Statement of Stephen E. Shay,* Partner, Ropes & Gray, Boston, Massachusetts
Testimony Before the House Committee on Ways and Means
Hearing on the WTO's Extraterritorial Income Decision
February 27, 2002
Mr. Chairman and Members of the Committee:
My name is Stephen Shay. I am a partner in the law firm Ropes & Gray in Boston and a Lecturer in Law at Harvard Law School. I specialize in U.S. international income taxation and was formerly an International Tax Counsel for the Department of the Treasury in the Reagan Administration. I was invited last Friday by the Committee to be a witness to discuss some of the potential fundamental tax reform alternatives that the Committee might consider in response to the WTO decision.[1]
With the Chairman’s permission, I would like to submit my testimony for the record and summarize my principal observations in oral remarks.
Overview
In the announcement for the Hearing, Chairman Thomas stated the purpose for the Hearing as follows:
Although the most recent [WTO] decision comes as no surprise, it illustrates the need to fundamentally reform our tax system so that U.S. workers, farmers and businesses are not disadvantaged in international trade. This will be the first of several hearings to consider the WTO Appellate Panel decision and to examine ways to maintain the international competitiveness of the United States.
The purpose of my testimony is to describe certain fundamental international tax reform alternatives and observe how they do or do not relate to the possible elimination of the Extraterritorial Income exclusion (“ETI”).
I will first briefly review the ETI and the activity it benefits. I next describe a territorial tax system, how it creates an incentive to locate investment in lower-taxed foreign countries, and how the activity it benefits differs from the activity benefited by the ETI. I then consider other approaches to international tax reform, including modifying the current U.S. system of worldwide taxation (with deferral of tax on business income earned through foreign corporations) to reduce rather than increase the incentive under current law to locate investment outside the United States in a low-taxed foreign country.
The ETI Regime
The ETI was enacted in November, 2000. Under the ETI, a taxpayer may exclude a percentage of income attributable to foreign trading gross receipts (“FTGR”) or net income from FTGR.[2] The bottom line effect of the ETI is to reduce the tax rate on this income by approximately 15%. Thus, a domestic corporation subject to a 35% Federal corporate tax rate will pay a 29.75% rate on its net income subject to the ETI regime.
The ETI is designed, like the FSC, to prevent a taxpayer electing the ETI from also obtaining the full benefit of the sales source rule for exporters under the Internal Revenue Code. The sales source rule permits taxpayers that manufacture in the United States and sell outside the United States to treat 50% of the income from the sale as foreign income. In most cases, this foreign income is in the general foreign tax credit limitation category and, for firms that have enough excess foreign tax credits (i.e., have paid foreign taxes at a rate higher than the effective U.S. rate on the same general limitation category of foreign income), permits this income to be exempt from U.S. tax. The marginal rate of U.S. Federal tax on these export sales is 17.50%.[3] For taxpayers with excess foreign tax credits, the benefit of the sales source rule is generally larger than the ETI benefit. Thus, the sales source rule causes the ETI to benefit taxpayers that do not have excess foreign tax credits, that is, taxpayers that either exclusively export from the United States or, if they also conduct foreign operations, have managed their foreign taxes to remain below the effective U.S. tax rate on the same income.
Alternatives to the ETI
As noted in the Hearing announcement, on January 14, 2002, the WTO Appellate Body issued a report upholding a dispute resolution panel finding that the ETI is a prohibited export subsidy.[4] The stated objective of the Committee’s Hearing is to “examine ways to maintain the international competitiveness of the United States.”
As an initial matter, it may be questioned whether the ETI (and its predecessors the FSC and DISC) did in fact improve the international competitiveness of the United States by comparison with alternative ways that the foregone revenues (or tax benefits) could have been spent. There appears to be support for the position that the impact of the ETI on net exports (the increase in exports reduced by the corresponding increase in demand for imports) was modest.[5]
In the following portions of my testimony, I assume for purposes of discussion that the Committee will not adopt a fourth proposal along the lines of DISC/FSC/ETI, but instead will consider other changes to the U.S. international tax rules. As described in the next section, the alternative to the ETI most frequently discussed in recent days, a territorial tax system, creates an incentive to locate investment outside the United States and does not benefit the exporter that carries on its manufacturing and/or selling operations entirely from within the United States. A territorial system also is often heralded as a simplification panacea, but as discussed in the next section, its simplification potential generally is overstated. I urge the Committee to also consider fundamental tax reform alternatives that would have the effect of decreasing U.S. tax benefits for foreign income and directing those revenues toward alternative uses, such as investment in domestic human capital or broader reductions in the level of taxation on all business income.
