Attorney Sent Suggestions for Amending Foreign Tax Credit

TAB 1. Analysis titled "Internal Revenue Code Section 904(g)

[3] The following are the names and vital statistics for the attendees at Tuesday's meeting:

o Jay Schwartz, International Tax Counsel, Merck & Company DOB:

Sincerely,

1. BACKGROUND

[5] The members of the Coalition are fully integrated U.S.- based multinational pharmaceutical companies that engage directly and through domestic and foreign subsidiary corporations in the discovery, development, manufacture, marketing and sale of prescription products. The foreign subsidiaries manufacture finished pharmaceutical products from bulk active compounds supplied by the U.S. parent company ("Parent") or other affiliates, and market, sell and distribute such products in their local markets. A number of these foreign subsidiaries also conduct research and development activities locally through their own research staffs, while others may fund research by third parties or affiliates on their behalf or pursuant to bona-fide cost sharing agreements within or outside their home countries. These foreign subsidiaries are incorporated in developed countries with which the U.S. has a tax treaty. All locally funded research and development expenses are deducted in their home country, foreign tax returns and expensed for local statutory accounting purposes. Consequently, worldwide patent rights that result from these efforts and expenses are owned by the foreign subsidiary.

[6] Quite often the foreign patent owner does not have a bulk chemical manufacturing plant. The decision about where to locate such a plant is based on a variety of business, legal and political considerations. Building a bulk manufacturing plant requires a very significant investment in capital, and approval of the local government is often required for the siting, design and construction of the plant. In addition, bulk chemical manufacturing typically involves complex chemistry, requiring specialized manufacturing know- how that the subsidiary may not possess. The foreign subsidiary would also need to recruit and train a manufacturing work force, which could require a significant investment of time, expense and management effort. In many cases, even if the subsidiary were willing to expend the time, expense and effort to acquire this capability itself, it could not construct a new bulk chemical plant in time to meet the anticipated launch date for a particular product

[7] For these reasons, worldwide patent rights owned by a foreign subsidiary ("Licensor") may be licensed at an arm's-length royalty rate to another affiliate that already owns and operates a bulk manufacturing plant and has the capacity and know-how to manufacture bulk chemical requirements for the product ("Licensee").

2. INTERNAL REVENUE CODE SECTION 904(g)

[8] Under Code section 861(a)(4) of the Internal Revenue Code ("Code"), royalties received for the use of a patent in the U.S. are U.S. source income. As a result, royalties paid by Licensee to Licensor for sales of product in the U.S. will generally be considered U.S. source income to Licensor. Moreover, under Code section 904(g), when Licensor pays an actual or deemed dividend to Parent, the dividend will be U.S. source income to the extent Licensor's earnings and profits are attributable to the U.S. source royalties. Any such dividend paid by Licensor will carry foreign tax credits at rates that may equal or exceed the U.S. statutory rate, but none of the royalty component of the dividend will be foreign source income.

[9] Alternatively, Section 904(g)(10) would permit Parent to avoid Section 904(g) resourcing if such resourcing would be inconsistent with an income tax treaty between the U.S. and Licensor's country of residence. Two requirements must be satisfied for Section 904(g)(10) to apply: (i) the treaty must give the foreign jurisdiction the right to tax dividends paid by Licensor to Parent (notwithstanding the dividend's domestic source under U.S. law), and (ii) the treaty must contain a special source rule that treats dividends that Licensor's jurisdiction may tax as arising in Licensor's jurisdiction for U.S. foreign tax credit purposes (see, e.g., Article 23 of the U.S.-U.K Income Tax Treaty). Section 904(g)(10) relief, therefore, is contingent on the right of Licensor's country to impose withholding tax on dividends paid to Parent, rather than its right under the treaty to tax Licensor on its U.S. source income. Thus, for example, if the new U.S.-U.K treaty (now under renegotiation) should no longer permit the U.K. to tax dividends paid to Parent (or, alternatively, no longer contain a special sourcing rule), Section 904(g)(10) relief would be unavailable even though Licensor has paid full U.K. corporate income tax on its royalty income. Loss of Section 904(g)(10) relief is a very real possibility in the U.K. because dividend withholding tax may be entirely eliminated under U.K. internal law. Moreover, resourcing provisions are now contained in only a limited number of treaties (perhaps a dozen), and United States treaty policy has generally been to reserve for the U.S. the right to apply Section 904(g) in post-enactment treaties (see, e.g. Treasury Department Explanation to Article 25 of the new U.S.-Luxembourg treaty). As newer treaties supersede older treaties, Section 904(g)(10) relief will become increasingly rare. Section 904(g)(10) also requires that the dividend income attributable to the resourced royalty be placed in a separate foreign tax credit limitation basket. ¹

