[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
CURRENT U.S. INTERNATIONAL TAX REGIME
=======================================================================
HEARING
before the
SUBCOMMITTEE ON OVERSIGHT
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
FIRST SESSION
__________
JUNE 22, 1999
__________
Serial 106-53
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
65-844 CC WASHINGTON : 2000
_______________________________________________________________________
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
______
Subcommittee on Oversight
AMO HOUGHTON, New York, Chairman
ROB PORTMAN, Ohio WILLIAM J. COYNE, Pennsylvania
JENNIFER DUNN, Washington MICHAEL R. McNULTY, New York
WES WATKINS, Oklahoma JIM McDERMOTT, Washington
JERRY WELLER, Illinois JOHN LEWIS, Georgia
KENNY HULSHOF, Missouri RICHARD E. NEAL, Massachusetts
J.D. HAYWORTH, Arizona
SCOTT McINNIS, Colorado
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
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C O N T E N T S
__________
Page
Advisory of June 14, 1999, announcing the hearing................ 2
WITNESSES
BMC Software, Inc., John W. Cox.................................. 34
Citigroup, Denise Strain......................................... 41
Deere & Company, Thomas K. Jarrett............................... 48
National Foreign Trade Council, Inc., and Exxon Corporation, Joe
O. Luby, Jr.................................................... 7
Northrop Grumman Corporation, Gary McKenzie...................... 51
Tax Executives Institute, Inc., and Hewlett-Packard Company,
Lester D. Ezrati............................................... 20
Warner-Lambert Company, Stan Kelly............................... 56
SUBMISSIONS FOR THE RECORD
European-American Business Council, William W. Chip, statement
and attachment................................................. 71
Financial Executives Institute, statement........................ 74
General Motors Corporation, Detroit, MI, statement............... 77
International Air Transport Association, Montreal, Quebec,
Canada, Howard P. Goldberg, statement.......................... 79
Investment Company Institute, statement.......................... 80
Munitions Industrial Base Task Force, Arlington, VA, et al,
Richard G. Palaschak, joint statement.......................... 81
National Defense Industrial Association, Arlington, VA, Lawrence
F. Skibbie, statement.......................................... 83
Tropical Shipping, Riviera Beach, FL, Richard Murrell, letter.... 84
Washington Counsel, P.C.:
LaBrenda Garrett-Nelson and Robert J. Leonard, statement..... 85
LaBrenda Garrett-Nelson, statement........................... 86
CURRENT U.S. INTERNATIONAL TAX REGIME
----------
TUESDAY, JUNE 22, 1999
House of Representatives,
Committee on Ways and Means,
Subcommittee on Oversight,
Washington, DC.
The Subcommittee met, pursuant to notice, at 1:03 p.m., in
room 1100, Longworth House Office Building, Hon. Amo Houghton
(Chairman of the Subcommittee), presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
June 14, 1999
No. OV-8
Houghton Announces Hearing on
Current U.S. International Tax Regime
Congressman Amo Houghton (R-NY), Chairman, Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee will hold a hearing on the complexity of the current U.S.
international tax regime. The hearing will take place on Tuesday, June
22, 1999, in the main Committee hearing room, 1100 Longworth House
Office Building, beginning at 1:00 p.m.
Oral testimony at this hearing will be from invited witnesses only.
Invited witnesses include representatives from the U.S. Department of
the Treasury, Tax Executives Institute, National Foreign Trade Council,
financial services industry, software industry, heavy equipment
manufacturing industry, pharmaceutical industry, and high-technology
manufacturing industry. However, any individual or organization not
scheduled for an oral appearance may submit a written statement for
consideration by the Committee and for inclusion in the printed record
of the hearing.
BACKGROUND:
The United States employs a ``worldwide'' system of taxation on
income of U.S. corporations and its foreign affiliates. A U.S.-parent
corporation incurs income taxes on the income of its affiliates earned
abroad to the extent that the affiliates repatriate that income either
through dividends or deemed dividends. This worldwide-tax system has
become a maze of complex rules for sourcing and timing foreign income
and expenses.
The laws enacted by Congress and regulations promulgated by the
Internal Revenue Service over the past 40 years have introduced an
amount of complexity which some believe has made the international tax
regime unworkable and has resulted in an increasing amount of double
taxation of U.S. corporations' foreign income. According to this
viewpoint, the competitiveness of U.S. corporations vis-a-vis their
international competitors thus is disadvantaged.
United States corporations remain the most competitive in the world
as a result of superior technology and access to skilled labor.
However, the current international tax regime may adversely affect the
competitive advantages that such corporations now hold.
On June 7, 1999, Chairman Houghton and Rep. Sander Levin introduced
H.R. 2018, the ``International Tax Simplification for American
Competitiveness Act of 1999.''
In announcing the hearing, Chairman Houghton stated: ``In an
increasingly competitive global market, Congress must examine whether
the complexity of the U.S. international tax regime puts U.S.
corporations and their employees at a competitive disadvantage.
Congressman Levin and I have introduced legislation to address several
of these concerns.''
FOCUS OF THE HEARING:
The Subcommittee will review problems faced by domestic
corporations in complying with the complexity of the current U.S.
international tax regime as well as proposals to change the law.
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Means, U.S. House of Representatives, 1102 Longworth House Office
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noted above.
Chairman Houghton. The hearing will come to order.
Good afternoon, ladies and gentleman; delighted to have you
here. The Ways and Means Committee holds a unique position, as
you know, in forming policies that will drive economic growth
in the next century. The committee has jurisdiction over tax
and trade matters, and each are intricately intertwined with
the other.
Since I have been on this Committee, Congress has passed a
variety of trade laws, including the Omnibus Trade and
Competitiveness Act of 1988, the implementing bills for NAFTA,
and the Uruguay Rounds Agreements. Each year, the committee
leads the effort in Congress to preserve normal trade relations
with China. Within the last month, the committee has passed 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, so that we can expand export
opportunities for U.S. firms and workers. The U.S. market, as
you know, is the most open in the world; yet, more than 96
percent of the world's population lives outside our borders.
So, it is important that we secure market access beyond our 50
States in order to sustain our record of economic growth and
job creation, as we look out at a new millennium within 6
months.
Unfortunately, over the last 40 years, since the inception
of Subpart F, the disconnect between trade and tax policy has
widened. With one hand, Congress passes laws to help U.S.
business expand and become competitive around the globe. With
the other, Congress hobbles these same businesses through
double taxation and a variety of obstacles to capital formation
in markets abroad. These mixed messages to U.S. businesses are
not helpful.
So, as I looked over the prepared testimony, I noticed a
couple of things. First of all, the diversity of industries
that are represented here today--banking, pharmaceutical,
software, high-tech, heavy manufacturing, and oil and gas. We
have to be very proud as these U.S. companies are world leaders
in their fields. We also have to keep an eye on the future to
make sure that these companies and the industries they
represent remain world leaders. And, so that means that we need
to build a coherent link between trade and tax policy. We need
to understand the correlation between the two and work to pass
laws with that understanding in mind, our goal is to help
expand jobs, not throw boulders in their path.
The second thing that I noticed was despite the impressive
brain power of these men and women and the tax professionals
that support them, each witness speaks of the incredible
complexity of the tax code and the burden it places on their
companies. How did we get where we are today with such a
hodgepodge of tax laws that put the U.S. businesses at such a
disadvantage in the global marketplace? Isn't it time to rework
that system so it helps U.S. businesses? A strong economy in
the United States is driven mainly by how competitive our
companies are around the globe. Today, the international tax
laws stand in their way.
The tax code should be designed to tax income fairly and
uniformly. With these goals in mind, Mr. Levin--who is sitting
over here to my left--and I have introduced H.R. 2018, the
International Tax Simplification for American Competitiveness
Act of 1999. We believe that this bill takes important steps to
help ensure that U.S.-owned businesses will not be subject to
double or premature taxation. Only when these concerns are
addressed will our tax and trade laws be in line.
I am pleased now to yield to our Ranking Democrat, Mr.
Coyne.
Mr. Coyne. Thank you, Mr. Chairman, and I want to thank you
for having these hearings. I have a written statement I would
like to submit for the record, and I yield the balance of my
time to the gentleman from Michigan, Mr. Levin.
[The opening statement follows:]
Opening Statement of Hon. William J. Coyne, a Representative in
Congress from the State of Pennsylvania
Our hearing today will focus on problems faced by domestic
corporations in complying with the complexity of the current
U.S. international tax system. I want to commend Chairman
Houghton and Congressman Levin for their leadership in this
area and for the introduction of H.R. 2018, the ``International
Tax Simplification for American Competitiveness Act of 1999.''
This bill is sponsored, on a bipartisan basis, by many Members
of the Ways and Means Committee. H.R. 2018 proposes changes to
various aspects of our international tax rules.
I share Chairman Houghton's concern that, given an
increasingly competitive global market, the Congress must
examine whether the complexity of the U.S. international tax
regime puts U.S. corporations and their employees at a
competitive disadvantage. Consequently, I believe that it is
timely that the Oversight Subcommittee review our international
tax rules to see how they might be reformed and simplified.
Consideration of H.R. 2018 is a good first step toward
understanding the problems of international taxation and
industries' proposals for reform.
Also, our hearing today will serve as an excellent
introduction to the full Committee's hearing, next week, to
review the impact of U.S. tax rules on the international
competitiveness of U.S. workers and businesses. I look forward
to hearing the testimony of the witnesses who support H.R.
2018, including the Tax Executives Institute, the National
Foreign Trade Council, and representatives of the financial
services, software, heavy equipment manufacturing,
pharmaceutical, and high-technology industries.
Finally, international tax systems are typically evaluated
in terms of efficiency (whether tax considerations are
sufficiently neutral to investment and employment decisions);
equity (whether domestic businesses are treated fairly in
comparison to foreign-based firms); growth (whether the tax
system promotes economic growth); simplicity (whether the tax
system imposes unnecessary complexity and administrative
burdens on taxpayers; and, harmonization (whether the tax
system conforms with international norms and promotes dealings
with foreign countries). I have a particular interest in the
effect U.S. international tax law has on workers and the
retention of jobs in the U.S. I hope that the witnesses today
will address that issue as well in their testimony.
Thank you.
Chairman Houghton. Mr. Levin.
Mr. Levin. Thank you very much, Mr. Coyne, and to you, Mr.
Chairman, thank you for your holding this hearing and also for
your leadership. It is a pleasure to collaborate with you on
this and other matters.
I have a statement. Let me, if I might, just go through it,
because I think it may help us to frame the issue. This bill
that you and I have introduced is an effort to rationalize and
simplify further the international tax provisions of U.S. tax
laws by streamlining foreign tax credits, encouraging exports,
providing incentives for the performance of research and
development in the United States, enhancing overall U.S.
competitiveness, and minimizing revenue loss.
International tax policies were created at a time when the
focus was on preventing tax avoidance, not promoting
international competitiveness. In the early sixties, for
example, U.S. companies focused their manufacturing and market
strategies in the United States, which at the time was, by far,
the largest consumer market in the world. U.S. companies
generally could achieve economies of scale and rapid growth,
selling exclusively or almost so into the domestic market. In
the early 1960's, foreign competition in U.S. markets
generally, therefore, was inconsequential.
Yet, increasingly, it has become vital for American
businesses and workers to compete beyond our borders. In
response, the United States generally tries to raise revenue in
a neutral manner; that is, one that does not discriminate in
favor of one investment over another. In the international
arena, this means the United States seeks to apply the same tax
burden on income from both domestic and foreign investment.
Accordingly, the United States generally taxes U.S. companies
on their worldwide income with a credit for taxes paid to
foreign jurisdiction.
There is one important exception, and this applies to
foreign subsidiaries of U.S. companies. Because these
subsidiaries would face substantially higher tax rates than
their local competitors if worldwide taxation were strictly
enforced, U.S. law defers tax on the subsidiary's income until
it is repatriated. But with that, there is one problem, and
that is that the deferral of a foreign subsidiary's tax until
repatriation can create an incentive for U.S. companies to keep
their profits abroad even when the profits are not plowed back
to an active business operation. To counteract this incentive
to keep profits abroad for non-business reasons, Congress, over
the years, has eliminated deferral and imposed current taxation
on various forms of passive investment income. Thus, active
foreign operations are exempt from tax until repatriation so
that U.S. companies are taxed at the same level as their
foreign competitors in a given market, but passive income
earned abroad generally is taxed currently. However, this
structure, as we all know so well, has developed increasing
complexities.
So, over the last few years, a number of us have tried to
achieve greater simplification and equity. This is, I think,
our fourth bill on this issue and the third with our Senator
counterparts, Orrin Hatch and Max Baucus. We made some progress
in the 1977 act; most importantly, giving foreign sales
corporations treatment to software, simplifying reporting rules
for 10/50 companies, and eliminating overlap in passive foreign
investment companies, PFIC--you have to know the acronyms in
this field, and controlled foreign corporation, CFC, rules.
Last year, we were able to include a 1-year change in the rules
for active financing income. We are now trying to get that
provision to extend its 1-year life.
These are important reforms--technical but important--which
have enabled American businesses and workers to be more
competitive abroad. I am pleased by how far we have come, but
there is still more work to be done, and then I would lay out a
bit of where we have to go, Mr. Chairman.
And I conclude with you and I and others believe that by
saying simplifying our existing rules, we can achieve our goals
of increasing competitiveness and fairness for our American
companies in the global marketplace.
Thank you, Mr. Chairman.
Chairman Houghton. Thank you very much, Mr. Levin.
So, you understand the thrust of this meeting. We
appreciate your being here.
I would like to introduce the first panel--Mr. Joe Luby,
Assistant General Tax Counsel of Exxon and Chair of the Tax
Committee of the National Foreign Trade Council, and, also, Mr.
Lester Ezrati, General Tax Counsel of Hewlett-Packard in Palo
Alto on behalf of The Tax Executives Institute.
Mr. Luby, would you give your testimony?
STATEMENT OF JOE O. LUBY, JR., ASSISTANT GENERAL TAX COUNSEL,
EXXON CORPORATION, IRVING, TEXAS, AND CHAIR, TAX COMMITTEE,
NATIONAL FOREIGN TRADE COUNCIL, INC.
Mr. Luby. As you said, I am here on behalf of the National
Foreign Trade Council. I am accompanied by Fred Murray who is
our vice president of Tax with NFTC. I will concentrate my
remarks on the impact of the U.S. tax system on the ability of
U.S. multinationals to compete with foreign-based competition.
While I cannot state that the U.S. system is solely responsible
for the decline in rank of U.S. multinationals, I submit it had
a major role in the United States going from 18 of the world's
20 largest corporations in 1960 to just 8 by the mid-1990's. I
do not have new statistics, but recent events will probably
result in an even lower number now that Amoco is a British
company; Chrysler, a German company, and Bankers Trust, a
German bank.
I will concentrate on how two of the provisions you have
included in your bill impact competitiveness. Your bill would
accelerate and grant look-through treatment for 10/50
companies. An example will show you the adverse impact of 10/50
on competitiveness. Assume a U.S. company's 10/50 affiliate is
competing with a French company for an investment in Singapore.
The project calls for a $1 billion investment, and it is
projected to earn $150 million before tax or a 15 percent
return. Singapore grants tax holidays, so there is no foreign
tax. Our French competitor would project a 15 percent after-tax
return, because France does not tax active business income from
foreign sources. In contrast, the U.S. company would have
projected a 9.8 percent return because of the 10/50 provisions
imposing a U.S. tax of $52.5 million. The return advantage of
5.2 percent enjoyed by the French competitor may allow it to
preempt the U.S. bid. In any event, the 5.2 percent detriment
may drive the return below the level that would allow the U.S.
company to even entertain the project.
The granting of full look-through and acceleration of
repeal will enhance U.S. competitiveness by eliminating the
kind of adverse impact on project returns I have just
illustrated. Our members are still walking away from
investments, deferring investments, or taking less than optimal
ownership positions in foreign ventures due to the 10/50 rules.
Thus, we welcome your acceleration in look-through treatment
for 10/50.
Section 907 came into the code in 1975 in reaction to the
first oil crisis and to the suspicion that some U.S. oil
companies might be taking foreign tax credits at rates so high
that they may be inclusive of royalties. In 1983, this concern
was addressed in IRS regulations to provide a formula for
splitting the amount paid the foreign government into a tax
component and a royalty component. These regulations have never
been controversial and have worked well. Despite that fact,
section 907 remains in the code requiring that taxpayers
determine the amount of their extracted income versus their
oil-related income and the foreign taxes associated with each
category. This requires determining the point at which income
changes from extracted to oil-related, also determining the
associated cost for every oil well in every foreign country. No
foreign country where we operate has these kinds of rules.
It also requires that the IRS audit such determinations.
This is a complete waste of shareholder and taxpayer money
since from its inception, section 907 has raised little if any
tax revenue for the U.S. fisc. An API study indicated that no
major U.S. company in our industry has paid tax under 907 from
its inception in 1975 through the tax year 1997. Spending money
to comply with a provision that has essentially been useless
and has been superseded by subsequent law changes does not make
sense or enhance U.S. competitiveness.
Do compliance costs make a difference? Let us give you a
couple of examples based on my own company's experience. We
have 121 people in tax departments all over the world doing
nothing but trying to comply with U.S. international tax rules;
25 of them do section 907. This does not include people who are
comptrollers and other departments that also much assist. We
have an average of 30 IRS auditors in our office every business
day of the year. The information document requests have ranged
from 944 for the 1980 to 1982 audit to 2,232 in our most recent
audit. In contrast, our affiliates in Japan file a tax return
at the end of March, are visited by five auditors, and within 2
months the audit is completed. In the Netherlands, an audit for
our 1991 to 1994 tax years was handled by one auditor and took
6 months. Finally, in the U.K., most audits are handled by two
auditors, and we have had an issue raised that required
litigation in over 20 years.
So, that you will know the size of those audits and that
they are about substantial companies when you compare, our
sales in Japan total $16.5 billion and $3.5 billion in tax; the
Netherlands, $9.5 billion in sales and $1.9 billion in tax, and
the U.K., sales of $16.4 billion and $6 billion in tax.
NFTC thanks you for the opportunity to present its views
and especially for your efforts to bring to the international
tax rules some semblance of common sense in regard for the
ability of U.S. companies to compete abroad.
[The prepared statement follows:]
Statement of Joe O. Luby, Jr., Assistant General Tax Counsel, Exxon
Corporation, Irving, Texas, and Chair, Tax Committee, National Foreign
Trade Council, Inc.
Mr. Chairman, and distinguished Members of the
Subcommittee:
My name is Joe Luby. I am Assistant General Tax Counsel of
Exxon Corporation. As Chairman of its Tax Committee, I am
appearing today as a witness for the National Foreign Trade
Council, Inc.
The National Foreign Trade Council, Inc. (the ``NFTC'' or
the ``Council'') is appreciative of the opportunity to present
its views on simplification of the international tax system of
the United States. The NFTC also wishes to congratulate you,
Mr. Chairman, and Mr. Levin, and Mr. Sam Johnson, as well as
the other Members who have joined you--Mr. Crane, Mr. Herger,
Mr. English, and Mr. Matsui--in the introduction of H.R. 2018,
the International Tax Simplification for American
Competitiveness Act of 1999. As I will further elaborate below,
the provisions of the bill, if enacted, will do much to affect
the concerns we express in this testimony and would
significantly lower the cost of capital, the cost of
administration, and therefore the cost of doing business in the
global marketplace for U.S.-based firms.
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.
United States policy in regard to trade matters has been
broadly expansionist for many years, but its tax policy has not
followed suit.
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
Subcommittee, which focuses the spotlight on U.S. international
tax policy, is valuable and should be applauded.
The NFTC is concerned that the current 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 (Title 26 of the United States Code is hereafter
referred to as the ``Code'') 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 the sections that follow, make American
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'' \1\ 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.
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\1\ 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.
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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. We further address one of the more significant
anomalies, that of the allocation and apportionment of interest
expense, later in this testimony.
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, 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.
U.S. government officials have increasingly criticized
suggestions that U.S. taxation of international business be
ameliorated and infused with common sense consideration of the
ability of U.S. firms to compete abroad. Their criticism either
directly or implicitly accuses proponents of such policies of
advocating an unwarranted reaction to ``harmful tax
competition,'' by joining a ``race to the bottom.'' The idea,
of course, is that any deviation from the U.S. model indicates
that the government concerned has yielded to powerful business
interests and has enacted tax laws that are intended to provide
its home-country based multinationals a competitive advantage.
It is seldom, if ever, acknowledged that the less stringent
rules of other countries might reflect a more reasonable
balance of the rival policy concerns of neutrality and
competitiveness. U.S. officials seem to infer from the
comparisons that what is being advocated is that the United
States should adopt the lowest common denominator so as to
provide U.S. businesses a competitive advantage. Officials
contend this is a ``slippery slope'' since foreign governments
will respond with further relaxations until each jurisdiction
has reached the ``bottom.''
The inference is unwarranted. Let us look at our subpart F
regime, for example. The regimes enacted by other countries
that we have studied all were enacted in response to, and after
several years of, scrutiny of the United States' regimes. They
reflect a careful study of the impact of our rules in subpart
F, and, in every case, embody some substantial refinements of
the U.S. rules. Each regime has been in place for a number of
years, giving the government concerned time to study its
operation and conclude whether the regime is either too harsh
or too liberal. While each jurisdiction has approached CFC
issues somewhat differently, as noted, each has adopted a
regime that, in at least some important respects, is less harsh
than the United States' subpart F rules. The proper inference
to draw from the 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 would help redress the competitive imbalance created by
subpart F without contributing to a race to the bottom.
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.\2\
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\2\ 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.\3\ 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 their U.S.-based counterparts.
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\3\ Id.
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In the 1960s, the United States completely dominated the
global economy, accounting for over 50% of worldwide cross-
border investment and 40% of worldwide GDP. As of the mid-
1990s, the U.S. economy accounted for about 25% of the world's
foreign direct investment and GDP.
The current picture is very different. 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 6, and $20 of every $100 of direct cross-border
investment flows into the United States. Foreign companies own
approximately 14% of all U.S. non-bank corporate assets, and
over 27% of the U.S. chemical industry alone. Moreover, imports
have tripled as a share of GDP in the 1960s to an average of
over 9.6% over the 1990-1997 period.
That the world economy has grown more rapidly that the U.S.
economy over the last 3 decades represents an opportunity for
U.S. companies and workers that are able to participate in
these markets. Foreign markets now frequently offer greater
growth opportunities to U.S. companies than the domestic
market. 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 percent of all U.S.
corporate income. A recent study of the 500 largest publicly-
traded U.S. corporations finds that sales by foreign
subsidiaries increased from 25 % of worldwide sales in 1985 to
34% in 1997. From 1986 to 1997, foreign sales of these
companies grew 10% a year, compared to domestic growth of just
3% annually. In fact, many of our members tell us that foreign
sales now account for more than 50% of their revenue and their
profits.
However, this growth in foreign markets is much more
competitive that in earlier decades. The 21,000 foreign
affiliates of U.S. multinationals now compete with about
260,000 foreign affiliates of multinationals headquartered in
other nations. Over the last three decades, the U.S. share of
the world's export market has declined. In 1960, one of every
$6 of world exports originated from the United States. By 1996,
the United States supplied only one of every $9 of world export
sales. Despite a 30% loss in world export market share, the
U.S. economy depends on exports to a much greater degree. The
share of our national income attributable to exports has more
than doubled since the 1960s.
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. In 1996, U.S.
multinational companies were involved in 65% of all U.S.
merchandise export sales. U.S. industries with a high
percentage of investment abroad are the same industries that
export a large percentage of domestic production. And studies
have shown that these exports support higher wages in exporting
companies in the United States.\4\
---------------------------------------------------------------------------
\4\ See, Ch. 6, The NFTC Foreign Income Project: International Tax
Policy for the 21st Century, March 25, 1999.
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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.\5\ These findings have an
ominous quality, given the recent spate of acquisitions of
large U.S.-based companies by their foreign competitors.\6\ In
fact, of the world's 20 largest companies (ranked by sales) in
1960, 18 were headquarter- ed in the United States. By the mid-
1990s, that number had dropped to 8.
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\5\ OECD, Taxing Profits in a Global Economy: Domestic and
International Issues (1991).
\6\ See, e.g., testimony before the Committee on Finance, U.S.
Senate, March 11, 1999.
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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, for example, the NFTC strongly supports the
International Tax Simplification for American Competitiveness
Act of 1999, H.R. 2018, recently introduced by you Mr.
Chairman, and Mr. Levin, and Mr. Sam Johnson, and joined by
four other Members: Mr. Crane, Mr. Herger, Mr. English, and Mr.
Matsui. We congratulate you on your 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.
Against this background, the NFTC would also like to
elaborate on some of the provisions in H.R. 2018 in areas that
illustrate problems with significant impact on our members, as
well as others that are under consideration in pending
legislation yet to be introduced.
Look Through for 10/50 Companies
The 1997 Tax Act no longer requires U.S. companies operating joint
ventures (``JVs'') in foreign countries to calculate separate foreign
tax credit (``FTC'') limitations for income earned from each JV in
which the U.S. owner holds at least 10 percent, but no more than 50
percent, of the JV ownership. The 1997 Tax Act now allows U.S. owners
to compute FTCs with respect to dividends from such entities based on
the underlying character of the entities' income (i.e., ``look-
through'' treatment). However, the change is only effective for
dividends received after the year 2002. A separate ``Super'' FTC basket
is still required to be maintained for dividends received after 2002
but attributable to earnings and profits of the JV from years before
2003.
As stated by the Clinton Administration in its budget proposals
issued earlier this year, the concurrent application of both a single
basket approach for pre-2003 earnings and a look-through approach for
post-2002 earnings would result in significant complexity to taxpayers.
Thus, Section 208 of your bill would offer much needed simplicity for
foreign JVs by eliminating the ``Super'' FTC basket and accelerating
the effective date for application of the ``look-through'' rules to all
dividends received after 1999, regardless of when the earnings and
profits underlying those dividends were generated. As stated earlier by
Treasury, this reduction in complexity and compliance burdens will
reduce the bias against U.S. participation in foreign JVs, and help
U.S.-based companies to compete more effectively with foreign-based JV
partners.
Look-Through Treatment for Interest, Rents, and Royalties
As just mentioned, the 1997 Tax Act extended look-through treatment
to certain dividends received from 10/50 Companies after the year 2002,
but it failed to extend look-through treatment to interest, rents, and
royalties from these same foreign JVs. U.S. shareholders of foreign JVs
are often unable (due either to government restrictions or business
practices) to acquire controlling interests, especially in cases where
the foreign JV partner is a foreign government, or the activity
involved in is a government regulated industry. It is patently unfair
to penalize such non-controlling JV partners. Thus, Section 205 of your
bill extends look-through treatment to interest, rents, and royalties
received from foreign JVs after this year.
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 percent by U.S. owners) must be
treated as separate basket income to the JV partners. Again, this
result is not good tax policy. Thus, your bill extends look-through
treatment to these entities as well. Such legislative action would
bring much needed consistency and fairness to this area of the tax law,
by allowing look-through treatment to all forms of income streams, and
to all forms of business enterprises.
Look-Through Treatment for Sales of Partnership Interests
Currently, gains from sales of partnership interests are also
treated as separate basket passive income, even though U.S. partners
owning 10 percent or more of the value of foreign partnerships can
apply look-through treatment for their distributive shares of such
partnership income (although not interest, rents or royalties as stated
before). Consistent with our earlier comments concerning look-through
treatment in general, we support your provision in Section 107, which
treats gains or losses associated with the disposition of a partnership
interest as a disposition of the partner's proportionate share of each
of the assets of the partnership.
Amend the Domestic Loss Recapture Rule
Currently, when a taxpayer has taxable income from U.S. sources but
an overall loss from foreign sources, the foreign source loss reduces
the U.S. source taxable income and U.S. tax liability by decreasing the
taxpayer's worldwide taxable income on which the U.S. tax is based.
When the taxpayer subsequently generates foreign source income, the
prior tax benefit is recaptured by treating a portion of that foreign
income as domestic source for purposes of determining the FTC
limitation. Current law also provides that an overall domestic loss
reduces a taxpayer's foreign source income. The U.S. loss reduces the
taxpayer's U.S. tax liability and, through application of the loss
against foreign income, the FTC limitation is correspondingly reduced.
There is no symmetry in these rules, however, in the case where it is a
domestic loss that is incurred. In contrast to the foreign provisions,
taxpayers are not allowed to recover or recapture foreign source income
that was lost due to a domestic loss. To prevent this inequity and
remove this anomaly, Section 202 of your bill would recharacterize such
subsequent domestic income as foreign source to the extent of the prior
domestic loss, and therefore allow the FTC that was disallowed because
of the domestic loss.
Subpart F Exemption for Active Financing Income
We also applaud Section 101 of your bill, which extends the one-
year provision enacted last year providing deferral of U.S. tax on non-
U.S. income earned in the active conduct of a banking, financial, or
similar business. This provision, particularly if made permanent, would
significantly assist U.S. based financial service companies to compete
successfully in the international marketplace against foreign based
companies. It would also bring some consistency in the U.S. tax rules
by treating active income earned by financial service companies
similarly to active income earned by U.S. companies in other
industries.
