Copyright 1999 Federal Document Clearing House, Inc.
Federal Document Clearing House Congressional Testimony
June 30, 1999
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 10320 words
HEADLINE:
TESTIMONY June 30, 1999 FRED MURRAY VICE PRESIDENT HOUSE WAYS
AND MEANS INTERNATIONAL TAX RULES
BODY:
Statement
of Fred F. Murray, Vice President for Tax Policy National Foreign Trade Council,
Inc. Testimony Before the House Committee on Ways and Means Hearing on Impact of
U.S. Tax Rules on International Competitiveness June 30, 1999 Mr. Chairman, and
Distinguished Members of the Committee: My name is Fred Murray. I am Vice
President for Tax Policy for the National Foreign Trade Council, Inc. I was
formerly Special Counsel (Legislation) for the Internal Revenue Service, and
before that represented taxpayers for seventeen years in private practice before
joining the Treasury. With me today are Mr. Phil Morrison, Director of the
International Tax Services Group in the Washington National Office of Deloitte
& Touche LLP and formerly International Tax Counsel at the U.S. Treasury,
and Mr. Peter Merrill, Director of the National Economic Consulting Practice at
Pricewaterhouse Coopers in their Washington National Tax Services Office and
formerly Chief Economist for the Joint Committee on Taxation. We intend to
summarize for you the analysis and conclusions that have been reached in the
ongoing National Foreign Trade Council Foreign Income Project. In addition to
the two gentlemen here with me today, the project has been drafted and reviewed
by more than fifty distinguished professionals: former Treasury and IRS
officials including Assistant Secretaries and Deputy Assistant Secretaries for
Tax Policy, International Tax Counsels, a Commissioner of Internal Revenue, and
other distinguished lawyers and economists, corresponding professionals from
Hill offices, and finally distinguished lawyers, accountants, and economists
from some of America's most prominent companies, professional firms, and
universities. The National Foreign Trade Council, Inc. (the "NFTC" or the
"Council") is appreciative of the opportunity to present its views on the impact
on international competitiveness of certain of the foreign provisions of the
Internal Revenue Code of the United States. 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. The
Council Believes That We Must Re-evaluate Current International Tax Policies
United States policy in regard to trade matters has been broadly expansionist
for many years, but its tax policy has not followed suit. The foreign
competition faced by U.S.-based companies has intensified as the globalization
of business has accelerated. At the same time, U.S.-based multinationals
increasingly voice their conviction that the Internal Revenue Code places them
at a competitive disadvantage in relation to multinationals based in other
countries. In 1997, the NFTC launched an international tax policy review
project, at least partly in response to this growing chorus of concern. The
project is presently divided into two parts, the first dealing with the United
States' anti- deferral regime, subpart F, the second dealing with the foreign
tax credit. The two parts are in turn divided into two phases. In both, an
analytical report examining the legal, economic and tax policy aspects of the
U.S. rules will be followed by legislative and policy recommendations based on
the analytical report. On March 25, 1999, the NFTC published a report analyzing
the competitive impact on U.S.-based companies of the rules under subpart F of
the tax code, which accelerate the U.S. taxation of income earned by foreign
affiliates.(1) The data and analysis presented in Part One support several
significant conclusions: Since the enactment of subpart F more than 35 years
ago, the development of a global economy has substantially eroded the rules'
economic policy rationale. The breadth of subpart F exceeds the international
norms for such rules, adversely affecting the competitiveness of U.S.-based
companies by subjecting their cross-border operations to a heavier tax burden
than that borne by their principal foreign-based competitors. Most importantly,
subpart F applies too broadly to various categories of income that arise in the
course of active foreign business operations, and should thus be substantially
narrowed. Our present testimony is in part based upon the findings described in
the Report. Fundamental Changes in the Economic Underpinnings of Our
International Tax System The compromise embodied in a significant portion of our
present international tax system was shaped in the global economic environment
of the early 1960s - a world economy that has changed almost beyond recognition
as the 20th century draws to a close. In the decades since subpart F was enacted
in 1962, the global economy has grown more rapidly than the U.S. economy. By
almost every measure - income, exports, or cross-border investment - U.S.-based
companies today represent a smaller share of the global market. At the same
time, U.S.-based companies have become increasingly dependent on foreign markets
for continued growth and prosperity. Over the last three decades, sales and
income from foreign subsidiaries have increased much more rapidly than sales and
income from domestic operations. To compete successfully both at home and
abroad, U.S.-based companies have adopted global sourcing and distribution
channels, as have their competitors. Changes introduced since 1962 in subpart F
and other important rules in our international tax system have imposed current
U.S. taxation on ever-larger categories of active foreign income. These two
incompatible trends - decreasing U.S. dominance in global markets set against
increasing U.S. taxation of CFC income - are not claimed to have any necessary
causal relation. However, they strongly suggest that re-evaluation of the
balance of policies that underlie our rules is long overdue. Because economic
arguments advanced against the backdrop of the 1962 economy are the foundation
upon which subpart F was erected, the balance that was struck in 1962 may no
longer be appropriate. The same is true for other provisions of our
international tax system that were constructed with far different bases in mind.
