**[CRITIQUE OF THE JOINT TAX COMMITTEE PROPOSAL]{.underline}**

**[TO MOVE TOWARD A TERRITORIAL TAX SYSTEM]{.underline}**

*[Introduction]{.underline}*

On January 27, in JCS-02-05, the Staff of the Joint Committee on
Taxation (\"JCT\") issued their *\"Options to Improve Tax Compliance and
Reform Tax Expenditures*.*\"* One of the Staff\'s proposals was to
\"Adopt a Dividend Exemption System for Foreign Business Income,\" which
was characterized as moving from a \"worldwide\" system of taxing
international business income to a \"territorial\" system of taxing
multinationals. The JCT explained that under a pure worldwide tax
system, resident corporations are taxed on their worldwide income,
regardless of source. Potential double taxation is alleviated by
utilizing a liberal foreign tax credit mechanism. In contrast, under a
pure territorial system, countries tax only income derived within their
borders, irrespective of the taxpayer\'s country of residence. Thus,
foreign-source income earned by resident companies is exempt from home
country taxation.

The JCT went on to explain that no large, industrialized country employs
a pure worldwide or pure territorial system, and that all systems share
at least some features of both approaches. For example, worldwide
systems often include territorial-type aspects such as the indefinite
deferral of tax on foreign business income earned through foreign
subsidiaries, while countries with territorial systems often still tax
passive income earned through foreign subs. Moreover, many countries
with territorial-type systems will exempt dividends received from
foreign subsidiaries only if the parent company\'s ownership exceeds a
certain threshold, or the exemption may be partial as a proxy for
disallowing expenses allocable to exempt income.

The United States employs a worldwide tax system under which domestic
corporations are taxed on all income, whether derived in the U.S. or
abroad. However, the U.S. parent generally is not taxed on income earned
by foreign corporate subsidiaries until that income is repatriated to
the parent through a dividend, although under anti-deferral rules, the
parent may be subject to current taxation on certain types of passive or
highly mobile income earned by those foreign subs regardless of whether
it has been distributed as a dividend. A foreign tax credit is generally
available to offset U.S. tax on foreign source income whether earned
directly by the U.S. parent, repatriated as a dividend, or included in
income under the anti-deferral rules. The credit is limited to the U.S.
tax liability on the foreign source income. It is applied separately to
different types of foreign income, in order to reduce the ability to
cross-credit taxes paid in high-taxed locations against income earned in
low-taxed jurisdictions, although a significant degree of
cross-crediting may be achieved within a single limitation category.

*[Reasons for Change]{.underline}*

The JCT argues that the worldwide, deferral-based system employed by the
United States distorts business decisions, for example, by creating
incentives to re-deploy foreign earnings abroad rather than in the U.S.
It also argues that repatriation is elective on the part of the U.S.
parent rendering the payment of U.S. tax an elective exercise. Thus, if
a U.S. parent can defer dividends indefinitely, it can achieve (in
effect) a 100 percent exemption on foreign earnings that are not
affected by the anti-deferral rules. Finally, taxpayers that repatriate
earnings from foreign jurisdiction that impose higher-than-U.S. tax
rates have the ability to use excess foreign tax credits attributable to
these dividends to shield residual U.S. tax on royalties and interest
earned in other foreign jurisdictions. At the same time, however, the
application of the highly complex anti-deferral rules arguably forces
U.S. companies to contend with a greater degree of complexity and to
engage in a greater degree of tax-distorted business planning than many
of their foreign competitors based in countries with exemption systems.

