U.S. tax policy: implications for multinationals. (International Taxation).

A host of issues and pending legislation is bringing wide attention to the U.S.' international tax system--and changes being hotly debated in Congress could greatly impact the competitiveness of U.S. businesses. That could make venues like Bermuda, pictured here, less attractive.

The U.S. regime (system) for taxing international business operations--long an area of debate largely limited to academics, corporate tax directors and think tanks--hit the front pages of newspapers in 2002, and may well stay there for some time.

The European Union (EU) has been authorized to hit U.S. goods with up to $4 billion in tariffs if the U.S. does not comply with a World Trade Organization (WTO) ruling outlawing a U.S. tax subsidy for American exports. (See "Washington Insights," September 2002.) Meanwhile, reports of U.S. companies moving headquarters offshore for tax reasons have played into the November elections, where control of both the House and Senate are up for grabs.

While much of the rhetoric to date has tended toward the sensationalist (questioning the "patriotism" of corporations), events and the media focus have touched off a healthy tax policy debate in an area that has for too long suffered from neglect. Sweeping modifications to the U.S. regime for taxing multinational operations are now squarely on the table for consideration by Congress and the Bush Administration.

For companies involved in international business, the stakes are considerable: Exporters face the loss of billions of dollars in tax breaks. U.S. companies operating in overseas markets see the possibility of real reforms that could enhance their competitiveness. Foreign-owned U.S. firms fear collateral damage. All are girding for what promises to be a pivotal debate, which will be fully engaged in 2003.

The perfect storm

A remarkable confluence of events has created today's highly combustible international tax policy environment. In 1998. the EU brought a suit before the WTO arguing that the U.S. foreign sales corporation (FSC) provisions, which since 1984 had provided beneficial tax treatment for U.S. exports, constituted a prohibited export subsidy under international trade law. At the time, few could have predicted the momentous implications of this challenge. After the WTO upheld the EU challenge, the U. S., in 2000, replaced the FSC provisions with a similar regime--the extraterritorial income tax (ETI) rules--that was also found by the EU to violate international trade law.

Four years after the EU challenge, Congress and the Bush Administration are now faced with the challenge of establishing compliance with the WTO decision, or being hit with up to $4 billion in retaliatory EU trade duties authorized by the WTO in August. That said, the EU faces something of a dilemma with respect to retaliation, since increased tariffs will raise prices at home and thus harm local economies. Recognizing this, the EU appears unlikely to impose sanctions anytime soon.

Meanwhile, policymakers this year began to take notice of a "runaway headquarters" problem attributable in no small part to the anti-competitive nature of the U.S. international tax law. So-called corporate "inversion" transactions--where a U.S. company unilaterally moves its headquarters outside the U.S. (such as to Bermuda) have been the most pointed manifestation of this phenomenon. Legislation introduced this year in both the House and Senate by Republicans and Democrats would disregard these transactions--effective, under the principal proposals, for transactions occurring after March 20, 2002--and continue to treat inverted companies as if they remained U.S.-based.

Some policymakers have recognized that these inversion transactions are really a symptom of a much larger problem. That is, the U.S. rules for taxing cross-border business operations are among the most burdensome in the world, imposing tax on foreign subsidiaries--while many of the U.S.'s trading partners impose none--and taxing foreign income twice in many cases.

Indeed, a primary motivation for inversion transactions has been to remove a company's foreign operations from the reach of the U.S. tax rules. Said another way, the U.S. is now viewed--from a tax perspective--as an inhospitable place to base a multinational corporation's operations. Recent statistics on cross-border mergers and acquisitions would appear to bear out this concern.

Data compiled by PricewaterhouseCoopers LLP and presented to the House Ways and Means Committee shows that most large cross-border mergers in recent years including U.S. companies have involved the foreign company acquiring the U.S. entity, meaning a loss of U.S. headquarters. In 2000, 73 percent of the large cross-border transactions, measured by deal value, were structured so that the combined entity was headquartered outside the U.S.

While taxes may not be the only consideration in determining a headquarters locale, they are surely taken into account. By locating the headquarters of the combined firm outside the U.S., planners can ensure that the onerous U.S. international tax regime will not apply to the company's non-U.S. operations.

The Bush Administration Treasury Department shares the view that the U.S. tax law may be contributing to the "runaway headquarters" phenomenon. In submitting a report to Congress on the inversion issue, Treasury Secretary Paul O'Neill stated the concern succinctly, saying, "I don't think anyone wants to wake up one morning to find every U.S. company headquartered offshore because our tax code drove them away and no one did anything about it." In its report, Treasury expressed concern that U.S. tax law has not kept pace with changes in the global economy, thus setting the stage for a broad reexamination of present-law rules.

In a sweeping attempt to address these issues, House Ways and Means Committee Chairman Bill Thomas (R-Calif.) in July introduced broad international legislation (H.R. 5095). The bill would block corporate inversion transactions, repeal the ETI regime and use the $51 billion in revenues raised by repeal to soften the blow for ETI beneficiaries and otherwise improve the competitiveness of U.S. companies. The legislation has been the subject of intense debate in the business community.

Charting Washington waters

The issues raised by Treasury and the Thomas legislation will stand atop the agenda of the Congressional tax-writing committees when Congress reconvenes in 2003. Senate Finance Committee Chairman Max Baucus (D-Mont.) and the ranking Republican, Charles Grassley (R-Iowa), have formed a "working group"--including Administration officials and Ways and Means Committee Chairman Thomas and the ranking Democrat, Charles Rangel (D-N.Y.)--intended to focus on means of bringing the U.S. into compliance with the WTO decision. A consensus is unlikely to be reached quickly, given the broad range of affected constituencies and sometimes-conflicting objectives.

Unfortunately for U.S. exporters, developing a WTO-compliant replacement for the ETI rules that delivers fully comparable benefits may be impossible. Where a U.S.-based manufacturer has little in the way of foreign operations, the pro-taxpayer provisions in Chairman Thomas's bill may provide little in the way of benefit. Indeed, Chairman Thomas has heard substantial criticism in this regard. A challenge will be to reform the tax law in a way that still provides sufficient incentives for a company, at the margin, to continue to invest in U.S. manufacturing. Indeed, this subject promises to be a central political issue in next year's debate over this legislation.

Also at risk in this debate are companies that have factored FSC and ETI benefits into cross-border leasing transactions. The Thomas legislation, in its current form, would provide no transition relief for existing leasing transactions. Furthermore, the provisions would eliminate grandfather rules enacted by Congress in 2000 that explicitly allowed the FSC rules -- which were repealed in the same legislation -- to continue to apply fully to prior leasing transactions.

The leasing industry will seek appropriate transition relief in conjunction with ETI repeal. The industry makes a sympathetic case, noting that leasing transactions are long-term, binding contracts entered into by taxpayers in good-faith reliance on present law. The industry has also noted that failure to provide appropriate FSC and ETI transition relief for leasing transactions would have a perversely harsh impact, since U.S. lessors typically receive their largest benefits in these deals only in the final years of the contract.

Many U.S.-based companies with extensive foreign operations would benefit from the reforms in the Thomas legislation. The legislation's modification to the 1986 interest allocation rules would eliminate a widely acknowledged and improper source of double taxation of foreign income, although it should be noted that this could be accomplished through regulatory action, which the Treasury Department should consider.

The bill also would make other important changes to the onerous "subpart F" regime and to the foreign tax credit rules. While these reforms have long been sought by the business community, they have not been contemplated as a trade-off for the FSC and ETI rules, which has tempered some of business community's support. A key challenge for U.S.-based multinational corporations visa-vis ETI repeal will be to prioritize reforms and articulate why they are needed and why they are not inconsistent with the goal of supporting U.S. jobs.

Inbound U.S. companies -- U.S. businesses with foreign parents -- also have been swept into the EFSCETI fray. As an initial matter, many benefit from the ETI rules and would suffer accordingly upon repeal. However, any concerns over loss of ETI benefits have been subsumed by concerns over proposals to tighten the "earnings stripping" rules that have been advanced in conjunction with the intertwined debate over inversion transactions.

Following on a Treasury Department recommendation, the Thomas legislation would tighten the earnings stripping rules, which are intended to prevent a U.S. company from inappropriately reducing U.S. taxable income by borrowing -- and creating U.S. interest deductions -- excessively from related foreign parties. Chairman Thomas and Treasury have argued that further limitations on related-party borrowings would eliminate tax benefits that "inverting" companies may have sought to realize.

Meanwhile, rank-and-file inbound companies (those that did not become foreign-based as a result of inversion transactions) have noted that the earnings stripping restrictions could result in significant tax increases in situations that should not be seen as abusive, such as when a foreign parent company simply guarantees the debt obligations of a U.S. subsidiary. Many of the potentially affected companies are major U.S. employers.

Companies that may have been contemplating inversion transactions at the time the Thomas bill was introduced appear to have postponed such plans. Media focus had centered on Connecticut-based Stanley Works, whose now-abandoned plans for foreign re-incorporation has been a significant campaign issue for Ways and Means Committee Member Nancy Johnson (R-Conn.) and her Democrat opponent.

As of this writing, Congress had not addressed the inversion issue, though similar legislation advanced by Finance Committee Chairman Baucus and Sen. Grassley was pending considerationin the Senate. Regardless of when the inversion legislation is taken up -- as part of a broader ETI replacement bill or as a separate measure -- the March 20, 2002 effective date would appear likely to remain in effect.

Ultimately, the U.S. response to the WTO rulings against the FSC and ETI regimes will set a course for international tax policy that will have important implications for the long-term competitiveness of U.S. companies and industries. The debate promises to be highly energized, and hopefully will minimize damage and produce positive results for U.S. businesses.

Kenneth J. Kies is managing director of Clark/Bardes Consulting's Federal Policy Group, which represents Fortune 500 companies, trade associations and other businesses before the U.S. government on legislative and regulatory policy matters. He served as Chief of Staff of the U.S. Congress's Joint Committee on Taxation from 1995 to 1998.