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84–168 2003

THIRD IN SERIES ON THE

EXTRATERRITORIAL INCOME REGIME

HEARING

BEFORE THE

SUBCOMMITTEE ON SELECT REVENUE MEASURES

OF THE

COMMITTEE ON WAYS AND MEANS 

HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

JUNE 13, 2002

Serial No. 107–90

Printed for the use of the Committee on Ways and Means

(

ii

COMMITTEE ON WAYS AND MEANS

BILL THOMAS, California, Chairman

PHILIP M. CRANE, Illinois 

E. CLAY SHAW, JR., Florida 

NANCY L. JOHNSON, Connecticut 

AMO HOUGHTON, New York 

WALLY HERGER, California 

JIM MCCRERY, Louisiana 

DAVE CAMP, Michigan 

JIM RAMSTAD, Minnesota 

JIM NUSSLE, Iowa 

SAM JOHNSON, Texas 

JENNIFER DUNN, Washington 

MAC COLLINS, Georgia 

ROB PORTMAN, Ohio 

PHIL ENGLISH, Pennsylvania 

WES WATKINS, Oklahoma 

J.D. HAYWORTH, Arizona 

JERRY WELLER, Illinois 

KENNY C. HULSHOF, Missouri 

SCOTT MCINNIS, Colorado 

RON LEWIS, Kentucky 

MARK FOLEY, Florida 

KEVIN BRADY, Texas 

PAUL RYAN, Wisconsin 

CHARLES B. RANGEL, New York 

FORTNEY PETE STARK, California 

ROBERT T. MATSUI, California 

WILLIAM J. COYNE, Pennsylvania 

SANDER M. LEVIN, Michigan 

BENJAMIN L. CARDIN, Maryland 

JIM MCDERMOTT, Washington 

GERALD D. KLECZKA, Wisconsin 

JOHN LEWIS, Georgia 

RICHARD E. NEAL, Massachusetts 

MICHAEL R. MCNULTY, New York 

WILLIAM J. JEFFERSON, Louisiana 

JOHN S. TANNER, Tennessee 

XAVIER BECERRA, California 

KAREN L. THURMAN, Florida 

LLOYD DOGGETT, Texas 

EARL POMEROY, North Dakota 

Allison Giles, Chief of Staff 

Janice Mays, Minority Chief Counsel 

SUBCOMMITTEE ON SELECT REVENUE MEASURES

JIM MCCRERY, Louisiana, Chairman

J.D. HAYWORTH, Arizona 

JERRY WELLER, Illinois 

RON LEWIS, Kentucky 

MARK FOLEY, Florida 

KEVIN BRADY, Texas 

PAUL RYAN, Wisconsin 

MICHAEL R. MCNULTY, New York 

RICHARD E. NEAL, Massachusetts 

WILLIAM J. JEFFERSON, Louisiana 

JOHN S. TANNER, Tennessee

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

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

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

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

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

is further refined. 

iii

C O N T E N T S 

Page 

Advisory of June 6, 2002, announcing the hearing ............................................... 2

WITNESSES 

Council of Economic Advisers, Hon. R. Glenn Hubbard, Chairman .................... 7

U.S. Department of the Treasury, Barbara Angus, International Tax Counsel 13

AeA, and Hewlett-Packard Company, Daniel Kostenbauder ............................... 41

International Mass Retail Association, and Wal-Mart Stores, Inc., Gary L. 

McLaughlin ........................................................................................................... 47

International Shipholding Corporation, and Overseas Shipholding Group, Inc., 

Robert Cowen ....................................................................................................... 54

National Association of Manufacturers, and Excel Foundry and Machine, 

Inc., Doug M. Parsons .......................................................................................... 61

National Foreign Trade Council, Hon. William A. Reinsch, accompanied by 

LaBrenda Garrett-Nelson, Washington Council Ernst & Young ..................... 35

Newlon, T. Scott, Horst Frisch Incorporated ......................................................... 63

Software Industry Coalition for Subpart F Equality, and Baker & McKenzie, 

Gary D. Sprague ................................................................................................... 48

SUBMISSIONS FOR THE RECORD 

Coalition of Service Industries, statement ............................................................ 79

Equipment Leasing Association, Arlington, VA, statement ................................. 82

Leasing Coalition, statement .................................................................................. 82

Patton Boggs LLP, Donald V. Moorehead, and Aubrey A. Rothrock III, statement ...................................................................................................................... 84

(1)

THIRD IN SERIES ON THE 

EXTRATERRITORIAL INCOME REGIME 

THURSDAY, JUNE 13, 2002

HOUSE OF REPRESENTATIVES, 

COMMITTEE ON WAYS AND MEANS, 

SUBCOMMITTEE ON SELECT REVENUE MEASURES, 

Washington, DC.

The Subcommittee met, pursuant to notice, at 10:05 a.m., in 

room 1100 Longworth House Office Building, Hon. Jim McCrery, 

(Chairman of the Subcommittee) presiding. 

[The advisory announcing the hearing follows:]

2

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

SUBCOMMITTEE ON SELECT REVENUE MEASURES 

FOR IMMEDIATE RELEASE CONTACT: (202) 226–5911

June 6, 2002

No. SRM–7

McCrery Announces Third in a Series of Hearings

on the Extraterritorial Income Regime

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

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

The hearing will take place on Thursday, June 13, 2002, in the main Committee hearing room, 1100 Longworth House Office Building, beginning at 

10:00 a.m.

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

hearing will be from invited witnesses only. However, any individual or organization 

not scheduled for an oral appearance may submit a written statement for consideration by the Committee and for inclusion in the printed record of the hearing.

BACKGROUND:

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

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

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

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

determination.

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

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

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

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

than $1.1 billion. Originally expected on April 29, 2002, a decision by the panel is 

now expected by June 17, 2002.

The Subcommittee held its first two hearings on the issue on April 10 and May 

9 of this year. The full Committee held a hearing on February 27, 2002.

In announcing the hearing, Chairman McCrery stated: ‘‘It was clear from our first 

hearing that we cannot replicate the benefits of FSC/ETI. Our second hearing examined whether this dispute presents an opportunity to fundamentally reform the Tax 

Code. This hearing will explore a third possible response to the WTO’s ruling, namely making changes to the Tax Code to promote the international competitiveness of 

U.S. companies.’’

FOCUS OF THE HEARING:

The focus of the hearing will be to consider proposals to modify the Tax Code in 

ways which promote the competitiveness of U.S. companies while respecting our 

international obligations under the WTO.

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

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

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

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

fax copy to (202) 225–2610, by the close of business, Thursday, June 27, 2002. Those 

filing written statements that wish to have their statements distributed to the press 

and interested public at the hearing should deliver their 200 copies to the Subcommittee on Select Revenue Measures in room 1135 Longworth House Office 

3

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

Capitol Police will refuse sealed-packaged deliveries to all House Office Buildings.

FORMATTING REQUIREMENTS:

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

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

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

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

files for review and use by the Committee.

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

printing must be submitted electronically to hearingclerks.waysandmeans@mail.house.gov, along 

with a fax copy to (202) 225–2610, in Word Perfect or MS Word format and MUST NOT exceed 

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

on electronic submissions for printing the official hearing record.

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

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

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

by the Committee.

3. Any statements must include a list of all clients, persons, or organizations on whose behalf 

the witness appears. A supplemental sheet must accompany each statement listing the name, 

company, address, telephone and fax numbers of each witness.

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

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

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

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

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

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

Chairman MCCRERY. The hearing will come to order. 

Today’s hearing continues the work of this Subcommittee to exf amine possible responses to the World Trade Organization (WTO) 

finding that the Extraterritorial Income (ETI) regime is an export 

subsidy in violation of our international trade obligations. 

Four days from today, an arbitration panel of the WTO will issue 

its decision on the level of remedies which the European Union 

(EU) may impose on products exported from the United States. 

While there is no requirement that the EU impose these sanctions, 

the decision of the arbitration panel will give them a fairly heavy 

club, and cast a shadow over American exports and the high paying 

jobs they support. 

Given this situation, it is clear to me and others that it would 

be unacceptable for the Congress to do nothing and just hope the 

Europeans decide against the use of authorized sanctions. We must 

show the world that our commitment to meeting our obligations 

under the WTO is not just lip service. 

These hearings are exploring possible solutions. I hope they will 

help the Committee as it contemplates possible responses to the 

WTO’s decisions. Our first hearing held in April examined whether 

the ETI regime could be fixed so as to provide the same benefits 

to the same companies while responding to the objections of our 

trading partners. The unanimous conclusion of the witnesses was 

that the WTO decision in the ETI case makes it clear any modification which constitutes a mere repackaging of the existing benefits 

will not survive the inevitable challenge. 

Our second hearing held a month later reviewed proposals which 

would fundamentally reform the Tax Code. Witnesses advocated a 

number of alternatives, including variations of a national sales tax 

4

or a value-added tax (VAT). The hearings showed the potential 

benefits of such wholesale reform as well as the difficult transition 

issues which any rewrite of the Tax Code would present. 

Today’s hearing explores another possible response to the WTO 

decision. Instead of either tinkering with ETI or fundamentally reforming the Tax Code, a third option would be to repeal the ETI 

regime and use the revenue raised to address some of the shortcomings of our international tax rules, which hinder the competitiveness of U.S. companies. 

The worldwide tax system employed by the United States and 

the resulting international tax rules are complex and often place 

U.S. business at a competitive disadvantage relative to their foreign counterparts. Moreover, in some instances the system actually 

encourages American companies to invest abroad, rather than here 

in the United States. 

Instead of investing profits in the United States to generate more 

economic growth and more jobs, our Tax Code actually encourages 

American companies with overseas operations to keep those funds 

abroad. The international Tax Code’s complexities and shortcomings have hindered the competitiveness of American companies, 

and has therefore made them excellent takeover targets by their 

international competitors. 

In the sixties, the United States served as the world’s dominant 

market. As we enter the new millennium, there is a real danger 

that U.S. businesses will be less competitive in the global marketplace. We cannot afford to sit idly by while economic growth and 

high paying jobs are forced overseas by a Tax Code cobbled together largely when America was the unchallenged economic leader 

of the world. 

Today’s hearings will provide the Committee with a wealth of 

ideas for possible reforms of the international Tax Code. In particular, Glenn Hubbard and Barbara Angus will give us insights 

into the thoughts of the Administration on this issue. 

Our second panel will provide us with input from several industry sectors, including large exporters, small manufacturers, large 

retailers, shippers, software manufacturers, and the electronics industry. Their suggestions on ways to make American companies 

more competitive will be helpful to us in determining whether 

changes to the Tax Code should accompany repeal of the ETI regime. 

[The opening statement of Chairman McCrery follows:]

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

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

Today’s hearing continues the work of this Subcommittee to examine possible responses to the WTO’s finding that the ETI regime is an export subsidy in violation 

of our international trade obligations. 

Four days from today, an Arbitration Panel of the WTO will issue its decision on 

the level of remedies which the European Union may impose on products exported 

from the United States. 

While there is no requirement that the EU impose those sanctions, the decision 

of the Arbitration Panel will give them a fairly heavy club and casts a shadow over 

American exports and the high-paying jobs they support. 

Given the situation, it is clear to me and others that it would be unacceptable 

for the Congress to do nothing and hope the Europeans decide against the use of 

authorized sanctions. 

5

We must show the world that our commitment to meeting our obligations under 

the WTO is not just lip service. These hearings are exploring possible solutions; I 

hope they will help the Committee as it contemplates possible responses to the 

WTO’s decisions. 

Our first hearing, held in early April, examined whether the ETI regime could be 

‘‘fixed’’ so as to provide the same benefits to the same companies while responding 

to the objections of our trading partners. The unanimous conclusion of the witnesses 

was that the WTO decision in the ETI case makes it clear any modification which 

constitutes a mere repackaging of the existing benefits will not survive the inevitable challenge. 

Our second hearing, held a month later, reviewed proposals which would fundamentally reform the Tax Code. Witnesses advocated a number of alternatives, including variations of a national sales tax or a VAT. The hearing showed the potential benefits of such wholesale reform as well as the difficult transition issues which 

any re-write of the Tax Code would present. 

Today’s hearing explores another possible response to the WTO decision. Instead 

of either tinkering with ETI or fundamentally reforming the Tax Code, a third option would be to repeal the ETI regime and use the revenue raised to address some 

of the shortcomings of our international tax rules which hinder the competitiveness 

of U.S. companies 

The worldwide tax system employed by the United States and the resulting international tax rules are complex and often place U.S. businesses at a competitive disadvantage relative to their foreign counterparts. Moreover, in some instances, the 

system actually encourages American companies to invest abroad, rather than here 

in the U.S. Instead of investing profits in the U.S. to generate more economic 

growth and more jobs, our Tax Code actually encourages American companies with 

overseas operations to keep those funds abroad. 

The international Tax Code’s complexities and shortcomings have hindered the 

competitiveness of American companies and has therefore made them excellent 

takeover targets by their international competitors. In the 1960’s, the U.S. served 

as the world’s dominant market, but as we enter the next millennium, there is a 

real danger that U.S. businesses will be less competitive in the global marketplace. 

We cannot afford to sit idly by while economic growth and high-paying jobs are 

forced overseas by a Tax Code cobbled together largely when America was the unchallenged economic leader of the world. 

Today’s hearing will provide the Committee with a wealth of ideas for possible 

reforms of the international Tax Code. In particular, Glenn Hubbard and Barbara 

Angus will give us insights into the thoughts of the Administration. 

Our second panel will provide us with input from several industry sectors, including large exporters, small manufacturers, large retailers, shippers, software manufacturers, and the electronics industry. Their suggestions on ways to make American 

companies more competitive will be helpful to us in determining whether changes 

to the Tax Code should accompany repeal of the ETI regime. 

I yield to my friend from New York, Mr. McNulty, for any opening statement he 

might wish to make. . . .

and Ranking Member of the Subcommittee, Mr. McNulty. 

Chairman MCCRERY. Now I would like to yield to my friend 

f Mr. MCNULTY. Thank you, Mr. Chairman. I welcome our guests 

today. I am pleased to join with the Select Revenue Measures Subcommittee in its third hearing on the replacement of the ETI regime, which the World Trade Organization ruled to be prohibited 

export subsidy. 

Our hearing today will focus on the three issues raised during 

our earlier Subcommittee hearings: Number one, how the United 

States should respond to the WTO ruling on the ETI; number two, 

whether fundamental corporate tax reform is a viable option for replacing the ETI; and number three, why there are concerns about 

the international competitiveness of U.S. companies. 

The Administration’s response to the WTO ruling must be done 

in a way that does not harm the overall competitiveness of American businesses in the global marketplace. There must be a bipartisan approach for handling the ETI, and our actions must be 

6

taken in a timely manner. Earlier testimony confirmed that overhaul of our current system of international taxation would be a 

major undertaking and something that must not be done in haste. 

The competitiveness of our multi-national companies is at stake 

and the issues merit full analysis and discussion. Finally, it is important that this Subcommittee continue its review of international 

tax issues and move the discussion from theoretical approaches to 

realistic alternatives. 

As always, the devil is in the details. Until specifics of a proposal 

are put on the table, it is unclear how the Committee should proceed, and who the winners and losers will be. Today’s testimony 

from experts in the area of international taxation and multinational corporate associations will be of assistance to us in each 

of these areas. 

I thank Chairman McCrery for scheduling this important hearing. Again, I thank our guests for taking the time to come before 

us and to share their expertise. 

[The opening statement of Mr. McNulty follows:]

Opening Statement of the Hon. Michael R. McNulty, a Representative of 

Congress from the State of New York 

I am pleased to join the Select Revenue Measures Subcommittee in its third hearing on replacement of the ‘‘Extraterritorial Income’’ (ETI) regime which the World 

Trade Organization (WTO) ruled to be a prohibited export subsidy. 

Our hearing focus today will focus on the three issues raised during our earlier 

Subcommittee hearings:

• how the U.S. should respond to the WTO ruling on the ETI; 

• whether ‘‘fundamental corporate tax reform’’ is a viable option for replacing 

the ETI; and, 

• why there are concerns about the international competitiveness of U.S. companies.

The Administration’s response to the WTO ruling must be done in a way that 

does not harm the overall competitiveness of American businesses in the global marketplace. There must be a bipartisan approach for handling the ETI and our action 

must be taken in a timely manner. 

Earlier testimony confirmed that overhaul of our current system of international 

taxation would be a major undertaking and something that must not be done ‘‘in 

haste.’’ The competitiveness of our multinational companies is at stake, and the 

issues merit full analysis and discussion. 

Finally, it is important that this Subcommittee continue its review of international tax issues and move the discussion from theoretical approaches to realistic 

alternatives. As always, the ‘‘devil is in the details.’’ Until the specifics of a proposal 

are put on the table, it is unclear how the Committee should proceed and who the 

‘‘winners and losers’’ will be. 

Today’s testimony—from experts in the area of international taxation and multinational corporate associations—will be of assistance to us in each of these areas. 

I thank Chairman McCrery for scheduling this important hearing and I thank our 

guests for coming before us to testify.

today is from the Administration. We have the Honorable Glenn 

Chairman MCCRERY. Thank you, Mr. McNulty. Our first panel 

f Hubbard, Chairman of the Council of Economic Advisers, and Ms. 

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

Mr. Hubbard, we welcome your testimony. Your written testimony will be in the record in full. We would like for you to try to 

summarize that within about 5 minutes. Thank you. 

7

STATEMENT OF THE HON. R. GLENN HUBBARD, CHAIRMAN, 

COUNCIL OF ECONOMIC ADVISERS 

Mr. HUBBARD. Okay. Thank you very much. Mr. Chairman, I 

will be brief. I think your own introduction covered a great many 

of the important issues. What I really wanted to do was three 

things: One, give you a sense of the charge from the President to 

his staff and to the Treasury Department about principles to use; 

second, to describe briefly the importance of the issue, that is, the 

important role multinationals play in our economy; and third, to 

tee up, as you did, Mr. Chairman, the idea that tax reform in this 

area is very, very important. 

The proximate reason that you called the hearing has to do with 

the Foreign Sales Corporation (FSC) ETI dispute. In light of the 

WTO finding, the President gave us two principles, one that he 

wanted the United States to honor quite explicitly its international 

commitments, and to be candid, not walk close to the line, that is, 

to have a genuine response to the finding. 

Second, to work with you in the Congress to come up with a policy instead which could, if possible, enhance, and certainly not diminish, the competitiveness of U.S. firms. 

To go to the issue of why this is so important for the economy, 

just put a fact out that you, of course, are familiar with on the Subcommittee, that multinationals account for quite a large chunk of 

American economic activity. About a quarter of our Nation’s gross 

national product is produced by nonfinancial multinationals. 

An economist would note that the primary motivation for being 

a multinational is to compete more effectively in foreign markets, 

not domestic markets. This is sometimes portrayed as an issue of 

domestic versus foreign in jobs. That is simply not the case. 

Multinationals’ activities generate substantial additional jobs at 

home, and more to the point, the kind of jobs that we all want, 

high-wage technical jobs in the United States. 

On the issue of tax policy in international competitiveness, I 

think it is quite clear that globalization has taken place faster than 

we have been able to reform our Tax Code. An example of this is 

the sharp decline over the past 40 years in American companies’ 

shares in the world’s largest multinationals. 

Tax policy matters a lot, and U.S. policy differs from that of our 

major trading partners in at least four important ways. 

First, about half of the Organization of Economic Cooperation 

and Development (OECD), about half of the industrial countries 

have territorial tax systems, so that a U.S. firm in such a case 

wouldn’t be subject to tax on active income earned abroad under 

such a system. 

Second, even among the countries that do tax worldwide income 

on a worldwide basis, as do we in the United States, active business income is generally not taxed until it is remitted to a parent. 

In some circumstances, for example, income that would arise from 

base companies’ sales or service, that is, business income that 

would be earned abroad, one foreign-controlled corporation to another, would not be deemed to be repatriated in alternative systems. 

Third, the United States tends to place greater restrictions on 

the use of foreign tax credits which, of course, were intended to 

8

avoid double taxation. This is beyond the issue you are very familiar with on multiple baskets, but allocation rules for interest and 

other expenses sometimes will preclude full offset. This is double 

taxation; it is not good tax policy. 

Fourth, the United States is one of only a handful of countries 

that fails to provide some integration of the corporate and individual tax systems, that is, again, double taxation of equity income. 

This absence of integration is a general problem; it extends far beyond international tax, but I would urge you to think of it in your 

discussion. Economists have been less helpful than we might in 

this debate over the years. You know, there are principles for neutrality that have been suggested: Both capital export neutrality 

which would say that an investor should face the same tax irrespective of where it places the investment, and capital import neutrality, which is focused more on competitiveness, that is equal taxation in the host country. 

Despite 40 years of debate, (and I promise you, I won’t go 

through the entrails of that debate) to cut to the chase, these notions have proven not to be terribly useful in practice. In part, that 

is because the debate among economists has been a bit simplistic. 

That is, we all know, of course, that capital can flow through multinationals making allocations; it can also flow through portfolio investors. Many ideas justifying capital export neutrality are based 

on a world that simply doesn’t exist. 

A perhaps larger weakness with traditional notions of capital export neutrality it is designed under the benchmark of perfect competition. Now, perfect competition is an exciting concept, and it is 

most exciting in economic textbooks. It, however, does not describe 

the world in which multinationals work. Indeed, it would be very 

hard to imagine why you would want to be a multinational if you 

were in a world of perfect competition. To cut to the chase, there 

is abundant work that suggests among economists that the theories 

of why a multinational exists point very strongly in the direction 

of something closer to capital import neutrality. 

Now, what does all of this have to do with implications for multinationals and what you are doing? It is very important for the Nation, from an economic perspective to maintain the viability of U.S. 

multinationals and the headquartering of U.S. multinationals in 

the United States. 

Tax policy matters for this, and frankly has played a role in the 

relocation for headquarters purposes of some multinationals. 

To conclude, Mr. Chairman, I agree with you in your introduction. This is a very important topic. I think the clear guidance from 

the President is that this topic be taken to try to improve the competitiveness of U.S. firms. There is quite specific guidance there in 

the sense of trying to avoid double taxation, and trying to promote 

competitiveness that translates into many of the proposals that you 

have been actively looking at on the Committee. I salute you for 

doing so. Thank you very much, sir. 

[The prepared statement of Mr. Hubbard follows:]

Statement of the Hon. R. Glenn Hubbard, Chairman, Council of Economic 

Advisers 

Chairman McCrery, Mr. McNulty, and Members of the Subcommittee, thank you 

for the opportunity to testify today on the effect of U.S. tax rules on the interVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00012 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
9

1Department of Commerce, Survey of Current Business, March 2002. 2Department of Commerce, Survey of Current Business, March 2002. 3 National Foreign Trade Council, International Tax Policy for the 21st Century, 2001. 4Organization for Economic Cooperation and Development, Open Markets Matter: The Benefits 

of Trade and Investment Liberalization, 1998. 5Department of Commerce, Survey of Current Business, March 2002. 

national competitiveness of U.S. companies. Increasingly, the markets for U.S. companies have become global, and foreign-based competitor companies operate under 

tax rules that are often more favorable than our own. The existing U.S. tax law governing the activities of multinational companies has been developed in a patchwork 

fashion, with the result that current law can result in circumstances that harm the 

competitiveness of U.S. companies. In addition to their economic implications, the 

international tax rules are among the most complex in the Code, with the result 

that they are both costly and difficult for companies to comply with and challenging 

for the Internal Revenue Service to administer. That is why I salute your interest, 

Mr. Chairman, in reviewing the current U.S. international tax rules with a view to 

reducing complexity and removing impediments to U.S. international competitiveness. 

The proximate cause of this hearing is the finding by the Appellate Panel of the 

World Trade Organization (WTO) that the United States’ Foreign Sales Corporation/

Extraterritorial Income (FSC/ETI) regime does not comply with our international 

agreements. In light of this finding, the President has emphasized that two principles will guide our response. First, the United States will honor its international 

commitments and come into compliance by modifying it tax laws. Second, in doing 

so, we should work with Congress to enhance if possible, but certainly not diminish, 

the competitiveness of our tax rules. This guidance raises the larger question of tax 

policy and international competitiveness, to which I will now turn. 

Multinational Corporations and the United States Economy

Multinational corporations are an important part of the United States economy. 

Approximately one quarter of the 1999 U.S. Gross National Product of $9.3 trillion 

was produced by U.S. non-bank multinationals. These corporations had a gross 

product of $2.4 trillion.1 In the manufacturing sector, the contribution is even higher, with U.S. parent firms producing 54 percent of all U.S. gross manufactured product. In the conduct of these operations, U.S. multinational firms provide a large 

number of jobs to American workers. In 1998, parent firms employed over 21 million 

people in the United States, compared to a national workforce of 130 million.2

The primary motivation for U.S. multinationals to operate abroad is to compete 

more effectively in foreign, not domestic, markets. Thus their overseas investment 

activities are largely aimed at providing services that cannot be exported, obtaining 

access to natural resources abroad, and to selling goods that are costly to export due 

to transportation costs, tariffs, and local content requirements. As one piece of evidence in this regard, the Department of Commerce notes that two-thirds of sales 

from U.S.-owned foreign affiliates were local (i.e., to their host country). Only 11 

percent of sales from these firms were made back to the United States, and less 

than 10 percent of U.S. plants abroad exported goods back to the U.S. market.3

Thus the primary market for foreign operations of U.S. companies is the host country, followed by other foreign countries. Indeed, more than one-half of all foreign affiliates of U.S. multinationals are in the service sector, including distribution, marketing, and servicing U.S. exports. 

Sales. By definition, multinationals operate and sell their products in more than 

one country. However, research indicates that U.S. operations abroad do not serve 

to displace exports. Indeed, in part because foreign affiliates of U.S. companies rely 

heavily on exports from the United States, the activities of multinationals generate 

a net trade surplus. A recent study by the Organization for Economic Cooperation 

and Development (OECD) complements other academic research in finding that 

each dollar of outward foreign direct investment is associated with $2.00 of additional exports and an increase in the bilateral trade surplus of $1.70.4

How important are multinationals in international transactions? In 1999 (the 

most recent year for which data are available), foreign affiliates of U.S. companies 

purchased $203 billion of goods from U.S. sources. At the same time, domestic operations of U.S. multinationals exported $267 billion to other foreign customers. Drawing these together, U.S. multinationals contributed roughly $440 billion of merchandise exports in 1999, or about two-thirds of overall U.S. merchandise exports.5

U.S. multinationals are also an important part of import behavior. Many are familiar with the notion that imported goods give domestic businesses and consumers 

access to a wider variety of goods at lower prices and competition that forces domesVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00013 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
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6Department of Commerce, Survey of Current Business, March 2002. 7David Riker and Lael Brainard, ‘‘U.S. Multinationals and Competition from Low Wage Countries,’’ National Bureau of Economic Research Working Paper No. 5959, 1997. 8See the Council of Economic Advisers, Economic Report of the President 1991, p. 259. 

tic firms to operate more efficiently. However, imports also provide specialized 

equipment that helps American businesses to compete and improve their productivity. The United States imported $377.1 billion of goods that involved multinationals, 37 percent of the share of U.S. total imports (down from 42 percent in 

1989). In total, U.S.-owned multinationals exported $64 more than they imported.6

Intangible Capital Assets. Physical capital assets often dominate the discussion 

of multinational investment decisions. However, among the assets of U.S. companies 

is their scientific expertise. Foreign physical capital investments are one avenue to 

increase their use of this expertise, thereby raising the rate of return on firm-specific assets such as patents, skills, and technologies. Not surprisingly, raising the 

rate of return provides enhanced incentives for investment in research and development. In 1999, non-financial U.S. multinationals performed $142 billion of research 

and development. Such research and development allows the United States to maintain its competitive advantage in business and be unrivaled as the world leader in 

scientific and technological know-how. In addition, this activity tends to be located 

in the United States—$123.5 billion, or nearly 90 percent, was done in a domestic 

operation. Thus, in this area as well, the foreign and domestic operations of multinationals tend to be complements, and not substitutes, for one another. 

Employment. A common concern is that the overseas activities of U.S. multinationals come at the expense of domestic employment. There are reasons, however, 

for the opposite to be true. The need for labor by any firm is related to its overall 

success. In the case of multinational corporations, this is no different. Foreign investments can lead to more domestic employment because the need for employees 

by a multinational is linked to its entire international, firm-level success at trade 

in intermediate and final goods.7 This link generates a complementary, as opposed 

to competitive, relationship between employment in industrialized and developing 

countries. 

Put differently, international investment by U.S. multinationals generates sales 

in foreign markets that could not be achieved by producing goods entirely at home 

and exporting them. U.S. multinationals use foreign affiliates in coordination with 

domestic operations to produce goods that allows them to compete effectively around 

the world, generating overall success evidenced by employment in the United States 

and significant exports. As evidence of their success, employment in these exportrelated activities yields higher-than-average wage rates. 

Put differently, suppose that a U.S. multinational chose to forego opening a foreign affiliate and relied exclusively on exports from domestic production. Without 

the benefit of local marketing and distribution support, it might be less successful 

in its sales. Or the sheer cost of transport may make it non-competitive. In either 

event, it would lose out to competitors that either pursued a presence in the country 

or had lower transportation costs. The end result may be a company with lower 

profits, slower growth, and fewer employment opportunities.8

For these reasons, it is unlikely that U.S. direct investment abroad displaces U.S. 

jobs or reduces U.S. exports on a net or overall basis. 

Summary. U.S. multinationals provide significant contributions to the U.S. economy through a strong reliance on U.S.-provided goods in both domestic and foreign 

operations. These activities generate additional domestic jobs at above average 

wages and domestic investments in equipment, technology, and research and development. As a result, the United States has a significant interest in insuring that 

its tax rules do not bias against the competitiveness of U.S. multinationals. 

TAX POLICY AND U.S. INTERNATIONAL COMPETITIVENESS

The increasing globalization of economic competition has centered attention on the 

impact of U.S. tax rules. Foreign markets represent an increasing fraction of the 

growth opportunities for U.S. businesses. At the same time, competition from multinationals headquartered outside of the United States is becoming greater. An example of this phenomenon is the sharp decline over the past 40 years in the United 

States share of the world’s largest multinational corporations. 