*[Description of Proposal]{.underline}*

As a result, the JCT recommends that the current worldwide,
deferral-based system should be replaced with a dividend exemption
system. Under this new system, all dividend income received from
controlled foreign corporations (CFCs) or from branches of U.S. parent
corporations[^1] would be exempt from U.S. tax and eligible for
repatriation tax-free, as long as the U.S. corporation owned at least 10
percent of the CFC\'s stock. However, passive and other highly mobile
income earned abroad by CFCs or branches would be currently taxed to the
U.S. parent under subpart F.[^2] Non-dividend payments from CFCs to a
U.S. corporation constituting interest, royalties, service fees, etc.,
would be fully subject to tax. In addition, dividends from non-CFCs, or
from CFCs with respect to which the U.S. corporation is not at least a
10-percent shareholder, would be fully subject to tax. Companies could
elect to treat companies owned between 10 and 50 percent (so-called
\"10-50 companies\") like CFCs for dividend exemption and subpart F
purposes; otherwise, 10-50 investments would be treated as
portfolio-type investments, as the indirect foreign tax credit of
section 902 would be repealed. Gains from sales of CFC stock would be
excluded from income to the extent of undistributed exempt earnings,
while excess gains would be taxable and no deductions would be allowed
for losses on stock sales.

In theory, the current foreign tax credit system would serve a much more
limited function since it would only be applicable to passive type
income, resulting in little cross-crediting. Under these conditions, it
would no longer be necessary to apply the limitation on a
separate-category basis; hence, the separate limitation categories of
section 904 would be repealed, and the foreign tax credit limitation
would apply on an overall basis. No change would be made to the 50/50
export source rule under Code Section 863(b), but the benefits would be
greatly reduced or eliminated in view of the narrowed scope of the
foreign tax credit and the likelihood that most taxpayers will be in an
excess limitation position.

Deductions for interest and certain other expenses incurred by the U.S.
parent would be disallowed to the extent allocable to exempt foreign
income. For example, interest expense would first be allocated between
U.S. and foreign source income as under current law, and then further
allocated between exempt foreign earnings and other foreign source
income on a pro rata basis based on assets. Research and experimentation
(\"R&D\") expenses would first be allocated between U.S. and foreign
source based on current law rules, and then further allocated first to
taxable royalties, then to exempt and non-exempt CFC earnings on a pro
rata basis, and finally to other foreign-source income. Allocations
would also be required for general and administrative (G&A) expenses and
stewardship expenses.

This new exemption system would only apply with respect to CFC earnings
generated after the law\'s effective date, while present law would
continue to apply to prior earnings, thus requiring ongoing, separate
tracking of earnings pools. In addition, the new system will require the
renegotiation of existing income tax treaties, as such treaties are
based on the premise that the United States has a worldwide tax system.

*[Analysis of the JCT Proposal]{.underline}*

While the JCT proposal could simplify the foreign tax credit regime,
whether the proposal would result in net simplification of the U.S.
international tax system as a whole depends on details yet to be fleshed
out -- in particular, on details the proposal would leave to
regulations. Moreover, the proposal would adversely affect the
competitiveness of U.S. companies abroad by substantially raising taxes
on foreign source income, including income earned on exports. Much of
this tax increase results from the allocation of R&D and G&A expenses to
exempt CFC income, a result that is improper because the CFCs will be
paying for the R&D and G&A in the form of taxable royalties and service
fees. The proposal would result in an effective tax increase on
U.S.-based R&D and export-oriented manufacturing that the U.S. should be
encouraging to remain at home.

*[Simplification]{.underline}*

One of the main reasons offered by the JCT to support the replacement of
the worldwide, deferral-based system with a dividend exemption system is
that the current system is too complex and a dividend exemption
alternative would be simpler. The JCT proposal should simplify the
foreign tax credit regime -- both by reducing the amount of income and
activity subject to these rules and eliminating the separate limitation
categories.

At the same time, however, the JCT proposal includes rules requiring
substantial new allocations of expenses, many of the details of which
would be left to the Treasury Department to determine through the
regulatory process. Allocations of expenses will necessarily mean
additional recordkeeping and additional accounting expense and are a
frequent source of disagreement between taxpayers and the IRS. That is
particularly likely to be the case under the JCT proposal since the
result of a reallocation may be a complete disallowance of an otherwise
deductible expense. While these problems could be minimized if
simplicity were prioritized, the lack of detail provided in the JCT
proposal coupled with the delegation of additional detail to Treasury
regulations suggests simplicity would take a back seat. Moreover, even
if the Treasury Department works overtime to provide the new rules,
there will be an inevitable delay in the provision of the guidance to
allow compliance by taxpayers during which taxpayers will bear a cost
for uncertainty. As is discussed below, many of the expense allocations
are inappropriate as a matter of sound economic and tax policy.

