eliminates deferral for active financial
services income received by a CFC from unrelated persons. Such
income is universally recognized as active trade or business
income. Thus, if the active financing provision were permitted
to expire at the end of 1999, U.S. banks, insurers, and other
financial services companies would find themselves at a
significant competitive disadvantage in relation to all their
major foreign competitors when operating outside the United
States.
Other major industrialized countries provide more lenient
requirements for a CFC to be able to defer the taxation of its
active financing income. German law merely requires that the
income must be earned by a bank with a commercially viable
office established in the CFC's jurisdiction and that the
income results from transactions with customers. Germany does
not require that the CFC conduct the activities generating the
income or that the income come from transactions with customers
solely in the CFC's country of incorporation. The United
Kingdom has an even less restrictive deferral regime than
Germany. The United Kingdom does not impose current taxation on
CFC income as long as the CFC is engaged primarily in
legitimate business activities primarily with unrelated
parties.
B. Dividends, Interest, and Royalties from Active Earnings
Received from Related Parties
Example 2 on the attached table addresses the case where a
CFC engaged in the active conduct of a trade or business
receives dividends from a subsidiary CFC, incorporated in a
different country, also engaged in the active conduct of a
trade or business.
For U.S. tax purposes, the dividend income would be taxed
to (attributed to) the CFC's U.S. shareholders. There would be
no attribution to Canadian shareholders because dividends
received from other foreign related parties out of active
earnings are excluded from attribution. French shareholders
would be exempt because the CFC is engaged in an active
business. The dividend income would not be considered to be
tainted income in Germany provided the parent CFC's holdings in
the subsidiary CFC are commercially related to its own excluded
active business operations (e.g., CFC is also engaged in a
similar manufacturing business) or if the dividends would have
been exempt if received directly by the German corporation.
Japanese shareholders would be exempt because the business of
CFC is conducted primarily in its country of incorporation
(even if business were not conducted in that country, Japanese
shareholders would be exempt if the main business of CFC were
wholesale, financial, shipping, or air transportation because
it is engaged in business primarily with unrelated parties).
U.K. shareholders would be exempt from attribution because the
recipient CFC is principally engaged in an active business and
the business operations of CFC are carried on principally with
unrelated parties.
Thus, in the case of an active business CFC that receives a
dividend from a CFC subsidiary engaged in active business in a
country other than the recipient CFC country, the United States
is the only country that always attributes the income to CFC
shareholders. While the foreign countries allow for situations
where legitimate active businesses earn dividend income in the
normal course of business, the United States puts its
multinational corporations at a disadvantage by always taxing
dividend income currently unless the extremely narrow same
country exception applies.
Example 3 assumes the same facts as Example 2 but deals
with interest. Thus, in Example 3, a CFC engaged in an active
trade or business pays interest to a parent or sister CFC in
another country that is also engaged in an active business.
Canadian, French, Japanese, and U.K. CFCs are allowed to
lend money to active business subsidiaries without being
penalized by the CFC rules. German CFCs are allowed to lend
money to foreign active business subsidiaries as long as the
loan is long-term and the money is borrowed by the CFC on
foreign capital markets. U.S. multinational corporations
generally are not able to provide a loan from a CFC engaged in
active business with an excess of cash to a subsidiary of the
CFC that is engaged in active business with a need for cash,
without incurring current U.S. taxation on the interest paid
from the subsidiary to the CFC. The only time U.S.
multinationals are able to provide such a loan without current
U.S. taxation is if both the CFC and the subsidiary are in the
same country. Although income used to pay the interest is
earned in an active foreign business by a party related to the
U.S. multinational and the income is reinvested in an active
foreign business, the U.S. rules still tax the income
currently.
Once again, U.S. multinationals are at a competitive
disadvantage in the international marketplace. This situation,
like the dividend example in Example 2, hamstrings U.S.
multinationals groups from redeploying foreign earnings of
their CFC group from jurisdiction to jurisdiction without
triggering an end to deferral.
Example 4 on the attached table is identical to Examples 2
and 3 except that it deals with royalties. Royalties are paid
by an active CFC in one country to an active CFC in another
country.
The Canadian CFC rules provide an exception that deems
amounts paid to a CFC by a related foreign corporation to be
active business income if the amount is deductible in computing
the income of the payer corporation. Therefore, the royalty
payments would be excluded from attribution. Income would not
be attributed to French shareholders or Japanese shareholders
because CFC is principally engaged in an active business
carried on in its residence country. Germany does not consider
royalty income to be passive tainted income provided the CFC
has used its own research and development activities without
the participation of German shareholders or an affiliated
person to create the patents, trademarks, know-how, or similar
rights from which the income is derived. U.K. shareholders
would be exempt from attribution because CFC is principally
engaged in an active business and the business operations of
CFC are carried on principally with unrelated parties.
Only members of U.S. multinational groups cannot pay
royalties to a CFC that actively develops intangibles without
triggering an anti-deferral regime. Even if earned in an active
business, royalties from related parties are subpart F income.
In each of the competitor countries' cases, such royalties are
not tainted income or otherwise attributable to the CFC's
shareholders.
C. Oil-Related Income
In 1982, the United States expanded subpart F income to
include ``foreign base company oil-related income.'' \8\
Congress claimed that, because of the fungible nature of oil
and because of the complex structures involved, oil income is
particularly suited to tax haven type operations.\9\ Under the
changes made foreign base company oil-related income was
defined as foreign oil-related income other than: (1) income
derived from a source within a foreign country in connection
with oil or gas extracted from an oil or gas well located in
that foreign country; or (2) income from oil, gas, or a primary
product of oil or gas that is sold by the foreign corporation
for use or consumption within the foreign country or is loaded
in such country on a vessel or aircraft as fuel for such vessel
or aircraft.\10\
---------------------------------------------------------------------------
\8\ Pub. L. No. 97-248, Sec. 212(a).
\9\ Joint Committee on Taxation, General Explanation of the Revenue
Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, at
72.
\10\ I.R.C. Sec. 954(g).
---------------------------------------------------------------------------
Example 5 compares the U.S. rules with respect to foreign
base company oil-related income to those applicable to CFCs of
companies incorporated in our competitor countries. Example 5
assumes that CFC operates a refinery in country X. CFC earns
oil-related income in X from purchasing oil extracted from a
country other than X and sells the refined product for
consumption outside of X. CFC's sales are primarily conducted
with unrelated parties.
Under subpart F, the income of CFC would be attributed to
its U.S. shareholders. None of the other countries have singled
out oil-related income as a type of income that should be
tainted. In the other countries, oil-related income is subject
to the same rules as other types of active business income. In
this example, however, income would be attributed to French
shareholders because CFC makes sales primarily outside the CFC
country. In the other countries examined, the income would not
be taxed.
Thus, U.S.-based and French-based multinational oil
companies are, in these circumstances, at a competitive
disadvantage in relation to oil companies from the other
compared countries with respect to income earned from
downstream activities. Only for U.S. and French multinational
oil companies will income from an active downstream business
conducted in a subsidiary in a foreign jurisdiction be
attributed to shareholders. In each of the other surveyed
jurisdictions, such income would be entitled to deferral or
exemption.
D. Base Company Sales Income
For U.S. tax purposes, foreign base company sales income
generally is income derived from the purchase and re-sale of
property that is not manufactured by the CFC where either the
seller or the buyer is related to the CFC.
In Example 6, CFC is engaged in the buying and selling of
personal property that it does not manufacture. The property is
bought from related parties outside CFC's residence country and
sold to unrelated parties outside CFC's residence country.
The income of CFC would be attributed to U.S. shareholders.
In Canada, CFC's income would be exempt from attribution
because the income is earned in active business. The income
would be attributed to French shareholders because the business
is conducted primarily outside the CFC country. Germany's
exemption for commercial activities does not generally apply
when goods are acquired by the CFC from, or sold to, a related
German party. If the goods are both purchased and sold outside
Germany, however, the sales income is exempt, even if the goods
are sold to a related party and the German shareholder of the
CFC actively participates. In this example, therefore, there
would be no attribution. To qualify for exemption from
attribution, a Japanese sales company must conduct its business
primarily with unrelated parties. To be conducting business
primarily with unrelated parties for Japanese purposes, the CFC
must either purchase more than 50 percent of its goods from
unrelated parties or sell more than 50 percent of its goods to
unrelated parties. The income of CFC would not be attributed to
Japanese shareholders because more than 50 percent of the goods
are sold to unrelated parties. A CFC controlled by U.K.
shareholders is subject to the CFC regime and income is
attributed to its shareholders if the main business of the CFC
is dealing in goods for delivery to or from the United Kingdom
or to or from related parties. The main business of the CFC is
dealing in goods from related parties, so the income of the CFC
would be attributed to its shareholders.
Canadian, German, and Japanese multinationals have a
competitive advantage over U.S. multinationals when goods
bought from related parties outside the home and CFC countries
are sold to unrelated parties outside the home and CFC
countries.
E. Increase in Investment in the Home Country
In Example 7, CFC has nothing invested in home country
property at the beginning of the year. CFC purchases tangible
property located in the home country for use in its business
during the year. CFC has earnings and profits in excess of the
value of the property.
Under subpart F, U.S. shareholders would have to include
the entire amount invested by the CFC in U.S. property for the
taxable year in its income.\11\ None of the other countries
studied have a provision that requires an inclusion in income
by the CFC shareholders for an increase in earnings invested by
the CFC in the home country. Canada and Germany have decided
that, if the income earned from that property invested in the
home country is of a type for which deferral should not be
granted, then it is sufficient to subject the income from that
investment to the anti-deferral regime (note that the CFC
itself may be subject to tax in the home country because the
income may be sourced in the home country). France, Japan, and
the United Kingdom do not even subject the income from such
property to tax under their anti-deferral regime, even if the
income is of a type for which deferral should not be granted,
if the CFC is engaged primarily in active business.
---------------------------------------------------------------------------
\11\ I.R.C. Sec. Sec. 951(a)(1)(B), 956(a).
---------------------------------------------------------------------------
IV. Conclusion--Anti-Deferral or CFC Regimes
Anti-deferral or CFC regimes have been enacted in each of
the countries studied. Most were enacted in the two decades
following the enactment of subpart F in the United States. It
is possible to argue that other countries, albeit slowly, have
followed the United States' lead. But no country has followed
our lead, even after 37 years, nearly as far as we have gone.
The United States clearly imposes the most burdensome regime.
Looking at any given category of income, it is sometimes
possible to point to one or two countries whose rules approach
the U.S. regime, but the overall trend is overwhelmingly clear:
U.S.-based multinationals with active foreign business
operations suffer much greater home-country tax burdens than
their foreign-based competitors.
The observation that the U.S. rules are out of step with
international norms, as reflected in the consistent practices
of our major trading partners, supports the conclusion that
U.S.-based companies suffer a competitive disadvantage vis-a-
vis their multinational competitors based in other countries.
The appropriate reform is to limit the reach of subpart F in a
manner that is more consistent with the international norm.
Some commentators have suggested that the competitive
imbalance created by dissimilar international tax rules should
be redressed not through any amelioration of the U.S. rules,
but rather through a broadening of comparable foreign regimes.
As a purely logical matter the point is valid--a see-saw can be
balanced either by pushing down the high end or pulling up the
low one. However, the suggestion is completely impractical for
several reasons. For one thing, since the U.S. rules are out of
step with the majority, from the standpoint of legislative
logistics alone it would be far easier to achieve conforming
legislation in the United States alone, rather than in more
than a dozen other countries. More fundamentally, there is no
particular reason to believe that numerous foreign sovereigns,
having previously declined to adopt subpart F's broad taxation
of active foreign businesses despite 37 years of the U.S.
setting the example, will now suddenly have a change of heart
and decide to follow the U.S. model. Clearly our competitor
jurisdictions have studied our subpart F and chosen a somewhat
less harsh balance between competitiveness and neutrality. It
is unwarranted and naive to think they have made this choice
without careful consideration or solely in an effort to
maintain a competitive advantage for ``their'' multinationals.
Further, recent OECD activities relating to ``unfair tax
competition'' do not increase the likelihood of foreign
conformity with subpart F's treatment of active foreign
businesses. It is important to recognize that those activities
relate to efforts by OECD member countries to limit the
availability and usage of ``tax haven'' countries and regimes.
The failure of a country to impose any type of CFC legislation
can be viewed as offering a type of tax haven opportunity,
since it may permit the creation of investment structures that
avoid all taxation. Thus, the OECD has recommended that
countries without any CFC regime ``consider'' enacting them.
However, in encouraging countries that have no CFC rules to
enact them, the OECD has in no way endorsed an effort to
promote conformity among existing CFC regimes, let alone
conformity with the U.S. system.
In conclusion, the U.S. rules under subpart F are well
outside the international mainstream, and should be conformed
more closely to the practices of our principal trading
partners. We emphasize that, contrary to the suggestions of
some commentators, we advocate only that the U.S. rules be
brought back to the norm so as to achieve competitive parity--
not that they be loosened further in an effort to confer
competitive advantage.
V. Foreign Tax Credit
As mentioned above, the NFTC foreign tax credit study is a
work-in-progress. While I am unable to report definitive
conclusions from the comparative law portion of that study, we
are far enough along to make some general observations. First,
while superficially less complex, exemption or territorial
systems have the potential for significant complexity. Because,
under an exemption or territorial system, foreign source income
is exempt, sourcing rules are as important and susceptible of
as much pressure as under a foreign tax credit system with a
complex limitation. Similarly, because income of foreign
subsidiaries is exempt under a territorial system, transfer
pricing rules can come under significant pressure. Finally,
most jurisdictions with exemption or territorial systems find
the need to not exempt certain types of passive income. Thus,
there may be a foreign tax credit system just for this type of
income, as well as an anti-deferral or CFC regime.
Second, no other country studied limits averaging between
high-and low-tax countries with either the severity or the
complexity of the U.S. foreign tax credit basket system. Even
the U.K., with a juridical per item limitation mitigates the
complexity and harshness of such a rule by permitting the
utilization of so-called ``mixer'' companies. Other credit
countries, such as Japan, adopt a straight-forward overall
limitation such as the United States has had in the past.
Third, no country studied appears to have anywhere near as
complex an expense allocation regime, particularly with respect
to interest, as the United States'. The U.S. interest
allocation rules appear, based on our preliminary work, to be
vastly more complex and unfair than the expense allocation
rules applicable in any of the other jurisdictions.
Finally, none of the other jurisdictions studied appear to
have a rule such as the U.S. overall foreign loss (``OFL'')
recapture rule. That rule, which causes U.S. multinationals
with OFLs to recapture future foreign source income as domestic
income, essentially eliminates the benefit of a foreign tax
credit in industries such as telecommunications and power
generation where significant capital outlays in early years of
foreign operations produce significant early years losses.
In sum, our preliminary findings show that, like subpart F,
the U.S. foreign tax credit regime places U.S. multinationals
at a competitive disadvantage versus multinationals from the
other countries studied. This is particularly true with respect
to either heavily leveraged industries or those that produce
significant foreign losses in the early years of operation
abroad.
VI. Overall Conclusion
The U.S. subpart F and foreign tax credit regimes are both
more complex and harsher than the comparable regimes in the six
other countries studied. The higher administrative cost in
dealing with this complexity, together with the higher domestic
tax on foreign-earned income, generally places U.S.
multinationals at a competitive disadvantage versus
multinationals based in these other countries.
[GRAPHIC] [TIFF OMITTED] T6775.002
Chairman Archer. Thank you, Mr. Morrison.
Our next witness is Mr. Merrill.
STATEMENT OF PETER R. MERRILL, PRINCIPAL, WASHINGTON NATIONAL
TAX SERVICES, AND DIRECTOR, NATIONAL ECONOMIC CONSULTING GROUP,
PRICEWATERHOUSECOOPERS, LLP; ON BEHALF OF THE NATIONAL FOREIGN
TRADE COUNCIL, INC.
Mr. Merrill. Thank you, Mr. Chairman and the Committee, for
the opportunity to testify before you this morning. I am
director of the National Economic Consulting Group at
Pricewaterhouse-
Coopers here in Washington. I am appearing today in my capacity
as a member of the drafting group of the NFTC study on Subpart
F.
I would like to cover today four points. First, how has the
global economy changed in the 37 years since Congress enacted
the Subpart F regime? Second, is foreign investment by U.S.
companies harmful to the domestic economy? Third, does the
competitiveness of U.S.-headquartered companies matter for our
national economic well-being? Fourth, how does U.S. tax policy
affect the competitiveness of U.S. companies?
I am going to conclude my testimony today by summarizing
some of the results from a new study that
PricewaterhouseCoopers has just completed, which looks at the
question that the chairman raised in announcing the hearing,
which is are American companies the losers in recent cross-
quarter mergers?
In 1962 when Subpart F was enacted, the United States was
on the gold standard, exchange rates were fixed, and the United
States was the world's largest capital exporter. Treasury was
concerned about keeping capital in the United States,
preventing it from flowing out. That was one of the main
rationales for the Subpart F regime, adopted in 1962--to keep
the capital at home. Today, of course, the gold standard is
gone. The dollar floats. The United States is the world's
largest capital importer. There is obviously hardly any reason
that we need tax legislation designed to keep the capital at
home.
The world has become a much more competitive place for U.S.
multinationals. In 1967, U.S. multinationals had a 50 percent
market share in cross-border investment. Today, they have a 25
percent share. As Mr. Murray has mentioned, in 1960, 18 of the
20 largest corporations in the world were headquartered in the
United States. But, today, just eight are headquartered in the
United States. Obviously, U.S. multinationals face much
heightened competition compared to what they did in 1962.
Second, does U.S. foreign direct investment abroad help or
hurt the U.S. economy? Obviously, some have argued that U.S.
investment abroad comes at the expense of the domestic economy.
Under this view, Subpart F and various rules that penalize U.S.
investment abroad are necessary to protect U.S. workers. I will
quote to the Committee a recent study by the OECD. It is a very
good study. It is called ``Open Markets Matter.'' The OECD
found that domestic firms and their employees, ``generally gain
from the freedom of businesses to invest overseas. As with
trade, foreign direct investment generally creates net benefits
for the host and the source countries alike.''
A few other points about U.S. investment abroad. First,
companies that don't invest abroad pay 5 to 15 percent lower
wages than similar U.S. multinational companies.
Second, U.S. multinationals account for $407 billion of
exports in 1996. That is in two-thirds of all exports a U.S.
multinational is involved in the export.
Third, the OECD study that I mentioned before found that
for each dollar of outward investment, there is an additional
$1.70 of contribution to the trade balance, a net trade surplus
of $1.70. U.S. multinationals certainly are a key component of
exports.
Companies that invest abroad invest to do so for foreign
markets. You heard in the earlier panel, that over 90 percent
of what U.S. companies abroad sell is destined for foreign
markets, not the U.S. market.
Thus, international competitiveness of U.S. multinationals
matter for the domestic economy. Laura Tyson, former Chair of
the Council of Economic Advisors in this administration and the
former director of the National Economic Council said, in an
article in the American Prospect Magazine, Yes, it is important
to have headquarters of companies here. She pointed out that 70
percent of the assets and jobs of U.S. multinationals are
located in the United States and 88 percent of the R&D they
perform is located in the United States. U.S.-headquartered
companies overwhelmingly have U.S. leadership and they source
the supplies for the products they make from U.S. suppliers
predominately.
Last, why do we think that it is important that we have a
competitive U.S. tax policy? If the United States taxes
foreign-source income of its multinationals more heavily than
other countries, then ultimately the world market share of U.S.
multinationals will decline. This can happen in a variety of
ways. It can happen through cross-border mergers. It can happen
because U.S. individuals invest in foreign mutual funds. The
portfolio capital that moves to foreign-headquartered companies
avoids the U.S. corporate tax rules.
I would like to in the last minute call your attention to a
recent PricewaterhouseCoopers' study. We just released this
today. It is a summary of large U.S. cross-border mergers and
acquisitions for 1998. We looked at all of the mergers and
acquisitions that were completed in 1998 involving transactions
of over $500 million. What we found--it is in the study--is
very striking.
We found that a net of $127 billion of U.S. assets moved
from U.S.-headquartered companies to foreign-headquartered
companies in 1998, that is, $127 billion moved out of U.S.-
headquartered companies. Future foreign investment by these
companies will generate income that will not ever be taxed by
the United States. Out to be, out of 51 transactions, 34 were
acquisitions of U.S. companies by foreigners, only 17 were
acquisitions of foreign companies by U.S. companies. Of the
$175 billion of deals, there were $151 billion where foreigners
acquired U.S. companies. Only $24 billion were U.S. acquired
foreign companies. So you can see that clearly there is a net
movement of $127 billion of U.S. assets out of U.S.-
headquartered companies.
I will conclude my testimony there and take questions.
[The prepared statement follows:]
Statement of Peter R. Merrill, Principal, Washington, National Tax
Services, and Director, National Economic Consulting Group,
PricewaterhouseCoopers LLP; on behalf of the National Foreign Trade
Council, Inc.
I. Introduction
I am Peter Merrill, a principal in the Washington National
Tax Services office of PricewaterhouseCoopers LLP, and director
of the National Economic Consulting group. I am testifying
today as a member of the drafting group of a recent National
Foreign Trade Council report on International Tax Policy for
the 21st Century: A Reconsideration of Subpart F.\1\ This
report is a comprehensive legal and economic review of the U.S.
anti-deferral rules that have applied to U.S. multinational
companies since they were enacted by Congress in 1962.
---------------------------------------------------------------------------
\1\ National Foreign Trade Council, Inc. International Tax Policy
for the 21st Century: A Reconsideration of Subpart F, March 25, 1999,
Washington, D.C.
---------------------------------------------------------------------------
This testimony \2\ briefly addresses four key economic
issues that are discussed more fully in the NFTC report:
---------------------------------------------------------------------------
\2\ This statement draws heavily on Chapter 5 and 6 and of the NFTC
report.
---------------------------------------------------------------------------
1. How has the global economy changed during the 37 years since
subpart F was enacted?
2. Is foreign investment by U.S. companies harmful to the domestic
economy?
3. Does the competitiveness of U.S.-headquartered companies matter
for U.S. well being?
4. How does U.S. tax policy affect the competitiveness of U.S.
multinational companies?
II. Global Economic Change Since 1962
In 1962, the Kennedy Administration proposed to subject the
earnings of U.S. controlled foreign corporations to current
U.S. taxation. At that time, the dollar was tied to the gold
standard, exchange rates were fixed, and the United States was
the world's largest capital exporter. These capital exports
drained Treasury's gold reserves, and made it more difficult
for the Administration to stimulate the economy. Thus the
proposed repeal of deferral was intended by Treasury Secretary
Douglas Dillon to serve as a form of capital control, reducing
the outflow of U.S. investment abroad.
The compromise adopted by Congress, in response to the
Kennedy Administration's proposal, was shaped by the global
economic environment of the early 1960s--a world economy that
has changed almost beyond recognition as the 20th century draws
to a close. The gold standard was abandoned during the Nixon
Administration, and the exchange rate of the dollar is no
longer fixed. The United States is now the world's largest
importer of capital, with net capital outflows of over $200
billion per year.
National economies are becoming increasingly integrated.
Globalization is being fueled both by technological change of
almost unimaginable rapidity, and a worldwide reduction in
tariff and regulatory barriers to the free flow of goods and
capital.
Foreign Direct Investment
In the 1960s, the United States completely dominated the
global economy, accounting for over 50 percent of worldwide
cross-border direct investment, and 40 percent of worldwide
Gross Domestic Product (GDP). In 1960, of the world's 20
largest corporations (ranked by sales), 18 were headquartered
in the United States (see Table 1).
Three decades later, the United States confronts far
greater competition in global markets. As of the mid-1990s, the
U.S. economy accounted for about 25 percent of the world's
foreign direct investment and GDP, and just 8 of the world's 20
largest corporations were headquartered in the United States.
The 21,000 foreign affiliates of U.S. multinationals now
compete with about 260,000 foreign affiliates of multinationals
headquartered in other nations.\3\ The declining dominance of
U.S.-headquartered multinationals is dramatically illustrated
by the recent acquisitions of Amoco by British Petroleum,
Chrysler by Daimler-Benz, AirTouch by Vodafone, Bankers Trust
by Deutsche Bank, and Transamerica by AEGON. These mergers have
the effect of converting U.S. multinationals to foreign-
headquartered companies.
---------------------------------------------------------------------------
\3\ UNCTAD, World Investment Report, 1997.
---------------------------------------------------------------------------
Bankers Trust by Deutsche Bank, and Transamerica by AEGON. These
mergers have the effect of converting U.S. multinationals to foreign-
headquartered companies.
[GRAPHIC] [TIFF OMITTED] T6775.003
Ironically, despite the intensified competition in world
markets, the U.S. economy is far more dependent on foreign
direct investment than ever before. In the 1960s, foreign
operations averaged just 7.5 percent of U.S. corporate net
income; by contrast, over the 1990-97 period, foreign earnings
represented 17.7 percent of all U.S. corporate net income. A
recent study of the Standard and Poors' 500 corporations (the
500 largest publicly-traded U.S. corporations) finds that sales
by foreign subsidiaries have increased from 25 percent of
worldwide sales in 1985 to 34 percent in 1997.\4\
---------------------------------------------------------------------------
\4\ IBES International based on Disclosure data as reported in the
Wall Street Journal, ``U.S. Firms Global Progress is Two-Edged,''
August 17, 1998.
---------------------------------------------------------------------------
The U.S. Market
In 1962, U.S. companies focused manufacturing and marketing
strategies in the United States, which at the time was the
largest consumer market in the world. U.S. companies generally
could achieve economies of scale and rapid growth selling
exclusively into the domestic market. In the early 1960's,
foreign competition in U.S. markets was inconsequential.
The picture is now completely changed. First, U.S.
companies now face strong competition at home. Since 1980, the
stock of foreign direct investment in the United States has
increased by a factor of six (from $126 billion to $752 billion
in 1997), and $20 of every $100 of direct cross-border
investment flows into the United States. Foreign companies own
approximately 14 percent of all U.S. non-bank corporate assets,
and over 27 percent of the U.S. chemical industry.\5\ Moreover,
imports have tripled as a share of GDP from an average of 3.2
percent in the 1960s to an average of over 9.6 percent over the
1990-97 period (see Table 5-1).
---------------------------------------------------------------------------
\5\ PricewaterhouseCoopers calculations based on Department of
Commerce and IRS data.
---------------------------------------------------------------------------
Second, foreign markets frequently offer greater growth
opportunities than the domestic market. For example, from 1986
to 1997, foreign sales of S&P 500 companies grew 10 percent a
year, compared to domestic sales growth of just 3 percent
annually.\6\
---------------------------------------------------------------------------
\6\ Wall Street Journal, Op. cit.
---------------------------------------------------------------------------
From the perspective of the 1960s, there was little
apparent reason for U.S. companies to direct resources to
penetrating foreign markets. U.S. companies frequently could
achieve growth and profit levels that were the envy of their
competitors with minimal foreign operations. By contrast, in
today's economy, competitive success frequently requires U.S.
companies to execute global marketing and manufacturing
strategies.
International Trade
Over the last three decades, the U.S. share of the world's
export market has declined. In 1960, one of every six dollars
of world exports originated from the United States. By 1996,
the United States supplied only one of every nine dollars of
world export sales. Despite a 30-percent loss in world export
market share, the U.S. economy depends on exports to a much
greater degree. During the 1960s, only 3.2 percent of national
income was attributable to exports, compared to 7.5 percent
over the 1990-97 period.
Foreign subsidiaries of U.S. companies play a critical role
in boosting U.S. exports--by marketing, distributing, and
finishing U.S. products in foreign markets. U.S. Commerce
Department data show that in 1996 U.S. multinational companies
were involved in 65 percent of all U.S. merchandise export
sales.\7\ The importance of foreign operations also is
indicated by the fact that U.S. industries with a high
percentage of investment abroad are the same industries that
export a large percentage of domestic production.\8\
---------------------------------------------------------------------------
\7\ U.S. Bureau of Economic Analysis, Survey of Current Business,
September 1998.
\8\ Robert E. Lipsey, ``Outward Direct Investment and the U.S.
Economy,'' in M. Feldstein, J. Hines, Jr., and G. Hubbard (eds.), The
Effects of Taxation on Multinational Corporations, University of
Chicago Press, 1995.
---------------------------------------------------------------------------
Foreign Portfolio Investment
In 1962, policymakers would scarcely have taken note of
cross-border flows of portfolio investment. As recently as
1980, U.S. portfolio investment in foreign private sector
securities amounted to only $62 billion--85 percent less than
U.S. direct investment abroad. By 1997, U.S. portfolio
investment abroad had increased 2,230 percent to over $1.4
trillion--40 percent more than U.S. direct investment abroad.
Similarly, foreign portfolio investment in U.S. private
securities increased from $90 billion in 1980 to over $2.2
trillion in 1997 (see Table 1).
Institutional changes have greatly facilitated foreign
portfolio investments, including the growth in mutual funds
that invest in foreign securities and the listing of foreign
corporations on U.S. exchanges. According to the New York Stock
Exchange, the trading volume in shares of foreign firms totaled
$485 billion in 1997, or over eight percent of total NYSE
trading volume.\9\ Market capitalization of foreign firms
listed on the NYSE topped $3 trillion in 1998.\10\
---------------------------------------------------------------------------
\9\ Trading in foreign companies is primarily, but not solely,
through depository receipts.
\10\ NYSE, Quick Reference Sheet, and discussion with NYSE
Research, September 1998.
---------------------------------------------------------------------------
The Administration's 1962 proposal to terminate deferral
for U.S. CFCs was motivated in large part by a desire to ensure
that foreign direct investment not flow off-shore for tax
reasons. At the time, U.S. direct investment abroad exceeded
private portfolio investment by a factor of 6.5 to 1; thus, it
is not surprising that the Administration focused much of its
attention on the taxation of direct investment abroad in 1962.
In the current economic environment, U.S. portfolio
investors (e.g., individuals, mutual funds, pension funds,
insurance companies, etc.) increasingly allocate capital to
foreign-based multinational companies whose foreign investments
are not subject U.S. corporate income tax. Under these
circumstances, the impact of U.S. multinational corporation tax
rules on the global allocation of capital is greatly
attenuated.\11\
---------------------------------------------------------------------------
\11\ See Section E of Chapter 6 of the NFTC report for a discussion
of this issue.
---------------------------------------------------------------------------
Market Integration
The explosive pace of economic integration has been aided
by governments that have liberalized trade and investment
climates. An alphabet soup of regional trade agreements has
complemented the original multilateral agreement, GATT. In
addition to the formation of the European Union--the world's
largest common market--free trade agreements are creating
increasingly integrated multinational markets. Examples include
the European Economic Area (European Union plus remaining
members of the European Free Trade Area), NAFTA (North
America), ASEAN (Southeast Asia), ANZCERTA (Australia and New
Zealand), and MERCOSUR (Latin America). Almost half of the 153
regional trade agreements notified to the GATT or the WTO have
been set up since 1990.\12\ Complementing these trade
agreements are hundreds of bilateral investment treaties (BITs)
which reduce barriers to foreign direct investment flows.
UNCTAD reports that there has been a three-fold increase in
BITs in the five years to 1997.\13\
---------------------------------------------------------------------------
\12\ The Economist, October 3, 1998, p. 19.
\13\ UNCTAD, World Investment Report, 1997.
---------------------------------------------------------------------------
A consequence of market integration is that U.S. companies
and their foreign competitors increasingly do not view their
business as occurring in separate country markets, but rather
in regional markets where national boundaries often have little
economic significance. In this economic environment, the
distinctions in subpart F, between economic activities
conducted within and outside a foreign subsidiary's country of
incorporation, have in many cases become artificial. When there
is a high degree of economic integration between national
markets, tax rules that treat these markets separately are as
arbitrary as distinctions between a company's transactions with
customers in different cities.
Conclusions
In the decades since the enactment of subpart F in 1962,
the global economy has grown more rapidly than the U.S.
economy. Concomitantly, U.S. companies have confronted both the
rise of powerful foreign competitors and the growth of market
opportunities abroad. By almost every measure--income, exports,
or cross-border investment--the United States today represents
a smaller share of the global market. At the same time, U.S.
companies have increasingly focused on foreign markets for
continued growth and prosperity. Over the last three decades,
sales and income from foreign subsidiaries have increased much
more rapidly than from domestic operations. To compete
successfully both at home and abroad, U.S. companies have
adopted global sourcing and distribution channels, as have
their competitors.
These developments have a number of potential implications
for tax policy. U.S. tax rules that are out of step with those
of other major industrial counties are now more likely to
hamper the competitiveness of U.S. multinationals in today's
global economy than was the case in the 1960s.
The growing economic integration among nations--especially
the formation of common markets and free trade areas--raises
questions about the appropriateness of U.S. tax rules that
treat foreign transactions differently if they cross national
borders than if they occur within the same country.
The eclipsing of foreign direct investment by portfolio
investment calls into question the ability of tax policy
focussed on foreign direct investment to influence the global
allocation of capital.
The abandonment of the gold standard has eliminated balance
of payment considerations as a rationale for using tax policy
to discourage U.S. investment abroad. Indeed, as the world's
largest debtor nation, tax policies that discourage U.S.
investment abroad are obsolete.
III. Is Foreign Investment By U.S. Companies Harmful to the
Domestic Economy?
While acknowledging the anti-competitive implications of
subpart F, opponents of deferral frequently argue that U.S.
direct investment abroad comes at the expense of the U.S.
economy. From this perspective, subpart F is viewed as
protecting the U.S. economy in general--and U.S. workers
specifically--from the flow of U.S. investment abroad.
Opponents of deferral often oppose free trade agreements
because the free flow of goods across national borders, much
like the free flow of investment, is perceived as jeopardizing
domestic jobs.
The data and economic studies, summarized below, however,
support the view that outward investment is beneficial rather
than harmful to the home country economy. As noted in a recent
report of the Organization for Economic Cooperation and
Development (OECD), critics of outward direct investment
sometimes fail to look at the broader economic ramifications:
The effects of direct investment outflows on the source
country, particularly on employment are sometimes still
regarded with some disquiet. Most concerns regarding the
effects of FDI [foreign direct investment] outflows may arise
because investment is viewed statically and without due regard
to the spillover effects it generates at home and abroad. In
fact, however, domestic firms and their employees generally
gain from the freedom of businesses to invest overseas. As with
trade, FDI generally creates net benefits for host and source
countries alike.\14\
---------------------------------------------------------------------------
\14\ OECD, Open Markets Matter: The Benefits of Trade and
Investment Liberalization, 1998, p. 49.
---------------------------------------------------------------------------
Background: Why Do U.S. Corporations Invest Abroad?
Contrary to the image some commentators have that U.S. corporations
set up foreign affiliates as substitutes for U.S. operations, the
latest UN report on foreign investment finds that ``accessing markets
will remain the principal motive for investing abroad.\15\ Tariff and
non-tariff barriers, transportation costs, local content requirements,
location of natural resources, location of customer facilities, and
other factors frequently make investing abroad the only feasible option
for successfully penetrating foreign markets. Moreover, a local
presence generally is required for services industries such as finance,
retail, legal, and accounting.\16\ In addition, multinational customers
frequently prefer to deal with suppliers and service providers who have
operations in all of the jurisdictions in which they operate. Foreign
investment also allows U.S. parent companies to diversify risks;
through diversification, a downturn in the home market may be offset by
an upturn abroad.
---------------------------------------------------------------------------
\15\ UNCTAD, World Investment Report, 1997, p. xix.
\16\ See, OECD, Open Markets Matter: The Benefits of Trade and
Investment Liberalization, 1998, p. 50.
---------------------------------------------------------------------------
High-income countries provide the most lucrative opportunities for
U.S. multinationals. As a result, government data show that the bulk of
U.S. direct investment abroad goes to high-wage, high-income countries.
In 1996, 81 percent of assets and 68 percent of employment were in
high-income developed countries rather than low-wage developing
nations.\17\ This pattern of investment is consistent with the view
that the presence of rich consumer markets is a much more important
explanation for U.S. investment abroad than low wages. Low wages
typically indicate low productivity, so there is little if any
advantage to be obtained from manufacturing in low-wage jurisdictions,
particularly where the economic infrastructure (e.g., transportation,
communication, electricity and water services) and legal infrastructure
are not adequately developed.
---------------------------------------------------------------------------
\17\ Developed countries are defined here as Europe, Canada,
Australia, New Zealand, South Africa, Japan, Singapore, and Hong Kong.
See, U.S. Department of Commerce, U.S. Direct Investment Abroad
(September 1998).
---------------------------------------------------------------------------
Further evidence for the hypothesis that U.S. direct investment
abroad is attracted by consumer demand rather than low-cost labor
supply is the fact that less than 10 percent of U.S.-controlled foreign
corporation sales were exported to the United States. If U.S.
investment abroad were motivated by the desire to substitute cheap
foreign labor, rather than to serve foreign markets, one would expect a
significant amount of U.S. multinational production abroad to be
shipped back to the United States.\18\ In fact, over half of all
foreign affiliates of U.S. companies are engaged in services and trade,
activities that are closely tied to the customers' location.\19\
---------------------------------------------------------------------------
\18\ See, Peter Merrill and Carol Dunahoo, ``Runaway Plant
Legislation: Rhetoric and Reality,'' Tax Notes (July 8, 1996) pp. 221-
226 and Tax Notes International (July 15, 1996) pp. 169-174.
\19\ Mathew Slaughter, Global Investment, American Returns,
Emergency Committee for American Trade, 1998.
---------------------------------------------------------------------------
If U.S. investment abroad were attracted by low wages, as critics
contend, foreign employment and production of U.S. multinationals
abroad would be rising in comparison to domestic employment and
production. In fact, the output and employment of U.S.-controlled
foreign corporations has declined as a share of domestic output and
employment since the CFC data were first published by the Bureau of
Economic Analysis in 1982.\20\
---------------------------------------------------------------------------
\20\ The gross product of controlled-foreign corporations (CFCs)
has fallen from 6.9 percent of U.S. GDP in 1982 to 6.6 percent in 1996.
Similarly, CFC employment as fallen from 5.0 percent of U.S. domestic
employment in 1982 to 4.9 percent in 1986.
---------------------------------------------------------------------------
The centrality of the sales expansion function of foreign
affiliates suggests that the operations of U.S. parent firms and their
foreign affiliates are mutually reinforcing rather than substitutes.
Direct investment abroad frequently leads to additional exports of
machinery and other inputs into the manufacturing process as well as
additional demand at home for headquarters services such as research,
engineering, finance, etc. The parent companies of U.S. multinationals
purchase over 90 percent of their inputs from U.S.-based suppliers.\21\
---------------------------------------------------------------------------
\21\ Mathew Slaughter. Global Investments, American Returns
Emergency Committee for American Trade, 1998.
---------------------------------------------------------------------------
Exports
U.S. multinational corporations play a crucial role in U.S. foreign
trade. As affiliates establish production and distribution facilities
abroad, export data indicate that they source a large quantity of
inputs from the United States. U.S. multinationals were responsible for
$407 billion of merchandise exports in 1996 representing almost two-
thirds of all U.S. merchandise exports.
Academic studies support the hypothesis that U.S. investment abroad
promotes U.S. exports. For example, Prof. Robert Lipsey finds a strong
positive relationship between manufacturing activity of foreign
affiliates of U.S. corporations and the level of exports from the U.S.
parent company.\22\ Similarly, a recent OECD study of 14 countries
found that ``each dollar of outward FDI [foreign direct investment] is
associated with $2 of additional exports and with a bilateral trade
surplus of $1.70.\23\ These studies support the conclusion that if U.S.
investment abroad were curtailed, U.S. exports would suffer.
---------------------------------------------------------------------------
\22\ Robert E. Lipsey, ``Outward Direct Investment and the U.S.
Economy,'' in M. Feldstein, J. Hines, Jr., and G. Hubbard (eds.), The
Effects of Taxation on Multinational Corporations, University of
Chicago Press, 1995.
\23\ See, OECD, Open Markets Matter: The Benefits of Trade and
Investment Liberalization, 1998, p. 50.
---------------------------------------------------------------------------
Headquarters services
In addition to their role in increasing demand for U.S. exports,
foreign affiliates of U.S. corporations also increase the demand for
U.S. headquarters services such as management, research and
development, technical expertise, finance, and advertising. These
support activities expand as U.S. affiliates compete successfully
abroad. For example, in 1996, nonbank U.S. multinationals performed 88
percent of their research and development in the United States, even
though one-third of their sales were abroad./24/
---------------------------------------------------------------------------
\24\ U.S. Department of Commerce, Survey of Current Busines,
(September 1998).
---------------------------------------------------------------------------
Headquarters functions, such as R&D, finance, and management, are
the types of activities that are prospering in the information-oriented
economy. As such, some economists have argued that U.S. tax policy
should seek to make the United States an attractive location for
multinational corporations to establish their headquarters.\25\
Unfortunately, because of subpart F and other aspects of U.S.
international tax rules, the United States is one of the least
attractive jurisdictions--from a tax perspective--for a multinational
corporation's headquarters.\26\
---------------------------------------------------------------------------
\25\ See Gary Hufbauer, U.S. Taxation of International Income:
Blueprint for Reform, Institute for International Economics, 1992.
\26\ See, Price Waterhouse LLP, Taxation of U.S. Corporations Doing
Business Abroad: U.S. Rules and Competitiveness Issues, Financial
Executives Research Foundation, 1996.
---------------------------------------------------------------------------
U.S. Investment Abroad and U.S. Employment
Rather than draining jobs and production from the United States,
the economic evidence points to the opposite conclusion--U.S.
investment abroad increases activity at home. The complementary
relationship between the foreign and domestic operations of U.S.
multinational corporations means that U.S. workers need not be harmed
by U.S. investment abroad.\27\ Profs. David Riker and National Economic
Council Deputy Director Lael Brainard find that the labor demand of
U.S. multinationals at home and abroad are linked, with an increase in
one supporting an increase in the other:
---------------------------------------------------------------------------
\27\ See, OECD, Open Markets Matter: The Benefits of Trade and
Investment Liberalization, 1998, pp. 73-76.
---------------------------------------------------------------------------
Labor demand of U.S. multinationals is linked internationally at
the firm level, presumably through trade in intermediate and final
goods, and this link results in complementarity rather than competition
between employers in industrialized and developing countries.\28\
---------------------------------------------------------------------------
\28\ David Riker and Lael Brainard, ``U.S. Multinationals and
competition from Low Wage Countries,'' NBER Working Paper No. 5959,
March 1997.
---------------------------------------------------------------------------
The foreign operations of U.S. companies also are associated with
higher wages of U.S. workers. U.S. companies that invest overseas, on
average, pay higher domestic wages than do purely domestic companies in
the same industries. Profs. Mark Doms and Bradford Jensen find that
U.S. parent companies pay higher wages to their entire workforce, and
that the wage premium in percentage terms is greater for lower paid
production workers than for higher paid non-production workers.\29\
Prof. Slaughter interprets this as evidence that U.S. parent companies
promote a more equal distribution of income by paying higher wage
premia to traditionally lower paid workers.\30\
---------------------------------------------------------------------------
\29\ Mark Doms and Bradford Jensen, ``Comparing Wages, Skills, and
Productivity Between Domestic and Foreign Owned Manufacturing
Establishments in the United States,'' mimeo., October 1996.
\30\ Matthew J. Slaughter, `Production Transfer Within
Multinational Enterprises and American Wages,'' mimeo., March 1998.
---------------------------------------------------------------------------
Investment abroad by U.S. multinationals not only is essential to
facilitating the distribution and servicing of U.S. exports, but
failure of U.S. multinationals to invest abroad would create an
opportunity for foreign-headquartered competitors to increase their
investment in and exports to foreign markets.
Returns to U.S. Investors
U.S. shareholders in U.S. multinationals directly realize the
benefits of the high profits and risk diversification offered by
international operations. The pre-tax return on assets earned by U.S.-
controlled foreign corporations was almost 30 percent higher than the
return earned on domestic corporate investment in 1995.\31\ These
foreign profits totaled $150 billion, and accounted for about 18
percent of all U.S. corporate profits in 1997.\32\
---------------------------------------------------------------------------
\31\ Earnings (excluding capital gains and special charges) before
interest and taxes as a percent of assets, as calculated by the U.S.
Dept. of Commerce.
\32\ U.S. Dept. of Commerce, Survey of Current Business, (August
1998).
---------------------------------------------------------------------------
The profits earned abroad by U.S. multinationals are part of
national income (GNP) and are reflected in the share valuations.
Moreover, much of the income earned abroad by foreign subsidiaries is
distributed back to the United States. According to the most recent
available IRS data, in 1994, distributions from the largest U.S.-
controlled foreign corporations totaled $50 billion, amounting to 67
percent of their after-tax earnings and profits.
Academic research has found a large premium in the returns from
foreign investment as compared to domestic investment. Prof. Martin
Feldstein concludes that 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.\33\
---------------------------------------------------------------------------
\33\ Martin Feldstein, ``Tax Rules and the Effect of Foreign Direct
Investment in U.S. National Income,'' in Taxing Multinational
Corporations, eds. Martin Feldstein, James Hines, and Glenn Hubbard,
1995.
---------------------------------------------------------------------------
Conclusion
Fears that U.S. investment abroad comes at the expense of output,
income, and employment at home are not supported by data or economic
research. Rather, the evidence strongly confirms that market access,
rather than cheap labor, primarily motivates foreign direct investment.
The overwhelming majority of foreign direct investment is in high-wage
countries, and very little of the foreign output of U.S. multinationals
is shipped back to the United States. Numerous studies have found that
foreign investment not only produces higher returns to U.S. investors
but also is complementary with economic activity in the United States--
leading to increased exports and high-paid research, engineering, and
other headquarters jobs in the United States. There is no evidence that
U.S. investment abroad has reduced employment in the United States;
indeed, the data show that companies with investment outside the United
States pay better wages than purely domestic companies in the same
industries.\34\
---------------------------------------------------------------------------
\34\ For anecdotal evidence from case studies of U.S.
multinationals, see Mathew Slaughter, Global Investments, American
Returns, Emergency Committee for American Trade, 1998 (Chapter V).
---------------------------------------------------------------------------
Restricting foreign investment in an attempt to protect domestic
employment ultimately is a self-defeating policy. Foreign companies
will seize these investment opportunities and increase market share at
the expense of U.S. multinationals' employment at home and abroad.
Like international trade in goods and services, foreign direct
investment benefits both home and host countries; thus, it is in the
mutual interest of home and host countries to reduce barriers to the
free flow of direct investment. In view of the recent downturn that has
struck a number of emerging market economies, it is important to
distinguish foreign direct investment from international portfolio
investment. Portfolio investment, such as investment in short-term
government and private debt obligations, can easily be withdrawn at the
first hint of an economic reversal. By contrast, foreign direct
investment, particularly in plant and equipment, is long-term in
nature, and cannot easily be removed. Barriers to U.S. direct
investment abroad not only harm the development of foreign countries,
but also deprive the U.S. economy of the increased returns, exports,
and wages associated with multinational investment.
IV. Does the Competitiveness of U.S.-Headquartered Companies Matter for
U.S. Economic Well-Being?
In a provocative article, former Labor Secretary Robert
Reich argues against multinational competitiveness as a goal
for U.S. policy.\35\ In Reich's view, where corporations happen
to be headquartered is ``fundamentally unimportant.'' Reich
believes U.S. policymakers should focus primarily on domestic
investments (whether by domestic or foreign companies) and less
on the strength of American companies.
---------------------------------------------------------------------------
\35\ Robert Reich, ``Who is Us?'' Harvard Business Review (January-
February 1990) pp. 53-64.
---------------------------------------------------------------------------
In response, Prof. Laura Tyson, former Chair of the Council
of Economic Advisers and former Director of the National
Economic Council, argues that under current conditions, the
``competitiveness of the U.S. economy remains tightly linked to
the competitiveness of U.S. companies.'' Tyson offers a number
of reasons for this linkage, including: \36\
---------------------------------------------------------------------------
\36\ Laura D'Andrea Tyson, ``They are not Us: Why American
Ownership Still Matters,'' The American Prospect, Winter, 1991.
---------------------------------------------------------------------------
U.S. multinationals locate over 70 percent of
their assets and employment in the United States;
U.S. multinationals invest more per employee and
pay more per employee at home than abroad in both developed and
developing countries;
U.S. multinationals perform the overwhelming
majority of their R&D at home;
The leadership of U.S. multinationals is
overwhelmingly American;
Trade barriers frequently require U.S. companies
to invest abroad in order to sell abroad; and
U.S. affiliates of foreign firms rely much more
heavily on foreign suppliers than on domestic companies.
Tyson believes that American interests will be advanced
through multilateral reductions in trade and investment
barriers, and through policies that make the U.S. an attractive
production location for high-productivity, high-wage, and
research-intensive activities.
V. How Does U.S. International Tax Policy Affect the Competitiveness of
U.S. Multinational Companies?
If policymakers wish to attract high-end jobs to the United
States, they must consider whether the U.S. income tax system
makes the United States a desirable location for establishing
and maintaining a corporate headquarters. If the U.S. corporate
income tax is not competitive, U.S. headquartered companies can
be expected to lose world market share with a commensurate loss
in the U.S. share of headquarter-type jobs. While the country
of incorporation is not necessarily where headquarters
functions are located, there is indisputably a very high
correlation between legal residence and headquarters
operations.
A number of studies have found that, compared to other
major industrial countries, the U.S. income tax system places a
relatively high burden on cross-border corporate
investment.\37\ The tax burden is relatively high for two main
reasons: (1) the U.S. international tax regime, including
subpart F, is more restrictive than that of most other
countries; and (2) unlike most other major industrial
countries, the United States does not relieve the double
taxation of corporate dividends.
---------------------------------------------------------------------------
\37\ For an international comparison U.S. multinational tax
competitiveness, see: Price Waterhouse LLP, Taxation of U.S.
corporations Doing Business Abroad: U.S. Rules and Competitiveness
Issues, Financial Executives Research Foundation, 1996 (Chapter 10).
---------------------------------------------------------------------------
Over time, countries that place relatively high tax burdens
on multinational corporations can expect to see a reduction in
investment in domestic headquartered companies. This can occur
through a loss in market share and profits that can be
reinvested in the business. Alternatively, domestic companies
may merge with foreign corporations in transactions that result
in a foreign-headquartered company. Recent U.S. examples
include the BP-Amoco, Daimler-Chrysler, Vodafone-AirTouch,
Deutsche Bank-Bankers Trust, and AEGON-Transamerica mergers. In
these examples, future investments outside the United States
will most likely not be made by the U.S. merger partner, but
instead by the foreign parent, permanently removing such
investment from the U.S. corporate income tax net.
Foreign-headquartered companies also can grow at the
expense of U.S.-headquartered companies, if U.S. investors buy
shares of foreign companies on U.S. or foreign exchanges. The
growth in U.S. mutual funds that invest in foreign stocks is an
illustration of this trend, as are investments in foreign firms
listed on U.S. stock exchanges.
While some have advocated increasing U.S. tax on the
foreign earnings of U.S. multinationals as a way to protect
U.S. jobs, the most likely consequence of such action will be a
loss in the global market share of U.S. headquartered
companies. Rather than protecting U.S. jobs, imposing a tax
system on U.S. multinationals that is more burdensome than that
of their foreign competitors will hamper the growth of U.S.
companies, ultimately reducing U.S. exports, research and
development, and high-quality American jobs.
Summary of Large U.S. Cross-Border Mergers and Acquisitions, 1998
Introduction
in announcing the June 30, 1999 hearing of the Committee on
Ways and Means regarding the impact of U.S. tax rules on the
international competitiveness of U.S. workers and businesses,
Chairman Archer posed the following questions:
``Is the U.S. tax system contribution to the de-Americanization
of U.S. industry? Do our tax laws force U.S. companies to be
domiciled in foreign countries? Are we making it a foregone
conclusion that mergers of U.S. companies with foreign
companies will always leave the resulting new company
headquartered overseas? '' \1\
\1\ U.S. House of Representatives, Committee on Ways and Means,
press release no. FC-12, June 15, 1999.
---------------------------------------------------------------------------
As an initial step towards answering these questions, this
report summarizes data on all large cross-border mergers and
acquisitions involving U.S. companies that were completed in
1998. Based on these data, one can determine whether U.S.
companies are more often the acquirer or the target (i.e., the
acquired company) in large cross-border mergers and
acquisitions.
Methodology
For purposes of this study, PricewaterhouseCooper LLP (PwC)
reviewed all mergers and acquisitions completed during 1998 as
reported by Mergers and Acquisitions, a journal that publishes
detailed information on all public transactions. From this
sample, we selected all transactions that met the following
criteria:
1. The terms of the transaction were in excess of $500
million;
2. The transaction involves the acquisition of all or a
remaining interest in the target company;
3. The transaction crosses country borders (i.e., acquirer
and target are headquartered in different in different
countries); and
4. A U.S.--headquartered company is the acquirer or the
target.
Information regarding the selected transactions is
summarized in Tables 1-4, including the name and country of
incorporation of the acquirer and the target, the target's
business, and the terms, type, and completion due of the
transaction.
Results
In 1998, there were a total of 51 cross-border mergers and
acquisitions involving U.S companies with terms in excess of
$500 million. The total dollar value of these transactions
exceeded $175 billion.
Foreign acquisitions of U.S. companies far exceeded U.S.
acquisitions of foreign companies, both in terms of the number
of transactions and the dollar value of these transactions. For
cross-border mergers and acquisitions exceeding $500 million in
1998:
Foreign companies made 34 acquisitions of U.S.
companies, while U.S. companies made 17 acquisitions of foreign
companies. Thus, the number of transactions that had the effect
of moving assets from U.S.-to foreign-headquartered firms
exceeded transactions moving assets in the opposite direction
by $127 billion, or 529 percent in dollar terms.
Foreign acquisitions of U.S. companies totaled
$151 billion, while U.S. acquisitions of foreign companies
totaled $24 billion. Thus, the number of transactions that had
the effect of moving assets from U.S.-to foreign-foreign-
headquartered firms exceeded transactions moving assets in the
opposite direction by $127 billion, or 529 percent in dollar
terms.
Foreign acquisitions of U.S. companies were
dominated, in dollar terms, by two mega-mergers--the
acquisition of Amoco Corp. by British Petroleum Co. PLC and the
acquisition of Chrysler Corp. by Daimler-Benz AG. These two
deals together represent the sale of U.S. companies valued at
$89 billion to foreign acquirers. However, even excluding these
two mega-mergers, transactions which had the effect of moving
assets from U.S.-to foreign-headquartered firms exceeded
transactions moving assets in the opposite direction by $38
billion, or 58 percent in dollar terms.
Transactions involving acquisitions of financial
services companies accounted for 15 of the 51 ross-border
deals, or 29 percent. Foreign acquisions of U.S. financial
services companies (12 transactions totaling $11.3 billion)
exceeded U.S. acquisitions of foreign financial services
companies (3 transactions totaling $3.6 billion) by 300 percent
in number, or by 214 percent in dollar terms. It should be
noted that some of the other U.s. target companies have large
financial services subsidiaries (e.g., Chrysler Corp.),
although these are not included in the statistics on financial
service mergers and acquisitions.
Conclusions
the structuring of cross-border acquisitions reflects a
variety of business reasons including domestic and foreign tax
considerations. The role of tax considerations in recent
across-border mergers and acquisitions is beyond the scope of
this study.
To the extent that U.S. multinational companies are subject
to more burdensome international tax rules than their foreign-
headquarter multinationals. In particular, one would expect to
see this result for target companies in industries where the
disparity between U.S. and foreign tax rules is large, such as
financial services. The data in this study show that, as a
result of cross-border mergers and acquisitions, assets are, on
balance moving from U.S.-to foreign-headquartered companies,
and this trend is pronounced in the financial services industry
(measured by the number of transactions).
While the recent cross-border merger and acquisition data
are consistent with the hypothesis that relatively burdensome
U.S. tax rules are influencing the movement of assets to
foreign-headquartered companies, they cannot be taken as proof
of this hypothesis. More research will be necessary to measure
the role, if any, of tax considerations.
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Chairman Archer. Thank you, Mr. Merrill.
Our last witness on this panel is Mr. Bouma. Welcome, you
may proceed.
STATEMENT OF HERMANN B. BOUMA, INTERNATIONAL TAX ATTORNEY, H.B.
BOUMA
Mr. Bouma. Thank you. Thank you very much, Mr. Chairman. My
name is Herm Bouma and I am an international tax attorney
engaged in private practice in Washington, D.C. I appreciate
very much the opportunity to appear before the Committee this
morning, almost afternoon now. And I commend the Committee for
focusing its time and energy on the international provisions of
the Code.
In my testimony, I would like to take a look at the forest,
rather than the trees, and focus on the basic foundations of
our international tax rules. I believe those foundations are
not tied into reality and that this accounts for much of the
arbitrariness and complexity of the current system.
Specifically, I would like to focus on three fundamental
issues: taxation of business entities in general, the taxation
of U.S. versus foreign corporations, and the rules for sourcing
income.
With respect to the taxation of business entities, under
the current Code, business entities are divided into two basic
types: corporations and partnerships. As used here, the term
partnership also includes a sole proprietorship. Radically
different tax rules apply to corporations and to partnerships.
Certain business entities are treated as per se corporations,
while other business entities are permitted to choose whether
they wish to be treated as a corporation or as a partnership.
There is no logical reason why per se corporations are treated
as such.
Certainly, this treatment cannot be justified on the
grounds that they provide limited liability to their interest
holders or that they are so-called separate entities. Many
business entities that are entitled to choose their
classification also have these same characteristics. When it
comes to the taxation of business entities, all business
entities should be subject to only one layer of taxation and
they should be taxed on a territorial basis.
Assuming the Code continues to classify business entities
as either corporations or partnerships, the next fundamental
issue I would like to address is whether there should be any
difference between the taxation of U.S. corporations on the one
hand and foreign corporations on the other.
Under present law, a corporation is considered a U.S.
corporation, simply by being organized under the laws of the
United States or some political subdivision thereof, such as
Delaware. I would like to emphasize whether the company has its
headquarters in the United States or does any business here is
completely irrelevant to whether or not it is a U.S.
corporation for purposes of the Internal Revenue Code.
Incorporation in the United States does not in any way
justify taxing a corporation on a worldwide basis. Thus, the
United States should adopt a territorial system for
corporations. Every corporation, whether U.S. or foreign,
should be taxed by the United States only on its income from
operations in the United States.
The third fundamental issue I would like to address
involves the rules for sourcing income as either U.S.-source or
foreign-source income. The current Code and regulations have
come up with a complex, arbitrary, and arcane set of rules for
sourcing all kinds of income. Replacing these rules with an
approach focused on permanent establishments would be a major
step toward rationalizing and simplifying the international
provisions.
Under this approach, the 30 percent gross basis tax would
apply to certain payments made by U.S. permanent establishments
and the foreign tax credit limitation, assuming such was still
necessary, would focus on income that is effectively connected
with a taxpayer's foreign permanent establishment or that is
received by the taxpayer from someone's foreign permanent
establishment. Thus, the arbitrary and complex sourcing rules
of the current Code could be replaced with a much more logical
and clear-cut approach.
Because of the arbitrariness and complexity of the current
international provisions, it is critical that they be revised
from the ground up so that they are tied into reality,
rationalized and simplified, thereby eliminating the major
burden they currently impose on the international
competitiveness of U.S. corporations.
Thank you, Mr. Chairman, and I would be happy to answer any
questions the Committee might have.
[The prepared statement follows:]
Statement of Hermann B. Bouma, International Tax Attorney, H.B. Bauma
Mr. Chairman and distinguished Members of the Committee on
Ways and Means:
My name is Herm Bouma and I appreciate very much the
opportunity to appear before the Committee this morning to
speak on the international provisions of the Internal Revenue
Code. I commend the Committee for focusing its time and energy
on this very important topic. I appear before the Committee on
my own behalf and not on behalf of any client.
