Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
REPORT OF THE TASK FORCE ON INTERNATIONAL TAX REFORM
Members of the Task Force who participated in the preparation of this Report are: Peter H. Blessing; Mark van Casteren; Robert E. Culbertson; Jasper L. Cummings, Jr.; William S. Dixon; Alan F. Fischl; Robert J. Peroni; Elinore J. Richardson; Leonard Schneidman (Co-Chairman); Stephen E. Shay (Co-Chairman); Carol P. Tello; Joni L. Walser; Philip R. West; and Lowell D. Yoder. Mr. Shay was the principal draftsman with significant contributions from Messrs. Blessing, Cummings, Dixon, Peroni, Schneidman, Yoder, and West and Ms. Tello. The Task Force has benefited greatly from consultations with foreign tax lawyers and fiscal economists. The Task Force is indebted for foreign tax law advice to Yash Rupal of Linklaters (London), Edouard Milhac of CMS Bureau Francis Lefebvre (Paris), Friedhelm Jacob of Hengeler Mueller (Frankfurt), Gary M. Thomas of White & Case (Tokyo), Mark van Casteren of Loyens & Loeff (Amsterdam and New York), and Elinore Richardson and Stephanie Wong of Borden Ladner Gervais (Toronto). The Task Force also appreciates the substantial contributions of Professors Mihir Desai and James R. Hines Jr., who met several times with the Task Force and advanced the Task Force’s understanding of fiscal economists’ perspectives on cross-border tax issues. Finally, the Task Force acknowledges the research and editorial assistance of Erica Fung and Kase Jubboori. The views expressed in this Report solely reflect the personal views of the authors and of the participants in the Task Force and do not represent the position of the American Bar Association, or of the Section of Taxation or any of its committees.
A. Objectives of the Report
The American Bar Association Section of Taxation convened the Task Force on International Tax Reform (the “Task Force”) to provide policymakers with objective criteria by which to evaluate reform proposals and to identify and analyze possible specific modifications to the U.S. international tax rules. This Report considers the taxation of U.S. persons’ foreign business income. 1 The Report identifies and evaluates possible changes to current law, but does not make legislative recommendations. 2
While there is current questioning as to whether an income tax should be replaced with a consumption tax, the income tax is unlikely to be displaced. The problems of transition and the rates that would be required to achieve revenue neutrality, as well as other problems, are extremely daunting. 3 The Report proceeds on the assumptions that the income tax will be retained as a material element of the U.S. tax system and that the United States will continue to impose an income tax on business income. 4
The remainder of Part I discusses topics covered in subsequent chapters and reasons to consider reforms of the international tax rules. Part II of this Chapter provides an executive summary of the discussion in each subsequent chapter of the Report.
Chapter 2 discusses tax policy criteria for evaluating international tax rules, including fairness, efficiency, and administrability. Chapter 3 provides an overview of existing U.S. international tax rules and describes how current U.S. rules are applied in practice by taxpayers. Chapter 4 evaluates the following alternatives to the current rules, under the policy objectives described in Chapter 2: (1) an exemption system for taxing foreign income and (2) taxing currently foreign income earned through a controlled foreign corporation.
Chapters 5 through 7 review structural elements of the current U.S. rules. These chapters identify and evaluate selected proposals for change in light of the policy objectives set out in Chapter 2. Chapter 5 discusses the foreign entity classification rules in the cross-border context and the rules for determining when a corporation (or a business entity treated as a corporation for tax purposes) should be treated as a U.S. tax resident. Chapter 6 analyzes selected aspects of the U.S. foreign tax credit rules for avoiding double taxation, including what income should be treated as foreign for purposes of the foreign tax credit limitation, when deductions should be considered to offset foreign income, how losses should be treated and the extent to which a credit for a foreign income tax should be allowed against U.S. tax on other foreign income (cross-crediting). Chapter 7 analyzes the taxation of foreign active business income earned by a U.S. person through a foreign corporation and makes proposals for reforming the subpart F base company sales and services rules. These subpart F proposals would have equal applicability if one of the proposals to move to a system for exempting foreign income were adopted.
The discussion in each of these chapters is summarized in Part II of this Chapter.
