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79–971 2002

WTO’S EXTRATERRITORIAL INCOME DECISION

HEARING

BEFORE THE

COMMITTEE ON WAYS AND MEANS

HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

FEBRUARY 27, 2002

Serial No. 107–67

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

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

Advisories announcing the hearing ........................................................................ 2, 3

WITNESSES

U.S. Department of the Treasury, Barbara Angus, International Tax Counsel 7

Office of the United States Trade Representative, Peter Davidson, General

Counsel .................................................................................................................. 12

Institute for International Economics, Gary Hufbauer ........................................ 45

Merrill, Peter R., Pricewaterhousecoopers LLP, and International Tax Policy

Forum .................................................................................................................... 51

Shay, Stephen E., Ropes & Gray, and Harvard Law School ................................ 62

SUBMISSIONS FOR THE RECORD

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

Irvine, CA, joint statement .................................................................................. 87

National Foreign Trade Council, William A. Reinsch, statement ....................... 89

(1)

WTO’S EXTRATERRITORIAL INCOME

DECISION

WEDNESDAY, FEBRUARY 27, 2002

HOUSE OF REPRESENTATIVES,

COMMITTEE ON WAYS AND MEANS,

Washington, DC.

The Committee met, pursuant to notice, at 10:45 a.m., in room

1100 Longworth House Office Building, Hon. Bill Thomas (Chairman of the Committee) presiding.

[The advisory and revised advisory announcing the hearing follow:]

2

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE CONTACT: (202) 225–1721

February 19, 2002

No. FC–16

Thomas Announces a Hearing on

WTO’s Extraterritorial Income Decision

Congressman Bill Thomas (R–CA), Chairman of the Committee on Ways and

Means, today announced that the Committee will hold a hearing on the World

Trade Organization’s (WTO’s) decision that the United States’ Extraterritorial Income Exclusion Act (ETI) is a prohibited export subsidy. The hearing will take

place on Wednesday, February 27, 2002, in the main Committee hearing

room, 1100 Longworth House Office Building, beginning at 10:00 a.m.

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 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 (FSC) 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 $956 million. The Arbitration Panel will issue its determination by the end of

April 2002.

In announcing the hearing, Chairman Thomas stated: ‘‘Although the most recent

decision comes as no surprise, it illustrates the need to fundamentally reform our

tax system so that U.S. workers, farmers and businesses are not disadvantaged in

international trade. This will be the first of several hearings to consider the WTO

Appellate Panel decision and to examine ways to maintain the international competitiveness of the United States.’’

FOCUS OF THE HEARING:

The hearing is expected to (1) outline the history of the FSC–ETI dispute, (2) analyze the January 14, 2002, WTO Appellate Panel Decision, and (3) discuss the potential trade ramifications of the decision.

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, March 13, 2002.

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

3

the press and interested public at the hearing should deliver their 300 copies to the

full Committee in room 1102 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. Failure to do

so may result in the witness being denied the opportunity to testify in person.

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.

* * * NOTICE—

fCHANGE IN TIME * * *

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE CONTACT: (202) 225–1721

February 26, 2002

No. FC–16 Revised

Change in Time for Committee Hearing on

WTO’s Extraterritorial Income Decision

Congressman Bill Thomas (R–CA), Chairman of the Committee on Ways and

Means, today announced that the Committee hearing on the World Trade Organization’s decision that the United States’ Extraterritorial Income Exclusion Act is a

prohibited export subsidy, scheduled for Wednesday, February 27, 2002, at 10:00

a.m., in the main Committee hearing room, 1100 Longworth House Office Building,

will now be held at 10:30 a.m.

4

All other details for the hearing remain the same. (See Committee Advisory No.

FC

Good morning. As the world

Chairman T

–16, dated February 19, 2002.)

HOMAS. If our guests will find their seats, please.

f’s largest importer and the world’s largest exporter, an orderly international trading system is crucial to

the economic success of the United States. Given our global leadership, it is important that America complies with the established

rules of engagement that the World Trade Organization (WTO) referees. It is in our interest that others follow the rules and therefore, it is imperative that we follow the rules as well.

To that end, we must carefully and thoroughly address the problems created at the intersection of our Tax Code, and our international trade obligations. On January 14 of this year, the WTO

issued an appellate ruling that the U.S. Tax Code provides an export subsidy. This decision marks the fourth time that the WTO

has ruled this way, twice in the foreign sales corporation (FSC)

case and now twice in the extraterritorial income (ETI) case. Four

times the WTO has sent the United States this same clear message. Our tax system, as it is currently constituted, violates international trade rules. In the opinion of the Chairman of this Committee, the time has come for us to listen.

Our corporate tax structure is in need of major restructuring, not

another attempt at a short-term fix. More fundamental reform is

required. In an economy struggling to recover, the United States

cannot afford to dismiss the Europeans’ proposed 4 billion, 3 billion, 2 billion, 1 billion, pick-a-number retaliation as an empty

threat. Many people said the Europeans would never challenge us

on this portion of the Code because they would be damaged as well.

It has even been called a nuclear weapon. Well, it has been triggered. It is not an empty threat.

U.S. Trade Representative (USTR) Robert Zoellick is forcefully

challenging the European Union’s (EUs) assessment of harm, but

if we do nothing, trade sanctions against our country remain a distinct possibility. The European Union has graciously indicated that

it will be reasonably patient and that it does recognize the difficulty of changing our corporate Tax Code. The Congress and I believe this Administration must also demonstrate its commitment to

address the problem. It is not an easy task. It will require collaboration from all Members of this Committee, Republican and Democrat. We must build a consensus on a new approach that will meet

our international obligations while maintaining the competitiveness of American businesses and workers in the global marketplace.

It will be impossible to recreate a system which duplicates the

current winners. But we must act in good faith. And we must begin

this difficult process now. Today’s hearing, where we will discuss

the history of the foreign sales corporation dispute, the January 14

appellate body decision and the threat of retaliation, marks the beginning of this process. Yet no discussion of history, no attempt to

justify the correctness of the U.S. position can be a beginning, a beginning begins with the realization that the previous attempts

have failed.

5

One chapter has been closed. We need to open a new one. Following the full Committee hearing, the Subcommittee on Select

Revenue will hold a series of hearings to examine options in reforming America’s corporate tax structure. To give you an idea of

how difficult that will be, we have a second panel today in which

there are some suggested options, and my assumption is there will

be an examination of the viability of some of those options. This is

never pleasant. It is always difficult. The United States believes

that we should set our own course, but we are a partner among

partners and we have to start with the recognition that we have

to change. And with that, does the gentleman from New York wish

to make any opening remarks.

[The opening statement of Chairman Thomas follows:]

Opening Statement of the Hon. Bill Thomas, a Representative in Congress

from the State of California, and Chairman, Committee on Ways and Means

Good morning. As the world’s largest importer and exporter, an orderly international trading system is crucial to the economic success of the United States.

Given our global leadership, it is important that America complies with the established rules of engagement that the World Trade Organization (WTO) referees. It

is in our interest that others follow the rules and therefore it is imperative that we

follow the rules as well.

To that end, we must carefully and thoroughly address the problems created at

the intersection of our tax code and our international trade obligations.

On January 14th of this year, the WTO issued an appellate ruling that the U.S.

tax code prohibits an export subsidy.

This decision marks the fourth time that the WTO has ruled this way, twice in

the Foreign Sales Corporation (FSC) case and now twice in the Extraterritorial Income (ETI) case.

Four times the WTO has sent the United States this same clear message—our tax system as it is currently constituted violates international trade rules. In the

opinion of the Chairman of this committee, the time has come for us to listen. Our

corporate tax structure is in need of major restructuring, not another attempt at a

short-term fix. More fundamental reform is required.

In an economy struggling to recover, the United States cannot afford to dismiss

the European’s proposed $4 billion, $3 billion, $2 billion, $1 billion, pick a number—

retaliation as an empty threat. Many people said the Europeans would never challenge us on this portion of the code because they would be damaged as well. It has

even been called a nuclear weapon. Well, it’s been triggered. It is not an empty

threat. The United States Trade Representative Robert Zoellick is forcefully challenging the EU’s assessment of harm, but if we do nothing trade sanctions against

our country still remain a distinct possibility.

The EU has graciously indicated that it will be reasonably patient and that it

does recognize the difficulty of changing our corporate tax code, but Congress and,

I believe, this Administration must also demonstrate its commitment to address the

problem.

It’s not an easy task—it will require collaboration from all Members of this Committee, Republican and Democrat. We must build consensus on a new approach that

will meet our international obligations while maintaining the competitiveness of

American businesses and workers in the global marketplace.

It will be impossible to recreate a system, which duplicates the current winners,

but we must act in good faith, and we must begin this difficult process now.

Today’s hearing, during which we will discuss the history of the Foreign Sales

Corporation dispute, the January 14th Appellate Body Decision, and the threat of

retaliation, marks the beginning of this process. But no discussion of history, no attempt to justify the correctness of the U.S. position can be a beginning.

A beginning begins with the realization that previous attempts have failed. One

chapter has been closed and we need to open a new one. Following this full committee hearing, the Subcommittee on Select Revenue will hold a series of hearings

to examine options in reforming America’s corporate tax structure.

To give you an idea how difficult that will be we have a second panel today in

which there will be some suggested options. My assumption is there will be an examination of the viability of several of those options. This is never pleasant and it

is always difficult. The United States believes we should set our own course, but

6

we are a partner among partners and we have to start with the recognition that

we have to change.

more particularly this Committee, has taken a lot of pride in the

I now recognize the ranking member from New York for his opening statement.

Mr. RANGEL. Thank you, Mr. Chairman. This Congress, and

f bipartisanship in which we have handled trade and issues before

the World Trade Organization. This dispute has gone on for decades, but we as a Committee have stood solidly behind this and

previous Administrations in letting the World Trade Organization

understand our unanimity of thought in trying to get a fair and flat

playing field. Now it appears as though we may have reached an

impasse. And I would hope that this Administration would come to

this Committee with strong recommendations as to how we could

maintain the integrity of our tax system, and at the same time, fulfill our international obligations.

I am fearful, however, that this crisis that we face with the WTO

may be used as a political vehicle to bring back the days when rhetorically we talked about pulling up the Tax Code by its roots and

getting on buses going into communities and saying that we are

going to simplify the system. That is a very, very political road, and

I would hate to see our European friends think that our division

in thought as to what the Tax Code should or should not be would

give them an opportunity to go into these sanctions that they are

threatening us with.

I do hope we can continue the spirit of bipartisanship on this

issue that historically we found ourselves. But having heard the

Secretary of Treasury talk about proposals to repeal the corporate

tax, knowing the rhetoric about substituting consumption taxes for

our tax system, realizing the lack of progressivity on some of these

things, the Chairman said it would be difficult. I say these are very

explosive political issues. I don’t want the crisis that we face as a

nation and certainly the responsibilities that we have as a—as the

tax writing Committee for the entire Congress—to allow our political preferences to interfere with obligations to attempt to resolve

this problem. The Administration—the Administration can avoid a

train wreck on this. The Administration should be giving us guidelines on this.

If you let us get started on this before the election, you can bet

your life you are going to have a political problem. If, on the other

hand, you give us direction as to what we can do legislatively, well,

you do the best you can diplomatically, I think we can maintain

our tradition and move forward as a bipartisan Committee. Thank

you, Mr. Chairman.

[The opening statements of Mr. Crane and Mr. Ramstad follow:]

Opening Statement of the Hon. Phillip M. Crane, a Representative in

Congress from the State of Illinois

Mr. Chairman, I want to thank you for holding this very important hearing. As

you know, I have been a longtime advocate for the repeal of the corporate income

tax. Corporations don’t pay taxes, instead, they pass along this cost of doing business to consumers through higher prices. The ruling by the WTO that makes illegal

the FSC/ETI is the perfect hook for us to finally repeal this insidious tax scheme.

7

Unfortunately, there are those that will advocate for a new iteration of the FSC.

I believe that this would be a major mistake. We have already made three attempts

to write an export subsidy law that is WTO compliant and each time we have failed.

Clearly, the WTO discriminates against our tax system, which is income based, as

opposed to favoring those tax systems that are consumption based. It’s not secret

that the Europeans provide similar subsidies to their domestic corporations. Yet,

there can be no successful challenge to those schemes because of the underlying assumption that a consumption based system is de facto WTO compliant.

That leaves us in the position to advocate for either a total repeal of the corporate

tax or, in the alternative, fundamentally reforming the system with a territorial or

border-adjustable VAT tax. If we are unable to repeal the corporate tax, then I’ll

support a territorial system. But I still believe the repeal of the corporate tax is the

best alternative. No corporate tax means that foreign corporations will race to set

up shop in the United States. That means more jobs for American workers, less people on welfare, and more tax revenues for the Treasury. I challenge anyone to argue

with those outcomes.

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

from the State of Minnesota

f Mr. Chairman, thank you for holding this important hearing on the WTO’s decision that the United States’ Extraterritorial Income Exclusion Act (ETI) rules

amount to an illegal export subsidy.

The ETI structure, and its predecessors the Foreign Sales Corporation (FSC) and

the Domestic International Sales Corporation (DISC), were attempts to level the tax

playing field for American companies doing business overseas.

Our international competitors have territorial tax systems and many allow ValueAdded Tax (VAT) rebates for their companies’ exports. This structure is acceptable

to the WTO, while the U.S. system of worldwide taxation, which taxes the income

of American businesses regardless of where they are doing business, combined with

an ETI-like structure is unacceptable to the WTO.

While our U.S. trade team deals with the fallout from the WTO decision, we must

begin to examine whether the foundations of our worldwide tax system are sustainable if American businesses are to remain competitive in our global economy. We

already have too many examples of former U.S. companies that now are

headquartered overseas because of our burdensome international tax system. The

WTO’s most recent decision and the resulting sanctions facing our businesses is another wake-up call for reform.

I look forward to hearing from our witnesses today about possible short-term and

long-term solutions to the massive trade challenge we are now facing following the

WTO’s ruling.

hear the first word from the Administration on this issue, the two

Thank you, Mr. Chairman.

Chairman THOMAS. Thank you very much, Mr. Rangel. And to

f departments that are clearly focused on this issue is Barbara

Angus, the International Tax Counsel, Office of Tax Policy, U.S.

Department of the Treasury; and Peter Davidson, the General

Counsel of the U.S. Trade Representative. I want to thank you both

for appearing. Your written testimony will be made a part of the

record and you may address us as any way you see fit during the

time you have available. The microphones need to be turned on and

they are very uni-directional, so you need to be right in front of it

so we can hear you. So with that, Ms. Angus.

STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX

COUNSEL, U.S. DEPARTMENT OF THE TREASURY

Ms. ANGUS. Mr. Chairman, Congressman Rangel and distinguished Members of the Committee. I appreciate the opportunity to

8

appear today at this hearing on the World Trade Organization’s recent decision regarding the extraterritorial income exclusion provisions of the U.S. tax law.

On January 29, the WTO dispute settlement body adopted a final

report finding that the ETI provisions of the U.S. tax law are inconsistent with U.S. obligations under the WTO. We are all disappointed with this outcome.

This decision is the culmination of a challenge brought by the

European Union in late 1997 against the FSC provisions then contained in the U.S. tax law. However the origins of this dispute go

back almost 30 years, predating the WTO itself. The United States

has consistently and vigorously pursued this matter and defended

its laws through 3 decades because of the importance of the provisions and principles at stake. At its core, this case raises fundamental questions regarding a level playing field with respect to tax

policy. The ETI provisions, like the FSC provisions that preceded

them, represent an integral part of our larger system of international tax rules. These provisions were designed to help level the

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

international tax rules. As we contemplate our next steps and address this decision, we should not lose sight of that objective.

The Congress has demonstrated its commitment to the U.S. businesses, both large and small, that operate in the global marketplace and to the U.S. workers that produce the output that is sold

in markets around the world. The Congress took decisive action on

a bipartisan basis under significant time pressure in passing legislation in November, 2000, to respond to the first WTO decision in

this dispute by repealing the FSC provisions and enacting the ETI

provisions. That legislation represented a good faith effort to bring

the United States into compliance with its WTO obligations, while

at the same time protecting the level playing field for U.S. businesses.

To be facing this same issue again so soon is certainly a disappointment. Nevertheless, we must look forward and pursue all

options to resolve this matter so that American workers and the

businesses that employ them will not be disadvantaged. We have

a serious problem, and we need to develop a serious solution. Mr.

Chairman, the Administration looks forward to working closely

with the Congress to find a solution that will protect America’s interest and honor our obligations in the WTO. Given the focus of

this hearing, our written testimony today focuses on the particular

provisions of our tax law at issue, the history of the dispute in the

WTO over these provisions and the findings and analysis of the

WTO dispute settlement body. I would be happy to answer any

questions. Thank you very much.

Chairman THOMAS. Thank you, Ms. Angus. Mr. Davidson.

[The prepared statement of Ms. Angus follows:]

Statement of Barbara Angus, International Tax Counsel, U.S. Department

of the Treasury

Mr. Chairman, Congressman Rangel, and distinguished Members of the Committee, we appreciate the opportunity to appear today at this hearing on the World

Trade Organization’s recent decision regarding the extraterritorial income exclusion

(ETI) provisions of the U.S. tax law.

9

On January 29th, the WTO Dispute Settlement Body adopted a final report finding that the ETI provisions of the U.S. tax law are inconsistent with the United

States’ obligations under the WTO. We all are very disappointed with this outcome.

This decision is the culmination of a challenge brought by the European Union in

late 1997 against the foreign sales corporation (FSC) provisions then contained in

the U.S. tax law. However, the origins of this dispute go back almost 30 years, predating the WTO itself. The United States has vigorously pursued this matter and

defended its laws because of the importance of the provisions and principles at

stake.

At its core, this case raises fundamental questions regarding a level playing field

with respect to tax policy. Few things are as central to a country’s sovereignty as

the right to choose its own tax system. The ETI provisions, like the FSC provisions

that preceded them, represent an integral part of our larger system of international

tax rules. These provisions were designed to help level the playing field for U.S.-

based businesses that are subject to those international tax rules. As we contemplate our next steps, we should not lose sight of that.

The Congress has demonstrated its commitment to the U.S. businesses, both large

and small, that operate in the global marketplace and to the U.S. workers that

produce the output that is sold in markets around the world. The Congress took decisive action, under significant time pressure, in passing legislation in November

2000 to respond to the first WTO decision in this dispute by repealing the FSC provisions and enacting the ETI provisions. That legislation represented a good faith

effort to bring the United States into compliance with its WTO obligations while

protecting the level playing field for U.S. businesses.

To be facing the same issue again so soon certainly is a disappointment. Nevertheless, we must look forward and pursue all options to resolve this matter so that

American workers and the businesses that employ them will not be disadvantaged.

Mr. Chairman, the Administration looks forward to working closely with the Congress, on a bipartisan basis, to find a solution that will protect America’s interests

and honor our obligations in the WTO.

Our testimony today will focus on the particular provisions of our tax law at issue,

the history of the dispute in the WTO over these provisions, and the findings and

analysis of the WTO Dispute Settlement Body with respect to these provisions.

The Foreign Sales Corporation Provisions

The FSC provisions were enacted in 1984. They provided an exemption from U.S.

tax for a portion of the income earned from export transactions. This partial exemption from tax was intended to provide U.S. exporters with tax treatment that was

more comparable to the treatment provided to exporters under the tax systems common in other countries.

A FSC that elected to be subject to these provisions generally was a foreign subsidiary of a U.S. manufacturer. The U.S. manufacturer sold its products to the FSC

for resale abroad or paid the FSC a commission in connection with its sales of products abroad. In order to qualify for these provisions, the FSC was required to be

managed outside the United States and was required to conduct certain economic

processes outside the United States with respect to these export transactions. These

economic processes related to the solicitation, negotiation, and making of contracts

with respect to such transactions.

The sales or commission income of the FSC on these transactions was determined

under specified pricing rules. The exemption from tax applied to a portion of the

FSC’s income from sales and leases of export property and from related services.

The FSC was subject to current U.S. tax on the remainder of its income from these

transactions.

The FSC provisions were enacted to resolve a General Agreement on Tariffs and

Trade (GATT) dispute involving a prior U.S. tax regime—the domestic international

sales corporation (DISC) provisions enacted in 1971. Following a challenge to the

DISC provisions brought by the European Union and a counter-challenge to several

European tax regimes brought by the United States, a GATT panel in 1976 ruled

against all the contested tax measures. This decision led to a stalemate that was

resolved with a GATT Council Understanding adopted in 1981 (the ‘‘1981 Understanding’’). Pursuant to this 1981 Understanding regarding the treatment of tax

measures under the trade agreements, the United States repealed the DISC provisions and enacted the FSC provisions.

The WTO Decision Regarding the FSC Provisions

The European Union formally challenged the FSC provisions in the WTO in November 1997, thirteen years after their enactment. Consultations to resolve the matter were unsuccessful, and the EU challenge was referred to a WTO dispute resoluVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00013 Fmt 6633 Sfmt 6621 E:\HR\OC\A971.XXX pfrm01 PsN: A971
10

tion panel. In October 1999, the WTO panel issued a report finding that the FSC

provisions constituted a violation of WTO rules. The United States appealed the

panel report; the European Union also appealed the report. In February 2000, the

WTO Appellate Body issued its report substantially upholding the findings of the

panel.

Although the United States believed that the FSC provisions were blessed by the

1981 Understanding, the WTO panel completely dismissed this argument, concluding that the 1981 Understanding had no continuing relevance in the interpretation of current WTO rules. The panel’s analysis focused mainly on the application

of the WTO Agreement on Subsidies and Countervailing Measures. The panel found

that the FSC provisions constituted a prohibited export subsidy under the Subsidies

Agreement.

Under the Subsidies Agreement, a subsidy exists if (1) government revenue otherwise due is foregone and (2) a benefit is thereby conferred. The Subsidies Agreement

prohibits subsidies that are contingent, in law or in fact, on export performance.

Looking first at the subsidy issue, the panel concluded that three specific aspects

of the FSC provisions, taken together, resulted in an exception from taxation for income that otherwise would be subject to U.S. tax; the panel therefore concluded that

the FSC provisions resulted in foregone government revenue through which a benefit was conferred. The panel then concluded that this subsidy provided by the FSC

provisions was export-contingent, and therefore prohibited, because the tax treatment under the FSC provisions depended upon the exportation of U.S. goods. The

panel further found that the FSC provisions constituted an export subsidy in violation of the WTO Agreement on Agriculture. The panel declined to rule on the European Union’s additional arguments that the pricing rules and ‘‘domestic content’’

rules contained in the FSC provisions constituted separate violations of the WTO

rules. The panel recommended that the subsidy provided by the FSC provisions be

withdrawn with effect from October 1, 2000 (which date was later extended to November 1, 2000, under a procedural agreement between the parties).

The Extraterritorial Income Exclusion Provisions

In response to the WTO decision against the FSC provisions, the FSC Repeal and

Extraterritorial Income Exclusion Act was enacted on November 15, 2000. This legislation had been voted out of this Committee with a vote of 34 to 1, and was passed

by the House with a vote of 316 to 72. The legislation repealed the FSC provisions

and adopted in their place the ETI provisions. The legislation was intended to bring

the United States into compliance with WTO rules by addressing the analysis reflected in the WTO decision. The new regime addressed the subsidy issue by establishing a new general rule of taxation under which extraterritorial income is excluded from gross income; the new regime addressed the export-contingency issue

by applying to income from all foreign sales and leases of property, without regard

to where the property is manufactured. At the same time, the legislation also was

intended to ensure that U.S. businesses not be foreclosed from opportunities abroad

because of differences in the U.S. tax laws as compared to the laws of other countries.

The ETI provisions provide an exclusion from U.S. tax for certain extraterritorial

income. This exclusion applies to a portion of the taxpayer’s income from foreign

sales and leases and certain related services. The ETI provisions apply to foreign

sales and leases of property manufactured in the United States and also to foreign

sales and leases of property manufactured outside the United States. In the case

of property manufactured outside the United States, the manufacturer either must

be subject to the taxing jurisdiction of the United States or must elect to subject

itself to such jurisdiction. Thus, the income from transactions to which the ETI provisions apply is subject to consistent U.S. tax treatment.

Unlike the FSC provisions, the ETI provisions do not require the filing of an election or the formation of a special entity to which sales are made or commissions

are paid. Also unlike the FSC provisions, the ETI provisions apply to both corporations and individuals in the same manner.

The exclusion provided under the ETI provisions generally is available only if certain economic processes are conducted outside the United States. As under the FSC

provisions, these economic processes relate to the solicitation, negotiation, and making of contracts. A portion of the income from foreign transactions covered by the

ETI provisions is exempt from U.S. tax. Because this exclusion is an alternative approach to addressing potential double taxation, foreign tax credits are not allowed

with respect to the excluded income.

11

The WTO Decision Regarding the ETI Provisions

Immediately following the enactment of the ETI Act, the European Union brought

a challenge in the WTO. In August 2001, a WTO panel issued a report finding that

the ETI provisions also violate WTO rules. The panel report contained sweeping language and conclusory statements that had broad implications beyond the case at

hand. Because of the importance of the issues involved and the troubling implications of the panel’s analysis, the United States appealed the panel report.

The WTO Appellate Body generally affirmed the panel’s findings. However, significantly, the Appellate Body modified and narrowed the panel’s analysis. The Dispute Settlement Body adopted the report as modified by the Appellate Body on January 29, 2002.

The Appellate Body report makes four main findings with respect to the ETI provisions: (1) the ETI provisions constitute a prohibited export subsidy under the WTO

Subsidies Agreement; (2) the ETI provisions constitute a prohibited export subsidy

under the WTO Agriculture Agreement; (3) the limitation on foreign content contained in the ETI provisions violate the national treatment provisions of Article III:4

of GATT; and (4) the transition rules contained in the ETI Act violate the WTO’s

prior recommendation that the FSC subsidy be withdrawn with effect from November 1, 2000.

Prohibited Export Subsidy Under the Subsidies Agreement

The analysis of the prohibited export subsidy under the Subsidies Agreement involved three separate issues.

First, the Appellate Body found that the ETI provisions constitute a subsidy

under Article 1.1(a)(ii) of the Subsidies Agreement. The Appellate Body compared

the ETI exclusion to the tax rules that otherwise would have applied to income from

this type of transaction. Based on that analysis, the Appellate Body found that the

ETI exclusion constitutes the ‘‘foregoing of revenue which is ‘otherwise due’,’’ that

it confers a benefit, and that it is therefore a subsidy.

Second, the Appellate Body found that the ETI provisions are export contingent

because of the provisions’ application only to income from transactions involving

property that is sold, leased, or rented for direct use, consumption, or disposition

outside the United States. As did the lower panel, the Appellate Body bifurcated the

ETI provisions, separating the application to transactions involving property produced within the United States from the application to transactions involving property produced abroad. For property produced within the United States, the foreign

use requirement could be met only by exporting the property. Based on this bifurcation, the Appellate Body found that the ETI provisions are export contingent with

respect to domestically produced products. This conclusion was not affected by the

fact that the ETI provisions apply in circumstances that are plainly not export contingent (i.e., with respect to property produced outside the United States and sold

for use outside the United States).

Third, the Appellate Body rejected the U.S. argument that the ETI provisions constitute a permitted measure for avoidance of double taxation. The United States believed that the ETI provisions fell within the fifth sentence of footnote 59 of the Subsidies Agreement which effectively permits a country to ‘‘tak[e] measures to avoid

the double taxation of foreign-source income,’’ even if the measures constitute export

subsidies. The Appellate Body found that footnote 59 applies only to ‘‘foreign-source

income’’ and that, to be considered ‘‘foreign-source income,’’ the income must have

sufficient links to another country that the income could be taxed by that other

country. The Appellate Body further viewed the ETI provisions as potentially applying to income that would not fall within the reach of this rule as so interpreted.

Therefore, the Appellate Body found that the ETI provisions do not constitute a

measure to avoid double taxation under footnote 59.

Export Subsidy Under the Agriculture Agreement

Because the Appellate Body held that the ETI provisions constitute a prohibited

export subsidy under the Subsidies Agreement, it followed that the ETI provisions

also violate the export subsidy provisions of the WTO Agriculture Agreement.

National Treatment Under GATT Article III:4

The Appellate Body affirmed the panel’s finding that the 50 percent limitation on

foreign articles and direct labor costs contained in the ETI provisions violates GATT

Article III:4. The Appellate Body dismissed the U.S. factual point that taxpayers

may meet this requirement without using any U.S. content whatsoever. The Appellate Body found that this limitation in the ETI provisions represents an encouragement of domestic manufacturers to use domestic over imported components, thereby

12

providing less favorable treatment to imported products than to like domestic products.

Withdrawal of FSC Benefits

The Appellate Body also rejected the transition rules included in the ETI Act,

finding no basis for permitting the continuance of the application of the FSC provisions beyond the November 1, 2000 date specified for withdrawal of the subsidy

found to have been provided by the FSC provisions. The Appellate Body rejected the

U.S. position that efficient and fair administration of the tax laws frequently requires tax legislation to include transition rules and binding contract relief for taxpayers that acted in reliance on the prior law provisions.

Current Arbitration Proceeding

When it challenged the ETI Act in November 2000, the European Union simultaneously requested authority from the WTO to impose trade sanctions on $4.043 billion worth of U.S. exports. The United States responded by initiating a WTO arbitration proceeding on the grounds that the amount of trade sanctions requested by

the European Union was excessive under WTO standards. This arbitration was suspended pending the outcome of the European Union’s challenge to the WTO-consistency of the ETI Act, and resumed on January 29th with the Dispute Settlement

Body’s adoption of its final report. The parties are filing written submissions and

will meet with the arbitration panel, which will issue its report on the appropriate

level of trade sanctions on April 29th. Following adoption of that report, the European Union will be authorized to begin imposing trade sanctions on U.S. exports up

to the level set by the arbitrators.

OFFICE OF THE UNITED STATES TRADE REPRESENTATIVE

STATEMENT OF PETER DAVIDSON, GENERAL COUNSEL,

f Mr. DAVIDSON. Thank you, Mr. Chairman, Representative Rangel, and Members of the Committee. It is a pleasure to be here

today. I do apologize in advance for my voice. I am working on a

little cold here, so I will try to speak as loudly as I can or put it

in my mouth here. But I do appreciate the opportunity to be here

to talk about this issue, a dispute between the United States and

the EU on the FSC and then the ETI case. As my detailed statement does go into somewhat more length on the historical record,

I will try to be brief here in my remarks about where we are going

to be going and be happy to answer any questions.

Ambassador Zoellick has said on a number of occasions in the

past year, noting the seriousness of the dispute with its potentially

large financial implications for U.S. companies, as the Chairman

noted last May, he likened the issue to a trade nuclear bomb

which, if not treated with the utmost care, could cause enormous

damage to the U.S.-EU relationship, and perhaps the trading system more generally.

Mr. Chairman, I agree with you we cannot treat the threat of retaliation as an empty threat. Ambassador Zoellick stated in his

joint press conference with Trade Commissioner Lamy of the EU

last month that the United States intends to seek to resolve this

dispute in a spirit of good faith, and that we intend to respect our

WTO obligations.

