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79–486 2002

FIRST IN SERIES ON THE EXTRATERRITORIAL

INCOME REGIME

HEARING

BEFORE THE

SUBCOMMITTEE ON SELECT REVENUE MEASURES

OF THE

COMMITTEE ON WAYS AND MEANS

HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

APRIL 10, 2002

Serial No. 107–63

Printed for the use of the Committee on Ways and Means

(

ii

COMMITTEE ON WAYS AND MEANS

BILL THOMAS, California, Chairman

PHILIP M. CRANE, Illinois

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

PHIL ENGLISH, Pennsylvania

WES WATKINS, Oklahoma

J.D. HAYWORTH, Arizona

JERRY WELLER, Illinois

KENNY C. HULSHOF, Missouri

SCOTT MCINNIS, Colorado

RON LEWIS, Kentucky

MARK FOLEY, Florida

KEVIN BRADY, Texas

PAUL RYAN, Wisconsin

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

EARL POMEROY, North Dakota

ALLISON GILES, Chief of Staff JANICE MAYS, Minority Chief Counsel

SUBCOMMITTEE ON SELECT REVENUE MEASURES

JIM MCCRERY, Louisiana, Chairman

J.D. HAYWORTH, Arizona

JERRY WELLER, Illinois

RON LEWIS, Kentucky

MARK FOLEY, Florida

KEVIN BRADY, Texas

PAUL RYAN, Wisconsin

MICHAEL R. MCNULTY, New York

RICHARD E. NEAL, Massachusetts

WILLIAM J. JEFFERSON, Louisiana

JOHN S. TANNER, Tennessee

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 March 27, 2002, announcing the hearing .......................................... 2

WITNESSES

U.S. Department of the Treasury, Barbara Angus, International Tax Counsel 25

Archer, Hon. Bill, PricewaterhouseCoopers LLP .................................................. 7

Chorvat, Terrence R., George Mason University School of Law .......................... 35

Garrett-Nelson, LaBrenda, Washington Council Ernst & Young ........................ 28

Gibbons and Company, Hon. Samuel M. Gibbons ................................................ 13

McIntyre, Michael J., Wayne State University ..................................................... 40

SUBMISSIONS FOR THE RECORD

Cifrulak, Stephen D., Jr., Sewickley, PA, statement ............................................ 53

McNulty, Hon. Michael, a Representative in Congress from the State of

New York, statement ........................................................................................... 42

MTI Services Limited, Princeton, NJ, and Western Growers Association,

Irvine, CA, joint statement .................................................................................. 57

(1)

FIRST IN SERIES ON THE

EXTRATERRITORIAL INCOME REGIME

WEDNESDAY, APRIL 10, 2002

HOUSE OF REPRESENTATIVES,

COMMITTEE ON WAYS AND MEANS,

SUBCOMMITTEE ON SELECT REVENUE MEASURES,

Washington, DC.

The Subcommittee met, pursuant to notice, at 2:05 p.m., in room

1100 Longworth House Office Building, Hon. Jim McCrery, (Chairman of the Subcommittee) presiding.

[The advisory announcing the hearing follows:]

2

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

SUBCOMMITTEE ON SELECT REVENUE MEASURES

FOR IMMEDIATE RELEASE CONTACT: (202) 226–5911

March 27, 2002

No. SRM–4

McCrery Announces First in a Series of

Hearings on the Extraterritorial Income Regime

Congressman Jim McCrery (R–LA), Chairman, Subcommittee on Select Revenue

Measures of the Committee on Ways and Means, today announced that the Subcommittee will hold its first hearing on the extraterritorial income (ETI) regime.

The hearing will take place on Wednesday, April 10, 2002, in the main Committee hearing room, 1100 Longworth House Office Building, beginning at

2:00 p.m.

In view of the limited time available to hear witnesses, oral testimony at this

hearing will be from invited witnesses only. 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:

On January 14, 2002, the World Trade Organization (WTO) Appellate Panel

issued its report finding the United States’ ETI rules to be a prohibited export subsidy. This marks the fourth time in the past two and one-half years that the United

States has lost this issue, twice in the Foreign Sales Corporation case and now twice

in the ETI case. There is no opportunity for the United States to appeal this latest

determination.

On January 29, 2002, a WTO Arbitration Panel began proceedings to determine

the amount of retaliatory trade sanctions that the European Union (EU) can impose

against U.S. exports to the EU. The EU has requested $4.043 billion in sanctions.

The United States has asserted that the proper measure of sanctions is no more

than $1.1 billion. The Arbitration Panel will issue its determination by April 29,

2002.

In announcing the hearing, Chairman McCrery stated: ‘‘With the arbitration

panel poised to rule on the level of sanctions which can be imposed by the EU, it

is critical that we make a prompt, yet thorough inquiry into possible changes to the

ETI system which are both WTO-compliant and foster the competitiveness of American companies. Witnesses at the hearing will help us explore the possibility of one

approach—leaving ETI in place but making modifications to it that address the objections raised by the EU.’’

FOCUS OF THE HEARING:

The focus of the hearing will be to examine whether adjustments can be made

to the existing ETI regime to bring it into compliance with WTO rules without undermining the competitiveness of U.S. businesses in the global marketplace.

3

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

Please Note: Due to the change in House mail policy, any person or organization

wishing to submit a written statement for the printed record of the hearing should

send it electronically to hearingclerks.waysandmeans@mail.house.gov, along with a

fax copy to (202) 225–2610 by the close of business, Wednesday, April 24, 2002.

Those filing written statements who wish to have their statements distributed to

the press and interested public at the hearing should deliver their 200 copies to the

Subcommittee on Select Revenue Measures in room 1135 Longworth House Office

Building, in an open and searchable package 48 hours before the hearing. The U.S.

Capitol Police will refuse unopened and unsearchable deliveries to all House Office

Buildings.

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. Due to the change in House mail policy, all statements and any accompanying

exhibits for printing must be submitted electronically to

hearingclerks.waysandmeans@mail.house.gov, along with a fax copy to (202) 225–

2610, in Word Perfect or MS Word format and MUST NOT exceed a total of 10

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

electronic submissions for printing the official hearing 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. Any statements must include a list of all clients, persons, or organizations on

whose behalf the witness appears. A supplemental sheet must accompany each

statement listing the name, company, address, telephone and fax numbers of each

witness.

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

Wide Web at http://waysandmeans.house.gov.

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.

We are told we are going to have a vote on the floor in about 10

Chairman MCCRERY. The Subcommittee will come to order.

f or 15 minutes, so if we can get Members to take their seats as well

as our guests, we will proceed and try to get through the first panel

before that vote.

Good afternoon, everyone. Today the Select Revenue Measures

Subcommittee begins its examination of the Extraterritorial Income

(ETI) Exclusion Act which replaced the Foreign Sales Corp. (FSC)

regime. I am glad that Chairman Thomas has asked our SubVerDate 11-MAY-2000 11:02 Jun 18, 2002 Jkt 079486 PO 00000 Frm 00007 Fmt 6633 Sfmt 6602 E:\HR\OC\C486.XXX pfrm12 PsN: C486
4

committee to delve into this difficult issue and hope that we are up

to the task of finding a way to untie this Gordian knot.

As Members of this panel are well aware, the United States has

a world-wide tax regime, meaning U.S. companies pay tax on all

of their income regardless of where it is earned. Some of the U.S.’s

major competitors have territorial tax systems. Under such systems

only income earned within the home country is taxed. Income

earned outside of the home country generally is not.

Our international tax rules that provide for deferral for certain

types of income earned abroad and which provide tax credits for income taxes paid to foreign countries are an endless source of complexity. Members of this Committee are interested in simplifying

these rules to improve the competitiveness of U.S. multinational

companies. I note that just last month Oversight Subcommittee

Chairman Houghton introduced legislation on this difficult subject.

The ETI FSC rules are an attempt to address a slightly different

issue impacting the ability of the U.S. companies to compete

abroad. For reasons buried deep in the past, the agreement establishing the World Trade Organization (WTO) expressly permits

countries to border adjust indirect taxes but not direct taxes, and

upon this distinction lies the prospect of a trade war with Europe.

Many European countries have relied on value-added taxes, or

VATs, for a significant share of their tax base. Under the terms of

the WTO, the embedded VAT may be rebated when products are

exported. By contrast, the United States raises most of its revenue

from income taxes which are considered direct taxes and are not

similarly rebatable on exported products.

In order to level the playingfield, the United States has provided

a tax benefit to our exporters in an attempt to replicate the benefits of border adjustability. But what was offered in incentives to

U.S. exporters lacked compliance with world trading rules.

Domestic sales corporations were replaced by foreign sales corporations in 1984. In 2000, the WTO ruled the FSC rules, the Foreign Sales Corporation rules, constituted an impermissible export

subsidy. Working with the Clinton Administration, the Congress

repealed FSC and replaced it with the extraterritorial income regime, which itself has been found to be in violation of those same

WTO rules.

The case is now before an arbitration panel. That body will, by

the 29th of April, set the amount of retaliation that the Europeans

may impose to mitigate the impact of our Tax Code’s impermissible

export subsidy. We fervently hope the Europeans will not immediately exercise their right to impose sanctions and recognize the

strong commitment of this Congress and the President to make the

necessary changes to the Tax Code as soon as practicable.

Today’s hearing explores one way to bring our Tax Code into

compliance with the WTO ruling. Some observers have suggested

that the WTO Appellate decision provides a road map for how the

ETI regime could be narrowly modified to come into technical compliance with the WTO’s rules while still providing the same benefits to the same set of taxpayers. Others, however, suggest the latest Appellate decision provides little wiggle room for cosmetic solution and believe the WTO will be very skeptical of supposed solutions that do not fundamentally revamp our Tax Code.

5

We have a distinguished group of witnesses to help us examine

these difficult questions, and I am particularly pleased to welcome

back to 1100 Longworth two good friends and long-time leaders of

the Committee on Ways and Means, Chairman Bill Archer and

Chairman Sam Gibbons.

Before I introduce them more fully, though, I would like to yield

to my good friend from Massachusetts who is substituting for my

good friend from New York today as acting Ranking Member, Mr.

Neal.

[The opening statement of Chairman McCrery follows:]

Opening Statement of the Hon. Jim McCrery, a Representative in Congress

from the State of Louisiana, and Chairman, Subcommittee on Select Revenue Measures

Good afternoon. Today, the Select Revenue Measures Subcommittee begins its examination of the Extra-Territorial Income Exclusion Act, which replaced the Foreign

Sales Corporation regime.

I am glad Chairman Thomas has asked our Subcommittee to delve into this difficult issue and hope we are up to the task of finding a way to untie this Gordian

Knot.

As Members of this panel are well-aware, the United States has a worldwide tax

regime, meaning U.S. companies pay tax on all of their income, regardless of where

it is earned. Some of the United States’ major competitors have territorial tax systems. Under such systems, only income earned within the home country is taxed;

income earned outside of the home country generally is not.

Our international tax rules that provide deferral for certain types of income

earned abroad and which provide tax credits for income taxes paid to foreign countries are an endless source of complexity. Members of this Committee are interested

in simplifying these rules to improve the competitiveness of U.S. multi-national

companies. I note that just last month, Oversight Subcommittee Chairman Houghton introduced legislation on this difficult subject.

The ETI/FSC rules are an attempt to address a slightly different issue impacting

the ability of U.S. companies to compete abroad.

For reasons buried deep in the past, the agreement establishing the World Trade

Organization expressly permits countries to border adjust indirect taxes but not direct taxes. And upon this distinction lies the prospect of a trade war with Europe.

Many European countries have relied on Value Added Taxes, or VATs, for a significant share of their tax base. Under the terms of the WTO, the embedded VAT

may be rebated when products are exported. By contrast, the United States raises

most of its revenue from income taxes, which are considered direct taxes and are

not similarly rebatable on exported products.

In order to level the playing field, the United States has provided a tax benefit

to our exporters in an attempt to replicate the benefits of border adjustability.

But what was offered in incentives to U.S. exporters lacked compliance with world

trading rules. Domestic Sales Corporations were replaced by Foreign Sales Corporations in 1984. In 2000, the WTO ruled the FSC rules constituted an impermissible

export subsidy. Working with the Clinton Administration, the Congress repealed

FSC and replaced it with the Extra-Territorial Income Regime, which itself has been

found to be in violation of those same rules.

The case is now before an arbitration panel. That body will, by the 29th of April,

set the amount of retaliation that the Europeans may impose to mitigate the impact

of our tax code’s impermissible export subsidy.

We fervently hope the Europeans will not immediately exercise their right to impose sanctions and recognize the strong commitment of the Congress and the President to making the necessary changes to the tax code as soon as practicable.

Today’s hearing explores one way to bring our tax code into compliance with the

WTO ruling. Some observers have suggested that the WTO appellate decision provides a road map for how the ETI regime could be narrowly modified to come into

technical compliance with the WTO’s rules while still providing the same benefits

to the same set of taxpayers.

Others, however, suggest the latest appellate decision provides little wiggle room

for a cosmetic solution and believe the WTO will be very skeptical of supposed solutions that do not fundamentally revamp the tax code.

We have a distinguished group of witnesses to help us examine these difficult

questions. I am particularly pleased to welcome back to 1100 Longworth two good

6

friends and long-time leaders of the Ways and Means Committee, Bill Archer and

Sam Gibbons.

Before I introduce them, however, I would like to yield to the gentleman from

New York for an opening statement.

Mr. N

I agree with you. You couldn

EAL. Thank you, Mr. Chairman.

f’t have met two finer people or two

better Chairmen. It is a great opportunity for Members of this

Committee to finally question two Chairmen of this Committee. It

is a rare opportunity we get, finally.

I do want to thank you, Mr. Chairman, for holding this important hearing today on ensuring the competitiveness of U.S. multinational businesses.

I also want to thank you and your staff in working in earnest on

another topic of interest to me, the corporate expatriate problem.

I understand a hearing will be held perhaps as early as the end

of this month when a U.S. Department of the Treasury report on

the issue is expected to be released. Either way, if that report is

not available, I think our hearing would certainly be instructive for

the Treasury officials doing the report since there really has been

no public debate on this issue thus far.

I do want to get to the question-and-answer period with our respective guests today. But I do also want to thank you Mr. Chairman publicly for agreeing to proceed with hearings on that expatriate issue.

Chairman MCCRERY. I thank the gentleman for his comments

and look forward to working with him and other Members of the

Subcommittee on that issue.

Our first two witnesses today are well known to this Committee

and undoubtedly to our audience and our guests today. This week

is Masters week, as some of you know, some of you golf addicts like

me know. I am looking forward to it. It is my favorite tournament

of the year. It is in the opinion of a great many people the bestrunning golf tournament in the world, and one of the great things

about the Masters is the chance for past champions to come back

and mingle with younger golfers, give them the benefit of their experience and their knowledge of the Masters Tournament and the

game.

Certainly today we have two past masters with us to share with

us their experiences and their knowledge of the game, so to speak;

and we couldn’t have chosen two finer examples of the greatness

embodied in the Members of the Committee on Ways and Means

which I think and most people believe is the greatest Committee

in Congress. I don’t get any disagreement with our panel or from

the dais.

So, welcome, gentlemen. We very much welcome you back. We

hope you won’t make this your last visit to the Committee on Ways

and Means. We hope to see much more of you. Certainly appreciate

your taking time out of your schedules to join us today and try to

help us with this issue.

We do have a vote on the floor—if it is just one vote. We could

find out if it is just one vote. It is just one vote. So why don’t I

suggest that the Members of the Subcommittee run over and cast

7

this one vote. Then we will be right back, and that way we can go

full on.

Thank you. The Subcommittee will be in recess.

[Recess.]

Chairman MCCRERY. The Subcommittee will come to order. Welcome back, everyone.

Our first two witnesses today are the Honorable Bill Archer and

the Honorable Sam Gibbons. Mr. Archer is presently Senior Policy

Advisor, Washington National Tax Services for PricewaterhouseCoopers. Mr. Gibbons is Chairman of Gibbons and Company. Gentlemen, once again, thanks for coming.

Today we will begin with Chairman Archer. Mr. Archer.

STATEMENT OF THE HON. BILL ARCHER, SENIOR POLICY ADVISOR, PRICEWATERHOUSECOOPERS LLP (FORMER MEMBER OF CONGRESS)

Mr. ARCHER. Mr. Chairman, thank you so much. Congressman

Neal and other Members of the Subcommittee, I think this is a extremely important hearing today; and I am honored to be a part

of it. Thank you for inviting me.

I have a longer written statement, Mr. Chairman, which I would

like to have inserted in the record; and I will shorten for my verbal

presentation.

Chairman MCCRERY. Without objection.

Mr. ARCHER. Today I will discuss briefly our current international tax system and the role of the ETI, and I will also offer

for the Committee’s consideration four fundamental principles for

international tax reform that I hope you will find useful during the

course of your work.

For the record, let me note that, as you mentioned, Mr. Chairman, I am currently serving as Senior Policy Advisor to the firm

of PricewaterhouseCoopers, but today I testify on my own behalf

and not as the representative of any organization.

I am extremely pleased to have the chance to discuss with my

former beloved colleagues—and I mean that genuinely—in this

auspicious environment of the Committee on Ways and Means

hearing room the critical issue of ensuring that U.S. international

tax rules provide a level playing field for U.S. businesses to compete globally; and I think that is what this issue basically is all

about. As President Bush stated early in his Administration, and

I quote, ‘‘Open trade fuels the engine of economic growth that creates new jobs and new income in the United States and around the

world.’’ I believe we must have a tax system that frees American

workers and businesses to participate fully and fairly in the benefits of an open global trading system.

Achieving that goal in a manner that honors our international

trade commitments is a fundamental imperative for our country

and for the world. I am confident that the Committee on Ways and

Means will address this challenge by once again demonstrating its

longstanding bipartisan commitment to putting first the interests

of American workers, farmers and businesses.

As we all know, the World Trade Organization ruled on January

the 14th, for the fourth time, that the U.S. Tax Code is inconsistent

8

with our obligations to the WTO. I share the disappointment that

you must have that Congress must once again confront this issue.

I had the distinct honor of chairing the Committee when we all

worked together in a totally bipartisan manner to pass legislation

in November 2000 that responded to an earlier WTO ruling when

we repealed the FSC and enacted the ETI provisions. Unfortunately, the WTO ruled against the ETI; and by April 29th it will

rule on sanctions. The amount and timing of any European Union

(EU) retaliation remains unclear. What is clear are the serious

risks posed by sanctions to our recovering U.S. economy and the orderly operation of the global trading system.

Chairman McCrery, when you announced this hearing you stated

that it is critical that we make a prompt yet thorough inquiry into

possible changes into the ETI system which are both WTO compliant and foster the competitiveness of American companies. I could

not agree more. You asked for help in exploring the possibility of

leaving the ETI in place but making modifications to it that address the objections raised by the European Union.

I have looked very carefully at the WTO decision, and let me

state emphatically today that the Committee should not in my

opinion consider another interim response to the WTO ruling. In

my opinion, the ETI cannot be modified to preserve effectively its

essential benefits and still be in compliance with the WTO.

I suppose that is really the guts of my comments today. I believe

the Committee needs to consider fundamental reform of the ways

that U.S.-based businesses are taxed. On this point I concur with

Chairman Thomas, although I would add a note of caution that

there will be winners and losers when you change the existing

rules.

I believe that it is important to balance the needs of various affected industries and implement any proposed legislation in a manner that avoids disruption of current business plans and activities.

In my view, we force U.S.-based businesses to enter the global

trading arena with one hand tied behind their backs relative to the

Tax Codes of the countries where corporations are competing

against us. The existing ETI provisions serve only in part to offset

some of the anti-competitive features of U.S. international tax

rules.

Under current law, a U.S.-based business operating internationally almost always pays a greater share of its income in foreign and

U.S. tax than does a competing multinational corporation

headquartered outside the United States.

In addition, the complexity and high compliance costs associated

with U.S. international tax rules represent essentially an additional hidden tax on American businesses that operate abroad. It

was most recently noted in a report that roughly 47 percent of the

compliance costs under our Tax Code are a result of the way we

tax foreign source income, and that should never be ignored. Because even though it is an administrative cost, it adds to the burden of our corporations that have to compete overseas.

You can witness the impact of an overly burdensome and complex tax regime on the U.S. economy in the area of corporate mergers and reorganizations. As this Committee knows from past hearings right in this room on international tax simplification, U.S.

9

international tax rules can play a key role in determining the location of a corporate headquarters.

This was clearly the situation in the case of Chrysler when it became, as a result of our Tax Code, DaimlerChrysler instead of

ChryslerDaimler, a German corporation, with the result that the

culture that now permeates that organization is directed out of

Germany, not out of the United States of America.

I do not believe that is in the best long-term interests of our

country. In fact, recent studies have shown that between 73 and 86

percent of large cross-border acquisitions involving U.S. companies

have resulted in a merged company being headquartered abroad.

Of the world’s 20 largest corporations, the number headquartered

in the United States has declined from 18 in 1960, the period of

time when our current code was put on the books in the early sixties, to just 8 in 1996. So from 1960, 18 of the largest—of the 20

largest corporations in the world were in the United States. Today,

only six. And that tells a story in itself.

In conclusion, let me say that we must consider the bigger picture when discussing the current U.S. international tax system.

Achieving a high standard of living for American workers and their

families ultimately rests on the productivity of U.S. investments.

The challenge is to design a tax system that raises revenue with

the least damage to investment and growth in productivity.

With these larger issues in mind, I would like to offer four fundamental principles that I hope you would consider during your deliberations. I believe that these bedrock guidelines should be a part

of the core criteria by which any proposal is judged.

First, if and to the extent that the ETI regime is repealed, any

scored positive revenues such action generates should be reserved

for measures to improve the competitiveness of U.S. corporations

operating in the world marketplace.

Second, in designing international tax reform measures, the

Committee should balance the needs of various affected industries.

All industries are not alike in the way they are impacted.

Thirdly, also, the Committee should seize every opportunity presented during this process to fashion international tax rules that

U.S. businesses can understand and the government can administer.

Finally, any repeal of the ETI should be accompanied by an adequate transition period to avoid disruption of current plans and

business activities.

A successful U.S. response to the WTO’s ruling against the ETI

has the potential to address two key priorities for our country.

First, we must make the United States more competitive internationally; and, second, we must address the underlying problems

with the U.S. international tax rules that are resulting in fewer

and fewer global business headquarters being located in our country.

Finally, although Ambassador Zoellick is making efforts to have

the European Union defer any retaliatory action while the United

States works to comply with our WTO commitments, there remains

the real possibility that some action may be required this year. Because of the potential magnitude of this issue, it would be highly

desirable for the Congress to work with the White House to put in

10

place a joint bipartisan task force to make formal recommendations

to the Congress on a solution. That task force should, in my opinion, include representatives of the White House, select Members of

Congress from both parties, representatives of business, farmers

and organized labor. I don’t think it can come too soon to lay the

groundwork for an ultimate solution to this problem.

For my part, I offer my assistance and the assistance of

PricewaterhouseCoopers as the Committee considers any replacement of the ETI regime. I played a very big role, as you may remember, in the development of the ETI, working very closely with

the Clinton Treasury and with both sides of the aisle. We did our

best, but it was not upheld by the WTO. Now again it must be on

the basis of full consideration on both sides of the aisle and the

White House.

I thank you again for letting me come and testify, and I will be

happy to answer any of your questions.

Chairman MCCRERY. Thank you, Chairman Archer.

[The prepared statement of Mr. Archer follows:]

Statement of the Hon. Bill Archer, Senior Policy Advisor,

PricewaterhouseCoopers LLP (former Member of Congress)

Mr. Chairman, Congressman McNulty, and distinguished members of the Subcommittee, I appreciate the opportunity to appear at this hearing to discuss the future of the extraterritorial income tax regime. Today, after exploring the current

state of our country’s international tax regime, I would like to offer for your consideration four fundamental principles for international tax reform that I hope you will

find useful during the course of the Committee’s work.

