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NY12529:385927.2 Presentation to President’s Advisory Panel on Federal Tax Reform International Provisions of the Internal Revenue Code March 31, 2005.

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Presentation on theme: "NY12529:385927.2 Presentation to President’s Advisory Panel on Federal Tax Reform International Provisions of the Internal Revenue Code March 31, 2005."— Presentation transcript:

1 NY12529:385927.2 Presentation to President’s Advisory Panel on Federal Tax Reform International Provisions of the Internal Revenue Code March 31, 2005 Willard Taylor

2 2 NY12529:385927.2 Outward and Inward Investment In teaching international tax, it is common to deal separately with “outward” and “inward” investment – that is, investment from and investment into the US In teaching international tax, it is common to deal separately with “outward” and “inward” investment – that is, investment from and investment into the US Export income (e.g., the DISC, FSC, ETI and domestic production rules) is generally thought of as a third category Most of the debate – and complaints – relate to outward investment Most of the debate – and complaints – relate to outward investment

3 3 NY12529:385927.2 What’s different? Witnesses on other subjects have spoken about the complexity and other problems of the Code Witnesses on other subjects have spoken about the complexity and other problems of the Code What’s different in the case of “outward” investment from the US? What’s different in the case of “outward” investment from the US?

4 4 NY12529:385927.2 What’s different? – cont’d First, the growth of international trade and investment have made the US tax rules much more important than when they took shape in 1962 A creditor nation and a modest exporter of capital in 1962, the US is now a large capital exporter and importer and also the world’s largest debtor nation

5 5 NY12529:385927.2 What’s different? – cont’d Second, the different rhetoric and values that drive the debate on the taxation of foreign income Not about fairness to US individuals and domestic economic efficiency, but rightly or wrongly, framed as a choice between “capital export” and “capital import” neutrality* (and sometimes “national neutrality”**) *Essentially, which country (residence or source) has the first claim to tax **Foreign taxes treated as an operating expense, not a tax credit

6 6 NY12529:385927.2 What’s different? – cont’d Third, the probable inability to achieve the goal of any system for taxing foreign income without some international con- sensus on the choice and on rates of tax, at least among major trading partners

7 7 NY12529:385927.2 What’s different? – cont’d The capital export/import neutrality debate The capital export/import neutrality debate Invokes issues of national competitiveness and world economic welfare There are other systems in the world for taxing foreign income  such as a “territorial” (or exemption) system There are other systems in the world for taxing foreign income  such as a “territorial” (or exemption) system In a pure territorial or exemption system, foreign income of domestic taxpayers is simply not taxed and no foreign tax credit is allowed

8 8 NY12529:385927.2 What’s different? – cont’d But choosing a different system would not But choosing a different system would not solve the complexity and other problems discussed hereafter or significantly change the terms of the debate

9 9 NY12529:385927.2 Where are we today? General agreement that the inability to resolve competing arguments has resulted in a system for taxing the foreign income of US taxpayers that is* General agreement that the inability to resolve competing arguments has resulted in a system for taxing the foreign income of US taxpayers that is* not “effective” or “administrable” “complex, easily avoided by the well advised and a trap for the poorly advised” “schizophrenia in the tax system” with “rules that lack coherence and often work at cross purposes” “absurd [in its] level of complexity” a “jerry-rigged system”, and/or “a cumbersome creation of stupefying complexity” *In the words of practitioners and academics

10 10 NY12529:385927.2 Where are we today? – cont’d Remarkably, no consensus on the economic consequences of what we now have – Does it or does it not make US-owned businesses less competitive than foreign- owned businesses? Hard to believe that the present complexity does not make US business less competitive than it could be in the absence of the complexity

11 11 NY12529:385927.2 Evolution of Code provisions on “outward” investment How did we get to where we are? How did we get to where we are? Started in 1954 with a system that, broadly Started in 1954 with a system that, broadly deferred taxing earnings of US-owned foreign subsidiaries until repatriated allowed a foreign tax credit for foreign income taxes on foreign income, but not in excess of the US tax on that income A progression, from 1962 through 2004, of ever more complicated limitations on A progression, from 1962 through 2004, of ever more complicated limitations on the deferral of tax, and the foreign tax credit

12 12 NY12529:385927.2 Evolution of Code provisions on “outward” investment – cont’d Because of a concern that the 1954 Code unfairly favored foreign investment by US persons over domestic investment, Because of a concern that the 1954 Code unfairly favored foreign investment by US persons over domestic investment, The 1962 Act limited the deferral of US tax on un-repatriated earnings of foreign subsidiaries These limitations were expanded in the 1975, 1976 and 1986 Acts

