FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Congressman McNulty, and distinguished Members of the Subcommittee, I appreciate the opportunity to appear today at this hearing focusing on international tax policy and competitiveness issues. The issues that the Subcommittee has explored in this series of hearings on the recent WTO decision regarding the U.S. extraterritorial income exclusion provisions are critically important as we work toward meaningful changes in our tax rules that will protect the competitive position of American businesses and workers and honor our WTO obligations.

The pace of technological advancement around the world is awe inspiring. Computer processing abilities are expanding at exponential rates, roughly doubling every year or two. Innovations in pharmaceuticals and biotechnology are providing breakthroughs in treating disease, permitting dramatic improvements in the quality of life. Today, the keys to production in even basic commodity industries like oil, paper, and steel are found in better knowledge and innovation: the ability to produce more with less waste.

The concern facing this Subcommittee today is that our tax code has not kept pace with the changes in our real economy. International tax policy remains rooted in tax principles developed in the 1950s and 1960s. That was a time when America’s foreign direct investment was preeminent abroad and competition from imports to the United States was scant. Today, we have a truly global economy, in terms of both trade and investment. The value of goods traded to and from the United States increased more than three times faster than GDP between 1960 and 2000, rising to more than 20 percent of GDP. The flow of cross-border investment, both inflows and outflows, rose from a scant 1.1 percent of GDP in 1960 to 15.9 percent of GDP in 2000.

The globalization of the world economy has provided tremendous benefits to consumers and workers. Those who can build a better mousetrap now can sell it to the world. The potential for a world market encourages companies to invest in research that leads to continuous innovation. At one time, the strength of America’s economy was thought to be tied to its abundant natural resources. Today, America’s strength is its ability to innovate: to create new technologies and to react faster and smarter to the commercialization of these technologies. America’s preeminent resource today is its knowledge base.

A feature of a knowledge-driven economy is that unlike physical capital, technological know-how can be applied across the world without reducing the productive capacity of the United States. For example, computer software designed to enhance the efficiency of a manufacturing process may require substantial investment, but once developed it can be employed around the world without diminishing the benefits of the know-how within the United States. Foreign direct investment by companies in a knowledge-driven economy provides opportunities to export this know-how at low cost and incentives to undertake greater domestic investment in developing these sources of competitive advantage.

There are many reasons to believe that the principles that guided tax policy adequately in the past should be reconsidered in today’s highly competitive, knowledge-driven economy. In this regard, it is significant that the U.S. tax system differs in fundamental ways from those of our major trading partners. In order to ensure the ability of U.S. workers to achieve higher living standards, we must ensure that the U.S. tax law does not operate to hinder the ability of the U.S. businesses that employ those workers to compete on a global scale.

There are several different ways in which tax policy can affect the ability of firms to compete. It may be helpful to consider the ways in which commercial operations based in different countries compete in the global marketplace.

Competition may be among:

• U.S.-managed firms that produce within the United States;

• U.S.-managed firms that produce abroad;

• Foreign-managed firms that produce within the United States;

• Foreign-managed firms that produce abroad within the foreign country in which they are headquartered; and

• Foreign-managed firms that produce abroad within a foreign country different from the one in which they are headquartered.

These entities may be simultaneously competing for sales within the United States, within a foreign country against local foreign production (either U.S., local, or other foreign managed), or within a foreign country against non-local production. Globalization requires that U.S. companies be competitive both in foreign markets and at home.

Other elements of competition among firms exist at the investor level: U.S.-managed firms may have foreign investors and foreign-managed firms may have U.S. investors. Portfolio investment accounts for approximately two-thirds of U.S. investment abroad and a similar fraction of foreign investment in the United States. Firms compete in global capital markets as well as global consumer markets.

In a world without taxes, competition among these different firms and different markets would be determined by production costs. In a world with taxes, however, where countries make different determinations with respect to tax rates and tax bases, these competitive decisions inevitably are affected by taxes. Assuming other countries make sovereign decisions on how to establish their own tax systems and tax rates, it simply is not possible for the United States to establish a tax system that restores the same competitive decisions that would have existed in a world without taxes.

The United States can, for example, attempt to equalize the taxation of income earned by U.S. companies from their U.S. exports to that of U.S. companies producing abroad for the same foreign market. However, in equalizing this tax burden, it may be the case that the U.S. tax imposed results in neither type of U.S. company being competitive against a foreign-based multinational producing for sale in this foreign market.