For the record, let me note that while I am currently serving as Senior Policy Advisor to PricewaterhouseCoopers, I am testifying today on my own behalf and not

as the representative of any organization.

First, I am extremely pleased to have this chance to discuss with my former colleagues the critical issue of ensuring that U.S. international tax rules provide a

level playing field for U.S. businesses to compete globally. As President Bush stated

early in his Administration, ‘‘Open trade fuels the engine of economic growth that

creates new jobs and new income in the United States and around the world.’’ We

must have a tax system that frees American workers and businesses to participate

fully and fairly in the benefits of an open global trading system.

Achieving this goal in a manner that honors our international trade commitments

is a fundamental imperative for our country. I am confident that the House Committee on Ways and Means will address this challenge by once again demonstrating

its longstanding bipartisan commitment to putting first the interests of American

workers and businesses.

The Subcommittee has been charged with the responsibility for exploring options

that respond to the January 14th World Trade Organization appellate ruling that

the U.S. tax code is inconsistent with our obligations under the WTO. This decision

marks the fourth time the WTO has ruled this way, twice in the Foreign Sales Corporation (FSC) case and now twice in the extraterritorial income (ETI) case.

I believe that I share the disappointment of each of you that Congress once again

must confront this issue. I had the distinct honor of chairing the House Committee

on Ways and Means when we all worked together in a bipartisan manner to pass

legislation in November 2000 that responded to an earlier WTO ruling by repealing

the FSC and enacting the ETI provisions.

Unfortunately, the most recent WTO rulings find that the current ETI, like the

FSC provisions that preceded them, are inconsistent with our international trade

commitments. A WTO Arbitration Panel is expected to rule by April 29 on the

amount of sanctions the European Union can impose against U.S. exports to EU

countries. The amount and timing of any retaliation remains unclear. What is clear

are the serious risks posed by sanctions to our recovering U.S. economy and the orderly operation of a global trading system.

Chairman McCrery, in announcing this hearing, you stated that ‘‘it is critical that

we make a prompt, yet thorough inquiry into possible changes to the ETI system

which are both WTO-compliant and foster the competitiveness of American companies.’’ You asked for help in exploring the possibility of leaving the ETI in place but

11

making modifications to it that address the objections raised by the European

Union.

I do not think it is possible to design a replacement that will replicate the same

benefits to the same taxpayers and still satisfy the WTO rules. On this point, I concur with Chairman Thomas. Thus, the Committee will need to recognize that there

will be winners and losers with respect to any change to the existing rules. However, I believe that it is important to balance the needs of various affected industries

and implement any proposed legislation in a manner that avoids disruption of current business plans and activities.

Let me state emphatically that the Committee should not consider another interim response to the WTO ruling. In my opinion, the ETI cannot be modified to

preserve effectively its essential benefits and still be in compliance with the WTO.

I believe the Committee needs to consider fundamental reform of the ways that

U.S.-based businesses are taxed. As you all know, I have been a long-time advocate

of fundamental tax reform. While reform of our overall tax system remains an issue

for another day, it is vital that the Congress begin to consider comprehensive overhaul of U.S. international tax rules.

The current ETI provisions, like the earlier FSC provisions, are integral parts of

a larger system of international tax rules under which U.S.-based businesses must

compete internationally. The ETI and FSC provisions were designed to level the

playing field at least partially for those U.S.-based businesses that are subject to

those rules.

In my view, we force U.S.-based businesses to enter the global trading arena with

one hand tied behind their backs relative to the tax codes of the countries where

corporations are competing against us. The existing ETI provisions serve only in

part to offset some of the anti-competitive features of U.S. international tax rules.

It is important that we examine just how complex and burdensome those rules are.

First, current international tax rules are grossly outdated. The basic Subpart F

rules, for example, were enacted in 1962. These rules reflect the economic climate

of that time. In 1962, the United States was a net exporter of capital and ran a

trade surplus. Imports and exports were only one-half of the percentage of GDP that

they are today. As we all know, the world has changed. Our tax laws need to change

too.

The impact of U.S. tax rules on the international competitiveness of U.S. multinationals is much more significant an issue than it was forty years ago. Today, foreign markets provide an increasing amount of the growth opportunities for U.S.

businesses. At the same time, competition from multinationals headquartered outside of the United States is becoming greater. Of the world’s 20 largest corporations,

the number headquartered in the United States has declined from 18 in 1960 to just

8 in 1996. Around the world, 21,000 foreign affiliates of U.S. multinationals compete

with about 260,000 foreign affiliates of foreign multinationals.

If U.S. rules for taxing foreign source income are more burdensome than those

of other countries, U.S.-based businesses will be less successful in global markets,

with negative consequences for exports and jobs at home. I think a fair comparison

of U.S. international tax rules and those of other nations shows that American businesses are increasingly put at a competitive disadvantage in the world marketplace.

First, about half of OECD countries have a territorial tax system under which a

company generally is not subject to tax on the active income earned by a foreign

subsidiary. By contrast, the United States taxes income of a U.S.-controlled foreign

corporation either when repatriated or when earned in cases where income is subject to U.S. anti-deferral rules.

Second, the scope of U.S. anti-deferral rules under subpart F is unusually broad

compared to those of other countries. While most countries tax passive income

earned by controlled foreign subsidiaries, the United States stands out for taxing

as a deemed dividend a wide range of active income under various subpart F provisions.

Third, the U.S. foreign tax credit, which is intended to prevent double taxation

of foreign source income, has a number of deficiencies that increase complexity and

prevent full double tax relief.

Taken all together, you find that a U.S.-based business operating internationally

frequently pays a greater share of its income in foreign and U.S. tax than does a

competing multinational company headquartered outside of the United States.

In addition to a comparatively higher effective tax rate, the U.S.-based business

is burdened by tax rules that are among the most complex in the entire U.S. tax

code. Economists who surveyed Fortune 500 companies found that 43.7 percent of

U.S. income tax compliance costs were attributable to foreign source income even

though foreign operations represented only 26–30 percent of worldwide employment,

assets, and sales. The complexity and high compliance costs associated with U.S.

12

international tax rules represent essentially an additional hidden tax on American

businesses that operate abroad.

One indication of the impact of an overly burdensome and complex tax regime on

the U.S. economy is in the area of corporate mergers and reorganizations. As this

Committee knows from past hearings on international tax simplification, U.S. international tax rules can play a key role in determining the location of a corporate

headquarter. This was clearly the situation in the case of DaimlerChrysler. In fact,

recent studies have shown that between 73 and 86 percent of large cross-border

transactions involving U.S. companies have resulted in the merged company being

headquartered abroad.

How we tax foreign source income will influence what kind of economy we have

in the long run—specifically, whether we have a strong and vibrant economy with

competitive workers and companies, and whether we can create more export-related

jobs which pay on average 17 percent more to the workers of this country.

In conclusion, let me say that we must consider the bigger picture when discussing the current U.S. international tax system. Achieving a high standard of living for American workers and their families ultimately rests on the productivity of

U.S. investments. Growing productivity in turn requires investment in plant and

equipment and in the further development of knowledge through research and education.

The challenge is to design a tax system that raises revenue with the least damage. An overly complex and burdensome tax system can impose unnecessarily high

costs to the economy by discouraging savings and investment, by causing investment to be allocated inefficiently, or by requiring excessive resources to be devoted

to complying with and administering the tax rules.

With these larger issues in mind, I would like to offer four fundamental principles

that I hope you would consider during your deliberations. I believe that the following bedrock guidelines should be part of the core criteria by which any proposal

is judged:

Four fundamental principles to guide WTO response

1. If and to the extent that the ETI regime is repealed, any scored positive

revenues such action generates should be reserved for measures to improve the

competitiveness of U.S. corporations operating in the world marketplace;

2. In designing international tax reform measures, the Committee should balance the needs of various affected industries;

3. The Committee should seize every opportunity presented during this process to fashion simplified international tax rules that U.S. businesses can understand and the government can administer; and

4. If the ETI regime is repealed or substantially changed, there should be an

adequate transition period to avoid disruption of current plans and business activities.

A successful U.S. response to the WTO’s ruling against the ETI has the potential

to address two key priorities for our country. First, we must make the United States

more competitive internationally, and, second, we must address the underlying

problems with the U.S. international tax rules that are resulting in fewer and fewer

global business headquarters being located in our country.

As Chairman Thomas noted to the full Committee at the February 27th hearing,

the task before you is not an easy one. It will require the collective effort of all

Members from both parties to build a consensus on an approach that will meet U.S.

international commitments while maintaining the competitiveness of American businesses and workers in the global marketplace. I am confident that the Members of

the House Committee on Ways and Means, with the active leadership of the Bush

Administration and the collaboration of Senate colleagues, will rise to the occasion

once again.

Finally, I would note Ambassador Zoellick’s efforts to have the European Union

defer any retaliatory action while the United States works to comply with our WTO

commitments. There remains the likelihood that some action may be required this

year. Because of the huge potential magnitude of this issue, it would be highly desirable for the Congress to work with the White House to put in place a joint bipartisan task force to make formal recommendations to the Congress on a solution.

That task force should include: (1) the Administration; (2) select Members of Congress from both parties; and (3) representatives of both business and organized

labor.

For my part, I would like to offer my assistance, and the assistance of

PricewaterhouseCoopers, as the committee considers any replacement of the ETI regime.

13

Thank you again for the opportunity to testify today. I will be happy to answer

record of examining this Nation

any questions you may have.

Chairman MCCRERY. Now another gentleman with a long track

f’s tax laws and regulations and one

who has put, I know, a lot of thought into our tax system, Mr. Gibbons. We are very thankful to have you also with us.

You might notice that we allowed Mr. Archer to go over the 5

minutes. We will extend that same courtesy to you. The panels that

are following, don’t get any bright ideas. We are doing this for two

former distinguished Chairmen of this Committee.

We certainly will allow you to speak for however long you wish,

Mr. Gibbons. Please address the Committee.

STATEMENT OF THE HON. SAMUEL M. GIBBONS, CHAIRMAN,

GIBBONS AND COMPANY (FORMER MEMBER OF CONGRESS)

Mr. GIBBONS. Mr. Chairman and Members of the Committee, let

me thank you for allowing me to come back here in this position

as a witness before the Committee. It is a high honor for me. I will

try to do my best.

Like I think Mr. Archer and I both feel, we would prefer to have

a dialogue with you which we hope our direct testimony will stimulate so that we can really pure out the knowledge that we have and

the thoughts that we have in that dialogue. So I will try to keep

my remarks brief; and, Mr. Chairman, just slam me with the gavel

when you think I have gone too far.

Mr. Chairman, I don’t disagree with a thing that Mr. Archer has

said. We talked about this when he and I were both on the Committee. We fundamentally understand the subject matter, and I

feel that it is our job and I am sure he feels it is our job to try

and impart some of that knowledge that we accumulated on our

years here so that you all can take some affirmative action on it.

Let me go back to the beginning. How did we get in this predicament? Well, it is certainly not your fault. It is not our fault. It is

the fault of a long time ago, an innocent decision that was made

at that time. And there were no villains in the whole process at all.

Let me paint the picture.

In 1947, I was a young lawyer down in Tampa, Florida. I had

just graduated from law school, spent 5 years in the Army, and

was not focused upon Washington at all. But the world was in

shambles. Europe looked like it was—we knew it was prostate because we had destroyed it during World War II. We thought it was

going Communist, because that was the emerging philosophy there.

And Japan was in terrible shape, China. Every place on Earth except the United States of America was in terrible shape.

The leaders at that time decided to convene here in Washington

in 1947 a conference on what to do about rebuilding the world. Everybody came to Washington from all over the world, knowing that

America was the number one economic engine of not only the

United States but of the world; and they had been defeated or had

worked with us in defeating the rest of the world in the war. So

they convened here in Washington in 1947, and they eventually

14

came out with something called the General Agreement on Tariffs

and Trades (GATT) with its rules.

That graduated over a period of time into the World Trade Organization. But essentially the rules are the same as they started in

1947. They were rules that the United States of America imposed

upon the rest of the world. Let’s have no doubt about it. We are

the ones that invented these rules that have us entrapped today.

The Europeans who had the strongest economy, such as it was,

and it was in terrible shape, came along and in that 1947 agreement this distinction between indirect and direct taxes was made.

And why was it made? Why did the United States impose that kind

of rule? Well, that is the same kind of rule that we had developed

in the United States in how we handle our sales tax. Today, and

even then, if you buy something in New York with a high sales tax

and you have it shipped to here in Washington, you don’t pay any

New York sales tax, and vice versa. If you buy something here in

Washington with its relatively high sales tax and have it shipped

to you in New York, you don’t end up paying any Washington sales

tax.

That is the same dilemma we are in this—the world rules today.

We imposed that rule on the rest of the world in 1947, and it hasn’t

changed.

Now, why did we do it? Well, we were trying to get rid of subsidies. We realized that the Tax Code could be used to subsidize

businesses. So we got rid of them in the direct subsidies; and when

we got to the subsidies that are embedded in the tax law we said,

well, we will adopt the same rule that we have for our own domestic sales tax. That is how we got where we are today, and that is

the same rule that comes back to haunt us.

Now the Europeans weren’t plotting against us when they agreed

to do that. They had the same kind of tax system in Europe, such

as it was, as we had in this country—high dependence upon excise

taxes and a heavy dependence upon income taxes and various other

nuisance taxes like alcohol and tobacco and excise taxes on fuel

and things of that sort. So the tax systems were roughly the same.

In 1965, the French had had so much trouble with their own income tax system that they started experimenting, and they came

up with something called a tax value added, TVA.

I first ran into it when I found myself without an overcoat in

Paris with Martha, oh, sometime in the late 1960s or early 1970s.

I had to go buy an overcoat. The embassy didn’t want me shivering

to death over there in that French weather, and I bought an overcoat.

Well, the fellow from the embassy who was with me jabbered off

in French to the clerk there something about TVA. I didn’t know

what the heck they were talking about. Well, 2 months later I was

sitting in my office in the Rayburn Building and in comes a check

from a bank in New York for about 200 bucks. No letter going with

it or anything else.

So I called the bank. I said, why did you send me $200? They

said, well, that is the rebate on the French TVA tax that I had paid

on the overcoat.

I called the colonel in who had been my escort. I said, how did

we get into this? He said, I turned in all those papers that you

15

gave me at the border when we left France and you got the tax

back that had been collected on your overcoat.

Well, that got me to scratching my head. Attending conferences

in Europe, I would meet with the European Commission and the

European Council, and I would complain about this rebate, this unfair advantage that they had against Americans. They would say,

it is a sales tax, just you all have got in the United States, State

level. You rebate that same thing when you make the sales.

So it dawned upon me that we are up against something that

was a little different, and the severity of it didn’t dawn on me until

American businesses kept coming to me saying, complaining, well,

we are at a disadvantage. The Europeans can rebate their cost of

government at the border on their products when they export them

into the world market, and we Americans can’t.

Well, about the early 1970s, I think it was, the Treasury Department came in. There were only 25 of us on the Committee. There

was no lower level down here. They took us over to H–208 and explained to us what the problem was. We came up with this way

to get around it, we thought. It was highly controversial within H– 208, but there were no newspaper reporters around, nobody else.

The doors were all closed, and we were just plotting up a solution

ourselves behind those closed doors.

After a few hours of arguing back and forth, we finally adopted

this monster that you all are dealing with right now. It has had

to be changed over the years as one time after another that the

monster got chopped down, and we had to fess up that, yeah, we

have committed a tax subsidy under the Income Tax Code. There

isn’t any way out of it. We imposed the rule on the world. It has

come back to haunt us.

Everybody on Earth has gone to a value-added tax. Instead of a

TVA, it is a VAT; and only our country and Australia have not

gone that route. So it is us against the world. We are eventually

going to have to conform to their set of rules or suffer the consequences. That means that they can levy offsetting duties against

our products if we continue to be the scofflaw in the international

situation, so there is no way out of it.

Maybe some kind of temporary something can be negotiated with

the rest of the world. I doubt it, but you can try. It will be very

frustrating, and you are not going to get very far. The rest of the

world is going to say, you know, Americans, if you don’t like the

rules, you join the club. You change your rules, you change your

tax laws, and you can join the same club we are all in.

Now, what is that club? That club is—let me take off these glasses, because they impede my ability to think.

If you manufacture these glasses in the United States and sell

them abroad—and nobody does that, but if you did, when they

went abroad, they would go with the full cost of the U.S. Government in here, the full tax cost of the U.S. government. It is a pretty

substantial burden to have to carry and go overseas.

When you hit their border you would not only have your cost of

government there, these glasses, but these glasses, when they pass

that border, would pick up under their value-added tax, their cost

of government. So these glasses would be burdened with two costs

of government going from our country to their country. But coming

16

from their country to our country, it is just the opposite. They take

off the value-added tax, their cost of government, at their border.

We have got nothing that effectively intercepts it on our side.

So what are we doing? We are exporting American jobs. Let me

repeat that. What are we doing? We are exporting American jobs,

good American jobs, because of the way we collect taxes.

Now, there is no solution through the income tax. We have tried

it for 20—almost 26, 27 years. Every time we have tried it, the

World Trade Organization says, you know, that is a subsidy. And

honestly it is, under the current rules. But—so, I don’t know of

anybody on this Committee that wants to continue to export American jobs, but that is what we are doing. That is what we have

been doing for quite some time. That is what we are going to be

doing at a greater rate unless we change our system.

So, men and women of the Committee on Ways and Means, the

burden comes back to you. You can’t judge it. You can’t fix it. You

can’t flinch it. You got to do it. You have got to adopt some kind

of tax system that will work in the world system.

We are a world power, but we are a limited world power. We are

only 4 percent of the Earth’s population, something that never

dawns upon most Americans. We are only 4 percent of its population, but we possess and control about 30 percent of its wealth.

We are bleeding that away, and we are bleeding it away primarily

not because we are not a productive nation, but because of our tax

system.

I don’t know what it costs to collect taxes in the United States

at the Federal level, but it is horrible. It is far greater than what

we pay the Internal Revenue Service (IRS). Because also out there

is tax deductible—are all of the tax firms that do tax law, all of

the people that write books and write electronic programs and everything else. It is a huge, huge industry.

All of you, like Mr. Archer, who fill out your tax return—I did

it for years until I finally got audited and wised up and found out

it was better for me to hire an accountant rather than explain to

the IRS why I didn’t fill out a tax return properly——

Chairman MCCRERY. You are going into areas now that this

Committee is not prepared to discuss.

Mr. GIBBONS. They audited my tax return when I was first a

Member of this Committee; and, believe me, that is an exquisite

feeling if you have never been through it. I don’t recommend it for

anybody.

I want to say right now I didn’t get caught, and I was clean, and

Martha didn’t have to pay anything, and I didn’t have to pay anything. But it is an exquisite feeling to have the people walk in from

the IRS and say, we are from the government. We are here to help

you, and we are going to audit your tax return. We want all your

books and records. And a cold sweat, even if you are a Congressman, breaks out all over you when that happens.

So that, you know, I do know something about what the cost of

collecting taxes is. It is a huge drag upon the American economy,

one that we insist on imposing on our economy; and we are going

to reduce ourselves to a third-world nation if we continue down this

path. That is how critical this issue is.

17

I have talked longer than Bill Archer, and I have talked longer

than most of you care to listen to me. But thank you very much.

If I can ever come back and spend time with you or go on a retreat

with you, Bill and I will be glad to go. There is a lot there that

we won’t be able to say because you just haven’t got the time to

listen. But we are here to help you. We are here to work with you.

Chairman MCCRERY. Thank you very much, both of you. And

quite the contrary, Mr. Gibbons, I think it is helpful for particularly the younger Members of the Committee to hear the history

of how we got to where we are. It is very helpful for us to hear

from the two of you who were intimately involved in various efforts

through the years to make our tax system work within the confines

of the rules of the World Trading Organization, whether it was

GATT or WTO.

I want to begin the questions by exploring a little bit those efforts that you went through. Just to use the most recent example,

back in 2000, when Chairman Archer worked with Charlie Rangel

and Members on both sides of the aisle and with the Clinton Administration to try to figure out a way to replace the FSC with

something that was workable and permissible under the rules and

they came up with ETI, that process took nearly a year. It would

have taken a lot longer except for the fact that everybody involved

agreed where we wanted to go and everybody was in agreement

that something had to be done. Everybody was in agreement that

we wanted to keep American workers and farmers and businesses

competitive and to keep Americans working. So we all worked together very expeditiously to go from FSC to ETI.

My question to you, though, relates to where we are today visa`-vis the sanctions that may be imposed upon us in the not-too-distant future. Do you believe that a similar—first of all, do you believe that a similar bipartisan effort is necessary to come up with

any solution that we arrive at?

Mr. ARCHER. As I stated in my testimony, I believe that.

Chairman MCCRERY. Mr. Gibbons.

Mr. ARCHER. But I do not believe that it can be done in a rapid

fashion. That is why I think you need to get started with the process by exploring the alternatives.

Chairman MCCRERY. That is my next question. Do you think we

can get the parties together—not just political parties but all the

parties that have to be involved in such a tremendous effort and

get something done before the end of this month when retaliation

is due to come from the WTO, from the Europeans?

Mr. ARCHER. I doubt it. But it is my understanding of the signals

that we have been getting from the Europeans, as particularly articulated by Lamy, that if there is a process under way which

shows good faith for us to reform our tax system that they will not

immediately retaliate.

Chairman MCCRERY. Mr. Gibbons, do you have an opinion on

how long it is going to take us?

Mr. GIBBONS. I think you could work out the bipartisan part in

the Congress and with the President. I don’t think that is the big

problem. I think the problem is, what are you going to do with the

rest of the world? When I say the rest of the world, you know there

are almost 160 members of the WTO. Everybody on Earth that we

18

have allowed in is in the WTO, and you have got—and all of them

have got a value-added type of system that they are working from,

and we have got—we depend heavily upon the income tax. They

are just—unless there is something within the psyche of those 157

other nations out there, I don’t think you got much negotiating

grounds.

Now, they want some things and we want some things, and

maybe I think with a wink and a nod and a handshake you could

work out something that would delay the impending execution of

those dates if you could show good-faith effort that you were moving ahead. It isn’t going to be easy. And the biggest part of the

problem is not the technical problem but the political problem within the United States of moving from an income-based tax and a

payroll tax to an indirect tax. That is the problem. And it is not

an easy problem.

But, friends, they have got the goods on us. We have got to show

some good-faith effort that we are ready to move and are willing

to move. I don’t know of any other short-term thing that could have

happened. We have got to go to the WTO and tell them we would

like to sit down and work this thing out and show some good-faith

effort that we are willing to work it out. I don’t think we can pass

any more changes in the income tax law that will stand up more

than to take the time to file a case in the WTO.

Chairman MCCRERY. Thank you. Mr. Neal.

Mr. NEAL. That was fine testimony, Mr. Chairman. I do not have

any questions at this time.

Chairman MCCRERY. Mr. Hayworth.

Mr. HAYWORTH. Thank you, Mr. Chairman.

Mr. Chairman, thank you for returning; and we appreciate your

insight.

Chairman Archer, as you laid out the four principal ideas and

guidelines for us in responding to the WTO, I was wondering, sir,

if you could elaborate a bit more on principle number two: In designing international tax reform measures the Committee should

balance the needs of various affected industries. For purposes of illustration only, could you elaborate a little bit on that?

Mr. ARCHER. That becomes the very difficult part of this process.