B. Reasons to Consider International Tax Reforms
A fundamental review of our rules for taxing foreign business income is long overdue for a number of reasons. There has been no such review since the 1960s. The Tax Reform Act of 1986 adopted substantial changes to the income source, expense allocation, and foreign tax credit rules largely in response to a concern that the 1986 Act’s substantial reduction in U.S. corporate income tax rates would result in use of excess foreign tax credits to erode the U.S. tax base. Other changes, such as the passive foreign investment company rules, were adopted as responses to perceived abuses. The possibility of fundamentally altering the existing rules was given very limited consideration. 5 The American Jobs Creation Act of 2004 (the AJCA) cannot be considered to have constituted international tax reform in any fundamental sense. The driving force behind adoption of the Act was to repeal the Extraterritorial Income Exclusion, which, as discussed in Chapter 3, benefits U.S. exporters that do not have foreign operations subject to high foreign taxes. In connection with that repeal, the Congress adopted a rate reduction on domestic manufacturing income and a series of other changes that reduced taxation of foreign business income. These changes continued the direction of existing U.S. rules that, as described more fully in Chapter 3, may be applied to achieve a very low effective rate of taxation of foreign business income.
For example, the AJCA’s changes to the foreign tax credit limitation rules substantially expand the extent to which high foreign taxes can be “cross-credited” against U.S. tax on other, low-taxed foreign income. As discussed below, cross-crediting is inconsistent with a position that income earned in another country should be taxed at the rate imposed by that country, because it effectively lowers the burden of the source country tax by allowing it as a credit against the U.S. tax on other foreign income. 6 At the same time, the AJCA also included a supposedly one-time 85% dividends-received deduction for so-called homeland dividends that will be utilized principally with respect to foreign earnings that have borne a low rate of foreign tax. The consistent feature of these and other AJCA international tax provisions is that they further reduce the U.S. taxation of foreign income of U.S. multinational corporations. 7
The President’s Advisory Panel Report also did not undertake a fundamental review of the international tax provisions. The Panel recommends adoption of a territorial system in its Simplified Income Tax Plan, citing research that “ suggests this reform could lead to both efficiency and simplification.” 8 Yet, the Report also argues that the proposal provides “no additional incentive to invest abroad, if, in response to the current system, firms have already arranged their affairs to avoid the repatriation tax” and that the “Simplified Income Tax Plan would produce no less revenue from multinational corporations than the current system.” 9
The analysis in the President’s Advisory Panel Report rests on the assumption that eliminating the tax on repatriation would not open up the benefits of low-taxed foreign income to new taxpayers, which, as discussed in Chapter 4, would appear to be clearly incorrect. The President’s Advisory Panel Report does not discuss the conflicting research on the efficiency effects of moving to an exemption system, and does not analyze any alternatives to exempting foreign business income.
The President’s Advisory Panel Report appears to have accepted current law treatment of foreign income as a measure of an appropriate level of taxation of foreign income. This was not a requirement of its mandate to propose reform plans that are revenue neutral overall. The effective rate of U.S. and foreign income taxation of foreign income is understood to be materially lower than the effective rate on domestic income. 10 The President’s Advisory Panel Report does not discuss this fact, question whether a disparity in taxation is good policy, or explore justifications for such a policy.
The President’s Advisory Panel Report set out the following standard for consideration of proposals that favor one activity over another:
Tax provisions favoring one activity over another or providing targeted tax benefits to a limited number of taxpayers create complexity and instability, impose large compliance costs, and can lead to an inefficient use of resources. A rational system would favor a broad tax base, providing special tax treatment only where it can be persuasively demonstrated that the effect of a deduction, exclusion, or credit justifies higher taxes paid by all taxpayers. 11
Instead of rigorously applying this standard to the taxation of foreign business income, including whether foreign income should be exempt from tax, the President’s Advisory Panel uncritically accepts the need for continued favorable taxation of foreign business income without analyzing its consequences for the overall U.S. taxation system. This Report takes a different approach and examines the taxation of international business income under standards that are consistent with the standard articulated above.
Before undertaking a review of U.S. international tax rules, the following sections describe changes to the context in which international tax rules are applied which have occurred since the adoption of the subpart F regime in the 1960s. These changes should be taken into account in connection with evaluating possible changes to current international tax rules.