I have been an international tax attorney now for almost 20
years, ever since I graduated from law school. Upon graduating
from law school, I went to work with the Office of Chief
Counsel at the Internal Revenue Service, where I worked in the
International Branch of the Legislation and Regulations
Division. My principal project there involved the final foreign
tax credit regulations under sections 901 and 903. After
fulfilling my four-year commitment there, I went into private
practice with the Washington tax firm known as McClure &
Trotter. I was a partner there for eight years and then left to
establish my own practice, continuing to focus on international
taxation. The rationalization and simplification of the
international tax provisions is a subject I have thought about
for a long time now.
Reality and the International Provisions
We international tax practitioners have a tendency to get
bogged down among the trees (of which there are many) and
seldom step back to view the forest as a whole. In my testimony
I would like to look at the forest and focus on the basic
foundational principles on which our international tax regime
should be constructed.
Judge Learned Hand once wrote:
. . . In my own case the words of such an act as the Income
Tax . . . merely dance before my eyes in a meaningless
procession . . . couched in abstract terms that offer no handle
to seize hold of . . . [A]t times I cannot help recalling a
saying of William James about certain passages of Hegel: that
they were no doubt written with a passion of rationality; but
that one cannot help wondering whether to the reader they have
significance save that the words are strung together with
syntactical correctness.
Learned Hand, Thomas Walter Swan, 57 Yale L.J. 167, 169 (1947).
Why is it that people find the Code so hard to understand?
There are a number of reasons but one explanation is that often
it is not tied in to reality. I believe this is the case with
the international provisions of the Code.
There is a huge gap between reality and those provisions.
If the international provisions can be based on certain
fundamental principles that are grounded in reality and that
make sense conceptually, then the provisions will be far less
arbitrary and far less complex. They will be easier to learn,
both for practitioners and the IRS, and easier to apply. Even
where a certain amount of complexity is still required, the
complexity will be based on sound fundamental principles, and
thus much easier to understand. Moreover, if the international
provisions are tied in to reality and make sense, then, when
one encounters a situation that is not directly addressed by
the provisions, it will be much easier to determine what the
answer should be.
When the foundation of a structure is wealc and rickety,
adding more to the top will not strengthen it; it will simply
add more weight so that eventually the whole structure may
collapse of its own weight. That is the point we are reaching
now with the international provisions of the Code, where the
structure has become so huge and so heavy, and yet the
foundation is extremely weak and rickety. The whole thing is in
danger of collapsing, collapsing in the sense that it is moving
beyond the capacity of the IRS to administer and enforce it.
``A Brief Description of Reality''
In order to tie the international provisions in to reality,
we first need to have a clear view of reality. Describing
reality in somewhat broad-brush strokes, reality consists of
God, people, and the world (which includes such things as rocks
and trees and squirrels). People have rights and obligations,
including financial rights and obligations, which are often
referred to as assets and liabilities. People can hold assets
and liabilities directly or through arrangements. Some
arrangements for assets and liabilities are intended to
generate income. An income-generating arrangement normally
consists of a set of rules which governs the management of the
assets and liabilities and the distribution of assets either to
persons who hold interests in the arrangement or to others.
Income-generating arrangements are of three basic types:
business entities, trusts, and non-profit organizations.
In focusing on the basic foundational principles on which
our international tax regime should be constructed, I would
like to consider three ``big-ticket'' items: the taxation of
business entities, the taxation of U.S. versus foreign
corporations, and the rules for sourcing income as either U.S.-
source or foreign-source.
Taxation of Business Entities
Obviously, the taxation of business entities is not an
issue that is limited to the international area. However, it
does have major ramifications for the international area and
thus is a foundational issue for an international tax regime.
Worldwide there is a great variety of business entities--
they come in all different shapes and sizes. However, they have
one thing in common--they are attempting to generate income for
their interest holders. Under the current Code, this great
variety of business entities is divided into two basic types,
corporations and partnerships (including, for this purpose,
sole proprietorships), and radically different tax regimes
apply to each. With respect to corporations, there are two
layers of taxation; with respect to partnerships, only one.
Under current IRS regulations, certain business entities,
including certain foreign business entities, are treated as per
se corporations. All other business entities are permitted to
choose whether they wish to be treated as a corporation or as a
partnership for U.S. tax purposes. There is no logical reason
why certain business entities are treated as per se
corporations, and thus subject to an additional layer of tax.
It is sometimes said that it is appropriate to treat
certain corporations as per se corporations because they
provide limited liability to their interest holders. However,
what logical connection is there between the two? Why should
two layers of tax apply just because the entity provides
limited liability to its interest holders? When an interest
holder receives a distribution of profits from an entity, the
interest holder benefits to the same extent, whether or not it
has limited liability. Moreover, many business entities that
are entitled to choose whether to be treated as a corporation
or a partnership do provide limited liability to their interest
holders. Thus, there is nothing in the nature of limited
liability that requires an additional layer of tax.
An extra layer of tax is sometimes justified for per se
corporations on the grounds that they are ``separate
entities.'' However, the concept of ``separate entity'' is
never defined and in fact there does not appear to be any
definition that would apply only to per se corporations and not
to other types of business entities also. Certainly, under
typical business law concepts, a traditional partnership under
state law, which may be treated as a partnership for U.S. tax
purposes, is as much a ``separate entity'' as is a corporation
under state law that is treated as a per se corporation for
U.S. tax purposes. Such a partnership can sue and be sued, it
can operate under its own name, and it can hold property in its
own name, including real estate. Thus, it would appear to be as
much of a ``separate entity'' as is a per se corporation. There
is, therefore, absolutely no justification for taxing certain
business entities as per se corporations, while permitting
other business entities to choose how they are taxed. Until
this can be remedied, we have a Code that at its very
foundation makes no sense.
Except as noted below with respect to publicly-traded
business entities, all business entities should be taxed in the
same way. Ideally, there should be only one layer of tax and it
should be imposed on the business entity on a territorial
basis. Requiring the business entity to pay the tax (rather
than the interest holders as is currently the case under the
Code with respect to the taxation of partnership income) would
promote efficiency and reduce the reporting burden on the
interest holders. If an interest holder sold its interest in
the business entity, the business entity would be responsible
for paying the tax on the gain (which would be withheld from
the proceeds due to the interest holder), and adjustments to
the entity's asset bases would be made in a manner similar to
that provided in section 743 of the current Code. If the
business entity were publicly-traded and an interest holder
with a less than 10% interest sold its interest, then the
interest holder would pay tax on the gain and there would be no
adjustment to the asset bases of the business entity.
Suppose, for example, a business entity (such as a large
law firrn) has 1,000 interest holders and conducts business in
five countries. Under the current Code, if one of those
countries is the United States and the business entity is
treated as a partnership for U.S. tax purposes, then each of
the 1,000 interest holders is required to file a U.S. tax
return because the business entity is engaged in the conduct of
a trade or business in the United States. However, the tax
obligation should be imposed on the business entity, not the
interest holders. Thus, instead of 5,000 returns being required
(assuming the other four countries also required a return from
each interest holder), only five returns would be necessary
(assuming all five countries adopted the approach of imposing
the tax obligation on the business entity).
An alternative approach would be to treat all non-publicly-
traded business entities as partnerships are treated under the
current Code. Thus, there would be only one layer of tax but
the income would be taxed through to the interest holders. If a
business entity were publicly-traded, it would be taxed as
discussed above under the ideal approach. Thus, there would be
only one layer of tax, but it would be imposed on the business
entity (except in the case of gain on the sale of an interest
by a less than 10% interest holder).
Thus, when it comes to the taxation of business entities,
the only distinguishing characteristic should be whether or not
they are publicly-traded, not whether or not they provide
limited liability or are ``separate entities''.
Taxation of U.S. vs. Foreign Corporations
If the Code continues to characterize business entities as
either corporations or partnerships and continues to subject
them to different tax regimes, the next ``big-ticket'' item is
whether there should be any difference between the taxation of
U. S. corporations as opposed to foreign corporations. Under
present law, a U.S. corporation is taxed by the United States
on its worldwide income, whereas a foreign corporation is taxed
by the United States only on certain U.S.-source income and on
income that is effectively connected with the conduct of a
trade or business in the United States.
It is important to understand what makes a corporation a
U.S. corporation or a foreign corporation for this purpose.
What makes the difference is a simple piece of paper, a paper
indicating whether the corporation has been organized under the
laws of the United States or a political subdivision thereof,
such as Delaware, or under the laws of a foreign jurisdiction,
such as the Cayman Islands. The location of the corporation's
headquarters, of most of its business operations, of most of
its property, where it first started business, and the
residency of most of its shareholders are all completely
irrelevant for this purpose. What matters is a simple piece of
paper. Thus, a corporation can be a U.S. corporation even if it
has no operations or property in the United States, and no
shareholders that are residents of the United States.
Similarly, a corporation can be a foreign corporation even if
it:s headquarters and most of its operations and property are
in the United States, and all of its shareholders are residents
of the United States.
Incorporation in the United States does not provide any
benefits that justify taxing a U.S. corporation on a worldwide
basis. In fact, given the many rules and regulations that apply
to U.S. corporations outside the tax area, one could argue that
incorporation in the United States is actually a detriment,
particularly when there are many other locations in the world
that have favorable corporate laws. Thus, incorporation in the
United States does not in any way justify taxing a corporation
on a worldwide basis. A corporation primarily benefits from the
countries in which it earns income, not from the country in
which it happens to be incorporated.
On March 11, 1999, Mr. Robert Perlman, Vice President for
Tax, Licensing & Customs for Intel Corporation, testified
before the Senate linance Committee concerning the
international provisions of the Code. Mr. Perlman stated that
if Intel had it to do all over again, it would incorporate as a
foreign corporation, not as a U.S. corporation. Some members
ofthe Committee took offense at this statement and considered
it unpatriotic. In addition, they pointed out all of the
benefits of doing business in the United States, including an
educated labor force, little regulation, and a stable
government, and they expressed skepticism that a company would
move its operations offshore in order to secure better tax
benefits. However, this reaction to Mr. Perlman's statement
reflected a basic misunderstanding of what it means, under the
Code, to be a U.S. corporation or a foreign corporation.
Mr. Perlman said that if Intel had it to do all over again,
it would incorporate in the Cayman Islands rather than the
United States. All that this would mean is that Intel would
have a piece of paper saying it was incorporated under the laws
of the Cayman Islands. Everything else about Intel's
operations, including its U.S. operations, would be exactly the
same. Intel would still have its headquarters in the United
States, and it would have just as many factories in the United
States, just as much research in the United States, and just as
many salesmen in the United States. The only difference is that
Intel would have a piece of paper saying it was incorporated in
the Cayman Islands and this would make all the diSerence in the
world taxwise. It would not be subject to the infamous Subpart
F regime, and in fact all of its income from foreign operations
would be completely free of U.S. tax.
Start-up companies are now being wisely advised to
incorporate in a foreign jurisdiction in order to avoid the
onerous rules of the U.S. tax regime, including worldwide
taxation and Subpart F. However, many companies which
incorporated as U. S. corporations many years ago are stuck
with the onerous U.S. tax regime because the ``toll charge''
under section 367(a) precludes a foreign reincorporation. It is
simply unfair for a corporation to now suffer inordinately
under the U.S. tax regime just because it made the unfortunate
decision, 50 or 100 years ago, to be incorporated in the United
States.
In a recent article, Professor Reuven S. Avi-Yonah, an
assistant professor at Harvard Law School, stated that ``it
does not seem to make sense to rely so much on formalities such
as which country an entity is incorporated in.'' Reuven S. Avi-
Yonah, Tax Competition and Multinational Competitiveness: The
New Balance of Subpart F, Tax Notes International, April 19,
1999, p. 1575, fn 45. Although Professor Avi-Yonah made this
statement in reference to controlled foreign corporations, it
certainly applies to the taxation of U.S. corporations also. It
is ironic that, while the IRS struggles to tax transactions
based on their substance and not their forrn, in this major way
the Code elevates form over substance.
It is extremely important, therefore, that all corporations
be treated the same, whether they are incorporated in the
United States or outside the United States. This means that the
United States should adopt a territorial system with respect to
the taxation of corporations; every corporation, whether U.S.
or foreign, should be taxed only on its income from operations
in the United States.
The Sourcing Rules
The third ``big-ticket'' item that I would like to address
involves the sourcing rules. The current Code operates on the
assumption that every item of income is either U.S.-source or
foreign-source. The use of the term ``source'' is misleading
because it gives the impression that there is a quarry of
income in each country and one simply determines whether an
item of income came from a quarry in the United States or from
a quarry in a foreign country. However, the matter is not that
simple. Income, which is an increase in value, is not a
physical object, and thus, by its very nature, does not have a
geographical location. Therefore, one cannot source income
simply by determining the geographical location from which it
came.
Given this conundrum, the Code and regulations have come up
with a complex, arbitrary, and arcane set of rules for sourcing
all kinds of income. Depending on the type of income that is
involved, these rules look at such factors as the residence,
citizenship, place of incorporation, or place of business of
the payor, the residence, citizenship, place of incorporation,
or place of business of the payee, and the place where services
were performed, where negotiations took place, where property
was at the time title to the property passed, where property is
used, where property is manufactured using certain
manufacturing intangibles, and where property is marketed using
certain marketing intangibles.
Supposedly, the intent of these rules is to identify the
country whose economy is most closely connected with the
particular item of income. However, in fact the result has been
a hodge-podge of extremely arbitrary rules that in many cases
make no sense. For example, income from the performance of
services is sourced to the country where the services were
performed. Thus, if I hire Tom Clancy to write a novel and he
spends three weeks on a beach in France writing it, the amount
I pay him will be foreign-source income, even though it is
extremely difficult to see how this income might have its
``source'' in France.
Given the arbitrariness and complexity of these rules, one
is led to ask the question, are these rules really necessary?
In fact they are not, and eliminating them would be a major
step towards rationalizing and simplifying the international
provisions of the Code.
Under the Code, the sourcing rules are generally used for
three purposes: (1) to deterrnine the effectively-connected
income of a foreign person that is engaged in the conduct of a
trade or business in the United States; (2) to determine the
income of a foreign person that is subject to a U.S. tax of 30%
on a gross basis (certain ``U.S.-source'' income that is not
effectively connected with the conduct of a trade or business
in the United States); and (3) to detertnine ``foreign-source''
income for purposes of the limitation on the foreign tax credit
for U. S. persons.
With respect to the determination of the effectively-
connected income of a foreign person, such income can be
determined by focusing direcl.ly on the business activities
being carried on in the United States and by determining what
income those activities give rise to. Although this
determination would not always be easy, the approach would be
much more direct and much easier to understand. There certainly
is no need to first ``source'' income before determining
whether a particular business activity has given rise to it.
With respect to the determination of the income of a
foreign person that is subject to a U.S. tax of 30% on a gross
basis, the sourcing rules are not needed for this purpose
either. Such income could be defined as income paid by a
perrnanent establishment in the United States to a foreign
person, provided the income is not effectively connected with
the conduct of a trade or business by the foreign person in the
United States. This approach would also be more direct and
easier to understand.
With respect to the deterrnination of the foreign tax
credit limitation for U.S persons, clearly the sourcing rules
would not be necessary if no foreign tax credit were given.
Such would be the case with respect to business entities if the
United States taxed every business entity, whether U.S. or
foreign, only on the portion of its worldwide income that is
allocable to a permanent establishment (or establishments) that
the business entity has in the United States. Since income that
is allocable to foreign permanent establishments would not be
taxed by the United States, there would be no need to provide a
foreign tax credit. If the United States had a 30% gross basis
tax for payments made by U.S. permanent establishments to
foreign persons, then the United States would need to allow a
foreign tax credit with respect to payments received by a U.S.
permanent establishment from a foreign permanent establishment
(since, in the eyes of the United States, those payments could
rightfully be subject to a gross basis tax by the country of
the foreign permanent establishment).
Even if the United States did not adopt a territorial
system, it still would not be necessary to retain the current
sourcing rules in order to determine the foreign tax credit
limitation of a U.S. person. The limitation could be determined
by adding together all the income of a U.S. person that is
allocable to foreign permanent establishments of the U.S.
person or that is received by the U.S. person from foreign
permanent establishments (whether or not belonging to the U.S.
person). This approach would not only be easier to apply but
would also make sense conceptually because the foreign tax
credit limitation would be based on the income of a U.S. person
that foreign countries would tax if they applied the rules of
the United States for taxing foreign persons. Under the current
Code, there is often a disconnect between the amount of a U.S.
person's foreign-source income for purposes of the foreign tax
credit limitation and the amount of income foreign countries
would tax if they applied to the U.S. person the rules applied
by the United States to foreign persons.
Thus, the arbitrary and complex sourcing rules of the
current Code could be replaced with much more clear-cut,
logical approach.
Conclusion
There is a fundamental disconnect between reality and the
international provisions of the current Code, and this
disconnect accounts for the arbitrariness and complexity of
those provisions. Because ofthis arbitrariness and complexity,
U.S. corporations are subject to both a much higher tax burden
and a much higher compliance burden than are many of their
foreign competitors. It is critical that the international
provisions be revised from the ground up, so that they are tied
in to reality, rationalized, and simplified, thereby
eliminating the current burden on the international
competitiveness of U.S. corporations.
Chairman Archer. Thank you, Mr. Bouma.
Does any member wish to inquire of this panel?
[No response.]
If not, we appreciate your testimony, and we thank you for
the opportunity to consider it as we move ahead in developing
this tax package.
The Committee will stand in recess until one o'clock so
everybody can get some lunch, and then we will hear from our
last panel.
[Whereupon, the Committee recessed to reconvene at 1 p.m.,
the same day.]
Chairman Archer. The Chair apologizes to our next panel of
witnesses for keeping you waiting for an extra 20 minutes. We
will be pleased to receive your testimony. Mr. Conway, if you
would lead off, please, sir.
STATEMENT OF KEVIN CONWAY, VICE PRESIDENT, TAXES, UNITED
TECHNOLOGIES CORPORATION, HARTFORD, CONNECTICUT, AND VICE
CHAIRMAN, SUBCOMMITTEE ON INTERNATIONAL TAXATION, NATIONAL
ASSOCIATION OF MANUFACTURERS
Mr. Conway. Thank you, Mr. Chairman. Members of the
Committee, my name is Kevin Conway. I am the vice president of
taxes at United Technologies Corp. I am here today on behalf of
the National Association of Manufacturers.
NAM is the oldest and largest multi-industry trade
association in the U.S. NAM's 14,000 members include 10,000
small and medium-sized companies and over 300 member
associations who represent manufacturers in every State. NAM
has long advocated international tax simplification to improve
the international competitiveness of U.S. companies. NAM
strongly supports the provisions of H.R. 2018.
I will focus my testimony on four areas of particular
concern. At United Technologies, the Otis Elevator Co. competes
in the global marketplace in the elevator service industry.
There are approximately 6 million elevators in the world that
are available to service. Over 5 million of those are located
outside the United States. So what this means is that 80
percent of that market is outside the United States.
In order for us to compete in that marketplace, we often
have to operate through corporate joint ventures. In order to
penetrate markets or expand in existing markets, we are
required to have partners and joint ventures. Very often, our
partners will want to retain at least a 50 percent ownership in
that venture. The result is that we often find ourselves in the
10/50 basket. What that means is that if the local income tax
rate is greater than the 35 percent U.S. rate, if we have
dividends from that 10/50 company, we will have excess credits
that we will never use.
In the same year, we have 10/50 company operations in
countries where the local rate is below the 35-percent rate. In
that case, when we take dividends back, we have excess
limitation that we will never use. Clearly, we think the 10/50
rule results in us being non-competitive and it is time that it
be repealed. The 1997 Act recognized that and it repealed the
10/50 basket. Unfortunately, there was a complex transition
rule which delayed the effective date of the repeal. And NAM
urges that the effective date be accelerated to the current
time.
The second area I want to talk about is the provision which
applies in the case of a taxpayer who is subject to the AMT,
the alternative minimum tax regime. That provision essentially
says that if you have foreign tax credits, you are subject to a
90 percent limitation. You can use the foreign tax credits, but
you can only reduce your liability up to 90 percent. We don't
believe that the AMT tax regime makes any sense. We think it
makes even less sense to have this 90 percent limitation. So we
urge that the rules be changed and that AMT taxpayers, just
like regular taxpayers, be permitted to use their foreign tax
credits to offset their tax liability.
The third area I would like to talk about is exports.
Exports are critical to the growth of U.S. jobs, U.S.
companies, and the U.S. economy. In 1998, United Technologies
had export sales of more than $4 billion. Those were products
that were manufactured in the United States and sold abroad. We
have two important provisions in the Internal Revenue Code
dealing with exports. The first provision is the foreign sales
corporation provision. We also have the export source rule
under section 863. They are both important export incentives
and should be maintained.
However, the FSC rules have a provision which essentially
provides that the FSC benefit is reduced by 50 percent in the
case of export sales of military or Defense products. This
provision was enacted back in 1976 on the theory that military
products weren't subject to competition. We know that is not
the case today. The competition from Europe is stiff on these
types of products and there is no reason why military products
should be treated differently than commercial products. So that
limitation should be repealed.
Finally, I would like to urge the Committee and Congress to
act on the legislation which would continue to ensure the
confidentiality of financial information which is submitted or
generated as part of an advance pricing agreement. The APA
program, I think, is one example we can all point to of a
program that has really worked well for the IRS, for taxpayers,
and foreign countries. It has enabled us to resolve
intercompany pricing issues to avoid audits and tax
controversies. And the issue we have before us is if this
information is not treated as confidential and it becomes
disclosed, there will be a significant chilling effect on the
use of the APA program, and we don't think that that is
appropriate.
I would like to thank the chairman and the Committee for
the progress that you have made in the international tax area
and urge that H.R. 2018 be adopted. Thank you.
[The prepared statement follows:]
Statement of Kevin Conway, Vice President, Taxes, United Technologies
Corporation, Hartford, Connecticut, and Vice Chairman, Subcommittee on
International Taxation, National Association of Manufacturers
I. Introduction
Chairman Archer, members of the committee, my name is Kevin
Conway. I am the vice president of taxes for United
Technologies Corporation. I thank you for this opportunity to
testify on behalf of the National Association of Manufacturers
(NAM). The National Association of Manufacturers--``18 million
people who make things in America''--is the nation's largest
and oldest multi-industry trade association. The NAM represents
14,000 members (including 10,000 small and mid-sized companies)
and 350 member associations serving manufacturers and employees
in every industrial sector and all 50 states. Headquartered in
Washington, D.C., the NAM has 11 additional offices across the
country.
The NAM has long advocated international tax
simplification, which would greatly improve the international
competitiveness of U.S. manufacturers and the U.S. economy
overall. There are many opportunities to improve the
international provisions of the Internal Revenue Code (IRC),
and the NAM strongly supports H.R. 2018, the ``International
Tax Simplification for American Competitiveness Act of 1999,''
by Representatives Houghton (R-31st NY) and Levin (D-12th MI).
However, due to time constraints and more extensive coverage of
several important issues by other members of this panel, I will
confine my remarks to four particular areas of concern: (1)
look-through for 10/50 companies; (2) the 90 percent limitation
on foreign tax credits applicable to companies in AMT status;
(3) advance pricing agreement (APA) disclosure; and (4) the 50
percent limitation on foreign sales corporation (FSC) benefits
applicable to defense exports.
II. Look-Through for 10/50 Companies
Until 1997, a separate foreign tax credit (FTC) limitation
(i.e., a separate ``basket'') computation was required for
dividends received from each ``noncontrolled Section 902
corporation.'' A ``noncontrolled Section 902 corporation'' is a
foreign corporation that satisfies the stock ownership
requirements of IRC section 902(a), yet is not a controlled
foreign corporation (CFC) under IRC section 957(a). More simply
stated, these are companies in which U.S. shareholders own at
least 10, but no more than 50, percent of the foreign
corporation, hence the name ``10/50 company.''
This rule imposed a tremendous compliance burden on
multinationals by requiring extensive, separate bookkeeping.
Additionally, it severely constrained the ability of U.S.-based
multinationals to use their FTCs in the most efficient manner
to alleviate double taxation. Only foreign taxes directly
associated with a 10/50 company's dividends could be credited
against the U.S. tax on that 10/50 company's income, i.e.,
excess FTCs from other sources could not offset FTC shortfalls
of 10/50 companies, and excess FTCs generated by 10/50
companies could not offset shortages incurred by other
companies, even other 10/50 companies. This is a deviation from
the general rules, which allow ``look-through'' treatment, as
in the case of CFC dividends. Furthermore, there is no tax
accounting or policy reason for differentiating between income
earned by noncontrolled corporations versus CFCs.
Look-through rules allow dividend income to be re-
characterized in accordance with the underlying sources of the
payor corporation's income. Thus, dividends associated with
overall limitation income would be eligible for inclusion in
the overall limitation income basket. Under the rules in place
before 1998, however, taxpayers were not allowed to ``look-
through'' dividends received from 10/50 companies, even though
10/50 company dividends are generally derived from overall
limitation income and would otherwise be eligible for inclusion
in the overall limitation income basket under the look-through
rules.
The 1997 Tax Relief Act corrected this inequity by
eliminating separate baskets for 10/50 companies. Instead, 10/
50 companies are treated just like CFCs, and taxpayers can
utilize look-through rules for re-characterizing dividend
income in accordance with the underlying sources of the payor
corporation's income. The 1997 act, however, did not make the
change effective for such dividends unless they were received
after the year 2003 and, even then, required two sets of rules
to apply for dividends from earnings and profits (E&P)
generated before the year 2003, and dividends from E&P
accumulated after the year 2002.
The ongoing requirement to use two sets of rules on
dividends before the year 2003 has been a concern of taxpayers,
members of Congress, and the Administration. Thus, to address
the complexity created by this much-delayed effective date, the
Administration has, as part of both its FY1999 and FY2000
budget proposals, recommended accelerating the effective date
of the 1997 Tax Act change. The proposal would apply the look-
through rules to all dividends received in tax years after
1998, no matter when the E&P constituting the makeup of the
dividend was accumulated.
This change would result in a tremendous reduction in
complexity and compliance burdens for U.S. multinationals doing
business overseas through foreign joint ventures. It would also
reduce the competitive bias against U.S. participation in such
ventures by placing U.S. companies on a much more level playing
field from a corporate tax standpoint. Finally, this proposal
epitomizes the favored policy goal of simplicity in the tax
laws and will go a long way toward helping the U.S. economy by
strengthening the competitive position of U.S.-based
multinationals.
III. Foreign Tax Credit Limitations on AMT Companies
A multinational corporation with a U.S. parent and foreign
subsidiaries can be double taxed on income earned by its
foreign subsidiaries when the income is repatriated to the U.S.
parent as a dividend. The U.S. government, recognizing that
these multiple levels of tax hurt the competitiveness of U.S.
corporations, alleviates this multiple tax burden by allowing
the U.S. company foreign tax credits (FTCs) for the income
taxes paid to foreign governments. These credits are allowed
for taxes paid by subsidiaries on dividends which are
distributed to the U.S. parent. Foreign tax credits are dollar-
for-dollar credits that offset U.S. tax liability. However, the
number of these credits that can actually be used to offset the
U.S. parent tax liability is determined by whether the parent
corporation has regular tax liability or alternative minimum
tax (AMT) liability.
Under a regular tax computation, the U.S. parent company
can use foreign tax credits to offset 100 percent of its U.S.
tax liability on the dividends it receives from the foreign
subsidiary. However, a similar company in AMT status would not
be permitted to alleviate all of its double taxation. The
resulting multiple taxation occurs because of a provision added
to the tax code as part of the Tax Reform Act of 1986,
providing that only 90 percent of the amount of AMT liability
can be offset by foreign tax credits.
The intent of this limitation was to ensure that a U.S.
corporation that earned U.S.-source income and was profitable
on its U.S. operations from a book perspective would incur a
minimum amount of U.S. taxes. In operation, however, U.S.
corporations that have a substantial amount of foreign source
income relative to their U.S.-source income or that have
taxable losses on their U.S. operations are forced to pay U.S.
taxes on income already heavily taxed outside the United
States. This result contravenes the very purpose for which
foreign tax credits were created.
AMT liability by its very nature actually represents a
prepaid double taxation. Because AMT is a prepayment of taxes,
the law allows corporations to accumulate credits for AMT taxes
that have been paid.
Theoretically, these credits can ultimately be used when
the corporation is no longer in AMT status and has fully
utilized all other available credits such as foreign tax
credits and research and development credits. In reality, a
corporation that has substantial U.S.-source losses over a
number of years or that has substantially more foreign source
income than U.S. source income may never actually recover the
taxes it prepaid. In this regard, the provision operates in a
punitive manner not anticipated when the provision was enacted.
IV. Advance Pricing Agreement (APA) Disclosure
The Advance Pricing Agreement (APA) program of the Internal
Revenue Service (IRS) began in 1991 as an innovative way for
taxpayers, the IRS, and foreign tax agencies to avoid costly
litigation and uncertainty over international transfer
pricing--i.e., the appropriate arm's length price for sales,
services, licenses and other transactions between related
parties. The program has been extremely successful and is often
cited as a model for how the IRS should interact with
taxpayers. From the beginning of the program, the IRS assured
taxpayers, Congress, and foreign governments that any
information ``received or generated'' by the IRS during the APA
process was ``subject to the confidentiality requirements of
Sec. 6103.'' (See Rev. Proc. 91-22 and Rev. Proc. 96-53).
Indeed, written assurances of confidentiality have often been
included in the APA itself. However, in January of this year,
as a concession in a lawsuit seeking public disclosure brought
by the Bureau of National Affairs (BNA), the IRS unexpectedly
reversed its long-standing policy and notified taxpayers that
APAs are subject to disclosure under IRC Sec. 6110--which
requires disclosure of any IRS ``written determination.''
Regardless of the outcome of the pending lawsuit, the IRS is
proceeding with redaction and release of APAs (now scheduled
for October 1999) in contravention of both its own prior
assurances of confidentiality to taxpayers and the express
intent of Congress (in 1993) that Sec. 6103 protects APAs from
disclosure.
First of all, APAs are not ``written determinations'' under
IRC Sec. 6110. In 1976, when Congress enacted Sec. 6110 to
allow disclosure of written determinations, negotiated taxpayer
agreements, such as closing agreements, were specifically
excluded because ``a negotiated settlement . . . as such, does
not necessarily represent the IRS view of the law.'' (S. Rep.
No. 938, 94th Cong. 2d Sess. 306-7 (1976); H.R. Rep. No. 658,
94th Cong., 2d Sess. 316 (1976)). APAs are not written
determinations (such as private letter rulings) that are
unilaterally issued to the taxpayer by the IRS and consist of
facts, law and the application of the law to the facts. Rather,
APAs are customized, binding, written contracts that determine
specific tax results and are carefully negotiated between the
taxpayer and the IRS, like closing agreements, which are not
subject to disclosure (Id). APAs are highly factual in nature,
making a fact-intensive economic determination, not a legal
one.
Second, APAs are protected return information under IRC
Sec. 6103. In 1993, when Congress amended Sec. 6103 to add
Sec. 6103(l)(14), which permits disclosure of certain return
information to the Customs Service, the Congress expressly
exempted APAs from such disclosure. This was done because APAs
were viewed as return information in the first instance. The
legislative history states: ``The effectiveness of the APA
program relies on voluntary disclosure of sensitive information
to the Internal Revenue Service; accordingly, information
submitted or generated in the APA negotiating process should
remain confidential.'' See H.R. Report. No. 103-361, Vol. I, at
104 (1993). Treasury regulations implementing this provision
also expressly describe APAs as ``return information.'' See
Treas. Reg. 301.6103(l)(14)-1(d). Public disclosure of APAs is
contrary to congressional intent and Treasury's own
regulations.
Third, redaction of APAs under IRC Sec. 6110 will strain
IRS and taxpayer resources. Prior to release of any APAs under
Sec. 6110, the IRS will be required to redact any identifying
taxpayer information. In addition, the ``background files''
will be subject to disclosure under IRC Sec. 6110(b)(2). These
background files are voluminous and contain highly sensitive
proprietary data that will have to be reviewed and redacted.
Redaction, especially of these background files, will strain
the resources of the IRS and be yet another cost, and likely
deterrent, for taxpayers participating in the APA program
Ironically, release and redaction of APAs under IRC
Sec. 6110 will create costly disputes and litigation. The APA
program was instituted specifically to curtail audit disputes
and litigation over transfer pricing, but the redaction process
required under IRC Sec. 6110 allows taxpayers and third parties
to challenge proposed redactions in court, creating a
significant risk of even more disputes and litigation. Disputes
will arise not only between the taxpayer and the IRS over what
should be redacted, but also between the taxpayer and third
parties seeking disclosure, and over what is or is not a
background file. Release and/or redaction of APAs and the
background files would be disastrous for both the IRS and the
taxpayer, as well as for our treaty partners.
Furthermore, confidentiality is essential to protect
taxpayer privacy and to assure continuation of the APA program.
The APA program has worked because taxpayers have trusted the
IRS and agreed to voluntarily submit sensitive pricing
information to the IRS in advance of an audit--based on a
promise of confidentiality. Release and redaction of APAs and
background files would be a betrayal of taxpayers who
voluntarily submitted sensitive information in the past and a
significant deterrent to taxpayers contemplating participation
in the APA program in the future. In addition, an increasing
number of APAs are bilateral or multi-lateral involving foreign
tax authorities and making confidentiality even more important.
Our treaty partners are very concerned about possible breach of
the promise of confidentiality in the APA program. If taxpayers
cannot obtain bilateral APAs because foreign tax authorities
refuse to participate, many taxpayers may decide not to pursue
an APA at all. IRS's concession has jeopardized the APA
program, which has been such a successful tool in helping the
IRS and taxpayers resolve difficult factual issues without
litigation.
Finally, disclosure of APAs could jeopardize the
confidentiality of competent authority proceedings and U.S.
relationships with foreign governments. When a taxpayer's
income is potentially subject to tax by both the United States
and a foreign jurisdiction, the IRS can enter into a
negotiation with the foreign ``competent authority'' to
determine how much tax should be paid to each jurisdiction.
These Competent Authority proceedings are confidential under
our tax treaties. Although these proceedings involve the
elimination of any type of double taxation, they often resolve
double taxation problems arising from transfer pricing
disputes--just like bilateral APAs. If APAs are subject to
disclosure, there is a real risk Competent Authority
proceedings could also be disclosed. Any suggestion that
Competent Authority proceedings should be subject to disclosure
would be viewed with tremendous concern by our treaty partners
and could seriously impair our ability to resolve claims
regarding double taxation in the future.
Congress should promptly confirm that APAs are protected
taxpayer information under IRC Sec. 6103 and not subject to
disclosure under IRC Sec. 6110. Congressional action is needed
to prevent the IRS from breaching its solemn assurances to
taxpayers, the Congress, and foreign governments that these
agreements are confidential taxpayer information. Failure to
take immediate action in this regard will severely cripple, if
not destroy, the APA program.
V. Foreign Sales Corporation (FSC) Benefits for Defense Exports
The Internal Revenue Code allows U.S. companies to
establish foreign sales corporations (FSCs), under which they
can exempt from U.S. taxation a portion of their earnings from
foreign sales. This provision is designed to help U.S. firms
compete against foreign companies relying more on value-added
taxes (VATs) than on corporate income taxes. When products are
exported from such countries, the VAT is rebated, effectively
lowering their prices. U.S. companies, in contrast, must charge
relatively higher prices in order to obtain a reasonable net
profit after taxes have been paid. By permitting a share of the
profits derived from exports to be excluded from corporate
income taxes, the FSC in effect allows companies to compete
with foreign firms that pay less tax.
In 1976, Congress reduced the Domestic International Sales
Corporation (DISC) tax benefits for defense products to 50
percent, while retaining the full benefit for all other
products. The limitation on military sales, currently contained
in IRC Sec. 923(a)(5), was continued when Congress enacted the
FSC (which replaced the DISC) in 1984. The rationale for this
discriminatory treatment--that U.S. defense exporters faced
little competition--no longer exists. Regardless of the
veracity of that premise 25 years ago, today military exports
are subject to fierce international competition in every area.
In the mid-1970s, roughly half of all the nations purchasing
defense products benefited from U.S. military assistance.
Today, U.S. military assistance has been sharply curtailed and
is essentially limited to two countries. European and other
countries are developing export promotion projects to counter
the industrial impact of their own declining domestic defense
budgets and are becoming more competitive internationally. In
addition, a number of Western purchasers of defense equipment
now view Russia and other former Soviet Union countries as
acceptable suppliers, further increasing the global
competition.
Circumstances have changed dramatically since the tax
limitation for defense exports was enacted in 1976. Total U.S.
defense exports and worldwide defense sales have both decreased
significantly. Over the past 15 years, the U.S. defense
industry has experienced spending reductions unlike any other
sector of the economy. During the Cold War, defense spending
averaged around 10 percent of U.S. Gross Domestic Product,
hitting a peak of 14 percent during the Korean War in the early
1950s and gradually dropping to 6-7 percent in the late 1980s.
That figure has now sunk to 3 percent of GDP and is projected
to go even lower, to 2.8 percent, by Fiscal Year (FY) 2001.
Since FY85 the defense budget has shrunk from 27.9 percent
of the federal budget to 14.8 percent in FY99. As a percentage
of the discretionary portion of the U.S. Government budget,
defense has slid from 63.9 percent to 45.8 percent over the
same time. Moreover, the share of the defense budget spent on
the development and purchase of equipment--Research,
Development, Test and Evaluation (RDT&E) and procurement--has
contracted. Whereas procurement was 32.2 percent and RDT&E 10.7
percent of the defense budget in FY85--for a total of 42.9
percent; those proportions are now 18.5 percent and 13.9
percent, respectively--for a total of 32.4 percent.
Obviously, statistics such as these are indicative that the
U.S. defense industry has lost much of its economic robustness.
This is additionally evidenced by massive consolidation and job
loss in the defense industry. Of the top 20 defense contractors
in 1990, two-thirds of the companies have merged, been sold or
spun off, and hundreds of thousands of jobs have been
eliminated in the industry.
Budget issues are always a concern to lawmakers. The Joint
Tax Committee estimates that extending the full FSC benefit to
defense exports will likely cost about $340 million over five
years. However, this expense is justified by both overriding
policy concerns and sound tax policy. With the sharp decline in
the defense budget over the past 15 years, exports of defense
products have become ever more critical to maintaining a viable
U.S. defense industrial base. Key U.S. defense programs rely on
international sales to keep production lines open and to reduce
unit costs. Repeal will benefit not only the large
manufacturers of military hardware, but also the smaller
munitions manufacturers, whose products are particularly
sensitive to price fluctuations.
The recent decision to transfer jurisdiction of commercial
satellites from the Commerce Department to the State Department
illustrates the fickleness of Section 923(a)(5). When the
Commerce Department regulated the export of commercial
satellites, the satellite manufacturers received the full FSC
benefit. Since the Congress transferred export control
jurisdiction to the State Department, the identical satellites,
manufactured in the same facility, by the same hard-working
employees, no longer receive the same tax benefit. Because
these satellites are now classified as munitions, their FSC
benefit has been cut in half. This result demonstrates the
inequity of singling out one class of products for different
tax treatment than every other product manufactured in America.
The Cox Committee, recognizing the absurdity of the
situation, recommended that the Congress take action to correct
this inequity as it applies to satellites. The Administration
has agreed with this recommendation. Section 303 would not only
correct the satellite problem, but would also change the law so
that all U.S. exports are treated the same under the FSC.
Repeal of Section 923(a)(5) of the tax code does not alter
U.S. export licensing policy. Military sales will continue to
be subject to the license requirements of the Arms Export
Control Act. Exporters will be able to take advantage of the
FSC only after the U.S. Government has determined that a sale
is in the national interest.
Decisions on whether to allow a defense export sale should
continue to be made on foreign policy grounds. However, once a
decision has been made that an export is consistent with those
interests, our government should encourage that such orders are
filled by U.S. companies and workers, not by our foreign
competitors. Discriminating against these sales in the tax code
puts our defense industry at great disadvantage and makes no
sense. Removing this provision of the tax code will further our
foreign policy objectives by making defense products more
competitive in the international market.
VI. Conclusion
In conclusion, the NAM has long advocated overhaul of the
overly complex and arcane international tax provisions in the
Internal Revenue Code and complete repeal of the punitive
alternative minimum tax (AMT). While the opportunities for
improvement in the code are numerous, the NAM strongly endorses
H.R. 2018, the ``International Tax Simplification for American
Competitiveness Act of 1999,'' and the simplification
provisions therein as a significant step toward improving the
competitiveness of U.S.-based manufacturers. However, we would
also urge the committee to address the impending disclosure by
IRS of advance pricing agreements (APAs) by clarifying their
status as return information under I.R.C. Sec. 6103.
With only about four percent of the world's population
residing in the United States, international trade is no longer
a luxury but necessary to the survival and growth of U.S.-based
manufacturers. While U.S. negotiators have actively pursued an
increasing number of trade agreements to improve access to
overseas markets, a major impediment to trade sits in our own
backyard, namely the U.S. tax code. The NAM thanks the
Committee on Ways and Means for recognizing the barriers our
tax code imposes and the decreased competitiveness that
results. Hearings such as this one are the first step to
achieving significant reform. Thank you for scheduling this
hearing to address these important issues and for allowing me
to testify today on the NAM's behalf.
Chairman Archer. Thank you, Mr. Conway. Mr. Mogenson, you
may proceed.
STATEMENT OF HARVEY B. MOGENSON, MANAGING DIRECTOR, MORGAN
STANLEY DEAN WITTER & CO.; ON BEHALF OF THE COALITION OF
SERVICE INDUSTRIES
Mr. Mogenson. Mr. Chairman, Members of the Committee, my
name is Harvey Mogenson. I am a managing director at Morgan
Stanley Dean Witter responsible for international tax matters
for the company. Morgan Stanley Dean Witter is a global
financial services firm and a market leader in securities,
asset management, and credit and transaction services. We have
offices in New York, London, Tokyo, Hong Kong, and all of the
other principal financial centers around the world.
However, today I am testifying on behalf of the Coalition
of Services Industries, CSI. CSI was established in 1982 to
create greater awareness of the major role services industry
play in our national economy, to promote the expansion of
business opportunities abroad for U.S. services, and to
encourage the U.S. leadership in attaining a fair and
competitive global marketplace. CSI represents a broad array of
U.S. service industries, including financial,
telecommunications, professional, travel, transportation,
information, and information technology sectors.
I would like to thank you, Mr. Chairman, for holding this
important meeting today regarding the U.S. tax rules and their
impact on the competitiveness of U.S. corporations doing
business abroad. I also want to thank Mr. Houghton and Mr.
Levin and other Members of the Ways and Means Committee and
members who have joined them in introducing H.R. 2018, the
International Tax Simplification For American Competitiveness
Act of 1999. And also I would like to thank Mr. McCrery and Mr.
Neal for the work that they are doing in this area.
Although my limited grey hair belies the fact, I have been
practicing international tax for 18 years. I can personally
attest that the U.S. international tax laws are complex,
cumbersome, and can stifle competitiveness of U.S. companies
doing business abroad. Because of this, international tax
reform is a critical element of an effective U.S. tax and trade
policy.
While U.S. trade policy has concentrated on opening world
markets to U.S. companies, particularly in the service sector,
the U.S. tax policy has not always moved in the same direction.
As trade policy moves into the 21st century, it seems our
international tax policy still reflects the business
environment of the sixties, as elaborated on by the previous
panel in citing the statistics regarding the segments of our
economy at that time. That is why we strongly support the
provisions of the Houghton-Levin Simplification bill. Further,
as part of that bill, CSI believes that the active financing
exception to subpart F for financial services companies active
business foreign earnings should be extended with other
expiring provisions for as long as possible.
To understand how important the U.S. tax laws are to
companies operating abroad, perhaps I will elaborate on why
U.S. firms and financial service companies in particular go
overseas in the first place. As the world economy has been
increasingly global in nature, the need to secure new markets
for U.S. corporations has intensified. As those companies, who
are our clients, expand overseas, the financial services firms
have had to go and do the same thing in order to support the
global expansion of those companies. In essence, financial
services companies are in the foreign markets initially because
that is where our customers are. Thus, as our customers have
become global, we have had to also become global rather than
lose that business to our global competitors.
Also, the U.S. financial markets are mature and it is
anticipated that much of the growth in the financial services
industry will come in foreign marketplaces as they open up to
the type of development that we have seen in the U.S. financial
services marketplace.
Many financial service companies have also had a local
presence abroad because we are heavily regulated and required
to conduct business through local companies. For example,
insurance and reinsurance companies, like securities dealers--
my company--are required to maintain significant levels of
capital with minimum solvency thresholds in order to be
licensed to operate in the foreign jurisdiction. In addition,
these regulated companies are subject to stringent regulation
that constrains the movement of capital, regardless of whether
such income has or has not been subject to U.S. taxation.
Most global services firms, therefore, including Morgan
Stanley Dean Witter, have operated through locally incorporated
and regulated affiliates in the major commercial centers.
As a way of background to the legislative approach to
active financing exception, I would just like to say that in
1986, Congress repealed the active financing exception because
of the concerns over active and passive income. In 1997 and
1998, those concerns were revisited and a compromise was
crafted to focus on the active activities of financial services
firms that do conduct substantial activities in the home
country. Active financial services, as we have heard, is
recognized by our major trading partners as active business
income. Thus, if the current law provision were permitted to
expire at the end of this year, U.S. financial services
companies would find themselves at a significant competitive
disadvantage vis-a-vis all of our major competitors operating
outside the United States.
Also, because the active financing exception is currently
temporary, it denies U.S. companies of a certainty their
foreign competitors have. I will conclude my remarks there.
[The prepared statement follows:]
Statement of Harvey B. Mogenson, Managing Director, Morgan Stanley Dean
Witter & Co.; on behalf of the Coalition of Service Industries
Introduction
Mr. Chairman and distinguished Members of the Committee:
My name is Harvey Mogenson, I am a Managing Director at
Morgan Stanley Dean Witter & Co. (MSDW). MSDW is a global
financial services firm and a market leader in securities,
asset management, and credit and transaction services. The Firm
has offices in New York, London, Tokyo, Hong Kong and other
principal financial centers around the world and has 456
securities branch offices throughout the United States. I am
testifying today on behalf of the Coalition of Services
Industries (CSI). CSI was established in 1982 to create greater
awareness of the major role services industries play in our
national economy; promote the expansion of business
opportunities abroad for U.S. services, and encourage U.S.
leadership in attaining a fair and competitive global
marketplace. CSI represents a broad array of U.S. service
industries including the financial, telecommunications,
professional, travel, transportation, information and
information technology sectors.
I want to thank you, Mr. Chairman for holding this
important hearing on the impact U.S. tax rules have on the
competitiveness of U.S. corporations doing business abroad. I
also want to thank Mssrs. Houghton and Levin and the other Ways
& Means Committee Members who have joined them in introducing
H.R. 2018, the International Tax Simplification for American
Competitiveness Act of 1999.
U.S. international tax laws are complex, cumbersome, and
can stifle the competitiveness of U.S. companies doing business
overseas. Because of this, international tax reform is a
critical element of an effective U.S. trade policy. While U.S.
trade policy has concentrated on opening world markets to U.S.
companies, our tax policy has not always moved in the same
direction. As trade policy moves into the 21st Century, it
seems our international tax policy still reflects the business
environment of the '60s. That is why we strongly support the
provisions in the Houghton-Levin Simplification bill. And, as
part of that bill, CSI believes that the active financing
exception to subpart F for financial services companies' active
business foreign earnings should be extended with the other
expiring provisions for as long as possible.
Why Financial Services Companies Operate Overseas
To understand how important U.S. international tax laws are
to companies operating abroad, it may be useful to elaborate on
why U.S. firms, and financial services companies in particular,
go overseas in the first place.
As the world economy has become increasingly global in
nature, the need to secure new markets for U.S. corporations
has intensified. As those companies expand overseas, financial
services firms have had to do the same in order to support that
global expansion and to stake out new markets for themselves.
In essence, financial services companies are in foreign markets
because that is where our customers are (both domestic and
foreign). Thus, as our customers have become more global, we
have also become global rather than lose the business to our
global competitors. Also, the U.S. financial markets are mature
and much of the growth in the industry will come in foreign
markets as they open up to the type of development we have seen
in the US financial services market-place.
You will hear today from manufacturing companies such as
United Technologies, which owns Otis Elevator Company. Otis
maintains a presence overseas in order to service and maintain
the elevators they sell around the world. In much the same way
financial services companies, be they banks, securities,
finance or insurance companies, need to have a local presence
to market, service and maintain financial services to their
customers. As with other non-financial companies that need to
be close to their customers because of the proximity to raw
materials and other inputs, financial services companies need
access to the local debt and financial markets to facilitate
their lending and securities activities. In most cases, such
access provides us with lower cost of funds and protection
against currency fluctuations.
Many financial services companies also have a local
presence because they are heavily regulated businesses and
foreign rules dictate that they conduct business through local
companies. In the case of insurance and reinsurance companies,
they are required to maintain significant levels of capital
with minimum solvency thresholds in order to be licensed in a
foreign jurisdiction. In addition, insurers are subject to
stringent regulation that constrain the movement of capital.
Most global securities firms, including Morgan Stanley Dean
Witter, have locally incorporated and regulated affiliates in
the major commercial centers within Europe (London, Frankfurt,
Paris, Milan) and Asia (Tokyo, Hong Kong, Singapore, Sydney).
Because each jurisdiction asserts full regulatory control for
activities within its country, local subsidiaries are used to
avoid overlapping regulatory supervision.
Legislative Background on Active Financing Exception
When subpart F was first enacted in 1962, the original
intent was to provide deferral for foreign operating income,
and require current U.S. taxation of foreign income of U.S.
multinational corporations that was passive in nature. The 1962
law was careful not to subject active financial services
business income to current taxation through a series of
detailed carve-outs. In particular, dividends, interest and
certain gains derived in the active conduct of a banking,
financing, or similar business, or derived by an insurance
company on investments of unearned premiums or certain reserves
were specifically excluded from current taxation if such income
was earned from activities with unrelated parties.
In 1986, Congress repealed deferral of controlled foreign
corporation's active financial services business income in
response to concerns about the difficulty in distinguishing
between active and passive income. In 1997, the 1986 rules were
revisited, and an exception to the subpart F rules was added
for the active income of U.S. based financial services
companies, along with rules to ensure that the exception would
not be available for passive income. The active financing
income provision was revised in 1998, in the context of
extending the provision for the 1999 tax year, and changes were
made to focus the provision on active overseas financial
services businesses that perform substantial activities in
their home country.
Active financial services income is recognized by our major
trading partners as active trade or business income. Thus, if
the current law provision were permitted to expire at the end
of this year, U.S. financial services companies would find
themselves at a significant competitive disadvantage vis-a-vis
all their major foreign competitors when operating outside the
United States. In addition, because the U.S. active financing
exception is currently temporary, it denies U.S. companies the
certainty their foreign competitors have. The need for
certainty in this area cannot be overstated. U.S. financial
services institutions need to know the tax consequences of
their business operations, especially since many client
transactions may be multiple year commitments or arrangements.
A comparative review of current U.S. law with the laws of
foreign countries conducted by the National Foreign Trade
Council, Inc.\1\ shows that the United States imposes a
stricter anti-deferral policy on U.S.-based financial services
companies than Canada, France, Germany, Japan and The
Netherlands. None of the countries listed eliminates deferral
for active financial services income. For example, ``German law
merely requires that the income must be earned by a bank with a
commercially viable office established in the CFC's
jurisdiction and that the income results from transactions with
customers. Germany does not require that the CFC conduct the
activities generating the income or that the income come from
transactions with customers solely in the CFC's country of
incorporation. The United Kingdom has an even less restrictive
deferral regime than Germany. The United Kingdom does not
impose current taxation on CFC income as long as the CFC is
engaged primarily in legitimate business activities primarily
with unrelated parties. In sum, current U.S. treatment of CFC
active financing income is more restrictive than the treatment
afforded such CFC income by many of the United States'
competitors.'' \2\
---------------------------------------------------------------------------
\1\ The NFTC Foreign Income Project: International Tax Policy For
The 21st Century A Report and Analysis Prepared by the National Foreign
Trade Council, Inc.
\2\ The NFTC Foreign Income Project. International Tax Policy For
The 21st Century p 4-11.
---------------------------------------------------------------------------
The Active Financing Exception is Essential to the Competitive Position
of American Financial Services Industries in the Global Marketplace
The financial services sector is one of the fast growing
components of the U.S. trade in services surplus (which is
expected to exceed $80 billion this year). It is therefore in
the economic interest of the United States that the Congress
act to maintain a tax structure that does not hinder the
competitive efforts of the U.S. financial services industry.
While the economic research is continuing, there seems to be a
growing awareness of the benefits to the U.S. economy of strong
U.S.-based global companies. And, certainly in the case of a
financial services company like MSDW, our global reach has
allowed us to be a stronger competitor and more successful
within the U.S.
The growing interdependence of world financial markets has
highlighted the urgent need to rationalize U.S. tax rules that
undermine the ability of American financial services industries
to compete in the international arena. From a tax policy
perspective, financial services businesses should be eligible
for the same U.S. tax treatment of worldwide income as that of
manufacturing and other non-financial businesses. The
inequitable treatment of financial services industries under
prior law jeopardizes the international expansion and
competitiveness of U.S.-based financial services companies,
including finance and credit entities, commercial banks,
securities firms, insurance, and reinsurance companies.
This active financing provision is particularly important
today as the U.S. financial services industry is the global
leader and plays a pivotal role in maintaining confidence in
the international marketplace. Also, recently concluded trade
negotiations have opened new foreign markets for this industry,
and it is essential that our tax laws complement this trade
liberalization effort. We hope the Congress will not allow the
tax code to revert to penalizing U.S.-based companies upon the
expiration of the temporary provision this year.
The Active Financing Exception Should be Extended for as Long as
Possible
According to the floor statement of Mr. Houghton during the
debate on the Conference Report of the Tax Act of 1997, the
fact that the original active financing exception would sunset
after one year was ``a function of revenue concerns, not doubts
as to its substantive merit.'' \3\ Indeed, even in the course
of subjecting this provision to a presidential line-item veto,
the Clinton Administration acknowledged, and continues to
acknowledge that the ``primary purpose of the provision was
proper.'' \4\
---------------------------------------------------------------------------
\3\ Congressional Record, July 31, 1997.
\4\ White House Statement, August 11, 1997.
---------------------------------------------------------------------------
Understanding that revenue constraints can impact U.S. tax
policy considerations, extending the provision for as long as
possible would greatly enhance the competitive position of the
U.S. financial services industry as they compete in the global
marketplace. Otherwise, the international growth of American
finance and credit companies, banks, securities firms,
insurance and reinsurance companies will continue to be
impaired by an on-again, off-again system of annual extensions
that does not allow for certainty.
Conclusion
On behalf of the entire U.S. financial services industry
and the Coalition of Services Industries, I want to thank you
Mr. Chairman and Members of the Committee for your efforts to
improve the international rules that affect not only the
financial services industry but all U.S. corporations operating
overseas. We urge the Committee to support H.R. 2018 which
would provide a more consistent, equitable and stable
international tax regime for the U.S. financial services
industry.
Chairman Archer. Thank you, Mr. Mogenson. I am sure all the
witnesses hear those buzzers, which mean that we are being
summoned to vote on the floor of the House. We have 10 more
minutes before we have to be over there. We will proceed for at
least one more witness and then we will have to recess and
vote. Two votes will be taken so it will be a while before we
get back. Mr. Chip, you may proceed.
STATEMENT OF WILLIAM W. CHIP, CHAIRMAN, TAX COMMITTEE,
EUROPEAN-AMERICAN BUSINESS COUNCIL, AND PRINCIPAL, DELOITTE &
TOUCHE LLP
Mr. Chip. Thank you, Mr. Chairman. I am an international
tax lawyer. I have been practicing for 20 years. I am
testifying today for the European-American Business Council.
The Council is an alliance of U.S. companies that have
operations in Europe and European companies that have
operations in the United States. Our membership has a lot of
experience in the relative impact of the U.S. tax rules
compared to foreign tax rules.
Mr. Chairman, I would agree with you that--what you said
this morning--that if we were to replace our income tax system
with a sales tax system that raised the same amount of revenue,
that would almost certainly confer a significant competitive
advantage on the United States. One reason it would is because
most of our competitors have income tax systems that, while
more competitive than ours, are not completely competitive.
Understanding what makes a competitive tax system and why
ours is not is actually not that hard. I think in an ideal
system, each country would tax the business income locally
generated at a rate sufficient to pay for roads and education
and other things needed to make that a desirable place to do
business. And the income would not be taxed again until it was
distributed to the individual owners of the enterprise to pay
for things that their resident country needed to make it a safe
and pleasant place to live.
The reason the U.S. tax system is uncompetitive is very
simple. Between the time the income is earned overseas and
distributed to the U.S. owners or the foreign owners, we impose
an extra level of tax at the U.S. corporate level when that
income is brought back to the United States to be distributed
to shareholders or invested in the United States. For example,
if we pay a lower rate of tax in Ireland on operations there,
the United States will impose a tax in the United States equal
to the difference between the United States and the foreign tax
rate.
What if a foreign operation had lower electricity charges?
What if we imposed a charge at the U.S. level on the difference
between U.S. electricity rates and foreign electricity rates
and the difference between U.S. labor rates. It is not that
hard to understand why the income tax system makes U.S.
companies uncompetitive.
This innate uncompetitive feature of the U.S. tax law has
been with us from the beginning and has been exacerbated,
rather than created, by Subpart F, which requires that this
extra level of corporate tax be imposed in many cases even if
the income has not been brought back to the United States.
In particular, I would like to focus on the foreign base
company rules, which provide that if a foreign subsidiary of a
U.S. company conducts sales and services activities outside the
country where it is incorporated, the income from that activity
is immediately taxed by the United States at whatever the U.S.
rate is over the local rate. This is a problem for U.S.
companies everywhere, but it is particularly a problem for us
in the European Union.
The European Union is a single marketplace. You can be a
successful global business without having an operation in
Nigeria or Thailand, but you cannot be a global competitor
unless you have a substantial, profitable, cutting-edge
operation in the European Union. U.S. companies are fiercely
competing with European companies to reorganize themselves and
structure themselves to take advantage of the common market
there. The Subpart F rules which treat an operation that is
incorporated in one EU country, but takes place in another EU
country, as, in effect, tax-shelter income that must
immediately be taxed by the United States, is a very serious
impediment to the rationalization of U.S. business in the
European Union.
That is why we are, of course, very grateful that Mr.
Houghton and Mr. Levin in their bill have asked for a study to
identify the consequences of this and to propose solutions. I
would say that the business community, almost since Subpart F
was enacted, have been complaining and pointing out to the
Congress the tremendous competitive disadvantage they suffer in
structuring their European operations and taking advantage of
European economic integration that this rule has imposed upon
them.
So, in closing, I would like to thank the chairman for
calling these hearings. This is a very important subject. I am
also very interested in the United States staying on top and I
hate to see our rules pushing us in any other direction.
[The prepared statement follows:]
Statement of William W. Chip, Chairman, Tax Committee, European-
American Business Council, and Principal, Deloitte & Touche LLP
My name is Bill Chip. I am a principal in Deloitte &
Touche, an international tax, accounting, and business
consulting firm. I have been engaged in international tax
practice for 20 years.
I am testifying today as Chairman of the Tax Committee of
the European-American Business Council (EABC). The EABC is an
alliance of 85 multinational enterprises with headquarters in
the United States and Europe. A list of EABC members is
attached. Because the EABC membership includes both US
companies with European operations and European companies with
U.S. operations, the EABC brings a unique but practical
perspective on how the U.S. international tax rules impact the
competitiveness of U.S. companies operating in the European
Union (EU)--the world's largest marketplace.
The points I would like to make today may be summarized as
follows:
1. U.S. international tax rules foster tax neutrality
between U.S. companies, but not between U.S. companies and
foreign companies.
2. In order for U.S.-parented companies to be truly
competitive in a globalized economy, the U.S. should not impose
a corporate income tax on income from foreign operations.
3. The enhanced power of the IRS to police transfer pricing
has eliminated the most important rationale for the subpart F
rules, which should therefore be relaxed.
