TEI endorses H.R. 1690, the International Tax Simplification and Reform Act of 1995.
As the premier organization of corporate tax professionals in North America, Tax Executives Institute has long been concerned about the complexity of the tax law, especially with respect to the Internal Revenue Code's international tax provisions. We believe that the Code's foreign provisions are in need of fundamental reform and simplification, and for this reason we support H.R. 1690, the International Tax Simplification and Reform Act of 1995, which was recently introduced by Congressmen Houghton and Levin.
TEI believes H.R. 1690 represents a large step in the right direction by generally reducing the costs of preparing and auditing U.S. corporate tax returns for American companies engaged in international trade without any material diminution in tax dollars flowing to the Treasury. Enactment of the bill would not only reduce compliance costs -- thereby enhancing the country's competitiveness -- but it would also signal Congress's commitment to the simplification of the tax law generally. The bill will also bring long overdue reform to the foreign tax credit area.
TEI recognizes that Congress is in the midst of a debate on the basic structure of the U.S. tax system. We also recognize that, in light of the impetus for a major overhaul, some may question the efficacy of the targeted, incremental changes proposed in H.R. 1690. The Institute believes, however, the prospects for major reform should not detract from the important goal of bringing immediate and constructive reform to the international arena. With this in mind, we include our support for, or recommendations to improve, certain provisions of the bill.
Simplification of the International Tax Provisions
The international provisions of the Internal Revenue Code have grown enormously in length and complexity during the past decade. Change has been piled upon change, with inadequate attention being paid to the administrative burdens spawned by the changes. H.R. 1690 would simplify the Code's international provisions by stripping away needless complexity in several areas:
* Reform of the PFIC Rules. When enacted in 1986, the passive foreign investment company (PFIC) rules were intended to limit the economic benefit of tax deferral available to U.S. investors in foreign investment funds, as well as to restrict the ability of such investors to convert ordinary income into capital gain. In addition, Congress was concerned that the tax rules not provide undue incentives to make investments outside the United States.
Unfortunately, when the PFIC provisions were enacted, the definition of a PFIC was so distended that it resulted in the classification of many corporations with active businesses as PFICs. The PFIC rules stand as an excellent example of overkill -- taxing not only passive income but also the operating income of controlled foreign corporations (CFCs), which are already subject to tax on their passive income under Subpart F of the Code.(1)
Even a corporation with a modest number of active subsidiaries is required to devote substantial time to analyzing the applicability of the PFIC rules. Such a compliance burden is not warranted, particularly in connection with CFCs whose U.S. shareholders must include the CFCs' passive income in their taxable income under Subpart F's rigorous rules. H.R. 1690 would redress the legislative overkill of the current PFIC provisions by exempting controlled foreign corporations from those rules. The remedy offered by the legislation is overdue and should be promptly enacted.
* Use of GAAP for E&P Calculations. The concept of "earnings and profits' (E&P) has relevance in the foreign tax area for several reasons. For example, E&P is used in measuring the amount of Subpart F inclusions, the portion of a distribution from a foreign corporation that is taxable as a dividend, the amount of foreign taxes deemed paid for purposes of the deemed-paid foreign tax credit, and the amount of section 1248 gain taxable as a dividend.
The Code currently provides that the E&P of a foreign corporation is to be computed in accordance with rules substantially similar to those applicable to domestic corporations. As a practical matter, however, a foreign corporation is frequently unable to compute E&P in the same manner as a domestic corporation. Although a domestic corporation generally calculates E&P by making adjustments to U.S. taxable income, a foreign corporation necessarily uses foreign book income as its starting point. The ensuing adjustments become especially difficult in the case of noncontrolled foreign corporations since the U.S. shareholder of such companies may be unable to obtain all the information required to compute E&P.
Although foreign corporations do not compute U.S. taxable income, they frequently do adjust foreign book income to conform with U.S. generally accepted accounting principles GAAP) for financial reporting purposes. There are numerous differences between GAAP and E&P, but most relate to timing differences and have at most a transitory and nominal effect on a company's U.S. tax liability, especially in light of the requirement of the Tax Reform Act of 1986 that taxpayers compute their deemed-paid credit on the basis of a "pool" of post-undistributed 1986 earnings.
Enactment of this provision is needed to simplify calculations of E&P in the foreign area. Accordingly, we recommend that taxpayers be generally permitted to elect to use U.S. GAAP in computing the E&P of foreign corporations. Although the Institute believes the Code currently provides the Treasury Department and IRS with adequate authority to prescribe such rules, H.R. 1690 would clarify that such authority exists. We therefore strongly endorse the adoption of this provision.(2)
* Limitation on UNICAP Rules. As enacted in 1986, section 263A of the Code requires the uniform capitalization of certain direct and indirect costs, including interest, incurred with respect to property produced by the taxpayer or acquired for resale (the "UNICAP rules"). The Treasury and IRS have taken the position that section 263A applies in the foreign context.
