International complexity and simplification.
On June 22, 1999, Tax Executives Institute testified before the Subcommittee on Oversight of the House Committee on Ways and Means concerning international complexity and simplification. The Institute's testimony was presented by its President, Lester D. Ezrati of Hewlett-Packard Company, and was prepared under the aegis of TEI's International Tax Committee, whose chair is Michael P. Boyle of Microsoft Corporation. The Institute's written statement is reprinted below.
Good afternoon. I am Lester D. Ezrati, General Tax Counsel for Hewlett-Packard Company in Palo Alto, California. I appear before you today as the president of Tax Executives Institute, the preeminent group of corporate tax professionals in North America. The Institute is pleased to provide the following comments on international complexity and simplification.
Tax Executives Institute is the preeminent association of corporate tax executives in North America. Our 5,000 members are accountants, attorneys, and other business professionals who work for the largest 2,800 companies in the United States and Canada; they are responsible for conducting the tax affairs of their companies and ensuring their compliance with the tax laws. Hence, TEI members deal with the tax code in all its complexity, as well as with the Internal Revenue Service, on almost a daily a basis. Most of the companies represented by our members are part of the IRS's Coordinated Examination Program, pursuant to which they are audited on an ongoing basis. TEI 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. Our background and experience enable us to bring a unique and, we believe, balanced perspective to the subject of international complexity and simplification.
The international provisions of the Internal Revenue Code are among the most complicated provisions in the tax law. The last several years have seen several small steps taken to reduce tax law complexity for multinational corporations. For example, three years ago, Congress repealed section 956A of the Internal Revenue Code, which in our view was ill-conceived when it was enacted in 1993. And in 1997, Congress rectified an inequity that has existed for the past decade when it eliminated the overlap between the controlled foreign corporation and passive foreign investment company rules. Although laudable, these actions represent only a small step on the journey of simplifying the international tax provisions of the Internal Revenue Code.
TEI believes that the Code's foreign provisions need fundamental reform and simplification, and for this reason we support H.R. 2018, the International Tax Simplification for American Competitiveness Act of 1999, which was introduced on June 7, 1999, by Oversight Subcommittee Chairman Arno Houghton and several other representatives. Enactment of this bill will generally reduce the costs of preparing U.S. corporate tax returns for American companies engaged in international trade without any material diminution in tax dollars flowing to the treasury. The bill will not only reduce compliance costs -- thereby enhancing the country's competitiveness -- but it will also signal Congress's continued commitment to the simplification of the tax law generally. In addition, the bill will bring long overdue, albeit partial, reform to the foreign tax credit area.
Any simplification efforts will need to comprehend the changing face of the business environment, owing, among other things, to the growth of electronic commerce and business technologies. As businesses become more global and as companies strive to manage their supply chains digitally, the need for meaningful tax reform will become more and more manifest. In addition, it will become increasingly important for governments and taxpayers to work together to resolve -- or forestall -- disputes in creative, cost-effective ways, such as advanced pricing agreements (APAs). Accordingly, TEI is very pleased that Congressman Houghton and other members have voiced support for preserving the confidentiality of APAs. TEI strongly believes that any compromise of taxpayer confidentiality will have a negative effect on the future of the APA program.
As Congressman Houghton noted in his introductory statement, H.R. 2018 seeks reform "in modest but important ways." We agree that, although a major leap forward, enactment of the bill will not obviate additional reform of the Code's international tax provisions -- for example, in respect of Subpart F, which Chairman Houghton himself has singled out as an extremely complex area of the law. Subpart F was initially enacted as an exception to the deferral principle in order to tax the types of income considered relatively "movable" from one taxing jurisdiction to another and therefore able to take advantage of low rates of tax. In the three decades since its enactment, however, Subpart F has been distended to capture active operating income. One solution to removing Subpart F's artificial barrier to competitiveness would be to exclude foreign base sales and services income from current taxation, allowing U.S. corporations to compete more effectively on a level international playing field.(1) Other areas that should be considered for simplification include the translation of the deemed paid tax credit under section 986, the aggregation of dividends from noncontrolled section 902 corporations in one basket, and the elimination of the interest allocation rules. These comments notwithstanding, we agree with Congressman Houghton and the other sponsors of H.R.2018 that the bill represents a "down payment on further reform."
H.R. 2018: A Good Start
I. Treatment of Controlled Foreign Corporations
A. 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. general]y 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-1986 undistributed earnings.
