Multinational Tax Coalition Sends Treasury Copy of International Tax Reform Statement

[2] We appreciated the opportunity to work with you in connection with the issuance of Notice 98-35, and believe that Treasury's comprehensive review of subpart F offers an opportunity for the Administration, the Congress, and U.S. businesses to engage in a constructive dialogue on a range of important issues, including the hybrid branch issue. We believe that a comprehensive study will demonstrate that the use of hybrid branches should not be a cause for concern or a reason to make fundamental changes in U.S. international tax policy. In connection with this study, we would like to discuss the issue of hybrid branches with you further, and will call to schedule a meeting. In the meantime, if you have any questions or comments, please call Ken at (202) 414-1300 or Barbara at (202) 414- 1685.

[3] Thank you very much.

Sincerely,

[5] Our comments center on a series of Clinton Administration initiatives relating to cross-border transactions -- involving "hybrid branches" -- undertaken by U.S. companies. The net effect of these Administration initiatives would be to increase taxes paid to foreign governments by American companies conducting business globally and thereby to hamper the ability of U.S.-based multinationals to compete in the global marketplace. These initiatives fail to recognize the fact that U.S. companies must be present in global markets in order to grow and that foreign operations do not come at the expense of, but rather contribute to the domestic economy.

[6] The Multinational Tax Coalition believes the Administration's views regarding hybrid branches -- reflected in Internal Revenue Service Notices 98-11 and 98-35 -- run counter to sound international tax policy principles. We respectfully ask that the Finance Committee give consideration to legislation that would reverse these ill-conceived initiatives as part of its review of the U.S. international tax system. As we explain in this statement, such action would promote U.S. competitiveness and would be consistent with other criteria outlined by Chairman Roth for reforming the U.S. tax rules applicable to foreign-source income.

II. BACKGROUND

[7] The Administration's initiatives regarding hybrid branches have been scrutinized by the Congress and criticized sharply by business groups over the past year. The following have been key milestones in this ongoing debate:

A. IRS NOTICE 98-11

[8] The Internal Revenue Service ("IRS") on January 16, 1998, issued Notice 98-11, announcing that Treasury regulations subsequently would be issued to prevent the use of certain "hybrid branch" arrangements deemed contrary to the policies and rules of subpart F of the Internal Revenue Code. ¹ These arrangements generally involve structures that are characterized for U.S. tax purposes as branches of a U.S. controlled foreign corporation ("CFC"), but are characterized under the tax law of the country in which the CFC is incorporated as a separate entity. The Notice stated that the regulations would recharacterize payments made by a hybrid branch to a CFC as subpart F income (i.e., income subject to immediate U.S. tax).

[9] IRS Notice 98-11 drew swift opposition from affected taxpayers and strong comments from Congressional tax-writers, who expressed the general view that the positions taken in Notice 98-11 would represent fundamental changes to U.S. tax policy that should be considered as part of the normal legislative process.

B. TEMPORARY TREASURY REGULATIONS

[10] The Treasury Department on March 23, 1998, issued temporary and proposed regulations providing detailed rules implementing the general principles outlined in Notice 98-11, generally effective with respect to hybrid branch arrangements entered into on or after January 16, 1998. Taxpayers questioned the statutory authority for these regulations. Taxpayers also noted that issuance of these regulations in temporary form with an immediate -- indeed, retroactive -- effective date represented a significant departure from the normal process of issuing regulations in proposed- only form and then allowing for an appropriate period of public comment.