The revenue raised by application of the UNICAP rules to foreign subsidiaries, however, is small compared with the administrative burden they impose on taxpayers. H.R. 1690 would redress this problem by providing that the UNICAP rules of section 263A apply to a non-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. It is a simplifying provision that should be adopted.(3)
* Treatment of EU Countries as One Country. In 1992, the European Community created a single market now comprised of 15 countries that led to the consolidation of many European business opportunities. The resulting reduction of operating costs enhanced the competitiveness of EC-based corporations, often to the detriment of U.S.-based companies that are subject to Subpart F.
Under the current Subpart F rules, certain sales and services income that is earned outside a CFC's home country is taxable, while income earned inside the home country is exempt from current taxation (the "same-country exception"). Computing Subpart F income significantly increases the administrative costs for U.S.-based companies; because of the generally high European tax rates, there is most often no increase in revenues for the United States. Thus, U.S. multinationals may be forced to choose between the potential for cost-efficient consolidation of operations in Europe and higher administrative costs.
H.R. 1690 would provide one solution to the problem by treating the EC countries as a single country for purposes of the same-country exception. This would permit the efficient consolidation of U.S. multinationals' European operations, thereby enhancing their ability to compete in the European Union. TEI urges the adoption of this provision.
* Permanent Extension of R&D Allocation Rules. In 1977, the Treasury Department issued regulations under section 861 relating to the allocation of U.S. research and experimental (R&E) expenses against foreign income. To encourage U.S.-based R&E, in 1981 Congress enacted a moratorium on the application of the Treasury Department's regulations. During the past 14 years, that moratorium has been extended and modified nine times. The most recent statutory rule permits taxpayers to allocate percent of U.S.-based R&E expenses to domestic-source income, and 50 percent of foreign-based research expenses to foreign-source income.
H.R. 1690 would adopt a 64-percent allocation rule (which was the applicable percentage for many years) and make the formula permanent. TEI believes there is a need for certainty and stability in this area. We recognize that recently proposed regulations would adopt a 50-percent allocation rule. Given the yo-yo treatment of these expenses, however, the Institute strongly believes that a permanent, legislative solution is warranted and urges the adoption of H.R. 1690's provision.
* Increase in Filing Thresholds. Section 6046(a) of the Code requires U.S. shareholders of five percent or more of the stock of a foreign corporation to file such information returns as are required by the Secretary of the Treasury. H.R. 1690 would increase the ownership requirement for filing from five to ten percent. This provision would lessen the administrative burden on U.S.-based corporations and should be adopted.
Reform of the Foreign Tax Credit Rules
The core purpose of the foreign tax credit, which has been part of the Internal Revenue Code for almost 80 years, is to prevent double taxation of the same income by both a foreign country and the United States. In recent years, the enactment of myriad and overlapping limitations has eroded the overall effectiveness of the foreign tax credit in alleviating double taxation. Provisions such as the foreign tax credit rules will never be truly simple, but compliance burdens associated with the credit can be eased through the enactment of de minimis rules and provisions that reduce the volume of paperwork and technical computations. More fundamentally, competitive disadvantages can be ameliorated by the elimination of artificial barriers to trade. H.R. 1690 is a good start in the reform process; its enactment would benefit not only taxpayers, but also the government without sacrificing sound tax policy goals or material amounts of revenue:
* Expansion of FTC Carryovers. Section 904(c) of the Code currently provides that any foreign tax credits (FTCs) not used against U.S. tax in the current year may be carried back two years and forward five. In contrast, the rules for the general business tax credit (section 39) and net operating losses (section 172(b)) provide for a three-year carryback and a fifteen-year carryforward.
H.R. 1690 would conform 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 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. The provision should be adopted.
* Translation of Foreign Taxes. TEI has long advocated a change in the manner in which foreign taxes are translated into U.S.-denominated funds under section 986 of the Code. The current system, which uses the exchange rate in effect on the date the taxes are paid, places considerable administrative burdens on taxpayers to collect and analyze information on a voluminous number of foreign tax payments.
Prior to the enactment of the Tax Reform Act of 1986, deemed-paid foreign taxes arising with respect to dividends from foreign corporations were translated at the exchange rate in effect on the date of the dividend distribution, in accordance with the seminal decision in Bon Ami Co., 39 B.T.A. 825 (1939). Accumulated profits were translated using the spot rate on the dividend date. By using the same rate to translate foreign taxes and accumulated profits, the Bon Ami approach preserved the historical ratio between those two items.