Why Tax Policy Matters. If U.S. businesses are to succeed in the global economy, 

the U.S. tax system must not generate a bias against their ability to compete effectively against foreign-based companies—especially in foreign markets. Viewed from 

the narrow perspective of income taxation, however, there is concern that the 

United States has become a less attractive location for the headquarters of a multiVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00014 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
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national corporation. This concern arises from several major respects in which U.S. 

tax law differs from that of most of our trading partners. 

First, about half of the OECD countries have a territorial tax system (either by 

statute or treaty), under which a parent company is not subject to tax on the active 

income earned by a foreign subsidiary. By contrast, the United States taxes income 

earned through a foreign corporation, either when the income is repatriated or 

deemed to be repatriated under the rules of the Tax Code. 

Second, even among countries that tax income on a worldwide basis, the active 

business income of a foreign subsidiary is generally not subject to tax before it is 

remitted to the parent. In some circumstances, for example income arising from 

‘‘base country sales or service’’ sources, the active business income is deemed to be 

repatriated and taxed immediately. Indeed, one reading of tax history is that the 

FSC regime originally developed at least in part in response to the pressures generated by the absence of deferral on these income sources. I will defer the details 

of the mechanics of these tax rules, and any potential routes to modification, to the 

testimony of my colleague Treasury International Tax Counsel Barbara Angus. 

Third, the United States places greater restrictions on the use of foreign tax credits than do other countries with worldwide tax systems. For example, there are multiple ‘‘baskets’’ of tax credits which serve to limit the flexibility of firms in obtaining 

credits against foreign taxes paid. In some circumstances, allocation rules for interest and other expenses also preclude full offset of foreign tax payments, raising the 

chances of double-taxation of international income. Again, I will leave the details 

for further discussion by my colleague. 

Fourth, the United States (along with Switzerland and the Netherlands) is one 

of only a handful of industrialized countries to fail to provide some form of integration of the corporate and individual income tax systems. The absence of integration 

results in double taxation of corporate income, making it more difficult for U.S. companies to compete against foreign imports at home, or in foreign markets through 

exports from the United States, or through foreign direct investment. 

Principles of Neutrality. A strict concern for the competitiveness of a U.S. multinational operating in a foreign country would dictate an approach to taxation that 

results in the same tax as a foreign-based multinational operating in that country. 

This competitiveness principle is also known as Capital Import Neutrality (CIN), as 

it results in the same rate of return for all capital flowing into a country. An alternative notion of efficiency is that a U.S. investor should be taxed equally whether 

the investment is made at home or abroad. This latter notion is referred to as Capital Export Neutrality (CEN). 

The debate regarding the principles of competitiveness and capital export neutrality dates back at least to the early 1960s and the proposal of the Kennedy Administration to tax immediately all foreign source income earned by subsidiaries of 

U.S. companies (except in developing countries). Despite 40 years of debate, however, CEN and CIN have not proven to be very useful principles in practice. The 

theories supporting the principles have been overly simplified and have not advanced much in the intervening time. In many instances, analysis fails to account 

for the existence of a corporate tax, the ability of portfolio investors to buy foreign 

corporate shares, and the utter complexity with which actual tax systems involve 

mixtures of residence-based and source-based taxation. 

The conventional economic analysis supporting CEN assumes that all foreign investment is in the form of direct equity and that there are no international flows 

of portfolio equity or debt investments. Under these assumptions, any decrease in 

foreign investment by U.S. companies would result in increased corporate investment in the United States. However, capital can flow out of the United States because portfolio investors can reinvest their shareholdings, selling U.S. in favor of 

foreign companies. Such investment can also flow into the U.S. non-corporate sector. 

Currently, portfolio investment accounts for about two-thirds of U.S. investments 

abroad and about two-thirds of foreign investment in the United States, casting 

doubt on any heavy reliance on a theory that excludes portfolio investment. 

A second weakness of the typical economic analysis underpinning CEN is the presumption of ‘‘perfect’’ competition. Perfect competition is a useful analytic benchmark for economists. However, strictly interpreted, it requires that firms produce 

the same products, cannot take advantage of scale economies, and do not ever earn 

above-market profits. In practice, multinationals produce differentiated products, 

and compete in industries where there are some economies of scale—which is one 

explanation why foreign plants are affiliated with a parent firm at all. A reevaluation of tax principles in a more realistic setting casts doubt on the traditional analysis, including my own research with Michael Devereux. We reexamined the theory 

of international tax policy, noting that foreign investment is different from portfolio 

investment. In particular, foreign investment offers the possibility of exploiting inVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00015 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
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9See Harry Grubert, ‘‘Dividend Exemption and Tax Revenue,’’ and Rosanne Altshuler, and 

Harry Grubert, ‘‘Where Will They Go if We Go Territorial? Dividend Exemption and the Location Decisions of U.S. Multinational Corporations,’’ papers presented at the Conference on Territorial Income Taxation, The Brookings Institution, April 30, 2001. 10Laura D’Andrea Tyson, ‘‘They Are Not Us: Why American Ownership Still Matters,’’ American Prospect, Winter 1991. 11Department of Commerce, Survey of Current Business, March 2002. 

tangible factors such as brands or patents and company-specific cost advantages. 

This research calls into question the basic findings that support CEN. Interestingly, 

in this setting it is often the case that average tax rates—not just marginal tax 

rates—have a large influence on investment decisions. 

One implication of the accumulation of research is that there is no simple general 

abstract principle that applies to all international tax policy issues. The best policy 

in each case depends on the facts of the matter and how the tax system really 

works. A U.S.-controlled operation abroad must compete in several ways for capital 

and customers. They might have to compete with foreign based companies for a foreign market. They might have to compete with U.S. exporters or domestic importcompeting companies. Each of these competing businesses can be controlled either 

by U.S.-based or foreign-based parents. It is a challenge for policy to determine the 

best path to a competitive tax system. 

A direct application of the simple CEN notion can actually make efficiency worse, 

even from the perspective of its objectives. A well-known economic theorem shows 

that when there is more than one departure from economic efficiency, correcting 

only one of them may not be an improvement. Unilateral imposition of capital export neutrality by the United States may fail to advance either worldwide efficiency 

or U.S. national well-being. 

A direct application of the alternative notion of neutrality, CIN can be equivalent 

to a territorial tax system. As noted above, it is unlikely that any single, pure theory 

of international tax rules will provide direct and universal policy guidance. Nevertheless, concerns have been raised over the possibility that using CIN to guide tax 

policy will result in a narrower tax base and a shift in the structure of production 

for multinational firms. In this light, it is interesting to note that recent analyses 

of territorial tax systems by Harry Grubert and Rosanne Altshuler depart from traditional conceptions of the implications of a territorial tax system, arguing that revenue may rise when moving to a territorial system and there may be little impact 

on plant location decisions by multinationals.9

Implications for U.S. Multinationals. As noted earlier, from a tax perspective the 

United States is now less favorably viewed as an industrial country in which a multinational corporation should locate. Over time, any such bias from U.S. tax rules 

could lead to a reduction in the share of multinational income earned by companies 

headquartered in the United States. Incentives supporting a decline in the importance of U.S. multinationals should be a concern, not out of any narrow concern over 

particular companies, but because of the potential loss in economic opportunities 

such a decline would bring about for American workers and their families. Professor 

Laura Tyson, one of my predecessors as Chair of the Council of Economic Advisers, 

points out a number of political, strategic, and economic reasons why maintaining 

a high share of U.S. control over global assets remains in the national interest.10

These include the fact that U.S. multinationals locate over 70 percent of their employment and capital assets in the United States. Also, they have higher pay and 

investment per employee in the United States than in either developed or developing countries. Finally, as noted earlier, U.S. multinationals conduct a very large 

percentage of their research and development domestically. 

The Department of Commerce data support the view that the vast majority of the 

revenue, investment and employment of U.S-based multinationals is located in the 

United States. This has not changed over time. In 1999, U.S. parents accounted for 

about three-fourths of the multinationals’ sales, capital expenditures and employment. These shares have been relatively stable for the last decade.11 Therefore 

where a firm chooses to place its headquarters will have a large influence on how 

much that country benefits from its domestic and international operations. 

The decline in the market share of multinationals headquartered in the United 

States has important implications for the well-being of the U.S. economy. To the extent that tax rules are the source of this shift, higher-paying manufacturing jobs 

and management functions may move along with these headquarters. Research and 

development may be shifted abroad, in addition to jobs in high-paying service industries, such as finance, associated with headquarters’ activities. Future investments 

made by these companies outside of the United States are unlikely to be made 

through the U.S. subsidiary since tax on these operations can be permanently reVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00016 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
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moved from the U.S. corporate income tax system by instead making them through 

the foreign parent. As I pointed out earlier, portfolio investment offers still another, 

perhaps less visible, route by which foreign-owned multinationals can expand at the 

expense of U.S. multinationals. If U.S. multinationals cannot profitably expand 

abroad due to unfavorable U.S. tax rules, foreign-owned multinationals will attract 

the investment dollars of U.S. investors. Individuals purchasing shares of foreign 

companies—either through mutual funds or directly through shares listed on U.S. 

and foreign exchanges—can generally ensure that their investments escape the U.S. 

corporate income tax on foreign subsidiary earnings. 

Conclusions

Multinational corporations are an integral part of the U.S. economy, and their foreign activities are part of their domestic success. Accordingly, we must ensure that 

U.S. tax rules do not impact the ability of U.S. multinationals to compete successfully around the world. I urge that this Committee continue to review carefully the 

U.S. international tax system with a view to removing biases against the ability of 

U.S. multinationals to compete globally. Such reforms would enhance the well-being 

of American families and allow the United States to retain its world economic leadership.

Chairman MCCRERY. Thank you, Mr. Hubbard. Ms. Angus. 

STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX 

f COUNSEL, U.S. DEPARTMENT OF THE TREASURY 

Ms. ANGUS. Mr. Chairman, Congressman McNulty, and distinguished Members of the Subcommittee. I appreciate the opportunity to appear today at this hearing focusing on international tax 

policy and competitiveness issues. The issues that the Subcommittee has explored in this series of hearings on the recent 

WTO decision are critically important as we work toward meaningful changes in our tax rules that will protect the competitive position of American businesses and workers and honor our WTO obligations. 

The concern facing the Subcommittee today is that our Tax Code 

has not kept pace with the changes in our real economy. International tax policy remains rooted in tax principles developed in 

the fifties and sixties. That was a time when America’s foreign direct investment was preeminent abroad and competition from imports to the United States was insignificant. 

Today we have a truly global economy in terms of both trade and 

investment. The principles that guided tax policy adequately in the 

past must be reconsidered in today’s highly competitive knowledgedriven economy. It is significant that the U.S. tax system differs in 

fundamental ways from those of our major trading partners. In 

considering these competitiveness issues, it is important to understand the major features of the U.S. tax system and to how they 

differ from those of our major trading partners. 

First, the United States has a worldwide tax system, while many 

of our trading partners do not tax on the basis of worldwide income. U.S. citizens and residents and corporations are taxed on all 

of their income regardless of where it is earned. Income earned 

from foreign sources is subject to tax both by the country where the 

income is earned and by the United States. 

To provide relief from this potential double taxation, the United 

States allows taxpayers a foreign tax credit. However, detailed 

rules apply to limit the foreign tax credit. A U.S. corporation generally is subject to U.S. tax on the active earnings of a foreign subsidiary once such income is repatriated as a dividend. However, the 

14

U.S. parent is subject to current U.S. tax on certain income earned 

by a foreign subsidiary without regard to whether the income is 

distributed. 

The U.S. worldwide system of taxation is in contrast to the territorial systems operated by half of the OECD countries. Under these 

systems, domestic residents and corporations generally are subject 

to tax only on their incomes from domestic sources. A domestic 

business is not subject to domestic tax on the active income earned 

abroad by a foreign branch or on dividends paid from active income 

earned by a foreign subsidiary. 

Differences between a worldwide tax systems and a territorial 

system can affect the ability of U.S.-based multinationals to compete for sales in foreign markets against foreign based multinationals. Under a worldwide tax system, repatriated income is 

taxed at the higher of the source country rate or the resident’s 

country rate. In contrast, foreign income under a territorial system 

is subject to tax at the source country rate. The use by the United 

States of a worldwide tax system may disadvantage the competitiveness of U.S. foreign direct investment in countries with effective corporate tax rates below those of the United States. The use 

of a worldwide tax system does not disadvantage in countries with 

effective corporate rates above those of the United States. In instances where the taxpayer has lower-taxed foreign income, that 

may actually result in favorable treatment for incremental U.S. investment relative to investment from companies established in territorial countries. 

Second, the U.S. worldwide tax system differs in significant ways 

from the worldwide systems of our major trading partners. About 

half of the OECD countries employ worldwide systems. Looking at 

competition among multinationals established in these countries, 

U.S. multinationals still may be disadvantaged when competing 

abroad. This is because the United States employs a worldwide system that, unlike other systems, may tax active forms of business 

income earned abroad before it has been repatriated and may more 

strictly limit the use of foreign tax credits to prevent double taxation. 

Income earned abroad by a foreign subsidiary generally is subject 

to U.S. tax at the U.S. parent 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, under which a U.S. parent is subject to current 

U.S. tax on certain income of its foreign subsidiaries. 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 forms of income from active foreign business operations. No 

other country has rules for the immediate taxation of foreign income that are comparable to the U.S. rules in terms of breadth and 

complexity. 

Under the worldwide system of taxation, U.S. 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 

foreign tax credit. The United States allows U.S. taxpayers a forVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00018 Fmt 6633 Sfmt 6602 E:\HR\OC\84168.XXX 84168
15

eign tax credit for taxes paid on income earned outside of the 

United States. However, complex rules apply to limit the availability of the foreign tax credits by requiring the categorization of 

income into multiple baskets to which the foreign tax credit rules 

are applied separately. Detailed rules also require the reduction of 

income for which foreign tax credits may be claimed to reflect a 

broad allocation of U.S.-incurred expenses without regard to locally 

incurred expenses. These rules can have the effect of denying U.S.-

based companies the full ability to credit foreign taxes paid on incomes 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. 

Finally, the U.S. domestic tax rules also differ significantly from 

those of our major trading partners. While concern about the effects of the U.S. tax system on international competitiveness may 

focus on the treatment of foreign income, competitiveness 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. 

One aspect of the U.S. system is that income from an equity-financed investment in the corporate sector is taxed twice: First, 

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, 

most other OECD countries offer some form of integration under 

which corporate tax payments are either partially or fully taken 

into consideration when assessing shareholder taxes. Whether competing at home or abroad, the U.S. double tax makes it harder for 

the U.S. company to compete successfully against a foreign competitor. 

Both the increase in foreign acquisitions of U.S. multinationals 

and the recent corporate inversion activity are evidence that the 

potential competitive disadvantages created by our international 

tax rules is a serious issue with significant consequences for U.S. 

businesses and the U.S. economy. The urgency of this issue is further heightened by the recent WTO decision against our ETI provisions and the need to respond promptly to that decision to come 

into compliance with the WTO rules. We must undertake a reexamination of the U.S. international tax rules and the fundamental 

assumptions underlying them. Given the global economy in which 

we live, that reexamination must consider the experiences and 

choices of our major trading partners in designing their international tax systems. These competitiveness issues should form the 

basis for the beginning of that reexamination. 

I would be happy to answer any questions. Thank you. 

[The prepared statement of Ms. Angus follows:]

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

of the Treasury 

Mr. Chairman, Congressman McNulty, and distinguished Members of the Subcommittee, I appreciate the opportunity to appear today at this hearing focusing on 

international tax policy and competitiveness issues. The issues that the Subcommittee has explored in this series of hearings on the recent WTO decision regarding the U.S. extraterritorial income exclusion provisions are critically important 

as we work toward meaningful changes in our tax rules that will protect the comVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00019 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
16

petitive position of American businesses and workers and honor our WTO obligations. 

Introduction

The pace of technological advancement around the world is awe inspiring. Computer processing abilities are expanding at exponential rates, roughly doubling 

every year or two. Innovations in pharmaceuticals and biotechnology are providing 

breakthroughs in treating disease, permitting dramatic improvements in the quality 

of life. Today, the keys to production in even basic commodity industries like oil, 

paper, and steel are found in better knowledge and innovation: the ability to 

produce more with less waste. 

The concern facing this Subcommittee today is that our Tax Code has not kept 

pace with the changes in our real economy. International tax policy remains rooted 

in tax principles developed in the 1950s and 1960s. That was a time when America’s 

foreign direct investment was preeminent abroad and competition from imports to 

the United States was scant. Today, we have a truly global economy, in terms of 

both trade and investment. The value of goods traded to and from the United States 

increased more than three times faster than GDP between 1960 and 2000, rising 

to more than 20 percent of GDP. The flow of cross-border investment, both inflows 

and outflows, rose from a scant 1.1 percent of GDP in 1960 to 15.9 percent of GDP 

in 2000. 

The globalization of the world economy has provided tremendous benefits to consumers and workers. Those who can build a better mousetrap now can sell it to the 

world. The potential for a world market encourages companies to invest in research 

that leads to continuous innovation. At one time, the strength of America’s economy 

was thought to be tied to its abundant natural resources. Today, America’s strength 

is its ability to innovate: to create new technologies and to react faster and smarter 

to the commercialization of these technologies. America’s preeminent resource today 

is its knowledge base. 

A feature of a knowledge-driven economy is that unlike physical capital, technological know-how can be applied across the world without reducing the productive 

capacity of the United States. For example, computer software designed to enhance 

the efficiency of a manufacturing process may require substantial investment, but 

once developed it can be employed around the world without diminishing the benefits of the know-how within the United States. Foreign direct investment by companies in a knowledge-driven economy provides opportunities to export this know-how 

at low cost and incentives to undertake greater domestic investment in developing 

these sources of competitive advantage. 

There are many reasons to believe that the principles that guided tax policy adequately in the past should be reconsidered in today’s highly competitive, knowledgedriven economy. In this regard, it is significant that the U.S. tax system differs in 

fundamental ways from those of our major trading partners. In order to ensure the 

ability of U.S. workers to achieve higher living standards, we must ensure that the 

U.S. tax law does not operate to hinder the ability of the U.S. businesses that employ those workers to compete on a global scale. 

Competitiveness and U.S. Tax Policy

There are several different ways in which tax policy can affect the ability of firms 

to compete. It may be helpful to consider the ways in which commercial operations 

based in different countries compete in the global marketplace. 

Competition may be among:

• U.S.-managed firms that produce within the United States; • U.S.-managed firms that produce abroad; • Foreign-managed firms that produce within the United States; • Foreign-managed firms that produce abroad within the foreign country in 

which they are headquartered; and • Foreign-managed firms that produce abroad within a foreign country different 

from the one in which they are headquartered.

These entities may be simultaneously competing for sales within the United 

States, within a foreign country against local foreign production (either U.S., local, 

or other foreign managed), or within a foreign country against non-local production. 

Globalization requires that U.S. companies be competitive both in foreign markets 

and at home. 

Other elements of competition among firms exist at the investor level: 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 United States. 

Firms compete in global capital markets as well as global consumer markets. 

17

In a world without taxes, competition among these different firms and different 

markets would be determined by production costs. In a world with taxes, however, 

where countries make different determinations with respect to tax rates and tax 

bases, these competitive decisions inevitably are affected by taxes. Assuming other 

countries make sovereign decisions on how to establish their own tax systems and 

tax rates, it simply is not possible for the United States to establish a tax system 

that restores the same competitive decisions that would have existed in a world 

without taxes. 

The United States can, for example, attempt to equalize the taxation of income 

earned by U.S. companies from their U.S. exports to that of U.S. companies producing abroad for the same foreign market. However, in equalizing this tax burden, 

it may be the case that the U.S. tax imposed results in neither type of U.S. company 

being competitive against a foreign-based multinational producing for sale in this 

foreign market. 

The manner in which balance is achieved among these competitive concerns 

changes over time as circumstances change. For example, as foreign multinationals 

have increased in their worldwide position, the likelihood of a U.S. multinational 

company competing against a foreign multinational in a foreign market has increased relative to the likelihood of U.S. export sales competing against sales from 

a U.S. multinational producing abroad. The desire to restore competitive decisions 

to those that would occur in the absence of taxation therefore may place greater 

weight today on U.S. taxes not impeding the competitive position of U.S. multinationals vis-a ́-vis foreign multinationals in the global marketplace. Similarly, while 

at one time U.S. foreign production may have been thought to be largely substitutable with U.S. domestic production for export, today it is understood that foreign 

production may provide the opportunity for the export of firm-specific know-how and 

domestic exports may be enhanced by the establishment of foreign production facilities through supply linkages and service arrangements. 

Given the significance today of competitiveness concerns, it is important to understand the major features of the U.S. tax system and how they differ from those of 

our major trading partners. The primary features of the U.S. tax system considered 

here are: (i) the taxation of worldwide income; (ii) the current taxation of certain 

types of active foreign-source income; (iii) the limitations placed on the use of foreign tax credits; and (iv) the unintegrated taxation of corporate income at both the 

entity level and the individual level. 

Taxation of Worldwide Income

The United States, like about half of the OECD countries, including the United 

Kingdom and Japan, operates a worldwide system of income taxation. Under this 

worldwide approach, U.S. citizens and residents, including U.S. corporations, are 

taxed on all their income, regardless of where it is earned. Income earned from foreign sources potentially is subject to taxation both by the country where the income 

is earned, the country of source, and by the United States, the country of residence. 

To provide relief from this potential double taxation, the United States allows taxpayers a foreign tax credit that reduces the U.S. tax on foreign-source income by 

the amount of foreign income and withholding taxes paid on such income. As discussed below, detailed rules apply to limit the foreign tax credit. A U.S. corporation 

generally is subject to U.S. tax on the active earnings of a foreign subsidiary if and 

when such income is repatriated as a dividend. However, the U.S. parent is subject 

to current U.S. tax on certain income earned by a foreign subsidiary, without regard 

to whether that income is distributed to the U.S. parent. As discussed further below, 

while these current taxation rules are focused on passive, investment-type income 

earned by a foreign subsidiary, their reach extends to active business income in certain cases. 

The U.S. worldwide system of taxation is in contrast to the territorial tax systems 

operated by the other half of the OECD countries, including Canada, Germany, 

France, and the Netherlands. Under these territorial tax systems, domestic residents and corporations generally are subject to tax only on their income from domestic sources. A domestic business is not subject to domestic taxation on the active 

income earned abroad by a foreign branch or on dividends paid from active income 

earned by a foreign subsidiary. A domestic corporation generally is subject to tax 

on other investment-type income, such as royalties, rent, interest, and portfolio dividends, without regard to where such income is earned; because this passive income 

is taxed on a worldwide basis, relief from double taxation generally is provided 

through either a foreign tax credit or a deduction allowed for foreign taxes imposed 

on such income. This type of territorial tax system sometimes is referred to as a 

‘‘dividend exemption’’ system because active foreign business income repatriated in 

the form of a dividend is exempt from taxation. By contrast, a pure territorial sysVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00021 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
18

tem would provide an exemption for all income received from foreign sources, including passive income such as royalties, rent, interest, and portfolio dividends. 

Such pure territorial systems have existed only in a few developing countries. 

Differences between a worldwide tax system and a territorial system can affect 

the ability of U.S.-based multinationals to compete for sales in foreign markets 

against foreign-based multinationals. Under a worldwide tax system, repatriated 

foreign income is taxed at the higher of the source country rate or the residence 

country rate. In contrast, foreign income under a territorial tax system is subject 

to tax at the source country rate. 

Consider a U.S.-based company and a foreign-based company established in a 

country with a territorial tax system. Each company is considering investment in 

a new foreign subsidiary to establish a manufacturing operation for the local foreign 

market. The effect of the worldwide system on this form of competition depends on 

the relationship of the foreign rate of tax on corporate income to that of the United 

States. 

Let us first assume that the effective tax rate on corporate income of this foreign 

country is lower than the effective U.S.-tax rate on corporate income (because the 

foreign country has a lower statutory rate on corporate income or because it has investment incentives such as accelerated depreciation). If the foreign subsidiary of 

the U.S.-based company repatriates on a current basis its economic profits to its 

U.S. parent, it will effectively be subject to the higher U.S. tax rate on its income. 

The foreign subsidiary of the company established in the territorial country, however, will be subject to the lower foreign rate of tax. If the U.S. company cannot 

garner sufficient efficiency advantages relative to its foreign competitor, it will be 

unable to compete since it must sell its product in this market at prices competitive 

with that of its foreign competition. 

An alternative outcome results if the foreign country in which the foreign investment is being considered has a higher effective corporate tax rate than the United 

States. In this case, the U.S. parent is not disadvantaged relative to the company 

established in a country with a territorial tax system. Income earned by the U.S.-

owned foreign subsidiary will be subject to tax at only the source country tax rate, 

the same result as under a territorial system. 

The foregoing examples assumed that the U.S. parent company had no other foreign-source income. The presence of other foreign-source income can affect the rate 

of tax paid on additional foreign-source income under U.S. tax rules because credits 

for taxes paid to one foreign country can effectively be pooled with credits for taxes 

paid to another foreign country. 

Consider for example the case of a U.S. parent that has other foreign-source income that is taxed at foreign rates higher than the U.S. tax rate. In this case, the 

U.S. parent will have excess foreign tax credits before considering its decision to invest in a new foreign subsidiary. If the U.S. parent is considering establishing its 

new foreign subsidiary in a country with a tax rate lower than the U.S. rate, these 

excess credits generally may be used to offset the additional U.S. tax that would 

be levied on the income of this new investment. The presence of excess foreign tax 

credits thus reduces the tax burden imposed by the United States on income from 

the new lower-taxed foreign location. As a result, a U.S. parent in this position will 

be relatively less disadvantaged by the U.S. tax system. If it has sufficient excess 

foreign tax credits, the U.S. parent can offset all of its U.S. corporate tax on the 

income from the new investment and its tax burden will be just the taxes paid in 

the foreign country—the same result as under a territorial system. 

A different competitive result occurs when the U.S. parent has other foreignsource income that is taxed at foreign rates lower than the U.S. tax rate. In such 

a case the U.S. tax rate is the effective tax rate on such foreign income. If the U.S. 

parent is now considering establishing its new foreign subsidiary in a country with 

a tax rate higher than the U.S. rate, the income earned from this new investment 

will generate excess foreign tax credits that can offset the additional U.S. tax paid 

on its preexisting foreign-source income. As a result, in this case the U.S. parent 

receives a tax advantage from making the new investment in the high-tax country 

relative to the treatment of such investment under a territorial system. 

These examples illustrate that the use by the United States of a worldwide tax 

system may disadvantage the competitiveness of U.S. foreign direct investment in 

countries with effective corporate tax rates below those of the United States. The 

use of a worldwide tax system does not disadvantage investment in countries with 

effective corporate tax rates above those of the United States, and in some instances 

may actually result in more favorable treatment for incremental U.S. investment 

relative to investment from companies headquartered in territorial countries. Of 

course, these results are based just on the distinction between a territorial and 

worldwide tax system, and ignore other key features of the U.S. tax system. 

19

The complexities present in taxing income generally are heightened in determining the taxation of income from multinational activities, where in addition to 

measuring the income one must determine its source (foreign or domestic). This 

complexity affects both tax administrators and taxpayers. Indeed, the U.S. international tax rules have been identified as one of the largest sources of complexity 

facing U.S. corporate taxpayers. 

The distinction in the treatment under a territorial tax system of foreign-source 

income relative to domestic-source income puts particular pressure on the determination of the source of items of income and expense. While classification of income as foreign source is important under a worldwide tax system because it determines availability of foreign tax credits, in a territorial system classification as foreign-source income gives rise to an exemption from tax. Similarly, under a territorial tax system, expenses allocable to foreign-source income would not be deductible for tax purposes while expenses so allocated in a worldwide tax system would 

reduce the availability of foreign tax credits. 

Under most territorial systems, certain investment-type income is subject to tax 

without regard to where that income is earned. This raises the further issue of classification of income as subject to tax under this exception from the generally applicable territorial principles. Moreover, to the extent that this income is eligible for 

a foreign tax credit, the computational steps that are required to determine the 

amount of foreign-source income for purposes of applying foreign tax credit rules in 

a worldwide tax system would be built into the territorial system as well. 

Given the complexity of the task of taxing multinational income under a worldwide or territorial system on top of the general complexity of the income tax system, 

some consideration might be given to alternative tax bases other than income. Other 

OECD countries typically rely on taxes on goods and services, such as under a value 

added tax, for a substantial share of tax revenues. In the European OECD countries, for example, these taxes raise nearly five times the amount of revenue as does 

the U.S. corporate income tax as a share of GDP. 

Differences in Worldwide Tax Systems

As described above, about half of the OECD countries employ a worldwide tax system as does the United States. However, even limiting comparison of competition 

among multinational companies established in countries using a worldwide tax system, U.S. multinationals may be disadvantaged when competing abroad. This is because the United States employs a worldwide tax system that, unlike other worldwide systems, may tax active forms of business income earned abroad before it has 

been repatriated and may more strictly limit the use of the 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 making 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 to 

make 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 intercompany 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. 

20

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. 

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 only to offset U.S. tax on foreign-source income 

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

recharacterize 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. 

U.S. Corporate Taxation

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 

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. 

21

One aspect of the U.S. tax system is that the income from an equity-financed investment in the corporate sector is taxed twice. Equity income, or profit, is taxed 

first under the corporate income tax. Profit is taxed 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, most other 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 non-integration of corporate and individual tax payments on corporate income 

applies equally to domestically earned income or foreign-source income of a U.S. 

company. This double tax increases the ‘‘hurdle’’ rate, or the minimum rate of return required on a prospective investment. In order 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 makes 

it less likely that the U.S. company can compete successfully against a foreign competitor. 

An example may help to clarify matters. Suppose that a corporation earns $100 

of pre-tax profit. Consider the tax burden imposed by the present U.S. tax system. 

