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.

Discussed below are the status of the European Union's (EU) challenge to the Foreign Sales Corporation provisions, the Treasury Department's tax deferral study, and tax simplification and other reform proposals. Given the budget deficit, it appears unlikely that Congress will actively consider changes to the international tax provisions of the U.S. code this year, except perhaps as an outgrowth of Congress' review of the proper response to the WTO decision in the Foreign Sales Corporation case.

Foreign Sales Corporation Rules

On January 14, 2002, the WTO Appellate Body issued its report ruling that provisions of the United States' Extraterritorial Income Act constituted prohibited export subsidies, like the predecessor Foreign Sales Corporation (FSC) provisions. A WTO arbitration panel is currently reviewing the level of damages imposed by this system on the EU; the EU has requested authorization to impose $4.043 billion in sanctions, while the United States has argued that the proper figure is $956 million. The Administration and Congress are currently exploring how best to address the Appellate Body ruling, while ensuring the international competitiveness of U.S. companies.

Background

In 1971, Congress established a system of tax deferral for Domestic International Sales Corporations (DISC). The legislation was aimed in part at promoting exports and 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, the House Ways and Means and Senate Finance Committees, and the 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 (ETI)

The ETI 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 ETI 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.

On August 20, 2001, the WTO panel reviewing the ETI Act issued its decision, finding that the Act continued to provide prohibited export subsidies. The United States appealed this decision to the WTO Appellate Body, which issued a report on January 14, 2002, agreeing with the lower panel ruling that the ETI Act constituted an illegal export subsidy. In particular, the Appellate Body reached the following conclusions:

The ETI allows U.S. taxpayers to forego revenue and that these benefits are contingent upon export performance because exports are subject to different rules than goods produced outside the United States. Consequently, the ETI provides an illegal export subsidy contrary to the WTO Agreement on Subsidies and Countervailing Measures and the WTO Agreement on Agriculture.
While finding that provisions necessary to avoid double taxation represented an appropriate exception to prohibition against export subsidies contained in the Agreement on Subsidies and Countervailing Measures, the Appellate Body found that the ETI did not satisfy this exception because it provided subsidies for income earned domestically, not just "foreign source income" which could potentially be subject to double taxation.
The requirement that goods subject to the ETI have no more than 50 percent foreign content represents a violation of the national treatment obligation.
The transitional rules constitute a violation since they essentially keep the former FSC rules in effect.

Following adoption of the Appellate Body and panel reports, the EU requested arbitration on the level of damages, requesting authorization to impose retaliation up to $4.043 billion. The United States has countered that the appropriate level of damage is $956 million. A decision is due from arbitration is due at the end of April 2002.

The Administration and Congress are currently reviewing the appropriate response to the Appellate Body decision, including whether the U.S. tax code needs to be fundamentally rewritten in order to ensure the competitiveness of U.S. companies. The Ways and Means Committee held a hearing on February 27, 2002 to review options, including modifications to the U.S. territorial model or moving to a border adjustable value-added tax similar to that applied in the EU.

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.

Congress has yet to consider fully the implications of the deferral study, although it may do so more actively in 2002, as its considers what if any changes to make to the ETI Act or more broadly to make U.S. companies more internationally competitive.

International Tax Simplification Legislation

In 1999 Congress passed, but President Clinton vetoed, H.R. 2488, tax legislation that among other provisions contained a number of significant reforms in the international area. Among them were allocation of interest expense on a worldwide basis, application of look-through treatment for 10/50 companies in certain situations, recharacterization of overall domestic loss, exception from subpart F treatment for certain pipeline transportation and electricity transmission income, repeal of the special foreign tax credit rules for foreign oil and gas income, treatment of regulated investment companies, and exemption from the 7.5 percent air passenger ticket tax on frequent flier miles to persons with foreign addresses. In addition the bill repealed the 90 percent limit on the foreign tax credit in the alternative minimum tax.

Also in 1999, Congressmen Amo Houghton (R-NY) and Sandy Levin (D-MI) introduced H.R. 2018, "The International Tax Simplification for American Competitiveness Act." Senator Baucus (D-MT) and Senator Hatch (R-UT) introduced the Senate companion bill, S.1164. Now Chairman of the Senate Finance Committee, Senator Baucus and the others are expected to reintroduce that legislation this year.

These simplification bills contained a number of the provisions included in the vetoed bill. In addition, among their other provisions, were provisions to extend the deferral of taxation on active financial services income, and to require Treasury to conduct a study on the feasibility of treating the EU as a single country. They 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.

