TEXT AVAILABLE OF TESTIMONY ON CFC INCOME BY TREASURY'S MORRISON.

Mr. Chairman and Members of the Committee:

I am pleased to present the views of the Administration on H.R. 2889, introduced by Representatives Dorgan and Obey, and on a proposal to allow U.S.-controlled foreign corporations to elect to be taxed as domestic corporations.

BACKGROUND

The income of foreign corporations controlled by U.S. shareholders generally is not subject to U.S. tax when earned; instead, U.S. tax is deferred until the income is repatriated. Subpart F of the Internal Revenue Code (Code) eliminates deferral, however, for certain types of income that are passive or particularly mobile, taxing the U.S. shareholder on his pro rata share of such income as it is earned by the controlled foreign corporation, rather than when it is later distributed to the shareholder.

Traditionally, subpart F has eliminated deferral only on income that is passive or particularly mobile, because such income presents obvious opportunities for tax avoidance and tax-motivated behavior. This was subpart F's relatively limited goal upon enactment in 1962 and has remained its goal through nearly three decades of amendments. In contrast, income earned by a U.S.-controlled foreign corporation from less mobile, active business activities such as manufacturing is excluded from subpart F and is subject to U.S. tax only when the profits are repatriated to the United States. Subpart F presumes that bricks and mortar will not ordinarily be moved for tax reasons alone. In some circumstances, active business income may be diverted via a conduit company, from the locus of economic activity from which it arises to a low-tax jurisdiction. The "base company" rules for sales and services income under subpart F were enacted in part to prevent this abuse.

In evaluating subpart F, and any proposals to amend it, administrability is an important factor. We are dealing with foreign corporations engaged in international trade, often with unrelated persons in jurisdictions from which we can obtain little information. We must assure ourselves that both the taxpayer and the Internal Revenue Service (IRS) can identify and compute the tainted subpart F income with reasonable clarity.

Subpart F must also be viewed in conjunction with the foreign tax credit, since the elimination of deferral will sometimes have no U.S. tax impact. This occurs, generally, whenever the income being taxed under subpart F has already borne creditable foreign tax equal to or in excess of the U.S. rate. Because that income has borne as much foreign tax in its country of source as we would impose, the foreign tax credit ensures that we do not tax it again. Eliminating deferral also may have no impact on U.S. tax liability, however, even when the foreign tax on a particular item of income is low, if there are similar items of foreign income that are high-taxed. This is because of the mechanics of our limitation on the foreign tax credit.

The foreign tax credit is generally limited to prevent a credit against U.S. tax for foreign taxes that exceed the U.S. rate. To prevent excessive averaging of high and low foreign taxes, the foreign tax credit limitation is applied separately to various categories or "baskets" of income so that income that is ordinarily subject to high foreign taxes or that is not easily moved is separated from income that is ordinarily subject to low or no foreign tax (or income that might easily be moved to jurisdictions with low or no tax on such income). When there are more high taxes in one basket than low taxes, the result is excess foreign tax credits. Excess foreign tax credits can be carried forward only five years and, if still unused, then expire. If, however, there is low-taxed income in the same basket as high-taxed income, those foreign taxes can be averaged and may, in many cases, eliminate any residual U.S. tax on all the income in that basket.

Because of excess foreign tax credits in the residual or active income basket, some U.S. corporations are essentially indifferent to deferral. In fact, if these companies could elect to have their controlled foreign subsidiaries taxed currently as domestic corporations, we speculate that many would, in order to avoid an extra allocation of interest expense to foreign income (and a corresponding reduction in allowable foreign tax credits) that may occur because of the inability to consolidate foreign subsidiaries with the U.S. group for interest allocation purposes.

H.R. 2889

H.R. 2889 would expand subpart F by eliminating deferral on a new class of income of controlled foreign corporations called "imported property income." The bill defines "imported property income" broadly to include profits, commissions, fees, and any other form of income from property imported into the United States, whether derived in connection with its manufacture, production, growth, or extraction; sale, exchange, or other disposition; or lease, rental, or licensing. "Imported property" includes not only property imported into the United States by the controlled foreign corporation or a related person, but also property sold to an unrelated person, if it was reasonable to expect that the unrelated person would import the property, or a product which incorporates the property as a component, into the United States. Exceptions are provided for foreign oil and gas extraction income, foreign oil related income, and income from subsequently exported property.