4. The anticompetitive flaws in the U.S. system cannot be
fully corrected without attending to other problems, such as
the taxation of dividends with no credit for corporate-level
taxes.
5. Certain changes are urgently needed pending more
fundamental reforms: (1) the EU should be treated as a single
country under the subpart F rules; (2) the U.S. should agree to
binding arbitration of transfer pricing disputes; and (3) the
rules for allocating interest between U.S. and foreign income
should be made economically realistic.
6. Many problems faced by U.S. companies operating
internationally cannot be resolved by U.S. tax policy alone,
and the U.S. should take the lead in erecting an international
tax system that does not impede cross-border business activity.
The EABC welcomes the Chairman's interest in reforming this
country's international tax rules. Those rules have always had
a negative impact on the ability of U.S. companies to compete
overseas. However, this anticompetitive impact has been masked
during most of this century by several U.S. business
advantages, including the world's largest domestic economy as a
base, a commanding technological lead in many industries, and
sanctuary from the destruction of two world wars. However, 50
years of peace and the rapid spread of new technologies have
leveled these advantages and exposed the anticompetitive thrust
of our international tax regime.
I would go so far as to say that the U.S. rules with
respect to income produced overseas were written without any
regard whatsoever for their impact on competitiveness. Their
goal instead was to ensure that any income controlled by a U.S.
person was eventually subject to U.S. tax. Thus, income of
foreign subsidiaries is taxed at the full U.S. corporate rate
when distributed to the U.S. parent (with a credit for any
foreign income taxes) and then taxed again (with no credit for
either U.S. or foreign income taxes) when distributed to the
U.S. shareholders. The imposition of U.S. tax is accelerated
when foreign earnings are redeployed from one foreign
subsidiary to another and also, under subpart F, when the
foreign income is one of the many types that Congress feared
could otherwise be ``sheltered'' in a ``tax haven.''
These rules do have the effect of neutralizing the impact
of foreign taxes on competition between U.S. companies. Because
all foreign earnings must eventually bear the full U.S. tax
rate, a U.S. company that produces in a low-tax foreign
jurisdiction enjoys at most a temporary tax advantage over one
that produces in the U.S.. Likewise, because all earnings of
U.S. companies eventually bear the same U.S. corporate tax
rate, the presence or absence of a shareholder-level credit for
corporate taxes is immaterial in a shareholder's decision to
invest in one U.S. company rather than in another.
In contrast, the U.S. tax system does not neutralize the
impact of taxes on competition between U.S. and foreign
companies. At the shareholder level, the absence of a credit
for corporate-level taxes favors investments in low-taxed
foreign companies over their U.S. equivalents. At the corporate
level, if the costs of producing a product, including tax
costs, are lower in a foreign country such as Ireland than they
are in the U.S., our free trade rules will likely result in
U.S. customers purchasing the Irish product rather than the
equivalent U.S. product. However, if a U.S. owner of an Irish
enterprise must also pay the excess of U.S. over the Irish tax
rate, then the Irish enterprise will likely end up being owned
by a foreign company whose home country does not tax the Irish
earnings, taxes them later, or provides a more liberal foreign
tax credit.
These competitive disadvantages are aggravated by business
globalization. Owing to the internationalization of capital
markets, an ever-larger percentage of U.S. shareholders are
able and willing to invest in foreign corporations and mutual
funds, impairing the ability of U.S. companies to raise capital
for their overseas operations even in the U.S. capital markets.
The electronic revolution in communications and computing has
also globalized the economic production process. Economic
output is increasingly the consequence of coordinated activity
in a number of different countries, expanding the range of
products impacted by anticompetitive tax rules. If the Irish
enterprise in the foregoing example is an integral part of a
global activity, U.S. companies may lose the opportunity to
sell, not only the Irish product, but also any integral U.S.
products.
The U.S. system leads to very anomalous results. Consider a
U.S. company with a German and Irish subsidiary, then consider
three identical companies, except that the U.S. and Irish
companies are subsidiaries of the German company. The U.S.
would never dream of trying to tax the income of the Irish
subsidiary in the second case, but in the first case insists on
taxing it when the income is repatriated, if not sooner. There
is no reason why this should be so. Most countries, like the
U.S., have a progressive income tax for individuals and, above
a certain level, a virtually flat income tax for corporations.
That being the case, there is a reason for imposing
shareholder-level taxes on dividends received from local and
foreign corporations (although there should be a credit for
taxes paid at the corporate level). There is no reason for
imposing a local corporate tax on foreign earnings as they make
their way from the foreign subsidiary to the ultimate
individual shareholders.
Nowhere is the anti-competitive burden imposed by U.S. tax
rules more evident and damaging than in the application of the
U.S. ``subpart F'' rules to U.S.-owned enterprises in the EU.
The subpart F rules were intended to prevent U.S. companies
from avoiding U.S. taxes by sheltering mobile income in ``tax
havens.'' The impact of these rules is exacerbated by the fact
that since 1986 any country with an effective tax rate not more
than 90% of the U.S. rate is effectively treated as a tax
haven. Even the United Kingdom, an industrialized welfare state
with a modern tax system, is treated as a tax haven by subpart
F because its 30% corporate rate is only 86% of the U.S.
corporate rate. (If the U.S. corporate tax rate when subpart F
was enacted were the benchmark, the U.S. today would itself be
considered a tax haven.)
Because Congress perceived that selling and services were
relatively mobile activities that could be separated from
manufacturing and located in tax havens, the ``foreign base
company'' rules of subpart F immediately tax income earned by
U.S.-controlled foreign corporations from sales or services to
related companies in other jurisdictions. Consider the impact
of this rule on a U.S. company that already has operations in
several EU countries but wishes to rationalize those operations
in order to take advantage of the single market. Such a company
may find it most efficient to locate personnel or facilities
used in certain sales and service activities in a single
location or at least to manage them from a single location.
While a number of factors will affect the choice of location,
all enterprises, whether U.S.-owned or EU-owned, will favor
those locations that impose the lowest EU tax burden on the
activity. However, if the enterprise is U.S.-owned, the subpart
F rules may eliminate any locational tax efficiency by
immediately imposing an income tax effectively equal to the
excess of the U.S. tax rate over the local tax rate. Thus, U.S.
companies are penalized for setting up their EU operations in
the manner that minimizes their EU tax burden (even though
reduction of EU income taxes will increase the U.S. taxes
collected when the earnings are repatriated). It makes as
little sense for the U.S. to penalize its companies in this way
as it would for the EU to impose a special tax on European
companies that based their U.S. sales and service activities in
the U.S. States that imposed the least tax on those activities.
The subpart F rules were enacted mostly out of concern that
certain types of income could readily be shifted into ``tax
havens.'' However, the term tax haven is misleading. Taxes are
only one of many costs that enter into the production process
and into the decision where to conduct a particular activity.
Some countries have low taxes, but others have low labor or
energy costs or a favorable climate or location. If an
enterprise is actually conducted in a low-tax jurisdiction, it
is anticompetitive for the U.S. to impose (let alone
accelerate) corporate taxes on the income properly attributable
to that enterprise, just as it would be anticompetitive to
impose a charge equal to any excess of U.S. over foreign labor
or energy costs. The imposition of taxes or other charges that
offset the competitive advantage of the foreign enterprise will
simply cause the enterprise to be owned by a non-U.S.
competitor that does not have subpart F rules.
When subpart F was enacted, Congress seemed to be concerned
that U.S. companies might arbitrarily attribute excessive
amounts of income to their low-taxed foreign operations.
Whether or not such concern was warranted then, it is not
warranted now. Since 1994 U.S. companies have been subject to
draconian penalties on any substantial failure to price their
international transactions at arm's length. Moreover, most of
our competitors, and even less developed countries such as
Mexico and Brazil, have followed suit and greatly enhanced
their enforcement of the arm's length standard. Having endowed
the IRS with ``weapons of mass destruction'' in the field of
transfer pricing, Congress can now afford to retire much of the
obsolete subpart F armory.
I would be remiss not to acknowledge that the globalization
of business poses important challenges to tax administrators in
the U.S. and elsewhere. Ever greater shares of the nation's
income derives from cross-border activity, while ever
increasing integration of cross-border activity makes it harder
to determining the source of business income. The IRS and most
foreign tax authorities are well aware of these challenges and
are working to surmount them. Indeed, the enhanced attention to
transfer pricing is one of the more important and obvious
responses to the globalization challenge.
The efforts of the U.S. and other countries to ensure
receipt of their ``fair share'' of global tax revenues through
transfer pricing enforcement points also to a need for
increased international cooperation. For example, each country
is likely to view arm's length transfer pricing as the pricing
that maximizes the amount of local income. Hence the need for
international mechanisms which ensure that the calculation of
national incomes under national transfer pricing policies does
not add up to more than 100% of a company's global income.
Unfortunately, although all tax treaties provide a mechanism
for reaching agreement on transfer pricing, very few require
that the countries actually reach agreement, meaning there is
no guarantee against double taxation. Even more unfortunately,
the U.S. is opposing such requirements. For example, while the
EU countries have entered into a convention that requires
arbitration of international transfer pricing disputes, the
U.S. has declined to exchange the notes that would effectuate
the arbitration clauses of the few U.S. tax treaties that have
them. For that reason the EABC strongly recommends that the
U.S. enter into negotiations with the EU members states to
extend the principles of the EU convention to transfer pricing
disputes between the U.S. and EU members.
International cooperation does not mean that tax rates
should be harmonized or even that the calculation of taxable
income should be harmonized. In fact, unharmonized tax rates
are a good thing, because tax competition is a useful
counterweight to the many pressures on government to increase
taxes and spending. For that reason the EABC shares many of the
concerns outlined in the response of the Business and Industry
Advisory Committee (BIAC) to the report on ``Harmful Tax
Competition'' by the Organization for Economic Cooperation and
Development (OECD). There is genuine alarm within the business
community that some OECD members are responding in an
anticompetitive way to the challenges of globalization. Rather
than working cooperatively to construct an international tax
system that ensures income is properly attributed to the
jurisdiction where it originates and not taxed more than once,
some countries seem more interested in maximizing the reach of
their tax jurisdiction and capturing any income under the
control of companies that are headquartered locally. The
efforts of the present U.S. Administration to expand the scope
of subpart F by regulation and legislation reflect such an
approach and should be rejected by the Congress.
I am worried about a deep and growing divide between the
business community and the tax authorities in many
industrialized countries on how to manage the fiscal challenges
of business globalization. At the EABC's recent Transatlantic
Tax Conference, officials of the U.S., EU, and OECD discussed
``harmful tax competition'' and other current issues with tax
leaders from BIAC and from leading U.S. and EU business
organizations. EU business was as frustrated with the inability
of the EU member states to eliminate obstacles to cross-border
business integration and dividend/royalty payments as was U.S.
business with IRS Notices 98-11 and 98-35. All business
representatives were concerned that the OECD seemed less intent
on eliminating tax obstacles to an efficient international
economy than on attempting to freeze in place existing revenue
sources.
The EABC welcomes attention by the U.S. Congress to how the
U.S. tax system impacts business decisionmaking and is ready to
work with your Committee to identify urgently needed reforms.
Members of the European-American Business Council
ABB
ABN Amro Bank
AgrEvo
Airbus Industrie
AirTouch Communications Inc.
Akin, Gump, Strauss, Hauer & Feld
Akzo Nobel Inc.
Andersen Worldwide
Astra Pharmaceutical Products Inc.
AT&T
BASF Corporation
BAT Industries
Bell Atlantic Inc.
Bell South Corporation
BMW (US) Holding Corporation
BP America, Inc.
BT North America, Inc.
Cable & Wireless
Chubb Corporation
Citicorp/Citibank
Cleary, Gottlieb, Steen & Hamilton
Compagnie Financiere de CIC et de l'Union Europeenne
Credit Suisse
DaimlerChrysler
Deloitte & Touche LLP
DIHC
Dun & Bradstreet Corporation
Eastman Kodak Company
ED&F Man Inc.
EDS Corporation
Ericsson Corporation
Finmeccanica
Ford Motor Company
Gibson, Dunn & Crutcher
Glaxo Inc.
IBM Corporation
ICI Americas Inc.
ING Capital Holding Corporation
Investor International
Koninklijke Hoogovens NV
Linklaters & Paines
Lucent Technologies
MCI Communications Corporation
Merrill Lynch & Company, Inc.
Michelin Tire Corporation
Monsanto Company
Morgan Stanley & Co.
Nestle USA, Inc.
Nokia Telecommunications Inc.
Nortel Networks
Novartis
Novo Nordisk of North America
Pechiney Corporation
Pfizer International Inc.
Philips Electronics North America
Pirelli
Powell, Goldstein, Frazer & Murphy
Procter & Gamble
Price Waterhouse LLP
Rabobank Nederland
Rolls-Royce North America Inc.
SAAB AB
Sara Lee Corporation
SBC Communications Inc.
Siegel & Gale
Siemens Corporation
Skandia
Skanska AB
SKF AB
SmithKline Beecham
Sulzer Inc.
Tetra Laval Group
Tractebel Energy Marketing
Unilever United States, Inc.
US Filter
Veba Corporation
VNU Business Information Svcs., Inc.
Volkswagen
Volvo Corporation
White Consolidated, Inc.
Xerox Corporation
Zeneca Inc.
Chairman Archer. Thank you, Mr. Chip. With the indulgence
of the other witnesses, we are going to have to go across the
street and vote. There will also be another 5-minute vote. It
will probably be somewhere between 10 and 15 minutes before we
get back. The Committee will stand in recess until then.
[Recess.]
Chairman Archer. The Committee will come to order. Mr.
Laitinen, would you give us your testimony?
STATEMENT OF WILLIAM H. LAITINEN, ASSISTANT GENERAL TAX
COUNSEL, GENERAL MOTORS CORPORATION, DETROIT, MICHIGAN
Mr. Laitinen. Thank you, Mr. Chairman. My name is Bill
Laitinen. I am Assistant General Tax Counsel for General Motors
Corporation.
I am testifying today on behalf of a coalition of U.S.
multinational companies that are severely penalized by a
particular aspect of the U.S. tax law affecting international
operations, that is, the rules regarding the allocation of
interest expense between U.S. source and foreign source income
for purposes of determining the foreign tax credits a U.S.
taxpayer may claim for taxes it pays to a foreign country.
I would like to express our appreciation to the Chairman
and the Members of the Committee for holding this hearing and
for the opportunity to testify on the vitally important issue
of the impact of U.S. tax rules on the international
competitiveness of U.S. workers and businesses. Also, I would
like to commend Representative Houghton and Representative
Levin on the introduction of their important international
simplification bill.
My testimony today will focus exclusively on the distortive
and anti-competitive impact of the current interest allocation
rules and the pressing need to reform these rules.
The United States taxes U.S. persons on their worldwide
income, but allows a credit against U.S. tax for foreign taxes
paid on income earned abroad. In order to determine the foreign
tax credits that may be claimed, taxpayers must allocate
expenses between U.S. source and foreign source income. Special
rules enacted in the Tax Reform Act of 1986 require that U.S.
interest expense be allocated to a U.S. multinational group's
investment and its foreign subsidiaries. Although the rules
purport to reflect a principle of fungibility of money, in
fact, they ignore the interest expense actually incurred by the
foreign subsidiaries. This one-way street approach to
fungibility is a gross economic distortion.
The interest allocation rules cause a disproportionate
amount of U.S. interest expense to be allocated to foreign
source income. This overallocation of U.S. interest expense
reduces the group's capacity to claim foreign tax credits for
the taxes it pays to foreign countries. Of course, the U.S.
interest expense so allocated is not deductible for foreign tax
purposes and, therefore, does not result in any reduction in
the foreign taxes a multinational group actually pays. Thus,
the ultimate distortion caused by the interest allocation rules
is the double-taxation of foreign income earned by the U.S.
multinational group.
This double-taxation represents a significant cost for U.S.
multinationals, a cost not borne by their foreign competitors.
This increased cost makes it more difficult for U.S.
multinationals to compete in the global marketplace. When a
U.S. multinational considers a foreign expansion or
acquisition, it must factor into its projections the double
taxation caused by the interest allocation rules. A foreign
competitor considering the same expansion or acquisition can do
so without this added cost.
Not only do the interest allocation rules impose a cost
that makes it more difficult for U.S. multinationals to compete
in overseas markets, the rules actually put U.S. multinationals
at a competitive disadvantage in making U.S. investments. When
a U.S. multinational incurs debt to make an additional
investment in the United States, a portion of the interest
expense on that debt is allocated to foreign source income. In
effect, the U.S. multinational is denied a current deduction
for that portion of the interest expense.
A foreign corporation that makes the same investment in the
United States will not be impacted by these interest allocation
rules. Thus the foreign corporation making an investment in the
United States will face lower costs than a U.S. multinational
making the same investment in this country. Under the interest
allocation rules, U.S. multinationals can't even compete on a
level playingfield when they are the home team.
There is no tax policy rationale that supports the
distortion caused by the current rules. The interest allocation
rules must be reformed to eliminate these distortions. First,
the interest allocation rules should take into account all the
interest expense incurred by the multinational group, that is,
both United States and foreign interest expense. Second, debt
incurred by a subsidiary member of the group based on its own
credit should be allocated separately, taking into account only
the assets of that member and its subsidiaries. Finally,
financial services entities, which borrow on their own credit
rather than that of the group, should be treated as a separate
group.
These important reforms to the interest allocation rules
are embodied in H.R. 2270, which was introduced recently by
Representative Portman and Representative Matsui. The interest
allocation rules reflected in H.R. 2270 eliminate the
distortions caused by the current rules, thereby allowing the
foreign tax credit to achieve its fundamental purpose, which is
to eliminate double taxation of income earned abroad.
In closing, I respectfully urge the Committee to enact the
reforms reflected in H.R. 2270. Reform of the interest
allocation rules is critical to ensuring the ability of U.S.
multinationals to compete with their foreign counterparts, both
abroad and in the United States. Thank you.
[The prepared statement follows:]
Statement of William H. Laitinen, Assistant General Tax Counsel,
General Motors Corporation, Detroit, Michigan
I. Introduction
General Motors Corporation appreciates the opportunity to
testify before the House Ways and Means Committee on
competitiveness issues raised by the international provisions
of the U.S. tax laws. Our testimony is submitted on behalf of a
coalition of U.S.-based multinational companies that are
severely penalized by a particular aspect of the international
provisions of the U.S. tax laws: the rules regarding the
allocation of interest expense between U.S.-source and foreign-
source income for purposes of determining the foreign tax
credit a U.S. taxpayer may claim for foreign taxes it pays. Our
testimony specifically focuses on the distortive and anti-
competitive impact of the present-law interest allocation
rules, which were enacted with the Tax Reform Act of 1986, and
the pressing need for reform of these rules.
The present-law interest allocation rules penalize U.S.
multinationals by artificially restricting the foreign tax
credits they may claim. By improperly denying a credit for
foreign taxes paid by U.S. multinationals on the income they
earn abroad, the rules result in double taxation of such
income. This double taxation is contrary to fundamental
principles of international taxation and imposes on U.S.-based
multinationals a significant cost that is not borne by their
competitors.
We respectfully urge the Ways and Means Committee to
consider legislation to reform the interest allocation rules.
Such reforms are embodied in H.R. 2270, which was introduced
recently by Representative Portman and Representative Matsui.
As we explain in this testimony, interest allocation reform is
necessary in order to reflect the fundamental tax policy goal
of avoiding double taxation and to eliminate the competitive
disadvantage at which the present-law interest allocation rules
place U.S.-based multinationals.
II. Present-Law Interest Allocation Rules
The United States taxes its corporations, citizens and
residents on their worldwide income, without regard to whether
such income is earned in the United States or abroad. In order
to avoid having the same dollar of income subjected to tax both
by the United States and by the country in which it is earned,
the United States allows U.S. persons to claim a credit against
U.S. taxes for the foreign taxes paid with respect to foreign-
source income. The U.S. tax laws have allowed such a foreign
tax credit since the Revenue Act of 1918.
The purpose of preventing double taxation requires allowing
foreign taxes paid by a U.S. person as a credit against the
potential U.S. tax liability with respect to the income earned
by such person abroad. However, foreign taxes are not allowed
as a credit against the U.S. tax liability with respect to
income earned in the United States. Accordingly, the foreign
tax credit limitation applies to limit the use of such credits
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
U.S. taxpayer must determine its taxable income from foreign
sources. This determination requires the allocation and
apportionment of expenses and other deductions between U.S.-
source gross income and foreign-source gross income. Deductions
that are allocated to foreign-source income for U.S. tax
purposes have the effect of reducing the taxpayer's foreign tax
credit limitation, thus reducing the amount of foreign taxes
that may be used to offset the taxpayer's potential U.S. tax on
income earned from foreign sources.
Special rules enacted with the Tax Reform Act of 1986 apply
for purposes of determining the allocation of interest expense
between U.S.-source income and foreign-source income. Interest
expense generally is allocated based on the relative amounts of
U.S. assets and foreign assets. The rules enacted with the 1986
Act generally require that interest expense be allocated by
treating all the U.S. members of an affiliated group of
corporations as a single corporation. Accordingly, the interest
allocation computation is done by taking into account all the
interest expense incurred by all the U.S. members of the group
on a group-wide basis. Moreover, such interest expense is
allocated based on the aggregate amounts of U.S. and foreign
assets of all such U.S. members of the affiliated group on a
group-wide basis.
Under the 1986 Act provisions, the group for interest
allocation purposes includes only the U.S. corporations in a
multinational group of corporations and does not include
foreign corporations that are part of the same multinational
group. Under this approach, the interest expense incurred by
the foreign subsidiaries in the multinational group is not
taken into account in the allocation determination. Moreover,
the assets of the foreign subsidiaries are not taken into
account in determining the aggregate U.S. and foreign assets of
the group. Rather, the stock of the foreign subsidiaries is
treated as a foreign asset held by the group for purposes of
allocating the interest expense of the U.S. members of the
group between U.S. and foreign assets.
Special rules apply to certain banks that are members of
the affiliated group. Under these rules, banks are not included
in the group for interest allocation purposes. Instead, such
banks are treated as a separate group and the interest
allocation rules are applied separately to such group.
In addition, the regulations apply more specific tracing
rules to allocate interest expense in certain situations. A
tracing approach applies to the allocation of interest expense
incurred with respect to certain nonrecourse indebtedness. Such
an approach also applies to the allocation of interest expense
incurred in connection with certain integrated financial
transactions.
III. Impact of the Present-Law Interest Allocation Rules
The present-law interest allocation rules purport to
reflect a principle of fungi-
bility of money, with interest expense treated as attributable
to all the activities and assets of the U.S. members of a group
regardless of the specific purpose for which the debt is
incurred. However, the approach adopted with the 1986 Act does
not truly reflect the fungibility principle because it applies
fungibility only in one direction. Under this approach, 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
corporations in the same multinational group. However, in this
calculation, the interest expense actually incurred by the
foreign corporations in the group is ignored. Thus, under the
present-law interest allocation rules, the interest expense
incurred by the foreign corporations in a multinational group
is not recognized as funding either the foreign corporation's
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.
The distortive impact of the present-law interest
allocation rules can be illustrated with a simple example.
Consider a U.S. parent with a single foreign subsidiary. The
two corporations are of equal size and are equally leveraged.
Thus, the total assets of the two corporations are equal and
the interest expense incurred by the two corporations is equal.
The U.S. parent's assets (other than the stock of the foreign
subsidiary) are all U.S. assets and the foreign subsidiary's
assets are all foreign assets. Under the present-law interest
allocation rules, only the interest expense of the U.S. parent
would be taken into account. This interest expense is allocated
based on only the U.S. parent's assets, taking into account the
stock of the foreign subsidiary as a foreign asset of the U.S.
parent. Thus, in this case, one-half of the U.S. parent's
assets are U.S. assets and one-half are foreign assets.
Accordingly, one-half of the U.S. parent's interest expense is
allocated to the foreign assets (i.e., the stock of the foreign
subsidiary). However, the foreign subsidiary itself has
incurred interest expense equal to that of the U.S. parent and
representing a leverage ratio equal to that of the U.S. parent.
From an economic perspective, none of the U.S. parent's
interest expense in this example should be treated as
supporting the activities or assets of the foreign subsidiary.
The allocation of a portion of the U.S. parent's interest
expense to foreign assets represents a double-counting of the
interest expense that is treated as relating to foreign assets.
Indeed, in this case, three-quarters of the group's interest
expense (i.e., one-half of the U.S. parent's interest expense
plus all of the foreign subsidiary's interest expense which is
disregarded under the interest allocation rules) effectively is
treated as relating to the foreign subsidiary, even though its
assets represent only one-half of the group's assets. There is
absolutely no economic basis for this result -it is an obvious
distortion.
By disregarding the interest expense of the foreign members
of a multinational 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 multinational 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. This reduction in the
foreign tax credit limitation has the effect of reducing the
amount of the group's foreign taxes that can be used to offset
its potential U.S. tax liability on its foreign-source income.
Of course, the U.S. interest expense that is allocated to
foreign assets under the interest allocation rules is not
deductible for foreign tax purposes and therefore such
allocation does not result in any reduction in the foreign
taxes the multinational group actually pays. The allocation
merely reduces the amount of such taxes paid that may be used
as a credit against the potential U.S. tax liability with
respect to the same foreign-source income. Thus, the ultimate
result of the distortion caused by the present-law interest
allocation rules is double taxation of the foreign income
earned by the U.S. multinational group.
The double taxation that results from the present-law
interest allocation rules represents a significant cost for
U.S.-based multinationals, a cost not borne by their foreign
competitors. This increased cost makes it more difficult for
U.S. multinationals to compete in the global marketplace. When
a U.S. multinational considers a foreign expansion or
acquisition, it must factor into its projections the fact that
the additional foreign asset will result in an additional
allocation to foreign-source income of the interest expense
incurred by the multinational group in the United States. An
additional allocation will result as the expansion or
acquisition generates earnings even if the expansion or
acquisition is fully supported by borrowing incurred outside
the United States. The resulting additional allocation of U.S.
interest expense will exacerbate the double taxation to which
the U.S.-based multinational is subject. A foreign-based
corporation considering the same expansion or acquisition can
do so without this cost that arises from the distortion in the
U.S. tax rules.
Not only do the interest allocation rules impose a cost
that makes it more difficult for U.S. multinationals to compete
with their foreign counterparts with respect to foreign
operations, the rules actually operate to put U.S.
multinationals at a competitive disadvantage with respect to
investments in the United States. This impact of the interest
allocation rules is especially troubling. When a U.S.-based
multinational makes an additional investment in the United
States and finances that investment with debt, a portion of the
interest expense incurred with respect to that debt is treated
as relating to its foreign subsidiaries, even if the foreign
subsidiaries are themselves leveraged to the same extent as the
U.S. members of the group. Thus, the U.S. multinational
effectively is denied a deduction for a portion of the interest
expense on the additional debt incurred to fund the U.S.
acquisition. A foreign corporation that makes the same
acquisition in the United States and finances it with the same
amount of debt will not be impacted by these interest
allocation rules and will be entitled to a deduction for U.S.
tax purposes for the full amount of the interest expense
related to the acquisition. Thus, the foreign corporation
considering an investment in the United States will face lower
costs than a U.S.-based multinational considering the same
investment in the United States.
IV. Proposed Reform of the Interest Allocation Rules
The interest allocation rules enacted with the Tax Reform
Act of 1986 were intended to eliminate the potential for
manipulation that arose under the then-applicable separate
company approach to interest allocation. The 1986 Act rules
requiring interest to be allocated on a group basis addressed
that concern. However, by drawing the line for interest
allocation at the water's-edge and ignoring the interest
expense incurred by the foreign members of a U.S. multinational
group, the present-law rules create a fundamental distortion.
There is no tax policy rationale that supports the distortion
caused by the present-law rules. The interest allocation rules
must be reformed to eliminate these distortions and to reflect
a defensible result from a tax policy perspective. Eliminating
such distortions will remove a significant barrier to the
competitiveness of U.S. multinationals in the global
marketplace.
First, interest expense should be allocated consistent with
the actual economics of the debt structure of the U.S.
multinational group. In order to accurately reflect the
principle of fungibility, such principle must be applied on a
worldwide basis. Under a worldwide fungibility approach, the
foreign-source income of the U.S. multinational group generally
would be determined by allocating all interest expense of the
worldwide affiliated group on a group-wide basis. The interest
allocation computation would take into account both the
interest expense of the foreign members of the affiliated group
and the assets of such members. Interest expense incurred by a
foreign subsidiary thus would reduce the amount of the U.S.
interest expense that would be allocated to foreign-source
income. This approach would eliminate the double-counting of
the amount of interest expense treated as the cost of holding
the assets of a foreign subsidiary that occurs under the
present-law rules.
Moreover, interest expense should be more specifically
allocated where the debt does not fund the entire multinational
group. In other words, the principle of fungibility should be
applied to a smaller group of companies in cases where the debt
is incurred by (and based on the credit of) a member other than
the common parent. While debt incurred by one lower-tier member
of an affiliated group may be viewed as funding the assets and
activities of that corporation and its subsidiaries, such debt
does not fund the assets and activities of other members of the
group (such as the parent or sister corporations of the
borrowing corporation). Thus, it is appropriate to permit the
interest expense associated with such debt to be allocated
based solely on the assets of the subgroup of corporations that
consists of the borrower and its subsidiaries.
Finally, it is appropriate to separate financial services
entities -which tend to have debt structures that are very
different from the other members of an affiliated group -for
purposes of the allocation of interest. This treatment of
financial services entities as a separate subgroup is
consistent with the present-law rule treating banks as a
separate subgroup. However, this expansion of the present-law
bank rule recognizes that such treatment should encompass all
financial services entities rather than only entities regulated
as banks.
These important reforms to the interest allocation rules
are embodied in H.R. 2270, the Interest Allocation Reform Act,
which was introduced recently by Representative Portman and
Representative Matsui. The interest allocation rules reflected
in H.R. 2270 eliminate the distortions caused by the present-
law rules, facilitating the operation of the foreign tax credit
to eliminate double taxation of income earned abroad. Enactment
of the reforms reflected in H.R. 2270 is critical to ensuring
the ability of U.S.-based multinationals to compete with their
foreign counterparts, both with respect to operations abroad
and with respect to operations in the United States.
V. Technical Explanation of H.R. 2270
A detailed technical explanation of the provisions of H.R.
2270 is set forth below.
In General
H.R. 2270 would modify the present-law interest allocation
rules of section 864(e) that were enacted by the Tax Reform Act
of 1986. Under the bill's modifications, interest expense
generally would be allocated 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. H.R. 2270 also would allow members engaged in the
active conduct of a financial services business to be treated
as a separate group. Finally, the bill would provide specific
regulatory authority for the direct allocation of interest
expense in other circumstances where such tracing is
appropriate.
Under H.R. 2270, a taxpayer would be able to make a one-
time election to apply the modified rules reflected in the bill
rather than the interest allocation rules of present law. Such
election would be required to be 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.
H.R. 2270 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 H.R. 2270, 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
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 H.R. 2270, 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 group, FSCs would not be included in the expanded
affiliated group.
Subgroup Election
H.R. 2270 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
qualify 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
support) 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
nonqualified. 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 nonqualified 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
nonqualified 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 H.R. 2270, 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.
IV. Conclusion
The present-law interest allocation rules operate to deny
U.S. multinationals foreign tax credits for the taxes they pay
to foreign jurisdictions. The rules thus subject U.S.
multinationals to double taxation of their income earned
abroad. This double taxation represents 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 foreign companies both with respect to foreign
operations and with respect to their operations in the United
States.
H.R. 2270 would reform the interest allocation rules to
eliminate these rules. The interest allocation rules reflected
in H.R. 2270 represent sound tax policy and are consistent with
the goal of eliminating double taxation. Such rules would allow
the foreign tax credit limitation to operate properly. We
respectfully urge the Congress to enact the reforms reflected
in H.R. 2270 in order to eliminate the unfair, anti-
competitive, and indefensible burden that the present-law
interest allocation rules have imposed on U.S. multinationals
for the last thirteen years.
Chairman Archer. Thank you, Mr. Laitinen. Mr. Hamod, you
may proceed.
STATEMENT OF DAVID HAMOD, EXECUTIVE DIRECTOR, SECTION 911
COALITION
Mr. Hamod. Thank you, Mr. Chairman, for the opportunity to
testify today. My name is David Hamod, and I serve as the
Executive Director of the section 911 Coalition. Our Coalition
consists of business organizations, non-profit entities, and
companies that have come together in recent years to call
attention to the importance of the Section 911 foreign earned
income exclusion. The Coalition has some 75 members, including
representatives of the more than 75 American chambers of
commerce around the world and nearly 550 American and
international schools abroad.
On a personal note, Mr. Chairman, Americans around the
world want to thank you for your consistent support for
American communities overseas. No one in Congress during the
past two decades has been a more outspoken advocate for, or
more tenacious defender of, the foreign earned income exclusion
and the jobs that it helps to create here in the United States.
Mr. Chairman, if I were to take this 23-page testimony and
boil it down to just a few words, they would be these:
Americans abroad = U.S. exports = U.S. jobs. Any businessowner
will tell you that to generate business, you have got to put
your sales people into the field. Experience shows that
Americans abroad are the best salesmen and best saleswomen for
U.S. goods and services overseas. They drive U.S. exports,
which, in turn, generate U.S. jobs. We know that Americans
abroad buy American, sell American, specify American, hire
American, and create other business opportunities for Americans
overseas.
Despite the obvious importance of employing Americans
overseas, U.S. tax policy puts American workers abroad and
their employers at a significant competitive disadvantage. The
United States is the only major industrial country in the world
that taxes on the basis of citizenship rather than residence.
Because this U.S. tax policy is out of step with the rest of
the world, American workers are significantly more expensive to
hire than are comparably qualified foreign nationals. As a
result, the trend worldwide is to replace American workers with
less expensive third-country nationals, particularly Europeans.
In the continuing battle for international market share,
Section 911 has proved to be one of the most important weapons
in America's trade arsenal because this exclusion: (1) makes
U.S. citizens working overseas more competitive with foreign
nationals, who pay no tax on their overseas earned income; (2)
makes American companies more competitive in their bids on
overseas projects; and, (3) helps to put Americans into the
field overseas where they promote U.S. goods and services and
create hundreds of thousands of jobs here in the United States.
In 1995, the section 911 Coalition commissioned two
independent studies that reinforced the long-held view that
section 911 is especially important to the little guy overseas:
small and medium-sized companies, American educators, clergy,
NGOs and others. Summaries of these studies are attached to
this testimony, but two key points bear repeating this
afternoon. First, nearly two-thirds of small and large
companies said their competitive advantage would improve if the
exclusion were increased from $70,000 to at least $100,000 back
in 1995.
Second, without Section 911, there would be a decline in
U.S. exports of almost 2 percent. This translates into $8.7
billion in lost exports and a loss of upward of 150,000 direct
U.S.-based jobs. These figures do not include service-related
jobs or indirect employment, which would probably double the
number of jobs lost.
Mr. Chairman, I have good news and I have bad news. First,
the good news is that 2 years ago, under your leadership, the
Ways and Means Committee and Congress helped to temporarily
shore up Section 911 through the Taxpayer Relief Act of 1997.
The bad news, as this chart illustrates, is that the
Section 911 exclusion continues to lose ground. According to
Pricewaterhouse-
Coopers, the 1999 exclusion amount in real dollars is 45
percent below its level in 1983, when the exclusion topped out
at $80,000. The real value of the exclusion is projected to
continue falling after 1999 and is expected to stabilize in the
year 2007 at approximately $65,150 in 1999 dollars.
Looked at from a purchasing power point of view, the value
of the exclusion will have plummeted in real dollars from
$134,197 back in 1983 to $65,150 in 2007, a devastating loss of
nearly $70,000 in 1999 dollars. The exclusion was $80,000 in
1983; it will again be $80,000 in 2008, 25 years later. And as
we all know, Mr. Chairman, $80,000 today doesn't buy what it
did a quarter-century ago.
In the long-run, Congress should remove the limitation on
the Section 911 exclusion. But in the short-term, the Coalition
is proposing an interim step designed to restore value to the
exclusion that has been eroded over the years as a result of
inflation. We recommend that the foreign earned income
exclusion be adjusted, beginning in calendar year 2000, to
compensate for the effects of inflation since 1983, when the
exclusion was frozen at $80,000. This indexation would help to
stop the deterioration of Section 911 and it would also be
consistent with the inflation adjustments made in many other
dollar amounts in the individual income tax system.
In conclusion, Mr. Chairman, as you yourself have said, our
work is not yet done. We hope that the Committee will look
favorably upon our proposal. It represents a small investment
that we believe will position the United States to compete in
the 21st century and yield billions of dollars worth of
dividends to the U.S. economy in the years ahead. Thank you,
Mr. Chairman, for the opportunity to testify today.
[The prepared statement follows:]
Statement of David Hamod, Executive Director, Section 911 Coalition
Thank you, Mr. Chairman, for the opportunity to testify
today. My name is David Hamod, and I serve as Executive
Director of the Section 911 Coalition. Our coalition consists
of business organizations, non-profit entities, and companies
that have come together in recent years to call attention to
the importance of the Section 911 foreign earned income
exclusion. The Coalition has some 75 members, including
representatives of more than 75 American chambers of commerce
overseas and nearly 550 American and international schools
abroad. (A list of Section 911 Coalition members is attached to
this testimony as Appendix A.)
In recent years, the stock market notwithstanding, exports
have been the most impressive engine of growth for America's
economy. It goes without saying that exports don't just happen
by themselves. Independent studies and raw statistical data
show a direct correlation between the number of Americans
working overseas and the level of U.S. exports. Any business
owner will tell you that to generate business, you've got to
put your sales people in the field. Experience shows that
Americans abroad are the best salesmen and saleswomen for U.S.
goods and services overseas. The bottom line, Mr. Chairman, is
this:
Americans Abroad = U.S. Exports = U.S. Jobs.
In the ongoing battle for international market share, the
Section 911 exclusion has proved to be one of the most
important weapons in America's trade arsenal. By helping to
maintain U.S. citizens ``in the field'' around the world, where
they promote America's national interests on a daily basis,
Section 911 has had a direct impact on the competitiveness of
American workers and U.S. companies operating in foreign
markets.
Two years ago, the Ways and Means Committee responded very
positively to an initiative by Americans worldwide to increase
the foreign earned income exclusion. Under your leadership, Mr.
Chairman, the Committee (and ultimately, Congress) increased
Section 911 by $2,000 per year, leveling off at $80,000 in
calendar year 2002. Beginning in calendar year 2008, the
$80,000 exclusion will also be adjusted for inflation for 2008
and subsequent years.
We are very grateful for this increase, which has helped to
shore up temporarily the backsliding that the foreign earned
income exclusion has experienced for more than a decade. But as
you have said yourself, Mr. Chairman, our work is not yet done.
The changes of two years ago represent an important step in the
right direction, but U.S. companies overseas and American
workers abroad must continue to make their case to Congress to
level the international business playing field for the United
States.
Even with the positive changes enacted under the Taxpayer
Relief Act of 1997, the Section 911 exclusion continues to lose
ground. According to Pricewaterhouse-
Coopers LLP, the 1999 exclusion amount, in real dollars, is 45
percent below its level in 1983 ($80,000 in nominal dollars and
$134,197 in 1999 dollars), following passage of the Economic
Recovery Tax Act of 1981. The real value of the exclusion is
projected to continue falling after 1999 and is expected to
stabilize in the year 2007 at approximately $65,150 in 1999
dollars. Looked at from a ``purchasing power'' point of view,
the value of the exclusion will have plummeted in real dollars
from $134,197 (1983) to $65,150 (2007), a devastating loss of
nearly $70,000 in 1999 dollars. Under these circumstances, Mr.
Chairman, the Section 911 Coalition is very concerned about
``locking in'' indexation of the exclusion at an unacceptable
level from the year 2008 onwards. (A copy of the June 28, 1999
report by PricewaterhouseCoopers LLP--The Effect of Inflation
on the Foreign Earned Income Exclusion Amount--is attached to
this testimony as Appendix B.)
Ideally, Congress should remove the limitations on the
Section 911 exclusion in order to give American workers an
equal footing in the global marketplace. None of America's
major trade competitors tax foreign earned income, and the U.S.
should also move to an unlimited exclusion. (The only countries
that tax on the basis of citizenship rather than residence,
like the United States, appear to be Bulgaria, Gabon, Honduras,
Indonesia, Jamaica, Kenya, Korea, Philippines, Senegal, and
Zambia.) Reinstating the unlimited exclusion today would be a
forward-looking measure and would do more to move the United
States toward a consistent foreign trade surplus than would
many other proposals under consideration by Congress.
We realize, however, that removing the cap on the foreign
earned income exclusion may not be possible at a time when
Congress is grappling with so many major budgetary
considerations. This is especially true because under the
current revenue estimating procedure, the unlimited exclusion,
in the short-term, would somewhat curtail tax revenues. Our
Coalition would argue, however, that in the medium-term and
long-term, net revenue gains would be substantial and would
more than compensate for short-term losses.
With this in mind, Mr. Chairman, the Section 911 Coalition
proposes an interim measure for the Committee's consideration.
This step is designed to restore value to the exclusion that
has been eroded over the years as a result of inflation.
We propose that the foreign earned income exclusion be
adjusted, beginning in calendar year 2000, to compensate for
the effects of inflation since 1983, when the Deficit Reduction
Act of 1984 froze the exclusion at $80,000. This indexation
would help to stop the deterioration of Section 911, and it
would also be consistent with the inflation adjustments made in
many other dollar amounts in the individual income tax system--
the standard deduction, personal exemption, tax bracket
amounts, earned income credit, phase-out of itemized deductions
and personal exemptions, and so on.
Enactment of this measure would represent an important step
forward for U.S. companies and American workers overseas. Our
Coalition believes that by making American workers more
affordable in the global marketplace, Congress would pave the
way for more U.S. citizens overseas to buy American, sell
American, specify American, hire American, and create
opportunities for other Americans abroad. In short, this
measure represents a relatively small investment that will
position the United States to compete in the twenty-first
century and yield billions of dollars worth of dividends to the
U.S. economy in the years ahead.
1. Section 911: The Big Picture
Section 911 provides for a foreign earned income exclusion
of up to $74,000 annually to Americans working overseas,
thereby assisting them to compete against comparably qualified
non-Americans (who pay no taxes on income earned abroad). A
U.S. citizen or resident alien whose tax home is outside the
United States and who is a bona fide resident of a foreign
country or who is present in a foreign country for 11 months
out of 12 (330 days in any 365 day period) may exclude from
gross income up to $74,000 per year of foreign earned income,
plus a housing cost amount.
The foreign earned income exclusion has been part of the
Internal Revenue Code since 1926, when it was unlimited for
bona fide residents of a foreign country. (For a short history
of the foreign earned income exclusion, see Appendix C.)
Congress enacted the exclusion more than 70 years ago in an
effort to ``encourage citizens to go abroad and to place them
in an equal position with citizens of other countries going
abroad who are not taxed by their own countries.'' (Senate
Report No. 781, 82nd Congress, 1st Session, 1951, pp. 52-53.)
America's trade competitors realized long ago that
encouraging their citizens to work overseas has a pronounced,
salutary impact on their domestic economies. Sending their
workers abroad has become an integral part of these nations'
export strategies. To facilitate this ``export'' of their
citizens (and thus the export of products and services), other
governments do not tax their citizens on the money they make
while working abroad. This makes these citizens extremely
competitive in foreign markets.
U.S. Government tax policies, by contrast, have generally
discouraged Americans from working abroad. Alone among the
world's industrialized nations, the United States still taxes
its citizens on the basis of citizenship rather than residence.
Further, overseas Americans must also pay U.S. income tax on
benefits, allowances, and overseas adjustments. The practical
effects of this tax policy are clear: Americans overseas are at
a significant competitive disadvantage and are being priced out
of foreign markets because prospective employers must provide
more income to compensate American workers for these additional
tax burdens.
Overseas employers are faced with a choice: They must pay
an American worker more than they would pay other comparably
qualified nationals (so that the American may keep a comparable
after-tax income) or they must utilize a tax equalization
program to keep the employee whole for his or her additional
tax burden. Both approaches involve additional costs to the
employer--a burden that many employers are unwilling to accept
even if the American worker is more productive and has better
professional qualifications than the competition.
For those companies that have a tax equalization program in
place, where the company pays any actual taxes for its overseas
employees, the Section 911 exclusion helps to mitigate the tax
burden mentioned above--thereby cutting company costs and
enabling it to be more competitive abroad. For companies that
do not utilize a tax equalization program--and most small and
medium-sized companies working overseas fall into this
category--the Section 911 exclusion is most helpful to the
employee, who is responsible for paying his own taxes. The
current exclusion helps to make a difference in both cases, but
the difference may still not be substantial enough to enable an
American worker overseas to defend his or her job against
foreign nationals.
The cost of hiring or maintaining an American worker is
inordinately high because non-salary, quality-of-life items
must be included in the worker's taxable income, often adding
as much as 50 -100 percent of base pay. Such ``income''
includes reimbursement for the cost of children's schooling,
cost-of-living allowances, home leave, emergency travel, and
other necessary and often expensive aspects of living overseas.
Because so many overseas contracts today are decided on the
basis of cost, and when companies' profit margins grow tighter
and tighter, many employers (including American employers)
simply aren't prepared to cover the additional tax burden to
``Hire American.''
A Section 911 Coalition member offered this case in point:
A large American company recently won a multi-billion dollar,
multi-year overseas contract to supply telecommunications
equipment and services. The U.S.-based company would prefer to
have Americans heading its overseas operations but, because the
U.S. tax system effectively prices Americans out of the
international job market, the company tends to hire Europeans
instead. The President of this company's international
operations is British, and his Vice President is Dutch. Not
surprisingly, the Human Resources Director, who answers to the
Vice President, is also from Holland. He has hired
approximately 2,000 technical employees for this project, most
of whom are Dutch. In addition, Volvos were purchased instead
of U.S.-made vehicles because they are considered ``more
suitable'' for the technical employees. If the U.S. tax system
were more like those of America's trade competitors, who
maintain an unlimited foreign earned income exclusion, most of
these 2,000+ jobs would have gone to Americans rather than
Europeans, and a large number of American cars would have been
exported and purchased instead of Volvos.
Section 911 is important because it makes a substantial
difference in our nation's efforts to compete on the
international business playing field. Without this exclusion,
there is good reason to believe that many thousands of
Americans currently overseas would be priced out of the global
marketplace. This would be a devastating blow to America's
national interests because Americans abroad:
Direct business and jobs to the United States;
Carry America's culture and business ethic to other
nations;
Specify and purchase U.S. goods and services for
overseas projects;
Set standards and shape ideas that guide future
policies in the development of infrastructures and economies
overseas.
In addition, for U.S. companies to continue expanding their
market share worldwide, they must think and act globally. To
stay competitive internationally, American managers need the
kind of ``hands on'' experience that can only be gained by
living and working abroad. In recent years, for example, two of
the traditional Big Three automobile companies promoted their
CEOs directly from European positions to corporate
headquarters. This clearly demonstrates recognition by these
companies of the role that international experience plays in
their economic futures.
In short, Mr. Chairman, Section 911 helps to protect
against replacement of Americans abroad by third country
nationals who pay no taxes at all on their overseas income.
Given the tens of thousands of overseas business opportunities
that are of interest to U.S. companies and U.S.-based
institutions each year, increasing the Section 911 exclusion
stands to make a substantial difference for American influence
abroad, U.S. exports, U.S. jobs, and overall American
competitiveness.
2. Who Benefits from Section 911?
The loss of U.S. market share and the cutback in American
jobs overseas represent a setback for American competitiveness.
However, this tells only part of the story. The other part, of
more immediate concern here at home, is the impact felt in
communities all across the United States as jobs created or
sustained by exports would disappear.
All Americans abroad, whatever their background, are
helping to fuel the economy in the United States. By securing
employment overseas, they free up jobs for other Americans back
home, thereby reducing unemployment. They also support the
American economy by repatriating much of their overseas
earnings back to the United States. Most important of all,
perhaps, Americans working overseas serve as the front-line
marketing and sales force for U.S. exports. Unless all
Americans support competitiveness through exports, our nation's
trade deficit will surely continue. I noted earlier that
exports are the engine of growth for the U.S. economy, and it
is generally accepted that small and medium-sized companies
provide the fuel for this engine. When the engine of growth is
stalled out by constrictive U.S. tax laws that are no longer
appropriate, Americans everywhere pay the price.
For years, supporters of Section 911 have emphasized that
the exclusion is especially important to small and medium-sized
companies operating in overseas markets. ``Real world''
experience has borne out that:
(1) Small companies, when trying to gain a foothold
overseas, are more likely than large companies (many with an
established overseas presence already) to draw on U.S.-based
personnel to penetrate foreign markets.
(2) Small and medium-sized companies, because they lack the
world-class name recognition that might provide them with open
access to foreign customers, traditionally rely very heavily on
Americans overseas to specify and purchase their products.
(3) Small and medium-sized companies are, by necessity,
much more sensitive to individual cost elements and the
financial bottom line. Without the $74,000 Section 911
exclusion to help make overseas Americans more competitive with
foreign nationals, relatively few of these small and medium-
sized companies would be able to hire Americans to fill
overseas slots.
In 1995, the Section 911 Coalition commissioned two
independent studies to look at the impact of the foreign earned
income exclusion on U.S. business. (A one-page summary of each
study is attached to this testimony as Appendices D and E.) One
study was conducted by Price Waterhouse LLP (Economic Analysis
of the Foreign Earned Income Exclusion), while the other was
undertaken by professors at The Johns Hopkins University School
of Advanced International Studies--SAIS (The Importance of
Section 911 for U.S. International Competitiveness). Both
studies reinforced the long-held view that Section 911 is
especially important to the ``little guy'' trying to do
business overseas. (This also applies to American schools
abroad, whose efforts to provide educational services overseas
have played an instrumental role in promoting an American
lifestyle and U.S. products.) The studies indicated that:
For small and medium-sized companies (0-500
employees), elimination of the Section 911 exclusion would have
a significant impact on the ability of American workers abroad
to keep their jobs. In a survey conducted by the SAIS
professors for the Section 911 Coalition, nearly two-thirds (64
percent) of small and medium-sized respondents said elimination
of Section 911 would result in a ``moderate'' change (6 to 25
percent) or a ``major'' change (above 25 percent) in their
ability to retain American employees overseas. (In the same
survey, 70 percent of large companies said elimination of
Section 911 would result in some job loss change, and 38
percent said this change would be a moderate or major change.)
For small and medium-sized companies, elimination
of Section 911 would have an even greater impact on prospective
U.S. citizen hires that would be lost or substituted with
foreign nationals. Eighty-five percent of these companies said
elimination of Section 911 would result in a moderate or major
change in their future hiring practices. (For small and medium-
sized companies responding to the survey, 32 percent of their
total overseas employees are U.S. nationals.) Fifty-four
percent of the large companies said elimination of Section 911
would result in a moderate or major change in their future
hiring practices.
For small and medium-sized companies, elimination
of Section 911 would have a substantial impact on these
companies' abilities to secure projects or compete abroad.
Eighty-two percent of these companies said the loss of this
exclusion would result in a moderate or major change in their
ability to secure projects or compete abroad. (The equivalent
number for large companies was 64 percent.)
For small and large companies alike, there was
widespread agreement that increasing the exclusion from $70,000
(in 1995) to $100,000 would have a substantive impact on their
ability to secure projects. Sixty-five percent of respondents
said their competitive advantage would improve, with 38 percent
stating that the improvement would be moderate or major.
For small and medium-sized companies, U.S.
nationals employed abroad are far more likely to source their
imports of goods and services from the United States. Eighty-
nine percent of these companies said there is a tendency to
source American, with 76 percent stating that this is a ``large
tendency.'' (The equivalent number for large companies was 77
percent and 46 percent, respectively. This is especially
meaningful because U.S. multinational corporations accounted in
1995 for 58 percent of U.S. exports and that almost half of
that trade was between parent companies and affiliates,
according to the March 1995 ``Survey of Current Business.'')
Seventy-seven percent of all respondents (small and large) made
it clear that U.S. citizens abroad ``Buy American'' and that
more than two-thirds of these found a ``large tendency'' to
source U.S. goods and services.
With regard to compensation levels, the benefits
of Section 911 are more important for lower-paid Americans
abroad (such as employees of small companies, educators, NGOs
and non-profit organizations) than for higher-paid Americans
abroad. If Section 911 had been eliminated in 1993, employers
would have needed to increase compensation by 12.7 percent to
protect the after-tax income of U.S. expatriates at the lower
end of the income scale (base pay of $12,720 per year). At the
other end of the scale, for those with a base pay of $152,640
per year, compensation would have needed to increase by an
average of only 6.8 percent.
This latter finding reinforces a 1993 U.S. Treasury
Department study which noted that Section 911 is an important
mechanism for mitigating the tax liability of lower income
taxpayers working abroad. (U.S. Department of the Treasury,
Taxation of Americans Working Overseas--Operation of the
Foreign Earned Income Exclusion in 1987, January 1993.) These
facts do not support the negative ``spin'' that some would put
on the foreign earned income exclusion--the wrongheaded
suggestion that the exclusion benefits only the so-called
corporate ``fat cats.''
It is also important to note, however, that more senior
(and consequently more expensive) managers working overseas
tend to be best positioned to benefit the U.S. economy most.
The senior managers are more likely to influence the buying and
hiring decisions of their company, and they are also more
likely to assist other U.S. companies trying to do business
abroad. In addition, they are the ones most apt to gain the
international experience required by future senior executives
for American companies looking to compete successfully in the
increasingly global economy.
Nevertheless, it is often very difficult to persuade key
employees to adjust their career paths and family situations by
leaving corporate headquarters and the United States. And from
the companies' perspective, despite the many advantages of
hiring American peak performers to head overseas offices,
current tax policies tend to make this option prohibitively
expensive.
3. Nuts and Bolts: How Section 911 Works
The cost of hiring an American varies widely around the
world depending on such factors as local housing costs, local
standards of living, availability of schools and recreation
facilities, remoteness and hardships, and so forth.
Nevertheless, it may be instructive to look at a typical
example of how the foreign earned income exclusion works. The
American Business Council of the Gulf Countries, an Executive
Committee member of the Section 911 Coalition, provided the
following example.
The cost for a grade school student to attend the American
School in Dubai is approximately $10,000 per year--not for an
exclusive private school, but for the only American curriculum
school there. If an employer reimburses this cost for two
children, the employee has an additional $20,000 of imputed
taxable ``income.'' This places an additional tax burden on the
individual of up to $8,000.
If the employer chooses to make the reimbursement of this
schooling cost tax-neutral to the employee, the total
reimbursement cost to the company could exceed $33,000
(including the compounding effect of tax reimbursements, which
are also considered taxable ``income'' to the employee). This
represents a $13,000 (65 percent) additional cost to the
company to provide education for the American employee's
children (compared to providing the same education for children
of a comparable European employee)--simply because of U.S. tax
policy.
If the employer provides an annual trip back to the United
States for home leave for the employee and family (spouse and
two children), the employee has an additional $10,000 or more
of taxable ``income.'' Emergency and sympathy travel generate
taxable income; cost of living adjustments are considered
taxable income; hardship allowances are taxable income; tax
reimbursement is taxable income.
In other words, as this typical example shows, taxable
compensation that does not represent either ``perks'' or
disposable income to the employee typically absorbs a very
large part of the current $74,000 exclusion. This is a burden
borne solely by Americans, significantly hampering their
ability to compete in the international arena.
The National Constructors Association, another member of
the Coalition's Executive Committee, asked one of its member
companies in recent years to compare the annual costs of
employing an engineer with and without the benefit of Section
911. The results of this comparison are striking:
----------------------------------------------------------------------------------------------------------------
Saudi
Hong Kong United Kingdom Arabia Chile
----------------------------------------------------------------------------------------------------------------
Engineer's Base Pay...................................... $112,800 $100,000 $121,824 $100,000
Tax Cost to Company with 911 Exclusion.................. $11,743 $34,275 $11,433 $4,843
Tax Cost to Company without 911 Exclusion............... $103,513 $51,151 $66,019 $27,413
Increased Tax Cost to Company............................ $91,770 $16,876* $54,586 $22,570*
----------------------------------------------------------------------------------------------------------------
* In high tax countries, these savings may not be typical but may be realized in certain dual-contract
situations. It should also be noted that the tax burden shown above includes taxes on allowances.
While the Section 911 exclusion is particularly helpful in
low-tax foreign jurisdictions like Saudi Arabia and Hong Kong,
it can also make a very substantial difference in those nations
with relatively high levels of individual income tax. Filings
of Internal Revenue Service Form 2555 provide an adequate
measure of those Americans abroad utilizing the Section 911
exclusion. According to IRS figures, nearly two-thirds (61.8
percent) of Forms 2555 filed in 1987 were submitted by
Americans in just 15 nations. (Internal Revenue Service, SOI
Bulletin, Winter 1992-93, p. 86.) The vast majority of these
nations--led by Germany and the United Kingdom, with Canada and
Japan not far behind--are considered relatively high-tax
jurisdictions. This was consistent with the 1995 Price
Waterhouse LLP findings which note that, absent Section 911,
required compensation would increase by an average of 8.6
percent in Australia, 8.0 percent in Japan, 5.4 percent in
Switzerland, 4.5 percent in France, 3.3 percent in Canada, and
3.1 percent in Germany (In Economic Analysis of the Foreign
Earned Income Exclusion, Price Waterhouse LLP calculated the
average change in compensation required if Section 911 were
repealed for all expatriates at all income levels in each of
the 15 nations.)
According to the Price Waterhouse LLP study, Section 911
can be beneficial in high-tax countries for a number of often
overlooked reasons, including:
Countries with very high statutory rates may have
generous deductions and exclusions that result in relatively
low tax liability, particularly for taxpayers at modest income
levels;
International assignments often begin or end at mid-
year, resulting in little foreign income tax liability in the
year of assignment and/or return;
Unlike the foreign tax credit, Section 911 may cause
U.S. source income of Americans working abroad to be taxed in
lower U.S. income tax brackets.
In short, no matter where in the world U.S. companies and
American citizens work, the Section 911 exclusion can make a
substantial difference for U.S. competitiveness.
4. Voices from Abroad: Americans Speak Out on Section 911
By their very presence overseas, U.S. citizens help to
promote America's national interests. This is true of all
Americans abroad--whether they are representatives of major
U.S. corporations, cultural or religious institutions, service
providers, educators, entrepreneurs, heads of charitable
organizations, or homemakers. Americans abroad foster a
positive image of the United States throughout the world while
also contributing to our nation's economic and cultural well-
being at home.
Based on 1995 survey feedback received by professors at The
Johns Hopkins University (SAIS), Americans who use the foreign
earned income exclusion come from all walks of life and can be
found in all parts of the globe. From these expatriates'
comments, a sampling of which are provided below, it is also
clear that Section 911 makes a substantial difference in the
lives of Americans abroad.
``When I first arrived here, Americans from our firm in the
U.S. totaled 90 percent of our professional staff. As time
progressed, because of the high cost of the tax equalization
program, we first changed to hiring local Americans [those not
recruited from the United States] and some foreign nationals.
Each year as the cost of Americans increased (the reduction to
$70,000 exclusion really hurt) we have slowly reduced our
American percentage to today's 28 percent. These professionals
not only 'buy American' for our company needs, but as
consultants to local businesses also recommend American
products to foreign companies. Without U.S. taxes overseas, we
would double the number of Americans employed.''
``In 1988 when I joined [Company X] our U.S. imports were 0.
Since starting our major import program in 1991 we are now
(1994) importing over 120 containers of U.S. product annually
plus air freight delivery of U.S. produce and beef on a weekly
basis.''
``Without the tax exclusion, we would not be able to attract
U.S. citizens to work at our school and they would be replaced
by locally hired Mexican nationals. U.S. textbooks and supplies
would probably be discontinued and Spanish materials would be
used in their place.''