On its $100 profit, the corporation must pay corporate income tax of $35 assuming 

a 35 percent corporate tax rate, leaving $65 to be distributed to shareholders or reinvested in the firm. If the money is distributed as a dividend, shareholders also 

must pay tax under the individual income tax. If shareholders are subject to an average tax rate of 20 percent, they pay tax of $13, leaving them $52 of after-tax income. In this example, the $100 profit is taxed twice—$35 in tax payments are collected under the corporate income tax and an additional $13 are collected under the 

individual income tax. In total, the tax system collects $48 in tax and so imposes 

a 48 percent ‘‘effective’’ tax rate on corporate profits distributed as dividends. 

Now consider how integration reduces the tax burden on income from corporate 

equity. Full integration of the partnership type eliminates the corporate income tax 

and imputes the $100 of pre-tax profit directly to the shareholders, where it is taxed 

at the shareholders’ 20 percent tax rate under the individual income tax. Full integration reduces the total tax on $100 in profits from $48 under present law to $20. 

A simple form of partial integration is a dividend exclusion, which exempts dividends from the shareholders’ taxable income. A dividend exclusion reduces the total 

tax burden to $35, entirely paid under the corporation income tax. 

Because the unintegrated tax system results in a higher effective tax rate on income earned in the corporate sector, it is more difficult for a given investment to 

achieve a desired after-tax return (after both corporate and individual taxes are 

paid) than in an integrated tax system. As a result, projects that could attract equity capital in an integrated tax system may not be sufficiently profitable to attract 

equity capital in the present unintegrated 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. 

As noted above, most OECD countries offer some form of tax relief for corporate 

profits. This integration typically is provided by reducing personal income tax payments on corporate distributions rather than by reducing corporate level tax payments. International comparisons of corporate tax burdens, however, sometimes fail 

to account for differences in integration across countries and consider only corporate 

level tax payments. To be meaningful, comparisons between the total tax burden 

faced on corporate investments by U.S. companies and those of foreign multinational 

companies must take into account the total tax burden on corporate profits at both 

the corporate and individual levels.

Both the increase in foreign acquisitions of U.S. multinationals and the recent corporate inversion activity are evidence that the potential competitive disadvantage 

created by our international tax rules is a serious issue with significant consequences for U.S. businesses and the U.S. economy. The urgency of this issue is 

further heightened by the recent WTO decision against our extraterritorial income 

exclusion provisions and the need to respond promptly to that decision to come into 

compliance with the WTO rules. 

A reexamination of the U.S. international tax rules is needed. It is appropriate 

to question the fundamental assumptions underlying the current system. We should 

look to the experiences of other countries and the choices that they have been made 

in designing their international tax systems. Consideration should be given to funVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00025 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
22

damental reform of the U.S. international tax rules. Consideration also should be 

given 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 also must work to simplify our international tax rules.

Chairman MCCRERY. Thank you, Ms. Angus. 

Well, if the opening testimony in today’s hearing has done nothf ing else, it has made all of us want to be tax lawyers. It is pretty 

exciting stuff. 

I am a lawyer, but I didn’t get into international tax issues back 

in Leesville, Louisiana, or even Shreveport. I have had to delve into 

them at length as our Subcommittee has studied this problem of 

the ETI regime, and before that, FSC, and before that Domestic 

International Sales Corporation (DISC). So, we all on this Subcommittee have had to become somewhat familiar with international tax rules and the complexity of international tax provisions in our Tax Code. I think it is safe to say that the DSC and 

FSC and ETI came about because of the complexities and the disadvantages that are apparent when one looks at treatment of foreign income by U.S. companies. 

So that is why we are here. 

First of all, I have three questions by Mr. Crane, who is not a 

Member of the Subcommittee, but a Member of the full Committee, 

and wanted me to ask. If it is okay with the witnesses from the 

Administration, I will submit these in writing and would ask that 

you return a response to Mr. Crane’s questions. They are regarding 

the 30 percent withholding tax on incomes from U.S. mutual funds. 

[The questions submitted from Mr. Crane to Ms. Angus, and her 

responses follow:]

U.S. Department of the Treasury 

Washington, DC 20220

Questions:

1. Would you agree that the current 30% withholding tax on the ‘‘dividend income’’ received by offshore investors in U.S. mutual funds acts as a punitive 

export tax? Does this force U.S. mutual funds to set up offshore ‘‘mirror’’ 

funds in order to be competitive with foreign investment funds?

2. I understand that the investment management industry pays some of the 

highest average wages in the U.S. Should we be concerned that American 

mutual fund companies are forced to send these jobs overseas to respond to 

the investment needs of non-citizens?

3. In light of the economic devastation from 9/11 that hit the financial services 

industry particularly hard, would correcting U.S. tax policy to remove the 

30% withholding of dividend income earned by foreign investors help restore 

this industry and the jobs they support? 

Response:

Distributions to shareholders from a U.S. regulated investment company, or mutual fund, are characterized as dividends. Under current law, such dividend distributions from a U.S. mutual fund to a foreign investor generally are subject to the 

U.S. 30-percent withholding tax. The U.S. withholding tax applies without regard 

to the character of the underlying earnings of the U.S. mutual fund out of which 

the distributions are made. Therefore, distributions from a U.S. mutual fund made 

out of earnings that are interest income or short-term capital gains are subject to 

the U.S. withholding tax, even though interest income and short-term capital gains 

generally would not be subject to the withholding tax if paid directly to a foreign 

investor. 

23

Characterization of all distributions from U.S. mutual funds as dividends which 

are subject to the U.S. withholding tax does not reflect the economic character of 

the underlying investment income. In addition, the imposition of the U.S. withholding tax in the case of investments made through a U.S. mutual fund, when none 

is imposed on comparable investments through a foreign mutual fund, inhibits the 

ability of U.S. mutual funds to attract foreign investors. Current law thus encourages the establishment of ‘‘mirror’’ funds outside the United States for foreign investors that wish to invest in U.S. securities. 

These economic distortions could be addressed by modifying the current-law rules 

so that the application of the U.S. withholding tax to distributions from a U.S. mutual fund to its foreign investors depended upon the character of the underlying 

earnings out of which the distribution was made. Under this approach, distributions 

to a foreign investor of interest income earned by a mutual fund would not be subject to the U.S. withholding tax, just as the interest income would not be subject 

to the U.S. withholding tax if paid directly to the foreign investor. Under this approach, foreign investors would not be subject to U.S. withholding tax on distributions of investment income from a U.S. mutual fund in situations where such investors would not be subject to withholding tax on such investment income if it were 

earned directly or if it were earned through a foreign mutual fund.

witnesses described by giving some special tax advantages to exObviously, we wanted to overcome some of the problems that the 

f porters, to companies in this country who wanted to sell their products overseas. 

The WTO has ruled that the method we chose was contrary to 

the rules of the WTO. I think we have decided that we can’t fight 

that any longer, and we must do something different to try to overcome these problems in our Tax Code. 

Those companies who are advantaged by ETI and who now face 

repeal of that and replacement with some other tax provisions tell 

me, and I am sure others on this Subcommittee that if we do that, 

it will cost jobs in their companies, in their industries that are directly benefited by the ETI, but will only perhaps be generally benefited, and not as much, by changes to the Tax Code, some of which 

we have talked about. 

So, Mr. Hubbard, I would like to ask you your opinion as to the 

impact on jobs generally in the country if we repeal ETI, but use 

the revenue raised from that repeal to give other tax breaks generally to the business community along the lines that—some of the 

lines that the Treasury Department has suggested. 

Mr. HUBBARD. Well, certainly. Mr. Chairman, I think it largely 

depends on what you decide to do. When you think about business 

tax reform, you could think generally about tax policy generally for 

corporations or you could think in the international area. Even in 

the international area, moving to better tax policy is likely for the 

economy as a whole to generate more jobs and income than was 

possible under the FSC ETI regime. There will be winners and losers. As you know, whenever you change tax policy, that is so. We 

can’t wish that away. 

For the economy as a whole, I think there are many options you 

could take which would make us generally better off. 

Chairman MCCRERY. You are saying that if we use that revenue to provide tax changes to industry and maybe particularly to 

industries that compete in the global marketplace, that it could result in more jobs, not just keep us even, but you think it could result in more economic activity here and more jobs here? 

24

Mr. HUBBARD. I think that is possible, Mr. Chairman. It depends on what you do. There are some very good tax policy options 

that are just good tax policy in the international area that you 

might wish to consider and no doubt are considering. So, I think 

that is possible, yes. 

Chairman MCCRERY. Now, let’s talk about the quality of those 

jobs. We are told over and over that jobs that are tied to exports 

are generally higher paying jobs. Some say 10 to 15 percent more, 

that those jobs pay 10 to 15 percent more than the average U.S. 

job. If all of that is true, and we think it is, then are we risking 

those higher paying jobs by changing, by doing away with ETI and 

not directing those revenues at the targets of the ETI? 

Mr. HUBBARD. Well, again, going back to the President’s principles, it is likely not possible for you to make whole the exact distribution. If it were, we wouldn’t be in this box. I think that there 

are also very high paying jobs associated with headquarters of multinationals, and there are tax policy changes that can be taken to 

make it attractive for multinationals to be in the United States. 

So, I think that those are also high paying jobs. So, on average, 

I think that there are things you can do that are very positive for 

the economy. No matter what you do, you are likely to create winners and losers. 

Chairman MCCRERY. Should we look, as much as possible, at 

directing this revenue to companies that export? 

Mr. HUBBARD. Well, I would urge you to look as much as possible for the best possible tax policy, because that is what is going 

to generate the highest gains for the economy as a whole. You identify, I think very aptly and more succinctly than Barbara and I did, 

the complex problems in the international area. This is an area 

that is really ripe for reform. I think there are some great things 

that you can do there that would be very positive for the economy. 

Chairman MCCRERY. So bottom line, you are confident that we 

can make this transition from ETI to maybe a simpler international Tax Code without doing damage, and in fact, we might 

even improve the Nation’s economy? 

Mr. HUBBARD. Well, I guess, first, I would suggest humbly to 

you that we must make the transition. It would be my judgment 

as an economist that you could find a package of policies that 

would make the economy as a whole as well off or better off. 

Chairman MCCRERY. Thank you. Ms. Angus, Mr. Newlon, who 

will testify later, states in his testimony that competitiveness is a 

particular concern for financial services income because integration 

of the international financial markets leads to direct competition 

among foreign financial institutions. 

While that is certainly true, is that the only arena where there 

is integration of world markets? 

Ms. ANGUS. No. It is certainly clear that there is integration of 

world markets in all industries. The globalization that is facing the 

financial services industry may be somewhat more recent than the 

globalization that has faced and is facing other industries equally. 

Chairman MCCRERY. In fact, we have pretty healthy integration in manufacturing, software, and other services as well as financial services, don’t we? 

25

Ms. ANGUS. Yes. Yes. The integration of markets is happening 

both with respect to goods and products and also increasingly in 

the service sectors of our economy. 

Chairman MCCRERY. So, competitiveness is an issue pretty 

much across the board with respect to our domestic corporations 

and multinationals residing here? 

Ms. ANGUS. Yes, it is. 

Chairman MCCRERY. Thank you. I would say to the Members 

of the Subcommittee we have a 15-minute vote followed by one 5-

minute vote. So, we will recess at this time and go vote. Please, as 

soon as possible, return to the hearing room and we will resume 

the hearing. The Subcommittee is in recess. 

[Recess.] 

Chairman MCCRERY. The Subcommittee will come to order. I 

appreciate the witnesses understanding of our need to go vote occasionally. I am told that we won’t have another vote for a couple of 

hours. So, maybe we can get the rest of the hearing in before we 

are interrupted again. 

I would like to now recognize my colleague, Mr. McNulty, for any 

questions that he may have of the panel. 

Mr. MCNULTY. Thank you, Mr. Chairman. Again, I thank both 

of our witnesses for testifying. Ms. Angus, does the Administration 

believe it will take major or minor changes to fix the ETI regime? 

Ms. ANGUS. Yes. In looking at the WTO opinion, we don’t believe that it is possible to tinker with the current provisions or 

make minor fixes. We will need to make more meaningful changes 

to our tax law. It won’t be possible simply to tweak around the 

edges and replicate the benefits. This is an exercise that will require that we look more fundamentally at our tax law and make 

more meaningful changes. 

Mr. MCNULTY. What are we looking at? What is on the table? 

Ms. ANGUS. Well, as Mr. Hubbard indicated, we think it is a 

priority that whatever we do must honor our WTO obligations and 

be compatible with the WTO rules. 

Mr. MCNULTY. What specifically do you think we would propose? What would the outline be of a solution, in the opinion of the 

Administration? 

Ms. ANGUS. I don’t——

Mr. HUBBARD. If I might, Mr. McNulty. You wanted to think 

of international tax reform. There are a whole variety of issues that 

the Subcommittee and the Committee has looked at in the past. I 

referred to two in my testimony that related to the President’s 

principles trying to emphasize competitiveness by looking at base 

company rules, avoiding double taxation in the interest allocation. 

There are many, many areas as the Chairman said in his remarks. 

This is both mindlessly inefficient and mindlessly complex, but 

there are many such policies that you could put together. 

Mr. MCNULTY. Can you give me some examples? Could you be 

any more specific than that? 

Mr. HUBBARD. Well, I just gave two that are probably on an 

economist’s list as among the areas needing greatest reform, if that 

were your objective. 

Mr. MCNULTY. Do you think those would do it? 

26

Mr. HUBBARD. It depends upon what you mean by ‘‘do it,’’ sir. 

Terms of improving tax policy in the international area——

Mr. MCNULTY. Fix it so we would be in compliance. 

Mr. HUBBARD. It would certainly be WTO compliant. The other 

part of the President’s charge had to do with improving competitiveness. It would accomplish that as well, but there are also other 

policies that would do the same thing. We would certainly look forward to working with you on that. 

Mr. MCNULTY. Would either of you have an idea of what a 

timeframe would be for getting an administrative proposal, a legislative proposal to us? 

Mr. HUBBARD. I think that from the President’s charge, we look 

forward to working with Congress. The President had asked us to 

work first with the Committee on Ways and Means. We have been 

doing so and continue to be at your service. 

Mr. MCNULTY. What do you think the timetable would be in 

order to avoid the imposition of penalties by the WTO? 

Ms. ANGUS. I think that that is certainly a difficult question. 

We believe that it is critically important that we address these 

issues promptly, that it is essential that we start making real 

progress toward a solution. Certainly the issues that are facing us, 

all of us, are complicated ones. 

It is important, particularly with the WTO arbitration decision 

expected very shortly, that we begin to show real progress. Obviously that has begun with the work of this Subcommittee, the three 

hearings in this Subcommittee as well as the full Committee hearing earlier this year. 

Mr. MCNULTY. I thank both of the witnesses. Thank you, Mr. 

Chairman. 

Chairman MCCRERY. Thank you, Mr. McNulty. Mr. Ryan. 

Mr. RYAN. Thank you, Mr. Chairman. Well, Mr. Hubbard, you 

were saying in your testimony that putting to the categories of different tax reform proposals into the capital import neutral system 

and the capital export neutral system is not really a good way to 

measure those things. 

Then, I think you went on in your testimony to talk about how 

capital import neutrality is basically a territorial system. What are 

your thoughts on a territorial system? What do you think are the 

benefits and the pros and the cons of a territorial system? 

Mr. HUBBARD. Well, of course, a territorial system is one example of a capital import neutral system. There might be others. I 

think a territorial system properly designed is consistent with a 

number of fundamental tax reform objectives. Remember, fundamental tax reform would not have you tax income multiple times. 

Since we are talking about dividends from foreign subsidiaries back 

to the parents, that is the same issue. 

So arguably, a territorial tax system could be consistent with 

both fundamental income tax reform or fundamental consumption 

tax reform, but here the devil really lies in the details. When people say territorial, they can mean very many different things. I 

think that a territorial tax discussion would be part of any fundamental tax reform discussion that you might decide to have. 

Mr. RYAN. Well, the third hearing that we are having here 

today is talking about sort of a rifle shot fix to ETI, FSC. UltiVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00030 Fmt 6633 Sfmt 6602 E:\HR\OC\84168.XXX 84168
27

mately do you believe that even if we do a narrow fix to FSC or 

ETI that that will have to be changed later in place of ultimate tax 

reform? Do you believe that the incompatibility of the U.S. business 

tax regime internationally with respect to our competitors is ultimately going to have to force the hand of our country to fundamentally reform our tax system? If that is the case, where do you think 

we should head? Which direction should we go? 

Mr. HUBBARD. To the first part of your question, I would hope 

that what you would do would buildupon, in other words, have fundamental tax reform be a logical follow on. There are many steps 

you could take that would be consistent, ultimately, with tax reform. I share your belief that ultimately we have to discuss fundamental tax reform in the United States. The Treasury Department, 

of course, is engaged in such an exercise. 

Mr. RYAN. Do you think that what we do right now to respond 

to FSC is going to set up the direction of tax reform with respect 

to whether we go territorial or whether we go to something like a 

subtraction method VAT or something like that? Do you think that 

it matters with respect to where we want to go on tax reform at 

the end of the day, based upon what we are going to do to respond 

this year, if we do this year, to this current problem? 

Mr. HUBBARD. Well, what I would say is, do you want to take 

an answer on the FSC ETI that doesn’t diminish the chance of fundamental tax reform? There are many things you could do as a replacement for FSC ETI that would be on the path toward tax reform. 

I am not sure that you could roll in a fundamental tax reform 

discussion into this and accomplish it in a short period of time. I 

think you do want to be consistent. 

Mr. RYAN. Ms. Angus, I know the Administration hasn’t come 

up with a specific proposal. I am not going to press you for one 

right now. We are trying to learn more about this ourselves to 

come up with a suitable response to the WTO problems we have, 

along the lines that the President mentioned, make sure that we 

don’t do harm to the economy, to jobs, and make sure that we improve our competitiveness, but time is ticking. We will have to put 

a response out there fairly soon. We at least have to show progress. 

When do you expect to bring a proposal to the Committee? Are 

you going to wait for the Committee to come up with something 

that you will then respond to, or are you actually planning on 

bringing a proposal to us this year? 

Mr. HUBBARD. Our current plan, Mr. Ryan, is to work with the 

Committee, and this work has already been going on at the technical level. We also, of course, in the Administration, plan to raise 

the issue of direct versus indirect taxes general in the WTO round. 

We will be doing that independent of the work of the work here, 

but we do look forward to working with the Committee. That work 

is already going on. 

Mr. RYAN. You don’t agree with their definition of direct taxes, 

correct? 

Mr. HUBBARD. I do not. I think that we will be working within 

the next round on that. 

Mr. RYAN. Okay. Thanks. 

Chairman MCCRERY. Mr. Neal. 

28

Mr. NEAL. Thank you, Mr. Chairman. Mr. Hubbard, regarding 

the corporate inversion problem, some have suggested that we 

move forward with a temporary fix. While reading both of your testimonies, I don’t see a consensus conclusion about what we should 

do. In fact, I don’t even see agreement on whether we should do 

fundamental reform within our system or fundamental reform 

within a whole new system of taxation. 

With no clear recommendation from the Administration, do you 

think Congress can overhaul our corporate tax system within the 

next 3 months? How about with an election coming up? Do you 

think this is doable within a year? 

Mr. HUBBARD. Sure. Why not? No. Going to your question in 

two parts. On corporate inversions. Inversions, of course, are an 

important question, slightly different question than was the subject 

of the hearing today. Inversions raise the important topic that the 

Tax Code itself has sufficient problems that lead to tax strategies 

that we would all wish were not there. I think solution there is to 

fix the Tax Code. The Treasury Department has made a very concrete suggestion there. 

As to the issue of overhauling the Tax Code within the next 3 

months, as I was suggesting to Mr. Ryan earlier, I think that having a very short-term discussion on fundamental tax reform is not 

likely to produce a quick answer for you on FSC ETI. What you 

might want to do is consider reforms that are consistent with a variety of fundamental tax reforms, but also help in the FSC ETI. 

There are several roads you could take; I know that the Committee 

is exploring. 

Mr. NEAL. In your previous presentation, you used the term 

‘‘best tax policy,’’ and you spoke about winners and losers. Would 

you agree that those who are currently winning think that is the 

current system is the best tax policy? 

Mr. HUBBARD. Well, I was speaking from the point of view of 

the national interests. In other words, if one’s objective in tax policy were to have the most efficient tax system so our economy as 

a whole is doing the best, that is what, from an economic perspective, would be the best tax policy? There are any of a number of 

winners in any particular tax policy, but overall for the country, 

what is best is what is in the national interest. 

Mr. NEAL. You think that is going to happen? 

Mr. HUBBARD. Well, of course, what we would look for is the 

best possible tax policy, as I am sure you would on the Committee. 

Mr. NEAL. Let me just refresh your memory, if I can, for a second here. The Majority Leader, upon taking office in 1994 said that 

we were going to change the tax system, fundamentally. The 

former Chairman of our Committee here, a good friend of mine, 

and if I can just give you the rhetoric of the time, because we listen 

to it here patiently, said, ‘‘We were going to pull the Tax Code up 

by its roots, we were going to drive a stake into the heart of the 

tax system.’’

He said we were all going to a long funeral procession for the tax 

system. Now, I ask you, Mr. Hubbard, what evidence do you have 

during the last 8 years that supports the suggestion today that we 

are about to radically reform the tax system at the same time allowing an opportunity for these companies to continue to move to 

29

Bermuda? While we have this academic discussion, here they are 

sneaking out of town in the dark of night? 

Does the Administration support these companies moving to Bermuda? 

Mr. HUBBARD. Well, first again, let me cut to the premise of 

your question. We have suggested a very concrete way to go at 

that. It does not require fundamental tax reform. It exposes the 

need for fundamental tax reform. There are certainly ways to deal 

with corporate inversions. I just remind you of the issue of tax reform generally; 1986, which was a landmark tax reform, was many, 

many years in the making. There was part of my earlier answer 

to you. Tax reform doesn’t happen overnight, you are quite right. 

There is much that we can do, both for inversions and in FSC 

ETI area that is consistent with tax reform and doable by you very 

quickly. 

Mr. NEAL. With the exception of what Mr. McCrery has done 

here to help us out in this discussion, I don’t recall the Committee 

having done a heck of a lot over the last 6 years about structural 

tax questions. 

Let me just ask. Does the Administration support those companies, agree with these companies sneaking out of town in the dark 

of night and moving to Bermuda? 

Mr. HUBBARD. The question from the perspective of the Administration and what the Treasury Department has helpfully suggested, is that we want to make sure that we fix the problems in 

the Internal Revenue Code that lead to this kind of behavior. 

We do believe that headquartering in the United States is a plus 

for the economy, and we want to make sure that we don’t have a 

Tax Code that is biasing companies from wanting to do business 

in the United States. 

Mr. NEAL. Mr. Hubbard, let me give you a third opportunity. 

Does the Administration support these companies moving to Bermuda—and I will use my previous suggestion—in the dark of 

night? 

Mr. HUBBARD. Rather than wishing the problem away, Congressman, what the Administration wants to do is to suggest a concrete proposal, and did, to remove the economic incentive for such 

transactions. 

Mr. NEAL. Mr. Hubbard, I understand the talk of economists, 

vague as it can be. Yes or no? 

Mr. HUBBARD. The Administration supports the fixes in the Internal Revenue Code that would not provide the incentive for the 

behavior you want. You simply can’t wish away activities. 

Mr. NEAL. I guess, then, in terms of economic nomenclature, yes 

and no don’t exist. Thank you, Mr. Chairman. 

Chairman MCCRERY. You are welcome. I will say to my good 

friend from Massachusetts that I don’t think we should condone 

that. 

Mr. NEAL. Mr. Chairman, I know you don’t. 

Chairman MCCRERY. I don’t think the Administration does. 

Mr. NEAL. Well, they could have said that. 

Chairman MCCRERY. They have. 

Mr. NEAL. Mr. Hubbard, do you want to say that? 

Chairman MCCRERY. They have said that. 

30

Mr. HUBBARD. I believe we actually put out a specific and concrete proposal. 

Mr. NEAL. Do you want to say no, Mr. Hubbard? 

Mr. HUBBARD. We put out a specific——

Mr. NEAL. You don’t agree with this. Do you want to say that? 

Chairman MCCRERY. Mr. Neal, I am reclaiming my time. 

Mr. NEAL. Thank you, Mr. Chairman. 

Chairman MCCRERY. The Administration has been very helpful, 

the Treasury Department has been very helpful in coming up with 

a very specific list of suggestions which would not prevent but certainly discourage companies from doing that. I think it is very constructive, and I think we will find, you and I and others, when we 

get further along into this that we might be able to put together 

a nice little package on inversions and on ETI that would make a 

lot of sense in terms of restructuring our international tax provisions, It would solve the problem that you are concerned about, 

that I am concerned about and would, I think, not make everybody 

happy that is getting ETI now, but get us a long way down the 

road to having a system that makes a lot more sense for our multinational companies. 

Mr. NEAL. Mr. Chairman, would you yield for a brief question? 

Chairman MCCRERY. Sure. 

Mr. NEAL. Would it be possible for you to ask Mr. Hubbard if 

the answer is yes or no to the question I raised? 

Chairman MCCRERY. Well, I will say that in my discussions 

with the Administration and based on their cooperation and suggestions through the Treasury Department, it is clear to me that 

the Administration thinks that the practice of companies moving 

offshore to reduce their tax burden is not a desirable outcome for 

the U.S. economy. They are trying very hard to work with us to restructure our tax provisions so that those things don’t happen. 

That is the best answer you are likely to get out of them. 

Mr. NEAL. Mr. Chairman, would you yield for one quick comment? Now, I understand why the framers of our Constitution decided to separate the executive branch from the legislative branch. 

You have really cleared that up. Thank you. 

Chairman MCCRERY. Let me say for the record, I do appreciate 

the cooperation we are getting from the Treasury Department and 

the expertise we are getting from the Treasury Department on the 

question of inversions and on this very complex question of the ETI 

and approaches to solving that. 

Now I would like to turn to Mr. Lewis. 

Mr. LEWIS. Thank you, Mr. Chairman. Ms. Angus, has the 

Treasury Department studied the effects of the Tax Code on the 

international shipping industry? 

Ms. ANGUS. We have not studied, those effects, although certainly I think that is something that we ought to be looking at as 

we talk about some of the aspects of our subpart F rules and the 

ways that the U.S. subpart F rules operate to impose current taxation on active business income earned abroad when the aim of the 

provisions is at passive income. That is something that is a real 

concern, and one of those areas is the treatment of shipping. 

We have talked a little bit about the need to look to the tax approaches of our major trading partners. When we look to other 

31

countries, none of our major trading partners treat shipping income 

in the same way that the U.S. tax rules treat shipping income. Certainly the evidence that has been presented about the changes in 

the U.S. shipping industry recently are dramatic and that is something that we ought to look at very carefully. 

Mr. LEWIS. What has actually happened to the U.S. controlled 

shipping interests? 

Ms. ANGUS. Well, I am not an expert on the shipping industry. 

I believe you actually have a witness that will be talking about 

that. Certainly from reading that testimony in preparation for this 

hearing, there has been a significant change in the shipping industry over the last decade or so, and that is something that we ought 

to look at very carefully. 

Mr. LEWIS. Well, it is evident it has had a very devastating effect to the shipping industry. So, I hope that will be something that 

you will look at. Thank you. 

Chairman MCCRERY. Thank you, Mr. Lewis. Mr. Foley. 

Mr. FOLEY. Thank you very much, Mr. Chairman. I feel somewhat compelled to at least respond to the gentleman from Massachusetts relative to this Committee’s endeavor on tax relief. There 

is no question since I have been in Congress in 1994 and joined 

this Committee in 1998, we have endeavored to try and straighten 

out the complexities of the Tax Code. We have tried to eliminate 

estate taxes, we have reduced capital gains taxes. We are on the 

Floor debating marriage penalty elimination. 

Almost every one of these measures has been universally met 

with opposition from the minority. Virtually every trade agreement 

we try to enunciate with world partners is met with a stunning rejection of the minority party. So when there are companies leaving, 

which I do not agree or support, they may be leaving because this 

Committee and the minority have obstructed the ability to give 

clear signals to the business community that we are, in fact, serious about trying to retain the best and brightest corporations in 

this country. The Senate rejected yesterday the ability to provide 

estate tax relief. 

Now, I know the Administration does not support the exodus of 

corporations offshore. I can answer that question for the Treasury 

Department, and I will for the President. 

Mr. NEAL. Gentleman yield? 

Mr. FOLEY. Absolutely. 

Mr. NEAL. If you can answer it for them, why can’t they answer 

it for them? 

Mr. FOLEY. They may not be here to answer that specific question. But let me speak——

Mr. NEAL. That was clearly——

Mr. FOLEY. I reclaim my time. The Treasury Department—

many times when we were sitting here listening to Mr. Rubin they 

wouldn’t answer direct questions posed by this Committee either. 

Mr. Rubin is probably one of the most talented men I have met in 

my time in this process, but we were met with stone-faced silence 

when we asked him about capital gains. In fact, he said to this 

Committee they not only didn’t support it, didn’t think it was appropriate, were going to cause deficits to soar and, to the contrary, 

32

we saw economic stimulus. So, even when they did answer on occasion their answers proved to be false. 

I think what we need to do is look at the problems we place before domestic companies, and I think this is systemic of the problems and the complexities of the Tax Code. I would work tirelessly 

with the Democratic leadership if they choose in fact to show a welcome attitude toward our domestic corporate partners on some of 

these global issues that we face because we are in a global world. 

There is an issue, Ms. Angus, I would like to inquire about relative to software. Their rents and royalties from software transactions should be considered active income and exempt from subpart F. Do you share that thought? 

Ms. ANGUS. I think it is fair to say that the treatment of software under our subpart F rules in particular raises a number of 

difficult issues, and some of them arise from the fact that our subpart F rules do date back to the sixties. So, we have got rules that 

are now covering transactions and a technology that wasn’t contemplated at the time that they were written. 

Over recent years Congress has been grappling with the application of the subpart F rules to the financial services industry and 

making some changes to modernize those rules as the financial 

services industry became more global, and I think those same 

issues need to be addressed in this industry as well. It is an industry that is obviously new relative to when the rules were written 

and also an industry that has become increasingly global. So we do 

need to take a hard look at our rules, subpart F in particular, but 

also other aspects of international rules to make sure that they are 

properly characterizing these transactions. 