I think politically, as you begin to move in to restructuring the Tax

Code, you are going to find domestic winners and losers. You cannot duplicate as we did with ETI the benefits so that everybody

was a winner. That was a big advantage that we had with the ETI.

I don’t think as you begin to move into a WTO-compatible system

that you are going to be able to do that.

But I think you need to give very strong consideration to businesses where the differences are great, for example, between an extractive industry and a manufacturing industry. The differences

are great between an industry that has to go overseas for most of

its business because that is where the markets are and one that

depends more upon the U.S. markets.

That is going to make your job very difficult. But I think you

have to look at it, and you have to carefully assess it and reach the

best possible result that you can.

Now, there are any number of options that you can use to address this problem. Again, the only thing that I don’t think you can

19

do, as I mentioned, is replicate the benefits for all of the people

who are exporting from this country who benefit under the ETI and

do it with a WTO-compatible result. I don’t think that is possible.

Today we don’t have time to try to brainstorm all of the alternatives, and that is where both Mr. Gibbons and I—and, by the

way, I associate myself with his remarks, which I think were beautifully stated—are available to the Committee in any way we can

help.

Then I would add also that all of the technical expertise of

PricewaterhouseCoopers is also available to you should you wish to

draw on it.

But if you see ultimately fit—and I am not recommending that

you abolish the ETI, but if you come to the point where you have

to do that, then whatever revenues result in the estimates that you

will get from the Joint Committee on Taxation, you should put

back as best you can into the system to reduce the barriers in our

Tax Code to our corporations that are operating overseas.

Now, just to reach out and talk about one or two things, the way

our subpart F operates, for example, can be changed to be very,

very helpful. The way we require interest allocations can be

changed. That will be very helpful. These will not duplicate the

current benefits under the ETI, but they will move in the right direction. So there are things that can be done within the current

system.

I must say that I agree completely with Chairman Gibbons that

in the long term you are going to have to throw out the income tax

system that we currently use in the corporate level and replace it.

Because, to me, we must in a competitive global marketplace, have

a Tax Code that at least gives us a level playingfield against our

foreign competitors.

What I have ascertained by looking at a number of different corporate structures is that, on average, our corporations pay an effective tax rate of around 39 percent. Now that is both Federal and

State taxes. There are foreign competitors who, on average, pay a

tax rate of about 24 percent. Now, that is a 15 percent margin of

difference, and that goes against the bottom line.

If our corporations are faced with this type of competition over

a long period of time, one of two things is going to happen: They

are either going to go out of business because they can’t sell their

goods and services competitively in the world marketplace with

this extra cost—and I am not yet including what Mr. Gibbons and

I referred to as the compliance cost, which are somewhere around

$250 billion a year in this country. Now, not all of that is corporate,

but that is an overall figure. But either they will decline and be

defeated by their foreign competition or, what is more likely, is

they will be taken over by foreign corporations like Chrysler was,

like Amoco and Arco were, like Bankers Trust was by Deutsch

Bank. Then the entire culture of that corporation is going to be removed into a foreign country, and I think that is the worst of all

worlds for the United States of America.

Mr. GIBBONS. May I add it would not only be their headquarters,

it will be American jobs that are removed——

Mr. ARCHER. Yes.

20

Mr. GIBBONS. And members. They are flowing out of this country

like a flood right now. There is not a day that you pick up the news

media that you don’t see American jobs flying overseas. We have

got to stem the flood. It is not the productivity of American labor

that is at fault, it is not the productivity of our other systems, it

is the tax system that is at fault, and there is no way we can escape that. The tax system has got to be changed.

Mr. HAYWORTH. Thank you both.

Chairman Gibbons, when you come to Arizona, chances are you

won’t have to buy an overcoat. We look forward to your visit.

Mr. GIBBONS. I spent some very happy hours in Arizona as a soldier. I kept all the Japanese out and not a single one of them penetrated our defense line.

Mr. HAYWORTH. We are very grateful for that; and, on a more serious note, we are very grateful for your service on June 6, 1944,

and, subsequently, in the European theater, too, sir.

Mr. GIBBONS. I was adequately paid for it. And thank you, sir.

Chairman MCCRERY. Mr. Lewis.

Mr. LEWIS. Chairman Archer and Chairman Gibbons, it really is

good to see you back here. I think we are hearing you loud and

clear that there is not a Band-aid approach to this, to solving the

problem. The ultimate answer is a change in the Tax Code.

I know, Chairman Archer, you have been a big advocate of a national sales tax and in doing away with the income tax. But that

is what I am hearing you say. The only way we are going to solve

this and solve it for good is to change the Tax Code. Is that what

you are saying?

Mr. ARCHER. Well, first, let me say that I have been for replacing

the income tax with another system that makes better sense for

this country. I have not spoken out in favor of a vehicle that is a

retail sales tax, but that is one way to do it.

In this instance, though, it seems to me that you have a great

opportunity because you can address this problem in a limited way

to the corporate Tax Code without having to get into all of the

more difficult ramifications of the individual income tax; and, hopefully, you make a decision that will help this country and the workers, as Mr. Gibbons said, the standard of living of the workers and

the jobs in this country for the next several generations.

Mr. GIBBONS. You see when all this first started the way you

measured America’s wealth was through the gross domestic product. Foreign trade or foreign commerce was an insignificant part of

America’s gross domestic product in the 1940s. Today, it is a huge

amount of America’s gross domestic product; and it is growing all

the time. Like it or not, stop it or not, you can’t stop it. We are

internationalizing. We have got to be in the world system or we are

going to suffer if we are not.

Let me say—I will do a little advertising here—when I could see

the beginning of the end of my career here in Congress, I left you

a heritage. I wrote it all out. It is all in the 1996 Congressional

Record, complete with legislation and an explanation of what ought

to be done. Now, I won’t take up your time today because it is not

the purpose of this hearing to explain how it could be done. But

it can be done, and it will be done. It is a question as to how much

longer we are going to bleed before we do it.

21

Mr. LEWIS. Thank you, sir. Thank you.

Chairman MCCRERY. In fact, Mr. Gibbons, another way of saying, your previous statement, that we represent only 4 percent of

the world’s population is 96 percent of the world’s customers live

outside the United States.

Mr. GIBBONS. Correct. That is it.

Chairman MCCRERY. Mr. Brady.

Mr. BRADY. Thank you, Mr. Chairman. And I want to welcome

my fellow Texan, and Houston area Member of Congress, Bill Archer to the hearing.

To let you know how strong his heritage is, Mr. Chairman, in our

part of the area I have the good fortune to represent a good part

of the former part of Mr. Chairman Archer’s district. And when you

ask people there who your Congressman is, they will say, well our

representative is Kevin Brady, but my Congressman is Bill Archer.

That will continue for decades to come.

Two questions. Chairman Archer, a task force you recommend.

How soon could a group meet, really thoroughly, examine the issue

and report back a good substantive change to Congress? How long

do you imagine that would take to really do a good job but move

quickly?

Mr. ARCHER. I think that will depend on how rapidly there is the

decision to put in place that task force.

I don’t think it is too early, for example, for leaders of the Congress to talk to people in the White House as a first step and see

about how this should be structured and how it should be moved

forward. And by leaders, I mean, both Democrats and Republicans

in the Congress.

What obviously will make it more unwieldy is to be able to take

into consideration the views of organized labor, the views of the

business community and the views of farmers. But I think that

needs to be done before any final decision is made.

Mr. BRADY. Sort of a follow-up to that, that second question. How

do we both stress the importance of bipartisanship and move in a

timely way? How do we educate Members of both parties and leaders of both parties that not only is this a problem, but this is an

opportunity to help make American companies more competitive

and an opportunity to slow the merge than move overseas trend

that is occurring?

How, in a period that can get pretty tense up here in Washington? How do we make sure that message gets heard and accepted by both parties?

Mr. ARCHER. Well, one method obviously is your intention to hold

hearings on this issue. Well, actually there is a hearing right now.

But the Chairman of the full Committee, I understand, plans on

holding hearings on how is our foreign—how do we tax foreign

source income? What can we do about it, and so forth?

And I think at those hearings, obviously you are going to have

witnesses who are going to be testifying. And hopefully the media

will cover those events and that information will be made available

to the American public. But, as so often is the case in Washington,

that both Mr. Gibbons and I found over the years, and which you

find today, is it is very, very difficult to let light overcome heat on

22

issues. And the light is the information that is presented as objectively as possible for people to understand.

But, Mr. Gibbons is absolutely right. When all of this started,

particularly back in the early sixties, we were the receptacle of investment capital, here in the United States. And we had just come

through the Marshall Plan period, and we had extended our capital

to the rest of the world. We had massive trade surpluses. And we

didn’t need to be so concerned about the negative aspects of our

Tax Code. We weren’t really looking overseas. We didn’t have a

global marketplace as we do today. And today it is very different.

And if our corporations again have to compete with one hand tied

behind their back, and their net is reduced by the extra operating

cost that is represented both by taxes and compliance, then their

cost of capital is going to go up.

As their net revenues and net profits go down, their cost of capital goes up and it just becomes a compounding problem over time.

And I think this is a great window of opportunity. It will not be

easy.

Mr. BRADY. Thank you, Mr. Chairman. Chairman Gibbons, anything to add?

Mr. GIBBONS. You know, excuse me. We often think of this as

just a problem of the export industries in the United States who

manufacture here. It is far beyond that. It is every American who

works and sweats in the system. High-tech industry, low-tech industry, any kind of job that is at a competitive disadvantage because of the way our tax system works in the international marketplace.

Whether you are a person who is trying to fight against a losing

a market overseas because your product is overtaxed when it goes

to consumption overseas, or whether you are working in an industry, it might be the same industry who is competing against an import, you are affected by this.

Everybody that works is affected by this. It is not just an isolated

problem that affects only the export industries. It is everybody that

is involved in it.

That is what they have got to understand. I am talking about the

great electorate out there. This is not a brandnew problem. The

Reagan Administration attempted to phase this in early in President Reagan’s Administration. If you go back, you will find that

they did a deep study into all of this. And they started to recommend to the Congress that we go to some kind of value-added

tax system then.

But the Congress was in control of the Democrats. The White

House was in control of the Republicans. They just didn’t feel like

that they could take that kind of political risk at this time. I don’t

know when we are ever going to get out of that political risk situation. But, you know, something has got to be done about it unless

we are content to allow our system to continue to bleed, and us to

become a third-rate economic power in the world. It is the tax system.

Mr. BRADY. That message is getting through loud and clear

today. I hope we can replicate it. Thank you, Mr. Chairman.

23

Chairman MCCRERY. Thank you, Mr. Brady. And now a representative from one of our other greats, represented by the panel

today, Mr. Foley from Florida.

Mr. FOLEY. Thank you very much, Mr. Chairman. I am trying to

focus on FSC. But I can’t get my mind off this coat you bought in 1960 where you got a $200 refund. I hope you still have that coat.

Mr. GIBBONS. That was a good French overcoat. I wore it for

years.

Mr. FOLEY. Because I am a consumer, I want to see that coat.

Mr. GIBBONS. That was just the rebate. They kept most of the

money over in France. But it was—you know, prices have changed

a lot since the late sixties.

Mr. FOLEY. I am still remembering Dick Nixon’s Pat analogy of

the plain cloth coat. So I just want to see this coat, Sam.

Chairman MCCRERY. Mr. Foley, let’s try to restrict our questions

to the matter at hand.

Mr. FOLEY. The Chairman and I get along well. We are both Floridians. And I just wanted to enjoy a moment.

But you just mentioned something, Sam, that is very, very important. And I think it underscores the complexities here. Because

a bipartisan group, after the WTO’s refusal of FSC, when to the

ETI, spent a lot of time on it.

I think the Europeans would like us to change our Tax Code, and

they may help us do it. It seems like the only thing acceptable to

them is a VAT concept.

It seems like everything else we create or try and put our hands

around fails. So I would like both of the participants, Mr. Archer

particularly, good to see you, both of your answers on, is the VAT

system the only acceptable mechanism by which the WTO will give

us a final resolution?

Mr. ARCHER. I think they would love for us to keep our system

with the income tax system so they have an advantage on us. I

don’t think they want to force us into any other form of taxation.

They are sitting smiling like a Cheshire cat now, because as Sam

mentioned, we created a system many, many years ago to which we

didn’t give adequate thought. And then we exacerbated it in 1986

in tax reform and made an absolute disaster out of the way that

we tax foreign source income. I am not going to go back into all

of that history.

But, we created this odium taxing our own corporations. And

then the only way out for us was to create an export subsidy. And

there is no doubt about it. We thought we were Okay because we

had an informal agreement with the Europeans back in the early

eighties that we weren’t going to attack each other’s tax systems

and all of that. But that was before the WTO was created.

And we put ourselves in the position that in order to have a level

playing field, we had to put into our code an export tax subsidy.

And we have got to remove that in some way or another and we

have got to replace it with something that gives us a better chance

to compete.

A VAT is not the only way to do it. And we can, you know—if

you want me to continue to work with you personally, I will be glad

to do it. There are a lot of options that can be considered. But, in

the long term, and you have heard me say this on this Committee,

24

and I say it because I personally believe it and have believed it.

I am not like one of our colleagues who told me one day I am a

very fair individual, all I want is a fair advantage.

I want a fair advantage for the United States of America. I

wished we would not stop at a level playing field. I wish we would

adopt a system that would give us a fair advantage under the WTO

rules. And that can be constructed. But again, we don’t have the

time today to go into all of the details.

Mr. FOLEY. I would welcome that engagement because I think it

is important. And I respect your expertise.

Chairman MCCRERY. If the gentleman will yield. We are going

to have a hearing later at which we will explore some of those alternatives.

Mr. FOLEY. Thank you, Mr. Chairman. Mr. Gibbons.

Mr. GIBBONS. Well, sitting here trying to respond to your first observation. At that time, the French had a number of different rates

at which they taxed under their TVA system, which is really a VAT

system. But the French called it a TVA system. And I would imagine they classified my French overcoat bought somewhere near the

embassy as a luxury item. And the tax on it may have been 50 or

60 percent.

Mr. NEAL. Mr. Chairman. Would you yield for 1 second, Mr.

Foley? Mr. Gibbons, can I ask you a question? It is on everybody’s

mind in this hearing room. What did you pay for the coat?

Mr. FOLEY. That was the crux of my earlier observation.

Mr. GIBBONS. Damn if I know.

I remember Martha and I didn’t have much spending money for

the rest of the trip. And, you know, I—at that time, the TVA might

have been 50 or 60 percent. Because, they—the French at the time

were administering their code under—they were taxing various

items at different rates.

Mr. FOLEY. Well, it continues today because when you travel——

Chairman MCCRERY. Mr. Foley, your time is up. Thank you very

much.

Mr. GIBBONS. The final voice has spoken.

Chairman MCCRERY. Thank you very much for your testimony.

We appreciate again your willingness to work with us to try to get

through this problem that we have got with our Tax Code. And we

welcome you back any time.

Mr. ARCHER. Mr. Chairman, if can I have one last quick thing.

I know you have got other witnesses coming. I don’t think that Mr.

Gibbons and certainly I mean to imply that the European credit invoice value-added tax system would ever be right for the United

States. I do not believe it would be. And I want to make that very

clear. That is an option that I do not think is a realistic one for

this country.

Chairman MCCRERY. Thank you very much. And we look forward

to seeing you again soon.

Our next witness is Ms. Barbara Angus, International Tax Counsel for the U.S. Department of the Treasury. Ms. Angus.

Ms. Angus, we will certainly put in the record any written testimony that you have for us. But if you would try to summarize that

within 5 minutes. You may proceed.

25

STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX

COUNSEL, U.S. DEPARTMENT OF THE TREASURY

Ms. ANGUS. Thank you, Mr. Chairman, Congressman Neal, and

distinguished Members of the Subcommittee. I appreciate the opportunity to appear today at this hearing on whether the existing

ETI regime can be modified in a manner that brings it into compliance with WTO rules without undermining the internal competitiveness of U.S. businesses and their employees.

Mr. Chairman, I would like to request your permission to read

a letter that Assistant Secretary Weinberger sent to you yesterday

regarding the matter that is before the Subcommittee today and

that states the administration’s views.

Chairman MCCRERY. You certainly may do that.

Ms. ANGUS. To read the letter:

‘‘Dear Chairman McCrery:

‘‘Thank you for the opportunity to have a representative of the Treasury Department appear before the Select Revenue Measures Subcommittee on April 10, 2002,

as your panel begins examining possible legislative solutions to the current FSC/ETI

dispute. As representative of the administration have said repeatedly, this is a very

serious matter requiring immediate attention and we must pursue all available avenues to achieve an appropriate final resolution, a resolution that protects America’s interests and satisfies our obligations under the WTO. We must continue to seek

every opportunity to address the underlying issues in the ongoing trade dialog. At

the same time, we must begin work toward meaningful changes to our tax rules to

respond to the decision in the FSC/ETI case. ‘‘We want to applaud you for the work your Subcommittee is doing. With the possibility that the European Union could move to impose trade sanctions against exports from the United States as early as May, the urgency of the situation is clear.

At the same time, we must not lose sight of the objective served by the ETI provisions and the FSC provisions that preceded them, which is to help level the

playingfield for U.S.-based businesses that are subject to the U.S. system of international tax rules.

‘‘We understand your hearing will explore whether minor changes can be made

to bring the current ETI regime into compliance with WTO rules. Given the analysis

of the current WTO rules reflected in the decisions in the FSC/ETI case, we do not

believe legislation that simply replicates FSC or ETI benefits will pass muster in

the WTO.

‘‘We must pursue all routes to resolving this matter promptly and fairly so that

American workers and the businesses that employ them will not be disadvantaged.

Addressing the decisions through the tax law without adversely affecting the competitive position of U.S.-based businesses in the global marketplace will require consideration of meaningful changes to our current international tax laws. We need to

explore a whole range of possible tax legislative options. This includes consideration

of changes that will help rationalize key components of our international tax rules

within the existing framework. It also includes consideration of comprehensive and

fundamental reforms of our international tax system. ‘‘While we work toward the needed changes to our international tax rules, we also

must continue to maintain a dialog with the European Union. Given the importance

of this matter, we must pursue a multifaceted approach to resolving it, including

both tax and trade approaches. It is essential that we achieve a resolution of this

matter that is clear, fair and final. We must take every step needed to ensure that

this does not further escalate to the detriment of the global trading environment.

‘‘Mr. Chairman, thank you again for this opportunity to discuss this matter and

for the work your Subcommittee is doing. We look forward to working closely with

Congress and all interested parties to develop and implement a solution that will

protect America’s interests and honor our obligations in the WTO.

Sincerely,

MARK A. WEINBERGER,

Assistant Secretary (Tax Policy).’’

Given the particular focus of this hearing, let me reiterate that

we believe legislation that simply replicates FSC or ETI benefits

will not pass muster in the WTO. We need to work together toward

26

meaningful changes in our international tax rules in order to protect the competitive position of American businesses and workers

and meet our WTO obligations.

I would be happy to answer any questions. Thank you.

Chairman MCCRERY. Thank you, Ms. Angus. And I gather from

the letter that you read from Mr. Weinberger and from your own

statements that the administration is spending some time now

looking at possible solutions to this matter on both the legislative

front and the trade front, and you are actively pursuing within the

Administration some recommendations that could be forthcoming

sometime in the future on this matter?

Ms. ANGUS. Yes, Mr. Chairman. The Administration and all of

the agencies are working together to explore all options for resolving this critically important matter. It is a complex matter that

cuts across areas of expertise and we need to bring together all of

that expertise to contribute to finding a solution now.

We believe the administration, Congress and all interested parties must work together to resolve this matter. We intend to consult closely with Congress on consideration of the types of meaningful changes to our international tax rules that will be needed to address the decisions. We applaud you and Chairman Thomas for

holding those hearings on this matter at this critical time.

Chairman MCCRERY. Thank you. Mr. Neal.

Mr. NEAL. Thank you very much, Mr. Chairman.

Ms. Angus, at a recent mark-up of this Committee where your

colleague from Treasury, Pam Olson was in the witness chair, the

Chairman of the full Committee stated his desire to have this Subcommittee investigate the expatriate issue and to report back fairly

quickly on why and how these companies are leaving the United

States, and why they are avoiding U.S. income taxes.

Your colleague, Ms. Olson, said at that time that the Treasury

study would be a preliminary report with recommendations coming

later. Is that still the expectation of your report on the corporate

expatriate problem?

Ms. ANGUS. Yes. We intend to release our preliminary views by

the end of April. This is a matter of priority for the Treasury Department. We believe that a detailed technical study can help to inform the debate over the appropriate response to these developments and will ensure that the government can act promptly and

effectively.

Mr. NEAL. Thank you. When we last met, it was, I believe, the

day before Treasury announced the study of the corporate expatriate issue. Since then, my staff has performed some research on

a handful of these expatriate companies. And it has come to my attention that these expatriate companies enjoy in excess of $2 billion

a year in Federal government contract money.

In fact, one of these expatriates has a $40 million contract to

help the IRS collect more tax revenue. Now, I find that more than

a little ironic that we are awarding Federal tax revenues to companies who have decided they are exempt from paying it. I wonder

if you can comment on whether the Treasury Department has considered a review of these particular contracts or the policy of

awarding these Treasury contracts to expatriate companies?

27

Ms. ANGUS. Congressman, that is certainly something that I can

look into and we can provide you a response. It is not something

that is within my area of expertise. From my perspective, the work

that we are doing within my group involves looking at these transactions from a technical perspective to understand the implications

for our tax law, the implications for our economy, and to work to

develop an appropriate response.

Mr. NEAL. I tried to be very precise in my questioning so as to

not appear irresponsible. But with April 15th looming, and September 11th just behind us, it seems to me that there is an ideal

opportunity to examine this question. Mr. McCrery has said he is

going to hold hearings on it. The Chairman of the full Committee

has indicated he is going to hold hearings on it. But this is a large

issue that looms for the American people. The President, in the

end, is going to get most of the defense buildup that he desires,

rightly so. It is also, I think, understandable that the American

people would ask: Who is going to help to pay for all of this?

So we have companies that are winning large contracts, and at

the same time setting up foreign addresses so that they don’t have

to pay corporate income tax.

Ms. ANGUS. As I indicated earlier, we are studying this issue. We

expect to have preliminary views by the end of this month. We do

believe that we need to determine whether there are any inadequacies in our tax law that companies can take advantage of or exploit

through those transactions. If those inadequacies exist, we need to

know about that. And we certainly intend to work with the IRS

and Congress to address those.

At the same time, we also believe we need to look at whether

there are aspects of our international tax rules that are driving

companies to feel they need to consider these transactions for competitiveness reasons. If that is the case, we also need to understand

that and consider our approach to that issue as well.

Mr. NEAL. Thank you.

Chairman MCCRERY. Mr. Lewis.

Mr. LEWIS. Thanks, Mr. Chairman. Ms. Angus, last week an EU

spokesman stated what we urgently need is a road map of what

kind of measures the American Government plans to take to comply with the WTO ruling.

What does the—what kind of road map can you give us today

about what the Administration plans to do in moving forward on

this?

Ms. ANGUS. Well, as Ambassador Zoellick has said, Commissioner Lamy wants to see us making progress toward resolving this

matter. It is critically important that the administration and the

Congress work together with all interested parties to address this

matter now.

This is an urgent matter requiring immediate attention. These

hearings represent a very important first step. We must work together toward consideration of meaningful changes to our international tax rules. We need to do so as soon as possible in order

to demonstrate real progress toward meeting our WTO obligations.

And as we do that, we believe it is important that we keep in

mind the objective of ensuring that we don’t adversely affect the

competitiveness of American-based businesses.

28

Mr. LEWIS. Okay. Thank you.