[10] Thus, the choices available to Parent under current law are: (1) to rely on the possibility of cross-crediting all the foreign income taxes in the five-year carry-forward period in its general limitation basket, or (2) to choose the benefits of a treaty, where available, and credit foreign taxes paid up to the effective U.S. tax rate but permanently lose the ability to credit local taxes in excess of the U.S. rate. ² If the product is generating substantial U.S. royalty income that is subject to tax in the foreign jurisdiction, it is extremely unlikely that Parent would be able to cross-credit the foreign taxes in its general limitation basket. Thus, either choice will result in serious double taxation for Parent. The separate basket approach also unfairly prevents a taxpayer from using other available credits to satisfy any residual U.S. tax liability on U S. source royalties taxed at a foreign rate below the U.S. statutory rate.

[11] As discussed below, the Coalition believes, based on the legislative history of Code section 904(g), that Congress did not intend this result. Conceding for purposes of argument that Congress did intend when it enacted Section 904(g) in 1984 that dividends paid by Licensor to Parent be treated as U.S. source income to the extent Licensor's earnings and profits were attributable to U.S. source royalties, evolving foreign business requirements during the intervening 14 years and the need for U.S. companies to compete in foreign markets should cause Congress to revisit and revise subsection (g).

3. LEGISLATIVE HISTORY

[12] The legislative history to the Deficit Reduction Act of 1984 ("the 1984 Act") expresses concern that, under existing law, a corporation could receive U.S. source income and subsequently repatriate the income as foreign source by flowing the income through an intermediate foreign corporation. By thus inflating foreign source income, U.S. companies with excess foreign tax credits could reduce U.S. tax on what would otherwise be U.S. source income and thus distort the foreign tax credit limitation. Congress also wanted to eliminate any competitive advantage to U.S. taxpayers that exported capital to be invested in the United States to foreign subsidiaries rather than investing it directly. Joint Committee Print, H.R. 4170, 98th Congress, Public Law 98-369, pp. 346-54 (copy attached).

[13] Examples in the Joint Committee Print make it clear that the abuse Congress was targeting was the conversion of U.S. source income to foreign source income by routing the income through a foreign subsidiary set up for that purpose: where, in other words, there was no business reason for the activities in question to be carried on by a foreign subsidiary instead of a U.S. subsidiary or the U.S. parent itself, and the primary reason for the establishment of a foreign subsidiary was tax avoidance. The example given by the Joint Committee is a foreign insurance subsidiary of a U.S. company that earns all its income from insuring U.S. risks of U.S. companies and distributes its profits to its parent as foreign source income.

4. APPLICATION OF CODE SECTION 904(g) APPEARS CONTRARY TO

[15] First, there is no export of capital involved in the ownership and commercialization of product by a foreign subsidiary where the patent is either discovered in the foreign jurisdiction and/or funded from Licensor's local business profits, ³ and all the R&D expenses are deducted in its local tax return. In these circumstances, no U.S. capital is exported, directly or indirectly, to Licensor for the discovery and development of the product. The patent rights to the product are clearly the property of Licensor, and Licensor therefore has no choice but to report the full profits from exploiting the patent in its local tax return. In any event, Code section 367(d), also enacted in 1984, put an end to the practice of transferring appreciated intangibles from a U.S. parent to a foreign subsidiary in a tax-free exchange. Under Code section 367(d), the intangible is treated as having been transferred in exchange for a royalty or other payment commensurate with the income earned on the intangible. Since the royalty would be U.S.-source if the intangible were used in the U.S., the outbound transfer would no longer result in either a deferral of income or a conversion of income from U.S. to foreign source.