Accordingly, with U.S.-based companies less dominant in foreign markets, but at
the same time more dependent on those markets, U.S. international tax rules that
are out of step with those of other major industrial countries are more likely
to hamper the competitiveness of U.S. multinationals than was the case in the
1960s. The growing economic integration among nations - especially the formation
of common markets and free trade areas - raises questions about the
appropriateness of U.S. tax rules regarding "base" companies that transact
business across national borders with affiliates. Finally, the eclipsing of
foreign direct investment by portfolio investment calls into question the
importance of tax policy focused on foreign direct investment for purposes of
achieving an efficient global allocation of capital. We will discuss these
issues in greater detail in the balance of my testimony and in that of my
colleagues. Where We Came From and Where We Are Today In 1962, the Kennedy
Administration proposed to subject the earnings of U.S. controlled foreign
corporations (CFCs) to current U.S. taxation. At this time, the dollar was tied
to the gold standard, and the United States was the world's largest capital
exporter. These capital exports drained Treasury's gold reserves, and made it
more difficult for the Administration to stimulate the economy. Thus, the
proposed repeal of deferral of tax on the foreign income of U.S. multinationals
was intended by Treasury Secretary Douglas Dillon to serve as a form of capital
control, reducing the outflow of U.S. investment abroad. The 1962 Legislation
Some commentators have taken the view that subpart F as enacted in 1962
reflected a compromise between two competing tax policy goals. Treasury itself
has recently described subpart F as enforcing a balance between the goal of
maintaining the competitiveness of U.S. business, on the one hand, and on the
other of maintaining neutrality as between the taxation of domestic and foreign
business (capital export neutrality(2)). The compromise between competitiveness
and neutrality that was struck in 1962 has been seriously disrupted by the legal
and economic changes of nearly four decades. The United States has never enacted
an international tax regime that makes capital export neutrality its principal
goal with respect to the taxation of business income. Indeed, during the period
1918-1928, the formative era for U.S. tax policy regarding international
business income, the United States ceded primary taxing jurisdiction over active
business income to the country of source.(3) Rules were formulated to protect
the ability of the United States to collect tax on U.S.-source income, and the
foreign tax credit was introduced allowing U.S. income tax to be imposed
whenever the foreign country where the income was sourced failed to tax the
income. The dominant purpose of the U.S. international tax system put in place
then -- a system that still governs U.S. taxation of international income -- was
to eliminate the double taxation of business income earned abroad by U.S.
taxpayers, which had been imposed under the taxing regime enacted at the
inception of the income tax.(4) When the foreign tax credit was first enacted in
1918, the United States taxed income earned abroad by foreign corporations only
when that income was repatriated to the United States. In addition to
implementing the basic policy decision to grant source countries the principal
claim to the taxation of business income, this "deferral of income"(5) reflected
concerns both about whether the United States had the legal power to tax income
of foreign corporations (even if owned by U.S. persons) and about the practical
ability of the United States to measure and collect tax on income earned abroad
by a foreign corporation.(6) Deferral of tax on active business income remained
essentially unchanged for the next 44 years -- until 1962. The only exception to
this rule was the result of "foreign personal holding company" legislation
enacted in 1937 to curb the use of foreign corporations to hold income-producing
assets and to sell assets with unrealized (and untaxed) appreciation. The
foreign personal holding company rules tax currently certain kinds of "passive"
income of a narrow class of corporations in the hands of their owners.(7)
However, President Kennedy urged a reversal of this longstanding U.S. tax policy
in 1961. The President called for the "elimination of tax deferral privileges in
developed countries and 'tax haven' privileges in all countries."(8) President
Kennedy's 1961 State of the Union Address, elaborated on in his tax message of
April 20, 1961, prompted Congressional consideration during 1961 and 1962 of
changes in the U.S. taxation of controlled foreign corporations. In addressing
broad balance of payments concerns, Kennedy announced in his State of the Union
Address that his administration would ask Congress to reassess the tax
provisions that favored investment in foreign countries over investment in the
United States. The President, in his April tax message, urged five goals for
revising U.S. tax policy: (1) to alleviate the U.S. balance of payments deficit;
(2) to help modernize U.S. industry; (3) to stimulate growth of the economy; (4)
to eliminate to the extent possible economic injustice; and (5) to maintain the
level of revenues requested by President Eisenhower in his last budget. In
addition to changes in foreign income tax provisions, President Kennedy, in both
his State of the Union Address and tax message, called for the introduction of