Recently, policymakers have been challenged to take account of fairness as a criterion in international tax policy and an analysis of our international rules should include consideration of fairness issues. 12 While there may be differences regarding the ideal tax base or rate structure to employ in taxing income, there is a broad consensus supporting application of fairness criteria to policy analysis of the income tax system.
One of the objectives of this Report is a balanced discussion of the consequences of different ways of taxing foreign income. 13 The Report identifies ways in which the international tax rules may be used to achieve a low level of taxation of income from U.S. economic activity that is treated as foreign income as well as on other “real” foreign income. A lower tax burden on foreign business income should be justified by benefits to U.S. citizens and residents that exceed the costs of the resulting increased taxation on domestic income.
2. Global Economic and Political Change
Our international tax rules need to take account of the economic and political context in which they are applied, including our relations with other countries and their peoples. Over the last half century, elimination of exchange controls and adoption of free exchangeability of currencies, increasingly efficient global capital markets, revolutions in communications and information processing, reductions in barriers to trade and movements of people, and faster and cheaper transportation of goods and people have contributed to a reconfiguration of our economy and its relationship to the global economy. The transaction costs of cross-border economic activity have been dramatically reduced. 14 Whole U.S. industries have died or moved to other countries and new U.S. industries have been born and thrive. These changes have contributed to a vastly increased economic and political interdependence of countries within and between regions of the world.
While the United States is currently the dominant global economic power, lowered barriers between markets for goods, services, labor, and knowledge are supporting economic growth and development in the European Union, the Peoples Republic of China, and formerly less developed countries such as India. Certainly, the stability and economic prosperity of developing countries is in the United States’ long-term interest. However, U.S. citizens and residents are competing in a global economic marketplace, and our government’s highest priorities should include the need to advance (and certainly not impede) the ability of American individuals, and the businesses that employ them, to be successful in the competition to sustain and create strong jobs in the United States.
3. Changes in Business Practice
Our international tax rules were designed when cross-border economic activity consisted principally of the sale of manufactured goods and certain services. Today, services and transfers of intangible property have dramatically increased in importance. International tax rules based on a paradigm of property being manufactured and sold do not readily accommodate the deconstruction of economic functions that characterizes modern business. Services are outsourced to related or unrelated providers. Manufacturing is performed at multiple locations, using related or unrelated vendors and employing just-in-time inventory and modern logistics. Intangible values are recognized in the market and legally protected intangibles are used as commercial swords and shields, and are located to maximize tax efficiency. These phenomena place pressure on the ability to apply transaction-based tax and intercompany transfer pricing rules to a range of common transactions.
In the past decade, multinational taxpayers have brought increased resources and focus to reducing their overall tax costs. Partly as a consequence of transfer pricing documentation requirements and partly as an effort to lower tax costs, multinational taxpayers pay increasing attention to transfer pricing, including transfer pricing planning. Taxpayers’ advisors routinely bring tax reduction planning ideas to their attention. In designing international tax rules, policy makers must take account of the effects of business pressures to lower tax costs on U.S. and foreign business activity, as well as broader competitive pressures arising from global markets.
4. Preservation of U.S. Tax Base
There is evidence that U.S. multinationals are shifting increasing portions of their profits to low- or zero-tax foreign countries. 15 Some of the profits shifted to low-tax countries likely are from the United States as well as from foreign countries. 16 While looking to international income as a source of additional revenue, it also should be evaluated in relation to other applicable tax policy criteria; it is important to analyze whether existing international rules adequately protect the intended U.S. tax base. 17 The description in Chapter 3 of current international tax rules and how they are employed in planning suggests that these rules permit substantial erosion of a reasonably defined U.S. tax base. If fundamental reform proposals are made that increase taxation of U.S. income, it will be important to assure U.S. taxpayers that foreign business income is not inappropriately advantaged. While changes to international tax rules generally have not been a source of revenue, changes that redress incursions into the U.S. tax base would indeed raise revenue.
5. Accretive Complexity
An additional reason for fundamental review of our current international tax rules is the burden of “accretive complexity” resulting from numerous changes to these rules (including by the AJCA) without a consistent tax policy direction. Indeed, most of the amendments to the international rules over the last two decades have been stop-gap responses to perceived abuses without significant consideration of underlying policies. 18 There is widespread consensus that our international tax rules are complex and impose substantial compliance burdens. It is appropriate to consider reforms that would meaningfully reduce this burden consistent with other policy objectives.