U.S. GOVERNMENT PRINTING OFFICE

65–844 CC WASHINGTON : 2000

CURRENT U.S. INTERNATIONAL TAX REGIME

HEARING

BEFORE THE

SUBCOMMITTEE ON OVERSIGHT

OF THE

COMMITTEE ON WAYS AND MEANS

HOUSE OF REPRESENTATIVES

ONE HUNDRED SIXTH CONGRESS

FIRST SESSION

JUNE 22, 1999

Serial 106–53

Printed for the use of the Committee on Ways and Means

(

For sale by the U.S. Government Printing Office

Superintendent of Documents, Congressional Sales Office, Washington, DC 20402

ii

COMMITTEE ON WAYS AND MEANS

BILL ARCHER, Texas, Chairman

PHILIP M. CRANE, Illinois

BILL THOMAS, California

E. CLAY SHAW, JR., Florida

NANCY L. JOHNSON, Connecticut

AMO HOUGHTON, New York

WALLY HERGER, California

JIM MCCRERY, Louisiana

DAVE CAMP, Michigan

JIM RAMSTAD, Minnesota

JIM NUSSLE, Iowa

SAM JOHNSON, Texas

JENNIFER DUNN, Washington

MAC COLLINS, Georgia

ROB PORTMAN, Ohio

PHILIP S. ENGLISH, Pennsylvania

WES WATKINS, Oklahoma

J.D. HAYWORTH, Arizona

JERRY WELLER, Illinois

KENNY HULSHOF, Missouri

SCOTT MCINNIS, Colorado

RON LEWIS, Kentucky

MARK FOLEY, Florida

CHARLES B. RANGEL, New York

FORTNEY PETE STARK, California

ROBERT T. MATSUI, California

WILLIAM J. COYNE, Pennsylvania

SANDER M. LEVIN, Michigan

BENJAMIN L. CARDIN, Maryland

JIM MCDERMOTT, Washington

GERALD D. KLECZKA, Wisconsin

JOHN LEWIS, Georgia

RICHARD E. NEAL, Massachusetts

MICHAEL R. MCNULTY, New York

WILLIAM J. JEFFERSON, Louisiana

JOHN S. TANNER, Tennessee

XAVIER BECERRA, California

KAREN L. THURMAN, Florida

LLOYD DOGGETT, Texas

A.L. SINGLETON, Chief of Staff

JANICE MAYS, Minority Chief Counsel

SUBCOMMITTEE ON OVERSIGHT

AMO HOUGHTON, New York, Chairman

ROB PORTMAN, Ohio

JENNIFER DUNN, Washington

WES WATKINS, Oklahoma

JERRY WELLER, Illinois

KENNY HULSHOF, Missouri

J.D. HAYWORTH, Arizona

SCOTT MCINNIS, Colorado

WILLIAM J. COYNE, Pennsylvania

MICHAEL R. MCNULTY, New York

JIM MCDERMOTT, Washington

JOHN LEWIS, Georgia

RICHARD E. NEAL, Massachusetts

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public hearing records

of the Committee on Ways and Means are also published in electronic form. The printed

hearing record remains the official version. Because electronic submissions are used to

prepare both printed and electronic versions of the hearing record, the process of converting

between various electronic formats may introduce unintentional errors or omissions. Such occurrences are inherent in the current publication process and should diminish as the process

is further refined.

iii

C O N T E N T S

Page

Advisory of June 14, 1999, announcing the hearing ............................................. 2

WITNESSES

BMC Software, Inc., John W. Cox .......................................................................... 34

Citigroup, Denise Strain ......................................................................................... 41

Deere & Company, Thomas K. Jarrett .................................................................. 48

National Foreign Trade Council, Inc., and Exxon Corporation, Joe O. Luby,

Jr. .......................................................................................................................... 7

Northrop Grumman Corporation, Gary McKenzie ............................................... 51

Tax Executives Institute, Inc., and Hewlett-Packard Company, Lester D.

Ezrati .................................................................................................................... 20

Warner-Lambert Company, Stan Kelly ................................................................. 56

SUBMISSIONS FOR THE RECORD

European-American Business Council, William W. Chip, statement and attachment ............................................................................................................... 71

Financial Executives Institute, statement ............................................................. 74

General Motors Corporation, Detroit, MI, statement ........................................... 77

International Air Transport Association, Montreal, Quebec, Canada, Howard

P. Goldberg, statement ........................................................................................ 79

Investment Company Institute, statement ............................................................ 80

Munitions Industrial Base Task Force, Arlington, VA, et al, Richard G.

Palaschak, joint statement .................................................................................. 81

National Defense Industrial Association, Arlington, VA, Lawrence F. Skibbie,

statement .............................................................................................................. 83

Tropical Shipping, Riviera Beach, FL, Richard Murrell, letter ........................... 84

Washington Counsel, P.C.:

LaBrenda Garrett-Nelson and Robert J. Leonard, statement ...................... 85

LaBrenda Garrett-Nelson, statement ............................................................. 86

(1)

CURRENT U.S. INTERNATIONAL TAX REGIME

TUESDAY, JUNE 22, 1999

HOUSE OF REPRESENTATIVES,

COMMITTEE ON WAYS AND MEANS,

SUBCOMMITTEE ON OVERSIGHT,

Washington, DC.

The Subcommittee met, pursuant to notice, at 1:03 p.m., in room

1100, Longworth House Office Building, Hon. Amo Houghton

(Chairman of the Subcommittee), presiding.

[The advisory announcing the hearing follows:]

2

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

SUBCOMMITTEE ON OVERSIGHT

FOR IMMEDIATE RELEASE CONTACT: (202) 225–7601

June 14, 1999

No. OV–8

Houghton Announces Hearing on

Current U.S. International Tax Regime

Congressman Amo Houghton (R–NY), Chairman, Subcommittee on Oversight of

the Committee on Ways and Means, today announced that the Subcommittee will

hold a hearing on the complexity of the current U.S. international tax regime. The

hearing will take place on Tuesday, June 22, 1999, in the main Committee hearing

room, 1100 Longworth House Office Building, beginning at 1:00 p.m.

Oral testimony at this hearing will be from invited witnesses only. Invited witnesses include representatives from the U.S. Department of the Treasury, Tax Executives Institute, National Foreign Trade Council, financial services industry, software industry, heavy equipment manufacturing industry, pharmaceutical industry,

and high-technology manufacturing industry. However, any individual or organization not scheduled for an oral appearance may submit a written statement for consideration by the Committee and for inclusion in the printed record of the hearing.

BACKGROUND:

The United States employs a ‘‘worldwide’’ system of taxation on income of U.S.

corporations and its foreign affiliates. A U.S.-parent corporation incurs income taxes

on the income of its affiliates earned abroad to the extent that the affiliates repatriate that income either through dividends or deemed dividends. This worldwidetax system has become a maze of complex rules for sourcing and timing foreign income and expenses.

The laws enacted by Congress and regulations promulgated by the Internal Revenue Service over the past 40 years have introduced an amount of complexity which

some believe has made the international tax regime unworkable and has resulted

in an increasing amount of double taxation of U.S. corporations’ foreign income. According to this viewpoint, the competitiveness of U.S. corporations vis-a`

-vis their

international competitors thus is disadvantaged.

United States corporations remain the most competitive in the world as a result

of superior technology and access to skilled labor. However, the current international tax regime may adversely affect the competitive advantages that such corporations now hold.

On June 7, 1999, Chairman Houghton and Rep. Sander Levin introduced H.R.

2018, the ‘‘International Tax Simplification for American Competitiveness Act of

1999.’’

In announcing the hearing, Chairman Houghton stated: ‘‘In an increasingly competitive global market, Congress must examine whether the complexity of the U.S.

international tax regime puts U.S. corporations and their employees at a competitive disadvantage. Congressman Levin and I have introduced legislation to address

several of these concerns.’’

3

FOCUS OF THE HEARING:

The Subcommittee will review problems faced by domestic corporations in complying with the complexity of the current U.S. international tax regime as well as

proposals to change the law.

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

Any person or organization wishing to submit a written statement for the printed

record of the hearing should submit six (6) single-spaced copies of their statement,

along with an IBM compatible 3.5-inch diskette in WordPerfect 5.1 format, with

their name, address, and hearing date noted on a label, by the close of business,

Tuesday, July 6, 1999, to A.L. Singleton, Chief of Staff, Committee on Ways and

Means, U.S. House of Representatives, 1102 Longworth House Office Building,

Washington, D.C. 20515. If those filing written statements wish to have their statements distributed to the press and interested public at the hearing, they may deliver 200 additional copies for this purpose to the Subcommittee on Oversight office,

room 1136 Longworth House Office Building, by close of business the day before the

hearing.

FORMATTING REQUIREMENTS:

Each statement presented for printing to the Committee by a witness, any written statement

or exhibit submitted for the printed record or any written comments in response to a request

for written comments must conform to the guidelines listed below. Any statement or exhibit not

in compliance with these guidelines will not be printed, but will be maintained in the Committee

files for review and use by the Committee.

1. All statements and any accompanying exhibits for printing must be on an IBM compatible

3.5-inch diskette in WordPerfect 5.1 format, typed in single space and may not exceed a total

of 10 pages including attachments. Witnesses are advised that the Committee will rely on

electronic submissions for printing the official record.

2. Copies of whole documents submitted as exhibit material will not be accepted for printing.

Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material

not meeting these specifications will be maintained in the Committee files for review and use

by the Committee.

3. A witness appearing at a public hearing, or submitting a statement for the record of a public hearing, or submitting written comments in response to a published request for comments

by the Committee, must include on his statement or submission a list of all clients, persons,

or organizations on whose behalf the witness appears.

4. A supplemental sheet must accompany each statement listing the name, company, address,

telephone and fax numbers where the witness or the designated representative may be reached.

This supplemental sheet will not be included in the printed record.

The above restrictions and limitations apply only to material being submitted for printing.

Statements and exhibits or supplementary material submitted solely for distribution to the

Members, the press and the public during the course of a public hearing may be submitted in

other forms.

Note: All Committee advisories and news releases are available on the World

Wide Web at ‘HTTP://WWW.HOUSE.GOV/WAYSlMEANS/’.

The Committee seeks to make its facilities accessible to persons with disabilities.

If you are in need of special accommodations, please call 202–225–1721 or 202–226–

3411 TTD/TTY in advance of the event (four business days notice is requested).

Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above.

Chairman HOUGHTON. The hearing will come to order.

Good afternoon, ladies and gentleman; delighted to have you

here. The Ways and Means Committee holds a unique position, as

4

you know, in forming policies that will drive economic growth in

the next century. The committee has jurisdiction over tax and

trade matters, and each are intricately intertwined with the other.

Since I have been on this Committee, Congress has passed a

variety of trade laws, including the Omnibus Trade and Competitiveness Act of 1988, the implementing bills for NAFTA, and the

Uruguay Rounds Agreements. Each year, the committee leads the

effort in Congress to preserve normal trade relations with China.

Within the last month, the committee has passed the African

Growth and Opportunities Act and the Caribbean Basin Initiative.

The policy behind each of these bills has been to break down trade

barriers, so that we can expand export opportunities for U.S. firms

and workers. The U.S. market, as you know, is the most open in

the world; yet, more than 96 percent of the world’s population lives

outside our borders. So, it is important that we secure market access beyond our 50 States in order to sustain our record of economic growth and job creation, as we look out at a new millennium

within 6 months.

Unfortunately, over the last 40 years, since the inception of Subpart F, the disconnect between trade and tax policy has widened.

With one hand, Congress passes laws to help U.S. business expand

and become competitive around the globe. With the other, Congress

hobbles these same businesses through double taxation and a variety of obstacles to capital formation in markets abroad. These

mixed messages to U.S. businesses are not helpful.

So, as I looked over the prepared testimony, I noticed a couple

of things. First of all, the diversity of industries that are represented here today—banking, pharmaceutical, software, high-tech,

heavy manufacturing, and oil and gas. We have to be very proud

as these U.S. companies are world leaders in their fields. We also

have to keep an eye on the future to make sure that these companies and the industries they represent remain world leaders. And,

so that means that we need to build a coherent link between trade

and tax policy. We need to understand the correlation between the

two and work to pass laws with that understanding in mind, our

goal is to help expand jobs, not throw boulders in their path.

The second thing that I noticed was despite the impressive brain

power of these men and women and the tax professionals that support them, each witness speaks of the incredible complexity of the

tax code and the burden it places on their companies. How did we

get where we are today with such a hodgepodge of tax laws that

put the U.S. businesses at such a disadvantage in the global marketplace? Isn’t it time to rework that system so it helps U.S. businesses? A strong economy in the United States is driven mainly by

how competitive our companies are around the globe. Today, the

international tax laws stand in their way.

The tax code should be designed to tax income fairly and uniformly. With these goals in mind, Mr. Levin—who is sitting over

here to my left—and I have introduced H.R. 2018, the International Tax Simplification for American Competitiveness Act of

1999. We believe that this bill takes important steps to help ensure

that U.S.-owned businesses will not be subject to double or premature taxation. Only when these concerns are addressed will our

tax and trade laws be in line.

5

I am pleased now to yield to our Ranking Democrat, Mr. Coyne.

Mr. COYNE. Thank you, Mr. Chairman, and I want to thank you

for having these hearings. I have a written statement I would like

to submit for the record, and I yield the balance of my time to the

gentleman from Michigan, Mr. Levin.

[The opening statement follows:]

Opening Statement of Hon. William J. Coyne, a Representative in Congress

from the State of Pennsylvania

Our hearing today will focus on problems faced by domestic corporations in complying with the complexity of the current U.S. international tax system. I want to

commend Chairman Houghton and Congressman Levin for their leadership in this

area and for the introduction of H.R. 2018, the ‘‘International Tax Simplification for

American Competitiveness Act of 1999.’’ This bill is sponsored, on a bipartisan basis,

by many Members of the Ways and Means Committee. H.R. 2018 proposes changes

to various aspects of our international tax rules.

I share Chairman Houghton’s concern that, given an increasingly competitive

global market, the Congress must examine whether the complexity of the U.S. international tax regime puts U.S. corporations and their employees at a competitive disadvantage. Consequently, I believe that it is timely that the Oversight Subcommittee review our international tax rules to see how they might be reformed and

simplified. Consideration of H.R. 2018 is a good first step toward understanding the

problems of international taxation and industries’ proposals for reform.

Also, our hearing today will serve as an excellent introduction to the full Committee’s hearing, next week, to review the impact of U.S. tax rules on the international

competitiveness of U.S. workers and businesses. I look forward to hearing the testimony of the witnesses who support H.R. 2018, including the Tax Executives Institute, the National Foreign Trade Council, and representatives of the financial services, software, heavy equipment manufacturing, pharmaceutical, and high-technology industries.

Finally, international tax systems are typically evaluated in terms of efficiency

(whether tax considerations are sufficiently neutral to investment and employment

decisions); equity (whether domestic businesses are treated fairly in comparison to

foreign-based firms); growth (whether the tax system promotes economic growth);

simplicity (whether the tax system imposes unnecessary complexity and administrative burdens on taxpayers; and, harmonization (whether the tax system conforms

with international norms and promotes dealings with foreign countries). I have a

particular interest in the effect U.S. international tax law has on workers and the

retention of jobs in the U.S. I hope that the witnesses today will address that issue

as well in their testimony.

Thank you.

Chairman HOUGHTON. Mr. Levin.

Mr. LEVIN. Thank you very much, Mr. Coyne, and to you, Mr.

Chairman, thank you for your holding this hearing and also for

your leadership. It is a pleasure to collaborate with you on this and

other matters.

I have a statement. Let me, if I might, just go through it, because I think it may help us to frame the issue. This bill that you

and I have introduced is an effort to rationalize and simplify further the international tax provisions of U.S. tax laws by streamlining foreign tax credits, encouraging exports, providing incentives

for the performance of research and development in the United

States, enhancing overall U.S. competitiveness, and minimizing

revenue loss.

International tax policies were created at a time when the focus

was on preventing tax avoidance, not promoting international competitiveness. In the early sixties, for example, U.S. companies focused their manufacturing and market strategies in the United

6

States, which at the time was, by far, the largest consumer market

in the world. U.S. companies generally could achieve economies of

scale and rapid growth, selling exclusively or almost so into the domestic market. In the early 1960’s, foreign competition in U.S. markets generally, therefore, was inconsequential.

Yet, increasingly, it has become vital for American businesses

and workers to compete beyond our borders. In response, the

United States generally tries to raise revenue in a neutral manner;

that is, one that does not discriminate in favor of one investment

over another. In the international arena, this means the United

States seeks to apply the same tax burden on income from both domestic and foreign investment. Accordingly, the United States generally taxes U.S. companies on their worldwide income with a credit for taxes paid to foreign jurisdiction.

There is one important exception, and this applies to foreign subsidiaries of U.S. companies. Because these subsidiaries would face

substantially higher tax rates than their local competitors if worldwide taxation were strictly enforced, U.S. law defers tax on the

subsidiary’s income until it is repatriated. But with that, there is

one problem, and that is that the deferral of a foreign subsidiary’s

tax until repatriation can create an incentive for U.S. companies to

keep their profits abroad even when the profits are not plowed

back to an active business operation. To counteract this incentive

to keep profits abroad for non-business reasons, Congress, over the

years, has eliminated deferral and imposed current taxation on

various forms of passive investment income. Thus, active foreign

operations are exempt from tax until repatriation so that U.S. companies are taxed at the same level as their foreign competitors in

a given market, but passive income earned abroad generally is

taxed currently. However, this structure, as we all know so well,

has developed increasing complexities.

So, over the last few years, a number of us have tried to achieve

greater simplification and equity. This is, I think, our fourth bill

on this issue and the third with our Senator counterparts, Orrin

Hatch and Max Baucus. We made some progress in the 1977 act;

most importantly, giving foreign sales corporations treatment to

software, simplifying reporting rules for 10/50 companies, and

eliminating overlap in passive foreign investment companies,

PFIC—you have to know the acronyms in this field, and controlled

foreign corporation, CFC, rules. Last year, we were able to include

a 1-year change in the rules for active financing income. We are

now trying to get that provision to extend its 1-year life.

These are important reforms—technical but important—which

have enabled American businesses and workers to be more competitive abroad. I am pleased by how far we have come, but there

is still more work to be done, and then I would lay out a bit of

where we have to go, Mr. Chairman.

And I conclude with you and I and others believe that by saying

simplifying our existing rules, we can achieve our goals of increasing competitiveness and fairness for our American companies in

the global marketplace.

Thank you, Mr. Chairman.

Chairman HOUGHTON. Thank you very much, Mr. Levin.

7

So, you understand the thrust of this meeting. We appreciate

your being here.

I would like to introduce the first panel—Mr. Joe Luby, Assistant

General Tax Counsel of Exxon and Chair of the Tax Committee of

the National Foreign Trade Council, and, also, Mr. Lester Ezrati,

General Tax Counsel of Hewlett-Packard in Palo Alto on behalf of

The Tax Executives Institute.

Mr. Luby, would you give your testimony?

STATEMENT OF JOE O. LUBY, JR., ASSISTANT GENERAL TAX

COUNSEL, EXXON CORPORATION, IRVING, TEXAS, AND

CHAIR, TAX COMMITTEE, NATIONAL FOREIGN TRADE COUNCIL, INC.

Mr. LUBY. As you said, I am here on behalf of the National Foreign Trade Council. I am accompanied by Fred Murray who is our

vice president of Tax with NFTC. I will concentrate my remarks on

the impact of the U.S. tax system on the ability of U.S. multinationals to compete with foreign-based competition. While I cannot state that the U.S. system is solely responsible for the decline

in rank of U.S. multinationals, I submit it had a major role in the

United States going from 18 of the world’s 20 largest corporations

in 1960 to just 8 by the mid-1990’s. I do not have new statistics,

but recent events will probably result in an even lower number

now that Amoco is a British company; Chrysler, a German company, and Bankers Trust, a German bank.

I will concentrate on how two of the provisions you have included

in your bill impact competitiveness. Your bill would accelerate and

grant look-through treatment for 10/50 companies. An example will

show you the adverse impact of 10/50 on competitiveness. Assume

a U.S. company’s 10/50 affiliate is competing with a French company for an investment in Singapore. The project calls for a $1 billion investment, and it is projected to earn $150 million before tax

or a 15 percent return. Singapore grants tax holidays, so there is

no foreign tax. Our French competitor would project a 15 percent

after-tax return, because France does not tax active business income from foreign sources. In contrast, the U.S. company would

have projected a 9.8 percent return because of the 10/50 provisions

imposing a U.S. tax of $52.5 million. The return advantage of 5.2

percent enjoyed by the French competitor may allow it to preempt

the U.S. bid. In any event, the 5.2 percent detriment may drive the

return below the level that would allow the U.S. company to even

entertain the project.

The granting of full look-through and acceleration of repeal will

enhance U.S. competitiveness by eliminating the kind of adverse

impact on project returns I have just illustrated. Our members are

still walking away from investments, deferring investments, or taking less than optimal ownership positions in foreign ventures due

to the 10/50 rules. Thus, we welcome your acceleration in lookthrough treatment for 10/50.

Section 907 came into the code in 1975 in reaction to the first

oil crisis and to the suspicion that some U.S. oil companies might

be taking foreign tax credits at rates so high that they may be inclusive of royalties. In 1983, this concern was addressed in IRS regulations to provide a formula for splitting the amount paid the forVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00011 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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eign government into a tax component and a royalty component.

These regulations have never been controversial and have worked

well. Despite that fact, section 907 remains in the code requiring

that taxpayers determine the amount of their extracted income

versus their oil-related income and the foreign taxes associated

with each category. This requires determining the point at which

income changes from extracted to oil-related, also determining the

associated cost for every oil well in every foreign country. No foreign country where we operate has these kinds of rules.

It also requires that the IRS audit such determinations. This is

a complete waste of shareholder and taxpayer money since from its

inception, section 907 has raised little if any tax revenue for the

U.S. fisc. An API study indicated that no major U.S. company in

our industry has paid tax under 907 from its inception in 1975

through the tax year 1997. Spending money to comply with a provision that has essentially been useless and has been superseded by

subsequent law changes does not make sense or enhance U.S. competitiveness.

Do compliance costs make a difference? Let us give you a couple

of examples based on my own company’s experience. We have 121

people in tax departments all over the world doing nothing but trying to comply with U.S. international tax rules; 25 of them do section 907. This does not include people who are comptrollers and

other departments that also much assist. We have an average of

30 IRS auditors in our office every business day of the year. The

information document requests have ranged from 944 for the 1980

to 1982 audit to 2,232 in our most recent audit. In contrast, our

affiliates in Japan file a tax return at the end of March, are visited

by five auditors, and within 2 months the audit is completed. In

the Netherlands, an audit for our 1991 to 1994 tax years was handled by one auditor and took 6 months. Finally, in the U.K., most

audits are handled by two auditors, and we have had an issue

raised that required litigation in over 20 years.

So, that you will know the size of those audits and that they are

about substantial companies when you compare, our sales in Japan

total $16.5 billion and $3.5 billion in tax; the Netherlands, $9.5 billion in sales and $1.9 billion in tax, and the U.K., sales of $16.4

billion and $6 billion in tax.

NFTC thanks you for the opportunity to present its views and especially for your efforts to bring to the international tax rules some

semblance of common sense in regard for the ability of U.S. companies to compete abroad.

[The prepared statement follows:]

Statement of Joe O. Luby, Jr., Assistant General Tax Counsel, Exxon Corporation, Irving, Texas, and Chair, Tax Committee, National Foreign

Trade Council, Inc.

Mr. Chairman, and distinguished Members of the Subcommittee:

My name is Joe Luby. I am Assistant General Tax Counsel of Exxon Corporation.

As Chairman of its Tax Committee, I am appearing today as a witness for the National Foreign Trade Council, Inc.

The National Foreign Trade Council, Inc. (the ‘‘NFTC’’ or the ‘‘Council’’) is appreciative of the opportunity to present its views on simplification of the international

tax system of the United States. The NFTC also wishes to congratulate you, Mr.

Chairman, and Mr. Levin, and Mr. Sam Johnson, as well as the other Members who

have joined you—Mr. Crane, Mr. Herger, Mr. English, and Mr. Matsui—in the introduction of H.R. 2018, the International Tax Simplification for American CompetiVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00012 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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1The foreign income of a foreign corporation is not ordinarily subject to U.S. taxation, since

the United States has neither a residence nor a source basis for imposing tax. This applies generally to any foreign corporation, whether it is foreign-owned or U.S.-owned. This means that

in the case of a U.S.-controlled foreign corporation (CFC), U.S. tax is normally imposed only

when the CFC’s foreign earnings are repatriated to the U.S. owners, typically in the form of

Continued

tiveness Act of 1999. As I will further elaborate below, the provisions of the bill,

if enacted, will do much to affect the concerns we express in this testimony and

would significantly lower the cost of capital, the cost of administration, and therefore the cost of doing business in the global marketplace for U.S.-based firms.

The NFTC is an association of businesses with some 550 members, originally

founded in 1914 with the support of President Woodrow Wilson and 341 business

leaders from across the U.S. Its membership now consists primarily of U.S. firms

engaged in all aspects of international business, trade, and investment. Most of the

largest U.S. manufacturing companies and most of the 50 largest U.S. banks are

Council members. Council members account for at least 70% of all U.S. non-agricultural exports and 70% of U.S. private foreign investment. The NFTC’s emphasis is

to encourage policies that will expand U.S. exports and enhance the competitiveness

of U.S. companies by eliminating major tax inequities and anomalies. International

tax reform is of substantial interest to NFTC’s membership.

The founding of the Council was in recognition of the growing importance of foreign trade and investment to the health of the national economy. Since that time,

expanding U.S. foreign trade and investment, and incorporating the United States

into an increasingly integrated world economy, has become an even more vital concern of our nation’s leaders. The share of U.S. corporate earnings attributable to foreign operations among many of our largest corporations now exceeds 50 percent of

their total earnings. Even this fact in and of itself does not convey the full importance of exports to our economy and to American-based jobs, because it does not address the additional fact that many of our smaller and medium-sized businesses do

not consider themselves to be exporters although much of their product is supplied

as inventory or components to other U.S.-based companies who do export. Foreign

trade is fundamental to our economic growth and our future standard of living. Although the U.S. economy is still the largest economy in the world, its growth rate

represents a mature market for many of our companies. As such, U.S. employers

must export in order to expand the U.S. economy by taking full advantage of the

opportunities in overseas markets.

United States policy in regard to trade matters has been broadly expansionist for

many years, but its tax policy has not followed suit.

There is general agreement that the U.S. rules for taxing international income are

unduly complex, and in many cases, quite unfair. Even before this hearing was announced, a consensus had emerged among our members conducting business abroad

that legislation is required to rationalize and simplify the international tax provisions of the U.S. tax laws. For that reason alone, if not for others, this effort by

the Subcommittee, which focuses the spotlight on U.S. international tax policy, is

valuable and should be applauded.

The NFTC is concerned that the current and previous Administrations, as well

as previous Congresses, have often turned to the international provisions of the Internal Revenue Code to find revenues to fund domestic priorities, in spite of the pernicious effects of such changes on the competitiveness of United States businesses

in world markets. The Council is further concerned that such initiatives may have

resulted in satisfaction of other short-term goals to the serious detriment of longerterm growth of the U.S. economy and U.S. jobs through foreign trade policies long

consistent in both Republican and Democratic Administrations, including the

present one.

The provisions of Subchapter N of the Internal Revenue Code of 1986 (Title 26

of the United States Code is hereafter referred to as the ‘‘Code’’) impose rules on

the operations of American business operating in the international context that are

much different in important respects than those imposed by many other nations

upon their companies. Some of these differences, noted in the sections that follow,

make American business interests less competitive in foreign markets when compared to those from our most significant trading partners:

• The United States taxes worldwide income of its citizens and corporations who

do business and derive income outside the territorial limits of the United States. Although other important trading countries also tax the worldwide income of their nationals and companies doing business outside their territories, such systems generally are less complex and provide for ‘‘deferral’’ 1 subject to less significant limitaVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00013 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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a dividend. However, subpart F of the Code alters these general rules to accelerate the imposition of U.S. tax with respect to various categories of income earned by CFCs.

It is common usage in international tax circles to refer to the normal treatment of CFC income as ‘‘deferral’’ of U.S. tax, and to refer to the operation of subpart F as ‘‘denying the benefit

of deferral.’’ However, given the general jurisdictional principles that underlie the operation of

the U.S. rules, we view that usage as somewhat inaccurate, since it could be read to imply that

U.S. tax ‘‘should’’ have been imposed currently in some normative sense. Given that the normative rule imposes no U.S. tax on the foreign income of a foreign person, we believe that subpart F can more accurately be referred to as ‘‘accelerating’’ a tax that would not be imposed

until a later date under normal rules.

tions under their tax statutes or treaties than their U.S. counterparts. Importantly,

many of our trading partners have systems that more closely approximate ‘‘territorial’’ systems of taxation, in which generally only income sourced in the jurisdiction is taxed. • The United States has more complex rules for the limitation of ‘‘deferral’’ than

any other major industrialized country. In particular, we have determined that: (1)

the economic policy justification for the current structure of subpart F has been substantially eroded by the growth of a global economy; (2) the breadth of subpart F

exceeds the international norms for such rules, adversely affecting the competitiveness of U.S.-based companies; and (3) the application of subpart F to various categories of income that arise in the course of active foreign business operations

should be substantially narrowed. • The U.S. foreign tax credit system is very complex, particularly in the computation of limitations under the provisions of section 904 of the Code. While the

theoretic purity of the computations may be debatable, the significant administrative costs of applying and enforcing the rules by taxpayers and the government is

not. Systems imposed by other countries are in all cases less complex. • The United States has more complex rules for the determination of U.S. and

foreign source net income than any other major industrialized country. In particular, this is true with respect to the detailed rules for the allocation and apportionment of deductions and expenses. In many cases, these rules are in conflict with

those of other countries, and where this conflict occurs, there is significant risk of

double taxation. We further address one of the more significant anomalies, that of

the allocation and apportionment of interest expense, later in this testimony. • The current U.S. Alternative Minimum Tax (AMT) system imposes numerous

rules on U.S. taxpayers that seriously impede the competitiveness of U.S. based

companies. For example, the U.S. AMT provides a cost recovery system that is inferior to that enjoyed by companies investing in our major competitor countries; additionally, the current AMT 90-percent limitation on foreign tax credit utilization imposes an unfair double tax on profits earned by U.S. multinational companies—in

some cases resulting in a U.S. tax on income that has been taxed in a foreign jurisdiction at a higher rate than the U.S. tax.

As noted above, the United States system for the taxation of the foreign business

of its citizens and companies is more complex than that of any of our trading partners, and perhaps more complex than that of any other country.

That result is not without some merit. The United States has long believed in the

rule of law and the self-assessment of taxes, and some of the complexity of its income tax results from efforts to more clearly define the law in order for its citizens

and companies to apply it. Other countries may rely to a greater degree on government assessment and negotiation between taxpayer and government—traits which

may lead to more government intervention in the affairs of its citizens, less even

and fair application of the law among all affected citizens and companies, and less

certainty and predictability of results in a given transaction. In some other cases,

the complexity of the U.S. system may simply be ahead of development along similar lines in other countries—many other countries have adopted an income tax similar to that of the United States, and a number of these systems have eventually

adopted one or more of the significant features of the U.S. system of taxing

transnational transactions: taxation of foreign income, anti-deferral regimes, foreign

tax credits, and so on. However, after careful inspection and study, we have concluded that the United States system for taxation of foreign income of its citizens

and corporations is far more complex and burdensome than that of all other significant trading nations, and far more complex and burdensome than what is necessitated by appropriate tax policy.

U.S. government officials have increasingly criticized suggestions that U.S. taxation of international business be ameliorated and infused with common sense consideration of the ability of U.S. firms to compete abroad. Their criticism either directly or implicitly accuses proponents of such policies of advocating an unwarranted

reaction to ‘‘harmful tax competition,’’ by joining a ‘‘race to the bottom.’’ The idea,

11

2See Marsha Blumenthal and Joel B. Slemrod, ‘‘The Compliance Cost of Taxing ForeignSource Income: Its Magnitude, Determinants, and Policy Implications,’’ in National Tax Policy

in an International Economy: Summary of Conference Papers, (International Tax Policy Forum:

Washington, D.C., 1994). 3 Id.

of course, is that any deviation from the U.S. model indicates that the government

concerned has yielded to powerful business interests and has enacted tax laws that

are intended to provide its home-country based multinationals a competitive advantage. It is seldom, if ever, acknowledged that the less stringent rules of other countries might reflect a more reasonable balance of the rival policy concerns of neutrality and competitiveness. U.S. officials seem to infer from the comparisons that

what is being advocated is that the United States should adopt the lowest common

denominator so as to provide U.S. businesses a competitive advantage. Officials contend this is a ‘‘slippery slope’’ since foreign governments will respond with further

relaxations until each jurisdiction has reached the ‘‘bottom.’’

The inference is unwarranted. Let us look at our subpart F regime, for example.

The regimes enacted by other countries that we have studied all were enacted in

response to, and after several years of, scrutiny of the United States’ regimes. They

reflect a careful study of the impact of our rules in subpart F, and, in every case,

embody some substantial refinements of the U.S. rules. Each regime has been in

place for a number of years, giving the government concerned time to study its operation and conclude whether the regime is either too harsh or too liberal. While each

jurisdiction has approached CFC issues somewhat differently, as noted, each has

adopted a regime that, in at least some important respects, is less harsh than the

United States’ subpart F rules. The proper inference to draw from the comparison

is that the United States has tried to lead and, while many have followed, none has

followed as far as the United States has gone. A relaxation of subpart F to even

the highest common denominator among other countries’ CFC regimes would help

redress the competitive imbalance created by subpart F without contributing to a

race to the bottom.

The reluctance of others to follow the U.S. may in part also be attributable to recognition that the U.S. system has required very significant compliance costs of both

taxpayer and the Internal Revenue Service, particularly in the international area

where the costs of compliance burdens are disproportionately higher relative to U.S.

taxation of domestic income and to the taxation of international income by other

countries.

There is ample anecdotal evidence that the United States’ system of taxing the foreign-source income of its resident multinationals is extraordinarily complex, causing the companies considerable cost to comply with

the system, complicating long-range planning decisions, reducing the accuracy of the information transmitted to the Internal Revenue Service (IRS),

and even endangering the competitive position of U.S.-based multinational

enterprises.2

Many foreign companies do not appear to face the same level of costs in their operations. The European Community Ruding Committee survey of 965 European

firms found no evidence that compliance costs were higher for foreign source income

than for domestic source income.3 Lower compliance costs and simpler systems that

often produce a more favorable result in a given situation are competitive advantages afforded these foreign firms relative to their U.S.-based counterparts.

In the 1960s, the United States completely dominated the global economy, accounting for over 50% of worldwide cross-border investment and 40% of worldwide

GDP. As of the mid-1990s, the U.S. economy accounted for about 25% of the world’s

foreign direct investment and GDP.

The current picture is very different. U.S. companies now face strong competition

at home. Since 1980, the stock of foreign direct investment in the United States has

increased by a factor of 6, and $20 of every $100 of direct cross-border investment

flows into the United States. Foreign companies own approximately 14% of all U.S.

non-bank corporate assets, and over 27% of the U.S. chemical industry alone. Moreover, imports have tripled as a share of GDP in the 1960s to an average of over

9.6% over the 1990–1997 period.

That the world economy has grown more rapidly that the U.S. economy over the

last 3 decades represents an opportunity for U.S. companies and workers that are

able to participate in these markets. Foreign markets now frequently offer greater

growth opportunities to U.S. companies than the domestic market. In the 1960s, foreign operations averaged just 7.5% of U.S. corporate net income; by contrast, over

the 1990–1997 period, foreign earnings represented 17.7 percent of all U.S. corporate income. A recent study of the 500 largest publicly-traded U.S. corporations

12

4See, Ch. 6, The NFTC Foreign Income Project: International Tax Policy for the 21st Century,

March 25, 1999. 5OECD, Taxing Profits in a Global Economy: Domestic and International Issues (1991). 6See, e.g., testimony before the Committee on Finance, U.S. Senate, March 11, 1999.

finds that sales by foreign subsidiaries increased from 25 % of worldwide sales in

1985 to 34% in 1997. From 1986 to 1997, foreign sales of these companies grew 10%

a year, compared to domestic growth of just 3% annually. In fact, many of our members tell us that foreign sales now account for more than 50% of their revenue and

their profits.

However, this growth in foreign markets is much more competitive that in earlier

decades. The 21,000 foreign affiliates of U.S. multinationals now compete with about

260,000 foreign affiliates of multinationals headquartered in other nations. Over the

last three decades, the U.S. share of the world’s export market has declined. In

1960, one of every $6 of world exports originated from the United States. By 1996,

the United States supplied only one of every $9 of world export sales. Despite a 30%

loss in world export market share, the U.S. economy depends on exports to a much

greater degree. The share of our national income attributable to exports has more

than doubled since the 1960s.