Chairman MCCRERY. Thank you very much, Ms. Angus. And we

look forward to working with you and others in the Administration

as we wrestle with this problem.

Ms. ANGUS. Thank you.

Chairman MCCRERY. And now the third panel. LaBrenda Garrett-Nelson, Terrence Chorvat, and Michael McIntyre. If you would

come to the front. Welcome. Our first witness on the third panel

is LaBrenda Garrett-Nelson. She is a Partner with Washington

Council, Ernst & Young.

And then Terrence Chorvat, Assistant Professor of Law at

George Mason University. And Mr. Michael McIntyre, Professor of

Law at Wayne State University, School of Law.

Ms. Garrett-Nelson, we will begin with you. You may proceed.

Please summarize your testimony for us within about 5 minutes.

STATEMENT OF LABRENDA GARRETT–NELSON, PARTNER,

WASHINGTON COUNCIL ERNST & YOUNG

Ms. GARRETT-NELSON. Thank you, Mr. Chairman and Members

of the Committee.

I am LaBrenda Garrett-Nelson. And I am appearing today on my

own behalf and not as a representative of any organization. The

testimony that I offer relates to the legislative drafting implications

of the WTO Appellate panel’s report on ETI. I do not offer any specific legislative proposals. Rather, my testimony highlights three

aspects of the Appellate body report that will become relevant if

the decision is made to pursue a legislative solution to the FSC/ETI

dispute.

First, that the legal analysis in the Appellate body report would

prevent the United States from coming into compliance simply by

making cosmetic changes to ETI.

Second, but significantly, for the first time, the Appellate body

has provided guidance regarding the extent to which an export tax

subsidy could be provided for foreign source income.

And last, but importantly, it should be kept in mind that there

is nothing in the Appellate body report that would prevent the

United States from amending its tax laws in a manner that could

provide a benefit to the same general class of taxpayers that utilize

the ETI regime. And that is relevant to the decision whether to

pursue a legislative solution.

The Congress clearly retains the ability to develop legislation

that would preserve the competitiveness of American companies.

Turning first to the basis for my conclusion that it will not be

possible to simply make adjustments to ETI. Two of the principal

legal issues before the Appellate body were, is there a subsidy? If

so, is the subsidy export contingent? The Appellate body broke new

ground, and in doing so, invalidated legal conclusions that had

been formed as the basis of drafting decisions in developing the

ETI statutory provisions.

On the threshold issue of whether a subsidy exists. When the Appellate body reviewed the FSC case, it applied a but-for test. It

looked to see whether the FSC was an exception to a general rule

with the result that more tax would been paid but-for the FSC.

29

In light of that but-for test, the ETI regime was drafted as a general rule with taxation cast as the exception. But when the Appellate body reviewed ETI, it decided that the but-for test should be

limited to cases where the measure at issue is an exception and instead applied a new test, a test that compared the treatment of income under the ETI regime to comparable foreign source income.

And particularly because the ETI regime is elective, on that basis

the Appellate body held that the ETI regime confers a subsidy.

On the question of export contingency. Before the Appellate body

report on the ETI regime, it was unclear whether export contingencies could be cured by expanding the universe of beneficiaries.

And in that regard, the ETI Act was drafted to apply to nonexport

foreign sales of certain property produced abroad.

So the ETI regime is legally not contingent on exportation because the operative rule could apply to nonexport sales. Well, the

Appellate body also decided against the United States on this issue

on the grounds that for property produced within the U.S. exportation was required.

So, apparently to avoid a finding of export contingency, it would

be necessary to apply a single operative rule without regard to

whether property is produced within or without the United States.

Now, there was the one instance in which the Appellate body did

agree with an interpretation offered by the United States. That

was on the ruling that there is an exception to the prohibition on

export subsidies for a measure to avoid double taxation of foreign

source income. And that is the exception based on what you may

hear referred to as Footnote 59 in the relevant trade agreement.

I would point out with respect to Footnote 59, that it remains to

be seen to what extent Footnote 59 would allow anything that looks

like a replication of ETI. I say that for two reasons: First, because

of the Appellate body’s definition of foreign source income that

could be treated under such an exception, and also because of the

related requirement that with respect to export sales, arms-length

pricing methods would be required to allocate income between foreign and domestic sources.

So in addition to the drafting possibilities presented by Footnote

59, I would remind the Committee again, that nothing in either the

Appellate body report or the applicable trade agreements would

prevent the United States from considering options for amending

general tax rules that affect the competitiveness of American exporters.

It is clear, however, that either of these possible drafting approaches would take time to implement and develop. This ends my

prepared statement. I would be happy to respond to questions you

may have.

[The prepared statement of Ms. Garrett-Nelson follows:]

Statement of LaBrenda Garrett-Nelson, Partner, Washington Council Ernst

& Young

My name is LaBrenda Garrett-Nelson and I am a partner in Washington Council

Ernst & Young, a division of the National Tax Practice of Ernst & Young. I am also

a consultant to the National Foreign Trade Council’s FSC–ETI Coalition; however,

I am testifying today on my own behalf and not as a representative of any organization.

30

1The European Community’s challenge of the 1971 DISC legislation and the United States’ counter-claims based on the tax exemptions for foreign-source income provided by Belgium,

France, and the Netherlands were brought under GATT 1947. 2 Because the Appellate Body’s treatment of the three, principal issues under the SCM Agreement also determined the outcome under the Agreement on Agriculture, the following discussion

focuses on the drafting implications of the SCM Agreement. 3See United States—Tax Treatment for ‘‘Foreign Sales Corporations’’ (‘‘US—FSC’’), WT/DS108/

AB/R, adopted 20 March 2000 (the ‘‘FSC Case’’).

Introduction

The January 14, 2002, WTO Appellate Body Report in United States—Tax Treatment for ‘‘Foreign Sales Corporations’’—Recourse to Article 21.5 of the DSU by the

European Communities (the ‘‘AB Report’’) upheld the decision of the WTO panel

that the FSC Replacement and Extraterritorial Income Exclusion (‘‘ETI’’) Act confers prohibited export subsidies in violation of the international trade obligations of

the United States. Consistent with the focus of today’s hearing, my statement is

based on my analysis of the legislative drafting implications of the AB Report. My

statement does not presuppose that a legislative response is the only response to

the FSC–ETI dispute, nor does it offer any specific legislative proposals. Rather, my

testimony highlights three aspects of the AB Report that will become relevant if the

decision is made to pursue a legislative solution to the FSC–ETI dispute (either

alone or in combination with trade initiatives). These three aspects are as follows:

(1) By providing definitive interpretations of the substantive provisions that

impose the prohibition on export subsidies, the AB Report precludes a drafting

approach that merely ‘‘tinkers’’ with the ETI regime;

(2) Significantly, however, the AB Report also allows for the consideration of

an alternative legislative response that targets exports in the context of a measure to avoid double taxation of foreign-source income; and

(3) Nothing in the AB Report would prevent the United States from amending

rules of general application in a manner that could benefit exporters, among

other taxpayers.

Discussion

The FSC–ETI case—brought under the 1995 World Trade Agreement—is the latest chapter in a long-running dispute between the United States and the European

Commission over the legality of export tax incentives. This, however, was a case of

first impression, as there were no WTO precedents involving export subsidies delivered through an income tax system.1 As in the original FSC dispute, three legal

issues were presented under the Agreement on Subsidies and Countervailing Measures (the ‘‘SCM Agreement’’) and the Agreement on Agriculture: 2 (1) whether the

ETI Act provides a subsidy; (2) whether the subsidy confers a benefit; and (3)

whether the subsidy is contingent on export performance.

Article 1.1(a)(1)(ii) of the SCM Agreement provides that a ‘‘subsidy’’ exists if ‘‘government revenue that is otherwise due is forgone or not collected.’’ In turn, Article

3.1(a) prohibits ‘‘subsidies contingent in law or in fact, whether solely or as one of

several conditions, upon export performance, including those illustrated in Annex I’’

(the Illustrative List of Export Subsidies that appears at the end of the SCM Agreement). Paragraph (e) of Annex I lists as an export subsidy ‘‘the full or partial exemption remission, or deferral specifically related to exports, of direct taxes . . .

paid or payable by industrial or commercial enterprises.’’ Importantly, however, the

fifth sentence of ‘‘Footnote 59’’ to Paragraph (e) provides that ‘‘Paragraph (e) is not

intended to limit a Member from taking measures to avoid the double taxation of

foreign-source income earned by its enterprises or the enterprises of another Member.

Additionally, the AB Report addressed the issue whether the ETI Act is inconsistent with the General Agreement on Tariffs and Trade 1994 (‘‘GATT 1994’’) by

reason of the limitation on the use of foreign articles and labor. Note that the Appellate Body upheld the adverse ‘‘findings,’’ as opposed to the rationale, of the WTO

panel that considered the validity of the ETI Act. Thus, it is the AB Report that

provides dispositive guidance on the drafting parameters of any replacement legislation.

While the basic legal issues addressed in the AB Report were identical to those

presented by the original FSC dispute,3 the Appellate Body broke new ground by

fleshing out the analytical framework that was used to draft the ETI Act. In clarifying the application of the applicable trade agreements, the AB Report invalidated

legal conclusions that supported drafting decisions reflected in various provisions of

31

4 Appellate Body Report. WT/DS70/AB/RW, adopted August 4, 2000, ¶ 90 (hereafter, the ‘‘FSC

Case’’). 5The AB Report at ¶ 86. 6 AB Report at ¶ 89. 7 Note that, in the original FSC case, the Appellate Body did express a reservation about applying the ‘‘but for’’ test in all cases (although it acknowledged that the test worked in that

case); and none of the parties raised this issue. (FSC Case at page 31) 8 United States’ appellant’s submission, ¶ 71. 9 AB Report at ¶ 91. 10 Id. 11 AB Report at ¶ 106. 12 AB Report at ¶ 104.

the ETI Act. Moreover, these new pronouncements ‘‘fixed’’ the parameters of any

legislative response that the United States might consider.

I. The analysis underlying the AB Report precludes a drafting apporach

that merely ‘‘tinkers’’ with the ETI regime.

The AB Report altered the legal landscape by clarifying the extent to which a

Member state can refrain from taxing foreign-source income without creating a subsidy, and providing substantive interpretations of provisions in the SCM Agreement.

A. First, in the context of defining a ‘‘subsidy,’’ the Appellate Body rejected

the notion that there might be a general category of foreign-source income that WTO Member states are free not to tax.

In the original FSC dispute, the Appellate Body indicated that ‘‘in principle, a

Member is free not to tax any particular category of income it wishes, even if this

results in the grant of a ‘‘subsidy’’ under Article 1.1 of the SCM Agreement, provided that the Member respects its WTO obligations with respect to the subsidy.’’ 4

In the AB Report, however, this statement was ‘‘explained away’’ as follows: ‘‘Article

1.1 of the SCM Agreement does not prohibit a Member from foregoing revenue that

is otherwise due under its rules of taxation, even if this also confers a benefit under

Article 1.1(b) of the SCM Agreement. However, if a Member’s rules of taxation constitute or provide a subsidy under Article 1.1, and this subsidy is specific under Article 2, the Member must abide by the obligations set out in the SCM Agreement

with respect to that subsidy, including the obligation not to ‘grant [] or maintain’

any subsidy that is prohibited under Article 3 of the Agreement.’’ 5

B. Additionally, the AB Report includes adverse interpretations of relevant

provisions in the SCM Agreement

1. Regarding the threshold issue of whether a subsidy exists, the Appellate Body

limited use of the ‘‘but for’’ test to the facts of the FSC case.

As in the original FSC dispute, the Appellate Body interpreted the phrase ‘‘otherwise due’’ (in Article 1.1(a)(1)(ii) of the SCM Agreement) as implying a comparison

with a ‘‘defined, normative benchmark.6 ’’ In the FSC proceeding, the Appellate Body

approved the use of a ‘‘but for’’ test formulated by the WTO panel.7 Under the ‘‘but

for’’ test, whether revenue forgone is ‘‘otherwise due’’ was determined by examining

the tax liability that would exist under a Member’s tax regime in the absence of

the measures at issue. In light of this ‘‘but for’’ test, the ETI Act was drafted as

a general rule of U.S. taxation whereby the income excluded from taxation was outside U.S. taxing jurisdiction.8

In the AB Report, however, the Appellate Body indicated that the ‘‘but for’’ test

is limited to situations where the measure at issue is an ‘‘exception’’ to a general

rule of taxation, adding that ‘‘Article 1.1(a)(1)(ii) does not always require panels to

identify, with respect to any particular income, the ‘general’ rule of taxation prevailing in a Member.’’ 9 Instead, the Appellate Body concluded, ‘‘panels should seek

to compare the fiscal treatment of legitimately comparable income to determine

whether the contested measure involves the foregoing of revenue which is ‘otherwise

due,’ in relation to the income in question.’’ 10 Under this standard, the Appellate

Body compared the treatment of income excluded under the ETI Act with the taxation of other foreign-source income, and upheld the finding that the United States

through the ETI regime ‘‘foregoes revenue that is otherwise due’’ and thus grants

a subsidy within the meaning of under Article 1.1(a)(1)(ii) of the SCM Agreement.11

Also, the Appellate Body opined that a taxpayer’s ability to ‘‘elect’’ application of the

ETI regime ‘‘confirms that the United States will forgo revenue . . . that would be

‘otherwise due,’ ’’ 12 (assuming that a taxpayer will elect the rules of taxation that

result in the payment of the lowest amount of tax).

32

13 AB Report at ¶ 114–115. 14 AB Report at ¶ 120. 15Trade lawyers caution, however, that export contingency could be found in any event if

beneficiaries under a replacement regime are ‘‘predominantly exporters.’’ 16 AB Report at ¶ 186. 17 AB Report at ¶ 140. 18 AB Report at ¶ 142.

Thus, under the AB Report’s interpretation of the phrase ‘‘otherwise due,’’ any

elective, replacement regime that departs from an otherwise applicable general rule

would be viewed as granting a subsidy.

2. The AB Report also makes clear that ‘‘export contingency’’ can be found if exporting is required of any beneficiary.

Although ETI involves a general rule that excludes a category of income that is

broader than exports, it clearly defines U.S. exports as covered transactions. In this

regard, prior to the AB Report, it was unclear whether expanding the universe of

taxpayers eligible for a subsidy could cure ‘‘export contingency.’’ The ETI Act was drafted to apply to income earned from certain non-export foreign sales of property produced outside the United States. Thus, the ETI regime is

not legally contingent on exportation because exportation is not mandatory. Notwithstanding the existence of a single operative rule, the Appellate Body bifurcated

the provisions of the ETI Act, on the grounds that the ‘‘conditions for the grant of

subsidy with respect to property produced outside the United States are distinct

from those governing the grant of subsidy in respect of property produced within

the United States.’’ 13 Viewing the two situations separately, the Appellate Body

upheld the finding—but only with respect to property ‘‘manufactured, produced,

grown, or extracted’’ within the United States—that the ETI regime grants subsidies contingent in law upon export performance within the meaning of Article

3.1(a) of the SCM Agreement (without opining on the alleged export contingency of

the subsidy in relation to property ‘‘manufactured, produced, grown, or extracted’’

outside the United States).14

Apparently, to avoid a finding of export contingency, it would be necessary to devise an operative rule that applies a single set of conditions to property produced

within and without the United States.15

II. Significantly, however, the Appellate Body ruled that Footnote 59 provides an exception to the prohibition on export subsidies for a measure

to avoid double taxation of foreign-source income.

The Appellate Body ruled that Footnote 59 permits a WTO Member state to adopt

a measure taken to avoid the double taxation of foreign-source income. In the

present case, however, ‘‘even though parts of the ETI measure may be regarded as

granting a tax exemption for foreign-source income, . . . the United States [did not

meet] its burden of proving that the ETI measure, viewed as a whole, falls within

the justification available under the fifth sentence of footnote 59 of the SCM Agreement.’’ 16 Nevertheless, the AB Report is instructive because it provides guidance regarding the extent to which foreign-source income from exports could be exempted

in a WTO-compliant manner.

A Footnote 59 approach could be used in the context of legislation that explicitly

confers an (otherwise prohibited) export subsidy, or in combination with amendments to rules of general application. In either case, however, the ability to replicate

the benefits of the ETI regime would be circumscribed by the AB Report’s definition

of ‘‘foreign-source income’’ and the related requirement that arm’s length pricing be

used to allocate income between foreign and domestic sources. Moreover, a Footnote

59 approach would not permit the Unites States to grant an exemption to small exporters without demonstrating that the income is foreign-source, or exempt income

from services that may be performed within the United States (as discussed below).

A. For purposes of Footnote 59, the AB Report requires that foreign-source

income be defined by reference to ‘‘widely recognized principles of taxation.’’

The term foreign-source income, as used in footnote 59, ‘‘cannot be interpreted by

reference solely to the rules of the Member taking the measure to avoid double taxation of foreign-source income.’’ 17 Rather, the Appellate Body deemed ‘‘it appropriate . . . to derive assistance from . . . widely recognized principles’’ from bilateral tax treaties and multilaterally developed model tax conventions dealing with

double taxation—noting that the majority of bilateral treaties adopt the principles

of the OECD and U.N. Model tax treaties.18

33

19Footnote 122 in the AB Report. 20 AB Report at ¶ 141 and 143. 21 AB Report at ¶ 137. 22 AB Report at ¶ 138. 23 AB Report at ¶ 146. 24 AB Report at ¶ 148. 25 AB Report at ¶ 154. 26See Footnote 133. 27 AB Report at ¶ 154. 28 AB Report at ¶ 176. 29 Regarding the ETI measure, the AB Report notes that, ‘‘the foreign economic process requirement establishes a link between some part of the qualifying transactions covered by the

ETI measure and a ‘foreign’ state.’ This does not necessarily mean that all of the income generated by such a transaction will be ‘foreign-source income.’ At ¶ 153–4. 30 AB Report at ¶ 183.

A taxpayer need not be required to maintain a permanent establishment in a foreign country to establish a sufficient link,19 although the Appellate Body did identify one common element that would be required of any definition of foreign-source

income: ‘‘Although there is no universally agreed meaning for the term ‘‘foreign-source in- come’’ in international tax law, . . . there seems to us to be a widely accepted common element to these rules. . . . The common element is that a ‘foreign’ State will

tax a non-resident on income which is generated by activities of the non-resident

that have some link with that State.’’ 20

There are, however, other statements of the Appellate Body’s views that suggest

other, possible meanings, including the statements that ‘‘the word ‘‘source’’, in the

context of the fifth sentence of footnote 59, has a meaning akin to ‘‘origin’’ and refers

to the place where the income is earned,’’ 21 and ‘‘the term ‘foreign-source income’ in footnote 59 refers to income which is susceptible of being taxed in two States.’’ 22

B. Nevertheless, Footnote 59 would allow a degree of flexibility in targeting the income to be exempted.

There is no need to show that income is actually taxed in another jurisdiction.

The Appellate Body recognized that ‘‘the avoidance of double taxation is not an

exact science. Indeed, the income exempted from taxation in the State of residence

of the taxpayer might not be subject to a corresponding, or any, tax in a ‘foreign’

State.’’ 23 The AB Report also makes clear that a partial exemption would pass muster: ‘‘[W]e do not believe that measures falling under footnote 59 must grant relief

from all double tax burdens. Rather, Members retain the sovereign authority to determine for themselves whether, and to what extent, they will grant such relief.’’ 24

C. On the other hand, an allocation between domestic and foreign sources

would be required for income from export transactions.

‘‘[U]nder footnote 59 . . . the ‘foreign-source income’ arising in such a transaction

is only that portion of the total income which is generated by and properly attributable to activities that do occur in a ‘foreign state.’ ’’ 25 In the case of a sale of

goods, the Appellate Body suggested that arm’s length pricing rules would be an acceptable basis for distinguishing between domestic and foreign-source income. The

manufacturer would be treated as if it had sold the goods to an independent distributor at arm’s length prices, who in turn resold the goods. This would ‘‘dissect’’

the transaction on the basis of the place where the different activities occurred.26

In the case of ‘‘a sale or lease transaction,’’ however, the AB Report indicates that

income may be attributable to activities such as research and development, manufacturing, advertising, selling, transport, and administration,’’ 27 suggesting the possible need to allocate beyond manufacturing versus sale and distribution income.

In allocating income to a foreign source, exportation would not be a sufficient

basis: ‘‘[S]ales income cannot be regarded as ‘foreign-source income’, under footnote

59, for the sole reason that the property, subject-matter of the sale, is exported to

another State, for use there. The mere fact that the buyer uses property outside the

United States does not mean that the seller undertook activities in a ‘foreign’ State

generating income.’’ 28

Similarly, the ‘‘foreign economic process requirements’’ utilized under the ETI regime would not suffice.29 In the view of the Appellate Body, the ETI regime falls

short of adequately identifying foreign-source income, to the extent that the ETI allocation rules apply fixed percentages to amounts that may include domestic-source

income, with the result that taxpayers can obtain a tax exemption for income that

is domestic-source income.30 The only aspect of ETI that passes muster is the general rule for Foreign Sale and Leasing Income (‘‘FSLI’’). For independent distribuVerDate 11-MAY-2000 11:02 Jun 18, 2002 Jkt 079486 PO 00000 Frm 00037 Fmt 6633 Sfmt 6621 E:\HR\OC\C486.XXX pfrm12 PsN: C486
34

31 All references to ‘‘sections’’ are to the Internal Revenue Code of 1986, as amended. 32 AB Report at ¶ 170. 33 AB Report at ¶ 171. 34 AB Report at ¶ 177. Thus, section 942(c)(1) was viewed as defective because it dispenses entirely with the foreign economic process requirement, treating ‘‘a portion of the taxpayers’ income—as exempt foreign-source income even though it—need not be established—that the taxpayer undertook any activities outside the United States.’’ AB Report at ¶ 175. 35 AB Report at ¶ 179–80. 36 AB Report at ¶ 222. 37 AB Report at ¶ 221. 38 AB Report at ¶ 231.

tors that sell to unrelated parties using arm’s length pricing, FSLI is limited to the ‘‘foreign trade income properly allocable to activities’’ that are performed . . . outside the United States in satisfaction of the foreign economic process requirement

described in sections 942(b)(2)(A)(i) and 942(b)(3).31 With respect to this category of

income, the Appellate Body opined as follows: ‘‘By requiring such a process of separating domestic- and foreign-source income,

on the basis of the locus of the activities generating the income, Section 941(a)(1)(A)

IRC includes in the calculation of FSLI only income which may properly be regarded

as ‘‘foreign-source income’’ under footnote 59 of the SCM Agreement. In other words,

Section 941(c)(1)(A) IRC separates out, or unbundles, the domestic- and foreignsource income that are combined in foreign trade income.’’ 32

The Appellate Body did not, however, approve of the treatment of FSLI that is

lease or rental income, as a ‘‘proper’’ allocation is not required of that type of

FSLI.33

D. Footnote 59 would not, however, permit any special provisions for small

exporters or services performed within the United States.

The Appellate Body made clear that Footnote 59 would not allow an exemption, such as the $5 million exception for small exporters in section 942(c)(1), unless the

income is demonstrated to be foreign-source income under the principles outlined

above.34 Similarly, where the ETI Act does not state expressly that subsidiary and

related service activities need to be performed outside the United States, the AB Report indicates that this would be a requirement of a regime based on Footnote 59.35

E. Other issues that were decided against the United States.

However flexible Footnote 59 proves to be, it is not at all clear that the United

States would be able to address every identified issue through legislative amendments.