In addition to the new subpart F income category, H.R. 2889 would create a new, separate foreign tax credit limitation basket for imported property income.

Because of a combination of factors, the Administration opposes H.R. 2889. First, we believe it will be exceedingly hard to administer and enforce and will add to the already considerable complexity of the taxation of U.S. multinationals. Second, we believe that the bill represents a significant departure from the traditional subpart F focus. Third, because of excess foreign tax credits and the opportunities for averaging of high and low foreign taxes within a basket, we think the bill could, in many cases, have little or no impact, even where a manufacturing plant is located in an offshore tax haven solely for tax purposes.

Our administrability, enforceability and complexity concerns are the most serious. The threshold fact that must be proved for the bill to apply -- that property produced by a controlled foreign corporation was destined for import into the United States -- would often be very difficult to determine. In the simplest case, where a finished product is shipped directly from a U.S.-controlled foreign corporation to the United States for consumption here, destination determination is straightforward. The bill itself, however, recognizes that simply addressing the direct import case is not enough since the simple case could be easily avoided. As a result, the bill requires tracing products through related and unrelated party sales (in the latter case under a "reasonable expectations" test), as well as tracing of components into the products in which they are embedded. These aspects of the bill's destination test are complex and would be unadministrable.

There are some destination-based rules already in the Code, such as the base company sales income rules under subpart F. Under these rules, a company earns subpart F foreign base company sales income when it re-sells property for use, consumption, or disposition in a country other than the same country in which it is incorporated. These rules generally do not present the significant enforcement problems that we foresee under H.R. 2889, however, because they address a narrower set of facts than the bill, i.e., either the buying or the reselling of the property must involve a related party. For this reason it is relatively easy for a foreign subsidiary to know whether it need be concerned about the base company rules. This in turn justifies the approach in the base company sales regulations which establish broad presumptions that the taxpayer must rebut. That is, all subsidiaries engaged in such purchases or re-sales are presumed to earn subpart F income unless the taxpayer can establish that the income is not subpart F income because of its source or destination. Thus, it is the taxpayer under these rules who has the incentive to know the destination of the property it sells.

It may not be feasible to adopt a comparable approach under H.R. 2889, i.e., to assume that all sales by foreign subsidiaries generate imported property income unless the taxpayer establishes the opposite. A presumption that property sold to an unrelated foreign person is destined for the country to which it is shipped would undercut the bill's rule, discussed below, that property is imported if it was "reasonable to expect" that it would be imported (or incorporated into a product that would be imported) by the unrelated buyer. A presumption that property sold to a related person was necessarily destined to be imported into the United States would be overbroad, given the common practice of locating production facilities overseas precisely to serve overseas, rather than U.S., markets.

As mentioned, the bill would tax the sale of property to an unrelated person if "it was reasonable to expect" that the property would be imported, presumably either by the unrelated buyer or anyone in its chain of distribution, whether related to the buyer or not. The IRS would thus be required to trace indirect sales through what may be a long chain of unrelated parties, some of whom may transform the property sold by the U.S. controlled foreign corporation or otherwise incorporate it into another product. In addition, the IRS would have to demonstrate whether the U.S.-controlled foreign corporation should reasonably have expected at the time of the initial sale that the property would ultimately be imported into the United States.

The first task could prove insurmountable without the cooperation of all of the parties. Such cooperation from unrelated foreign customers with no financial or legal interest in cooperating, however, may be unlikely. The IRS may also have to trace sales through multiple unrelated foreign parties in several countries, including countries with which we have no tax treaty relationship and from which we cannot readily obtain information. The likelihood of obtaining accurate information and of being able to perform an audit in such a case is very low. If the transactions involve fungible property, such as minerals, agricultural products, or other commodities, the IRS would have no practical way to tell what was imported indirectly by a U.S.-controlled foreign corporation and what was not. Further, where property produced by a U.S-controlled foreign corporation is substantially transformed by its purchaser, as, for example, when bauxite mined by the controlled foreign corporation is used to make aluminum which is then imported into the United States, it is unclear whether the property that was transformed (the bauxite) should be considered imported property or not.