Foreign subsidiaries of U.S. companies play a critical role in boosting U.S. exports—by marketing, distributing, and finishing U.S. products in foreign markets.

In 1996, U.S. multinational companies were involved in 65% of all U.S. merchandise

export sales. U.S. industries with a high percentage of investment abroad are the

same industries that export a large percentage of domestic production. And studies

have shown that these exports support higher wages in exporting companies in the

United States.4

Taking into account individual as well as corporate-level taxes, a report by the

Organization for Economic Cooperation and Development (OECD) finds that the cost

of capital for both domestic (8.0 percent) and foreign investment (8.8 percent) by

U.S.-based companies is significantly higher than the averages for the other G–7

countries (7.2 percent domestic and 8.0 percent foreign). The United States and

Japan are tied as the least competitive G–7 countries for a multinational company

to locate its headquarters, taking into account taxation at both the individual and

corporate levels.5 These findings have an ominous quality, given the recent spate

of acquisitions of large U.S.-based companies by their foreign competitors.6 In fact,

of the world’s 20 largest companies (ranked by sales) in 1960, 18 were headquartered in the United States. By the mid-1990s, that number had dropped to 8.

Short of fundamental reform—a reform in which the United States federal income

tax system is eliminated in favor of some other sort of system—there are many aspects of the current system that could be reformed and greatly improved. These reforms could significantly lower the cost of capital, the cost of administration, and

therefore the cost of doing business for U.S.-based firms.

In this regard, for example, the NFTC strongly supports the International Tax

Simplification for American Competitiveness Act of 1999, H.R. 2018, recently introduced by you Mr. Chairman, and Mr. Levin, and Mr. Sam Johnson, and joined by

four other Members: Mr. Crane, Mr. Herger, Mr. English, and Mr. Matsui. We congratulate you on your efforts to make these amendments. They address important

concerns of our companies in their efforts to export American products and create

jobs for American workers.

Against this background, the NFTC would also like to elaborate on some of the

provisions in H.R. 2018 in areas that illustrate problems with significant impact on

our members, as well as others that are under consideration in pending legislation

yet to be introduced.

LOOK THROUGH FOR 10/50 COMPANIES

The 1997 Tax Act no longer requires U.S. companies operating joint ventures

(‘‘JVs’’) in foreign countries to calculate separate foreign tax credit (‘‘FTC’’) limitations for income earned from each JV in which the U.S. owner holds at least 10 percent, but no more than 50 percent, of the JV ownership. The 1997 Tax Act now allows U.S. owners to compute FTCs with respect to dividends from such entities

based on the underlying character of the entities’ income (i.e., ‘‘look-through’’ treatment). However, the change is only effective for dividends received after the year

2002. A separate ‘‘Super’’ FTC basket is still required to be maintained for dividends

received after 2002 but attributable to earnings and profits of the JV from years

before 2003.

As stated by the Clinton Administration in its budget proposals issued earlier this

year, the concurrent application of both a single basket approach for pre-2003 earnVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00016 Fmt 6633 Sfmt 6621 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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ings and a look-through approach for post-2002 earnings would result in significant

complexity to taxpayers. Thus, Section 208 of your bill would offer much needed

simplicity for foreign JVs by eliminating the ‘‘Super’’ FTC basket and accelerating

the effective date for application of the ‘‘look-through’’ rules to all dividends received

after 1999, regardless of when the earnings and profits underlying those dividends

were generated. As stated earlier by Treasury, this reduction in complexity and

compliance burdens will reduce the bias against U.S. participation in foreign JVs,

and help U.S.-based companies to compete more effectively with foreign-based JV

partners.

LOOK-THROUGH TREATMENT FOR INTEREST, RENTS, AND ROYALTIES

As just mentioned, the 1997 Tax Act extended look-through treatment to certain

dividends received from 10/50 Companies after the year 2002, but it failed to extend

look-through treatment to interest, rents, and royalties from these same foreign JVs.

U.S. shareholders of foreign JVs are often unable (due either to government restrictions or business practices) to acquire controlling interests, especially in cases where

the foreign JV partner is a foreign government, or the activity involved in is a government regulated industry. It is patently unfair to penalize such non-controlling

JV partners. Thus, Section 205 of your bill extends look-through treatment to interest, rents, and royalties received from foreign JVs after this year.

Current tax rules also require that payments of interest, rents, and royalties from

noncontrolled foreign partnerships (i.e., foreign partnerships owned between 10 and

50 percent by U.S. owners) must be treated as separate basket income to the JV

partners. Again, this result is not good tax policy. Thus, your bill extends lookthrough treatment to these entities as well. Such legislative action would bring

much needed consistency and fairness to this area of the tax law, by allowing lookthrough treatment to all forms of income streams, and to all forms of business enterprises.

LOOK-THROUGH TREATMENT FOR SALES OF PARTNERSHIP INTERESTS

Currently, gains from sales of partnership interests are also treated as separate

basket passive income, even though U.S. partners owning 10 percent or more of the

value of foreign partnerships can apply look-through treatment for their distributive

shares of such partnership income (although not interest, rents or royalties as stated before). Consistent with our earlier comments concerning look-through treatment

in general, we support your provision in Section 107, which treats gains or losses

associated with the disposition of a partnership interest as a disposition of the partner’s proportionate share of each of the assets of the partnership.

AMEND THE DOMESTIC LOSS RECAPTURE RULE

Currently, when a taxpayer has taxable income from U.S. sources but an overall

loss from foreign sources, the foreign source loss reduces the U.S. source taxable income and U.S. tax liability by decreasing the taxpayer’s worldwide taxable income

on which the U.S. tax is based. When the taxpayer subsequently generates foreign

source income, the prior tax benefit is recaptured by treating a portion of that foreign income as domestic source for purposes of determining the FTC limitation. Current law also provides that an overall domestic loss reduces a taxpayer’s foreign

source income. The U.S. loss reduces the taxpayer’s U.S. tax liability and, through

application of the loss against foreign income, the FTC limitation is correspondingly

reduced. There is no symmetry in these rules, however, in the case where it is a

domestic loss that is incurred. In contrast to the foreign provisions, taxpayers are

not allowed to recover or recapture foreign source income that was lost due to a domestic loss. To prevent this inequity and remove this anomaly, Section 202 of your

bill would recharacterize such subsequent domestic income as foreign source to the

extent of the prior domestic loss, and therefore allow the FTC that was disallowed

because of the domestic loss.

SUBPART F EXEMPTION FOR ACTIVE FINANCING INCOME

We also applaud Section 101 of your bill, which extends the one-year provision

enacted last year providing deferral of U.S. tax on non-U.S. income earned in the

active conduct of a banking, financial, or similar business. This provision, particularly if made permanent, would significantly assist U.S. based financial service companies to compete successfully in the international marketplace against foreign

based companies. It would also bring some consistency in the U.S. tax rules by

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treating active income earned by financial service companies similarly to active income earned by U.S. companies in other industries.

Let us underscore the importance of this provision—U.S. banks and financial companies have historically expanded abroad hand-in-hand with U.S. industrial and

service companies. They have, however, become an endangered species, as now only

two (2) are ranked in the top twenty-five (25) financial services companies in the

world, ranked by asset size (Citigroup and Chase Manhattan Corporation). Recent

acquisitions of U.S.-based companies, such as Bankers Trust and Republic Bank, as

well as growth in foreign-based companies have changed the global landscape beyond recognition.

REPEAL THE ALTERNATIVE MINIMUM TAX 90 PERCENT LIMITATION ON FOREIGN

TAX CREDITS

Current law limits the ability of taxpayers to offset their corporate AMT liability

by only allowing FTCs to offset up to 90 percent of such AMT. This has the likely

result of taxing certain U.S. multinationals more heavily on their foreign income

than their foreign competitors, or other domestic companies that have no foreign operations. Section 207 of your bill repeals this limitation and merely permits foreign

taxes actually paid to be offset up to the amount of AMT liability on foreign source

income, without affecting any U.S. source tax liability. As a result, the likelihood

of double and sometimes triple taxation of foreign source income would be lessened,

making U.S. multinationals more competitive internationally.

RESTRICT APPLICATION OF EXCISE TAX TO AIRLINE MILEAGE AWARDS

The 1997 Tax Act imposed a 7.5 percent aviation excise tax on amounts paid to

air carriers for the right to provide mileage awards (or other cost reductions) for air

transportation. However, that legislation failed to specify the geographical or transactional scope of the excise tax, and has caused significant problems in the tourism

industry and complaints from other governments. Your Section 307 would clarify

that the excise tax does not apply to certain payments for the right to provide mileage awards predominantly to foreign persons (who are outside the taxing arm of the

U.S. government).

REMOVE PIPELINE TRANSPORTATION INCOME AND INCOME FROM TRANSMISSION OF

HIGH VOLTAGE ELECTRICITY FROM SUBPART F TREATMENT

In 1982, Congress expanded subpart F income to include certain types of oil related income, such as income from operating an oil or gas pipeline in a country

other than where the oil or gas was extracted or sold. The expansion of subpart F

was due to a concern that petroleum companies had been paying too little U.S. tax

on their foreign subsidiaries’ operations relative to their high revenue. Specifically,

Congress thought that U.S. tax could be avoided on the downstream activities of a

foreign subsidiary because the income of the subsidiary was not subject to U.S. tax

until that income was paid to its shareholders. The argument was that because of

the fungible nature of oil and because of the complex structures involved, oil income

was particularly suited to tax haven type operations.

However, this treatment is contrary to the original intent of subpart F, which primarily was aimed at passive and other easily movable income, rather than active

income. Pipeline income, on the other hand, is neither passive nor easily movable.

Moreover, no other major industrial country has special rules that sweep pipeline

income into its anti-deferral regime. Consequently, U.S. companies find it difficult

to compete with foreign-based multinationals for pipeline projects that would generate income subject to subpart F. Therefore, we applaud Section 105 of your bill,

which would no longer treat as subpart F income, any income derived from the pipeline transportation of oil or gas within a foreign country.

Similarly, Section 106 of your bill would allow U.S.-based utility companies to

enter foreign markets for electricity. These complex projects often involve the construction of costly fixed transmission systems that in some cases cross national

boundaries. This income is also neither passive nor easily movable. Imposition of

subpart F treatment on them is not justifiable, and is counterproductive to the interests of the United States.

EXTENSION OF CARRYFORWARD PERIOD AND ORDERING RULES FOR FOREIGN TAX

CREDIT CARRYOVERS

When companies invest overseas, they often receive favorable local tax treatment

from foreign governments, at least in the early years of operation. For example,

15

companies are sometimes granted rapid depreciation write-offs, and/or low or even

zero tax rates, for a period of years until the new venture is up and running. This

results in a low effective tax rate in those foreign countries for those early years

of operation. For U.S. tax purposes, however, those foreign operations must utilize

much slower capital recovery methods and rates, and are still subject to residual

U.S. tax at 35 percent. Thus, even though those foreign operations may show very

little profit from a local standpoint, they may owe high incremental taxes to the

U.S. government on repatriations or deemed distributions to the U.S. parent. However, once such operations are ongoing for some length of time, this tax disparity

often turns around, with local tax obligations exceeding residual U.S. taxes. At that

point, the foreign operations generate excess FTCs but, without an adequate

carryback and carryforward period, those excess FTCs will expire.

The U.S. tax system is based on the premise that FTCs help alleviate double taxation of foreign source income. By granting taxpayers a dollar-for-dollar credit

against their U.S. liability for taxes paid to local foreign governments, the U.S. government allows its taxpayers to compete more fairly and effectively in the international arena. However, by imposing limits on carryovers of excess FTCs, the value

of these FTCs diminish considerably (if not entirely in many situations). Thus, the

threat of double taxation of foreign earnings becomes much more likely.

Sections 201 and 206 of your bill extend the carryover period, and useful life, respectively, of FTCs. Section 201 extends the carryover period from 5 to 10 years,

while Section 206 allows old carryovers to be utilized first, which results in a ‘‘freshening’’ of unexpired FTCs. Both of these provisions would help reduce the costs of

doing business overseas for U.S. multinationals, and help eliminate competitive disadvantages suffered by U.S.-based companies versus foreign-based companies.

Please keep in mind that higher business taxes for U.S. companies may result in

higher prices for goods and services sold to U.S. consumers, stagnant or lower wages

paid to American workers in those businesses, reduced capital investment leading,

perhaps, to work force reductions or decreased benefits, and smaller returns to

shareholders. Those shareholders may be the company’s employees, or the pension

plans of other middle class workers.

We also note that the President’s Fiscal Year 1998 Budget contained a proposal

to reduce the carryback period for excess foreign tax credits from two years to one

year. This proposal has been and is currently being considered in the Senate as a

revenue raiser for one or more pending bills. The NFTC strongly opposes this proposal. Like the carryforward period, the carryback of foreign tax credits helps to ensure that foreign taxes will be available to offset U.S. taxes on the income in the

year in which the income is recognized for U.S. purposes. Shortening the carryback

period also could have the effect of reducing the present value of foreign tax credits

and therefore increasing the effective tax rate on foreign source income.

REPEAL OF CODE SECTION 907

Under current law, in additional to having to calculate separate foreign tax credit

(‘‘FTC’’) limitations for income earned from each separate category or ‘‘basket’’ under

section 904(d) (e.g., the passive income basket, shipping income basket, etc.), multinational oil companies are also required to calculate a separate limitation on their

foreign oil and gas extraction income (‘‘FOGEI’’) under Code Section 907. Section

208 of your bill would repeal Code Section 907 and, thus, eliminate the additional

separate limitation on FOGEI.

As background, Section 907 was originally enacted in response to a Congressional

concern that oil industry taxpayers were paying amounts to foreign governments

that were ostensibly ‘‘taxes’’ but were in reality ‘‘disguised royalties.’’ The issue

arose from the fact that in foreign countries, the sovereign usually retains the right

to its natural resources in the ground. Thus, a major concern was whether payments

made to foreign governments were for grants of specific economic benefits or general

taxes. Congress wanted to limit the FTC to that amount of the ‘‘government take’’

which was perceived to be a tax payment, and not a royalty. Moreover, once the tax

component was identified, Congress wanted to prevent oil companies from using excess FOGEI credits to shield U.S. tax on certain low-taxed ‘‘other’’ income, such as

passive income or shipping income.

However, both concerns have already been adequately addressed in subsequent

legislation or rulemaking. First, under Treasury Decision 7918, so-called ‘‘dual capacity taxpayer’’ regulations were issued which help taxpayers to determine how to

separate payments to foreign governments into their income tax element and ‘‘specific economic benefit’’ element. Second, the 1986 Tax Act fragmented foreign source

income into various FTC ‘‘baskets,’’ restricting taxpayers from offsetting excess

16

FTCs from high-taxed income, including FOGEI, against taxes due on low-taxed categories of income, such as passive or shipping income.

We emphasize that compliance with the rules under Code § 907 is extremely complicated and time consuming for both taxpayers and the IRS. Distinctions must be

made as to various items of income and expense to determine whether they properly

fall under the FOGEI category, or the FORI (or other) category. Painstaking efforts

are often needed to categorize and properly account for thousands of income and expense items, which must then be explained to IRS agents upon audit. Ironically,

such efforts typically result in no or little net tax liability changes, since U.S.-based

oil companies have, since the inception of section 907, had excess FTCs in their

FORI income category. As a result, oil industry taxpayers, which already must deal

with depressed world oil prices, also must incur large administrative costs to comply

with a section of the Income Tax Code that results in little or no revenue to the

Federal Treasury.

Current Section 907 clearly increases the cost for U.S. companies of participating

in foreign oil and gas development. Ultimately, this will adversely affect U.S. employment by hindering U.S. companies in their competition with foreign concerns.

Although the host country resource will be developed, it will be done so by foreign

competition, with the adverse ripple effect of U.S. job losses and the loss of continuing evolution of U.S. technology. The loss of any major foreign project to a U.S.

company will mean less employment in the U.S. by suppliers, and by the U.S. parent, in addition to fewer U.S. expatriates at foreign locations. By contrast, foreign

oil and gas development by U.S. companies assures utilization of U.S. supplies of

hardware and technology, ultimately resulting in increased U.S. job opportunities.

EXTENSION OF FSC BENEFITS TO EXPORTS OF DEFENSE PRODUCTS

Code Section 923(a)(5) reduces the tax exemption available to companies that sell

defense products abroad to 50 percent of the benefits available to other exporters.

This provision prevents defense companies from competing as effectively as they

could in increasingly challenging foreign markets.

Any U.S. exporter may establish Foreign Sales Corporations (FSCs) under which

a portion of their earnings from foreign sales is exempt from U.S. taxation. This provision is designed to achieve tax parity with the territorial tax systems of our trading partners, i.e., it mirrors the economic effects of European Union tax systems on

their exported products, for example.

For exporters of defense products, however, the FSC tax incentive is reduced by

50 percent, compared to the full benefit for all other products. That limitation, enacted in 1976, was based on the premise that military products were not sold in

a competitive market environment and the FSC benefit was therefore not necessary

for defense exporters.

Whatever the veracity of that premise 20 years ago, today military exports are

subject to fierce international competition in every area. Moreover, with the sharp

decline in the defense budget over the past decade, exports of defense products have

become ever more critical to maintaining a viable U.S. defense industrial base. The

aerospace industry alone provides over 800,000 jobs for U.S. workers. Roughly onethird of these jobs are tied directly to export sales. In 1996, for example, total industry sales were $112 billion, $37 billion of which was for exports.

Maintaining exports of defense products is today more difficult than ever before.

First, the U.S. government prohibits the sale of defense products to certain countries and must approve all others in advance. Second, European and other states

are developing export promotion projects to counter the industrial impact of their

own declining defense budgets by being more competitive internationally. Finally,

a number of Western purchasers of defense equipment now view Russia and other

formerly communist countries as acceptable suppliers, further intensifying the global competition.

No valid economic or policy reason exists for continuing a tax policy that discriminates against a particular class of manufactured products. Furthermore, repealing

this section will not impact the foreign policy of the United States. Military sales

will continue to be subject to the license requirements of the Arms Export Control

Act.

An egregious example of how these rules discriminate against certain products involves commercial communications satellites. U.S. manufacturers are the world’s

leaders in the production and deployment of communications satellites. Until this

year, commercial communications satellites manufactured in the United States

qualified for full FSC benefits. For export control purposes, the Strom Thurmond

National Defense Authorization Act for Fiscal Year 1999 transferred jurisdiction

over commercial satellite exports from the Commerce Department Commerce ConVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00020 Fmt 6633 Sfmt 6621 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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trol List (CCL) to the State Department U.S. Munitions List (USML), effective

March 15, 1999. An unintended result of this jurisdictional change is that commercial communications satellites and related items are now ‘‘military property’’ for purposes of the FSC rules. This unintended result should be corrected and the full FSC

benefit for commercial communications satellites should be restored. In fact, the

House of Representatives Select Committee on Technology Transfers to the Peoples

Republic of China, chaired by Representative Christopher Cox, recommended that

satellite manufacturers should not suffer a tax increase because of the transfer from

CCL to USML.

Improvement of the U.S. trade imbalance is fundamental to the health of our

economy. The benefits provided by the FSC provisions contribute significantly to the

ability of U.S. exporters to compete effectively in foreign markets. The FSC limitation on the exemption for defense exports hampers the ability of U.S. companies,

many of whom already have access to large foreign markets, to compete effectively

abroad with many of their products. Section 923(a)(5) should be repealed immediately to remove this impediment to the international competitiveness and to the

future health of our defense industry.

Section 303 of your bill, Mr. Chairman, and an identical provision included in a

stand-alone bill, H.R. 796, would remedy this situation. H.R. 796 currently has 54

cosponsors, including 28 of the 39 members of the Committee.

In addition to these areas of concern that have been addressed in your bill, as

noted above we have significant concerns in another area that we would like to address.

ALLOCATION OF INTEREST EXPENSE

Prior to January 3, 1977, when Treasury issued its final Regulation § 1.861–8,

there essentially was no requirement to allocate and apportion U.S. interest expense

to foreign-sourced income. Moreover, even under these 1977 regulations, opportunities were available to minimize the impact of interest allocation. For example, interest could be allocated on a separate company basis. Thus, corporate structures could

be organized so that U.S. debt could be carried only by companies in an affiliated

group that had domestic source income, eliminating any allocation of interest to foreign sourced income.

The 1986 Tax Reform Act required that allocation of interest now be made on a

consolidated group basis. It also eliminated the optional gross income method for allocating interest, and required that earnings and profits of more than ten percent

owned subsidiaries be added to their stock bases for purposes of allocating interest

under the asset-tax basis method. Also in 1986, while advancing the concept of

‘‘fungibility,’’ Congress nevertheless failed to allow an offset for interest expense incurred by foreign affiliates. Although such a ‘‘worldwide fungibility’’ provision was

included in the Senate-passed version of the bill in 1986, it was dropped in Conference. Similarly, a subgroup/tracing exception approved by the Senate was also

dropped from the final 1986 Act. While these fungibility and subgroup/tracing provisions have appeared in later tax bills (see e.g., H.R. 2948 (‘‘Gradison Bill’’) introduced in 1991 and H.R. 5270 (‘‘Rostenkowski Bill’’) introduced in 1992), they have

never been enacted.

The NFTC strongly suggests that Congress fix the inequitable interest allocation

rules currently existing in the law. They are extremely costly and particularly anticompetitive for multinational corporations. By failing to take into account borrowings of foreign affiliates, the law results in a double allocation of interest expense. Moreover, these rules operate to impede a U.S. multinational corporation’s

ability to utilize the foreign tax credit for purposes of mitigating double taxation.

It is simply unfair that U.S. multinationals with U.S. subsidiaries operating solely

in the U.S. market, where the subsidiary incurs its debt on the basis of its own credit, must nevertheless allocate part of that interest expense against wholly unrelated

foreign generated income.

One solution, of course, is simply to reinstate and codify the pre–1986 Act interest

allocation rules permitting interest expense to be allocated on a separate company

basis. However, due to the strong criticism of the rules in 1986, this approach is

unlikely to succeed. We, therefore, suggest an alternative approach of advancing the

provisions that were passed by the Senate in connection with the 1986 Act. Recall

that under the earlier Senate version, interest expense of foreign affiliates would

be added to the total interest expense ‘‘pot’’ to be allocated among all affiliates.

Thus, this approach allows adoption of the ‘‘worldwide fungibility’’ concept of allocating interest, as opposed to the ‘‘water’s edge’’ approach of current law. We also

suggest the inclusion of an elective ‘‘subgroup’’ or tracing rule that allows interest

expense to be allocated based on a subgroup consisting of only the borrower and its

18

direct and indirect subsidiaries. This approach allows interest that should be specifically allocated to a particular domestic operation to remain identified with such operation, a much more equitable approach than under current law.

IN CONCLUSION

In particular, our study of the international tax system of the United States has

led us so far to four broad conclusions:

• U.S.-based companies are now far less dominant in global markets, and hence

more adversely affected by the competitive disadvantage of incurring current homecountry taxes with respect to income that, in the hands of a non-U.S. based competitor, is subject only to local taxation; and

• U.S.-based companies are more dependent on global markets for a significant

share of their sales and profits, and hence have plentiful non-tax reasons for establishing foreign operations.

• Changes in U.S. tax law in recent decades have on balance increased the taxation of foreign income.

• United States policy in regard to trade matters has been broadly expansionist

for many years, but its tax policy has not followed suit.

These two incompatible trends—decreasing U.S. dominance in global markets set

against increasing U.S. taxation of foreign income—are not claimed by us to have

any necessary causal relation. However, they strongly suggest that we must reevaluate the balance of policies that underlie our international tax system.

Again, the Council applauds the Chairman and the Members of the Subcommittee

for beginning the process of reexamining the international tax system of the United

States. These tax provisions significantly affect the national welfare, and we believe

the Congress should undertake careful modification of them in ways that will enhance the participation of the United States in the global economy of the 21st Century. We would enjoy the opportunity to work with you and the Committee in further defining both the problems and potential solutions. The NFTC would hope to

make a contribution to this important business of the Subcommittee. The NFTC is

prepared to make recommendations for broader reforms of the Code to address the

anomalies and problems noted in our review of the U.S. international tax system,

and would enjoy the opportunity to do so.

19

20

Chairman HOUGHTON. Thanks very much, Mr. Luby.

Before we go on, I want to introduce Mr. Wes Watkins, Congressman from Oklahoma. We are delighted you are here, Mr. Watkins.

And, then, Mr. Lester Ezrati, would you please testify?

STATEMENT OF LESTER D. EZRATI, GENERAL TAX COUNSEL,

HEWLETT-PACKARD COMPANY, PALO ALTO, CALIFORNIA,

AND PRESIDENT, TAX EXECUTIVES INSTITUTE, INC.

Mr. EZRATI. Thank you, Mr. Chairman. I am general tax counsel

for Hewlett-Packard Company in Palo Alto, California. I am here

today as president of Tax Executives Institute, the preeminent

group of in-house tax professionals in North America. Our 5,000

members represent the 2,700 largest corporations in the United

States and Canada, most of which have significant operations overseas.

TEI believes that the Code’s foreign provisions need fundamental

reform and simplification, and for this reason, we support H.R.

2018. Enactment of this bill will generally reduce the cost of complying with the laws without any material diminution in tax dollars flowing to the Treasury. The bill will not only reduce administrative burdens, thereby enhancing the country’s competitiveness,

but will also signal Congress’s commitment to the simplification of

the tax law generally. In addition, the bill will bring overdue reform to the foreign tax credit area where taxpayers have been especially burdened.

Mr. Chairman, the proposals in H.R. 2018 have been described

as modest. It marks a beginning, not an end. For example, in the

more than three decades since their enactment, the Subpart F

rules have been distended to capture more and more active operating income. Reform is needed here. One solution is to remove

Subpart F’s artificial barriers to competitiveness by excluding foreign-based companies’ sales and services income from current taxation and allowing U.S. corporations to compete more effectively.

Other areas to be addressed are the translation of the deemed-paid

foreign tax credit rule under section 906 and the elimination of the

current interest allocation rules. These comments notwithstanding,

we agree with you, Mr. Chairman, that the bill represents a significant downpayment on further reform.

I would now like to highlight two provisions in H.R. 2018 that

we believe are particularly important for the reform of international tax laws.

First, TEI believes that taxpayers should be permitted to use

generally accepted accounting principles to calculate the earnings

and profits of controlled foreign corporations under Subpart F. Current law provides that a foreign corporation’s earnings and profits

is to be computed in accordance with rules substantially similar to

those for domestic corporations. As a practical matter, however, a

foreign corporation is frequently unable to compute E&P in the

same manner as a domestic corporation. Although a domestic corporation generally calculates E&P by making adjustments to U.S.

taxable income, a foreign corporation necessarily uses foreign book

income as its starting point. This bill will provide significant simVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00024 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
21

plification by permitting taxpayers to reduce their administrative

burdens by using United States’ generally accepted accounting

principles (GAAP) to compute E&P. In our view, however, the provision should be elective, not mandatory.

Second, TEI applauds section 207, which would eliminate the 90-

percent limitation on the use of the foreign tax credit to offset any

alternative minimum tax liability. Giving taxpayers the ability to

offset their entire liability with their foreign taxes will not frustrate the policy underlying the AMT and will further the goal of

eliminating double taxation. A taxpayer with an AMT liability and

sufficient foreign tax credits to offset that liability, has already

paid a significant amount of tax. Clearly, that the tax has not been

paid to the United States has no bearing on the economic cost it

represents to the taxpayer. We therefore support the enactment of

this provision.

H.R. 2018 would also mandate two Treasury Department studies:

one on the treatment of the European Union as a single country

for purposes of the same-country exception to Subpart F and a second on the interest allocation rules. We commend the Chairman for

recognizing that the European Community’s elimination of barriers

to cross-borders payments places U.S. corporations at a disadvantage. We suggest, however, that companies need relief now in order

to remain competitive and urge Congress to consider the immediate

adoption of this proposal.

As for the interest allocation rules, we agree that they desperately need reform. In our view, the rules are not justified on

economic grounds.

Finally, I would like to address an issue not included in H.R.

2018—confidentiality of advance pricing agreements. Mr. Chairman, you recently voiced support for legislation to protect APAs

from disclosure. As businesses become more global, it will become

increasingly important for governments and taxpayers to work together to resolve disputes in creative, cost-effective ways, such as

the APA Program. TEI strongly believes that any compromise of

taxpayer confidentiality will have a negative effect on the future of

this important program.

Information set forth in an APA is highly fact-specific and involves sensitive financial and commercial information. Taxpayers

submitted the pricing information to the IRS with the understanding that it would be kept confidential. That the IRS is preparing to disclose APAs threatens these companies’ legitimate privacy interests and has already begun to undermine our relations

with treaty partners and the future of the APA Program. For these

reasons, TEI strongly supports enactment of legislation to protect

APAs and supporting documents from disclosure.

Mr. Chairman, we commend you for recognizing that the international provisions are among the most complex provisions of the

Internal Revenue Code, and we pledge our support for your efforts

to effect meaningful simplification and reform.

Thank you for giving us the opportunity to testify, and I would

be pleased to respond to your questions.

[The prepared statement follows:]

22

Statement of Lester D. Ezrati, General Tax Council, Hewlett-Packard Company, Palo Alto, California, and President, Tax Executives Institute, Inc.

Good afternoon. I am Lester D. Ezrati, General Tax Counsel for Hewlett-Packard

Company in Palo Alto, California. I appear before you today as the president of Tax

Executives Institute, the preeminent group of corporate tax professionals in North

America. The Institute is pleased to provide the following comments on international complexity and simplification.

BACKGROUND

Tax Executives Institute is the preeminent association of corporate tax executives

in North America. Our 5,000 members are accountants, attorneys, and other business professionals who work for the largest 2,800 companies in the United States

and Canada; they are responsible for conducting the tax affairs of their companies

and ensuring their compliance with the tax laws. Hence, TEI members deal with

the tax code in all its complexity, as well as with the Internal Revenue Service, on

almost a daily basis. Most of the companies represented by our members are part

of the IRS’s Coordinated Examination Program, pursuant to which they are audited

on an ongoing basis. TEI is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the

tax laws, and to reducing the cost and burden of administration and compliance to

the benefit of taxpayers and government alike. Our background and experience enable us to bring a unique and, we believe, balanced perspective to the subject of

international complexity and simplification.

The international provisions of the Internal Revenue Code are among the most

complicated provisions in the tax law. The last several years have seen several

small steps taken to reduce tax law complexity for multinational corporations. For

example, three years ago, Congress repealed section 956A of the Internal Revenue

Code, which in our view was ill-conceived when it was enacted in 1993. And in 1997,

Congress rectified an inequity that has existed for the past decade when it eliminated the overlap between the controlled foreign corporation and passive foreign investment company rules. Although laudable, these actions represent only a small

step on the journey of simplifying the international tax provisions of the Internal

Revenue Code.

TEI believes that the Code’s foreign provisions need fundamental reform and simplification, and for this reason we support H.R. 2018, the International Tax Simplification for American Competitiveness Act of 1999, which was introduced on June

7, 1999, by Oversight Subcommittee Chairman Amo Houghton and several other

representatives. Enactment of this bill will generally reduce the costs of preparing

U.S. corporate tax returns for American companies engaged in international trade

without any material diminution in tax dollars flowing to the treasury. The bill will

not only reduce compliance costs—thereby enhancing the country’s competitiveness—but it will also signal Congress’s continued commitment to the simplification

of the tax law generally. In addition, the bill will bring long overdue, albeit partial,

reform to the foreign tax credit area.

Any simplification efforts will need to comprehend the changing face of the business environment, owing, among other things, to the growth of electronic commerce

and business technologies. As businesses become more global and as companies

strive to manage their supply chains digitally, the need for meaningful tax reform

will become more and more manifest. In addition, it will become increasingly important for governments and taxpayers to work together to resolve—or forestall—disputes in creative, cost-effective ways, such as advanced pricing agreements (APAs).

Accordingly, TEI is very pleased that Congressman Houghton and other members

have voiced support for preserving the confidentiality of APAs. TEI strongly believes

that any compromise of taxpayer confidentiality will have a negative effect on the

future of the APA program.

As Congressman Houghton noted in his introductory statement, H.R. 2018 seeks

reform ‘‘in modest but important ways.’’ We agree that, although a major leap forward, enactment of the bill will not obviate additional reform of the Code’s international tax provisions—for example, in respect of Subpart F, which Chairman

Houghton himself has singled out as an extremely complex area of the law. Subpart

F was initially enacted as an exception to the deferral principle in order to tax the

types of income considered relatively ‘‘movable’’ from one taxing jurisdiction to another and therefore able to take advantage of low rates of tax. In the three decades

since its enactment, however, Subpart F has been distended to capture active operating income. One solution to removing Subpart F’s artificial barrier to competitiveness would be to exclude foreign base sales and services income from current taxation, allowing U.S. corporations to compete more effectively on a level international

23

1The proposal in H.R. 2018 to treat the countries in the European Community as a single

country for purposes of the ‘‘same-country’’ exception to Subpart F would also effect some relief.

See the discussion of this provision at pages 7–8. 2 Regulations proposed in 1992 would eliminate the need to adjust financial statements prepared in accordance with GAAP, but only with respect to uniform capitalization and depreciation for purposes of computing a foreign corporation’s E&P. The proposed regulations do not address the computation of E&P for Subpart F purposes because the IRS and Treasury question

whether they have the authority to effect such a change by regulation.

playing field.1 Other areas that should be considered for simplification include the

translation of the deemed paid tax credit under section 986, the aggregation of dividends from noncontrolled section 902 corporations in one basket, and the elimination of the interest allocation rules. These comments notwithstanding, we agree

with Congressman Houghton and the other sponsors of H.R. 2018 that the bill represents a ‘‘down payment on further reform.’’

H.R. 2018: A GOOD START

I. Treatment of Controlled Foreign Corporations

A. Use of GAAP for E&P Calculations. The concept of ‘‘earnings and profits’’

(E&P) has relevance in the foreign tax area for several reasons. For example, E&P

is used in measuring the amount of Subpart F inclusions, the portion of a distribution from a foreign corporation that is taxable as a dividend, the amount of foreign

taxes deemed paid for purposes of the deemed-paid foreign tax credit, and the

amount of section 1248 gain taxable as a dividend.

The Code currently provides that the E&P of a foreign corporation is to be computed in accordance with rules substantially similar to those applicable to domestic

corporations. As a practical matter, however, a foreign corporation is frequently unable to compute E&P in the same manner as a domestic corporation. Although a

domestic corporation generally calculates E&P by making adjustments to U.S. taxable income, a foreign corporation necessarily uses foreign book income as its starting point. The ensuing adjustments become especially difficult in the case of noncontrolled foreign corporations since the U.S. shareholder of such companies may be unable to obtain all the information required to compute E&P.

Although foreign corporations do not compute U.S. taxable income, they frequently do adjust foreign book income to conform with U.S. generally accepted accounting principles (GAAP) for financial reporting purposes. There are numerous

differences between GAAP and E&P, but most relate to timing differences and have

at most a transitory and nominal effect on a company’s U.S. tax liability, especially

in light of the requirement of the Tax Reform Act of 1986 that taxpayers compute

their deemed-paid credit on the basis of a ‘‘pool’’ of post-1986 undistributed earnings.

Because we believe that taxpayers should generally be permitted to elect to use

U.S. GAAP in computing the E&P of foreign corporations, we endorse section 104

of H.R. 2018, which would clarify the Treasury Department and IRS’s authority to

provide such an election.2 Enactment of this provision is needed to simplify calculations of E&P in the foreign area.

B. De Minimis Rule for Subpart F Income. Section 954(b)(3) of the Code provides

that no part of a CFC’s gross income is treated as foreign-based company income

(FBCI) if its FBCI and insurance income for the year is less than the smaller of

(i) five percent of its gross income for the year or (ii) $1 million. Section 103 of H.R.

2018 would increase the FBCI de minimis income from five to ten percent of gross

income, thereby reducing the reporting requirements for many companies. The bill

would also increase the $1 million ceiling to $2 million, a provision that would assist

companies with relatively small overseas operations.

TEI endorses this provision, which would simplify the computation of FBCI. We

suggest, however, that consideration be given to eliminating the dollar threshold altogether (or increasing it to $5 million). These changes would restore the de minimis

rule that was in effect before 1987.

C. Treatment of the European Union Under the Same-Country Exception. In 1992,

the European Community created a single market now comprised of 15 countries

that led to the consolidation of many European business opportunities. The resulting reduction of operating costs enhanced the competitiveness of EC-based corporations, often to the detriment of U.S.-based companies that are subject to Subpart

F. The conversion of 11 currencies to the euro can only exacerbate the problem.

Under the current Subpart F rules, certain sales and services income that is

earned outside a CFC’s home country is taxable, while income earned inside the

home country is exempt from current taxation under the ‘‘same-country exception.’’

