1. INTERNATIONAL TAX SEMINAR for Congressional Staff International Tax Policy Forum Rayburn Building B338 U.S. House of Representatives February 1, 2002

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

3. 3 Introduction International Tax Policy Forum (www.itpf.org) 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. PricewaterhouseCoopers is a consultant to the Forum.

4. 4 Economic background Global economic trends Global economic trends Foreign direct investment Foreign direct investment Foreign portfolio investment Foreign portfolio investment Cross-border mergers and acquisitions Cross-border mergers and acquisitions

5. 5 Global economic trends The U.S. share of the world economy has declined due to faster economic growth abroad since World War II The U.S. share of the world economy has declined due to faster economic growth abroad since World War II 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 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

6. 6 Global economic trends International trade  US economy has become more open  Imports have increased more rapidly than exports resulting in a trade deficit  Services have become an increasingly important component of exports

7. 7 Global economic trends US FDI in the world economy Cross-border Foreign Direct Investment (FDI) has expanded Cross-border Foreign Direct Investment (FDI) has expanded U.S. MNC’s share of world FDI has fallen U.S. MNC’s share of world FDI has fallen

8. 8 Global economic trends Market integration GATT & WTO rounds have substantially reduced global tariff levels GATT & WTO rounds have substantially reduced global tariff levels Regional trade agreements have proliferated Regional trade agreements have proliferated — Euro Econ Area, NAFTA, ASEAN, Mercosur, etc. Half of the 153 FTAs created since 1990 Half of the 153 FTAs created since 1990 MNCs view their business regionally MNCs view their business regionally

9. 9 U.S. foreign direct investment U.S. MNCs and U.S. economy are far more dependent on FDI abroad U.S. MNCs and U.S. economy are far more dependent on FDI abroad

10. 10 U.S. foreign direct investment Location U.S. FDI primarily is located in developed countries U.S. FDI primarily is located in developed countries — In 1994, 78% of foreign affiliate assets and sales were in developed countries, and 64% of foreign affiliate employment U.S. FDI overwhelmingly supplies foreign, not US markets U.S. FDI overwhelmingly supplies foreign, not US markets — In 1995, less than 10% of sales of U.S.-controlled foreign corporations were back to US (less than 6% if Canada excluded) Foreign affiliates of U.S. companies are primarily in the services sector Foreign affiliates of U.S. companies are primarily in the services sector — 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” According to the UN “… accessing markets will remain the principal motive for investing abroad”

11. 11 U.S. foreign direct investment CFC Sales The overwhelming majority of goods and services produced by US-controlled foreign corporations are sold into foreign markets. In 1995, less than 10 percent of US-controlled foreign corporation sales were exported to the US. (Source: PwC analysis based on US Department of Commerce data.) 68% 23% 9%

12. 12 U.S. foreign direct investment Exports In 1996, U.S. MNCs accounted for 65% of all U.S. exports In 1996, U.S. MNCs accounted for 65% of all U.S. exports According to the OECD 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. 5p

13. 13 U.S. foreign direct investment US wages 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 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

14. 14 Foreign direct investment US employment Foreign and domestic employment of US MCS are complements not substitutes. 1 Foreign and domestic employment of US MCS are complements not substitutes. 1 According to the Council of Economic Advisers: 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

15. 15 U.S. foreign direct investment Foreign share of US MNC operations Employment in US CFCs dropped from 5.0% of US civilian employment in 1982 to 4.9% in 1996. Similarly, gross output of US-controlled foreign corporations has declined from 6.9 percent of US GDP in 1982 to 6.6 percent in 1996. (Source: PricewaterhouseCoopers calculations based on US Department of Commerce data.) 5.0% 4.9% 6.9% 6.6% Foreign share of investment Foreign share of employment

16. 16 U.S. foreign direct investment Financing The most recent IRS data shows that foreign subs of US parents distributed $50 billion or 67% of foreign earnings and profits (1994 tax returns) The most recent IRS data shows that foreign subs of US parents distributed $50 billion or 67% of foreign earnings and profits (1994 tax returns) 76% of U.S.-controlled foreign corporation financing is from foreign sources (1995 data) 76% of U.S.-controlled foreign corporation financing is from foreign sources (1995 data)

17. 17 US foreign direct investment Financing of CFCs 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. 14% 24% 62%

18. 18 Foreign direct investment Comparative tax burdens 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 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).

