Economist's Testimony at W&M Subcommittee Hearing on the Extraterritorial Regime

[2] Thank you for inviting me to testify today on changes to the Tax Code to promote the international competitiveness of U.S. companies in the light of the WTO ruling. My name is Scott Newton. I am a managing director of Horst Frisch Incorporated, an economics consulting firm. Throughout my career my work has focused on the economic analysis of international tax issues in academic research, policy analysis while at the Treasury Department, and in my consulting practice working with multinational companies and tax authorities. For the record, I am testifying today on my own behalf and not as a representative of any organization.

I. Objectives and Principal Conclusions

[3] In the announcement of this hearing, Chairman McCrery stated that the purpose of the hearing was to "explore a third possible response to the WTO's ruling, namely making changes to the Tax Code to promote the international competitiveness of U.S. companies." In my comments today, I would like to focus on responses involving the international provisions of the Tax Code, an area in which there is certainly room for improvement. In considering such responses, we should not lose sight of the fact that there are various objectives possible for U.S. domestic and international tax policy:

• Competitiveness: Which is generally understood to mean the ability of U.S. firms to compete successfully with foreign firms in domestic and international markets. This includes competition by U.S. firms from operations in the U.S. to serve domestic and foreign markets and competition by U.S. firms through their foreign subsidiaries and branches.

• Economic efficiency: Which is generally understood to mean that the tax system should affect as little as possible the allocation of resources to the most productive investments. In the international context, this means that the tax system ideally would not favor foreign investment over domestic investment or vice versa.

• Preservation of the tax base: The U.S. international tax regime should not undermine our ability to collect tax on the U.S. tax base.

• Simplicity: Complexity can create substantial costs of compliance for taxpayers and administration for the IRS.

[5] With these objectives in mind, I will focus in the remainder of my testimony on three areas. First, I will discuss briefly the effect [of] the WTO ruling and its implications for the objectives we discussed above. Second, I will discuss the current tax system and how it measures up in terms of competitiveness concerns and the other objectives discussed above. Finally, I will discuss one of the principal alternatives to the current system that is currently under discussion, some form of a territorial tax system.

[6] To summarize my principal conclusions:

• If the WTO decision results in the repeal of the extraterritorial income regime (ETI), we should be grateful to the WTO for forcing us to do something that will benefit Americans as a whole. The ETI represents an export subsidy, which distorts trade. It may benefit particular companies and possibly their workers, but overall it makes us poorer than a free trade policy would.

• The current U.S. international tax regime represents a mixed bag in terms of its effects on competitiveness, economic efficiency and protection of the tax base. In general, relatively little U.S. tax is collected on foreign source income of U.S. companies from active non-financial foreign investment. This suggests that, in terms of the direct burden of U.S. taxes, the competitiveness objective is most close to being satisfied. At the same time, in specific areas in which location of investment is often considered more mobile, such as financial services, the rules emphasize efficiency and tax base protection over competitiveness. However, given the increasing global integration of these markets and the ease with which companies operate across borders, it may be time to give competitiveness concerns greater weight.

• The current U.S. international tax regime clearly fails on simplicity grounds. In many cases U.S. companies face onerous burdens of compliance with exceedingly complex rules. Changes that reflect a rebalancing of competing objectives in favor of simplicity could result in net improvements in competitiveness and economic efficiency, without substantially undermining the U.S. tax base.

• A realistic territorial tax regime could have some attractive features, however, its impacts on U.S. multinationals would vary, and for broad classes of companies, it would not necessarily lower tax burdens. In addition, the prospects for simplification may not be significantly better than under the current system, if we continue to care about preventing erosion of the U.S. tax base.

[7] As I have stated, the WTO ruling should be considered a victory for Americans, assuming that the extraterritorial income regime (ETI) is repealed and the tax revenues thereby saved are used for some more worthy policy objective. The ETI is in fact an export subsidy, which distorts trade by subsidizing the consumption of U.S. products by foreigners. If the subsidy increases exports at all, it has to be because the price of U.S. exports falls relative to foreign imports. Thus, all least a part of the benefit from this subsidy is passed through to foreigners, and Americans as a whole are made poorer as a result. The shareholders and workers of particular companies may get some of the benefit from the subsidy if it increases company profits and/or wages, but if exports are increased at all it has to be because part of the benefit goes to foreigners.