``It becomes very obvious to me around October of each year
when the physicians submit their budget requests to me how
nationality affects one's thinking. The American (or American
trained) physicians will request U.S. manufactured supplies,
equipment and pharmaceutical items. Likewise the Germans,
British and French physicians request those that they are more
familiar with.''
``As we are strictly tuition based, an increase in personnel
costs is directly reflected in the cost of tuition. In the past
we have chosen to hire less expensive teachers from other
countries. If we raise tuition, many companies will not send
families to Korea. American businesses need a high quality
school in Seoul in order to convince their best people to come.
Were we to lose our Section 911 it would have a serious impact
on the competitiveness of other American businesses in Korea.''
``If the exclusion is lost, the company will probably lose
the American management it prides itself on and turn to Saudis
or British nationals. If this happens, the odds of Americans
ever working for this company again will be nil.''
``Under [President] Carter, the tax exclusion was eliminated,
U.S. companies pulled out of many foreign locations (or greatly
reduced their expatriate contingent) and U.S. overseas schools
suffered tremendous enrollment/revenue losses. The losses were
compensated by increasing host country populations in the
schools, an effect which is still felt today, particularly in
Latin America.''
``We constantly hear it clearly stated by business people
here that they would not be here if they did not have access to
an American educational program. During the last draw down of
the exclusion in the late seventies, the availability of
teachers willing to come overseas to work dropped
significantly. They saw no advantage to being overseas.''
``Elimination of the Section 911 exclusion and even the
current limitation dictates that we recruit on a cost-effective
basis; i.e., lower cost nationalities due to tax advantages.
This will be particularly true for our smelter project in
[country X] which requires an expatriate staff of about 185.
Projections are that between 60-80 percent will be TCNs [third-
country nationals].''
``Administering an overseas school in 1980 in Bangladesh when
the foreign earned income exclusion was taken away, I observed
first hand the impact on American business, especially on the
construction industry. I was building a new school at the time
for $4,000,000, half of which was financed by the U.S.
government. There were 2 bidders: a U.S. company and a Korean
company. The Americans lost the contract on price, and the
difference was the tax on U.S. personnel! . . . It was proven
back then that abolishing the 911 exemption cost money: it
didn't gain a dime. Have we learned nothing from experience? ''
The Section 911 Coalition believes that having Americans
overseas is not just helpful, it is essential. In effect,
taxation of foreign earned income amounts to a shortsighted,
indirect tax on U.S. exports and American culture. This is a
debilitating and entirely self-inflicted wound--a policy which
discriminates against America's companies, U.S. workers, and
American educational institutions abroad.
5. Tax Policy Implications of Section 911
The concept of a foreign earned income exclusion has been
part of U.S. tax law for more than 70 years. During that time,
the exclusion has undergone a number of configurations. The
debate over whether to increase Section 911, decrease Section
911, or maintain it at current levels centers on an evaluation
of basic tax policy rationale for and implications of such an
exclusion.
The results of the 1995 Price Waterhouse LLP study suggest
that the traditional standards for evaluating income tax
provisions--fairness and economic efficiency--justify exclusion
of the portion of foreign earned income attributable to the
additional costs of living abroad. The Section 911 exclusion is
an approximate method for meeting the equity and efficiency
standards and also satisfies a third tax policy objective:
simplicity.
Fairness--Price Waterhouse LLP noted that the concept of
``ability to pay'' taxes is inherently subjective, but that it
has generally been recognized that an individual's costs
associated with earning income reduce the ability to pay taxes
and should be deducted. By this logic, individuals on
international assignment should not be taxed on that part of
their compensation which reasonably reflects the added costs of
working abroad (extra housing costs, the education of children,
home leave, cost-of-living adjustments, etc.).
Economic Efficiency--This standard dictates that the tax
law not interfere with the efficient allocation of resources.
Economic efficiency suggests that in foreign markets, American
workers should be allowed to compete according to prevailing
rules. Absent Section 911, Price Waterhouse LLP found, the tax
law would frequently discourage U.S. companies from hiring
Americans in overseas positions, causing foreign nationals to
be hired even where Americans would, but for taxes, be
preferred.
Simplicity--By all accounts, the Section 911 exclusion
simplifies deductions revolving around doing business overseas,
especially when compared to the 1978 rules that the current
exclusion replaced.
Three additional tax policy standards are often used to
evaluate U.S. tax provisions that affect international income:
competitiveness, harmonization, and protection of the U.S. tax
base. Once again, Price Waterhouse LLP found that the Section
911 exclusion clearly meets these standards.
International competitiveness--This standard requires that
U.S. capital and labor employed in foreign markets bear the
same tax burden as foreign capital and labor in those markets.
Price Waterhouse LLP noted that for Americans abroad,
``the competitiveness standard would be achieved if the
United States excluded all foreign earned income without the
$70,000 limitation in present law. In this way, Americans
working abroad would be subject only to foreign income taxes on
their foreign earned income in exactly the same manner as
foreign workers are taxed.''
Harmonization--Price Waterhouse LLP pointed out that
Section 911 provides a ``glaring example of the failure on the
part of the United States to harmonize with international tax
practice. As noted by the General Accounting Office, the United
States is the only major industrial power that taxes its
individuals on the basis of citizenship rather than residence.
In today's global economy . . . the failure of the United
States to harmonize the tax treatment of expatriate workers
means that U.S. citizens are more expensive to employ abroad
than citizens of many other industrial nations. In summary, the
principle of tax harmonization strongly argues for complete
exclusion of foreign earned income'' as was the case in the
United States during the period 1926-1952.
Protecting the U.S. Tax Base--This standard is intended to
prevent U.S. source income from escaping the income tax net.
The Section 911 exclusion does not undermine the U.S. tax base
because the exclusion has been carefully designed to prevent
U.S. source income from escaping U.S. taxation.
In summary, according to the Price Waterhouse LLP study,
``an unlimited foreign earned income exclusion would be
consistent with the international tax policy standards of
competitiveness, preservation of the U.S. tax base, and
harmonization. Thus it would be appropriate to lift the . . .
cap on the foreign earned income exclusion to better achieve
these tax policy objectives.''
6. Conclusion: Increasing Section 911 = Increasing Business and Jobs
As I noted at the outset of my remarks today, Americans
Abroad = U.S. Exports = U.S. Jobs. Perhaps more than any other
provision of law, Section 911 helps to put U.S. citizens ``in
the field'' around the world where they buy American, sell
American, specify American, hire American, and create
opportunities for other Americans. As such, Section 911 has a
direct impact on the competitiveness of American workers and
U.S. companies operating in foreign markets--a substantial
growth area for the United States as we move into the twenty-
first century.
To help place America on a more level footing with our
trade competitors, the Section 911 Coalition encourages
Congress to adjust the foreign earned income exclusion,
beginning in calendar year 2000, to compensate for the effects
of inflation since 1983, when the exclusion was frozen at
$80,000. This will not make American workers and companies as
competitive as an unlimited exclusion would, but it is
certainly an important step in the right direction. U.S.-based
jobs are on the line, especially for small and medium-sized
businesses, and we look forward to an opportunity to work with
the Ways and Means Committee to strengthen Section 911 -an
unheralded but vital part of the U.S. tax code.
Thank you, Mr. Chairman, for the opportunity to testify
today. I would be pleased to answer any questions that you or
the Committee might have.
APPENDIX A
Section 911 Coalition Members
American Business Council of the Gulf Countries
American Citizens Abroad
American Consulting Engineers Council
American Express
American Institute of Architects
American International School of Budapest
Asia Pacific Council of American Chambers of Commerce
Ass'n of American Chambers of Commerce in Latin America
Association of Americans Resident Overseas
BDM International, Inc.
Baker Hughes, Inc.
Bechtel Group, Inc.
Booz-Allen & Hamilton Arabia
Brown and Root/Halliburton
COLSA International
CRSS--Metcalf & Eddy Joint Venture
Caltex Petroleum Corporation
Caterpillar, Inc.
Chicago Bridge & Iron Company
Chrysler Technologies Corp.--Middle East Ltd.
Coalition for Employment through Exports, Inc.
Coopers & Lybrand L.L.P.
Culligan Italiana SpA
Cummins Engine Company, Inc.
Deloitte & Touche LLP
Democrats Abroad
Dillingham Construction International, Inc.
Dresser Industries, Inc.
Economic Strategy Institute Employee Relocation Council
European Council of American Chambers of Commerce
FMC Arabia Ltd.
Federated League of Americans Around the Globe
Federation of American Women's Clubs Overseas
Fluor Corporation
Foster Wheeler
Hoechst Celanese Corporation
Hughes Saudi Arabia Ltd.
Intercom International Consultants
Int'l Engineering & Construction Industries Council
International School of Islamabad
International School of Tanganyika
International Schools Services
J.A. Jones Construction
John Brown Constructors
Juraid & Company
Lockheed Middle East Services
Loral Corporation
M.W. Kellogg Company
Mansour General Dynamics Ltd.
McDonnell Douglas Middle East Ltd.
Middle East Policy Council
National Constructors Association
Occidental Petroleum Corporation
Oracle Corporation
Parsons Brinckerhoff
Parsons Corporation
Republicans Abroad
Saudi American Bank
Saudi Arabian International School--Dhahran
Saudi Arabian International School--Riyadh
Science Applications International Corporation
Small Business Exporters Association
Sogerep, Ltd.
Stafford & Paulsworth
Stone & Webster, Inc.
U.S. Chamber of Commerce
United Technologies
Unocal Corporation
Verdala International Schools
Vinnell Corporation--Saudi Arabia
Vinnell Corporation--U.S.A.
Westinghouse Electric Corporation
World Federation of Americans Abroad
APPENDIX B
The Effect of Inflation on the Foreign Earned Income Exclusion Amount
Introduction
This report updates information on the effect of inflation
on the real value of the foreign earned income exclusion
amount, which was originally included in an October 1995 report
(entitled Economic Analysis of the Foreign Earned Income
Exclusion) prepared by Price Waterhouse LLP for The Section 911
Coalition.
Under the provisions of Section 911 of the Internal Revenue
Code, a U.S. citizen or resident alien whose tax home is
outside the United States, and who meets a foreign residence or
foreign presence test, may exclude from gross income in 1999 up
to $74,000 per year of foreign earned income plus a housing
cost amount. Historically, the principal rationale for the
exclusion has been to make the tax treatment of Americans
working abroad more competitive with that of foreign nationals
and, thereby, to promote exports of U.S. goods and services.
History of the Foreign Earned Income Exclusion
The foreign earned income exclusion originally was enacted
in 1926 to help promote U.S. exports. From 1926 to 1952, the
exclusion was unlimited, corresponding to the present day
practice of other major industrial countries. From 1953 to
1977, the exclusion was limited to $20,000 per year; however,
for Americans working abroad for more than three years, the
exclusion was increased to $35,000 from 1962 to 1964 and
subsequently reduced to $25,000 from 1965 to 1977.
In 1978, the Foreign Earned Income Act replaced the Section
911 exclusion with Section 913, a series of deductions for
certain excess costs of living abroad.
The Economic Recovery Tax Act of 1981 restored Section 911
and increased the exclusion to $75,000 in 1982 with scheduled
increases to $95,000 in 1986. The legislative history indicates
that Congress was concerned that the rules enacted in 1978 made
it more expensive to hire Americans abroad compared to foreign
nationals, reduced U.S. exports, rendered the United States
less competitive abroad, and due to the complexity, the new
rules required many Americans employed abroad to use
professional tax preparers.
Among a number of other deficit reduction measures, the
Deficit Reduction Act of 1984 delayed the scheduled increases
in the foreign earned income exclusion, freezing the benefit at
$80,000 through 1987. The Tax Reform Act of 1986 reduced the
exclusion to $70,000 beginning in 1987. The exclusion remained
at this level through 1997.
Present Law
The Taxpayer Relief Act of 1997 increased the $70,000
exclusion to $80,000 in increments of $2,000 beginning in 1998.
The following table shows the exclusion amounts specified by
the Act.
Table 1.--Present Law Section 911 Exclusion Amounts
------------------------------------------------------------------------
Calendar Year Exclusion Amount
------------------------------------------------------------------------
1998...................................... $72,000
1999...................................... $74,000
2000...................................... $76,000
2001...................................... $78,000
2002-2007................................. $80,000
2008 and thereafter....................... $80,000 adjusted for
inflation
------------------------------------------------------------------------
As noted in the table, beginning in 2008 the $80,000
exclusion for foreign earned income will be adjusted for
inflation. Thus, for any calendar year after 2007, the
exclusion amount will be equal to $80,000 times the cost-of-
living adjustment for that calendar year. The cost-of-living
adjustment will be calculated using the methodology that
adjusts the income brackets in the tax rate schedules (Section
1(f)(3) of the Internal Revenue Code). The Consumer Price Index
for all urban consumers (CPI-U) that is published by the
Department of Labor will be used to determine the adjustment.
Specifically, the cost-of-living adjustment for a calendar year
will equal the CPI-U for the preceding calendar year divided by
the CPI-U for calendar year 2006 (the base year). The Internal
Revenue Code further specifies that, in making this
calculation, the CPI-U for a calendar year is to be calculated
as the average of the CPI-U as of the close of the 12-month
period ending on August 31 of such calendar year. Finally, the
Taxpayer Relief Act of 1997 stipulates that if the adjusted
exclusion amount is not a multiple of $100, then it is to be
rounded to the next lowest multiple of $100.
For this report, we have estimated the inflation-adjusted
exclusion amounts for 2008 and 2009 to be $82,000 and $84,200,
respectively. These estimates assume that the CPI-U will
increase by 2.6 percent annually beginning in calendar year
2000. This assumption is based on the Congressional Budget
Office's (CBO) most recent published economic projections (The
Economic and Budget Outlook: Fiscal Years 2000-2009, January
1999, Table 1.4).
Effect of Inflation
Figure 1 shows the exclusion amount in both nominal and
real (1999) dollars. The nominal dollar line shows the
exclusion amounts specified by legislation. The effect of the
Taxpayer Relief Act of 1997 is shown starting in 1998 when the
exclusion amount begins to increase in $2,000 increments from
the $70,000 amount established by the Tax Reform Act of 1986.
In 2002, the exclusion amount reaches $80,000 and remains at
that level until 2008 when the exclusion amount begins to be
adjusted for inflation.
As illustrated in Figure 1, the real value of the exclusion
has dropped substantially. In real 1999 dollars, the 1999
exclusion amount of $74,000 is 45 percent below its level in
1983 ($134,197 in 1999 dollars) when the nominal dollar amount
of the exclusion ($80,000) reached its highest level after the
1981 Act.
Figure 1 also shows that the real value of the exemption is
projected to continue to fall after 1999, even though the
Taxpayer Relief Act of 1997 eventually will raise the exclusion
amount to $80,000.
The provision to adjust the exclusion amount for inflation
will stabilize the real value of the exclusion amount beginning
in 2008. Based on the CBO's projection that consumer prices
will be 2.5 percent higher in 1999 than they were in 1998 and
that annual price increases will amount to 2.6 percent
thereafter, the value of the exclusion amount will stabilize at
approximately $65,150 in 1999 dollars--an amount that is 12
percent below the current exclusion amount in real terms and 51
percent below the 1983 peak as measured in 1999 dollars.
Conclusion
Since the Section 911 exclusion amount has not been
automatically indexed for inflation in the way that the
Internal Revenue Code adjusts the income tax tables and other
dollar amounts, the real value of the exclusion has dropped
substantially. If the $80,000 exclusion that was in effect in
1983 had been continually adjusted for inflation, the exclusion
would be approximately $134,000 in 1999. Based on current CBO
projections of inflation, the exclusion amount in the year 2000
would be nearly $138,000.
[GRAPHIC] [TIFF OMITTED] T6775.004
APPENDIX C
The Foreign Earned Income Exclusion
A Short History
The foreign earned income exclusion has been part of the
Internal Revenue Code since 1926, when it was unlimited for
bona fide residents of a foreign country. Congress enacted the
exclusion more than 70 years ago in an effort to ``encourage
citizens to go abroad and to place them in an equal position
with citizens of other countries going abroad who are not taxed
by their own countries.'' (Senate Report No. 781, 82nd
Congress, 1st Session, 1951, pp. 52-53.)
Limiting the foreign earned income exclusion is a concept
that goes back to 1953, when Congress first capped the
exclusion. In the immediate aftermath of World War II, there
may have been a good reason for limiting the exclusion.
However, times have changed dramatically since the 1950s, when
the U.S. economy was a global colossus with no serious
competition, and U.S. tax policy has not kept pace with the
changing times.
In 1978, the Foreign Earned Income Act replaced the
exclusion with a series of deductions for certain expenses
associated with living abroad (former Section 913). American
workers and U.S. companies in overseas markets were hit hard by
the 1978 amendments and lost considerable overseas market share
as a result. Recognizing this, Congress in 1981 restored the
flat earned income exclusion (Section 911) at $75,000 per year
for 1982 with scheduled increases to $95,000 in 1986. Noting
that the rules enacted in 1978 reduced exports, Congress in
1981 ``was concerned with the increasing competitive pressures
that American businesses faced abroad. The Congress decided
that in view of the nation's continuing trade deficits, it is
important to allow Americans working overseas to contribute to
the effort to keep American business competitive'' through
Section 911. (Joint Committee on Taxation, General Explanation
of the Economic Recovery Tax Act of 1981, JCS-71-81, December
29, 1981, p. 43.)
The exclusion was revisited in 1984 and 1986. The Deficit
Reduction Act of 1984 delayed the scheduled increases in the
exclusion, freezing the benefit at $80,000 (the 1983 benefit
level) through 1987. The Tax Reform Act of 1986 reduced the
exclusion to $70,000, and it remained at that level through
1997. The Taxpayer Relief Act of 1997 increased the $70,000
exclusion to $80,000 in increments of $2,000 per year,
beginning in 1998. In addition, beginning in the year 2008, the
$80,000 exclusion will be adjusted for inflation.
Because the exclusion has not been adjusted for inflation
over the years, its real value has dropped substantially.
According to a June 28, 1999 report by PricewaterhouseCoopers
LLP, the 1999 exclusion amount, in real dollars, is 45 percent
below its level in 1983, following passage of the Economic
Recovery Tax Act of 1981. (The exclusion in 1983 was $80,000 in
nominal dollars and $134,197 in 1999 dollars.) If the $80,000
exclusion that was in effect in 1983 had been continually
adjusted for inflation, the exclusion would be approximately
$134,000 in 1999, rising to nearly $138,000 in the year 2000.
The real value of the exclusion is projected to continue
falling after 1999 and is expected to stabilize in the year
2007 at approximately $65,150 in 1999 dollars. Looked at from a
``purchasing power'' point of view, the value of the exclusion
will have plummeted in real dollars from $134,197 (1983) to
$65,150 (2007)--a devastating loss of nearly $70,000 in 1999
dollars.
* * * * *
Many Members of Congress serving today were not witness to
the extensive Congressional debates which resulted in the
enactment of the exclusion in 1981. As a result, this short
history should provide some insights into why the exclusion
came about, why it provides a return to the U.S. economy that
far exceeds its estimated revenue losses, and why the Section
911 exclusion has such an impact on U.S. business
competitiveness overseas.
In the 1970s, in an effort to move away from the foreign
earned income exclusion, Congress took steps that proved to be
disastrous. The Tax Reform Act of 1976 generally reduced the
exclusion to $15,000 per year. While this cut in the exclusion
did not take effect in the end, it nevertheless had a
``chilling'' effect on U.S. companies' efforts to send American
workers abroad. A 1978 General Accounting Office (GAO) survey
of 183 U.S. companies found that more than 80 percent of these
companies felt that reducing the exclusion along the lines of
the 1976 Act would result in a reduction of U.S. exports by at
least five percent. (U.S. GAO, Impact on Trade of Changes in
Taxation of U.S. Citizens Employed Overseas, ID-78-13, February
21, 1978.)
Two years after the 1976 Act, the situation went from bad
to worse. The Foreign Earned Income Act of 1978 repealed the
foreign earned income exclusion and put in its place Section
913, composed of five factors: (1) A cost-of-living deduction
based on the differential between U.S. and overseas costs of
living; (2) A housing deduction; (3) A deduction for schooling
expenses where a U.S.-type school was not within a reasonable
commuting distance; (4) A travel expense deduction for an
annual round-trip visit to the United States; 5) A deduction
for work in a hardship area.
The 1978 Act, compared to prior law, represented a 23
percent reduction in the tax benefit of the exclusion. To
determine the impact of this reduction, the GAO conducted a
survey in 1980 of 33 key firms in four industries. The GAO
found that additional costs attributable to the 1978 Act was a
primary reason why these firms had decreased their employment
of Americans abroad. The numbers decreased absolutely from 1979
to 1980 in three of the industries and, during the period 1976
to 1980, the relative number of Americans abroad dropped
compared to third country nationals. (U.S. GAO, American
Employment Abroad Discouraged by U.S. Income Tax Laws, ID-81-
29, February 27, 1981.)
As a result of these findings, the 1981 GAO report produced
the following recommendation:
``We believe that the Congress should consider placing
Americans working abroad on an income tax basis comparable with
that of citizens of competitor countries who generally are not
taxed on their foreign earned income.''
The GAO went on to say that ``complete exclusion or a
limited but generous exclusion of foreign earned income for
qualifying taxpayers . . . would establish a basis of taxation
comparable with that of competitor countries and, at the same
time, be relatively simple to administer.''
Findings in a 1980 report by Chase Econometrics provided
more evidence of the dangers for U.S. competitiveness of
restricting the foreign earned income exclusion. As a result of
the changes in 1976 and 1978, Chase noted, a significant number
of Americans working overseas would be forced to return home.
Chase determined that a ten percent drop in Americans overseas
would lead to a five percent drop in U.S. exports. The study
went on to say that the ``drop in U.S. income due to a five
percent drop in real exports will raise domestic unemployment
by 80,000 [persons] and reduce federal receipts on personal and
corporate income taxes by more than $6 billion, many times the
value of increased taxes on overseas workers.'' (Chase
Econometrics, Economic Impact of Changing Taxation of U.S.
Workers Overseas, June 1980, p. 2.)
The U.S. & Overseas Tax Fairness Committee, an ad hoc group
established in the late 1970s to defend the foreign earned
income exclusion, noted in 1980 that ``of all the current U.S.
disincentives that discourage trade, none is easier to
eliminate than the U.S. practices of taxing foreign earned
income . . . and none will produce faster or more substantial
results for our balance of trade.'' In an effort to show what
damage the 1976 and 1978 Acts had done as of 1980, the
Committee cited the example of the U.S. construction and
engineering industry operating in the Middle East. American
companies in this sector ``had over ten percent of the
construction volume in the Middle East four years ago and now
has less than two percent--almost entirely due to the current
U.S. tax treatment of overseas Americans,'' the Committee
noted, ``and industry is finding it very difficult to recapture
its former standing.'' (U.S. & Overseas Tax Fairness Committee,
Press Release, June 16, 1980.)
* * * * *
The message is as clear today as it was in 1980: Changes in
the foreign earned income exclusion generate a substantial and
direct impact--positive or negative--on the ability of U.S.
companies and American workers to compete in overseas markets.
APPENDIX D
Highlights of the Price Waterhouse Study
``Economic Analysis of the Foreign Earned Income Exclusion''
Price Waterhouse LLP, in a study prepared in 1995 for the
Section 911 Coalition, found that:
The U.S. is the only major industrial country that
does not completely exempt from taxation the foreign earned
income of its citizens working abroad.
Because the Section 911 exclusion is not adjusted
for inflation, its real value has dropped by 43 percent since
1982. If the exclusion had been adjusted for inflation since it
was set at $70,000 in 1987, the exclusion would rise to over
$111,000 in the year 2000. If the exclusion is not indexed for
inflation soon, its value will continue to decline.
Without the Section 911 exclusion, compensation
levels for Americans abroad would need to increase by an
average of 7.19 percent to preserve after-tax income. Section
911 was shown to provide benefits in both low tax and high tax
nations. Moreover, the exclusion represents a larger share of
the compensation of low income than of high income Americans
working abroad.
A 7.19 percent increase in required compensation
would result in a 2.83 percent decrease in Americans working
abroad. Without Section 911, U.S. exports would decline by 1.89
percent or $8.7 billion. This translates into a loss of
approximately 143,000 U.S.-based jobs. [N.B.-These figures do
not include service-related jobs or indirect employment, which
would likely double the number of jobs lost.]
From a tax policy standpoint, the 911 exclusion
meets the traditional standards for evaluating income tax
provisions: Fairness--Absent Section 911, Americans working
abroad would pay much higher taxes than U.S.-based workers with
the same base pay. Economic efficiency--Absent 911, U.S. tax
law would discourage U.S. companies from hiring Americans in
overseas positions, causing foreign nationals to be hired even
where Americans would, but for taxes, be preferred.
Simplicity--The current structure of Section 911 was
specifically enacted by Congress in 1981 in reaction to the
unmanageable complexity of the rules enacted in 1978.
Section 911 also adheres to three additional tax
policy standards often used to evaluate provisions that affect
international income: Competitiveness--The competitiveness
standard, that U.S. capital and labor employed in foreign
markets bear the same tax burden as foreign capital and labor
in those markets, would be achieved if the U.S. excluded all
foreign earned income (without the current cap). Protecting the
U.S. tax base--Section 911 applies only to income that is
earned abroad for activities that are performed abroad by
individuals who are not residents of the USA. Harmonization--
True harmonization with other nations would require an
unlimited exclusion, as was in effect in the USA from 1926 to
1952.
APPENDIX E
Section 911 Survey Results are in
Survey Finds Exclusion is Especially Important to Small & Medium-Sized
Companies
The Section 911 Coalition has announced the findings of its
``American Competitiveness Survey.'' With nearly 150 companies
and associations responding to the survey, it represents the
largest and most broad-based Section 911 survey ever conducted.
The six-page survey examined the importance of the $70,000
foreign earned income exclusion (under Section 911 of the U.S.
Tax Code) and its impact on America's global competitiveness. A
report prepared by economists at the Johns Hopkins University
School of Advanced International Studies, Drs. Charles Pearson
and James Riedel, found that:
The Section 911 exclusion is especially important
to small and medium-sized firms (including International and
American schools abroad), which are at least ten times more
dependent on Section 911 than are the large firms that were
surveyed. Eighty-two percent of small and medium-sized firms
said that a loss of the exclusion would result in a moderate (6
to 25 percent) or major (above 25 percent) change in their
ability to compete abroad.
Nearly two-thirds (65 percent) of respondents felt
that their ability to secure projects and compete abroad would
be improved if the exclusion ($70,000 in 1995) were raised to
$100,000--a long-standing position of Americans resident
overseas.
Americans abroad showed a strong tendency to
source goods and services produced in the United States.
Seventy-seven percent of respondents said that nationality has
an effect on sourcing decisions. Among small and medium-sized
firms, the number is even higher: 89 percent said their
American expatriate employees prefer to Buy American.
Compensation costs are significant in determining
whether or not to hire U.S. nationals overseas, and the Section
911 exclusion is important in holding down compensation costs.
Eighty percent of respondents said elimination of Section 911
would have a moderate or major negative effect on compensation
costs, with 66 percent saying elimination of the exclusion
would have an important negative impact on future hiring
practices.
The survey results strongly suggest that the Section 911
exclusion plays a key role in America's competitiveness and the
creation of U.S. jobs through exports. For further information,
please contact the Section 911 Coalition.
Chairman Archer. Thank you, Mr. Hamod. Mr. Dean, you may
proceed.
STATEMENT OF WARREN L. DEAN, JR., PARTNER, THOMPSON COBURN LLP,
AND REPRESENTATIVE, SUBPART F SHIPPING COALITION
Mr. Dean. Good afternoon, Chairman Archer, and
distinguished Members of the Committee. On behalf of the
Subpart F Shipping Coalition, I commend the Committee for
examining U.S. international tax policy and its impact on
competitiveness in the U.S. economy.
The Subpart F Shipping Coalition is a group of U.S.-
controlled foreign-flag shipping companies that are adversely
affected by U.S. international tax policy. They strongly
support the Shaw-Jefferson bill, H.R. 265, the Shipping Income
Reform Act of 1999, which is pending before the Committee.
Mr. Chairman, I represent the interests of transportation
companies engaged in foreign commerce. For the last 10 years, I
have also been an adjunct professor in international
transportation law in the graduate program of Georgetown
University Law Center. I have taught and written extensively on
the affects of U.S. tax and regulatory policy on the
competitiveness of U.S. enterprise.
To make a long story short, Mr. Chairman, if the United
States wants a shipping presence of any kind, U.S. or foreign
flag in its foreign commerce, then the application of Subpart F
to shipping income has got to go. It is just that simple.
Subpart F's affect on the economy is essentially threefold. It
erodes the competitiveness of the shipping industry. It effects
the results of the worldwide consolidation affecting shipping.
And it has an adverse affect on U.S. exports that are carried
by that shipping.
Prior to the inclusion of shipping income in Subpart F in
1975, the United States owned approximately 25 percent of the
world fleet. That number has declined to 5 percent today and is
continuing to fall fast. As U.S.-controlled investment in
shipping has declined, so has sealift capability and the
Treasury revenues from that income.
The National Foreign Trade Council's recently completed
study entitled ``The NFTC Foreign Income Project International
Tax Policy for the 21st Century'' confirms those findings. The
study showed that the U.S.-controlled foreign fleet cannot
afford to compete effectively in an international market
against trading partners that have adopted tax policies and
incentives to support their international shipping industries.
Last, the purpose of the inclusion of shipping income in
Subpart F has not been achieved. Shipping industry tax revenues
decreased from approximately $90 million in the year before
1975 (that's $250 million in today's dollars) that resulted
from the voluntary repatriation of dividends from that income--
to less than $50 million today.
Further, the application of Subpart F to shipping income
has affected the trend in worldwide consolidation in
transportation industries. To survive in increasingly
competitive international markets, transportation enterprises,
like American President Lines, must be able to expand their
operations, often through combinations with other carriers.
Assuming a suitable foreign flag carrier can be identified, the
only question then is the form of the merged entity, whether
the U.S. carrier is the acquired or the acquiring company. That
decision should be a marketplace decision, even though there
are compelling national interests at stake in preserving U.S.
control over U.S. flag shipping.
Subpart F's application to foreign-based shipping income of
companies like American President Lines ensures that the
surviving company cannot be a U.S. taxpayer. If the foreign
corporation acquires American President Lines and rationalizes
its operations, none of its foreign flag vessels will be
subject to U.S. taxation. If, on the other hand, American
President Lines were to acquire a foreign company, all of the
foreign flag vessels of the combined enterprise would be
subject to current U.S. taxes. In cases like the acquisition of
American President Lines or the acquisition of Lykes Steamship
Co. by a Canadian corporation, those cases demonstrate that
Subpart F substantially harms the competitiveness of U.S.-owned
foreign-flag shipping, fails to raise revenues, and it
adversely affects the national security, and it costs American
workers their jobs.
The last thing I want to address is the impact of this tax
on our exports. Sir Walter Raleigh once observed that whoever
commanded the sea commanded the trade of the world and, hence,
the world itself. Subpart F has cost American jobs and export
opportunities in related industries as a result of our
declining presence in world shipping. U.S. owned and controlled
transportation companies are much more likely to identify and
promote export opportunities for both related and unrelated
U.S. manufacturers and their employees. The fact of the matter
is that if we act like isolationists on tax policy, it should
be no surprise that the American public is going to turn
isolationist on trade policy and reject further liberalization.
Mr. Chairman, we live in the global marketplace with
formidable challenges and opportunities. Americans, I believe,
are prepared to embrace those challenges, provided Washington
doesn't get in the way. We have seen too many Americans
recently lose their job in shipping and other important
industries just because poorly conceived tax policies
inadvertently dictate that they would lose in this era of
worldwide consolidation. In this regard, I refer you to the
compelling statement of Crowley American Transport submitted to
this Committee on June 24, 1999. If we want to be competitive
in world commerce, we must start here in Washington. Thank you,
Mr. Chairman.
[The prepared statement follows:]
Statement of Warren L. Dean, Jr., Partner, Thompson Coburn LLP, and
Representative, Subpart F Shipping Coalition
Good morning, Chairman Archer and distinguished Members of
the Committee. On behalf of the Subpart F Shipping Coalition, I
commend the Committee for examining U.S. international tax
policy and its impact on the competitiveness of the U.S.
economy. The coalition appreciates the opportunity to appear
before you today.
The Subpart F Shipping Coalition is a group of U.S.-
controlled foreign-flag shipping companies that are adversely
affected by U.S. international taxation policy. Our members
include General Ore International Corporation Limited, Seaboard
Marine (a wholly-owned subsidiary of Seaboard Corporation), and
Tropical Shipping (a wholly-owned subsidiary of NICOR, Inc.).
Our members support the Shaw-Jefferson bill, H.R. 265, which is
pending before the Committee, and they are submitting
statements on the record in support of that legislation.
Mr. Chairman, I chair the Transportation Group at Thompson
Coburn LLP and represent the interests of transportation
companies engaged in foreign commerce. For the last ten years I
have also been an Adjunct Professor of International
Transportation Law in the Graduate Program of Georgetown
University Law Center. I have taught and written extensively on
the effects of U.S. tax and regulatory policy on the
competitiveness of U.S. enterprise. My statement will,
therefore, be general and policy-oriented.
At the outset, let me clarify one very important point.
Amending Subpart F to reinstate the deferral of foreign-base
company shipping income will not adversely affect the
competitive position of the remaining subsidized U.S.-flag
shipping companies that operate in our foreign commerce. In
fact, as reflected in written statements submitted to this
Committee, it would substantially improve their ability to
compete in foreign commerce, since they also operate foreign-
flag vessels.
In sum, if the United States wants a shipping industry of
any kind--U.S.-flag or foreign-flag--then the application of
Subpart F has got to go. It is just that simple.
* * * * *
My testimony focuses on three key issues that are of great
concern to U.S. shipping companies and U.S. manufacturers and
exporters. First, I will discuss the impact of U.S.
international tax policies on the competitiveness of the U.S.
shipping industry. Next, I will describe how the shipping
industry's worldwide consolidation has exacerbated this
decline. And finally, my testimony will describe the impact
that this decline in U.S. shipping capability is having on U.S.
exports.
Competitiveness of the U.S. Shipping Industry
International shipping is a highly competitive industry.
Foreign-flag operators that are relatively unburdened by direct
or indirect national taxes determine its rate structure. Most
maritime nations, including those in the European Union, have
adopted tax policies that ensure that their operators are able
to compete with ships operated under flags of convenience. The
United States has taken no such action. Instead, in response to
the liberalization of international shipping taxes by the
world's great shipping nations, it has increased its taxes. As
a result, the United States is no longer a major force in
international shipping.
Of course, the tax I am referring to is Subpart F of the
Internal Revenue Code, which imposes taxes on U.S.-owned
businesses abroad as if they were operating in the United
States. Before Subpart F was extended to shipping--it was
extended partially in 1975 and fully in 1986--American citizens
and corporations owned or controlled more than 25 percent of
the world's fleet. Now that figure has slipped to less than 5
percent, and is falling fast. As U.S.-controlled investment in
shipping has declined, so have U.S. sealift capability and U.S.
Treasury revenues from shipping. This anti-competitive tax
regime has also reduced new ship acquisition by U.S.-controlled
companies, and it has resulted in U.S. owners becoming minority
participants in vessels they once owned and operated.
The National Foreign Trade Council's recently completed
study, titled ``The NFTC Foreign Income Project: International
Tax Policy for the 21st Century,'' confirms these findings. The
study showed that the U.S.-controlled foreign fleet cannot
afford to compete effectively in the international market
against trading partners that have adopted tax policies and
incentives to support their international shipping industries.
Let me give you an example. Assume an American-controlled
shipping company needs, for competitive purposes, to offer
service between Indonesia and Japan. U.S.-flag services by a
U.S. corporation is not an option. The expense of flying crews
back and forth alone would be prohibitive. Subpart F, the
purpose of which is to prevent tax-motivated earnings through
foreign corporations, reaches this transportation service and
taxes it more onerously than it would tax U.S.-flag service--
even though this transportation is not within any rational
definition of U.S. commerce. There is no legitimate tax policy
foundation for this absurd result.
Sadly, the U.S. government has gained nothing from
extending Subpart F to shipping income. While the tax imposed
upon this industry was originally designed to generate
revenues, it has cost the U.S. Treasury millions of dollars.
Shipping industry tax revenues have decreased from
approximately $90 million a year before 1975 ($250 million in
today's dollars) to less than $50 million today.
Worldwide Consolidation
The marketplace for transportation services is increasingly
global, as international trade responds to the liberalization
of commerce under new multilateral trade agreements. In
response, the ocean shipping industry has been consolidating to
take advantage of worldwide service networks. These actions are
not unique to ocean shipping. The international airline
industry is experiencing a comparable evolution.
This worldwide consolidation is leaving the United States
with significantly diminished shipping capacity, due in large
part to U.S. international tax policy. Take, for example,
American President Lines, one of the premier U.S.-flag
operators for nearly 150 years with terminal and transportation
facilities on the West Coast that are extraordinarily valuable,
both economically and militarily. It is also one of the major
participants in the Maritime Security Program. American
President Lines relies in part on its foreign-flag fleet to
compete on a global basis.
To survive in the increasingly competitive international
markets, transportation enterprises like American President
Lines must be able to expand their operations, often through
combinations with other carriers. Assuming a suitable foreign-
flag carrier can be identified, the only question then is the
form of the merged entity, i.e., whether the U.S. carrier is
the acquired or the acquiring company. That decision should be
a marketplace decision, even though there are national
interests at stake in preserving U.S. control over subsidized
U.S.-flag operators.
Subpart F's application to the foreign-base company
shipping income of companies like American President Lines
ensures that the surviving company cannot be a U.S. taxpayer.
If a foreign corporation acquires American President Lines and
rationalizes its operations, none of its foreign-flag vessels
will be subject to U.S. taxation. If American President Lines
were to acquire a foreign company, on the other hand, all of
the foreign-flag vessels of the combined enterprise would be
subject to U.S. taxes.
In fact, Neptune Orient Lines, a Singapore corporation,
acquired American President Lines. As a result, American
President Lines' foreign-flag operations are effectively exempt
from U.S. taxation. (Singapore does not tax the shipping income
of its nationals, whether from Singaporean or non-Singaporean
vessels.) The U.S. government has lost in terms of both a
potential dividend revenue base and the realization of its
taxpayer-subsidized national security objectives.
If our tax laws had been more competitive--meaning the
United States had maintained a policy to allow vessels to
compete in the tax-free environment that determines the rate
structure for international shipping--American President Lines
might have acquired Neptune Orient Lines instead. Examples like
American President Lines, or the acquisition of Lykes Steamship
Co. by a Canadian corporation, demonstrate that Subpart F
substantially harms the competitiveness of U.S.-owned foreign-
flag shipping, fails to raise revenue to the U.S. Treasury,
adversely affects U.S. national security, and costs American
workers their jobs.
U.S. Exports
Sir Walter Raleigh once observed that whoever commanded the
sea commanded the trade of the world and hence the world
itself. More recently, Tom Clancy wrote a novel describing a
world eventually dominated by a third-world nation that gained
control of ocean shipping. Simply put, our tax laws effectively
prohibit Americans from owning and operating the shipping
companies that carry the world's commerce. This means lost tax
revenue, diminished presence in international markets, and an
increased threat to the nation's economic security.
Subpart F has cost Americans jobs and export opportunities
in related industries as well. As the once significant U.S.-
owned fleet expatriated to remain competitive, related
industries, including insurance brokers, ship management
companies, surveyors, ship brokers, technical consultants, and
many others who provided services to the maritime industry,
followed. Further, Subpart F's application to shipping
adversely affects the export opportunities of U.S. enterprises.
U.S.-owned and controlled transportation companies are much
more likely to identify and promote export opportunities for
both related and unrelated U.S. manufacturers and their
employees. They are also more likely to offer jobs to American
citizens, such as ships' officers, who are not already employed
on U.S.-flag shipping. That's how real economic opportunities
for Americans are developed and marketed in a global economy.
If we act like isolationists on tax policy, it should be no
surprise that the American public may turn isolationist on
trade policy by rejecting further liberalization of
international trade.
Conclusion
The Subpart F Shipping Coalition urges the Committee to
level the playing field so that U.S.-shipping companies can
once again be viable competitors in the international market.
We encourage the Committee to approve H.R. 265, sponsored by
Congressmen Shaw and Jefferson. It would restore the
competitive opportunities for U.S.-controlled foreign-flag
corporations by excluding shipping income from Subpart F. Under
the proposed legislation, taxes would be deferred, not
exempted, and would eventually be paid into the U.S. Treasury
when repatriated.
Mr. Chairman, we live in a global marketplace, with
formidable challenges and opportunities. Americans, I believe,
are prepared to embrace those challenges--provided Washington
doesn't get in the way. We have seen too many Americans
recently lose their jobs in shipping, and other important
industries, just because poorly conceived tax policies
inadvertently dictated that they would lose in this era of
worldwide consolidation. In this regard, I refer you to the
compelling statement of Crowley American Transport, Inc.
submitted to this Committee on June 24, 1999. If we want to be
competitive in world commerce, we must start here in
Washington.
If Subpart F is not amended, companies like the ones I am
representing today will eventually be forced out of business or
driven into partnerships with foreign companies, having been
weakened over the years by unnecessary tax obligations. We look
forward to working with you and the Ways and Means Committee to
address this important issue.
Chairman Archer. Thank you, Mr. Dean. Mr. Houghton.
Mr. Houghton. Thank you very much, Mr. Chairman. Yes, I
would like to ask two or three different questions and whoever
would like to respond, I would appreciate that. If you were to
take a look--and you probably have been here through some of
the other testimony--at all the testimonies that have been
given, concentrating on various aspects of the tax law, what is
the number one change you would make in the United States
international tax laws? If you could pick one thing?
Mr. Laitinen. Well, I have, obviously, testified on the
interest allocation rule and I think that is one of the most
egregious examples.
Mr. Houghton. It is important, but is it the most
important?
Mr. Laitinen. Yes, sir. I believe so.
Mr. Houghton. You are a good advocate for your cause. Does
anybody else have a comment?
Mr. Conway. Mr. Houghton, I would like to suggest that I
think the most important change would be if we looked at an
alternative, maybe a territorial system. I think the foreign
tax credit system that we put in place when we enacted the
income tax system was designed to be a de facto territorial
system. We pay tax in the United States and we pay tax outside
the United States, but we get a full credit when we brought the
money back and we were taxed. And I think what has happened is
over the past 25 years since I have been involved in taxes, we
have chipped away at that foreign tax credit system and
introduced tremendous complexities.
So I think the most important change we could make is to
really reconsider what kind of a system we want to have. Half
of the OECD member countries have territorial systems, and I
think we ought to look at that alternative. So I think that
would be the most important change.
Mr. Houghton. Well, now, Mr. Chip, didn't you--I wasn't
here for your testimony, but I read it. Didn't you talk a
little bit about that in terms of the European Union as one
basket?
Mr. Chip. Yes, sir. I would have to agree, though, with my
colleague from General Motors. If you asked the business
community at large the one thing, assuming we kept our basic
system, that they find the most unconstructive are the interest
allocation rules. Although I would say that for those companies
that operate in Europe--and I think any company that wants to
be a global business nowadays has to have a strong European
presence--being able to treat the European Union as a single
country so that it would be possible to incorporate your
business in one of those countries and not be treated as
engaged in tax haven operations simply because you then had
activities in other parts of the European Union would be very
important.
But all of these problems--and I have to agree with what
was said before--all of these issues would go away if we had a
territorial tax system that accepted that the country where the
business actually is conducted should have the only right to
tax that business income to pay for business infrastructure and
the United States should tax the income only when it is
distributed to U.S. individual shareholders to pay for the
things that they need in the country where they reside.
Short of moving to a territorial system, which is really
the answer, I would have to agree that the interest allocation
rules are probably the biggest problem for U.S. business, but I
would put the problems we have rationalizing our business in
the European Union as a close second.
Mr. Dean. Congressman.
Mr. Houghton. Yes.
Mr. Dean. Congressman, I would like to add one thing. The
problems we are discussing are all symptomatic of a broader
problem. The Tax Code is being gamed in the application of
these rules to collect revenue in circumstances where it is
simply not appropriate. We have to take a fundamentally careful
look at the way we apply these rules to make sure that
enterprises are not punished solely because they are owned and
controlled by our own citizens. It is a truly pathetic irony
that we are in a situation now where American owned enterprises
are being punished by their own government precisely because of
the nationality of their ownership.
That is the case of Subpart F. That is the case of the
interest allocation expense. And it is the case of the foreign
tax credit as well.
Mr. Houghton. Well, I think it is very helpful to be able
to listen to people like yourselves because I have a feeling
that business is far ahead of government in this respect. In
the old days, businesses used to have export agreements,
licensing agreements; what was made overseas was for them and
what was made here was for us. And, of course, that is
absolutely out now. And we obviously have got to bring up our
tax laws to recognize that.
Now let me just ask you one other question. Mr. Levin and I
have proposed a tax simplification bill. Are there any other
issues--I don't know if you have seen this--are there any other
issues we should get into that we haven't touched on? Not that
we can put them in now, but thinking ahead for another session?
Mr. Chip. As some of the other witnesses have said, in
addition to studying some of these micro issues, I would hope
that Congress would give serious consideration to studying
moving to a fully territorial system. Short of moving to a pure
sales tax system, which probably would be more competitive than
our competitors since they have income tax systems, would at
least give us the most competitive income tax system possible.
Most of our competitors come much closer to the most
competitive income tax system that you can have if you are
going to have that kind of system. And I think it would be
worthwhile for--but it is not something that you can do very
simply. And I would be fooling you if I pretended that it is.
Among other things, you have to get into the issue of the
double taxation of shareholders. When we distribute corporate
income to shareholders, they don't get a credit for the taxes
paid by the company. Most of our competitors--at least, a lot
of our competitors--do have an integrated tax system.
So you can't really isolate even the international area.
You have to look very deeply into the system, and I think that
now is as good a time to get started as any.
Mr. Mogenson. I think that what you are hearing is various
themes all of which kind of come back to a similar concept
which is give the freedom for U.S. multinationals to compete on
a foreign marketplace, you know, on equal footing with the
competitors that are not United States based. The notion that
the U.S. rules should extend globally is what is causing the
handicap.
I can tell you that I sit daily and deal with transactions
which are entirely foreign-to-foreign transactions that are
being proposed or conducted by our foreign affiliates and need
to overlay the U.S. rules on top of that, whereas a similarly
situated foreign bank or foreign securities firm merely has to
focus on what are the U.K. rules or what are the German rules
in that particular situation. And I come back to the common
theme of saying let the foreign transactions or foreign
business opportunities stand in that marketplace and don't
extend the U.S. rules into there, whether it be compliance or
substantive.
Mr. Houghton. Well, thanks very much. Thank you, Mr.
Chairman.
Mr. Hamod. Congressman, if I may be an advocate for Section
911 very briefly. I don't believe it is in the bill now, but we
hope you will give it serious consideration. One of the things
that impresses me most about Section 911 is its remarkable
versatility. It helps large companies, it helps small
companies. It helps big wage earners, it helps small wage
earners. It helps in high-tax nations, it helps in low-tax
nations. In fact, as far as we can tell, the only folks it
doesn't help is the competition, and that's the way it should
be. Thank you.
Chairman Archer. Amo, you have asked some very excellent
questions and it has piqued my interest to follow up a little
bit.
What, if we went to a purely territorial system, would you
recommend as the best way to implement that? Simply not to tax
foreign-source income or find a way to give a tax credit for
foreign-source income?
Mr. Conway. Mr. Chairman, I think we really should
seriously look at a system which would exempt foreign income
from tax. We operate in 180 countries and if you read our
annual report, you will see that we pay a lot of taxes both in
the United States and outside the United States. The minute
that you have a foreign tax credit system, it introduces
tremendous complication. Every time we go to make an
acquisition and we compete for acquisitions with non-U.S.
companies, we find ourselves doing an analysis and coming out
on the short end of the stick because of these rules.
We have learned in business that the best way to simplify a
process is, many times, to eliminate a process. If we can, we
should eliminate the foreign tax credit system. Our main goal
is to increase our net income. If our taxes go up, that is OK.
We don't mind paying taxes as long as our profits go up at the
same time. So I think the point is that American companies
would be in a much more competitive position. We would still be
paying taxes. And, in the end, I think we would wind up winning
the global competition.
Chairman Archer. With all of the capabilities today and
with the enormous intricate interrelationship between companies
operating all over the world would there not be some opening
for gaming of the system so that you would be able to transfer
your domestic income to become foreign income to where it would
not be taxed? Depending again upon the level of taxation in the
country in which you were operating, would not transfer pricing
methods and other methods, be an attractive nuisance to
encourage a gaming of the system?
Mr. Conway. I think there would be issues, but I think,
given the sophistication in technology and information, we
ought to take a serious look at a territorial system. I think
those issues could be addressed just by defining the source
rules and could be dealt with that way. What we find in our
businesses is that we are generating income where the customers
are. And I gave the example of the Otis Elevator Co. We have to
operate where the elevators are in order to earn the income.
And it is pretty clear what the source of income is in that
case. When we are manufacturing and selling, then, you know,
there are some issues because we cross borders with an export
sale.
But I think it would be worthwhile to seriously study those
issues. I think we would be far ahead in trying to craft some
reasonable rules. There will always be people who will game the
rules. But I think we could craft rules that could cover the
vast majority of companies, and I don't think we would
necessarily jeopardize our revenue base.
Mr. Chip. Mr. Chairman, those transfer pricing issues you
alluded to are present in the current system because we still
allow a certain amount of deferral of foreign income and there
is an advantage to a U.S. company today to try to allocate as
much income as possible to its lowest taxed subsidiaries. For
that matter, that problem would exist in a sales tax system.
And a concern about that, I think, was one of the main reasons
subpart F was enacted in the first place and, indeed, it is one
the main reasons for not having a territorial system.
But I think we need to take account that the Congress has
amended the Internal Revenue Code to provide the Internal
Revenue Service with very powerful tools in the transfer
pricing area, including very severe penalties for transfer
pricing violations. And most of our competitor countries have
followed our lead in that area so that the likelihood that a
large company could successfully achieve an irrational shifting
of large amounts of income, even under the current system let
alone under an exemption system, is not nearly as severe as
perhaps it may have been perceived to be 30 years ago and
should not really stand in the way of moving to any other
system, because the problem will exist under all systems. It is
not limited to any one system.
Mr. Mogenson. That is right, Mr. Chairman. When you
contemplate a new system, you are correct that you would have
to craft rules that would maintain the integrity of the U.S.
tax base and the U.S. income that is earned here. That means
that you would have to accurately define foreign-source income
that is going to be exempted as under a territorial system and
you must define the deductions or the expenses that relate to
the income that you are not taxing.
However, following up on the transfer pricing point, at
least you would deal with transfer pricing in a very detailed
way when the United States is one side of the transaction where
it is in or out of the United States, but you have taken off
the table the multitude of foreign-to-foreign transactions as
far as applying the U.S. rules to them.
Chairman Archer. Well, I can see that there would still be
complexities with the IRS requiring an awful lot of compliance
types of administrative red tape for you to be sure that,
quote, we are not in some way taking domestic income and
putting it into foreign income through all of the various
methods that would be possible to a clever individual who knows
how to work the intricacies and the sophistication that is
available today. I do wonder why you say the sales tax would
bring the same thing, because in the sales tax, you would have
no recordkeeping for income whatsoever.
Mr. Chip. Well, you do have the issue of inputs coming into
the United States and items going out.
Chairman Archer. Now if you just had a retail sales tax,
you would not have any question of input coming into the United
States.
Mr. Chip. Well, not if you are thinking of a Customs system
where you apportion the tax depending on the value-added or the
value of the product. There will always be a question of what
the real value is when it is being passed from a related to an
unrelated person.
Chairman Archer. Not with a retail sales tax, Mr. Chip.
With a retail sales tax it would be all collected at the point
of sale irrespective of how much came into the country through
imports or how much was domestically produced. There would be
no records for an income tax that would have to be kept.
Transfer pricing or any other manipulation through some
sophisticated system of interrelationship between two different
countries would not be questioned. You eliminate all of that.
Mr. Chip. Yes, Mr. Chairman, a purely retail sales tax that
applied exclusively to transactions between businesses and
unrelated customers would, you are correct, not have those
problems.
Chairman Archer. Well, I just wanted to make that clear,
because you said you would have the same problem with the sales
tax but you would not have the same problem in a sales tax.
Mr. Chip. Many of the alternatives to the income tax system
that have been considered, including value-added taxes and
other taxes do have those problems, but, I agree that a purely
retail sales would not have that problem.
Chairman Archer. OK. Because your statement was even with
the sales tax, you would have the same problem and that is not
accurate relative to a retail sale tax.
Mr. Chip. Not a retail sales tax.
Chairman Archer. OK. OK. All right. Well, I hope I live
long enough to where we can see an elimination of all the extra
complexities that an income tax inevitably seems to put on us.
The sad thing about an income tax is that we can talk about how
we are going to simplify it, but I have been through many
efforts to simplify the income tax and each time we attempt to
simplify it, we make it more complex.
1986 was the great simplification Act, and we added many
new complexities that were not present prior to 1986. In fact,
I was sitting right here at the time of the debate on the 1986
Act and my friend Jimmy Baker, who was then Secretary of the
Treasury, who I grew up with in Houston was testifying. He was
presenting Treasury II, which was a 500-page summary of their
proposal for tax reform, entitled Fairness, Growth, and
Simplicity.
I had scanned through it the night before, which was the
only time we had available. I came to the foreign-source income
provision section and read with incredulity what was in their
own summary. In their own summary. It said the current system
is extremely complex and very difficult to administer and our
proposal will make it more complex. I read that to him and I
said how can you entitle this Fairness, Growth, and Simplicity
and he smiled and said that is why we put simplicity third in
the order of things. [Laughter.]
Then the Congress made it worse.
So I have about lost confidence that we can simplify the
income tax. We will get into that at another time.
Are there any other questions? Mr. Portman.
Mr. Portman. Mr. Chairman, that is a perfect segue because,
as you know, it was the 1986 Act that you looked at that made
these interest allocation rules so complicated and it really
puts us here.
Chairman Archer. By the way, I ended up leading the
opposition to that bill, I want all of you to know. I am on
record.
Mr. Portman. Yes. But I also would say that even
eliminating the corporate income tax and instituting a business
sales tax, which could be called a VAT tax, whether it is
subtraction or a credit method, would avoid many of these
problems of allocation of income. It would create new problems,
but I would venture to say they would not be nearly as complex
for you all and ultimately for the American consumer as the
current income tax system.
But let me get back to reality for a second to what we
might be able to do in the short-term on interest allocation.
The Houghton-Levin bill, I think, is wonderful and Mr. Houghton
and Mr. Levin are to be commended for rolling up their sleeves
and getting into this international area at all. It is an area
only less attractive to most members than the pension laws that
we are trying to get into as well. But they deserve a lot of
credit. They have a study, as you know, on the interest
allocation rules. And then there is this additional legislation
that I just dropped in recently with Mr. Matsui that tries to
get at some of the points that were raised both in this panel
and in the previous panel on interest allocation.
And I just have a couple of follow-up questions to see
whether we can maybe better identify some of the problems. And
then, perhaps, talk about ways in which that legislation could
be altered to make it more broadly applicable to some of the
companies including, I listened to Mr. Green's testimony
earlier, to UtiliCorp. He had some concerns, I think, about
applicability to some companies, perhaps focusing on the 80
percent rule. Maybe lowering that 80 percent to some smaller
percentage.
But if I could start with asking you, Mr. Laitinen, about
your question regarding U.S. investment. You basically said
that the home team is disadvantaged even on the home court, in
so many words. And if you could follow through on that a little
bit and explain why, for instance, a foreign car manufacturer,
as compared to a GM, would be at an advantage.
And I guess this relates also to the fact that all of your
competitors probably live under a different tax system. So we
know with some certainty how they are going to be taxed, which
would be on the U.S. system, to the extent they are investing
in the United States. Whereas our tax system would have
interest allocated that is U.S. domestic interest allocated to
foreign sources and therefore would put us at a disadvantage.
Could you explain that?
Mr. Laitinen. Well, basically, interest on U.S. debt
incurred by a U.S. multinational to invest in the United States
is subject to these interest allocation rules, whereas a
foreign-based company with a subsidiary in the United States
that borrows funds here to make a similar investment in the
United States is not subject to those rules because that U.S.
subsidiary of the foreign company is not going to have foreign
assets to allocate interest to.
An example, if I could give one, would be in the late
1980s, when GM borrowed funds in the United States to build a
Saturn Corporation plant in Spring Hill, Tennessee. And a
portion of the interest expense on the debt was allocated to
foreign-source income and, in effect, a current deduction was
lost for part of that interest expense. But, by way of
contrast, about the same time, Nissan built a plant down the
road in Smyrna, Tennessee. As a foreign-based competitor, they
weren't subject to the interest allocation rules on any
borrowings they might have had for that plant. That is the type
of thing that can happen again.
Mr. Portman. So they got the full deduction on their
interest that they borrowed for their expansion, whereas GM did
not because some of that was allocated to foreign-source.
Mr. Laitinen. Right. I use that as an example. I don't know
their actual facts as to their borrowings and so on, but----
Mr. Portman. Yes. Well, you don't know about their
borrowings, necessarily, but we do know enough about the tax
system in Japan or in Germany or in any of the other EU
countries to know with some certainty that they would have been
subject to a different set of rules.
Mr. Laitinen. Right, but, in effect, the U.S.-based
multinational investing in the United States is at a
competitive disadvantage. That is why I was saying that it is
not a level playing field, even in our home turf.
Mr. Portman. Right. The other question I have which I
raised a second ago was do you all have any thoughts as to how
the legislation that we introduced, H.R. 2270, might be altered
to make it more applicable to more companies? I mentioned the
percentage of foreign ownership, for instance. Any thoughts of
any of the panelists? Mr. Laitinen, anybody?
Mr. Laitinen. Well, the percentage of affiliation is 80
percent in your bill and it could be lowered to 50 percent. The
CFC rule, for example, could be used for what foreign
affiliates you take into account. I mean, that would be a way
of broadening it. Also, there is a subgroup rule in the bill
which we think is important. Under your bill, as I understand
it, a company could elect to stay in the current law or elect
worldwide fungibility with the subgroup election also. If that
subgroup election were made available under current law, again,
it would provide some additional flexibility.
I mean, there are ways to broaden the bill slightly and
still maintain the two important points of worldwide
fungibility and subgroup elections, which are, as you know, the
key points in your bill.
Mr. Portman. Well, again, we appreciate your help and
giving us advice on that. I will say that any change,
obviously, has an impact on revenue. At least those two changes
you mentioned would, I believe, raise an issue as to the
revenue impact. But I think we have made some progress through
Mr. Houghton's legislation and if we can get some interest
allocation relief as well, it seems to me from what we have
heard today, that will be a major help to U.S. companies trying
to compete worldwide. Thank you, Mr. Chairman.
Chairman Archer. I am constrained to ask whether there is
any coalition of overseas companies that has been put together
to try to determine the best way to do the interest allocation
change. I understand that different businesses are affected
differently, based on how we make the change. The 1986 Senate
proposal, for example, does not help a lot of businesses. I
wonder if there has been any effort to get the business
community together to make a recommendation. I see Mr. Murray
raising his hand in the audience out there. [Laughter.]
Mr. Portman. National Foreign Tax Council.
Chairman Archer. Well, we would appreciate the input of any
one with practical experience on how we to make the best
possible choice to remove this barrier to our competitiveness
overseas. I think Mr. Portman's questions were very well-taken.
Let me quickly ask you this and then excuse you and move
on. If we were to get a pure territorial system, would most of
the research that your corporations do be brought back to the
United States? There would be no incentive to do it overseas if
you are not. By reducing your foreign-source income, you would
not be helping yourself in your bottom line net. However, if
you brought it here and you take a deduction against your
domestic income, then it seems to me it would be very
attractive for you to start bringing your research activities,
whatever they might be, back to the United States of America.
Am I correct in that?
