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89–891—PDF 2004

S. HRG. 108–337

AN EXAMINATION OF U.S. TAX POLICY

AND ITS EFFECT ON THE INTERNATIONAL

COMPETITIVENESS OF U.S.-OWNED

FOREIGN OPERATIONS

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

JULY 15, 2003

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

DON NICKLES, Oklahoma

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

TOM DASCHLE, South Dakota

JOHN BREAUX, Louisiana

KENT CONRAD, North Dakota

BOB GRAHAM, Florida

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

KOLAN DAVIS, Staff Director and Chief Counsel

JEFF FORBES, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Bingaman, Hon. Jeff, a U.S. Senator from New Mexico ...................................... 2

CONGRESSIONAL WITNESSES

Ensign, Hon. John, a U.S. Senator from Nevada .................................................. 3

Boxer, Hon. Barbara, a U.S. Senator from California .......................................... 5

Allen, Hon. George, a U.S. Senator from Virginia ................................................ 6

ADMINISTRATION WITNESSES

Olson, Hon. Pamela, Assistant Secretary, Department of the Treasury, Washington, DC ............................................................................................................. 8

PUBLIC WITNESSES

Hines, Prof. James R., Jr., University of Michigan Business School, Office

of Tax Policy Research, Ann Arbor, MI .............................................................. 28

Kostenbauder, Dan, vice president, transaction taxes, Hewlett-Packard Company, Palo Alto, CA .............................................................................................. 30

Hahn, Charles J., director of taxes, tax department, The Dow Chemical Company, Midland, MI ................................................................................................ 32

Gaffney, Mike, co-head of Global Tax, first vice president, Merrill Lynch,

New York, NY ...................................................................................................... 33

Rosenbloom, H. David, Caplin & Drysdale, Chartered, Washington, DC ........... 35

Shay, Stephen E., Esq., partner, Ropes & Gray, LLP, Boston, MA .................... 37

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Allen, Hon. George:

Testimony .......................................................................................................... 6

Prepared statement .......................................................................................... 45

Baucus, Hon. Max:

Prepared statement .......................................................................................... 46

Bingaman, Hon. Jeff:

Opening statement ........................................................................................... 2

Boxer, Hon. Barbara:

Testimony .......................................................................................................... 5

Bunning, Hon. Jim:

Prepared statement .......................................................................................... 46

Ensign, Hon. John:

Testimony .......................................................................................................... 3

Prepared statement .......................................................................................... 47

Gaffney, Mike:

Testimony .......................................................................................................... 33

Prepared statement .......................................................................................... 50

Responses to questions from Senator Grassley .............................................. 55

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

Prepared statement .......................................................................................... 56

Page

IV

Hahn, Charles J.:

Testimony .......................................................................................................... 32

Prepared statement .......................................................................................... 57

Responses to questions from Senator Grassley .............................................. 62

Hatch, Hon. Orrin G.:

Prepared statement .......................................................................................... 64

Hines, Prof. James R., Jr.:

Testimony .......................................................................................................... 28

Prepared statement .......................................................................................... 65

Responses to questions from Senators Grassley and Hatch ......................... 72

Kostenbauder, Dan:

Testimony .......................................................................................................... 30

Prepared statement .......................................................................................... 75

Responses to questions from Senator Grassley .............................................. 82

Olson, Hon. Pamela:

Testimony .......................................................................................................... 8

Prepared statement .......................................................................................... 86

Responses to questions from Senators Grassley, Smith, Bunning, and

Bingaman ...................................................................................................... 92

Rosenbloom, H. David:

Testimony .......................................................................................................... 35

Prepared statement .......................................................................................... 98

Responses to questions from Senators Grassley and Hatch ......................... 101

Shay, Stephen E., Esq.:

Testimony .......................................................................................................... 37

Prepared statement .......................................................................................... 241

Smith, Hon. Gordon:

Prepared statement .......................................................................................... 245

COMMUNICATIONS

American Business Council .................................................................................... 247

American Institute of Certified Public Accountants ............................................. 248

Commonwealth of Puerto Rico ................................................................................ 266

Cowen, Robert .......................................................................................................... 272

Center for Freedom and Prosperity ....................................................................... 277

Puerto Rico Business Alliance ................................................................................ 279

Senate of Puerto Rico USA ..................................................................................... 282

University of Michigan Law School ....................................................................... 284

(1)

AN EXAMINATION OF U.S. TAX POLICY AND

ITS EFFECT ON THE INTERNATIONAL COMPETITIVENESS OF U.S.-OWNED FOREIGN OPERATIONS

TUESDAY, JULY 15, 2003

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10:00 a.m., in

room 215, Dirksen Senate Office Building, Hon. Charles E. Grassley (chairman of the committee) presiding.

Also present: Senators Hatch, Nickles, Kyl, Thomas, Bunning,

Baucus, Breaux, Conrad, and Bingaman.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. This is our second hearing on the international

competitiveness and U.S. tax policy. Normally, I do not start until

Senator Baucus is here, but he is necessarily delayed and he told

me to go ahead. So, we are going to start our hearing.

Last week, we focused on the international competitiveness of

U.S.-based businesses. Today, we focus on international competitiveness of U.S.-owned foreign operations.

During this hearing, we will examine what we mean by the term

‘‘international competitiveness.’’ Understanding this term, and particularly how this term is measured, is very important in light of

last week’s testimony.

As many of you know, it has been suggested that we repeal FSC/

ETI and use the proceeds to reform our international tax rules. Advocates of this approach claim that this is the best way to shore

up our U.S. economy and create U.S. jobs.

But during last week’s hearing, our witnesses said that this ap- proach would be a $50 billion tax increase on U.S. manufacturing

and U.S. job space. Witnesses said that a tax increase of this size

could force them to move their operations out of the United States

to remain, in their words, internationally competitive.

One witness with both foreign and U.S. operations candidly stated, ‘‘You can reduce my foreign taxes if you want to, but I will just

move my U.S. operations there.’’

If we are forced to trade off a domestic tax increase against international tax reform, then we need to understand how international

competitiveness will replace any job loss from the tax increase,

what kind of jobs it will create, and how it benefits the everyday

2

* For more information, see also, ‘‘The U.S. International Tax Rules: Background and Selected

Issues Relating to the Competitiveness of U.S. Businesses Abroad,’’ Joint Committee on Taxation staff report, July 14, 2003 (JCX–68–03).

working American. Personally, I think this trade-off is an unfortunate choice. Some refer to it as a false choice.

International tax reform is long overdue. Our current system is

based on a framework enacted during President Kennedy’s administration. In an era of expanding global markets, falling trade barriers, and technological innovations that melt away traditional notions of national borders, it is critical that our international tax

laws keep pace with the new business realities.

Today we will hear that our international tax laws have not kept

pace. Today, we will hear some fresh and creative thinking on what

we should do to reform our international provisions, and yet remain globally competitive.

We are fortunate to have several Senators on this committee who

are deeply committed to reforming our international tax laws. Senator Hatch and Senator Baucus have led the charge on this issue

for many years.

In addition, during last July’s hearing 1 year ago, Senator

Graham of Florida expressed grave concerns about the problems of

our international tax laws. As a result, he and Senator Hatch

formed an international tax reform working group within this committee to evaluate various international reforms and simplification

measures.

I said last year in my floor remarks, when Senator Baucus and

I introduced an anti-inversion bill, that I recognized that the rising

tide of corporate expatriations demonstrate that our international

tax laws are deeply flawed.

In many cases, those flaws seriously undermine an American

company’s ability to compete in the global marketplace. We need to

bring our international tax system in line with our open market

trade policies. Reform of our international tax laws is necessary for

our U.S. businesses to remain competitive in their global marketplace.

More importantly, those U.S. companies that reject doing a corporate inversion are left to struggle with the complexities of competitive impediments of our international tax law rules.*

This is an unjust result for companies that choose to remain in

the United States of America, and I think we all need to be committed, as I have said I am, to remedy the inequity.

Let me ask if Senator Bingaman, who is here, would like time

to speak for the other side of the aisle.

Senator BINGAMAN. Mr. Chairman, I would like just a few minutes, if I could.

The CHAIRMAN. Yes.

OPENING STATEMENT OF HON. JEFF BINGAMAN, A U.S.

SENATOR FROM NEW MEXICO

Senator BINGAMAN. Mr. Chairman, first, thank you for having

this second hearing on international tax issues. I think it is very

important that the committee focus on this subject and that we try

to make some progress.

3

I hope that out of these hearings will come a consensus that a

major, probably the major, result and goal that we ought to be aiming for in any changes in this area is to incentivize job creation in

this country.

Clearly, we have seen a dramatic reduction in the number of

manufacturing jobs in this country. There is a chart behind me

that shows both unemployment rates and the unemployment rate

in the manufacturing sector.

You can see that the unemployment rate in the manufacturing

sector, which is the red line, is moving up much more quickly than

the unemployment rate generally. They are both moving up, which

is not good.

But the unemployment rate in manufacturing is going up much

more quickly than the unemployment rate generally. We need to

find ways, in our consideration of these tax provisions, where we

can help reduce that trend and change that trend.

The other chart I just wanted to show very briefly relates to the

trade deficit. It just makes the point, which I think we are all

aware of to some extent, that according to the Commerce Department, the trade deficit for May was $41.84 billion. Now, that is

growing, and has been growing.

In spite of reports that some of our exporters are doing reasonably well, it is clear that much of what we are buying a larger and

larger portion of what we are buying, is produced abroad.

That translates into a loss of jobs here, a loss of jobs in the manufacturing sector, a loss of jobs in the service sector. I hope that

the Department of Treasury can give us some suggestions for ways

that they think this can be reversed.

If there are biases built into our Tax Code that incentivize companies to manufacture overseas or do service jobs overseas, then we

need to correct that. I hope that will be what comes out of this set

of hearings.

Again, I thank you for having today’s hearing. I hope that, in the

question and answer period, we can get into some of these issues

in more detail. Thank you.

The CHAIRMAN. We are joined by three of our outstanding colleagues to discuss the legislation on international tax that they are

concerned about.

We, first, have Senator John Ensign of Nevada, and Senator Barbara Boxer of California regarding the Homeland Investment Act,

and when he comes, Senator George Allen of Virginia, to express

his views on repealing the FSC/ETI regime.

Who would like to go first?

Senator BOXER. You can go first.

The CHAIRMAN. All right. Then Senator Ensign?

STATEMENT OF HON. JOHN ENSIGN, A U.S. SENATOR FROM

NEVADA

Senator ENSIGN. Thank you, Mr. Chairman.

Mr. Chairman, I ask consent that my full statement be made

part of the record. That way I will save you some time.

The CHAIRMAN. Yes. And the same for Senator Boxer.

[The prepared statement of Senator Ensign appears in the appendix.]

4

Senator ENSIGN. I would just summarize my remarks.

The bill that we are here to talk about today was passed on the

Senate floor 75 to 25, with a broad bipartisan support.

Just to summarize what it does, currently U.S. companies that

have invested abroad, when they pay tax on those earnings, if they

want to bring that cash back into the United States, the differential between the tax that they paid and the U.S. corporate tax of

35 percent, they will pay that again.

Consequently, what they do, is most of the companies leave a

huge amount of cash overseas. As we have all seen, the U.S. economy, while it looks like it is showing signs of recovery, it is certainly not what any of us would like to see. It is certainly not a

robust recovery, by any stretch of the imagination.

In listening to people, there is a huge amount of cash sitting

overseas that companies would like to bring back into this country,

but because of the effective tax rates, those companies, frankly, just

will not bring back that money.

You can argue whether it is the right tax policy, whatever you

want to argue. The bottom line is, they will leave the money overseas if we do not enact this piece of legislation that Senator Boxer,

myself, Senator Allen, and others have sponsored.

What the bill will do is set an effective tax rate of about 3.5 percent, when it is all said and done, on the money that they will

bring back in. J.P. Morgan has done a study and said that about

$300 billion will come back into this country in that 12-month period.

Now, $300 billion is a lot of money, even to the size of the U.S.

economy. When we are looking for an economic stimulus, this truly

would be an economic stimulus.

Just anecdotally, I have talked to many companies, even since we

had the bill on the floor. What is interesting, is that several of

these were companies who were not part of the coalition pushing

the bill.

As you know, the entire package that you have before you is fairly controversial on some of the provisions. Some are going to be

winners, some are going to be losers when we are trying to fix

some of the FSC provisions.

Because of that, a lot of the companies do not want to look like

they are getting something with the Invest in the USA Act, because they may be a winner or loser depending on which side on

the Foreign Sales Corporation side of it they come down on.

But, anecdotally, just three companies that I talk to, $28 billion

would come back into the United States. For three companies that

are not part of the coalition, $28 billion. Just three companies. The

numbers are so staggering on what will come back in, it truly is

amazing.

And, Mr. Chairman and members of the committee, when I was

talking to the Treasury Department, because they have raised

some concerns over this bill, they said there is no guarantee because money is fungible.

What will happen to the money? It is pretty obvious what will

happen to the money, because everybody agrees money is fungible,

but some companies will pay down debt. Well, the last time I

5

checked, that is actually good and healthy for companies to pay

down debt.

Some amount is going to be invested. There is no question that

some amount will be invested. Some, by the way, will be given in

dividends. I mean, we just passed a dividends tax cut because we

know that that will help stimulate the stock market. This is one

of the ways that we can get money turning in the stock market,

providing capital for other companies.

So I think that there are great benefits to the Invest in the USA

Act. It is the reason that I sponsored the bill. I think it is one of

the most important economic stimulus tools that we have before us

today.

And, Mr. Chairman and members of the committee, I am hoping

that it does not get bogged down in the controversy over the legislation before us.

I know that there are a lot of good people on both sides of the

other pieces of legislation that are before you, but I am hoping that

this thing will actually be able to make it into law.

Because if we want to see those jobs that are being lost right now

actually start being created, this is the type of legislation that we

need to enact to create jobs in the United States to say, you know

what? We do not like the fact, necessarily, that the money was invested overseas, but let us at least bring that money back into the

United States and put it to work here so that we can create jobs

in the United States.

I thank you for this opportunity to testify.

The CHAIRMAN. Thank you.

Senator Boxer.

STATEMENT OF HON. BARBARA BOXER, A U.S. SENATOR FROM

CALIFORNIA

Senator BOXER. Thank you so much. I will be very brief here, because my colleague has covered a lot of ground.

We call this the Invest in the USA Act of 2003, and that is exactly its purpose. Its purpose is not to give executive pay raises. As

a matter of fact, Senator Ensign and I would like to see our bill

strengthened a little bit on that point. The idea is for these funds

to be used to create jobs and create product.

I was really rather stunned when the House decided they did not

want this because, after all, when do we see something pass 75/25

in the U.S. Senate, something that is probably the best stimulus

we could have right now?

I want to show you a chart, Mr. Chairman, to explain what we

are talking about here. Mr. Chairman, can you see this or is this

too small for you? Can you read that chart?

The CHAIRMAN. Yes, I can.

Senator BOXER. Oh, good.

The CHAIRMAN. Yes.

Senator BOXER. Because you see, right now, we tax profits when

they are earned abroad at 35 percent. We are suggesting 5.25 percent for just 1 year, that is all.

Now, Senator Ensign has said the economic stimulus effect is $300 billion, and he is quoting the private sector. Is it Morgan

Stanley that came up with that?

6

Senator ENSIGN. J.P. Morgan.

Senator BOXER. J.P. Morgan. Our own Joint Committee on Taxation puts it at $140 billion. So

if you figure somewhere in the middle, it is one of the best, I think,

economic stimuluses we could have here.

The beneficial effect on revenue the first year is $3.9 billion because these monies will be brought back in, so it is actually, for the

first year, a revenue raiser. After that, the 10-year cost is only $3.8

billion when all is said and done.

The bottom line is, if you are concerned—and I know you are—

as we all are, that we have seen three million jobs lost, and an economic recovery, which if it is happening at all has not hit my State

quite yet—and my State, as the largest State in the union, is pretty important to what happens. We are talking about 6.6 percent

employment in California. This is a way that we could really do

something to help move things along.

So that is really my message to you. I think that sometimes we

do some very interesting things, some obtuse things to stimulate

growth. This is something that is pretty direct.

Funds are sitting out there away from this country. We want to

bring them back. The legislation is very clear that the purpose is

to be used for putting people to work, producing products, hiring,

training the rest, and it will be stimulative to this economy and I

believe this economy needs that stimulus.

So, I thank you very much for the opportunity to appear before

you today.

The CHAIRMAN. Thank you, Senator Boxer.

[The prepared statement of Senator Boxer appears in the appendix.]

The CHAIRMAN. Now, Senator Allen, welcome to the committee.

I have already announced that you were going to speak about the

repeal of FSC/ETI. I hope I am right.

STATEMENT OF HON. GEORGE ALLEN, A U.S. SENATOR FROM

VIRGINIA

Thank you for allowing me to appear before this committee.

I know this is a very important issue. I want to comment on this

ongoing debate on how to effectively comply with WTO obligations

relative to the Extraterritorial Income Tax Exclusion Act of 2000

without adversely affecting U.S. jobs and business.

ETI and its predecessor, the Foreign Sales Corporation and the

Domestic Sales Corporation Acts, were originally enacted to ensure

U.S. exporters were competing on a level playing field internationally.

At the time, high U.S. taxes were forcing United States companies to make difficult choices on how and where to establish manufacturing and production facilities.

Congress wisely crafted the program to encourage production in

the United States. Today, the threat of American companies and

jobs going overseas remains; not necessarily just on tax policies,

but for a variety of competitive factors that threat still continues.

While ETI provides tax benefits of our $4 billion a year on exported goods for eligible companies, it has been asserted that ETI

also supports over 3.5 million American jobs directly and indirectly.

7

If ETI is simply repealed without enactment of sound legislation

in its place, these benefits will be lost to U.S. companies and to

U.S. workers at a time when they are most needed. You know of

the statistics. You have seen them over these most recent months

and over the years.

In fact, over the last 2 years, 2.6 million manufacturing jobs have

been lost in this country. More jobs have been lost in the manufacturing sector than in any other economic sector combined.

Mr. Chairman, repealing ETI without an alternative will unfortunately encourage U.S.-based exporters with significant sales

abroad to move their operations, and also their jobs, outside of the

United States.

Legislation repealing ETI must include tax treatment that accords some alternative provisions for U.S. exporters with primarily

domestic production. In my State, the Commonwealth of Virginia,

we rank 16th in exports amongst all States, so Virginians are especially concerned with the impact of the ETI repeal.

With the simple repeal of ETI, Virginia would stand to lose up

to 82,600 export-related jobs. This is not unique to Virginia. You

will find this in a variety of ways across the whole country. This

will harm good, hardworking Virginians and Americans across the

country in the manufacturing sector and deliver a serious blow to

related industries.

The changes, as you well know, in the manufacturing sector, reverberate throughout our economy. ETI’s repeal, without anything

to take its place, will amount to a tax increase of over $50 billion

over the next 10 years on U.S. manufacturing jobs.

So the bottom line principle, Mr. Chairman, is that tax reform

ought to be promoting the creation and retention of jobs in America, and this tax reform should enhance the competitiveness of

U.S.-based companies, not penalize them.

I know you, Mr. Chairman, and members of this committee,

agree with these principles and will be working in that light.

I would also like to briefly comment on the other topic of discussion, the Homeland Investment Act. This legislation, in my view,

Mr. Chairman and members of the committee, would really be a

complement to the job growth and tax relief package we just recently passed in Congress.

Temporarily reducing the tax burden associated with bringing

back or repatriating accumulated foreign earnings of U.S. companies will provide an incentive of bringing back at least $140 billion

into the United States.

The net result of this temporary change in tax policy would be

greater investment in capital and personnel, and, most importantly, it is going to create more U.S. jobs.

Mr. Chairman, the Senate has already acted on this. Unfortunately, the House has not been able to act on it. But as you are

looking at foreign investment and U.S. companies that invest

abroad, we want them to be investing in this country with American jobs, competing on a level playing field. Let us take back any

impediments that harm U.S. companies from reinvesting back in

this country.

Mr. Chairman, thank you for the opportunity to appear before

this very important committee. I look forward to working with you

8

and your members in the months to come to get this economy moving stronger for American jobs. I thank you.

[The prepared statement of Senator Allen appears in the appendix.]

The CHAIRMAN. All right. I have no questions of this panel.

Do any of my colleagues, rather than call off names? If you have

a question, just jump in.

[No response.]

The CHAIRMAN. All right. Thank you very much.

Our next witness is Ms. Pam Olson, Assistant Secretary for Tax

Policy, Department of Treasury. Welcome, Secretary Olson.

Ms. OLSON. Thank you, Mr. Chairman.

The CHAIRMAN. Your entire statement as well will be put in the

record. We appreciate your summary, and appreciate your being

here. Thank you.

STATEMENT OF HON. PAMELA OLSON, ASSISTANT

SECRETARY, TAX POLICY, DEPARTMENT OF TREASURY

Ms. OLSON. Thank you. Mr. Chairman, distinguished members of

the committee, I appreciate the opportunity to appear here this

morning. I applaud the committee for examining the effect of U.S.

tax policy on the international competitiveness of U.S.-owned foreign operations.

The importance of our international tax rules to the competitiveness of U.S. businesses and workers is well known to this committee, as evidenced by the fact that the committee has previously

approved legislation addressing many issues in the international

area.

Unfortunately, this committee’s good work on those issues in previous sessions has not resulted in enacted legislation. Nevertheless,

the need for changes, such as the changes previously approved by

this committee, continues. Indeed, with the growing importance of

international competitiveness of the U.S. economy, the need is even

more immediate.

Many areas of our tax law are in need of reform to ensure that

our tax system does not impede the efficient, effective, and successful operation of U.S. companies and the American workers they

employ in today’s global marketplace.

I have enumerated a few of them in my written statement, but

in keeping with the focus of today’s hearing, will address my remarks this morning to the tax policy issues specific to U.S.-based

companies competing in markets around the world.

The concern this committee faces today is that our tax code has

not kept pace with the changes in the worldwide economy. From

the vantage point of the increasingly global marketplace in which

U.S. companies compete, our tax rules are outmoded at best, and

punitive of U.S. economic interests at worst.

Most other developed countries of the world are concerned with

setting a competitiveness policy that permits their workers to benefit from globalization. As former Deputy Secretary Dam observed

last year, we, by contrast, appear to have based our international

tax policy on the principle that we should tax our competitive advantages.

9

We made significant changes to the international areas of the tax

code in 1962, and again in 1986. Those rules, particularly the subpart F changes in 1962, have not advanced with advances in the

economy. Many of the 1986 changes had dubious economic

underpinnings in 1986. That has not changed as the years have

passed.

The significance of the internationalization of the U.S. economy

since the enactment of subpart F is apparent from the statistics on

international trade and investment.

In 1960, trade in goods to and from the U.S. represented just

over 6 percent of GDP. Today, trade in goods to and from the U.S.

represents over 20 percent of GDP, a three-fold increase, while

trade in goods and services represents more than 25 percent of

GDP today.

Cross-border investment, both in-flows and out-flows, also has

grown dramatically in the last 40 years. In 1960, cross-border investment represented just over 1 percent of GDP. In 2001, it was

more than 11 percent of GDP, representing annual cross-border

flows of more than $1.1 trillion.

U.S. multinational corporations are now responsible for more

than one-quarter of U.S. output and about 15 percent of U.S. employment. Those same multinational corporations produced between one-half and three-quarters of U.S. exports annually.

As a general rule, the ideal tax system should seek to minimize

distortions to trade or investment relative to what would occur in

a world without taxes. It is impossible, and indeed it would be undesirable, for the U.S. to try to level all playing fields. But we can

ensure that our own rules minimize the barriers to the free flows

of capital that globalization necessitates. Unfortunately, we have

often done the opposite by erecting costly barriers to the free flows

of capital that would maximize our international competitiveness,

sometimes in the name of leveling the playing field.

As the committee considers reforms to our international tax

rules, I would urge you to consider three things. First, changes to

subpart F. The target of the subpart F rules is intended to be passive investment type income earned through a foreign subsidiary.

However, our subpart F rules extend to some forms of active income from foreign business operations, an extension no other country has undertaken. In other words, in seeking to capture as much

passive foreign income as possible, subpart F captures a large

share of active income as well, putting the U.S. companies that

earn this active income at a distinct competitive disadvantage to

companies organized elsewhere.

For example, a U.S. company that uses a centralized foreign distribution company to handle sales of its products in foreign markets is subject to current U.S. tax on the income of that foreign distribution subsidiary. The effect of this rule is the imposition of current U.S. tax on income from active marketing operations abroad.

Consequently, U.S. companies seeking more efficient foreign distribution facilities face a tax penalty that is not imposed on their

foreign competitors.

Another example is that the subpart F rules impose current U.S.

taxation on income from certain services transactions performed

10

abroad. Given the importance of the service sector to our economy

today, this rule is particularly in need of reconsideration.

While the purpose of these rules is to differentiate passive or mobile income from active business income, they operate to tax currently some classes of active income arising from business operations structured and located in a particular country for business

reasons wholly unrelated to tax considerations.

Second, changes to the foreign tax credit limitation. The foreign

tax credit may be used to offset U.S. tax on foreign-source income,

but not to offset U.S. tax on U.S.-source income. The rules for determining and applying this limitation are detailed, complex, and

can have the effect of subjecting U.S.-based companies to double

taxation on their income earned abroad.

The current U.S. foreign tax credit regime also requires that the

rules be applied separately to separate categories, or ‘‘baskets,’’ of

income. Foreign taxes paid with respect to income in a particular

basket may be used only to offset the U.S. tax and income from

that same basket. Computations of foreign and domestic source income, allocable expenses, and foreign taxes paid must be made separately from each of these separate foreign tax credit baskets, further adding to the complexity of the system.

Interest expense is allocated pursuant to an arbitrary formula

that results in an over-allocation to foreign income. A restriction

tied to an overall foreign loss gives rise to the potential for double

taxation when the U.S. company’s business cycle for its U.S. operations does not match the business cycle for its foreign operations.

Finally, changes to reduced complexity. We have given the complexity of the rules wholly inadequate consideration. When the

international rules were first developed, they affected relatively few

taxpayers and relatively few transactions. Today, there is hardly a

U.S.-based company that is not faced with applying the U.S. international tax rules to some aspect of its business.

It has been observed that it is difficult to predict the future of

an economy in which it takes more brains to figure out the tax on

our income than it does to earn it. That is the situation we face.

Our tax laws are extraordinarily complex, and that complexity is

nowhere more evident than in our international tax rules.

The challenge for businesses trying to comply with the law, or

the U.S. government trying to administer and enforce it, is enormous. As we move forward, simplifying our international tax rules

should be a paramount goal.

Thank you, Mr. Chairman. I would be pleased to answer any

questions.

[The prepared statement of Ms. Olson appears in the appendix.]

The CHAIRMAN. Thank you very much. I have four questions. If

we cannot get through them, since we only have time for one round

of questions, I will submit the others for answer in writing.

This is asking you maybe to plow ground twice, but I think, even

though it is an elementary question, it is very important to our

consideration of this. I would ask you for some sort of explanation,

particularly from your position, of the international competitiveness and the increase in U.S. jobs, what kind of jobs it creates, and

benefits to the average American, and not just necessarily to the

worker?

11

Ms. OLSON. Well, there is considerable economic evidence that

any kind of international growth actually adds to our domestic

economy. There is one study that indicates that, for every job we

produce abroad, we produce two jobs at home.

Moreover, those jobs tend to be higher paying jobs. They are jobs

in things like research and development, engineering, and so forth

that can be put to extra-productive employment, to the extent that

the benefits of those undertakings can be applied abroad as well as

domestically.

The CHAIRMAN. We have heard the repealing of the foreign-based

company sales and service rules will put great pressure on transfer

pricing regulations and the IRS’s ability to enforce them. I need

your reaction to that.

Ms. OLSON. Certainly, part of the reason for the foreign base

company sales and service rules was to backstop our transfer pricing rules. In the last couple of decades, we have made significant

advances in the transfer pricing rules. We have requirements for

immediate documentation. We have increased penalties for failure

to comply.

We have a much greater level of cooperation among our foreign

trading partners and ourselves in determining what the proper

pricing should be, so it is not as great a concern as it was when

the rules were first enacted.

The CHAIRMAN. Your testimony has many references to the R&D

credit, depreciation proposals, corporate AMT, and net operating

loss carry-backs. I am curious why you included these items in a

hearing, as this one is, concentrating on international tax reform.

With the exception of R&D, you did not include these items in

the administration’s fiscal year 2004 revenue proposals. Are you

laying down a marker on what you would want to do with the proceeds of the FSC/ETI repeal, which is about $50 billion?

Ms. OLSON. Actually, some of those other changes are in the

budget as well. For example, the AMT NOL limitation. There are

a number of things that we could do that would improve the competitiveness of U.S. companies operating here in the U.S., as well

as U.S. companies operating abroad.

Anything we can do to improve the competitiveness of U.S. companies is going to inure to the benefit of the U.S. economy and U.S.

workers.

The CHAIRMAN. I think you were here when we had Senator Ensign and Senator Boxer discuss the Homeland Investment bill. I

need the administration’s and/or your view on the Homeland Investment bill.

Ms. OLSON. Let me give you mine, since I am not sure that the

administration’s position is entirely ironed out on that.

We think that the bill addresses one of the oddities of our tax

rules, which is that we have a worldwide tax system with a foreign

tax credit system with a lot of limitations, which means that a lot

of income is subject to double taxation. The provision would reduce

the tax rate on those untaxed foreign earnings on a one-year basis.

We do not think that a tax holiday like that is the best way to

address the issues in our international tax rules. We think it would

be far better to do something on a long-term, permanent basis that

would improve the competitiveness of U.S. businesses.

12

The CHAIRMAN. Are you refuting the fact that, even though it is

as you describe it, and are you saying that it would not be the immediate shot in the arm to the economy that the sponsors of it say

it will be?

Ms. OLSON. We have some doubts about whether or not it would

have the stimulative effect that has been suggested.

The CHAIRMAN. I have voted for it, and I have expressed my approval of it. I promised Senator Ensign we would have it on the

agenda shortly. So, you need to be prepared for that, if the administration does not like it.

We have more international tax reform proposals than we can

pay for, so I need some prioritization on your part. As part of my

last question, if you were prioritizing international reforms, what

would you address first?

Ms. OLSON. I think that we definitely need to address the limitations on the foreign tax credit. The one that always comes to mind

first is the interest allocation rules, which did not make any sense

in 1986 and do not make any sense today.

I think we ought to take a serious look at the foreign base company sales and service rules as well, given the development of the

service sector in our economy.

The CHAIRMAN. All right. Thank you very much.

Now I am calling on Senator Baucus, and then in this order: Kyl,

Bingaman, Bunning, Conrad, Thomas, Breaux, Hatch, and Nickles.

Go ahead.

[The questions appear in the appendix.]

Senator BAUCUS. Thank you, Mr. Chairman.

Madam Secretary, clearly this body wants to help American competitiveness, and clearly there are a lot of factors that apply here.

The provisions of the Code certainly are some, but I also believe

that the rising U.S. deficits and national debt is another, for a lot

of reasons.

I understand the administration says that the deficit this year will be $450 billion. That is a record. That is, by far, a big record.

I would like to know why, in your judgment. Is it because of reduction in revenues? If so, what revenues? Is it income, personal, individual, corporate, estate tax? What is it?

Clearly, with rising deficits, we are going to have competitiveness

problems worldwide, for a lot of reasons. One, we will not always

have current low interest rates. We will not always have current

low rates of inflation.

It is my very strongly held view that the more these deficits increase and the debt rises, the more likely it is that sooner, rather

than later, we are going to be facing high-interest expenses in the

U.S., who for lots of reasons want to attract foreign capital, that

in the meantime will start to leave because other foreign investors

will start to have less confidence in America’s ability to manage its

own affairs. I hear that in spades from businessmen in the U.S.

and around the world. It may be partly why the dollar is low.

How can we pass a tax simplification measure which costs revenue, which adds further to the deficit? It seems to me that it all

should be revenue neutral.

Now, some respond and say, as a percent of GDP, these deficits

are not so bad. Well, that is not right. That is not accurate. This

13

is 4.2 percent of GDP. The average deficit during the Reagan administration was 4.2 percent, the average. So here we are now facing the average during the Reagan presidency.

So, I would just like to know what the administration is doing,

what the Treasury is doing, to get these deficits down, other than

just glibly, blithely, rhetorically saying we will grow the economy.

That is words, not deed. What are the deeds? What is the administration going to do to make us more competitive by addressing

these budget deficits?

Ms. OLSON. Well, I do not want to sound either glib or blithe, but

the administration does believe that an important way to address

the deficits is to grow the economy.

Obviously, some of the increase in the deficit that we are seeing

is attributable to the tax cut package that just passed the House

and the Senate, because it did concentrate the tax relief in the first

2 years; over $200 billion of the $350 billion that was part of the

tax relief package is going to go out in 2003 and 2004.

We are also still seeing the effects of the passage of the stimulus

bill in March of 2002. The stimulus bill in March of 2002, among

other things, allowed companies to carry back for 5 years net operating losses, and that has sent a considerable additional sum of

money out into the economy for companies.

Senator BAUCUS. But collections are dropping.

Ms. OLSON. Collections are certainly dropping, yes, because people’s incomes are down.

Senator BAUCUS. Well, is it corporate or individual?

Ms. OLSON. They are on both sides.

Senator BAUCUS. Well, then that is counter to what you just said.

I mean, you mentioned that the changes in the Code enabled companies to save, and you have got collections that are dropping.

Ms. OLSON. Well, we expect that the deficit would have been

worse, the problems would have been worse in the economy but for

the tax cuts that left more money in people’s pockets to save, invest, and keep workers on the payrolls.

Senator BAUCUS. Do you think large deficits matter?

Ms. OLSON. I definitely think large deficits matter.

Senator BAUCUS. Are these large deficits?

Ms. OLSON. Well, relative to my personal pocketbook, yes, they

are very large.

Senator BAUCUS. Are they large in the context of what we are

talking about? That is, they matter?

Ms. OLSON. Deficits matter. This is at a size that we need to

focus attention on bringing it down. Obviously, there are two sides

to the equation, both the spending side and the tax side. We need

to look at the spending side of the equation as well.

Senator BAUCUS. Military spending?

Ms. OLSON. I think, given the current world situation, we would

be well advised to focus our spending towards the military.

Senator BAUCUS. Should additional tax cuts be revenue neutral?

Ms. OLSON. We look forward to working with Congress in making

decisions about what to do on future tax cuts. We do not have

plans in the budget, or in the mid-session review which will be

coming out later today, for additional tax cuts beyond what we

have already rolled out in the budget this year.

14

Senator BAUCUS. I appreciate your response. I just frankly believe that the administration and the Congress have to do a better

job of working together to get these deficits down, because they are

going to come back and haunt us.

I am reminded of a Japanese poem, which I read many, many

years ago. It is to the effect of, I always knew that 1 day I would

travel down this road, only I did not know it would be so soon. My

guess is, they are going to be here sooner rather than later, those

high interest rates, unless we do something about it now.

Thank you.

The CHAIRMAN. Senator Baucus, thank you.

Now, Senator Kyl.

Senator KYL. Thank you, Mr. Chairman.

I want to get back on the road here and off the detour to the

question before us. Let me ask the first question regarding foreign

tax credits. You have identified complexity as one of the primary

problems with this, the need to simplify it.

I am curious what your recommendations would be for legislatively making this more simple and making it work, and second,

your opinion as to whether Treasury has the necessary regulatory

authority to deal with this, short of legislation. Is there a possible

mix of the two that we could combine here? I am talking primarily

about the interest allocation problems.

Ms. OLSON. Yes. That is an issue that has been raised with us

on several previous occasions, and we have looked at it on those

previous occasions. We have not found ways for us to deal with it

without a statutory change, so I do think we need some statutory

help there.

In terms of simplifying the foreign tax credit, the biggest problem

stems probably from the number of baskets into which companies

must separate their income and their foreign tax credits.

The computational work that goes along with that is a nightmare. So if we could reduce the number of baskets, we could significantly simplify those calculations.

Senator KYL. Will the administration be suggesting some specific

reforms to the committee or will you be responding? Do you have

an idea on that yet?

Ms. OLSON. We included some items in the budget this year that

are possibilities. We did not pick and choose among them because

it, in some measure, will depend on the amount of revenues that

are available for enacting international reforms. But the ones that

I have just enumerated were both included in that.

Senator KYL. Let me turn to the subpart F reforms. The idea is

to defer the tax liability, but in practice, at least we are advised,

these foreign-based company rules can actually operate to deny deferral and thus subject profits to immediate tax in the United

States, even when the money is still being used in an active business overseas.

How does this actually happen and what is the best way for us

to deal with that phenomenon, if it is true?

Ms. OLSON. It is true. Because of the operation of the rules, a

company that is earning foreign base company sales and service income will be taxed on that income in the country in which it is operating and will be taxed again currently here in the U.S.

15

In calculating foreign tax credits and comparing them to the U.S.

tax, you have got different things in play. You have got the base

that is subject to tax in the U.S. and in the foreign country, you

have got the timing of the income and deductions which may differ

in the U.S. and the foreign country, and then you have got the

rate.

So to the extent that those things all line up and the tax rate

in the foreign country is equal to the tax rate in the U.S., and we

do not have anything else kicking in, like for example the interest

allocation rules, that would alter the foreign-source income, the foreign tax credit would cover it.

But in many situations, because of combinations of differences,

the foreign tax credit will not be able to cover it, will not be able

to be used, and the result will be that a company will pay double

tax, both in the foreign country in which it is operating, and then

here in the U.S.

That puts the company at a disadvantage relative to companies

that are headquartered in other countries where they either have

a territorial system or have a worldwide system like ours, but without either subpart F rules as broad as ours, or without the foreign

tax credit limitations that we have. So, we subject our companies

to a tax burden that their competitors in other countries may not

be bearing.

Senator KYL. Do you believe that we can exempt the passive income, the rents and royalties and so on, and leave some version of

that in subpart F and comply with the trade rulings that have been

issued?

Ms. OLSON. Yes, we think we can do that.

Senator KYL. So you distinguish between the active and passive

income, and you would be urging us to make that distinction in the

reforms that we adopt?

Ms. OLSON. Yes.

Senator KYL. One other question about the whole nature of the

global economy. I see the time is about up, so I will make it very

quick. Regarding subpart F, how is it that this changing nature of

the global economy has made the subpart F and foreign-based company rules outdated? Is there anything beyond just the United

States’ complexity in our Code that has actually moved to make the

concept of this rule outdated?

Ms. OLSON. Well, part of it is the complexity of the rules, but

part of it is just the way that the economy has shifted in terms of

the fact that it is much more global than it was 40 years ago when

the rules were enacted, the fact that we have a large service sector,

and large service companies are often subject to these rules on the

services that they provide in foreign countries.

The object, back in 1962, was to catch income that was mobile.

But if you are providing service income, you have got to be in the

country where your customer is. So it is not that you have moved

business there for purposes of reducing your taxes or for some

other reason, but because that is where you need to be in order to

earn the income. So those are the kinds of things that we need to

think about as we update the rules.

Senator KYL. Thank you very much.

The CHAIRMAN. Thank you, Senator Kyl.

16

The next person is Senator Bingaman.

Senator BINGAMAN. Thank you very much.

Ms. Olson, let me ask if you agree with my view that the primary goal we should be trying to achieve through these international tax laws is retention and creation of jobs in this country.

Ms. OLSON. I think it is very important that we retain and continue to create jobs in this country.

Senator BINGAMAN. Is there any other objective that you believe

is more important?

Ms. OLSON. That is probably paramount.

Senator BINGAMAN. That is fair, you say, as the most important?

Ms. OLSON. I think that is paramount.

Senator BINGAMAN. All right.

I am a little concerned that we are not able to get from the general down to real specific legislative proposals that we could take

action on here.

You have indicated that you think we should make changes in

subpart F, we should make changes in the foreign tax credit limitation, we should reduce the complexity.

Are there specific recommendations that Treasury has provided

to us as to how to eliminate the complexity and do these other

things that we could bring up and vote out of this committee and

through the Senate?

Ms. OLSON. We have enumerated some of them that could be

considered in the budget this year, but we have not gone into a

specific detailing of the ones that are most important. But we

would be delighted to work with the committee on that.

Senator BINGAMAN. Do you think that is the right way to have

us get to specific recommendations is to have Treasury come up

with those, or do you think we should have an outside group of experts come up with recommendations? How do we really get beyond

the wailing and gnashing of teeth stage and to a stage where we

can take some action?

Ms. OLSON. Well, this committee has previously considered and

approved legislation in the international tax area that would have

done much to improve the operation of the international rules. I believe that the committee staff, working with the Treasury and the

Joint Committee on Taxation, should be able to develop a good

package for the committee to consider.

Senator BINGAMAN. Do you believe these changes that you are

recommending, changes to subpart F, changes to the foreign tax

credit limitation, and reducing complexity, that those, if enacted,

would be adequate to eliminate any bias against domestic job retention and job creation that may exist in our Tax Code today or

do you think something more comprehensive should be looked at?

Ms. OLSON. If revenues were not a consideration, we might do

something larger than the items that we have enumerated. Another thing that I think would do a lot for the U.S. economy is to

make the R&E credit permanent. We might also take a look at

whether those rules should be updated. They, right now, turn off

a base period that goes back to the mid-1980’s, and that has the

effect of denying to an awful lot of large U.S. companies much of

a credit for R&E expenses.

17

Senator BINGAMAN. Last week when we had our hearing on this

related set of issues, we had representatives here from Nestle

and——

Senator BAUCUS. Emerson.

Senator BINGAMAN. No, we had another one on the second panel.

Electrolux. That is right. Both Nestle and Electrolux’s representatives, of course of international companies that have substantial

employment in this country, were complaining that they though

these earning-stripping proposals that have come out of the Treasury Department would make it more difficult for them to maintain

their employment in this country, and that, rather than creating

jobs, those proposals would discourage job creation.

Is this something that Treasury is looking at for modifying these

proposals? How are we to take these criticisms that were leveled

against the administration proposals last week?

Ms. OLSON. Well, we rolled out a set of proposals a year ago. In

response to criticism of them, much of which we found to be warranted, we modified those proposals in what we put into the budget

this year.

Our hope was that, with the modifications that we had proposed

in the budget this year, we would have addressed many of the concerns of the foreign companies. I know that a number of companies

that we have spoken with are, in fact, satisfied with the modifications that we have made.

Our objective was to tailor the rules so that they pick up foreignowned companies who are stripping the U.S. tax base. One of the

things that we think is important for the competitiveness of U.S.

companies and the competitiveness of U.S. workers is that foreignowned companies not have an advantage over U.S.-owned companies in the domestic marketplace, and that is what these rules are

intended to achieve.

Senator BINGAMAN. Let me just ask one final follow-up. Would

you be willing to meet with the representatives of these companies

that were testifying last week and see if additional changes in

what you are recommending is justified?

Ms. OLSON. I believe we have met with both of the companies,

although I am not sure that we have met with them this year. But,

certainly, we are always eager to understand completely the impact

of our proposals.

Senator BINGAMAN. Thank you very much.

The CHAIRMAN. Thank you, Senator Bingaman.

Now it is Senator Bunning’s turn.

Senator BUNNING. Thank you, Mr. Chairman.

I want to revisit something that Senator Kyl said was off the

beaten path. It seems to me, when Ronald Reagan proposed his tax

reductions, he proposed $1 of tax reduction for $3 of every spending

cuts in the early 1980’s.

Unfortunately, or fortunately, depending on which way you look

at it, we did do the tax reduction. Unfortunately, we did not do the

spending reduction. Therefore, the 4.2 or 4.3 percentage of national

debt that occurred at that time was because of the inability of Congress to reduce the spending. So much for that. Let us get to the

point at hand.

18

Ms. Olson, along with a number of my colleagues on both the

Senate Finance Committee and Banking Committees, I contacted

Secretary Snowe earlier this year to express my opposition to the

proposed IRS regulation requiring U.S. banks to report the interest

income on accounts held by non-resident aliens.

My concern is that this proposal does not appear to be needed

to enforce any U.S. tax laws. I do not believe the IRS should

prioritize activities that will serve only to allow European nations

to tax their residents who invest in the United States.

At a higher level, I am still much opposed to the rule and would

like to know if the Treasury plans on officially withdrawing it, if

so, when, and if not, why not?

Ms. OLSON. Thank you, Senator. We are continuing to consider

what to do with the proposed rulemaking that you referenced. As

you may know, this was our second effort in that regard to propose

a rule that would cover the issue.

The first set of rules was put out in January of 2001. It would

have required domestic banks to gather information on all non-resident aliens. The Treasury and IRS received significant comments

on those regulations from people who were justifiably concerned

that there were some countries for which we were gathering information where we would not be sharing the information, and that

the effect on depositors from those countries could be adverse.

So, we revised those regulations to take those comments into account, but we have continued to get comments and continue to consider those comments.

The regulations, although they are focused on gathering information on non-resident aliens that would not pay tax on that income

in the U.S., are for purposes of putting the IRS in a position to exchange that information with other countries who are gathering

the same kind of information on U.S. residents who have money in

banks in those countries.

So the purpose of the regulations is not for us to help foreign

countries enforce their laws, but rather to put us in a position so

that we can better enforce our own.

Senator BUNNING. Well, we have a disagreement then. We will

strongly object to the rulemaking and will, if necessary, take legislative action to change it.

One of the principles of the U.S. tax system has always been to

avoid double taxation of income earned by U.S. citizens abroad.

This is largely accomplished through the availability of credits

against U.S. tax and for taxes paid abroad.

Obviously, a number of aspects of subpart F which have been

discussed, particularly the existence of numerous baskets of income, limit the effectiveness of these foreign tax credits.

To accomplish this goal of eliminating the double taxation of income, could you please comment on which aspects of the Tax Code

do an especially good job of achieving this principle and which are

particularly troublesome?

Ms. OLSON. Well, the foreign tax credit itself, certainly, is intended to eliminate the double taxation of income. To the extent

that it functions with as few limitations as possible, it can readily

do that.

19

We have tried over the years to attain, I think, sort of a theoretical perfection in the limitations on the foreign tax credit, but

that theoretical perfection does not match real life.

There are too many differences between our tax rules and the tax

rules of other countries for us to be able to load it up with a lot

of limitations, such as the multiple baskets that you mentioned,

and the interest allocation rules that we have discussed earlier.

So, the consequence is that it does not do what it was intended

to do in many situations. So, liberalizing the limitations would go

a long ways towards ensuring that it does, in fact, eliminate double

taxation.

Senator BUNNING. The last question I have, is how does the

Treasury feel about the security industry proposal to make the financial service income basket their base case basket to allow them

to better use foreign tax credits?

Ms. OLSON. We think that is a proposal that is worth consideration by the committee.

Senator BUNNING. By our committee?

Ms. OLSON. Yes.

Senator BUNNING. And the Treasury would favor that?

Ms. OLSON. Yes. Yes, we would.

Senator BUNNING. Thank you very much.

Thank you, Mr. Chairman.

The CHAIRMAN. Senator Bunning, thank you.

Now I go to Senator Conrad.

Senator CONRAD. Thank you, Mr. Chairman.

Ms. Olson, would the proposals contained in your suggestions increase revenue, would they be revenue neutral, or would they reduce revenue?

Ms. OLSON. They would be scored by the Joint Committee on

Taxation in all likelihood as reducing revenue.

Senator CONRAD. And can you tell us by how much they would

reduce revenue?

