Statement of John L. Loffredo,
Vice President and Chief Tax Counsel, DaimlerChrysler Corporation

Testimony Before the House Committee on Ways and Means

Hearing on Impact of U.S. Tax Rules on International Competitiveness

June 30, 1999

My name is John Loffredo, and I am Vice President and Chief Tax Counsel for DaimlerChrysler Corporation, the U.S. arm of DaimlerChrysler. The merger of Chrysler Corporation and Daimler Benz A.G. was a marriage of two global manufacturing companies, one with its core operations in North America and the other headquartered in Europe, with operations around the world. However, the U.S. tax system puts global companies at a decisive disadvantage. This issue became a major concern and when the time came to choose whether the new company should be a U.S. company or a foreign company, Management chose a company organized under the laws of Germany.

Generally, the German tax system is based on a "Territorial" theory. By contrast, the U.S. tax system follows the philosophy of taxing the worldwide income of a U.S. company while allowing tax credits for taxes paid to foreign governments. In theory, it is possible for both systems to result in the same tax being imposed on a company whether they are U.S. or German. However, in practice this does NOT happen.

Before I go further, I want to make it clear that the former Daimler Benz has been a good corporate citizen in the U.S. and has paid all taxes believed legally due on its U.S. operations. The same is true for the former Chrysler Corporation. In addition, Daimler and Chrysler will continue to be subject to the U.S. tax laws on their U.S. operations and will continue to pay their fair share of U.S. taxes. However, what we did not want to happen as part of this merger was to increase the company's tax burden by subjecting to U.S. tax Daimler Benz's non-U.S. operations that were NEVER subject to U.S. tax laws in the past.

As mentioned, the main reason that Germany's tax system on global corporations is preferable to the U.S. is the "Territorial" nature of their tax system. What does this mean from a practical standpoint?

1. Worldwide vs. Territorial Tax System

As of the date of our merger, the German Territorial Tax System exempted qualified dividends received from foreign subsidiaries from taxation . (Recent German law changes now tax 15% of such dividends). When DaimlerChrysler Corporation earns income in the U.S. it may elect to dividend some of its after-tax earnings from the U.S. to Germany, (less a 5% withholding tax). Before 1999 these dividends were not subject to German income tax but now 15% of the dividend is taxed (resulting in a 3.5% German tax on the gross dividend before U.S. tax).

However, under the U.S.'s worldwide tax system a U.S. parent company receiving dividends from its foreign affiliates must include the dividends and corresponding foreign taxes paid in its U.S. taxable income. Then it must determine the U.S. tax on those dividends. The U.S. company may be able to offset the U.S. tax on that income if it can meet certain limitations and utilize the foreign tax credits generated by these foreign subsidiaries. If the foreign tax rate is the same or higher than the U.S. tax rate, the foreign tax credits should, in theory, offset the U.S. tax on those dividends. If this occurred, the result would be the same in the U.S. as it is under the German Territorial System. That is, no further U.S. corporate tax would be imposed and the earnings will have been taxed by only one country. However, under restrictions put in the U.S. tax laws over the past several decades, this theoretical result is typically NOT achieved and, in many cases, the U.S. taxpayer can NEVER fully utilize all of the foreign taxes paid by its subsidiaries to offset the U.S. tax on foreign earnings. The result is taxation of at least a portion of the earnings twice, by two countries.

Under these circumstances, the German Territorial Tax System provides a greater degree of certainty for the new DaimlerChrysler company that corporate income earned outside of the country of incorporation for the parent will only be taxed once. (Although as of January 1, 1999 dividends remitted to Germany will be subject to the new tax equivalent of 3.5% of the gross dividend before U.S. tax).

Why does a U.S. company have a problem utilizing all its foreign tax credits so that foreign source income is only taxed once? The main reason for this problem is that a U.S. company has to apportion many of its domestic business expenses (especially interest expense) against its foreign source income, thus reducing the amount of foreign income that may be taken into account in meeting the limitation. This would create unused foreign tax credits.

2. Apportionment of Business Expenses

The U.S. tax system requires certain domestic company's business expenses to be apportioned to foreign source income for purposes of determining the amount of foreign tax credits that may be claimed. This apportionment of expenses has the effect of reducing the amount of a taxpayer's foreign source income. The result is a taxpayer does not have sufficient foreign source income to utilize all of its foreign tax credits. In effect, this apportionment of expenses to foreign source income results in an amount of foreign income equal to the apportioned expenses being taxed in the U.S. with NO credit offset. This amount of income is thus subjected to tax twice, once by the foreign country and again by the U.S.

The expense apportioned to foreign source income that creates the most difficulty to a company like DaimlerChrysler, and to many other U.S. companies, is interest expense, which must be apportioned on the basis of the location of an affiliated group's assets. Since interest is apportioned on an asset basis, it is apportioned to foreign source income categories whether or not the foreign affiliates have current income subject to U.S. taxation (e.g., dividends that are paid from a foreign subsidiary).

DaimlerChrysler has a large affiliated finance company in the U.S. whose primary business purpose is to provide financing to Chrysler dealers and customers who buy Chrysler products in the U.S. However, under the U.S. tax laws, DaimlerChrysler must apportion its U.S. affiliated group's interest expense between its U.S. income and its worldwide income. Had the former Chrysler Corporation become the parent company of the merged group, substantially over 50% of the value of the assets of the combined companies would have been located outside of the United States. This would have meant that more than 50% of the U.S. affiliated group's interest would have been apportioned to foreign source income. This would have decreased the amount of foreign source income that was eligible for offset by the foreign tax credit. In effect, U.S. tax would have to be paid on the amount of foreign source income equal to the expenses allocated to that income, and that would have been quite a large number.