13 13 NY12529:385927.2 Evolution of Code provisions on “outward” investment – cont’d Because of a concern that the foreign tax credit permitted the use of foreign taxes on one class of income against US tax on another, Because of a concern that the foreign tax credit permitted the use of foreign taxes on one class of income against US tax on another, The 1962 Act created a separate foreign tax credit “basket” for passive interest income – taxes on income in that basket could not be used against US tax on other income More “baskets” were added in the 1975, 1976, 1984 and 1986 Acts

14 14 NY12529:385927.2 Evolution of Code provisions on “outward” investment – cont’d Since the foreign tax credit is limited to the US tax on foreign source taxable income, the foreign tax credit rules require an allocation of expenses Since the foreign tax credit is limited to the US tax on foreign source taxable income, the foreign tax credit rules require an allocation of expenses Including, with modifications in 2004, interest expense incurred by US corporations

15 15 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Sources of complexity What were the sources of complexity resulting from the limitation on deferral? What were the sources of complexity resulting from the limitation on deferral? Income of foreign subsidiaries that was not eligible for deferral had to be put in categories Foreign personal holding company income – 1962 Foreign base company sales and services income – 1962 Income from insurance – 1962, 1986 and 1988 Oil related income – 1975 Shipping and aircraft income – 1975 Sales of property that did not produce active income – 1986 Income from commodities transactions – 1986 Income from foreign currency transactions – 1986 Income from a banking or similar business – 1986

16 16 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d What were the sources of complexity resulting from the limitation on deferral? What were the sources of complexity resulting from the limitation on deferral? Host of special rules for Business rents and royalties Income from sales or services outside of the foreign subsidiary’s country of incorporation In-country related party dividends, interest, rents and royalties Income from notional principal contracts

17 17 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d What were the sources of complexity in the foreign tax credit changes? What were the sources of complexity in the foreign tax credit changes? Growth in separate “baskets” Passive interest income – 1962 Some dividend income – 1984 Foreign oil related income – 1975 All passive income – 1986 High withholding tax interest – 1986 Financial services income – 1986 Shipping and aircraft income – 1986 Dividends from certain non-controlled foreign corporations – 1986

18 18 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d What were the sources of complexity in the foreign tax credit changes? What were the sources of complexity in the foreign tax credit changes? In the “basket” system The need to identify taxes on specific types of income To separately allocate expenses to that income To do this for taxes paid and expenses incurred through tiers of entities To relate these calculations to income eligible/not eligible for deferral

19 19 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Other provisions Focusing on the foreign tax credit and the anti- deferral rules should not diminish the importance of other legislative changes in the last 50-plus years – rules for Focusing on the foreign tax credit and the anti- deferral rules should not diminish the importance of other legislative changes in the last 50-plus years – rules for International boycotts – 1976 Cross-border mergers and acquisitions – principally, 1976 “Stapled” entities – 1984 Related party factoring income – 1984 “Passive foreign investment companies” – 1986 “Functional currency” and foreign exchange gain or loss – 1986 Related party transfers of intangibles – 1986 “Dual consolidated losses” – 1986

20 20 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Regulations, etc. In evaluating what has happened since 1962, need also to grasp that In evaluating what has happened since 1962, need also to grasp that Many statutory changes have since enact- ment been further amended – in some cases, reversing the original legislative solution Many of the statutory changes were followed by pages and pages of explanatory IRS regulations The IRS on its own has issued significant regulations affecting outward investment

21 21 NY12529:385927.2 Other developments – the check-the-box regulations One specific set of regulations deserves a comment -- the check-the-box regulations One specific set of regulations deserves a comment -- the check-the-box regulations Provided the ability, for 1997 and later years, to choose whether an entity would for tax purposes be a corporation, a branch or a partnership A revolution for foreign operations of US taxpayers Simplified the task of reporting foreign income, but Allowed the use of “hybrid”* branches to undercut the anti-deferral rules *An entity treated as a corporation for purposes of the foreign country’s tax law but not for US tax purposes

22 22 NY12529:385927.2 Evolution of Code provisions on “outward” American investment – Jobs Creation Act of 2004 What ultimately became the American Jobs Creation Act of 2004 had the articulated objectives of simplification and rolling back some of the anti-deferral rules What ultimately became the American Jobs Creation Act of 2004 had the articulated objectives of simplification and rolling back some of the anti-deferral rules Some simplification but more than offset by the complexity of other newly-enacted rules Did not even begin the process of addressing broad simplification or the development of coherent rules Dropped the ball on corporate expatriations “earnings stripping” --- the deductibility of interest paid to related foreign persons

23 NY12529:385927.2 “Inward” Investment

24 24 NY12529:385927.2 Evolution of Code provisions on “inward” investment Rules on “inward” investment – i.e., US invest- ment by foreign persons Rules on “inward” investment – i.e., US invest- ment by foreign persons Big change in US position since 1954 – now a major importer of capital and the world’s largest debtor nation Inward investment rules Do not reflect the debate on capital import/export neutrality Generally, lack a political constituency for reform Have remained more constant than the outward investment rules, taking (again) the 1954 Code as a starting point