Let us underscore the importance of this provision--U.S. banks and
financial companies have historically expanded abroad hand-in-hand with
U.S. industrial and service companies. They have, however, become an
endangered species, as now only two (2) are ranked in the top twenty-
five (25) financial services companies in the world, ranked by asset
size (Citigroup and Chase Manhattan Corporation). Recent acquisitions
of U.S.-based companies, such as Bankers Trust and Republic Bank, as
well as growth in foreign-based companies have changed the global
landscape beyond recognition.
Repeal the Alternative Minimum Tax 90 Percent Limitation on Foreign
Tax Credits
Current law limits the ability of taxpayers to offset their
corporate AMT liability by only allowing FTCs to offset up to 90
percent of such AMT. This has the likely result of taxing certain U.S.
multinationals more heavily on their foreign income than their foreign
competitors, or other domestic companies that have no foreign
operations. Section 207 of your bill repeals this limitation and merely
permits foreign taxes actually paid to be offset up to the amount of
AMT liability on foreign source income, without affecting any U.S.
source tax liability. As a result, the likelihood of double and
sometimes triple taxation of foreign source income would be lessened,
making U.S. multinationals more competitive internationally.
Restrict Application of Excise Tax to Airline Mileage Awards
The 1997 Tax Act imposed a 7.5 percent aviation excise tax on
amounts paid to air carriers for the right to provide mileage awards
(or other cost reductions) for air transportation. However, that
legislation failed to specify the geographical or transactional scope
of the excise tax, and has caused significant problems in the tourism
industry and complaints from other governments. Your Section 307 would
clarify that the excise tax does not apply to certain payments for the
right to provide mileage awards predominantly to foreign persons (who
are outside the taxing arm of the U.S. government).
Remove Pipeline Transportation Income and Income from Transmission of
High Voltage Electricity from Subpart F Treatment
In 1982, Congress expanded subpart F income to include certain
types of oil related income, such as income from operating an oil or
gas pipeline in a country other than where the oil or gas was extracted
or sold. The expansion of subpart F was due to a concern that petroleum
companies had been paying too little U.S. tax on their foreign
subsidiaries' operations relative to their high revenue. Specifically,
Congress thought that U.S. tax could be avoided on the downstream
activities of a foreign subsidiary because the income of the subsidiary
was not subject to U.S. tax until that income was paid to its
shareholders. The argument was that because of the fungible nature of
oil and because of the complex structures involved, oil income was
particularly suited to tax haven type operations.
However, this treatment is contrary to the original intent of
subpart F, which primarily was aimed at passive and other easily
movable income, rather than active income. Pipeline income, on the
other hand, is neither passive nor easily movable. Moreover, no other
major industrial country has special rules that sweep pipeline income
into its anti-deferral regime. Consequently, U.S. companies find it
difficult to compete with foreign-based multinationals for pipeline
projects that would generate income subject to subpart F. Therefore, we
applaud Section 105 of your bill, which would no longer treat as
subpart F income, any income derived from the pipeline transportation
of oil or gas within a foreign country.
Similarly, Section 106 of your bill would allow U.S.-based utility
companies to enter foreign markets for electricity. These complex
projects often involve the construction of costly fixed transmission
systems that in some cases cross national boundaries. This income is
also neither passive nor easily movable. Imposition of subpart F
treatment on them is not justifiable, and is counterproductive to the
interests of the United States.
Extension of Carryforward Period and Ordering Rules for Foreign Tax
Credit Carryovers
When companies invest overseas, they often receive favorable local
tax treatment from foreign governments, at least in the early years of
operation. For example, companies are sometimes granted rapid
depreciation write-offs, and/or low or even zero tax rates, for a
period of years until the new venture is up and running. This results
in a low effective tax rate in those foreign countries for those early
years of operation. For U.S. tax purposes, however, those foreign
operations must utilize much slower capital recovery methods and rates,
and are still subject to residual U.S. tax at 35 percent. Thus, even
though those foreign operations may show very little profit from a
local standpoint, they may owe high incremental taxes to the U.S.
government on repatriations or deemed distributions to the U.S. parent.
However, once such operations are ongoing for some length of time, this
tax disparity often turns around, with local tax obligations exceeding
residual U.S. taxes. At that point, the foreign operations generate
excess FTCs but, without an adequate carryback and carryforward period,
those excess FTCs will expire.
The U.S. tax system is based on the premise that FTCs help
alleviate double taxation of foreign source income. By granting
taxpayers a dollar-for-dollar credit against their U.S. liability for
taxes paid to local foreign governments, the U.S. government allows its
taxpayers to compete more fairly and effectively in the international
arena. However, by imposing limits on carryovers of excess FTCs, the
value of these FTCs diminish considerably (if not entirely in many
situations). Thus, the threat of double taxation of foreign earnings
becomes much more likely.
Sections 201 and 206 of your bill extend the carryover period, and
useful life, respectively, of FTCs. Section 201 extends the carryover
period from 5 to 10 years, while Section 206 allows old carryovers to
be utilized first, which results in a ``freshening'' of unexpired FTCs.
Both of these provisions would help reduce the costs of doing business
overseas for U.S. multinationals, and help eliminate competitive
disadvantages suffered by U.S.-based companies versus foreign-based
companies. Please keep in mind that higher business taxes for U.S.
companies may result in higher prices for goods and services sold to
U.S. consumers, stagnant or lower wages paid to American workers in
those businesses, reduced capital investment leading, perhaps, to work
force reductions or decreased benefits, and smaller returns to
shareholders. Those shareholders may be the company's employees, or the
pension plans of other middle class workers.
We also note that the President's Fiscal Year 1998 Budget contained
a proposal to reduce the carryback period for excess foreign tax
credits from two years to one year. This proposal has been and is
currently being considered in the Senate as a revenue raiser for one or
more pending bills. The NFTC strongly opposes this proposal. Like the
carryforward period, the carryback of foreign tax credits helps to
ensure that foreign taxes will be available to offset U.S. taxes on the
income in the year in which the income is recognized for U.S. purposes.
Shortening the carryback period also could have the effect of reducing
the present value of foreign tax credits and therefore increasing the
effective tax rate on foreign source income.
Repeal of Code Section 907
Under current law, in additional to having to calculate separate
foreign tax credit (``FTC'') limitations for income earned from each
separate category or ``basket'' under section 904(d) (e.g., the passive
income basket, shipping income basket, etc.), multinational oil
companies are also required to calculate a separate limitation on their
foreign oil and gas extraction income (``FOGEI'') under Code Section
907. Section 208 of your bill would repeal Code Section 907 and, thus,
eliminate the additional separate limitation on FOGEI.
As background, Section 907 was originally enacted in response to a
Congressional concern that oil industry taxpayers were paying amounts
to foreign governments that were ostensibly ``taxes'' but were in
reality ``disguised royalties.'' The issue arose from the fact that in
foreign countries, the sovereign usually retains the right to its
natural resources in the ground. Thus, a major concern was whether
payments made to foreign governments were for grants of specific
economic benefits or general taxes. Congress wanted to limit the FTC to
that amount of the ``government take'' which was perceived to be a tax
payment, and not a royalty. Moreover, once the tax component was
identified, Congress wanted to prevent oil companies from using excess
FOGEI credits to shield U.S. tax on certain low-taxed ``other'' income,
such as passive income or shipping income.
However, both concerns have already been adequately addressed in
subsequent legislation or rulemaking. First, under Treasury Decision
7918, so-called ``dual capacity taxpayer'' regulations were issued
which help taxpayers to determine how to separate payments to foreign
governments into their income tax element and ``specific economic
benefit'' element. Second, the 1986 Tax Act fragmented foreign source
income into various FTC ``baskets,'' restricting taxpayers from
offsetting excess FTCs from high-taxed income, including FOGEI, against
taxes due on low-taxed categories of income, such as passive or
shipping income.
We emphasize that compliance with the rules under Code Sec. 907 is
extremely complicated and time consuming for both taxpayers and the
IRS. Distinctions must be made as to various items of income and
expense to determine whether they properly fall under the FOGEI
category, or the FORI (or other) category. Painstaking efforts are
often needed to categorize and properly account for thousands of income
and expense items, which must then be explained to IRS agents upon
audit. Ironically, such efforts typically result in no or little net
tax liability changes, since U.S.-based oil companies have, since the
inception of section 907, had excess FTCs in their FORI income
category. As a result, oil industry taxpayers, which already must deal
with depressed world oil prices, also must incur large administrative
costs to comply with a section of the Income Tax Code that results in
little or no revenue to the Federal Treasury.
Current Section 907 clearly increases the cost for U.S. companies
of participating in foreign oil and gas development. Ultimately, this
will adversely affect U.S. employment by hindering U.S. companies in
their competition with foreign concerns. Although the host country
resource will be developed, it will be done so by foreign competition,
with the adverse ripple effect of U.S. job losses and the loss of
continuing evolution of U.S. technology. The loss of any major foreign
project to a U.S. company will mean less employment in the U.S. by
suppliers, and by the U.S. parent, in addition to fewer U.S.
expatriates at foreign locations. By contrast, foreign oil and gas
development by U.S. companies assures utilization of U.S. supplies of
hardware and technology, ultimately resulting in increased U.S. job
opportunities.
Extension of FSC Benefits to Exports of Defense Products
Code Section 923(a)(5) reduces the tax exemption available to
companies that sell defense products abroad to 50 percent of the
benefits available to other exporters. This provision prevents defense
companies from competing as effectively as they could in increasingly
challenging foreign markets.
Any U.S. exporter may establish Foreign Sales Corporations (FSCs)
under which a portion of their earnings from foreign sales is exempt
from U.S. taxation. This provision is designed to achieve tax parity
with the territorial tax systems of our trading partners, i.e., it
mirrors the economic effects of European Union tax systems on their
exported products, for example.
For exporters of defense products, however, the FSC tax incentive
is reduced by 50 percent, compared to the full benefit for all other
products. That limitation, enacted in 1976, was based on the premise
that military products were not sold in a competitive market
environment and the FSC benefit was therefore not necessary for defense
exporters.
Whatever the veracity of that premise 20 years ago, today military
exports are subject to fierce international competition in every area.
Moreover, with the sharp decline in the defense budget over the past
decade, exports of defense products have become ever more critical to
maintaining a viable U.S. defense industrial base. The aerospace
industry alone provides over 800,000 jobs for U.S. workers. Roughly
one-third of these jobs are tied directly to export sales. In 1996, for
example, total industry sales were $112 billion, $37 billion of which
was for exports.
Maintaining exports of defense products is today more difficult
than ever before. First, the U.S. government prohibits the sale of
defense products to certain countries and must approve all others in
advance. Second, European and other states are developing export
promotion projects to counter the industrial impact of their own
declining defense budgets by being more competitive internationally.
Finally, a number of Western purchasers of defense equipment now view
Russia and other formerly communist countries as acceptable suppliers,
further intensifying the global competition.
No valid economic or policy reason exists for continuing a tax
policy that discriminates against a particular class of manufactured
products. Furthermore, repealing this section will not impact the
foreign policy of the United States. Military sales will continue to be
subject to the license requirements of the Arms Export Control Act.
An egregious example of how these rules discriminate against
certain products involves commercial communications satellites. U.S.
manufacturers are the world's leaders in the production and deployment
of communications satellites. Until this year, commercial
communications satellites manufactured in the United States qualified
for full FSC benefits. For export control purposes, the Strom Thurmond
National Defense Authorization Act for Fiscal Year 1999 transferred
jurisdiction over commercial satellite exports from the Commerce
Department Commerce Control List (CCL) to the State Department U.S.
Munitions List (USML), effective March 15, 1999. An unintended result
of this jurisdictional change is that commercial communications
satellites and related items are now ``military property'' for purposes
of the FSC rules. This unintended result should be corrected and the
full FSC benefit for commercial communications satellites should be
restored. In fact, the House of Representatives Select Committee on
Technology Transfers to the Peoples Republic of China, chaired by
Representative Christopher Cox, recommended that satellite
manufacturers should not suffer a tax increase because of the transfer
from CCL to USML.
Improvement of the U.S. trade imbalance is fundamental to the
health of our economy. The benefits provided by the FSC provisions
contribute significantly to the ability of U.S. exporters to compete
effectively in foreign markets. The FSC limitation on the exemption for
defense exports hampers the ability of U.S. companies, many of whom
already have access to large foreign markets, to compete effectively
abroad with many of their products. Section 923(a)(5) should be
repealed immediately to remove this impediment to the international
competitiveness and to the future health of our defense industry.
Section 303 of your bill, Mr. Chairman, and an identical provision
included in a stand-alone bill, H.R. 796, would remedy this situation.
H.R. 796 currently has 54 cosponsors, including 28 of the 39 members of
the Committee.
In addition to these areas of concern that have been addressed in
your bill, as noted above we have significant concerns in another area
that we would like to address.
Allocation of Interest Expense
Prior to January 3, 1977, when Treasury issued its final Regulation
Sec. 1.861-8, there essentially was no requirement to allocate and
apportion U.S. interest expense to foreign-sourced income. Moreover,
even under these 1977 regulations, opportunities were available to
minimize the impact of interest allocation. For example, interest could
be allocated on a separate company basis. Thus, corporate structures
could be organized so that U.S. debt could be carried only by companies
in an affiliated group that had domestic source income, eliminating any
allocation of interest to foreign sourced income.
The 1986 Tax Reform Act required that allocation of interest now be
made on a consolidated group basis. It also eliminated the optional
gross income method for allocating interest, and required that earnings
and profits of more than ten percent owned subsidiaries be added to
their stock bases for purposes of allocating interest under the asset-
tax basis method. Also in 1986, while advancing the concept of
``fungibility,'' Congress nevertheless failed to allow an offset for
interest expense incurred by foreign affiliates. Although such a
``worldwide fungibility'' provision was included in the Senate-passed
version of the bill in 1986, it was dropped in Conference. Similarly, a
subgroup/tracing exception approved by the Senate was also dropped from
the final 1986 Act. While these fungibility and subgroup/tracing
provisions have appeared in later tax bills (see e.g., H.R. 2948
(``Gradison Bill'') introduced in 1991 and H.R. 5270 (``Rostenkowski
Bill'') introduced in 1992), they have never been enacted.
The NFTC strongly suggests that Congress fix the inequitable
interest allocation rules currently existing in the law. They are
extremely costly and particularly anti-competitive for multinational
corporations. By failing to take into account borrowings of foreign
affiliates, the law results in a double allocation of interest expense.
Moreover, these rules operate to impede a U.S. multinational
corporation's ability to utilize the foreign tax credit for purposes of
mitigating double taxation. It is simply unfair that U.S.
multinationals with U.S. subsidiaries operating solely in the U.S.
market, where the subsidiary incurs its debt on the basis of its own
credit, must nevertheless allocate part of that interest expense
against wholly unrelated foreign generated income.
One solution, of course, is simply to reinstate and codify the pre-
1986 Act interest allocation rules permitting interest expense to be
allocated on a separate company basis. However, due to the strong
criticism of the rules in 1986, this approach is unlikely to succeed.
We, therefore, suggest an alternative approach of advancing the
provisions that were passed by the Senate in connection with the 1986
Act. Recall that under the earlier Senate version, interest expense of
foreign affiliates would be added to the total interest expense ``pot''
to be allocated among all affiliates. Thus, this approach allows
adoption of the ``worldwide fungibility'' concept of allocating
interest, as opposed to the ``water's edge'' approach of current law.
We also suggest the inclusion of an elective ``subgroup'' or tracing
rule that allows interest expense to be allocated based on a subgroup
consisting of only the borrower and its direct and indirect
subsidiaries. This approach allows interest that should be specifically
allocated to a particular domestic operation to remain identified with
such operation, a much more equitable approach than under current law.
In 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.
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
Subcommittee for beginning the process of reexamining 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 Subcommittee. The NFTC is prepared to make
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.
[GRAPHIC] [TIFF OMITTED] T5844.001
Chairman Houghton. Thanks very much, Mr. Luby.
Before we go on, I want to introduce Mr. Wes Watkins,
Congressman from Oklahoma. We are delighted you are here, Mr.
Watkins.
And, then, Mr. Lester Ezrati, would you please testify?
STATEMENT OF LESTER D. EZRATI, GENERAL TAX COUNSEL, HEWLETT-
PACKARD COMPANY, PALO ALTO, CALIFORNIA, AND PRESIDENT, TAX
EXECUTIVES INSTITUTE, INC.
Mr. Ezrati. Thank you, Mr. Chairman. I am general tax
counsel for Hewlett-Packard Company in Palo Alto, California. I
am here today as president of Tax Executives Institute, the
preeminent group of in-house tax professionals in North
America. Our 5,000 members represent the 2,700 largest
corporations in the United States and Canada, most of which
have significant operations overseas.
TEI believes that the Code's foreign provisions need
fundamental reform and simplification, and for this reason, we
support H.R. 2018. Enactment of this bill will generally reduce
the cost of complying with the laws without any material
diminution in tax dollars flowing to the Treasury. The bill
will not only reduce administrative burdens, thereby enhancing
the country's competitiveness, but will also signal Congress's
commitment to the simplification of the tax law generally. In
addition, the bill will bring overdue reform to the foreign tax
credit area where taxpayers have been especially burdened.
Mr. Chairman, the proposals in H.R. 2018 have been
described as modest. It marks a beginning, not an end. For
example, in the more than three decades since their enactment,
the Subpart F rules have been distended to capture more and
more active operating income. Reform is needed here. One
solution is to remove Subpart F's artificial barriers to
competitiveness by excluding foreign-based companies' sales and
services income from current taxation and allowing U.S.
corporations to compete more effectively. Other areas to be
addressed are the translation of the deemed-paid foreign tax
credit rule under section 906 and the elimination of the
current interest allocation rules. These comments
notwithstanding, we agree with you, Mr. Chairman, that the bill
represents a significant downpayment on further reform.
I would now like to highlight two provisions in H.R. 2018
that we believe are particularly important for the reform of
international tax laws.
First, TEI believes that taxpayers should be permitted to
use generally accepted accounting principles to calculate the
earnings and profits of controlled foreign corporations under
Subpart F. Current law provides that a foreign corporation's
earnings and profits is to be computed in accordance with rules
substantially similar to those for domestic corporations. As a
practical matter, however, a foreign corporation is frequently
unable to compute E&P in the same manner as a domestic
corporation. Although a domestic corporation generally
calculates E&P by making adjustments to U.S. taxable income, a
foreign corporation necessarily uses foreign book income as its
starting point. This bill will provide significant
simplification by permitting taxpayers to reduce their
administrative burdens by using United States' generally
accepted accounting principles (GAAP) to compute E&P. In our
view, however, the provision should be elective, not mandatory.
Second, TEI applauds section 207, which would eliminate the
90-percent limitation on the use of the foreign tax credit to
offset any alternative minimum tax liability. Giving taxpayers
the ability to offset their entire liability with their foreign
taxes will not frustrate the policy underlying the AMT and will
further the goal of eliminating double taxation. A taxpayer
with an AMT liability and sufficient foreign tax credits to
offset that liability, has already paid a significant amount of
tax. Clearly, that the tax has not been paid to the United
States has no bearing on the economic cost it represents to the
taxpayer. We therefore support the enactment of this provision.
H.R. 2018 would also mandate two Treasury Department
studies: one on the treatment of the European Union as a single
country for purposes of the same-country exception to Subpart F
and a second on the interest allocation rules. We commend the
Chairman for recognizing that the European Community's
elimination of barriers to cross-borders payments places U.S.
corporations at a disadvantage. We suggest, however, that
companies need relief now in order to remain competitive and
urge Congress to consider the immediate adoption of this
proposal.
As for the interest allocation rules, we agree that they
desperately need reform. In our view, the rules are not
justified on economic grounds.
Finally, I would like to address an issue not included in
H.R. 2018--confidentiality of advance pricing agreements. Mr.
Chairman, you recently voiced support for legislation to
protect APAs from disclosure. As businesses become more global,
it will become increasingly important for governments and
taxpayers to work together to resolve disputes in creative,
cost-effective ways, such as the APA Program. TEI strongly
believes that any compromise of taxpayer confidentiality will
have a negative effect on the future of this important program.
Information set forth in an APA is highly fact-specific and
involves sensitive financial and commercial information.
Taxpayers submitted the pricing information to the IRS with the
understanding that it would be kept confidential. That the IRS
is preparing to disclose APAs threatens these companies'
legitimate privacy interests and has already begun to undermine
our relations with treaty partners and the future of the APA
Program. For these reasons, TEI strongly supports enactment of
legislation to protect APAs and supporting documents from
disclosure.
Mr. Chairman, we commend you for recognizing that the
international provisions are among the most complex provisions
of the Internal Revenue Code, and we pledge our support for
your efforts to effect meaningful simplification and reform.
Thank you for giving us the opportunity to testify, and I
would be pleased to respond to your questions.
[The prepared statement follows:]
Statement of Lester D. Ezrati, General Tax Council, Hewlett-Packard
Company, Palo Alto, California, and President, Tax Executives
Institute, Inc.
Good afternoon. I am Lester D. Ezrati, General Tax Counsel
for Hewlett-Packard Company in Palo Alto, California. I appear
before you today as the president of Tax Executives Institute,
the preeminent group of corporate tax professionals in North
America. The Institute is pleased to provide the following
comments on international complexity and simplification.
Background
Tax Executives Institute is the preeminent association of corporate
tax executives in North America. Our 5,000 members are accountants,
attorneys, and other business professionals who work for the largest
2,800 companies in the United States and Canada; they are responsible
for conducting the tax affairs of their companies and ensuring their
compliance with the tax laws. Hence, TEI members deal with the tax code
in all its complexity, as well as with the Internal Revenue Service, on
almost a daily basis. Most of the companies represented by our members
are part of the IRS's Coordinated Examination Program, pursuant to
which they are audited on an ongoing basis. TEI is dedicated to the
development and effective implementation of sound tax policy, to
promoting the uniform and equitable enforcement of the tax laws, and to
reducing the cost and burden of administration and compliance to the
benefit of taxpayers and government alike. Our background and
experience enable us to bring a unique and, we believe, balanced
perspective to the subject of international complexity and
simplification.
The international provisions of the Internal Revenue Code are among
the most complicated provisions in the tax law. The last several years
have seen several small steps taken to reduce tax law complexity for
multinational corporations. For example, three years ago, Congress
repealed section 956A of the Internal Revenue Code, which in our view
was ill-conceived when it was enacted in 1993. And in 1997, Congress
rectified an inequity that has existed for the past decade when it
eliminated the overlap between the controlled foreign corporation and
passive foreign investment company rules. Although laudable, these
actions represent only a small step on the journey of simplifying the
international tax provisions of the Internal Revenue Code.
TEI believes that the Code's foreign provisions need fundamental
reform and simplification, and for this reason we support H.R. 2018,
the International Tax Simplification for American Competitiveness Act
of 1999, which was introduced on June 7, 1999, by Oversight
Subcommittee Chairman Amo Houghton and several other representatives.
Enactment of this bill will generally reduce the costs of preparing
U.S. corporate tax returns for American companies engaged in
international trade without any material diminution in tax dollars
flowing to the treasury. The bill will not only reduce compliance
costs--thereby enhancing the country's competitiveness--but it will
also signal Congress's continued commitment to the simplification of
the tax law generally. In addition, the bill will bring long overdue,
albeit partial, reform to the foreign tax credit area.
Any simplification efforts will need to comprehend the changing
face of the business environment, owing, among other things, to the
growth of electronic commerce and business technologies. As businesses
become more global and as companies strive to manage their supply
chains digitally, the need for meaningful tax reform will become more
and more manifest. In addition, it will become increasingly important
for governments and taxpayers to work together to resolve--or
forestall--disputes in creative, cost-effective ways, such as advanced
pricing agreements (APAs). Accordingly, TEI is very pleased that
Congressman Houghton and other members have voiced support for
preserving the confidentiality of APAs. TEI strongly believes that any
compromise of taxpayer confidentiality will have a negative effect on
the future of the APA program.
As Congressman Houghton noted in his introductory statement, H.R.
2018 seeks reform ``in modest but important ways.'' We agree that,
although a major leap forward, enactment of the bill will not obviate
additional reform of the Code's international tax provisions--for
example, in respect of Subpart F, which Chairman Houghton himself has
singled out as an extremely complex area of the law. Subpart F was
initially enacted as an exception to the deferral principle in order to
tax the types of income considered relatively ``movable'' from one
taxing jurisdiction to another and therefore able to take advantage of
low rates of tax. In the three decades since its enactment, however,
Subpart F has been distended to capture active operating income. One
solution to removing Subpart F's artificial barrier to competitiveness
would be to exclude foreign base sales and services income from current
taxation, allowing U.S. corporations to compete more effectively on a
level international playing field.\1\ Other areas that should be
considered for simplification include the translation of the deemed
paid tax credit under section 986, the aggregation of dividends from
noncontrolled section 902 corporations in one basket, and the
elimination of the interest allocation rules. These comments
notwithstanding, we agree with Congressman Houghton and the other
sponsors of H.R. 2018 that the bill represents a ``down payment on
further reform.''
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\1\ The proposal in H.R. 2018 to treat the countries in the
European Community as a single country for purposes of the ``same-
country'' exception to Subpart F would also effect some relief. See the
discussion of this provision at pages 7-8.
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H.R. 2018: A Good Start
I. Treatment of Controlled Foreign Corporations
A. Use of GAAP for E&P Calculations. The concept of
``earnings and profits'' (E&P) has relevance in the foreign tax
area for several reasons. For example, E&P is used in measuring
the amount of Subpart F inclusions, the portion of a
distribution from a foreign corporation that is taxable as a
dividend, the amount of foreign taxes deemed paid for purposes
of the deemed-paid foreign tax credit, and the amount of
section 1248 gain taxable as a dividend.
The Code currently provides that the E&P of a foreign
corporation is to be computed in accordance with rules
substantially similar to those applicable to domestic
corporations. As a practical matter, however, a foreign
corporation is frequently unable to compute E&P in the same
manner as a domestic corporation. Although a domestic
corporation generally calculates E&P by making adjustments to
U.S. taxable income, a foreign corporation necessarily uses
foreign book income as its starting point. The ensuing
adjustments become especially difficult in the case of
noncontrolled foreign corporations since the U.S. shareholder
of such companies may be unable to obtain all the information
required to compute E&P.
Although foreign corporations do not compute U.S. taxable
income, they frequently do adjust foreign book income to
conform with U.S. generally accepted accounting principles
(GAAP) for financial reporting purposes. There are numerous
differences between GAAP and E&P, but most relate to timing
differences and have at most a transitory and nominal effect on
a company's U.S. tax liability, especially in light of the
requirement of the Tax Reform Act of 1986 that taxpayers
compute their deemed-paid credit on the basis of a ``pool'' of
post-1986 undistributed earnings.
Because we believe that taxpayers should generally be
permitted to elect to use U.S. GAAP in computing the E&P of
foreign corporations, we endorse section 104 of H.R. 2018,
which would clarify the Treasury Department and IRS's authority
to provide such an election.\2\ Enactment of this provision is
needed to simplify calculations of E&P in the foreign area.
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\2\ Regulations proposed in 1992 would eliminate the need to adjust
financial statements prepared in accordance with GAAP, but only with
respect to uniform capitalization and depreciation for purposes of
computing a foreign corporation's E&P. The proposed regulations do not
address the computation of E&P for Subpart F purposes because the IRS
and Treasury question whether they have the authority to effect such a
change by regulation.
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B. De Minimis Rule for Subpart F Income. Section 954(b)(3)
of the Code provides that no part of a CFC's gross income is
treated as foreign-based company income (FBCI) if its FBCI and
insurance income for the year is less than the smaller of (i)
five percent of its gross income for the year or (ii) $1
million. Section 103 of H.R. 2018 would increase the FBCI de
minimis income from five to ten percent of gross income,
thereby reducing the reporting requirements for many companies.
The bill would also increase the $1 million ceiling to $2
million, a provision that would assist companies with
relatively small overseas operations.
TEI endorses this provision, which would simplify the
computation of FBCI. We suggest, however, that consideration be
given to eliminating the dollar threshold altogether (or
increasing it to $5 million). These changes would restore the
de minimis rule that was in effect before 1987.
C. Treatment of the European Union Under the Same-Country
Exception. In 1992, the European Community created a single
market now comprised of 15 countries that led to the
consolidation of many European business opportunities. The
resulting reduction of operating costs enhanced the
competitiveness of EC-based corporations, often to the
detriment of U.S.-based companies that are subject to Subpart
F. The conversion of 11 currencies to the euro can only
exacerbate the problem.
Under the current Subpart F rules, certain sales and
services income that is earned outside a CFC's home country is
taxable, while income earned inside the home country is exempt
from current taxation under the ``same-country exception.''