19. 19 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

20. 20 U.S. foreign portfolio investment In 1999, two-thirds of U.S. investment abroad was portfolio investment, compared to less one-seventh in 1980

21. 21 Cross-border mergers and acquisitions

22. 22 1 Source: L. D’Andrea Tyson, They are not us: why American ownership still matters, The American Prospect, Winter 1991, pp. 37-49 Does location of headquarters matter? US MNCs... locate over 70% of assets & jobs in US locate over 70% of assets & jobs in US Invest and pay more per job at home than abroad (including in developed countries) Invest and pay more per job at home than abroad (including in developed countries) perform 88% of R&D in US (vs. 67% of sales) perform 88% of R&D in US (vs. 67% of sales) overwhelmingly have US leadership overwhelmingly have US leadership supply foreign subs much more heavily from US sources supply foreign subs much more heavily from US sources

23. The US International Tax System 23 l Overview l Foreign Tax Credit l Anti-deferral regime

24. The US International Tax System: Overview 24

25. 25 Overview Income from cross-border investment may be subject to income tax in both source and residence countries 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: Residence countries use various mechanisms to avoid double tax: — Worldwide system Residents are taxed on their worldwide income with a credit (or, in some cases, a deduction) for foreign taxes Residents are taxed on their worldwide income with a credit (or, in some cases, a deduction) for foreign taxes — Dividend exemption (“territorial”) system In a pure territorial tax system, residents are taxed only on domestic source income with all foreign source income exempt In a pure territorial tax system, residents are taxed only on domestic source income with all foreign source income exempt Most territorial systems are hybrids, with exemption for non- portfolio dividends and worldwide taxation for most other income Most territorial systems are hybrids, with exemption for non- portfolio 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 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

26. 26 Overview International Income Taxation, OECD Countries, 1990 1 For non-treaty countries, worldwide tax with credit. 2 For non-treaty countries, worldwide tax with deduction. 3 Exemption of 90% of gross dividend. 4 Treaty countries with tax system similar to Australia's. 5 25% ownership requirement and tax system similar to Denmark's. 6 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.

27. 27 Overview Role of tax treaties Bilateral income tax treaties are used, inter alia, to: Bilateral income tax treaties are used, inter alia, to: — 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 Model income tax treaties — OECD Model (including transfer pricing guidelines) — US Model — UN Model

28. 28 Overview Timing of tax on foreign income Most countries respect foreign subsidiaries as separate legal entities and tax income from such subsidiaries only when received by a resident shareholder 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) 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. 29 Overview Domestic double taxation Double taxation also may occur when US corporate income is distributed to US shareholders Double taxation also may occur when US corporate income is distributed to US shareholders Most countries provide some form of relief from domestic double taxation of corporate dividends 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

30. 30 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.

31. The US International Tax System: The Foreign Tax Credit 31

32. 32 The foreign tax credit: Background The US was the first country to provide a foreign tax credit, enacted in 1918 The US was the first country to provide a foreign tax credit, enacted in 1918 — 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 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 Purpose of FTC is to eliminate double tax on foreign source income FTC is allowed for foreign income taxes paid directly or indirectly with respect to foreign source income FTC is allowed for foreign income taxes paid directly or indirectly with respect to foreign source income

33. 33 The foreign tax credit: Computation FTC Limitation, enacted in 1921, is intended to prevent FTC from reducing US tax on US source income 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) 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 X US tax on worldwide income FTC Limit = Foreign source income X US tax on worldwide income Worldwide income Worldwide income (Note: US and foreign income measured under US rules) FTC = lesser of FTC Limit and foreign taxes FTC = lesser of FTC Limit and foreign taxes Excess FTCs may be carried back 2 years and carried forward 5 years Excess FTCs may be carried back 2 years and carried forward 5 years

34. 34 The foreign tax credit: Computation This FTC Limitation computation must be done separately for each “basket” of foreign source income This FTC Limitation computation must be done separately for each “basket” of foreign source income The purpose of the “basket” rules is to prevent averaging of taxes among different types of income The purpose of the “basket” rules is to prevent averaging of taxes among different types of income Losses Losses — Losses in one basket are allocated to other baskets and recaptured in subsequent years — Overall foreign losses are recaptured in subsequent years — Domestic losses that reduce foreign source income are not recaptured

