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

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Presentation to president s advisory panel on federal tax reform l.jpg

Presentation to President’s Advisory Panel on Federal Tax Reform

International Provisions of the Internal Revenue CodeMarch 31, 2005

Willard Taylor

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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

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What’s different?

  • Witnesses on other subjects have spoken about the complexity and other problems of the Code

  • What’s different in the case of “outward” investment from the US?

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What’s different? – cont’d

  • First, the growth of international trade and investment have made the US tax rules much more important than when they took shape in 1962

    • A creditor nation and a modest exporter of capital in 1962, the US is now a large capital exporter and importer and also the world’s largest debtor nation

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What’s different? – cont’d

  • Second, the different rhetoric and values that drive the debate on the taxation of foreign income

    • Not about fairness to US individuals and domestic economic efficiency, but

    • rightly or wrongly, framed as a choice between “capital export” and “capital import” neutrality* (and sometimes “national neutrality”**)

      *Essentially, which country (residence or source) has the first claim to tax

      **Foreign taxes treated as an operating expense, not a tax credit

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What’s different? – cont’d

  • Third, the probable inability to achieve the goal of any system for taxing foreign income without some international con-sensus on the choice and on rates of tax, at least among major trading partners

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What’s different? – cont’d

  • The capital export/import neutrality debate

    • Invokes issues of national competitiveness and world economic welfare

  • There are other systems in the world for taxing foreign income  such as a “territorial” (or exemption) system

    • In a pure territorial or exemption system, foreign income of domestic taxpayers is simply not taxed and no foreign tax credit is allowed

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What’s different? – cont’d

  • But choosing a different system would not

    • solve the complexity and other problems discussed hereafter or

    • significantly change the terms of the debate

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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

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Where are we today? – cont’d

  • Remarkably, no consensus on the economic consequences of what we now have –

    • Does it or does it not makeUS-owned businesses less competitive than foreign-owned businesses?

    • Hard to believe that the present complexity does not make US business less competitive than it could be in the absence of the complexity

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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

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Evolution of Code provisions on “outward” investment – cont’d

  • Because of a concern that the 1954 Code unfairly favored foreign investment by US persons over domestic investment,

    • The 1962 Act limited the deferral of US tax on un-repatriated earnings of foreign subsidiaries

    • These limitations were expanded in the 1975, 1976 and 1986 Acts

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Evolution of Code provisions on “outward” investment – cont’d

  • Because of a concern that the foreign tax credit permitted the use of foreign taxes on one class of income against US tax on another,

    • The 1962 Act created a separate foreign tax credit “basket” for passive interest income – taxes on income in that basket could not be used against US tax on other income

    • More “baskets” were added in the 1975, 1976, 1984 and 1986 Acts

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Evolution of Code provisions on “outward” investment – cont’d

  • Since the foreign tax credit is limited to the US tax on foreign source taxable income, the foreign tax credit rules require an allocation of expenses

    • Including, with modifications in 2004, interest expense incurred by US corporations

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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

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Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d

  • What were the sources of complexity resulting from the limitation on deferral?

    • Host of special rules for

      • Business rents and royalties

      • Income from sales or services outside of the foreign subsidiary’s country of incorporation

      • In-country related party dividends, interest, rents and royalties

      • Income from notional principal contracts

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Evolution of Code provisions on “outward” investment – Sources of complexity – cont’d

  • What were the sources of complexity in the foreign tax credit changes?

    • Growth in separate “baskets”

      • Passive interest income – 1962

      • Some dividend income – 1984

      • Foreign oil related income – 1975

      • All passive income – 1986

      • High withholding tax interest – 1986

      • Financial services income – 1986

      • Shipping and aircraft income – 1986

      • Dividends from certain non-controlled foreign corporations – 1986

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Evolution of Code provisions on “outward” investment – Sources of complexity –cont’d

  • What were the sources of complexity in the foreign tax credit changes?

    • In the “basket” system

      • The need to identify taxes on specific types of income

      • To separately allocate expenses to that income

      • To do this for taxes paid and expenses incurred through tiers of entities

      • To relate these calculations to income eligible/not eligible for deferral

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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

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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

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Other developments – the check-the-box regulations

  • One specific set of regulations deserves a comment -- the check-the-box regulations

    • Provided the ability, for 1997 and later years, to choose whether an entity would for tax purposes be a corporation, a branch or a partnership

    • A revolution for foreign operations of US taxpayers

      • Simplified the task of reporting foreign income, but

      • Allowed the use of “hybrid”* branches to undercut the anti-deferral rules

        *An entity treated as a corporation for purposes of the foreign country’s tax law but not for US tax purposes

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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

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“Inward” Investment

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Evolution of Code provisions on “inward” investment

