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Document 14 of 15.

MARCH 11, 1999, THURSDAY

SECTION: IN THE NEWS

LENGTH: 10217 words

HEADLINE: PREPARED STATEMENT BY
BOB PERLMAN
VICE PRESIDENT OF TAXES, INTEL CORPORATION
BEFORE THE SENATE FINANCE COMMITTEE
SUBJECT - U.S. INTERNATIONAL TAX REFORM

BODY:

INTRODUCTION AND OVERVIEW
The following introductory comments were generally presented by Bob Perlman, Vice President of Taxes of Intel Corporation, before the Senate Finance Committee on March 11, 1999.
Let me begin by stating that if I had known at Inters founding (over thirty years ago) what I know today about the international tax rules, I would have advised that the parent company be established outside the U.S. This reflects the reality that our Tax Code competitively disadvantages multinationals simply because the parent is a U.S. corporation.
The U.S., economically speaking, is not an 'island'. Certainly, U.S. companies recognized many years ago that business is truly global, and becoming increasingly so. With the capabilities of the Internet, cross-border business decision-making and transactions that formerly took substantial time are now being completed in nanoseconds. Significantly, our government has recognized that tax policy should not impede the growth of this new technology and its ability to increase the productivity of U.S. companies.
Competing in global markets means that the number of competitors broadens, and their costs, including taxes, become highly relevant. U.S. international tax policy which does not acknowledge that this global reality puts a price on the consequences of the actions of U.S. companies creates a competitive disadvantage.
This competitive disadvantage is, tangible, measurable, and is recognized by senior management of U.S. companies and is taken into account in business decisions. Several years ago, Dr. Gordon Moore, one of Intel's founders, noted the irony of one consequence of the so- called "Excess Passive Assets Rule". It motivated U.S. companies to invest in physical assets overseas, despite the rule's avowed purpose of causing the opposite result. Nonetheless, Gordon also appreciated and understood the need for U.S. companies to avail themselves of this course of action to avoid suffering a competitive disadvantage relative to our international competitors. Their home countries had no comparable rule (and they suffered no adverse tax consequences if cash or other passive assets were retained abroad). Wisely, the excess passive assets rule was subsequently repealed.
Competitive disadvantage can occur from procedural as well as substantive governmental action. Frequent changes in the tax code, and the administrativerules to enforce it, create uncertainty which is highly disruptive to sound business planning. An example of this is the recent schizophrenic experience with so-called hybrid entities. The Treasury Department and IRS initially issued regulatory rules which greatly simplified entity classification for tax purposes. Shortly thereafter, they attempted to revoke the regulations. The rationale of the hybrid regulations was to allow certainty, reduce the costs of international business, and reduce compliance burdens as well as potential disputes, including litigation. After Congressional concern was expressed, Treasury withdrew the revocation, but also announced its intention to issue similar regulations in the future. Businesses that had acted upon the hybrid regulations cannot simply undo structuring, and thus, would have suffered adverse U.S. tax consequences.
Another area subject to great uncertainty is the Possessions Tax Credit, which has undergone numerous changes and curtailments throughout its history. Notably, this part of the Tax Code was intended by our government to stimulate U.S. investments in possessions, and yet that result has prompted frequent reconsideration and change.
In contrast to foreign competitors, U.S. companies cannot proceed with sound business planning, without checking numerous non-intuitive, potential tax consequences first. The degree to which our tax code intrudes upon business decision-making is unparalleled in the world. Complex rules relate to numerous foreign tax credit "baskets", extensive expense allocations, and detailed earnings and profits computations. Other countries do not have such complex rules. Simplicity in our Tax Code seems at times the eternal dream. The international tax rules engender much of the Cede's complexity, and policy changes in these rules offer great potential for significant simplification. For example, the anti-deferral rules, under Subpart F, are very complicated - with reform of them based on sound policy, greater simplicity will also be a welcome outcome.
When politics enters the equation, in lieu of policy, perception becomes of paramount importance; good economic policy becomes the victim of terms such as "loophole closers" and "corporate welfare". When unintended or inappropriate results are recognized later, it is very difficult to correct them. A notable example of this occurred with the overlapping rules within the Passive Foreign Investment Company provisions, which duplicated the anti-deferral rules, under Subpart F, already applicable to foreign subsidiaries of U.S. multinationals. Once this over-kill was acknowledged, the fiscal cost to correct the unintended portion of the result exceeded the original revenue estimate of the entire statutory provision by a factor of ten, and the correction was not completed for over ten years.
I said earlier that competitive disadvantages suffered by U.S. companies via our international tax rules are measurable. An example is the contrast between our deferral-based international tax system and those systems that employ tax sparing or are territorial-based. Given the global business reality of needing to securemarket access and service international customers, U.S. multinationals, such as Intel, need to locate production and other facilities in foreign countries. Interestingly, our international competitors line the streets in these same locations.
If an international competitor's home country tax system is based upon territoriality, income generated by the foreign facility is not taxed at all, currently or upon repatriation. Consequently, a U.S. company will have a sixty-five cent residual in the U.S., with which to do research or otherwise invest, while the foreign competitor will have a full dollar in its home country. Tax sparing provisions, found in many tax treaties between developing countries and developed countries, produce similar results.
An area of our international tax rules particularly ripe for reform is Subpart F. These anti-deferral rules have been in place for thirty- seven years and, although subject to periodic changes, the rules have not been purposefully re-examined in light of the global business realities that U.S. multinationals face today. Although certain other countries followed our lead and adopted similar rules, none today are as expansive as ours.
The anti-deferral rules were, in substantial part, intended to be a "back-stop" to U.S. transfer pricing rules, which were yet to be fully developed in 1962. In contrast, today's strict enforcement of transfer pricing rules occurs on a worldwide basis. Accordingly, manufacturing, sales, and services income should not be taxed until remitted. The foreign base company sales income and foreign base company services income provisions should be repealed.

