LEXIS-NEXIS® Congressional Universe-Document

Search Terms: interest w/5 expense w/5 allocation, House or Senate or Joint

Document 5 of 15.

JUNE 30, 1999, WEDNESDAY

SECTION: IN THE NEWS

LENGTH: 4686 words

HEADLINE: PREPARED TESTIMONY OF
WILLIAM H. LAITINEN
ASSISTANT GENERAL TAX COUNSEL
GENERAL MOTORS CORPORATION
BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS

BODY:

I. INTRODUCTION
General Motors Corporation appreciates the opportunity to testify before the House Ways and Means Committee on competitiveness issues raised by the international provisions of the U.S. tax laws. Our testimony is submitted on behalf of a coalition of U.S.-based multinational companies that are severely penalized by a particular aspect of the international provisions of the U.S. tax laws: the rules regarding the allocation of interest expense between U.S.-source and foreign-source income for purposes of determining the foreign tax credit a U.S. taxpayer may claim for foreign taxes it pays. Our testimony specifically focuses on the distortive and anti-competitive impact of the present-law interest allocation rules, which were enacted with the Tax Reform Act of 1986, and the pressing need for reform of these rules.
The present-law interest allocation rules penalize U.S. multinationals by artificially restricting the foreign tax credits they may claim. By improperly denying a credit for foreign taxes paid by U.S. multinationals on the income they earn abroad, the rules result in double taxation of such income. This double taxation is contrary to fundamental principles of international taxation and imposes on U.S.- based multinationals a significant cost that is not borne by their competitors.
We respectfully urge the Ways and Means Committee to consider legislation to reform the interest allocation rules. Such reforms are embodied in H.R. 2270, which was introduced recently by Representative Portman and Representative Matsui. As we explain in this testimony, interest allocation reform is necessary in order to reflect the fundamental tax policy goal of avoiding double taxation and to eliminate the competitivedisadvantage at which the present-law interest allocation rules place U.S.-based multinationals.
lI. PRESENT-LAW INTEREST ALLOCATION RULES
The United States taxes its corporations, citizens and residents on their worldwide income, without regard to whether such income is earned in the United States or abroad. In order to avoid having the same dollar of income subjected to tax both by the United States and by the country in which it is earned, the United States allows U.S. persons to claim a credit against U.S. taxes for the foreign taxes paid with respect to foreign-source income. The U.S. tax laws have allowed such a foreign tax credit since the Revenue Act of 1918.
The purpose of preventing double taxation requires allowing foreign taxes paid by a U.S. person as a credit against the potential U.S. tax liability with respect to the income earned by such person abroad. However, foreign taxes are not allowed as a credit against the U.S. tax liability with respect to income earned in the United States. Accordingly, the foreign tax credit limitation applies to limit the use of such credits to offset only the U.S. tax on foreign-source income and not the U.S. tax on U.S.-source income.
In order to compute the foreign tax credit limitation, the U.S. taxpayer must determine its taxable income from foreign sources. This determination requires the allocation and apportionment of expenses and other deductions between U.S.-source gross income and foreign- source gross income. Deductions that are allocated to foreign-source income for U.S. tax purposes have the effect of reducing the taxpayer's foreign tax credit limitation, thus reducing the amount of foreign taxes that may be used to offset the taxpayer's potential U.S. tax on income earned from foreign sources.
Special rules enacted with the Tax Reform Act of 1986 apply for purposes of determining the allocation of interest expense between U.S.-source income and foreign-source income. Interest expense generally is allocated based on the relative amounts of U.S. assets and foreign assets. The rules enacted with the 1986 Act generally require that interest expense be allocated by treating all the U.S. members of an affiliated group of corporations as a single corporation. Accordingly, the interest allocation computation is done by taking into account all the interest expense incurred by all the U.S. members of the group on a group-wide basis. Moreover, such interest expense is allocated based on the aggregate amounts of U.S. and foreign assets of all such U.S. members of the affiliated group on a group-wide basis.
Under the 1986 Act provisions, the group for interest allocation purposes includes only the U.S. corporations in a multinational group of corporations and does not include foreign corporations that are part of the same multinational group. Under this approach, the interest expense incurred by the foreign subsidiaries in the multinational group is not taken into account in the allocation determination. Moreover, the assets of the foreign subsidiaries axe not taken into account in determining the aggregate U.S. and foreign assets of the group. Rather, the stock of the foreign subsidiaries is treated as a foreignasset held by the group for purposes of allocating the interest expense of the U.S. members of the group between U.S. and foreign assets.
Special rules apply to certain banks that are members of the affiliated group. Under these rules, banks are not included in the group for interest allocation purposes. Instead, such banks are treated as a separate group and the interest allocation rules are applied separately to such group.
In addition, the regulations apply more specific tracing rules to allocate interest expense in certain situations. A tracing approach applies to the allocation of interest expense incurred with respect to certain nonrecourse indebtedness. Such an approach also applies to the allocation of interest expense incurred in connection with certain integrated financial transactions.
III. IMPACT OF THE PRESENT-LAW INTEREST ALLOCATION RULES
The present-law interest allocation rules purport to reflect a principle of fungibility of money, with interest expense treated as attributable to all the activities and assets of the U.S. members of a group regardless of the specific purpose for which the debt is incurred. However, the approach adopted with the 1986 Act does not truly reflect the fungibility principle because it applies fungibility only in one direction. Under this approach, the interest expense incurred by the U.S. members of an affiliated group is treated as funding all the activities and assets of such group, including the activities and assets of the foreign corporations in the same multinational group. However, in this calculation, the interest expense actually incurred by the foreign corporations in the group is ignored. Thus, under the present-law interest allocation rules, the interest expense incurred by the foreign corporations in a multinational group is not recognized as funding either the foreign corporation's own activities and assets or any of the activities and assets of other group members. This one-way street approach to fungibility is a gross economic distortion. The distortive impact of the present-law interest allocation rules can be illustrated with a simple example. Consider a U.S. parent with a single foreign subsidiary. The two corporations are of equal size and are equally leveraged. Thus, the total assets of the two corporations are equal and the interest expense incurred by the two corporations is equal.

