FROM THE OFFICE OF PUBLIC AFFAIRS

The U.S. international tax rules have developed over the last 40 years. The development of those rules began at a time when the global economy looked very different than it does today. The basic structure of the U.S. international tax regime dates from the early 1960s where the U.S. economy was dominant, accounting for over half of all multinational investment in the world.

The world has changed in the last 40 years. The globalization of the U.S. economy puts ever more pressure on our international tax rules. When the rules first were developed, they affected only relatively few taxpayers and only relatively few transactions. Today, there is hardly a U.S.-based company that is not faced with applying the international tax rules to some aspect of its business.

In the creation of the international tax rules policymakers always try and weigh principles of export neutrality against import neutrality (competitiveness). I think such a weighing is important. In light of the changing global economy it is appropriate to put our international tax laws back on the scale and recalibrate the balance if necessary.

There can be no doubt that re-examination of the U.S. international tax rules is appropriate and timely.

As we look at our international tax system and consider appropriate reforms - both large and small - to that system, there are several competing principles to keep in mind.

• Tax rules should not serve as a barrier to cross-border investment.
• Tax rules should not place an undue burden on the competitive position of U.S.-based companies.
• Tax rules should minimize distortion of investment decisions through tax considerations.
• Tax rules should not create a bias for or against particular activities. Tax rules should be neutral, except where incentives are necessary to account for unrecouped social good (e.g., R&D).
• Tax rules should minimize compliance and administrative burdens. Complexity, both substantive and administrative, can impose significant costs for both taxpayers and the governments.

These principles necessarily are in conflict and require a continual balancing. These principles are only a subset of the considerations that must be taken into account in considering the optimal design of any set of tax rules, but they are principles that have particular relevance in considering the tax rules affecting international activities and transactions.

We have been very active in the international tax area in ways that further these principles. Let me highlight some of the issues we have been addressing.

One key principle is that tax rules should not serve as an artificial barrier to cross-border investment. This is an issue not just with respect to our own tax rules but with respect to the interaction of our tax rules with the tax rules of our trading partners.

The coordination between tax systems, along with the reduction of "toll charges" for cross-border investment are the central goal of our tax treaty network. We have an ambitious tax treaty program, with a two-pronged objective: to update and modernize our existing tax treaties with our major trading partners and to expand our treaty network to cover new and potential trading partners with which we have not previously had a treaty relationship.

We are constantly working to update and expand our treaty network. We are also re-considering treaty policies as necessary to ensure that they serve U.S. interests.

The reduction of the withholding rate on direct dividends to zero in our recently-signed treaty with the United Kingdom represents the first time the United States has included such an elimination of withholding taxes on cross-border dividends in a treaty.

This was followed closely by the inclusion of a similar provision in the protocol to the U.S.-Australia treaty, which was signed on September 27.

We also were able to open formal negotiations with Japan to renegotiate our treaty that dates back 20 years.

While these two agreements were different in scope, they demonstrate that we are willing to be flexible to secure a balanced package for both treaty partners and to serve the interests of the businesses affected.

New U.S.-U.K. treaty, the U.S.-Australia protocol and the beginning of formal negotiations with Japan are important developments that will help to facilitate cross-border investment.

We are currently in negotiations with Canada, France, Korea, Hungary and Iceland to update our existing treaties with those countries.

We also are negotiating with Chile, Bangladesh and Sri Lanka in order to expand our treaty network to countries with which we have not had a treaty.

We look forward to input from the business community about where we should be focusing our efforts in the future, since we want to make sure that our priorities reflect your priorities.

The issue of a level playing field for U.S.-based businesses competing in the global marketplace is very important. It is an issue that has gotten particular attention in recent years in connection with the EU's challenge in the WTO to our FSC rules and then to our ETI rules.

The FSC and ETI provisions do not provide a special advantage to U.S. companies relative to their foreign competitors. Rather, these provisions help to level the playing field by mitigating the costs that would be imposed on U.S.-based companies under the U.S. international tax rules and that would not be borne by their foreign competitors in the same marketplace.

We are disappointed with the WTO panel report finding that the ETI regime constitutes a prohibited export subsidy. We continue to believe ETI regime is consistent with our WTO obligations. We filed a notice of appeal in this case with the WTO Dispute Settlement Body on October 15^th. We filed our brief on November 1^st.