The U.S. tax consequence of an activity should depend upon whether the activity occurred within the U.S. taxing jurisdiction, and not upon whether sales or service activities occurred within the country in which a foreign subsidiary was incorporated. Minimization of foreign taxes through a foreign base sales or services company should not concern the U.S. Many of our foreign competitors' tax jurisdictions do not tax such earnings, and reserve their anti-deferral rules only for passive income. This reduction of foreign taxes through the use of base companies ultimately benefits the U.S. Treasury through reduced foreign tax credits upon ultimate remittance.
Another troubling outcome of the current Subpart F rules occurs when U.S. companies attempt to cope with difficult exchange control and customs issues, frequently in developing countries. These risks of controlled currencies and adverse customs results can be avoided if the U.S. multinational sells into the country through a subsidiary incorporated elsewhere. Unfortunately, doing so runs afoul of the Subpart F anti-deferral regime. For example, for a U.S. company wanting to sell in China, if it located a corporation there it would be exposed to currency controls and customs issues; if, instead, the U.S. company sells into China through a HongKong subsidiary it would avoid the foreign currency and customs exposures. However, by doing so, it would suffer the loss of deferral on the sales income. It is difficult to understand why avoiding adverse business risks of currency controls harsh customs rules and foreign taxation should also cause an adverse U.S. tax impact. This "Hobson's Choice" is not suffered by foreign competitors. Similarly, if faced with a high dividend withholding tax, but no branch profits tax in a foreign country, doing business through a branch of a foreign subsidiary would minimize tax costs. However, Subpart F would apply, even though the withholding tax ultimately would be borne by the U.S. Treasury through increased foreign tax credits.
Also, under Subpart F, certain profits of foreign subsidiaries of U.S. multinationals lose deferral when the profits are "invested" in the U.S. These rules penalize U.S. companies from investing in, among other things, stock of start-up companies unrelated to the investor or its parent company. For example, if the Japanese subsidiary of a U.S. company were to use its profits to invest in an unrelated Internet start-up company in the U.S., there would be a U.S. tax cost suffered if the acquired stock exceeded twenty-five per cent of the Internet company. If a Japanese competitor made a similar investment in the same start-up company, it could do so without triggering Japanese or U.S. tax.
Another indication of Subpart F not keeping pace with the changing international business environment is its restrictive focus on activities occurring within the country of incorporation of a foreign subsidiary (for the activities to retain deferral of U.S. tax on earnings produced.) In 1992, the European Community created a single market -- now fifteen countries. This action enables European business operations to be consolidated, producing reduced operating costs. However, the failure of our Subpart F rules to acknowledge this single market, and treat it as a single country, prevents U.S. companies from availing themselves of similar cost savings to those enjoyed by our European competitors.
Other provisions than the Subpart F anti-deferral rules in our international tax rules should also be examined and reformed. The U.S. system taxes worldwide income of U.S. multinationals on a current or deferred basis, and the foreign tax credit is essential to income earned in foreign jurisdictions not being taxed by the U.S. as we!!. The credit enables such income to be taxed primarily in the jurisdiction in which it is earned. This is a long-standing, fundamental premise of our Tax Code. For alternative minimum tax purposes, however, such double taxation is only relieved to the extent of ninety per cent. This restriction of the foreign tax credit originated more from revenue considerations than policy reasons, and is yet another competitive disadvantage suffered by some U.S. companies competing internationally. This produces a guaranteed 10% current double taxation result.
Another aspect of the foreign tax credit which can increase tax costs for U.S. companies operating globally is the limited nature of the carry-over period forexcess foreign tax credits, compared with periods for other business credits. Unlike such incentive credits, this instead prevents exposure to double taxation; yet, business credits enjoy substantially longer carry-over periods - 21 years versus 7. More akin to the foreign tax credit is the net operating loss provision (since both are based upon fairness) - its carryover period spans 22 years. Recently, proposals have been made to further curtail the foreign tax credit carry-over period - instead, it should be unlimited, at least prospectively.
The comments which follow are more detailed points on some of the issues, discussed above, as well as additional areas in the U.S. international tax rules, which entail competitive disadvantages and which would also benefit from reform.
SUBPART F
OVERVIEW
The Subpart F rules have been the subject of much discussion recently - and with good reason. Originally enacted in 1962, these rules were intended to curb the ability of US companies to unjustifiably allocate income and/or assets to controlled foreign subsidiaries, of U.S. multinationals, in low-tax jurisdictions. Ordinarily, if the income of such subsidiaries was not repatriated to the U.S., a "deferral" of the u.S. tax on that income was achieved. A potential for abuse existed through inappropriate income allocations, and by simply moving passive assets to controlled foreign subsidiaries. Consequently, deferral under Subpart F is denied to certain types of income produced by activities of controlled foreign corporations. In the ensuing thirty- seven years since enactment of the Subpart F rules, however, there have been significant changes to the tax laws in the U.S. and other countries, and significant changes in the U.S. industrial and economic profile. In particular, the enactment and enforcement of the 482 transfer pricing rules has made the Subpart F provisions relating to active income superfluous. At this point it is virtually impossible to simply "allocate" income to another taxing jurisdiction - the transfer pricing rules ensure that functions and income are aligned and determined under an arms-length standard. Even the IRS recognizes that the original policy objectives for Subpart F may no longer be appropriate, and solicited taxpayer feedback in Notice 98-35. Unfortunately, the Notice suggested that nonetheless new policy objectives for Subpart F might include:
1. To prevent undue incentives for U.S. businesses to invest in operations abroad;
2. To prevent U.S. businesses operating internationally from achieving lower rates of taxation than their domestic counterparts; and 3. To deter harmful tax competition between countries.These suggestions signal a clear message that U.S. tax policy makers may not grasp the realities of today's global economics. Nowhere are these realities more sharply illustrated than in the area of high technology. Taking each of the above points in order, the following comments are relevant:
1. The first thing to understand about investing abroad is that not all investments are created equal. Clearly, the act of simply moving cash offshore to avoid the taxation of investment income should be discouraged, and we would not propose a change in this respect. However, investing abroad in business operations (manufacturing, distribution and services) may be essential to the ultimate survival of a business. For example, in the technology sector, rapid software and hardware innovation drive short product lifecycles and our customers must minimize their start-up time and inventory risk. This means that they not only want the latest technology, but they want it exactly when and where they need it, and they want the technical support to get their products to market as quickly as possible: To meet these demands, U.S. businesses must invest in regional distribution and support infrastructures for our offshore customers. If we cannot deliver, our customers will go elsewhere. Unfortunately, the Subpart F provisions make this business necessity more costly for a U.S. multinational than for a foreign-based multinational. 2. This brings us to the apparent Treasury/I.R.S. belief that it is necessary to equalize the tax burden of U.S. multinational and U.S. domestic companies. This rationale only makes sense if you assume that these companies are primary competitors. However, the true competitors to U.S.- based businesses with international operations are not only domestic companies, but also foreign-based businesses. One telling confirmation of this is the loss of the DRAM semiconductor business by U.S. chip companies to foreign competitors a number of years ago. This has been the story time and again for American businesses; in the 60's, eighteen of the twenty largest industrial corporations were U.S.-based, but by the 90's this number had fallen to eight.

