Emergency Committee For American Trade - Publications

SECTION III.9: 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 studies, Global Investments, American Returns and the “1999 Update,” the trade and investment of American companies with global operations together are 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 plays 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 Internal Revenue 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 Internal Revenue Code, the resolution of the U.S.-EU dispute over certain U.S. tax provisions, and the U.S. bilateral tax treaty program.

Reform and Simplification of U.S. International Tax Laws

Despite the reforms enacted in 2004 as part of the American Jobs Creation Act, several provisions of the Internal Revenue 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 Internal Revenue 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 basis 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 Internal Revenue Code:

Make permanent the temporary Subpart F rules on deferral applicable to active financial services income;
Make permanent 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;
Exempt active rent and royalty income from the definition of foreign personal holding company income and not make it subject to Subpart F;
Repeal special foreign tax credit rules for certain pipeline transportation and electricity transmission income;
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 two-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
Modify the interest allocation rules to take effect before 2009.

The Administration and Congress are also actively considering reform of the international tax provisions of the Internal Revenue Code. ECAT will be reviewing proposals that arise and continue to support proposals that promote and do not undermine the competitiveness of U.S. companies. ECAT and its members are concerned that several proposals for international tax reform from the Joint Committee on Taxation, the President’s tax reform panel and others, would further complicate the code and continue to impose substantially higher burdens on U.S. companies than our global competitors face.

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. The Treasury Department has constantly supported the provisions of these treaties designed to promote information sharing and 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 Bilateral Tax Treaty 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 Bilateral Tax Treaty 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.

In November, 2005, the Administration submitted three tax instruments to the Senate for ratification:

A protocol to update the U.S.-Swedish Bilateral Tax Treaty, including through providing for a zero withholding rate on related-entity dividends and safeguards to prevent treaty shopping. The Senate ratified this treaty on March 31, 2006.

Protocols to update the U.S.-French Bilateral Tax Treaty, including through the incorporation of current U.S. tax policies regarding hybrid entities, pension and benefit rules and rules relating to REITs. The Senate ratified this treaty on March 31, 2006.

The U.S.-Bangladesh Bilateral Tax Treaty, which the Senate ratified on March 31, 2006.

The Treasury Department has completed negotiations on several treaties. Tax treaties with Germany, Denmark and Finland have been signed and sent to the Senate Foreign Relations Committee. Negotiations have been completed and treaties have been signed with Belgium, Norway and Bulgaria. All six of these treaties are likely to be ready for action by the Senate Foreign Relations Committee later this year.

Negotiations on the U.S.–Iceland Treaty are complete, but that treaty is waiting signature in Iceland. Negotiations with Canada and Chile are close to resolution. The Treasury Department is also in negotiations with Korea. The Treasury Department recently published a new U.S. Model Tax Treaty.

The Administration is also considering tax treaties with several of the former Soviet republics, which 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 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.

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 Internal Revenue Code. Following further WTO dispute settlement, Congress passed and the President signed into law a repeal of certain grandfathering provisions that had been found by the WTO to contravene U.S. obligations.

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 (ETI) 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

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. The legislation was signed into law (Pub. L. 108-357) on October 22, 2004.

In principal part, the American Jobs Creation Act:

Repealed the ETI provisions, with a phase-out through 2006. Binding contracts in effect on September 17, 2003, continue to retain FSC benefits.
Allowed 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.
Included numerous reforms and international tax simplification discussed above, including allocation of interest expense on a worldwide basis and the recharacterization of overall domestic loss.

Revisions to American Jobs Creation Act

While welcoming the United States’ repeal of the FSC/ETI provisions, on January 13, 2005, the EU requested formation of a WTO panel arguing that the transition and grandfathering provisions of this legislation were not consistent with U.S. WTO commitments or the WTO’s Appellate Body decisions. On September 30, 2005, the WTO panel ruled that the United States had failed to withdraw fully the tax subsidy provisions given grandfathering and transition provisions. After the United States’ appeal, the WTO Appellate Body ruled against the United States on February 13, 2006, holding that the transition and grandfather rules that were included in the 2004 Jobs bill are contravene U.S. WTO obligations.

In May 2006, Congress passed and the President signed into law H.R. 4297, Tax Increase Prevention and Reconciliation Act of 2005, that repealed the grandfathering provisions (and the transition provisions expired in 2006).

ECAT Position: ECAT strongly supports continued efforts to reform and simplify the international provisions of the Internal Revenue Code that currently undermine the global competitiveness of U.S. companies. 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 supports Senate ratification this year of the protocols updating the U.S. bilateral tax treaties with Germany, Finland, Belgium, Norway, Bulgaria and Denmark.