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Presentation to President’s Advisory Panel on Federal Tax Reform

Presentation to President’s Advisory Panel on Federal Tax Reform. International Provisions of the Internal Revenue Code March 31, 2005. Willard Taylor. Outward and Inward Investment .

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Presentation to President’s Advisory Panel on Federal Tax Reform

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

  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 • 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 NY12529:385927.2

  3. What’s different? • 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? NY12529:385927.2

  4. 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 NY12529:385927.2

  5. 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 NY12529:385927.2

  6. 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 NY12529:385927.2

  7. What’s different? – cont’d • 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 • In a pure territorial or exemption system, foreign income of domestic taxpayers is simply not taxed and no foreign tax credit is allowed NY12529:385927.2

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

  9. 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* • 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 NY12529:385927.2

  10. Where are we today? – cont’d • Remarkably, no consensus on the economic consequences of what we now have – • Does it or does it not makeUS-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 NY12529:385927.2

  11. Evolution of Code provisions on “outward” investment • How did we get to where we are? • 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 • the deferral of tax, and • the foreign tax credit NY12529:385927.2

  12. 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, • 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 NY12529:385927.2

  13. 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, • 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 NY12529:385927.2

  14. 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 • Including, with modifications in 2004, interest expense incurred by US corporations NY12529:385927.2

  15. Evolution of Code provisions on “outward” investment – Sources of complexity • 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 NY12529:385927.2

  16. Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d • 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 NY12529:385927.2

  17. Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d • 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 NY12529:385927.2

  18. Evolution of Code provisions on “outward” investment – Sources of complexity –cont’d • 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 NY12529:385927.2

  19. 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 • 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 NY12529:385927.2

  20. Evolution of Code provisions on “outward” investment – Regulations, etc. • 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 NY12529:385927.2

  21. Other developments – 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 NY12529:385927.2

  22. 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 • 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 NY12529:385927.2

  23. “Inward” Investment NY12529:385927.2

  24. Evolution of Code provisions on “inward” investment • 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 NY12529:385927.2

  25. 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 • 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 NY12529:385927.2

  26. 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* • 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 NY12529:385927.2

  27. “Inward” investment – What are the problems? – cont’d • 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 NY12529:385927.2

  28. Conclusions NY12529:385927.2

  29. Are there solutions? • 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 NY12529:385927.2

  30. Are there solutions? – cont’d • 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 NY12529:385927.2

  31. Are there solutions? – cont’d • 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?) NY12529:385927.2

  32. Are there solutions? – cont’d • 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 NY12529:385927.2

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

  34. Evolution of Code provisions on “outward” investment • How did we get to where we are? • 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 NY12529:385927.2

  35. 1954 Code • 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 NY12529:385927.2

  36. 1954 Code – cont’d • 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** * Other than passive income of foreign personal holding companies ** In Section 482 of the Code NY12529:385927.2

  37. 1954 Code – cont’d • “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 • 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 NY12529:385927.2

  38. Evolution of Code provisions on “outward” investment – the 1962 Act • 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 NY12529:385927.2

  39. 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 • 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 NY12529:385927.2

  40. Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d • 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 NY12529:385927.2

  41. Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d • 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 NY12529:385927.2

  42. Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d • 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” NY12529:385927.2

  43. Evolution of Code provisions on “outward” investment – the 1986 Act • 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 NY12529:385927.2

  44. Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d • 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 NY12529:385927.2

  45. 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 • 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 • foreign base company oil related income • foreign base company shipping (including aircraft) income NY12529:385927.2

  46. Evolution of Code provisions on “outward” investment – the 1976 Act • 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 NY12529:385927.2

  47. Evolution of Code provisions on “outward” investment – the 1984 Act • 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 NY12529:385927.2

  48. 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 • 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 NY12529:385927.2

  49. Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d • 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 NY12529:385927.2

  50. Evolution of Code provisions on “outward” investment – 1986 Act – cont’d • 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 NY12529:385927.2

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