Computing Subpart F income significantly increases the
administrative costs for U.S.-based companies; because of the
generally high European tax rates, there is most often no
increase in revenues for the United States. Thus, U.S.
multinationals may be forced to choose between the potential
for cost-efficient consolidation of operations in Europe and
higher administrative costs.
Section 102 of H.R. 2018 would provide for a Treasury
Department study on the feasibility of treating all countries
included in the European Community as one country for purposes
of applying the same-country exception under Subpart F of the
Code.\3\ The European Community is eliminating barriers to
cross-border payments--an initiative that places U.S.
corporations at a disadvantage. Accordingly, TEI believes that
companies need relief now in order to remain competitive, and
we regret that a study will only further delay the proper
economic result: treatment of the EC countries as one country.
Such a solution would permit the efficient consolidation of
U.S. multinationals' European operations, thereby enhancing
their ability to compete in the European Union. TEI strongly
urges Congress to consider the outright adoption of this
proposal.
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\3\ Prior iterations of this bill provided for the treatment of EC
countries as a single country for purposes of the same-country
exception. See, e.g., H.R. 1690, 104th Cong., 2d Sess. (introduced on
May 24, 1995).
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II. Foreign Tax Credit Rules
A. Creditability against Alternative Minimum Tax. Under
section 59(a)(2) of the Code, a taxpayer's foreign tax credit
(FTC) may offset no more than 90 percent of the taxpayer's
alternative minimum tax (AMT) liability.\4\ In contrast, a
taxpayer that is subject to a regular income tax liability is
not subject to the 90-percent restriction. The 90-percent
limitation is presumably the result of Congress's efforts to
reconcile the arguably conflicting policies underlying the FTC
and AMT.
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\4\ This limitation is imposed in addition to the foreign source
income limitations of section 904 as it applies to both AMT and regular
taxpayers.
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Because the United States taxes the worldwide income of its
citizens and residents, the FTC was introduced to limit the
incidence of double taxation--the taxation of the same income
by two jurisdictions. The policy underlying the FTC has not
changed over the years, though certain limitations have been
imposed to prevent what has been deemed to be the improper
averaging of high- and low-tax foreign source income. Thus,
under the regular income tax provisions, a U.S. taxpayer may
offset fully 100 percent of its U.S. tax liability on foreign-
source income with its FTC. This does not mean that the
taxpayer is not paying any tax, but rather simply acknowledges
that the taxpayer has already paid a tax (to the jurisdiction
where the income was derived) at the rate equal to or greater
than the amount the United States would assess on that income.
When the AMT was enacted as part of the Tax Reform Act of
1986, Congress had ``one overriding objective: to ensure that
no taxpayer with substantial economic income can avoid
significant tax liability by using exclusions, deductions, and
credits.'' S. Rep. No. 99-313, 99th Cong., 2d Sess. 518-19
(1986). Thus, the AMT was deemed necessary to address public
perceptions about the fairness of the tax system.
TEI has serious reservations about the policy basis for the
AMT generally, but we recognize that calls for its outright
repeal are beyond the scope of this hearing. Accordingly, we
applaud section 207 of H.R. 2018, which proceeds from the
premise that, even if the AMT remains in effect, it makes no
sense to retain the 90-percent FTC limitation. According a
taxpayer the ability to offset its entire liability with its
foreign taxes would not frustrate the legitimate policy
underlying the AMT. Unlike the other items that may serve to
reduce a taxpayer's regular tax liability (which taxpayers are
not permitted to take fully into account for AMT purposes), the
foreign tax credit represents precisely what its name suggests:
a tax. A taxpayer with an AMT liability and sufficient FTC to
offset that liability has already paid a significant tax.
Clearly, that the tax has not been paid to the United States
has no bearing on the economic cost it represents to the
taxpayer. Moreover, to the extent the FTC and AMT regimes do
conflict, TEI submits that the policy supporting the FTC (and
complementary provisions in U.S. tax treaties)--which is based
upon sound economic reasoning and comports with longstanding
international norms--should prevail. We therefore support the
enactment of this provision.\5\
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\5\ This provision mirrors the relief provided in H.R. 1633, which
was introduced by Chairman Houghton in April.
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B. Expansion of FTC Carryforward and Ordering Rules.
Section 904(c) of the Code currently provides that any foreign
tax credits (FTCs) not used against U.S. tax in the current
year may be carried back two years and forward five. In
contrast, the rules for the general business tax credit
(section 39) and net operating losses (section 172(b)) provide
for a three-year carryback and a fifteen-year carryforward.
In addition, the ordering rules set forth in section 904(c)
for FTCs require that the current year's credits be utilized
before any carryovers are taken into account. By contrast, in
respect of the general business tax credit, a carryover is to
be used first, before the current year's credits, to afford the
taxpayer the maximum opportunity for using the credit. See
I.R.C. Sec. 38(a).
The inconsistency in carryback/carryforward periods is not
only inequitable, but also complicates the tax laws. The
current rules create administrative burdens for the government
and taxpayers alike. More fundamentally, the rules effectively
penalize taxpayers that experience operating losses, thereby
creating a windfall for the federal government that may
``collect'' a substantial portion (if not all) of the FTCs
previously earned and claimed because of the unduly short
carryback/carryforward period. Current law effects an
especially harsh result in respect of taxpayers in cyclical
industries whose ability to utilize FTCs is limited because of
income fluctuations and start-up companies with initial losses.
Section 201 of H.R. 2018 would expand the FTC carryforward
rules to 10 years, bringing them more in line with the rules
for net operating losses and general business tax credits.
Although the Institute believes that the rules for the three
credits should be the same, we recognize that the proposal
would limit the situations where the purpose of the FTC--the
elimination of double taxation--is frustrated by
unrealistically short carryover periods. We also endorse
section 206, which would change the ordering rules whereby any
carryover FTC would be taken into account before the current
year's credit. Permitting the oldest credits to be used first
would mitigate the problem of expiring credits.\6\
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\6\ We recognize that legislation has been proposed (e.g., S. 1134,
the Affordable Education Act of 1999, and S. 331, the Workers
Incentives Improvement Act) to shorten the FTC carryback from two years
to one and expand the carryforward from five years to seven. Enactment
of this revenue raiser would exacerbate the double taxation caused by
expiring FTCs, particularly for companies in cyclical industries.
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C. Treatment of Overall Domestic Loss. Section 904(f) of
the Code provides for the ``recapture'' of ``overall foreign
losses'' where the taxpayer sustains a foreign-source loss in
one year and there is foreign-source income in a subsequent
year; the recapture is accomplished by treating income in the
later years as domestic-source income. The law does not,
however, provide for similar recapture treatment when there is
an overall domestic loss that is offset against foreign income
in one year and in a subsequent year there is sufficient
domestic income to otherwise absorb the domestic loss.
Section 202 of H.R. 2018 would apply a resourcing rule to
U.S. income where the taxpayer has suffered a reduction in the
amount of its FTC limitation due to a domestic loss. The bill
would recharacterize into foreign-source income U.S.-source
income (up to 50 percent of taxable income) earned in a year
subsequent to a year in which an overall domestic loss offset
foreign-source income. Adoption of this provision not only
would provide parallel treatment for foreign and domestic
losses, but would also foster U.S. competitiveness. TEI
recommends enactment of the provision.\7\
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\7\ The bill's introduction of an overall domestic loss provision
would remedy an inequity faced by taxpayers attempting to claim FTCs.
This reform would not eliminate the need to address current section
904(f) (relating to overall foreign losses), which limits a taxpayer's
ability to claim FTCs. Consideration should be given to either
repealing or modifying both the overall foreign loss rules and section
864(e)'s interest expense allocation provisions, because these rules
place U.S. corporations at a competitive disadvantage.
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D. ``Look-Through'' Rules for Dividends, Interest, Rents,
and Royalties from 10/50 Companies. The 1986 Act categorized
foreign affiliates that are owned between 10 and 50 percent by
a U.S. shareholder as a ``noncontrolled section 902 company''
and created a separate FTC limitation for each such company.
The requirement that dividends from each noncontrolled section
902 company be placed in a separate ``basket'' was generally
recognized as among the most maddeningly, mind-numbingly
complex rules of the 1986 Act's provisions. Last year, Congress
acted to remedy this problem by permitting taxpayers to elect a
``look-through'' rule for dividends similar to the one provided
for CFCs under section 904(d)(3). The use of this rule was
delayed, however, until 2002.
Section 204 of H.R. 2018 would advance the effective date
of the 1998 provision to taxable years beginning after December
31, 1999; section 205 would expand look-through treatment to
include interest, rents, and royalties. TEI agrees that
enactment of these provisions would alleviate some of the
complexity in current law and for sophisticated taxpayers might
be especially beneficial. From an administrative perspective,
however, we suggest that a better approach would be to permit
dividends from noncontrolled corporations to be aggregated into
a single basket.
III. Other Provisions
A. Limitation on UNICAP Rules. As enacted in 1986, section
263A of the Code requires the uniform capitalization of certain
direct and indirect costs, including interest, incurred with
respect to property produced by the taxpayer or acquired for
resale (the ``UNICAP rules''). Although section 263A applies in
the foreign context, the revenue raised by application of the
UNICAP rules to foreign subsidiaries is small compared with the
administrative burden they impose on taxpayers.
Section 302 of H.R. 2018 would provide that the UNICAP
rules of section 263A apply to a non-U.S. person only to the
extent necessary for purposes of determining the amount of tax
imposed on Subpart F income or on U.S. effectively connected
income. It is a simplifying provision that should be
adopted.\8\
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\8\ The adoption of the GAAP E&P rules discussed on pages 5-6 of
this submission would render this change unnecessary.
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B. Study of Interest Allocation Rules. H.R. 2018 requires
the Treasury Department to conduct a study of the rules under
section 864(e) of the Code relating to the allocation of
interest expense among members of an affiliated group.
TEI commends the Chairman for recognizing that the interest
allocation rules are in desperate need of reform. In our view,
the interest allocation rules were enacted as a revenue raiser
in 1986 and are not justified on economic grounds. The rules
have spawned not revenue so much as a series of complex
transactions to minimize their effect. Hence, TEI believes that
section 864(e) should be repealed. We are confident that the
Treasury study will confirm that view and urge that action be
taken as soon as possible.
C. Reporting Requirements for Foreign-Owned Corporations.
Section 6038A of the Code sets forth reporting requirements for
any corporation engaged in a trade or business in the United
States that is at least 25 percent owned by a foreign person.
Substantial penalties are imposed for noncompliance. The
statute contains no de minimis reporting rule. In addition,
Treas. Reg. Sec. 1.6038A-3(f)(2) provides that documents
maintained outside of the United States must be produced within
60 days of a request by the IRS and must be translated within
30 days of a request for translation.
Section 311 of H.R. 2018 would provide that a reporting
corporation will not be required to report any information with
respect to any foreign-related person if the aggregate value of
the transactions between the corporation and the related person
during the taxable year does not exceed $5 million. In
addition, the provision would expand the time in which a
taxpayer may produce translations of documents from 30 days to
at least 60 days. The subsection also provides that nothing
shall limit the right of the taxpayer to request additional
time to comply with the request for translation.
TEI supports enactment of the de minimis rule, which will
ease the reporting burdens on taxpayers. In addition, we agree
that an expansion of time in which to produce translated
documents recognizes the practical difficulties inherent in a
global marketplace where documents may be kept in various
languages and at various locations. We suggest, however, that
the proposed language--``nothing shall limit the right of the
taxpayer to request additional time''--be revised to read ``the
Internal Revenue Service shall have the authority to grant all
reasonable requests for additional time to furnish the
requested translations.''
Safeguarding the APA Process
Congressman Houghton has voiced support for legislation
that would amend section 6103(b)(2)(A) of the Code to provide
protection from disclosure for negotiated agreements between
taxpayers and the IRS. Included in the proposal's protection
are advanced pricing agreements (APAs), as well as closing
agreements and competent authority agreements.\9\ The bill
responds to recent litigation to seeking disclosure of APAs and
closing agreements.
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\9\ The bill would also amend section 6110(b)(1) to exclude these
agreements from the definition of ``written determinations'' subject to
disclosure.
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The APA program is designed to forestall contentious and
expensive transfer pricing disputes between taxpayers and the
IRS. A voluntary venture, it is one of the IRS's success
stories of the 1990s and furthers the goal of eliminating
unnecessary complexity in the tax law. Each APA specifies a
methodology negotiated between the specific taxpayer and the
IRS (and, at times, a foreign country) for the taxpayer to use
in determining its intercompany pricing and thereby assure
compliance with section 482 of the Code. The information set
forth in an APA--the method by which a company determines its
profit margins--is highly fact specific and involves sensitive
financial and commercial information. Almost 200 APAs have been
negotiated since the program began in 1991 and the program has
been used as a model by the international community as a means
of minimizing double taxation of income and settling costly
transfer pricing disputes.
Since the inception of the APA program until January 8,
1999, the IRS treated the APAs and their supporting
documentation as tax return information that was not subject to
disclosure. On that date--in conjunction with a suit to compel
release of the APAs under the Freedom of Information Act--the
IRS said it now takes the position that APAs constitute
``written determinations'' under section 6110 of the Code and
therefore may be publicly released in a redacted form. TEI
believes that the IRS's position is wrong and we have filed a
brief amicus curiae in the case.
As a professional association dedicated to the development
and implementation of sound tax policy, TEI is concerned that
the release of the APAs--even in redacted form--will adversely
affect the APA program. Taxpayers submitted the pricing
information to the IRS with the understanding that the
information would be subject to the same confidentiality
restrictions as tax returns. Companies' legitimate privacy
interests--as well as the privacy interest of our treaty
partners in respect of bilateral APAs--will be compromised by
the release of the APA background documents and their ability
to compete effectively in the marketplace could be harmed.
Moreover, the very redaction process that accompanies release
of the information would be extremely difficult, burdensome,
and time-consuming.
More important, the knowledge that such information will be
released in the future will discourage taxpayers from seeking
APAs. TEI believes that the APA program represents the best way
for companies to resolve transfer pricing controversies and
avoid costly and time-consuming audits and litigation. At a
time when the IRS is seeking more taxpayer-friendly ways of
doing business, programs such as the APA program should
actively be encouraged, rather than jeopardized by a mistaken
interpretation of the law.
For these reasons, TEI strongly supports enactment of
legislation to protect APAs and supporting documents from
disclosure.
Conclusion
Tax Executives Institute appreciates this opportunity to
present its views on international complexity and
simplification. Any questions about the Institute's views
should be directed to either Michael J. Murphy, TEI's Executive
Director, or Timothy J. McCormally, the Institute's General
Counsel and Director of Tax Affairs. Both individuals may be
contacted at (202) 638-5601.
Chairman Houghton. Thank you very much, Mr. Ezrati.
I am going to forego my questions until the end. I would
like to pass the questioning over to Mr. Coyne.
Mr. Coyne. Thank you, Mr. Chairman, and thank you for your
testimony.
I would just like to ask, in considering the various
provisions of H.R. 2018, I wonder if each of you would be able
to tell us how the provisions would affect each of your
individual firms, and I know, Mr. Ezrati, you are representing
the TEI, but if you could tell us about Hewlett-Packard?
Mr. Ezrati. Certainly. If I can focus on just a few of
them. The adoption of the elective GAAP E&P provisions will be
a major simplification. Hewlett-Packard has about 65 foreign
subsidiaries in which we employ a similar number of people like
Mr. Luby does to help HP comply with these provisions. This
would allow us to employ them in other active pursuits rather
than complying with the tax law.
The treatment of the European Union as a single country
would be key for our business in Europe. The trade barriers are
coming down in Europe for our competitors, but, right now, we
are obligated to create a separate subsidiary in each one of
those countries. Our businesses don't want to do business that
way. They want a central spot in Europe where they can
distribute all over the continent, and, right now, the U.S. tax
rules make that difficult.
Mr. Coyne. Mr. Luby.
Mr. Luby. As I mentioned, 907, of course, would save us a
lot of compliance costs. The GAAP rules for Subpart F would be
important. Another important provision is pipeline
transportation income provision. That makes pipeline
transportation income Subpart F, currently deemed up should it
cross the border. That is active business income. It is very
difficult to ship pipelines around, as you might expect, so
that would be important to our industry. And look-through
treatment for the sales of partnership interests would be a
major improvement for our industry. As you know, our
investments are so large, we have to do joint ventures that
result in partnerships, and we think that the treatment of the
sale, the partnership interests, should be the same as the
underlying income.
Mr. Coyne. Could each of you give just a brief description
about how your international operations would change as a
result if these changes were to be implemented?
Mr. Ezrati. Again, I will focus on the European Union. I
think we would see a smaller infrastructure in Europe and a
greater ability to distribute products all over Europe. That
would be key. Right now, customers in Europe don't want to deal
with salespeople and service operations and markets in each of
their countries; they want to deal with one European-wide
operation, and that is what our businesses want to move to. As
we move to more electronic commerce, we just want one central
focal point in Europe, and we will be able to achieve that.
Similarly, operations in China would improve dramatically
if there were improvements in the Subpart F arrangements,
because it is very difficult to do business in China with
currency controls and similar restrictions. Improvements in
Subpart F would help us dramatically in that major market.
Mr. Luby. The 10/50 provisions have hurt us enormously in
various joint ventures. You have situations such as in Malaysia
where they don't really want to hear about a partnership; they
don't want to hear about ``check the box;'' they want their own
kind of corporation. Therefore, we have to forego investments
because of the return detriment. I used an example. We have had
situations in the North Sea where we have actually had to pay
our partner's share of the gross receipts tax in order to get
them to agree to a partnership so that we could avoid the
earnings hit of 10/50, and we have had situations in China
where we have actually deferred investments because of this
provision.
Mr. Coyne. Thank you.
Chairman Houghton. Thank you, Mr. Coyne. Mr. Watkins.
Mr. Watkins. Thank you, Mr. Chairman. I am delighted you
are having these oversight hearings on the international tax
simplification.
I was in Congress for 14 years before being out about 6
years, and as I worked on a number of things--in fact, in the
early 1980's, I put an international trade center in the State
of Oklahoma, because I realized that we were not prepared, I
think, in the global competitive world that we were going to be
entering in. I was out about 6 years and decided I would try to
come back for two reasons: No. 1, I felt like a balanced
budget, that I had kind of been unfair to my children and
grandchildren for not in those 14 years being able to achieve
that, and the other reason was I wanted to try to do my darnest
to prepare this country for a global competitive economy, a
21st century global competitive economy. You and I might be
able to escape being personally involved as much as a lot, but
the young people--our children and grandchildren--have no
choice; they are thrust into that. And by a 21st century global
competitive economy, I mean one that has got less taxation, a
more simplified or fair way to work things through on taxation.
No. 2, less regulation that we have to try to uncomplicate that
situation as much as we can, and, third, less litigation. I
just read something, Mr. Chairman, coming up here that in
Japan, they have got about 16,000 lawyers and we have got over
900 and some odd thousand, nearly a million, and lots of times
that is dealing with a lot of liability
But I guess what I am concerned about is--or I would say
that I know the Chairman here and also our Ranking Members want
to make sure we have a less complicated and more workable
allowing us to be competitive overseas, and I kind of mentioned
those three things, because I think that gives us, within that
structure, we have got an overburden--what I call an overburden
in the oil patch--an overburden of being able to do business
overseas.
So, are you involved in pipeline construction,
multinational pipeline construction, overseas, Mr. Luby, at
your company?
Mr. Luby. Yes, we are, and we are also users of pipelines
owned by others, so that the change in the bill, for example,
would, hopefully, either lower our investment costs or lower
the costs of renting space in the pipeline.
Mr. Watkins. I think that this question is asked kind of
indirectly, but probably the three most general changes that we
could look at, I mean, that would affect all businesses and
industry, so to speak, allowing us to be more competitive in
that global economy, what would your thoughts be? What three?
Mr. Luby. I would substantially reform the Subpart F rules
to a major extent. I believe that since pay-go became the watch
word here that policy flew out the window and basically the
foreign area didn't have a constituency, and, therefore, a lot
of the pay-fors for domestic initiatives, be they child care
credits or what--and I am not criticizing child care credit; I
am just using that as an example--have been paid for out of our
international rules with no policy justification. That is why
we have 10/50; that is why we have the PFIC overlap; that is
why we have 956A that you repealed in 1997 due to these
gentlemen's efforts. So, that is one area that I think needs to
really be reworked.
And the other area in international is the various foreign
tax credit baskets. There is a chart right here; we have got
nine of them. There is no reason on Earth that we need to have
nine separate foreign tax credit baskets in order to determine
whether we owe a residual U.S. tax on foreign source income. It
is just nonsense, and it wastes money on compliance. Those are
the major things.
Mr. Watkins. We appreciate those. Any quick thoughts you
might have on----
Mr. Ezrati. Absolutely. The only thing I would add is that
the adoption of the elective GAAP E&P would greatly simplify
things, and removal of the 90-percent limitation on using the
foreign tax credits to offset U.S. alternative minimum tax
would remove all double taxation in that area.
Mr. Watkins. I appreciate those comments on that, and,
again, I want to thank the Chairman for having these, because
we truly are in this global competitive world, and we have got
to streamline some things, and I think it has got to begin with
taxes and then regulatory policies we have and also the
litigation situation we are confronted in trying to do that and
conduct that business. So, Mr. Chairman, thank you so much.
Chairman Houghton. Thanks, Mr. Watkins.
Mr. Levin.
Mr. Levin. Mr. Chairman, should I defer to Ms. Dunn, if she
would like. I am not on the Subcommittee, so maybe I should--I
don't want to be chivalrous but also abide by protocol.
Chairman Houghton. Sure. Ms. Dunn has joined us. Would you
like to inquire?
Ms Dunn. I simply want to thank you gentleman for coming
over. I had lunch, Mr. Luby, with one of the folks who works
for your company today at a speech that I gave, and, so
greetings from her, and thank you for coming and testifying on
something that is critically important as we look at the rules
we set up to become more competitive through industry.
Chairman Houghton. Mr. Levin.
Mr. Levin. Thank you, Mr. Chairman.
If I might just make a couple of comments, because this is
really interesting testimony, and I believe it relates to my
first comment. There is a lot of skepticism here on this level
and the next level about simplification that it can ever occur.
In this field, it does seem feasible. Some steps you can take,
but further steps can be taken that are sound tax policy. They
simply can be made much less complex.
Second, I would hope that you could help us inspire some
discussion of this. I think the Chairman of the Full Committee
is interested in international tax issues. I think that is true
on both sides of the aisle. It is unclear what is going to be
the life of the tax bill here, and I do think that we need to
foster some further discussion to ensure that the international
tax area is part of the next.
So, if you could continue to raise these issues. It is not
easy, because these are detailed provisions, but you have been
able to give a few concrete examples in response to Mr. Coyne's
excellent questions as to what it would mean for your company
within the
parameters of sound tax policy, and, Mr. Chairman, I would
guess you would share my sentiments that we need all the help
we can get to try to boil these issues down so that they are
understandable, and we avoid having people choose up sides as
happens too much around here kind of an automatic or
stereotypical basis. These provisions are good for basic
economic operations in this country, and therefore can have a
positive impact on both business and workers, the business
community and workers.
So, your testimony has been very salient, and I hope you
will help us spread the word.
Mr. Ezrati. Absolutely.
Chairman Houghton. Thank you, Mr. Levin.
We have been joined by Mr. Neal. Mr. Neal, would you like
to----
Mr. Neal. I don't have any questions.
Chairman Houghton. No questions. OK, well, I have some
questions. They are really sort of generic questions.
You know, Mr. Levin and I have got a bill out there, and I
would really like you to sort of coalesce your ideas into what
are the two or three things in that bill that really are going
to help you. And then, also, secondly, where do we go from
here? What other things--what more should we be doing? So, I
throw those questions to both you gentleman for an answer.
Mr. Ezrati. I don't want to repeat myself too much, but
here are three things: adoption of the GAAP E&P provisions,
removal of the 90-percent limitation on the foreign tax credit
for the alternative minimum tax, and go beyond studying to
treat the European Union as a single country for purposes of
Subpart F. Not just for my company, but I think for the
majority of the 5,000 members of TEI and the 2,700 companies
they represent, it will make a huge difference.
And let me echo Mr. Luby. If you want to know where to go
from there, it's to those nine foreign tax credit baskets that
we enacted in 1986 and that are the worst complexities we face
today. Repeal those nine baskets, and the world would be a lot
easier, and U.S. business would be more competitive.
Chairman Houghton. Do you feel the same about the Far East
as you do about the European Union?
Mr. Ezrati. I think it is a little more difficult in the
Far East; it is not one economic trade block. I could see it
actually happening in Latin America more quickly than in the
Far East. As the Mercisol countries move together to form one
trade block, we are finding that U.S. companies will be less
competitive in Latin America, and so I could see the same thing
happening there, especially after NAFTA where you removed those
trade barriers, only to erect, as Mr. Levin said, tax barriers.
It is going to be a little more difficult in Asia, because they
haven't come together as one trade block. So, as I said,
substantially reforming Subpart F will make things lots easier
in China to do business there.
Chairman Houghton. All right. Mr. Luby.
Mr. Luby. In addition to the items I have already
mentioned--which I won't bore you with going over again--I
would mention that for our membership doing something again on
active financing income would be very helpful, and I know that
you have a witness in another panel that will address that much
more eloquently than I ever could. Extending the foreign tax
credit carryover provision would be of great assistance.
Because of the mismatch between
foreign law and U.S. law, we sometimes end up under the current
system with credits expiring. That is not the purpose of the
credit system. The purpose is to eliminate double taxation. And
we appreciate your including a call for an interest allocation
study. That is definitely needed. Something needs to be done
there. The way that works today, it rigs the system so that we
are in effect double taxed. So, those would be the items that I
would mention in addition to the earlier items in response to
other questions.
Chairman Houghton. OK, thanks very much.
We have been joined by Mr. Weller. Would you like to ask
questions?
Mr. Weller. Thank you, Mr. Chairman.
I guess as we look this year at what type of tax cut we are
going to provide--and, of course, we have opportunity in this
year's budget for almost a $770 billion tax cut over 10 years--
I am one of those who advocates that as we put together those
tax provisions in this year's budget, we should focus on
simplifying and bringing fairness to the code, and many in the
business community have said,
Well, you know, when you have these temporary extenders
that every year have to reauthorize, that is really an issue of
fairness, because it is hard to make a decision on how to move
forward.
And, of course, the Subpart F treatment of financial
services with overseas income, I was wondering can you give
some examples of whether or not it is fair to annually extend
that provision for
financial services?
Mr. Luby. We don't have--my company, personally, doesn't
have a problem in that area, because we are not in that
particular business, but I would say that based on the way we
do our corporate plans, we look beyond the next quarter,
obviously; we look 3 to 5 years out in planning our business
and in planning where we may want to budget our investments. If
I have a provision that hurts me competitively, that is
renewable annually, then that is going to definitely crimp my
plans beyond that one-year outlook, and when I am looking at
projects or investments that are very substantial in the
context of what I have available--the shareholders' money at
risk--it can cause me to make wrong or less than optimum
decisions, so that is about as much detail as I could give you
on that point.
Mr. Weller. Mr. Ezrati.
Mr. Ezrati. We have looked at that financial services
provision, and the company has thought about adjusting the way
we finance products, and we do a lot of financing, though the
provision does nothing for us at the moment, because it is so
narrowly crafted and so complex. But we have asked, ``Should we
adjust the way we do business to take advantage of that
provision? Will that make us more competitive in financing our
products versus our competitors?'' And you say, ``But is it
worth it? It will take us 6 months to gear up for it, and it is
a year provision.'' Thus, I do think it is terribly unfair that
those provisions are enacted year-by-year, and you need to
guess whether they will be there next year. In fact, this
provision itself, when it was originally enacted, was different
from the one you extended last year. It is even more difficult
when it is different each year.
Mr. Weller. I am one who believes that we should, of
course, make that provision permanent; same with the R&D tax
credit or opportunity tax credit, because businesses are making
decisions, having to invest large amounts of money, trying to
make decisions, and, of course, the consequence in not knowing
if that provision in the tax code is going to be there long-
term. If we are unable to make Subpart F permanent, what is the
minimum number of years you feel is necessary, really, from a
management standpoint when you are considering how to invest
millions of dollars?
Mr. Luby. In the context of our company, I would say a
minimum of 3 years.
Mr. Weller. A minimum of 3? Would you agree, Mr. Ezrati?
Mr. Ezrati. I think I would like to go even longer. You
mentioned the research and experimentation tax credit, and I
think that has never been longer than about 5 years. I now hear
that 5 is now considered permanent, but that is what I would
like to see, because that is the time horizon for making large
investments. Three might work, but five would certainly be
preferable.
Mr. Weller. Mr. Chairman, I certainly believe from a
fairness standpoint, if we are asking these employers to invest
for the long-term, we should certainly ensure that the tax
provision they are basing decisions on is for the long-term, as
well, and that is why I hope we can work together not only for
permanency but, at a minimum, for a long multiyear extension so
they can make some long-term decisions.
Chairman Houghton. I agree with you, Mr. Weller.