C. SENATE-PASSED MORATORIUM ON REGULATIONS

[11] As part of its consideration of the IRS Restructuring and Reform Act of 1998, the Senate Finance Committee on April 1, 1998, approved a six-month moratorium on implementation of the Treasury regulations issued with respect to Notice 98-11. The Committee report explained the reasons for this action:

Notice 98-11 and the regulations thereunder address complex

The subpart F provisions of the Code reflect a balancing of

[13] The threat of a Congressionally imposed moratorium and the strongly worded "Sense of the Senate" resolution led Treasury on June 19, 1998, to issue IRS Notice 98-35, withdrawing Notice 98-11 and announcing the intention to withdraw the related temporary and proposed regulations and to reissue the regulations in proposed form only. In Notice 98-35, consistent with the views of the Committee regarding the need for Congressional consideration of these issues, Treasury stated that it would not finalize before January 1, 2000, any regulations in this area in order to give Congress time to consider the issues originally raised by Notice 98-11 and to take legislative action, if appropriate.

[14] Because of the issuance of Notice 98-35, which reflected Treasury's agreement to a moratorium on the hybrid regulations, the final conference agreement on the IRS reform legislation did not include the Senate-passed moratorium. In this regard, the conference report indicates that the conferees expected that the Congress would consider the policy issues and would consider taking legislative action. The conference report further provides that no inference was intended regarding the authority to issue the Notice or the regulations.

III. TAX POLICY CONCERNS

[15] As Treasury itself indicated in Notice 98-35, the Notices and the related regulations raise important tax policy issues. The Multinational Tax Coalition has fundamental policy concerns regarding both the positions reflected in the Notices and the manner in which those positions have been implemented.

[16] First, we disagree with the statements made in Notices 98- 11 and 98-35 that hybrid branch arrangements "circumvent the purposes of subpart F." The rules of subpart F do not operate to impose U.S. tax currently on all income that is not subject to a certain level of foreign tax. Had the Congress intended to provide such a rule, presumably it would have done so. Instead, the Congress enacted a general deferral regime, and chose to impose U.S. tax currently only on specified types of income. Accordingly, U.S. tax generally is deferred without regard to the level of foreign tax on the income (other than a tax-favorable exception for certain high-taxed income).

[17] As was noted in Notice 98-11, subpart F reflects a balance between various international tax policy objectives. However, the Congress in 1962 gave far more weight to competitiveness concerns in enacting the subpart F rules than is suggested by Treasury and the IRS. Both the House and Senate reports to the 1962 Act cite preservation of the international competitiveness of U.S. business as the major reason for rejecting a proposal at that time to eliminate deferral altogether. Moreover, this emphasis on competitiveness concerns is evidenced by the statutory regime itself, which retains deferral as the general rule rather than the exception.

[18] Indeed, the competitiveness concerns that the Congress focused on in 1962 have only increased over the intervening years. U.S. businesses face far more intense competition around the world than was the case in 1962. With the increasing globalization of the economy, it has become critical for businesses to compete internationally if they wish to remain competitive in their home markets. As discussed in more detail in the following section, many features of the U.S. tax rules operate to hinder the ability of U.S. -based businesses to compete in the global economy; the positions reflected in the Notices only serve as a further impediment to the global competitiveness of U.S. business.

[19] The attack on hybrid branch arrangements in Notices 98-11 and 98-35 is premised on the view that these arrangements somehow undermine the integrity of the U.S. tax system. The Multinational Tax Coalition strongly believes there is nothing inherently abusive about the reduction of foreign taxes as contemplated by applicable foreign law. Indeed, the IRS and the courts have recognized that a reduction of foreign tax is a legitimate business purpose. ⁴ Moreover, if U.S. multinationals are able to pay less in foreign tax, they will have fewer foreign tax credits to claim and can be expected over the long term to pay more residual U.S. tax on their foreign-source income. Notice 98-11 and 98-35 seem to be aimed at ensuring that U.S. multinations pay higher foreign taxes than would be permitted under the foreign countries' own tax laws. We are at a loss to understand why it would being the United States' interest to insist that its multinationals pay more foreign tax than their foreign competitors.