Ms. OLSON. No, I am sorry, Senator. I do not know.

Senator CONRAD. Can you give us some range of estimate of how

much they would reduce revenue?

Ms. OLSON. I am sorry, Senator, but I do not have the numbers.

Senator CONRAD. I would just say to you, I think to come before

a committee at this point and make recommendations, and not

know what the revenue effect is, is really off the mark.

The President’s administration today is going to announce the

largest deficit in our history by a very large margin, $450 billion.

The previous largest deficit in our history is $290 billion. As a

share of Gross Domestic Product, this deficit is going to be the second highest in 57 years if Social Security is left out of the calculation, as it should be. The revenue this year is headed for the lowest

since 1959.

The President’s long-term outlook suggests, in his own budget

document, that we are never going to get out of deficit under his

plan, and that, in fact, although we are at record deficit now, the

deficits will explode as the baby boomers retire and the cost to the

Federal Government goes up, and the cost of the tax cuts that he

has proposed go up as well.

20

So I think at this juncture, for anybody to come in with a plan

and not know what the revenue effect is, is just not responsible.

Ms. OLSON. Senator, we think it is appropriate for us to work

with the committee to come up with a good set of changes that

would enhance the competitiveness of U.S. businesses, and we

would be delighted to work with the committee to do that on a revenue neutral basis, or whatever other basis you would like to have

it done.

Senator CONRAD. Well, I appreciate that. I think that is the appropriate way to proceed.

But I would say this to you. I think that if you make proposals,

which is what you have done today, you have come in and said

these are things we should do, you have got an obligation to know

what the effect is on the revenue of the country. I mean, we are

awash in red ink here. Part of the equation is revenue. That is half

of the equation.

The other half is spending. Spending has gone up. Spending has

gone up. Ninety-four percent of the increase is because of defense

and homeland security, which virtually all of us supported. I tell

you, at this juncture I think all of us are going to have to go back

to the drawing board.

One place I think we are going to have to go back to the drawing

board, is considering our whole revenue system, my own sense is

our revenue system—and you may agree with this—is becoming

more and more out of synch with how the rest of the world is operating.

One of the things I am concerned about, is I see our attempt to

keep the playing field roughly level for our manufacturers and our

producers by FSC and by ETI, and we keep getting ruled GATTillegal. So, now we have got to find some different way to move.

We see the Europeans. They have got a tax system that allows

them to rebate at the border. If we do not find a way to level the

playing field here, it confers an 18 percent advantage on their manufacturers. That is clearly not something that is sustainable for our

manufacturers.

As Senator Bingaman has pointed out, it is going to put us in

an increasingly difficult circumstance with respect to job base in an

income and economic base for this country.

But I do not think any of us can make proposals any more that

do not look at the effect on the revenue base of the country, because what we have got here is a calamity. I do not know when

we are going to face up to it, but I would repeat, we are going to

have the largest deficit as a share of the national income, the second largest in 57 years. That is serious.

I thank the Chairman.

The CHAIRMAN. Now it is Senator Thomas.

Senator THOMAS. Thank you, Mr. Chairman.

This is sort of a new issue for me. I am not an expert at all. I

am interested in what is being said here. I hope that as we proceed, we will pay as much attention to spending as my friends have

talked about here. That is where we are.

But I would like to just have you share with us a little bit in

terms of a vision of where we are going, what our goal is here in

terms of globalization. You have mentioned that several times.

21

What impact does this have, for instance, on our trade deficit,

and so on? Are we encouraging people to go overseas to do their

business? Tell me a little bit about what you see happening over

time in terms of our position in globalization in terms of trade and

our deficit.

Ms. OLSON. Well, that is a question that oftentimes comes up

and a concern that is oftentimes expressed. The economics literature suggests that the more we do to increase our international

competitiveness, the better we do here at home, that we create jobs

here at home by creating jobs abroad.

The more that we make our companies able to compete internationally in the global marketplace, the more opportunities we

have for people back here in the U.S. There are a couple of different things that go on here.

One is that as we allow companies to be more competitive

abroad, U.S. companies create supply chains back to the U.S. so we

increase opportunities for other U.S. companies, U.S. businesses,

U.S. workers by virtue of the activities of the U.S. companies

abroad.

That is a very significant one that is oftentimes overlooked, but

it is really critical that we do focus on the fact that creating opportunities abroad does mean opportunities at home.

The other thing is the opportunities that those things done

abroad create here at home tend to be high-income kinds of opportunities. So, for example, as we allow companies to be more competitive abroad, we give them more opportunities to use profitably

the research and experimentation, the engineering activities, and

so forth that they are undertaking here in selling more products

and more services abroad, so we end up encouraging the kinds of

activities that are most important to increasing the standard of living here in the U.S.

Senator THOMAS. That is interesting. That, so far, has not been

the case. Our trade deficit has continued to grow. So when you talk

about opportunities overseas, are you talking about the opportunity

to create a business overseas rather than take a product from here?

Ms. OLSON. What we see most often in terms of U.S. companies’

participation in markets abroad is not, for example, that they are

manufacturing products or undertaking services abroad that then

come back to the U.S. Rather, what they are doing is breaking into

markets that they would otherwise not be able to break into by virtue of establishing operations abroad.

Senator THOMAS. They are providing the services for that market

overseas, not here.

Ms. OLSON. Providing services or they may be manufacturing

products. But because of either domestic content limitations, or tariffs, or transportation costs, were they not manufacturing those

products where they are manufacturing them, they would not have

those sales at all, and if they did not have those sales at all, that

would ultimately mean less for the U.S. economy.

Senator THOMAS. So the product that we basically get is the profit being sent back, or encouraging the profit to be sent back from

overseas into this economy.

Ms. OLSON. And the additional use of the U.S.-created intangibles, the research and experimentation, the engineering, the addiVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 89891.000 SFINANC2 PsN: SFINANC2
22

tional use and the additional profit margin that comes from the use

of those activities.

Senator THOMAS. Are those benefits figured into the trade deficit?

Ms. OLSON. To the extent that the money comes back in some

fashion. It may form part of our service surplus, but it does not

show up in the manufactured goods line.

Senator THOMAS. I guess it is a little difficult to get an image in

your mind of where you want to be in 20 years, or 10 years. So

what we are doing, is we seem to be totally obsessed with what is

going on next week, where we really need to be looking at where

we want to be over time. As we look at trade, we seem to be increasing the deficit, of course, all the time, and I just wondered.

Again, I am not an expert in this, but it seems like the more we

can encourage activities here with products being sold overseas,

that that would be what we would really prefer to do.

Thank you for being here.

Ms. OLSON. Thank you.

Senator HATCH. Senator Breaux?

Senator BREAUX. Thank you, Mr. New Chairman.

Senator HATCH. What is the world coming to?

Senator BREAUX. Secretary Olson, thank you very much. Unfortunately, you have the duty of coming to the Senate Finance Committee today to talk about foreign tax policy, on the day that the

announcement that the Federal deficit is at an all-time record.

The numbers are so shocking, it really should be like a slap in

the face to all of us with a wet towel because of the significance

of how big it is. We can argue about, well, the deficit is as large

as it is because we do not tax enough, or it is as large as it is because we spend too much money. There is a little bit of truth on

both sides.

I was looking at the charts in the President’s budget this year on the non-defense discretionary spending, and it is $386.6 billion.

If we eliminated all the non-defense discretionary spending, it still

does not come close to getting rid of the deficit if we did not spend

a nickel. So, it is not just spending. I mean, obviously we could

eliminate all of that and still not come close to getting rid of the

deficit for this year.

So it is a huge problem. If you look at your own estimates, I

think, of about $26 trillion that we are going to need in additional

revenues just to cover the baby boomers’ entitlement obligations, it

is truly a frightening situation. It is like we are a gigantic California, almost. So, there are enough challenges for everybody.

Ms. OLSON. It is a good thing Senator Boxer left.

Senator BREAUX. Yes. I mean, I did not like hers, either. I mean,

22 of us thought her proposal was kind of off the wall, too.

One of the things that was supposed to be used for the offset in

the recent tax bill was the Section 911, as you know, the foreign

tax exclusion on foreign workers

Can you give me a little bit of the administration’s policy on that

aspect? Is this going to come back as a pay-for somewhere? What

is the administration’s position on that particular aspect?

Ms. OLSON. Well, Senator, we appreciate the concerns that drove

the committee to consider it in the legislation that was considered

23

by the committee a couple of months ago, in particular, that we are

treating U.S. foreign workers differently than domestic U.S. workers.

But the fact of the matter is foreign U.S. workers are in a different environment, and we think that the tax code treatment that

they currently get is probably warranted.

Foreign workers, U.S. workers who are located abroad, serve an

important interest of the U.S. economy, and that is that, like U.S.

international operations in general, they serve as part of the supply

network that encourages the purchase of additional goods and services from U.S. companies. So, they have a very important effect on

the U.S. economy.

For the most part, U.S. rules are different than the rules that expatriates from different countries operate under, because those

other countries tend not to tax them.

Senator BREAUX. They are not taxed at all, basically.

Ms. OLSON. At all. That is correct. So as companies are considering whether to hire and an expatriate from a European country

or a U.S. expatriate, there is a built-in tax preference for the European expatriate over the U.S. expatriate. The Section 911 exclusion

goes some distance to minimize that difference, and we think it is

probably a pretty important difference for the U.S. economy.

Senator BREAUX. So the administration basically supports the

concept of Section 911?

Ms. OLSON. That is correct, Senator.

Senator BREAUX. Now, on the proposal to allow for the money to

be brought back to the United States at a 5 percent rate for 1 year,

I take it it is pretty clear the administration does not support that.

Am I correct?

Ms. OLSON. I am speaking for myself rather than for the administration because the administration’s position is not firm yet.

Senator BREAUX. Not developed.

And my concern was that it was 1 year, no consistency. I did not

think there were any real requirements on what would have to be

done with it. I mean, it certainly did not demand that it be spent

on new projects that would not have already been done despite that

relief. I mean, they could have brought it back and used it for dividend declarations, if they wanted to.

What are your concerns from your standpoint as tax counsel?

Ms. OLSON. Well, we do not believe that a 1-year tax holiday is

the right thing to do for sound tax policy. We think we ought to

make changes to the tax code that are sensible, long-term changes

to the tax code.

This will have the effect of penalizing some companies that have

repatriated earnings as they have gone along and paid the tax relative to those that have not. Because it is just a 1-year provision,

it opens lot of opportunities for planning that certainly some companies will take advantage of in ways that the committee might

not find appropriate.

Based on our discussions with a number of different companies

that are interested in the proposal, it seems likely that it will mean

some additional investment in the U.S., but it also seems likely

that it will mean some dividend payout, some debt reduction, and

perhaps some pension funding. The debt reduction is the one that

24

is probably cited most frequently, and is probably not going to have

a particularly stimulative effect on the economy.

Senator BREAUX. Thank you very much.

Senator HATCH. Thank you, Senator Breaux.

Ms. Olson, you just have two more to go, unless somebody else

shows up, myself and Senator Nickles.

But I think most of the members of this committee agree that we

need to repeal the FSC/ETI provisions in order to honor our WTO

obligations. However, many of us are concerned that we find a way

to help the companies that are currently benefitting from these

provisions so that they do not face a huge tax increase as they are

repealed.

Unfortunately, it is impossible to replicate these benefits without

violating WTO rules. Therefore, it seems to me that we ought to

focus our efforts on passing tax provisions to help U.S. corporations

or companies become more productive and help them to compete

globally.

Now, to me, this means a mix of incentives, such as making the

research credit permanent and allowing faster depreciation on productive equipment, combined with fixing the international tax laws

or tax rules.

Now, does the Treasury Department agree that legislation that

helps only domestic companies or that focuses only on multinational firms is not a complete solution?

Ms. OLSON. It definitely would not be a complete solution to the

repeal of FSC/ETI. We do need to ensure that the companies that

are currently benefitting get a soft landing and transition from the

current rules.

Senator HATCH. All right. All of the corporate inversions over the

last few years demonstrate that it can be an advantage to a company to sidestep the U.S. international tax laws. Now, if a company

starts up here and wants to expand overseas, it soon finds that the

Tax Code is a barrier.

Does the Treasury believe that it is better to address the inversion issue by punishing companies that move their headquarters

offshore or by making our international tax rules friendlier to global expansion?

Ms. OLSON. We would prefer to have a set of tax rules that are

conducive to international operations and not rules that penalize

certain companies. I think our biggest concern with the proposals

that would just penalize certain companies is that we believe that

people would quickly find a way around them, that we would then

be embarked on an ongoing effort to plug those holes.

Moreover, and this is perhaps the most important part, we would

not have a level playing field for U.S. companies vis- ́a-vis foreign

companies, so we would give foreign companies an advantage over

U.S. companies. That concerns us.

Senator HATCH. When companies expand overseas, they likely

hire more people at their U.S. headquarters. At least, that is my

view. It is my understanding that every time Wal-Mart opens up

stores in a new country, that means more jobs in Arkansas in order

to keep overseas operations running smoothly.

I am sure that is true for lots of companies, the R&D jobs, the

marketing jobs, the management and support jobs. We can have

25

those jobs here supporting U.S. companies’ worldwide operations. I

think we ought to make it easier to grow those kinds of good-paying headquarter jobs right here at home.

Now, let me just ask you this one final question, Secretary Olson.

Is it the Treasury’s view that our international tax rules make it

harder to get and keep those kinds of good-paying jobs in our domestic corporate headquarters?

Ms. OLSON. Yes, it definitely impedes the ability of U.S. companies to expand and compete abroad.

Senator HATCH. Thank you.

We will turn to Senator Nickles.

Senator NICKLES. Mr. Chairman, thank you very much. Secretary Olson, thank you as well.

I am interested in trying to come up with a solution. I am assuming the administration says, to be WTO compliant FSC will be repealed, and now how do we fix it?

Ms. OLSON. Correct.

Senator NICKLES. Is that correct?

Ms. OLSON. That is correct.

Senator NICKLES. And for the most part, I think I have heard

you say, well, we need to change our international taxation laws

to be not only compliant, but competitive.

Ms. OLSON. Yes, that is correct.

Senator NICKLES. And I am trying to figure out how to do that.

I have gleaned some suggestions from your statement. But some

parts of your statement, as it pertains to repatriation—and I can

understand your statement saying we want something long term,

not just a one-term shot. This is interesting. That was probably my

initial thought, too.

Some people have told me, though, if you do not do repatriation,

you are never going to get that money back. Do you agree with

some of the estimates that there might be as much as $200, 300,

350 billion that might be repatriated if we did have a one-term or

1-year shot of, say, a tax at 5.25 percent?

Ms. OLSON. We have not tried to run numbers ourselves on the

amount of money that might come back. But the estimates that

have been made by the Joint Committee and by the private sector

groups that have looked at it seem reasonable in terms of the

amount that might be repatriated.

Senator NICKLES. So it might be as much as $200 or 300 billion.

Ms. OLSON. That is correct.

Senator NICKLES. Some individuals, some companies, some

CEOs, have told me that they definitely would bring back billions

of dollars, so that maybe would whet my appetite a little bit more

to give it a more serious consideration.

You mentioned your personal position was not in favor of it, but

the department and the administration have not taken a final position. Is that correct?

Ms. OLSON. That is correct.

Senator NICKLES. All right.

Also, looking at your statement, there are just two or three

things in your segment talking about U.S. taxation on income

earned abroad.

26

You mentioned, ‘‘The practical effect of the worldwide system is

a tax on U.S. companies, repatriating their earnings to the extent

that foreign tax credits are unavailable to offset U.S. taxes.’’ Skip

a couple of lines. ‘‘This creates an incentive for U.S. companies to

keep their income abroad, which can increase the cost of investment in the United States. This results in a disadvantage to U.S.

workers.’’

You go on to say, ‘‘This is because the U.S.’s worldwide tax system, unlike other worldwide systems, can tax active forms of business income earned abroad before it has been repatriated, and it

often imposes stricter limits on the use of foreign tax credits that

prevent double taxation on income earned abroad. I am just looking

a this, and it almost seems we ought to repatriate.

Ms. OLSON. I have given speeches on this a number of times,

Senator Nickles, and every time I have to pause and say that that

does not mean that I am supporting the repatriation proposal.

Senator NICKLES. I can imagine, because I can see the proponents. I am surprised that some of the proponents of the package

did not quote your statement.

Ms. OLSON. And they may at their later testimony. We do think

that it would be worthwhile our taking a long-term look at the

structure of the Tax Code to see whether or not our worldwide system continues to make sense or whether we would be better off

with a territorial system. That is not an effort that we have had

time to undertake. What we do not think would be good policy

would be to just do it on a 1-year basis.

We do think that if the committee considers and moves forward

with modifications of the subpart F rules and modifications of some

of the foreign tax credit rules, you will go some distance to addressing these issues.

Senator NICKLES. Well, I appreciate those two suggestions. I

think we need to be looking at those. Concerning Senator Conrad’s

comments as to how much of this is paid for, assuming that we repealed FSC, am I correct that there is about $50 billion over the

next 10 years?

Ms. OLSON. I believe that is the most recent estimate, Senator.

Senator NICKLES. I keep hearing that. I am assuming that what

you are suggesting is within that category.

Ms. OLSON. You could certainly use some of the revenues to do

some international reform, yes.

Senator NICKLES. You could probably use a lot of it to do international reform, could you not?

Ms. OLSON. My guess is that there is probably more than $50 billion in international reform that would be worth considering.

Now, there may be other things that we could do that would

ameliorate that effect, but one of the concerns that I have had over

the last couple of years in looking at our formulation of tax policy,

is that we seem to make our decisions purely on the basis of revenues as opposed to sound tax policy. And I think when we let the

revenues drive our policy decisions, we are probably making some

mistakes in terms of the effect on the economy.

Senator NICKLES. I might agree with a lot of that, but I would

think that there are two or three things. One, I think we need to

have that menu of options on how we can fix the dilemma.

27

This is a heck of a dilemma, to have a Tax Code that is so complicated that very few people understand it, and basically has an

ultimate impact of discouraging U.S. investment, and putting us at

a competitive disadvantage. We need to fix that.

It is appalling to think of people saying, well, I am debating

making an investment. Do I want to make it in the United States,

or make it in Europe, or make it in China? And to say, well, the

Tax Code is pushing me overseas. Or, if we are going to have a conglomeration of companies, it is advantageous to be headquartered

someplace else other than the United States.

I find that offensive. I think we need to change it. We need to

improve it. I also think if repatriation does mean bringing in $200,

300 billion back to the United States, there is a lot of merit there.

You mentioned that while payment of debt would not be that

stimulative, and maybe the money would be used for pension losses

that occurred because the markets have declined, and so on, I

think those are all pluses, from a person that used to run a corporation.

If you have had a significant downturn, those could be very big

pluses that might enable pension payments to be made. It might

enable you to survive another period of time in a difficult environment.

So I hope that the administration will keep an open mind on repatriation, and let us consider the pluses as we consider some of

the other options to make us more competitive internationally.

Thank you very much.

Ms. OLSON. Thank you.

Senator NICKLES. Thank you, Mr. Chairman.

Senator HATCH. Well, I just want to add that I think repatriation

might be find if it is done permanently, which is pretty hard to do.

But to do it in just a 1-year shot is, I think, pretty poor tax policy.

I just wanted to add that to these comments.

Ms. Olson, we want to tell you that we appreciate you for the

calm, measured, deliberative style that you have shown here today

in answering all of these questions. We appreciate having you here

and appreciate your wisdom and advice. Thanks so much.

Ms. OLSON. Thank you.

Senator HATCH. Our third panel includes representatives from

the technology, manufacturing, and financial services sectors. They

will explain how our international tax laws hamper their global

competitiveness.

In addition, we have two former international tax counsels from

the Department of Treasury who will provide their views on international reform, and a leading economist on international taxation.

Mr. Dan Kostenbauder, vice president of Taxes for Hewlett-Packard, will discuss the effects of tax policy on the technology sector.

Mr. Charles Hahn, director of Taxes for Dow Chemical, will discuss the concerns of multinational manufacturers.

Mr. Michael Gaffney, first vice president at Merrill Lynch, will

talk about the competitiveness of the financial services industry.

We will also hear from Mr. David Rosenbloom of Caplin &

Drysdale, who is a former international tax counsel with the Department of Treasury and is presently the director of the InterVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 89891.000 SFINANC2 PsN: SFINANC2
28

national Tax Law Program at the New York University School of

Law.

Mr. Stephen Shay, a tax partner with the Boston firm of Ropes

& Gray, will provide his views. Mr. Shay is a former international

tax counsel during the Reagan administration.

Mr. Shay, I understand that you were willing to accept our invitation at a very late date, and we appreciate your efforts to be with

us here today.

Finally, we have one of the Nation’s leading economic experts on

international taxation, Dr. James Hines. Dr. Hines is a professor

of Economics, Public Policy, and Business Economics at the University of Michigan. He has written extensively on today’s topic.

So we will begin with Dr. Hines, then we will go to Mr.

Kostenbauder, then Mr. Hahn, Mr. Gaffney, Mr. Rosenbloom, and

finally, Mr. Shay.

Dr. Hines.

STATEMENT OF PROFESSOR JAMES R. HINES, JR., UNIVERSITY OF MICHIGAN BUSINESS SCHOOL, OFFICE OF TAX POLICY RESEARCH, ANN ARBOR, MI

Dr. HINES. Mr. Chairman and members of this distinguished

committee, my name is James Hines. I am honored to have the opportunity to participate in these hearings.

The contribution of the U.S. tax system to the competitiveness of

American multinational firms and the performance of the U.S.

economy has been the subject of extensive analysis and rethinking

in recent years.

What we have learned can be summarized in two points. The

first, is that the ownership and activities of multinational corporations are highly sensitive to taxation, much more so than what was

previously believed to be the case.

The second, is that the competitiveness of the world economy has

the potential to change everything we think, about the features

that characteristic tax systems that promote economic efficiency.

Together, these two findings carry dramatic implications for the

kind of tax policies that advance the competitiveness of U.S.-owned

firms, the well-being of Americans, and the productivity of the

world economy.

Much of the current structure of U.S. taxation of foreign income

dates to the early 1960’s when the world economy looked very different than it does today. The United States taxes the worldwide

incomes of American companies, granting foreign tax credits for

foreign income taxes paid.

At the time it was enacted, this structure was thought to promote global economic efficiency. Most observers are considerably

less confident now that this kind of tax system, imbedded as it is

in a world economy in which many other countries exempt foreign

income from taxation, is efficient.

The most recent research suggests just the opposite, that the

U.S. effort to subject foreign income to taxation at the same total

rate as domestic income is likely to reduce the productivity of the

world economy and the well-being of Americans.

These are difficult concepts, particularly since the tax policy

stance that the United States has maintained over the last 40

29

years, increasingly to our detriment and to the detriment of the

world economy, nonetheless has considerable intuitive appeal.

It is useful in this context to consider what other countries do

and what it implies for the design of U.S. policies. Business income

earned abroad by American firms is subject to taxation by the

United States, whereas business income earned abroad by firms

based in other countries is often not subject to taxation by their

home governments.

Furthermore, even those countries that tax foreign income do not

impose the kind of strict foreign tax regime that the United States

does. These differences influence the competitiveness of American

firms in certain foreign markets.

Firms from countries that exempt foreign income from taxation

have the most to gain from locating their foreign investments in

low-tax countries, leaving investors from countries such as the

United States that tax foreign income more heavily concentrated in

high-tax countries.

As if this were not problematic enough, the U.S. tax system has

many other features that distinguish it from the systems even of

other countries that tax foreign income. The American subpart F

system, our unwillingness to grant tax-sparing credits for investments in developing countries, and the unfortunate proliferation of

baskets used to calculate foreign tax credit limits, are just three examples of features that our major competitors are unwilling to

adopt because they impose such evident burdens on American taxpayers and the U.S. economy.

The welfare principles that underlie the U.S. taxation of foreign

income rely on the premise that direct investment abroad by American firms reduces the level of investment in the United States,

since foreign competitors are assumed not to react to new investments by Americans.

It follows from this premise that national welfare is maximized

by taxing the foreign incomes of American companies, whereas

global welfare is maximized by providing foreign tax credits.

If, instead, direct investment abroad by American companies

triggers additional investment in the United States by foreign companies, which is likely in a globally competitive market, then entirely different prescriptions follow.

National welfare is then maximized by exempting foreign income

from taxation and global welfare is maximized by conformity in the

systems of taxing foreign income among capital-exporting countries.

All of these considerations suggest that the longstanding U.S.

policy goal of subjecting foreign income to strict taxation by the

United States is detrimental to the functioning of the world economy and contrary to U.S. interests.

Senator HATCH. Thank you, Dr. Hines.

[The prepared statement of Dr. Hines appears in the appendix.]

Senator HATCH. We will next go to Mr. Kostenbauder.

30

STATEMENT OF DAN KOSTENBAUDER, VICE PRESIDENTTRANSACTION TAXES, HEWLETT-PACKARD COMPANY, PALO

ALTO, CA

Mr. KOSTENBAUDER. Mr. Chairman, members of the committee,

thank you for the opportunity to appear today. My name is Dan

Kostenbauder. I am vice president of Transaction Taxes at Hewlett-Packard.

HP has about 65,000 U.S. employees, following our merger with Compaq last year. We have revenues of about $72 billion. We conduct about $4 billion of research and development annually, and

about 80 percent of that is conducted in the United States.

It is clear to me, as someone who has been with Hewlett-Packard

and interested in our international activities and international tax

for over 20 years, that the ability of HP to compete outside of the

United States is very helpful and very powerful for HP’s ability to

have jobs and employment in the United States.

The graph on page 3 of my testimony is interesting. I will refer

you to it. It shows the percentage of HP revenue derived from activities outside of the United States over the last 20-plus years.

And from a low in 1983 of a little over 40 percent, now almost 60

percent of our revenue is derived from sales to customers outside

of the United States.

On page 4 is a graph that shows that HP’s experience tracks the

impact of the relatively more rapid growth of other country economies than the U.S. economy since World War II. So, again, to be

successful in this global economy, we need to be successful in the

U.S., but we also need to be successful outside of the U.S.

In particular, from an HP perspective as an information technology company, why does this occur? One reason is that we have

global customers. A lot of our customers like to have one IT vendor,

or a limited number.

So if we are going to provide services and products to either U.S.-

based multinationals or foreign-based multinationals, we have got

to have a global capability. That implies that we have a lot of activity outside of the U.S.

Another reason that we need to be successful outside the U.S. is

that research and development is very important to us. To the extent that we develop a new product, we have spent the R&D dollars.

If we can amortize that benefit over the broadest possible market, it reduces the average R&D expense per dollar of revenue.

That has got to be helpful. To the extent we have a more constricted market, our R&D as a percentage of revenue goes up and

we will be less able to compete against our foreign competitors.

And, finally, there is a need for us to manufacture close to our

markets. Some of our products are relatively heavy compared to

their value. To the extent we manufacture them locally, that is

helpful. Also, a number of our products fall pretty rapidly in value.

The closer we are to customers, the more able we are to compete.

I want to talk about a couple of specific international tax provisions. First, the foreign-based company sales and services income

provision. The base company rules—again, I will refer you to my

testimony on page 7—apply to cases where there is a transaction

between related parties, and there is also some activity outside of

31

the country in which a company is incorporated, often when, they

are buying or selling to or from one of those related parties. It is

a complex concept and somewhat hard to describe.

But if I can just point you to the first chart there, what I am

really trying to demonstrate is that if you have a whole number of

factories in different countries selling to a whole number of markets in other countries, to the extent that you have those transactions, there is no subpart F income implicit in the manufacturing

or selling activity.

When you move to the more simplified example showing the

trading company, typically the activities and the revenue earned by

that trading company are what would be called base company income and would be subject to current U.S. tax.

So in the first example, any earnings receive the benefit of deferral of U.S. tax until dividends of those earnings are paid to the

U.S., whereas, in the second example, any earnings of that trading

company would automatically be taxed in the U.S., even though it

reflects just part of the income from what might otherwise be completely foreign-related activities.

Why do companies use trading companies? The trading company

helps to simplify a great number of business processes that are

necessary: foreign exchange currency exposure management, VAT

registrations, invoicing, accounting, Customs declarations. All of

that is facilitated by having a trading company. If you look at that

second picture, each of the factories has one customer, and each of

the selling companies has one vendor.

I want to also discuss the Invest in USA Act, or Homeland Investment provisions. We think that they would be very helpful for

the U.S. economy. It has been described as a temporary provision,

yet I think it is a temporary provision with permanent consequences. It will permanently allow the movement of between

$150 and $300 billion worth of cash that now is outside of the U.S.

economy into the U.S. economy for investment and use here.

We believe that the many uses that would occur, a variety of

them discussed already, would be extremely helpful and valuable

for the U.S. economy. Companies would not move that cash if they

did not think there was some benefit to having it here, and a lot

of us that are interested in that provision do.

I also think that more risk taking would be encouraged by having that much cash. It is just that much of a fall-back for companies willing to assume additional risk.

One final point. Other countries that have territorial systems essentially tax that same type of income at a zero rate rather than

5.25 percent. So, even at 5.25 percent, we are paying a much higher rate than our foreign competitors pay to move cash back to their

home countries.

Thank you.

Senator HATCH. Thank you.

[The prepared statement of Mr. Kostenbauder appears in the appendix.]

Senator HATCH. Mr. Hahn?

32

STATEMENT OF CHARLES J. HAHN, DIRECTOR OF TAXES, TAX

DEPARTMENT, THE DOW CHEMICAL COMPANY, MIDLAND, MI

Mr. HAHN. Thank you, Mr. Chairman and members of the committee. My name is Charles Hahn, and I am tax director of The

Dow Chemical Company.

Dow is a diversified chemical, plastics, and agricultural company.

We have sales in more than 170 countries totally $28 billion annually; 41 percent of that is domestic and 59 percent is international.

We have 191 manufacturing sites in 38 countries around the

world; 62 of those sites are located in the United States. They represent 57 percent of our long-lived assets. Most of our employees

are in the U.S., and we are a major exporter.

The chemical markets that we face are global and fiercely competitive. Dow is the largest U.S. chemical company, but only third

largest in the world. Of the top 10, only three chemical companies

are from the U.S.

So for those reasons, the topics of this hearing, ETI repeal and

international competitiveness, are critical to us. For companies like

mine to continue playing the vital role in increasing U.S. exports

and creating American jobs, repeal of those provisions must be coupled with much-needed reforms of our outmoded international tax

laws.

U.S. manufacturing is not isolated. In fact, it is integrated with,

and highly dependent upon, global operations. Making those global

operations more competitive through international tax reform will

directly help U.S. manufacturing and other U.S. jobs, and help to

counteract the effect of the ETI repeal.

The impact of the ETI repeal is very substantial in U.S. multinational companies. For example, Dow’s 2002 ETI benefit was $38

million. Collectively, U.S. multinational companies current provide

56 percent of all U.S. exports. They also provide 23 million American jobs, 21 percent of U.S. GDP, and $131 billion in annual U.S.

R&D spending.

Enhancing the competitiveness of this group through international tax reform would contribute directly to the U.S. economy

by both increasing exports in U.S. manufacturing jobs and other

jobs supporting those global operations.

Foreign direct investment by Dow and others creates new markets for American products. In the chemical industry, transportation costs are high and times for delivery are long, so locating

near customers or raw materials is critical.

Customers also want a local presence as a way to solve problems

and to provide supplies quickly. Local plants not only serve as customers for our U.S. exports, but they also provide distribution for

full product lines, even though only a small portion of those products may be manufactured locally.

In 2002, Dow exported $3.76 billion and 80 percent of those went

to related companies, in recent studies by OACD, and the Commerce Department confirmed that relationship.

In addition, many non-manufacturing jobs support and depend

on the overseas operations of U.S. firms. Dow is typical. We are

headquartered in Midland, Michigan, and naturally many of our

global processes occur there. For example, 87 percent of Dow’s over

33

$1 billion in R&D took place in the United States, a majority in

Midland.

Additionally, small businesses support and depend on Dow’s

global operations. Unfortunately, over the last few years we have

been increasingly harmed by the basic structure of the international tax regime.

Dow typically operates in countries that have tax rates that are

very similar to that of the U.S. But because we can only carry forward taxes, for example, for 5 years, we are currently faced with

the expiration of foreign tax credits, caused primarily by domestic

losses, which are not then recaptured when domestic profits return.

The problem is made worse by the high interest allocation and

other expenses to foreign-source income. This and other flaws serve

to go ahead and be a double tax on our income, and a tax that our

competitors do not, in fact, face. Because of this, it erodes the competitiveness of our company, and all U.S. companies that face this

system.

Finally, the system is simply too complex and results in a huge

compliance burden. But, more importantly, in my opinion, it distracts our non-U.S. business and causes them to slow down in what

they are doing because they have to take all of these effects into

account, and in the end changes how we do that. That may be the

biggest penalty of all.

In conclusion, the WTO-mandated changes to the U.S. tax law

should include reforms to our international tax rules. These

changes will help ensure that Dow and other U.S. companies can

continue to compete globally against foreign-based companies operating under more advantageous tax regimes. We stand ready to

help the committee in doing that.

Thank you.

Senator HATCH. Thank you, Mr. Hahn.

[The prepared statement of Mr. Hahn appears in the appendix.]

Senator HATCH. Mr. Gaffney, we will take your testimony.

STATEMENT OF MIKE GAFFNEY, CO-HEAD OF GLOBAL TAX,

FIRST VICE PRESIDENT, MERRILL LYNCH, NEW YORK, NY

Mr. GAFFNEY. Mr. Chairman, Senator Hatch, Senator Bingaman,

Senator Breaux, thanks for allowing me to come down and testify.

My name is Mike Gaffney. I am a first vice president and the cohead of the Global Tax group at Merrill Lynch. I am appearing on

behalf of the Securities Industry Association today.

The SIA welcomes the opportunity to come down and summarize

our perspective on how U.S. tax policy affects the international

competitiveness of our industry. We realize that this is a challenging time for international tax policy, and the choices that are

made by Congress in revising the international tax rules will be vitally important to the future health of the U.S. economy, as well

as the SIA member firms.

I think traditionally when policymakers have debated the effects

of U.S. tax policy on international competitiveness, the focus has

been primarily on the consequences to industrial firms.

To be clear, the SIA does support the objective of a vibrant domestic industrial sector, as most of those client and companies will

ultimately be clients, hopefully, of Merrill Lynch and will lead to

34

future capital generations which Merrill Lynch can be a part of, as

well as other member firms.

We also recognize the power of the argument that a significant

portion of the revenues generated from the repeal of the FSC/ETI

regime should be reinvested in the domestic manufacturing base.

Nonetheless, the financial services sector also makes significant

contributions to domestic jobs and revenue and is profoundly affected by the international tax environment in which we do business.

I speak today to advocate international tax rules that will promote a fair and competitive environment for securities firms,

banks, and similar financial service entities, and thus strengthen

our domestic economy.

Merrill Lynch does do business in all 50 States and the District,

and we also operate in 35 countries overseas. Our current employee

roster is about 40,000 here in the States, and about 51,000 around

the world. Of the 11,000 around the world, about half are situated

in London, about another 1,500 in Tokyo. So, we tend to congregate

in the large financial service centers around the world.

Those figures of 40,000 in the U.S. and 51,000 around the world

are down pretty significantly over the last 3 years, as we have hit

a difficult working environment both domestically and overseas. At

the end of 2000, our employee roster was about 72,000, of which

50,000 were in the U.S. and the other 21,000 or so were overseas.

So, we have had to retrench a bit, specifically overseas. There

has been about a 45 percent reduction in the employee base as we

have had to rationalize businesses going forward.

We have a pretty straightforward perspective on the goals of U.S.

tax policy with respect to domestic international competitiveness.

We believe our country’s tax rules should not distort the outcome

of commercial competition among global firms or across industries.

As a result, we believe that U.S.-based financial service firms

that are operating globally should be able to compete in London,

Frankfurt, Tokyo, and the other major financial centers around the

world under a tax regime that is comparable to the way which

those who are non-U.S.-based global competitors operate.

We support fair rules for U.S.-based global financial services

firms doing business in the U.S. Those firms are members of the

securities industry and are vibrant competitors to Merrill Lynch

and the other U.S.-based firms.

We believe the international tax policies of the U.S. should be

even-handed across different sectors of the economy. We believe

that the report prepared last week in preparation for these hearings by the Joint Committee illustrates the importance and significance of the financial services sector to the U.S. and to the global

economy.

I think my paper references some of the statistics that shows foreign direct investment by U.S. firms abroad in financing, insurance, and real estate represented about 43 percent of total direct

foreign investment, while investment by U.S. manufacturers overseas was about 28 percent.

The one basic question that is sometimes lost is, why have U.S.

securities firms and other financial institutions made such large inVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 89891.000 SFINANC2 PsN: SFINANC2
35

vestments overseas? I think it is not that different than my colleagues here have mentioned: that is where our customers are.

We are providing a service. We are in a service business. In order

to actively compete overseas, like any other service industry, we

have to go out, get customers, and attempt to keep customers that

we have by providing them services that they require.

I think the statistics on Merrill’s overseas expansion going up

and down the last several years is indicative that we are there trying to compete overseas, sometimes with success, sometimes with

not great success.

But the underlying concept is, some of the proposals that we

would like to see, the committee has already wrestled with and approved. The basic tenet is the active financing exception to subpart

F.

Some of the other things that the SIA would like to see are corollaries to that, having to do with taking that concept, that what

a financial service entity earns, interest and dividend income, is in

fact the life blood, or the equivalent of the inventory and sales to

a non-financial institution.

Some of what we are supporting is to have provisions that are

there already, made permanent, and certain other smaller changes

made in other areas of the Code that are corollary to that.

With that, that is my testimony.

Senator HATCH. Thank you, Mr. Gaffney.

[The prepared statement of Mr. Gaffney appears in the appendix.]

Senator HATCH. Mr. Rosenbloom.

STATEMENT OF H. DAVID ROSENBLOOM, CAPLIN &

DRYSDALE, CHARTERED, WASHINGTON, DC

Mr. ROSENBLOOM. Thank you, Mr. Chairman and members of the

committee. I am grateful for this opportunity to express my views

on the subject of this important hearing.

My name is David Rosenbloom. I am a lawyer, specialized for

over 30 years in international taxation, and a practitioner and professor in that field.

I am not representing anyone here today, or any institution. I am

speaking merely as a reasonably knowledgeable citizen.

No reasonable person would oppose the goal of maintaining competitiveness of U.S.-owed foreign corporations. The hard question,

however, is what that implies for the rules of tax policy.

If it implies rules that guarantee the ability of U.S.-owed foreign

companies to stand toe-to-toe with foreign firms engaged in similar

active businesses, that is one thing.

If it implies adopting in U.S. law the most taxpayer favorable

rules from every other industrialized country, that is something entirely different.

Like any rules, the present international tax rules of the United

States can certainly be improved. If it were left to me, I would revamp them completely in the name of simplicity, administrability,

competitiveness, and fairness, fairness to all taxpayers in the

United States.

This would lead to far more sweeping changes than are presently

contemplated. I would favor a targeted exemption for active busiVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 89891.000 SFINANC2 PsN: SFINANC2
36

ness income in real countries, countries with real tax systems. I

would favor tightening of rules with respect to income not attributable to active business and income earned in tax havens.

I would favor the intelligent use of international tax treaties to

tailor these basic rules to fit particular circumstances, and I would

favor authorization of the Revenue Service to develop rules to ensure that the new regime does not allow tax sheltering activity.

The United States has always been a leader in international taxation, not a follower. When we adopted legislation with respect to

CFCs in 1962, we stood alone in the world. Since that time—a

point that has not been made here today—a large and growing

number of other countries have adopted similar legislation.

In 1986, there were six countries with CFC legislation. Today,

there are approximately 25. The CFC rules in these countries are

all modeled, to some extent, on the U.S. rules from 1962, though

of course there are important differences.

Many of the countries that have adopted CFC legislation have

employed either a black list or a white list to differentiate among

foreign countries; they would tax income in black list countries;

they would allow deferral for income in white list countries.

Alternatively, some countries use a high tax/low tax approach. I

think these approaches are something the United States should

consider.

The implicit judgment in our law that all foreign jurisdictions

stand on the same footing is incorrect and it leads to many problems in the application of our laws.

It is crystal clear that the rest of the world has been tightening,

not loosening, home country taxation of foreign operations and foreign income, particularly in tax havens.

In these circumstances especially, the committee should take

time to consider carefully where the all-important lines between

current taxation and deferral should be drawn.

I urge you not to rush, in the name of competitiveness, to surrender segments of the U.S. tax base without considering offsetting

measures with respect to income that is not active business income

and income benefitting from tax haven regimes.

CFC legislation is not the province of only the Fortune 500. In

the year 1998, there were approximately 46,000 CFCs that reported, owned by nearly 2,000 U.S. domestic companies.

Many of these CFCs are not engaged in active business. Many

are located in tax havens. Many cannot make any reasonable claim

to a competitiveness concern. There is unquestionably a tax shelter

component to some CFC planning and implementation.

In addition, our CFC rules serve to protect our domestic tax base

by deterring U.S. persons from deflecting their income to foreign

corporations.

I am very concerned that the competitive interests of some companies may carry on their coattails unjustified benefits for persons

whose foreign operations are unworthy of protection and would be

deemed unworthy of protection by just about everyone.

Our foreign tax credit rules are, in my view, even more problematic than the CFC rules. These rules are so complicated, as has

been said today, that only specialists can now understand them.

37

It is for that reason, as well as my understanding that very little

tax revenue derives from foreign active business income, that I

would favor exemption of such income when earned in jurisdictions

that have real tax systems comparable to our own, which is where

most of our investment is located.

On the other hand, I would be much more wary of other types

of income. If the committee opts for lesser measures, I recommend

it proceed cautiously, considering tightening along with loosening,

and that it strive to do no harm to the existing and functioning

U.S. international tax system, which truly is not so bad.

In fact, although that system can be improved, it is wrong to emphasize its dysfunctionality. The present rules have served the

country well for more than 40 years, and in that time I have not

noticed any terrible deterioration of U.S. economic interests.

As a general matter, I think it is important to recognize there

is no other tax system in the world that works better than, or even

as well as, the present U.S. system. Each year, it touches the lives

of more than 150 million people with virtually no corruption, surprisingly little error, and remarkable efficiency. This is rare in the

world.

Both the system as a whole, and the agency that administers it,

are the envy of just about every other country that has devoted serious thought to these subjects.

In my judgment, these sentiments apply to the international aspects of the system no less than to the rest of it. Such are the principles I think should inform, a fresh view of the important subjects

of today’s hearing.

The moment appears to offer a rare opportunity for Congress to

take such a fresh view and to consider genuine, and not piecemeal,

international tax reform. I hope it will do so. I would be pleased

to respond to any questions that members may have.

Senator HATCH. Thank you, Mr. Rosenbloom.

[The prepared statement of Mr. Rosenbloom appears in the appendix.]

Senator HATCH. Mr. Shay, you are our final witness here.

I have to step out for a minute. I will be right back. Then we

will start questions after Mr. Shay.

STATEMENT OF STEPHEN E. SHAY, ESQ., PARTNER, ROPES &

GRAY, LLP, BOSTON, MA

Mr. SHAY. Thank you, Mr. Chairman and members of the committee.

As may become clear in a moment, I am expressing my own personal views and not the views of either my clients or my law firm.

I want to follow up on what David was just saying from a slightly different tack. The thrust of my remarks, is really that there is

much that needs to be improved about our rules, but they are not

nearly as bad as some claim, viewed from an overall perspective.

My first comment goes to the question of competitiveness. Clearly, this committee wants to look at that issue from the context of,

what will improve the living standards of Americans? So any proposal needs to be not tested.

Not just will it improve the after-tax incomes of our multinationals, which is not insignificant as an issue. But the question

38

is, how will that translate and how will the rules translate into a

benefit for the Americans that live, reside, and work in this country?

In that connection, I have long been very skeptical about the

claims made for the ETI. One of the things that concerns me, is

it is very hard to have one of our own proposals found an illegal

export subsidy, and then to have to change it, apparently under

pressure.

But I have questioned whether we have re-examined the ETI appropriately since its inception in 1971. In 1971, we did not have

floating exchange rates. We put in place an export subsidy and we

have not really looked closely at whether it was cost effective since

then, in my judgment.

Once exchange rates began to float in the 1970’s, there is a question as to whether export subsidy was in the overall interest of this

country. Yes, it helps the firms that were benefitting from it. It

helps their employment.

But the fact is, the cost of that subsidy probably exceeded the net

export increases. While I am not an economist, that is a proposition

to be tested. I am not sure it has been tested. I think we need to

take all the claims that are being made to support a proposal and

look at them objectively.

The main point I wanted to make in my testimony was that,

looked at as a whole, there is a real question as to whether U.S.

companies are disadvantaged in the international marketplace by

the U.S. tax system.

Why do I say that? I do not mean to minimize that there are

some provisions that are, in fact, harmful and can very adversely

affect a particular company, such as the unevenness of our loss or

capture rules that Mr. Hahn referred to.

But taken as a whole, we do not, as was suggested earlier, tax

the worldwide income of our U.S. multinationals, at least to the extent the income is earned through a foreign corporation. That income is not taxed by the United States until it is repatriated as a

dividend.

There has been a lot of discussion today of foreign-based company sales rules. That is correct. When those rules apply, they do,

indeed, cause current taxation. While it is onerous and they probably should be revised, the fact is, if one looks at the data, I suspect that you will not find much foreign-based company sales income because they are relatively easily avoidable.

So in terms of looking at where the data is, it is not clear to me

that we have a crisis on the deferral side. In fact, our system of

deferring taxation of foreign income earned from a foreign corporation, I think, at a very general level, puts us in roughly the equivalent position of countries that exempt foreign income.

That would raise a question of, well, would an exception not be

simpler or easier? In some respects, yes, in other respects, no. It

is interesting to me that we are not proposing an exemption. I have

seen no major proposal proposing an exemption. I think the reason

for that is, the current system is better for our taxpayers in terms

of being able to have a lower level of tax.

Why is that? When you are in a high-tax country as opposed to

a low-tax country, you have to pay those taxes. Our system, our

39

foreign tax credit system, has a number of rules that are disadvantageous in crediting those taxes. They have all been discussed.

Let us discuss some of the rules that are advantageous. There

are, in fact, some major parts of the American tax rules that permit a foreign tax to offset what any other country would call U.S.

income.

Two examples. Foreign royalty income, or royalty income that is

earned from abroad. Most exemption countries do not allow exemption for foreign royalty income. They treat it as their home country

income. They say, well, you have got a deduction in the other country, and so we should tax it here. The other example is the sale

source rule, which I am not going to go into in detail.

So my plea to the committee is, step back, take a deep breath.

Look carefully at the claims that are made as to the effect of the

overall structure. It needs to be changed. I think we have time to

change it. It is not at all clear to me that we should be earmarking

ETI revenue for international tax reform.

I think that is an open question that should be judged. That revenue should be weighed against what is the absolute best result for

the overall American public from use of that revenue.

Thank you, Mr. Chairman.

[The prepared statement of Mr. Shay appears in the appendix.]

Senator HATCH. Thank you very much.

Mr. Hahn, you mentioned in your testimony that Dow believes

that the repeal of FSC/ETI must be accompanied by the reform of

the international tax rules.

As you know, some repeal proposals would allocate all of the revenues raised by the repeal of FSC/ETI provisions to tax changes

benefitting only domestic manufacturers.

We have been told that, absent such legislation, U.S. jobs would

be lost. Now, do you believe that U.S. jobs will be lost if we fail

to also address the much-needed changes in our international tax

rules?

