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US Treasury Sets Out International Tax Agenda

Tax-News.com, Washington

17 December 2002


Speaking last week at George Washington University's 15th Annual Institute on Current Issues in International Taxation, Assistant Treasury Secretary for Tax Policy Pam Olson set out her views on the United States' international tax policy.

'Viewed from the vantage point of an increasingly global marketplace,' said Ms Olson, 'our tax rules appear outmoded, at best, and punitive of U.S. economic interests, at worst. Most other developed countries of the world are concerned with setting a competitiveness policy that permits their workers to benefit from globalization. As Deputy Secretary Dam observed recently, however, our international tax policy seems to have been based on the principle that if we have a competitive advantage, we should tax it!

'Let’s start with the basics. Our income tax system as a whole dates back to shortly after the turn of the last century, a time when cars were called horseless carriages and buggy whip makers had just gone out of business. A bit has happened since then. Of course, significant changes have been made to the tax code as well. In the international area, we added the subpart F rules back in 1962.

'I would say that they haven’t aged as well as a lot of the 40 somethings in this room. In fact, they are showing their age. We also made fairly significant changes to the international tax rules in 1986. That would make those rules teenagers now, and they have the characteristics of the average teenager. They’re hard to understand, messy, inconsistent, and display little regard for the real world.

'The global economy looked very different when the subpart F rules were put in place than it does today. The same is true of the U.S. role in the global economy. Forty years ago the U.S. was dominant and accounted for over half of all multinational investment in the world. We could make decisions about our tax system essentially on the basis of a closed economy, and we could generally count on our trade partners to follow our lead in tax policy.

'The world has changed in the last 40 years. The globalization of the U.S. economy puts ever more pressure on our international tax rules. When the rules were first developed, they affected relatively few taxpayers and relatively few transactions. Today, there is hardly a U.S.-based company that is not faced with applying the U.S. international tax rules to some aspect of its business.

'What does globalization mean? This audience needs no explanation, but it is useful to think about it for a minute. It means the growing interdependence of countries resulting from increasing integration of trade, finance, investment, people and ideas in one global marketplace. Globalization results in increased cross-border trade, and the establishment of production facilities and distribution networks around the globe. Technology is a key driving force behind globalization. Advances in communications, information technology, and transport have slashed the cost and time taken to move goods, capital, people, and information. Firms in this global marketplace differentiate themselves by being smarter: applying more cost efficient technologies or innovating faster than their competitors. The returns to being smarter are much higher than they once were as the benefits can be marketed worldwide.

'The significance of globalization to the U.S. economy since the enactment of subpart F is apparent from the statistics on international trade and investment. In 1960, trade in goods to and from the U.S. represented just over six percent of GDP. Today, trade in goods to and from the U.S. represents over 20 percent of GDP, more than three times larger than in 1960, while trade in goods and services represents more than 25 percent of GDP today. It is worth noting that numerous studies confirm a strong link between trade and economic growth. Trade appears to raise income by spurring the accumulation of physical and human capital and by increasing output for given levels of capital.

'Cross border investment, both inflows and outflows, also has grown dramatically in the last 40 years. In 1960, cross border investment represented just over one percent of GDP. In 2000, it was nearly 16% of GDP, representing annual cross-border flows of more than $1.5 trillion. The aggregate cross border ownership of capital is valued at $15 trillion. In addition, U.S. multinational corporations are now responsible for more than one-quarter of U.S. output and about 15 percent of U.S. employment.

'At the same time companies are competing for sales, they are also competing for capital: U.S.-managed firms may have foreign investors, and foreign-managed firms may have U.S. investors. Portfolio investment accounts for approximately two-thirds of US investment abroad and a similar fraction of foreign investment in the U.S.

'The U.S. tax rules have important effects on international competitiveness both because of the integration of domestic activities of U.S. multinational companies with their foreign activities and because repatriated foreign earnings of foreign investments are subject to U.S. domestic tax. Increasingly, the flow of goods and services is not through purchases between exporters and importers, but through transfers between affiliates of multinational corporations. The rules governing transfer pricing, interest allocation, withholding rates, foreign tax credits, and the taxation of actual or deemed dividends impacts these flows.

