FROM THE OFFICE OF PUBLIC AFFAIRS

I want to thank Gerry, Ed and the AICPA for inviting me to speak today.

Given that others already have discussed the "tax legislative outlook" such as it is, I thought I would exercise some license to look forward and examine the challenges that the tax system, and those fortunate enough to have some responsibility for it, will face in the coming years. Some of these challenges are caused by changes in the economy, such as globalization and e-commerce. Others involve concerns that must be addressed to preserve the tax base. And finally there are those that involve taking advantage of opportunities presented by budget surpluses to address areas of need in the system.

Much has changed since I entered the government 8-1/2 years ago. Globalization and information technologies have ushered in an economic transformation as profound as that of the Industrial Revolution of the 19th century. The scale of change is enormous, as are the potential benefits.

Trade barriers are falling, the market for capital is international, and access to information from around the world is instantaneous. As a result, economies are increasingly interdependent. As national borders become less relevant, business enterprises will be increasingly global in scale and mobile with regard to the location of their management and activities. But while capital, goods, and services increasingly move without regard to borders, national borders will continue to confine tax authorities.

The implications of this natural tension for tax policy are just beginning to be appreciated. We, at Treasury, are actively examining and responding to the challenges raised by the emerging global environment. The challenge is how to tax the activities of our citizens and residents on a neutral basis when their activities increasingly transcend our borders and thus are more difficult for us to discover and evaluate. I want to focus today on three areas in particular: harmful tax competition, tax arbitrage, and the challenges posed by the advent of electronic and information technology.

International tax competition occurs when one country provides a tax inducement to attract capital from another country. When practiced unfairly, tax competition can severely erode the capital tax base of the losing country. Harmful tax competition also distorts investment decisions and undermines fiscal stability. Eventually, this means that the losing country may have to make up the lost tax revenue through higher taxes on the income it still can get a hold of -- like income from labor. The most aggressive forms of harmful tax competition are practiced by countries we commonly think of as tax havens.

By tackling these practices, we should help businesses compete on a level playing field and help encourage investment growth and jobs. It also will play an important role in promoting the health of the global economy and global financial system.

With respect to tax havens, the United States has pursued a parallel track of advancing unilateral initiatives and working in multilateral forums such as the OECD. For example, our recent "QI" regulations, which streamline the procedures by which banks can verify the foreign residence of recipients of interest income from the United States, impose special, more rigorous requirements on banks based in tax havens. These requirements are geared to ensure that such banks have access to, and can provide information regarding, the beneficial owners of interest income. We also have opened a guidance project to consider the imposition of a withholding tax on portfolio interest paid to accounts or corporations in tax havens, even though such interest paid to nonresidents generally is exempt from U.S. withholding tax.

On a multilateral basis, we have taken an active role in the OECD's work in the area of harmful tax competition. The OECD's initiative to identify harmful tax regimes focuses on three narrowly defined counts:

• Lack of transparency,
• Lack of information exchange, or
• Discrimination between residents and nonresidents.

Because of these identification efforts, over thirty countries already have committed to eliminate their harmful tax practices and more are expected to do so in the near future.

The OECD's work is a first step to ensuring that policy objectives of member countries can be realized without the fear of an eroding tax base and other distortions that could undermine the benefits of the enhanced capital mobility in today's global economy. Non-member countries have much to gain from joining such an effort. For example, at a recent 60-nation conference on tax competition, delegates from developing countries noted that these harmful practices constitute a more severe threat to their countries than to that of developed countries, in part because tax base erosion can translate directly into increased poverty. These delegates warned that tax competition could contribute significantly to a backlash against globalization, already seen in many quarters as benefiting the developed world at the expense of the developing world. One of our primary interests in the OECD's initiative, which should be shared by the U.S. business community, is to eliminate harmful tax competition so it cannot be used as an argument against globalization.

A similar challenge to tax systems is the use of tax arbitrage. Tax arbitrage involves the exploitation of differences in the tax laws of two or more jurisdictions, resulting in the lowering of a taxpayer's worldwide tax liability by ensuring that income is not taxed anywhere.

Tax laws are written based upon certain assumptions, including the principle that income should not be subject to double taxation. In the cross-border context, this has been implemented through international conventions that have been widely adopted. For example, interest generally is deductible by the payor in the source country, but generally is included in income upon receipt by the investor in the country of residence. In this circumstance, the source country cedes primary taxing jurisdiction of the interest to the country of residence. Conversely, because dividends generally represent underlying earnings that have been subject to tax by the source country and are generally not deductible when paid, the country of residence of the recipient will generally cede primary taxing jurisdiction to the source country through an exemption or credit mechanism. In each instance, the ceding of primary taxing jurisdiction by one country is based on the assumption that the amount is more appropriately taxed in the other country.

If, however, both countries characterize a transaction differently, tax arbitrage can arise in which both countries cede taxing jurisdiction simultaneously and the income is not taxed by any jurisdiction. Countries may characterize a transaction differently because of a variety of reasons, including differences in rules with respect to ownership, entity characterization, instrument characterization, timing, or source.

Some would argue that arbitrage is not troubling because a transaction is characterized correctly under domestic tax rules. Under this view, as long as a transaction does not rise to the level of being a tax shelter, taxpayers should obtain the tax results as permitted by each individual jurisdiction's laws.

At Treasury, however, we believe that tax arbitrage is problematic for several policy reasons. By creating double non-taxation, tax arbitrage distorts economic behavior because taxpayers will tend to favor cross-border tax arbitrage transactions over domestic transactions or other types of cross-border transactions, thereby undermining the principle of neutrality. Furthermore, taxpayers who do not have access to arbitrage opportunities will have higher costs of operations and will thus be prejudiced because they will not have the benefit of such de facto subsidies. Taxpayers who do engage in tax arbitrage transactions tend to be the wealthy and well advised, because the nature of such transactions often require many resources and the expertise of tax advisors. Finally, as with harmful tax competition, governments may ultimately need to compensate for a shortfall in revenue by shifting the burden of tax to other constituents, such as to labor.

The advent of the electronic and information technology age also poses serious substantive and administrative challenges for the tax system. These include:

• Determining who has the jurisdiction to tax companies that are engaged in electronic commerce or otherwise make use of the Internet. For U.S. federal purposes, the issue involves, in the tax treaty context, the definition of the concepts "permanent establishment" and "income attributable to a permanent establishment," and, outside the treaty context, the definition of the concept "income effectively to a U.S. trade or business."
• Determining the source of income generated from electronic commerce. This determination can affect both the taxability of such income (i.e., jurisdiction to tax) and the availability of a foreign tax credit. For example, income from services is traditionally "sourced" according to where the services are performed, but determining geographic place of performance with respect to services provided over the Internet may be difficult.
• Determining the characterization of income from electronic commerce. This can affect both jurisdiction and source (and possibly rate of tax). For example, if income from the sale of downloaded software is characterized as a royalty one set of sourcing and jurisdiction rules will apply while if such income is characterized as income from the sale of a good or as from the provision of services, other rules would apply.
• Applying the anti-deferral rules, such as subpart F of the U.S. Internal Revenue Code, to companies engaged in electronic commerce or that otherwise make use of the Internet. Our subpart F study, which will be issued shortly, is looking at the extent to which these rules reflect the way business is done today. It also examines the extent to which the current rules are being circumvented.

In particular, we are looking at the extent to which the rules may need to change in light of new technologies, including new communications technologies and electronic commerce. With respect to services like Internet access, remote database access, remote order processing and video conferencing, new technologies may make it difficult to determine where the services are performed. Similarly, new technologies may make it difficult to determine the place of use, consumption or disposition with respect to electronically delivered products, such as music and computer software. To the extent the Subpart F rules rely on place of use, those rules may become increasingly difficult to apply.

Moreover, new technologies increase the ease with which employees of a CFC can be located outside the CFC's jurisdiction of incorporation and increase the ability of CFCs to acquire products and services remotely. This increases the opportunities for CFCs to be incorporated in low- or no-tax jurisdictions while they provide services to others located elsewhere.

