INTERNATIONAL TAX SEMINAR for Congressional Staff International Tax

INTERNATIONAL TAX SEMINAR for Congressional Staff International Tax Policy Forum Finance Committee Hearing Room U. S. Senate February 15, 2002

2 International Tax Seminar Contents n Introduction n Economic background n US International tax system: Overview n Current International tax policy issues — Extra-territorial income (“ETI”) regime — Dividend exemption (“territorial”) tax systems n US International tax system: Primer — Anti-deferral regime (subpart — The foreign tax credit F)

3 Introduction n International Tax Policy Forum (www. itpf. org) Founded in 1992, the International Tax Policy Forum is an independent group of over 30 US MNCs with a diverse industry representation. The primary purpose of the Forum is to promote research and education on taxation of income from cross-border investment. To this end, the Forum sponsors research and conferences on international tax issues and meets periodically with academic and government experts. As a matter of policy, the Forum does not take positions on legislative or regulatory proposals. Mr. John Samuels (General Electric Co. ) serves as Chairman of the Forum and Prof. James Hines, Jr. (University of Michigan) is the Forum's research director. Pricewaterhouse. Coopers is a consultant to the Forum. For more information contact: Margery Sweat (202 -414 -1620).

4 Introduction Presenters — Alan Fischl, Pw. C International Tax Services alan. fischl@us. pwcglobal. com (202. 414. 1030) — Carl Dubert, Pw. C International Tax Services carl. dubert@us. pwcglobal. com (202. 414. 1718) — Peter Merrill, Pw. C National Economic Consulting peter. merrill@us. pwcglobal. com (202. 414. 1666)

5 Introduction Some current international tax policy issues: n Response to WTO decision on FSC/ETI — — n n Dividend exemption (“territorial”) tax systems Other changes in structure of US international tax rules Active financing extension Simplification — — — JCT study Treasury study announced in budget: short- and long-term parts Other simplification initiatives

6 Economic background n Global economic trends n Foreign direct investment n Foreign portfolio investment n Cross-border mergers and acquisitions

7 Global economic trends n The U. S. share of the world economy has declined due to faster economic growth abroad since World War II n A domestic company that limited itself to the U. S. market in 1945 would have foreclosed half the world market, today it would lose 80 percent Source: Mathew J. Slaughter, Global Investments American Returns, 1998, p. 6.

8 Global economic trends International trade § US economy has become more open – trade is now over 24% of GDP § US now runs a large trade deficit in goods (3. 7% of GDP) § US now runs a trade surplus in services (1. 0% of GDP)

9 Global economic trends US FDI in the world economy n n n Cross-border Foreign Direct Investment (FDI) has expanded U. S. MNC’s share of world FDI has fallen In 1960, 18 of the world’s 20 largest companies (ranked by sales) were US headquartered. In 1996, 8 were.

10 Global economic trends Market integration n GATT & WTO rounds have substantially reduced global tariff levels n Regional — Euro n Half trade agreements have proliferated Econ Area, NAFTA, ASEAN, Mercosur, etc. of the 153 FTAs created since 1990 n MNCs view their business regionally

11 U. S. foreign direct investment Foreign receipts as a percent of corporate profits in GNP n U. S. MNCs and U. S. economy are far more dependent on FDI abroad

12 U. S. foreign direct investment Location n U. S. FDI primarily is located in developed countries — n U. S. FDI overwhelmingly supplies foreign, not US markets — n In 1998, less than 11% of sales of U. S. -controlled foreign corporations were back to US (less than 7% if Canada excluded) Foreign affiliates of U. S. companies are primarily in the services sector — n In 1998, 73% of foreign affiliate assets and sales were in developed countries*, and 58% of foreign affiliate employment 56% of U. S. MNC affiliate abroad are classified in the services sector, including wholesale/retail trade (compared to 27% of U. S. parents) According to the UN “… accessing markets will remain the principal motive for investing abroad” * Developed countries defined as Canada, Europe and Japan.