The oral hearing in the WTO is scheduled for November 26^th, with a decision likely around Mid-January. If that decision is adverse to the United States, the next step will be the resumption of arbitration over the measure of damages and authorization of retaliation, which is expected to take approximately 60 to 90 days or until approximately April of 2002.

Given the importance of the tax provisions that are the subject of the panel report and the potential adverse implications of the panel's analysis for other tax and trade provisions, we believe we must challenge the decision. The analysis in the panel report, which we believe is erroneous in significant respects, has far-reaching implications not just for the United States but for the European Union as well.

We announced last week that Treasury Deputy Secretary Kenneth Dam will make the opening argument for the United States. Also participating in the opening argument will be the Assistant to the Solicitor General for tax maters. We believe this sends an important signal as to the seriousness with which the Administration takes this case.

As we state in our brief in this case, we believe the Panel's analysis of the ETI regime and the application of the WTO rules to the regime was erroneous in all respects; contrary to the Panel's analysis, the ETI is not a subsidy, it is not export-contingent and it is a measure for the avoidance of double taxation. We further believe that the Panel's analysis has implications for tax systems throughout the world and for the WTO itself. The Panel's analysis seems to mean either that all tax systems will need to be reformed or that the WTO rules contain an inherent bias in favor of one type of tax system over another; neither of these can be true.

At the same time, we believe we must continue to pursue an appropriate resolution of this matter on all fronts. This is not the only matter between the United States and the European Union and an issue of this magnitude needs to be resolved in the context of that larger relationship.

This case is too big to leave solely to litigation to resolve. We need to pursue a multifaceted approach.

We take this matter very seriously and intend to take all steps necessary to protect and defend the competitive position of U.S. businesses. At the same time, we intend to resolve this matter and honor our WTO obligations.

During last year's effort to develop legislation to respond to the prior WTO decision, the Administration, the Congress, and the business community worked together in a very effective partnership. We must continue that close and effective collaboration.

We look forward to consulting closely with the Congress and the business community as we move forward on this critically important matter.

The issue of fundamental reform of our international tax rules has been raised in connection with the WTO FSC case. While this case may be an impetus for consideration of such reforms, it is not, and should not be viewed as, the only impetus for such consideration. As I noted in my opening, re-examination of the international tax rules that have developed over the last 40 years is appropriate and timely given all the ways in which the world has changed in that period.

While the competitiveness of our international tax rules relative to those of other countries can and should be addressed through needed reforms, reform of our international tax system should be undertaken under our own terms and in our own time. We should not do this complex work under a schedule or parameters set by the WTO or the European Union.

One of the most comprehensive options for international tax reform would be to replace our current system of worldwide taxation with a territorial tax system.

In this regard, it is important to note that the differences between a worldwide-based tax system, like the U.S. system, and a territorial-based system are not as stark as they might be - all developed countries that use the territorial base as the starting point for their corporate tax systems also have provisions that tax certain categories of foreign-source income.

Half of OECD countries, including Canada, Germany, France, and the Netherlands, operate territorial tax systems under which dividends paid from active income earned by foreign subsidiaries and profits earned by foreign branches are exempt from domestic taxation. Passive income generally is taxed on a worldwide basis, with either a tax credit or deduction allowed for foreign withholding taxes imposed on such income.

The United States, like the United Kingdom, Japan, and the other half of all OECD countries, operates a worldwide system of income taxation under which domestic residents are taxed on income regardless of where it is earned. Relief from double taxation is provided through the foreign tax credit mechanism. But, our deferral and certain exemptions in the U.S. system, are examples of how we don't have a purely worldwide system.

Consideration of a possible move away from our current tax system and toward this type of system involves significant and complex issues:

• Design issues, such as what categories of income should be exempt and how to allocate expenses between categories of income;
• Impact on investment decisions;
• Issues of complexity;
• Impact on multinational businesses;
• Impact on federal tax revenues; and
• Politics.

Comprehensive reform of the international tax rules is an enormous and long-term project, which will require that the Administration, the Congress, and the business community work closely together.

As we begin work on consideration of fundamental reform of our tax system, we should not lose sight of the goal of reducing the complexity of our tax system. We can make some significant advances in this area in the near term.

There is much that can be done to reduce the complexity of our international tax rules. These rules are cited by businesses as one of the major sources of administrative complexity and compliance costs.

In the international area, the issue of simplification is not just a matter of reducing the number of lines in the Internal Revenue Code or eliminating some IRS forms, although those both would be worthwhile accomplishments. It is a matter of reducing the instances in which the tax law drives taxpayers to engage in transactions or steps that otherwise are unnecessary or non-economic.

The Joint Committee on Taxation's simplification study includes proposals in the international area that should be given serious consideration.

The international simplification and reform bills that are introduced each Congress on a bipartisan, bicameral basis also include important provisions that would help to reduce the complexity of the international tax rules.
Simplification provisions that should be explored further include:

• Narrowing the scope of subpart F to avoid inadvertently covering income that is neither passive nor mobile. The exception for active financial services income, which was enacted in 1997, was an important first step in this regard.
• Revisiting the expense allocation rules, particularly the interest allocation rules, to reduce the distortions that can arise in the application of the current law rules. In this regard, we recently issued a Notice requesting comments from taxpayers regarding the appropriateness of expanding the circumstances in which an integrated transaction or "netting" approach is used for purposes of the interest allocation rules.
• Rationalization of the various anti-deferral regimes - including subpart F, the PFIC provisions and the foreign personal holding company provisions - to eliminate the overlaps between regimes and to reduce the circumstances in which a taxpayer is subject to multiple regimes would be a significant advance in terms of simplification.

I have talked about the need to re-examine our international tax rules in light of the developments in the global economy. Before I close, let me touch briefly on an area of technological development that presents special challenges for the tax systems of the world.

E-commerce is still evolving and we have not yet seen its full impact on the way the world does business. We must anticipate its implications for our tax system so that we are not in a position of responding after the fact.

The global nature of e-commerce necessitates global consensus on the principles underlying any e-commerce taxation. In the absence of such consensus, stifling multiple taxation may result.

Our goal should be to ensure that e-commerce tax rules allow business decisions to be responsive to economic considerations and market conditions.

Thus we would be very concerned about any cross-border e-commerce tax rules or tax proposals that discriminate against e-commerce or that are so difficult to implement that they impose an unfair burden on e-commerce participants.

We would also be concerned about any efforts to implement a proposal in advance of international consensus and in advance of a technologically and commercially feasible implementation mechanism.

These issues have to be faced most immediately in the application of consumption taxes to e-commerce. We must also address the implications of e-commerce and other technological developments on income tax application and administration. The direct tax issues raised by e-commerce may not be as immediate as those regarding consumption taxes, but they may be more fundamental and ultimately more difficult to address. These issues include questions of both source and character of income arising from e-commerce, as well as issues regarding attribution of such income to a permanent establishment.

We are currently working within international organizations and bilaterally with our trading partners to ensure that any taxation of e-commerce is clear, consistent, neutral and non-discriminatory and to ensure that administration of any such taxation is simple and transparent.

And we will continue to consult actively with the business community to help ensure that the formulation of these tax rules is based on full knowledge of their effects and on full understanding of the underlying technologies.

Economic Stimulus

Before I close, let me comment for a moment on the Administration's efforts with respect to economic growth, both in the United States and globally. Senate Republicans were right to reject a bad spending bill that wasn't stimulative. Everyone - both Republicans and Democrats - knew that the partisan, big-spending approach taken by the Finance committee would not work on the Senate floor. It's a shame that the Senate had to waste valuable time in this unrealistic political exercise. Centrists have made a proposal that moves away from the big-spending approach. That's a welcome step toward bipartisanship. We are willing to work day and night with Finance committee and Ways and Means committee members to get a bipartisan package that is truly stimulative as soon as possible.

In addition to our efforts domestically, we are discussing with our major economic partners ways in which economic and financial policy reform can have a marked impact on global economic growth. The U.S. has identified a number of policies --liberalizing trade, improving educational opportunity, increasing capital mobility, encouraging labor market flexibility, and fiscal reforms--that could benefit all economies. In particular, reducing both high levels of non-productive government expenditure and distortionary taxes will help to increase the rate of real economic growth. Therefore, fiscal reforms can be expected to strengthen substantially economic performance.