Mr. Conway. Mr. Chairman, I think you are correct. If you
are potentially adversely impacted by the foreign tax credit
rules in the R&D allocation, it absolutely would make sense to
move the R&D back because, you know, it would absolutely
neutral from a tax standpoint and, quite frankly, I think for
most companies, most of the R&D is done in the United States
anyway. This is where the technology base is and to the extent
that we not only get a deduction, but we get an R&D credit here
as well, which has been extended--in fact, it has been approved
with the alternative research credit--more and more countries
are enacting R&D incentives.
There are now 16 major countries which have R&D incentives.
So I think a territorial system would provide an incentive to
do more R&D here.
Chairman Archer. OK. Thank you very much. Are there any
other questions by members? Thank you very much. Your input has
been very helpful to us. The Committee will be adjourned.
[Whereupon, at 2:42 p.m., the hearing was adjourned.]
[Submissions for the record to follow:]
Statement of LaBrenda Garrett-Nelson, Ad Hoc Coalition of Finance and
Credit Companies, and Washington Counsel, P.C.
Both H.R. 681 (introduced by Reps. McCrery and Neal) and
Section 101 of the International Tax Simplification for
American Competitiveness Act of 1999 (H.R. 2018, introduced by
Reps. Houghton and Levin) highlight the need to extend the
provision that grants active financial services companies an
exception from subpart F. In light of the growing
interdependence and integration of world financial markets,
coupled with the international expansion of U.S.-based
financial services entities, the foreign activities of the
financial services industry should be eligible for deferral on
terms comparable to that of manufacturing and other non-
financial businesses. This statement was prepared on behalf of
an ad hoc coalition of leading finance and credit companies
whose activities fall within the catch-all concept of a
``financing or similar business.''
The ad hoc coalition of finance and credit companies
includes entities providing a full range of financing, leasing,
and credit services to consumers and other unrelated
businesses, including the financing of third-party purchases of
products manufactured by affiliates (collectively referred to
as ``Finance and Credit Companies''). This statement describes
(1) the ordinary business transactions conducted by Finance and
Credit Companies, including information regarding the unique
role these companies play in expanding U.S. international
trade, and (2) the importance of the active financing exception
to subpart F to the international competitiveness of these
companies.
I. The International Operations of U.S.-Based Finance and Credit
Companies
A. Finance and Credit Companies Conduct Active Financial
Services Businesses.
Finance and Credit Companies are financial intermediaries
that borrow to engage in all the activities in which banks
customarily engage when issuing and servicing a loan or
entering into other financial transactions. Indeed, many
countries (e.g., Germany, Austria, and France) actually require
that such a company be chartered as a regulated bank. For
example, one member of the ad hoc group has a European Finance
and Credit Company that is regulated by the Bank of England
and, under the European Union (``EU'') Second Banking
Coordination Directive, operates in branch form in Austria,
France, and a number of other EU jurisdictions. The principal
difference between a typical bank and a Finance and Credit
Company is that banks normally borrow through retail or other
forms of regulated deposits, while Finance and Credit Companies
borrow from the public market through commercial paper or other
publicly issued debt instruments. In some cases, Finance and
Credit Companies operating as regulated banks are required to
take deposits, although they may not rely on such deposits as a
primary source of funding. In every important respect, Finance
and Credit Companies compete directly with banks to provide
loan and lease financing to retail and wholesale consumers.
B. A Finance and Credit Company's Activities Include A Full
Range Of Financial Services.
The active financial services income derived by a Finance
and Credit Company includes income from financing purchases
from third parties; making personal, mortgage, industrial or
other loans; factoring; providing credit card services; and
hedging interest rate and currency risks with respect to active
financial services income. As an alternative to traditional
lending, leasing has developed into a common means of financing
acquisitions of fixed assets, and is growing at double digit
rates in international markets. These activities include a full
range of financial services across a broad customer base and
can be summarized as follows:
Specialized Financing--Loans and leases for major
capital assets, including aircraft, industrial facilities and
equipment and energy-related facilities; commercial and
residential real estate loans and investments; loans to and
investments in management buyouts and corporate
recapitalizations.
Consumer Services--Private label and bank credit
card loans; merchant acquisition, card issuance, and financing
of card receivables; time sales and revolving credit and
inventory financing for retail merchants; auto leasing and
lending and inventory financing; and mortgage servicing.
Equipment Management--Leases, loans and asset
management services for portfolios of commercial and
transportation equipment, including aircraft, trailers, auto
fleets, modular space units, railroad rolling stock, data
processing equipment, telecommunications equipment, ocean-going
containers, and satellites.
Mid-Market Financing--Loans and financing and
operating leases for middle-market customers, including
manufacturers, vendors, distributors, and end-users, for a
variety of equipment, such as computers, data processing
equipment, medical and diagnostic equipment, and equipment used
in construction, manufacturing, office applications, and
telecommunications activities.
Each of the financial services described above is widely
and routinely offered by foreign-owned finance companies in
direct competition with Finance and Credit Companies.
C. Finance and Credit Companies Are Located In The Major
Markets In Which They Conduct Business And Compete Head-on
Against ``Name Brand'' Local Competitors.
Finance and Credit Companies provide services to foreign
customers or U.S. customers conducting business in foreign
markets. The customer base for Finance and Credit Companies is
widely dispersed; indeed, a large Finance and Credit Company
may have a single customer that itself operates in numerous
jurisdictions. As explained more fully below, rather than
operating out of regional, financial centers (such as London or
Hong Kong), Finance and Credit Companies must operate in a
large number of countries to compete effectively for
international business and provide local financing support for
foreign offices of U.S. multinational vendors. One Finance and
Credit Company affiliated with a U.S auto maker, for example,
provide services to customers in Australia, India, Korea,
Germany, the U.K., France, Italy, Belgium, China, Japan,
Indonesia, Mexico, and Brazil, among other countries. Another
member of the ad hoc coalition conducts business through
Finance and Credit Companies in virtually all the major
European countries, in addition to maintaining headquarters in
Hong Kong, Europe, India, Japan, and Mexico. Yet another member
of the ad hoc coalition currently has offices that provide
local leasing and financing products in 22 countries.
Finance and Credit Companies are legally established,
capitalized, operated, and managed locally, as either branches
or separate entities, for the business, regulatory, and legal
reasons outlined below:
1. Marketing and supervising loans and leases generally
require a local presence. The provision of financial services
to foreign consumers requires a Finance and Credit Company to
have a substantial local presence--to establish and maintain a
``brand name,'' develop a marketing network, and provide pre-
market and after-market services to customers. A Finance and
Credit Company must be close to its customers to keep abreast
of local business conditions and competitive practices. Finance
and Credit Companies analyze the creditworthiness of potential
customers, administer and collect loans, process payments, and
borrow money to fund loans. Inevitably, some customers have
trouble meeting obligations. Such cases demand a local presence
to work with customers to ensure payment and, where necessary,
to terminate the contract and repossess the asset securing the
obligation. These active functions require local employees to
insure the proper execution of the Finance and Credit Company's
core business activities--indeed, a single member of the ad hoc
group has approximately 15,000 employees in Europe. From a
business perspective, it would be almost impossible to perform
these functions outside a country of operation and still
generate a reasonable return on the investment. ``Paper
companies'' acting through computer networks would not serve
these local business requirements.
In certain cases, a business operation and the employees
whose efforts support that operation may be in separate, same-
country affiliates for local business or regulatory reasons.
For example, in some Latin American jurisdictions where profit
sharing is mandatory, servicing operations and financing
operations may be conducted through separate entities. Even in
these situations, the active businesses of the Finance and
Credit Companies are conducted by local employees.
2. Like other financial services entities, a Finance and
Credit Company requires access to the debt markets to finance
its lending activities, and borrowing in local markets often
affords a lower cost of funds. Small Finance and Credit
Companies, in particular, may borrow a substantial percentage
of their funding requirements from local banks. Funding in a
local currency reduces the risk of economic loss due to
exchange rate fluctuations, and often mitigates the imposition
of foreign withholding taxes on interest paid across borders.
Alternatively, a Finance and Credit Company may access a
capital market in a third foreign country, because of limited
available capital in the local market--Australian dollar
borrowings are often done outside Australia for this reason.
The latter mode of borrowing might also be used in a country
whose government is running a large deficit, thus ``soaking
up'' available local investment. A Finance and Credit Company
may also rely for funding on its U.S. parent company, which
issues debt and on-lends to affiliates (with hedging to address
foreign exchange risks).
3. In many cases, consumer protection laws require a local
presence. Finance and Credit Companies must have access to
credit records that are maintained locally. Many countries,
however, prohibit the transmission of consumer lending
information across national borders. Additionally, under
``door-step selling directives,'' other countries preclude
direct marketing of loans unless the lender has a legal
presence.
4. Banking or currency regulations may also dictate a local
presence. Finance and Credit Companies must have the ability to
process local payments and--where necessary--take appropriate
action to collect a loan or repossess collateral. Foreign
regulation or laws regarding secured transactions often require
U.S. companies to conduct business through local companies with
an active presence. For example, as noted above, French law
generally compels entities extending credit to conduct their
operations through a regulated ``banque'' approved by the
French central bank. Other jurisdictions, such as Spain and
Portugal, require retail lending to be performed by a regulated
entity that need not be a full-fledged bank. In addition,
various central banks preclude movements of their local
currencies across borders. In such cases, a Finance and Credit
Company's local presence (in the form of either a branch or a
separate entity) is necessary for the execution of its core
activities of lending, collecting, and funding.
EU directives allow a regulated bank headquartered in one
EU jurisdiction to have branch offices in another EU
jurisdiction, with the ``home'' country exercising the majority
of the bank regulation. Thus, for example, one Finance and
Credit Company in Europe operates in branch form, engaging in
cross-jurisdictional business in the economically integrated
countries that comprise the EU. The purpose of this branch
structure is to consolidate European assets into one
corporation to achieve increased borrowing power within the EU,
as well as limit the number of governmental agencies with
primary regulatory authority over the business.
D. Finance and Credit Companies Play A Critical Role In
Supporting International Trade Opportunities
As U.S. manufacturers and distributors expand their sales
activities and operations around the world, it is critical that
U.S. tax policy be coordinated with U.S. trade objectives, to
allow U.S. companies to operate on a level playing field with
their foreign competitors. One of the important tools available
to U.S. manufacturers and distributors in seeking to expand
foreign sales is the support of Finance and Credit Companies
providing international leasing and financing services. U.S.
tax policy should not hamper efforts to provide financing
support for product sales.
U.S. manufacturers, in particular, include the availability
of financing services offered by Finance and Credit Companies
as an integral component of the manufacturer's sales promotion
in foreign markets. For related manufacturing or other
businesses to compete effectively, Finance and Credit Companies
establish local country financial operations to support the
business. As an example, the Finance and Credit Company
affiliate of a U.S. auto maker establishes its operations where
the parent company's sales operations are located, in order to
provide marketing support.
In supporting the international sales growth of U.S.
manufacturers and distributors in developed markets, Finance
and Credit Companies are themselves forced into competition
with foreign-owned companies offering the same or similar
leasing and financing services. To the extent Finance and
Credit Companies are competitively disadvantaged by U.S. tax
policy, U.S. manufacturers and distributors either are
prevented from competing with their counterparts or must seek
leasing and financing support from foreign-owned companies
operating outside the United States.
II. The Need to Continue the Subpart F Exception for Active
Financing Income
A. Legislative Background
When deferral for active financial services income was
repealed in 1986, the Congress was concerned about the
potential for abuse by taxpayers routing passive or mobile
income through tax havens. At that time. the U.S. financial
services industry was almost entirely domestic, and so little
thought was given to the appropriateness of applying the 1986
Act provisions to income earned by the conduct of an active
business. The subsequent international expansion of the U.S.
financial services industry created a need to modernize Subpart
F by enacting corrective legislation.
The Taxpayer Relief Act of 1997 introduced a temporary
(one-year) Subpart F exception for active financing income, and
1998 legislation revised and extended this provision for an
additional year. The financial services industry continues to
seek a more permanent Subpart F exception for active financing
income.
But for the Active financing exception, current law would
discriminate against the U.S. financial services industry by
imposing a current U.S. tax on interest, rentals, dividends
etc., derived in the conduct of an active trade or business
through a controlled foreign corporation. From a tax policy
perspective, a financial services business should be eligible
for the same U.S. tax treatment of worldwide income as that of
manufacturing and other non-financial businesses.
B. The Active Financing Exception is Necessary To Allow U.S.
Financial Services Companies To Compete Effectively In Foreign
Markets
U.S. financial services entities engaged in business in a
foreign country would be disadvantaged if the active financing
exception were allowed to expire (and the United States thereby
accelerated the taxation of their active financing income).
To take a simplified example, consider a case where a
Finance and Credit Company establishes a U.K. subsidiary to
compete for business in London. London is a major financial
center, and U.S.-based companies compete not only against U.K.
companies but also against financial services entities from
other countries. For example, Deutsche Bank is a German
financial institution that competes against U.S. Finance and
Credit Companies. Like many other countries in which the parent
companies of major financial institutions are organized,
Germany generally refrains from taxing the active financing
income earned by its foreign subsidiaries. Thus, a Deutsche
Bank subsidiary established in London defers the German tax on
its U.K. earnings, paying tax on a current basis only to the
U.K.
The application of Subpart F to the facts of the above
example would place the U.S. company at a significant
competitive disadvantage in any third country having a lower
effective tax rate (or a narrower current tax base) than the
United States (because the U.S. company would pay a residual
U.S. tax in addition to the foreign income tax). The
acceleration of U.S. tax under Subpart F would run counter to
that of many other industrialized countries, including France,
Germany, the United Kingdom, and Japan.\1\ All four of these
countries, for example, impose current taxation on foreign-
source financial services income only when that income is
earned in tax haven countries with unusually low rates of tax.
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\1\ For detailed analyses of other countries' approaches to anti-
deferral policy with respect to active financing income, see ``The NFTC
Foreign Income Project: International Tax Policy for the 21st
Century,'' Chapter 4 (March 25, 1999).
---------------------------------------------------------------------------
In view of the relatively low profit margins in the
international financing markets, tax costs might have to be
passed on to customers in the form of higher financing rates.
Obviously, foreign customers could avoid higher financing costs
by obtaining financing from a foreign-controlled finance
company that is not burdened by current home-country taxation,
or--in the case of Finance and Credit Companies financing
third-party purchases of an affiliate's product--purchasing the
product from a foreign manufacturer offering a lower all-in
cost. The active financing exception advances international
competitiveness by insuring that financial services companies
are taxed in a manner that is consistent with their foreign
competitors--consistent with the legislative history of Subpart
F and the long-standing tax policy goal of striking a
reasonable balance that preserves the ability of U.S.
businesses to compete abroad.
III. The Definition of a Finance Company Under the Active Financing
Exception to Subpart F was Carefully Crafted to Limit Application of
the Exception to Bona Fide Businesses
The 1998 legislation introduced a statutory definition of a
``lending or finance business'' for purposes of the active
financing exception to subpart F. A lending or finance business
is defined to include very specific activities:
(i) making loans;
(ii) purchasing or discounting accounts receivable, notes, or
installment obligations;
(iii) engaging in leasing;
(iv) issuing letters of credit or providing guarantees;
(v) providing charge or credit services; or
(vi) rendering related services to an affiliated corporation
that is so engaged.
A. A Finance Company Must Satisfy a Two-pronged Test to be
Eligible to Qualify any Income for the Active Financing
Exception.
1. Predominantly Engaged Test.--Under a rule that applies
to all financial services companies, a finance company must
first satisfy the requirement that it be ``predominantly
engaged'' in a banking, financing, or similar business. To
satisfy the ``predominantly engaged'' test, a finance company
must derive more than 70 percent of its gross income from the
active and regular conduct of a lending or finance business (as
defined above) from transactions with unrelated ``customers.''
2. Substantial Activity Test.--Even if a finance company is
``predominantly engaged,'' as in the case of all financial
services companies, it will flunk the test of eligibility
unless it conducts ``substantial activity with respect to its
business. The ``substantial activity'' test, as fleshed out in
the committee report, is a facts-and-circumstances test (e.g.,
overall size, the amount of revenues and expense, the number of
employees, and the amount of property owned). In any event,
however, the legislative history prescribes a ``substantially
all'' test that requires a finance company to ``conduct
substantially all of the activities necessary for the
generation of income''--a test that cannot be met by the
performance of back-office activities.
B. Once Eligibility is Established, Additional Requirements
Must be Satisfied Before Income From Particular Transactions
Can be Qualified Under the Active Financing Exception.
As listed in the relevant committee report, there are only
21 types of activities that generate income eligible for the
active financing exception. In addition, an eligible Finance
and Credit Company cannot qualify any income under the
exception unless the income meets four, additional statutory
requirements that apply to all financial services businesses:
1. The Exception Is Limited to Active Business Income.--
First, the income must be ``derived by'' the finance company in
the active conduct of a banking, financing or similar business.
This test, alone, would preclude application of the active
financing exception to the incorporated pocketbook of a high
net worth individual or a pool of offshore passive assets.
2. Prohibition on Transactions With U.S. Customers.--
Secondly, the income must be derived from one or more
transactions with customers located in a country other than the
United States.
3. Substantial Activities.--Substantially all of the
activities'' in connection with a particular transaction must
be conducted directly by the finance company in its home
country.
4. Activities Sufficient For a Foreign Country To Assert
Taxing Jurisdiction.--The income must be ``treated as earned''
by the Finance and Credit Company--i.e., subject to tax--for
purposes of the tax laws of its home country.
C. In any Event, a Finance Company Cannot Qualify any Income
Under the Active Financing Exception Unless it meets an
Additional 30-Percent Home Country Test.
Under a ``nexus'' test applicable to Finance and Credit
Companies (but not banks or securities firms with respect to
which government regulation satisfies the nexus requirement), a
company must derive more than 30 percent of its separate gross
income from transactions with unrelated customers in its home
country. This rule makes it highly unlikely that taxpayers
could locate a finance company in a tax haven and qualify for
the active financing exception, because tax havens are unlikely
to provide a customer base that would support the transactions
required to meet the 30-percent home country test. Even if such
a well-populated tax haven could be found, the ability to
qualify income would be self-limiting (in terms of absolute
dollars) by the dollar-value of transactions that could be
derived from unrelated, home-country customers.
Conclusion
We urge the Congress to extend the provision that grants
active financial services companies an exception from subpart
F. Without this legislation, the current law provision that
keeps the U.S. financial services industry on an equal footing
with foreign-based competitors will expire at the end of this
year. Moreover, this legislation will afford America's
financial services industry parity with other segments of the
U.S. economy.
Statement of Larry Bossidy, AlliedSignal, and The Business Roundtable
I am Larry Bossidy, Chairman and CEO of AlliedSignal and
Chairman of the Fiscal Policy Task Force of The Business
Roundtable. I am submitting this statement for the record to
express the views of The Business Roundtable on the corporate
tax component of the 1999 tax reduction bill. The Business
Roundtable is an association of chief executive officers of
leading corporations with a combined workforce of more than 10
million employees in the United States.
As the Committee designs a tax cut to return the budget
surplus to taxpayers, we urge that you allocate the tax cut
between corporate and individual taxpayers as their tax
collections have jointly contributed to the budget surplus.
Specifically, we urge the Committee to reduce corporate income
taxes by $1 for every $4 that it cuts from individual income
taxes, as this $1 to $4 ratio reflects the collection of income
tax over the current economic expansion from 1992. Thus, if a
tax bill is structured around income tax cuts of $778 billion,
the 10-year target for corporate income tax reduction would be
approximately $156 billion. Such a corporate tax cut would
stimulate savings, investment, economic growth and job
creation.
In the United States, corporations employ more people, pay
more wages, fund more research, invest in more plant and
equipment, and support more employee benefits than any other
type of business. We also pay more federal income tax.
Therefore, one of our main public policy interests is how taxes
are affecting corporations in their central economic role as
engines pulling the national economy.
From that perspective, we urge the Committee to reduce the
corporate income tax. Corporate funds that are not diverted to
taxes can go into building the economy and underwriting
prosperity in future years. The old saying is true: the time to
invest is when you have it. The condition of the federal
budget, itself a beneficiary of economic growth, makes
corporate tax reduction feasible. Corporate tax reduction, in
turn, can help sustain a strong recovery.
As shown in the accompanying table, the proposed 1-to-4 tax
cut ratio reflects the collection of federal income taxes since
the U.S. economy began its solid, long period of growth in
1992. Following the 1-to-4 guideline for the corporate
component of the tax bill will----
Be equitable, because the budget surplus will be paid back to
taxpayers in the same proportion as it is being created.
Preserve the balance between individual and corporate income
taxes that has prevailed during our sustained prosperity, and
Assure that some portion of the tax bill will make a
contribution to continuing economic growth and job creation.
The Roundtable believes that the corporate portion of the
tax-cut bill should center around reducing corporate income tax
rates. A rate reduction is the fairest and simplest way to cut
business taxes. It would benefit corporations of all sizes. It
would put funds into play to compete for economic projects that
have the best prospects for creating value and stimulating
growth. The alternative is for the government to pick business
winners based on politics and thus dilute the beneficial impact
of a business tax reduction. As you know, the top corporate tax
rate was raised from 34 percent to 35 percent in 1993 solely
for deficit reduction, which is now an obsolete rationale. A
two-percentage-point rate cut might be phased in--one point
early in the 10-year planning period and another point later--
to fit the time pattern of cuts that Congress has defined.
We are also interested in other aspects of corporate taxes,
such as simplification of international tax rules, a permanent
R&E credit, and repeal of the corporate AMT.
The international provisions of the U.S. tax law represent
a significant barrier to the competitiveness of U.S. companies
in the global marketplace. The U.S. tax regime imposes costs on
the foreign operations of U.S.-based multinationals that are
not borne by our foreign competitors. With the ever-increasing
globalization of the economy, there is a great need for
fundamental reform of the U.S. international tax rules. U.S.
companies must be able to compete abroad on equal terms if we
are to compete successfully at home.
The International Tax Simplification for American
Competitiveness bill, introduced recently by Representative
Houghton and Representative Levin and supported by many Members
of the Committee, addresses many of the needed reforms. Of
particular significance is the request that the Treasury
Department study the interest expense allocation rules. The
present-law rules severely penalize U.S.-based multinationals
by artificially restricting their ability to claim foreign tax
credits for the taxes they pay to foreign countries, thereby
subjecting them to double taxation. The interest allocation
rules must be reformed to eliminate the distortions that cause
this double taxation and to eliminate the competitive
disadvantage at which the present-law rules place U.S.
multinationals.
The Tax Reform Act of 1997 included the prospective repeal
of a rule enacted in 1986 that restricted the ability of U.S.
companies to claim foreign tax credits for foreign taxes paid
by less-than-majority owned foreign subsidiaries; the
international simplification bill enhances this important
simplification by accelerating the repeal of this rule. In
addition, the bill would provide more appropriate tax treatment
for the sale by a foreign subsidiary of an interest in a
partnership.
In addition to these simplification measures, another
particularly important provision is the permanent extension of
the subpart F exception for active financial services income.
This provision is essential to allowing the U.S. financial
services industry compete with their foreign counterparts.
These are just a few of the most pressing issues that need
to be addressed in the U.S. international tax rules. We commend
the Committee for its attention to these critical issues and
look forward to working with the Committee to achieve the
necessary reforms.
We will make our tax directors available to your staff with
information and comments in these and other areas if that would
be helpful to your Committee.
Federal Income Tax Collections During the Current Economic Expansion,
1992-1998
[By fiscal year, in billions of dollars]
------------------------------------------------------------------------
Individual/
Fiscal year Individual Corporate Corporate
Income Taxes Income Taxes Ratio
------------------------------------------------------------------------
1992.......................... 476.0 100.3 4.7
1993.......................... 509.7 117.5 4.3
1994.......................... 543.1 140.4 3.9
1995.......................... 590.2 157.0 3.8
1996.......................... 656.4 171.8 3.8
1997.......................... 737.5 182.3 4.0
1998.......................... 828.6 188.7 4.4
Total....................... 4,341.4 1,058.0 4.1
------------------------------------------------------------------------
Statement of the American Bankers Association
The American Bankers Association (ABA) is pleased to have
an opportunity to submit this statement for the record on the
impact of U.S. tax rules on international competitiveness.
The ABA brings together all elements of the banking
community to best represent the interests of this rapidly
changing industry. Its membership--which includes community,
regional, and money center banks and holding companies, as well
as savings associations, trust companies, savings banks and
thrifts--makes ABA the largest banking trade association in the
country.
As technology and expanding trade opportunities change the
global market place, financial institutions have had to make
rapid adjustments in order to remain competitive with foreign
financial entities. With respect to the international
operations of U.S.-based financial institutions, the tax law
has not kept pace with technological advances and changes in
the global economy.
The ABA supports the enactment of legislation that would
simplify the international tax law and that would assist,
rather than hinder, U.S. financial institutions' global
competitiveness. We agree with the observation that we can't
afford a tax system that fails to keep pace with fundamental
changes in the global economy or that creates barriers that
place U.S. financial services companies at a competitive
disadvantage. In that regard, the ABA would like to commend
Representatives Amo Houghton (R-NY) and Sander Levin (D-MI) for
the introduction of H.R. 2018, the International Tax
Simplification for American Competitiveness Act of 1999. H.R.
2018 contains a number of important provisions that would do
much to update U.S. international tax law and promote global
competitiveness in the financial services industry. We would
also like to commend Representatives Jim McCrery (R-LA) and
Richard Neal (D-MA) for the introduction of H.R. 681, which
would permanently extend the active financing exception to
subpart F.
This statement will address a number of proposals currently
under consideration, many of which have been included in H.R.
2018 and H.R. 681.
Permanent Extension for Subpart F Active Financing Income Exception
Prior to 1987, subpart F allowed deferral of U.S. tax on
income derived in the active conduct of a banking business
until the income was distributed to a U.S. shareholder. In
1986, Congress repealed the provisions put in place to ensure
that a controlled foreign corporation's active financial
services business income would not be subject to current tax in
response to concerns about the potential for taxpayers to route
passive or mobile income through tax havens.
In 1997, Congress added an exception to the subpart F rules
for the active income of U.S.-based financial services
companies. The 1986 rules were modified for a number of
reasons. An important reason was the fact that many U.S.
financial services companies found that the existing rules
imposed a competitive barrier in comparison to the home-country
rules of many foreign-based financial services companies.
Moreover, the logic of the subpart F regime was flawed, given
that most other U.S. businesses were not subject to similar
subpart F restrictions on their active trade or business
income. The 1997 Taxpayer Relief Act added rules to address
concerns that the provision would be available to shelter
passive operations from U.S. tax. Due primarily to revenue
constraints, the exception was made effective for only one
year. In 1998, the provision was extended and modified for the
1999 tax year.
Thus, under current law, the active business income of U.S.
financial institutions is subject to tax only when that income
is distributed back to the U.S. This temporary exception to
subpart F will expire in 1999, ending deferral of financial
services income and placing financial institutions on a more
uneven playing field vis-a-vis domestic manufacturing companies
and global competitors.
Generally, active financial services income is generally
recognized as active trade or business income. Thus, if the
current-law provision were permitted to expire at the end of
this year, U.S. financial services companies would find
themselves at a significant competitive disadvantage vis-a-vis
major foreign competitors when operating outside the United
States. In addition, because the U.S. active financing
exception is currently temporary, it denies U.S. companies the
certainty their foreign competitors have. The need for
certainty in this area is important to U.S. companies. They
need to know the tax consequences of their business operations,
which are generally evaluated on a multi-year basis.
Failure to extend the active financing exception this year
would countermine legislative efforts to promote
competitiveness and simplification. Moreover, the tax structure
would revert to a regime that inequitably penalizes
international financial institutions, as the National Foreign
Trade Council's report on subpart F \1\ indicates.
---------------------------------------------------------------------------
\1\ International Tax Policy for the 21st Century: A
Reconsideration of Subpart F (March 25, 1999). In that report, the NFTC
concluded that the development of a global economy has substantially
eroded subpart F's policy rationale; that subpart F subjects U.S.-based
companies cross border operations to a heavier tax burden than that
borne by their foreign-based competitors; and that subpart F applies
too broadly to various categories of income that arise in the course of
active foreign business operations, and should be substantially
narrowed.
---------------------------------------------------------------------------
The ABA supports the permanent extension of the active
financing exception to the subpart F for financial services
companies.
Simplify the Foreign Tax Credit Limitation for Dividends from 10/50
Companies
The foreign tax credit rules impose a separate foreign tax
credit limitation (separate baskets) for companies in which
U.S. shareholders own at least 10 but no more than 50, percent
of the foreign corporation. The old law 10/50 rule imposed an
unreasonable level of complexity, which Congress sought to
correct in the 1997 Tax Relief Act by eliminating the separate
baskets for 10/50 companies using a ``look through'' rule.
However, the 1997 Act change is not effective until after year
2002, and itself imposes an additional set of complex rules.
The ABA supports the proposal to accelerate the effective
date of the 1997 Act change to apply the look-through rules to
all dividends received in tax years after December 31, 1998,
irrespective of when the earnings constituting the makeup of
the dividend were accumulated. Such change would dramatically
reduce tax credit complexity and the administrative burdens on
financial institutions doing business internationally. It would
also help level the playing field with respect to global
competitors.
Subpart F Earnings and Profits Determined under Generally Accepted
Accounting Principles (GAAP)
The ABA supports the proposal to determine the subpart F
earnings and profits of foreign subsidiaries under GAAP. Under
current rules, determining the earnings and profits of foreign
subsidiaries for subpart F purposes may comprise as many as
five steps involving a series of complex and time-consuming
computations. For example, the process would start with the
local books of account of the foreign subsidiary, continuing
through a series of complicated accounting and tax adjustments
to the parent institution. On audit, each of the steps would
have to be explained and justified to IRS agents. We agree with
the proposition offered by certain witnesses at this hearing
that using GAAP to determine earnings and profits would provide
equally reliable figures at a fraction of the time and cost to
the institution. In this connection, we point out that H.R.
2018 contains such a provision, which we urge you to consider.
Treatment of Certain Dividends of Regulated Investment Companies
The ABA supports legislation that would exempt from U.S.
withholding tax certain dividends distributed by a U.S. mutual
fund to non-resident alien individuals.
The U.S. mutual fund industry has established a favorable
global reputation for providing professional portfolio
management as well as significant shareholder safeguards.
However, current law hinders foreign individual investment in
U.S. mutual funds in that the law does not extend the exemption
from U.S. withholding tax on capital gains and interest income
in investment portfolios to such funds. In particular, interest
income and short-term capital gains, which otherwise would be
exempt from U.S. withholding tax when received by foreign
investors directly or through a foreign fund, are subject to
U.S. withholding tax as ``dividends'' when distributed by a
U.S. fund to its investors.
We note that H.R. 2018 contains a provision that would
exempt such dividends from U.S. withholding tax. This change
would help U.S. firms compete with foreign-based companies in
attracting investments and we commend it to you for your
consideration.
Conclusion
We appreciate having this opportunity to present our views
on these issues. We look forward to working with you in the
further development of solutions to our above-mentioned
concerns.
[By permission of the Chairman]
Statement of Hon. Bill Alexander, American Citizens Abroad (ACA),
Geneva, Switzerland
Mr. Chairman, Members of the Committee: Let me thank you
for the great pleasure of having this opportunity to submit a
written statement. The subject that you are addressing is a
worthy one and also a challenging and perplexing one. It is a
subject that has been of particular interest to me for many
years, including the twenty-four years while I served in this
body representing my constituents in the First Congressional
District of Arkansas.
My District is one of the major rice growing areas of the
United States. Having open and fair access to world markets is
of great concern to my former constituents. To better
understand their challenges, and to better serve their
interests, I helped organize the House Export Caucus. Later,
because of active involvement in issues of trade and
competitiveness, I had the privilege of serving on the
President's Export Council during the Carter Administration.
Through contacts with American business and labor leaders, I
began to understand even more clearly how the laws we enact,
with what we believe to be a very justifiable and noble purpose
in mind, can have very important unintended consequences in
other areas that are also vital to the health and welfare of
all Americans. It is in this conflict between noble and
justifiable aims, and their related unintended consequences,
that leads to the necessity to continually revisit questions
such as the one we are addressing here again today.
While serving on the Export Caucus and the President's
Export Council, I had the opportunity to meet with leaders of a
number of organizations which have been created by Americans
living abroad, whose daily lives are touched by the laws and
regulations of the United States and, in particular, those laws
and regulations that alter the nature of their competitive
standing in the marketplaces of the world.
One of these organizations, American Citizens Abroad (ACA),
has been forceful and eloquent in articulating the concerns of
this expatriate community. For more than twenty years they have
been writing reports, drafting legislation, and proposing other
forms of appropriate redress for the grievances that they feel
are causing harm not only to themselves but also to all
Americans. It is my privilege today to be speaking on behalf of
ACA, one of the strongest and clearest voices of the more than
3 million U.S. citizens who live and work abroad.
Addressing the specific topic of this hearing, we ask:
``Are the tax laws of the United States having an impact on the
competitiveness of American goods and services in world
markets?''
There is another equally important and often overlooked
question. Are U.S. tax laws making it difficult for U.S.
citizens to live and work abroad in competition for jobs and as
entrepreneurs with citizens of other countries?
The quick answer to both of these questions is quite
simple. Yes, the tax laws are having an impact and it is highly
negative.
It is negative principally because the United States is the
only country that has seen fit to extend its domestic tax laws
to embrace the income of its citizens living and working away
from home. This extra-territorial reach of domestic legislation
into foreign markets fundamentally distorts the economic rules
of the game and tilts the playing field. Competitors in the
marketplaces of the world compete by two sets of rules and two
cost structures. One applies to Americans, the other applies to
everyone else.
What the United States did in unilaterally distorting the
competitive environment to the detriment of its expatriate
citizens did not pass unnoticed. Shortly after the United
States started to impose domestic taxation on its overseas
citizens in 1962, the major developed countries of the world,
meeting under the auspices of the Organization for Economic
Cooperation and Development (OECD), took up this very question
of how citizens living away from home should be treated from a
taxation point of view. The OECD members decided that a common
set of standard rules applying to all participants in the same
market should be the norm. The OECD drafted, therefore, a model
bi-lateral tax treaty that defines the tax status of citizens
living away from their home countries. This bi-lateral tax
treaty takes as its fundamental premise that workers should
have a unique tax liability to be defined by the country in
which the individual is residing after a certain minimum period
of time. Double taxation is considered not only unfair but also
detrimental to efficient trading. The OECD model proposes
taxation of individuals that is predictable, consistent and
applies equally to everyone in the same geographical market.
When the United States negotiates tax treaties, it also
uses the OECD model as a base. Then, however, it unilaterally
adds additional language that states boldly that the
protections in these treaties against double taxation will not
apply to U.S. citizens! In other words, bi-lateral tax treaties
negotiated by the United States that ensure competitive
equality to foreign citizens living and working in the United
States, at the same time guarantee competitive inequality and
extra competitive handicaps to Americans living and working
abroad. That, surely, is an incomprehensible trade policy.
Does this really make a difference? Does imposing an
additional tax burden on overseas Americans really have any
impact on the ability of the United States to export American
goods and services?
When I was serving on President Carter's Export Council in
1979, we set up a special task force to look into these and
related questions on the impact of American taxation on trade.
Our analysis was convincing and our conclusions were
unambiguous. The taxation of overseas Americans was costing the
United States billions of dollars in lost trade, and tens of
thousands of export-related jobs each year. We recommended
twenty years ago that the United States stop taxing Americans
living and working abroad so that they might once again enjoy a
level playing field throughout the world.
How has the situation changed since then? We have a lot of
anecdotal evidence to suggest that it hasn't improved very
much. I regret very much that more concrete official
statistical and analytical data is still lacking on this
subject. I would have welcomed the chance to comment on any
studies of the cost-benefit analysis of the taxation of
overseas Americans carried out recently by at least one
responsible agency of the U.S. Government. Unfortunately, no
such studies seem to be available.
How do we explain that the U.S. Commerce Department
prepares an annual assessment of barriers to trade imposed by
other countries, but has never shown any similar curiosity
concerning the barriers we impose on ourselves?
How do we explain the anomaly of the aggressive efforts of
the Office of the Special Trade Representative, ardently
negotiating at the WTO and with foreign governments to open up
foreign markets for U.S. origin goods and services, but never
negotiating internally within the U.S. Government to eliminate
the impediments that we ourselves have erected to the
exploitation of these new market opportunities by our own
citizens?
In the absence of any such official information on this
subject, I asked ACA to prepare the table that is attached to
my statement. This shows the evolution of the Gross Domestic
Product (GDP) of the United States since 1960, before the
taxation of overseas Americans began, right up through the end
of 1998. It also shows the evolution of imports, exports and
the balance of trade since then.
This table shows that when the law introducing expatriate
taxation was first enacted, trade was still a very modest
percentage of GDP, and the United States was enjoying a small
trade surplus. Not long thereafter, when the tax bite was
starting to be felt abroad, trade grew to play a more important
role in our domestic economy and a trade deficit began to
appear. Trade as a percentage of GDP increased from less than
10% in 1962 to almost 25% in 1998. At the same time, the United
States began to generate and accumulate the world's largest and
most chronic trade deficit, which grew to 2% of GDP in 1998
alone.
Taking an international comparative perspective, are the
practices of the United States really that different from those
of other countries? One of the founders of ACA looked
specifically at this question. He carried out a study a few
years ago comparing the way the major trading nations of the
world treat their citizens living and working in foreign
countries, and discovered that taxation was only one of the
areas where the practices of the United States differed
fundamentally from the practices of our competitors.
Citizenship of children born abroad, access to social security
programs, health care, educational benefits, and myriad other
issues are all areas where other countries are usually much
more generous than the United States. These are additional
dimensions of the competitive advantage enjoyed by non-
Americans. Sadly, the United States comes last in two
categories. It imposes heavier burdens and grants fewer
benefits than almost every other major trading nation.
Does it make a difference when it is more expensive and
bureaucratically burdensome for an American expatriate than an
expatriate of another country? Let's put the question a
different way. Would we ever consciously send our armed forces
abroad to fight in foreign conflicts with severe competitive
military handicaps compared with our adversaries? If not, why
do we feel so complacent and have such a different attitude
toward our overseas Americans who have to compete in the
equally ferocious trade battles?
How specifically does the U.S. taxation of overseas
Americans create a handicap? Let me give a few brief examples.
If Americans have to pay taxes to two countries on the same
income, and if both countries define income, and taxes,
differently, there will inevitably be income that is taxed more
than once. Many taxes paid abroad are not recognized as tax
eligible for credit under U.S. tax rules because the tax is
novel and not used the same way in the USA. Even in the case of
credit given for some foreign income taxes paid abroad, the
United States has moved recently to reduce the value of this
credit by applying the Alternative Minimum Tax to the foreign
earned income exclusion. In other words, today there is a
mandatory minimum amount of double tax that has to be paid on
certain incomes, even if that income has already been fully
taxed at the same rate by another country!
The extra tax paid abroad obviously has to come from
somewhere. Either the American expatriate taxpayer then has to
live with a lower take-home pay than colleagues of other
nationalities earning the same gross income, or the employer
will have to make up the difference. In many multinational
companies, the practice in recent years has been for equal
take-home pay for equal work for all expatriate employees of
any nationality. Thus, the employer has to endure an extra
expense for every U.S. citizen on the payroll. Ask, as I have
done, whether corporations overseas are less inclined to hire
Americans than people of other nationalities and the answers
are usually clear and unambiguous. Americans are less likely to
be hired because they are more expensive. The net difference in
cost is a payment that has to be made to the U.S. government
for the privilege of having an American on the payroll. And,
because of the way the repayment of the extra tax is made, the
burden grows larger every year. So even if an American is hired
to work abroad, the extra cost for an expatriate American keeps
getting larger and larger. This is another incentive to reduce
the American expatriate staff.
Even more perplexing and competitively debilitating is the
exquisite complexity of the U.S. tax laws as they apply to
Americans living and working abroad. Because they are so hard
to understand, many Americans are forced to have recourse to
expensive tax and legal consultants and can end up paying even
more in service charges to correctly fill out their tax returns
than they end up paying in tax. The competitive handicap then
becomes double. Not only is the tax a burden, but the cost of
complying with the complexity of the tax compounds the burden.
Finally, Mr. Chairman, we should be paying much more
attention to the competitive handicap that our tax laws create
for American entrepreneurs overseas, especially those who are
willing to set up a small business in remote parts of the
world. The costs associated with the filling out of forms and
filing returns for small entrepreneurial controlled foreign
corporations are a very heavy disincentive. The only way many
such businesses could survive is by simply ignoring the current
law and risking the consequences. Yet who better than an
American entrepreneur should be encouraged to go abroad, set up
an innovative new business, and manifest the virtues and
benefits of the liberal democratic political and economic
system we have found to be so propitious to our welfare and way
of life at home.
In other words, does it really make sense for the United
States to spend billions of dollars each year of taxpayer money
on aid projects in developing countries when, without any cost
to the United States, we could simply turn loose our American
entrepreneurs and wish them well? If we would get rid of the
expense and complexity of our current tax laws as a
disincentive to our entrepreneurs, I believe we could much more
effectively help developing countries become much more
prosperous, and at a much lower cost to the American taxpayer.
My concern about the importance of overseas Americans to
the long term economic health and vitality of our country
motivated me to introduce legislation to end the taxation of
Americans overseas. The last bill, which I introduced in 1992
(102nd Congress HR 4562), was co-sponsored by my good friend
Congressman Ben Gilman, now the Chairman of the House Committee
on International Relations.
In summary, my conviction is that changing the tax laws of
the United States would have a dramatic and material impact on
the ability of Americans to compete in foreign markets. I
believe that this would encourage many more Americans to live
and work abroad, to set up small businesses abroad, and be a
powerful contribution toward a more safe and prosperous world.
It is noteworthy that overseas Americans have never asked
the U.S. Government for special competitive favors abroad. Are
they really asking for too much when they request the right to
be able to compete on a more level playing field? I think not.
My hope, therefore, Mr. Chairman, is that you and your
colleagues will agree that giving overseas Americans a fair and
equal chance to compete abroad is not only good for them, but
good for us all. Amending the tax laws of the United States
would have a positive impact on the international
competitiveness of our country and its citizens at home and
abroad.
Thank you.
[GRAPHIC] [TIFF OMITTED] T6775.005
Statement of the American Petroleum Institute
I. Introduction
This statement is submitted by the American Petroleum
Institute (API) for the June 30, 1999 Ways and Means hearing on
the impact of U.S. tax rules on the international
competitiveness of U.S. workers and businesses. API represents
approximately 300 companies involved in all aspects of the oil
and gas industry, including exploration, production,
transportation, refining and marketing.
Significance of Foreign Operations for U.S. Oil Companies
While U.S. petroleum reserves are depleting, federal and
state government policies increase restrictions on exploration
for, and development of, new deposits. To stay in business,
U.S. petroleum companies must find new reserves overseas. This
is at a time when U.S. oil industry is losing its leadership
position because of the shrinking advantages over its foreign
competition from U.S. technology and investment capital.
The loss of ground by U.S. oil companies relative to their
foreign competitors is alarming. In 1974, 6 of the 10 largest
oil companies in the world, and 4 of the top 5, were U.S.-
based. In 1995, only 5 of the top 10 companies, and 2 of the
top 5, were U.S.-based. According to a recent API study for the
period of 1985 to 1995, foreign production by U.S. companies
increased by 300,000 barrels/day. Nevertheless, that was not
enough to offset the declines in U.S. production, so that U.S.
companies' total global production during that period actually
declined. Over that same period, production by similarly sized
foreign oil companies other than those from OPEC countries
expanded nearly 60%.
U.S. Tax Policy Adversely Affects Competitiveness
A major factor in the decline in U.S. companies' relative
share in global production is U.S. international tax policy.
U.S. tax rules impose a substantial economic burden on U.S.
companies not faced by their foreign competition. This is
because the U.S. tax regime exposes U.S. multinational
companies to double taxation (that is, the payment of tax on
foreign source income to both the host country and to the U.S.)
and to taxation before repatriation of profits. Moreover,
complexities of the U.S. tax rules result in significant
compliance costs not faced by foreign competitors. As a result,
U.S. companies may be forced to forego foreign investment
altogether based on projected after-tax rates of return, or
they may be preempted in bids for overseas investments by their
foreign competitors.
Since the early sixties, U.S. tax policy has been driven by
the goal of capital export neutrality which purports to remove
any tax advantages of foreign investment by equalizing the tax
burden for U.S. and foreign investments. A continuing adherence
to this policy ignores that the allocation of investment
capital is no longer controlled by multi-national corporations
alone but is increasingly influenced by portfolio investors,
reflecting the development of a global capital market. Thus,
tax policy no longer exerts the same control over domestic vs.
foreign investment by U.S. corporations as in the past, but may
affect whether U.S. residents invest through U.S. or foreign
corporations.
Foreign Investment Strengthens the U.S. Economy
U.S. tax policy with respect to foreign source income,
although intending to tax the return on foreign and domestic
investment the same, has developed a demonstrable bias against
foreign operations. This policy was based on the postulate that
foreign investment by U.S. business loses jobs and capital for
the domestic market. This is not empirically demonstrable. More
importantly, this ineffective policy, as a relict of a past
era, conflicts with global integration and removal of trade
barriers.
With the entry into the information age, foreign investment
by U.S. companies must no longer be viewed in the context of a
Runaway Plant problem, but as creating new opportunities for
U.S. employment in management and support functions as well as
the export of products and technology. Moreover, for U.S. oil
companies the location of opportunities for investment is
dictated by subterraneous geological history. It is merely a
question of whether the U.S. company or its foreign competitor
will have the opportunity of the investment in the oil and gas
project. But in case of a failure of the U.S. company to obtain
the business opportunity, it is not at all certain that the
freed up capital be invested in the U.S. First of all, there
may be a lack of comparable domestic investment opportunities.
Secondly, the U.S. portfolio investor, who ultimately controls
the available capital, may shift his investment to a foreign
competitor who has access to more profitable projects.
Foreign investment by a U.S. oil company has significant
benefits. A persistent, strong foreign presence of U.S. oil
companies maintains foreign employment of U.S. personnel and
utilization of U.S. technology in foreign markets and maintains
domestic employment in activities which support those
companies' foreign operations. The U.S. oil and gas industry
directly employs almost 60,000 Americans in the U.S. in jobs
directly dependent on these companies' international
operations. Over 140,000 additional Americans are employed in
the U.S. by U.S. suppliers to the industry's foreign
operations. An additional 150,000 Americans are employed in the
U.S. supporting those working for the oil companies and their
suppliers. Thus, over 350,000 Americans owe their jobs to the
international success of the U.S. oil and gas industry.
As distinguished from tax policy, U.S. trade policy
supports foreign investment by U.S. oil companies. Examples are
the encouragement to U.S. participation in the oil field of the
Caspian Sea countries which was praised by the Administration
as fostering the political independence of those newly formed
nations, as well as securing new sources of oil to Western
nations, still too heavily dependent on Middle-East imports.
The opening of the countries of the former Soviet-Union to
foreign capital and the privatization of energy in portions of
Latin America, Asia and Africa--all offer the potential for
unprecedented opportunity in meeting the challenges of
supplying fuel to a rapidly growing world economy. In each of
these frontiers, U.S. companies are poised to participate
actively. However, if U.S. companies cannot compete because
they operate under comparatively disadvantageous home country
tax rules, foreign resources will instead be produced by
foreign competitors, with little or no benefit to the U.S.
economy, U.S. companies, or American workers.
The Goal of Capital Export Neutrality Overshot
Tax Code provisions that are driven by capital export
neutrality often violate their theoretical underpinning. As we
will discuss below, the fractioning of the foreign tax credit
(FTC) basket, the income sourcing and deduction allocation
rules, the imposition of U.S. concepts in testing the income
tax character of a foreign tax,\1\ the limited excess credit
carryover, and the transfer pricing criteria, all can result in
double taxation, clearly in violation of capital export
neutrality. Similarly, where the foreign tax is higher, there
is no reduction of the U.S. tax and the foreign investment
bears more tax as compared to the domestic opportunity, failing
to assure export neutrality.
---------------------------------------------------------------------------
\1\ In other words, the arrogated preemption of the foreign
sovereign's choice of how to exercise its power to tax.
---------------------------------------------------------------------------
Hearing Promises Correction in Priorities of U.S. tax policy
We welcome this Hearing as a recognition of the need of an
overhaul of the taxation of foreign source income that is
driven by a reformulated U.S. tax policy with multinational
competitiveness \2\ as primary criterion.
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\2\ By the JCT defined as ``the ability of U.S. multinationals
(firms headquartered in the United States that operate abroad) that
locate production facilities overseas to compete in foreign markets. .
. . This definition of competitiveness focuses on the after-tax returns
to investments in production facilities abroad.'' E.g., JCS-6-91, at 8
(1991).
---------------------------------------------------------------------------
In the past, revenue raising in and of itself was
paramount. One will recall that in the last hours of the
deliberations of the Tax Reform Act of 1986 it was the taxation
of foreign source income that was used as a source of
additional revenue. To further illustrate, the Treasury
Department's January 1993 interim report on ``International Tax
Reform'' lists simplification as primary objective, followed by
administrability, consistency, economic efficiency, and (only
last) ``competitiveness.'' The Committee's focus on what should
be the primary criterion of a sound tax policy for the taxation
of foreign source income will assure that tax policy will fall
into step with a modern trade policy.
The international competitiveness of U.S. firms must become
the primary criterion for U.S. taxation of foreign source. This
will agree with U.S. foreign trade policy for the new global
market place which. Efforts must continue to level the playing
field as regards home country taxation. Such efforts should
include considerations of whether the time has come for the
introduction of a territorial system of taxation by the United
States.
A realignment of the present system with today's global
market place will contribute to a strengthening of the foreign
presence of U.S. oil companies which assures not only
employment of U.S. personnel both abroad and in domestic
support functions, but also exports of equipment and supplies
from the U.S. for use in the foreign operations.
Passage of The International Tax Simplification for American
Competitiveness Act of 1999, H.R. 2018 Would be a Significant
Step Towards Leveling the Playing Field in the Global Market
Place
The proposed International Tax Simplification for American
Competitiveness Act of 1999, H.R. 2018, goes a long way toward
simplifying the current U.S. international tax rules and
removing some of the inequities in the existing system. As
reflected in our subsequent discussion, of particular interest
to our members are: the repeal of compliance costly Code
Section 907 additional separate limitation on Foreign Oil and
Gas Extraction Income (FOGEI) as obsolete because of the
numerous cross-crediting limitations under the FTC basket rules
and the all industry encompassing dual capacity taxpayer
regulations (Sec. 208); the acceleration of the repeal of the
separate FTC limitation for dividends received from
noncontrolled 10/50 companies (Sec. 204); the recognition of
the need to treat the European Union as one country under the
subpart F rules (Sec. 102); the introduction of symmetry
through the adoption of an overall domestic loss recapture
(Sec. 202); the look-through for sales of partnership interests
(Sec. 107); the extension of look-through rules to interest,
rents, and royalties from a noncontrolled Section 902
corporation or a noncontrolled foreign partnership (Sec. 205);
the repeal of the 10% limitation on the use of FTCs under the
Alternative Minimum Tax (AMT)(Sec. 207); the option to
determine subpart F E&P under generally accepted accounting
principles (Sec. 104); the exception of foreign operations of
foreign persons from the uniform capitalization rules (UNICAP)
(Sec. 302); the clarification that income solely from pipeline
transportation through a foreign country is not subject to
subpart F (Sec. 105); the extension of the FTC carryforward to
ten years (Sec. 201) and the change of the ordering rules so
that carryover credits are deemed to be used first (Sec. 206);
and the recognition of the need to correct the distorting and
complex interest allocation rules (Sec. 309).
Our statement comments in more detail on these provisions.
We also highlight other aspects of current law which affect our
members' international competitiveness due to potential double
taxation, the taxation of controlled foreign corporations'
(CFC) earnings before repatriation, and the disproportionate
compliance costs. We suggest relief from these problems which
should have no or little revenue effects.
II. How U.S. Tax Rules Place U.S. Companies at a Competitive
Disadvantage in the Global Marketplace
Foreign Tax Credit and Deferral as Corollaries of World Wide
Taxation
One of the most serious risks to foreign operations by
multinational firms is their vulnerability to double taxation.
Two approaches have been adopted to remedy this problem:
worldwide taxation with a credit for taxes paid to foreign
governments, and territorial taxation which limits a home
country's taxation of its citizens to income generated within
its national boundaries.
The U.S. taxes domestic corporations on worldwide income.
That is, U.S. companies are subject to the same U.S. tax
liability whether that income is earned at home or abroad. As a
complement to world-wide taxation, the FTC is, of course,
designed to prevent double taxation. Furthermore, world-wide
income should be taxed only when realized by the subjects of
U.S. taxation, i.e., U.S. citizens (including U.S.
corporations) and resident aliens. Legislative and
administrative changes within the last several decades have
severely diluted and emasculated these tenets.
The Flawed Foreign Tax Credit Regime
Although the U.S. allows a credit against a company's U.S.
tax liability for taxes paid to foreign governments, the FTC
does not fully protect U.S. companies against double taxation,
placing U.S. companies at a competitive disadvantage. In
addition, the FTC will not assure export neutrality where the
host country imposes a higher tax than the U.S. tax because
there is no refund of the excess tax burden.
But even where the host country tax is equal to or lower
than the U.S., many of the FTC rules prevent export neutrality
because they subject US corporations to double taxation. As
discussed, these restrictive features include the rules on (1)
creditability of foreign taxes which impose U.S. income tax
criteria on foreign tax regimes; (2) limited credit carryover
periods which do not take into account the differences in
income and deduction recognition timing under the host country
rules; (3) the numerous FTC baskets; (4) transfer pricing; (5)
sourcing of income; (6) allocation of deductions; (6) transfer
pricing; (7) and loss of deferral which inhibits effective tax
credit management.
Many of our trading partners limit home country tax of
their citizens to income generated within their national
boundaries. Foreign competitors based in territorial taxation
countries still enjoy a benefit even where the host country tax
is lower than the U.S. tax and the above mentioned distorting
effects do not come into play.
For example, when income earned abroad by a U.S. company is
subject to a foreign income tax rate that is less than the U.S.
rate, then U.S. companies are subjected to a tax burden (to the
U.S.) not borne by foreign competition from a country with
territorial taxation:
------------------------------------------------------------------------
Competitor from
U.S.-based territorial
company system home
country
------------------------------------------------------------------------
Income from Host Country.......... 100 100
Host country tax at 25%........... 25 25
Take home......................... 75 75
Home country taxable income....... 100 0
U.S. tax at 35%................... 35
FTC............................... 25
Residual U.S. tax................. 10
After Tax Income.................. 65 75
Competitor's Higher Return........ 15.4%
------------------------------------------------------------------------
U.S. Shareholders are Taxed on Deemed Dividends
As originally adopted, world-wide taxation by the U.S. was
intended to capture the income of citizens and residents.
However, driven by a concern that US taxpayers could keep
movable passive income in CFCs outside the US taxation, anti-
deferral rules were adopted which tax the U.S. shareholder
before it realizes certain earnings of its CFC. Despite this
``movable passive income'' rationale for the subpart F regime,
anti-deferral rules were extended to certain operating income
despite the fact that such earnings were not received by the
shareholder and may have been reinvested by the CFC in active
business operations.
III. Relief from Major Adverse Rules
A. Defects in the Foreign Tax Credit Regime
Foreign Tax Credit Separate Basket Rules. Foreign taxes can
be utilized as a credit only up to the amount of U.S. tax on
foreign source income. Thus, an overall limitation on currently
usable FTC's is computed by taking the ratio of foreign source
income to worldwide taxable income and multiplying this by the
tentative U.S. tax on worldwide income. The FTC separate basket
rules further limit the allowable FTC. The overall FTC
limitation must be computed separately for more than nine
separate categories, or baskets, of foreign source income.
Thus, U.S. tax rules force taxpayers in the active conduct of a
trade or business to divide their active business income into
multiple baskets, with the concomitant inability to cross
credit. U.S. companies are often unable to make up for
differences in timing and the mutations of the income/expense
profiles, etc., of the tax regimes of the host countries.
Because the separate basket rules increase the likelihood that
a U.S. company will owe residual U.S. tax on foreign source
income, they further widen the gap between the U.S. companies'
and their competitors' home countries tax systems, to the
disadvantage of U.S. businesses.
Foreign taxes on active business income should be available
for cross credit. We must return to the roots of the FTC and
allow full credit against U.S. taxes on foreign business income
for all foreign taxes and not limit their use through the
imposition of a schedular system. Any undesirable shielding of
U.S. tax on offshore passive income can be prevented by one
separate passive basket.
Foreign Oil and Gas Extraction Income and Foreign Oil
Related Income. Code Section 907. In the computation of the
overall FTC limitation foreign oil and gas income falls into
the general limitation basket. But before this limitation for
general operating income, foreign income taxes on foreign oil
and gas income have to clear the additional tax credit hurdle
of Code Section 907.
Section 907 limits the utilization of foreign income taxes
on FOGEI to that income times the current U.S. corporate income
tax rate. The excess credits may be carried back two years and
carried forward five years, with the creditability limitation
of Section 907 being applicable for each such year. Section 907
also authorizes Treasury to provide in regulations that a
purported income tax on foreign oil related income (FORI) is
not creditable but only deductible to the extent such income
tax on FORI is materially greater than the amount of tax
imposed on income other than FORI or FOGEI. FORI is income
derived from the foreign refining, transportation, and
distribution, of oil and gas and its primary products.
Furthermore, Section 907 provides that, if the taxpayer has an
overall foreign extraction loss in a year that reduces non-
extraction income, a corresponding amount of FOGEI in a
subsequent year has to be re-characterized as income which is
not FOGEI.
Section 907 was originally enacted in 1975 in reaction to
the first oil crisis and out of a concern that the high oil and
gas production taxes paid to host countries might be in part
the economic equivalent of ground rents or royalties. Unlike
the U.S. and some Canadian provinces, mineral rights in other
countries vest in the foreign sovereign, which then grants
exploitation rights. Because of this identity of the grantor of
the mineral rights and the taxing sovereign, the high tax rates
imposed on oil and gas profits have become subject to scrutiny
whether this government take is in part payment for the grant
of ``a specific economic benefit'' from the mineral
exploitation rights.
Congress intended for the FOGEI and FORI rules to purport
to identify the tax component of payments by U.S. oil companies
to foreign governments. The goal was to limit the FTC to that
amount of the foreign government's ``take'' which was perceived
to be a tax payment vs. a royalty as payment for the production
privilege. But even the so identified creditable tax component
should be not be used to shield the U.S. tax on certain low
taxed other foreign income, such as shipping.
These concerns have been adequately addressed in subsequent
administrative rulemaking and legislation. After several years
of discussion and drafting, Treasury completed in 1983 the
``dual capacity taxpayer rules'' of the FTC regulations which
set forth a methodology for determining how much of an income
tax payment to a foreign government will not be creditable
because it is a payment for a specific economic benefit. Such a
benefit could, of course, also be derived from the grant of oil
and gas exploration and development rights. These regulations
have worked well for both IRS and taxpayers in various
businesses (e.g., foreign government contractors), including
the oil and gas industry. In addition, the multiple separate
basket rules were enacted in 1986, restricting taxpayers from
offsetting excess FTC's from high-taxed income against taxes
due on low-tax categories of income.
Since 907 has been rendered obsolete since the function of
Section 907 is now fully covered by the FTC baskets of the 1986
Act and the ``dual capacity taxpayer regulations'' under Code
Section 901. Furthermore, the Section 907 limitation has raised
little, if any, additional tax revenue because excess FOGEI
taxes would not have been needed to offset U.S. tax on other
foreign source income. Nevertheless, oil and gas companies
continue to be subject to burdensome compliance work. Each
year, they must separate FOGEI from FORI and the foreign taxes
associated with each category. These are time consuming and
work intensive analyses, which have to be replicated on audit.