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3Prior iterations of this bill provided for the treatment of EC countries as a single country

for purposes of the same-country exception. See, e.g., H.R. 1690, 104th Cong., 2d Sess. (introduced on May 24, 1995). 4This limitation is imposed in addition to the foreign source income limitations of section 904

as it applies to both AMT and regular taxpayers. 5This provision mirrors the relief provided in H.R. 1633, which was introduced by Chairman

Houghton in April.

Computing Subpart F income significantly increases the administrative costs for

U.S.-based companies; because of the generally high European tax rates, there is

most often no increase in revenues for the United States. Thus, U.S. multinationals

may be forced to choose between the potential for cost-efficient consolidation of operations in Europe and higher administrative costs.

Section 102 of H.R. 2018 would provide for a Treasury Department study on the

feasibility of treating all countries included in the European Community as one

country for purposes of applying the same-country exception under Subpart F of the

Code.3 The European Community is eliminating barriers to cross-border payments—

an initiative that places U.S. corporations at a disadvantage. Accordingly, TEI believes that companies need relief now in order to remain competitive, and we regret

that a study will only further delay the proper economic result: treatment of the EC

countries as one country. Such a solution would permit the efficient consolidation

of U.S. multinationals’ European operations, thereby enhancing their ability to compete in the European Union. TEI strongly urges Congress to consider the outright

adoption of this proposal.

II. Foreign Tax Credit Rules

A. Creditability against Alternative Minimum Tax. Under section 59(a)(2) of the

Code, a taxpayer’s foreign tax credit (FTC) may offset no more than 90 percent of

the taxpayer’s alternative minimum tax (AMT) liability.4 In contrast, a taxpayer

that is subject to a regular income tax liability is not subject to the 90-percent restriction. The 90-percent limitation is presumably the result of Congress’s efforts to

reconcile the arguably conflicting policies underlying the FTC and AMT.

Because the United States taxes the worldwide income of its citizens and residents, the FTC was introduced to limit the incidence of double taxation—the taxation of the same income by two jurisdictions. The policy underlying the FTC has

not changed over the years, though certain limitations have been imposed to prevent

what has been deemed to be the improper averaging of high- and low-tax foreign

source income. Thus, under the regular income tax provisions, a U.S. taxpayer may

offset fully 100 percent of its U.S. tax liability on foreign-source income with its

FTC. This does not mean that the taxpayer is not paying any tax, but rather simply

acknowledges that the taxpayer has already paid a tax (to the jurisdiction where

the income was derived) at the rate equal to or greater than the amount the United

States would assess on that income.

When the AMT was enacted as part of the Tax Reform Act of 1986, Congress had

‘‘one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits.’’

S. Rep. No. 99–313, 99th Cong., 2d Sess. 518–19 (1986). Thus, the AMT was deemed

necessary to address public perceptions about the fairness of the tax system.

TEI has serious reservations about the policy basis for the AMT generally, but

we recognize that calls for its outright repeal are beyond the scope of this hearing.

Accordingly, we applaud section 207 of H.R. 2018, which proceeds from the premise

that, even if the AMT remains in effect, it makes no sense to retain the 90-percent

FTC limitation. According a taxpayer the ability to offset its entire liability with its

foreign taxes would not frustrate the legitimate policy underlying the AMT. Unlike

the other items that may serve to reduce a taxpayer’s regular tax liability (which

taxpayers are not permitted to take fully into account for AMT purposes), the foreign tax credit represents precisely what its name suggests: a tax. A taxpayer with

an AMT liability and sufficient FTC to offset that liability has already paid a significant tax. Clearly, that the tax has not been paid to the United States has no bearing

on the economic cost it represents to the taxpayer. Moreover, to the extent the FTC

and AMT regimes do conflict, TEI submits that the policy supporting the FTC (and

complementary provisions in U.S. tax treaties)—which is based upon sound economic reasoning and comports with longstanding international norms—should prevail. We therefore support the enactment of this provision.5

B. Expansion of FTC Carryforward and Ordering Rules. Section 904(c) of the Code

currently provides that any foreign tax credits (FTCs) not used against U.S. tax in

the current year may be carried back two years and forward five. In contrast, the

25

6We recognize that legislation has been proposed (e.g., S. 1134, the Affordable Education Act

of 1999, and S. 331, the Workers Incentives Improvement Act) to shorten the FTC carryback

from two years to one and expand the carryforward from five years to seven. Enactment of this

revenue raiser would exacerbate the double taxation caused by expiring FTCs, particularly for

companies in cyclical industries. 7The bill’s introduction of an overall domestic loss provision would remedy an inequity faced

by taxpayers attempting to claim FTCs. This reform would not eliminate the need to address

current section 904(f) (relating to overall foreign losses), which limits a taxpayer’s ability to

claim FTCs. Consideration should be given to either repealing or modifying both the overall foreign loss rules and section 864(e)’s interest expense allocation provisions, because these rules

place U.S. corporations at a competitive disadvantage.

rules for the general business tax credit (section 39) and net operating losses (section 172(b)) provide for a three-year carryback and a fifteen-year carryforward.

In addition, the ordering rules set forth in section 904(c) for FTCs require that

the current year’s credits be utilized before any carryovers are taken into account.

By contrast, in respect of the general business tax credit, a carryover is to be used

first, before the current year’s credits, to afford the taxpayer the maximum opportunity for using the credit. See I.R.C. § 38(a).

The inconsistency in carryback/carryforward periods is not only inequitable, but

also complicates the tax laws. The current rules create administrative burdens for

the government and taxpayers alike. More fundamentally, the rules effectively penalize taxpayers that experience operating losses, thereby creating a windfall for the

federal government that may ‘‘collect’’ a substantial portion (if not all) of the FTCs

previously earned and claimed because of the unduly short carryback/carryforward

period. Current law effects an especially harsh result in respect of taxpayers in cyclical industries whose ability to utilize FTCs is limited because of income fluctuations and start-up companies with initial losses.

Section 201 of H.R. 2018 would expand the FTC carryforward rules to 10 years,

bringing them more in line with the rules for net operating losses and general business tax credits. Although the Institute believes that the rules for the three credits

should be the same, we recognize that the proposal would limit the situations where

the purpose of the FTC—the elimination of double taxation—is frustrated by unrealistically short carryover periods. We also endorse section 206, which would change

the ordering rules whereby any carryover FTC would be taken into account before

the current year’s credit. Permitting the oldest credits to be used first would mitigate the problem of expiring credits.6

C. Treatment of Overall Domestic Loss. Section 904(f) of the Code provides for the

‘‘recapture’’ of ‘‘overall foreign losses’’ where the taxpayer sustains a foreign-source

loss in one year and there is foreign-source income in a subsequent year; the recapture is accomplished by treating income in the later years as domestic-source income. The law does not, however, provide for similar recapture treatment when

there is an overall domestic loss that is offset against foreign income in one year

and in a subsequent year there is sufficient domestic income to otherwise absorb

the domestic loss.

Section 202 of H.R. 2018 would apply a resourcing rule to U.S. income where the

taxpayer has suffered a reduction in the amount of its FTC limitation due to a domestic loss. The bill would recharacterize into foreign-source income U.S.-source income (up to 50 percent of taxable income) earned in a year subsequent to a year

in which an overall domestic loss offset foreign-source income. Adoption of this provision not only would provide parallel treatment for foreign and domestic losses, but

would also foster U.S. competitiveness. TEI recommends enactment of the provision.7

D. ‘‘Look-Through’’ Rules for Dividends, Interest, Rents, and Royalties from 10/50

Companies. The 1986 Act categorized foreign affiliates that are owned between 10

and 50 percent by a U.S. shareholder as a ‘‘noncontrolled section 902 company’’ and

created a separate FTC limitation for each such company. The requirement that

dividends from each noncontrolled section 902 company be placed in a separate

‘‘basket’’ was generally recognized as among the most maddeningly, mind-numbingly

complex rules of the 1986 Act’s provisions. Last year, Congress acted to remedy this

problem by permitting taxpayers to elect a ‘‘look-through’’ rule for dividends similar

to the one provided for CFCs under section 904(d)(3). The use of this rule was delayed, however, until 2002.

Section 204 of H.R. 2018 would advance the effective date of the 1998 provision

to taxable years beginning after December 31, 1999; section 205 would expand lookthrough treatment to include interest, rents, and royalties. TEI agrees that enactment of these provisions would alleviate some of the complexity in current law and

for sophisticated taxpayers might be especially beneficial. From an administrative

26

8The adoption of the GAAP E&P rules discussed on pages 5–6 of this submission would

render this change unnecessary. 9The bill would also amend section 6110(b)(1) to exclude these agreements from the definition

of ‘‘written determinations’’ subject to disclosure.

perspective, however, we suggest that a better approach would be to permit dividends from noncontrolled corporations to be aggregated into a single basket.

III. Other Provisions

A. Limitation on UNICAP Rules. As enacted in 1986, section 263A of the Code

requires the uniform capitalization of certain direct and indirect costs, including interest, incurred with respect to property produced by the taxpayer or acquired for

resale (the ‘‘UNICAP rules’’). Although section 263A applies in the foreign context,

the revenue raised by application of the UNICAP rules to foreign subsidiaries is

small compared with the administrative burden they impose on taxpayers.

Section 302 of H.R. 2018 would provide that the UNICAP rules of section 263A

apply to a non-U.S. person only to the extent necessary for purposes of determining

the amount of tax imposed on Subpart F income or on U.S. effectively connected income. It is a simplifying provision that should be adopted.8

B. Study of Interest Allocation Rules. H.R. 2018 requires the Treasury Department

to conduct a study of the rules under section 864(e) of the Code relating to the allocation of interest expense among members of an affiliated group.

TEI commends the Chairman for recognizing that the interest allocation rules are

in desperate need of reform. In our view, the interest allocation rules were enacted

as a revenue raiser in 1986 and are not justified on economic grounds. The rules

have spawned not revenue so much as a series of complex transactions to minimize

their effect. Hence, TEI believes that section 864(e) should be repealed. We are confident that the Treasury study will confirm that view and urge that action be taken

as soon as possible.

C. Reporting Requirements for Foreign-Owned Corporations. Section 6038A of the

Code sets forth reporting requirements for any corporation engaged in a trade or

business in the United States that is at least 25 percent owned by a foreign person.

Substantial penalties are imposed for noncompliance. The statute contains no de

minimis reporting rule. In addition, Treas. Reg. § 1.6038A–3(f)(2) provides that documents maintained outside of the United States must be produced within 60 days

of a request by the IRS and must be translated within 30 days of a request for

translation.

Section 311 of H.R. 2018 would provide that a reporting corporation will not be

required to report any information with respect to any foreign-related person if the

aggregate value of the transactions between the corporation and the related person

during the taxable year does not exceed $5 million. In addition, the provision would

expand the time in which a taxpayer may produce translations of documents from

30 days to at least 60 days. The subsection also provides that nothing shall limit

the right of the taxpayer to request additional time to comply with the request for

translation.

TEI supports enactment of the de minimis rule, which will ease the reporting burdens on taxpayers. In addition, we agree that an expansion of time in which to

produce translated documents recognizes the practical difficulties inherent in a global marketplace where documents may be kept in various languages and at various

locations. We suggest, however, that the proposed language—‘‘nothing shall limit

the right of the taxpayer to request additional time’’—be revised to read ‘‘the Internal Revenue Service shall have the authority to grant all reasonable requests for

additional time to furnish the requested translations.’’

SAFEGUARDING THE APA PROCESS

Congressman Houghton has voiced support for legislation that would amend section 6103(b)(2)(A) of the Code to provide protection from disclosure for negotiated

agreements between taxpayers and the IRS. Included in the proposal’s protection

are advanced pricing agreements (APAs), as well as closing agreements and competent authority agreements.9 The bill responds to recent litigation to seeking disclosure of APAs and closing agreements.

The APA program is designed to forestall contentious and expensive transfer pricing disputes between taxpayers and the IRS. A voluntary venture, it is one of the

IRS’s success stories of the 1990s and furthers the goal of eliminating unnecessary

complexity in the tax law. Each APA specifies a methodology negotiated between the

specific taxpayer and the IRS (and, at times, a foreign country) for the taxpayer to

use in determining its intercompany pricing and thereby assure compliance with

27

section 482 of the Code. The information set forth in an APA—the method by which

a company determines its profit margins—is highly fact specific and involves sensitive financial and commercial information. Almost 200 APAs have been negotiated

since the program began in 1991 and the program has been used as a model by the

international community as a means of minimizing double taxation of income and

settling costly transfer pricing disputes.

Since the inception of the APA program until January 8, 1999, the IRS treated

the APAs and their supporting documentation as tax return information that was

not subject to disclosure. On that date—in conjunction with a suit to compel release

of the APAs under the Freedom of Information Act—the IRS said it now takes the

position that APAs constitute ‘‘written determinations’’ under section 6110 of the

Code and therefore may be publicly released in a redacted form. TEI believes that

the IRS’s position is wrong and we have filed a brief amicus curiae in the case.

As a professional association dedicated to the development and implementation of

sound tax policy, TEI is concerned that the release of the APAs—even in redacted

form—will adversely affect the APA program. Taxpayers submitted the pricing information to the IRS with the understanding that the information would be subject

to the same confidentiality restrictions as tax returns. Companies’ legitimate privacy interests—as well as the privacy interest of our treaty partners in respect of

bilateral APAs—will be compromised by the release of the APA background documents and their ability to compete effectively in the marketplace could be harmed.

Moreover, the very redaction process that accompanies release of the information

would be extremely difficult, burdensome, and time-consuming.

More important, the knowledge that such information will be released in the future will discourage taxpayers from seeking APAs. TEI believes that the APA program represents the best way for companies to resolve transfer pricing controversies

and avoid costly and time-consuming audits and litigation. At a time when the IRS

is seeking more taxpayer-friendly ways of doing business, programs such as the

APA program should actively be encouraged, rather than jeopardized by a mistaken

interpretation of the law.

For these reasons, TEI strongly supports enactment of legislation to protect APAs

and supporting documents from disclosure.

CONCLUSION

Tax Executives Institute appreciates this opportunity to present its views on

international complexity and simplification. Any questions about the Institute’s

views should be directed to either Michael J. Murphy, TEI’s Executive Director, or

Timothy J. McCormally, the Institute’s General Counsel and Director of Tax Affairs.

Both individuals may be contacted at (202) 638–5601.

Chairman HOUGHTON. Thank you very much, Mr. Ezrati.

I am going to forego my questions until the end. I would like to

pass the questioning over to Mr. Coyne.

Mr. COYNE. Thank you, Mr. Chairman, and thank you for your

testimony.

I would just like to ask, in considering the various provisions of

H.R. 2018, I wonder if each of you would be able to tell us how the

provisions would affect each of your individual firms, and I know,

Mr. Ezrati, you are representing the TEI, but if you could tell us

about Hewlett-Packard?

Mr. EZRATI. Certainly. If I can focus on just a few of them. The

adoption of the elective GAAP E&P provisions will be a major simplification. Hewlett-Packard has about 65 foreign subsidiaries in

which we employ a similar number of people like Mr. Luby does

to help HP comply with these provisions. This would allow us to

employ them in other active pursuits rather than complying with

the tax law.

The treatment of the European Union as a single country would

be key for our business in Europe. The trade barriers are coming

28

down in Europe for our competitors, but, right now, we are obligated to create a separate subsidiary in each one of those countries.

Our businesses don’t want to do business that way. They want a

central spot in Europe where they can distribute all over the continent, and, right now, the U.S. tax rules make that difficult.

Mr. COYNE. Mr. Luby.

Mr. LUBY. As I mentioned, 907, of course, would save us a lot of

compliance costs. The GAAP rules for Subpart F would be important. Another important provision is pipeline transportation income

provision. That makes pipeline transportation income Subpart F,

currently deemed up should it cross the border. That is active business income. It is very difficult to ship pipelines around, as you

might expect, so that would be important to our industry. And

look-through treatment for the sales of partnership interests would

be a major improvement for our industry. As you know, our investments are so large, we have to do joint ventures that result in partnerships, and we think that the treatment of the sale, the partnership interests, should be the same as the underlying income.

Mr. COYNE. Could each of you give just a brief description about

how your international operations would change as a result if these

changes were to be implemented?

Mr. EZRATI. Again, I will focus on the European Union. I think

we would see a smaller infrastructure in Europe and a greater ability to distribute products all over Europe. That would be key. Right

now, customers in Europe don’t want to deal with salespeople and

service operations and markets in each of their countries; they

want to deal with one European-wide operation, and that is what

our businesses want to move to. As we move to more electronic

commerce, we just want one central focal point in Europe, and we

will be able to achieve that.

Similarly, operations in China would improve dramatically if

there were improvements in the Subpart F arrangements, because

it is very difficult to do business in China with currency controls

and similar restrictions. Improvements in Subpart F would help us

dramatically in that major market.

Mr. LUBY. The 10/50 provisions have hurt us enormously in various joint ventures. You have situations such as in Malaysia where

they don’t really want to hear about a partnership; they don’t want

to hear about ‘‘check the box;’’ they want their own kind of corporation. Therefore, we have to forego investments because of the return detriment. I used an example. We have had situations in the

North Sea where we have actually had to pay our partner’s share

of the gross receipts tax in order to get them to agree to a partnership so that we could avoid the earnings hit of 10/50, and we have

had situations in China where we have actually deferred investments because of this provision.

Mr. COYNE. Thank you.

Chairman HOUGHTON. Thank you, Mr. Coyne. Mr. Watkins.

Mr. WATKINS. Thank you, Mr. Chairman. I am delighted you are

having these oversight hearings on the international tax simplification.

I was in Congress for 14 years before being out about 6 years,

and as I worked on a number of things—in fact, in the early 1980’s,

I put an international trade center in the State of Oklahoma, beVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00032 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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cause I realized that we were not prepared, I think, in the global

competitive world that we were going to be entering in. I was out

about 6 years and decided I would try to come back for two reasons: No. 1, I felt like a balanced budget, that I had kind of been

unfair to my children and grandchildren for not in those 14 years

being able to achieve that, and the other reason was I wanted to

try to do my darnest to prepare this country for a global competitive economy, a 21st century global competitive economy. You and

I might be able to escape being personally involved as much as a

lot, but the young people—our children and grandchildren—have

no choice; they are thrust into that. And by a 21st century global

competitive economy, I mean one that has got less taxation, a more

simplified or fair way to work things through on taxation. No. 2,

less regulation that we have to try to uncomplicate that situation

as much as we can, and, third, less litigation. I just read something, Mr. Chairman, coming up here that in Japan, they have got

about 16,000 lawyers and we have got over 900 and some odd thousand, nearly a million, and lots of times that is dealing with a lot

of liability

But I guess what I am concerned about is—or I would say that

I know the Chairman here and also our Ranking Members want to

make sure we have a less complicated and more workable allowing

us to be competitive overseas, and I kind of mentioned those three

things, because I think that gives us, within that structure, we

have got an overburden—what I call an overburden in the oil

patch—an overburden of being able to do business overseas.

So, are you involved in pipeline construction, multinational pipeline construction, overseas, Mr. Luby, at your company?

Mr. LUBY. Yes, we are, and we are also users of pipelines owned

by others, so that the change in the bill, for example, would, hopefully, either lower our investment costs or lower the costs of renting space in the pipeline.

Mr. WATKINS. I think that this question is asked kind of indirectly, but probably the three most general changes that we could

look at, I mean, that would affect all businesses and industry, so

to speak, allowing us to be more competitive in that global economy, what would your thoughts be? What three?

Mr. LUBY. I would substantially reform the Subpart F rules to

a major extent. I believe that since pay-go became the watch word

here that policy flew out the window and basically the foreign area

didn’t have a constituency, and, therefore, a lot of the pay-fors for

domestic initiatives, be they child care credits or what—and I am

not criticizing child care credit; I am just using that as an example—have been paid for out of our international rules with no policy justification. That is why we have 10/50; that is why we have

the PFIC overlap; that is why we have 956A that you repealed in

1997 due to these gentlemen’s efforts. So, that is one area that I

think needs to really be reworked.

And the other area in international is the various foreign tax

credit baskets. There is a chart right here; we have got nine of

them. There is no reason on Earth that we need to have nine separate foreign tax credit baskets in order to determine whether we

owe a residual U.S. tax on foreign source income. It is just nonVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00033 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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sense, and it wastes money on compliance. Those are the major

things.

Mr. WATKINS. We appreciate those. Any quick thoughts you

might have on——

Mr. EZRATI. Absolutely. The only thing I would add is that the

adoption of the elective GAAP E&P would greatly simplify things,

and removal of the 90-percent limitation on using the foreign tax

credits to offset U.S. alternative minimum tax would remove all

double taxation in that area.

Mr. WATKINS. I appreciate those comments on that, and, again,

I want to thank the Chairman for having these, because we truly

are in this global competitive world, and we have got to streamline

some things, and I think it has got to begin with taxes and then

regulatory policies we have and also the litigation situation we are

confronted in trying to do that and conduct that business. So, Mr.

Chairman, thank you so much.

Chairman HOUGHTON. Thanks, Mr. Watkins.

Mr. Levin.

Mr. LEVIN. Mr. Chairman, should I defer to Ms. Dunn, if she

would like. I am not on the Subcommittee, so maybe I should—I

don’t want to be chivalrous but also abide by protocol.

Chairman HOUGHTON. Sure. Ms. Dunn has joined us. Would you

like to inquire?

Ms DUNN. I simply want to thank you gentleman for coming

over. I had lunch, Mr. Luby, with one of the folks who works for

your company today at a speech that I gave, and, so greetings from

her, and thank you for coming and testifying on something that is

critically important as we look at the rules we set up to become

more competitive through industry.

Chairman HOUGHTON. Mr. Levin.

Mr. LEVIN. Thank you, Mr. Chairman.

If I might just make a couple of comments, because this is really

interesting testimony, and I believe it relates to my first comment.

There is a lot of skepticism here on this level and the next level

about simplification that it can ever occur. In this field, it does

seem feasible. Some steps you can take, but further steps can be

taken that are sound tax policy. They simply can be made much

less complex.

Second, I would hope that you could help us inspire some discussion of this. I think the Chairman of the Full Committee is interested in international tax issues. I think that is true on both sides

of the aisle. It is unclear what is going to be the life of the tax bill

here, and I do think that we need to foster some further discussion

to ensure that the international tax area is part of the next.

So, if you could continue to raise these issues. It is not easy, because these are detailed provisions, but you have been able to give

a few concrete examples in response to Mr. Coyne’s excellent questions as to what it would mean for your company within the

parameters of sound tax policy, and, Mr. Chairman, I would guess

you would share my sentiments that we need all the help we can

get to try to boil these issues down so that they are understandable, and we avoid having people choose up sides as happens too

much around here kind of an automatic or stereotypical basis.

These provisions are good for basic economic operations in this

31

country, and therefore can have a positive impact on both business

and workers, the business community and workers.

So, your testimony has been very salient, and I hope you will

help us spread the word.

Mr. EZRATI. Absolutely.

Chairman HOUGHTON. Thank you, Mr. Levin.

We have been joined by Mr. Neal. Mr. Neal, would you like

to——

Mr. NEAL. I don’t have any questions.

Chairman HOUGHTON. No questions. OK, well, I have some questions. They are really sort of generic questions.

You know, Mr. Levin and I have got a bill out there, and I would

really like you to sort of coalesce your ideas into what are the two

or three things in that bill that really are going to help you. And

then, also, secondly, where do we go from here? What other

things—what more should we be doing? So, I throw those questions

to both you gentleman for an answer.

Mr. EZRATI. I don’t want to repeat myself too much, but here are

three things: adoption of the GAAP E&P provisions, removal of the

90-percent limitation on the foreign tax credit for the alternative

minimum tax, and go beyond studying to treat the European Union

as a single country for purposes of Subpart F. Not just for my company, but I think for the majority of the 5,000 members of TEI and

the 2,700 companies they represent, it will make a huge difference.

And let me echo Mr. Luby. If you want to know where to go from

there, it’s to those nine foreign tax credit baskets that we enacted

in 1986 and that are the worst complexities we face today. Repeal

those nine baskets, and the world would be a lot easier, and U.S.

business would be more competitive.

Chairman HOUGHTON. Do you feel the same about the Far East

as you do about the European Union?

Mr. EZRATI. I think it is a little more difficult in the Far East;

it is not one economic trade block. I could see it actually happening

in Latin America more quickly than in the Far East. As the

Mercisol countries move together to form one trade block, we are

finding that U.S. companies will be less competitive in Latin America, and so I could see the same thing happening there, especially

after NAFTA where you removed those trade barriers, only to

erect, as Mr. Levin said, tax barriers. It is going to be a little more

difficult in Asia, because they haven’t come together as one trade

block. So, as I said, substantially reforming Subpart F will make

things lots easier in China to do business there.

Chairman HOUGHTON. All right. Mr. Luby.

Mr. LUBY. In addition to the items I have already mentioned—

which I won’t bore you with going over again—I would mention

that for our membership doing something again on active financing

income would be very helpful, and I know that you have a witness

in another panel that will address that much more eloquently than

I ever could. Extending the foreign tax credit carryover provision

would be of great assistance. Because of the mismatch between

foreign law and U.S. law, we sometimes end up under the current

system with credits expiring. That is not the purpose of the credit

system. The purpose is to eliminate double taxation. And we appreciate your including a call for an interest allocation study. That is

32

definitely needed. Something needs to be done there. The way that

works today, it rigs the system so that we are in effect double

taxed. So, those would be the items that I would mention in addition to the earlier items in response to other questions.

Chairman HOUGHTON. OK, thanks very much.

We have been joined by Mr. Weller. Would you like to ask questions?

Mr. WELLER. Thank you, Mr. Chairman.

I guess as we look this year at what type of tax cut we are going

to provide—and, of course, we have opportunity in this year’s budget for almost a $770 billion tax cut over 10 years—I am one of

those who advocates that as we put together those tax provisions

in this year’s budget, we should focus on simplifying and bringing

fairness to the code, and many in the business community have

said,

Well, you know, when you have these temporary extenders that every year have

to reauthorize, that is really an issue of fairness, because it is hard to make a decision on how to move forward.

And, of course, the Subpart F treatment of financial services with

overseas income, I was wondering can you give some examples of

whether or not it is fair to annually extend that provision for

financial services?

Mr. LUBY. We don’t have—my company, personally, doesn’t have

a problem in that area, because we are not in that particular business, but I would say that based on the way we do our corporate

plans, we look beyond the next quarter, obviously; we look 3 to 5

years out in planning our business and in planning where we may

want to budget our investments. If I have a provision that hurts

me competitively, that is renewable annually, then that is going to

definitely crimp my plans beyond that one-year outlook, and when

I am looking at projects or investments that are very substantial

in the context of what I have available—the shareholders’ money

at risk—it can cause me to make wrong or less than optimum decisions, so that is about as much detail as I could give you on that

point.

Mr. WELLER. Mr. Ezrati.

Mr. EZRATI. We have looked at that financial services provision,

and the company has thought about adjusting the way we finance

products, and we do a lot of financing, though the provision does

nothing for us at the moment, because it is so narrowly crafted and

so complex. But we have asked, ‘‘Should we adjust the way we do

business to take advantage of that provision? Will that make us

more competitive in financing our products versus our competitors?’’ And you say, ‘‘But is it worth it? It will take us 6 months

to gear up for it, and it is a year provision.’’ Thus, I do think it

is terribly unfair that those provisions are enacted year-by-year,

and you need to guess whether they will be there next year. In fact,

this provision itself, when it was originally enacted, was different

from the one you extended last year. It is even more difficult when

it is different each year.

Mr. WELLER. I am one who believes that we should, of course,

make that provision permanent; same with the R&D tax credit or

opportunity tax credit, because businesses are making decisions,

having to invest large amounts of money, trying to make decisions,

33

and, of course, the consequence in not knowing if that provision in

the tax code is going to be there long-term. If we are unable to

make Subpart F permanent, what is the minimum number of years

you feel is necessary, really, from a management standpoint when

you are considering how to invest millions of dollars?

Mr. LUBY. In the context of our company, I would say a minimum of 3 years.

Mr. WELLER. A minimum of 3? Would you agree, Mr. Ezrati?

Mr. EZRATI. I think I would like to go even longer. You mentioned the research and experimentation tax credit, and I think

that has never been longer than about 5 years. I now hear that 5

is now considered permanent, but that is what I would like to see,

because that is the time horizon for making large investments.

Three might work, but five would certainly be preferable.

Mr. WELLER. Mr. Chairman, I certainly believe from a fairness

standpoint, if we are asking these employers to invest for the longterm, we should certainly ensure that the tax provision they are

basing decisions on is for the long-term, as well, and that is why

I hope we can work together not only for permanency but, at a

minimum, for a long multiyear extension so they can make some

long-term decisions.

Chairman HOUGHTON. I agree with you, Mr. Weller.

I have just one more question, The National Foreign Trade Council came out with a report on anti-deferral rules. Can you sort of

spell out a few of those things—how they compare with other countries, and where we end up if we proceed with those rules?

Mr. LUBY. Well, an example is the one I used earlier in the testimony. The French exempt back these incomes from foreign taxation that comes from foreign sources, whereas, we do not. In many

cases, active financing is a good example. That is active business

income to our banking companies, and they have to pay current

U.S. tax on that income. That puts them at a definite disadvantage

vis-a`-vis a French banking competitor, if they are looking at investments in Europe or elsewhere around the globe.

Other countries are very similarly situated. You hear about territorial versus our type of system, and you find that although very

few have a territorial system, well, they really have a territorial

system, but it is with a wink and a nod so that they can say that

they followed our lead and have controlled foreign corporation

rules. Great Britain has tightened their rules quite a bit, but they

still allow a Bermuda headquartered company to put in low-taxed

financing income and high-taxed other income and mix it all up,

and guess what? You average it out, and there is no residual for

you to pay for tax. We have a competitor—who I am sure you can

guess—that is headquartered both there and in the Netherlands

that happens to use that to their advantage when they are competing with us on projects.

So, our report shows that Subpart F needs to be reexamined;

that it is a drag on the competitiveness of U.S. companies. We have

now formulated recommendations that are coming out of that report, and we hope to release them in the very short term, and, as

Les said a few minutes ago, echoing my earlier comment on the

baskets, we have now begun the second phase of that project,

which is a study of the foreign tax credit, and we will have recVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00037 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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ommendations come out of that, as well. So, we will, at least at the

NFTC, heed Mr. Levin’s suggestion and continue to bring attention

to the area of international tax.

Chairman HOUGHTON. OK, well, thank you very much. We look

forward to working with you, and, gentleman, I really appreciate

your testimony. Thank you.

Mr. EZRATI. Thank you.

Chairman HOUGHTON. Now, I will call the panel composed of Mr.

Cox, who is Vice President of Tax at BMC Software in Houston,

Texas; Denise Strain, General Tax Counsel at Citicorp in New

York; Thomas Jarrett, Director of Taxes at the Deere Company in

Moline, Illinois; Gary McKenzie, Vice President of Tax for the Northrop Grumman Corporation in Los Angeles, California; and Stan

Kelly, Vice President of Tax for Warner-Lambert in Morris Plains,

New Jersey.

If you would come forward.

Mr. Cox, good to have you here. Would you proceed?

STATEMENT OF JOHN W. COX, VICE PRESIDENT OF TAX, BMC

SOFTWARE, INC., HOUSTON, TEXAS

Mr. COX. Thank you, Mr. Chairman. Good afternoon. I am John

Cox, vice president, Tax, for BMC Software. BMC is headquartered

in Houston, Texas and is a worldwide developer and vendor of software solutions for automating application and database management across host-based and distributed systems environments. I

thank the committee for giving me this opportunity to present my

views on international tax simplification.

The U.S. software industry currently leads the international

marketplace for developing new technologies used to create new

products. This technology is the product of U.S.-based research and

development which produces market leading patents and copyrights. The ability to efficiently use these intangible assets

throughout the world is a key component in the operations of U.S.

software businesses.

Currently, U.S. tax policy hinders U.S. competitiveness when

compared with the tax regimes of other countries. Not only is our

worldwide system of taxation more burdensome than systems of

many of our trading partners, but also our incentives to encourage

R&D in the United States are less beneficial than the incentives

offered by many of our trading partners. In addition, U.S. rules for

taxing foreign income are extraordinarily complex. As a result, an

inordinate amount of resources are devoted to structuring transactions that will accomplish the business goals of U.S. companies

without incurring a heavy tax burden. BMC applauds the efforts of

Chairman Houghton and Congressman Levin to bring simplicity to

the international tax rules of the Internal Revenue Code.

Although I favor many, if not most, of the proposals in H.R.

2018, my testimony today will highlight two provisions that I believe will particularly helpful to the software industry. In addition,

my testimony will include two issues that are not addressed in the

current legislation.

I support the bill’s alternative minimum tax proposal. Under the

current law, U.S. taxpayers subject to the AMT regime may claim

a foreign tax credit against their alternative minimum tax only to

35

the extent of 90 percent of the actual tax paid or accrued in foreign

countries. Thus, foreign tax credits can never entirely extinguish

U.S. tax liability under the AMT regime.

This rule has been widely criticized on several grounds. First,

foreign tax credit is not a tax preference but simply a means of reducing unfair and unavoidable double taxation that would otherwise fall on U.S. taxpayers earning income abroad. Second, the

AMT limitation is fundamentally inconsistent with international

tax treaty norms. U.S. treaty partners have frequently expressed

dissatisfaction with this feature of U.S. law. Finally, the 90-percent

limitation adds complexity to the AMT regime, which is notoriously

complicated even without the provision.

I also support the effort to move towards treating the EU as one

country for Subpart F purposes. Under current law, the member

countries of the EU are treated as separate countries for purposes

of the various ‘‘same-country exceptions’’ to Subpart F income.

Treating the EU as a single country for these purposes would help

U.S. corporations operating in the EU take full advantage in that

market, and it would also help the U.S. corporations compete more

effectively against EU corporations that are already able to enjoy

the benefits of these initiatives.

I now turn to two international tax matters that are not covered

by the bill but that deserve the Committee’s attention. The first is

the inconsistent characterization of cross-border transactions by

the United States and its trading partners. For example, income

from the sale of a disk containing a computer program might be

treated as business profits by the United States but as a royalty

by the customer’s country of residence. Double taxation can therefore arise. These problems have in fact cropped up repeatedly in

cross-border activities for software companies. Treaty mutual

agreement procedures can be effective, but they are costly, timeconsuming, and uncertain. We recognize that this problem is not

resolvable by unilateral U.S. action; however, we do encourage

Congress and the administration to pursue all available opportunities for resolving these issues, both treaty-by-treaty and multilaterally.

The last point I wish to discuss is the challenge to the Foreign

Sales Corporation regime now pending before the World Trade Organization. The FSC rules are extremely important to U.S. software companies, which derive 30 percent of their revenue from exports, and the industry is grateful that Congress clarified this application of these rules to software licenses as part of the 1997 Tax

Act. The FSC rules were enacted to offset a competitive disadvantage faced by U.S. exporters, because the U.S. tax system is not as

generous to exports as are the tax systems of our trading partners.

These concerns still exist today. As we await a final decision from

the WTO panel on the FSC issue, I wanted to make you aware of

the importance of this issue to the software industry.

In conclusion, Mr. Chairman, thank you again for this opportunity to present my views on these important issues. I am happy

to answer any questions you might have.

[The prepared statement follows:]

36

Statement of John W. Cox, Vice President of Tax, BMC Software, Inc.,

Houston, Texas

INTRODUCTION

I am John W. Cox, Vice President of Tax for BMC Software, Inc. BMC,

headquartered in Houston, is a worldwide developer and vendor of software solutions for automating application and data management across host-based and open

system environments. The software industry is growing at an extremely rapid pace.

Since 1994, software sales have been growing at a constant rate of 15.4% annually,

which is three times the growth rate of the GDP. Much of the growth in the industry is due to expansion in overseas markets. BMC operates in approximately 30 different foreign markets. Our fiscal year 1999 revenue was $1.3 billion, of which approximately 40% is from foreign sales.

The U.S. software industry currently leads the international marketplace in developing new technologies used to create new products. This technology is the product

of U.S.-based research and development, which produces market leading patents

and copyrights. The ability to efficiently use these intangible assets throughout the

world is a key component in the operations of a U.S. software business.

In recent years the Congress and the Administration have made noteworthy improvements in the international tax rules affecting software companies. First, in

1997 Congress passed legislation clarifying that software exports qualify for FSC

benefits. Then in 1998 the Treasury finalized regulations providing clear guidance

on the proper characterization of software revenue that is generally consistent with

industry business practice and will help reduce the potential for burdensome taxation by our trading partners. We thank you for these improvements. However, current U.S. tax policy still hinders U.S. competitiveness, when compared with the tax

regimes of other countries. Not only is our worldwide system of taxation more burdensome than the systems of many of our trading partners, but also our incentives

to encourage R&D in the United States are less beneficial than the incentives offered by many of our trading partners.