The second task, determining whether "it was reasonable to expect" that the property would be imported, would also be difficult. If reasonable expectations require an inquiry into intent, the inability to prove or disprove a state of mind at a point in the past will likely stymie effective enforcement. Even if reasonable expectations can be established by objective facts existing at the time of sale without an inquiry into intent, however, the task will not be easy. The investigation would require not only an examination of the documentary and other evidence actually in the U.S.-controlled foreign corporation's possession but also a determination of whether it was reasonable for the controlled foreign corporation not to have made further inquiry. Is it reasonable, for example, for a U.S- controlled foreign corporation to rely on a buyer's statement that it has no present intention to import the property into the United States, or must the U.S.-controlled foreign corporation exercise some form of due diligence to look behind the statement? Must it go even further and insist on a warranty to enforce the statement?

From the perspective of the U.S.-controlled foreign corporation, the broad application of H.R. 2889 could also make a good faith attempt to comply very difficult. For example, the bill would require a U.S.-controlled foreign corporation selling personal computers to an unrelated Hong Kong company to predict whether the Hong Kong company would subsequently import the computers into the United States or sell the computers to a third party that would import them. Even if the U.S.-controlled foreign corporation had no indication of such intent, its income from the initial sale would become subject to current U.S. tax if it turns out that the computers actually were imported into the United States and it is found that the controlled foreign corporation should have anticipated that outcome.

The enforcement and compliance problems posed by H.R. 2889 are further complicated by the fact that the bill applies not only to finished products, but also to components that may be incorporated into other products prior to importation. We recognize that, if the bill is to be effective, it cannot simply exempt component parts. On the other hand, the administrative and compliance burden could be overwhelming if components must be traced in every case, even where the imported product contains relatively few components manufactured by a U.S.-controlled foreign corporation.

It would be difficult, for example, to trace a component, such as a semiconductor chip, once it has been incorporated into a product, such as a personal computer. Such tracing might be impossible if the component is produced in accordance with the purchaser's specifications, as is often the case, and is therefore indistinguishable from components manufactured by other suppliers. As another example, where recycled paper and virgin paper from different sources are both used to produce cardboard boxes that are shipped both to the United States and abroad, the commingling of raw material inputs can make it impossible to distinguish which boxes contain which paper.

This problem is compounded because an unrelated foreign purchaser of components from a U.S.-controlled foreign corporation would have no incentive, financial or otherwise, to provide the information necessary to determine whether or NOT the components will be incorporated into products for the U.S. market. Indeed, the incentive is likely the opposite -- not to provide such information -- since it may be proprietary or of a competitively sensitive nature or quite costly to obtain. For example, a U.S.- controlled foreign corporation manufacturing television components may be aware that an unrelated foreign purchaser of such components is selling some of its output of televisions to the U.S. market. The purchaser, however, may well be unwilling to put in place the expensive inventory tracking mechanisms necessary to trace the components, solely for its supplier's benefit. Nor would such a purchaser divulge such information to a supplier if it were likely to give that supplier an advantage over other suppliers. If a U.S.- controlled foreign corporation component manufacturer insists on information from its foreign customers regarding the finished product into which the component is incorporated and its destination, the foreign customer might simply choose other, non-U.S. controlled sources of supply rather than disclosing sensitive, competitive information.

The administrative problems of H.R. 2889 are further complicated by the exception the bill provides for property imported into the U.S. but subsequently exported. It is common for U.S. manufacturers in certain industries to produce components overseas for use in U.S.- manufactured or U.S.-assembled products that are then sold both in U.S. and foreign markets. In some cases, this may be the only way for a U.S. manufacturer to avoid relying on a foreign-owned parts supplier. Under the bill, however, if a U.S.-controlled foreign corporation is used, the U.S. manufacturer will be taxed on the controlled foreign corporation's income unless it can trace the parts through the finished product and show that the finished product is exported.

