Statement on H.R. 5270: the Foreign Income Tax Rationalization and Simplification Act of 1992.

On July 22, 1992, Tax Executives Institute testified before the House Committee on Ways and Means on H.R. 5270, the Foreign Income Tax Rationalization and Simplification Act of 1992. The Institute's testimony was presented by its International President, Reginald W. Kowalchuk of the Bank of Nova Scotia. H.R. 5270 was introduced by Committee Chairman Dan Rostenkowski and Congressman Willis Gradison on May 27, 1992. TEI's written statement on the legislation is reprinted below. The statement was prepared under the aegis of its International Tax Committee, whose 1991-1992 chair is Raymond G. Rossi of Intel Corporation.

Tax Executives Institute (TEI) is the principal association of corporate tax executives in North America. Our approximately 4,800 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works - one that is consistent with sound tax policy, one that taxpayers can comply with, and one in which the Internal Revenue Service can effectively perform its audit function. TEI is pleased to submit the following comments to the Committee on Ways and Means on H.R. 5270, The Foreign Income Tax Rationalization and Simplification Act of 1992.

Overview

H.R. 5270 was introduced by Chairman Rostenkowski and Representative Gradison on May 27, 1992, in response to 10 days of public hearings on the factors affecting international competitiveness. In announcing these hearings on the bill, Congressman Rostenkowski stated that "[tlhe relief provided to U.S.-based multinational corporations and the important simplification contained in this legislation would provide significant assistance to companies competing in the global marketplace." The legislation has three goals: (1) to improve international competitiveness of U.S.-based multinationals; (2) to improve and simplify the international tax rules; and (3) to ensure that foreign persons doing business in the United States pay their "fair share" of taxes. As Congressman Gradison correctly observed in introducing H.R. 5270, changes in the international tax area are needed because "foreign source income is not undertaxed. If anything, it may face a higher tax burden than domestic source income."

TEI commends Chairman Rostenkowski and Congressman Gradison for recognizing that the international tax provisions are sadly in need of revision. The Institute has long been concerned that the complicated U.S. tax system impairs the ability of U.S. corporations to compete domestically and abroad. For far too long, the focus has been on revenue and on closing "tax pinholes" to the exclusion of symmetry, simplification, common sense, and the need to integrate U.S. tax and trade policies. The current provisions embody myriad policy decisions made over the past 50 years - decisions that regrettably may have been made without a full appreciation of their long-term effect on the economic viability of U.S. businesses operating overseas. This myopia especially manifests itself in the Tax Reform Act of 1986, where the international tax provisions were advanced in large measure to pay for fundamental changes in other areas of the tax law. The use of that funding mechanism exacted a severe cost from U.S. multinationals. The 1986 Act changes - including the interest allocation rules, the exponential increase in the number of the foreign tax credit limitation "baskets," and the introduction of the passive foreign investment company provisions - imposed a heavy burden on U.S. companies, not only with respect to the tax revenue raised but also in terms of increased compliance costs. The 1986 Act's bottom line for multinational corporations is indisputable: the tax law changes severely affected the ability of U.S. companies to operate overseas.

TEI applauds the recognition inherent in H.R. 5270 that the pendulum must swing in the other direction. Where U.S. tax rules restrict the ability of U.S. companies to operate in a cost-efficient manner, the competitive position of the Nation as a whole suffers. That the Committee is attempting to restore balance in the international arena, therefore, is laudable. Indeed, the Committee's simplification efforts have already had one positive effect. Specifically, the Treasury Department recently announced an 18-month extension of the congressional compromise on the allocation of research and development expenses under section 861 of the Internal Revenue Code, albeit with further study of the underlying issues. The administrative resolution of this "on again/off again" issue on a permanent basis will bring a modicum of certainty and stability to a complex area.

Moreover, many of the provisions contained in H.R. 5270 will enhance U.S. competitiveness. TEI is pleased that the bill includes several provisions long advocated by the Institute: the allocation of interest expense on a worldwide asset basis, the recharacterization of overall domestic losses, the extension of the foreign tax credit carryback and carryforward provisions, and the repeal of the 90-percent limitation on the use of the foreign tax credit to offset the alternative minimum tax. Adoption of these provisions will reduce complexity and foster international competitiveness.

We question, however, whether a true balance can be struck as long as the beneficial changes in the international tax provisions are required to be funded by adverse changes in other international tax provisions. Simplification and "rationalization" of the international tax rules are worthwhile national goals. Given the harsh, unequal, and counterproductive treatment of U.S. multinational corporations under the 1986 Act, the search for funding should not necessarily be limited to the international provisions.