Mr. Chairman, as you noted, you can forcefully challenge the

amount at issue. And the arbitration phase will also work cooperatively to show the progress necessary to prevent retaliation. I hope

we can work through our differences with the EU in a way that

will result in a true level playing field with respect to taxation, but

it will be a difficult road and one that will require patience on all

13

sides. The solution will be found in an appreciation of the need to

move the global trading system forward to advance the U.S.-EU

trading relationship overall, and at the same time, to find a solution to this dispute within which all parties can prosper.

I understand that the primary purpose of today’s hearing is to

review the history of this important case, and therefore I hope my

comments will provide the Committee with a bit of context, both

historical and WTO procedural, to help establish a framework for

future discussions.

As we approach April 15, I am also reminded to provide another

caveat that I am very far from a tax expert on any of these issues,

and so I will defer most of those questions to the Treasury. But I

will try to clarify some of the highlights if I can.

Barbara Angus just went through the history of the dispute. It

is a long history. As the Chairman noted, it is history. And so I will

not go through that about each of those stages at this point. A detailed account is in my written testimony. But to summarize, essentially since 1997, the FSC, and later the ETI, with both twice

judged by the WTO, found to be an illegal export subsidy under

WTO rules. The latest chapter began with the WTO panel finding

against the ETI Act in August of 2001. After consulting extensively

with Congress and the private sector last November, we proceeded

to appeal the latest panel result challenging all of the panels’ ultimate findings with respect to the ETI Act.

We chose to appeal even though we are not optimistic of achieving a reversal of all the panels’ findings, we thought we could perhaps obtain greater clarity from the appellate body. The appellate

bodies’ report was formally adopted on January 29. At that point,

the arbitration proceeding which had been suspended by mutual

agreement with the EU in November of 2000 for purposes of determining the level of countermeasures to which the EU is entitled,

resumed.

A WTO arbitration proceeding normally takes no more than 60

days. In this case, the arbitrators have informed us that they expect to take until April 29 to finish their work and issue their determination on the authorized maximum level of countermeasures.

The EU and United States have, in recent days, submitted to the

arbitrators our respective arguments on the appropriate maximum

level for authorized countermeasures in this case. The EU is expected, and has argued, should be allowed to adopt countermeasures with a value of up to $4.043 billion. The EU essentially

claims that this amount is reasonable because it estimates the actual effects of the ETI to be far greater than this amount.

In contrast, the United States holds that the EU should only be

entitled to countermeasures totaling from $1 billion to $1.1 billion,

depending on the base year chosen. This represents appropriately,

in our view, the proportion of the FSC ETI subsidy that applies to

the EU based on the EU’s share of total nongoods production

worldwide. If the arbitrators find that the EU is entitled to countermeasures in some amount, the EU would be in the same position to ask for WTO authority to impose countermeasures sometime in May.

However, there is no deadline by which the EU must request this

nor is there any deadline by which the EU must impose counterVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00017 Fmt 6633 Sfmt 6602 E:\HR\OC\A971.XXX pfrm01 PsN: A971
14

measures once the authority is received. The European Commission (EC) in the fall of 2000 notified the WTO that it would seek

authorization, when appropriate, to increase tariffs on U.S. exports

to be selected from a very broad potential list. To date, we are unaware of any further-refined list of potential targets by the Commission.

Throughout the WTO dispute settlement process, we have maintained our contacts with EU counterparts with a view toward managing the dispute in a manner that does not disrupt the general

progress being made in international trade liberalization. Ambassador Zoellick and Commissioner Lamy have met numerous times

and with other counterparts in the European Commission Member

States.

Mr. Chairman, I hope that this thumbnail sketch of our origin

and current status of the dispute will prove useful in forming the

Committee’s future consideration of these issues. Given our understanding of the Committee’s objectives for this hearing, I have refrained from going too far into thinking on how to move the topic

forward in the coming weeks and months, but we look forward to

working closely with Congress, the private sector, and in particular, this Committee, in developing ideas on how to respond to

the WTO ruling and other aspects of this important issue. Thank

you. And I would be happy to take any questions that the Committee would have.

[The prepared statement of Mr. Davidson follows:]

Statement of Peter Davidson, General Counsel, Office of the United States

Trade Representative

Mr. Chairman, Representative Rangel, and Members of the Committee:

I would like to thank you for the opportunity to testify before the Committee

today on the dispute between the United States and the European Union (EU) in

the World Trade Organization, first over the Foreign Sales Corporation (FSC) rules

of the U.S. tax code, and most recently over the FSC Repeal and Extraterritorial

Income Exclusion Act of 2000 (ETI Act).

Ambassador Zoellick has on a number of occasions in the past year noted the seriousness of this dispute and its potentially large financial implications for U.S. companies. In Strasbourg, France, last May, Ambassador Zoellick likened the issue to

a trade ‘‘nuclear bomb,’’ which, if not treated with the utmost care, could cause enormous damage to the U.S.-EU relationship and perhaps the trading system more

generally. There has certainly been no lack of expressions of concern coming in recent months to USTR from the private sector, other agencies, and of course the Congress emphasizing the need to find a way through the dispute that avoids EU retaliation.

As Ambassador Zoellick stated in his joint press conference with EU Trade Commissioner Lamy last month, the United States intends to seek to resolve this dispute in a spirit of good faith. He also said that we intend to respect our WTO obligations and seek to come into compliance with the WTO ruling.

I am hopeful that we will work through our differences with the EU in a way that

will result in a true level playing field with respect to taxation. But it will be a difficult road, and one that will require patience on all sides. The solution will be

found in an appreciation of the need to move the global trading system forward, to

advance the U.S.-EU trading relationship overall, and at the same time, to find a

solution to this dispute within which all parties can prosper.

All this being said, I understand that the primary purpose of today’s hearing is

to review the history of this important case. Therefore I hope my comments will provide the Committee with a bit of context, both historical and WTO/procedural, to

help establish a framework for future discussions. The approach of April 15th reminds me that I need to underscore to you my lack of credentials as an expert on

tax questions. However, I will do my best to make clear a rather complicated story.

15

History

The U.S.-EU disagreement over FSC/ETI in fact has been simmering for a long

time. Indeed, the case began with a challenge in 1972 under the General Agreement

on Tariffs and Trade (GATT) by the then European Economic Community (EC) to

the Domestic International Sales Corporation (DISC) provisions of U.S. tax law,

forerunner to the FSC. The EC’s challenge alleged that the DISC rules constituted

an export subsidy that was prohibited under the GATT. In its defense, the United

States contended that the DISC in essence operated no differently from methods of

exempting foreign-source income used by the tax regimes of EC Member States Belgium, France and the Netherlands. In the U.S. view, the DISC simply ‘‘looked different’’ from European approaches because it operated within the U.S. worldwide (or

residence-based) system of income taxation as opposed to European-style territorial

tax systems. The United States proceeded to bring its own GATT disputes against

the three EC Member States.

In 1976, a GATT dispute settlement panel ruled against the DISC and the three

European tax regimes, finding that each allowed exports to be taxed more favorably

than comparable domestic transactions. In 1981, the panel’s findings were adopted

by the GATT Contracting Parties, together with an Understanding which essentially

overturned the legal conclusions of the panel with respect to the European systems.

In 1984, the United States enacted the FSC legislation, claiming in the GATT that

the new U.S. tax rules conformed to the principles elaborated in the 1981 Understanding. Though the EC and Canada promptly requested GATT dispute settlement

consultations on the new FSC, and joint consultations were held with these trading

partners in 1985, neither Canada nor the EC thereafter chose to pursue the matter

further in the GATT.

Ten years later, in 1995, the WTO came into existence, along with a new Subsidies Agreement. In 1997, the EC, now the EU, requested WTO dispute settlement

consultations with respect to the FSC. In 1998, a WTO dispute settlement panel

was established to consider the EU’s complaint. In developing the U.S. defense in

the case, USTR worked closely with the Treasury Department and private sector

representatives of FSC users. The U.S. brief covered a range of technical areas, but

the key U.S. arguments were:

• The FSC exempted income attributable to foreign economic activities, as expressly permitted by the 1981 Understanding; and • In substance, if not form, the FSC was no different from the territorial exemption method used by many European countries. Like the DISC, it simply ‘‘looked

different’’ due to the different nature of the U.S. tax system.

In 1999, the WTO panel issued its report, finding the FSC to be a prohibited export subsidy under both the WTO Subsidies and Agriculture Agreements. Essentially, the panel found that the FSC was an export-specific exemption from otherwise applicable U.S. tax rules. The panel also found that because the 1981 Understanding did not form part of the WTO rules on subsidies, there was no exception

for tax measures that exempted income attributable to foreign economic activities.

As a result, the panel did not make findings as to whether the FSC actually did

exempt foreign-source, as opposed to domestic-source, income. Also on grounds of judicial economy, the panel did not address the EU’s challenges to the FSC administrative pricing rules, which were alleged to be inconsistent with the arm’s length

principle; and to the FSC definition of ‘‘export property,’’ which was alleged to violate the WTO prohibition against subsidies contingent upon the use of domestic over

imported goods. The panel said that the United States should withdraw the FSC

subsidy effective October 1, 2000.

The United States appealed the panel decision, but in February 2000, the WTO

Appellate Body affirmed the panel’s findings, although it modified its reasoning

somewhat. Through the summer of 2000, Congress and the former Administration

worked on replacement legislation. The parameters for this legislation were: (1) no

significant revenue consequences; (2) no significant diminution of existing FSC benefits; and (3) WTO-consistency.

During this time the former Administration also attempted to engage the EU in

discussions on what could go into the replacement legislation that would alleviate

EU WTO concerns. Former Deputy Secretary of the Treasury Eizenstat visited

Brussels in May 2000 and met with EU Trade Commissioner Pascal Lamy. Unfortunately, the European Commission declined to enter into substantive discussions of

what the new legislation should look like, claiming that the EU was not in a position to advise the United States on how to write its tax laws and insisting that compliance with WTO rules was the only criterion that mattered to the EU.

After an intense several months of consultations between Congress, the Administration and the private sector, Congress in November 2000 enacted the FSC Repeal

16

and Extraterritorial Income Exclusion Act of 2000 (ETI Act). The EU promptly challenged the ETI Act as an inadequate response to the earlier panel findings. At the

same time, it requested authority from the WTO to withdraw WTO concessions to

the United States (i.e., impose countermeasures) in the amount of over $4 billion,

in line with the EU’s calculation of the amount of the subsidy provided by the FSC

rules. However, under a procedural agreement the Administration had negotiated

with the EU in September 2000, a WTO arbitration proceeding to determine the

amount of countermeasures to which the EU actually was entitled was suspended

pending the outcome of the EU’s challenge to the WTO-consistency of the ETI Act.

In August 2001, the WTO panel issued its report, finding against the ETI Act.

Specifically, the panel found that:

• The ETI Act’s exclusion from taxation of certain extraterritorial income constitutes a prohibited export subsidy under the Subsidies Agreement. • The tax exclusion is not protected as a measure to avoid double taxation of foreign-source income within the meaning of footnote 59 to the Subsidies Agreement. • The tax exclusion constitutes an export subsidy in violation of U.S. obligations

under the Agreement on Agriculture. • The ETI Act’s 50 percent rule regarding certain foreign value violates the national treatment provisions of Article III:4 of GATT 1994. • The ETI Act’s transition rules resulted in a failure to withdraw the FSC subsidies by the recommended date. • On grounds of judicial economy, the panel did not address the EU’s claims that

the 50 percent rule rendered the tax exclusion a prohibited import substitution

subsidy under the Subsidies Agreement.

Where We Are Today

After consulting extensively with the Congress and the private sector, on October

15, 2001, we filed a notice of appeal, challenging all of the panel’s ultimate findings

with respect to the ETI Act. We decided to appeal because, even though we were

not optimistic about achieving a reversal of all of the panel’s findings, we thought

we could perhaps obtain greater clarity from the Appellate Body, which would be

of assistance in making any further modifications to U.S. tax law. On November 1,

we filed our appellant submission. As you will recall, the Appellate Body on January

14 of this year rejected our appeal on all counts. The Appellate Body’s report was

formally adopted on January 29, at which point the arbitration proceeding for purposes of determining the level of countermeasures to which the EU is entitled,

which we had been suspended by mutual agreement with the EU in November of

2000, resumed. One would normally expect a WTO arbitration proceeding to take

no more than 60 days. In this case, the arbitrators have informed us that they expect to take until April 29 to finish their work and issue their determination on the

authorized maximum level of countermeasures.

The EU and the United States have in recent days submitted to the arbitrators

our respective arguments on the appropriate maximum level for authorized countermeasures in this case. The EU, as expected, argued that they should be allowed to

adopt countermeasures with a value up to $4.043 billion. The EU essentially claims

that this amount is reasonable because it estimates the actual effects of the ETI to

be far greater than this amount. In contrast, the United States holds that the EU

should only be entitled to countermeasures totaling from 1.0 billion to 1.1 billion,

depending on the base year chosen. Our reasoning is that WTO principles require

that countermeasures be proportionate to the trade impact on the complaining WTO

Member of a WTO-inconsistent measure adopted by the defending Member. To

measure the trade impact of the ETI Act on the EU, we used the amount of the

subsidy as a proxy for the actual trade impact, and assigned to the EU a portion

of this amount based on the EU’s share of total non-U.S. goods production worldwide.

If the arbitrators find that the EU is entitled to countermeasures in some amount,

the EU would be in position to ask for WTO authority to impose countermeasures

sometime in May. However, there is no deadline by which the EU must request authority to impose countermeasures, nor is there any deadline by which the EU must

impose countermeasures once the authority is received. If the European Commission

decides to utilize whatever authority it receives from the WTO to impose countermeasures, we expect it would then move to seek approval from the EU Council of

Ministers, representing the EU Member States, to impose increased tariffs on selected imports from the United States. How long such a process would take is not

clear at present. The Commission in the fall of 2000 notified the WTO Dispute Settlement Body that it would intend to seek authorization, when appropriate, to increase tariffs on U.S. exports to be selected from a very broad potential list. To date,

17

we are unaware of any further-refined lists of potential targets produced by the

Commission.

I should add that, throughout the WTO dispute settlement process, we have maintained our contacts with our EU counterparts with a view toward managing the dispute in a manner that does not disrupt the general progress being made in international trade liberalization.

Future Work

Mr. Chairman, I hope this thumbnail sketch of the origin and current status of

the FSC/ETI dispute will prove useful in informing the Committee’s future consideration. Given our understanding of the Committee’s objectives for this hearing, I

have refrained from going into too much detail today with respect to our thinking

on how to move this topic forward in coming weeks and months. We at USTR look

forward to working with the Congress and the private sector to develop further our

ideas on how to respond to the WTO ruling and other aspects of this important

issue.

Thank you and I will be happy to answer any questions you may have.

Chairman T

As I said in my opening statement, reinforced by my colleague,

HOMAS. Thank you very much both of you.

f the Ranking Member, working a solution to this will be difficult,

one, because it is hard, and two, because anyone who wants to— may or may not be true—but anyone who wants to can twist this

in terms of a partisan reason for trying to change the Tax Code.

I guess the first question that I need to ask to reinforce where we

ultimately need to go is, do you believe there is any response that

will have a lasting result short of changing the Tax Code?

Ms. Angus, can we do something other than changing the Tax

Code to respond to this. It probably is a yes or no question.

Ms. ANGUS. In terms of the issue of tax changes, given the

WTO’s analysis of the WTO rules, we do think that significant

change in the system would be necessary and that legislation that

simply replicates the FSC or ETI provisions would be unlikely to

pass muster.

Chairman THOMAS. Or is anywhere in the ball park of replicating

or looks anything like it? Do you agree with that?

Ms. ANGUS. We need to look at this much more fundamentally

and examine the whole range of possible ways to address the decision while ensuring that we continue to help maintain that level

playingfield for U.S.-based businesses.

Chairman THOMAS. In your oral testimony, you used the term

‘‘disappointed’’ twice—we were disappointed. Well, all of us were

disappointed that the Europeans didn’t continue to honor the gentleman’s agreement. Were you surprised?

Ms. ANGUS. I certainly was disappointed.

Chairman THOMAS. The point is that there is a legal argument

to be made, but some of us who are not attorneys or legal or constitutional scholars have lived this. We were on the Committee

when we marched through the alphabet with the Domestic International Sales Corp. (DISC), FSC, and up the hill on ETI. Has the

Administration, or at least that portion of the Administration

which this Committee has to work closely with in dealing with our

laws, come to the conclusion, and I believe you said it, but I just

want to underscore it, that we can’t continue down the same similar trail and expect the Europeans to honor what, at one time, had

been a gentleman’s agreement, not to probe?

18

Ms. ANGUS. Again, in light of the decision of both appellate bodies and their fairly compelling statements rejecting that gentleman’s agreement, taking the position that it had no continuing relevance under the WTO rules, we are faced with a situation with

the appellate body’s analysis of those rules, that legislation that

takes a similar approach is not likely to pass muster at all.

Chairman THOMAS. I don’t need to get more out of an attorney

than that. I would appreciate more, but I will accept that. Not likely. I think that is an understatement. Can we get away with doing

nothing?

Mr. DAVIDSON. Mr. Chairman—— Chairman THOMAS. And what are the consequences of doing

nothing?

Mr. DAVIDSON. I think doing nothing and this comes from the

conversations that Ambassador Zoellick has had with Commissioner Lamy and that we have had with a number of Member

States and other Europeans. I think the comments you made in

your opening remarks that retaliation is not an empty threat is accurate. I think that the United States taking a position that we

need to do nothing to comply with the appellate body’s decision

would invite retaliation.

And I applaud the Committee for taking the step of having the

hearing today and talking about the positive steps that we are

going to make because Commissioner Lamy has made it clear, both

in private and in public, most explicitly in the press conference, in

meetings that he had with Ambassador Zoellick last month, that

the EU will be looking for solid steps of progress in terms of what

the Administration and Congress are going to do working together

to move forward on this issue. And if we are doing that and it appears to the Europeans that we are taking our obligations seriously, that he believes it is possible to hold off retaliation. It is yet

to be seen what level of retaliation will be authorized. Whatever

level is authorized, it will be one of the largest, if not the largest

amount in the history of the—short history of the WTO. So I think

it is something that needs to be taken very seriously.

Chairman THOMAS. Well, if we agree that we can’t stay where we

are, which is the now and we have to go somewhere which is the

then, between now and then, we will be looking to diplomatic initiatives to get people to understand that getting between now and

then is difficult. It just so happens that I had a very interesting

conversation with Mr. Superchi in the World Economic Forum up

in New York and I found it ironic as he was talking about taking

over the leadership of the WTO and some of the sensitive issues

that they were going to have to face, he immediately presented to

me two dates around which he needed to work, August and September, involving the parliamentary elections in France and the

ministerial or the executive elections in Germany.

The Europeans have been very successful in selling how difficult

it is to make change during the season of elections. I think you just

heard from the Ranking Member that we will move forward on

this, but it is very difficult for us to make change during the season

of our elections as well. So I would hope that the Ambassador conveys to Mr. Lamy that there are other elections that people should

be sensitive to and they are in November of this year and that we

19

will be moving forward on statutory changes to the Tax Code to

comply with the WTO ruling.

But if we are not successful by the time of the election, it is in

great part due to the fact that we do have elections and that we

will address this issue and we will resolve it. But to expect us to

resolve these difficult fundamental issues in an election season

when everyone else gets an automatic pass from difficult decisions,

because it is an electoral decision is a point I think that this Administration needs to stress with our friends as we look at the calendar that you outlined in terms of potential pitfalls along the way

to a resolution of this concern.

We will be holding hearings on ways in which we can resolve this

problem. But I also want to underscore what my colleague from

New York said about the role that this Administration needs to

play. You cannot follow and expect Congress to lead in this difficult

issue. We have to be full working partners. And to a very great extent, given the brilliance and the talent and the expertise in both

the USTR and in the Treasury, if you could come up with some potential resolutions that you could present to us, it would be a very

great help in us moving forward. I believe we understand our responsibilities. I am not comfortable with the timeframe. It is going

to be very difficult. To the degree you can buy us some time on our

way to resolving the issue, it would be greatly appreciated, and to

the degree you can present some potential solutions to the problem,

that would also be greatly appreciated.

Mr. DAVIDSON. Mr. Chairman, could I respond to that briefly? I

do think Commissioner Lamy and many in the EU understand the

complexity of our system, and particularly, I think they understand

the difficulty of dealing with tax legislation. Mr. Rangel referenced

the complexity and difficulty of that issue in his statement as well.

So I think that there is a sound understanding. At the same time

he has been very clear that he needs to see signs of progress

throughout that—in the near future and very quickly. That doesn’t

mean—I take that as meaning that the end of the process he understands is a long time, but there are a number of steps in the

interim that progress needs to be shown.

Your point about the elections in the EU I think is a very good

point. This issue must also be seen in the context of the overall

trading relationship and there are a number of controversial issues

we have with the EU. When we have things that we are concerned

about they make the point to us about we have political problems

in some of our Member States, we have elections, this is going to

be a difficult issue to resolve for awhile, have patience with us. I

think your point is entirely accurate as well to be able to make the

same point to them here. It is not a process that can be created

quickly. And particularly when you are talking about the kinds of

fundamental reforms that you are talking about.

In terms of the Administration presenting alternatives and interaction with the Congress, we have every intention of being full

working partners and engaging proactively in putting forward some

ideas of what we can move forward on, but we are going to need

some help and interaction as well so that we can share some of

these ideas and get a feel for whether they are moving in the right

direction.

20

In that vein, I know that Secretary O’Neill, Ambassador Zoellick,

Secretary Evans, and others are looking forward to creating a more

formalized consultation process which I am sure they will be talking with you about so that we can put that full working partnership into effect in a way that moves expeditiously, at least in the

interim steps toward moving toward some consensus solution.

Thank you.

Chairman THOMAS. Thank you. Just so you clearly understand,

the statements of my friend from New York were not taken by the

Chairman as a threat or a promise. They were understood to be

factual statements about the reality of the situation that we are in.

The Congress—and Europeans are sophisticated enough to clearly

understand our system—that clearly Congress needs to forward.

But to the degree they don’t see the cooperation and more importantly the understanding of the need to move forward from the Administration, they can rightly believe that we are not presenting as

broad and honest an approach in trying to resolve the issue as we

could. So it is going to take a full partnership. And we cannot be

Alphonse and Gastone asking someone else to go through the door

first. You don’t wait for us, we don’t wait for you. Both of us need

to move forward. And the argument that somehow you have to

have a formal invitation to help us address an international problem is not what I really want to hear.

What I want to hear is, you folks get it, we have got to change,

notwithstanding the difficulty of the change, we are beginning with

this hearing and we will move forward. Now is behind us and then

is in front of us. Between now and then, our diplomatic and legislative and executive efforts, all of us have to be part of this team

pulling together. I know we will. And I appreciate your testimony.

Gentleman from New York.

Mr. RANGEL. Well, I feel a little awkward in agreeing with almost everything the Chairman has said. And I don’t really like the

idea of foreign governments making the determination as to how

quickly we are making progress. You see Mr. Davidson, your office

has a very responsible diplomatic role to play. But it is the Secretary of the Treasury that has a real realistic role to play in giving us a road map as to what the Administration would like to see

the objectives to be. It is never easy making dramatic changes in

the Tax Code, and when the Chair asked the question, do we have

to change the Tax Code, that is all we do is change the Tax Code.

We change it, it doesn’t mean we reached the results that we would

want.

So that you could be disappointed, but you had a series of disappointments because we never really reached a point that we

found an international legislative resolution of this problem that

has been hanging over our heads for decades. Now I think it is safe

to say that the Chairman and I have not built up a reservoir of bipartisanship that the Administration can rely on. And that means

that no matter how much of us have love for our country, that we

just can’t wave the flag and move forward and say we want to accommodate USTR and our friends in the European Union.

We have to find out just what changes—how these changes are

going to impact on American taxpayers, on American industry,

whether they would be a flight of American industry if we changed

21

the tax system so there is no corporate taxes. It is very complicated, but a very political decision—very political decisions have

to be reached.

So I think what the Chairman is saying is, you can’t—you should

not rely on us in coming up with the answers alone. We will do

what we have done in the past and we have supported each Administration, Democrat and Republican, to let our foreign friends know

that we intend to be treated fairly on this issue. But if you leave

it up to us to come up with solutions that tear us apart without

having your help in bringing us together, then whether or not

progress has been made, it will just be a moot issue.

So I cannot think of an issue more than the war that should

bring us together in a bipartisan way to try to work out before we

go public, and so I am glad that the Chairman has restricted the

testimony this morning to the history of what got us to where we

are.

And I don’t know what the Oversight Subcommittee is going to

do, Mr. Chairman, but I hope that the fireworks are kept down to

a minimum over there until we can get a handle as to which road

we can walk down to comfortably, and then just try to work out

the details to it. But if we are going to have a dramatic change in

our tax law, we can just hope that the Administration helps us to

progress quickly toward resolution of this long time problem we

face.

Thank you, Mr. Chairman.

Chairman THOMAS. Thank you very much. As the gentleman

from New York can see, there are no TV cameras at the full Committee, and the chances of a TV camera getting to a Subcommittee

are even less. So our purpose of moving the issues of resolution to

a Subcommittee is clearly to pursue options that not only seem to

be viable but acceptable. And it will be a difficult road.

Mr. RANGEL. If I may, I think the Administration had suggested,

or at least Mr. Davidson, that we might have some informal meetings between Mr. Evans, O’Neill, and USTR and Members of the

Committee.

Chairman THOMAS. Let me suggest that what the Administration

has proposed, my understanding is that they are going to put together a working team among the Administration and that they

will bring outsiders and academians, laypeople and others in looking at options that they have. My encouragement is that they move

fairly quickly through that process. We can meet informally or formally. I think work product is the most important thing, and that

if they are able to come up with some suggestions as the gentleman

has indicated repeatedly, we need them as soon as possible.

Mr. DAVIDSON. Mr. Chairman and Mr. Rangel, if I could just

clarify my statements, I completely agree with your assessment

that we need to move together on this and work closely and work

quickly. I did not mean to imply in any way that we should hold

back on either of the fronts before one of the other front was moving forward. I applaud the Committee for having the hearing today,

beginning the process of looking at where we need to go in the formal setting of a hearing room. I think that the informal process

and consultation needs to move forward simultaneously. But I don’t

22

think we can wait on any one stage to move forward on all of them. 

And that is our position. 

Chairman THOMAS. Gentleman from Illinois, the Chairman of the 

Trade Subcommittee, wish to inquire? 

Mr. CRANE. Thank you, Mr. Chairman. Ms. Angus, what types 

of fiscal alternative proposals are being considered to keep U.S. 

businesses competitive in the global marketplace? 

Ms. ANGUS. We believe that we need to consider the full range 

of options, all possible alternatives that will address this issue, but 

as you say, ensure that we maintain the competitiveness of U.S. 

businesses and their workers. We need to thoroughly examine the 

U.S. international tax rules. Those rules were first developed 40 

years ago when the global economy and the U.S. place in that global economy were very different than they are today. We need to 

look at all of those rules from the beginning in order to find a way 

to address this issue that doesn’t disadvantage U.S. businesses. 

Mr. CRANE. Well, I would hope that you would incorporate in 

your considerations a total repeal of any tax on business whatsoever. I pushed for that for the entire time I have been in Congress, 

but before that, when I was teaching. And the thing that is so disturbing about taxing business is that they don’t pay taxes. They 

gather taxes. That is a cost, like, planned equipment and labor, 

and you have got to pass it through and get a fair return or you 

are out of business. 

And there are countries that are providing that kind of window 

of opportunity, and there are American businesses running to 

places like Bermuda because of it. And I would hope that we might 

consider something wholesome and healthy like elimination of that 

stupid tax all together. And I yield back the balance of my time. 

Chairman THOMAS. Now that oil has been poured on troubled 

waters, gentleman from Michigan wish to inquire? 

Mr. LEVIN. I am going to try to take back some of that oil, Mr. 

Chairman. 

Chairman THOMAS. As long as you don’t light it. 

Mr. LEVIN. No. Indeed, within the bipartisan spirit the two of 

you preceded the Chairman and Ranking Member, I want to try to 

cast this in a somewhat different light, not only for those of us in 

this country, but for those in Europe and the WTO. First of all, we 

have gone over the background and I hope that there is not only 

a sense of disappointment in this country, but really a sense of outrage. 

This was more than a gentleman’s agreement. After the General 

Agreement on Tariffs and Trade (GATT) decision in the early 

1980s, this thing was worked out through the GATT council with 

an official understanding. And we, as a result, passed legislation in 

1984 as we all know. That legislation was an effort to fulfill the 

understanding that we had on this issue. And for the next—1984. 

And for the next decade plus, that approach prevailed. It wasn’t 

seriously challenged. It wasn’t raised in the Uruguay round when 

the Europeans could have raised it and it was only after the Europeans lost a series of cases really that they raised this issue. And 

I think everybody should understand that—this background, so 

that is point one. It was more than a gentleman’s agreement. It 

was a—it was a structure that was enacted pursuant to discussions 

23

within the GATT, and it was the structure that prevailed without

any serious challenge until the Europeans lost a series of cases.

Number two, I don’t think we should act as if this is a dagger at

the United States. What this is is a dagger at the U.S. and European economic relationship. I don’t like the nuclear trade bomb description very well.

Mr. Zoellick said trade nuclear bomb, not nuclear bomb. But if

it is a trade nuclear bomb, that means that both sides better be

weary about its use. And I think the same is true if you call it a

dagger. In this respect, Mr. Davidson, I want to read back to you

your testimony which I assume has been cleared by USTR and I

think the Europeans should listen to this, and I am not saying anything that I haven’t said to Mr. Zoellick and this is on page one.

The solution will be found in an appreciation of the need to move

the global trading system forward to advance the U.S.-European

trading relationship overall, and at the same time, to find a solution to this dispute within which all parties can prosper.

Now we should embrace that language and make it clear to the

Europeans and everybody else that this dispute is a threat to the

global trading system. And if anybody tries to grab it to their advantage, they are, I think threatening the global trading system.

And so, we are not the only ones who should have a concern

about this. So should the Europeans, and for them to think there

is a major tactical advantage here I think is, for them, a serious

mistake. And therefore, I want to make one last point. The Chairman talked about the difficulty of moving this in an election season. That is part of it, Mr. Chairman, but it is not only because

this is an election year. These are exceptionally difficult issues. Mr.

Crane says he has been advocating the change of all of his years

here. That is what, Mr. Crane, 3 decades?

Now maybe that says something about the substantive difficulties. Mr. Davidson, when you talk about signs of progress, let the

Europeans not misunderstand that there is an easy solution to this

in terms of American policy because there is not. There are deep

differences and they cannot expect to use a temporary tactical advantage to expect that there will be major tax changes in this country in any foreseeable future. We can work on it and I am glad we

are going to do it, but there should not be false expectations here.

And I don’t want to make it difficult by saying zero will happen because if Mr. Lamy wants something to point to, we should give it

to him.

