Emergency Committee For American Trade - Publications

ECAT 2008 AGENDA

SECTION III.9: TAXATION OF FOREIGN SOURCE INCOME

U.S. and foreign tax laws and policies have major impacts on the international competitiveness of U.S. industries and their workers, which study-after-study has demonstrated provide important benefits to the United States. As Congress and the Administration consider modifications to the U.S. tax regime, it is critical the competitiveness of U.S. companies be enhanced, particularly given the major changes to the U.S. and international economy since the international portion of the U.S. tax regime was adopted over 20 years ago.

As documented in ECAT’s studies, Global Investments, American Returns and the “1999 Update” discussed in section I.1, the trade and investment of American companies with global operations strongly promote U.S. economic growth and an improved 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, rather than substitute for, their domestic activities. Similarly, in 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 improvement in U.S. living standards.

In light of these findings and the enormous changes in the U.S. and international economy in the last 20 years, ECAT very strongly urges the review and reform of U.S. tax policy to promote more effectively U.S. competitiveness and U.S. economic interests in an increasingly integrated and global marketplace. Tax reform is a key issue already under consideration in the 110th Congress and will continue to be a major issue in 2009 and 2010, when a new Congress and Administration will be faced with an unprecedented number of expiring tax provisions and what is expected to be a difficult fiscal outlook.

This section provides some background on international tax policy and discusses proposals to reform and simplify the international provisions of the Internal Revenue Code that could be considered by the Congress. This section concludes with a discussion of current issues in the U.S. bilateral tax treaty program.

Background on Key International Tax Rules

The taxation of revenue earned by foreign subsidiaries of U.S. companies – including what is taxed, when it is taxed and the rate at which it is taxed – has important impacts on policy choices of both U.S. and foreign businesses:

Since the early part of the twentieth century, U.S. tax law requires U.S. industries and individuals to pay tax on their worldwide income, but allow credits for taxes paid to foreign governments. The U.S. system also allows industries to defer taxes on certain unrepatriated foreign income (earned by separately-incorporated foreign subsidiaries), which represents a deviation from a purely worldwide tax system as discussed below. The worldwide system is generally consistent with capital-export neutrality principles, based on tax earnings from investments at the U.S. rate whether the investment is made domestically or abroad. Such a system would also require that all earnings of U.S. companies with global operations would be taxed in the current year and would allow an unlimited credit for all foreign taxes paid with the goal of preventing double taxation. Early proponents of this theory believed that it would work in an environment in which each and every country with jurisdiction to tax would adopt the same principles.
Many other countries have adopted largely “territorial” regimes which exempt from tax the active business income from foreign operations. A territorial regime is generally consistent with capital-import neutrality principles that seek to ensure that all investment in a particular country is treated the same, regardless of the citizenship or residence of the investor.

The current U.S. international tax regime largely reflects policy choices made in the 1960s, when international economic integration was much less advanced and U.S. industries with global operations faced only limited competition from foreign companies. The international tax regime adopted in 1962 reflects a largely worldwide or capital-export neutrality approach, although it includes several important exceptions from that model, reflecting important capital-import neutrality principles, most notably its deferral provisions. Deferral refers to the longstanding principle that foreign subsidiary earnings are taxed only after they are paid as dividends to the U.S. parent company. Long a feature of U.S. tax policy, deferral is a key element of an efficient tax policy that ensures that U.S. companies can compete on a level playing field. While Congress maintained deferral provisions in 1962 despite calls for their repeal, Congress also limited the deferral provisions by imposing current income tax on the “passive” or “mobile” income earned by foreign subsidiaries outside the United States.

At the time these provisions were enacted, U.S. companies with global operations were strong global competitors, accounting for over half of private investment globally. At the same time, market-economy countries existed in only a relatively small part of the globe, particularly in North America, Western Europe, and parts of Latin America. Even in developed countries, laws and business operations tended to be more locally and regionally oriented, rather than focused on the international economy.

Since the adoption of the major parts of the U.S. international tax regime in 1962, however, there have been seminal changes to the U.S. economy and its relationship to external markets (and few corresponding changes to the U.S. international tax regime). By 1989, a period of significant and rapid change began around the world as the former Soviet Union, China and other parts of Asia started moves towards more market-oriented approaches and became increasingly significant participants in international economy. Advances in information and communication technologies dramatically reduced the cost of doing business internationally, enabling industries of virtually all countries to maximize their global reach while maximizing the efficiencies of their supply chains, as well as the delivery of products and services to customers and consumers around the globe. The rapid growth in large new developing markets has had a lasting impact on such basics as the world-wide demand for energy, consumer goods, transportation and financial services. Markets also rapidly became more intensely competitive.

In many cases, governments too responded to these market changes, including through the adoption of a stronger multilateral trade framework (the World Trade Organization) and bilateral and regional trading and investment arrangements. Many governments also responded with domestic legal and regulatory changes, including to their tax regimes. For example, many developed countries lowered their overall corporate tax rate and moved to adopt more capital-import neutrality principles. While the United States dramatically reduced its own corporate tax in 1986, the United States corporate tax rate is currently the second highest of all major developed countries. As well, the United States has made relatively minimal changes to the overall structure of its international tax regime.

Critical Choices Ahead

The differences between the worldwide and territorial regimes and the interface of these regimes present enormous complications for U.S. industry and, in many cases, result in U.S. companies with global operations paying much more significant taxes than their major foreign competitors. The United States’ failure to update its tax regime, despite enormous change in the U.S. and global economies, is also putting U.S. industries and their workers at a significant disadvantage globally.

International tax is currently a major issue and will continue to be so in 2009 and 2010 when a new Congress and Administration will be faced with an unprecedented number of expiring tax provisions and what is expected to be a difficult fiscal outlook. The confluence of these and other issues will warrant a thorough review of U.S. tax policy, including international tax policy.

As this review unfolds, ECAT urges Congress and the Administration to recognize the implications of the current tax code on U.S. international competitiveness and the need to reform and modernize the international tax provisions to help advance America’s economic interests internationally. Despite the salutary changes made in the American Jobs Creation Act of 2004, there are many other key changes that may be far more important to level the playing field internationally and, thereby promote greater economic growth and further improvements in the U.S. standard of living.

Many of the recent debates have focused on whether proposed changes to the U.S. tax regime would encourage American business “to make it here or to make it there.” While this metric for international tax policy may have made some sense at a time of less global integration, when U.S. industry dominated the world’s markets, it makes little sense today as the United States faces substantial competitive pressures from major international competitors and products are increasingly manufactured through global production networks that greatly promote U.S. competitiveness. (Indeed, as ECAT’s 2003 Technology, Trade and Investment: The Public Opinion Disconnect report found, global production networks have been vital to promote the growth and leadership of U.S. industry). Further, given the opportunities offered by international markets and the fact that 95 percent of the world’s people live outside the United States, U.S. businesses are making decisions to invest both at home and abroad. As ECAT’s studies and the underlying data consistently demonstrate, foreign investment by U.S. companies with global operations complements their activities at home; it is not a substitute.

Reform of U.S. tax policy should focus on improving overall U.S. competitiveness in the international economy through ensuring that U.S. industry and its workers do not carry a greater tax burden than their foreign competitors and do not face greater tax burdens for investing at home. American businesses need a level playing field in order to have a fair chance to succeed.

H.R. 3970, the Tax Reduction and Reform Act of 2007

On October 25, 2007, Ways and Means Committee Chairman Rangel introduced H.R. 3970, the Tax Reduction and Reform Act of 2007, that would reduce corporate tax rates and make substantial changes to the international portions of the U.S. tax code, as well as corporate and individual taxes. The significant changes for U.S. companies with global operations include:

Deferral. H.R. 3970 would essentially eliminate deferral for U.S. companies with global operations by disallowing current deductions for expenses allocable to non-repatriated foreign income.
Foreign Tax Credit. H.R. 3970 would also require the recalculation of foreign tax credits through so-called year-by-year layering, which would significantly reduce the amount of foreign tax credits that U.S. companies with global operations can use, resulting in double taxation of foreign income.
Interest Expense Allocation. H.R. 3970 would also repeal the worldwide allocation of interest expense, scheduled to become law in 2009.

Although H.R. 3970 includes a cut in the corporate tax rate, it would effectively require many U.S. companies with global operations to pay substantial additional tax because H.R. 3970 would:

disallow deductions for costs incurred in the United States in an amount equal to the ratio of current year’s deferred foreign-source income divided by total foreign-source income.
effectively eliminate any traditional foreign-tax credit planning that under current law would allow companies to choose which foreign earnings are repatriated to the U.S. parent company.

U.S. companies with global operations already shoulder a great deal of the current U.S. corporate tax load (which is the second highest among developed countries). Ranked by asset size, the largest one-half of one percent of non-financial U.S. companies paid almost two-thirds of the U.S. corporation income tax. Reducing the corporation income tax rate is a laudable goal, but it should not be accompanied by international tax provisions that undermine the competitiveness of U.S. industries and their workers.

In addition, an American company using borrowed funds to make a very similar investment in the United States would suffer the loss of deductions for these types of costs related to the project to the extent of its deferred foreign income. This means that the American company would require a greater risk-adjusted rate of return on its U.S. investment than the foreign company. Thus, the American company would be less competitive both at home and abroad.

American companies that enjoy a relatively low foreign effective tax rate would be faced with the decision to lose deductions for current U.S. expenses or repatriate a greater amount of foreign earnings on which there could be substantial amounts of residual U.S. tax. The additional U.S. tax would be imposed on the American company, while its foreign competitor would generally not suffer any similar tax under its home-country law. The longstanding principle of deferral in U.S. tax law protects the American company from this type of anti-competitive tax burden. With deferral, American companies can compete in foreign markets on a level playing field with their foreign counterparts. H.R. 3970 substantially tilts the playing field against American companies competing to serve customers and consumers abroad.

While several changes proposed by H.R.3970 would make U.S. industry less competitive in serving customers and consumers abroad, in some cases H.R. 3970 could also make U.S. industry less competitive here in the United States. For example, the tax treatment of interest and other administrative and management expenses could benefit a foreign company that makes its U.S. investment through a U.S. subsidiary since that subsidiary would not be subject to the international provisions or the disallowance of the deduction for interest and other administrative and management expense that a U.S. company with global operations would face.

In sum, H.R. 3970 would undermine rather than advance the competitive position of U.S. industries and their workers in the international economy, resulting in the loss of economic opportunities that are so beneficial for the United States.

The 2008 Agenda

ECAT and its member companies will be working throughout the remainder of this Congress to support of the following types of proposals to improve 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 inter-affiliate payments of active foreign earnings between related controlled foreign corporations.
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).
Work to ensure that the interest allocation rules will still take effect in 2009.
Move to a true two-basket system for foreign tax credits by removing the special limitation on oil and gas activities, i.e., the additional foreign tax-credit limitations under Code §907 applicable only to oil and gas companies.
Prevent the current taxation of active foreign oil or gas business income, including any income derived in connection with the pipeline transportation of oil or gas between foreign countries.
Modify the foreign tax credit ordering rules so that taxpayers are allowed to use their oldest, expiring, tax credits first, instead of using current credits first, and running the risk of having earlier credits expire.

The Administration is also actively considering reform of the international tax provisions of the Internal Revenue Code. ECAT will be reviewing proposals from the Treasury’s December 20, 2007, report on Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century. The Treasury’s work in this area deserves serious consideration. Any international tax reform proposal that purports to relieve the burden of complexity and make U.S. international tax law more competitive should be very carefully examined.

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 gross-basis withholding taxes and prevent discriminatory taxation. The Treasury Department has consistently 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 (OECD).

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 November 2007, the Senate ratified the protocols updating the U.S.-Finnish, U.S.-German, and U.S.-Danish Bilateral Tax Treaties. In December 2007, the Senate ratified the protocol to update the U.S.-Belgium Bilateral Tax Treaty, which was signed on June 21, 2007. Negotiations have also been completed and treaties have been signed with Norway and Bulgaria, which are also likely to be ready for action by the Senate this year. Negotiations on the U.S.–Iceland Treaty are complete, but that treaty is waiting signature in Iceland. Negotiations with Canada culminated in the fifth protocol to the United States-Canada Tax Convention (discussed below), while negotiations with Chile are nearing 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 former 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.

The history of these bilateral tax-treaty relationships is very important to the free flow of capital between and among countries by providing reduced withholding taxes and a substantial reduction in the incidence of double taxation. Treasury’s consistent pursuit of substantially reduced withholding taxes on dividends, interest, and royalties supports the competitiveness of U.S. industries. Recent treaties have moved toward this goal.

ECAT strongly supports zero withholding in all future treaties, especially with our largest trading partners.

Binding arbitration of tax disputes between the competent authorities of the United States and its treaty partners is an important recent development in tax-treaty policy. Over the last several years, protracted double-taxation disputes and lengthy negotiations between competent authorities have challenged the mutual agreement procedures. ECAT strongly supports the binding arbitration procedure adopted in recent treaties. By putting a realistic time frame on the resolution of double-tax cases, this procedure is likely to assure more timely resolution of even very difficult cases.

A new provision in some recent treaties expands the scope of what entities are treated as permanent service establishments and, therefore, subject to taxation. This provision could have adverse consequences for the competitiveness of U.S. service industries. For example, unlike current practice, the recent Bulgarian and Canadian protocols make a services project a “permanent establishment” even if they lack a “fixed place of business. Such new rules could adversely affect U.S. services companies by subjecting them and their employees to additional source taxation. The exception to the permanent establishment rules for services is widely recognized as not being within the framework of traditional U.S. tax treaty policy. Its inclusion in current treaties such as the Canadian protocol should not be considered a precedent.

ECAT is also monitoring recent activities within the Organization for Economic Cooperation and Development, 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 Internal Revenue Code with a view to enhance the global competitiveness of U.S. companies. ECAT is concerned that the changes to the international tax provisions proposed by H.R. 3970 will undermine, rather than enhance, U.S. competitiveness. American businesses need a level playing field in order to have a fair chance to succeed. 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.