In addition, it appears the steps toward simplification would be offset
by substantial transitional complexities. First, during the transition
period, taxpayers would have to comply both with the new tax law (for
CFC earnings generated after the effective date) and the old tax law
(for pre-effective date earnings), requiring the ongoing tracking of
separate earnings pools. Second, the changes would require that
taxpayers, who have years of experience with the current international
tax rules, to become familiar with a new set of rules (in addition to
the old set of rules for any company operating under the current rules)
and to make adjustments to tax accounting systems and compliance
activities to conform to the changes. Third, companies have arranged
their affairs in compliance with and in reliance on the current rules.
Implementation of a dividend exemption system would require companies to
review and reconsider all of their international business operations. It
would likely necessitate the restructuring of some of those operations
to take advantage of the intended benefits of a dividend exemption
system as well as to avoid the inevitable adverse -- and often
unintended -- consequences. As the JCT proposal acknowledges, there
would be a need to review and renegotiate income tax treaties, which
would leave companies with some degree of uncertainty regarding the
taxation of their investments and operations until the negotiations were
completed and the changes ratified.

The JCT proposal would allow U.S. corporations to effectively choose
between treating investments in 10-50 companies as a portfolio-type
investment or as a direct, CFC-type investment. Thus, the possible
treatments of 10-50 investments would increase from one (deferral with
indirect foreign tax credits upon repatriation) to three
(portfolio-treatment or exemption or current taxation under subpart F),
requiring an increase in tax planning. While it is possible that the
election system for investments in 10-50 companies could be simpler than
the current regime \-- and, even it were not, many taxpayers might still
prefer it \-- it is widely-recognized that elections in and of
themselves oftentimes significantly increase complexity.

Finally, the JCT proposal leaves a door open to increased complexity by
explicitly failing to address the scope of subpart F, deeming the issue
\"largely independent of the question of whether to adopt a dividend
exemption system.\" Updating subpart F to reflect changes in the economy
and in business operations is long overdue. The mere conversion to a
territorial system without updating subpart F would do nothing for the
industries and business operations covered by subpart F\'s outmoded
rules. Should Congress choose to implement a territorial system and then
address purported \"capital flight\" concerns associated with
territoriality by expanding the categories of income taxed currently
under subpart F, the reforms would introduce greater complexity that
would offset any simplification achieved in the foreign tax credit
realm. Expansion of subpart F would also worsen the international
competitiveness of U.S. businesses.

*[International Competitiveness]{.underline}*

The JCT estimates that its new system would generate over \$50 billion
in increased corporate revenues to the U.S. Government over the budget
estimating period. While no specific breakdown of the revenue estimate
is available, it appears that much of this increase stems from the
allocation of interest, R&D, G&A and stewardship expenses to tax exempt
CFC earnings and the consequent disallowance of deductions for these
expenses. Allocating, R&D and G&A expenses, in particular, to exempt CFC
income would be inappropriate, however, because the CFC effectively pays
for the R&D and G&A via royalties and service fees that would be fully
taxable to the U.S. parent.[^3]