[20] The saga over the U.S. tax treatment of hybrid branch arrangements began in January of 1998 and continues today. Treasury and the IRS thus far have used the administrative route -- through Notice and regulations -- to address fundamental tax policy issues. As the Committee noted in the "Sense of the Senate" resolution it approved last April, developments of this magnitude "should be considered by the Congress as part of the normal legislative process." Indeed, even Treasury recognized this with its decision to issue Notice 98-35 withdrawing Notice 98-11 and with its announced intention to undertake a comprehensive reexamination of subpart F. However, in the meantime, considerable uncertainty over these issues remains. And that uncertainty continues to have a significant and detrimental chilling effect on normal business operations. The only way to remove the cloud of uncertainty that has been created in this area is through legislative action.

IV. ECONOMIC ISSUES

[21] In announcing the Committee's March 11, 1999, hearing on international taxation, Chairman Roth identified five specific criteria for reforming the U.S. rules for taxing foreign source income, which are listed in summary fashion, below:

1. Reduce complexity;

[23] In this section we consider -- from an economic standpoint -- whether Treasury's approach to hybrid branches is consistent with the Chairman's vision for promoting long-term competitiveness (Criterion 5) and promoting exports (Criterion 2). We also address the revenue implications of hybrid branches.

A. U.S. INTERNATIONAL COMPETITIVENESS

[24] The hybrid branch structures that Treasury has sought to curtail through Notices 98-11 and 98-35 are used by U.S. multinationals to reduce their FOREIGN income tax obligations. Such structures, where permitted by applicable foreign law, increase after-tax cash flow, and thus facilitate increased foreign investment and growth in global market share. Moreover, these structures allow U.S. multinationals to compete on a more equal basis with foreign- headquartered multinationals that can reduce foreign taxes without running afoul of home country tax rules. As a result, the policy embodied in Notices 98-11 and 98-35 is antithetical to the long-run competitiveness of U.S. multinationals.

[25] Even without Notices 98-11 and 98-35, U.S. multinationals operate under tax rules that frequently put them at a competitive disadvantage in foreign and domestic markets:

o Worldwide vs. territorial tax system: Many of our trading

[27] A non-competitive international tax regime ultimately will cause a reduction in the global market share of U.S. headquartered companies. From 1960 to 1996, the number of U.S.-headquartered companies among the 20 largest companies in the world (ranked by sales) declined from 18 to 8. ¹⁰ While foreign-headquartered companies can operate in the U.S. market without subjecting their foreign activities to the complex and burdensome U.S. international tax system, a U.S.-headquartered company does not have this advantage. ¹¹

[28] The U.S. tax rules already in place make it difficult for American companies to compete in global markets. Treasury's anti- hybrid initiatives only serve to exacerbate this problem, contrary to the Chairman's goal of promoting long-term U.S. competitiveness. The Treasury anti-hybrid initiatives focus on the use of hybrid branches to reduce foreign taxes; as discussed above, this ability to reduce foreign taxes is important to the ability of U.S. companies to compete in foreign markets.

B. U.S. EXPORTS AND JOBS

[29] Some have argued that U.S. investment abroad comes at the expense of exports and thus U.S. jobs. However, the facts do not support this claim; indeed, U.S. multinational corporations play a crucial role in promoting U.S. exports and high-paying U.S. jobs. The most recent Commerce Department data show that U.S. multinationals were responsible for $407 billion of merchandise exports in 1996 -- 65 percent of all U.S. merchandise exports.

[30] Foreign affiliates of U.S. companies promote exports in a variety of ways. First, many foreign affiliates market and distribute U.S. exports. In 1994, 25 percent of all foreign affiliates were primarily involved in wholesale trade. ¹² Without on-the-ground marketing and distribution facilities, U.S. companies would be less successful in exporting into foreign markets. Second, foreign manufacturing affiliates of U.S. companies rely heavily on U.S. sources for inputs. Third, due to local content requirements, it is often necessary to have some level of investment in a country in order to gain access for U.S. exports (e.g., the Canadian auto pact). Fourth, foreign acquisitions and joint ventures frequently result in access to new technology that can be used in domestic manufacturing operations.