  • Rules on “inward” investment – i.e., US invest-ment by foreign persons

    • Big change in US position since 1954 – now a major importer of capital and the world’s largest debtor nation

    • Inward investment rules

      • Do not reflect the debate on capital import/export neutrality

      • Generally, lack a political constituency for reform

      • Have remained more constant than the outward investment rules, taking (again) the 1954 Code as a starting point

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Evolution of Code provisions on “inward” investment – cont’d

  • In 1954, and for many years prior thereto, the rules for taxing inward investment consisted of

    • A flat 30% tax, collected by withholding at source, on US “source” dividends, interest, royalties and like income of a foreign person that did not otherwise carry on business in the US

    • Tax at the regular individual or corporate rate on the US business income of foreign persons – that is, on income that was “effectively connected” with a US business

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Evolution of Code provisions on “inward” investment – cont’d

  • There was (and is) the rule that requires taxable income from transactions between commonly-controlled corporations to reflect arm’s length dealings*

    • Of great importance, because “inward” invest-ment typically is through foreign-owned US subsidiaries

    • Apart from the statutory “earnings stripping” rules, arm’s length pricing is the main rule that protects the US tax base from mispricing between US subsidiaries and their foreign affiliates

      *Section 482 of the Code

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“Inward” investment – What are the problems? – cont’d

  • What are the problems in the US taxation of inward investment?

    • Complexity – although possibly not to the same extent as for outward investment

    • Specific rules that are neither administrable nor, as a practical matter, are in fact administered

    • Other rules that are out of date – e.g., they turn on physical presence in the US and the “source” of income

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Conclusions

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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

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Are there solutions? – cont’d

  • Like the system we now have, a territorial (or exemption) system would have to

    • Classify income as foreign or domestic

    • Distinguish between passive and active business income

      • Address how passive (or non-exempt) income will be treated (e.g., no deferral and a foreign tax credit?)

    • Distinguish between partially and wholly-US owned foreign corporations

    • Allocate expenses between foreign and domestic, and passive and active business, income

    • Enforce arm’s length pricing among affiliates

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Are there solutions? – cont’d

  • A territorial system would also have to

    • Address foreign branches of US corporations

    • Possibly distinguish between “good” and bad” foreign tax systems (and systems that are someplace in between)

    • Deal with the transition from the existing to the new system (e.g., what happens to untaxed retained earnings?)

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Are there solutions? – cont’d

  • Simplification is not possible without

    • In the case of outward investment, a serious compromise between proponents of capital export and capital import neutrality

    • In the case of inward and outward investment, a serious intent to simplify for that reason alone

  • Need also to consider tax treaties and the desirability of international consensus

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Appendix 1

Evolution of Code provisions on “outward” investment

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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

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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

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1954 Code – cont’d

  • Earnings of US-owned foreign corporations were not taxed until repatriated*

    • Further, certain branches of US corporations could elect to be treated as foreign corporations

  • There was (and is) a general rule that taxable income from transactions between commonly controlled corporations, whether US or foreign, must reflect arm’s length terms**

    *Other than passive income of foreign personal holding companies

    **In Section 482 of the Code

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1954 Code – cont’d

  • “Special” provisions were essentially limited to Western Hemisphere Trade, China Trade Act and “possessions” corporations

    • In effect, subsidies for operations in specific geographic areas

  • The basic rules had been unchanged for many years

    • In origin, the rules did not respond to any stated theoretical view – i.e., were not in response to any capital export/import neutrality debate

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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

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Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

  • Got instead an end to deferral for so-called “subpart F” income with back-up rules which treated

    • untaxed earnings of a controlled foreign corporation as repatriated if used to make “investments in United States property”, and

    • gain from the sale of stock of a controlled foreign corporation as a dividend to the extent attributable to retained earnings

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Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

  • Thus, a combination of capital export and capital import neutrality

    • Set the framework for the debate in the next 50-plus years about which system was the “better” one

    • Also put the Code distinctly on the path to complexity

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Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

  • What were the sources of complexity resulting from the limitation on deferral?

    • Income of foreign subsidiaries that was not eligible for deferral had to be put in categories –

      • Foreign personal holding company income

      • Foreign base company sales and services income

      • Income from insurance

      • Oil related income

      • Shipping and aircraft income

      • A host of special rules for

        • business rents and royalties

        • income from sales or services outside of the foreign subsidiary’s country of incorporation

        • income from a banking, financing or similar business

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Evolution of Code provisions on “outward” investment – the 1962 Act – cont’d

  • The 1962 Act also introduced a separate foreign tax credit “basket” for foreign taxes on passive interest income

    • Idea was that the foreign tax credit limitation – which limits the credit to the US tax on foreign source taxable income – ought to be applied separately to each “basket” of income

      • so that taxes on one basket of income could not be used to offset US tax on another basket of income

      • or, colloquially, no “cross-crediting”

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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

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Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d

  • What were the sources of complexity in the 1975-1986 tax legislation?

