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SECTION 12: 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. In early 2003, ECAT released its latest study, Technology, Trade and Investment: The Public Opinion Disconnect, that documents the critical role that trade and investment liberalization play in promotion of industries that produce and use technology - industries that are responsible for the significant acceleration in productivity over the last half-decade, which has contributed to a significant increase in U.S. living standards. The study recommended that the Administration and Congress continue to pursue policies that promote and protect trade and investment, including through the promotion of appropriate tax policies. ECAT strongly seeks to ensure, therefore, that the international provisions of the U.S. tax code promote, and do 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 and tax reform and simplification proposals.
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 found that the EU could seek compensation or impose retaliation in the amount of $4.043 billion. 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 DISC 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 rules 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 repealed the FSC provisions found by the WTO to be inconsistent with WTO rules, effective on September 30, 2000. This Act also modified 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 legislation 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 in September 2000, 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 argued 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 the 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, an arbitration panel determined the EU could impose retaliatory tariffs up to $4.043 billion. In February 2003, the EU presented its final draft retaliation list that includes a wide range of products, from jewelry and jewels to agricultural goods, wood and paper, engines, textiles and apparel and other manufactured items. The final list is expected to be approved in April. EU Trade Minister Lamy continues to press the United States on compliance, but has not set any deadline for retaliation.
The Administration and members of Congress are reviewing options and considering numerous proposals to address these rulings. In 2002, Ways and Means Committee Chairman Bill Thomas (R-CA) introduced H.R. 5095, the American Competitiveness and Corporate Accountability of 2002, which would repeal the FSC and ETI provisions struck down by the WTO. At the same time, the legislation proposes numerous reforms of the U.S. international tax law, as discussed below. The Administration has also emphasized, as part of its FY 2004 budget, the importance of coming into compliance with the WTO decisions, while also promoting the competitiveness of U.S. companies.
Another proposal, being drafted by private sector companies, would allow for a six-year phase out of the FSC/ETI provisions. In their place, the proposal would introduce a tax exclusion for certain U.S. manufacturing and U.S. production activity.
The Administration and members of Congress will continue to review potential responses to the Appellate Body decision in 2003, including whether the U.S. tax code needs to be fundamentally rewritten in order to ensure the competitiveness of U.S. companies.
Reform and Simplification of U.S. International Tax Laws
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 (many of which were included in H.R. 5095 from the 107th Congress, referenced above). 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. 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.
In 2002, Ways and Means Committee Chairman Bill Thomas introduced H.R. 5095, the American Competitiveness and Corporate Accountability Act of 2002, which would repeal the FSC and ETI provisions struck down by the WTO, while also making many long overdue and important changes to the treatment of Controlled Foreign Corporations (CFCs) and the Foreign Tax Credit. In particular, the legislation would make the following modifications:
This legislation has caused significant concern in some quarters as a result of its repeal of the FSC and ETI provisions without proposing alternative legislation that would make companies that had relied on the FSC/ETI provisions whole. This legislation does propose, however, a number of the long overdue improvements in and greater simplification of the treatment of Controlled Foreign Corporations (CFCs), as well as necessary modifications to the Foreign Tax Credit rules to protect more adequately against double taxation. Chairman Thomas has announced that he will reintroduce this legislation in 2003 with important modifications to try to address some of the concerns that have been raised.
In its General Explanations of the Administration's Fiscal Year 2004 Revenue Proposals (the so-called Blue Book), released as part of the Administration's FY 2004 budget, the Administration called for a "complete reexamination of all of the U.S. international tax rules to ensure that the U.S. tax rules do not adversely impact the ability of American workers and U.S. businesses to compete successfully around the world." The Administration also made the following analysis:
The U.S. international tax rules can impose a burden on U.S.-based companies disproportionate to the tax burden imposed by our trading partners on the foreign operations of their companies. The U.S. rules for the taxation of foreign source income are unique in their breadth of reach and degree of complexity. That complexity itself represents a significant burden that should be addressed.
The Blue Book focused in particular on complex and burdensome sub-part F rules and the foreign tax credit rules as examples.
In 2003, therefore, there will be increased attention to the need to reform and simply U.S. international tax rules.
ECAT POSITION: ECAT supports efforts to resolve our longstanding dispute with the EU over U.S. taxation of foreign source income in a manner that promotes, and does not 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 more recent tax reform and simplification proposals that would make U.S. companies more competitive.
1 An inversion takes place when a company changes its principal place of incorporation to a foreign jurisdiction.
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Copyright 1999-2002, the Emergency Committee for American Trade
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