[16] Second, there is no manipulation of the foreign tax credit. If Licensor had manufactured the product itself, Licensor's income from sales of product into the U.S. would be foreign source income. Because Licensor has no bulk chemical manufacturing plant, it will license worldwide patent rights to an affiliate that does have such a plant in return for an arm's length royalty. Thus, the decision to license to an affiliate is made for sound business reasons. Moreover, all of Licensor's income, including royalties, is subject to full local taxation in its jurisdiction of residence. Even if Parent had a choice about where to report the income from exploiting the patent, it could not obtain a foreign tax credit benefit by routing U.S. source income through a full tax-paying foreign jurisdiction. On the contrary, Parent's foreign tax credit capacity is reduced to the extent it incurs local tax in excess of the U.S. tax rate. Because the Licensor that the Coalition is focused upon is incorporated and residing in a developed country with which the U.S. has a tax treaty, there is little or no opportunity for manipulation of the foreign tax credit rules.

[17] Finally, it appears that Code section 904(g) would apply even if Licensor had actually IMPORTED capital into the U.S. by manufacturing product and selling it in the U.S. through a U.S. branch -- a structure clearly not designed either to export capital or distort the foreign tax credit limitation. In that case, Licensor would be subject to a 35% U.S. federal tax on its income, plus a 5% branch profits tax. Licensor would also be subject to full local income tax less a credit for U.S. taxes incurred. A dividend from Licensor under these circumstances would likewise be subject to Code section 904(g), and, thus, a pro rata portion, would be U.S. source income. Consequently, Parent would face the same foreign tax credit problem discussed above.

[18] In sum, Parent has not attempted to transfer a U.S. asset or business to a foreign jurisdiction to convert U.S. source income into foreign source income. The capital to create the asset is of foreign origin, all R&D expenses are deducted in Licensor's local tax return, and Parent has never owned the asset. The foreign subsidiary that owns the patent is incorporated and residing in a country with which the U.S. has a tax treaty. The foreign tax jurisdiction, moreover, has very reasonable expectations that any profit resulting from commercialization of the patent will be subject to full income taxation in that jurisdiction. U.S. tax policy actually endorses this expectation through income tax treaties by ceding primary taxing jurisdiction to that other country on royalty income that is U.S. source income under Section 861 principles. There is no valid U.S. tax policy objective in these circumstances for limiting utilization of foreign tax credits under Section 904(g).

5. EVOLVING FOREIGN BUSINESS CONDITIONS NECESSITATE MODIFICATIONS TO

[20] Clearly, Congress was not focused on a foreign subsidiary that was developing worldwide patent rights to a compound and would eventually license such patent to another foreign affiliate. In the pharmaceutical business today, U.S. parent companies are increasingly designating foreign subsidiaries as centers for worldwide research in a particular field of therapy. These decisions are dictated by business necessity in today's international business climate. Increasingly, foreign governments are looking for strengthened local business ties as a prerequisite for important local business opportunities. These may include enhanced patent protection under local law, expedited review of new drug applications, and pricing and reimbursement decisions in countries where these decisions are controlled largely by local governments.

[21] The increased "nexus" local governments are more increasingly focused on is the funding of worldwide research costs for a particular class of compounds. This requirement is based on the expectation that increased R&D will lead to the recruiting of local scientists and ultimate ownership of worldwide patent rights if the research efforts should prove successful. It is imperative that U.S. companies be free to compete with their foreign counterparts in meeting these local business requirements without subjecting themselves to the potential risk of future double taxation. The Coalition believes that this result is clearly inconsistent with broader goals of U.S. tax policy.

