TEXT AVAILABLE OF NATIONAL FOREIGN TRADE COUNCIL'S TESTIMONY ON CFC INCOME.

Mr. Chairman, Members of the Committee:

Good morning. My name is Robert T. Cole.

I appreciate the opportunity to testify today on behalf of the National Foreign Trade Council, Inc. (NFTC) in my capacity as Vice Chair of the Tax Committee. The NFTC, organized in 1914, is an association of some 500 U.S. business enterprises engaged in all aspects of international trade and investment.

I am a member of the law firm of Cole Corette & Abrutyn. Our firm has offices in Washington, London, Moscow and Warsaw. We specialize in international tax and other international legal matters and represent a broad range of U.S. and foreign private and public clients.

As a representative of a broad spectrum of United States industrial, commercial, financial, and service activities, the NFTC seeks to foster an environment to permit U.S. companies to be dynamic and effective competitors in the international business arena. Through direct investment in facilities abroad and in the export of goods, services, technology, and entertainment, the international business activities of American companies constitute one of the vital underpinnings of the economic well-being of our country. Indeed, as foreign competition at home and abroad becomes more intense, it becomes all that more important for U.S. enterprises to fully participate in business activities throughout the world. U.S. enterprises must not be handicapped in global competition, and this requires that the taxes to which they are subject, including foreign taxes, not act as an impediment.

The NFTC strongly opposes passage of H.R. 2889 because it.:

o ignores the fact that U.S. enterprises manufacture overseas because of business necessity, and not to escape taxation;

o is anticompetitive, hurting U.S. businesses in their competition with foreign owned businesses;

o is unnecessary as the U.S. already taxes passive income of controlled foreign corporations and when their profits are used in the United States; and

o could be illegal under GATT.

The bill would amend the Internal Revenue Code of 1986 to end deferral for U.S. shareholders on income of controlled foreign corporations (CFCs) attributable to property imported into the United States (imported property income), taxing such income anticipatorily under subpart F before it is returned to the U.S. shareholder. The bill also would add a new separate foreign tax credit limitation for imported property income, whether earned by controlled foreign corporations or directly by U.S. taxpayers.

DEFERRAL

1. DEFERRAL PRINCIPLE. The bill takes as its premise existing law under which the U.S. shareholder of a controlled foreign corporation generally is not taxed on income until it is distributed to the U.S. shareholder.

The NFTC agrees with this premise. Let me briefly state why. We believe that foreign operations of U.S. businesses which typically are conducted through controlled foreign corporations should face no impediments to their competing in every corner of the world. Such ability to compete benefits not only U.S. businesses, but the U.S. economy as a whole by fostering exports, supporting U.S. R&D, and returning income to the U.S. in the form of royalties, interest, and dividends. Accordingly, it is right for U.S. tax to be postponed as long as the profits are used by the controlled foreign corporation in business activities outside of the U.S. In such a way the tax burden on the controlled foreign corporation is the same as the tax burden of its competitors, but once the income is returned to the U.S., its tax burden is the same as that of any other U.S. corporation. It is noted that a number of major countries have a territorial system and do not tax earnings of their CFCs, even when repatriated. While the NFTC believes that such a system should be examined, that is beyond the scope of this hearing.

Indeed, when CFC profits are repatriated to the U.S., they pay a higher tax than would be the case with manufacturing in a U.S. plant. The reason for this is the U.S. tax rules governing depreciation of plant and equipment used outside of the U.S. For example, a U.S. factory building might be depreciated using accelerated depreciation over a useful life of 31.5 years, whereas a similar foreign factory must be depreciated on a straight-line basis over a period of 40 years. The effect of these rules is that ultimate distributions will be taxed at higher effective U.S. rates because smaller deductions for depreciation will be available to reduce the earnings subject to tax. Thus, to the extent deferral is considered a tax benefit, the benefit is offset on repatriation.

Mention should also be made of section 482 of the Internal Revenue Code which provides that transactions between related persons must be at arm's length. In other words, transfer prices between affiliated corporations within a corporate group are subject to scrutiny by the IRS and to the extent they do not reflect arm's length pricing, they are subject to adjustment. This rule applies to imported products so that, to the extent that economic activity takes place in the U.S., the U.S. is sure of taxing the income. What is particularly important about this section is that it applies equally to foreign multinational groups as to U.S. multinational groups and, therefore, protects the U.S. revenue without putting U.S. groups at a competitive disadvantage.

2. LEGISLATION UNNECESSARY AS SUBPART F ALREADY ASSURES TIMELY U.S. TAXATION. It is noted that the Internal Revenue Code already contains limitations on deferral principally set forth in the subpart F provisions, including rules under which the profits of a CFC from passive investments are deemed distributed and taxed to the U.S. parent. Thus, if a CFC retains its foreign manufacturing profits, for example, and uses it for passive investments, in an effort to continue deferral beyond the time the profits are used in the foreign business -- beyond the time the CFC is using the profits to compete abroad -- such profits have become immediately taxable in the U.S.

Similarly, if a CFC loans its retained profits to the parent, or another affiliate in the U.S. guarantees their obligations or otherwise invests in U.S. property, deferral is terminated and there is immediate U.S. taxation.

Indeed, under the PFIC rules enacted in 1986, when the CFC becomes predominantly passive in character, ALL of its earnings are subject to current taxation or a special charge which achieves the same effect, but the NFTC hopes PFIC will be made inapplicable to CFCs as subpart F is more than adequate to limit deferral.

3. FOREIGN ACTIVITIES RESULT FROM BUSINESS NECESSITY. Wherever possible, the NFTC members will locate their manufacturing and other activities in the U.S.; but to serve and benefit from worldwide markets and resources, this is often not possible.

The reasons for choosing to locate a plant outside of the U.S. and using part of the production of that plant for supplying the U.S. market are varied, but tax is probably the least important factor. On the whole, foreign manufacturing operations are expensive, difficult to administer, and generally are only created because they are necessary for one or more of the following:

o entry into the foreign market which is best served by close-by manufacturing (and in some cases, through that market into the common regional market such as the European Community or the Andean Pact);

o access to raw materials which, in some cases, cannot be exported in such form, but must be manufactured locally into some product;

o local content restrictions requiring use of local plant and workers in order to sell the product within the country; and

o local "standards" rules requiring foreign manufactured products to meet stringent import tests.

The decision to place a plant overseas is driven by the operations and sales departments of a company, not by its tax department.

In most cases where there are exports to the U.S., it is an offshoot of manufacturing for the foreign market, so located for the types of reasons I have just described. For example, the U.S. market may not be the principal market for a particular product, and since it is usually technically and economically preferable to produce a product near its principal market and at a limited number of locations, a planned location for worldwide sourcing would likely be near the principal market rather than within the U.S.

A CASE IN POINT: In the mid-1960's, one of our member companies acquired a U.K. consumer products company with the intention of expanding the markets of the acquired product through the member company's established worldwide sales and distribution network. The acquired company was founded in the late 1800's and in the 1930's introduced a product that still sells well today. Prior to the acquisition, the product was sold in the U.K. and certain limited markets. Following acquisition, the development of overseas markets for the product was accelerated. The U.K. plant remained the primary source of production.

U.S. sales of the product increased significantly in the late 1960's and required additional production capacity. This production capacity was built in the U.S. as part of a larger plant and now directly employs an average of 100 manufacturing and research personnel. At this time, the U.K. plant continues to supply a significant amount of the product for the U.S. market.

H.R. 2889 would illogically apply in this case where the plant has "run-in" rather than "away." Surely this cannot be good tax policy.

Given these purposes for establishing manufacturing outside of the U.S., it is submitted that it is inappropriate to expand subpart F to tax foreign manufacturing profits prior to distribution where the foreign manufacturing profits result from exports to the U.S.

4. EXPANDING SUBPART F TO COVER EXPORTS TO THE U.S. WOULD BE ANTICOMPETITIVE. Not only is there no reason to penalize foreign manufacturing for the U.S. market by expanding subpart F, but to do so would be counterproductive and detrimental to the international competitiveness of U.S. businesses. The central reason for this is that in virtually all sectors U.S. business competes with foreign business. Indeed, that is the main reason for the deferral principle as discussed above. U.S. business needs no less capital than its competition, and U.S. taxation of profits while still used abroad in active business is a drain on those resources and a deterrent to U.S. competitiveness. As stated, when the use in active business abroad ends by passive investment or investment in the U.S., deferral ends and U.S. tax applies.

While in most cases manufacturing abroad relates to foreign markets, when the manufacturing also supplies U.S. markets, the competition is no less and the need for U.S. business to have comparable resources at its disposal is no less.

Indeed, in some cases the expansion of subpart F could make the U.S. business abroad sufficiently less competitive so that it cannot continue. This means abandoning the business to foreign competition, which would not be subject to H.R. 2889 or comparable foreign provisions, hardly an advantage to the U.S. economy.