But—and we will work on this issue but this is not mainly an

election year issue. And their advantage is, I think something that

can come back to haunt them. I told Mr. Lamy, he is like the dog

that caught the bus, and I hope he takes it seriously. We didn’t

raise this at Doha. We didn’t raise it before Doha, and we need to

raise it now.

And Mr. Davidson, I will finish by saying I think the words here

about where the solution will lie is surely something that should

be taken seriously. We will work hard on legislation but the Europeans should understand the ramifications of action on their part

challenging a structure that they lived with for more than a decade

without challenge and did not really challenge until they lost a series of cases in the WTO.

24

Chairman THOMAS. Thank the gentleman. I want to underscore

the point that he made. I did start out in my statement by saying

that this is going to be very hard to do. I pointed out the elections

and I stand corrected. The French elections are on April 21, and

Germans in September, because that is what they always use as

an excuse. And I wanted to lay the groundwork that, in fact, we

have a pretty darn good one as well. But clearly, the gentleman

from Michigan’s point is well taken. The primary reason we may

not be able to resolve this in several months is underscored. This

is going to be a hard thing to do. Gentlewoman from Connecticut

wish to inquire?

Mrs. JOHNSON OF CONNECTICUT. I thank the Chairman, and I too

join the gentleman from Michigan in expressing my very strong

concerns that after living with a regimen that was agreed to by

both sides for over a decade, that they should have raised this. On

the other hand, it is extremely important to us as a Nation that

we have a rule based enforceable trade structure and that issue of

abiding by decisions is just extremely important to America.

If we can’t enforce the intellectual property provisions of the

World Trade agreements, we will be the ones to pay over and over

again, and it will, in the end, have a serious effect on our economy.

So we depend on a rules-based system. This has gone against us.

We do have to find a way to deal with it. It will take time.

But I want my colleagues on this Committee to—I want to just

express to them and to you that I hope that we will deal with this

issue at the same time we look at what is causing the American

Tax Code to drive international mergers to be controlled by foreign

entities.

We had testimony before this Committee that DaimlerChrysler is

DaimlerChrysler because of our Tax Code. It could have been

Chrysler Daimler. And we see now that they are downsizing.

Where is the power when the tough decisions are made? They are

being made out of Germany. They are not being made out of America. We had testimony behind closed doors, and we had statements

behind closed doors in some of the big international bank mergers

that they are going to be foreign-owned, primarily because of our

Tax Code. Last year or year before we saw insurance companies organizing in Bermuda.

Now we are seeing tool makers organizing in Bermuda because

it saves them millions and millions of dollars without laying anyone off or other consequences. So we do have to look at how our

Tax Code is driving control over major actors in our economy offshore, and often into foreign arms. And I just think we need to look

closely at that and maybe from looking at that, we will find things

that also might solve this other problem or move us in a direction

that will make us somewhat more harmonious with the world, because I think our tax structure is beginning to drive jobs abroad

just like a few decades ago, some of our environmental regulations

drove the cost of production so high that jobs went abroad. Now

those things are beginning to even out at least in some parts of the

world. But our Tax Code is now showing evidence of driving jobs

abroad, the movie industry and all across the front. So we have our

work cut out for us and we need you and the Secretary of the

Treasury to begin to put a strong shoulder to the wheel. Thanks.

25

Chairman THOMAS. Gentleman from Washington, Mr.

McDermott wish to inquire?

Mr. MCDERMOTT. Thank you, Mr. Chairman. Seems to me like

you walked into a lecture hall here today and hearing lectures. And

I just would make a discussion that when you put that panel or

working panel together, you try and make it an open one so that

we don’t have any trouble with people deciding decisions being

made behind closed doors. But one of the things that strikes me as

I listen to this whole thing—and I think Mr. Crane is the most

honest man on the Committee. At least he will put a plan on the

table. Nobody else. But I have been sitting here listening to this

baloney for 8 years now and nobody will put a plan on the table.

Everybody says, well, we will figure it out, we will go back and we

will challenge them and we keep losing.

We have done it a couple of times and you ought to learn after

the second one that this isn’t going to work. But I think you can

count on this Committee for doing nothing. We are not going to do

anything until you do something.

I think that the record in the course of last 8 years has been actually we have done very little. Now, I used to represent one of the

major exporters of this country. I still represent some pieces of it,

but the major piece went to Chicago. And I don’t know—I used to

worry about this FSC thing, but I don’t worry about it anymore because it looks to me like it is permanent employment for tax lawyers and trade lawyers because nobody seems very worried about

this thing.

Can you give me a cutoff date when we are really going to get

slammed, or is this thing just going to go on forever, we will be

looking at this when I retire in 25 years, and we will still be thinking we are going to deal with FSC one of these days? Is this just

passive-aggressive on our part?

Mr. DAVIDSON. Mr. McDermott, I can’t give you a specific date

by which there will be retaliation and I can’t tell you, regardless

of the retaliation—that is actually given to the EU by the panel— what amount they may choose to proceed with. All I can say is that

in conversations with Commissioner Lamy and others and Member

States, that I don’t think—they will not be hesitant to retaliate if

they believe that we are going to go through another what you

said, 8 years of doing nothing. So I don’t know when the cutoff date

is.

It seems to us from all the indications that we have seen—I was

in Europe a couple months ago meeting with some Member States,

and I received the same message from them. So I think that it is

a question of looking at what—what our government is doing, how

serious an effort they are taking toward—steps toward reforming

the system, and I think that if we don’t take those steps—— Mr. MCDERMOTT. What steps did you suggest—I mean, I heard

there was some progress. What steps did you tell the Europeans

that we were taking toward a resolution of this? We are going to

form a Committee? Is that what the progress was?

Mr. DAVIDSON. No. We didn’t give a specific list of things that we

were doing, procedures we are going to be taking, other than to say

that we are going to be working closely with you, with Congress,

in terms of moving forward on the issue. Now, I am sure their reVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00029 Fmt 6633 Sfmt 6602 E:\HR\OC\A971.XXX pfrm01 PsN: A971
26

sponse is well, you know, we will believe it when we see it; the jury

is out and so——

Mr. MCDERMOTT. But there is nothing in the rules of the WTO

that gives them a date where they can say, look, March 1, you either do something or here comes the penalty?

Mr. DAVIDSON. Once they get the—on April 29 or thereabout,

there is a perfunctory procedure——

Mr. MCDERMOTT. Perfunctory?

Mr. DAVIDSON. Well, there is one more—once they get the number from the panel, there is one more stage which they have to go

through but that is perfunctory——

Mr. MCDERMOTT. The panel has to decide how much to

finance——

Mr. DAVIDSON. Find how much, and then for all practical purposes essentially they can retaliate to that amount in a WTO legal

manner. They don’t have to wait. There are some—hopefully some

consultations that go on, but——

Mr. MCDERMOTT. So Boeing airplanes could go up in price, 10

percent or 5 percent or something else, on that day.

Mr. DAVIDSON. That is right. That is right. And there is no——

Mr. MCDERMOTT. The 29th of April, when we have just laid off

30,000 people.

Mr. DAVIDSON. But there is—there is no deadline by which they

have to exercise that authority; so there is an opportunity for us

to continue to work through the issue to—we have established

quite an arsenal of weapons here, from daggers and nuclear bombs

and things like that and——

Mr. MCDERMOTT. I am more worried about price increases.

Mr. DAVIDSON. An effort to prevent that from happening I think

is what we are here talking about; what is the process that prevents that from happening? And to answer your question, there is

simply no set date. They can delay as long as they would like to

delay before imposing retaliation, but retain the ability to do so.

Mr. MCDERMOTT. Are you betting that they will just let it ride

a while?

Mr. DAVIDSON. No. I think, Mr. McDermott, our belief is that if

the EU does not see what they consider to be credible progress in

terms of us moving forward, that we face a high likelihood of some

type of retaliation.

Mr. MCDERMOTT. So you think—if they see a Committee, do you

think they would think that was credible progress?

Mr. DAVIDSON. Mr. McDermott, I can’t speak to what they would

see, but I think—I think what they are looking for is a credible

process and that is—that is, you know, actually making some

progress toward talking about the kinds of things that the Chairman was talking about and Mr. Rangel was talking about earlier.

So I don’t think—if your question is can we hold a series of meetings and hearings and things like that and hope to hold off retaliation if there is no substance there, I don’t think that that is going

to be sufficient.

Mr. MCDERMOTT. And the substance would be a proposal on the

table that we were considering—or what would the substance—I

would like to know what the substance is that I need——

27

Mr. DAVIDSON. The substance would be a substantive discussion

of options.

Mr. MCDERMOTT. Thank you. That sounds pretty clear to me.

Mr. CRANE. If the gentleman could yield for just a moment, he

made a reference, and I expressed appreciation for his nice compliment, but we lost this distinguished gentleman from Chicago. He

moved out to Seattle, and Seattle graciously traded off by giving us

Boeing. And what we both want to guarantee is that Boeing doesn’t

become Lufthansa-Boeing.

Chairman THOMAS. The Chair would now like to recognize the

gentleman from New York, Mr. Houghton, if he has a question or

two.

Mr. HOUGHTON. Yeah. Thanks very much. I would like to make

a couple of statements and then have you challenge them. First of

all, I see no way in order to help a business to solve this thing in

a hurry, because if something else has to happen to our tax structure it is going to take a long time. You know how the process

works around here. We don’t even have the ideas. Take a long

time.

So something in the meantime, in the interim, has to come into

play. And frankly, the only thing that I can think of, and challenge

me on this, is that we—we say to the Europeans we are going to

have more time on this thing. We are working on it, we are doing

whatever we can, we are not going to be put on the defensive, and

frankly if that is not good for you, then we are going to start challenging you.

I mean, we have just been over in—Mr. English and I have just

been over at a meeting in Germany, and they are complaining

about some of the steel cases, the 201 situation, forgetting entirely

that they upheld—they invested in the steel industry from the government. I mean, that is something which we can challenge.

I don’t know what happened as far as the foreign source income

used by the tax regimes of Belgium, France and Netherlands,

whether that was resolved or not. But they are not lily white clean

on this thing, and frankly the only thing we can do—and, again,

challenge me—is to say we have got to have time on this thing.

Now, as far as the—as far as the taxes are concerned overall, I

am not convinced that—that ChryslerDaimler would have been

ChryslerDaimler if we had had a different tax situation. The fact

is that Daimler had more of the stock, and that is pretty clear to

me, and therefore they call the shots on this. There are always

going to be places you can go.

I know there was a wonderful suggestion at one time that the

ideal situation would be for a business to own an island, and then

have the domicile of that business on that island and establish its

own tax rules. Well, that may happen in the future and they are

going to be trading back and forth, and the question of where you

can get the best price and the best cost structure, but those are big,

big, big issues; and at the moment, it seems to that we must bide

for time, and if we don’t, then the people that we are trying to help

are going to go under. Four billion dollars is not an inconsequential

price tag. Maybe you can comment on that.

Mr. DAVIDSON. Mr. Houghton, I concur with you completely and

we have made the case strongly to the Europeans that we need

28

time to comply. And in fact, you know, we have been working with

them throughout my entire tenure at USTR for the last year or so

on pushing hard on that area, and I think they do understand the

complexity of this area. So we have made that case forcefully.

In terms of talking about if you were heading in the direction of

filing other cases to provide leverage or something like that, for

strategy like that to—I think there are some concerns about a

strategy like that. You have to have—you actually have to have

some arrows in your quiver that are of commensurate value, and

second I think such a strategy runs the risk of a never-ending cycle

of litigation that doesn’t actually help you solve the underlying

problem.

I think if you look at—the bananas dispute that we have been

working on is a good example. You know, counter cases to the bananas dispute I am not sure would have helped us reach a resolution. Instead we rolled up our sleeves, got down to work, and we

actually worked out a resolution on that case and it took some

time—it took some time to do it.

I think what is going to drive the resolution of—and this is my

own opinion, but I think what will ultimately drive the resolution

of this will be both sides looking at it seriously, working hard, and

looking at it in the context of the overall U.S.-EU relationship. We

have got a lot at stake in terms of the positive trade liberalizing

agenda and we can’t allow disputes like this to throw those important initiatives off track.

We have the launch of the new round in Doha recently. Both the

United States and the EU were instrumental in moving that forward. Both sides have a real interest in moving the broader context

forward, and so I think that is the positive incentive to work

through this issue and come up with a result that will actually get

us there as opposed to more negative incentives. That is my own

personal opinion.

Chairman THOMAS. Thank you. The gentleman from

Massachusetts——

Mr. NEAL. Mr. Chairman, could you come back to me after we

vote?

Chairman THOMAS. Well, I think everyone would like to do that,

and, if in fact, we are not going to be able to carry on the hearing,

do we have just—the Chair understands it is a vote on the rule,

and so there are other Members who wish to inquire, the Chair assumes. Let us then say that we will reconvene at 20 minutes after

12, and if you will allow us to do that and remain, because there

are further questions by Members of the Committee, the Committee will stand in recess until 12:20.

[Recess.]

Chairman THOMAS. The Chair wants to thank the representatives of the Administration. Holding hearings during voting clearly

means we have to do two things at once sometimes, and we are not

able. The gentleman from Louisiana wish to inquire?

Mr. MCCRERY. Yes, Mr. Chairman. First of all I want to thank

Chairman Thomas. I and the other Members of the Select Revenue

Measures Subcommittee appreciate the opportunity to move this

process forward and to seek a legislative solution to this matter. So

29

we will be working on that at your direction, Mr. Chairman, and

look forward to working with you to accomplish that goal.

I would like to pose this question to either of you or both of you,

and it concerns the question of jobs in the United States. Can you

tell us how the FSC or ETI rules affect jobs here in the United

States, or does it have any effect on job creation or job retention

here in the United States?

Ms. ANGUS. The ETI provisions, as a part of our international

tax rules, help to allow U.S. companies to compete better in the

international marketplace, and that in turn allows them to expand

their production, investment and employment here in the United

States. So these provisions, by allowing them to be more competitive in the international marketplace, in the markets where the

customers are and where they need to compete, allow them to

produce more here in the United States and employ more workers

here in the United States.

Mr. MCCRERY. That is the right answer. Mr. Davidson, I guess

you don’t have anything to add to that.

Mr. DAVIDSON. Yeah. Mr. McCrery, I don’t really have any economic data to back up any different opinions, so I defer to Treasury

on that analysis.

Mr. MCCRERY. It sounds like she was well prepared for that.

Now I would like for you to talk about this distinction between direct and indirect taxes and what difference that makes in terms of

the WTO and the rules allowing indirect taxes to be rebated at the

border. Can you give us a little background on that, explain that

a little bit?

Ms. ANGUS. The United States imposes an income tax which is

considered a direct tax. Under the trade rules as I understand

them, direct taxes are not border-adjustable. So under the trade

rules the U.S. income tax isn’t—isn’t and cannot be—rebatable on

exports. An indirect tax is a tax on transactions, goods or consumption; in other words, a tax that isn’t on income. The definition

seems to be that indirect tax is anything that isn’t a tax on income.

Value added taxes and sales taxes are considered indirect taxes.

As I understand the trade rules, a tax is considered a border-adjustable indirect tax if it is levied on the destination principle.

Under the trade rules, a tax is not border-adjustable if it is levied

on the origin principle. There are some indirect taxes that are levied on the origin principle. Direct taxes, like income taxes, are levied on the origin principle. I think on the next panel, Mr. Hufbauer

in his testimony traces this distinction in the trade rules between

the treatment of direct and indirect taxes all the way back to a

1960 GATT, General Agreement on Tariffs and Trade, working

party.

Mr. MCCRERY. And what difference does it make if indirect taxes

are rebated at the border? What practical effect does that have?

Ms. ANGUS. Well, I think that the real issue is one of consistent

treatment; the treatment on the way in, and the treatment on the

way out. This distinction under the trade rules on how they allow

income taxes or direct taxes to be treated versus how the rules

allow indirect taxes to be treated is one that has long historical

roots. I think the economists will tell us that the distinctions in incidence between direct and indirect taxes really shouldn’t be relVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00033 Fmt 6633 Sfmt 6602 E:\HR\OC\A971.XXX pfrm01 PsN: A971
30

evant for purposes of determining whether one or the other should

be border-adjustable.

Mr. MCCRERY. But the practical effect of allowing indirect taxes

to be rebated at the border, and not direct taxes as they are defined by the WTO, is that a product coming from, say, France,

which has a price attached to it, part of which is the value-added

tax, the indirect tax, when you subtract that part of the price, what

happens to the price that we pay in the United States for that

product? It is reduced, isn’t it? Whereas the same product emanating from the United States, going to France, and the tax component is an income tax, that can’t be rebated at the border so you

don’t get that reduction of the price, right?

Ms. ANGUS. Yes. And another aspect of this difference in treatment between income and non-income taxes, direct and indirect

taxes, is that should be looked at in the context of the fact that the

United States has a tax system that is heavily reliant on an income

tax, whereas while other countries do have income taxes, a larger

portion of their tax is made up of consumption taxes for which

these border adjustments are permitted.

Mr. MCCRERY. Thank you.

Chairman THOMAS. I thank the gentleman. I guess that was a

discussion with a lawyer about what goes on in terms of rebatable

taxes at the border. I noticed during that discussion the long-time

Trade Subcommittee Chair of this Committee and the interim

Chairman of this Committee, the gentleman from Florida, Mr. Gibbons, came in, and I know he followed the lawyerly argument

there; but I think probably if you will allow me for just a moment,

a perhaps more English answer would be that the Europeans have

a tax structure which allows them when they export products to rebate a tax, and when products are brought into the country, to impose it.

Let me put it another way. Since we use an income tax, and we

have taxes and some of the taxes that are the largest part of our

tax system are social welfare costs, the Medicare and the Social Security Trust Fund moneys, that those costs are embedded in our

products, whether they are in this country or whether they go oversees. So we have social welfare costs embedded in our products domestically or internationally.

When the Germans or the Japanese or any other major industrial country with which we trade—as I said in my opening statement, we are the world’s largest importer and the world’s largest

exporter. When their products remain in their country, it is true

their social welfare costs remain, because those taxes have been

added to their product domestically, whether it is Germany, Japan,

or another country. But when they export those products, they get

those taxes rebated, so the social welfare costs are lifted from the

foreign products going into the United States. But when the U.S.

exports into the EU, Japan, or any other major industrial country,

those taxes are added. So we carry the embedded social welfare

costs for the United States, and we carry the additional social welfare costs of every other country we export products into. But the

Europeans coming to the United States have had that tax lifted.

So they come into the U.S. market, the world’s largest trading market, unencumbered to a very great extent by those taxes. They go

31

on the shelf in direct competition with U.S. products that have

those taxes embedded in them.

So in one of the most fundamental ways, we are at a disadvantage by our unwillingness to change our Tax Code, and every other

country with which we trade is advantaged by their Tax Code on

social welfare costs.

Let me put it a bit more practical way. The United States pays

the world’s social welfare costs along with ours, and we don’t have

any other country sharing the paying of our social welfare costs because of our tax system, and we have tried to modify that slightly.

That is why we are here. We have to address the fundamentals.

And it seems to me—this is an editorial comment. We are not supposed to look at the future at this hearing, but it seems to me that

if we come up with a solution to our current dilemma and don’t

deal with the rebatable tax question, we have not really taken advantage of an opportunity to make a change that puts us on a level

playing field in terms of those rebatable taxes. That does narrow

our options. But for us to go back into the tranche of income is to

continue to pay the world’s social welfare costs, and the world

doesn’t help us with ours. And that is an undercurrent that will

continue throughout all of the discussions as to what our response

will be in dealing with the ETI, Foreign Sales Corp., DISC, or any

other attempt to take away the advantage the Europeans have because of their tax systems.

And I thank the Committee for allowing me to lay that out, because it is an issue that we are going to have to face. The gentleman from New York.

Mr. RANGEL. Mr. Chairman, I hope that my silence is not interpreted as being supportive of what you said.

Chairman THOMAS. Whether the gentleman is silent or voices his

opinion, I have never assumed it is supportive of what I say.

The gentleman from Massachusetts wish to inquire?

Mr. NEAL. Thank you, Mr. Chairman. Just one—since you editorialized, let me do the same for just a couple of seconds. Mr. Chairman, despite the talk that we heard around here, for a considerable

period of time beginning in 1992, 1993, 1994, we are no closer to

a flat tax today or no closer to a consumption tax. I mean, it sounded great in terms of campaign sloganeering and all those things,

but a fundamental discussion of simplification is a good starting

point for all of us, and I am convinced we can find some middle

ground.

But, more to the subject at hand. Ms. Angus, we have heard

some comments today, and I expect we are going to hear a few

more about some U.S. corporations becoming fed up with our U.S.

tax system and leaving the country. Some have advocated fundamental tax reform, which will certainly take a lot of time to implement. But in the meantime, how might you respond if individuals

decided that they, too, were fed up with the tax system and they

decided to decamp to the Caribbean?

Is the Treasury Department disturbed about this trend? Do you

have any proposals to stop these departures, either corporate or individual?

And we have also heard that some of these corporations must decide between layoffs and paying their share of U.S. income taxes.

32

Tough decisions indeed. What if a company shuts down the factories and moves offshore to avoid U.S. tax, and does the Treasury

Department have a concern about this?

There is this great aura of patriotism that surrounds the country, and then there are those who in the next breath argue that

somehow paying their share puts them at an anticompetitive position. We have read some disturbing news accounts. I assume that

there are some discussions taking place within Treasury about

what has been happening. And what is the long view of Treasury

in this instance?

Ms. ANGUS. Thank you. We need to look carefully at these transactions that have been reported recently to understand exactly

what is being done from a transactional perspective and also from

a tax treatment perspective. We need to understand the impact at

the corporate level. We need to understand the impact at the

shareholder level. We need to make sure that the transactions are

properly reported and that our laws are complied with.

We also need to examine why U.S. companies are entering into

these transactions. We need to look at all the factors, tax and

nontax, that may be encouraging a U.S. company to undertake this

type of reorganization. An examination of the U.S. tax rules that

affect international business certainly needs to be a part of that exercise.

Many parts of our international tax rules were developed 30 to

40 years ago. As I noted earlier, it was a time when the global

economy looked very different and the U.S. place in that global

economy was very different. We need to make sure that our international tax rules operate efficiently and appropriately in light of

the current global environment. We need to make sure and address

any ways in which our international tax rules may be impeding the

ability of U.S. companies to compete internationally, and if there

are aspects of our U.S. tax rules that are driving companies to consider this type of transaction, we need to understand that and understand why it is happening.

Mr. NEAL. Based upon preliminary discussions that you have

had, would you be prepared to characterize any of what you have

witnessed as tax avoidance?

Ms. ANGUS. It is very difficult to characterize anything. We certainly need to look at all of these transactions carefully. We certainly do need to make sure that our tax laws are complied with

and that everyone is bearing their fair share of tax liability, and

there are a number of things that we are doing in that area in a

whole range of areas.

Just one particular project for which the Secretary, Secretary

O’Neill, has made a major commitment, looking at internationally,

is the need for us to be able to have the information about crossborder transactions so that we can enforce our tax laws.

We do everything we can to enforce our tax laws, but there are

sometimes situations, particularly when you are looking at a transaction that crosses a border, where we need information from another country to ensure that our tax laws have been properly complied with. The Secretary earlier this year made a commitment

that he was going to expand our network of arrangements that

would allow us to have the appropriate information exchange with

33

other countries to get the information we need when we suspect

that someone may not be complying with our tax laws and may be

using the institutions of another country to avoid our tax laws.

We think it is more important than ever not to allow the financial institutions of any country to be used for any illicit purpose,

including cheating on taxes. And so we are very pleased that we

recently signed three new information exchange agreements with

significant financial centers, and we are working to continue that,

all to the end of having the information that we need to ensure

that our laws are complied with.

Mr. NEAL. Mr. Chairman, can I just finish for 30 seconds? Thank

you. I think I totally agree with the second half of your answer. I

thought it was very good. But might I point out that when we talk

about competition, that the people that are visiting my office, the

corporate representatives that are coming to my office that are

upset about this, they are arguing that their competitive position

is being compromised by this occurrence, and I think we have to

keep light of that as well.

Some of my best employers think this is outrageous that this is

happening, so I am not driven here by some notion of wealth redistribution as much as hearing from those who do abide by the rules,

who do pay their fair share. They are great employers and they feel

very strongly that they are being put at a disadvantage by what

they are witnessing.

Thank you. Thanks, Mr. Chairman.

Chairman THOMAS. Thank the gentleman. The gentleman from

California, Mr. Herger, wish to inquire?

Mr. HERGER. Yes. Thank you very much, Mr. Chairman. And,

Mr. Chairman, I want to thank you for the comments that you just

previously made. I feel that you very accurately described and outlined the situation that the United States is both the largest importer and exporter of goods of any nation in the world.

My question, beginning question, one of a couple to you, Ms.

Angus, comes from someone who has the privilege of representing

one of the richest, most fertile, and productive agricultural areas

in the world, the northern Sacramento Valley of California. We

produce a major percentage of the world’s peaches, walnuts, almonds, dried plums, all of which we in California and the United

States cannot consume; we are dependent on exporting.

And today’s hearing feels a little bit like, as Yogi Berra used to

say, ‘‘deja vu all over again.’’ This Committee and Congress have

spent years attempting to fine-tune our tax system to provide

American exporters a level playing field with their international

competitors in a WTO-consistent manner.

Unfortunately, we do not have much time given the WTO’s most

recent decision. My questions today deal with the short term and

how we manage this issue until a final resolution can be worked

out. And, Ms. Angus, given the impending April retaliation determination, what specific effort is the Administration making to lessen trade tensions with the EU and to prevent the imposition of

trade sanctions against U.S. goods exported to the EU?

Ms. ANGUS. I think, really, I ought to turn that question over to

Peter on the trade side of things to talk about exactly what we are

doing, as we face that deadline at the same time that we are lookVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00037 Fmt 6633 Sfmt 6602 E:\HR\OC\A971.XXX pfrm01 PsN: A971
34

ing at some of these more fundamental changes to our tax system

and other changes, to address this in a more long-term way.

Mr. DAVIDSON. Mr. Herger, I think—to summarize some of my

earlier comments as well, I think if I get the gist of your question,

Commissioner Lamy has laid out some of the criteria that he believes will be—will allow the Europeans to put off retaliation, and

those are efforts on behalf of the United States to come to terms

with the appellate body decision and make progress in terms of

what he sees as compliance.

We had a discussion a little bit earlier with Mr. McDermott

about precisely what steps need to be taken. I think it is more difficult; I think it is more art than science. But I think it is a question of managing the relationship between the United States and

the EU, which gets back to the question of the close working relationship between the Administration and Congress.

So, in a nutshell, clear steps, looking at satisfying our international obligations which are credible and move us closer to a

final result that is acceptable to all parties, recognizing that this

is a very complex process and a topic we have talked about at

length; and so it is going to take some time. Within that amount

of time, a demonstration of concrete steps toward the end point, I

think is the best formula that I can articulate at this point.

Mr. HERGER. So, then, would you say that the USTR is working

on agreement with the EU to provide Congress the time—possibly

2 to 3 years—it may take to craft new legislation to keep U.S. businesses competitive in agriculture?

Mr. DAVIDSON. Mr. Herger, I am not sure that I would characterize it as an agreement as such. What I would characterize it as

is a working understanding that, as long as we are making credible

progress, EU will hold off retaliation. And again I don’t know that

it is possible to put down on paper precisely what the terms of such

an agreement or working understanding might be, so I think it is

closer to a working agreement or a working understanding than an

agreement as such.

Mr. HERGER. Thank you. Thank you, Mr. Chairman.

Chairman THOMAS. Thank the gentleman. Gentlewoman from

Washington wish to inquire?

Ms. DUNN. Thank you very much, Mr. Chairman. I feel the same

concern that everybody else on this Committee does when it comes

to FSC or ETI. I am from the same State as Congressman

McDermott is from, and I represent 25,000 workers in the company

that he showed concern about.

For me, it is an easy story. Airbus gets a rebate and Boeing does

not, and it creates huge competitiveness problems with this. And

yet the catch 22 is who is the sore thumb sticking in the air when

the EU decides to retaliate? And it is going to be Boeing and it is

going to be Mr. Herger’s agricultural constituents. That is where

it is going go, so it is going to hurt us over and over again unless

we do something. So I am eager to see a solution to this problem

as everybody else is eager to see a solution.

I am amazed more companies have not moved their production

out of this country. Between the burden of our tax system and the

huge costs of labor, particularly in a State like mine, I don’t see

35

how shareholders are going to allow companies to continue to operate in this environment.

My interest is in a trade war. I don’t want to see a trade war.

I don’t want to see my companies penalized because of the amount

of exporting they do, because it is a very simple ratio. The more

you export, the more jobs you have. So I am wondering if you have

garnered data over the last years on the relationship between the

number of jobs and our use of the FSC provisions or the ETI provisions. Are there data out there we ought to be using in some way

to further our case?

Ms. ANGUS. I don’t have data in front of me. We will certainly

look into it and look for those studies. But it is absolutely clear

that the ETI provisions are designed as a part of our current tax

system to allow U.S. companies to compete better in the international marketplace and those marketplaces where it is absolutely

essential that they be able to compete; and that ensuring their ability to compete is key to allowing them to continue to expand and

grow their production and investment and employment here in the

United States.

So we see a clear link between the role of these provisions and

the importance of a level playing field from a tax perspective and

jobs here in the United States.

Mr. DAVIDSON. Ms. Dunn, can I respond quickly to your question,

or your statement, on not wanting to see a trade war?

I think that is also precisely where we are coming from, and

when I was speaking earlier—before about the larger context of the

U.S.-EU relationship, I think it is moving in a very positive direction overall right now. I think the launch of the round in Doha,

other sectoral initiatives going on, there are some very positive directions in the relationship.

There are a number—as there are with any trading partners that

have a huge volume, a trillion dollars of trade volume that we have

with the EU, there are going to be cases like this which are major

cases and other cases as well; and we have to manage each of

those. And so what I think I have been trying to say here this

morning is, it is our attempt to manage this issue with the EU in

a way that moves us forward and allows us to move forward on a

broader context.

But that is precisely where we are coming from, as well, because

it would be very destructive for the EU to retaliate and then have

this issue degenerate further.

Ms. DUNN. I appreciate that, obviously being hurtful to everybody.

As you meet with companies who come in to assist you—as we

know, ETI was important to have the input of the companies, as

well as tax authorities and trade authorities—are you seeing the

development of—what I have heard you say so far is, the relationship is strong enough that we may be able to be allowed a little

more time to solve the problem, and that we are negotiating with

the EU. Are you seeing any particular direction that these discussions are going—what sort of a solution it will be, combination of

tax policy and trade policy?

Mr. DAVIDSON. I can start, and then Barbara may want to answer that as well.

36

I think it is too early to say exactly what the ultimate proposals

will be, and I think that is precisely what we want to work both

with the private sector and with Congress on. We are working

closely with the private sector, and as we have historically,

throughout this process consulting on the stages of the litigation.

And I think it is going to be very important also to have import

from the private sector in terms of where we go from here.

Barbara, do you have anything else to add?