[31] Academic studies confirm that U.S. investment abroad promotes U.S. exports. For example, Professor Robert Lipsey finds a strong positive relationship between foreign direct investment (FDI) by U.S. multinationals and the level of exports from the U.S. parent company. ¹³ A recent study based on 14 OECD countries found that "each dollar of outward FDI is associated with $2 of additional exports and with a bilateral trade surplus of $1.7." ¹⁴ These studies support the conclusion that if U.S. investment abroad were curtailed, exports would be lower.

[32] While some believe U.S. investment abroad drains jobs and production from the United States, the economic evidence points to the opposite conclusion -- U.S. investment abroad increases employment at home. ¹⁵ This complementary relationship between the foreign and domestic operations of U.S. multinationals means that U.S. workers need not be harmed by investment abroad. ¹⁶ The foreign operations of U.S. companies also are associated with higher wages of domestic workers. Holding constant other factors that affect wages, domestic companies pay domestic workers 5-15 percent LESS than U.S. multinationals pay their domestic workers; moreover, the wage differential, in percentage terms, is greater for lower-paid production workers than for higher-paid non-production workers. ¹⁷ Thus, U.S. multinationals appear to promote a more equal distribution of income by paying higher wage premiums to traditionally lower-paid workers.

[33] The relationship between the ability of U.S. companies to compete abroad and their ability to provide employment opportunities at home was noted by the Council of Economic Advisers in the 1991 Economic Report to the President:

In most cases, if U.S. multinationals did not establish

C. CAPITAL MOBILITY AND REVENUE EFFECTS

[34] Concerns have also been raised that the use of hybrid branch arrangements by U.S. multinationals may adversely affect U.S. tax revenue collections. We believe this concern is unwarranted and that the likely effect of hybrid arrangements rather is to increase U.S. tax collections.

[35] With respect to PAST equity investments in foreign subsidiaries, any transaction (including a hybrid branch) that reduces foreign income tax cannot adversely affect U.S. tax revenues; indeed, U.S. tax revenues ultimately will increase due to lower foreign tax credits when this income is distributed.

[36] Some have argued that the use of hybrid branch arrangements will increase future foreign investment at the expense of U.S. tax revenues. However, we are unaware of any credible economic analysis supporting this view, and would note the following points.

[37] First, the rate of return on assets invested abroad historically has been higher than the return on assets invested domestically, and these higher returns ultimately will be subject to U.S. tax. The most recent Commerce Department data show that the return on assets (earnings before interest and taxes as a percent of assets) of nonfinancial U.S. majority-owned foreign affiliates was 9.8 percent in 1995 as compared to 7.6 percent for domestic corporations. Moreover, high-profit foreign operations increase domestic share values, thereby boosting capital gains tax revenues when shares are sold.

[38] Second, recent econometric analysis of U.S. multinational corporations by Prof. Jason Cummins and Kevin Hassett supports the view that a reduction in foreign taxes increases worldwide output, which increases employment and investment in the United States. ¹⁹ Thus, to the extent the use of hybrid branch arrangements encourages foreign investment by lowering foreign tax burdens -- as Treasury contends -- there would be an increase in domestic economic activity and associated tax revenues.

[39] Finally, as a practical matter, it is unlikely that the use of hybrid branches has any material effect on the decision by U.S. companies to invest abroad. These arrangements depend on the tax laws in a limited number of foreign countries, which can change their tax rules. Thus, even absent Notices 98-11 and 98-35, it would be foolhardy for a U.S. company to make a long-term investment abroad, rather than at home, based on the foreign tax benefits associated with hybrids.