I have just one more question, The National Foreign Trade
Council came out with a report on anti-deferral rules. Can you
sort of spell out a few of those things--how they compare with
other countries, and where we end up if we proceed with those
rules?
Mr. Luby. Well, an example is the one I used earlier in the
testimony. The French exempt back these incomes from foreign
taxation that comes from foreign sources, whereas, we do not.
In many cases, active financing is a good example. That is
active business income to our banking companies, and they have
to pay current U.S. tax on that income. That puts them at a
definite disadvantage vis-a-vis a French banking competitor, if
they are looking at investments in Europe or elsewhere around
the globe.
Other countries are very similarly situated. You hear about
territorial versus our type of system, and you find that
although very few have a territorial system, well, they really
have a territorial system, but it is with a wink and a nod so
that they can say that they followed our lead and have
controlled foreign corporation rules. Great Britain has
tightened their rules quite a bit, but they still allow a
Bermuda headquartered company to put in low-taxed financing
income and high-taxed other income and mix it all up, and guess
what? You average it out, and there is no residual for you to
pay for tax. We have a competitor--who I am sure you can
guess--that is headquartered both there and in the Netherlands
that happens to use that to their advantage when they are
competing with us on projects.
So, our report shows that Subpart F needs to be reexamined;
that it is a drag on the competitiveness of U.S. companies. We
have now formulated recommendations that are coming out of that
report, and we hope to release them in the very short term,
and, as Les said a few minutes ago, echoing my earlier comment
on the baskets, we have now begun the second phase of that
project, which is a study of the foreign tax credit, and we
will have recommendations come out of that, as well. So, we
will, at least at the NFTC, heed Mr. Levin's suggestion and
continue to bring attention to the area of international tax.
Chairman Houghton. OK, well, thank you very much. We look
forward to working with you, and, gentleman, I really
appreciate your testimony. Thank you.
Mr. Ezrati. Thank you.
Chairman Houghton. Now, I will call the panel composed of
Mr. Cox, who is Vice President of Tax at BMC Software in
Houston, Texas; Denise Strain, General Tax Counsel at Citicorp
in New York; Thomas Jarrett, Director of Taxes at the Deere
Company in Moline, Illinois; Gary McKenzie, Vice President of
Tax for the Northrop Grumman Corporation in Los Angeles,
California; and Stan Kelly, Vice President of Tax for Warner-
Lambert in Morris Plains, New Jersey.
If you would come forward.
Mr. Cox, good to have you here. Would you proceed?
STATEMENT OF JOHN W. COX, VICE PRESIDENT OF TAX, BMC SOFTWARE,
INC., HOUSTON, TEXAS
Mr. Cox. Thank you, Mr. Chairman. Good afternoon. I am John
Cox, vice president, Tax, for BMC Software. BMC is
headquartered in Houston, Texas and is a worldwide developer
and vendor of software solutions for automating application and
database management across host-based and distributed systems
environments. I thank the committee for giving me this
opportunity to present my views on international tax
simplification.
The U.S. software industry currently leads the
international marketplace for developing new technologies used
to create new products. This technology is the product of U.S.-
based research and development which produces market leading
patents and copyrights. The ability to efficiently use these
intangible assets throughout the world is a key component in
the operations of U.S. software businesses.
Currently, U.S. tax policy hinders U.S. competitiveness
when compared with the tax regimes of other countries. Not only
is our worldwide system of taxation more burdensome than
systems of many of our trading partners, but also our
incentives to encourage R&D in the United States are less
beneficial than the incentives offered by many of our trading
partners. In addition, U.S. rules for taxing foreign income are
extraordinarily complex. As a result, an inordinate amount of
resources are devoted to structuring transactions that will
accomplish the business goals of U.S. companies without
incurring a heavy tax burden. BMC applauds the efforts of
Chairman Houghton and Congressman Levin to bring simplicity to
the international tax rules of the Internal Revenue Code.
Although I favor many, if not most, of the proposals in
H.R. 2018, my testimony today will highlight two provisions
that I believe will particularly helpful to the software
industry. In addition, my testimony will include two issues
that are not addressed in the current legislation.
I support the bill's alternative minimum tax proposal.
Under the current law, U.S. taxpayers subject to the AMT regime
may claim a foreign tax credit against their alternative
minimum tax only to the extent of 90 percent of the actual tax
paid or accrued in foreign countries. Thus, foreign tax credits
can never entirely extinguish U.S. tax liability under the AMT
regime.
This rule has been widely criticized on several grounds.
First, foreign tax credit is not a tax preference but simply a
means of reducing unfair and unavoidable double taxation that
would otherwise fall on U.S. taxpayers earning income abroad.
Second, the AMT limitation is fundamentally inconsistent with
international tax treaty norms. U.S. treaty partners have
frequently expressed dissatisfaction with this feature of U.S.
law. Finally, the 90-percent limitation adds complexity to the
AMT regime, which is notoriously complicated even without the
provision.
I also support the effort to move towards treating the EU
as one country for Subpart F purposes. Under current law, the
member countries of the EU are treated as separate countries
for purposes of the various ``same-country exceptions'' to
Subpart F income. Treating the EU as a single country for these
purposes would help U.S. corporations operating in the EU take
full advantage in that market, and it would also help the U.S.
corporations compete more effectively against EU corporations
that are already able to enjoy the benefits of these
initiatives.
I now turn to two international tax matters that are not
covered by the bill but that deserve the Committee's attention.
The first is the inconsistent characterization of cross-border
transactions by the United States and its trading partners. For
example, income from the sale of a disk containing a computer
program might be treated as business profits by the United
States but as a royalty by the customer's country of residence.
Double taxation can therefore arise. These problems have in
fact cropped up repeatedly in cross-border activities for
software companies. Treaty mutual agreement procedures can be
effective, but they are costly, time-consuming, and uncertain.
We recognize that this problem is not resolvable by unilateral
U.S. action; however, we do encourage Congress and the
administration to pursue all available opportunities for
resolving these issues, both treaty-by-treaty and
multilaterally.
The last point I wish to discuss is the challenge to the
Foreign Sales Corporation regime now pending before the World
Trade Organization. The FSC rules are extremely important to
U.S. software companies, which derive 30 percent of their
revenue from exports, and the industry is grateful that
Congress clarified this application of these rules to software
licenses as part of the 1997 Tax Act. The FSC rules were
enacted to offset a competitive disadvantage faced by U.S.
exporters, because the U.S. tax system is not as generous to
exports as are the tax systems of our trading partners. These
concerns still exist today. As we await a final decision from
the WTO panel on the FSC issue, I wanted to make you aware of
the importance of this issue to the software industry.
In conclusion, Mr. Chairman, thank you again for this
opportunity to present my views on these important issues. I am
happy to answer any questions you might have.
[The prepared statement follows:]
Statement of John W. Cox, Vice President of Tax, BMC Software, Inc.,
Houston, Texas
Introduction
I am John W. Cox, Vice President of Tax for BMC Software,
Inc. BMC, headquartered in Houston, is a worldwide developer
and vendor of software solutions for automating application and
data management across host-based and open system environments.
The software industry is growing at an extremely rapid pace.
Since 1994, software sales have been growing at a constant rate
of 15.4% annually, which is three times the growth rate of the
GDP. Much of the growth in the industry is due to expansion in
overseas markets. BMC operates in approximately 30 different
foreign markets. Our fiscal year 1999 revenue was $1.3 billion,
of which approximately 40% is from foreign sales.
The U.S. software industry currently leads the
international marketplace in developing new technologies used
to create new products. This technology is the product of U.S.-
based research and development, which produces market leading
patents and copyrights. The ability to efficiently use these
intangible assets throughout the world is a key component in
the operations of a U.S. software business.
In recent years the Congress and the Administration have
made noteworthy improvements in the international tax rules
affecting software companies. First, in 1997 Congress passed
legislation clarifying that software exports qualify for FSC
benefits. Then in 1998 the Treasury finalized regulations
providing clear guidance on the proper characterization of
software revenue that is generally consistent with industry
business practice and will help reduce the potential for
burdensome taxation by our trading partners. We thank you for
these improvements. However, current U.S. tax policy still
hinders U.S. competitiveness, when compared with the tax
regimes of other countries. Not only is our worldwide system of
taxation more burdensome than the systems of many of our
trading partners, but also our incentives to encourage R&D in
the United States are less beneficial than the incentives
offered by many of our trading partners.
In addition, U.S. rules for taxing foreign income are
extraordinarily complex. As a result, an inordinate amount of
resources are devoted to structuring transactions that will
accomplish the business goal of U.S. companies, without
incurring a heavy tax burden. BMC applauds the efforts of
Chairman Houghton and Congressman Levin to bring simplicity to
the international tax rules in the Internal Revenue Code. My
testimony today will highlight provisions in H.R. 2018, the
``International Tax Simplification for American Competitiveness
Act of 1999,'' that we believe will be particularly helpful to
the software industry. In addition, my testimony will include
two issues that are not addressed in the legislation--(1)
inconsistent characterization of income by the United States
and other countries, and (2) the WTO controversy between the
United States and the EU over the U.S. foreign sales
corporation (FSC) rules.
Provisions in H.R. 2018
A. AMT Foreign Tax Credit Rules
Under current law, taxpayers are required to pay an income
tax that is the greater of their tax computed under the normal
rules of the Internal Revenue Code (the ``Code'') or the
special ``alternative minimum tax'' (``AMT'') rules. The AMT
regime is intended to ensure that high-income taxpayers making
extensive use of so-called ``tax preference items'' pay at
least a minimum level of tax. The recapture of the tax benefit
afforded by the tax preference items is generally achieved by
adding back to income the ``excessive'' portion of the
deduction or exclusion granted by the preference.
The AMT regime also limits the ability of AMT taxpayers to
use otherwise allowable credits against their overall U.S. tax
liability. In the case of the credit allowed for income taxes
paid to foreign governments (the foreign tax credit or
``FTC''), the regime essentially limits the credit to 90% of
the U.S. tax owed. This rule ensures that FTCs can never
entirely extinguish U.S. tax liability under the AMT regime.
This rule has been widely criticized on several grounds.
First, the FTC is unlike most other credits, which are
essentially intended to act as incentives to modify taxpayer
behavior (such as the low-income housing credit or the alcohol
fuels credit). The FTC is remedial in nature in that it seeks
to avoid double taxation of income. Far from being a tax
preference intended to reward taxpayers that take certain
affirmative action, the FTC alleviates the unfair and
unavoidable double taxation that would otherwise fall on U.S.
taxpayers earning income abroad. It is illogical to treat this
relief provision as a ``tax preference'' subject to overuse or
abuse.
Second, the AMT limitation is fundamentally inconsistent
with international tax treaty norms. Relief from double
taxation is the primary purpose of income tax treaties, and the
credit provision is widely recognized as an acceptable method
of complying with the treaty obligation. The majority of the
over 1200 bilateral income tax treaties in force throughout the
world provides for double taxation relief through a credit
mechanism.
Limiting the FTC to 90% of the U.S. tax due prevents tax
treaties from achieving their full objective of eliminating
double taxation. While most U.S. treaties are drafted in a way
that prevents the limitation from technically violating the
treaty, U.S. treaty partners have frequently expressed
dissatisfaction with this feature of U.S. law, which
contravenes internationally accepted principles.
Finally, the FTC limitation adds complexity to the AMT
regime, which is notoriously complicated even without the
provision. Because the FTC is applied separately with respect
to separate categories or ``baskets'' of income, the AMT
limitation is not a single computation, but requires a series
of computations that must be undertaken in addition to the
normal FTC calculations.
Section 207 of the Bill would repeal the FTC limitation now
found in the AMT provisions. For all of the reasons detailed
above, we endorse this proposal.
B. Treatment of the European Union
The controlled foreign corporation (``CFC'') provisions of
the Code impose current U.S. taxation on the U.S. shareholders
of foreign corporations that they control. This taxation is
limited to so-called ``subpart F income'' earned by the CFC.
Among the various categories of subpart F income is passive
income such as dividends, interest, rents, and royalties. The
policy underlying the current taxation of such income is that
it is inherently mobile, so that a worldwide group of
corporations can route the income to a low-tax jurisdiction and
avoid both U.S. and foreign taxes. Similarly, income from
sales, services, and insurance outside the CFC's country of
incorporation is subpart F income if related party transactions
are involved, on the theory that taxpayers could transfer
profits from these activities to a low-tax jurisdiction.
The Code provides an exception for certain dividends,
interest, rents, and royalties paid to a CFC by a related party
located in the same country as the CFC's country of
organization. Subpart F income also does not include sales,
services, and insurance income earned in that country. The
policy underlying these exceptions is that transactions
occurring in the same country will rarely, if ever, result in
inappropriate avoidance of local tax, and taxpayers should
therefore be free to adopt in each country corporate structures
and business operations that are not artificially affected by
tax considerations.
Under current law, the member countries of the European
Union (``EU'') are treated as separate countries for purposes
of the ``same country'' exception. Thus, payments of dividends,
interest, and similar amounts from an entity organized in one
EU country to a related entity in a different EU country are
treated for U.S. tax purposes as subpart F income. Sales,
service, and insurance income earned in another EU country may
also be subpart F income.
Section 102 of the Bill would direct the Treasury
Department to study the feasibility of treating the EU as a
single country for purposes of the same-country exception.
Under this approach, sales, service, and insurance income
earned anywhere within the EU by an EU country entity, as well
as passive income received from an EU affiliate by a controlled
foreign corporation in an EU member state would not generally
be treated as subpart F income.
We fully support the effort to move towards treating the EU
as one country for subpart F purposes. This approach would help
U.S. corporations operating in the EU take full advantage of
the EU initiatives to create a single market with the free flow
of goods, services, labor, and capital across national borders.
It would also help U.S. corporations compete more effectively
against EU corporations that are, by virtue of their countries
of residence, already able to enjoy the benefit of these
initiatives.
We understand that the Bill proposes only a study of the
issue because of concerns that the EU member countries have
different tax systems and rates. While we do not oppose a
Treasury study, we submit that Congress should consider more
immediate and direct action. The possibility of applying same-
country status to the EU has been under consideration by
Congress for several years.\1\ We question whether a Treasury
study, which would further delay direct Congressional
consideration of this important issue, would shed a great deal
of additional light on the area, particularly as the EU
countries continue to move toward integrating their tax
systems.
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\1\ See section 601 of H.R. 5270, the Foreign Income Tax
Rationalization and Simplification Act of 1992 (introduced on May 27,
1992) 102nd Cong., 2nd Sess.; H.R. 1401 (introduced on March 18, 1993),
103rd Cong., 1st Sess.; section 8 of H.R. 1690, the International Tax
Simplification and Reform Act of 1995 (introduced on May 24, 1995),
104th Cong., 1st Sess.; section 206 of S. 2086, the International Tax
Simplification for American Competitiveness Act (introduced on
September 17, 1996), 104th Cong., 2nd Sess.
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C. Expansion of subpart F de minimis rule
Under current law, a de minimis rule excludes all gross
income of a CFC from subpart F income if what would otherwise
be the CFC's gross subpart F income \2\ is less than the lesser
of (1) 5% of the CFC's gross income or (2) $1 million. Thus,
the maximum exclusion per CFC is $1 million, which will be
available only if the CFC's gross income equals or exceeds $20
million.
---------------------------------------------------------------------------
\2\ Technically, the test applies to the sum of gross foreign-based
company income and gross insurance income, but for most CFCs these are
the only categories of subpart F income that commonly arise.
---------------------------------------------------------------------------
The exclusion is an acknowledgement that it is difficult
for corporations to avoid earning some subpart F income--
interest on bank deposits, gain on the sale of unproductive
assets, small royalties, and similar items. If the bulk of the
CFC's income is active, however, it is administratively
burdensome to keep track of relatively minor amounts of subpart
F income, and there is little revenue to be gained by
attempting to tax such income currently.
The Code has contained the de minimis rule in its current
form since 1986. Before that year, the exclusion was available
if 10% or less of the CFC's gross income would otherwise be
subpart F income, with no dollar limitation. Section 103 of the
Bill would return to this 10% limitation and increase the
dollar threshold to $2 million.
We support this proposal. The return to the percentage
threshold under pre-1986 law leads to increased administrative
convenience and efficiency at a low revenue cost. The increase
in the dollar threshold is an appropriate adjustment to reflect
inflation, and CFCs with at least 90% active income should not
be burdened with the need to keep careful track of small
amounts of other income.
D. Extension of foreign tax credit carryforward
Under current law, unused foreign tax credits may be
carried back to the two previous taxable years and forward for
five taxable years. If not usable within that time period, they
expire, and the foreign taxes become a simple cost of doing
business. These unused taxes may not be deducted for Federal
income tax purposes, because they relate to a year in which the
taxpayer elected credit treatment.
Expiring credits are a problem for many companies in our
industry. Although it is often possible to control the timing
and amount of foreign taxes to some extent, thereby maximizing
the ability of the U.S. taxpayer to benefit from the credit,
five years may not be enough time in all cases to fully enjoy
this benefit. The result is that the U.S. taxpayer's overall
costs rise, and its ability to compete globally decreases, even
in cases where, taking a longer view, the overall worldwide tax
rate is no higher than the U.S. rate.
From the taxpayer's point of view, an unlimited carryover
of unused credits would of course be ideal. We recognize,
however, that from the government's point of view an unlimited
credit might pose an administrative and recordkeeping problem.
Section 201 of the Bill would extend the current carryforward
period to ten years. We believe that this period represents a
reasonable--and more realistic--compromise that accommodates
the concerns of both taxpayers and the government.
E. Recharacterization of overall domestic loss
U.S. taxpayers with foreign branch operations may deduct
losses generated by the branch against U.S. source income in
the same taxable year. This deduction reduces U.S. source
income subject to U.S. tax. When in a subsequent year the
branch generates income subject to foreign tax, the taxpayer
may be able to claim a foreign tax credit to offset the U.S.
tax on the income. This arguably creates a ``double benefit''
for the taxpayer arising solely from the timing of foreign
income and loss.
In 1976, Congress enacted an overall foreign loss (``OFL'')
recapture rule to prevent this result. The Code provides that a
taxpayer must create a special OFL account whenever a foreign
source loss reduces U.S. source income. If positive foreign
source income is generated in a later year, the income is re-
sourced to the United States, effectively preventing foreign
taxes on that income from being credited against the U.S. tax
due.
In the reciprocal situation, however, where timing rules
could operate to the taxpayer's detriment, there is no
corresponding recapture rule. For example, if a taxpayer has a
U.S. source loss that offsets foreign source income in the same
year, the taxpayer's available foreign tax credit may be
reduced because the foreign tax credit limitation is computed
on the basis of net foreign source income. In a later year,
U.S. source income is not re-sourced to foreign, so that the
available foreign tax credit in that year is not increased.
This lack of parallelism has often been criticized as
illogical, because it corrects the mismatch when favorable to
the government but not when favorable to the taxpayer.\3\ In
addition, taxpayers lose the value of their foreign tax credits
as an offset against double taxation of income at a time when
they are already losing money in the United States. Section 202
of the Bill would remedy this defect and provide for equitable
treatment of taxpayers by applying the same rules to both
foreign and domestic losses. We support this provision as a way
of adding fairness and neutrality to the international
provisions of the Code.
---------------------------------------------------------------------------
\3\ See, for example, Isenbergh, International Taxation: U.S.
Taxation of Foreign Taxpayers and Foreign Income (1990), at para.
21.3.3, which notes that the subsequent U.S. source income ``will
effectively be overtaxed.''
---------------------------------------------------------------------------
F. Ordering rules for FTC carryovers
Under current law, a taxpayer with FTC carryovers in a
taxable year must first claim credits for taxes paid or accrued
in that year before crediting taxes carried over from other
periods. This rule suffers from the same problems as the five-
year carryforward provision discussed above. The ability of
taxpayers to obtain credit for taxes paid in prior years is
circumscribed.
Section 206 of the Bill would reverse this rule, and give
credit for taxes carried over from prior years before current
year taxes were credited. The current year taxes would
themselves be eligible for carryover if the taxpayer remained
with excess credits after the credit computation.
We support this change. Like the extension of the carryover
from five years to ten, it will smooth out year-to-year
fluctuations in levels of foreign income and taxes and allow a
more efficient operation of the foreign tax credit regime.
G. Application of UNICAP rules to foreign persons
The uniform capitalization (``UNICAP'') rules of the Code
generally require taxpayers to capitalize both direct costs and
a properly allocable portion of indirect costs attributable to
property produced or acquired for resale. These rules require a
detailed allocation of costs to various activities and then to
the products themselves. Almost 100 pages of regulations
prescribe the specific accounting procedures and computations
that must be made.
The UNICAP rules are not currently limited to U.S. persons.
Foreign taxpayers are also subject to the rules to the extent
that their income, deductions, credits, and other tax
attributes are relevant to U.S. tax. For example, a CFC must
use the UNICAP rules in computing its earnings and profits for
purposes of determining the subpart F inclusions of its U.S.
shareholders.
The application of UNICAP to foreign taxpayers is a
substantial increase in complexity and administrative burden.
These rules apply only for U.S. tax purposes, and a foreign
corporation with no U.S. connection other than its owners would
ordinarily not have to make the detailed allocations called for
by the rules. Full compliance with these rules is costly for
taxpayers, and often makes no revenue difference because there
is usually a cushion of undistributed and untaxed CFC earnings
to absorb any adjustments attributable to UNICAP allocations.
Section 302 of the Bill would provide that the UNICAP rules
would apply to foreign persons only for purposes of computing
the tax on income effectively connected with the conduct of a
U.S. trade or business. We endorse this proposal, which will
significantly simplify tax compliance for U.S. taxpayers with
foreign subsidiaries. The proposal is also sound on tax policy
grounds. Activities to which the rules apply are typically
those of an active business, which when conducted by a CFC
outside the United States are not normally subject to current
U.S. tax.
Inconsistent Characterization of Income from Cross-Border Transactions
In connection with the Committee's consideration of
international tax rules, we wish to draw attention to a
significant problem that is not addressed by the Bill but that
has cost our industry needless time and money--and may
ultimately reduce tax revenue to the U.S. Treasury. This
problem is the characterization of income for a foreign
country's tax purposes in a way that is inconsistent with the
U.S. tax characterization of the same income.
For example, assume that a U.S. taxpayer sells a disk
containing a copyrighted computer program to a foreign buyer.
Under the U.S. regulations governing transactions in computer
software, this transaction is characterized as the sale of a
copyrighted article. Under U.S. income tax treaties, sales
income is taxable under the Business Profits article. Under
this interpretation, if the U.S. taxpayer does not have a
permanent establishment in the country of sale, the foreign
country is prohibited from imposing tax.
However, the foreign tax authorities may not agree that the
transaction gives rise to business profits. Because the
transaction involves copyrighted software, the payment may be
viewed as a royalty, which the source country may be permitted
to tax (usually at reduced rates) under the treaty. This tax
may not be creditable against U.S. tax because the U.S. does
not view the foreign country as having tax jurisdiction over
the payment.
These problems have arisen repeatedly in the cross-border
activities of software companies. Some of these companies have
sought relief under the mutual agreement procedures available
under tax treaties. While these avenues can be effective, they
are costly, time-consuming, and uncertain. Furthermore, the
problem is a recurring one, and taxpayers would prefer not to
resort to the mutual agreement procedure on a regular basis.
We recognize that this problem is not resolvable by
unilateral U.S. action, short of deferring in all cases to
another country's characterization of income--a step that the
government is understandably unwilling to take. However, we
encourage the Congress and the Administration to pursue all
available opportunities for resolving these issues on a
bilateral or multilateral basis.
Bilaterally, the tax treaty process--in which the Senate
plays a significant role--can be used to forge country-by-
country agreements on specific points that have arisen with
particular countries. Multilaterally, work with international
organizations such as the Organizations for Economic
Cooperation and Development can often lead to fruitful common
understandings in key areas of international taxation. Congress
should support the participation of the United States in these
efforts, and be willing to participate fully in implementing
points on which agreement is reached.
Foreign Sales Corporation Rules
The U.S. Foreign Sales Corporation (FSC) rules have
recently been challenged by the E.U. and a decision with
respect to the legality of the FSC under multilateral trade
agreements is currently pending before a WTO panel. The FSC
rules are extremely important to the U.S. software industry,
which derive 30% of their revenue from exports, and the
industry is grateful that Congress clarified the application of
these rules to software licenses as part of the 1997 Tax Act.
The current FSC rules, and the DISC rules that they replaced,
were enacted to offset a competitive disadvantage faced by U.S.
exporters because the U.S. tax system is not as generous to
exports as are the tax systems of our trading partners. These
concerns still exist today. As we await a final decision from
the WTO panel on the FSC issue, I wanted to make you aware of
the importance of this issue to the software industry.
Conclusion
We appreciate the opportunity to present our views on
international tax simplification. We appreciate the Chairman's
efforts to provide some much-needed simplification to this
highly complicated area of the law. In addition, we look
forward to continued Congressional attention to U.S. tax rules
that hinder competition. In particular, we need a permanent R&D
credit that compares favorably to the incentives offered by
other countries. We also need to assure that the United States
does not impose higher levels of tax on exports than do our
trading partners. Finally, U.S. tax rules should not hinder
efficient utilization of technology around the world. We look
forward to working with the Subcommittee on these important
issues.
Chairman Houghton. Ms. Strain, please.
STATEMENT OF DENISE STRAIN, GENERAL TAX COUNSEL, CITICORP,
CITIGROUP, NEW YORK, NEW YORK
Ms. Strain. My name is Denise Strain, and I am the general
tax counsel for Citicorp, a wholly-owned subsidiary of
Citigroup. I want to thank the Chairman and the Subcommittee
Members for their invitation to testify today on the topic of
international tax simplification and for the Chairman's
leadership in this area.
Over the last several years, the Houghton-Levin legislation
has provided an approach for Congress to simplify and
rationalize the U.S. tax rules that apply to the global
operations of U.S.-based, multinational companies. The U.S.
international tax rules are important to Citigroup because of
the global reach of the company. Citigroup is a diversified
financial services company which offers banking, insurance,
credit cards, asset management, and investment banking to our
customers throughout the world. Citigroup has 170,000 employees
located in 100 countries, including 112,000 employees in the
United States. This global business requires us to prepare a
complicated and time-consuming tax return.
To give you some idea of the compliance burden these rules
impose on Citigroup, let me describe our tax filings. In
September of 1999, Citigroup will file its 1998 tax return. It
will exceed 30,000 pages in length, including computations for
more than 2,000 companies located in 50 States and 100
countries. More than 200 tax professionals, both here and
overseas, will be involved in this process. To say the least,
it is a formidable task.
My company understands first-hand that the global economy
has become increasingly integrated; financial transactions have
become more complex; financial decisions are made more quickly,
and the tax implications, both here in the United States and in
foreign jurisdictions, have become more difficult to resolve.
It is not an easy task to structure a tax system that addresses
both the evolving world of financial globalization in a manner
that is fair and neutral while maintaining competitiveness for
U.S. businesses.
H.R. 2018, the legislation introduced earlier this month by
Chairman Houghton and Congressman Levin, will go a long way
toward simplifying our rules and encouraging competitiveness. I
would like to highlight a couple of proposals in the bill.
First, the proposal to make permanent, or at least extend, the
deferral from Subpart F income for the active income of
financial services companies is of critical importance to the
U.S. financial services industry and is one of the key
provisions in your bill. The provisions that permit the active
business income of U.S. banks, securities firms, insurance
companies, finance companies, and other financial services
firms to be subject to U.S. tax only when that income is
distributed back to the United States will expire at the end of
this year. Active financial services income is universally
recognized as active trade or business income. Thus, if the
current law provisions 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
their major foreign competitors.
Not only should the current rules be extended, but we hope
very much that Congress will refrain from making another round
of major changes to these rules. In order to comply with the
deferral rules, over the past 2 years, U.S. companies have
implemented numerous systems changes to accurately follow two
very different versions of the active financing law. Further
changes at this time would create excruciating complexity and
compliance burdens with no commensurate benefits to the U.S.
Treasury.
Another proposal in your bill would greatly simplify the
foreign tax credit rules. As a regulated industry in many
countries, U.S.-based financial services companies operating
outside the United States are often required by local laws to
operate in joint ventures with local banks and other financial
services companies. For this reason, it is so important for my
industry that the tax rules be simplified for income from
foreign joint ventures and other business operations in which
U.S. companies own at least 10 percent but not more than 50
percent of the stock in a foreign company. The so-called ``10/
50'' foreign tax credit limitation is bad tax policy and
increases the cost of doing business for U.S. companies
operating abroad.
The 1997 Tax Relief Act sought to correct these problems by
eliminating separate foreign tax credit baskets for 10/50
companies. However, this important change will not take effect
until after 2002, and it is accomplished in a rather
complicated manner. Your bill, Mr. Chairman, will fix this
problem. The proposal, which is also included in President
Clinton's fiscal year 2000 budget, would accelerate from 2003
to 2000 the repeal of the separate foreign tax credit basket
for such ``10/50 companies,'' and would make this change for
all dividends received in tax years after 1999.
