Mr. Chairman and Members of the Committee:

My name is Steven C. Salch.  I sincerely appreciate the invitation to appear before you today and discuss with you the subject of corporate inversions.  The statements and views I will express today are my own personal views and do not represent the views of the law firm, its clients, or any association or professional organization of which I am a member.

Later this month, I will celebrate my 34^th anniversary as a lawyer with the Houston, Texas office of Fulbright & Jaworski L.L.P.  Prior to joining that firm, I was a tax accountant for a major energy company then located in Dallas, Texas.  I am a former Chair of the Section of Taxation of the American Bar Association and am currently the Fifth Circuit Regent of the American College of Tax Counsel.  I have been involved with international commercial, regulatory, and tax issues since I entered into the private practice of law in 1968.  As you might expect from a Texas lawyer, a good deal of my practice has focused on the energy industry and financial and service sectors relating to that industry.  However, over the years I have represented both domestic and foreign clients in the agriculture, construction, manufacturing, distribution, financial, and service sectors regarding their operations in this country and abroad.  My testimony today is predicated on that experience and background.

This Committee and its Subcommittee on Select Revenue Measures have undertaken a formidable task:  rationalizing the U.S. income tax system’s treatment of foreign operations in an era of globalization of business and financial resources and the enhanced competition that creates for contracts, sales, financial services, and jobs.

Looking back today, it is hard to imagine that the United States once imposed restrictions of direct foreign investments by U.S. businesses and an interest equalization tax on foreign borrowings.  Forty years ago, the Congress, at the urging of the Kennedy administration, enacted Subpart F of the Code[1], which in its original form essentially eliminated deferral for U.S. businesses that utilized certain foreign business structures to reduce their foreign tax liability while simultaneously deferring the lower-taxed foreign income from current U.S. income tax.  Starting a decade later in 1971, the Congress and the Executive Branch have endeavored to level the playing field between U.S. businesses and their foreign competitors within the constraints presented by our income tax system, multilateral international agreements, and bilateral treaties, while concurrently endeavoring to preserve the U.S. income tax base, through a variety of statutory mechanisms.

As we all know, the export incentive elements of those efforts have consistently been found to be contrary to GATT or WTO, in large measure because of the different manner in which those trade agreements regard the application of territorial tax systems employed by most other countries, as contrasted to the worldwide tax system the United States employs to tax the income of resident business taxpayers.  Consequently, a U.S.-based business with multinational operations today generally faces a higher rate of worldwide income taxation of its net income than does a foreign-based competitor with the same operations, business locations, and employee locations.  The reason for this difference generally is that the foreign competitor will not be subject to U.S. federal income tax on its income from sources without the United States that is not effectively connected with a U.S. trade or business or attributable to a U.S. permanent establishment and also will not be subject to income taxation in its base country on foreign business income (income from business operations outside its foreign base company).

Under a pure territorial tax system the business revenues derived from outside the foreign residence country of the foreign business do not sustain taxation by its country of residence.  More significantly, perhaps, many foreign countries do not share the same concern about external structures that permit their resident businesses to minimize their business income tax burden in other countries in or with which they do business.[2]  Over two decades ago, one of my foreign friends from what was then a fairly popular base country characterized his country’s exemption of income from direct foreign business investments as “pragmatic” and intended to “facilitate the expansion of both the base country revenue and employment by attracting base companies and at the same time permit resident companies to be extremely competitive in foreign markets.” 

For over 34 years, I have worked with U.S. businesses seeking to minimize their cost of capital and maximize their net after-tax earnings by managing the combined U.S. and foreign effective tax rate on their business income.  During that same period, I have worked with foreign businesses seeking to achieve the same goals by minimizing the U.S. income taxation of their U.S. operations or foreign taxation of their third-country business operations.  On one hand, the latter group of clients is generally easier to serve since in many instances their U.S. and foreign business revenues were not taxed in their home countries, while on the other it is somewhat more challenging to explain that the U.S. will tax foreign operating revenues of their U.S. subsidiaries or foreign subsidiaries of those subsidiaries.  It doesn’t take foreign clients a long time to appreciate that, as a general rule, they should not have operating foreign subsidiaries below their U.S. subsidiaries or conduct non-U.S. operations through U.S. subsidiaries.

At the same time, it has always been trying to explain to a U.S. businessperson or entrepreneur that they will be competing with foreign businesses that enjoy the benefits of VAT rebates on exports and what are explicitly or effectively territorial systems with largely unrestricted opportunities to minimize foreign taxation of their business income.  As economies become more intertwined and competition increases around the globe, these experiences have become more trying.

Here is an example of a typical situation and concerns that the Code’s approach to income taxation of foreign business operations produces.