In addition, U.S. rules for taxing foreign income are extraordinarily complex. As

a result, an inordinate amount of resources are devoted to structuring transactions

that will accomplish the business goal of U.S. companies, without incurring a heavy

tax burden. BMC applauds the efforts of Chairman Houghton and Congressman

Levin to bring simplicity to the international tax rules in the Internal Revenue

Code. My testimony today will highlight provisions in H.R. 2018, the ‘‘International

Tax Simplification for American Competitiveness Act of 1999,’’ that we believe will

be particularly helpful to the software industry. In addition, my testimony will include two issues that are not addressed in the legislation—(1) inconsistent characterization of income by the United States and other countries, and (2) the WTO controversy between the United States and the EU over the U.S. foreign sales corporation (FSC) rules.

PROVISIONS IN H.R. 2018

A. AMT Foreign Tax Credit Rules

Under current law, taxpayers are required to pay an income tax that is the greater of their tax computed under the normal rules of the Internal Revenue Code (the

‘‘Code’’) or the special ‘‘alternative minimum tax’’ (‘‘AMT’’) rules. The AMT regime

is intended to ensure that high-income taxpayers making extensive use of so-called

‘‘tax preference items’’ pay at least a minimum level of tax. The recapture of the

tax benefit afforded by the tax preference items is generally achieved by adding

back to income the ‘‘excessive’’ portion of the deduction or exclusion granted by the

preference.

The AMT regime also limits the ability of AMT taxpayers to use otherwise allowable credits against their overall U.S. tax liability. In the case of the credit allowed

for income taxes paid to foreign governments (the foreign tax credit or ‘‘FTC’’), the

regime essentially limits the credit to 90% of the U.S. tax owed. This rule ensures

that FTCs can never entirely extinguish U.S. tax liability under the AMT regime.

This rule has been widely criticized on several grounds. First, the FTC is unlike

most other credits, which are essentially intended to act as incentives to modify taxpayer behavior (such as the low-income housing credit or the alcohol fuels credit).

The FTC is remedial in nature in that it seeks to avoid double taxation of income.

Far from being a tax preference intended to reward taxpayers that take certain affirmative action, the FTC alleviates the unfair and unavoidable double taxation that

would otherwise fall on U.S. taxpayers earning income abroad. It is illogical to treat

this relief provision as a ‘‘tax preference’’ subject to overuse or abuse.

37

1See section 601 of H.R. 5270, the Foreign Income Tax Rationalization and Simplification Act

of 1992 (introduced on May 27, 1992) 102nd Cong., 2nd Sess.; H.R. 1401 (introduced on March

18, 1993), 103rd Cong., 1st Sess.; section 8 of H.R. 1690, the International Tax Simplification

and Reform Act of 1995 (introduced on May 24, 1995), 104th Cong., 1st Sess.; section 206 of

Continued

Second, the AMT limitation is fundamentally inconsistent with international tax

treaty norms. Relief from double taxation is the primary purpose of income tax treaties, and the credit provision is widely recognized as an acceptable method of complying with the treaty obligation. The majority of the over 1200 bilateral income tax

treaties in force throughout the world provides for double taxation relief through a

credit mechanism.

Limiting the FTC to 90% of the U.S. tax due prevents tax treaties from achieving

their full objective of eliminating double taxation. While most U.S. treaties are

drafted in a way that prevents the limitation from technically violating the treaty,

U.S. treaty partners have frequently expressed dissatisfaction with this feature of

U.S. law, which contravenes internationally accepted principles.

Finally, the FTC limitation adds complexity to the AMT regime, which is notoriously complicated even without the provision. Because the FTC is applied separately

with respect to separate categories or ‘‘baskets’’ of income, the AMT limitation is not

a single computation, but requires a series of computations that must be undertaken

in addition to the normal FTC calculations.

Section 207 of the Bill would repeal the FTC limitation now found in the AMT

provisions. For all of the reasons detailed above, we endorse this proposal.

B. Treatment of the European Union

The controlled foreign corporation (‘‘CFC’’) provisions of the Code impose current

U.S. taxation on the U.S. shareholders of foreign corporations that they control. This

taxation is limited to so-called ‘‘subpart F income’’ earned by the CFC. Among the

various categories of subpart F income is passive income such as dividends, interest,

rents, and royalties. The policy underlying the current taxation of such income is

that it is inherently mobile, so that a worldwide group of corporations can route the

income to a low-tax jurisdiction and avoid both U.S. and foreign taxes. Similarly,

income from sales, services, and insurance outside the CFC’s country of incorporation is subpart F income if related party transactions are involved, on the theory

that taxpayers could transfer profits from these activities to a low-tax jurisdiction.

The Code provides an exception for certain dividends, interest, rents, and royalties

paid to a CFC by a related party located in the same country as the CFC’s country

of organization. Subpart F income also does not include sales, services, and insurance income earned in that country. The policy underlying these exceptions is that

transactions occurring in the same country will rarely, if ever, result in inappropriate avoidance of local tax, and taxpayers should therefore be free to adopt in each

country corporate structures and business operations that are not artificially affected by tax considerations.

Under current law, the member countries of the European Union (‘‘EU’’) are treated as separate countries for purposes of the ‘‘same country’’ exception. Thus, payments of dividends, interest, and similar amounts from an entity organized in one

EU country to a related entity in a different EU country are treated for U.S. tax

purposes as subpart F income. Sales, service, and insurance income earned in another EU country may also be subpart F income.

Section 102 of the Bill would direct the Treasury Department to study the feasibility of treating the EU as a single country for purposes of the same-country exception. Under this approach, sales, service, and insurance income earned anywhere

within the EU by an EU country entity, as well as passive income received from

an EU affiliate by a controlled foreign corporation in an EU member state would

not generally be treated as subpart F income.

We fully support the effort to move towards treating the EU as one country for

subpart F purposes. This approach would help U.S. corporations operating in the

EU take full advantage of the EU initiatives to create a single market with the free

flow of goods, services, labor, and capital across national borders. It would also help

U.S. corporations compete more effectively against EU corporations that are, by virtue of their countries of residence, already able to enjoy the benefit of these initiatives.

We understand that the Bill proposes only a study of the issue because of concerns that the EU member countries have different tax systems and rates. While

we do not oppose a Treasury study, we submit that Congress should consider more

immediate and direct action. The possibility of applying same-country status to the

EU has been under consideration by Congress for several years.1 We question

38

S. 2086, the International Tax Simplification for American Competitiveness Act (introduced on

September 17, 1996), 104th Cong., 2nd Sess. 2Technically, the test applies to the sum of gross foreign-based company income and gross

insurance income, but for most CFCs these are the only categories of subpart F income that

commonly arise.

whether a Treasury study, which would further delay direct Congressional consideration of this important issue, would shed a great deal of additional light on the area,

particularly as the EU countries continue to move toward integrating their tax systems.

C. Expansion of subpart F de minimis rule

Under current law, a de minimis rule excludes all gross income of a CFC from

subpart F income if what would otherwise be the CFC’s gross subpart F income 2

is less than the lesser of (1) 5% of the CFC’s gross income or (2) $1 million. Thus,

the maximum exclusion per CFC is $1 million, which will be available only if the

CFC’s gross income equals or exceeds $20 million.

The exclusion is an acknowledgement that it is difficult for corporations to avoid

earning some subpart F income—interest on bank deposits, gain on the sale of unproductive assets, small royalties, and similar items. If the bulk of the CFC’s income

is active, however, it is administratively burdensome to keep track of relatively

minor amounts of subpart F income, and there is little revenue to be gained by attempting to tax such income currently.

The Code has contained the de minimis rule in its current form since 1986. Before

that year, the exclusion was available if 10% or less of the CFC’s gross income

would otherwise be subpart F income, with no dollar limitation. Section 103 of the

Bill would return to this 10% limitation and increase the dollar threshold to $2 million.

We support this proposal. The return to the percentage threshold under pre-1986

law leads to increased administrative convenience and efficiency at a low revenue

cost. The increase in the dollar threshold is an appropriate adjustment to reflect inflation, and CFCs with at least 90% active income should not be burdened with the

need to keep careful track of small amounts of other income.

D. Extension of foreign tax credit carryforward

Under current law, unused foreign tax credits may be carried back to the two previous taxable years and forward for five taxable years. If not usable within that

time period, they expire, and the foreign taxes become a simple cost of doing business. These unused taxes may not be deducted for Federal income tax purposes, because they relate to a year in which the taxpayer elected credit treatment.

Expiring credits are a problem for many companies in our industry. Although it

is often possible to control the timing and amount of foreign taxes to some extent,

thereby maximizing the ability of the U.S. taxpayer to benefit from the credit, five

years may not be enough time in all cases to fully enjoy this benefit. The result is

that the U.S. taxpayer’s overall costs rise, and its ability to compete globally decreases, even in cases where, taking a longer view, the overall worldwide tax rate

is no higher than the U.S. rate.

From the taxpayer’s point of view, an unlimited carryover of unused credits would

of course be ideal. We recognize, however, that from the government’s point of view

an unlimited credit might pose an administrative and recordkeeping problem. Section 201 of the Bill would extend the current carryforward period to ten years. We

believe that this period represents a reasonable—and more realistic—compromise

that accommodates the concerns of both taxpayers and the government.

E. Recharacterization of overall domestic loss

U.S. taxpayers with foreign branch operations may deduct losses generated by the

branch against U.S. source income in the same taxable year. This deduction reduces

U.S. source income subject to U.S. tax. When in a subsequent year the branch generates income subject to foreign tax, the taxpayer may be able to claim a foreign

tax credit to offset the U.S. tax on the income. This arguably creates a ‘‘double benefit’’ for the taxpayer arising solely from the timing of foreign income and loss.

In 1976, Congress enacted an overall foreign loss (‘‘OFL’’) recapture rule to prevent this result. The Code provides that a taxpayer must create a special OFL account whenever a foreign source loss reduces U.S. source income. If positive foreign

source income is generated in a later year, the income is re-sourced to the United

States, effectively preventing foreign taxes on that income from being credited

against the U.S. tax due.

39

3See, for example, Isenbergh, International Taxation: U.S. Taxation of Foreign Taxpayers and

Foreign Income (1990), at ¶ 21.3.3, which notes that the subsequent U.S. source income ‘‘will

effectively be overtaxed.’’

In the reciprocal situation, however, where timing rules could operate to the taxpayer’s detriment, there is no corresponding recapture rule. For example, if a taxpayer has a U.S. source loss that offsets foreign source income in the same year,

the taxpayer’s available foreign tax credit may be reduced because the foreign tax

credit limitation is computed on the basis of net foreign source income. In a later

year, U.S. source income is not re-sourced to foreign, so that the available foreign

tax credit in that year is not increased.

This lack of parallelism has often been criticized as illogical, because it corrects

the mismatch when favorable to the government but not when favorable to the taxpayer.3 In addition, taxpayers lose the value of their foreign tax credits as an offset

against double taxation of income at a time when they are already losing money in

the United States. Section 202 of the Bill would remedy this defect and provide for

equitable treatment of taxpayers by applying the same rules to both foreign and domestic losses. We support this provision as a way of adding fairness and neutrality

to the international provisions of the Code.

F. Ordering rules for FTC carryovers

Under current law, a taxpayer with FTC carryovers in a taxable year must first

claim credits for taxes paid or accrued in that year before crediting taxes carried

over from other periods. This rule suffers from the same problems as the five-year

carryforward provision discussed above. The ability of taxpayers to obtain credit for

taxes paid in prior years is circumscribed.

Section 206 of the Bill would reverse this rule, and give credit for taxes carried

over from prior years before current year taxes were credited. The current year

taxes would themselves be eligible for carryover if the taxpayer remained with excess credits after the credit computation.

We support this change. Like the extension of the carryover from five years to

ten, it will smooth out year-to-year fluctuations in levels of foreign income and taxes

and allow a more efficient operation of the foreign tax credit regime.

G. Application of UNICAP rules to foreign persons

The uniform capitalization (‘‘UNICAP’’) rules of the Code generally require taxpayers to capitalize both direct costs and a properly allocable portion of indirect

costs attributable to property produced or acquired for resale. These rules require

a detailed allocation of costs to various activities and then to the products themselves. Almost 100 pages of regulations prescribe the specific accounting procedures

and computations that must be made.

The UNICAP rules are not currently limited to U.S. persons. Foreign taxpayers

are also subject to the rules to the extent that their income, deductions, credits, and

other tax attributes are relevant to U.S. tax. For example, a CFC must use the

UNICAP rules in computing its earnings and profits for purposes of determining the

subpart F inclusions of its U.S. shareholders.

The application of UNICAP to foreign taxpayers is a substantial increase in complexity and administrative burden. These rules apply only for U.S. tax purposes,

and a foreign corporation with no U.S. connection other than its owners would ordinarily not have to make the detailed allocations called for by the rules. Full compliance with these rules is costly for taxpayers, and often makes no revenue difference

because there is usually a cushion of undistributed and untaxed CFC earnings to

absorb any adjustments attributable to UNICAP allocations.

Section 302 of the Bill would provide that the UNICAP rules would apply to foreign persons only for purposes of computing the tax on income effectively connected

with the conduct of a U.S. trade or business. We endorse this proposal, which will

significantly simplify tax compliance for U.S. taxpayers with foreign subsidiaries.

The proposal is also sound on tax policy grounds. Activities to which the rules apply

are typically those of an active business, which when conducted by a CFC outside

the United States are not normally subject to current U.S. tax.

INCONSISTENT CHARACTERIZATION OF INCOME FROM CROSS-BORDER TRANSACTIONS

In connection with the Committee’s consideration of international tax rules, we

wish to draw attention to a significant problem that is not addressed by the Bill

but that has cost our industry needless time and money—and may ultimately reduce tax revenue to the U.S. Treasury. This problem is the characterization of inVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00043 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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come for a foreign country’s tax purposes in a way that is inconsistent with the U.S.

tax characterization of the same income.

For example, assume that a U.S. taxpayer sells a disk containing a copyrighted

computer program to a foreign buyer. Under the U.S. regulations governing transactions in computer software, this transaction is characterized as the sale of a copyrighted article. Under U.S. income tax treaties, sales income is taxable under the

Business Profits article. Under this interpretation, if the U.S. taxpayer does not

have a permanent establishment in the country of sale, the foreign country is prohibited from imposing tax.

However, the foreign tax authorities may not agree that the transaction gives rise

to business profits. Because the transaction involves copyrighted software, the payment may be viewed as a royalty, which the source country may be permitted to

tax (usually at reduced rates) under the treaty. This tax may not be creditable

against U.S. tax because the U.S. does not view the foreign country as having tax

jurisdiction over the payment.

These problems have arisen repeatedly in the cross-border activities of software

companies. Some of these companies have sought relief under the mutual agreement

procedures available under tax treaties. While these avenues can be effective, they

are costly, time-consuming, and uncertain. Furthermore, the problem is a recurring

one, and taxpayers would prefer not to resort to the mutual agreement procedure

on a regular basis.

We recognize that this problem is not resolvable by unilateral U.S. action, short

of deferring in all cases to another country’s characterization of income—a step that

the government is understandably unwilling to take. However, we encourage the

Congress and the Administration to pursue all available opportunities for resolving

these issues on a bilateral or multilateral basis.

Bilaterally, the tax treaty process—in which the Senate plays a significant role—

can be used to forge country-by-country agreements on specific points that have

arisen with particular countries. Multilaterally, work with international organizations such as the Organizations for Economic Cooperation and Development can

often lead to fruitful common understandings in key areas of international taxation.

Congress should support the participation of the United States in these efforts, and

be willing to participate fully in implementing points on which agreement is

reached.

FOREIGN SALES CORPORATION RULES

The U.S. Foreign Sales Corporation (FSC) rules have recently been challenged by

the E.U. and a decision with respect to the legality of the FSC under multilateral

trade agreements is currently pending before a WTO panel. The FSC rules are extremely important to the U.S. software industry, which derive 30% of their revenue

from exports, and the industry is grateful that Congress clarified the application of

these rules to software licenses as part of the 1997 Tax Act. The current FSC rules,

and the DISC rules that they replaced, were enacted to offset a competitive disadvantage faced by U.S. exporters because the U.S. tax system is not as generous

to exports as are the tax systems of our trading partners. These concerns still exist

today. As we await a final decision from the WTO panel on the FSC issue, I wanted

to make you aware of the importance of this issue to the software industry.

CONCLUSION

We appreciate the opportunity to present our views on international tax simplification. We appreciate the Chairman’s efforts to provide some much-needed simplification to this highly complicated area of the law. In addition, we look forward

to continued Congressional attention to U.S. tax rules that hinder competition. In

particular, we need a permanent R&D credit that compares favorably to the incentives offered by other countries. We also need to assure that the United States does

not impose higher levels of tax on exports than do our trading partners. Finally,

U.S. tax rules should not hinder efficient utilization of technology around the world.

We look forward to working with the Subcommittee on these important issues.

Chairman HOUGHTON. Ms. Strain, please.

41

STATEMENT OF DENISE STRAIN, GENERAL TAX COUNSEL,

CITICORP, CITIGROUP, NEW YORK, NEW YORK

Ms. STRAIN. My name is Denise Strain, and I am the general tax

counsel for Citicorp, a wholly-owned subsidiary of Citigroup. I want

to thank the Chairman and the Subcommittee Members for their

invitation to testify today on the topic of international tax simplification and for the Chairman’s leadership in this area.

Over the last several years, the Houghton-Levin legislation has

provided an approach for Congress to simplify and rationalize the

U.S. tax rules that apply to the global operations of U.S.-based,

multinational companies. The U.S. international tax rules are important to Citigroup because of the global reach of the company.

Citigroup is a diversified financial services company which offers

banking, insurance, credit cards, asset management, and investment banking to our customers throughout the world. Citigroup

has 170,000 employees located in 100 countries, including 112,000

employees in the United States. This global business requires us to

prepare a complicated and time-consuming tax return.

To give you some idea of the compliance burden these rules impose on Citigroup, let me describe our tax filings. In September of

1999, Citigroup will file its 1998 tax return. It will exceed 30,000

pages in length, including computations for more than 2,000 companies located in 50 States and 100 countries. More than 200 tax

professionals, both here and overseas, will be involved in this process. To say the least, it is a formidable task.

My company understands first-hand that the global economy has

become increasingly integrated; financial transactions have become

more complex; financial decisions are made more quickly, and the

tax implications, both here in the United States and in foreign jurisdictions, have become more difficult to resolve. It is not an easy

task to structure a tax system that addresses both the evolving

world of financial globalization in a manner that is fair and neutral

while maintaining competitiveness for U.S. businesses.

H.R. 2018, the legislation introduced earlier this month by Chairman Houghton and Congressman Levin, will go a long way toward

simplifying our rules and encouraging competitiveness. I would like

to highlight a couple of proposals in the bill. First, the proposal to

make permanent, or at least extend, the deferral from Subpart F

income for the active income of financial services companies is of

critical importance to the U.S. financial services industry and is

one of the key provisions in your bill. The provisions that permit

the active business income of U.S. banks, securities firms, insurance companies, finance companies, and other financial services

firms to be subject to U.S. tax only when that income is distributed

back to the United States will expire at the end of this year. Active

financial services income is universally recognized as active trade

or business income. Thus, if the current law provisions were permitted to expire at the end of this year, U.S. financial services companies would find themselves at a significant competitive disadvantage vis-a`

-vis their major foreign competitors.

Not only should the current rules be extended, but we hope very

much that Congress will refrain from making another round of

major changes to these rules. In order to comply with the deferral

rules, over the past 2 years, U.S. companies have implemented nuVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00045 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
42

merous systems changes to accurately follow two very different

versions of the active financing law. Further changes at this time

would create excruciating complexity and compliance burdens with

no commensurate benefits to the U.S. Treasury.

Another proposal in your bill would greatly simplify the foreign

tax credit rules. As a regulated industry in many countries, U.S.-

based financial services companies operating outside the United

States are often required by local laws to operate in joint ventures

with local banks and other financial services companies. For this

reason, it is so important for my industry that the tax rules be simplified for income from foreign joint ventures and other business

operations in which U.S. companies own at least 10 percent but not

more than 50 percent of the stock in a foreign company. The socalled ‘‘10/50’’ foreign tax credit limitation is bad tax policy and increases the cost of doing business for U.S. companies operating

abroad.

The 1997 Tax Relief Act sought to correct these problems by

eliminating separate foreign tax credit baskets for 10/50 companies.

However, this important change will not take effect until after

2002, and it is accomplished in a rather complicated manner. Your

bill, Mr. Chairman, will fix this problem. The proposal, which is

also included in President Clinton’s fiscal year 2000 budget, would

accelerate from 2003 to 2000 the repeal of the separate foreign tax

credit basket for such ‘‘10/50 companies,’’ and would make this

change for all dividends received in tax years after 1999.

My written testimony, submitted for the hearing record, details

a number of other important proposals included in H.R. 2018 that

we support and we believe will go a long way toward making our

international tax regime less complex and more rational.

On behalf of Citigroup, I want to thank you, Mr. Chairman, and

the members of the Ways and Means Committee for your interest

in international tax simplification. As a representative of a U.S.-

based financial services company with operations throughout the

world, I believe your efforts to simplify and rationalize the U.S.

international tax rules are vitally important.

Thank you.

[The prepared statement follows:]

Statement of Denise Strain, General Tax Counsel, Citicorp, Citigroup, New

York, New York

INTRODUCTION

My name is Denise Strain, and I am the General Tax Counsel for Citicorp, a

wholly-owned subsidiary of Citigroup. Citigroup, the product of last year’s merger

of Citicorp and the Travelers Group, is a diversified financial services holding company whose businesses provide a broad range of financial services to consumers and

corporate customers around the world.

On behalf of Citigroup, I want to thank the Chairman and the Subcommittee for

their invitation to testify today on the topic of international tax simplification. I also

want to express my appreciation, and the appreciation of Citigroup, to Chairman

Houghton, Chairman Archer, Congressman Levin, and other members of the House

Ways and Means Committee for your efforts in this area. Over the last several

years, the Houghton-Levin legislation has provided a road map for Congress in seeking to simplify and rationalize the U.S. tax rules that apply to the global operations

of U.S.-based multinational companies.

Citigroup understands first hand that as the global economy has become increasingly more integrated, financial transactions have become more complex, financial

decisions are being made more quickly, and the tax implications both here in the

43

United States and in foreign jurisdictions have become more difficult to resolve. It

is not an easy task to structure a tax system that addresses this evolving world of

financial globalization in a manner that is fair and neutral while maintaining the

competitiveness of U.S. business. The simple fact that you are conducting this hearing today sends a strong signal that we are making progress. The legislation introduced earlier this month by Chairman Houghton and Congressman Levin, which is

aimed at further simplifying key aspects of the U.S. international tax rules, includes

a number of important proposals. If enacted, these proposals will go a long way towards achieving a simpler and fairer tax regime for U.S. companies operating overseas. Mr. Chairman, in my testimony today, I would like to discuss why we believe the

goal of maintaining a tax system that keeps pace with global competition and economic integration is important. Specifically, I will discuss a number of provisions

in H.R. 2018, the International Tax Simplification for American Competitiveness

Act of 1999, that are of significance to the financial services industry, including

Citigroup.

THE IMPORTANCE OF INTERNATIONAL TAX RULES TO CITIGROUP

To understand why U.S. international tax rules are so important to Citigroup, I

think it will be helpful to the Committee if I explain a little bit about my company.

As I mentioned in my introduction, Citigroup is a diverse company. We offer our

customers a broad range of financial services, including banking, insurance, credit

cards, asset management, securities brokerage, and investment banking. The principal subsidiaries of Citigroup include Citibank, Travelers Insurance, Salomon

Smith Barney, and Commercial Credit. Citigroup has 170,900 employees located in

100 countries, including 111,640 employees in the United States.

Historically, U.S. financial services companies expanded abroad to support the

global expansion of U.S. commercial businesses. As companies such as Caterpillar,

General Motors, Exxon, and IBM have become global powerhouses and household

names outside the United States, Citicorp and Citigroup have been there to provide

capital for their expansions, and to provide banking and other investment services

and advice to their employees. This is still the case as a new generation of American

companies, including Microsoft, Intel, and Hewlett-Packard, have launched and expanded their foreign operations.

Unfortunately, U.S.-based multinational financial services companies could soon

become an endangered species. Most of the world’s large financial services players

are foreign-based companies. Only three U.S.-based companies—Citigroup,

BankAmerica, and Chase—are among the top 25 financial services companies in the

world, as measured by asset size. Citigroup’s foreign-based competitors are competing with us not only on foreign soil, but also on U.S. soil. These include such

companies as Deutsche Bank, which recently completed its acquisition of Bankers

Trust, and HSBC Holding, which is in the process of acquiring Republic Bank. Our

foreign-based competitors in insurance are also increasingly making inroads into

U.S. markets. For example, just recently, German-based Allianz AG acquired Fireman’s Fund Insurance and the acquisition of Transamerica Corp. by Dutch-based

insurance company Aegon NV is currently pending.

It is no coincidence that, for the most part, the home-country tax systems of these

companies are simpler and more neutral when it comes to taxing home-country and

international investment than the U.S. system, according to a National Foreign

Trade Council (NFTC) study of foreign tax regimes and subpart F released earlier

this year.

This level of increased competition from non-U.S.-based financial services entities

results from the fact that national economies are becoming increasingly global.

Globalization is being fueled by rapid technological changes and a worldwide reduction in tax and regulatory barriers to the free international flow of goods and capital. These changes are all for the good. However, these changes are also putting

tremendous pressure on our tax rules, which have become increasingly antiquated

over the last 30 years.

We can not afford a tax system that fails to keep pace with fundamental changes

in the global economy, or that creates barriers that place U.S. financial services

companies, as well as other U.S.-based multinationals, at a competitive disadvantage. Some have questioned whether the globalization of U.S.-based companies does

much for U.S. economic growth and employment. In my company, the answer is

easy. As Citigroup has grown internationally, our domestic support for those international activities has grown accordingly. For example, Citibank’s U.S.-based credit

card manufacturing and processing facilities produce credit card statements, inserts,

and actual credit cards for Citibank customers in Europe, Latin America, and the

44

Caribbean. Other Citigroup service centers in the United States process all the bills

and payments for outside vendors the corporation utilizes around the globe, along

with employee expense reports and reimbursements. We’ve found that consolidating

many of these back-office functions in the United States achieves a maximum level

of efficiency, just as the centralization of credit card manufacturing and processing

takes advantage of economies of scale and R&E performed in this country.

U.S. trade policy has clearly recognized that breaking down barriers to international trade is a key factor in spurring U.S. economic growth and jobs, and this

committee has played a leading role in that regard. It is ironic, therefore, that our

international tax policy at times seems to go in a different direction. For example,

we continue to face double taxation because our foreign tax credit rules are antiquated. In addition, the question still remains among some whether the active income of financial services companies should continue to be subject to the anti-deferral regime of subpart F. These two factors—the incidence of double taxation and the

premature imposition of U.S. tax on our foreign earnings—together hinder our ability to compete against foreign-based companies that face less hostile home-country

tax regimes, according to the NFTC international tax study.

THE COMPLEXITIES IN OUR SYSTEM

Moreover, our international tax regime imposes layer upon layer of needless complexity, creating an environment where taxpayers and the IRS are in a constant

tug-of-war over rules that were not designed to apply in the context of many modern

cross-border financial transactions.

From the standpoint of one of the largest financial services companies in the

world based in the United States, we see the evidence of this first hand, every day.

The labyrinth of rules and regulations we face are almost beyond comprehension.

More often than not, applying these rules to increasingly complex transactions produces more questions than answers.

To give just one example of the complexities we face, at a time when American

corporations are trying to concentrate on competitiveness and pare down nonessential costs, determining the earnings and profits of our foreign subsidiaries for

subpart F purposes requires our staff to go through a five-step procedure. This process starts with the local books of account and then continues with a series of complicated accounting and tax adjustments. On audit, each of these steps must be explained and justified to IRS agents. Yet, equally reliable figures could be provided,

at a fraction of the time and cost, by simply using GAAP to determine earnings and

profits. I am glad to say that H.R. 2018 includes just such a rule, and we would

recommend that this GAAP provision be extended to apply to calculations of earnings and profits of all foreign corporations for all purposes.

More generally, one of the biggest problems we face involves the coordination of

U.S. rules with those of the countries in which we do business. It is a fact of life

for Citigroup that our U.S. tax filing deadlines and requirements generally bear no

relationship to those of other countries. This means that we generally do not have

all the foreign information we need when our U.S. tax return is due, so our return

contains tentative information, and we are forced to adjust our returns during the

IRS audit process.

Mr. Chairman, I ask you to think about this: when you and I and tens of millions

of other Americans finish our individual tax returns by April 15 every year, we

breathe a long sigh of relief that an annoying, stressful, and time consuming process

has been completed—until next year. For Citigroup, however, this task of filing our

annual tax return is an ongoing process that often takes years to complete. This situation is ameliorated somewhat by a network of bilateral tax treaties intended to

limit double taxation and coordinate information and other requirements between

two countries’ tax regimes. However, this network does not extend to many countries in which Citigroup does business, including such emerging market countries

as Brazil and Argentina.

To give you some idea of the scope of the compliance burden for Citigroup, let me

describe our tax filings. In September, Citigroup will file its 1998 tax return. It will

exceed 30,000 pages in length, including computations for more than 2,000 companies located in 50 states and 100 countries. More than 200 tax professionals, both

here and overseas, will be involved in this process. The end of this process is the

examination of this return by IRS auditors, generally years from now. To say the

least, it’s a formidable process.

TAX SIMPLIFICATION PROPOSALS

Mr. Chairman, we do believe that enactment of a modest number of changes to

the current system will go a long way to help simplify some rules that are unnecesVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00048 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
45

sarily complex and time consuming to deal with. Moreover, I believe these changes

will help us be more competitive.

Active Financing Exception to Subpart F

The rules that permit the active business income of U.S. banks, securities firms,

insurance companies, finance companies and other financial services firms to be

subject to U.S. tax only when that income is distributed back to the United States,

expire at the end of this year. The proposal to make permanent or, at the very least

extend, the exception to the anti-deferral regime of subpart F for the active income

of financial services companies is of crucial importance to the U.S. financial services

industry and is one of the key provisions in your bill.

By way of background, when subpart F was first enacted in 1962, the basic intent

was to require current U.S. taxation of foreign income of U.S. multinational corporations that was passive in nature. The 1962 law was careful not to subject active financial services business income to current taxation, through a series of detailed

carve-outs. In particular, dividends, interest and certain gains derived in the active

conduct of a banking, financing, or similar business, or derived by an insurance

company on investments of unearned premiums or certain reserves received from

unrelated persons, were specifically excluded from current taxation. In 1986, however, the provisions that were put in place to ensure that a controlled foreign corporation’s active financial services business income would not be subject to current

tax were repealed in response to concerns about the potential for taxpayers to route

passive or mobile income through tax havens.

In 1997, the 1986 rules were revisited for several reasons. A key reason was the

fact that many U.S. financial services companies found that the existing rules imposed a competitive barrier in comparison to home-country rules of many foreignbased financial services companies. Moreover, the logic of the subpart F regime

made no sense, given that most other U.S. businesses were not subject to similar

subpart F restrictions on their active trade or business income. The 1997 Tax Act

created an exception to the subpart F rules for the active income of U.S.-based financial services companies, along with rules to address concerns that the provision

would be available to shelter passive operations from U.S. tax. At the time, the exception was included for only one year primarily for revenue reasons, as you yourself pointed out, Mr. Chairman, in remarks in support of the provision made on the

House floor.

The active financing income provision was reconsidered again in 1998, in the context of extending the provision for the 1999 tax year, and considerable changes were

made in response to Congressional and Administration concerns.

Active financial services income is generally recognized as active trade or business

income. Thus, if the current-law provision were permitted to expire at the end of

this year, U.S. financial services companies would find themselves at a significant

competitive disadvantage vis-a`-vis major foreign competitors when operating outside

the United States. In addition, because the U.S. active financing exception is currently temporary, it denies U.S. companies the certainty their foreign competitors

have. The need for certainty in this area cannot be overstated. U.S. companies need

to know the tax consequences of their business operations, which are generally evaluated on a multi-year basis.

Not only should the current rules be extended, but we hope very much that Congress will refrain from making another round of major changes to these rules. In

order to comply with the deferral rules, over the last two years U.S. companies have

implemented numerous system changes to accurately follow two significantly different versions of the active financing law. While some in government have indicated problems still exist, we all need to remember that many U.S. companies, including Citigroup, have yet to file their first U.S. tax returns incorporating the 1997

Tax Act rules in this area. It will be another 15 months before tax returns are filed

incorporating the rules that were enacted last year to apply to the 1999 tax year.

Further changes at this time would create excruciating complexity and compliance

burdens with no commensurate benefits for the U.S. Treasury.

Despite any real evidence that the current rules are not working, I understand

that the Treasury Department has suggested that Congress hold off extending the

active financing exception until Congress has had the time to review the Treasury’s

suggestions. However, the international growth of American finance and credit companies, banks, securities firms, and insurance companies would be impaired by an

‘‘on-again, off-again’’ system of annual extensions that does not allow for certainty.

Failing to extend the active financing exception this year would be the antithesis

of tax simplification. In contrast, making this provision a permanent part of the law,

or at least extending the provision, would greatly simplify U.S. international tax

rules and enhance the global position of the U.S. financial services industry.

46

The 10/50 Foreign Tax Credit Basket

As a regulated industry in many countries, U.S.-based financial services companies operating outside the United States are often required by local laws to operate

in joint ventures with local banks and other financial services companies. That is

why it is so important for my industry that the tax rules be simplified for income

from foreign joint ventures and other business operations in which U.S. companies

own at least 10 percent but not more than 50 percent of the stock in the foreign

company.

In particular, the so-called 10/50 foreign tax credit rules impose a separate foreign

tax credit limitation for each corporate joint venture in which a U.S. company owns

at least 10 percent but not more than 50 percent of the stock of the foreign entity.

The 10/50 regime is bad tax policy. The current rules increase the cost of doing business for U.S. companies operating abroad by singling out income earned through a

specific type of corporate business form for separate foreign tax credit ‘‘basket’’

treatment. Moreover, the current rules impose an unreasonable level of complexity,

especially for companies with many foreign corporate joint ventures.

The 1997 Tax Relief Act sought to correct these problems by eliminating separate

foreign tax credit baskets for 10/50 companies. However, this important change will

not take effect until after 2002, and it is accomplished in a rather complicated manner. Under the new rules, dividends from earnings accumulated after 2002 will get

so-called look-through treatment, effectively repealing the 10/50 rules, while dividends from pre-2003 earnings will all be part of a single ‘‘super’’ 10/50 foreign tax

credit basket.

Your bill, Mr. Chairman, would fix this problem. The proposal, which is also included in President Clinton’s FY 2000 budget, would accelerate from 2003 to 2000

the repeal of the separate foreign tax credit basket for such ‘‘10/50 companies.’’ In

doing so, so-called look-through treatment would apply in order to categorize income

from all such ventures according to the type of earnings from which the dividends

are paid. The proposal would apply the look-through rules to all dividends received

in tax years after 1999, regardless of when the earnings constituting the makeup

of the dividend were accumulated.

We very much support this approach and hope it can be enacted this year. In particular, the requirement of current law that we use two sets of rules on dividends

beginning with the year 2003 has been a concern of taxpayers, members of Congress, and the Administration. That is why it is so important that the effective date

of the 1997 Tax Act changes be accelerated and that the ‘‘super’’ 10/50 basket be

repealed.

Application of the U.S. Aviation Ticket Tax to Foreign Frequent-Flyer Programs

Significant administrative and compliance problems have arisen due to the interpretation that the aviation ticket tax rules as modified in 1997 may apply to certain

frequent-flyer ‘‘affinity’’ programs that operate outside the United States but involve

carriers with flights to the United States. Your bill contains a modest change to the

statute, giving the IRS and Treasury authority to address this issue in regulations

that would adequately address this problem at very little cost to the Treasury.

This is important to my industry, Mr. Chairman, because credit card companies

are among the largest providers of such affinity programs. Citibank and Diners

Club, for example, compete throughout the world with locally-based banks and credit card companies. Under these affinity programs, these banks permit their customers to earn miles on air carriers when they make credit card purchases. We provide these miles to our customers by purchasing the mileage award points from the

carriers.

Specifically, the problem relates to the extension of the 7.5 percent ticket tax to

these purchases from air carriers of frequent-flyer miles by credit card companies,

hotels, telephone companies and other consumer businesses for the benefit of their

customers. The statute has been interpreted to apply this tax to the purchase of all

mileage awards on a worldwide basis, including miles that could be redeemed for

transportation that has no relationship to the United States. This interpretation has

led to numerous diplomatic protests and has created competitive and administrative

issues for the U.S. travel and tourism industry.