an 8 percent investment tax credit on purchases of machinery and equipment to
"spur our modernization, our growth and our ability to compete abroad."(9)
Kennedy urged that this credit be limited to expenditures on new machinery and
equipment "located in the United States."(10) Emphasis added. Specifically, with
regard to the taxation of foreign income, the President stated that "changing
conditions" made continuation of the "deferral privilege undesirable," and
proposed the elimination of tax deferral in developed countries and in tax
havens everywhere. The President stated: "To the extent that these tax havens
and other tax deferral privileges result in U.S. firms investing or locating
abroad largely for tax reasons, the efficient allocation of international
resources is upset, the initial drain on our already adverse balance of payments
is never fully compensated, and profits are retained and reinvested abroad which
would otherwise be invested in the United States. Certainly since the post-war
reconstruction of Europe and Japan has been completed, there are no longer
foreign policy reasons for providing tax incentives for foreign investment in
the economically advanced countries."(11) The Kennedy Administration's
recommendations with respect to deferral and the investment tax credit were not
neutral toward the location of capital. It is clear that neither the House nor
the Senate embraced the Kennedy Administration's call. The President's proposal
was rejected by the Congress, and the legislation that eventually passed as the
Revenue Act of 1962 provided for much narrower constraints on deferral of the
taxation of active business income. Congress aimed to curb tax haven abuses
rather than to end the deferral of U.S. income tax on active business income in
developed countries. The 1962 legislation, as ultimately enacted, was targeted
at eliminating certain "abuses" permitted under prior law, although, the
historical record is far from clear about exactly what the "abuses" were that
Congress intended to curb. The abuses that the Revenue Act of 1962 sought to
rectify changed substantially as the legislation made its way through the
legislative process. Under President Kennedy's original proposal contained in
his tax message of April 1961, and urged throughout the Congressional process by
Treasury Secretary Dillon, any deferral of U.S. taxation constituted an abuse.
An exception to current taxation would have been provided for (and limited to)
investments in less developed countries, but this exception was explicitly
grounded in foreign policy, not tax policy, considerations. Treasury's proposal
of July 20, 1961, implicitly treated as abusive the deferral of tax on income
from transactions between a foreign corporation and a related party outside the
country in which the foreign corporation was organized.(12) In the Senate
Finance Committee hearings, Secretary Dillon singled out as abusive the use of
foreign corporations that market their goods or services in third countries with
the subjective intent of "reducing taxes."(13) The potential of transfer pricing
abuses between related companies were a concern. In the legislation sent to the
House by the Committee on Ways and Means and adopted by the House, the abuse
appeared to be the avoidance of "taxation by the United States on what could
ordinarily be expected to be U.S. source income."(14) As stated above, this
concern was consistent with U.S. tax policy dating back to the formative period
of 1918-1928, and can be viewed, not as a change in policy, but rather as an
application of longstanding policies to new circumstances. It is clear, however,
that Congress did not intend to reverse the policy of generally permitting
deferral of active business income earned abroad. Ultimately, no clear
Congressional understanding of exactly what constituted an abuse can be
determined from the history of the 1962 Revenue Act. Indeed, the Act left
determinations of abuse - at least to some extent - up to the Treasury on a
case-by-case basis. What these provisions seek to do is still mysterious even
today. The Importance of Transfer Pricing Developments In reviewing Secretary
Dillon's concerns, and the subsequent enactment of the base company rules, it is
clear that the subpart F provisions were intended to be a "backstop" to the then
existing transfer pricing regime of the Code. Very significant changes have
taken place in the field of transfer pricing administration since the 1962
legislation, as Treasury itself has testified in recent years. When subpart F
was enacted, the use of improper transfer pricing to shift income into tax haven
jurisdictions was a major concern of Treasury and Congress. Although
contemporaneous efforts were being made to address transfer pricing concerns via
regulations under section 482, significant aspects of subpart F were
specifically intended to backstop transfer pricing enforcement by imposing
current U.S. tax on various forms of tax haven income, thus reducing U.S.
taxpayers' incentives to shift income into tax havens. In particular, this was
one of the stated reasons for the rules relating to foreign base company sales
and services. By limiting the benefit of maximizing sales or services profits in
a tax haven, these rules were intended to relieve some of the pressure on the
still-nascent transfer pricing regime's ability to police the pricing of
cross-border transactions.(15) Nearly four decades later, transfer pricing law
and administration have undergone profound changes that call into serious
question the continued relevance of subpart F to transfer pricing enforcement.