Some of these transactions in the software area are fairly complex and there may be several different forms in which a transaction can be done and the subpart F may give a different answer 

depending on which form is done. That doesn’t make sense when 

the transactions are all economically equivalent. So, it is an area 

that needs a careful look. 

Mr. FOLEY. It seems though we are very late in coming to the 

table on some of these more complex issues. The dynamics of those 

business models seem to be thriving and yet we are slow to catch 

up with their technology. 

Ms. ANGUS. I would agree that it is fair to say that the U.S. 

tax rules and the international rules in particular have not kept up 

with the changes in our economy, and that is why we do need to 

take a careful relook at these rules so that they aren’t out of step 

with the way that business is done in today’s global economy. 

Mr. FOLEY. Thank you very much. I yield back. 

Chairman MCCRERY. Thank you, Mr. Foley. Mr. Doggett is not 

a Member of the Subcommittee, but he is a Member of the full 

Committee, and he is with us this morning. 

Mr. DOGGETT. Thank you very much. 

Chairman MCCRERY. If you would like to inquire of the witnesses, please proceed. 

Mr. DOGGETT. Appreciate it, Mr. Chairman. Ms. Angus, I know 

that in the Treasury Department report there was a recommendation to take a look at section 163(j) of the Tax Code. Is it your belief 

that section 163(j) should be amended? 

33

Ms. ANGUS. Yes, and in fact at the hearing last week we proposed some very specific amendments to revise those rules in order 

to address concerns about the ability for foreign based companies 

to use debt as a form of shifting income out of the United States 

and reducing their tax on income that would otherwise be subject 

to U.S. taxes. 

Mr. DOGGETT. So whatever else, this Committee does on a 

short-term or a long-term basis, one thing it most certainly should 

do is to amend section 163(j), and do it now. 

Ms. ANGUS. We certainly do believe that it is important to address the section 163(j) issue immediately. 

Mr. DOGGETT. Isn’t it true that section 163(j) would only capture interest payments and not royalty fees? 

Ms. ANGUS. Section 163(j) is focused on interest payments. In 

the proposals that we made last week and in the issues that were 

discussed in our study from last month, we also talked about the 

need to take a careful look at our transfer pricing rules and in particular——

Mr. DOGGETT. I hope we have time to get into that because I 

am very interested in that issue also. Closing the—you don’t really 

close it, but changing section 163(j) will get to interest payments. 

It does not get to royalty payments, correct? 

Ms. ANGUS. No. We need to look at the transfer pricing rules 

to address the royalty payments. There are very difficult issues 

that arise there and something that——

Mr. DOGGETT. Section 163(j) won’t address transfer pricing or 

royalty payments, correct? 

Ms. ANGUS. Right, which is why we have——

Mr. DOGGETT. Have your other recommendations——

Ms. ANGUS. Need to work in that area. 

Mr. DOGGETT. Your recommendation on those matters relates 

more to study than changing a statute now? 

Ms. ANGUS. No, I wouldn’t describe it that way because we indicated that we were going to work immediately to look at our transfer pricing rules. The transfer pricing rules are based on an arm’slength standard. We do believe that that is the standard that is an 

appropriate economic standard. There are very difficult issues that 

arise in applying that, particularly in the case of transfer of intangibles. So, we need to take an immediate look at our rules and to 

work with the Internal Revenue Service (IRS) on enforcement practices to make sure that those rules are operating correctly. 

Mr. DOGGETT. I believe the other area that Ms. Olson actually 

mentioned in her testimony before the full Committee are our tax 

treaties because there has been exploitation of our tax treaties, has 

there not, in this area? 

Ms. ANGUS. There have been some issues that have arisen 

under some of our tax treaties and, as Ms. Olson indicated in her 

testimony last week, we intend to take a comprehensive look at our 

tax treaties. The purpose of our network of tax treaties is to eliminate double taxation. We need to make sure that that is what our 

treaties do and that they don’t serve to eliminate all taxation together. If there are instances where they operate that way, we 

need to address that. 

34

Mr. DOGGETT. That would be a—when you say address it, it 

would be through renegotiation, which could take several years 

with the dozens of tax treaties that we have. 

Ms. ANGUS. Well, I think we need to identify the treaties where 

there are particular problem areas and address those immediately 

and obviously focusing on the places where these issues arise. 

Mr. DOGGETT. There is no doubt, as indicated in the prospectus 

for Stanley Works and the claims of reduced tax savings, that it 

was concerned not only about reducing any double taxation that 

may occur on its international operations but to reduce taxes on its 

American-based operations also. Isn’t that correct? 

Ms. ANGUS. That is exactly the issue that we think needs to be 

addressed through changes to section 163(j). The transactions that 

you can do through creation of debt that allow you to reduce the 

U.S. tax on income earned in the United States that would otherwise be subject to U.S. tax is something that we need to deal with. 

Mr. DOGGETT. Let me just ask then in closing, so it will be in 

the record, that I want to renew my request from February 27, 

when you testified, and asked you for the names of the members 

of the 877 Coalition and the Coalition of Corporate Taxpayers 

which you represented to preserve tax shelters. I would renew that 

request. I know it is pending in the—before you and the Treasury 

Department, but would ask you to supply that information. 

I thank you for your testimony. 

Chairman MCCRERY. Thank you, Mr. Doggett. That was very 

nice. Excellent questions, and I want to thank all the Members of 

the Subcommittee for your excellent questions. I do think we share 

a common goal here to get something done in the international 

field, and again I appreciate the cooperation of the Administration 

and thank you for your excellent testimony and responses to questions. We will welcome you back, I am sure, at a later date. Thank 

you. 

Now I would call up our final panel, the Honorable William A. 

Reinsch, the President of National Foreign Trade Council; Dan 

Kostenbauder, General Tax Counsel for Hewlett-Packard, Palo 

Alto, California, on behalf of AeA; Gary McLaughlin, Senior Director, International Tax, Wal-Mart Stores, Inc., Bentonville, Arkansas, on behalf of the International Mass Retail Association; Gary 

D. Sprague, Partner, Baker & McKenzie, from Palo Alto, California, on behalf of the Software Industry Coalition for Subpart F 

Equality; Robert Cowen, Senior Vice President and Chief Operating 

Officer for Overseas Shipholding Group, New York; Doug Parsons, 

President, Excel Foundry and Machine, Inc., Pekin, Illinois, on behalf of the National Association of Manufacturers; and Scott 

Newlon, Managing Director of Horst Frisch. 

I am sorry if I mangled any of those names. I hope I got close. 

Welcome, everybody. Thank you for coming today to try to help us 

sort through this quagmire of international tax complexity. 

Mr. Reinsch. Is that how you pronounce your name? 

Mr. REINSCH. Yes, it is. Well done, Mr. Chairman. 

Chairman MCCRERY. Thank you. We will begin with you. Your 

full written testimony will be entered into the record, but we would 

ask you to summarize that if you could in about 5 minutes. You 

may begin. 

35

STATEMENT OF THE HON. WILLIAM A. REINSCH, PRESIDENT, 

NATIONAL FOREIGN TRADE COUNCIL, AND FORMER 

UNDERSECRETARY FOR EXPORT ADMINISTRATION, U.S. DEPARTMENT OF COMMERCE; ACCOMPANIED BY LABRENDA 

GARRETT-NELSON, PARTNER, WASHINGTON COUNCIL 

ERNST & YOUNG 

Mr. REINSCH. Thank you, Mr. Chairman. This is the first time 

I have been able to testify before this Subcommittee, and it is an 

honor to be with you. I am Bill Reinsch. I am President of the National Foreign Trade Council (NFTC), founded in 1914. The NFTC 

is an association of businesses with some 400 members. It is the 

oldest and largest U.S. association of businesses in support of open 

rules based trade. 

The NFTC FSC/ETI Coalition, which is composed of many of the 

companies currently using FSC/ETI, has developed a conceptual 

draft of a proposal of modifications to the Tax Code that combined 

with the repeal of the ETI regime we believe will bring the United 

States into compliance with its international trade obligation as 

well as ensuring that U.S. exporters are not disproportionately disadvantaged. I would like to describe those concepts underlying the 

proposal briefly, and I would ask, Mr. Chairman, that a copy of the 

Coalition’s entire draft proposal be inserted into the record. 

Chairman MCCRERY. Without objection. 

Mr. REINSCH. Thank you very much. The Coalition does not believe that an appropriate response to the WTO decision would be 

to simply repeal ETI, which we believe would have an adverse impact on the international competitiveness of domestic exporters and 

threaten thousands of American jobs. 

Our proposal is a conceptual draft. It is not a finished legislative 

document. We have already begun to meet with Members of the 

Committee, and we are ready to work with all of you on further 

improvements in it. We have worked very hard on it, and we believe that it comes close to ensuring that as many companies as 

possible approach the level of their current ETI tax benefits. No 

company, however, would obtain a greater benefit than under current law because our proposal includes an overall cap. 

We also believe that our proposal meets the stringent test of 

WTO compliance, although we expect that whatever resolution 

Congress comes to will ultimately be subject to discussions or negotiations with the European Commission. We believe our proposal 

would be a good basis for those discussions. 

Our proposal has four parts. First, it would permit taxpayers to 

exclude from U.S. tax foreign source income earned by U.S. taxpayers in export transactions. We believe that this concept complies with the appellate body rulings in the FSC/ETI case that the 

fifth sentence of Footnote 59 of the Agreement on Subsidies and 

Countervailing Measures permits a WTO member state to adopt 

the measure taken to avoid the double taxation of foreign source 

income. The exclusion would apply to foreign source income from 

property sold, leased, or licensed for direct use outside the United 

States and income from services as a commissioned agent in connection with the sale, lease, or license of property for export. The 

proposal would have—the property would have to be manufactured 

36

or produced in the States for final disposition outside the United 

States. 

The second part of our proposal would restrict the scope of subpart F in a manner that would partially conform to the less stringent anti-deferral rules adopted by the countries, including member 

states of the Commission, which countries generally apply anti-deferral regimes only to passive investment income earned by foreign 

subsidiaries. This proposal would eliminate the provisions that define subpart F income to include foreign based company sales income. 

The proposal also would exempt a portion of the Foreign Base 

Company Source Income from U.S. tax as permitted by Footnote 59 

and permit the tax free transfer of a limited category of associated 

marketing intangibles to control foreign corporations under section 

367(d). No foreign tax credits would be allowed for taxes associated 

with income exempted under this proposal. 

The third part of our proposal, Mr. Chairman, retains ETI-like 

benefits for a limited category of qualifying international transportation property such as aircraft, rolling railroad stock, vessels, 

motor vehicles, containers, orbiting satellites, and other property 

used for international transportation purposes. Although these 

transactions qualified for ETI treatment under the predominant 

use test of existing law, they are not considered exports under 

trade law and therefore should not be considered, in our judgment, 

to be contingent on export performance within the meaning of the 

agreement on subsidies. 

Finally, in our proposal, in order to provide some level of tax benefits for direct exporters, we have developed a wage tax credit for 

manufacturers of qualifying property based on the wages paid to 

employees producing the qualifying property. The credit would be 

1 percent of qualifying wages. 

In closing, Mr. Chairman, I would like to reiterate that our proposal is conceptual and not a finished legislative package. We continue to review it and work on it, and we welcome the opportunity 

to work with you and the other Members of the Committee as you 

decide how you want to proceed. Thank you. 

[The prepared statement of Mr. Reinsch follows:]

Statement of the Hon. William A. Reinsch, President, National Foreign 

Trade Council, and former Undersecretary for Export Administration, 

U.S. Department of Commerce 

Chairman McCrery, Ranking Member McNulty and distinguished Members of the 

Subcommittee. 

My name is Bill Reinsch and I am the President of the National Foreign Trade 

Council (NFTC). The NFTC, founded in 1914, is an association of businesses with 

some 400 members. It is the oldest and largest U.S. association of businesses devoted to international trade matters. Its membership consists primarily of U.S. 

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

of the largest U.S. manufacturing companies are NFTC members. The NFTC’s emphasis is to encourage policies that will expand open trade and U.S. exports and 

enhance the competitiveness of U.S. companies by eliminating major tax inequities 

and anomalies. 

Thank you for holding this important hearing on the WTO Appellate Body (AB) 

ruling, United States—Tax Treatment for ‘‘Foreign Sales Corporations’’—Recourse to 

Article 21.5 of the DSU by the European Communities. According to the Hearing Advisory, the focus of the Subcommittee hearing is to ‘‘consider proposals to modify the 

37

1Ways and Means Committee Advisory Number SRM–7. 

2The NFTC FSC/ETI Coalition is a broad-based group of companies with varying business 

models representative of typical FSC/ETI users. Companies in the Coalition employ thousands 

of Americans in high-paying export related jobs.

Tax Code in ways which promote the competitiveness of U.S. companies while respecting our intentional obligations under the WTO.’’ 1

The NFTC FSC/ETI Coalition 2 (the Coalition) has developed a conceptual draft 

of a unitary proposal of modifications to the Tax Code that, combined with a repeal 

of the ETI regime, we believe will bring the United States into compliance with its 

international trade obligations as well as ensuring that U.S. exporters are not disproportionately disadvantaged. I would like to focus my testimony on describing the 

concepts underlying the proposal and the need to take a holistic approach to any 

legislative changes to promote the competitiveness of U.S. exporters, as illustrated 

by the NFTC’s unitary proposal. With your permission, I would ask that a copy of 

the Coalition’s conceptual draft of a unitary proposal be inserted into the record. 

Introduction

I. Historical Background

The Tax Code has provided explicit tax incentives for U.S. exporters since 1971 

with the enactment of the Domestic International Sales Corporation (DISC) regime. 

The DISC provisions were designed to restore the competitiveness of U.S. exporters 

hampered by the 1962 enactment of the Subpart F rules. The DISC was successfully 

challenged by the Europeans at the General Agreement on Tariffs and Trade 

(GATT), the predecessor organization of the WTO. Relying on a 1981 ‘‘Understanding’’ reached in the DISC case, the United States enacted the Foreign Sales 

Corporation (FSC) tax provisions in 1984. After a string of WTO losses, the European Commission (‘‘Commission’’) filed a WTO challenge against the FSC in 1997; 

both the WTO Panel and Appellate Body ruled that the FSC was a prohibited export 

subsidy. 

Accordingly, the United States enacted the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (P.L. 106–519) (the ‘‘ETI’’ regime). The ETI regime, 

while enacting a new general rule that excluded extraterritorial income, closely 

tracked the tax benefits available to American exporters through the FSC. The Commission immediately brought a WTO challenge against ETI. In August of last year, 

a WTO Panel upheld the Commission’s claim and, after the United States appealed 

this decision, the WTO Appellate Body affirmed the panel decision (while substantially refining the legal reasoning underlying the ruling). In essence, the case turned 

on the fact that WTO rules prohibit the rebate of direct taxes on export transactions, although rebates of indirect taxes on exports are permitted. 

The United States and the Commission are currently awaiting an arbitration panel’s decision regarding the appropriate level of sanctions the Commission will be authorized to charge U.S. exports, with the Commission having argued for a $4.043 

billion figure and the United States maintaining that the appropriate amount is in 

the neighborhood of $1.1 billion. The WTO arbitration panel’s ruling giving the 

Commission the legal authority to impose sanctions on U.S. exports is expected on 

June 17. 

II. The NFTC Conceptual Unitary Proposal

Having briefly considered the historical background and policy underpinnings of 

the FSC/ETI issue, it is clear that this Committee has long been cognizant of the 

need to ensure that our tax system does not unfairly penalize U.S. businesses, especially vis-a ́-vis our foreign competitors. The Coalition does not believe that an appropriate response to the WTO ETI decision would be to simply repeal ETI—in effect, 

a tax increase on American exporters. Such a result would have an adverse impact 

on the international competitiveness of domestic exporters, threatening thousands 

of American jobs. 

The Coalition supports compliance with America’s international trade obligations. 

We stand ready to work with the Administration and the Congress, on a bipartisan 

basis, to find a solution that brings the United States into compliance with the WTO 

ruling. The unitary proposal I will describe, supported by a broad array of America’s 

leading exporters, provides a set of legislative recommendations that would preserve 

U.S. jobs, promote the international competitiveness of U.S. corporations, and enable the United States to fulfill its WTO obligations. 

As indicated previously, the Coalition’s proposal is a conceptual draft—we do not 

view our package as a finished legislative document. We stand ready to work with 

38

3 United States—Tax Treatment for ‘‘Foreign Sales Corporations’’—Recourse to Article 21.5 of 

the DSU by the European Communities, at ¶ 132. 

the Members of this Committee to improve the ideas contained in our document and 

assist in the development of legislation. 

I also would like to stress that the Coalition views this package as a unitary proposal. Since our coalition runs the gamut from pure exporters to broad-based multinational corporations, not all of the provisions benefit every company. In fact, some 

companies may only benefit from one of the provisions. We have worked very hard 

on the proposal and believe that it comes very close to ensuring that as many companies as possible get close to their ETI tax benefits. No company, however, would 

obtain a greater benefit under our proposal than under current law because our proposal contemplates the adoption of an overall cap on the tax benefits provided by 

any combination of the proposals. 

The Coalition developed these provisions with a careful eye on the WTO case law 

and with the understanding that any legislative package must be WTO-compliant. 

We believe that the unitary proposal meets that stringent test. As Ways and Means 

Committee Members, you have had this issue you before you several times and, understandably, will want assurances that the legislative package you adopt will put 

this matter to rest, once and for all. This level of confidence in the WTO-legality 

of a replacement package can be achieved through discussions or negotiations with 

the Commission. The Coalition believes that our unitary proposal would serve as a 

good basis for these discussions with the Commission.

Discussion

Recognizing the diverse nature of American exporters, the NFTC’s conceptual 

draft of a unitary proposal takes a four-pronged approach: (1) implement the exception to the prohibition on export subsidies for measures to avoid double taxation, 

in the case of income derived from certain sales, leases, and licenses of property; 

(2) repeal certain exceptions to the general rule of deferral for active business income derived by U.S.-controlled foreign corporations (‘‘CFCs’’) from foreign sources; 

(3) enact an exemption for a limited category of transactions that are WTO-permissible; and (4) provide a new wage-based tax credit of general application. 

I. A Measure to Avoid Double Taxation

Conceptually, a legislative response could target exports in the context of a measure to avoid double taxation of foreign-source income.

This proposal would permit taxpayers to exclude from U.S. tax (up to prescribed 

limits) all foreign-source income earned by U.S. taxpayers in export transactions. 

We believe that this concept complies with WTO rules, as interpreted by the January 14, 2002 Appellate Body ruling in the FSC–ETI case. The Appellate Body ruled 

that the fifth sentence of Footnote 59 of the Agreement on Subsidies and Countervailing Measures (the ‘‘SCM Agreement’’) permits a WTO member state to adopt a 

measure taken to avoid the double taxation of foreign-source income (the ‘‘Footnote 

59 exception’’).3

The exclusion would apply to foreign-source income from property sold, leased, or 

licensed for direct use outside the United States, and income from services as a commission agent in connection with the sale, lease or license of property for export. 

The property would be required to be manufactured or produced in the United 

States for final disposition outside the United States. 

The foreign-source income eligible for exclusion would be calculated using arm’s 

length pricing methods (ensuring that only was foreign-source—and no U.S.-

sourced—income is excluded). In addition, the provision would require that the definition of foreign-source income qualify under widely recognized international norms 

of taxation, as prescribed by the WTO Appellate Body. 

Finally, the proposal would allow taxpayers to treat excluded foreign-source income as previously taxed income (‘‘PTI’’) when received from a controlled foreign corporation (CFC). 

II. Subpart F Modifications

Conceptually, the United States remains free to amend any of its general rules 

for the taxation of income earned abroad; the applicable WTO agreements would 

not prevent the United States from amending rules of general application in a 

manner that could benefit exporters, among other taxpayers.

39

4See National Foreign Trade Council, Inc., International Tax Policy for the 21st Century, Part 

One: A Reconsideration of Subpart F (December 15, 2001), for a discussion of the subpart F 

rules and a summary of several other CFC-like regimes. 5See S. Rep. No. 1881, 87th Cong., 2d Sess. 78 (1962) (quoting a message from the President). 6See the discussion of this issue beginning on page 65 of the NFTC Foreign Income Project: 

International Tax Policy for the 21st Century, Conclusions and Recommendations (December 15, 

2001). 

The general rule under U.S. tax law provides for unlimited deferral of U.S. tax 

on business profits earned abroad through CFCs. Such income is subject to tax 

when it is distributed to the U.S. in the form of dividends or other transactions. The 

‘‘subpart F’’ anti-deferral regime is an exception to the general rule of deferral and 

results in the imposition of a current U.S. tax. The proposal would restrict the scope 

of subpart F in a manner that would partially conform to the less stringent antideferral rules adopted by other countries (including member states of the Commission), which countries generally apply anti-deferral regimes only to passive investment income earned by foreign subsidiaries.4

The Congress defined subpart F income to include ‘‘foreign base company sales 

income’’ and ‘‘foreign base company services income’’ (collectively, ‘‘FBCSI’’), in part 

to stop domestic corporations from shifting income to foreign subsidiaries through 

‘‘artificial arrangements between parent and subsidiary regarding intercompany 

pricing.’’ 5 The precursor of ETI, the DISC, was designed to restore the competitiveness of U.S. exporters hampered by the enactment of the FBCSI rules. The current 

state of U.S. transfer-pricing law and administration (including the globalization of 

transfer pricing enforcement) calls into question the continued need for subpart F 

to serve as a backstop to the transfer-pricing rules.6

This proposal would eliminate the provisions that define subpart F income to include FBCSI. Very generally, FBCSI refers to related-party transactions in which 

income is earned by a CFC outside of its country of incorporation. Unlike most other 

definitions of Subpart F, FBCSI constitutes active business income (not passive income). 

The proposal also would exempt a portion of income that would be defined as 

FBCSI from U.S. tax (as permitted by Footnote 59), and permit the tax-free transfer 

of a limited category of associated marketing intangibles to CFCs under Section 

367(d). No foreign tax credits would be allowed for taxes associated with income exempted under this proposal. In conforming amendments, the proposal would clarify 

the extent to which royalty and rental income qualifies for the ‘‘active rents and royalties exception’’ to subpart F. 

III. International Transportation Property

Conceptually, property that qualifies for ETI tax treatment under the ‘‘predominant use’’ test of current, but that is not a Trade-Law Export, should not be considered to be contingent on export performance within the meaning of the applicable WTO agreements.

This proposal envisions retaining ETI-like benefits for a limited category of qualifying ‘‘international transportation property.’’ Sales and leases of qualifying property 

to U.S. companies for predominant use outside the United States are not considered 

exports under international trade law norms. International transportation property 

includes aircraft, railroad rolling stock, vessels, motor vehicles, containers, orbiting 

satellites and other property used for international transportation purposes (including engines, components and spare parts). 

Although these transactions qualify for ETI tax treatment under the ‘‘predominant use’’ test of existing law, they are not considered exports under trade law and, 

therefore, should not be considered to be contingent on export performance within 

the meaning of the Agreement on Subsidies. 

IV. Wage Tax Credit

Conceptually, consideration could be given to the development of legislation that 

might benefit broad classes of taxpayers of a type that currently utilize the ETI 

regime (e.g., small exporters) without requiring exportation.

As indicated previously, the Coalition is comprised of a broad cross-section of U.S. 

companies, including ‘‘direct exporters,’’ U.S. taxpayers that sell to unrelated foreign 

businesses but whose activities are (for the most part) located in the United States. 

Similarly, many farmers receive ETI benefits for the agricultural products they export overseas. They currently qualify for ETI benefits but would not obtain any tax 

benefits from modifications to U.S. international tax rules if they have no overseas 

operations. 

40

In order to provide some level of tax benefits for direct exporters, the Coalition 

has developed the concept of a wage tax credit. The proposal envisions the creation 

of a tax credit for manufacturers of qualifying property based on the wages paid to 

employees producing the qualifying property. The credit would be 1% of qualifying 

wages. As mentioned previously, the credit proposal (as well as all of the other provisions of the unitary proposal) would be subject to an overall combined cap on benefits to ensure that a taxpayer did not receive greater benefits under the wage credit 

than under current ETI benefits.

Conclusion

In closing, I would like to again thank the Subcommittee for the opportunity to 

testify on behalf of the NFTC FSC/ETI Coalition and explain the concepts underlying our unitary proposal. As I indicated earlier, our proposal is a conceptual paper 

and should not be considered a finished legislative package. Crafting legislation that 

replaces the ETI regime and complies with our WTO obligations while ensuring the 

competitiveness of American exporters is a very challenging task. The Coalition 

would like to assist you in that endeavor and believes that our conceptual draft of 

a unitary proposal could serve as a useful starting point as the Committee begins 

this legislative process. I would be happy to answer any questions you may have.

APPENDIX 

April 30, 2002

NFTC FSC–ETI COALITION

DRAFTING SPECIFICATIONS FOR UNITARY PROPOSAL 

EXECUTIVE SUMMARY

The Appellate Body Report in United States—Tax Treatment for ‘‘Foreign Sales 

Corporations’’—Recourse to Article 21.5 of the DSU by the European Communities

upheld the decision of the WTO panel that the FSC Replacement and 

Extraterritorial Income Exclusion (‘‘ETI’’) Act confers prohibited export subsidies in 

violation of the international trade obligations of the United States.

• It will take a considerable amount of time to develop and implement an appropriate response to the WTO decision in the FSC–ETI case, one that is likely to require some combination of negotiations with the European Commission 

and legislation. 

• Accordingly, the NFTC FSC–ETI Coalition has developed preliminary drafting concepts, to facilitate the discussion of legislative options for addressing 

the resolution of the FSC–ETI dispute in a manner that brings the United 

States into compliance with its international trade obligations while maintaining the international competitiveness of U.S. exporters and workers. 

• Drafting Parameters. The WTO decision AB Report precludes a legislative response that merely ‘‘tinkers’’ with the ETI regime, and thus, it will not be 

possible to replicate present law.

• There is, however, a limited category of transactions for which ETI-like 

treatment should be maintained. 

• Also, and significantly, the WTO decision confirms the availability of an exception for legislation that targets exports in the context of a measure to 

avoid double taxation of foreign-source income. 

• Moreover, nothing in the WTO decision would prevent the United States 

from amending rules of general application in a manner that could benefit 

exporters, among other taxpayers.

• Summary of Unitary Proposal. The unitary proposal is premised on the repeal 

of the ETI provisions, and includes all of the following elements:

• Footnote 59 Exception.—Implementing the recognized exception to the prohibition on export subsidies for measures to avoid double taxation, by excluding from U.S. tax (up to prescribed limits) foreign-source income earned 

by U.S. taxpayers in export transactions. The exclusion would apply to income from property manufactured within the United States and sold, 

leased, or licensed for direct use, consumption or disposition outside the 

United States, and income from services as a commission agent in connecVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00044 Fmt 6633 Sfmt 6621 E:\HR\OC\84168.XXX 84168
41

tion with a sale or license of property for export or otherwise related and 

subsidiary to a sale, lease, or license of property for export. • Subpart F Modification.—Repealing certain exceptions to the general rule 

of deferral for active business income derived by U.S.-controlled foreign corporations (‘‘CFC(s)’’) from foreign-sources sales and services in a manner 

that would partially conform to the less stringent anti-deferral rules adopted by other countries (including EC member states). The general rule under 

U.S. tax law provides unlimited deferral of U.S. income tax on business 

profits earned abroad through CFCs. Deferral results from a basic structural feature of the U.S. system, namely, the treatment of a corporation and 

its shareholders as separate taxpayers. The anti-deferral regime of ‘‘Subpart F’’ is an exception to the general rule of deferral. The proposal would 

restrict the scope of Subpart F by repealing the provisions that define subpart F income to include ‘‘foreign base company sales income’’ and ‘‘foreign 

base company services income.’’ The proposal would also exempt a portion 

of such foreign-source earnings from U.S. tax (as permitted by the recognized exception for foreign-source income). • WTO-permissible Transactions.—Enacting an exemption for a limited category of transactions that are WTO-permissible because they are not exports under international norms. • Wage-based Tax Credit.—Providing a new wage-based tax credit of general 

application, for taxpayers engaged in businesses in specified North American Industrial Classification System (NAICS) industry codes.

• To constrain the revenue effect to the current law cost of ETI, the unitary 

proposal contemplates that an overall cap would be imposed on the benefits 

Kostenbauder, is that close? 

Chairman MCCRERY. Thank you, Mr. Reinsch. Mr. 

that could be obtained by use of any combination of the individual proposals.

f Mr. KOSTENBAUDER. Yes, very good. 

Chairman MCCRERY. Very good. Thank you. I think your microphone needs to be turned on. 

Mr. KOSTENBAUDER. There we go. Thank you. 

Chairman MCCRERY. Thank you. 

STATEMENT OF DANIEL KOSTENBAUDER, GENERAL TAX 

COUNSEL, HEWLETT-PACKARD COMPANY, PALO ALTO, CALIFORNIA, ON BEHALF OF AeA 

Mr. KOSTENBAUDER. Thank you, Mr. Chairman. I appreciate 

the opportunity to be here today on behalf of Hewlett-Packard (HP) 

Company. HP is based in Palo Alto, California. We have over half 

of our revenue from outside of the United States, so that means 

that we are both an exporter, and we care greatly about the treatment of U.S. companies by the international provisions of the Tax 

Code. I am also appearing on behalf of AeA, formerly the American 

Electronics Association, which has about 3,500 members, and a 

great number of these companies have global markets for their 

high tech electronics products. So again, they are both exporters 

and care deeply about the treatment of U.S. companies with respect to their international activities. 

We appreciate very much your having these hearings, looking at 

both the big picture of international reform and possible approaches to improving the U.S. tax system as well as more specific, 

focused possibilities, and we have some thoughts today on those. 

We think that the provisions and the legislation you are about to 

work on should help exporters and should also help the competitiveness of U.S. companies in international markets. 