Ms. ANGUS. I would just add and echo certain remarks that,

given the importance of this matter, it is essential that we pursue

all options and all possible routes to resolving this in a way that

does protect American interests and, at the same time, honors our

WTO obligations.

Chairman THOMAS. Thank you. Gentleman from Tennessee wish

to inquire?

Mr. TANNER. Thank you very much, Mr. Chairman.

I appreciate you all being here today. I just returned from a

NATO, North Atlantic Treaty Organization, trip to Brussels, and

while there went by the Organization of Economic Cooperation and

Development (OECD) and wound up in London. This is a very, very

contentious and serious issue for the Europeans, as you know. And

I was sitting here thinking as I was listening to your comments,

perhaps this is the debate on the trade bill.

Because in some ways what we are talking about goes far beyond

the momentary disagreement we have with the Europeans and

with WTO. Because if one looks at it in context and in total, it may

be that our system of taxation is doing as much, or more, to export

jobs than any sort of trade agreement we could possibly enter into.

And so I want to premise my remarks by saying that in my judgment, there may be no more important issue coming before this

Committee any time than the subject matter at hand.

I heard you talking about origin-based taxes, territorial-based

taxes versus consumption taxes. And would you explain again to

the Committee the WTO rules and the way they treat—however

one wishes to characterize it—consumption taxes versus territorial

or direct or indirect? Could you go over that one more time, please.

Ms. ANGUS. Certainly. And perhaps Peter has something that he

would like to add to this.

The WTO rules treat differently direct taxes and income—indirect taxes. The U.S. income tax is a direct tax, and under the trade

rules, direct taxes are not border adjustable.

An indirect tax, a tax on transactions, goods or consumption,

such as a value-added tax or a sales tax, is treated differently

under the trade rules. Under the trade rules, an indirect tax that

is levied on the destination principle is border adjustable. And this

distinction in the trade rules or the history of the trade rules distinction between these two types of taxes dates back, all the way

back to 1960.

And I think, actually, Mr. Hufbauer’s testimony will cover some

of the roots of that. That was before my time.

Mr. TANNER. Thank you very much. I wanted that again on the

record because in looking at this issue—and I have been for the

last 10 days—I am not sure that there is a fix as long as there is

this difference in our system of taxation that would be WTO comVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00040 Fmt 6633 Sfmt 6602 E:\HR\OC\A971.XXX pfrm01 PsN: A971
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pliant and would be capable of being passed and signed by the

President.

And, Mr. Chairman, my observation was, given the distinction,

I am not sure there is a legislative fix that is both WTO compliant

and capable of being passed by this Congress and signed by the

President, given our two extremely different philosophies with respect to taxation on this issue of border adjustability.

Do you have any ideas as to how those two could be married, as

it were?

Ms. ANGUS. I think it is certainly a difficult issue. At this hearing today there has been a lot of acknowledgment about how difficult it will be to find a solution that addresses all of the needs

here and something that we need to look at very carefully.

We need to keep focused on some of the objectives of the provisions that the WTO has looked at, the provisions in our tax law,

their objective in ensuring a level playingfield. We need to look at

the WTO rules and their treatment of taxes. And, again, we think

that it is very important that we look at all aspects of this, and

that our solution looks at all options and takes into account all of

the things that need to be done to address this.

Mr. TANNER. I appreciate your time.

Mr. Chairman, I think that this is a question for Harry Houdini,

if you can find him, to try to match these two differing philosophies

together. Maybe we can get him to come testify next time. But I

want to thank you for this hearing. This is the trade hearing.

Chairman THOMAS. Thank the gentleman for his comments. And

his observation is a real one, and what I would offer now, prior to

listening to the hearings and the comments, is that if we cannot

fundamentally change the Tax Code to allow us to have the same

relative advantages as the Europeans, because there is an ideological, philosophical problem associated with it, perhaps an alternative way of looking at it—and I only suggest this now, and I

don’t want to enter into a debate about it—is that although it is

true that corporations are fictitious, people designed them originally to create an ability to accumulate capital in multiple ways,

if you would view corporations as the victims in this, we might be

able to deal with resolving some of the problems around the victims.

If you choose to view it as a victimless crime, then, yeah, we are

back to the fundamentals of dealing with underlying Tax Code

changes.

But if the corporations are the victims in this, we might be able

to deal with the victims and provide a solution for the victims. And

I will simply leave it at that now.

Gentleman from Georgia wish to inquire?

Mr. COLLINS. Mr. Chairman, the gentleman from Georgia is a

victim. You know, Yogi was brought up awhile ago, and I believe

old Yogi also said, ‘‘When you come to a fork in the road, take it.’’

That is about where we are today. We are at the fork in the road,

so we are going to take it.

You know, the Foreign Sales Corp., as I understand it, was put

in place for competitive purposes, is that right, to allow our businesses to be more competitive in a global market? Is that true?

38

Ms. ANGUS. Yes, it was aimed in addressing differences between

our tax system and other tax systems that had the effect of impeding the competitiveness. So the provisions in the context of our system were aimed at addressing exactly that issue.

Mr. COLLINS. And that provision of Tax Codes is noncompliance

with the WTO rules, right?

Ms. ANGUS. Yes.

Mr. COLLINS. Based on what I hear coming from this hearing and

what I read about the European Union, their only solution is repeal

of that provision, basically.

Mr. DAVIDSON. You are right, Mr. Collins.

Mr. COLLINS. That is enough. Stop while you are ahead.

So we have a choice, status quo or repeal. What is the difference

cost-wise? Status quo, do we not then continue to allow the business to use the Foreign Sales, and we have to pay compensation

or higher tariffs on products we export? Is that the choice?

Mr. DAVIDSON. Yes, Mr. Collins. I think the costs of status quo

would be most likely, probably inevitably, paying the cost of retaliation, which means putting—basically, American products being

exported at a higher cost overseas, harming our ability to export,

or paying compensation back here in the United States, which

would be lowering the cost of European goods.

Mr. COLLINS. So it is a higher cost—reduces the advantage of

being, or reduces the competitiveness of the world markets. That

is the end result whether you repeal or don’t repeal the status quo.

Well, back then, it relates to consumers and the cost to consumers because if you repeal or if you don’t repeal, either way, the

cost is going to be passed on to the consumers, domestic or foreign.

The only thing that I can see in the interim is the fact that Congress imposes a lot of cost on business. We impose cost through either rules, regulations, taxation. There are a multiple number of

ways that the Congress imposes costs on business. That is where

we hear a lot of discussion about tax reform.

And then the gentleman from Tennessee made a very good observation of where we are with this. Reform will come from a mandate

from the people or it will not come from this Congress because it

is too political. That mandate is not there yet. Further discussion

of reform may lead to such a mandate.

But here we need some simplification, and that goes back to the

one provision that the EU has problems with. If we were to repeal

that or if we leave it in place, we need to look at the Codes themselves and see how we can change the codes that will lessen the

cost to business for both domestic and foreign sales that will leave

us to be in a competitive state.

Well, that is going to disrupt somewhere the cash flow in this

town. I mean, the focus here in this town is the cash flow of the

Treasury, because we get our cash flow from people and business

and such. So that is the cash flow we ought to be focused on. This

Congress, particularly this Committee, should focus on substance,

substance of simplification of tax law that we have jurisdiction over

that will focus on the reduction of cost of goods both domestically

or exported.

As I say, there will be a disruption in cash flow. The only way

you deal with the disruption in cash flow is one of two: You raise

39

another tax to offset that disruption or you look at your spending

habits. Folks at home tell me, look at spending first, because we

ain’t spending a lot of money in this town.

And I see the red light is on, and I am going to close with this;

and this is probably going to blow somebody’s skirt up. I hear constantly that I am left out. This is just an effort on the part of some

people that I am left out. You know, phone lines in my office run

both ways. You can receive a call or you can make a call. When

I walk down one of these halls, both ways, I meet people coming

and going.

There has to be an effort on both sides to reach something—an

agreement that has substance to it. And that is what we need to

do here.

I appreciate your patience and your indulgence. Come back to us

with something of substance, and hopefully, by the time you get

back, we will have something of substance.

Thank you, Mr. Chairman.

Chairman THOMAS. Thank the gentleman.

I also would like to have heard the panel’s response to you that

since we are the world’s largest importer and the world’s largest

exporter, our failure to abide by the rules is not just the direct loss

of any financial transaction, but it is a fundamental erosion of the

rules by which the world trades; and that we cannot afford any erosion of those rules because we will be the losers in that, not others.

That is why we have fought so hard for another round to perfect,

even beyond current rules, the rules of world trade.

Mr. COLLINS. Well, that is true; and it could, far beyond just the

European Union.

Chairman THOMAS. It is trying to get the world to comply with

the trading rules.

We are focused on America’s failure to comply. The real problem

is the world in general tries to fail to comply. Our job is to set the

example of how we ought to operate.

Gentleman from Pennsylvania wish to inquire?

Mr. ENGLISH. Thank you, Mr. Chairman. I think this hearing has

explored this issue very thoroughly, and I simply want to say that

examining the WTO decision in this area leads me to associate myself with those who have said today that they are disappointed.

It is fairly clear the WTO decision overlooked existing past practices within this jurisdiction. It created a precedent for a massive

intrusion into the design of individual States’ tax practices. It

has—by ‘‘individual States,’’ I mean countries. It has, I think, created the specter of future intrusion into legitimate tax design and

tax policy decisions that are made by sovereign States. And I am

particularly concerned about the long-term impact on the world

trading system.

I do have one question for the panel, and that is, looking at this

decision and having analyzed it, do you see any jurisdictions within

the European Union where their tax system would be equally subject to challenge, based on the principles that the WTO has announced?

Mr. DAVIDSON. Thank you, Mr. English.

I think that one of the reasons is that we decided—and there was

a discussion about the process of appeal. We worked with the priVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00043 Fmt 6633 Sfmt 6602 E:\HR\OC\A971.XXX pfrm01 PsN: A971
40

vate sector and worked closely with Congress. And one of the most

important factors in terms of deciding to take the appeal, knowing

as we did ultimately where it was likely to head, was obtaining

some kind of clarity in the ultimate rules, which would both guide

us in terms of our efforts to comply with the decision, but also give

us some indication about where other systems might be in terms

of the new appellate body standard.

I think it is unclear right now as to whether there might be EU

Member-States that would be vulnerable under the current criteria. It is something that we are looking at, and we will continue

to look at that as we move through the process. We will inform you

further if we find any provisions there that we think need to be

acted on. But for now, I think that is an interesting question and

something we are going to be pursuing, but I am not sure that is

an answer to our current situation of where we go from here.

Mr. ENGLISH. I recognize that. And may I say, I would welcome

correspondence with you in the future as you look at other tax systems. I think it is fair game for us to assess whether we can appropriately challenge some of our trading partners’ tax systems if that

is the path they have chosen to pursue.

My final comment, Mr. Chairman, Mr. McDermott earlier, and I

think with some justification, expressed a gloomy view of the likelihood of our coming up with a solution. I am not quite as gloomy.

I think, as you do, Mr. Chairman, that we need to have fundamental reform of the business Tax Code with the objective of creating a system which is simpler, which accommodates our exports

and the capital investments that are necessary for some of our

companies to compete globally. With that in mind, I would encourage Mr. McDermott and others to consider the business side of a

bill that I have reintroduced in this Congress, the Simplified USA

Tax, which would establish a WTO consistent business consumption tax similar to that that was included in Nunn-Domenici, but

which would provide for full expensing of capital investments.

I believe that this approach to reform is certainly one of the options that needs to be considered, and I salute you, Mr. Chairman,

for being willing to raise the banner of business tax reform; and I

hope you receive support for that.

And I yield back the balance of my time.

Chairman THOMAS. Thank the gentleman. The gentleman from

Texas, Mr. Doggett, wish to inquire?

Mr. DOGGETT. Thank you, Mr. Chairman. And thanks to both of

you for your testimony this morning.

Ms. Angus, is it correct that the law at issue before us today represents legislation for which, prior to your coming to your current

job, you were a principal advocate and lobbyist on behalf of the

FSC 2000 coalition?

Ms. ANGUS. In my prior job, before I came to the U.S. Department of the Treasury, I did represent companies that were very interested in the issue of the FSC.

Mr. DOGGETT. That is what I wanted to ask you about.

This 2000 Coalition, in which you filed a disclosure form that you

were the principal of, who are the principal individual members of

that coalition?

41

Ms. ANGUS. I don’t think that I can give—I could recite to you

right now—— Mr. DOGGETT. Just tell me three or four that you remember.

Ms. ANGUS. They were—the members of that coalition were— there were several companies involved in that group, all very interested in this issue.

Mr. DOGGETT. Any of the names that you recall today? You were

lobbying for them this time last year.

Ms. ANGUS. I am a little bit uncomfortable with not being able

to give a complete list. I did give a complete list in disclosure forms

that I filed and am certainly happy to provide that to you.

Mr. DOGGETT. You gave a complete list of all the companies that

were members of the FSC 2000 Coalition?

Ms. ANGUS. In disclosure forms that I filed in connection with my

current position, releasing information regarding companies—— Mr. DOGGETT. Where did you file that?

Ms. ANGUS. The financial disclosure forms.

Mr. DOGGETT. Listed the names of all the individuals?

Ms. ANGUS. Information regarding all companies with whom I

worked previously.

Mr. DOGGETT. If you don’t want to single out some of them today,

can you provide me that information this week, the names of the

individual companies that comprised the FSC 2000 Coalition?

Chairman THOMAS. If the gentleman would yield briefly.

Mr. DOGGETT. As soon as I finish with her.

Chairman THOMAS. It is on this. I want to know if there is a

legal question.

Mr. DOGGETT. It is not a legal question.

Chairman THOMAS. You indicated you filed this information

somewhere. Is that public information?

Ms. ANGUS. I am not certain about that. Obviously there are a

variety of disclosure forms that are filed. We will certainly—— Mr. DOGGETT. I am just asking for the names of the companies

that composed the FSC 2000 Coalition for which you were lobbying

last year, the year before and perhaps longer before that.

Ms. ANGUS. We will certainly look into this and get you the information that—— Mr. DOGGETT. And that information will contain the names of

the members of the FSC 2000 Coalition?

Ms. ANGUS. We will certainly go back and look at this and get

you——

Mr. DOGGETT. What is there to look at? Can you not tell me the

names of any member of the FSC 2000 Coalition that lobbied, with

you as their principal, for the very bill that we have up for consideration today?

Chairman THOMAS. Will the gentleman yield? There is no bill up

for consideration today.

Mr. DOGGETT. It is the law we have. The bill you lobbied for is

the one that the WTO found noncompliant. And I am asking the

names of any of the companies that composed the FSC 2000 Coalition for which you were working as principal.

Chairman THOMAS. I think if the witness understands the question, and I believe the concern is whether or not there is any legal

concern about answering the question——

42

Mr. DOGGETT. To identify whom she was lobbying for?

Chairman THOMAS. If the gentleman believes that is not a problem, then my assumption is he has resources and either knows the

answer—— Mr. DOGGETT. I am sure she is about to give it.

Chairman THOMAS. I am sure she is about to tell you that she

will make sure that there is no legal violation to her answer and

that she will provide it. But let us hear what her answer is.

Mr. RANGEL. Mr. Chairman.

Chairman THOMAS. I tell the gentleman from New York, I am

trying to move away from what is getting very close to badgering

the witness.

Mr. DOGGETT. It is simply asking for information from a witness.

Mr. RANGEL. I am not saying that you are wrong in that pursuit,

but you could be a little more sophisticated in planting an answer

in the witness’ mouth.

Mr. DOGGETT. And if I may ask—— Ms. ANGUS. As I indicated earlier, I would like the opportunity

to go back and determine what is appropriate information to provide, and will certainly provide all of that information that is appropriate and required.

[The information is being retained in the Committee files.]

Chairman THOMAS. Gentleman’s time has expired.

Mr. DOGGETT. Mr. Chairman, I haven’t been given 5 minutes.

Chairman THOMAS. You had 5 minutes.

Mr. DOGGETT. May I have just another 30 seconds?

Chairman THOMAS. Gentleman can have 30 seconds.

Mr. DOGGETT. I would extend that answer to the 877 Coalition

for which you were lobbying. People that renounced their American

citizenship, just like what Mr. Neal was asking about for corporations, but for individuals; and also the coalition of corporate taxpayers—taxpayers that were also involved in international tax

issues.

I want to know the names of the individual companies that are

part of that coalition, those three together, according to the records

that are public——

Chairman THOMAS. Gentleman’s extension of time has expired.

Mr. DOGGETT. Over the last 18 months, and I would like to know

who did that.

Chairman THOMAS. Gentleman from Oklahoma wish to inquire?

Mr. WATKINS. Yes, sir. Thank you Mr. Chairman. And I have

something that might be worthwhile. Probably a little bit of an editorial comment, but I hope it is helpful with the Committee, maybe

our panel.

First, let me say I think the gentleman from Tennessee—Mr.

Tanner, I think you are right on the button. This is very crucial

and very important, and I think we have to work on it. I don’t have

all the disagreement that Mr. Doggett has because I hope we do

have some people who are knowledgeable sitting at this table. And

I hope we do have people that have a background in FSC and some

things that are going on, because we don’t want people who are totally inept sitting out here trying to resolve our problems.

And let me say to Ms. Angus here, the FSC provisions were enacted to resolve-—and I would like the panel to know this, enacted

43

to resolve a GATT dispute involving a prior U.S. tax regime that

DISC enacted back in 1971. Remember that date, 1971.

Now, nearly a generation later, in 1998, WTO came along and

said the dispute settlement—that this was not kosher. And the European Union challenged that along the way, and in 1999 a WTO

panel was set up.

The point I would like to make here is, FSC came into being because we are trying to resolve differences and it was accepted then.

But, Mr. Chairman, 25, 30 years later, they say, Whoa, you’ve got

to change that. It is not a level playing field.

Well, you know, let us go back to Ground Zero. We have to level

some other things in with them.

Now, Mr. Davidson, let me say that I read your statement too,

and I think we have some arrows in the quivers, so to speak, that

we can work with because this deals also with agriculture; and I

think you indicated, I think your testimony indicated, this is about

a $4 billion problem.

Mr. DAVIDSON. The EU claims that their retaliation is a $4 billion retaliation.

Mr. WATKINS. And I would like that to be considered, $4 billion

against business, industry as in agriculture. I don’t know what percentage of that is agriculture. Do you know?

Mr. DAVIDSON. What percentage of FSC users in the United

States are agricultural?

Mr. WATKINS. Could that be provided, a real short answer?

Mr. DAVIDSON. We can certainly get back to you on that.

Mr. WATKINS. If you don’t mind. But agriculture is affected with

that.

Now, Mr. Chairman, also we do have some arrows in the quiver,

because I would like the panel to talk about it. And you mentioned

bananas, and I have led the fight about the beef industry because

the EC, in an unscientific way, has blocked our beef from being

sold in Europe. That is a blatant trade barrier, maybe not a big

number, but maybe 250 million or more and sometimes larger than

that.

But the point is, we also settled in the Uruguay talks for a peace

clause, and when you get to the peace clause, it lets the ECU have

$7 billion worth of agricultural subsidies, I think we have an

arrow; I think we have got a big-time one. We only have about 200

million export subsidies that were accepted. They got $7 billion,

and they come to us with $4 billion in FSC.

We should not consider only taxation, by itself. We should bring

the subsidies to the table at the same time. And we need to have

someone looking at the big picture, not just simply a tax deal. And

we are talking about—because we are being hurt, Mr. Rangel. We

have been sold down the drain, and we should not let them escape

this time sequence and say, Oh, now today we come back 30 years

later and say, Let me have that, because it was accepted then.

So I am very concerned. And, you know, I don’t want to get concerned about it very much, and that is why I want you to get me

the figures later.

But it is not just a fly-by-night thing for me. I end up building

a Center for International Trade in Oklahoma, trying to move us

forward in trade, and I find all these problems.

44

So an editorial comment, Mr. Chairman, I hope the comments of

the gentleman from Tennessee and I hope something I said might

be of help, but we need to use the arrow that we have, and we have

$7 billion, and we need to take it to the table to solve this problem.

Thank you so much. I appreciate your being here, and I am glad

you are knowledgeable about the FSC.

Mr. DAVIDSON. Thank you.

I think you know how important agriculture is in terms of the

President’s trade agenda. And Ambassador Zoellick has appeared

here several times to make that point; I think it is our number one

priority in terms of the new round of trade negotiations.

And we want to make sure we are continuing to make progress,

as I said before, on the broader trade agenda because it is so important to keep that on track to make sure that American agricultural products are being able to be treated fairly overseas. And we

have a number of issues we are engaging people on, on the GMOs,

genetically modified organisms, and other issues.

Mr. WATKINS. Are we putting agriculture on the table for discussions or leaving them off? Are we resolving that at the same time?

Mr. DAVIDSON. In terms of the round, I mean, agriculture is front

and center in terms of the issues we want to address.

Mr. WATKINS. Thank you.

Chairman THOMAS. Mr. Ryan, wish to inquire?

Mr. RYAN. We are in this situation because we are in this situation. It is important to note that this is the fourth time, so I think

that we are in agreement here between the Administration and

most members of this Committee that we need to come up with a

fundamental solution.

We can’t pass something that is similar to what we just had

struck down by the WTO. So it is going to require this Committee

and the Administration to think fundamentally how we restructure

corporate taxes to respond to this, and to do so in a way that we

can continue to send our businesses overseas with confidence and

on a level playing field so they can compete in the global marketplace. That means jobs here in America, and that is what this is

all about.

The reason I decided to comment, Ms. Angus, is there is an old

trick in Washington, and I am a relatively new guy, but the oldest

trick here is, if you don’t want to debate somebody on the merits

of an argument, impugn their motives. And I think you are seeing

a little bit of that here; and it is unfortunate because it soils the

tone of the debate we have here, which is a very important and

time-sensitive issue.

We need to have experienced people in government. We need to

have people who have experience in dealing with these types of tax

issues, who know what corporations face when they run into these

tax regimes and who know the consequences of this FSC ruling. So

I think it is important in our executive branch that we have people

who know what they are talking about, who know how these policies affect real people in our economy and how they affect corporations.

It is not an issue that we should be ashamed of in any way, and

it is a shame that we have to go down the road of impugning someone’s motives when we are trying to find a solution on a bipartisan

45

basis to an issue that we are forced to deal with. Hopefully, we will

rise above that in the future.

Our next panel have some interesting ideas that we need to look

at, and I just encourage you to work with us very quickly to come

up with a fundamental answer to this problem. With that, I just

yield.

Chairman THOMAS. I thank the gentleman.

And I want to thank the panel. Obviously we will be pursuing

more specific concerns in Subcommittee, and clearly the full Committee needs to revisit it. Thank you very much.

Chair would ask the second panel to come forward. And, first of

all, thank you for bearing with us.

The second panel consists of Gary Hufbauer, Senior Fellow for

the Institute for International Economics; Mr. Peter Merrill, who is

a Partner and Director of the Economic International Consulting

Group from PricewaterhouseCoopers; and Mr. Stephen Shay, who

is a Tax Partner at Ropes & Gray in Boston, Massachusetts.

We have written testimony from each of you and make it a part

of the record without objection. You may address us in the time you

have in any way you see fit to enlighten us from your perspective.

And if we can start with Mr. Hufbauer and move across the

panel. Welcome and we look forward to your testimony. And you

are going to need to turn the microphones on and they are very

uni-directional.

STATEMENT OF GARY HUFBAUER, SENIOR FELLOW,

INSTITUTE FOR INTERNATIONAL ECONOMICS

Mr. HUFBAUER. Thank you very much, Mr. Chairman.

As was mentioned in the earlier panel and reinforced, this case

seems to date back to 1971 and these core issues have been both

negotiated and litigated for more than 30 years in the GATT and

WTO. I subscribe to the view that the time has come for Congress

to settle this dispute once and for all; and I think it should settle

the dispute by eliminating the competitive disadvantage to the U.S.

economy arising from the ancient practice of taxing foreign income

generated when American firms export their goods and services to

world markets and when they produce abroad.

In the outline that accompanies my remarks, I traced the history.

The most recent appellate body decision, while an improvement on

the second panel report, contains a good deal of mischief. The second panel report stretched to declare the ETI Act was a prohibited

export subsidy. The way it stretched was to create a new test

which was not found in the first panel report, namely this concept

of a normative benchmark for judging national tax systems.

The second appellate body used a less sweeping, ‘‘but for’’ rule to

invalidate the ETI. In terms of legal rationale, that counts as an

improvement. In addition, the second appellate body actually reaffirmed most but not all of the elements of that 1981 Council Decision that was spoken of and what had been dismissed by the first

appellate body. So you had kind of a circular process. They tossed

the Decision out in the first round; and in the second round, at the

appellate body level, they reinstated many of the provisions. So I

guess I have to say that is another improvement.

46

But these improvements came at a cost by comparison with the

first panel report and first appellate body report. And even under

the second panel report, it would have been relatively easy for the

United States to mount an attack on European corporate tax systems. But the easy shots were foreclosed in the second appellate

body report.

There is a lot of tax detail there, and I know people don’t really

want to go into that here. I am not saying that the European systems are immune to attack under the second appellate body report,

but I am saying that the area of attack was substantially circumscribed.

Apart from that, there is other mischief in the second appellate

body report. These WTO judicial mechanisms will become the

world arbiter of what is, and what is not, foreign-source income if

they go down the path they have set. And they will decide what

mixture of exemptions and credit systems do and do not create prohibited export subsidies.

If this judicial activism is pursued by future appellate body

judges and not curbed by WTO Members in their Doha Round negotiations, I think we will be traveling down the road of more intrusive WTO examination of national tax systems that differentiate

between export oriented and domestically oriented sectors of national economies.

I believe in the virtues of uniform taxation, but I don’t think

those virtues should be imposed from Geneva. The challenge for

Congress is to reform the U.S. tax laws so as to accomplish two

goals. First, eliminate the huge bargaining chip that the WTO Appellate body has handed the European Union. I think it is a far

larger chip than the EU ever contemplated in the beginning. To

paraphrase Senator Dirksen, after a billion dollars, who is counting, but the FSC decision is a huge chip for the EU and Congress

has to remove the chip from the table or the United States will pay

for it throughout the Doha Round.

Second, I hope the Congress will remove the competitive tax disadvantage that U.S. firms face when they export to world markets

and produce abroad. In his statement, Peter Merrill goes into some

length on these disadvantages. Let me just say here that I totally

disagree with the suggestion that Mr. Shay will be offering later

in this panel to eliminate deferral.

If the United States actually eliminated the practice known as

‘‘deferral,’’ the whole U.S. economy, including all exporters, would

be placed at an extremely serious competitive disadvantage in the

global marketplace, and we would see far more examples of inverted ownership. In fact, U.S. companies would become easy pickings for foreign purchasers, just based on tax differences, if we

eliminate deferral.

Well, a final word on the ETI case. As a supplement to congressional action taken in consultation with the Treasury Department,

the Administration should renegotiate the WTO Code on Subsidies

and Countervailing Measures, both to achieve greater parity in

rules that are applied to direct and indirect taxation and to curb

judicial activism in the WTO. But I want to emphasize those negotiations are a supplement and not a substitute for congressional action.

47

Thank you, Mr. Chairman.

[The prepared statement of Mr. Hufbauer follows:]

Statement of Gary Hufbauer, Senior Fellow, Institute for International

Economics

Chairman Thomas and members of the Committee, thank you for inviting me to

testify on the second WTO Appellate Body decision in the FSC/ETI case (United

States—Tax Treatment for ‘‘Foreign Sales Corporations’’ Recourse to Article 21.5 of

the DSU by the European Communities. AB–2001–8, decided 14 January 2002.) In

a sense, this case is three decades old: its antecedents date to the Domestic International Sales Corporation legislation enacted in 1971. The core issues have been

repeatedly negotiated and litigated for nearly thirty years in the GATT and now the

WTO.

The time has come for Congress to settle the dispute once and for all. It should

settle the dispute by eliminating the competitive disadvantage to the U.S. economy

arising from our ancient practice of taxing foreign income generated when American

firms export their goods and services to world markets, and when they produce

abroad.

In the outline that follows, I trace the history of the current FSC dispute back

to the 1960 GATT Working Party. The most recent Appellate Body decision, while

an improvement on the second Panel Report contains a good deal of mischief. The

second Panel Report, stretching to declare the ETI Act an export subsidy, created

a new test not found in the first Panel Report—namely the concept of a ‘‘normative

benchmark’’ for judging national tax systems. The Appellate Body used a less

sweeping ‘‘but for’’ rule to invalidate the ETI. In terms of legal rationale, that counts

as an improvement. Moreover, the Appellate Body, in its second decision, reaffirmed

most (but not all) the elements of the 1981 Council Decision—a decision that had

been tossed aside (not a ‘‘legal instrument’’) in the first Panel Report and Appellate

Body decision. Again, this is an improvement.

But mischief remains. Under the second Appellate Body decision, the WTO’s judicial mechanisms will become the world arbiter of what is, and what is not, foreign

source income. These same mechanisms will decide what mixture of exemption and

credit systems do and do not create prohibited export subsidies. This judicial activism, if pursued by future Appellate Body judges, and not curbed by the WTO members in their Doha Round negotiations, points to more intrusive WTO examination

of domestic tax systems that differentiate between export-oriented and domesticallyoriented sectors of national economies. Like most economists, I believe in the virtues

of uniform taxation. But I do not believe these virtues should be imposed from Geneva.

The challenge for Congress is to reform U.S. tax laws so as to accomplish two

goals. First, eliminate the huge bargaining chip that the WTO Appellate Body has

handed to the European Union. Second, remove the competitive tax disadvantage

that U.S. firms face when they export to world markets and produce abroad.

Supplementary to Congressional action, the Administration should renegotiate the

WTO code on Subsidies and Countervailing Measures both to achieve greater parity

in rules applied to ‘‘direct’’ and ‘‘indirect’’ taxation, and to curb judicial activism in

the WTO. But negotiations in the Doha Round should be a supplement, not a substitute, for Congressional action.

Thank you.

THE FSC CASE: BACKGROUND AND IMPLICATIONS

A. Quick background

• A 1960 GATT Working Party codified the ancient distinction between permissible border adjustments for direct and indirect taxes: origin principle for direct

(no adjustments at the border); destination principle for indirect (adjustments

permitted at the border—i.e., impose the tax on imports, exempt the tax on exports). Hence destination principle adjustments for corporate profits taxes on

export earnings (classified as a direct tax) are both an impermissible export

subsidy and a violation of national treatment. But destination principle adjustments for VAT taxes on export and import sales are permitted. This distinction

persists, despite the obvious economic point that a VAT amounts to a combination of a direct tax on profits, a direct tax on interest and rent paid by the corporation, and a direct tax on wages. In other words, by GATT alchemy, direct

taxes can be transformed into indirect taxes and adjusted at the border. But

48

without this magical transformation, direct taxes cannot be adjusted at the border. • In 1962, the United States enacted Subpart F of the Internal Revenue Code.