For example, let's examine what would happen where the German company is a subsidiary of the U.S. Company. Assume DaimlerChrysler Corporation sold one vehicle in the U.S. and made $1,000 of net taxable income on the sale. DaimlerChrysler's finance subsidiary financed the sale of the vehicle and that company incurred $100 of interest expense. Also, in that year, the former Daimler Benz AG earned $100, paid $50 in tax to the German tax authorities, and remitted a $50 dividend to the DaimlerChrysler parent company in the U.S.

Let's assume that 50% of DaimlerChrysler Corporation's assets were foreign. Therefore, 50% of the interest expense or $50 is allocated to foreign source income. Of DaimlerChrysler Corporation's total income subject to U.S. tax of $1,100 only $100 is foreign source income ($50 dividend plus $50 gross-up for German taxes). Under the method used to calculate foreign tax credits in the U.S., the $100 in foreign source income is reduced by the $50 U.S. interest expense apportioned to foreign source income. This results in net foreign source income of $50. The U.S. tax on that amount is $17.50 which is the maximum amount of credit that may be claimed on the $100 of German income. Therefore on the $100 earnings in Germany, 67.5% would be paid in taxes (50 in Germany; 17.5 in the U.S.). That is, a portion of the German income will have been taxed twice.

With DaimlerChrysler A.G. as the parent company, if its U.S. subsidiary earned $100 of income from U.S. sources, that income would have been subject to a tax at the 35% U.S. rate. A subsequent dividend to Germany would be subject to an additional 5% U.S. withholding tax and then the new German tax (equivalent to 3.5% of the $100 earned from U.S. sources) for a total effective tax of around 44%, rather than 67.5%.

In addition to the apportionment of expenses problem, there were three other areas of concern to DaimlerChrysler under the laws in the U.S. for taxation of foreign subsidiaries of U.S. companies:

(A) foreign finance subsidiaries;

(B) incidental investment income earned by foreign operating subsidiaries; and

(C) foreign base company sales income.

A. Foreign Finance Subsidiaries

Prior to 1997, foreign subsidiaries of U.S. companies who were carrying on an active finance business (borrowing and lending) in a foreign location had to be concerned that these operations were subject to U.S. tax on their earnings even though not distributed to the U.S. parent. The problem has been alleviated by recent legislation that has given taxpayers temporary relief to exclude such active business income from U.S. taxation. The German tax system would NOT tax such an active business. DaimlerChrysler Corporation, which continues to own active finance companies in Canada and Mexico, strongly supports this rule which allows active foreign finance company income to be exempt from U.S. taxation until remitted to the U.S. and urges that it be made permanent.

B. Incidental Investment Income Earned by Foreign Operating Subsidiaries

The U.S. will tax in the year earned passive foreign income (interest) if the tax rate in the foreign country is less than 90% of the U.S. tax rate or less than 31.5%. The Germans, on the other hand, will not tax incidental income (interest on working capital) earned at an active operating company. However, both the German's and the U.S. have similar rules when it comes to taxing foreign sourced passive income where such income is in a tax haven country. In Germany, the income is taxed immediately if it is not subject to a 30% tax rate in the country where it is earned and, as mentioned before, the U.S. rule is that such income must be taxed at a 31.5% tax rate to avoid immediate U.S. taxation.

C. Foreign Base Company Sales Income

DaimlerChrysler is in the business of selling vehicles worldwide. Let us assume DaimlerChrysler A.G., a German company, establishes a regional distribution center in the United Kingdom as a staging area for the sale of right-hand drive vehicles worldwide. Vehicles manufactured in Germany are sold to the distribution center in the U.K., and then on to a third country. The income earned by the U.K. distribution center would be taxed in the U.K. (and not Germany until a dividend was eventually paid to Germany in which case the new tax on 15% of the dividend would apply).

Now assume that DaimlerChrysler, a U.S. company, sent vehicles manufactured by its German subsidiary to the U.K. center. The vehicles in the U.K. will be sold throughout the world. Under U.S. tax laws the income earned by the U.K. distribution center on vehicles shipped to other countries would be taxed immediately in the U.S. The reason for this is because the new U.K. tax rate of 30% is less than 90% of the U.S. tax rate. In the above two scenarios there is no difference in operation for the DaimlerChrysler group, only a difference in tax results. The only change in facts is the country of incorporation of the parent company. The U.S. company is placed at a decisive disadvantage.

In the above three circumstances, the foreign source income included in U.S. taxable income is reportable in the year the income is earned by the foreign company. This is the case whether or not the income is repatriated to the U.S. or whether or not the U.S. taxpayer is in a net U.S. taxable income or loss position for the year. Because of the "basket" rules adopted in 1986, many taxpayers with losses may be in a position of including this income in their tax base but they cannot offset the tax on this income with current foreign tax credits. In these cases, the chance for double taxation on the foreign source income increases.

As can be seen from above, DaimlerChrysler Corporation, now a subsidiary of a German company, has minimized the possibility of paying ADDITIONAL tax (NOT TAXES) on its foreign operations. This should help the operations of the company to continue to compete on a global scale. However, there are many U.S. companies which have foreign operations and they are put at a competitive disadvantage in the global economy, just because they are competing against companies who do not have to follow the way the U.S. tax system taxes foreign operations.

[THE REPORT, ENTITLED "THE NFTC FOREIGN INCOME PROJECT:   INTERNATIONAL TAX POLICY FOR THE 21ST CEN TURY," DATED MARCH 25, 1999, IS BEING RETAINED IN THE COMMITTEE.]