1. The Appellate Body upheld the finding ‘‘that, by virtue of the fair market value

rule, the measure accords less favourable treatment within the meaning of Article III:4 of the GATT 1994 to imported products than to like products of United

States origin.’’ 36

The GATT 1994 was not at issue in the original FSC dispute; rather, a claim was

made that the prior-law limitation on the use of foreign articles rendered the ‘‘subsidy’’ contingent on the use of U.S. goods over imported goods, contrary to Article

3.1(b) of the SCM Agreement. A claim that the foreign articles/labor limitation violates Article 3.1(b) of the SCM Agreement was also made with respect to the ETI

Act, as a conditional appeal, but the Appellate Body declined to consider any conditional appeals (leaving this issue open).

The Appellate Body’s analysis of the ‘‘national treatment’’ principle under Article

III:4 of GATT 1994 indicates that any similar provision might fail if it provides an

impetus for manufacturers to use domestic products, rather than like imported ones:

‘‘[T]he . . . conclusion is not nullified by the fact that the fair market value rule

will not give rise to less favourable treatment for like imported products in each and

every case.’’ 37 Note also that there is no indication that Footnote 59 provides an

exception to this trade agreement.

2. The Appellate Body flatly rejected the inclusion of transition rules in any replacement legislation.

In the view of the Appellate Body, the inclusion of transition rules covering FSC

users means that the United States has not fully withdrawn the FSC subsidies

found to be prohibited export subsidies.38 The AB Report includes the statements

that ‘‘a Member’s obligation under . . . the SCM Agreementto withdraw prohibited

subsidies ‘without delay’ is unaffected by contractual obligations that the Member

itself may have assumed under municipal law. Likewise, a Member’s obligation to

withdraw prohibited export subsidies, . . . cannot be affected by contractual obligaVerDate 11-MAY-2000 11:02 Jun 18, 2002 Jkt 079486 PO 00000 Frm 00038 Fmt 6633 Sfmt 6621 E:\HR\OC\C486.XXX pfrm12 PsN: C486
35

39 AP Report at ¶ 230. 40 AB Report at ¶ 139.

tions which private parties may have assumed inter se in reliance on laws conferring prohibited export subsidies. Accordingly, we see no legal basis for extending the

time-period for the United States to withdraw fully the prohibited FSC subsidies.’’ 39

III. Nothing in the applicable trade agreements would prevent the United

States from responding to the AB Report by replacing ETI with rules

of general application.

There is nothing in the AB Report that would preclude a direct response to the

Appellate Body’s findings. As noted by the Appellate Body, ‘‘each Member is free to

determine the rules it will use to identify the source of income and the fiscal consequences—to tax or not to tax the income—flowing from the identification of

source.’’ 40 By way of example, and quite apart from the Footnote 59 exception for

foreign-source income, the United States remains free to amend any of its general

rules for the taxation of income earned abroad.

Similarly, consideration could be given to the development of legislation that

might benefit classes of taxpayers that currently utilize the ETI regime (e.g., small

exporters) without requiring exportation. Alternatively, some have argued that it is

possible to model a replacement regime on the footnote in the SCM Agreement on

which the EU relies in concluding that rebates of indirect taxes (such as Value

Added Taxes) do not violate WTO rules—which footnote is based on the rationale

that indirect taxes are passed on to consumers, but direct taxes (such as income

taxes) are not. It seems clear, however, that any of these possible, legislative responses would take time to develop and implement.

Conclusion

To summarize the principal drafting implications of the AB Report, it will not be

possible to draft a single replacement regime that complies with the trade obligations of the United States and replicates the tax benefits of the ETI statute. It is

now clear, however, that a WTO Member can provide an export subsidy in the form

of a tax exemption if it is a measure to avoid double taxation of foreign-source income. Moreover, there is no prohibition on a Member State’s ability to liberalize

rules of general application that have the incidental effect of benefiting exporters.

Thus, relevant to the decision whether to pursue a legislative resolution of the FSC–

ETI dispute, the Congress retains the ability to develop legislation that preserves

the competitiveness of American companies.

STATEMENT OF TERRENCE R. CHORVAT, ASSISTANT PROChairman MCCRERY. Thank you. Mr. Chorvat.

f FESSOR OF LAW, GEORGE MASON UNIVERSITY SCHOOL OF

LAW, FAIRFAX, VIRGINIA

Mr. CHORVAT. First of all, I would like to thank Chairman

McCrery and the Members of the Subcommittee for inviting me

here to talk about the extraterritorial income regime and possible

modifications to it.

My name is Terrence Chorvat, and I am Assistant Professor of

Law at George Mason University. And for the record, I am testifying today on my own behalf and not as a representative of any

organization.

As all prior witnesses have testified, the WTO panel has held

that the FSC and the ETI regime violate the GATT Treaties. If the

ETI and FSC regimes are not permitted under the GATT Treaties,

what types of rules that promote exports are permitted? As described below, there are quite a number of ways the country can

promote exports and not, at least as of yet, be held to violate free

trade agreements.

36

As a number of commentators have pointed out, there have not

been many decisions by the WTO with respect to income tax rules.

And, therefore, we do not know how this jurisprudence will develop. Consequently any conclusions we express today are dependent upon how this body of law will develop in the future. In the

last 10 to 15 years the European countries have been reducing

their corporate taxes and their place relying more heavily on consumption taxes, like the value added taxes or VATs.

Under European VATs, when the product leaves the country or

taxing jurisdiction then the VAT is refunded. This is because such

taxes are intended to tax consumption that occurs within the country. If such consumption does not occur in the jurisdiction, it is not

taxed there.

One can argue that this has the effect of encouraging exports, because exported products are not subject to the VAT. Importantly,

because these taxes are indirect taxes, such export adjustment are

permitted under the GATT Treaties. Such indirect taxes are viewed

as being imposed on the ultimate consumer rather than on the producer, therefore, they are not viewed as export subsidies.

In addition, it appears that having an income tax system which

exempts all foreign source income is also permissible. Such a system would impose lower taxes on exports than on domestically sold

goods because income earned abroad would not be subject to tax.

Many European countries have adopted territorial tax systems.

One of the key arguments for a regime like the ETI is that it

would merely level the playing field for U.S. corporations selling

abroad. Because European producers are able to receive tax deductions on some of the products they export, it seems U.S. producers

should also receive tax concessions on exports to prevent distortions in the market.

Another set of rules which seems immune to challenge are the

source rules found in section 863(b) of the Internal Revenue Code.

These rules define the source of income for the sale of property

which is manufactured in the United States and sold abroad. They

are often said to be export subsidies, because they allow U.S. taxpayers to increase their use of foreign tax credits, which can decrease the tax paid to the United States.

However, because those rules are fundamental source rules

which apply both to imports and exports, they do not constitute a

special regime. These are the only source rules that apply to these

products manufactured in one country and sold in another. Hence,

these rules should not fun afoul of the GATT Treaties as interpreted by the WTO.

The fundamental purpose of the deferral regimes found in the

Tax Code, such as subpart F, is to eliminate a taxpayer’s ability

to avoid U.S. tax by shifting income to low-tax jurisdictions.

Generally, the United States allows income earned by foreign

subsidiaries to be deferred until the income is repatriated to the

United States. The exception to deferral are primarily related to

passive income and other types of income that are easily manipulated. Active business income of a controlled foreign corporation or

CFC is generally only subject to U.S. tax where there is an insufficient economic connection with the jurisdiction in which the CFC

is organized.

37

On the other hand, the FSC and the ETI regimes were intended

to exempt from U.S. taxation income from good manufactured in,

or extracted from, the United States and sold abroad. Under the

FSC regime, this required an exception to the subpart F rules.

These two important portions of the U.S. system are in conflict.

Conflicts like this allow the Europeans to argue that the ETI and

the FSC provisions are exceptions to the general patterns of taxation.

While then, what are our alternatives? There are four basic ones.

First, repeal the ETI provisions and use the revenue to reduce

other taxes. While this is the simplest response, it does not address

the concerns that created the Domestic International Sales Corporation (DISC), the FSC, and the ETI regimes in the first place.

The second would be to adopt a territorial system. This would

seem to be allowed under the GATT Treaties. However, it seems

that as such a small portion of it, like the FSC or the ETI regimes

changing our entire system of taxing foreign source income, just

based on this seems a little bit extreme, although there might be

good reasons for doing that.

The third is to adopt a system that involves significant reliance

on indirect taxes such as VATs. That has also been discussed. But

again moving to that system merely because of the ETI holding

again seems a bit extreme, although there may be good reasons for

doing that.

And the fourth is to repeal or to significantly alter subpart F.

There are a number of provisions which one could either change

within subpart F or get rid of entirely, that would—probably be

viewed as not an export subsidy, because they are, instead of adding something additional, they are paring away from what we already have.

However, again, we are not confident as to how the WTO panel

would view that because there has not been much jurisprudence in

that area.

None of these alternatives are simple replacements for the ETI

regime. They all involve a change in rules as they apply to all taxpayers and not simply U.S. manufacturers.

And I would be happy to answer any questions on this.

[The prepared statement of Mr. Chorvat follows:]

Statement of Terrence R. Chorvat, Assistant Professor of Law, George

Mason University School of Law, Fairfax, Virginia

I would like to thank Chairman McCrery, Ranking Member McNulty, and the

members of the Subcommittee for inviting me here to talk about the Extraterritorial

Income Regime and the possible modifications to it.

I. Introduction

My name is Terrence R. Chorvat, and I am an assistant professor of law at

George Mason University. For the record, I am testifying today on my own behalf

and not as a representative of any organization.

II. Background of the FSC and ETI Cases

The dispute over whether the United States gives impermissible export subsidies

through the income tax code has been going on for thirty years. It began in 1972

with a challenge by what was then called the European Economic Community (EC)

to the Domestic International Sales Corporation (DISC) regime then in place. The

GATT Dispute Settlement Panel ruled that the DISC regime was a prohibited export subsidy. In 1984, after negotiations with various members of the EC, the

United States enacted the Foreign Sales Corporation (FSC) regime. This was

38

thought to overcome the problems with the DISC rules because it required significant foreign activity.

In 1995, the World Trade Organization (WTO) came into existence. In 1997, the

European Union (EU), the successor of the EC, requested WTO dispute settlement

consultations with respect to the FSC rules. In 1999, the WTO panel found that the

FSC was a prohibited export subsidy. On November 15, 2000, Congress enacted the

FSC Repeal and Extraterritorial Income Exclusion Act of 2000 which repealed the

FSC regime and put in its place the Extraterritorial Income Regime (ETI). The ETI

allowed for the exemption of income from products which had a higher level of foreign produced content than did the FSC. In addition, the number of persons eligible

for the new regime was greatly expanded. It was thought that these and other

changes would overcome the problems the WTO had with the FSC regime.

However, on August 20, 2002, WTO panel issued a report that held the ETI regime violated the GATT Code on Subsidies and Countervailing Measures (SCM).

The United States appealed this decision. On January 14, 2002, the WTO Dispute

Settlement Unit issued a report which found against the United States. On January

29, 2002 the WTO Dispute Settlement Body (DSB) adopted the two earlier reports.

There are no further avenues of appeal for the United States. Currently, the WTO

panel is determining the damages they will assess against the United States. The

damages will be somewhere between about a $1 billion to $4 billion in potential

trade sanctions against the United States by the EU. This does not include the

amounts that might have to be paid to Australia, Canada, Japan and India who had

all filed briefs against the ETI regime in this case, and who will be able to petition

the WTO for relief from damages that they arguably suffered from the ETI regime.

III. Analysis of the WTO Ruling and the Current U.S. Tax Rules

A. The Report Issued by the WTO

The report issued on January 14, 2002 was based an the interpretation of the

DSM that tax provisions must not ‘‘forego revenue’’ otherwise due and this ‘‘reduction in taxes must not be contingent. . . . upon export performance.’’ The report

held that because the exemption in section 114 of the Internal Revenue Code was

conditioned both upon the ‘‘use [of the products] outside of the United States’’ and

upon at least 50% of the value of the product being generated by economic processes

that occurred within the United States, the ETI provision was a prohibited export

subsidy. Furthermore, it held that the exception to the general rules that allows for

tax provisions that attempt to avoid double-taxation, did not apply and so nothing

prevented the ETI regime from being held a prohibited subsidy.

While many have criticized these decisions, both that their interpretation of the

term ‘‘subsidy’’ is incorrect and that the policy of allowing income tax decisions to

be determined by international organizations is troubling, the interpretation of the

treaty provisions adopted by the WTO is clearly a defensible reading of the GATT

treaties. There is little question that the ETI regime does reduce tax revenue (at

least on a short-term basis) and that this reduction is to some degree based upon

property being exported from the United States. Hence, the decision of the WTO in

this matter is far from arbitrary or capricious.

B. Permitted Export Favorable Rules

If the ETI and FSC regimes are not permitted under the GATT treaties, what

types of rules that promote exports are permitted? It cannot be the case that the

GATT treaties require countries to adopt rules which are exclusively neutral or discourage exports. As described below, there are quite a number of ways a country

can promote exports and not (at least as of yet) be held to violate free-trade agreements.

As a number of commentators have pointed out, there have not been many decisions by the WTO with respect to income tax rules. Therefore, we do not know how

this jurisprudence will develop. Consequently, the conclusions expressed below are

dependent upon how this body of law will develop in the future.

In the last ten to fifteen years, the European countries have been reducing their

corporate taxes and in their place relying more heavily on consumption taxes like

the value added taxes (VATs). Under European VATs, when the product leaves the

country or taxing jurisdiction, then the VAT is refunded. This is because such taxes

are intended to tax consumption that occurs within the country. If such consumption does not occur in the jurisdiction, it is not taxed there. One can argue that this

has the effect of encouraging exports because exported products are not subject to

the VAT. Importantly, because these taxes are indirect taxes such export adjustments are permitted under the GATT treaties. Such indirect taxes are viewed as

being imposed on the ultimate consumer, rather than on the producer. Therefore,

they are not viewed as export subsidies.

39

In addition, it appears that having an income tax system which exempts all foreign source income is also permissible. Such a system would impose lower taxes on

exports than on domestically sold goods because income earned abroad would not

be subject to tax. Many European countries have adopted territorial tax systems.

One of the key arguments for a regime like the ETI is that it would merely level

the playing field for U.S. corporations selling abroad. Because European producers

are able to receive tax reductions on some of the products they export, it seems U.S.

producers should also receive tax concessions on exports to prevent distortions in

the market.

Another set of rules which seems immune to challenge are the source rules found

in Section 863(b) of the Internal Revenue Code. These rules define the source of income for the sale of property which is manufactured in the United States and sold

abroad. They are often said to be export subsidies because they allow U.S. taxpayers

to increase their use of the foreign tax credits, which can decrease the tax paid to

the United States. However, because these rules are fundamental source rules

which apply both to imports and exports, they do not constitute a special regime.

These are the only source rules that apply to products manufactured in one country

and sold in another. Clearly, it is necessary to define what the source of the income

is in this situation, and the approach the rules take, which generally results in a

half of the income being treated as foreign source income and half U.S. source, is

easily defensible. Hence, these rules should not run afoul of the GATT treaties as

interpreted by the WTO.

C. Inherent Conflict between ETI and Subpart F

The fundamental purpose of the anti-deferral regimes in the U.S. tax code, such

as subpart F, is to eliminate a taxpayer’s ability to avoid U.S. tax by shifting income

to low tax-jurisdictions. Generally, the U.S. allows income earned by foreign subsidiaries to be deferred until the income is repatriated to the United States. The exceptions to deferral are primarily limited to passive income and other types of income

that are easily manipulated. Active business income of a controlled foreign corporation (CFC) is generally only subject to U.S. tax where there is an insufficient economic connection with the jurisdiction in which the CFC is organized.

On the other hand, the FSC and ETI regimes were intended to exempt from U.S.

taxation income from goods manufactured in or extracted from the United States

and sold abroad. Under the FSC regime, this required an exception to the subpart

F rules. These two important portions of the U.S. system (Subpart F and the ETI)

are in conflict. Conflicts like this allow the Europeans to argue that the ETI and

FSC provisions are exception to our general patterns of taxation.

IV. Alternatives to the ETI Regime

The structure of the U.S. tax system makes it more difficult to encourage exports

than other systems. By basing our tax system on income taxes which have, at least

in principle, a worldwide reach, it is difficult to draft provisions which do not run

afoul of the GATT treaties and which give our multinationals benefits comparable

to those enjoyed by European multinationals.

While, as discussed below, a number of possible solutions exist, there are some

approaches that clearly will not be approved by the WTO. Merely increasing the

amount of foreign content allowable for the exemption, or any other proposal which

only slightly alters the provisions in the ETI rules, is unlikely to be ruled upon favorably. Any attempt to replace the ETI regime will require a fundamental re-thinking of the approach taken. The replacement cannot be something which can be

thought of as a special exemption or a ‘‘loophole.’’ It needs to be something which

is an integral part of the system. It will have to apply to foreign corporations and

other non-U.S. taxpayers with the same force it applies to U.S. manufacturers.

The following are the basic alternatives:

A. Repeal of the ETI Provisions and Use the Revenue to Reduce Other Taxes. The

additional revenue raised by the repeal of the ETI could be used for other purposes

like repealing the Corporate AMT etc. While this is the simplest response, it does

not address the concerns which created the DISC, FSC and ETI regimes, in the first

place.

B. Adopt a Territorial System. This would seem to be allowed under the GATT

treaties. Furthermore, by defining U.S. source income as products that are sold

here, (i.e. retaining the 863(b) source rule or something like it), this would reduce

the tax on products which are exported and would likely not run afoul of the GATT

40

1Terrence R. Chorvat Ending the Taxation of Foreign Business Income 42 ARIZ. L. REV. 835

(2000)

provisions as interpreted by the WTO. I myself have argued for a territorial system

in the past.1

C. Adopt a System that Involves a Significant Reliance on Indirect Taxes (such

as VATs). If we adopted a VAT that only applied to consumption within the United

States, (sometimes referred to as a destination-based VAT) we would be able to exempt exported property from these taxes. Such a change would involve a large restructuring of the current federal tax system. While the response to the WTO ruling

on the ETI regime is very important, it seems that an issue which involves between

four or five billion dollars annually should not be the chief reason for making a

change as large as this.

D. Repeal or Significantly Alter Subpart F. If the Foreign Base Company Sales

and Services rules were repealed, much of the profit from products produced in the

United States and sold abroad could be deferred (which amounts to a tax cut if the

foreign subsidiary is incorporated in a low-tax jurisdiction). U.S. businesses could

sell the products produced in the United States through foreign subsidiaries and the

profits allocated to the subsidiaries would not be taxed in the United States until

they are repatriated to the United States. Currently, relatively little money is raised

from the Foreign Base Company Sales and Services provisions. As discussed above,

these provisions are fundamentally in conflict with the ETI provisions. Repealing

these rules is unlikely to run afoul of the GATT provisions because it would apply

to all transactions by U.S. subsidiaries whether the products had a direct U.S. connection or not. If this alternative is chosen, we could still retain the Foreign Personal Holding Company provisions which tax passive income earned by controlled

foreign corporations. This approach would not have quite the same effect as ETI because it would give tax benefits to U.S. multinationals to produce in any of the high

tax jurisdictions in which they operate.

E. Retain Subpart F, but Loosen the Manufacturing Exception to Subpart F. One

alternative would involve allowing foreign subsidiaries of U.S. corporations to manufacture in the United States without being treated as being engaged in a U.S. trade

or business and without being subject to the Foreign Base Company Sale and Services Income rules, which would in either case result in the income being taxable in

the United States in the year in which it is earned. Products produced in this fashion would not be subject to U.S. tax and would only be taxed in the jurisdictions

where the company is organized or a resident and where the products are ultimately

sold. In order to not violate the GATT provisions, such a regime would have to apply

to subsidiaries of corporations headquartered in other countries with the same force

as it applies to subsidiaries of U.S. corporations. In conjunction with this or in the

alternative we could allow foreign corporations to use contract manufacturers in the

United States and allow such activities to not be treated as a U.S. trade or business

and to be treated as manufacturing for purposes of the subpart F definitions. This

would imply overturning the ruling position of the I.R.S. announced in Revenue Ruling 97–48.

None of these alternatives have are simple replacement for the ETI regime. They

all involve a change to the rules as they apply to all taxpayers, not simply U.S.

manufacturers.

STATEMENT OF MICHAEL J. McINTYRE, PROFESSOR OF LAW,

Chairman MCCRERY. Thank you. Mr. McIntyre.

fWAYNE STATE UNIVERSITY, DETROIT, MICHIGAN

Mr. MCINTYRE. Thank you. I have a prepared statement that I

would like to submit for the record.

Chairman MCCRERY. Without objection. Is your microphone on,

Mr. McIntyre?

Mr. MCINTYRE. I believe it now is. Thank you.

I am here in part to make a plea for free trade. I was invited

to a panel back in 1975 when DISC legislation was being considered. I said at that time that the DISC legislation was inconsistent

with free trade, that it would be so found by GATT, and that even

41

if it weren’t, it would not be in the interests of the United States

to be promoting an export subsidy. All theorists on free trade believe that tax subsidies for exports and tax impediments to imports

make countries poorer.

If we want our country to be competitive in world markets, we

need to embrace free trade. I have heard a lot of rhetoric today

about free trade. But, when we get down to it, we have people telling us that the United States should want a ‘‘fair advantage,’’ or

at least some advantage, over our competitors. The implicit message we are getting is that we need to do something special in violation of free trade to help our economy and to help our businesses

or we are going to end up as a third world country.

I don’t think we are at risk of being a third world country. And

if we were actually facing such a risk, there is nothing we could

do with a small subsidy of this nature that would change that fate.

This is the strongest economy in the world. If people in other

countries were listening to the kind of worry about competitiveness

that we are hearing today they would be quite shocked. They think

we are formidable competitors.

All over the world, countries are wanting to emulate the American success. We have just come out of a decade of enormous

growth, enormous vigor. And to have us be considering this freetrade issue as if we were at the bottom of the heap or just about

to tumble off the top of the heap strikes me as missing the mark

entirely.

I am very pleased, however, to see that everyone who has been

involved in this discussion agrees that we cannot simply let the situation with ETI stand. Everyone seems to agree that this legislation, which was found to be in violation of our international agreements, has to be repealed. So that is the number one task, I believe, of the Congress—to get rid of this legislation and to get rid

of it as quickly as possible before it sours our relationships with

our trading partners.

There are other options, of course, that one might consider in addition to the repeal of ETI. All of those options are more complex,

they take a lot of time, they involve tradeoffs, they involve political

battles over who pays the tax and who gets the benefits.

Those battles are necessarily prolonged. All of the proposals that

I have heard in this discussion, both today and in previous periods,

have enormous effects on our State governments. And I am sure

that our 27 Republican Governors and our 21 Democratic Governors and our independent Governors would like to be heard on

these issues.

These complex measures cannot be done quickly. We should take

this opportunity to immediately repeal a subsidy that is in violation of our WTO agreement, and then in our leisure, we can examine the range of options that are before us.

In considering options, I think that we have to put the full set

of options on the table, not simply that small set of options that

are particularly appealing to a few of our multinational companies

that have the ear of some people.

I think that we need to look at options that protect the American

economy, not simply American business. American business is not

synonymous with America. It is merely an important part of AmerVerDate 11-MAY-2000 11:02 Jun 18, 2002 Jkt 079486 PO 00000 Frm 00045 Fmt 6633 Sfmt 6602 E:\HR\OC\C486.XXX pfrm12 PsN: C486
42

ica. We need to have tax rules that are fair and reasonable and enforceable for our business interests. But, we don’t want to have

taxes that are driven only by the interests of business.

Our tax rules need to be driven by our concerns for the wellbeing of Americans generally. And I think that when we look at the

full plate of options, what we would be looking for is some simplification in our system and for more coordination with our trade

partners. When we look at trade issues, we always look at them

as a cooperative matter. When we look at our income tax issues

that related to trade, we also should look at them in a cooperative

manner. Thank you very much.

