TEI comments on repeal of the FSC/ETI provisions and other international and corporate reform and simplification proposals.

March 10, 2004

On March 10, 2004, Tax Executives Institute sent the following letter to the tax-writing committees of the Senate and House of Representatives on legislation to repeal the FSC/ETI provisions of the Internal Revenue Code and effect other changes to the international provisions of the Code.

On behalf of Tax Executives Institute, I submit the following comments relating to repeal of the FSC/ETI provisions of the Code and other international and corporate reform and simplification proposals contained in H.R. 2896, the "American Jobs Creation Act of 2003" and S. 1637, the "JOBS Act of 2003," currently before the House and Senate. These bills contain a number of very important proposals that would address raised by repeal of the FSC/ETI provisions and other international tax rules of the Code, significantly benefit U.S. businesses, and improve the operation of U.S. international tax laws. Given the imposition of trade sanctions by the European Union, we urge the Congress to address the concerns described in this letter and then complete its work on this important legislation as soon as possible.

Tax Executives Institute

Tax Executives Institute was established in 1944 to serve the professional needs of business tax professionals. Today, the broad membership of the Institute is organized into 53 chapters in the United States, Canada, and Europe. Our diverse membership of more than 5,400 accountants, attorneys, and other business professionals work for 2,800 of the leading companies in North America and Europe. As a professional organization, the Institute 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 costs and burdens of administration and compliance to the benefit of taxpayers and government alike. The Institute is committed to maintaining a system that works--one that builds upon the principle of voluntary compliance and is consistent with sound tax policy, one that taxpayers can comply with, and one in which the IRS can effectively perform its audit function without unduly burdening taxpayers. Our background and experience enable us to bring a unique and, we believe, balanced perspective to the subject of international complexity and simplification.

Executive Summary

The FSC/ETI provisions accord significant benefits to U.S. exporters that to some degree balance the tax treatments afforded by other trading nations to their exports (e.g., territorial systems and VAT exemptions). Finding a replacement for these rules is critically important to the country.

Certain provisions in the international sections of the Code impose costly tax burdens on U.S. multinationals, and are among the most complicated provisions in the tax law. Likewise, many Code provisions that affect international transactions go beyond the norm established by major U.S. trading partners or are significantly out of date. They contain a number of anomalies that place international businesses at a disadvantage. TEI believes that the Code's foreign provisions need significant reform and simplification.

* The repeal of the FSC/ETI provisions will impose a significant tax increase on those currently benefitting from the provisions, and the inclusion of replacement provisions like those under consideration, with broad transition relief of at least three years, will help to lessen the effects of such a significant tax increase.

* Overall, the anti-deferral rules of the United States are broader and more burdensome than those of its major trading partners. A number of the provisions in the House and Senate bills address these concerns. In particular, TEI supports:

() Elimination of the Foreign Base Company Sales and Services Rules, or at least the House proposal allowing for the treatment of the European Union as one country for the FBCSI rules.

() Creation of a meaningful de minimis exception.

() Repeal of the FPHC and FIC Rules.

() Limited tax-favored repatriation for certain dividends received from a CFC.

* U.S.-based multinationals confront double taxation in situations where their foreign-based competitors do not, in many cases because of anomalies in the U.S. foreign tax credit system. Because of layers of limitations and adjustments made over the decades since its adoption, the present foreign tax credit system fails to eliminate double taxation in a number of circumstances. Provisions in the House and Senate bills address these concerns, and TEI believes that enactment of these provisions will greatly improve the U.S. tax system. In particular, TEI supports:

() Elective adoption of worldwide interest allocation rules.

() Extension of the foreign tax credit carryover period from 5 years to 20 years.

() Recharacterization of Overall Domestic Losses.

() Reduction of the number of foreign tax credit limitation baskets from 9 to 2.

() Elimination of 90 percent limitation on the use of foreign tax credits and use of NOLs against alternative minimum tax and expansion of exemption amounts.

() Look-through rules for dividends from noncontrolled section 902 (10/50) companies.

() Election not to use average exchange rate for foreign tax paid in a nonfunctional currency.

() Limited application of uniform capitalization rules to foreign persons.

() Significantly narrowed limitations on the deductibility of interest.