The manner in which balance is achieved among these competitive concerns changes over time as circumstances change. For example, as foreign multinationals have increased in their worldwide position, the likelihood of a U.S. multinational company competing against a foreign multinational in a foreign market has increased relative to the likelihood of U.S. export sales competing against sales from a U.S. multinational producing abroad. The desire to restore competitive decisions to those that would occur in the absence of taxation therefore may place greater weight today on U.S. taxes not impeding the competitive position of U.S. multinationals vis-à-vis foreign multinationals in the global marketplace. Similarly, while at one time U.S. foreign production may have been thought to be largely substitutable with U.S. domestic production for export, today it is understood that foreign production may provide the opportunity for the export of firm-specific know-how and domestic exports may be enhanced by the establishment of foreign production facilities through supply linkages and service arrangements.

Given the significance today of competitiveness concerns, it is important to understand the major features of the U.S. tax system and how they differ from those of our major trading partners. The primary features of the U.S. tax system considered here are: (i) the taxation of worldwide income; (ii) the current taxation of certain types of active foreign-source income; (iii) the limitations placed on the use of foreign tax credits; and (iv) the unintegrated taxation of corporate income at both the entity level and the individual level.

The United States, like about half of the OECD countries, including the United Kingdom and Japan, operates a worldwide system of income taxation. Under this worldwide approach, U.S. citizens and residents, including U.S. corporations, are taxed on all their income, regardless of where it is earned. Income earned from foreign sources potentially is subject to taxation both by the country where the income is earned, the country of source, and by the United States, the country of residence. To provide relief from this potential double taxation, the United States allows taxpayers a foreign tax credit that reduces the U.S. tax on foreign-source income by the amount of foreign income and withholding taxes paid on such income. As discussed below, detailed rules apply to limit the foreign tax credit. A U.S. corporation generally is subject to U.S. tax on the active earnings of a foreign subsidiary if and when such income is repatriated as a dividend. However, the U.S. parent is subject to current U.S. tax on certain income earned by a foreign subsidiary, without regard to whether that income is distributed to the U.S. parent. As discussed further below, while these current taxation rules are focused on passive, investment-type income earned by a foreign subsidiary, their reach extends to active business income in certain cases.

The U.S. worldwide system of taxation is in contrast to the territorial tax systems operated by the other half of the OECD countries, including Canada, Germany, France, and the Netherlands. Under these territorial tax systems, domestic residents and corporations generally are subject to tax only on their income from domestic sources. A domestic business is not subject to domestic taxation on the active income earned abroad by a foreign branch or on dividends paid from active income earned by a foreign subsidiary. A domestic corporation generally is subject to tax on other investment-type income, such as royalties, rent, interest, and portfolio dividends, without regard to where such income is earned; because this passive income is taxed on a worldwide basis, relief from double taxation generally is provided through either a foreign tax credit or a deduction allowed for foreign taxes imposed on such income. This type of territorial tax system sometimes is referred to as a "dividend exemption" system because active foreign business income repatriated in the form of a dividend is exempt from taxation. By contrast, a pure territorial system would provide an exemption for all income received from foreign sources, including passive income such as royalties, rent, interest, and portfolio dividends. Such pure territorial systems have existed only in a few developing countries.

Differences between a worldwide tax system and a territorial system can affect the ability of U.S.-based multinationals to compete for sales in foreign markets against foreign-based multinationals. Under a worldwide tax system, repatriated foreign income is taxed at the higher of the source country rate or the residence country rate. In contrast, foreign income under a territorial tax system is subject to tax at the source country rate.

Consider a U.S.-based company and a foreign-based company established in a country with a territorial tax system. Each company is considering investment in a new foreign subsidiary to establish a manufacturing operation for the local foreign market. The effect of the worldwide system on this form of competition depends on the relationship of the foreign rate of tax on corporate income to that of the United States.

Let us first assume that the effective tax rate on corporate income of this foreign country is lower than the effective U.S.-tax rate on corporate income (because the foreign country has a lower statutory rate on corporate income or because it has investment incentives such as accelerated depreciation). If the foreign subsidiary of the U.S.-based company repatriates on a current basis its economic profits to its U.S. parent, it will effectively be subject to the higher U.S. tax rate on its income. The foreign subsidiary of the company established in the territorial country, however, will be subject to the lower foreign rate of tax. If the U.S. company cannot garner sufficient efficiency advantages relative to its foreign competitor, it will be unable to compete since it must sell its product in this market at prices competitive with that of its foreign competition.

An alternative outcome results if the foreign country in which the foreign investment is being considered has a higher effective corporate tax rate than the United States. In this case, the U.S. parent is not disadvantaged relative to the company established in a country with a territorial tax system. Income earned by the U.S.-owned foreign subsidiary will be subject to tax at only the source country tax rate, the same result as under a territorial system.

