LEXIS-NEXIS® Congressional Universe-Document

Search Terms: tax w/5 foreign w/5 income, House or Senate or Joint

Document 52 of 113.

JUNE 30, 1999, WEDNESDAY

SECTION: IN THE NEWS

LENGTH: 3939 words

HEADLINE: PREPARED TESTIMONY OF
HERMANN B. BOUMA
INTERNATIONAL TAX ATTORNEY
WASHINGTON, D.C.
BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS

BODY:

Major Recommendations for Reducing the Arbitrariness and Complexity of International Taxation Under the U.S. Internal Revenue Code
Mr. Chairman and distinguished Members of the Committee on Ways and Means:
My name is Herm Bouma and I appreciate very much the opportunity to appear before the Committee this morning to speak on the international provisions of the Internal Revenue Code. I commend the Committee for focusing its time and energy on this very important topic. I appear before the Committee on my own behalf and not on behalf of any client.
I have been an international tax attorney now for almost 20 years, ever since I graduated from law school. Upon graduating from law school, I went to work with the Office of Chief Counsel at the Internal Revenue Service, where I worked in the International Branch of the Legislation and Regulations Division. My principal project there involved the final foreign taxcredit regulations under sections 901 and 903. After fulfilling my four-year commitment there, I went into private practice with the Washington tax firm known as McClure & Trotter. I was a partner there for eight years and then left to establish my own practice, continuing to focus on international taxation. The rationalization and simplification of the international tax provisions is a subject I have thought about for a long time now.
Reality and the International Provisions
We international tax practitioners have a tendency to get bogged down among the trees (of which there are many) and seldom step back to view the forest as a whole. In my testimony I would like to look at the forest and focus on the basic foundational principles on which our international tax regime should be constructed.
Judge Learned Hand once wrote:
... In my own case the words of such an act as the Income Tax ... merely dance before my eyes in a meaningless procession.., couched in abstract terms that offer no handle to seize hold of... (A)t times I cannot help recalling a saying of William James about certain passages of Hegel: that they were no doubt written with a passion of rationality; but that one cannot help wondering whether to the reader they have significance save that the words are strung together with syntactical correctness.
Learned Hand, Thomas Walter Swan, 57 Yale L.J. 167, 169 (1947). Why is it that people find the Code so hard to understand? There are a number of reasons but one explanation is that often it is not tied in to reality. I believe this is the case with the international provisions of the Code.
There is a huge gap between reality and those provisions. If the international provisions can be based on certain fundamental principles that are grounded in reality and that make sense conceptually, then the provisions will be far less arbitrary and far less complex. They will be easier to learn, both for practitioners and the IRS, and easier to apply. Even where a certain amount of complexity is still required, the complexity will be based on sound fundamentalprinciples, and thus much easier to understand. Moreover, if the international provisions are tied in to reality and make sense, then, when one encounters a situation that is not directly addressed by the provisions, it will be much easier to determine what the answer should be.
When the foundation of a structure is weak and rickety, adding more to the top will not strengthen it; it will simply add more weight so that eventually the whole structure may collapse of its own weight. That is the point we are reaching now with the international provisions of the Code, where the structure has become so huge and so heavy, and yet the foundation is extremely weak and rickety. The whole thing is in danger of collapsing, collapsing in the sense that it is moving beyond the capacity of the IRS to administer and enforce it.
"A Brief Description of Reality"
In order to tie the international provisions in to reality, we first need to have a clear view of reality. Describing reality in somewhat broad-brush strokes, reality consists of God, people, and the world (which includes such things as rocks and trees and squirrels). People have rights and obligations, including financial rights and obligations, which are often referred to as assets and liabilities. People can hold assets and liabilities directly or through arrangements. Some arrangements for assets and liabilities are intended to generate income. An income-generating arrangement normally consists of a set of rules which governs the management of the assets and liabilities and the distribution of assets either to persons who hold interests in the arrangement or to others. Income-generating arrangements are of three basic types: business entities, trusts, and non-profit organizations.
In focusing on the basic foundational principles on which our international tax regime should be constructed, I would like to consider three "big-ticket" items: the taxation of businessentities, the taxation of U.S. versus foreign corporations, and the rules for sourcing income as either U.S.-source or foreign-source.
Taxation of Business Entities
Obviously, the taxation of business entities is not an issue that is limited to the international area. However, it does have major ramifications for the international area and thus is a foundational issue for an international tax regime.
Worldwide there is a great variety of business entities -- they come in all different shapes and sizes. However, they have one thing in common -- they are attempting to generate income for their interest holders. Under the current Code, this great variety of business entities is divided into two basic types, corporations and partnerships (including, for this purpose, sole proprietorships), and radically different tax regimes apply to each. With respect to corporations, there are two layers of taxation; with respect to partnerships, only one.
Under current IRS regulations, certain business entities, including certain foreign business entities, are treated as per se corporations. All other business entities are permitted to choose whether they wish to be treated as a corporation or as a partnership for U.S. tax purposes. There is no logical reason why certain business entities are treated as per se corporations, and thus subject to an additional layer of tax.
It is sometimes said that it is appropriate to treat certain corporations as per se corporations because they provide limited liability to their interest holders. However, what logical connection is there between the two? Why should two layers of tax apply just because the entity provides limited liability to its interest holders? When an interest holder receives a distribution of profits from an entity, the interest holder benefits to the same extent, whether or not it has limitedliability.

Moreover, many business entities that are entitled to choose whether to be treated as a corporation or a partnership do provide limited liability to their interest holders. Thus, there is nothing in the nature of limited liability that requires an additional layer of tax.
An extra layer of tax is sometimes justified for per se corporations on the grounds that they are "separate entities." However, the concept of "separate entity" is never defined and in fact there does not appear to be any definition that would apply only to per se corporations and not to other types of business entries also. Certainly, under typical business law concepts, a traditional partnership under state law, which may be treated as a partnership for U.S. tax purposes, is as much a "separate entity" as is a corporation under state law that is treated as a per se corporation for U.S. tax purposes. Such a partnership can sue and be sued, it can operate under Rs own name, and R can hold property in its own name, including real estate. Thus, it would appear to be as much of a "separate entity" as is a per se corporation. There is, therefore, absolutely no justification for taxing certain business entries as per se corporations, while permitting other business entities to choose how they are taxed. Until this can be remedied, we have a Code that at its very foundation makes no sense.
Except as noted below with respect to publicly-traded business entries, all business entities should be taxed in the same way. Ideally, there should be only one layer of tax and it should be imposed on the business entity on a territorial basis. Requiring the business entity to pay the tax (rather than the interest holders as is currently the case under the Code with respect to the taxation of partnership income) would promote efficiency and reduce the reporting burden on the interest holders. Iran interest holder sold its interest in the business entity, the business entity would be responsible for paying the tax on the gain (which would be withheld from the proceedsdue to the interest holder), and adjustments to the entity's asset bases would be made in a manner similar to that provided in section 743 of the current Code. If the business entity were publicly- traded and an interest holder with a less than 10% interest sold its interest, then the interest holder would pay tax on the gain and there would be no adjustment to the asset bases of the business entity.
Suppose, for example, a business entity (such as a large law firm) has 1,000 interest holders and conducts business in five countries. Under the current Code, if one of those countries is the United States and the business entity is treated as a partnership for U.S. tax purposes, then each of the 1,000 interest holders is required to file a U.S. tax rerum because the business entity is engaged in the conduct of a trade or business in the United States. However, the tax obligation should be imposed on the business entity, not the interest holders. Thus, instead of 5,000 returns being required (assuming the other four countries also required a return from each interest holder), only five returns would be necessary (assuming all five countries adopted the approach of imposing the tax obligation on the business entity).
An alternative approach would be to treat all non-publicly-traded business entities as partnerships are treated under the current Code. Thus, there would be only one layer of tax but the income would be taxed through to the interest holders. If a business entity were publicly-traded, it would be taxed as discussed above under the ideal approach. Thus, there would be only one layer of tax, but it would be imposed on the business entity (except in the case of gain on the sale of an interest by a less than 10% interest holder).Thus, when it comes to the taxation of business entities, the only distinguishing characteristic should be whether or not they are publicly-traded, not whether or not they provide limited liability or are "separate entities".
Taxation of U.S. vs. Foreign Corporations
If the Code continues to characterize business entities as either corporations or partnerships and continues to subject them to different tax regimes, the next "big-ticket" item is whether there should be any difference between the taxation of U.S. corporations as opposed to foreign corporations. Under present law, a U.S. corporation is taxed by the United States on its worldwide income, whereas a foreign corporation is taxed by the United States only on certain U.S.-source income and on income that is effectively connected with the conduct of a trade or business in the United States.