American industry has had to make the tough, but necessary, decisions to reclaim its global economic position by increasing productivity, quality and service, while also decreasing costs. The Subpart F provisions are one more economic hurdle for American industry that our foreign-based competitors simply do not face. It is time for U.S. tax policy to be part of the solution rather than part of the problem.
3. The IRS perception that the Subpart F provisions can prevent harmful tax competition between countries is problematic and unrealistic. The first problem with this concept is the assumption that tax competition is, de facto, harmful. The reality is that foreign countries, particularlydeveloping countries, view the ability to provide tax incentives for investment as critical to their national economic futures. For U.S. tax policy to attempt to control or undermine these sovereign decisions is futile at best, and arrogant at worst. The reality is that the Subpart F provisions can only attempt to curb tax competition with respect to U.S. multinationals. Foreign- based multinationals will continue to seek - and obtain - the most favorable tax treatment possible. Ignoring this, U.S. tax policy places U.S. multinationals at an economic disadvantage in the global economy.
The following sections provide brief explanations of the operation of the Subpart F provisions in specific situations, and illustrate the disadvantages produced in the global context.
FOREIGN BASE COMPANY SALES INCOME
Foreign Base Company Sales Income (FBCSI) is subject to current U.S. taxation under the Subpart F rules - even though there is no repatriation of income to the U.S. FBCSI is income earned by a controlled foreign corporation (CFC) from the purchase and sale of personal property, if the property was either purchased from a related person or sold to a related person, and if the property was manufactured outside and sold for use outside the CFC's country of incorporation. The original intent of this provision was to prevent a CFC of a U.S. company from earning income in a low-tax rate jurisdiction without having added any appreciable value to the product. As mentioned previously, transfer pricing rules now essentially no longer permit the allocation of income without verifiable corresponding value being added, so this provision, as a tax policy, is no longer relevant. This provision can render active foreign business income subject to current U.S. income tax. For example, the sales and distribution logistics of U.S. companies in Asia make it most efficient to channel sales through a single CFC that handles all regional order management, freight scheduling, VAT reporting, customs clearance, and inventory management. This CFC definitely adds value to the product by ensuring maximum efficiency in getting it to Asian customers. Nevertheless, because this CFC is purchasing from a related party, and selling to customers throughout Asia (not just within its country of incorporation), virtually all of its income will be considered FBCSI subject to current U.S. taxation. If the CFC's tax burden were only, say 17%, the overall tax cost would still be the U.S. effective rate - 35%. Compare this result with that of a German parent company with the same sales and distribution model in Asia: German tax law would not subject the income to current taxation, so their tax cost is truly only 17%. This clearly gives the German company a competitive cost advantage in doing business in Asia Eliminating this portion of the Subpart F provisions will "level the playing field" for U.S. multinationals. At the same time, eliminating this provision should result in no particular advantage for U.S. multinationals over U.S. domestic corporations, as both companies will continue to bear a comparable tax burden on income earned in the U.S.
FOREIGN BASE COMPANY SERVICES INCOME
Like FBCSI, Foreign Base Company Services Income is also subject to current U.S. taxation under the Subpart F rules - even if there is no repatriation of the income to the U.S. Such income is derived from the performance of technical, managerial, engineering, architectural, scientific, skilled industrial and commercial services which are performed for any related party, outside of a CFC's country of incorporation. This makes little sense in today's world. The original tax objective in 1962 was to discourage U.S.- based companies from separating services from manufacturing activities, and organizing the service activities in a low-tax country. Once again, the transfer pricing rules have essentially neutralized the potential for abuse in this area. Furthermore, the provision can result in the current taxation of active business service income simply by virtue of the place of incorporation - even if it is the optimal structure from a business, administrative, and tax perspective.
For example, optimal parent-branch structuring permits a taxpayer to segregate active and passive income taxation. Some countries permit a business to operate through a foreign parent - local branch structure, and do not tax the earnings of the non-resident foreign parent. Furthermore, the country may also permit the free remittance of cash from the operating branch to the foreign parent. In this scenario, the branch can remit all excess capital to the foreign parent, which it would then invest, creating foreign base personal holding company income - subject to U.S. taxation. To illustrate how this provision can cost U.S. tax dollars, assume a service business in country (A) that taxes both active business income and investment income at a 25% tax rate - but also permits the foreign parent-operating branch structure. Further, assume that the foreign parent is in country (B) and the tax rate is zero. The tax consequences under current law would be:
- Subsidiary Incorporated in Country A - All income would be subject to the local 25% income tax. The active business income would not be subject to current U.S. tax under Subpart F, however, any interest on excess funds would fall under the Subpart F FPHCI rules. The Subpart F inclusion would carry a 25% foreign tax credit as well, so the net U.S. tax dollars amount to only the 10% tax rate difference between the U.S. tax rate and the local tax rate levied specifically on interest income.
- Foreign Parent/Local Branch Structure - Active business income of the branch will be taxed locally at 25%, however, the interest income will not be taxed at either the branch or parent company level. Because services are now being provided outside the country of incorporation, the entire parent/branch income would be subject to current U.S. tax of 35%. Under this structure, the service operation would have a higher tax cost overall, and would be at a significant economic disadvantage relative to companies domestic to country (A) and most other non-U.S, multinational companies.If the Subpart F provisions were amended to eliminate the same-country incorporation requirement, the branch would retain an effective tax rate of 25%, and only the parent's interest income would be taxed currently in the U.S. at the 35% rate. Further, the interest income would carry no offsetting credits, and as such, would fully produce tax revenues for the U.S. Overall, this would yield a more competitive profile, while ensuring that tax dollars on passive income are accrued solely to the U.S.
FOREIGN PERSONAL HOLDING COMPANY INCOME
The U.S. normally imposes tax based on either (a) the residence of the taxpayer, or (b) the source of the income. The worldwide income earned directly by U.S. resident companies and certain U.S. source income of non-resident companies is taxed in the U.S. on a current basis. The foreign-source income of foreign corporations, on the other hand, is not ordinarily subject to tax in the U.S., because the U.S. has neither a residence basis nor a source basis for imposing tax. In the case of foreign corporations controlled by U.S.based companies, U.S. tax is normally not imposed until the foreign earnings are repatriated to the U.S.-based companies.
Foreign Personal Holding Company Income (FPHCI) generally consists of dividends, interest, rents, royalties, and other ostensibly "passive" income earned by foreign corporations that are controlled by U.S.- based companies. The U.S. generally accelerates the taxation of U.S.- based companies on such foreign affiliate income by deeming such income to be a "dividend" when earned.
The U.S. imposes tax on the FPHCI of foreign affiliates controlled by U.S.-based companies, even though (a) the income is from foreign sources, (b) the income is earned by foreign taxpayers, and (c) the income remains offshore. The basis for the U.S. imposing such tax on FPHCI (and other Subpart F income) appears to be founded on the principle of "capital export neutrality". Capital export neutrality means that income from capital is taxed in the same manner whether the capital is deployed in the jurisdiction of the investor or in a foreign jurisdiction.
In Notice 98-11, the U.S. Treasury Department summarized the purposes of Subpart F as follows:
U.S. international tax policy seeks to balance the objective of neutrality of taxation as between domestic and foreign business enterprises (seeking to neither encourage nor to discourage one over the other), with the need to keep U.S. business competitive. Subpart F strongly reflects and enforces that balance.

Thus, with a view to creating a "level playing field", the U.S. generally taxes FPHCI (and the U.S.-based company is eligible for a limited foreign tax credit for the taxes paid by the affiliate on such income in the foreign jurisdiction).The reality is that a "balance" between maintaining U.S. business competitiveness abroad and capital export neutrality does not exist. U.S.-based companies are placed at a distinct disadvantage when competing with foreign-based companies for offshore business. In its efforts to foster capital export neutrality, the U.S. has lost sight of the importance of permitting U.S. companies to engage in business abroad on an equal footing with foreign competitors.
Capital export neutrality, while an admirable goal, only works if other jurisdictions share the same goal and make cross-border investments subject to similar rules. Capital export neutrality cannot be achieved unilaterally. For example, assume X and Y are controlled foreign corporations owned by P, a U.S.-based company, and that X and Y are incorporated in different foreign jurisdictions. X is engaged in an active business with primarily unrelated parties and develops intellectual property. Y is also engaged in an active business and pays X royalties for the use of the intellectual property.
In the U.S., the royalty income earned by X would be FPHCI and would be attributed to P. As a result, U.S. tax would be accelerated on the royalty income, notwithstanding the fact that the income is from foreign sources, earned by a foreign corporation, kept offshore, and is traceable to an active foreign business.
If P were instead a German, Canadian, U.K., French or Japanese company, the royalty income would not be taxable to P. Unless other taxing jurisdictions adopt tax systems consistent with the capital export neutrality principle, and the notion that profit-seeking companies should make cross-border investments as if in a world without taxes, the application of the capital export neutrality principle by the U.S. is not viable. With it, U.S.-based companies are placed at a competitive disadvantage.
To combat this competitive disadvantage, undistributed FPHCI that remains offshore should not be taxed in the U.S., provided the FPHCI is traceable to active income earned by the foreign affiliate or is active foreign income itself. The FPHCI characterized as active foreign income or attributable to active foreign income would become taxable, but only upon repatriation to the U.S. In effect, a "look- through" role for FPHCI should be enacted. The FPHCI should be looked through to the ultimate source of the income, and if that income is active and foreign-source, then the FPHCI should be characterized as such, and hence be non-taxable until repatriated to the U.S.Interest and Other Investment Income
If a U.S. company sets up a Cayman Islands corporation for the purpose of investing some of its U.S. passive assets, then clearly any FPHCI earned by the Cayman company should be taxed in the U.S., whether or not the investment income is repatriated to the U.S. While the investment income may be traceable to active income, the active income would be U.S.-source. Taxing the FPHCI in this case is the right result, because there are no competitive disadvantage implications and, more importantly, taxpayers would otherwise be free to shift their U.S. capital to low-tax jurisdictions for the purpose of avoiding U.S. tax (i.e., an "incorporated offshore pocket-book").
On the other hand, for example, if an Israeli subsidiary with active income from its microprocessor factory invests some of the Israeli profits either directly within Israel or through a Cayman Islands subsidiary, then the FPHCI earned by the Israeli company or the Cayman subsidiary should not be taxed in the U.S., unless and until the investment income is repatriated to the U.S. The investment income is traceable to the active foreign income of the Israeli subsidiary. The Israeli company should be free to invest its profits to grow capital for a new factory if it so chooses without effectively having its capital base undercut, by its U.S. parent having to pay U.S. tax on the investment income.
Similarly, if the Israeli company lends some of its profits to another foreign affiliate, then the interest income earned that is traceable to active foreign income should not be subject to U.S. tax, until the income is repatriated to the U.S. Redeployment of active foreign earnings among foreign affiliates should be a natural by-product of conducting business on a globally-competitive basis. Under the current Subpart F regime, the interest income would be FPHCI taxed in the U.S., unless the borrower were an Israeli affiliate. The situs of incorporation of the borrower should not be relevant for purposes of determining whether the income is taxable in the U.S.
Dividends
In the context of foreign dividends, if a Dutch distribution company pays dividends to its Cayman Islands parent holding company, the dividends that are traceable to active foreign income (both FBCSI and income from sales within Holland should be active foreign income) should not be subject to U.S. tax, until the income is repatriated to the U.S. The same competitiveness concerns as above apply in connection with the redeployment of active foreign earnings. The Cayman company should be free to use the dividends to fund the operations of other foreign subsidiaries without U.S. tax first being imposed on such dividends. In addition, it is worth noting that dividends paid by active foreign companies to holding companies in different foreign jurisdictions are tax-deferred or exempt to the ultimate parent in many countries, including the U.K., Canada, France, and the Netherlands.Under the current Subpart F regime, the dividend income, as FPHCI, would be taxed in the U.S., unless the holding company were incorporated in Holland. Again, the situs of incorporation of the holding company should not be relevant for purposes of determining whether the income is taxable in the U.S.
Rents and Royalties
The rental and royalty income of foreign affiliates controlled by U.S.-based parent companies is considered FPHCI and is, thus, taxed currently in the U.S. There is a "same country" exception that applies if the underlying property is used within the country where the lessor or licensor is incorporated, and also an exception for rental and royalty income derived in an active business if the income is received from unrelated parties.
Whether the foreign rental or royalty income is taxable currently in the U.S. should hinge on whether the lessor or licensor is engaged in an active business. If the lessor or licensor is engaged in an active business, then such rental and royalty income should be characterized as active foreign income, and hence not be taxable in the U.S., until the income is repatriated to the U.S. This should be the case whether or not the underlying property is used within the country of the lessor or licensor, and also whether or not the property is licensed or leased to an unrelated or related party.
If an Israeli manufacturing subsidiary leases manufacturing equipment to another manufacturing affiliate, the rental income received by the Israeli subsidiary should be characterized as active foreign income, because the subsidiary is engaged in an active business. The same analysis should apply in the context of royalty income. Otherwise, competitors with foreign-based parent companies enjoy a competitive advantage, because rents and royalties earned in active businesses are not taxed to the parent companies in most foreign jurisdictions until repatriation occurs.
With a view to achieving tax parity with foreign competitors, U.S.- based companies should not be currently taxed on the FPHCI of its controlled affiliates where the income is either (a) traceable to active foreign income, or (b) royalty or rental income earned in an active business. Such income should not be taxable in the U.S., until such income is repatriated. However, investment income earned by controlled foreign affiliates on capital that originated from the U.S. should continue to be taxed by the U.S. on a current basis, and rents and royalties of controlled foreign affiliates where no active business exists should also be taxed by the U.S. on a current basis.
FOREIGN SUBSIDIARY INVESTMENTS IN U.S. PROPERTY The U.S. generally taxes the profits of foreign affiliates controlled by U.S.-based companies where the profits are (a) loaned to the U.S.- based company, or (b) used to purchase at least a 25% interest in an unrelated U.S. company. The profits of the foreign affiliate are treated as deemed dividend distributions to its U.S.-based parent company.The legislative intent behind this rule was essentially to restrict U.S.-based companies from doing an "end run" around the taxable dividend rules by effecting foreign subsidiary repatriations to the U.S. in a form other than as a dividend.