Moreover, the revenue-raising provisions set forth in H.R. 5270 raise serious tax policy questions. Several sections represent a radical departure from international norms. For example, the provision mandating a minimum level of taxation for foreign companies dangerously disregards the arm's-length standard - a standard which the United States was instrumental in establishing as the worldwide criterion for transfer pricing policies. The arm's-length standard is central to our system of international taxation; it is the underlying premise upon which the U.S. treaties were negotiated. To abandon it in favor of a formulary approach seriously undermines the United States' credibility with its trading partners and invites retaliation by other countries. This increased potential for double taxation cannot help but adversely affect the ability of U.S. multinationals to compete abroad. It would therefore violate a basic goal of H.R. 5270: to enhance the competitiveness of U.S.-based companies. It would also signal a retreat from our commitment to the treaty system and make future treaty negotiations more difficult.

The bill also undermines one of the longstanding principles of taxation: the deferral of tax on foreign income until it is repatriated. Under the bill, the earnings and profits of controlled foreign corporations would be treated as Subpart F income currently subject to U.S. tax. Such an approach is inconsistent with tax policy established in the United States (and elsewhere) since the inception of the income tax system.

TEI believes that in several respects H.R. 5270 is a classic example of placing the cart before the horse. Section 601 of the bill provides for a study by the Treasury Department on the tax issues relating to the maintenance and enhancement of the competitiveness of the American economy in light of changing economic policies in Europe and the increasing globalization of the world economy. We strongly suggest that such a study be completed before the enactment of any legislation adversely affecting broad classes of U.S. multinationals. Although Chairman Rostenkowski has announced that the bill was intended to "further the debate on international competitiveness," we believe that care must be taken that the taxpayer-adverse provisions are not adopted without a comprehensive review of their long-term impact on U.S. business.

In sum, despite the bill's stated purpose of "rationalizing" the international tax provisions, the thrust of certain portions of H.R. 5270 cannot be said to further that goal. We agree that the Code's international provisions are in drastic need of overhaul and that the burden imposed on U.S. corporations must be decreased if this country is to compete more effectively in the global marketplace. We do not, however, agree that the approach taken in H.R. 5270 is the proper response. The good intentions of the drafters notwithstanding, we regret that, on balance, the bill's burdens seriously outweigh its benefits.

TEI's comments on the specific provisions of H.R. 5270 are set forth below. We will discuss the sections of the bill seriatim.

Interest Allocation Rules

Section 864(e) of the Code provides that the taxable income of each member of an affiliated group from sources outside the United States must be determined by allocating and apportioning interest expense for each member as if all members of such group were a single corporation. This "fungibility" principle was adopted because of the congressional perception that taxpayers could arrange to have interest expense reduce U.S. income, although the interest expense funded foreign activities (or freed up cash to fund foreign activities), the income from which was sheltered from U.S. tax by the foreign tax credit or deferral. S. Rep. No. 99-313, 99th Cong., 2d Sess. 347 (1986). This interest allocation provision fails to take into account, however, the interest expense incurred by a taxpayer's foreign affiliates.

Section 101 of the bill remedies this situation by providing that taxpayers may take into account the interest expense and assets of foreign subsidiaries for purposes of allocating and apportioning interest expense between gross income from U.S. and foreign sources. As the Senate Finance Committee recognized when considering a similar proposal in respect of the Tax Reform Act of 1986, to the extent section 864(e) employs a fungibility concept, it is appropriate to consider the interest expense incurred and assets owned by foreign affiliates, because borrowing of foreign affiliates "may bear on the allocation of the interest expense that the U.S. group does incur." S. Rep. No. 99-313, at 349. Adopting this provision is not only consistent with the fungibility concept, but also substantially reduces the administrative complexity engendered by the interest allocation rules.

TEI endorses this provision.

Repeal of the 90 Percent

Limitation for AMT Purposes

Under section 59(a) of the Code, a taxpayer's foreign tax credit (FTC) may offset no more than 90 percent of the taxpayer's alternative minimum tax (AMT) liability. In contrast, a taxpayer that is subject to a regular income tax liability is not subject to the 90-percent limitation.

Section 111 of the bill permits a full offset of foreign tax credits against the AMT liability. The provision thus vindicates the policy underlying the FTC - the elimination, or at least reduction, of the incidence of double taxation. It acknowledges that the taxpayer has already paid a tax (to the jurisdiction where the income was derived) at a rate equal to or greater than the amount the United States would assess on that income.

TEI endorses this provision.