• Identifying "taxing points" to impose tax with respect to e-commerce. In general, tax compliance is facilitated by identifying key "taxing points" in a transaction that may give rise to tax. One example would be the transfer of funds through a financial institution. Electronic commerce, however, often eliminates the need for intermediating institutions. Elimination of the traditional checkpoints, however, may make tax administration increasingly difficult.
• Verifying the identity and location of transactions occurring through a Web site. These transactions cannot be associated necessarily with a specific taxpayer, nor can the taxpayer's actual geographic location be easily ascertained. Moreover, while Web sites and e-mail addresses may be associated with specific individuals, the relationship of those addresses to the physical world is not fixed as they can be established and accessed from anywhere in the world where there is a computer linked to the Internet. Thus, even if tax authorities can track activities or income to a Web site or e-mail address, they may nevertheless not be able to identify the persons or persons behind the electronic front.
• Use of E-Mail. Internet messages, especially secure or encrypted transmissions, create opportunities for untraceable transfers of assets and other activities that will hinder audits of taxable activities.

Let me state a few guiding principles to meet these challenges:

• Any taxation of the Internet and electronic commerce should be clear, consistent, neutral and non-discriminatory. Neutrality and non-discrimination must be the fundamental principles that guide the development of tax rules with respect to electronic commerce. In addition, tax rules should be consistent across jurisdictions, to minimize the possibility of multiple or no taxation. The rules should be transparent and easy to administer.
• Close cooperation and mutual assistance are necessary between the U.S. and its trading partners to ensure effective tax administration and combat illegal activities on the Internet.
• 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.

Another challenge for the system is addressing the problem of "corporate tax shelters." These transactions are marketed to corporations eager for a positive impact on their financial statements from a substantial reduction in taxes. A significant feature of these transactions is that they have little or no business purpose or economic substance, other than the reduction of taxes, and thus, often involve the artificial shifting of income to foreign affiliates or accommodation parties who are free from U.S. tax. During my tenure at Treasury, a great deal of time and effort has been spent addressing specific tax shelters. I will not belabor the point here, having done so many times in the past. Suffice it to say that I believe the current ad hoc approach is insufficient and must give way to a more global approach that would:

• Require corporate taxpayers to disclose transactions that meet certain objective criteria;
• Strengthen penalties applicable to underpayments with respect to such transactions, particularly in the absence of disclosure;
• Elevate existing judicial doctrines; and
• Provide consequences to all the parties to a transaction (including promoters and foreign "accommodation" taxpayers).

As part of this effort, we still intend to complete our current project to update Circular 230. The current standards need to be modernized to address the current types of marketed transactions. We requested comments in May relating to factual due diligence standards, the extent to which judicial doctrines must be addressed, and whether a contingent fee may be charged. I expect this project to be completed shortly.

Financial products present all of the issues with which our current tax system is concerned, including: timing, matching, arbitrage, character, source, debt v. equity, principal v. interest, and entity classification.

Moreover, financial markets act and react faster than the tax guidance and legislative processes. Traditional tax rules that address the proper treatment of holders and issuers of financial instruments were developed decades ago.

These traditional rules generally depend on the "cubby-hole" in which a transaction is placed -- and that determination is too often based on form. Moreover, the rules applicable to instruments that are labeled differently are often mutually inconsistent. For example, there is often little economic difference between unsecured debt and certain types of preferred stock. A forward contract, a futures contract, and the combination of a written put and a purchased call may all produce the same exposure to changes in the price of some underlying position, but all have different tax consequences.

Many of the instruments traded on today's markets -- especially private markets -- may not comfortably fit under the current rules. Targeted rules designed to address the latest financial instrument fad soon become outdated and create a quilt work of patches that, at best, complicate the law and, at worst, present new opportunities to exploit.

Any deviation from the underlying economics of a transaction -- even a deviation that traditionally favored the Government -- can be leveraged today into a tax-reducing technique. The only effective governmental response is to tax a transaction according to its economics, but that goal often runs into practical or legal difficulties.

What is needed, therefore, is a fundamental reexamination of the taxation of financial instruments with the goal of making the rules more consistent and more economically sensitive. This process may demand significant departures from long-established fundamentals. What we need may be comprehensive rules and guidance that follow the economics of a transaction and treat similarly situated financial products and taxpayers equally.