Subpart F eliminated deferral for ‘‘foreign base company income’’ earned by controlled foreign corporations in tax haven countries. Base company income includes profits from handling the sales of U.S. exports to third countries. This

‘‘anti-abuse’’ provision put U.S. exporters at a tax disadvantage compared to

other industrial country exporters. • In 1971, faced with a growing trade deficit, the U.S. introduced the Domestic

International Sales Corporation (DISC)—tax deferral for the export earnings of

a U.S. corporation. In tax terms, the DISC softened the impact of Subpart F,

which subjected foreign base company income to U.S. tax. The United States

argued that tax deferral under the DISC was not the same as tax exemption.

The EC challenged the DISC in 1974. In turn, the U.S. challenged the European ‘‘territorial approach’’ to taxing export earnings. Specifically, the U.S. challenged tax exemption for the portion of export earnings attributed to a sales

subsidiary located in a tax haven country. (None of the European countries then

or now has an effective equivalent of Subpart F for current taxation of ‘‘foreign

base company income’’.) • A GATT panel decided the four ‘‘tax cases’’ in 1976: all defendants lost. Retaliation was held in abeyance during the Tokyo Round negotiations. • The Tokyo Round Code on Subsidies & Countervailing Duties settled the four

tax cases, based on four principles: (a) the distinction between direct and indirect taxes was preserved; (b) U.S. agreed to repeal DISC (tax deferral was conceded to be an export subsidy, like tax exemption); (c) however, methods of

avoiding double taxation—both the exemption method associated with territorial systems of taxation and the foreign tax credit method associated with

worldwide systems of taxation—are defined not to be subsidies; (d) the arm’s length pricing standard is to be observed in transactions between parent exporting companies and their foreign sales subsidiaries. • Following the conclusion of the Tokyo Round, in 1981 a GATT Council Decision

disposed of the four tax cases, with a Chairman’s note that reiterated the bargain struck in the Tokyo Round Code. In particular the Chairman’s note stated: ‘‘The Council adopts these reports on the understanding that with respect to

these cases, and in general, economic processes (including transactions involving exported goods) located outside the territorial limits of the exporting country

and should not be regarded as export activities in terms of Article XVI:4. It is

further understood that Article XVI:4 requires that arm’s-length pricing be observed—Furthermore, Article XVI:4 does not prohibit the adoption of measures

to avoid double taxation of foreign source income.’’ • Based on this note, in 1984 the United States repealed the DISC, and enacted

the Foreign Sales Corporation (FSC). The FSC allowed partial tax exemption

for the income of a foreign corporate subsidiary derived from handling U.S. export sales. The amount of income exempted was calculated by a formula designed to approximate arm’s length pricing (dividing export profits between domestic and foreign sources).

B. First Round of FSC Litigation

• In 1999, the EU challenged the FSC as a violation of the Uruguay Round Code

on Subsidies & Countervailing Measures (SCM). This was a surprise to the

United States, since the FSC had not been challenged during the course of the

Uruguay Round negotiations. The EU motivation was to create bargaining chips

to resolve other WTO disputes (e.g., bananas, beef hormones), potential disputes

(e.g., Airbus and steel), and pending disputes at the expiration of the agricultural peace clause (December 2003).

• The first WTO FSC Panel, in its October 1999 decision, stated that the 1981

Council Decision was not ‘‘a legal instrument’’ of the GATT–1947 that had been

adopted by the GATT–1994, by virtue of the Annex 1A of the Uruguay Round

(the grandfather or savings clause). Surprise! The Panel then went on to hold

that the FSC is a prohibited export subsidy because: (a) revenue is foregone;

(b) exports are taxed more favorably than production abroad. The Panel did not

rule on the EC claim that FSC violates the SCM because exports are taxed

more favorably than production for the home U.S. market. However, the Panel

did rule that the FSC is not a permissible application of the territorial approach—i.e., the exemption approach—to avoiding taxation of foreign source income because the FSC invokes the territorial principle for only the export segment of foreign source income. In February 2000, the WTO Appellate Body affirmed the Panel Report in all essential respects.

49

C. The Extraterritorial Income Exclusion (ETI) Act

• In November 2000, the U.S. Congress passed the ETI Act in response to the

WTO Appellate Body decision. The ETI Act excluded from the U.S. definition

of gross income certain foreign source income—namely a portion of export earnings, and a portion of earnings from production abroad—with the condition that

this territorial method of avoiding double tax relief could only be used if the

taxpayer did not claim foreign tax credits with respect to the same earnings.

The benefits of the ETI Act were also conditioned on the sale of the goods outside the United States, and the use of less than 50% non-U.S. (i.e., imported)

inputs. Under the ETI Act, FSC benefits are phased out. • In the U.S. view, the ETI Act conformed to the Appellate Body decision because:

(a) revenue was no longer foregone—ETI income was no longer part of gross income subject to corporate tax; (b) export earnings and foreign production earnings were similarly taxed under the ETI Act.

D. Second Round of FSC/ETI Litigation

• The EU brought a second case to the WTO, claiming: (a) notwithstanding the

ETI Act, revenue was still foregone; (b) the export contingency remained, even

if foreign production was, in some circumstances, covered; (c) the U.S. content

requirements for export earnings under ETI violate Article III (national treatment); (d) the FSC phase-out does not respect the first Appellate Body deadline

(October 2000).

• In August 2001, the WTO FSC/ETI Panel endorsed the EU arguments in all

essential respects. In reaching its decision, the Panel, like its predecessor, continued to disdain any deference to established tax practices. Instead:

• The Panel arrogated the power to decide when a mixed system of double

tax relief (territorial exemption plus foreign tax credits) amounts to a prohibited export subsidy. The ETI exclusion flunked, according to the Panel,

partly because it was too broadly drawn (it could exempt income not taxed

by another country) and partly because it was too narrowly drawn (only exports and selected foreign production are covered).

• On the way to creating this power, the Panel claimed the power to say that

any deduction or exclusion from gross income could amount to a departure

from the ‘‘normative benchmark’’ of the offending nation’s tax system, and

thus could amount to a relief from tax ‘‘otherwise due’’ (SCM 1.1(ii)), and

thus could amount to a subsidy.

• The Panel did not bother to examine actual U.S. tax practice, developed

since 1913, which has long allowed deferred taxation of the income of controlled foreign corporations (CFCs). In economic terms, deferral amounts to

a partial or near-total exemption. The ETI provision allows an explicit exemption where prior and current law allow for its first cousin, deferral.

• The Panel decided that the ETI exemption was ‘‘contingent on’’ exports—

in other words, that exporting is a necessary condition for receiving the

subsidy—even though the ETI exclusion also applies to foreign production

in designated circumstances. This, despite footnote 4 to the SCM which

states: ‘‘The mere fact that a subsidy is granted to enterprises which export

shall not for that reason alone be considered to be an export subsidy . . .

• Not surprising, the Panel found that the U.S. content rule violated Article

III.

• The Appellate Body affirmed the Panel decision, but narrowed the rationale

with two important twists. (a) The Appellate Body walked away from the Panel’s ‘‘normative benchmark’’ concept and instead defined ‘‘revenue otherwise

due’’ by referring to the taxation of ETI income when the taxpayer elects to

claim a foreign tax credit rather than the exemption. Since the taxpayer will

only elect the exemption method when his bottom line U.S. taxes are less under

the credit method, it follows that the U.S. Treasury has foregone ‘‘revenue otherwise due’’. (b) The Appellate Body delved into ETI Act rules for determining

the division of export income between domestic and foreign sources. Using simple-minded examples, the Appellate Body found circumstances where the rules

could improperly characterize domestic source income as foreign source income.

• In important ways, the Appellate Body returned to the main outlines of the bargain struck in the 1981 GATT Council Decision. The Appellate Body reaffirmed

the arm’s length principle for distinguishing between domestic source and foreign source income earned on export sales. The Appellate Body confirmed that

foreign source income, properly computed, could be exempt from tax and the exemption does not automatically amount to an export subsidy prohibited by the

SCM.

50

E. Questions Raised

• First question: how big is the bargaining chip that the WTO has created for the

WTO? Under the SCM, the Arbitral Panel decides the permitted level of retaliation—i.e. ‘‘appropriate countermeasures’’ (Article 4.11 of the SCM)—in the event

that the subsidizing member does not ‘‘withdraw the subsidy without delay’’.

The Arbitral Panel has said it will reach a decision at the end of April 2002.

Once decided, the Arbitral Panel’s ruling cannot be appealed. There is little case

guidance on ‘‘appropriate countermeasures’’—only the Brazil-Aircraft arbitration. In that case, the Arbitral Panel decided that ‘‘appropriate countermeasures’’ means the ‘‘the full amount of the subsidy to be withdrawn’’—not the

level of trade impairment to Canada (as Brazil had argued). Following this

precedent, the U.S. argues that the bargaining chip is $956 million, calculated

with reference to the tax benefits on FSC/ETI exports to the EU directly, and

to third country markets where U.S. and EU exports compete. The EU says the

bargaining chip is $4,043 million, based on total FSC tax benefits on exports

to the world. Both submissions avoid an explicit calculation of the trade impact

of the FSC/ETI benefit. However, their implicit calculations assume that the

size of trade impact equals the size of tax benefit (i.e., an export demand elasticity of—1.0). The Arbitral Panel’s decision will set an important precedent for

calculating ‘‘appropriate countermeasures’’.

• Second question: what is in the EU shopping bag? The EU claims that it only

wants the U.S. to amend or repeal the ETI law in a WTO-consistent manner.

This oft-repeated EU statement is only a ploy to force the U.S. into opening negotiations, offering ‘‘compensation’’ in the form of concessions on other trade

issues. Plausible candidates for the EU shopping bag: (a) beef hormones and potential biotechnology claims; (b) Section 201 restrictions on steel imports (but

there the EU can retaliate directly); (c) agricultural subsidies. The logic from

Pascal Lamy’s standpoint is to hold the bargaining chip in his pocket, and

threaten but not invoke retaliation. Possible outcome: a standstill on all retaliation that lasts until the end of the Doha Work Programme in 2005.

• Third question: will other WTO members use the decision to create their own

bargaining chips for negotiations and dispute resolution with the United States?

They would have to mount new cases against the FSC/ETI to get permission

to retaliate, but the precedent seems straightforward. If this scenario unfolds,

how will future Arbitral Panels go about allocating the rights to ‘‘appropriate

countermeasures’’ among WTO complainants?

• Fourth question: will the U.S. (and possibly other members) use the logic of the

WTO’s decision to launch their own tax cases against their trading partners?

Export processing zones, widely used by developing countries, are vulnerable.

So is the U.S. export source rule. The EU countries may have arbitrary formulas for calculating exempt foreign source income tucked away in their tax

laws and regulations. The Appellate Body decision is an invitation to tax litigation—member A can respond to a non-tax WTO case brought against it by

launching its own tax case against member B. This danger underscores the

standstill option mentioned earlier.

• Fifth question: will WTO members renegotiate the SCM in the Doha Work Programme? Two possible objectives: (a) Stop the DSM from turning itself into a

World Tax Court. For example, the SCM could instruct the DSM to defer to jurisprudence established in bilateral tax treaties and the OECD for defining foreign source income. (b) Eliminate the artificial distinction between border adjustment rules for direct and indirect business taxes. For example, the SCM

rules could allow members to exempt 50% of export earnings from corporate

profits tax. (c) As a matter of transparency, require WTO members to publish

their schedules of border tax adjustments applied on a product basis, following

the Harmonized Tariff System.

• Sixth question: how will the U.S. Congress change the tax law? Congressional

action is clearly necessary, both to take away bargaining chips from the EU and

to avert ‘‘piling on’’ by other WTO members. There are three broad options: (a)

The ‘‘minimal’’ fix—repeal the ETI Act, and exclude export income from ‘‘foreign

base company’’ income under Subpart F. (b) Abandon export tax relief—repeal

the ETI and use the revenue for other business tax reform, for example phasing

out the AMT. (c) Use the WTO decision as a springboard for fundamental reform, through a territorial system of taxing corporate profits. This is clearly the

best answer. Politically, it may be the most difficult.

f51

Chairman THOMAS. Thank you Mr. Hufbauer.

Mr. Merrill.

STATEMENT OF PETER R. MERRILL, PRINCIPAL AND DIRECTOR, NATIONAL ECONOMIC CONSULTING GROUP,

PRICEWATERHOUSECOOPERS LLP, AND CONSULTANT,

INTERNATIONAL TAX POLICY FORUM

Mr. MERRILL. Thank you, Mr. Chairman, Mr. Rangel, Members

of the Committee. I am Peter Merrill, Director of the National Economic Consulting Group at PricewaterhouseCoopers. I am also a

consultant to the International Tax Policy Forum (ITPF) and co-author of a book published recently by the National Foreign Trade

Council on international tax policy.

For the record, I am testifying today on my own behalf. The focus

of my testimony is the relationship between U.S. tax policy and

international competitiveness.

Current rules regarding the taxation of both domestic and foreign income create barriers that harm the competitiveness of U.S.

companies. These rules are also horribly complex to comply with

and to administer. Regardless of how the ETI dispute is ultimately

resolved, I believe it is important for this Committee to review the

current U.S. tax rules with a view to reducing complexities and removing impediments to U.S. competitiveness.

In a global market the competitiveness of the country depends on

the ability of its enterprises to produce goods and services that are

successful both at home and in foreign markets. Today, almost 80

percent of world income and purchasing power lies outside the

United States. Foreign affiliate sales are growing three times as

fast as domestic sales within Standard and Poor’s, S&P, 500 companies.

It is a common perception that the investment abroad by U.S.

multinationals comes at the expense of the domestic economy. This

is an incorrect view. According to the U.S. Department of Commerce, less than 11 percent of sales by U.S.-controlled foreign corporations were made back to the United States.

In 1998, U.S. multinationals were directly responsible for almost

two-thirds of all U.S. exports. A recent study by the OECD found

each dollar of outward foreign direct investment is associated with

$2 of additional exports. A number of studies have found U.S. investment abroad generates additional employment at home

through an increase in the domestic operations of U.S. multinationals. Moreover, research has shown that workers at domestic

plants owned by U.S. multinationals earn higher wages than workers at domestic plants owned by companies with only domestic operations.

In summary, U.S. multinationals provide significant contributions to the U.S. economy through sales of U.S. goods and services

abroad and employment at above average wages at home.

With the reduction of the U.S. corporate income tax rate from 46

to 34 percent in 1986, it is commonly thought that the United

States is a low-tax jurisdiction for corporations. While this was true

immediately after the 1986 tax, it is no longer true today. The

52

United States increased the corporate income tax rate to 35 percent

in 1991. Meanwhile, the average OECD corporate tax rate has fallen to 4.5 percentage points less than the U.S. rate.

In addition to a relatively high corporate income tax rate, the

United States is one of only three OECD Member Countries that

does not provide some form of relief from the double taxation of

corporate dividends. For a shareholder in the top individual income

tax bracket, the combination of corporate and individual income tax

is over 60 percent of distributed corporate income in the United

States. And while the total U.S. tax burden as a percentage of GDP

is relatively light compared to other OECD countries, reliance on

income and profits tax is unusually high.

In 1999, the U.S. relied on income and property taxes for almost

half of all revenues, compared to slightly over a third in the average OECD country. Indeed, the United States is the only one of the

30 OECD Member Countries that does not have a national valueadded tax.

A study published by the European Commission last year found

that, on average, U.S. multinationals bear a higher effective tax

rate when investing into the European Union than do EU multinationals. This is a European Commission study. The additional

tax burden ranged from 3 to 5 percentage points depending on the

type of finance.

There are a number of reasons why the United States has become an unattractive jurisdiction in which to locate the headquarters of a multinational company, aside from our relatively high

corporate tax rate.

First, unlike the United States, about half of the OECD countries

have a dividend exemption, also called a ‘‘territorial’’ tax system

under which a parent company generally is not subject to tax on

the active income earned by foreign subsidiaries.

Second, the foreign tax credit, which is intended to prevent double taxation of foreign-source income, has a number of deficiencies

that increase the complexity and prevent full double tax relief.

Third, the scope of the U.S. anti-deferral rules under subpart F

is unusually broad. While most countries tax passive income

earned by controlled foreign subs, the United States is unusual in

taxing a wide range of active foreign income that is reinvested

abroad.

In conclusion, short of adopting a territorial tax system, there

are significant opportunities to increase the competitiveness and

reduce the complexity of U.S. tax rules applicable to foreign source

income.

One opportunity that is worth special attention within the context of these hearings is the foreign base company sales rules

adopted by Congress in 1962. Part of the benefit of the FSC regime

that was rejected by the WTO was the fact that it created an exception to the base company rules. If the foreign base company

rules were to be repealed, U.S. companies would be put in a position more comparable to their foreign competitors.

Moreover, the original policy rationale for the base company

rules was thrown into doubt by the Treasury Department’s study

of subpart F.

53

1Wall Street Journal, ‘‘U.S. Firms Global Progress is Two-Edged,’’ August 17, 1998.

In conclusion, U.S. rules for taxing domestic and foreign source

income are out of step with other major industrial countries in a

number of ways. Regardless of the ultimate resolution of the ETI

case, Congress should consider changes to the U.S. system that

promote economic growth and reduce the costs of complying with

the tax system.

Thank you.

Chairman THOMAS. Thank you, Mr. Merrill.

Mr. Shay?

[The prepared statement of Mr. Merrill follows:]

Statement of Peter R. Merrill, Principal and Director, National Economic

Consulting Group, PricewaterhouseCoopers LLP, and Consultant, International Tax Policy Forum

U.S. TAX POLICY AND INTERNATIONAL COMPETITIVENESS

I. INTRODUCTION

I am Peter Merrill, a Principal and Director of the National Economic Consulting

group at PricewaterhouseCoopers LLP. I am also a consultant to the International

Tax Policy Forum, a group of U.S.-based multinational companies from a broad

range of industries, and co-author of a recent book published by the National Foreign Trade Council on International Tax Policy for the 21st Century. For the record,

I am testifying today on my own behalf and not as a representative of any organization.

The focus of my testimony is the relationship between U.S. tax policy and international competitiveness. In many instances, current rules regarding the taxation

of both domestic and foreign income create barriers that harm the competitiveness

of U.S. companies. These rules also are horribly complex both for taxpayers to comply with and for the Internal Revenue Service to administer.

The existing extraterritorial income (ETI) tax regime serves in part to offset some

of the anti-competitive features of U.S. tax policy. Thus, the WTO’s adverse decision

in the ETI case raises the question how Congress can strengthen the competitive

position of the U.S. tax system. Regardless of how the ETI dispute is resolved, I believe it is important for this Committee to review the current U.S tax rules with

a view to reducing complexity and removing impediments to U.S. competitiveness.

II. TAX POLICY AND INTERNATIONAL COMPETITIVENESS

While there are a variety of ways to define competitiveness, in this testimony I

focus on the standard of living of U.S. residents as the measure of economic performance. Achieving a high standard of living ultimately rests on the productivity

of U.S. investments. Growing productivity in turn requires investment—in plant

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

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

the least damage to the growth of productivity and national income. A poorly designed tax system can impose unnecessarily high costs to the economy—so-called

dead-weight loss—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.

III. U.S. MULTINATIONALS AND INTERNATIONAL COMPETITIVENESS

In a global market, the competitiveness of a country depends on the ability of its

enterprises to produce goods and services that are successful both at home and in

foreign markets. Today, almost 80 percent of world income and purchasing power

lies outside of U.S. borders. Opportunities for U.S. companies to grow their businesses increasingly lie overseas. From 1986 to 1997, foreign sales of S&P 500 companies grew 10 percent a year, compared to domestic sales growth of just 3 percent

annually.1

A. U.S. Investment Abroad and Exports

It is a common perception that investment abroad by U.S. multinationals comes

at the expense of the domestic economy. This is an incorrect view. The primary motivation for U.S. multinationals to operate abroad is to compete better in foreign

54

2 U.S. Department of Commerce, Survey of Current Business (July 2000). Note that 40 percent

of the sales back to the United States were from Canadian subsidiaries. 3Matthew Slaughter, Global Investments, American Returns. Mainstay III: A Report on the

Domestic Contributions of American Companies with Global Operations, Emergency Committee

for American Trade (1998). 4 National Foreign Trade Council, The NFTC Foreign Income Project: International Tax Policy

for the 21st Century, chapter 6 (1999). 5OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, p. 50

(1998). 6David Riker and Lael Brainard, U.S. Multinationals and Competition from Low Wage Countries, National Bureau of Economic Research Working Paper no. 5959 (1997) p. 19. 7Mark Doms and Bradford Jensen, Comparing Wages, Skills, and Productivity between Domestic and Foreign-Owned Manufacturing Establishments in the United States, mimeo. (October

1996). 8 Robert Lipsey, ‘‘Outward Direct Investment and the U.S. Economy,’’ in The Effects of Taxation on Multinational Corporations, p. 30 (1995). 9 U.S. Department of Commerce, Survey of Current Business (September 1998).

markets, not domestic markets. According to the Commerce Department, less than

11 percent of sales by U.S.-controlled foreign corporations were made to U.S. customers.2

Investment abroad is required to provide services that cannot be exported, to obtain access to natural resources, and to provide goods that are costly to export due

to transportation costs, tariffs, and local content requirements. Foreign investment

allows U.S. multinationals to compete more effectively around the world, ultimately

increasing employment and wages of U.S. workers.

While about one-fourth of U.S. multinational parent companies are in the services

sector, 56 percent of all foreign affiliates are this sector, which includes distribution,

marketing, and product support services.3 Without these sales and services subsidiaries, it would be impossible to sustain current export volumes.

According to the U.S. Commerce Department, in 1998, U.S. multinationals were directly responsible, through their domestic and foreign affiliates, for $438 billion

of U.S. merchandise exports—almost two-thirds of all merchandise exports.4

A recent study by the Organization for Economic Cooperation and Development

(OECD) found that each dollar of outward foreign direct investment is associated

with $2.00 of additional exports.5

B. U.S. Employment

Foreign investment by U.S. multinationals generates sales in foreign markets that

generally could not be achieved by producing goods entirely at home and exporting

them.

A number of studies find U.S. investment abroad generates additional employment at home through an increase in the domestic operations of U.S. multinationals. As noted by Professors David Riker and Lael Brainard: ‘‘Specialization in complementary stages of production implies that affiliate employees in industrialized countries need not fear the multinationals’ search for evercheaper assembly sites; rather, they benefit from an increase in employment in developing country affiliates.’’ 6

Moreover, workers at domestic plants owned by U.S. multinational companies earn higher wages than workers at domestic plants owned by companies without

foreign operations, controlling for industry, size of company, and state where the

plant is located.7

C. U.S. Research and Development

Foreign direct investment allows U.S. companies to take advantage of their scientific expertise, increasing their return on firm-specific assets, including patents,

skills, and technologies. Professor Robert Lipsey notes that the ability to make use

of these firm-specific assets through foreign direct investment provides an incentive

to increase investment in activities that generate this know-how, such as research

and development.8

Among U.S. multinationals, total research and development in 1996 amounted to $113 billion, of which $99 billion (88 percent) was performed in the United States.9

Such research and development allows the United States to maintain its competitive

advantage in business and be unrivaled as the world leader in scientific and technological know-how.

D. Summary

U.S. multinationals provide significant contributions to the U.S. economy through:

• Sales of U.S. goods and services abroad; • Domestic employment at above average wages; and

55

10 Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the top individual

income tax rate is scheduled to be reduced to 35 percent in 2006.

• Critical domestic investments in equipment, technology, and research and development.

As a result, the United States has an important interest in insuring that its tax

rules do not hinder the competitiveness of U.S. multinationals.

IV. DOMESTIC TAX COMPETITIVENESS

A. Corporate Income Tax Rate

With the reduction in the U.S. corporate income tax rate from 46 to 34 percent,

as a result of the Tax Reform Act of 1986, it is commonly thought that the United

States is a low-tax jurisdiction for corporations. While true immediately after the

1986 Act, it is no longer true today. The United States increased the corporate income tax rate to 35 percent in 1991. Meanwhile, the average central government

corporate tax rate in OECD member states has fallen since 1986 to 30.5 percent in

2001—4.5 percentage points less than the U.S. rate (see Exhibit 1). This disparity

in corporate tax rates would be even larger if corporate income taxes imposed by

subnational levels of government were taken into account.

B. Double Taxation of Corporate Dividends

In addition to a relatively high corporate income tax rate, the United States is

one of only three OECD member countries that does not provide some form of relief

from the double taxation of corporate dividends (see Exhibit 2). Most OECD countries relieve double taxation of corporate dividends at the shareholder level through

some form of credit, exemption, or special tax rate for dividend income. For a shareholder in the top individual income tax bracket (38.6 percent 10), the combination

of corporate and individual income tax is over 60 percent of distributed corporate

income (see Exhibit 3). The combined income tax rate on distributed corporate income is even higher if state and local tax on corporate and individual income are

taken into account.

C. Reliance on Income and Profit Taxation

While the total tax burden as a percent of Gross Domestic Product (GDP) is relatively light in the United States compared to other OECD countries, reliance on

income taxes to fund spending at all levels of government is unusually high. In

1999, the United States relied on income and profits taxes for almost half of all revenues (49.1 percent) while the average OECD country raised slightly over one-third

of revenues (35.3 percent) from this source (see Exhibit 4). The U.S. data include

sales taxes imposed by state and local governments; the federal government is even

more heavily reliant on income and profits taxes as there is no broad-base consumption tax at the federal level. Indeed, the United States is the only one of the 30

OECD member countries that does not have a national value-added tax.

D. Conclusion

When compared to other OECD and EU member countries, the United States relies relatively heavily on income taxes to fund government operations, has a comparatively high corporate income tax rate, and is unusual in not providing a mechanism for relieving the double taxation of corporate income.

From a trade standpoint, heavy reliance on income taxes relative to consumption

taxes may be viewed as disadvantageous because the WTO Agreement on Subsidies

and Countervailing Measures permits border tax adjustments for indirect taxes such

as consumption taxes, but prohibits such adjustments for income and profits taxes.

However, from the standpoint of U.S. economic growth, the main reason to avoid

over-reliance on income and profit taxes is that they discourage savings and investment, which are closely linked to growth in national income.

V. INTERNATIONAL TAX COMPETITIVENESS

A. Rising Level of International Competition

In 1962, when the controlled foreign corporation rules in Subpart F were adopted,

the U.S. multinationals overwhelmingly dominated global markets. In this environment, the consequences of adopting tax rules that were out-of-step with other countries were of less concern to many policymakers.

Today, the increasing integration of the world economies has magnified the impact of U.S. tax rules on the international competitiveness of U.S. multinationals.

Foreign markets represent an increasing fraction of the growth opportunities for

56

11See, National Foreign Trade Council, International Tax Policy for the 21st Century, vol. 1,

2001, pp 95–96. 12See, National Foreign Trade Council, U.S. International Tax Policy for the 21st Century, vol.

1, Part II, 2001 13 Ibid., vol. 1, Part I.

U.S. businesses. At the same time, competition from multinationals headquartered

outside of the United States is becoming greater.11

• 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. • U.S. multinational companies’ share of global cross-border investment has declined from 50 percent in 1967 to 25 percent in 1996. • The 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. multinationals will be less successful in global markets, with

adverse consequences for exports and employment at home.

B. International Comparison of U.S. Rules for Taxing Multinational Companies

A study published by the European Commission last year found that, on average,

U.S. multinational companies bear a higher effective tax rate when investing into

the European Union than do EU multinationals. The additional tax burden borne

by U.S. multinationals ranges from 3 to 5 percentage points depending on the type

of finance used (see Exhibit 5).

In addition to the relatively high U.S. corporate income tax rate, there are a number of other reasons why United States has become a relatively unattractive jurisdiction in which to locate the headquarters of a multinational corporation.

First, about half of the OECD countries have a dividend exemption (‘‘territorial’’)

tax system under which a parent company generally is not subject to tax on the active income earned by a foreign subsidiary (see Exhibit 6). By contrast, the United

States taxes income earned through a foreign corporation when repatriated (or when

earned if subject to U.S. anti-deferral rules).

Second, 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, including: 12

• Over allocation of U.S. interest expense against foreign source income due to

failure to take into account foreign debt. This reduces the foreign tax credit limitation and can cause income that has been subject to foreign tax at a rate of

35 percent or more to be subject to additional U.S. tax;

• Asymmetric loss recapture rules that have the effect of restoring U.S. but not

foreign income, thereby reducing the foreign tax credit limitation;

• The limitation on foreign tax credits to 90 percent of alternative minimum tax

liability;

• The limited carryover period for foreign tax credits (two years back and five

years forward); and

• The complexity associated with the numerous separate foreign tax credit limitations and the ‘‘high-tax kick out’’ rules that move certain income out of the passive basket.

A third difference from the multinational tax rules of other countries is the unusually broad scope the U.S. anti-deferral rules under subpart F. While most countries tax passive income earned by controlled foreign subsidiaries, the United States

is unusual in taxing a wide range of unrepatriated active income as a deemed dividend to the U.S. parent, including: 13

• Foreign base company sales income;

• Foreign base company services income; and

• Active financial services income (an exclusion of this income from Subpart F expired last year).

The net effect of these tax differences is that a U.S. multinational 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.

Complexity. The U.S. rules for taxing foreign source income are among the most

complex in the Internal Revenue Code. A survey of 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

57

14Marsha Blumenthal and Joel Slemrod, ‘‘The Compliance Costs of Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy Implications, International Tax and Public Fi- nance, vol. 2, no. 1, 37–54 (1995). 15 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code

of 1986, JCS–3-01 (April 2001). 16Office of Management and Budget, Budget of the United States Government, Fiscal Year

2002, Analytical Perspectives, p. 79 17This exception was one of the reasons that the FSC regime was determined by the WTO

to violate the Agreement on Subsidies and Countervailing Measures under the ‘‘but for’’ test.] 18 U.S. Department of the Treasury, Office of Tax Policy, The Deferral of Income Earned

through U.S. Controlled Corporations: A Policy Study (December 2000) p. 47. The report reached

similar conclusions regarding the other foreign-to-foreign related party rules of Subpart F such

as the foreign base company services income rules.

worldwide employment, assets and sales.14 These data show that U.S. tax compliance costs related to foreign source income are grossly disproportionate. These high

compliance costs are a hidden form of taxation that discourages small U.S. companies from operating abroad and makes it more difficult for larger companies to compete successfully with foreign multinationals.

The international tax recommendations in the Joint Committee on Taxation’s simplification study are a good start to begin addressing the high compliance burden

imposed by U.S. international tax rules.15 It should also be noted that the Treasury

Department’s tax simplification project, described in the Administrations FY 2003

Budget, identifies the international tax rules as an area singled out by taxpayers

as one of the biggest sources of compliance burden.16

C. Conclusion

Short of adopting a territorial tax system, there are significant opportunities to

increase the competitiveness and reduce the complexity of the U.S. tax rules applicable to foreign source income. Indeed, there are a number of reasons to think very

carefully before adopting a territorial income tax system.

First, foreign experience suggests that adopting a territorial income tax system

does not guarantee a simple tax regime. OECD Countries with territorial income

tax systems also have parallel foreign tax credit rules for foreign income that is not

exempt. Moreover, many OECD countries with territorial income tax systems also

have anti-deferral rules that tax certain income earned by foreign subsidiaries on

a current basis.