We also understand that the only parties actually paying the tax at this time are

U.S.-based taxpayers, including U.S. purchasers of mileage awards and U.S.-based

carriers. Because foreign-based carriers and purchasers of miles apparently take the

position that the tax should not apply to transactions outside our borders, they are

not paying the tax. This pattern of compliance is creating an unfair playing field

for U.S. companies doing business in foreign markets.

47

The application of the aviation ticket tax to these foreign programs is a prime example of the need for simplification and rationalization in our tax rules. A simple

solution to this problem would be to provide the IRS and Treasury with regulatory

authority to exclude payments for mileage awards from the tax as long as the

awards relate to individuals with non-U.S. addresses.

Withholding Tax Exemption for Certain Mutual Fund Distributions

We very much support the proposal included in the Houghton/Levin bill to exempt

from U.S. withholding tax all distributions of interest and short-term capital gains

to foreign investors by a U.S. mutual fund, including equity, balanced, and bond

funds. Under the proposal, mutual fund distributions would be exempt from U.S.

withholding tax if they were received by a foreign investor either directly or through

a foreign fund. Similar legislation has been introduced in prior Congresses by Representatives Crane, Dunn, and McDermott.

Mr. Chairman, while the U.S. mutual fund industry is the global leader, foreign

investment in U.S. funds is low. Today, less than one percent of all U.S. fund assets

are held by non-U.S. investors. The current withholding tax that applies to all dividends distributed from a U.S. fund to foreign investors is a clear disincentive to foreign investment in U.S. funds. This is the case because distributions of interest income and short-term capital gains received directly, rather than from a fund investment, are not subject to withholding tax.

The proposed legislation would enhance the competitive position of U.S. fund

managers and their U.S.-based workforce and simplify the administration of these

funds.

OTHER SIMPLIFICATION PROPOSALS

H.R. 2018 includes a number of other international simplification proposals that

we would like to highlight.

Provide an Ordinary Course Exception to the Income Re-sourcing Rule for U.S.-

Owned Foreign Securities Dealers

Current law provides that income received by a U.S. parent from its CFC will be

re-sourced from foreign source to U.S. source to the extent the CFC is treated as

having earned U.S. source income (for example, if the CFC derives interest income

from a Eurobond). Recognizing that the existing rule is inequitable when applied

to securities dealers, the bill would create an exception to the existing re-sourcing

rule by providing that income earned by a securities dealer from securities held in

the ordinary course of conducting its customer business will not be re-sourced.

Treat a Foreign Securities Firm’s Market-Making Activities in its Parent Company’s

Issuances Consistently with its Market-Making Activities in Other U.S. Companies’

Securities

U.S.-owned foreign securities firms, as part of their ordinary course market-making activities, will hold in inventory securities of U.S. corporations. Thus, for example, a foreign securities firm may hold in inventory a Eurobond issued by General

Motors. However, Citigroup’s foreign securities dealers are effectively prohibited

from holding Citigroup issuances in inventory over quarter-end because the holding

of that security would give rise to a subpart F deemed dividend. The bill would

eliminate this rule for parent and affiliate securities held by a U.S.-owned foreign

securities dealer in the ordinary course of its market making activity.

CONCLUSION

On behalf of Citigroup, we want to thank you, Mr. Chairman, and Members of

the Ways and Means Committee for your interest in international tax simplification

and the impact of current rules on my company. As a representative of a U.S.-based

financial services company with operations throughout the world, I believe your efforts to simplify and rationalize the U.S. international tax rules are vitally important. Thank you again for the opportunity to testify today.

Chairman HOUGHTON. Thanks very much, Ms. Strain.

Mr. Jarrett.

48

STATEMENT OF THOMAS K. JARRETT, DIRECTOR OF TAXES,

DEERE & COMPANY, MOLINE, ILLINOIS

Mr. JARRETT. Good afternoon, Mr. Chairman, Members of the

Committee. My name is Tom Jarrett, director of Taxes for Deere

& Company. In this position, I am responsible for Deere’s worldwide tax and compliance measures.

Deere is the world’s largest producer and distributor of agricultural equipment and a leading producer and distributor of construction and grounds care equipment. It also finances and leases

equipment and has insurance and health care operations. We employ 26,000 people in the United States, 37,000 worldwide.

Mr. Chairman, we want to thank you for your efforts to make the

U.S. Tax Code not only simpler and fairer but also one that helps

American corporations compete abroad. In my written testimony, I

have focused on the details of three specific areas of interest to

Deere and other manufacturers: foreign interest expense allocation,

active financing income exemption, and foreign tax credit ordering

rules. The reason this Committee’s attention to these issues is critical is something you understand well. Deere and other U.S. manufacturers are in a global race with our foreign competitors. Many

of these foreign companies are provided tax policy advantages that

support their operations around the world. The U.S. Tax Code

should level the playing field for American companies so that they

may compete successfully for international business.

The issue here is cost. Bad tax policy adds cost. For instance, the

allocation of our U.S. credit subsidiaries’ interest expense to foreign

operations doubles the allocation of interest to foreign operations,

yet our U.S. credit operation has basically no foreign assets. Regarding the active financing exemption, retaining this measure will

permit Deere and others to compete on equal terms with U.S.

banks and foreign finance competitors. It is extremely important

for us to expand our markets and export our U.S. goods.

The John Deere brand is sought around the world as a result of

our reputation for quality and genuine value. Our customers are

willing to pay a premium for our products, innovative technology,

superior engineering, and overall quality. The company’s costs for

research and development and quality improvement may be reflected in the price the customer pays, but there are limits to what

the market will bear. The world market won’t allow costs associated with outdated and disproportionate tax obligations to be

passed to our customers. These costs simply slow us down in our

global race.

John Deere is a global enterprise. About one-third of Deere’s

total equipment sales in 1998 took place outside the United States.

While the U.S. farmer remains our number one customer, Deere’s

growth opportunities are increasingly tied to our ability to compete

in the global marketplace. We have aggressive growth objectives,

both in this country and abroad. Our experience is that growth

here and abroad is complimentary. Our presence abroad helps our

U.S. exports and helps to provide product volumes that keep U.S.

products less expensive for our customers. Sometimes products produced for markets outside the United States also have a use in the

United States. Our balance of payments from a U.S. perspective is

clearly positive.

49

In summary, Deere & Company must be able to compete effectively overseas in order to continue to provide jobs to its employees,

expand its business, and provide genuine value to shareholders.

The three recommendations we are making today will favorably affect all U.S. equipment manufacturers. Moreover, they will

strengthen our ability to compete favorably overseas and provide

more jobs in and exports from this country.

Thank you.

[The prepared statement follows:]

Statement of Thomas K. Jarrett, Director of Taxes, Deere & Company,

Moline, Illinois

Good afternoon Mr. Chairman and Members of the Committee. I am Tom Jarrett,

Director of Taxes for Deere & Company. In this position I am responsible for Deere’s

worldwide tax planning and compliance.

Deere & Company is the world’s largest producer and distributor of agricultural

equipment and a leading producer and distributor of construction and grounds care

equipment. It also finances and leases equipment and has insurance and health care

operations. Deere employs approximately 26,000 people in the United States and

37,000 worldwide.

The company has factories in nine states and eleven countries. Our products are

distributed and serviced worldwide by a large number of independent John Deere

dealers.

We have aggressive growth objectives both in this country and abroad. Our experience is that growth here and abroad is complimentary. Our presence abroad helps

our U.S. exports and helps provide product volumes that keep U.S. products less expensive for our customers. Sometimes products produced for markets abroad also

have a use in the U.S. Our balance of payments—from a U.S. perspective—is clearly

positive.

For Deere to continue expanding our businesses at a level acceptable to our shareholders, Deere clearly must continue to expand and be competitive overseas.

One of the greatest challenges faced by Deere and other multinational companies

is the complexity of U.S. international tax rules. Many provisions of the U.S. tax

code not only result in a paperwork burden unmatched anywhere in the world, but

also hinder the ability of American companies to compete in the international arena.

Mr. Chairman, we appreciate your leadership in examining this issue. Your legislation (H.R. 2018) addresses many areas where the U.S. Code could be improved. I

would like to focus on a few specific areas of interest to Deere and other manufacturers.

Three key tax issues that affect our competitiveness overseas are: the foreign interest expense allocation; the active financing income exemption; and, the foreign

tax credit ordering rules. The way these issues are currently handled causes U.S.

manufacturers to be less competitive with overseas manufacturers and, as a result,

reduces U.S. manufacturers’ ability to sell U.S. products overseas. For this reason,

we have advocated for several years that U.S. international tax laws must be addressed in these areas.

(1) FOREIGN INTEREST EXPENSE ALLOCATION

The maximum foreign tax credit a U.S. company can receive is equal to the U.S.

tax rate times the foreign taxable earnings less the U.S. expenses incurred to generate those earnings. In determining the U.S. expense incurred, Regulation

1.861–11T requires that the total U.S. affiliated company interest expense be allocated between domestic and foreign source income based on assets.

The Deere U.S. credit and leasing companies only finance equipment sold or

leased within the U.S. The Deere U.S. credit and leasing company assets represent

over 50 percent of the total asset allocation base. By comparison, foreign assets are

less than 13 percent of total assets. The credit and leasing companies account for

80 percent of the U.S. consolidated income tax return interest expense. The tax regulations force a disproportionate allocation of interest expense to foreign assets. The

arbitrary interest expense allocation has reduced Deere’s foreign tax credit by 11 to

20 percent in recent years. The resulting double taxation of foreign earnings makes

Deere and other manufacturers less competitive in foreign markets.

Currently, the interest expense allocation regulation exempts certain financial institutions, including chartered banks and thrifts, from the 861–11 allocation. HowVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00053 Fmt 6633 Sfmt 6621 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
50

ever, other active domestic finance companies that are defined in Section

1.904–4(e)(3) of the Regulations are actually performing the same functions as chartered banks and thrifts (such as Deere’s credit and leasing operations), but are not

included in the exemption.

We recommend that the exemption to the interest allocation regulation be expanded to include all active domestic financial institutions. In this manner, our foreign income will be more accurately reflected and our eligibility for an appropriate

level of foreign tax credit will be restored. This issue must be addressed to ensure

that U.S. companies’ international tax burden approximates that of our competitors.

(2) ACTIVE FINANCING INCOME EXEMPTION

Another important foreign tax issue to equipment manufacturers is the exemption

for active financing income. In 1997 Congress adopted an exception to subpart F of

the Code for foreign finance companies that comply with the significant active business tests in Section 954(h)(2)(A) of the Code. Prior to its adoption, subpart F taxed

all income on foreign loans and leases as the income was earned, rather than permit

such income to be deferred until foreign dividends were paid. The law viewed all

finance activity as passive investment activity.

However, Section 954(h)(2)(A) established an exception to the subpart F rules for

foreign finance companies where their principal business activity is to provide financing to unrelated parties located in the country in which the foreign finance

company was organized. This exception strengthens the business carried on by the

foreign finance companies.

Moreover, the exception was, and continues to be, extremely important to equipment manufacturers such as Deere as we expand our markets overseas and as we

expand financing activities abroad to South America, Eastern Europe and Asia. All

of these markets have a high demand for our products, but the customers have had

difficulty in securing adequate financing for their purchases of equipment. With the

expansion of our financing operations overseas during the period of the exemption,

this problem has been minimized and Deere, like other equipment manufacturers,

is able to compete successfully in the foreign marketplace.

The exemption for active financing income is scheduled to expire on December 30,

2000. Deere recommends that the active financing income exemption be made permanent. A permanent exemption would enable Deere and other manufacturers to

continue to expand our financing operations overseas, export more equipment

abroad and expand our U.S. workforce.

(3) FOREIGN TAX CREDIT ORDERING RULES

The third area of concern to Deere and other manufacturers is the manner in

which corporations must use unused foreign tax credits. Currently, unused foreign

tax credits that are earned in a given year must be used before any carryover credits can be used in that year. As a result, equipment manufacturers that are experiencing a downturn find it very difficult to claim any carryover foreign tax credit in

years of reduced profits.

Many companies often find that in a downturn (1) lower manufacturing activity

reduces foreign royalty income; (2) foreign source export sales income is greatly reduced as the demand for equipment softens overseas; (3) foreign dividends are withheld to finance the buildup of inventory and trade receivables abroad; (4) U.S. interest expense allocated to foreign source income increases as U.S. borrowings increase

to finance the buildup of similar U.S. inventory and receivables; and (5) the combination of lower foreign source income and rising 861 interest expense allocations

reduces a company’s ability to claim a foreign tax credit. And without the benefit

of a foreign tax credit, that company’s foreign earnings are being double taxed.

Accordingly, we recommend that the Committee establish ‘‘ordering rules’’ for foreign tax credits similar to the rules governing net operating losses. These rules

would permit the ‘‘earliest-to-expire’’ carryover credit to be used before any credit

that is earned in the current year—just as currently is the case with NOL

carryovers. In this manner, a company would be able to maximize its foreign tax

credit carryovers without losing them during a downturn. This would enable equipment manufacturers to maximize their foreign tax credits and remain competitive

in their overseas markets following a downturn.

In summary, Deere & Company must be able to compete effectively overseas in

order to continue to provide jobs to its employees, expand its business and provide

genuine value to its shareholders. The three recommendations that we are making

today will favorably affect all U.S. equipment manufacturers. Moreover, they will

strengthen our ability to compete favorably overseas and therefore provide more jobs

in and exports from this country.

51

Thank you.

Chairman HOUGHTON. Thank you very much. You are a very efficient man. You did it well within the time limit.

Now, I would like to turn to Mr. McKenzie.

STATEMENT OF GARY MCKENZIE, VICE PRESIDENT OF TAX,

NORTHROP GRUMMAN CORPORATION, LOS ANGELES, CALIFORNIA

Mr. MCKENZIE. Thank you, Mr. Chairman and Members of the

Subcommittee for the opportunity to appear before you today.

Northrop Grumman Corporation is a leading designer and manufacturer of defense products, and our most widely known products

are the B–2 and the Joint STARS aircraft——

Chairman HOUGHTON. Do you want to bring that mike just a little closer to you? Bring the mike a little closer to you.

Mr. MCKENZIE. I am sorry. Would you like me to start over?

Chairman HOUGHTON. No, that is fine.

Mr. MCKENZIE. OK. First, I want to commend Chairman Houghton and Congressman Levin for the many constructive changes included in H.R. 2018. In my view, Subpart F of the Internal Revenue Code has become overly complex and restrictive to the point

that it actually interferes with the conduct of international business. The reevaluation of the policy goals of Subpart F and the entire scheme of international taxation is overdue, and I applaud

your efforts to begin that process, and I would be happy to share

more of my thoughts on that once we have reached the end of this.

However, I will now focus my comments specifically on the benefits of section 303 of H.R. 2018, which repeals section 923(a)(5) of

the code that severely discriminates against U.S. exporters of products on the United States munitions list. Specifically, current law

reduces Foreign Sales Corporation benefits available to companies

that sell military products abroad to 50 percent of the benefits

available to all other exporters. The provision is essentially a penalty tax imposed only on U.S. exporters with military property and

should be repealed; its time has passed. Today, military exports,

like commercial exports, are subject to fierce international competition in every area from companies such as British Aerospace,

Aerospacio, Daimler-Benz, and others.

Since fiscal 1985, the United States defense budget has shrunk

from 27.9 percent of the Federal budget, now, to 14.8 percent in fiscal 1999; that is almost a half decrease. And in facing such dramatic cuts in U.S. defense spending, the international market has

become increasingly important to U.S. defense contractors and to

maintaining the defense industrial base. For example, of the three

fighter aircraft programs under production in this country currently, two are largely dependent on foreign customers. The same

is true for the manufacturer of the M–1A1 tank. Repeal will not

only benefit the large manufacturers of military hardware, but also

smaller munitions manufacturers whose products are particularly

sensitive to price fluctuations.

One of Northrop Grumman’s main export product lines is ground

radars. In this market, we compete against companies from France,

52

Germany, Italy, and Great Britain, which are often government

subsidized, and price is often a key factor as to who wins the foreign sale. The restoration of the full FSC benefit has the potential

to strengthen the U.S. defense industry base by leveling the playing field with our international competition.

I now want to talk about Northrop Grumman’s real-time FSC

analysis. The FSC tax benefits have a real impact on our international sales and pricing. As an example, Northrop Grumman performs the FSC benefit analysis on a real-time basis. Under our internal procedures, the tax department is responsible for reviewing

the company’s foreign bids, proposals, contracts, and joint ventures.

Our program managers and contracts negotiators are generally

aware of the FSC benefits, and we often consult with them about

it at the time the bids are prepared and the contract prices with

foreign customers are being negotiated. So, my point here is that

the FSC benefits are cranked into pricing and considered at the

time that the prices are being negotiated with foreign customers,

and if we can roll down the price, that gives us a competitive advantage against foreigners.

Now, I would like to point out that the provision is support by

the Department of Defense. For example, in a letter dated August

26, 1998, Deputy Secretary of Defense, John Hamre, wrote Treasury Secretary Rubin about the FSC. And Mr. Hamre wrote—and

here I am quoting: ‘‘The Department of Defense supports extending

the full benefits of the FSC exemption to the defense exporters. I

believe, however, that putting defense and non-defense companies

on the same footing, would encourage defense exports that would

promote standardization and interoperability of equipment among

our allies. It could also result in a decrease in the cost of defense

products to the defense products to the Department of Defense.’’

Continued export license reviews: I would now like to emphasize

that the repeal of section 923(a)(5) of the tax code, the discriminatory provision against defense contractors, does not alter U.S. export licensing policy. Military sales will continue to be subject to

the license requirements of the Arms Export Control Act. As under

current law, exporters of military property will only be able to take

advantage of the FSC after the U.S. Government has to determined

that a sale is in the national interest. However, once a decision has

been made that the military export is consistent with the national

interest, our Government should encourage such sales to go to U.S.

companies and workers, not to our foreign competitors.

As you probably know, Congressman Sam Johnson’s bill, the Defense Jobs and Trades Promotion Act of 1999, includes language

identical to section 303 of H.R. 2018. This bill enjoys broad bipartisan support. Currently, 54 Members of Congress are co-sponsors

of the bill, including 9 of the 12 members of this Subcommittee and

28 of 39 members of the full Ways and Means Committee. In addition, Senators Mack and Feinstein have introduced identical legislation in the Senate, which also enjoys broad bipartisan support.

In conclusion, I urge the Congress to enact H.R. 2018. The enactment of section 303 of H.R. 2018, in particular, will provide fair

and equal treatment to our defense industry and its workers and

enable American defense companies to compete more successfully

in the increasingly challenging international market.

53

Thank you for your time, and I will be pleased to answer any

questions that you may have.

[The prepared statement follows:]

Statement of Gary McKenzie, Vice President of Tax, Northrop Grumman

Corporation, Los Angeles, California

Mr. Chairman and Members of the Subcommittee, thank you for providing me the

opportunity to appear before you today. My name is Gary McKenzie and I am Vice

President of Tax for Northrop Grumman Corporation. Northrop Grumman,

headquartered in Los Angeles, is a leading designer, systems integrator and manufacturer of military surveillance and combat aircraft, defense electronics and systems, airspace management systems, information systems, marine systems, precision weapons, space systems, and commercial and military aerostructures. We employ about 49,000 people based almost entirely in the United States. In 1998 we had

sales of $8.9 billion. Many of our products, including the B–2 bomber and the Joint

STARS surveillance aircraft, were used extensively during the recent conflict in

Kosovo.

I am pleased to provide testimony on the myriad problems facing U.S. corporations in complying with the complexity of the current U.S. international tax regime.

I also want to commend Chairman Houghton and Congressman Levin for the many

constructive changes included in H.R. 2018, the ‘‘International Tax Simplification

for American Competitiveness Act of 1999.’’ My specific comments on the bill will

concentrate, in particular, on Section 303, the ‘‘Treatment of Military Property of

Foreign Sales Corporations.’’

Before I discuss the Foreign Sales Corporation provision, however, I would like

to say why the time has come (and, indeed, is long overdue) to reform the entire

U.S. international tax system. Particularly needing reform is our system for taxing

the foreign income of U.S. corporations under the so-called ‘‘subpart F’’ regime. The

complexity of the subpart F rules and the pressing need for a fresh look at, and complete reevaluation of, subpart F was presented in a recent report prepared by the

National Foreign Trade Council, ‘‘International Tax Policy for the 21st Century: A

Reconsideration of Subpart F.’’ I strongly agree with the report’s recommendations,

and I would like to highlight some of the issues discussed in the report.

As I am sure many of you know, subpart F was initially added to the Internal

Revenue Code (IRC) almost 40 years ago, during the Kennedy Administration. Before the enactment of the subpart F rules, U.S. tax generally was imposed on earnings of a U.S.-controlled foreign corporation (a ‘‘CFC’’) only when the CFC’s foreign

earnings were actually repatriated to the U.S. owners, usually in the form of a dividend. Subpart F is referred to by many tax professionals as an ‘‘anti-deferral’’ regime. That is, its intended purpose, which has been achieved quite effectively during

the course of numerous legislative changes since 1962, is to prevent U.S. companies

from deferring the payment of U.S. tax on income earned abroad by CFCs in their

foreign operations, including various categories of ‘‘active’’ business income. Put another way, the anti-deferral rules under subpart F frequently accelerate the imposition of U.S. tax on various types of income earned by CFCs, even though the income

has not been repatriated to the U.S. This regime places U.S. companies at a clear

disadvantage to foreign companies, which frequently do not operate under these

kinds of harsh and complex taxing rules. The simple fact is that the application of

subpart F to various categories of active foreign business income should be substantially narrowed as a first step to reforming the current anti-deferral regime.

A certain irony underlies this entire discussion. The subpart F rules were originally intended to achieve capital export ‘‘neutrality’’ when they were enacted in

1962. That is, it was intended that the subpart F rules would play no part in influencing the decision of whether to invest in the U.S. or a foreign country. Unfortunately, subpart F has developed over the last 40 years into an arcane set of rules

that not only are enormously complex, but also clearly place U.S. companies at a

competitive disadvantage in the global marketplace. It is my view, which I believe

is shared by many others, that tax rules play a key role in America’s continuing

prosperity, particularly in the context of an increasingly global marketplace. A reevaluation of the policy goals of subpart F and, indeed, the entire scheme of international taxation is long overdue; and I applaud your efforts to begin that process.

I will now discuss Section 303 of H.R. 2018, which eliminates a provision of the

tax code that severely discriminates against United States exporters of products on

the U.S. Munitions List. Specifically, Section 303 repeals IRC Section 923(a)(5),

which reduces the Foreign Sales Corporation (FSC) benefits available to companies

that sell military goods abroad to 50 percent of the benefits available to other exporters.

54

1 ‘‘The Post-Deconstruction Defense Industry,’’ 1999 Revised Edition, Dr. Loren B. Thompson,

Lexington Institute, April 1, 1999.

Congressman Sam Johnson’s bill, H.R. 796, the ‘‘Defense Jobs and Trade Promotion Act of 1999,’’ includes language identical to Section 303. This bill enjoys

broad bipartisan support. Currently 54 members of Congress are cosponsors of the

bill, including 10 of the 13 members of this subcommittee and 28 of the 39 members

of the full Ways and Means Committee, as well as a number of members from the

defense oversight and appropriations committees. Senators Mack and Feinstein

have introduced S. 1165, a companion bill in the Senate, which also enjoys broad

bipartisan support.

Repeal of Section 923(a)(5) will help protect our defense industrial base and insure that American defense workers—who have already had to endure sharply declining defense budgets—do not see their jobs lost to foreign competitors because of

detrimental U.S. tax policy.

The Internal Revenue Code allows U.S. companies to establish FSC’s, under

which they can exempt from U.S. taxation a portion of their earnings from foreign

sales. This provision is designed to help U.S. firms compete against foreign companies relying more on value-added taxes (VAT’s) than on corporate income taxes.

When products are exported from such countries, the VAT is rebated, effectively

lowering their prices. U.S. companies, in contrast, must charge relatively higher

prices in order to obtain a reasonable net profit after taxes have been paid. By permitting a share of the profits derived from exports to be excluded from corporate

income taxes, the FSC in effect allows companies to compete with foreign firms who

pay less tax.

In 1976 the Congress reduced the Domestic International Sales Corporation

(DISC) tax benefits for defense products to 50 percent, while retaining the full benefits for all other products. The limitation on military sales, currently IRC Section

923(a)(5), was continued when Congress enacted the FSC in 1984. The rationale for

this discriminatory treatment—that U.S. defense exporters faced little competition—

no longer exists. Whatever the veracity of that premise 25 years ago, today military

exports are subject to fierce international competition in every area. In the mid1970’s, roughly half of all the nations purchasing defense products benefited from

U.S. military assistance. Today U.S. military assistance has been sharply curtailed

and is essentially limited to two countries. European and other countries are developing export promotion projects to counter the industrial impact of their own declining domestic defense budgets and are becoming more competitive internationally. In

addition, a number of Western purchasers of defense equipment now view Russia

and other former Soviet Union countries as acceptable suppliers, further increasing

the global competition.

Circumstances have changed dramatically since the tax limitation for defense exports was enacted in 1976. Total U.S. defense exports and worldwide defense sales

have both decreased significantly. Over the past fifteen years, the U.S. defense industry has experienced reductions unlike any other sector of the economy. During

the Cold War defense spending averaged around 10 percent of U.S. Gross Domestic

Product, hitting a peak of 14 percent with the Korean War in the early 1950’s and

gradually dropping to 6–7 percent in the late 1980’s. That figure has now sunk to

3 percent of GDP and is planned to go even lower, to 2.8 percent by Fiscal Year

(FY) 2001.

Since FY85 the defense budget has shrunk from 27.9 percent of the federal budget

to 14.8 percent in FY99. As a percentage of the discretionary portion of the U.S.

Government budget, defense has slid from 63.9 percent to 45.8 percent over the

same time. Moreover, the share of the defense budget spent on the development and

purchase of equipment—Research, Development, Test and Evaluation (RDT&E) and

procurement—has contracted. Whereas procurement was 32.2 percent and RDT&E

10.7 percent of the defense budget in FY85—for a total of 42.9 percent; those proportions are now 18.5 percent and 13.9 percent, respectively—for a total of 32.4 percent.

Obviously, statistics such as these are indicative that the U.S. defense industry

has lost much of its economic robustness. I know members of Congress are well

aware of the massive consolidation and job loss in the defense industry. Out of the

top 20 defense contractors in 1990, two-thirds of the companies have merged, been

sold off or spun off; hundreds of thousands of jobs have been eliminated in the industry. To put this in perspective, consider, for instance, the fact that in 1998

WalMart had $138 billion in revenues; in comparison, the combined revenues of the

top five defense contractors totaled $61 billion—less than half the WalMart results

for the year.1

55

Budget issues are always a concern to lawmakers. The Joint Tax Committee estimates that extending the full FSC benefit to defense exports will likely cost about

$340 million over five years. Overriding policy concerns justify this expense. With

the sharp decline in the defense budget over the past fifteen years, exports of defense products have become ever more critical to maintaining a viable U.S. defense

industrial base. Several key U.S. defense programs rely on international sales to

keep production lines open and to reduce unit costs. For example, of the three fighter aircraft under production in this country, two are largely dependent on foreign

customers. The same is true for the manufacturer of the M–1A1 tank, which must

compete with several foreign tank companies. Repeal will not only benefit the large

manufacturers of military hardware, but also the smaller munitions manufacturers,

whose products are particularly sensitive to price fluctuations.

One of Northrop Grumman’s main product lines is ground radars. In this market

we compete against companies from France, Germany, Italy and Great Britain, and

these companies are often government subsidized. Price is frequently a key factor

as to who wins the sale. The restoration of the full FSC benefit has the potential

to improve the defense industrial base and our ability to compete on a more level

playing field with foreign firms.

The recent conflict in Kosovo demonstrated the importance of interoperability of

equipment among NATO allies. Unfortunately, when our foreign competitors win a

sale, not only does a U.S. business lose a contract, the U.S. military must then conduct operations with a military using different equipment. For example, Northrop

Grumman and Lockheed Martin recently competed against a Swedish company,

Ericsson, for a contract to supply an Airborne Early Warning System (AEW) to the

Greek Government. Despite the fact that both U.S. companies were offering proven,

state-of-the-art technology at a fair price, the Greek Government selected the

Ericcson proposal, which had never been tested and will lack commonality with the

NATO AEW system when built.

This is one reason why the Department of Defense supports repeal of Section

923(a)(5). In an August 26, 1998, letter, to Treasury Secretary Rubin, Deputy Secretary of Defense John Hamre wrote:

The Department of Defense (DoD) supports extending the full benefits of the

FSC exemption to defense exportersI believe, however, that putting defense and

non-defense companies on the same footing would encourage defense exports

that would promote standardization and interoperability of equipment among

our allies. It also could result in a decrease in the cost of defense products to

the Department of Defense.

Section 303 implements the DoD recommendation and calls for the repeal of this

outdated tax provision.

The recent decision to transfer jurisdiction of commercial satellites from the Commerce Department to the State Department illustrates the fickleness of Section

923(a)(5). When the Commerce Department regulated the export of commercial satellites, the satellite manufacturers received the full FSC benefit. When the Congress

transferred export control jurisdiction to the State Department, the identical satellites, manufactured in the same facility, by the same hard working employees, no

longer receive the same tax benefit. Why? Since these satellites are now classified

as munitions, they receive 50 percent less of a FSC benefit than before. This result

demonstrates the inequity of singling out one class of products for different tax

treatment than every other product manufactured in America.

The Cox Committee, recognizing the absurdity of the situation, recommended that

the Congress take action to correct this inequity as it applies to satellites. The

administration has agreed with this recommendation. Section 303 would not only

correct the satellite problem, but would also change the law so that all U.S. exports

are treated in the same manner under the FSC. The Department of Defense and

the Cox Committee are not the only entities that have commented publicly about

this provision. Several major trade associations including the National Association

of Manufacturers, the U.S. Chamber of Commerce, and the Electronics Industry

Alliance, to name just a few, have stated that Section 923(a)(5) is bad tax policy

and should be repealed.

A joint project of the Lexington Institute and the Institute for Policy Innovation,

entitled ‘‘Out of Control: Ten Case Studies in Regulatory Abuse,’’ highlighted the

FSC. The December 1998 article, fittingly titled ‘‘26 U.S.C. 923(a)(5): Bad for Trade,

Bad for Security, and Fundamentally Unfair,’’ because it reveals the many problems

with this provision. In the paper, Dr. Thompson argues that Congress’ decision to

limit the FSC benefit for military exports was not based on sound analysis of tax

law, but on the general anti-military climate that pervaded this country in the mid1970’s. Congress enacted Section 923(a)(5), and I quote: ‘‘to punish weapons makers.

56

Section 923(a)(5) was simply one of many manifestations of congressional antimilitarism during that period.’’

I want to emphasize that the repeal of Section 923(a)(5) of the tax code does not

alter U.S. export licensing policy. Military sales will continue to be subject to the

license requirements of the Arms Export Control Act. Exporters will only be able

to take advantage of the FSC after the U.S. Government has determined that a sale

is in the national interest.

Decisions on whether or not to allow a defense export should continue to be made

on foreign policy grounds. However, once a decision has been made that an export

is consistent with those interests, surely our government should encourage such

sales to go to U.S. companies and workers, not to our foreign competitors. Discriminating against these sales in the tax code puts our defense industry at great disadvantage and makes no sense in today’s environment. Removing this provision of

the tax code will further our foreign policy objectives by making defense products

more competitive in the international market.

I urge the Congress to repeal this provision in order to provide fair and equal

treatment to our defense industry and its workers and to enable American defense

companies to compete more successfully in the increasingly challenging international market.

I thank you for your time and will be pleased to answer any questions that you

have.

Chairman HOUGHTON. Thank you, Mr. McKenzie.

Now, Mr. Kelly.

STATEMENT OF STAN KELLY, VICE PRESIDENT-TAX, WARNERLAMBERT COMPANY, MORRIS PLAINS, NEW JERSEY

Mr. KELLY. Good afternoon. I am honored to appear before the

Ways and Means Committee. I am Stan Kelly, Vice President of

Tax for Warner-Lambert Company, a $10 billion U.S. multinational

headquartered in Morris Plains, New Jersey.

Warner-Lambert employs 41,000 people in 150 countries and operates 78 manufacturing facilities worldwide. Warner-Lambert has

three principal product lines: confections, consumer health products, and pharmaceuticals. Well known Warner-Lambert brands include Listerine, Benadryl, Sinutab, Trident gums, and Halls lozenges. Warner-Lambert’s pharmaceutical line includes Lipitor, the

world’s leading cholesterol reducing agent, and Viracept, the

world’s leading AIDS treatment.

The pharmaceutical industry is on the brink of a scientific revolution that will be sparked by the decoding of the human genome

during the next few years. This revolution will be global. Drug targets will jump from 500 to 15,000, triggering a tidal wave of competition. Warner-Lambert’s competition will come primarily from

Japan and Europe whose tax policies support their multinationals

better than U.S. policies support our multinationals. U.S. international tax policy must change in order to improve the competitive position of U.S. companies.

Mr. Chairman, your bill and this hearing are important steps

that can help to move U.S. international tax policy in the right direction. Warner-Lambert strongly supports H.R. 2018 because it

promotes three sound, international tax policies that would help to

improve American competitiveness. First, your bill would begin to

reverse the anti-deferral rules in our tax system. I refer to section

107 of the bill, which provides for look-through treatment for sales

with partnership interest. In addition, although it does not affect

57

Warner-Lambert, I refer to section 101 of the bill, which provides

for permanent Subpart F exemption for active financing income.

Second, your bill would improve the operation of the foreign tax

credit system by reducing double taxation that is inherent in the

system today. Eliminating double taxation is a fundamental objective of U.S. international tax policy. I refer to section 207 of the

bill, which provides for the repeal of the 90 percent foreign tax

credit limitation under the alternative minimum tax.

Third, your bill would simplify the administration of our international tax rules. I refer to section 306 of the bill instructing the

Treasury to issue regulations stating that agreements which are

not legally enforceable are not intangible property for various purposes. Warner-Lambert supports this provision, which mandates a

bright-line test in an area where Treasury has not exercised the

regulatory authority given to it more than 15 years ago.

I would now like to direct your attention to two provisions of the

bill that may need further clarification. First, section 102 of the bill

authorizes Treasury to conduct a study of the feasibility of treating

the European Union as one country for purposes of the same-country exceptions under Subpart F. Warner-Lambert supports this

concept, but section 102(a) also provides,

Such studies shall include consideration of methods of ensuring that taxpayers

are subject to a substantial effective rate of foreign tax in such countries if such

treatment is adopted.

The policy goals represented by this sentence are unclear. Does

the United States have a tax or trade policy requiring U.S. multinationals to pay substantial amounts of foreign tax on profits made

outside the U.S.? Wouldn’t such a policy make it easier for other

developed countries to fund the support of their own multinationals? Mr. Chairman, I strongly urge you to reconsider the language in section 102 of your bill.

The second provision that may need clarification is section 310

of your bill, which would amend the earning stripping rule in section 163(j) of the code. I believe that this provision could actually

facilitate stripping of U.S. earnings by our foreign competitors, and

Warner-Lambert could not identify any benefit to U.S. multinationals in section 310. I am concerned that section 310 may inadvertently impose a competitive tax disadvantage on U.S. multinational corporations.

Overall, H.R. 2018 is a good step in the right direction for U.S.

international tax policy, but more can be done to improve the competitiveness of U.S. multinationals. I encourage this committee to

continue its efforts. Warner-Lambert is ready to offer its assistance.

I want to thank you all for your time today and commend and

thank you, Mr. Chairman, for introducing H.R. 2018 and for holding this hearing.

[The prepared statement follows:]

Statement of Stan Kelly, Vice President-Tax, Warner-Lambert Company,

Morris Plains, New Jersey

Good afternoon, Chairman Houghton and members of the Committee, I am

pleased to testify today about the impact of the current U.S. tax system on the competitiveness of U.S. multinationals. I will also comment on your effort to improve

58

and simplify the U.S. tax system, specifically H.R. 2018, the ‘‘International Tax Simplification for American Competitiveness Act of 1999.’’