Section 907 should be repealed as obsolete [Sec. 208 of The
International Tax Simplification for American Competitiveness
Act of 1999] which would promote simplicity and efficiency of
tax compliance and audit.
Dividends Received from 10/50 Companies. The 1997 Tax Act
repealed the separate basket rules for dividends received from
10/50 companies, effective after the year 2002. A separate FTC
basket will be required for post-2002 dividends received from
pre-2003 earnings. Because of these limitations, U.S. companies
will continue to forego in many cases foreign projects through
noncontrolled 10/50 corporations. Accordingly, the repeal will
remove significant complexity and compliance costs for
taxpayers and foster their global competitiveness.
The repeal of the separate limitation basket requirement
with respect to dividends received from 10/50 companies
therefore should be accelerated. In addition, the requirement
of maintaining a separate limitation basket for dividends
received from E&P accumulated before the repeal should be
eliminated [see Sec. 204 of The International Tax
Simplification for American Competitiveness Act of 1999].
Look-through Treatment for Sale of Partnership Interests.
The distributive share of partnership income of an at least 10%
partner of a foreign partnership brings with it all tax
attributes, including the FTC basket classification. By
contrast, the gain on the sale of a partnership interest falls
into the passive income FTC category. A 1988 amendment to Code
Section 954 characterizes the gain on the disposition of a
foreign partnership as Foreign Personal Holding Company Income
(FPHCI) which is referenced in the passive income definition of
the FTC categories.
The passive income categorization is particularly
burdensome for the oil and gas industry. Because of frequent
inability to secure 100% of the mineral interest from foreign
governments, the business strategy to spread the risk of
exploration by participating in several projects instead of
``putting all the eggs into one basket,'' or because of capital
restraints, U.S. companies typically find themselves as joint
venturers in foreign exploration projects. Unless there is an
election-out under the Joint Operating Agreement, the venture
will be a partnership for U.S. purposes. Under current rules
the gain from the sale of such venture participation would be
passive income even though it is the disposition of an interest
in business operations whose venue was not chosen for tax
reasons but because of nature's placement of the natural
resource.
The 1988 amendment conflicts with the aggregate theory of
partnership taxation. It is generally applied in foreign income
taxation with respect to the effect of partner level
transactions. Furthermore, there is no rationale for treating
the disposition gain different from the income distribution.
Both are realizations of values generated in the partnership
and differ only in the form of realization.
Economically, any gain on the sale of the partnership
interest is attributable to the value of the partnership
assets. If the partnership sold the assets, the FTC categories
for such income would flow through to the partner. The same
rule should apply if the partner by selling its partnership
interest sells the equivalent of its undivided interest in the
partnership assets [See Section 107 of The International Tax
Simplification for American Competitiveness Act of 1999 which
removes the gain on disposition of a partnership interest from
passive income not only for purposes of the FTC basket rules
but also from FPHCI]. It is not only inequitable but also
counterintuitive for the legal form of the value realization to
control the FTC basket characterization.
Look-through Treatment for Interest, Rents, and Royalties
With Respect To Non-Controlled Foreign Corporations and
Partnerships. U.S. companies are often unable, due to
government restrictions or operational considerations, to
acquire controlling interests in foreign corporate joint
ventures. To align their position with general participation
situations in foreign projects, they also should be granted the
look-through treatment for interest, rents and royalties
received from foreign joint ventures as in the case of
distributions from a CFC.
Current tax rules also require that payments of interest,
rents and royalties from noncontrolled foreign partnerships
(i.e., foreign partnerships owned between 10 and 50% by U.S.
owners) must be treated as separate basket income to the joint
venture partners. Again, as in the case of corporate joint
ventures, look-through treatment should be extended to these
business entities. This would abolish distinctions in treatment
of distributions that are based on participation percentages
which may be beyond the control of the U.S. taxpayer [See
Section 205 of The International Tax Simplification for
American Competitiveness Act of 1999].
Recapture of Overall Domestic Losses. When in a tax year
foreign source losses reduce U.S. source income (overall
foreign loss or OFL), this perceived beneficial domestic
taxation effect has to be ``recaptured'' by resourcing foreign
source income in a subsequent tax year as domestic source. Of
course, this re-characterization reduces the ratio of foreign
source income to total income, which in turn reduces the ratio
of tentative U.S. tax which can be offset against foreign
taxes. However, if foreign source income is reduced by U.S.
source losses, there is no parallel system of ``recapture.''
Taxpayers are not allowed to recover or recapture foreign
source income that was lost due to a domestic loss. The U.S.
losses thus can give rise to excess FTC's which, due to the FTC
carryover restrictions, may expire unused. Only a corresponding
re-characterization of future domestic income as foreign source
income will reduce the risk that FTC carryovers do not expire
unused [See Section 202 of The International Tax Simplification
for American Competitiveness Act of 1999].
Foreign Tax Credit Carryover Rules. The utilization of
income taxes paid to foreign countries as FTC is limited to the
U.S. tax that is owed on the foreign source income. Thus, an
overall limitation on currently usable FTC's is computed by
taking the ratio of foreign source income to worldwide taxable
income and multiplying this by the tentative U.S. tax on
worldwide income. The excess FTC's can be carried back to the
two preceding taxable years, or to the five succeeding taxable
years, subject in each of those years to the same overall
limitation. If the credits are not used within this time frame,
they expire.
Because of the ever increasing limitations on the use of
FTC's, coupled with the differences in income recognition
between foreign and U.S. tax rules, excess credit positions are
frequent. Present law's short seven year carryover (2-year
carryback and 5-year carryforward) period easily results in
credits being lost, most likely resulting in double taxation.
As a modernization step, clearly within the long-standing
policy of not taxing the same income twice, the carryover
periods for excess FTCs should be extended, in accordance with
the rationale of the much longer period allowed for net
operating loss utilization [See Section 201 of The
International Tax Simplification for American Competitiveness
Act of 1999 which extends the carryforward to 10 years and Sec.
206 assuring first use of carryover credits].
Allocation of Interest Expense. Current law requires the
interest expense of all U.S. members of an affiliated group to
be apportioned to all domestic and foreign income, based on
assets. The current rules deny U.S. multinationals the full
U.S. tax benefit from the interest incurred to finance their
U.S. operations. For example, if a domestically operating
member of a U.S. tax consolidation with foreign operations
incurs interest to finance the acquisition of new environmental
protection equipment, a portion of the interest will be
allocated against foreign source income of the group and
therefore become ineffective in reducing U.S. tax. A U.S.
subsidiary of a foreign corporation (or a U.S. corporation--or
affiliated group--without foreign operations) would not suffer
a comparable detriment.
Unless allocation based on fair market value of assets is
elected, allocations of interest expense according to the
adjusted tax bases of assets allocate too much interest to
foreign assets. For U.S. tax purposes, foreign assets generally
have higher adjusted bases than similar domestic assets because
domestic assets are eligible for accelerated depreciation while
foreign-sited assets are assigned a longer life and limited to
straight-line depreciation. For purposes of the allocation, the
E&P of a CFC is added to the stock basis. Since the E&P
reflects the slower depreciation, the interest allocated
against foreign source income is disproportionately high.
Rules similar to the Senate version of interest allocation
in the Tax Reform Act of 1986 would alleviate the current anti-
competitive results. In addition to the domestic consolidated
group, the allocation group would include all companies that
would be eligible for U.S. tax consolidation but for being
foreign corporations. The interest allocated to foreign source
income under this worldwide taxpayer rule would be reduced by
the interest that would be allocable to foreign source income
from the foreign corporations if treated as separate group.
Second, as an exception to the ``one taxpayer'' rule, ``stand
alone'' subsidiaries could elect to allocate interest on
certain qualifying debt on a mini-group basis, i.e., looking
only to the assets of that subsidiary, including stock.
Furthermore, taxpayers should be allowed to elect to use
the E&P bases of assets, rather than the adjusted tax bases,
for purposes of allocating interest expense. Use of E&P basis
would produce a fair result because the E&P rules are similar
to the rules now in effect for determining the tax bases of
foreign assets [See H.R. 2270 introduced by Messrs. Portman and
Matsui as the Interest Allocation Reform Act].
Foreign Tax Credit Limitation under the Alternative Minimum
Tax. U.S. tax rules prohibit the use of FTC's to reduce the
tentative minimum tax (AMT) to less than 10% of the tax before
the FTC (AMT FTC Cap). Excess credits are eligible for
carryover under the same carryover rules discussed above. The
AMT FTC Cap was part of a general floor for the use of net
operating loss (NOL) and investment tax credit (ITC)
carryovers. But the FTC serves a function distinct and
different from NOLs or the ITCs, the other tax attributes whose
utilization is limited for AMT purposes.
The NOL carryover rules are designed to overcome any
hardships resulting from the annual accounting concept. The ITC
is a tax benefit designed to foster investment in productive
capital. Both provisions developed only over time and do not
have the systematic cogency of the FTC. As the logical and
systematic result of the U.S. claiming worldwide taxing
jurisdiction over U.S. corporations, the FTC has been a fixture
of the U.S. tax system since 1918. Concurrently with the
adoption of worldwide taxing jurisdiction, the U.S. ceded
primary taxing jurisdiction to the host country. To deny a full
offset of AMT with FTC violates this principle of secondary
U.S. taxation of foreign source income.
The AMT's rationale to assure U.S. tax payments on economic
income is inappropriate with respect to foreign source economic
income if the result is double taxation. While the AMT
envisions acceleration of tax payments which otherwise would
become due in the future (only deferred because of preferences
or tax attributes like NOL and ITC), the availability of FTC's
reflects that an appropriate tax already has been exacted from
the taxpayer. To the extent of FTC's, there is no economic
income which escapes taxation. Accordingly, the AMT FTC Cap
should be repealed [See Section 207 of The International Tax
Simplification for American Competitiveness Act of 1999].
Repeal Code Section 901(j) which Denies Foreign Tax Credit
with Respect to Countries Supporting Terrorism, Etc. The global
political landscape has changed considerably since the
enactment of this provision in 1986. Not only are
confrontational polarizations into opposing power centers
fading, so is terrorism as means of international politics.
Barriers have come down so fast that the establishment of
diplomatic relations cannot keep up with global integration.
The retention of this provision merely hinders business
developments because of the lag in establishing full diplomatic
relations.
State Tax Allocation to Foreign Income. Pursuant to a
statutory grant of general rulemaking authority, Treasury has
issued regulations requiring the allocation of State income
taxes or income based franchise taxes to foreign source income
if taxable income determined under State law exceeds Federal
taxable income. Because of the often substantial variances
between these two tax bases, U.S. taxpayers may be subject to
double taxation because foreign taxes attributable to the
foreign income that is eliminated by the misallocation of State
taxes will not offset U.S. tax on worldwide income. State
income taxes are a cost of doing business in a particular State
and generally have nothing to do with a U.S. taxpayer's foreign
operations; they should affect only income generated from
activities within the State. From a technical standpoint, the
allocation rule is defective because it compares State taxable
income with Federal taxable income; the respective regimes may
differ substantially as to inclusiveness and timing. This
misallocation therefore should be abolished.
Overreaching Treasury Regulations on Dual Consolidated
Losses. IRC Section 1503(d) was designed to forestall a
perceived abuse where a U.S. affiliate's net operating loss was
not only deducted against the income of another U.S. company
but under a foreign tax regime also reduced the income of a
foreign affiliate. That Section authorizes regulations to
except U.S. corporations from this loss disallowance to the
extent the losses do not offset the income of another foreign
corporation under the foreign tax law. Treasury has issued a
regulation pursuant to which practically every foreign business
operation of a U.S. corporation jeopardizes the deduction of a
loss from the foreign venture for the U.S. tax consolidation
unless unreasonable administrative undertakings are stipulated.
For example, a U.S. consolidated return corporation with
foreign nexus, including a mere interest in a foreign
partnership, can use a loss in computing consolidated return
income only if it enters into a burdensome agreement with the
IRS which requires continuous monitoring and in many cases
annual reporting. In light of the burdensome and overreaching
administrative rule, the statute should limit loss disallowance
to the targeted abuse and preempt the current regulatory
overkill.
B. Relief from Shareholders' Current Taxation of CFC Earnings
Repeal the Byzantine High-Tax Kick-Out. According to FTC
basket rules, otherwise passive income is not included in the
passive FTC basket if it is subject to a foreign tax rate in
excess of the U.S. rate. The implementing regulations impose a
regime that defies a brief summary.
These labyrinthine rules add enormous complexity. The
computation of sub-groups and sub-baskets, together with the
various sets of rules for determining the amount of tax on a
particular type of income, impose inordinate burdens on the
foreign and domestic tax personnel of U.S. multi-national
corporations.
The primary reason for the separate passive income basket
is the perceived easy mobility into low tax jurisdiction. If
this goal is not realized, there is no reason to mingle passive
income with operating income, because the underlying
characteristic of mobility and its passive character remains.
``Once passive income, always passive income.'' Accordingly,
the ``high-tax kick-out'' should be repealed.
E&P for Sub-part F Should be Based on GAAP Financial
Statements. Under current rules, for the taxation of the US
shareholder, E&P of foreign corporations have to be determined
according to US tax accounting rules. The accounting personnel
and accounting systems of foreign subsidiaries typically do not
allow simple adjustments to US tax books. Proposed regulations
under Code S964 recognize the unrealistic nature of such a
requirement and grant relief from most book to tax adjustment.
Unfortunately, this relief--because of a perceived lack of
statutory authority--does not extend to the determination of
E&P in connection with computing whether or not there is a
deemed distribution of subpart F income that may have been
realized by the CFC.
Nevertheless, the reasons for the dispensation from the
book to tax adjustments under the proposed Section 964
regulations apply equally in connection with subpart F. Without
extension of the relief to the E&P computation for subpart F
purposes, the Section 964 relief is meaningless. Because of the
possibility that a CFC may realize income of the type that may
give rise to subpart F income it has to track its E&P under
current rules according to US tax accounting principles.
A uniform recognition of financial statements of CFCs for
all purposes of the taxation of its US shareholders would
remove an unnecessary, costly compliance feature [See Section
104 of The International Tax Simplification for American
Competitiveness Act of 1999].
Anti-Deferral Rules Should Not Be Applied To Pipeline
Transportation. Under Code Section 954(g), a CFC's foreign base
company oil related income (FBCORI, i.e., a CFC's FORI derived
other than in a country of extraction or consumption) includes
pipeline transportation income. In the past such income was
typically derived as integral part of downstream oil and gas
operation (processing, refining, and marketing).
Large pipeline projects through non-producing countries
without further processing are a recent phenomenon. The
original ratio legis behind the FBCORI category does not apply
to such pipeline transportation. The location is not subject to
tax consideration but is controlled by the most feasible
connection between production site and intended naval
transshipping or consumption point, taking into account
construction and maintenance cost, as well as political
considerations.
Accordingly, income from carrying oil and gas in a pipeline
through a country should be excepted from FBCORI [See Section
105 of The International Tax Simplification for American
Competitiveness Act of 1999].
Treat European Community as Single Country. In recognition
of economic realities, all countries comprising the European
Community (EC) should be treated as a single country for
purposes of the subpart F rules on foreign base company sales
income and foreign base company service income. Where the
perceived taint of tax arbitrage through cross-border
transactions is missing, US tax rules except what would
otherwise be subpart F income if derived from transactions
within the CFC's country of incorporation. The same rationale
should applies in excepting transactions to the unified market
of the EC nations, representing customs and monetary unity with
the goal of tax harmonization. This would be an important step
in the reduction of the disadvantage CFCs experience in the
common market vis a vis their EC based competitors.
The recognition of the EC as one country should also apply
to the ``same country'' exception FBCORI. Without such
modification, the EC's recognition as one country would not
carry over into refining, distribution, and marketing of oil
and gas as well as their primary products. For example, a CFC's
sale in Germany of gasoline from its refinery in The
Netherlands would continue to be tainted, even though the
transaction takes place within the borders of what now is
recognized as one economy [The problem is recognized in the
study commissioned under Section 102 of The International Tax
Simplification for American Competitiveness Act of 1999].
IV. Provisions Common to FTC and Anti-Deferral Rules
Exempt Foreign Operations of Foreign Persons from the Uniform
Capitalization Rules
The Uniform Capitalization Rules (UNICAP) of Code Section
263A are designed to assure that (1) all production cost are
capitalized and (2) the same rules apply to the production
activities of all industries. Perceived tax accounting
differences among industries and activities were seen as
unwelcome factors in resource allocation and structural
alignments. Moreover, it was argued that a better matching of
income and expenses would also prevent unwarranted deferral of
income taxes.
The application of UNICAP to foreign operations of foreign
persons was not a concern of Congress. It has been the
Service's failure to exercise its regulatory discretion which
still subjects foreign operations of foreign persons to UNICAP.
An exemption from UNICAP would bring simplicity. It would
not violate equity. Any attempt to equalize tax postures of
foreign persons with respect to foreign operations is futile
because of the ever changing tax regimes in the host countries.
Because of excess FTCs it would be revenue neutral. Because of
a relief from compliance cost, the exemption would promote
competitiveness [See Section 302 of The International Tax
Simplification for American Competitiveness Act of 1999].
V. Conclusions
The risk of double taxation presented (1) by restrictions
on the use of FTC and (2) by the current taxation to the U.S.
shareholder of certain CFC income regardless of distribution,
continues to adversely affect the ability of U.S. businesses to
compete worldwide. The complexity of the U.S. tax rules
obfuscate tax planning and introduce often substantial risks,
hindering effective capital investment. Simplification, removal
of inequitable and ineffective rules, and alignment with
today's global economy would encourage compliance, facilitate
the free flow of capital, and improve the competitive position
of U.S. multinational concerns. The passage of The
International Tax Simplification for American Competitiveness
Act of 1999 would go a long way to the realization of these
goals.
Statement of Rod Paige, Council of the Great City Schools, and
Superintendent of Houston Public Schools
Mr. Chairman, Congressman Rangel, and members of the Ways
and Means Committee, I am Rod Paige, Superintendent of the
Houston Public Schools. I am submitting testimony regarding the
significant need for major federal school infrastructure aid on
behalf the Houston Public Schools and the Council of the Great
City Schools, the coalition of some fifty of the largest
central city school districts of the nation.
It has been five years since the General Accounting
Office's study of school infrastructure needs garnered national
attention. To the surprise of many, the school infrastructure
inadequacies were found to be nearly universal, though not
unexpectedly more severe in urban schools. A $112 billion
backlog of serious infrastructure needs was identified back in
1994. But despite the efforts of some states, and school
districts like Houston committing significant resources to
address our most severe facility problems, the remainder of the
$112 billion historic backlog still remains. In fact, the wave
of new school enrollments from the so-called ``baby boom echo''
have lifted the estimated national school infrastructure needs
to approximately $200 billion as this century comes to a close.
Houston is very proud that our voters elected to finance a
$678 million bond authority in 1998 by a 73% to 27% vote. I
believe that this represents a renewed vote of confidence in
our public schools after a narrow defeat of a previous bond
authority in 1996. However, even though Houston will be
spending over $1/2 billion in the next 3 years, we have not
addressed the full range of our school facility needs. Our
facilities staff projects the need for over $800 million in
additional funds to meet our current requirements. In fact,
during a review of needs before our bond election, we estimated
that unless we are able to address our needs in deferred
maintenance and renovations, in 10 years time the cost to
repair the schools would approach replacement value. At that
time, it is unlikely we would ever catch up with the problem.
Infrastructure problems if not addressed in a timely manner,
may be the most serious facilities problem facing large urban
district now and certainly in the future.
The State of Texas has done little to assist districts such
as Houston over the years. Although the State does have an
education fund which is used to help obtain higher bond
ratings, little money has been put into the big districts for
facilities. While we are continuing to work for the full
inclusion of facilities funding into the State's school funding
laws and some movement in that direction occurred this year, I
see little hope that the State will soon come to our aid in any
significant manner.
In order to address the massive national school facility
needs, substantial participation is critical not only from our
local public schools, but also from our state and our national
governments. A $200 billion gap cannot be closed without a
significant financial commitment from all levels. The Houston
Public Schools and the Council of the Great City Schools,
therefore, support a major federal investment to close a
sizable portion of this national school facilities gap.
It also is essential to optimize the volume and the
timeliness of school construction and renovation generated by
each federal aid dollar, and that the communities with the
highest concentrations of poor are assured of receiving the
greatest amount of assistance.
There are a variety of school infrastructure assistance
bills pending before both houses of the Congress. I would like
to address a few of these legislative proposals using Houston
as an example:
Tax Subsidized, Zero Interest School Facility Bonds
There are a number of tax-subsidized, zero-interest school
facility bond proposals pending in both houses of Congress with
the major difference found primarily in the distribution
formulas of the tax subsidizes. Cong. Rangel's H.R. 1660, Cong.
Johnson's H.R. 1760, and Sen. Lautenberg's S. 223, each provide
tax credits in lieu of interest income to the holders of
qualified school facility bonds, thus allowing school districts
to pay back these infrastructure bonds without the normally
associated interest costs of such financing. This mechanism
could cut the cost of school construction financing by nearly
half. Both H.R. 1660 and S. 223 would ensure that the school
districts with the largest number of low-income children would
receive a substantial benefit from these tax incentives.
Houston would be authorized to issue $240 million under H.R.
1660 and $168 million under S. 223 in these bonds. H.R 1760
would leave allocations for Houston and other school districts
with the highest numbers of poor children in the nation to the
political whims of their states--an historically inequitable
position. The tax credit mechanism in these three bills would
have a five-year federal budget impact of approximately $3.5
billion, but would leverage approximately $25 billion in school
construction and renovation.
Arbitrage Spend-down Flexibility
There are also a number of legislative proposals, including
Cong. Goodling's H.R. 2, Cong. Dunn's H.R. 1084, and Sen.
Graham's S. 526, which would extend the spend-down restrictions
on safe harbor arbitrage income from two years to four years,
and would increase the small issuer exception to $15 or $20
million. These arbitrage flexibility proposals would have a
five-year federal budget impact of approximately $1.4 billion.
Using our recent $678 million Houston bond issue as an example,
under current market conditions 28 basis points are being
realized by investing our unexpended funds. Therefore, the
maximum annual benefit for Houston on a $678 million issue
would be about $1.9 million in arbitrage.
Tax Exempt Private Activity Bonds for School Construction
Another legislative proposal, included in Sen. Graham's S.
526, is the proposed use of tax exempt private activity bonds
for school construction purposes. A new $10 per capita volume
limit would be authorized for each state to allow private
entities to finance the development of schools through these
tax-exempt instruments. This private activity bond proposal
would have a five-year federal budget impact of approximately
$1.2 billion. Though the allocation of these tax-exempt bonds
would be at the discretion of the state, Houston could issue
nearly $20 million in bonds, if the state allotted us our per
capita share of the state's allotment. Operationally, the
school district would lease the school facility from the
private developer until the bond was paid, and then the school
would be turned over to the school district. Unfortunately,
most school districts would have to make lease payments out of
their operating budgets, thus diluting available funds for
teacher compensation, instructional materials, computers, and
even facility maintenance. Based on market conditions, we would
expect lease payments to be at higher rates than would
traditional bonds. The amount of the school lease payments
appears to be at the discretion of the private developers.
Obviously, Houston would be glad to accept all the school
infrastructure assistance that Congress can provide. But
realistically all of these legislative proposals cannot be
enacted with limited federal resources. Therefore, Congress
should spend its federal budget resources as efficiently and
effectively as possible--in effect securing the most school
construction for the buck. From our analysis, H.R 1660 would
subsidize $240 million of school construction bonds for Houston
at a cost of five-year $3.5 billion to the federal treasury. At
one-third to two-fifths of the costs to the Treasury, neither
arbitrage reform nor private activity bonds would provide one-
tenth of this level of school facility aid. Qualified school
facility bonds, in our opinion, represent the approach to
federal aid that will have a truly consequential impact on
meeting the infrastructure needs of Houston and other large
urban high poverty districts. Under a similar H.R. 1776,
Houston would not be assured of receiving any assistance at
all, as the state would have total discretion over the
allocation of this federal assistance--a major weakness from
out perspective.
Mr. Chairman, there is a clear link between proper school
facilities and improved educational achievement. How can we
hold our children accountable for educational progress, if
their local, state and national leaders are not providing them
with modern schools and the tools needed for success? Thank you
for focusing the attention of the Committee on this issue
during the hearing process. It is encouraging that the
Committee is looking at the school facility needs of the
nation. On behalf of the Houston Public Schools and our
colleagues in the other Great City Schools, I urge the
Committee to include in the upcoming tax bill at least $3 to $4
billion in immediate subsidies that will leverage $25 to $30
billion in new school infrastructure improvements. Thank you
for the opportunity to submit testimony for the Committee
hearing record.
Crowley Maritime Corporation
Washington, D.C., 20004
June 24, 1999
Hon. Bill Archer, Chairman,
House Ways & Means Committee
Washington, DC.
Re: June 30 Hearing on International Tax Rules--Statement of Crowley
Maritime Corporation
Dear Chairman Archer:
Crowley Maritime Corp. (Crowley) commends the Chairman and
committee for holding this hearing, and appreciates the
opportunity to submit this statement on the subject of
international tax rules. Our statement consists of this letter
and the attached presentation on ``Shipping Income Tax Reform''
given last September at the national meeting of the Propeller
Club of the United States. We hope soon to provide a
supplemental statement updating some of the information in the
attached presentation.
We have also discussed these issues with others who will be
submitting oral testimony at the hearing, including Mr. Peter
Finnerty of Sea-Land Service, Inc., and Prof. Warren Dean. We
anticipate general agreement with their testimony, and submit
this separate statement only because of the importance of these
issues and the urgency with which they need to be addressed.
By way of background, Crowley (headquartered in Oakland) is
the second-largest American shipping company. Crowley
subsidiary Crowley American Transport, Inc. (CATI) (based in
Jacksonville) is a major regional liner operator, offering the
most comprehensive container services to Latin America. Other
operating subsidiaries include Crowley Marine Services, Inc., a
diversified marine contractor, Crowley Petroleum Transport,
Inc. (both based in Seattle), and Crowley Marine Transport,
Inc. (based in Houston).
As discussed in the attached presentation, tax reform
legislation is urgently needed to level the playing field for
American carriers competing against foreign carriers, and to
provide an environment in which American citizens will maintain
and expand their investments in the maritime industry.
According to Journal of Commerce PIERS data, nine of the top
ten liner shipping companies carrying America's imports and
exports are foreign carriers (eight of which are based in
Asia). Moreover, according to Maritime Administration data, the
U.S. flag liner companies' share of the U.S. import-export
market fell by about 50% between 1990 and 1996. As others have
demonstrated, American citizen control of the world's
commercial fleet fell by about 80% between 1975 (the last year
in which American carriers were taxed about the same as foreign
carriers) and 1996.
It must be emphasized that the decline of America's
shipping companies has nothing to do with any comparative
advantage foreign carriers have over American carriers. In
fact, given nondiscriminatory government policies, and
recognizing that American carriers are based in the world's
largest trading nation, American carriers likely would have an
inherent competitive advantage over foreign-based carriers if
the market for international shipping services were totally
free of government influence.
As we all know, however, many governments subsidize
shipping in a wide variety of ways and for many reasons.
American subsidies over the past quarter-century, for good and
sufficient reasons, have been focussed on maintaining a fleet
of US-flag vessels. Subsidies would not be needed for American
shipping companies (as distinct from their US-flag fleets)
except for the fact that foreign governments, through income
tax policy, subsidize their shipping companies. An internal
Crowley study shows that, in 1996, American carriers paid more
than 45% of their profits in income taxes, while foreign
carriers received a net tax credit of about 2%.
This huge disparity in bottom line earnings goes a long way
in explaining why it is that American carriers have sold out to
foreign competitors. Given their inherent competitive advantage
over foreign carriers, the loss of American shipping companies
reflects the utter failure of American tax policy in the
international arena. Thousands of high-paying jobs have been
lost, jobs that should, in a free market, go to Americans. Our
nation's security has been harmed as the amount and reliability
of sealift available for military contingencies is reduced. Our
economic security is degraded as foreign firms exert total
control over the movement of our imports and exports.
Legislation that takes important steps toward correcting
this tax disadvantage has been introduced. As a matter of sound
tax policy, and to address clear threats to our nation's
military and economic security, we strongly urge that it be
enacted as quickly as possible.
Respectfully Submitted,
Michael G. Roberts
Vice President, Government Relations
Shipping Income Tax Reform
Good morning and thank you for including me in this
discussion of legislation affecting the maritime industry. Two
years ago last week, at the end of the 104th Congress, we
celebrated passage of the Maritime Security Act. The MSP saved
what was surely one of the most endangered species existing in
the world's oceans--American mariners sailing on commercial
ships in international trades. With the clock running out on
the existing government support programs, enactment of MSP was
essential--in the words of Congressman Herb Bateman, a matter
of the very survival of the American mariner in international
trade. The entire maritime industry--liner carriers, non-liner
carriers, unions, shipbuilders, ports--the entire industry
pulled together and pushed MSP through Congress despite long
odds. While MSP needs to be expanded and made permanent, its
passage has helped assure the survival of a critical part of
the American maritime industry.
We are now confronted, as we move toward the 106th
Congress, with the threatened extinction of another critical
part of our industry--the American shipping company operating
in international trade. According to the U.S. Maritime
Administration, American liner carriers' share of the market
for moving U.S. import and export cargoes fell by almost half
between 1990 and 1996, from over 17% of the market in 1990, to
less than 9% in 1996. As the first slide shows, that's a huge
and precipitous drop, an exodus that starts from an already
unacceptably low level of U.S. carrier participation. Let me
add that, while this slide focuses on liner cargoes, I
understand that U.S. carriers' share of non-liner cargoes is
even more dismal--in the one to three percent range.
We can assess the strength of American shipping companies
not only on the basis of our share of the cargo market, but
also based on the vessel capacity we own or operate. With this
group I don't need to go into the number of U.S. flag vessels
remaining. We know the U.S. flag fleet operated in
international trades has been in long term decline. It is
approaching the 47 ships in the MSP, and it will likely expand
only if and when the government decides to expand MSP.
Slide 2 shows the decline in U.S. controlled tonnage flying
foreign flags of convenience. And let me at this point touch on
the issue of U.S. carriers operating foreign flags of
convenience vessels. We all want to see as many ships as
possible flying the U.S. flag and manned by U.S. crews. That's
one of the central purposes of this organization. But unless
and until we are able to eliminate the huge cost advantages
available to flag of convenience vessels, we have to fully
reconcile ourselves, as most of us have, to the fact that U.S.
carriers must have the same ability to operate flag of
convenience vessels as do our foreign competitors. To the
extent we limit or condition U.S. carriers' rights in this
regard (and not also limit or condition foreign carriers'
rights), we don't stop or reduce flag of convenience shipping
one bit. We simply shift it to foreign carriers instead of U.S.
shipping companies. And U.S. shipping companies become more and
more irrelevant.
This is not in any way meant as an endorsement of flag of
convenience shipping. On the contrary, I thoroughly and
completely agree that flag of convenience shipping fosters a
``culture of evasion'' that hurts the entire industry. David
Cockroft, one of the leaders of the International Transport
Workers Federation, was a little more blunt when he said the
system ``stinks,'' and I agree with that, too.
But as we all know, we have tried for decades to come up
with a way to stop foreign flags of convenience, and as this
chart shows, all we've succeeded in doing is to take Americans
out of the business while flag of convenience shipping
continues to grow. In 1975, U.S. carriers owned about 22
million of the 85 million gross registered tons in the world
flag of convenience fleet. This accounted for about 26% of the
world fleet. By 1996, the world flag of convenience fleet had
almost tripled, to 241 million tons, while U.S. carrier
ownership fell almost in half. The next slide shows what this
means on a percentage basis, as American carriers' share of
that fleet fell in 1996 to one-fifth the level it was in 1975.
So it's not a pretty picture, whether you look at cargo
flows or vessel ownership. America, the world's largest trading
nation, is almost a non-factor in the business of transporting
its imports and exports.
Let me take a few minutes to talk now about why it is we
have seen such a stark decline in the American shipping
industry, and then get into what we might consider doing about
it. First, let's be clear as to what is not the cause of our
decline. It is not because we are incompetent. Looking at the
liner sector, Sea-Land is the largest container shipping
company serving the United States. Not the most profitable, but
the biggest. Crowley is not the most profitable nor the
biggest, but it is big and has consistently been rated the
``Best of the Best'' of the world's shipping companies. Lest
this seem too much like a plug, APL has for many years been one
of the world's strongest container lines, and other American
shipping companies have been similarly well-managed. Even our
biggest detractor, Rob Quartel, has conceded that Americans are
the best in the world at this business.
So I'm pleased to report that we're not stupid and
incompetent. And I don't believe the decline of our industry
results from a comparative cost advantage that foreign carriers
enjoy over U.S. carriers. Certainly in the liner sector, most
costs are simply not affected by the nationality of the
shipping company. With respect to vessel costs, which account
for about one-fifth of total costs, American carriers operating
U.S. flag MSP ships or foreign flag charters can be fully cost
competitive. The remaining portion of liner operating costs,
consisting of administration and overhead, does vary by
nationality of the carrier, according to living costs in the
area where these services are provided. But with headquarters
located in places like Jacksonville or Charlotte, American
carriers actually have a cost advantage over foreign carriers
operating out of Tokyo or Hong Kong or London.
So what is the problem, why is the American shipping
industry internationally in such a state of decline if not
because of incompetence or cost disadvantages? The answer, as a
matter of simple logic, must be profitability. The prices we
charge keep going down, revenues are inadequate and returns, or
profitability, is unacceptably low. This next slide, from
Mercer Management, shows operating margins for the liner
shipping industry compared to the operating margins for
companies included in the Standard & Poors 500. As you can see,
profits for the 24 liner shipping companies surveyed
consistently averaged between one-third and one-half of the
average profits earned by S&P 500 companies.
The unprofitability of the international liner industry can
be traced, at least in substantial part, to two factors. First
is overcapacity, which is attributable in part to the cyclical
nature of the business, but also to the fact that governments
love to subsidize the building of ships. Too many ships are
built not because of market demand for transportation services,
but because of the desire primarily of foreign governments to
put their people to work building ships. Those of us in the
ship operating business are left to deal with this mess and try
to make a living with too much capacity in our markets.
Hopefully, the OECD Shipbuilding Agreement or something like it
will be implemented so that capacity in the shipping business
can settle back toward a more rational, market-based level.
Another reason for unprofitability, at least in the liner
sector, is a hyper-competitive market structure. Having 15 or
20 shipping companies doing the same thing in the same markets
is not efficient nor conducive to rational business decision
making, especially when some of the state-owned competitors are
not fully motivated to making decent profits. Industry
consolidation may be painful, but it is needed and is likely,
particularly given the imminent enactment of the Ocean Shipping
Reform Act. Consolidation, we hope, will eventually produce a
more stable market structure and better profit margins.
These factors help explain why the industry as a whole is
not profitable, but not why it is apparently less profitable
for American carriers than for foreign carriers. Why is it,
then, that foreign carriers are growing while American carriers
decline if foreign carriers (1) have no cost advantage, (2)
have no quality advantage, and (3) foreign investors apparently
have the same incentive as Americans to seek higher investment
returns elsewhere? Who can say for sure, but the one factor
that we can readily identify and that goes a long way in
explaining this mystery, is income taxes. To be clear, I'm
talking about income taxes, below-the-line taxes assessed after
all the costs and above-the-line tax benefits--accelerated
depreciation, generous deductions, etc.,--are taken out of the
revenues. American carriers pay income tax at a base rate of
36%. Most foreign carriers pay little or no income tax. The
next slide is an analysis we've done in-house using the actual
financial statements of nine liner carriers--three American,
six foreign. While a larger sample of financial statements
needs to be analyzed, even this small sample absolutely
illustrates the point. On average, the foreign carriers sampled
got a net tax credit in 1996, while American carriers paid over
45% of their profits to Uncle Sam. In 1997, it was about 7%
foreign income tax liability versus 43% for the Americans.
What this all means is that, if the industry has an average
profit margin of say 6%, the effective rate of return for
foreign investors may range from 8% to 11% depending on foreign
income tax rates. Considering that some companies in some years
do much better than 6%, it's not a bad return if you're a
foreign carrier paying no income tax. Certainly, the incentive
for foreign investors to leave the industry is much less than
for American investors. In short, it is the income tax
disadvantage, more than any other factor that I can identify,
that explains the current condition of the American shipping
industry. In fact, I understand that income tax liability
played a crucial--perhaps decisive--role in the decision to
merge APL into NOL instead of the other way around.
We've got to fix this problem, and there are any number of
ways to do it. Most of the attention has centered around
restoring Subpart F tax deferral, which until 1986 provided a
means for American carriers to defer their income tax liability
on shipping income earned using foreign flag vessels.
Congressmen Shaw and Jefferson have introduced legislation that
would restore the Subpart F exemption, but improve on it by
allowing tax deferred money to be invested in U.S. flag
shipping. Their bill has broad but not unanimous support within
the industry. A variation on this approach would not just allow
tax deferred money to be reinvested in U.S. flag shipping, but
require such reinvestment as a condition for receiving tax
deferral on some or all of the foreign flag earnings. Still
another approach would not involve Subpart F at all, but would
simply adjust the income tax rates of American shipping
companies engaged exclusively in international trade to match
the average tax rates of our foreign competitors.
I'm not here today to suggest a specific solution to the
problem. But I would like to do two things. First, is to
express the hope that the top leadership of the maritime
industry--primarily seagoing unions and shipping companies--
will commit to make a concentrated effort over the next several
months until we find a solution to this problem. It took a long
time, but the entire industry eventually came together over MSP
and we got a program that has helped insure the survival of
American mariners. We need to make the same commitment to
assure the survival of American shipping companies, and I am
hopeful and optimistic that we will.
Secondly, I'd like to suggest at least a couple of
principles that would help guide our work. There are
undoubtedly others, but the two that come to my mind are as
follows:
First, ``Foreign income tax advantages harm all American
shipping companies in international trade, and must be
addressed on an industry wide basis.'' We simply cannot afford
to lose time while companies or unions jockey for advantage
against one another over this issue. If we succeed in fixing
the problem, the pie will grow maybe a lot and everyone's
sustainable, long-term benefit will far exceed what might be
gained or lost by attempting to rig the system. Let's not beat
each other up, but let's be fair and work together for tax
equity.
Secondly, ``The solution to this problem must avoid placing
burdens on American carriers that are not faced by their
foreign competitors.'' This is the whole point of the exercise.
If we don't stick to that very basic and obvious and important
principle, we run a real risk of getting nowhere, or passing
legislation that will accomplish nothing, and see the final
loss of what's left of our industry.
Thank you very much for your attention, and I'd be happy to
hear your comments and answer your questions.
[Charts are being retained in committee filed.]
Ernst & Young LLP
Washington, D.C., 20036
July 7, 1999
Hon. Bill Archer, Chairman
House Committee on Ways and Means
Washington, D.C.
Dear Mr. Chairman:
We are pleased have an opportunity to share with the Committee on
Ways and Means our views on an issue of vital importance to high
technology businesses--the tax rules regarding bona fide research and
development (``R&D'') cost sharing arrangements. We are concerned that
recent interpretations of the R&D cost sharing rules by the Internal
Revenue Service (``IRS'') will make leading edge U.S. based companies
less competitive than their foreign counterparts and, in some cases,
will have the effect of encouraging such companies to relocate R&D
activities outside the United States. We request that this letter be
made part of the formal record of the Committee's June 30, 1999,
hearing to examine the effect of U.S. tax rules on the competitiveness
of U.S. businesses as well as ``. . . the policies (tax or otherwise)
our international tax rules ought to reflect and implement.''
Background
The proper allocation of income resulting from research and
development activities, and the derivation of benefit from the
use of valuable intangible property developed from those
activities, has been a continuing source of controversy between
the IRS and taxpayers, especially when an affiliate of a U.S.
multinational company is using the intangible property in a low
tax jurisdiction. Prior to 1984, the IRS had adopted an
administrative ruling position that allowed intangible property
developed in the U.S. to be transferred in a tax-free
transaction under Internal Revenue Code (``IRC'') section 367
to a foreign affiliate of a U.S. taxpayer provided that the
intangible property was not used to create products destined
for the U.S. market. In 1984, Congress ended this practice by
enacting section 367(d), which requires arm's length taxable
compensation on intercompany transfers of intangible property.
As part of the Tax Reform Act of 1986, Congress amended
section 482 by adding a sentence that provides, ``In the case
of any transfer (or license) of intangible property . . . , the
income with respect to such transfer or license shall be
commensurate with the income attributable to the intangible.''
The legislative history to this provision indicated that by
enacting the ``commensurate with income'' provision, Congress
did not intend to prohibit use of bona fide R&D cost-sharing
agreements, provided that such agreements were structured
consistently with the intent of the provision.
Under a cost sharing agreement, related parties agree in
advance to share the financial risk (i.e., the costs) of R&D
activities in return for agreed-upon rights to exploit any
intangible property developed as a result of the R&D. Cost
sharing payments received by a U.S. party conducting R&D reduce
the deductible amount of R&D expense, while cost sharing
payments made by a U.S. taxpayer are a deductible expense. A
U.S. multi-national company conducting R&D in the U.S. that is
a party to a cost sharing arrangement with a foreign affiliate
gives up the right to current R&D deductions to the extent of
the cost sharing payment. In return, the foreign affiliate
attains the right to exploit any valuable intangible property
created without further payment (other than its annual
obligation to fund additional R&D under the cost sharing
agreement).
The 1989 Treasury/IRS White Paper on Transfer Pricing and
the 1996 cost sharing regulations enunciated several principles
that ought to be taken into account if a cost sharing
arrangement was to meet the criteria of the commensurate with
income provision. These principles included the following:
Costs of R&D should be shared proportionately
based upon expected benefits to be earned by the participants.
Costs should include direct and indirect operating
expenses attributable to the covered R&D.
Provisions should be made in the arrangement to
account for material changes in actual benefits from expected
benefits.
Participants entering into a cost sharing
arrangement should pay an arm's length amount for preexisting
and in process R&D (a ``buy in'') that may take the form of a
declining arm's length royalty.
Subsequent to enactment of the ``commensurate with income''
provision, the IRS engaged in a series of litigation
challenging transfers of intangible property with limited
success. These cases have involved such industries and products
as contact lenses, medical equipment, semiconductors and
computer disk drives.\1\ The IRS's typical position in these
cases is to limit the profitability of the offshore affiliate
to a limited function contract manufacturer's profit and to
ignore the fact that arm's length parties who make substantial
investments to exploit technologies created by another expect
to receive a reasonable share of the profits to be earned from
exploiting the intangible property.
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\1\ Bausch & Lomb (contact lenses); Perkin Elmer (medical
equipment); National Semiconductor (semiconductors); Seagate (disk
drives).
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In order to avoid the costs \2\ and risks inherent in
licensing intangible property for which no exact comparable
licensing transactions exist, many taxpayers have entered into
cost sharing agreements. Until recently, most taxpayers
believed that these agreements would be respected as bona fide
by the IRS provided there was a reasonable buy-in payment and
that U.S. Generally Accepted Accounting Principles (``GAAP'')
R&D expenses were shared based upon reasonably expected
benefits of the R&D activity the costs of which were being
shared.
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\2\ The recent IRS ``Report on the Application and Administration
of Section 482 ``estimates IRS litigation costs in two recent cases at
$4.6 million and $2.1 million. Taxpayer costs were much higher.
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The Issue
The IRS National Office has recently advanced two new
positions for evaluating bona fide cost sharing arrangements
that have the effect of making the tax cost of such
arrangements so high that they are uneconomical for U.S.
technology-intensive companies. These positions are that:
Costs to be shared should include stock option
``expense'' attributed to R&D activities.
A buy-in payment should be measured either by the
taxpayer's total market capitalization less the value of its
book assets or by reference to premiums in value over book
assets in recent M & A transactions.
Why the IRS's Positions are Unwise Tax Policy
The IRS's positions are technically insupportable
and conflict with the legislative support for cost sharing.
Congress recognized in the 1986 Tax Reform Act that bona
fide R&D cost sharing arrangements should be available as an
alternative to licensing under the commensurate with income
standard. The abuse that Congress sought to eliminate in the
1986 Act (and in 1984) was that technology developed in the
U.S. was being transferred outside the U.S. for no
consideration to the U.S. developer. However, Congress neither
prohibited transfers of intangible property outside the U.S.,
nor did it outlaw the availability of cost sharing
arrangements.
No party at arm's length would enter into a technology
development (cost sharing) arrangement where it was required to
buy into the agreement by paying a share of the U.S.
developer's market capitalization. In addition, at any moment,
in-time market capitalization of an individual company is
profoundly affected by the intrinsic volatility of the overall
market; the market's view of the industry and the company's
overall competitive position within that industry; and the
anticipated long-term earnings power of the company which
extends far beyond the useful life of its current technology or
other intangibles. Thus, market capitalization value is not a
good benchmark upon which to base a buy-in payment.
Furthermore, accounting goodwill created in an acquisition is
as much a measurement of post-merger synergy of the two
companies as it is a measure of the intangibles of the acquired
company.
R&D cost sharing is not an uncommon risk sharing
arrangement between unrelated joint parties, especially in
technology-driven industries. We have never observed an
instance in which unrelated parties have agreed to cost share
the compensation element (i.e., the difference between the fair
market value of the stock and the exercise price) of stock
options attributable to R&D employees, nor do we think
unrelated parties would even consider sharing such an
unpredictable, non-cash expense. Thus, we believe that the
IRS's position on stock option expense as it relates to cost
sharing is non-arm's length.
These positions will lead to double taxation of
U.S. multinationals.
In our experience, the conventional arm's length methods,
all of which are based on varying degrees of comparability in
third-party transactions, are still the international norm for
settling cross-border disputes regarding intercompany
compensation for the use of intangibles. Market capitalization
for intangibles is clearly unconventional. As a result, a U.S.
government position based on market capitalization values will
lead to irreconcilable differences in competent authority
proceedings resulting in higher incidents of double taxation of
U.S. multinationals.
In a similar vein, the treatment of stock option exercises
varies by country. For example, the spread between the fair
market value of the option and the exercise price in not the
measure of compensation in all countries, nor is the employee's
exercise the event which gives rise to the compensation in all
countries. Accordingly, even in the unlikely event that a
foreign country can be persuaded that arm's length parties
would incorporate a stock option additive into a cost sharing
equation, it is unlikely that the foreign country would agree
on the U.S. definition of the timing or amount. Thus, this
stock option position, if pursued by the IRS, will also
inevitably lead to double taxation of U.S. multinationals.
These positions may encourage U.S. companies to
move R&D out of the U.S.
Simply put, U.S. multinationals just could not afford the
tax cost of licensing or transferring intangibles to affiliates
if today's market capitalization values became a proxy for the
required arm's length consideration. A U.S. tax-induced
limitation on the deployment of intangibles will undoubtedly
hurt U.S. competitiveness. It may, in fact, encourage U.S.
multinationals to move their R&D activities outside the U.S.
where the resulting intangibles can be exploited in a far more
tax effective manner. Many tax have jurisdictions already offer
significant incentives to locate R&D in their countries; the
IRS position will add to those existing incentives.
Compensation for qualified U.S. engineers is already among
the highest in the world. Stock options have become a common
incentive for attracting and retaining U.S. engineers in this
highly competitive market place. Clearly, the tax deductible
portion of the stock option spread defrays some of the high
compensation costs for U.S. engineers. If the deduction is lost
because it is required to be charged to cost sharing foreign
affiliates, the defrayal is lost as well. Absent this much
needed defrayal, U.S. multinationals may establish R&D
operations outside the U.S., staffed with lower cost
engineering talent.
These positions are an indirect attempt by the IRS
to eliminate deferral contrary to Congressional intent.
Since 1962, Congress has recognized that U.S.
multinationals should be allowed to defer U.S. tax on active
business income earned by affiliates outside the U.S. until
such income is repatriated in the form of dividends. Rather
than undertake a direct challenge to deferral, as the IRS and
Treasury attempted in Notices 98-11 and 98-35, the IRS's recent
adoption of these positions is a back door attack on deferral.
By imposing excessive charges on foreign affiliates for buy-in
and cost sharing payments, the IRS intends that there will be
little or no profit to defer or repatriate.
Why Congress Should Act Now
Cost sharing arrangements are used by some of the most
innovative and dynamic growth companies in the U.S. The active
business profits generated by foreign affiliates of these
companies are used to fund overseas expansion. Many of these
companies are global leaders in their fields. Under the old IRS
``contract manufacturer'' position and its new cost sharing
position, the IRS would subject all or nearly all of the active
business profits of these foreign operations to a ``toll
charge'' of current U.S. taxability. The abuse that Congress
sought to end in 1984 and 1986 was the tax-free transfer
overseas of intangible property developed in the U.S., not to
end deferral for active profits earned outside the U.S. after
payment to the U.S. of a fair amount for developing the
intangible property.
Under typical IRS dispute resolution procedures, issues
like these can take 5-12 years to resolve. While the issues
remain in dispute, taxpayers will be required to incur
substantial administrative costs and outside adviser fees to
defend against the IRS's claims.\3\ In addition, these claims
cause substantial financial uncertainty for companies since IRS
agents often demand several times the amounts they
realistically expect to obtain.\4\ Taxpayers use cost sharing
arrangements to avoid the uncertainties inherent in the
``commensurate with income'' standard applicable to licenses.
Years of uncertainty and inefficiency could be avoided if
Congress would move now to establish some objective criteria
for cost sharing arrangements.
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\3\The recent IRS Report on Section 482 states that IRS costs for
resolving two recent transfer pricing litigation were $4.6 million and
$2.1 million while costs to resolve comlex Advance pricing Agreements
averaged $72,000.
\4\ According to the IRS report, since 1994, the average amount of
Section 482 adjustments proposed by IRS examiners sustained by Appeals
was 27%. In the recent litiigation with DHL, the IRS Notice of
Deficiency asserted a value in excess of $500 million for the
transferred trademark and trade name, which value was reduced by IRS to
around $300 million at trial, of which the Tax court sustained an
adjustment of $100 million.
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Our Recommendations. We believe that Congress should:
Clarify the cost sharing rules to limit buy-in
payments and cost sharing payments to amounts that unrelated
parties dealing at arm's length would pay. We believe that
actual transfers of reasonably comparable intangible property
are a proper reference point for buy-in payments and that
direct and indirect R&D expenses as determined under GAAP are a
good reference point for defining R&D costs to be shared.
Consider whether the ``commensurate with income''
provision is serving its intended purpose or whether, as
interpreted by the IRS it is being used as a device to end
legitimate deferral of U.S. tax by U. S. multinationals.
These views and recommendations are based on our nearly 50
years of collective experience with Ernst & Young LLP providing
tax advice to many of the leading U.S. biomedical and high-tech
firms that operate on a worldwide basis. Should you wish, we
would be happy to meet with you or your staff to discuss these
important issues. We can be contacted through Donna Steele
Flynn in Ernst & Young LLP's Tax Legislative Services group in
Washington at 202-327-6664.
Sincerely,
Peter Kloet
Michael F. Patton
John Wills
Statement of the Financial Executive Institute, Morristown, NJ
Chairman Bill Archer and Members of the House Ways and
Means Committee:
The Financial Executives Institute (``FEI'') Committee on
Taxation appreciates this opportunity to present its views on
the impact of U.S. tax rules on international competitiveness.
FEI is a professional association comprising 14,000 senior
financial executives for over 8,000 major companies throughout
the United States. The Tax Committee represents the views of
the senior tax officers from over 30 of the nation's largest
corporations.
At the outset, FEI would like to thank you, Mr. Chairman,
for your support of H.R. 2018, the International Tax
Simplification for American Competitiveness Act of 1999,
recently introduced by Mr. Houghton and Mr. Levin. This
legislation builds on your previous successful efforts to keep
step with the rapid globalization of the economy by simplifying
and rationalizing the international provisions of the Internal
Revenue Code (the ``Code'').
Taxation in a Global Economy
The U.S. international tax regime reflects a balance
between two important, but sometimes conflicting, goals:
neutrality and competitiveness. The U.S. generally tries to
raise revenue in a neutral manner that does not discriminate in
favor of one investment over another. At the same time, the
U.S. seeks to raise revenue in a way that does not hinder, and
where possible helps, the competitiveness of the American
economy, its firms and its workers.
The current balance between neutrality and competitiveness
was struck almost four decades ago during the Kennedy
Administration. At the time, the rest of the world was still in
large measure trying to rebuild from the social, physical and
political devastation of World War II. The United States was a
comparative economic giant, accounting for 50 percent of
worldwide foreign direct investment and 40 percent of worldwide
GDP. Under these circumstances, policymakers were more
concerned with the impact of tax law on the location decisions
of U.S. firms--i.e., neutrality--than on the effect of tax law
on the competitiveness of those firms.
Accordingly, the Code taxes U.S. taxpayers on their
worldwide income, with a tax credit for taxes paid to foreign
jurisdictions. In theory, this approach ensures that a given
investment by a U.S. firm will experience roughly the same
level of taxation regardless of location. The Code takes
competitiveness concerns into account by deferring tax on the
active income of foreign subsidiaries of U.S. firms until the
income is repatriated. This ensures that active subsidiaries
are not more heavily taxed currently than their non-U.S.
competitors down the street. Over the years, this deferral has
been increasingly limited as competitiveness has taken a back
seat to concerns about tax avoidance by U.S. taxpayers.
Today, the global economic landscape looks very different
than it did during the Kennedy Administration. Europe, Japan
and a host of other nations have emerged as tough competitors.
Revolutions in transportation, telecommunications and
information technology mean that firms increasingly compete
head-to-head on a global basis. As a result, the U.S. is
fighting harder than ever to maintain its share, now down to
about 25 percent, of the world's foreign direct investment and
GDP, and many U.S. firms now focus as much or more on fast-
growing overseas markets as on the mature U.S. market.
The U.S. needs to adapt its international tax regime to
this new reality. It is no longer acceptable merely to strive
to treat U.S. taxpayers or their investments in a neutral
manner. We must also consider how their competitors from other
nations are taxed by their host governments. For example, while
the United States continues to tax its taxpayers on a worldwide
basis, many of our trading partners tend to tax their
businesses on a ``territorial'' basis in which only income
earned (``sourced'') in the home jurisdiction is subject to
taxation. Even countries which tax on a worldwide basis do so
with far fewer limitations and less complex rules on deferral,
the foreign tax credit and the allocation and apportionment of
income, deductions and expenses between domestic and foreign
sources.
Making America More Competitive
With your leadership, Mr. Chairman, Congress in recent
years has taken some positive steps to reform the international
tax rules and make America more competitive. Among the
important changes: eliminating the PFIC/CFC overlap,
simplifying the 10/50 basket, applying the FSC regime to
software, repealing section 956A, and extending deferral to
active financing income.
H.R. 2018 includes many of the necessary next steps for
reform. FEI strongly endorses this legislation and associates
itself with the testimony of the National Foreign Trade Council
with respect to specific provisions of the bill.
For example, FEI strongly supports the provision in H.R.
2018 that seeks to treat the European Union as a single
country. The European Union created a single market in 1992 and
a single currency, the euro, in 1999. Yet U.S. international
tax rules still treat the EU as 15 separate countries. This has
made it difficult for U.S. companies to consolidate their EU
operations and take advantage of the new economies of scale.
Over time, our European competitors, who do not face such
obstacles to consolidation, will gain a competitive advantage.
Another example is the provision that would accelerate the
effective date for ``look-through'' treatment in applying the
foreign tax credit baskets to dividends from 10/50 companies.
The 1997 tax law allows such look-through treatment for
dividends paid out of earnings and profits accumulated in
taxable years beginning after December 31, 2002. This means
U.S. corporate taxpayers face an unnecessary tax cost until
2003.
Threats to Competitiveness
Notwithstanding these positive developments, there have
been some ominous clouds on the international tax horizon. The
Treasury Department early last year issued guidance on so-
called ``hybrid entities'' that would have substantially
hindered the ability of U.S. companies to compete abroad
(Notice 98-11). Although the original ``hybrid'' rules were
withdrawn and we understand that the subsequent notice (Notice
98-35) is being reconsidered, Treasury has given every
indication that it will continue to push neutrality concerns
over competitiveness. (e.g., seeking limits on deferral and
promoting the OECD effort on ``harmful tax competition'').
These and other proposals to amend the Code in ways that
threaten U.S. competitiveness take us in precisely the opposite
direction from where we need to go in the global economy.
Consider the effort by some to further limit deferral.
Under current law, ten percent or greater U.S. shareholders of
a controlled foreign corporation (``CFC'') generally are not
taxed on their proportionate share of the CFC's operating
earnings until those earnings are actually paid in the form of
a dividend. Thus, U.S. tax on the CFC's earnings generally is
``deferred'' until an actual dividend payment to the parent
company, just as tax is ``deferred'' when an individual holds
shares in a company until such time as the company actually
pays a dividend to the individual. However, under Subpart F of
the Code, deferral is denied--so that tax is accelerated--on
certain types of CFC income.
Subpart F was originally enacted in 1962 to curb the
ability of U.S. companies to allocate income and/or assets to
low-tax jurisdictions for tax avoidance purposes. Today, it is
virtually impossible under the Section 482 transfer pricing and
other rules to allocate income in this manner. Indeed, the
acceleration of tax on shareholders of CFC operations has no
counterpart in the tax laws of our foreign trading partners.\1\
Nevertheless, Subpart F remains in the Code, putting U.S.
companies at a disadvantage. In many instances, Subpart F
results in the taxation of income that may never be realized--
perhaps because of the existence in a foreign country of
exchange or other restrictions on profit distributions,
reinvestment requirements of the business, devaluation of
foreign currencies, subsequent operating losses, expropriation,
and the like--by the U.S. shareholder.
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\1\ For example, according to a 1990 ``White Paper'' submitted by
the International Competition Subcommittee of the American Bar
Association Section of Taxation to congressional tax writing
committees, countries such as France, Germany, Japan, and The
Netherlands do not tax domestic parents on the earnings of their
foreign marketing subsidiaries until such earnings are repatriated.
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Other problems posed by the acceleration of tax under
Subpart F and similar proposals include:
Acceleration of tax may lessen the likelihood or
totally prevent U.S. companies from investing in developing
countries by vitiating tax incentives offered by such countries
to attract investment. This result would be counter to U.S.
foreign policy objectives by opening the door to foreign
competitors who would likely order components and other
products from their own suppliers rather than from U.S.
suppliers. Moreover, any reduced tax costs procured by these
foreign competitors would likely be protected under tax
sparing-type provisions of tax treaties that are typically
agreed to by other nations, although not by the U.S. Treasury.
Subpart F adversely affects companies attempting
to cope with difficult exchange control and customs issues,
frequently encountered in developing countries. The risks of
controlled currencies and adverse customs results can be
avoided if the U.S. multinational sells into the country
through a controlled subsidiary incorporated in another
country. However, the current Subpart F regime results in loss
of deferral. Non-U.S. competitors are not faced with this
additional cost.
It may result in double taxation in those
countries which permit more rapid recovery of investment than
the U.S., because the U.S. tax would precede the foreign
creditable income tax by several years and the carryback period
may be inadequate. Moreover, even if a longer carryback period
were enacted, the acceleration of the U.S. tax would be a
serious competitive disadvantage vis-a-vis foreign-owned
competition.
It would discriminate against shareholders of U.S.
companies with foreign operations, as contrasted with domestic
companies doing business only in the U.S., by accelerating the
tax on unrealized income. This is poor policy because U.S.
multinational companies have been and continue to be
responsible for significant employment in the U.S. economy,
much of which is generated by their foreign investments.
It could harm the U.S. balance of payments.
Earnings remitted to the U.S. have exceeded U.S. foreign direct
investment and have been the most important single positive
contribution to the U.S. balance of payments. The ability to
freely reinvest earnings in foreign operations results in
strengthening those operations and assuring the future
repatriation of earnings. Accelerating tax on CFCs would
greatly erode this advantage.
Acceleration of tax on CFCs is often justified by the
belief that U.S. jobs will somehow be preserved if foreign
subsidiaries are taxed currently. However, in reality, foreign
operations of U.S. multinationals create rather than displace
U.S. jobs, while also supporting our balance of payments and
increasing U.S. exports. Foreign subsidiaries of U.S. companies
play a critical role in boosting U.S. exports by marketing,
distributing, and finishing American-made products in foreign
markets. In 1996, U.S. multinational companies were involved in
an astounding 65 percent of all U.S. merchandise export sales.
And studies have shown that these exports support higher wage
jobs in the United States.
U.S. firms establish operations abroad because of market
requirements or marketing opportunities. For example, it is
self-evident that those who seek natural resources must develop
them in the geographical locations where they are found, or
that those who provide time-sensitive information technology
products and services must have a local presence. In addition,
as a practical matter, local conditions normally dictate that
U.S. corporations manufacture in the foreign country in order
to enjoy foreign business opportunities. This process works in
reverse: it has now become commonplace for foreign companies
like BMW, Honda, Mercedes, and Toyota to set up manufacturing
operations in the U.S. to serve the U.S. market. It is not just
multinationals that benefit from trade. Many small and medium-
sized businesses in the U.S. either export themselves or supply
goods and services to other export companies.
Moreover, CFCs generally are not in competition with U.S.
manufacturing operations but rather with foreign-owned and
foreign-based manufacturers. A very small percentage (less than
10% in 1994) of the total sales of American-owned foreign
manufacturing subsidiaries are made to the U.S. Most imports
come from sources other than foreign affiliates of U.S. firms.
Therefore, a decrease in foreign investment by U.S. companies
would not result in an increase in U.S. investment, primarily
because foreign investments are undertaken not as an
alternative to domestic investment, but to supplement such
investment.
Indeed, there is a positive relationship between investment
abroad and domestic expansion. Leading U.S. corporations
operating both in the U.S. and abroad have expanded their U.S.
employment, their domestic sales, their investments in the
U.S., and their exports from the U.S. at substantially faster
rates than industry generally. In a 1998 study entitled
``Mainstay III: A Report on the Domestic Contributions of
American Companies with Global Operations,'' and an earlier
study from 1993 entitled ``Mainstay II: A New Account of the
Critical Role of U.S. Multinational Companies in the U.S.
Economy,'' the Emergency Committee for American Trade
(``ECAT'') documented the importance to the U.S. economy of
U.S. based multinational companies. The studies found that
investments abroad by U.S. multinational companies provide a
platform for the growth of exports and create jobs in the
United States. (The full studies are available from The
Emergency Committee for American Trade, 1211 Connecticut
Avenue, Washington, DC 20036, phone (202) 659-5147).
Proposals to accelerate tax through the repeal of
``deferral'' are in marked contrast and conflict with over 50
years of bipartisan trade policy. The U.S. has long been
committed to the removal of trade barriers and the promotion of
international investment, most recently through the NAFTA and
WTO agreements. Moreover, because of their political and
strategic importance, foreign investments by U.S. companies
have often been supported by the U.S. government. For example,
participation by U.S. oil companies in the development of the
Tengiz oil field in Kazakhstan has been praised as fostering
the political independence of that newly formed nation, as well
as securing new sources of oil to Western nations, which are
still heavily dependent on Middle Eastern imports.
Conclusion
Current U.S. international tax rules create many
impediments that cause severe competitive disadvantages for
U.S. based multinationals. By contrast, the tax systems of
other countries actually encourage our foreign-based
competitors to be more competitive. It is time for Congress to
improve our system to allow U.S. companies to compete more
effectively, and to reject proposals that would create new
impediments making it even more difficult and in some cases
impossible to succeed in today's global business environment.
We thank you for the opportunity to provide our comments on
this extremely important issue.
Statement of Warren Thompson, Director of Tax, Frank Russell Company,
Tacoma, WA
My name is Warren Thompson; I am the Director of Tax for
Frank Russell Company. The testimony offered herein presents
Russell's experience concerning the manner in which current US
tax law seriously impedes the growth potential of the US mutual
fund industry. In addition, we would like to register our
support of H.R. 2430, the Investment Competitiveness Act of
1999. H.R. 2430 is sensible and long overdue legislation that
is critical if the US mutual fund industry is to become an
attractive investment alternative for global investors. The
Frank Russell Company strongly supports this legislation and
commends the bill's sponsors, Representatives Crane, Dunn, and
McDermott for their efforts to address this issue.
The Frank Russell Company, headquartered in Tacoma,
Washington, is recognized as one of the premier global money
managers and pension consulting firms in the world, providing
investment strategy consulting worldwide to such institutional
investors as GM, IBM, AT&T, XEROX, Boeing, UAL, Unilever,
Shell, Monsanto, and others. From nine offices worldwide,
Russell advises clients on over $1 trillion of investment
assets and manages over $50 billion in funds, including mutual
funds (otherwise known as regulated investment companies or
``RICs''), common trust funds, commingled employee benefit
funds, and private investment partnerships. In addition,
Russell conducts research on nearly 2000 investment managers in
more than twenty countries.
We have found, from our experience around the world, that
the US mutual fund industry is the most technologically
advanced in the world and, therefore, the most efficient in
delivering services to clients. However, research of the
current practices of global investment managers shows that
global institutional investors and managers use US mutual funds
very sparingly. One of the principle reasons they do not use US
mutual funds is the withholding tax on dividends and short-term
capital gains imposed under current US tax law.
As the Committee is already well aware, current US tax laws
have, in many cases, failed to kept pace with our increasingly
dynamic and competitive US and global market, often to the
detriment of US companies. In the case of the US mutual fund
industry, current US law blocks US-based mutual funds from
competing for international investment dollars by making it
virtually impossible for US mutual funds to sell their products
outside the United States. As a direct result, US mutual fund
companies are forced outside the United States to simply sell
their products and compete with foreign funds that are not
subject to similar withholding taxes.
Current Tax Rules
Income earned by a mutual fund is comprised of four
elements: (1) interest; (2) short-term capital gains; (3) long-
term capital gains; and (4) dividends. Of these four,
generally, only dividend income is subject to withholding tax.
Under current law, when the income earned by a mutual fund
is distributed, the interest income and short-term capital
gains income are converted into dividend income, effectively
re-characterizing the principal earnings of the mutual fund as
dividend income. When received by a foreign investor, this
``dividend income'' is subject to a 30 percent withholding tax.
Tax treaties may reduce this rate to 15 percent or less for
residents of certain treaty countries. Nonetheless, this tax
significantly reduces the attractiveness of US-based mutual
funds to foreign investors.
Interest Income
The Deficit Reduction Act of 1984 generally repealed the 30
percent withholding tax for portfolio interest paid to foreign
investors on obligations issued after July 18, 1984. Tax
treaties between the United States and a number of foreign
countries also exempt interest paid to foreign investors from
the withholding tax.
For a US mutual fund, however, interest income is
characterized as dividend income when it is distributed. The
portfolio interest exemption and reduced treaty rates,
therefore, do not apply and all such income is subject to
withholding tax when received by foreign investors.
Short-term capital gains
A US mutual fund must also characterize short-term capital
gains as ordinary income dividends, making such income subject
to withholding tax when received by foreign investors. In
direct contrast, if a foreign investor invests directly in US
securities, through a unit-trust, partnership, or foreign
mutual fund, such short-term capital gain income is not be
subject to withholding tax.
Current US Tax Law Creates a Major Impediment to Foreign Investment
We have found, in our discussions with potential investors
throughout the world, that the first fund of choice for a
foreign investor is one based in its own country. The second
choice, all other things being equal, typically is investment
in US funds, for the following reasons:
The US system of regulation is unparalleled in its
commitment to investor protector.
The US fund system uses the most advanced
investment management technology, including the best accounting
and recordkeeping knowledge and expertise.
The US mutual fund industry has by far the best
marketing and client servicing capabilities.
Until 1980, US-based institutional investors had very few,
if any, investments outside the United States. Today, these
funds invest 15 percent or more of their assets in overseas
equity and debt instruments. Similarly, institutional investors
in foreign countries, such as those in the United Kingdom,
Japan, and Switzerland are also increasing their investments
outside their home country. These investors include insurance
companies, banks, trusts, pension funds, reinsurance pools,
central banks, and government entities.
The US withholding tax, however, provides a strong
disincentive for foreign investors for two reasons--it
effectively imposes an export tax on the US mutual fund
industry, making US based funds less attractive from a pricing
standpoint; and it creates an administrative burden.
Large, institutional investors have a broad choice of
investment vehicles worldwide. It has been our experience that
these investors will not hesitate to move investment assets
wherever necessary to obtain the highest after-tax yield
available at their particular risk-tolerance level. The US
withholding rate of 30 percent reduces yields for US mutual
funds to levels substantially below world market rates, thus
creating a significant impediment to US investment managers
selling their funds outside the US.
While some foreign investors may be entitled to a refund of
the withholding tax paid (under tax treaty provisions), the
administrative burden and the loss of use of the funds (for
periods of time frequently in excess of a year) outweigh the
expected yields. Thus, the foreign investment in US securities
is achieved through other means.
Foreign investors can avoid the withholding tax by
investing directly in US securities. However, our experience is
that foreign investors, particularly institutional investors,
prefer to employ highly experienced professional investment
managers to diversify their investments overseas through the
use of ``pooled'' vehicles. Recently, Russell conducted a
survey of its potential investment clients in Europe. We
learned that, in general, those investors prefer a pooled
vehicle such as a mutual fund for their global investment
strategies. This is no surprise. Pooled investments represent
the most efficient way to diversify a portfolio across multiple
markets and among several currencies. However, because the US
tax code imposes a tax penalty in the form of the 30 percent
withholding tax, those investors generally go elsewhere to
access the global markets.
This has resulted in the dramatic increase in institutional
funds located in such tax-favored jurisdictions as Luxembourg,
Ireland, Bermuda, and the Cayman Islands. Many of the funds
created in these jurisdictions invest in US securities.
Foreign-based institutional investors find these funds
attractive because their investments are not subject to the US
withholding tax.
US Mutual Fund Companies Must Locate Outside the US in Order
to Compete
The 30 percent withholding tax imposed on US mutual funds
can be totally avoided by establishing funds outside the US.
Since interest and capital gains earned directly (i.e. without
being ``converted'' into dividends) generally are not subject
to US withholding tax, funds based outside the US are not
subject to the same 30 percent cut that is imposed on funds
located inside the US. US mutual fund companies, therefore,
routinely set up ``clone'' or ``mirror'' funds of their US-
based funds outside US borders. This is currently the only way
US funds can effectively avoid the 30 percent tax and compete
for foreign investment dollars.
Frank Russell Company, along with many other US mutual fund
companies, would prefer not to have to set up operations
outside the US to make their products attractive to foreign
investors. Keeping these operations at home would allow US
companies to benefit from their existing operations and
systems. It would also allow us to avoid additional taxation
and expenses associated with locating in foreign countries and
it would allow us to develop jobs at home rather than abroad.
Russell's experience in Canada exemplifies this point and
the impact of the US withholding tax.
Russell's Experience
In 1992, Russell entered into an arrangement to provide a
series of investment funds to be marketed to the individual
retirement account market in Canada by a Canadian brokerage.
The US withholding tax made Russell's existing US mutual funds
unattractive investment vehicles for Canadian investors.
Russell was thus forced to create a new Canadian-based
family of funds (that are essentially ``clones'' of existing
Russell US-based mutual funds), solely for the purpose of
providing a tax efficient pooled investment vehicle to Canadian
investors who wish to invest a substantial portion of their
retirement portfolio in US securities. These funds became fully
operational in January 1993, and grew to over $100 million
(Canadian) in assets in less then six months. They have since
grown to over $2 billion in assets.
One reason these funds are so successful is because,
increasingly, foreign investors are attracted to Russell's
``multi-style, multi-manager'' investment approach. This
investment approach is particularly attractive to investors
with a long-term asset/liability management focus, such as
pension funds, individual retirement plans, and insurance
pools. In using the investment technology it has developed over
the last 25 years advising some of the world's largest
investment pools, Russell is regarded as possessing cutting
edge global investment technology. This proprietary technology
and ``know-how'' represents a quantum leap over other
investment products available in the global market.
Yet, these funds--managed in Canada but substantially
invested in US securities--employ Canadian accounting,
custodial, trustee, and recordkeeping services and pay
investment management fees to select Canadian investment
managers. Russell's Canadian affiliate pays Canadian corporate
income tax on its earnings from this operation.
It is worth noting at this point that several foreign
jurisdictions have enacted ``magnet'' legislation to attract
the pooled investment business to their countries. Ireland is a
recent example of this trend, having enacted legislation to
permit pure ``pass-through'' treatment for funds located there,
and significantly lowering the income tax rate for investment
management firms that conduct funds operations in Dublin. Such
foreign legislation thus creates a double incentive to locate
US funds businesses off shore.
H.R. 2430, The Investment Competitiveness Act of 1999
If H.R. 2430 had been in place at the time Russell was
organizing its funds in Canada, there would have been no need
for Russell to create a separate set of ``clone'' funds in
Canada.
In general, H.R. 2430 effectively removes the 30 percent
penalty imposed on US mutual funds by allowing interest and
short-term capital gains income to retain their original
character when distributed to a foreign shareholder. Rather
than being converted to dividend income subject to the 30
percent withholding tax, interest earned by a US mutual fund
would flow through to foreign shareholders as interest income.
Likewise, short-term capital gains income would flow through as
short-term capital gains income. This would permit US mutual
funds to sell their investment products to investors outside
the US without the withholding tax impediment.
Policy Issues Relating to H.R. 2430
Competitive Considerations. US mutual funds, such as those
sponsored by Frank Russell Company, should be placed on a level
playing field with foreign mutual funds. The international
funds business is highly competitive and marked by very narrow
profit margins. Often, mere basis points (hundredths of a
percentage point) separate the bidders for institutional
investment business. The US fund industry, if allowed to
compete on level ground with foreign funds, could employ its
production efficiencies and cutting edge technology to
attracting significant foreign capital. Under current US tax
law, companies like Frank Russell cannot compete, and the
foreign investment dollar is left to a foreign fund, with
little or no direct benefit accruing to the United States.
Neutrality of Tax Law In Investment Decisions. Foreign
investment in US securities may be accomplished in several
ways: directly, or indirectly, through foreign or US vehicles.
Current US tax law favors direct investment or indirect
investment through foreign funds. Effectively, US tax law
compels a particular investment approach by foreign investors,
which denies US mutual funds access to the market. We do not
believe sound tax policy is served by the current tax
structure. Tax law should be neutral with respect to its impact
on investment decisions. We believe that such tax neutrality
would permit taxpayers such as Frank Russell Company the
ability to fully benefit from the technological and strategic
advantage we have worked hard to develop over the years.
Application of the 1984 Act. In the Deficit Reduction Act
of 1984, Congress exempted from US withholding tax certain
payments to foreign direct investors and exempted investments
in the underlying obligations from US estate tax. Congress
enacted these provisions to promote capital formation and
substantial economic growth in the United States. This bill
would continue to foster capital formation and economic growth
by providing wider access for US mutual funds to the billions
of foreign investment dollars currently lodged in foreign
mutual funds.
Conclusion
During the last decade, the US mutual fund industry has
become one of the fastest growing segments of the US financial
services industry. US mutual fund assets now total over $2
trillion. Such a thriving domestic industry must be allowed to
flourish on an international level as well. Yet, the current
tax environment prevents this industry from exporting its
product. H.R. 2430 would create a worldwide market for US
mutual funds, thus unleashing additional flows of international
capital into US investments. For the Frank Russell Company,
H.R. 2430 adjusts US tax law to reflect today's dynamic,
international financial services market. It is legislation that
it critically important from both a business and policy
prospective.
Statement of M. David Blecher, Principal, Hewitt Associates, LLC
Introduction
Hewitt Associates is a global management consulting firm
specializing in human resource solutions, with 10,000
associates worldwide, and 73 offices in 34 different countries,
including 27 offices across the U.S. We have been recognized by
Business Insurance magazine as the largest U.S. benefits
consulting firm and the second-largest benefits consulting firm
worldwide. Our clients include over 75 percent of Fortune 500
companies.
Our primary business falls into three main areas:
Strategy, design, and implementation of human
resources, benefits, and compensation programs both
domestically and globally.
Financial and performance management of programs
including actuarial services, cost quality, employee
satisfaction, measurement, and analysis for all retirement and
health-related benefits.
Ongoing administration of programs including
outsourced delivery. For example, we manage all aspects of
employee benefits plan administration, including coordination
with third parties (e.g., individual health plans) and improve
customer service for employee benefits plan participants.
Both in our capacity as a global employer and in our
capacity as a consultant to companies with international
interests, we have, over time, become aware of various problems
with U.S. tax laws, problems caused in some instances by the
contents of the laws and in other instances by the way the laws
are enforced.
Some of our concerns have been ably addressed in the
materials filed by witnesses at the June 30 hearing.
Specifically, we endorse the need to correct problems created
by subpart F, section 911, the foreign tax credit rules, and
the alternative minimum tax, and we generally support the
current efforts to reform these areas of the law. Some of the
items that we have found especially troublesome are listed,
without discussion, as ``Other Important Items'' toward the end
of this statement.
Rather than use up our limited space in reiterating
arguments that have already been cogently made, we would like
to focus on some specific problems that, as far as we are
aware, have not been raised before the Committee. These relate
to the effect of tax rules on individuals rather than
corporations. In their way, they contribute toward the
reduction in global competitiveness of U.S. companies.
Summary
In our current age of increasing globalization, U.S.
companies more than ever before need employees with
international experience. Increasingly, this need is no longer
confined to corporate executives, but is felt at a much broader
level than formerly. Features of the tax code and its
application, however, militate against the transfer of
employees overseas; indeed, they encourage companies to operate
abroad employing non-U.S. employees. We believe that the effect
of this is to impair the competitiveness of companies in the
United States.
The problem stems from the requirements of the Internal
Revenue Code relating to individuals living and working outside
the United States. In addition to substantive rules that we
would consider anti-competitive, the Code's provisions are
complicated and make compliance difficult. The complicated tax
law, lengthy forms, and cost to individuals and companies for
tax preparation services encourages companies to eliminate U.S.
employees from the candidate pool when considering
international assignments. The converse is true, too; we have
seen U.S. employees refuse overseas assignments because of
their complicated and unpleasant tax implications. Without
international work and living experiences, U.S. employees will
become less competitive in the global workforce.
Topics that illustrate the problems we perceive are the
complex tax filing requirements, the tax-related costs
typically borne by U.S. employers (and, if not the employer,
then the U.S. employees), and the rules relating to retirement
benefits for expatriate employees; each of these we discuss
briefly below. While these issues may not in themselves cause a
company to take such drastic action as establishing
headquarters outside the U.S., they do contribute to overall
anti-competitiveness and could be addressed without major
overhaul of the Internal Revenue Code.
Recommendations for Further Study by the Committee
Our suggestions of areas for further study by the Committee
with respect to the taxation of individuals include:
1. Review tax forms such as Forms 673, 2555, 5471, and W-4,
with a view to reducing their complexity or even eliminating
forms where administrative costs outweigh the benefits of the
information contained in the forms.
2. Consider legislation under which the U.S. would enable
expatriate employees participating in foreign retirement plans
to be treated for U.S. income tax purposes as if the employees
were participating in U.S. qualified plans, provided the
foreign plans are genuine retirement plans and are qualified
under the laws of the host country. Tax-deferred rollovers or
transfer of distributions from foreign retirement plans to U.S.
plans should be included in any such rules.
3. Consider negotiating tax treaty provisions that would
prevent expatriate employees from being taxed in the host
country when they continue to accrue benefits under U.S. plans
while on assignment in the host country.
4. Explore ways of encouraging states to adopt uniform
provisions for the consistent tax treatment of individuals on
international assignments.
In addition, we suggest the Committee consider addressing
the items listed as ``Other Important Items'' toward the end of
this statement pertaining to both business and individual
taxation.
Filing Requirements
The filing requirements for expatriates have been made
somewhat simpler in recent years. Form 2555EZ, on which a
taxpayer claims relief under the foreign earned income
exclusion of Code section 911, is more straightforward than the
standard Form 2555, although the bookkeeping requirements to
complete the form are substantial--the taxpayer must carefully
track when he is in and out of the U.S., and what he was doing
when he was in each location (work versus personal time)--and
the ``EZ'' form cannot be used if the taxpayer also wishes to
claim the foreign housing exclusion.
In addition to tracking travel and work days, the employee
must complete Form 673, Statement for Claiming Benefits
Provided by Section 911 of the Internal Revenue Code. This form
provides written documentation to the employer that the
employee is eligible for the section 911 exclusions, and
provides the amounts by which income may be reduced before
withholding is necessary. The employee may also need to
complete a revised Form W-4 to take into account the foreign
tax credit or a statement indicating that the employee is
subject to tax withholdings in the host country, so that no
federal withholding is necessary. Both Form 673 and Form W-4
are difficult to understand and complete; the average taxpayer
is unable to complete either form without professional
assistance.
The U.S. filing complexity is eclipsed only by the various
states' requirements for residents on international
assignments. Much of the difficulty of state tax filings would
be eliminated if unnecessary federal filing requirements were
curtailed or if the states could agree on a uniform approach to
the taxation of employees on international assignments.
Tax-Related Costs
Many U.S. taxpayers on international assignments are paying
some income tax required by the U.S. tax code even though they
did not earn the income in the U.S. Because the majority of
U.S. multinational companies have a policy of tax-equalization
(the employees will pay only as much in taxes as they would
have paid had they remained at home), this cost is borne by
U.S. corporations. On top of the tax cost, we must consider the
cost to administer payroll (calculating appropriate
withholdings, reviewing documentation for payroll, etc.) and
the cost of tax return preparation services relating to
employees' overseas employment.
In our professional experience, we have seen companies
decide not to transfer U.S. citizens or residents because of
the additional costs and complexities involved. If they are to
continue to succeed in the global economy, U.S. companies need
employees with international experience. In short, the U.S. tax
code may adversely affect the competitiveness of U.S. companies
by making international assignments prohibitively expensive and
complicated.
Retirement Income
(a) U.S. Plans v. Foreign Plans
The U.S. system of taxing its citizens and residents on
their worldwide income has some adverse effects in the area of
retirement benefits. For example, if a company transfers a U.S.
citizen abroad, the expatriate employee may continue to be
covered in his or her U.S. retirement plans (commonly the case
where the employee is transferred for a relatively short-term
assignment) or the employee may cease participation in U.S.
plans and, instead, become a member of one or more plans in the
host country. These two scenarios have different tax results:
(1) Continued participation in U.S. plans. Under current
law, if the expatriate employee continues to participate in
U.S. plans, the U.S. tax treatment will be essentially the same
as if he or she were still in the U.S. Specifically,
contributions on the employee's behalf to, and benefits under,
U.S. qualified plans will not normally be taxable to the
employee until he or she receives a distribution of benefits
from the plans. The problem for U.S. expatriate employees is
that the employee may well find that the host country is
subjecting the employee to taxation on his or her U.S.
benefits, such as 401(k) deferrals or benefit accruals under a
pension plan, on the basis that they represent income with a
host-country source and that U.S. plans do not qualify for
favorable tax treatment under the host country's laws.
When this occurs, U.S. law may afford the employee a
foreign tax credit to offset those taxes, but the way the
foreign tax credit works, it will not always operate to fully
avoid double taxation of the individual.
(2) Participation in host country plans. If an expatriate
employee participates in retirement plans in the host country,
the employee may escape current taxation in the host country if
those plans are qualified for favorable tax treatment in that
country. From the U.S. perspective, however, it is close to
certain that the foreign plans will not contain all the
provisions needed for them to be qualified in the U.S. To the
extent, therefore, that an expatriate's overseas accruals are
vested, the U.S. will subject the individual to current rather
than deferred taxation of the benefits. This gives rise to
complicated tax calculations when the individual eventually
retires, having already been taxed on the overseas benefit and
being likely taxed by the host country at the time of payout.
It would be much simpler, and should involve no significant
(if any) loss of revenue if the U.S. and foreign countries
could work out a system of reciprocity under which an
expatriate participating in tax-qualified retirement plans in
the host country could have the home country deem the host
country plans to be tax-qualified in this situation.
This kind of arrangement is not unprecedented. The income
tax treaty between the U.S. and Canada contains a provision
(Article XVIII, section 7) that enables expatriate employees
(e.g., U.S. citizens working in Canada and participating in
Canadian retirement plans) to defer the taxation of retirement
income in the home country until the time the employee actually
receives a distribution of that income.
In addition, in the United Kingdom, the Inland Revenue
(without reciprocity from the U.S.) has a procedure under which
U.S. retirement plans can be submitted for ``corresponding
approval'' under U.K. law. In order to obtain such approval, a
plan need not demonstrate that it complies with all the
requirements for a U.K. ``approved scheme.''
We believe that the U.S. should seriously consider
establishing similar procedures under which the Internal
Revenue Service could deem foreign retirement plans to be
qualified for purposes of deferring taxation of U.S. citizens
and residents.
(b) Rollovers and Transfers of Benefits.
Under current rules, benefits from a nonqualified
retirement plan cannot be rolled over or transferred to a
qualified retirement plan without jeopardizing the
qualification of the latter plan. As virtually no foreign plans
are qualified for U.S. purposes, this effectively precludes an
employee who is transferring to (or back to) the United States
from transferring any benefits he or she may have received from
a qualified foreign plan to the U.S. qualified retirement plans
in which the employee participates. Such transfers, if
permitted, would facilitate the transfer of needed employees to
the U.S. This would, however, require careful investigation and
might be best handled through reciprocal arrangements in income
tax treaties.
The coordination of retirement benefits for mobile
employees is a complicated topic. We do not claim to have all
the answers. We do believe, however, that it is an issue that
will affect the competitiveness of U.S. companies, particularly
as other regions of the world tackle this issue. We follow with
interest the movement in the European Union toward pan-European
pensions and the ability of workers to move among European
countries without adversely affecting their pensions. While
Europe has not yet achieved these goals, there are forces
committed to their achievement. If and when this happens,
companies may have one more reason to site operations in Europe
rather than the United States. With this in mind, we believe
that the U.S. should pay serious attention to the tax problems
confronting U.S. citizens and residents working abroad.
Other Important Items
Additional items that we, in our experience, would classify
as anti-competitive from a U.S. perspective include:
the complexity of the foreign tax credit rules,
which place an undue administrative burden on U.S. taxpayers;
the alternative minimum tax;
the inequity of the rules under which unused foreign
tax credits can be carried forward only five years and backward
only one year, while overall foreign losses (which operate to
reduce the credits) are carried forward without limit;
lack of a ``deemed paid'' foreign tax credit for
non-corporate taxpayers, with the result that U.S. corporations
can take a U.S. tax credit for foreign taxes paid directly by
corporate subsidiaries, while non-corporate U.S. taxpayers
(such as partnerships) are denied such a credit;
the mind-numbingly complex deemed dividend rules
(e.g., under Subpart F), which are effectively tax traps for
the unwary; and
the requirement to file costly and extremely
burdensome annual ``Information Returns'' (e.g., Form 5471) for
certain foreign corporate and partnership subsidiaries--forms,
in our view, of which the cost to taxpayers far outweighs the
benefit of their contents to the government.
Conclusion
We thank the Committee for giving us the opportunity to
express our views on this subject. We would be happy to work
with the Committee in further understanding the ramification of
the issues discussed in this statement.
Statement of Timothy A. Brown, President, International Organization of
Masters, Mates & Pilots, Linthicum, MD and Lawrence H. O'Toole,
President, Marine Engineers' Beneficial Association
Mr. Chairman and Members of the Committee: On behalf of the
International Organization of Masters, Mates & Pilots (MM&P)
and the Marine Engineers' Beneficial Association (MEBA), we
thank you for the opportunity to submit this statement
specifically addressing our proposal to make section 911 of the
Internal Revenue Code applicable to certain American merchant
mariners. The MM&P primarily represents Masters and Licensed
Deck Officers working aboard commercial vessels operating in
our nation's foreign and domestic shipping trades. The MEBA
primarily represents Licensed Engineers working aboard
commercial vessels also operating in our nation's foreign and
domestic shipping trades.
We would first like to emphasize our support for the views
presented at the June 30 hearing by Mr. Peter Finnerty, Vice
President for SeaLand Service, Inc., in support of H.R. 2159,
the ``United States-flag Merchant Marine Revitalization Act of
1999.'' We agree wholeheartedly that changes to the existing
Capital Construction Fund as embodied in H.R. 2159 will help
increase the competitiveness of the United States-flag merchant
marine by facilitating the accumulation of capital necessary
for the construction of new, modern commercial vessels in
American shipyards for operation under the United States-flag.
We similarly urge its favorable consideration by the Committee.
At the same time, we believe it is equally important that
Congress examine ways to increase the employment of American
merchant mariners aboard commercial vessels in the foreign and
international trades. We are convinced that extending the same
foreign earned income exclusion available to other American
workers to American mariners working aboard commercial vessels
operating outside the United States will help American merchant
mariners compete more equally with comparably qualified non-
American mariners for these jobs.
As the Committee is well aware, under section 911 of the
Internal Revenue Code, American citizens employed outside the
United States may exclude from their gross income for Federal
income tax purposes up to $74,000 of their foreign-earned
income. American merchant mariners, working aboard United
States-flag or foreign flag commercial vessels in the foreign
or international trades, are not qualified to take advantage of
the foreign earned income exclusion primarily because they are
not deemed to be working in a foreign country as defined in
Internal Revenue Service regulations.
We strongly believe that changing the definition of
``foreign country'' and altering the ``foreign residence'' test
for merchant mariners to better reflect the true nature of
their employment, and making section 911 applicable to merchant
mariners, will be consistent with the important purposes and
objectives of the foreign earned income exclusion.
Clearly, one of the primary goals of section 911 is to
promote America's national interests through the employment of
American citizens outside the United States. Ensuring that the
United States has a sufficient number of loyal, trained
American merchant mariners to crew the government-owned and
private vessels needed during war or other national or
international emergency is a key component of America's sealift
capability. Making section 911 applicable to merchant mariners,
and increasing the opportunity for Americans to compete for
employment on commercial vessels, will augment America's
available seapower force. As in the case of other Americans
seeking employment in the international marketplace, it is
extremely difficult for American mariners, who are subject to
the full range of American tax law, to secure employment
opportunities outside the United States.
Similarly, extending section 911 to American mariners will
have a direct and positive impact, not only on the ability of
Americans to secure employment on foreign vessels, but also on
American companies operating vessels in the international
shipping arena. Presently, vessel owners must pay an American
mariner more than they would pay mariners from other nations so
that American mariners may retain a comparable after-tax
income. All too often, in the maritime industry as in other
industries, the employer is unwilling to pay this premium, even
when the American mariner is more qualified, more professional
and more productive than his foreign counterparts.
Today, privately-owned United States-flag commercial
vessels are forced to compete for cargoes in an environment
largely dominated by heavily subsidized and foreign state-owned
fleets, and fleets registered in tax-haven countries, such as
Liberia, Honduras, and Vanuatu. These fleets have significant
economic and tax advantages as compared to American shipping
companies. In reality, some of these discrepancies will
continue to exist for the foreseeable future. For example,
American companies extend health and welfare benefits that
foreign governments rather than foreign companies provide to
their nationals, and Americans are subject to a wide range of
U.S. government-imposed rules and regulations generally not
applicable to their foreign competitors. Extending section 911
to American mariners is one thing that Congress can do so that
it will no longer mean an economic penalty or burden if a
vessel operator--American or foreign--chooses to employ
American mariners.
Today, despite the efforts of our organizations and other
maritime labor organizations, American mariners are at a
significant competitive disadvantage and are being priced out
of their foreign markets--employment on commercial vessels
operating outside the United States in the foreign or
international trades--because prospective employers must
provide more income to American mariners to compensate them for
the tax burden that is not faced by foreign mariners.
We would point out that other nations are pursuing changes
in their tax laws to increase employment opportunities for
their merchant mariners. It has been reported that the
Government of Ireland has decided to make concessions in its
taxation of seafarers to make it more attractive to use Irish
seafarers on Irish vessels and that a draft Government of India
shipping policy includes, among other things, a proposal to
provide ``income tax exemptions for Indian seafarers, to
attract talent to the field.''
Similarly, both Great Britain and Germany announced at the
end of 1998 that they were each exploring a variety of tax-
related measures and incentives, including those relating to
their merchant mariners, in order to revitalize their fleets
and increase employment for their nationals. Germany is
specifically addressing whether they can attract more young
Germans to seafaring jobs by further exempting from taxes a
portion of the wages of new seafarers.
Indeed, it is also worth noting that some foreign nations
have already exempted their mariners from their national income
tax, including Cyprus, Denmark, the Netherlands, Norway, and
Spain.
We believe that Congress can help achieve the dual
objective of enhancing the competitiveness of United States-
flag commercial vessels operating in international and foreign
commerce, and increasing the opportunity for American merchant
mariners to secure employment aboard foreign and American
commercial vessels. We recommend that Congress make section 911
applicable to American mariners working aboard either a United
States-flag commercial vessel or aboard a vessel documented
under the laws of a foreign country, to the extent the income
earned by the American mariner is attributable to employment
performed outside the territorial waters of the United States.
We thank you and your Committee for your consideration of
this proposal and we stand ready to provide whatever additional
information you or your staff may require.
Statement of the Interstate Natural Gas Association of America
The Interstate Natural Gas Association of America
(``INGAA'') is a non-profit national trade association that
represents virtually all of the major interstate natural gas
transmission companies operating in the United States. These
companies handle over 90 percent of all natural gas transported
and sold in interstate commerce. INGAA's United States members
are regulated by the Federal Energy Regulatory Commission
pursuant to the Natural Gas Act, 15 U.S.C. Sec. Sec. 717-717w,
and the Natural Gas Policy Act of 1978, 15 U.S.C.
Sec. Sec. 3301-3432.
In recent years a number of INGAA's members have become
engaged in the design, construction, engineering, ownership and
operation of major pipeline and power plant projects outside
the United States. Investments are made in these foreign
projects generally by foreign subsidiaries of the U.S.
companies. These projects, which are highly capital-intensive,
often involve construction of a natural gas pipeline and
related facilities to transport gas from its point of
extraction within one or more foreign countries for industrial
uses, gas distribution and to electric generating facilities
for use as fuel in the generation of power. The pipeline
construction project may include the electric generating plant,
and in some cases may also include an interest in the gas wells
which provide the gas supply. The gas being transported in the
pipeline may or may not be owned by the pipeline owner. Most of
these projects are being undertaken in countries in Latin
America, such as Argentina, Bolivia and Chile, in countries in
Asia, such as India, Oman, and Abu Dhabi and in less developed
countries in other parts of the world.
Generally, large energy projects are awarded through a
bidding process. The bidding is highly competitive, and the
economics of such projects are extremely tax sensitive. In many
cases, the country or countries where the project is based
impose substantial taxes on the project. U.S. tax law currently
disadvantages U.S. companies vis-a-vis their foreign
competitors, including particularly those based in Canada,
Australia, or Europe.
In announcing this hearing, Chairman Archer stated: ``I
strongly believe that our tax rules must help, rather than
hinder, the competitiveness of American businesses.'' INGAA
urges Congress to reform the taxation of foreign oil and gas
income to eliminate the clear inequities of current law as
applicable to foreign pipeline projects. It is INGAA's position
that the ownership and operation of gas pipelines and other
immovable assets in foreign countries as described herein
should never result in Subpart F income, whether or not the
activities occur in a country where the gas was extracted or
consumed, and whether or not the controlled foreign corporation
takes title to the gas being transported, because these
activities do not produce income which is passive or
manipulable. Accordingly, we urge the Committee to support H.R.
1127, introduced by Representatives McCrery and Watkins, which
clarifies the treatment of pipeline transportation income, and
section 105 of H.R. 2018, ``International Tax Simplification
for American Competitiveness Act of 1999,'' introduced by
Representatives Houghton and Levin. Both bills would exclude
income from the transportation of oil and gas by pipeline from
subpart F income. Companion bills in the Senate, S. 1116
introduced by Senator Nickles and section 105 of S. 1164
introduced by Senators Hatch and Baucus, would similarly
exclude active oil and gas pipeline income from subpart F
income. At a minimum, current law should be amended: (i) to
apply both the current law ``consumption'' and ``extraction''
exceptions to subpart F treatment in the same manner, i.e.,
their application should not be dependent upon whether the
controlled foreign corporation takes title to the gas it is
transporting; and (ii) to apply the high-tax exception to
foreign base company income to foreign base company oil related
income.
Moreover, the Administration's proposal to revise the tax
treatment of foreign oil and gas income (the ``Proposal'')
should be rejected. The Proposal would, if enacted, exacerbate
the current law bias against INGAA members in competing for
these projects, and would drastically affect the economics of
projects already undertaken. Accordingly, INGAA also urges
Congress to reject the Proposal.
This statement describes current law, illustrates the
inequity of current law to INGAA members, and then further
illustrates how the Proposal would greatly exacerbate this
inequity.
I. U.S. Taxation of Foreign Pipelines Under Current Law
A. Subpart F
Under the Subpart F rules, U.S. ``10 percent shareholders''
\1\ of a ``controlled foreign corporation'' (``CFC'') \2\ are
subject to U.S. tax currently on their proportionate shares of
``Subpart F income'' earned by the CFC, whether or not it is
distributed to the U.S. shareholders.\3\ Included among the
categories of Subpart F income is ``foreign base company oil
related income.'' \4\ Foreign base company oil related income
is income derived outside the United States from the processing
of minerals extracted from oil or gas wells into their primary
products; the transportation, distribution or sale of such
mineral or primary products; the disposition of assets used in
a trade or business involving the foregoing; or the performance
of any related services.
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\1\ See section 951(b).
\2\ See section 957(a).
\3\ Section 951(a).
\4\ See section 954(g).
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There are two significant exceptions to the foreign base
oil related income class:
1. The extraction exception: income, including income from
operating a pipeline, derived from a source within a foreign
country in connection with oil or gas which was extracted by
any person from a well located in such foreign country is not
treated as foreign base company oil related income; \5\ and
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\5\ Section 954(g)(1)(A).
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2. The consumption exception: income, including income from
operating a pipeline, derived from a source within a foreign
country in connection with oil or gas (or a primary product
thereof) which is sold by the CFC or a related person for use
or consumption within the foreign country is not foreign base
company oil related income.\6\
---------------------------------------------------------------------------
\6\ Section 954(g)(1)(B).
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In addition, there is a general exception for CFCs which do
not produce 1,000 barrels per day of foreign crude oil and
natural gas.\7\ This exception, however, often is not available
because for this purpose all related persons are aggregated,
and many significant investors in natural gas pipelines and
power projects around the world own foreign production which
exceeds 1,000 barrels per day. Indeed, this limited exception
is particularly non-competitive as it applies to production in
Canada.
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\7\ Section 954(g)(2).
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All types of foreign base company income except foreign oil
related income may be excluded from current taxation under
Subpart F if the income is subject to an effective rate of
local income tax greater than 90 percent of the U.S. corporate
rate.\8\ No reason is given in the legislative history as to
why this high tax exception is not applicable to foreign oil
related income.
---------------------------------------------------------------------------
\8\Section 954(b)(4).
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The Subpart F taxation of foreign oil related income was
enacted in the Tax Equity and Fiscal Responsibility Act of 1982
(``TEFRA''), P.L. 97-248, September 3, 1982. The legislative
history explaining the tax policy rationale for the Subpart F
treatment of foreign oil and gas income is as follows:
[B]ecause of the fungible nature of oil and because of the
complex structures involved, oil income is particularly suited
to tax haven type operations.
S. Rep. No. 494, 97th Cong., 2d Sess. 150 (1982).
The only other reference made in the legislative history of
TEFRA to any reason for including foreign oil related income in
Subpart F is the general statement of the Finance Committee
that ``the petroleum companies have paid little or no U.S. tax
on their foreign subsidiaries' operations despite their
extremely high revenue.'' Id. Accordingly, Subpart F taxation
was imposed on all foreign oil related income without analysis
of whether such income fit the criteria of Subpart F, i.e., was
passive in nature or moveable. Income from the ownership and
operation of foreign gas pipelines is neither passive or
moveable. Moreover, it is unlikely that such income could have
been a target of TEFRA because INGAA members only began
building pipelines outside the United States in the 1990s.
As described above, CFCs owned by INGAA members participate
in large foreign projects which typically involve the
construction and operation of gas pipelines and related
facilities, sometimes include the participation in power
plants, and occasionally also include investment in gas wells.
These are all active business activities which have become
common only in recent years. This foreign income of CFCs owned
by INGAA members is no more ``particularly suited to tax haven
operations'' (as the Senate Finance Committee Report states)
than is any foreign manufacturing or processing activity
conducted by a CFC, such as the manufacture of consumer or
industrial goods. Surely it is not possible to ``manipulate''
income earned by a CFC from operating a gas pipeline
permanently installed in a particular foreign country.
Most U.S. bidders have generally only won projects where
either the ``extraction'' or ``consumption'' exceptions to
Subpart F treatment applied. If a pipeline project does not
qualify for one of these exceptions to Subpart F it is unlikely
that a U.S. bidder could successfully win a bid for that
project against foreign competitors. Indeed, such a U.S. bidder
is at a competitive disadvantage even for projects with local
income taxes higher than the U.S. corporate rate because the
Subpart F exception for high-tax income does not apply.
Moreover, the exceptions to Subpart F for foreign oil
related income apply irrationally. Consider the example where
gas is extracted and processed by persons unrelated to the CFC
in country A. The CFC constructs a pipeline from country A
through country B and into country C where the gas is delivered
to a power plant. Assume that the CFC receives $100 for
transportation of the gas in each of countries A, B, and C, and
that each country imposes tax on the CFC of $35. The U.S.
taxation of the $300 of income is as follows:
Country A--The $100 is not subpart F income because the
extraction exception applies--the income is derived from
country A where the gas was extracted.
Country B--The $100 is Subpart F income, currently taxed in
United States because the income is not earned either in a
country where the gas was extracted (Country A) or consumed
(Country C).
Country C--The $100 is Subpart F income if the CFC does not
own the gas but instead charges a tariff for transportation.
However, if the CFC takes title to the gas and sells it in
country C, the consumption exception applies and the $100 is
not Subpart F income.
As a matter of tax policy, different tax treatment of each
separate $100 of income cannot be justified. None of this $300
of income should be Subpart F income because it is not passive
or moveable. Moreover, because, as explained below, INGAA
members are frequently in an excess foreign tax credit
position, there are many instances in which a foreign tax
credit is not available to offset the current U.S. tax on
subpart F income from the operation of foreign pipelines by a
CFC, with the result that international double taxation occurs.
B. Foreign Tax Credit
U.S. persons are subject to U.S. income tax on their
worldwide income. To eliminate international double taxation,
i.e., the taxation of the same income by more than one tax
authority, the United States allows a credit against the U.S.
tax on foreign source income for foreign income taxes paid.\9\
The amount of credits that a taxpayer may claim for foreign
taxes paid is subject to a limitation intended to prevent
taxpayers from using foreign tax credits to offset U.S. tax on
U.S. source income.\10\ The foreign tax credit limitation is
calculated separately for specific categories of income.\11\
Generally speaking, the foreign income activities conducted by
INGAA members, such as operating pipelines to transport natural
gas in foreign countries, produce ``active basket'' (sometimes
referred to as ``general basket'') foreign source income.
Income from the extraction of oil and gas is also generally
``active basket'' income, although foreign oil and gas
extraction income taxes are creditable only to the extent that
they do not exceed 35 percent of the extraction income.\12\
---------------------------------------------------------------------------
\9\ Section 901(a).
\10\ Section 904(a).
\11\ Section 904(d).
\12\ Section 907.
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The ``separate basket'' approach of current law was
instituted in the Tax Reform Act of 1986. In 1986 Congress
expressed a concern that the overall foreign tax credit
limitation permitted a ``cross crediting'' or averaging of
taxes so that high foreign taxes on one stream of income could
be offset against U.S. tax otherwise due on only lightly taxed
foreign income. Nevertheless, in 1986 Congress endorsed the
overall limitation as being ``consistent with the integrated
nature of U.S. multi-national operations abroad,'' and
therefore concluded that averaging credits for taxes paid on
active income earned anywhere in the world should generally be
allowed to continue.\13\ Congress limited the cross crediting
of foreign taxes when it would ``distort the purpose of the
foreign tax credit limitation.'' \14\ For example, one
identified concern was the use of portfolio investments in
stock in publicly-traded companies, which could quickly and
easily be made in foreign countries rather than in the United
States. In order to limit the opportunities for cross-
crediting, Congress added additional baskets for income that
frequently either bore little foreign tax or abnormally high
foreign tax, or was readily manipulable as to source. The
baskets enacted in 1986 included passive income, financial
services income, shipping income, high withholding tax
interest, and dividends from non-controlled section 902
corporations.\15\
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\13\ General Explanation of the Tax Reform Act of 1986, 99th Cong.,
2d Sess. 862 (1986) (``1986 Blue Book'').
\14\ Id.
\15\ H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. 564-66 (1986).
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Current law, which treats all income from the
transportation of natural gas through a foreign pipeline as
active basket income, is clearly the correct result. INGAA
members, however, are frequently in an excess foreign tax
credit position because of the substantial interest expense on
debt incurred to finance domestic capital expenditures which is
apportioned to foreign source income, reducing the numerator of
the foreign tax credit limitation which in turn reduces the
amount of the foreign tax credit. Thus, as a practical matter
it is difficult for a U.S. pipeline company to obtain foreign
tax credits with respect to the income earned from its foreign
operations.\16\ Such companies, however, should not be
precluded from using available credits.
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\16\ In the example described above, although the $200 of income
frm Countries B and C would be subject to U.S. tax under Subpart F, it
is unlikely that the $70 of foreign income taxes paid to Countries B
and C would be available as a foreign tax credit to offset the U.S. tax
on such income. As a result, there would be international double
taxation of the $200 of income.
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II. The Administration's Proposal
On February 1, 1999, the Administration put forth the
Proposal which would result in a substantial change in the
taxation of foreign oil and gas income. The Proposal would
treat all foreign income taxes paid by a CFC relating to oil
and gas income, including income from the transportation of gas
through a pipeline, as being subject to a separate foreign tax
credit limitation instead of being included as part of the
``general basket'' of active income.
In the General Explanation of the Proposal, the Treasury
Department does not articulate any reason for creating a
separate basket for foreign oil and gas income under the
foreign tax credit limitation. In its ``Description of Revenue
Provisions Contained in the President's Fiscal Year 2000 Budget
Proposal,'' issued February 22, 1999, the Staff of the Joint
Committee on Taxation stated that the proposal ``may provide
some simplification by eliminating issues that arise under
present law in distinguishing between income that qualifies as
extraction income and income that qualifies as oil related
income.'' \17\
---------------------------------------------------------------------------
\17\ Staff of the Jt. Com. on Tax., 106th Cong., 1st Sess.,
Description of Revenue Provisions Contained in the President's Fiscal
Year 2000 Budget Proposal, 310 (Comm. Print 1999).
---------------------------------------------------------------------------
The policy rationale of simplification does not apply to
pipeline companies, which do not have extraction income.
Accordingly, there is no policy justification for separating
foreign oil and gas transportation income from other active
income for purposes of the foreign tax credit limitation.
Moreover, separating foreign oil and gas income into a separate
foreign tax credit limitation basket would be contrary to the
general principle of the separate basket regime enacted by
Congress in 1986 that all active business income should be
included in one foreign tax credit limitation basket to enable
the cross-crediting of all taxes on such income.\18\
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\18\ Shipping and financial services income, which are both active
income, were subjected to separate basket treatment in 1986, either
because the income ``frequently'' bore little foreign tax or abnormally
high foreign tax or was manipulable as to source. 1986 Blue Book at
863-64. The income from operating foreign gas pipelines is not more
frequently subject to either abnormally high or low foreign tax than
manufacturing income, nor is it manipulable as to source.
---------------------------------------------------------------------------
The Proposal would materially harm U.S. businesses,
affecting U.S. jobs and U.S. competitiveness in the global
economy. The effect of the Proposal would be to limit further
the amount of foreign tax credits available to INGAA members
and preclude most U.S. investors from successfully bidding for
the capital-intensive foreign pipeline projects. This would
significantly hinder a thriving business currently available to
INGAA members. This business creates a demand for U.S. jobs,
particularly engineering and support services. Elimination of
most U.S. pipeline companies from participating in foreign
pipeline projects seems to INGAA to be wholly counterproductive
and misguided tax policy which would cost U.S. jobs.
In addition, the Proposal would apply to projects already
completed and in operation. U.S. investors would therefore
realize returns different from their economic projections, with
materially adverse financial statement impacts. In short,
enactment of the Proposal would create profound economic harm
for INGAA members with foreign pipeline activities.
III. Recommendations
A. Reform the Subpart F Taxation of Foreign Oil-Related Income
As It Applies to Gas Pipelines
Current law includes all foreign oil related income in
Subpart F income. It is INGAA's position that the ownership and
operation of gas pipelines and other immovable assets in
foreign countries as described herein should never result in
Subpart F income, whether or not the activities occur in a
country where the gas was extracted or consumed, and whether or
not the CFC takes title to the gas being transported, because
these activities do not produce income which is passive or
manipulable. Accordingly, we urge the Committee to support H.R.
1127, introduced by Representatives McCrery and Watkins which
clarifies the treatment of pipeline transportation income, and
section 105 of H.R. 2018, ``International Tax Simplification
for American Competitiveness Act of 1999'' introduced by
Representatives Houghton and Levin. Both bills would exclude
income from the transportation of oil and gas by pipeline from
subpart F income. At a minimum, (i) the consumption exception
should be amended to apply in the same manner as the extraction
exception, i.e., its application should not be dependent upon
whether the CFC takes title to the gas it is transporting, and
(ii) the high-tax exception to foreign base company income
should be amended so that it applies to foreign base company
oil related income as it does to all other foreign base company
income.
B. Reject the Administration Proposal
The Proposal should be rejected. As applied to foreign gas
pipelines, there is no tax policy justification for the
Proposal. It is inconsistent with the separate basket approach
of current law and would preclude most U.S. investors from
successfully bidding for the capital-intensive foreign pipeline
projects. It also could result in a substantial ``tax
increase'' for INGAA members that own foreign gas pipelines.
* * * * *
INGAA appreciates the opportunity to provide this statement
and would be pleased to furnish any information requested by
the Committee.
Statement of the Investment Company Institute
The Investment Company Institute (the ``Institute'') \1\
urges the Committee to enhance the international
competitiveness of U.S. mutual funds, treated for federal tax
purposes as ``regulated investment companies'' or ``RICs,'' by
enacting legislation that would treat certain interest income
and short-term capital gains as exempt from U.S. withholding
tax when distributed by U.S. funds to foreign investors.\2\ The
proposed change merely would provide foreign investors in U.S.
funds with the same treatment available today when comparable
investments are made either directly or through foreign funds.
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\1\ The Investment Company Institute is the national association of
the American investment company industry. Its membership includes 7,576
open-end investment companies (``mutual funds''), 479 closed-end
investment companies and 8 sponsors of unit investment trusts. Its
mutual fund members have assets of about $5.860 trillion, accounting
for approximately 95% of total industry assets, and have over 73
million individual shareholders.
\2\ The U.S. statutory withholding tax rate imposed on non-exempt
income paid to foreign investors is 30 percent. U.S. income tax
treaties typically reduce the withholding tax rate to 15 percent.
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I. The U.S. Fund Industry is the Global Leader
Individuals around the world increasingly are turning to
mutual funds to meet their diverse investment needs. Worldwide
mutual fund assets have increased from $2.4 trillion at the end
of 1990 to $7.6 trillion as of September 30, 1998. This growth
in mutual fund assets is expected to continue as the middle
class continues to expand around the world and baby boomers
enter their peak savings years.
U.S. mutual funds offer numerous advantages. Foreign
investors may buy U.S. funds for professional portfolio
management, diversification and liquidity. Investor confidence
in our funds is strong because of the significant shareholder
safeguards provided by the U.S. securities laws. Investors also
value the convenient shareholder services provided by U.S.
funds.
Nevertheless, while the U.S. fund industry is the global
leader, foreign investment in U.S. funds is low. Today, less
than one percent of all U.S. fund assets are held by non-U.S.
investors.
II. U.S. Tax Policy Encourages Foreign Investment in the
U.S. Capital Markets
Pursuant to U.S. tax policy designed to encourage foreign
portfolio investment \3\ in the U.S. capital markets, U.S. tax
law provides foreign investors with several U.S. withholding
tax exemptions. U.S. withholding tax generally does not apply,
for example, to capital gains realized by foreign investors on
their portfolio investments in U.S. debt and equity securities.
Likewise, U.S. withholding tax generally does not apply to U.S.
source interest paid to foreign investors with respect to
``portfolio interest obligations'' and certain other debt
instruments. Consequently, foreign portfolio investment in U.S.
debt instruments generally is exempt from U.S. withholding tax;
with respect to portfolio investment in U.S. equity securities,
U.S. withholding tax generally is imposed only on dividends.
---------------------------------------------------------------------------
\3\ ``Portfolio investment'' typically refers to a less than 10
percent interest in the debt or equity securities of an issuer, which
interest is not ``effectively'' connected to a U.S. trade or business
of the investor.
---------------------------------------------------------------------------
III. U.S. Tax Law, However, Inadvertently Encourages Foreigners to
Prefer Foreign Funds Over U.S. Funds
Regrettably, the incentives to encourage foreign portfolio
investment are of only limited applicability when investments
in U.S. securities are made through a U.S. fund. Under U.S. tax
law, a U.S. fund's distributions are treated as ``dividends''
subject to U.S. withholding tax unless a special
``designation'' provision allows the fund to ``flow through''
the character of its income to investors. Of importance to
foreign investors, a U.S. fund may designate a distribution of
long-term gain to its shareholders as a ``capital gain
dividend'' exempt from U.S. withholding tax.
For certain other types of distributions, however, foreign
investors are placed at a U.S. tax disadvantage. In particular,
interest income and short-term capital gains, which otherwise
would be exempt from U.S. withholding tax when received by
foreign investors either directly or through a foreign fund,
are subject to U.S. withholding tax when distributed by a U.S.
fund to these investors.
IV. Congress Should Enact Legislation Eliminating U.S. Tax Barriers to
Foreign Investment In U.S. Funds
The Institute urges the Committee to support the enactment
of H.R. 2430,\4\ which generally would permit all U.S. funds to
preserve, for withholding tax purposes, the character of short-
term gains and interest income distributed to foreign
investors.\5\
---------------------------------------------------------------------------
\4\ Introduced by Representatives Crane, Dunn and McDermott as the
``Investment Competitiveness Act of 1999.''
\5\ The taxation of U.S. investors in U.S. funds would not be
affected by these proposals.
---------------------------------------------------------------------------
For these purposes, U.S.-source interest and foreign-source
interest that is free from foreign withholding tax under the
domestic tax laws of the source country (such as interest from
``Eurobonds'' \6\ would be eligible for flow-through treatment.
The legislation, however, would deny flow-through treatment for
interest from any foreign bond on which the source-country tax
rate is reduced pursuant to a tax treaty with the United
States.
---------------------------------------------------------------------------
\6\ ``Eurobonds'' are corporate or government bonds denominated in
a currency other than the national currency of the issuer, including
U.S. dollars. Eurobonds are an important source of capital for
multinational companies.
---------------------------------------------------------------------------
The Institute fully supports H.R. 2430 because it would
eliminate the U.S. withholding tax barrier to foreign
investment in U.S. funds, while containing appropriate
safeguards to ensure that (1) flow-through treatment applies
only to interest income and gains that would be exempt from
U.S. withholding tax if received by a foreign investor directly
or through a foreign fund and (2) foreign investors cannot
avoid otherwise-applicable foreign tax by investing in U.S.
funds that qualify for treaty benefits under the U.S. income
tax treaty network.
* * * * *
The Institute urges the enactment of legislation to make
the full panoply of U.S. funds--equity, balanced and bond
funds--available to foreign investors without adverse U.S.
withholding tax treatment. Absent this change, foreign
investors seeking to enter the U.S. capital markets or obtain
access to U.S. professional portfolio management will continue
to have a significant U.S. tax incentive not to invest in U.S.
funds.
Joint Venture: Silicon Valley Network
San Jose, California, 95113-1605
July 6, 1999
A.L. Singleton, Chief of Staff,
Committee on Ways and Means
U.S. House of Representatives
Washington, DC.
Re: Hearing on the Impact of U.S. Tax Rules on International
Competitiveness
The following comments are being submitted on behalf of
Joint Venture: Silicon Valley Network. Joint Venture: Silicon
Valley Network is a non-profit dynamic model for regional
rejuvenation. Our vision is to build a sustainable community
collaborating to compete globally. Joint Venture brings people
together from business, government, education, and the
community to identify and act on regional issues affecting
economic vitality and quality of life.\1\
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\1\ This letter represents the collective views of the Tax Policy
Group within the Council on Tax & Fiscal Policy of Joint Venture:
Silicon Valley Network (described on the last page of this letter), and
not necessarily the views of any individual member of the Tax Policy
Group. This letter is a summary of a larger Tax Policy Group position
paper on International Tax Reform, which is expected to be published
soon. The primary draftsperson of this letter was William C. Barrett
(Applied Materials, Inc.). The ideas expressed in this letter represent
the joint efforts of the following members of the Tax Policy Group: Jim
Cigler (PricewaterhouseCoopers, LLP), Harry Cox (Aspec Technology
Corporation), Randy George (Adaptec Corporation), Dan Kostenhauder
(Hewlett Packard, Inc.), Larry Langdon (Hewlett Packard, Inc.), Suzanne
Luttman (Santa Clara University), Annette Nellen (San Jose State
University), Sandra Olsen (Solectron Corporation), and Don Scott
(Oracle Corporation).
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The Importance of the Global Marketplace
In order for companies in the high-tech sector to thrive,
including those in Silicon Valley, they must expand their
business outside the United States. One critical reason for
developing worldwide markets is to spread large R&D and other
developmental costs over the largest possible product base in
order to keep prices low in a highly competitive global
economy. Perhaps the most important message that Congress can
give businesses in the United States is through the tax
provisions relating to the treatment of international
operations of U.S.-based companies. Congress can encourage or
discourage the expansion of U.S. companies outside the United
States. Congressional action will make a great deal of
difference with regard to whether U.S. businesses will thrive
in the 21st century. Tax policy needs to be formulated on a
long-term basis and it needs to encourage U.S. businesses,
especially those in the high-tech sector, to expand outside the
United States. Any efforts to modify international tax rules
should consider how tax policy--can support trade policy,
international competitiveness, simplification, and the reality
that today's global economy is not the one that existed when
some of these international rules were created years ago.
U.S. Tax Policy is U.S. Trade Policy
Tax policy should not impede trade policy. To that end,
changes in U.S. tax policy should consider global tax trends,
such as converging corporate income tax rates, and strive for
reducing complexity. Converging corporate income tax rates
around the world make a strong case for territorial-based tax
systems, which reduce complexity. U.S. tax policy should
encourage ``headquarters'' activities, such as research and
development and non-commodity manufacturing, that will in turn
produce higher profits in the future and higher U.S. wages. If
changes to the current international tax rules are made without
full consideration of all factors of today's global economy,
economic growth in the United States could be adversely
affected. Finally, U.S. international tax reform should occur
within the context of global business and economic trends with
a goal of designing tax policy that does not impede trade
policy or is inconsistent with tax trends around the world.
Economic Tax Models
An appropriate starting point to understanding
international taxation related to foreign transactions is to
compare the current U.S. system to classic economic tax models.
There are two classic economic models in the area of foreign
taxation: capital export neutrality (CEN) and capital import
neutrality (CIN).
The CEN concept holds that an item of income, regardless of
where it is earned, should bear a global rate of tax equivalent
to the home country tax rate. As applied in the U.S., the CEN
model allows a foreign tax credit to a U.S. corporation facing
U.S. taxation on it's worldwide income in order to reduce the
risk of double taxation of the foreign earnings. Under the CEN
model, tax rates are equivalent for investors residing in the
same country.