[8] Eliminating trade distortions like the ETI and following a policy of free trade is likely to lead to a higher standard of living for Americans as a whole.

III. Current U.S. Policy Towards Foreign Income

[9] The United States taxes its resident corporations and individuals on their worldwide income. For U.S. multinational corporations, this system is complicated and sets up varying incentives for foreign investment and income repatriation depending on the particular circumstances of the U.S. parent corporation.

A. Key Elements of the System

[10] The key elements of the system are deferral, the foreign tax credit, the allocation of expenses to foreign income, and the income source rules.

Deferral

[11] The timing of the imposition of U.S. tax on the income of U.S. companies from their foreign operations depends upon the way in which the foreign operation is organized. If it is organized as a branch of the U.S. corporation, then the income of the branch is taxed as it accrues. If it is organized as a controlled foreign corporation (i.e., it is separately incorporated in the foreign country), then the income (with some important exceptions) is not generally taxed until it is remitted to the U.S. parent. This delay in the taxation of a subsidiary's profits until they are actually remitted is known as deferral.

[12] Under the current tax rules deferral is limited by anti- deferral rules that are targeted at certain types of income that are considered to be particularly mobile or low-taxed. These anti- deferral rules (largely the subpart F provisions) are the source of considerable complexity.

Foreign Tax Credit

[13] To avoid double taxation, a credit against U.S. tax is provided for foreign taxes paid on foreign source income. The credit covers both taxes incurred directly on payments of income from abroad, such as withholding taxes on dividends, interest and royalties, and, for income from a controlled foreign corporation (i.e., a separately incorporated subsidiary of a U.S. company) the foreign taxes on income out of which a dividend distribution is made to the U.S. parent company. The foreign tax credit is limited to the amount of U.S. tax payable on the foreign income. If the foreign tax exceeds the U.S. tax payable, excess credits are created. These excess credits may be carried back two years or forward five years to offset U.S. tax payable on foreign income in another tax year.

[14] The limitation on the foreign tax credit operates to a large extent on an overall basis, that is, income from different sources can be mixed together and excess credits from a source of income that faces a high foreign tax rate may be used to offset U.S. tax from a source of income that faces a low foreign tax rate. This "cross-crediting" is limited by the placement of various different types of foreign source income into nine different "baskets" that are each subject to a separate foreign tax credit limitation. Most foreign source income falls into the general limitation basket. The separate limitation categories generally include types of income that are subject to low foreign taxes or are considered to be particularly mobile and thus easily located in low-tax locations.

[15] The large number of separate limitation baskets creates a substantial degree of complexity and imposes costly recordkeeping burdens.

Expense Allocation

[16] The allocation of expenses to foreign source income has the objective of determining the appropriate amount of foreign source net income, which feeds into the calculation of the foreign tax credit limitation. In principle, only expenses that support the earning of the foreign source income should be allocated to foreign source income. Since the allocated expenses are typically not deductible in the foreign jurisdiction, the effect of allocating expenses against foreign source income is to reduce the foreign tax credit limitation. If the taxpayer has excess foreign tax credits at the margin the allocation of expenses to foreign source income in this case effectively represents a denial of the deduction.

[17] The rules regarding allocation of interest expense merit specific discussion. These rules provide for what is referred to as "water's edge fungibility." This means that U.S. interest expense is allocated between domestic and foreign source income. The idea is that the U.S. borrowing supports both the U.S. and foreign operations. However, as is widely understood, this method ignores the fact that a foreign subsidiary of a U.S. company may be supported by its own external borrowing.

Source Rules

[18] Any system that treats foreign source income differently from domestic income (e.g., by allowing a foreign tax credit or exemption) requires source rules to determine what income should be considered foreign source. The only aspect of these rules which I will comment on is the sales source rule. This rule permits U.S. companies that manufacture in the United States and export their products to treat 50 percent of the income from those exports as foreign income. For those companies that have excess foreign tax credits, this amounts to an exemption of this income from U.S. tax.