[The prepared statement of Mr. McIntyre follows:]

Statement of Michael J. McIntyre, Professor of Law, Wayne State

University, Detroit, Michigan

My name is Michael J. McIntyre, and I teach international tax and various other

tax courses at Wayne State University in Detroit, Michigan. I thank the subcommittee for inviting me to participate in this hearing. In the time allotted to me,

I will explain why I believe the United States should promptly repeal what the

World Trade Organization has found to be an illegal export subsidy. I also will explain why I believe it best serves the interests of the American people and the

American economy for Congress to support free trade by refraining from adopting

any type of replacement for that subsidy.

History of U.S. Export Subsidies

The United States has provided a tax subsidy for exports since 1971. The subsidy

was initially provided by granting tax deferral for export income earned through a

U.S. corporation that qualified as a Domestic International Sales Corporation

(DISC). In 1984, Congress largely replaced the DISC subsidy with an subsidy for

export income channeled through a foreign corporation that qualifies as a Foreign

Sales Corporation (FSC). The FSC legislation was adopted in an attempt to avoid

conflicts with U.S. trading partners under the General Agreement on Tariffs and

Trade (GATT).

In 1997, the European Communities, with support from Canada and Japan, challenged the FSC legislation before the World Trade Organization (WTO), asserting

that it constituted an impermissible export subsidy. That FSC was an export subsidy was beyond debate. The issue was whether the United States would be able

to get the WTO to accept certain technical arguments that the particular type of

subsidy was not inconsistent with the language of the GATT. A final decision

against the FSC subsidy was issued on February 24, 2000.

Congress responded in 2000 to the WTO decision against the FSC legislation by

repealing FSC and enacting a new export subsidy called the Extraterritorial Income

Exclusion Act of 2000 (ETI). ETI borrowed many features of FSC, but it avoided

those features of FSC that the WTO had specifically cited as objectionable. Not surprisingly, the ETI legislation was again challenged by the European Communities,

this time with support from Australia, Canada, India and Japan. The WTO again

rejected the U.S. attempt at subsidizing exports in a broad-gauged opinion that evaluated the legality of ETI by reference to its substance rather than its form.

Congressional Options

The Congress of the United States must now decide how it should respond to the

decision of the WTO. I suggest that Congress has the following four options:

(1) Do Nothing. Congress can do nothing and simply allow the United States to

remain in violation of its international trade agreements. This option would open

the United States to sanctions by our trading partners. More fundamentally, it

would undermine the movement towards free trade that the United States has

championed for over half a century.

(2) Support Free Trade. The most attractive option, from a public policy perspective, would be to support free trade by repealing the ETI provisions without any replacement. The virtues of free trade have been well known at least since the publication of Wealth of Nations by Adam Smith in 1776. Free trade—the removal of export subsidies and import barriers—strengthens a nation’s economy and lifts the living standards of its workers. These benefits of free trade have been touted by politicians from both of our major parties in every election I can remember. As an added

bonus, support for free trade and honoring our international agreements will foster

43

1 I have two reasons for believing that radical reform of the corporate tax is unlikely in the

near term. First, the radical reform proposals are likely to attract serious opposition from one

or both political parties as their economic and political implications become better understood

by Congress. Second, the radical proposals, if enacted in a revenue-neutral way, would shift tax

burdens significantly—increasing taxes on some taxpayers and lowering them on others. I believe that Congress would find some difficulty in acting swiftly to raises taxes on a large segment of the voting public. 2 In my view, these radical proposals have nothing to do with genuine tax reform. As the

Enron debacle illustrates, the starting point for genuine corporate tax reform is to close off opportunities for offshore tax avoidance and evasion. The effect of both radical reform proposals,

however, would be to enhance and legitimize those opportunities.

improved relations with U.S. allies. Avoiding needless conflicts with our trading

partners is particularly important at a time when we must rely on them for support

in our efforts at combating international terrorism.

(3) Grandson of FSC. A third option, which is not really a practical option at all,

would be to develop some revised version of ETI that would subsidize exports without violating the WTO agreements. The game of disguising a trade subsidy as a normal part of the tax code, however, is no longer winnable. The ETI legislation is skillfully drafted. It adopts a mechanism for delivering a subsidy to exporters that is

export-neutral in form. It might even have been approved by adjudicators in some

forums. It had little chance of approval, however, in a forum that is dedicated to

upholding the substance of free trade against the inevitable pressures from governments to obtain an unfair trade advantage over their trading partners. It should

now be clear that the WTO is not prepared to uphold a U.S. export subsidy, however

well disguised it may be. Further legislative efforts at hiding the subsidy will simply

antagonize our trading partners.

(4) Radical Reform. The fourth option is to repeal ETI as part of a plan to repeal

or radically modify the corporate income tax. One radical reform plan floated by

some commentators is to adopt what they characterize as a ‘‘territorial’’ tax as a replacement for the corporate income tax. Another plan would substitute a broadbased consumption tax for the corporate income tax. The United States would not

have a problem with the WTO if it repealed the corporate tax completely, and the

territorial system also would be acceptable to the WTO as long as it was clear that

it was not intended as a disguised export subsidy. These radical proposals, nevertheless, are disproportionate and inappropriate responses to the ETI problem, for reasons discussed in detail below. They also would not be helpful in dealing with the

ETI problem unless they could be enacted quickly, before the ETI problem provokes

a trade conflict that would be harmful to the U.S. economy and to U.S. interests

abroad.1

Option 2 is the free-trade option, and options 1 and 3 are the anti-free-trade options. The case for adopting option 2 depends, therefore, on the strength of the case

for free trade. I set forth that case below. I argue that the United States policy over

the past half-century of fostering free trade has enriched Americans and strengthened the U.S. economy. I also argue that under the widely accepted theory of free

trade, export subsidies distort trade patterns, resulting in a decline in worldwide

welfare. Export subsidies do not produce, however, a net increase in jobs or economic activity in the exporting country even ignoring the likelihood that they would

provoke retaliatory measures. In brief, free trade makes America richer, and export

subsidies make us poorer.

The radical reform proposals that I have labeled Option 4 should not be evaluated

only or even primarily with respect to their potential for dealing with the ETI issue.

Those proposals should be accepted or rejected—and I would hope rejected—based

on their substantial impact on the distribution of U.S. tax burdens generally, with

the trade issue being a relatively minor consideration.2

The only reason for considering the radical reform proposals in the context of a

discussion of ETI is the claim of their proponents that enactment of one or the other

proposal would stimulate U.S. exports. If the radical reform proposals would stimulate exports, they become variants of option 3. As a result, they are not an appropriate response to the ETI issue because, according to the theory of free trade, they

would make America poorer rather than richer.

The radical reform proposals are also an inappropriate response to the ETI issue

for another reason, namely that they are unlikely to actually stimulate U.S. exports.

The impact on exports of income tax concessions is a complex issue, which I address

in some detail below. I conclude that the impact of the radical reform proposals on

exports is likely to be negligible. I reach a similar conclusion with respect to ETI

itself. That is, I believe that income tax concessions directed at profits derived from

exports or from foreign activities are likely to have little or no impact on the overall

level of exports. Lobbyists seeking to retain or replace ETI apparently agree, for it

44

3When the DISC legislation was first under consideration in 1969, the value of the dollar was

fixed as $32 per ounce of gold. When DISC was adopted in 1971, however, the United States

had replaced the gold standard with a floating rate system. This change to floating rates made

DISC obsolete just as it was going into effect. See Michael J. McIntyre, ‘‘DISC After Four Years:

seems unlikely that they would be working so diligently to preserve a tax subsidy

if most or all of the benefits of the subsidy were being passed on to foreign consumers.

The Virtues of Free Trade

The primary purpose of the WTO is to promote and safeguard free trade. In playing a major role in the establishment of the WTO, the United States showed its

commitment to free trade. It recognized that some international institution is needed to get national governments to give up their predilection to manage trade for the

benefit of the few and to allow the free market to operate as Adam Smith envisioned.

In the ETI case, the WTO has operated exactly as it was designed to operate. It

correctly labeled ETI as an export subsidy and determined that the continued operation of ETI was inconsistent with U.S. treaty obligations. Any other decision would

have struck a blow for protectionism and undermined the credibility of a major

international institution that serves America’s long-term economic and political interests and the long-term interests of its trading partners.

Some advocates of managed trade contend that ETI is necessary to allow American companies to compete against foreign firms that are obtaining export subsidies

in their home country. They become vague to the point of incoherence, however,

when they are asked to identify these foreign subsidies. If there are identifiable foreign subsidies, the proper U.S. response is to point them out and bring an action

for relief to the WTO. The United States should not ignore the rule of law and take

unilateral actions contrary to our international agreements. The precedent set by

the WTO’s decision in the ETI case should make it quite easy for any member of

the WTO to challenge successfully any export subsidy that it is able to identify.

According to free-trade theory, export subsidies benefit the recipients of the subsidies at the expense of the general population and the national economy. If that

theory is correct—and most commentators believe it is—then the WTO decision

against the U.S. government will actually advance the best interests of the American public and the American economy if it leads to the demise of ETI. That is, the

WTO decision can be a major victory for free trade and therefore a victory for America if Congress simply repeals ETI.

As a simplified illustration of the case for free trade, assume that Country A decides it wants to stimulate exports by providing a subsidy of $25 per spool for each

spool of copper wire that is exported, provided that the exporter demonstrates that

it lowered the price of copper wire in the foreign market by the full amount of the

subsidy. XCo manufactures wire in Country A. It takes advantage of the subsidy

to lower the unit price of its wire in foreign markets by $25, resulting in an increase

in its exports. To meet the new demand, it hires some additional employees in

Country A. So far, the subsidy seems to be working.

A trade subsidy, however, is unlikely to have just one effect. Assume that YCo

is a domestic company that manufactures electric motors in Country A and sells

them domestically and abroad. Copper wire is a major component of an electric

motor. YCo’s price for wire, which it buys from XCo, is not changed by the export

subsidy. Its foreign competitors, however, can now buy copper wire at the subsidized

price. As a result, they are able to reduce their price for electric motors in Country

A and in foreign markets, creating competitive problems for YCo. As a result of the

new competition, YCo experiences a reduction in its domestic and foreign sales of

motors and is forced to reduce the number of employees at its production plant in

Country A. Whatever jobs were gained from the expansion of XCo’s business might

be lost from the contraction of YCo’s business. In addition, Country A is now paying

the bill for an export subsidy that probably has added no new jobs and certainly

has distorted normal trade patterns.

The above example may appear to be something of a special case. In a world of

floating exchange rates, however, an export subsidy is likely to have negative effects

on domestic production of unsubsidized products. The reason is that an export subsidy is likely to cause an increase in the relative value of a country’s currency when

currency exchange rates are set by the market. That increase obviously would affect

trade flows. In general, the changes in trades flows would tend to wash out any economic benefits that a country would hope to obtain from pursuing a beggar-thyneighbor trade policy.3

45

Reassessment Needed,’’ 3 Tax Notes 9–14 (September 29, 1975) (Based on testimony as invited

witness before Ways and Means Committee, July 23, 1975). 4Some proponents of a territorial system assert, contrary to fact, that Canada operates a territorial system. For a discussion of the Canadian international tax system by a leading Canadian commentator and a clear refutation of the arguments being advanced for a territorial system, see Brian J. Arnold, ‘‘Comments on the Proposed Adoption of a Territorial Tax System in

the United States,’’ 25 Tax Notes Int’l 1091–94 (March 11, 2002). 5 A detailed revenue estimate of adopting a territorial system is not possible at this point, due

in part to the lack of specificity about the intended features of the system. Some idea of the

costs can be gotten by realizing that Enron enjoyed the benefits of a self-help territorial system

through mechanisms that would become perfectly legal under a territorial system. 6 In Europe, the VAT is imposed in addition to a corporate income tax.

7This business activity tax was promoted by the Kemp Commission in its 1996 report. Its appeal is due in part to the fact that it is likely to be a hidden tax on consumers. Quite comically,

the particular form of value-added tax proposed by the Kemp Commission called for the imposition of the tax on exports and the exemption of imports from the tax. See Michael J. McIntyre,

Continued

To illustrate the above point, assume that no companies in Country A manufacture electrical motors or anything else using copper wire. In that case, Country A

would not have to be concerned that the export subsidy for wire would harm its domestic industries directly. Because of the currency-exchange effect, however, Country A almost certainly would be harmed by the export subsidy. The subsidy, by increasing the demand for the products of Country A in foreign markets, almost certainly would increase the value of Country A’s currency relative to other currencies.

As the following example illustrates, the expected result of the higher exchange rate

would be an increase in imports into Country A and a loss of jobs in the businesses

in Country A that make products in competition with the new imports.

The facts of this example are similar to the facts in the example above, with the

additional facts that Country A uses the dollar as its currency, and Country B uses

the franc. The exchange rate before the export subsidy for copper wire was one dollar for two francs. After the subsidy was granted and exports of wire increased, the

value of a Country A dollar rose so that it now commands three francs. Country

B produces apples, which it sells for 30 francs a crate. The price of apples in Country A is 14 dollars (28 francs at the pre-subsidy exchange rate). Before the export

subsidy caused the exchange rate to change, apples produced in Country B were not

competitive with apples produced in Country A. After the exchange rate adjustment,

however, a producer in Country B that sold apples in Country A for 10 dollars a

crate could convert the proceeds into 30 francs. As a result, apples produced in

Country B are now competitive in Country A, and exports of apples from Country

B should be expected to go up. Producers of apples in Country A would lose sales,

and jobs in the apple business in Country A would be lost.

In the above examples, the violation of free trade by Country A produced a bad

result, for it and the rest of the world, even without any retaliation by Country A’s

trading partners. The worldwide economic costs of Country A’s conduct would be

magnified many times if other countries responded by erecting barriers to trade or

by adopting their own export subsidies. One of the major purposes of the United

States in helping to establish the WTO was to keep countries from making themselves poorer by behaving like Country A. Another major purpose was to prevent

the almost inevitable disputes over trade practices from escalating out of control.

Why the Radical Proposals Do Not Solve ETI Problem

There are two major proposals for radical reform of the corporate income tax currently being floated. One is to convert the corporate income tax into a ‘‘territorial’’

system. The basic idea is that U.S. corporations would be exempt from tax on dividends, rents, royalties, interest, and other receipts from their foreign affiliates, and

they would be able to more fully utilize foreign tax havens to avoid both U.S. taxes

and the income taxes imposed by our trading partners. I call the territorial system

‘‘Enron on stilts’’ because of its clear potential for promoting unbridled tax avoidance

and evasion.4

The tax revenue cost of moving to a territorial system would be many, many times

the tax savings from the repeal of ETI.5 As a result, its adoption would require a

sharp increase in other taxes or a sharp increase in the budget deficit.

The other proposal for radical reform is to adopt some form of consumption tax

as a replacement for the corporate income tax. One variant of this proposal is a European-style value-added tax (VAT). The European VAT is a tax on domestic retail

sales collected in stages from manufacturers, wholesalers and retailers.6 Another

variant is a business activity tax (BAT), similar to the business-tax component of

the Hall-Rabuska flat tax.7 Both the VAT and the BAT have economic effects simiVerDate 11-MAY-2000 11:02 Jun 18, 2002 Jkt 079486 PO 00000 Frm 00049 Fmt 6633 Sfmt 6621 E:\HR\OC\C486.XXX pfrm12 PsN: C486
46

‘‘International Aspects of the Kemp Commission Report,’’ 70 Tax Notes 607–609 (Jan. 29, 1996),

reprinted in 12 Tax Notes Int’l 417–420 (Feb. 5, 1996). 8 In allowing U.S. corporations to claim a credit for foreign income taxes, Congress has implicitly treated those corporations as having paid the tax. If the tax is passed on to consumers, no

credit should be allowed. See Michael J. McIntyre, The International Income Tax Rules of the

United States, Lexis Publishing (2000) at ch. 5/G.2. 9To fully pass on a 35% corporate income tax, PCo would need to sell its dresses for $25.39 each. That amount is determined as follows: If N equals the pre-tax profit on a dress and $10

is the after-tax profit, then N—(35% of N) = $10. Thus N = $10/0.65 = $15.3846, and the price necessary for PCo to bear no net tax burden would be $15.39 pre-tax profit + $10 cost = $25.39. 10The example is intended as a counter to the claim made by some supporters of export subsidies that U.S. corporate taxes paid with respect to profits on export sales are routinely passed

on to foreign customers. The incidence of the corporate income tax is a complex and controversial issue. My own view is that the tax generally is paid by equity investors, although some

portion of the tax may be shifted to workers and even to consumers under some circumstances.

lar to a retail sale tax. That is, the burden of a VAT or a BAT would be passed

on to consumers in the form of higher prices.

Advocates for these radical reform proposals obviously have agendas that extend

well beyond ETI. They attempt to link their proposals to ETI by claiming that elimination of the corporate income tax on profits earned abroad would stimulate foreign

sales of goods and services produced in the United States by making those goods

and services cheaper in foreign markets. This claim is unsupportable. The U.S. corporate tax on foreign profits is not currently being paid by foreign consumers, so

its elimination would not lower the price of goods and services in foreign markets.

To be sure, in some quarters it seems to be an article of faith that the corporate

income tax is passed on to consumers through higher prices.8 There is little in the

tax literature, however, to support that belief. According to standard economic theory, the price of goods and services in a market is set by supply and demand in

that market. The U.S. corporate tax paid by a U.S. corporation is highly unlikely

to affect significantly either the supply or the demand for goods and services in foreign markets. Consequently, the tax would not affect the price of those goods and

services significantly.

Consider, for example, PCo, a U.S. manufacture of children’s clothing that manu- factures dresses in the United States for $10 and sells them in France for $20.

French, German, Dutch and Italian companies are selling similar dresses for $20.

Their cost of producing a dress is also $10. Now suppose the U.S. Congress adopts

a corporate income tax that requires PCo to pay a tax of $3.50 (35% of $10) on the

profits it earns on each dress sold in France. The officers and shareholders of PCo

are unhappy with the tax and would like to pass some or all of the tax on to consumers. PCo can attempt to do so by advertising its dresses for a price above $20.9

If it refuses to sell the dresses for the market price of $20, however, it will end up

making no sales at all in the French market because it cannot control the supply

or demand for dresses in that market. Because it is still making a good profit on

its sales of dresses in France at $20, it has no incentive to forgo those sales.10

An argument I have heard on occasion in support of the proposition that an income tax cut on export profits would result in lower prices for exports is that business executives set their prices so as to obtain a target after-tax profit. According

to that argument, if the tax rate is cut, then business executives would cut their

prices so as to maintain the same after-tax rate of return. I have not seen any empirical support for the argument. Its implausibility is illustrated by the following example.

Assume that Country A has an income tax with a top marginal rate of 39.6 percent. Among those paying at this rate are some wealthy doctors and lawyers. The

legislature of Country A cuts the top marginal rate to 30 percent, resulting in a big

tax reduction for the doctors and lawyers. How likely is it that the doctors and lawyers will respond to the tax rate cut by lowering their prices for medical and legal

services in the hope of attracting more customers? I expect that few people would

anticipate that the price for medical and legal services would be dropped. There is

little reason to believe, moreover, that corporate executives seeking to maximize

their profits would be more inclined than the doctors and lawyers to share their

new-found tax benefits with their customers.

Conclusion

Of the four options available to Congress, only the second option—repeal of ETI

without any replacement—is consistent with free trade and offers Congress an honorable and effective solution to its ETI problem. It is mistaken to think that some

drafting wizard can come up with a new export subsidy that will reward the current

beneficiaries of ETI and still pass muster with the WTO. It is equally mistaken to

think that some embryonic plan for radical tax reform will suddenly solve the probVerDate 11-MAY-2000 11:02 Jun 18, 2002 Jkt 079486 PO 00000 Frm 00050 Fmt 6633 Sfmt 6621 E:\HR\OC\C486.XXX pfrm12 PsN: C486
47

lem. The clear reality is that ETI must go if the United States is to satisfy its obligations under international law and maintain its position as a leader of the freetrade movement. It is equally clear that any alternative mechanism for stimulating

exports, even one that is acceptable to the WTO, will simply distort trade patterns

without increasing U.S. jobs or strengthening the U.S. economy. The best course of

action for Congress is to stay the free-trade course that the United States chartered

more than a half-century ago.

Although free trade can provide many economic benefits, it is not a free lunch.

It can bring dislocations to communities and to workers when established businesses are unable to compete with foreign-based competitors. Many proponents of

free trade, myself included, support the use of government authority to ameliorate

hardships resulting from robust international competition. Programs that provide

job retraining, unemployment benefits and community support are all consistent

with a commitment to free trade. Free trade provides major economic benefits to the

U.S. economy, and those benefits should be shared equitably. Fortunately, the revenue generated from repeal of ETI is fully adequate to deal with the short-term dislocations of American workers that may result from that repeal.

A repeal of ETI presents Congress with a political dilemma. The costs to U.S. consumers and U.S. companies from the ETI export subsidy are substantially greater

in aggregate than the benefits to the users of ETI. Those costs, however, are often

hidden and diffused. In contrast, the benefits to the companies that use ETI are palpable and large. For example, a handful of U.S. airplane manufacturers garnered

hundreds of millions of dollars in tax savings from FSC and presumably are benefiting similarly from ETI. I do not pretend to have a solution to this political dilemma. The best that those of us in the academic community can do is to make the

case for repeal of ETI as forcefully and clearly as we can, with the hope that our

defense of free trade will be helpful to Congress in resisting the inevitable political

pressures for protectionism.

Well, I think what I have heard from all three of you is that in

Chairman MCCRERY. Thank you, Mr. McIntyre.

f your opinion, it is impossible to exactly replicate the FSC or the

ETI in terms of those American companies that will be advantaged

under the current system; is that correct?

Ms. GARRETT-NELSON. I think that is correct, Mr. Chairman. It

would be impossible to replicate the essential features of ETI, the

targeted prescribed tax rate reduction for U.S. exports is clearly

not permissible under the Appellate Panel opinion.

Mr. MCINTYRE. I agree with that fully. I would also say that it

not be in the interests of the United States and the U.S. economy

to try to replicate it, even if it were possible. But, I certainly agree

it cannot be done consistent with our international obligations.

Mr. CHORVAT. I also second that. Any real attempt to try and

replicate it I think is only going to irritate the WTO, because they

will see through what we are trying to do. And they will rule

against us and maybe even give us greater sanctions.

Chairman MCCRERY. Mr. McIntyre, I agree with your favor of

free trade. And I admire your saying so.

Mr. MCINTYRE. Thank you.

Chairman MCCRERY. However, I don’t think I agree with your

conclusion that the ETI or FSC has nothing to do or should have

nothing to do with our trade situation. And giving our domestic

companies a level playingfield in the arena of free trade.

Mr. MCINTYRE. It was not my intention to suggest that ETI or

its equivalents had no effect on the particular companies that were

trying to export. In large measure, I think that the tax benefits

were not passed on to foreign consumers by way of lower prices,

48

and, therefore, they had very little effect on total production in the

United States.

I certainly agree that ETI and FCS were of assistance to U.S. exporters, probably reduced their capital costs to some degree. But,

the problem is that if you provide a stimulus for exports and it actually works in increasing exports, there is a currency exchange affect. That always happens.

What that means is that imports now become cheaper. So if we

have a business in the United States that is absolutely competitive

right now making bread, and suddenly we have changed the exchange rate so that Canadian bread can come over here at a lower

price, we have helped, perhaps, our aircraft industry with the export subsidy, but we have also hurt our bread industry.

The point about free trade is that there are all of those tradeoffs.

Any benefit that you get for one industry you are almost certainly

going to lose in another industry.