25 25 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d In 1954, and for many years prior thereto, the rules for taxing inward investment consisted of In 1954, and for many years prior thereto, the rules for taxing inward investment consisted of A flat 30% tax, collected by withholding at source, on US “source” dividends, interest, royalties and like income of a foreign person that did not otherwise carry on business in the US Tax at the regular individual or corporate rate on the US business income of foreign persons – that is, on income that was “effectively connected” with a US business

26 26 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d There was (and is) the rule that requires taxable income from transactions between commonly-controlled corporations to reflect arm’s length dealings* There was (and is) the rule that requires taxable income from transactions between commonly-controlled corporations to reflect arm’s length dealings* Of great importance, because “inward” invest- ment typically is through foreign-owned US subsidiaries Apart from the statutory “earnings stripping” rules, arm’s length pricing is the main rule that protects the US tax base from mispricing between US subsidiaries and their foreign affiliates *Section 482 of the Code

27 27 NY12529:385927.2 “Inward” investment – What are the problems? – cont’d What are the problems in the US taxation of inward investment? What are the problems in the US taxation of inward investment? Complexity – although possibly not to the same extent as for outward investment Specific rules that are neither administrable nor, as a practical matter, are in fact administered Other rules that are out of date – e.g., they turn on physical presence in the US and the “source” of income

28 NY12529:385927.2 ConclusionsConclusions

29 29 NY12529:385927.2 Are there solutions? What are the issues with the way the Code and regulations have evolved? What are the issues with the way the Code and regulations have evolved? General agreement that the subpart F and foreign tax credit rules are “stupefying” in their complexity and not administrable – the same could be said about some of the inward investment rules No easy solution Changing to a territorial or exemption system would neither simplify nor fundamentally change the terms of the debate Nor are all of the 1962-2004 changes, however complex, “bad” and it would therefore be a mistake to simply go back to the 1954 Code

30 30 NY12529:385927.2 Are there solutions? – cont’d Like the system we now have, a territorial (or exemption) system would have to Like the system we now have, a territorial (or exemption) system would have to Classify income as foreign or domestic Distinguish between passive and active business income Address how passive (or non-exempt) income will be treated (e.g., no deferral and a foreign tax credit?) Distinguish between partially and wholly-US owned foreign corporations Allocate expenses between foreign and domestic, and passive and active business, income Enforce arm’s length pricing among affiliates

31 31 NY12529:385927.2 Are there solutions? – cont’d A territorial system would also have to A territorial system would also have to Address foreign branches of US corporations Possibly distinguish between “good” and bad” foreign tax systems (and systems that are someplace in between) Deal with the transition from the existing to the new system (e.g., what happens to untaxed retained earnings?)

32 32 NY12529:385927.2 Are there solutions? – cont’d Simplification is not possible without Simplification is not possible without In the case of outward investment, a serious compromise between proponents of capital export and capital import neutrality In the case of inward and outward investment, a serious intent to simplify for that reason alone Need also to consider tax treaties and the desirability of international consensus Need also to consider tax treaties and the desirability of international consensus

33 NY12529:385927.2 Appendix 1 Evolution of Code provisions on “outward” investment

34 34 NY12529:385927.2 Evolution of Code provisions on “outward” investment How did we get to where we are? How did we get to where we are? Historically, the US has Historically, the US has been a foreign tax credit country, that deferred taxing foreign earnings of foreign subsidiaries until repatriated, and classified corporations as foreign or not on the basis of where incorporated, not where managed or controlled Not the only model in the world, but neither was the US model uncommon at the time Not the only model in the world, but neither was the US model uncommon at the time

35 35 NY12529:385927.2 1954 Code The 1954 Code rules on outward investment allowed a foreign tax credit for direct and “indirect”* foreign income taxes The 1954 Code rules on outward investment allowed a foreign tax credit for direct and “indirect”* foreign income taxes Limited to the US tax on foreign source income, calculated on a country-by- country basis *Generally, a credit for foreign taxes paid by a foreign corporation on earnings distributed to a 10% or greater US corporate shareholder

36 36 NY12529:385927.2 1954 Code – cont’d Earnings of US-owned foreign corporations were not taxed until repatriated* Earnings of US-owned foreign corporations were not taxed until repatriated* Further, certain branches of US corporations could elect to be treated as foreign corporations There was (and is) a general rule that taxable income from transactions between commonly controlled corporations, whether US or foreign, must reflect arm’s length terms** There was (and is) a general rule that taxable income from transactions between commonly controlled corporations, whether US or foreign, must reflect arm’s length terms** *Other than passive income of foreign personal holding companies **In Section 482 of the Code