My written testimony, submitted for the hearing record,
details a number of other important proposals included in H.R.
2018 that we support and we believe will go a long way toward
making our international tax regime less complex and more
rational.
On behalf of Citigroup, I want to thank you, Mr. Chairman,
and the members of the Ways and Means Committee for your
interest in international tax simplification. As a
representative of a U.S.-based financial services company with
operations throughout the world, I believe your efforts to
simplify and rationalize the U.S. international tax rules are
vitally important.
Thank you.
[The prepared statement follows:]
Statement of Denise Strain, General Tax Counsel, Citicorp, Citigroup,
New York, New York
Introduction
My name is Denise Strain, and I am the General Tax Counsel
for Citicorp, a wholly-owned subsidiary of Citigroup.
Citigroup, the product of last year's merger of Citicorp and
the Travelers Group, is a diversified financial services
holding company whose businesses provide a broad range of
financial services to consumers and corporate customers around
the world.
On behalf of Citigroup, I want to thank the Chairman and
the Subcommittee for their invitation to testify today on the
topic of international tax simplification. I also want to
express my appreciation, and the appreciation of Citigroup, to
Chairman Houghton, Chairman Archer, Congressman Levin, and
other members of the House Ways and Means Committee for your
efforts in this area. Over the last several years, the
Houghton-Levin legislation has provided a road map for Congress
in seeking to simplify and rationalize the U.S. tax rules that
apply to the global operations of U.S.-based multinational
companies.
Citigroup understands first hand that as the global economy
has become increasingly more integrated, financial transactions
have become more complex, financial decisions are being made
more quickly, and the tax implications both here in the United
States and in foreign jurisdictions have become more difficult
to resolve. It is not an easy task to structure a tax system
that addresses this evolving world of financial globalization
in a manner that is fair and neutral while maintaining the
competitiveness of U.S. business. The simple fact that you are
conducting this hearing today sends a strong signal that we are
making progress. The legislation introduced earlier this month
by Chairman Houghton and Congressman Levin, which is aimed at
further simplifying key aspects of the U.S. international tax
rules, includes a number of important proposals. If enacted,
these proposals will go a long way towards achieving a simpler
and fairer tax regime for U.S. companies operating overseas.
Mr. Chairman, in my testimony today, I would like to
discuss why we believe the goal of maintaining a tax system
that keeps pace with global competition and economic
integration is important. Specifically, I will discuss a number
of provisions in H.R. 2018, the International Tax
Simplification for American Competitiveness Act of 1999, that
are of significance to the financial services industry,
including Citigroup.
The Importance of International Tax Rules to Citigroup
To understand why U.S. international tax rules are so
important to Citigroup, I think it will be helpful to the
Committee if I explain a little bit about my company. As I
mentioned in my introduction, Citigroup is a diverse company.
We offer our customers a broad range of financial services,
including banking, insurance, credit cards, asset management,
securities brokerage, and investment banking. The principal
subsidiaries of Citigroup include Citibank, Travelers
Insurance, Salomon Smith Barney, and Commercial Credit.
Citigroup has 170,900 employees located in 100 countries,
including 111,640 employees in the United States.
Historically, U.S. financial services companies expanded
abroad to support the global expansion of U.S. commercial
businesses. As companies such as Caterpillar, General Motors,
Exxon, and IBM have become global powerhouses and household
names outside the United States, Citicorp and Citigroup have
been there to provide capital for their expansions, and to
provide banking and other investment services and advice to
their employees. This is still the case as a new generation of
American companies, including Microsoft, Intel, and Hewlett-
Packard, have launched and expanded their foreign operations.
Unfortunately, U.S.-based multinational financial services
companies could soon become an endangered species. Most of the
world's large financial services players are foreign-based
companies. Only three U.S.-based companies--Citigroup,
BankAmerica, and Chase--are among the top 25 financial services
companies in the world, as measured by asset size. Citigroup's
foreign-based competitors are competing with us not only on
foreign soil, but also on U.S. soil. These include such
companies as Deutsche Bank, which recently completed its
acquisition of Bankers Trust, and HSBC Holding, which is in the
process of acquiring Republic Bank. Our foreign-based
competitors in insurance are also increasingly making inroads
into U.S. markets. For example, just recently, German-based
Allianz AG acquired Fireman's Fund Insurance and the
acquisition of Transamerica Corp. by Dutch-based insurance
company Aegon NV is currently pending.
It is no coincidence that, for the most part, the home-
country tax systems of these companies are simpler and more
neutral when it comes to taxing home-country and international
investment than the U.S. system, according to a National
Foreign Trade Council (NFTC) study of foreign tax regimes and
subpart F released earlier this year.
This level of increased competition from non-U.S.-based
financial services entities results from the fact that national
economies are becoming increasingly global. Globalization is
being fueled by rapid technological changes and a worldwide
reduction in tax and regulatory barriers to the free
international flow of goods and capital. These changes are all
for the good. However, these changes are also putting
tremendous pressure on our tax rules, which have become
increasingly antiquated over the last 30 years.
We can not 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, as well
as other U.S.-based multinationals, at a competitive
disadvantage. Some have questioned whether the globalization of
U.S.-based companies does much for U.S. economic growth and
employment. In my company, the answer is easy. As Citigroup has
grown internationally, our domestic support for those
international activities has grown accordingly. For example,
Citibank's U.S.-based credit card manufacturing and processing
facilities produce credit card statements, inserts, and actual
credit cards for Citibank customers in Europe, Latin America,
and the Caribbean. Other Citigroup service centers in the
United States process all the bills and payments for outside
vendors the corporation utilizes around the globe, along with
employee expense reports and reimbursements. We've found that
consolidating many of these back-office functions in the United
States achieves a maximum level of efficiency, just as the
centralization of credit card manufacturing and processing
takes advantage of economies of scale and R&E performed in this
country.
U.S. trade policy has clearly recognized that breaking down
barriers to international trade is a key factor in spurring
U.S. economic growth and jobs, and this committee has played a
leading role in that regard. It is ironic, therefore, that our
international tax policy at times seems to go in a different
direction. For example, we continue to face double taxation
because our foreign tax credit rules are antiquated. In
addition, the question still remains among some whether the
active income of financial services companies should continue
to be subject to the anti-deferral regime of subpart F. These
two factors--the incidence of double taxation and the premature
imposition of U.S. tax on our foreign earnings--together hinder
our ability to compete against foreign-based companies that
face less hostile home-country tax regimes, according to the
NFTC international tax study.
The Complexities in Our System
Moreover, our international tax regime imposes layer upon
layer of needless complexity, creating an environment where
taxpayers and the IRS are in a constant tug-of-war over rules
that were not designed to apply in the context of many modern
cross-border financial transactions.
From the standpoint of one of the largest financial
services companies in the world based in the United States, we
see the evidence of this first hand, every day. The labyrinth
of rules and regulations we face are almost beyond
comprehension. More often than not, applying these rules to
increasingly complex transactions produces more questions than
answers.
To give just one example of the complexities we face, at a
time when American corporations are trying to concentrate on
competitiveness and pare down nonessential costs, determining
the earnings and profits of our foreign subsidiaries for
subpart F purposes requires our staff to go through a five-step
procedure. This process starts with the local books of account
and then continues with a series of complicated accounting and
tax adjustments. On audit, each of these steps must be
explained and justified to IRS agents. Yet, equally reliable
figures could be provided, at a fraction of the time and cost,
by simply using GAAP to determine earnings and profits. I am
glad to say that H.R. 2018 includes just such a rule, and we
would recommend that this GAAP provision be extended to apply
to calculations of earnings and profits of all foreign
corporations for all purposes.
More generally, one of the biggest problems we face
involves the coordination of U.S. rules with those of the
countries in which we do business. It is a fact of life for
Citigroup that our U.S. tax filing deadlines and requirements
generally bear no relationship to those of other countries.
This means that we generally do not have all the foreign
information we need when our U.S. tax return is due, so our
return contains tentative information, and we are forced to
adjust our returns during the IRS audit process.
Mr. Chairman, I ask you to think about this: when you and I
and tens of millions of other Americans finish our individual
tax returns by April 15 every year, we breathe a long sigh of
relief that an annoying, stressful, and time consuming process
has been completed--until next year. For Citigroup, however,
this task of filing our annual tax return is an ongoing process
that often takes years to complete. This situation is
ameliorated somewhat by a network of bilateral tax treaties
intended to limit double taxation and coordinate information
and other requirements between two countries' tax regimes.
However, this network does not extend to many countries in
which Citigroup does business, including such emerging market
countries as Brazil and Argentina.
To give you some idea of the scope of the compliance burden
for Citigroup, let me describe our tax filings. In September,
Citigroup will file its 1998 tax return. It will exceed 30,000
pages in length, including computations for more than 2,000
companies located in 50 states and 100 countries. More than 200
tax professionals, both here and overseas, will be involved in
this process. The end of this process is the examination of
this return by IRS auditors, generally years from now. To say
the least, it's a formidable process.
Tax Simplification Proposals
Mr. Chairman, we do believe that enactment of a modest
number of changes to the current system will go a long way to
help simplify some rules that are unnecessarily complex and
time consuming to deal with. Moreover, I believe these changes
will help us be more competitive.
Active Financing Exception to Subpart F
The rules that permit the active business income of U.S.
banks, securities firms, insurance companies, finance companies
and other financial services firms to be subject to U.S. tax
only when that income is distributed back to the United States,
expire at the end of this year. The proposal to make permanent
or, at the very least extend, the exception to the anti-
deferral regime of subpart F for the active income of financial
services companies is of crucial importance to the U.S.
financial services industry and is one of the key provisions in
your bill.
By way of background, when subpart F was first enacted in
1962, the basic intent was to 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 received from unrelated persons,
were specifically excluded from current taxation. In 1986,
however, the provisions that were put in place to ensure that a
controlled foreign corporation's active financial services
business income would not be subject to current tax were
repealed in response to concerns about the potential for
taxpayers to route passive or mobile income through tax havens.
In 1997, the 1986 rules were revisited for several reasons.
A key reason was the fact that many U.S. financial services
companies found that the existing rules imposed a competitive
barrier in comparison to home-country rules of many foreign-
based financial services companies. Moreover, the logic of the
subpart F regime made no sense, given that most other U.S.
businesses were not subject to similar subpart F restrictions
on their active trade or business income. The 1997 Tax Act
created an exception to the subpart F rules for the active
income of U.S.-based financial services companies, along with
rules to address concerns that the provision would be available
to shelter passive operations from U.S. tax. At the time, the
exception was included for only one year primarily for revenue
reasons, as you yourself pointed out, Mr. Chairman, in remarks
in support of the provision made on the House floor.
The active financing income provision was reconsidered
again in 1998, in the context of extending the provision for
the 1999 tax year, and considerable changes were made in
response to Congressional and Administration concerns.
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 cannot be overstated. U.S. companies need to know the tax
consequences of their business operations, which are generally
evaluated on a multi-year basis.
Not only should the current rules be extended, but we hope
very much that Congress will refrain from making another round
of major changes to these rules. In order to comply with the
deferral rules, over the last two years U.S. companies have
implemented numerous system changes to accurately follow two
significantly different versions of the active financing law.
While some in government have indicated problems still exist,
we all need to remember that many U.S. companies, including
Citigroup, have yet to file their first U.S. tax returns
incorporating the 1997 Tax Act rules in this area. It will be
another 15 months before tax returns are filed incorporating
the rules that were enacted last year to apply to the 1999 tax
year. Further changes at this time would create excruciating
complexity and compliance burdens with no commensurate benefits
for the U.S. Treasury.
Despite any real evidence that the current rules are not
working, I understand that the Treasury Department has
suggested that Congress hold off extending the active financing
exception until Congress has had the time to review the
Treasury's suggestions. However, the international growth of
American finance and credit companies, banks, securities firms,
and insurance companies would be impaired by an ``on-again,
off-again'' system of annual extensions that does not allow for
certainty. Failing to extend the active financing exception
this year would be the antithesis of tax simplification. In
contrast, making this provision a permanent part of the law, or
at least extending the provision, would greatly simplify U.S.
international tax rules and enhance the global position of the
U.S. financial services industry.
The 10/50 Foreign Tax Credit Basket
As a regulated industry in many countries, U.S.-based
financial services companies operating outside the United
States are often required by local laws to operate in joint
ventures with local banks and other financial services
companies. That is why it is so important for my industry that
the tax rules be simplified for income from foreign joint
ventures and other business operations in which U.S. companies
own at least 10 percent but not more than 50 percent of the
stock in the foreign company.
In particular, the so-called 10/50 foreign tax credit rules
impose a separate foreign tax credit limitation for each
corporate joint venture in which a U.S. company owns at least
10 percent but not more than 50 percent of the stock of the
foreign entity. The 10/50 regime is bad tax policy. The current
rules increase the cost of doing business for U.S. companies
operating abroad by singling out income earned through a
specific type of corporate business form for separate foreign
tax credit ``basket'' treatment. Moreover, the current rules
impose an unreasonable level of complexity, especially for
companies with many foreign corporate joint ventures.
The 1997 Tax Relief Act sought to correct these problems by
eliminating separate foreign tax credit baskets for 10/50
companies. However, this important change will not take effect
until after 2002, and it is accomplished in a rather
complicated manner. Under the new rules, dividends from
earnings accumulated after 2002 will get so-called look-through
treatment, effectively repealing the 10/50 rules, while
dividends from pre-2003 earnings will all be part of a single
``super'' 10/50 foreign tax credit basket.
Your bill, Mr. Chairman, would fix this problem. The
proposal, which is also included in President Clinton's FY 2000
budget, would accelerate from 2003 to 2000 the repeal of the
separate foreign tax credit basket for such ``10/50
companies.'' In doing so, so-called look-through treatment
would apply in order to categorize income from all such
ventures according to the type of earnings from which the
dividends are paid. The proposal would apply the look-through
rules to all dividends received in tax years after 1999,
regardless of when the earnings constituting the makeup of the
dividend were accumulated.
We very much support this approach and hope it can be
enacted this year. In particular, the requirement of current
law that we use two sets of rules on dividends beginning with
the year 2003 has been a concern of taxpayers, members of
Congress, and the Administration. That is why it is so
important that the effective date of the 1997 Tax Act changes
be accelerated and that the ``super'' 10/50 basket be repealed.
Application of the U.S. Aviation Ticket Tax to Foreign
Frequent-Flyer Programs
Significant administrative and compliance problems have
arisen due to the interpretation that the aviation ticket tax
rules as modified in 1997 may apply to certain frequent-flyer
``affinity'' programs that operate outside the United States
but involve carriers with flights to the United States. Your
bill contains a modest change to the statute, giving the IRS
and Treasury authority to address this issue in regulations
that would adequately address this problem at very little cost
to the Treasury.
This is important to my industry, Mr. Chairman, because
credit card companies are among the largest providers of such
affinity programs. Citibank and Diners Club, for example,
compete throughout the world with locally-based banks and
credit card companies. Under these affinity programs, these
banks permit their customers to earn miles on air carriers when
they make credit card purchases. We provide these miles to our
customers by purchasing the mileage award points from the
carriers.
Specifically, the problem relates to the extension of the
7.5 percent ticket tax to these purchases from air carriers of
frequent-flyer miles by credit card companies, hotels,
telephone companies and other consumer businesses for the
benefit of their customers. The statute has been interpreted to
apply this tax to the purchase of all mileage awards on a
worldwide basis, including miles that could be redeemed for
transportation that has no relationship to the United States.
This interpretation has led to numerous diplomatic protests and
has created competitive and administrative issues for the U.S.
travel and tourism industry.
We also understand that the only parties actually paying
the tax at this time are U.S.-based taxpayers, including U.S.
purchasers of mileage awards and U.S.-based carriers. Because
foreign-based carriers and purchasers of miles apparently take
the position that the tax should not apply to transactions
outside our borders, they are not paying the tax. This pattern
of compliance is creating an unfair playing field for U.S.
companies doing business in foreign markets.
The application of the aviation ticket tax to these foreign
programs is a prime example of the need for simplification and
rationalization in our tax rules. A simple solution to this
problem would be to provide the IRS and Treasury with
regulatory authority to exclude payments for mileage awards
from the tax as long as the awards relate to individuals with
non-U.S. addresses.
Withholding Tax Exemption for Certain Mutual Fund Distributions
We very much support the proposal included in the Houghton/
Levin bill to exempt from U.S. withholding tax all
distributions of interest and short-term capital gains to
foreign investors by a U.S. mutual fund, including equity,
balanced, and bond funds. Under the proposal, mutual fund
distributions would be exempt from U.S. withholding tax if they
were received by a foreign investor either directly or through
a foreign fund. Similar legislation has been introduced in
prior Congresses by Representatives Crane, Dunn, and McDermott.
Mr. Chairman, while the U.S. mutual 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. The current withholding tax that applies to all
dividends distributed from a U.S. fund to foreign investors is
a clear disincentive to foreign investment in U.S. funds. This
is the case because distributions of interest income and short-
term capital gains received directly, rather than from a fund
investment, are not subject to withholding tax.
The proposed legislation would enhance the competitive
position of U.S. fund managers and their U.S.-based workforce
and simplify the administration of these funds.
Other Simplification Proposals
H.R. 2018 includes a number of other international
simplification proposals that we would like to highlight.
Provide an Ordinary Course Exception to the Income Re-sourcing
Rule for U.S.-Owned Foreign Securities Dealers
Current law provides that income received by a U.S. parent
from its CFC will be re-sourced from foreign source to U.S.
source to the extent the CFC is treated as having earned U.S.
source income (for example, if the CFC derives interest income
from a Eurobond). Recognizing that the existing rule is
inequitable when applied to securities dealers, the bill would
create an exception to the existing re-sourcing rule by
providing that income earned by a securities dealer from
securities held in the ordinary course of conducting its
customer business will not be re-sourced.
Treat a Foreign Securities Firm's Market-Making Activities in
its Parent Company's Issuances Consistently with its Market-
Making Activities in Other U.S. Companies' Securities
U.S.-owned foreign securities firms, as part of their
ordinary course market-making activities, will hold in
inventory securities of U.S. corporations. Thus, for example, a
foreign securities firm may hold in inventory a Eurobond issued
by General Motors. However, Citigroup's foreign securities
dealers are effectively prohibited from holding Citigroup
issuances in inventory over quarter-end because the holding of
that security would give rise to a subpart F deemed dividend.
The bill would eliminate this rule for parent and affiliate
securities held by a U.S.-owned foreign securities dealer in
the ordinary course of its market making activity.
Conclusion
On behalf of Citigroup, we want to thank you, Mr. Chairman,
and Members of the Ways and Means Committee for your interest
in international tax simplification and the impact of current
rules on my company. As a representative of a U.S.-based
financial services company with operations throughout the
world, I believe your efforts to simplify and rationalize the
U.S. international tax rules are vitally important. Thank you
again for the opportunity to testify today.
Chairman Houghton. Thanks very much, Ms. Strain.
Mr. Jarrett.
STATEMENT OF THOMAS K. JARRETT, DIRECTOR OF TAXES, DEERE &
COMPANY, MOLINE, ILLINOIS
Mr. Jarrett. Good afternoon, Mr. Chairman, Members of the
Committee. My name is Tom Jarrett, director of Taxes for Deere
& Company. In this position, I am responsible for Deere's
worldwide tax and compliance measures.
Deere is the world's largest producer and distributor of
agricultural equipment and a leading producer and distributor
of construction and grounds care equipment. It also finances
and leases equipment and has insurance and health care
operations. We employ 26,000 people in the United States,
37,000 worldwide.
Mr. Chairman, we want to thank you for your efforts to make
the U.S. Tax Code not only simpler and fairer but also one that
helps American corporations compete abroad. In my written
testimony, I have focused on the details of three specific
areas of interest to Deere and other manufacturers: foreign
interest expense allocation, active financing income exemption,
and foreign tax credit ordering rules. The reason this
Committee's attention to these issues is critical is something
you understand well. Deere and other U.S. manufacturers are in
a global race with our foreign competitors. Many of these
foreign companies are provided tax policy advantages that
support their operations around the world. The U.S. Tax Code
should level the playing field for American companies so that
they may compete successfully for international business.
The issue here is cost. Bad tax policy adds cost. For
instance, the allocation of our U.S. credit subsidiaries'
interest expense to foreign operations doubles the allocation
of interest to foreign operations, yet our U.S. credit
operation has basically no foreign assets. Regarding the active
financing exemption, retaining this measure will permit Deere
and others to compete on equal terms with U.S. banks and
foreign finance competitors. It is extremely important for us
to expand our markets and export our U.S. goods.
The John Deere brand is sought around the world as a result
of our reputation for quality and genuine value. Our customers
are willing to pay a premium for our products, innovative
technology, superior engineering, and overall quality. The
company's costs for research and development and quality
improvement may be reflected in the price the customer pays,
but there are limits to what the market will bear. The world
market won't allow costs associated with outdated and
disproportionate tax obligations to be passed to our customers.
These costs simply slow us down in our global race.
John Deere is a global enterprise. About one-third of
Deere's total equipment sales in 1998 took place outside the
United States. While the U.S. farmer remains our number one
customer, Deere's growth opportunities are increasingly tied to
our ability to compete in the global marketplace. We have
aggressive growth objectives, both in this country and abroad.
Our experience is that growth here and abroad is complimentary.
Our presence abroad helps our U.S. exports and helps to provide
product volumes that keep U.S. products less expensive for our
customers. Sometimes products produced for markets outside the
United States also have a use in the United States. Our balance
of payments from a U.S. perspective is clearly positive.
In summary, Deere & Company must be able to compete
effectively overseas in order to continue to provide jobs to
its employees, expand its business, and provide genuine value
to shareholders. The three recommendations we are making today
will favorably affect all U.S. equipment manufacturers.
Moreover, they will strengthen our ability to compete favorably
overseas and provide more jobs in and exports from this
country.
Thank you.
[The prepared statement follows:]
Statement of Thomas K. Jarrett, Director of Taxes, Deere & Company,
Moline, Illinois
Good afternoon Mr. Chairman and Members of the Committee. I
am Tom Jarrett, Director of Taxes for Deere & Company. In this
position I am responsible for Deere's worldwide tax planning
and compliance.
Deere & Company is the world's largest producer and
distributor of agricultural equipment and a leading producer
and distributor of construction and grounds care equipment. It
also finances and leases equipment and has insurance and health
care operations. Deere employs approximately 26,000 people in
the United States and 37,000 worldwide.
The company has factories in nine states and eleven
countries. Our products are distributed and serviced worldwide
by a large number of independent John Deere dealers.
We have aggressive growth objectives both in this country
and abroad. Our experience is that growth here and abroad is
complimentary. Our presence abroad helps our U.S. exports and
helps provide product volumes that keep U.S. products less
expensive for our customers. Sometimes products produced for
markets abroad also have a use in the U.S. Our balance of
payments--from a U.S. perspective--is clearly positive.
For Deere to continue expanding our businesses at a level
acceptable to our shareholders, Deere clearly must continue to
expand and be competitive overseas.
One of the greatest challenges faced by Deere and other
multinational companies is the complexity of U.S. international
tax rules. Many provisions of the U.S. tax code not only result
in a paperwork burden unmatched anywhere in the world, but also
hinder the ability of American companies to compete in the
international arena. Mr. Chairman, we appreciate your
leadership in examining this issue. Your legislation (H.R.
2018) addresses many areas where the U.S. Code could be
improved. I would like to focus on a few specific areas of
interest to Deere and other manufacturers.
Three key tax issues that affect our competitiveness
overseas are: the foreign interest expense allocation; the
active financing income exemption; and, the foreign tax credit
ordering rules. The way these issues are currently handled
causes U.S. manufacturers to be less competitive with overseas
manufacturers and, as a result, reduces U.S. manufacturers'
ability to sell U.S. products overseas. For this reason, we
have advocated for several years that U.S. international tax
laws must be addressed in these areas.
(1) Foreign Interest Expense Allocation
The maximum foreign tax credit a U.S. company can receive is equal
to the U.S. tax rate times the foreign taxable earnings less the U.S.
expenses incurred to generate those earnings. In determining the U.S.
expense incurred, Regulation
1.861-11T requires that the total U.S. affiliated company interest
expense be allocated between domestic and foreign source income based
on assets.
The Deere U.S. credit and leasing companies only finance equipment
sold or leased within the U.S. The Deere U.S. credit and leasing
company assets represent over 50 percent of the total asset allocation
base. By comparison, foreign assets are less than 13 percent of total
assets. The credit and leasing companies account for 80 percent of the
U.S. consolidated income tax return interest expense. The tax
regulations force a disproportionate allocation of interest expense to
foreign assets. The arbitrary interest expense allocation has reduced
Deere's foreign tax credit by 11 to 20 percent in recent years. The
resulting double taxation of foreign earnings makes Deere and other
manufacturers less competitive in foreign markets.
Currently, the interest expense allocation regulation exempts
certain financial institutions, including chartered banks and thrifts,
from the 861-11 allocation. However, other active domestic finance
companies that are defined in Section
1.904-4(e)(3) of the Regulations are actually performing the same
functions as chartered banks and thrifts (such as Deere's credit and
leasing operations), but are not included in the exemption.
We recommend that the exemption to the interest allocation
regulation be expanded to include all active domestic financial
institutions. In this manner, our foreign income will be more
accurately reflected and our eligibility for an appropriate level of
foreign tax credit will be restored. This issue must be addressed to
ensure that U.S. companies' international tax burden approximates that
of our competitors.
(2) Active Financing Income Exemption
Another important foreign tax issue to equipment manufacturers is
the exemption for active financing income. In 1997 Congress adopted an
exception to subpart F of the Code for foreign finance companies that
comply with the significant active business tests in Section
954(h)(2)(A) of the Code. Prior to its adoption, subpart F taxed all
income on foreign loans and leases as the income was earned, rather
than permit such income to be deferred until foreign dividends were
paid. The law viewed all finance activity as passive investment
activity.
However, Section 954(h)(2)(A) established an exception to the
subpart F rules for foreign finance companies where their principal
business activity is to provide financing to unrelated parties located
in the country in which the foreign finance company was organized. This
exception strengthens the business carried on by the foreign finance
companies.
Moreover, the exception was, and continues to be, extremely
important to equipment manufacturers such as Deere as we expand our
markets overseas and as we expand financing activities abroad to South
America, Eastern Europe and Asia. All of these markets have a high
demand for our products, but the customers have had difficulty in
securing adequate financing for their purchases of equipment. With the
expansion of our financing operations overseas during the period of the
exemption, this problem has been minimized and Deere, like other
equipment manufacturers, is able to compete successfully in the foreign
marketplace.
The exemption for active financing income is scheduled to expire on
December 30, 2000. Deere recommends that the active financing income
exemption be made permanent. A permanent exemption would enable Deere
and other manufacturers to continue to expand our financing operations
overseas, export more equipment abroad and expand our U.S. workforce.
(3) Foreign Tax Credit Ordering Rules
The third area of concern to Deere and other manufacturers is the
manner in which corporations must use unused foreign tax credits.
Currently, unused foreign tax credits that are earned in a given year
must be used before any carryover credits can be used in that year. As
a result, equipment manufacturers that are experiencing a downturn find
it very difficult to claim any carryover foreign tax credit in years of
reduced profits.
Many companies often find that in a downturn (1) lower
manufacturing activity reduces foreign royalty income; (2) foreign
source export sales income is greatly reduced as the demand for
equipment softens overseas; (3) foreign dividends are withheld to
finance the buildup of inventory and trade receivables abroad; (4) U.S.
interest expense allocated to foreign source income increases as U.S.
borrowings increase to finance the buildup of similar U.S. inventory
and receivables; and (5) the combination of lower foreign source income
and rising 861 interest expense allocations reduces a company's ability
to claim a foreign tax credit. And without the benefit of a foreign tax
credit, that company's foreign earnings are being double taxed.
Accordingly, we recommend that the Committee establish ``ordering
rules'' for foreign tax credits similar to the rules governing net
operating losses. These rules would permit the ``earliest-to-expire''
carryover credit to be used before any credit that is earned in the
current year--just as currently is the case with NOL carryovers. In
this manner, a company would be able to maximize its foreign tax credit
carryovers without losing them during a downturn. This would enable
equipment manufacturers to maximize their foreign tax credits and
remain competitive in their overseas markets following a downturn.
In summary, Deere & Company must be able to compete effectively
overseas in order to continue to provide jobs to its employees, expand
its business and provide genuine value to its shareholders. The three
recommendations that we are making today will favorably affect all U.S.
equipment manufacturers. Moreover, they will strengthen our ability to
compete favorably overseas and therefore provide more jobs in and
exports from this country.
Thank you.
Chairman Houghton. Thank you very much. You are a very
efficient man. You did it well within the time limit.
Now, I would like to turn to Mr. McKenzie.
STATEMENT OF GARY MCKENZIE, VICE PRESIDENT OF TAX, NORTHROP
GRUMMAN CORPORATION, LOS ANGELES, CALIFORNIA
Mr. McKenzie. Thank you, Mr. Chairman and Members of the
Subcommittee for the opportunity to appear before you today.