The U.S. parent's assets (other than the stock of the foreign subsidiary) are all U.S. assets and the foreign subsidiary's assets are all foreign assets. Under the present-law interest allocation rules, only the interest expense of the U.S. parent would be taken into account. This interest expense is allocated based on only the U.S. parent's assets, taking into account the stock of the foreign subsidiary as a foreign asset of the U.S. parent. Thus, in this case, one-half of the U.S. parent's assets are U.S. assets and one-half are foreign assets. Accordingly, one-half of the U.S. parent's interest expense is allocated to the foreign assets (i.e., the stock of the foreign subsidiary). However, the foreign subsidiary itself has incurred interest expense equal to that of the U.S. parent and representing a leverage ratio equal to that of the U.S. parent. From an economic perspective, none of the U.S. parent's interest expense in this example should be treated as supporting theactivities or assets of the foreign subsidiary. The allocation of a portion of the U.S. parent's interest expense to foreign assets represents a double- counting of the interest expense that is treated as relating to foreign assets. Indeed, in this case, three-quarters of the group's interest expense (i.e., one-half of the U.S. parent's interest expense plus all of the foreign subsidiary's interest expense which is disregarded under the interest allocation rules) effectively is treated as relating to the foreign subsidiary, even though its assets represent only one-half of the group's assets. There is absolutely no economic basis for this result- it is an obvious distortion.
By disregarding the interest expense of the foreign members of a multinational group, the approach reflected in the present-law interest allocation rules causes a disproportionate amount of U.S. interest expense to be allocated to the foreign assets of the group. This over-allocation of U.S. interest expense to foreign assets has the effect of reducing the amount of the multinational group's income that is treated as foreign-source income for U.S. tax purposes, which in turn reduces the group's foreign tax credit limitation. This reduction in the foreign tax credit limitation has the effect of reducing the amount of the group's foreign taxes that can be used to offset its potential U.S. tax liability on its foreign-source income. Of course, the U.S. interest expense that is allocated to foreign assets under the interest allocation rules is not deductible :for foreign tax purposes and therefore such allocation does not result in any reduction in the foreign taxes the multinational group actually pays. The allocation merely reduces the amount of such taxes paid that may be used as a credit against the potential U.S. tax liability with respect to the same foreign-source income. Thus, the ultimate result of the distortion caused by the present-law interest allocation rules is double taxation of the foreign income earned by the U.S. multinational group.
The double taxation that results from the present-law interest allocation rules represents a significant cost for U.S.-based multinationals, a cost not borne by their foreign competitors. This increased cost makes it more difficult for U.S. multinationals to compete in the global marketplace. When a U.S. multinational considers a foreign expansion or acquisition, it must factor into its projections the fact that the additional foreign asset will result in an additional allocation to foreign-source income of the interest expense incurred by the multinational group in the United States. An additional allocation will result as the expansion or acquisition generates earnings even if the expansion or acquisition is fully supported by borrowing incurred outside the United States. The resulting additional allocation of U.S. interest expense will exacerbate the double taxation to which the U.S.-based multinational is subject. A foreign-based corporation considering the same expansion or acquisition can do so without this cost that arises from the distortion in the U.S. tax rules.
Not only do the interest allocation rules impose a cost that makes it more difficult for U.S. multinationals to compete with their foreign counterparts with respect to foreign operations, the rules actually operate to put U.S. multinationals at a competitive disadvantage with respect to investments in the United States. This impact of the interest allocation rules is especially troubling. When a U.S.-based multinational makes an additional investment in the United States and finances that investment with debt, aportion of the interest expense incurred with respect to that debt is treated as relating to its foreign subsidiaries, even if the foreign subsidiaries are themselves leveraged to the same extent as the U.S. members of the group. Thus, the U.S. multinational effectively is denied a deduction for a portion of the interest expense on the additional debt incurred to fund the U.S. acquisition. A foreign corporation that makes the same acquisition in the United States and finances it with the same amount of debt will not be impacted by these interest allocation rules and will be entitled to a deduction for U.S. tax purposes for the full amount of the interest expense related to the acquisition. Thus, the foreign corporation considering an investment in the United States will face lower costs than a U.S.-based multinational considering the same investment in the United States.