When I started my career in government, people were preoccupied with -- and tax policy was captive to -- soaring budget deficits. Now, after two deficit reduction bills (in 1990 and 1993), nearly a decade of fiscal discipline, technological advancements, and what will soon be the longest economic expansion in history, we are running surpluses that are forecast to persist for nearly 50 years.

Before I explore tax policy priorities in a world of surpluses, let me state three important caveats. First, we must be careful not to fall prey to irrational exuberance. A fundamental question is how real are the projected surpluses. So far, we have experienced a surplus for just three years, compared with two decades of deficits. Exuberance may be premature for at least two reasons: (1) the extraordinary economic conditions that led to the surplus may not persist, and (2) surpluses in a political environment may tend to be self-correcting.

Second, we must consider other possible uses of the surplus outside the tax realm. The President would preserve the great bulk of the surpluses for Social Security, Medicare and debt reduction. Under the President's plan, the national debt would be eliminated by 2012. This has several long run benefits. Future taxes will be lower, the economy will be stronger, and the Social Security and Medicare guarantees so important to working people would be absolutely secured. It is also prudent, given the uncertainty of the long-run surplus projections.

Third, it is important to note that the need for revenue offsets is decreased in an era of surpluses. Concomitantly, policymakers' appetite for provisions that raise revenue, even if loophole closers, is diminished. This may make it more difficult to address certain types of structural concerns with the tax system.

That being said, I believe that budget surpluses provide compelling opportunities to make the tax system fairer and simpler, and to address serious long-run structural concerns. In the interest of time, I will discuss only one of them - the alternative minimum tax (AMT) problem. By this, I do not mean to suggest that other potential uses of the surpluses are not important. For example, I believe strongly that simplification should be a priority of the next decade. Hank Gutman, in his recent Woodworth address, suggested that the surplus might be used to craft a more global solution to the ever-present INDOPCO issue. This is a worthy, albeit difficult, goal.

Absent reform, the AMT will hit more and more middle income families. By 2010, 45 percent of families with two children will be subject to the AMT. Millions of taxpayers have to do complicated calculations to ascertain that they are not subject to the AMT. The 1999 provision to allow personal credits against the AMT alleviated this problem considerably, but it did not solve the threat of the AMT to large families. The AMT makes the income tax seem unfair and complex to many moderate-income people who are trying to play by the rules.

The AMT was originally intended to ensure that high-income taxpayers could not eliminate their income tax through extensive use of special tax breaks or "tax preferences." Because of design flaws, however, the AMT increasingly applies to middle-income taxpayers, particularly to families with children. The number of taxpayers subject to the AMT is expected to grow, if no change is made, from 1.3 million today to 17 million by 2010. This is due in part because, under current law, the AMT treats personal exemptions and the standard deduction as "preference items" in the same category as special tax breaks such as intangible drilling costs and tax shelter losses. Taxpayers subject to the AMT are denied these deductions. As a result, under current law, a couple with five children and $70,000 of income that claims the standard deduction would be subject to the AMT in 2000. The AMT was never intended to affect such families.

The Administration's proposal would address these design flaws in two ways. First, when fully phased in, the proposal would allow taxpayers to deduct all of their dependent exemptions against the AMT, thereby ensuring that no taxpayers would become subject to the AMT simply because they claim personal exemption deductions for their children. This would reduce the number of taxpayers subject to the AMT in 2010 by more than half to 7.6 million. Second, the proposal would allow taxpayers to claim the standard deduction for AMT purposes in 2000 and 2001. This proposal is a continuation of the Administration's efforts to provide relief from the AMT for middle-income taxpayers in a fiscally responsible manner.

In closing, I want to stress the importance of continued involvement by all of you in meeting these important challenges. The AICPA historically has been an active participant in commenting on legislation and regulations. With the rapid pace of change in our economy, we will need to rely even more heavily on you, and other similar groups, for your help and guidance. Thank you for the opportunity to be here.

I would be happy to take a few questions.