Northrop Grumman Corporation is a leading designer and
manufacturer of defense products, and our most widely known
products are the B-2 and the Joint STARS aircraft----
Chairman Houghton. Do you want to bring that mike just a
little closer to you? Bring the mike a little closer to you.
Mr. McKenzie. I am sorry. Would you like me to start over?
Chairman Houghton. No, that is fine.
Mr. McKenzie. OK. First, I want to commend Chairman
Houghton and Congressman Levin for the many constructive
changes included in H.R. 2018. In my view, Subpart F of the
Internal Revenue Code has become overly complex and restrictive
to the point that it actually interferes with the conduct of
international business. The reevaluation of the policy goals of
Subpart F and the entire scheme of international taxation is
overdue, and I applaud your efforts to begin that process, and
I would be happy to share more of my thoughts on that once we
have reached the end of this.
However, I will now focus my comments specifically on the
benefits of section 303 of H.R. 2018, which repeals section
923(a)(5) of the code that severely discriminates against U.S.
exporters of products on the United States munitions list.
Specifically, current law reduces Foreign Sales Corporation
benefits available to companies that sell military products
abroad to 50 percent of the benefits available to all other
exporters. The provision is essentially a penalty tax imposed
only on U.S. exporters with military property and should be
repealed; its time has passed. Today, military exports, like
commercial exports, are subject to fierce international
competition in every area from companies such as British
Aerospace, Aerospacio, Daimler-Benz, and others.
Since fiscal 1985, the United States defense budget has
shrunk from 27.9 percent of the Federal budget, now, to 14.8
percent in fiscal 1999; that is almost a half decrease. And in
facing such dramatic cuts in U.S. defense spending, the
international market has become increasingly important to U.S.
defense contractors and to maintaining the defense industrial
base. For example, of the three fighter aircraft programs under
production in this country currently, two are largely dependent
on foreign customers. The same is true for the manufacturer of
the M-1A1 tank. Repeal will not only benefit the large
manufacturers of military hardware, but also smaller munitions
manufacturers whose products are particularly sensitive to
price fluctuations.
One of Northrop Grumman's main export product lines is
ground radars. In this market, we compete against companies
from France, Germany, Italy, and Great Britain, which are often
government subsidized, and price is often a key factor as to
who wins the foreign sale. The restoration of the full FSC
benefit has the potential to strengthen the U.S. defense
industry base by leveling the playing field with our
international competition.
I now want to talk about Northrop Grumman's real-time FSC
analysis. The FSC tax benefits have a real impact on our
international sales and pricing. As an example, Northrop
Grumman performs the FSC benefit analysis on a real-time basis.
Under our internal procedures, the tax department is
responsible for reviewing the company's foreign bids,
proposals, contracts, and joint ventures. Our program managers
and contracts negotiators are generally aware of the FSC
benefits, and we often consult with them about it at the time
the bids are prepared and the contract prices with foreign
customers are being negotiated. So, my point here is that the
FSC benefits are cranked into pricing and considered at the
time that the prices are being negotiated with foreign
customers, and if we can roll down the price, that gives us a
competitive advantage against foreigners.
Now, I would like to point out that the provision is
support by the Department of Defense. For example, in a letter
dated August 26, 1998, Deputy Secretary of Defense, John Hamre,
wrote Treasury Secretary Rubin about the FSC. And Mr. Hamre
wrote--and here I am quoting: ``The Department of Defense
supports extending the full benefits of the FSC exemption to
the defense exporters. I believe, however, that putting defense
and non-defense companies on the same footing, would encourage
defense exports that would promote standardization and
interoperability of equipment among our allies. It could also
result in a decrease in the cost of defense products to the
defense products to the Department of Defense.''
Continued export license reviews: I would now like to
emphasize that the repeal of section 923(a)(5) of the tax code,
the discriminatory provision against defense contractors, 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. As under current law, exporters of military
property will only be able to take advantage of the FSC after
the U.S. Government has to determined that a sale is in the
national interest. However, once a decision has been made that
the military export is consistent with the national interest,
our Government should encourage such sales to go to U.S.
companies and workers, not to our foreign competitors.
As you probably know, Congressman Sam Johnson's bill, the
Defense Jobs and Trades Promotion Act of 1999, includes
language identical to section 303 of H.R. 2018. This bill
enjoys broad bipartisan support. Currently, 54 Members of
Congress are co-sponsors of the bill, including 9 of the 12
members of this Subcommittee and 28 of 39 members of the full
Ways and Means Committee. In addition, Senators Mack and
Feinstein have introduced identical legislation in the Senate,
which also enjoys broad bipartisan support.
In conclusion, I urge the Congress to enact H.R. 2018. The
enactment of section 303 of H.R. 2018, in particular, will
provide fair and equal treatment to our defense industry and
its workers and enable American defense companies to compete
more successfully in the increasingly challenging international
market.
Thank you for your time, and I will be pleased to answer
any questions that you may have.
[The prepared statement follows:]
Statement of Gary McKenzie, Vice President of Tax, Northrop Grumman
Corporation, Los Angeles, California
Mr. Chairman and Members of the Subcommittee, thank you for
providing me the opportunity to appear before you today. My
name is Gary McKenzie and I am Vice President of Tax for
Northrop Grumman Corporation. Northrop Grumman, headquartered
in Los Angeles, is a leading designer, systems integrator and
manufacturer of military surveillance and combat aircraft,
defense electronics and systems, airspace management systems,
information systems, marine systems, precision weapons, space
systems, and commercial and military aerostructures. We employ
about 49,000 people based almost entirely in the United States.
In 1998 we had sales of $8.9 billion. Many of our products,
including the B-2 bomber and the Joint STARS surveillance
aircraft, were used extensively during the recent conflict in
Kosovo.
I am pleased to provide testimony on the myriad problems
facing U.S. corporations in complying with the complexity of
the current U.S. international tax regime. I also want to
commend Chairman Houghton and Congressman Levin for the many
constructive changes included in H.R. 2018, the ``International
Tax Simplification for American Competitiveness Act of 1999.''
My specific comments on the bill will concentrate, in
particular, on Section 303, the ``Treatment of Military
Property of Foreign Sales Corporations.''
Before I discuss the Foreign Sales Corporation provision,
however, I would like to say why the time has come (and,
indeed, is long overdue) to reform the entire U.S.
international tax system. Particularly needing reform is our
system for taxing the foreign income of U.S. corporations under
the so-called ``subpart F'' regime. The complexity of the
subpart F rules and the pressing need for a fresh look at, and
complete reevaluation of, subpart F was presented in a recent
report prepared by the National Foreign Trade Council,
``International Tax Policy for the 21st Century: A
Reconsideration of Subpart F.'' I strongly agree with the
report's recommendations, and I would like to highlight some of
the issues discussed in the report.
As I am sure many of you know, subpart F was initially
added to the Internal Revenue Code (IRC) almost 40 years ago,
during the Kennedy Administration. Before the enactment of the
subpart F rules, U.S. tax generally was imposed on earnings of
a U.S.-controlled foreign corporation (a ``CFC'') only when the
CFC's foreign earnings were actually repatriated to the U.S.
owners, usually in the form of a dividend. Subpart F is
referred to by many tax professionals as an ``anti-deferral''
regime. That is, its intended purpose, which has been achieved
quite effectively during the course of numerous legislative
changes since 1962, is to prevent U.S. companies from deferring
the payment of U.S. tax on income earned abroad by CFCs in
their foreign operations, including various categories of
``active'' business income. Put another way, the anti-deferral
rules under subpart F frequently accelerate the imposition of
U.S. tax on various types of income earned by CFCs, even though
the income has not been repatriated to the U.S. This regime
places U.S. companies at a clear disadvantage to foreign
companies, which frequently do not operate under these kinds of
harsh and complex taxing rules. The simple fact is that the
application of subpart F to various categories of active
foreign business income should be substantially narrowed as a
first step to reforming the current anti-deferral regime.
A certain irony underlies this entire discussion. The
subpart F rules were originally intended to achieve capital
export ``neutrality'' when they were enacted in 1962. That is,
it was intended that the subpart F rules would play no part in
influencing the decision of whether to invest in the U.S. or a
foreign country. Unfortunately, subpart F has developed over
the last 40 years into an arcane set of rules that not only are
enormously complex, but also clearly place U.S. companies at a
competitive disadvantage in the global marketplace. It is my
view, which I believe is shared by many others, that tax rules
play a key role in America's continuing prosperity,
particularly in the context of an increasingly global
marketplace. A reevaluation of the policy goals of subpart F
and, indeed, the entire scheme of international taxation is
long overdue; and I applaud your efforts to begin that process.
I will now discuss Section 303 of H.R. 2018, which
eliminates a provision of the tax code that severely
discriminates against United States exporters of products on
the U.S. Munitions List. Specifically, Section 303 repeals IRC
Section 923(a)(5), which reduces the Foreign Sales Corporation
(FSC) benefits available to companies that sell military goods
abroad to 50 percent of the benefits available to other
exporters.
Congressman Sam Johnson's bill, H.R. 796, the ``Defense
Jobs and Trade Promotion Act of 1999,'' includes language
identical to Section 303. This bill enjoys broad bipartisan
support. Currently 54 members of Congress are cosponsors of the
bill, including 10 of the 13 members of this subcommittee and
28 of the 39 members of the full Ways and Means Committee, as
well as a number of members from the defense oversight and
appropriations committees. Senators Mack and Feinstein have
introduced S. 1165, a companion bill in the Senate, which also
enjoys broad bipartisan support.
Repeal of Section 923(a)(5) will help protect our defense
industrial base and insure that American defense workers--who
have already had to endure sharply declining defense budgets--
do not see their jobs lost to foreign competitors because of
detrimental U.S. tax policy.
The Internal Revenue Code allows U.S. companies to
establish FSC's, 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 (VAT's) 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 who pay less tax.
In 1976 the Congress reduced the Domestic International
Sales Corporation (DISC) tax benefits for defense products to
50 percent, while retaining the full benefits for all other
products. The limitation on military sales, currently IRC
Section 923(a)(5), was continued when Congress enacted the FSC
in 1984. The rationale for this discriminatory treatment--that
U.S. defense exporters faced little competition--no longer
exists. Whatever the veracity of that premise 25 years ago,
today military exports are subject to fierce international
competition in every area. In the mid-1970's, 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 fifteen years, the U.S. defense
industry has experienced 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 with the Korean War in the early 1950's and
gradually dropping to 6-7 percent in the late 1980's. That
figure has now sunk to 3 percent of GDP and is planned 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.
I know members of Congress are well aware of the massive
consolidation and job loss in the defense industry. Out of the
top 20 defense contractors in 1990, two-thirds of the companies
have merged, been sold off or spun off; hundreds of thousands
of jobs have been eliminated in the industry. To put this in
perspective, consider, for instance, the fact that in 1998
WalMart had $138 billion in revenues; in comparison, the
combined revenues of the top five defense contractors totaled
$61 billion--less than half the WalMart results for the
year.\1\
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\1\ ``The Post-Deconstruction Defense Industry,'' 1999 Revised
Edition, Dr. Loren B. Thompson, Lexington Institute, April 1, 1999.
---------------------------------------------------------------------------
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. Overriding policy concerns justify this expense. With
the sharp decline in the defense budget over the past fifteen
years, exports of defense products have become ever more
critical to maintaining a viable U.S. defense industrial base.
Several key U.S. defense programs rely on international sales
to keep production lines open and to reduce unit costs. For
example, of the three fighter aircraft under production in this
country, two are largely dependent on foreign customers. The
same is true for the manufacturer of the M-1A1 tank, which must
compete with several foreign tank companies. Repeal will not
only benefit the large manufacturers of military hardware, but
also the smaller munitions manufacturers, whose products are
particularly sensitive to price fluctuations.
One of Northrop Grumman's main product lines is ground
radars. In this market we compete against companies from
France, Germany, Italy and Great Britain, and these companies
are often government subsidized. Price is frequently a key
factor as to who wins the sale. The restoration of the full FSC
benefit has the potential to improve the defense industrial
base and our ability to compete on a more level playing field
with foreign firms.
The recent conflict in Kosovo demonstrated the importance
of interoperability of equipment among NATO allies.
Unfortunately, when our foreign competitors win a sale, not
only does a U.S. business lose a contract, the U.S. military
must then conduct operations with a military using different
equipment. For example, Northrop Grumman and Lockheed Martin
recently competed against a Swedish company, Ericsson, for a
contract to supply an Airborne Early Warning System (AEW) to
the Greek Government. Despite the fact that both U.S. companies
were offering proven, state-of-the-art technology at a fair
price, the Greek Government selected the Ericcson proposal,
which had never been tested and will lack commonality with the
NATO AEW system when built.
This is one reason why the Department of Defense supports
repeal of Section 923(a)(5). In an August 26, 1998, letter, to
Treasury Secretary Rubin, Deputy Secretary of Defense John
Hamre wrote:
The Department of Defense (DoD) supports extending the full
benefits of the FSC exemption to defense exportersI believe,
however, that putting defense and non-defense companies on the
same footing would encourage defense exports that would promote
standardization and interoperability of equipment among our
allies. It also could result in a decrease in the cost of
defense products to the Department of Defense.
Section 303 implements the DoD recommendation and calls for
the repeal of this outdated tax provision.
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. When 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. Why? Since
these satellites are now classified as munitions, they receive
50 percent less of a FSC benefit than before. 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 in the same
manner under the FSC. The Department of Defense and the Cox
Committee are not the only entities that have commented
publicly about this provision. Several major trade associations
including the National Association of Manufacturers, the U.S.
Chamber of Commerce, and the Electronics Industry
Alliance, to name just a few, have stated that Section
923(a)(5) is bad tax policy and should be repealed.
A joint project of the Lexington Institute and the
Institute for Policy Innovation, entitled ``Out of Control: Ten
Case Studies in Regulatory Abuse,'' highlighted the FSC. The
December 1998 article, fittingly titled ``26 U.S.C. 923(a)(5):
Bad for Trade, Bad for Security, and Fundamentally Unfair,''
because it reveals the many problems with this provision. In
the paper, Dr. Thompson argues that Congress' decision to limit
the FSC benefit for military exports was not based on sound
analysis of tax law, but on the general anti-military climate
that pervaded this country in the mid-1970's. Congress enacted
Section 923(a)(5), and I quote: ``to punish weapons makers.
Section 923(a)(5) was simply one of many manifestations of
congressional anti-
militarism during that period.''
I want to emphasize that the 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
only be able to take advantage of the FSC after the U.S.
Government has determined that a sale is in the national
interest.
Decisions on whether or not to allow a defense export
should continue to be made on foreign policy grounds. However,
once a decision has been made that an export is consistent with
those interests, surely our government should encourage such
sales to go to U.S. companies and workers, not to our foreign
competitors. Discriminating against these sales in the tax code
puts our defense industry at great disadvantage and makes no
sense in today's environment. Removing this provision of the
tax code will further our foreign policy objectives by making
defense products more competitive in the international market.
I urge the Congress to repeal this provision in order to
provide fair and equal treatment to our defense industry and
its workers and to enable American defense companies to compete
more successfully in the increasingly challenging international
market.
I thank you for your time and will be pleased to answer any
questions that you have.
Chairman Houghton. Thank you, Mr. McKenzie.
Now, Mr. Kelly.
STATEMENT OF STAN KELLY, VICE PRESIDENT-TAX, WARNER-LAMBERT
COMPANY, MORRIS PLAINS, NEW JERSEY
Mr. Kelly. Good afternoon. I am honored to appear before
the Ways and Means Committee. I am Stan Kelly, Vice President
of Tax for Warner-Lambert Company, a $10 billion U.S.
multinational headquartered in Morris Plains, New Jersey.
Warner-Lambert employs 41,000 people in 150 countries and
operates 78 manufacturing facilities worldwide. Warner-Lambert
has three principal product lines: confections, consumer health
products, and pharmaceuticals. Well known Warner-Lambert brands
include Listerine, Benadryl, Sinutab, Trident gums, and Halls
lozenges. Warner-Lambert's pharmaceutical line includes
Lipitor, the world's leading cholesterol reducing agent, and
Viracept, the world's leading AIDS treatment.
The pharmaceutical industry is on the brink of a scientific
revolution that will be sparked by the decoding of the human
genome during the next few years. This revolution will be
global. Drug targets will jump from 500 to 15,000, triggering a
tidal wave of competition. Warner-Lambert's competition will
come primarily from Japan and Europe whose tax policies support
their multinationals better than U.S. policies support our
multinationals. U.S. international tax policy must change in
order to improve the competitive position of U.S. companies.
Mr. Chairman, your bill and this hearing are important
steps that can help to move U.S. international tax policy in
the right direction. Warner-Lambert strongly supports H.R. 2018
because it promotes three sound, international tax policies
that would help to improve American competitiveness. First,
your bill would begin to reverse the anti-deferral rules in our
tax system. I refer to section 107 of the bill, which provides
for look-through treatment for sales with partnership interest.
In addition, although it does not affect Warner-Lambert, I
refer to section 101 of the bill, which provides for permanent
Subpart F exemption for active financing income.
Second, your bill would improve the operation of the
foreign tax credit system by reducing double taxation that is
inherent in the system today. Eliminating double taxation is a
fundamental objective of U.S. international tax policy. I refer
to section 207 of the bill, which provides for the repeal of
the 90 percent foreign tax credit limitation under the
alternative minimum tax.
Third, your bill would simplify the administration of our
international tax rules. I refer to section 306 of the bill
instructing the Treasury to issue regulations stating that
agreements which are not legally enforceable are not intangible
property for various purposes. Warner-Lambert supports this
provision, which mandates a bright-line test in an area where
Treasury has not exercised the regulatory authority given to it
more than 15 years ago.
I would now like to direct your attention to two provisions
of the bill that may need further clarification. First, section
102 of the bill authorizes Treasury to conduct a study of the
feasibility of treating the European Union as one country for
purposes of the same-country exceptions under Subpart F.
Warner-Lambert supports this concept, but section 102(a) also
provides,
Such studies shall include consideration of methods of
ensuring that taxpayers are subject to a substantial effective
rate of foreign tax in such countries if such treatment is
adopted.
The policy goals represented by this sentence are unclear.
Does the United States have a tax or trade policy requiring
U.S. multinationals to pay substantial amounts of foreign tax
on profits made outside the U.S.? Wouldn't such a policy make
it easier for other developed countries to fund the support of
their own multinationals? Mr. Chairman, I strongly urge you to
reconsider the language in section 102 of your bill.
The second provision that may need clarification is section
310 of your bill, which would amend the earning stripping rule
in section 163(j) of the code. I believe that this provision
could actually facilitate stripping of U.S. earnings by our
foreign competitors, and Warner-Lambert could not identify any
benefit to U.S. multinationals in section 310. I am concerned
that section 310 may inadvertently impose a competitive tax
disadvantage on U.S. multinational corporations.
Overall, H.R. 2018 is a good step in the right direction
for U.S. international tax policy, but more can be done to
improve the competitiveness of U.S. multinationals. I encourage
this committee to continue its efforts. Warner-Lambert is ready
to offer its assistance.
I want to thank you all for your time today and commend and
thank you, Mr. Chairman, for introducing H.R. 2018 and for
holding this hearing.
[The prepared statement follows:]
Statement of Stan Kelly, Vice President-Tax, Warner-Lambert Company,
Morris Plains, New Jersey
Good afternoon, Chairman Houghton and members of the
Committee, I am pleased to testify today about the impact of
the current U.S. tax system on the competitiveness of U.S.
multinationals. I will also comment on your effort to improve
and simplify the U.S. tax system, specifically H.R. 2018, the
``International Tax Simplification for American Competitiveness
Act of 1999.''
Warner-Lambert: A Global Leader Building Global Brands
I am Stan Kelly, Vice President of Tax for Warner-Lambert
Company. Warner-Lambert is a U.S. multinational company
headquartered in Morris Plains, New Jersey, which employs
approximately 41,000 people devoted to developing,
manufacturing and marketing quality health care and consumer
products worldwide. The members of the Subcommittee may be
familiar with some of Warner-Lambert's brand name products,
such as Listerine, Sudafed, Benadryl, Schick and Wilkinson
Sword shaving products, Tetra, Rolaids, Halls, Trident, Dentyne
and Certs. Our Pharmaceutical sector is comprised of three
parts: Parke-Davis, which has been engaged in the
pharmaceutical business for 127 years; Agouron, a wholly-owned
subsidiary of Warner-Lambert, an integrated pharmaceutical
company engaged in the discovery, development and
commercialization of drugs for treatment of cancer, viral
diseases, and diseases of the eye; and Capsugel, the world
leader in manufacturing empty, hard gelatin capsules. Warner-
Lambert's leading pharmaceutical products, Lipitor, Rezulin,
Neurotin, Accupril, and Agouron's Viracept were developed to
treat patients suffering from high cholesterol, diabetes,
epilepsy, heart failure, and AIDS.
It is an honor to appear before the Ways and Means
Committee and to continue our company's participation in the
trade and tax policy-making process. Our Chairman and CEO,
Lodewijk de Vink, testified two years ago before the
Subcommittee on Trade. Warner-Lambert is proud to be a leader
in promoting free trade policies and my remarks today regarding
the U.S.'s international tax regime are closely intertwined
with those same policies.
In 1998, Warner-Lambert had total revenues of approximately
$10.2 billion ($4.3 billion, or 40% from international sales)
and sold product in over 150 countries. Warner-Lambert has
approximately 78 production plants in its six lines of business
worldwide.
The Biomedical Century
Senator Daniel Patrick Moynihan (D-NY) recently said that the 21st
century would be the ``Biomedical Century.'' At the heart of this
statement are the significant potential biomedical advances that
Warner-Lambert and other companies in the pharmaceutical industry will
make in the next decade. Scientists will soon complete a project
started in 1990, to map the code of life itself, the Human Genome.
Within five years, the number of targets for drug therapy will increase
from 500 today, to more than 15,000, as scientists apply the findings
of this project. That is a thirty-fold increase at a time when even 500
drug targets keeps the global pharmaceutical industry going at full
bore. So, for this reason and others, we agree with Senator Moynihan's
statement. We are on the brink of a revolution in research and
development that will lead to new forms of prevention, new cures, and
new treatments. This revolution is global and U.S. companies need to
compete aggressively in product discovery, development, manufacturing,
marketing, and delivery with equally talented and driven foreign
competitors primarily from Europe and Japan. U.S. trade policy and U.S.
international tax policy must keep pace with these changes in order to
mitigate competitive disadvantages facing U.S.-based companies.
Let me emphasize this last part: the global pharmaceutical industry
is highly competitive, with many of the world's largest pharmaceutical
corporations headquartered outside the United States. These competitors
such as Glaxo-Wellcome, Novartis, Astra Zeneca, Roche, Hoechst Marion
Roussel, and SmithKline Beecham are not subject to the worldwide tax
system similar to that used by the United States.
The U.S. has long recognized the importance of open global markets
in the continued growth of the U.S. economy. The U.S. trade policy is
evolving to ensure that U.S. companies are able to remain competitive
in a global economy. Conversely, U.S. tax policy, particularly as it
relates to the taxation of international activities, has not kept pace
with changes in the global market place in helping to promote U.S.
competitiveness. Simply stated, U.S. tax policy is out of step with the
broader objectives of our country's evolving trade policy. Mr.
Chairman, your bill and this hearing are important steps towards
harmonizing these two important and related policy areas.
Before I turn to my specific comments on your bill, let me give you
an example of how well the system can work when U.S. businesses and the
Government work together toward a common objective. Last year Warner-
Lambert and others had the opportunity to work with the U.S. Treasury
Department and foreign revenue officials in coordinating the tax
consequences of the conversion to the Euro. The policy asserted by U.S.
business was tax neutrality, i.e., the U.S. tax cost of converting to
the Euro should be the same to a U.S. multinational corporation
operating in Europe as the foreign tax cost to a foreign multinational
corporation operating in Europe. By maintaining tax neutrality, the
competitiveness of U.S. multinational corporations operating in Europe
was maintained. The U.S. Treasury should be complimented for quickly
developing a practical policy that enabled a smooth transition to the
Euro.
Turning now to your bill.
Warner-Lambert Strongly Supports H.R. 2018
Warner-Lambert strongly supports H.R. 2018 because it
promotes three sound overall international tax policies: (i)
reversing the growth of anti-deferral rules in our tax system
by narrowing the scope of subpart F; (ii) improving the
operation of the foreign tax credit system by reducing double
taxation; and (iii) simplifying tax compliance.
Reversing Anti-Deferral rules: The proposed changes would
restore aspects of deferral that have been eliminated since the
enactment of subpart F in 1962. This is an important contribution to
the continued effort to improve the competitiveness of American
industry. I refer to Sections 103 (expansion of the de minimis rule
under subpart F) and 107 (look-through treatment for sales of
partnership interests) of the bill as examples of this policy. In
addition, even though not of direct interest to Warner-Lambert, I also
refer to Section 101 of the bill (permanent subpart F exemption for
active financing income) as an example of this policy.
Improving the Operation of the Foreign Tax Credit System
By Reducing Double Taxation: The foreign tax credit system is the
United States' attempt at fairness to U.S. multinationals (as compared
to the exemption system used by many countries), with the intention of
eliminating double taxation of income earned outside the United States.
Eliminating double taxation through the foreign tax credit system is a
fundamental objective of U.S. international tax policy. Accomplishing
this objective is critical to the competitiveness of American industry.
I refer to Sections 201 (extension of period to which excess foreign
taxes may be carried) and 207 (repeal of limitation of foreign tax
credit under alternative minimum tax) of the bill as examples of this
policy.\1\
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\1\ Section 207 of H.R. 2018 is identical to H.R. 1633 (introduced
on April 29, 1999 by Chairman Houghton and 25 other members of the Ways
and Means Committee) and S. 216 (introduced on January 19, 1999 by
Sens. Moynihan and Jeffords (R-VT)).
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Simplifying Tax Compliance: Simplifying the administration
of tax compliance is another important element in improving the
competitiveness of American industry. U.S. tax compliance is generally
considered much more burdensome than tax compliance under the laws of
many of our principal trading partners. I refer to Section 306 of the
bill (instructing the Treasury to issue regulations to the effect that
agreements which are not legally enforceable are not intangible
property for various purposes) as an example of this policy. Warner-
Lambert supports this provision, which mandates a bright-line test in
an area where Treasury has not exercised regulatory authority given to
it more than 15 years ago.
I would like to direct your attention to one section of
H.R. 2018 that is of particular interest to Warner-Lambert.
Section 107(a) would amend Section 954(c) of the Internal
Revenue Code (the ``Code'') to provide a look-through rule for
the sale of a partnership interest by a controlled foreign
corporation (``CFC''). If a CFC disposes of an interest in a
partnership, the CFC would be deemed to have sold its pro rata
share of the underlying assets of the partnership. This look-
through rule only applies if the CFC has a 10% or greater
interest in the partnership. This rule makes sense for three
reasons. First, with the proliferation of international joint
ventures there are instances where a transfer of a partnership
interest is deemed to be a sale and gain recognized for U.S.
tax purposes. Thus, the U.S. tax treatment of gain from the
sale of a partnership interest by a CFC is becoming a more
common issue.
Second, under the present law the gain on the sale of a
partnership interest is treated as passive subpart F income.
That is the case even if 100% of the income generated by the
partnership in its business is otherwise treated as active non-
subpart F income. Thus, under this amendment gain from a
partnership interest is treated in a manner similar to the
income earned from the partnership, which is a rational tax
policy.
Third, under current law the transfer of a partnership
interest is frequently treated as a deemed transfer of a pro
rata share of the partnership's underlying assets, such as
under Code Section 367(a)(4). Thus, this change enhances
consistency in the treatment of a sale of a partnership
interest in the international tax area.
Overall H.R. 2018 is clearly a step in the right direction.
It should be noted, however, that there are confusing signals
from Congress. For example, Section 201 of H.R. 2018 expands
the carryover period for foreign tax credits, but, in contrast,
the Senate Finance Committee earlier this year once again
approved a proposal to reduce the carryback period.\2\
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\2\ A reduction in the carryback period from two years to one year
was most recently approved by the Senate Finance Committee on May 19,
1999 as Section 401 of S. 1134, the Affordable Education Act of 1999.
---------------------------------------------------------------------------
Request for Clarification
There are two provisions of your bill, Mr. Chairman, that
need further clarification. Section 102(a) of the bill
authorizes the Secretary of the Treasury to conduct a study on
the feasibility of treating all countries included in the
European Union as one country for purposes of applying the same
country exceptions under subpart F. That aspect of Section 102
represents a positive step, which Warner-Lambert strongly
supports. That provision is attractive to us because it would
lessen the gap between ourselves and our European based
pharmaceutical competitors in that market. But then Section
102(a) provides as follows:
Such study shall include consideration of methods of ensuring
that taxpayers are subject to a substantial effective rate of
foreign tax in such countries if such treatment is adopted.