5. GATT ILLEGAL. It is noted that the proposed legislation would, in effect, create a scheme reminiscent of DISC. Under H.R. 2889, like DISC, income from foreign sales would be deferred for tax purposes, while income from domestic sales would not be deferred. In the case of DISC, the U.S. for the first time in history agreed that it had created an illegal export subsidy which it needed to and did terminate. The objection was deferral of tax on a portion of the income generated by exPort sales through a DISC, while domestic sales of similar property were subject to immediate U.S. income taxation. The H.R. 2889 regime is the obverse of DISC in that it discourages exports to the U.S. through the selective use of tax deferral. This raises the question of whether it is similarly GATT-illegal. Moreover, H.R. 2889 also could be considered an investment impediment. At a time when the U.S., in the Uruguay round, is fiercely negotiating away various types of trade and investment barriers erected by other countries, it would be extremely inappropriate and indeed imprudent to recreate a potential trade complaint or negotiating point other countries could use against the United States.

Avoiding GATT violations is not only a matter of adhering to international obligations, but GATT adherence benefits the U.S. economy and U.S. jobs. The U.S. economy benefits from an open trading and investment system. A substantial portion of U.S. jobs are the result of U.S. exports. While the current trade imbalance is of concern, the solution is better U.S. competition, not closing our markets through quotas, tariffs, or tax impediments.

6. SIMPLIFICATION. The NFTC would be remiss if it did not also point out that operating under subpart F involves major complexity and that any expansion of subpart F just adds to the problem. At a time when the Ways and Means Committee and the Senate Finance Committee are seriously working on simplification, H.R. 2889 goes in the wrong direction. In other words, in addition to the objections on policy grounds, the bill is objectionable because of the administrative burdens it would add. In addition to the normal burdens of complying with subpart F, H.R. 2889 would require CFCs to trace the disposition of their products and technology to determine whether any purchaser in a chain of transactions had shipped goods containing the CFC's products and technology to the U.S.

FOREIGN TAX CREDIT

The second provision of the bill would provide a separate foreign tax credit limitation, or basket, for "imported property income." As stated, the NFTC also opposes this provision.

In order to recognize the primary tax jurisdiction of the countries in which foreign source income is earned and to avoid double taxation, the U.S. Internal Revenue Code provides a foreign tax credit for foreign income taxes. The amount credited against the tentative U.S. income tax cannot exceed that portion of the tentative tax attributable to foreign source income. For the most part, the U.S. tax on foreign source income is determined on a worldwide basis, which permits U.S. taxpayers to average their foreign taxes for purposes of determining whether they exceed the tentative U.S. tax. There are a number of important exceptions, some of which overlap the subpart F non-deferral rules and some of which are different. The income which is treated specially and cannot be averaged appears to represent policy judgments that certain income is "tainted"; constitutes income from a separate type of business (such as financial services or shipping); is treated specially by other provisions of the Internal Revenue Code (such as DISC and FSC) and, therefore, should not be averaged with normal income; or needs to be specially treated for administrative reasons. Income which is treated specially and not averaged is effectively subject to a greater U.S. tax burden than other income.

In our view, the taxation of foreign manufacturing income does not fall in the tainted or other categories which justify a harsher foreign tax credit regime. Our analysis in connection with the deferral provision also applies here.

SERVICES

The notice of this hearing also asked for comments on service activities conducted outside of the U.S. by controlled foreign corporations. Let me emphasize that the members of the NFTC prefer to carry out service activities at home and only in special cases where competition demands do such activities take place outside of the U.S.

For the same reason we oppose expanding subpart F and establishing a separate foreign tax credit basket for manufacturing activities outside of the U.S., we oppose such provisions for service activities outside of the U.S.

CONCLUSION

In conclusion, the NFTC opposes H.R. 2889 because it ignores the fact that U.S. enterprises manufacture overseas because of business necessity, it would be harmful to the competitiveness of U.S. business, it is unnecessary, and it could be illegal under GATT and otherwise hurt U.S. trade and investment negotiations under the Uruguay round.

We recognize that there is a concern whenever economic activities take place outside of the U.S. and that concern is heightened when the destination is the U.S. However, for the reasons stated, we urge congress not to enact H.R. 2889. In our view, the concern about U.S. economic activity and U.S. jobs needs to be addressed, not by closing our borders, but by enhancing U.S. competitiveness.