The AeA has four specific proposals that we would recommend 

to your attention. One is to repeal the foreign base company servVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00045 Fmt 6633 Sfmt 6602 E:\HR\OC\84168.XXX 84168
42

ices income and foreign base company sales income provisions. Another would be to remove active software rents and royalties from 

the subpart F provisions. In the foreign tax credit area, we recommend extending the foreign tax credit carryforward period from 

5 to 10 years, and eliminating the restriction on using foreign tax 

credits to offset the alternative minimum tax (AMT). Today they 

are limited to offsetting only 90 percent of the AMT, and we would 

propose that in pursuit of the principle of avoiding double taxation, 

that corporations should be permitted to offset 100 percent of the 

AMT with foreign tax credits. 

Let me make just a very quick review of the international tax 

system for the United States. We, as you all know, tax on a worldwide basis. The tax on active income earned by controlled foreign 

corporation (CFC) subsidiaries of U.S. companies is generally deferred until there is a distribution of those earnings. Subpart F, a 

very complex provision, provides exceptions to that deferral, which 

means immediate U.S. taxation of some aspect of international activity. Certainly the passive income rules are well accepted and 

very standard in most countries’ international tax systems. The 

United States, however, has a far more robust subpart F, and that 

is one of the reasons we are suggesting the repeal of these base 

company rules. 

Let me briefly describe what these base company rules are. Foreign base company income generally includes sales income that is 

earned by a controlled foreign corporation in a country that neither 

manufactures or sells property and which it purchases from or sells 

to a related party. The service company rules are similar. When I 

think of these base company rules, and nobody in the world uses 

the word ‘‘base company’’ except in the context of subpart F, I think 

of the words ‘‘trading company.’’ The key things you look for are 

a transaction with a related party and a transaction outside the 

country of its incorporation. If you have both of those, generally 

that is what we are talking about. Is this a tax dodge or does this 

make sense? Let me give you an example. 

If you had a company with 10 factories and 10 sales companies 

all outside the United States and if all the factories were going to 

sell to all the sales companies, you have right there a hundred different sets of transactions, a hundred value-added tax registrations 

to comply with, lots of data processing systems, and lots of 

logistical challenges. The way companies short circuit all that extra 

work is to put a trading company, or a ‘‘base company,’’ in the middle. Then all of the factories sell to one company and one company 

sells to all of the sales companies. Voila, you have 20 transactions, 

you have a lot better management, and that is what base companies are all about, whether it is sale of goods or sale of services. 

Notice, this is all related to normal active business. 

One of the concerns and one of the reasons these base company 

rules have been in the subpart F for the last 40 years has been the 

concern about transfer pricing. Since 1962, the transfer pricing 

rules and their enforcement have been dramatically improved both 

in the United States and elsewhere. Also, repealing these base 

company rules would encourage exports to the extent that the 

United States is the factory that is manufacturing and selling to 

one of these trading companies that would have some subpart F 

43

imposed. Quite clearly, those transactions have an extra U.S. tax 

that would not otherwise exist with the repeal of the base company 

rules. So, there is a very direct relief from their repeal and then 

more broadly, to the extent that U.S. companies can organize themselves to compete better internationally, they will be more competitive. It is important to note that most exports of U.S. companies 

are actually to their foreign subsidiaries and probably to foreign 

trading companies that then distribute into foreign markets. 

I will make one final comment, which is that removing those 

rules will greatly simplify the Tax Code and the operation of the 

Tax Code for taxpayers. So, the repeal of the base company rules 

will have that additional benefit. 

Thank you. 

[The prepared statement of Mr. Kostenbauder follows:]

Statement of Daniel Kostenbauder, General Tax Counsel, Hewlett-Packard 

Company, Palo Alto, California, on behalf of AeA 

My name is Dan Kostenbauder, General Tax Counsel at Hewlett-Packard Company in Palo Alto, California. HP was founded in 1939. With our recent merger with 

Compaq Computer Corporation, the new HP is a leading technology solutions provider for consumers and businesses with market leadership in fault-tolerant servers, 

UNIX servers, Linux servers, Windows servers, storage solutions, management 

software, imaging and printing and PCs. Furthermore, 65,000 professionals worldwide lead our IT services team. Our $4 billion annual R&D 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. 

I am appearing today on behalf of the AeA, formerly the American Electronics Association. Advancing the business of technology, AeA is the nation’s largest hightech trade association. AeA represents more than 3,500 member companies that 

span the high-technology spectrum, from software, semiconductors and computers to 

Internet technology, advanced electronics and telecommunications systems and services. With 18 regional U.S. councils and offices in Brussels and Beijing, AeA offers 

a unique global policy grassroots capability and a wide portfolio of valuable business 

services and products for the high-tech industry. AeA has been the accepted voice 

of the U.S. technology community since 1943. 

Summary of Testimony

Repeal of the Extraterritorial Income Exclusion regime (‘‘ETI’’) is a possible response to the World Trade Organization (‘‘WTO’’) Appellate Body decision that ETI 

is a prohibited export incentive. If the ETI is repealed, then it should be replaced 

with tax legislation that clearly will comply with WTO rules. Such legislation should 

be designed to help those sectors of the U.S. economy that currently benefit from 

the ETI and to improve the competitiveness of U.S. based companies. If the timeframe for such legislation probably is too short to permit a complete review and reform of the international provisions of the U.S. tax system, AeA believes that a 

number of improvements can be made to today’s rules that will be consistent with 

future efforts toward more comprehensive reform. AeA believes that reforms in the 

Subpart F and foreign tax credit areas would be good tax policy and very straightforward to adopt. 

In particular, the AeA suggests that the following provisions should be among 

those that should be adopted upon repeal of the ETI:

1. Repeal the foreign base company sales income and the foreign base company 

services income rules under Subpart F, 

2. Remove active rents and royalties from the passive income rules under Subpart F, 

3. Increase the foreign tax credit carryforward period to 10 years, and 

4. Repeal the limitation on use of foreign tax credits to offset the corporate alternative minimum tax. 

44

Benefits of Current ETI Regime Should Be Preserved to the Extent Possible

The WTO decision that the ETI regime enacted by Congress in 2000 is a prohibited export subsidy violating U.S. international treaty obligations could lead to significant sanctions against the United States. There are other sources of trade friction between the United States and many of our trading partners that should be 

resolved in a manner that enhances international trade. The ‘‘compliance work 

plan’’ announced by Ambassador Zoellick and EU Commissioner Lamy, under which 

the Administration and Congress will together to develop a proposal that will allow 

the U.S. to comply with the Appellate Panel ruling, is a good step forward. 

AeA is pleased to contribute its ideas at this hearing, which is an important step 

in the process of developing an alternative to the ETI. We hope the process is both 

credible and rapid enough to forestall retaliation by the EU, or at least to minimize 

the possibility of sanctions and the attendant trade friction that would result. 

As part of this process, AeA believes that the ETI regime should be replaced with 

legislation that helps those sectors of the economy that currently benefit from the 

ETI and that helps to improve the international competitiveness of U.S. based companies. 

Since it would be imprudent to enact provisions that once again test the limits 

of what constitutes an export subsidy, Congress should exercise its judgment to support sectors of the economy enjoying benefits of ETI in a way that does not have 

a direct reliance upon exports.

The AeA recommends that the foreign base company sales income and foreign base company services income rules of Subpart F be repealed in their 

entirety.

In general, U.S. tax is imposed under Subpart F not only on a foreign subsidiary’s 

passive income (interest, dividends, etc.) but also on income earned from certain active business transactions with related persons. For example, U.S. tax is imposed 

on the income of a foreign subsidiary from purchasing goods from legal entities 

within the multinational group and reselling them outside its country of incorporation. By imposing U.S. tax on intercompany payments between foreign subsidiaries, 

Subpart F of the Internal Revenue Code puts U.S. multinationals at a competitive 

disadvantage in the global marketplace by imposing current U.S. tax on ordinary 

foreign business transactions that otherwise would not be subject to current U.S. 

taxation. 

The Subpart F base company rules have been justified as measures that counteract efforts by U.S. multinationals to shift foreign profits to tax havens, in part by 

making payments to related companies located in tax havens. 

The 1962 legislative history to Subpart F reveals that the related person provisions were targeted at transfer pricing abuses. Since 1962, however, the ability of 

the IRS and foreign tax authorities to combat transfer-pricing abuses has improved 

dramatically. The IRS has issued increasingly detailed transfer pricing regulations 

to provide guidance, and Congress has enacted stern penalties for non-compliance. 

As a result, the profits of the various members of a U.S.-based multinational group 

are much more likely today to be properly allocated based on real economic factors 

(such as the functions performed, investments made, and risks borne). 

Subpart F generally does not apply to transactions within a single ‘‘country’’ 

under the rationale that, in such cases, artificial profit shifting between tax jurisdictions does not occur. For example, the provisions applicable to intercompany payments (the ‘‘foreign personal holding company income’’ rules) exclude dividends and 

interest received by a controlled foreign corporation (‘‘CFC’’) from a related person 

that is (1) a corporation organized under the laws of the same country in which the 

CFC was created; and (2) has a substantial part of its assets used in a trade or business located in such same foreign country. 

Additionally, in the early 1960’s, foreign subsidiaries of U.S. multinationals typically operated only in their country of incorporation, in part because each country 

presented a unique market. With the rise of globalization, the falling of trade barriers (e.g., the economic integration of the EU countries), and improvements in technology, foreign subsidiaries can now more efficiently and effectively conduct business on a regional or even global basis. For example, many multinational groups 

now seek to centralize functions in regional hubs or service centers. However, Subpart F imposes a tax cost on foreign subsidiaries that operate outside their country 

of incorporation, and as a result, they are penalized for acting in the most economically efficient manner (e.g., by operating on a regional basis). Accordingly, U.S. multinationals are forced to either pay the extra tax cost or to needlessly duplicate functions in multiple foreign countries. The Subpart F related person provisions create 

45

unnecessary complexity, which leads to excessive taxpayer compliance costs, increased IRS audit costs, and additional burdens on the courts. 

The revenue effects of the Subpart F base company rules are not strictly revenue 

generating for the U.S. Treasury. In cases where Subpart F income is generated by 

activities in high tax countries, foreign tax credits can eliminate any residual U.S. 

tax liability. 

As companies continue to adopt integrated business models dictated by the global 

marketplace, such provisions act as a hindrance to U.S. competitiveness. 

An interesting proposal that was considered, but rejected, in 1962 when Subpart 

F was enacted would have treated the European Economic Community (now the European Union) as a single country for purposes of the Subpart F related persons provisions. 

According to the legislative history, the basis for this decision was the fact that, 

although the European countries had formed a common market, they did not yet 

have a unified tax system. 

Recent proposals introduced to simplify Subpart F include provisions relating to 

the treatment of the EU as one country. For example, in H.R. 2018 (106th Congress), the Secretary of the Treasury would have been tasked with analyzing the 

impact of treating the EU as one country for purposes of applying the same country 

exceptions under Subpart F. 

This treatment makes even more sense today than it did in 1962. Greater political 

and economic integration among EU countries has been achieved over the last forty 

years, including adoption of the euro as a common currency by most member countries. Furthermore, the EU has been working to achieve tax harmonization. For the 

past three years, the EU members have been negotiating a ‘‘code of conduct’’ with 

respect to tax matters, in order to eliminate harmful tax competition among member 

states. More recently, the EU Commission has begun investigating whether certain 

member state tax regimes constitute unlawful state aids. 

There are several ways that repeal of the base company rules would encourage 

U.S. exports. First, if the base company rules apply to purchases from the U.S. that 

are exported to foreign customers, then an export transaction probably bears more 

U.S. tax as a result of the Subpart F base company rules. 

Second, if the foreign subsidiaries of U.S. multinational companies are healthy 

and competitive, the U.S. parent company almost always prospers as well. Since the 

U.S. foreign base company rules have not been duplicated by other countries (unlike 

the passive income rules), foreign subsidiaries of U.S. companies face greater complexity and higher taxes than the foreign companies in whose home markets they 

are trying to compete. Since such foreign subsidiaries of U.S. companies are the conduit into foreign markets for most U.S. exports, the healthier they are the greater 

the prospects for U.S. exports. 

Exclude Active Software Royalties from Passive Income

An important policy goal of ETI replacement legislation should be to provide benefits to those U.S.-based taxpayers that previously qualified for FSC/ETI benefits. 

Since software rents and royalties expressly qualify for ETI benefits today, any reform of Subpart F should include relief for active business income from rents and 

royalties. 

The software industry is unique in that it delivers its products and services to 

customers via delivery methods that, depending on the facts of the transaction, 

produce either rents, royalties, sale of goods income or services income. In all cases, 

the vendor company is engaged in essentially the same business activity of developing, marketing and supporting its products. The reason a software company may 

have rent and royalty income therefore is due to its choice of delivery methods, and 

does not imply that the company is not engaged in an active trade or business. 

Accordingly, to achieve parity with other industries which deliver their products 

only by means of sales of goods, any Subpart F reform should amend section 

954(c)(2)(A) both to eliminate the current complete prohibition on deferral for related party rents and royalties and to rationalize the active trade or business test. 

These reforms would place software companies on a tax parity with other U.S. companies, and would allow Congress to meet the policy goal of matching the beneficiaries of the proposed legislation as closely as possible with the groups that historically benefited from FSC/ETI. 

Two primary concerns have been expressed concerning whether this proposal 

would be appropriate—that rents and royalties are somehow by their very nature 

indicia of passive activity, and that even if some reform is appropriate, the scope 

of qualifying rents and royalties should be appropriately limited. 

With respect to the concern that all rents and royalties are inherently passive, 

it is important to emphasize that the classification of income as active or passive 

46

based merely on whether it is characterized as a sale of goods, rents or royalties 

is not necessarily appropriate, at least in the software context. It would be inconsistent and unfair from a policy perspective to treat transactions that arise from the 

same business activity differently, based solely on their nominal classification. 

Also, it should be possible to create an active trade or business test which appropriately distinguishes between rents and royalties derived in the conduct of an active business, and income from more passive, investment oriented activities. This 

test almost certainly should refer to activities conducted by other members of the 

group to characterize a revenue stream as active or passive, as is currently provided 

for in certain other contexts. Perhaps the most straightforward approach would be 

to limit the scope of any reform to those industries that historically have derived 

rents and royalties through active business operations, and retain current law for 

other income such as real property rents. This approach would be consistent with 

other statutory provisions reflecting the Congressional desire to equalize the treatment of computer software royalties and other forms of active business income. One 

possible means to narrowly limit the scope of the proposal is to apply the proposal 

only to rents and royalties which currently qualify for FSC/ETI benefits. Another 

possible approach is to define a qualified recipient as an entity engaged in an active 

software business based on some appropriate measure, such as the presence in the 

affiliated group of substantial development, marketing, and/or other business activities. 

Increase Foreign Tax Credit Carryforward Period from 5 Years to 10 Years

Reform of the foreign tax credit (‘‘FTC’’) carryover rules is needed to provide for 

an effective operation of U.S. tax laws intended to protect against double taxation. 

The AeA further recommends that the ordering rules be amended such that credits 

would be used first from carryforwards to such taxable year, second from the current year, and third from carrybacks. 

U.S. taxpayers may claim FTCs against U.S. tax in order to avoid double taxation 

of income. The amount of FTCs 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 the amount of creditable taxes of 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, the 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 FTCs 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 of the 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. 

This modification would allow U.S. taxpayers that had accrued or paid foreign 

taxes additional time to utilize their FTC carryovers. 

In addition, with the enactment of transfer pricing legislation in many foreign jurisdictions, U.S. multinational corporations are required to recognize income and 

pay foreign taxes in foreign jurisdictions even when they have losses on a consolidated basis. The vagaries of the economy and other business cycles are additional 

factors that sometimes prevent utilization of FTCs before their expiration. 

Remove 90% Limitation on Claiming Foreign Tax Credits from 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. Only 90 percent of the alternative minimum tax (‘‘AMT’’) may be offset by 

FTCs that would otherwise be available. This rule causes double taxation of foreign 

income and thwarts a fundamental and long-standing principle of U.S. tax policy. 

The Joint Committee on Taxation April 2001 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 terms of overall international competitiveness, however, eliminating the double taxation of international income clearly is 

appropriate. 

47

The AMT has a 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 FTCs, 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 vis-a ́-vis 

their foreign competitors in overseas markets.

McLaughlin. 

Chairman MCCRERY. Thank you, Mr. Kostenbauder. Mr. 

f STATEMENT OF GARY L. MCLAUGHLIN, SENIOR DIRECTOR, 

INTERNATIONAL TAX, WAL-MART STORES, INC., BENTONVILLE, ARKANSAS, ON BEHALF OF INTERNATIONAL MASS 

RETAIL ASSOCIATION 

Mr. MCLAUGHLIN. Thank you, Mr. Chairman. I appear here 

today on behalf of the International Mass Retail Association 

(IMRA). The IMRA is the world’s leading alliance of retailers and 

their product and service suppliers. As IMRA retailers have expanded into the EU, Mexico, China, and other international markets, there has been an unleashing of pent-up demand for affordable U.S. products. Most of our U.S. vendors that supply the U.S. 

retail products we sell overseas export through and realize the 

meaningful benefits of FSC/ETI. The U.S. tax that vendors and retailers pay impacts the price we charge our customers worldwide. 

Thus, IMRA has a vested interest in FSC, FSC alternatives, or ETI 

and the solutions that Congress is considering. 

Retailers and our vendors are clearly the largest employers in 

the United States and by being able to compete worldwide we generate dollars to invest in the United States for job growth and economic expansion. 

In announcing these hearings, Mr. Chairman, you noted that 

Congress cannot replicate the benefits of FSC and ETI and that 

these hearings will focus on tax proposals which promote the competitiveness of U.S. companies while respecting our international 

obligations under WTO. The United States is not a low-tax country 

for corporations. With U.S. taxation, of worldwide income and the 

flaws in our deferral and foreign tax credit mechanisms, the most 

meaningful action that Congress could take to enhance the international competitiveness of U.S. corporations would be to reduce 

the U.S. corporate income tax rate. 

However, I realize that such reduction may not be feasible in today’s environment, and I will therefore focus on various changes 

that could and should be made to the subpart F and the foreign 

tax credit provisions of the Tax Code. These changes will both enhance American competitiveness and simplify the operation of 

those provisions. There are four specific change proposals in my 

written submission which are illustrative rather than comprehensive, but do reflect the manner in which the current foreign tax 

provisions of the Tax Code compromise American international 

competitiveness. I will summarize the two most important from the 

retailer perspective. 

First, due to the cyclical nature of the retail business and the associated large amounts of working capital required to address such, 

the current de minimis exception of section 954 creates a situation 

48

where in many cases U.S. retailers’ income from working capital is 

taxed currently in the United States even though such working 

capital is required for the active conduct of our businesses in the 

international arena. For these reasons, section 954 should be 

amended to preserve deferral for working capital of a CFC attributable to active business operations. This could be accomplished by 

either returning the current threshold to its original 1962 level or 

Congress could create a working capital exception from the section 

954 foreign base company income inclusion provisions. 

Second, under subpart F certain intercompany sales and services 

income of a CFC is classified as foreign base company income and 

is thus not eligible for deferral even though the income is generated in the active conduct of a trade or business with the exception of transactions within the same country. This same country exception which permits deferral should be revised in the case of 

member countries within the EU or within China, Hong Kong. The 

income encompassed by the foreign base company sales and services income rules is active business income of the type frequently 

not taxed on a current basis by other countries that have enacted 

anti-deferral regimes. Such income should not be subject to current 

U.S. tax. 

The remaining points in my submission focus on the need to revise the stacking rules for foreign tax credit utilization and the interest allocation rules in order to assure double taxation is avoided, 

as my colleagues have mentioned, and aid in international competitiveness for all U.S. multinational corporations. Additionally, the 

carryforward period for unused foreign tax credits should be increased from 5 to 10 years. 

Thank you, Mr. Chairman and Subcommittee Members. 

Chairman MCCRERY. Thank you, Mr. McLaughlin. Mr. 

Sprague. 

STATEMENT OF GARY D. SPRAGUE, PARTNER, BAKER & 

McKENZIE, PALO ALTO, CALIFORNIA, ON BEHALF OF SOFTWARE INDUSTRY COALITION FOR SUBPART F EQUALITY 

Mr. SPRAGUE. Mr. Chairman and Members of the Subcommittee, it is my pleasure to speak with you this morning about 

possible subpart F reforms that will enhance the competitiveness 

of American business internationally. I am a partner in the law 

firm of Baker & McKenzie in Palo Alto, California, and as such 

fully endorse the Chairman’s remark that these are times when 

one enjoys, actually enjoys being an international tax lawyer. I am 

testifying today on behalf of the Software Industry Coalition for 

Subpart F Equality, which includes many of the country’s, indeed 

the world’s leading software companies. A list of coalition members 

is attached to my written testimony. 

One of the proposals before you is to exclude foreign base company sales and services income from subpart F. This reform would 

enhance the competitiveness of American business while respecting 

our WTO obligations. Although we strongly support these changes, 

it is essential that any modifications to subpart F not be biased 

against computer software companies solely because of the unique 

characteristics of the income earned by these companies. 

49

My testimony today will address those special features of how 

software companies deliver their products to users which demand 

revisions to our 40-year-old rules in subpart F. I believe this is exactly the question raised by Mr. Foley a few minutes ago. Computer software companies are engaged in active businesses just like 

traditional manufacturing companies. Unlike traditional manufacturers, however, computer software companies generally deliver 

their products under license agreements rather than contracts of 

sale. I am sure each Member of this Subcommittee has carefully 

read and thoughtfully considered the license agreements included 

with all of your personal software. 

This contractual form is necessary for reasons of intellectual 

property law and other business considerations completely unrelated to taxation. Because of this contractual form, however, and 

due to the evolving business models of this industry, income earned 

by a company from exactly the same software program may be 

characterized as rents, royalties, sales of goods, or services depending on the facts of the particular transaction. 

Let’s take, for example, a word processing program. When the 

program is sold through a retail distribution channel under a 

shrink wrap license, the transaction, despite the form of license, is 

nevertheless treated as a sale of goods for tax purposes. At the 

same time, if the software company selects a distribution channel 

for exactly the same software program involving arrangements allowing the distributor to duplicate the software, revenue from that 

transaction, from the same program, is treated as a royalty. Furthermore, if the software company chooses a model which requires 

a user to make periodic payments for the continued right to use the 

program, that revenue is characterized as a rent. Finally, software 

may be made available to users in hosting arrangements, which 

frequently gives rise to services income. 

In all four cases, the software company is engaged in essentially 

the same business activity of developing, marketing, delivering, 

and supporting its products, but earns four different types of revenue for tax purposes. Subpart F, however, currently treats those 

four revenue streams in dramatically different ways. The software 

company’s sale of goods and services income would fall within the 

purview of the foreign base company sales and services income 

rules while the rent and royalty income, in contrast, is within the 

scope of the foreign personal holding company regime. Foreign personal holding company income, however, is intended as a policy 

matter to represent passive investment income. Therefore, it includes interest, dividends, capital gains, and rents and royalties. 

Subpart F, like many other parts of the Tax Code, discriminates 

against rent and royalty income on the policy basis that those income items presumably constitute passive investment type income. 

One element of that discrimination is a near complete ban on deferral for software rents and royalties received from related parties, 

which is a rule that is not mirrored in the sale of goods and services context. As a result, different revenue streams of a single software company can receive highly disparate treatment under subpart F despite the fact that all revenues are derived in the context 

of a company’s single active business. 

50

1www.hoovers.com/industry/snapshot/profile, June 6, 2002. 

2Taylor, Paul, Financial Times, ‘‘Reaping the Rewards of IT Growth’’ September 1, 1999. 3 Id. 4www.hoovers.com/industry/snapshot, June 6, 2002. 

Accordingly, subpart F must be modernized to eliminate the inconsistent and inequitable treatment of software income and to 

achieve parity for the software industry relative to other industries 

that deliver their products only by traditional means. Congress can 

ensure that active business income earned by software companies 

is treated in the same way regardless of its nominal classification 

by doing two things: one, amending the definition of foreign personal holding company income to eliminate the current complete 

prohibition on deferral for related party software rents and royalties, and two, rationalizing the active trade or business test under 

the foreign personal hold company rules. 

I note that other speakers today have supported this reform of 

the rent and royalty rules in their oral or written testimony. 

This reform also would allow Congress to meet the policy goal of 

matching the beneficiaries of proposed reform as closely as possible 

with those groups which have historically benefited from ETI. 

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

happy to answer any questions you may have and ask that my 

written statement be made a part of the record of this meeting. 

[The prepared statement of Mr. Sprague follows:]

Statement of Gary D. Sprague, Partner, Baker & McKenzie, Palo Alto, 

California, on behalf of Software Industry Coalition for Subpart F Equality

Mr. Chairman and Members of the Committee, it is my pleasure to appear before 

you today to discuss legislative alternatives to the FSC/ETI regimes that will comply 

with international trade rules and enhance the global competitiveness of U.S. companies. 

I am testifying today on behalf of the Software Industry Coalition for Subpart F 

Equality, which includes many of the world’s leading software companies. A list of 

the members of the Coalition is attached. 

As other witnesses have testified today, it is imperative that the U.S. tax system 

does not hinder United States companies from effectively competing in the global 

markets. This was the primary intent of the Foreign Sales Company (FSC) and 

Extraterritorial Income (ETI) regimes; the competitiveness concerns that led to the 

enactment of the FSC/ETI regime are no less pressing today. Therefore, FSC/ETI 

replacement legislation should provide benefits to those U.S. taxpayers, including 

computer software companies, which have previously qualified for FSC/ETI benefits.

I. Importance of the Software Industry

The software industry is one of the fastest growing sectors of the global economy, 

generating revenues of more than $150 billion every year.1 Its importance to the 

U.S. economy’s current health and future prosperity is undisputed. In 1998, information technology contributed 8% to the U.S. gross domestic product (‘‘GDP’’),2 and 

it is estimated that by 2006 industries that heavily utilize or produce information 

technology will employ 49% of the U.S. private sector workforce.3 Today, nine of the 

world’s ten biggest software companies are located in the United States.4

Congress demonstrated its commitment to supporting the competitiveness of U.S. 

software companies in 1997 by clarifying that FSC benefits specifically include income from software licenses as qualifying income under the FSC/ETI regime. Although FSC/ETI benefits are not generally available for income derived from transfers of intellectual property, Congress recognized the importance of the software industry to the U.S. economy by clarifying that the FSC rules apply to ‘‘computer software (whether or not patented).’’ This provision carried over to the ETI regime. 

Therefore, any replacement for the FSC/ETI regime must include the computer software industry.

51

5 Joseph Isenbergh, International Taxation: U.S. Taxation of Foreign Persons and Foreign Income § 20.2 (3d ed. 2002). 

II. Subpart F Relief

Congress is considering various proposals for replacing FSC/ETI. One set of proposals involves an amendment to Subpart F of the Internal Revenue Code that excludes foreign base company sales income and foreign base company services income 

from the definition of Subpart F income. This would be a significant reform of U.S. 

tax laws that would increase the international competitiveness of U.S. corporations 

and respect the United States’s obligations under the GATT. Subpart F discriminates against U.S. companies that operate abroad in many ways by, for example, 

currently taxing income earned by foreign subsidiaries without giving equal treatment to losses. We support these changes. 

Although we support the goal of reforming Subpart F, any modification of the 

Subpart F provisions must take into account taxpayers, such as computer software 

companies who derive income from licensing intellectual property that can be classified as income derived from the conduct of an active business rather than from passive activities. My testimony will focus on the special features of the computer software industry that must be taken into account when considering Subpart F reform.

III. Unique Features of the Software Industry

Subpart F, which was enacted at a time when intellectual property played a 

smaller role in the economy, uses heavy manufacturing as its business model. Since 

that time, intellectual property has come to play a major role in the economy as 

business models have changed. For example, the computer software industry, which 

did not exist when Subpart F was enacted, is now an important part of the economy 

and a major U.S. exporter. 

Computer software companies generally earn income by developing computer programs, which are protected by copyrights and patents, and delivering these programs to their customers. These delivery methods may produce rents, royalties, sale 

of goods income, or services income, depending on the facts of the transaction. The 

development process frequently involves thousands of highly trained professionals 

and the expenditure of many millions of dollars and years of effort to create new 

software that may or may not be commercially successful. As one commentator on 

the international provisions of the Code has observed, in the context of distinguishing between taxpayers engaged in an active trade or business from mere passive investors, ‘‘we can readily sense a difference between the activities of those who 

dig, plow, shape, make, buy, sell, cajole, and those who merely glance at a market 

quotation in the newspapers or perhaps merely remove a check from an envelope 

with fingers left slender and pale from the absence of toil.’’ 5 By this standard, the 

software industry is no less of an active business than the heavy manufacturing 

that was Congress’s paradigm when Subpart F was enacted. 

The software industry is unique among active businesses, however, in that that 

it delivers its products and services to customers via delivery methods that produce 

rents, royalties, sale of goods income and services income, depending on the facts 

of the transaction. In this respect, software companies are unlike manufacturers, 

which only earn income from the sale of goods. For example, computer software 

companies frequently deliver their products under commercial arrangements structured as licenses for reasons of intellectual property law and other business reasons 

that are completely unrelated to taxation. Many software companies deliver their 

products through time-limited licenses, or through hosting arrangements, which 

may produce revenue properly characterized under the tax law as rents and service 

fees, respectively. In all cases, the company, be it a software company or a steel 

mill, is engaged in essentially the same business activity of developing, marketing 

and supporting its products. Thus, even if a software company earns income that 

is characterized as rent or royalty income, it does not imply that the company is 

not engaged in an active trade or business. In addition, developments in communications technology now allow multinational businesses to operate in an integrated 

manner that would not have been possible when Subpart F was enacted.

IV. Today Subpart F Discriminates Against the Software Industry

Subpart F of the Code requires a ‘‘United States shareholder’’ of a ‘‘controlled foreign corporation’’ (CFC) to include currently in its gross income its pro rata portion 

of the CFC’s ‘‘subpart F income’’ as a deemed dividend. Subpart F income includes 

foreign personal holding company income, foreign base company sales income, and 

foreign base company services income. Foreign base company sales income includes 

52

income derived from transactions in inventory property if the property was purchased from, or sold to, a related party and the property was neither manufactured, 

nor sold for use, in the CFC’s country of incorporation and certain other conditions 

are met. Foreign base company services income includes income arising from services performed outside the CFC’s country of incorporation that are performed for or 

on behalf of a related person, including under a regulatory interpretation of the 

statute, services for which a related person provides ‘‘substantial assistance.’’