13 U. S. foreign direct investment Exports n In 1998, U. S. MNCs accounted for 64% of all U. S. exports n According to the OECD “Each dollar of outward FDI is associated with $2 of additional exports and with a bilateral trade surplus of $1. 70” 1 1 OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, 1998, p. 5 p

14 U. S. foreign direct investment US wages n US plants of companies without foreign operations pay lower wages than domestic plants of US MNCs, controlling for industry, firm size, age of firm, and state location Source: Mark Doms and Brad Jensen, 1996

15 Foreign direct investment US employment n n Foreign and domestic employment of US MCS are complements not substitutes. 1 According to the Council of Economic Advisers: “On a net basis, it is highly doubtful that US direct investment abroad reduces US exports or displaces US jobs. Indeed, US direct investment abroad stimulates US companies to be more competitive internationally … [and] to allocate their resources more efficiently, thus creating healthier domestic operations, which, in turn, tend to create jobs. ” 2 1 D. A. Riker and S. L. Brainard, “U. S. Multinationals and Competition from Low Wage Countries, ” NBER, WP no. 5959, March 1997 2 US Council of Economic Advisers, Economic Report of the President, 1991, p. 259

16 U. S. foreign direct investment Foreign share of US MNC operations 6. 9% 5. 0% Foreign share of gross output 5. 8% 5. 0% Foreign share of employment Employment in US CFCs remained at 5. 0% of US civilian employment over the 1982 -1998 period. Gross output of US-controlled foreign corporations has declined from 6. 9 percent of US GDP in 1982 to 5. 8 percent in 1998. (Source: Pricewaterhouse. Coopers calculations based on US Department of Commerce data. )

17 U. S. foreign direct investment Financing n IRS data shows that foreign subs of US parents distributed $69 billion or 63% of net foreign earnings and profits (1996 tax returns) n 76% of U. S. -controlled foreign corporation financing is from foreign sources (1995 data)

18 US foreign direct investment Financing of CFCs 24% 14% 62% 76% of the financing of US-controlled foreign corporations comes from foreign sources -- not US parents. Debt and equity from US parents financed less than 24% of total assets in 1995.

19 Foreign direct investment Comparative tax burdens n Over the 1992 -97 period, US MNCs paid 7. 4% more of net income in taxes than US domestics (controlling for industry and other factors), up from a 4. 4% multinational tax “penalty” during the 1982 -91 period. 1 1 J. Collins and D. Shackelford, “Taxes and Cross-Border Investments: The Empirical Evidence, ” American Enterprise Institute, Seminar Series in Tax Policy (February 19, 1999).

20 Foreign direct investment Comparative tax burdens The effective tax rate on cross-border investment is higher for US MNCs than EU MNCs according to European Commission

21 U. S. foreign portfolio investment I n 1999, two-thirds of U. S. investment abroad was portfolio investment, compared to less one-seventh in 1980

22 Cross-border mergers and acquisitions

Does location of headquarters matter? US MNCs. . . n locate over 70% of assets & jobs in US n Invest and pay more per job at home than abroad (including in developed countries) n perform 88% of R&D in US (vs. 67% of sales) n overwhelmingly have US leadership n supply foreign subs much more heavily from US sources 1 Source: L. D’Andrea Tyson, They are not us: why American ownership still matters, The American Prospect, Winter 1991, pp. 37 -49 23

The US International Tax System: Overview 24 24

25 Overview n n Income from cross-border investment may be subject to income tax in both source and residence countries Residence countries use various mechanisms to avoid double tax: — — n Worldwide system l Residents are taxed on their worldwide income with a credit (or, in some cases, a deduction) foreign taxes Dividend exemption (“territorial”) system l In a pure territorial tax system, residents are taxed only on domestic source income with all foreign source income exempt l Most territorial systems are hybrids, with exemption for nonportfolio dividends and worldwide taxation for most other income Since 2000, the US technically has had a territorial income tax system with an exception (i. e. , worldwide taxation) for all income other than income qualifying for the ETI regime

Overview International Income Taxation, OECD Countries, 1990 1 2 3 4 5 6 For non-treaty countries, worldwide tax with credit. For non-treaty countries, worldwide tax with deduction. Exemption of 90% of gross dividend. Treaty countries with tax system similar to Australia's. 25% ownership requirement and tax system similar to Denmark's. Credit for Swiss tax on foreign dividends effectively exempts these dividends from Swiss tax. Source: OECD, Taxing Profits in a Global Economy: Domestic and International Issues, 1991, pp. 63 -64. 26

