Emergency Committee For American Trade - Publications

SECTION 13: 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 Technology, Trade and Investment: The Public Opinion Disconnect, a study 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.

This section discusses proposals to reform and simplify the international provisions of the tax code, the United States’ enactment of the American Jobs Creation Act in 2004, and the U.S. bilateral tax treaty program.

Reform and Simplification of U.S. International Tax Laws

Despite the reforms enacted last year as part of the American Jobs Creation Act, several provisions of the U.S. tax code dealing with foreign source income and other international tax issues continue to undermine the competitiveness of U.S. companies. U.S. international tax rules impose more significant burdens on U.S. companies than our foreign competitors typically face and these rules have also not kept pace with the demands of the global marketplace.

These concerns were summarized as follows in the General Explanations of the Administration’s Fiscal Year 2004 Revenue Proposals (the so-called FY 2004 Blue Book), released as part of the Administration’s FY 2004 budget:

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 FY 2004 Blue Book focused in particular on complex and burdensome sub-part F rules and the foreign tax credit rules as examples. 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.”

In 2004, several long overdue and important changes in the international provisions of the U.S. tax code were enacted as part of the American Jobs Creation Act, discussed below, to modify the tax rules on U.S. treatment of foreign source income, including allocation of interest expense on a worldwide base and the recharacterization of overall domestic loss. Yet, other important provisions (several included in earlier versions of the legislation) were not included in the final legislation.

Given the strong need for additional reform, ECAT and its member companies will be working throughout this year in support of the following types of proposals to modify the international provisions of the U.S. tax code:

Make permanent the temporary Subpart F rules on deferral applicable to active financial services income;
Apply look-through treatment for payments between related controlled foreign corporations (i.e., inter-affiliate payments of active foreign earnings);
Apply look-through rules to interest income, and rents and royalties, received from a 10/50 company;
Repeal the base company sales and services income rules (connected to related party income outside of a company’s country of incorporation), including through repeal of the substantial assistance rules and codification of the attribution of manufacturing rule;
Exempt active rent and royalty income from the definition of foreign personal holding company income and not subject to Subpart F;
Repeal special foreign tax credit rules for certain pipeline transportation and electricity transmission income;
Extend carryback period for excess foreign income taxes and excess oil and gas extraction taxes from one year to three years;
Remove the special limitation on oil and gas activities, i.e., the additional foreign tax credit basket applicable only to oil and gas companies, by repealing Code §907 and moving to a true 2-basket system for foreign tax credits;
Amend current law to prevent the current taxation of active foreign oil or gas business income, including income derived in connection with the pipeline transportation of oil or gas between foreign countries; and
Adopt a fair approach to interest allocation by modifying the rules for purposes of calculating a U.S. taxpayer’s FTC limitation.
Modify the interest allocation rules to take effect before 2009.

The Administration and Congress are also actively considering reform of the international tax code, including the Joint Committee on Taxation's proposal (JCS-02-05) of January 27, 2005. ECAT will be reviewing proposals that arise and continue to support proposals that promote and do not undermine the competitiveness of U.S. companies. Thus, while ECAT welcomes the efforts of the Joint Committee on Taxation to reform the international provisions of the U.S. tax code, ECAT and its members are concerned that several proposals would further complicate the code and continue to impose substantially higher burdens on U.S. companies than our global competitors face.

American Jobs Creation Act, Extraterritorial Income Act and Foreign Sales Corporation Rules

On October 22, 2004, the American Jobs Creation Act (Pub. L. 108-357) was enacted both to address several World Trade Organization (WTO) decisions and to improve the international provisions of the U.S. tax code.

Background

The European Union (EU) has successfully challenged before WTO panels, as well as the WTO’s predecessor organization, the General Agreement on Tariffs and Trade (GATT), several different formulations of U.S. tax rules that were enacted to offset the EU competitive advantage arising from its practice of rebating value-added taxes on export. These provisions, the 1971 Domestic Sales Corporation (DISC) rules, the 1984 Foreign Sales Corporation (FSC) rules and the Extraterritorial Income Act of 2000, were found by several panels to represent an export subsidy contrary to U.S. GATT and now WTO commitments. On March 1, 2004, the EU began to phase in its imposition of retaliatory tariffs (which a WTO arbitration panel indicated could be set as high as $4.043 billion annually).

American Jobs Creation Act of 2004

In order to bring the United States into compliance with the WTO rulings and end the retaliation, the U.S. Congress engaged in considerable debate on reforming the ETI provisions. To that end, the House passed the conference report to the American Jobs Creation Act of 2004 by a vote of 280-to-141 on October 7, 2004 and the Senate passed the conference report by a vote of 69-to-17. The legislation was signed into law (Pub. L. 108-357) on October 22, 2004.

In principal part, the American Jobs Creation Act:

Repeals the ETI provisions, with a phase out through 2006. Binding contracts in effect on September 17, 2003 continue to retain FSC benefits.
Allows deduction (by corporations and pass-through entities) for nine percent of qualified domestic production activities, beginning in 2010 up to 50 percent of wages paid. Phases in deduction at the rate of three percent in 2005 and 2006 and six percent for 2007, 2008, and 2009.
Includes numerous reforms and international tax simplification, including allocation of interest expense on a worldwide basis and the recharacterization of overall domestic loss.

Current Status

While welcoming the United States’ repeal of the FSC/ETI provisions, the EU remains concerned over the transition and grandfathering provisions of the American Jobs Creation Act, which it argues are not consistent with the WTO Appellate Body decisions. On January 13, 2005, the EU requested formation of a WTO panel to review these provisions and that panel was established in February 2005. The EU lifted sanctions previously imposed, but has indicated that such sanctions could be reimposed in part if the WTO panel ruled against the United States.

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 growth-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 57 bilateral tax treaties covering 65 countries. 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. The updated U.S.-Japan BIT was approved by the U.S. Senate on March 9, 2004 and by Japan on March 30, 2004; the tax withholding benefits took effect July 1, 2004 and all other provisions took effect January 1, 2005. The updated U.S.-Sri Lanka BIT was ratified by the Senate on March 25, 2004 and entered into force in July 2004. In March 2004, the United States signed new protocols to existing bilateral tax treaties with the Netherlands and Barbados, both of which the Senate ratified in November 2004. The Administration is also continuing work on updating the U.S.-France treaty.

In addition, the United States is also seeking to negotiate tax treaties with emerging economies. In September 2004, the United States and Bangladesh signed a bilateral tax treaty, which will be submitted this year for Senate ratification.

The Administration is also in negotiations with Canada, Chile, Hungary, Iceland, Korea and Norway and is beginning discussions with Germany. The Administration is also considering tax treaties with several of the former Soviet republics, who are currently covered under the USSR treaty. ECAT 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, urging Italy to quickly ratify the U.S.-Italy bilateral tax treaty.

ECAT is also monitoring recent activities within the Organization of Economic Cooperation and Development (OECD), including those that could expand the scope of the definition of what is considered a “permanent establishment” under the tax treaties and therefore subject to tax in a particular jurisdiction, and the allocation of profits to a “permanent establishment”. Such proposals could create significant risks of double taxation of multinational companies and thus increase barriers to trade and investment.

ECAT POSITION: ECAT strongly supports continued efforts to reform and simplify the international provisions of the U.S. tax code that currently undermine the global competitiveness of U.S. companies. ECAT welcomes enactment of the American Jobs Creation Act to resolve our longstanding dispute with the EU over U.S. taxation of foreign source income. 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. ECAT also supports efforts to update the U.S. Model Tax Treaty to include the complete exemption from withholding taxes on dividends received as reflected in more recent bilateral treaties.