Mr. HAHN. Yes, I absolutely do. As I said, it is becoming quite

a burden for us. It affects our ability to compete. Again, our extension into international markets has greatly increased our exports

by our sales to our related subsidiaries, and more importantly, the

distribution of product lines.

It also, as has been mentioned several times, supports what I

would call our headquarters jobs, the R&D type of jobs, the functions that we have relating globally.

So, if we do not have a competitive international tax system and

U.S. companies are not out there in that international market, we

are going to lose U.S. manufacturing jobs. That is one of the key

things we ought to be looking at.

Senator HATCH. Mr. Kostenbauder, you spoke avidly about allowing companies the opportunity to repatriate their overseas profits

at a greatly reduced dividend rate. Now, I agree, this is an intriguing concept, one that I supported both in the Finance Committee

and on the floor of the Senate.

Can you tell us why this reduced dividend should not just be

made a permanent part of the Tax Code? Why should we not simply allow the earnings to be repatriated without imposing any tax?

40

Mr. KOSTENBAUDER. Well, with respect to the rate, I think the

5.25 percent rate was chosen as sort of a balance between a rate

that was low enough to really encourage companies to move cash

back to the United States (and thereby generate some positive revenue for the proposal), versus being too high and consequently discouraging the significant movement of cash to the United States.

In terms of permanence, you might actually design a regime

where we could have zero tax, or a very low rate, on a permanent

basis, which would be a significant step toward what would be described as a territorial system of taxation.

The U.S. system, since its inception, has been a worldwide system. I think the change from the worldwide approach that we have

adopted, with its many modifications and imperfections, to a territorial or substantially territorial system is really a very big decision.

I do not think that the deliberations necessary to make that decision have really been thought through and processed. We have not

reached a general consensus reached that that is where we should

be.

However, the U.S. economy has been suffering, particularly the

tech economy, very serious job losses and serious competitive challenges for 3 years. I think the stimulative effect right now of allowing that cash to move to the U.S. would be very beneficial to the

U.S. economy, and that would help all of us.

I think it is also consistent with the direction of many of the reforms currently under consideration to allow companies to reposition their global cash. And, as I indicated in my testimony, I think

it allows, depending on the estimates, $150 billion to maybe $300

billion of cash that now sits outside the United States to be moved

back to the United States permanently. So, I think it is permanent

in that respect.

Senator HATCH. In your statement, I noticed the two charts

where you were emphasizing the importance of a trading company.

You talked about how our outdated foreign-based company rules

encouraged companies to put marketing and trading operations in

each and every country in which they do business.

Now, that seems like that has to automatically arise the costs of

selling U.S.-made and U.S.-designed products overseas. How do you

think those rules affect smaller American companies that are trying to start selling their products overseas?

Mr. KOSTENBAUDER. I think they create a lot of complexity that

would be eliminated. Certainly, Hewlett-Packard is a major corporation. We have a lot of resources. It is a challenge for us, with

the resources we have available, to keep track of and deal with all

of the complex international tax rules.

Certainly for the smallest U.S. companies, it is a real challenge.

I think the base company rules provide a tremendous amount of

complexity without really a concomitant increase in U.S. revenue.

I might also point out that the proposal, although it is a part of

subpart F, is certainly distinct from all of the passive income rules,

and we are not proposing or advocating any changes in the passive

rules at this point.

Senator HATCH. Well, thank you. I will turn this back to the real

chairman of this committee, and thank you all personally for your

41

testimony and the time you have spent in coming here and helping

us.

Now I would like to submit questions for answer in writing.

The CHAIRMAN. Yes.

[The questions appear in the appendix.]

The CHAIRMAN. I was necessarily called away for a news conference on another subject, so I did not get a chance to introduce

all of you, or any of you. So, I appreciate the opportunity to have

you here as expert witnesses.

I am going to call on, I think, Senator Bingaman, then Senator

Breaux. I may have some questions when they are done, but I want

to let them go first.

Senator BINGAMAN. Thank you very much, Mr. Chairman. Thank

you all for being here and testifying.

I wanted to ask, first, Professor Hines, one of the issues I have

been trying to understand is, does the current set of international

tax laws that we have in place encourage job creation and retention

in this country, or discourage it, or is it basically irrelevant to the

issue? I mean, do you have any thought on that?

Dr. HINES. Yes. If there are inefficiencies in the tax system, and

I think all the speakers have agreed that there are, ultimately

what that does is reduce the well-being of Americans. The way that

happens, is by depressing job creation, or if there are jobs, lowering

the wages that people earn in those jobs.

If the economy becomes less productive, then wages fall and the

rate of profit falls. That is what happens when we permit the tax

system to be inefficient.

Senator BINGAMAN. So you are saying the inefficiencies in the

system that we now have depress job creation, and presumably also

depress job retention.

Dr. HINES. And wages. Yes.

Senator BINGAMAN. And wages as well.

In order to deal with the problem I am a little confused about

how major a reform is called for. The Department of Treasury and

Ms. Olson testified that, in the administration’s view, we need to

reduce complexity, we need to change subpart F, and we need to

make changes in the foreign tax credit limitation rules.

That seems to me to be a fairly modest set of proposals if, in fact,

we have got depression of job creation that you described going on.

Do you think something more fundamental, more widespread, more

basic is required in order to deal with the problem?

Dr. HINES. Senator Bingaman, there are two ways to think about

this problem. Yes, I do think that something broader would be

helpful to the U.S. economy and would stimulate job creation and

wage growth.

But I also think that modest reforms have the prospect of doing

some of that. It is hard to see sometimes the beneficial effects of

reform because it has modest effects on wages. But we have more

than 100 million workers, so when you add it all up, it adds up to

a lot of money for the U.S. economy.

So, yes, subpart F reform, reforming the baskets, the expense allocation rules, and the other things that Assistant Secretary Olson

talked about would be beneficial and would feed back to the well

being of American workers. Broader reforms would do even more.

42

Senator BINGAMAN. Mr. Rosenbloom, you make reference to this.

You say that my personal preference in regard to outbound taxation would be to revamp the rules completely in the name of simplicity, administrative fairness, and competitiveness. This would be

far more sweeping changes than are presently being contemplated.

Is it your thought that it is worth the effort to do something comprehensive here? Toward the end of your testimony you seemed to

be saying the system is working pretty well and it is better than

anyone else’s system, so do not get too concerned.

What is your view on that?

Mr. ROSENBLOOM. Yes. I think that the present system and the

people who administer it deserve a lot of respect. Your predecessors

have considered these rules many times, and the rules are the

product of a lot of thought that has gone before this. A lot of the

discussion has been in terms that are very similar to the terms

that have been discussed in this chamber today.

I realize that this is a political process. But if one could move to

a perfect system, an ideal system for the United States, in my

view, we would not tax active foreign business income.

I think the literature suggests that our current rate of taxation

on active foreign business income is actually negative. That may be

one of the reasons that, as Mr. Shay suggested, you are not encountering any proposals to actually achieve exemption, because people

do better under the current system than with exemption, which is

a fairly amazing fact, but I think it is probably true.

I would recommend moving in the direction of identifying and exempting active business income—and I would distinguish from that

passive income, and probably tax haven income. I repeat that

many, many countries in the world today, including almost all European countries and lots of our competitors, Japan, Germany, the

UK, France, Italy, all of them go after tax haven income today.

So I think, when you cut through the discussion that has been

held today, that is really the nub of it. What are we going to do

about tax haven income under these rules? Because I think I do

not have any problem with the active income in the Germanys, the

Frances, the UKs, the Switzerlands. No problem with that at all.

I do not think most people do.

Senator BINGAMAN. So is it fair to assume that you could make

the changes you just described with regard to active foreign income

and with regard to going after tax haven income and all and come

out somewhat revenue neutral?

Mr. ROSENBLOOM. I think you might actually raise revenue.

Senator BINGAMAN. That is an encouraging suggestion.

Thank you very much.

Senator BREAUX. Let me just ask a couple of questions on the

whole system that we have in place now. Maybe Hewlett-Packard,

Mr. Kostenbauder. Why would HP not be advantaged by just taking your foreign tax credit? You are not located in countries that

have no taxes and tax havens in particular, are you? Or have the

tax credits just expired? I mean, what is it, 5 years? Why can you

not just take your credits under the current system and do very

well?

Mr. KOSTENBAUDER. Well, as a global company we operate in lots

of different jurisdictions, certainly throughout Europe and Asia. I

43

mean, the entire world is covered. We have a current practice of

regular dividend flows. We take foreign tax credits where appropriate on those.

We also have, as many companies do, certain activities in lowtax jurisdictions—very active factory and real business activity.

That activity helps us, from the point of view of the benefits of deferral, have a more competitive global enterprise. Some of those

low-tax earnings are prohibitively expensive to bring back to the

U.S. because they would, in fact, be taxed pretty much at a full

35% U.S. corporate tax rate.

Senator BREAUX. Well, it seems to me that is one of the reasons

it is structured like that, so that U.S. companies just do not go pick

out all the non-tax countries in the world and move everything over

there, and then have absolutely no tax on any of your earnings.

Mr. KOSTENBAUDER. Well, Senator, certainly we have not moved

all of our activities to other countries.

Senator BREAUX. I am talking, theoretically. We could just have

every company in America doing business in every country that

does not charge any taxes whatsoever. I mean, all of a company’s

income would be produced in no-tax or tax haven countries.

Mr. KOSTENBAUDER. One way to think about that, is that we

have a portfolio of foreign jurisdictions in which we do business. So

we have the biggest part of our international activity in Europe,

which has tax rates that are certainly comparable to the U.S. tax

rates. We also operate in Puerto Rico, which generally has a lower

rate on most of our manufacturing activity. We do that in Ireland

as well, where we manufacture for the European market.

That is part of a portfolio. Our international competitors are located in those places. Those locations have advantages not only

from the point of view of low taxes, but they may have low labor

rates. They are certainly close to local markets. So, there are a lot

of reasons for conducting business in such locations.

But, again, 100 percent of Hewlett-Packard’s international activity has not, over time, migrated to those countries. It is a small

part of the portfolio. It makes sense for a lot of reasons, and certainly a low tax rate is a positive for locating some activities in

those countries. But it certainly does not draw all of our activity.

The incentive effect is just one factor that we consider.

Senator BREAUX. Well, I understand it is not all. I am just talking hypothetically. If I was a company and it was structured along

those lines, I would just be inclined to put everything in a no-tax

country.

Mr. Rosenbloom, do you have any comment on that concept?

Mr. ROSENBLOOM. I would tend to think that a company would

be remiss not to do that.

Senator BREAUX. Well, we have had a good discussion. I do not

want to belabor it. We have a vote that has just started. But hopefully we will be able to make some improvements and reform, and

yet at the same time keep something on balance that makes sense.

I thank the panel very much.

The CHAIRMAN. Yes. Thank you, Senator Breaux.

Since there is a vote starting, and since I think it would be rude

to keep you sitting around here for 15 minutes while I recess the

44

committee, I have got three or four questions that I am going to

submit for answer in writing.

Normally, we would like to have those back in about 2 weeks, if

you could. I would appreciate it very much.

Thank you all very much for your contribution.

[The questions appear in the appendix.]

[Whereupon, at 12:20 p.m., the hearing was concluded.]

(45)

A P P E N D I X

PREPARED STATEMENT OF HON. GEORGE ALLEN

Thank you Mr. Chairman. I appreciate the opportunity to come before the Committee today and comment on the ongoing debate over how to effectively repeal the

Extraterritorial Income Exclusion Act of 2000 without adversely impacting U.S. jobs

and business.

ETI and its predecessors, the Foreign Sales Corporation, and Domestic International Sales Corporation acts, were originally enacted to ensure U.S. exporters

were competing on a level playing field internationally. At the time, high U.S. income taxes were forcing U.S. firms to make difficult choices on how and where to

establish manufacturing and production facilities. Congress crafted the program to

encourage production in the U.S.

Today, the threat of American companies and jobs going overseas remains. While

ETI provides tax benefits of over $4 billion a year on exported goods for eligible companies, ETI also helps support over 3.5 million jobs, directly and indirectly, in the

U.S. If ETI is simply repealed without enactment of sound legislation in its place,

these benefits will be lost to U.S. companies and to U.S. workers when they are

most needed. Indeed, last month alone, the U.S. lost more than 56,000 manufacturing jobs, following a steady decline over several years. Over 2.6 million manufacturing jobs have been lost over the past two years. More jobs have been lost in the

manufacturing sector than in all sectors of the U.S. economy combined. Mr. Chairman, repealing ETI without an alternative will encourage U.S.-based exporters with

significant sales abroad to move their operations and jobs out of the U.S.

Legislation repealing ETI must include provisions that provide some alternative

relief to U.S. exporters with primarily domestic production. Virginia ranks sixteenth

in exports among all States, so Virginians are especially concerned about the impact

of ETI repeal. With a simple repeal of ETI, Virginia stands to lose up to 82,600 export-related jobs. This will harm good hardworking people in Virginia’s manufacturing sector, and deliver a serious blow to related industries. And, changes in the

manufacturing sector echo throughout the economy.

ETI’s repeal, without anything to take its place, will amount to a tax increase of

over $50 billion over the next ten years on the U.S. manufacturing jobs base which

is now covered by ETI. Tax reform should promote creation and retention of jobs

for Americans and the competitiveness of U.S.-based companies, not penalize them.

International tax reforms to maintain our international competitiveness would be

a positive change, but such reforms should not be paid for by increasing taxes on

the domestic manufacturing and production base, which would increase the cost of

doing business in this country, but more importantly would severely jeopardize the

livelihood of millions of Americans.

If I may, I would also like to briefly comment on the other topic of discussion for

this hearing, the Homeland Investment Act. This legislation would be an effective

compliment to the recent tax relief package the Congress recently passed.

By temporarily reducing the tax burden associated with repatriating the accumulated foreign earnings of U.S. companies, we can provide an incentive for businesses

to bring approximately $140 billion back to the U.S.

The net result of this temporary change in tax policy would be greater investment

in new capital and personnel, but most importantly, new U.S. jobs.

The Senate has already overwhelmingly supported this initiative once, I respectfully urge the Finance Committee to bring it before the full Senate once again for

consideration.

46

Thank you Mr. Chairman for the opportunity to testify before you today. I look

forward to working with you and the Committee on these important tax issues in

the coming months.

PREPARED STATEMENT OF HON. MAX BAUCUS

Today’s hearing take us one step closer to streamlining our sprawling international tax laws. More than a year ago, Senators Graham, Hatch, Grassley, and

I formed an International Tax Working Group. The Working Group was put together to review our international tax laws and make recommendations for improvement.

We focused on simplification of these laws, so that U.S.-based multinationals

could compete in the global economy. Achieving this goal will encourage American

companies to remain in this country, while creating jobs and promoting economic

growth. Our international tax laws have not kept up with the increased

globalization of the economy. The Working Group has made great strides toward

pinpointing areas for reform. And I am pleased that these efforts reinforce the objectives Senator Hatch and I have made in the past.

And I am also pleased that today’s hearing turns an eye towards simplification.

Today we will address such complex tax laws as—anti-deferral regimes, the foreign

tax credit and sourcing and allocation rules. Reform in these areas would have a

significant effect on U.S. companies competing in the global marketplace. At last

week’s hearing, we heard testimony about the decline of the manufacturing sector

and ways to help industry. Providing incentives to reverse this decline and keep

manufacturing jobs in the U.S. is not inconsistent with reforming our international

tax rules and making corporations more competitive.

Mr. Chairman, it is critically important to have laws that benefit, rather than penalize, U.S. corporations competing globally with foreign counterparts. International

tax reform is about keeping jobs in America. And we need to ensure that the United

States provides an environment that U.S. corporations want to conduct business

in—not an environment American businesses choose to flee. Common sense would

indicate that the more corporations headquartered—and incorporated—in the U.S.,

the more jobs we have here at home.

Department of Commerce data shows that in 1999 U.S. multinationals employed

over 21 million people in the United States—out of a workforce of 130 million. In

2000, foreign affiliates of U.S. companies purchased $203 billion of goods from U.S.

sources, while domestic operations of U.S. multinationals exported $236 billion to

other foreign customers. Thus, U.S. multinationals accounted for $439 billion of

merchandise exports in 2000, or about two-thirds of overall U.S. merchandise exports.

But we don’t want to enact laws that will encourage companies to move operations offshore to avoid taxes. Rather, we want to take advantage of this opportunity to review the U.S. system of international taxation, make modifications

where appropriate, eliminate overlap and simplify where possible. Mr. Chairman, I

want to thank you for holding this hearing today. And, I want to thank Senators

Graham and Hatch for their continuing efforts in the area of international tax reform. I look forward to hearing from our witnesses on this important and timely

issue.

PREPARED STATEMENT OF HON. JIM BUNNING

Thank you, Mr. Chairman.

I am grateful to the chairman for holding this hearing today. As my colleagues

are all aware, the issue of the effect that our tax system has on the international

competitiveness of American-based companies is one that is fundamental to our economic future.

Hardly anyone will disagree that the U.S. tax system is fundamentally outdated

in many areas of international taxation. The bulk of our international tax rules

were written over 40 years ago. The intervening decades have seen significant

changes both in the business models of multinational corporations and in the world

economy. Many of the rules that are currently in place do not meet the basic goal

of the avoidance of double taxation. This has to change if American-based companies

are to be competitive. The recent focus on corporate inversions is disturbing evidence of this fact.

This committee will be making a number of important decisions in the coming

months that could have wide-reaching impact on the place of America and American

47

businesses in the future world economy. I am indebted to our witnesses today for

taking the time to share their expertise and experience with us as we grapple with

the issues before us.

I look forward to an informative and enlightening exchange of ideas.

Thank you.

PREPARED STATEMENT OF HON. JOHN ENSIGN

The United States has maintained a tax system for decades that makes it prohibitively expensive for our U.S.-based companies to bring foreign earnings back for investment in the United States and thus encourages reinvestment of those earnings

offshore.

Under international tax principles, primary jurisdiction to tax income is the country where the business operates rather than the country where the business is

based.

Many countries (but not the U.S.) exclude foreign dividends from domestic taxation, which encourages the reinvestment of surplus foreign earnings back home

into these countries.

In the U.S., by contrast, companies are required to pay tax on foreign subsidiary

earnings when the earnings are brought back to the U.S. at a 35-percent U.S. tax

rate.

As a result, foreign earnings of U.S.-based companies have accumulated abroad

because companies are reluctant to repatriate these funds at this high tax rate.

In the simplest and worst case, a company that is faced with a 35% U.S. tax on

a $100 profit can invest $65 dollars in the United States or $100 in a foreign country. Obviously, the foreign investment is the better choice.

This aspect of U.S. tax law is a significant incentive to leave foreign earnings offshore. As a result, less desirable foreign investments are frequently more profitable

for U.S. companies despite better investment opportunities in the United States.

Based on an examination of the financial statements of the S&P 500, JP Morgan

conservatively estimates that the pool of foreign earnings that has accumulated over

the years and is eligible to be brought to the United States is about $300 billion.

Much of this accumulated foreign investment is designated for financial reporting

purposes as permanently invested overseas and thus there is no expectation of any

U.S. tax being paid in the future.

Invest in the U.S.A. proposal included in S. 1056

The Senate-passed Jobs and Economic Growth tax bill included a provision originally introduced as S. 596 by myself, and Senators Boxer, Smith, Bayh, Allen and

Enzi. It was adopted by voice vote after a 75–25 vote adopting a procedural motion

on the floor to consider it.

All the Republicans and half the Democrats voted in favor. Similar bipartisan proposals have been introduced in the House.

Proposed Change

For a one-year period, the 35% tax rate on transfers to the U.S. of foreign corporate earnings would be replaced with a 5.25% toll charge on transfers in excess

of the company’s historical average.

No foreign tax credit would be allowed for 85% of the foreign taxes associated

with dividends and other transfers qualifying for the 5.25% toll charge. The 5.25%

toll charge could not be reduced by net operating losses.

This amounts to about a 3.75 percent U.S. tax after foreign tax credits—about the

same as what companies have show that they are willing to pay on average.

PricewaterhouseCoopers examination of the most recent IRS tax data shows that,

on average, companies repatriate earnings when the additional U.S. tax burden is

about 3.7 percent. If the rate were increased it would encourage less investment in

the United States. Reducing the rate could result in less U.S. revenue.

To encourage immediate economic stimulus, the reduced rate of tax would be effective for the first taxable year ending 120 days or more after the date of enactment. Thus, for example, if the bill was enacted on May 25, 2003 and the electing

taxpayer is on a calendar year, the bill will apply to the taxpayer’s taxable year ending December 31, 2003.

Obviously, since the bill was not enacted as part of the growth package, I will

encourage this Committee to select an effective date that maximizes the economic

benefit in the next twelve months—to encourage the maximum amount of U.S. reinvestment as quickly as possible.

48

Estimated additional U.S. investment from accumulated foreign earnings

JP Morgan performed an independent study of S&P 500 financial data for its investors and conservatively estimates that it would briny in about $300 billion and

advises that the proposal will result in a significant amount of economic stimulus

including:

• A 2–3% cumulative increase in domestic investment during 2003–04,

• A 1 % cumulative increase in GDP growth (.5 % in 2003 and .5% in 2004) and

• A 3% reduction in nonfinancial corporate debt that strengthens corporate balance sheets and lowers corporate bond rates.

To provide a sense of the significance of this one-percent of additional GDP, we

can compare it to the stimulus in the just passed growth bill.

Standard & Poor and Morgan Stanley Company estimated that the portion of the

President’s tax proposals that were enacted this year would increase GDP by about

one-percent in 2003. Bank of American estimated the impact as about .5 percent in

2004.

Prudential Financial published a Research Report in June on the proposal, stating:

‘‘We believe that a fund transfer of this magnitude would have significant

macroeconomic implications, spurring growth, driving employment, stimulating

domestic U.S. capital expenditures, easing the burden of under-funded pension

programs, and in particular, helping hard-pressed U.S. manufacturing corporations to pay down debt and de-lever their balance sheets to better cope with deflationary pressures.’’

A PricewaterhouseCoopers survey of just 14 companies showed that the proposed

change would result in an additional $47 billion reinvestment in the United States

from just those 14 companies.

This would increase domestic investment in plant, equipment, R&D, and pension

plans depleted by decline in the stock market; reduce domestic debt loads; increase

dividends that could be productively redeployed; and raise equity market valuations

by increasing funds available for share repurchases.

The extent to which this is beneficial to the U.S. economy is determined by the

use of the funds when they are reinvested. Although the PricewaterhouseCoopers

survey on use of the funds focuses on 14 relatively large companies, the change will

improve the financial condition of all U.S.-based companies regardless of size.

I ask unanimous consent that the results of this survey be entered into the record:

49

Revenue estimate

The Joint Committee on Taxation’s preliminary revenue estimates is that S. 596

will increase tax receipts by about $3.8 billion in the first year, and reduce net revenue by $3.8 over the 10-year budget period. I believe that the JCT estimating work

is ongoing.

PricewaterhouseCoouers, JP Morgan and a statement by House Ways and Means

Committee Chairman Thomas at a hearing disagree with the JCT estimate. PwC

and JP Morgan both estimate that the proposal increases federal receipts over the

10-year period.

The Invest in the U.S.A. Act is a bipartisan, sensible, fiscally responsible way to

encourage companies to invest these earnings here at home and provide immediate

investment and growth in the American economy.

Lowering the tax burden on foreign subsidiary income for a limited time will open

the floodgates for privately held foreign funds to be brought back into the American

economy to provide immediate economic stimulus.

Thank you for allowing me to testify here before you today.

50

1The Securities Industry Association, established in 1972 through the merger of the Association of Stock Exchange Firms and the Investment Banker’s Association, brings together the

shared interests of more than 600 securities firms to accomplish common goals. SIA memberfirms (including investment banks, broker-dealers, and mutual fund companies) are active in all

U.S. and foreign markets and in all phases of corporate and public finance. According to the

Bureau of Labor Statistics, the U.S. securities industry employs more than 700,000 individuals.

Industry personnel manage the accounts of nearly 93-million investors directly and indirectly

through corporate, thrift, and pension plans. In 2002, the industry generated $214 billion in

U.S. revenue and $285 billion in global revenues. (More information about SIA is available on

its home page: www.sia.com.) 2See Joint Committee on Taxation, THE U.S. INTERNATIONAL TAX RULES: BACKGROUND, DATA, AND SELECTED ISSUES RELATING TO THE COMPETITIVENESS OF

U.S.-BASED BUSINESS OPERATIONS, JCX–67–03, at 46 (July 3, 2003). 3See Merrill Lynch & Co., 2002 ANNUAL REPORT, at 15, 24–6 (2003).

PREPARED STATEMENT OF MICHAEL GAFFNEY

I. INTRODUCTION.

Mr. Chairman and Members of the Committee, I am a First Vice President and

the CoHead for Global Tax at Merrill Lynch & Co., and I am appearing today on

behalf of the Securities Industry Association (the ‘‘SIA’’).1 The SIA thanks you for

this opportunity to summarize our perspective on how U.S. tax policy affects the

international competitiveness of U.S. firms. This is a challenging time for international tax policy. The choices that Congress makes in revising our international

tax rules will be vitally important to the future health of the U.S. economy.

Traditionally, when policymakers debate the effects of U.S. tax policy on international competitiveness, they focus primarily on the consequences of various policy

choices to industrial firms. The SIA fully supports the objective of a vibrant domestic industrial sector, and we also recognize the power of the argument that a significant portion of the revenues generated from repeal of the ETI regime should be reinvested in domestic manufacturing. Nonetheless, the financial services sector also

makes significant contributions to domestic jobs and revenue and is profoundly affected by the international tax environment in which we do business. I speak before

you today to advocate international tax rules that will promote a fair competitive

environment for securities firms, banks and similar financial services firms and, as

a result, strengthen our domestic economy.

We have a straightforward perspective on the goals of U.S. tax policies with respect to domestic and international competitiveness: our country’s tax rules should

not distort the outcomes of commercial competition among global firms, or across

industries. As a result, we believe that U.S.-based global securities firms, banks and

similar financial services firms should compete in London, Frankfurt, Tokyo and

other major financial centers under a tax regime that is comparable to those under

which our non-U.S. based global competitors operate in those same centers.

Similarly, we support fair rules for non-U.S. based global financial services firms

doing business in the United States; we have no truck with tax protectionism. Finally, we believe that the international tax policies of the United States must be

evenhanded across the different sectors of the U.S. economy, and not distort capital

allocations within the U.S. economy by preferring one sector over another.

The report prepared by the Staff of the Joint Committee on Taxation for these

hearings illustrates the importance of the financial services industries to our country’s global competitiveness. That report concludes that, on an historical cost basis

at year-end 2000, U.S. direct investment abroad in ‘‘finance, insurance and real estate,’’ in addition to direct investment in foreign banks, was $534.5 billion (or 42.9

percent of the total investment), while US direct investment in foreign manufacturers amounted to $344 billion (or 27.6 percent of the total investment).2

Why have U.S. securities firms, banks and similar financial institutions made

such large direct investments in overseas markets? The answer is simple, but often

overlooked: although our businesses require substantial capital, at their heart our

firms are engaged in services businesses. Like any other services industry, we have

to go to our customers to provide the services they require. In this respect, there

is a fundamental difference between all services firms, on the one hand, and manufacturers, on the other: we have no uniform ‘‘product’’ that can be manufactured in

one location and sold in many others.

To see the magnitude of the investments that U.S. financial services firms have

made in providing services to their local customers around the world, one only needs

to look at the 2002 Annual Report of any major U.S.-based multinational financial

services firm. As of the end of calendar year 2002, for example, my own firm of Merrill Lynch employed over 10,000 of our 50,900 worldwide employees outside the

United States, of which nearly 5,500 were in London alone.3

51

For the same reasons that U.S.-based financial services firms have expanded

abroad, they compete here in U.S. domestic markets with foreign-based financial

services firms that have invested billions of dollars to tap into U.S. markets and

to reach U.S. customers.

It is critical to note that the expansion of our international business has not come

at the expense of U.S. jobs, because our employees outside the United States service

local customers, not U.S. customers. To the contrary, our growth internationally has

created more jobs in the United States to support and manage our global customer

base.

Because securities firms and similar financial services businesses are engaged primarily in the delivery of sophisticated services to customers in major financial centers, we have relatively little flexibility on where we locate our international operations. Financial services firms generally are subject to local regulation, and in

order to deal with customers we are required to establish a substantial presence in

each such jurisdiction. More generally, because our business model is based on providing services to customers—whether in an advisory role or by applying capital to

provide services, financial services firms effectively are required to establish a substantial local presence in order to reach any local customer base, regardless of the

regulatory environment. This comparative immobility in where we site our operations means that we are particularly sensitive to the international tax rules of the

United States, as well as the local tax rules in the world’s principal financial centers: we cannot, for example, simply choose to move from London to the Cayman

Islands and to export our ‘‘product’’ back to our U.K. customer base.

To be fair, it is more difficult to design appropriate tax rules for financial services

firms than it is for some other services businesses, because so much of our business

involves the application of capital to provide customer services. Interest income, for

example, is passive investment income when earned by an individual investor, or

even by a mutual fund—but, in the hands of a securities firm or bank, interest income arising from a loan to a customer, or from a bond held in inventory for sale

to customers, is active business income attributable to our core customer services

of market making and financial and credit intermediation. As a result, income from

capital has different economic and tax consequences depending on the context in

which it is earned.

This Committee, and its counterpart in the House, worked very hard to implement this basic principle, for example, in the ‘‘active financing income’’ rules of subpart F. We very much appreciate the commitment of the Committee and its staff

in developing workable tests under subpart F to distinguish between passive interest income, on the one hand, and active financing income, on the other.

I will now turn to specific international tax issues of particular importance to the

members of the SIA. There are many provisions of general application that affect

financial services firms, but the following remarks focus solely on issues that are

uniquely relevant to our industry.

II. SUBPART F OF THE CODE—ACTIVE FINANCIAL SERVICES PROVISION.

Congress enacted crucial but temporary reforms of the international tax rules for

financial services firms in the Taxpayer Relief Act of 1997. As a result of these reforms, ‘‘active financing income’’ earned by foreign subsidiaries of U.S.-based financial services firms now is taxed in the same general manner as the active business

income earned by foreign subsidiaries of U.S.-based industrial firms. Since 1997,

Congress has renewed the active financial services provision three times. Most recently, the provision was extended for five years in the Job Creation and Worker

Assistance Act of 2002 and is scheduled to expire at the end of 2006.

As Congress recognized in 1997, 1998, 1999 and again in 2002, a U.S.-based financial services firm should not be liable for U.S. tax on the active business income

earned by its foreign subsidiaries until those earnings are returned to the U.S. parent. Foreign-based competitors have always enjoyed either delayed taxation of such

income or total home country exemption from tax. Similarly, U.S.-based industrial

firms have never been subject to the immediate tax regime of subpart F in respect

of the overseas business income of their foreign subsidiaries. In order to allow financial services firms to formulate long-range business plans in a stable and appropriate business environment, we urge that the active financing income rules be

made permanent as soon as possible. This issue is the single most important international tax legislative priority of the SIA.

52

4Treasury Regulation section 1.904–4(e)(3)(ii).

III. FOREIGN TAX CREDIT PROVISIONS.

1 . Interest Allocation.

To prevent double taxation, U.S. taxpayers may use foreign income taxes that

they incur in their international operations as credits against their U.S. tax liabilities. This credit is, however, subject to an important ceiling, which is that a U.S.

company’s foreign tax credit cannot exceed what the U.S. tax would have been on

the company’s ‘‘foreign-source income.’’ Unlike other countries, the U.S. today calculates foreign-source income by allocating some U.S.-only expenses—in particular,

interest expense—against foreign-source income, based on simplified apportionment

formulas. These mandatory apportionment formulas are intended to do ‘‘rough justice.’’ Current law’s ‘‘water’s edge’’ apportionment formula for interest expense, in

addition, ignores any debt and interest expense of a U.S. company’s foreign subsidiaries. As a result, for many taxpayers (particularly industrial firms), current law allocates too much U.S. interest expense to reduce foreign source income for U.S. tax

purposes, leaving the taxpayer unable to credit some of its foreign tax payments

against its U.S. tax liability.

As an alternative to the ‘‘water’s-edge’’ formula, some policymakers have proposed

that taxpayers be required to allocate their interest expense using a ‘‘worldwide

fungibility’’ approach. This approach in effect views each asset of a global company

as debt-financed to the same extent and at the same financing rate as every other

asset of the company, including for this purpose all the assets and borrowings of

all domestic and foreign subsidiaries.

The worldwide apportionment formula effectively assumes that a multinational

group’s domestic and international businesses are similar in their capital needs, and

that money is perfectly fungible across all of the group’s worldwide operations. In

reality, of course, these assumptions are never perfectly correct, either with respect

to the leverage of different domestic and foreign operations, or the different financing rates available in the U.S. and foreign markets. Because securities firms, banks

and other similar financial institutions are very highly leveraged compared to industrial firms, any differences between commercial reality and the theoretical construct

of worldwide fungibility are greatly magnified in the financial services industry.

U.S.-based securities firms have adapted their operations as best as they can to

the current tax regime. Some dealers, like most industrial firms, find the current

rules to be unfair, because their domestic and foreign business profiles are similar,

and the premise of the worldwide fungibility of money therefore reasonably describes their operations. Other firms, however, have found that worldwide

fungibility would only make matters worse, because of significant differences between the kinds of businesses they conduct domestically and internationally (and

therefore the leverage or financing rates applicable to each).

We frankly have not been able to construct a single interest allocation model that

accurately reflects the business realities of different highly-leveraged financial institutions with different business mixes, given that money in fact is not perfectly fungible across global businesses. Accordingly, we propose that financial services groups

be permitted to elect to allocate their interest expense under the current law provisions, or alternatively to apply the ‘‘worldwide fungibility’’ approach, depending, in

effect, on which regime more closely describes their business model. We suggest that

the election be made once every five years. This would prohibit attempts to game

the system, but would permit taxpayers to revise their elections as their long-term

business strategies (and hence mix of business) evolve. The election should apply

only to taxpayers that are bona fide financial services groups, which meet the qualitative and quantitative income requirements for the group as a whole to qualify as

a financial services entity for foreign tax credit purposes.4

In addition, consideration could be given to reducing the cost of such an election,

and simplifying its administration, by providing that current law’s financial institution subgroup rule would not apply to a financial services group that elects to allocate interest expense under current law.

Finally, if worldwide fungibility is enacted for any group of taxpayers (industrial

or financial), the application of those rules to intercompany debt owed by foreign

subsidiaries to the U.S. parent must be addressed. It is tempting to suggest that

this is the sort of technical matter best left to regulations, but in light of the amount

of intercompany debt outstanding among multinational groups today, and the confusion that would result if implementing regulations either were not issued quickly

or were not clear, it is imperative that a worldwide fungibility statute be clear on

its face, and applied in a manner that is consistent with its purpose.

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5For example, if a U.S. financial services company acquires a foreign target that holds a portfolio stock investment in a third company and the acquiror makes a section 338 election, the

resulting step-up in the subsidiary’s tax bases in its assets will mean that the foreign subsidiary

may not recognize gain on a subsequent resale of that portfolio stock investment for U.S. tax

purposes, while recognizing gain (and incurring a real tax liability) under local law. The result

is a permanent reduction in the subsidiary’s total income from a U.S. perspective, when compared to foreign law tax accounting norms. 6Thus, for example, if a U.S. corporation earns interest income from a U.S. Treasury held as

an investment, that interest income is U.S. source. Section 904(g) provides that the result is

the same (i.e., U.S. source income) if the U.S. parent company causes a subsidiary to buy that

U.S. Treasury as an investment, and then derives interest, dividend or subpart F income from

its subsidiary attributable to the earnings on that U.S. Treasury.

2. Permanent Difference Items.

Current law assigns a taxpayer’s items of foreign income to nine different income

baskets: the first eight baskets address specific categories of income, and all remaining income is assigned to a ‘‘residual’’ or ‘‘general limitation’’ basket. Treasury regulations then allocate the foreign taxes incurred by the taxpayer to the different income baskets to which those relate.

For a manufacturing or typical services firm, the ‘‘general limitation’’ basket effectively is the base case: income from core business activities falls into that basket,

and only in specific (and generally exceptional) cases does income fall into other baskets. For a financial services firm, by contrast, the ‘‘financial services income’’ basket is intended to sweep within it all of its core business income, and the general

limitation basket in fact holds only income derived from peripheral activities not

connected with the firm’s core financial services business.

It sometimes is the case that a foreign jurisdiction will impose tax on amounts

that are not (and never will be) income in a U.S. sense; these amounts are generally

described as ‘‘permanent difference items.’’5 Current Treasury regulations (§ 1.904–

6(a)(1)(iv)) arbitrarily assign foreign taxes paid on a permanent difference item to

the general limitation basket.

The current rule makes sense for U.S. manufacturing firms; because the general

limitation basket is the base case income basket for those companies, U.S. manufacturing companies will more likely be able to eventually credit those real foreign tax

costs. This same rule penalizes financial services firms, however, because for the financial services industry only income (and taxes) from peripheral activities fall into

the general limitation basket. For financial services firms, the financial services basket, not the general limitation basket, is the base case.

This problem arises as a result of many acquisitions and other commonplace

transactions; accordingly, the SIA recommends that a statutory provision be adopted

to recognize that the financial services income basket is the base case basket for

financial services firms, and therefore to put otherwise unclassified foreign taxes on

permanent difference items into this base case basket. This solution will provide financial services with the same opportunities that are already provided to industrial

firms to recoup their actual foreign tax costs derived from active business activities.

3. Section 904(g) Reform.

Section 904(g) is part of the regime for determining the source of income for purposes of section 904’s limitations on the utilization of foreign tax credits. Section

904(g) currently provides as a general rule that income derived by a U.S. parent

company from its foreign subsidiary will be resourced from foreign-source income to

U.S.-source income, to the extent that the foreign subsidiary in turn is treated as

having earned that income from U.S. sources.6

When applied to foreign securities dealer subsidiaries of U.S. financial services

firms, the resourcing rules inequitably limit the ability of U.S. securities firms to

utilize U.S. tax credits for foreign taxes paid on income derived from their overseas

securities dealing businesses. Foreign securities dealer subsidiaries of U.S. firms

often deal in U.S. securities, such as U.S. Treasurys and U.S. issuer-Eurobonds, to

serve local customer needs or as hedges of local customer contracts. Since dividends

and interest payments generally are sourced for U.S. tax purposes according to the

residence of the payor thereof, foreign securities dealer subsidiaries of U.S. firms

necessarily receive U.S. source dividends and interest in the ordinary course of their

securities dealing businesses with customers, and are subject to tax on such income

in the foreign jurisdictions in which they operate.

The policy underlying the sourcing rules of section 904(g) is to prevent the

resourcing of passive and mobile income derived from U.S. sources through the use

of foreign subsidiaries. This policy concern, however, is not implicated in the case

of dividends and interest income received on U.S. securities held by a U.S.-owned

foreign securities dealer for purposes of conducting its securities dealing businesses

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7 A similar amendment was proposed by section 203 of the International Tax Simplification

for American Competitiveness Bill (introduced in the 105th Congress, 2d session, as H.R. 4173). 8The Taxpayer Relief Act of 1997 amended section 956 by adding two exceptions to cover ordinary course transactions entered into by foreign securities dealer affiliates of U.S. securities

firms, e.g., securities loans and sale repurchase agreements. Under both types of transactions,

collateral equal in value to the cash or securities loaned is required to be posted, as is the case

in similar transactions with unrelated parties at arm’s length. See section 956(c)(2)(J) and section 956(c)(2)(K). 9For example, a domestic corporation that ‘‘is neither a U.S. shareholder (as defined in section

951(b)) of the controlled foreign corporation, nor a domestic corporation, 25 percent or more of

the total combined voting of which, immediately after the acquisition of any stock in such domestic corporation by the controlled foreign corporation, is owned, or is considered as being

owned, by such United States shareholders in the aggregate.’’

with foreign customers. Therefore, the SIA recommends that an amendment be

made to section 904(g) to exclude from its scope income derived from a U.S.-owned

foreign securities dealer subsidiary that is in turn derived from any security (as defined by section 475(c)(2), which includes physical securities and derivative instruments) held by a person in connection with its activities as a securities dealer.7

4. 10/50 Corporations.

The SIA endorses proposals of policymakers which would apply a look-through approach to dividends paid by so-called ‘‘10/50 corporations,’’ regardless of the year in

which the relevant earnings and profits were accumulated.

IV. SECTION 956—INVESTMENT IN UNITED STATES PROPERTY.

Section 956 of the Code is an anti-abuse measure that treats an investment by

a foreign subsidiary of a U.S. parent company in ‘‘United States property,’’ such as

stock or debt of a U.S. affiliate, as a deemed dividend for subpart F purposes, on

the theory that such transactions economically are similar to a direct repatriation

of the subsidiary’s earnings. In this regard, Congress has recognized in the past that

certain exceptions to the definition of ‘‘United States property’’ are warranted to

cover ordinary course business transactions entered into by foreign securities dealer

affiliates of U.S. securities firms because such transactions do not violate the purpose of section 956.8 All of the issues described below relate to continuing technical

problems in the mechanical application of current section 956 to U.S. securities

firms, banks and similar financial services firms, in contexts that do not implicate

section 956’s policy agenda.

1. Sale of U.S. Affiliate’s Securities in the Ordinary Course of Business.

‘‘United States property’’ generally includes stock or debt of a foreign subsidiary’s

U.S. parent (or any other U.S. affiliate). Currently, there is no exception to this general rule to cover the case, which commonly occurs, of a foreign securities dealer

subsidiary of a U.S. financial services firm that makes a market in the securities

of a U.S. affiliate. The effect of current law is to provide a disincentive for U.S. financial services firms to use their own foreign subsidiaries to make markets in securities that the U.S. group issues to international investors, which is a nonsensical

result as a commercial matter.

The solution to this very frustrating problem is to exclude from the definition of

United States property any security issued by a U.S. affiliate held by a foreign dealer in securities, provided that (i) such securities are held primarily for sale to customers in the ordinary course of business, and (ii) the dealer in fact disposes of such

securities within a period consistent with holding such securities for sale to customers in the ordinary course of business.

2. Investments in Unrelated Non-Corporate Entities and Individuals.

Section 956(c)(2)(F) provides that United States property does not include the

stock or obligation of an unrelated domestic corporation.9 There is no parallel exception to the definition of United States property for investments made in obligations

of unrelated U.S. partnerships, trusts, estates, or individuals.

As a result, section 956 today applies beyond its intended scope. It also hinders

the ordinary course overseas business activities of U.S.-based financial services

firms and, in addition, gives preferential treatment to offshore investment funds as

compared to onshore funds, by placing barriers to domestic partnerships looking to

finance purchases of foreign securities. Section 956 should be amended to provide

for an exception from the definition of United States property for obligations of unrelated U.S. partnerships, trusts, estates and individuals, provided, of course, that

those entities in turn hold no securities of a U.S. affiliate.

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V. EARNINGS STRIPPING.

The earnings stripping rules of section 1630) primarily are relevant to foreignowned firms, because they limit the ability of foreign-based multinationals to reduce

the taxable income of their U.S. subsidiaries through the payment of interest expense to foreign affiliates (or to third parties in respect of debt that is guaranteed

by foreign affiliates).

Proposals have been made to significantly tighten the ‘‘earnings stripping’’ rules

of section 1630). If enacted, some of these proposals could have dramatic adverse

consequences to the U.S. securities dealer affiliates of foreign banking institutions.

As discussed previously, interest expense often represents the largest single category of tax deduction to a financial institution, and any distortion in the amount

that the Code treats as deductible therefore can have enormous repercussions. As

a result, any change to the tax rules in this area must be carefully considered and

based on sound tax policy.

The SIA believes that it is vitally important that all securities firms doing business in the United States compete on a level playing field. This issue is important

not simply to our member firms that ultimately are foreign-owned. U.S.-based member firms also are interested in a fair resolution to this issue, because, if the United

States were to adopt rules that were perceived as a form of tax protectionism, our

U.S.-based members see the possibility of foreign retaliatory ‘‘mirror’’ rules as a real

possibility.

VI. GLOBAL DEALING OPERATIONS/DIVIDENDS-RECEIVED DEDUCTION.

Some financial services businesses, such as some derivatives or foreign currency

dealer operations, typically are organized and conducted in a single globally-coordinated fashion (generally referred to as ‘‘global dealing’’ operations). U.S.-based financial services firms engaged in global dealing operations have faced many tax

issues over the years relating to the allocation and sourcing of income and deductions among related taxpayers engaged in such operations, and the possibility of

multiple layers of taxation.

Foreign subsidiaries of U.S.-based financial services firms may operate global

dealing activities through branches in several countries, including the United

States. As a result, these foreign subsidiaries of U.S. firms may derive income that

is subject both to U.S. net income and branch taxes and to tax in their home jurisdictions. The net result can be the imposition of up to four layers of taxation (one

foreign, and three U.S. layers) on the same item of income, as it is distributed back

to the U.S. parent: (1) U.S. net-basis taxation of trading profits attributable to the

U.S. branch of the foreign subsidiary, (2) foreign net-based taxation ofthe global income of the foreign subsidiary, (3) U.S. branch taxes (including the branch level tax

on ‘‘excess interest’’ and the tax on the ‘‘dividend equivalent amount’’) and (4) U.S.

taxation of dividend income when the foreign subsidiary pays an actual dividend to

its U.S. parent corporation—even when the dividend is attributable to ‘‘effectively

connected income’’ (‘‘ECI’’) and a U.S. corporate tax has been previously paid—with

no credit or other relief for any foreign withholding tax paid to the foreign subsidiary’s home country.

The SIA is optimistic that in due course final Treasury regulations will develop

a rational regime to reduce the instances in which the IRS asserts that a global

dealing operation gives rise to an inadvertent deemed U.S. branch. In the meantime, however, we urge adoption of the following three legislative actions to prevent

a U.S. securities firm engaged in a global dealing operation from suffering unintended triple taxation of income:

• Amend section 245(b) to permit a 100 percent dividends-received deduction

(‘‘DRD’’) where a dividend is attributable, directly or indirectly, to earnings of

a 100 percent owned foreign subsidiary that have been subject to U.S. net income tax;

• Amend the branch tax rules to provide an exception for ECI of a 100 percent

owned foreign subsidiary that has been subject to U.S. net income tax; and

• Provide a direct foreign tax credit to the U.S. parent for foreign taxes payable

on the portion of dividends received from a foreign subsidiary that are treated

as derived from U.S. sources and are paid out of earnings previously subject to

U.S. net income tax.

RESPONSES TO QUESTIONS FROM SENATOR GRASSLEY

Question 1. I noticed your testimony on earnings stripping. You are in an industry

that is very sensitive to competitive interest rates. Do U.S. companies in your indusVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00059 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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try believe they are at a competitive disadvantage because of earnings stripping tactics by foreign companies?

Answer. I have never viewed the earnings stripping rules as a provision that puts

U.S. based financial services companies at a competitive disadvantage, because the

earnings stripping rules only affect the ability of non-U.S. based companies to deduct interest. When I think of provisions that place U.S. based financial service

companies at a competitive disadvantage, I think more of the need for a permanent

active financing rule to exempt active income earned by our overseas affiliates from

the scope of subpart F, as well as the two changes to section 956 which are described in my written testimony.