D. CONCLUSIONS

[40] The Multinational Tax Coalition believes the economic evidence strongly supports the following conclusions:

o U.S. investment abroad INCREASES exports and wages at home;

V. RECOMMENDATION

[42] As discussed above, the Multinational Tax Coalition believes the positions to be taken by the Treasury Department in regulations to be issued under Notice 98-35 are contrary to sound and longstanding tax policy principles and would impede the ability of U.S. companies to compete in global markets. In the event that Treasury does not rethink these positions, we respectfully would urge the Congress to take legislative action to reverse these initiatives and to prevent these regulations from taking effect. The Multinational Tax Coalition stands ready to work with the Congress to reach a resolution of these issues.

² S. Rpt. 105-174, 105" Cong., 2d Sess., at 110.

³ Id, at 113-14.

⁴ See, e.g., Rev. Rul. 89-101, 1989-2 CB 67, and Betty M. Ellis v. Commissioner, 50 T.C.M. 1202 (1985).

⁵ As of 1990, half of the 24 member countries of the OECD operated territorial tax systems. Organization for Economic Cooperation and Development, Taxing Profits in a Global Economy: Domestic and International Issues, 1991.

⁶ Organization for Economic Cooperation and Development, Controlled Foreign Company Legislation, 1996.

⁷ Price Waterhouse LLP, Taxation of U.S. Corporations Doing Business Abroad: U.S. Rules and Competitiveness Issues, Financial Executives Research Foundation, 1996.

⁸ Sijbren Cnossen, Reform and harmonization of the company tax systems in the European Union, Research Memorandum 9604, Research Centre for Economic Policy, Erasmus University, Rotterdam, 1996. In announcing the hearing, Chairman Roth specifically queried whether the United States should strive for integration in order to address the long-term competitiveness of U.S. companies.

⁹ Organization for Economic Cooperation and Development, Taxing Profits in a Global Economy: Domestic and International Issues, 1991.

¹⁰ Hoover's Handbook of World Business, 1998 Edition.

¹¹ See, John Loffredo, "Testimony before the Senate Finance Committee," March 11, 1999. Mr. Loffredo testified, "DaimlerChrysler Corporation, now a subsidiary of a German company, has minimized the possibility of paying additional tax . . . on its foreign operations. This should help the operations of the company to continue to compete on a global scale. However, there are many U.S. companies which have foreign operations and they are put at a competitive disadvantage in the global economy, just because they are competing against companies who do not have to follow the way the U.S. tax system taxes foreign operations."

¹² Matthew J. Slaughter, Global Investments: American Returns, Emergency Committee on Foreign Trade, 1998.

¹³ Robert E. Lipsey, "Outward Direct Investment and the U.S. Economy," in M. Feldstein, J. Hines, Jr., and G. Hubbard (eds.), The Effects of Taxation on Multinational Corporations, University of Chicago Press, 1995. See also, Robert E. Lipsey and Merle Weiss, "Foreign Production and Exports in Manufacturing Industries," Review of Economics and Statistics, pp. 488-494 and "Foreign Production and Exports of Individual Firms," Review of Economics and Statistics, pp. 304-308.

¹⁴ See, OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, 1998, p. 50.

¹⁵ See, David Riker and Lael Brainard, "U.S. Multinationals and Competition from Low Wage Countries," NBER Working Paper No. 5959, March 1997; and Mathew J. Slaughter, "Production Transfer within Multinational Enterprises and American Wages," mimeo., March 1998.

¹⁶ See, OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, 1998, pp. 73-76.

¹⁷ Mark Doms and Bradford Jensen, "Comparing Wages, Skills, and Productivity Between Domestic and Foreign Owned Manufacturing Establishments in the United States," mimeo., October 1996.

¹⁸ U.S. Council of Economic Advisers, Economic Report of the President, 1991, p. 259.

¹⁹ Jason G. Cummins and Kevin Hassett, "Structural Estimates of Factor Substitution from Firm-Level Panel Date on Multinational Corporations," International Tax Policy Forum and American Enterprise Institute, February 19, 1999.