Even if U.S.-controlled foreign corporations can surmount these compliance problems and determine whether and to what extent their gross income is derived from "imported property," H.R. 2889 would result in onerous new accounting and reporting requirements. For example, to compute the amount of "imported property income," both for subpart F and for foreign tax credit purposes, the corporations would have to determine their expenses deductible against that income. This would place additional pressure on the already complex and controversial expense apportionment provisions of the Code and the regulations. Where the imported property income arises as the result of the unanticipated subsequent actions of an unrelated party, the U.S.-controlled foreign corporations may not have maintained books and records to support an allocation of expenses.

Compliance and enforcement problems are not the sole reason for opposing this bill. As noted above, subpart F generally does not tax non-mobile, active income such as most income from manufacturing. Since H.R. 2889 would impose current U.S. tax on a category of non- mobile, active business income, it departs in an important way from the traditional rationale for subpart F.

Foreign production of goods for the U.S. market may, in many cases, be primarily attributable to factors such as the proximity of raw materials and other natural resources, or to comparative economic advantages such as lower labor costs or a more favorable climate. In comparison, the data suggest that taxes often represent a relatively small part of total costs, particularly where the savings are not likely to be inflated artificially by non-arm's length transfer pricing.

Further, the goods produced by a U.S.-owned company abroad may not necessarily replace those that it would produce if it were operating in the United States. The most obvious example is that of agricultural products, such as bananas, or minerals that cannot be grown or extracted in adequate quantities in the United States because of climate or insufficient deposits. The bill appears to recognize the importance of some geographical limitations, since it provides an exception for foreign oil and gas extraction income and foreign oil related income, but it ignores other geographic factors. The bill may, therefore, serve to increase taxes for U.S.-controlled foreign agricultural companies or non-oil mineral companies that have no choice but to produce or extract abroad.

Finally, we have serious reservations about whether the bill would accomplish its intended purposes in certain circumstances. Commerce Department data indicate that a relatively small share -- approximately 15 percent -- of total imports come from U.S. affiliates located in low-tax countries. Most imports from affiliates are from Canada, Japan and Europe. If the same U.S. multinational company that imports from its manufacturing plant in a low-tax country also imports from an affiliate in relatively high-tax Canada or Germany, the excess foreign tax credits from the Canadian or German imports would be averaged with those from the low-taxed country imports, since both would be in the new "imported property income" basket. Those credits would thus shield the low-taxed country income from residual U.S. tax under an amended subpart F. This could, of course, essentially eliminate the impact of the bill for such companies.

U.S. ELECTION FOR CONTROLLED FOREIGN CORPORATIONS

The Committee has also requested our views on allowing U.S. shareholders to elect to treat their controlled foreign corporations as U.S. corporations for tax purposes. The Administration opposes this proposal because it would entail a substantial revenue loss. Preliminary estimates are that the provision would lose about $1.5 billion over the five-year budget window, even with safeguards.

Obviously, taxpayers would make such an election only if it reduced their U.S. tax liability. A reduction in U.S. taxes could occur for a significant number of U.S. multinationals through the greater use of foreign tax credits obtained via the election. Specifically, the election would permit a U.S. multinational to treat its controlled foreign corporations as members of its U.S. affiliated group for purposes of allocating interest expense between domestic and foreign source income. The effect for many U.S. multinationals would be a smaller allocation of interest expense to foreign source income. The resulting increase in foreign source income would permit the multinational to utilize more foreign tax credits. While the existing interest allocation rules are often criticized on policy grounds for allocating too much interest expense to foreign source income, and the elimination of deferral via the U.S. election would remove a policy objection to allocating interest on a worldwide group basis, elective relief from these rules would be very costly.

If such a provision were to be considered by Congress, certain safeguards could be desirable to help to minimize revenue loss and to prevent abuse. These include a consistency rule requiring that a U.S. shareholder make the election with respect to all affiliated controlled foreign corporations of which it is a U.S. shareholder, and not merely those that generate net operating losses or bear high foreign taxes. In addition, each controlled foreign corporation to which an election applied could be treated as transferring all of its assets to a domestic corporation at the time of the election, and the "toll charge" now imposed on inbound reorganizations could apply. Finally, restrictions could be imposed on revocation of the election.