Because we believe that taxpayers should generally be permitted to elect to use U.S. GAAP in computing the E&P of foreign corporations, we endorse section 104 of H.R. 2018, which would clarify the Treasury Department and IRS's authority to provide such an election.(2) Enactment of this provision is needed to simplify calculations of E&P in the foreign area.
B. De Minimis Rule for Subpart F Income: Section 954(b)(3) of the Code provides that no part of a CFC's gross income is treated as foreign base company income (FBCI) if its FBCI and insurance income for the year is less than the smaller of(i) five percent of its gross income for the year or (ii) $1 million. Section 103 of H.R. 2018 would increase the FBCI de minimis income from five to ten percent of gross income, thereby reducing the reporting requirements for many companies. The bill would also increase the $1 million ceiling to $2 million, a provision that would assist companies with relatively small overseas operations.
TEI endorses this provision, which would simplify the computation of FBCI. We suggest, however, that consideration be given to eliminating the dollar threshold altogether (or increasing it to $5 million). These changes would restore the de minimis rule that was in effect before 1987.
C. Treatment of the European Union under the Same-Country Exception. 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. The conversion of 11 currencies to the euro can only exacerbate the problem.
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 under 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.
Section 102 of H.R. 2018 would provide for a Treasury Department study on the feasibility of treating all countries included in the European Community as one country for purposes of applying the same-country exception under Subpart F of the Code.(3) The European Community is eliminating barriers to cross-border payments -- an initiative that places U.S. corporations at a disadvantage. Accordingly, TEI believes that companies need relief now in order to remain competitive, and we regret that a study will only further delay the proper economic result: treatment of the EC countries as one country. Such a solution would permit the efficient consolidation of U.S. multinationals' European operations, thereby enhancing their ability to compete in the European Union. TEI strongly urges Congress to consider the outright adoption of this proposal.
II. Foreign Tax Credit Rules
A. Creditability against Alternative Minimum Tax: Under section 59(a)(2) 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.(4) In contrast, a taxpayer that is subject to a regular income tax liability is not subject to the 90-percent restriction. The 90-percent limitation is presumably the result of Congress's efforts to reconcile the arguably conflicting policies underlying the FTC and AMT.
Because the United States taxes the worldwide income of its citizens and residents, the FTC was introduced to limit the incidence of double taxation -- the taxation of the same income by two jurisdictions. The policy underlying the FTC has not changed over the years, though certain limitations have been imposed to prevent what has been deemed to be the improper averaging of high- and low-tax foreign source income. Thus, under the regular income tax provisions, a U.S. taxpayer may offset fully 100 percent of its U.S. tax liability on foreign-source income with its FTC. This does not mean that the taxpayer is not paying any tax, but rather simply acknowledges that the taxpayer has already paid a tax (to the jurisdiction where the income was derived) at the rate equal to or greater than the amount the United States would assess on that income.
When the AMT was enacted as part of the Tax Reform Act of 1986, Congress had "one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits." S. Rep. No. 99-313, 99th Cong., 2d Sess. 518-19 (1986). Thus, the AMT was deemed necessary to address public perceptions about the fairness of the tax system.
TEI has serious reservations about the policy basis for the AMT generally, but we recognize that calls for its outright repeal are beyond the scope of this hearing. Accordingly, we applaud section 207 of H.R. 2018, which proceeds from the premise that, even if the AMT remains in effect, it makes no sense to retain the 90-percent FTC limitation. According a taxpayer the ability to offset its entire liability with its foreign taxes would not frustrate the legitimate policy underlying the AMT. Unlike the other items that may serve to reduce a taxpayer's regular tax liability (which taxpayers are not permitted to take fully into account for AMT purposes), the foreign tax credit represents precisely what its name suggests: a tax. A taxpayer with an AMT liability and sufficient FTC to offset that liability has already paid a significant tax. Clearly, that the tax has not been paid to the United States has no bearing on the economic cost it represents to the taxpayer. Moreover, to the extent the FTC and AMT regimes do conflict, TEI submits that the policy supporting the FTC (and complementary provisions in U.S. tax treaties) -- which is based upon sound economic reasoning and comports with longstanding international norms -- should prevail. We therefore support the enactment of this provision.(5)
B. Expansion of FTC Carry-forward and Ordering Rules. 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.
In addition, the ordering rules set forth in section 904(c) for FTCs require that the current year's credits be utilized before any carryovers are taken into account. By contrast, in respect of the general business tax credit, a carryover is to be used first, before the current year's credits, to afford the taxpayer the maximum opportunity for using the credit. See I.R.C. [sections] 38(a).