6. CODE SECTION 904(g) DISCOURAGES REPATRIATION, RESULTING IN NET

7. RECOMMENDATION

[23] It is recommended that Code section 904(g) be amended to prevent its application when the owner who has funded development of a patent or other intangible receives a royalty or other income from exploiting an intangible and such income is subject to tax in a country with which the U.S. has an income tax treaty, which treaty permits the foreign country to tax such U.S. source income. The fact that the United States has entered into an income tax treaty with that other country is indicative that a tax haven jurisdiction is not being availed of and foreign tax credit manipulation is not involved (compare, e.g., Bermuda captive insurance or finance companies).

[24] The Coalition believes that if Code section 904(g) is amended as suggested above, there will be no additional export of capital from the U.S. or manipulation of the U.S. foreign tax credit rules.

² In practice the capacity to credit taxes within a separate 904(g)(10) basket will be limited to rates below the U.S. statutory rate because of the allocation of expenses under Reg. Sec. 1.861-8.

³ A formula can be developed to assure that funds expended for R&D were derived from Licensor's own profits rather than from capital contributions made by Parent.

⁴ See page 348 of the Joint Committee Print which states that: "The [pre 1984] source rules arguably allowed the circumvention of the foreign tax credit limitation. The CITATION of foreign income that either attracted high foreign taxes directly or absorbed foreign tax credits that arose from unrelated high-taxed foreign income passed the cost of high foreign taxes from the U.S. taxpayer to the U.S. government. The [Deficit Reduction] Act [of 1984] prevents that result by its general rule that ensures full U.S. tax when U.S. source income flows through a U.S.-owned foreign corporation."

July 18, 2000

[26] Section 904(g) requires domestic sourcing of certain payments ("payments"), including royalties and interest, received by U.S. shareholders of certain foreign corporations under certain conditions. As a result, the sourcing rule under section 904(g) generally reduces the amount of foreign source income attributable to a taxpayer's operations for the purpose of calculating foreign tax credits, and may reduce the amount of foreign tax credits that a taxpayer can claim. An exception to the general rule of section 904(g) is contained in section 904(g)(5), which applies if the foreign corporation making the payment has a de minimis amount of U.S. source income. In addition, the treatment of payments is coordinated in cases where treaty obligations are in force, as stipulated in section 904(g)(10). A taxpayer qualifying for coordination under section 904(g)(10) is not required to domestically source these payments for foreign tax credit purposes, but can instead treat these payments as foreign source, with the constraint that such payments must be isolated from other foreign source income, effectively eliminating opportunities that might otherwise be available for the cross-crediting of foreign income taxes.

[27] Under this proposal, a new exception to section 904(g) would be created for certain royalties. Royalties and other intangible property income received by certain foreign corporations and that meet certain treaty, earnings and profits, and effective tax rate requirements would be excepted from section 904(g). The effect of this proposal would be twofold. First, taxpayers who qualify under present law for treaty coordination under section 904(g)(10), and could qualify for this new exception, would now be able to cross- credit certain foreign taxes. Second, some taxpayers who currently do not qualify for the sourcing exception under section 904(g)(5), or treaty coordination under 904(g)(10), may be able to qualify for the new exception and thereby increase their foreign source income for foreign tax purposes, potentially increasing the amount of claimable foreign tax credits.

[28] In estimating this proposal, we have assumed that excess foreign tax credits carried over as a result of prior treaty coordination under section 904(g)(10) would be available for cross- crediting. The proposal is assumed to be enacted on August 1, 2000, and effective for taxable years beginning after 1999. We estimate that this proposal would reduce Federal budget receipts as follows:

                            Fiscal Years

[30] You also inquired about extending the new exception to interest income. We will provide this estimate when it becomes available.

[31] I hope this information is helpful to you. If we can be of further assistance in this matter, please let me know.

Sincerely,