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THE U.S. INTERNATIONAL TAX SYSTEM AND THE COMPETITIVENESS OF

AMERICAN COMPANIES

Submitted by:

Judy Scarabello

Vice President for Tax Policy

National Foreign Trade Council

An Association

April 20, 2005

THE NATIONAL FOREIGN TRADE COUNCIL COMMENTS

TO THE PRESIDENT'S ADVISORY PANEL ON FEDERAL TAX REFORM

THE U.S. INTERNATIONAL TAX SYSTEM AND THE COMPETITIVENESS OF

AMERICAN COMPANIES

The National Foreign Trade Council (the "NFTC") is pleased to have the
opportunity to offer input to the President's Advisory Panel on Federal
Tax Reform (the "Panel"). We commend the Panel for including
international tax issues and the competitiveness of American companies
in their consideration of tax reform.

The NFTC, organized in 1914, is an association of some 300 U.S. business
enterprises engaged in all aspects of international trade and
investment. Our membership covers the full spectrum of industrial,
commercial, financial, and service activities. As such, the NFTC seeks
to foster an environment in which U.S. companies can be dynamic and
effective competitors in the international business arena. To achieve
this goal, American businesses must be able to participate fully in
business activities throughout the world through the export of goods,
services, technology, and entertainment, and through direct investment
in facilities abroad.

As global competition grows ever more intense, it is vital to the health
of U.S. enterprises and to their continuing ability to contribute to the
U.S. economy that they be free from the possibility of double taxation,
excessive foreign taxation, and other impediments to the flow of capital
that can serve as barriers to full participation in the international
marketplace. Foreign trade is fundamental to the economic growth of U.S.
companies. An efficient, fair tax regime that promotes competitiveness
and compatibly with international norms and that is easily administered,
is a crucial component of the framework that is necessary to allow that
growth.

The foreign competition faced by American companies has intensified as
the globalization of business has accelerated. American multi-nationals
continue to voice their concerns that

the Internal Revenue Code places them at a competitive disadvantage in
relation to multinationals based in other countries. *The NFTC Foreign
Income Project: International Tax Policy for the 21^st^ Century* (the
"NFTC FIP") [^1], an international tax policy review project, was
undertaken in response to this concern. The analysis with respect to the
NFTC FIP led us to believe that the core principles and the basic
structure of the U.S. international tax rules remain sound, although
certain competing policies (as reflected in current law) have not kept
pace with the rapid development of a global economy. The NFTC FIP
focused on the anti-deferral, or income acceleration rules of subpart F,
and the foreign tax credit. While many of the recommendations put
forward in the NFTC FIP to overhaul the U.S. foreign tax credit regime
were included in the *American Jobs Creation Act of 2004* (the AJCA"),
the 40 year old plus subpart F regime was left virtually untouched and
remains a significant challenge for U.S. companies competing in the
international marketplace.

The ability of American companies to compete in the global marketplace
is far more compelling today than 40 years ago when the subpart F rules
became law; the U.S. dominance of international markets no longer
exists. Back then, 18 U.S. companies were counted among the 20 largest
international industrial companies; today, that number has declined to
eight. While the U.S. has still not reevaluated its position to
accelerate tax on the active business income of foreign affiliates of
American companies, our major trading partners have generally declined
to tax their companies in a similar fashion; American companies have
been left to bear higher domestic taxation than their foreign
competitors. The 21,000 foreign affiliates of U.S. multinationals now
compete with the 260,000 non-U.S. affiliates of multinationals. While
the U.S. economy represents a mature market for most companies and is
relatively slow growing, the rapid expansion of the world economy over
the last three decades represents an opportunity for U.S. companies that
are able to participate in those growth markets.

Although it is difficult to compare the overall impact of a country's
income tax system on the cost of cross-border investments, the data and
analyses reviewed in the NFTC FIP suggest that, from a tax perspective,
the United States is a relatively undesirable location for a
multinational company's legal domicile. Recent trends indicate that the
vast majority of cross-border mergers and acquisitions have been
structured as foreign acquisitions of U.S. companies, thus converting
U.S. multinationals to non-U.S. multinationals and thereby reducing the
number of U.S. multinationals. Recent examples include:
Daimler-Chrysler, BP-Amoco, and Deutsche Bank-Bankers Trust mergers.
Despite the intensified competition in world markets, the U.S. economy
is more dependent on foreign direct investment than ever before. The
United States is the world's largest importer of capital, with foreign
investments in U.S. assets exceeding U.S. investments in foreign assets
by over \$100 billion per year.