    • The further expansion of the categories of subpart F income to include, e.g.,

      • A much broader class of insurance income

      • Banking, financing and similar income

      • Foreign oil related income

      • Commodities income

      • Shipping income

      • Foreign exchange gain

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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

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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

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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

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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

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Evolution of Code provisions on “outward” investment – the 1986 Act – cont’d

  • The 1986 Act also rewrote the rules for determining foreign source taxable income, and thus the allowable foreign tax credit

    • Required an allocation of domestically-incurred interest expense to determine foreign source taxable income

      • Dramatically affected the foreign tax credit limitation

      • The allocation reduced foreign source income by an expense that was not deductible in the foreign country

    • Provided statutory rules (replacing 1977 regulations) for the apportionment of R & D expenses

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Evolution of Code provisions on “outward” investment – 1986 Act – cont’d

  • 1986 Act expanded Subpart F to include income from

    • insurance outside of the foreign corporation’s country of incorporation

    • sales of property that did not produce active income

    • commodities transactions

    • foreign currency transactions

    • a banking or similar business

    • shipping, even though reinvested

  • In 1988, the insurance rules were amended again to apply subpart F to “related party insurance income” of a foreign insurance company owned to the extent of 25% or more by US shareholders

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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

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Evolution of Code provisions on “outward” investment – Regulations – cont’d

  • 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 arm’s 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

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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

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Other developments – the check-the-box regulations – cont’d

  • 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 country’s tax law but not for US tax purposes

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Other developments – the check-the-box regulations – cont’d

  • 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 country’s tax law

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Evolution of Code provisions on “outward” investment – cont’d

  • 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

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Evolution of Code provisions on “outward” investment – cont’d

  • 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

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Evolution of Code provisions on “outward” investment – cont’d

  • 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

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Evolution of Code provisions on “outward”investment – 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

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Evolution of Code provisions on “outward” invest-ment – American Jobs Creation Act of 2004 – cont’d

  • 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

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Evolution of Code provisions on “outward” invest-ment – American Jobs Creation Act of 2004 – cont’d

  • 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

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Appendix 2

Inward Investment

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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

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Evolution of Code provisions on “inward” investment – cont’d

  • In 1954, and for many years prior thereto, the rules for taxing “inward” investment consisted of

    • A flat 30% tax, collected by withholding at source, on US “source” dividends, interest, royalties and like income of a foreign person that did not otherwise carry on business in the US

    • Tax at the regular individual or corporate rate on the US business income of foreign persons – that is, on income that was “effectively connected” with a US business

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Evolution of Code provisions on “inward” investment – cont’d

  • There was (and is) the rule that requires taxable income from transactions between commonly-controlled corporations to reflect arm’s length dealings*

    • Of great importance, because “inward” investment typically is through foreign-owned US subsidiaries

    • Apart from the statutory “earnings stripping” rules, arm’s length pricing is the main rule that protects the US tax base from mispricing between US subsidiaries and their foreign affiliates

      *Section 482 of the Code

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Evolution of Code provisions on “inward” investment – cont’d

  • 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

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Evolution of Code provisions on “inward” investment – cont’d

  • 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

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Evolution of Code provisions on “inward” investment – cont’d

  • The 1986 imposition of withholding tax on a foreign partner’s 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

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Evolution of Code provisions on “inward” investment – cont’d

  • 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

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Evolution of Code provisions on “inward” investment – cont’d

  • 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

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Evolution of Code provisions on “inward” investment – cont’d

  • 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

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Evolution of Code provisions on “inward” investment – cont’d

  • 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

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“Inward” investment – What are the problems? – cont’d

  • What are the problems in the US taxation of inward investment?

  • Complexity -- although possibly not to the same extent as for outward investment

    • 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

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“Inward” investment – What are the problems? – cont’d

  • 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

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“Inward” investment – What are the problems? – cont’d

  • Rules for determining arm’s length pricing for services, intangibles and other items are not working well

    • the so-called advance pricing agreement program is not an answer

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Appendix 3

DISCs, FSCs and Domestic Production

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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

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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

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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

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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

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Appendix 4

US income tax treaties

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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

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US income tax treaties – cont’d

  • 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

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Appendix 5

Some possible simplifications

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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, shouldn’t the subpart F rules be revised to accept that? Or, if not, the check-the-box regulations changed?

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Simplifications – cont’d

  • 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?

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Simplifications? – cont’d

  • 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

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