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Document 49 of 113.

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JUNE 30, 1999, WEDNESDAY

SECTION: IN THE NEWS

LENGTH: 4943 words

HEADLINE: PREPARED TESTIMONY OF
PHILIP D. MORRISON
ON BEHALF OF THE
NATIONAL FOREIGN TRADE COUNCIL
SUBJECT - THE IMPACT OF U.S. TAX RULES
ON INTERNATIONAL COMPETITIVENESS
BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS

BODY:

Mr. Chairman, distinguished Members of the Committee, and staff:
My name is Phil Morrison. I am a Principal with Deloitte & Touche LLP and the Director of Deloitte's Washington International Tax Services Group. I appear today on behalf of the National Foreign Trade Council ("NFTC").
I. Introduction
I am co-author of the NFTC's report on subpart F1 and am currently working with others on an NFTC-sponsored report on the foreign tax credit. My role with respect to these reports was to compare the United States subpart F and foreign tax credit regimes to the comparable regimes of Canada, France, Germany, Japan, the Netherlands, and the United Kingdom. These countries were selected for comparison because they constitute, together with the United States, the countries with the most corporations that are among the world's largest 500 corporations. In the aggregate, these countries are home to 412 of the 500 largest corporations in the world,2 and it is large multinational corporations from these countries that are the competition for U.S. corporations that conduct business abroad.
The subpart F comparison illustrates that, in many important respects, the U.S. controlled foreign corporation (CFC) provisions in subpart F are harsher than the rules in the foreign countries' comparable regimes.3 While the foreign tax credit comparison is still a work- inprogress, preliminary results indicate that the U.S. limitations on the use of the credit and expense allocation provisions are both more complex and more likely to result in double taxation than the foreign countries' comparable regimes. These comparisons demonstrate that U.S. multinationals operate at a competitive disadvantage abroad as compared to multinationals from these other major jurisdictions.
By pointing out this competitive disadvantage, we do not mean to imply that the United States should inaugurate a "race to the bottom," a race to provide the most lenient tax rules. The comparison does demonstrate, however, that the rest of the developed world has not joined the United States in a "race to the top." If the rest of the developed world is not going to join the United States and mimic the harshness of subpart F and the complexity of our foreign tax credit rules, and history has shown that it will not, then it is incumbent upon Congress to carefully examine whether the resulting competitive imbalance is warranted for other policy reasons. Since, as the NFTC report demonstrates and as is summarized in the testimony of Messrs. Murray and Merrill, it is not, it would be sensible to relax the U.S. rules. This relaxation need not be a relaxation to the lowest common denominator but only to a more reasonable middle position among those adopted by our competitor countries.
The unstated assumption of those who raise the spectre of a race to the bottom, is that any significant deviation from the U.S. model that exists in another country indicates that the other government has yielded to powerful business interests and has enacted tax laws that are intended to provide its home-country based multinationals a distinct competitive advantage. It is seldom, if ever, acknowledged that the less stringent rules adopted in other countries might reflect a conscious but different balance of the rival policy concerns of neutrality and competitiveness.
The unstated assumption is incorrect. The CFC regimes enacted by the countries studied, for example, all were enacted in response to and after several years of scrutiny of the U.S. subpart F regime. They reflect a careful study of the impact of subpart F and, in every case, include some significant refinements of the U.S. rules. Each regime has been in place long enough for each respective government to study its operation and to conclude whether it is either too harsh or too liberal. While each jurisdiction has approached CFC issues somewhat differently, each has adopted a regime that, in at least some important respects, is materially less harsh than subpart F.
The proper inference to draw from this comparison is that the United States has tried to lead and, while many have followed, none has followed as far as the United States has gone. A relaxation of subpart F to even the highest common denominator among other countries' CFC regimes, let alone to a moderate middle ground, would help redress the competitive imbalance created by subpart F without contributing to a race to the bottom.
II. Anti-Deferral or CFC Regimes-Generally
Each of the countries examined in the NFTC study on subpart F has enacted a regime aimed at preventing taxpayers from obtaining deferral with respect to certain types of income of, or income earned by certain types of, CFCs. At the same time, however, each country has balanced its anti-deferral concerns with the need not to interfere with the ability of domestic taxpayers to compete in genuine business activities in international markets. Resolution of the conflict between these two policy objectives typically hinges on the definition of what constitutes genuine foreign business activity. Genuine business activity gains deferral; a lack of genuine business activity triggers the anti-deferral regime. As might be expected, the definition of genuine foreign business activity varies widely.
There are two primary ways in which countries prevent what they consider to be improper deferral of domestic taxation of foreign- source income earned by CFC's. A country may end deferral with respect to certain types of"tainted" income that it believes should not receive deferral. This transactional approach is the approach taken by the United States, Canada, and Germany. The alternative is to deem all income to be tainted when a CFC meets certain criteria (such as having a significant amount of tainted income or being located in certain jurisdictions). If the CFC does not meet the criteria for application of the regime, deferral is allowed for all of the income. This jurisdiction-based approach is taken by France, Japan, and the United Kingdom. Both approaches provide exemptions and modifications that tend to minimize the differences between them, however. The Netherlands, through a participation exemption, broadly exempts foreign income of CFCs. While the participation exemption is denied for certain passive investments, liberal safe harbors preserve the exemption in most cases.Deferral is ended (and current inclusion achieved) by attributing either the tainted income or all income earned by the CFC to certain shareholders (usually those holding a minimum percentage ownership). Shareholders must include the attributed income in their own income currently. CFC regimes that attribute only tainted income provide for exclusions that remove specific types of income from classes of income that normally are considered to be tainted. CFC regimes that attribute all income provide exemptions that remove all or certain income from attribution under the regime. III.