37 37 NY12529:385927.2 1954 Code – cont’d “Special” provisions were essentially limited to Western Hemisphere Trade, China Trade Act and “possessions” corporations “Special” provisions were essentially limited to Western Hemisphere Trade, China Trade Act and “possessions” corporations In effect, subsidies for operations in specific geographic areas The basic rules had been unchanged for many years The basic rules had been unchanged for many years In origin, the rules did not respond to any stated theoretical view – i.e., were not in response to any capital export/import neutrality debate

38 38 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1962 Act The Kennedy Administration thought that these rules unfairly favored foreign over US investment The Kennedy Administration thought that these rules unfairly favored foreign over US investment Sought in 1962 to end deferral for all of the income of US-owned foreign corporations Not pure “capital export neutrality” because of exceptions – would have retained deferral for earnings from less developed countries and also in part for income of export trade corporations

39 39 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d Got instead an end to deferral for so-called “subpart F” income with back-up rules which treated Got instead an end to deferral for so-called “subpart F” income with back-up rules which treated untaxed earnings of a controlled foreign corporation as repatriated if used to make “investments in United States property”, and gain from the sale of stock of a controlled foreign corporation as a dividend to the extent attributable to retained earnings

40 40 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d Thus, a combination of capital export and capital import neutrality Thus, a combination of capital export and capital import neutrality Set the framework for the debate in the next 50-plus years about which system was the “better” one Also put the Code distinctly on the path to complexity

41 41 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d What were the sources of complexity resulting from the limitation on deferral? What were the sources of complexity resulting from the limitation on deferral? Income of foreign subsidiaries that was not eligible for deferral had to be put in categories – Foreign personal holding company income Foreign base company sales and services income Income from insurance Oil related income Shipping and aircraft income A host of special rules for business rents and royalties income from sales or services outside of the foreign subsidiary’s country of incorporation income from a banking, financing or similar business

42 42 NY12529:385927.2 The 1962 Act also introduced a separate foreign tax credit “basket” for foreign taxes on passive interest income The 1962 Act also introduced a separate foreign tax credit “basket” for foreign taxes on passive interest income Idea was that the foreign tax credit limitation – which limits the credit to the US tax on foreign source taxable income – ought to be applied separately to each “basket” of income so that taxes on one basket of income could not be used to offset US tax on another basket of income or, colloquially, no “cross-crediting” Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

43 43 NY12529:385927.2 What were the sources of complexity in the 1975-1986 tax legislation? What were the sources of complexity in the 1975-1986 tax legislation? In the “basket” system, the need to identify taxes on specific types of income to separately allocate expenses to that income to do this for taxes paid and expenses incurred through tiers of entities to relate these calculations to income eligible/not eligible for deferral Evolution of Code provisions on “outward” investment – the 1986 Act

44 44 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d What were the sources of complexity in the 1975-1986 tax legislation? What were the sources of complexity in the 1975-1986 tax legislation? The further expansion of the categories of subpart F income to include, e.g., A much broader class of insurance income Banking, financing and similar income Foreign oil related income Commodities income Shipping income Foreign exchange gain

45 45 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1975 Act In 1975, special foreign tax credit rules were enacted for foreign oil and gas income – ultimately In 1975, special foreign tax credit rules were enacted for foreign oil and gas income – ultimately Credits for taxes on “foreign oil and gas exploration income” were limited to the US tax rate Credits for taxes on “foreign oil related income” were subject to a limitation that was comparable in intent but different “Recapture” if foreign oil and gas extraction losses offset domestic income Subpart F income expanded in 1975 to include Subpart F income expanded in 1975 to include foreign base company oil related income foreign base company shipping (including aircraft) income

46 46 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1976 Act The 1976 Act further tightened up what had been started in 1962 – in 1976 The 1976 Act further tightened up what had been started in 1962 – in 1976 No more deferral for earnings from less developed countries Recapture of foreign losses used to offset domestic income Capital gains rate differential taken into account in the foreign tax credit limitation Repeal of the per country calculation of the limitation on foreign tax credit – henceforth, a worldwide calculation

47 47 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1984 Act The 1984 Act added The 1984 Act added A new foreign tax credit “basket” for certain dividend income A rule to prevent US source income from becoming foreign source when it was received by a US-owned foreign corporation and paid out to (or included in income by) US persons

48 48 NY12529:385927.2 Evolution of Code provisions on “outward” investment – the 1986 Act To the separate “baskets” for interest, dividend and foreign oil and gas income, the 1986 Act added 4 new baskets, in addition to an expanded “passive income” basket To the separate “baskets” for interest, dividend and foreign oil and gas income, the 1986 Act added 4 new baskets, in addition to an expanded “passive income” basket High withholding tax interest, financial services income, shipping income and dividends from non- controlled Section 902 corporations In many cases with sub-baskets – e.g., export financing income was excluded from high withholding tax interest and high-taxed income from passive income The baskets were applied on a look-through basis to dividends, interest and other income from foreign subsidiaries