Question 2. In your testimony regarding ‘‘permanent differences’’ what are your

views on simply enacting a de minimis rule that would transfer over trapped foreign

credits in a rarely used basket? AT what level or percentage would you set such

a rule?

Answer. My views are that instead of creating additional complexity inherent in

any new de minimis rule (which would then have to be coordinated with a transfer

to another basket rule), the better answer would be to place the creditable foreign

tax in the correct basket to begin with. The SIA believes the better answer would

be to change the statute to recognize that the financial services income basket is

the base case basket for financial services firms, and therefore to put otherwise unclassified foreign taxes on permanent difference items into this base case basket. It

should be noted that the IRS considered and rejected this proposal in drafting recent Treasury regulations. In the Preamble to those regulations, the IRS explained

its rejection on the grounds that the problem we describe ‘‘rarely occurs.’’ Our response is twofold: First, the problem is not at all rare, but in fact arises as a result

of many acquisitions and other commonplace transactions. Second, the relative rarity of an occurrence does not justify a clearly wrong answer.

Question 3. Company X manufactures widgets in the United States for sale in the

United States and abroad. It forms a subsidiary, Y, in a zero-tax jurisdiction such

as Bermuda to serve as a trading company. Y hires 200 persons in Hamilton. Widgets are sold by X to Y for 100, then Y re-sells the widgets (without changing them)

for 125 to unrelated parties in the United States and throughout the rest of the

world. The transfer price from X to Y is defensible. The 25 earned by Y is attributable to economic functions that Y performs in Bermuda. Should the United States

currently tax that 25? Why or why not?

Answer. Since your fact pattern assumes an appropriate transfer price, your question goes to the heart of whether the foreign base company sales and services rules

operate effectively, or require change. Frankly, those sections do not impact the financial services industry to a significant degree, and therefore these rules are not

one of our industry’s major concerns.

PREPARED STATEMENT OF HON. CHARLES E. GRASSLEY

This is the second of two hearings on international competitiveness and U.S. tax

policy. Last week, we focused on the international competitiveness of U.S.-based

businesses. Today, we focus on the international competitiveness of U.S.-owned foreign operations. During this hearing, we will examine what we mean by the term

‘‘international competitiveness.’’ Understanding this term, and how it is measured,

is very important in light of last week’s testimony. As many of you know, it has

been suggested that we repeal FSC–ETI and use the proceeds to reform our international tax rules. Advocates of this approach claim that this is the best way to

shore up the U.S. economy and grow U.S. jobs. But during last week’s hearing, our

witnesses said this approach would be a $50 billion tax increase on U.S. manufacturing and the U.S. jobs base. They said a tax increase of this size could force them

to move their operations out of the U.S. to remain ‘‘internationally competitive.’’ One

witness with both foreign and U.S. operations candidly stated ‘‘you can reduce my

foreign taxes if you want to, but I’ll just move my U.S. operations there.’’

If we are forced to trade off a domestic tax increase against international tax reform, then we need to understand how international competitiveness will replace

any jobs lost from the tax increase, what kind of jobs it will create, and how it benefits the everyday American. Personally, I think this trade-off is an unfortunate

choice. Some have called it a ‘‘false choice.’’ International tax reform is long overdue.

Our current system is based on a framework enacted during President Kennedy’s

administration. In an era of expanding global markets, falling trade barriers, and

technological innovations that melt away traditional notions of national borders, it

is critical that our international tax laws keep pace with new business realities.

Today, we will hear how our international tax laws have not kept pace. Today, we

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1The January 14, 2002, WTO Appellate Body Report in United States—Tax Treatment for

‘‘Foreign Sales Corporations’’—Recourse to Article 21.5 of the DSU by the European upheld the

decision of the WTO panel that the FSC Replacement and Extraterritorial Income Exclusion Act

confers prohibited export subsidies in violation of the international trade obligations of the

United States.

will hear some fresh and creative thinking on what we should do to reform our

international provisions and remain globally competitive.

We are fortunate to have several senators on this committee who are deeply committed to reforming our international tax laws. Sen. Hatch and Sen. Baucus have

led the charge on this issue for many years. In addition, during last July’s hearing,

Sen. Graham expressed grave concerns about the problems in our international tax

laws. As a result, he and Sen. Hatch formed an International Tax Reform Working

Group within this committee to evaluate various international reforms and simplification measures. As I said last year in my floor remarks when Sen. Baucus and

I introduced our anti-inversion bill, I recognize that the rising tide of corporate expatriations demonstrates that our international tax rules are deeply flawed. In

many cases, those flaws seriously undermine an American company’s ability to compete in the global marketplace. We need to bring our international tax system in

line with our open market trade policies. Reform of our international tax laws is

necessary for our U.S. businesses to remain competitive in the global marketplace.

More importantly, those U.S. companies that reject doing a corporate inversion are

left to struggle with the complexity and competitive impediments of our international tax rules. This is an unjust result for companies that chose to remain in

the United States of America. I am committed to remedying this inequity.

PREPARED STATEMENT OF CHARLES J. HAHN

Mr. Chairman and members of the Committee, I am Charles Hahn, Director of

Taxes for The Dow Chemical Company. My company, as a member of the Coalition

for Fair International Taxation (C–FIT), believes the international competitiveness

of U.S. companies operating in the global marketplace should be the focus of any

legislative response to the World Trade Organization (WTO) ruling that invalidated

the ‘‘Foreign Sales Corporation (FSC) Replacement and Extraterritorial Income Exclusion (ETI) Act.’’1

Dow is a diversified, integrated science and technology company that develops and

manufactures innovative chemical, plastic and agricultural products and services to

many essential consumer markets worldwide. We serve customers in more than 170

countries in a wide range of markets, including food, transportation, health and

medicine, personal and home care, and building and construction, among others.

Dow’s annual sales equal approximately $28 billion, with 40.8 percent in the U.S.

and 59.2 percent international. We have 191 manufacturing sites in 38 countries;

62 of those sites are in the U.S. representing 57 percent of the long-lived assets of

the company.

Chemical markets are necessarily worldwide and fiercely competitive. Dow is the

largest U.S. chemical company, but only the third largest in the world. Of the ten

largest chemical companies, only three are from the U.S. The topics of this hearing,

ETI replacement and international competitiveness, are critical to us.

INTRODUCTION

This statement focuses on the importance of enacting FSC/ETI replacement legislation to Dow and other U.S.-based multinational companies in the manufacturing

industry. In order to allow companies like mine to continue playing a vital role in

increasing U.S. exports and maintaining millions of American jobs, repeal of the ETI

provisions must be coupled with much needed reforms of our outmoded international tax laws. In any case, the Congress should strive to maintain the competitiveness of all American businesses and their workers, without discriminating

against U.S. companies that have substantial, active businesses abroad. To do otherwise would penalize U.S. workers whose jobs depend on their companies’ ability to

sell products and services throughout the globe.

DISCUSSION

Today’s hearing springs from a WTO dispute initiated by the European Community (EC), leading to a WTO ruling that both the FSC and the ETI regime that replaced it are impermissible export subsidies. The WTO has authorized the EC to

impose over $4 billion in annual sanctions against American products, and the EC

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2 US Council of Economic Advisors, Economic Report of the President, 2003, p 208.

has threatened to impose these sanctions on January 1, 2004, if the Congress has

not made ‘‘significant progress’’ in complying with the WTO’s ruling by the fall of

this year. In view of the magnitude of the potential sanctions, we understand the

inevitability of the ETI regime’s repeal. At the same time, we understand the Congress is expected to fashion replacement legislation that is WTO-compliant but that

also addresses the competitiveness of American companies. The core element of any

replacement legislation should be reform of antiquated U.S. tax rules that undermine the international competitiveness of U.S.-based multinational corporations and

their workers.

I. REPLACEMENT LEGISLATION SHOULD TAKE ACCOUNT OF THE VITAL ROLE OFU.S.

MULTINATIONAL CORPORATIONS

The ETI regime in current law is intended to create a level playing field for U.S.

companies competing in markets outside the United States. If the goal of replacement legislation is to target former ETI users, then the Congress must take into

account the impact of repeal on U.S.-based multinational companies like Dow. Dow

is a major exporter with $3.76 billion of export sales in 2002. Our ETI benefit in

2002 was $38 million. For all of the U.S. chemical industry, ETI benefits range from

$750 million to $1 billion annually. Collectively, U.S.-based multinational corporations, which manufacture in whole or in part in the United States but also rely on

foreign operations to carry out distribution, marketing, or other export-related activities, currently provide 56 percent of all U.S. exports.

Repeal of the ETI benefits would result in a huge tax increase at a time when

the chemical industry is severely depressed. Our industry has suffered its worst two

years in two decades and its most prolonged downturn since the 1930’s, in large

part due to the overall economic downturn and high energy and feedstock prices.

Additionally, if the focus is on improvements to the U.S. economy, then the Congress must consider that U.S. multinational corporations are responsible for 23 million American jobs; 21 percent of U.S. GDP; $131 billion in annual U.S. R&D spending; and 49 percent of U.S. corporate income tax payments. Enhancing the competitiveness of this large and important sector would contribute directly to the domestic

economy.

A. FOREIGN OPERATIONS OF U.S. MULTINATIONALS INCREASE U.S. EXPORTS

Foreign direct investment by Dow creates new markets for American products.

This activity leads to sales in foreign markets that likely would not occur by simply

exporting goods. In the chemical industry, particularly for basic chemicals, transportation costs are high and times for production long, so locating near customers or

raw materials is critical. Customers want a local presence as a way to solve problems more expeditiously and to provide supplies quickly. Local plants not only serve

as customers for raw materials produced in the U.S.; but, in the case of Dow, these

overseas facilities also provide distribution for full product lines, even though only

a small portion is produced locally.

A recent study by the Organization for Economic Cooperation and Development

(OECD) found that each dollar of outward foreign direct investment led to two dollars of additional exports and a $1.70 increase in the U.S. bilateral trade surplus.

The Commerce Department’s ‘‘Survey of Current Business’’ indicates that in 2000

(the most recent year for which data are available), U.S.-based multinationals accounted for nearly two-thirds of overall U.S. merchandise exports. Foreign affiliates

of U.S.based multinationals purchased $203 billion of goods from U.S. sources, while

domestic operations of U.S.-based multinationals exported $236 billion to other foreign customers. Dow is a good example. As mentioned previously, in 2002, Dow exported $3.76 billion, with 80 percent of those sales to related subsidiaries.

B. THE INTERNATIONAL OPERATIONS OF U.S. MULTINATIONALS ENHANCE

JOBOPPORTUNITIES IN THE UNITED STATES

As noted by the Council of Economic Advisors in 2003, ‘‘The U.S. economy is increasingly linked to the world economy through trade and investment. Domestically

based multinational businesses and their foreign investment help bring the benefits

of global markets back to the U.S. by providing jobs and income.’’2 Indeed, U.S. multinational corporations are major employers of American workers. The most recent

Department of Commerce data indicate that U.S. multinationals employed over 23

million people in the United States in 2000, out of a national workforce of 139.2 million. Many of these U.S. jobs support and depend on the overseas operations of U.S.

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3SBA Office of Advocacy, ‘‘The New American Evolution: The Role and Impact of Small

Firms’’ (June, 1998). 4 H.R. 1769, a bill introduced on April 11, 2003 by House Ways and Means Committee members, Rep. Crane (RIL) and Rep. Rangel (D–NY), in order to bring the United States into compliance with the WTO ruling by replacing the current-law ETI benefit with a deduction of up to

Continued

firms, particularly jobs related to maintaining and expanding U.S. product development and research initiatives. Dow is typical of many U.S. global companies. We

are headquartered in Midland, Michigan, and naturally many of the functions necessary for our global operations are performed at that U.S. location. For example,

87 percent of Dow’s over $1 billion in 2002 global R&D spending was performed in

the U.S., the majority in Midland.

Additionally, small businesses support and depend on Dow’s global operations. As

the Small Business Administration found in a report discussing the role of small

businesses in the global economy, ‘‘smaller firms can conduct international expansion on their own, or by collaborating with a multinational firm. The intermediated

form of international expansion has certain advantages. The small firm benefits

from having access to the multinational firm’s global market reach.’’3 Accordingly,

reforms that increase the international competitiveness of U.S. multinationals

would have a positive ‘‘spill-over’’ effect on those small businesses that contract with

Dow.

II. THE FOCUS SHOULD BE ON PRO-COMPETITIVE REFORMS TO OURINTERNATIONAL TAX

RULES

Dow is increasingly harmed by the basic structure of the U.S. international tax

regime, which was enacted over 40 years ago, when the U.S. economy dominated

the world. At that time, 18 out of the top 20 global companies were headquartered

here, and this country accounted for over half of all multinational investment in the

world. Today, to remain competitive and fuel U.S. economic growth and jobs, Dow

and other domestic companies must compete against foreign-owned firms for clients

and customers that are located around the globe.

U.S. tax policy should compliment rather than frustrate U.S. trade policy. The domestic economic benefits of free and open trade are not only challenged by ongoing

tariff and non-tariff barriers in many global growth markets but are also being frustrated by an outdated domestic international tax regime written decades ago in a

vastly different competitive environment.

Restrictive aspects of the foreign tax credit limitation have the effect of subjecting

Dow to double taxation of foreign source income and inefficient operations. Dow

typically operates in countries with tax rates similar to that of the U.S. We are currently faced with the expiration of foreign tax credits caused by the erosion of our

foreign tax credit limitation by domestic losses, with no offsetting recapture when

domestic profits return. The problem is made worse by the high allocation of expenses to foreign source income. The overly broad scope of current law also results

in the current taxation of active business income earned abroad. These and other

flaws in our U.S. tax rules operate, in a sense, as an extra ‘‘tax’’ on Dow. Because

this ‘‘tax’’ is not borne by foreign multinationals, the effect impedes the competitiveness of Dow and all U.S. companies that have substantial active businesses abroad.

Additionally, the current system for taxing international operations is overly complex. We spend an enormous amount of time complying with the worldwide and detailed reach of the U.S. system. This has a large compliance cost (6100 of our 7800

page 2001 tax return dealt with international issues, and this is representative of

the relative effort we are required to expend). More importantly, our non-U.S. business operations have to understand and deal with the U.S. tax effects of their transactions, which slows them down, distracts them, and changes how they operate. (Attachment A provides a detailed list of provisions, supported by Dow and other C–

FIT member companies, that should be included among the core elements of replacement legislation to maintain the international competitiveness of U.S. businesses.)

III. IN ANY EVENT, REPLACEMENT LEGISLATION SHOULD TAKE ACCOUNT OF THE FULL

RANGE OF AMERICAN BUSINESSES THAT UTILIZED FSC/ETI

The ETI regime was created to help U.S.-based companies compete with foreignbased companies that operate under significantly different and more favorable

home-country tax rules. Replacement legislation must continue this objective of

global competitiveness for U.S. goods and services. A proposal introduced in the

House of Representatives,4 however, would focus on domestic manufacturing and acVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00063 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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10 percent of the income attributable to domestic production. This bill would also discriminate

against companies in industries other than manufacturing that currently make use of the ETI

regime, including services businesses that either facilitate U.S. exports or provide services relating to those exports in foreign jurisdictions.

* The provisions are not listed in any particular order; all are of equal importance.

5 All references to ‘‘sections’’ are to the Internal Revenue Code of 1986, as amended, unless

otherwise noted.

tually penalize U.S. companies that seek to compete overseas. We believe this is the

wrong approach. Instead, replacement legislation should take into account the interests of all American businesses and their workers, and ensure that they are not

placed at a disadvantage in relation to their foreign competitors.

CONCLUSION

The challenge for Dow and other U.S. companies to remain competitive on an

international basis has never been greater than it is today. When U.S. firms are

competitive in the global marketplace, we are better able to enhance the demand

for U.S.produced products and create U.S. jobs. In view of this reality, the WTOmandated changes to U.S. tax law should include much needed reforms to our international tax regime. These changes will help ensure that Dow and other U.S.based

companies can continue to compete globally against foreign-based companies operating under more advantageous tax regimes. We stand ready to work with the Finance Committee to achieve this result.

Attachment A

The following provision * should be included among the core elements of legislation

to maintain the international competitiveness of U.S. businesses:

Foreign base company sales and services income. Repeal rules that impose current

U.S. taxation on income from active foreign business operations involving certain

sales and services transactions of a controlled foreign corporation (‘‘CFC’’). If repeal

of the foreign base company rules is subject to any exception, care must be taken

to avoid ‘‘creating’’ subpart F income where no such income would arise under current law, and thus report language should make clear that the ‘‘manufacturing’’ exception of current law would continue to apply.

The following provisions were not included on this list, on the assumption that

the Congress will enact both the provision to repeal the foreign base company rules

and the provision to add look-through rules to prevent the current taxation of payments between related CFCs (discussed below): study of proper treatment of the European Union under same country exceptions; and expansion of subpart F de minimis rule to the lesser of five percent of gross income or $5 million.

Provide comparable relief for other income. Current law should also be amended

to prevent the current taxation of active foreign oil or gas business income, including income derived in connection with the pipeline transportation of oil or gas between foreign countries (without regard to whether the CFC that owns the pipeline

also owns an interest in the oil and gas that is transported, or whether the oil or

gas was extracted or consumed within the foreign country).

Provide comparable relief for commodities transactions. Amend theexceptions to

the definition of subpart F rules that generally provide for the treatment of net

gains on commodities transactions as foreign personal holding company income

(‘‘FPHCI’’), to clarify that the exceptions cover (1) commodity hedges entered into

in the normal course of a CFC’s trade or business, primarily to manage the risk of

price changes or currency fluctuations with respect to ordinary property or property

described in section 1231(b)5 that is held or to be held by the CFC; and (2) sales

of stock in trade of the CFC or other property that would be included in inventory,

property that is depreciable in the hands of the CFC, or supplies of a type regularly

used or consumed by the CFC in the ordinary course of business.

Look-through rules to prevent the current taxation of payments between related

CFCs. Present law imposes current U.S. tax under the foreign personal holding company rules of subpart F on any dividends, interest, rents and royalties received by

a CFC from a related CFC when those two subsidiaries are located in different

countries. A ‘‘same-country’’ exception applies when the two related CFCs are organized and operated in the same country. Subpart F should not apply regardless of

the location of the related CFCs as long as the income from which the payment is

derived is non-subpart F income of the paying company. Permitting look-through

treatment for these payments makes sense—as long as the payments reflect active

business income that normally would not be subject to current taxation unless paid

back to the U.S. parent. Current law appears designed to protect the tax base of

other countries or to promote overseas investments in the same jurisdiction where

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the paying/distributing subsidiary of the U.S. parent company is located. Neither of

these policies appears compatible with a system designed to make American companies competitive with foreign-based companies.

Provide look-through rules for sales of partnership interests. For purposes of determining subpart F income that is FPHCI, a CFC that sells an interest in a partnership in which the CFC owns 25 percent or more of the capital or profits interests

should be treated as selling a proportionate share of the partnership’s assets attributable to such interest.

10-year foreign tax credit (‘‘FTC’’) carryforward. Extend the carry-forward period

for excess foreign income taxes and excess oil and gas extraction taxes from five

years to ten years, effective for existing carry-forwards.

Worldwide interest allocation. Modify the interest allocation rules applicable for

purposes of calculating a U.S. taxpayer’s FTC limitation, by providing for worldwide

allocations, to prevent the over-allocation of interest expense. Consideration should

be given to making this rule elective, and to addressing inequities arising under the

specific allocation methodologies prescribed by current Treasury regulations.

Re-characterization of overall domestic loss. Conform the treatment of an overall

domestic loss to that of an overall foreign loss by re-characterizing subsequent U.S.-

source income as foreign.

Consolidation of FTC baskets. Repeal the FTC ‘‘baskets,’’ including the special section 907 limitation, and replace them with a three-basket system for passive income

and ‘‘other passive category income,’’ financial services income, and ‘‘general basket’’

income.

Alternative minimum tax (‘‘AMT’’) limit on FTCs. Repeal the 90 percent limit on

the utilization of the AMT FTC.

Look-through rules for dividends from noncontrolled section 902 (10/50) companies. A 10/50 company is a foreign joint venture in which the U.S. ownership is more

than 10 percent but not more than 50 percent. Through 2002, earnings and foreign

taxes relating to these companies are segregated into a separate FTC basket that

applies for each such joint venture, thus precluding use of these credits in either

a company’s general FTC basket (the financial services basket in the case of banks)

or to average among 10/50 companies. While changes to the law made in 1997 repeal the 10/50 rules for foreign earnings after 2002, the Congress failed to provide

adequate relief for significant transition issues.

These transition issues were not solved by the rules articulated in Notice 20035,

recently released by the Treasury Department to address the transition to the new

10/50 regime. Specifically, credits derived from dividends paid after 2002 out of pre2003 earnings and profits will be confined to a single 10/50 basket. Further, 10/50

credits carried forward from pre-2003 years will be confined to a single 10/50 basket.

Effectively, in both instances, any such excess credits will expire unused because,

under the existing rules, no new income will be generated of the sort needed to absorb these credits. This result appears to have been unintended when the 1997 rules

were drafted, and the proposal would correct this flaw in the 1997 legislation. The

proposal, as outlined in the Joint Committee on Taxation’s staff simplification study

published in 2001, would permit full ‘‘look-through’’ treatment for both credits being

carried forward as well as new credits produced from pre-2003 earnings, thus permitting taxpayers to determine the allocation of credits based on the nature of the

underlying earnings rather than the form of business from which the income was

earned.

FTCs claimed indirectly through partnerships. For purposes of determining indirect FTCs, stock owned, directly, or indirectly, by or for a partnership should be

treated as owned proportionately by its partners when applying the constructive

ownership rules for determining whether applicable ownership thresholds are satisfied.

Include transition rules if FSC/ETI is repealed. Many U.S. financial institutions

finance multi-year leases of various U.S. manufactured goods, including aircraft,

under the FSC/ETI rules. The Congress is considering repeal of these provisions in

response to a World Trade Organization (‘‘WTO’’) ruling that both the ETI regime

and FSC transition rules contained in the ETI statute violate existing WTO agreements. Failure to preserve transition benefits for FSC/ETI leases would create a

competitive disadvantage for U.S. financial institutions and have a serious negative

impact on U.S. companies that have structured lease agreements in reliance on existing law. Appropriate transition rules should be provided to preserve the total FSC

and ETI benefit contemplated by the parties for transactions closed prior to enactment of any FSC and ETI repeal legislation.

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Other provisions:

‘‘Working Capital’’ Exception to Subpart F. Fluctuations in a CFC’s working capital held in the active conduct of a trade or business should not result in FPHCI

that is currently taxed under subpart F.

Application of look-through rules to interest, rents or royalties for purposes of the

FTC. Extend the look-through treatment applicable to dividends from 10/50 companies to any interest, rent, or royalty received or accrued from a 10/50 company.

Ordering rules for FTC carryovers. FTCs used in a taxable year would be treated

as used first from carry-forwards to such year. To provide further relief, consideration should be given to extending the carryback period to three years.

Active financial services income. The rules that permit U.S.-based financial services companies to defer U.S. tax on the active financial services income of a CFC

(the active financing exception to the anti-deferral rules of subpart F) were extended

in 2002 for five years. These rules, which are permanent fixtures of the Internal

Revenue Code for most other non-financial U.S.-based multinationals and are the

norm for foreign-based competitors, should be made permanent.

Election not to use average exchange rate for foreign tax paid in a nonfunctional

currency. Permit an election to determine the amount of foreign taxes paid at the

exchange rate in effect on the date of payment rather than the average exchange

rate for the taxable year, if the liability for such taxes is denominated in any currency other than the taxpayer’s functional currency (with regulatory authority to

make the election available with respect to a qualified business unit).

Application of uniform capitalization rules to foreign persons. The uniform capitalization rules should apply to foreign taxpayers only for purposes of taxing income

effectively connected with the conduct of a U.S. trade or business, if the taxpayer

capitalizes costs of produced property or property acquired for resale in accordance

with the method used in its financial statements.

Clarification of the financial services basket. The scope of the financial services

basket should be clarified to include all income from all activities that relate to the

active conduct of a banking, insurance, financing, or similar business. Current law

can create anomalies in which financial services income is not necessarily treated

as financial services basket income. For example, under Treasury regulation section

1.904–6(a)(1)(iv), differences between the U.S. tax base and that of foreign countries

can create non-financial services basket income for financial services companies.

This ‘‘base difference’’ rule should be clarified so that income and related FTCs relating to base differences are treated as financial services basket income for financial services companies.

RESPONSES TO QUESTIONS FROM SENATOR GRASSLEY

Questions 1. I was interested in your testimony that FSC–ETI repeal should not

discriminate against companies with foreign activities and should be coupled with

international tax reform. Would you support a proposal that helps U.S. manufacturing without this discrimination, especially if it was coupled with international reform?

Answer. Yes, we would support such a proposal, BUT ONLY if it were coupled

with significant international reform.

Dow strongly supports measures that make U.S. manufacturing and U.S. companies competitive in international markets. In particular we have long supported fast

capital cost recovery, the R&D credit, FSC/ETI and international tax reform. Each

individual element addresses a different aspect of competitiveness and each is important, but none is sufficient alone. When FSC/ETI is repealed, reform of our outmoded international tax provisions is the most critical item the Congress must address. Our current international tax rules create significant competitive disadvantages for U.S. based multinational companies. When combined with the clear relationship between increases in the foreign operations of such companies and their exports from and jobs in the United States, international tax reform must take priority. Furthermore, focusing solely on manufacturing is misplaced to the extent that

it detracts from Congress’ need to consider the full range of U.S. businesses that

currently utilize FSC/ETI. Because the ability to compete worldwide is critical to our

capacity to retain and grow our job base in the United States, we believe that revenue constraints should be resolved in favor of coupling ETI repeal with reform of

our international tax laws.

Question 2. You mention your foreign tax credit problems. How much of this is

caused by the interest allocation rules?

Answer. Dow’s current foreign tax credit problem is primarily caused by the effect

of domestic losses on our foreign tax credit limitation. Those losses and the lack of

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a domestic loss recapture provision have created excess credits and effectively shortened the carryforward period in which we can use such credits.

The use of worldwide interest allocation rather that the current interest allocation

rules would have reduced our current excess foreign tax credits by approximately

11%. This understates the effect somewhat because in 2000 and 2001 Dow had a

net operating loss and the interest allocation rules had no effect. On a long-term

basis we estimate that moving to worldwide interest allocation, not taking into account the repeal of FSC/ETI, would change our normal foreign tax credit position

from excess credits of $30 million per year to excess limitation of $10 million per

year.

Question 3. Repeal of the foreign base company rules will cost around $37 billion.

Is there a more targeted way to fix the problems you are having with these rules?

Answer. The most promising alternative we know of is the provision in the bill

recently introduced by Senator Hatch (although we do not know the potential revenue cost). That provision would repeal the foreign base company sales and services

rules for income derived from foreign-to-foreign transactions, transactions covered

by an Advanced Pricing Agreement with the IRS, or from transactions with countries with whom the U.S. has a comprehensive income tax treaty which includes an

exchange of information program (excluding the Barbados treaty in force on July 28,

2003), subject to an exception for ‘‘round-tripping.’’ C–FIT companies are currently

focusing on these provisions.

Question 4. Would you explain in more detail your problem with foreign oil & gas

pipeline transportation?

Answer. This is not an issue we face, but an oil company member of C–FIT has

described an example where subpart F inappropriately triggers current income, involving the pipeline transportation of oil from a landlocked country to a contiguous

country with a seaport.

Question 5. On your suggestion regarding payments between related controlled

foreign corporations, how can we be certain that repealing these rules will not result

in abuses?

Answer. Dow is normally in a ‘‘balanced’’ or slight excess foreign tax credit position. As a result these provisions often have little actual effect on our U.S. tax. However, they do add substantial complexity to how we structure legal entities, and to

decisions regarding intercompany transactions between such entities. By triggering

U.S. taxation of active business income when subsidiaries make crossborder payments, current law penalizes U.S.-based multinationals for responding to market or

investment opportunities by redeploying active foreign earnings among foreign businesses conducted through multiple CFCs.

Providing look-through treatment for payments between related CFCs properly focuses subpart F on the underlying activities that generated the income, rather than

the business form used. As revised, the code would continue to tax nonactive, mobile

income. Section 367 and the intercompany pricing rules protect the U.S. against attempts to transform U.S. or passive income into active income, such as the artificial

transfer from the U.S. of intangible property.

Furthermore, far from creating a potential for abuse of U.S. rules, eliminating the

foreign-to-foreign related party rules would encourage U.S. taxpayers to reduce their

foreign tax liability, ultimately reducing the amount of foreign tax credits claimed

against U.S. tax liability.

Question 6. I read that you want transition for the FSC–ETI rules. What, in your

view, is a reasonable transition period?

Answer. Dow believes that a two-year transition period is reasonable, particularly

based on testimony provided to the Finance Committee by U.S. Trade Representative General Counsel John Veroneau, on July 8. Current FSC/ETI users like Dow

would suffer economic harm if the Congress departs from its general practice of including grandfather provisions to cover taxpayers that utilized the ETI rules to facilitate exports. As a member of C–FIT, we also support grandfather provisions comparable to those when ETI was enacted in 2000, along with equivalent transition

relief, including an extension to leasing transactions that qualified under ETI. C–

FIT companies believe taxpayers in these ETI transactions fairly priced their leases

in reliance on an assessment of Congressional intent—as reflected in the legislative

history—that the law in effect when the transactions were closed complied with the

WTO obligations of the United States.

Question 7. I see that you receive FSC–ETI benefits of $38 million a year. How

many percentage points does FSC–ETI reduce your tax liability?

Answer. Expressing FSC–ETI benefits as a tax percentage rate can be highly misleading. Similar amounts of FSC–ETI benefits can produce significantly different

tax percentages because such percentages depend on the amount of net income

earned in a year and where that income was earned. Companies like Dow in cyclical

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industries, often find their tax liabilities widely variable from year to year. FSCETI

benefits are more stable.

On average, for the past five years, the FSC–ETI benefit has reduced Dow’s global

tax rate by 3.2%. However, for years of more normal profitability, the FSC–ETI benefit is 1.5% to 2.0%.

Question 8. What percentage of your manufacturing is done outside the U.S. as

opposed to within the U.S.?

Answer. Approximately 43% of Dow’s manufacturing is done outside the united

States. Non-U.S. sales are 59% of total sales.

Dow is a capital intensive manufacturing company. The best measure of the manufacturing Dow conducts in the United States is the percentage of our long-lived assets located here. In 2002, 57% of our long-lived assets were located in the United

States.

Question 9. To what degree are your U.S. operations dependent on your

foreignsales?

Answer. Dow’s U.S. exports have historically remained stable at about 15% of

Dow’s non-U.S. sales. As Dow’s non-U.S. sales and operations grew, so did our exports. After the acquisition of Union Carbide Corporation, the U.S. exports/non-U.S.

sales ratio increased to 20%.

In 2002 Dow had a positive U.S. trade balance of approximately $2.6 billion.

In addition many functions performed in the United States support foreign as well

as United States sales. R&D is a good example. In 2002 Dow had 4500 R&D positions in the United States. R&D for Dow is constant at about 4% of sales. Without

the 59% of our sales that are foreign, we could not fund as much R&D and 2250

or about 50% of the U.S. R&D positions would be in jeopardy.

Question 10. Company X manufactures widgets in the United States for sale in

the United States and abroad. It forms a subsidiary, Y, in a zero-tax jurisdiction

such as Bermuda to serve as a trading company. Y hires 200 persons in Hamilton.

Widgets are sold by X to Y for $100, and Y re-sells the widgets (without changing

them) for $125 for unrelated parties in the United States and throughout the rest

of the world. The transfer price from X to Y is defensible. The $25 earned by Y is

attributable to economic functions that Y performs in Bermuda. Should the United

States currently tax that $25? Why or why not?

Answer. The United States should not automatically tax the $25 before it is repatriated. In this example the functions performed in the trading company constitute

an active business, are substantial and justify the profit earned. The location of

those activities should not be determinative of whether to impose current tax.

The rule that would trigger income under current law was written in the absence

of a well-developed transfer-pricing regime, when it was possible for taxpayers to

seek to shift profits to low-taxed foreign sales subsidiaries. The policy concern was

not focused on the movement abroad of an income-producing activity, but rather on

the inability of the old rules to ensure that U.S. income was not being over-allocated

to the foreign jurisdiction. The legislative history of the base company sales rules

include no suggestion indicating the mere fact that a sales function might be easily

located overseas is in and of itself a basis for imposing U.S. tax on the sales income.

Thus, for example, a CFC’s home-country sales income has never been subject to

the base company rules.

The development of transfer-pricing regimes in the United States and around the

world has greatly reduced the concern that taxpayers will be able to shift more income out of U.S. taxing jurisdiction than is justified by their foreign activities. I

would also note that subpart F does not currently apply to most active business operations in low-taxed countries; the real issue is the identification of cases in which

the principle of deferral may be subject to abuse. For example, in your fact pattern,

it appears that some of the property is ‘‘round tripping’’—produced and sold in the

United States, a fact that may indicate tax avoidance as the predominant motive

for the exportation of that property.

PREPARED STATEMENT OF HON. ORRIN G. HATCH

Thank you for scheduling this second hearing on the competitiveness implications

of our international tax rules, Mr. Chairman. Last week we concentrated on domestic companies and U.S. subsidiaries of foreign corporations. This week we are focusing on the effect of these rules on U.S.-based multinational companies.

This Committee faces a major challenge in connection with the WTO’s ruling that

our FSC/ETI tax provisions are illegal trade subsidies. While it is clear that we

must repeal FSC/ETI, it is not as clear how we can best craft tax provisions that

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not only help our companies deal with the loss of these benefits, but also keep U.S.

workers and their employers the most productive and most competitive in the world.

As we heard from some of the witnesses at last week’s hearing, proposals have

already been developed to help domestic manufacturers cope with the repeal of FSC/

ETI by providing an exemption that would lower their effective tax rate. One such

proposal enjoys the bipartisan support of more than 120 House members.

While I am certainly not opposed to lowering tax rates on U.S. manufacturers,

I am convinced that such a solution, by itself, is not adequate. This is because it

ignores the very real problems our tax code presents to U.S. businesses that expand

overseas. I will not take the time now to go into detail about those problems, but

this Committee has examined them before, and we will hear more about them

today.

The point I wish to make, Mr. Chairman, is that as we decide how to reallocate

the FSC/ETI benefit, which we must do, we should strive to pass tax provisions that

would increase the ability of all American firms to compete and gain in productivity,

both those just at home and those which also operate abroad.

There is a false notion we hear from time to time that if we make it easier for

U.S. companies to operate effectively on a worldwide basis, we are making them

more likely to move U.S. jobs abroad. I believe just the opposite is true—that making U.S. firms more competitive worldwide increases the quality and quantity of

American jobs.

Mr. Chairman, I plan to introduce legislation later this month that would repeal

the FSC/ETI provisions and provide significant incentives for increased productivity

here at home and greatly improved competitiveness of American firms around the

globe, while also simplifying the tax code. This bill will build on legislation I previously introduced with Ranking Democrat Baucus.

The issues before the Committee are very significant for the future of our commercial leadership in the world, as well as the prosperity of our people, for decades

to come. I look forward to listening to the witnesses and exploring these issues in

further detail.

PREPARED STATEMENT OF JAMES R. HINES, JR.

Mr. Chairman and Members of this distinguished Committee, my name is James

R. Hines Jr. I am Professor of Economics, Public Policy, and Business Economics

at the University of Michigan, where I am also Research Director of the Office of

Tax Policy Research. I am a Research Associate of the National Bureau of Economic

Research, and the Research Director of the International Tax Policy Forum. I am

honored to have the opportunity to participate in these hearings on the effect of U.S.

tax policy and its impact on the competitiveness of U.S.-owned foreign corporations.

The contribution of the U.S. tax system to the competitiveness of American multinational firms and the performance of the U.S. economy has been the subject of extensive analysis and rethinking in recent years. What we have learned can be summarized in two points. The first is that the ownership and activities of multinational

corporations are highly sensitive to taxation, much more so than what was previously believed to be the case. The second is that the competitiveness of the world

economy has the potential to change everything we think about the features that

characterize tax systems that promote economic efficiency. Together, these two findings carry dramatic implications for the kinds of tax policies that advance the competitiveness of U.S.-owned firms, the well-being of Americans, and the productivity

of the world economy.

Much of the current structure of U.S. taxation of foreign income dates to the early

1960s, when the world economy looked very different than it does today. The United

States taxes the worldwide incomes of American companies, granting foreign tax

credits for foreign income taxes paid, and permits taxpayers to defer U.S. taxation

of certain kinds of active foreign income. At the time it was enacted, this structure

was thought to promote global economic efficiency. Most observers are considerably

less confident now that this kind of tax system, embedded, as it is, in a world economy in which many other countries exempt foreign income from taxation, contributes to the efficiency of resource allocation. The most recent research suggests just

the opposite—that the U.S. effort to subject foreign income to taxation at the same

(total) rate as domestic income is likely to reduce the productivity of the world economy and the well-being of Americans.

These are difficult concepts, particularly since the tax policy stance that the

United States has maintained over the last 40 years, increasingly to our detriment

and to the detriment of the world economy, nonetheless has considerable intuitive

appeal. It is helpful, therefore, to parse this issue first by evaluating the impact of

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U.S. taxation on the position of American firms operating abroad, and second by

considering the implications for the design of U.S. tax policies.

Taxation and the competitiveness of American firms

Business income earned abroad by American firms is subject to taxation by the

United States, whereas business income earned abroad by firms based in other

countries is often not subject to taxation by their home governments. Major capitalexporting countries such as Germany, France, Canada, the Netherlands, and Australia effectively exempt most or all of the foreign income earned by their companies. To be sure, some other countries, including Greece, Italy, Japan, Norway, and

the United Kingdom, tax the foreign business incomes of their resident companies,

but even these countries do not impose the kind of strict foreign tax regime that

the United States does.

These differences influence the competitiveness of American firms in certain foreign markets. Firms from countries that exempt foreign income from taxation have

the most to gain from locating their foreign investments in low-tax countries, since

such investors benefit in full from any foreign tax savings. Firms from countries

(such as the United States) that tax foreign profits while providing foreign tax credits may benefit very little (in some cases not at all) from lower foreign tax rates,

since foreign tax savings are offset by reduced foreign tax credits and therefore

higher homecountry taxation. These relative tax incentives therefore create incentives for investors from countries that exempt foreign income from taxation to concentrate their investments in low-tax countries, leaving investors from countries

that tax foreign income while providing foreign tax credits more heavily concentrated in high-tax countries.

There is considerable evidence that the patterns of ownership associated with foreign investment respond to these incentives created by home-country tax regimes.

Taxation within the United States offers one such example. Recent research compares the location of investment in the United States by foreign investors whose

home governments grant foreign tax credits for federal and state income taxes with

the location of investment by those whose home governments do not tax income

earned in the United States. Firms that are able to claim credits against their

homecountry tax liabilities for state income taxes paid in the United States should

be much less likely than others to avoid high-tax states. The evidence bears this

out: Japanese and British investment in the United States is concentrated in hightax states, whereas German, French, Dutch, and Australian investment in the

United States is concentrated in low-tax states. The difference is in large part attributable to the ability of Japanese and British firms to claim credits in their home

countries for taxes paid to U.S. states.

The lesson of American states is applicable to U.S. investment abroad. Since the

United States taxes the foreign incomes of American companies and permits a foreign tax credit for income taxes paid to foreign governments, American firms may

receive very little benefit from the low tax rates available in some foreign countries,

since income earned in such countries produces sizable U.S. tax liabilities. As a result, German, French, or Dutch firms, that do benefit from low tax rates available

in some foreign countries, are at times able to outbid their American competitors

for foreign acquisitions or other investments based solely on tax advantages.

More detailed provisions of U.S. and foreign taxation of foreign income can

produce dramatic examples of the impact of our tax system on the competitiveness

of American firms. One such example is provided by ‘‘tax sparing.’’ Most high-income countries other than the United States include ‘‘tax sparing’’ clauses in the

treaties that they sign with many developing countries, but the United States has

steadfastly declined to do so. ‘‘Tax sparing’’ is the practice by which capital exporting countries amend their taxation of foreign source income to allow firms to retain

the advantages of tax reductions provided by host countries. Specifically, ‘‘tax sparing’’ often takes the form of allowing firms to claim foreign tax credits against homecountry tax liabilities for taxes that would have been paid to foreign. governments

in the absence of special abatements. Since foreign tax credits are then based on

tax obligations calculated without regard to taxes actually paid, any special tax

breaks offered by host country governments enhance the after-tax profitability of

foreign investors and are not simply offset by higher homecountry taxes.

Japan permits its firms to claim ‘‘tax sparing’’ credits for investments in certain

developing countries, while the United States does not. Recent research compares

patterns of Japanese and American foreign investment over the same time period.

Holding other considerations constant, it follows that, to the extent that ‘‘tax sparing’’ is effective, Japanese firms should exhibit greater willingness than American

firms to invest in developing countries. In addition, Japanese firms should be more

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likely than are Americans to receive special tax breaks from countries with whom

Japan has ‘‘tax sparing’’ agreements.

The evidence indicates that ‘‘tax sparing’’ is effective in stimulating foreign investment. Japanese firms locate a much higher fraction of their foreign investment in

countries with whom Japan has ‘‘tax sparing’’ agreements than do American firms.

Furthermore, host governments appear to grant Japanese firms significant tax reductions that are not available to their American counterparts. Holding constant

other considerations, ‘‘tax sparing’’ agreements are associated with 140 percent

higher foreign investment levels by Japanese firms than by American firms, and 23

percent lower tax rates imposed on Japanese rather than American investors.

The details of the foreign tax credit calculation method offers another insight into

the impact of the U.S. tax system on the competitiveness of American firms operating abroad. The foreign tax credit is limited to the amount of U.S. tax that would

otherwise be due on foreign income. Taxpayers are permitted to add together different sources of foreign income in calculating their foreign tax credit limits, but

only within ‘‘baskets’’ of income types. These ‘‘baskets’’ were introduced with the

idea that they would prevent widespread avoidance of U.S. taxes by taxpayers

claiming foreign tax credits, but in practice they have contributed greatly to the

complexity and inefficiency of the U.S. tax system. Notably, other countries that tax

foreign income have not been eager to copy the U.S. ‘‘basket’’ system.

The Tax Reform Act of 1986 required that the income from each foreign corporation owned between 10 and 50 percent by Americans be placed in a separate ‘‘basket’’ for the purpose of calculating the foreign tax credit limit. This provision imposes a potentially quite large tax cost on American firms participating as minority

or 50 percent partners in international joint ventures. While some joint venture operations could be restructured to avoid the punishing impact of this provision, others could not, and as a result, American firms were uniquely disadvantaged in competition with firms from other countries to participate in international joint ventures. This disadvantage was particularly pronounced in the case of joint ventures

operating in low-tax foreign countries.

American participation in international joint ventures fell sharply after 1986 as

a consequence of the separate ‘‘basket’’ rules introduced by the Tax Reform Act of

1986. Figure 1 illustrates this decline in joint venture participation. Partly in response, Congress in 1997 changed (on a phased-out basis over a number of years)

the separate ‘‘basket’’ treatment of international joint ventures, removing some (but

not all) of the special tax cost associated with international joint venture participation by American companies. Separate ‘‘baskets’’ continue to be used to calculate foreign tax credit limits for such items as passive income, shipping income, and financial services income, and there is ample evidence that this treatment penalizes and

thereby discourages American firms from participating in business ventures that are

attractive to foreigners and would otherwise be attractive to Americans.

The U.S. tax system differs sharply from the systems used by other countries to

tax their multinational firms. The impact of the unwillingness of the United States

to grant ‘‘tax sparing’’ for investments in developing countries, or the use of separate

‘‘baskets’’ used to calculate foreign tax credit limits, while interesting in themselves,

more importantly serve as illustrations of the effects of the U.S. tax system. Those

who study the available quantitative information on the effect of the U.S. tax system do not doubt that it has an important influence on the behavior of taxpayers

and the positioning of American firms in the global economy. The question that we

face is how this insight should be used to enlighten American tax policy.

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Analysis of taxing foreign income

Until relatively recently, there was a commonplace belief that the U.S. policy of

taxing foreign income while granting foreign tax credits was if anything too generous from the standpoint of advancing American interests, and could be justified

only as a gesture that advances well-being around the world. This belief persisted

in spite of the differing practices of so many other countries, and the evident impact

of American tax policy on the foreign business activity of U.S.-owned firms. In recent years those who think about these questions have come to some very different

conclusions, but in order to understand the latest thinking on these issues, it is

helpful to appreciate what we used to believe, and where it has gone wrong.

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An older framework for evaluating policy

Capital export neutrality (CEN) is the doctrine that the return to capital should

be taxed at the same total rate regardless of the location in which it is earned. If

a home country tax system satisfies CEN, then a firm seeking to maximize aftertax returns has an incentive to locate investments in a way that maximizes pre-tax

returns. This allocation of investment corresponds to global economic efficiency

under certain circumstances. The CEN concept is frequently invoked as a normative

justification for the design of tax systems similar to that used by the United States,

since the taxation of worldwide income with provision of unlimited foreign tax credits satisfies CEN. This is not exactly the system that the United States uses, since

taxpayers are permitted to defer home country taxation of certain unrepatriated foreign income, and foreign tax credits are subject to various limits. Nonetheless, CEN

is often used as a normative benchmark against which to evaluate contemplated

changes to the U.S. system of taxing foreign income, since tax systems that satisfy

CEN are thought to enhance world welfare.

The standard analysis further implies that governments acting on their own,

without regard to world welfare, should tax the foreign incomes of their resident

companies while permitting only a deduction for foreign taxes paid. Such taxation

satisfies what is known as national neutrality (NN), discouraging foreign investment by imposing a form of double taxation, but doing so in the interest of the home

country that disregards the value of tax revenue collected by foreign governments.

From the standpoint of the home country, foreign taxes are simply costs of doing

business abroad, and therefore warrant the same treatment as other costs. The

home country’s desired allocation of capital is one in which its firms equate marginal after-tax foreign returns with marginal pretax domestic returns, a condition

that is satisfied by full taxation of foreign income after deduction of foreign taxes.

This line of thinking suggests that the American policy of taxing foreign income

while granting foreign tax credits fails to advance American interests because it

treats foreign income too generously. In this view there is a tension between tax

policies that advance national welfare (NN) by taxing after-tax foreign income, and

those that advance global welfare (CEN) by taxing foreign income while permitting

taxpayers to claim foreign tax credits. The practice of much of the world, including

Germany, France, Canada, and the Netherlands, that effectively exempts foreign income from taxation, is, by this reasoning, difficult to understand, since it is inconsistent with either national or global interests.

The third of the standard efficiency principles is capital import neutrality (CIN),

the doctrine that the return to capital should be taxed at the same total rate regardless of the residence of the investor. Pure source-based taxation at rates that differ

between locations can be consistent with CIN, since different investors are taxed (at

the corporate level) at identical rates on the same income. In order for such a system to satisfy CIN, however, it is also necessary that individual income tax rates

be harmonized, since CIN requires that the combined tax burden on saving and investment in each location not differ between investors. While CEN is commonly

thought to characterize tax systems that promote efficient production, CIN is

thought to characterize tax systems that promote efficient saving. Another difference is that CIN is a feature of all tax systems analyzed jointly, whereas individual country policies can embody CEN or NN. As a practical matter, since many

national policies influence the return to savers, CIN is often dismissed as a policy

objective compared to CEN and NN.