27 Overview Role of tax treaties n Bilateral income tax treaties are used, inter alia, to: — — — n Coordinate income tax systems to prevent double taxation Reduce or eliminate source based taxes (e. g. , withholding taxes on interest, dividends, rents & royalties) Provide non-discrimination in the application of domestic taxes to foreign residents Establish procedures to resolve double taxation disputes Provide mutual assistance in tax administration, such as sharing of taxpayer information Model income tax treaties — — — OECD Model (including transfer pricing guidelines) US Model UN Model

28 Overview Timing of tax on foreign income n n Most countries respect foreign subsidiaries as separate legal entities and tax income from such subsidiaries only when received by a resident shareholder The United States and about half of the OECD countries have controlled-foreign corporation (CFC) rules that accelerate tax on certain types of CFC income (deemed dividend) — — CFC regimes typically apply to passive income and certain low-taxed “mobile” income US CFC regime (“subpart F”) applies to other categories of active income as well as “investments in US property” made with untaxed foreign income

29 Overview Domestic double taxation n Double taxation also may occur when US corporate income is distributed to US shareholders n Most countries provide some form of relief from domestic double taxation of corporate dividends — Shareholder imputation credit for all or a part of the corporate tax — Partial shareholder exclusion — Reduced individual tax rate for corporate dividends — Corporate deduction for dividends paid

Overview Corporate Taxation in OECD Member Countries, 1990 */ Hybrid tax system (relief from double taxation at both corporate and shareholder levels). #/ Deduction for dividends paid may offset fully the corporate and personal income tax for dividends up to 15% of capital value. Dividends in excess of this limit are fully taxed at both levels. Sources: Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, Research Memorandum 9604. Erasmus University, Rotterdam. OECD, Taxing Profits in a Global Economy: Domestic and International Issues, 1991, p. 57. 30

Current International Tax Policy Issues • Extraterritorial Income (“ETI”) regime • Dividend exemption (“territorial”) tax systems 31 31

Extraterritorial Income (“ETI”) Regime 32 32

33 History of Export Incentives n China Trade Corporations (1922) — n Western Hemisphere Trade Corporations (1942) — n Exemption method Exemption Method Export Trade Corporations (1962) — Deferral Method (as a limitation on Subpart F)

34 History of Export Incentives (cont. ) n Domestic International Sales Corporations (1971) — n Foreign Sales Corporations (1984) — n Deferral Method Exemption Method (partial) Extraterritorial Income (2000) — Exemption Method (partial)

35 Justification for Export Incentives n Tax incentives used by competitor countries that are allowed under WTO rules — WTO permits both FTC and exemption to mitigate double taxation as part of “normal” tax system Most territorial tax system exempt base company sales income l — WTO permits border tax adjustments for indirect but not direct taxes l All OECD countries except US have VAT system l Economic effects are uncertain

36 Origins of ETI Regime n 1998: EU filed a complaint with the WTO regarding the FSC regime. n 1999: WTO dispute panel found the FSC regime to be a “prohibited export subsidy”. — Benefits contingent upon exports — Revenue foregone is “otherwise due” l Exception from base company rules l Exception from effectively connected income rule l Dividend-received deduction for FSC dividends n 2000: The Administration and Congress worked together to develop bi-partisan legislation to repeal the FSC regime and replace it with a new regime designed to satisfy WTO rules n 2002: US loses appeal of WTO dispute panel decision on ETI

37 Mechanics of ETI Regime n Gross income does not include extraterritorial income that constitutes “Qualifying Foreign Trade Income” n QFTI is a percentage of “Foreign Trading Gross Receipts” n FTGR generated from sale or lease of “Qualifying Foreign Trade Property” n QFTP consists of property: — Manufactured within or outside the United States, — Sold or leased for use outside the United States, and — Not more than 50% of the value of which is attributable to foreign components and foreign labor (Foreign Content Test)

