National Foreign Trade Council Foreign Income Project International

National Foreign Trade Council Foreign Income Project: International Tax Policy for the 21 st Century Press Briefing United States Capitol December 19, 2001

2 Background Ø NFTC FIP initiated in July 1998 Ø Conceived of as a comprehensive review of U. S. international tax policy in the context of a global economy l Ø Ø Intended to provide a Blueprint for reform Drafting team includes lawyers and economists with both policy and practical experience. l Michael Graetz, Yale l Rob Culbertson, King & Spalding l Phil Morrison, D&T l Alan Fischl, Pw. C l Peter Merrill, Pw. C Review panel includes NFTC tax committee members, practitioners, and academics

3 Background Ø Initial focus on U. S. anti-deferral rules (Subpart F), in part as a response to Notice 98 -11 Ø Treasury subsequently announced its own study of Subpart F in December 1998 Ø Part One, “A Reconsideration of Subpart F” released March 25, 1999 Ø Treasury Subpart F study released December 2000 Ø Today the complete FIP report is being released including: Ø l Part Two, “Relief of International Double Taxation” and l Part Three, “Conclusions and Recommendations” Report is bound in two volumes, totaling 335 pages

4 Reason why a review of U. S. tax policy is timely Ø Ø Global competition and market integration has increased substantially since foundations of U. S. international tax system were put in place. Many of the rules added over time cause unnecessary complexity and do not advance tax policy goals. Foreign markets now account for about 17% of total U. S. corporate profits (much more for MNCs) and the best growth opportunities for the future: l l Ø U. S. tax system departs from international norms in ways that hinder the ability of U. S. MNCs to complete l Ø Ø 80% of world income is now outside of US borders For S&P 500 companies, foreign subsidiaries now account for 34% of global sales, up from 25% in 1985 Compounded by numerous changes made in the 1986 Act that were not copied by other major industrial countries A much higher percentage of U. S. companies now must comply with U. S. rules for taxation of foreign income Prior efforts to address problems with U. S. international tax system have been piecemeal

5 Framework of NFTC study Ø Study takes as a starting point the taxation of worldwide income, which has been a feature of the U. S. corporate income tax since its inception l Territorial taxation would be more difficult to enact l Territorial taxation is not essential to achieving a more competitive tax system today, notwithstanding WTO dispute involving the FSC & ETI regimes l A worldwide income tax system can, in principle, be made almost as simple as a territorial income tax system àSome territorial tax systems such as VAT and Flat tax achieve greater simplicity by taxing consumption rather than income àSee territorial income tax systems are quite complex, e. g. , Canada papers presented at the April 30, 2001, Brookings/ITPF conference on territorial income taxation (www. itpf. org).

6 Policy Principles Ø NFTC Study starts with five criteria that have historically been used by Treasury to evaluate international tax policy: l Neutrality--minimize tax considerations in business decisions l Competitiveness--allow US MNCs to compete on equal terms with foreign-based competitors l Simplicity--minimize compliance and administrative burdens l Harmonization--conform with international tax norms where possible l Fairness--meet revenue needs in a fair manner

7 Policy Principles Ø Ø Historically, Treasury has given more weight to neutrality than competitiveness l For example, on competitiveness grounds, Congress rejected Treasury’s proposal to eliminate deferral in 1962. l More recently, Congress evidenced little support for Notice 98 -11 (regarding hybrid entities) Part One of FIP suggests that policy emphasis should be moved more to competitiveness for two reasons l US MNCs face heightened competition from foreign-based MNCs l There are many reasons to doubt that neutrality criteria actually results in claimed economic benefits

8 Policy Principles Ø Ø Basis for Capital Export Neutrality (CEN) principle is economic efficiency; however, theory makes many unrealistic assumptions, including: l Assumes no portfolio capital flows (considers only “runaway plants” not “runaway headquarters”) l Assumes all other countries follow CEN principles l Cost of compliance is assumed irrelevant in measuring tax burden l Assumes corp. tax burdens are unrelated to govt. services provided l Assumes no “rents” earned on intangible assets l Ignores incentives created by tax policy to reduce foreign taxes l Assumes savings are fixed so domestic and foreign investment are substitutes When more realistic assumptions are made, CEN may not achieve claimed results.

9 Policy conclusions Ø NFTC report provides substantial evidence that US international tax regime is out of step with international norms àComparisons to six other countries that collectively are headquarters for 412 of the 500 largest global companies àControlled àMethods income foreign corporation regimes for avoiding double taxation of international

10 Policy conclusions Ø US tax rules impose very high compliance burdens on foreign source income relative to U. S. source income and relative to tax liability on foreign income l Ø Ø Based on research conducted by Joel Slemrod (U. Michigan) In a number of situations, U. S. tax rules directly interfere with the ability of U. S. companies to compete with foreign-based MNCs l Financial services, shipping, cross-border pipelines l US MNCs face global effective income tax rates at least as high as comparable domestic companies New EU Commission study on company taxation, based on 1999 data, finds higher average effective tax rates for US MNCs than EU MNCs regardless of how foreign subsidiaries are financed. 1 l For example, for subsidiary financed with retained earnings, average effective tax rate is 30. 1% for EU MNCs vs. 33. 2% for US MNCs 1 European Commission, “Towards an Internal Market without Tax Obstacles, ” COM(2001) 582, October 23, 2001, p. 25.

11 Policy conclusions Ø Failure to address major departures from international norms may have unintended consequences l Growth in global market share of foreign-headquartered companies relative to U. S. headquartered companies (for tax rather than market reasons) à 80% of deal value of large cross-border M&As over the last 3 years have involved transactions where headquarters ends up abroad àInversion transactions àAccording to Laura Tyson, the “competitiveness of the U. S. economy remains tightly linked to the competitiveness of U. S. companies” l Reduction in US foreign direct investment à 2/3 rds of U. S. exports are to related parties. Moreover, there is a high correlation between the manufacturing activities of foreign affiliates and the level of exports by the U. S. parent àU. S. MNCs account for a disproportionate share of U. S. R&D àU. S. MNCs pay higher wages than domestic-only companies controlling for size and industry Ø NFTC report identifies many opportunities to simplify, harmonize and improve competitiveness without harm to CEN.

12 Legislative recommendations Ø Subpart F Reforms 1. Repeal foreign-to-foreign base company income rules à These rules inhibit the ability of U. S. companies to reduce foreign taxes à Treasury Subpart F study concludes that the effect of these rules on CEN is “ambiguous” 2. Other subpart F reforms

13 Legislative recommendations Ø Foreign Tax Credit Reforms 1. Reduce number of foreign tax credit baskets à Pure CEN theory requires no FTC limitation at all à Even accepting the principle of limitation, reduction in tax rates abroad since 1986 now means that multiple foreign tax credit baskets are more likely to distort investment location decisions than an overall limitation. Thus, overall limitation is now more consistent with CEN than multiple limitations

14 Legislative recommendations Ø Foreign tax credit reforms (cont’d) 2. Adopt symmetric worldwide interest allocation rule à Current water’s-edge fungibility approach can result in double taxation, is not used by other countries, and hurts the ability of U. S. MNCs to compete in both domestic and foreign markets 3. Adopt symmetric loss recapture rules à Recapture of foreign but not domestic losses also can result in double taxation, is not used by other countries and adversely affects U. S. competitiveness 4. Eliminate 90% of AMT limitation on foreign tax credits à This limitation also can result in double taxation, is not used by other countries and adversely affects competitiveness. 5. Other foreign tax credit reforms