The foregoing examples assumed that the U.S. parent company had no other foreign-source income. The presence of other foreign-source income can affect the rate of tax paid on additional foreign-source income under U.S. tax rules because credits for taxes paid to one foreign country can effectively be pooled with credits for taxes paid to another foreign country.

Consider for example the case of a U.S. parent that has other foreign-source income that is taxed at foreign rates higher than the U.S. tax rate. In this case, the U.S. parent will have excess foreign tax credits before considering its decision to invest in a new foreign subsidiary. If the U.S. parent is considering establishing its new foreign subsidiary in a country with a tax rate lower than the U.S. rate, these excess credits generally may be used to offset the additional U.S. tax that would be levied on the income of this new investment. The presence of excess foreign tax credits thus reduces the tax burden imposed by the United States on income from the new lower-taxed foreign location. As a result, a U.S. parent in this position will be relatively less disadvantaged by the U.S. tax system. If it has sufficient excess foreign tax credits, the U.S. parent can offset all of its U.S. corporate tax on the income from the new investment and its tax burden will be just the taxes paid in the foreign country -- the same result as under a territorial system.

A different competitive result occurs when the U.S. parent has other foreign-source income that is taxed at foreign rates lower than the U.S. tax rate. In such a case the U.S. tax rate is the effective tax rate on such foreign income. If the U.S. parent is now considering establishing its new foreign subsidiary in a country with a tax rate higher than the U.S. rate, the income earned from this new investment will generate excess foreign tax credits that can offset the additional U.S. tax paid on its preexisting foreign-source income. As a result, in this case the U.S. parent receives a tax advantage from making the new investment in the high-tax country relative to the treatment of such investment under a territorial system.

These examples illustrate that the use by the United States of a worldwide tax system may disadvantage the competitiveness of U.S. foreign direct investment in countries with effective corporate tax rates below those of the United States. The use of a worldwide tax system does not disadvantage investment in countries with effective corporate tax rates above those of the United States, and in some instances may actually result in more favorable treatment for incremental U.S. investment relative to investment from companies headquartered in territorial countries. Of course, these results are based just on the distinction between a territorial and worldwide tax system, and ignore other key features of the U.S. tax system.

The complexities present in taxing income generally are heightened in determining the taxation of income from multinational activities, where in addition to measuring the income one must determine its source (foreign or domestic). This complexity affects both tax administrators and taxpayers. Indeed, the U.S. international tax rules have been identified as one of the largest sources of complexity facing U.S. corporate taxpayers.

The distinction in the treatment under a territorial tax system of foreign-source income relative to domestic-source income puts particular pressure on the determination of the source of items of income and expense. While classification of income as foreign source is important under a worldwide tax system because it determines availability of foreign tax credits, in a territorial system classification as foreign-source income gives rise to an exemption from tax. Similarly, under a territorial tax system, expenses allocable to foreign-source income would not be deductible for tax purposes while expenses so allocated in a worldwide tax system would reduce the availability of foreign tax credits.

Under most territorial systems, certain investment-type income is subject to tax without regard to where that income is earned. This raises the further issue of classification of income as subject to tax under this exception from the generally applicable territorial principles. Moreover, to the extent that this income is eligible for a foreign tax credit, the computational steps that are required to determine the amount of foreign-source income for purposes of applying foreign tax credit rules in a worldwide tax system would be built into the territorial system as well.

Given the complexity of the task of taxing multinational income under a worldwide or territorial system on top of the general complexity of the income tax system, some consideration might be given to alternative tax bases other than income. Other OECD countries typically rely on taxes on goods and services, such as under a value added tax, for a substantial share of tax revenues. In the European OECD countries, for example, these taxes raise nearly five times the amount of revenue as does the U.S. corporate income tax as a share of GDP.

As described above, about half of the OECD countries employ a worldwide tax system as does the United States. However, even limiting comparison of competition among multinational companies established in countries using a worldwide tax system, U.S. multinationals may be disadvantaged when competing abroad. This is because the United States employs a worldwide tax system that, unlike other worldwide systems, may tax active forms of business income earned abroad before it has been repatriated and may more strictly limit the use of the foreign tax credits that prevent double taxation of income earned abroad.

Under the U.S. international tax rules, income earned abroad by a foreign subsidiary generally is subject to U.S. tax at the U.S. parent corporation level only when such income is distributed by the foreign subsidiary to the U.S. parent in the form of a dividend. An exception to this general rule is provided with the rules of subpart F of the Code, under which a U.S. parent is subject to current U.S. tax on certain income of its foreign subsidiaries, without regard to whether that income is actually distributed to the U.S. parent. The focus of the subpart F rules is on passive, investment-type income that is earned abroad through a foreign subsidiary. However, the reach of the subpart F rules extends well beyond passive income to encompass some forms of income from active foreign business operations. No other country has rules for the immediate taxation of foreign-source income that are comparable to the U.S. rules in terms of breadth and complexity.