Changing from A Worldwide Tax System with Deferral to A Territorial Tax System
The major approaches by which the tax system of a country (the "residence country") accounts for income earned by its residents in a foreign country ("foreign-source income") are a worldwide system and an exemption, or territorial, system. If the United States were to adopt a territorial system comparable to the systems adopted in other countries, the United States (i) would not tax its own residents’ foreign-source business income that is subject to taxation in another country,[6] (ii) would disallow the deduction of foreign business losses,[7] and (iii) would tax currently portfolio dividends and all foreign source interest and royalties. In other words, only foreign‑source business income would be exempt from U.S. tax and this income would bear the tax only in the foreign country where the income was produced (the "source country").
The principal objection to a territorial system is that it creates a bias, not in favor of investment in domestic production for export, but in favor of investment in foreign operations. In the worst case, this bias causes a foreign investment to be preferred even though the U.S. investment has a higher before‑tax rate of return and is, therefore, economically superior.[8]
The justification for exempting U.S. multinationals’ foreign-source business income is based principally on a competitiveness argument that is usually stated as follows: foreign corporations operating businesses in low-tax foreign countries owned by residents of countries with a territorial tax system, as well as local businesses in the low-tax foreign countries, pay only the low local income tax on their in-country profits. Without exemption, U.S. multinationals are unduly disadvantaged when competing against these foreigners in low-tax foreign countries because in addition to the foreign tax, a U.S. multinational will pay a U.S. residual tax on its foreign profits, while the foreigners would pay only the low foreign tax. Therefore a U.S. multinational should be given a countervailing exemption from the U.S. residual tax.[9]
This argument is not a request for the United States to give U.S. multinationals relief from international double taxation. The foreign tax credit already addresses that issue. Instead, this is a request for tax system assistance that is not available to pure exporters or other earners of U.S.-source income.
Relieving U.S. multinationals’ foreign-source income from U.S. tax would be a poorly structured tax assistance measure because the assistance would not be targeted at U.S. corporations that face tax-related competition. To be specific, a U.S. multinational facing little tax-related foreign competition in low‑tax foreign countries, whether because (i) it is selling paten- or copyright-protected goods, (ii) its principal competitor is from a foreign country that does not have a territorial system, or (iii) its competitor is another U.S. corporation, would benefit as extensively from a territorial system as a U.S. multinational facing the tax-based competition.
In the current context of the possible repeal of the ETI, proponents of a territorial system should be required to go further than making generalized competitiveness arguments, and should link the tax benefits of an exemption system to promotion of U.S. exports. It is anticipated that the proponents will argue that these benefits for operations in lower tax foreign countries will generate greater purchases of U.S. goods because U.S. multinationals will buy from their U.S. affiliates and suppliers. Although this is a claim that deserves some scrutiny, at best this is an assertion that tax assistance to the operations of U.S. multinationals in low-taxed foreign countries indirectly encourages U.S. exports. This is a remote and somewhat speculative support for U.S. exporters and is heavily weighted for businesses with foreign operations that already are advantaged by deferral. There is no direct relationship between adoption of a territorial system and benefiting domestic U.S. exporters that do not carry on foreign operations.
Adoption of a territorial system also is not a simplification panacea. The allocation of expenses between U.S. and foreign source income would be critical to determining which expenses are allocable to exempt foreign income under a territorial system and therefore disallowed as deductions. Today, the allocation of expenses to foreign income is a potential audit issue primarily for taxpayers that have excess foreign tax credits. Under an exemption system, there would be pressure for all taxpayers that earn exempt foreign income to allocate expenses, such as interest and research and development costs, to domestic income and away from exempt foreign income. Thus, the IRS would have to increase its scrutiny of this difficult area.
Similar to the transfer pricing pressures existing today, taxpayers with foreign operations would have an incentive to shift U.S. income to exempt lower taxed foreign operations. Under a territorial system, however, the benefit is permanent (and not a deferral of tax until repatriation) and transfer pricing would take on commensurately greater significance.
Adoption of a territorial system would not eliminate the need for anti-abuse measures that are comparable in effect to our current highly complex anti-deferral regimes. Major developed countries that have territorial systems also have adopted controlled foreign corporation (“CFC”) regimes or other legislation to prevent tax-motivated offshore investment. France, for example, provides for exemption of, or a reduced tax on, foreign income, but has adopted expansive CFC legislation. Germany, which exempts foreign business income earned in treaty partner countries, has adopted foreign investment fund legislation that denies favorable tax treatment to certain diversified foreign investment funds that are not listed in Germany or do not have a tax representative in Germany. These sophisticated territorial countries recognize the need to protect the domestic tax base by reducing the incentive to shift income-producing activity abroad. Indeed, the need to protect the domestic tax base is more pronounced for a country that does not tax foreign income than for a country that taxes foreign income and employs a foreign tax credit system.