49 49 NY12529:385927.2 The 1986 Act also rewrote the rules for determining foreign source taxable income, and thus the allowable foreign tax credit The 1986 Act also rewrote the rules for determining foreign source taxable income, and thus the allowable foreign tax credit Required an allocation of domestically-incurred interest expense to determine foreign source taxable income Dramatically affected the foreign tax credit limitation The allocation reduced foreign source income by an expense that was not deductible in the foreign country Provided statutory rules (replacing 1977 regulations) for the apportionment of R & D expenses Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d

50 50 NY12529:385927.2 Evolution of Code provisions on “outward” investment – 1986 Act – cont’d 1986 Act expanded Subpart F to include income from 1986 Act expanded Subpart F to include income from insurance outside of the foreign corporation’s country of incorporation sales of property that did not produce active income commodities transactions foreign currency transactions a banking or similar business shipping, even though reinvested In 1988, the insurance rules were amended again to apply subpart F to “related party insurance income” of a foreign insurance company owned to the extent of 25% or more by US shareholders In 1988, the insurance rules were amended again to apply subpart F to “related party insurance income” of a foreign insurance company owned to the extent of 25% or more by US shareholders

51 51 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Regulations In evaluating what happened between 1962 and 1986, need to grasp that In evaluating what happened between 1962 and 1986, need to grasp that Many of the statutory changes were followed by pages and pages of explanatory IRS regulations Most of the statutory changes have since enactment been further amended (with exceptions, special rules and complex definitions), in some cases on a regular basis A number of the statutory changes (e.g., the treatment for subpart F purposes of income from the conduct of a banking or similar business) reversed, then reversed again, the original legislative solution

52 52 NY12529:385927.2 Evolution of Code provisions on “outward” investment – Regulations – cont’d Apart from the statutory changes, the IRS independently issued extensive regulations on a number of major international subjects, including, e.g., Apart from the statutory changes, the IRS independently issued extensive regulations on a number of major international subjects, including, e.g., In 1991, the definition of a creditable foreign income tax The standards for arm’s length pricing – in the ‘90s, the IRS embarked on a major and on-going effort to cover specific situations, such as transfers of tangible and intangible property

53 53 NY12529:385927.2 Other developments – the check-the-box regulations For 1997 and later years, the classification of an entity as a corporation, a branch or a partnership became (under the check-the-box regulations) largely elective For 1997 and later years, the classification of an entity as a corporation, a branch or a partnership became (under the check-the-box regulations) largely elective The check-the-box regulations The check-the-box regulations Were a simplification for domestic entities, but a revolution for foreign operations of US taxpayers The ability to elect to treat foreign entities as branches or as partnerships has vastly simplified the task of reporting foreign income, but The ability to elect to treat foreign entities as branches or as partnerships has vastly simplified the task of reporting foreign income, but IRS had not thought through the implications of the check-the-box regulations on foreign operations

54 54 NY12529:385927.2 Other developments – the check-the-box regulations – cont’d Elective classification permits Elective classification permits the use of “hybrid”* branches to eliminate foreign tax and thus replicate the low-taxed foreign income that subpart F was directed at The IRS sought to address “hybrid” entities in the so-called hybrid branch payment rules, but Congress objected and these have not been adopted The IRS sought to address “hybrid” entities in the so-called hybrid branch payment rules, but Congress objected and these have not been adopted *An entity treated as a corporation for purposes of the foreign country’s tax law but not for US tax purposes

55 55 NY12529:385927.2 Other developments – the check-the-box regulations – cont’d The check-the-box regulations also permit the separation of foreign taxes from the underlying foreign income, either through The check-the-box regulations also permit the separation of foreign taxes from the underlying foreign income, either through partnership allocations (which has been addressed) and the use of reverse “hybrid” entities* *An entity treated as a corporation for US tax purposes but as transparent for purposes of the foreign country’s tax law

56 56 NY12529:385927.2 Evolution of Code provisions on “outward” investment – cont’d To focus on the foreign tax credit and subpart F is not to diminish the importance of other changes in the last 50-plus years To focus on the foreign tax credit and subpart F is not to diminish the importance of other changes in the last 50-plus years The enactment in 1976 of the international boycott rules Apart from reporting, disallow credits and end deferral and other benefits for income from boycott operations The repeated changes, beginning largely in 1976, to the rules in Section 367 These govern the extent to which reorganizations and exchanges that are tax-free if purely domestic will be tax-free if a foreign corporation is involved The 1984 enactment of Section 269B, relating to foreign corporations whose ownership is “stapled” to the ownership of a US corporation

