Presentation to President

1
Presentation to Presidents Advisory Panel on
Federal Tax Reform

• International Provisions of the Internal Revenue
  CodeMarch 31, 2005

Willard Taylor
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

3
Whats different?

• Witnesses on other subjects have spoken about the
  complexity and other problems of the Code
• Whats different in the case of outward
  investment from the US?

4
Whats different? contd

• 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 worlds
  largest debtor nation

5
Whats different? contd

• 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

6
Whats different? contd

• 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

7
Whats different? contd

• 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

8
Whats different? contd

• But choosing a different system would not
• solve the complexity and other problems discussed
  hereafter or
• significantly change the terms of the debate

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

10
Where are we today? contd

• Remarkably, no consensus on the economic
  consequences of what we now have
• Does it or does it not make US-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

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

12
Evolution of Code provisions on outward
investment contd

• 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

13
Evolution of Code provisions on outward
investment contd

• 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

14
Evolution of Code provisions on outward
investment contd

• 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

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

16
Evolution of Code provisions on outward
investment Sources of complexity contd

• 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 subsidiarys country of incorporation
• In-country related party dividends, interest,
  rents and royalties
• Income from notional principal contracts

17
Evolution of Code provisions on outward
investment Sources of complexity contd

• 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

18
Evolution of Code provisions on outward
investment Sources of complexity contd

• 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

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

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

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 countrys tax law but not for US
  tax purposes

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

23
Inward Investment
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 worlds 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

25
Evolution of Code provisions on inward
investment contd

• 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

26
Evolution of Code provisions on inward
investment contd

• There was (and is) the rule that requires taxable
  income from transactions between
  commonly-controlled corporations to reflect arms
  length dealings
• Of great importance, because inward invest-ment
  typically is through foreign-owned US
  subsidiaries
• Apart from the statutory earnings stripping
  rules, arms 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

27
Inward investment What are the problems?
contd

• 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

28
Conclusions
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

30
Are there solutions? contd

• 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 arms length pricing among affiliates

31
Are there solutions? contd

• 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?)

32
Are there solutions? contd

• 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

33
Appendix 1

• Evolution of Code provisions on outward
  investment

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

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

36
1954 Code contd

• 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 arms length terms
• Other than passive income of foreign personal
  holding companies
• In Section 482 of the Code

37
1954 Code contd

• 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

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

39
Evolution of Code provisions on outward
investment the 1962 Act contd

• 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

40
Evolution of Code provisions on outward
investment the 1962 Act contd

• 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

41
Evolution of Code provisions on outward
investment the 1962 Act contd

• 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 subsidiarys country of incorporation
• income from a banking, financing or similar
  business

42
Evolution of Code provisions on outward
investment the 1962 Act contd

• 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

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

44
Evolution of Code provisions on outward
investment the 1986 Act contd

• 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

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

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

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

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

49
Evolution of Code provisions on outward
investment the 1986 Act contd

• 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

50
Evolution of Code provisions on outward
investment 1986 Act contd

• 1986 Act expanded Subpart F to include income
  from
• insurance outside of the foreign corporations
  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

51
Evolution of Code provisions on outward
investment Regulations

• In evaluating what happened between 1962 and
  1986, need to grasp that
• Many of the statutory changes were followed by
  pages and pages of explanatory IRS regulations
• Most of the statutory changes have since
  enactment been further amended (with exceptions,
  special rules and complex definitions), in some
  cases on a regular basis
• A number of the statutory changes (e.g., the
  treatment for subpart F purposes of income from
  the conduct of a banking or similar business)
  reversed, then reversed again, the original
  legislative solution

52
Evolution of Code provisions on outward
investment Regulations contd

• Apart from the statutory changes, the IRS
  independently issued extensive regulations on a
  number of major international subjects,
  including, e.g.,
• In 1991, the definition of a creditable foreign
  income tax
• The standards for arms length pricing in the
  90s, the IRS embarked on a major and on-going
  effort to cover specific situations, such as
  transfers of tangible and intangible property

