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 and the "1999 Update," the trade and investment of American companies with global operations are together a powerful engine of U.S. economic growth and a high U.S. standard of living. In particular, these studies demonstrated that: (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. It is imperative, therefore, that the international provisions of the U.S. tax code not undermine the international competitiveness of American firms.

On February 28, the Bush Administration presented its FY 2002 Budget Blueprint to Congress. While tax was a major issue in the proposal, the Administration did not propose any significant modifications in the international tax area. The Administration is expected to release its formal budget on April 3rd.

Discussed below are the replacement legislation for the Foreign Sales Corporation provisions, the Treasury Department’s tax deferral study, and tax simplification proposals.

Foreign Sales Corporation Rules

In 2000, the WTO ruled that the United States’ foreign sale corporation (FSC) provisions constituted prohibited export subsidies. The United States enacted legislation in November 2000 repealing the FSC provisions and established a new general rule for the treatment of extraterritorial income.

Background

In 1971, Congress established a system of tax deferral for ADomestic International Sales Corporations@ (DISC). The legislation was aimed in part at promoting exports and at offsetting what was viewed as a European competitive advantage arising from its practice of rebating value-added taxes on exports. The European Union (EU) filed a GATT case against the United States in 1972. In 1976, a GATT panel found that the DISC constituted a prohibited export subsidy. In settlement of the EU=s case and three cases filed by the United States against certain European tax exemptions, a 1981 GATT Council decision stated that export income generated outside of a country=s territory could be exempt from taxation (and that exemption would not constitute an illegal export subsidy).

In 1984, the United States replaced the DISC with the FSC program to conform to the 1981 GATT Council decision. The FSC allowed a certain portion of income related to exports generated by a FSC to be exempt from U.S. taxation. Under these provisions, FSCs were established as subsidiaries of U.S. corporations, organized under the laws of a qualified foreign nation or U.S. possession. The FSC provisions contained several requirements intended to ensure that a FSC has a genuine foreign presence and that its income is attributable to substantial commercial activity outside the United States. FSC exports were also required to contain 50 percent U.S. content.

EU Challenge to FSC Provisions

Despite the 1981 understanding, the EU challenged the U.S. FSC provisions in November 1997. Following the request for the establishment of a panel in July 1998, the United States filed challenges to the tax policies of five EU member states (France, Ireland, Greece, Belgium and the Netherlands). The United States has not requested the formation of a panel in any of those cases.

In September 1999, the panel reviewing the FSC provisions issued its decision that the FSC provides an export subsidy and stated that the United States had until October 2000 to bring its law into compliance. In April 2000, the WTO Appellate Body agreed with the panel’s primary conclusions.

Following the April decision, the Administration, House Ways and Means and Senate Finance Committees, and private sector worked to develop new legislation to bring U.S. law into compliance. That legislation, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, was enacted in November 2000.

FSC Repeal and Extraterritorial Income Act

The Act repeals the FSC provisions found by the WTO to be inconsistent with WTO rules, effective on September 30, 2000. This Act also modifies the general rule of U.S. taxation by amending the definition of gross income to exclude income derived from certain activities performed outside the United States, referred to as extraterritorial income, from the definition of gross income. As explained in the Senate Finance Committee’s report (No. 106-416): "This new general rule thus becomes the normative benchmark for taxing income derived in connection with certain activities performed outside the United States." The exclusion applies to foreign trade income, whether the goods are manufactured in the United States or abroad. An exception from this general rule is provided for extraterritorial income that is not "qualifying foreign trade income." The proposal applies in the same manner with respect to both individuals and corporations who are U.S. taxpayers. In addition, the exclusion from gross income applies for corporate and individual alternative minimum tax purposes. As also noted in the Finance Committee report, "the extraterritorial income excluded by this legislation from the scope of U.S. income taxation parallels the foreign-source income excluded under most territorial tax systems, particularly those employed by European Union member states."

In November 2000, the EU challenged the Act’s extraterritorial income tax benefits and the transition periods for the elimination of the FSC provisions. The EU also threatened sanctions worth $4.043 billion, on which the United States has requested arbitration. The EU issued a so-called "indicative" list of selected chapters of the U.S. tariff schedule that would be subject to retaliation, although no individual products were identified. As agreed to last September, the EU indicated that it would await the panel’s decision before implementing retaliatory measures. Following consultations with the United States, the EU formally requested a WTO review of the new legislation, which it argues is still inconsistent with the WTO’s rules. The WTO panel reviewing this legislation is expected to issue a decision by early summer 2001.

However, in early 2001, the EU indicated that it would request authorization from the WTO to retaliate immediately if the Bush Administration implements the carousel provisions of the Trade and Development Act of 2000 (which require the periodic revision of retaliation lists to provide maximum pressure on the EU as discussed in Section 3). Bush Administration officials indicated that they may implement these provisions in this spring if the EU implements the first-come, first-served marketing proposal to replace its existing banana import regime. The threat of retaliation subsided somewhat following a March 9th announcement by U.S. Trade Representative Robert Zoellick and EU Trade Commissioner Pascal Lamy that they would conduct further discussions on the banana dispute.