Foreign personal holding company income, which is intended to represent passive 

income, includes interest, dividends, rents, royalties, and capital gains. Subpart F, 

like many other areas of the Code, discriminates against rent and royalty income 

by generally treating them as a type of passive income. Subpart F attempts to limit 

its discriminatory treatment of rent and royalty income by providing a limited exception for certain active rents and royalties. This provision excludes from foreign 

personal holding company income rents and royalties that are both derived in the 

active conduct of a trade or business and received from an unrelated person. 

Although this active rent and royalty exception clearly shows Congress’ intent to 

distinguish income that is earned through active business activity from passive income derived solely from the ownership of intangible property, the regulations make 

this determination with respect to each CFC on a stand-alone basis. This separate 

application of Subpart F to each CFC was appropriate in the era when Subpart F 

was enacted because foreign subsidiaries were likely to operate on a stand-alone 

basis. However, computer software companies, like most knowledge-based companies, operate in an integrated global manner, unlike the manufacturing companies 

that were the norm when Subpart F was enacted. Through the use of new communications technology and business models, a software company’s domestic and foreign subsidiaries work together in developing new products, entering into global 

sales contracts with multinational customers, and supporting their products around 

the clock. This business model is far different from the country-specific model that 

was the norm when Subpart F was enacted.

V. Software Income Should Be Kept on a Par with Other Active Industries

In order for the computer software industry to obtain parity with other industries 

that deliver their products only by means of sales of goods, subpart F reform must 

be modernized to eliminate the inequitable treatment of software rent and royalty 

income. Congress can achieve this result by amending Code section 954(c)(2)(A) to 

(i) eliminate the current complete prohibition on deferral for related party software 

rents and royalties, and (ii) rationalize the active trade or business test by including 

the activities performed by members of the CFC’s group of corporations and activities performed by third parties on behalf of the CFC. 

These reforms would provide software companies with tax parity with other U.S. 

companies, and would allow Congress to meet the policy goal of matching the beneficiaries of the proposed legislation as closely as possible with the groups that historically benefited from FSC/ETI.

VI. Our Proposal Will Not Lead to Inappropriate Tax Deferral

Some have expressed concern that this proposal would lead to inappropriate tax 

deferral, namely (i) that rents and royalties are somehow by their very nature indicia of passive activity and thus should not enjoy deferral at all, and (ii) that even 

if some reform is appropriate, the scope of qualifying rents and royalties should be 

appropriately limited. 

With respect to the concern that all rents and royalties are inherently passive, 

it is important to emphasize that the classification of income as active or passive 

based merely on whether it is characterized as sale of goods income, rents or royalties is not a valid assumption, at least in the software context. The income derived 

by software companies normally is not passive income, but rather is active income 

that is classified in a variety of ways, including as sales, rents, royalties or services 

income, based on the facts and circumstances of each transaction. It would be inconsistent and unfair from a policy perspective to treat transactions that arise from the 

same business activity differently, based solely on their nominal classification. 

The factors that cause an item of income arising from a computer software transaction to be either sale of goods income, on one hand, or rent or royalty income, on 

the other, have no bearing on whether the income is active or passive. The characterization of an item of software revenue can be affected by the period of time that 

the customer can utilize the software without making an additional payment or 

whether the customer is granted the right to make derivative works based on the 

software. For example, a transfer of a copy of a computer program will be classified 

as a sale of goods transaction if the customer makes a single payment in exchange 

53

for the right to use the software in perpetuity but will be classified as a rental 

transaction if the customer is required to make periodic payments in order to continue using the software. Alternatively, if the customer has the right to use the software in perpetuity but obtains a significant right to make a derivative work based 

on the original software, the transaction will be classified as a license of copyright 

rights instead of a sale of goods. These factors can cause an item of software income 

to be treated as rents or royalties, instead of sale of goods income, which are treated 

differently under current Subpart F rules. However, these factors have no relationship to whether the income was earned in an active business. Congress should 

eliminate these distinctions and put the software industry on a level playing field 

with all other active businesses. 

We also note that the U.S. transfer pricing rules are entirely adequate to prevent 

any inappropriate allocation of income to CFCs earning software revenues. U.S. 

transfer pricing rules have become much more sophisticated since Subpart F was 

enacted forty years ago. Modern transfer pricing rules are based on the functions 

performed by each entity and not the label assigned to that entity’s income. These 

rules take into account the need for multiple operating locations in an integrated 

global business. In many cases, a CFC earning software revenue also will be subject 

to transfer pricing scrutiny under the various foreign laws of the market jurisdictions. 

With respect to the second point, namely the desire to appropriately limit the 

scope of this provision, we are confident that it will be possible to create an active 

trade or business test which appropriately distinguishes between rents and royalties 

derived in the conduct of an active business, and income from more passive, investment oriented activities. This test almost certainly should refer to activities conducted by other members of the group for purposes of characterizing a revenue 

stream as active or passive, as is currently provided for in certain other contexts. 

Perhaps the most straightforward approach would be to limit the scope of any reform to those business activities which historically generated rents and royalties 

through active business operations, and retain current law for other income such as 

real property rents. This approach would be consistent with other statutory provisions reflecting the Congressional desire to equalize the treatment of computer software royalties with other forms of active business income. One possible means of 

limiting the scope of the proposal is to define a qualified recipient as an entity engaged in an active software business based on some appropriate measure, such as 

the presence in the affiliated group of substantial development, marketing, and/or 

other business activities. 

In closing, it is important to note that, if FSC/ETI is repealed, these Subpart F 

reform proposals will not completely make up any lost FSC/ETI benefit to the U.S. 

software industry. However, these reforms will provide a portion of the lost benefit 

and will significantly improve the international competitiveness of U.S. industry. 

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

questions you may have, and I ask that my written statement be made a part of 

the record of this hearing.

The Software Industry Coalition for Subpart F Equality

Adobe Systems Incorporated 

Amazon.com 

Attachmate Corporation 

BMC Software 

Citrix Systems, Inc. 

i2 Technologies, Inc. 

IBM Corporation 

J.D. Edwards & Company 

Microsoft Corporation 

Network Associates, Inc. 

Novell, Inc. 

Onyx Software Corporation 

Oracle Corporation 

Parametric Technology Corporation 

Peregrine Systems, Inc. 

Rational Software Corporation 

Symantec Corporation 

VERITAS Software Corporation 

54

6 ITAA provides global public policy, business networking, and national leadership to promote 

the continued rapid growth of the information technology industry. ITAA consists of over 500 

corporate members throughout the U.S., and has a global network of 46 countries’ IT associations called the World Information Technology and Services Alliance (WITSA). 7The Business Software Alliance (BSA) is a leading organization dedicated to promoting a 

safe and legal online world. BSA educates computer users on software copyrights and cyber security; advocates public policy that fosters innovation and expands trade opportunities; and 

fights software piracy. BSA members represent the fastest growing industries in the world. 8The Software Finance and Tax Executives Council (SoFTEC) is a trade association providing 

software industry focused public policy advocacy in the areas of tax, finance and accounting.

Information Technology Association of America (ITAA) 6

Business Software Alliance (BSA) 7

Software Finance & Tax Executives Council (SoFTEC)

f 8

Chairman MCCRERY. Certainly will, Mr. Sprague. Thank you 

for your testimony. Mr. Cowen? 

STATEMENT OF ROBERT COWEN, SENIOR VICE PRESIDENT 

AND CHIEF OPERATING OFFICER, OVERSEAS SHIPHOLDING 

GROUP, INC., NEW YORK, NEW YORK, ON BEHALF OF INTERNATIONAL SHIPHOLDING CORPORATION, NEW ORLEANS, 

LOUISIANA 

Mr. COWEN. Thank you, Mr. Chairman, and thank you to all 

the Members of the Subcommittee for affording us the opportunity 

to testify today on these important issues. My name is Bob Cowen. 

I am Senior Vice President and Chief Operating Officer of Overseas 

Shipholding Group (OSG). My testimony today focuses on the significant hardship created for U.S.-based shipping companies by the 

present subpart F rules. My testimony today is endorsed by International Shipholding Corporation, headquartered in Louisiana, 

which also operates in our business. 

My company, OSG, is a major international shipping business 

domiciled in Delaware and headquartered in New York. Through 

our subsidiaries we own a diversified fleet of oceangoing oil tankers 

and other bulk cargo vessels which operate in both the U.S. flag 

and international flags markets. The OSG is the sixth largest tanker owner in the world today. 

Precisely because OSG is a U.S. company, we face an overwhelming tax disadvantage as we compete in the global shipping 

marketplace. As a result of legislation enacted in 1975 and 1986, 

the United States imposes tax currently on the income earned 

abroad by OSG’s subsidiaries. By contrast, our foreign competitors 

typically are not taxed at all on their shipping income. 

The shipping industry is a prime example of the issues that are 

the subject of this hearing and also of the debate over so-called corporate inversion transactions. It is telling that the treatment of 

shipping income was the first example of anti-competitive U.S. tax 

law that was cited by the Treasury Department in its report on inversion transactions. I note that Barbara Angus this morning in 

her testimony also alluded to our problem. As the Treasury Department noted, the disadvantages under present law mean U.S.-based 

shipping companies have less after tax income to reinvest in their 

business, which means basically less growth. Put differently, OSG’s 

ships would be more valuable today if they were owned by a foreign company. 

55

You might ask what does it matter if U.S.-based carriers are 

taxed more heavily than their foreign competitors. There is a simple and compelling answer. If the law is not changed, there will be 

fewer and fewer U.S.-based carriers and fewer and fewer U.S.-controlled ships to meet America’s national security and economic security needs. Indeed, U.S. participation in international shipping is 

already in a state of dramatic decline. In a world where almost all 

bulk seagoing transportation is conducted on foreign flag vessels, 

the number of U.S.-owned foreign flag vessels has declined by over 

60 percent since 1974. From 1988 to 2000, the number of U.S.-

owned foreign flag tankers was cut nearly in half from 246 to only 

126 ships. Today U.S.-owned foreign flag vessels constitute barely 

3 percent of the world merchant fleet, an astonishing figure. 

Because of the unfavorable tax treatment of U.S. companies competing in foreign trade, we have seen the ownership of two leading 

U.S. container operators, American President Lines (APL) and SeaLand move offshore. In 1997, APL was taken over by Neptune Orient Lines of Singapore and in 1993 the A.P. Moller group of Denmark acquired Sea-Land. In 1998, OMI, a U.S.-domiciled tanker 

company, moved offshore to the Marshall Islands in order to avoid 

the adverse competitive effects of the subpart F rules. 

Unless we change the subpart F rules a further decline in U.S. 

ownership of international merchant fleets is inevitable. The dramatic decline in U.S.-owned international fleets raises significant 

national security and economic concerns for our Nation. In times 

of emergency, the U.S. military relies on its ability under law to 

requisition these U.S.-owned foreign flag tankers, bulk carriers, 

and other vessels to carry oil, gasoline, and other materials in defense of the U.S. interests overseas. 

The sharp decline in this fleet since the 1975 and 1986 tax law 

changes and the adverse implications to U.S. strategic interests are 

expected to be confirmed soon in a study commissioned by the U.S. 

Navy. 

Our national security also depends on America’s ability to maintain adequate domestic oil supplies in times of emergency. One-half 

of every gallon of oil consumed in the United States is imported on 

foreign-owned vessels. This growing dependence on foreign parties 

who may not be sympathetic to American interests and who have 

the ability to choke off our vital supplies of oil in times of global 

crisis is cause for alarm and must be addressed. 

As Congress considers ways to make the U.S. international tax 

system more competitive, whether in conjunction with the FSC/ETI 

issue or the inversion debate, OSG would respectfully submit that 

changes to the treatment of shipping income should be at the top 

of list. 

The OSG is encouraged that bipartisan legislation that would 

seek to address the problems created by current law has been introduced by Representative Weller and three other Members of this 

Subcommittee, Mr. Lewis, Mr. Foley, and Mr. Jefferson. We respectfully urge Congress to enact legislation as soon as possible 

that will help level the playingfield for U.S.-based carriers operating abroad. Such action will assure the United States has an adequate available fleet in times of global crisis, both to meet our military requirements and to protect our economic security. 

56

The OSG looks forward to working with all interested parties to 

fashion a solution that will not only help U.S. companies reclaim 

their share of the global shipping markets, but will also help preserve and enhance U.S. flag shipping. 

Thank you for your attention, and I would be glad to answer any 

questions you might have. 

[The prepared statement of Mr. Cowen follows:]

Statement of Robert Cowen, Senior Vice President and Chief Operating Officer, Overseas Shipholding Group, Inc., New York, New York, on behalf 

of International Shipholding Corporation, New Orleans, Louisiana

I. Introduction

On behalf of the Overseas Shipholding Group, Inc. (‘‘OSG’’), I appreciate the opportunity to testify today before the Subcommittee on Select Revenue Measures on 

international competitiveness issues raised by the U.S. tax system. My testimony 

focuses on the significant problems created by the present-law rules under subpart 

F of the Internal Revenue Code applicable to shipping income. The views expressed 

in this testimony are endorsed by the International Shipholding Corporation, 

headquartered in Louisiana. 

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 recently has noted, 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 50 vessels with an aggregate carrying capacity of more than 7.4 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 10 vessels aggregating approximately 665,000 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 40 foreign flag 

vessels, amounting to almost 7 million deadweight tons. These foreign flag vessels 

include 38 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 

57

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 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. 

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, are expected to be 

confirmed soon in a study that has been commissioned by the U.S. Navy. This study 

is likely to conclude that the current EUSC fleet is not large enough to satisfy U.S. 

strategic needs. 

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 

58

3 National Security Directive 28, October 5, 1989. 

4 According 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. 

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: 

[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 U.S. 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 U.S. 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 so-called ‘‘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 foreign-controlled 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 

59

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 

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. 7 ‘‘The Restore Access to Foreign Trade Act,’’ (H.R. 3312).

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

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 foreignowned 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. Treasury Secretary O’Neill put 

it well when he released the corporate inversion report: 

In addition, if the Tax Code disadvantages U.S. companies competing in the global 

marketplace, then we should address the anti-competitive provisions of the Code. I 

don’t think anyone wants to wake up one morning to find every U.S. company 

headquartered offshore because our Tax Code drove them away and no one did anything about it. This is about competitiveness and complications in the Tax Code that 

put U.S.-based companies out of step with their foreign competitors. 

OSG is encouraged that bipartisan legislation that would seek to address the 

problems created by current law has been introduced in this Congress by Rep. Jerry 

Weller (R–IL) and co-sponsored by Representatives Charles Rangel (D–NY), Phil 

Crane (R–IL), Ron Lewis (R–KY), Mark Foley (R–FL), William Jefferson (D–LA), 

John Shimkus (R–IL), and Judy Biggert (R–IL).7 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.

60

Exhibit A

Exhibit B


Insert 084168A.000 Insert 084168A.001
61

Exhibit C

Sources 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 

fNo. 2, 2000.

Chairman MCCRERY. Thank you, Mr. Cowen. Mr. Parsons? 

STATEMENT OF DOUG M. PARSONS, PRESIDENT AND CHIEF 

EXECUTIVE OFFICER, EXCEL FOUNDRY AND MACHINE, INC., 

PEKIN, ILLINOIS, ON BEHALF OF NATIONAL ASSOCIATION 

OF MANUFACTURERS 

Mr. PARSONS. Well, good afternoon now, Chairman McCrery 

and Members of the Subcommittee, I want to thank you for the opportunity to appear before you today and present the views of Excel 

Foundry and Machine, and the National Association of Manufacturers (NAM) on the way to promote the competitiveness of U.S. 

companies while respecting international obligations under the 

World Trade Organization agreement. 

I am Doug Parsons, and I am President and Chief Executive Officer of Excel Foundry and Machine, and before I go on with that 

I just want to interject a few points, and that is I am a pretty small 

fish in this room. I am a manufacturing company, do about $12 

million in revenue, and I just want you to know that the elimination of the FSC/ETI benefit would greatly impact my company. 

A third of my business is international and a lot of those countries 

I try to get product into have tariffs on my product and some very 

tough competition. 


Insert 084168A.002
62

So, I just want to get that across in that this isn’t all about big 

huge multinational organizations. This is about small manufacturing companies that are looking to international markets not just 

to grow but to survive. 

The National Association of Manufacturers is the Nation’s largest industrial trade organization, representing 14,000 member companies, including 10,000 small and mid-sized companies and 350 

member associations serving manufacturers and employees in 

every industry sector in all 50 States. 

Headquartered in Washington, D.C., the NAM has 10 additional 

offices across the country. Excel Foundry and Machine supplies 

precision machines, bronze and steel parts for heavy equipment-related industries, such as mining, crushing, and mineral processing. 

Founded in 1929, the company had $12 million in sales in 2001 

and projects $14 million in 2002. Excel, which operates a subchapter S corporation, has 95 employees at its facility in Pekin, Illinois. 

The current extraterritorial income regime as well as its predecessors, the DISC and FSC, have been integral factors in increasing export activities by U.S. manufacturers. According to the IRS, 

of the roughly 4,300 FSCs in existence in 1996, 89 percent of them 

exported manufactured products. Congress first created the DISC 

in 1971 to level the playingfield for U.S. companies, large and 

small, selling their products overseas. These three types of tax incentives created over the past three decades were designed to neutralize some of the tax advantages enjoyed by our foreign competitors located in countries with territorial tax systems which generally exempt income earned outside of the country from income 

tax and exports from value added and other consumption taxes. 

Traditionally, much of the attention in this area has been focused 

on FSCs used by large companies. The FSC benefits also are important to small and mid-sized manufacturers that export. In fact, exporting goods overseas is more than a sideline for many of these 

small companies, essentially it’s a necessity of staying in business. 

Smaller companies often turn to export tax incentives to effectively 

compete in global marketplaces. According to the NAM survey in 

2000, small and mid-sized manufacturers save on average about 

$124,000 annually by using the FSC. 

It is critically important to continue to encourage export activity 

by these small companies. Of all the exporting manufacturers in 

America, 93 percent are small and mid-sized manufacturers. These 

firms, which individually employ anywhere from 10 to 2000 employees, together employ roughly 9.5 million people. Small and 

mid-sized manufacturers add jobs 20 percent faster than firms that 

remain solely domestic and are 9 percent less likely to go out of 

business. 

For my company, Excel Foundry and Machine, selling products 

in an international market means more than reaching a few additional customers. International sales contribute to the growth and 

health of the company, allowing us to expand by adding new space, 

hiring more employees, and making capital investment. International sales account for one-third of our revenue and these sales 

are responsible for the tremendous growth of the company, 30 percent over the last 4 years, and we anticipate 20-percent growth this 

63

year. They have enabled the company to begin building a 20,000 

square foot expansion. 

In the past Excel used a foreign sales corporation, and we currently use the extraterritorial income regime. The benefit provided 

by FSC/ETI justified the additional efforts to go into these overseas 

markets to compete. For example, the tax system in some South 

American countries heavily favor local suppliers. The FSC/ETI 

have leveled the playingfield and you just can’t pull that incentive 

away from us. 

Moreover, the loss of tax incentives like those provided by FSC/

ETI would have a tremendous impact on the company, affecting 

revenues and employment. There are many hidden costs in doing 

business internationally. In markets where margins are already 

thin we would lose sales due to an uneven playingfield. If these 

sales slump, Excel would likely have to cut between 3 and 5 percent of its workforce. 

With the June 17, 2002, scheduled release date for the WTO arbitration panel’s sanctions report fast approaching, we are pleased 

that the EU recognizes the difficulties of the situation and has 

agreed to delay imposing sanctions until at least 2003. However, 6 

months is not enough time. It is clear the international tax issues 

involved are complex and a considerable amount of time will be required to develop and implement appropriate legislative response. 

Let me skip to the end here. 

Really, no consensus has been found yet on an appropriate solution, and the current proposals vary considerably, ranging from 

substituting other changes in the international tax area for the 

FSC/ETI to a legislative framework and timeline to achieve compliance with WTO rulings. 

As a small U.S.-based manufacturer, I am concerned that some 

of the proposed solutions are targeted to multinational corporations 

with subsidiary operations and employees outside the United 

States. These changes will not benefit small exporters like Excel 

with operations only in the United States and thus will not serve 

as an adequate substitute for FSC/ETI. 

I want to thank you for your time today and just for providing 

the tools for American manufacturers, large and small, to effectively compete with their foreign counterparts. 

Chairman MCCRERY. Thank you, Mr. Parsons. Mr. Newlon?

STATEMENT OF T. SCOTT NEWLON, MANAGING DIRECTOR, 

HORST FRISCH INCORPORATED 

Mr. NEWLON. Thank you, Mr. Chairman and Members of the 

Subcommittee, for giving me the opportunity to testify before you 

today. My name is Scott Newlon. I am a Managing Director of 

Horst Frisch Incorporated, an economics consulting firm. For the 

record, I am testifying today on my own behalf and not as a representative of any organization. 

My testimony focuses on the international provisions of the Tax 

Code, which is an area in which there is certainly great scope for 

improvement and reform. There are of course worthy policy options 

that should be considered in the context of a broader reform of corporate taxation within the United States, such as fixing the alterVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00067 Fmt 6633 Sfmt 6602 E:\HR\OC\84168.XXX 84168
64

native minimum tax and integration of the corporate and individual tax systems. 

In considering policy options, we should not lose sight of the fact 

that there are various valid objectives in developing tax policy. 

Those include of course competitiveness, the ability of U.S. firms to 

compete successfully with foreign firms in domestic and international markets. There is economic efficiency, which is generally 

understood to mean that the tax system should affect as little as 

possible the allocation of resources to the most productive investments. In other words, to the greatest extent possible, the tax system should stay out of the way of the decisions of individuals and 

businesses. 

There is preservation of the tax base. The U.S. international tax 

regime should not undermine our ability to collect tax on the U.S. 

tax base, whatever we decide is the appropriate U.S. tax base. 

Finally there is simplicity. Complexity in tax provisions can create substantial costs of compliance for taxpayers and Administration for the IRS. 

These objectives, while sometimes they go together, often they 

are competing, and there have been tradeoffs made in the development of tax policy. Over the years, in the development of international tax policy, I think we have seen a lot of focus on the first 

three of those objectives that I mentioned: Competitiveness, economic efficiency, and preservation of the tax base. The simplicity 

objective has received short shrift. As a result, over the years we 

have ended up with a hodgepodge of international tax rules that 

are complex and difficult to administer. 

Given the limited amount of time I have for my comments, I 

wanted to summarize my principal conclusions. First, and maybe 

I am a little bit alone here but I will state it, I think if the WTO 

decision on FSC/ETI results in the repeal of those provisions, I 

think we are ahead of the game in terms of the welfare of the 

American people in general. These provisions are an export subsidy 

that distorts trade. It may benefit particular companies and to 

some extent their workers, but in terms of the overall economy and 

the American people, it makes us poorer than a free trade policy 

would. 

Second, the current U.S. international tax regime represents a 

mixed bag in terms of its effects on competitiveness, economic efficiency, and protection of the tax base. In general, there is actually 

relatively little U.S. tax that is collected on foreign source income 

of U.S. companies from active nonfinancial foreign investment. This 

suggests that at least in this area the actual tax burden from payments of tax is not so much the issue as other issues. At the same 

time, in certain other areas our tax system does present more of 

a burden in terms of direct tax payments. Those are areas in which 

investment and activities have been thought to be more mobile in 

the past and we have developed tax provisions that maybe didn’t 

give enough weight to competitiveness concerns, particularly with 

the increasing integration of markets and globalization of competition. 

The U.S. international tax regime clearly fails on simplicity 

grounds, and in many cases U.S. companies face onerous burdens 

of compliance with exceedingly complex rules. Changes that reflect 

65

a rebalancing of our objectives in favor of simplicity could have 

beneficial effects in terms of economic efficiency and competitiveness as well. 

Finally, in considering the options, one of the options would be 

a territorial tax regime. That could have some attractive features, 

but we should keep in mind that its impacts on U.S. multinationals 

would vary. For broad classes of companies it would not necessarily 

lower their tax burden. In addition, the prospects for simplification 

may not be significantly better under such a system than they are 

under the current system. 

Thank you. 

[The prepared statement of Mr. Newlon follows:]

Statement of T. Scott Newlon, Managing Director, Horst Frisch 

Incorporated 

Mr. Chairman and Members of the Committee:

Thank you for inviting me to testify today on changes to the Tax Code to promote 

the international competitiveness of U.S. companies in the light of the WTO ruling. 

My name is Scott Newlon. I am a managing director of Horst Frisch Incorporated, 

an economics consulting firm. Throughout my career my work has focused on the 

economic analysis of international tax issues in academic research, policy analysis 

while at the Treasury Department, and in my consulting practice working with multinational companies and tax authorities. For the record, I am testifying today on 

my own behalf and not as a representative of any organization. 

I. Objectives and Principal Conclusions

In the announcement of this hearing, Chairman McCrery stated that the purpose 

of the hearing was to ‘‘explore a third possible response to the WTO’s ruling, namely 

making changes to the Tax Code to promote the international competitiveness of 

U.S. companies.’’ In my comments today, I would like to focus on responses involving the international provisions of the Tax Code, an area in which there is certainly 

room for improvement. In considering such responses, we should not lose sight of 

the fact that there are various objectives possible for U.S. domestic and international tax policy:

• Competitiveness: Which is generally understood to mean the ability of U.S. 

firms to compete successfully with foreign firms in domestic and international 

markets. This includes competition by U.S. firms from operations in the U.S. 

to serve domestic and foreign markets and competition by U.S. firms through 

their foreign subsidiaries and branches. 

• Economic efficiency: Which is generally understood to mean that the tax system should affect as little as possible the allocation of resources to the most 

productive investments. In the international context, this means that the tax 

system ideally would not favor foreign investment over domestic investment 

or vice versa. 

• Preservation of the tax base: The U.S. international tax regime should not undermine our ability to collect tax on the U.S. tax base. 

• Simplicity: Complexity can create substantial costs of compliance for taxpayers and administration for the IRS.

These objectives cannot always (or, realistically, ever) be met simultaneously, and 

the attempt to satisfy at least the first three of these competing concerns, or at least 

to pay homage to them, has over the years created the current hodgepodge of international tax rules. The one objective that has received short shrift in this process 

is certainly simplicity. Simplicity is related to, and can at times be complementary 

with some of the other objectives. In particular, simplicity can improve competitiveness and efficiency by reducing burdensome compliance and planning costs. 

With these objectives in mind, I will focus in the remainder of my testimony on 

three areas. First, I will discuss briefly the effect the WTO ruling and its implications for the objectives we discussed above. Second, I will discuss the current tax 

system and how it measures up in terms of competitiveness concerns and the other 

objectives discussed above. Finally, I will discuss one of the principal alternatives 

to the current system that is currently under discussion, some form of a territorial 

tax system. 

To summarize my principal conclusions:

66

• If the WTO decision results in the repeal of the extraterritorial income regime 

(ETI), we should be grateful to the WTO for forcing us to do something that 

will benefit Americans as a whole. The ETI represents an export subsidy, 

which distorts trade. It may benefit particular companies and possibly their 

workers, but overall it makes us poorer than a free trade policy would. 

• The current U.S. international tax regime represents a mixed bag in terms 

of its effects on competitiveness, economic efficiency and protection of the tax 

base. In general, relatively little U.S. tax is collected on foreign source income 

of U.S. companies from active non-financial foreign investment. This suggests 

that, in terms of the direct burden of U.S. taxes, the competitiveness objective 

is most close to being satisfied. At the same time, in specific areas in which 

location of investment is often considered more mobile, such as financial services, the rules emphasize efficiency and tax base protection over competitiveness. However, given the increasing global integration of these markets and 

the ease with which companies operate across borders, it may be time to give 

competitiveness concerns greater weight. 

• The current U.S. international tax regime clearly fails on simplicity grounds. 

In many cases U.S. companies face onerous burdens of compliance with exceedingly complex rules. Changes that reflect a rebalancing of competing objectives in favor of simplicity could result in net improvements in competitiveness and economic efficiency, without substantially undermining the U.S. tax 

base. 

• A realistic territorial tax regime could have some attractive features, however, its impacts on U.S. multinationals would vary, and for broad classes of 

companies, it would not necessarily lower tax burdens. In addition, the prospects for simplification may not be significantly better than under the current 

system, if we continue to care about preventing erosion of the U.S. tax base. 

II. The WTO Decision

As I have stated, the WTO ruling should be considered a victory for Americans, 

assuming that the extraterritorial income regime (ETI) is repealed and the tax revenues thereby saved are used for some more worthy policy objective. The ETI is in 

fact an export subsidy, which distorts trade by subsidizing the consumption of U.S. 

products by foreigners. If the subsidy increases exports at all, it has to be because 

the price of U.S. exports falls relative to foreign imports. Thus, at least a part of 

the benefit from this subsidy is passed through to foreigners, and Americans as a 

whole are made poorer as a result. The shareholders and workers of particular companies may get some of the benefit from the subsidy if it increases company profits 

and/or wages, but if exports are increased at all it has to be because part of the 

benefit goes to foreigners. 

Eliminating trade distortions like the ETI and following a policy of free trade is 

likely to lead to a higher standard of living for Americans as a whole. 

III. Current U.S. Policy Towards Foreign Income

The United States taxes its resident corporations and individuals on their worldwide income. For U.S. multinational corporations, this system is complicated and 

sets up varying incentives for foreign investment and income repatriation depending 

on the particular circumstances of the U.S. parent corporation.

A. Key Elements of the System

The key elements of the system are deferral, the foreign tax credit, the allocation 

of expenses to foreign income, and the income source rules.

Deferral 

The timing of the imposition of U.S. tax on the income of U.S. companies from 

their foreign operations depends upon the way in which the foreign operation is organized. If it is organized as a branch of the U.S. corporation, then the income of 

the branch is taxed as it accrues. If it is organized as a controlled foreign corporation (i.e., it is separately incorporated in the foreign country), then the income (with 

some important exceptions) is not generally taxed until it is remitted to the U.S. 

parent. This delay in the taxation of a subsidiary’s profits until they are actually 

remitted is known as deferral. 

Under the current tax rules deferral is limited by anti-deferral rules that are targeted at certain types of income that are considered to be particularly mobile or lowtaxed. These anti-deferral rules (largely the subpart F provisions) are the source of 

considerable complexity.

67

Foreign Tax Credit 

To avoid double taxation, a credit against U.S. tax is provided for foreign taxes 

paid on foreign source income. The credit covers both taxes incurred directly on payments of income from abroad, such as withholding taxes on dividends, interest and 

royalties, and, for income from a controlled foreign corporation (i.e., a separately incorporated subsidiary of a U.S. company) the foreign taxes on income out of which 

a dividend distribution is made to the U.S. parent company. The foreign tax credit 

is limited to the amount of U.S. tax payable on the foreign income. If the foreign 

tax exceeds the U.S. tax payable, excess credits are created. These excess credits 

may be carried back two years or forward five years to offset U.S. tax payable on 

foreign income in another tax year. 

The limitation on the foreign tax credit operates to a large extent on an overall 

basis, that is, income from different sources can be mixed together and excess credits from a source of income that faces a high foreign tax rate may be used to offset 

U.S. tax from a source of income that faces a low foreign tax rate. This ‘‘cross-crediting’’ is limited by the placement of various different types of foreign source income 

into nine different ‘‘baskets’’ that are each subject to a separate foreign tax credit 

limitation. Most foreign source income falls into the general limitation basket. The 

separate limitation categories generally include types of income that are subject to 

low foreign taxes or are considered to be particularly mobile and thus easily located 

in low-tax locations. 

The large number of separate limitation baskets creates a substantial degree of 

complexity and imposes costly recordkeeping burdens.

Expense Allocation 

The allocation of expenses to foreign source income has the objective of determining the appropriate amount of foreign source net income, which feeds into the 

calculation of the foreign tax credit limitation. In principle, only expenses that support the earning of the foreign source income should be allocated to foreign source 

income. Since the allocated expenses are typically not deductible in the foreign jurisdiction, the effect of allocating expenses against foreign source income is to reduce 

the foreign tax credit limitation. If the taxpayer has excess foreign tax credits at 

the margin the allocation of expenses to foreign source income in this case effectively represents a denial of the deduction. 

The rules regarding allocation of interest expense merit specific discussion. These 

rules provide for what is referred to ‘‘water’s edge fungibility.’’ This means that U.S. 

interest expense is allocated between domestic and foreign source income. The idea 

is that the U.S. borrowing supports both the U.S. and foreign operations. However, 

as is widely understood, this method ignores the fact that a foreign subsidiary of 

a U.S. company may be supported by its own external borrowing.

Source Rules 

Any system that treats foreign source income differently from domestic income 

(e.g., by allowing a foreign tax credit or exemption) requires source rules to determine what income should be considered foreign source. The only aspect of these 

rules which I will comment on is the sales source rule. This rule permits U.S. companies that manufacture in the United States and export their products to treat 50 

percent of the income from those exports as foreign income. For those companies 

that have excess foreign tax credits, this amounts to an exemption of this income 

from U.S. tax. 

This rule effectively amounts to an export subsidy similar to (and more generous 

than) the ETI, but of benefit only to U.S. companies that have excess foreign tax 

credits. The same analysis applies to this subsidy as to the ETI: It may benefit particular firms, but it is a distortion of trade that is likely to harm Americans as a 

whole.

B. Effects of the Current System

How does the current system measure up in terms of competitiveness and the 

other objectives I listed above? 

Standard economic analysis indicates that economic efficiency is promoted if U.S. 

firms face the same tax on investment income, whether that income is earned from 

a domestic investment or a foreign investment. This is generally referred to as ‘‘capital export neutrality.’’ On the other hand, competitiveness is promoted if U.S. firms 

investing abroad face the same tax as local firms. This is generally referred to as 

‘‘capital import neutrality.’’ The current rules regarding deferral and the foreign tax 

credit reflect a compromise between the competitiveness and efficiency objectives 

and the objective of preserving the U.S. tax base. 

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1 As discussed further below, this ignores taxes on deductible payments back to the United 

States, such as intercompany royalties, fees and interest. 2See Rosanne Altshuler and T. Scott Newlon, ‘‘The Effects of U.S. Tax Policy on the Income 

Repatriation Patterns of U.S. Multinational Corporations,’’ in Studies in International Taxation, 

ed. A. Giovannini, G. Hubbard, and J. Slemrod, pp. 77–115, Chicago: University of Chicago 

Press, 1993. 3See Harry Grubert and John Mutti, ‘‘Taxing Multinationals in a World with Portfolio Flows 

and R&D: Is Capital Export Neutrality Obsolete?’’ International Tax and Public Finance, 2, No. 

3, November 1995, pp. 439–57. 

If we only cared about competitiveness, that objective could be achieved by exempting foreign source income from U.S. tax. In that case, the only tax that would 

apply would be the local tax.1 In many cases, the current system in effect works 

like an exemption system. If excess foreign tax credits are available for cross-crediting, investment in a low-tax jurisdiction will in fact bear no additional U.S. tax. 

Even if there are no excess foreign tax credits, if the U.S. tax on low-tax foreign 

earnings can be deferred through reinvestment abroad, its present value is reduced. 

If the deferral is for a sufficiently long period of time, it is virtually equivalent to 

exemption. 

In fact, studies indicate that non-financial U.S. companies do a good job of avoiding substantial U.S. tax on their foreign earnings. Using tax return data, Rosanne 

Altshuler and I found that non-financial U.S. companies as a whole paid little in 

the way of U.S. taxes on their foreign earnings.2 We found that the average U.S. 

tax rate on the foreign source income of these companies was only 3.4 percent in 

1986. Harry Grubert and John Mutti performed similar, but more sophisticated calculations using data from 1990 and found an effective U.S. tax rate of only 2.7 percent on income paid back to the United States and 1.9 percent on total foreign income, both repatriated and unrepatriated.3 These data of course only deal with nonfinancial companies, and they are bound to mask considerable variation across companies in terms of their mix of business and tax position. However, they suggest 

that for many U.S. companies the direct U.S. tax burden on their foreign source income is small. 

We have anti-deferral rules for two reasons. One is the concern about potential 

erosion of the U.S. tax base if tax can be deferred indefinitely on highly mobile types 

of income. If deferral were available on passive income, for example, foreign subsidiaries could be used essentially as mutual funds that could invest passively and 

avoid U.S. tax on earnings indefinitely. There was also a concern that in the case 

of business activities that were considered to be particularly mobile, such as foreign 

base company sales and services operations and financial services, deferral would 

provide too great an incentive to shift activities to low-tax jurisdictions. This raised 

concerns in regards both to tax base erosion and efficiency in the allocation of investment between the United States and low-tax foreign locations. 

However, competitiveness concerns may be particularly relevant in respect of the 

taxation of financial services income. Integration of international financial markets 

has placed U.S. financial institutions in increasingly direct competition with foreign 

financial institutions. The current U.S. taxation of foreign source financial services 

income may disadvantage the U.S. firms relative to some of their foreign competitors. 

In any case, both the U.S. anti-deferral regime and the foreign tax credit regime 

involve substantial complexity. Simplifying them could bring benefits in terms of reduced compliance burdens. While there would be some potential trade-off with competing objectives, given the extreme complexity of the current rules, there are 

worthwhile trade-offs to be made. 

As noted above, the current interest expense allocation rules generally amount to 

a partial disallowance of U.S. interest deductions if the U.S. parent company has 

excess foreign tax credits. This raises the cost of borrowing through the U.S. company and provides a strong incentive to shift borrowing to foreign subsidiaries. This 

may harm the firm if borrowing through foreign subsidiaries involves higher costs. 

A better approach would be to allow the allocation of worldwide interest expense 

for a multinational group.

IV. The Territorial Income Tax Alternative

About half of the OECD countries have a territorial system under which dividends 

a company receives from foreign subsidiaries are exempt from tax. If the United 

States were to adopt such a system, it is not clear whether this would be beneficial 

it terms of the criteria we have discussed: competitiveness, efficiency, preservation 

of the tax base or and simplicity. 

The typical territorial approach in other countries exempts only dividend income 

from active businesses. Dividends from portfolio investments and all interest and 

69

4For a complete discussion of issues in the implementation of an exemption system, see Michael J. Graetz and Paul W. Oosterhuis, ‘‘Structuring an Exemption System for Foreign Income 

of U.S. Corporations,’’ National Tax Journal, 44, No. 4, December 2001, pp. 771–86. 5See Harry Grubert, ‘‘Enacting Dividend Exemption and Tax Revenue,’’ National Tax Journal, 44, No. 4, December 2001, pp. 811–28. 

royalties are taxed when they are paid, with a foreign tax credit provided for foreign 

taxes paid only on these items of income. In addition, to varying degrees these countries also may have their own anti-deferral regimes that tax certain income earned 

by foreign subsidiaries as it accrues. 

It is only natural that these countries limit the exemption in this way. They are 

concerned about preservation of their tax base and do not wish to provide their companies with inordinate incentives to invest abroad. Exempting foreign source royalties from taxation would make it enormously rewarding for companies to transfer 

intangible assets such as patents, technology and know-how to a foreign subsidiary, 

since the returning royalty could be largely untaxed. Similarly, exempting interest 

receipts from foreign subsidiaries would make it enormously rewarding for companies to push down the income of the subsidiary by financing the subsidiary largely 

with debt, effectively avoiding any tax. 

Given that substantial categories of income would still be taxed on a worldwide 

basis, with a foreign tax credit, and that anti-deferral measures would remain necessary, it is unclear that an exemption system would necessarily be any simpler 

than the current system.4

Perhaps surprisingly, moving to a territorial system along these lines would likely 

increase U.S. tax payments for many companies. This would occur for three reasons. 

First, many companies currently use excess foreign tax credits from highly taxed 

foreign source income to offset U.S. tax on foreign source royalties. Under an exemption system, these companies would continue to pay the same high foreign taxes on 

their operations, but they would no longer be able to shelter their foreign source 

royalties from U.S. tax with foreign tax credits. Second, and similarly, many companies now benefit from the sales source rule—but they only do so because they have 

excess foreign tax credits to offset U.S. tax on the sales income that is treated as 

foreign source under this rule. Under an exemption system there would be no foreign tax credits, so this benefit would disappear. Finally, currently allocations of 

U.S. interest and overhead expenses against foreign source income result in an effective disallowance of these deductions only when a company has overall excess foreign tax credits. Under an exemption system, these allocations would virtually always result in a disallowance of the deduction, since there is no tax on the foreign 

source income and it would be difficult to get many foreign tax authorities to accept 

a deduction against their own tax for expense allocations of this nature. Together, 

these effects are so substantial that Harry Grubert has estimated that substituting 

an exemption system for the current system would actually raise tax revenue.5

Companies that operate predominately in low-tax jurisdictions would be more 

likely to benefit directly from a territorial system, since they are not able under the 

current system to cross-credit to shield their low-tax foreign income from U.S. tax. 

Because of this, there would be increased incentives for companies to shift operations from high-tax to low-tax locations. To the extent this reduces total foreign 

taxes paid, it is a benefit to the United States. On the other hand, to the extent 

that there is a substantial tax-induced shift of investment out of the United States 

to low-tax locations, this would be harmful both in terms of the economic efficiency 

of the allocation of our capital stock and because of erosion of the U.S. tax base. 

The ultimate effects of moving to a territorial system would depend on the specific 

provisions of the system as adopted. Given that there are competing valid policy objectives, and the impacts of moving to such a system would likely vary across companies and industries, it is unclear at this point what such a system might end up 

looking like if it were actually implemented. Therefore we should be cautious about 

comparing the current international tax system to an idealized territorial system.

the witnesses for your testimony. I have got a lot of questions, but 

Chairman MCCRERY. Thank you, Mr. Newlon, and thank all of 

f before I get to any of these specific concerns, it just seems to me, 

listening to this array of witnesses, that pretty well cuts across our 

industrial base, our manufacturing base, and to some extent services, and, Mr. Newlon, it just strikes me that we policymakers and 

those before us maybe, have not done a good job in keeping our Tax 

70

Code modern, current. A lot of these tax rules were written 30, 40 

years ago when things were a lot different in terms of how we 

make a living and the kind of business we do, the kind of products 

we sell, where we sell them. 

So, I don’t know about ripping the Tax Code out by its roots, but 

it seems to me that there is a lot of spade work that needs to be 

done. 

We are the guys to do it. 

So, Mr. Newlon, would you agree with that—that our Tax Code 

is somewhat antiquated in view of the changes that have taken 

place in the market over the last 10, 15, 20 years? 

Mr. NEWLON. I think certainly over time that the Tax Code—

to some extent, I would say we started out with a base that we 

have added to along the way. In adding to that, in some respect 

we lose sight of the overall principles, and we end up with sort of 

a camel that doesn’t get to any of our objectives or maybe doesn’t 

have the appropriate tradeoffs we would want moving forward into 

the future. 

Chairman MCCRERY. The subpart F exceptions and—not the 

exceptions; the subpart F rules were written at a time when we 

manufactured widgets and sold widgets. Now, we have got software. We have got all kinds of services that just don’t seem to fit 

very well under our current subpart F. That is just one example 

where it seems to me we have been asleep at the switch here. 

Mr. REINSCH. That is a good example. I am going to say something that fundamentally agrees with you, Mr. Chairman. 

Globalization, which has been a long-term development, really 

has changed the way that we do business in a lot of significant 

ways. Free flow of capital, free flow of technology, in particular, has 

made it possible for companies to do many things now that they 

couldn’t do before. We used to think of trade as we export, which 

means the good is made here and is shipped over there; or we import, vice versa. Now companies have many different options, as 

you have seen by the comments made here, and the subpart F 

rules, in particular, haven’t kept up. 

At the same time, one of the things that I learned in watching 

our coalition work—and I confess, as will be obvious if you ask me 

any detailed questions, I am a trade person not a tax person, and 

you know there is a big difference. What I learned in watching this 

coalition develop is that there remain in this country a number of 

very significant companies and sectors that are still fundamentally 

exporters. For a variety of reasons, they have not chosen or are not 

able to, or in the case of defense-related companies are not allowed 

to, take significant portions of their activities offshore. 

One of the reasons we developed the proposal the way we did is 

because of our realization that dealing only with subpart F and the 

base rules accommodate the concerns of a number of people who 

have adjusted to the changes reflected. There are a significant 

number of sectors, primarily aerospace and agriculture, that are 

simply not in a position to take advantage of the trends that I have 

been talking about, and those are sectors we ought to worry about 

too. 

Chairman MCCRERY. Well, thank you. Let me get to your proposal since you spoke up. 

71

I have some concerns about some of the particulars with regard 

to WTO compliance, and so I just want to throw a few of these 

things out and give you a chance to respond. I am sure our staff 

will be working with folks from your industry to flesh out some of 

these concerns and get responses more in detail. 

Just to give you some idea of some of the things we are looking 

at—let’s see. Your list for wage credits, for example. How did you 

pick the goods eligible for the wage credit? Why didn’t you include 

all products that are exported, like wood products and so forth? 

How did you pick just that list of goods eligible for the wage credit? 

Mr. REINSCH. Well, I think there are probably two things to say 

about that, Mr. Chairman. One, if we had attempted to focus exclusively on industries that exported, or on exports, we would probably have the same WTO problem that we have run into with ETI. 

So we explicitly couldn’t do that, and had to take a different direction. 

As to why we chose what we chose, I mean, to be quite frank 

about it, we have a coalition, and the members of the coalition put 

together the industry codes that were of interest to them. If other 

people would like to join the coalition, we would be happen to listen 

to them. 

I would point out, there are revenue implications to that one in 

particular. That is another reason why we put in an overall cap. 

Chairman MCCRERY. Thank you. 

Also in your Footnote 59 proposal, there are a number of things 

that you propose—expanded version of the ETI rules to determine 

what is an export transaction, references to an ETI cap, provisions 

permitting a tax-tree transfer of marketing intangibles and election 

to use in the provision, a definition of foreign source income including any goods susceptible to tax and not actually subject to tax. 

Did you all scrub all of these things individually and in terms of 

WTO compliance? It just seems to me that some of those might 

present a problem. 

Mr. REINSCH. Well, if by ‘‘scrub’’ you mean, did we consult with 

the European Commission, no. Did we—yes, in terms of working 

with our own counsel, our trade counsel as well as our tax counsel, 

yes, we did. We believe they are compliant. 

With respect to just one of them, because I don’t want to use up 

all of your time, Mr. Chairman, but the cap that we employ is not 

really related to—we don’t think, in particular, that presents a 

WTO problem. It is an effort to determine the total amount of benefit that would accrue, but it is based on the past amount of the 

tax benefit, not based on exports. It is not based on current company activity, and so we think that it wouldn’t raise a compliance 

problem. 

Our judgment at the end of the day on the Footnote 59 provision 

was that it would be compliant. If you would like, we can present 

you in writing with a longer analysis of that subject. 

Chairman MCCRERY. Sure. 

[The information is being retained in the Committee files.] 

Mr. REINSCH. At the same time, I am constrained to say, Mr. 

Chairman, it is my view from a trade policy standpoint that whatever you ultimately do is likely to be challenged by the European 

Commission regardless of what you or I think is complaint. 

72

Chairman MCCRERY. That may be the case. That is why I want 

to make sure that we scrub all of these provisions and make sure 

that we have the best possible case when it is, or when it might 

be challenged. So, I appreciate your response. 

We would like to see maybe a little more detailed explanation of 

how you think these provisions would be in compliance, and then 

we might take the opportunity later to actually meet with some of 

your folks to go over all of that. 

Mr. REINSCH. We would be glad to provide it. We would be delighted to meet. 

[The information is being retained in the Committee files.] 

Chairman MCCRERY. Thank you. Mr. McNulty. 

Mr. MCNULTY. Thank you, Mr. Chairman. I thank all of the 

witnesses for their testimony. 

Mr. Newlon, in your opinion, how competitive are U.S. companies 

right now, today, internationally? 

Mr. NEWLON. Well, I think obviously that varies from company 

to company. Clearly the U.S. economy and U.S. companies are 

some of the most competitive in the world. Obviously, the U.S. 

economy has been the envy of most of the world, over the last decade at least. 

Mr. MCNULTY. Under a territorial system, who, in your opinion, 

are the winners or the losers? 

Mr. NEWLON. It is a little bit difficult to say until we actually 

have a particular proposal for a specific territorial system. If we 

went to the sort of territorial system that you see in a lot of the 

other OECD countries that have territorial systems, in which an 

exception was provided for active business income, dividends effectively, or branch income, I think that what you might see are companies that currently have excess foreign tax credits from high-tax, 

foreign income, active—that are in our active, the general limitation basket—I don’t want to get too technical here—but also have 

a lot of income coming back in the same basket that doesn’t face 

much foreign tax at all, in particular, royalties, or intercompany interest that might be in that basket. 

Many of those companies are able to shelter that royalty income, 

those deductible payments from abroad, from U.S. tax using the excess foreign tax credits that they get from their operations in hightax foreign locations. That is a big benefit to them. 

There are also benefits in terms of the sales source rule, where 

excess foreign tax credits may shelter U.S. income on exports. 

Those benefits could be lost to those companies if we move to a territorial system. A reasonable, logical territorial system wouldn’t exempt foreign royalties coming back, but you would no longer have 

the excess foreign tax credits to shelter that income from U.S. tax. 

There would also be issues relating to allocations of U.S. expenses against foreign income under a territorial system, and how 

that gets sorted out could affect different companies differently. 

Mr. MCNULTY. Do you see any viable proposals on the table 

right now to replace the ETI? 

Mr. NEWLON. I would have to say, given my testimony that 

what I would really be looking for myself in this area is a broader 

perspective in terms of, if we are looking at the international tax 

rules, going at them there is a lot of scope for reforms that are 

73

clear winners in terms of good tax policy. That is what I would look 

to if we want to use this opportunity to improve our tax rules. 

Mr. MCNULTY. Thank you, Mr. Chairman. 

Chairman MCCRERY. Just following up quickly on the competitiveness issue, you said that during the nineties the U.S. economy 

was the envy of the world, and certainly our manufacturers and so 

forth were very competitive. 

Let’s go back to the seventies. Was the picture the same then, 

late seventies, early eighties? 

Mr. NEWLON. No, it was not at that time. 

Chairman MCCRERY. These things come and go. Some of it is 

due to macroeconomic events that we can’t control here. Some of 

it is due to tax policy. In the early eighties, when we allowed the 

manufacturing sector very liberal expensing rules, they rebuilt, became much more efficient, became competitive with the Japanese, 

and so forth. 

I mean, there are a lot of things that go into this, but I think 

it is incumbent upon us to continually review this and make sure, 

or try to make sure, that the things we can control, like tax policy, 

don’t impede our domestic industries as they try to stay competitive. We can’t just rest on our laurels and say we are good, so we 

will just say that way forever. 

So, I just wanted to throw that in. Mr. Ryan. 

Mr. RYAN. Thank you, Mr. Chairman. 

Mr. Reinsch, I have a question on your subpart F proposal, and 

I just want you to clear up something for me, if you could. Your 

subpart F base company proposal permits base company income 

from exports to be repatriated to the United States tax free, but 

would not allow the same tax-free repatriation for nonexport-based 

company income. 

Why do you distinguish between the two? Don’t you create a 

WTO problem by doing that? 

Mr. REINSCH. Well, as I mentioned to Mr. McCrery, Mr. Ryan, 

I am a trade policy person. 

I would like to ask Ms. LaBrenda Garrett-Nelson to comment on 

that—she was the consultant that developed that piece of our proposal—with your permission. 

Ms. GARRETT-NELSON. That element of what is a conceptual 

proposal is, based on the rationale of Footnote 59, that you can permit an exemption for that type of income. That is why we did not 

believe it would present a WTO compliance problem. 

Mr. RYAN. It changes the tax treatment on exporters vs. nonexporters. So, if a U.S. company is building it here and selling it 

there, they can repatriate the income tax free, but if they build it 

there, sell it there, they get taxed on it? 

Ms. GARRETT-NELSON. That is the correct reading of it. 

Mr. RYAN. You don’t think that that appears to be——

Ms. GARRETT-NELSON. Well, part of the problem, this is why 

Mr. Reinsch was suggesting that we would need to work with the 

Committee and its staff. Part of the problem is that we are dealing 

with language in a WTO opinion that really is dicta, because what 

it had before it was a system that did not fit within the exception, 

but they acknowledged that there is an exception. So there is some 

74

uncertainty; short of the EC blessing a package, there will be uncertainty. 

Mr. RYAN. We are having these discussions because their definition of indirect and direct taxes are different than our definitions, 

and so we are going down this road. I guess we will just talk about 

this later. 

It doesn’t seem to be WTO compliant to me, but maybe I am 

wrong. I would love to learn more about the proposal. 

Ms. GARRETT-NELSON. We would love to share more about it 

with you. 

Mr. RYAN. Thank you. 

Mr. Newlon, I want to ask you a quick question. When you summarized your testimony a minute ago, and correct me if I am 

wrong, you said that it would be better for U.S. competitiveness to 

simply eliminate the ETI, period, and that we would need to go to, 

down the road, fundamental tax reform, making our international 

rules more competitive. 

Is that your testimony? Are you suggesting that ETI only benefits a handful of companies and that if we eliminated ETI, it would 

be make us more competitive, in and of itself? 

Mr. NEWLON. What I would say, I don’t think we need to go to 

a necessarily—to fundamental tax reform to have improvements 

that would help our competitiveness more generally and just represent good tax policy. 

In the international tax area there are lots of things that can be 

done. Simplify the system to eliminate some disadvantages potentially in some areas where we may have had a lot of concerns about 

the location of investment that may have now been overtaken by 

developments in the global economy. 

In terms of the ETI/FSC, obviously it depends on what you do 

with the money that comes out of that. You know, if the money is 

thrown away or used for something that is bad tax policy, we could 

end up worse off. My view is that FSC/ETI isn’t good tax policy in 

itself. So eliminating that, we have the opportunity to do a lot better. 

Mr. RYAN. Something needs to replace it to end the double taxation on the income, correct? 

Mr. NEWLON. I don’t think that there is a double-taxation-ofincome issue necessarily there. I would say there is plenty of opportunity here to replace—if we want to view it in that way, use those 

revenues for things that will help the American economy and help 

the American people, improve the productivity of our economy. 

Mr. RYAN. Okay. Well, I have many follow-ups, but I see my 

time has run out, so I will yield. 

Chairman MCCRERY. Thank you, Mr. Ryan. 

I would tell the Members, if you desire a second round of questioning, we certainly can do that. Mr. Neal. 

Mr. NEAL. Can we get Mr. Hubbard to come back? 

Thank you. I want to agree with Jim McCrery in his comments 

a couple of moments ago about the changes that have taken place 

and what it had done to promote the economic growth of the nineties. I don’t think we should discount deficit reduction and debt reduction either; that had a huge impact on what happened throughout the nineties. 

75

Mr. Reinsch, in your June 11 report you say that you are against 

the territorial tax system. I bet you were surprised at the amount 

of attention given to this subject in the Administration’s testimony 

on the prior panel. 

Is it your understanding that territoriality is one of the options 

that the Treasury Department is seriously considering to replace 

the current system of taxation? 

Mr. REINSCH. We have not thus far believed that that was the 

case. I think that the signals we have gotten from them in our 

meetings with them, and that includes the witnesses that you had, 

were primarily that they intend to work closely with your Committee and would be guided in part by where you all want to go. 

We have not had the sense that they are dying to go down that 

road. 

Mr. NEAL. Fair enough. 

I also noted that Ingersoll-Rand is a member of this study group 

that issued the report. Is the National Foreign Trade Council, representing U.S. multinational businesses, aware that Ingersoll-Rand 

is a Bermuda company, having forsaken U.S. citizenship to avoid 

taxes? 

Mr. REINSCH. They are on our board. Yes, I am aware of it. 

They are—well, let me just stop there. 

Mr. NEAL. You don’t have to. 

Mr. REINSCH. Prudence would dictate. Let me just say they are 

not a member of the FSC/ETI coalition. They did participate in the 

territorial study. 

Mr. NEAL. Thank you. 

Mr. Cowen, the Chairman of the Subcommittee, Mr. McCrery, 

and I, we have worked very hard, we have done it hand in glove 

with the issue of trying to reform subpart F of the Tax Code. So, 

we hear what you are saying. 

In the past years, the industry does not always present, as you 

know, a united front. So let me ask just three specific questions. 

Do you have an idea of the cost to the Treasury Department of 

making a tax change to benefit your industry? 

Mr. COWEN. My understanding is that there is no current estimate available, and we are in the process of providing information 

to the staff so that one can be obtained. 

Mr. NEAL. How many jobs do you estimate would be created for 

American citizens by that tax change? 

Mr. COWEN. Well, of course I would have to make certain assumptions as to the amount of increased activity there would be in 

our business. 

I would only say this. I believe that if we create an opportunity 

for American companies to be competitive in the foreign trades, we 

will see business created here, we will see capital flow in, we will 

see companies based in the United States with shore-side staffs 

and technical expertise. 

We will also see, I believe, a U.S. flag component of that, with 

U.S. jobs, because when the companies are here with that expertise 

and those headquarters, they are going to actually be looking at 

U.S. business the same way that we do today. 

Mr. NEAL. Fair enough. The last part of it, number three, does 

organized labor support the proposal? 

76

Mr. COWEN. We are in discussions with our unions. I am optimistic that they will come along with us, because in the long run, 

OSG has demonstrated, and some of our competitors have demonstrated too, that if you are strong on the foreign side, you can 

also be there on the American side, to do the Jones Act, to build 

the ships we need for the Jones Act trade and the Alaska trade and 

other activities domestically. 

Mr. NEAL. Thank you. 

Chairman MCCRERY. Mr. Cowen, let me follow up. You pointed 

out in your testimony that there have been a number of high-profile transactions in which foreign shippers have bought American 

shippers, and they have become foreign-owned companies. You talk 

about the tax policy that contributes to that. 

Are there other reasons besides tax policy that we have seen so 

many American shippers leave or be bought? 

Mr. COWEN. I think in our case it is really that simple; it is 

driven by tax policy. The normal flow of capital would suggest that 

with the high level of interest in the United States in the movement of oil and movement of bulk commodities worldwide, you 

would expect there to be a flow of capital here into unto that activity. It is simply the fact that the incentives are turned upside 

down, and our foreign competitors have different economics than 

we have, because of the tax law that the United States has in place 

today under subpart F. 

I think that really goes a long way in explaining why we don’t 

see the U.S. companies staying here, but we have seen a lot of companies bought out or move. 

Chairman MCCRERY. Thank you. 

Mr. Kostenbauder, you talked a little bit about the foreign-based 

company sales and services rules and how Hewlett-Packard might 

be affected by those changes. Can you expand upon that a little 

bit—how you might arrange your business activities in Europe, for 

example, differently if those rules were repealed? 

Mr. KOSTENBAUDER. Sure. Let me make a point about the 

general European environment. 

Certainly it is a very big market. We have a lot of very powerful 

competitors, and they are free to organize themselves considering 

tax, as well as their normal business considerations, in a way that 

optimizes their performance. The way our competitors organize 

themselves might focus on lowering taxes, but it could also focus 

on reducing other kinds of costs, concentrating headquarters activities in a particular location, or other considerations. 

Our competitors there have the ability to do that as European 

companies focusing on the European tax environment. A company 

like Hewlett-Packard, which is subject to the subpart F rules, can 

try to maximize its efficiency and organize itself much like our European competitors. Our foreign competitors are often organized in 

a way that the subpart F rules would be applicable if they were 

subject to them, but they are not. So, U.S. companies would never 

be able to achieve the same kind of simplification and reduction of 

costs and tax expense because subpart F puts a 35-percent automatic tax on most such cost reductions. 

I joined HP in 1980, so it is about half the lifetime ago of subpart 

F, and one of the things that happened in my experience with a 

77

company like HP—I think it was very typical of most companies—

was that activity used to be very country-based. 

So, we had a German subsidiary. It basically dealt with the German marketplace, and a French subsidiary dealt with the French 

marketplace. 