Section 986(a)(1) was added to the Code in 1986 to address a perceived inconsistency between the rules applicable to taxpayers operating through branches and those operating through foreign subsidiaries. This change, however, exponentially increased a U.S. corporation's administrative burdens in respect of translating foreign taxes. Multinational corporations now find it difficult, if not impossible, to literally comply with the statutory requirements for translating their myriad foreign tax payments. To our mind's eye, the administrative burdens engendered by section 986 are totally disproportionate to any practical or policy purpose that may be served, especially since the Code translates foreign taxes into dollars as of the date the taxes are paid, but still translates accumulated profits using the spot rate on the dividend date. The simplest and easiest way to remedy this problem would be to return to the Bon Ami rule -- a solution that would translate taxes in the same manner as all other costs of doing business.
H.R. 1690 adopts an alternative approach, under which foreign taxes would be translated at the average exchange rate in effect for the year that the foreign taxes accrue for FTC purposes. While not perfect, this approach marks a significant improvement over current law and hence seems a reasonable compromise. We recommend that it be adopted.
* "Look-through" Rules for Dividends from 10150 Companies. The 1986 Act categorized foreign affiliates that are owned between 10 and 50 percent by a U.S. shareholder as a "noncontrolled section 902 company" and created a separate FTC limitation for each such company. The requirement that dividends from each noncontrolled section 902 company be placed in a separate "basket' has generally been recognized as among the most maddeningly, mind-numbingly complex rules of the 1986 Act's provisions. H.R. 1690 would permit taxpayers to elect a "look-through" rule for dividends similar to the one provided for CFCs under section 904(d)(3) -- a significant improvement over current law. Dividends from so-called 10/50 companies, where information to comply with a lookthrough rule is not available, would be placed into a single basket. TEI recommends enactment of this provision.
* Extension of FTC to Sixth-Tier CFCs. Under sections 902 and 960 of the Code, the deemed-paid FTC applies only to dividends paid by (or the Subpart F income of) a first-tier corporation, 10 percent or more of the voting stock of which is owned by a U.S. corporation. The credit also applies to second- and third-tier subsidiaries, as long as the product of the percentage ownership of voting stock at each level equals at least 5 percent.
The "three-tier" limitation on the deemed-paid FTC was adopted more than two decades ago as a matter of administrative convenience.(4) There is no tax policy reason for restricting the indirect credit to three tiers. Indeed, sound tax policy favors expansion: It would further alleviate the double taxation of U.S. companies operating abroad. Moreover, it would not increase the administrative burden on CFCs, which are now required to provide this information for purposes of Subpart F. H.R. 1690 would expand the FTC to sixth-tier subsidiaries and TEI endorses this provision.
* Treatment of Overall Domestic Loss. Section 904(f) of the Code provides for the "recapture" of "overall foreign losses' where the taxpayer sustains a foreign-source loss in one year and there is foreign-source income in a subsequent year; the recapture is accomplished by treating income in the later years as domestic-source income. The law does not, however, provide for similar recapture treatment when there is an overall domestic loss that is offset against foreign income in one year and in a subsequent year there is sufficient domestic income to otherwise absorb the domestic loss.
H.R. 1690 would apply 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 loss. The bill would recharacterize into foreign-source income U.S.-source income earned in a year subsequent to a year in which an overall domestic loss offset foreign source income. Adoption of this provision would provide parallel treatment for foreign and domestic losses, and would also foster U.S. competitiveness. This epitomizes equity and simplicity. TEI recommends enactment of the provision.(5)
Tax Executives Institute appreciates this opportunity to present our views on H.R. 1690. If you have any questions, please do not hesitate to contact me at (412) 553-4153 or Timothy J. McCormally of the Institute's professional staff at (202) 638-5601. (1) U.S. tax law generally allows taxpayers to defer paying tax on income earned abroad until that income is repatriated. Under Subpart F, however, certain types of income received by CFCs are currently taxed as a constructive dividend to U.S. shareholders. Subpart F income is generally income that is considered relatively "movable" from one taxing jurisdiction to another and that is subject to low rates of tax. There are elective exceptions from taxation under Subpart F, for example, for income that is subject to a high rate of tax in the foreign country (the "high-tax" exception). (2) Regulations proposed in 1992 would eliminate the need to adjust financial statements prepared in accordance with GAAP, but only with respect to uniform capitalization and depreciation for purposes of computing a foreign corporation's E&P. The proposed regulations do not address the computation of E&P for Subpart F purposes because the IRS and Treasury question whether they have the authority to effect such a change by regulation. (3) The adoption of the GAAP E&P rules discussed on page 3 of this submission would render this change unnecessary. (4) In 1970, the deemed-paid credit was expanded to domestic corporations claiming a foreign tax credit for foreign taxes paid through a third-tier subsidiary In making this change, Congress found that expanding the credit through the third tier would not create administrative problems for the IRS because of the reporting requirements and the imposition of the burden of proof on taxpayers to substantiate the credits. S. Rep. No. 91-1527, 91st Cong., 2d Sess. 2 (1971).