It is important to understand what makes a corporation a U.S. corporation or a foreign corporation for this purpose. What makes the difference is a simple piece of paper, a paper indicating whether the corporation has been organized under the laws of the United States or a political subdivision thereof, such as Delaware, or under the laws of a foreign jurisdiction, such as the Cayman Islands. The location of the corporation's headquarters, of most of its business operations, of most of its property, where it first started business, and the residency of most of its shareholders are all completely irrelevant for this purpose. What matters is a simple piece of paper. Thus, a corporation can be a U.S. corporation even if it has no operations or property in the United States, and no shareholders that are residents of the United States. Similarly, a corporation can be a foreign corporation even if its headquarters and most of its operations and property are in the United States, and all of its shareholders are residents of the United States.Incorporation in the United States does not provide any benefits that justify taxing a U.S. corporation on a worldwide basis. In fact, given the many rules and regulations that apply to U.S. corporations outside the tax area, one could argue that incorporation in the United States is actually a detriment, particularly when there are many other locations in the world that have favorable corporate laws. Thus, incorporation in the United States does not in any way justify taxing a corporation on a worldwide basis. A corporation primarily benefits from the countries in which it earns income, not from the country in which it happens to be incorporated.
On March 11, 1999, Mr. Robert Perlman, Vice President for Tax, Licensing & Customs for Intel Corporation, testified before the Senate Finance Committee concerning the international provisions of the Code. Mr. Perlman stated that if Intel had it to do all over again, it would incorporate as a foreign corporation, not as a U.S. corporation. Some members of the Committee took offense at this statement and considered it unpatriotic. In addition, they pointed out all of the benefits of doing business in the United States, including an educated labor force, little regulation, and a stable government, and they expressed skepticism that a company would move its operations offshore in order to secure better tax benefits. However, this reaction to Mr. Perlman's statement reflected a basic misunderstanding of what it means, under the Code, to be a U.S. corporation or a foreign corporation.
Mr. Perlman said that if Intel had it to do all over again, it would incorporate in the Cayman Islands rather than the United States. All that this would mean is that Intel would have a piece of paper saying it was incorporated under the laws of the Cayman Islands. Everything else about Intel's operations, including its U.S. operations, would be exactly the same. Intel would still have its headquarters in the United States, and it would have just as many factories in theUnited States, just as much research in the United States, and just as many salesmen in the United States. The only difference is that Intel would have a piece of paper saying it was incorporated in the Cayman Islands and this would make all the difference in the world taxwise. It would not be subject to the infamous Subpart F regime, and in fact all of its income from foreign operations would be completely free of U.S. tax.
Start-up companies are now being wisely advised to incorporate in a foreign jurisdiction in order to avoid the onerous rules of the U.S. tax regime, including worldwide taxation and Subpart F. However, many companies which incorporated as U.S. corporations many years ago are stuck with the onerous U.S. tax regime because the "toll charge" under section 367(a) precludes a foreign reincorporation. It is simply unfair for a corporation to now suffer inordinately under the U.S. tax regime just because it made the unfortunate decision, 50 or 100 years ago, to be incorporated in the United States.
In a recent article, Professor Reuven S. Avi-Yonah, an assistant professor at Harvard Law School, stated that "it does not seem to make sense to rely so much on formalities such as which country an entity is incorporated in." Reuven S. Avi-Yonah, Tax Competition and Multinational Competitiveness: The New Balance of Subpart F, Tax Notes International, April 19, 1999, p. 1575, fn 45. Although Professor Avi- Yonah made this statement in reference to controlled foreign corporations, it certainly applies to the taxation of U.S. corporations also. It is ironic that, while the IRS struggles to tax transactions based on their substance and not their form, in this major way the Code elevates form over substance.
It is extremely important, therefore, that all corporations be treated the same, whether they are incorporated in the United States or outside the United States.

This means that the UnitedStates should adopt a territorial system with respect to the taxation of corporations; every corporation, whether U.S. or foreign, should be taxed only on its income from operations in the United States.
The Sourcing Rules
The third "big-ticket" item that I would like to address involves the sourcing rules. The current Code operates on the assumption that every item of income is either U.S.-source or foreign-source. The use of the term "source" is misleading because it gives the impression that there is a quarry of income in each country and one simply determines whether an item of income came from a quarry in the United States or from a quarry in a foreign country. However, the matter is not that simple Income, which is an increase in value, is not a physical object, and thus, by its very nature, does not have a geographical location. Therefore, one cannot source income simply by determining the geographical location from which it came.
Given this conundrum, the Code and regulations have come up with a complex, arbitrary, and arcane set of rules for sourcing all kinds of income. Depending on the type of income that is involved, these rules look at such factors as the residence, citizenship, place of incorporation, or place of business of the payor, the residence, citizenship, place of incorporation, or place of business of the payee, and the place where services were performed, where negotiations took place, where property was at the time title to the property passed, where property is used, where property is manufactured using certain manufacturing intangibles, and where property is marketed using certain marketing intangibles.
Supposedly, the intent of these rules is to identify the country whose economy is most closely connected with the particular item of income. However, in fact the result has been ahodge-podge of extremely arbitrary rules that in many cases make no sense. For example, income from the performance of services is sourced to the country where the services were performed. Thus, if I hire Tom Clancy to write a novel and he spends three weeks on a beach in France writing it, the amount I pay him will be foreign-source income, even though it is extremely difficult to see how this income might have its "source" in France.
Given the arbitrariness and complexity of these rules, one is led to ask the question, are these rules really necessary? In fact they are not, and eliminating them would be a major step towards rationalizing and simplifying the international provisions of the Code.
Under the Code, the sourcing rules are generally used for three purposes: (1) to determine the effectively-connected income of a foreign person that is engaged in the conduct of a trade or business in the United States; (2) to determine the income of a foreign person that is subject to a U.S. tax of 30% on a gross basis (certain "U.S.- source" income that is not effectively connected with the conduct of a trade or business in the United States); and (3) to determine "foreign-source" income for purposes of the limitation on the foreign tax credit for U.S. persons.
With respect to the determination of the effectively-connected income of a foreign person, such income can be determined by focusing directly on the business activities being carried on in the United States and by determining what income those activities give rise to. Although this determination would not always be easy, the approach would be much more direct and much easier to understand. There certainly is no need to first "source" income before determining whether a particular business activity has given rise to it.
With respect to the determination of the income of a foreign person that is subject to a U.S. tax of 30% on a gross basis, the sourcing rules are not needed for this purpose either. Suchincome could be defined as income paid by a permanent establishment in the United States to a foreign person, provided the income is not effectively connected with the conduct of a trade or business by the foreign person in the United States. This approach would also be more direct and easier to understand.
With respect to the determination of the foreign tax credit limitation for U.S. persons, clearly the sourcing rules would not be necessary if no foreign tax credit were given. Such would be the case with respect to business entities if the United States taxed every business entity, whether U.S. or foreign, only on the portion of its worldwide income that is allocable to a permanent establishment (or establishments) that the business entity has in the United States. Since income that is allocable to foreign permanent establishments would not be taxed by the United States, there would be no need to provide a foreign tax credit. If the United States had a 30% gross basis tax for payments made by U.S. permanent establishments to foreign persons, then the United States would need to allow a foreign tax credit with respect to payments received by a U.S. permanent establishment from a foreign permanent establishment (since, in the eyes of the United States, those payments could rightfully be subject to a gross basis tax by the country of the foreign permanent establishment).
Even if the United States did not adopt a territorial system, it still would not be necessary to retain the current sourcing rules in order to determine the foreign tax credit limitation of a U.S. person. The limitation could be determined by adding together all the income of a U.S. person that is allocable to foreign permanent establishments of the U.S. person or that is received by the U.S. person from foreign permanent establishments (whether or not belonging to the U.S. person). This approach would not only be easier to apply but would also make senseconceptually because the foreign tax credit limitation would be based on the income of a U.S. person that foreign countries would tax if they applied the rules of the United States for taxing foreign persons. Under the current Code, there is often a disconnect between the amount of a U.S. person's foreign-source income for purposes of the foreign tax credit limitation and the amount of income foreign countries would tax if they applied to the U.S. person the rules applied by the United States to foreign persons.
Thus, the arbitrary and complex sourcing rules of the current Code could be replaced with a much more clear-cut, logical approach.
Conclusion
There is a fundamental disconnect between reality and the international provisions of the current Code, and this disconnect accounts for the arbitrariness and complexity of those provisions. Because of this arbitrariness and complexity, U.S. corporations are subject to both a much higher tax burden and a much higher compliance burden than are many of their foreign competitors. It is critical that the international provisions be revised from the ground up, so that they are tied in to reality, rationalized, and simplified, thereby eliminating the current burden on the international competitiveness of U.S. corporations.
END

LOAD-DATE: July 1, 1999

Document 52 of 113.


Search Terms: tax w/5 foreign w/5 income, House or Senate or Joint
To narrow your search, please enter a word or phrase: