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Thank you for this opportunity to speak to you about two recent events that have brought the international rules of U.S. corporate income tax to the center of the legislative agenda.  The first, which has drawn considerable media attention, is the phenomenon of “inversions.” Inversions are the deliberate expatriation of a U.S. corporation through a change of corporate address, typically from a U.S. state to Bermuda.  The second event has been less publicized: the recent judgment against the United States in a World Trade Organization (WTO) dispute settlement case regarding tax policy.

These two events are related, more closely than they might seem at first glance.  Both concern our system of international taxation in very fundamental ways.  And any thorough solution to either of these issues – inversions or the WTO decision – should address them both. 

The sad truth is that our international tax rules no longer serve our national interest.  In this age of globalization, international transactions generate a large and growing share of our national income.  Yet changes to the international provisions of the U.S. corporate tax code in recent decades have ignored this trend, and have oftentimes more impaired than improved American companies’ ability to compete abroad.  More often, changes to the tax code have focused on increasing tax revenues rather than assuring the competitiveness of U.S. business operations, and thus, assuring the health of our economy.
The WTO Decisions in the FSC-ETI Cases

First, consider the situation regarding the recent WTO decision.  Earlier this year, a WTO appellate panel held that the U.S. Extraterritorial Income Exclusion (ETI) regime constituted a subsidy violating the WTO rules.  Just two years before, a WTO appellate panel held that the Foreign Sales Corporation (FSC) provisions constituted a similar, prohibited subsidy. 

It is well-known that the ETI had been intended by the previous Administration, and by the Congress, as a substitute for the FSC provisions, guaranteeing the beneficiaries of the ETI similar tax benefits to those they had enjoyed under the FSC provisions. 

If I may summarize in two sentences a 90-page WTO opinion, the panel found that the ETI was an export subsidy in a violation of WTO rules for more or less the same reasons as the FSC provisions.  And, perhaps to assure that no further attempts were made to resurrect a FSC-type benefit for U.S. exports, it further bolstered the reasoning from the FSC case in its latest opinion.

Where do these WTO decisions leave us?  Essentially, they say that any attempt to replicate the benefits of FSC or ETI is legally doomed.  To make such an attempt would simply lead to fruitless WTO litigation and could well bring on a trade war with the European Union, which would almost certainly insist on retaliating against U.S. exports. 

In August, the WTO arbitration panel issued its findings on damages, which will authorize retaliation of up to $4 billion a year of exports, a figure unprecedented in WTO history.  Such retaliation would have an impact on the global economy far beyond the specific U.S. products targeted.  A trade war of such proportions is not in the interests of American businesses, workers, or consumers.

For that reason, President Bush decided several months ago that the United States would comply with the WTO ruling.  The President made two further decisions.  He said that any response to the ruling would have to increase the competitiveness of U.S. business.  He also pledged to work with the Congress to create the solution, and we have been working closely with Chairman Thomas and the House Ways and Means Committee.  We have begun to work just as closely with Chairman Baucus and the Senate Finance Committee.

In working with the Congress we need to focus on two aspects of international tax policy.  First, we must keep in mind the fiscal implications of abolishing ETI. Second, we must focus on the changes that can best make U.S. business more competitive internationally.  In the short term, abolishing ETI will increase federal revenues.  We will work with the Congress to make these changes, taken together, as close to revenue neutral as possible over the ten-year budget period.  And we should all focus on ensuring that the changes enhance the international competitiveness of U.S. businesses and American workers.

One of the ironies of the FSC/ETI saga is that it can be viewed, across the history of the past half-century of tax legislation, as a self-inflicted wound. To see why this is so, consider that the United States has a worldwide system of taxation, while many other countries have a territorial system.  Second, so far as the corporate income tax is concerned, it has traditionally been  worldwide in scope only for companies incorporated in the United States. U.S. tax is not imposed on the foreign-source income of the foreign subsidiaries of U.S. companies.  This is true even for wholly-owned foreign subsidiaries.  Dividends received by the U.S. parent from the foreign subsidiary are taxed but that is true also of dividends  from any unrelated foreign company. 

As a result, when a U.S. parent decides to manufacture abroad, it can carry out the manufacturing operations in a foreign subsidiary.  The manufacturing profits, as foreign-source income, are not subject to U.S. tax until repatriated to the U.S. parent.

A point to be stressed, however, is that a principal exception to this proposition stems from the 1962 enactment of Subpart F.  For reasons that had nothing to do with the competitiveness of the U.S. companies, some transactions by foreign subsidiaries were deemed to generate so-called Subpart F income to the U.S. parent. 

After many amendments and elaborations, Subpart F today, generally speaking, taxes the U.S. parent on passive income earned by its controlled foreign subsidiaries.  Moreover, in some cases Subpart F income includes income from active business pursuits abroad.  For example, even the marketing activities of foreign subsidiaries aiding exports from a U.S. parent may produce Subpart F income.  The same is true for various forms of service transactions by foreign subsidiaries. 