The inconsistency in carryback/ carryforward periods is not only inequitable, but also complicates the tax laws. The current rules create administrative burdens for the government and taxpayers alike. More fundamentally, the rules effectively penalize taxpayers that experience operating losses, thereby creating a windfall for the federal government that may "collect" a substantial portion (if not all) of the FTCs previously earned and claimed because of the unduly short carryback/carryforward period. Current law effects an especially harsh result in respect of taxpayers in cyclical industries whose ability to utilize FTCs is limited due to income fluctuations and start-up companies with initial losses.
Section 201 of H.R. 2018 would expand the FTC carryforward rules to 10 years, bringing them more in line with the rules for net operating losses and general business tax credits. Although the Institute believes that the rules for the three credits should be the same, we recognize that the proposal would limit the situations where the purpose of the FTC -- the elimination of double taxation -- is frustrated by unrealistically short carryover periods. We also endorse section 206, which would change the ordering rules whereby any carryover FTC would be taken into account before the current year's credit. Permitting the oldest credits to be used first would mitigate the problem of expiring credits.(6)
C. 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.
Section 202 of H.R. 2018 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 (up to 50 percent of taxable income) earned in a year subsequent to a year in which an overall domestic loss offset foreign-source income. Adoption of this provision not only would provide parallel treatment for foreign and domestic losses, but would also foster U.S. competitiveness. TEI recommends enactment of the provision.(7)
D. "Look-Through" Rules for Dividends, Interest, Rents, and Royalties from 10/50 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" was generally recognized as among the most maddeningly, mind-numbingly complex rules of the 1986 Act's provisions. Last year, Congress acted to remedy this problem by permitting taxpayers to elect a "look-through" rule for dividends similar to the one provided for CFCs under section 904(d)(3). The use of this rule was delayed, however, until 2002.
Section 204 of H.R. 2018 would advance the effective date of the 1998 provision to taxable years beginning after December 31, 1999; section 205 would expand look-through treatment to include interest, rents, and royalties. TEI agrees that enactment of these provisions would alleviate some of the complexity in current law and for sophisticated taxpayers might be especially beneficial. From an administrative perspective, however, we suggest that a better approach would be to permit dividends from noncontrolled corporations to be aggregated into a single basket.
III. Other Provisions
A. 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"). Although section 263A applies in the foreign context, the revenue raised by application of the UNICAP rules to foreign subsidiaries is small compared with the administrative burden they impose on taxpayers.
Section 302 of H.R. 2018 would provide 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.(8)
B. Study of Interest Allocation Rules. H.R. 2018 requires the Treasury Department to conduct a study of the rules under section 864(e) of the Code relating to the allocation of interest expense among members of an affiliated group.
TEI commends the Chairman for recognizing that the interest allocation rules are in desperate need of reform. In our view, the interest allocation rules were enacted as a revenue raiser in 1986 and are not justified on economic grounds. The rules have spawned not revenue so much as a series of complex transactions to minimize their effect. Hence, TEI believes that section 864(e) should be repealed. We are confident that the Treasury study will confirm that view and urge that action be taken as soon as possible.
C. Reporting Requirements for Foreign-Owned Corporations. Section 6038A of the Code sets forth reporting requirements for any corporation engaged in a trade or business in the United States that is at least 25 percent owned by a foreign person. Substantial penalties are imposed for noncompliance. The statute contains no de minimis reporting rule. In addition, Treas. Reg. [sections] 1.6038A-3(f)(2) provides that documents maintained outside of the United States must be produced within 60 days of a request by the IRS and must be translated within 30 days of a request for translation.
Section 311 of H.R. 2018 would provide that a reporting corporation will not be required to report any information with respect to any foreign related person if the aggregate value of the transactions between the corporation and the related person during the taxable year does not exceed $5 million. In addition, the provision would expand the time in which a taxpayer may produce translations of documents from 30 days to at least 60 days. The subsection also provides that nothing shall limit the right of the taxpayer to request additional time to comply with the request for translation.
TEI supports enactment of the de minimis rule, which will ease the reporting burdens on taxpayers. In addition, we agree that an expansion of time in which to produce translated documents recognizes the practical difficulties inherent in a global marketplace where documents may be kept in various languages and at various locations. We suggest, however, that the proposed language -- "nothing shall limit the right of the taxpayer to request additional time" -- be revised to read "the Internal Revenue Service shall have the authority to grant all reasonable requests for additional time to furnish the requested translations."
