Emergency Committee For American Trade - Publications

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 also among 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 demonstrate 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 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.

One of the most difficult issues in recent years concerns the European Union’s challenge of the U.S. Foreign Sales Corporation and then Extraterritorial Income Act provisions of the Internal Revenue Code before the World Trade Organization (WTO). As well, the United States’ bilateral tax treaty program and proposals to reform and simplify the international provisions of the U.S. tax code are discussed below.

Extraterritorial Income Act and 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. Starting March 1, 2004, the EU began to impose retaliatory tariffs on 1,608 U.S. products. Although a WTO arbitration panel found that the EU could impose retaliation in the amount of $4.043 billion, the EU chose to impose a much lower level of retaliation; the EU imposed an initial five percent tariff, which will be increased automatically by one percentage point monthly until it reaches 17 percent in March 2005. The Commerce Department estimates that the sanctions imposed on U.S. products between March 2004 and March 2005 could result in approximately $475 million in duties. The EU has indicated that it will review its decision in March 2005. 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 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. Despite efforts by Members of Congress and the Administration to develop alternative provisions, no legislation has been enacted by either body of Congress by the end of April 2004. As discussed above, the EU began to phase in the imposition of retaliatory tariffs on March 1, 2004. Such tariffs will be imposed on products within the following categories, precious stones and metals, articles of jewelry, certain agricultural products (including soybeans, linseed, sunflower seed, orange juice and horse meat), wood products, toys, sporting equipment, board games, textile and apparel products, refrigeration equipment, heavy machinery (including engines, boilers, refrigerators), construction equipment and paper products.

Legislative Proposals to Repeal ETI Provisions

Numerous legislative proposals have been made to repeal the ETI provisions, yet still ensure the international competitiveness of U.S. companies. The primary proposals are discussed below. The only proposal that is actively being considered on the floor is S. 1637, Jumpstart Our Business Strength (JOBS) Act, introduced by Finance Committee Chairman Grassley (R-IA) and Ranking Member Baucus (D-MT) and others. The primary provisions of this bill include:

Repeals the ETI provisions, with a phase-out through 2006.
Allows deduction (by corporations and pass-through entities) for nine percent of qualified domestic production activities of up to 50 percent of wages paid, but temporarily reduces this benefit the more a company produces abroad.
Extends foreign tax credit carryforward period to 20 years and limits the carryback period to one year.
Applies look-through approach to dividends paid by section 902 corporation.
Repeals 90-percent limitation on the use of the alternative minimum tax foreign tax credit.
Recharacterizes overall domestic losses.
Modifies interest expense allocation rules.
Modifies calculation of foreign personal holding company income.
Adopts international tax simplification provisions, including repeal of foreign personal holding company rules and foreign investment company rules, expansion of de minimis rule, attribution of stock ownership, application of uniform capitalization rules for foreign persons, and repeal of special capital gains tax of certain aliens.
Adopts a variety of other foreign tax modifications, including Subpart F exception for active aircraft and vessel leasing income, certain modifications to look-through treatment of payments, and election not to use average exchange rate for foreign tax paid.
Adopts a variety of domestic tax modifications, including expansion of qualified small-issue bond program, rules for the expensing of broadband equipment investments, exemption from natural aging from interest capitalization, application of “active business test” to chains of affiliated corporations, exclusion of certain indebtedness of small business investment companies, and three-year carryback of net operating losses.
Adopts provisions designed to curb tax shelters.

This legislation was reported by the Senate Finance Committee on November 7, 2003. On March 3, 2004, the Senate began floor consideration. The legislation faces numerous amendments, some germane to the underlying bill, others not.

Other major proposals include the following:

