International taxation issues still problematic. (Washington Insights).

A new international tax simplification bill has drawn widespread attention -- and not a little criticism -- for its competitiveness provisions. These provisions would radically rewrite many international tax provisions in the U.S. Code in ways that would benefit U.S. multinationals but would also eliminate the Extraterritorial Income (ETI) Act regime that currently provides targeted tax relief to U.S. exporters.

The American Competitiveness and Corporate Accountability Act of 2002 (HR 5095) was introduced in July by House Ways and Means Committee Chairman William Thomas (R-Calif.). The legislation has three sections: Section 1 addresses "competitiveness" issues; Section 2 deals with corporate inversions, which occur when a U.S. corporation decides to reincorporate in an offshore tax haven; and Section 3 covers tax shelters.

The inversion and tax shelter provisions generated little notice, primarily because both the House and Senate are already weighing several such measures. Likewise, the Administration has stated repeatedly that the President will sign any reasonable inversion/tax shelter legislation that hits his desk. In other words, everyone in Washington supports these reforms, and Thomas' bill added little to the mix.

Why would Thomas, a staunch proponent of minimal taxation, introduce legislation eradicating a tax break for U.S. companies doing business abroad? Because the World Trade Organization (WTO) recently concluded that the ETI framework provides American exporters with prohibited export subsidies that violate U.S. treaty obligations. If the U.S. ignores the WTO decision, the European Union will almost certainly impose sanctions on U.S. exports totaling more than $4 billion. This could precipitate a prolonged trade war that would harm all countries involved.

The U.S. finds itself at odds with its trading partners primarily because it employs a worldwide system of taxation, which means the United States taxes its corporate and individual citizens 'income wherever it is earned.

Because taxes are levied on income earned outside U.S. borders, the U.S. tax system provides some relief from double taxation of foreign income. This relief comes in two forms: (1) limited deferral of U.S. taxation of active income earned abroad until it is paid to the U.S. parent company; and (2) foreign tax credits for income tax paid to a foreign country to offset, at least partially, the U.S. tax on the same foreign income. However, these deferral and tax credit rules are extremely complex and often inadequate to prevent double taxation of the same income.

WTO Sees ETI as Subsidy

In an effort to ameliorate the burden on U.S. businesses competing globally, the U.S. enacted the ETI Act and its predecessor, the Foreign Sales Corporation (FSC) Act. However, last January, the WTO Appellate Panel ruled that the U.S. ETI measure represented a prohibited export subsidy. This marked the fourth time in 2-1/2 years that the FSC-ETI tax regime has been found to be an export subsidy, in violation of U.S. treaty obligations.

The FSC and ETI rules essentially bestow a 5.25 percent U.S. income tax reduction on export income. WTO rules treat direct taxes (income taxes) differently from indirect taxes (such as value-added taxes). Unlike income taxes, indirect taxes, common in Europe, can be rebated or reduced on exported goods. The WTO relied on this distinction to find that the FSC and ETI rules, which reduce income tax on exports, were illegal subsidies.

So now the U.S. faces two, linked problems. First, it has a complex and burdensome tax code that hampers U.S. multinationals competing in foreign markets. Second, the FSC-ETI attempt to reduce these burdens has been ruled an impermissible export subsidy by the WTO.

What can be done? Chairman Thomas has crafted a bill that would eliminate the FSC-ETI framework while making significant, positive changes to the U.S. tax code's international provisions. However, the business community has not lined up behind his bill, largely because most U.S. multinationals continue to hope that the U.S. can negotiate a special exemption for the ETI regime.

Whatever the outcome -- and it's not at all clear what that will be -- the stakes are high: U.S. multinationals employ over 20 million people in the U.S., or about one in every six American workers, and about one-fourth of the output produced by U.S. workers and U.S.-owned companies comes from non-bank U.S. multinationals, either at home or abroad. Multinationals in the manufacturing sector produce over half of U.S. gross manufactured product.

Considering the enormity of these numbers, it is imperative that Congress and the Administration craft a solution that not only appeases the WTO but also retains -- or even heightens -- the ability of U.S. companies to compete in foreign markets.

Mark Prysock is the Director of Tax and Economic Policy for FEI.