[19] This rule effectively amounts to an export subsidy similar to (and more generous than) the ETI, but of benefit only to U.S. companies that have excess foreign tax credits. The same analysis applies to this subsidy as to the ETI: It may benefit particular firms, but it is a distortion of trade that is likely to harm Americans as a whole.

B. Effects of the Current System

[20] How does the current system measure up in terms of competitiveness and the other objectives I listed above?

[21] Standard economic analysis indicates that economic efficiency is promoted if U.S. firms face the same tax on investment income, whether that income is earned from a domestic investment or a foreign investment. This is generally referred to as "capital export neutrality." On the other hand, competitiveness is promoted if U.S. firms investing abroad face the same tax as local firms. This is generally referred to as "capital import neutrality." The current rules regarding deferral and the foreign tax credit reflect a compromise between the competitiveness and efficiency objectives and the objective of preserving the U.S. tax base.

[22] If we only cared about competitiveness, that objective could be achieved by exempting foreign source income from U.S. tax. In that case, the only tax that would apply would be the local tax. ¹ In many cases, the current system in effect works like an exemption system. If excess foreign tax credits are available for cross-crediting, investment in a low-tax jurisdiction will in fact bear no additional U.S. tax. Even if there are no excess foreign tax credits, if the U.S. tax on low-tax foreign earnings can be deferred through reinvestment abroad, its present value is reduced. If the deferral is for a sufficiently long period of time, it is virtually equivalent to exemption.

[23] In fact, studies indicate that non-financial U.S. companies do a good job of avoiding substantial U.S. tax on their foreign earnings. Using tax return data, Rosanne Altshuler and I found that non-financial U.S. companies as a whole paid little in the way of U.S. taxes on their foreign earnings. ² We found that the average U.S. tax rate on the foreign source income of these companies was only 3.4 percent in 1986. Harry Grubert and John Mutti performed similar, but more sophisticated calculations using data from 1990 and found an effective U.S. tax rate of only 2.7 percent on income paid back to the United States and 1.9 percent on total foreign income, both repatriated and unrepatriated. ³ These data of course only deal with non-financial companies, and they are bound to mask considerable variation across companies in terms of their mix of business and tax position. However, they suggest that for many U.S. companies the direct U.S. tax burden on their foreign source income is small.

[24] We have anti-deferral rules for two reasons. One is the concern about potential erosion of the U.S. tax base if tax can be deferred indefinitely on highly mobile types of income. If deferral were available on passive income, for example, foreign subsidiaries could be used essentially as mutual funds that could invest passively and avoid U.S. tax on earnings indefinitely. There was also a concern that in the case of business activities that were considered to be particularly mobile, such as foreign base company sales and services operations and financial services, deferral would provide too great an incentive to shift activities to low-tax jurisdictions. This raised concerns in regards both to tax base erosion and efficiency in the allocation of investment between the United States and low tax foreign locations.

[25] However, competitiveness concerns may be particularly relevant in respect of the taxation of financial services income. Integration of international financial markets has placed U.S. financial institutions in increasingly direct competition with foreign financial institutions. The current U.S. taxation of foreign source financial services income may disadvantage the U.S. firms relative to some of their foreign competitors.

[26] In any case, both the U.S. anti-deferral regime and the foreign tax credit regime involve substantial complexity. Simplifying them could bring benefits in terms of reduced compliance burdens. While there would be some potential trade-off with competing objectives, given the extreme complexity of the current rules, there are worthwhile tradeoffs to be made.

[27] As noted above, the current interest expense allocation rules generally amount to a partial disallowance of U.S. interest deductions if the U.S. parent company has excess foreign tax credits. This raises the cost of borrowing through the U.S. company and provides a strong incentive to shift borrowing to foreign subsidiaries. This may harm the firm if borrowing through foreign subsidiaries involves higher costs. A better approach would be to allow the allocation of worldwide interest expense for a multinational group.

IV. The Territorial Income Tax Alternative

[28] About half of the OECD countries have a territorial system under which dividends a company receives from foreign subsidiaries are exempt from tax. If the United States were to adopt such a system, it is not clear whether this would be beneficial in terms of the criteria we have discussed: competitiveness, efficiency, preservation of the tax base or [sic] and simplicity.