H.R. 2896, American Jobs Creation Act, introduced by Ways and Means Chairman Bill Thomas (R-CA) to repeal the ETI provisions and make other changes to the Internal Revenue Code, outlined below. While it contains many of the same provisions contain in his 2002 bill, this legislation also includes significant new tax benefits by reducing corporate tax rates overall. This bill was favorably reported by the House Committee on Ways and Means on November 21, 2003 and is awaiting floor consideration. In principal part, the bill:
Repeals the ETI provisions, with a phase out through 2006. Binding contracts continue to retain FSC benefits.
Reduces tax rate on manufacturing and production income from 35 to 34 percent in 2004-06 and to 32 percent from 2007 onward.
Reduces corporate tax rate to 32 percent for all corporations with less than $20 million of taxable income, with a phase down depending on the size of the corporation.
Treats EU as one country.
Provides look-through treatment for payments between related controlled foreign corporations.
Provides look-through treatment for sales of partnership interests;
Repeals duplicative foreign personal holding company and foreign investment company rules.
Applies look-through rules to dividends from noncontrolled section 902 companies (10/50 companies).
Provides deferral for pipeline transportation income.
Provides for attribution of stock ownership through partnerships to determine section 902 and 960 credits.
Provides deferral for commodity hedging income for materials used in manufacturing operations.
Defines U.S. property so as not to include certain assets acquired by dealers in ordinary course of business.
Provides for equitable treatment of certain mutual fund dividends.
Provides an election not to use average exchange rate for foreign tax paid other than in functional currency.
Repeals withholding tax on dividends from certain foreign corporations.
Repeals anti-deferral foreign shipping rules.
Reforms interest allocation rules.
Reduces foreign tax credit baskets from nine to two.
Recharacterizes overall domestic losses.
Increases section 179 small business expensing from $25,000 to $100,000,000 and increases eligible investment limits from $200,000 to $400,000.
Expands the size of companies exempt from the alternative minimum tax (AMT) from $7.5 million in gross receipts to $20 million in gross receipts (taking 97 percent of corporations out of the AMT).
Repeals the 90-percent limitation on the use of foreign tax credits or net operating losses against AMT.
Reduces leasehold and restaurant depreciation lives from 39 to 15 years through 2005.
Extends research and development tax credit by two and a half years.
Simplifies taxation of S corporations.
Ensures that companies pay a tax when they transfer assets offshore.
Ensures that top executives pay tax on their stock.
Reforms rules governing the deduction of interest payments by U.S. subsidiaries to their foreign parents.
S. 970 and H.R. 1769, Job Protection Act, introduced by Senator Hollings (D-SC) and Representatives Crane (R-IL), Rangel (D-NY), Manzullo (R-IL), Levin (D-MI) and others in the House, to repeal the ETI provisions, with an exemption for certain contracts in effect before the date of enactment of the Act, and to make the following other modifications to the international tax provisions of the Internal Revenue Code:
Allows a deduction for income attributable to U.S. production activities equal to 10 percent of qualified production activities. Provides a 2006 through 2009 phase-in period.
Permits a foreign corporation that elected to be treated as a domestic corporation to revoke such election and be treated as a domestic corporation transferring its property to a foreign corporation with no gain or loss recognized on the transfer.
Provides: (1) a transitional 2004 through 2008 sliding-scale deduction for an FSC/ETI beneficiary based on the corporation's 2001 FSC/ETI benefit; and (2) special rules for 2003 and for fiscal year taxpayers.
H.R. 3827, Job Protection Act, introduced by Representative Rangel (D-NY), to make the same changes included in H.R. 1769 and to make the following additional modifications:
Extends provision from 2006 to 2008 for increased expensing of small business assets;
Places limits on the transfer or importation by a corporation of built-in losses, prohibits allocation of any decrease in the adjusted basis of partnership property to stock in a corporation that is a partner in such partnership; repeals special rules for financial asset securitization investment trusts (FASITS); expands the definition of a disqualified debt instrument for purposes of the disallowance of interest deductions on certain corporate debt instruments; expands the authority of the Secretary of the Treasury to disallow tax benefits derived from stock transfers designed to evade taxes; and modifies certain rules relating to tax treatment of income of passive foreign investment companies.
Amends the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) to extend provisions imposing fees for certain customs services through FY 2006 and fees for processing of merchandise through FY 2013.
S. 1922, American Manufacturing Jobs Act, introduced by Senators Smith (R-OR) and Breaux (D-LA), which mirrors S. 1637 but eliminates the reduction in benefit for domestic manufacturers who produce abroad.
S. 1964, MORE JOBS Act, introduced by Senators Stabenow (D-MI) and Graham (R-SC), which mirrors S. 1637 but makes permanent the reduction in the benefit for domestic manufacturers who produce abroad.
S.1688, Securing American Factory Employment (SAFE) Act, introduced by Senator Rockefeller (D-WV), to repeal the ETI provisions and provide a nine percent deduction for qualified domestic production activities and allow a tax credit for 75 percent of employer provided retiree health insurance. (1) repeal the exclusion of extraterritorial income from gross income; (2) allow a nine percent deduction for qualified production activities attributable to domestic production; and (3) allow, through 2003, a tax credit for 75 percent of employer provided retired employee health insurance expenses.

The Administration and members of Congress will continue efforts to bring the United States into compliance with the WTO rulings in the FSC/ETI cases, while addressing broader issues in the U.S. tax code. ECAT strongly supports efforts that will bring the United States into compliance and end the EU’s retaliatory sanctions, while ensuring that the U.S. tax code promotes 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 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 2004, there will be continued attention on such changes in the context of Congress’ consideration of proposals to repeal ETI, several of which include many of these long overdue and important tax simplification rules.

Bilateral Tax Treaties

One of the most significant tools for eliminating tax barriers to trade and investment is the bilateral tax treaty. Such treaties create greater certainty regarding a taxpayer’s potential tax liability in foreign countries, allocate taxing rights between the two countries to avoid double taxation, reduce the risk of high grow-basis withholding taxes and prevent discriminatory taxation. A key policy is that the provisions of these treaties be designed to prevent “treaty-shopping.” There are over 2000 bilateral tax treaties throughout the world. Since 1950, the United States has concluded and ratified 56 bilateral tax treaties. The United States has treaties with all 29 of the other members of the Organization for Economic Cooperation and Development.

The United States is currently renegotiating several of the older tax treaties to ensure that they reflect current U.S. tax treaty policy, while also seeking to fill the gap in the treaty network. In 2003, the Senate ratified updated bilateral tax treaties with the United Kingdom, Australia and Mexico. In November 2003, Treasury Secretary Snowe and Japanese Ambassador Kato signed an updated treaty, which the Senate ratified on March 9, 2004. Following ratification procedures by Japan, the United States and Japan formally exchanged instruments and the updated U.S.-Japan tax treaty entered into force on March 30th. The Senate also ratified the 2002 protocol updating our bilateral tax treaty with Sri Lanka on March 25, 2004. The Senate will soon be considering a similar protocol with respect to the Netherlands bilateral tax treaty and the Administration is in negotiations with Chile, Iceland, Hungary, Barbados, France, Bangladesh, Canada, and Korea. The U.S. business community has also expressed a strong interest in the negotiation of a U.S. tax treaty with Brazil, which would provide significant benefits. A key provision for each of these negotiations is to provide for zero withholding tax on royalties, interest and dividends. ECAT also supports efforts to ensure that existing bilateral tax treaties are fully implemented, including, in particular, the U.S.-Italy bilateral tax treaty.

ECAT POSITION: ECAT strongly 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. ECAT also strongly supports the bilateral tax treaty program that promotes greater certainty, the avoidance of double taxation and the prevention of discriminatory treatment against U.S. companies.