IV. PROPOSED REFORM OF THE INTEREST ALLOCATION RULES
The interest allocation rules enacted with the Tax Reform Act of 1986 were intended to eliminate the potential for manipulation that arose under the then-applicable separate company approach to interest allocation. The 1986 Act rules requiring interest to be allocated on a group basis addressed that concern. However, by drawing the line for interest allocation at the water's-edge and ignoring the interest expense incurred by the foreign members of a U.S. multinational group, the present-law rules create a fundamental distortion. There is no tax policy rationale that supports the distortion caused by the present- law rules. The interest allocation rules must be reformed to eliminate these distortions and to reflect a defensible result from a tax policy perspective. Eliminating such distortions will remove a significant barrier to the competitiveness of U.S. multinationals in the global marketplace.
First, interest expense should be allocated consistent with the actual economics of the debt structure of the U.S. multinational group. In order:to accurately reflect the principle of fungibility, such principle must be applied on a worldwide basis. Under a worldwide fungibility approach, the foreign-source income of the U.S. multinational group generally would be determined by allocating all interest expense of the worldwide affiliated group on a group-wide basis. The interest allocation computation would take into account both the interest expense of the foreign members of the affiliated group and the assets of such members. Interest expense incurred by a foreign subsidiary thus would reduce the mount of the U.S. interest expense that would be allocated to foreign-source income. This approach would eliminate the double-counting of the amount of interest expense treated as the cost of holding the assets of a foreign subsidiary that occurs under the present-law rules.
Moreover, interest expense should be more specifically allocated where the debt does not fund the entire multinational group. In other words, the principle of fungibility should be applied to a smaller group of companies in cases where the debt is incurred by (and based on the credit of) a member other than the common parent. While debt incurred by one lower-tier member of an affiliated group may be viewed as funding the assets and activities of that corporation and its subsidiaries, such debt does not fund the assets and activities of other members of the group (such as the parent or sister corporations of the borrowing corporation). Thus, it is appropriate to permit the interest expense associatedwith such debt to be allocated based solely on the assets of the subgroup of corporations that consists of the borrower and its subsidiaries.
Finally, it is appropriate to separate financial services entities - which tend to have debt structures that are very different from the other members of an affiliated group - for purposes of the allocation of interest. This treatment of financial services entities as a separate subgroup is consistent with the present-law rule treating banks as a separate subgroup. However, this expansion of the present- law bank role recognizes that such treatment should encompass all financial services entities rather than only entities regulated as banks.
These important reforms to the interest allocation rules are embodied in H.R. 2270, the Interest Allocation Reform Act, which was introduced recently by Representative Portman and Representative Matsui. The interest allocation rules reflected in H.R. 2270 eliminate the distortions caused by the present-law rules, facilitating the operation of the foreign tax credit to eliminate double taxation of income earned abroad. Enactment of the reforms reflected in H.R. 2270 is critical to ensuring the ability of U.S.-based multinationals to compete with their foreign counterparts, both with respect to operations abroad and with respect to operations in the United States.
V. TECHNICAL EXPLANATION OF H.R. 2270
A detailed technical explanation of the provisions of H.R. 2270 is set forth below.