Treasury Deferral Study

In late 1999, the U.S. Treasury Department undertook a study of the impact of the rules governing the deferral of taxation on foreign source income, so-called subpart F rules which were enacted over 37 years ago. The study, The Deferral of Income Earned Through U.S. Controlled Corporations, was released in December 2000 and examines the purpose and effectiveness of the subpart F rules. The Treasury study concluded that the principle of "capital export neutrality" (i.e., that U.S. and foreign income should be taxed at the same rates) should remain the governing principle and, as a result, that some type of deferral regime continues to be needed to address the significant disparity between the taxation of U.S. and foreign income. Nevertheless, the study found that some technical assumptions may no longer be accurate and that some changes to the deferral rules may be required.

On the issue of competitiveness, the study concluded that the data were insufficient to permit an accurate and comprehensive comparison of the effective tax rates of U.S. companies and their foreign competitors. Thus, the study was unable to reach any documented conclusion about the effect of the subpart F rules on international competitiveness. The study suggests, however, that subpart F may not affect international competitiveness because other countries have adopted similar provisions.

Prior to the release of this study, the U.S. business community completed its own review of the U.S. anti-deferral regime under Subpart F, which documented that the breadth of the subpart F rules exceeds international norms and continues to undermine the competitiveness of U.S. firms. This study concluded that the economic policy justification underlying subpart F has been substantially eroded by the growth of the global economy and recommended that application of subpart F to various categories of foreign source income should be substantially narrowed.

International Tax Simplification Legislation

In 1999, Congressmen Amo Houghton (R-NY 31st) and Sandy Levin (D-MI 12th) 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. These bills proposed restoring the deferral of taxation on active financial services income, 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 re-characterize overall domestic losses and 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. It is expected that this legislation will be reintroduced in the 107th Congress.