This is a valid concern where the profits of the foreign subsidiary actually end in the hands of the U.S.-based company or one of its U.S. affiliates. The rule, however, does not make sense where the foreign subsidiary profits are invested in, or are used to purchase, U.S. property wholly disconnected from the U.S.-based parent company.
A foreign affiliate controlled by a U.S.-based company should be free to invest its profits in U.S. property without triggering U.S. tax, so long as such profits are not disguised dividends that are destined for the U.S.-based company or one of its affiliates. In the case where the foreign subsidiary profits are used to purchase stock in an unrelated U.S. company, however large the ownership interest, no U.S. tax should apply.
If a multinational's Japanese subsidiary uses its available profits to invest in an unrelated start-up company in the U.S., and the subsidiary's profits have not yet been taxed in the U.S., the profits of the Japanese subsidiary should not be taxable in the U.S. until the profits are repatriated to the U.S. If a Japanese competitor wanted to make a similar investment in the start-up company, it could do so without triggering Japanese or U.S. tax.
There is no reason why the U.S. parent company should be penalized, nor is there any reason why the start-up company should be penalized, as a result of there not being competition on an equal basis between the U.S. parent company and its Japanese competitor. Under current law, the U.S. multinational would be penalized because there would be a tax cost to having its Japanese subsidiary acquire 25% or more of the stock of the company. The company could be penalized, because it may not get the highest price for the sale of its stock, given that there is not free and open competition (the U.S. multinational has to take into the extra tax cost into account in making its bid).
EARNINGS AND PROFITS OF CONTROLLED FOREIGN CORPORATIONS
The "earnings and profits" ("E&P") of foreign affiliates of U.S.-based companies must be tracked by such U.S. companies for a variety of reasons. In the international tax area, E&P is used to determine the amount of Subpart F income that will be taxable in the U.S. on a current basis, the amount of a foreign affiliate distribution that will be taxable as a dividend, the amount of foreign taxes that are deemed paid by the U.S.-based company for foreign tax credit purposes, and the amount of gain taxable as a dividend upon the sale by the U.S.-based company of a foreign affiliate's stock.
The Internal Revenue Code essentially requires that the E&P of a foreign corporation be computed substantially in accordance with the accounting rules that apply for domesticcorporations. The E&P for a domestic corporation is generally calculated by making adjustments to U.S. taxable income.
The inherent problem is that the E&P of foreign corporations must necessarily start with foreign book income. As a result, the adjustments that must be made to convert (a) from foreign book income to U.S. taxable income, and (b) from U.S. taxable income to E&P are an administrative nightmare. The adjustments are particularly difficult in the case of minority-owned foreign corporation, since the U.S.- based company may be unable to obtain all the information that is necessary to compute E&P.
Although foreign corporations owned by U.S.-based companies do not adjust foreign book income to conform to U.S. taxable income, they do often adjust foreign book income to conform to U.S. generally accepted accounting principles ("GAAP") for financial reporting purposes. There are many differences between GAAP and E&P, but most are short-term timing differences. The differences as a result have a small and transitory impact on the determination of U.S. tax liability.
Corporate taxpayers should be allowed to use the earnings of foreign affiliates adjusted to conform to U.S. GAAP as E&P for their respective foreign affiliates. This approach is necessary to ease the substantial administrative burden currently borne by corporate taxpayers in calculating the E&P of foreign affiliates.
UNIFORM CAPITALIZATION RULES
Adoption of a GAAP E&P role, as suggested above, would have an added benefit of confining the application of the uniform capitalization rules to domestic companies. Under Section 263A, manufacturers and certain retailers and wholesalers must uniformly capitalize direct and certain indirect costs, including interest, incurred with respect to property produced or acquired for resale. The capitalized costs become part of the tax basis of the property.
When the property is sold or otherwise disposed of, the capitalized costs reduce the taxable profit or increase the taxable loss. In effect, the uniform capitalization rules postpone the ability to take the tax benefits associated with the incurred costs.
The Treasury Department and the I.R.S. currently take the position that the uniform capitalization rules apply to foreign affiliates of U.S.-based companies. The revenue raised through the application of the uniform capitalization rules to foreign companies is relatively small, particularly when balanced against the sizable administrative burden imposed on U.S.-based taxpayers. The uniform capitalization rules should not be applied at the foreign level.
EXPENSE ALLOCATION AND APPORTIONMENT RULES
OVERVIEW
While the Subpart F rules on anti-deferral rules originated in 1962, the rules for allocating and apportioning deductions to worldwide income, prescribed under 861 of the Code, has its roots dating back to 1918 (Revenue Act of 1918, sections 214(b) and 234(b)). Initially, the goal was to properly apportion and allocate deductions to the net income of "in-bound" taxpayers (i.e., non-resident aliens and foreign corporations). The shift of focus from primarily an in-bound concern to an out-bound - U.S. multinational view occurred as post-war U.S. multinational corporations expanded overseas and the Code was used to reduce the availability of foreign tax credits to offset U.S. tax.
The expense allocation and apportionment rules impact the foreign tax credit (FTC), because the FTC limitation is calculated based on a formula, the numerator of which is foreign source taxable income (after deductions); consequently, as foreign source income is reduced, so too are foreign tax credits that can be claimed to offset U.S. tax liability. The unfairness in this calculation occurs when a foreign taxing authority doesn't permit the same deductions. As a result, the income is exposed to international double taxation.
The calculation, in its purest theoretical state, is not offensive to sound tax policy. However, practically speaking, the calculation is very burdensome. As described above, the taxpayer must first calculate its various foreign income sources by category. Once the foreign source income is calculated, the regulations provide extensive and detailed rules relating to the following types of expenses:
1. Interest expense 2. Research and Experimental expense 3. Stewardship expense 4. Professional Fees expense 5. Income Tax expense 6. Losses
(It should be noted that before allocation and apportionment rules are applied, the taxpayer must already have made all necessary 482 adjustments.
The administrative burden to analyze, and gather information, and calculate the allocated and apportioned deduction is enormous. To make a reasonable allocation and apportionment, the taxpayer must create information-gathering systems not otherwise required by their financial books and records. Much of the data, both financial and operational, are not found in accounting books and records or even on tax returns. The regulations and rules envision documentation that includes personnel interviews, time reports, work assignments, comparison of sales, cost of sales, profits, assets, andvaluation records. The degree to which such precise record-keeping will be required can only actually be known during audit.
For Intel, it takes over two weeks to calculate the interest expense allocation. The principal time commitment is in the development of a tax basis balance sheet. All of this time and effort reduces our active foreign source gross income by only 00.33%.