It is important to clarify that there are important assumptions built into the

standard normative framework that delivers CEN and NN as global and national

welfare criteria, and in particular, it is critical that foreign firms are assumed not

to respond to changes induced by homecountry taxation. Realistically, however, investment by domestic firms at home and abroad may very well influence investment

by foreign firms, a scenario that is inconsistent with the logic underlying CEN and

NN. If greater investment abroad by home-country firms triggers greater investment by foreign firms in the home country, then it no longer follows that the home

country maximizes its welfare by taxing foreign income while permitting only a deduction for foreign taxes paid. From the standpoint of global welfare, if home and

foreign firms compete for the ownership of capital around the world, and the productivity of an investment depends on its ownership, then it is no longer the case that

the taxation of foreign income together with the provision of foreign tax credits necessarily contributes to productive efficiency.

Modern thinking on the desirability of taxing foreign income

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ership patterns. It is easiest to understand the welfare properties of CON by considering the extreme case in which the total stock of physical capital in each country

is unaffected by international tax rules. In this setting, the function of foreign direct

investment is simply to reassign asset ownership among domestic and foreign investors. If the productivity of capital depends on the identities of its owners (and there

is considerable reason to think that it does), then the efficient allocation of capital

is one that maximizes output given the stocks of capital in each country. It follows

that tax systems promote efficiency if they encourage the most productive ownership

of assets within the set of feasible investors.

Consider the case in which all countries exempt foreign income from taxation.

Then the tax treatment of foreign investment income is the same for all investors,

and competition between potential buyers allocates assets to their most productive

owners. Note that what matters for asset ownership is comparative advantage rather than absolute advantage: if French firms are always the most productive owners

of capital, but they do not have the resources necessary to own everything, then efficiency requires that French firms own the capital for which their rate of return difference with the rest of the world is the greatest. The United States would reduce

world welfare by taxing foreign income while permitting taxpayers to claim foreign

tax credits, since such a system encourages American firms to purchase assets in

high-tax countries and foreign firms to purchase assets in low-tax countries. These

tax incentives distort the allocation of ownership away from one that is strictly associated with underlying productivity differences.

CON is satisfied if all countries exempt foreign income from taxation, but the exemption of foreign income from taxation is not necessary for CON to be satisfied

in this particular case. If all countries tax foreign income (possibly at different

rates), while permitting taxpayers to claim foreign tax credits, then ownership

would be determined by productivity differences and not tax differences, thereby

meeting the requirements for CON. In this case the total tax burden on foreign and

domestic investment varies between taxpayers with different home countries, but

every investor has an incentive to allocate investments in a way that maximizes

pretax returns. More generally, CON requires that income is taxed at rates that,

if they differ among investors, do so in fixed proportions. Thus, CON would be satisfied if investors from certain European countries face home and foreign tax rates

that are uniformly 1.2 times the tax rates faced by all other investors.

In order for the allocation of capital ownership to be efficient it must be the case

that it is impossible to increase output by trading capital ownership among investors. This efficiency condition requires not necessarily that capital be equally productive in the hands of each investor, but that the potential gain of reallocating

ownership to a higher-productivity owner be exactly equal to the cost of such a reallocation by offsetting ownership changes elsewhere. Since , taxpayers allocate

their investments to maximize after-tax returns, the marginal dollar spent on new

investments by any given investor must yield the same (expected, risk-adjusted)

after-tax return everywhere. It follows that, if net (host country plus home country)

tax rates differ between investments located in different countries, marginal investments in high-tax locations must generate higher pre-tax returns than do marginal

investments in low-tax locations. Selling an asset in a low-tax location and purchasing an investment in a high-tax location increases output by the firm engaging

in the transaction, but (generally) reduces output by the firm on the other side of

this transaction. If both parties face the same tax rates, or face taxes that differ

in fixed proportions from each other, then CON is satisfied, ownership reallocation

would have no effect on total productivity, and the outcome is therefore efficient.

If some countries tax foreign income while others do not, then it is impossible to

restore CON without bringing them all into alignment, though individual countries

have the potential to improve global welfare by moving their taxation of foreign income into conformity with an average global norm.

The welfare implications of CON are less decisive in settings in which the location

of plant, equipment, and other productive factors is mobile between countries in response to tax rate differences. Tax systems then determine the location of production as well as patterns of ownership and control, so the net effect of taxation on

global welfare depends on the sum of these effects. There is considerable statistical

evidence that international tax rate differences influence the location of property,

plant and equipment investment, which conforms to anecdotal accounts of tax-motivated investment in low-tax locations such as Singapore and Ireland. Hence pure

source-based taxation at rates that differ between countries may encourage excessive investment in low-tax countries, even though it would satisfy CON. If one country were then to tax foreign income while providing foreign tax credits, it would

have the effect of reducing the welfare cost of real capital misallocation, but do so

at the cost of distorting the ownership and operation of industry. Whether the cost

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of having too many factories in the Bahamas is larger or smaller than the cost of

discouraging value-enhancing corporate acquisitions is ultimately an empirical question, though the importance of ownership suggests that the attendant welfare impact of distorting ownership allocation can be very large.

The welfare properties of CON emphasize the allocation of ownership of a given

volume of business activity between locations whose tax attributes differ. The taxation of foreign income also has the potential to influence rates of national saving

and the sizes of domestic firms, though this effect is not explicitly incorporated in

the analysis. National saving is affected by a large range of public policies including

monetary policy, intergenerational redistribution programs such as social security,

the taxation of personal income, estate taxation, and other policies that influence

the discount rates used by savers. Business activity is likewise influenced by a host

of fiscal, monetary, and regulatory policies. Given these various factors that influence national saving and corporate investment, it is appropriate to analyze the optimal taxation of foreign v. domestic income separately from the question of how

much governments should encourage capital accumulation and total investment of

home-based firms.

The same circumstances that make CON desirable from the standpoint of world

welfare also imply that countries acting on their own, without regard to world welfare, have incentives to exempt foreign income from taxation no matter what other

countries do. The reason is that additional outbound foreign investment does not reduce domestic tax revenue, since any reduction in home-country investment by domestic firms is offset by greater investment by foreign firms. With unchanging domestic tax revenue, home-country welfare increases in the after-tax profitability of

domestic companies, which is maximized if foreign profits are exempt from taxation.

Tax systems that exempt foreign income from taxation can therefore be said to satisfy ‘‘national ownership neutrality’’ (NON). Hence it is possible to understand why

so many countries exempt foreign income from taxation, and it follows that, if every

country did so, capital ownership would be allocated efficiently and global output

thereby maximized.

National welfare is maximized by exempting foreign income from taxation in cases

in which additional foreign investment does not reduce domestic tax revenue raised

from domestic economic activity. This condition is satisfied if, to the extent that

marginal foreign investment reduces domestic investment by domestic firms, it triggers an equally productive amount of new inbound investment from foreign firms.

In more general cases, the welfare-maximizing tax treatment of foreign investment

depends on the extent to which foreign investment substitutes for domestic investment lost due to new outbound FDI, and the relative productivities of foreign-owned

and domestic-owned capital in the home country. If foreign investment and domestic

investment are equally productive in the home country, but inbound foreign investment replaces only 75 percent of domestic investment lost due to outbound FDI,

then the analysis implies that the optimal home-country policy is to tax 34 percent

of the after-tax foreign income earned by home-country firms.

Implications for American tax policy

There is extensive evidence that tax systems influence the magnitude and composition of international economic activity, and there is good reason to believe that

improved tax design has the potential to enhance the performance of national economies. The welfare principles that underlie the U.S. taxation of foreign income rely

on the premise that direct investment abroad by American firms reduces the level

of investment in the United States, since foreign competitors are assumed not to

react to new investments by Americans. It follows from this premise that the opportunity cost of investment abroad includes foregone domestic economic activity and

tax revenue, so national welfare is maximized by taxing the foreign incomes of

American companies, whereas global welfare is maximized by providing foreign tax

credits. If, instead, direct investment abroad by American companies triggers additional investment in the United States by foreign companies, which is likely in a

globally competitive market, then entirely different prescriptions follow. National

welfare is then maximized by exempting foreign income from taxation (NON), and

global welfare is maximized by conformity in the systems of taxing foreign income

among capital-exporting countries (CON).

It is tempting to think of international tax differences as influencing the location

of economic activity rather than determining the ownership of assets around the

world. In fact tax systems do both, but given the central importance of ownership

to the nature of multinational firms, there is good reason to be particularly concerned about the potential for economic inefficiency due to distortions to ownership

patterns. Tax systems that satisfy CON ensure that the identities of capital owners

are unaffected by tax rate differences, thereby permitting the market to allocate

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ownership rights to where they are most productive. Proposed and pending international tax reforms in the United States have the potential to affect national and

global welfare. In order to evaluate these tax reforms properly, it is necessary to

consider their implications for patterns of capital ownership throughout the world.

RESPONSES TO QUESTIONS FROM SENATOR GRASSLEY

Question 1. What are the latest trends in international competitiveness and what

do they mean for the U.S. economy?

Answer. The world economy continues to grow more competitive, reflecting a trend

that has persisted certainly since the early 1970s and very likely prior to that. The

strength of American exports and American firms operating in foreign markets depends in part on the performance of foreign economies, which we do not control. The

world economy is still reacting to the events of the last decade and early part of

this decade, including the financial crises in Asia, South America, Russia, and elsewhere, the U.S. recession and stock market reversal, slow European growth, and

continued Japanese stagnation. The weak performance of foreign economies has reduced demand for U.S. exports and contributed to the U.S. current account deficit

and a falling value of the U.S. dollar. While foreign economies can be expected to

grow in strength in the coming years, this growth is likely to be gradual; individual

foreign firms with which American firms compete, however, have shown considerable innovativeness and ability to capture market shares around the world.

What these trends imply is that the U.S. economy needs to grow in strength in

order to maintain its competitive position in the world. This has been true throughout the postwar era and is certainly no less true now. What tax policy can do to

foster such growth is to provide American companies with efficient incentives and

appropriate total tax burdens.

Question 2. We need to understand how reforming our international tax laws benefit the everyday American. We often hear that reforming our international tax laws

will cause jobs to leave the United States. Do you know of any data or studies addressing this issue?

Answer. I agree that one often hears that efficiency-enhancing reforms might

cause jobs to leave the United States. But in fact, the opposite is the case: U.S. tax

reforms that improve the efficiency of the economy make the country more productive and thereby increase the demand for labor (and land) located here, which translates into more employment and higher wages.

The key to helping American workers is to adopt policies that enhance the productivity of labor in the United States, and to avoid policies that reduce productivity.

All around the world, as well as within the United States, greater productivity is

associated with higher wages and lower levels of unemployment. What does this

have to do with tax policy? Tax laws that give firms inefficient incentives reduce

the productivity of resources that firms use to produce output—and labor is the primary resource that firms use.

The question asks about studies. The most important and influential study of this

issue is by Peter Diamond (of MIT) and James Mirrlees (of Cambridge University,

England), entitled ‘‘Optimal taxation and public production,’’ and published in the

March and June 1971 issues of the American Economic Review. This study is rather

abstract in its formulation, and its argument therefore somewhat difficult to follow.

Roger Gordon (of the University of California-San Diego) and I recently re-cast and

extended this argument, and attempted an accessible explanation, in our paper

‘‘International taxation,’’ published in the Handbook of Public Economics, volume 4,

Alan J. Auerbach and Martin Feldstein eds., (Amsterdam: North-Holland, 2002), pp.

1935–1995.

There are other empirical studies that attempt to examine directly the impact of

foreign investment on domestic and foreign employment levels. These empirical efforts are fraught with difficulties, most notably that the general equilibrium impact

of tax policies are impossible to evaluate by looking only at the employment practices of individual companies that invest abroad. While I usually prefer to analyze

the impact of tax policies using data from actual experience, I am unaware of any

reliable statistical evidence on this question. Since we have very powerful analytical

studies that address this question, and they offer unambiguous answers, I believe

that we should rely on their implications instead.

Question 3. You state that American companies do not benefit from the low tax

rates in some countries because we use a worldwide system of taxation. But what

about the benefit of deferral? We generally don’t tax active business income until

it is brought home. If a company can defer bringing it back for a long time, they

pay a low effective U.S. tax when you consider the present value of those future

payments. Do you have any comment?

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Answer. It is true that the United States permits companies to defer U.S. taxes

on certain unrepatriated foreign profits, and that this deferral reduces the effective

U.S. tax rate on foreign income. There are, however, two important mitigating considerations to bear in mind. The first is that the U.S. Subpart F rules limit the ability of American taxpayers to benefit from deferral, so only certain types of foreign

income, and certain types of activities, permit a taxpayer to qualify for deferral. In

part due to this limitation, American firms repatriate roughly half of their after-foreign-tax profits in dividends each year, and effectively repatriate more than that in

the form of currently-taxed Subpart F income.

The second consideration is that the effective U.S. tax burden on foreign income

significantly exceeds the effective tax rate calculated on the basis of the present

value of U.S. tax payments. The reason is that firms undertake costly actions to

avoid U.S. taxes, and the costs of these actions are properly included in the total

burden imposed on foreign investment. All of international tax planning falls in this

category. For example, firms are often willing to accept lower returns on new foreign

investments financed out of retained foreign profits in order to defer repatriation

(and the accompanying U.S. taxes). A naı ̈ve calculation of the present value of taxes

would then significantly understate the ultimate burden borne by American firms

doing business abroad.

Taken together, these two considerations suggest that the ability to defer U.S.

taxation of foreign income, while partially mitigating the U.S. tax burden on foreign

income earned by American companies, leaves a substantial burden. There is ample

evidence that the behavior of American companies is affected by this burden; my

testimony, for example, discussed the impact of introducing the ‘‘10–50 basket’’ on

the reluctance of U.S. firms to participate in international joint ventures after 1986.

Question 4. In your testimony, you infer that lower taxes attract investment from

states using a territorial tax system. If we repeal FSC–ETI, we will increase the

tax rate on manufacturers in the U.S. Will that create disincentives for new investment in the U.S. manufacturing sector?

Answer. The impact of FSC–ETI repeal depends on how it is accomplished. If the

current ETI system were simply removed without adoption of any mitigating business tax reduction, then yes, business investment in the United States would be adversely affected. I might note that the impact would not be quite as severe as some

predict, since the removal of the ETI tax benefit will reduce the value of the U.S.

dollar, thereby partly compensating for the loss of tax benefits by helping American

exporters through another route.

If FSC–ETI repeal is part of a broad and sound package of revenue-neutral business tax reforms, then it should be expected to encourage investment in U.S. manufacturing. The reason is that efficient tax provisions make the United States a desirable place to invest. The current FSC–ETI system provides a more favorable tax

treatment of domestic economic activity directed at exports than it does domestic

economic activity directed at domestic sales, and as a consequence, it reduces efficiency somewhat. The resources that are currently devoted to export subsidies

would create greater economic value if they were used instead to reduce other

distortionary incentives created by the tax system.

Congress in reforming the FSC–ETI system has the opportunity to enhance efficiency and thereby improve the attractiveness of the United States as a place to invest. If FSC–ETI repeal is implemented without using the added tax revenue to reduce other business tax burdens, then the accompanying improvement in efficiency

will not be sufficient to offset the greater burden on domestic manufacturing. If, on

the other hand, the tax revenue generated by FSC–ETI repeal were to be used to

reduce other tax burdens on American businesses, and these reductions are chosen

wisely, then we can expect greater investment in American manufacturing as a result.

Question 5. Dr. Hines, in your testimony, you suggest the more traditional view

generally held in the U.S. is that foreign investment by American firms reduces the

level of investment in the U.S. Hence, many people believe we should tax the foreign income earned by U.S. companies on their overseas investment because it helps

to discourage American companies from moving U.S. jobs overseas. However, you

suggest there has been a gradual shift in thinking regarding the taxation of foreign

source income. Specifically, you state that if direct investment abroad by American

companies triggers additional investment in the U.S. by foreign companies, then the

U.S. would benefit by exempting foreign income of American companies.

What evidence do you have that U.S. investment abroad triggers additional foreign investment in the U.S.?

Answer. We have indirect evidence that bears on this question. The available evidence indicates that the vast majority of foreign direct investment consists of acquisitions of existing companies, and not so-called ‘‘greenfield’’ investments in which

74

new plant and equipment is acquired in order to start new companies or expand

old ones. This is consistent with modern theories of why firms undertake foreign direct investment: firms engage in foreign investment in order to exploit within-firm

economies that make it more profitable for certain owners, and not others, to control

foreign assets.

For a given total volume of business investment, the decision to acquire a foreign

business means foregoing the acquisition of a substitute domestic business. From

the standpoint of the economy as a whole, this leaves additional domestic businesses

available for acquisition by foreigners. This is the market implication of a foreign

direct investment process that is dominated by acquisitions of existing businesses.

It would be useful to buttress this conclusion with direct evidence of the impact

of outbound foreign direct investment on the level of foreign investment in the

United States. Unfortunately, there does not exist any reliable evidence of that sort,

so we are left to draw inferences from indirect evidence. The good news is that the

evidence we have is consistent with our theories of foreign direct investment, and

both point in the direction of U.S. investment abroad triggering greater foreign investment in the United States.

Question. Does this mean we should abandon our current system of taxing foreign

income and adopt the territorial used by many of our competitors?

Answer. Yes, the implication of thinking about foreign direct investment in a competitive world economic environment is that U.S. welfare would be enhanced by exempting foreign income from taxation. Adopting a territorial tax system would make

the U.S. economy more efficient and would thereby enhance the well-being of Americans.

Question 6. Company X manufactures widgets in the United States for sale in the

United States and abroad. It forms a subsidiary Y, in a zero-tax jurisdiction such

as Bermuda to serve as a trading company. Y hires 200 persons in Hamilton. Widgets are sold by X to Y for 100, and Y re-sells the widgets (without changing them)

for 125 to unrelated parties in the United States and throughout the rest of the

world. The transfer price from X to Y is defensible. The 25 earned by Y is attributable to economic functions that Y performs in Bermuda. Should the United States

currently tax the 25? Why or why not?

Answer. If the conditions posited by the question are in fact all satisfied, then no,

the United States should not tax the 25 earned by the firm in Bermuda. The reason

is that exempting foreign income from taxation improves the efficiency of the U.S.

economy. Attempts to tax the 25 would discourage foreign business activity on the

part of the U.S. manufacturing firm, and reduce its competitiveness relative to producers in other countries that are not taxed on their Bermuda profits. Over time,

the U.S. manufacturing firm will shrink in size as it is overtaken by these competitors. If, instead, the United States were to exempt the 25 from taxation, the manufacturer would be more productive, and the resources (200 employees) that it employs in Bermuda and would otherwise have employed in the United States could

instead be used by U.S. firms for whom they would be more productive. On net, this

would improve the productivity of American labor and capital, improving wages and

profit rates.

It is critical in answering this question that the 200 persons in Hamilton in fact

are adding economic value in a way that makes a return of 25 appropriate for their

actions. In the absence of arm’s length transactions against which to compare the

transfer price of 100 for the sale from the United States to Bermuda, the transfer

price must be properly evaluated in other ways. The question posits that the widgets have not changed during their period of Bermuda ownership, so presumably the

200 Bermuda employees are engaged in marketing and other sales-related (but not

manufacturing) services. If the return of 25 is appropriate for these activities, then

it should be exempted from U.S. taxation. If, instead, some of the 25 is more properly attributed to the U.S. manufacturing operation (and the appropriate transfer

price therefore somewhere between 100 and 125), then the domestic component of

the 25 should be subject to U.S. taxation, but this is really a transfer pricing issue

rather than one of the proper taxation of foreign income.

RESPONSE TO A QUESTION FROM SENATOR HATCH

Question. Professor Hines, in your testimony you seemed to be saying that if we

want to raise American productivity and American incomes, we ought to follow

something you call ‘‘capital ownership neutrality.’’ You say that if we care about increasing the American standard of living, then we should exempt most or maybe

even all overseas business profits from U.S. tax. I really find this idea intriguing.

Can you tell me more about how you think the U.S. could move toward such a system? And in particular, does the proposal that Senator Allen and Senator Boxer just

75

spoke about, this dividends-received deduction on repatriated earnings, start moving

us in that direction?

Answer. Tax systems satisfy ‘‘capital ownership neutrality’’ if they do distort the

worldwide pattern of capital ownership, thereby leaving market forces to determine

ownership. The proposal for a dividends-received deduction, about which Senators

Allen and Boxer spoke, would contribute only very little to capital ownership neutrality, for the simple reason that it is purely a temporary gesture. A permanent

and complete exemption of foreign dividends from U.S. taxation, along with some

other changes, would move the United States very strongly in the direction of national ownership neutrality and capital ownership neutrality. Temporary changes

would have very little impact on ownership patterns, and therefore would not trigger the kind of efficiency-enhancing ownership reallocations that make national

ownership neutrality and capital ownership neutrality desirable.

There are many other intermediate steps that the Congress might consider in

moving toward a system that is consistent with national ownership neutrality and

capital ownership neutrality. One might, for example, consider a permanent exemption from U.S. taxation of a certain fraction of foreign dividend income. This could

be coupled with changes in the foreign tax credit rules that simplify the system and

give taxpayers greater ability to apply credits for certain foreign taxes paid against

U.S. taxes due on other sources of foreign income. The Subpart F rules might also

be changed to permit deferral of U.S. taxation of foreign income in situations where

deferral is now not possible.

A broad range of options is available to Congress. In considering these and other

alternatives, I recommend that Congress guard against the natural urge to attempt

to eliminate apparent tax avoidance opportunities wherever they appear. The object

of sound tax policy is not to raise revenue at every turn. The object of sound tax

policy is to raise needed revenue in the most sensible way, which means not taxing

some economic activities and taxing others quite lightly. We do not do the United

States and the world economy a favor by imposing a tight regime of taxing the foreign incomes of American companies. We can take steps to reform this system in

a way that makes the economy more efficient, and thereby helps everyone, but doing

so entails changing the way we have taxed income for many years.

PREPARED STATEMENT OF DAN KOSTENBAUDER

Mr. Chairman, Senator Baucus, and Members of the Committee, thank you for

the opportunity to testify here today. My name is Dan Kostenbauder. I am Vice

President—Transaction Taxes at Hewlett-Packard Company in Palo Alto, California.

Bill Hewlett and Dave Packard founded HP in 1939. HP completed its merger transaction involving Compaq Computer Corporation on May 3, 2002. HP had worldwide

revenue of over $72 billion for the fiscal year ending October 31, 2002.

HP is a leading global provider of products, technologies, solutions and services

to consumers and businesses. The company’s offerings span IT infrastructure, personal computing and access devices, global services and imaging and printing. HP

expects to spend over $4 billion on R&D this fiscal year. This investment fuels the

invention of products, solutions and new technologies, so that we can better serve

customers and enter new markets. HP invents, engineers and delivers technology

solutions that drive business value, create social value and improve the lives of our

customers.

Summary of Comments

My comments will focus on a few key topics:

Some general information about Hewlett-Packard Company and the high-tech

electronics industry that should help to provide a context for our views on the

need for improvements to the U.S. tax system to improve our international competitiveness,

Proposed reforms of the U.S. tax rules that apply to international activities

of U.S.based taxpayers, and

The benefits of encouraging U.S.-based taxpayers to move offshore cash into

the U.S. economy.

Background on Hewlett-Packard Company

As a leading global information technology company, HP operates in numerous

countries. In the United States, HP has over 65,500 employees. Of the $4 billion

that HP spends on R&D, 80% is spent 11 the United States—mostly to support

high-paying jobs. In addition to sales of computers and printers, HP has a sib sigVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00079 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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nificant and growing services business. Last year HP Services generated 16 percent

of HP’s worldwide revenue and 37% of HP’s worldwide profits.

HP also has significant operations overseas because business realities dictate that

we do so. Our competitors are global in scope. It would be impossible for HP to succeed in the United States if we could not compete successfully outside of the United

States. This is true for several key reasons.

First, many of our customers operate globally. They typically prefer to have one

or a few IT technology providers. To meet the needs of these multinational customers, HP needs to have a significant presence to sell and support products outside

of the United States. Quite simply, if we did not have a global presence, we would

get fewer contracts with foreign-based or with U.S.-based multinational companies.

Instead, those contracts might go to our foreign-based competitors—a result that no

one on this Committee would think could be good for the American economy.

A second reason is that R&D is critical to high-tech companies. Our product life

cycles are very short. In order to keep prices competitive, we need to amortize the

costs of R&D over the maximum number of units sold worldwide. If we did not, our

foreign competitors would eventually be able to under price our products and ultimately have the resources to do the R&D that we could no longer afford. This would

leave us in the technological dust.

A third reason is that many products must be manufactured close to their markets. Usually it is not economically viable to ship products overseas that have relatively low values compared to their weight. In addition, with products like personal

computers that fall in value very rapidly, supply chain considerations often dictate

that they must be manufactured near their markets.

The following graph indicates the importance of HP’s ability to compete in foreign

markets. In our last fiscal year, about 59% of HP’s trade revenues were from customers outside of the United States. (Prior to fiscal year 1999, the chart reflects the

percentage of orders, rather than revenue, from outside of the Unites States.) The

trend is clear.

The increased importance of foreign markets to HP is not an isolated phenomenon. The U.S. share of the world economy has declined due to faster economic

growth abroad since World War II. A domestic company that limited itself to the

U.S. market in 1945 would have foreclosed half the world market; today it would

lose 80 percent.

The following graph illustrates this point for the whole U.S. economy.

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HP has been affected in many significant ways by the high-tech recession that has

lasted over three years. HP, along with many other U.S. exporters, almost certainly

will lose the FSC/ETI tax benefits on exports in the near future. HP believes that

one of the best ways to address the technology recession and to offset the loss of

FSC/ETI would be the enactment of the international reform provisions detailed

below.

The U.S. High-Tech Electronics

The technology industry has suffered a massive recession over the past three

years that started with the bursting of the ‘‘NASDAQ bubble’’ and has accelerated

with the weak business demand for technology products. We have seen overwhelming job losses in many parts of the country. This Committee heard testimony

last week on the recession facing the U.S. manufacturing industry, but the technology sector has suffered a similar recession.

According to a report of the AeA (American Electronics Association) released in

March of this year, the U.S. technology sector lost about 560,000 jobs in 2001 and

2002. The sector’s workforce fell 10 percent to 5.15 million in December 2002 from

5.7 million in December 2001. The technology sector lost 415,000 manufacturing

jobs, a 20 percent decrease to 1.62 million jobs. Total high-tech services jobs fell by

144,600, or 4 percent, to 3.52 million.

The United States Needs International Tax Reform

We believe that Congress should enact forward-looking reforms to the international tax provisions of the Internal Revenue Code that will enhance the ability

of American companies to compete in global markets and emphasize the strengths

of the U.S. economy. Such reforms will benefit the bottom line of our company operations, benefiting our shareholders, employees and customers, and ultimately the

U.S. economy.

HP believes that the Congress is faced with an excellent opportunity to examine

U.S. international tax rules and adopt a system that makes sense for our early 21st

century economy. As the Committee well knows, the bulk of our international tax

rules were written over 40 years ago and largely reflected a much different economy.

In 1962, the United States was the world’s preeminent economic powerhouse. It

did not need to consider issues of competitiveness—both for individual companies

and the broader economy—as seriously as it does today.

Of the world’s largest companies in 1960, 18 of 20 were U.S. corporations, and

they faced less foreign competition. Today, the situation is vastly different. In 2001,

only 8 of the 20 largest companies (based on sales) were U.S. corporations. U.S.-

based companies face very serious competition, both at home and abroad, from forVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00081 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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1FBCSI may result under when a CFC purchases personal property from anyone and sells

it to a related person (or purchases personal property from a related person and sells it to anyone), if the property that is purchased is (1) manufactured outside of the CFC’s home country,

and (2) sold for use, consumption, disposition outside such home country. This definition of

FBCSI does not apply to property that is ‘‘manufactured’’ by the CFC. (The technical explanation accompanying the House Report on enactment of the FBCSI provision in subpart F includes the statement that because the definition covers only transactions involving both a purchase and a sale, it does not apply to income of a CFC from the sale of a product that it manufactures. H.R. Rep. No. 1447, 87th Cong. 2d Sess. (1962); 1962–3 C.B. 405, 466.)

eign-based companies that frequently operate under more advantageous home-country tax rules.

Another change since 1962 is that today the United States, many believe, should

worry more about its own competitiveness compared to foreign countries as an attractive place to do business and establish company headquarters. ‘‘Inversion’’ transactions have been of concern to the Committee in recent years. While we can all

agree that these transactions should be prevented, they point to a disturbing fact:

many companies view the tax ramifications of having a U.S. headquarters negatively enough that they are willing to engage in these transactions. Beyond inversions, we see a similar concern expressed with regard to cross-border acquisitions—

all too often the resulting combined business entity is foreign-headquartered, usually because of tax considerations. This matters because economic studies demonstrate that many jobs and economic opportunities follow the headquarters. Consequently, if the headquarters of a formerly U.S.-based company moves to Europe,

chances are that many good, high-paying jobs and future economic activity also goes

to Europe—not the United States. Furthermore, we understand that some promising U.S. start-up companies are being organized at the outset with foreign parent

corporations.

The growing importance of the services sector is another major change from the

early 1960s, when manufacturing dominated the U.S. economy. Today, the U.S.

services sector is one of the most dynamic elements of our economy and it is where

the United States enjoys a high ‘‘comparative advantage’’ over many foreign countries. In 2002, exports of services accounted for 30 percent of all U.S. exports. Consequently, there are real concerns about any approach to promoting U.S. exports

that is limited to the manufacturing sector. HP believes that the U.S. tax laws

should reflect the dominant position of our services sector and enhance its ability

to compete overseas. Further, we believe the following changes would help to accomplish the goal of enhancing the international competitiveness of U.S. companies generally, and companies in the services sector specifically.

Congress Should Repeal the Foreign Base Company Rules

HP supports the reform of the U.S. international tax rules, particularly of Subpart

F of the Code. HP also supports improvements to the Foreign Tax Credit rules.

The foreign base company sales income and foreign base company services income

rules of Subpart F place major constraints on the ability of U.S.-based companies

to operate in overseas markets—a restriction that is not shared by our foreign competitors.

Like our foreign competitors, HP centralizes its sales activities in regional hubs

(for regional markets, like Europe, Asia or Latin America) within a single controlled

foreign corporation (‘‘CFC’’). It is too expensive to maintain redundant operations in

each of several different countries within a single geographic region. The foreign

base company rules, however, impose a current U.S. tax on income earned outside

the CFC’s home country for transactions with a related party.1

The following two graphics demonstrate why companies often conduct their international activities through ‘‘base companies’’ or trading companies. If a company has

factories and sales companies in many different countries, it would be very complex

and expensive to manage all of the different transactions necessary to allow each

of the factories to sell into each of the different market countries. The complexity

and expense would occur because of the need to replicate the many business processes necessary to facilitate crossborder transactions. Such processes include: VAT

registration and compliance, foreign currency exchange exposure management, customs declarations, export controls monitoring, invoice preparation, invoice payment,

cash management, accounting, withholding tax management, and many more.

The capability to manage such complex transactions would need to be replicated

many times over unless a trading company is used. Tremendous cost savings are

achieved by placing a regional or global trading company in the middle of transactions between production centers that supply goods or services and selling entities. The simplicity of the second graphic reflects the fact that each factory can conduct its business selling to only one customer, while each selling company needs to

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purchase from only one supplier. Furthermore, it becomes vastly easier to add new

factories or sales subsidiaries using this model. With increasing globalization, falling

trade barriers (e.g., the economic integration of the EU countries and of China and

Hong Kong) and improvements in technology, it is now more efficient and effective

for foreign subsidiaries to conduct business on a regional or global basis than ever

before.

With respect to the vast preponderance of transactions to which the Subpart F

foreign base company rules apply, the transactions are between CFC’s operating exclusively in foreign countries. Yet, the overly broad Subpart F rules impose current

U.S. corporate income tax on such active business transactions. The U.S. approach

to taxing foreign activities of U.S. taxpayers generally allows deferral of U.S. tax

on active business income earned abroad. By imposing a current U.S. tax on strictly

foreign transactions, the foreign base company rules place U.S. firms at a competitive disadvantage in the global marketplace.

Repeal of the foreign base company rules would permit a CFC to sell property or

provide services in transactions involving related parties without generating currently taxable income. Also, the expense of complying with these complex rules

would be avoided.

The original rationale in 1962 for the foreign base company rules was to prevent

U.S. taxpayers from artificially shifting income into trading companies located in

low-taxed jurisdictions by manipulating pricing. This concern could have arisen if

one of the companies represented in the earlier graphics operated in the United

States. Today, the IRS and many other country tax authorities are much more capaVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00083 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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ble of enforcing the transfer pricing rules than they were when the foreign base

company rules were enacted. In addition, the global enforcement of transfer pricing

rules is much stronger due to better disclosure (attributable to contemporaneous

documentation requirements), severe penalties, international exchange of information treaties, and Advanced Pricing Agreements between taxpayers and the Internal

Revenue Service, as well as the tax authorities of other countries.

Congress Should Increase Foreign Tax Credit Care forward Period from 5 to

10 years

Reform of the foreign tax credit (‘‘FTC’’) carryover rules is needed to ensure that

U.S. companies are effectively protected against double taxation. Under current law,

the amount of FTC’s that may be claimed in a year is subject to a limitation, so

that the credit is allowed only to offset U.S. tax on foreign source income. To the

extent that the amount of creditable taxes for a given taxable year exceeds the limitation, the excess may be carried back two years and forward five years.

Problems of double taxation often arise because the foreign tax treatment of items

of income and expense may differ from the U.S. tax treatment. For example, the

same income may arise in different taxable years for foreign and U.S. tax purposes.

As a result, foreign taxes may be imposed in a year during which little or no foreign

income may arise under U.S. tax principles.

The rules for FTC carryovers seek to address this problem by allowing the FTC’s

to be carried over from years in which foreign taxes are imposed to years in which

the foreign source income arises under U.S. tax principles. Extending the period for

FTC carryforwards would allow companies to offset their U.S. tax liabilities in later

years when they are profitable without facing the pressure of expiring FTC

carryovers. The vagaries of the economy and normal business cycles are additional

factors that sometimes prevent utilization of FTC’s before their expiration.

This modification would allow U.S. taxpayers that had accrued or paid foreign

taxes additional time to utilize their FTC carryovers.

Congress Should Remove the 90% Limitation on Claiming Foreign Tax Credits

from the Alternative Minimum Tax

The regular corporate income tax allows companies a credit of 100 percent of the

foreign taxes on income earned abroad, subject to various limitations and restrictions. Under the alternative minimum tax (‘‘AMT’’), however, only 90 percent of the

AMT may be offset by FTC’s that otherwise would be available. This rule causes

double taxation of foreign income and thereby thwarts a fundamental and longstanding principle of U.S. tax policy.

The Joint Committee on Taxation April 2001 Simplification Study (JCX–27–01, 4/

25/01) recommended that the corporate AMT be eliminated. The report concluded,

‘‘The original purpose of the corporate AMT is no longer served in any meaningful

way.’’ Furthermore, it has been estimated that the cost of tax compliance alone for

the complexities costs companies many times the amount of AMT collected. Repeal

of the entire AMT is an issue for another day. In terns of overall international competitiveness, however, eliminating the double taxation of international income clearly is appropriate.

The AMT has the perverse effect of penalizing U.S. global companies for distributing overseas earnings to U.S. parent companies to support domestic operations.

Because of the AMT’s limit on use of FTC’s, earnings distributed from abroad are

effectively taxed at a higher rate than domestic earnings, and certainly at a higher

rate than the earnings of non-U.S. competitors operating in those same foreign markets. This puts U.S. companies in this position at a competitive disadvantage visa ́-vis their foreign competitors in overseas markets.

The United States Would Benefit by Encouraging Offshore Cash to Move Into the

U.S. Economy

The Senate-passed Jobs and Economic Growth tax bill included a provision originally introduced as S. 596 by Senators Ensign, Boxer, Smith, Allen, Enzi and Bayh.

It was adopted by voice vote after a 75–25 vote adopting a procedural motion on

the floor to consider it. Similar bipartisan proposals have been introduced in the

House.

S. 596 would, for a period of one year or less, impose a 5.25 percent toll charge

on dividends or other transfers of foreign corporate earnings that exceed a company’s historical average dividend flow. This toll charge would be imposed instead

of the normal 35 percent tax. Any dividends taxed under the 5.25 percent toll charge

would be permitted to claim only 15 percent of the foreign tax credits that otherwise

would be allowed.

A recent PricewaterhouseCoopers analysis of the most recent IRS data—for

1999—shows that the average U.S. tax after taking foreign tax credits into account

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on ordinary distributions (non-Subpart F) of foreign income was just 3.7 percent.

This low effective tax rate is a consequence of U.S. tax laws that encourage companies to pay dividends from foreign companies operating in countries that subject

their income to higher levels of foreign tax while discouraging payment of dividends

from countries that impose lower rates of corporate income tax. Dividends from

high-tax jurisdictions carry more foreign tax credits, which reduce U.S. tax liabilities on such dividends. On the other hand, lowtax foreign earnings carry few foreign tax credits, so companies have a powerful incentive to reinvest such earnings

abroad rather than subject such earnings to the normal 35 percent U.S. corporate

income tax rate.

In contrast to the U.S. system, many foreign countries do not tax dividends of

earnings from outside their own countries. By excluding such earnings from domestic taxation, many other countries encourage the payment of such surplus foreign

earnings as dividends back to those countries, where they can then be reinvested.

The structure of U.S. tax law that creates a significant incentive to leave foreign

earnings offshore has in fact had a very substantial impact. Based on an examination of the financial statements of the S&P 500, a recent, independent JP Morgan

study conservatively estimates that the pool of foreign earnings that has accumulated over the years and is eligible to be brought to the United States is about $500

billion. This estimate is consistent with a PricewaterhouseCoopers’ detailed review

of IRS tax data. Much of this accumulated foreign investment is designated for financial reporting purposes as permanently invested overseas and thus there is no

expectation of any U.S. tax being paid in the future.

Enactment of the proposed temporary toll charge on dividends of foreign earnings

would encourage a permanent movement of a tremendous amount of cash into the

U.S. economy. The JPMorgan study estimates that about $300 billion would move

from offshore to the U.S. economy. The impact of such a cash infusion would have

an exceptionally powerful and positive short-term impact on the U.S. economy. If

passed in the near future, the JPMorgan study anticipates:

A 1% cumulative increase in GDP growth (.5% in 2003 and .5% in 2004),

A 2–3% cumulative increase in U.S. investment during 2003–2004, and

A 3% reduction in corporate debt, which would strengthen corporate balance

sheets and lower the interest rates on corporate bonds.

At a time when the U.S. economy, and particularly the high-tech sector, appears

to be having a jobless recovery, the opportunity to generate increased U.S. investment and GDP growth should be seized upon. To demonstrate the relative significance of the incentives for growth and investment that the 5.25 percent toll charge

proposal could generate, it would be useful to compare it to estimates of the economic impact of the recently-enacted Jobs and Growth Tax Relief Reconciliation Act

of 2003.

Standard & Poors and Morgan Stanley Company estimated that the portion of the

President’s tax proposals that were enacted this year would increase GDP by about

one percent in 2003. Bank of America estimated the impact at about .5 percent in

2004. Prudential Financial published a Research Report in June on the 5.25 percent

toll charge proposal, stating: ‘‘We believe that a fund transfer of this magnitude

would have significant macroeconomic implications, spurring growth, driving employment, stimulating domestic U.S. capital expenditures, easing the burden of

under-funded pension programs, and in particular, helping hard-pressed U.S. manufacturing corporations to pay down debt and de-lever their balance sheets to better

cope with deflationary pressures.’’ The Invest in the USA proposal provides stimulus

at levels similar to the just-adopted growth package, but at about 1% of the cost.

This is an opportunity that we should not pass up!

A PricewaterhouseCoopers survey showed that the proposed change would result

in an additional $47 billion reinvestment in the United States from just 14 companies. The funds would be used to increase domestic investment in plant, equipment,

and R&D; contribute to pension plans depleted by recent declines in the stock market; reduce domestic debt loads; increase dividends that could be productively redeployed; and raise equity market valuations by increasing funds available for share

repurchases.

The rate of the toll charge proposal was chosen to strike a balance between generating revenue for the U.S. and encouraging dividend payments. Based on prior revenue estimates, it is likely that modest increases in the rate of the toll charge would

reduce dividend flows significantly. The 3.7 percent additional U.S. tax burden on

dividends of foreign earnings to the United States (based on the

PricewaterhouseCoopers study referred to above) is very close to the current corporate cost of funds to borrow. Hence, if the toll charge rate were increased above

the proposed level of 5.25 percent, less investment in the United States would be

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stimulated. In addition, state income taxes and withholding taxes at source also increase the tax burden on dividends.

To encourage immediate economic stimulus, the reduced rate of tax would be effective for the first taxable year ending 120 days or more after the date of enactment. Thus, for example, if the bill was enacted on August 25, 2003 and the electing

taxpayer is on a calendar year, the bill would apply to the taxpayer’s taxable year

ending December 31, 2003. To the extent that this proposal would be included in

future legislation to be acted upon by this Committee, I would encourage the Committee to select effective dates that maximize the economic benefit in the near future in order to encourage the maximum amount of U.S. reinvestment as quickly

as possible, while allowing companies sufficient time to plan for the movement of

substantial amounts of cash in an orderly way.

Conclusion

I appreciate the opportunity the Committee has given me to share HP’s views on

possible changes to the U.S. income tax laws that apply to the foreign activities of

U.S.-based taxpayers. The long-term international competitiveness of U.S. companies could be improved if the cost and complexity of the foreign base company sales

income and services income provisions were removed from Subpart F of the Internal

Revenue Code, and other international tax reforms adopted. In the short run, passage of the Invest in the U.S.A. Act of 2003 would act as a powerful stimulus to

the U.S. economy. We encourage the Committee to pass legislation that includes

both of these elements.

RESPONSES TO QUESTIONS FROM SENATOR GRASSLEY

Question 1. You recommend extending the foreign tax credit period to 10 years.

Why did you choose this instead of changing the order in which credits are used

up?

Answer. Increasing the carryforward period for foreign tax credits from 5 to 10

years would provide significant help in avoiding double taxation. Five years is frequently too short a period in which to overcome the effects of an adverse business

cycle or extraordinary transactions that might interfere with a company’s ability to

use foreign tax credits. Extending the period to ten years should decrease significantly the number of companies that would be so affected.

Changing the order in which credits are used to a first in-first out approach would

also help achieve the same result. In fact, many companies advocate taking both of

these approaches at the same time. It is our understanding that the U.S. Treasury

department supports extending the carryforward period but opposes changing the

ordering rules. Treasury takes this position, at least in part, because of potential

mismatches between foreign tax credits and the income on which they were imposed. Compared to more expansive proposals, Treasury’s approach goes a long way

toward helping companies to avoid double taxation of foreign earnings while minimizing revenue losses.

Question 2. Repeal of the foreign base company rules will cost around $37 billion.

Is there a more targeted way to fix the problems you are having with these rules?

Answer. Repeal would be the comprehensive way to address three adverse consequences of the foreign base company rules—higher tax costs, compliance burdens

and complexity they impose on international operations of U.S.-based companies.

There are more targeted ways to address some of these problems. Transactions

involving only foreign parties could be exempt from the foreign base company sales

and services income rules. More narrowly, the EU (and perhaps other trade blocs)

could be treated as one country for purposes of the foreign base company sales and

services income rules. In addition, the substantial assistance rules imposed by the

regulations under the foreign base company services income provision could be

eliminated.

Question 3. You say you are a current FSC-ETI user, but much of this benefit depends on your level of U.S. manufacturing. What percentage of the manufacturing

is done outside the U.S. as opposed to within the U.S.?

Answer. HP’s FSC-ETI benefit is a function of U.S. manufacturing. The percentage of manufacturing done outside the United States as opposed to within the

United States in not readily available because there is no SEC reporting requirement for us to track this information separately and because the complexities of our

internal product flows (particularly after our Compaq merger) make it difficult to

provide an answer to the Committee that we would have adequate confidence in.

As suggested in my testimony to the Committee at the hearing on July 15, however, HP manufacturing and selling activity is aligned with HP’s high levels of foreign sales—almost 60% of HP’s revenue is from customers outside of the United

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States. On the other hand, about 48% of HP’s total employees worldwide live in the

United States. More than 1,000 HP employees live in each of the following states:

California, Colorado, Georgia, Idaho, Maryland, Massachusetts, Nebraska, New

Hampshire, New Jersey, Texas and Washington. In addition, the level of R&D that

HP conducts in the United States (about 80%) is disproportionately higher than U.S.

revenue (about 40%).

Question 4. How many percentage points does FSC-ETI reduce your tax liability?

Answer. HP has claimed an average of almost $37 million of FSC-ETI benefit during the past three years. During this period HP reported average worldwide annual

earnings of over $1.4 billion. This means that the FSC-ETI benefit claimed for this

period was about 2.6% of HP’s worldwide income.

Question 5. You say that manufacturing should not receive export benefits because service is our fastest growing export sector. Are your services currently eligible for FSC-ETI benefits?

Answer. HP traditionally has been a manufacturing company and we believe that

provisions in the U.S. tax laws that encourage manufacturing in the United States

are good provisions to have. Of course, encouraging U.S. manufacturing through ‘‘export benefits’’ is what has led to the FSC-ETI controversy. In recent years, however,

HP has committed to a strategy that involves significant expansion of our service

businesses as well. Since the service sector of the U.S. economy is so important, my

testimony questioned whether focusing only on incentives for the manufacturing sector would be the best policy judgment.

To illustrate that services jobs include many very good jobs for the U.S. economy,

a description of the services provided by HP Services should be helpful. HP Services

provides a comprehensive, integrated portfolio of IT services including customer support, consulting and integration, and managed services. Customer support provides

a range of services from standalone product support to high availability services for

complex, global, networked, multi-vendor environments. Consulting and integration

provides services to design, build and integrate IT infrastructure. Managed services

offers a range of IT management services, both comprehensive and selective, including transformational infrastructure services, client computing managed services,

managed web services, and application services, as well as business continuity and

recovery services. HP Services teams with the leading software, networking and

services companies to bring complete solutions to our customers.

Services performed by HP in the United States are not eligible for FSC-ETI benefits.

Question 6. We heard testimony last week that every dollar of finished goods manufacturing sales creates 76 cents in services income and 67 cents in other manufactured products. Do you have any comment on that from a service industry perspective?

Answer. Certainly every dollar spent on service activities generates additional

services income and manufacturing income. I am not aware of studies that quantify

these amounts, however.

Question 7. I have voted for the Homeland Investment Act, but I have a few questions that need to be answered.

a. Your support of the Homeland Investment Act assumes that U.S. investment

is best for our economy. In promoting your international tax reforms, you say being

internationally competitive and expanding in foreign markets is good for U.S. jobs

and the U.S. economy. If your claims are true, then why should we care whether

you invest your foreign profits offshore or in the U.S.? Please explain these seemingly inconsistent positions.

Answer. HP’s positions are not inconsistent. We believe that both proposals would

stimulate the U.S. economy. The Homeland Investment Act will stimulate economic

growth in the United States by significantly increasing the liquidity of many U.S.

companies. As they put this cash to use, the U.S. economy will grow. In addition,

if reforms of the U.S. international tax rules allow U.S.-based companies to be more

competitive in foreign markets, we believe that growth of the U.S. economy will be

stimulated.