Second, depending on how a territorial tax system is designed, it could cause a

substantial tax increase for companies that currently repatriate dividends from

high-tax jurisdictions. Present law allows excess foreign tax credits on high-taxed

foreign income to be used to reduce U.S. tax on low-taxed foreign income within the

same limitation category. Under a dividend exemption system, cross crediting between dividends and other types of foreign income generally is not possible.

Third, allocation of U.S. interest and other domestic expenses against foreign

source income causes these expenses to be nondeductible under a territorial income

tax system. Double taxation will result unless foreign governments allow a deduction for these allocated expenses.

One opportunity for international tax reform is worth special mention within the

context of these hearings, i.e., the foreign base company sales rules adopted by Congress in 1962 as part of Subpart F of the Internal Revenue Code. Absent these

rules, U.S. companies would be able to set up sales companies in low-tax jurisdictions and reinvest their active foreign earnings without current U.S. tax. In fact,

part of the benefits of the FSC regime were attributable to the fact that it created

an exception to the foreign base company sales rules.17 Repeal of the foreign base

company sales rules would put U.S. companies in a more comparable position to

their foreign competitors who generally can use these structures with being subject

to home country tax. Moreover, the original policy rationale for these rules was

thrown into doubt by the Treasury Department’s policy study on Subpart F, released in December 2000, which concluded that the economic efficiency effects of the

base company rules were ‘‘ambiguous.’’ 18

VI. SUMMARY

U.S. rules for taxing both domestic and foreign source income are out of step with

other major industrial countries in a number of ways. Regardless of the ultimate

resolution of the ETI case, Congress should consider changes to the U.S. system

that promote economic growth and reduce costs of complying, with and administering the tax system.

58

19 Recent examples include: AEGON–Transamerica, BP–Amoco, Daimler-Chrysler, Deutsche

Bank-Bankers Trust, and Vodafone-AirTouch. 20See, John L. Loffredo, ‘‘Testimony before the Senate Finance Committee’’ (March 11, 1999)

regarding the Daimler-Chrysler transaction. 21Where business reasons dictate the form of a transaction, there generally is no cause for

concern. The concern we are raising is that non-competitive U.S. tax rules may be influencing

the form of transactions.

If the United States is an unattractive location—from a tax standpoint—to headquarter a multinational corporation, then U.S. multinationals will lose global market share. This can happen in a variety of ways.

First, U.S. individual and institutional investors can choose to invest in foreign

rather than U.S. headquartered companies. Indeed, as of 1999, almost two-thirds

(66 percent) of all U.S. private investment abroad was in the form of portfolio rather

than foreign direct investment. This allows U.S. investors to invest in multinational

companies whose foreign operations generally are outside the scope of U.S. tax

rules.

Second, in a cross-border merger, the transaction may be structured as a foreign

acquisition of a U.S. company rather than the reverse. Measured by deal value, over

the 1998–2000 period, between 73 and 86 percent of large cross-border transactions

involving U.S. companies have been structured so that the merged company is

headquartered abroad.19 Clearly taxes are only one of many considerations in the

structuring of these transactions, but it is notable that in one large transaction,

taxes were specifically identified as a significant factor.20 By choosing to be

headquartered abroad, the merged entity can invest outside the United States without being subject to the complex and onerous U.S. rules that apply to the foreign

source income of U.S.-headquartered companies.21

Third, and most starkly, a growing number of U.S. companies have structured

transactions in which their U.S. parents are acquired by their own foreign subsidiaries. Such ‘‘inversion’’ transactions, like foreign acquisitions of U.S. companies,

allow new foreign investments to be structured as subsidiaries of a foreign parent

corporation and thus not subject to U.S. rules relating to the taxation of foreign

source income.

Fourth, an increasing number of new ventures are being incorporated at inception

as foreign corporations.

While some have suggested that reducing the U.S. tax burden on foreign source

income could lead to a movement of manufacturing operations out of the United

States (‘‘runaway plants’’), an alternative scenario is that a noncompetitive U.S. tax

system will lead to a migration of multinational headquarters outside the United

States.

A decline in the market share of U.S. multinationals may affect the well being

of the U.S. economy because, as noted above, U.S. multinationals play an important

role in promoting U.S. exports and creating high-wage jobs.

EXHIBIT 1—CENTRAL GOVERNMENT CORPORATE INCOME TAX RATES, 1986–2001

Country 1986 1991 1995 2001

Australia ............................................. 49.0 39.0 33.0 34.0

Austria ................................................ 30.0 30.0 34.0 34.0

Belgium ............................................... 45.0 39.0 39.0 40.2

Canada ................................................ 36.0 29.0 29.0 27.0

Denmark ............................................. 50.0 38.0 34.0 30.0

Finland ................................................ 33.0 23.0 25.0 29.0

France ................................................. 45.0 34/42 33.0 33.3

Germany ............................................. 56.0 50/36 45/30 25.0

Greece .................................................. 49.0 46.0 35/40 37.5

Iceland ................................................. 51.0 45.0 33.0 Na

Ireland ................................................. 50.0 43.0 40.0 20.0

Italy ..................................................... 36.0 36.0 36.0 36.0

Japan ................................................... 43.0 38.0 38.0 30.0

Luxembourg ........................................ 40.0 33.0 33.0 30.0

Netherlands ........................................ 42.0 35.0 35.0 35.0

New Zealand ....................................... 45.0 33.0 33.0 33.0

Norway ................................................ 28.0 27.0 19.0 28.0

Portugal ............................................... 42/47 36.0 36.0 34.0

Spain ................................................... 35.0 35.0 35.0 35.0

Sweden ................................................ 52.0 30.0 28.0 28.0

59

EXHIBIT 1—CENTRAL GOVERNMENT CORPORATE INCOME TAX RATES, 1986–2001—Continued

Country 1986 1991 1995 2001

Switzerland ......................................... 4–10 4–10 4–10 8.5

Turkey ................................................. 46.0 49.0 25.0 30.0

United Kingdom ................................. 35.0 34.0 33.0 30.0

United States ................................... 46.0 34.0 35.0 35.0

Unweighted averages: 1

EU ....................................................... 42.8 35.9 34.4 31.8

OECD .................................................. 41.4 35.0 32.0 30.5

1Midpoint tax rate used for countries with multiple rates.

Sources: Jeffrey Owens, Tax Reform for the 21st Century, Tax Notes International. 2001 data from American

Council for Capital Formation, ‘‘The Role of Federal Tax Policy and Regulatory Reform in Promoting Economic

Recovery and Long-Term Growth,’’ November 28, 2001.

EXHIBIT 2—TAXATION OF CORPORATE DIVIDENDS IN OECD COUNTRIES, 1999

No relief from

double taxation

of corporate dividends

Method of relieving double taxation of corporate dividends

Shareholder level

Corporate level Imputation

system

(partial or complete)

Tax credit

method

Special personal

tax rate

Netherlands Australia Canada Austria Iceland 2

Switzerland Finland 5 Rep. of Korea Belgium 5

United States France Spain Czech Republic

Ireland 3 Denmark

Mexico Germany 1

New Zealand Greece 5

Norway Hungary

Portugal Italy

United Kingdom Japan

Luxembourg 4

Poland

Sweden

Turkey

United Kingdom

1Germany recently has adopted a 50 percent dividend exclusion.

2Deduction for dividends paid may offset fully the corporate and personal income tax for dividends up to 15

percent of capital value. Dividends in excess of this limit are fully taxed at both levels.

3 Ireland eliminated its imputation credit effective April 6, 1999.

4Luxembourg has a 50 percent dividend exclusion.

5 Information as of 1996 based on S. Cnossen.

Sources: PricewaterhouseCoopers, Individual Taxes 1999–2000: Worldwide Summaries (John Wiley & Sons,

1999) and Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, Research Memorandum 9604, Erasmus University, Rotterdam (1996).

EXHIBIT 3—COMBINED U.S. INDIVIDUAL AND CORPORATE STATUTORY TAX RATE IN 2002:

CORPORATE INCOME DISTRIBUTED AS DIVIDEND TO INDIVIDUAL SHAREHOLDER IN TOP BRACKET

Corporate income ........................................................................................................ $100.00

Less corporate income tax at 35% (federal) .......................................................... $35.00

Net income .................................................................................................................. $65.00

Dividend assuming 100% distribution ...................................................................... $65.00

Less individual income tax at 38.6% (federal) ...................................................... $25.09

Net income after federal and individual income tax ............................................... $39.91

Combined corporate and individual income tax rate ............................................... 60.09%

60

EXHIBIT 4—INCOME AND PROFITS TAXATION, 1999

Percent of Total Taxation in OECD Countries

Rank Country Percent

1 Australia 59%

2 Denmark 58.9%

3 New Zealand 57.2%

4 United States 49.1%

5 Canada 48.9%

6 Ireland 42.2%

7 Sweden 41.6%

8 Finland 41.1%

9 United Kingdom 39.2%

10 Iceland 39.1%

11 Belgium 38.6%

12 Luxembourg 36.2

13 Switzerland 36.2%

14 Norway 35.8%

15 Italy 34.0%

16 Japan 31.4%

17 Turkey 31.4%

18 Mexico 30.0%

19 Germany 29.8%

20 Portugal 28.8%

21 Austria 28.7

22 Spain 28.1

23 Greece 26.4%

24 Netherlands 25.3%

25 Korea 24.8%

26 France 24.0%

27 Slovak Republic 24.0%

28 Hungary 23/2%

29 Poland 22.6%

30 Czech Republic 22.3%

Unweighted averages

OECD 35.3%

EU 34.9%

Source: OECD, Revenue Statistics, 1965–2000 (2001)

61

EXHIBIT 5—EFFECTIVE AVERAGE TAX RATE FOR INVESTMENT INTO EU

Investment from MNC based in:

Financing of foreign subsidiary

Retained

earnings New equity Debt Average

EU ....................................................... 30.1% 30.4% 30.2% 30.2%

US ........................................................ 33.2% 35.7% 34.7% 34.5%

Source: Commission of the European Communities, ‘‘Towards an Internal Market without Obstacles,’’

Com(2001)582, Brussels, October 23, 2001.

EXHIBIT 6—TAXATION OF FOREIGN SUBSIDIARY DIVIDENDS IN OECD COUNTRIES, 1999

Dividend exemption (territorial) system (Either

by statute, by treaty or for listed countries) Worldwide taxation system

1. Australia 1. Czech Republic

2. Austria 2. Greece

3. Belgium 3. Iceland2

4. Canada 4. Italy

5. Denmark 5. Japan

6. Finland2 6. Rep. of Korea

7. France 7. Mexico

8. Germany 8. New Zealand

9. Hungary 9. Norway

10. Ireland1 10. Poland

11. Luxembourg 11. Portugal

12. Netherlands 12. Spain3

13. Sweden 13. Turkey

14. Switzerland 14. United Kingdom

15. United States

1 Although Ireland nominally has a worldwide tax system, under the Finance Act of 1988, foreign subsidiary

dividends generally are exempt if re-invested in employment-generating activities within Ireland. 2 Information as of 1990 based on OECD.

3Some treaties provide for the exemption method.

Sources: (1) PricewaterhouseCoopers, Individual Taxes 1999–2000: Worldwide Summaries (John Wiley & Sons,

1999). (2) OECD, Taxing Profits in a Global Economy: Domestic and International Issues (1991).

62

EXHIBIT 7

STATEMENT OF STEPHEN E. SHAY, PARTNER, ROPES & GRAY,

BOSTON, MASSACHUSETTS, AND LECTURER IN LAW, HARf VARD LAW SCHOOL

Mr. SHAY. Thank you, Mr. Chairman, Mr. Rangel and Members

of the Committee. My name is Stephen Shay. My testimony is in

the record along with my biography.

I want to emphasize the views I am expressing are my personal

views and do not represent the views of either my clients or my law

firm. I just want to touch on four points.

The unspoken premise of everything that has been discussed so

far relies on a definition of competitiveness that aligns U.S. competitiveness with benefits to U.S. multinationals. I think the Committee should adopt a view of competitiveness that is implicit in

the Chairman’s statement. Does any proposal ultimately improve

the welfare of American citizens and residents, that is, individual

citizens, individual residents? That is what all of this is ultimately

about.

So when we talk about a proposal that will improve the profitability of a multinational, the task for it should be, will it meet

that test, will it ultimately improve the welfare of the individual

citizens and residents of this country?

Second, the ETI. What the ETI does, at the bottom line, is reduce

the effective tax rate on income from exports by roughly 5.25 percent. So your effective rate, instead of 35 percent for a corporate

taxpayer, is 29.75 or thereabouts.

63

Who benefits from the ETI? Because of other rules, we have in

our code, particularly something called the ‘‘sales source rule,’’ companies that operate abroad and have excess foreign tax credits normally will elect to take advantage of the sales source rule and not

the ETI. So the ETI benefits, principally, two categories of taxpayers, those that export exclusively from the United States don’t

pay foreign taxes, and those that do operate abroad, that manage

their foreign taxes to remain below the U.S. tax rate. That is who

benefits.

The third point I would like to make relates to adoption of a territorial system, the exemption of U.S. tax on foreign business income. Is that relevant? Is that responsive to the taxpayers who are

affected by a repeal or demise of the ETI? I submit that it is not.

If you adopt a territorial system, it generally has three key elements. First and most relevant, it provides that business income

earned by a U.S. person outside the United States from operations

outside the United States would be exempted from U.S. tax under

a territorial system.

Second, losses from operations outside the United States normally would be disallowed. In other words, you have exempt income, you don’t get to take deductions against exempt income.

Third, most countries—in fact, I think almost all countries that

have adopted a territorial system—tax fully foreign-source interest

and royalties, including royalties from the license of U.S. intellectual property abroad. Thus, the benefit of a territorial system applies where there is foreign-located economic activity and there is

a lower tax rate than the U.S. tax rate.

This is not a substitute, in terms of impact, for a replacement of

the ETI. There are other problems with a territorial system. First,

it does create a bias if you can find a place to locate activity that

is subject to a lower tax rate than the United States. If it is otherwise something you were doing in your business and you were indifferent at the margin you would place the activity where there

is lower tax.

For that reason, a territorial system needs very significant safeguards, more than what we have today. You need to be sure that

expenses are not allocated to foreign income. You need to be sure

that pricing does not shift income to the exempt area. You need to

be sure that there are anti-abuse rules, so that inappropriate

transfers of businesses aren’t occurring.

A territorial system is not a simplification panacea. So if this

Committee chooses to look at it, you need to look at it very carefully with those in mind.

As Mr. Hufbauer has suggested, I encourage the Committee to

look at other alternatives that, frankly, go the other way, that

would increase the taxation of foreign income to equalize it with

what it would be on U.S. income.

My time has expired. I would be happy to take any questions

from the Committee.

[The prepared statement of Mr. Shay follows:]

64

*Mr. Shay is not appearing on behalf of any client or organization.

1 I have attached a copy of my biography to this testimony. The views I am expressing are

my personal views and do not represent the views of either my clients or my law firm. 2FTGR generally are receipts from sales of qualified foreign trade property, leasing of qualified foreign trade property for use outside the United States, certain services in connection with

foreign construction projects. Certain foreign economic processes have to be met in connection

with earning FTGR. Qualifying foreign trade property is defined substantially in the same manner as ‘‘export property’’ under the FSC, including that no more than 50% of the property may

be attributable to foreign content. The principal difference in definition, apparently thought by

this Committee to be sufficient to satisfy the WTO rules, was that qualifying foreign trade property need not be manufactured in the United States. 3 If the sales source rule applies to income of $100, the U.S. tax on $50 allocated to foreign

income is $17.50 and is offset by foreign tax credits, the U.S. tax on the remaining 50 would

be $17.50. Thus, the effective tax rate would be 17.50%.

Statement of Stephen E. Shay,* Tax Partner, Ropes & Gray, Boston,

Massachusetts, and Lecturer in Law, Harvard Law School

Mr. Chairman and Members of the Committee:

My name is Stephen Shay. I am a partner in the law firm Ropes & Gray in Boston and a Lecturer in Law at Harvard Law School. I specialize in U.S. international

income taxation and was formerly an International Tax Counsel for the Department

of the Treasury in the Reagan Administration. I was invited last Friday by the Committee to be a witness to discuss some of the potential fundamental tax reform alternatives that the Committee might consider in response to the WTO decision.1

With the Chairman’s permission, I would like to submit my testimony for the

record and summarize my principal observations in oral remarks.

Overview

In the announcement for the Hearing, Chairman Thomas stated the purpose for

the Hearing as follows:

Although the most recent [WTO] decision comes as no surprise, it illustrates the need to fundamentally reform our tax system so that U.S. workers, farmers and businesses are not disadvantaged in international trade.

This will be the first of several hearings to consider the WTO Appellate

Panel decision and to examine ways to maintain the international competitiveness of the United States.

The purpose of my testimony is to describe certain fundamental international tax

reform alternatives and observe how they do or do not relate to the possible elimination of the Extraterritorial Income exclusion (‘‘ETI’’).

I will first briefly review the ETI and the activity it benefits. I next describe a

territorial tax system, how it creates an incentive to locate investment in lowertaxed foreign countries, and how the activity it benefits differs from the activity benefited by the ETI. I then consider other approaches to international tax reform, including modifying the current U.S. system of worldwide taxation (with deferral of

tax on business income earned through foreign corporations) to reduce rather than

increase the incentive under current law to locate investment outside the United

States in a low-taxed foreign country.

The ETI Regime

The ETI was enacted in November, 2000. Under the ETI, a taxpayer may exclude

a percentage of income attributable to foreign trading gross receipts (‘‘FTGR’’) or net

income from FTGR.2 The bottom line effect of the ETI is to reduce the tax rate on

this income by approximately 15%. Thus, a domestic corporation subject to a 35%

Federal corporate tax rate will pay a 29.75% rate on its net income subject to the

ETI regime.

The ETI is designed, like the FSC, to prevent a taxpayer electing the ETI from

also obtaining the full benefit of the sales source rule for exporters under the Internal Revenue Code. The sales source rule permits taxpayers that manufacture in the

United States and sell outside the United States to treat 50% of the income from

the sale as foreign income. In most cases, this foreign income is in the general foreign tax credit limitation category and, for firms that have enough excess foreign

tax credits (i.e., have paid foreign taxes at a rate higher than the effective U.S. rate

on the same general limitation category of foreign income), permits this income to

be exempt from U.S. tax. The marginal rate of U.S. Federal tax on these export

sales is 17.50%.3 For taxpayers with excess foreign tax credits, the benefit of the

sales source rule is generally larger than the ETI benefit. Thus, the sales source

rule causes the ETI to benefit taxpayers that do not have excess foreign tax credits,

that is, taxpayers that either exclusively export from the United States or, if they

65

4The ETI was the successor to the Foreign Sales Corporation (‘‘FSC’’), enacted by the Congress in 1984 and found by a WTO Appellate Body in February, 2000, to be a prohibited export

subsidy. The FSC was the successor to the Domestic International Sales Corporation (‘‘DISC’’)

enacted in 1971, and found to be an export subsidy in a panel report adopted by the GATT

Council in 1981. The 1981 GATT Council decision was subject to an understanding that a country need not tax export income attributable to economic processes outside their territory. This

understanding was the source of the U.S. approaches in the FSC and the ETI to characterize

the benefited income as being taxed in a manner comparable to the taxation under a territorial

system. I do not discuss here the substance of the U.S. position nor its merits as a matter of

trade law. Suffice it to say, the WTO has twice rejected the U.S. efforts in this regard. 5 A 2000 Report on the FSC by the Congressional Research Service cites a 1992 Treasury Department analysis that repealing the FSC would have reduced net exports by 140 million. If

the impact of the ETI on net exports was in fact less than the tax expenditure, it would be ironic

that the United States now is faced with having to arbitrate EU claims for compensatory damages that are based on U.S. tax expenditure estimates. The CRS Report also observed that

under traditional economic analysis the FSC by definition reduces U.S. economic welfare (as opposed to the welfare of the firms benefited by the subsidy and their shareholders) because at

least some portion of the benefit is presumed to be passed on to foreign consumers in the form

of lower prices. 6For this purpose, foreign business income includes foreign dividends or gains from substantial shareholdings. 7 In some cases, foreign losses are allowed, but are recaptured as domestic income when the

taxpayer next realizes positive foreign net income.

also conduct foreign operations, have managed their foreign taxes to remain below

the effective U.S. tax rate on the same income.

Alternatives to the ETI

As noted in the Hearing announcement, on January 14, 2002, the WTO Appellate

Body issued a report upholding a dispute resolution panel finding that the ETI is

a prohibited export subsidy.4 The stated objective of the Committee’s Hearing is to

‘‘examine ways to maintain the international competitiveness of the United States.’’

As an initial matter, it may be questioned whether the ETI (and its predecessors

the FSC and DISC) did in fact improve the international competitiveness of the

United States by comparison with alternative ways that the foregone revenues (or

tax benefits) could have been spent. There appears to be support for the position

that the impact of the ETI on net exports (the increase in exports reduced by the

corresponding increase in demand for imports) was modest.5

In the following portions of my testimony, I assume for purposes of discussion

that the Committee will not adopt a fourth proposal along the lines of DISC/FSC/

ETI, but instead will consider other changes to the U.S. international tax rules. As

described in the next section, the alternative to the ETI most frequently discussed

in recent days, a territorial tax system, creates an incentive to locate investment

outside the United States and does not benefit the exporter that carries on its manufacturing and/or selling operations entirely from within the United States. A territorial system also is often heralded as a simplification panacea, but as discussed in

the next section, its simplification potential generally is overstated. I urge the Committee to also consider fundamental tax reform alternatives that would have the effect of decreasing U.S. tax benefits for foreign income and directing those revenues

toward alternative uses, such as investment in domestic human capital or broader

reductions in the level of taxation on all business income.

Changing from A Worldwide Tax System with Deferral to A Territorial Tax

System

The major approaches by which the tax system of a country (the ‘‘residence country’’) accounts for income earned by its residents in a foreign country (‘‘foreignsource income’’) are a worldwide system and an exemption, or territorial, system.

If the United States were to adopt a territorial system comparable to the systems

adopted in other countries, the United States (i) would not tax its own residents’

foreign-source business income that is subject to taxation in another country,6 (ii)

would disallow the deduction of foreign business losses,7 and (iii) would tax currently portfolio dividends and all foreign source interest and royalties. In other

words, only foreign-source business income would be exempt from U.S. tax and this

income would bear the tax only in the foreign country where the income was produced (the ‘‘source country’’).

The principal objection to a territorial system is that it creates a bias, not in favor

of investment in domestic production for export, but in favor of investment in foreign operations. In the worst case, this bias causes a foreign investment to be preVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00069 Fmt 6633 Sfmt 6621 E:\HR\OC\A971.XXX pfrm01 PsN: A971
66

8For example, assume that USCo is a U.S. corporation considering a new business that will

produce a 10 percent return, before U.S. income taxation, if the business is located in the United

States, and an 8 percent return, before U.S. income taxation, if the business is established in

a foreign country. Assume further that the United States will tax USCo at a flat 35 percent

rate and that the foreign country will impose a 10 percent rate of tax. If USCo is exempt from

U.S. tax on profits from the foreign investment under a territorial system, USCo will be choosing between after-tax returns of 6.5 percent (.10 x [1-.35]) in the U.S. location and 7.2 percent

(.08 x [1-.10]) in the foreign location. In this example, the pre-tax rate of return of the U.S. investment is 20% higher than the foreign investment, but the after-tax rate of return under a

territorial system is 10.77% lower than the foreign investment. Thus, the effect of a territorial

system is to create a strong incentive for USCo to make the economically inferior foreign investment. 9 Although a territorial system provides no direct benefit for foreign operations in countries

with effective tax rates equal to or higher than the U.S. rate, it does offer greater potential for

a U.S. multinational to reduce high foreign taxes through tax planning techniques that shift

income from a high tax to a lower-tax foreign country. Although often effective today, these

planning techniques would be frustrated by expansion of the high tax countries’ CFC regimes

which is the general trend in these countries.

ferred even though the U.S. investment has a higher before-tax rate of return and

is, therefore, economically superior.8

The justification for exempting U.S. multinationals’ foreign-source business income is based principally on a competitiveness argument that is usually stated as

follows: foreign corporations operating businesses in low-tax foreign countries owned

by residents of countries with a territorial tax system, as well as local businesses

in the low-tax foreign countries, pay only the low local income tax on their in-country profits. Without exemption, U.S. multinationals are unduly disadvantaged when

competing against these foreigners in low-tax foreign countries because in addition

to the foreign tax, a U.S. multinational will pay a U.S. residual tax on its foreign

profits, while the foreigners would pay only the low foreign tax. Therefore a U.S.

multinational should be given a countervailing exemption from the U.S. residual

tax.9

This argument is not a request for the United States to give U.S. multinationals

relief from international double taxation. The foreign tax credit already addresses

that issue. Instead, this is a request for tax system assistance that is not available

to pure exporters or other earners of U.S.-source income.

Relieving U.S. multinationals’ foreign-source income from U.S. tax would be a

poorly structured tax assistance measure because the assistance would not be targeted at U.S. corporations that face tax-related competition. To be specific, a U.S.

multinational facing little tax-related foreign competition in low-tax foreign countries, whether because (i) it is selling paten—or copyright-protected goods, (ii) its

principal competitor is from a foreign country that does not have a territorial system, or (iii) its competitor is another U.S. corporation, would benefit as extensively

from a territorial system as a U.S. multinational facing the tax-based competition.

In the current context of the possible repeal of the ETI, proponents of a territorial

system should be required to go further than making generalized competitiveness

arguments, and should link the tax benefits of an exemption system to promotion

of U.S. exports. It is anticipated that the proponents will argue that these benefits

for operations in lower tax foreign countries will generate greater purchases of U.S.

goods because U.S. multinationals will buy from their U.S. affiliates and suppliers.

Although this is a claim that deserves some scrutiny, at best this is an assertion

that tax assistance to the operations of U.S. multinationals in low-taxed foreign

countries indirectly encourages U.S. exports. This is a remote and somewhat speculative support for U.S. exporters and is heavily weighted for businesses with foreign

operations that already are advantaged by deferral. There is no direct relationship

between adoption of a territorial system and benefiting domestic U.S. exporters that

do not carry on foreign operations.

Adoption of a territorial system also is not a simplification panacea. The allocation

of expenses between U.S. and foreign source income would be critical to determining

which expenses are allocable to exempt foreign income under a territorial system

and therefore disallowed as deductions. Today, the allocation of expenses to foreign

income is a potential audit issue primarily for taxpayers that have excess foreign

tax credits. Under an exemption system, there would be pressure for all taxpayers

that earn exempt foreign income to allocate expenses, such as interest and research

and development costs, to domestic income and away from exempt foreign income.

Thus, the IRS would have to increase its scrutiny of this difficult area.

Similar to the transfer pricing pressures existing today, taxpayers with foreign operations would have an incentive to shift U.S. income to exempt lower taxed foreign

operations. Under a territorial system, however, the benefit is permanent (and not

67

10See generally Cohen and Hankin, ‘‘A Decade of DISC: Genesis, and Analysis,’’ 2 Va. Tax

Rev. 7 (1982). 11See Michael J. Graetz, The David Tillinghast Lecture: Taxing International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies, 54 Tax Law Rev. 261, 284

(2001).

a deferral of tax until repatriation) and transfer pricing would take on commensurately greater significance.

Adoption of a territorial system would not eliminate the need for anti-abuse measures that are comparable in effect to our current highly complex anti-deferral regimes. Major developed countries that have territorial systems also have adopted

controlled foreign corporation (‘‘CFC’’) regimes or other legislation to prevent taxmotivated offshore investment. France, for example, provides for exemption of, or a

reduced tax on, foreign income, but has adopted expansive CFC legislation. Germany, which exempts foreign business income earned in treaty partner countries,

has adopted foreign investment fund legislation that denies favorable tax treatment

to certain diversified foreign investment funds that are not listed in Germany or do

not have a tax representative in Germany. These sophisticated territorial countries

recognize the need to protect the domestic tax base by reducing the incentive to shift

income-producing activity abroad. Indeed, the need to protect the domestic tax base

is more pronounced for a country that does not tax foreign income than for a country that taxes foreign income and employs a foreign tax credit system.

The Committee should take these considerations into account if it considers a territorial tax system.

Reform of the Current U.S. Tax System of Worldwide Taxation with Deferral

In practice the current U.S. system of worldwide taxation with deferral of U.S.

tax on foreign corporate business income operates in much the same manner as a

territorial system. If U.S. multinationals earn income through active business operations carried on by foreign corporations in low-tax source countries, the U.S. multinationals generally pay no residual U.S. tax until they either receive dividends or

sell their shares. This phenomenon is referred to as ‘‘deferral.’’ Deferral obviously

decreases the present value of the U.S. residual tax. When this value reduction is

combined with certain other features of the U.S. international tax regime (i.e., crosscrediting foreign taxes and certain source rules that overstate foreign-source income), well-advised U.S. multinationals can frequently reduce the U.S. residual tax

on their repatriated foreign-source income to zero. Stated differently, the U.S. worldwide system, with deferral, frequently provides the same result as a territorial system (exemption from U.S. tax on foreign-source income).

The current U.S. system therefore is subject to many of the same criticisms as

a territorial system. An appropriate response to those criticisms, however, only may

be achieved through a reform of the current worldwide tax system. Adoption of a

territorial system would be a second best solution to a reasoned reform of the current rules.

The original proponents of the DISC argued for the export subsidy in part on the

grounds that exporters were disadvantaged relative to taxpayers that could locate

their operations abroad and take advantage of deferral. In other words, an original

rationale for the DISC predecessor of the ETI was to equalize for exporters the advantages realized by U.S. multinationals from deferral.10 If the ETI is repealed and

a third DISC successor is precluded by the WTO rules, as a logical matter the Committee could consider decreasing the tax advantages to earning low-taxed foreign income through foreign corporations.

Does decreasing the tax benefits for foreign income improve competitiveness? An

initial question is how to define competitiveness. It is questionable whether U.S.

competitiveness should be defined in terms of U.S. multinationals’ profitability. A

more meaningful measure of competitiveness is whether any proposal will advance

the welfare of individual U.S. citizens and residents.11 The proponents of tax assistance to enhance the returns of U.S. multinationals, and their shareholders, from foreign operations should be expected to carry the burden of demonstrating the value

of the assistance will exceed both the revenue cost and the opportunity cost of alternative uses for that revenue. For example, would investment of a given amount of

revenue in education grants to localities improve the living standard for Americans

more than the same amount of tax relief for foreign income of U.S. multinational

businesses?