The allocation of state income taxes involves similar time commitments and the benefit to the Treasury is only a 00.73% allocation to foreign source gross income. In the first year after the final state income tax regulations were issued, the time spent analyzing the regulations, working with outside consultant experts, and developing a methodology to implement them involved over four weeks (and produced 145 pages of work-papers). Even IRS auditors are dumbfounded when it comes to the execution of these regulations. Aside from the complexity and administrative burden that is placed on taxpayers, the allocation and apportionment rules place U.S. taxpayers in a non-competitive position in comparison to foreign owned corporations, because their home jurisdictions do not impose similar rules and compliance burdens.
INTEREST EXPENSE
The theory underlying the allocation and apportionment of interest expense is based upon the premise that money is fungible. In determining the allocation and apportionment, affiliated groups are treated as one taxpayer. This approach considers that, in the use of funds, and those corporate activities that acquire funds, corporate management has flexibility as to where those funds will be employed. As an example, if management decides to borrow funds for Project A, it frees-up other corporate funds for Project B. This approach differs from most of the allocation rules, under 861, that require a factual relationship exist between the items of expense and income for the expense to be allocated and apportioned to such income. Instead, the rules deem interest expense attributable to all income-producing activities and assets of the taxpayer. In order to accomplish this objective, the rules require the use of an asset-based apportionment formula. The use of an asset based formula causes great complexity, administrative burden, and time commitment to achieve the required allocation and apportionment.
The rules do not allow netting of interest expense to interest income. Thus, a U.S. multinational corporation that has interest income in excess of interest expense will nonetheless required to apply the rules to interest expense. In the case of Intel, with a balance sheet reflecting over $12 billion of cash and $700 million of interest and other investment income, the rules still have to be applied to less than $50 million of interest expense. It is questionable how this reconciles with the fungibility theory. Without a netting of such income and expense, the application if these rules results in an unbalanced allocation of expenses.With the current state of the global economy, why should the worldwide capital structure of a U.S. multinational corporation be impacted by the application of these rules, and the result in double taxation. For example:
Assume two similarly-sized multinational corporations, one in the U.S. and the other in a foreign country. Each corporation has similar home country internal expense. Both have similarly-sized subsidiaries in the same third foreign country. These subsidiaries are highly leveraged, with local debt (in a high tax jurisdiction, this would be considered good local tax planning). In applying the U.S. rules, the assets of the U.S. parent's foreign subsidiary would be included in the interest expense allocation and apportionment formula, which would attract U.S. sourced interest expense, thereby reducing foreign source income, and a resulting reduction in foreign tax credits. The foreign corporation would not be generally confronted with such rules, and its cost of business would be less. The U.S. corporation is placed at a competitive disadvantage.
The current structure of the interest expense rules have exceeded the goal of reining in perceived tax abuses and instead, impose a competitive disadvantage on U.S. multinational corporations.
RESEARCH EXPENSES
The underlying rationale, for the allocation and apportionment of research and experimental (R&E) expense conflicts with the national economic need to creme and retain research in the U.S. Congress and Treasury is concerned that U.S.-created R&E would, without allocation and apportionment, result in foreign source income disproportionately large compared to U.S. source income. Through the allocation and apportionment of R&E expenses, foreign source income and associated foreign tax credits are reduced. In this manner, it is argued that the R&E expenses are assigned to the foreign source income they, in part, produce.
Contrary to the goal of encouraging U.S. research (as seen through the R & E Credit), the allocation and apportionment of such expenses results in an increased cost of undertaking U.S. research activities. This can be shown in the following example:
If a U.S. multinational corporation performs significant domestic R&D activity, its R&E costs must be allocated and apportioned to foreign source income. If the foreign jurisdiction doesn't recognize such U.S. domestic R&E expenses as allowable expenses in computing taxable income, the corporation will pay foreign income tax on foreign income without the benefit of the deductions. Particularly in high-tax foreign countries, this results in a portion of the corporation's worldwide income being subject to double taxation.A corporation with continuing excess foreign credits would be adversely impacted by the R&E allocation and apportionment rules. Such companies would be put in a competitive disadvantage relative to their foreign competition which would enjoy a lower cost for their research activities. Obviously, the U.S. corporation could avoid this extra cost and exposure to double taxation by simply moving their R&D activities offshore (equally obviously, this would be counter to the national goal of keeping research in the U.S.).
The inherent conflict between the pure tax policy of the allocation and apportionment rules versus the retention of research in the U.S. has, since 1977, produced a myriad of rules and confusion for taxpayers and the government alike. There have been at least eight major statutory or regulatory events. These have included an outright moratorium on the application of the regulations. At other times, mandated allocations of varied percentages of U.S. research to U.S. source income have been in effect (the most recent rule includes a 50% mandated allocation). If a U.S. corporation tried to look for jurisdictional stability in the treatment of R&E expenses, the U.S. would not be a country that would come to mind. Coupled with limited extensions of the research tax credit, our national research policy is left wanting. In the interest of assuring that research remains in the U.S., as well as to stay competitive with foreign multinationals, the rule should be that U.S. research is allocated solely to U.S. source income.
HYBRID ENTITY REGULATIONS
The Treasury Department and IRS, in issuing the so-called hybrid regulations (sections 301.7701-1 through 301.7701-3) greatly simplified entity classification for tax purposes. Prior to the issuance of these regulations, U.S. multinational corporations could generally achieve the same entity classification results, but through far more complicated mechanisms. These regulations reduce the costs of tax planning and compliance, as well as significantly reduce, if not eliminate, disputes, including litigation, in this area.
Subsequently, Treasury attempted a partial "take back" of the favorable hybrid rules, under Notice 98-11 and proposed regulations. This was unfortunate, and is counterproductive to U.S. interests in the global arena. Although Notice 98-11 and the related proposed and temporary regulations were ultimately withdrawn, after Congressional concern and interest was expressed, it is still Treasury's intention (as announced in Notice 98-35) to issue similar regulations in the future.
If the Treasury Department does issue such regulations, it will penalize U.S. multinational corporations by requiring recognition of Subpart F income where, among other things, foreign taxes are reduced. This not only places U.S. multinationals at a competitive disadvantage, but is also counter to the fiscal interests of the U.S., since the additional foreign taxes that the Treasury policy will cause to be paid will come out of the Treasury in the form of additional foreign tax credits.The perversity of this policy, coupled with making the United States the tax "policeman" for other countries, has motivated some members of the House and Senate to introduce legislation to prevent the I.R.S. and the Treasury Department from issuing future regulations dealing with foreign hybrid transactions and Subpart F. We applaud these legislative efforts, and encourage their continuation.
OVERALL "DOMESTIC" LOSSES
The U.S. taxes worldwide income of U.S. corporations. Dividends received from foreign subsidiaries and Subpart F income deemed received from foreign subsidiaries are included in worldwide income.