The policy represented by this sentence is unclear. Should
the policy of the United States be that non-U.S. business
activities of a U.S. multinational corporation must be subject
to ``substantial'' foreign tax? If so, how did we reach this
point? Mr. Chairman, I strongly urge you to reconsider the
language in Section 102(a) of your bill and in particular ask
that you do so in light of the recent National Foreign Trade
Council's (the ``NFTC'') report on international tax policy for
the 21st century.
Also Section 310 in H.R. 2018 appears to be inconsistent
with the notion of ``International Tax Simplification for
American Competitiveness.'' Section 310 would amend the so-
called ``earnings stripping'' rule in Section 163(j) of the
Code. The earnings stripping rule imposes a limitation on the
amount of interest expense that may be deducted by a foreign-
owned domestic corporation. This subsection was enacted to stop
the practice by foreign multinationals of ``stripping'' the
earnings out of their domestic subsidiaries through related-
party loans. Many other developed countries have similar
restrictions, frequently in the form of debt/equity ratio
requirements.
I believe that this provision might potentially facilitate
earnings stripping by our foreign competitors. Warner-Lambert
could not identify a benefit to U.S. multinationals of Section
310. Let us make certain that Section 310 is not an instance
where by unilateral action the United States indirectly imposes
a competitive tax disadvantage on its own multinational
corporations.
Although this amendment to Code Section 163(j) may have
merit, I ask this Committee to take into account the treatment
accorded U.S. multinationals in the reverse situation before
proceeding with this subsection. I would also point out that
Section 310 incorporates what may be considered a subjective
test, i.e., satisfying the Secretary that a loan would have
been made without a parent guarantee. A number of years ago the
subjective test in the high-tax exception of Code Section
954(b)(4) (no tax avoidance intention) was repealed because of
alleged administrative difficulties in applying the test.
The NFTC Report
Before I conclude, I would like to comment on a recent
report issued by the NFTC, an organization of which I am
pleased to be a member of the Board of Directors. This report,
The NFTC Foreign Income Project: International Tax Policy for
the 21st Century (the ``Report''), is the first of a series of
studies commissioned by the NFTC to evaluate our international
tax policies in light of the globalization of the world's
economy. The first report focused on the subpart F rules of the
Code, which provide a number of exceptions to the principal
U.S. international tax policy of deferral of U.S. taxation on
foreign earnings until distributed. The Report highlights the
slow breakdown of deferral. Your bill focuses on and addresses
this trend.
The Report concludes 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.
When subpart F was enacted in 1962, 18 of the 20 largest
corporations in the world (ranked by sales) were headquartered
in the U.S. Now there are eight. In 1962 over 50% of worldwide
cross-border direct investment was made by U.S. businesses. Now
that number is 25%. U.S. gross domestic product as a percentage
of the world total has gone from 40% to 26%. As these figures
suggest, the competitive environment in 1962 and the
competitive environment today are completely different. Thus,
international tax policy should reflect this change to a global
economy.
In 1962 subpart F included a de minimis test where a CFC
was deemed to have no subpart F income if certain designated
categories of income constituted 30% or less of total gross
income. That test over time has been reduced to the lesser of
5% of gross income or $1,000,000. As a result, we have reached
the point where incidental interest income earned on normal
levels of working capital used in an active business
constitutes subpart F income. In 1962, the ``high-tax
exception'' referred to the alternative of a specified
effective tax rate or establishment of no tax avoidance intent.
Now a mechanical effective tax rate test creates anomalous
situations in which, for example, a CFC organized in Italy
(with a statutory tax rate in excess of the U.S. rate) may fail
the high-tax exception because U.S. and Italian capital
recovery rules are not identical. Also, the U.K. now
constitutes a low-tax jurisdiction under our subpart F rules
and, therefore, a CFC doing business in the U.K may no longer
qualify for the high-tax exception of Code Section 954(b)(4).
A subsequent NFTC report will focus on the functioning of
the second principal U.S. international tax policy--avoidance
of double taxation through the foreign tax credit system.
Conclusion
In conclusion, I commend and thank you Mr. Chairman for
introducing H.R. 2018 and holding a hearing on what is a highly
technical but extremely important area of our tax laws. Warner-
Lambert supports the bill but more can be done in the
international tax area to improve the competitiveness of U.S.
multinationals. I encourage this Committee to continue its
efforts in this regard. Warner-Lambert is ready to offer its
assistance in your efforts. Finally, I urge you to include the
important provisions in H.R. 2018 in the tax bill the Committee
will be marking up early next month.
Mr. Chairman, I am pleased to answer any questions.
Chairman Houghton. Well, thank you very much.
I am going to ask one question, and then I am going to pass
it over to Mr. Coyne.
Tell me, gentlemen, how do we treat the European Union as
one tax entity when there are so many different tax laws in the
various countries? Help us on that.
That is a question, and I hear no answers.
Mr. Kelly. Maybe I will try.
Chairman Houghton. Well, yes, because--I mean, it is very
easy to say that there are too many baskets and a lot of bows
being thrown the way of U.S. corporations that make us
uncompetitive with other parts of the world and other European
countries, but to move from the principle to the practical, how
does it get done?
Mr. Kelly. Mr. Chairman, just to make sure I understand the
question, are we talking about the provision related to the
European Union?
Chairman Houghton. Yes.
Mr. Kelly. OK. The way I understand that provision is that
it is really addressing the treatment of Subpart F income in
the European Union so that it is dealing with movements of
funds across borders. It is not trying to say that all of the
rules and all of those countries should be treated the same. It
is only saying that if you move cash back and forth with
royalty payments or interest payments, et cetera, that we not
treat those movements of cash as taxable in the United States.
Mr. Cox. I think that is right, Mr. Chairman, and I think
also, to give you an example in our industry, Germany is our
biggest market; Switzerland is a small market, so I actually
had a discussion with our German country manager one time that
said he wanted to service the Swiss market by having men and
women sales representatives just either fly in or drive into
the Swiss market. I told him he couldn't do that. He looked at
me like I was cross-eyed, and I said, ``Well, you can't do it
because of U.S. Subpart F,'' and then he really went cross-eyed
on me. But the importance of that--and the gentleman is exactly
correct--the issue is not how much tax we would pay in
Switzerland or how much tax we would pay in Germany, the issue
is, absent setting up--and I believe Mr. Jarrett pointed it out
correctly--adding additional costs, administrative costs,
setting up a new subsidiary in Switzerland, all that cost, why
do I have to do that as a corporation? Why do I need to make
that decision? I am going to pay tax, and the foreign taxes I
pay and I credit will simply be determined based on whichever
country I do business in, irrespective of and knowing full well
that all those countries will have different rates. So, I think
we are maybe trying to make that a little more complicated than
it should be.
Chairman Houghton. Well, we will get back to this in a
minute.
I want to call on Mr. Coyne.
Mr. Coyne. Thank you, Mr. Chairman.
One would hope that our international tax policies would
lend themselves to domestic firms having incentives to retain
operations and workers here in the United States. Which
provisions of the proposed bill, 2018, would do that? They
would lend themselves to retain jobs in the United States.
Anyone can answer.
Mr. McKenzie. I think, if I could speak, that section 303
of the bill clearly would aid in doing that by making us more
competitive on international bids and for selling military
property overseas. That would tend to strengthen the industrial
base for defense companies, keep workers employed here to the
extent that we could win those contracts, and, as a byproduct,
even though we get somewhat of a tax break on the FSC rules,
overall, we pay more U.S. tax if we are able to generate
additional U.S. profits overseas. So, as I see it, it is a win-
win situation for everybody.
Mr. Coyne. Anyone else care to comment?
Ms. Strain. I would agree with that. If one assumes that,
for example, the active financing provision helps us U.S.
companies be more competitive in the overseas marketplace and
therefore be able to expand our businesses there. We see,
today, in my company that we have a number of locations in the
United States which originally started out servicing just a
domestic customer base which now service our global customers.
It is the credit card business, our payables, some of our cash
management functions--all are done in the United States for
overseas markets. Similarly, our R&D, is developed primarily
first for the American market, and then we export. It,
therefore, becomes cheaper for us to develop if we have a
larger customer base.
Mr. Coyne. Can you cite what types of industries, however,
would be more likely to move operations overseas and why that
would be an advantage to them? Just by type of industry.
Mr. Cox. Congressman, specifically related to provisions in
this bill?
Mr. Coyne. Right.
Mr. Cox. I cannot.
Mr. Coyne. All right, thank you.
Chairman Houghton. All right. Mr. Watkins.
Mr. Watkins. Let me ask the question a little differently
in something that might be in the real practical phase of it.
By the way, I have used a lot of that green and yellow.
Each of you see some of these provisions were enacted to
take place. How many more jobs--let me say it right now--what
percentage of exports do you do now, so to speak, from this
country? What additional increases and exports would you think
your company would achieve by these provisions? And then we
were talking about, probably, economic growth here, jobs over
here in this country, too, and you tried to give us a little
bit of insight on that. A lot of companies do not do a very
good job educating their employees that their job depends on
export trade. Now, I have talked to some of my businesses,
because we can't pass Fast Track, we can't do other things, and
people are voting actually against their jobs, in many cases,
with some of these industries. Now, what kind of increase do
you think you would have with jobs in this country if some of
these provisions would be passed?
Mr. McKenzie. Well, Congressman, if I may answer that the
way I understand your question, I think it cuts two ways. If a
company forms a ``maquiladora'' in Mexico to attain cheaper
wages in Mexico, that may, in fact, have some effect of
transferring jobs overseas to obtain the cheaper labor.
However, the case that we are after--if I could just point out
a couple of statistics. In 1998, for example, Northrop Grumman
had export sales qualifying for the FSC treatment of
approximately $1 billion. That is up 128 percent over 1997, and
it is up 278 percent over 1994. So, that created U.S. jobs, OK?
Because the manufacturing that took place on those qualifying
sales took place in the United States by definition, in order
to meet the requirements to qualify for a foreign export sale.
That is what we mean by strengthening the U.S. defense base in
the workplace.
Mr. Watkins. Right. You see where I am coming from. I think
this is going to be the compelling argument on how this is
going to be helping over here and sharing with us.
How about you, Mr. Jarrett and John Deere?
Mr. Jarrett. As I mentioned in my statement, I think about
one-third of Deere's sales today are export sales. Deere serves
an agricultural market for half of its income, basically. It is
a very mature market in the United States. The growth in our
agricultural products, many of our construction products is
going to be overseas. The markets in South America, the markets
in Asia are growing, and that is where the farmers, the
customers need equipment. Much of that equipment comes from the
United States. It is going to be our ability to not only
produce equipment in the United States but also to produce
equipment in the countries that need it. The technology, the
competitiveness, the research and development all comes from
the United States, and that is what we want to retain from our
perspective or from a manufacturers perspective. I need to
control that technology; I need to control that patent and the
ability to make that equipment worldwide. That is where we will
gain from having an even playing field from a tax structure.
Mr. Watkins. Well, I know your company has done a good job.
I am product of using the old Pop and Johnny, what we called it
years ago, the old Pop and Johnny, and it has changed a whole
lot since that day when I used to crank them a little bit. I am
not that old, but, you know, just back where you couldn't get
them to me. Any other comment on some of the other companies?
I think we have done a poor job of educating the American
people--if I can just say this--and part of it--I am
challenging the companies that I know of and I have worked with
to get off their duffs and help, because they expect a lot of
things from us, and I am a believer. I am willing to get into
the trenches and try to make sure we don't have certain
barriers out there that make it difficult to burst into those
markets overseas and be able to do business. But I know the
chairman of Boeing is leading an effort and realizes that--a go
trade effort and hope that your companies are involved in that,
because we have got to do a lot in those areas, including, as I
said, not only the taxation policy but the regulatory and
litigation policies that you are confronted with and many
companies are, and what little work I have done outside the
Congress in the international field, I found it very
complicated.
Mr. Chairman, thank you very, very much, and I appreciate
the insight in your companies; something is happening there.
Chairman Houghton. Is that it? OK. Mr. Neal.
Mr. Neal. Thank you, Mr. Chairman.
Ms. Strain, the Treasury Department has urged Congress to
delay any extension of the active financing exception to the
Subpart F rules until after it completes a thorough study of
the Subpart F regime later this year. Do you believe that we
should agree to that proposal from Treasury?
Ms. Strain. I would urge you to continue with the provision
that you have. I think that the Treasury study that is being
undertaken is very worthwhile. I think it needs to be done. We
need simplification and reform, and perhaps, answers, to Mr.
Levin's question earlier of what more needs to be done. We
probably need to have that discussion, but I think that we also
need to get on with business and continue to maintain a
competitive posture. The Treasury study, I believe, will spark
a lot of conversation, a lot of study, and a lot of analysis,
and that is not going to be a short-term effort. It will be a
longer-term effort. But in the shorter-term, now, we need to
have the provision renewed and extended.
Mr. Neal. Thank you. Mr. McKenzie, thank you for your
statement on the Foreign Sales Corporation rules for military
property. From a tax perspective, can you think of any
legitimate policy reason why defense projects should be singled
out from receiving the full FSC benefit?
Mr. McKenzie. No, sir. As a matter of fact, we view in the
industry as a penalty tax against U.S. defense contractors. In
other words, we are the only ones who are not permitted to
claim the full FSC benefit, and we were singled out and
discriminated against and allowed only half the benefit that
was allowed to everyone else. Now, in my view--and I am
speaking strictly for myself here--this provision came into law
back in 1975 at the height of the global arms race between the
United States and Russia, at a time when Vietnam was the hot
issue, and there were those on both sides of the aisle who, on
the one hand, wanted to disallow all benefits for FSC for
military contractors and those on the other side that wanted to
allow full benefits, seeing no difference whatsoever between
exporting military sales approved by DOD and all other
products. And I think what happened in the end was the baby was
cut in half as a compromise, and that is where we have been so
far. I see no logic, really, to allowing half if there are
sound arguments for repeal. It seems to me, it should either
come out one way or the other, and now that the environment has
totally changed, it seems to me that we should allow and treat
military product exports that are approved by DOD as being in
the national interest as no different from any other export
product.
Mr. Neal. Fair enough.
Thank you, Mr. Chairman.
Chairman Houghton. Thanks very much.
Mr. Portman.
Mr. Portman. Thank you, Mr. Chairman, and I want to commend
Mr. Levin and the Chairman, Mr. Houghton, for doggedly pursuing
this issue over the years since I have been on the Ways and
Means Committee. It is a simplification issue and a
competitiveness issue, the two being related, and I think it is
great that we are rolling up our sleeves and getting into some
of these issues, and I hope on this tax bill we will be able at
least to make the downpayment.
I have an interest in the territorial tax system. I am told
that this didn't come up today--and I apologize that I am
late--but if we could talk a little about the territorial tax
system and its impact on your companies as compared to some of
your competitors. Maybe if I could just ask a couple of
questions, Mr. Chairman, the first being, do you have any
competitors in developed countries, industrialized countries
like the United States, that use other than a territorial tax
system for their employees, their foreign employees? Are there
any other competitors of yours that are based in a foreign
country that have a tax situation that is similar to the one
you face being a U.S. company? Are you aware of any?
Mr. Cox. With few exceptions, Congressman. In the software
industry, most of the companies are U.S.-based multinationals.
There are some exceptions, but most of them are similar to us.
Mr. Portman. Ms. Strain.
Ms. Strain. In the financial services industry, I would say
that most of our foreign competitors are not U.S.-based
multinationals. Deutsche Bank, HSBC, Standard Charter, are our
major competitors in a number of different jurisdictions. If
you look at their published effective tax rates compared to the
effective tax rates of U.S. financial institutions, they are
generally lower.
Mr. Portman. And that is because they have territorial tax
system, correct?
Ms. Strain. You are crossing a number of different
jurisdictions, but that is a factor, also probably, more
liberal controlled foreign corporation rules. Integration
systems, as well. So there will be a number of different
factors, but the data shows that they are generally facing
lower effective tax rates.
Mr. Portman. Mr. Jarrett.
Mr. Jarrett. That is very true with manufacturing. We face
local competitors in those countries, and U.S. tax law today
for international operations forces us at a significant
disadvantage. As I mentioned earlier, in just looking at my
interest allocation rules, over half of the interest expense
that Deere incurs this year relates to our credit operation.
Our credit operation has no foreign assets; it basically
operates within the United States to provide credit to the
Deere customers here, but we have to allocate almost 60 percent
of that interest expense overseas. That causes us to lose about
20 percent of our foreign tax credit, raising our price to our
customers.
Mr. Portman. The interest allocation issue is one that is
near and dear to my heart, and I understand it is not a subject
of this hearing, particularly. We are addressing it during a
competitiveness hearing that is coming up, but getting back to
the territorial issue, the territorial system versus a
worldwide system, does that put you at a competitive
disadvantage?
Mr. Jarrett. Yes, it does.
Mr. Portman. Mr. McKenzie.
Mr. McKenzie. Yes, I couldn't agree more. One of the
biggest problems I see is being able to move excess cash in one
country to another country where it's needed to enhance the
overall conduct of the business. That gets very difficult under
current subpart F rules. Of course there's tremendous U.S.
taxes. If you simply loan excess capital from a subsidiary in
Germany to a subsidiary in Switzerland, that is considered to
be a deemed dividend back to the United States, taxable in the
United States, and then back to Switzerland. That seems to me
totally unfair. That is why I say it interferes with the
conduct of good U.S. business practices. That is just one
example.
All of the other examples come under section 367(d). When
you want to transfer products overseas, section 482 for inter-
company pricing allocations. Foreign tax credits when you do
want to bring income back to the United States. You have to be
extremely careful about what you invest or U.S. foreign
earnings in. When you liquidate a company, it gets very
complicated, but when you want to reorganize foreign
subsidiaries, that also gets extremely complicated to avoid
U.S. taxes.
Mr. Portman. And many of these are not problems that a
foreign competitor of Northrop Grumman would experience?
Mr. McKenzie. In my experience, the foreign competition we
face have much more lax rules in that area. It is much easier
for them to move working capital around to where they need it.
As a matter of fact, I would be in favor actually of going back
to the 1962 proposals that the Kennedy Administration came up
with to tax U.S. companies currently on their U.S. worldwide
operations, and in exchange for that, allow foreign tax credits
for foreign taxes actually paid overseas. If that is too much
to put through all at once, perhaps establish some arbitrary
limit on the foreign tax credit of 80 to 85 percent. That would
dramatically simplify the rules in this area, it seems to me,
and do away with a lot of the bells and whistles that we have
hung onto the system. I would not--however, support a change in
current law that would lead to a higher tax burden for U.S.
taxpayers.
I don't mean to castigate the system. I think that the
principles and fundamentals that we have in the Internal
Revenue Code are sound. It is just a matter that we tried to
hand too many bells and whistles on it that we need to scale it
back.
Mr. Portman. Mr. Kelly, do you have anything to add?
Mr. Kelly. Yes. In the case of the pharmaceutical industry,
we have obviously some U.S. competitors and some foreign
competitors. With respect to the foreign competitors, some are
located in countries which use territorial systems. For
example, the German pharmaceutical companies, Hoechst Marion
Roussel and Scherig AG operate under a territorial system.
With respect to the other competitors, foreign competitors
who are not located in territorial systems, if you were to look
at the NFTC study I think you would see that although they
appear to be systems like ours, in fact there is substantially
less taxing of off-shore operations by countries such as Japan,
the UK, France, et cetera.
Mr. Portman. Thank you, Mr. Kelly.
Thank you, Mr. Chairman.
Chairman Houghton. Thanks very much.
Mr. Levin.
Mr. Levin. Thank you, Mr. Chairman. This is becoming an
increasingly interesting hearing. There are some policy bases
or maybe irrational policy bases for all these provisions. I
appreciate the questions of our colleagues, Mr. Chairman; Mr.
Coyne, and Mr. Neal's questions I think helped to bring out
issues like the impact on jobs in this country. I appreciate
Mr. Portman's kind words.
His question raises the most basic issue about our system.
I think we should always be ready to look at the assumptions in
our system, always though careful to avoid the conclusion that
there is an easy alternative. Radical reform is often more
easily said than done. We have essentially proceeded I hope
importantly, but somewhat incrementally. That has been the
assumption. We hope it has made a difference and there is more
ground to cover.
In that regard, Mr. Kelly, we will take another look at the
language about the study. I think actually one of your
colleagues, panelists, kind of answered it. The question
relates not to--it doesn't really I think reflect the fact that
there are different tax rates and structures in the country, in
the various European countries, but the notion that we could
for the purposes of this provision, treat all those systems,
the countries the same. Whether that is really an appropriate
assumption, I don't know. We will take another look at it.
Mr. Kelly. Thank you.
Mr. Levin. It was to look at tax havens within the European
Community and the impact of them on these provisions.
Let me say, Mr. McKenzie, I asked some of the staff who
have been around here I think longer than I have, but who are
younger than I, whether they remembered the rationale for the
50 percent. Their explanation was the same as yours, if you can
call it a rationale.
Mr. McKenzie. Yes.
Mr. Levin. I think that may have been a case where you
split the baby in half and it clearly doesn't make any sense.
Mr. McKenzie. I believe so, yes.
Mr. Levin. But we need to take a look at that as we're
doing in this provision. I hope we can have some rational
discussions.
Just quickly, the question about active financing and the
Treasury. Were we talking about two different things? I think
maybe we were. The Treasury study about the entire structure
and the Treasury response to extension of this provision. I am
not sure they are one in the same, maybe they are. I would hope
Treasury could give us their suggestions about extending the
active financing provision in time for us to act, even if they
are looking at the broader picture.
Let me close, Mr. Chairman, and just ask Mr. Cox, because I
think you stated correctly that it is hard for us I think to
adopt a policy that simply says that we'll accept the
characterization of other countries in your field. So I think
you need to help us come up with how we resolve that riddle,
because I am not sure what we do about it. It seems to me if we
allowed the characterization of other countries to determine
our tax treatment, it would be subject to manipulation on their
part. Correct?
Mr. Cox. I agree, Congressman Levin. One of the things that
Congress can do is play an active role in treaty negotiations.
Obviously that is usually done on the Senate side, but in
following recognized bodies like OECD, OECD has now come with
models that they are coming to a position that has agreed upon
with regard to characterization of a lot of things, one of
which is software income. So I think by supporting those types
of efforts, that is one thing that Congress can do.
Mr. Levin. OK. But let's talk further about it because I
would believe--and this relates to Mr. Coyne's good question
about the impact on businesses and jobs here. I think your
answer was a very responsive one. The jobs are basically here,
not entirely, but substantially, which we want to be able to
continue. I think we would like to find ways to be helpful
without adopting a statutory provision that really would not be
workable. So let us know. Give us some further ideas.
Mr. Cox. That is correct. I mean whether it's changes in
subpart F, which allow us, as Mr. Jarrett said, those are cost
issues. Cost issues means do I spend money on tax issues or do
I spend money hiring people to do jobs which can create a new
product in my particular industry. In my particular company,
the average wage of the U.S.-based workforce exceeds $75,000
per annum. So these are extremely good jobs that we would like
to keep in the United States. So whether it's issues like
extending the research credit on a more permanent basis, you
had a discussion about that earlier, all of these things are
important as we look at where do we place jobs. We would like
to place them here, whether it's in the United States.
Mr. Levin. We surely agree with that.
Mr. Cox. I didn't think you would have any objection.
Mr. Levin. No.
Mr. Cox. We're on the same page there.
Mr. Levin. Absolutely.
Mr. Cox. But realize as we make business decisions, those
are factors, maybe not the only factor, maybe not even the most
important factor, but those are factors that business men and
women look at every day in terms of where to----
Mr. Levin. Right. That is the gist of this legislation.
Thanks.
Thanks, Mr. Chairman.
Chairman Houghton. Thanks. I just have a few questions.
Mr. Jarrett, you talk about controlling technology, it's
important that you control technology. Tell me how the
treatment of international tax laws affects the control of
technology.
Mr. Jarrett. The treatment of international tax policy will
affect that because if your U.S. tax policy forces me or other
companies overseas, we get into regimes that we have to develop
technology in those countries. Those countries will own that
technology from the standpoint of the sub that's there. The
United States loses some of its effectiveness to control where
that technology goes from there. All countries don't have the
same laws to protect trademarks, patents. If we have some of
those in our overseas subsidiaries, we have to follow their
country rules. I like to keep that technology at home where it
is controlled, where we can dole it out as it needs to be, make
the investment in it in U.S. property and export the product.
Chairman Houghton. Still--you have to help me. I am a
little slow on this. What you are saying is that if you move
basic weight of industry abroad--jobs, investment, and,
technology will be there. The reason that's its moved abroad is
because of the tax laws. Therefore, less of our technology can
be produced in this country. Is that right?
Mr. Jarrett. If that technology is developed overseas, that
belongs to that overseas subsidiary. It doesn't belong to our
U.S. subsidiary. There is a cost to bring that back home. We
are trying to keep that technology home where I believe we
should keep that technology at home.
Chairman Houghton. Yes. But as you look way out, I mean,
you can take a look at the past 30 years of your company and
you take it and look at another 30 years, won't you be doing a
great deal more sort of spot manufacturing and spot development
in the areas where you have got to serve that market? So, you
still will have that problem in terms of controlling
technology. It doesn't have anything to do with the tax laws.
Mr. Jarrett. We would have that problem, except we license
that technology overseas rather than develop it overseas. We
want our U.S. parent to own that technology.
Chairman Houghton. OK. Thank you.
I would like to ask Ms. Strain the question about the
active financing exception to subpart F. Tell me a little bit
about this. How does this help you?
Ms. Strain. In a couple of different ways. From my
perspective, I worry about the computation of our ultimate U.S.
tax liability. It is a complicated procedure. We have had two
different tax laws that we have had to deal with in the last 2
years. In terms of gathering information, calculating it for
our tax return, I am sending requests out to personnel in 100
different countries. English is not necessarily their first
language. I am asking them to interpret U.S. tax law and give
information back. So in that regard, I would hope that we don't
have a change for a third year in a row in terms of the law,
considering the compliance aspect to it.
Without active financing we are required to provide for
U.S. taxes whether we distribute income or not. In terms of our
acquisition activity, which as you might guess, has been
increasing over the last couple of years of the financial
services industry worldwide consolidates, when we are bidding
for a company overseas, we are using a U.S. tax rate rather
than the local tax rate. We find that many of our competitors
obviously are operating in lower tax jurisdictions or have
lower effective rates. Again, not 100 percent of the time is
the tax reason why we may not win a bid, but it is certainly an
important factor in terms of our ability to expand overseas.
Last, it helps in normal planning. The subpart F
requirements in terms of recognizing income on a current basis
require us to calculate income as if it was distributed back to
the United States. It does not obviously reflect a reality. It
is more complicated. It affects our foreign tax credit
computations. It makes the whole management of our overseas
operations more difficult.
Chairman Houghton. OK. That is very helpful. Thanks a lot.
Now let me just come back to the basic question which I had
posed earlier. I have a report here from the Joint Committee on
Taxation. Again, I have got to go back to the concept of the
European Union as being considered one tax entity. Our bill, as
you probably have read, will direct the Secretary of the
Treasury to study this feasibility, and I know the European
Union has taken great steps to integrate their economies and so
on and so forth, but they do have different tax rules. I just
wondered how you feel about whether these tax rules are
sufficiently harmonized to allow sort of a single treatment.
Anyone?
Ms. Strain. I think the answer is that the tax rules are
probably not harmonized at this point in time, but I believe
that the answer to that question was that it relates to the
treatment of subpart F income and how it should be calculated.
One of the factors though I think we should point out is
that if we are looking at the European Union, the OECD is also
concerned about this issue in terms of tax haven activity. They
are trying to exclude from the definition of the European Union
so-called ``tax havens,'' which I think they are working to
develop. So I think in one sense there is a certain amount of
pressure off the notion that the European Union contains within
it, tax havens that will draw more and more business activity
to that location. But the answer I think was that the subpart F
rules have to be reviewed in the context of whether they still
make sense.
Chairman Houghton. Does anybody have any other comments on
that?
Mr. Kelly. I hope this is helpful. If a member of the E.U.
makes a dividend distribution back to its U.S. parent, we are
going to look at the tax structure in that country to determine
the U.S. tax consequences. So that actual distributions and
actual pavements back to the United States, as far as I
understand the provision, wouldn't be affected by our using the
single country exception for all the E.U. That is just for
Subpart F. So in effect, you kind of split the system. The
advantage of doing that is really to facilitate our handling of
cash off shore and to simplify our compliance here in the
United States.
Mr. Cox. I think Mr. Kelly is exactly correct on that. It
eliminates that need to worry about common everyday business
issues, movement of funds. You know, one subsidiary needs
money, one does not, irrespective of the differing rules which
is when you actually do have a distribution from one of those
foreign corporations.
Chairman Houghton. OK. That is very helpful. Any other
questions? All right. Well, ladies and gentlemen, thank you
very much for being with us. I look forward to working with
you.
The hearing is adjourned.