Recharacterization of Overall

Domestic Loss

The FTC recapture rules lack symmetry where foreign-source income is offset by a domestic-source loss. Section 904(f) of the Code provides for recapture of overall foreign losses, but does not provide for similar recapture treatment when there is an overall domestic loss that is offset against foreign income in year one and in a subsequent year there is sufficient domestic income to otherwise absorb the domestic loss.

Section 112 of the bill applies a resourcing rule to U.S. income where the taxpayer has suffered a reduction in the amount of its FTC limitation due to a domestic lose. The bill recharacterizes into foreign-source income U.S.-source income earned in a year subsequent to a year in which an overall domestic lose offset foreign source income.

Adoption of this provision not only provides parallel treatment for foreign and domestic losses, but will also foster U.S. competitiveness.

TEI endorses this provision.

Foreign Tax Credit Carryovers

Section 904(c) of the Code currently provides that any FTCs not used against U.S. tax in the current year may be carried back two years and forward five. The rules for the general business tax credit (section 39) and net operating losses (section 172(b)) provide, however, for a three-year carryback and a fifteen-year carryforward.

Section 113 of the bill conforms the FTC carryover rules to those allowed for net operating losses and general business tax credits (i.e., three years back and fifteen years forward). The provision applies with respect to excess foreign taxes paid or deemed paid in taxable years beginning after December 31, 1992. The provision not only furthers the goal of simplifying the Code, but also limits the situations where the purpose of the FTC - the elimination of double taxation - is frustrated by unrealistically short carryover periods.

TEI endorses this provision.

Election to Treat Companies

as Controlled Foreign

Corporations

Under section 904(d(1)(E) of the Code, dividends from each 10-percent to 50-percent owned foreign subsidiary ("10/50 companies") must be separately calculated and placed in a separate FTC limitation "basket." Unlike dividends from CFCs, dividends from such companies are not subject to the "look-through" rules, i.e., they may not be separated into specific baskets of income for purposes of the FTC limitation.

Section 114 of the bill permits domestic taxpayers that are shareholders in one or more 10/50 companies to treat the company as a controlled foreign corporation for purposes of the FTC limitation and Subpart F rules, thereby permitting look-through treatment. The election applies to all 10/50 companies.

TEI has previously endorsed the application of the "look-through" rules to 10/50 companies; we continue to believe that such a proposal has merit. We note, however, that given the proposed lose of deferral under section 201 of the bill for CFCs, this provision provides precious little relief to U.S.-based companies.

Limitation on UNICAP Rules

Section 263A of the Code requires the uniform capitalization of certain direct and indirect costs incurred with respect to property produced by the taxpayer or acquired for resale. In the case of interest expense, section 263A(f) applies these UNICAP rules to interest paid or incurred during the production period of such property.

Section 263A(i)(l) provides for regulations to prevent the use of related parties ... to avoid the application of [this rule]." The preamble to the temporary regulations under section 1.263A-1T, published on March 30, 1987, states that the UNICAP provisions are applicable to all persons engaging in the production of property, or the acquisition of property for resale, including certain foreign persons. In addition, IRS Notice 88-99 requires the application of the UNICAP rules to the interest expense of all parties related to the taxpayer, including foreign subsidiaries outside the consolidated group.

Section 121 of the bill grants the Treasury Department the regulatory authority to provide that the UNICAP rules of section 263A apply to a non-U.S. U.S. person only to the extent necessary for purposes of determining the amount of tax imposed on Subpart F income or on U.S. effectively connected income.

Although this provision may seem beneficial to taxpayers, in reality it would provide little relief. First, the provision does not mandate relief, but only delegates authority over the UNICAP rules to Treasury. Second, the relief would essentially be limited to 10/50 companies that do not have effectively connected income and do not elect CFC status under section 114 of the bill. (We are assuming that this provision was not intended to apply to CFCs.)

Under current law, the revenue raised by application of the UNICAP rules to foreign subsidiaries is small compared with the administrative burden they impose on taxpayers. Rather than shifting regulatory authority to deal with this issue to the Treasury Department (and then only on a less than complete basis), we believe Congress should act decisively and specifically exempt CFCs and other corporations without effectively connected income from the application of the UNICAP rules.(1) This solution is sounder and simpler than that contained in H.R. 5270.

Repeal of Deferral

U.S. corporations are subject to U.S. tax on their worldwide income. U.S. tax on foreign corporations, however, is generally not imposed until the foreign corporation's earnings and profits are repatriated to the United States. An exception to this "deferral" of tax exists with respect to Subpart F income, i.e., income of a controlled foreign corporation (CFC) that is relatively movable from one jurisdiction to another and subject to low rates of tax.