I respectfully submit that the Committee should consider proposals that would cut

back on the deferral benefit for foreign income as an alternative to the ETI or a

territorial system. I and my co-authors, Professors Robert J. Peroni and J. Clifton

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12 Robert J. Peroni, J. Clifton Fleming, Jr. & Stephen E. Shay, Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source Income, 52 SMU L. Rev. 455 (1999); J. Clifton

Fleming, Jr., Robert J. Peroni & Stephen E. Shay, Deferral: Consider Ending It Instead of Expanding It, 86 Tax Notes 837 (2000). 13The current foreign tax credit mechanism could be improved by repeal of the sales source

rule combined with improvements to the interest allocation rules and allowance of foreign as

well as domestic loss recapture. Finally, some simplification may be achieved in the U.S. international rules by consolidating anti-deferral rules and rationalizing the source rules. 14 It might be argued that these changes would pressure U.S. companies to become foreign

companies. If this is perceived as a significant problem, the Committee could consider a range

of alternatives. For example, the Committee adapt existing U.S. tax provisions to require U.S.

investors to take account at the time of sale whether a publicly-traded foreign corporation’s

earnings during the investor’s ownership have borne a level of foreign tax equal to or greater

than the U.S. corporate tax rate. If not, the investor could be taxed on the gain to make up

the difference in the same manner as currently applies under Section 1248(b) of the Code. An

alternative approach would be to re-examine the circumstances in which a foreign corporation

should be taxed as a domestic corporation.

Fleming, Jr., have outlined a proposal for a broad repeal of deferral.12 Essentially,

our proposal would apply mandatory pass-through treatment to 10% or greater

shareholders in foreign corporations.

One would not have to go so far as our proposal to make substantial improvements in the current international tax rules without increasing the current incentives to locate investment outside the United States. There would be substantial improvements to the controlled foreign corporation rules if the current foreign base

company sales and services rules applied without exception whenever the CFC’s income, determined separately for each foreign legal entity and qualified business unit

of the CFC, was not taxed at a effective foreign tax rate of some minimum amount.

Under current law, a safe harbor exists for income taxed at 90% of the U.S. rate;

the Committee could choose to employ a lower percentage of the U.S. rate.13 Although this is a second best approach to the mandatory pass-through approach, it

would be a substantial improvement over today’s rules.14

The kinds of changes just described could be combined with revenue neutral reductions in tax for business income generally. This approach would assist U.S. businesses that export from the United States or compete against foreign imports as

well as those that operate abroad. Alternatively, any revenue increase from these

changes could pay for more favorable depreciation and amortization for investment

in productive property, used to improve U.S. education or fund anti-terrorism initiatives. Whatever the choice, I respectfully urge the Committee to consider international tax reform proposals that will improve the well-being of all U.S. citizens,

workers, farmers and businesses and not just those in the multinational sector.

I would be pleased to work with the Committee to analyze and develop alternative

fundamental international tax reform proposals.

written testimony, which gives us at least a disembarking point on

Chairman THOMAS. I want to thank all of you, especially for your

f looking at some options that are inevitable as we are going to, as

they say, round up the usual suspects. We want as much help as

we can get in fully understanding what those suspects look like

and clear the territorial taxes often offered as a potential.

Mr. Hufbauer, let me understand your oral statement, because I

would like to ask the question this way.

We had a first appeal of the decision. We modified our position

slightly, obviously, and certainly not enough; and we got a second

decision. Are you saying by the fact that there was a change in the

substance and manner of the second appeal that perhaps the

United States would have been relatively advantaged in how many

hostages we could take under the first appeal, that on balance we

probably should not have taken the second appeal?

Mr. HUFBAUER. I guess it is always easy to do quarterbacking on

these difficult legal decisions. But the rationale changed very dramatically between WTO reports. I know you did read, Mr. ChairVerDate 11-MAY-2000 08:08 Jul 10, 2002 Jkt 079971 PO 00000 Frm 00072 Fmt 6633 Sfmt 6602 E:\HR\OC\A971.XXX pfrm01 PsN: A971
69

man, and I know everybody here did read, that first appellate body

report. What the WTO focused on in the first report was the difference in taxation between production abroad and exports. And, as

you know, the ETI was an attempt—and I think a good-faith attempt at the time—to come up to the letter of the first set of decisions, because foreign production and export taxation was harmonized.

The goal post moved in the second round, and in the second

round the WTO said, well, what we have got to do is look at the

normative benchmark. That was at the panel level, and at the appellate level—and really I am condensing a lot—they came to this

‘‘but for’’ test, but for ETI, the export income would be taxed with

a foreign tax credit. And the only reason a company would choose

ETI is because the tax was less. So, the WTO reasoned, ETI is a

goner. But they moved the goal post.

Now, I suppose with a good crystal ball you could have said, if

the WTO doesn’t like the FSC, it is going to move the goal post to

catch ETI; with this crystal ball, you wouldn’t have enacted the

ETI, or you would have done it differently. But that is all rewriting

history. But, I want to emphasize, the goal post moved. And it

moved further between the panel report and the appellate body report in the second round.

In the first round, the appellate body said, ‘‘Panel, you are in

good shape.’’ In the second round, the appellate body said, ‘‘This is

a bombshell.’’ We are going to get rid of the normative benchmark

idea and instead we are going to go for a, ‘‘but for’’ test. Under the

normative benchmark, the United States could have looked at

whatever the normative benchmark—whatever that means—was

for each and—every tax system, and then pointed out exceptions

and 25 possible subsidies. And we could have said, ‘‘You (Country

X) are not following your own normative benchmark; you (Country

Y) are not following yours.’’ We could have brought a boatload of

cases.

But under the ‘‘but for’’ test, it will not be a boatload of potential

cases. There will be some—but I don’t have the expertise that Peter

Merrill does or Steve Shay does to say how many. I am sure there

are ‘‘but for’’ problems out there, but they are not as big as with

the normative benchmark.

I am sorry to be so long on that.

Chairman THOMAS. I think very few, if anyone, agrees with your

conclusion that they moved the goal posts. But in our pursuit of solutions, it might be at least helpful for us to understand the relationship that we are now in with the Europeans. And then the

question goes not to what the goal posts did, but the why.

In your opinion, was it because we were pretty good on the ETI

in terms of the first appellate decision, and it may have fit, had

they remained consistent; or was it that there was too much collateral damage to the Europeans, based upon that first decision, and

since we decided to try again instead of going in a different direction, that decision couldn’t stand and that they needed some cover?

Clearly, it is probably a little bit of each, but do you have any

insight for the Committee in helping us understand the shifting of

the goal posts?

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Mr. HUFBAUER. I don’t have any inside information in from talking to the judges or the panelists, but I think the direction which

you are seeing is absolutely right. They reflected and—they saw all

the comments from here and around the world, and those judges

and panelists reflected and said, ‘‘Look, we are becoming a World

Tax Code Court too fast, too soon, and we are going to create just

too much of a backlash.’’

There is a big issue on the balance between the judicial role of

the WTO and its legislative (negotiating) role, I won’t go into that,

but the judges probably saw they were really over the hill on this

one and thought, ‘‘Yeah, we don’t like the FSC, we don’t like the

ETI, we think it is just a continuation of the DISC, and we are

going to try to nail it more specifically.’’

Chairman THOMAS. Mr. Merrill, in your presentation, you talked

about making some adjustments going back to some decisions that

were made in 1962, and certainly the world has changed.

Do you have any indication of what the revenue forgone would

be if we made some of those adjustments? Whether we look at it

or not—as I discussed briefly with the gentleman from Tennessee,

if we are going to look at victims here, there are people who are

going to be looking for compensation and adjustments whether it

merits it or not.

Could you give us some idea of the level of dollars we are talking

about in the disruption in the Tax Code if we make some of the

changes you suggested?

Mr. MERRILL. I have not done revenue estimates for these provisions, and certainly the official scorekeepers for these provisions

are the Joint Committee on Taxation. And I am not aware—I have

not seen any published estimates they have done on any of these

provisions. It may well be that some of these provisions would be

scored as relatively expensive.

Chairman THOMAS. And I think that our Joint Tax Committee

does an excellent job, but it seems this is very difficult to mark,

and as they are having difficulty determining what the compensation is, the actual dollar values, this Committee is going to need

as bright a light as we can get on the decisions that we make relative to revenue shifts and winners and losers. Whether we like it

or not, that has to be part of the decision process.

If you know of any, it would be very helpful; and we may rely

on some of you in at least providing an alternative set of numbers,

because in all likelihood it is going to be somewhere in between.

No one is going to get this one right.

Mr. Shay, you began your testimony a little bit defensively, because Mr. Hufbauer said he disagreed with you before you started;

and you identified pretty much where it was that he may have disagreed with you without his indicating any particulars. So did you

guys talk ahead of time about what is obvious about the presentation Mr. Shay, that others would react negatively to or at least

not agree?

Mr. SHAY. Are you asking me to point out where in my

presentation——

Chairman THOMAS. I am asking you to defend the part that you

felt sensitive about. I think some people maybe didn’t follow.

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Mr. SHAY. Well, the thrust of my testimony, which I think Gary

was referring to, which I did not really spend time at length in my

oral comments on, was that much of the discussion has been about

how to potentially reduce U.S. taxation on foreign income by creating an exemption from U.S. tax on business income earned

abroad. And indeed I think this may have come up earlier in today’s hearing.

In fact, one of the original reasons for the DISC back in 1971,

at least as reported in an article by somebody who was there cited

in my testimony, was to equalize the treatment of exporters with

those companies who could earn foreign income through foreign

corporations and not pay current U.S. tax on that income. And part

of what I was pointing out in my testimony is that if you go further, as some have suggested, and not just defer U.S. tax on foreign

income earned through foreign corporations, but exempt from U.S.

tax all foreign income, whether earned through a foreign operation

directly or through a corporation, then you further exacerbate the

distinction between the exporter who is operating exclusively in the

United States—perhaps in Washington, perhaps in Chicago—from

the multinational that is conducting part of their operations outside the United States.

So, as a matter of logic, there is an alternative approach to exempting foreign business income. It is to tax it and tax it equally

so that that exporter in Washington or Chicago that may not have

foreign operations is bearing the same U.S. tax burden as is the

multinational, basically, that is performing aboard.

Now, then, to answer your question, the objection is made that

some other countries do adopt a territorial system and do not tax

that income earned in that other country when our company is in

that other country. And that comes back to the first part of my testimony, Mr. Chairman, how significant is that element, the taxation element in that competitive mix; because if that is Pepsi and

Coke, it is not relevant. If that is a company that is operating there

under the protection of intellectual property laws that are respected in that country, so that they effectively have a monopoly

on that product, the tax is not relevant.

So some of the solutions that are being proposed do not meet my

criterion that I set out at the beginning of the testimony: Do they

enhance overall U.S. competitiveness, not defining it in terms of

the profitability of the multinational?

I am a private, practicing tax lawyer. If you give me the opportunity to advise my clients to enhance their profitability through

the rules you will pass, I guarantee you I will take it, and I have

taken it for 25 years.

I am here today before the Committee in a private capacity, not

representing my clients, but representing what I perceive to be the

best tax policy for the United States. And that is the standard I

am asking the Committee to adopt, and for that reason, I am asking the Committee to include in its range of options that it is considering options that do not lower income U.S. taxation on foreign

income, but increase it.

Mr. Hufbauer has extensively criticized that position, and I respect his arguments and I respect his position, but it seems to me

that is what the debate should be about.

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Chairman THOMAS. And I want to underscore that the reason I

asked you to make those comments is that this Committee is certainly not going to arbitrarily or artificially cut off any avenue of

investigation.

I do think, as you said, logic leads you to a particular position.

We have to approach this with a somewhat scientific method

which—more often than not, our hypotheses will be disproven. But

in being disproven, it allows us then to move on to other areas.

The thrust of a fundamental change in the Tax Code is so difficult that we may have to look at some of these alternatives, and

I can assure you that while we will not dismiss any alternative

without having gone through the process to the best of our ability,

looking at the pros and cons, and especially if we are going to add

several different components together to get a full impact of exactly

who the winners and losers are, our goal is not to try to respond

to a WTO panel’s attempt to determine our internal taxes and wind

up punishing ourselves even more. Our goal is, to the best of our

ability, change our system; and to the degree we can’t do it, fundamentally to offset some of the negatives caused by this decision.

Gentleman from New York?

Mr. RANGEL. I thank all of you witnesses. You have been very,

very helpful.

Mr. Hufbauer, do you believe there was justification for the

WTO’s decision to reject the way we handle our exports?

Mr. HUFBAUER. Not based on their first report. If you read the

letter of the first report, I thought that the ETI—and I said so at

the time, and I was obviously mistaken, but I thought it was consistent with the first panel report and the first appellate body report on the theory that we are a very contract-driven system in the

WTO, and it is not a common law system.

It is becoming a common law system, and therefore, you could

look at the letter, you could respect the letter and—— Mr. RANGEL. I was really referring to our last legislative response to their rejection. The last case that we lost, do you believe

that was justification for the decision by the WTO to disregard

what we thought was a remedial solution to our problem?

Mr. HUFBAUER. Mr. Rangel, I have read the decision. I see where

they are making the arguments. I totally disagree with the second

appellate body decision and the second panel report. They are the

judges, not me, obviously.

Mr. RANGEL. While you disagree with their decision, you do believe under existing law that United States firms suffer a competitive disadvantage.

Mr. HUFBAUER. Yes, I do.

Mr. RANGEL. So that the WTO decision really gives us an opportunity to even better our position, even though their decision was

that it put our friends at an advantage.

Mr. HUFBAUER. Absolutely. It can be changed in a way that we

could be better off than we were before the FSC or before the

DISC. It is up to the Congress and Treasury Department and people of America.

Mr. RANGEL. And are you suggesting that we should adopt a territorial system in terms of part of the solution to the problem that

we face?

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Mr. HUFBAUER. The word ‘‘territorial’’ is one of these plastic

words that means different things to different people. And with my

own nuances—and everybody would have their nuances—the fundamental answer is ‘‘yes.’’ And I co-authored a book 10 years ago,

U.S. Taxation of International Income, where we advanced this position, and while I would certainly have changes to whatever I said

10 years ago on this or any other subject, the basic answer remains

‘‘yes.’’

Mr. RANGEL. Would you support the suggestion made by Mr.

Shay, that would create a large incentive for U.S. companies to

move to countries that have low corporate taxes?

Mr. HUFBAUER. Absolutely not. I fundamentally disagree with

that. Now I have to talk about one of the nuances. I go for a territorial system which is territorial with respect to countries which

have normal tax systems. And I realize, ‘‘normal tax system’’ is a

plastic term. But all these kind of ‘‘run away’’ arguments are talking about running away from the United States to the Bahamas or

running away from the United States to I don’t know where. Our

whole international tax system is focused on a handful of little

countries where nobody is running to except maybe some insurance

companies. And that is where I would put my nuances. But our big

competitors—you know the countries. U.S. companies are not going

to run away to tax havens countries, but instead to Canada, to

Mexico, to Germany, to Japan, to China. Under a territorial system, our companies are in fact going to be much more competitive

doing business here, exporting directly, and especially exporting to

their operations abroad, which Peter Merrill emphasized. This is

terribly important in a global economy.

Mr. RANGEL. Mr. Shay, would you care to respond to Mr.

Hufbauer?

Mr. SHAY. I guess there are two comments. One is that there are

very legitimate taxing countries that have chosen to adopt a low

rate of tax. A country I have enormous admiration for is Ireland,

and they have chosen to adopt a corporate income tax rate which

I think is now 12 percent. That is substantially below 35 percent.

And I could in very good conscience counsel a client, if we had a

tax-exempt system, to say if from a business perspective you could

ship your product to your customers from the United States to Ireland and the customer would be equally satisfied—well, I don’t

think anybody here would make a different decision as to where

they would locate the operation.

Second, I have been engaged in numerous planning exercises involving some of the countries that Mr. Hufbauer named that have

what he calls normal tax systems, where we are able to bring the

effective rate down not quite to 10 percent but substantially below

35 percent. And, in fact, I have worked with some at least former

colleagues of people on the panel. So it is a complicated question.

I think the short answer is that most businesses run their businesses for business objectives first. There is a point where they

come to their tax lawyers and they say, Okay, I have got two

choices; does tax make a difference? Sometimes they come to the

tax lawyer earlier, but the fact is taxes at the margin make a difference or else we wouldn’t have been having this discussion.

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Mr. RANGEL. Mr. Merrill, you are very cautious about the territorial system yourself.

Mr. MERRILL. That is correct. In my written statement, I raise

a number of practical problems. I should say that in April of last

year, the International Tax Policy Forum and the Brookings Institute and had a conference on territorial income taxation. All the

papers for that are available on the ITPF Web site. There were a

number of papers that described how territorial systems worked in

Canada, Netherlands, and so forth. And what those detailed descriptions showed is that a territorial system is not necessarily a

simpler tax system. So I think that is one concern.

There is also a concern that there could be a number of taxpayers that would have a substantial tax increase under a territorial tax system depending on how it was structured. And I think

you would want to think carefully about redistributing the tax burdens in that way. And, frankly, one concern is that actually some

exporters could face some very large tax increases under a territorial tax system, which again I think is something you would want

to look at pretty carefully.

A third issue is the allocation of expenses, which under a territorial system means those expenses are nondeductible if allocated

abroad. That is an issue we face today with interest allocation and

the foreign tax credit. It affects so-called excess credit taxpayers.

It is a much bigger problem under a territorial tax system.

So I think you have to look at it really carefully and, as Gary

said, there are many different ways to do it and not all of them are

particularly attractive.

Mr. CRANE. [Presiding.] I would like to throw a hypothetical

question out at you, and it gets back to the proposal that I pushed

for all the years that I have been here, and that is the total elimination of any tax whatsoever on business. And my argument has

always been that they don’t pay taxes in the first place, they gather taxes. And that is the cost of doing business just like plant and

equipment and labor, and you got to pass it through and get a fair

return or you are out of business.

So, given the hypothetical, let me ask you the question, if we

eliminated any tax on business whatsoever in this country, what

would be your assessment as to the impact on our exports?

Mr. HUFBAUER. Let me just make a distinction, Mr. Crane, between eliminating a tax on business and who actually writes the

check. It is much easier for any tax authority to collect taxes from,

let’s say, 100,000 business firms than 100 million households. And

so you do have the issue of who writes the check, if I can put it

that way, who has the legal liability, which I think is quite distinct

from the tax on business the way you are framing it in the question.

Now let me come to the question itself. The estimates that I have

seen on responsiveness of investment to tax differences between

countries, between States, between provinces, show a tremendous

response. When I was young and going to university, in formal

terms this responsiveness or elasticity was thought to be either

zero or one half, 0.5. In other words, if you change your tax by 10

percent, at most you would get a 5 percent change in investment.

Maybe you would get zero.

75

Recent studies are going to much higher numbers. The recent

studies are more sophisticated, in their econometrics, but they are

also capturing something that is happening in the real economy,

which is that our firms, advised by Steve Shay and other bright

people like Peter Merrill—are comparing taxes as well as everything else to a much greater extent than they once did, and probably the elasticity now internationally is three. That is to say,

change your tax by 1 percentage point, and you get a 3 percentage

change in investment, which is a big impact. So—Within the

United States, the elasticity may be as high as 10 between States.

I think if we got rid of the corporate income tax as we know it

today, and replaced it with something else on a revenue-neutral

basis, there would be—— Mr. CRANE. Not replace it; eliminate it entirely, and no offset.

Don’t come up with—— Mr. HUFBAUER. Well, then cut the spending. You would have to

cut the spending side, and I am trying to deal with the fiscal balance—but keeping the fiscal balance the same by cutting spending

or replacing the tax. But I think it would be a tremendous stimulus

to investment and the competitiveness of the American economy in

exports worldwide.

Mr. CRANE. Let me ask you one other follow-up question. To

what degree do you think that provides an attraction to foreign

companies to locate here in the United States?

Mr. HUFBAUER. That would be a big part of it. If we had a lower

tax rate on business—— Mr. CRANE. Not lower; eliminate.

Mr. HUFBAUER. If we had elimination, you know we already have

a lot of foreign direct investment in the United States.

Mr. CRANE. I have got a small steel company in my district that

has just moved down to Bermuda because they don’t have to pay

taxes in Bermuda. What I am thinking about is the dynamics of

the attraction of business here and job creation. And I don’t think

anyone could even begin to speculate on what that might translate

into as far as increased revenues here in D.C.

Mr. HUFBAUER. I agree.

Mr. CRANE. Could you other folks comment on that, Mr. Merrill?

Mr. MERRILL. If I understand your proposal, you would dramatically reduce the tax burden on capital. That would have the effect

of lowering the costs for U.S. companies that are capital intensive

in producing their goods. It would make their goods more competitive in world markets. There is no doubt about that.

Your proposal, as I understand it, would make the United States

a very attractive place to locate your operations, because income

earned within the United States would be subject to only one level

of tax for U.S. shareholders and that should attract investment

into the United States.

Mr. CRANE. Mr. Shay.

Mr. SHAY. I think you would have to be careful about what you

actually mean. If you mean by eliminating tax on business, as

Peter just assumed, eliminating a tax on capital and only taxing

wages that is one thing. But you suggested before that you didn’t

mean that; that what you meant was eliminating tax on business

and reducing spending and leaving the income tax on individuals.

76

Mr. CRANE. Well, wait. I didn’t say reducing spending, because

I think the dynamics of it would not necessarily dictate reducing

spending.

Mr. SHAY. Then I think we are getting back to where Peter was.

You would be eliminating tax on business, and all of that tax revenue would be made up at the individual level, correct?

Mr. CRANE. Well, not necessarily made up. We passed a tax cut

last year, $1.3 trillion over 10 years. And I have seen projections

that if you eliminated any tax whatsoever on business it would

amount, I think, like $25 to $30 billion a year over 10 years.

Mr. SHAY. Implicitly what you are assuming then is that, because what you anticipate to be the enhanced economic growth,

there will be——

Mr. CRANE. That would be an offset that would neuter that revenue loss.

Mr. SHAY. Then I think you are assuming the answer to your

question, which is there would be economic growth, which I think

does incorporate Peter’s response. I am not sure—where I would

have difficulty with that is, I am not persuaded by the evidence I

have seen that you are going to have that degree of economic

growth that you make up the revenue. If you don’t make up the

revenue and your spending decreases, if it decreases in productivity

to the United States, I am not sure where they come out.

Mr. CRANE. Do you agree or disagree that it would attract businesses here and increase jobs?

Mr. SHAY. If you define it as Peter was defining it. If you define

it as eliminating the tax on capital and you apply only taxes to

wages—I in fact cited an article that I co-authored, which agrees

would have a great tendency to attracting foreign capital. But I

think you would find it would be difficult to maintain another principle which is essential to our system, and that is taxing people on

the ability to pay, because it would levy that tax burden on workers and they would have to make up for it. And the foreign investors, the reason they would be attracted here is because they would

not be paying that tax.

Mr. CRANE. You are assuming you would have to have an offset

for this.

Mr. SHAY. I am assuming that either you are going to reduce

spending—and you are saying no to that.

Mr. CRANE. I am in favor of reducing spending, but my point is

the projected budget surpluses—when we passed the $1.3 trillion

tax cut last year over 10 years, there was no pass-through to put

that burden on anybody in the Tax Code. The assumption was that

we were producing surpluses because of record high taxes, and the

taxpayers needed relief and we gave them relief with that tax

measure.

Mr. SHAY. I think the facts are that the assumption was there

would be economic growth that has not materialized, and that with

the declining economic growth——

Mr. CRANE. That was historic economic growth.

Mr. SHAY. The future surpluses, which are no longer projected,

were projected as a result of an anticipated economic growth that

we are now scaling back. So in fact there would have to be a tax

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makeup on the current assumptions, it seems to me, to get to what

you are driving at.

Mr. CRANE. But getting back to my question, if you eliminated

that tax, would it not provide an incentive for businesses to locate

here and we wouldn’t have DaimlerChrysler, we would have

ChryslerDaimler.

Mr. SHAY. I agree with the following. If you eliminated the tax

on capital you would indeed attract capital to this market—and let

me hasten to say, I am not an economist, but I agree with that

proposition. I will not tell you, as Mr. Houghton said earlier, there

are not other dynamics as to what was Chrysler and what was

Daimler. But what you would see are other collateral effects that

are very dramatic socially. You would have taxes on wages that

would be bearing the burden of the cost of the U.S. government,

including the cost of supporting that foreign investment which is

in our market. And I think that is part of the equation that the

Committee as a whole would have to take into account.

Mr. CRANE. Well, I think Mr. Greenspan was testifying today,

and I think there are some good turnaround events, information

that was coming in today that suggests the economy may be doing

better. Well let me—Mr. Levin?

Mr. LEVIN. Thank you. We kind of dipped our toes in the water— maybe more than our toes. So thank you very much.

I won’t get into the last exchange, though it was interesting to

hear Mr. Shay’s response. So let me just suggest that what I think

your testimony shows, Mr. Hufbauer, I think your analysis of the

WTO decisions is a cogent one and I hope that the Europeans and

others will listen to it, that if they thought that tactical advantage

could be gained from dipping into this area, it is very problematic.

I don’t think any more murkier subject could be used to try to gain

a trade advantage in this one. And I also think they should listen

to the three of you as you discuss and sometimes argue about what

other solutions might be undertaken by us, because if anyone

thinks that that can happen in a short period of time, I think they

are being misled.

And I think today, really, we didn’t want to get into the substance, but you helped us do that, and it showed that we have a

long journey ahead. So your testimony has been especially helpful,

and I hope we will circulate it to all the Members who were unable

to get here so that they realize that there is a difficult journey

ahead here.

So thank you to you all very, very much.

Mr. CRANE. Mr. McCrery.

Mr. MCCRERY. Yes. Thank you, Mr. Chairman. Mr. Shay, I came

in after your testimony and got in just on the tail end of your discussion with Mr. Thomas. So I heard you talking about raising

taxes on foreign operations, I guess, of multinational corporations

and how that would level the playingfield. And while that may be

true vis-a-vis, say, Boeing and some other domestic corporation, the

problem at least as I appreciate it is not a relative tax burden between American multinationals and American corporations that

just do business here. The problem is the relative taxation of American companies, whether they are multinational or not, and foreign

companies that are exporting into the United States. And that part

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of your—maybe there is much more to your solution than that, but

that part of your solution doesn’t seem to address what I perceive

to be the principal problem here. Did I miss something here? And

I apologize if I did.

Mr. SHAY. What I pointed out was that in arguing that tax differences are the key to competitive differences, when two companies from different countries, let’s assume, are competing in a third

market, and the U.S. company is going to pay tax at the U.S. rate

and the other company is from a country that is going to let the

foreign country rate apply, even if it is lower than their home rate,

my first observation is that there is no competitive issue if the local

country rate is higher than the U.S. rate, because we give a credit

for that, Okay. So the only circumstance that we are talking

about—— Mr. MCCRERY. That is correct insofar as income is concerned.

Mr. SHAY. We will come back to indirect taxes in a moment. On

direct taxes, the only circumstance, then, that your concern arises

is A, the foreign country is at a lower rate than the U.S. rate; B,

the other company is not taxed at the same rate as the U.S. rate

back in its home country; and C, the premise is that the difference

in taxation is the driver of a competitive difference. So when we

talk about income tax, one of the problems that befuddles, I think

it is fair to say, some economists—I am not an economist-—is what

is the incidence of that tax, who ends up bearing it? Does it reflect

in price? Does it reflect in lower shareholder profit and so on?

Before you give U.S. tax relief in that case, my experience is that

there are very great advantages coming from the United States.

We have a market that supports those companies a way that the

other countries’ own company market may not. There are many

other factors. And so the only observation I was making is—and I

left out a piece.

The other piece I observed in my testimony is there may not, in

fact, be that competitive difference as a business matter if the U.S.

company owns intangibles or has other benefits that effectively preclude the competitor from selling the same quality product in the

market. And that may come from our R&D, research and development in the United States. It is a rich and complex picture.

So the test I was asking the Committee to apply before reducing

the U.S. tax on all foreign income of a U.S. company, which is

going to affect a lot of cases where we are going to be reducing our

revenue not really for the immediate competitive issue addressed,

we need to ask ourselves are we getting the bang for the buck? Is

that a better use of our money? Because if it is going to the profitability of two U.S. companies competing in that market, then there

may have been a better use for it. It may be that we could have

reduced all corporate rates in this country, and that would not help

the company that is not in that market but the exporter. That is

the argument I was making.

Mr. MCCRERY. So you weren’t making a blanket statement. You

are just saying in those isolated instances, we ought to look at that

in terms of relative taxation. Any of you, Mr. Merrill or Mr.

Hufbauer, want to comment on what Mr. Shay just said?

Mr. MERRILL. As I understand one of the options that Steve has

put forward, it would be to eliminate deferral, which would tax

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U.S. companies operating abroad currently on their income, active

and passive. That is something that this Committee considered 40

years ago and was proposed by the Kennedy Administration, and

your Committee decided not to do that. No other country in the

world has repealed deferral. The implication would be that a U.S.

company doing business abroad would be taxed in a very different

way than multinationals anywhere else in the world.

The consequence of that would be that it would be extremely unattractive to headquarter your company in the United States because if you were a U.S.-headquartered company, you would pay

U.S. tax everywhere you operated in the world, where your foreign

competitors would only pay local country tax, in most cases, where

they operated.

In that sort of a world you would see an explosion of the phenomenon that we are already seeing, which is not only companies

deciding to invert, which is not very common yet—only about 28

transactions—but also acquisitions of U.S. companies by foreign

companies, because that allows the acquired company to operate

abroad essentially free of U.S. tax where they invest outside the

United States. We are not talking about income earned in the

United States. We are talking about income earned outside of the

United States and if the United States imposes current tax on that,

the U.S. companies will very logically find ways to headquarter

outside the United States.

We will also see increased portfolio investment. Two-thirds of all

our investment outside the United States is not multinationals, it

is pension funds, it is institutional investors, it is portfolio capital

investing in foreign-headquartered companies.

So I think it would be pretty clear, Stephen, in your capacity as

advisor to companies, if they had a choice to set up an operation

in the United States or abroad and if they set up the operation in

the United States, their entire foreign operations would be subject

to current U.S. tax. If they set up abroad, only their U.S.-source

income would be subject to tax; it is obviously what you would advise your companies to do. So that type of activity, setting up headquarters abroad, would skyrocket.

Mr. MCCRERY. [Presiding.] Thank you. Very quickly, Mr.

Hufbauer.

Mr. HUFBAUER. I obviously affiliate myself with what Peter Merrill has just said. And the way I see it is, without making a lot of

complication, if you tried to make taxation of U.S. companies working abroad equivalent to what taxation is in the United States and

try to achieve that parity, (‘‘capital export neutrality’’ in the lingo

of the tax world), you have the competitive problem all of these

other different companies used in different places. It is not 1950,

when 80 percent of multinationals were U.S.-based; it is 2002, and

it is down to a quarter or something like that.

Anyway, you have a lot of companies based in other countries

who can do business in those low-tax countries and not face this

disadvantage that we are suddenly going to impose on U.S. companies doing business there.

And then the point you made, Mr. McCrery, was that they will

produce in those countries and ship back into the United States.

80

So you have got the third country competition coming back into the

United States.

And what kind of parity do you want to achieve? If you try to

achieve the parity that Steve is advocating, I think you are just

putting all U.S.-based companies at a horrendous competitive disadvantage in a global market.

Mr. MCCRERY. Thank you.

Mr. McDermott?

Mr. MCDERMOTT. Thank you, Mr. Chairman. I am not sure I am

smart enough to ask any questions here, but I do have some anyway.