[Whereupon, at 2:49 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of William W. Chip, Chairman, Tax Committee, European-
American Business Council
My name is Bill Chip. I have been engaged in international
tax practice for 20 years and am a principal in Deloitte &
Touche LLP. 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's
members is attached. Because the EABC membership includes US
companies with European operations and European companies with
US operations, the EABC brings a unique but practical
perspective to how the complexity of the US international tax
regime may impede US companies from competing in the European
Union (EU)--the world's largest marketplace.
The EABC welcomes the efforts underway in this Subcommittee
and elsewhere in Congress to reconsider the international tax
rules that have accumulated in the Internal Revenue Code. The
current regime imposes tax burdens on US-owned foreign
enterprises that are not borne by the same foreign enterprises
when owned by non-US companies. If US ownership of a foreign
enterprise is not tax-efficient, that enterprise will not
relocate to the US but will instead become foreign-owned. The
foreign-owned enterprise may continue to ship its output to the
US, but its profits will be forever exempt from US taxation.
Nowhere is the anti-competitive burden imposed by US tax
rules more evident and damaging than in the application of the
US ``subpart F'' rules to US-owned enterprises in the EU. The
subpart F rules were intended to prevent US companies from
avoiding US 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 US 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 US corporate
rate. If the US corporate tax rate when subpart F was enacted
were the benchmark, the US today would itself be considered a
tax haven.
Subpart F focuses on economic activity that Congress
perceived as ``mobile'' and therefore readily located in a tax
haven. Manufacturing income was generally exempted from subpart
F because manufacturing was perceived as geographically tied to
transportation facilities and to sources of energy and
materials and therefore unlikely to be artificially located in
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 US-controlled foreign corporations from sales
or services to related companies in other jurisdictions.
How do these rules impede the competitiveness of a US
company seeking to do business in the EU? Consider a US 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 US-
owned or EU-owned, will favor those locations that impose the
lowest EU tax burden on the activities in question. However, if
the enterprise is US-owned, the subpart F rules may eliminate
any locational tax efficiency by immediately imposing an income
tax effectively equal to the excess of the US tax rate over the
local tax rate. Thus, US 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 US taxes collected when the earnings are repatriated). It
makes as little sense for the US to penalize its companies in
this way as it would for the EU to impose a special tax on
European companies that based their US sales and service
activities in the US states that imposed the least taxes on
those activities.
The original rationale for the foreign-base company rules
was twofold. The first was that companies with operations in
low-tax jurisdictions might abuse transfer pricing to allocate
unwarranted amounts of income to those operations. This concern
is obsolete in light of the powerful tools acquired by the IRS
in the past decade to enforce arm's length transfer pricing.
The second was that, if a mobile sales or service activity did
not need to be located in any particular location, there was
generally no valid business purpose served by incorporating
that activity in a tax haven company rather than a US company.
This rationale has no application to US companies that locate
their EU-wide sales and service functions in a single EU
location, from which other EU subsidiaries are then served. The
current subpart F rules would not tax the income of a UK
subsidiary from serving another UK subsidiary, but they would
tax such income if the UK company's personnel went to France to
serve a French subsidiary. It should be self-evident that there
are valid business reasons for not establishing a separate
company in France, let alone a US company, to perform the
latter services. Moreover, there is little likelihood of US
companies achieving ``tax haven'' results through EU locational
decisions, since the EU member states have ample reason
themselves not to permit the formation of tax shelters within
the EU, as evidenced by the emerging EU Code of Conduct against
harmful tax competition.
For the foregoing reasons, the EABC was pleased to see that
section 102 of H.R. 2018 acknowledges the importance of this
issue by requiring a Treasury study to be concluded within six
months of enactment. However, the EABC believes that further
study is unwarranted. The EU is unique--nowhere else in the
world have so many important trading nations established a
truly integrated market. Success in this fiercely competitive
market is critical to success in the world at large. Almost
since the inception of subpart F, US companies attempting to
exploit the opportunities of the common European marketplace
have pleaded for relief from the application of subpart F rules
that treat the location of EU-wide activity in one EU member
rather than in another as a form of tax avoidance that must be
penalized. We respectfully observe that the time for correcting
this most blatant of the unwarranted consequences of the US
subpart F regime is long overdue.
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.
Statement of the Financial Executives Institutes, Detroit, MI
Chairman Amo Houghton and Members of the Subcommittee on
Oversight of the House Ways and Means Committee:
The Financial Executives Institute (``FEI'') Committee on
Taxation appreciates this opportunity to present its views on
the current U.S. international tax regime.
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 Chairman Houghton
and Mr. Levin for introducing H.R. 2018, the International Tax
Simplification for American Competitiveness Act of 1999. 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 oral
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 income produced by CFCs.
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.
---------------------------------------------------------------------------
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.
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 show 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.
In addition, 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.
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 General Motors Corporation
General Motors is pleased to submit comments on
simplification of the international tax system of the United
States and how the system could be changed to make U.S.
business more competitive in the global market place. We
commend Chairman Houghton, Representative Levin and the other
members who joined in the recent introduction of H.R. 2018, the
International Simplification for American Competitiveness Act
of 1999.
We believe the U.S. rules for taxing international income
are unduly complex and, in many cases, inequitable. We believe
that legislation is required to rationalize and simplify the
international provisions of the U.S. tax law. Thus, we are
pleased with the recent introduction of H.R. 2018 and this
hearing by the Subcommittee which focuses attention on this
important area of U.S. tax law.
The International Simplification Bill (H.R. 2018) contains
important provisions which are a good start to making the tax
rules more rational and workable and to remove some of the tax
barriers currently faced by U.S.-based multinational companies.
We would like to highlight three issues addressed in the bill
that we at General Motors believe are particularly important.
Allocation of Interest Expense (Sec. 309 of H.R. 2018)
First, the bill includes a requirement that the Secretary of
Treasury conduct a study of the rules for allocating U.S. interest
expense of an affiliated group of companies between domestic and
foreign-source income. We would like to see the bill go farther and
actually include provisions that substantively fix the onerous interest
allocation rules. In fact, GM strongly supports the Interest Allocation
Reform Act, H.R. 2270, introduced recently by Congressmen Portman and
Matsui which we believe is the right approach toward fixing the problem
and should be included in any international tax reform legislation.
By way of background, the U.S. tax system currently requires U.S.
interest expense of U.S. multinational companies to be apportioned to
foreign-source income for purposes of determining the amount of foreign
tax credits that may be claimed. This apportionment of interest expense
reduces the taxpayer's foreign-source income and thereby restricts its
capacity to utilize foreign tax credits. This effectively results in an
amount of income equal to the apportioned interest expense being taxed
in the United States with no offsetting credit for foreign taxes.
Another way of looking at it is that, in this circumstance, there is
effectively no U.S. tax deduction for this apportioned interest
expense. And, of course, there is no deduction for this amount in any
foreign country. The result is double taxation.
The interest allocation rules put U.S. companies at a competitive
disadvantage in both foreign markets and in the United States. An
investment by a U.S. company in a foreign market results in an
additional allocation of U.S. interest expense with the consequent
double taxation. However, foreign-based companies competing in that
foreign market are not faced with losing any part of related interest
expense deductions in their home country. We are not aware of any
foreign competitor being subjected to as harsh a tax regime on its
interest expense as a U.S.-based company.
The interest allocation rules also discourage investments by U.S.
businesses to enhance their domestic competitiveness vis-a-vis foreign
competition in the United States. An expansion by a U.S.-based
multinational of operations in the U.S. through the use of debt results
in the apportioning of additional interest expense against foreign-
source income and an increased U.S. tax liability. GM itself
experienced this in its creation of Saturn Corporation, (which, in a
twist of irony, was conceived as an import-fighting line of small
cars). GM incurred debt in the U.S. to finance the construction of
Saturn facilities in Spring Hill, Tennessee. A portion of the interest
on that debt was allocated to foreign-source income, and in effect a
current deduction for some of that interest was lost. By contrast,
foreign-owned competitors who were constructing new U.S. plants at
about the same time could finance them with U.S. borrowings and get the
full U.S. tax benefit from this interest expense, as they were unlikely
to have any foreign-source income or foreign assets. Thus, under
current interest allocation rules, U.S. companies can't even compete on
a level playing field when they're the home team!
Another problem with the interest allocation rules arises in the
case of ``subgroups'' of U.S.-affiliated companies. By way of example,
GM has a wholly-owned domestic subsidiary, GMAC, whose principal
business is to provide financing to GM dealers and customers who buy or
lease GM motor vehicles in the United States. GMAC borrows on the basis
of its own credit and uses the proceeds in its own operations. Yet
under current tax rules, GMAC's interest expense must be lumped
together with all GM's U.S. affiliates in making the allocation. This
has the effect of over-allocating U.S. interest expense to foreign-
source income.
The Portman-Matsui bill (H.R. 2270) would substantially correct the
adverse effect of these rules by taking into account as an offset the
interest expense incurred by foreign affiliates, thus reducing the
amount of U.S. interest expense allocated to foreign-source income.
Also, it would allow an election to make a separate allocation
computation in certain circumstances for subgroups of U.S. affiliates,
including financial services subgroups, such as GMAC.
Recharacterization of Overall Domestic Loss (Sec. 202 of H.R. 2018)
The second provision in H.R. 2018 which we would like to mention is
the one which would recharacterize an overall domestic loss in a year
as foreign-source income in subsequent years to prevent permanent
double taxation.
Under current tax law, a U.S. taxpayer experiencing an overall loss
on its domestic operations must offset that loss against its foreign-
source income. Today, this permanently reduces the capacity of the
taxpayer to claim foreign tax credits and can result in double
taxation. The proposal would in effect convert this to a timing
difference by recharacterizing certain future domestic income as
``foreign-source,'' and thus, restore the taxpayer's capacity to claim
foreign tax credits in later years.
The tax law already requires that when foreign loss exceeds
domestic income the overall foreign loss amount is recaptured in
subsequent years by recharacterizing similar amounts of foreign income
as ``domestic income.'' Thus, the current proposal appropriately adds
important and needed symmetry and fairness to present law. This would
eliminate a ``trap'' in the current foreign tax credit rules for the
unfortunate company that incurs domestic losses.
With our current robust economy, people do not want to think these
days about such problems as economic downturns or tax losses. But, for
a company such as GM which is in an economically cyclical industry, and
which in the past has been adversely impacted by such things as work
stoppages and oil embargoes, the possibility of tax losses can never be
totally dismissed. And with the economy now ``running on full,'' there
couldn't be a better time to fix tax problems related to tax losses,
i.e., when the revenue cost would be minimized.
Permanent Subpart F Exemption for Active Financing Income (Sec. 101 of
H.R. 2018)
Prior to 1998, the earnings of foreign subsidiaries which carried
on an active financial services business in a foreign country were
subject to U.S. tax even though the earnings were not distributed to
the U.S. parent. That problem was alleviated temporarily through
legislation which excludes such active business income from current
U.S. taxation. However, that temporary relief expires at the end of
this year and needs to be made permanent. This important provision
allows U.S.-owned foreign finance companies, including foreign
subsidiaries of GMAC, to compete on an equal footing with their
foreign-based financing competitors. GM strongly supports making this
rule permanent.
In closing, General Motors again commends the Subcommittee for its
consideration of the U.S. international tax provisions. We urge the
Subcommittee in its review to give particular attention to remedying
the interest allocation rules along the lines proposed in H.R. 2270.
This is the single most important reform that's needed in the
international area. In addition, permitting domestic loss
recharacterization and extending the subpart F exception for active
financing income are very badly needed provisions.
Statement of Howard P. Goldberg, Assistant Director, Taxation, Mileage
Award Tax Committee, International Air Transport Association, Montreal,
Quebec, Canada
Mr. Chairman, Members of the Committee, on behalf of the
IATA Mileage Award Tax Committee, the International Air
Transport Association (IATA) appreciates the opportunity to
submit these written comments on the complexity of the current
U.S. international tax regime.\1\ As part of the 1997
amendments, section 4261(e)(3) imposed an excise tax on an
airline's sale of frequent flyer miles to third party vendors
like hotels, car rental agencies and credit card companies (the
``mileage credit excise tax''). The tax is imposed on
purchasers but is required to be collected by the selling
airline.
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\1\ The International Air Transport Association (IATA) is a
worldwide association comprised of 263 member airlines. The members of
IATA carry the bulk of the world's scheduled international and domestic
air transportation under the flags of some 150 nations. The stated
purposes of IATA include the promotion of safe, regular and economical
air transport for the benefit of the peoples of the world and the
fostering of international air commerce. All non-U.S. IATA member
airlines have been established under the laws of their respective
countries and many are duly designated and licensed to provide
international transportation of passengers, cargo and mail to and from
points in the United States. The IATA members who comprise the IATA
Mileage Award Tax Committee are Aer Lingus, Aerolineas Argentina, Air
Canada, Air France, Air New Zealand, Alitalia, British Airways, CSA
Czech Airlines, Finnair, Iberia Airlines, Japan Airlines, KLM Royal
Dutch Airlines, Lufthansa German Airlines, Qantas Airways, Sabena World
Airlines, Swissair, Thai Airways, Turkish Airways, and Varig.
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Amendments made in 1997 to the aviation ticket tax rules of
the Internal Revenue Code have increased both the complexity
and the uncertainty regarding the application of excise taxes
to international aviation. For example, it has been argued that
the mileage credit tax might apply to a sale of miles from a
foreign airline to a foreign hotel which provides those miles
to its foreign hotel guests. Application of the tax in that
situation, however, would be an infringement of the tax
prerogatives of other sovereign nations. Such an infringement
could lead to reciprocating tax regimes in foreign countries
seeking to tax a U.S. carrier's sale of frequent flyer miles to
U.S. hotels, credit card companies and car rental agencies.
Diplomatic Notes. Some twenty foreign countries have
submitted diplomatic notes to the Department of State and to
Congress protesting any interpretation that would impose the
mileage credit on an extraterritorial basis. The United States
has been requested to confirm that such tax would not be
imposed on non-U.S. commerce or in contravention of the U.S.'s
obligations under its treaties, international agreements or
international law.
An Unfair User Fee. Section 4261(e)(3) cannot fairly be
read to apply on an extraterritorial basis to sales of frequent
flyer miles by foreign airlines. The aviation ticket taxes,
including the mileage credit tax, are user fees which are
dedicated to support the operation of the U.S. aviation
infrastructure and are imposed based on a fair approximation of
the use of U.S. aviation infrastructure. See, H.R. Rep. No. 91-
601, at 41 (1970); and S. Rep. No. 91-706, at 11 (1970) (both
directing the Department of Transportation to prepare a report
on the aviation user fees ``in order to insure an equitable
distribution of future tax burdens among the various categories
of airport and airway users as well as other persons deriving
benefits from the aviation system''). The 1997 amendments to
the aviation ticket tax, including section 4261(e)(3), were
intended to improve the fairness of the aviation ticket taxes
by expanding the taxation of currently untaxed payments to the
extent that such payments benefit from the U.S. aviation
infrastructure. H.R. Rep. No. 105-148, at 482-483.\2\ Payments
by foreign vendors, for example, to participate in a foreign
airline's frequent flyer program do not have an immediate or
ascertainable impact on or derive a quantifiable benefit from
the U.S. aviation infrastructure. Imposing the mileage credit
tax on such payments would be an unfair application of the
aviation ticket taxes and would not be based on or correlate to
any benefit derived from the U.S. aviation infrastructure.
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\2\ The House Report states: ``the Committee determined that the
perceived fairness of the passenger air transportation excise taxes
will be improved if certain currently untaxed payments and passengers
were required to contribute to the financing of the FAA programs from
which they benefit. In furtherance of this goal, the bill extends the
tax to internationally arriving passengers and clarifies that the tax
applies applies to payments to airlines (and related parties) from
credit card and other companies in exchange for the right to award
frequent flyer or other reduced air travel rights.''
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Extraterritorial Application Would Violate U.S.
Obligations. In addition, any extraterritorial application of
the mileage credit excise tax would violate international
agreements to which the United States is a party and would be
inconsistent with principles of international law. The
relationship of payments by vendors to foreign airlines for
miles that ultimately might or might not be used for U.S. air
transportation does not satisfy the just and reasonable
requirements for user fees under international agreements to
which the United States is party, or the norms of international
law for excise taxation.
The United States is party to numerous bilateral aviation
agreements under which it has agreed that neither state may
impose user fees on transactions that do not reasonably relate
to a state's expenditures for the provision of aviation
facilities. The United States has agreed under its bilateral
aviation agreements that each state's airlines shall have fair
and equal rights to compete in providing international air
transportation. E.g., Air Transport Agreement of Jan. 17, 1966,
as amended Feb. 24, 1995, U.S.-Can., arts. 4, 8.\3\ In order to
respect the bilateral aviation agreements, the mileage credit
excise ticket tax cannot apply on an extraterritorial basis to
payments made by a vendor to participate in a foreign airline's
frequent flyer program.
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\3\ Article 4(1) of the U.S.-Canada Air Transport Agreement states:
``[e]ach Party shall allow a fair and equal opportunity for the
designated airlines of both Parties to compete in providing the
international air transportation governed by this Agreement.'' Articles
8(A) and 8(B) require user charges to be ``just and reasonable'' and
``just, reasonable, not unjustly discriminatory, and equitably
apportioned among categories of users.''
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Under U.S. law, U.S. statutes are presumed and interpreted
not to violate international law. Murray v. The Schooner
Charming Betsy, 6 U.S. (2 Cranch) 64, 118 (1804). International
law prohibits excise taxes on transactions that do not occur,
originate or terminate in or have substantial relation to the
state imposing the tax. Restatement (Third) of Foreign
Relations Law of the United States, Sec. 412(4). Payments by a
foreign vendor, for example, to participate in a foreign
airline's frequent-flyer program do not have a substantial
relationship to the United States and do not occur, originate
or terminate in the United States. Application of the mileage
credit tax on an extraterritorial basis to a foreign airline's
sale of frequent flyer miles would be inconsistent with
international law.
As a matter of tax policy and international law, U.S. tax
laws should not be applied on an extraterritorial basis to non-
U.S. commerce.
Thank you very much for your consideration of this matter.
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.
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\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.
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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\ 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.
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\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.
\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.
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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.
Statement of Richard G. Palaschak, Director of Operations, Munitions
Industrial Base Task Force, Arlington, VA
Mr. Chairman and Members of the Subcommittee, thank you for
providing this opportunity to submit a statement for
consideration by the Committee. This statement is offered on
behalf of the fourteen companies in the munitions business that
are members of the Munitions Industrial Base Task Force
(MIBTF). The member companies are: Aerojet General Corp.;
Alliant Techsystems, Inc.; Armtec Defense Products Co.; Bulova
Technologies, Inc.; Chamberlain Manufacturing; Day &
Zimmermann, Inc.; General Dynamics Ordnance Systems, Inc.; KDI
Precision Products, Inc.; Mason & Hanger Co., Inc.; Primex;
Talley Defense Systems, Inc.; Textron Systems; Thiokol Corp.;
Valentec International Corp.
In May and June 1993, executives from a cross section of
the nation's private munitions companies and its arsenal
operators met and concluded that they were in the middle of an
unplanned free-fall in munitions funding which would, if not
reversed, cause the destruction of the United States munitions
industrial base. This conclusion led to the formation of the
Munitions Industrial Base Task Force, a non-profit organization
representing the nation's munitions developers and producers,
and to an intense effort to quantify the crisis and communicate
its dimensions to decision-makers in the administration and the
Congress. Task Force membership represents many of the major
munitions prime contractors, as well as a cross section of
subcontractors and suppliers. We manage both government-owned
facilities as well as those owned solely by the private sector.
The Task Force does not advocate specific programs on behalf of
any of its members. Its sole purpose is to pursue a common
goal:
Adequate funding and policies to sustain a responsive,
capable U.S. munitions industrial base to develop, produce, and
support superior munitions for the U.S. and its allies.
Throughout its existence our member companies have worked
in cooperation with the DOD's Single Manager for Conventional
Ammunition (SMCA) and other DOD and service ammunition oriented
organizations to preserve threatened portions of the munitions
production and design base. Let me emphasize that our purpose
is not to ensure the survival of individual companies, but to
ensure the survival of those threatened research, development,
and production capabilities, and the associated skilled
workforce, somewhere within the U.S. domestic industrial base.
Mr. Chairman, our organization was formed because the munitions
portion of the Department of Defense (DOD) budget declined by
nearly 80% between fiscal year 1985 and fiscal year 1994. This
precipitous funding decline seriously damaged the U.S.
munitions industrial base and compromised its viability as well
as its ability to support the national security strategy. The
U.S. munitions base lost nearly 70% of its major munitions
companies during this period. It is estimated that the base
also lost thousands of second/third tier subcontractors. Thanks
to actions taken by the DOD and the Congress, this decline has
been stopped, but even the most recent assessment of the
munitions industrial base by the Army Materiel Command (AMC)
still characterizes the base as ``weak.''
This situation is exacerbated by the unfair and
discriminatory provision contained in Section 923(a)(5) of the
Internal Revenue Code which reduces the Foreign Sales
Corporation (FSC) benefits available to companies that sell
defense materiel to foreign countries to 50 percent of that
available to other exports. As the surviving companies struggle
to remain viable, the international marketplace affords them an
opportunity to supplement the U.S. domestic production needs
and, thereby, sustain their workforce and maintain an available
industrial capability to sustain our armed forces with
ammunition or replenish expenditures of ammunition by our
forces after a conflict. However, the sale of munitions
overseas is one of this nation's most tightly regulated areas.
In several instances, U.S. weapons have been provided or sold
to friendly countries but the sale of the associated U.S.
munitions has been disapproved. Even when regulators approve
the sale of an item, U.S. munitions manufacturers are faced
with a growing array of foreign competitors, many of whom are
not only financially supported by their government, but also
supported by their government's tax and procurement policies.
Rare is the country that has no capability for munitions
manufacturing, and many developed countries market, produce,
and sell very competitive products. In fact, the U.S. itself
has procured numerous foreign designed munitions that are in
today's service inventories. These countries have sustained
their indigenous munitions manufacturing capability, in the
face of declining domestic defense budgets, by emphasizing
exports. Many of them subsidize their munitions companies,
restrict their own munitions procurements to domestic sources,
help indigenous munitions companies market their products, and
forgive Value Added Taxes for munitions exports. The current
FSC provision places U.S. munitions companies at a serious
disadvantage when they compete in this environment.
In addition, the current FSC provision is a significant
handicap to U.S. companies because of today's budget reality.
In the past U.S. munitions companies could often overcome the
FSC penalty imposed on munitions exports because of the large
production requirements of the U.S. military. Economies of
scale could sometimes offset that penalty as well as the
advantages that foreign governments provided to their domestic
manufacturers. That situation no longer exists.
While the size of the U.S. military has been reduced by
about a third, the munitions war reserve requirements of the
U.S. military have plummeted by over 80% (in terms of tonnage)
during the past decade. Concurrently, the requirements for
training ammunition have been dramatically reduced by the
innovative use of simulators and other changes instituted by
the services. The net result has been smaller production runs
or no production at all. Consequently, U.S. munitions companies
lost one of the few offsets to the fierce foreign government
supported competition that exists today for the international
sale of munitions to countries approved by the U.S. government.
Removal of the FSC tax penalty against the export of defense
materiel will help level the international playing field and,
in the process, help preserve a U.S. industrial capability that
is absolutely essential to the conduct of successful warfare in
support of the nation's national security strategy.
We, the members of the Munitions Industrial Base Task
Force, urge the Congress to repeal the FSC penalty on the
export of defense products in order to provide a fair and
equivalent treatment to our nation's defense industry and its
workers, and to improve our industry's competitiveness in the
international marketplace. The repeal of this provision is
particularly vital to the U.S. munitions industrial base
because of its unique circumstances as detailed above. This
action is not only in the best interests of the U.S. defense
industry and its workforce, but also in the best interests of
the nation in ensuring a capable, viable, and enduring U.S.
industrial base to support American armed forces in the future.
Statement of Lawrence F. Skibbie, President, National Defense
Industrial Association, Arlington, VA
Mr. Chairman, Members of the Subcommittee, I am Larry
Skibbie, president of the National Defense Industrial
Association (NDIA). On behalf of NDIA, I want to compliment you
for holding this important hearing and to express our
appreciation for the opportunity to provide this statement.
NDIA is the largest defense-related association dedicated
to the viability of the technology and industrial base. Our
24,000 individual Members and nearly 900 Member companies,
which employ the preponderance of the two million men and women
in the defense sector and represent the full spectrum of the
base, are vitally interested in maintaining a strong,
responsive national security infrastructure.
A little background is in order so that the Subcommittee
has the full appreciation of both NDIA'S position and the
current U.S. International Tax Regime's adverse impact on the
defense sector.
Currently, the Internal Revenue Code allows U.S. exporters
to establish Foreign Sales Corporations (FSC) under which they
can exempt from U.S. taxation a portion of their earnings from
foreign sales. Enacted in 1976, this provision was intended to
help U.S. firms compete against companies in other countries
which rely more on value-added taxes (VATS) than on corporate
income taxes. Generally, VATS on products are rebated as they
are exported.
For U.S. exporters of defense products, however, the FSC
tax incentive is reduced by 50 percent. Specifically, section
923(A)(5) of the Internal Revenue Code reduces the tax
exemption available to companies which export defense products
to 50 percent of the benefits available to other exporters.
Initially, the limitation of section 923 was based on the
premise that military products are not sold in competitive
market environments, therefore the FSC incentive is unnecessary
for defense exporters.
However, examination of today's market environment argues
heavily against the original premise. Competition among defense
exporting countries is intense and likely to intensify as
budgets continue to be reduced. The United States faces
increased European export promotion incentives, and Russia has
become a major exporter in world markets. In addition, the U.S.
Government prohibits the sale of defense products to certain
countries and requires advanced approval of all sales.
There is no valid economic or policy basis for continuing
the discriminatory treatment that U.S. defense exporters face.
NDIA is strongly opposed to such treatment and supports the
repeal of section 923(A)(5), of the Internal Revenue Code.
Moreover, repeal of section 923 will not impact foreign policy
objectives of the United States. The same checks and balances
will remain in place and sales of defense exports will continue
to be subject to existing policy dictates and review processes.
Therefore, NDIA strongly supports restoring Foreign Sales
Corporation (FSC) tax benefits for defense products to full
comparability with other U.S. exports. The FSC limitation for
defense exports hampers the ability of U.S. companies to
compete effectively abroad with many of their products. The FSC
program was enacted to promote trade, which is fundamental to
our economic health. Discriminating against the defense
industry only contributes to our trade imbalance, reduces
employment stability in the defense sector and allows
competitors to capture business that would likely go to U.S.
firms.
Recently, Chairman Houghton and Representative Sander Levin
introduced H.R. 2018, the international tax simplification for
American competitiveness act of 1999. Section 303 of the bill
represents a step toward rectifying a major tax inequity for
U.S. defense exports. This Omnibus bill seeks to simplify
certain international taxation rules for U.S. businesses
operating abroad. Specifically, Section 303 repeals IRC Section
923(a)(5), which reduces the FSC benefits available to
companies that sell military goods abroad to 50 percent of the
benefits available to other exporters.
NDIA supports a strong, viable and competitive U.S. defense
industrial base that contributes to our overall national and
economic security. Unfortunately, the defense industry is
hindered by the enactment and maintenance of tax laws based on
outdated premises which represent serious barriers to our
international competitiveness. These impediments, such as
section 923(A)(5), should be dismantled as quickly as possible.
Therefore, prompt repeal of section 923(A)(5) is in order.
Mr. Chairman, Members of the Subcommittee, thank you again
for permitting NDIA this opportunity to submit this statement.
Tropical Shipping
Riviera Beach, FL,
July 6, 1999.
The Honorable A.L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
Washington, D.C.
Re: June 22, 1999 Oversight Subcommittee Hearing on Current U.S.
International Tax Regime
Dear Mr. Singleton:
The U.S. international tax regime is forcing the U.S.-owned fleet
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 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 U.S.
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 as this is
beneficial for Tropical Shipping's long term interests.
Our tax laws force U.S. companies to become acquired by foreigners
because these countries have adopted tax policies to ensure that their
international shipping is competitive in world markets. The U.S.
international tax system puts U.S. corporations and their employees at
a competitive disadvantage. 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 sales of U.S. companies to
foreigners or mergers of U.S. companies with foreign companies will
leave the resulting entity headquartered overseas. Because of the
adverse consequences resulting under the current foreign tax system,
U.S. shipping companies are being forced out of the growing world
market.
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
overly complex 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.
This tax system is contributing to the de-Americanization of U.S.
industry because the U.S.-owned fleet is forced to expatriate to remain
competitive. 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 1988. 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, by reinstating the deferral of
foreign-based company shipping income, so that the U.S. shipping
industry is placed in a position of global competitiveness, rather than
a competitive disadvantage. 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), 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.
Statement of LaBrenda Garrett-Nelson, Washington Counsel, P.C., on
behalf of the Ad Hoc Coalition of Finance and Credit Companies
Section 101 of the International Tax Simplification for
American Competitiveness Act of 1999 (H.R. 2018) highlights 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).
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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.