53
Other developments the check-the-box regulations

• For 1997 and later years, the classification of
  an entity as a corporation, a branch or a
  partnership became (under the check-the-box
  regulations) largely elective
• The check-the-box regulations
• Were a simplification for domestic entities, but
  a revolution for foreign operations of US
  taxpayers
• The ability to elect to treat foreign entities as
  branches or as partnerships has vastly simplified
  the task of reporting foreign income, but
• IRS had not thought through the implications of
  the check-the-box regulations on foreign
  operations

54
Other developments the check-the-box
regulations contd

• Elective classification permits
• the use of hybrid branches to eliminate
  foreign tax
• and thus replicate the low-taxed foreign income
  that subpart F was directed at
• The IRS sought to address hybrid entities in
  the so-called hybrid branch payment rules, but
  Congress objected and these have not been adopted
• An entity treated as a corporation for purposes
  of the foreign countrys tax law but not for US
  tax purposes

55
Other developments the check-the-box
regulations contd

• The check-the-box regulations also permit the
  separation of foreign taxes from the underlying
  foreign income, either through
• partnership allocations (which has been
  addressed) and
• the use of reverse hybrid entities
• An entity treated as a corporation for US tax
  purposes but as transparent for purposes of the
  foreign countrys tax law

56
Evolution of Code provisions on outward
investment contd

• To focus on the foreign tax credit and subpart F
  is not to diminish the importance of other
  changes in the last 50-plus years
• The enactment in 1976 of the international
  boycott rules
• Apart from reporting, disallow credits and end
  deferral and other benefits for income from
  boycott operations
• The repeated changes, beginning largely in 1976,
  to the rules in Section 367
• These govern the extent to which reorganizations
  and exchanges that are tax-free if purely
  domestic will be tax-free if a foreign
  corporation is involved
• The 1984 enactment of Section 269B, relating to
  foreign corporations whose ownership is stapled
  to the ownership of a US corporation

57
Evolution of Code provisions on outward
investment contd

• The 1984 rules that treat income from related
  party factoring as interest received from a
  related party for subpart F and specified other
  purposes
• The enactment in 1986 of the passive foreign
  investment company rules
• impose penalty taxes on US shareholders of
  broadly-defined passive foreign investment
  companies
• Co-existed until 2004 with foreign personal
  holding company and foreign investment company
  rules

58
Evolution of Code provisions on outward
investment contd

• The 1986 enactment of rules that establish a
  functional currency and thus foreign exchange
  gain or loss for non-functional currency
  transactions
• The 1986 amendment which specified that the
  income from a related-party transfer of an
  intangible had to be commensurate with the
  income from the intangible
• The 1986 prohibition on the use of a dual
  consolidated loss of a dual resident
  corporation to reduce the income of other
  members of a US consolidated group

59
Evolution of Code provisions on
outwardinvestment American Jobs Creation Act
of 2004

• What ultimately became the American Jobs Creation
  Act of 2004 had the articulated objective of
  reforming subpart F and foreign tax credit
  rules essentially targeting what had happened
  in 1986 and rolling back some capital export
  neutrality rules
• There was some simplification
• E.g., the elimination of some baskets, of the
  foreign personal holding company and foreign
  investment company rules
• But that simplification was more than offset by
  the complexity of other newly-enacted rules, such
  as the new elective interest allocation rules

60
Evolution of Code provisions on outward
invest-ment American Jobs Creation Act of 2004
contd

• The Act lacked balance and perspective did not
  comprehensively address, or even begin the
  process of addressing, broad simplification or
  the development of coherent rules
• The provisions of the Act
• were mostly borrowed from industry-inspired wish
  lists, and
• what was ultimately included or not, and its
  effective dates, responded to revenue projections
  and the lobbies influence

61
Evolution of Code provisions on outward
invest-ment American Jobs Creation Act of 2004
contd

• Dropped the ball on
• the treatment of corporate inversions, and
• whether the earnings stripping rules needed
  revisions in order to achieve a different balance
  between the treatment of foreign and US-owned US
  corporations

62
Appendix 2

• Inward Investment

63
Evolution of Code provisions on inward
investment

• Rules on inward investment i.e., US
  investment by foreign persons
• Do not involve the capital export/import
  neutrality debate
• Do not, with exceptions, have a political
  constituency for reform
• Have remained more constant than the inward
  investment rules, taking (again) the 1954 Code as
  a starting point