Several categories of active business income are covered by the subpart F rules. Under subpart F, a U.S. parent company is subject to current U.S. tax on income earned by a foreign subsidiary from certain sales transactions. Accordingly, a U.S. company that uses a centralized foreign distribution company to handle sales of its products in foreign markets is subject to current U.S. tax on the income earned abroad by that foreign distribution subsidiary. In contrast, a local competitor making sales in that market is subject only to the tax imposed by that country. Moreover, a foreign competitor that similarly uses a centralized distribution company to make sales into the same markets also generally will be subject only to the tax imposed by the local country. While this subpart F rule may operate in part as a "backstop" to the transfer pricing rules that require arms’ length prices for intercompany sales, this rule has the effect of imposing current U.S. tax on income from active marketing operations abroad. U.S. companies that centralize their foreign distribution facilities therefore face a tax penalty not imposed on their foreign competitors.

The subpart F rules also impose current U.S. taxation on income from certain services transactions performed abroad. In addition, a U.S. company with a foreign subsidiary engaged in shipping activities or in certain oil-related activities, such as transportation of oil from the source to the consumer, will be subject to current U.S. tax on the income earned abroad from such activities. In contrast, a foreign competitor engaged in the same activities generally will not be subject to current home-country tax on its income from these activities. While the purpose of these rules is to differentiate passive or mobile income from active business income, they operate to subject to current tax some classes of income arising from active business operations structured and located in a particular country for business reasons wholly unrelated to tax considerations.

Under the worldwide system of taxation, income earned abroad potentially is subject to tax in two countries – the taxpayer’s country of residence and the country where the income was earned. Relief from this potential double taxation is provided through the mechanism of a foreign tax credit, under which the tax that otherwise would be imposed by the country of residence may be offset by tax imposed by the source country. The United States allows U.S. taxpayers a foreign tax credit for taxes paid on income earned outside the United States.

The foreign tax credit may be used only to offset U.S. tax on foreign-source income and not to offset U.S. tax on U.S.-source income. The rules for determining and applying this limitation are detailed and complex and can have the effect of subjecting U.S.-based companies to double taxation on their income earned abroad. The current U.S. foreign tax credit regime also requires that the rules be applied separately to separate categories or "baskets" of income. Foreign taxes paid with respect to income in a particular category may be used only to offset the U.S. tax on income from that same category. Computations of foreign and domestic source income, allocable expenses, and foreign taxes paid must be made separately for each of these separate foreign tax credit baskets, further adding to the complexity of the system.

The application of the foreign tax credit limitation to ensure that foreign taxes paid offset only the U.S. tax on foreign-source income requires a determination of net foreign-source income for U.S. tax purposes. For this purpose, foreign-source income is reduced by U.S. expenses that are allocated to such income. Under the current rules, interest expense of a U.S. affiliated group is allocated between U.S. and foreign-source income based on the group’s total U.S. and foreign assets. The stock of foreign subsidiaries is taken into account for this purpose as a foreign asset (without regard to the debt and interest expense of the foreign subsidiary). These rules thus treat interest expense of a U.S. parent as relating to its foreign subsidiaries even where those subsidiaries are equally or more leveraged than the U.S. parent. This over-allocation of interest expense to foreign income inappropriately reduces the foreign tax credit limitation because it understates foreign income. The effect can be to subject U.S. companies to double taxation. Other countries do not have expense allocation rules that are nearly as extensive as ours.

Under the current U.S. rules, if a U.S. company has an overall foreign loss in a particular taxable year, that loss reduces the company’s total income and therefore reduces its U.S. tax liability for the year. Special overall foreign loss rules apply to recharacterize foreign-source income earned in subsequent years as U.S.-source income until the entire overall foreign loss from the prior year is recaptured. This recharacterization has the effect of limiting the U.S. company’s ability to claim foreign tax credits in those subsequent years. No comparable recharacterization rules apply in the case of an overall domestic loss. However, a net loss in the United States would offset income earned from foreign operations, income on which foreign taxes have been paid. The net U.S. loss thus would reduce the U.S. company’s ability to claim foreign tax credits for those foreign taxes paid. This gives rise to the potential for double taxation when the U.S. company’s business cycle for its U.S. operations does not match the business cycle for its foreign operations.