38 WTO decision on ETI Regime n EU filed a complaint with the WTO regarding the ETI regime. n Despite U. S. efforts to design a regime to satisfy WTO rules, WTO dispute panel found the ETI regime nonetheless to be a “prohibited export subsidy”. n — Benefits still found to be contingent upon exports — Revenue foregone is still found to be “otherwise due” In January 2002, WTO appellate panel upheld dispute panel’s findings

39 Future of ETI regime n WTO arbitrator has 90 days to decide amount of retaliatory tariffs the EU may impose on U. S. exports n Commission must decide whether and how to distribute tariff increases among categories of US exports n US Options — Repeal ETI regime immediately l — Replacement? Postpone repeal of ETI regime within a negotiated framework l This would likely require some trade concessions by the US and/or limited retaliation — Do nothing l European Commission has said it will impose retaliatory tariffs l Note other WTO member countries may exercise right to file a complaint against US ETI regime

Dividend exemption (“territorial”) tax systems 40 40

41 Territorial tax systems q Worldwide tax systems tax all foreign source income –- most when repatriated and some currently through anti-deferral regimes q. Territorial systems differ from worldwide systems by treating some or all of the income that is not taxed currently as exempt Worldwide Territorial Taxed on repatriation (with FTC) Taxable currently (with FTC) Exempt Taxable currently (with FTC)

42 Territorial tax systems n Taxation of exempt bucket — — n Income typically assigned to the exempt bucket: — — n Non-portfolio dividends Active branch income (net of imputed royalty) Income typically assigned to the currently taxable bucket — — — n Taxes directly and indirectly attributable to exempt dividends are not creditable or deductible Expenses allocated or apportioned to exempt income are not deductible Portfolio and passive income Royalty income Export income not attributable to foreign economic activities Income typically assigned to the deferred bucket — — Low or no-tax active income Active income earned in non-treaty countries

43 Territorial tax systems n If a territorial tax system has three buckets of income (e. g. , Canada), little or no simplification is achieved — — n Income, expense, and foreign taxes must be allocated among three rather than two buckets Ordering rules are necessary to determine whether dividends are paid out of exempt, previously taxed, or deferred income. A two bucket territorial tax system is possible, however many countries are not willing to allow all types of low-taxed active income to be exempt, but do not wish to impose current taxation for competitive or diplomatic reasons — — — Income from ocean and space activities Income earned in low or no tax jurisdictions Income earned in non-treaty countries

44 Territorial tax systems Revenue effect n Adopting a territorial system in US could raise revenue, depending on design — Putting dividends in the exempt bucket limits the ability to average foreign tax credits Under present law, excess foreign tax credits attributable to high-tax dividends can be used to reduce US tax on currently includible low-tax income such as royalties and foreign income attributable to exports l — Expenses allocated to exempt income are non-deductible. Under present law, taxpayers without excess FTCs receive full benefit of deduction l l. Territorial tax system might raise revenue even if worldwide rather than water’s-edge fungibility approach to interest allocation were adopted n Transition rules for accumulated deferred foreign income?

45 Territorial tax system Economic impacts n Increased pressure on transfer pricing rules? — n Increased incentive to invest in low tax jurisdictions? — n n Data are inconclusive Increased incentive to shift debt to high-tax jurisdictions — n No evidence found in Treasury study Beneficial to US revenues Incentive to increase dividend repatriations provided that exempt income is stacked first Incentive to suppress royalties in countries with tax rates less than US — Adverse to US revenues

46 Simplification possible under either system n Reduce number of anti-deferral regimes, limit scope of rules, and provide meaningful de minimis rule n Use GAAP for E&P calculations n Reduce number of foreign tax credit baskets n Eliminate high-tax kick-out from passive foreign tax credit basket n Eliminate AMT foreign tax credit limitation

47 Complexity inherent under either system n Application of foreign tax credit rules for nonexempt income, including sourcing of income and allocation and apportionment of expenses n Operation of anti-deferral regime n Application of transfer pricing rules n Definition of active business income (e. g. , active financial services) n Taxation of outbound transfers of property

The US International Tax System: Primer l l Anti-deferral regime Foreign Tax Credit 48 48

The US International Tax System: Anti-Deferral Regime 49 49

50 Deferral as general rule n US generally defers its tax on foreign earnings of foreign subs until they are remitted. n US tax is imposed on foreign earnings when they are earned (or deemed earned) by a US person (i. e. , US corporation, citizen or resident individual). n Fundamental TIMING principle of US tax law n Issue is not WHETHER but WHEN US shareholder is taxed on income earned by foreign corporations

51 Exceptions to deferral n General rule always has been to defer US tax on foreign earnings of foreign subs until dividends are paid to a US person. n However, various exceptions have been enacted over the years. n Where an exception applies, a US shareholder may be subject to current US tax (or an interest charge).