' The U.S. tax system should not distort trade or investment relative to what would occur in a world without taxes. The difficulty is that every country makes sovereign decisions about its own tax system, so it is impossible for the U.S. to level all playing fields simultaneously for each of the different forms competition might take in every country.

'The question we must answer is what should we do to increase the competitiveness of U.S. businesses and workers. Professor Michael Graetz observed in his book, The Decline (and Fall?) of the Income Tax:

'The internationalization of the world economy has made it far more difficult for the United States, or any other country for that matter, to enact a tax system radically different from those in place elsewhere in the world. In today’s worldwide economy, we can no longer look solely to our own navels to answer questions of tax policy.

'To date, our attempts to address one of the perceived competitive disadvantages created by our laws have been repeatedly ruled inconsistent with the World Trade Organization’s rules. Earlier this year, a WTO appellate panel held that the extraterritorial income exclusion regime of our tax law constituted a prohibited export subsidy under the WTO rules. Just two years before, a WTO appellate panel held that the foreign sales corporation provisions constituted a similar, prohibited subsidy. President Bush has made clear that the U.S. must comply with the WTO rulings. That result should be obvious because - let’s face it - no one has a greater stake in the WTO and in free trade than the U.S. Despite the WTO decisions against our foreign sales corporation and extraterritorial income regimes, the WTO rules serve the economic interests of American businesses and workers by opening markets and ensuring fair play.

'In addition to making clear that the U.S. must comply, the President made two further decisions. He said that any response to the ruling must increase the competitiveness of U.S. businesses. He also pledged to work with the Congress to create the solution. Treasury is working closely with the tax-writing committees of Congress to develop legislation that makes meaningful changes to our tax law to satisfy the twin goals of honoring our WTO obligations and preserving the competitiveness of U.S. businesses operating in the global marketplace.

'We must consider the ways in which our tax system differs from that of our major trading partners to identify aspects that may hinder the competitiveness of U.S. companies and workers. About half of the OECD countries employ a worldwide tax system as does the U.S. However, even limiting comparison of competition among multinational companies established in countries using a worldwide tax system, U.S. multinationals can be disadvantaged when competing abroad. This is because the United States employs a worldwide tax system that, unlike other worldwide systems, may tax active forms of business income earned abroad before it has been repatriated and may more strictly limit the use of the foreign tax credits that prevent double taxation of income earned abroad.

'The Accelerator—Subpart F. The focus of the subpart F rules is on passive, investment-type income that is earned abroad through a foreign subsidiary. However, the reach of the subpart F rules extends well beyond passive income to encompass some forms of income from active foreign business operations. No other country has rules for the immediate taxation of foreign-source income that are comparable to the U.S. rules in terms of breadth and complexity.

'For example, under subpart F, a U.S. company that uses a centralized foreign distribution company to handle sales of its products in foreign markets is subject to current U.S. tax on the income earned abroad by that foreign distribution subsidiary. In contrast, a local competitor making sales in that market is subject only to the tax imposed by that country. Similarly, a foreign competitor that uses a centralized distribution company to make sales into the same markets generally will be subject only to the tax imposed by the local country. U.S. companies that centralize their foreign distribution facilities therefore face a tax penalty not imposed on their foreign competitors.

'The subpart F rules also impose current U.S. taxation on income from certain services transactions, shipping activities and oil related activities performed abroad. In contrast, a foreign competitor engaged in the same activities generally will not be subject to current home-country tax on its income from these activities. While the purpose of these rules is to differentiate passive or mobile income from active business income, they operate to currently tax some classes of income arising from active business operations structured and located in a particular country for business reasons wholly unrelated to tax considerations.

'Limitations on Foreign Tax Credits. The rules for determining and applying the foreign tax credit are detailed and complex and can have the effect of subjecting U.S.-based companies to double taxation on their income earned abroad. For example, the foreign tax credit may be used only to offset U.S. tax on net foreign-source income and not to offset U.S. tax on U.S.-source income. Net foreign-source income is determined by reducing foreign-source income by U.S. expenses allocated to such income. Under the current rules, the interest expense of a U.S. affiliated group is allocated between U.S. and foreign-source income based on the group’s total U.S. and foreign assets. These rules treat the interest expense of a U.S. parent as relating to its foreign subsidiaries even where those subsidiaries are equally or more leveraged than the U.S. parent. This over-allocation of interest expense to foreign income inappropriately reduces the foreign tax credit limitation because it understates foreign income. The effect can be to subject U.S. companies to double taxation. Other countries do not have expense allocation rules that are nearly as extensive as ours.

