Copyright 1999 Federal Document Clearing House, Inc.
Federal Document Clearing House Congressional Testimony
June 22, 1999
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 7677 words
HEADLINE:
TESTIMONY June 22, 1999 JOE O. LUBY, JR ASSISTANT GENERAL TAX COUNSEL EXXON
CORPORATION HOUSE WAYS AND MEANS OVERSIGHT INTERNATIONAL TAX
LAW
BODY:
Statement of Joe O. Luby, Jr., Assistant
General Tax Counsel Exxon Corporation, and Chair, Tax Committee National Foreign
Trade Council, Inc. Testimony Before the Subcommittee on Oversight of the House
Committee on Ways and Means Hearing on the Current U.S. International Tax Regime
June 22, 1999 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.
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) 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. 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) 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 headquartered in the United States. By the
mid-1990s, that number had dropped to 8. 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 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 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.
LOAD-DATE: June 23, 1999 