[29] The typical territorial approach in other countries exempts only dividend income from active businesses. Dividends from portfolio investments and all interest and royalties are taxed when they are paid, with a foreign tax credit provided for foreign taxes paid only on these items of income. In addition, to varying degrees these countries also may have their own anti-deferral regimes that tax certain income earned by foreign subsidiaries as it accrues.

[30] It is only natural that these countries limit the exemption in this way. They are concerned about preservation of their tax base and do not wish to provide their companies with inordinate incentives to invest abroad. Exempting foreign source royalties from taxation would make it enormously rewarding for companies to transfer intangible assets such as patents, technology and know-how to a foreign subsidiary, since the returning royalty could be largely untaxed. Similarly, exempting interest receipts from foreign subsidiaries would make it enormously rewarding for companies to push down the income of the subsidiary by financing the subsidiary largely with debt, effectively avoiding any tax. Given that substantial categories of income would still be taxed on a worldwide basis, with a foreign tax credit, and that anti-deferral measures would remain necessary, it is unclear that an exemption system would necessarily be any simpler than the current system. ⁴

[31] Perhaps surprisingly, moving to a territorial system along these lines would likely increase U.S. tax payments for many companies. This would occur for three reasons. First, many companies currently use excess foreign tax credits from highly taxed foreign source income to offset U.S. tax on foreign source royalties. Under an exemption system, these companies would continue to pay the same high foreign taxes on their operations, but they would no longer be able to shelter their foreign source royalties from U.S. tax with foreign tax credits. Second, and similarly, many companies now benefit from the sales source rule - but they only do so because they have excess foreign tax credits to offset U.S. tax on the sales income that is treated as foreign source under this rule. Under an exemption system there would be no foreign tax credits, so this benefit would disappear. Finally, currently allocations of U.S. interest and overhead expenses against foreign source income result in an effective disallowance of these deductions only when a company has overall excess foreign tax credits. Under an exemption system, these allocations would virtually always result in a disallowance of the deduction, since there is no tax on the foreign source income and it would be difficult to get many foreign tax authorities to accept a deduction against their own tax for expense allocations of this nature. Together, these effects are so substantial that Harry Grubert has estimated that substituting an exemption system for the current system would actually raise tax revenue. ⁵

[32] Companies that operate predominately in low-tax jurisdictions would be more likely to benefit directly from a territorial system, since they are not able under the current system to cross-credit to shield their low-tax foreign income from U.S. tax. Because of this, there would be increased incentives for companies to shift operations from high-tax to low-tax locations. To the extent this reduces total foreign taxes paid, it is a benefit to the United States. On the other hand, to the extent that there is a substantial tax-induced shift of investment out of the United States to low-tax locations, this would be harmful both in terms of the economic efficiency of the allocation of our capital stock and because of erosion of the U.S. tax base.

[33] The ultimate effects of moving to a territorial system would depend on the specific provisions of the system as adopted. Given that there are competing valid policy objectives, and the impacts of moving to such a system would likely vary across companies and industries, it is unclear at this point what such a system might end up looking like if it were actually implemented. Therefore we should be cautious about comparing the current international tax system to an idealized territorial system.

² See Rosanne Altshuler and T. Scott Newlon, "The Effects of U.S. Tax Policy on the Income Repatriation Patterns of U.S. Multinational Corporations," in Studies in International Taxation, ed. A. Giovannini, G. Hubbard, and J. Slemrod, pp. 77- 115, Chicago: University of Chicago Press, 1993.

³ See Harry Grubert and John Mutti, "Taxing Multinationals in a World with Portfolio Flows and R&D: Is Capital Export Neutrality Obsolete?" International Tax and Public Finance, 2, No. 3, November 1995, pp. 439-57.

⁴ For a complete discussion of issues in the implementation of an exemption system, see Michael J. Graetz and Paul W. Oosterhuis, "Structuring an Exemption System for Foreign Income of U.S. Corporations," National Tax Journal, 44, No. 4, December 2001, pp. 771-86.

⁵ See Harry Grubert, "Enacting Dividend Exemption and Tax Revenue," National Tax Journal, 44, No. 4, December 2001, pp. 811-28.