Company X and its subsidiaries, domestic and foreign, are in a service industry.  Over the years, their customers’ activities have become increasingly focused on foreign business opportunities.  As a result, the percentage of the gross revenue and income that Company X and its subsidiaries derive from performing services outside the United States has grown.  It now is more than 50% of their gross revenue from operations and generally is projected to either remain at that level or increase over the foreseeable future.  Company X competes with other U.S. firms and with foreign-based companies.  Within the last six months, Company X was unable to achieve an acquisition of substantially all the assets of Company A, a domestic company whose business would complement Company X’s operations with over 60% of its operating income from foreign operations, because foreign Company Z offered a cash price that was substantially more than the price Company X thought was feasible based on its targeted goals for return on capital and concerns about maintaining share value in an equity marketplace environment that is becoming increasingly discriminating.  Company X’s Board asks its management to analyze the situation and report back on the failed bid.

Company X’s analysis indicates that Company Z has a lower tax rate on operations than Company X, or indeed any of Company X’s U.S. competitors.  One of the reasons is that Company Z does not pay tax in its home country on income from foreign operations or foreign subsidiaries.  Another reason is that Company Z’s home country’s exemption of Company Z’s foreign operational income from tax permits Company Z to conduct its foreign operations in the manner that minimizes taxation by other countries.  While other factors, such as higher employment taxes and office rental, partially offset the tax savings, Company Z has a higher rate of return on invested capital than Company X, largely because of the tax differential.

When Company X’s personnel applied Company Z’s after-tax rate of return from operations to Company A, the result was a price that was actually higher than the price Company Z paid for Company A.  Thus, if Company Z is able to achieve its pre-acquisition rate of return with respect to Company A’s business, the acquisition should actually increase the value of Company Z since the acquisition price, though higher than Company X could pay, was based on a lower rate of return than Company Z actually achieves.  Company X’s analysis showed that under Company Z’s ownership the only portion of the operations of Company A that would continue to pay U.S. corporate income tax were those that served the U.S. market exclusively.

In that regard, since Company Z had purchased Company A’s assets, all the intellectual property of Company A was now owned by a foreign corporation that would charge and receive an arm’s length royalty from Company A’s U.S. operations (determined pursuant to the section 482 regulations) that would be deductible for federal income tax purposes and be exempt from U.S. withholding tax by virtue of a bilateral income tax treaty.  The income derived from the foreign operations of Company A would no longer by subject to U.S. federal income tax or state income tax.

Company X’s CEO reported to the Board that Company Z was in the process of downsizing Company A’s U.S. workforce by terminating personnel in the research, engineering and design, procurement, and administrative areas because those tasks would be performed by existing staff of Company Z in foreign locations for a fee paid by the U.S. operations.  Manufacturing jobs in Company A would remain in the U.S. as needed to serve the U.S. plants.  What was not known was how long those plants would all remain active to provide goods for foreign markets, as well as the domestic U.S. market.  The CEO commented that it was likely Company X would see a decline in sales to what was Company A as Company Z’s foreign engineers and procurement specialists began specifying foreign supplier’s components, including those of Company Z and its affiliates, whenever customers did not specifically request open sourcing or Company X components.

Company X’s Board quickly grasped the concept that Company X’s rate of return on invested capital, and presumably its share price, would increase if Company X could restructure so that it’s income from foreign operations was not subject to U.S. corporate income taxation.  The question was whether that could be achieved.  That’s when the outside tax and investment banking experts were brought into the picture.

They suggested to Company X’s Board that it should effectively reincorporate itself as a Bermudian company and utilize a domestic holding company to own its U.S. operations.  The transaction would involve the U.S. shareholders exchanging Company X shares for shares of a Bermuda company (“BCo”).  That exchange would trigger realization of any built-in gain in the Company X shares, but not loss.  While precise data were not obtainable, in view of the decline in the stock prices over the past several years, the investment bankers advised that it was probable that there were a great many shareholders who had losses and the amount of gain for stockholders who had held Company X shares for more than three years would be relatively low.

Company X’s foreign subsidiaries would be held by a foreign subsidiary of BCo.  The existing intercompany pricing policies of Company X and its affiliates would continue to be observed by BCo and its foreign subsidiaries and the U.S. holding company.  The U.S. holding company would continue to operate the U.S. fixed facilities.  With proper attention to the Code provisions regarding effectively connected income, the income produced by BCo and the foreign subsidiaries should not be subject to U.S. corporate income tax, other than withholding on dividends distributed by the U.S. holding company.  The savings achieved by eliminating U.S. corporate income taxation on BCo and its foreign subsidiaries significantly enhance BCo’s return on capital and hopefully, its share price.  It also makes BCo more competitive with Company Z and other foreign firms.