Today, as a company, HP is trying to become much more active 

in services. The whole electronics industry, instead of selling people 

computers or software, is trying to sell solutions. So if you think 

about solutions, there is not a German or a British solution, but 

rather there is a solution for the financial services sector, or the 

retail sector, or for manufacturers. So increasingly, we have expertise related to financial institutions that may be headquartered in 

London. 

Well, everybody is using network software, computers, and so 

forth. What is different? Well, the financial services customers really need security. They really need encryption, they need a lot of 

powerful fire walls. 

There may be a concentration in France of employees who have 

an expertise in retail. So you have some concern about security in 

a retail context, but you really want to have all of those cash registers out there collecting all of that point of sale information, on 

a realtime basis putting that in a database. 

Well, our people that sell those things have expertise in those 

different areas, and other kinds of expertise that might relate to 

manufacturing. So today, and as I look at HP’s future, we are going 

to have a lot more of these kinds of market focused activity that 

are going to be headquartered in one country with people traveling 

to other countries. As I mentioned earlier, when services are purchased from one affiliate and delivered in another country, you 

have that combination of a related party transaction and some activity outside of the country of incorporation which triggers subpart 

F foreign base company rules. 

Our European competitors would not need to worry at all about 

the subpart F rules. They also wouldn’t have to worry one little bit 

about the compliance and even the planning for it. When we do 

some of these things, again that European companies can do, based 

upon European considerations, our U.S. tax department has to be 

involved to oversee that and to try to make sure that we are, in 

fact, complying with the requirements of U.S. laws as well. 

Chairman MCCRERY. Mr. Sprague, how about the software 

manufacturers? Would repeal of the base company sales and service rules be beneficial to you? 

Mr. SPRAGUE. Yes, very much so, essentially for the same reasons that Dan mentioned with respect to HP. The software industry also is heading toward business models that involve regionalized locations—software development located in a certain place, 

software support services being provided from a different place, 

along with intangible property being licensed between related entities in order to allow distribution of products. 

When you think about what subpart F addresses, it addresses or 

it impacts any transaction that goes across country borders. So, 

subpart F puts a real burden on any company that tries to centralize functions in one place, but provides value, whether it is 

goods, services, licensing, or whatever, across country borders. 

78

It is still the case that, from a local perspective, you tend to want 

a separate German entity and a separate French entity and a separate Japanese entity for labor law reasons and all sorts of other 

things. When you overlay that separate company or separate country entity regime on top of a globalized and regionalized distribution system, you run into subpart F complications every which way 

from Sunday. 

So, the repeal of foreign base company sales income, and services 

income also, would benefit the software industry. 

The additional point about the need to also reform the rent and 

royalty rules comes from the situation that we have a law that was 

enacted 40 years ago when the software industry just did not exist. 

Today, it is a $150 billion a year industry around the world, with 

business models that just were not within the contemplation of 

Congress when subpart F was enacted. We need to do the right 

thing to bring the law into the 21st century. 

There is one other point I would like to make. The thought was 

inspired by some of Mr. Neal’s questions. 

In subpart F today, there does exist an active trade or business 

test, in the context of rents or royalties, that attempts to distinguish between more active rent and royalty income versus investment-type rent and royalty income. Today that rule has real perverse incentives. It operates today to give incentives to U.S. companies to locate value-added activities overseas in foreign subsidiaries. 

So, what I would like to see happen is that the active rent or royalty rule be revised so that there is not an incentive for U.S. software companies to locate development activity or marketing activity in foreign countries. 

Chairman MCCRERY. Thank you. 

Mr. McLaughlin, you mentioned that Wal-Mart owns a 6-percent 

share of a large Japanese retailer, and you have the right to purchase up to 66 percent of that Japanese retailer. 

To what extent would your decision about expanding your Japanese holdings be affected by how the Congress responds to the 

WTO ruling in the ETI case? 

Mr. PARSONS. Of course, the retail industry does not directly 

use FSC/ETI, as I mentioned in my testimony, but rather it is our 

vendors and suppliers that take advantage of these benefits. To the 

extent that they are not addressed, it would drive up the costs of 

our suppliers, which means it makes us more noncompetitive as we 

try to go in and work in that Japanese market, as we try to introduce U.S. goods. 

Chairman MCCRERY. What would that do to your decision to 

expand your ownership share in the Japanese company? 

Mr. PARSONS. We are in the process at the moment of looking 

at that market and doing those economics to see whether or not we 

will exercise those options to move up to two-thirds. I can only say 

that it will be an economic decision considering all of the factors, 

including taxes. 

Chairman MCCRERY. Mr. Parsons, I understand where you are 

coming from. It is a problem that we have talked about on the 

Committee and among staff. We don’t have a magic wand that we 

can wave and solve problems of compliance with the WTO and conVerDate Jan 31 2003 04:14 Feb 21, 2003 Jkt 084168 PO 00000 Frm 00082 Fmt 6633 Sfmt 6602 E:\HR\OC\84168.XXX 84168
79

tinue to provide the same benefits. So we are looking at other ways 

to assist small manufacturers to try to help. 

One way that we came up with earlier this year was in the stimulus bill for the 30-percent expensing, and also we have looked at 

section 179 expensing. Are you able to take advantage of section 

179 expenses? 

Mr. PARSONS. Yes, we are. 

Chairman MCCRERY. So any increase in that would help you? 

Mr. PARSONS. Yes. 

Chairman MCCRERY. Anything else that you can give us in a 

general way, outside of the export realm, that can be helpful to 

you? 

Mr. PARSONS. Subchapter S tax relief would be greatly appreciated. Even little things like—for a small company, I don’t have 

an international tax department. We depend a lot on sources like 

the National Association of Manufacturers and others. 

Just to—even in collections there are currency risks that I take 

in doing business in countries such as Australia and doing business 

in South America. Just collections sometimes are very difficult, and 

spending 2 years collecting on an account in Peru is not exactly 

how I want to spend my time. 

It is difficult for a small manufacturer to go out and be competitive in areas where we are hit with tariffs going in, and we have 

a higher cost of labor. Yet, we will continue to pound on these doors 

and try to generate that business, because that is where it is at. 

Chairman MCCRERY. You mentioned tariffs, so another way 

that we can be helpful is to work through trade agreements to 

bring down those barriers to your products entering these countries? 

Mr. PARSONS. Absolutely. If we could extend the North American Free Trade Agreement to Chile, for instance, that would be a 

tremendous benefit for us. 

Chairman MCCRERY. Okay. Well, thank you. Again, I want to 

thank all of the witnesses today. I thank Mr. McNulty for his participation today. 

Gentlemen, we will, I am sure, be talking with you again as we 

search for a solution to this problem and the inversion problem. 

Thank you. 

[Whereupon, at 12:55 p.m., the hearing was adjourned.] 

[Submissions for the record follow:]

Statement of the Coalition of Service Industries 

The European Commission (‘‘Commission’’) filed a World Trade Organization 

(‘‘WTO’’) challenge against the Foreign Sales Corporation (‘‘FSC’’) regime in 1997. 

The United States replaced the FSC with the extraterritorial income (or (‘‘ETI’’) regime) in 2000, after the WTO Appellate Body ruled that the FSC was a prohibited 

export subsidy. On January 14, 2002, the WTO Appellate Body issued a final report 

finding that the ETI regime also violates WTO agreements to which the United 

States is a party. The June 13, 2002 hearing was held to explore ‘‘making changes 

to the Tax Code to promote the international competitiveness of U.S. companies,’’ 

as a possible response to the WTO’s ruling. 

CSI welcomes the opportunity to submit its comments for the record of the June 

13, 2002 hearing. CSI’s members represent a broad range of service sectors, including financial services, transportation services, accounting, legal, and other professional services as well as telecommunications, energy, and information technology. 

CSI members entered into cross-border leasing transactions that utilized the foreign 

sales corporation (‘‘FSC’’) or the ETI tax rules. 

80

1For example, the ‘‘Reasons For Change’’ in the Report of the House Committee on Ways and 

Means, H.R. Rep. No. 106–845, 106th Cong., 2d. Sess., includes the following statement: ‘‘The 

Committee strongly believes that the substantial modification to the U.S. tax law provided in 

this bill is WTO compliant.’’ See also S. Rep. No. 106–416, 106th Cong., 2d Sess. page 5, regarding the statement that the ETI ‘‘legislation addresses both the broader issue of U.S. taxation 

of income derived from foreign sales, i.e., ‘‘extraterritorial income,’’ as well as complying with 

the WTO rulings.’’ 2See United States—Tax Treatment for ‘‘Foreign Sales Corporations, Appellant Submission of 

the United States, (November 1, 2002) paragraph. 67. 3 United States—Tax Treatment for ‘‘Foreign Sales Corporations, Appellant Submission of the 

United States, (November 1, 2002) paragraph. 262. 

Introduction

Before enactment of the ETI regime, a taxpayer could utilize a FSC to facilitate 

exports by entering into leasing transactions, particularly long-term leases of heavy 

equipment, U.S.-manufactured airplanes, rolling stock, etc. Consistent with the general practice of the Congress, the ETI Act included grandfather provisions to cover 

such cases. Grave economic harm would result to U.S. exporters and U.S. financing 

companies that entered into these transactions if the grandfather provisions enacted 

in 2000 as part of ETI are not continued in any future legislation. Taxpayers should 

be able to proceed on the assumption that the transition rules for leasing transactions involving a FSC will be continued. 

Similarly, if the Congress determines that ETI should be replaced, equivalent 

transition relief should be extended to leasing transactions that qualified under ETI. 

The taxpayers in these ETI transactions priced their leases in reliance on the assessment of the Congress—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.1 A similar analysis applies to taxpayers who entered into long-term 

FSC leases containing lessee options which, while not binding on the lessor, were 

also priced in reliance on FSC benefits should the options be exercised by the lessee 

and accepted by the lessor—these FSC leases and options are today eligible for tax 

benefits under the ETI regime. Similar to the applicable legislative history, the Administration’s ‘‘Appellant Submission’’ to the WTO argued that the ETI regime was 

drafted to comply with the applicable WTO agreements.2 The Congress should seek 

to ensure the provision of transition relief that will fairly treat taxpayers who have 

detrimentally relied on the U.S. Government’s assessment regarding the validity of 

current law. 

The Congress should make clear that the Administration would be expected to negotiate with the Commission and insist on the Commission’s acceptance of prospective effective dates and reasonable transition rules in any legislative response to the 

WTO FSC–ETI dispute. This is particularly appropriate in view of the fact the 

United States is in the position of considering amendments to its tax law because 

of a ruling handed down by an international body—not because U.S. lawmakers determined that a policy change was in order. Indeed, as the Administration observed 

in its Appellant Submission to the WTO, ‘‘in requiring a sovereign country to subject 

its taxpayers to such a shift, the WTO rules cannot have been intended to further 

require that the country deny its taxpayers the right to an orderly shift through 

transition relief consistent with it practice.’’ 3

The FSC Transition Rules Honor Binding Contracts Entered into by FSCs 

or Related Parties before the Enactment of ETI

The United States’ repeal of the FSC was required to ‘‘have effect from October 

1, 2000.’’ Many affected leases are long-term in nature, some with terms as long as 

20 years. The repeal of the FSC transition rules would wreck the economics of an 

existing lease that was priced by taking into account the FSC benefit to the lessor 

or its affiliate (resulting in lower rentals). 

The repeal of the FSC provisions was a fundamental change in tax policy, and—

as such—should not apply on a mandatory basis to contracts that were entered into 

before the date of enactment. Any other treatment could result in an unwarranted 

retroactive tax increase and be totally inconsistent with past Congressional practice. 

Transition Rules Included in the ETI Act Preserved the Benefits of the FSC 

Regime for Leasing Transactions

In considering the transition from the FSC rules to the ETI regime, the Congress 

recognized the need for a general transition rule that took account of existing leasing contracts. For FSCs that were in existence on September 30, 2000, and at all 

times thereafter, the amendments made by the ETI Act did not apply to any transaction in the ordinary course of trade or business involving the FSC that occurred—

(a) Before January 1, 2002, or 

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4 United States—Tax Treatment for ‘‘Foreign Sales Corporations, Appellant Submission of the 

United States, (November 1, 2002) paragraph. 265. 5See page 76 of the General Explanation of the Revenue Provisions of the Deficit Reduction 

Act of 1984, prepared by the staff of the Joint Committee on Taxation (December 31, 1984). 

(b) After December 31, 2001, pursuant to a binding contract that—

(1) Is between the FSC (or any related person) and any person that is not 

a related person, and 

(2) Is in effect on September 30, 2000, and at all times thereafter.

For purposes of this general transition rule, a binding contract included a purchase option, renewal option, or replacement option that was included in such contract and which was enforceable against the seller or lessor. Thus, transition relief 

was provided to preserve the benefits of the current FSC regime for: The remaining 

term of existing leases; The term of a new lease entered into pursuant to a renewal 

option; The term of a replacement lease entered into pursuant to a replacement option; The sale of property pursuant to a purchase option; and other lease options 

that would have been eligible for FSC benefits. 

The WTO’s View of the Transition Rules is Simply Unacceptable

The United States must weigh the WTO Appellate Body’s ruling—that ‘‘a member’s obligation to withdraw prohibited export subsidies . . . cannot be affected by 

contractual obligations which private parties may have assumed inter se in reliance 

on laws conferring prohibited export subsidies,’’ (¶ 230 of the AB Report)—against 

the fundamental unfairness inherent in significant tax law changes that have an adverse economic impact on taxpayers who relied on their government’s assessment 

of current law to their detriment. 

As the Administration pointed out in its Appellant Submission to the WTO, ‘‘without such transition rules, taxpayers lose confidence that the tax treatment they expect will in fact prevail. The absence of such certainty affects the ability of taxpayers to plan for their businesses, either in the long term or even in the short 

term. Failure to maintain a consistent practice of transition relief would result in 

significant and inefficient transaction costs as taxpayers are required to factor in 

the risk of tax changes into their transactional planning.’’ 4

U.S. practice in the development of tax law changes is to accommodate contracts 

that relied on the law as it existed when the contract was made. Thus, while it probably will be necessary to seek the Commission’s agreement to continue the FSC 

transition rules and provide similar rules for ETI transactions, we believe the Administration should strive to respect congressional precedents and the contractual 

obligations of the parties who entered into leasing transactions. Any other treatment would result in an unwarranted retroactive tax increase and be totally inconsistent with past Congressional practice. 

In the Interests of Fairness and Equity, The United States Should Not 

Abandon It’s Long-standing Practice of Promulgating Transition Rules 

When Repealing Significant Tax Legislation

The United States rarely enacts retroactive tax provisions. Generally, retroactivity 

is reserved for situations where affected transactions are viewed as ‘‘abusive’’ and

some significant Congressional action has already occurred by the effective date. 

The FSC transition rules were enacted because the ETI Act effected a fundamental change in the treatment of foreign sales transactions. The United States 

generally provides transition rules when taxpayers can demonstrate that they had 

already taken steps in reliance on existing law on or before the date on which a 

proposed change is effective. There are numerous precedents for providing transition 

rules on the basis of a binding contract, even if subject to a condition if the condition 

is not within the control of the affected taxpayer. Note that even tax treaties typically have one-year transition provisions under which you can continue to apply the 

old treaty if you choose. 

There is also ample precedent for providing specific grandfather rules for leasing 

transactions, mainly in the context of legislation affecting capital cost recovery provisions. For example, the effective date of the 1984 Tax-exempt Leasing rules 5 was 

for property ‘‘placed in service’’ after the relevant date, thus excluding property already under lease. Also under a provision in the 1984 legislation that applied the 

effective date to property leased after the relevant date, a lease was ‘‘not treated 

as entered into or renewed . . . merely by reason of the exercise of the lessee of a 

written option’’ that was enforceable against the lessor on the effective date and at 

all times thereafter. 

82

Conclusion

As noted above, U.S. financing companies and other parties to leasing transactions fully acknowledge that the WTO decision found fault with the FSC transition rules, and the WTO maintained that these transition rules should be withdrawn. Nevertheless, we believe the United States should protect U.S. taxpayers 

who relied on U.S. law and regulations from retroactive changes in this area after 

the tax benefits have already been irrevocably factored into the economics of leases. 

We urge the Congress and the Administration to include appropriate transition 

rules in any legislation that moves forward to otherwise repeal the ETI statute. We 

also pledge to work vigorously with this Committee and the Administration to help 

obtain the Commission’s support for continuing these transition rules as part of any 

final resolution of the FSC/ETI matter.

The Equipment Leasing Association (ELA) is submitting this statement for the 

Statement of the Equipment Leasing Association, Arlington, Virginia 

f record to express our views on the need for Congress to retain the FSC leasing transition rules in any FSC/ETI legislation enacted by Congress, and to protect lease 

transactions done pursuant to the Extraterritorial Income Act. ELA has over 800 

member companies throughout the United States who provide financing for all types 

of businesses in all types of markets. Large ticket leasing includes the financing of 

transportation equipment such as aircraft, rail cars and vessels. Middle market lessors finance high-tech equipment including mainframe computers and PC networks, 

as well as medical equipment such as MRIs (magnetic resonance imaging) and CT 

(computed tomography) systems. Lessors in the small ticket arena provide financing 

for equipment essential to virtually all businesses such as phone systems, pagers, 

copiers, scanners and fax machines. 

Prior to the enactment of the Extraterritorial Income Regime, U.S. leasing companies were able to facilitate the financing of exports by utilizing a foreign sales corporation (FSC). At the time a FSC transaction was closed, both the lessor and lessee 

relied upon the law in existence at the time of the transaction in pricing the lease. 

When Congress enacted the ETI Act, it correctly included grandfather provisions. 

It is imperative that leasing companies which entered into FSC/ETI transactions be 

able to proceed on the assumption that the transition rules for FSC leasing transactions will be continued in any future legislation. The failure to grandfather FSC 

and ETI leasing transactions will have grievous consequences for both U.S. exporters and leasing companies which relied on the tax regimes in existence at the time 

they entered into the transactions, as by their nature, these types of leasing transactions are long-term and take numerous years to complete. 

Our position that existing FSC and ETI lease transactions be grandfathered is 

consistent with the approach Congress took in considering the original transition 

from the FSC rules to the ETI regime, wherein Congress provided a general transition rule taking into account existing lease contracts. Pursuant to the general transition rule adopted by Congress, a binding contract included a purchase option, renewal option, or replacement option that was included in such contract and which 

was enforceable against the seller or lessor. Thus, transition relief was provided to 

preserve the benefits of the current FSC regime for: the remaining term of existing 

leases; the term of a new lease entered into pursuant to a renewal option; the term 

of a replacement lease entered into pursuant to a replacement option; the sale of 

property pursuant to a purchase option; and other lease options that would have 

been eligible for FSC benefits. 

It is common practice for Congress to provide transition rules in situations where 

taxpayers can show that they relied on existing law when entering into a binding 

contract on or before the date on which a proposed change may become effective. 

Therefore, we strongly urge the U.S. Government to protect and defend U.S. taxpayers who entered into binding contracts and priced those transactions based on 

existing U.S. law as Congress moves forward in addressing the FSC/ETI replacement issue.

Statement of the Leasing Coalition

f I. INTRODUCTION

The Leasing Coalition, a group of U.S. businesses operating in the global leasing 

marketplace, appreciates the opportunity to present this written statement to the 

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1 U.S. Department of Commerce. 

2 Equipment Leasing Association. 

3 Equipment Leasing Association. 

4 I.R.C. section 168(g). 

5 I.R.C. section 168(h). 

6 ‘‘Long Live le Leveraged Lease,’’ Asset Finance, July/August 2001. 

Select Revenue Measures Subcommittee in conjunction with its June 13, 2002, hearing on proposals to modify the Tax Code to promote the competitiveness of U.S. companies. 

In these comments, the Leasing Coalition discusses the significant competitive 

disadvantage created for the U.S. leasing industry by the so-called ‘‘Pickle’’ rules 

under present law. We urge the Congress, as part of its examination our international tax rules, to repeal the limitations on depreciation under these rules for 

equipment leased by U.S. taxpayers to foreign parties. These rules are a specific detriment to U.S. exports. Repealing them is one of the few changes that Congress can 

make in the tax area that would benefit U.S. exports and still comply fully with 

our obligations under the World Trade Organization.

II. IMPORTANCE OF THE LEASING INDUSTRY

The leasing industry is important to the American economy. U.S. manufacturers 

use leasing as a means to provide financing for exports of their goods in overseas 

markets, and many have leasing subsidiaries that arrange for such financing. Many 

U.S. financial companies also arrange for lease financing as one of their core financial intermediation services. Ultimately, the activities of these companies support 

U.S. jobs and investment. 

To put the size of the leasing industry into perspective, it has been estimated that 

approximately 30 percent of all equipment investment is financed through leasing 

rather than outright acquisition.1 Approximately 80 percent of U.S. companies lease 

some or all of their equipment.2 Currently, more than 2,000 companies act as equipment lessors, and equipment leasing is estimated to be a $240–280 billion industry.3

Leasing also promotes exports of U.S. equipment, and thus helps U.S. companies 

compete in the global economy. Many lease transactions undertaken by U.S. lessors 

are cross-border leases, i.e., leases of equipment to foreign users. These involve all 

types of equipment, including tankers, railroad cars, machine tools, computers, copy 

machines, printing presses, aircraft, mining and oil drilling equipment, and turbines 

and generators. Many of these leases are supported in one form or another by the 

Export-Import Bank of the United States, which insures the credit of foreign lessees.

III. ADVERSE IMPACT OF THE ‘‘PICKLE’’ RULES

The Deficit Reduction Act of 1984 enacted the ‘‘Pickle’’ rules (named after one of 

the sponsors of the provision, then-Representative J.J. Pickle), which reduce the tax 

benefits of depreciation in the case of property leased to a tax-exempt entity. The 

Pickle rules generally provide that, in the case of any ‘‘tax-exempt use property’’ 

subject to a lease, the lessor is entitled to depreciate the property using the straightline method and a recovery period of no less than 125 percent of the lease term.4

Tax-exempt use property, for this purpose, generally is tangible property leased to 

a tax-exempt entity, which is defined to include any foreign person or entity.5

The present-law Pickle rules place the American leasing industry and U.S. products at a severe competitive disadvantage in overseas markets. Because of the adverse impact of the Pickle rules on cost recovery, U.S. lessors are unable in many 

cases to offer U.S.-manufactured equipment to overseas customers on terms that are 

competitive with those offered by foreign counterparts. Many European countries, 

for example, provide favorable lease rules for home-country lessors leasing equipment manufactured in the home country. In France, for example, government approval of leveraged leases is contingent on the investment providing an economic 

and social benefit for France.6

There is no compelling tax policy rationale for maintaining the Pickle rules as 

they apply to export leases. The Pickle rules were enacted in part to address situations where the economic benefit of accelerated depreciation and the investment tax 

credit were indirectly transferred to foreign entities not subject to U.S. tax through 

reduced rentals under a lease. That rationale no longer applies. The investment tax 

credit was repealed in 1986, and property used outside the United States generally 

is no longer eligible for accelerated depreciation.

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IV. REFORMS NEEDED TO STRENGTHEN COMPETITIVENESS OF U.S.

LEASING INDUSTRY

The global leasing markets have greatly expanded since 1984. The competitive 

pressures on U.S. businesses from their foreign counterparts also have increased 

dramatically. Repealing the Pickle rules as they apply to leases to foreign parties, 

as has been proposed by Subcommittee Chairman Jim McCrery (R–LA) in H.R. 1493 

and by Ways and Means Committee Member Bob Matsui (D–CA) in H.R. 1492, will 

strengthen the competitiveness of the U.S. leasing industry and promote U.S. jobs 

and investment. 

The World Trade Organization’s rulings against the foreign sales corporation 

(‘‘FSC’’) and extraterritorial income (‘‘ETI’’) regimes have only bolstered the rationale for repeal of the Pickle rules as they apply to export leases. On balance, U.S. 

exports are likely to be harmed by legislation that replaces the ETI rules with provisions that do not confer a specific export subsidy. While the Pickle repeal bills discussed above would benefit U.S. exports, they could not be read to provide a prohibited subsidy. Rather, they simply would remove a blatant disadvantage for export 

leases under U.S. law compared to domestic leases. Surely, removing overt currentlaw tax burdens on U.S. exports would be an advisable course of action in response 

to the WTO’s rulings.

Aubrey A. Rothrock III, Partner, Patton Boggs LLP 

Statement of Donald V. Moorehead, Partner, and

f This statement is submitted for inclusion in the record of the hearings held by 

the Subcommittee on Select Revenue Measures on June 13, 2002 concerning possible changes to the Internal Revenue Code of 1986, as amended (the ‘‘Code’’), in 

light of the recent decision of the World Trade Organization (the ‘‘WTO’’) with respect to the extraterritorial income provisions of the Code. We understand that, in 

fashioning a legislative response to the WTO decision, consideration may be given 

to making numerous changes to the provisions of the Code governing the taxation 

of income earned by U.S.-based businesses from their international operations. In 

this statement, we describe two proposals that should be included as part of such 

a legislative package.

Passive Income Attributable to Assets Held to Match CFC Pension Liabilities

In the United States and many foreign countries, employers may establish pension plans for their employees and fund those plans through annual contributions 

to a separate trust or its equivalent. Employees and their beneficiaries generally are 

taxed only when the benefits are paid to them. In some countries such as Germany, 

however, the use of a trust or similar funding mechanism would result in the imposition of tax on the employees prior to the commencement of distributions to them 

upon retirement. 

Under German law, if an employer creates a pension plan for its employees, it 

is required by law to establish a reserve on its balance sheet to reflect liabilities 

under the plan and to make annual additions to the reserve to reflect the discounted 

present value of its future obligations under the plan. Although the basic benefits 

provided under the plan are insured, the insurance is payable only if the employer 

is unable to pay the benefits as they fall due. Employers may not formally fund 

these plans, through an irrevocable trust or similar arrangement without adverse 

tax consequences to their employees. 

In some instances, both as a matter of financial prudence and to foster good working relationships with their employees, an employer may seek to ‘‘match’’ its pension 

obligations (and offset its balance sheet liability) through the purchase of investment assets. German law implicitly encourages such practices by providing special 

tax treatment for certain types of investments. 

When the employer is a controlled foreign corporation (a ‘‘CFC’’), the purchase of 

assets to match pension obligations can create adverse U.S. tax consequences. Specifically, the passive income generated by such investments will be treated as foreign base company income under the subpart F provisions of the Code and thus, 

unless it is de minimis in amount, will taxed to the U.S. shareholders of the CFC 

(e.g., the U.S. parent corporation) in the year earned by the CFC. Moreover, that 

income will be allocated to the ‘‘passive’’ basket for purposes of computing the foreign tax credit limitation, even though it is incidental to the active business operations of the CFC. 

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We believe this is an inappropriate result as a matter of policy. The investment 

of earnings to fund retirement plans has long been recognized as desirable from a 

public policy standpoint and Congress itself has sought to provide relief in most instances through section 404A of the Code. Where, however, the host country does 

not permit the use of a trust or other similar arrangement without adverse tax consequences to employees, section 404A provides no relief if assets are acquired to 

‘‘match’’ the liability represented by the pension reserve. 

We recommend that, in the case of a CFC engaged in the active conduct of a trade 

or business, income attributable to investment assets purchased to match pension 

reserves should be placed in the same foreign tax credit ‘‘basket’’ as the income attributable to the CFC’s active business operations. We also recommend that such 

income be excluded from the definition of foreign base company income and thus 

not taxed to the U.S. shareholders of the CFC unless and until distributed to them 

as a dividend or invested in U.S. property.

Foreign Tax Credit ‘‘Stacking’’ Rules

Because U.S. businesses are taxed on their worldwide income, the income they 

earn from international operations is potentially subject to double taxation: once by 

the foreign country in which it is earned and a second time by the U.S. Depending 

upon the character of such income and whether it is earned directly by the U.S. 

business or indirectly through a CFC, the U.S. tax on foreign source income will be 

payable either in the year it is earned or deferred until the income is distributed 

as a dividend to the U.S. shareholders or invested in U.S. property. 

The foreign tax credit provisions of the Code are intended to reduce the actual 

incidence of such double taxation and the effectiveness with which this objective is 

achieved is critical to the competitive position of American businesses in the world’s 

markets. By reason of the operation of certain of these foreign tax credit provisions, 

a U.S. corporation may in fact be unable to claim credits on a current basis for all 

of the foreign taxes paid with respect to the foreign source income included in its 

U.S. tax return. This is true even where the applicable foreign tax rates are less 

than the U.S. corporate rate of 35 percent. 

In such situations, the excess credits may be carried back to the two preceding 

taxable years and then forward to the succeeding five taxable years. If they cannot 

be used during this carryover period, they expire. Under current law, however, excess credits that are carried over to another taxable year may in fact be used only 

after the credits used in that taxable year have been fully utilized. This stacking 

rule thus increases the likelihood that otherwise valid credits for foreign taxes actually paid on foreign source income that is subject to U.S. tax will not be used and 

expire. 

We believe this is inappropriate as a matter of policy. Credits for foreign taxes 

actually paid on income that is subject to U.S. tax should in our view be permitted 

to be used at the earliest possible date and the Code should be structured so that 

expiration is only a remote possibility. This is particularly true since many U.S. corporations are in ‘‘excess credit’’ positions largely because of provisions of the Code 

that reduce foreign source income artificially (e.g., the over allocation of interest expense to foreign source income) or otherwise make it difficult to use credits in the 

first year they are available (e.g., the allocation of types of foreign source income 

to different ‘‘baskets’’ and the prohibition on the use of credits earned with respect 

to income in one basket to offset the U.S. tax on income in another basket). 

For these reasons, we recommend that section 904(c) of the Code be amended to 

provide that, with respect to any taxable year, foreign tax credits would be applied 

in the following order: (1) credits carried forward to that year; (2) credits earned 

in that year; and (3) credits carried back to that taxable year. This approach was 

taken in prior proposed bipartisan international tax simplification legislation and, 

is we believe, a more direct solution to the problem than that contained in H.R. 

4541. The proposed change would enable the foreign tax credit to achieve its objective more effectively and would reduce the incentive now inherent in section 904(c) 

for taxpayers to engage in transactions principally to enable them to use foreign tax 

credits that might otherwise expire.

Æ