Again, no specific breakdown of the revenue estimate is available, but
it appears that the remainder of the revenue increase results from the
loss of U.S. companies\' ability to \"cross-credit\" foreign taxes paid
in high-tax foreign jurisdictions against the residual U.S. tax on
income earned in other foreign jurisdictions. For instance, U.S.
companies would no longer have excess foreign tax credits associated
with dividends from one CFC in a higher-tax jurisdiction to reduce the
residual U.S. tax owed with respect to royalties from another CFC. The
JCT proposal would also significantly reduce or eliminate the benefit of
the export source rule under section 863(b), due to the narrowed scope
of the foreign tax credit and the likelihood that many taxpayers would
be in excess-limitation positions under the new system. While the
elimination of both benefits is the natural consequence of any
territorial system (as opposed to a conceptual oversight), the result
would be a tax increase on U.S.-based multinational companies that
reduces their international competitiveness. More specifically, the
elimination of these benefits amounts to tax increases levied on
U.S.-based R&D and export-oriented manufacturing -- both sectors the
U.S. should want to preserve given the decline in U.S. manufacturing and
increased concerns about maintaining R&D and technology development in
the U.S. The current international tax system encourages U.S. companies
to keep these jobs at home.

*[An Alternative Territorial System]{.underline}*

If, notwithstanding the reasons that support maintaining the current
system, the President\'s Advisory Panel on Federal Tax Reform were to
decide to advance a territorial dividend exemption proposal, the
discussion above suggests that achieving the goals of simplicity, as
well as improving the competitiveness of U.S. based multinational
companies, would require that the proposal:

> 1.) minimize transitional complexity by applying the exemption system
> to all CFC earnings rather than only post-effective date CFC earnings
>
> 2.) provide for only two categories of income earned abroad by 10-50
> companies: exempt or subpart F

3.) commit to modernizing, not expanding, subpart F

> 4.) revise the allocation provisions, including eliminating the
> proposal to allocate R&D, G&A, and stewardship expenses to exempt CFC
> earnings
>
> 5.) allocate interest according to the provisions recently approved as
> part of the American Jobs Creation Act of 2004[^4]

To ensure that a territorial proposal does not worsen the international
competitiveness of U.S. companies, any revenue raised from the proposal
should be used for the following:

1.) Modernize Subpart F as follows:

> a.) repeal the foreign base company sales and services income rules
>
> b.) make permanent the active financing exception of sections 954(h)
> and (i) and 953(e)
>
> c.) provide for look-thru treatment of payments between related CFCs
> under foreign personal holding company income rules
>
> d.) treat members states of the European Union as one country for
> subpart F purposes
>
> e.) expand the subpart F de minimis rule
>
> 2.) Reduce corporate tax rates to a competitive international rate

Consideration might also be given to a reduced tax on royalties in order
to provide companies with continued encouragement to locate their
royalty-generating R&D activities in the U.S.^.^[^5]

Narrowing subpart F and lowering corporate tax rates may also be
considered as reforms that would reduce complexity and/or improve
international competitiveness regardless of whether a territorial system
is adopted. Indeed, pursuing reform of our current system would be a
better use of resources.

[*Conclusion*:]{.underline}

While the JCT dividend exemption proposal does simplify the foreign tax
credit regime, it is unlikely that it results in net simplification, and
it decreases the international competitiveness of U.S. exporters and
R&D-intensive companies. If the Panel decides to advance a territorial
proposal notwithstanding these drawbacks, it should consider the
provisions listed above as a way to mitigate the damage imposed on U.S.
companies operating abroad and maximize the simplicity potential of
territoriality.

abb

9/2/05

[^1]: Foreign branches would be treated just like CFCs for exemption and
    deferral purposes, although Treasury would have to issue rules to
    place branches and CFCs on an equal footing for these purposes.

[^2]: A special rule would provide that no subpart F inclusions would be
    created as a dividend moves up a chain of CFCs, to the extent that
    the dividend is attributable to a 10 percent of great direct or
    indirect interest in the dividend-paying CFC owned by the U.S.
    parent.

[^3]: While CFCs are not charged for stewardship expenses, we
    nonetheless question the wisdom of providing an incentive to move
    desirable stewardship jobs to low-tax jurisdictions.

[^4]: *See, e.g.*, American Jobs Creation Act of 2004, Pub. L. No. L.
    108-357, § 401 (codified as amended in § 864(f)(1)(B) (2004). These
    rules still may require a number of technical changes.

[^5]: France imposes a reduced rate of 19 percent on royalty income from
    patents, compared to a regular corporate rate of about 34 percent.