III.
Specific Comparison of CFC Regimes with Respect to Particular Types of Income
A. Active Financial Services Income
Prior to 1986, a CFC's active financial services income was treated much the same as other types of active income. From 1986 until 1998, however, most income earned by a CFC of a U.S. financial services company was subject to tax when earned, apparently because Congress believed that deferral of such income provided excessive opportunities to route income through foreign countries to maximize tax beneflts.5 The pre-1986 treatment for active financial services income was temporarily restored in 1997,/6 with the addition of rules to address the concerns that led to the repeal in 1986.
The active financing income provision was revisited in 1998, in the context of extending the provision for the 1999 tax year. Considerable changes were again made to address concerns relating to income mobility. The newly crafted provision is narrowly drawn. Under the 1999 active financing provision, a financial services business must have a substantial number of employees carrying on substantial managerial and operational activities in the foreign country. The activities must be carried on almost exclusively with unrelated parties, and the income from the activities must be recorded on the books and records of the CFC in the country where the income was earned and the activities were performed.7 In addition, an active banking, financing, securities, or insurance business is painstakingly defined by statute and accompanying legislative history. The activities that may be taken into account in determining whether a business is active also are carefully delineated in the statute and legislative history and substantially all of the CFC's activities must be comprised of such activities as defined.
As Example 1 on the attached table shows, none of the countries surveyed eliminates deferral for active financial services income received by a CFC from unrelated persons. Such income is universally recognized as active trade or business income. Thus, if the active financing provision were permitted to expire at the end of 1999, U.S. banks, insurers, and other financial services companies would find themselves at a significant competitive disadvantage in relation to all their major foreign competitors when operating outside the United States.
Other major industrialized countries provide more lenient requirements for a CFC to be able to defer the taxation of its active financing income. German law merely requires that the income must be earned by a bank with a commercially viable office established in the CFC's jurisdiction and that the income results from transactions with customers. Germany does not require that the CFC conduct the activities generating the income or that the income come from transactions with customers solely in the CFC's country of incorporation. The United Kingdom has an even less restrictive deferral regime than Germany. The United Kingdom does not impose current taxation on CFC income as long as the CFC is engaged primarily in legitimate business activities primarily with unrelated parties.
B. Dividends, Interest, and Royalties from Active Earnings Received from Related Parties
Example 2 on the attached table addresses the case where a CFC engaged in the active conduct of a trade or business receives dividends from a subsidiary CFC, incorporated in a different country, also engaged in the active conduct of a trade or business.
For U.S. tax purposes, the dividend income would be taxed to (attributed to) the CFC's U.S. shareholders. There would be no attribution to Canadian shareholders because dividends received from other foreign related parties out of active earnings are excluded from attribution. French shareholders would be exempt because the CFC is engaged in an active business. The dividend income would not be considered to be tainted income in Germany provided the parent CFC's holdings in the subsidiary CFC are commercially related to its own excluded active business operations (e.g., CFC is also engaged in a similar manufacturing business) or if the dividends would have been exempt if received directly by the German corporation. Japanese shareholders would be exempt because the business of CFC is conducted primarily in its country of incorporation (even if business were not conducted in that country, Japanese shareholders would be exempt if the main business of CFC were wholesale, financial, shipping, or air transportation because it is engaged in business primarily with unrelated parties). U.K. shareholders would be exempt from attribution because the recipient CFC is principally engaged in an active business and the business operations of CFC are carried on principally with unrelated parties.
Thus, in the case of an active business CFC that receives a dividend from a CFC subsidiary engaged in active business in a country other than the recipient CFC country, the United States is the only country that always attributes the income to CFC shareholders. While the foreign countries allow for situations where legitimate active businesses earn dividend income in the normal course of business, the United States puts its multinational corporations ata disadvantage by always taxing dividend income currently unless the extremely narrow same country exception applies. Example 3 assumes the same facts as Example 2 but deals with interest. Thus, in Example 3, a CFC engaged in an active trade or business pays interest to a parent or sister CFC in another country that is also engaged in an active business.
Canadian, French, Japanese, and U.K. CFCs are allowed to lend money to active business subsidiaries without being penalized by the CFC rules. German CFCs are allowed to lend money to foreign active business subsidiaries as long as the loan is long-term and the money is borrowed by the CFC on foreign capital markets. U.S. multinational corporations generally are not able to provide a loan from a CFC engaged in active business with an excess of cash to a subsidiary of the CFC that is engaged in active business with a need for cash, without incurring current U.S. taxation on the interest paid from the subsidiary to the CFC. The only time U.S. multinationals are able to provide such a loan without current U.S. taxation is if both the CFC and the subsidiary are in the same country. Although income used to pay the interest is earned in an active foreign business by a party related to the U.S. multinational and the income is reinvested in an active foreign business, the U.S. rules still tax the income currently.
Once again, U.S. multinationals are at a competitive disadvantage in the international marketplace. This situation, like the dividend example in Example 2, hamstrings U.S. multinationals groups from redeploying foreign earnings of their CFC group from jurisdiction to jurisdiction without triggering an end to deferral.
Example 4 on the attached table is identical to Examples 2 and 3 except that it deals with royalties. Royalties are paid by an active CFC in one country to an active CFC in another country.
The Canadian CFC rules provide an exception that deems amounts paid to a CFC by a related foreign corporation to be active business income if the amount is deductible in computing the income of the payer corporation. Therefore, the royalty payments would be excluded from attribution. Income would not be attributed to French shareholders or Japanese shareholders because CFC is principally engaged in an active business carried on in its residence country. Germany does not consider royalty income to be passive tainted income provided the CFC has used its own research and development activities without the participation of German shareholders or an affiliated person to create the patents, trademarks, know-how, or similar rights from which the income is derived. U.K. shareholders would be exempt from attribution because CFC is principally engaged in an active business and the business operations of CFC are carried on principally with unrelated parties.
Only members of U.S. multinational groups cannot pay royalties to a CFC that actively develops intangibles without triggering an anti- deferral regime. Even if earned in an active business, royalties from related parties are subpart F income. In each of the competitor countries' cases, such royalties are not tainted income or otherwise attributable to the CFC's shareholders.
C. Oil-Related Income
In 1982, the United States expanded subpart F income to include "foreign base company oil-related income.