Growth based on our ability to compete in foreign markets will generate not only

more jobs, but also better jobs. The wages for production workers employed by U.S.

companies without global operations have been estimated by Mark Dorms to be

9.5% to 15.2% less than those for U.S. companies with global operations. [‘‘Comparing Wages, Skills, and Productivity between Domestically and Foreign-Owned

Manufacturing Establishments in the United States.’’ 1998. In Geography and Ownership as Bases for Economic Accounting, NBER Studies in Income and Wealth, vol.

59. Chicago and London: University of Chicago Press, pp. 235-255. (With J. Bradford

Jensen.)]

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b. The Joint Committee estimates that this proposal will lose about $4.4 billion

over 10 years. Given that we have a limited amount of money for international reform, is it better to use this money to do permanent foreign tax credit and subpart

F reform, or is it better spent doing this repatriation proposal?

Answer. We strongly urge the Finance Committee to analyze the assumptions underlying the Joint Committee on Taxation revenue estimate to ensure that they are

consistent with the information provided to the Committee by Senators Smith, Ensign and Boxer and by the companies that are working on this proposal. Given that

the structure of the proposal is to reduce the tax rate on dividends paid in excess

of a base amount, we remain puzzled by the estimate that projects a revenue loss

over the 10-year scoring period. There will be such a large amount of earnings that

will be subject to U.S. taxation that otherwise would go untaxed that we do not see

how this proposal could possibly result in a decline in U.S. revenue.

We view the Homeland Investment Act as an economic stimulus measure that

would encourage growth in the U.S. economy. JP Morgan and the Bank of America

have estimated that $300 billion to $400 billion of cash would move into the U.S.

economy in response to homeland investment legislation. The JP Morgan study estimates that the Homeland Investment Act would stimulate the U.S. economy over

the next couple years as much as the $350 billion economic growth package that

the Congress passed in May. Such additional stimulus, even if it has an estimated

cost of about $4 billion, seems to be very appropriate at this time. It is imperative

for the United States to move from a jobless recovery to a robust recovery that once

again creates new jobs and other opportunities, and this proposal will help to accomplish that objective. At a cost of about $4 billion, HP believes that Congress should

enact the homeland investment provision. Use of dynamic scoring would likely show

that this cost would be paid for by economic growth. Although proposed international tax reform is clearly necessary from a policy perspective, significant reforms (such as repeal of the foreign base company sales and services rules) will result in a higher revenue cost with less immediate impact on the U.S. economy. c. How much money does your company have ‘‘trapped’’ in foreign jurisdictions,

and in which countries is it trapped?

Answer. It is important to understand that the cash under discussion is ‘‘trapped’’

outside of the United States, but not within any particular foreign country.

Current U.S. tax rules encourage HP to continue to invest such cash anywhere

but the United States. HP’s l OK filed with the Securities and Exchange Commission for our fiscal year ending October 31, 2002, indicated that ‘‘HP has not provided

for U.S. federal income and foreign withholding taxes on $14.5 billion of undistributed earnings from non U.S. and Puerto Rican operations as of October 31, 2002

because such earnings are intended to be reinvested indefinitely.’’ Most of the $14.5

billion referred to above represents earnings from active business operations in

Puerto Rico, Ireland and Singapore.

d.What does your company do with the trapped money at the present time?

Some of the cash is kept in very liquid investments as a financial reserve.

Most of the cash is loaned to other HP subsidiaries outside of the United States.

These funds are then used by HP’s foreign subsidiaries to finance the growth of

their active businesses, including inventories, accounts receivable, and leases of HP

equipment.

e.What would your company do with it if they could repatriate it?

Answer. HP U.S. operations would become stronger and more competitive. If HP

moved cash from offshore to the United States in response to a homeland investment provision, it would have several consequences. First, during the recent hightech electronics recession, HP’s U.S. borrowings have grown. We would set aside

funds to repay these loans, which would strengthen our balance sheet as well as

provide some additional earnings (interest rates on our U.S. borrowings are higher

than the interest rates on offshore cash investments). It is likely that some portion

of the funds would be used to fund U.S. employee benefit plans and R&D. We have

not developed specific plans for other uses of the cash. Having a stronger U.S. cash

position, however, should enable HP to take risks that that might be imprudent

with lower levels of cash.

It is important to realize that improvements to HP’s balance sheet alone help us

compete around the world. We have a significant business leasing HP equipment

that would benefit from any improvement in HP’s borrowing costs and access to

credit. HP is beginning to achieve greater success than ever before in providing a

wide range of outsourced information technology services to our largest customers,

whether they are based inside or outside of the United States. In addition to technical capability and global reach, having a strong balance sheet is a critical factor

in our ability to compete for and win such business.

f.What level of repatriations has HP maintained under present law?

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Answer. During the past three years, the average amount of gross cash dividends paid by foreign subsidiaries to HP in the United States was almost $ 1.5 billion per

year.

g.From which countries has HP paid dividends under present law?

Answer. Foreign subsidiaries of HP in about 25 countries have paid dividends to

HP in the United States during each of the past three years. These countries include Argentina, Australia, Austria, Belgium, Brazil, Canada, Denmark, Finland,

France, Germany, Hong Kong, Ireland, Italy, Korea, Malaysia, Netherlands, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, Taiwan, Turkey and the

United Kingdom.

h.Why will this tax break cause you to build facilities in the U.S. that would be

uneconomic under present law?

Answer. I would not characterize a homeland investment provision as a ‘‘tax

break.’’ Instead, it removes the impediment under U.S. tax laws for U.S. based companies to pay dividends out of foreign earnings. As indicated above, it is not certain

that HP would use additional U.S. cash to build additional facilities. However, it

is clear that having more cash in the United States would help to make HP a

stronger company that would enable us to compete more effectively.

i.Does the location of accumulated funds in their U.S. treasury center as opposed

to their overseas treasury center have that huge an impact on HP’s investment decisions?

Answer. Yes. While HP’s investment decisions are driven by a variety of considerations, our current ‘‘hurdle’’ rate (i.e., the threshold rate at which it is profitable to

make investments) is substantially higher for U.S. than foreign investments because

of the imbalance HP is experiencing between available U.S. and foreign cash. Enactment of the homeland investment legislation would equalize the relative hurdle

rates for evaluating investments, and thus would improve the relative position of

the United States when we evaluate future investments.

j.Why not make homeland investment permanent? Do you think that this temporary relief should henceforth be included in Congress’s anti-recession toolbox?

Answer. The homeland investment provision is a cost-effective economic stimulus

that will have maximum effect if it is available for a short period of time. Making

a homeland investment provision permanent would be such a major change to the

U.S. tax system that it would be premature at this time because the necessary consensus for such change has not been reached. Also, it is unclear that a permanent

solution would clear up the problems of the past that has resulted in about $500

billion effectively being trapped offshore.

There are two classic models that countries use to tax the foreign operations of

domestic companies—worldwide or territorial systems. I am not aware of any major

trading partner that has a ‘‘pure’’ system under either approach. The United States

uses the worldwide model. Making a homeland investment provision permanent

would move the Unites States along the continuum between these two approaches

significantly toward the territorial approach. As a country, we have not developed

a consensus that we should move so far in that direction so quickly. Furthermore,

because other countries that have adopted the territorial approach have not adopted

‘‘pure’’ territorial systems, it is virtually certain that the UnitedStates would not

adopt a ‘‘pure’’ territorial system either. Adding a homeland investment provision

to the existing U.S. tax system definitely would be far from a pure territorial system. One could anticipate that other provisions might be adopted to customize any

U.S. version of a territorial system. Without having had a thorough national debate

about the merits of moving toward a territorial system and particularly without

having developed a consensus about the nature of any adjustments to a pure territorial system that the Congress would consider appropriate, it is too early to say

that such a provision should be permanent.

If a homeland investment provision was adopted and it proved to be quite successful, a future Congress certainly might consider adopting a similar measure. From

HP’s perspective, however, it is not at all clear that this provision would become

part of an anti-recession toolbox for several reasons. The political consensus to adopt

a homeland investment provision during the current period of economic weakness

has been slow to develop, so it is unclear whether it would be achievable under future circumstances. Although the U.S. economy has experienced regular business cycles, during the last three years the U.S. high-tech electronics industry has witnessed one of the longest periods ever of downturn followed by a slow recovery. Because of this prolonged period of weak economic performance in the high-tech sector

coupled with other recent HP-specific events, HP is more interested in a homeland

investment provision than it probably would have been had such a provision been

actively considered in prior periods of recession and recovery. Similar experience of

other high-tech companies helps explain why the homeland investment idea has a

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large number of supporters in that sector at this time. Another consideration is that

the amount of offshore cash held by controlled foreign corporations that would be

available for payment to the United States for many years would be far smaller

than the pool available today. This means that the stimulus effect of a homeland

investment provision adopted during the next few economic downturns probably

would be significantly smaller than it would be today. In addition, until this Congress, companies have never had any expectation of a homeland investment provision being enacted, so it would not have had any impact on their decision-making.

Future Congresses, on the other hand, would have to consider whether having a

homeland investment provision in their ‘‘toolbox’’ would influence company decisionmaking in ways not intended. As this Congress considers a homeland investment

provision, however, that would not seem to be a significant concern. Assuming that

a homeland investment provision is enacted this year, I personally would advise

management at HP not to base any of their decisions on the prospect that such a

provision would be enacted again in the future.

Question 8. Company X manufactures widgets in the United States for sale in the

United States and abroad. It forms a subsidiary, Y, in a zero-tax jurisdiction such

as Bermuda to serve as a trading company. Y hires 200 persons in Hamilton. Widgets are sold by X to Y for 100, and Y re-sells the widgets (without changing them)

for 125 to unrelated parties in the United States and throughout the rest of the

world. The transfer price from X to Y is defensible. The 25 earned by Y are attributable to economic functions that Y performs in Bermuda. Should the United States

currently tax that 25? Why or Why not?

Answer. The United States should not currently tax that 25 earned in Bermuda

for two reasons. First, the transfer price from X to Y is appropriate, so the income

earned by X that is subject to U.S. income tax is based on an arm’s length transfer

price that reflects fair compensation to X for activities conducted and risks taken

in the United States. Second, the activity of Yin buying and selling widgets is an

active business, so the earnings of Y from that business should be deferred under

the U.S. tax principle that taxation is deferred on active business income until dividends of those earnings are paid to the United States. However, the United States

does currently tax the 25 as Subpart F foreign base company sales income provisions.

PREPARED STATEMENT OF PAMELA OLSON

Mr. Chairman, Senator Baucus, and distinguished Members of the Committee, I

appreciate the opportunity to appear today at this hearing focusing on international

tax policy and competitiveness issues. I applaud the Committee for holding this

hearing to examine U.S. tax policy and its effect on the international competitiveness of U.S.-owned foreign operations. The importance of our international tax rules

to the competitiveness of U.S. businesses and workers is well known to this Committee, as evidenced by the fact that the Committee has previously approved legislation addressing many issues in the international area. Unfortunately, this Committee’s good work on those issues in previous sessions has not resulted in enacted legislation. Nevertheless, the need for changes, such as the changes previously approved by this Committee, continues. Indeed, with the growing importance of international competitiveness to the economy, the need is even more immediate.

Many areas of our tax law are in need of reform to ensure that our tax system

does not impede the efficient, effective, and successful operation of U.S. companies

and the American workers they employ in today’s global marketplace. In keeping

with the focus of today’s hearing, I will address my remarks this morning to the

tax policy issues specific to U.S.-based companies competing in markets around the

world.

Introduction

Both the increase in foreign acquisitions of U.S. multinationals and the corporate

inversion activity of the past few years evidence the potential competitive disadvantage created by our international tax rules. The concern this Committee faces today

is that our tax code has not kept pace with the changes in our economy. From the

vantage point of the increasingly global marketplace in which U.S. companies compete, our tax rules appear outmoded, at best, and punitive of U.S. economic interests, at worst. Most other developed countries of the world are concerned with setting a competitiveness policy that permits their workers to benefit from

globalization. As former Deputy Secretary Dam observed last year, we, by contrast,

appear to have based our international tax policy on the principle that we should

tax our competitive advantages.

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Our income tax system as a whole dates back to shortly after the turn of the last

century. Much has changed since then. Of course, significant changes have been

made to the tax code as well. In the international area, we added the subpart F

rules back in 1962. Those rules have not advanced with advances in the economy.

We also made fairly significant changes to the international tax rules in 1986. Many

of the 1986 changes had dubiouseconomic underpinnings in 1986. They also have

not advanced with advances in the economy.

The global economy looked very different in 1962 than it looks today. The same

is true of the U.S. role in the global economy. Forty years ago the U.S. was dominant, accounting for over half of all multinational investment in the world. With a

dominant role, we were free to make decisions about our tax system essentially on

the basis of a closed economy. Moreover, our trade partners generally followed our

lead in tax policy.

Things have changed. When the international rules were first developed, they affected relatively few taxpayers and relatively few transactions. Today, there is hardly a U.S.based company that is not faced with applying the U.S. international tax

rules to some aspect of its business.

Globalization—the growing interdependence of countries resulting from increasing

integration of trade, finance, investment, people, information and ideas in one global

marketplace—has resulted in increased cross-border trade, and the establishment of

production facilities and distribution networks around the globe. Technology will

continue to accelerate the growth of the worldwide marketplace for goods and services. Advances in communications, information technology, and transport have dramatically reduced the cost and time taken to move goods, capital, people, and information around the world. Firms in this global marketplace differentiate themselves

by being smarter: applying more cost efficient technologies or innovating faster than

their competitors. The returns are much higher than they once were as the benefits

can be marketed worldwide.

The significance of globalization to the U.S. economy since the enactment of subpart F is apparent from the statistics on international trade and investment. In

1960, trade in goods to and from the U.S. represented just over six percent of Gross

Domestic Product (GDP). Today, trade in goods to and from the U.S. represents over

20 percent of GDP, a threefold increase, while trade in goods and services represents more than 25 percent of GDP today. It is worth noting that numerous studies confirm a strong link between trade and economic growth. Trade appears to

raise income by spurring the accumulation of, and raising the returns to, physical

and human capital.

Cross border investment, both inflows and outflows, also has grown dramatically

in the last 40 years. In 1960, cross border investment represented just over one percent of GDP. In 2001, it was more than 11% of GDP, representing annual crossborder flows of more than $1.1 trillion. The aggregate cross border ownership of capital is valued at $16 trillion. In addition, U.S. multinational corporations are now

responsible for more than one-quarter of U.S. output and about 15 percent of U.S.

employment.

Globalization and Competitiveness and U.S. Tax Policy

At the same time companies are competing for sales, they are also competing for

capital: U.S.-managed firms may have foreign investors, and foreign-managed firms

may have U.S. investors. Portfolio investment accounts for approximately two-thirds

of U.S. investment abroad and a similar fraction of foreign investment in the U.S.

The U.S. tax rules have important effects on international competitiveness both

because of the integration of domestic activities of U.S. multinational companies

with their foreign activities and because repatriated foreign earnings of foreign investments are subject to U.S. domestic tax. Increasingly, the flow of goods and services is not through purchases between exporters and importers, but through transfers between affiliates of multinational corporations. The rules governing transfer

pricing, interest allocation, withholding rates, foreign tax credits, and the taxation

of actual or deemed dividends affect these flows.

As a general rule, the ideal tax system should seek to minimize distortions to

trade or investment relative to what would occur in a world without taxes. Every

country makes sovereign decisions about its own tax system, so it is impossible for

the U.S. to level all playing fields simultaneously. But we can ensure that our own

rules minimize the barriers to the free flows of capital that globalization necessitates. Similarly, every country makes sovereign decisions about its labor markets,

environmental regulations, and health and safety regimes. Fortunately, we have

had enough wisdom over the years to avoid attempting to level these playing fields.

But our attempts to level the playing field in tax policy have often erected costly

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barriers to the free flows of capital that maximizing our international competitiveness necessitates.

The question we must answer is what we can do to increase the competitiveness

of U.S. businesses and workers. Professor Michael Graetz observed in his book, The

Decline (and Fall?) of the Income Tax:

The internationalization of the world economy has made it far more difficult

for the United States, or any other country for that matter, to enact a tax system radically different from those in place elsewhere in the world. In today’s

worldwide economy, we can no longer look solely to our own navels to answer

questions of tax policy.

Professor Graetz is right. We must write tax rules that take into account what

other countries are doing. If what they are doing is inconsistent with improving

their own international competitiveness, then we should not follow. But if they appear to be moving in ways that will improve their ability to compete, then we must

reconsider the extent to which our rules impede the flow of capital of US businesses,

necessitate inefficient business structures and operations, and leave US companies

and workers in a less competitive position.

U.S. Taxation of Income Earned Abroad

Given the significance of competitiveness concerns, we should consider the ways

in which our tax system (1) differs from that of our major trading partners to identify aspects that may hinder the competitiveness of U.S. companies and workers,

and (2) creates barriers to efficient capital flows. About half of the OECD countries

employ a worldwide tax system similar to that of the United States. The practical

effect of a worldwide system is a tax on U.S. companies repatriating their earnings

to the extent foreign tax credits are unavailable to offset U.S. taxes. That tax creates a hurdle to companies bringing profits back to the United States. It means U.S.

investments abroad often face a higher hurdle than if a foreign competitor made the

same investment. That is a hurdle foreign competitors in territorial tax systems do

not face, for example, and a hurdle foreign competitors investing in the U.S. do not

face. This creates an incentive for U.S. companies to keep their income abroad,

which can increase the cost of investment in the United States. That is a result that

disadvantages U.S. workers.

Even limiting comparisons of our system to that of countries using a worldwide

tax system, U.S. multinationals can be disadvantaged when competing abroad. This

is because the U.S. worldwide tax system, unlike other worldwide systems, can tax

active forms of business income earned abroad before it has been repatriated, and

it often imposes stricter limits on the use of foreign tax credits that prevent double

taxation of income earned abroad.

Limitations on Deferral

Under the U.S. international tax rules, income earned abroad by a foreign subsidiary generally is subject to U.S. tax at the U.S. parent corporation level only

when such income is distributed by the foreign subsidiary to the U.S. parent in the

form of a dividend. An exception to this general rule is provided with the rules of

subpart F of the Code, under which a U.S. parent is subject to current U.S. tax on

certain income of its foreign subsidiaries, without regard to whether that income is

actually distributed to the U.S. parent. The focus of the subpart F rules is on passive, investment-type income that is earned abroad through a foreign subsidiary.

However, the reach of the subpart F rules extends well beyond passive income to

encompass some forms of income from active foreign business operations. No other

country has rules for the immediate taxation of foreign-source income that are comparable to the U.S. rules in terms of breadth and complexity.

Several categories of active business income are covered by the subpart F rules.

Under subpart F, a U.S. parent company is subject to current U.S. tax on income

earned by a foreign subsidiary from certain sales transactions. Accordingly, a U.S.

company that uses a centralized foreign distribution company to handle sales of its

products in foreign markets is subject to current U.S. tax on the income earned

abroad by that foreign distribution subsidiary. In contrast, a local competitor with

sales in that market is subject only to the tax imposed by that country. Moreover,

a foreign competitor that similarly uses a centralized distribution company with

sales into the same markets also generally will be subject only to the tax imposed

by the local country. While this subpart F rule may operate in part as a ‘‘backstop’’

to the transfer pricing rules that require arms’ length prices for inter-company

sales, this rule has the effect of imposing current U.S. tax on income from active

marketing operations abroad. U.S. companies that centralize their foreign distribution facilities therefore face a tax penalty not imposed on their foreign competitors.

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The subpart F rules also impose current U.S. taxation on income from certain

services transactions performed abroad. In addition, a U.S. company with a foreign

subsidiary engaged in shipping activities or in certain oil-related activities, such as

transportation of oil from the source to the consumer, will be subject to current U.S.

tax on the income earned abroad from such activities. In contrast, a foreign competitor engaged in the same activities generally will not be subject to current homecountry tax on its income from these activities. While the purpose of these rules is

to differentiate passive or mobile income from active business income, they operate

to subject to current tax some classes of income arising from active business operations structured and located in a particular country for business reasons wholly unrelated to tax considerations. In other words, in seeking to capture as much passive

international income as possible, subpart F captures a large share of active income

as well, putting the companies that earn this active income at a distinct competitive

disadvantage.

Limitations on Foreign Tax Credits

Under the worldwide system of taxation, income earned abroad potentially is subject to tax in two countries—the taxpayer’s country of residence and the country

where the income was earned. Relief from this potential double taxation is provided

through the mechanism of a foreign tax credit under which the tax that otherwise

would be imposed by the country of residence may be offset by tax imposed by the

source country. The United States allows U.S. taxpayers a foreign tax credit for

taxes paid on income earned outside the United States.

The foreign tax credit may be used to offset U.S. tax on foreign-source income but

may not offset U.S. tax on U.S.-source income. The rules for determining and applying this limitation are detailed, complex, and can have the effect of subjecting U.S.-

based companies to double taxation on their income earned abroad. The current U.S.

foreign tax credit regime also requires that the rules be applied separately to separate categories or ‘‘baskets’’ of income. Foreign taxes paid with respect to income in

a particular category may be used only to offset the U.S. tax on income from that

same category. Computations of foreign and domestic source income, allocable expenses, and foreign taxes paid must be made separately for each of these separate

foreign tax credit baskets, further adding to the complexity of the system.

The application of the foreign tax credit limitation to ensure that foreign taxes

paid offset only the U.S. tax on foreign-source income requires a determination of

net foreign-source income for U.S. tax purposes. For this purpose, foreign-source income is reduced by U.S. expenses that are allocated to such income. Under the current rules, interest expense of a U.S. affiliated group is allocated between U.S. and

foreign-source income based on the group’s total U.S. and foreign assets. The stock

of foreign subsidiaries is taken into account for this purpose as a foreign asset (without regard to the debt and interest expense of the foreign subsidiary). These rules

thus treat interest expense of a U.S. parent as relating to its foreign subsidiaries

even where those subsidiaries are equally or more leveraged than the U.S. parent.

This over-allocation of interest expense to foreign income inappropriately reduces

the foreign tax credit limitation because it understates foreign income. The effect

can be to subject U.S. companies to double taxation. Other countries do not have

expense allocation rules nearly as extensive as ours.

Under the current U.S. rules, if a U.S. company has an overall foreign loss in a

particular taxable year, that loss reduces the company’s total income and therefore

reduces its U.S. tax liability for the year. Special overall foreign loss rules apply to

re-characterize foreign-source income earned in subsequent years as U.S.-source income until the entire overall foreign loss from the prior year is recaptured. This recharacterization has the effect of limiting the U.S. company’s ability to claim foreign

tax credits in those subsequent years. No comparable recharacterization rules apply

in the case of an overall domestic loss. However, a net loss in the United States

would offset income earned from foreign operations, income on which foreign taxes

have been paid. The net U.S. loss thus would reduce the U.S. company’s ability to

claim foreign tax credits for those foreign taxes paid. This gives rise to the potential

for double taxation when the U.S. company’s business cycle for its U.S. operations

does not match the business cycle for its foreign operations.

These rules can have the effect of denying U.S.-based companies the full ability

to credit foreign taxes paid on income earned abroad against the U.S. tax liability

with respect to that income and therefore can result in the imposition of the double

taxation that the foreign tax credit rules are intended to eliminate.

Double Taxation of Corporate Income

While concern about the effects of the U.S. tax system on international competitiveness may focus on the tax treatment of foreign-source income, competitiveness

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issues arise in very much the same way in terms of the general manner in which

corporate income is subject to tax in the United States.

Prior to the enactment of the Jobs and Growth Tax Relief Reconciliation Act of

2003 (JGTRRA), the United States was one of the few industrialized countries that

failed to provide some form of integration of corporate and individual income taxes.

Income from an equityfinanced investment in the corporate sector was taxed twice,

first as profit under the corporate income tax and again under the individual income

tax when received by the shareholder as a dividend or as a capital gain on the appreciation of corporate shares. In contrast, under a fully integrated tax system, the

double tax would be eliminated and a single tax would be imposed on corporate

profit. Most OECD countries offer some form of integration under which corporate

tax payments are either partially or fully taken into consideration when assessing

shareholder taxes on this income, eliminating or reducing the double tax on corporate profits.

The prior non-integration of corporate and individual tax payments on corporate

income applied equally to domestically earned income or foreign-source income of a

U.S. company. The double tax increased the ‘‘hurdle’’ rate, or the minimum rate of

return required on a prospective investment. To yield a given after-tax return to an

individual investor, the pre-tax return must be sufficiently high to offset both the

corporate level and individual level taxes paid on this return.

Whether competing at home against foreign imports or competing abroad through

exports from the United States or through foreign production, the double tax made

it less likely that the U.S. company could compete successfully against a foreign

competitor.

To address the high effective tax rate on corporate equity investments, JGTRRA

partially integrated corporate and individual taxes by providing relief from the double tax at the individual level through reduced tax rates on corporate dividends and

capital gains. The maximum tax rate on dividends paid by corporations to individuals and on individuals’ capital gains is reduced to 15 percent in 2003 through 2008.

For taxpayers in the 10 percent and 15 percent income tax rate brackets, the rate

on dividends and capital gains is reduced to 5 percent in 2003 through 2007, and

to zero in 2008.

Because JGTRRA reduced the effective tax rate on income earned in the corporate

sector, many more investments can achieve a desired after-tax return (after both

corporate and individual taxes are paid) than under the prior non-integrated tax

system. As a result, projects that could not attract equity capital in a non-integrated

tax system because they might not be sufficiently profitable are able to attract equity capital in the present partially integrated system. Nevertheless, taxes on equity

investments in the corporate sector are still higher than they would be under a fully

integrated system. In the context of competitiveness, this may mean that a project

that would otherwise be undertaken by a U.S. company, either at home or abroad,

is instead undertaken by a foreign competitor. An additional concern is that the

present relief from the double tax is scheduled to expire in 2009. To help ensure

the competitiveness of U.S. companies, the present relief from the double tax for

dividends and capital gains should be made permanent.

Additional Issues Involving Business Taxation

Mr. Chairman, in addition to the need to reevaluate our international tax rules,

there are other tax policy issues that require consideration.

The President’s February budget contained a number of tax provisions in addition

to those that were eventually enacted in JGTRRA that are also intended to

strengthen the economy. Those proposals affect a wide range of areas, including encouraging saving, strengthening education, investing in health care, increasing

housing opportunities, protecting the environment, encouraging telecommuting, and

providing incentives for charitable giving. They also include specific proposals to rationalize the tax laws, such as the repeal of section 809, and to simplify the tax

laws, such as a permanent expansion of section 179, and to improve tax administration. To maintain their favorable effects and provide greater certainty for economic

and financial planning, the Budget proposed to extend several tax provisions that

expire in 2003 and 2004, and to make permanent the tax cuts enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001.

The President’s budget also proposes to make permanent the research and experimentation tax credit. Research is central to American businesses’ ability to compete

successfully in the global economy. It results in new processes and innovative products that open up new markets and create job opportunities. American businesses

can continue to compete only if they stay at the forefront of technological innovation.

The research credit encourages technological developments that are an essential

component of economic growth and a high standard of living in the future. A permaVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00094 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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nent research credit would remove the uncertainty about its availability in the future and thereby enable businesses to factor the credit into their decisions to invest

in research projects.

The current system of tax depreciation also merits reevaluation. The 2000 Treasury Report to Congress on Depreciation Recovery Periods and Methods identified a

number of issues with the current system of tax depreciation. Each issue represents

a potential avenue to improving the tax system, and may warrant further study.

One such issue is that the current system lacks a firm conceptual rationale. For example, it does not reflect inflation-indexed economic depreciation. This means that

tax depreciation allowances can deviate significantly from those required to properly

measure income and from those that would provide a uniform investment incentive

for all assets.

A second issue in depreciation policy is that the current system is dated. The

asset class lives that serve as the primary basis for assignment of recovery periods

have remained largely unchanged since 1981, and most class lives date back at least

to 1962. Entirely new industries have developed in the interim, and production processes in existing industries have changed.

A third issue is that the current depreciation system suffers from an ambiguous

system for determining each asset’s cost recovery period. This ambiguity contributes

to administrative problems, makes it difficult to integrate new assets and activities

into the system rationally, and inhibits rational changes in class lives for existing

categories of investment.

Finally, in addition to these broad issues, the existing system is hampered by a

number of narrower controversies, including the proper determination of the recovery period for real estate, the possible recognition of losses on the retirement of

building components, and the presence of cliffs and plateaus in cost recovery periods

that distorts the relationship between economic life and tax life.

The corporate alternative minimum tax (AMT) is an alternative tax system to the

regular tax system. When investments and other expenses are large relative to a

company’s taxable income, as occurs during economic downturns, alternative minimum tax may be owed. Corporate AMT payments represent a pre-payment of tax

that the taxpayer will get back when and if the taxpayer returns to a sufficient level

of profitability.

A significant problem with the AMT that is especially relevant today is that the

AMT reduces the stabilizing property of the corporate income tax, raising tax liabilities just when the taxpayer is most troubled economically. In general, tax payments

should help stabilize the economy by falling as the economy’s performance declines,

thereby reducing the impediment taxes place on consumption, investment, and production. The AMT tends to impose an increased tax burden during an economic

downturn, which prolongs periods of economic weakness by reducing business activity. During an economic downturn, companies that seek to maintain a constant level

of investment and employment are more likely to pay AMT or pay larger amounts

of AMT. This is because AMT adjustments and preferences will represent a larger

portion of their taxable income than during periods of high profitability.

The AMT also limits the use of net operating losses (NOLs) which tend to increase

during economic downturns. Under the AMT, NOLs may not reduce a taxpayer’s alternative minimum taxable income (AMTI) by more than 90 percent. The Job Creation and Worker Assistance Act of 2002 temporarily waived the AMTI limitation

for NOL carrybacks arising in 2001 and 2002 as well as carryforwards to those

years. In view of the slow pace of the economy recovery, the President’s Budget proposed to waive the AMTI limitation for NOL carrybacks originating in 2003, 2004,

and 2005, as well as for NOLs carried forward into those years. This change would

provide appropriate tax relief for businesses in difficult financial straits.

Another aspect of the AMT is that it limits the use of foreign tax credits. Foreign

tax credits can offset no more than 90 percent of the tentative minimum tax. Excess

AMT foreign tax credits can be carried forward 5 years or back 2 years. Because

the foreign tax credit is intended to ensure that foreign income of US corporations

is not double taxed, the AMT’s limitation on the use of foreign tax credit should be

reconsidered.

It has been observed that ‘‘it is difficult to predict the future of an economy in

which it takes more brains to figure out the tax on our income than it does to earn

it.’’ That is the situation we face. Our tax laws are extraordinarily complex. A recent

IRS study of the burden and cost of complexity to individual taxpayers put the burden well in excess of three billion hours per year and the cost well in excess of $60

billion per year. And that is just the individual side. The rules on the business side

are even worse. While large businesses can grapple with it, many small and medium-size businesses cannot. The challenge for businesses trying to comply with the

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law—or the IRS trying to administer and enforce it—is enormous. It is time for us

to undertake a serious effort to simplify our tax rules.

The complexity is nowhere more evident than in our international tax rules. A

reexamination is needed, including of the fundamental assumptions underlying the

current system. We should look to the experiences of other countries and the choices

they have made in designing their international tax systems. Consideration should

be given to fundamental reform of the U.S. international tax rules and to significant

reforms within the context of our current system.

The many layers of rules in our current system arise in large measure because

of the difficulties inherent in satisfactorily defining and capturing income for tax

purposes, particularly in the case of activities and investments that cross jurisdictional boundaries. However, the complexity of our tax law itself imposes a significant burden on U.S. companies. Therefore, we must not lose sight of the need to

simplify our international tax rules.

RESPONSE TO A QUESTION FROM SENATOR GRASSLEY

Question. Company X manufactures widgets in the United States for sale in the

United States and abroad. It forms a subsidiary, Y, in a zero-tax jurisdiction such

as Bermuda to serve as a trading company. Y hires 200 persons in Hamilton. Widgets are sold by X to Y for 100, and Y re-sells the widgets (without changing them)

for 125 to unrelated parties in the United States and throughout the rest of the

world. The transfer price from X to Y is defensible. The 25 earned by Y is attributable to economic functions that Y performs in Bermuda. Should the United States

currently tax that 25? Why or why not?

Answer. Under the U.S. international tax rules, income earned abroad by a foreign subsidiary generally is subject to U.S. tax at the U.S. parent corporation level

only when such income is distributed by the foreign subsidiary to the U.S. parent

in the form of a dividend. An exception to this general rule is provided with the

rules of subpart F of the Internal Revenue Code, under which a U.S. parentis subject to current U.S. tax on certain income of its foreign subsidiaries without regard

to whether that income is actually distributed to the U.S. parent. The focus of the

subpart F rules is on passive, investment-type income that is earned abroad through

a foreign subsidiary. The reach of the subpart F rules, however, extends well beyond

passive income to encompass some forms of income from active foreign business operations. This feature of our subpart F rules raises concern that subpart F can operate to create an inappropriate impediment to the competitiveness of U.S.-based multinational enterprises.

The impact of the subpart F rules on some forms of active foreign business operations is illustrated in the situation described in your question. If Company X is a

domestic company, the subpart F rules provide that Company X would be subject

to current U.S. tax on the active business income of the type earned by its foreign

subsidiary Company Y. The active business income earned outside the U. S. by

Company Y also may be subject to local income or other tax, and a foreign tax credit

would be available to Company X for any local income tax. Thus, the 25 earned by

Company Y would be subject to full U.S. tax on a current basis.

In contrast, if Company X were not a U.S. company, the 25 earned by Company

Y generally would be subject to local tax only, which in the facts described in your

question would be zero. If Company X were located in a country with a territorial

tax system, the home country would not impose tax even when the 25 earned by

Company Y is distributed to Company X. Thus, the 25 earned by Company Y would

never be subject to tax outside the country in which it was earned. Alternatively,

even if Company X were located in a country with a worldwide tax system, the

home country would impose tax only when the 25 earned by Company Y is distributed to Company X. Thus, the 25 earned by Company Y would be subject to tax

in Company X’s home country only upon repatriation. This illustrates how U.S.-

based companies may be disadvantaged under the subpart F base company sales

rules relative to companies based in countries with a territorial system or with a

worldwide system without rules like the U.S. subpart F base company sales rules.

It should be noted that the facts described in your question state that the transfer

pricing analysis of the related-party transactions between Company X and Company

Y is defensible. Therefore the transfer prices are consistent with the results that

would have occurred had Company X and Company Y been dealing at arm’s length

and the 25 earned by Company Y is attributable to its active business operations.

The purpose of our transfer pricing rules is to ensure that Company Y is properly

treated as earning the amount of income attributable to its economic functions, and

income may be reallocated under the transfer pricing rules to achieve the arm’s

length, economic results.

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No other country has rules comparable to the U.S. subpart F rules in terms of

the extent to which active business income is taxed on a current basis. Thus, a U.S.-

based multinational enterprise faces a tax burden not imposed on its foreign competitors, which would be taxed on such income in their home countries upon repatriation or not at all. A system that did not impose current tax on active business income earned outside the United States by foreign subsidiaries would put U.S. companies on a more level playing field with their foreign competitors.

RESPONSE TO A QUESTIONS FROM SENATOR SMITH

Question. I echo the concerns that a number of my colleagues on both the Senate

and House tax-writing committees have made regarding our opposition to the proposed IRS rule requiring U.S. banks to report the deposit income on accounts held

by non-resident aliens. I still have concerns over the proposed rule and would like

to know if the Treasury plans on officially withdrawing it? If so, when, and, if not,

why not?

As I said in my letter to Secretary Snow in February, this rule, if enacted, would

help drive much foreign investment out of the U.S. into other countries. At this time

when our economy may be on the verge of some form of recovery, the last thing we

need is a policy to discourage that investment to leave our capital markets.

Answer. It is more important today than ever that no safe haven exist anywhere

in the world for the funds associated with illicit activities. Greater transparency can

aid in preventing illicit activities by making it more difficult to conceal them.

Treasury and the IRS are concerned about the use of offshore bank accounts by

U.S. taxpayers to avoid or evade taxes. We must address the potential for tax evasion through the use of offshore accounts or entities in order to maintain the confidence of all Americans in the fairness of our tax system.

Studies have shown that information that is reported to the IRS is significantly

more likely to be reported on a tax return. In order to obtain the information we

need to ensure compliance with U.S. tax laws, we must be prepared, in appropriate

cases, to provide comparable information to our treaty partners. The proposed regulation, if finalized, would reduce opportunities for offshore tax avoidance or tax evasion by facilitating the exchange of information important to tax compliance. Such

exchange of information would be pursuant to a U.S. income tax treaty and subject

to strict protections with respect to confidentiality of taxpayer information.

The information reporting in the proposed regulation is similar to the information

reporting currently required for other kinds of investment income paid to foreign

persons, including interest paid on other debt instruments, and is identical to the

information reporting currently required with respect to interest on bank deposits

paid to Canadian residents. Information reporting also is required for all manner

of investment income paid to U.S. persons.

Enhancing appropriate information exchange pursuant to our bilateral tax treaties in appropriate circumstances, subject to strict protections of the confidentiality

of taxpayer information, is an important means of reducing opportunities for tax

avoidance in the offshore sector. This proposed regulation is just one element of our

multi-faceted effort to protect the interests of honest taxpayers who are prepared

to pay their fair share of U.S. taxes and who should not have to bear a greater burden because of the few who are less than honest.

RESPONSES TO QUESTIONS FROM SENATOR BUNNING

Question 1. Along with a number of my colleagues on both the Senate Finance

and Banking Committees, I contacted Secretary Snow earlier this year to express

my opposition to the proposed I.R.S. regulation requiring U.S. banks to report the

interest income on accounts held by nonresident aliens. According to the Treasury

Department and Commerce Department, U.S. banks have more than $1 trillion of

deposits from overseas. Most of these funds appear to be bank-to-bank deposits, but

a significant portion presumably is in nonresident alien accounts. Could you please

provide a detailed breakdown of the sources of foreign deposits, both by origin and

type of deposit? Moreover, does the Treasury Department believe that the regulation

will lead to the loss of any deposits?

Answer. Treasury data provide a $45 billion figure for the bank deposits of individuals, institutions, and entities, and the balances of foreign brokers (a type of deposits recently added to this data category), from the 15 countries covered by the

proposed regulation. We do not have data that is limited to the deposits of individuals, which is what the proposed regulation covers. (Data are from Treasury International Capital (TIC) System, ‘‘US Banking Liabilities to Foreigners’’.)

The $45 billion figure includes:

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(1) demand and time deposits and nonnegotiable certificates of deposit from foreign individuals, foreign partnerships, and foreign non-financial corporations from

the 15 countries;

(2) negotiable certificates of deposit from all foreign persons (including foreign

governments and financial institutions as well as other foreign non-financial corporations and foreign individuals and partnerships) from the 15 countries; and

(3) balances of foreign brokers from the 15 countries.

As the proposed regulation does not apply to deposits of foreign corporations,

banks, brokers, or governments, which are the main foreign holders of U.S. deposits,

and only applies to foreign individuals resident in the 15 countries, the total U.S.

deposits covered by the proposed regulation is likely to be significantly less than $45

billion.

The $45 billion figure is less than one percent of total foreigners’ financial assets in the United States. The $45 billion figure also is less than one percent of total

U.S. bank deposits.

Treasury data do not show an outflow of funds surrounding prior changes in the

information reporting rules. For example, similar concerns regarding the potential

outflow of funds were voiced when identical reporting rules currently in place for

Canadian residents were first proposed, but the predicted capital flight did not occur

when the reporting rules were implemented.

Nonresidents have many reasons for depositing money in U.S. banks, including

our nation’s political and economic stability, the strength and stability of our financial institutions, and the quality of our regulatory supervision.

Question 2. Foreigners withdrew a significant amount of time deposits, $40 billion

on an annualized basis, in the first quarter of 2001 following the initial announcement of the proposed rule. Do you think this was a coincidence, or could it have

been associated with the announced rule?

Answer. The change in deposits in the first quarter of 2001 does not appear to

be related to the announcement of the original proposed regulation relating to information reporting for bank deposit interest paid to foreign persons. Rather, as the

numbers below reveal, the change in deposits in the first quarter of 2001 reflected

an unusually high amount of deposits as of December 2000 rather than an unusually low amount of deposits as of March 2001.

The Flow of Funds quarterly data on Foreigners’ Time & Savings Deposits was

as follows (in billions):

Sept. 2000—$98

Dec. 2000—$107.2

Mar. 2001—$97.2

Jun. 2001—$97.8

The level of total foreign deposits in U.S. banks as of March 2001 was consistent

with the level as of September 2000 and the level as of June 2001.

(The reduction in deposits of $10 billion between December 2000 and March 2001

was multiplied by 4 to obtain the referenced annualized reduction of $40 billion.

Note, these figures include deposits of foreign governments and foreign banks from

all countries. As discussed in response to the prior question, deposits of individuals

generally, and of individuals in the 15 countries covered by the current proposed

regulation in particular, make up a small subset of total U.S. bank deposits.)

Question 3. European Union officials have stated that the interest-reporting regulation is a measure of whether the United States supports an EU scheme known

as the savings tax directive. The White House, however, already has announced that

the Administration will not participate in the European Union’s so-called savings

tax directive. How does the Treasury Department’s position on the savings tax directive differ from the President’s position?

Answer. The Treasury Department’s position with respect to the European

Union’s Savings Directive is identical to the President’s position.

The Savings Directive is a pending internal EU initiative regarding the exchange

of information for tax purposes among EU countries with respect to certain crossborder payments. The United States is not a party to this EU initiative.

The United States has tax information exchange relationships through bilateral

treaties and agreements, including bilateral income tax treaties with countries that

are members of the European Union. These relationships provide us with information that is critical to our ability to enforce the U.S. tax laws. The provisions of bilateral income tax treaties and tax information exchange agreements, which are

subject to our required conditions regarding the strict protection of the confidentiality of taxpayer information, are the only means by which the United States exchanges tax information.

Question 4. In the past, you have stated that the interest-reporting regulation was

revised to take into account the comments received on the January 2001 regulaVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00098 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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tions. The only meaningful difference between the original regulation and the revised regulation, however, is that the new version applies to depositors from a narrower range of nations. Could you specifically cite the comments that guided the

change in the proposed regulation?

Answer. The proposed regulation was revised to take into account the concern expressed by the banking industry that the regulation could cause foreign depositors

from some countries to withdraw their funds from U.S. banks because of worries

about the potential misuse of such information for purposes of violence if it were

to be obtained by their own governments. These concerns of the banking industry

in this regard were focused on less-stable countries. The United States generally

does not have tax treaties with such countries, and tax information would not under

any circumstances be provided to any country with which the United States does

not have a tax treaty or tax information exchange agreement.

Any foreign government that receives tax information pursuant to a treaty or tax

information exchange agreement with the United States is subject to stringent restrictions. It is required to keep such information confidential and to use such information only for tax administration purposes. Moreover, the IRS closely monitors the

administrative law and practice of the countries with which the United States has

treaties or agreements that would permit tax information exchange in order to ensure compliance with these legal requirements.

Thus, there was no real potential for misuse of the information that would have

been covered by the original proposed regulation. Nevertheless Treasury recognized

the overbreadth of the original proposed regulation, which would have required information reporting with respect to residents of countries with which the United

States does not have an income tax treaty or tax information exchange agreement

under which such information could be used. Accordingly, responding to the banking

industry’s concerns about the perceived threat, Treasury and the IRS withdrew and

revised the proposed regulation. The revised proposed regulation would require reporting only for bank deposit interest paid to residents of 15 specified countries (e.g.,

Australia, New Zealand, and various European countries), all of which are countries

with which the United States has a bilateral tax treaty and a strong reciprocal exchange of information relationship. The Florida Bankers Association, which was

very active in communicating the banking industry’s concerns about the potential

implications of the original proposed regulation, has welcomed this narrowing of the

proposed regulation. Identical reporting regulations are currently in place for interest paid to residents of Canada, another country with which the United States has

a bilateral tax treaty and a strong reciprocal exchange of information relationship.

Question 5. You stated that the re-proposed regulation will facilitate the goal of

ensuring compliance with U.S. tax laws, but the United States does not tax this income. Could you please indicate how this regulation assists in the enforcement of

U.S. tax law? Specific examples of how this regulation will help achieve that goal

would be helpful as would references to existing tax treaties and tax information

exchange agreements, along with the sections that require the collection of information that is not needed for domestic enforcement purposes.

Answer. It is more important today than ever that no safe haven exist anywhere

in the world for the funds associated with illicit activities. Greater transparency can

aid in preventing illicit activities by making it more difficult to conceal them.

Treasury and the IRS are concerned about the use of offshore bank accounts by

U.S. taxpayers to avoid or evade taxes. We must address the potential for tax evasion through the use of offshoreaccounts or entities in order to maintain the confidence of all Americans in the fairness of our tax system.

Studies have shown that information that is reported to the IRS is significantly

more likely to be reported on a tax return. In order to obtain the information we

need to ensure compliance with U.S. tax laws, we must be prepared, in appropriate

cases, to provide comparable information to our treaty partners. The proposed regulation, if finalized, would reduce opportunities for offshore tax avoidance or tax evasion by facilitating the exchange of information important to tax compliance. Such

exchange of information would be pursuant to a U.S. income tax treaty and subject

to strict protections with respect to confidentiality of taxpayer information.

The information reporting in the proposed regulation is similar to the information

reporting currently required for other kinds of investment income paid to foreign

persons, including interest paid on other debt instruments, and is identical to the

information reporting currently required with respect to interest on bank deposits

paid to Canadian residents. Information reporting also is required for all manner

of investment income paid to U.S. persons.

Enhancing appropriate information exchange pursuant to our bilateral tax treaties in appropriate circumstances, subject to strict protections of the confidentiality

of taxpayer information, is an important means of reducing opportunities for tax

96

avoidance in the offshore sector. This proposed regulation is just one element of our

multi-faceted effort to protect the interests of honest taxpayers who are prepared

to pay their fair share of U.S. taxes and who should not have to bear a greater burden because of the few who are less than honest.

Question 6. Congress repeatedly has examined the tax treatment of interest paid

to nonresident aliens and always decided not to tax the income. Congress also has

never sought to require the reporting of this income. According to legislative records,

lawmakers were motivated by a desire to attract capital to the U.S. economy. Could

you explain, therefore, how the interest-reporting regulation is consistent with existing law?

Answer. The exchange of information for tax purposes is a longstanding tenet of

U.S. international tax policy. The importance of tax information exchange between

the United States and other countries has long been recognized by Congress. In

1983, for example, Congress enacted the Caribbean Basin Economic Recovery Act,

which contains provisions designed to foster negotiation of tax information exchange

agreements. In particular, section 274(h)(6) of the Internal Revenue Code allows deductions to U.S. taxpayers for the expenses of a convention held in certain foreign

jurisdictions (which deductions otherwise would be limited under the Code), provided that the jurisdiction has a tax information exchange agreement with the

United States that meets specified minimum standards. The minimum standards

for tax information exchange reflected in section 274(h)(6) form the basis of current

international standards in this area.

In its advice and consent role with respect to U.S. income tax treaties, the Senate

Foreign Relations Committee has repeatedly expressed strong opposition to any perceived softening of the United States’ commitment to full tax information exchange.

In 1999, the Foreign Relations Committee expressed its concern about the potential

for bank secrecy rules to operate to limit access to information: ‘‘The Committee

would have serious concerns with respect to a proposed treaty if the other country

restricted access to this information and were unwilling to change its internal laws

to accommodate full exchanges of information. The exchange of information provisions in treaties are central to the purposes for which tax treaties are entered into,

and significant limitations on their effect, relative to the preferred U.S. tax treaty

position, should not be accepted in negotiations with other countries that seek to

have or maintain the benefits of a tax treaty relationship with the United States.’’