64
Evolution of Code provisions on inward
investment contd

• 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

65
Evolution of Code provisions on inward
investment contd

• There was (and is) the rule that requires taxable
  income from transactions between
  commonly-controlled corporations to reflect arms
  length dealings
• Of great importance, because inward investment
  typically is through foreign-owned US
  subsidiaries
• Apart from the statutory earnings stripping
  rules, arms 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

66
Evolution of Code provisions on inward
investment contd

• The principal changes in the treatment of
  inward investment since 1954 have been
• The 1966 enactment of rules which eliminated
  uncertainties about the tax consequences of, and
  thus encouraged, investment in US stocks,
  securities and commodities
• The 1980 imposition of tax at regular rates on
  gain from a sale of an interest in US real estate
• including an interest in a US corporation
  predominantly invested in such assets the
  so-called FIRPTA tax

67
Evolution of Code provisions on inward
investment contd

• The imposition in 1984 of withholding by a
  purchaser of US real property as a means of
  collecting the FIRPTA tax
• The 1984 repeal of the 30 withholding tax on
  portfolio interest paid to unrelated foreign
  investors,
• reflects the importance of permitting US
  borrowers to access foreign capital
• The 1984 enactment of a statutory rule for
  determining when a non-citizen is a US resident
  and therefore subject to full US tax

68
Evolution of Code provisions on inward
investment contd

• The 1986 imposition of withholding tax on a
  foreign partners share of partnership income
  attributable to a US business
• The 1986 enactment of source rules for
  international communications and space and ocean
  activity income
• The 1987 enactment of a statutorily mandated
  minimum rate of investment return for foreign
  insurance companies doing business in the US

69
Evolution of Code provisions on inward
investment contd

• The 1986 enactment of branch taxes
• Repatriation of profits of a US branch treated
  substantially as a dividend from a US subsidiary
• Interest paid by a branch treated substantially
  as a payment of interest by a US subsidiary

70
Evolution of Code provisions on inward
investment contd

• The 1986 revision to the rules for taxing
  transportation income of foreign shipping and
  airline companies
• Limited the historical equivalent exemption
  rule to publicly traded companies or companies
  locally owned
• Imposed a 4 excise tax on the gross US source
  transportation income of a company not eligible
  for the exemption to the extent the income is not
  taxable as income from a US business

71
Evolution of Code provisions on inward
investment contd

• The 1989 enactment, and 1993 extension to
  guaranteed debt, of the earnings stripping
  rules
• Disallow a current deduction for interest paid
  to, or on debt guaranteed by, a related foreign
  person that would otherwise reduce taxable income
  by more than 50
• The 1993 enactment of anti-conduit rules
  directed at avoidance of US withholding tax
  through the use of tax treaty provisions

72
Evolution of Code provisions on inward
investment contd

• The 1996 enactment of rules on the expatriation
  of individual taxpayers
• The 1997 enactment to deal with withholding on
  interest, dividend and like payments to hybrid
  entities

73
Inward investment What are the problems?
contd

• What are the problems in the US taxation of
  inward investment?
• Complexity -- although possibly not to the same
  extent as for outward investment
• As in the case of outward investment, many of the
  statutory amendments have been followed by pages
  and pages of IRS regulations
• Other complex regulations have been initiated
  without legislative prompting -- e.g., those
  dealing with
• withholding at source on interest and dividends,
  and
• with the taxation of US branches of foreign banks

74
Inward investment What are the problems?
contd

• What are the problems?
• Many of the rules are neither administrable nor,
  as a practical matter, are in fact administered
• E.g., the PFIC or FIRPTA rules
• The rules for determining the taxability of
  increasingly important items of income are out of
  date they turn on physical presence and
  source
• For example, income from e-commerce and in some
  cases from derivatives
• Residence-based sourcing does not work in a world
  with abundant tax havens

75
Inward investment What are the problems?
contd

• Rules for determining arms length pricing for
  services, intangibles and other items are not
  working well
• the so-called advance pricing agreement program
  is not an answer

