Statement of Donald V. Moorehead, Partner, and Aubrey A. Rothrock III, Partner, Patton Boggs LLP

This statement is submitted for inclusion in the record of the hearings held by the Subcommittee on Select Revenue Measures on June 13, 2002 concerning possible changes to the Internal Revenue Code of 1986, as amended (the “Code”), in light of the recent decision of the World Trade Organization (the “WTO”) with respect to the extraterritorial income provisions of the Code.  We understand that, in fashioning a legislative response to the WTO decision, consideration may be given to making numerous changes to the provisions of the Code governing the taxation of income earned by U.S.-based businesses from their international operations.  In this statement, we describe two proposals that should be included as part of such a legislative package.

Passive Income Attributable to Assets Held to Match CFC Pension Liabilities

In the United States and many foreign countries, employers may establish pension plans for their employees and fund those plans through annual contributions to a separate trust or its equivalent.  Employees and their beneficiaries generally are taxed only when the benefits are paid to them.  In some countries such as Germany, however, the use of a trust or similar funding mechanism would result in the imposition of tax on the employees prior to the commencement of distributions to them upon retirement.

Under German law, if an employer creates a pension plan for its employees, it is required by law to establish a reserve on its balance sheet to reflect liabilities under the plan and to make annual additions to the reserve to reflect the discounted present value of its future obligations under the plan.  Although the basic benefits provided under the plan are insured, the insurance is payable only if the employer is unable to pay the benefits as they fall due.  Employers may not formally fund these plans, through an irrevocable trust or similar arrangement  without adverse tax consequences to their employees.

In some instances, both as a matter of financial prudence and to foster good working relationships with their employees, an employer may seek to “match” its pension obligations  (and offset its balance sheet liability) through the purchase of investment assets.  German law implicitly encourages such practices by providing special tax treatment for certain types of investments.

When the employer is a controlled foreign corporation (a “CFC”), the purchase of assets to match pension obligations can create adverse U.S. tax consequences.  Specifically, the passive income generated by such investments will be treated as foreign base company income under the subpart F provisions of the Code and thus, unless it is de minimis in amount, will taxed to the U.S. shareholders of the CFC (e.g., the U.S. parent corporation) in the year earned by the CFC.  Moreover, that income will be allocated to the “passive” basket for purposes of computing the foreign tax credit limitation, even though it is incidental to the active business operations of the CFC.

We believe this is an inappropriate result as a matter of policy.  The investment of earnings to fund retirement plans has long been recognized as desirable from a public policy standpoint and Congress itself has sought to provide relief in most instances through section 404A of the Code.  Where, however, the host country does not permit the use of  a trust or other similar arrangement without adverse tax consequences to employees, section 404A provides no relief if assets are acquired to “match” the liability represented by the pension reserve.

We recommend that, in the case of a CFC engaged in the active conduct of a trade or business, income attributable to investment assets purchased to match pension reserves should be placed in the same foreign tax credit “basket” as the income attributable to the CFC’s active business operations.  We also recommend that such income be excluded from the definition of foreign base company income and thus not taxed to the U.S. shareholders of the CFC unless and until distributed to them as a dividend or invested in U.S. property.

Foreign Tax Credit “Stacking” Rules

Because U.S. businesses are taxed on their worldwide income, the income they earn from international operations is potentially subject to double taxation:  once by the foreign country in which it is earned and a second time by the U.S.  Depending upon the character of such income and whether it is earned directly by the U.S. business or indirectly through a CFC, the U.S. tax on foreign source income will be payable either in the year it is earned or deferred until the income is distributed as a dividend to the U.S. shareholders or invested in U.S. property.

The foreign tax credit provisions of the Code are intended to reduce the actual incidence of such double taxation and the effectiveness with which this objective is achieved is critical to the competitive position of American businesses in the world’s markets.  By reason of the operation of certain of these foreign tax credit provisions, a U.S. corporation may in fact be unable to claim credits on a current basis for all of the foreign taxes paid with respect to the foreign source income included in its U.S. tax return.  This is true even where the applicable foreign tax rates are less than the U.S. corporate rate of 35 percent.

In such situations, the excess credits may be carried back to the two preceding taxable years and then forward to the succeeding five taxable years.  If they cannot be used during this carryover period, they expire.  Under current law, however, excess credits that are carried over to another taxable year may in fact be used only after the credits used in that taxable year have been fully utilized.  This stacking rule thus increases the likelihood that otherwise valid credits for foreign taxes actually paid on foreign source income that is subject to U.S. tax will not be used and expire.

We believe this is inappropriate as a matter of policy.  Credits for foreign taxes actually paid on income that is subject to U.S. tax should in our view be permitted to be used at the earliest possible date and the Code should be structured so that expiration is only a remote possibility.  This is particularly true since many U.S. corporations are in “excess credit” positions largely because of provisions of the Code that reduce foreign source income artificially (e.g., the over allocation of interest expense to foreign source income) or otherwise make it difficult to use credits in the first year they are available (e.g., the allocation of  types of foreign source income to different “baskets” and the prohibition on the use of credits earned with respect to income in one basket to offset the U.S. tax on income in another basket).

For these reasons, we recommend that section 904(c) of the Code be amended to provide that, with respect to any taxable year, foreign tax credits would be applied in the following order:  (1) credits carried forward to that year; (2) credits earned in that year; and (3) credits carried back to that taxable year.  This approach was taken in prior proposed bipartisan international tax simplification legislation and, is we believe, a more direct solution to the problem than that contained in H.R. 4541.  The proposed change would enable the foreign tax credit to achieve its objective more effectively and would reduce the incentive now inherent in section 904(c) for taxpayers to engage in transactions principally to enable them to use foreign tax credits that might otherwise expire.