In general
H.R. 2270 would modify the present-law interest allocation rules of section 864(e) that were enacted by the Tax Reform Act of 1986. Under the bill's modifications, interest expense generally would be allocated by applying the principle of fungibility to the taxpayer's worldwide affiliated group (rather than to just the U.S. affiliated group). In addition, under special rules, interest expense incurred by a lower-tier U.S. member of an affiliated group could be allocated by applying the principle of fungibility to the subgroup consisting of the borrower and its direct and indirect subsidiaries. H.R. 2270 also would allow members engaged in the active conduct of a financial services business to be treated as a separate group. Finally, the bill would provide specific regulatory authority for the direct allocation of interest expense in other circumstances where such tracing is appropriate.
Under H.R. 2270, a taxpayer would be able to make a one-time election to apply the modified rules reflected in the bill rather than the interest allocation rules of present law. Such election would be required to be made for the taxpayer's first taxable year to which the bill is applicable and for which it is a member of an affiliated group, and could be revoked only with IRS consent. Such election, if made, would apply to all the members of the affiliated group.H.R. 2270 generally is not intended to modify the interpretive guidance contained in the regulations under the present-law interest allocation rules that is relevant to the rules reflected in the bill, and such guidance is intended to continue to be applicable.
Worldwide fungibility
Under H.R. 2270, the taxable income of an affiliated group from sources outside the United States generally would be determined by allocating and apportioning all interest expense of the worldwide affiliated group on a group-wide basis. For this purpose, the worldwide affiliated group would include not only the U.S. members of the affiliated group, but also the foreign corporations that would be eligible to be included in a consolidated return if they were not foreign. Both the interest expense and the assets of all members of the worldwide affiliated group would be taken into account for purposes of the allocation and apportionment of interest expense. Accordingly, interest expense incurred by a foreign subsidiary would be taken into account in determining the initial allocation and apportionment of interest expense to foreign-source income. The interest expense incurred by the foreign subsidiaries would not be deductible on the U.S. consolidated return. Accordingly, the amount of interest expense allocated to foreignsource income on the U.S. consolidated return would be reduced (but not below zero) by the amount of interest expense incurred by the foreign members of the worldwide group, to the extent that such interest would be allocated to foreign sources if these rules were applied separately to a group consisting of just the foreign members of the worldwide affiliated group. As under the present-law rules for affiliated groups, debt between members of the worldwide affiliated group, and stockholdings in group members, would 'be eliminated for purposes of determining total interest expense of the worldwide affiliated group, computing asset ratios, and computing the reduction in the allocation to foreign-source income for interest expense incurred by a foreign member.
As under the present-law rules, taxpayers would be required to allocate and apportion interest expense on the basis of assets (rather than gross income). Because foreign members would be included in the worldwide affiliated group, the computation would take into account the assets of such foreign members (rather than the stock in such foreign members). For purposes of applying this asset method, as under the present-law lades, if members of the worldwide affiliated group hold at least 10 percent (by vote) of the stock of a corporation (U.S. or foreign) that is not a member of such group, the adjusted basis in such stock would be increased by the earnings and profits that are attributable to such stock and that are accumulated during the period that the members hold such stock. Similarly, the adjusted basis in such stock would be reduced by any deficit in earnings and profits that is attributable to such stock and that arose during such period. However, unlike under the present-law rules, these basis adjustment rules would not be applicable to the stock of the foreign members of the expanded affiliated group (because such members would be included in the group for interest allocation purposes).
Under H.R. 2270, interest expense would be allocated and apportioned based on the assets of the expanded affiliated group. For interest allocation purposes, the affiliated group would be determined under section 1504 but would include life insurancecompanies without regard to whether such companies are covered by an election under section 1504(c)(2) to include them in the affiliated group under section 1504. This definition of affiliated group would be the starting point for the expanded affiliated group. In addition, the expanded affiliated group would include section 936 companies (which are included in the group for interest allocation purposes under present law). The expanded affiliated group also would include foreign corporations that would be included in the affiliated group under section 1504 if they were domestic corporations; consistent with the present-law exclusion of DISCs from the affiliated group, FSCs would not be included in the expanded affiliated group.