Most conspicuously, based on legislative changes in the 1986 and 1993 tax acts,
Treasury has promulgated detailed regulations that have drastically altered the
transfer pricing enforcement landscape.(16) These regulations clarify many areas
of substantive transfer pricing controversy, but perhaps more importantly they
implement a structure of reporting and penalty rules that have had a
considerable impact on taxpayer behavior. Further, although audit experience
with the new rules is still limited, it is anticipated that the widespread
availability of contemporaneous transfer pricing documentation will markedly
enhance the Internal Revenue Service's ability to perform effective transfer
pricing examinations. Almost as important is the globalization of transfer
pricing enforcement efforts; partly in response to U.S. initiatives in the area,
and partly because of compliance concerns of their own, many of the United
States' major trading partners have recently stepped up their own transfer
pricing enforcement efforts, enhancing reporting and penalty regimes and
increasing audit activity. As a result, the role of the Organisation for
Economic Cooperation and Development (OECD) as a forum for the development of
international consensus on transfer pricing matters has attained new prominence,
with the United States making notable efforts to ensure that its own transfer
pricing initiatives win international acceptance via the OECD. Accordingly, the
ability of U.S. taxpayers to shift income into a sales base company by
manipulating the pricing of transactions is far more circumscribed than it was
when transfer pricing as a discipline was in its infancy. This basic change in
the landscape, in combination with the general development of a global economy,
suggests that transfer pricing considerations no longer provide much support for
the base company sales and services rules. Indeed, treating international
transactions through centralized sales or services companies as per se tax
abusive ignores the current realities of both transfer pricing enforcement and
the globally integrated business models demanded by the global marketplace.
Development of subpart F A lack of clarity in the historical record of the 1962
Act about what constituted an abuse of tax deferral in international
transactions has resulted in ongoing debates about the proper scope of subpart F
that continue to this day. Legislation since 1962 has changed the rules for when
current taxation is required, but has not resolved the basic debate that raged
in 1962. Interpretations of the 1962 Act subsequent to its enactment have
sometimes described as abusive any transaction where a foreign government
imposes lower tax than would be imposed by the United States on the same
transaction or income.(17) This cannot be right. In 1962, Congress clearly
rejected making capital export neutrality the linchpin of U.S. international tax
policy. Attempting to force a strained interpretation of the legislation it did
enact into an endorsement of capital export neutrality by defining anything that
departs from capital export neutrality as an abuse flagrantly disregards the
historical record. Nevertheless, in the years since 1962, subpart F has been the
subject of numerous revisions, including substantial overhauls in 1975 and 1986:
by the addition of new categories of subpart F income; by the narrowing of
exceptions to subpart F income; and by the creation of additional anti-deferral
regimes (i.e., the Passive Foreign Investment Company provisions). This constant
tinkering has created both instability and a forbiddingly arcane web of general
rules, exceptions, exceptions to exceptions, interactions, cross references, and
effective dates, generating a level of complexity that cannot be defended.
Further, while Congress has over the years modified the rules in ways that both
tightened and relaxed the anti-deferral rules, it is clear that the overall
trend has been to expand the scope of those rules. Particularly with the changes
made in 1975 and 1986, Congress has brought more and more income within the net
of current taxation, to the point where Treasury now feels justified in positing
that current taxation is the general rule, with deferral permitted only as an
exception. A review of this legislative activity makes it clear that U.S.
international tax policy has remained largely unchanged for more than three
decades. Legislative activity has continued to focus on perceived abuses of
deferral (as well as the foreign tax credit), with relatively little
consideration given to the changing relationship between the U.S. economy and
the rest of the world. 1999 Is Not 1962 The compromise embodied in subpart F was
shaped in the global economic environment of the early 1960s - a world economy
that has changed almost beyond recognition as the 20th century draws to a close.
The gold standard was abandoned during the Nixon Administration, and the
exchange rate of the dollar is no longer fixed. The United States is now the
world's largest importer of capital, with foreign investment in U.S. assets
exceeding U.S. investment in foreign assets by over $100 billion per year. With
the completion of the post-World War II economic recovery in Europe and Japan,
the growth of an industrial economy in many countries in Asia and elsewhere, and
the overall development of a global economy, U.S. dominance of international
markets is only a memory. The competition from foreign-based companies in U.S.
and international markets is far more intense today than it was in 1962.(18)
While competition in international markets has grown stiffer, those markets have
simultaneously become more important to the prosperity of U.S.-based companies,
as foreign income has come to constitute an increasing percentage of U.S.
corporate earnings. The relentless tightening of the subpart F and foreign tax
credit rules since 1962, plus the enactment of additional anti-deferral regimes,
has steadily increased the tension between U.S. international tax policy and the
competitive demands of a global economy. A comparison between the policy goals
of our international tax system and changes in the global economy is thus long
overdue. Relevant Tax Policy Considerations Without foreclosing the
consideration of other factors, it should be noted that Treasury officials in
recent months have suggested that five tax policy considerations will need to be
taken into account in the process of reforming subpart F: Capital export
neutrality Competitiveness Conformity with international norms Minimizing
compliance and administrative burdens Meeting revenue needs in a fair manner
Capital Export Neutrality As explained in detail in the Report, and as further
explained by my colleagues with me on the panel this morning, the NFTC believes
that the historical significance of capital export neutrality ("CEN") in the
enactment of subpart F has come to be exaggerated by subsequent commentators.