"8 Congress claimed that, because of the fungible nature of oil and because of the complex structures involved, oil income is particularly suited to tax haven type operations? Under the changes made foreign base company oil-related income was defined as foreign oilrelated income other than: (1) income derived from a source within a foreign country in connection with oil or gas extracted from an oil or gas well located in that foreign country; or (2) income from oil, gas, or a primary product of oil or gas that is sold by the foreign corporation for use or consumption within the foreign country or is loaded in such country on a vessel or aircraft as fuel for such vessel or aircraft.'x
Example 5 compares the U.S. rules with respect to foreign base company oil-related income to those applicable to CFCs of companies incorporated in our competitor countries. Example 5 assumes that CFC operates a refinery in country X. CFC earns oil-related income in X from purchasing oil extracted from a country other than X and sells the refined product for consumption outside of X. CFC's sales are primarily conducted with unrelated parties.
Under subpart F, the income of CFC would be attributed to its U.S. shareholders. None of the other countries have singled out oil-related income as a type of income that should be tainted. In the other countries, oil-related income is subject to the same rules as other types of active business income. In this example, however, income would be attributed to French shareholders because CFC makes sales primarily outside the CFC country. In the other countries examined, the income would not be taxed.
Thus, U.S.-based and French-based multinational oil companies are, in these circumstances, at a competitive disadvantage in relation to oil companies from the other compared countries with respect to income earned from downstream activities. Only for U.S. and French multinational oil companies will income from an active downstream business conducted in a subsidiary in a foreign jurisdiction be attributed to shareholders. In each of the other surveyed jurisdictions, such income would be entitled to deferral or exemption.
D. Base Company Sales Income
For U.S. tax purposes, foreign base company sales income generally is income derived from the purchase and re-sale of property that is not manufactured by the CFC where either the seller or the buyer is related to the CFC.
In Example 6, CFC is engaged in the buying and selling of personal property that it does not manufacture. The property is bought from related parties outside CFC's residence country and sold to unrelated parties outside CFC's residence country.
The income of CFC would be attributed to U.S. shareholders. In Canada, CFC's income would be exempt from attribution because the income is earned in active business. The income would be attributed to French shareholders because the business is conducted primarily outside the CFC country. Germany's exemption for commercial activities does not generally apply when goods are acquired by the CFC from, or sold to, a related German party. If the goods are both purchased and sold outside Germany, however, the sales income is exempt, even if the goods are sold to a related party and the German shareholder of the CFC actively participates. In this example, therefore, there would be no attribution. To qualify for exemption from attribution, a Japanese sales company must conduct its business primarily with unrelated parties. To be conducting business primarily with unrelated parties for Japanese purposes, the CFC must either purchase more than 50 percent of its goods from unrelated parties or sell more than 50 percent of its goods to unrelated parties. The income of CFC would not be attributed to Japanese shareholders because more than 50 percent of the goods are sold to unrelated parties. A CFC controlled by U.K. shareholders is subject to the CFC regime and income is attributed to its shareholders if the main business of the CFC is dealing in goods for delivery to or from the United Kingdom or to or from related parties. The main business of the CFC is dealing in goods from related parties, so the income of the CFC would be attributed to its shareholders.
Canadian, German, and Japanese multinationals have a competitive advantage over U.S. multinationals when goods bought from related parties outside the home and CFC countries are sold to unrelated parties outside the home and CFC countries.
E. Increase in Investment in the Home Country
In Example 7, CFC has nothing invested in home country property at the beginning of the year. CFC purchases tangible property located in the home country for use in its business during the year. CFC has earnings and profits in excess of the value of the property.
Under subpart F, U.S. shareholders would have to include the entire amount invested by the CFC in U.S. property for the taxable year in its income." None of the other countries studied have a provision that requires an inclusion in income by the CFC shareholders for an increase in earnings invested by the CFC in the home country. Canada and Germany have decided that, if the income earned from that property invested in the home country is of a type for which deferral
"I.R.C. 951(a)(1)(B),956(a).should not be granted, then it is sufficient to subject the income from that investment to the antideferral regime (note that the CFC itself may be subject to tax in the home country because the income may be sourced in the home country). France, Japan, and the United Kingdom do not even subject the income from such property to tax under their anti-deferral regime, even if the income is of a type for which deferral should not be granted, if the CFC is engaged primarily in active business.
IV. Conclusion--Anti-Deferral or CFC Regimes
Anti-deferral or CFC regimes have been enacted in each of the countries studied. Most were enacted in the two decades following the enactment of subpart F in the United States. It is possible to argue that other countries, albeit slowly, have followed the United States' lead. But no country has followed our lead, even after 37 years, nearly as far as we have gone. The United States clearly imposes the most burdensome regime. Looking at any given category of income, it is sometimes possible to point to one or two countries whose rules approach the U.S. regime, but the overall trend is overwhelmingly clear: U.S.-based multinationals with active foreign business operations suffer much greater home-country tax burdens than their foreign-based competitors.
The observation that the U.S. rules are out of step with international norms, as reflected in the consistent practices of our major trading partners, supports the conclusion that U.S.-based companies suffer a competitive (disadvantage vis-a-vis their multinational competitors based in other countries. The appropriate reform is to limit the reach of subpart F in a manner that is more consistent with the international norm.
Some commentators have suggested that the competitive imbalance created by dissimilar international tax rules should be redressed not through any amelioration of the U.S. rules, but rather through a broadening of comparable foreign regimes. As a purely logical matter the point is valid -- a see-saw can be balanced either by pushing down the high end or pulling up the low one. However, the suggestion is completely impractical for several reasons. For one thing, since the U.S. rules are out of step with the majority, from the standpoint of legislative logistics alone it would be far easier to achieve conforming legislation in the United States alone, rather than in more than a dozen other countries. More fundamentally, there is no particular reason to believe that numerous foreign sovereigns, having previously declined to adopt subpart F's broad taxation of active foreign businesses despite 37 years of the U.S. setting the example, will now suddenly have a change of heart and decide to follow the U.S. model. Clearly our competitor jurisdictions have studied our subpart F and chosen a somewhat less harsh balance between competitiveness and neutrality. It is unwarranted and naive to think they have made this choice without careful consideration or solely in an effort to maintain a competitive advantage for "their" multinationals.
Further, recent OECD activities relating to "unfair tax competition" do not increase the likelihood of foreign conformity with subpart F's treatment of active foreign businesses. R is important to recognize that those activities relate to efforts by OECD member countries to limit the availability and usage of"tax haven" countries and regimes. The failure of a country to impose any type of CFC legislation can be viewed as offering a type of tax haven opportunity,since it may permit the creation of investment structures that avoid all taxation. Thus, the OECD has recommended that countries without any CFC regime "consider" enacting them. However, in encouraging countries that have no CFC rules to enact them, the OECD has in no way endorsed an effort to promote conformity among existing CFC regimes, let alone conformity with the U.S. system.