While acknowledging the anti-competitive implications of subpart F,
opponents of deferral frequently argue that U.S. direct investment
abroad comes at the expense of the U.S economy. Contrary to the current
"outsourcing" argument that investing abroad drains jobs and production
from the United States, economic evidence points to the opposite
conclusion---U.S. investments abroad increases economic activity at
home. This complementary relationship between the foreign and domestic
operations of U.S. multinational corporations is discussed more fully in
the NFTC FIP. In fact, academic studies support the hypothesis that U.S.
investment abroad promotes U.S. exports. The NFTC FIP cites an OECD
study that found that a dollar spent on foreign investment resulted in
two dollars of additional exports. As demand for U.S. exports increases
there is an associated increase in the demand for U.S. support services
that creates additional U.S. jobs. There is also evidence that workers
at U.S. companies with foreign operations earn higher wages than their
counterparts in purely domestic companies in the same industries.

A territorial tax exemption system has frequently been touted as the
solution to the ills of the U.S. international tax system. Most
recently, a dividend exemption form of territorial tax system was
suggested as a way to reform the U.S. international tax regime in
"Options to Improve Tax Compliance and Reform Expenditures," a report
issued by the Joint Committee on Taxation. There was also interest in a
territorial tax system as a resolution to the unfavorable World Trade
Organization decisions regarding the U.S. Foreign Sales Corporation and
the Extra-Territorial Income regimes. The NFTC undertook a study, the
*Territorial Tax Study Report* (the "Territorial Study")[^2] to evaluate
the efficacy of implementing some form of a territorial tax exemption
system in the United States. The study evaluated the basic features of
traditional territorial systems, as well as the features of one or more
possible alternative exemption systems, in terms of: future U.S.
competitiveness, effect on the WTO challenge, tax simplification and
administration, and long term stability. Consideration was also given as
to whether a switch to a territorial system would more likely address
these considerations than simply reforming the current U.S.
international tax system.

The Territorial Study concluded that a broad based, traditional
territorial exemption system would improve the competitiveness of those
U.S. companies with substantial foreign active business income taxed at
source country rates that are significantly less than U.S. tax rates;
U.S. companies with foreign business income in high tax countries might
be worse off. However, the overriding conclusion was that to improve the
competitiveness of any substantial group of U.S. companies would require
resolving many of the same issues that make our current rules
anti-competitive: the overly broad scope of subpart F with respect to
active business income, the over allocation of expenses to foreign
income, and the restrictive aspects of the foreign tax credits (note
that most of the foreign tax credit issues were resolved by the AJCA).

Left unresolved, the traditional territorial exemption system would not
only fail to improve competitiveness significantly, but would also leave
in place the complexity and instability of the current U.S. tax system.
Taking these factors into account, the Territorial Study concluded that
efforts to improve the international tax system were best spent on
adopting specific reforms to the current rules rather than adopting some
form of a territorial exemption system.

The AJCA was a significant step toward that reform; however, expanding
rather than contracting deferral, *e.g*., eliminating subpart F, is
essential to the long term health of American business. Without further
reform, the U.S. international tax rules hinder the ability of U.S.
companies to compete in the global marketplace.

We strongly urge you to preserve and to extend the deferral of U.S. tax
on active business income earned by foreign subsidiaries of American
companies. Broadening the U.S. tax deferral system (so that it does what
it is intended to do, *i.e.*, defer tax on the earnings of a foreign
subsidiary that engages in genuine business activities), is consistent
with the basic tenets of U.S. taxation. Despite that, subpart F captures
active income in the U.S. tax net without a policy justification.  Some
examples of active income that are subject to current U.S. taxation are:
income that is earned outside a foreign corporation's country of
incorporation (base company sales and services income), active financial
services income, and certain oil-related income (*e.g*., income from
operating an oil or gas pipeline outside the country in which the oil or
gas was extracted or sold).  Active financial services income has had a
temporary reprieve from characterization as subpart F income until the
end of 2006, but unless it is extended, U.S. based financial services
companies will again be at a competitive disadvantage vis-à-vis their
foreign counterparts.  Payments from one foreign affiliate (dividends,
interest, rents, or royalties) to another foreign affiliate are also
subject to current U.S. taxation. This ultimately limits the flexibility
of U.S. companies to expand internationally.  It is critical that these
issues are resolved to safeguard the competitive position of U.S. firms
abroad thereby safeguarding American jobs. 

The growing economic integration among nations and the formation of
common markets and free trade areas raises questions about the
appropriateness of U.S. international tax rules that treat foreign
transactions that cross national borders differently from those that
occur within the same country. The use of tax policy by the United
States to discourage investment in the world's growth areas is
thoroughly antiquated. With the significant reform of the foreign tax
credit area behind us, it is time to take today's competitive
marketplace into account by modernizing subpart F so that U.S. based
multinationals can compete more effectively with their non-U.S.
counterparts.

[^1]: The NFTC FIP is available on the NFTC website at:
    [www.nftc.org](http://www.nftc.org/).

[^2]: