Emergency Committee For American Trade - Publications

Taxation of Foreign Source Income

One of the major challenges facing American companies with global operations is dealing with a U.S. international tax regime that is unnecessarily complex and increasingly out of step with the realities of global economic integration. America’s participation in the global marketplace no longer consists solely of U.S. companies importing and exporting. Instead, U.S. companies that already are the world’s largest exporters are becoming the world’s leading foreign investors, financiers, and service providers. As documented in ECAT’s study, Global Investments, American Returns, the trade and investment of American companies with global operations are together a powerful engine of U.S. economic growth and higher U.S. living standards. It is, therefore, imperative that the international provisions of the U.S. tax code not undermine the competitiveness of American firms as they compete in the global marketplace.

Finance Committee Chairman Bill Roth (R-DE) held a series of Finance Committee hearings last year to examine the ways in which the U.S. tax code may be modified to enhance American competitiveness in the global economy. Chairman Roth’s hearings also examined the ways in which U.S. international tax and trade policies could better work together to promote the international competitiveness of U.S. companies. Dr. Matthew Slaughter, the Dartmouth College economist who wrote Global Investments, American Returns (GIAR), testified during the Roth hearings on the ECAT study. He stressed the significant contribution of U.S. foreign direct investment to improvements in U.S. productivity and living standards.

To examine further the relationship between U.S. foreign direct investment and U.S. living standards, ECAT issued a "1999 Update" of its GIAR study. The update confirms the key findings of the study: 1) American companies with global operations make greater contributions to U.S. economic growth and living standards than American companies with purely domestic operations, and 2) the international operations of American companies generally complement their domestic activities.

The following paragraphs highlight some of the major issues likely to be the focus of debate in the international tax area this year.

Revenue Provisions in the Administration’s Fiscal Year (FY) 2001 Budget Proposal

The Administration’s fiscal year 2001 Budget Proposal includes a number of revenue-raising proposals that would undermine the competitiveness of U.S. companies and only one proposal that would promote the growth and international competitiveness of U.S. firms. The positive proposal is the acceleration of the effective date of a tax change affecting foreign joint ventures in which U.S. parent companies have a 10-to-50 percent ownership interest. The budget proposals that would have a negative impact on the international operations of U.S. companies include repealing the export source rule, imposing complex new regulations on U.S. company operations in countries that impose zero or nominal tax rates, and limiting foreign oil and gas foreign tax credits.

Accelerating the Effective Date of the Change in Rules on "10/50" Companies

The Administration’s Budget proposal would accelerate the effective date of a tax change made in the 1997 Tax Relief Act, affecting foreign joint ventures in which U.S. parents have between a 10 and 50 percent ownership interest, referred to as "10/50" companies. U.S. persons may credit foreign taxes against U.S. tax on foreign source income. The amount of foreign tax credits that may be claimed in a given year is subject to a limitation that prevents U.S. companies from using foreign tax credits to offset tax on U.S. source income.

The budget proposal would eliminate the single-basket limitation and accelerate the application of the look-through provisions with regard to dividends received from a 10/50 company in tax years after 1998. The changes will reduce the compliance burdens and reduce the inequity of the current provisions for U.S. companies doing business through foreign joint ventures.

Repeal of the Export Source Rule

Since 1922, Internal Revenue Code regulations have allowed the income from goods that are manufactured in the United States and sold abroad (with title passing in the United States) to be treated as 50 percent U.S. source income and 50 percent foreign source income. The export source rule helps level the competitive playing field for U.S. companies that manufacture in the United States and export their products overseas because it increases their foreign source income and allows them to fairly utilize their foreign tax credits. This is significant because the U.S. tax code restricts the ability of U.S. companies to claim credit for foreign taxes paid, thereby increasing the risk that U.S. companies will face double taxation on their foreign source income.

The Administration’s FY 2001 budget proposes to eliminate the 50 percent allocation rule and replace it with an activities-based test that would require U.S. companies to allocate income from exports to foreign and domestic sources based on the amount of activity that takes place in the United States and the amount that takes place overseas. The Administration argues that the 50-percent-allocation rule should be repealed because it gives American companies operating in high-tax foreign countries a competitive advantage over U.S. exporters that conduct all of their business activities in the United States. The Administration also contends that U.S. tax treaties protect U.S. export sales from foreign taxation in countries that have such treaties with the United States, thereby eliminating the need for the export source rule.

The Administration’s arguments do not justify the repeal of the export source rule. The rule does not give an extra advantage to U.S. exporters that operate in high-tax countries. Exporters with only domestic operations are not subject to the burden of foreign taxation and therefore do not face the risk of double taxation. These companies also have the benefit of deductions under U.S. tax law for all of their U.S. expenses, such as interest paid and research and development, because they do not have to allocate any of their expenses against foreign income. Therefore, the export source rule is simply leveling the playing field for U.S. exporters that do not have operations overseas.

The Administration’s arguments also ignore the effectiveness of the export source rule in promoting U.S. exports, which are vital to our economic growth and standard of living. Over the last several years, exports have accounted for roughly one-quarter of our total economic growth. The export source rule has operated to encourage U.S. companies to produce goods in their U.S. plants, rather than in their foreign facilities. Repeal of the rule will reduce U.S. exports and threaten the higher-paying U.S. jobs that are created by exports.

Imposition of Complex New Rules on U.S. Company Operations in Nominal Tax Rate Countries

Another provision of concern in the Administration’s budget proposal would impose complex new rules on the operations of U.S. companies in nominal tax rate or "tax haven" countries. These countries are defined as countries that impose no or nominal tax, either generally or on specific classes of income, and have strict confidentiality rules or ineffective information exchange practices. The U.S. Treasury Department would compile a list of tax haven countries based on this definition. U.S. companies would be denied foreign tax credit treatment for foreign taxes paid in countries included on the Treasury Department’s tax haven country list and such taxes would be treated in a separate foreign tax credit basket. In addition, the Administration’s proposal would require that all tax payments over a certain threshold be reported annually on the taxpayer’s return, subject to a penalty of 20 percent of the unreported tax payment amount.

The Administration’s proposal attempts to force certain countries to reform their bank secrecy laws and tax-information-sharing regimes by imposing harsh tax rules on U.S. companies. It is also troubling that, as a matter of policy, the provision is seeking to characterize a country as a "tax haven," even though it may only be imposing a low tax rate on a specific as opposed to a general class of income.

Limits on Use of Foreign Oil and Gas Income Tax Credits

The Administration’s budget proposal would limit the use of the foreign tax credit on foreign oil and gas income. U.S.-based oil companies are already at a competitive disadvantage under current law, as most of their foreign competitors pay little or no tax on foreign oil and gas income in their own countries. The Administration’s proposal raises the risk that foreign oil and gas income will be subject to double taxation, which will undermine the ability of U.S. oil companies to expand their global oil and gas exploration, production, refining, and marketing.

International Tax Simplification Legislation

Last year, Congressmen Amo Houghton (R-31 NY) and Sandy Levin (D-12 MI) introduced H.R. 2018, "The International Tax Simplification for American Competitiveness Act." Senators Hatch (R-UT) and Baucus (D-MT) introduced the Senate companion bill, S.1164. The provisions in last year’s bill include extending the carryforward period for foreign tax credits, restoring the deferral of taxation on active financial services income, re-characterizing overall domestic losses, reforming the interest allocation rules, making the research and development tax credit permanent, and requiring Treasury to conduct a study on the feasibility of treating the EU as a single country. The bill would also extend the carryforward period for foreign tax credits from five to 10 years to minimize the loss of foreign tax credits and reduce the risk of double taxation of income.

EU’s WTO Challenge to the Foreign Sales Corporation Provisions of U.S. Tax Law

Last October, the EU won a WTO challenge against U.S. tax exemptions for Foreign Sales Corporations (FSCs) on the grounds that they are illegal export subsidies. The WTO dispute settlement panel ruled that the United States has to repeal or modify the FSC rules by October 1, 2000. In late February of this year, the WTO Appellate Body affirmed the panel’s ruling that the FSC is a prohibited export subsidy and recommended that the United States conform the FSC to WTO rules.

The United States has stated that it strongly disagrees with the Appellate Body’s ruling and believes that the FSC is completely consistent with U.S. WTO obligations. The United States has said that it respects its WTO obligations and will seek a resolution of the dispute that ensures that U.S. firms and workers are not at a competitive disadvantage with their European counterparts. It is in the mutual interest of the United States and the EU to resolve the case without resorting to retaliation. If the matter is not resolved, as much as $2 billion worth of U.S. exports could be subject to retaliation, and it would severely damage U.S. bilateral relations with the EU.

The FSC provisions were enacted in 1984 and allow a certain portion of income related to exports generated by a FSC to be exempt from U.S. taxation. To qualify as a FSC, an entity must be organized as a corporation and carry out certain economic activities outside the United States. FSC exports must also contain 50 percent U.S. content.

FSC legislation replaced the Domestic International Sales Corporation (DISC) legislation that was determined to be an illegal export subsidy by a GATT panel in 1976. The 1976 GATT panel decision was adopted pursuant to a 1981 understanding which provided that: 1) GATT does not prohibit measures to avoid double taxation of income, and 2) GATT members need not tax income generated by economic processes outside of their territories to which arm’s length pricing rules should be applied. The FSC legislation was drafted to conform to the 1981 understanding.

The EU has argued before the WTO dispute panel that the FSC is an illegal export subsidy in violation of Article 3 of the Subsidies Code and Article XVI of the GATT. Furthermore, the EU contends that according to the 1981 Understanding, which allowed the adoption of the DISC panel report, WTO members must adopt either purely territorial or global tax systems. Under a territorial tax system, the government only taxes income earned inside its territory. The EU maintained that because the United States has a global tax system, it could not allow an exemption that excludes a portion of FSC income from taxation based on the fact that the income was earned outside U.S. territory. The EU also contended that even if the FSC is permissible under a global tax system, it is still a prohibited export subsidy because its provisions do not require enough economic activity to occur offshore to justify the administrative pricing rules used. In addition, the EU alleged that the FSC is an illegal export subsidy under the WTO agreement on agriculture and that the 50-percent domestic content requirements violate the national treatment provisions of Article III of the GATT.

The United States argued that: 1) The FSC is not an export subsidy and was specifically drafted to conform to the 1981 understanding that permitted the adoption of the DISC panel report; 2) Since the complaint involves transfer-pricing issues, it should be dealt with under U.S. tax treaties rather than the WTO; and 3) The EU has failed to identify any agricultural products that are being adversely affected. In addition to the arguments the United States made in response to the EU complaint against the FSC, in May 1998, the United States filed five WTO dispute settlement complaints against certain European income tax subsidies in France, the Netherlands, Greece, Ireland, and Belgium.

The United States and the EU are now engaged in ongoing consultations to resolve the dispute.

Treasury Deferral Study

The U.S. Treasury Department is currently conducting a study of the impact of the rules governing the deferral of taxation on foreign source income. There is concern that the Treasury study could prompt an overall review of the deferral provisions, which would result in increased taxation of foreign source income under subpart F and further limitations on the use of foreign tax credits.

In response to the Treasury study, the U.S. business community completed a review of the U.S. anti-deferral regime under Subpart F and is continuing its study of the application of U.S. foreign tax credits. The Sub-part F study demonstrated that: 1) The economic policy justification underlying Subpart F has been substantially eroded by the growth of the global economy; 2) The breadth of the Subpart F rules exceeds international norms and is undermining the competitiveness of U.S. business; and 3) The application of Subpart F to various categories of foreign source income should be substantially narrowed.

ECAT POSITION: ECAT opposes any modification to the rules governing the taxation of foreign source income that would undermine the competitiveness of U.S. companies. Specifically, we oppose the proposals in the Administration’s fiscal year 2001 budget to replace the export source rule with an activities-based rule, to impose complex new rules regarding nominal tax countries, and to limit the use of the foreign tax credit for oil and gas income. ECAT supports legislation to make the exemption for active financial services income under Subpart F and the research and development tax credit permanent, and to provide relief from the interest allocation rules. ECAT opposes changes in the deferral of taxation of foreign source income.

ECAT supports the U.S. effort to work with the EU to resolve the WTO dispute over the U.S. Foreign Sales Corporation provisions. The dispute must be resolved in a manner that ensures that U.S. firms and workers are not at a competitive disadvantage with their European counterparts and guarantees a level playing field for American companies with international operations.


	Taxation of Foreign Source Income One of the major challenges facing American companies with global operations is dealing with a U.S. international tax regime that is unnecessarily complex and increasingly out of step with the realities of global economic integration. America’s participation in the global marketplace no longer consists solely of U.S. companies importing and exporting. Instead, U.S. companies that already are the world’s largest exporters are becoming the world’s leading foreign investors, financiers, and service providers. As documented in ECAT’s study, Global Investments, American Returns, the trade and investment of American companies with global operations are together a powerful engine of U.S. economic growth and higher U.S. living standards. It is, therefore, imperative that the international provisions of the U.S. tax code not undermine the competitiveness of American firms as they compete in the global marketplace. Finance Committee Chairman Bill Roth (R-DE) held a series of Finance Committee hearings last year to examine the ways in which the U.S. tax code may be modified to enhance American competitiveness in the global economy. Chairman Roth’s hearings also examined the ways in which U.S. international tax and trade policies could better work together to promote the international competitiveness of U.S. companies. Dr. Matthew Slaughter, the Dartmouth College economist who wrote Global Investments, American Returns (GIAR), testified during the Roth hearings on the ECAT study. He stressed the significant contribution of U.S. foreign direct investment to improvements in U.S. productivity and living standards. To examine further the relationship between U.S. foreign direct investment and U.S. living standards, ECAT issued a "1999 Update" of its GIAR study. The update confirms the key findings of the study: 1) American companies with global operations make greater contributions to U.S. economic growth and living standards than American companies with purely domestic operations, and 2) the international operations of American companies generally complement their domestic activities. The following paragraphs highlight some of the major issues likely to be the focus of debate in the international tax area this year. Revenue Provisions in the Administration’s Fiscal Year (FY) 2001 Budget Proposal The Administration’s fiscal year 2001 Budget Proposal includes a number of revenue-raising proposals that would undermine the competitiveness of U.S. companies and only one proposal that would promote the growth and international competitiveness of U.S. firms. The positive proposal is the acceleration of the effective date of a tax change affecting foreign joint ventures in which U.S. parent companies have a 10-to-50 percent ownership interest. The budget proposals that would have a negative impact on the international operations of U.S. companies include repealing the export source rule, imposing complex new regulations on U.S. company operations in countries that impose zero or nominal tax rates, and limiting foreign oil and gas foreign tax credits. Accelerating the Effective Date of the Change in Rules on "10/50" Companies The Administration’s Budget proposal would accelerate the effective date of a tax change made in the 1997 Tax Relief Act, affecting foreign joint ventures in which U.S. parents have between a 10 and 50 percent ownership interest, referred to as "10/50" companies. U.S. persons may credit foreign taxes against U.S. tax on foreign source income. The amount of foreign tax credits that may be claimed in a given year is subject to a limitation that prevents U.S. companies from using foreign tax credits to offset tax on U.S. source income. The budget proposal would eliminate the single-basket limitation and accelerate the application of the look-through provisions with regard to dividends received from a 10/50 company in tax years after 1998. The changes will reduce the compliance burdens and reduce the inequity of the current provisions for U.S. companies doing business through foreign joint ventures. Repeal of the Export Source Rule Since 1922, Internal Revenue Code regulations have allowed the income from goods that are manufactured in the United States and sold abroad (with title passing in the United States) to be treated as 50 percent U.S. source income and 50 percent foreign source income. The export source rule helps level the competitive playing field for U.S. companies that manufacture in the United States and export their products overseas because it increases their foreign source income and allows them to fairly utilize their foreign tax credits. This is significant because the U.S. tax code restricts the ability of U.S. companies to claim credit for foreign taxes paid, thereby increasing the risk that U.S. companies will face double taxation on their foreign source income. The Administration’s FY 2001 budget proposes to eliminate the 50 percent allocation rule and replace it with an activities-based test that would require U.S. companies to allocate income from exports to foreign and domestic sources based on the amount of activity that takes place in the United States and the amount that takes place overseas. The Administration argues that the 50-percent-allocation rule should be repealed because it gives American companies operating in high-tax foreign countries a competitive advantage over U.S. exporters that conduct all of their business activities in the United States. The Administration also contends that U.S. tax treaties protect U.S. export sales from foreign taxation in countries that have such treaties with the United States, thereby eliminating the need for the export source rule. The Administration’s arguments do not justify the repeal of the export source rule. The rule does not give an extra advantage to U.S. exporters that operate in high-tax countries. Exporters with only domestic operations are not subject to the burden of foreign taxation and therefore do not face the risk of double taxation. These companies also have the benefit of deductions under U.S. tax law for all of their U.S. expenses, such as interest paid and research and development, because they do not have to allocate any of their expenses against foreign income. Therefore, the export source rule is simply leveling the playing field for U.S. exporters that do not have operations overseas. The Administration’s arguments also ignore the effectiveness of the export source rule in promoting U.S. exports, which are vital to our economic growth and standard of living. Over the last several years, exports have accounted for roughly one-quarter of our total economic growth. The export source rule has operated to encourage U.S. companies to produce goods in their U.S. plants, rather than in their foreign facilities. Repeal of the rule will reduce U.S. exports and threaten the higher-paying U.S. jobs that are created by exports. Imposition of Complex New Rules on U.S. Company Operations in Nominal Tax Rate Countries Another provision of concern in the Administration’s budget proposal would impose complex new rules on the operations of U.S. companies in nominal tax rate or "tax haven" countries. These countries are defined as countries that impose no or nominal tax, either generally or on specific classes of income, and have strict confidentiality rules or ineffective information exchange practices. The U.S. Treasury Department would compile a list of tax haven countries based on this definition. U.S. companies would be denied foreign tax credit treatment for foreign taxes paid in countries included on the Treasury Department’s tax haven country list and such taxes would be treated in a separate foreign tax credit basket. In addition, the Administration’s proposal would require that all tax payments over a certain threshold be reported annually on the taxpayer’s return, subject to a penalty of 20 percent of the unreported tax payment amount. The Administration’s proposal attempts to force certain countries to reform their bank secrecy laws and tax-information-sharing regimes by imposing harsh tax rules on U.S. companies. It is also troubling that, as a matter of policy, the provision is seeking to characterize a country as a "tax haven," even though it may only be imposing a low tax rate on a specific as opposed to a general class of income. Limits on Use of Foreign Oil and Gas Income Tax Credits The Administration’s budget proposal would limit the use of the foreign tax credit on foreign oil and gas income. U.S.-based oil companies are already at a competitive disadvantage under current law, as most of their foreign competitors pay little or no tax on foreign oil and gas income in their own countries. The Administration’s proposal raises the risk that foreign oil and gas income will be subject to double taxation, which will undermine the ability of U.S. oil companies to expand their global oil and gas exploration, production, refining, and marketing. International Tax Simplification Legislation Last year, Congressmen Amo Houghton (R-31 NY) and Sandy Levin (D-12 MI) introduced H.R. 2018, "The International Tax Simplification for American Competitiveness Act." Senators Hatch (R-UT) and Baucus (D-MT) introduced the Senate companion bill, S.1164. The provisions in last year’s bill include extending the carryforward period for foreign tax credits, restoring the deferral of taxation on active financial services income, re-characterizing overall domestic losses, reforming the interest allocation rules, making the research and development tax credit permanent, and requiring Treasury to conduct a study on the feasibility of treating the EU as a single country. The bill would also extend the carryforward period for foreign tax credits from five to 10 years to minimize the loss of foreign tax credits and reduce the risk of double taxation of income. EU’s WTO Challenge to the Foreign Sales Corporation Provisions of U.S. Tax Law Last October, the EU won a WTO challenge against U.S. tax exemptions for Foreign Sales Corporations (FSCs) on the grounds that they are illegal export subsidies. The WTO dispute settlement panel ruled that the United States has to repeal or modify the FSC rules by October 1, 2000. In late February of this year, the WTO Appellate Body affirmed the panel’s ruling that the FSC is a prohibited export subsidy and recommended that the United States conform the FSC to WTO rules. The United States has stated that it strongly disagrees with the Appellate Body’s ruling and believes that the FSC is completely consistent with U.S. WTO obligations. The United States has said that it respects its WTO obligations and will seek a resolution of the dispute that ensures that U.S. firms and workers are not at a competitive disadvantage with their European counterparts. It is in the mutual interest of the United States and the EU to resolve the case without resorting to retaliation. If the matter is not resolved, as much as $2 billion worth of U.S. exports could be subject to retaliation, and it would severely damage U.S. bilateral relations with the EU. The FSC provisions were enacted in 1984 and allow a certain portion of income related to exports generated by a FSC to be exempt from U.S. taxation. To qualify as a FSC, an entity must be organized as a corporation and carry out certain economic activities outside the United States. FSC exports must also contain 50 percent U.S. content. FSC legislation replaced the Domestic International Sales Corporation (DISC) legislation that was determined to be an illegal export subsidy by a GATT panel in 1976. The 1976 GATT panel decision was adopted pursuant to a 1981 understanding which provided that: 1) GATT does not prohibit measures to avoid double taxation of income, and 2) GATT members need not tax income generated by economic processes outside of their territories to which arm’s length pricing rules should be applied. The FSC legislation was drafted to conform to the 1981 understanding. The EU has argued before the WTO dispute panel that the FSC is an illegal export subsidy in violation of Article 3 of the Subsidies Code and Article XVI of the GATT. Furthermore, the EU contends that according to the 1981 Understanding, which allowed the adoption of the DISC panel report, WTO members must adopt either purely territorial or global tax systems. Under a territorial tax system, the government only taxes income earned inside its territory. The EU maintained that because the United States has a global tax system, it could not allow an exemption that excludes a portion of FSC income from taxation based on the fact that the income was earned outside U.S. territory. The EU also contended that even if the FSC is permissible under a global tax system, it is still a prohibited export subsidy because its provisions do not require enough economic activity to occur offshore to justify the administrative pricing rules used. In addition, the EU alleged that the FSC is an illegal export subsidy under the WTO agreement on agriculture and that the 50-percent domestic content requirements violate the national treatment provisions of Article III of the GATT. The United States argued that: 1) The FSC is not an export subsidy and was specifically drafted to conform to the 1981 understanding that permitted the adoption of the DISC panel report; 2) Since the complaint involves transfer-pricing issues, it should be dealt with under U.S. tax treaties rather than the WTO; and 3) The EU has failed to identify any agricultural products that are being adversely affected. In addition to the arguments the United States made in response to the EU complaint against the FSC, in May 1998, the United States filed five WTO dispute settlement complaints against certain European income tax subsidies in France, the Netherlands, Greece, Ireland, and Belgium. The United States and the EU are now engaged in ongoing consultations to resolve the dispute. Treasury Deferral Study The U.S. Treasury Department is currently conducting a study of the impact of the rules governing the deferral of taxation on foreign source income. There is concern that the Treasury study could prompt an overall review of the deferral provisions, which would result in increased taxation of foreign source income under subpart F and further limitations on the use of foreign tax credits. In response to the Treasury study, the U.S. business community completed a review of the U.S. anti-deferral regime under Subpart F and is continuing its study of the application of U.S. foreign tax credits. The Sub-part F study demonstrated that: 1) The economic policy justification underlying Subpart F has been substantially eroded by the growth of the global economy; 2) The breadth of the Subpart F rules exceeds international norms and is undermining the competitiveness of U.S. business; and 3) The application of Subpart F to various categories of foreign source income should be substantially narrowed. ECAT POSITION: ECAT opposes any modification to the rules governing the taxation of foreign source income that would undermine the competitiveness of U.S. companies. Specifically, we oppose the proposals in the Administration’s fiscal year 2001 budget to replace the export source rule with an activities-based rule, to impose complex new rules regarding nominal tax countries, and to limit the use of the foreign tax credit for oil and gas income. ECAT supports legislation to make the exemption for active financial services income under Subpart F and the research and development tax credit permanent, and to provide relief from the interest allocation rules. ECAT opposes changes in the deferral of taxation of foreign source income. ECAT supports the U.S. effort to work with the EU to resolve the WTO dispute over the U.S. Foreign Sales Corporation provisions. The dispute must be resolved in a manner that ensures that U.S. firms and workers are not at a competitive disadvantage with their European counterparts and guarantees a level playing field for American companies with international operations. ECAT - Homepage About ECAT \| Hot Issues \| ECAT Positions Press Releases \| Trade Resources \| Key Trade Votes \| Publications Steel \| CAFTA \| Search \| Members Only Copyright 1999-2002, the Emergency Committee for American Trade