In conclusion, the U.S. rules under subpart F are well outside the international mainstream, and should be conformed more closely to the practices of our principal trading partners. We emphasize that, contrary to the suggestions of some commentators, we advocate only that the U.S. rules be brought back to the norm so as to achieve competitive parity -- not that they be loosened further in an effort to confer competitive advantage.
V. Foreign Tax Credit
As mentioned above, the NFTC foreign tax credit study is a work-in- progress. While I am unable to report definitive conclusions from the comparative law portion of that study, we are far enough along to make some general observations. First, while superficially less complex, exemption or territorial systems have the potential for significant complexity. Because, under an exemption or territorial system, foreign source income is exempt, sourcing rules are as important and susceptible of as much pressure as under a foreign tax credit system with a complex limitation. Similarly, because income of foreign subsidiaries is exempt under a territorial system, transfer pricing rules can come under significant pressure. Finally, most jurisdictions with exemption or territorial systems find the need to not exempt certain types of passive income. Thus, there may be a foreign tax credit system just for this type of income, as well as an anti- deferral or CFC regime.
Second, no other country studied limits averaging between high- and low-tax countries with either the severity or the complexity of the U.S. foreign tax credit basket system. Even the U.K., with a juridical per item limitation mitigates the complexity and harshness of such a rule by permitting the utilization of so-called "mixer" companies. Other credit countries, such as Japan, adopt a straight-forward overall limitation such as the United States has had in the past.
Third, no country studied appears to have anywhere near as complex an expense allocation regime, particularly with respect to interest, as the United States'. The U.S. interest allocation rules appear, based on our preliminary work, to be vastly more complex and unfair than the expense allocation rules applicable in any of the other jurisdictions.
Finally, none of the other jurisdictions studied appear to have a rule such as the U.S. overall foreign loss ("OFL") recapture rule. That rule, which causes U.S. multinationals with OFLs to recapture future foreign source income as domestic income, essentially eliminates the benefit of a foreign tax credit in industries such as telecommunications and power generation where significant capital outlays in early years of foreign operations produce significant early years losses.In sum, our preliminary findings show that, like subpart F, the U.S. foreign tax credit regime places U.S. multinationals at a competitive disadvantage versus multinationals from the other countries studied. This is particularly true with respect to either heavily leveraged industries or those that produce significant foreign losses in the early years of operation abroad.
VI. Overall Conclusion
The U.S. subpart F and foreign tax credit regimes are both more complex and harsher than the comparable regimes in the six other countries studied. The higher administrative cost in dealing with this complexity, together with the higher domestic tax on foreign-earned income, generally places U.S. multinationals at a competitive disadvantage versus multinationals based in these other countries.
FOOTNOTES:
1 International Tax Policy for the 21't Century: A Reconsideration of Subpart F, (March 25, 1999).
2 Based upon the Financial Times 500, THE FINANCIAL TIMES, January 22, 1998.
3 For convenience, the anti-deferral regimes of all of the countries will be referred to as "CFC regimes." The actual names of the particular regimes vary. 4 In each of the examples below, it is assumed that a single home- country shareholder (a parent company) owns 100% of the CFC. Because of this, in each of the examples outlined below, the Dutch anti- deferral regime (exceptions from the Dutch exemption system) will not apply.
5 JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986, at 966 (Comm. Print 1986).
6 Pub. L. No. 105-34, 1175(a); H.R. REP. NO. 105-220, at 639-645 (1997)(Taxpayer Relief Act of 1997, Conference Report to H.R. 2014).
7 See H.R. REP. NO. 105-825, at 921 (1998)(Conference Report to H.R. 4328, section 1005 of the Omnibus Consolidated and Emergency Supplemental Appropriations Act of 1999).
8 Pub. L. No. 97-248, 212(a).
9 JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE TAX EQUITY AND FISCAL RESPONSIBILITY ACT OF 1982, at 72.
10 I.R.C. 954(g).
END

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