52 Anti-deferral regimes — Personal Holding Company (1934) — Foreign Personal Holding Company (1937) — Foreign Investment Company (1962) — Controlled — Passive l Foreign Corporation (Subpart F) (1962) Foreign Investment Company (1986) Overlap with CFC regime eliminated in 1997 — “Excess” passive asset regime (1993 -96)

53 Anti-deferral regimes n n Application of exceptions to deferral typically has depended on two factors: — Level of US ownership — Type of income involved Present law is complex because there are many sets of potentially overlapping exceptions, each with its own detailed set of rules and definitions.

54 Subpart F n Foreign Personal Holding Company Income — passive income (e. g. , dividends and interest) — active finance exception (expired) n Foreign — income from related party purchases/sales n Foreign — Base Company Sales Income Base Company Service Income income from related party services

55 Subpart F (cont. ) n Subpart F insurance income n Subpart F shipping income n Foreign oil related income n Illegal payments n Section 956 (Investments in US Property)

56 Rules of Canada, France, Germany, Japan, the Netherlands and the United Kingdom 1 n n Half have transaction-based systems (like Subpart F), while half have jurisdiction-based systems Other transaction-based systems generally exempt active business income — — — n Foreign base company sales and service income Active financial income Other active business income Jurisdiction-based systems generally tax all income of subsidiaries in low-tax countries, but generally exempt active business income that has some local connection Based on National Foreign Trade Council, Inc. , International Tax Policy for the 21 st Century, Volume 1, 67 -92 (2001). 1

57 Recent JCT staff recommendations 1 n Eliminate FIC and FPHC anti-deferral regimes n Exclude foreign corporations from PHC regime n Increase Subpart F de minimis threshold for active foreign subsidiaries with relatively small amounts of Subpart F income (also recommended in 1987 ALI report) Staff of the Joint Comm. on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume II, 398420 (2001). 1

The US International Tax System: The Foreign Tax Credit 58 58

The foreign tax credit: Background n The US was the first country to provide a foreign tax credit, enacted in 1918 — n n n 59 A foreign tax credit has been allowed in some form under US law ever since FTC is a dollar-for-dollar offset of foreign tax against US tax Purpose of FTC is to eliminate double tax on foreign source income. Not listed as a federal tax expenditure. FTC is allowed foreign income taxes paid directly or indirectly with respect to foreign source income

The foreign tax credit: Computation n FTC Limitation, enacted in 1921, is intended to prevent FTC from reducing US tax on US source income A formula is used to determine the FTC Limitation (i. e. , the share of US tax (before FTC) attributable to foreign source income) FTC Limit = Foreign source income Worldwide income X US tax on worldwide income (Note: US and foreign income measured under US rules) n n FTC = lesser of FTC Limit and foreign taxes Excess FTCs may be carried back 2 years and carried forward 5 years 60

The foreign tax credit: Computation n This FTC Limitation computation must be done separately for each “basket” of foreign source income n The purpose of the “basket” rules is to prevent averaging of taxes among different types of income Losses n — — Overall foreign losses are recaptured in subsequent years Domestic losses that reduce foreign source income are not recaptured 61

62 Some foreign tax credit baskets n General Limitation Income n High Withholding Tax Income n Passive Income n Shipping Income n Financial Services Income n DISC Dividends n FSC Distributions n Foreign Trade Income n 10 -50 Dividends (until 2002)

63 Steps to compute FTC Limitation 1. Determine source of gross income — Gross Receipts (minus cost of goods sold) — Other Gross Income 2. Determine deductions allocable to US and foreign income 3. Determine net US and foreign source income