Chairman MCCRERY. I don’t disagree with that. And we all know

that there are great many things that affect exchange rates, and

we can’t control all of those things. But what we can control is our

own tax system. If we know that our domestic manufacturers who

want to take advantage of foreign markets by selling in those markets are having to imbed in the cost of the product to the ultimate

consumer a tax that we impose that their foreign competitors are

not having to bear because of their nation’s tax system, it seems

to me we would want to address that.

Mr. MCINTYRE. That is a very clear statement of the issue, Congressman, and I appreciate that. Let me give you a couple of points

on that. First, Australia was cited a little bit earlier as a country

without a value-added tax. They very recently adopted one. No one

thinks this has helped their exports. We should look at that. I

think the Committee ought to have someone on the staff talk to

some people involved in Australian government on that issue. I

think that you will see that it is not the view of the Australians

that adding this tax changed their export position at all. That is

one part of the answer.

The second point is, I don’t think I agree with the economic theory that you implied—that was embedded in your comment—that

the corporate tax is passed on to consumers in the way of higher

prices.

I think that the price of goods in foreign markets is determined

by supply and demand. The U.S. corporate tax generally has no effect either on the supply or the demand in foreign markets, and,

therefore, it has very little to do with foreign prices. For the most

part, the corporate tax is absorbed in lower profits which is the intent, of course, of a profits tax.

Chairman MCCRERY. Well, we will have just have to disagree on

that. There is no question in my mind that the level of taxation

that a corporation has to pay is reflected, to some extent, in the

price that they have to charge for the product. You are right, there

are a great many other factors that determine the price that the

market will bear.

But, it just may be that because of the price that the market will

bear, our producers are unable to compete because they can’t sell

49

their product at a profit at the price that the market will bear

there.

Mr. MCINTYRE. It is not my place, of course, to ask you a question. But, rhetorically, we just cut taxes on some high income people and some middle income people as well. But let’s look just at

the high income people. Some doctors received a substantial tax reduction. Is it your expectation that this tax cut has been reflected

in lower fees that doctors are now charging?

Chairman MCCRERY. That could happen. But it could also happen that they would consume more and create more jobs. So there

could be a good result in any number of ways by that tax cut. I

thank you for asking that question.

Mr. Chorvat or Ms. Garrett-Nelson, do you have any comment on

this discussion, before I go to Mr. Neal?

Ms. GARRETT-NELSON. Well, I don’t know. Should I comment on

the Australian VAT tax system? I would agree with you on that.

I would take issue with you and I think—I am not an economist

and never want to be one. But I think some economists would also

disagree with you, though, on the correlation or the degree to

which there is a correlation between exchange rates and exports.

And I read something recently, I think by Huffbauer suggesting

that that view has been somewhat discredited. But I think your

point, though, that we can agree on was that all options, legislative

options should be viewed and reviewed at this time. I would strongly disagree that the ETI provisions should be repealed before the

Congress determines that there is an appropriate legislative solution to replace it.

Chairman MCCRERY. Mr. Chorvat.

Mr. CHORVAT. Just one comment on essentially the incidence of

the corporate tax. In other words, who is really paying the tax.

That is one of the most knotty empirical problems that—the odds

are that it is probably allocated amongst consumers and labor and

capital. Some of it—we don’t really know how much, but they probably think some of it.

Chairman MCCRERY. Thank you. Fortunately we don’t have an

economist on this panel who would take the time to explain that

to us.

Mr. Neal.

Mr. NEAL. Thanks, Mr. Chairman.

Mr. McIntyre just three easy questions for you. Isn’t it true that

no major developed nation has a pure territorial tax system?

Mr. MCINTYRE. No country that I know of has a territorial system, as I have heard it described today. Certainly some of the discussion I have heard has suggested that Canada, for example, has

a territorial system. That is a substantial misstatement of the Canadian system. It has some elements that some might properly be

described as territorial, but it is essentially a global income tax system.

And an income tax by its very nature is a global tax—an origin

tax and not a territorial tax.

Mr. NEAL. Let me follow up on that. Isn’t it true that a territorial

system is of no benefit to the U.S. companies with only domestic

operations?

50

Mr. MCINTYRE. Yes. Well, I would have to give a qualified yes

to that. A territorial system, as I have seen it described, and I am

not being cute on that, it is just that there is a variety of territorial

systems out there, does create a lot of opportunities for tax advance. So I think even a purely domestic company would almost

certainly set up offshore leasing arrangements and the like to substantially reduce its U.S. source income when a territorial system.

So I would say that a domestic company, a purely domestic one,

might engage in some forms of tax avoidance that we would find

inappropriate and would cost the government some revenue, but

the territorial system would certainly not improve its economic performance.

Mr. NEAL. Is it possible that under a territorial tax system that

some companies actually might have a higher tax burden than they

do now?

Mr. MCINTYRE. Again, that would depend on the territorial system. If we were having a territorial system that was very strict on

not allowing deductions that related to foreign source income, some

companies would pay higher taxes. There are lots of ways that one

could design a territorial system that, for some taxpayers, would

result in substantially a higher tax burden.

But, again, the impact would depend on the technical rules that

were designed. In a paper that my colleague here, Mr. Chorvat,

wrote sometime ago looking at a territorial system, he tried to keep

some elements of anti-avoidance rules in the system. And that is

a commendable thing if you are going to adopt such a system.

On the other hand, I see from the testimony today Professor

Chorvat was suggesting that Congress might manipulate the

source rules so that some U.S. source income—what we would generally think of as U.S. source income—would not be taxed. So if

you are going to manipulate the source rules so that a manufacturer in the United States doesn’t produce U.S. income for us to

tax, then, of course, the territorial system would be a very substantial drain on revenue and wouldn’t raise taxes on people.

So you have to look to see the details of the particular proposal.

But, a genuine effort at fully taxing territorial or U.S. source income would very likely raise taxes on some taxpayers.

Mr. NEAL. In fairness, let me ask the other panelists if you would

like to comment.

Ms. GARRETT-NELSON. I am sorry. I was trying to follow your

questions. And when Professor McIntyre started talking about tax

avoidance I thought I perhaps didn’t hear the question correctly.

But he is correct that no two countries have the same type of territorial system. And it would depend entirely on how it is structured.

I would point out that the issues that would determine results

like whether tax liability would be higher would depend entirely on

the kinds of choices that are made, including the level of anti-deferral rules that might be employed in the context of such a system.

And those are the very same decisions that could be made within

our current system. The underlying issues are the same. The

source of income would be very important, for example. And you

would face the same issues whether we have a territorial system

or our current worldwide system.

Mr. NEAL. Okay. Mr. Chorvat.

51

Mr. CHORVAT. Actually in the article that Professor McIntyre was

referring to, I basically argued that the difference between a territorial system and the system that we have now effectively for most

U.S. multinational corporations isn’t all that great for most of

them. And that we would still have to have rules essentially like

what we have now to get rid of the antiabuse—to prevent abuse

so that a pure territorial system—very few, if any, countries have,

and I don’t think we would have a pure territorial system.

Mr. NEAL. Thank you all very much.

Chairman MCCRERY. Mr. Brady.

Mr. BRADY. Thank you, Mr. Chairman. Actually I agree with Professor McIntyre. There are a number of companies that don’t pass

their corporate taxes down to the consumers. I think we call them

failed businesses. Overhead is overhead.

I hear consensus about the fact that it is not possible to replicate

the ETI regime in a way that is WTO compliant. So it is important

not only to know what to do, which is to bring about real change,

but what not to do. I know that each of you have looked at and

rejected a number of proposals that we are going to hear about for

just tinkering. Can you share some of the proposals that you think

will come to Congress to be considered as a tinkering and what you

find objectionable to them?

Ms. GARRETT-NELSON. Well, I am not prepared to share conclusions about particular proposals. But, I can say that under the

legal analysis in the Appellate body report, it is clear that whatever is put in place of ETI, assuming that that is the route the

Committee goes down, much more economic substance will be required, or I should say, more substance would be required than has

been required under the DISC or the FSC or ETI.

Even under a Footnote 59 approach, for example, it is clear that

a requirement for export transactions that arms-lengths pricing be

used, would mean that something would actually have to occur

overseas. Some value would have to be maintained overseas in a

way that is not required under current law.

And for that reason, we are clearly talking about going beyond

what current law requires pure exporters to do.

Mr. BRADY. Great. Thank you. Mr. Chorvat.

Mr. CHORVAT. Yeah, just to sort of amplify that a little bit, if

something is done it is going to have to be something that would

also permit tax advantages, I guess in the most broad sense, to

products which are entirely produced overseas and have nothing to

do with what occurred here, I think that is part of what is going

on is that we were giving tax advantages for things that were, to

some degree, produced here and were used overseas.

Whatever happens, if it is going try to be compliant with the

WTO, is not going to have to be focused on exports per se, but on

something else, possibly in connection with the United States or

being foreign sourced or something like that. But it cannot be

something which has the word ‘‘export’’ in it or anything that could

arguably be exports.

Mr. MCINTYRE. I would agree with that assessment that anything that was seen as providing a benefit primarily to U.S. businesses engaging in export activities would have some issues with

the WTO. That is, anything that I would think that this Committee

52

would be interested in doing in this area as a replacement for ETI

would create a problem. But as was noted earlier, we have only

had a few opinions from the WTO. I think we have got one clue,

and that is that if the WTO thinks that this latest legislation is

a runaround, we will lose. I thought we would lose with ETI, even

though I admire the drafting skill of its authors. I was very confident that we would lose, and so told my students, because it

seemed to me that the WTO’s message was not that it had this little technical problem with FSC, it was that the WTO would not

permit free trade to be undermined. That is, the WTO did not want

to be the body that undermined free trade.

The Appellate body was saying that free trade is important to us,

and we will make decisions based on whether we think they further free trade. I think that there was no doubt that they felt, and

many others felt, and virtually everyone outside the United States

felt, that the prior FSC legislation was inconsistent with free trade.

Mr. BRADY. I see my time is up. Thank you, Mr. Chairman.

Thank you, members of the panel.

Chairman MCCRERY. Thank you Mr. Brady. And I want to thank

all of the members of the panel for your excellent testimony and

responses to our questions and for your excellent questions also.

Mr. MCINTYRE. Thank you very much.

Chairman MCCRERY. We hope you will continue to work with us

as we try to get through this.

Mr. MCINTYRE. I am sure I will, and I am sure other panelists

will be happy to do that.

Chairman MCCRERY. Thank you very much. Before the Committee adjourns, I would like to, without objection, introduce for

the record the statement of my colleague from New York, Mr.

McNulty, who unfortunately was ill today and had to miss the Subcommittee hearing. And with that, the hearing is adjourned.

[The statement of Mr. McNulty follows:]

Statement of the Hon. Michael McNulty, a Representative in Congress from

the State of New York

Historically, there has been a broad bipartisan commitment to preserve the Foreign Sales Corp. (FSC) tax code provision and later the extraterritorial income (ETI)

regime. We have worked together on the FSC–ETI issue in the past and I hope that

we will continue to do so in the future.

I believe that the Administration should take the lead on this important issue just

as prior Administrations have done. We had the opportunity to hear from officials

from the Treasury Department and U.S. Trade Representative Office on this issue

during a full Committee hearing on February 28, 2002. It is now the time for the

Administration to develop a strategy for resolving this issue.

It is clear that we must respond to the World Trade Organization (WTO) ruling.

However, the right solution is not an obvious one. As is often the situation, generalized or theoretical solutions may sound good, but the ‘‘devil is in the details.’’ I look

forward to the witnesses’ discussion of the direction this Committee may take in the

coming weeks.

Finally, I would suggest that the Committee Chairman and others not use the

FSC–ETI controversy as an opportunity to quickly push-through proposals that

would fundamentally alter our corporate income tax system. There is no consensus

on a proposal to repeal the corporate income tax and substitute in a consumption

tax, nor is there a consensus to limit our corporate income tax only to activities in

the United States.

Such alternatives merit thorough evaluation of the potential impact on U.S. competitiveness worldwide and whether this action might result in creating unintended

incentives for U.S. companies to move operations overseas. As time has proven, it

is unlikely that the Congress could act on such proposals any time soon and the

53

1See § 8.80 of the WTO Panel report entitled ‘‘United States—Tax Treatment for ‘‘Foreign

Sales Corporations’’—Recourse to Article 21.5 of the DSU by the European Communities.’’ 20

August 2001. Document # WT/DS108/RW.

World Trade Organization is poised to issue its determination of sanctions at the

end of this month.

I look forward to the expert testimony we will hear today on these and related

issues. And, of course, I want to thank Subcommittee Chairman McCrery for setting

up this important series of hearings.

[Whereupon, at 11:45 a.m., the hearing was adjourned.]

[Submissions for the record follow:]

f Statement of Stephen D. Cifrulak, Jr., Sewickley, Pennsylvania

I. EXECUTIVE SUMMARY:

On January 14, 2002, an Appeals Panel of the World Trade Organization (WTO)

held that the Foreign Sales Corporation (FSC) Repeal and Extraterritorial Income

Exclusion Act of 2000 (P.L. 106–519) is inconsistent with international trade agreements. As a result, it is expected that, on or around June 17, WTO arbitrators will

impose sanctions against the US in an amount less than $4 billion, but probably

more than $1 billion. The EU, however, is not expected to immediately impose sanctions because to do so might negatively impact EU businesses (and possibly initiate

a US–EU trade war.) Thus, the EU may agree to a 2 to 3 year ‘‘cease-fire’’ . . . provided that the US works in ‘‘good faith’’ to resolve the issue on a long-term basis.

For that reason, on April 8, the EU requested a ‘‘road map’’ from the US detailing

how it plans comply with the WTO ruling. The House Ways and Means Committee

then held a public hearing on April 10 to discuss various options for changing America’s extraterritorial income (ETI) regime. In that hearing, virtually every commentator agreed that ‘‘it will not be possible to draft a single replacement regime that

complies with the trade obligations of the United States and replicates the tax benefits of the ETI statute.’’ I respectfully disagree with such commentary. Indeed, the

purpose of this paper is to provide a ‘‘road map’’ of at least one ‘‘good faith’’ measure

that the US can pursue in order to preserve its export benefits.

In short, this paper will hopefully demonstrate that, while the WTO’s interpretation of footnote 59 may effectively preclude ETI reform, it nonetheless

seems to re-open the door for continued FSC use. After all, everyone seems

to have forgotten that the WTO has never specifically interpreted footnote

59 in a FSC-only context. Rather, the WTO actually ‘‘decline[d] to examine

the US argument that the FSC measure is a measure to avoid double taxation within the meaning of footnote 59’’ because the WTO said that the US

had ultimately failed to properly raise the matter as an affirmative defense

in the original suit. As such, it may be premature for commentators to proclaim that ‘‘it will not be possible to draft a single replacement regime that

complies with the trade obligations of the United States and replicates the

tax benefits of the ETI statute.’’ An alternate solution might be for the US

to now apply the WTO’s interpretation of footnote 59 back to the old FSC

regime in order to see if any conforming modifications can be made. If this

is done, then this paper suggests that the US may find additional innovative ways

to solve some of its other international tax problems (such as deferral, corporate inversions, Subpart F abuse, and various tax avoidance schemes.)

II. FOOTNOTE 59

(1) Background/Explanation

Footnote 59 of the SCM Agreement provides an exemption for measures taken to

avoid the double taxation of foreign-sourced income. This is true even if the measure

is determined to be an ‘‘export-contingent subsidy’’ (such as was determined for both

FSC and ETI benefits).

The standard of analysis for determining if a Member State might prevail with

a footnote 59 argument is that, the WTO must determine that: 1

1. The Act is a measure to avoid the double taxation of foreign-source income

within the meaning of the [last] sentence of footnote 59 of the SCM Agreement

as an exception to Article 3.1(a); and that,

54

2 Id. at § 8.108. 3 Id. at § 8.77. 4The original WTO Panel report versus ETI. Entitled ‘‘United States-Tax Treatment for ‘‘Foreign Sales Corporations’’—Recourse to Article 21.5 of the DSU by the European Communities.

Report of the Panel.’’ 20 August 2001. Document # WT/DS108/RW. 5The subsequent WTO Appeals Panel report versus ETI. Entitled ‘‘United States-Tax Treatment for ‘‘Foreign Sales Corporations’’—Recourse to Article 21.5 of the DSU by the European

Communities. Report of the Appellate Body.’’ 14 January 2001. Document # WT/DS108/RW (AB–

2001–8).

2. the [last] sentence of footnote 59 falls within the scope of footnote 5 of the

SCM Agreement.

In relation to requirement 2, the WTO ‘‘found that [since] the [ETI] Act does not

fall within the scope of the fifth sentence of footnote 59, [it did] not believe that it

[was] necessary to reach the issue of whether the fifth sentence of footnote 59 also

falls within the scope of footnote 5 of the SCM Agreement.’’ 2 In any case, the EU

ultimately stipulated that it saw ‘‘no reason to contest that the last sentence of footnote 59 may be an exception to Article 3.1(a).’’ 3 As such, requirement 2 seems to be a moot point.

Conversely, in interpreting requirement 1, the WTO focused on three main terms

in both its initial ETI-Panel Report,4 and in its subsequent ETI-Appeals Report 5—

‘‘Avoid’’, ‘‘Double Taxation’’, and ‘‘Foreign Source Income’’—which were defined as

follows:

Term ‘‘ETI-Panel Report’’ Comments ‘‘ETI-Appeals Report’’ Comments

‘‘Avoid’’ ............................................ • The purpose of the measure (or at

least one of its purposes) must be to

avoid (i.e. ‘‘prevent’’ or ‘‘obviate’’) the

double taxation of foreign-source income. (§ 8.94).

• We do not view footnote 59 as requiring that a measure ‘‘to avoid’’ the

double taxation of foreign-source income must avoid double taxation entirely, exclusively or precisely. However,

we consider that the relationship between the measure and its asserted

purpose—i.e. ‘‘to avoid the double

taxation of foreign-source income

. . .’’— must be discernable . . . [in

relation to] the overall structure, design, and operation of the Act in the

broader context of the US tax system.

(§ 8.95).

• The avoidance of double taxation is

not an exact science. Indeed, the income exempted from taxation in the

State of residence of the taxpayer

might not be subject to a corresponding, or any, tax in a ‘‘foreign’’

State. Yet, this does not necessarily

mean that the measure is not taken

to avoid double taxation of foreignsource income. Thus, we agree with

the panel, and the United States, that

measures falling under footnote

59 are not required to be perfectly

tailored to the actual double tax burden. (Para. 146)

‘‘Double Taxation’’ ........................... • The term ‘‘double taxation’’ refers to

the situation where the same income

is taxed in more than one jurisdiction.

(§ 8.92).

• ‘‘double taxation’’ occurs when the

same income, in the hands of the

same taxpayer, is liable to tax in different States (Para. 137)

55

6 ETI-Panel Report. Id. at § 8.106. 7Statement of LaBrenda Garrett-Nelson. Partner, Washington Council Ernst & Young On the

Extraterritorial Income Regime. Hearing before the Subcommittee on Select Revenue Measures.

Committee on Ways and Means. On April 10, 2002. Page 5. 8See Para. 103 of the subsequent WTO Appeals Panel report versus FSC. Entitled ‘‘United

States—Tax Treatment for ‘‘Foreign Sales Corporations’’—Report of the Appellate Body.’’ AB–

1999–9. (24 Feb 2000). 9 Id. at Page 10.

Term ‘‘ETI-Panel Report’’ Comments ‘‘ETI-Appeals Report’’ Comments

‘‘Foreign Source Income’’ ................ • . . . it is not clear to us that the term

has obtained a universally agreed

upon special meaning . . [and] no

such definition or meaning has been

included in the SCM Agreement as a

common understanding among WTO

Members. Therefore . . . we do not

impose a single rigid definition or interpretation of the term ‘‘foreignsource income’’ nor do we import into

the WTO Agreement any definition of

the term that may exist in other international instruments or fora. Nor are

we of the view that the meaning of

the term ‘‘foreign-source’’ as used in

footnote 59 need necessarily be

determined purely by reference to the

domestic laws of the Member invoking

the footnote. . . . We understand the

term ‘‘foreign source income’’ as used

in footnote 59 to refer to certain

income susceptible to ‘‘double taxation’’. (§ 8.93).

• In our view, ‘‘foreign source income’’

in footnote 59 to the SCM Agreement refers to income generated by

activities of a non-resident taxpayer in

‘‘foreign’’ State which have such links

with that State so that the income

could properly be subject to tax in

that State. (Para. 137)

Based on the above interpretations, the WTO expressly stated that its test for

analyzing compliance with footnote 59 will ultimately hinge on ‘‘whether legislators

concerned with avoiding the double taxation of foreign-source income might reasonably have been expected to draft legislation such as the Act.’’ 6 This test is important

because, as the recent House Ways and Means Committee hearing revealed, many

commentators seem to agree that:

A footnote 59 approach could be used in the context of legislation that explicitly confers an (otherwise prohibited) export subsidy, or in combination with

amendments to rules of general application. In either case, however, the ability

to replicate the benefits of the ETI regime would be circumscribed by the AB

Report’s definition of ‘‘foreign source income’’ and the related requirement that

arm’s length pricing be used to allocate income between foreign and domestic

sources.’’ 7 (Emphasis added.)

As highlighted above, the relevant question now seems to be whether ‘‘the ability

to replicate the benefits of the FSC regime would be circumscribed by the AB Report’s definition of ‘‘foreign source income’’ and the related requirement that arm’s

length pricing be used to allocate income between foreign and domestic sources.’’

After all, the WTO has never specifically interpreted footnote 59 in a FSC-only context. Instead, the WTO actually ‘‘decline[d] to examine the US argument that the

FSC measure is a measure to avoid double taxation within the meaning of footnote

59’’ 8 because the WTO said that the US had ultimately failed to properly raise the

matter as an affirmative defense in the original suit.

It therefore seems to be premature for commentators to proclaim that ‘‘it will not

be possible to draft a single replacement regime that complies with the trade obligations of the United States and replicates the tax benefits of the ETI statute.’’ 9 After

all, now that the WTO has more clearly interpreted footnote 59, a better course of

action might be to apply this interpretation back to the old FSC regime in order

to see if any conforming modifications are necessary concerning (1) the definition of

‘‘foreign source income’’; and/or (2) the requirement for arm’s length pricing.

(2) Criteria for Determining Footnote 59 Compliance in a FSC-only context

As previously noted, the WTO Appeals Panel Report for ETI states that:

56

10 ETI-Appeals Panel report. Id. at Para. 137. 11 ETI-Panel Report. Id. at § 8.106. 12Summarized from the subsequent WTO Appeals Panel report versus FSC. 13 ETI—Appeals Panel report. Id. at Para. 167.