Repeal of the FSC/ETI Provisions

Like many other countries, the United States has long provided export-related benefits under its tax law to enhance the global competitiveness of U.S. business. In the United States, for almost the last two decades, these benefits were provided by the FSC regime, and then by its successor, the ETI regime. (1) In 2000, the World Trade Organization declared the FSC regime a prohibited export subsidy, and in 2002, a WTO Appellate Body reached the same conclusion for the ETI regime. Under the panel findings, the EU is permitted to impose more than $4 billion a year in countervailing trade measures unless the United States acts to withdraw the measures or obtains a waiver from the EU with respect to all or certain parts of them. The EU began retaliating on a specified list of U.S. goods on March 1, 2004, with five percent additional duties, and this will increase one percent per month until the additional duties total seventeen percent.

If the FSC/ETI provisions are repealed without the enactment of reasonable alternatives, the results will be both inequitable and dramatic (2)--significantly increasing the effective tax rates of many companies. While there are a variety of proposals under consideration (some broad based, others quite narrow), there is near unanimity that action--prompt action--is essential. In moving forward in this area, we urge Congress to follow the principle that any action resulting in the repeal of the FSC/ETI provisions should not be taken without correlative benefits to the U.S. companies and their workers who suffer the loss of the FSC/ETI provisions and others significantly affected by the U.S. system of international taxation.

We also note that that provisions that reduce the rate of tax on U.S. businesses (or that have that effect) are important to address fundamental disadvantages placed on U.S. companies. That reduction in taxation should be significant and should be constructed in as broad a manner as possible so that its effects will be felt by all companies and other business units affected by the repeal of the FSC/ETI provisions (many businesses operate in the form of pass-through entities such as subchapter S corporations, cooperatives, and partnerships). The provisions currently being discussed are an important step in the right direction.

In 1986, when the United States was considering the Tax Reform Act of 1986, the top federal corporate income tax rate was 46.0 percent, higher than the unweighted average rates for the European Union (42.8 percent) and the OECD (41.4 percent). Only 8 of the 24 countries in those groupings bad higher rates. After the legislation, in 1991, the United States rate of 34.0 percent was then lower than the unweighted averages for the European Union (35.9 percent) and the OECD (35.0 percent). Other countries though had begun to adjust their rates in response to the rate changes in the U.S. and the realities of the emerging global economy. By 1995, the U.S. rate of 35.0 percent had remained above the average for the European Union (34.4 percent) and that of the OECD (32.0 percent) as the rates in other countries with whom the U.S. has some of its most significant economic relations had been significantly reduced across-the-board. Only six of the countries in the group then had higher rates. (3) That number had dwindled to one in 2002 as we head into this new century and an increasingly globalized economy.

The solution crafted by Congress should grant as broad transition relief as possible, including relief with respect to existing contracts and leases that were structured before repeal. Similarly, the final provisions and the transition rules should take into account the effects of the significant structural shifts in taxation and their effects on financial statements and financial markets.

Lastly, the provision contained in the Senate bill that would provide for a "haircut," reducing the benefits relating to foreign manufacturing and production activities, is counter-productive. There are many reasons why U.S. businesses must invest in foreign facilities in the course of pursuing foreign markets. Applying a penalty to those businesses simply places them, their workers, and their shareholders at a competitive disadvantage that mutes the relief of the provision. We urge Congress to abandon this provision.

Anti-Deferral Rules Reforms

A recent detailed study that compared the international tax rules of the United States to those of its major trading partners found that for every category of income considered the United States imposed the severest anti-deferral regime (although in a few cases a minority of the other countries imposed a rule of comparable reach). (4) A number of the provisions in the House and Senate bills address these concerns, and TEI believes that such efforts have important beneficial effects on U.S. companies. Without implication to its broad support of reform of this area, a few provisions merit special mention.