64 Steps to compute FTC Limitation 4. Characterize gross income (for baskets) 5. Allocate and apportion deductions among FTC categories of gross income 6. Determine amount of creditable foreign taxes within each category

65 Source of income rules Different Source Rules for Different Types of Income: n n n n Income from the Sale of Purchased Inventory Income from the Sale of Manufactured Inventory Dividends Interest Rents Royalties Sale of stock n n n Sale of Intangibles Sale of other personal property Sale of real property Personal services Maintain source of US source income earned through foreign corporation Underwriting income

66 Expense allocation rules Different Allocation Rules for Different Expenses: n Interest n Research & Development n General & Administrative n State and local income tax n Other

67 Example 1 n n USCO has a foreign subsidiary XCO that earns $1, 000 on which it pays Country X income tax at a rate of 35% ($350) USCO earns $1, 000 taxable income in US If all XCO foreign earnings are distributed as a $650 dividend to USCO, USCO would be allowed a foreign tax credit of $350. Foreign tax credit limit = $350 $1, 000 Foreign Income X $2, 000 Worldwide Income $700 (US tax before FTC)

68 Example 2 Allocating and apportioning expenses reduces the maximum amount of foreign tax credit a US company may receive n Same as Example 1, except: — $200 of US expenses are allocable against foreign income which are not deductible by XCO in calculating Country X tax

69 Example 2 (cont. ) — — If all XCO earnings are distributed as a $650 dividend to USCO, USCO would be allowed a foreign tax credit of $280, leaving $70 of foreign taxes paid for which USCO would receive no credit. Thus $420 of total income tax would be paid on $1000 of income earned by XCO (42% rate) even though US and Country X have the same 35% tax rate Foreign tax credit limitation = $280 ($1, 000 Foreign Income - $200 Allocable Expenses) $2, 000 Taxable Income X $700 (US tax before FTC)

70 Other rules n FTC only for income tax or “in lieu of” income tax n Foreign tax must be considered to be paid n FTC is elective n n FTC allowed when tax is paid or accrued Overall Foreign Losses/Recapture n Look-thru Rules n AMT--90% Limitation n No FTC allowed for taxes paid/accrued to certain foreign countries n Person allowed to claim FTC n Holding period n Six tier limit

71 Typical obstacles to FTC utilization n Foreign tax rates higher than US tax rate n Separate basket limitations n Required allocation and apportionment of deductions (not recognized as deductions by source country) n “Overall foreign loss” recapture n AMT

72 Foreign Tax Credit Rules of Canada, France, Germany, Japan, the Netherlands and UK 1 n Half have partial exemption (“territorial”) systems n Per country, per item (avoidable foreign dividends), and overall basket systems all in use n Detailed interest expense allocation rules generally do not exist n Most have no equivalent to overall foreign loss recapture. — n The Netherlands has domestic and foreign loss recapture and Canada offers domestic loss relief. Credit carryforward and carryback range from none to unlimited carryforward Based on National Foreign Trade Council, Inc. , International Tax Policy for the 21 st Century, Volume 1 274 -75 (2001). 1

73 Recent Joint Committee on Taxation Staff recommendations on foreign tax credit 1 n Accelerate repeal of 10 -50 dividend baskets and characterize these dividends instead under look-thru rules regardless of year the distributed earnings arose n Clarify that indirect credits are available to a US corporation that holds a 10% voting interest in a foreign corporation indirectly through a foreign or US partnership Staff of the Joint Comm. On Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume II 42127 (2001). 1

74 1987 Recommendations of American Law Institute on foreign tax credit 1 n n Recommendations included: — General basket system with smaller number of separate baskets than today, the most important for passive income — Adopt domestic loss recapture David Tillinghast 2, reporter for the ALI study: — Recommended elimination of passive basket high-tax kick-out — Recommended elimination of separate basket for highwithholding tax interest — Questioned need for section 907 limitation American Law Institute, Federal Income Tax Project, Proposals of the American Law Institute on United States Taxation of Foreign Persons and of the Foreign Income of United States Persons, 307421 (1987). 1 2 David Tillinghast, “International Tax Simplification, ” 8 American J. Tax Policy, 187 -215 (1990).