Section 201 of the bill repeals deferral for CFCs by treating as Subpart F income all of a CFC's earnings and profits for the year. The bill also eliminates the exception provided under section 954(b)(4) of the Code for certain income subject to high rates of foreign tax.

This provision violates a long-standing principle of taxation relating to the deferral of tax on foreign income until that income is repatriated. Subpart F was enacted in 1962 to prevent the use of artificial devices to shift income from high-tax to low-tax jurisdictions, usually by employing a holding company in the low-tax country to receive passive (or easily movable) forms of investment income. This targeted anti-abuse exception should not overwhelm the general rule by sweeping all foreign operating income within its scope.

Moreover, the repeal of deferral adversely affects the competitiveness of U.S. multinationals. In 1976, a task force made up of members of this Committee and chaired by Chairman Rostenkowski reviewed U.S. policy toward the taxation of foreign-source income, including whether deferral should be repealed or at least significantly curtailed. The task force rejected the suggestion, concluding that certain changes "were found not to be acceptable if unilaterally adopted by the United States because they would subject U.S. businesses operating abroad to tax while their foreign competitors would not be similarly taxed, thus placing the U.S. businesses at a competitive disadvantage." House Committee on Ways and Means, Recommendations of the Task Force on Foreign Source Income, 95th Cong., lot Sess. 2, 59 (Comm. Print 1977). We believe that this reasoning is still valid today.

Start-up companies in particular will suffer from the harsh effect of the rule. For companies operating in high-tax jurisdictions, the provision imposes significant administrative costs with little, or no, revenue effect.

TEI opposes this provision.

Inventory Export Source Rule

Under Treas. Reg. [section] 1.863-3(b), taxpayers may apportion 50 percent of the income derived from the manufacture of products within the United States and their sale outside the United States on the basis of the location of assets held to produce income from the sale. The other 50 percent of the income is sourced on the basis of the place of sale determined under the title-passage rule.

Section 203 of the bill imposes a limit on the amount of section 863(b) income attributable to production activities where the inventory property is sold by the taxpayer to a related person. The amount attributable to production activities cannot be less than the portion of the combined taxable income of the taxpayer and the related person attributable to the inventory property that would have been apportioned to production activities under section 863(b) had both parties been treated as one U.S. taxpayer.

This provision adversely affects U.S.-based companies that manufacture in the United States and use a foreign subsidiary to market their exports. The ability of these companies to compete overseas will be impaired because companies dealing with an unrelated party will not be subject to the same restrictions. As the Senate Finance Committee recognized in 1986 when it considered changes to the title passage rule, "with the substantial trade deficits of the United States, [the Committee] does not want to impose any obstacles on U.S. businesses that may exacerbate the problems of U.S. competitiveness abroad." S. Rep. No. 99-313, 99th Cong., 2d Sess. 329 (1986). The reservations expressed in 1986 are just as valid today. Moreover, the provision raises significant compliance issues since there is no indication how a taxpayer determines the portion of a foreign affiliate's income that is attributable to the exported product.

TEI opposes this provision.

Limitation on Tax

Treaty Benefits

The United State regularly enters into bilateral tax treaties to reduce the statutory U.S. tax on non-effectively connected U.S.-source income earned by a resident of a treaty country. For example, these treaty provisions may reduce the statutory rate of 30 percent on dividends to 5 percent. In many cases, the benefit of these rate reductions is limited to residents of the two treaty countries.

Section 302 of the bill imposes a qualified resident requirement, similar to that now in the branch tax provisions, as a prerequisite for reducing U.S. tax on a foreign entity under a treaty. The provision also prevents any person from obtaining U.S. tax benefits under a treaty with respect to any income that bears a significantly lower tax under the laws of the other treaty country than similar income arising from sources within such foreign country derived by residents of such foreign country. The amendment becomes effective on January 1, 1993, and overrides any treaty "whether entered into before, on, or after such date."

TEI recognizes that this provision is intended to stop "treaty shopping," i.e., a situation where a person who is not a resident of either country seeks certain benefits under the income tax treaties between the two countries. We are concerned, however, that the proposal would invite retaliation from our treaty partners. Moreover, the provision is particularly offensive to those countries with a territorial concept of taxation (i.e., countries that do not tax foreign source income). We also question its effectiveness to override future treaties, given the U.S. rule that the later-in-time doctrine generally controls in cases of conflicts between a statute and a tax treaty. We suggest that any abuse in this area is more appropriately addressed directly through the treaty process, rather than by unilateral flat.

TEI opposes this provision.