These rules can have the effect of denying U.S.-based companies the full ability to credit foreign taxes paid on income earned abroad against the U.S. tax liability with respect to that income and therefore can result in the imposition of the double taxation that the foreign tax credit rules are intended to eliminate.

While concern about the effects of the U.S. tax system on international competitiveness may focus on the tax treatment of foreign-source income, competitiveness issues arise in very much the same way in terms of the general manner in which corporate income is subject to tax in the United States.

One aspect of the U.S. tax system is that the income from an equity-financed investment in the corporate sector is taxed twice. Equity income, or profit, is taxed first under the corporate income tax. Profit is taxed again under the individual income tax when received by the shareholder as a dividend or as a capital gain on the appreciation of corporate shares. In contrast, most other OECD countries offer some form of integration, under which corporate tax payments are either partially or fully taken into consideration when assessing shareholder taxes on this income, eliminating or reducing the double tax on corporate profits.

The non-integration of corporate and individual tax payments on corporate income applies equally to domestically earned income or foreign-source income of a U.S. company. This double tax increases the "hurdle" rate, or the minimum rate of return required on a prospective investment. In order to yield a given after-tax return to an individual investor, the pre-tax return must be sufficiently high to offset both the corporate level and individual level taxes paid on this return.

Whether competing at home against foreign imports or competing abroad through exports from the United States or through foreign production, the double tax makes it less likely that the U.S. company can compete successfully against a foreign competitor.

An example may help to clarify matters. Suppose that a corporation earns $100 of pre-tax profit. Consider the tax burden imposed by the present U.S. tax system. On its $100 profit, the corporation must pay corporate income tax of $35 assuming a 35 percent corporate tax rate, leaving $65 to be distributed to shareholders or reinvested in the firm. If the money is distributed as a dividend, shareholders also must pay tax under the individual income tax. If shareholders are subject to an average tax rate of 20 percent, they pay tax of $13, leaving them $52 of after-tax income. In this example, the $100 profit is taxed twice – $35 in tax payments are collected under the corporate income tax and an additional $13 are collected under the individual income tax. In total, the tax system collects $48 in tax and so imposes a 48 percent "effective" tax rate on corporate profits distributed as dividends.

Now consider how integration reduces the tax burden on income from corporate equity. Full integration of the partnership type eliminates the corporate income tax and imputes the $100 of pre-tax profit directly to the shareholders, where it is taxed at the shareholders’ 20 percent tax rate under the individual income tax. Full integration reduces the total tax on $100 in profits from $48 under present law to $20. A simple form of partial integration is a dividend exclusion, which exempts dividends from the shareholders’ taxable income. A dividend exclusion reduces the total tax burden to $35, entirely paid under the corporation income tax.

Because the unintegrated tax system results in a higher effective tax rate on income earned in the corporate sector, it is more difficult for a given investment to achieve a desired after-tax return (after both corporate and individual taxes are paid) than in an integrated tax system. As a result, projects that could attract equity capital in an integrated tax system may not be sufficiently profitable to attract equity capital in the present unintegrated system. In the context of competitiveness, this may mean that a project that would otherwise be undertaken by a U.S. company, either at home or abroad, is instead undertaken by a foreign competitor.

As noted above, most OECD countries offer some form of tax relief for corporate profits. This integration typically is provided by reducing personal income tax payments on corporate distributions rather than by reducing corporate level tax payments. International comparisons of corporate tax burdens, however, sometimes fail to account for differences in integration across countries and consider only corporate level tax payments. To be meaningful, comparisons between the total tax burden faced on corporate investments by U.S. companies and those of foreign multinational companies must take into account the total tax burden on corporate profits at both the corporate and individual levels.

Both the increase in foreign acquisitions of U.S. multinationals and the recent corporate inversion activity are evidence that the potential competitive disadvantage created by our international tax rules is a serious issue with significant consequences for U.S. businesses and the U.S. economy. The urgency of this issue is further heightened by the recent WTO decision against our extraterritorial income exclusion provisions and the need to respond promptly to that decision to come into compliance with the WTO rules.

A reexamination of the U.S. international tax rules is needed. It is appropriate to question the fundamental assumptions underlying the current system. We should look to the experiences of other countries and the choices that they have been made in designing their international tax systems. Consideration should be given to fundamental reform of the U.S. international tax rules. Consideration also should be given to significant reforms within the context of our current system.

The many layers of rules in our current system arise in large measure because of the difficulties inherent in satisfactorily defining and capturing income for tax purposes, particularly in the case of activities and investments that cross jurisdictional boundaries. However, the complexity of our tax law itself imposes a significant burden on U.S. companies. Therefore, we also must work to simplify our international tax rules.