In order to prevent double taxation of a U.S. corporation's foreign earnings (dividends and "deemed" dividends from foreign subsidiaries plus any foreign branch and partnership income), the U.S. corporation is entitled to a foreign tax credit for foreign income taxes paid or deemed paid on the foreign earnings.
The ability to actually take the foreign tax credit is generally limited to the amount of U.S. tax that would otherwise be imposed on the taxpayer's taxable foreign source income that year. Stated in terms of a fraction, the foreign tax credit is limited to foreign source taxable income over worldwide taxable income multiplied by the pre-credit U.S. tax on the U.S. corporation's worldwide income.
Thus, if a taxpayer has foreign source income of $500, worldwide income of $1000, a pre-credit U.S. tax liability of $350, and foreign taxes paid of $250, the foreign tax credit limitation is $175 ((500/1000)'350). Thus, although foreign taxes of $250 have been paid, only $175 may be credited in that year.
Section 904(f) provides that a taxpayer who has sustained an "overall foreign loss" (OFL) in a prior year and that has foreign source taxable income in the current year must "recapture" the OFL by re- characterizing foreign source taxable income as U.S. source taxable income to the extent of the OFL.
Consequently, in the above example, if the taxpayer had a prior year OFL of $100, then its foreign source income would be reduced from $500 to $400. The ultimate impact of the OFL is that the ability to take a foreign tax credit would be further limited, and the foreign tax credit limitation would decrease from $175 to $140.
The Tax Code contains no corollary provision for overall "domestic" losses. If a taxpayer sustains an overall domestic loss in a prior year and has foreign and domestic source income in the current year, then the overall domestic loss should be applied to recharacterize domestic source income as foreign source.
The net effect of being able to use the overall domestic loss is that the ability to take a foreign tax credit is increased. Symmetrical treatment for foreign and domestic losses is amore equitable approach, and through the enhanced ability to claim foreign tax credits it would foster U.S. competitiveness. TRANSFER PRICING / ADVANCED PRICING AGEEMENTS / COST-PLUS RULINGS
As previously mentioned, the transfer pricing rules of 482 are the cornerstone to ensuring that CFC profits are determined in an arms- length manner. However, the globalization of these rules present new challenges to taxpayers, as well as the competent authority mechanism. As other countries have enacted transfer pricing laws and enforcement practices, it has become apparent that there are inconsistencies that will give rise to instances of double taxation. This will, in turn, burden the competent authority system.
As other countries issue their transfer pricing rules, the common stated objective of these rules is to derive an arms-length determination of profit. However, some countries may sanction audit practices that leave the taxpayer in an indefensible position, and result in the wrong profitability conclusion. Specifically, the practice of utilizing "secret" cornparables as well as "cherry- picking": comparables in audit situations are simply untenable for the taxpayer. This leads to situations where the taxpayer literally cannot see the documentation on which the assessment is based, and there is simply no way to evaluate appropriateness or applicability. It is also frustrating when tax authorities attempt to set a business profit level on the basis of an extremely small population of transactions, while ignoring the preponderance of industry and transactional evidence. U.S. tax policy must not only make clear that such practices are unacceptable, but also that competent authority will aggressively challenge inappropriate assessments based on these practices. To safeguard their foreign tax credit, it would seem that taxpayers would need to seek competent authority on any incremental transfer price assessment. This could, indeed, create an enormous logjam in the competent authority mechanism.
Following the 1986 Tax Act, the U.S. risked veering from the ann- length standard for transfer pricing as the rest of the world knew it and producing international double taxation that would result for U.S. multinationals. Fortunately, through administrative interpretation, this was largely avoided. In positive contrast, the U.S. has implemented another program which many other countries have acknowledged and accepted as offering a way to avoid transfer pricing disputes, and international double taxation, through advance clearance of transfer pricing methodology by the I.R.S. (in some instances, bilaterally by the U.S. and other jurisdictions). This program, the Advanced Pricing Agreement (APA) program, has proven useful to many U.S. multinationals, and has likely avoided many disputes and the potential for litigation. The program, however, could be made better by extending the period of time for which agreements can be obtained, and by reducing the annual reporting required to be filed to maintain the agreements. Recently, the IRS agreed to the disclosure of APAs, following court action to mandate such disclosure. This could have a chilling effect on taxpayers who would otherwise have sought such agreements, but are now fearful that disclosure could makepublic their proprietary information. It also may dissuade other countries from entering bilateral APAs, since their involvement would also be disclosed.
Another transfer pricing area of contrast between foreign jurisdictions and the U.S. relates to the availability of, and certainty produced by, so-called cost-plus rulings. Such rulings are typically applicable to the rendering of service, and are readily available to assure that the tax consequences and the amount of income from such services can be known in advance. Such rulings are routine in many foreign countries, but not in the U.S.
TRANSACTION APPROVAL AUTHORITY
On occasion, complex U.S. tax rules, completely unrelated to the substance of a transaction, can lead to a surprising and unfortunate outcome for U.S. tax revenue collection. Consideration should be given to establishing a mechanism to cut through the maze of the law and regulations, which strangle the ability to get to the right answer. An example follows where the U.S. lost tax revenues due to the inability to execute a simple reorganization:
In 1994, Japan implemented a tax incentive designed to reduce the Japanese income tax paid by high technology companies that increased qualified imports into Japan. This program was designed to help reduce the Japanese trade surplus with the United States and was, therefore, very much in line with U.S. trade policy. The incentive could be taken in one of two ways: 1) as a permanent credit reduction in Japanese income tax or 2) as a temporary reduction tO taxable income in Japan through a current deduction that would be reversed over the subsequent five years. Either method would be a "tax neutral" decision for Intel, since we consistently dividend all income from our Japanese distribution subsidiary and would be subject to full taxation either way. However, method 1 clearly would shift permanent tax dollars from Japan to the U.S. Unfortunately, one clear requirement to qualify for the permanent credit was that our Japanese sales company needed to be directly owned by the manufacturer of the product - in this case, the U.S. company. Unfortunately, although this is a 100% owned and controlled subsidiary, it was a second-tier subsidiary. What we needed to do was a simple change of shareholder. However, executing this is no simple matter under U.S. tax law. To effect a reorganization free of any other tax consequences, we would have needed to establish the fair market value for some twenty brothersister subsidiaries and also implement a complex compliance system to track resulting deferred inter-company profits for the indefinite future. The overall time and cost to execute were simply prohibitive.
Even more frustrating, the IRS had no authority to waive the complex reorganization requirements to facilitate this transaction, the sole purpose of which was to legitimately reduce Japanese income tax and, therefore, the foreign tax credits the U.S. would allow. Intel should have been the "poster-child" for theJapanese import tax incentive, and the U.S. government should have been the beneficiary. The incentive was in effect only through 1997, so the opportunity has been lost. For the future, however, it is strongly urged that there be a foram to which a taxpayer can go for approval to "fast track" such transaction and shed unnecessary compliance requirements where U.S. tax avoidance is not a motive of the transaction.
END

LOAD-DATE: March 13, 1999

Document 14 of 15.


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