The Internal Revenue Code provides that Treasury and the IRS may require information reporting even though such investment income is not subject to taxation

in the United States. The information reporting in the proposed regulation is identical to the information reporting currently required with respect to interest on bank

deposits paid to Canadian residents and is similar to the information reporting currently required for other kinds of investment income paid to foreign persons, including interest paid on other debt instruments.

Question 7. Earlier in its tenure, the Bush Administration agreed to give the EU

and its WTOinconsistent regime for licensing banana imports more than five years

of transition. Given this precedent, what length of transition relief do you feel would

be appropriate for American users of ETI?

Answer. The issue of transition relief in connection with the current-law ETI provisions is an important one. Compliance with the WTO rules will require repeal of

the ETI provisions, which were enacted in 2000 to replace the prior-law FSC provisions. The ETI provisions provide a significant benefit to many U.S. companies and

we believe that the required repeal should be coupled with other changes to our tax

law that will help enhance the competitiveness of U.S. companies and American

workers in today’s global marketplace.

Given the significance of the changes that will be made to our tax rules, a period

of transition relief for those companies that have made plans and decisions based

on the availability of the ETI rules certainly is reasonable. Indeed, transition relief

is typically included in this kind of tax law changes. However, the WTO considered

the transition relief that was provided in 2000 when the FSC provisions were repealed, subject to transition rules, and the ETI provisions were enacted. The WTO

made clear in its opinion regarding the ETI provisions that this transition relief was

itself a violation of WTO rules. Therefore, the inclusion of transition relief in the

legislation needed to come into compliance with our WTO obligations will require

discussion with the European Union. It is not clear what the European Union will

be willing to accept in terms of transition relief but the shorter the transition period, the less the risk of retaliation by the European Union.

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RESPONSES TO QUESTIONS FROM SENATOR BINGAMAN

Question 1. During today’s question and answer period, you mentioned several

studies that indicate that for every job created overseas by a U.S. corporation creates two jobs in the United States. Could you please provide me with these studies?

Answer. There are two studies that provide valuable information regarding the

complementarity between the foreign activities and outlook of U.S.-based multinational corporations and their current and future contribution to the domestic

economy. They are: OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, 1998, and Laura D’Andrea Tyson, ‘‘They Are Not Us: Why

American Ownership Still Matters,’’ American Prospect, Winter 1991. My answer

mistakenly combined two separate points from these studies which I have corrected

below.

The first point relates to the relationship between U.S. operations abroad and exports from the United States. The foreign affiliates of U.S. corporations rely heavily

on exports from the United States. When it comes to the export of American manufactured products, U.S. multinationals are their own best customer. Rather than displacing exports from the United States, the international activities of U.S. multinational corporations generate a net trade surplus. The Organization for Economic

Cooperation and Development study referenced above finds that $1.00 of outward

foreign direct investment is associated with $2.00 of additional exports and an increase in the bilateral trade surplus of $1.70.

The second point relates to the positive relationship between the international activities of U.S. companies and employment and jobs here in the United States. In

the Tyson study referenced above, Professor Tyson, former Chair of the Council of

Economic Advisors, has pointed out a number of political, strategic, and economic

reasons why maintaining a high share of U.S. control over global assets is important

to our national interest. These include the fact that U.S. multinationals locate over

70 percent of their employment and capital assets in the United States; that is, over

two jobs in the United States for every job abroad and more than $2.00 of capital

assets for every $1.00 of assets abroad. Their pay and investment per employee in

the United States is greater than in either developed or developing countries. Finally, U.S. multinationals conduct a very large percentage of their research and development domestically, which is critical to maintaining our technological leadership.

The bottom line is that the global success of U.S. companies competing in today’s

economy matters in terms of economic growth and jobs in the United States.

Question 2. During the same period, you mentioned that Treasury agreed that job

creation and job retention is one of the primary goals of our international tax system although your testimony was more focused on tax provisions that would benefit

U.S. corporations operating overseas. Could you please provide me with any provisions not included in your testimony that you believe would benefit U.S. manufacturing, including costs associated with these options?

Answer. It is important to begin with an appreciation of the fact that multinational corporations’ international operations are closely linked to their domestic

operations. Over half of U.S. exports are produced by multinational corporations.

More than 40% of those exports are sold to foreign affiliates of the U.S. producer.

The consequence of that relationship is that changes to the international tax rules

under which U.S. multinational corporations operate affects their global competitiveness and, therefore, the competitiveness of their domestic operations. The competitiveness of U.S. exporters also affects the competitiveness of their domestic suppliers, who may not export themselves but, who through their sales to exporters,

depend on and are part of the global marketplace. Changes to the international tax

rules may have a less direct effect on U.S. operations, but the effect is particularly

important in the increasingly global marketplace.

There are also changes that would affect positively and directly U.S. operations,

some of which are included in the Administration’s mid-session review of the FY

2004 budget. The midsession review includes several proposals that would strengthen the economy and benefit manufacturing, including several proposals that would

provide incentives for investment and innovation. For example, it would make the

following provisions permanent: the reduced tax rates for dividends and capital

gains enacted under JGTRRA at a cost of $57 billion and $44 billion, respectively,

for FY 2003–13; the increase in the amount of investment that may be expensed

at a cost of $24 billion for FY 2003–13; and the research and experimentation tax

credit at a cost of $68 billion for FY 2003–13.

Other areas of business taxation merit consideration, and many of them have

been included in various bills introduced to address the need to bring our tax law

into compliance with the World Trade Organization rules on export subsidies. They

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include the following: (1) Reduce corporate income tax rates in order to boost profitability, such as the tax rates that largely apply to small and medium-sized enterprises; (2) Reduce the burden of the corporate alternative minimum tax (AMT), such

as by reducing or eliminating the AMT depreciation adjustment, expanding taxpayers’ ability to use losses and foreign tax credits to reduce AMT tax liability, and

increasing the number of small corporations that are exempt from the AMT; (3) Extend the NOL carryback period beyond two years so that taxpayers who experience

losses have the ability to increase their cash flow through the refund of income

taxes paid in prior years; (4) Shorten depreciation recovery periods where tax depreciation may be slower than economic depreciation, such as for certain real estate;

and (5) Simplify tax rules to reduce compliance burdens, such as rules related to

cost capitalization and long term contracts. These changes would have a particularly

positive effect on cyclical and capital intensive industries, such as manufacturing.

PREPARED STATEMENT OF H. DAVID ROSENBLOOM

Mr. Chairman and Members of the Committee: Thank you for the opportunity to

express my views on ‘‘U.S. Tax Policy and Its Effect on the International Competitiveness of U.S.-Owned Foreign Operations.’’

My name is David Rosenbloom. I am an attorney engaged in the private practice

of tax law and have specialized in the field of international taxation for nearly 30

years. I was International Tax Counsel at the United States Treasury Department

from 1978 through early 1981. I have taught international taxation at five U.S. law

schools and at educational institutions in many foreign countries. I am presently Director of the International Tax Program at the New York University School of Law

and a lecturer at the Faculty of Law of the University of Sydney, in Sydney, Australia.

It is commendable that the Committee is focusing specifically on tax policy relating to international, or cross-border, taxation. This is a complex subject and, all too

often, it has become a stepchild in the midst of larger, more general tax legislation.

My intent today is to describe a context in which the international tax issues facing

the Committee might be considered.

I am, of course, aware of the pressures to reduce the burden on taxpayers in the

international area, as in others. Such pressures always exist, and often stem from

justified and well-documented concerns. There are, however, other important facets

to tax policy in addition to tax reduction.

No reasonable person would oppose the goal of maintaining competitiveness of

U.S.-owned foreign operations. It is surely in the interest not only of the owners

themselves but of the nation as a whole for U.S. business enterprise to prosper in

the international arena. The real question, however, is exactly what international

competitiveness implies for tax policy. If it implies rules that guarantee the ability

to stand toe-to-toe on the proverbial level playing field with foreign firms pursuing

active business endeavors, that is one thing. If it implies adopting in U.S. law the

most taxpayer-favorable provisions from the laws and practices of every other industrialized country, that is quite a different proposition.

The present international tax rules of the United States can certainly be improved

and, in the process, the competitiveness of U.S.-owned foreign operations enhanced.

The inbound aspects of those rules, relating to foreign persons investing in the

United States, date for the most part from 1966. The outbound aspects relating to

controlled foreign corporations—a focus of today’s hearing—were adopted in large

part in 1962. Much has obviously changed in the interim, and all aspects of the

rules could usefully be re-thought. As in other areas of U.S. tax policy, the substantive reach of our rules has come to exceed by far the grasp of tax administration, with the result that the law is much more intricate and bewildering than either necessary or desirable.

My personal preference in regard to outbound taxation would be to revamp the

rules completely in the name of simplicity, administrability, fairness, and competitiveness. This would lead to far more sweeping changes than are presently being

contemplated. Among the concepts I would favor would be: (a) a targeted exemption

system for active business income earned in developed countries and other countries

with acceptable tax systems, whether that income is earned in a foreign corporation

or not; (b) a tightening of rules with respect to income not attributable to an active

business and income derived in, or through the use of, tax havens; (c) the flexibility

through international tax treaties to tailor the basic rules to fit particular circumstances; and (d) a broad authorization to the Internal Revenue Service to ensure

that the new rules do not allow, but rather actually deter, tax sheltering activity.

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The United States has always been a leader in international taxation, not a follower. When we adopted legislation with respect to controlled foreign corporations

in 1962, we stood alone in the world. Last week I attended a conference in Austria

where representatives of a number of countries discussed recent developments in

CFC legislation and related case decisions in Italy, France, Finland, the United

Kingdom, Sweden, New Zealand, Australia, Canada, Germany, Austria, Japan, Norway, and several smaller countries. The CFC rules in these countries are all modeled to some extent on the U.S. rules from 1962, though they differ from ours in

various respects.

It appears that most countries that have adopted CFC laws have employed either

a ‘‘black list’’ or a ‘‘white list’’ to classify countries. This classification has been used

to identify home country shareholders that are taxed on income of controlled foreign

corporations in ‘‘black list’’ countries and that benefit from deferral of taxation in

‘‘white list’’ countries. In my view, this general approach is something the United

States should consider. The implicit judgment in our law that all foreign jurisdictions are alike is strikingly incorrect and leads to substantial problems both in the

rules we adopt and in their application. There are doubtless political implications

to making distinctions between countries, but we appear capable of making such

distinctions in other areas and I see no reason why the tax area is unique.

In any event, it is clear that the trend in the rest of the world is toward tightening home country taxation of foreign operations and foreign income, particularly

operations and income in tax havens. In these circumstances especially, the Committee should take time to consider carefully where the all-important lines between

current taxation and deferral should be drawn. I urge you not to rush, in the name

of competitiveness, to surrender segments of the U.S. tax base without at least considering countervailing measures with respect to income that is not active business

income and income benefiting from a tax haven regime.

For 1998, the Revenue Service received reports with respect to approximately

46,000 controlled foreign corporations owned by approximately 1,750 domestic corporations, as well as with respect to controlled foreign corporations owned by individuals. There are probably also many CFCs for which there has been no reporting.

Thus, CFC legislation is not relevant only to the Fortune 500. Many CFCs are not

engaged in active businesses, many are located in tax haven jurisdictions, and many

cannot make any reasonable claim to a competitiveness concern. There is unquestionably a ‘‘tax shelter’’ component to CFC planning and implementation. I am concerned that the legitimate competitiveness interests of some companies may carry

on their coattails unjustified benefits for persons whose foreign ‘‘operations’’ would

be deemed unworthy of protection by just about everyone.

A great deal of the recent discussion of outbound international tax policy has focused on how we tax the income of controlled foreign corporations, but our foreign

tax credit rules are, in my view, even more problematic. Excruciatingly complicated,

interpreted and reinterpreted in ways that can defy understanding, these rules are

now the province of a very limited group of specialists. It is largely for that reason,

as well as my understanding that little revenue derives from the taxation of foreign

active business income, that I would favor exemption of such income when it is

earned in jurisdictions that have real tax systems comparable in some way to our

own.

My comments have focused on controlled foreign corporations. There is much to

be said in addition about joint ventures and other outbound issues, including special

industry and special jurisdiction questions, transfer pricing, source rules, and the

relationship between statutory law and international tax treaties. As I have indicated, my preference would be to re-think all these matters before undertaking more

piecemeal reforms, but I recognize that may not be practical. In the circumstances,

I recommend that the Committee proceed carefully, considering tightening along

with loosening, and that it strive to do no harm to an existing and functioning U.S.

international tax system that, truly, is not so bad.

In fact, although that system can surely be improved, it is wrong to emphasize

the dysfunctionality of the present rules. Those rules have served the country well

for more than 40 years, and, in that time, I have not noticed any terrible deterioration of U.S. economic interests. Particular aspects of the rules have, on occasion,

produced distortions, but the distortions have been identified and eventually removed. There have also been some anecdotes relating to the general burden that

the rules impose, but there will always be anecdotal evidence of the adverse effect

of tax rules.

I think it important to recognize that there is no other tax system in the world

that works better than, or even as well as, the present U.S. system: it touches the

lives of more than 150 million people year in and year out, and does so with virtually no corruption, surprisingly little error, and remarkable efficiency, given the

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scope of the system and the complexity of our national economic life. Both the system as a whole and the agency that administers it are national treasures—the envy

of just about every other country that has devoted serious thought to these subjects.

In my judgment these sentiments apply to the international aspects of the system

no less than to the rest of it.

Such are the principles I think should inform any fresh view of the important subject of today’s hearing. The moment appears to offer one of the rare opportunities

in my professional lifetime for Congress to take such a fresh view and consider genuine international tax reform. I hope it will do so.

I would pleased to respond to any questions that Members of the Committee may

have.

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PREPARED STATEMENT OF STEPHEN E. SHAY

Mr. Chairman and Members of the Committee:

My name is Stephen Shay. I am a partner. in the law firm Ropes & Gray in Boston. 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 the

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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. 2See Michael J. Graetz, The David Tillinghast Lecture: Taxing International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies, 54 Tax Law Rev. 261, 284

(2001). 3Tax policy proposals are traditionally tested against the following criteria: tax rules should

(i) be efficient in that they should distort economic decisions and allocation of resources as little

as possible (unless the rule has an explicit subsidy or deterrent objective), (ii) be consistent with

U.S. fairness or welfare objectives as determined by the political branches of government, and

(iii) raise the intended revenue at a reasonable cost to the taxpayer and the government. See

U.S. Treasury Department, 3 Tax Reform for Fairness, Simplicity and Economic Growth 13–19

(1984). 4 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. 5On January 14, 2002, the WTO Appellate Body issued a report upholding a dispute resolution panel finding that the ETI is a prohibited export subsidy. Subsequent appeals have been

effects of U.S. tax policy on the international competitiveness of U.S.-owned foreign

corporations.1

With the Chairman’s permission, I would like to submit my testimony for the

record and summarize my principal observations in oral remarks. Because I learned

of my invitation to be a witness three days ago, I will necessarily keep my remarks

limited to a few aspects of this topic.

Overview

My first observations relate to the objectives of U.S. tax policy—of which international tax policy is only a part. The primary focus of U.S. income tax policy should

be to improve the lives and living standards of American citizens and residents.2

The question raised by the topic of this hearing is in what circumstances, if any,

improving the ‘‘taxcompetitiveness’’ of U.S.-owned foreign corporations (meaning reduced U.S. tax on their U.S. shareholders) improves the standards of living of American citizens and residents more than alternative uses of those tax dollars.

My second set of observations address the question whether U.S.-owned multinational corporations are ‘‘tax-disadvantaged’’ in relation to foreign-owned corporations conducting business operations outside the United States. Although aspects of

the U.S. tax rules excessively burden international commerce, to the detriment of

a particular U.S. company or even industry, I have not seen compelling evidence

that the U.S. tax rules taken as a whole are more onerous than the rules of other

countries, even including countries that employ a traditional exemption system. Indeed, there is legitimate debate as to whether adoption of a exemption system by

the United States would actually raise rather than lose revenue.

I encourage the Committee to consider international tax changes in the context

of the overall U.S. tax system. I suggest that the tax savings from the repeal of ETI

not be earmarked for international corporate taxation reforms, but instead be devoted to changes that are likely to improve the living standards of all Americans.

If a proposal to modify an international tax rule is superior to all other proposals

under that standard, then I would support it. I am not yet persuaded that the current international tax reform proposals meet that mark.

United States International Competitiveness

The objectives of the United States international income tax rules are to provide

for the interaction between the United States Federal income tax system and the

income tax systems (or absence of income tax systems) of other countries in a manner that achieves overall objectives of the United States. The international tax rules

are a subset of the overall U.S. income tax system, the principal objective of which

should be to collect revenue in the amount needed to fund the needs determined

by the political branches of government to improve over some reasonable period the

standard of living of U.S. citizens and residents.

The tax policy decisions before this Committee should be evaluated against a simple standard of U.S. competitiveness: will it improve over some reasonable period

the standard of living of individual U.S. citizens and residents? The fact that a policy increases the after-tax profitability of U.S. owners of foreign business entities

in relation to foreign owned business entities carrying on non-U.S. business should

be relevant only to the extent it may be demonstrated that U.S. citizens and residents will realize a benefit commensurate with the cost of the policy.3

Although not directly the topic of this hearing, the ETI does not appear to have

been tested against this or any other measurement standard. The effect of the ETI

regime is to reduce the tax rate on certain export income by approximately 15%.4

In the initial rush to find fault with the WTO decision finding the ETI to be an illegal export subsidy,5 and then to adopt some form of substitute benefit, I have not

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rejected and the United States has committed to repeal the ETI. The 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. 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 to further perpetuate the export benefits that commenced in 1971. 6 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. 7The approach proposed by House Ways and Means Committee Chairman Thomas last year

would substantially expand the scope of permitted deferral of U.S. tax on foreign business income earned through a foreign corporation and address provisions limiting the foreign tax credit

(but would not restrict provisions that permit foreign taxes to offset U.S. income). 8For this purpose, foreign business income includes foreign dividends or gains from substantial shareholdings. 9 In some cases, foreign losses are allowed, but are recaptured as domestic income when the

taxpayer next realizes positive foreign net income. 10See Michael J. Graetz and Paul Oosterhuis, Structuring an Exemption System for Foreign

Income of U.S. Corporations, 54 Nat’l Tax J. 771, 774 (2002). 11The traditional 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.

seen discussed the question: Does the ETI improve the overall living standards of

American citizens and residents?

It is questionable whether the ETI (and its predecessors the FSC and DISC) does

in fact improve the living standards of Americans by comparison with alternative

ways that the foregone revenues (or tax benefits) could have been employed. 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) is modest at best and likely does not exceed the tax revenue lost as a result

of the tax incentive.6 In addition to the obvious questions that should be asked

about any proposal that would perpetuate ETI benefits for old users (but apparently

not new ones) and continue a benefit already found illegal, it should be asked

whether an inefficient tax subsidy is good policy.

I turn next to the question whether U.S.-owned foreign corporations (or their U.S.

parent companies) are disadvantaged in relation to foreign-owned corporations carrying on business outside the United States.

Evaluating the U.S. Worldwide Tax System with Deferral in Relation 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.

Although a number of major trading partners employ some form of territorial system, none of the international competitiveness or simplification tax proposals currently under discussion would adopt an exemption system.7

One question implied by a claim that the U.S. tax rules are anti-competitive is

whether U.S. companies would be better off under a territorial tax 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’ foreignsource business income that is subject to taxation in another country,8 (ii) would disallow deduction of foreign business losses,9 and (iii) would tax currently portfolio

dividends and all foreign source interest and royalties.10 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’’).11

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12The principal objection to a territorial system is that it creates a bias in favor of investment

in foreign operations. In the worst case, this bias causes a foreign investment to be preferred

even though the U.S. investment has a higher before-tax rate of return and is, therefore, economically superior. 13 None of the current international proposals (including Chairman Thomas’s) would provide

for tax-free repatriation of future earnings eligible for deferral. The Homeland Reinvestment Act

would allow a reduced tax on currently deferred income—much in the nature of a tax amnesty. 14 In none of the corporate inversions that attracted so much attention in the last two years

did companies re-domicile their parent company in a major trading partner, such as United

Kingdom, Canada, France, Germany of Japan. 15 It may be anticipated that the proponents will argue that 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 reduced taxation of the operations of U.S. multinationals in low-taxed foreign countries indirectly encourages U.S. exports and economic activity. It is unclear how much support there is for this claim, but no proposal to expand deferral

would limit its scope to businesses with foreign operations that purchase goods from the United

States.

Note that adoption of the form of exemption system just described would result

in heavier taxation than under current U.S. rules in at least three respects: Foreign

income generally is not exempt unless it is subject to some level of foreign tax,

whereas the United States allows deferral from U.S. tax for income that is not taxed

at all. Foreign source royalty income would be subject to full U.S. tax, whereas the

United States allows U.S. tax on foreign royalty income to be offset by excess foreign

tax credits on other income. Finally, foreign losses are not allowed as deductions,

whereas the United States permits losses to be deducted (subject to possible recapture which in any event would result in a timing benefit). One response to these

observations might be that taxpayers can be expected to adjust their behavior so

as to obtain the full benefit of the exemption system, i.e., by paying less royalties

and so on.

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. If there is lower taxation of foreign income, taxpayers with foreign operations

have an incentive to shift higher taxed U.S. (and foreign) income to lower taxed foreign operations.12 Significantly, an exemption system also permits repatriation of

future exempted foreign business earnings without further U.S. tax.13

Notwithstanding the potential advantages of an exemption system and the assertion that companies from other countries have a competitive tax advantage, U.S.

companies apparently do not support a shift to an exemption system. In this context, the Committee should view assertions that foreign tax systems are better for

taxpayers with skepticism.14

It is not my purpose to defend the current U.S. rules; they can and should be improved. It simply has not been proven that the direction of policy should be to decrease as opposed to increase the tax on foreign income. Proponents of reduced taxation of foreign income should be required to go further than making generalized

competitiveness arguments, and should link the tax benefits of a proposal to increased American living standards.15

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). In a high-tax environment,

the ability to credit excess foreign taxes against royalty income and export sales income makes the U.S. system more generous than an exemption system.

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

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16See generally, Cohen and Hankin, ‘‘A Decade of DISC: Genesis, and Analysis,’, 12 Va. Tax

Rev. 7 (1982). 17 I and my co-authors, Professors Robert J. Peroni and J. Clifton Fleming, Jr., have outlined

a proposal for a broad repeal of deferral. Essentially, our proposal would apply mandatory passthrough treatment to 10% or greater shareholders in foreign corporations. 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).

rationale for the DISC predecessor of the ETI was to equalize for exporters the advantages realized by U.S. multinationals from deferral.16

If the ETI is repealed, as a logical matter the Committee also should consider decreasing the tax advantages to earning low taxed foreign income through foreign

corporations.17 One would not have to repeal deferral to make substantial improvements in the current international tax rules without increasing the current incentives to locate investment outside the United States. It would be helpful to rationalize the current antideferral rules in a manner that would limit use of tax havens,

but would impose less of a burden on normal business operations.

The current foreign tax credit mechanism could be improved by repeal of the sales

source rule and other rationalization of source rules combined with improvements

to the interest allocation rules and modification of the domestic loss recapture rules.

If there were revenue available, 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 encourage the Committee to consider international tax reform proposals that will improve the well-being of all U.S. citizens

and residents, including workers, farmers and small business men and women, and

not just those in the multinational sector.

I would be pleased to answer any questions the Committee might have.

PREPARED STATEMENT OF HON. GORDON SMITH

I want to thank the Chair for holding this hearing on the different international

tax issues that face the Senate Finance Committee. In talking about these issues

I believe it is of the utmost importance to consider passing repatriation legislation,

similar to the Invest in the USA Act that has been considered before this very committee.

The U.S. tax rate of 35 percent on foreign earnings makes it prohibitively expensive for our U.S.based companies to bring foreign earnings back for investment in

the United States unless the U.S. tax rate is substantially offset with foreign tax

credits for taxes paid to foreign governments. As the Joint Committee pamphlet

notes, it encourages investment of those earnings outside the United States when

better investments can be made here.

The impact of this has accumulated over decades. JP Morgan looked at the this

issue on behalf of its investors and conservatively estimates that the pool of foreign

earnings that current law discourages U.S. companies from reinvesting in the

Unites States is now about $500 billion—it may be substantially more. A good starting point for any international reform legislation would be to permit those dollars

to be reinvested here. We need the stimulus and job creation here.

I am please to see that Senator Ensign, the sponsor of S. 596 (‘‘Invest in the USA

Tax Act’’), will be testifying along with Senators Allen and Boxer, both cosponsors

with me on that bill which the Senate has already passed once this year. It would

unlock those dollars for investment in the United States at relatively no cost to the

federal government.

For a one-year period, it would open the door to the reinvestment of those dollars

in the United States. The 35 percent tax rate on dividends paid by a foreign subsidiary to a U.S. company would be replaced with a tax burden equivalent to the

average tax rate at which companies have demonstrated they will bring the dollars

back to the United States. Thus it would impose a 5.25 percent toll charge on dividends in excess of the company’s historical average, which is the equivalent of an

85 percent dividends received deduction. No foreign tax credit would be allowed for

85 percent of the foreign taxes associated with dividends qualifying for the 5.25 percent toll charge.

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According to JP Morgan’s analysis for its investors, it would result in about as

much economic stimulus as the portion of the President’s tax proposals that were

enacted this year—about a one-percent increase in GDP.

These are difficult economic times and enacting S. 596 is one way we can help.

I am pleased to see that my colleagues are making the strong bipartisan effort to

get it enacted this year.

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COMMUNICATIONS

AMERICAN BUSINESS COUNCIL

[SUBMITTED BY JOHN E. PRATT, CHAIRMAN]

Mr. Chairman and members of the committee, the American Business Council of

the Gulf Countries (ABCGC) would like to add a written statement to the record

of these proceedings. Although these hearings focused on the international competitiveness of U.S. businesses operating abroad, the American Business Council of the

Gulf Countries would like to complement the testimony of the distinguished Panel

by speaking of the importance of maintaining and increasing Section 911 of the tax

code, the Foreign Earned Income Exclusion.

All of the witnesses testified to the benefits of a U.S. tax code that allows American businesses to be competitive with foreign competition. However, the ABCGC believes that an important aspect of this strategy is to assist the U.S. workers employed by these multinationals, live in these foreign countries, and help sell the

goods and services that create jobs back home. In the Jobs and Growth Tax Bill that

emerged from this Committee in May, the Foreign Earned Income Exclusion was

targeted for elimination. Eliminating the Foreign Earned Income Exclusion would

cost countless jobs at home in America.

To remain competitive, American Companies are increasingly forced to fire American employees and hire foreign nationals that cost significantly less money to employ. Fewer Americans working abroad means fewer American goods and services

sold overseas. Simply put, one billion dollars of exports creates 15,000 jobs for

American workers. It is a trade competitiveness issue, not a tax issue. Why should

Americans be penalized when competing in the global marketplace?

The American Business Council of the Gulf Countries and the 750 U.S. companies

that it represents urges the Senate Finance Committee to help level the playing

field for American companies abroad and not favor foreign companies, from every

other industrialized nation, who do not tax foreign earned income. Please stand up

for U.S. citizens abroad who keep America competitive and risk so much in these

dangerous times overseas.

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AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

[SUBMITTED BY EILEEN SHERR, AICPA TECHNICAL MANAGER]

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COMMONWEALTH OF PUERTO RICO

Mr. Chairman and Members of the Committee on Finance, my name is Milton E.

Segarra, and I am Secretary of Economic Development and Commerce for the Government of the Commonwealth of Puerto Rico. On behalf of Governor Sila Calderon,

I am pleased to have this opportunity to present testimony in support of a new tax

incentive (the ‘‘Section 956 proposal’’) to replace the now repealed possessions tax

credit (Sections 936 and 30A of the U.S. Internal Revenue Code (‘‘Code’’) and to create jobs and economic growth in Puerto Rico. Under the Section 956 proposal, a

qualified U.S.-controlled foreign corporation (‘‘CFC’’) organized in and engaged in

the active conduct of a trade or business in the Commonwealth of Puerto Rico (or

in the U.S. possessions) would be permitted to repatriate qualified earnings to the

U.S. parent on a tax-preferred basis, providing Puerto Rico and the small U.S. terriVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00270 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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1 Under Subpart F of the U.S. Internal Revenue Code, a ‘‘controlled foreign corporation’’ is a

foreign corporation, 50 percent or more of the combined voting power or total value of the stock

of such corporation is U.S.-owned. See generally Code § 951–964. 2While U.S. corporations are generally subject to U.S. tax on their worldwide income, income

earned by a foreign subsidiary of a U.S. corporation generally is not subject to U.S. tax until

it is repatriated as a dividend to its U.S. shareholders. Under Subpart F, however, 10 percent

U.S. shareholders of a CFC are taxed currently on certain categories of CFC income even if such

income is not repatriated or distributed. For example, dividends, interest and other passive income received by a CFC generally are taxable on a current basis even if such income is not

repatriated as a dividend to the CFC’s U.S. shareholders. In addition, foreign earnings of a CFC

otherwise eligible for deferral but which are invested in qualified ‘‘U.S. property’’ are taxable

as if the underlying earnings had been distributed to the CFC’s U.S. shareholders as a dividend.

See Code § 956.

tories with a limited but important compensatory advantage over CFCs operating

in competitor foreign jurisdictions.

The need for federal tax incentives to attract U.S. outbound investment to Puerto

Rico is demonstrated by experience and economic reality. U.S. tax incentives for investment and economic growth in Puerto Rico are not new. The antecedents of the

possessions tax credit were first enacted in 1921 to assist the development of Puerto

Rico’s isolated and dependent agrarian economy. Since the establishment of Operation Bootstrap in 1948, the interplay of federal and local tax incentives in Puerto

Rico has helped fuel the transformation of one of the poorest islands in the Caribbean into a modern industrial society with the highest standard of living in all of

Latin America. Indeed, in large part as a result of these enlightened federal and

Commonwealth policies, Puerto Rico has increased its per capita income from 16.2

percent of the U.S. average in 1948 to 32.3 percent in 2002, while supporting a dynamic manufacturing sector that today represents more than 42 percent of Puerto

Rico’s economic output.

In 1996, Congress voted to repeal Section 936 and Section 30A, subject to a 10-

year phase-out for existing claimants and lines of businesses, as a ‘‘revenue offset’’

for a number of tax relief provisions intended to help small businesses in the United

States mitigate the impact of the concurrent statutory increase in the federal minimum wage. While the federal minimum wage laws also apply to Puerto Rico, the

business relief provisions enacted in 1996 did not benefit Puerto Rico. Indeed, in

just under seven years since the repeal of Section 936 and Section 30A, Puerto Rico

has lost over 26,000 manufacturing jobs—roughly 18 percent of its manufacturing

employment—while unemployment has increased to over 12 percent, double the

U.S. rate. Unless Congress acts, the loss of high-paying manufacturing jobs—the

foundation of Puerto Rico’s middle class economy—will only accelerate as the 2005

date for the expiration of Sections 936 and 30A approaches.

While it is true that tax policy alone cannot create or sustain economic growth

in the absence of other necessary conditions such as an educated workforce, and

adequate infrastructure and telecommunications, it is also true that, in the competition for U.S. foreign investment, targeted tax incentives can help offset the higher

operational costs faced by Puerto Rico as a result of its geographic isolation from

the mainland, its relative lack of natural resources, and externally imposed factors

such as the application U.S. minimum wage laws, environmental standards, and

other regulatory requirements.

To address the job losses and harm to the Puerto Rico economy caused by the repeal of Section 936 and Section 30A, the Commonwealth Government has developed

a new proposal, based on the fact that many of the U.S. companies that have chosen

to remain in Puerto Rico have restructured their operations and converted their domestic entities into CFCs.1 By utilizing CFCs, U.S. companies earning active business income in Puerto Rico exchange partial exemption from U.S. tax under the

scheduled phase-out of Section 936 and Section 30A for the possibility of unlimited

deferral of U.S. tax, provided that the Puerto Rico earnings of the CFC are not repatriated to the United States.2 Without some modification of the Subpart F rules,

however, the CFC model has limited value and utility for investment in Puerto Rico.

In fact, CFCs in Puerto Rico are in direct competition with CFCs in low-wage and

low-cost countries around the world. In particular, Puerto Rico is at a significant

disadvantage in competing for U.S. investment with many countries such as Mexico,

Malaysia, Ireland and Singapore. These disadvantages include the application of

U.S. minimum wage laws, U.S. environmental, health and safety regulations, and

other federal regulatory standards generally more rigorous than those imposed by

competitor countries. CFC status, by itself, does not offset the higher cost of doing

business in Puerto Rico in comparison with these other foreign jurisdictions.

Under the Commonwealth proposal, which was introduced in the House of Representatives and in the U.S. Senate on a bi-partisan basis in the last Congress as

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3 As originally introduced, H.R. 2550 and S. 1475 had four substantive components. First, in

accordance with prior Congressional legislation, sections 30A and 936 would be allowed to expire

at the end of 2005. Second, section 956 of the Code (relating to investments in U.S. property

by CFCs) would be amended to defer from current U.S. tax 90 percent of the otherwise taxable

investments in U.S. property (e.g., loans to the CFC’s U.S. parent corporation or investments

in the U.S. parent’s stock) made by a qualified CFC out of its ‘‘qualified income’’ (i.e., income

from the active conduct of a trade or business in Puerto Rico or a possession of the U.S.). Third,

as an alternative to the new section 956 rule, the qualified CFC could elect to have its shareholders in the U.S. benefit from an 85 percent dividendsreceived deduction for dividends paid

by the qualified CFC out of its qualified income. Fourth, a special transition rule was provided

for certain companies now doing business in Puerto Rico or a possession that would be required

to transfer those operations to a CFC in order to benefit from the new tax incentives.

The proposal now before the Committee has been modified, as a result of continuing discussions with staff of the House Ways and Means Committee, the Senate Finance Committee, and

the Joint Committee on Taxation, in order to reduce the revenue cost of the original proposal.

First, the new tax incentives would take effect only after the existing Section 936 and Section

30A credits expire at the end of 2005. Second, a qualified CFC must be organized in Puerto Rico

or a U.S. possession, as well as be engaged in the active conduct of a trade or business in Puerto

Rico or a U.S. possession. Third, the transition rule contained in the original proposal would

be eliminated; as a result, the general rules of the Code, including the transfer pricing rules,

would be applicable to transactions in which a branch of a U.S. corporation now conducting operations in Puerto Rico is incorporated in order to be eligible for the new tax incentives. And

fourth, additional requirements have been included to ensure that qualified active businesses

have a substantial business presence in Puerto Rico and that certain passive investment activities could not qualify for the new tax incentives. 4For example, IRS data for 1994 indicate that CFCs in ‘‘tax haven’’ countries paid an effective

income tax rate of 9.1 percent on current earnings and profits and repatriated only 13.9 percent

of such earnings and profits not subject to the anti-deferral rules of Subpart F. As a practical

matter, U.S. companies generally do not repatriate low-tax foreign income unless U.S. tax on

such income can be offset by excess foreign tax credits on high-tax foreign income.

H.R. 2550 and S. 1475, respectively, a CFC organized in Puerto Rico or in a U.S.

possession would be incentivized to invest their Puerto Rico or possession source

earnings in the United States when those earnings were not currently needed for

operations in Puerto Rico or the U.S. possessions. By providing an incentive not generally available to CFCs doing business in other foreign jurisdictions, the proposal

would enable Puerto Rico to maintain and, over time, strengthen its economic base.

By providing an incentive to invest surplus earnings in the United States rather

than in other foreign jurisdictions, the proposal would, consistent with the original

intent of the possessions tax credit, also benefit the U.S. economy and create jobs

in the United States. In addition, under existing U.S. tax rules, the tax-deferred income of a CFC organized and doing business in Puerto Rico or a U.S. possession

would, like all other CFCs, remain subject to U.S. tax when ultimately repatriated

as a dividend.3

Much of the concern over the Section 936 and Section 30A program since its inception has been not its unquestioned success in transforming the economy of Puerto Rico, but rather the perceived high cost of the program attributable to the special

rules governing the allocation of intangible income between certain U.S. companies

and their Puerto Rico subsidiaries. Indeed, as recently as two years ago, the Joint

Committee on Taxation estimated the cost of the existing credits as high as $4 billion for 2001 and as much as $16.6 billion for the five-year period 20012005.

By eliminating the special allocation rules and applying standard arms-length

transfer pricing rules set forth in Section 482 of the Code, together with the modifications to H.R. 2550 and S. 1475 discussed above, the Section 956 proposal was

preliminarily estimated by the Joint Committee on Taxation last year to cost approximately $600 million a year beginning in 2006—a fraction of the estimated cost

of the existing credits.

Even these preliminary estimates may be far too high if one accepts that the competition for U.S. investment is not between the United States and Puerto Rico, but

rather between Puerto Rico and foreign jurisdictions such as Mexico, Malaysia and

Singapore. Indeed, studies by the Puerto Rico Industrial Development Company

(‘‘PRIDCO’’) indicate that most U.S. companies leaving Puerto Rico relocate as CFCs

in other foreign jurisdictions rather than return to the United States. Further studies by the U.S. Treasury Department also suggests that most income earned by

CFCs is, in fact, reinvested abroad and thus U.S. parent companies currently pay

little, if any, U.S. tax on their CFC income.4

Puerto Rico’s proposal for revitalized tax incentives for U.S. investment in the

Commonwealth economy cannot be viewed in isolation, but rather must be considered in the context that a strong Puerto Rico economy is essential to the economic

prosperity of the United States. Indeed, Puerto Rico is not only one of the largest

markets for U.S. products, it is also ranked among the top four per capita conVerDate 11-MAY-2000 12:23 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00272 Fmt 6601 Sfmt 6621 89891.000 SFINANC2 PsN: SFINANC2
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sumers of U.S. products in the world. In 2001, Puerto Rico purchased nearly $16

billion worth of U.S. products, surpassing much larger countries such as Italy,

Spain, Argentina, Russia and Australia. With over $55 billion in total exports and

imports, Puerto Rico is the eighth largest trading partner of the United States in

the world. Indeed, over 30 percent of the entire U.S. maritime coastwise trade is

between Puerto Rico and the U.S. mainland.

A recent study by PricewaterhouseCoopers concluded that 73,000 U.S. jobs were

directly attributable to the production and distribution of U.S. goods exported to

Puerto Rico in 2001, while 201,000 U.S. jobs were indirectly attributable to U.S. exports to Puerto Rico in the same year, for a total of 274,000 jobs—an average of

5,400 jobs per state. A copy of the PWC study and a list of the number of jobs in

each state attributable to exports to Puerto Rico have been separately provided to

the Committee on Finance.

Mr. Chairman, the Section 956 proposal enjoys the strong support of all of the

major business groups, manufacturers associations, and unions in Puerto Rico. A

copy of the Statement of Principles signed by organizations representing over 95

percent of Puerto Rico’s private sector is attached hereto as Appendix B. Failure to

enact new incentives to stem the current accelerating loss of manufacturing jobs in

Puerto Rico as a result of the scheduled phaseout of the existing Section 936 and

Section 30A tax credits will inevitably have dire consequences for the Puerto Rico

economy, as well as for the U.S. economy. Puerto Rico and the United States, as

partners bound by common citizenship and history, have a moral, if not an economic, obligation to work together to restart the engines of progress for the U.S.

shining star in the Caribbean and Latin America. Accordingly, I respectfully urge

your support for inclusion of the Section 956 proposal in the international tax reform bill which will be considered by this Committee later this year and which is

the subject of the present hearing.

Thank you very much.

APPENDIX A

STATEMENT OF PRINCIPLES

ECONOMIC STIMULUS FOR THE COMMONWEALTH OF PUERTO RICO

As our national leaders in the Congress and Administration develop initiatives to

stimulate the economy it is important for us in the Commonwealth of Puerto Rico’s

business community to voice our support for measures that will provide for the long

term economic future of Puerto Rico.

Currently, Puerto Rico’s unemployment rate is 11.4 percent compared to 5.8 percent nationwide, close to twice the national average. In 1996 Congress enacted a

phase out of Section 936, which has been a tax incentive designed to attract investment to the Island and available in various forms since 1921. Since the enactment

of the phase out, the Island has lost 17 percent of its manufacturing jobs, most of

which have gone to foreign countries.

The phase out of Section 936 not only removes federal incentives for investment

in Puerto Rico but it effectively eliminates any economic value of tax benefits Puerto

Rico has instituted in the Commonwealth’s tax code because of the structure of the

foreign tax credit in the US tax code.

In order to counter the effect of this phase out and prevent further loss of jobs,

as well as helping to bring a more stable, secure and attractive investment climate

to the Island, Governor Calderon and Resident Commissioner Acevedo-Vila continue

to aggressively work with Congress and the President’s Administration to pursue

the enactment of a proposal to attract new investment to the Island.

The Governor’s plan is designed to bring benefits to both the Island and the mainland, and it recognizes that many large employers in the Commonwealth have

changed their status from domestic corporations to Controlled Foreign Corporations

(CFCs) since Congress enacted the phase out of Section 936 incentives in 1996. The

Governor’s proposal calls for amending Section 956 of the IRS Code to allow CFCs

to defer tax payment of 90 percent of taxable income if invested in U.S. property

or exclude 85 percent of dividends received only if that income is attributable to active business operations in the Commonwealth of Puerto Rico or U.S. territories.

Puerto Rico is the 13th largest trading partner of the United States, generating

and supporting over 270,000 jobs on the U.S. mainland. This economic incentive will

make Puerto Rico more competitive and will act as a stimulus for Puerto Rican

CFCs to reinvest their earnings in the mainland United States rather than abroad.

Therefore, this proposal will benefit Puerto Rico and the United States, and will also

serve to protect the national security interests of both as well as those companies

who will return to the United States to operate their businesses in Puerto Rico.

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The undersigned participants support and join in the efforts of the Commonwealth to urge the prompt enactment of the Section 956 proposal in order to preserve the flexibility of the Commonwealth’s tax system and to provide a level business environment so the Commonwealth can more effectively compete with investments targeted for offshore locations.

As witnesses and party to the preceding, the Resident Commissioner in Washington, the Secretary of Economic Development and Commerce and members of Government, Private Industry and Commerce subscribe to this joint proposal on this

day, March 31, 2003, in the city of San Juan, Puerto Rico.

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COWEN, ROBERT, SENIOR VICE PRESIDENT AND CHIEF OPERATING OFFICER,

OVERSEAS SHIPHOLDING GROUP

I. INTRODUCTION

On behalf of the Overseas Shipholding Group, Inc. (‘‘OSG’’), I appreciate the opportunity to submit this statement to the Senate Finance Committee on international competitiveness issues raised by the U.S. tax system. My statement focuses

on the significant problems created by the present-law rules under subpart F of the

Internal Revenue Code applicable to shipping income.

OSG, a Delaware corporation listed on the New York Stock Exchange and

headquartered in New York, is a major international shipping enterprise owning

and operating through its subsidiaries a diversified fleet of oceangoing oil tankers

and other bulk cargo vessels. Measured by the carrying capacity of our fleet, OSG

is the sixth largest tanker owner in the world. OSG charters its ships to commercial

carriers and to U.S. and foreign governmental agencies for the carriage of petroleum

and related products to destinations around the world and in the United States.

As a result of tax-law changes enacted in 1975 and 1986, U.S. shipping companies

are required to pay tax on income earned by subsidiaries overseas immediately rather than when such income is later brought back to the United States. This treatment represents a sharp departure from the generally applicable income tax principle of ‘‘deferral’’ and, as the Treasury Department has noted on several occasions,

operates to place U.S.-based owners of international fleets at a distinct tax disadvantage compared to their foreign-based competitors. The upshot is that the number of international tankers and vessels owned by the U.S. companies has fallen to

historically low levels, a state of affairs that is raising dramatic national security

and economic security concerns. Congress can reverse this trend, and strengthen

U.S. security, by enacting legislation that restores international parity for the

U.S.owned shipping industry.

II. OSG’S SHIPPING OPERATIONS

OSG is engaged in the ocean transportation of crude oil petroleum products and

dry bulk cargoes in both the worldwide and self-contained U.S. markets. It is one

of the largest bulk shipping companies in the world, owning and operating a fleet

(including vessels on order) currently numbering 52 vessels with an aggregate carrying capacity of almost 7.5 million deadweight tons. Ownership of a diversified

fleet, with vessels of different flags, types, and sizes, provides operating flexibility

and permits maximum usefulness of its vessels. For a variety of business reasons,

each vessel is owned by a separate corporate subsidiary, most of which are organized in foreign countries.

With respect to the domestic bulk shipping markets, OSG is one of the largest

independent owners of U.S.-flag bulk tonnage, with a fleet that consists of 9 vessels

aggregating almost 600,000 deadweight tons. U.S. flag bulk vessels, which must be

crewed by U.S. seamen, cannot typically compete in foreign trades. The operating

costs of a U.S. flag tanker are significantly higher than those of a comparable foreign flag tanker. Today, U.S. flag bulk vessels primarily serve U.S. coastal trade

and other niche domestic markets and government programs.

International bulk shipping markets are primarily served by ‘‘open registry’’ ships.

To serve these worldwide markets, OSG employs a modern fleet of 45 foreign flag

vessels, amounting to almost 7.1 million deadweight tons. These foreign flag vessels

include 43 tankers that range in size from the large double-hull crude carriers moving out of the Middle East to product tankers serving U.S. ports on the Atlantic and

Pacific coasts. Competition in these markets is extremely keen, and the markets

served by OSG are highly dependent upon world oil production and consumption.

Charter rates are determined by market forces and are highly sensitive to changes

in supply or demand. Thus, any change in labor or other operational costs—including taxes—or any governmental regulations can have a direct and adverse impact

if borne by some but not all carriers.

The economic viability of OSG’s foreign flag fleet has special importance to the

viability of its U.S. flag fleet. When markets served by the U.S. flag fleet deteriorate, the revenues generated by the foreign fleet can provide critical support for

these domestic operations.

III. DECLINE IN U.S.-OWNED INTERNATIONAL SHIPPING

The number of U.S.-owned foreign flag ships has dropped precipitously in the

aftermath of the 1975 and 1986 tax-law changes, which are discussed further below.

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1Sources for data include Marcus, Henry et al, ‘‘U.S. Owned Merchant Fleet: The Last WakeUp Call?’’ M.I.T., 1991; Dean, Warren L. and Michael G. Roberts, ‘‘Shipping Income Reform Act

of 1999: Background Materials Regarding Proposal to Revitalize the U.S. Controlled Fleet

Through Increased Investment in International Shipping,’’ Thomas Coburn LLP, 1999; U.S.

Maritime Administration; Fearnleys World Bulk Fleet, July 1998, July 1993, July 1999;

Fearnleys Review, 1993, 1998, 1999; Fearnleys Oil & Tanker Market Quarterly, No. 1, 2000;

Fearnleys Dry Bulk Market Quarterly No. 2, 2000. 2The EUSC fleet is comprised of merchant vessels, flagged in ‘‘open registry’’ countries (e.g.,

Liberia, Panama, Honduras, the Bahamas, and the Marshall Islands), that are owned and operated internationally (often through foreign subsidiaries) by American companies, and which are

available for requisition, use, or charter by the United States in the event of war or national

emergency.