WARNER-LAMBERT: A GLOBAL LEADER BUILDING GLOBAL BRANDS

I am Stan Kelly, Vice President of Tax for Warner-Lambert Company. WarnerLambert is a U.S. multinational company headquartered in Morris Plains, New Jersey, which employs approximately 41,000 people devoted to developing, manufacturing and marketing quality health care and consumer products worldwide. The

members of the Subcommittee may be familiar with some of Warner-Lambert’s

brand name products, such as Listerine, Sudafed, Benadryl, Schick and Wilkinson

Sword shaving products, Tetra, Rolaids, Halls, Trident, Dentyne and Certs. Our

Pharmaceutical sector is comprised of three parts: Parke-Davis, which has been engaged in the pharmaceutical business for 127 years; Agouron, a wholly-owned subsidiary of Warner-Lambert, an integrated pharmaceutical company engaged in the

discovery, development and commercialization of drugs for treatment of cancer, viral

diseases, and diseases of the eye; and Capsugel, the world leader in manufacturing

empty, hard gelatin capsules. Warner-Lambert’s leading pharmaceutical products,

Lipitor, Rezulin, Neurotin, Accupril, and Agouron’s Viracept were developed to treat

patients suffering from high cholesterol, diabetes, epilepsy, heart failure, and AIDS.

It is an honor to appear before the Ways and Means Committee and to continue

our company’s participation in the trade and tax policy-making process. Our Chairman and CEO, Lodewijk de Vink, testified two years ago before the Subcommittee

on Trade. Warner-Lambert is proud to be a leader in promoting free trade policies

and my remarks today regarding the U.S.’s international tax regime are closely

intertwined with those same policies. In 1998, Warner-Lambert had total revenues of approximately $10.2 billion ($4.3

billion, or 40% from international sales) and sold product in over 150 countries.

Warner-Lambert has approximately 78 production plants in its six lines of business

worldwide.

THE BIOMEDICAL CENTURY

Senator Daniel Patrick Moynihan (D–NY) recently said that the 21st century

would be the ‘‘Biomedical Century.’’ At the heart of this statement are the significant potential biomedical advances that Warner-Lambert and other companies in

the pharmaceutical industry will make in the next decade. Scientists will soon complete a project started in 1990, to map the code of life itself, the Human Genome.

Within five years, the number of targets for drug therapy will increase from 500

today, to more than 15,000, as scientists apply the findings of this project. That is

a thirty-fold increase at a time when even 500 drug targets keeps the global pharmaceutical industry going at full bore. So, for this reason and others, we agree with

Senator Moynihan’s statement. We are on the brink of a revolution in research and

development that will lead to new forms of prevention, new cures, and new treatments. This revolution is global and U.S. companies need to compete aggressively

in product discovery, development, manufacturing, marketing, and delivery with

equally talented and driven foreign competitors primarily from Europe and Japan.

U.S. trade policy and U.S. international tax policy must keep pace with these

changes in order to mitigate competitive disadvantages facing U.S.-based companies.

Let me emphasize this last part: the global pharmaceutical industry is highly

competitive, with many of the world’s largest pharmaceutical corporations

headquartered outside the United States. These competitors such as GlaxoWellcome, Novartis, Astra Zeneca, Roche, Hoechst Marion Roussel, and SmithKline

Beecham are not subject to the worldwide tax system similar to that used by the

United States.

The U.S. has long recognized the importance of open global markets in the continued growth of the U.S. economy. The U.S. trade policy is evolving to ensure that

U.S. companies are able to remain competitive in a global economy. Conversely, U.S.

tax policy, particularly as it relates to the taxation of international activities, has

not kept pace with changes in the global market place in helping to promote U.S.

competitiveness. Simply stated, U.S. tax policy is out of step with the broader objectives of our country’s evolving trade policy. Mr. Chairman, your bill and this hearing

are important steps towards harmonizing these two important and related policy

areas. Before I turn to my specific comments on your bill, let me give you an example

of how well the system can work when U.S. businesses and the Government work

together toward a common objective. Last year Warner-Lambert and others had the

opportunity to work with the U.S. Treasury Department and foreign revenue officials in coordinating the tax consequences of the conversion to the Euro. The policy

59

1Section 207 of H.R. 2018 is identical to H.R. 1633 (introduced on April 29, 1999 by Chairman

Houghton and 25 other members of the Ways and Means Committee) and S. 216 (introduced

on January 19, 1999 by Sens. Moynihan and Jeffords (R–VT)).

asserted by U.S. business was tax neutrality, i.e., the U.S. tax cost of converting

to the Euro should be the same to a U.S. multinational corporation operating in Europe as the foreign tax cost to a foreign multinational corporation operating in Europe. By maintaining tax neutrality, the competitiveness of U.S. multinational corporations operating in Europe was maintained. The U.S. Treasury should be complimented for quickly developing a practical policy that enabled a smooth transition

to the Euro.

Turning now to your bill.

WARNER-LAMBERT STRONGLY SUPPORTS H.R. 2018

Warner-Lambert strongly supports H.R. 2018 because it promotes three sound

overall international tax policies: (i) reversing the growth of anti-deferral rules in

our tax system by narrowing the scope of subpart F; (ii) improving the operation

of the foreign tax credit system by reducing double taxation; and (iii) simplifying

tax compliance.

• Reversing Anti-Deferral rules: The proposed changes would restore aspects of

deferral that have been eliminated since the enactment of subpart F in 1962. This

is an important contribution to the continued effort to improve the competitiveness

of American industry. I refer to Sections 103 (expansion of the de minimis rule

under subpart F) and 107 (look-through treatment for sales of partnership interests)

of the bill as examples of this policy. In addition, even though not of direct interest

to Warner-Lambert, I also refer to Section 101 of the bill (permanent subpart F exemption for active financing income) as an example of this policy.

• Improving the Operation of the Foreign Tax Credit System By Reducing Double

Taxation: The foreign tax credit system is the United States’ attempt at fairness to

U.S. multinationals (as compared to the exemption system used by many countries),

with the intention of eliminating double taxation of income earned outside the

United States. Eliminating double taxation through the foreign tax credit system is

a fundamental objective of U.S. international tax policy. Accomplishing this objective is critical to the competitiveness of American industry. I refer to Sections 201

(extension of period to which excess foreign taxes may be carried) and 207 (repeal

of limitation of foreign tax credit under alternative minimum tax) of the bill as examples of this policy.1

• Simplifying Tax Compliance: Simplifying the administration of tax compliance

is another important element in improving the competitiveness of American industry. U.S. tax compliance is generally considered much more burdensome than tax

compliance under the laws of many of our principal trading partners. I refer to Section 306 of the bill (instructing the Treasury to issue regulations to the effect that

agreements which are not legally enforceable are not intangible property for various

purposes) as an example of this policy. Warner-Lambert supports this provision,

which mandates a bright-line test in an area where Treasury has not exercised regulatory authority given to it more than 15 years ago.

I would like to direct your attention to one section of H.R. 2018 that is of particular interest to Warner-Lambert. Section 107(a) would amend Section 954(c) of

the Internal Revenue Code (the ‘‘Code’’) to provide a look-through rule for the sale

of a partnership interest by a controlled foreign corporation (‘‘CFC’’). If a CFC disposes of an interest in a partnership, the CFC would be deemed to have sold its

pro rata share of the underlying assets of the partnership. This look-through rule

only applies if the CFC has a 10% or greater interest in the partnership. This rule

makes sense for three reasons. First, with the proliferation of international joint

ventures there are instances where a transfer of a partnership interest is deemed

to be a sale and gain recognized for U.S. tax purposes. Thus, the U.S. tax treatment

of gain from the sale of a partnership interest by a CFC is becoming a more common

issue.

Second, under the present law the gain on the sale of a partnership interest is

treated as passive subpart F income. That is the case even if 100% of the income

generated by the partnership in its business is otherwise treated as active non-subpart F income. Thus, under this amendment gain from a partnership interest is

treated in a manner similar to the income earned from the partnership, which is

a rational tax policy.

Third, under current law the transfer of a partnership interest is frequently treated as a deemed transfer of a pro rata share of the partnership’s underlying assets,

60

2 A reduction in the carryback period from two years to one year was most recently approved

by the Senate Finance Committee on May 19, 1999 as Section 401 of S. 1134, the Affordable

Education Act of 1999.

such as under Code Section 367(a)(4). Thus, this change enhances consistency in the

treatment of a sale of a partnership interest in the international tax area.

Overall H.R. 2018 is clearly a step in the right direction. It should be noted, however, that there are confusing signals from Congress. For example, Section 201 of

H.R. 2018 expands the carryover period for foreign tax credits, but, in contrast, the

Senate Finance Committee earlier this year once again approved a proposal to reduce the carryback period.2

REQUEST FOR CLARIFICATION

There are two provisions of your bill, Mr. Chairman, that need further clarification. Section 102(a) of the bill authorizes the Secretary of the Treasury to conduct

a study on the feasibility of treating all countries included in the European Union

as one country for purposes of applying the same country exceptions under subpart

F. That aspect of Section 102 represents a positive step, which Warner-Lambert

strongly supports. That provision is attractive to us because it would lessen the gap

between ourselves and our European based pharmaceutical competitors in that market. But then Section 102(a) provides as follows:

Such study shall include consideration of methods of ensuring that taxpayers

are subject to a substantial effective rate of foreign tax in such countries if such

treatment is adopted.

The policy represented by this sentence is unclear. Should the policy of the United

States be that non-U.S. business activities of a U.S. multinational corporation must

be subject to ‘‘substantial’’ foreign tax? If so, how did we reach this point? Mr.

Chairman, I strongly urge you to reconsider the language in Section 102(a) of your

bill and in particular ask that you do so in light of the recent National Foreign

Trade Council’s (the ‘‘NFTC’’) report on international tax policy for the 21st century.

Also Section 310 in H.R. 2018 appears to be inconsistent with the notion of ‘‘International Tax Simplification for American Competitiveness.’’ Section 310 would

amend the so-called ‘‘earnings stripping’’ rule in Section 163(j) of the Code. The

earnings stripping rule imposes a limitation on the amount of interest expense that

may be deducted by a foreign-owned domestic corporation. This subsection was enacted to stop the practice by foreign multinationals of ‘‘stripping’’ the earnings out

of their domestic subsidiaries through related-party loans. Many other developed

countries have similar restrictions, frequently in the form of debt/equity ratio requirements.

I believe that this provision might potentially facilitate earnings stripping by our

foreign competitors. Warner-Lambert could not identify a benefit to U.S. multinationals of Section 310. Let us make certain that Section 310 is not an instance

where by unilateral action the United States indirectly imposes a competitive tax

disadvantage on its own multinational corporations.

Although this amendment to Code Section 163(j) may have merit, I ask this Committee to take into account the treatment accorded U.S. multinationals in the reverse situation before proceeding with this subsection. I would also point out that

Section 310 incorporates what may be considered a subjective test, i.e., satisfying

the Secretary that a loan would have been made without a parent guarantee. A

number of years ago the subjective test in the high-tax exception of Code Section

954(b)(4) (no tax avoidance intention) was repealed because of alleged administrative difficulties in applying the test.

THE NFTC REPORT

Before I conclude, I would like to comment on a recent report issued by the NFTC,

an organization of which I am pleased to be a member of the Board of Directors.

This report, The NFTC Foreign Income Project: International Tax Policy for the 21st

Century (the ‘‘Report’’), is the first of a series of studies commissioned by the NFTC

to evaluate our international tax policies in light of the globalization of the world’s

economy. The first report focused on the subpart F rules of the Code, which provide

a number of exceptions to the principal U.S. international tax policy of deferral of

U.S. taxation on foreign earnings until distributed. The Report highlights the slow

breakdown of deferral. Your bill focuses on and addresses this trend.

The Report concludes that (1) the economic policy justification for the current

structure of subpart F has been substantially eroded by the growth of a global economy; (2) the breadth of subpart F exceeds the international norms for such rules,

61

adversely affecting the competitiveness of U.S.-based companies; and (3) the application of subpart F to various categories of income that arise in the course of active

foreign business operations should be substantially narrowed.

When subpart F was enacted in 1962, 18 of the 20 largest corporations in the

world (ranked by sales) were headquartered in the U.S. Now there are eight. In

1962 over 50% of worldwide cross-border direct investment was made by U.S. businesses. Now that number is 25%. U.S. gross domestic product as a percentage of

the world total has gone from 40% to 26%. As these figures suggest, the competitive

environment in 1962 and the competitive environment today are completely different. Thus, international tax policy should reflect this change to a global economy.

In 1962 subpart F included a de minimis test where a CFC was deemed to have no subpart F income if certain designated categories of income constituted 30% or

less of total gross income. That test over time has been reduced to the lesser of 5%

of gross income or $1,000,000. As a result, we have reached the point where incidental interest income earned on normal levels of working capital used in an active

business constitutes subpart F income. In 1962, the ‘‘high-tax exception’’ referred to

the alternative of a specified effective tax rate or establishment of no tax avoidance

intent. Now a mechanical effective tax rate test creates anomalous situations in

which, for example, a CFC organized in Italy (with a statutory tax rate in excess

of the U.S. rate) may fail the high-tax exception because U.S. and Italian capital

recovery rules are not identical. Also, the U.K. now constitutes a low-tax jurisdiction

under our subpart F rules and, therefore, a CFC doing business in the U.K may

no longer qualify for the high-tax exception of Code Section 954(b)(4).

A subsequent NFTC report will focus on the functioning of the second principal

U.S. international tax policy—avoidance of double taxation through the foreign tax

credit system.

CONCLUSION

In conclusion, I commend and thank you Mr. Chairman for introducing H.R. 2018

and holding a hearing on what is a highly technical but extremely important area

of our tax laws. Warner-Lambert supports the bill but more can be done in the

international tax area to improve the competitiveness of U.S. multinationals. I encourage this Committee to continue its efforts in this regard. Warner-Lambert is

ready to offer its assistance in your efforts. Finally, I urge you to include the important provisions in H.R. 2018 in the tax bill the Committee will be marking up early

next month.

Mr. Chairman, I am pleased to answer any questions.

Chairman HOUGHTON. Well, thank you very much.

I am going to ask one question, and then I am going to pass it

over to Mr. Coyne.

Tell me, gentlemen, how do we treat the European Union as one

tax entity when there are so many different tax laws in the various

countries? Help us on that.

That is a question, and I hear no answers.

Mr. KELLY. Maybe I will try.

Chairman HOUGHTON. Well, yes, because—I mean, it is very easy

to say that there are too many baskets and a lot of bows being

thrown the way of U.S. corporations that make us uncompetitive

with other parts of the world and other European countries, but to

move from the principle to the practical, how does it get done?

Mr. KELLY. Mr. Chairman, just to make sure I understand the

question, are we talking about the provision related to the European Union?

Chairman HOUGHTON. Yes.

Mr. KELLY. OK. The way I understand that provision is that it

is really addressing the treatment of Subpart F income in the European Union so that it is dealing with movements of funds across

borders. It is not trying to say that all of the rules and all of those

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countries should be treated the same. It is only saying that if you

move cash back and forth with royalty payments or interest payments, et cetera, that we not treat those movements of cash as taxable in the United States.

Mr. COX. I think that is right, Mr. Chairman, and I think also,

to give you an example in our industry, Germany is our biggest

market; Switzerland is a small market, so I actually had a discussion with our German country manager one time that said he

wanted to service the Swiss market by having men and women

sales representatives just either fly in or drive into the Swiss market. I told him he couldn’t do that. He looked at me like I was

cross-eyed, and I said, ‘‘Well, you can’t do it because of U.S. Subpart F,’’ and then he really went cross-eyed on me. But the importance of that—and the gentleman is exactly correct—the issue is

not how much tax we would pay in Switzerland or how much tax

we would pay in Germany, the issue is, absent setting up—and I

believe Mr. Jarrett pointed it out correctly—adding additional

costs, administrative costs, setting up a new subsidiary in Switzerland, all that cost, why do I have to do that as a corporation? Why

do I need to make that decision? I am going to pay tax, and the

foreign taxes I pay and I credit will simply be determined based

on whichever country I do business in, irrespective of and knowing

full well that all those countries will have different rates. So, I

think we are maybe trying to make that a little more complicated

than it should be.

Chairman HOUGHTON. Well, we will get back to this in a minute.

I want to call on Mr. Coyne.

Mr. COYNE. Thank you, Mr. Chairman.

One would hope that our international tax policies would lend

themselves to domestic firms having incentives to retain operations

and workers here in the United States. Which provisions of the

proposed bill, 2018, would do that? They would lend themselves to

retain jobs in the United States. Anyone can answer.

Mr. MCKENZIE. I think, if I could speak, that section 303 of the

bill clearly would aid in doing that by making us more competitive

on international bids and for selling military property overseas.

That would tend to strengthen the industrial base for defense companies, keep workers employed here to the extent that we could

win those contracts, and, as a byproduct, even though we get somewhat of a tax break on the FSC rules, overall, we pay more U.S.

tax if we are able to generate additional U.S. profits overseas. So,

as I see it, it is a win-win situation for everybody.

Mr. COYNE. Anyone else care to comment?

Ms. STRAIN. I would agree with that. If one assumes that, for example, the active financing provision helps us U.S. companies be

more competitive in the overseas marketplace and therefore be able

to expand our businesses there. We see, today, in my company that

we have a number of locations in the United States which originally started out servicing just a domestic customer base which

now service our global customers. It is the credit card business, our

payables, some of our cash management functions—all are done in

the United States for overseas markets. Similarly, our R&D, is developed primarily first for the American market, and then we exVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00066 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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port. It, therefore, becomes cheaper for us to develop if we have a

larger customer base.

Mr. COYNE. Can you cite what types of industries, however,

would be more likely to move operations overseas and why that

would be an advantage to them? Just by type of industry.

Mr. COX. Congressman, specifically related to provisions in this

bill?

Mr. COYNE. Right.

Mr. COX. I cannot.

Mr. COYNE. All right, thank you.

Chairman HOUGHTON. All right. Mr. Watkins.

Mr. WATKINS. Let me ask the question a little differently in

something that might be in the real practical phase of it. By the

way, I have used a lot of that green and yellow.

Each of you see some of these provisions were enacted to take

place. How many more jobs—let me say it right now—what percentage of exports do you do now, so to speak, from this country?

What additional increases and exports would you think your company would achieve by these provisions? And then we were talking

about, probably, economic growth here, jobs over here in this country, too, and you tried to give us a little bit of insight on that. A

lot of companies do not do a very good job educating their employees that their job depends on export trade. Now, I have talked to

some of my businesses, because we can’t pass Fast Track, we can’t

do other things, and people are voting actually against their jobs,

in many cases, with some of these industries. Now, what kind of

increase do you think you would have with jobs in this country if

some of these provisions would be passed?

Mr. MCKENZIE. Well, Congressman, if I may answer that the

way I understand your question, I think it cuts two ways. If a company forms a ‘‘maquiladora’’ in Mexico to attain cheaper wages in

Mexico, that may, in fact, have some effect of transferring jobs

overseas to obtain the cheaper labor. However, the case that we are

after—if I could just point out a couple of statistics. In 1998, for

example, Northrop Grumman had export sales qualifying for the

FSC treatment of approximately $1 billion. That is up 128 percent

over 1997, and it is up 278 percent over 1994. So, that created U.S.

jobs, OK? Because the manufacturing that took place on those

qualifying sales took place in the United States by definition, in

order to meet the requirements to qualify for a foreign export sale.

That is what we mean by strengthening the U.S. defense base in

the workplace.

Mr. WATKINS. Right. You see where I am coming from. I think

this is going to be the compelling argument on how this is going

to be helping over here and sharing with us.

How about you, Mr. Jarrett and John Deere?

Mr. JARRETT. As I mentioned in my statement, I think about onethird of Deere’s sales today are export sales. Deere serves an agricultural market for half of its income, basically. It is a very mature

market in the United States. The growth in our agricultural products, many of our construction products is going to be overseas. The

markets in South America, the markets in Asia are growing, and

that is where the farmers, the customers need equipment. Much of

that equipment comes from the United States. It is going to be our

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ability to not only produce equipment in the United States but also

to produce equipment in the countries that need it. The technology,

the competitiveness, the research and development all comes from

the United States, and that is what we want to retain from our

perspective or from a manufacturers perspective. I need to control

that technology; I need to control that patent and the ability to

make that equipment worldwide. That is where we will gain from

having an even playing field from a tax structure.

Mr. WATKINS. Well, I know your company has done a good job.

I am product of using the old Pop and Johnny, what we called it

years ago, the old Pop and Johnny, and it has changed a whole lot

since that day when I used to crank them a little bit. I am not that

old, but, you know, just back where you couldn’t get them to me.

Any other comment on some of the other companies?

I think we have done a poor job of educating the American people—if I can just say this—and part of it—I am challenging the

companies that I know of and I have worked with to get off their

duffs and help, because they expect a lot of things from us, and I

am a believer. I am willing to get into the trenches and try to make

sure we don’t have certain barriers out there that make it difficult

to burst into those markets overseas and be able to do business.

But I know the chairman of Boeing is leading an effort and realizes

that—a go trade effort and hope that your companies are involved

in that, because we have got to do a lot in those areas, including,

as I said, not only the taxation policy but the regulatory and litigation policies that you are confronted with and many companies are,

and what little work I have done outside the Congress in the international field, I found it very complicated.

Mr. Chairman, thank you very, very much, and I appreciate the

insight in your companies; something is happening there.

Chairman HOUGHTON. Is that it? OK. Mr. Neal.

Mr. NEAL. Thank you, Mr. Chairman.

Ms. Strain, the Treasury Department has urged Congress to

delay any extension of the active financing exception to the Subpart F rules until after it completes a thorough study of the Subpart F regime later this year. Do you believe that we should agree

to that proposal from Treasury?

Ms. STRAIN. I would urge you to continue with the provision that

you have. I think that the Treasury study that is being undertaken

is very worthwhile. I think it needs to be done. We need simplification and reform, and perhaps, answers, to Mr. Levin’s question earlier of what more needs to be done. We probably need to have that

discussion, but I think that we also need to get on with business

and continue to maintain a competitive posture. The Treasury

study, I believe, will spark a lot of conversation, a lot of study, and

a lot of analysis, and that is not going to be a short-term effort.

It will be a longer-term effort. But in the shorter-term, now, we

need to have the provision renewed and extended.

Mr. NEAL. Thank you. Mr. McKenzie, thank you for your statement on the Foreign Sales Corporation rules for military property.

From a tax perspective, can you think of any legitimate policy reason why defense projects should be singled out from receiving the

full FSC benefit?

65

Mr. MCKENZIE. No, sir. As a matter of fact, we view in the industry as a penalty tax against U.S. defense contractors. In other

words, we are the only ones who are not permitted to claim the full

FSC benefit, and we were singled out and discriminated against

and allowed only half the benefit that was allowed to everyone else.

Now, in my view—and I am speaking strictly for myself here—this

provision came into law back in 1975 at the height of the global

arms race between the United States and Russia, at a time when

Vietnam was the hot issue, and there were those on both sides of

the aisle who, on the one hand, wanted to disallow all benefits for

FSC for military contractors and those on the other side that wanted to allow full benefits, seeing no difference whatsoever between

exporting military sales approved by DOD and all other products.

And I think what happened in the end was the baby was cut in

half as a compromise, and that is where we have been so far. I see

no logic, really, to allowing half if there are sound arguments for

repeal. It seems to me, it should either come out one way or the

other, and now that the environment has totally changed, it seems

to me that we should allow and treat military product exports that

are approved by DOD as being in the national interest as no different from any other export product.

Mr. NEAL. Fair enough.

Thank you, Mr. Chairman.

Chairman HOUGHTON. Thanks very much.

Mr. Portman.

Mr. PORTMAN. Thank you, Mr. Chairman, and I want to commend Mr. Levin and the Chairman, Mr. Houghton, for doggedly

pursuing this issue over the years since I have been on the Ways

and Means Committee. It is a simplification issue and a competitiveness issue, the two being related, and I think it is great that

we are rolling up our sleeves and getting into some of these issues,

and I hope on this tax bill we will be able at least to make the

downpayment.

I have an interest in the territorial tax system. I am told that

this didn’t come up today—and I apologize that I am late—but if

we could talk a little about the territorial tax system and its impact on your companies as compared to some of your competitors.

Maybe if I could just ask a couple of questions, Mr. Chairman, the

first being, do you have any competitors in developed countries, industrialized countries like the United States, that use other than

a territorial tax system for their employees, their foreign employees? Are there any other competitors of yours that are based in a

foreign country that have a tax situation that is similar to the one

you face being a U.S. company? Are you aware of any?

Mr. COX. With few exceptions, Congressman. In the software industry, most of the companies are U.S.-based multinationals. There

are some exceptions, but most of them are similar to us.

Mr. PORTMAN. Ms. Strain.

Ms. STRAIN. In the financial services industry, I would say that

most of our foreign competitors are not U.S.-based multinationals.

Deutsche Bank, HSBC, Standard Charter, are our major competitors in a number of different jurisdictions. If you look at their published effective tax rates compared to the effective tax rates of U.S.

financial institutions, they are generally lower.

66

Mr. PORTMAN. And that is because they have territorial tax system, correct?

Ms. STRAIN. You are crossing a number of different jurisdictions,

but that is a factor, also probably, more liberal controlled foreign

corporation rules. Integration systems, as well. So there will be a

number of different factors, but the data shows that they are generally facing lower effective tax rates.

Mr. PORTMAN. Mr. Jarrett.

Mr. JARRETT. That is very true with manufacturing. We face

local competitors in those countries, and U.S. tax law today for

international operations forces us at a significant disadvantage. As

I mentioned earlier, in just looking at my interest allocation rules,

over half of the interest expense that Deere incurs this year relates

to our credit operation. Our credit operation has no foreign assets;

it basically operates within the United States to provide credit to

the Deere customers here, but we have to allocate almost 60 percent of that interest expense overseas. That causes us to lose about

20 percent of our foreign tax credit, raising our price to our customers.

Mr. PORTMAN. The interest allocation issue is one that is near

and dear to my heart, and I understand it is not a subject of this

hearing, particularly. We are addressing it during a competitiveness hearing that is coming up, but getting back to the territorial

issue, the territorial system versus a worldwide system, does that

put you at a competitive disadvantage?

Mr. JARRETT. Yes, it does.

Mr. PORTMAN. Mr. McKenzie.

Mr. MCKENZIE. Yes, I couldn’t agree more. One of the biggest

problems I see is being able to move excess cash in one country to

another country where it’s needed to enhance the overall conduct

of the business. That gets very difficult under current subpart F

rules. Of course there’s tremendous U.S. taxes. If you simply loan

excess capital from a subsidiary in Germany to a subsidiary in

Switzerland, that is considered to be a deemed dividend back to the

United States, taxable in the United States, and then back to Switzerland. That seems to me totally unfair. That is why I say it interferes with the conduct of good U.S. business practices. That is just

one example.

All of the other examples come under section 367(d). When you

want to transfer products overseas, section 482 for inter-company

pricing allocations. Foreign tax credits when you do want to bring

income back to the United States. You have to be extremely careful

about what you invest or U.S. foreign earnings in. When you liquidate a company, it gets very complicated, but when you want to

reorganize foreign subsidiaries, that also gets extremely complicated to avoid U.S. taxes.

Mr. PORTMAN. And many of these are not problems that a foreign

competitor of Northrop Grumman would experience?

Mr. MCKENZIE. In my experience, the foreign competition we face

have much more lax rules in that area. It is much easier for them

to move working capital around to where they need it. As a matter

of fact, I would be in favor actually of going back to the 1962 proposals that the Kennedy Administration came up with to tax U.S.

companies currently on their U.S. worldwide operations, and in exVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00070 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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change for that, allow foreign tax credits for foreign taxes actually

paid overseas. If that is too much to put through all at once, perhaps establish some arbitrary limit on the foreign tax credit of 80

to 85 percent. That would dramatically simplify the rules in this

area, it seems to me, and do away with a lot of the bells and whistles that we have hung onto the system. I would not—however,

support a change in current law that would lead to a higher tax

burden for U.S. taxpayers.

I don’t mean to castigate the system. I think that the principles

and fundamentals that we have in the Internal Revenue Code are

sound. It is just a matter that we tried to hand too many bells and

whistles on it that we need to scale it back.

Mr. PORTMAN. Mr. Kelly, do you have anything to add?

Mr. KELLY. Yes. In the case of the pharmaceutical industry, we

have obviously some U.S. competitors and some foreign competitors. With respect to the foreign competitors, some are located in

countries which use territorial systems. For example, the German

pharmaceutical companies, Hoechst Marion Roussel and Scherig

AG operate under a territorial system.

With respect to the other competitors, foreign competitors who

are not located in territorial systems, if you were to look at the

NFTC study I think you would see that although they appear to

be systems like ours, in fact there is substantially less taxing of offshore operations by countries such as Japan, the UK, France, et

cetera.

Mr. PORTMAN. Thank you, Mr. Kelly.

Thank you, Mr. Chairman.

Chairman HOUGHTON. Thanks very much.

Mr. Levin.

Mr. LEVIN. Thank you, Mr. Chairman. This is becoming an increasingly interesting hearing. There are some policy bases or

maybe irrational policy bases for all these provisions. I appreciate

the questions of our colleagues, Mr. Chairman; Mr. Coyne, and Mr.

Neal’s questions I think helped to bring out issues like the impact

on jobs in this country. I appreciate Mr. Portman’s kind words.

His question raises the most basic issue about our system. I

think we should always be ready to look at the assumptions in our

system, always though careful to avoid the conclusion that there is

an easy alternative. Radical reform is often more easily said than

done. We have essentially proceeded I hope importantly, but somewhat incrementally. That has been the assumption. We hope it has

made a difference and there is more ground to cover.

In that regard, Mr. Kelly, we will take another look at the language about the study. I think actually one of your colleagues, panelists, kind of answered it. The question relates not to—it doesn’t

really I think reflect the fact that there are different tax rates and

structures in the country, in the various European countries, but

the notion that we could for the purposes of this provision, treat

all those systems, the countries the same. Whether that is really

an appropriate assumption, I don’t know. We will take another look

at it.

Mr. KELLY. Thank you.

Mr. LEVIN. It was to look at tax havens within the European

Community and the impact of them on these provisions.

68

Let me say, Mr. McKenzie, I asked some of the staff who have

been around here I think longer than I have, but who are younger

than I, whether they remembered the rationale for the 50 percent.

Their explanation was the same as yours, if you can call it a rationale.

Mr. MCKENZIE. Yes.

Mr. LEVIN. I think that may have been a case where you split

the baby in half and it clearly doesn’t make any sense.

Mr. MCKENZIE. I believe so, yes.

Mr. LEVIN. But we need to take a look at that as we’re doing in

this provision. I hope we can have some rational discussions.

Just quickly, the question about active financing and the Treasury. Were we talking about two different things? I think maybe we

were. The Treasury study about the entire structure and the Treasury response to extension of this provision. I am not sure they are

one in the same, maybe they are. I would hope Treasury could give

us their suggestions about extending the active financing provision

in time for us to act, even if they are looking at the broader picture.

Let me close, Mr. Chairman, and just ask Mr. Cox, because I

think you stated correctly that it is hard for us I think to adopt

a policy that simply says that we’ll accept the characterization of

other countries in your field. So I think you need to help us come

up with how we resolve that riddle, because I am not sure what

we do about it. It seems to me if we allowed the characterization

of other countries to determine our tax treatment, it would be subject to manipulation on their part. Correct?

Mr. COX. I agree, Congressman Levin. One of the things that

Congress can do is play an active role in treaty negotiations. Obviously that is usually done on the Senate side, but in following recognized bodies like OECD, OECD has now come with models that

they are coming to a position that has agreed upon with regard to

characterization of a lot of things, one of which is software income.

So I think by supporting those types of efforts, that is one thing

that Congress can do.

Mr. LEVIN. OK. But let’s talk further about it because I would

believe—and this relates to Mr. Coyne’s good question about the

impact on businesses and jobs here. I think your answer was a

very responsive one. The jobs are basically here, not entirely, but

substantially, which we want to be able to continue. I think we

would like to find ways to be helpful without adopting a statutory

provision that really would not be workable. So let us know. Give

us some further ideas.

Mr. COX. That is correct. I mean whether it’s changes in subpart

F, which allow us, as Mr. Jarrett said, those are cost issues. Cost

issues means do I spend money on tax issues or do I spend money

hiring people to do jobs which can create a new product in my particular industry. In my particular company, the average wage of

the U.S.-based workforce exceeds $75,000 per annum. So these are

extremely good jobs that we would like to keep in the United

States. So whether it’s issues like extending the research credit on

a more permanent basis, you had a discussion about that earlier,

all of these things are important as we look at where do we place

69

jobs. We would like to place them here, whether it’s in the United

States.

Mr. LEVIN. We surely agree with that.

Mr. COX. I didn’t think you would have any objection.

Mr. LEVIN. No.

Mr. COX. We’re on the same page there.

Mr. LEVIN. Absolutely.

Mr. COX. But realize as we make business decisions, those are

factors, maybe not the only factor, maybe not even the most important factor, but those are factors that business men and women

look at every day in terms of where to——

Mr. LEVIN. Right. That is the gist of this legislation. Thanks.

Thanks, Mr. Chairman.

Chairman HOUGHTON. Thanks. I just have a few questions.

Mr. Jarrett, you talk about controlling technology, it’s important

that you control technology. Tell me how the treatment of international tax laws affects the control of technology.

Mr. JARRETT. The treatment of international tax policy will affect

that because if your U.S. tax policy forces me or other companies

overseas, we get into regimes that we have to develop technology

in those countries. Those countries will own that technology from

the standpoint of the sub that’s there. The United States loses

some of its effectiveness to control where that technology goes from

there. All countries don’t have the same laws to protect trademarks, patents. If we have some of those in our overseas subsidiaries, we have to follow their country rules. I like to keep that technology at home where it is controlled, where we can dole it out as

it needs to be, make the investment in it in U.S. property and export the product.

Chairman HOUGHTON. Still—you have to help me. I am a little

slow on this. What you are saying is that if you move basic weight

of industry abroad—jobs, investment, and, technology will be there.

The reason that’s its moved abroad is because of the tax laws.

Therefore, less of our technology can be produced in this country.

Is that right?

Mr. JARRETT. If that technology is developed overseas, that belongs to that overseas subsidiary. It doesn’t belong to our U.S. subsidiary. There is a cost to bring that back home. We are trying to

keep that technology home where I believe we should keep that

technology at home.

Chairman HOUGHTON. Yes. But as you look way out, I mean, you

can take a look at the past 30 years of your company and you take

it and look at another 30 years, won’t you be doing a great deal

more sort of spot manufacturing and spot development in the areas

where you have got to serve that market? So, you still will have

that problem in terms of controlling technology. It doesn’t have

anything to do with the tax laws.

Mr. JARRETT. We would have that problem, except we license

that technology overseas rather than develop it overseas. We want

our U.S. parent to own that technology.

Chairman HOUGHTON. OK. Thank you.

I would like to ask Ms. Strain the question about the active financing exception to subpart F. Tell me a little bit about this. How

does this help you?

70

Ms. STRAIN. In a couple of different ways. From my perspective,

I worry about the computation of our ultimate U.S. tax liability. It

is a complicated procedure. We have had two different tax laws

that we have had to deal with in the last 2 years. In terms of gathering information, calculating it for our tax return, I am sending

requests out to personnel in 100 different countries. English is not

necessarily their first language. I am asking them to interpret U.S.

tax law and give information back. So in that regard, I would hope

that we don’t have a change for a third year in a row in terms of

the law, considering the compliance aspect to it.

Without active financing we are required to provide for U.S.

taxes whether we distribute income or not. In terms of our acquisition activity, which as you might guess, has been increasing over

the last couple of years of the financial services industry worldwide

consolidates, when we are bidding for a company overseas, we are

using a U.S. tax rate rather than the local tax rate. We find that

many of our competitors obviously are operating in lower tax jurisdictions or have lower effective rates. Again, not 100 percent of the

time is the tax reason why we may not win a bid, but it is certainly

an important factor in terms of our ability to expand overseas.

Last, it helps in normal planning. The subpart F requirements

in terms of recognizing income on a current basis require us to calculate income as if it was distributed back to the United States. It

does not obviously reflect a reality. It is more complicated. It affects our foreign tax credit computations. It makes the whole management of our overseas operations more difficult.

Chairman HOUGHTON. OK. That is very helpful. Thanks a lot.

Now let me just come back to the basic question which I had

posed earlier. I have a report here from the Joint Committee on

Taxation. Again, I have got to go back to the concept of the European Union as being considered one tax entity. Our bill, as you

probably have read, will direct the Secretary of the Treasury to

study this feasibility, and I know the European Union has taken

great steps to integrate their economies and so on and so forth, but

they do have different tax rules. I just wondered how you feel

about whether these tax rules are sufficiently harmonized to allow

sort of a single treatment. Anyone?

Ms. STRAIN. I think the answer is that the tax rules are probably

not harmonized at this point in time, but I believe that the answer

to that question was that it relates to the treatment of subpart F

income and how it should be calculated.