As a result, the definition of income taxable on a current basis to a U.S. parent, leaving aside dividend payments to the parent, has become one of the most complex parts of the U.S. tax code. Without the 1962 Subpart F legislation, there almost certainly would have been no FSC or ETI legislation.  Without that legislation, a U.S. exporter could sell its exports through a foreign sales subsidiary without paying U.S. tax on the earnings derived from the subsidiary’s foreign sales activity.

One of the first by-products of that 1962 legislation was the 1971 Domestic Sales Corporation legislation (DISC).  That law allowed a U.S. parent to establish a domestic subsidiary that would handle its foreign sales, and that would not be subject to U.S. tax on any part of the resulting income.  In the 1981 Tax Legislation Cases, a GATT panel held that the DISC law was a violation of GATT rules, and the panel held that tax provisions of three European countries were also violations. After extensive international negotiation that produced even more complex GATT/WTO rules, the U.S. Congress passed the 1984 FSC provisions, in large measure as a substitute for DISC.  In short, FSC, like DISC, was an attempt to limit the adverse consequences of Subpart F.  Today, after the FSC and ETI decisions, we are still dealing with the tangled history of Subpart F.

I believe that legislative changes could be enacted to limit Subpart F to truly passive income – such as portfolio dividends, interest and the like.  At the very least we should take a hard look at the so-called active/passive dichotomy in Subpart F rules. We should not preserve tax rules that do not reflect the present realities of international corporate business, in which globalization requires centralization of functions, and in which services are not just a major wealth-creating activity, but one in which U.S. businesses have a comparative advantage.  In short, I believe that we can sweep away the cobwebs of outmoded rules, and make U.S. businesses and workers more competitive.

Corporate Inversion Transactions

Now consider the other recent phenomenon that has put a spotlight on U.S. international tax rules: the problem of corporate “inversions,” in which U.S. companies move their corporate situs abroad.  Why do some U.S. companies choose to invert? The answer is simple – to save U.S. tax dollars. Yet the bulk of these companies intend to continue doing business in the United States just as they did before.  How, then, do inversions reduce taxes?  The answer is complex.  One part of the answer is that they are able to reduce the U.S. tax they pay on their operations in the U.S.  The other part of the answer is that they are able to reduce their overall tax on earnings from foreign operations.

Let’s focus on the first part of the answer.  Through an inversion transaction, a company is able to take certain kinds of deductions that it could not take before, and it can thereby structure its affairs in a way that reduces taxes on income earned in the United States.  For example, the company may create a debt obligation from the corporation’s new U.S. subsidiary to the new foreign parent, typically incorporated in a low-tax jurisdiction.  The interest payments on this related-party debt create deductions that reduce U.S. tax without creating an offsetting increase in the foreign tax due.  In the tax vernacular this is called “earnings stripping.”
There are also ways in which the inverting enterprise may be able to shift income outside the United States by transferring assets or business opportunities from the U.S. subsidiary to the new foreign parent.  This moves the income and appreciation from these assets and opportunities outside the U.S. tax jurisdiction, even though the costs associated with their development were deducted for U.S. tax purposes.

Exacerbating these opportunities for earnings stripping through artificial deductions and income shifting, there may be opportunities to exploit the network of tax treaties the United States maintains around the world.  By achieving resident status for treaty purposes in a country with which the U.S. has a tax treaty, the new parent in an inversion transaction may qualify for reduced U.S. withholding tax on certain kinds of income.  All of these techniques allow inverted companies to avoid U.S. tax that otherwise would be payable on income from their U.S. operations.

A natural first reaction to the recent stories about corporate inversions has been to propose prohibiting such transactions.  But that approach confuses the symptoms with the disease.  The disease is that the U.S. corporate tax system does not create a level playing field for U.S. companies.  Those that choose to invert are taking advantage of the same opportunity available to any foreign company to reduce U.S. taxes on U.S. operations. Indeed, it is possible that the growing number of acquisitions of U.S. companies by foreign companies is in part caused by our U.S. tax rules.  When a U.S. company and a foreign company are considering a merger, it can be more tax-effective for the foreign enterprise to acquire the U.S. enterprise, rather than the other way around.  Also, we are seeing U.S.-based start-up companies choosing to incorporate abroad to reduce U.S. taxes on their U.S. business. We need legislation to take away the incentive to invert.  Only then can we create a level playing field for U.S. and foreign companies.   

An approach that narrowly targets inversions without eliminating the underlying cause is not a real solution for the long term.  To create a level playing field, we need to attack the incentives for inversions.  Specifically, we need to deal with such matters as earnings stripping through related-party interest deductions, income shifting through transfers of intangible and other assets, and unintended benefits of tax treaties. The U.S. Treasury has already made clear, both in a comprehensive study and through Congressional testimony, how we would deal with these incentives.