More importantly, the Report finds numerous reasons to reject CEN as a
foundation of U.S. international tax policy. Briefly summarized, these reasons
include: The futility of attempting to achieve globally efficient capital
allocation by unilateral action. The similar futility of attempting to advance
investment neutrality by focusing solely on direct investment, particularly in
light of the fact that international portfolio investment now significantly
exceeds direct investment. The failure of the United States itself to take CEN
seriously as a matter of tax policy, other than in the one relatively narrow
area of subpart F, where it appears to operate largely as a rationale of
convenience. Growing criticism of CEN in current economic literature. The
anomalousness of adopting a tax policy that encourages the payment of higher
taxes to foreign governments. The fact that CEN is the wrong starting point for
our international tax policy is particularly well illustrated by the last item.
Several provisions of subpart F have the effect of penalizing a taxpayer that
reduces its foreign tax burden, apparently based on the CEN principles.
Presumably the idea is that preventing U.S. taxpayers from reducing foreign
taxes will ensure that they do not make investment decisions based on the
prospect of garnering a reduced rate of foreign taxation (while deferring U.S.
taxation until repatriation). However, insisting that U.S. taxpayers pay full
foreign tax rates when market forces require that they do business in another
jurisdiction is a flawed policy from at least three perspectives. First, from
the standpoint of the tax system, insisting on higher foreign tax payments
obviously increases the amount of foreign taxes available to be credited against
U.S. tax liability, thus decreasing U.S. tax collections in the long run.
Second, from the standpoint of competitiveness, it leaves U.S.-based companies
in a worse position than their foreign-based competitors: the U.S. company must
either pay the high local rate, or if it attempts to reduce that tax it will
instead trigger subpart F taxes at the U.S. rate, while the foreign competition
will reduce their local taxes through perfectly normal transactions such as
paying interest on a loan from an affiliate, and trigger no home country taxes
by doing so.(19) Third, the belief that the level of foreign investment by U.S.
companies will be significantly increased by the ability to reduce foreign taxes
(while deferring U.S. taxation) is seriously antiquated in the context of the
global economy. Such a belief may have been justified in the early 1960's, when
the business reasons for U.S. companies to invest offshore were more limited.
But today, when the principal opportunities for expansion are offered by foreign
markets, so that U.S.-based companies derive an ever-greater proportion of their
earnings from offshore activities, a presumption that foreign tax reduction will
generate tax-motivated foreign investment is not merely out of touch with
economic reality, but seriously harmful to the competitiveness of U.S.-based
companies (as further discussed below). We submit that the at best highly
theoretical global capital allocation benefits that may be achieved by subpart
F's haphazard pursuit of CEN principles do not even come close to justifying the
fiscal and competitive damage caused by denying U.S. companies the ability to
reduce local taxes on the foreign businesses that are critical to their future
prosperity and that of their workers. Accordingly, the NFTC believes that CEN is
not a sound basis on which to build U.S. international tax policy for the coming
century, and recommends that in redesigning subpart F it be given no greater
weight than it has been given in the case of other major international
provisions such as the foreign tax credit. Competitiveness Accelerating the U.S.
taxation of overseas operations (while permitting a foreign tax credit) means
that a U.S.-based company will pay tax at the higher of the U.S. or foreign tax
rate. If the local tax rate in the company of operation is less than the U.S.