Treatment of European Union as One Country for FBCSI Rules

TEI understands that for revenue reasons, provisions that would have repealed the Foreign Base Company Sales and Service (FBCSI) rules were removed from the House bill before it was voted out of committee. That is regrettable, as these rules no longer serve a useful purpose, and in fact pose a significant burden on business and should be repealed. Although, from a business perspective it is often sensible to have centralized sales or services entities, the base company sales and services rules effectively impose a tax cost on the use of such entities by accelerating U.S. taxation. Further, the base company sales and services rules interfere with legitimate foreign tax reduction efforts when locating production and sales facilities in the same regional (but not the same national) markets. Unfortunately, the base company rules defeat the point of that planning by imposing current U.S. tax on the distributor's sales. With the maturity of global transfer pricing enforcement, those concerns that some maintain underlie the existing law are effectively addressed. The limited proposal adopted by the House committee to address these issues across the countries of the European Union is worthwhile, and TEI supports it. We continue to believe, however, that enactment of the broader proposal is appropriate.

De Minimis Exception

Rather than imposing a complex subpart F analysis on the active income of all business operations, the original 1962 legislation provided a substantial de minimis rule that excluded from subpart F amounts equal to up to 30 percent of a CFC's gross income. That rule was substantially modified in 1975 to 10 percent of gross income. This worthy provision was essentially repealed in 1986 by limiting it to the lesser of 5 percent of gross income or $1 million. For larger multinational companies, that $1 million threshold is easily exceeded. The drafters of the original legislation fully appreciated that active businesses would generate a certain amount of subpart F income and were willing to forgo the accelerated taxation of that income. The fact that the amount may be significant in absolute terms does not detract from the fact that it is insignificant in relative terms and does not undermine the basic purpose of the statutes. TEI appreciates that the Senate addresses these concerns in a different manner, but recommends that Congress simplify subpart F and restore this provision to its former usefulness with the enactment of a meaningful de minimis rule excepting from subpart F amounts that do not exceed 10 percent of a CFC's gross income.

Repeal of the FPHC and FIC Rules

One of the significant complexities of the international provisions is the overlap of the various antideferral regimes, many of which produce minimal or no ultimate tax consequences. The overlaps require significant coordination efforts and detailed specific rules governing that coordination. The bills contain a provision that eliminates the rules applicable to foreign personal holding companies and foreign investment companies, excludes foreign corporations from the application of the personal holding company rules, and includes as subpart F foreign personal holding company income personal services contract income that is subject to the present-law personal holding company rules. TEI supports the provision.

Tax-Favored Repatriation for Certain Dividends Received From a CFC

Section 231 of S.1637 provides a time-limited 5.25 percent reduced rate of tax for actual and deemed dividends from CFCs (equivalent to an 85 percent dividends received deduction for corporations taxed at the maximum rate of 35 percent) in excess of a base period amount that are subject to a "domestic reinvestment plan." The residual U.S. tax imposed on the repatriation of foreign earnings serves as a disincentive to repatriate such earnings. This proposal is explicitly short-term and does not affect other issues within our deferral-based tax system, such as section 956 and its adverse effect on lending offshore funds back to the United States, that also merit attention in the future. TEI believes that this limited, temporary relief will significantly benefit the U.S. economy.

Elimination of Double Taxation

U.S.-based multinationals can confront double taxation (5) in situations where their foreign-based competitors do not, in many cases because of anomalies in the U.S. foreign tax credit system. The United States has neither a pure territorial income tax system nor a worldwide system with an unlimited foreign tax credit, either of which would forestall double taxation. Because of layers of limitations and adjustments made over the decades since its adoption, the present foreign tax credit system fails to eliminate double taxation in a number of circumstances. For example, the United States allocates U.S. interest expense of the consolidated group, and certain other U.S. expenses (e.g., certain research expenses) against foreign-source income for purposes of the foreign tax credit. Because foreign governments do not allow a corresponding deduction for these expenses, U.S. taxpayers in an excess foreign tax credit position are effectively precluded from deducting these expenses, and double taxation occurs.