57 57 NY12529:385927.2 Evolution of Code provisions on “outward” investment – cont’d The 1984 rules that treat income from related party factoring as interest received from a related party for subpart F and specified other purposes The 1984 rules that treat income from related party factoring as interest received from a related party for subpart F and specified other purposes The enactment in 1986 of the “passive foreign investment company” rules The enactment in 1986 of the “passive foreign investment company” rules impose penalty taxes on US shareholders of broadly-defined “passive foreign investment companies” Co-existed until 2004 with foreign personal holding company and foreign investment company rules

58 58 NY12529:385927.2 Evolution of Code provisions on “outward” investment – cont’d The 1986 enactment of rules that establish a “functional currency” and thus foreign exchange gain or loss for non-functional currency transactions The 1986 amendment which specified that the income from a related-party transfer of an intangible had to be “commensurate with” the income from the intangible The 1986 prohibition on the use of a “dual consolidated loss” of a “dual resident corporation” to reduce the income of other members of a US consolidated group

59 59 NY12529:385927.2 Evolution of Code provisions on “outward” investment – American Jobs Creation Act of 2004 What ultimately became the American Jobs Creation Act of 2004 had the articulated objective of “reforming” subpart F and foreign tax credit rules – essentially targeting what had happened in 1986 and rolling back some capital export neutrality rules What ultimately became the American Jobs Creation Act of 2004 had the articulated objective of “reforming” subpart F and foreign tax credit rules – essentially targeting what had happened in 1986 and rolling back some capital export neutrality rules There was some simplification There was some simplification E.g., the elimination of some “baskets”, of the foreign personal holding company and foreign investment company rules But that simplification was more than offset by the complexity of other newly-enacted rules, such as the new elective interest allocation rules But that simplification was more than offset by the complexity of other newly-enacted rules, such as the new elective interest allocation rules

60 60 NY12529:385927.2 Evolution of Code provisions on “outward” invest- ment – American Jobs Creation Act of 2004 – cont’d The Act lacked balance and perspective – did not comprehensively address, or even begin the process of addressing, broad simplification or the development of coherent rules The Act lacked balance and perspective – did not comprehensively address, or even begin the process of addressing, broad simplification or the development of coherent rules The provisions of the Act The provisions of the Act were mostly borrowed from industry- inspired wish lists, and what was ultimately included or not, and its effective dates, responded to revenue projections and the lobbies’ influence

61 61 NY12529:385927.2 Evolution of Code provisions on “outward” invest- ment – American Jobs Creation Act of 2004 – cont’d Dropped the ball on Dropped the ball on the treatment of corporate inversions, and whether the earnings stripping rules needed revisions in order to achieve a different balance between the treatment of foreign and US-owned US corporations

62 NY12529:385927.2 Appendix 2 Inward Investment

63 63 NY12529:385927.2 Evolution of Code provisions on “inward” investment Rules on “inward” investment – i.e., US investment by foreign persons Rules on “inward” investment – i.e., US investment by foreign persons Do not involve the capital export/import neutrality debate Do not, with exceptions, have a political constituency for reform Have remained more constant than the inward investment rules, taking (again) the 1954 Code as a starting point

64 64 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d In 1954, and for many years prior thereto, the rules for taxing “inward” investment consisted of In 1954, and for many years prior thereto, the rules for taxing “inward” investment consisted of A flat 30% tax, collected by withholding at source, on US “source” dividends, interest, royalties and like income of a foreign person that did not otherwise carry on business in the US Tax at the regular individual or corporate rate on the US business income of foreign persons – that is, on income that was “effectively connected” with a US business

65 65 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d There was (and is) the rule that requires taxable income from transactions between commonly- controlled corporations to reflect arm’s length dealings* There was (and is) the rule that requires taxable income from transactions between commonly- controlled corporations to reflect arm’s length dealings* Of great importance, because “inward” investment typically is through foreign-owned US subsidiaries Apart from the statutory “earnings stripping” rules, arm’s length pricing is the main rule that protects the US tax base from mispricing between US subsidiaries and their foreign affiliates *Section 482 of the Code

66 66 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d The principal changes in the treatment of “inward” investment since 1954 have been The principal changes in the treatment of “inward” investment since 1954 have been The 1966 enactment of rules which eliminated uncertainties about the tax consequences of, and thus encouraged, investment in US stocks, securities and commodities The 1980 imposition of tax at regular rates on gain from a sale of an interest in US real estate including an interest in a US corporation predominantly invested in such assets – the so-called “FIRPTA” tax

67 67 NY12529:385927.2 The imposition in 1984 of withholding by a purchaser of US real property as a means of collecting the FIRPTA tax The imposition in 1984 of withholding by a purchaser of US real property as a means of collecting the FIRPTA tax The 1984 repeal of the 30% withholding tax on “portfolio” interest paid to unrelated foreign investors, The 1984 repeal of the 30% withholding tax on “portfolio” interest paid to unrelated foreign investors, reflects the importance of permitting US borrowers to access foreign capital The 1984 enactment of a statutory rule for determining when a non-citizen is a US resident and therefore subject to full US tax The 1984 enactment of a statutory rule for determining when a non-citizen is a US resident and therefore subject to full US tax Evolution of Code provisions on “inward” investment – cont’d