35. 35 Some foreign tax credit baskets General Limitation Income General Limitation Income Passive Income Passive Income Financial Services Income Financial Services Income 10-50 Dividends (until 2002) 10-50 Dividends (until 2002) High Withholding Tax Income High Withholding Tax Income Shipping Income Shipping Income DISC Dividends DISC Dividends FSC Distributions FSC Distributions Foreign Trade Income Foreign Trade Income

36. 36 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

37. 37 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

38. 38 Different Source Rules for Different Types of Income: Source of income rules Income from the Sale of Purchased Inventory Income from the Sale of Purchased Inventory Income from the Sale of Manufactured Inventory Income from the Sale of Manufactured Inventory Dividends Dividends Interest Interest Rents Rents Royalties Royalties Sale of stock Sale of stock Sale of Intangibles Sale of Intangibles Sale of other personal property Sale of other personal property Sale of real property Sale of real property Personal services Personal services Maintain source of US source income earned through foreign corporation Maintain source of US source income earned through foreign corporation Underwriting income Underwriting income

39. 39 Different Allocation Rules for Different Expenses: Expense allocation rules Interest Interest Research & Development Research & Development General & Administrative General & Administrative State and local income tax State and local income tax Other Other

40. 40 $700 (US tax before FTC) $1,000 Foreign Income $2,000 Worldwide Income X Example 1 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 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 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. 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 Foreign tax credit limit = $350

41. 41 Example 1 (cont.) All foreign taxes ($350) are creditable All foreign taxes ($350) are creditable FTC fully offsets US tax on foreign income (since foreign rate is equal to US rate) FTC fully offsets US tax on foreign income (since foreign rate is equal to US rate) It does not matter when the US taxes the earnings in this case (since there is no residual US tax) It does not matter when the US taxes the earnings in this case (since there is no residual US tax)

42. 42 Allocating and apportioning expenses reduces the maximum amount of foreign tax credit a US company may receive Example 2 Same as Example 1, except: 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

43. 43 $700 (US tax before FTC) ($1,000 Foreign Income - $200 Allocable Expenses) $2,000 Taxable Income X 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

44. 44 Other rules FTC only for income tax or “in lieu of” income tax FTC only for income tax or “in lieu of” income tax FTC is elective FTC is elective FTC allowed when tax is paid or accrued FTC allowed when tax is paid or accrued Person allowed to claim FTC Person allowed to claim FTC Holding period Holding period Six tier limit Six tier limit Foreign tax must be considered to be paid Foreign tax must be considered to be paid Overall Foreign Losses/Recapture Overall Foreign Losses/Recapture Look-thru Rules Look-thru Rules AMT--90% Limitation AMT--90% Limitation No FTC allowed for taxes paid/accrued to certain foreign countries No FTC allowed for taxes paid/accrued to certain foreign countries

45. 45 Typical obstacles to FTC utilization Foreign tax rates higher than US tax rate Foreign tax rates higher than US tax rate Separate basket limitations Separate basket limitations Required allocation and apportionment of deductions (not recognized as deductions by source country) Required allocation and apportionment of deductions (not recognized as deductions by source country) “Overall foreign loss” recapture “Overall foreign loss” recapture AMT AMT

46. 46 Foreign Tax Credit Rules of Canada, France, Germany, Japan, the Netherlands and UK Foreign Tax Credit Rules of Canada, France, Germany, Japan, the Netherlands and UK 1 Half have partial exemption (“territorial”) systems Half have partial exemption (“territorial”) systems Per country, per item (avoidable for foreign dividends), and overall basket systems all in use Per country, per item (avoidable for foreign dividends), and overall basket systems all in use Detailed interest expense allocation rules generally do not exist Detailed interest expense allocation rules generally do not exist Most have no equivalent to overall foreign loss recapture. Most have no equivalent to overall foreign loss recapture. — The Netherlands has domestic and foreign loss recapture and Canada offers domestic loss relief. Credit carryforward and carryback range from none to unlimited carryforward Credit carryforward and carryback range from none to unlimited carryforward 1 Based on National Foreign Trade Council, Inc., International Tax Policy for the 21 st Century, Volume 1 274-75 (2001).

47. 47 Recent Joint Committee on Taxation Staff recommendations on foreign tax credit Recent Joint Committee on Taxation Staff recommendations on foreign tax credit 1 Accelerate repeal of 10-50 dividend baskets and characterize these dividends instead under look-thru rules regardless of year the distributed earnings arose Accelerate repeal of 10-50 dividend baskets and characterize these dividends instead under look-thru rules regardless of year the distributed earnings arose 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 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 1 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 421- 27 (2001).

48. 48 1987 Recommendations of American Law Institute on foreign tax credit 1987 Recommendations of American Law Institute on foreign tax credit 1 Recommendations included: Recommendations included: — Have general basket system with smaller number of separate baskets than today, the most important being for passive income — Adopt domestic loss recapture 1 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, 307-421 (1987).

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

50. 50 Deferral as general rule US generally defers its tax on foreign earnings of foreign subs until they are remitted. US generally defers its tax on foreign earnings of foreign subs until they are remitted. 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). 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). Fundamental TIMING principle of US tax law Fundamental TIMING principle of US tax law Issue is not WHETHER but WHEN US shareholder is taxed on income earned by foreign corporations Issue is not WHETHER but WHEN US shareholder is taxed on income earned by foreign corporations

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

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

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

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

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

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

57. 57 Recent JCT staff recommendations 1 Eliminate FIC and FPHC anti-deferral regimes Eliminate FIC and FPHC anti-deferral regimes Exclude foreign corporations from PHC regime Exclude foreign corporations from PHC regime Increase Subpart F de minimis threshold for active foreign subsidiaries with relatively small amounts of Subpart F income (also recommended in 1987 ALI report) Increase Subpart F de minimis threshold for active foreign subsidiaries with relatively small amounts of Subpart F income (also recommended in 1987 ALI report) 1 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, 398- 420 (2001).

58. Current International Tax Policy Issues 58

59. Extraterritorial Income (“ETI”) Regime 59

60. 60 History of Export Incentives China Trade Corporations (1922) China Trade Corporations (1922) — Exemption method Western Hemisphere Trade Corporations (1942) Western Hemisphere Trade Corporations (1942) — Exemption Method Export Trade Corporations (1962) Export Trade Corporations (1962) — Deferral Method (as a limitation on Subpart F)

61. 61 History of Export Incentives (cont.) Domestic International Sales Corporations (1971) Domestic International Sales Corporations (1971) — Deferral Method Foreign Sales Corporations (1984) Foreign Sales Corporations (1984) — Exemption Method (partial) Extraterritorial Income (2000) Extraterritorial Income (2000) — Exemption Method (partial)

62. 62 Justification for Export Incentives Tax incentives used by competitor countries that are allowed under WTO rules 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 Most territorial tax system exempt base company sales income — WTO permits border tax adjustments for indirect but not direct taxes All OECD countries except US have VAT system All OECD countries except US have VAT system Economic effects are uncertain Economic effects are uncertain

63. 63 Origins of ETI Regime 1998: EU filed a complaint with the WTO regarding the FSC regime. 1998: EU filed a complaint with the WTO regarding the FSC regime. 1999: WTO dispute panel found the FSC regime to be a “prohibited export subsidy”. 1999: WTO dispute panel found the FSC regime to be a “prohibited export subsidy”. — Benefits contingent upon exports — Revenue foregone is “otherwise due” Exception from base company rules Exception from base company rules Exception from effectively connected income rule Exception from effectively connected income rule Dividend-received deduction for FSC dividends Dividend-received deduction for FSC dividends 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 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 2002: US loses appeal of WTO dispute panel decision on ETI 2002: US loses appeal of WTO dispute panel decision on ETI

64. 64 Mechanics of ETI Regime Gross income does not include extraterritorial income that constitutes “Qualifying Foreign Trade Income” Gross income does not include extraterritorial income that constitutes “Qualifying Foreign Trade Income” QFTI is a percentage of “Foreign Trading Gross Receipts” QFTI is a percentage of “Foreign Trading Gross Receipts” FTGR generated from sale or lease of “Qualifying Foreign Trade Property” FTGR generated from sale or lease of “Qualifying Foreign Trade Property” QFTP consists of property: 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)

65. 65 WTO decision on ETI Regime EU filed a complaint with the WTO regarding the ETI regime. EU filed a complaint with the WTO regarding the ETI regime. 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”. 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”. — 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 In January 2002, WTO appellate panel upheld dispute panel’s findings