Subgroup election
H.R. 2270 also provides a special method for the allocation and apportionment of interest expense with respect to certain debt incurred by members of an affiliated group below the top tier. Under this method, interest expense attributable to qualified debt incurred by a U.S. member of an affiliated group could be allocated and apportioned by looking just to the subgroup consisting of the borrower and its direct and indirect subsidiaries (including foreign subsidiaries). Debt would qualify for this purpose if it is a borrowing from an unrelated person that is not guaranteed or otherwise directly supported by any other corporation within the worldwide affiliated group (other than another member of such subgroup). Debt that does not qualify because of such a guarantee (or other direct support) would be treated as debt of the guarantor (or, if the guarantor is not in the same chain of corporations as the borrower, as debt of the common parent of the guarantor and the borrower). IfPs subgroup method is elected by any member of an affiliated group, it would be required to be applied to the interest expense attributable to all qualified debt of all U.S. members of the group.
When this subgroup method is used, certain transfers from one U.S. member of the affiliated group to another would be treated as reducing the amount of qualified debt. If a U.S. member with qualified debt makes dividend or other distributions in a taxable year to another member of the affiliated group that exceed the greater of its average annual dividend (as a percentage of current earnings and profits) during the five preceding years or 25 percent of its average annual earnings and profits for such period, an amount of its qualified debt equal to such excess would be recharacterized as nonqualified. A similar rule would apply to the extent that a U.S. member with qualified debt deals with a related party on a basis that is not arm's length. Interest attributable to any debt that is recharacterized as nonqualified would be allocated and apportioned by looking to the entire worldwide affiliated group (rather than to the subgroup).
If this subgroup method is used, an equalization rule would apply to the allocation and apportionment of interest expense of members of the affiliated group that is attributable to nonqualified debt. Such interest expense would be allocated and apportioned first to foreign sources to the extent necessary to achieve (to the extent possible) the allocation and apportionment that would have resulted had the subgroup method not been applied.
Financial services group election
Under H.R. 2270, a modified and expanded version of the special bank group rule of present law would apply. Under this election, the allocation and apportionment of interest expense could be determined separately for the subgroup of the expanded affiliated group that consists solely of members that are predominantly engaged in the active conduct of a banking, insurance, financing or similar business. For this purpose, the determination of whether a member is predominantly so engaged would be made under rules similar to the rules of section 904(d)(2)(C) and the regulations thereunder (relating to the determination of income in the financial services basket for foreign tax credit purposes). Accordingly, a member would be considered to be predominantly engaged in the active conduct of a banking, insurance, financing, or similar business if at least 80 percent of its gross income is active financing income as described in Treas. Reg. sec. 1.904-4(e)(2). As under the subgroup role, certain transfers of funds from a U.S. member of the financial services group to another member of the affiliated group that is not a member of the financial services group would reduce the interest expense that is allocated and apportioned based on the financial services group. Also as under the subgroup role, if elected, this role would apply to all members that are considered to be predominantly engaged in the active conduct of a banking, insurance, financing, or similar business.
VI. CONCLUSION
The present-law interest allocation rules operate to deny U.S. multinationals foreign tax Credits for the taxes they pay to foreign jurisdictions. The rules thus subject U.S. multinationals to double taxation of their income earned abroad. This double taxation represents a burden on U.S.-based multinationals that hinders their ability to compete against their foreign counterparts. Indeed, the distortions caused by the interest allocation rules impose a substantial cost that affects the ability of U.S.-based multinationals to compete against foreign companies both with respect to foreign operations and with respect to their operations in the United States.
H.R. 2270 would reform the interest allocation rules to eliminate these rules. The interest allocation rules reflected in H.R. 2270 represent sound tax policy and are consistent with the goal of eliminating double taxation. Such rules would allow the foreign tax credit limitation to operate properly. We respectfully urge the Congress to enact the reforms reflected in H.R. 2270 in order to eliminate the unfair, anti-competitive, and indefensible burden that the present-law interest allocation rules have imposed on U.S. multinationals for the last thirteen years.
END

LOAD-DATE: July 1, 1999

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