Under a CIN model, tax rates are equivalent for all
investment located in the same country. If such a model were
used in the U.S., foreign income would not be taxed in the
United States in the year in which it is earned or when
received as a dividend. Territorial-based tax systems (e.g.,
The Netherlands and France) are patterned after the CIN concept
where a country only taxes income earned within its borders.
Under CIN, income would be allocated between U.S. and foreign
operations based on functions and risks performed in the
respective geographic locations.
The U.S. tax system is a hybrid approach with
characteristics of both the classic CEN and CIN models. Except
for certain proscribed activities (e.g., subpart F), the U.S.
tax system is best described as a system based on deferral,
where income earned offshore in a separate legal entity is not
taxed until distributed (paid as a dividend of the foreign
earnings) back to the U.S. The U.S. hybrid system includes
incentives to encourage U.S.-based research, manufacturing, and
export.
Numerous studies exist that debate the relative merits of
the CEN vs. CIN economic models.\2\ However, fewer studies
exist that debate the [practical] distinctions between the two
models. Practical considerations would include the following:
---------------------------------------------------------------------------
\2\ For example, Overview of Present-Law Rules and Economic Issues
in International Taxation, Joint Committee on Taxation, March 9, 1999,
JCX-13-99.
---------------------------------------------------------------------------
1. Global tax rates around the world for major trading
partners are converging.\3\ This global tax trend leads to the
conclusion that, net of foreign tax credit, the U.S. government
gains little by taxing foreign earnings.
---------------------------------------------------------------------------
\3\ For example, see Jeffrey Owens, ``Emerging Issues in Tax
Reform: The Perspective of an International Bureaucrat,'' Tax Notes
International, December 22, 1997. Nominal tax rates tend to converge
around 30-40%.
---------------------------------------------------------------------------
2. Studies have shown that the amount of foreign taxes paid
by U.S. multinationals are matched closely with the amount of
foreign tax credit claimed on their U.S. returns.\4\ Therefore,
the amount of U.S. tax revenue generated by taxing foreign
earned income may be insignificant. In the interest of
simplicity, the extremely complex provisions in the Internal
Revenue Code that trigger 'deemed' income inclusions make
little sense.
---------------------------------------------------------------------------
\4\ In an article written by Sarah Nutter, Assistant Professor at
George Mason University, and attached to the 1997 IRS Statistics of
Income Bulletin, Prof. Nutter points out that U.S. multinationals paid
$23.7 billion of foreign taxes in 1993 and claimed $22.9 billion of
foreign tax credits (see Tax Notes International, January 12, 1998, p.
89). The $600 million differential raises interesting observations,
which seem to lead to the conclusion that the U.S. fiscal gains little
by taxing foreign earned income of U.S. multinationals. For example, if
the assumption is made that the $600 million differential are taxes
associated with `low-tax' offshore earnings (e.g., 10% tax rate
earnings), the base income `deferred' offshore would be $6 billion. The
tax rate differential between the 10% and 35% U.S. tax rate would lead
one to the conclusion that only $1.5 billion tax was deferred by U.S.
multinationals. If these conclusions are correct, Congress should
seriously question whether it makes sense to retain unnecessarily
complex provisions of the U.S. Tax Code, such as subpart F, that tax
these foreign earnings. Eliminating subpart F provisions of the Code,
with the possible exception for incorporation of `offshore pocket
books', or adopting a `territorial' based tax system are equally
compelling and would eliminate unnecessary complication without
sacrificing significant tax revenue.
---------------------------------------------------------------------------
3. Global mergers involving U.S. companies (e.g., Daimler/
Chrysler) are becoming more common. Integration of the global
marketplace and financial markets portends of an increase in
these global mergers. These mergers provide an opportunity for
the parties to re-evaluate their global tax structure and as a
result, U.S. companies may have the opportunity to create a
`territorial' tax base for U.S. operations when the foreign
party becomes the parent company of the newly merged global
operation. Again, policy makers should seriously re-evaluate
whether the taxation of foreign earned income makes any sense
(1) when a territorial tax base is possible through global
restructuring, and (2) under our worldwide-based taxation
system with a foreign tax credit operating in a world with
converging corporate tax rates.
4. The IRS and the U.S. Treasury adopted extensive transfer
pricing regulations, and Congress enacted related penalty
provisions, in 1993. Foreign governments in turn have adopted
many of the concepts in these U.S. regulations. In addition,
the `Advanced Pricing Agreement' program has been used
extensively by U.S. multinationals and the IRS where the IRS
and U.S. multinational agree prospectively to transfer pricing
methodologies. Consistency in global transfer pricing practices
portends of more efficient transfer pricing audit resolution.
These very significant developments to proper allocation of
cross-border income eliminate many of the concerns the Kennedy
administration had in 1962 when subpart F, and other anti-
deferral provisions, were enacted.
These practical observations lead to a very compelling
argument that when there are minimal [practical] distinctions
between CEN, CIN, or the U.S. hybrid method, the U.S.
government should align international tax reform with a model
that is the easiest to administer. From a U.S. tax revenue
perspective, it matters little whether foreign earned income is
taxed at all in the United States when U.S. tax on this income
is offset by foreign tax credits that on average, are very
close to the U.S. statutory tax rate. Repealing anti-deferral
provisions in the U.S. tax code would be a tremendous tax
simplification step with minimal downside tax revenue loss.
Aspiring towards international tax simplification is an
attainable pursuit in this increasingly integrated global
economy and convergence of tax rates around the world.
Global Economic and Business Trends
The Brookings Institution analyzed the impact that trade
barriers have on trade balance and export-related jobs.\5\ The
report concludes that trade barriers increase the cost of an
exported product and, as a result, reduce the number of high-
paying jobs in export-related industries. Therefore, it stands
to reason that by reducing trade barriers, U.S. companies are
able to support a higher wage base and focus on new product
innovation that accompanies these higher-paying and export-
related jobs. Extending the Brookings report logic, U.S. tax
policy that increases the tax cost of export-related products
will suppress high wage U.S. export-related jobs.
---------------------------------------------------------------------------
\5\ Globaphobia: The Wrong Debate Over Trade Policy, by Robert Z.
Lawrence and Robert E. Litan, September 1997, http://www.brook.edu/
comm/policybriefs/pbO24/pb24.htm. The Brookings report states that
export related jobs on average pay 15% more than the average U.S. wage.
The Bank of Montreal published a survey (Trade And Investment In The
Americas, Survey of North American Businesses, Bank of Montreal/Harris
Bank) revealing that after implementation of NAFTA, 47% of all North
American businesses have gained employees while another 41% employ
about the same number of employees. Only 11% of the surveyed firms lost
employees. Further, the Hudson Institute has published a sequel to its
study Workforce 2000 that reinforces many of these conclusions
(Workforce 2020, Work and Workers in the 21st Century, Hudson
Institute, Indianapolis Indiana, 1997).
---------------------------------------------------------------------------
Global business consolidation is a trend seen across
numerous industries. This trend hints of a more subtle
evolution which is the consolidation of core ``headquarters''
functions. Core ``headquarters'' functions encompass research
and development; centralized corporate functions, such as
office of the Chief Executive Officer wherein global policy
setting occurs for multinationals; and non-commodity
manufacturing related to new product development. These
functions are primary profit drivers for a multinational
company and are critical to product innovation.\6\ For many
companies, there is one centralized headquarters location.
Understanding the ``headquarters'' relationship is important in
developing tax policy because a tax policy that encourages
locating these functions in the U.S. will reap a higher U.S.
profit base, higher wages, a stronger local economy, and future
U.S. innovation that perpetuates the cycle.
---------------------------------------------------------------------------
\6\ Gary Hufbauer, U.S. Taxation of International Income, Blueprint
for Reform, Institute for International Economics, October 1992,
characterizes ``headquarters'' activities as ``incubators of human
capital.'' ``Non-commodity manufacturing'' is used in this context to
distinguish between lower profit ``commodity'' manufacturing. In an
increasingly global marketplace, sound business governance dictates
that to remain competitive in selling commodity products, business must
seek lower cost production sites, leaving higher profit and higher
paying wage jobs associated with ``non-commodity'' high-tech products
in the United States.
---------------------------------------------------------------------------
Calls to Abolish ``Corporate Welfare'' Miss the Point
``Anti-deferral'' legislation (e.g., ``runaway plant'' type
legislation) is popular within protectionist camps.\7\ The
concern from these groups is that when U.S. multinational
corporations invest in offshore manufacturing locations it is
being done solely to reduce U.S. labor costs. The protectionist
fears are largely unfounded considering the global trends
discussed above and should be resisted. Multinationals will
locate major income-producing functions (i.e., ``headquarters''
functions) where they can achieve the highest rate of return in
terms of both human capability and financial return on
investment and it is these ``headquarters'' functions that
attract economic income. Concerns about losing low-wage/low-
tech jobs misinterpret global trends and the factors that
promote economic growth and improve wages in the United States.
---------------------------------------------------------------------------
\7\ See for example, S. 1597 as proposed by Senator John Dorgan (R-
S. Dakota.) in March 1996 and Amendment No. 5223 (Sept. 11, 1996). S.
1597 would have taxed offshore income associated with the sale of goods
back into the U.S. The Asian economic crisis has heightened concerns
from economists and business leaders that politicians may respond to
price reductions with protectionist legislation which might in turn
lead to deterioration of the global economy (see for example Wall
Street Journal, January 5, 1998, editorial page).
---------------------------------------------------------------------------
The ongoing debate about whether to further restrict
deferral is engaged in by parties that view the world from
different perspectives. There are those who believe that
eliminating deferral for the foreign earnings of U.S.-based
companies while the foreign earnings of foreign-based
competitors obtain the advantages of tax-sparing treaties or
territorial tax systems puts U.S. companies at a major
competitive disadvantage that works to the detriment of the
entire U.S. economy. On the other side are those who focus on
the potential loss of U.S. manufacturing jobs that could occur
because U.S. companies would be attracted to foreign, low-tax
jurisdictions.
Perhaps the most interesting way to think of these
alternative views is through the prism of trade policy. The
U.S. has been a leader since the middle of this century in
dropping barriers to the free flow of goods and services across
international boundaries. It is generally recognized that such
a liberal trade policy has provided great economic benefits to
all the countries of the world, including the Unites States. In
the same vein, it is likely that allowing capital to flow more
freely across borders will have a beneficial impact on U.S. and
global economies. If some of the proposed anti-deferral
legislation were adopted, the United States would be the first
major country to eliminate deferral of income from active
business activity. This would make U.S. companies less
competitive without providing significant offsetting benefits.
Contact Information
Any questions on our comments should be directed to either
Bill Barrett, Chair of the Tax Policy Group's International Tax
Reform Subcommittee at (408) 235-4389 or barrett--
[email protected], or Annette Nellen, Chair of the Tax Policy
Group, at (408) 924-3508 or [email protected].
Sincerely,
Larry Langdon
Vice President: Tax, Licensing, & Customs
Hewlett Packard
Co-Chairs, Council on Tax and Fiscal Policy
Jane Decker
Deputy County Executive
County of Santa Clara
Joint Venture: Silicon Valley Network (www.jointventure.org) is a
non-profit dynamic model for regional rejuvenation. Our vision is to
build a sustainable community collaborating to compete globally. Joint
Venture brings people together from business, government, education,
and the community to identify and act on regional issues affecting
economic vitality and quality of life. One of OUI initiatives is the
Council on Tax and Fiscal Policy.
Council on Tax & Fiscal Policy and the Tax Policy Group: The
mission of the Council on Tax and Fiscal Policy is to bring together
Silicon Valley's public and private sectors to identify common tax and
fiscal needs and to work for mutually beneficial policy change at the
regional, state, and federal levels. The Council champions reform by
crafting legislation, supporting legislation, conducting special
analysis, and serving as an educational forum. The Council's Tax Policy
Group consists of individuals from high tech industry, government, and
academia who analyze various state and federal tax rules and proposals
to consider the impact to local governments and high tech industries.
The Group's current work encompasses international tax reform, worker
classification, R&D incentives, major federal tax reform, incentives
for donations of technology to K-14, and sales tax issues of electronic
commerce. The Group works to promote better understanding of tax and
fiscal issues of significance to the Silicon Valley economy, through
distribution of its reports and quarterly tax and fiscal newsletter,
sponsorship of seminars and discussion forums, and submission of
testimony to legislators and tax administrators.
NEU Holdings Corporation
Whippany, NJ, 07981
June 28, 1999
The Honorable Bill Archer, Chairman
Committee on Ways and Means
U.S. House of Representatives
Washington, DC.
Re: Hearing on International Tax Rules, June 30, 1999
Dear Representatives Archer and Rangel:
We greatly appreciate your efforts to examine the United States'
international tax policy and its impact on U.S.-controlled shipping
companies. Your attention to this matter, as well as the Shaw-Jefferson
bill, H.R. 265, which is pending before the Committee, are the first
vital steps toward strengthening the U.S.-controlled foreign-flag
shipping industry and restoring the United States' competitive
opportunities internationally.
General Ore International Corporation Limited (GOIC Ltd.) is one of
the largest American-controlled industrial shippers of iron ore and
liquid petroleum products in world markets, and it is one of the last
corporations, privately-owned by U.S. citizens, that operates foreign-
flag vessels. Nevertheless, GOIC Ltd. is a very small operator compared
to its international competitors.
Our continued success is dependent upon our ability to compete
fairly and openly in the international market. However, burdensome U.S.
tax policies have hindered our ability to compete. Shipping income
earned by GOIC Ltd. is subject to taxation under Subpart F of the
Internal Revenue Code regardless of whether that income is reinvested
in the business.
Subpart F, enacted in 1962, imposes taxes on certain U.S.-owned
businesses operating abroad that are more onerous than if those
businesses were operating in the United States. As originally enacted,
U.S.-controlled foreign shipping companies were not subject to Subpart
F and were taxed no differently than their competitors--their earnings
were not taxed until they were repatriated. In 1975, this changed.
Congress amended Subpart F to limit the deferral of foreign flag
shipping income so that income not reinvested into shipping operations
was taxed currently. As a result, the industry and the tax revenues it
produced began to decline.
In 1986, Congress eliminated the deferral for reinvested income.
Now the income from the U.S.-controlled foreign fleet is subject to
U.S. tax whether or not those revenues are realized. This places
companies like ours at a competitive disadvantage relative to our
competitors, which are not subject to these taxes. Further, the United
States cannot compete effectively in international markets with its
major trading partners that have adopted tax policies and incentives to
support their international shipping industries and, through them,
their exports.
Extending Subpart F to shipping income has devastated the U.S.-
controlled foreign shipping industry. Before 1975, U.S.-owned foreign-
flag shipping companies controlled 25 percent of the world's fleet.
Because of the tax burdens imposed by Subpart F, that number has
declined to less than 5 percent today. This anti-competitive tax regime
has reduced new ship acquisition, and it has resulted in U.S. owners
becoming minority owners in the vessels they once owned and operated.
The U.S. government has gained nothing from extending Subpart F to
shipping income. While the tax imposed upon this industry was
originally designed to generate revenues, it has cost the U.S. Treasury
millions of dollars. Please see the enclosed analysis by KPMG Company.
In addition, U.S. national security is eroding with the declining
sealift capability.
The U.S. Congress must take action to restore the industry's
competitive opportunities with its foreign trading partners. We
encourage the Ways and Means Committee to move H.R. 265 through the
House. Under the proposed legislation, taxes would be deferred, not
exempted, and would be paid into the U.S. Treasury when repatriated.
The bill allows growth in the U.S.-controlled fleet and restores the
ability of U.S citizens to be active competitors in the global market.
Without immediate action, the United States risks losing the few
remaining U.S.-controlled shipping companies to countries whosetax laws
are more favorable.
Thank you for your attention to this matter. We look forward to
working with you and the Ways and Means Committee to address this
important issue. If you or your staff would like any additional
information, please contact my Washington counsel, Warren L. Dean of
Thompson Coburn LLP, at (202) 508-1004.
Very truly yours,
Richard W. Neu
[Attachment is being retained in Committee files.]
Seaboard Corporation
Washington, DC, 20006
July 7, 1999.
Hon. Bill Archer, Chairman,
House Ways & Means Committee,
Washington, DC
Re: June 30, 1999 Committee Hearing on the Impact of U.S. Tax Rules on
International Competitiveness
Dear Chairman Archer:
Seaboard Marine commends the Chairman and Committee for
holding its recent hearing on the international tax regime. We
appreciate the opportunity to submit this statement regarding
critical changes that are necessary in the U.S. tax code.
Seaboard is in agreement with the testimony that Prof. Warren
Dean provided June 30 on behalf of the Subpart F Shipping
Coalition, of which we are part, and provides this separate
statement because of the urgency and significance of these
issues.
Seaboard Marine, based in Miami, is a wholly-owned
subsidiary of Seaboard Corporation. It is one of the few
remaining U.S.-owned shipping lines. Our company is one of the
nation's premier carriers to the Carribean Basin, Central
America and the west coast of South America. Additionally,
Seaboard Marine is the largest carrier operating out of the
Port of Miami, the world's leading shipping port to the
Carribean Basin and Central America.
Seaboard Marine competes internationally with carriers from
around the world. Our ability to compete, however, is
significantly hampered because of oppressive and repressive
U.S. tax and regulatory policy. These rules and regulations
favor foreign shippers at the expense of the U.S. maritime
industry, creating a lopsided playing field. The imposition of
punitive taxes on U.S.-owned international shipping companies
has decimated the maritime industry. Specifically, the current
provisions of Subpart F of the Internal Revenue Code have made
it virtually impossible for Seaboard Marine and other U.S.-
owned shipping companies to remain competitive in the global
marketplace.
As one of the last remaining U.S.-owned shipping lines, we
urge the Committee to approve H.R. 265, sponsored by
Congressmen Clay Shaw (R-Fla.) and William Jefferson. (D-La.)
This proposed legislation would restore the competitive
opportunities for U.S.-controlled foreign-flag corporations by
excluding shipping income from Subpart F of the Internal
Revenue Code. Under H.R. 265, taxes would be deferred, not
exempted, and would eventually be paid into the U.S. Treasury
when repatriated. If the current provisions of Subpart F are
not amended and corrected, the American maritime industry faces
extinction.
Besides employing more than 500 U.S. citizens and
generating revenues in excess of $300 million, Seaboard Marine
tangentially affects the employment of thousands of other
American workers who are necessary to the inherent capital-
intensive nature of the marine shipping industry. These
ancillary businesses include trucking, warehousing, banking and
manufacturing industries, and freight forwarders. Moreover, the
vast portion of the capital assets that Seaboard Marine
utilizes in its business are produced in the United States,
such as flat racks, refrigeration equipment, chassis and
forklifts. For Seaboard Marine, the loss of Subpart F
protection has meant not only decreased revenues, but also a
disincentive to reinvest and expand.
If this disincentive were eliminated, the industries upon
which the maritime industry depends for goods and services also
would benefit. Finally, Seaboard Marine provides a critical
trade link to key countries in Latin America, such as
Guatemala, Honduras, El Salvador, Nicaragua and the Dominican
Republic. For these countries, the United States is the
principal source of trade, of which Seaboard Marine plays a
major role. The U.S.' ability to maintain its dominance in this
important trade zone will be enhanced by the reinstitution of
Subpart F protections for our industry.
Besides the specific implications for Seaboard Marine, the
ramifications of current Subpart F provisions are far-reaching
for the U.S. maritime industry. It is not incorrect or an
exaggeration to say that the American maritime industry faces
extinction if the current provisions of Subpart F are not
amended and corrected.
Alarmingly, the U.S.-controlled fleet has declined from
representing more than twenty-five (25) percent of the world
fleet in 1975, when Subpart F was first altered, to less than
five (5) percent today. American carriers' share of the market
of the U.S. import/export cargoes fell by half between 1990 and
1996, according to the U.S. Maritime Administration. Equally
striking is that in 1975, U.S. carriers owned nearly 22 million
of the 85 million gross registered tonnage in the world flag-
of-convenience fleet. This accounted to approximately 26
percent of the world fleet. By 1996, however, the world-flag-
of-convenience fleet had almost tripled, to 241 million tons,
while U.S. carrier ownership fell almost by half.
The downfall of the American shipping industry is directly
attributable to the devastating income tax burden that the U.S.
government imposes upon it. American carriers pay income tax at
a base rate of 36 percent. Most foreign carriers, however, pay
little or no income tax.
A study conducted by Crowley Maritime Corp., which also
submitted a statement to the Committee regarding its June 30
hearing, illustrates the disparity of the tax ramifications
between U.S. and foreign shippers. The Crowley study found that
on average, the foreign carriers sampled received a net tax
credit in 1996, while American carriers sampled paid more than
45 percent of their profits to the U.S. government in taxes in
1996; 43 percent in 1997.
With this tax disparity in mind, there is little wonder why
the American shipping industry is struggling for survival.
Before the protection of Subpart F was stripped away, the
once-proud U.S.-owned fleet controlled a quarter of the world's
fleet. Hundreds of millions of dollars were generated in annual
tax revenues as a result of the voluntary repatriation of
earnings. The associated infrastructure generated billions of
additional dollars of taxable economic activity. After the 1975
alteration to Subpart F, the once significant U.S.-owned fleet
was forced to expatriate to remain competitive. Related
industries, such as insurance brokerage, ship management,
surveying, chartering, technical consultancies, etc., who
serviced the maritime industry, followed.
Conversely, foreign shippers have taken advantage of a
favorable tax regime both in the U.S. and abroad. This has a
given them a great advantage and thus a stranglehold on the
industry. Consequently, the economic leadership of the United
States in this critical sector of the economy has been lost.
This has been painfully demonstrated and made obvious by recent
international maritime transactions.
In 1997, for example, the American President Lines, a
bastion of the American maritime industry for more than 100
years, was sold to Neptune Orient Lines Ltd. of Singapore.
Shortly thereafter, Lykes Steamship Company, another prominent
old-line shipper, sold its assets to Canadian Pacific Ltd. In
short, these venerable lines fell into foreign hands because of
the repressive and noncompetitive tax burdens the U.S.
government placed on the lines' American owners.
The elimination of the exclusion for shipping income from
Subpart F of the Internal Revenue Code is thus illogical. The
current provisions of Subpart F do not achieve the objective
for which they were created. This repressive tax burden has not
generated the tax revenues which were expected. Instead of
increasing the tax revenue from the 1975 level of slightly more
than $200 million to a projected revenue of almost $800 million
in 1998, the revenue has, in fact, plummeted to (approx.) a
meager $50 million.
The decline of the maritime industry has additionally
weakened the national defense, threatened existing maritime
jobs and prevented the creation of new job opportunities.
America's national defense is weakened because the military has
historically relied upon the U.S. fleet to meet its marine
transportation requirements. We must now depend upon ships
under foreign ownership.
The current provisions of Subpart F threaten thousands of
U.S. maritime jobs, and prevent the creation of countless
others because of the disincentive for American investment or
reinvestment in shipping enterprises. Relieving the onerous
burden that Subpart F presently imposes on the U.S. maritime
industry not only would secure existing American jobs, but
would no doubt be conducive to the creation of new job
opportunities.
As one of the last surviving players in the American
maritime industry, Seaboard Marine urges you to give close and
careful scrutiny to the ramifications of H.R. 265. Without the
repeal of the repressive provisions of the current Subpart F
legislation, the extinction of the U.S. maritime industry is
inevitable.
Seaboard Marine appreciates the opportunity to contribute
to this vital tax debate. Our industry has been made to suffer
by repressive taxation. It is time to halt and correct this
crippling of a vital American industry.
Sincerely,
Ralph L. Moss
Director, Government Affairs
Statement of the Section 904(g) Coalition
Mr. Chairman, the Section 904(g) Coalition commends you for
holding this hearing on the impact of U.S. tax rules on the
international competitiveness of U.S. businesses. Foreign
competition faced by U.S. businesses has intensified with the
acceleration of globalization. Over the years, Congress has
revised the Internal Revenue Code to address the expanding
activities of U.S. businesses in overseas markets.
Unfortunately, a number of those revisions have negatively
impacted the ability of U.S. businesses to compete in the
global marketplace. One such provision, Section 904(g), enacted
as part of the Deficit Reduction Act of 1984, can result in
double taxation of income earned by a foreign subsidiary of a
U.S. company. This testimony describes the situation in which
double taxation can arise under Section 904(g) and proposes a
narrow amendment to prevent such a result.
1. Background
The members of the Section 904(g) Coalition are fully
integrated U.S.-based multinational companies that engage
directly and through domestic and foreign subsidiary
corporations in the discovery, development, manufacture,
marketing and sale of products. The foreign subsidiaries
manufacture finished products from materials supplied by the
U.S. parent company (``Parent'') or other affiliates, and
market, sell and distribute such products in their local
markets. A number of these foreign subsidiaries also conduct
research and development activities locally through their own
research staffs, while others may fund research by third
parties or affiliates on their behalf or pursuant to bona-fide
cost sharing agreements within or outside their home countries.
These foreign subsidiaries are incorporated in developed
countries with which the U.S. has a tax treaty. All locally
funded research and development expenses are deducted in their
home country, foreign tax returns and expensed for local
statutory accounting purposes. Consequently, worldwide patent
rights that result from these efforts and expenses are owned by
the foreign subsidiary.
Quite often the foreign patent owner does not have a
manufacturing plant. The decision about where to locate such a
plant is based on a variety of business, legal and political
considerations. Building a manufacturing plant often requires a
very significant investment in capital, and approval of the
local government is often required for the siting, design and
construction of the plant. In addition, manufacturing often
involves specialized manufacturing know-how that the subsidiary
may not possess. The foreign subsidiary would also need to
recruit and train a manufacturing work force, which could
require a significant investment of time, expense and
management effort. In many cases, even if the subsidiary were
willing to expend the time, expense and effort to acquire this
capability itself, it could not construct a new manufacturing
plant in time to meet the anticipated launch date for a
particular product.
For these reasons, worldwide patent rights owned by a
foreign subsidiary (``Licensor'') may be licensed at an arm's-
length royalty rate to another affiliate (``Licensee'') that
already owns and operates a manufacturing plant and has the
capacity and know-how to manufacture the patented product.
2. Internal Revenue Code Section 904(g)
Under Code section 861 (a)(4) of the Internal Revenue Code
(``Code''), royalties received for the use of a patent in the U.S. are
U.S. source income. As a result, royalties paid by Licensee to Licensor
for sales of product in the U.S. will generally be considered U.S.
source income to Licensor. Moreover, under Code section 904(g), when
Licensor pays an actual or deemed dividend to Parent, the dividend will
be U.S. source income to the extent Licensor's earnings and profits are
attributable to the U.S. source royalties. Any such dividend paid by
Licensor will carry foreign tax credits at rates that may equal or
exceed the U.S. statutory rate, but none of the royalty component of
the dividend will be foreign source income.
Alternatively, Section 904(g)(10) would permit Parent to avoid
Section 904(g) resourcing if such resourcing would be inconsistent with
an income tax treaty between the U.S. and Licensor's country of
residence. Two requirements must be satisfied for Section 904(g)(10) to
apply: (i) the treaty must give the foreign jurisdiction the right to
tax dividends paid by Licensor to Parent (notwithstanding the
dividend's domestic source under U.S. law), and (ii) the treaty must
contain a special source rule that treats dividends that Licensor's
jurisdiction may tax as arising in Licensor's jurisdiction for U.S.
foreign tax credit purposes (see, e.g., Article 23 of the U.S.-UK
Income Tax Treaty). Section 904(g)(10) relief, therefore, is contingent
on the right of Licensor's country to impose withholding tax on
dividends paid to Parent, rather than its right under the treaty to tax
Licensor on its U.S. source income. Thus, for example, if the new U.S.-
UK treaty (now under renegotiation) should no longer permit the U.K. to
tax dividends paid to Parent (or, alternatively, no longer contain a
special sourcing rule), Section 904(g)(10) relief would be unavailable
even though Licensor has paid full U.K. corporate income tax on its
royalty income. Loss of Section 904(g)(10) relief is a very real
possibility in the U.K. because dividend withholding tax may be
entirely eliminated under U.K. internal law. Moreover, resourcing
provisions are now contained in only a limited number of treaties
(perhaps a dozen), and United States treaty policy has generally been
to reserve for the U. S. the right to apply Section 904(g) in post-
enactment treaties (see, e.g. Treasury Department Explanation to
Article 25 of the new U.S.-Luxembourg treaty). As newer treaties
supersede older treaties, Section 904(g)(10) relief will become
increasingly rare. Section 904(g)(10) also requires that the dividend
income attributable to the resourced royalty be placed in a separate
foreign tax credit limitation basket.\1\
---------------------------------------------------------------------------
\1\ Section 904(g)(10) is further limited where Parent has dividend
income under Subpart F by requiring treaty protection at each level of
ownership where there are intermediary holding companies. Section
904(g)(10)B.
---------------------------------------------------------------------------
Thus, the choices available to Parent under current law are: (1) to
rely on the possibility of cross-crediting all the foreign income taxes
in the five-year carry-forward period in its general limitation basket,
or (2) to choose the benefits of a treaty, where available, and credit
foreign taxes paid up to the effective U.S. tax rate but permanently
lose the ability to credit local taxes in excess of the U.S. rate.\2\
If the product is generating substantial U.S. royalty income that is
subject to tax in the foreign jurisdiction, it is extremely unlikely
that Parent would be able to cross-credit the foreign taxes in its
general limitation basket. Thus, either choice will result in serious
double taxation for Parent. The separate basket approach also unfairly
prevents a taxpayer from using other available credits to satisfy any
residual U.S. tax liability on U S. source royalties taxed at a foreign
rate below the U.S. statutory rate.
---------------------------------------------------------------------------
\2\ In practice the capacity to credit taxes within a separate
904(g)(10) basket will be limited to rates below the U.S. statutory
rate because of the allocation of expenses under Reg. Sec. 1.861-8.
---------------------------------------------------------------------------
As discussed below, the Coalition believes, based on the
legislative history of Code section 904(g), that Congress did not
intend this result. Conceding for purposes of argument that Congress
did intend when it enacted Section 904(g) in 1984 that dividends paid
by Licensor to Parent be treated as U.S. source income to the extent
Licensor's earnings and profits were attributable to U.S. source
royalties, evolving foreign business requirements during the
intervening 14 years and the need for U.S. companies to compete in
foreign markets should cause Congress to revisit and revise subsection
(g).
3. Legislative History
The legislative history to the Deficit Reduction Act of
1984 (``the 1984 Act'') expresses concern that, under existing
law, a corporation could receive U.S. source income and
subsequently repatriate the income as foreign source by flowing
the income through an intermediate foreign corporation. By thus
inflating foreign source income, U.S. companies with excess
foreign tax credits could reduce U.S. tax on what would
otherwise be U.S. source income and thus distort the foreign
tax credit limitation. Congress also wanted to eliminate any
competitive advantage to U.S. taxpayers that exported capital
to be invested in the United States to foreign subsidiaries
rather than investing it directly. Joint Committee Print, H.R.
4170, 98th Congress, Public Law 98-369, pp. 346-54.
Examples in the Joint Committee Print make it clear that
the abuse Congress was targeting was the conversion of U.S.
source income to foreign source income by routing the income
through a foreign subsidiary set up for that purpose: where, in
other words, there was no business reason for the activities in
question to be carried on by a foreign subsidiary instead of a
U.S. subsidiary or the U.S. parent itself, and the primary
reason for the establishment of a foreign subsidiary was tax
avoidance. The example given by the Joint Committee is a
foreign insurance subsidiary of a U.S. company that earns all
its income from insuring U.S. risks of U.S. companies and
distributes its profits to its parent as foreign source income.
4. Application Of Code Section 904(g) Appears Contrary To
Congressional Intent
As discussed above, Congress had two concerns when it
enacted Code section 904(g) in 1984: the export of capital and
the manipulation of the foreign tax credit. Neither of these
concerns applies to the activities of Licensor in the
circumstances described above.
First, there is no export of capital involved in the
ownership and commercialization of product by a foreign
subsidiary where the patent is either discovered in the foreign
jurisdiction and/or funded from Licensor's local business
profits,\3\ and all the R&D expenses are deducted in its local
tax return. In these circumstances, no U.S. capital is
exported, directly or indirectly, to Licensor for the discovery
and development of the product. The patent rights to the
product are clearly the property of Licensor, and Licensor
therefore has no choice but to report the full profits from
exploiting the patent in its local tax return. In any event,
Code section 367(d), also enacted in 1984, put an end to the
practice of transferring appreciated intangibles from a U.S.
parent to a foreign subsidiary in a tax-free exchange. Under
Code section 367(d), the intangible is treated as having been
transferred in exchange for a royalty or other payment
commensurate with the income earned on the intangible. Since
the royalty would be U.S.-source if the intangible were used in
the U.S., the outbound transfer would no longer result in
either a deferral of income or a conversion of income from U.S.
to foreign source.
---------------------------------------------------------------------------
\3\ A formula can be developed to assure that funds expended for
R&D were derived from Licensor's own profits rather than from capital
contributions made by Parent.
---------------------------------------------------------------------------
Second, there is no manipulation of the foreign tax credit.
If Licensor had manufactured the product itself, Licensor's
income from sales of product into the U.S. would be foreign
source income. Because Licensor has no manufacturing plant, it
will license worldwide patent rights to an affiliate that does
have such a plant in return for an arm's length royalty. Thus,
the decision to license to an affiliate is made for sound
business reasons. Moreover, all of Licensor's income, including
royalties, is subject to full local taxation in its
jurisdiction of residence. Even if Parent had a choice about
where to report the income from exploiting the patent, it could
not obtain a foreign tax credit benefit by routing U.S. source
income through a full tax-paying foreign jurisdiction. On the
contrary, Parent's foreign tax credit capacity is reduced to
the extent it incurs local tax in excess of the U.S. tax rate.
Because the Licensor that the Coalition is focused upon is
incorporated and residing in a developed country with which the
U.S. has a tax treaty, there is little or no opportunity for
manipulation of the foreign tax credit rules.
Finally, it appears that Code section 904(g) would apply
even if Licensor had actually imported capital into the U.S. by
manufacturing product and selling it in the U.S. through a U.S.
branch--a structure clearly not designed either to export
capital or distort the foreign tax credit limitation. In that
case, Licensor would be subject to a 35% U.S. federal tax on
its income, plus a 5% branch profits tax. Licensor would also
be subject to full local income tax less a credit for U.S.
taxes incurred. A dividend from Licensor under these
circumstances would likewise be subject to Code section 904(g),
and, thus, a pro rata portion would be U.S. source income.
Consequently, Parent would face the same foreign tax credit
problem discussed above.
In sum, Parent has not attempted to transfer a U.S. asset
or business to a foreign jurisdiction to convert U.S. source
income into foreign source income. The capital to create the
asset is of foreign origin, all R&D expenses are deducted in
Licensor's local tax return, and Parent has never owned the
asset. The foreign subsidiary that owns the patent is
incorporated and residing in a country with which the U. S. has
a tax treaty. The foreign tax jurisdiction, moreover, has very
reasonable expectations that any profit resulting from
commercialization of the patent will be subject to full income
taxation in that jurisdiction. U.S. tax policy actually
endorses this expectation through income tax treaties by ceding
primary taxing jurisdiction to that other country on royalty
income that is U.S. source income under Section 861 principles.
There is no valid U.S. tax policy objective in these
circumstances for limiting utilization of foreign tax credits
under Section 904(g).
5. Evolving Foreign Business Conditions Necessitate Modifications to
Section 904(g)
There is language in the attached Joint Committee Print to
the effect that Congress intended to preserve full U.S. tax on
U.S. source income earned by foreign subsidiaries of U.S.
corporations upon repatriation to the U.S. regardless of the
rate of tax paid by the foreign subsidiary on the income.\4\
Thus, the Committee Print appears to reflect U.S. tax policy
concern even where the U.S. source income is subject to high
rates of foreign taxes, the cost of which the taxpayer then
seeks to shift to the U.S. government through the foreign tax
credit mechanism. The Coalition believes, however, as discussed
earlier, that Congress was principally concerned with
situations where the high rate of local tax results from the
U.S. parent company having either transferred a U.S. source-
income-generating-asset to the foreign subsidiary or having
allowed the subsidiary to conduct business in the U.S., rather
than engaging in the U.S. business activity itself.
---------------------------------------------------------------------------
\4\ See page 348 of the Joint Committee Print which states that:
``The [pre 1984] source rules arguably allowed the circumvention of the
foreign tax credit limitation. The creation of foreign income that
either attracted high foreign taxes directly or absorbed foreign tax
credits that arose from unrelated high-taxed foreign income passed the
cost of high foreign taxes from the U.S. taxpayer to the U.S.
government. The [Deficit Reduction] Act [of 1984] prevents that result
by its general rule that ensures full U.S. tax when U.S. source income
flows through a U.S.-owned foreign corporation.''
---------------------------------------------------------------------------
Clearly, Congress was not focused on a foreign subsidiary
that was developing worldwide patent rights to a product and
would eventually license such patent to another foreign
affiliate. In today's global economy, U.S. parent companies are
increasingly designating foreign subsidiaries as centers to
undertake a portion of their research. These decisions are
dictated by business necessity in today's international
business climate. Increasingly, foreign governments are looking
for strengthened local business ties as a prerequisite for
important local business opportunities. These may include
enhanced patent protection under local law, expedited review of
new product applications, and pricing decisions in countries
where these decisions are controlled largely by local
governments.
The increased ``nexus'' local governments are more
increasingly focused on is the funding of research costs for
particular products. This requirement is based on the
expectation that increased R&D will lead to the recruiting of
local scientists and ultimate ownership of worldwide patent
rights if the research efforts should prove successful. It is
imperative that U.S. companies be free to compete with their
foreign counterparts in meeting these local business
requirements without subjecting themselves to the potential
risk of future double taxation. The Coalition believes that
this result is clearly inconsistent with broader goals of U.S.
tax policy.
6. Code Section 904(a) Discourages Repatriation, Resulting In Net
Revenue Loss
Because repatriation of earnings could put Parent in an
excess foreign tax credit position, Licensor could reasonably
decide not to pay a dividend to Parent. Retaining earnings in
the foreign jurisdiction would defer the repatriation of local
tax credits. Profits from reinvested capital would be subject
to tax in the foreign jurisdiction but not in the U.S., with a
corresponding loss of U.S. tax revenue. The loser in this
scenario is the U.S. government because capital imports are
diminished, and profits from reinvested capital are subject
only to foreign tax, not to U.S. tax.
7. Recommendation
It is recommended that Code section 904(g) be amended to
prevent its application when the owner who has funded
development of a patent or other intangible receives a royalty
or other income from exploiting an intangible and such income
is subject to tax in a country with which the U.S. has an
income tax treaty, which treaty permits the foreign country to
tax such U.S. source income. The fact that the United States
has entered into an income tax treaty with that other country
is indicative that a tax haven jurisdiction is not being
availed of and foreign tax credit manipulation is not involved
(compare, e.g., Bermuda captive insurance or finance
companies). The royalty income would, in any event, be subject
to U.S. tax under subpart F if it is taxed at a rate that is
less than 90% of the U.S. rate. See Section 954(b)(4).
The Coalition believes that if Code section 904(g) is
amended as suggested above, there will be no additional export
of capital from the U.S. or manipulation of the-U.S. foreign
tax credit rules.
[Attachment is being retained in Committee files.]
Tax Council
Washington, DC, 20005
July 7, 1999
The Honorable Bill Archer, Chairman
Committee on Ways and Means
U.S. House of Representatives
Washington, D.C.
Dear Mr. Chairman:
On June 30, 1999 the Ways & Means Committee held a hearing
on the Impact of U.S. Tax Rules on International
Competitiveness. The Tax Council commends you and the other
members of the committee for scheduling the hearing on this
issue which is so important to American workers and businesses.
In addition to Representatives Houghton and Levin, you
heard from 16 outstanding private sector witnesses who possess
an unprecedented amount of expertise and knowledge regarding
taxes and international business. All of the witnesses
presented convincing and well thought out statements that
justify the urgent need to reform and simplify the U.S.
international tax laws. Over half of the witnesses you called
to testify represent members of The Tax Council and we would
like to state for the record that we, as an association,
strongly support their collective call for international tax
reform.
In particular, we support the provisions in H.R. 2018 that
would accelerate the effective date for look-through treatment
in applying the foreign tax credit baskets to dividends from
10/50 companies; repeal Section 907 with its excessively
burdensome record keeping requirements; apply look-through
rules on sales of foreign partnerships; and provide a permanent
subpart F exemption for active financing income. In addition,
we recommend the recently proposed legislation that would treat
Advance Pricing Agreements as confidential return information.
These provisions would help to simplify the tax code and assist
U.S. companies to compete more effectively against foreign-
based competitors.
The Tax Council is a nonprofit association that has been in
existence since 1966 and has 110 major companies and businesses
as members. In addition to providing an ongoing forum for the
discussion of important tax policy questions, it supports
efforts to assure that all federal tax laws are based on sound
tax and budget policies.
The Tax Council, which has been actively involved in the
debate on international tax reform for a long time, urges the
Committee to move as quickly as possible on the recommendations
that were presented during this hearing. If we can be of any
assistance, please do not hesitate to call upon us.
Sincerely,
Roger J. LeMaster
Executive Director
Tropical Shipping
Riviera Beach, FL, 33404-6902
July 6, 1999
A.L. Singleton, Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
Washington, D.C.
Re: June 30, 1999 Committee Hearing on Impact of U.S. Tax Rules on
International Competitiveness
Dear Mr. Singleton:
The current U.S. international tax regime is contributing
to the de-Americanization of U.S. industry because the U.S.
owned fleet is being forced to expatriate to remain
competitive. An unintended result of the 1986 and 1975 tax law
changes has been the near complete removal of U.S. investment
from the Ocean Shipping industry leaving the cargo trades of
the United States almost entirely in the hands of foreign owned
and foreign controlled shipping companies. Overall, U.S.
ownership of the world fleet has declined from 25% of world
tonnage in 1975 when Congress enacted the first tax code change
affecting shipping, to less than 5% today!
This unintended consequence has profound implications for
the United States, as international trade and commerce of goods
have historically been influenced by the national interests of
the country of ultimate ship ownership.
Tropical Shipping is a U.S.-owned container shipping
company (CFC) with a business focus on serving ports of call in
the Caribbean, the only region in the world in which the United
States has a balance of trade surplus. The exports to this
region create numerous jobs throughout the U.S. agricultural
and manufacturing sectors as well as our own company's
employment of over 500 people in the United States.
The existence of the U.S. balance of trade surplus with the
Caribbean is no coincidence. This region is the last area in
the world where U.S. owned shipping companies dominate the
carriage of general cargo and this contributes to the success
and promotion of U.S. exports. Our company, and our U.S. owned
competitors, are active every day, putting Caribbean buyers in
touch with U.S. exporters which is beneficial for Tropical
Shipping's long term interests.
Our tax laws force U.S. companies to become acquired by
foreigners because their countries have adopted tax policies to
ensure that their international shipping industry is
competitive in world markets. Our foreign-owned competitors
have a great advantage in their accumulation of capital, as
they are not taxed on a current basis and generally only pay
tax when the dividends are repatriated. It is inevitable that
mergers of U.S. companies with foreign companies will leave the
resulting new company headquartered overseas. Examples of this
are found in the decrease of the U.S. controlled fleet and the
foreign acquisition of American President Lines and Lykes
Steamship Co. Because of the adverse consequences resulting
under the current U.S. international tax system, U.S. shipping
companies are being forced out of the growing world market for
the carriage of cargo.
Buying and operating ships is capital intensive. U.S.
owners in this capital intensive and very competitive shipping
industry, have sold out, gone out of business, and not invested
in shipping because they just cannot compete due to the
unintended consequences of the U.S. international tax regime.
It is simply this regime that places U.S. owners at a distinct
disadvantage in the global commerce of ocean transportation.
U.S. owners can compete in all other respects.
In the containerized shipping industry, U.S. owned
participation in the carriage of U.S. trade has steadily
declined to an all time low of 14.2% of the container trade in
1998. The decline is not in the economic interest of the United
States and weakens U.S. exports contributing to fewer U.S.
based jobs. It will be a sad day indeed if all the ocean
commerce created in the growing market of the Americas as a
result of NAFTA and the FTAA ends up benefiting foreign owners
with no chance for U.S. investors to participate.
Please correct the tax code so that the U.S. will increase
their global competitiveness, expand and stabilize itself in
the international shipping industry and strengthen U.S. exports
which would result in more U.S. based jobs. H.R. 265,
introduced by Congressman Shaw and co-sponsored by Congressman
Jefferson, is an important response to this problem.
Sincerely yours,
Richard Murrell
President and CEO.
Statement of LaBrenda Garrett-Nelson, and Robert J. Leonard, Washington
Counsel, P.C.
Washington Counsel, P.C. is a law firm based in the
District of Columbia that represents a variety of clients on
tax legislative and policy issues.
Introduction
The provisions that make up the U.S. international tax
regime rank among the most complex provisions in the Code. This
statement discusses section 308 of the International Tax
Simplification for American Competitiveness Act of 1999 (H.R.
2018, introduced by Reps. Houghton and Levin), a proposal to
reduce complexity in this area by repealing the little used
regime for export trade corporations (``ETCs''). The ETC rules
were enacted in 1962 to provide a special export incentive in
the form of deferral of U.S. tax on export trade income. The
rationale for the proposed repeal is that the special regime
for ETCs was, effectively, repealed by the 1986 enactment of
the passive foreign investment company (``PFIC'') rules. At the
same time, the proposal would provide appropriate (and
prospective) transition relief for ETCs that were caught in a
bind created by enactment of the PFIC regime.
I. The Overlap Between the ETC Regime and the PFIC Rules
Effectively Nullified the ETC Rules For Many Corporations
Although the PFIC rules were originally targeted at foreign
mutual funds, the Congress has recognized that the scope of the
PFIC statute was too broad. Thus, for example, the Taxpayer
Relief Act of 1997 eliminated the overlap between the PFIC
rules and the subpart F regime for controlled foreign
corporations. Similarly, in the 1996 Small Business Jobs
Protection Act, the Congress enacted a technical correction to
clarify that an ETC is excluded from the definition of a PFIC.
The 1996 technical correction came too late, however, for
ETCs that took the reasonable step of making ``protective''
distributions during the ten-year period between the creation
of the uncertainty caused by enactment of the PFIC regime and
the passage of the 1996 technical correction. Although U.S. tax
on distributed earnings would have been deferred but for the
ETC/PFIC overlap, these ETCs made distributions out of
necessity to protect against the accumulation of large
potential tax liabilities under the PFIC rules. Thus, the PFIC
rules, in effect, repealed the ETC regime.
II. Congressional Precedents for Providing Transition Relief
for ETCs
The proposal would simplify the foreign provisions of the
tax code by repealing the ETC regime. When the Congress enacted
the Domestic International Sales Company (``DISC'') rules in
1971, and again when those rules were replaced with the Foreign
Sales Corporation (``FSC'') rules in 1984, existing ETCs were
authorized to remain in operation. Moreover, ETCs that chose to
terminate pursuant to the 1984 enactment of the FSC regime were
permitted to repatriate their undistributed export trade income
as nontaxable previously taxed income (or ``PTI'').
The Proposal also provides a mechanism for providing
prospective relief to ETCs that were caught in the bind created
by the PFIC rules. Consistent with the transition rule made
available in the 1984 FSC legislation, the proposal would grant
prospective relief to ETCs that made protective distributions
after the 1986 enactment of the PFIC rules. Essentially, future
(actual or deemed) distributions would be treated as derived
from PTI, to the extent that pre-enactment distributions of
export trade income were included in a U.S. shareholder's gross
income as a dividend. Note that the proposed transition relief
would provide only ``rough justice,'' because taxes have
already been paid but the proposed relief will occur over time.
Conclusion
Repeal of the ETC provisions would greatly simplify the
international tax provisions of the Code, but such a repeal
should be accompanied by relief for ETCs that were caught in
the bind created by the PFIC rules.
Youngstein & Gould
London W1M 5FQ,
June 25, 1999
Ways and Means Committee
United States House of Representatives
Washington, D.C.
Dear Sirs:
In connection with hearings which are to be held this
Wednesday, June 30, 1999, I enclose a letter by me on 11th
December 1998 to the U.K. Inland Revenue and U.S. Treasury
Department (the ``Letter'') in connection with negotiations
which commenced early this year to modernize the US/UK income
tax treaty. The points made there are highly relevant to any
inquiry into the effect of U.S. tax law on the international
competitiveness of U.S. workers who are working in countries
which also impose worldwide taxation of income (e.g. the OECD
countries).
As the Letter illustrates, U.S. citizens who are resident
for tax purposes in another jurisdiction which imposes
worldwide income taxation tend to be subject to the harshest
aspects of the U.S. and foreign taxation systems without the
benefit of either system's tax incentives/reliefs (tax exempt
pensions, reduced taxation of capital gains, etc. etc.). The
result is that such individuals pay much higher tax than either
U.S. citizens who remain in the U.S. or non U.S. citizens
resident in the same foreign jurisdiction, as well as being
subject to exponentially greater compliance burdens. The effect
is nothing less than economic ``second class citizenship.''
The Letter notes that a solution to the most severe aspects
of this problem would be simply to eliminate the ``saving
clause'' which is inserted by the Treasury Department as a
matter of rote in all U.S. double tax treaties, providing that
U.S. citizens resident in the other treaty jurisdictions may
not claim relief from U.S. tax under such treaties. It is
unclear that the policy for inclusion of the saving clause in
the U.S. treaties has ever been clearly considered, and
certainly not by the House of Representatives which is not
involved in the treaty process. As noted in the Letter, it is
fallacious to argue that the saving clause is an extension of
the policy of the U.S. to tax its citizens regardless of
residence.
Also as noted in the Letter, the inclusion of the saving
clause in treaties implies a level of responsibility of the
Treasury Department to recommend and Congress to adopt domestic
taxation provisions for U.S. citizens resident abroad which
mitigate the harsh consequences of the denial of treaty relief,
yet neither the Treasury Department nor Congress appear to
appreciate that this responsibility exists. Clearly it has not
been fulfilled.
The position of U.S. citizens resident in other countries
imposing worldwide taxation deserves your urgent attention. It
would undoubtedly improve the morale of expatriate Americans if
your Committee would acknowledge the problems which exist and
assume responsibility for developing and implementing a
solution.
Yours sincerely,
Jeffrey L. Gould
Youngstein & Gould
London W1M 5FQ,
Dec. 11, 1998
Bob Wightman Esq
Inland Revenue International Division
London WC2R 1HH
Joseph H Guttentag Esq.
Deputy Assistant Secretary (International Tax Affairs)
U.S. Treasury Department
Washington, D.C.
Dear Mr. Wightman and Mr. Guttentag:
I understand from our tax publications that the Inland
Revenue and IRS have announced plans to modernise the UK/US
double taxation convention for income taxes.
I. Background
A. As a U.S. lawyer who has practised in London for the
past 20 years, specializing in taxation matters, I have had
occasion to advise on many aspects of the current treaty. I am
aware of many areas where ``modernization'' is certainly
required, to take into account developments in the domestic
taxation rules and commercial environments of the two countries
since the present treaty was agreed. I would like to focus on
one area in which I am aware of a desperate need for a more
sensible approach, namely the taxation by the U.S. of its
citizens who are resident in the U.K. without affording the
benefit of ``dual resident relief'' provided, for example, in
the OECD Model Income Tax Treaty.
B. As indicated below, the effect of the present treaty is
a sort of ``second class citizenship'' for U.S. Expatriates
resident in the U.K., who are unable to lead a fiscally
``normal'' life because they have to face the harshest aspects
of both the U.K. and the U.S. systems without the mitigating
effects of the reliefs offered in either country.
II. The Problem Areas
A. The fact that the U.S. imposes taxation of the worldwide
income of its nationals, regardless of residence, raise unique
problems particularly for U.S. citizens who are resident in
countries like the U.K. which impose their own worldwide
taxation. The ``International'' solution to such problems, as
exemplified by the OECD Model Income Tax Treaty, is found in
the ``dual resident'' provisions under which in cases of an
individual who is fiscally resident in both treaty countries,
the country with the greater claim to imposing worldwide
taxation is accorded the status of the country of residence for
treaty purposes while the other country may impose worldwide
taxation but subject to the reliefs given under the treaty. The
U.S. rejects this solution in the case of its nationals
residing overseas (``U.S. Expatriates'') through requiring the
inclusion in its double taxation treaties of ``saving clauses''
reserving to the U.S. the right to tax its nationals without
regard to treaty reliefs.
B. Unfortunately, the U.S. domestic tax law offers nothing
for U.S. Expatriates who are subject to worldwide taxation in
another country to take the place of dual resident treaty
relief. As a result, the only protection against double
taxation of such U.S. Expatriates rests in claiming foreign
credits. Relief from double taxation by way of credit or
exemption is a feature of the domestic tax law in virtually
every other OECD country as well, but such relief clearly has
been considered inadequate to deal with the problems of
worldwide double taxation, as evidenced by the almost uniform
inclusion of ``dual resident'' provisions in treaties between
OECD countries
C. The sometimes Draconian consequences to U.S. Expatriates
of the U.S. approach are proof of the wisdom of the OECD
approach. With only the foreign tax credit to rely upon, U.S.
Expatriates residing in the U.K. are unable to obtain any
benefit from tax-favored transactions in either country because
of inconsistency in approach. For example:
1. While the U.S. offers a rate of capital gains tax which
is one-half that of the U.K., the U.S. taxes capital gains
which are exempt under U.K. rules, such as the annual exemption
from U.K. capital gains tax, gain from the disposal of a
principal residence and gain which would qualify for U.K.
retirement relief. The U.S. Expatriate who is resident in the
U.K. must pay U.K. capital gains tax at the U.K.'s higher rate
on those gains which are not exempt, and U.S. capital gains tax
at the U.S.'s lower rate on gains which are exempt from the
U.K. capital gains tax. Thus the U.S. Expatriate obtains the
benefit of neither system's taxation of capital gains.
The difference in tax treatment of gain from the sale of a
residence is exacerbated by an unenlightened U.S. tax policy
regarding currency gains and losses realized on foreign
currency (e.g. pound sterling) mortgages.
2. The U.S. and U.K. rules for tax-deferred pension and
profit sharing plans are similar, but each impose different
specific requirements as a result of which no U.K. exempt
approved pension scheme will meet U.S. requirements for a
qualified plan, and vice-versa. The U.K. at least offers the
possibility of ``corresponding relief'' for certain U.K.
residents who are covered by U.S. plans, but the vast majority
of U.S. Expatriates who are resident in the U.K. are unable to
avail themselves of such relief.
U.S. Expatriates participating in U.K. pension plans may be
liable to U.S. tax not only on employer contributions but also
on a pro rata share of any income and gain realized in the
pension fund. As this income is not liable to tax in the U.K.,
no credits for U.K. tax are available to offset the U.S.
liability, while on the other hand when benefits are received,
they will be largely tax-free in the U.S. (having already been
taxed) while U.K. tax will then be due. The result is that in
the extremely important area of pension planning U.S.
Expatriates uniquely are unable to benefit from tax deferred
pensions and are likely to suffer true double taxation if they
are so ill-advised as to participate in a U.K. exempt approved
scheme.
3. Tax incentives for charitable giving differ between the
U.S. and U.K. and it is difficult to get them to match.
D. A similar problem has arisen from proliferation of U.S.
anti-avoidance legislation, which is frequently focussed on
overseas activities of U.S. taxpayers but always from the point
of view of preventing avoidance by U.S. resident taxpayers. In
fact, it is U.S. Expatriates who are most often affected by
these rules, and in ways not intended by Congress.
1. For example, the ``passive foreign investment company''
(``PFIC'') rules penalize minority investment in foreign
companies which are organized to earn passive income. To
prevent the last scintilla of avoidance, the term PFIC is so
broadly defined as to include many purely active commercial
ventures. Similarly, very restrictive tax credit provisions are
embodied in the PFIC rules, which are inconsistent with the
principles of double taxation relief as contained in Article 23
of the present UK/US treaty. The result is that U.S.
Expatriates who are resident in U.K. are subject to anti-
avoidance rules when making investments in U.K. companies in
circumstances where there is no tax avoidance, resulting both
in punitive rates of U.S. tax and denial of effective relief
for U.K. taxation imposed on the same income/gain, i.e. true
double taxation.
2. Other U.S. anti-avoidance provisions such as the
``controlled foreign corporation'' rules may result in
attribution of income of a foreign entity to a U.S. Expatriate
prior to the time when that income would be taxed to him in the
U.K., creating a potential mismatch of credits and, once again,
the possibility of true double taxation.
3. A further problem of certain anti-avoidance rules both
in the U.K. and the U.S. is the attribution of income to
someone other than he who has earned it. The frequent result
will be that income is taxed to one person by the U.K. and to
another by the U.S., so that once again the foreign tax credit
becomes an inadequate shield against double taxation.
E. Many of the above problems would be avoided if a U.S.
Expatriate residing in the U.K. were able to claim relief from
the U.S. taxation under the US/UK double tax treaty.
III. The Solution
A. The most comprehensive solution to these problems would
be to eliminate the saving clause from the new US/UK income tax
treaty. A U.S. Expatriate resident in the U.K. and eligible for
relief from U.S. tax under the new treaty would, for the most
part, be able to plan his affairs on the basis of being liable
to tax on his income only in the U.K. and therefore have the
same possibility as any other U.K. resident to mitigate his tax
liability through adoption of acceptable forms of planning such
as pensions. It is true that, because of the absence of a
provision which deals with capital gain, the present treaty
would not afford U.S. Expatriates relief from inconsistent
treatment of capital gains even if there were no saving clause.
However, the U.S.'s unilateral approach to treaty claims by
U.S. resident aliens (pursuant to Treasury Regulations Section
301.7701 (b) -7) would satisfactorily address this problem.
B. It therefore seems to me high time for the IRS to
reexamine the wisdom of incorporating the saving clause into
its treaties. So far as I am aware, the saving clause has no
congressional sanction. Presumably, the rationale for requiring
the saving clause is to serve the U.S. policy of taxing its
citizens on a worldwide basis, but there is no reason why this
policy should be any stronger than U.S. policy of taxing its
resident aliens on a worldwide basis, yet resident aliens are
freely able to claim the benefit of ``dual resident''
provisions of U.S. treaties when applicable. The difficulties
faced by a U.S. Expatriate residing in a country like the U.K.
amply demonstrate that the U.S. has not taken responsibility in
the drafting of its domestic legislation for the impact of the
saving clause on such individuals.
C. Another reason to reconsider the saving clause is that,
in practice, the saving clause operates to the disadvantage of
the U.S.'s treaty partners. Although typically (as in present
US/UK treaty) the saving clause is drafted so as to afford
either treaty partner the ability to tax its own nationals as
if the treaty had not come into effect, it is only the U.S.
which reaps a fiscal benefit from the saving clause because:
1. the U.S. is the only country which impose worldwide
taxation of its nationals; and
2. in those cases where a country such as the U.K. could
avail itself of the saving clause to deny treaty relief (i.e.
in relation to claims of U.K. nationals resident in the U.S.),
in practice it does not do so, either because it is not geared
to enforce a ``one-off'' provision which is inconsistent with
its normal treaty obligations or for cultural reasons.
D. If the Treasury Department is not persuaded that it
should take a fresh look at this issue, an alternative which
certainly should be considered is a series of specific treaty
provisions to deal with specific problems (e.g. pensions,
capital gains, charitable contributions). This is less than
ideal, both because of the difficulty of drafting all the
provisions that ought to be included and because of the risk of
rapid obsolescence. Nonetheless, ``half a loaf'' would be far
better than none.
IV. Conclusion
It would be a very positive development if the re-
negotiation of theUS/UK income tax treaty could pave the way
for a more considered treatment of U.S. Expatriates in future
treaty negotiations (or indeed, unilateral relief through U.S.
domestic legislation wholly or partly overriding saving clauses
in existing U.S. treaties).
I would be very interested in assisting the Inland Revenue
and /or the IRS during the course of these discussions, both in
relation to the problem of U.S. Expatriates and generally.
Please do not hesitate to contact me if I may be of service.
Yours sincerely,
Jeffrey L. Gould
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