One of the factors though I think we should point out is that if

we are looking at the European Union, the OECD is also concerned

about this issue in terms of tax haven activity. They are trying to

exclude from the definition of the European Union so-called ‘‘tax

havens,’’ which I think they are working to develop. So I think in

one sense there is a certain amount of pressure off the notion that

the European Union contains within it, tax havens that will draw

more and more business activity to that location. But the answer

I think was that the subpart F rules have to be reviewed in the

context of whether they still make sense.

Chairman HOUGHTON. Does anybody have any other comments

on that?

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Mr. KELLY. I hope this is helpful. If a member of the E.U. makes

a dividend distribution back to its U.S. parent, we are going to look

at the tax structure in that country to determine the U.S. tax consequences. So that actual distributions and actual pavements back

to the United States, as far as I understand the provision, wouldn’t

be affected by our using the single country exception for all the

E.U. That is just for Subpart F. So in effect, you kind of split the

system. The advantage of doing that is really to facilitate our handling of cash off shore and to simplify our compliance here in the

United States.

Mr. COX. I think Mr. Kelly is exactly correct on that. It eliminates that need to worry about common everyday business issues,

movement of funds. You know, one subsidiary needs money, one

does not, irrespective of the differing rules which is when you actually do have a distribution from one of those foreign corporations.

Chairman HOUGHTON. OK. That is very helpful. Any other questions? All right. Well, ladies and gentlemen, thank you very much

for being with us. I look forward to working with you.

The hearing is adjourned.

[Whereupon, at 2:49 p.m., the hearing was adjourned.]

[Submissions for the record follow:]

Statement of William W. Chip, Chairman, Tax Committee, EuropeanAmerican Business Council

My name is Bill Chip. I have been engaged in international tax practice for 20

years and am a principal in Deloitte & Touche LLP. I am testifying today as Chairman of the Tax Committee of the European-American Business Council (EABC).

The EABC is an alliance of 85 multinational enterprises with headquarters in the

United States and Europe. A list of EABC’s members is attached. Because the

EABC membership includes US companies with European operations and European

companies with US operations, the EABC brings a unique but practical perspective

to how the complexity of the US international tax regime may impede US companies

from competing in the European Union (EU)—the world’s largest marketplace.

The EABC welcomes the efforts underway in this Subcommittee and elsewhere in

Congress to reconsider the international tax rules that have accumulated in the Internal Revenue Code. The current regime imposes tax burdens on US-owned foreign

enterprises that are not borne by the same foreign enterprises when owned by nonUS companies. If US ownership of a foreign enterprise is not tax-efficient, that enterprise will not relocate to the US but will instead become foreign-owned. The foreign-owned enterprise may continue to ship its output to the US, but its profits will

be forever exempt from US taxation.

Nowhere is the anti-competitive burden imposed by US tax rules more evident

and damaging than in the application of the US ‘‘subpart F’’ rules to US-owned enterprises in the EU. The subpart F rules were intended to prevent US companies

from avoiding US taxes by sheltering mobile income in ‘‘tax havens.’’ The impact

of these rules is exacerbated by the fact that since 1986 any country with an effective tax rate not more than 90% of the US rate is effectively treated as a tax haven.

Even the United Kingdom, an industrialized welfare state with a modern tax system, is treated as a tax haven by subpart F because its 30% corporate rate is only

86% of the US corporate rate. If the US corporate tax rate when subpart F was enacted were the benchmark, the US today would itself be considered a tax haven.

Subpart F focuses on economic activity that Congress perceived as ‘‘mobile’’ and

therefore readily located in a tax haven. Manufacturing income was generally exempted from subpart F because manufacturing was perceived as geographically tied

to transportation facilities and to sources of energy and materials and therefore unlikely to be artificially located in a tax haven. Because Congress perceived that selling and services were relatively mobile activities that could be separated from manufacturing and located in tax havens, the ‘‘foreign-base company’’ rules of subpart

F immediately tax income earned by US-controlled foreign corporations from sales

or services to related companies in other jurisdictions.

How do these rules impede the competitiveness of a US company seeking to do

business in the EU? Consider a US company that already has operations in several

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EU countries but wishes to rationalize those operations in order to take advantage

of the single market. Such a company may find it most efficient to locate personnel

or facilities used in certain sales and service activities in a single location or at least

to manage them from a single location. While a number of factors will affect the

choice of location, all enterprises, whether US-owned or EU-owned, will favor those

locations that impose the lowest EU tax burden on the activities in question. However, if the enterprise is US-owned, the subpart F rules may eliminate any locational tax efficiency by immediately imposing an income tax effectively equal to the

excess of the US tax rate over the local tax rate. Thus, US companies are penalized

for setting up their EU operations in the manner that minimizes their EU tax burden (even though reduction of EU income taxes will increase the US taxes collected

when the earnings are repatriated). It makes as little sense for the US to penalize

its companies in this way as it would for the EU to impose a special tax on European companies that based their US sales and service activities in the US states

that imposed the least taxes on those activities.

The original rationale for the foreign-base company rules was twofold. The first

was that companies with operations in low-tax jurisdictions might abuse transfer

pricing to allocate unwarranted amounts of income to those operations. This concern

is obsolete in light of the powerful tools acquired by the IRS in the past decade to

enforce arm’s length transfer pricing. The second was that, if a mobile sales or service activity did not need to be located in any particular location, there was generally

no valid business purpose served by incorporating that activity in a tax haven company rather than a US company. This rationale has no application to US companies

that locate their EU-wide sales and service functions in a single EU location, from

which other EU subsidiaries are then served. The current subpart F rules would not

tax the income of a UK subsidiary from serving another UK subsidiary, but they

would tax such income if the UK company’s personnel went to France to serve a

French subsidiary. It should be self-evident that there are valid business reasons

for not establishing a separate company in France, let alone a US company, to perform the latter services. Moreover, there is little likelihood of US companies achieving ‘‘tax haven’’ results through EU locational decisions, since the EU member

states have ample reason themselves not to permit the formation of tax shelters

within the EU, as evidenced by the emerging EU Code of Conduct against harmful

tax competition.

For the foregoing reasons, the EABC was pleased to see that section 102 of H.R.

2018 acknowledges the importance of this issue by requiring a Treasury study to

be concluded within six months of enactment. However, the EABC believes that further study is unwarranted. The EU is unique—nowhere else in the world have so

many important trading nations established a truly integrated market. Success in

this fiercely competitive market is critical to success in the world at large. Almost

since the inception of subpart F, US companies attempting to exploit the opportunities of the common European marketplace have pleaded for relief from the application of subpart F rules that treat the location of EU-wide activity in one EU member

rather than in another as a form of tax avoidance that must be penalized. We respectfully observe that the time for correcting this most blatant of the unwarranted

consequences of the US subpart F regime is long overdue.

Members of the European-American Business Council

ABB

ABN Amro Bank

AgrEvo

Airbus Industrie

AirTouch Communications Inc.

Akin, Gump, Strauss, Hauer & Feld

Akzo Nobel Inc.

Andersen Worldwide

Astra Pharmaceutical Products Inc.

AT&T

BASF Corporation

BAT Industries

Bell Atlantic Inc.

Bell South Corporation

BMW (US) Holding Corporation

BP America, Inc.

BT North America, Inc.

Cable & Wireless

Chubb Corporation

Citicorp/Citibank

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Cleary, Gottlieb, Steen & Hamilton

Compagnie Financiere de CIC et de l’Union Europeenne

Credit Suisse

DaimlerChrysler

Deloitte & Touche LLP

DIHC

Dun & Bradstreet Corporation

Eastman Kodak Company

ED&F Man Inc.

EDS Corporation

Ericsson Corporation

Finmeccanica

Ford Motor Company

Gibson, Dunn & Crutcher

Glaxo Inc.

IBM Corporation

ICI Americas Inc.

ING Capital Holding Corporation

Investor International

Koninklijke Hoogovens NV

Linklaters & Paines

Lucent Technologies

MCI Communications Corporation

Merrill Lynch & Company, Inc.

Michelin Tire Corporation

Monsanto Company

Morgan Stanley & Co.

Nestle USA, Inc.

Nokia Telecommunications Inc.

Nortel Networks

Novartis

Novo Nordisk of North America

Pechiney Corporation

Pfizer International Inc.

Philips Electronics North America

Pirelli

Powell, Goldstein, Frazer & Murphy

Procter & Gamble

Price Waterhouse LLP

Rabobank Nederland

Rolls-Royce North America Inc.

SAAB AB

Sara Lee Corporation

SBC Communications Inc.

Siegel & Gale

Siemens Corporation

Skandia

Skanska AB

SKF AB

SmithKline Beecham

Sulzer Inc.

Tetra Laval Group

Tractebel Energy Marketing

Unilever United States, Inc.

US Filter

Veba Corporation

VNU Business Information Svcs., Inc.

Volkswagen

Volvo Corporation

White Consolidated, Inc.

Xerox Corporation

Zeneca Inc.

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Statement of the Financial Executives Institutes, Detroit, MI

Chairman Amo Houghton and Members of the Subcommittee on Oversight of the

House Ways and Means Committee:

The Financial Executives Institute (‘‘FEI’’) Committee on Taxation appreciates

this opportunity to present its views on the current U.S. international tax regime.

FEI is a professional association comprising 14,000 senior financial executives for

over 8,000 major companies throughout the United States. The Tax Committee represents the views of the senior tax officers from over 30 of the nation’s largest corporations.

At the outset, FEI would like to thank Chairman Houghton and Mr. Levin for introducing H.R. 2018, the International Tax Simplification for American Competitiveness Act of 1999. This legislation builds on your previous successful efforts to keep

step with the rapid globalization of the economy by simplifying and rationalizing the

international provisions of the Internal Revenue Code (the ‘‘Code’’).

TAXATION IN A GLOBAL ECONOMY

The U.S. international tax regime reflects a balance between two important, but

sometimes conflicting, goals: neutrality and competitiveness. The U.S. generally

tries to raise revenue in a neutral manner that does not discriminate in favor of

one investment over another. At the same time, the U.S. seeks to raise revenue in

a way that does not hinder, and where possible helps, the competitiveness of the

American economy, its firms and its workers.

The current balance between neutrality and competitiveness was struck almost

four decades ago during the Kennedy Administration. At the time, the rest of the

world was still in large measure trying to rebuild from the social, physical and political devastation of World War II. The United States was a comparative economic

giant, accounting for 50 percent of worldwide foreign direct investment and 40 percent of worldwide GDP. Under these circumstances, policymakers were more concerned with the impact of tax law on the location decisions of U.S. firms—i.e., neutrality—than on the effect of tax law on the competitiveness of those firms.

Accordingly, the Code taxes U.S. taxpayers on their worldwide income, with a tax

credit for taxes paid to foreign jurisdictions. In theory, this approach ensures that

a given investment by a U.S. firm will experience roughly the same level of taxation

regardless of location. The Code takes competitiveness concerns into account by deferring tax on the active income of foreign subsidiaries of U.S. firms until the income is repatriated. This ensures that active subsidiaries are not more heavily taxed

currently than their non-U.S. competitors down the street. Over the years, this deferral has been increasingly limited as competitiveness has taken a back seat to concerns about tax avoidance by U.S. taxpayers.

Today, the global economic landscape looks very different than it did during the

Kennedy Administration. Europe, Japan and a host of other nations have emerged

as tough competitors. Revolutions in transportation, telecommunications and information technology mean that firms increasingly compete head-to-head on a global

basis. As a result, the U.S. is fighting harder than ever to maintain its share, now

down to about 25 percent, of the world’s foreign direct investment and GDP, and

many U.S. firms now focus as much or more on fast-growing overseas markets as

on the mature U.S. market.

The U.S. needs to adapt its international tax regime to this new reality. It is no

longer acceptable merely to strive to treat U.S. taxpayers or their investments in

a neutral manner. We must also consider how their competitors from other nations

are taxed by their host governments. For example, while the United States continues to tax its taxpayers on a worldwide basis, many of our trading partners tend

to tax their businesses on a ‘‘territorial’’ basis in which only income earned

(‘‘sourced’’) in the home jurisdiction is subject to taxation. Even countries which tax

on a worldwide basis do so with far fewer limitations and less complex rules on deferral, the foreign tax credit and the allocation and apportionment of income, deductions and expenses between domestic and foreign sources.

MAKING AMERICA MORE COMPETITIVE

With your leadership, Mr. Chairman, Congress in recent years has taken some

positive steps to reform the international tax rules and make America more competitive. Among the important changes: eliminating the PFIC/CFC overlap, simpliVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00078 Fmt 6633 Sfmt 6621 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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1For example, according to a 1990 ‘‘White Paper’’ submitted by the International Competition

Subcommittee of the American Bar Association Section of Taxation to congressional tax writing

committees, countries such as France, Germany, Japan, and The Netherlands do not tax domestic parents on the earnings of their foreign marketing subsidiaries until such earnings are repatriated.

fying the 10/50 basket, applying the FSC regime to software, repealing section 956A,

and extending deferral to active financing income.

H.R. 2018 includes many of the necessary next steps for reform. FEI strongly endorses this legislation and associates itself with the oral testimony of the National

Foreign Trade Council with respect to specific provisions of the bill.

For example, FEI strongly supports the provision in H.R. 2018 that seeks to treat

the European Union as a single country. The European Union created a single market in 1992 and a single currency, the euro, in 1999. Yet U.S. international tax rules

still treat the EU as 15 separate countries. This has made it difficult for U.S. companies to consolidate their EU operations and take advantage of the new economies

of scale. Over time, our European competitors, who do not face such obstacles to

consolidation, will gain a competitive advantage.

Another example is the provision that would accelerate the effective date for

‘‘look-through’’ treatment in applying the foreign tax credit baskets to dividends

from 10/50 companies. The 1997 tax law allows such look-through treatment for

dividends paid out of earnings and profits accumulated in taxable years beginning

after December 31, 2002. This means U.S. corporate taxpayers face an unnecessary

tax cost until 2003.

THREATS TO COMPETITIVENESS

Notwithstanding these positive developments, there have been some ominous

clouds on the international tax horizon. The Treasury Department early last year

issued guidance on so-called ‘‘hybrid entities’’ that would have substantially hindered the ability of U.S. companies to compete abroad (Notice 98–11). Although the

original ‘‘hybrid’’ rules were withdrawn and we understand that the subsequent notice (Notice 98–35) is being reconsidered, Treasury has given every indication that

it will continue to push neutrality concerns over competitiveness. (e.g. seeking limits

on deferral and promoting the OECD effort on ‘‘harmful tax competition’’). These

and other proposals to amend the Code in ways that threaten U.S. competitiveness

take us in precisely the opposite direction from where we need to go in the global

economy. Consider the effort by some to further limit deferral.

Under current law, ten percent or greater U.S. shareholders of a controlled foreign

corporation (‘‘CFC’’) generally are not taxed on their proportionate share of the

CFC’s operating earnings until those earnings are actually paid in the form of a dividend. Thus, U.S. tax on the CFC’s earnings generally is ‘‘deferred’’ until an actual

dividend payment to the parent company, just as tax is ‘‘deferred’’ when an individual holds shares in a company until such time as the company actually pays a

dividend to the individual. However, under Subpart F of the Code, deferral is denied—so that tax is accelerated—on certain types of income produced by CFCs.

Subpart F was originally enacted in 1962 to curb the ability of U.S. companies

to allocate income and/or assets to low-tax jurisdictions for tax avoidance purposes.

Today, it is virtually impossible under the Section 482 transfer pricing and other

rules to allocate income in this manner. Indeed, the acceleration of tax on shareholders of CFC operations has no counterpart in the tax laws of our foreign trading

partners.1 Nevertheless, Subpart F remains in the Code, putting U.S. companies at

a disadvantage. In many instances, Subpart F results in the taxation of income that

may never be realized—perhaps because of the existence in a foreign country of exchange or other restrictions on profit distributions, reinvestment requirements of

the business, devaluation of foreign currencies, subsequent operating losses, expropriation, and the like—by the U.S. shareholder.

Other problems posed by the acceleration of tax under Subpart F and similar proposals include:

• Acceleration of tax may lessen the likelihood or totally prevent U.S. companies

from investing in developing countries by vitiating tax incentives offered by such

countries to attract investment. This result would be counter to U.S. foreign policy

objectives by opening the door to foreign competitors who would likely order components and other products from their own suppliers rather than from U.S. suppliers.

Moreover, any reduced tax costs procured by these foreign competitors would likely

be protected under tax sparing-type provisions of tax treaties that are typically

agreed to by other nations, although not by the U.S. Treasury.

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• It may result in double taxation in those countries which permit more rapid recovery of investment than the U.S., because the U.S. tax would precede the foreign

creditable income tax by several years and the carryback period may be inadequate.

Moreover, even if a longer carryback period were enacted, the acceleration of the

U.S. tax would be a serious competitive disadvantage vis-a`-vis foreign-owned competition. • It would discriminate against shareholders of U.S. companies with foreign operations, as contrasted with domestic companies doing business only in the U.S., by

accelerating the tax on unrealized income. This is poor policy because U.S. multinational companies have been and continue to be responsible for significant employment in the U.S. economy, much of which is generated by their foreign investments. • It could harm the U.S. balance of payments. Earnings remitted to the U.S. have

exceeded U.S. foreign direct investment and have been the most important single

positive contribution to the U.S. balance of payments. The ability to freely reinvest

earnings in foreign operations results in strengthening those operations and assuring the future repatriation of earnings. Accelerating tax on CFCs would greatly

erode this advantage.

Acceleration of tax on CFCs is often justified by the belief that U.S. jobs will

somehow be preserved if foreign subsidiaries are taxed currently. However, in reality, foreign operations of U.S. multinationals create rather than displace U.S. jobs,

while also supporting our balance of payments and increasing U.S. exports. Foreign

subsidiaries of U.S. companies play a critical role in boosting U.S. exports by marketing, distributing, and finishing American-made products in foreign markets. In

1996, U.S. multinational companies were involved in an astounding 65 percent of

all U.S. merchandise export sales. And studies have show that these exports support

higher wage jobs in the United States.

U.S. firms establish operations abroad because of market requirements or marketing opportunities. For example, it is self-evident that those who seek natural resources must develop them in the geographical locations where they are found, or

that those who provide time-sensitive information technology products and services

must have a local presence. In addition, as a practical matter, local conditions normally dictate that U.S. corporations manufacture in the foreign country in order to

enjoy foreign business opportunities. This process works in reverse: it has now become commonplace for foreign companies like BMW, Honda, Mercedes, and Toyota

to set up manufacturing operations in the U.S. to serve the U.S. market. It is not

just multinationals that benefit from trade. Many small- and medium-sized businesses in the U.S. either export themselves or supply goods and services to other

export companies.

Moreover, CFCs generally are not in competition with U.S. manufacturing operations but rather with foreign-owned and foreign-based manufacturers. A very small

percentage (less than 10% in 1994) of the total sales of American-owned foreign

manufacturing subsidiaries are made to the U.S. Most imports come from sources

other than foreign affiliates of U.S. firms. In addition, a decrease in foreign investment by U.S. companies would not result in an increase in U.S. investment, primarily because foreign investments are undertaken not as an alternative to domestic investment, but to supplement such investment.

There is a positive relationship between investment abroad and domestic expansion. Leading U.S. corporations operating both in the U.S. and abroad have expanded their U.S. employment, their domestic sales, their investments in the U.S.,

and their exports from the U.S. at substantially faster rates than industry generally. In a 1998 study entitled ‘‘Mainstay III: A Report on the Domestic Contributions of American Companies with Global Operations,’’ and an earlier study from

1993 entitled ‘‘Mainstay II: A New Account of the Critical Role of U.S. Multinational

Companies in the U.S. Economy,’’ the Emergency Committee for American Trade

(‘‘ECAT’’) documented the importance to the U.S. economy of U.S. based multinational companies. The studies found that investments abroad by U.S. multinational companies provide a platform for the growth of exports and create jobs in

the United States. (The full studies are available from The Emergency Committee

for American Trade, 1211 Connecticut Avenue, Washington, DC 20036, phone (202)

659–5147).

Proposals to accelerate tax through the repeal of ‘‘deferral’’ are in marked contrast

and conflict with over 50 years of bipartisan trade policy. The U.S. has long been

committed to the removal of trade barriers and the promotion of international investment, most recently through the NAFTA and WTO agreements. Moreover, because of their political and strategic importance, foreign investments by U.S. companies have often been supported by the U.S. government. For example, participation

by U.S. oil companies in the development of the Tengiz oil field in Kazakhstan has

been praised as fostering the political independence of that newly formed nation, as

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well as securing new sources of oil to Western nations, which are still heavily dependent on Middle Eastern imports.

CONCLUSION

Current U.S. international tax rules create many impediments that cause severe

competitive disadvantages for U.S.-based multinationals. By contrast, the tax systems of other countries actually encourage our foreign-based competitors to be more

competitive. It is time for Congress to improve our system to allow U.S. companies

to compete more effectively, and to reject proposals that would create new impediments making it even more difficult and in some cases impossible to succeed in today’s global business environment.

We thank you for the opportunity to provide our comments on this extremely important issue.

Statement of General Motors Corporation

General Motors is pleased to submit comments on simplification of the international tax system of the United States and how the system could be changed to

make U.S. business more competitive in the global market place. We commend

Chairman Houghton, Representative Levin and the other members who joined in

the recent introduction of H.R. 2018, the International Simplification for American

Competitiveness Act of 1999.

We believe the U.S. rules for taxing international income are unduly complex and,

in many cases, inequitable. We believe that legislation is required to rationalize and

simplify the international provisions of the U.S. tax law. Thus, we are pleased with

the recent introduction of H.R. 2018 and this hearing by the Subcommittee which

focuses attention on this important area of U.S. tax law.

The International Simplification Bill (H.R. 2018) contains important provisions

which are a good start to making the tax rules more rational and workable and to

remove some of the tax barriers currently faced by U.S.-based multinational companies. We would like to highlight three issues addressed in the bill that we at General Motors believe are particularly important.

ALLOCATION OF INTEREST EXPENSE (§ 309 OF H.R. 2018)

First, the bill includes a requirement that the Secretary of Treasury conduct a

study of the rules for allocating U.S. interest expense of an affiliated group of companies between domestic and foreign-source income. We would like to see the bill

go farther and actually include provisions that substantively fix the onerous interest

allocation rules. In fact, GM strongly supports the Interest Allocation Reform Act,

H.R. 2270, introduced recently by Congressmen Portman and Matsui which we believe is the right approach toward fixing the problem and should be included in any

international tax reform legislation.

By way of background, the U.S. tax system currently requires U.S. interest expense of U.S. multinational companies to be apportioned to foreign-source income

for purposes of determining the amount of foreign tax credits that may be claimed.

This apportionment of interest expense reduces the taxpayer’s foreign-source income

and thereby restricts its capacity to utilize foreign tax credits. This effectively results in an amount of income equal to the apportioned interest expense being taxed

in the United States with no offsetting credit for foreign taxes. Another way of looking at it is that, in this circumstance, there is effectively no U.S. tax deduction for

this apportioned interest expense. And, of course, there is no deduction for this

amount in any foreign country. The result is double taxation.

The interest allocation rules put U.S. companies at a competitive disadvantage in

both foreign markets and in the United States. An investment by a U.S. company

in a foreign market results in an additional allocation of U.S. interest expense with

the consequent double taxation. However, foreign-based companies competing in

that foreign market are not faced with losing any part of related interest expense

deductions in their home country. We are not aware of any foreign competitor being

subjected to as harsh a tax regime on its interest expense as a U.S.-based company.

The interest allocation rules also discourage investments by U.S. businesses to enhance their domestic competitiveness vis-a`

-vis foreign competition in the United

States. An expansion by a U.S.-based multinational of operations in the U.S.

through the use of debt results in the apportioning of additional interest expense

against foreign-source income and an increased U.S. tax liability. GM itself experiVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00081 Fmt 6633 Sfmt 6621 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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enced this in its creation of Saturn Corporation, (which, in a twist of irony, was conceived as an import-fighting line of small cars). GM incurred debt in the U.S. to finance the construction of Saturn facilities in Spring Hill, Tennessee. A portion of

the interest on that debt was allocated to foreign-source income, and in effect a current deduction for some of that interest was lost. By contrast, foreign-owned competitors who were constructing new U.S. plants at about the same time could finance them with U.S. borrowings and get the full U.S. tax benefit from this interest

expense, as they were unlikely to have any foreign-source income or foreign assets.

Thus, under current interest allocation rules, U.S. companies can’t even compete on

a level playing field when they’re the home team!

Another problem with the interest allocation rules arises in the case of ‘‘subgroups’’ of U.S.-affiliated companies. By way of example, GM has a wholly-owned

domestic subsidiary, GMAC, whose principal business is to provide financing to GM

dealers and customers who buy or lease GM motor vehicles in the United States.

GMAC borrows on the basis of its own credit and uses the proceeds in its own operations. Yet under current tax rules, GMAC’s interest expense must be lumped together with all GM’s U.S. affiliates in making the allocation. This has the effect of

over-allocating U.S. interest expense to foreign-source income.

The Portman-Matsui bill (H.R. 2270) would substantially correct the adverse effect of these rules by taking into account as an offset the interest expense incurred

by foreign affiliates, thus reducing the amount of U.S. interest expense allocated to

foreign-source income. Also, it would allow an election to make a separate allocation

computation in certain circumstances for subgroups of U.S. affiliates, including financial services subgroups, such as GMAC.

RECHARACTERIZATION OF OVERALL DOMESTIC LOSS (§ 202 OF H.R. 2018)

The second provision in H.R. 2018 which we would like to mention is the one

which would recharacterize an overall domestic loss in a year as foreign-source income in subsequent years to prevent permanent double taxation.

Under current tax law, a U.S. taxpayer experiencing an overall loss on its domestic operations must offset that loss against its foreign-source income. Today, this

permanently reduces the capacity of the taxpayer to claim foreign tax credits and

can result in double taxation. The proposal would in effect convert this to a timing

difference by recharacterizing certain future domestic income as ‘‘foreign-source,’’

and thus, restore the taxpayer’s capacity to claim foreign tax credits in later years.

The tax law already requires that when foreign loss exceeds domestic income the

overall foreign loss amount is recaptured in subsequent years by recharacterizing

similar amounts of foreign income as ‘‘domestic income.’’ Thus, the current proposal

appropriately adds important and needed symmetry and fairness to present law.

This would eliminate a ‘‘trap’’ in the current foreign tax credit rules for the unfortunate company that incurs domestic losses.

With our current robust economy, people do not want to think these days about

such problems as economic downturns or tax losses. But, for a company such as GM

which is in an economically cyclical industry, and which in the past has been adversely impacted by such things as work stoppages and oil embargoes, the possibility of tax losses can never be totally dismissed. And with the economy now ‘‘running on full,’’ there couldn’t be a better time to fix tax problems related to tax losses,

i.e., when the revenue cost would be minimized.

PERMANENT SUBPART F EXEMPTION FOR ACTIVE FINANCING INCOME (§ 101 OF

H.R. 2018)

Prior to 1998, the earnings of foreign subsidiaries which carried on an active financial services business in a foreign country were subject to U.S. tax even though

the earnings were not distributed to the U.S. parent. That problem was alleviated

temporarily through legislation which excludes such active business income from

current U.S. taxation. However, that temporary relief expires at the end of this year

and needs to be made permanent. This important provision allows U.S.-owned foreign finance companies, including foreign subsidiaries of GMAC, to compete on an

equal footing with their foreign-based financing competitors. GM strongly supports

making this rule permanent.

In closing, General Motors again commends the Subcommittee for its consideration of the U.S. international tax provisions. We urge the Subcommittee in its review to give particular attention to remedying the interest allocation rules along the

lines proposed in H.R. 2270. This is the single most important reform that’s needed

in the international area. In addition, permitting domestic loss recharacterization

and extending the subpart F exception for active financing income are very badly

needed provisions.

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1The International Air Transport Association (IATA) is a worldwide association comprised of

263 member airlines. The members of IATA carry the bulk of the world’s scheduled international and domestic air transportation under the flags of some 150 nations. The stated purposes of IATA include the promotion of safe, regular and economical air transport for the benefit

of the peoples of the world and the fostering of international air commerce. All non-U.S. IATA

member airlines have been established under the laws of their respective countries and many

are duly designated and licensed to provide international transportation of passengers, cargo

and mail to and from points in the United States. The IATA members who comprise the IATA

Mileage Award Tax Committee are Aer Lingus, Aerolineas Argentina, Air Canada, Air France,

Air New Zealand, Alitalia, British Airways, CSA Czech Airlines, Finnair, Iberia Airlines, Japan

Airlines, KLM Royal Dutch Airlines, Lufthansa German Airlines, Qantas Airways, Sabena

World Airlines, Swissair, Thai Airways, Turkish Airways, and Varig. 2The House Report states: ‘‘the Committee determined that the perceived fairness of the passenger air transportation excise taxes will be improved if certain currently untaxed payments

and passengers were required to contribute to the financing of the FAA programs from which

they benefit. In furtherance of this goal, the bill extends the tax to internationally arriving passengers and clarifies that the tax applies applies to payments to airlines (and related parties)

from credit card and other companies in exchange for the right to award frequent flyer or other

reduced air travel rights.’’

Statement of Howard P. Goldberg, Assistant Director, Taxation, Mileage

Award Tax Committee, International Air Transport Association, Montreal, Quebec, Canada

Mr. Chairman, Members of the Committee, on behalf of the IATA Mileage Award

Tax Committee, the International Air Transport Association (IATA) appreciates the

opportunity to submit these written comments on the complexity of the current U.S.

international tax regime.1 As part of the 1997 amendments, section 4261(e)(3) imposed an excise tax on an airline’s sale of frequent flyer miles to third party vendors

like hotels, car rental agencies and credit card companies (the ‘‘mileage credit excise

tax’’). The tax is imposed on purchasers but is required to be collected by the selling

airline.

Amendments made in 1997 to the aviation ticket tax rules of the Internal Revenue Code have increased both the complexity and the uncertainty regarding the

application of excise taxes to international aviation. For example, it has been argued

that the mileage credit tax might apply to a sale of miles from a foreign airline to

a foreign hotel which provides those miles to its foreign hotel guests. Application

of the tax in that situation, however, would be an infringement of the tax prerogatives of other sovereign nations. Such an infringement could lead to reciprocating

tax regimes in foreign countries seeking to tax a U.S. carrier’s sale of frequent flyer

miles to U.S. hotels, credit card companies and car rental agencies.

Diplomatic Notes. Some twenty foreign countries have submitted diplomatic notes

to the Department of State and to Congress protesting any interpretation that

would impose the mileage credit on an extraterritorial basis. The United States has

been requested to confirm that such tax would not be imposed on non-U.S. commerce or in contravention of the U.S.’s obligations under its treaties, international

agreements or international law.

An Unfair User Fee. Section 4261(e)(3) cannot fairly be read to apply on an

extraterritorial basis to sales of frequent flyer miles by foreign airlines. The aviation

ticket taxes, including the mileage credit tax, are user fees which are dedicated to

support the operation of the U.S. aviation infrastructure and are imposed based on

a fair approximation of the use of U.S. aviation infrastructure. See, H.R. Rep. No.

91–601, at 41 (1970); and S. Rep. No. 91–706, at 11 (1970) (both directing the Department of Transportation to prepare a report on the aviation user fees ‘‘in order

to insure an equitable distribution of future tax burdens among the various categories of airport and airway users as well as other persons deriving benefits from

the aviation system’’). The 1997 amendments to the aviation ticket tax, including

section 4261(e)(3), were intended to improve the fairness of the aviation ticket taxes

by expanding the taxation of currently untaxed payments to the extent that such

payments benefit from the U.S. aviation infrastructure. H.R. Rep. No. 105–148, at

482–483.2 Payments by foreign vendors, for example, to participate in a foreign airline’s frequent flyer program do not have an immediate or ascertainable impact on

or derive a quantifiable benefit from the U.S. aviation infrastructure. Imposing the

mileage credit tax on such payments would be an unfair application of the aviation

ticket taxes and would not be based on or correlate to any benefit derived from the

U.S. aviation infrastructure.

Extraterritorial Application Would Violate U.S. Obligations. In addition, any

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3 Article 4(1) of the U.S.-Canada Air Transport Agreement states: ‘‘[e]ach Party shall allow a

fair and equal opportunity for the designated airlines of both Parties to compete in providing

the international air transportation governed by this Agreement.’’ Articles 8(A) and 8(B) require

user charges to be ‘‘just and reasonable’’ and ‘‘just, reasonable, not unjustly discriminatory, and

equitably apportioned among categories of users.’’ 1The Investment Company Institute is the national association of the American investment

company industry. Its membership includes 7,576 open-end investment companies (‘‘mutual

funds’’), 479 closed-end investment companies and 8 sponsors of unit investment trusts. Its mutual fund members have assets of about $5.860 trillion, accounting for approximately 95% of

total industry assets, and have over 73 million individual shareholders. 2The U.S. statutory withholding tax rate imposed on non-exempt income paid to foreign investors is 30 percent. U.S. income tax treaties typically reduce the withholding tax rate to 15 percent.

national agreements to which the United States is a party and would be inconsistent with principles of international law. The relationship of payments by vendors

to foreign airlines for miles that ultimately might or might not be used for U.S. air

transportation does not satisfy the just and reasonable requirements for user fees

under international agreements to which the United States is party, or the norms

of international law for excise taxation.

The United States is party to numerous bilateral aviation agreements under

which it has agreed that neither state may impose user fees on transactions that

do not reasonably relate to a state’s expenditures for the provision of aviation facilities. The United States has agreed under its bilateral aviation agreements that each

state’s airlines shall have fair and equal rights to compete in providing international

air transportation. E.g., Air Transport Agreement of Jan. 17, 1966, as amended Feb.

24, 1995, U.S.-Can., arts. 4, 8.3 In order to respect the bilateral aviation agreements,

the mileage credit excise ticket tax cannot apply on an extraterritorial basis to payments made by a vendor to participate in a foreign airline’s frequent flyer program.

Under U.S. law, U.S. statutes are presumed and interpreted not to violate international law. Murray v. The Schooner Charming Betsy, 6 U.S. (2 Cranch) 64, 118

(1804). International law prohibits excise taxes on transactions that do not occur,

originate or terminate in or have substantial relation to the state imposing the tax.

Restatement (Third) of Foreign Relations Law of the United States, § 412(4). Payments by a foreign vendor, for example, to participate in a foreign airline’s frequentflyer program do not have a substantial relationship to the United States and do

not occur, originate or terminate in the United States. Application of the mileage

credit tax on an extraterritorial basis to a foreign airline’s sale of frequent flyer

miles would be inconsistent with international law.

As a matter of tax policy and international law, U.S. tax laws should not be applied on an extraterritorial basis to non-U.S. commerce.

Thank you very much for your consideration of this matter.

Statement of the Investment Company Institute

The Investment Company Institute (the ‘‘Institute’’) 1 urges the Committee to enhance the international competitiveness of U.S. mutual funds, treated for federal tax

purposes as ‘‘regulated investment companies’’ or ‘‘RICs,’’ by enacting legislation

that would treat certain interest income and short-term capital gains as exempt

from U.S. withholding tax when distributed by U.S. funds to foreign investors.2 The

proposed change merely would provide foreign investors in U.S. funds with the same

treatment available today when comparable investments are made either directly or

through foreign funds.

I. The U.S. Fund Industry is the Global Leader. Individuals around the world increasingly are turning to mutual funds to meet their diverse investment needs.

Worldwide mutual fund assets have increased from $2.4 trillion at the end of 1990

to $7.6 trillion as of September 30, 1998. This growth in mutual fund assets is expected to continue as the middle class continues to expand around the world and

baby boomers enter their peak savings years.

U.S. mutual funds offer numerous advantages. Foreign investors may buy U.S.

funds for professional portfolio management, diversification and liquidity. Investor

confidence in our funds is strong because of the significant shareholder safeguards

provided by the U.S. securities laws. Investors also value the convenient shareholder services provided by U.S. funds.

Nevertheless, while the U.S. fund industry is the global leader, foreign investment

in U.S. funds is low. Today, less than one percent of all U.S. fund assets are held

by non-U.S. investors.

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3 ‘‘Portfolio investment’’ typically refers to a less than 10 percent interest in the debt or equity

securities of an issuer, which interest is not ‘‘effectively’’ connected to a U.S. trade or business

of the investor. 4 Introduced by Representatives Crane, Dunn and McDermott as the ‘‘Investment Competitiveness Act of 1999.’’ 5The taxation of U.S. investors in U.S. funds would not be affected by these proposals.

6 ‘‘Eurobonds’’ are corporate or government bonds denominated in a currency other than the

national currency of the issuer, including U.S. dollars. Eurobonds are an important source of

capital for multinational companies.