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. ECAT supports legislation to make the exemption for active financial services income under Subpart F and the research and development tax credit permanent, to reform the interest allocation rules, to re-characterize domestic losses, to extend the carryforward period for foreign tax credits, and to treat the EU as a single country. ECAT supports the enactment last year of legislation that puts the United States into compliance with the WTO decisions regarding U.S. Foreign Sales Corporation provisions and supports a final resolution of this dispute this year 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 and the "1999 Update," the trade and investment of American companies with global operations are together a powerful engine of U.S. economic growth and a high U.S. standard of living. In particular, these studies demonstrated that: (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. It is imperative, therefore, that the international provisions of the U.S. tax code not undermine the international competitiveness of American firms. On February 28, the Bush Administration presented its FY 2002 Budget Blueprint to Congress. While tax was a major issue in the proposal, the Administration did not propose any significant modifications in the international tax area. The Administration is expected to release its formal budget on April 3rd. Discussed below are the replacement legislation for the Foreign Sales Corporation provisions, the Treasury Department’s tax deferral study, and tax simplification proposals. Foreign Sales Corporation Rules In 2000, the WTO ruled that the United States’ foreign sale corporation (FSC) provisions constituted prohibited export subsidies. The United States enacted legislation in November 2000 repealing the FSC provisions and established a new general rule for the treatment of extraterritorial income. Background In 1971, Congress established a system of tax deferral for ADomestic International Sales Corporations@ (DISC). The legislation was aimed in part at promoting exports and at offsetting what was viewed as a European competitive advantage arising from its practice of rebating value-added taxes on exports. The European Union (EU) filed a GATT case against the United States in 1972. In 1976, a GATT panel found that the DISC constituted a prohibited export subsidy. In settlement of the EU=s case and three cases filed by the United States against certain European tax exemptions, a 1981 GATT Council decision stated that export income generated outside of a country=s territory could be exempt from taxation (and that exemption would not constitute an illegal export subsidy). In 1984, the United States replaced the DISC with the FSC program to conform to the 1981 GATT Council decision. The FSC allowed a certain portion of income related to exports generated by a FSC to be exempt from U.S. taxation. Under these provisions, FSCs were established as subsidiaries of U.S. corporations, organized under the laws of a qualified foreign nation or U.S. possession. The FSC provisions contained several requirements intended to ensure that a FSC has a genuine foreign presence and that its income is attributable to substantial commercial activity outside the United States. FSC exports were also required to contain 50 percent U.S. content. EU Challenge to FSC Provisions Despite the 1981 understanding, the EU challenged the U.S. FSC provisions in November 1997. Following the request for the establishment of a panel in July 1998, the United States filed challenges to the tax policies of five EU member states (France, Ireland, Greece, Belgium and the Netherlands). The United States has not requested the formation of a panel in any of those cases. In September 1999, the panel reviewing the FSC provisions issued its decision that the FSC provides an export subsidy and stated that the United States had until October 2000 to bring its law into compliance. In April 2000, the WTO Appellate Body agreed with the panel’s primary conclusions. Following the April decision, the Administration, House Ways and Means and Senate Finance Committees, and private sector worked to develop new legislation to bring U.S. law into compliance. That legislation, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, was enacted in November 2000. FSC Repeal and Extraterritorial Income Act The Act repeals the FSC provisions found by the WTO to be inconsistent with WTO rules, effective on September 30, 2000. This Act also modifies the general rule of U.S. taxation by amending the definition of gross income to exclude income derived from certain activities performed outside the United States, referred to as extraterritorial income, from the definition of gross income. As explained in the Senate Finance Committee’s report (No. 106-416): "This new general rule thus becomes the normative benchmark for taxing income derived in connection with certain activities performed outside the United States." The exclusion applies to foreign trade income, whether the goods are manufactured in the United States or abroad. An exception from this general rule is provided for extraterritorial income that is not "qualifying foreign trade income." The proposal applies in the same manner with respect to both individuals and corporations who are U.S. taxpayers. In addition, the exclusion from gross income applies for corporate and individual alternative minimum tax purposes. As also noted in the Finance Committee report, "the extraterritorial income excluded by this legislation from the scope of U.S. income taxation parallels the foreign-source income excluded under most territorial tax systems, particularly those employed by European Union member states." In November 2000, the EU challenged the Act’s extraterritorial income tax benefits and the transition periods for the elimination of the FSC provisions. The EU also threatened sanctions worth $4.043 billion, on which the United States has requested arbitration. The EU issued a so-called "indicative" list of selected chapters of the U.S. tariff schedule that would be subject to retaliation, although no individual products were identified. As agreed to last September, the EU indicated that it would await the panel’s decision before implementing retaliatory measures. Following consultations with the United States, the EU formally requested a WTO review of the new legislation, which it argues is still inconsistent with the WTO’s rules. The WTO panel reviewing this legislation is expected to issue a decision by early summer 2001. However, in early 2001, the EU indicated that it would request authorization from the WTO to retaliate immediately if the Bush Administration implements the carousel provisions of the Trade and Development Act of 2000 (which require the periodic revision of retaliation lists to provide maximum pressure on the EU as discussed in Section 3). Bush Administration officials indicated that they may implement these provisions in this spring if the EU implements the first-come, first-served marketing proposal to replace its existing banana import regime. The threat of retaliation subsided somewhat following a March 9th announcement by U.S. Trade Representative Robert Zoellick and EU Trade Commissioner Pascal Lamy that they would conduct further discussions on the banana dispute. Treasury Deferral Study In late 1999, the U.S. Treasury Department undertook a study of the impact of the rules governing the deferral of taxation on foreign source income, so-called subpart F rules which were enacted over 37 years ago. The study, The Deferral of Income Earned Through U.S. Controlled Corporations, was released in December 2000 and examines the purpose and effectiveness of the subpart F rules. The Treasury study concluded that the principle of "capital export neutrality" (i.e., that U.S. and foreign income should be taxed at the same rates) should remain the governing principle and, as a result, that some type of deferral regime continues to be needed to address the significant disparity between the taxation of U.S. and foreign income. Nevertheless, the study found that some technical assumptions may no longer be accurate and that some changes to the deferral rules may be required. On the issue of competitiveness, the study concluded that the data were insufficient to permit an accurate and comprehensive comparison of the effective tax rates of U.S. companies and their foreign competitors. Thus, the study was unable to reach any documented conclusion about the effect of the subpart F rules on international competitiveness. The study suggests, however, that subpart F may not affect international competitiveness because other countries have adopted similar provisions. Prior to the release of this study, the U.S. business community completed its own review of the U.S. anti-deferral regime under Subpart F, which documented that the breadth of the subpart F rules exceeds international norms and continues to undermine the competitiveness of U.S. firms. This study concluded that the economic policy justification underlying subpart F has been substantially eroded by the growth of the global economy and recommended that application of subpart F to various categories of foreign source income should be substantially narrowed. International Tax Simplification Legislation In 1999, Congressmen Amo Houghton (R-NY 31st) and Sandy Levin (D-MI 12th) 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. These bills proposed restoring the deferral of taxation on active financial services income, 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 re-characterize overall domestic losses and 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. It is expected that this legislation will be reintroduced in the 107th Congress. 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. ECAT supports legislation to make the exemption for active financial services income under Subpart F and the research and development tax credit permanent, to reform the interest allocation rules, to re-characterize domestic losses, to extend the carryforward period for foreign tax credits, and to treat the EU as a single country. ECAT supports the enactment last year of legislation that puts the United States into compliance with the WTO decisions regarding U.S. Foreign Sales Corporation provisions and supports a final resolution of this dispute this year 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. 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