76
Appendix 3

• DISCs, FSCs and Domestic Production

77
The DISC regime was enacted in 1971 to permit
deferral of export-related income

• US has a history of providing tax benefits for
  exports
• 1962 Act included special rules for export trade
  corporations whose qualification as such
  depended on US manufacture or production
• In 1971, went further and enacted the DISC
  (Domestic International Sales Corporation)
  rules a partial roll back of the anti-deferral
  measures in the 1962 Act
• A DISC is a U.S. corporation which devotes 95 of
  its activities to exports, and
• Usually a paper corporation through which its
  US parent channels exports
• Earnings not taxed until distributed
• GATT countries objected to DISCs because the
  deferral of domestic tax had the effect of an
  export subsidiary

78
In response to GATT objections, the US enacted
the FSC provisions in 1984

• In 1984, deferral benefits of DISCS were ended
  an interest charge on deferred income
• Enacted FSC (Foreign Sales Corporation)
  provisions to respond to GATT rulings which
  approved of tax exemptions for activities
  abroad
• A foreign corporation owned by a U.S. exporter
• Allowed to contract with a related U.S. entity to
  produce all of its products, thus substantially
  skirting the abroad requirement
• Rule of origin required imported components to
  contribute no more than 50 of the exports fair
  market value
• The WTO found the FSC regime to be an illegal
  export subsidiary

79
ETI was U.S.s response to the WTO ruling

• In 2000, the ETI (Extraterritorial Income)
  legislation repealed the FSC provisions and
  exempted from tax qualifying foreign trade
  income, which included
• 30 of foreign sales and leasing income
• 1.2 of foreign trading gross receipts
• 15 of foreign trade income
• Like the FSC provision, ETI
• Only exempted export income
• Retained the 50 rule of origin
• The WTO ruled the ETI regime to be illegal in 2002

80
American Jobs Creation Act of 2004

• The American Jobs Creation Act of 2004 responded
  by phasing-out the ETI system and phasing-in a
  reduced rate of tax for income from qualified
  domestic production

81
Appendix 4

• US income tax treaties

82
US income tax treaties

• Treaties cut back on the reach of the Code by,
  among other things
• reducing the rates of US withholding tax on
  dividends, interest, royalties and like items
• using a more restrictive permanent
  establishment test before business income is
  taxed
• limiting the US tax on service income of
  individuals
• providing rules for foreign taxes eligible for
  credit
• Treaties also provide a process for resolving
  conflicting tax claims between taxing authorities

83
US income tax treaties contd

• In 1954, the US had some 18 income tax treaties
• There are now more than 60, and US negotiations
  now generally begin with a model treaty
• The spread of treaties can only be good, but US
  treaties have also become a separate body of
  knowledge
• The terms differ materially, in part because
  entered into at different times
• Limitation-on-benefit articles, which vary from
  treaty to treaty, are as complicated as any
  provision of the Code

84
Appendix 5

• Some possible simplifications

85
Simplifications?

• Eliminate provisions which are out-of-date or
  whose complexity cannot be justified, such as
• Are foreign tax credit limitations on FOGEI and
  FORI needed, given the subsequent regulatory
  definition of creditable foreign taxes?
• Would it be simpler to treat related party
  factoring income as interest for all tax
  purposes?
• Are the anti-conduit regulations needed now
  that most US tax treaties have limitation on
  benefit articles?
• Can the reach of the PFIC rules be justified?
• If hybrid entities erode subpart F, shouldnt
  the subpart F rules be revised to accept that?
  Or, if not, the check-the-box regulations changed?

86
Simplifications contd

• Eliminate provisions which are out-of-date or
  whose complexity cannot be justified, including
• In light of the repeal of the withholding tax on
  portfolio interest, do the compliance rules
  imposed on banks and other intermediary holders
  of debt make sense?
• If dividend flows can be replicated by
  derivatives, is there any point in imposing
  withholding tax on portfolio dividends?
• In the case of a foreign and domestic
  corporation, do we need the stapled entities rule
  in Section 269B?
• Can the Section 367 regulations on corporate
  inversions be eliminated now that Congress has
  addressed the subject in Section 7874?
• With changes in securities markets, is the bank
  loan exception to the portfolio interest
  exemption still relevant?

87
Simplifications? contd

• Eliminate (or move elsewhere) provisions whose
  purpose seems more driven by ideology than sound
  tax policy
• The FIRPTA tax on sales and dispositions of US
  real property (and the related withholding tax)
• The international boycott participation and
  related bad country rules
• The rules relating to dual consolidated losses of
  dual resident entities