Interest Allocation Rules

Despite the adoption of the concept of fungibility, the affiliated group concept that underlies the current interest expense allocation regime is based on an affiliated U.S. group only. The affiliated group does not include foreign subsidiaries; rather, the stock bases and earnings and profits of foreign subsidiaries are treated as assets of the U.S. group. Because of this "water's-edge" approach, whenever a U.S. parent of a foreign subsidiary incurs debt, the interest expense allocation rules effectively treat the U.S. parent as doing so in part to invest in the equity of the foreign subsidiary. Interest expense incurred by foreign affiliates, even if the affiliates borrow solely on their own credit, however, is never treated as supporting assets of the U.S. parent. As a result, even if a U.S. parent and its foreign subsidiary have identical debt-to-equity ratios, the effect of the interest expense allocation rules is to reallocate interest expense to foreign source income. In contrast, the foreign jurisdiction in which the foreign source income is earned does not treat any part of the interest expense on debt borrowed by a U.S. corporation as deductible in determining the amount of foreign tax due with respect to that income.

The result of the interest expense allocation rules, therefore, is that a U.S. taxpayer's foreign source income is larger for purposes of calculating its foreign tax liability than for purposes of calculating its U.S. tax liability. In other words, for U.S. tax purposes only, net U.S. source income effectively is increased and net foreign source income effectively is reduced by operation of these rules. Under the FTC limitations, the more interest expense that is allocated to foreign-source income, the less FTC may be claimed. The effect of this reduction in the amount of a U.S. corporation's foreign source income is thus to limit the ability of the taxpayer to utilize its foreign tax credits for U.S. tax purposes. To the extent foreign tax credits expire unutilized as a result, the U.S.-taxpayer loses a tax benefit (deduction) for the interest allocated, and significant double taxation results.

TEI supports the provision that would allow an election to adopt worldwide interest allocation contained in both the House and Senate bills.

Extend Foreign Tax Credit Carryover Period from 5 Years to 20 Years

TEI understands that, for revenue reasons, provisions that would have extended the carryover period for foreign tax credits to 20 years and made them comparable to NOLs were removed from the House bill before it was voted out of committee. The Senate bill contains such a provision. Extending the carryover period would significantly benefit companies in an excess limitation position that often see credits expire under the existing five-year carryover period. TEI supports this change.

Recharacterization of Overall Domestic Losses

Companies that experience losses at home while earning income abroad suffer a reduction in foreign tax credits. Consequently, it may not be possible to fully credit foreign taxes paid on foreign income, even though the foreign tax rate is less than or equal to the U.S. rate. This is in direct contrast to the special rules in place in the Code that limit the credit when foreign losses are incurred, a "heads-we-win / tails-you-lose" result imposed on taxpayers in cyclical businesses.

The bills include an Overall Domestic Loss recapture rule that mirrors the Overall Foreign Loss recapture rule of section 904(f). There is little policy disagreement that current year reductions in foreign-source income by U.S. losses should later be reversed just as current year reductions in U.S.-source income by foreign losses are later reversed under section 904(f). Domestic loss recapture would ensure that foreign as well as U.S.-source income is, over time, computed separately, that is, with reduction by losses in the other category. TEI supports this provision.

Reduce Number of Foreign Tax Credit Limitation Baskets from 9 to 2

The 1986 Act foreign tax credit and expense allocation and apportionment amendments to section 904(d), along with the IRS guidance interpreting them, represent a quantum leap in the complexity of the foreign tax credit and the uncertainty of its application. Each limitation introduces a detailed set of rules for determining whether income is subject to that separate limitation. Additionally, for the various separate limitations to operate as intended, elaborate look-through and tax allocation rules are required that introduce another tier of complexities and uncertainties, placing an unnecessary burden on the IRS and taxpayer alike. The basic integrity of the limitation system of section 904 can be maintained by reducing the baskets to two as contained in provisions in the bills. TEI supports this change as a significant reduction in complexity of the Code.

Eliminate 90-Percent Limitation on the Use of Foreign Tax Credits and Use of NOLs Against Alternative Minimum Tax and Expansion of Exemption Amounts

The corporate alternative minimum (AMT) tax requires businesses to prepay their taxes when they can least afford it, during or soon after a business downturn. Its perverse countercyclical nature provides a major obstacle to business recoveries at such times. Companies subject to the alternative minimum tax face additional limitations on foreign tax credits and losses that specifically are designed to ensure the payment of a minimum amount of U.S. tax even where foreign-source income has been taxed at rates that exceed the U.S. rate.