'The U.S. foreign tax credit rules are further complicated by the need to calculate foreign and domestic source income, allocable expenses, and foreign tax credits separately for different categories or “baskets” of income. Foreign taxes paid with respect to income in a particular category may be used only to offset the U.S. tax on income from that same category.

'Under the current U.S. rules, if a U.S. company has an overall foreign loss in a particular taxable year, that loss reduces the company’s total income and therefore reduces its U.S. tax liability for the year. Special overall foreign loss rules apply to recharacterize foreign-source income earned in subsequent years as U.S.-source income until the entire overall foreign loss from the prior year is recaptured. This recharacterization has the effect of limiting the U.S. company’s ability to claim foreign tax credits in those subsequent years. No comparable recharacterization rules apply in the case of an overall domestic loss. However, a net loss in the U.S. would offset income earned from foreign operations, income on which foreign taxes have been paid. The net U.S. loss thus would reduce the U.S. company’s ability to claim foreign tax credits for those foreign taxes paid. This gives rise to the potential for double taxation when the U.S. company’s business cycle for its U.S. operations does not match the business cycle for its foreign operations.

'Double Tax on Equity-Financed Investments. The U.S. is one of the few OECD countries that does not provide for some form of integration between taxes paid at the corporate level and taxes paid by individuals on distributions from corporations.

'Under U.S. law, $100 of corporate profits is first taxed at a 35% corporate tax rate. The remaining $65 is then available for distribution to shareholders or for reinvestment. If distributed to shareholders, it is subject to tax at the shareholders tax rate – ranging from 0% for investments in qualified pension savings to 38.6% at the top individual rate. If dividend tax rates paid by individuals average 25%, then only 75% of the $65 distribution is left after individual taxes are paid, or less than $50 of the original $100 in corporate profit.

'The present U.S. system, by taxing income at the corporate level and dividends at the individual level, increases the hurdle rate of return (i.e., the minimum rate of return required on a prospective investment) undertaken by corporations. Whether competing at home against foreign imports or competing abroad through exports from the U.S. or through foreign production, the double tax makes it less likely that the U.S. company can compete successfully against a foreign competitor. Most OECD countries alleviate this problem by reducing personal income tax payments on corporate distributions.

'Time for reform. We have a tax code that has not kept pace with the globalization that has transpired over the last 40 years. It is time for us to review our rules based on the world in which we live today and the world we imagine for the future.

'We must design rules that equip us to compete in the global economy – not fearfully, but hopefully. The fact of the matter is that we – all of us - benefit significantly from vigorous participation in the global economy.
Over the past 20 years, U.S. companies that invest abroad exported more (exporting between one-half and three-quarters of all U.S. exports), paid their workers more, and spent more on R&D and physical capital than companies not engaged globally.

'While 80 percent of U.S. investment abroad is located in high-income countries, it is useful to say a word about the investment that goes into developing countries. These countries recognize U.S. investment as important to achieving sustainable poverty-reducing growth and development. I’m asking you to look at this altruistically, but if you can’t, then look at it selfishly. Poker games are revenue neutral, but international trade and investment are not poker games. Healthy foreign economies mean more markets for our products. They mean more opportunities for us to profitably invest. But, I have to return the altruistic point. Foreign investment means sharing our ideas, our knowledge, our values, and our capital. That is not a zero sum game. I hope you will engage with us in a discussion of what the future might bring.

'Let me close by noting that we are committed to a better and more open dialogue with the public. The discussion we are having on international tax reform is one illustration of that dialogue. The recent release of our promised quarterly update of the business plan which reflects our continued conversation with you about the issues we need to address is another illustration. Still another illustration is the issuance in proposed form of section 302, consolidated return, and tax shelter regulations. All of these are the opening in a dialogue with the public about what the rules should be. We will work diligently to propose sound rules and to do so rapidly enough to meet your needs.

'Unfortunately, no immortals have yet been hired to work at IRS or Treasury. We’re all human. We will make mistakes. We will also have differences of opinion from time to time. But have no doubt about it. While we much appreciate your praise, we especially value your criticism. It helps us stay on track.

Thank you.'


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