This example is what I refer to as the classic or straight inversion.  It was employed for the first time approximately 70 years ago.  Approximately 30 years ago I obtained from the IRS a private letter ruling that dealt with inversion issues.  For various non-tax reasons that transaction did not go forward.  Subsequently McDermott did invert and Congress tightened the Code to assure that there was an exit fee for similar transactions.  Subsequent inversions have likewise generated legislative amendments designed to prevent others from pursuing a similar transaction without additional cost.

The recent increase in proposed inversion transactions and corresponding publicity have caught the attention of the Treasury Department and both the House and the Senate.  One result is that a number of members and senators have proposed legislation to address or suppress inversions in several different ways.

I respectfully submit that one of the problems with several of the pending anti-inversion legislative proposals is that they have effective dates that would extend to transactions that were done decades ago.  Not all inversion transactions in the past were undertaken solely or perhaps even principally for U.S. tax reasons.  To go back into the past and attempt to determine which “old and cold” inversions that were entirely legal when they were implemented, should now be penalized, strikes me as unfair, unsound, and overkill.

I also submit to you that the classic or straight inversion is not a “tax shelter,” “abusive transaction,” “job loser,” or “unpatriotic.”  As the foregoing example illustrates, the classic inversion generally is motivated by systemic features of the Code and a discontinuity between those features of our law and comparable features of the tax laws of other countries.  The classic inversion does not reduce U.S. tax on U.S. source business revenue, except insofar as section 482 dictates that there be an arm’s length charge for intercompany transactions in which the foreign affiliate is a provider to a U.S. business.

The example also shows that in the simplest terms, the classic inversion is all about numbers that investors and investment bankers translate into stock prices or purchase prices of businesses.  In that context, preserving U.S. ownership of business, a classic inversion can also directly and indirectly save U.S. jobs and business that would be lost if the same business came under foreign ownership. 

I realize that Congress needs time to study and develop solutions to the systemic issues, including the export issue and the WTO.  However, I am concerned that unless Congress can also enact a moratorium on foreign purchases or acquisitions of U.S. businesses, a moratorium on inversions that precludes U.S. businesses with substantial foreign operations from engaging in the classic inversion will merely provide foreign purchasers an opportunity to extend their present competitive advantage in purchasing and operations during the moratorium period.  No matter what your views may be on inversions, I hope you can all agree that result would not be desirable.

If classic or straight inversions were the only type of inversion transaction that we are seeing, I’m not sure we would all be here today for this purpose.  We are also seeing transactions that are derivative of the classic inversion in some respects but go beyond it.  One such derivative generally involves companies that do not have or reasonably anticipate substantial business income from foreign sources.  A simple inversion does not produce a tax benefit for those companies because the systemic issue is not present in the absence of foreign source income.  Thus, any tax savings that are achieved are a result of something else and are achieved with respect to U.S. source income.  Transactions that fit that description are the transactions I believe the Committee and the Treasury Department should scrutinize carefully.  However, any solutions should apply equally to both domestically and foreign owned U.S. businesses, in order to avoid the inadvertent creation of an additional competitive advantage for foreign owned businesses.

Some inversion transactions implicate bilateral income tax conventions to which the United States is a party.  If in scrutinizing those transactions, the Congress determines that there are issues that require action, I hope the Congress will provide the Treasury Department with an opportunity to address those issues in negotiations with the other countries that are parties to the treaties in question, rather than unilaterally overriding those treaties.  Treaties work for U.S. businesses and are beneficial to international business and financial transactions.  Thus, it is in everyone’s best interest to permit the normal treaty negotiation or renegotiation process to occur in an orderly fashion, rather than jeopardize an entire treaty over any single issue or transaction.

It is a part of our American culture that we will compete on a level playing field with anyone, anytime, and anyplace.  Once the playing field was local.  Then it became regional, and later it became national.  Today the playing field is international, and our rules are not the only rules in play.  Thus, we need to be vigilant that others do not adopt rules that unfairly penalize our businesses seeking to operate abroad.  We also need to be vigilant that our rules neither penalize U.S. businesses operating abroad nor grant an unfair advantage to foreign businesses operating here.

Mr. Chairman, classic inversions are not “the problem.”  They are symptoms that indicate a systemic problem exists.  I urge the Committee and the Congress to seek a solution that cures those systemic problems as the best means of alleviating the symptoms.  At the same time, Congress and the Treasury should also address variations of classic inversions that achieve savings by reducing taxation of U.S. source business income and assure that any remedial measures apply equally to domestic and foreign investors.

Mr. Chairman, thank you again for the opportunity to appear today.  I will be pleased to respond to any questions.

[1] Unless otherwise noted, references to the “Code” are references to the Internal Revenue Code, 26 USC, then in effect, and references to “section” are to sections of the Code.

[2] That low level of concern about business taxation does not extend to individual taxation or passive investment income taxation, however.