In our view, ‘‘foreign source income’’, in footnote 59 to the SCM Agreement,

refers to income generated by activities of a non-resident taxpayer in a ‘‘foreign’’ State which have such links with that State so that the income could properly

be subject to tax in that State.10

This statement is significant because, under the old FSC regime, there was in fact a ‘‘link with a foreign State’’ via a separate entity (i.e., the FSC). In addition, these

links were such ‘‘so that the [FSC’s] income could properly be subject to tax in that

[foreign] State.’’ In practice, however, most foreign states did not ultimately choose

to tax FSC income. Instead, they levied an annual registration fee of a fixed amount

against the FSC. The more important point, however, is that these foreign states

clearly could have taxed FSC income if they had so desired and therein lies the first

hurdle concerning FSC compliance with footnote 59. For example, if a given foreign

State did choose to tax FSC income, then the FSC rules are clearly deficient in that

they do not allow for a corresponding US foreign tax credit. As a result, the FSC

rules may not be viewed by the WTO as a means of preventing ‘‘double taxation.’’ (After all, as previously noted, the WTO’s test for determining footnote 59 compliance is ‘‘whether legislators concerned with avoiding the double taxation of foreignsource income might reasonably have been expected to draft legislation such as the

Act.’’) 11

As for the second problem cited by commentators—‘‘that arm’s length pricing be

used to allocate income between foreign and domestic sources’’—the FSC regime,

once again, seems to be guilty as charged. For example, in the original FSC-only

Appeal, the WTO noted that:

There is no limitation on the amount of exempt foreign trade income that

may be earned by a FSC. Therefore, the legal entitlement that the FSC measure establishes is unqualified as to the amount of export subsidies that may be

claimed by FSCs. There is, in other words, no mechanism in the measure for

stemming, or otherwise controlling, the flow of FSC subsidies that may be

claimed.12

In the light of footnote 59, this original FSC-only argument now seems to be a

moot point. After all, as previously noted, footnote 59 of the SCM Agreement provides an exemption for measures taken to avoid the double taxation of foreignsourced income. This is true, for example, even if the measure is determined to be

an ‘‘export-contingent subsidy. Seemingly then, the actual amount of the subsidy is

probably irrelevant . . . provided, of course, that the measure is otherwise in compliance with footnote 59.

Nonetheless, in its ETI-Appeals Report, the WTO further refined its argument

concerning the need for arm’s length pricing in a footnote 59 context by specifically

noting that:

Related parties are able to ‘‘sweep into’’ the calculation of QFTI income from

purely domestic transactions, involving in that example domestic-source manufacturing income. In the absence of this provision, the separate transactions between the manufacturer and related distributor, and between the distributor

and unrelated foreign buyer, would have operated as a means of separating out

some domestic-source and foreign-source income in those separate transactions.

In other words, the domestic source income in the first transaction would not

be included in the calculation of QFTI.13

If the US therefore attempts to revive FSC use, it is clear that certain modifications will be required, but unlike ETI (which does not utilize a separate entity),

these modifications will not necessarily be ‘‘deal killers’’. Rather, they might actually

provide the US with creative alternatives for solving some of its other international

tax problems (such as deferral, corporate inversions, Subpart F abuse, and various

tax avoidance schemes.)

III. CONCLUSION: A ‘‘ROAD MAP’’ FOR FSC COMPLIANCE

Based on the above analysis, I therefore suggest that the US immediately provide

the EU with the following ‘‘road map’’ that outlines at least one ‘‘good faith’’ measure that the US can pursue to preserve export benefits:

1. The ETI Statutes will be repealed as soon as possible; at the same time,

however,

57

1We have previously commented to the full Committee on the World Trade Organization’s decision that the United States’ Extraterritorial Income Exclusion Act is a prohibited export subsidy, at the Committee’s hearing on Wednesday, February 27, 2002. On that occasion we addressed the History of the FSC–ETI Dispute—The Role of Decisions Made in the 1960s; The

Continued

2. The FSC Statutes will be re-instated, but with the following modifications

...

a. All restrictions prohibiting the application of US foreign tax credits to

FSC income will be removed. (Indeed, the stated goal of this new FSC regime will be ‘‘to facilitate the repatriation of certain US-related income by

implementing measures designed to avoid (and/or significantly reduce) the

double taxation of foreign-source income.’’)

b. The US will also immediately begin to research ways in which it can

make its FSC administrative pricing rules conform to the ‘‘arm’s length’’

concerns outlined in the WTO’s recent ETI-Appeals decision. The US will

keep the EU informed concerning the status of this research. Moreover, the

US will pledge to complete this research in a reasonable amount of time,

and to ultimately bring its pricing rules in compliance with WTO standards.

3. In exchange for a reasonable amount of time to implement the above

changes, the US will also agree not to bring future WTO suits which characterize the various EU VAT regimes as ‘‘prohibited export subsidies regimes not

in compliance with WTO rules.’’

If the EU agrees to the above ‘‘road map’’, then from a ‘‘policy’’ standpoint, the

benefits of the suggested changes would be as follows:

• A trade war could be averted (both now and in the future);

• The US and the EU will both preserve certain export benefits on a longterm basis;

• The existing tenets of US international tax policy—such as the foreign tax

credit, subpart F, and section 863(b)—could all remain in place;

• Treasury could continue its commitment to the doctrine of capital export

neutrality;

• The dual issues of anti-deferral and hybrid use would, most likely, become

less of a problem. (Indeed, the current focus on the precise details of Subpart

F reform could probably be somewhat avoided. After all, if FSCs are allowed

to utilize US foreign tax credits, then presumably, US taxpayers would have a

legitimate means of repatriating certain qualified income at rates that are more

in line with worldwide standards, e.g., 12.17% to 29.75%.); and finally,

• US businesses could continue in their pursuit of ‘‘globalization.’’ (Moreover,

they would now have less of an incentive to renounce US incorporation status.)

At any rate, I hope the analysis contained herein will re-energize the current

FSC/ETI debate. More importantly, I hope that it demonstrates that there is at

least one as-of-yet unexplored solution for resolving this seemingly complex problem;

and that this solution may actually allow all parties involved to save face in this

matter.

As for more specific details concerning other aspects of FSC reform, I have some

thoughts concerning these matters as well . . . but alas, that is a battle best saved

for another day.

Statement of MTI Services Limited, Princeton, New Jersey, and Western

Growers Association, Irvine, California

f MTI Services Limited, acting through its Tax Committee, and the Western Growers Association submit the following written testimony to the Subcommittee for its

consideration. MTI Services Limited’s Tax Committee is represented by Ms. Deborah Fehr-Niswanger (Military Truck Parts, Inc., Many, Louisiana), Brian Ward

(Cortland Line Company, Inc., Cortland, New York), and John Andrews (QSC Audio

Products, Inc., Costa Mesa, California).

We appreciate this opportunity to make our views known, and we would be

pleased to work with Congress, the Treasury Department and the Internal Revenue

Service over the coming weeks and months to overcome the current problem posed

by the WTO’s decisions.1

58

WTO Appellate Body’s Decision—A Misconception of the Nature of U.S. Tax Rules; Impact of

Changes in the FSC–ETI Rules—Effects on Medium-Size and Smaller Taxpayers; The EU’s Request for Sanctions—A Proposal for Attacking the Numbers; and Multiple Ownership—Need for

Continued Support. During the development of the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, we were active in contributing proposals and comments to the tax-writing

committees, the Joint Committee on Taxation and the Treasury Department.

THE POSITION OF SMALL AND MEDIUM-SIZE EXPORTERS

We support the proposition put forward by some large multinational corporations

that Congress and the Administration should carefully consider changing from a

‘‘worldwide tax system’’ to a ‘‘territorial tax system’’ and amending the Subpart F

and related rules. It must be emphasized, however, that NONE OF THE STEPS

BEING DISCUSSED WOULD BENEFIT SMALL AND MEDIUM-SIZE EXPORTERS. Smaller companies, unlike many large corporations, do not have plants outside

the U.S., and they have no incentive or desire to move any part of their operations

to a foreign jurisdiction. They typically ‘‘sell out the back of the plant,’’ and the

plant is here in this country. Agricultural businesses grow, pack and sell from their

farms, again here in this country.

Realistically, we think it should be acknowledged that wide-ranging changes in

the way the United States taxes international business, including exporting, will not

come quickly. Also, these changes may not come by themselves but as part of a very

broad reform of the Internal Revenue Code, which, frankly, has not changed to reflect today’s business practices and life styles.

Our point is simple and straightforward: Small and medium-size exporters do not

want Congress to ‘‘trade off’’ the ETI provisions for enactment of these or any other

new rules. The tax treatment of export income under DISC, FSC and ETI was and

is important, and we want to keep ETI or something like it in one form or another.

As explained briefly below and in greater detail in memoranda prepared for the

Congressional and Treasury Department staffs, we believe that the tax treatment

afforded under FSC and ETI can be replicated under existing non-FSC, non-ETI law

without violating trade obligations and without doing injury to generally-accepted

tax principles. This approach to the problem is not for small and medium-size companies only; large companies can join in. Also, since it relies upon rulings, in the

form of Pre-Filing Agreements (‘‘PFAs’’) or Private Letter Rulings (‘‘PLRs’’), it is a

simple matter, in effect, to ‘‘sunset’’ them when more comprehensive changes are enacted.

We would add that our Representatives in Congress, we believe, should be as attentive to the views of small and medium-size exporters as they are to large exporters. Smaller exporters, including agricultural exporters, represent a disproportionate

number of ‘‘users’’ of the subject tax provisions. Of the 4,363 FSC returns filed in

1996, for example, the largest 40% of the exporter population, by size of total assets,

filed 1,659 returns, while the remaining 60%—the smaller companies—filed 2,704

returns. Smaller exporters employ a large number of people. And the tax savings,

frankly, can be critical to the company’s efforts to export.

As the owner of one of our companies recently wrote to the Chairman of this Subcommittee:

Our company does a good deal of export business, and the FSC/ETI program

has assisted us in being competitive in international markets where the negotiations for contracts can be intensely challenging. In a new venture outside basic

truck parts, I have just completed a two-year negotiation for American-made ambulances, fully equipped with American-made medical equipment for Egypt. This

negotiation was successfully completed with direct low-margin profits, but it

should be kept in mind that the advantage with the FSC/ETI program made

it possible to compete and win. These provisions have helped us grow our export

market and increase the number of employees as we have grown.

Letter from Deborah L. Fehr-Niswanger, President, Military Truck Parts, Inc. to

Congressman Jim McCrery dated April 8, 2002.

To our fellow taxpayers that are larger companies, we point out that the exporting

community has only succeeded in making their case to Congress and the Executive

Branch when as a group we have been able correctly to say that the provisions in

question do not merely help the largest 10–20% of exporters. Otherwise, the approach is too lopsided and takes on the appearance of corporate welfare. Keeping

smaller exporters in the game is the rationale behind numerous provisions in the

statute, such as the exemption from the foreign economic processes requirements

and the shared provisions, and in the Treasury Department regulations.

59

2 United States—Tax Treatment For ‘‘Foreign Sales Corporations’’ Recourse to Article 21.5 of

the DSU by the European Communities, WT/DS108/AB/RW dated Jan. 14, 2002, Report of the

Appellate Body, pp. 26–33. 3Section 911.

4For example, the exception for export property to the rule that taxes foreign controlled corporations on amounts reinvested in U.S. property looks a little anemic, and Congress may wish

at some time to broaden it. Section 956(c)(2) (United States Property Defined; Exceptions). 5 Id. at pp. 41–59.

LEAVING ETI IN PLACE BUT MAKING MODIFICATIONS

The Chairman’s announcement asks that persons submitting testimony help the

Subcommittee ‘‘explore the possibility of one approach—leaving ETI in place but

making modifications to it that address the objections raised by the EU. * * * The

focus of the hearing will be to examine whether adjustments can be made to the existing ETI regime to bring it into compliance with WTO rules without undermining the

competitiveness of U.S. businesses in the global marketplace.’’ In summary, our suggestion is that ETI be kept in place and, at the same time,

exporters be encouraged to set up operations under existing non-ETI law so as to

dramatically reduce the revenue cost of the ETI provisions. It is this figure that the

European Union has fixed on in its request for authorization to impose sanctions.

Put differently, we need to focus on reducing the ETI revenue cost figure, not making amendments to the ETI provisions.

The United States, As A Matter Of Technical Tax And Trade Law, Probably Cannot Enact Yet Another Version Of Exporter Tax Rules That Will

Be WTO-Compliant

Having worked with the FSC and ETI provisions in great detail since as far back

as 1984 and studied the various WTO reports and decisions, we believe that it

would be extremely difficult if not impossible to solve the current problem by enacting yet another version of the exporter tax rules. This is because the World Trade

Organization’s FSC and ETI reports and decisions have been written quite purposefully to make this as difficult as possible.

Without reviewing each of the numerous problem areas in what runs to over 500

pages of writing, including the original FSC report and decision, and over twice this

amount taking into account the various submissions, questions and comments, we

will look at two by way of example.

First, in finding that the ETI provisions constitute a subsidy, the Appellate Body

found that the ETI exclusion amounted to a forgoing of revenue that is ‘‘otherwise

due.’’ In doing so, it opined that the normal or ‘‘benchmark’’ rule under U.S. law

is that U.S. persons are taxable on their foreign source income and, therefore, ETI

operates as an exception. By characterizing the U.S. tax system in these terms and

labeling as a subsidy anything that diverges from the proclaimed norm, the WTO

has made it very difficult to do anything that does not tax the foreign source income

of exporters.2

It is odd that the United States should be constrained by competitors’ characterization of its own laws. This is especially true where the characterization is overly

broad to the point of being simplistic. As Congress and the Treasury Department

are well aware, the U.S. tax system is not that sheer or pristine. To take just one

example, Americans residing abroad are exempt from U.S. tax, up to the level of

$80,000, on their foreign earned income.3 Also, should Congress wish to rethink

anti-exporting measures that it put in place in the past, must it be barred from acting? 4

Secondly, in finding that the ETI provisions did not qualify for the exception in

Footnote 59 of the Agreement on Subsidies and Countermeasures for measures to

avoid double taxation, the Appellate Body characterized income falling within the

purview of the ETI rules as not solely foreign-source income but also U.S. source

income. Here it opines on the definition of foreign source income, what degree of

foreign presence must exist for the exception to come into play, and whether formulae can be employed to allocate income.5 This treatment makes it difficult to construct simple, easily administered rules and, instead, pushes tax writers toward the

arm’s-length, case-by-case standard. Incidentally, it also ignores qualitative factors

and the existence of electronic commerce, which was almost nonexistent when the

foreign economic processes were first drafted in the early to mid-1980s.

We note that the Appellate Body seems to have a great deal of difficulty dealing

with the 30% of foreign sale and leasing income method in section 941(a)(1). With

FSC, there was the possibility using the sale price actually charged, subject to section 482 pricing. Also, with FSC, there was the possibility of arm’s length pricing

between the related supplier and the FSC. These possibilities, in effect, fell away

60

6 In fact, while only a small percentage of companies used, with FSC, a method other than

one of the administrative pricing methods, significant amounts of income travelled through

these ‘‘nonadministrative’’ routes, that is, the section 482 method and the arm’s length method.

C. Belmonte, ‘‘Foreign Sales Corporations, 1996,’’ SOI Bulletin (Spring 2000). 7 ETI was adopted by the Senate by Unanimous Consent and by the House on a vote of 316

to 72. The House Ways and Means Committee, led by Chairman Archer and ranking Democrat

Congressman Rangel, adopted it with only one member, Congressman Stark, voting against.

Two other Members, Congressman Doggett and Congressman Lewis, expressed concerns about

benefiting some types of exporters.

with ETI. While with hindsight one is tempted to say that it might have been better

to move farther away from formulaic approaches, we doubt that it would have made

a difference.6

Looking at the Appellate Body’s work as a whole, it is safe to say that in addition

to making it very difficult for the United States to comply, the authors very much

wanted also to avoid creating a ‘‘roadmap’’ for that compliance.

The United States Should Not Even Try To Enact New Legislation

We think that having changed our rules twice—once from DISC to FSC in 1984

and again from FSC to ETI in 2000—and done so in good faith in order to try to

comply with the views of our trade competitors, ‘‘enough is enough.’’ It is simply inappropriate for this country—Congress, the Administration, the export community—

to go through that process again, especially since it can be predicted that those who

will sit in judgment of the work product are strongly inclined against its success.

It is far preferable for exporters to fall back upon existing law that does not tie

to the ETI provisions. Congress and the Administration can facilitate this course of

action by urging Treasury Department and the IRS to act expeditiously.

At the same time, the U.S. Trade Representative can pursue one or more avenues

to ameliorate the problem, negotiating an acceptable approach to sanctions and/or

compensation, trading off some items in the mix of trade issues, and, most importantly, taking tax issues out of the disputes settlement process. When dealing with

the question of sanctions, it needs to be made clear that since the European Union

is tying its figures to the ETI tax cost figure, as this number drops, the authorized

sanctions number drops as well.

Congress Should Not Repeal ETI

The U.S. has never wanted simply unilaterally—without the Europeans and others dropping their subsidization of their exporters—to drop its tax rules favoring exporters. President Nixon and Congress helped exporters in 1971 with DISC; President Reagan and Congress helped in 1984 with FSC; President Clinton and Congress, with remarkable unanimity, helped exporters in 2000 with ETI.7 President

Bush and this Congress should not be the ones to preside over defeat.

Some might say that encouraging exporters to proceed under existing non-ETI is

an unusual step under these circumstances. But one should recall that DISC was

a highly unusual step in 1971, on the heels of enactment of Subpart F and the

changes in the section 482 regulations. The conversion of DISC to FSC in 1984 was

probably the most remarkable of all the steps because it necessitated constructing

from whole cloth a unique set of statutory rules, followed by hundreds of pages of

regulations. Enactment of ETI and the effort that went into accommodating the concerns of our competitors was, as we all know, truly extraordinary. In this light,

avoiding the current problem, which is pressed on us by our competitors, and reducing tensions among the parties by fostering a set of rulings or Pre-Filing Agreements is not very remarkable. It is relatively simple. It does not require a great deal

of time and effort; indeed, very little effort on the part of Congress is called for. And

in a very appropriate way it ‘‘buys time’’ for the development of more comprehensive

measures.

Exporters Should Be Encouraged To Solve The Problem Under Existing,

Non-ETI Law

Treasury and the IRS should work with groups of exporters, such as trade associations and groups sponsored by State Development Offices, to conclude Pre-Filing

Agreements or Private Letter Rulings with the IRS. These PFAs or PLRs would determine how exporters that operate through a multiple ownership or ‘‘shared’’ foreign corporation will be taxed. The resulting business structure is similar to that

used with Shared FSCs, under the FSC provisions, and Shared Partnerships, under

the new ETI rules. Companies successfully used Shared FSCs over a 14-year period.

The two tax-writing committees, the House Ways and Means Committee and the

61

8There may well be more than one way of achieving this end. Also, there doubtless will need

to be modifications for different situations, including ones involving leasing and cooperatives.

Senate Finance Committee, together with the Administration, should encourage this

approach.

By joining in groups, the companies can best deal with the pricing and allocation

rules and the rules in section 245(a) for a 70% dividends-received deduction. The

details can be worked out in the context of the PFA or PLR.8

Foreign countries, including Barbados, have expressed a willingness to work with

these groups in order to arrive at a practical solution.

This approach springs from the fact that the United States has repeatedly argued

that FSC, and now ETI, is not a radical departure from our ‘‘normal’’ international

tax rules. These provisions made it easier for U.S. companies to comply, but they

are not the only avenues available.

Since Exporters Would Not Be Relying Upon The ETI Provisions And No

New Special Tax Rules Would Be Needed, There Is No Subsidy For Our

Trade Competitors To Complain About; Nor Would There Be Any Special

Treatment Afforded In The Form Of A Ruling Or Audit Practice

Under the proposed approach, the U.S. would be in a position to demonstrate,

using actual tax numbers taken from taxpayers’ returns, that the amount of tax

benefits claimed under ETI (section 114 of the Code) has dropped dramatically. It

will have dropped because exporters will have gone through the PFA or PLR process.

If the EU wishes to continue to raise objections, we strongly recommend that the

U.S. attack the notorious rulings practices of The Netherlands, France and other

countries, which help their exporters.

This Approach Is Not For Smaller And Medium-Size Companies Only

While only a handful of large companies in the past participated in any form of

shared entity, the approach being suggested certainly applies to large companies as

well as smaller companies. Large companies can form their own groups based on

any number of factors, joining with unrelated companies near their geographic location or in their industry. If they wish, they can help with the day-to-day operations

of the entity; in fact, this can be a significant contribution to the effort.

When this approach was first ‘‘floated’’ in 2000, companies thought that the ETI

changes would provide the solution. This has turned out, unfortunately, not to be

the case. Now a number of large exporters have indicated a willingness to travel

down this road.

MULTIPLE OWNERSHIP; THE NEED FOR CONTINUED SUPPORT

It needs to be reiterated that whatever approaches are contemplated in the future, these approaches should accommodate U.S. exporters that wish to band together in a shared entity of some sort. These provisions have always existed—with

DISCs, FSCs and the ETI regime. They should continue to exist. They help medium

size and smaller companies that cannot afford the time and expense of ‘‘going it

alone.’’ It is a way of ‘‘outsourcing,’’ in a fashion, some of the international aspects

of their business. Also, these provisions are used by trade associations and state

trade development offices to help their members and constituents.

Shared FSCs and Shared Partnerships under the ETI rules, by their nature, perform greater services for the exporters and have a greater presence in the foreign

jurisdiction.

It is interesting that neither the ETI Panel Report nor the ETI Appellate

Body decision makes any mention of shared partnerships or shared FSCs. The

FSC Panel Reports simply states: In addition many US States, regional authorities, trade associations, or private businesses sponsor ‘‘shared FSCs’’ for their

companies, members or customers. A ‘‘shared FSC’’ is a FSC which is ‘‘shared’’

by 25 or fewer unrelated exporter ‘‘shareholders’’, so as to reduce the costs while

obtaining the full tax benefit of a FSC. Each exporter-shareholder owns a separate class of stock and each runs its own business as usual. The US Department

of Commerce grants written Export Trade Certificates to shared FSCs that

allow US exporters to engage in joint export conduct with other US companies.

Certified exporters are virtually immune from all federal and state government

antitrust action.

The FSC Appellate Body report pays the subject even less attention: ‘‘We note

here that special rules apply inter alia in the case of agricultural cooperatives, small

62

FSCs, shared FSCs, FSCs owned by individual rather than corporate shareholders,

and transactions involving military property.’’

The WTO appears not to be aware of the potential for shared or grouped entities

to perform the operations of a true trading company, much like a trading company

acting on behalf of Dutch, French or Japanese companies.

MTIS is a FSC-ETI management company that manages solo and shared entities,

some of which are ‘‘sponsored’’ by organizations, such as the Delaware Economic Development Office, the Pennsylvania Office of International Trade and the National

Association of Manufacturers. Over the last 16 years, MTIS and its subsidiary have

helped approximately 500 exporters utilize the relevant benefits. Annually its companies export around $500 million in total. These companies represent a broad spectrum of exporters from small (a couple of million dollars of gross receipts from exports) to medium size (approximately $50 million gross receipts from exports). The

items of export range from automobile parts to fishing line, and they include agricultural and forest products.

The Tax Committee of MTIS is represented by Ms. Deborah Fehr-Niswanger

(Military Truck Parts, Inc., Many, Louisiana), Brian Ward (Cortland Line Company,

Inc., Cortland, New York), and John Andrews (QSC Audio Products, Inc., Costa

Mesa, California). Military Truck Parts, Inc. sells and services specialty vehicles including trucks and Hummers. Cortland Line Company, Inc. manufactures and sells

fishing line and related equipment. QSC Audio Products, Inc. manufactures, sells

and installs professional audio equipment including fully integrated audio systems.

WGA, which is headquartered in Irvine, California, is the largest and most active

regional fresh produce trade association in the United States. Its members grow,

pack and ship over 90% of the fresh vegetables and 60% of the fresh fruit grown

in California and Arizona. The actual items (carrots, tomatoes, broccoli, citrus, lettuce, etc.) number in excess of 250; and they constitute over 50% of the fresh

produce grown in the United States. They are shipped throughout Europe and Asia,

as well as Canada and Mexico. WGA began creating shared FSCs for its members

in 1992. Since that time, it estimates that its members have shipped over $1.5 billion through its shared entities. Approximately 95 companies participate in the

WGA export program. The smallest of these has exports of around $400,000.

Questions concerning this testimony can be directed to Charles M. Bruce (1–202–

965–5300)

Æ