Safeguarding the APA Process
Congressman Houghton has voiced support for legislation that would amend section 6103(b)(2)(A) of the Code to provide protection from disclosure for negotiated agreements between taxpayers and the IRS. Included in the proposal's protection are advanced pricing agreements (APAs), as well as closing agreements and competent authority agreements.(9) The bill responds to recent litigation to seeking disclosure of APAs and closing agreements.
The APA program is designed to forestall contentious and expensive transfer pricing disputes between taxpayers and the IRS. A voluntary venture, it is one of the IRS's success stories of the 1990s and furthers the goal of eliminating unnecessary complexity in the tax law. Each APA specifies a methodology negotiated between the specific taxpayer and the IRS (and, at times, a foreign country) for the taxpayer to use in determining its intercompany pricing and thereby assure compliance with section 482 of the Code. The information set forth in an APA -- the method by which a company determines its profit margins -- is highly fact specific and involves sensitive financial and commercial information. Almost 200 APAs have been negotiated since the program began in 1991 and the program has been used as a model by the international community as a means of minimizing double taxation of income and settling costly transfer pricing disputes.
Since the inception of the APA program until January 8, 1999, the IRS treated the APAs and their supporting documentation as tax return information that was not subject to disclosure. On that date -- in conjunction with a suit to compel release of the APAs under the Freedom of Information Act -- the IRS said it now takes the position that APAs constitute "written determinations" under section 6110 of the Code and therefore may be publicly released in a redacted form. TEI believes that the IRS's position is wrong and we have filed a brief amicus curiae in the case.
As a professional association dedicated to the development and implementation of sound tax policy, TEI is concerned that the release of the APAs -- even in redacted form -- will adversely affect the APA program. Taxpayers submitted the pricing information to the IRS with the understanding that the information would be subject to the same confidentiality restrictions as tax returns. Companies' legitimate privacy interests -- as well as the privacy interest of our treaty partners in respect of bilateral APAs -- will be compromised by the release of the APA background documents and their ability to compete effectively in the marketplace could be harmed. Moreover, the very redaction process that accompanies release of the information would be extremely difficult, burdensome, and time-consuming.
More important, the knowledge that such information will be released in the future will discourage taxpayers from seeking APAs. TEI believes that the APA program represents the best way for companies to resolve transfer pricing controversies and avoid costly and time-consuming audits and litigation. At a time when the IRS is seeking more taxpayer-friendly ways of doing business, programs such as the APA program should actively be encouraged, rather than jeopardized by a mistaken interpretation of the law.
For these reasons, TEI strongly supports enactment of legislation to protect APAs and supporting documents from disclosure.
(1) The proposal in H.R. 2018 to treat the countries in the European Community as a single country for purposes of the "same-country" exception to Subpart F would also effect some relief. See the discussion of this provision below.
(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) Prior iterations of this bill provided for the treatment of EC countries as a single country for purposes of the same-country exception. See, e.g., H.R. 1690, 104th Cong., 2d Sess. (introduced on May 24, 1995).
(4) This limitation is imposed in addition to the foreign source income limitations of section 904 as it applies to both AMT and regular taxpayers.
(5) This provision mirrors the relief provided in H.R. 1633, which was introduced by Chairman Houghton in April.
(6) We recognize that legislation has been proposed (e.g., S. 1134, the Affordable Education Act of 1999, and S. 331, the Workers Incentives Improvement Act) to shorten the FTC carryback from two years to one and expand the carryforward from five years to seven. Enactment of this revenue raiser would exacerbate the double taxation caused by expiring FTCs, particularly for companies in cyclical industries.
(7) The bill's introduction of an overall domestic loss provision would remedy an inequity faced by taxpayers attempting to claim FTCs. This reform would not eliminate the need to address current section 904(f) (relating to overall foreign losses), which limits a taxpayer's ability to claim FTCs. Consideration should be given to either repealing or modifying both the overall foreign loss rules and section 864(e)'s interest expense allocation provisions, because these rules place U.S. corporations at a competitive disadvantage.
(8) The adoption of the GAAP E&P rules discussed elsewhere in this submission would render this change unnecessary.
(9) The bill would also amend section 6110(b)(1) to exclude these agreements from the definition of "written determinations" subject to disclosure.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||international tax|
|Date:||Jul 1, 1999|
|Previous Article:||Buying or selling a member of a consolidated group.|
|Next Article:||United States of America Plaintiff-Appellee, v. Richard A Frederick, Defendant-Appellant, and Randolph W. Lenz, Karin Lenz, and KCS Industries, Inc.,...|