Whatever its original purpose may have been, the impact of the AMT is a major problem for many companies. TEI strongly supports repeal of the corporate AMT, and short of its repeal, the provisions in the House bill that would eliminate the limitation on use of NOLs in computation of AMTI, repeal the 90-percent limitation on utilization of the AMT foreign tax credit, and increase AMTI exemption amounts. These are important improvements to the Code.

Look-through Rules for Dividends from Noncontrolled Section 902 (10/50) Companies

Like the committees, TEI believes that significant simplification can be achieved by elimination of the requirement that taxpayers segregate the earnings and profits of 10/50 companies on the basis of when such earnings and profits arose. This is an important issue for many companies who operate joint ventures and who have a significant but not controlling share of the operations of the venture.

Election Not to Use Average Exchange Rate for Foreign Tax Paid in a Nonfunctional Currency

This provision simplifies the complex rules applicable to the determination of the amount of foreign taxes paid for determination of the foreign tax credit. TEI supports the provision.

Limited Application of Uniform Capitalization Rules to Foreign Persons

Under the Senate bill, uniform capitalization rules under section 263A will apply to foreign taxpayers only for purposes of taxing income effectively connected with the conduct of a U.S. trade or business if the taxpayer capitalizes costs for produced property or property acquired for resale in accordance with the method used in its financial statements. TEI supports the provision.

Limitations on the Deductibility of Interest

Both committees have focused much attention on the problems created by so-called corporate inversions, a problem that can be tied, at least in part, to the existing burdens in current law that these bills are intended to address. Regrettably, pending proposals designed to staunch abusive transactions have the potential to adversely affect legitimate inbound investment of funds by foreign companies in their U.S. subsidiaries (or by foreign companies borrowing from banks to invest into their U.S. subsidiaries or using guarantees for their U.S. subsidiaries' borrowings). TEI believes that the Senate bill provision to revise section 163(j)'s limitations on the deductibility of interest is more focused and appropriate. Broader provisions to restrict interest deductions of U.S. companies owned by foreign parents could have the perverse effect of discouraging inbound investment by effectively imposing a significant tax increase on such investment in the United States. Further, TEI suggests that global debt-to-equity relaxation should be a topic for future treaty discussions because the present rules in some foreign jurisdictions have a comparably negative effect on U.S. companies' investments into those jurisdictions.

Conclusion

TEI agrees that the United States must comply with its WTO obligations, but the repeal of the FSC/ETI provisions will substantially increase the tax burden on those currently benefitting from the provisions. The enactment of remedial provisions like those discussed in this letter, together with broad transition relief of at least three years will help to lessen the impacts of a significant tax increase on U.S. companies at a time when the U.S. economy is still getting back on its feet. Similarly, the international provisions of the Internal Revenue Code are among the most complicated provisions in the tax law and contain serious flaws that disadvantage U.S. businesses. TEI supports the efforts to bring about needed significant policy and simplification changes in the Internal Revenue Code's foreign provisions.

Any questions about the Institute's views should be directed to either Timothy J, McCormally, TEI Executive Director, or Fred F. Murray, the Institute's General Counsel and Director of Tax Affairs, at 202.638.5601.

(1) Prior to FSC and ETI, the Domestic International Sales Corporation (DISC) performed a similar role.

(2) $54.522 billion over 10 years (without consideration of transition relief). Staff of the Joint Committee on Taxation, JCX-15-04, Updated Estimated Budget Effects of S. 1637, the "Jumpstart Our Business Strength ('JOBS') Act, as Reported by the Committee on Finance, (JCX-15-04, March 3, 2004).

(3) See Jeffrey Owens, Tax Reform for the 21st Century, Tax Notes International (1995).

(4) See THE NFTC FOREIGN INCOME PROJECT: INTERNATIONAL TAX POLICY FOR THE 21st CENTURY, REPORT AND ANALYSIS, National Foreign Trade Council, Washington, D.C. (2001), at Volume I, Part One, Chapter 4. The report compares the U.S. rules with those of Canada, France, Germany, Japan, the Netherlands, and the United Kingdom. These countries, together with the U.S. are home to 412 of the 500 largest corporations in the world.

(5) Double taxation is defined to occur when an item of multi-national income effectively is taxed at a rate in excess of the greater of the home or host country income tax rates.