First, we support amendments to section 163(j) to disallow cross-border intercorporate interest payments as deductions against U.S. tax, to the extent that the corporate group’s level of U.S. indebtedness relative to assets exceeds its worldwide ratio of indebtedness to assets. The present formulation of section 163(j) unfortunately provides an unjustified safe harbor for deduction of interest payments by a U.S. corporation to a foreign related party so long as the payments meet certain statutory guidelines that have nothing to do with the corporate group’s overall indebtedness.

With regard to income shifting, especially by transfers of intangibles, we are reexamining the regulations under section 482.  That reexamination encompasses both the substantive rules and the rules related to reporting, documentation and penalties. We will make appropriate revisions to these regulations so that the arm’s length standard of section 482 operates properly.  And we will report to the Congress if any legislation is needed in this area.

In addition to our section 482 study, we will also review the Code’s organization and reorganization provisions, as well as the implementing regulations, as they apply to international transactions.  After all, these provisions were drafted at a time when the focus was almost solely on domestic transactions, and that is not the world we live in today.

With regard to tax treaties, we are carrying out a thorough study of our existing tax treaties, which are intended to reduce or eliminate double taxation of income, to determine whether any of our treaties have provisions that can be used instead to eliminate taxation on income.  Any treaties that operate in this matter will be renegotiated.

Creating a Competitive Set of Tax Rules

The tax changes I have described will help level the playing field, and eliminate the incentive to undergo an inversion to reduce U.S. tax on income from U.S. business operations.  But there are other areas that must be addressed to make sure that our international tax rules promote the competitiveness of U.S. companies.  Indeed, the other part of the reason for inversion transactions is to avoid the application of the U.S. international tax rules to income from foreign operations, so that those operations remain competitive.  We need to address this competitiveness concern as well, so that the United States remains a place in which businesses choose to be headquartered. To truly level the playing field we need to revisit the U.S. tax rules for foreign earned income.  These rules have not kept pace with the rules of our major trading partners.

A number of technical changes have been made over the years that make the U.S. international tax rules unduly restrictive.  Sometimes the motive has been to raise federal tax revenues by changes in the abstruse international tax rules.  However, with today’s global economy, the bottom line is clear.  If we want U.S. businesses, and thus the U.S. economy, to be competitive in international transactions, then we have to reconsider our international tax rules.

Let me give you an example. The foreign tax credit is designed to eliminate double taxation of foreign-source income, once by a foreign country and then by the U.S.  Yet the ability of a U.S. company to avoid paying tax twice on the same income is limited by a host of highly technical rules.  These have the effect of disallowing a credit in certain circumstances.  One of the limitations that causes the most distortion is the impact of the interest expense allocation rules, which reduce a U.S. company’s ability to use foreign tax credits by allocating some of its U.S. interest expense against the assets of its foreign affiliates, even though those foreign affiliates are equally or even more highly leveraged.  Perhaps this limitation once made sense, but it makes sense no longer. 

The Subpart F rules I discussed earlier are another major area where significant changes are needed.  Changes would ensure that our rules are not an anti-competitive burden for U.S. businesses operating in today’s global economy.

Extensive studies of the economic effect of foreign investment point to the same conclusion: foreign direct investment by American firms is good not just for the U.S. firm and the foreign economy recipient, but also for the U.S. economy, and hence for Americans in general.  The notion that foreign direct investment displaces U.S. exports is not only wrong and flies in the face of the evidence.  Evidence also shows there is no basis for the notion that foreign direct investment is an effort to displace domestic U.S. production.  If foreign direct investment is good for the U.S. economy overall -- and it is -- we have to make sure that we are not unintentionally discouraging it through obsolete rules that tax foreign income twice or that tax the income in a way that is harsher than the tax regimes of our major trading partners.  This is what I mean when I call for U.S. tax law changes that make U.S. business more competitive internationally.

A Concluding Thought

When considering the totality of legislation needed to address the WTO ruling, I want to stress one point I made earlier.  The chances of going back to a FSC look-alike law are nil. The President has recognized that the United States must comply with its international obligations. We have too great a stake in the WTO and in free trade to turn our backs on the WTO rules.

Consequently, it will not be possible to replicate for each and every American company the tax relief they obtained under FSC or ETI.  Nor can we assure each and every American company that it will receive any tax relief at all from the tax legislation now being considered in Congress.  We need to focus on making the U.S. economy -- and that means U.S. enterprises as a whole -- better off as a result of the legislative changes.  That is what a level playing field is all about.  To give an example, there is no reason why a U.S.-owned firm should be acquired by a foreign-owned firm simply because of ill-designed international corporate tax rules.  When U.S. tax law treats U.S.-owned and foreign-owned firms alike, our economy will be stronger and U.S. enterprises will be more competitive around the world.

Thank you.


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