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, such as the provisions that had been included in the vetoed tax reform bill in 1999 and in simplification proposals that would make U.S. companies more competitive. ECAT supports the resolution of the U.S.-EU dispute over U.S. Foreign Sales Corporation provisions 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. Discussed below are the status of the European Union's (EU) challenge to the Foreign Sales Corporation provisions, the Treasury Department's tax deferral study, and tax simplification and other reform proposals. Given the budget deficit, it appears unlikely that Congress will actively consider changes to the international tax provisions of the U.S. code this year, except perhaps as an outgrowth of Congress' review of the proper response to the WTO decision in the Foreign Sales Corporation case. Foreign Sales Corporation Rules On January 14, 2002, the WTO Appellate Body issued its report ruling that provisions of the United States' Extraterritorial Income Act constituted prohibited export subsidies, like the predecessor Foreign Sales Corporation (FSC) provisions. A WTO arbitration panel is currently reviewing the level of damages imposed by this system on the EU; the EU has requested authorization to impose $4.043 billion in sanctions, while the United States has argued that the proper figure is $956 million. The Administration and Congress are currently exploring how best to address the Appellate Body ruling, while ensuring the international competitiveness of U.S. companies. Background In 1971, Congress established a system of tax deferral for Domestic International Sales Corporations (DISC). The legislation was aimed in part at promoting exports and 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, the House Ways and Means and Senate Finance Committees, and the 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 (ETI) The ETI 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 ETI 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. On August 20, 2001, the WTO panel reviewing the ETI Act issued its decision, finding that the Act continued to provide prohibited export subsidies. The United States appealed this decision to the WTO Appellate Body, which issued a report on January 14, 2002, agreeing with the lower panel ruling that the ETI Act constituted an illegal export subsidy. In particular, the Appellate Body reached the following conclusions: The ETI allows U.S. taxpayers to forego revenue and that these benefits are contingent upon export performance because exports are subject to different rules than goods produced outside the United States. Consequently, the ETI provides an illegal export subsidy contrary to the WTO Agreement on Subsidies and Countervailing Measures and the WTO Agreement on Agriculture. While finding that provisions necessary to avoid double taxation represented an appropriate exception to prohibition against export subsidies contained in the Agreement on Subsidies and Countervailing Measures, the Appellate Body found that the ETI did not satisfy this exception because it provided subsidies for income earned domestically, not just "foreign source income" which could potentially be subject to double taxation. The requirement that goods subject to the ETI have no more than 50 percent foreign content represents a violation of the national treatment obligation. The transitional rules constitute a violation since they essentially keep the former FSC rules in effect. Following adoption of the Appellate Body and panel reports, the EU requested arbitration on the level of damages, requesting authorization to impose retaliation up to $4.043 billion. The United States has countered that the appropriate level of damage is $956 million. A decision is due from arbitration is due at the end of April 2002. The Administration and Congress are currently reviewing the appropriate response to the Appellate Body decision, including whether the U.S. tax code needs to be fundamentally rewritten in order to ensure the competitiveness of U.S. companies. The Ways and Means Committee held a hearing on February 27, 2002 to review options, including modifications to the U.S. territorial model or moving to a border adjustable value-added tax similar to that applied in the EU. 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. Congress has yet to consider fully the implications of the deferral study, although it may do so more actively in 2002, as its considers what if any changes to make to the ETI Act or more broadly to make U.S. companies more internationally competitive. International Tax Simplification Legislation In 1999 Congress passed, but President Clinton vetoed, H.R. 2488, tax legislation that among other provisions contained a number of significant reforms in the international area. Among them were allocation of interest expense on a worldwide basis, application of look-through treatment for 10/50 companies in certain situations, recharacterization of overall domestic loss, exception from subpart F treatment for certain pipeline transportation and electricity transmission income, repeal of the special foreign tax credit rules for foreign oil and gas income, treatment of regulated investment companies, and exemption from the 7.5 percent air passenger ticket tax on frequent flier miles to persons with foreign addresses. In addition the bill repealed the 90 percent limit on the foreign tax credit in the alternative minimum tax. Also in 1999, Congressmen Amo Houghton (R-NY) and Sandy Levin (D-MI) introduced H.R. 2018, "The International Tax Simplification for American Competitiveness Act." Senator Baucus (D-MT) and Senator Hatch (R-UT) introduced the Senate companion bill, S.1164. Now Chairman of the Senate Finance Committee, Senator Baucus and the others are expected to reintroduce that legislation this year. These simplification bills contained a number of the provisions included in the vetoed bill. In addition, among their other provisions, were provisions to extend the deferral of taxation on active financial services income, and to require Treasury to conduct a study on the feasibility of treating the EU as a single country. They 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. 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, such as the provisions that had been included in the vetoed tax reform bill in 1999 and in simplification proposals that would make U.S. companies more competitive. ECAT supports the resolution of the U.S.-EU dispute over U.S. Foreign Sales Corporation provisions 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