68 68 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d The 1986 imposition of withholding tax on a foreign partner’s share of partnership income attributable to a US business The 1986 imposition of withholding tax on a foreign partner’s share of partnership income attributable to a US business The 1986 enactment of “source” rules for international communications and space and ocean activity income The 1986 enactment of “source” rules for international communications and space and ocean activity income The 1987 enactment of a statutorily mandated minimum rate of investment return for foreign insurance companies doing business in the US The 1987 enactment of a statutorily mandated minimum rate of investment return for foreign insurance companies doing business in the US

69 69 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d The 1986 enactment of branch taxes The 1986 enactment of branch taxes Repatriation of profits of a US branch treated substantially as a dividend from a US subsidiary Interest paid by a branch treated substantially as a payment of interest by a US subsidiary

70 70 NY12529:385927.2 The 1986 revision to the rules for taxing transportation income of foreign shipping and airline companies The 1986 revision to the rules for taxing transportation income of foreign shipping and airline companies Limited the historical “equivalent exemption” rule to publicly traded companies or companies locally owned Imposed a 4% excise tax on the gross US source transportation income of a company not eligible for the exemption to the extent the income is not taxable as income from a US business Evolution of Code provisions on “inward” investment – cont’d

71 71 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d The 1989 enactment, and 1993 extension to guaranteed debt, of the “earnings stripping rules” The 1989 enactment, and 1993 extension to guaranteed debt, of the “earnings stripping rules” Disallow a current deduction for interest paid to, or on debt guaranteed by, a related foreign person that would otherwise reduce taxable income by more than 50% The 1993 enactment of anti-conduit rules directed at avoidance of US withholding tax through the use of tax treaty provisions The 1993 enactment of anti-conduit rules directed at avoidance of US withholding tax through the use of tax treaty provisions

72 72 NY12529:385927.2 Evolution of Code provisions on “inward” investment – cont’d The 1996 enactment of rules on the expatriation of individual taxpayers The 1996 enactment of rules on the expatriation of individual taxpayers The 1997 enactment to deal with withholding on interest, dividend and like payments to “hybrid” entities The 1997 enactment to deal with withholding on interest, dividend and like payments to “hybrid” entities

73 73 NY12529:385927.2 What are the problems in the US taxation of inward investment? What are the problems in the US taxation of inward investment? Complexity -- although possibly not to the same extent as for outward investment Complexity -- although possibly not to the same extent as for outward investment As in the case of outward investment, many of the statutory amendments have been followed by pages and pages of IRS regulations Other complex regulations have been initiated without legislative prompting -- e.g., those dealing with withholding at source on interest and dividends, and with the taxation of US branches of foreign banks “Inward” investment – What are the problems? – cont’d “Inward” investment – What are the problems? – cont’d

74 74 NY12529:385927.2 “Inward” investment – What are the problems? – cont’d “Inward” investment – What are the problems? – cont’d What are the problems? What are the problems? Many of the rules are neither administrable nor, as a practical matter, are in fact administered E.g., the PFIC or FIRPTA rules The rules for determining the taxability of increasingly important items of income are out of date – they turn on physical presence and “source” For example, income from e-commerce and in some cases from derivatives Residence-based sourcing does not work in a world with abundant tax havens

75 75 NY12529:385927.2 “Inward” investment – What are the problems? – cont’d “Inward” investment – What are the problems? – cont’d Rules for determining arm’s length pricing for services, intangibles and other items are not working well Rules for determining arm’s length pricing for services, intangibles and other items are not working well the so-called advance pricing agreement program is not an answer

76 NY12529:385927.2 Appendix 3 DISCs, FSCs and Domestic Production

77 77 NY12529:385927.2 The DISC regime was enacted in 1971 to permit deferral of export-related income US has a history of providing tax benefits for exports US has a history of providing tax benefits for exports 1962 Act included special rules for “export trade corporations” – whose qualification as such depended on US manufacture or production In 1971, went further and enacted the DISC (“Domestic International Sales Corporation”) rules – a partial roll back of the anti-deferral measures in the 1962 Act A DISC is a U.S. corporation which devotes 95% of its activities to exports, and Usually a “paper” corporation through which its US parent channels exports Earnings not taxed until distributed GATT countries objected to DISCs because the deferral of domestic tax had the effect of an export subsidiary