66. 66 Future of ETI regime WTO arbitrator has 60 days to decide amount of retaliatory tariffs the EU may impose on U.S. exports WTO arbitrator has 60 days to decide amount of retaliatory tariffs the EU may impose on U.S. exports Commission must decide whether and how to distribute tariff increases among categories of US exports Commission must decide whether and how to distribute tariff increases among categories of US exports US Options US Options — Repeal ETI regime immediately Replacement? Replacement? — Postpone repeal of ETI regime within a negotiated framework This would likely require some trade concessions by the US and/or limited retaliation This would likely require some trade concessions by the US and/or limited retaliation — Do nothing European Commission has said it will impose retaliatory tariffs European Commission has said it will impose retaliatory tariffs Note other WTO member countries may exercise right to file a complaint against US ETI regime Note other WTO member countries may exercise right to file a complaint against US ETI regime

67. Dividend exemption (“territorial”) tax systems 67

68. 68 Territorial tax systems Taxed on repatriation Taxable currently Taxed on repatriation Exempt Taxable currently  Worldwide tax systems tax all foreign source income –- most when repatriated and some currently through anti-deferral regimes  Territorial systems differ from worldwide systems by treating some or all of the income that is not taxed currently as exempt World- wide Terri- torial

69. 69 Territorial tax systems Taxation of exempt bucket Taxation of exempt bucket — Taxes directly and indirectly attributable to exempt dividends are not creditable or deductible — Expenses allocated or apportioned to exempt income are not deductible Income typically assigned to the exempt bucket: Income typically assigned to the exempt bucket: — Non-portfolio dividends — Active branch income (net of imputed royalty) Income typically assigned to the currently taxable bucket Income typically assigned to the currently taxable bucket — Portfolio and passive income — Royalty income — Export income not attributable to foreign economic activities Income typically assigned to the deferred bucket Income typically assigned to the deferred bucket — Low or no-tax active income — Active income earned in non-treaty countries

70. 70 Territorial tax systems If a territorial tax system has three buckets of income (e.g., Canada), little or no simplification is achieved If a territorial tax system has three buckets of income (e.g., Canada), little or no simplification is achieved — 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 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

71. 71 Territorial tax systems Revenue effect Adopting a territorial system in US could raise revenue, depending on design 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 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 — Expenses allocated to exempt income are non-deductible. Under present law, taxpayers without excess FTCs receive full benefit of deduction Under present law, taxpayers without excess FTCs receive full benefit of deduction Territorial tax system might raise revenue even if worldwide rather than water’s-edge fungibility approach to interest allocation were adopted Territorial tax system might raise revenue even if worldwide rather than water’s-edge fungibility approach to interest allocation were adopted Transition rules for accumulated deferred foreign income? Transition rules for accumulated deferred foreign income?

72. 72 Territorial tax system Economic impacts Increased pressure on transfer pricing rules? Increased pressure on transfer pricing rules? — No evidence found in Treasury study Increased incentive to invest in low tax jurisdictions? Increased incentive to invest in low tax jurisdictions? — Data are inconclusive Increased incentive to shift debt to high-tax jurisdictions Increased incentive to shift debt to high-tax jurisdictions — Beneficial to US revenues Incentive to increase dividend repatriations provided that exempt income is stacked first Incentive to increase dividend repatriations provided that exempt income is stacked first Incentive to suppress royalties in countries with tax rates less than US Incentive to suppress royalties in countries with tax rates less than US — Adverse to US revenues

73. 73 Simplification under either system Reduce number of anti-deferral regimes, limit scope of rules, and provide meaningful de minimis rule Reduce number of anti-deferral regimes, limit scope of rules, and provide meaningful de minimis rule Use GAAP for E&P calculations Use GAAP for E&P calculations Reduce number of foreign tax credit baskets Reduce number of foreign tax credit baskets Eliminate high-tax kick-out from passive foreign tax credit basket Eliminate high-tax kick-out from passive foreign tax credit basket Eliminate AMT foreign tax credit limitation Eliminate AMT foreign tax credit limitation

74. 74 Complexity inherent under either system Application of foreign tax credit rules for non- exempt income, including sourcing of income and allocation and apportionment of expenses Application of foreign tax credit rules for non- exempt income, including sourcing of income and allocation and apportionment of expenses Operation of anti-deferral regime Operation of anti-deferral regime Application of transfer pricing rules Application of transfer pricing rules Definition of active business income (e.g., active financial services) Definition of active business income (e.g., active financial services) Taxation of outbound transfers of property Taxation of outbound transfers of property