Mr. Shay, I was reading your testimony, and in the first paragraph, or the bottom paragraph on the first page, it says: I next

describe a territorial tax system, how it creates an incentive to locate investment in lower tax forum countries and how the activity

it benefits differs from the activity benefited by the ETI.

Unfortunately, coming from Seattle, one does think about Boeing.

You mentioned Chicago and Washington, and I suppose you were

talking about Boeing. They are the biggest exporter. And what I

am trying to figure out is, I watch these companies like Stanley

sort of go off to Bermuda, and I figure, well, I wonder about Boeing.

How does this extraterritorial thing affect Boeing? Would they

have to move their headquarters or would they have to move their

production out of Seattle and Wichita to get the benefit?

Or tell me how they would construct it under this new system

or this extraterritorial system.

Mr. SHAY. Let me start with today. What has been happening,

what you are referring to is a phenomenon where companies that

are U.S. corporations in their parent companies are engaging in reorganizations, in most cases taxable, but because their stock prices

have been down, they are willing to take that hit, although that

is actually quite a difficult issue, for them to transfer the parent

company to another jurisdiction.

It does not necessarily mean at all that the group’s headquarters

leave the United States. In fact, a well-known example is Tyco,

which took advantage of a merger a couple of years ago, to merge

into a company that is a Bermuda company but the headquarters

of Tyco, the executive headquarters, are in New Hampshire. The

U.S. operations remain in the United States. They are in U.S. corporations.

What is going on, though, is their other non-U.S. operations, by

being under a foreign parent, are not being subjected to rules that

they would be subjected to if it were a domestic corporation parent.

It really is the phenomenon that Peter was accusing me of permitting to happen under my proposal, for which I have a response buried in the testimony at footnote 14; that is what has been going on.

The ETI really has nothing to do with that at all. The adoption

of a territorial system does not answer that in any sort of directly

coherent way. It is a creature are of the fact that today we honor

the identification of a legal entity called a corporation and treat it

as a U.S. taxpayer if it is organized under the laws of a State or

the District of Columbia. And if it is organized under the laws of

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the Cayman Islands, we say it is a foreign corporation and we accord enormous—quite substantial significance to that.

Now that significance does not apply if they are actually operating in the United States; we will tax them. If that Cayman Islands company is actually operating in the United States, we will

tax them. If they own a subsidiary in the United States, we will

tax that subsidiary. But what it does mean is that our rules affecting the non-U.S. income are basically cut out.

Part of my proposal that Peter was criticizing would be an effort

that would make that less relevant or not relevant. Now, I did not

describe my proposal in detail in testimony, and indeed in the article I refer to, we have thought about additional things that would

have to be done basically to address the concern that Peter has addressed, and indeed some of that is in my testimony buried in the

footnote.

This is a complicated area, but I think one thing that should be

clear about it is that you have a set of issues that are raised by

the inversion transactions. They are susceptible to being dealt with

by this Committee, but essentially the options boil down to, adopt

rules that make it irrelevant, because basically you are not going

to try to tax foreign income at all; or try to fix what you currently

have and try to have more of an equalized taxation of all of your

income, have neutral taxation of U.S. and foreign income. And

these are difficult issues.

The comments that Gary made and Peter made, they are legitimate comments, but they are not insoluble issues if there is the

will.

Mr. And what is the solution for Boeing, then, so that they could

keep jobs in the United States and not be at a disadvantage with

Airbus?

Mr. SHAY. That is a unique situation because you essentially

have a two-competitor market. And the answer that I frankly—I

am not at all comfortable that that is a tax-driven problem or that

there is the problem—I don’t know enough about how they are disadvantaged vis-a-vis Airbus, I don’t know enough that it derives

from the tax treatment of Airbus as opposed to government purchasing approaches, other nontax issues.

I am very reluctant, and I think we all should be, to assume that

there is a tax answer for everything. There is not. They have to

compete head to head with Airbus. They do it by having the best

educated workers and having good management that prunes away

all the excess costs and all the ABCs of good business, and in my

experience, tax comes at the end of the dog.

Mr. MCCRERY. Before going to Mr. Watkins, that may be true,

but at least at margin the tax burden is relevant, and I think that

is what Mr. McDermott is getting at.

Mr. WATKINS. Mr. Chairman and Members of the Committee, I

will say thanks for these two panels, the one earlier and Messrs.

Hufbauer, Merrill and Shay. I think this is probably the most informative educational phase of this, and I appreciate getting some

meat around the bone, because I think it is very good. Tax does affect that—there is no question about it—in many ways.

Mr. Hufbauer, you said, in the fifties, 80 percent of the corporations were U.S.-based. Was this multinationals?

82

Mr. HUFBAUER. I am giving very loose figures, but if you looked

at multinational, or what was called ‘‘foreign direct investment,’’ multinational corporations, and go back to those years 40, 50 years

ago, it was predominantly a U.S.-driven phenomenon. But now, of

course, a lot of other folks are in the game.

Mr. WATKINS. We are in a global economy, and it is not really

that way.

Mr. Merrill, you have an—I have read all of your statements. All

of you have some very good—I will take it home and read it, and

I will read it on the plane flying back and forth. But I noticed, Mr.

Merrill stated of the world’s 20 largest corporations, the number

headquartered in the United States has declined from 18 in 1960

to just 8. I think everyone who is wanting to tax corporations

should look at that a little bit. Declined from 18 out of the top 20,

from 18 to down to only 8. And the multinational companies’ share

of global cross-border investment has declined from 50 percent in

1967; now it is down to only 25 percent. We were talking about an

economic base out here, or our economic undergirding of our country; some of it is gradually eroding in the United States.

I do not know about Boeing, Mr. Shay, but taxes do matter. But

I know—my friend, Mr. McDermott, just left, but I also know that

subsidies matter. And I also know that some of the environmental

and labor deals matter because there are some variables, more

than just taxes, as you say.

But I know I speak of ‘‘taxes’’ and ‘‘Texas,’’ I have two colleagues

here Mr. Brady and Mr. Doggett. I am from Oklahoma; that is just

above, geographically, Texas. The fact is, Texas does not have a

corporate tax or a personal income tax, though it has a franchise.

I know we lose businesses and industries from Oklahoma to Texas

because of that very reason.

Now, they could have the same environmental base that we have

because most of it is the United States. But it is tax driven.

Let me assure you, I think what we are talking about is—and

today it is probably one of the most significant issues facing the future of our country and its role if we are going to remain the number one economic power in the world, which also drives where we

are as far as militarily, educationally or anything else—we have

got to have the base to do that.

I appreciate this, Mr. Chairman. Again, I think this is a very,

very important—to my friend from Tennessee, I hate that he left

because I know that he is also concerned about some of these

things we were just talking about. I will talk to him personally.

I thank you so much for being here. I will probably have some

questions I may call some of you on or ask you to give me more

information on. Thank you.

Mr. MCCRERY. Mr. Hayworth.

Mr. HAYWORTH. Thank you, Mr. Chairman.

Gentlemen, thank you for coming down and for your testimony

today. And I listened with interest to my colleague from Oklahoma

talking about the environment he sees at home and the analogy

with what transpires internationally in terms of tax law.

Mr. Merrill, you pointed out during your testimony, foreign markets in today’s global economy represent an ever-increasing opportunity for the growth of U.S. companies. Furthermore, competition

83

for these markets is at an all-time high. And echoes of what my

friend from Oklahoma talked about, Mr. Merrill, in your testimony

you also point out that our U.S. tax rules put our companies at a

disadvantage when competing in foreign markets.

To amplify this and get past theory and abstraction, can you

offer an example-—I don’t know if you would call it ‘‘everyday’’ or

something that is so compelling and so notable that it certainly

bears amplification in this type of setting?

Mr. MERRILL. I think one of the most graphic examples is the

U.S.-owned foreign shipping industry. That is an area where Congress, in 1986, actually did what Steve recommends. It terminated

deferral for foreign shipping income. The result is that the U.S.-

owned foreign shipping income has been eliminated. There are

very, very few carriers left now that operate a foreign flag fleet.

And this happened because they sold or they decontrolled. They

sold majority ownership so they would get out of these rules. I

think that is an example where it is crystal clear the United States

changed the law in 1986 and U.S. ownership of a foreign flag fleet

was almost eliminated.

Mr. HAYWORTH. Thank you, sir. Would anyone else care to elaborate?

Mr. Shay, we do not have an equal-time provision, but do—were

there mitigating circumstances in your mind or would you concur

with Mr. Merrill’s analysis?

Mr. SHAY. Well, I can’t speak to the shipping case, because I

have not studied it, but part of my caution is that you are being

asked by companies to reduce their tax burden.

I served 5 years in the Treasury. I had to use the word ‘‘no’’ more

than any other word in the 5 years I was in the Treasury, because

when you are in your position in the Treasury, you are always

going to be asked to reduce the tax burden.

The question is, is it in the overall best interest of the United

States? And the analogy I would make to my private experience is,

sometimes clients say, if I can just make that investment, I will

have a bigger market share.

That is not the only question. Will they make a profit? There are

some investments you should not make.

And that is the way you should analyze each of the questions

that come before you. Because my clients do not just go for market

share if they are not going to make a profit. And the analogy here

is, if the United States is going to invest in our multinationals,

which we do, we reap a huge benefit.

Let me summarize—first, tax does matter; I have been clear

about that in my testimony.

Two, these are very important issues. But part of the importance

is not only listening to the people who get the benefit. If you ask

my clients would they like the ETI, would they like a territorial

system, and you ask me, am I lobbying for them, of course, I would

say yes. How can you say no?

But that is not the issue before you. You folks have a difficult

task. You have got to sort out what is not just in the best interest

of the companies, but what is in the best interest of the country.

And the first point I made in my oral testimony is that there is

not a perfect identity, notwithstanding the old statement of Mr.

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Wilson from General Motors. We have limited resources for the

government. Tax is coercion, so when we impose that coercion, if

we are going to reduce it on the multinationals and we are going

to keep spending the same and we do not have surpluses, it is

going to come from somewhere else. And that is just the burden we

are under.

So I am not going to speak to the shipping example, but I just

want to say that it is not automatic that tax is causing—you have

to be skeptical and shine a light on the question of whether in a

particular case tax is creating a competitive disadvantage.

I do not want to go further because it wasn’t in your question.

But there has been a lot of discussion here today about the advantage of countries that use indirect taxes to give an export an advantage to their exports. I have not heard any part of this discussion today getting into some of the economics of the difference between an indirect tax or a direct tax; and I encourage the Committee to find the people who can inform them adequately on that

issue, because it is not as simple as today’s discussion has suggested.

Mr. MCCRERY. Thank you. Mr. Doggett.

Mr. DOGGETT. Thank you very much, and thanks to all of you for

staying for an informative discussion.

Mr. Merrill, are you still lobbying for the contract manufacturing

coalition?

Mr. MERRILL. Yes, sir. Well, as you may have read in the Wall

Street Journal today, our legislative practice at

PricewaterhouseCoopers has been sold to Clark/Bardes and that

project has gone with it.

Mr. DOGGETT. All right. Were you lobbying for them before yesterday, or the sale?

Mr. MERRILL. I was registered as a lobbyist because I did some

economic work for the coalition.

Mr. DOGGETT. And also for the FSC 2000 coalition?

Mr. MERRILL. I was registered for them. I did some economic

work for that group.

Mr. DOGGETT. Is your former client, Enron, or any of its subsidiaries, partnerships, or joint ventures a Member of either of those

coalitions or any of the other coalitions that your firm has represented?

Mr. MERRILL. Well, I can only tell you about the International

Tax Policy Forum. And there was a Wall Street Journal article—

incorrect, actually-—but Enron was a Member of the International

Tax Policy Forum along with 30 other companies. It withdrew

when it became bankrupt.

Mr. DOGGETT. Do you know if it is a Member of the FSC 2000

coalition for which you lobbied?

Mr. MERRILL. No. I would not know; my role there was to provide

economic research for Ken Kies.

Mr. DOGGETT. As to either of those coalitions, can you tell us who

some of the other Members are?

Mr. MERRILL. I do not believe that would be appropriate for me

to disclose more than I disclosed in the lobby disclosure form.

85

Mr. DOGGETT. The lobby disclosure form, of course, discloses

nothing, except for the name of the coalition. It does not identify

a single company, does it?

Mr. MERRILL. As far as I know, it does not.

Mr. DOGGETT. Yes, sir. Are you declining to tell me and the Committee today the names of any of the Members of the coalitions for

which you have been lobbying right up to this past week?

Mr. MERRILL. Well, one, I certainly do not know all the names.

Mr. DOGGETT. No, I am not asking you for all of them. I am asking if you can identify any of them for the Committee.

Mr. MERRILL. I think it would be unfair for me to identify a few

and not all. And I actually want to find out about disclosing all by

asking whether it is possible to do that with the clients involved,

since that is not something they agreed to.

Mr. DOGGETT. Just so the record will be clear as to the FSC 2000

coalition, you will not identify any of the Members of that coalition

to us today?

Mr. MERRILL. Not today. I would be happy to find out from the

coalition whether they would be prepared—— Mr. DOGGETT. The coalition is something that is set up in your

office there at Pricewaterhouse isn’t it?

Mr. MERRILL. It is not there at the moment. It is at Clark/

Bardes.

Mr. DOGGETT. That was the case last week or last month?

Mr. MERRILL. Right. Right.

Mr. DOGGETT. With reference to the Contract Manufacturing Coalition, you decline to provide any of those names, though that also

is an entity set up there at Pricewaterhouse?

Mr. MERRILL. Right. Again, it is no longer with

PricewaterhouseCoopers. At this point I would not be prepared to

disclose more than I was disclosing on the lobby disclosure forms.

Mr. DOGGETT. And the Multinational Tax Coalition, its work was

directed at a regulation of the Treasury Department was it not— 9835, I believe?

Mr. MERRILL. Actually, I am trying to recall. I think it was originally 9811 and then 9835.

Mr. DOGGETT. I believe that is right. And that is where—that coalition lobbied in an effort to try to bring change to 9811 and 9835

Treasury IRS proposals?

Mr. MERRILL. That is correct.

Mr. DOGGETT. And can you tell the Committee the names of any

of the members of that coalition which was also formed there at

Pricewaterhouse?

Mr. MERRILL. The same answer.

Mr. DOGGETT. Am I correct—since the caution light is on—am I

correct that if Enron or one of its subsidiaries or Global Crossings

or the ABC Corporation wants to hide its identity in its lobbying

efforts of Treasury or any other part of this Congress or of our government, all they have to do is come to firms like the one you have

worked for and form a coalition with them and hide their identity

from the public? Is that the way it works?

Mr. MERRILL. I am not an expert on lobby disclosure rules. All

I can tell you is that we disclose everything we are required to disclose.

86

Mr. DOGGETT. A coalition could consist of nothing but Enron and

itself, could it not?

Mr. MERRILL. I don’t know the answer to that.

Mr. DOGGETT. Thank you very much. And thank you, Mr. Chairman.

Mr. MCCRERY. Mr. Brady.

Mr. BRADY. I am confused. Mr. Merrill, are you complying with

all of the disclosure laws that Congress has asked you to comply

with?

Mr. MERRILL. I certainly hope so. We have someone in our office

whose job it is to file the lobby disclosure forms, and we have a regular canvassing of the entire Washington office. We are very conservative in our disclosure. Even though I, for example, haven’t

talked to any Member of Congress or staff about any of the coalitions that were just mentioned, we still disclose that I worked on

it; and I feel that we ought to be conservative and disclose everything that we might conceivably be required to disclose. I hope that

we are doing a complete and thorough job on that.

Mr. BRADY. I appreciate you for following the laws of the land

and engaging in legal activity the last time I checked.

Obviously, we have a big problem in front of us. This was a great

panel, by the way—extremely informative.

Sort of narrowing it back down to the end, Mr. Chairman, with

a simple question. We ought to be trying to find a solution that is

real and is not in your interest but in the interest of America.

The question is, at this point, what would you recommend to

Congress, if our goal is a substantial solution that creates American jobs or at least makes us more competitive to do so, what approach would you recommend that we take at this point for each

of the panelists?

Mr. HUFBAUER. Well, I would recommend going to a modified territorial system. To spell out the modifications would take more

time than anybody wants today, but I would be happy to talk about

that later.

I believe the foreign tax credit system is hopelessly complex and

hard to administer. I appreciate what Stephen Shay has said, that

a territorial system is not easy. I am not saying it is easy. I am

saying it is an improvement over where we are today. Instead of

chasing these wills-of-the-wisp and so forth. And in connection with

that, I would provide for equivalent taxation of U.S. export earnings exactly like—well, not exactly, but very similar to what the

Netherlands or France does. That would be part of this general system that I would urge.

Mr. BRADY. Do you mind, at some point, could we get your

thought on the modifications?

Mr. HUFBAUER. I would be delighted, Congressman.

Mr. BRADY. Thank you, sir.

Mr. MERRILL. I will take this as an opportunity to mention a

book done for the National Foreign Trade Council. It is called ‘‘U.S.

International Tax Policy for the 21st century.’’ It represents the

work of four or five different authors; I was one of them. And the

purpose of this book is essentially a blueprint for how to reform the

U.S. taxation of multinational companies. So I think that would

provide a place to start.

87

1We would emphasize that, in our view, the problem extends beyond just Subpart F.

2 Cohen & Hankin, ‘‘A Decade of DISC: Genesis and Analysis,’’ 2 VA. TAX REV. 7, 225 (1982);

Bruce, Lieberman & Hickey, 934 T.M., Foreign Sales Corporations. 3Section 911.

It does not address territorial taxation. It takes as a starting

point our existing worldwide system and asks the question, how

can we make our existing worldwide tax system simpler, more competitive, in many cases not inconsistent with the capital export

neutrality doctrine.

Mr. BRADY. Would it address the WTO dispute?

Mr. MERRILL. It does not directly address the WTO issues that

are at stake. It asks, how can we make our multinationals more

competitive. That would, I think indirectly address that issue, because as I testified, multinationals are an extremely important part

of U.S. exports. They account for two-thirds of U.S. exports. In

many cases, the foreign operations of multinationals are the sellers, distributors, the servicers of U.S. exports. So I think the two

go hand in hand.

Mr. BRADY. Great.

Mr. MCCRERY. Mr. Brady, I am afraid I have to close this hearing. We have a vote. They are holding the vote for you and me.

Thank you, gentlemen, very much for your testimony. The hearing is adjourned.

[Whereupon, at 3 p.m., the hearing was adjourned.]

[Submissions for the record follow:]

Statement of MTI Services Limited, Princeton, New Jersey, and the

Western Growers Association, Irvine, California

MTI Services Limited (MTIS) and the Western Growers Association (WGA) submit the following written testimony to the Committee for its consideration. We appreciate this opportunity to make our views known.

History of the FSC–ETI Dispute—The Role of Decisions Made in the 1960s

Regarding the history of the FSC–ETI dispute, the origins lie with the enactment

of Subpart F in 1962 and the tightening of the section 482 allocation regulations

in 1968. These changes, taken together, tightened the tax regime too much, with

the result that exporters, among others, were unfairly disadvantaged.1 At the beginning of the 1970s, the decision was made, in effect, to loosen the rules. However,

instead of amending Subpart F and the allocation regulations, it was thought better

to enact a new, separate set of rules—the DISC provisions. These provisions and

the subsequent FSC and ETI rules give the appearance of special exceptions for exporters, when in fact they are a modification in the treatment of international income.2 It is submitted that Congress should reconsider the decision made in the

early 1970s not to amend the Subpart F and section 482 rules.

The WTO Appellate Body’s Decision—A Misconception of the Nature of U.S.

Tax Rules

The WTO Appellate Body’s conclusions are based in part on the notion that the

normal or ‘‘benchmark’’ rule is that U.S. persons are taxable on their foreign source

income and, therefore, ETI operates as an exception; thus, the United States foregoes revenue that otherwise would be due. The U.S. tax system, however, is not this

pristine. For example, Americans residing abroad are exempt from U.S. tax, up to

the level of $80,000, on their foreign earned income.3 Moreover, the United States

has repeatedly argued that the FSC and ETI regimes are not that distant from what

could be achieved, albeit with a good deal more trouble, under existing ‘‘regular’’ international tax rules. Indeed, as noted below, exporters, with clarification by the

Internal Revenue Service of existing law, could obtain the same level of benefits.

Impact of Changes in the FSC–ETI Rules—Effects on Medium Size and

Smaller Taxpayers

The FSC–ETI tax benefit, while not enormous, is significant for the typical medium size and smaller exporter. The impact of changes in this area of the tax law

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4 Experience shows that it takes some time for taxpayers to understand a new set of rules

such as the ETI rules. With FSCs, the ‘‘learning curve’’ extended for 8–10 years. With ETI, we

believe, it is shorter but still considerable. 5For an explanation of how this might be achieved, see Bruce, ‘‘The WTO’s FSC Ruling: Let’s

All Relax,’’ 86 Tax Notes 1927 (Mar. 27, 2000). It will be noted that this type of approach is

WTO-legal. There are no special provisions associated with it that benefit exporters; therefore,

there is nothing that can properly be characterized as a subsidy.

on these exporters is great. The changes create confusion. Transitioning from one

regime to another is costly and time-consuming. They cause an air of uncertainty.

Many smaller exporters are simply falling by the wayside; how many will not be

know for certain until the tax return information for 2002 is captured, presumably

in late 2003 or early 2004.4

The EU’s Request for Sanctions—A Proposal for Attacking the Numbers

The European Union’s estimate of the harm caused it by the ETI provisions (ap- proximately $4 billion per annum) is grossly overstated for the reasons stated by

the United States in its submissions and the ‘‘fall off’’ in use, especially among

smaller exporters. The Treasury Department and taxpayers, working together, can

drive down the revenue loss due to ETI by engineering a solution under existing

‘‘regular’’ U.S. international tax statutory and treaty provisions. One approach is for

the Internal Revenue Service to issue pre-filing agreements under existing law,

without regard to the ETI provisions, to shareholders and their multiple ownership

entities and to take such other steps as may be necessary, including negotiate with

treaty partners, to clarify the tax treatment of these taxpayers under section 245(a)

and sections 951–964. 5 There may be other approaches. The point is a simple one:

It is within the Treasury Department’s and taxpayers’ power to ‘‘devalue’’ the figure

that underpins the EU’s position on sanctions and, in so doing, to promote a reasonable negotiated resolution. It would be surprising if highly intelligent tax lawyers

in the Service and accounting and law firms could not map out a suitable plan.

Then, the more companies that ‘‘buy into’’ the solution, i.e., obtain an agreement,

the more effective it is.

Driving down the figure for sanctions and negotiating a resolution buys time for

a larger solution in the form of rethinking Subpart F and the income allocation

rules.

Multiple Ownership—Need for Continued Support

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.

*****

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. It is based Hamilton, Bermuda, with a subsidiary in

Princeton, NJ. 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.

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.

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Statement of William A. Reinsch, President, National Foreign Trade

Council

The National Foreign Trade Council (NFTC), founded in 1914, is an association

of businesses with some 400 members. It is the oldest and largest U.S. association

of businesses devoted to international trade matters. Its membership consists primarily of U.S. firms engaged in all aspects of international business, trade, and investment. Most of the largest U.S. manufacturing companies are NFTC members.

The NFTC’s emphasis is to encourage policies that will expand open trade and U.S.

exports and enhance the competitiveness of U.S. companies by eliminating major

tax inequities and anomalies.

Introduction

The NFTC applauds Chairman Thomas’s decision to hold a hearing on the WTO

Appellate Body ruling in United States—Tax Treatment for ‘‘Foreign Sales Corporations’’—Recourse to Article 21.5 of the DSU by the European Communities. This

statement follows the outline of the matters identified in the announcement of the

hearing: (1) outline the history of the FSC–ETI dispute, (2) analyze the January 14,

2002, WTO Appellate Panel Decision, and (3) discuss the potential trade ramifications of the decision. Regarding the potential trade ramifications, this statement

highlights the importance of developing a process for resolving the FSC–ETI dispute

in a manner that preserves the competitiveness of American companies while lessening trans-Atlantic trade tensions. The NFTC appreciates the opportunity to submit its views for the hearing record.

Background

The Domestic International Sales Corporation (‘‘DISC’’) provisions were enacted

to restore the competitiveness of U.S. exporters that were adversely affected by the

1962 enactment of the Subpart F rules. The WTO FSC–ETI case can be traced back

to 1972 when the European Community (‘‘EC’’) objected to the 1971 enactment of

the DISC legislation, and the United States counter-claimed that the tax exemptions

for foreign-source income provided by Belgium, France, and the Netherlands were

export subsidies. A 1976 GATT panel issued reports finding both that the DISC had

some characteristics of an illegal export subsidy and that the three European territorial tax systems provided impermissible export subsidies. It was not until 1981

that the parties agreed to the adoption of the GATT panel’s reports, based on an ‘‘Understanding’’ adopted by the GATT Council that provided the blueprint that was

used to develop the Foreign Sale Corporation (FSC) as a replacement for the DISC.

In particular, the 1981 Understanding made clear that a country is not required to

tax income from foreign economic processes.

The FSC provided a limited tax exemption for certain U.S. export transactions.

Income earned in these transactions from economic activities occurring within the

United States was fully taxed. Income earned in FSC transactions from economic

activities taking place outside the United States was subject to an exemption. The

FSC replicated central aspects of territorial taxation as applied to export transactions. The major difference between the FSC and territorial tax systems was that

the FSC applied specifically to exports while territorial systems applied to exports

as well as other international transactions.

The 1981 Understanding laid the issue to rest for more than 15 years until the

European Commission (‘‘Commission’’) challenged the FSC in late 1997. Regrettably,

both a WTO Panel and Appellate Body all but ignored the 1981 Understanding in

holding that the FSC was a prohibited export subsidy. Accordingly, the United

States repealed the FSC regime and enacted a regime for ‘‘extraterritorial income’’

(‘‘ETI’’) in November 2000. The ETI regime represented a fundamental change in

U.S. tax law, notably, a new, general exclusion of income earned in a broad range

of overseas transactions. Unlike the FSC, the ETI regime did not require any exportation from the United States and was available to (essentially) all U.S. taxpayers— treating foreign and domestic businesses subject to U.S. taxation alike.

Nevertheless, the Commission brought a WTO challenge immediately following

enactment of the ETI regime. In August of last year, a WTO Panel agreed with the

Commission, and the Appellate Body affirmed the Panel’s decision on January 14,

2002. The matter is now before an arbitration panel where the Commission is seeking authorization to impose more than $4 billion in trade sanctions on U.S. exports.

The arbitration process likely will be completed by the end of April 2002, at which

time the Commission would be free to retaliate.

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Brief Analysis of WTO Appellate Body Report

The January 14, 2002, Appellate Body Report upheld each of the adverse ‘‘findings’’ (as opposed to the rationale) of the Panel that considered the validity of the

ETI regime. As in the original dispute, the Appellate Body was required to determine whether the ETI regime provides a subsidy before reaching the issues of

whether the subsidy confers a benefit and whether the subsidy is contingent on export performance. The Appellate Body was also required to decide whether the ETI

is inconsistent with GATT 1994 by reason of the foreign articles/labor limitation.

To summarize the principal conclusions in the Appellate Body’s report, any elective, replacement regime that departs from an otherwise applicable general rule

would be viewed as granting a subsidy. 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. In this regard, the foreign economic process requirement under the ETI regime was viewed as sufficient to establish the presence of ‘‘some’’ foreign-source income, but the ETI regime as a whole

fell short of adequately identifying ‘‘foreign-source income’’ (primarily because allocation rules apply fixed percentages to amounts that may include domestic-source

income).

The Appellate Body also upheld the Panel’s finding that, by virtue of the fair market value rule, the ETI regime accords less favorable treatment to imported products than to like products of U.S. origin, within the meaning of Article III:4 of the

GATT 1994. Similarly, the Appellate Body upheld the Panel’s finding ‘‘that the ETI

measure involves export subsidies inconsistent with the United States’ obligations

under Articles 3.3, 8, and 10.1 of the Agreement on Agriculture. Finally, the Appellate Body made clear that the United States has no legal basis for providing transition rules that extend the time-period for fully withdrawing the prohibited FSC subsidies.

Trade Ramifications

The dispute between the United States and the Commission over the ETI provisions poses a grave danger to the future stability of the trans-Atlantic economic relationship and, more broadly, the global trading system. As an organization that

represents companies keenly interested in the future progress of both, the NFTC believes it is imperative that this dispute be resolved equitably.

The European Union is one of our largest trading partners; in 2000 the two-way

volume of U.S.-EU trade totaled roughly $385 billion. In recent years, however, the

relationship has been marred by a number of contentious trade disputes, many of

which have been litigated before the WTO (hormone-fed beef, bananas, Havana

Rum, and the 1916 Antidumping Act). Other potential trade cases may follow: the

systemic failure of the Commission to approve GMO products absent scientific backing and the U.S. imposition of section 201 tariffs on steel imports. If both parties

do not pull back from the brink of this seemingly ceaseless trade litigation, the

NFTC fears they may be risking long-term damage to the health of this vital economic partnership.

This continued deterioration in U.S.-Commission relations will have consequences

for the broader trading system as well. The United States and the Commission have

traditionally played leading roles in charting and driving the global trade agenda,

as evidenced by the successful creation and expansion of the GATT and then the

WTO to cover an ever broader array of trade disciplines (i.e. services, intellectual

property). A fractured U.S.-EU relationship will hamper the ability to successfully

complete the Doha Round and strengthen the hand of nations inclined to retard

progress.

The Resolution Process

The NFTC agrees with comments made by Chairman Thomas and other Members

of the Committee that it is important for the United States—as the world’s leading

exporter—to comply with its international trade obligations in a timely manner so

as to set an example for other WTO member countries. To achieve this end, the Administration must demonstrate leadership by implementing a comprehensive process that will lead to an acceptable resolution of the FSC–ETI dispute that does not

place U.S. businesses at a competitive disadvantage.

The Administration must make the resolution of this dispute a high priority. In

the end, some combination of trade and tax initiatives may be necessary to resolve

this dispute. It seems clear, however, that a legislative response or a negotiated solution would take time to develop and implement, and that this should be accomplished without subjecting American businesses to a competitive disadvantage.

Thus, the NFTC urges the chairman and members of this Committee to press the

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Administration to engage the Commission in serious, high-level discussions, with

the aim of avoiding retaliation before an accord is reached. In addition to forcefully

and consistently negotiating with the Commission on the issue of the timetable for

coming into compliance, the Administration should seek assurances that the Commission would be willing to consult with our government to obtain a measure of certainty regarding any response that may be forthcoming.

In any event, the Administration and the Congressional tax-writing committees

should remain focused on leveling the playing field between U.S. exporters and their

foreign competitors. The NFTC looks forward to working with the Committee and

its staff in resolving this issue.

Conclusion

It is imperative that the United States and the Commission agree on a mutually

acceptable solution that ensures that U.S. businesses, farmers, and workers are not

placed at a disadvantage in relation to their foreign competitors. Resolving this matter and avoiding the destabilizing consequences it threatens are as important as any

trade issue currently facing our country. The NFTC stands ready to work with this

Committee and the Administration to achieve this result.

Æ