II. U.S. Tax Policy Encourages Foreign Investment in the U.S. Capital Markets.

Pursuant to U.S. tax policy designed to encourage foreign portfolio investment 3 in

the U.S. capital markets, U.S. tax law provides foreign investors with several U.S.

withholding tax exemptions. U.S. withholding tax generally does not apply, for example, to capital gains realized by foreign investors on their portfolio investments

in U.S. debt and equity securities. Likewise, U.S. withholding tax generally does not

apply to U.S. source interest paid to foreign investors with respect to ‘‘portfolio interest obligations’’ and certain other debt instruments. Consequently, foreign portfolio investment in U.S. debt instruments generally is exempt from U.S. withholding

tax; with respect to portfolio investment in U.S. equity securities, U.S. withholding

tax generally is imposed only on dividends.

III. U.S. Tax Law, However, Inadvertently Encourages Foreigners to Prefer Foreign

Funds Over U.S. Funds. Regrettably, the incentives to encourage foreign portfolio

investment are of only limited applicability when investments in U.S. securities are

made through a U.S. fund. Under U.S. tax law, a U.S. fund’s distributions are treated as ‘‘dividends’’ subject to U.S. withholding tax unless a special ‘‘designation’’ provision allows the fund to ‘‘flow through’’ the character of its income to investors. Of

importance to foreign investors, a U.S. fund may designate a distribution of longterm gain to its shareholders as a ‘‘capital gain dividend’’ exempt from U.S. withholding tax.

For certain other types of distributions, however, foreign investors are placed at

a U.S. tax disadvantage. In particular, interest income and short-term capital gains,

which otherwise would be exempt from U.S. withholding tax when received by foreign investors either directly or through a foreign fund, are subject to U.S. withholding tax when distributed by a U.S. fund to these investors.

IV. Congress Should Enact Legislation Eliminating U.S. Tax Barriers to Foreign

Investment In U.S. Funds. The Institute urges the Committee to support the enactment of H.R. 2430,4 which generally would permit all U.S. funds to preserve, for

withholding tax purposes, the character of short-term gains and interest income distributed to foreign investors.5 For these purposes, U.S.-source interest and foreignsource interest that is free from foreign withholding tax under the domestic tax laws

of the source country (such as interest from ‘‘Eurobonds’’) 6 would be eligible for

flow-through treatment. The legislation, however, would deny flow-through treatment for interest from any foreign bond on which the source-country tax rate is reduced pursuant to a tax treaty with the United States.

The Institute fully supports H.R. 2430 because it would eliminate the U.S. withholding tax barrier to foreign investment in U.S. funds, while containing appropriate safeguards to ensure that (1) flow-through treatment applies only to interest

income and gains that would be exempt from U.S. withholding tax if received by

a foreign investor directly or through a foreign fund and (2) foreign investors cannot

avoid otherwise-applicable foreign tax by investing in U.S. funds that qualify for

treaty benefits under the U.S. income tax treaty network.

* * * * *

The Institute urges the enactment of legislation to make the full panoply of U.S.

funds—equity, balanced and bond funds—available to foreign investors without adverse U.S. withholding tax treatment. Absent this change, foreign investors seeking

to enter the U.S. capital markets or obtain access to U.S. professional portfolio management will continue to have a significant U.S. tax incentive not to invest in U.S.

funds.

Statement of Richard G. Palaschak, Director of Operations, Munitions

Industrial Base Task Force, Arlington, VA

Mr. Chairman and Members of the Subcommittee, thank you for providing this

opportunity to submit a statement for consideration by the Committee. This statement is offered on behalf of the fourteen companies in the munitions business that

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are members of the Munitions Industrial Base Task Force (MIBTF). The member

companies are: Aerojet General Corp.; Alliant Techsystems, Inc.; Armtec Defense

Products Co.; Bulova Technologies, Inc.; Chamberlain Manufacturing; Day & Zimmermann, Inc.; General Dynamics Ordnance Systems, Inc.; KDI Precision Products,

Inc.; Mason & Hanger Co., Inc.; Primex; Talley Defense Systems, Inc.; Textron Systems; Thiokol Corp.; Valentec International Corp.

In May and June 1993, executives from a cross section of the nation’s private munitions companies and its arsenal operators met and concluded that they were in

the middle of an unplanned free-fall in munitions funding which would, if not reversed, cause the destruction of the United States munitions industrial base. This

conclusion led to the formation of the Munitions Industrial Base Task Force, a nonprofit organization representing the nation’s munitions developers and producers,

and to an intense effort to quantify the crisis and communicate its dimensions to

decision-makers in the administration and the Congress. Task Force membership

represents many of the major munitions prime contractors, as well as a cross section

of subcontractors and suppliers. We manage both government-owned facilities as

well as those owned solely by the private sector. The Task Force does not advocate

specific programs on behalf of any of its members. Its sole purpose is to pursue a

common goal:

Adequate funding and policies to sustain a responsive, capable U.S. munitions

industrial base to develop, produce, and support superior munitions for the U.S.

and its allies.

Throughout its existence our member companies have worked in cooperation with

the DOD’s Single Manager for Conventional Ammunition (SMCA) and other DOD

and service ammunition oriented organizations to preserve threatened portions of

the munitions production and design base. Let me emphasize that our purpose is

not to ensure the survival of individual companies, but to ensure the survival of

those threatened research, development, and production capabilities, and the associated skilled workforce, somewhere within the U.S. domestic industrial base. Mr.

Chairman, our organization was formed because the munitions portion of the Department of Defense (DOD) budget declined by nearly 80% between fiscal year 1985

and fiscal year 1994. This precipitous funding decline seriously damaged the U.S.

munitions industrial base and compromised its viability as well as its ability to support the national security strategy. The U.S. munitions base lost nearly 70% of its

major munitions companies during this period. It is estimated that the base also lost

thousands of second/third tier subcontractors. Thanks to actions taken by the DOD

and the Congress, this decline has been stopped, but even the most recent assessment of the munitions industrial base by the Army Materiel Command (AMC) still

characterizes the base as ‘‘weak.’’

This situation is exacerbated by the unfair and discriminatory provision contained

in Section 923(a)(5) of the Internal Revenue Code which reduces the Foreign Sales

Corporation (FSC) benefits available to companies that sell defense materiel to foreign countries to 50 percent of that available to other exports. As the surviving companies struggle to remain viable, the international marketplace affords them an opportunity to supplement the U.S. domestic production needs and, thereby, sustain

their workforce and maintain an available industrial capability to sustain our armed

forces with ammunition or replenish expenditures of ammunition by our forces after

a conflict. However, the sale of munitions overseas is one of this nation’s most tightly regulated areas. In several instances, U.S. weapons have been provided or sold

to friendly countries but the sale of the associated U.S. munitions has been disapproved. Even when regulators approve the sale of an item, U.S. munitions manufacturers are faced with a growing array of foreign competitors, many of whom are

not only financially supported by their government, but also supported by their government’s tax and procurement policies. Rare is the country that has no capability

for munitions manufacturing, and many developed countries market, produce, and

sell very competitive products. In fact, the U.S. itself has procured numerous foreign

designed munitions that are in today’s service inventories. These countries have sustained their indigenous munitions manufacturing capability, in the face of declining

domestic defense budgets, by emphasizing exports. Many of them subsidize their

munitions companies, restrict their own munitions procurements to domestic

sources, help indigenous munitions companies market their products, and forgive

Value Added Taxes for munitions exports. The current FSC provision places U.S.

munitions companies at a serious disadvantage when they compete in this environment.

In addition, the current FSC provision is a significant handicap to U.S. companies

because of today’s budget reality. In the past U.S. munitions companies could often

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duction requirements of the U.S. military. Economies of scale could sometimes offset

that penalty as well as the advantages that foreign governments provided to their

domestic manufacturers. That situation no longer exists.

While the size of the U.S. military has been reduced by about a third, the munitions war reserve requirements of the U.S. military have plummeted by over 80%

(in terms of tonnage) during the past decade. Concurrently, the requirements for

training ammunition have been dramatically reduced by the innovative use of simulators and other changes instituted by the services. The net result has been smaller production runs or no production at all. Consequently, U.S. munitions companies

lost one of the few offsets to the fierce foreign government supported competition

that exists today for the international sale of munitions to countries approved by

the U.S. government. Removal of the FSC tax penalty against the export of defense

materiel will help level the international playing field and, in the process, help preserve a U.S. industrial capability that is absolutely essential to the conduct of successful warfare in support of the nation’s national security strategy.

We, the members of the Munitions Industrial Base Task Force, urge the Congress

to repeal the FSC penalty on the export of defense products in order to provide a

fair and equivalent treatment to our nation’s defense industry and its workers, and

to improve our industry’s competitiveness in the international marketplace. The repeal of this provision is particularly vital to the U.S. munitions industrial base because of its unique circumstances as detailed above. This action is not only in the

best interests of the U.S. defense industry and its workforce, but also in the best

interests of the nation in ensuring a capable, viable, and enduring U.S. industrial

base to support American armed forces in the future.

Statement of Lawrence F. Skibbie, President, National Defense Industrial

Association, Arlington, VA

Mr. Chairman, Members of the Subcommittee, I am Larry Skibbie, president of

the National Defense Industrial Association (NDIA). On behalf of NDIA, I want to

compliment you for holding this important hearing and to express our appreciation

for the opportunity to provide this statement.

NDIA is the largest defense-related association dedicated to the viability of the

technology and industrial base. Our 24,000 individual Members and nearly 900

Member companies, which employ the preponderance of the two million men and

women in the defense sector and represent the full spectrum of the base, are vitally

interested in maintaining a strong, responsive national security infrastructure.

A little background is in order so that the Subcommittee has the full appreciation

of both NDIA’S position and the current U.S. International Tax Regime’s adverse

impact on the defense sector.

Currently, the Internal Revenue Code allows U.S. exporters to establish Foreign

Sales Corporations (FSC) under which they can exempt from U.S. taxation a portion

of their earnings from foreign sales. Enacted in 1976, this provision was intended

to help U.S. firms compete against companies in other countries which rely more

on value-added taxes (VATS) than on corporate income taxes. Generally, VATS on

products are rebated as they are exported.

For U.S. exporters of defense products, however, the FSC tax incentive is reduced

by 50 percent. Specifically, section 923(A)(5) of the Internal Revenue Code reduces

the tax exemption available to companies which export defense products to 50 percent of the benefits available to other exporters. Initially, the limitation of section

923 was based on the premise that military products are not sold in competitive

market environments, therefore the FSC incentive is unnecessary for defense exporters.

However, examination of today’s market environment argues heavily against the

original premise. Competition among defense exporting countries is intense and

likely to intensify as budgets continue to be reduced. The United States faces increased European export promotion incentives, and Russia has become a major exporter in world markets. In addition, the U.S. Government prohibits the sale of defense products to certain countries and requires advanced approval of all sales.

There is no valid economic or policy basis for continuing the discriminatory treatment that U.S. defense exporters face. NDIA is strongly opposed to such treatment

and supports the repeal of section 923(A)(5), of the Internal Revenue Code. Moreover, repeal of section 923 will not impact foreign policy objectives of the United

States. The same checks and balances will remain in place and sales of defense exports will continue to be subject to existing policy dictates and review processes.

84

Therefore, NDIA strongly supports restoring Foreign Sales Corporation (FSC) tax

benefits for defense products to full comparability with other U.S. exports. The FSC

limitation for defense exports hampers the ability of U.S. companies to compete effectively abroad with many of their products. The FSC program was enacted to promote trade, which is fundamental to our economic health. Discriminating against

the defense industry only contributes to our trade imbalance, reduces employment

stability in the defense sector and allows competitors to capture business that would

likely go to U.S. firms.

Recently, Chairman Houghton and Representative Sander Levin introduced H.R.

2018, the international tax simplification for American competitiveness act of 1999.

Section 303 of the bill represents a step toward rectifying a major tax inequity for

U.S. defense exports. This Omnibus bill seeks to simplify certain international taxation rules for U.S. businesses operating abroad. Specifically, Section 303 repeals

IRC Section 923(a)(5), which reduces the FSC benefits available to companies that

sell military goods abroad to 50 percent of the benefits available to other exporters.

NDIA supports a strong, viable and competitive U.S. defense industrial base that

contributes to our overall national and economic security. Unfortunately, the defense industry is hindered by the enactment and maintenance of tax laws based on

outdated premises which represent serious barriers to our international competitiveness. These impediments, such as section 923(A)(5), should be dismantled as quickly

as possible. Therefore, prompt repeal of section 923(A)(5) is in order.

Mr. Chairman, Members of the Subcommittee, thank you again for permitting

NDIA this opportunity to submit this statement.

TROPICAL SHIPPING

RIVIERA BEACH, FL,

July 6, 1999.

The Honorable A.L. Singleton

Chief of Staff

Committee on Ways and Means

U.S. House of Representatives

Washington, D.C.

Re: June 22, 1999 Oversight Subcommittee Hearing on Current U.S. International

Tax Regime

Dear Mr. Singleton:

The U.S. international tax regime is forcing the U.S.-owned fleet to expatriate to

remain competitive. An unintended result of the 1986 and 1975 tax law changes has

been the near complete removal of U.S. investment from the Ocean Shipping industry leaving the cargo trades of the United States almost entirely in the hands of

foreign-owned and foreign-controlled shipping companies. Overall, U.S. ownership of

the world fleet has declined from 25% of world tonnage in 1975 when Congress enacted the first tax code change affecting shipping, to less than 5% today!

This unintended consequence has profound implications for the United States, as

international trade and commerce of goods have historically been influenced by the

national interests of the country of ultimate ship ownership.

Tropical Shipping is a U.S.-owned container shipping company (CFC) with a business focus on serving the Caribbean, the only region in the world in which the

United States has a balance of trade surplus. The exports to this region create numerous jobs throughout the U.S. agricultural and manufacturing sectors as well as

our own company’s employment of over 500 people in the U.S.

The existence of the U.S. balance of trade surplus with the Caribbean is no coincidence. This region is the last area in the world where U.S.-owned shipping companies dominate the carriage of general cargo and this contributes to the success and

promotion of U.S. exports. Our company, and our U.S.-owned competitors, are active

every day, putting Caribbean buyers in touch with U.S. exporters as this is beneficial for Tropical Shipping’s long term interests.

Our tax laws force U.S. companies to become acquired by foreigners because these

countries have adopted tax policies to ensure that their international shipping is

competitive in world markets. The U.S. international tax system puts U.S. corporations and their employees at a competitive disadvantage. Our foreign-owned competitors have a great advantage in their accumulation of capital, as they are not

taxed on a current basis and generally only pay tax when the dividends are repatriated. It is inevitable that sales of U.S. companies to foreigners or mergers of U.S.

85

companies with foreign companies will leave the resulting entity headquartered

overseas. Because of the adverse consequences resulting under the current foreign

tax system, U.S. shipping companies are being forced out of the growing world market.

Buying and operating ships is capital intensive. U.S. owners in this capital intensive and very competitive shipping industry, have sold out, gone out of business, and

not invested in shipping because they just cannot compete due to the unintended

consequences of the overly complex U.S. international tax regime. It is simply this

regime that places U.S. owners at a distinct disadvantage in the global commerce

of ocean transportation. U.S. owners can compete in all other respects.

This tax system is contributing to the de-Americanization of U.S. industry because

the U.S.-owned fleet is forced to expatriate to remain competitive. In the containerized shipping industry, U.S.-owned participation in the carriage of U.S. trade has

steadily declined to an all time low of 14.2% of the container trade in 1988. The

decline is not in the economic interest of the United States and weakens U.S. exports contributing to fewer U.S.-based jobs. It will be a sad day indeed if all the

ocean commerce created in the growing market of the Americas as a result of

NAFTA and the FTAA ends up benefiting foreign owners with no chance for U.S.

investors to participate.

Please correct the tax code, by reinstating the deferral of foreign-based company

shipping income, so that the U.S. shipping industry is placed in a position of global

competitiveness, rather than a competitive disadvantage. H.R. 265, introduced by

Congressman Shaw and co-sponsored by Congressman Jefferson, is an important response to this problem.

Sincerely yours,

RICHARD MURRELL

President and CEO

Statement of LaBrenda Garrett-Nelson, and Robert J. Leonard, Washington

Counsel, P.C.

Washington Counsel, P.C. is a law firm based in the District of Columbia that

represents a variety of clients on tax legislative and policy issues.

INTRODUCTION

The provisions that make up the U.S. international tax regime rank among the

most complex provisions in the Code. This statement discusses section 308 of the

International Tax Simplification for American Competitiveness Act of 1999 (H.R.

2018), a proposal to reduce complexity in this area by repealing the little used regime for export trade corporations (‘‘ETCs’’). The ETC rules were enacted in 1962

to provide a special export incentive in the form of deferral of U.S. tax on export

trade income. The rationale for the proposed repeal is that the special regime for

ETCs was, effectively, repealed by the 1986 enactment of the passive foreign investment company (‘‘PFIC’’) rules. At the same time, the proposal would provide appropriate (and prospective) transition relief for ETCs that were caught in a bind created by enactment of the PFIC regime.

I. The Overlap Between the ETC Regime and the PFIC Rules Effectively Nullified

the ETC Rules For Many Corporations

Although the PFIC rules were originally targeted at foreign mutual funds, the

Congress has recognized that the scope of the PFIC statute was too broad. Thus,

for example, the Taxpayer Relief Act of 1997 eliminated the overlap between the

PFIC rules and the subpart F regime for controlled foreign corporations. Similarly,

in the 1996 Small Business Jobs Protection Act, the Congress enacted a technical

correction to clarify that an ETC is excluded from the definition of a PFIC.

The 1996 technical correction came too late, however, for ETCs that took the reasonable step of making ‘‘protective’’ distributions during the ten-year period between

the creation of the uncertainty caused by enactment of the PFIC regime and the

passage of the 1996 technical correction. Although U.S. tax on distributed earnings

would have been deferred but for the ETC/PFIC overlap, these ETCs made distributions out of necessity to protect against the accumulation of large potential tax liabilities under the PFIC rules. Thus, the PFIC rules, in effect, repealed the ETC

regime.

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II. Congressional Precedents for Providing Transition Relief for ETCs

The proposal would simplify the foreign provisions of the tax code by repealing

the ETC regime. When the Congress enacted the Domestic International Sales Company (‘‘DISC’’) rules in 1971, and again when those rules were replaced with the

Foreign Sales Corporation (‘‘FSC’’) rules in 1984, existing ETCs were authorized to

remain in operation. Moreover, ETCs that chose to terminate pursuant to the 1984

enactment of the FSC regime were permitted to repatriate their undistributed export trade income as nontaxable previously taxed income (or ‘‘PTI’’).

The Proposal also provides a mechanism for providing prospective relief to ETCs

that were caught in the bind created by the PFIC rules. Consistent with the transition rule made available in the 1984 FSC legislation, the proposal would grant prospective relief to ETCs that made protective distributions after the 1986 enactment

of the PFIC rules. Essentially, future (actual or deemed) distributions would be

treated as derived from PTI, to the extent that pre-enactment distributions of export

trade income were included in a U.S. shareholder’s gross income as a dividend. Note

that the proposed transition relief would provide only ‘‘rough justice,’’ because taxes

have already been paid but the proposed relief will occur over time.

CONCLUSION

Repeal of the ETC provisions would greatly simplify the international tax provisions of the Code, but such a repeal should be accompanied by relief for ETCs that

were caught in the bind created by the PFIC rules.

Statement of LaBrenda Garrett-Nelson, Washington Counsel, P.C., on

behalf of the Ad Hoc Coalition of Finance and Credit Companies

Section 101 of the International Tax Simplification for American Competitiveness

Act of 1999 (H.R. 2018) highlights the need to extend the provision that grants active financial services companies an exception from subpart F. In light of the growing interdependence and integration of world financial markets, coupled with the

international expansion of U.S.-based financial services entities, the foreign activities of the financial services industry should be eligible for deferral on terms comparable to that of manufacturing and other non-financial businesses. This statement

was prepared on behalf of an ad hoc coalition of leading finance and credit companies whose activities fall within the catch-all concept of a ‘‘financing or similar business.’’

The ad hoc coalition of finance and credit companies includes entities providing

a full range of financing, leasing, and credit services to consumers and other unrelated businesses, including the financing of third-party purchases of products manufactured by affiliates (collectively referred to as ‘‘Finance and Credit Companies’’).

This statement describes (1) the ordinary business transactions conducted by Finance and Credit Companies, including information regarding the unique role these

companies play in expanding U.S. international trade, and (2) the importance of the

active financing exception to subpart F to the international competitiveness of these

companies.

I. THE INTERNATIONAL OPERATIONS OF U.S.-BASED FINANCE AND CREDIT COMPANIES

A. Finance and Credit Companies Conduct Active Financial Services Businesses

Finance and Credit Companies are financial intermediaries that borrow to engage

in all the activities in which banks customarily engage when issuing and servicing

a loan or entering into other financial transactions. Indeed, many countries (e.g.,

Germany, Austria, and France) actually require that such a company be chartered

as a regulated bank. For example, one member of the ad hoc group has a European

Finance and Credit Company that is regulated by the Bank of England and, under

the European Union (‘‘EU’’) Second Banking Coordination Directive, operates in

branch form in Austria, France, and a number of other EU jurisdictions. The principal difference between a typical bank and a Finance and Credit Company is that

banks normally borrow through retail or other forms of regulated deposits, while Finance and Credit Companies borrow from the public market through commercial

paper or other publicly issued debt instruments. In some cases, Finance and Credit

Companies operating as regulated banks are required to take deposits, although

they may not rely on such deposits as a primary source of funding. In every important respect, Finance and Credit Companies compete directly with banks to provide

loan and lease financing to retail and wholesale consumers.

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B. A Finance and Credit Company’s Activities Include A Full Range Of Financial

Services.

The active financial services income derived by a Finance and Credit Company

includes income from financing purchases from third parties; making personal,

mortgage, industrial or other loans; factoring; providing credit card services; and

hedging interest rate and currency risks with respect to active financial services income. As an alternative to traditional lending, leasing has developed into a common

means of financing acquisitions of fixed assets, and is growing at double digit rates

in international markets. These activities include a full range of financial services

across a broad customer base and can be summarized as follows:

• Specialized Financing: Loans and leases for major capital assets, including aircraft, industrial facilities and equipment and energy-related facilities; commercial

and residential real estate loans and investments; loans to and investments in management buyouts and corporate recapitalizations.

• Consumer Services: Private label and bank credit card loans; merchant acquisition, card issuance, and financing of card receivables; time sales and revolving credit

and inventory financing for retail merchants; auto leasing and lending and inventory financing; and mortgage servicing.

• Equipment Management: Leases, loans and asset management services for portfolios of commercial and transportation equipment, including aircraft, trailers, auto

fleets, modular space units, railroad rolling stock, data processing equipment, telecommunications equipment, ocean-going containers, and satellites.

• Mid-Market Financing: Loans and financing and operating leases for middlemarket customers, including manufacturers, vendors, distributors, and end-users,

for a variety of equipment, such as computers, data processing equipment, medical

and diagnostic equipment, and equipment used in construction, manufacturing, office applications, and telecommunications activities.

Each of the financial services described above is widely and routinely offered by

foreign-owned finance companies in direct competition with Finance and Credit

Companies.

C. Finance and Credit Companies Are Located In The Major Markets In Which They

Conduct Business And Compete Head-on Against ‘‘Name Brand’’ Local Competitors.

Finance and Credit Companies provide services to foreign customers or U.S. customers conducting business in foreign markets. The customer base for Finance and

Credit Companies is widely dispersed; indeed, a large Finance and Credit Company

may have a single customer that itself operates in numerous jurisdictions. As explained more fully below, rather than operating out of regional, financial centers

(such as London or Hong Kong), Finance and Credit Companies must operate in a

large number of countries to compete effectively for international business and provide local financing support for foreign offices of U.S. multinational vendors. One

Finance and Credit Company affiliated with a U.S auto maker, for example, provide

services to customers in Australia, India, Korea, Germany, the U.K., France, Italy,

Belgium, China, Japan, Indonesia, Mexico, and Brazil, among other countries. Another member of the ad hoc coalition conducts business through Finance and Credit

Companies in virtually all the major European countries, in addition to maintaining

headquarters in Hong Kong, Europe, India, Japan, and Mexico. Yet another member

of the ad hoc coalition currently has offices that provide local leasing and financing

products in 22 countries.

Finance and Credit Companies are legally established, capitalized, operated, and

managed locally, as either branches or separate entities, for the business, regulatory, and legal reasons outlined below:

1. Marketing and supervising loans and leases generally require a local presence.

The provision of financial services to foreign consumers requires a Finance and

Credit Company to have a substantial local presence—to establish and maintain a

‘‘brand name,’’ develop a marketing network, and provide pre-market and after-market services to customers. A Finance and Credit Company must be close to its customers to keep abreast of local business conditions and competitive practices. Finance and Credit Companies analyze the creditworthiness of potential customers,

administer and collect loans, process payments, and borrow money to fund loans.

Inevitably, some customers have trouble meeting obligations. Such cases demand a

local presence to work with customers to ensure payment and, where necessary, to

terminate the contract and repossess the asset securing the obligation. These active

functions require local employees to insure the proper execution of the Finance and

Credit Company’s core business activities—indeed, a single member of the ad hoc

group has approximately 15,000 employees in Europe. From a business perspective,

it would be almost impossible to perform these functions outside a country of operVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00091 Fmt 6633 Sfmt 6621 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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ation and still generate a reasonable return on the investment. ‘‘Paper companies’’

acting through computer networks would not serve these local business requirements.

In certain cases, a business operation and the employees whose efforts support

that operation may be in separate, same-country affiliates for local business or regulatory reasons. For example, in some Latin American jurisdictions where profit

sharing is mandatory, servicing operations and financing operations may be conducted through separate entities. Even in these situations, the active businesses of

the Finance and Credit Companies are conducted by local employees.

2. Like other financial services entities, a Finance and Credit Company requires

access to the debt markets to finance its lending activities, and borrowing in local

markets often affords a lower cost of funds. Small Finance and Credit Companies,

in particular, may borrow a substantial percentage of their funding requirements

from local banks. Funding in a local currency reduces the risk of economic loss due

to exchange rate fluctuations, and often mitigates the imposition of foreign withholding taxes on interest paid across borders. Alternatively, a Finance and Credit

Company may access a capital market in a third foreign country, because of limited

available capital in the local market—Australian dollar borrowings are often done

outside Australia for this reason. The latter mode of borrowing might also be used

in a country whose government is running a large deficit, thus ‘‘soaking up’’ available local investment. A Finance and Credit Company may also rely for funding on

its U.S. parent company, which issues debt and on-lends to affiliates (with hedging

to address foreign exchange risks).

3. In many cases, consumer protection laws require a local presence. Finance and

Credit Companies must have access to credit records that are maintained locally.

Many countries, however, prohibit the transmission of consumer lending information across national borders. Additionally, under ‘‘door-step selling directives,’’ other

countries preclude direct marketing of loans unless the lender has a legal presence.

4. Banking or currency regulations may also dictate a local presence. Finance and

Credit Companies must have the ability to process local payments and—where necessary—take appropriate action to collect a loan or repossess collateral. Foreign regulation or laws regarding secured transactions often require U.S. companies to conduct business through local companies with an active presence. For example, as

noted above, French law generally compels entities extending credit to conduct their

operations through a regulated ‘‘banque’’ approved by the French central bank.

Other jurisdictions, such as Spain and Portugal, require retail lending to be performed by a regulated entity that need not be a full-fledged bank. In addition, various central banks preclude movements of their local currencies across borders. In

such cases, a Finance and Credit Company’s local presence (in the form of either

a branch or a separate entity) is necessary for the execution of its core activities

of lending, collecting, and funding.

EU directives allow a regulated bank headquartered in one EU jurisdiction to

have branch offices in another EU jurisdiction, with the ‘‘home’’ country exercising

the majority of the bank regulation. Thus, for example, one Finance and Credit

Company in Europe operates in branch form, engaging in cross-jurisdictional business in the economically integrated countries that comprise the EU. The purpose

of this branch structure is to consolidate European assets into one corporation to

achieve increased borrowing power within the EU, as well as limit the number of

governmental agencies with primary regulatory authority over the business.

D. Finance and Credit Companies Play A Critical Role In Supporting International

Trade Opportunities

As U.S. manufacturers and distributors expand their sales activities and operations around the world, it is critical that U.S. tax policy be coordinated with U.S.

trade objectives, to allow U.S. companies to operate on a level playing field with

their foreign competitors. One of the important tools available to U.S. manufacturers and distributors in seeking to expand foreign sales is the support of Finance and

Credit Companies providing international leasing and financing services. U.S. tax

policy should not hamper efforts to provide financing support for product sales.

U.S. manufacturers, in particular, include the availability of financing services offered by Finance and Credit Companies as an integral component of the manufacturer’s sales promotion in foreign markets. For related manufacturing or other businesses to compete effectively, Finance and Credit Companies establish local country

financial operations to support the business. As an example, the Finance and Credit

Company affiliate of a U.S. auto maker establishes its operations where the parent

company’s sales operations are located, in order to provide marketing support.

In supporting the international sales growth of U.S. manufacturers and distributors in developed markets, Finance and Credit Companies are themselves forced

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1For detailed analyses of other countries’ approaches to anti-deferral policy with respect to

active financing income, see ‘‘The NFTC Foreign Income Project: International Tax Policy for

the 21st Century,’’ Chapter 4 (March 25, 1999).

into competition with foreign-owned companies offering the same or similar leasing

and financing services. To the extent Finance and Credit Companies are competitively disadvantaged by U.S. tax policy, U.S. manufacturers and distributors either

are prevented from competing with their counterparts or must seek leasing and financing support from foreign-owned companies operating outside the United States.

II. THE NEED TO CONTINUE THE SUBPART F EXCEPTION FOR ACTIVE

FINANCING INCOME

A. Legislative Background

When deferral for active financial services income was repealed in 1986, the Congress was concerned about the potential for abuse by taxpayers routing passive or

mobile income through tax havens. At that time. the U.S. financial services industry

was almost entirely domestic, and so little thought was given to the appropriateness

of applying the 1986 Act provisions to income earned by the conduct of an active

business. The subsequent international expansion of the U.S. financial services industry created a need to modernize Subpart F by enacting corrective legislation.

The Taxpayer Relief Act of 1997 introduced a temporary (one-year) Subpart F exception for active financing income, and 1998 legislation revised and extended this

provision for an additional year. The financial services industry continues to seek

a more permanent Subpart F exception for active financing income.

But for the Active financing exception, current law would discriminate against the

U.S. financial services industry by imposing a current U.S. tax on interest, rentals,

dividends etc., derived in the conduct of an active trade or business through a controlled foreign corporation. From a tax policy perspective, a financial services business should be eligible for the same U.S. tax treatment of worldwide income as that

of manufacturing and other non-financial businesses.

B. The Active Financing Exception is Necessary To Allow U.S. Financial Services

Companies To Compete Effectively In Foreign Markets

U.S. financial services entities engaged in business in a foreign country would be

disadvantaged if the active financing exception were allowed to expire (and the

United States thereby accelerated the taxation of their active financing income).

To take a simplified example, consider a case where a Finance and Credit Company establishes a U.K. subsidiary to compete for business in London. London is a

major financial center, and U.S.-based companies compete not only against U.K.

companies but also against financial services entities from other countries. For example, Deutsche Bank is a German financial institution that competes against U.S.

Finance and Credit Companies. Like many other countries in which the parent companies of major financial institutions are organized, Germany generally refrains

from taxing the active financing income earned by its foreign subsidiaries. Thus, a

Deutsche Bank subsidiary established in London defers the German tax on its U.K.

earnings, paying tax on a current basis only to the U.K.

The application of Subpart F to the facts of the above example would place the

U.S. company at a significant competitive disadvantage in any third country having

a lower effective tax rate (or a narrower current tax base) than the United States

(because the U.S. company would pay a residual U.S. tax in addition to the foreign

income tax). The acceleration of U.S. tax under Subpart F would run counter to that

of many other industrialized countries, including France, Germany, the United

Kingdom, and Japan.1 All four of these countries, for example, impose current taxation on foreign-source financial services income only when that income is earned

in tax haven countries with unusually low rates of tax.

In view of the relatively low profit margins in the international financing markets, tax costs might have to be passed on to customers in the form of higher financing rates. Obviously, foreign customers could avoid higher financing costs by obtaining financing from a foreign-controlled finance company that is not burdened by current home-country taxation, or—in the case of Finance and Credit Companies financing third-party purchases of an affiliate’s product—purchasing the product from

a foreign manufacturer offering a lower all-in cost. The active financing exception

advances international competitiveness by insuring that financial services companies are taxed in a manner that is consistent with their foreign competitors—consistent with the legislative history of Subpart F and the long-standing tax policy

goal of striking a reasonable balance that preserves the ability of U.S. businesses

to compete abroad.

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III. THE DEFINITION OF A FINANCE COMPANY UNDER THE ACTIVE FINANCING EXCEPTION TO SUBPART F WAS CAREFULLY CRAFTED TO LIMIT APPLICATION OF THE EXCEPTION TO BONA FIDE BUSINESSES

The 1998 legislation introduced a statutory definition of a ‘‘lending or finance

business’’ for purposes of the active financing exception to subpart F. A lending or

finance business is defined to include very specific activities:

(i) making loans;

(ii) purchasing or discounting accounts receivable, notes, or installment obligations;

(iii) engaging in leasing;

(iv) issuing letters of credit or providing guarantees;

(v) providing charge or credit services; or

(vi) rendering related services to an affiliated corporation that is so engaged.

A. A Finance Company Must Satisfy a Two-pronged Test to be Eligible to Qualify

any Income for the Active Financing Exception.

1. Predominantly Engaged Test. Under a rule that applies to all financial services

companies, a finance company must first satisfy the requirement that it be ‘‘predominantly engaged’’ in a banking, financing, or similar business. To satisfy the

‘‘predominantly engaged’’ test, a finance company must derive more than 70 percent

of its gross income from the active and regular conduct of a lending or finance business (as defined above) from transactions with unrelated ‘‘customers.’’

2. Substantial Activity Test. Even if a finance company is ‘‘predominantly engaged,’’ as in the case of all financial services companies, it will flunk the test of

eligibility unless it conducts ‘‘substantial activity with respect to its business. The

‘‘substantial activity’’ test, as fleshed out in the committee report, is a facts-and-circumstances test (e.g., overall size, the amount of revenues and expense, the number

of employees, and the amount of property owned). In any event, however, the legislative history prescribes a ‘‘substantially all’’ test that requires a finance company

to ‘‘conduct substantially all of the activities necessary for the generation of income’’—a test that cannot be met by the performance of back-office activities.

B. Once Eligibility is Established, Additional Requirements Must be Satisfied Before

Income From Particular Transactions Can be Qualified Under the Active Financing

Exception.

As listed in the relevant committee report, there are only 21 types of activities

that generate income eligible for the active financing exception. In addition, an eligible Finance and Credit Company cannot qualify any income under the exception unless the income meets four, additional statutory requirements that apply to all financial services businesses:

1. The Exception Is Limited to Active Business Income. First, the income must be

‘‘derived by’’ the finance company in the active conduct of a banking, financing or

similar business. This test, alone, would preclude application of the active financing

exception to the incorporated pocketbook of a high net worth individual or a pool

of offshore passive assets.

2. Prohibition on Transactions With U.S. Customers. Secondly, the income must

be derived from one or more transactions with customers located in a country other

than the United States.

3. Substantial Activities. Substantially all of the activities’’ in connection with a

particular transaction must be conducted directly by the finance company in its

home country.

4. Activities Sufficient For a Foreign Country To Assert Taxing Jurisdiction. The

income must be ‘‘treated as earned’’ by the Finance and Credit Company—i.e., subject to tax—for purposes of the tax laws of its home country.

C. In any Event, a Finance Company Cannot Qualify any Income Under the Active

Financing Exception Unless it meets an Additional 30-Percent Home Country Test.

Under a ‘‘nexus’’ test applicable to Finance and Credit Companies (but not banks

or securities firms with respect to which government regulation satisfies the nexus

requirement), a company must derive more than 30 percent of its separate gross income from transactions with unrelated customers in its home country. This rule

makes it highly unlikely that taxpayers could locate a finance company in a tax

haven and qualify for the active financing exception, because tax havens are unlikely to provide a customer base that would support the transactions required to

meet the 30-percent home country test. Even if such a well-populated tax haven

could be found, the ability to qualify income would be self-limiting (in terms of absoVerDate 20-JUL-2000 07:34 Oct 05, 2000 Jkt 060010 PO 00000 Frm 00094 Fmt 6633 Sfmt 6602 K:\HEARINGS\65844.TXT WAYS1 PsN: WAYS1
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lute dollars) by the dollar-value of transactions that could be derived from unrelated, home-country customers

CONCLUSION

We urge the Congress to extend the provision that grants active financial services

companies an exception from subpart F. Without this legislation, the current law

provision that keeps the U.S. financial services industry on an equal footing with

foreign-based competitors will expire at the end of this year. Moreover, this legislation will afford America’s financial services industry parity with other segments of

the U.S. economy.

Æ