rate, this means that locally-based competitors will be more lightly taxed than
their U.S.-based competition. Moreover, companies based in other countries will
also enjoy a lighter tax burden, unless their home countries impose a regime
that is as broad as subpart F, and none have to date done so. While the
competitive impact of a heavier corporate tax burden is difficult to quantify,
it is clear that a company that pays higher taxes suffers a disadvantage
vis-a-vis its more lightly taxed competitors. That disadvantage may ultimately
take the form of a decreased ability to engage in price competition, or to
invest funds in the research and capital investment needed to build future
profitability, or in the ability to attract capital by offering an attractive
after-tax rate of return on investment. Whatever its ultimate form, however, it
cannot be seriously questioned that a heavier corporate tax burden will harm a
company's ability to compete.(20) Competitiveness concerns were central to the
debate when subpart F was enacted, even at a time when U.S.-based companies
dominated the international marketplace. This apparent dominance did not
convince Congress that the competitive position of U.S. companies in
international markets could be ignored. Thus, although the Administration
originally proposed the acceleration of U.S. taxation of most foreign-affiliate
income, that proposal was firmly rejected by Congress based largely on concerns
about its competitive impact.(21) If competitiveness was a consideration when
subpart F was enacted, there are compelling reasons to treat it as a far more
serious concern today. Conformity with International Norms As will be further
developed by my colleagues on the panel this morning, conformity with
international norms is important from a competitiveness standpoint, but it bears
further emphasis here that our principal trading partners have consistently
adopted rules that are less burdensome than subpart F. We do not dispute the
fact that subpart F established a model for the taxation of offshore affiliates
that has been imitated to a greater or lesser degree in the CFC legislation of
many countries. But looking beyond the superficial observation that other
countries have also enacted CFC rules, the detailed analysis in the Part One
Report showed that in virtually every scenario relating to the taxation of
active offshore operations, the United States 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 detriment vis-a-vis their multinational competitors based
in such countries as Germany and the United Kingdom, and that 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 -- conformity and competitive balance are far more likely to be
achieved through a modernization of the U.S. rules. 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, will now suddenly have a change of heart and decide
to follow the U.S. model. 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. It 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. By imposing
abnormally low rates of taxation, such countries or regimes may be viewed as
improperly reducing other countries' tax bases and distorting international
investment decisions. 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 CFC regimes "consider" enacting
them. However, in encouraging countries that have no CFC rules to enact them,
the OECD has done nothing to advance the degree of conformity among existing CFC
regimes. Based on the materials that are publicly available, it does not appear
that the OECD has sought to address the lack of conformity between the
highly-developed CFC rules of the United States and its major trading partners,
particularly as they affect active foreign business operations. 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. Minimizing Compliance and Administrative Burdens
The NFTC applauds Treasury's inclusion of administrability among the principal
tax policy goals that will be considered in reforming our international tax
system. Subpart F includes some of the most complex provisions in the Code, and
it imposes administrative burdens that in many cases appear to be
disproportionate to the amount of revenue at stake. There are several sources of
complexity within subpart F, including the following: The basic design and
drafting of the subpart F regime was complex; That initial complexity has been
exacerbated over the years by numerous amendments, which have created an
increasingly arcane web of rules, exceptions, exceptions to exceptions, etc.;
and The subpart F rule require coordination with several other regimes that are
themselves forbiddingly complex, including in particular the foreign tax credit
and its limitations. The complexity of the rules long ago reached the point that
the ability of taxpayers to comply, and the ability of the IRS to verify
compliance, were both placed in serious jeopardy. The NFTC therefore urges that
administrability concerns be given serious weight in the process of modernizing
the tax system. To that end, we urge that the drafters of the Code and
regulations consider not only the legal operation of the rules, but also their
practical implementation in terms of forms and recordkeeping requirements. In
addition, we urge that fuller consideration be given to the interaction of
multiple complex regimes; it may be possible to read section 904(d) and its
implementing regulations and conclude that the provision can be understood, and
it may likewise be possible to read section 954 and its implementing regulations
and conclude that that provision is also understandable, but when the two sets
of rules must be read and implemented together, we submit that the limits of
human understanding are rapidly exceeded. Meeting Revenue Needs in a Fair Manner
The final policy criterion recently mentioned by Treasury is fairness. While no
one could quarrel with the notion of fairness in tax policy, what fairness means
in practice is somewhat less clear. Our understanding is that Treasury is
concerned about preservation of the corporate tax base: it would be unfair if
U.S.-based multinationals could eliminate or significantly reduce their U.S. tax
burden through the use of CFCs. This analysis presumably requires that a
distinction be drawn between those cases in which it is "fair" to accelerate the
U.S. taxation of foreign affiliates' income, and those in which it is not. There
should be general agreement about two cases in which accelerated U.S. taxation
is appropriate: first, where passive income is shifted into an offshore
incorporated pocketbook, and second, where income is inappropriately shifted
offshore through abusive transfer pricing. The first case is well-addressed by
the extensive subpart F rules concerning foreign personal holding company
("FPHC") income, while the second case is addressed by extensive transfer
pricing and related penalty rules which give the IRS ample authority to curb
transfer pricing abuses. Thus, little needs to be done to advance fairness in
these regards. Conversely, it should generally be agreed that it is not fair to
accelerate U.S. taxation when a foreign subsidiary engages in genuine business
activity in its foreign country. Unless Treasury is considering a radical
redefinition of the scope of U.S. international taxing jurisdiction, the normal
U.S. rules that impose U.S. tax only when income is repatriated should continue
to be viewed as fair. This leaves a relatively narrow band of potential
controversy: whether there are certain types of income that should be taxed
currently even though they are associated with active foreign business
operations. Subpart F currently identifies a number of such categories, and
imposes current tax on them for reasons that are not always clear, but appear to
be generally bound up with the notion of capital export neutrality, as advanced
by Treasury at the time of the 1962 legislation. We have already stated our view
that U.S. international tax policy needs a firmer foundation than the economic
theorizing that underlies CEN, and would only add here that CEN should be of no
relevance to the definition of fairness in international tax policy. Finally, we
conclude by noting that as a practical matter, Treasury concerns for the
preservation of the corporate tax base and distributional equity in the U.S. tax
system should not be exaggerated in the context of the relatively modest reforms
that we advocate. We do not believe that the rationalizations of subpart F and
the foreign tax credit to be proposed will alter historical patterns of offshore
investment and profit repatriation (although they will improve our companies'
ability to compete). Those patterns show that U.S. companies invest and operate
overseas in response to market rather than tax considerations, that offshore
operations do not substitute for investments in U.S. operations, that offshore
investments in fact have a positive impact on U.S. employment, and that a
significant percentage of offshore profits will be repatriated currently
regardless of the applicable tax rules. Accordingly, while the distributional
equity of the U.S. tax system is really not at stake here, the fairness of the
system will be meaningfully improved by rationalizing and modernizing the
taxation of U.S. companies that compete in the global marketplace. Conclusion
The NFTC believes that the tax policy criteria of competitiveness,
administrability, and international conformity all support a significant
modernization of our international tax systemat this time, and that fairness
considerations are at worst a neutral factor. Finally, even if Congress and the
Administration are persuaded to given continued weight to the policy of capital
export neutrality (which we do not believe to be justified), the countervailing
considerations are sufficiently powerful to justify meaningful reform.
Improvement of the U.S. International Tax System Is Necessary 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 Committee, which focuses the spotlight on U.S. international tax
policy, is valuable and should be applauded. The NFTC is concerned that this 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 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 previous
sections of this testimony, make U.S.-based 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"
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.(22) 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. In some cases, U.S. rules by themselves cause double taxation, as for
example, in one of the more significant anomalies, that of the
allocation and apportionment of interest
expense. The current U.S. international tax system contains
many other anomalies that make little sense when considered in the context of
the matters we discuss today. Under present law, the treatment of subpart F
income and the treatment of losses generated by subpart F-type activities are
not symmetrical, creating many "heads-I-win-tails-you-lose" scenarios that are
difficult to justify on a principled basis. Income from subpart F activities is
always recognized currently on the U.S. tax return, but if those activities
should instead generate losses they will generally be given no current U.S. tax
effect. (As a threshold matter, we can't resist noting that this restrictive
treatment of losses realized by CFCs, as compared with the treatment of losses
realized by domestic affiliates, is a distinct departure from CEN principles,
since it creates a genuine tax disincentive to carry out certain activities
abroad. If the activities targeted by subpart F are carried out in a foreign
corporation, subpart F will accelerate any income but defer any losses. If those
activities were instead placed in a U.S. corporation, both income and losses
would be recognized for U.S. tax purposes. Since the likelihood of any given
activity's producing losses rather than income is not generally known at the
outset, the system creates a structural bias in favor of U.S. investment, rather
than anything approaching neutrality. But as we noted elsewhere, U.S. allegiance
to CEN as a tax policy principle has been haphazard at best.) The rules carry
this bias not only in their basic structure, but also in the way they apply to
carryover restrictions, consolidation of affiliate losses, and the offsetting of
losses among subpart F income categories. Similarly, other provisions in the
Code apply in an asymmetrical way. This is true with respect to the rules
relating to overall foreign losses. Other rules determine the composition of
affiliated groups for the filing of consolidated returns and do not allow the
inclusion of foreign corporations, except in very limited circumstances. 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, and as my colleague will discuss in greater
detail, 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. 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."(23) 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.(24) 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
U.S. based companies. 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.(25) These
findings have an ominous quality, given the recent spate of acquisitions of
large U.S.-based companies by their foreign competitors.(26) 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, the NFTC strongly supports the International Tax Simplification
for American Competitiveness Act of 1999, H.R. 2018, recently introduced by Mr.
Houghton, and Mr. Levin, and Mr. Sam Johnson, and joined by four other members:
Mr. Crane, Mr. Herger, Mr. English, and Mr. Matsui. We congratulate them on
their 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. The NFTC is preparing 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. 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. - The U.S. international tax system is much more complex and burdensome
than that of our trading partners. - 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 Committee for beginning the process of reexamining of 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 Committee. 1. The NFTC Foreign
Income Project: International Tax Policy for the 21st Century; Part One: A
Reconsideration of Subpart F (hereinafter referred to as "Part One" or "the
Report"). 2. "Capital export neutrality" is a term used to describe a situation
in which tax considerations will play no part in influencing a decision to
invest in another country. 3. See Michael J. Graetz & Michael O'Hear, The
Original Intent of U.S. International Taxation, 46 Duke L.J. 1021 (1997). 4. Id.