Special Section 482 Rules

Section 482 of the Code authorizes the Internal Revenue Service to re-determine the tax of an entity subject to U.S. tax in cases where there has been an improper shifting of items of income or deductions between the taxpayer and a related party. Although section 482 is not limited in application to U.S. taxpayers and their foreign subsidiaries, the statute has particular significance in the establishment of transfer prices between those two entities. Under guidelines established by the Organisation for Economic Co-operation and Development (OECD) (of which the United States is a member), countries generally recognize a transfer price that is established according to the arm's-length standard, i.e., the price set by unrelated parties, neither being under a compulsion to buy or sell.

Section 304 of the bill establishes a minimum amount of taxable income to be reported by 25-percent foreign-owned domestic corporations that engage in more than a threshold level of transactions with related foreign persons. The provision applies to aggregate transactions that exceed the lesser of $2 million or 10 percent of the gross income of the domestic corporation. The taxpayer's taxable income will be no less than 75 percent of the product of its gross receipts multiplied by an appropriate profit percentage, based upon the Standard Industrial Classification (SIC) Code categories, computed in advance by the IRS on the basis of relevant industry financial data. An exception is provided for taxpayers that enter into an advance pricing agreement (APA) with the IRS, although the scope of the APA may be much broader.

The Technical Explanation of this provision tentatively states that "[i]t is believed that the bill does not violate treaties." Staff of the Joint Committee on Taxation, Explanation of H.R. 5270 (Foreign Income Tax Rationalization and Simplification Act of 1992) (JCS-11-92) at 54 (May 29,1992). It concludes, however, that "[i]f, despite the beliefs expressed above, it is ultimately determined that this provision of the bill violates a treaty obligation of the United States, it is intended that the provisions of the bill will nevertheless apply." Id. at 55.

TEI submits that the provision does, indeed, violate the non-discrimination articles of the U.S. tax treaties providing that the United States may not impose higher taxes or more restrictive requirements on residents of the treaty country than are imposed on its own residents. See U.N. Model Income Tax Treaty, art. 24, [paragraph] 1. By requiring a minimum level of taxable income on those U.S. corporations owned by foreign corporations, the bill discriminates between U.S.- and foreign-owned entities. In addition, the proposal essentially abandons the international arm's-length standard by adopting a formulary approach to transfer pricing - an approach which has not been adopted by any of our trading partners. Thus, the provision invites retaliation against U.S-based companies from our treaty partners.

The provision also violates one of the underlying premises of an income tax system since the provision would virtually create a tax on gross receipts, not income. Moreover, such a provision fails to reflect economic reality by requiring that there be U.S. income even where there is an overall foreign loss. In essence, the provision represents a "one-way street" for the government: it establishes a minimum taxable income that must be reported, but corporations with income above that amount must still report the higher amount under arm's-length principles. Finally, the provision raises significant compliance concerns, especially with respect to the "stainless" of the industry data the IRS is required to compile.

TEI opposes this provision.

Reduction of Puerto Rico and

Possessions Tax Credit

Domestic corporations may elect under section 936 of the Code to eliminate the U.S. tax on certain income related to their possession-based operations (generally in Puerto Rico and the U.S. Virgin Islands). The credit spares the electing corporation tax whether or not it pays income tax to the possession.

Section 411 of the bill limits to 85 percent the amount of U.S. tax that a company may reduce with the section 936 credit on possession source income.

TEI believes that this provision adversely affects investment in possession countries such as Puerto Rico and makes U.S. companies operating in such areas less competitive. The Technical Explanation of H.R. 5270 offers no policy justification for such a curtailment. Moreover, the provision creates the possibility of double taxation with respect to the 15-percent disallowance.

TEI opposes this provision.

Simplification Provisions

H.R. 5270 also includes the same provisions included in sections 4401 to 4404 in H.R. 4210, as passed by the House and Senate and vetoed by the President earlier this year. TEI filed comments on these provisions on July 23, 1991. A copy of those comments is attached to this statement. [The attachment was published in the September-October 1991 issue of The Tax Executive.]

(1) The ERS recently issued proposed regulations that would simplify the computation of a foreign corporation's earnings and profits by permitting taxpayers to use U.S. generally accepted accounting principles (GAAP) for certain purposes. The proposed regulations would largely eliminate the required book-to-tax adjustments attributable to depreciation and to the UNICAP rules. If these rules become final, they would ameliorate the need for congressional action with respect to 10/50 companies and would also effect simplification for CFCs. We suggest, however, that Congress could effect meaningful reform in this area by clarifying the Treasury Department's authority under section 964 of the Code to permit the use of U.S. GAAP in computing the E&P of foreign corporations for all purposes, including the computation of taxable income under Subpart R