The Committee should take these considerations into account if it considers a territorial tax system.
Reform of the Current U.S Tax System of Worldwide Taxation with Deferral
In practice the current U.S. system of worldwide taxation with deferral of U.S. tax on foreign corporate business income operates in much the same manner as a territorial system. If U.S. multinationals earn income through active business operations carried on by foreign corporations in low-tax source countries, the U.S. multinationals generally pay no residual U.S. tax until they either receive dividends or sell their shares. This phenomenon is referred to as "deferral." Deferral obviously decreases the present value of the U.S. residual tax. When this value reduction is combined with certain other features of the U.S. international tax regime (i.e., cross-crediting foreign taxes and certain source rules that overstate foreign-source income), well-advised U.S. multinationals can frequently reduce the U.S. residual tax on their repatriated foreign-source income to zero. Stated differently, the U.S. worldwide system, with deferral, frequently provides the same result as a territorial system (exemption from U.S. tax on foreign-source income).
The current U.S. system therefore is subject to many of the same criticisms as a territorial system. An appropriate response to those criticisms, however, only may be achieved through a reform of the current worldwide tax system. Adoption of a territorial system would be a second best solution to a reasoned reform of the current rules.
The original proponents of the DISC argued for the export subsidy in part on the grounds that exporters were disadvantaged relative to taxpayers that could locate their operations abroad and take advantage of deferral. In other words, an original rationale for the DISC predecessor of the ETI was to equalize for exporters the advantages realized by U.S. multinationals from deferral.[10] If the ETI is repealed and a third DISC successor is precluded by the WTO rules, as a logical matter the Committee could consider decreasing the tax advantages to earning low-taxed foreign income through foreign corporations.
Does decreasing the tax benefits for foreign income improve competitiveness? An initial question is how to define competitiveness. It is questionable whether U.S. competitiveness should be defined in terms of U.S. multinationals’ profitability. A more meaningful measure of competitiveness is whether any proposal will advance the welfare of individual U.S. citizens and residents.[11] The proponents of tax assistance to enhance the returns of U.S. multinationals, and their shareholders, from foreign operations should be expected to carry the burden of demonstrating the value of the assistance will exceed both the revenue cost and the opportunity cost of alternative uses for that revenue. For example, would investment of a given amount of revenue in education grants to localities improve the living standard for Americans more than the same amount of tax relief for foreign income of U.S. multinational businesses?
I respectfully submit that the Committee should consider proposals that would cut back on the deferral benefit for foreign income as an alternative to the ETI or a territorial system. I and my co-authors, Professors Robert J. Peroni and J. Clifton Fleming, Jr., have outlined a proposal for a broad repeal of deferral.[12] Essentially, our proposal would apply mandatory pass-through treatment to 10% or greater shareholders in foreign corporations.
One would not have to go so far as our proposal to make substantial improvements in the current international tax rules without increasing the current incentives to locate investment outside the United States. There would be substantial improvements to the controlled foreign corporation rules if the current foreign base company sales and services rules applied without exception whenever the CFC’s income, determined separately for each foreign legal entity and qualified business unit of the CFC, was not taxed at a effective foreign tax rate of some minimum amount. Under current law, a safe harbor exists for income taxed at 90% of the U.S. rate; the Committee could choose to employ a lower percentage of the U.S. rate.[13] Although this is a second best approach to the mandatory pass-through approach, it would be a substantial improvement over today’s rules.[14]
The kinds of changes just described could be combined with revenue neutral reductions in tax for business income generally. This approach would assist U.S. businesses that export from the United States or compete against foreign imports as well as those that operate abroad. Alternatively, any revenue increase from these changes could pay for more favorable depreciation and amortization for investment in productive property, used to improve U.S. education or fund anti-terrorism initiatives. Whatever the choice, I respectfully urge the Committee to consider international tax reform proposals that will improve the well-being of all U.S. citizens, workers, farmers and businesses and not just those in the multinational sector.
I would be pleased to work with the Committee to analyze and develop alternative fundamental international tax reform proposals.
*Mr. Shay is not appearing on behalf of any client or organization.
[1] I have attached a copy of my biography to this testimony. The views I am expressing are my personal views and do not represent the views of either my clients or my law firm.
[2] FTGR generally are receipts from sales of qualified foreign trade property, leasing of qualified foreign trade property for use outside the United States, certain services in connection with foreign construction projects. Certain foreign economic processes have to be met in connection with earning FTGR. Qualifying foreign trade property is defined substantially in the same manner as “export property” under the FSC, including that no more than 50% of the property may be attributable to foreign content. The principal difference in definition, apparently thought by this Committee to be sufficient to satisfy the WTO rules, was that qualifying foreign trade property need not be manufactured in the United States.