In 1976, there were 739 U.S.-owned foreign flag ships. The U.S.-owned foreign flag

fleet had shrunk to 429 ships by 1986 and to 273 ships by 2000. (See Exhibit A.)1

This decline is also pronounced in the tanker market, which is particularly vital

to U.S. security interests, as discussed further below. From 1988 to 2000, the number of U.S.owned foreign-flag tankers fell by nearly 50 percent, from 246 ships to

only 126 ships. (See Exhibit B.)

As a result, U.S. companies now hold precious little share of the world shipping

marketplace. From 1988 to 1999, the number of U.S.-owned foreign flag ships as a

percentage of the world merchant fleet dropped from 5.6 percent to 2.9 percent. (See

Exhibit C.)

Part of this decline in recent years has been attributable to corporate

restructurings that had the effect of moving the headquarters of global shipping

companies outside the United States. Consider the following three transactions: • In April 1997, American President Lines (‘‘APL’’), then the largest U.S. shipper,

announced that it was merging with Neptune Orient Lines (‘‘NOL’’) of Singapore and that the headquarters of the newly merged company would be in

Singapore. • In 1998, OMI Corporation distributed to its shareholders stock of a subsidiary

in a transaction that resulted in OMI’s international shipping operations being

owned by a Marshall Islands corporation. • In December 1999, the A.P. Moller Group, headquartered in Copenhagen, Denmark, acquired the international liner business of Sea-Land Services, Inc., a

subsidiary of CSX Corporation, to form Maersk Sealand. Sea-Land Services,

Inc., was previously the largest U.S. shipper of containers.

Absent a change to the subpart F rules, whose defects are discussed further

below, a continued loss of U.S. ownership of international merchant fleets can be

expected.

IV. ECONOMIC, NATIONAL SECURITY ISSUES

The decline in U.S.-owned international shipping is fundamentally inconsistent

with national security and economic objectives. The U.S. military, in times of emergency, relies on the ability to requisition U.S.-owned foreign-flagged tankers, bulk

carriers, and other vessels to carry oil, gasoline, and other materials in defense of

U.S. interests overseas. These vessels comprise the Effective United States Control

(‘‘EUSC’’) fleet.2 The sharp decline in the EUSC fleet since the 1975 and 1986 taxlaw changes, and the resulting adverse strategic consequences, were confirmed in

a study commissioned by the Department of the Navy and released in December of

last year. That study concluded that ‘‘the cause for decline in the size of the

EUSC fleet of tankers has been legislation that changed the fundamental

economics of American ownership of open registry vessels.’’ The study recommended that in the short term the most practical and cost-effective means of reversing this trend would be to ‘‘revise legislation to reflect tax deferment of

income for someor all EUSC and U.S. flag vessels.’’

American security also depends in no small part on our ability to maintain adequate domestic oil supplies in times of emergency. The United States consumes approximately 19.6 million barrels of oil per day, of which roughly 55 percent, mostly

crude, is imported into the United States. It is estimated that 95 percent of all oil

imported into the United States by sea is now imported on foreign-owned tankers.

This means that one half of every gallon of oil consumed in the United States is

carried on foreign-owned vessels. This growing dependence on foreign parties—who

may not be sympathetic to U.S. interests—to deliver our oil in times of global crisis

is cause for potential alarm.

The importance of a robust U.S.-owned international shipping fleet was underscored in a 1989 National Security Directive on ‘‘sealift’’ sent by President George

Bush to Cabinet officials (including the Treasury Secretary) directing them to take

steps to enhance the competitiveness of the U.S. industry:

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3 National Security Directive 28, October 5, 1989.

4 4According to the 1962 legislative history, this exclusion for shipping income was provided

‘‘primarily in the interests of national defense.’’ 5General Explanation of the Tax Reform Act of 1986, at 970.

6Price Waterhouse, ‘‘Decline in the U.S.-Controlled Share of the Open-Registry Merchant

Shipping Fleet Since 1975,’’ June 6, 1997. The U.S. share percentages discussed in the Price

[A]ppropriate agencies shall ensure that international agreements and federal

policies governing use of foreign flag carriers protect our national security interests and do not place US industry at an unfair competitive disadvantage in

world markets, During peacetime, federal agencies shall promote, through efficient application of laws and regulations, the readiness of the US merchant marine and supporting industries to respond to critical national security requirements.3

In terms of U.S. tax policy affecting the shipping industry, it is clear that this

mandate has not been met.

V. THE PROBLEM WITH U.S. TAX LAW

The dramatic reduction in U.S.-controlled international shipping, and the EUSC

fleet, over the last 25 years can be traced in no small part to a succession of U.S.

tax law changes that have placed U.S.-based shipping companies at a significant

disadvantage to their competitors. Most foreign-based carriers pay no home-country

taxes on income they earn abroad from international shipping.

By way of background, the United States generally does not tax the income

earned abroad by separately incorporated controlled foreign subsidiaries of U.S. corporations until the income is repatriated (e.g., as a dividend by the foreign subsidiary to the U.S. parent corporation). The socalled ‘‘subpart F’’ provisions enacted

in 1962 are an exception to this general tax principle. Under the subpart F regime,

the principal U.S. shareholders of a U.S.-controlled foreign corporation (‘‘CFC’’) are

taxed on the ‘‘Subpart F income’’ of the CFC in the year that income is earned by

the CFC, even though the income may not yet have been repatriated to the U.S.

parent.

From 1962 until 1975, the subpart F regime specifically excluded foreign shipping

income from its operation.4 Accordingly, under the general ‘‘deferral’’ principles applicable to subsidiaries of U.S. corporations, the income attributable to foreign operations of the EUSC fleet was, during that period, subject to U.S. tax only to the

extent it was actually (or constructively) repatriated to the United States.

In the Tax Reduction Act of 1975, Congress designated foreign shipping income

of a CFC as subpart F income, but provided that such income would not be subject

to the subpart F current taxation rule to the extent the income was reinvested by

the CFC in its foreign shipping operations. When the 1975 legislation was enacted,

the reinvestment rule was acknowledged to be necessary given the capital-intensive

nature of the foreign shipping business and the importance to the nation of a viable

U.S.-owned maritime fleet.

In the Tax Reform Act of 1986, Congress repealed the reinvestment exception and

thereby eliminated the ability to defer tax on shipping income generated by foreign

subsidiaries of U.S. corporations. The Joint Committee on Taxation staff noted, as

a reason for eliminating deferral, that ‘‘shipping income is seldom taxed by foreign

countries.’’5 As an aside, one wonders what staff thought would be the consequence

of having the United States become the only country to attempt to tax such income.

Whatever may have been the ‘‘tax policy’’ rationale for subjecting shipping income

to the subpart F taxing regime, the change had but one effect: reducing the viability

of EUSC foreign shipping operations by imposing a tax burden not applicable to

competitors.

Because of the 1986 Act change, U.S. investors in international shipping effectively now pay a ‘‘premium’’ because their investments must be made with aftertax dollars, while most foreigncontrolled competitors invest with pre-tax dollars.

Over time, these premiums on U.S. investments require U.S.-owned vessels to command higher charter rates than their competition in order to maintain overall rates

of return that are comparable to those earned by their foreign-based competitors.

To the extent such comparatively higher charter income cannot be obtained—and

it is clearly not possible to do so—the overall economic picture of U.S.-owned shipping will continue to be eroded.

The 1975 and 1986 tax-law changes trace closely to the decline in U.S.-owned

shipping highlighted above. Before subpart F was extended to shipping income in

1975, the U.S.owned share of the world’s open-registry shipping fleet stood at 26

percent. By 1986, when the reinvestment exception was eliminated, the U.S. share

had dropped to 14 percent. By 1996, the U.S. share had dropped to 5 percent.6

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Waterhouse study relate to the world’s total open registry fleet, which is smaller than the total

world merchant fleet referenced in other statistics cited in this testimony.

In its recent preliminary report on corporate inversion transactions, the Treasury

Department clearly stated the problem with present law applicable to U.S.-owned

shipping:

. . . the U.S. tax system imposes current tax on the income earned by a

U.S.-owned foreign subsidiary from its shipping operations, while that company’s foreign-owned competitors are not subject to tax on their shipping income. Consequently, the U.S.based company’s margin on such operations is reduced by the amount of the tax, putting it at a disadvantage relative to the foreign competitor that does not bear such a tax. The U.S.-based company has less

income to reinvest in its business, which can mean less growth and reduced future opportunities for that company.

Without prompt action by the Congress to reverse the misguided application of

subpart F rules to shipping income, in a short time there are likely to be more ‘‘runaway headquarters’’ transactions like those described above and therefore little or

no remaining U.S.-controlled international shipping.

OSG is encouraged that bipartisan legislation that would seek to address the

problems created by current law has been introduced in this Congress by Senator

Gordon Smith (ROR) (S. 1326) and Rep. Jerry Weller (R–IL)(HR 772). OSG appreciates that other Members of Congress, including Rep, Clay Shaw (R–FL), have introduced similarly oriented bills in the past.

VI. RECOMMENDATION

OSG respectfully urges the Congress to enact legislation as soon as possible that

will help level the playing field for U.S.-based carriers operating abroad. Such action

will help provide the United States with a robust available fleet in times of global

crisis, which will restore U.S. strategic capabilities and strengthen our economic security. OSG looks forward to working with all affected parties to fashion a solution,

which not only will help U.S. companies reclaim their share of the global shipping

markets but also will help preserve and enhance U.S.-flag shipping.

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CENTER FOR FREEDOM AND PROSPERITY

[SUBMITTED BY ANDREW F. QUINLAN, PRESIDENT]

Thank you for the opportunity to share my views with you. My name is Andrew

Quinlan, President of the Center for Freedom and Prosperity, an Alexandria, Virginia-based, 501(c)(4) citizen organization that lobbies Congress and the Administration on tax competition, financial privacy and fiscal sovereignty.

I also coordinate the activities of the Coalition for Tax Competition, which is made

up of more than three-dozen free-market public policy organizations, including taxpayer groups, senior citizen and family organizations, civil liberties activists, and industry and business advocates.

The Committee is examining how the impact of U.S. policies on foreign investment in the U.S. economy. This is a critical issue in today’s economy, and I applaud

this muchneeded assessment.

There are two types of investment in the U.S. economy, direct and indirect. The

typical example of foreign direct investment is a factory built by a foreign-based

company. Foreign direct investment is very important to the United States and is

responsible for millions of American jobs.

Indirect investment occurs when foreigners invest money in America. Foreign indirect investment can take many forms, including money deposited in U.S. banks,

purchases of stocks and/or bonds issued by U.S. companies, and purchases of U.S.

government debt. These various forms of indirect investment boost U.S. financial

markets and help finance businesses and provide capital for home mortgages and

car loans.

My testimony will focus on indirect investment, specifically an IRS proposal that

significantly could undermine the flow of capital to the U.S. banking system.

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IRS’s Interest Reporting Regulation.

U.S. banks and financial institutions benefit greatly from the bank deposits of

nonresident aliens. These deposits, in turn, benefit every American by helping to

create jobs, finance small business loans and improve the general welfare of all. For

decades, United States lawmakers have understood the importance of attracting

capital to America, which is why Congress has chosen not to tax the interest paid

on bank deposits of nonresident aliens and, the further step, of not reporting this

deposit income to their home governments.

In fact, foreigners have invested more than $1 trillion in capital in the United

States banks. This influx of capital will be jeopardized if a proposed Internal Revenue Service rule is implemented. The regulation (133254–02) would require banks

to report interest paid to nonresident aliens, although their deposits are not subject

to U.S. taxes. This would harm America’s economy and undermine the competitiveness of U.S. financial institutions.

Unfortunately, despite the clear intent of Congress, the Internal Revenue Service

is seeking to require the reporting of bank deposit interest paid to nonresident

aliens. This information, according to the proposed regulation, would then be turned

over to foreign tax collectors. The price is high, especially given that the IRS does

not have the authority to issue this rule.

More than 100 individuals and institutions have denounced the proposed regulation, including Senators (18), Congressmen (58) and Public Policy Organizations

(35). They are joined by many U.S. financial institutions [http://

www.freedomandprosperity.org/aizainst-irsreg.pdfl.

The following are ten reasons why this regulation should be withdrawn.

IRS Abuse of Its Regulatory Authority.

Executive branch agencies and departments are supposed to issue regulations

that implement laws enacted by Congress. More specifically, the IRS is supposed to

promulgate regulations that help enforce U.S. tax law. Since the United States government does not tax bank deposit interest paid to nonresident aliens, the IRS does

not need to collect this information. Indeed, the IRS admits that the purpose of this

regulation is to help foreign governments tax the income their citizens earn in the

United States.

The IRS Is Flouting the Law.

Congress has examined the tax treatment of indirect foreign investment for the

last 82 years. The desire to attract capital has always led lawmakers to decide not

to tax or require reporting of bank deposit interest paid to nonresident aliens. The

proposed IRS regulation, however, seeks to overturn the outcome of this democratic

process. This would undermine the rule of law and President Bush’s efforts to rein

in regulatory abuses. For more information, the CF&P Foundation issued a paper

entitled ‘‘Who Writes the Law: Congress or the IRS?’’ [Link: http://

www.freedomandprosperity.org/Pi!pers/irsreg/irsreg.shtmll

Capital Will Flee American Banks.

As the Figure shows, the current tax and privacy rules for foreign investors have

been a huge success, attracting about $1 trillion to U.S. financial institutions. These

funds finance car loans, home mortgages and small business expansion in America.

If the regulation is approved, however, foreigners will shift a substantial share of

their funds to London, Hong Kong and other jurisdictions that protect investors’ interests. In fact, the Federal Deposit Insurance Corporation has expressed grave concerns that the rule will drive capital from the U.S. and threaten the soundness and

security of the U.S. banking system. [Link http://www.freedomandprosperity.or/g

fdic.pdf]

U.S. Banks Will Be Less Competitive.

Financial institutions around the world compete for liquid capital. American

banks have successfully competed, but this profitable source of deposits will become

very unstable if banks are forced to put foreign tax law above U.S. tax law. Money

will flow out of America, making it more difficult for U.S. banks to meet the challenge of foreign competition. The economic loss would be substantial; Stephen Entin

of the Institute for Research on Economics of Taxation estimates the regulation

would annually cost $80 billion in lost output, or 0.8 percent of U.S. gross domestic

product.

Banks’ Paperwork Burden Will Increase.

The IRS asserts that the total regulatory burden on financial institutions will increase by only 500 hours. This estimate is absurdly low. To read and interpret the

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rule, seek appropriate legal and accounting advice and report on thousands of accounts will surely impose a far greater burden.

The Rule Is Bad Tax Policy.

The IRS regulation is a slap in the face of tax reformers. All proposals to fix the

tax code, such as the flat tax, are based on common-sense principles such as taxing

income only once and taxing only income inside our borders. But the new regulation

would sabotage tax reform by helping foreign governments double-tax income

earned in America.

For example, the European Union would like the United States to join a cartel

for the purpose of double-taxing cross-border savings. The Bush administration has

rejected the EU request, but the IRS rule undermines that position. In fact, the EU

considers the proposed regulation supportive of its cartel.

The Required Cost-Benefit Analysis Was Not Performed.

The IRS is ignoring laws requiring cost-benefit analysis of proposed regulations.

It has effectively exempted itself from regulatory oversight by incorrectly declaring

most of its regulations either ‘‘interpretative’’ within the meaning of the Administrative Procedure Act or not ‘‘major’’ within the meaning of Executive Order 12866. Yet

many IRS regulations impose significant economic costs and should be subject to

regulatory review.

International Competition for Capital Will Be Undermined.

Collecting private financial information on nonresident investors and sharing that

data with foreign governments hinders jurisdictional competition. It enables hightax governments to impose levies on income earned outside their borders, particularly discriminatory taxes on capital. Thus the regulation would encourage governments to increase marginal tax rates on mobile capital.

The Rule Differs Little from the Clinton Administration’s Proposal.

The current version of the regulation is a slight modification of a rule proposed

in the waning days of the Clinton administration. The original proposal required reporting deposit interest paid to all nonresident aliens, but intense opposition led to

its withdrawal in the summer of 2002. The IRS immediately issued the new version,

which limits information collection to residents of 15 developed countries, including

some EU members. However, it is clear that the IRS intends to eventually extend

the regulation to citizens of all nations.

The Regulation Violates the Treasury Department’s Position on Information-Sharing.

The regulation is also contrary to the administration’s position on the treatment

of confidential taxpayer information. On several occasions, former Secretary Paul

O’Neill and other Treasury officials stated that the U. S. government does not support automatic information sharing. Rather, O’Neill said information should only be

provided on a case-by-case basis in response to specific requests—and with full respect for due process and individual privacy. The proposed rule clearly violates this

commitment, since any information collected would be automatically forwarded to

foreign governments. The following link is to a Southeastern Legal Foundation

memorandum on this topic: http://www.freedomandprosperity.org/slf-memo.pdf

Conclusion.

The proposed IRS regulation is bad tax policy and bad regulatory policy. It is inconsistent with President Bush’s tax reform agenda. And it will hurt the U.S. economy by reducing the capital available for workers, consumers, homeowners and entrepreneurs. The rule would become effective following its final publication in the

Federal Register. Therefore, on behalf of millions of Americans represented by the

members of the Coalition for Tax Competition, I today ask that your Committee review this regulation and then ask the Treasury Department to permanently withdraw it as soon as possible.

The following is a link to additional information on the IRS’s Interest Reporting

Regulation: http://www.freedomandprosperity.org/update/irsreg/irsreg.shtml

Thank you.

PUERTO RICO BUSINESS ALLIANCE

[SUBMITTED BY SYLVIA HERNANDEZ, ESQ.]

Chairman Grassley, Ranking Minority Member Baucus, and other Distinguished

Members:

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During the Committee’s May 9th meeting, Members suggested that the question

of replacing Internal Revenue Code Section 936 be considered in a hearing regarding the taxation of income from outside the States of companies based in the States.

I am submitting this statement because I understand that this hearing will be the

last on the subject before the Committee considers legislation on it.

I am also submitting this statement to ensure that you are aware of the perspective of common citizens and business owners in the U.S. territory of Puerto Rico.

I know that you have been lobbied heavily on behalf of the self-serving objectives

of a limited group of multinational and national corporations and the local government’s current plurality administration.

The Puerto Rico Business Alliance is an organization of local business and professional men and women concerned with Puerto Rico’s economic development. We are,

for the most part, small business owners, entrepreneurs and professionals interested

in sound fiscal policy and a favorable business climate for the people of Puerto Rico.

As you know, Sec. 936 was enacted to encourage businesses in the States to make

jobcreating investments in U.S. territories. It provides a credit against the tax on

40% of the income that companies attribute to business in the islands. As you also

know, Sec. 936 was repealed because it has provided many companies with tax benefits much greater than the economic benefits to Puerto Rico—the territory in which

almost all of the companies using it operated. In repealing the credit, the Congress

gave the companies a generous phase-out of more than nine years that expires at

the end of 2005.

The territorial administration, working hand-in-hand with many of these companies, has proposed a replacement that would be similar to Sec. 936 in effect—although it would lavish a bigger tax cut on the companies. Amending IRC Sec. 956,

it would permanently exempt from the corporate income tax 85%, 90%, or 100% of

profits that Controlled Foreign Corporations in U.S. territories transfer to parent

companies in the States. (The percentage would depend on the method of transfer

that a company uses. Descriptions of the proposal only highlight the 85% and 90%

exemption methods; the legislative language would also effectively enable 100% of

the profits to escape taxation.)

As you know, companies already enjoy an indefinite deferral of taxation on these

profits until the income is actually transferred from their territorial subsidiaries. A

goal of the proposal is to make Puerto Rico a more attractive location for manufacturing by companies based in the States than anywhere else in the world—the

States as well as foreign countries.

The proposal would immediately add billions of dollars to the profits of companies

already in Puerto Rico by relieving them of their current tax liability. The Congress’

Joint Committee on Taxation has estimated that the proposal would cost up to $33.1

billion in revenue over 10 years.

These companies do not need the windfall; by definition, they would already have

to be profitable to obtain the tax benefit. In fact, they are already so profitable in

Puerto Rico that many are expanding their operations here.

Investments by pharmaceutical companies—the primary users of the 936 credit

and the majority of the companies lobbying for the 956 amendment—prove the

point. These major corporations have invested $2.9 billion in Puerto Rico since Sec.

936 was sunsetted in 1996—creating 5,500 jobs. They are now making $3.5 billion

in additional investments through 2009—which will create thousands more jobs—

even though the 936 credit will expire as of 2006.

The 956 proposal would not, however, require companies to make investments or

create jobs to have their income exempted from federal taxation. The drug companies would avoid billions of dollars in federal taxes without necessarily making any

greater contribution to Puerto Rico’s economy than they would without federal tax

exemption.

These and other manufacturers from the States also enjoy territorial tax rates as

low as 0%. This means that a company that took full advantage of the 956 amendment would pay no income taxes to either the territorial or federal governments.

My principal problem with the proposed 956 amendment is the same problem that

led to the bipartisan repeal of 936: it would benefit the limited number of companies

using it far more than it would benefit our territorial community.

I believe that the primary reason that Members of the Congress have considered

Sec. 936 and the Sec. 956 amendment is that they have wanted to help their fellow

citizens in the territory. In reality, however, both measures are prime examples of

‘‘trickle-down’’ economics. Gallons of federal economic incentives are being poured to

help Puerto Ricans but only drops trickle down to most of us.

This is why 936 was called ‘‘the poster child of corporate welfare.’’ It used the

needs of the low-income majority of our population to mask huge tax grants to

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wealthy companies. The 956 amendment can fairly be called ‘‘the return of the poster child of corporate welfare.’’

The 956 amendment—like 936—also is a strategy for an artificial economy. Businesses that would never be viable if they had to make the same contribution to society that other businesses make are subsidized. They are not given a ‘‘leg-up’’ until

they can stand on their own feet; they are perpetually propped up. Sustainable development is not promoted and real economic development does not occur.

Both measures, additionally, encourage disinvestment from Puerto Rico. The tax

benefits provide an incentive to take earnings out of the territory. Most profits are

not reinvested and the investment in our community is not permanent.

There is also an inequity in the benefits that do accrue to Puerto Ricans. A relative few blue collar workers and white collar supervisors get good jobs. Work is

also created for lawyers, accountants, and bankers. Despite $100 billion in federal

corporate tax breaks over the years, however, our unemployment rate is in the double digits and our labor participation rate is low.

In noting our employment problem, I must also point out that our jobless rate decreased from 1993 through 2000—despite the 1993 reduction and 1996 sunsetting

of 936—and that it has only increased over the past two years. Combinations of national economic developments and local policies cut the jobless rate in the 1990s and

other combinations hiked it over the past couple of years.

You know about the national economic developments. You should also know about

the local policies. In the 1990s, a previous territorial administration worked to diversify our economy and markets, substantially enhance our physical and human

infrastructure, and facilitate entrepreneurship and investment. During the past couple of years, a new administration has idled the wheels of government and construction and made tax exemptions for selected companies from the States the centerpiece of its economic plan. Because of its failures, its leader has been forced to abandon her campaign for a second term.

During this period, Puerto Rico has lost a number of plants in labor-intensive industries such as garment manufacturing—as have the States. Companies relocated

plants to countries which now have the advantage of no U.S. trade barriers in addition to the advantage of low wage and other costs.

The 956 amendment’s tax exemptions would not have helped keep these plants

in the territory . . . and it was not intended to. The plants would not have been

helped because—unlike the pharmaceuticals, for example—they did not have significant profits to exempt from taxation. The territorial administration chose to seek

tax exemptions for profitable companies rather than trying to retain operations such

as garment plants.

One of my greatest concerns about the 956 amendment is that Members of the

Congress would be misled into thinking that they would substantially help their 3.8

million fellow citizens in the territory by passing it and would, therefore, not take

other measures that would really help our economy and people as a whole.

My goal in this statement is to convince you to take the other measures instead.

These measures need not be special exemptions for special interests. Our territory

and people would be helped more by policies already applied to our fellow citizens

elsewhere in the nation.

Three measures would be of particular help—expanding the consumer demand

that actually drives the economy, rewarding work, and filling a gaping hole in the

social safety net.

• No measure would have a greater, more positive economic impact or benefit

more Americans in the territory than extending the Earned Income Credit as

it applies to workers in the States and the District of Columbia with incomes

too low to have a federal income tax liability.

• A related measure would extend the refundable Child Credit as it applies in

Puerto Rico to workers with three or more children to workers with one child

or two children—families who are covered in the States and D.C.

• The third measure would extend Supplemental Security Income for the needy

aged, blind, and disabled—the neediest in society. Still under SSTs predecessor

program, they currently receive a tiny fraction of the aid that SSI would provide.

What reason can there possibly be for not extending these programs to American

citizens in American territory? These citizens do not enjoy the federal tax exemptions that wealthy companies from the States and wealthy Puerto Ricans enjoy.

They have the same tax liability as beneficiaries of the programs in the States—

payroll taxes. They can receive the benefits of the programs simply by moving to

the States—at costs to the States as well as the federal government.

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I respectfully suggest that it would be a travesty to grant special tax exemptions

to wealthy companies from the States in Puerto Rico but not extend equal treatment

to low-income workers and the neediest in society in the territory.

There are also measures that the territorial government should take that you

should require as a condition of any special assistance. • One would be to require the government to collect its own taxes. It is widely

agreed in Puerto Rico that the underground economy in the territory is half the

real, total economy. Rampant tax evasion—including by government employees—penalizes those of us who pay all our taxes . . . as well as federal taxpayers. It is a significant factor in statistics such as labor rates.

• The other condition would be to require that special assistance beyond that

granted to States, such as the third of a billion dollars a year in transfers to

the territorial treasury of federal excise taxes on rum and federal Customs duties, be expended for economic development purposes, such as transportation infrastructure and job training and apprenticeship.

I have been candid in this statement and reflected views that many others in the

local business and broader communities have been afraid to express. The territorial

government is very centrally controlled and exercises extensive powers in permitting, contracting, etc. to marshal support for its programs and silence criticism.

Many in business have gone along with the 956 amendment, for example, because

the local administration has insisted on it and has been unwilling to consider alternatives. As a citizen, however, I believe that I have a right to petition my national

government for what is best for my community even if the local plurality, lame-duck

administration is serving other interests.

I would be honored to work with the Committee to further the ideas that I have

expressed or on other matters that would benefit my territory and nation.

SENATE OF PUERTO RICO, USA

[SUBMITTED BY HON. KENNETH D. MCCLINTOCK]

Chairman Grassley, Ranking Minority Member Baucus, and other Members of the

Committee:

My name is Kenneth D. McClintock. I am the Floor Leader in the SENATE OF

PUERTO Rico from the territorial political party that received 46.5% of the vote in

Puerto Rico’s most recent general election and an absolute majority in the preceding

election. I am also Puerto Rico’s DEMOCRATIC NATIONAL COMMITTEEMAN

and a former Chairman of the COUNCIL OF STATE GOVERNMENTS of the

United States.

My purpose in submitting this statement is to urge respectfully that the Committee include, in a bill pertaining to the taxation of companies based in the 50

states that have subsidiary operations situated outside the 50 states, a provision to

preserve and enhance Section 30A of the Internal Revenue Code [IRC].

As you know, Section 30A grants tax credits based on the payment of wages and

local taxes in Puerto Rico as well as capital investments in the territory. It dates to

a 1993 reform of Section 936, which provides credits for income merely attributed

to territorial operations.

The reform continued the attributed income based credit but scaled it down from

100% of tax liability to 40% and also created what was later renumbered as Section

30A as a federally preferred alternative credit.

Providing an incentive for companies to make job-creating investments in U.S.

territories, which are relatively less developed areas of the American political family, had been the congressional purpose in enacting Section 936. The provision was

abused for years, however, by some companies and regulatory and statutory restrictions failed to end the abuse.

The primary abuse was that companies attributed income to Puerto Rico that

should have been attributed to the States. This enabled them to avoid billions of

dollars a year in taxes on income for which taxable stateside operations were responsible.

At the same time, the companies were employing relatively few workers in Puerto

Rico in comparison to the taxes they were avoiding. In the heyday of the Section

936 era, some enterprises were reaping tax credits equal to several hundred thousand

dollars for each individual on their Puerto Rico payrolls.

Continuing concerns about abuses of the Section 936 credit based on attributed

income led the Congress in 1995 and 1996 to pass legislation to phase-out the credit.

The 1996 bill was enacted. It limited the credit to existing users, capped the credit

in 2002, and ends it entirely as of 2006.

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It also, however, applied the phase-out to the federally-preferred alternative credit

based on wages, capital investments, and local taxes, although that provision was

renumbered as Section 30A.

There were bipartisan efforts from 1997 through 2000 to open Section 30A to new

investments and extend it. Proposals won support from a majority of the members

of this committee and the House committee but were blocked by the then House

committee chairman, who had been in the small minority of the Congress that supported Section 936. He is no longer a member of the Congress.

In 2001, the now lame-duck governor of Puerto Rico and a number of profitable

companies with plants in Puerto Rico, primarily multinational pharmaceuticals,

came up with a new proposal. In contrast to Section 30A, it has not won the support

of a majority of the members of this committee or the House committee or the

Treasury Department or the White House. This is because it is similar to Section

936 prior to the 1993 reform, essentially recreating that discredited provision. It

would exempt, depending on the method used, 85–100% of the profits that subsidiaries of companies based in the States organized as Controlled Foreign Corporations

(CFCs) in territories transfer to their parent companies.

The proposal would amend Section 956. It would simply add to profits rather than

provide tax benefits for employment or investment. It also would not address the

challenge that free trade has created for labor-intensive manufacturing in Puerto

Rico as well as labor-intensive manufacturing in the States.

The immediate beneficiaries would be the existing profitable pharmaceutical and

similar subsidiaries that worked with the governor to craft the amendment. And

they would benefit to the extent of billions of dollars a year. The Congress’ Joint

Committee on Taxation estimated the taxes they would escape paying at $33.1 billion over ten years and at $4.6 billion in the first year alone. At the same time, the

proposal does not link tax benefits to jobs or investments.

The companies that would get the windfall have been prospering and expanding

in Puerto Rico since Section 936 was ‘‘sun-setted.’’ The pharmaceuticals alone have

invested $2.9 billion in Puerto Rico since 1996 and created 5,500 new jobs in the

territory. They are now investing another $3.5 billion, planning investments that

will extend years past the total end of Section 936 and that will create thousands

more jobs.

At the same time, labor-intensive manufacturing operations have been lured to

low-wage foreign locations from which they can now send products into the U.S.

market duty and quota free. The makers of numerous consumer products have been

mounting a gradual retreat from Puerto Rico.

Unlike the pharmaceuticals, for example, these operations have not been big

money-makers in Puerto Rico. Their operations in the territory have been marginal.

For this reason, they would not benefit from the governor’s proposal to exempt profits from taxation. The proposal, aides to the governor have acknowledged, accepts

the departure of these plants and jobs from Puerto Rico.

The proposal, they say, is also intended to make Puerto Rico more competitive as

a location for manufacturing than anyplace else in the world—including the States.

It is because of failed policies such as this that the governor has been forced by

public opinion to drop her bid for a second term. It is also because of flaws, such

as those I have described, that neither the Committee nor its colleagues in making

federal tax policy have approved the proposal despite two years and tens of millions

of dollars of lobbying by the governor and the companies that would receive an immediate multibillion dollar windfall addition to their already substantial profits.

A June 26, 2003 MOODY’S [INVESTORS SERVICE] OPINION report sums up

Puerto Rico’s situation:

‘‘Puerto Rico’s economy continues to adjust to . . . the phase-out of Section

936 . . .; while some US-owned manufacturers have downsized or left . . .,

others have continued to expand; the ultimate economic impact of the Section

936 phase-out is still developing . . .; the island has lost . . . in low-skill

sectors such as textiles, apparel, food products, and electronics assembly. However, the important pharmaceutical sector has continued to see plant expansions and job growth in recent years, which is a positive sign of the island’s

ability to remain competitive in technical/high-skill sectors. We expect the island’s economy to recover reasonably well.’’

The labor-intensive firms that are being lured away from Puerto Rico by low-cost

foreign locations create relatively more jobs than, for example, the pharmaceuticals.

And while the overall economy of the territory may be able to ‘‘recover reasonably

well’’ if Sections 936 and 30A both expire as scheduled, many thousands of Puerto

Rican families may not.

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They—and the companies they work for—would, however, be helped by an extension of Section 30A. The plants that are at risk do not have big profits to exempt

from taxation, but they do have big wage costs.

From statements by members of the Committee, I know that it shares my goal

of job retention and creation in Puerto Rico.

Because I come not to bury the governor’s moribund proposal, but to

praise Section 30A, it is without rancor that I volunteer the following two

observations in closing: • The proposal and the pharmaceuticals contemplate the creation of a permanent

tax exemption. This implies that Puerto Rico will forever be incapable of achieving convergence with the national economy; that Puerto Rico can never be selfsustaining. Puerto Ricans are just as capable as other citizens are, but we need

a leg-up. The governor’s pessimistic, condescending hypothesis ignores the territory’s impressive levels of development over the past halfcentury. If her proposal were an orthopedic surgeon, it would permanently consign every leg injury victim to a wheel chair when temporary physical rehabilitation programs

might quickly have most such patients back on their feet.

• Lobbyists for the proposal of the governor and the pharmaceuticals point out

that Puerto Rico’s unemployment rate is double the national average. What

they omit mentioning is that, until after the sun-setting of Section 936, Puerto

Rico’s unemployment rate was triple the national average. It is thus preposterous to allege that the territory’s high unemployment rate is, in any general

sense, a direct consequence of the Section 936 phase-out. Moreover, total Puerto

Rico employment is higher today than it was in 1996 when Congress sun-setted

Section 936. In addition unemployment in Puerto Rico was down to the single

digits when the current governor took office in January 2001. Unemployment has

since increased because of the national and world economic slowdowns as well

as because of the economic policies that contributed to the governor’s political demise and the departure of the labor-intensive companies that would not have

been helped by the proposal of the governor and the pharmaceuticals.

This Committee can best support the goal of boosting productive territorial employment by extending Section 30A and opening it to new investments.

UNIVERSITY OF MICHIGAN LAW SCHOOL

[SUBMITTED BY MARTIN B. TITTLE, RESEARCHER]

INTRODUCTION

My name is Martin B. Tittle. I am a licensed attorney in the state of Michigan,

and I am employed as a researcher at the University of Michigan Law School in

Ann Arbor. One of my research topics for the past twelve months has been the Foreign Sales Corporation and Extraterritorial Income Exclusion Act cases in the World

Trade Organization (WTO) and the U.S. response to those cases. My statement is

submitted on my own behalf and not on behalf of any government or private entity.

At the July 15 Senate Finance Committee hearing, Assistant Treasury Secretary

Pamela F. Olson stated that it would be worthwhile for the United States to ‘‘tak[e]

a long-term look at the structure of the Tax Code to see whether or not our worldwide system continues to make sense or whether we would be better off with a territorial system.’’ Senate Committee on Finance, ‘‘Treasury’s Olson Testifies on Need

for New U.S. International Tax Plan,’’ 2003 Worldwide Tax Daily 142–13 para. 383

(July 24, 2003). Worldwide systems tax residents on their worldwide incomes,

whereas territorial systems usually do not tax residents on active foreign-source income.

A THIRD OPTION: EXTENDING FOREIGN TAX CREDIT TO VATS

The ‘‘either-or’’ choice presented by Secretary Olson should be broadened to include a third option. We could alter our worldwide system to achieve a territorial

result—little or no taxation of offshore business income—without the upheaval of

changing to a territorial system. One alteration that would help achieve this result

is foreign tax credit for value added taxes (VATs).

VATs are transaction taxes that businesses must pay on in-country sales. They

differ from sales taxes in that they have an internal mechanism for giving businesses a credit for the VAT they pay on their purchases. VATS exist in more than

120 countries that cumulatively account for about 70% of the world’s population.

Liam Ebrill et al., The Modern VAT xiv (2001). Therefore, many U.S. companies

doing businesses overseas will have paid VAT to one or more foreign governments.

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Allowing credit for VATS would tend to eliminate U.S. taxation of foreign-source

business income because VAT is a tax on gross sales, while income tax is a tax on

net income. For instance, sale of $100 worth of widgets on which the profit margin

is 10% would yield a profit of $10 and an income tax of only $3.50, assuming a tax

rate of 35%. That same sale, however, would yield $15 of VAT in Luxembourg,

where the standard VAT rate is 15%, and $25 dollars in Denmark or Sweden, where

the rate is 25%.

Credit for VATS need not be an all-or-nothing proposition; it could be phased in.

We could either limit the credit to a percentage of each VAT dollar and allow that

percentage to increase over time, or we could offer dollar-for-dollar credit with a cap

on the maximum reduction of any single year’s tax bill, and gradually raise the cap.

THEORETICAL BASIS FOR EXTENDING CREDIT TO VATS

Historically, U.S. foreign tax credit has been limited to income-type taxes, but the

reason for this limitation remains a mystery. No explanation was included in the

1918 act that introduced the credit, and, surprisingly, none has been enunciated in

subsequent legislation.

In 1956, Professor Stanley Surrey speculated that the basis for the limitation

might lie in the purported ‘‘nonshiftability’’ of income taxes. Stanley S. Surrey, ‘‘Current Issues in the Taxation of Corporate Foreign Investment,’’ 56 Colum. L. Rev.

815, 820–821 (1956). ‘‘Shifting’’ taxes, he explained, were those whose economic incidence was generally assumed to be passed on from the statutory or nominal payor

to someone else. Examples included sales, turnover, and excise taxes. Income taxes,

on the other hand, were generally assumed to be ‘‘nonshiftable,’’ and therefore actually borne, or suffered by the taxpayer.

Five years later, Elisabeth Owens came to same conclusion, saying ‘‘the chief determinative factor in deciding whether a tax qualifies for the credit should be

whether or not the tax is shifted or passed on by the person paying the tax.’’

Elisabeth Owens, The Foreign Tax Credit 83 (1961), quoted in Karen Nelson Moore,

‘‘The Foreign Tax Credit for Foreign Taxes Paid in Lieu of Income Taxes: An Evaluation of the Rationale and a Reform Proposal,’’ 7 Am. J. Tax Pol’y 207, 217–218

(1988).

Joseph Isenbergh repeated that theory of creditability in 1984, calling it the ‘‘only

plausible explanation that has ever appeared for limiting the foreign tax credit to

income taxes.’’ Joseph Isenbergh, ‘‘The Foreign Tax Credit: Royalties, Subsidies, and

Creditable Taxes,’’ 39 Tax L. Rev. 227, 288 (1984).

The issue of shiftability is not merely a technical one. As Judge Karen Nelson

Moore has correctly noted, ‘‘the goal of achieving tax neutrality between foreign and

domestic investment [sometimes called capital export neutrality, or CEN] is satisfied [only] if taxes do not alter the relative rates of return on investments; allowance

of a tax credit limited to taxes that are not shifted to others is consistent with that

goal, since taxes that can be shifted do not affect the taxpayer’s rate of return.’’

Moore, supra, at 217 (paraphrasing Owens, supra, at 84).

Shiftability and nonshiftability are understood today, not as separate states that

are fixed characteristics of different taxes, but as the opposite ends of a continuum

across which all taxes move in response to market circumstances. In 1989, Judge

Moore reviewed over 40 sources before saying, ‘‘The tax policy maker must conclude

that a conclusive answer is not available today to the question whether the corporate income tax is shifted or whether it is in fact borne by the corporation and

its owners.’’ Id. at 222. That question has not been resolved in the years between

1989 and the present. See, e.g., Douglas A. Kahn and Jeffrey S. Lehman, Corporate

Income Taxation 22–25 (5th ed. 2001) (noting ‘‘substantial uncertainty about the incidence of the corporate income tax’’); Cheryl D. Block, Corporate Taxation 14 (1998)

(noting that the extent and direction of corporate tax shifting ‘‘is the subject of much

debate and the incidence question remains unresolved’’).

Similarly, Liam Ebrill and his co-authors freely admit in the International Monetary Fund’s book The Modern VAT that ‘‘[t]he effective incidence of a VAT, like that

of any other tax, is determined not by the formal nature of the tax but by market

circumstances, including the elasticity of demand for consumption and the nature

of competition between suppliers . . . . The real burden of the VAT tax may not

fall entirely on consumers but may in part be passed back to suppliers of factors

through lower prices received by producers.’’ Ebrill, supra, at 15, 76. The VAT that

U.S.-based e-tailers are now required to pay under the EU’s e-commerce VAT Directive is likely nonshiftable either largely or completely because they face EU competition that can charge lower VAT and no VAT. See Martin B. Tittle, ‘‘U.S. Foreign

Tax Creditability for VAT: Another Arrow in the ETI/E–VAT Quiver,’’ 30 Tax Notes

International 809, 813815 (May 26, 2003).

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Judge Moore’s solution to the income tax’s quasi-shiftable character was to suggest that the foreign tax credit be eliminated as a windfall, and that foreign income

taxes be returned to their pre-1918, deductible-only status. Moore, supra at 226.

However, an equally rational solution would be to continue the credit for income

taxes, so as not to disadvantage businesses when income taxes cannot be shifted,

and, with appropriate limitations, to expand the credit to VATs and other taxes

that, like income taxes, are sometimes nonshiftable. See Isenbergh, supra, at 294–

295 (suggesting expansion of the foreign tax credit to include all foreign taxes and

noting that, if the amount of the credit is capped, ‘‘the Treasury has little reason

to care about [the foreign government’s] precise methods [of taxing]’’).

The fact that the shiftability of both income taxes and VATS varies dynamically

in step with market forces is indicative of a broader similarity. Direct taxes like income tax and indirect taxes like VAT are not opposites, but rather are alternate

methods for allocating the same tax burdens. For example, it is widely acknowledged that VATs are essentially equivalent to a combination of several direct taxes,

including a direct tax on business profits and a direct tax on wages. Ebrill, supra,

at 18–19, 198.

On the other hand, taxes that, under WTO rules, must be classified as direct are

sometimes so similar to VATs that the difference is not substantive. For instance,

the flat tax proposed by Congressman Richard Armey and Senator Richard Shelby

in 1995 was essentially a flat-rate subtraction VAT in which collection of the tax

had been divided between business and individuals. See Freedom and Fairness Restoration Act of 1995, H.R. 2060, 104th Cong. (1995); S. 1050, 104th Cong. (1995).

That division of collection was not considered significant by knowledgeable observers including University of California, Berkeley economics and law professor Alan

J. Auerbach. See Michael J. Graetz, ‘‘International Aspects of Fundamental Tax Restructuring: Practice Or Principle?,’’ 51 U. Miami L. Rev. 1093, 1098 (1997). It was,

however, enough to make the flat tax a direct, and not an indirect tax under existing WTO rules. As such, it could not have been remitted on exports and applied to

imports, as VATs are, despite the fact that it was in essence a ‘‘broad-based flat rate

consumption tax.’’ Id. at 1097.

In the face of this virtual equivalence, it is no wonder that House Ways and

Means Committee Chairman William M. Thomas, R-California, has said that the

distinction between direct and indirect taxes is, ‘‘in today’s world, . . . a distinction without a difference.’’ Chuck Gnaedinger and Natalia Radziejewska, ‘‘U.S. Lawmakers Still Divided Over FSC–ETI Remedy,’’ 2003 Worldwide Tax Daily 31–1 (Feb.

14, 2003).

Senators Max Baucus, D-Montana, and Charles E. Grassley, R-Iowa, have voiced

similar sentiments. See Chuck Gnaedinger and Natalia Radziejewska, ‘‘Baucus

Deems WTO Dispute Settlement System ‘Kangaroo Court’ Against U.S.’’, 2002

Worldwide Tax Daily 188–1 (Sept. 27, 2002) (quoting Senator Baucus as saying,

‘‘The [WTO] appellate body’s FSC decisions make an unworkable distinction between countries that rely primarily on direct taxes . . . and countries that rely

primarily on indirect taxes . . . . Although the appellate body acknowledged

countries’ sovereign right to set their own tax systems, they interpret WTO rules

in a way that heavily favors one particular system.’’); Chuck Gnaedinger and

Natalia Radziejewska, ‘‘White House Urges U.S. Senate Finance Committee To Repeal ETI Act,’’ 2002 Worldwide Tax Daily 147–5 (July 31, 2002) (quoting Senator

Grassley as saying, with respect to the distinction between direct and indirect taxes,

‘‘How can we justify allowing this distinction to continue?’’).

Recognition of both the economic parity between income taxes and VATS and

their equivalence in meeting the foreign tax credit criterion of nonshiftability

strongly suggests that both income taxes and VATs should be creditable. Alternate

bases for extending credit to VATs could include the competitive needs of U.S. businesses, see Glenn E. Coven, ‘‘International Comity and the Foreign Tax Credit:

Crediting Nonconforming Taxes,’’ 4 Fla. Tax Rev. 83, 86 (1999), or the fact that VAT

is the ‘‘principal tax’’ of various foreign countries. See Surrey, supra, at 820 (noting

the need, in 1954, to exclude sales and turnover taxes from the ‘‘principal tax’’ proposal). The nonshiftability criterion has the advantage of being a classic theory and

thus does not require ‘‘breaking new ground’’ to validate VAT creditability.

PROPOSED STANDARDS FOR VAT CREDITABILITY

The standards for creditability of VATS may need to be slightly more stringent

than the standards for income taxes. The three criteria for income tax creditability

are: (1) the tax must be due from the taxpayer (the ‘‘technical taxpayer’’ rule), (2)

there must be proof of payment, and (3) the tax must not have been refunded. See

I.R.C. 1.901–2(t) (the ‘‘technical taxpayer’’ rule); 1.905–2 (taxpayer must present

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proof of payment); 1.905–3T (refund of a foreign tax constitutes a change in foreign

tax liability).

The first and third of these should be applied to VATs without change. With respect to the second, however, the ‘‘gross-up’’ rule allows foreign tax credit for taxes

paid by others as long as the taxpayer claiming credit was liable for the tax. See

I.R.C. 1.901–2(f)(l)–(2). If that rule were applied to VAT creditability, then in theory

everyone with an invoice showing a charge for VAT might claim a tax credit. Allowing credits on this basis would undermine the rationale for extending credit in the

first place—to prevent double taxation from discouraging business activity abroad—

because people who make a single purchase abroad are not necessarily attempting

to engage in business activity there, even if the purchase is for business purposes.

It would be possible to bar such claims on the ground that the taxpayer could not

demonstrate that the tax shown on the invoice had actually been paid by the party

issuing the invoice (that is, that it had not been partially or totally offset by deductions). Alternatively, it could be argued that the claimant was not the ‘‘technical taxpayer.’’ That argument would be more tenuous because, according to the EU’s Sixth

Directive, all taxable persons must pay VAT, and the term ‘‘taxable persons’’ includes everyone ‘‘who independently carries out in any place’’ any of the economic

activities of ‘‘producers, traders, and persons supplying services.’’ That category includes even those who, as members of special classes, are exempted from payment,

and therefore, it might also include casual purchasers. Therefore, unless there is a

clear advantage in keeping the criteria for income tax and VAT creditability identical and addressing this issue in an exception, VAT creditability should require

that the taxpayer demonstrate direct payment of VAT to the foreign government.

That proof could be a VAT return and payment authorization, or, if no VAT return

has been or will be filed, it could be the receipt issued to the taxpayer or its representative by customs when VAT was paid at the time of importation into the VAT

jurisdiction. Either way, those with no more than an invoice showing a charge for

VAT should not be able to claim the credit.

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