The original system had allowed only a deduction for foreign income taxes. 5.
The foreign income of a foreign corporation is not ordinarily subject to U.S.
taxation, since the United States has neither a residence nor a source basis for
imposing tax. This applies generally to any foreign corporation, whether it is
foreign-owned or U.S.-owned. This means that in the case of a U.S.-controlled
foreign corporation (CFC), U.S. tax is normally imposed only when the CFC's
foreign earnings are repatriated to the U.S. owners, typically in the form of a
dividend. However, subpart F of the Code alters these general rules to
accelerate the imposition of U.S. tax with respect to various categories of
income earned by CFCs. It is common usage in international tax circles to refer
to the normal treatment of CFC income as "deferral" of U.S. tax, and to refer to
the operation of subpart F as "denying the benefit of deferral." However, given
the general jurisdictional principles that underlie the operation of the U.S.
rules, we view that usage as somewhat inaccurate, since it could be read to
imply that U.S. tax "should" have been imposed currently in some normative
sense. Given that the normative rule imposes no U.S. tax on the foreign income
of a foreign person, we believe that subpart F can more accurately be referred
to as "accelerating" a tax that would not be imposed until a later date under
normal rules. 6. See supra note 3. 7. See I.R.C. secc. 552 and 553. 8. Message
of the President's Tax Recommendations, April 20, 1961, reprinted in H.R. Doc.
No. 87-140, at 6 (1961). 9. See H.R. Rep. No. 87-2508, at 2 (1962)(Conference
Report). 10. See Message of the President's Tax Recommendations ( April 20,
1961), reprinted in H.R. Doc. No. 87-140, at 4 (1961). 11. Id., at 6-7. 12.
Staff of the Joint Comm. on Internal Revenue Taxation, 87th Cong., General
Explanation of Comm. Discussion Draft of Revenue Bill of 1961, at 5 (Comm. Print
1961). 13. Id. 14. H.R. Rep. No. 87-1447, at 58 (1962)(Committee on Ways and
Means, Revenue Act of 1962). 15. Transfer pricing was not, of course, the sole
or even the principal rationale for these rules; they were also said to be
justified by "anti-abuse" notions that related to protection of the U.S. tax
base and, in the views of some, capital export neutrality. 16. I.R.C. secc. 482
(last sentence) and 6662(e); Treas. Reg. secc. 1.482-1 through -8 and 1.6662-6.
17. See Stanford G. Ross, Report on the United States Jurisdiction to Tax
Foreign Income, 49b Stud. on Int'l Fiscal L. 184, 212 (1964). 18. Some Treasury
officials have suggested that the loss of U.S. dominance is simply a function of
the rest of the world "catching up" after the devastation of World War II. This
may well be true, but it is also irrelevant: whatever the reasons for the loss
of U.S. dominance, the point is that the competitive landscape is completely
different today, so that it is high time to reconsider the competitive impact of
legislative provisions enacted when the world was a very different place. 19.
Local tax authorities may well scrutinize the amount of outbound deductible
payments under transfer pricing and thin- capitalization principles, but subject
to that discipline there is nothing inherently objectionable about an allocation
of functions and risks among affiliates that gives rise to a deductible payment
in a high-tax jurisdiction. Treasury has not made a case that protection of the
foreign tax base should in any event be a concern of the U.S. tax system. 20.
Congress has previously acknowledged the connection between corporate tax burden
and competitiveness. For example, in connection with the enactment of the dual
consolidated loss rules under Code section 1503(d) as part of the Tax Reform Act
of 1986 (the "'86 Act"), Congress observed that the ability of a foreign
corporation to reduce its worldwide corporate tax burden through the use of a
dual resident company enabled such corporations "to gain an advantage in
competing in the U.S. economy against U.S. corporations." Joint Committee on
Taxation, General Explanation of the Tax Reform Act of 1986 (the "'86 Act
General Explanation"), at 1065. 21. See Part One, Chapter 2. 22. We start from
the fundamental assumption that the United States taxes the income of its
citizens and domestic corporations on a worldwide basis. We do not attempt to
address either the desirability or the implications of the adoption of a
territorial system of taxation, an alternative that could itself be the subject
of substantial analysis and debate. Therefore, for this analysis the question is
stated not as whether but as when should foreign income be taxed. 23. See Marsha
Blumenthal and Joel B. Slemrod, "The Compliance Cost of Taxing Foreign-Source
Income: Its Magnitude, Determinants, and Policy Implications," in National Tax
Policy in an International Economy: Summary of Conference Papers, (International
Tax Policy Forum: Washington, D.C., 1994). 24. Id. 25. OECD, Taxing Profits in a
Global Economy: Domestic and International Issues (1991). 26. See, e.g.,
testimony before the Committee on Finance, U.S. Senate, March 11, 1999.
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