[3] If the sales source rule applies to income of $100, the U.S. tax on $50 allocated to foreign income is $17.50 and is offset by foreign tax credits, the U.S. tax on the remaining 50 would be $17.50. Thus, the effective tax rate would be 17.50%.
[4] The ETI was the successor to the Foreign Sales Corporation (“FSC”), enacted by the Congress in 1984 and found by a WTO Appellate Body in February, 2000, to be a prohibited export subsidy. The FSC was the successor to the Domestic International Sales Corporation (“DISC”) enacted in 1971, and found to be an export subsidy in a panel report adopted by the GATT Council in 1981. The 1981 GATT Council decision was subject to an understanding that a country need not tax export income attributable to economic processes outside their territory. This understanding was the source of the U.S. approaches in the FSC and the ETI to characterize the benefited income as being taxed in a manner comparable to the taxation under a territorial system. I do not discuss here the substance of the U.S. position nor its merits as a matter of trade law. Suffice it to say, the WTO has twice rejected the U.S. efforts in this regard.
[5] A 2000 Report on the FSC by the Congressional Research Service cites a 1992 Treasury Department analysis that repealing the FSC would have reduced net exports by 140 million. If the impact of the ETI on net exports was in fact less than the tax expenditure, it would be ironic that the United States now is faced with having to arbitrate EU claims for compensatory damages that are based on U.S. tax expenditure estimates. The CRS Report also observed that under traditional economic analysis the FSC by definition reduces U.S. economic welfare (as opposed to the welfare of the firms benefited by the subsidy and their shareholders) because at least some portion of the benefit is presumed to be passed on to foreign consumers in the form of lower prices.
[6] For this purpose, foreign business income includes foreign dividends or gains from substantial shareholdings.
[7] In some cases, foreign losses are allowed, but are recaptured as domestic income when the taxpayer next realizes positive foreign net income.
[8] For example, assume that USCo is a U.S. corporation considering a new business that will produce a 10 percent return, before U.S. income taxation, if the business is located in the United States, and an 8 percent return, before U.S. income taxation, if the business is established in a foreign country. Assume further that the United States will tax USCo at a flat 35 percent rate and that the foreign country will impose a 10 percent rate of tax. If USCo is exempt from U.S. tax on profits from the foreign investment under a territorial system, USCo will be choosing between after-tax returns of 6.5 percent (.10 x [1-.35]) in the U.S. location and 7.2 percent (.08 x [1-.10]) in the foreign location. In this example, the pre-tax rate of return of the U.S. investment is 20% higher than the foreign investment, but the after-tax rate of return under a territorial system is 10.77% lower than the foreign investment. Thus, the effect of a territorial system is to create a strong incentive for USCo to make the economically inferior foreign investment.
[9] Although a territorial system provides no direct benefit for foreign operations in countries with effective tax rates equal to or higher than the U.S. rate, it does offer greater potential for a U.S. multinational to reduce high foreign taxes through tax planning techniques that shift income from a high tax to a lower-tax foreign country. Although often effective today, these planning techniques would be frustrated by expansion of the high tax countries’ CFC regimes which is the general trend in these countries.
[10] See generally Cohen and Hankin, “A Decade of DISC: Genesis, and Analysis,” 2 Va. Tax Rev. 7 (1982).
[11] See Michael J. Graetz, The David Tillinghast Lecture: Taxing International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies, 54 Tax Law Rev. 261, 284 (2001).
[12] Robert J. Peroni, J. Clifton Fleming, Jr. & Stephen E. Shay, Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source Income, 52 SMU L. Rev. 455 (1999); J. Clifton Fleming, Jr., Robert J. Peroni & Stephen E. Shay, Deferral: Consider Ending It Instead of Expanding It, 86 Tax Notes 837 (2000).
[13] The current foreign tax credit mechanism could be improved by repeal of the sales source rule combined with improvements to the interest allocation rules and allowance of foreign as well as domestic loss recapture. Finally, some simplification may be achieved in the U.S. international rules by consolidating anti-deferral rules and rationalizing the source rules.
[14] It might be argued that these changes would pressure U.S. companies to become foreign companies. If this is perceived as a significant problem, the Committee could consider a range of alternatives. For example, the Committee adapt existing U.S. tax provisions to require U.S. investors to take account at the time of sale whether a publicly-traded foreign corporation’s earnings during the investor’s ownership have borne a level of foreign tax equal to or greater than the U.S. corporate tax rate. If not, the investor could be taxed on the gain to make up the difference in the same manner as currently applies under Section 1248(b) of the Code. An alternative approach would be to re-examine the circumstances in which a foreign corporation should be taxed as a domestic corporation.