78 78 NY12529:385927.2 In response to GATT objections, the US enacted the FSC provisions in 1984 In 1984, deferral benefits of DISCS were ended – an interest charge on deferred income In 1984, deferral benefits of DISCS were ended – an interest charge on deferred income Enacted FSC (“Foreign Sales Corporation”) provisions to respond to GATT rulings which approved of tax exemptions for activities “abroad” Enacted FSC (“Foreign Sales Corporation”) provisions to respond to GATT rulings which approved of tax exemptions for activities “abroad” A foreign corporation owned by a U.S. exporter Allowed to contract with a related U.S. entity to produce all of its products, thus substantially skirting the “abroad” requirement ”Rule of origin” required imported components to contribute no more than 50% of the exports’ fair market value The WTO found the FSC regime to be an illegal export subsidiary The WTO found the FSC regime to be an illegal export subsidiary

79 79 NY12529:385927.2 ETI was U.S.’s response to the WTO ruling In 2000, the ETI (“Extraterritorial Income”) legislation repealed the FSC provisions and exempted from tax qualifying foreign trade income, which included In 2000, the ETI (“Extraterritorial Income”) legislation repealed the FSC provisions and exempted from tax qualifying foreign trade income, which included 30% of foreign sales and leasing income 1.2% of foreign trading gross receipts 15% of foreign trade income Like the FSC provision, ETI Like the FSC provision, ETI Only exempted export income Retained the 50% rule of origin The WTO ruled the ETI regime to be illegal in 2002 The WTO ruled the ETI regime to be illegal in 2002

80 80 NY12529:385927.2 American Jobs Creation Act of 2004 The American Jobs Creation Act of 2004 responded by phasing-out the ETI system and phasing-in a reduced rate of tax for income from qualified domestic production The American Jobs Creation Act of 2004 responded by phasing-out the ETI system and phasing-in a reduced rate of tax for income from qualified domestic production

81 NY12529:385927.2 Appendix 4 US income tax treaties

82 82 NY12529:385927.2 US income tax treaties Treaties cut back on the reach of the Code by, among other things Treaties cut back on the reach of the Code by, among other things reducing the rates of US withholding tax on dividends, interest, royalties and like items using a more restrictive “permanent establishment” test before business income is taxed limiting the US tax on service income of individuals providing rules for foreign taxes eligible for credit Treaties also provide a process for resolving conflicting tax claims between taxing authorities Treaties also provide a process for resolving conflicting tax claims between taxing authorities

83 83 NY12529:385927.2 US income tax treaties – cont’d In 1954, the US had some 18 income tax treaties In 1954, the US had some 18 income tax treaties There are now more than 60, and US negotiations now generally begin with a “model” treaty There are now more than 60, and US negotiations now generally begin with a “model” treaty The spread of treaties can only be good, but US treaties have also become a separate body of knowledge The spread of treaties can only be good, but US treaties have also become a separate body of knowledge The terms differ materially, in part because entered into at different times Limitation-on-benefit articles, which vary from treaty to treaty, are as complicated as any provision of the Code

84 NY12529:385927.2 Appendix 5 Some possible simplifications

85 85 NY12529:385927.2 Simplifications?Simplifications? Eliminate provisions which are out-of-date or whose complexity cannot be justified, such as Eliminate provisions which are out-of-date or whose complexity cannot be justified, such as Are foreign tax credit limitations on FOGEI and FORI needed, given the subsequent regulatory definition of creditable foreign taxes? Would it be simpler to treat related party factoring income as interest for all tax purposes? Are the “anti-conduit” regulations needed now that most US tax treaties have limitation on benefit articles? Can the reach of the PFIC rules be justified? If “hybrid” entities erode subpart F, shouldn’t the subpart F rules be revised to accept that? Or, if not, the check-the-box regulations changed?

86 86 NY12529:385927.2 Simplifications – cont’d Eliminate provisions which are out-of-date or whose complexity cannot be justified, including Eliminate provisions which are out-of-date or whose complexity cannot be justified, including In light of the repeal of the withholding tax on “portfolio” interest, do the compliance rules imposed on banks and other intermediary holders of debt make sense? If dividend flows can be replicated by derivatives, is there any point in imposing withholding tax on “portfolio” dividends? In the case of a foreign and domestic corporation, do we need the stapled entities rule in Section 269B? Can the Section 367 regulations on corporate “inversions” be eliminated now that Congress has addressed the subject in Section 7874? With changes in securities markets, is the bank loan exception to the portfolio interest exemption still relevant?

87 87 NY12529:385927.2 Simplifications? – cont’d Eliminate (or move elsewhere) provisions whose purpose seems more driven by ideology than sound tax policy Eliminate (or move elsewhere) provisions whose purpose seems more driven by ideology than sound tax policy The FIRPTA tax on sales and dispositions of US real property (and the related withholding tax) The international boycott participation and related “bad” country rules The rules relating to dual consolidated losses of dual resident entities


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