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FOUNDATION OF INTERNATIONAL TAX REFORM:

WORLDWIDE, TERRITORIAL, AND

SOMETHING IN BETWEEN

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

SECOND SESSION

JUNE 26, 2008

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

MAX BAUCUS, Montana, Chairman

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

DEBBIE STABENOW, Michigan

MARIA CANTWELL, Washington

KEN SALAZAR, Colorado

CHUCK GRASSLEY, Iowa

ORRIN G. HATCH, Utah

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

PAT ROBERTS, Kansas

JOHN ENSIGN, Nevada

JOHN E. SUNUNU, New Hampshire

RUSSELL SULLIVAN, Staff Director

KOLAN DAVIS, Republican Staff Director and Chief Counsel

(II)

C O N T E N T S

OPENING STATEMENTS

Page

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

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

Grassley, Hon. Chuck, a U.S. Senator from Iowa ................................................. 9

WITNESSES

Hines, James R., Jr., professor, University of Michigan Law School, Ann

Arbor, MI .............................................................................................................. 3

Shay, Stephen E., partner, Ropes and Gray, Boston, MA .................................... 5

Dilworth, Robert H., partner, McDermott, Will, and Emery LLP, Washington,

DC .......................................................................................................................... 6

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

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

Bunning, Hon. Jim:

Prepared statement .......................................................................................... 27

Dilworth, Robert H.:

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

Prepared statement .......................................................................................... 28

Grassley, Hon. Chuck:

Opening statement ........................................................................................... 9

Hines, James R., Jr.:

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

Prepared statement .......................................................................................... 61

Kerry, Hon. John:

Prepared statement .......................................................................................... 76

Shay, Stephen E.:

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

Prepared statement .......................................................................................... 77

COMMUNICATIONS

3M Company ............................................................................................................ 97

Treasury Department, Office of Public Affairs ...................................................... 103

Voinovich, Hon. George V. ...................................................................................... 109

(III)

(1)

FOUNDATION OF INTERNATIONAL TAX

REFORM: WORLDWIDE, TERRITORIAL,

AND SOMETHING IN BETWEEN

THURSDAY, JUNE 26, 2008

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10:02 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Conrad, Bingaman, Wyden, Stabenow, Grassley, and Bunning.

Also present: Democratic Staff: Bill Dauster, Deputy Staff Director and General Counsel; Josh Odintz, Tax Counsel; and Cathy

Koch, Senior Advisor, Tax and Economics. Republican Staff: Mark

Prater, Deputy Chief of Staff and Chief Tax Counsel; Ellen McCarthy, Tax Counsel; and Nick Wyatt, Tax Staff Assistant.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The hearing will come to order.

The Italian Renaissance historian Francesco Guicciardini said,

‘‘Industries . . . are at their best before . . . people recognize how

profitable they are. As soon as that happens, they decline, for

strong competition makes them less profitable. Thus, in all matters, it is wise to get up very early.’’

Today we will discuss international tax competition. We will try

to assess whether we are at our best—or whether strong competition is making us less profitable. Either way, we may find it wise

to get to tax reform very early.

Tax competition happens when countries compete with each

other about how much they tax multinational businesses.

To understand this competition, we need to explore how America

taxes the foreign income of U.S.-based multinational businesses

now. And we need to explore the various ways that America could

tax that income in the future.

At the extremes, there are two ways to tax foreign income of

these businesses. The first is to tax all the activities of the businesses no matter where they take place. This is called ‘‘worldwide

taxation.’’ A worldwide system avoids double taxation by allowing

a business to take a credit against U.S. taxes in the amount of foreign taxes paid overseas. The second way to tax multinational businesses is for a country to tax only income derived within its borVerDate 11-MAY-2000 15:36 Aug 20, 2010 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 57821.000 TIMD PsN: TIMD
2

* For more information, see also, ‘‘Economic Efficiency and Structural Analyses of Alternative

U.S. Tax Policies for Foreign Direct Investment,’’ Joint Committee on Taxation staff report, June

25, 2008 (JCX–55–08), http://www.jct.gov/publications.html?func=startdown&id=1284.

ders. This is called ‘‘territorial taxation.’’ In a territorial tax system, a country taxes this income whether the taxpayer is a resident or not.

In a territorial system, any entity earning income in the resident

country will owe tax on that income. And, if the entity earns income outside the resident country, then the entity won’t owe the

tax.

Our system is somewhere in between. America’s system is partly

worldwide and partly territorial. In 1962, Congress enacted subpart

F of the Internal Revenue Code. Subpart F applies when an American company runs an active business in a foreign country. Subpart

F allows the company to defer paying tax on the foreign income

until it repatriates the foreign income back to America.

Subpart F generally does not allow deferral, however, for passive

income. Passive income includes rents, royalties, and interest. This

income is mobile. With the aid of the Internet, it can move quickly

from one country to another.

Critics of subpart F argue that much has changed since 1962. In

1962, America was a net exporter of capital; now we are a net importer of capital. In 1962, manufacturing dominated America’s

economy. Now our economy is quite diverse. Intellectual property

is our most important export. After 46 years, it’s time to consider

whether subpart F still functions properly. It’s time to consider

whether we need to make minor tune-ups to subpart F or start

anew.

Congress and the new President will need to work together to ensure that the Internal Revenue Code will collect the revenue that

we will need. And at the same time, we will need to ensure that

American businesses are able to compete in the global economy.

Other countries are also considering changing how they tax foreign income. The United Kingdom and Japan are looking to modify

territorial tax systems. The European Union may consider changes

for business activities within the EU. Clearly, we need to keep this

competition in mind.

American businesses are competing for capital. They are competing for jobs. Let’s try to be at our best. Let’s ensure that strong

competition does not make us less profitable. And let us act wisely

and get to tax reform very early.*

Now I would like to introduce the panel. The first witness is Dr.

James Hines. He is the Musgrave collegiate professor of economics

at the University of Michigan. Welcome, Prof. Hines.

The second witness is Stephen Shay, a tax partner in the Boston

office of Ropes and Gray. Mr. Shay was the co-chairman of the

American Bar Association’s Tax Force on International Tax Reform.

Finally, we have Robert Dilworth, who is a tax partner in the

Washington, DC office of McDermott, Will, and Emery. Mr.

Dilworth was a Senior Advisor to the Assistant Treasury Secretary

for Tax Policy from 2005 to 2007.

3

Dr. Roseann Altschuler was scheduled to testify this morning.

Unfortunately, she was unable to appear due to a death in the family. We send our deep condolences to her and to her family.

But thank the rest of you for coming. As is our regular practice,

your prepared statements will be included in the record, and I

would ask you to speak about 5 minutes.

Prof. Hines, it is all yours.

STATEMENT OF JAMES R. HINES, JR., PROFESSOR,

UNIVERSITY OF MICHIGAN LAW SCHOOL, ANN ARBOR, MI

Prof. HINES. Thank you, Mr. Chairman and members of the committee. It is a pleasure to be here this morning.

We are here to discuss the taxation of foreign income, but with

your indulgence I would like us all to think for a minute about our

system of excise taxation. The Federal Government has excise

taxes on gasoline, alcohol, tobacco, firearms, things like that, and

they are all imposed on a territorial basis, meaning that our gasoline tax applies if an American company sells gasoline in the

United States but it does not apply if an American company sells

gasoline abroad.

That is the way excise taxes are administered all throughout the

world, and that is the right way to have excise taxes. But you could

convince yourself, maybe if you thought about it, that this is a bad

system of just having territorial excise taxes. The reason is that

there are some countries with much lower excise taxes than the

United States and maybe that difference between their excise tax

rates and ours gives American companies an incentive to do extra

business in those places relative to the United States. As a result,

there is more foreign employment and less domestic employment,

you might think.

This reasoning would not be good reasoning, but it is superficially appealing. So you could imagine someone coming before this

committee and saying, we should have a worldwide system of stiff

excise taxation. What would happen if we actually enacted laws

saying that an American-based company has to pay U.S. excise

taxes on its sales of alcohol, tobacco, or whatever around the world?

Well, it is pretty clear what would happen. A lot of American companies would be in a position where they would wind up selling off

their foreign operations to companies from other countries.

Take the case of gasoline. If Exxon-Mobil has to pay U.S. excise

taxes on its gas sales in Mexico, what it would do is sell off some

of its Mexican gas stations to British Petroleum, which is not subject to a regime like that. Would that be good for the United States

if that happened? No, it would not be good for the United States

because all you are doing is impairing the ability of Exxon-Mobil

and other U.S. companies to earn profits. As a result, they become

less productive in the United States, and it is not good for anyone

here if we were to have such a thing. That is why we do not have

it.

All right. That is the excise tax world, and we are very comfortable with a territorial system of excise taxes because we do not

want to create the incentives for American firms to have to sell off

their operations to companies from other countries.

4

But here is the thing: exactly the same process works with income taxes. It is not actually any different. As a result of our system of income taxation that does impose U.S. taxes on worldwide

profits, especially in low-tax foreign countries, American companies

have incentives to sell off their business operations or never get

them in the first place, in other parts of the world. It is just exactly

the same process as if we had worldwide excise taxes, it is just

slightly subtler in the case of income taxes so it is not as upsetting

as it would be if we were actually to think about doing this with

excise taxes.

Furthermore, of course, neither the United States, nor any other

country in the world, has a worldwide system of excise taxation.

With income taxes, there is a dwindling number, as the chairman

pointed out, of countries with worldwide income tax systems, too.

The United States really stands alone now in having a largely

worldwide system where we restrict the ability of American firms

to claim foreign tax credits, we restrict their ability to defer U.S.

tax on their foreign-source income, and as a result, we discourage

American firms from conducting profitable business opportunities

abroad.

The consequence of that is that it lowers their productivity in

general, and in particular in the United States. Because of that,

the demand for labor is less than it would be in the United States,

and as a result there are fewer jobs, and the jobs that we have

offer lower wages.

If you reduce the productivity of American-based companies, the

impact is largely felt in the United States among the factors that

are residents of the United States, primarily labor. So when we

think about worldwide income taxation, I urge us to think of it as

equivalent to worldwide excise taxation with all the dire consequences that are associated with that.

Now, what is the solution to this problem? The solution is to

have a tax system that is more like countries in the rest of the

world. In other words, not to move in the direction of stiffer U.S.

taxation of foreign income, but the other way, to think about a territorial system or at least move in the direction of a territorial system of taxation.

The consequence of that would be felt mostly by American labor

in the form of higher wages. Would we have to worry about loss

of American tax base? It is the other way around. If you have a

strong economy and a strong business sector, that is where you get

American tax base. So for all of those reasons, I urge the committee

to think about moving more in the direction of a territorial tax system.

The CHAIRMAN. Thank you, Prof. Hines, very much.

[The prepared statement of Prof. Hines appears in the appendix.]

The CHAIRMAN. Mr. Shay?

5

STATEMENT OF STEPHEN E. SHAY, PARTNER,

ROPES AND GRAY, BOSTON, MA

Mr. SHAY. Thank you, Mr. Chairman, and members of the committee.

I want to emphasize that the views I am expressing are my personal views and do not represent the views of either my law firm,

its clients, or the American Bar Association.

With the chairman’s permission, my written remarks have been

submitted for the record.

The primary focus of U.S. income tax policy, including the policy

regarding taxation of international business, should be how to fulfill the revenue needs of the government and their budgets passed

by this Congress in a manner that improves the lives and living

standards of U.S. citizens. We traditionally look at three criteria

when we evaluate any income tax proposal. They are: fairness, efficiency, and administrability.

Jim has just made comments that respect the view about efficiency, as to which I think there are differing views. My focus

today is really somewhat different. It is that of a practitioner who

practices international tax law every day. Our international tax

rules today are broken. Significant defects of the current international tax regime include permitting combined U.S. and foreign

effective rates of taxation of foreign income to be so low as to encourage shifting of activity and income outside the United States

for tax, rather than business, reasons.

Let me say in making that comment, that is not to say that businesses only, or even predominantly, are motivated by tax. This is

all at the margin. But the point is, our current rules create that

marginal incentive, and so part of the question is, how do we think

about reforms that affect that marginal incentive?

Second, our rules subsidize high foreign taxes through allowing

excessive cross-crediting of foreign taxes against U.S. tax on repatriations of low-tax foreign income.

Finally, our rules impose, when cross-crediting is not available,

an additional tax on foreign income when it is repatriated rather

than when it is earned, so it affects, it distorts, the decision whether or not to repatriate.

People refer to this as the repatriation tax. I refer to this as the

deferred tax. Without a deferred tax, if there were tax at the time

the income is earned, that inefficiency would be addressed.

These defects are exacerbated by use of transfer pricing. I describe in my testimony at some length why enforcing transfer pricing rules is difficult for any country. Part of the thrust of my comments is, very strongly, that there is only so far you can go with

transfer pricing. You have to address and limit the incentives of

transfer pricing through structural change.

For reasons I describe in my testimony, adopting formula apportionment is not a viable answer to addressing these problems in

the absence of a very broad international agreement for formula

apportionment, and it would take years to accomplish.

When evaluating these reform alternatives, it is essential to take

account of these effective rate disparities. There is data that shows

that the effective rates of large controlled foreign corporations have

6

declined from 34 percent in 1986 to 19 percent in 2002, and there

may be more recent data.

Changing to an exemption system would compound the problem

of the erosion of the U.S. tax base. The incentive for incomeshifting activity to low-tax locations would increase. The exemption

in tax-free repatriation of foreign earnings would expand the range

of businesses that could take advantage of exemptions because they

could bring their money back without further taxation.

Under an exemption system, the misallocation of expense against

domestic income instead of foreign exempt income would, in effect,

exempt domestic income from tax, and this risk of misallocating expenses is very much heightened in an exemption system. I discuss

that at greater length in my testimony.

I respectfully submit that reducing the scope of deferral and

more closely aligning the foreign tax credit rules to the purpose of

avoiding double taxation as part of an overall reform achieving a

lower corporate tax rate for all taxpayers would be preferred

through exemption of foreign income and should be supported on

grounds of fairness and efficiency.

The theoretically optimal approach to adopting worldwide taxation would be to adopt pass-through treatment. In the event that

that is not viewed as feasible, less fundamental reforms, including

current taxation of U.S. shareholders under expansion of subpart

F, would be a substantial improvement over current law. It also is

possible to rehabilitate the subpart F rules if one wants to preserve

some deferral for active income, which is, I submit, very challenging and not to be preferred to taxing all income currently.

A base-broadening approach such as I have described in my testimony that contributes to a meaningful reduction in corporate rates

will assist all U.S. businesses, whether they operate abroad, export

from the United States, or compete against foreign imports. The result would be a fairer tax system.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Mr. Shay.

[The prepared statement of Mr. Shay appears in the appendix.]

The CHAIRMAN. Mr. Dilworth?

STATEMENT OF ROBERT H. DILWORTH, PARTNER,

McDERMOTT, WILL, AND EMERY LLP, WASHINGTON, DC

Mr. DILWORTH. Chairman Baucus, Senator Grassley, members of

the committee, thank you for inviting me to appear.

To put my remarks in context, the first thing I must say is they

certainly do not represent the views of any firm with which I have

ever been associated, or indeed of the Treasury Department. They

are my own views.

I have practiced for more than 40 years. I have practiced in two

law firms. I have practiced on the East Coast, the West Coast, the

Midwest, and I even spent 2 years in Taiwan, which is the mother

of tax incentive jurisdictions. I joined the Office of Tax Policy in

2005 because I wanted to give a little back. I am obviously nearing

the end of my career.

My written testimony for the record examines several topics in

greater depth. First, the various proposals to end deferral, amply

exposited by my colleague, Steve Shay. The other proposal is to

7

curtail the foreign tax credit. Both of those are wrapped up in the

President’s Advisory Panel proposals and in the JCT options proposal.

In my written testimony I also refer to a laundry list of additional items that you might want to consider as part of a comprehensive overhaul of the international tax regime. In my view,

we should approach international tax reform very carefully. We

are, in fact, very integrated into a global economy, and the risk of

unanticipated consequences can be high and hard to see before the

fact.

Chairman Baucus, you said the question before us is whether we

should try a minor fix or start over. I think we should not start

over. I think we should fix only what is clearly broken. I think we

should tailor the remedy to the problem. We should avoid the

temptation to find a grand, simplifying assumption like the General Theory of Relativity. Einstein supposedly thought income taxes

were complicated, and there is a reason.

Now, the pamphlet that the Joint Committee issued last night—

I have obviously not studied it—refers frequently to the point that

the evidence is inconclusive. It is not clear what causes taxpayer

behavior.

Inferences can be drawn at the margins, but you cannot be sure.

So, in the absence of certainty, I would be very careful. I do not

think the passage of 40 years since the enactment of subpart F is

a definition of broken.

In my view, the U.S. tax regime for cross-border trade and investment should be adjusted to better accommodate common, current business models for international business. Business is conducted across national boundaries, goods are manufactured in several countries and distributed in both the countries of manufacture

and other countries. The EU is a market. It is not 37 different

countries. NAFTA is a market. Subpart F assumes hermetically

sealed national bubbles as the proper way to conduct foreign business. It is out of date.

Main Street businesses that conduct cross-border business have

to manage their financial assets and exposures. Subpart F assumes

that gains or income from managing such assets and exposures

should be taxed as a form of tax-avoidance income. It is out of date.

Currency risks and funding risks are no longer readily managed by

dealing with the single bank that manages all those risks for Main

Street firms.

U.S. multinationals are managers of portfolio investment capital

assembled from all over the world and deployed in direct business

activities all over the world. If we are going to tax GE very differently from NB Phillips or ABB on their non-U.S. and nonresidence country activities, we should be confident that foreign

portfolio investment capital will not be sensitive to that difference.

It may not be, but we had better make sure we are not going to

decapitalize our own U.S.-managed enterprises.

U.S. MNCs participate in joint ventures with non-U.S. MNCs.

When I was a little boy—and I began my practice shortly after the

enactment of subpart F—everybody did business through wholly

owned subsidiaries. Now there are many, many multinational joint

ventures between U.S. and non-U.S. MNCs.

8

If we subject U.S. MNCs to tax on the undistributed share of

joint venture income, we increase the hurdle rate for U.S. MNC

participation in those joint ventures.

I am out of time. I apologize.

The CHAIRMAN. Go ahead. Take another minute.

Mr. DILWORTH. I think the dividend exemption regime and the

Rangel bill continue to assume that multi-country and regional

business is undertaken in order to reduce taxes on high-tax manufacturing income and that they should be taxed by the U.S. in the

case of dividend exemption regimes without the benefit of foreign

tax credits from ordinarily high-taxed business. Those are just out

of touch with the routine business practices by most MNCs, both

U.S. and foreign.

So now, the unpopular part. I recommend that we repeal the

foreign-base company sales provisions, the services provisions. I

recommend making permanent what is in 954(c)(6), the lookthrough rule. Then the next at least as unpopular thought is, I

would explore limiting the current deduction for foreign-related expenses to aggregate foreign-related income. This is not the Rangel

bill. I would not limit the deductions solely with respect to deferred

foreign income. I would instead ask myself, is total foreign income

in excess of the deductions that are taken otherwise against U.S.

income?

Foreign-related income should pay its way, should pay its freight.

It should not reduce the U.S. tax on U.S. income, but beyond that

there is no compelling need, other than behavior modification, to

get people to invest somewhere else, to start disallowing the foreign

tax credit or denying deductions.

Then to close up, I would recommend that the committee have

a serious discussion with some other disciplines. Lawyers and

economists come and talk to you, but I recommend that you also

talk very carefully to FASB. I was struck that the Financial Accounting Standards Board had no participation, as far as I can tell,

in either the Joint Committee materials or in the President’s Advisory Panel. The people who participated had one set of views and

they were useful, but earnings per share really drives behavior.

You ought to talk to an expert about how earnings per share are

determined.

I think I would also, having perused the report last night, get

some business school professors in here to find out whether behavior at the margins is really primarily in pursuit of a tax reduction,

and then also affected by other factors.

In my life as a trusted advisor to multinationals, people try to

make profit first. Taxes are an afterthought. So the rational economic animal argument needs to be tested by somebody who actually is involved in business decision-making. Do people actually behave that way or is this just an inference one can derive from the

50,000-foot statistical test?

Thank you.

The CHAIRMAN. Thank you very much.

[The prepared statement of Mr. Dilworth appears in the appendix.]

The CHAIRMAN. Senator Grassley, you were not here at the beginning. Do you want to make a statement?

9

OPENING STATEMENT OF HON. CHUCK GRASSLEY,

A U.S. SENATOR FROM IOWA

Senator GRASSLEY. I apologize to my colleagues and the witnesses for being late. This hearing sets the stage for the debate on

international tax reform. It is long overdue. I made that very same

statement 5 years ago when this committee held a series of hearings on this very same subject. With the current economic slowdown that we have now, I think it is even more important to explore what Congress should do or not do to make U.S. businesses

competitive globally.

The current economic environment should be a wake-up to pay

attention to how the tax rules impact U.S. businesses and their

ability to thrive in a global marketplace. I agree with the premise

that the U.S. multinationals should pay their fair share of U.S.

taxes. It is a fact of life that we must fund our government, and

taxing business entities is one of the ways to do that, even though

we all know that corporations do not pay taxes, only people pay

taxes, and corporations are tax collectors. But we still get a massive amount of money from that source and we are going to continue to, so we have to make it work.

Our goal, however, should be to minimize as much as possible

the tax system’s interference with rational business behavior. We

need to carefully examine, and also carefully balance, approaches

that would raise the necessary revenue, but we should be mindful

that we not poison the well with anti-competitive tax policy.

Our current system is based on the framework enacted during

President Kennedy’s administration. Since then, we have seen an

era of expanding global markets, falling trade barriers, and technological innovations that have served to take away traditional notions of national borders.

Our tax code has obviously not kept pace with these changes.

Our tax policy should enable U.S. companies to operate in the global marketplace without the artificial boundaries set in place by the

tax code. Globalization of the marketplace creates its own unique

set of rules and complexities. Companies have responded by updating their systems and business models. Our tax code should address that reality.

One would hope that a country known for great innovation, as

we are, would be able to craft a tax code that encourages economic

development, collects the necessary revenues, and fosters growth of

jobs. There has been a longstanding debate about whether our

international tax system should be fundamentally changed. Some

say that the transfer pricing regime used by virtually every major

country is broken and call for tax on all foreign income on a current basis.

Without significant corporate tax rate reduction, eliminating deferral would have the effect of exporting our high tax rates and

putting our companies at a competitive disadvantage in the global

marketplace. Furthermore, the piecemeal cutbacks on deferral for

active foreign income that we have seen here in the Senate would

do nothing but complicate the tax code and create opportunities for

tax planning around those cutbacks.

Others argue for completely exempting active foreign income

under a territorial system, as many of our trading partners do.

10

However, this proposal is not without its issues. Concerns about

tax treatment of royalties and transfer pricing would need to be addressed head-on in exploring this as an option.

So we have a few real choices: to build a protectionist wall or develop a tax system that fosters growth and innovation. I am on

record as criticizing legislation that would eliminate or whittle

away the current deferral of active foreign earnings. Beyond that,

however, I do not profess to have preconceived notions as to which

direction our tax rules should go. We seem to all agree that something should be done, and I believe we should be open-minded

about what direction that reform should take.

The CHAIRMAN. Thank you, Senator Grassley.

A question I know a lot of Americans have is, what in the world

is going on when so many American companies have subsidiaries,

say, in low-tax jurisdictions like the Cayman Islands and so forth,

seemingly for non-business reasons, purely tax reasons? For example, it is my understanding that when Congress passed the repatriation provision not long ago, about $362 billion was repatriated to

the United States and most of that came from low-tax jurisdictions

like the Cayman Islands, Bermuda, Ireland, and so forth.

Is that a problem? A lot of Americans think it is a problem. It

just does not look right. Is that something you think that, when we

reform here, among all the things we have to do, is that part of

it? Should we do something to make it more difficult for American

companies to park that income, park their subsidiaries overseas to

avoid paying taxes? Prof. Hines?

Prof. HINES. No, I do not think it is a problem. I agree with you

that the optics on that are bad, but the first point is, it is not just

American companies that have a lot of operations in tax havens.

Other countries’ companies do, too. So it is the way that international business is conducted. A lot of the function of holding companies in tax havens like the Cayman Islands is to avoid foreign

taxes.

That is, a way to rationalize the foreign business operations of

American companies is often to structure the holdings through tax

haven holding company affiliates in places like the Cayman Islands. There is very little in the way of productive activity, manufacturing or things like that, going on in the Cayman Islands; obviously, it is financial transactions. They are the ones that are taking

place there.

A lot of those holdings are directed at trying to avoid a set of

structures that trigger high rates of foreign tax. The United States

should be totally in favor of that, because, if our companies can

structure their foreign business operations in a way that generates

as much after-tax profit as possible, that is good for the United

States.

If they can structure their foreign business activities in ways

that avoid, say, high Japanese tax rates or German tax rates, that

means we give them fewer foreign tax credits. It means that these

companies wind up with higher after-tax profitability, which is only

good for American owners of the companies and American workers

for the company.

The CHAIRMAN. Mr. Shay, do you have a thought on that?

11

Mr. SHAY. As a practitioner, I look for low-tax opportunities

wherever they arise. So one thing, focusing on tax havens—if you

use a pejorative term—but low-tax countries that, for their own

reasons, have adopted tax systems that are different from ours run

the risk of trying to differentiate what income is there and what

income is somewhere else. The fact is, if the homeland dividend debacle evidences anything, it is that money is fungible. It is going

to find the lowest effective tax rate. If you try to silo particular approaches, then other approaches risk popping up.

So, while in general the thrust of my testimony is, yes, I think

we have a problem, I think we have a very large amount of foreign

earnings that are not being redeployed for tax reasons that may

have been earned in various ways; and other tax avoidance

schemes and low-tax jurisdictions are an important part of that.

They are also an important part of regular, ongoing business. But

my solution is not to target, it is to say, let us tax foreign income

on a comparable basis. At that point, companies are still going to

want to be reducing foreign taxes, at least to the point where they

can take——

The CHAIRMAN. Right. But do we run the risk of having a race

to the bottom? Lots of countries are starting to reduce their corporate rates to attract investment. Ireland, as an example. To what

degree do you see that as an issue? If it is an issue, how do you

address it?

Mr. SHAY. I think that the corporate tax rates of other countries

operate as a very, very broad boundary. I do not think they dictate

U.S. tax policy on corporations, but I think they are——

The CHAIRMAN. Not Ireland. Ireland is very aggressive. Companies go to Ireland.

Mr. SHAY. I am sorry. I thought you were asking whether that

should affect how we set the U.S. rates.

The CHAIRMAN. My question is, in terms of getting revenue for

government—you have to have some revenue—is there a problem,

a race to the bottom, in the corporate world?

Mr. SHAY. Yes, I think there is a problem. I think my testimony

supports the view that there are steps that can be taken to address

that problem. But it would be pretty broad-based and it would not

be singling out individual areas. It seems to me, while it is still

possible to substantially reform subpart F and try to single out

what is good foreign income and what is not good foreign income,

what is active foreign business, what is not active foreign business,

I think that that is a difficult task.

It has proven to be complex for companies to administer, which

is one reason why I favor taxing foreign income, all foreign income,

and giving credits for foreign taxes. That would fully address the

problem that you are alluding to. The question that is raised by

other panelists is: would it adversely affect the U.S. economy and

U.S. businesses?

The CHAIRMAN. All right. Thank you.

Senator Grassley?

Senator GRASSLEY. In previous hearings I raised the question of

what revenue neutrality means in the whole concept of tax reform.

If we assume revenue neutrality against current law, then individual income taxpayers are going to have to face a 10-percent tax

12

increase. If we assume revenue neutrality against current-law policy reflecting this year’s tax burden, then there is no widespread

tax increase. If it is decided that revenue neutrality against current

law is the test, then there will be major political pressure to alleviate that huge burden on individual income taxpayers.

Our last big test on this point occurred in the 1986 Tax Reform

Bill. In that case, Joint Tax told us we shifted $120 billion from

individuals to business. That was $120 billion over 5 years in 1986

dollars. Today that figure would be much higher.

So my question to the panel is this, particularly Mr. Shay: if

Congress were to face similar political pressures in a reform exercise, would you caution us to forego that path? That is, would you

suggest we not use tax reform to shift more burden onto business?

Mr. SHAY. Not as a per se recommendation. I guess I am not sure

I am quite following the question. There is always a decision in an

overall tax system as to the allocation of tax on businesses and individuals. I share the view that tax on business ultimately is borne

by the participants. We do not really know the breakdown of corporate taxes very clearly, but it is partly shareholders, partly consumers. But there is no reason, on a per se basis, to say you should

not increase the tax on business. This is part of a broader fairness

decision that you are making.

Part of my recommendation of increasing taxation of foreign income, again, is, if you are going to tax businesses on income, it is,

in my view, unwise to differentiate, to the extent we do, between

foreign income and domestic income because it creates bad incentives, and it is unfair. I think we are looking for solutions to help

the exporter as much as multinational or foreign activities, and for

the purely domestic business as well.

So, if that results in an increased tax on business, which it probably would, although it is not really revenue-oriented as such, the

proposals I am making are—you can set the tax rate, the corporate

rate where you want. The proposals I am making are really designed to have a more efficient tax base across the board so that

hopefully you can get to lower corporate rates within your overall

revenue needs, but that there will be less incentive to artificially

shift income outside the United States.

Senator GRASSLEY. Prof. Hines and Mr. Dilworth, do you want to

comment?

Prof. HINES. The United States already has a very heavy business tax burden compared to other countries. That is the issue.

That is part of the reason why—Steve Shay is right, and others are

right, that we need to be concerned about the shifting of taxable

income outside the United States to other countries. We definitely

need good enforcement of our rules on that. But the reason it happens is because the tax rates are high in the United States.

Movement in the direction of higher-still business tax rates

would have consequences for that, as well as consequences for productivity of the economy and all the things that go along with it—

employment and affluence. So, I would be wary about a 1986-style

solution where you lowered the tax burden on individuals in return

for a higher burden on corporations.

Senator GRASSLEY. Mr. Dilworth?

13

Mr. DILWORTH. I think that the question, from the standpoint of

a practitioner, is very much like what Chairman Rostenkowski said

in 1986: ‘‘Don’t tax you and don’t tax me, tax the companies beyond

the sea.’’

The CHAIRMAN. I think that was Russell Long.

Mr. DILWORTH. That was ‘‘tax the guy under the tree,’’ I think.

But I thought it was refined in 1986 to make sure that we hammered the foreign companies.

The CHAIRMAN. Oh, all right.

Senator GRASSLEY. Thank you, Mr. Chairman.

Mr. DILWORTH. I do not think that is a very good idea. The reason I do not think it is a very good idea is, we do not know who

owns the U.S. multinationals, for openers, so some portion of it—

no doubt, the burden of the tax—falls on U.S. shareholders, the

wealthier among us, but some of it falls on foreigners. If they have

competing alternative investment opportunities between MB Phillips and GE, we will not have done ourselves a good day’s deed.

The second point, the lock-in effect, going back to Chairman Baucus’s posit about, do we not have a problem with $365 billion in

Ireland or wherever, the Cayman Islands, I do not know how big

a problem that is. I am not confident, as Prof. Hines is, that it is

not a problem. It could very well be a problem. But I do not know

what the total pool of income of all those enterprises was on a

worldwide basis during the period that the income was accumulated in the foreign jurisdiction.

Was that all of the income of these 863 companies or was it just

half? Was it a third? Was it a tenth? What was it attributable to?

Was it attributable to U.S.-origin IP? Is that what the problem is

really all about? If it is U.S.-origin IP, let us look at U.S.-origin IP

and not disable the rest of the conduct of U.S. multinational business overseas by repealing deferral, because unlike Steve, I do not

think anybody who has ever done section 959 calculations would

confuse that with beach reading. That is what happens when you

try to deal with undistributed income that has been previously

taxed. You know that you are eventually going to pay tax on a

number different than what you put on the tax return because you

will have future losses, you will have currency fluctuation.

Finally, as far as the lock-in effect on not being able to deploy

assets in the United States, we are the only country I ever heard

of that prohibits foreign subsidiaries from making business investments in the residence country. We put that back in in 1962 as a

vestige, almost like an appendix, to an entirely different system

that was proposed in subpart F and passed the House. The Senate

rejected that version, but left the section 956 piece in there.

Mr. Miller from Iowa correctly pointed out that the premise of

956, as finally passed, was strange because it allowed the deployment of assets outside the United States and not in the United

States. So I think you have to break the problem down into the

smaller pieces. What really bothers you about that debacle?

The CHAIRMAN. Thank you very much.

Senator Bingaman?

Senator BINGAMAN. Well, thank you all very much. Let me just

ask a couple of questions. I am trying to understand differences

14

that each of you have with some of the suggestions of the other witnesses.

Mr Dilworth has a couple of very specific proposals here that I

would like Mr. Shay’s reaction to. One is the repeal of related-party

base erosion components of subpart F related to mobile income. Is

that something that is consistent with what you—you were advocating, as I understood your testimony, reducing the scope of deferral. Is this part of what you are saying should be done, or is this

inimical to what you think should be done?

Mr. SHAY. Can I frame the question a little bit?

Senator BINGAMAN. Sure. Go ahead.

Mr. SHAY. You have some big, basic choices. You can tax foreign

income currently, the sort of thrust of my recommendation. There

are alternatives. Another alternative is to go back and try to reconstruct a balance in the taxation of foreign income and tax active

income, leave active income deferred, tax passive income currently,

and the question that you are raising is really a subset, a small

question of, when you earn active income should you treat it as

passive when you distribute it somewhere else in your group? Bob

is saying, no, it should maintain its active character. I think there

is room to disagree with that, but frankly that is a marginal question.

The important question is, do you think you, as a Congress, can

decide what is good foreign income earned and what is not good

foreign income earned and set up rules to determine that? They did

that in 1962. They came up with a set of foreign-based company

sales rules, services rules which said, if you do certain things we

are going to tax that income currently, even if it is active. Basically, those certain things were if you move it from where you are

earning income to a low-tax jurisdiction for a tax avoidance purpose.

That was the original 1962 compromise, with the original proposal from the administration being, tax everything currently. That

compromise has totally eroded because of changes, legal changes,

in the tax system, because of the way we classify corporations, because, as Bob said correctly, structuring out all according to countries is no longer relevant. We have a written description in chapter 3 of the ABA Tax Section Task Force on International Tax Reform which tells you what you could do if you wanted to go back

to that approach.

Senator BINGAMAN. And that is what you are advocating?

Mr. SHAY. No, actually. That is there, if that is a direction you

want to take. I think it is too difficult. It is too difficult to get it

right. It is too difficult, and in the process of trying to get all those

things right, other anomalies will develop. That is, frankly, what

at least two of us are in the business of exploiting, and I do not

mean that as a bad thing. That is all part of trying to be taxefficient.

So my conclusion is, the better solution is, as part of an overall

package of broader business tax reform, tax foreign income currently, try to bring the rate down so that you are still competitive

around the world and you give credits for foreign taxes. But I

frankly think a competitive rate is—there was a proposal on the

House side to get you at 30.5 percent. No. I do not think you have

15

to be—within some range of that, I still think American business

will do very well.

Senator BINGAMAN. Let me ask Mr. Dilworth to just comment as

to your opinion about his main recommendation there.

Mr. DILWORTH. Well, I believe we should not lower the threshold

for ending deferral. I believe the part of the ABA report that Steve

was responsible for suggests dropping the ownership threshold to

25 percent, and the thesis was that such a concentrated block

would give the U.S. investor influence on the behavior of the CFC,

the controlled foreign corporation.

But I think, in my testimony, I suggested that you are basically

going to freeze out too many companies from multinational joint

ventures. Having the required distribution to fund the tax is probably going to make it too hard to put the deal together.

So, I do not support the idea of ending deferral, and I think, in

my experience—and it is anecdotal—trying to figure out how to

keep track of previously taxed income and keeping it right, it is

just enormously difficult. I think the concept was dreamed up, with

all due respect, by economists. But economists do not do stuff like

that. They do important, high-level intellectual things. Grunts have

to figure out section 959.

The CHAIRMAN. Thank you very much.

Senator Bunning?

Senator BUNNING. Which economists were those? [Laughter.]

Which one of the 100 that we have consulted with? Never mind.

I am just kidding.

Professor James Hines, which tax system, worldwide or territorial, will be better for us in the long run? Which system will do

more to increase our standard of living and allow us to grow our

way out of the looming fiscal crisis caused by the unwillingness of

the majority in Congress to reign in mandatory spending? Which

system will ultimately be better for our children and grandchildren,

and why?

Prof. HINES. The territorial system is better. That is what most

of the world has discovered, but the United States has not yet. The

reason is that you get more efficient business operations if you

have a territorial tax system. More efficient business operations

produce this country’s affluence. Why are we rich? We are rich because we have strong businesses here, and that is because we have

embraced capitalist principles. One capitalist principle in the international tax area is, why do you want to impose worldwide taxes

on your companies when it reduces their productivity as a result?

Other countries do not do it, and I do not see why we would want

to do it.

Senator BUNNING. That will address all the other problems I

talked to you about?

Prof. HINES. There will still be an agenda for Congress on some

of those other problems, but it certainly will help. I mean, the current system impairs the productivity of American businesses relative to the businesses of residents in other countries, and most of

the benefits of stronger business operations are felt in the United

States in the form of greater demand for factors that are resident

to the United States, specifically labor and land, but mostly labor.

So, if you make American business more productive, most of the reVerDate 11-MAY-2000 15:36 Aug 20, 2010 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 57821.000 TIMD PsN: TIMD
16

sults of that is higher wages and greater employment for Americans, which I think we all want.

Senator BUNNING. Thank you.

This is for all of the panel. Last year, foreign businesses acquired more U.S. businesses than at any time in our history, $414 billion

worth of business assets. With the weakness of the dollar this year,

it is likely to set a new record. Does our tax system have anything

to do with the fact that our U.S.-based firms are more often the

targets of acquisitions than acquirers? Now that the average OECD

corporate rate is 28 percent or less, is it more effective to locate

headquarters outside the United States? Why should we care about

where headquarters are located? Would anyone like to chomp on

that?

Prof. HINES. Sure. Yes, the U.S. tax system has an impact on acquisitions and other countries’ tax systems influence that, too. If

you think about when there is a merger of two large companies,

you can structure it in a way so that they can be a resident for tax

purposes in either of the countries.

If a German firm and an American firm are going to wind up

merging their assets, and these are companies that have a lot of

foreign operations, there is a strong advantage to being a German

resident for tax purposes because Germany has, effectively, an exemption system so that the foreign earnings of German companies

are not subject to German tax, and, if a German firm acquires an

American firm in a certain way, then the American firm’s foreign

earnings will not be subject to American or German tax as a result.

So, yes, there is a reason. There certainly are tax reasons, and

there is ample evidence that these tax motives wind up affecting

the bid prices in these acquisitions and the quantity of the acquisitions by foreigners. What are the consequences for the United

States? That is a little subtler, frankly, to know. Does it matter

that American companies are owned by foreign entities? It certainly matters, but mostly the reason it matters is because what

we want is the business activities in the United States to be as productive as possible.

If a foreign owner is the most productive owner, I am all for it,

and we should be all for it because that means that the business

will be most efficient and it will create the greatest demand for

labor in the United States, and so on.

The concern is, if you have a foreign owner who is the owner not

because they are the most productive, but because the tax incentives are driving the ownership to be foreign rather than American,

and, if that is true, then we must be concerned because that means

you are going to give an incentive for inefficient ownership and

then you have less demand for labor in the United States, less productivity.

So what we want is a system that encourages efficient ownership, and the way to do that is to have a tax system that is more

similar to other countries’ systems, i.e., an exemption system.

The CHAIRMAN. Senator Conrad?

Senator CONRAD. Thank you, Mr. Chairman. Thank you very

much for holding this hearing, and thanks to this panel.

We all come at this from our own perspectives. Mr. Shay and Mr.

Dilworth, you come at this from a perspective of practitioners. I can

17

tell very much that you have been in the pit, as we say, and I very

much appreciate your practical advice. And Mr. Hines, you come at

this from an academic background, and you have a perspective that

is important for us to hear as well.

I come at this from, in my previous career I was a tax commissioner of my State and the chairman of the Multi-State Tax Commission, and I served during the Reagan administration on the

Commission on Taxation of Multinational Corporations. I learned

a great deal about negotiating on that commission. It was one of

the most fascinating, incredibly intricate negotiations I have ever

been part of.

I come at this from a perspective of somebody who tried to make

certain that taxes that were in law were, in fact, enforced. As a result, I have audited hundreds of major multinationals. It is probably surprising to some that a State like North Dakota would have

engaged in that effort, but my State is an energy State, so we had

many energy operations in my State that were very large corporate

entities. Not surprisingly, they tried to avoid paying taxes to the

extent they could. My job was to try to make sure they paid what

they owed.

I found a couple of things. One, I reached the conclusion that

there is a lot of nowhere income sloshing around out there. It is

not even a question in my mind, because I have seen it. Nobody

who has not seen it through audit could dispute what we saw happening.

Second, like a couple of you as practitioners, I concluded transfer

pricing as a mechanism is just broken. There is just no way you

can try to recreate arm’s length transactions from the interactions

of hundreds of entities, wholly or partly owned. You just cannot do

it, I do not care how smart you are. There is not enough time or

enough resources to do it.

My own conclusion was, in a perfect world, something like formula apportionment would be a good way of resolving things, because we would look at our share of a company’s property payroll

and sales in relationship to the worldwide property payroll and

sales, and we would get that fraction for taxation purposes—not a

perfect measure, but a rough justice measure. The problem is, as

Mr. Shay, you have quite correctly pointed out, it would take time

to get in place a worldwide regimen that would have everybody on

the same page.

So where are we? I would be very interested to hear from each

of you. I have just a minute and a half left, so, if I could get 30

seconds from each of you on, what do you think we could do that

would help American competitiveness, and also address the fairness question? Now, I, for one, think the Caymans is a huge problem. That Ugland House that I have shown on the floor many

times, 12,000 companies call that little 5-story building down there

home. They are not there to do business, as you, Prof. Hines, pointed out. They are there to do tax avoidance. Anybody who has audited those companies knows that is what is going on.

Mr. Shay, I think you have given some very good, specific recommendations here. If we were going to go for some more farreaching reform, what would it be?

18

Mr. SHAY. As I say in my testimony, if it were far-reaching and

did include some reduction in the corporate rate, I would tax the

foreign income of U.S. companies that own a material portion of

foreign subsidiaries on a current basis.

Senator CONRAD. To me, that is a very practical recommendation. Anything else? Anything more far-reaching?

Mr. SHAY. The far-reaching comment is, simply, I think competitiveness comes from us investing in Americans, educating them, allowing them to compete globally, having the smartest people in the

world. So, part of where I come on this issue is, we should structure our budgets and raise the revenue necessary to accomplish

that purpose. I do not think foreign income should get extraordinarily special treatment, or special treatment unless we can demonstrate it is justified. That is the short answer.

Senator CONRAD. My time has expired.

The CHAIRMAN. Yes. Does that mean no deferral?

Mr. SHAY. My recommendation is conventionally understood to

refer to no deferral. That is correct.

The CHAIRMAN. All right. Thank you.

Senator Wyden?

Senator WYDEN. Mr. Chairman, thank you. It has been an excellent hearing.

Mr. Dilworth, I especially liked your comments about how the

tax code is overgrown with weeds because, you look at 16,000 tax

breaks since 1986, it comes to three for every working day. I think

it is extraordinarily important to clean out this clutter. I think that

is key to holding down rates and keeping progressivity. That is

what I tried to do in my proposal, the Fair Flat Tax legislation. I

think it would be very helpful if you could give us, in your view,

some specific examples of tax preferences that affect the foreign operations of U.S. companies that, frankly, we would all be better off

without.

Mr. DILWORTH. Well, the preferences that would make us all better off if we got rid of them would probably require first that we

drop our rates. I do not think that we can start by abolishing the

tax on foreign income rather than domestic income, but when I talk

about the weeds, the weeds are the weeds that involve collecting

information and tax on behavior that we do not actually want to

discourage and in many cases have stopped collecting for more

than 10 years. Much of the subpart F provision has been rendered

largely inoperative by reason of various administrative law

changes.

Senator WYDEN. How about preferences that favor one sort of

business over another in their foreign operation?

Mr. DILWORTH. I am trying to be responsive, but I am trying to

think. The way I categorize the business activities of the companies

I deal with, you will occasionally have a financial services company, and they have their own set of needs because of the way they

conduct business.

So there is perennially before this committee something called

section 954(h), an exception from foreign-base company income. If

that is viewed as a preference, I suppose that you could increase

the revenue, but I do not think you would be better off necessarily

by letting the provision lapse.

19

In the case of companies that exploit high-value intangibles, I

suppose you could say, well, the transfer pricing system is broken.

That is a common allegation. I am not actually persuaded that it

is. Everybody talks about the Microsoft problem, but in my written

testimony I refer you to the article in the same publication from

some years earlier about the Xerox problem, where the transfer

pricing system resulted in parking large losses in a tax haven jurisdiction.

So, if the problem is that you are worried about risk-based allocations of income among related parties and groups, then I do not

know that that is a clear-cut subsidy. It is complicated. I think my

own impression is that collecting tax on the basis of hypothetical

arm’s length transactions is enormously time-consuming. I think I

refer to that in my testimony as a war of expert witnesses.

Senator WYDEN. So what would you give up to get the lower

rates? I mean, that is the whole point, that at some point you have

to clean out something specific. That was why I asked the question.

Mr. DILWORTH. Sir, I am going to try to stay away——

Senator WYDEN. All right. Let me see if I can get one other question in, and that deals with health care. If you look at the situation

for American companies in global markets, our companies are paying more than the competition, and the competition often gets

health care from the government. I think we have a pretty good example of what is at stake right now in this Boeing/Airbus debate,

and you have seen many commentators say that Boeing really is

up against it because it is paying a lot more for health care.

So what we have tried to do in our bipartisan health legislation—there are seven Democrats and seven Republicans on it—is

to modernize the system so that employers and employees will both

have more tools to hold down costs than we have with a system

that, today, is not much different than it was in the 1940s.

How do you all see tax reform fitting into this debate about

health care? Let us just see if we can go right down the row. Go

ahead.

Prof. HINES. I think you are absolutely right that reforming

health care would improve competitiveness of American businesses

and probably help the American economy generally. The issue is,

we are going to have to pay for it somehow. That is an opportunity

to think about some fundamental issues in tax reform, because that

is where the money has to come from.

So one thing that we can do, if we were to enact fundamental

health reform that costs a lot of money, is to think about embracing a bigger tax that people will understand they are getting benefits for, like a value added tax that most of the rest of the world

has. I think the American taxpayer will understand that they are

getting high-quality health care in return for that.

Senator WYDEN. Senator Baucus is giving me extra time. I will

just say, it does not have to break the bank, sir. If you look at the

Congressional Budget Office’s analysis of our proposal, it is revenue-neutral. It is revenue-neutral because we shift the incentives.

We no longer subsidize in the tax code inefficiency and start rewarding those who hold the costs down.

Mr. Chairman, you have given me a lot of time. Can these two

just answer the question?

20

Mr. SHAY. Well, it has not been the subject of my testimony, and

I am not an expert in health care. It does seem to me, and my understanding is, the incentives currently in the code do create distortive effects that are unhelpful, and proposals that would—that

should—be a part of any comprehensive health care approach need

to deal with those current incentives.

My understanding is, the incentives tend to promote over-investment in health care in ways that are inefficient and drive up costs.

It is very clear, and one thing that I agree with Jim on, that if we

could bring down health care costs it would allow American businesses to be more competitive.

The CHAIRMAN. Let me just ask you another question with respect to the tax treatment of research and development. We want

to reward research in the United States, theoretically, and we have

an R&D tax credit that is designed to reward that research in the

United States. But what happens to a United States company, a

parent company, who jointly conducts that research in another

country with a controlled foreign corporation?

As I understand it, the parent company still gets the full credit

even though some of the research is conducted overseas. There may

be an offsetting deduction, but the basic question is, what suggestions do you have, if any, assuming my understanding is correct,

to modify the United States’ research and development tax credit

in a way to promote research in the United States?

Mr. SHAY. I am not sure that you actually get the credit, as such,

for research performed outside the United States. I think an issue

that has arisen—and I may be wrong about that—is that you can

shift the results of that research to a foreign corporation, and to

have the return on that research outside of the United States

through cost sharing.

So, if a foreign corporation cost-shares for research that is performed in the United States, my understanding is that that research still qualifies for the credit, but the intangible that is acquired through the cost-sharing mechanism is considered owned by

the controlled foreign corporation. They then take the deduction at

a much lower value, but then they earn the income in a lower-tax

environment.

The CHAIRMAN. So you do not think we need to consider modifying the credit?

Mr. SHAY. Well, I think the question that is raised is whether

you should allow the credit when the research is paid for with the

cost sharing payment from a CFC. I think that is the issue that

your question is identifying.

The CHAIRMAN. Let me ask another question. This is complicated

stuff, and a lot of Americans say, what in the world is going on

here? I would say most members of this committee find it extremely complicated, and I do. So the real question is, is it worth

our while to spend a lot of time trying to change taxation of foreign

income in the United States or not? From a practitioner’s point of

view, it is probably maddeningly complex and difficult. A lot of

members of Congress might say, well, so what? It is their profession, that is their job, their paycheck, let them work it out, and so

forth.

21

But on the other hand, if we are losing in this country our competitive position, that is a whole different question. So I am asking

you guys, all right, from an American layman’s point of view, is

this real, is this not real and, if it is real, from what perspective

is this real?

Mr. SHAY. There are going to be different perspectives on that

question, but I will give you what I think is a simple one. Taxing

income is hard, as you can see. The way to think about foreign income is that we do have global businesses, they operate on a global

basis. If you think of it as a bathtub and you say foreign income,

you create a hole in the bathtub for foreign income.

It is not going to be surprising to you that water is going to go

through that hole, and that is why addressing the taxation of foreign income and limiting the extent to which there is artificial

shifting of profits outside of the United States is an important part

of being sure that our overall income tax system is sound. That is

the best way I can think of to characterize it.

The CHAIRMAN. Do you think the hole in the bathtub is too big?

Mr. SHAY. I am sorry?

The CHAIRMAN. The hole in the bathtub is just too big?

Mr. SHAY. Yes, that is correct.

The CHAIRMAN. That is basically what you are saying.

Mr. SHAY. Correct.

The CHAIRMAN. All right.

Mr. Dilworth?

Mr. DILWORTH. I do not.

The CHAIRMAN. You do not think so?

Mr. DILWORTH. No. The reason I do not is, I think what we are

really talking about in terms of what has everybody upset is the

high-value intangibles. I do not think focusing on that problem and

eliminating credits and eliminating deferral just to get at highvalue intangibles is the right way to go. Now, just turning to the

high-value intangibles, however——

The CHAIRMAN. Well, I am asking this question with respect to

American competitiveness.

Mr. DILWORTH. Yes.

The CHAIRMAN. American investments, jobs, productivity. That is

the perspective I am asking this question from. That is, in order

to enhance American competitiveness, investments, jobs, et cetera,

to what degree is it important to make significant changes to how

we treat taxation of foreign income? That is the question I am asking.

Mr. DILWORTH. Yes. My suggestion in the testimony is, let us

clean up the way subpart F breaks up the foreign markets.

The CHAIRMAN. So you think it is currently broken with the effect that it hurts American competitiveness?

Mr. DILWORTH. Yes, it does because it distorts. You sort of have

to figure out how to restructure your operations when you do not

have a single-sale subsidiary in every country in the world, that

kind of thing.

The CHAIRMAN. All right.

Mr. Hines, what do you think?

Prof. HINES. I agree with Mr. Dilworth that it is important, there

are sizeable, measurable benefits from reform that are out there for

22

us to take if we want to enact those reforms. Think about it this

way. The United States is unique right now. We uniquely, of all the

countries in the world, impose heavy taxation of active foreign

business income. We are the only one that does that. Why are we

the only one that does it? Is it the case that 100 other countries

are all wrong? No.

The CHAIRMAN. What is it? What is the reason?

Prof. HINES. The reason is, we slipped into the habit in 1962 and

we have not gotten out of it yet.

The CHAIRMAN. So, do you think we should kick the habit?

Prof. HINES. I think we should kick the habit. If you do not want

to kick the habit, if you want to keep our heavy taxation of foreign

income, you could ask, why do we not have heavy extraterritorial

excise taxes, too? Why stop at income taxes?

The CHAIRMAN. Well, because currently, if I understand, the difference between excise and income taxes, we have a deferral regime for income taxes which we do not have for excise taxes.

Prof. HINES. That is right. We could have worldwide excise taxes

with deferral. I mean, it would be crazy to have a system like that.

But that is the system we have for income tax.

The CHAIRMAN. But do we not have deferral in part to keep income overseas so American companies can compete overseas?

Prof. HINES. Because it is much better than not having deferral

and having accrual taxes, I agree. But, as a result of the deferral

regime, as other witnesses have pointed out, you have this problem

of repatriation. That is, you discourage repatriation.

The CHAIRMAN. You do. Right.

Prof. HINES. There is no good reason for that.

The CHAIRMAN. This question was asked by another Senator in

a different way. What is the ideal way to handle this whole subject,

looking at the modern world, how companies put together deals,

joint ventures? We are becoming more, if not homogenized, but a

lot of these American companies morph into other countries’ companies and vice versa in some respect. Everybody is looking to

make a buck, as they should, to come up with new product, as they

should, some new organization, partly to enhance shareholder

value, and so forth.

We are still the largest—and hopefully the most influential—

country in the world. So what would you suggestion as an ideal?

Put aside the practicalities for a moment, and the politics for a moment. If we were to start from scratch, what would the ideal be?

Sometimes I think it is important to try to figure out what the

ideal would be, even though it is difficult to get there, even though

it is not possible to get there.

I am thinking about Taiwan and health care. About 23 years ago,

Taiwan looked around the world at all the different countries’

health care systems and picked all the parts they thought were

best for Taiwan, and they just built a whole new health care system basically from scratch. Now, that is health care. Health care

is pretty complicated. Taxes are pretty complicated. But what is

the ideal, or the direction in which the ideal would be, even though

it might be difficult to get there, if the United States would lead

and get some kind of a regime that makes more sense? Does anybody have a thought?

23

Prof. HINES. The ideal system would have three pieces to it. The

first piece would be a territorial system where we tax income that

is earned in the United States and not income that is earned outside. The second piece would be a better-developed set of rules for

figuring out what income is earned in the U.S. and the stuff outside. Many people have expressed concern today about that, and

rightly so. So, if you have a territorial system, you have to be able

to determine what was actually earned inside, and we already have

rules for that but we need more and better rules, and probably

more resources devoted to enforcement.

The third piece is more international agreements. This is one of

these things that you cannot implement by yourself. We need international agreements—tax treaties, basically—that conform to our

tax system and that would do things, for example, like permit the

allocation of expense deductions. If an American company incurs

$100 of expense in the United States, some of which is being used

to produce income abroad, then the appropriate thing would be to

allow the foreign operations of that company to get part of the deduction for that expense. We do not currently have an agreement

with other countries that says that, but you asked about the ideal,

and the ideal is——

The CHAIRMAN. Yes. I am asking for the ideal.

Prof. HINES. Yes. I would have a different set of international

agreements to go along with the territorial system and better definition of what income——

The CHAIRMAN. So you would have a territorial system, we would

have a second, better definition of what is income earned in the

United States, and third, you need some treaties to address, what,

basically interest allocation, or address what?

Prof. HINES. Interest and other expense allocations, transfer pricing. We already have treaties that address that.

The CHAIRMAN. All right.

Prof. HINES. And other things like that.

The CHAIRMAN. All right. Mr. Shay? Go for it. This is your——

Mr. SHAY. Well, no. I think I would agree with the latter two of

Jim’s points. The difference is, he would do a territorial system

which would leave income untaxed if somebody can find a way to

put it in a low-tax environment, and, if you get everything right,

I suppose it is possible to use a territorial system.

I just do not have confidence it can be done under any realistic

set of parameters, which is why I would say, lower the business tax

rate and tax on a global basis, tax worldwide income and allow a

credit for foreign income taxes. I hope I have not been misunderstood. I believe in the foreign tax credit. In other words, there

should be a credit for foreign taxes.

But the difference is that the no-tax income that Mr. Conrad was

referring to might still exist, unless we get it just right in Jim’s

proposal. I do not propose that we can get it just right, which is

why I support my proposal, which is to tax much more broadly. I

would take the comment, I think the real question of an ideal income tax system cannot be asked in the context solely of foreign

income.

It is a mistake to think that, all of a sudden, you are outside the

border and everything changes. It is a part of our overall U.S. tax

24

system. That is why I come back to the bathtub. It has to be coherent as a whole. If you have the ability to earn materially lower

taxed income, U.S. income is going to become non-U.S. income because that is what we do. So, that is my overall comment.

The CHAIRMAN. Thank you.

Mr. Dilworth? I am pushing you for the ideal now.

Mr. DILWORTH. I understand.

The CHAIRMAN. I know it is hard for you to answer.

Mr. DILWORTH. Not the measured proposals I make, but the

ideal. The ideal would be to abolish the corporate income tax and

increase the individual tax, and quit trying to figure out the difference between partnerships, corporations, trusts, and everything

else. But that is not going to happen.

The CHAIRMAN. No, no, no, no, no. I said, put aside the

practicalities and the politics. I am asking for the ideal.

Mr. DILWORTH. I understand. That would be my ideal. But I

would not actually go to a territorial system, and the reason I

would not is, if we are going to view a domestic corporate income

tax and a foreign operation——

The CHAIRMAN. You would just abolish the corporate income tax.

Mr. DILWORTH. Basically, I would. Because, if it is a collection of

taxes on individuals, I would collect it from the individuals. But I

do not expect anybody ever to do that.

The CHAIRMAN. Come on. That is unfair. You have to stick with

my rules here.

Mr. DILWORTH. I understand. But going back to the international

piece, what worries me about the territorial system is that it gets

jury-rigged every time it is floated to pick up the hobby-horses of

what people are worried about. So you pull out of the territorial

system those things you think ought to be taxed, like U.S.-origin

intangibles. Next year it will be financial services. The problem is

that there is no territorial system that is stable. In its pure form

it is like abolishing the corporate income tax, and you are not going

to do it to the foreign, first.

The CHAIRMAN. To what degree is any of this relevant? My question is this: we are a democracy. We are a collection of hundreds

of thousands of companies. We are 535 members of Congress. We

react to pressures, pressures from constituents and groups that

think they have a legitimate claim, and most of them do. But it is

a hodgepodge. So we react to some degree to the squeaky wheel

that squeaks the loudest and react somewhat on merit, sometimes

on the basis of volume—that is, how loud the squawk is.

So is it relevant that we have to try to find the perfect system?

Because Congress will meet tomorrow and enact legislation, theoretically addressing new needs, domestic and foreign. But as Americans, we are going to represent American companies and American

individuals and so forth. The reason the code is complicated is, I

think, for that reason, that Congress reacted in lots of different

ways. So does it matter? The question is, irrespective of the system,

will Congress—maybe a little slowly—not deal with the most important changes? So is it relevant? Is it relevant, what system we

have?

Mr. DILWORTH. Yes, it is relevant.

25

Mr. SHAY. I think we would all agree it is relevant. One way to

look at this is, once you make your decision, having an income tax

base—or whatever mix if you want more consumption taxes, Jim—

or a revenue-raising base is just critical for our future. We have

large expenditure needs that we all know are coming down the

pike that we are not paying for, so this in my view may be a small

corner, but it is an important corner.

But it is part of the much bigger picture. We have to establish

an income tax and excise tax. Whatever combination of tax, we

have to establish a revenue system that can meet the needs of the

country that are going to allow us to be competitive. We have really

talked about a small element of it. It has much greater perception

of importance among some groups, and that is international income.

But I encourage the committee to think about this as part of the

overall tax system, and I would encourage the committee, as part

of an overall tax system, to broaden the income tax base, spread

the pain across a broad range of people, and lower tax rates. I

thought the 1986 Act approach was basically a good approach and

that gives this country flexibility to increase revenue if it is needed

for war, and decrease tax rates when they are not needed. It gives

us flexibility to be responsive in the international world.

The CHAIRMAN. Mr. Dilworth?

Mr. DILWORTH. I would agree with everything Steve said, up

until the end. But I think the 1986 Act and the succeeding 15,000

amendments suggest that base-broadening and rate-reduction are

promptly followed by rate increases, and at that point we do not

have a stable tax system. I would prefer to have a stable international system that the population thinks is paying its way. Business needs stability.

The CHAIRMAN. Yes. All right. This has been very, very helpful.

Clearly, we are just getting started. But thank you very much for

your time and indulgence. I think we will have many future discussions. Thank you very much.

The hearing is adjourned.

[Whereupon, at 11:27 a.m., the hearing was concluded.]

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