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Document 83 of 113.

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JUNE 22, 1999, TUESDAY

SECTION: IN THE NEWS

LENGTH: 3892 words

HEADLINE: PREPARED STATEMENT OF
JOHN W. COX
VICE PRESIDENT OF TAX
BMC SOFTWARE, INC.
BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON OVERSIGHT
SUBJECT - THE CURRENT U.S. INTERNATIONAL TAX REGIME

BODY:

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 B (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.
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.
The exclusion is an acknowledgement that it is difficult for corporations to avoid earning some subpart F income B 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 B and more realistic B 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.
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 B 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. --------------------------------------
FOOTNTOES:
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.
2. Technically, the test applies to the sum of gross foreign base company income and gross insurance income, but for most CFCs these are the only categories of subpart F income that commonly arise.
3. See, for example, Isenbergh, International Taxation: U.S. Taxation of Foreign Taxpayers and Foreign Income (1990), at 621.3.3, which notes that the subsequent U.S. source income"will effectively be overtaxed."
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LOAD-DATE: June 23, 1999

Document 83 of 113.


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