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These comments to Congress evaluate the international tax aspects of the proposed H.R. 5095, American Competitiveness and Corporate Accountability Act. The comments generally support Title III—Simplification of Rules Relating to the Taxation of United States Businesses Operating Abroad and discuss generally concerns with Title II, Section 201, Reduction in Potential for Earnings Stripping by Further Limiting Deduction for Interest on Certain Indebtedness.
October 1, 2002
The Honorable William M. Thomas
Chairman, House Ways and Means Committee
1110 Longworth House Office Building
Washington, D.C. 20515
Re: Comments on the International Tax Provisions in H.R. 5095, the American Competitiveness and Corporate Accountability Act
Dear Chairman Thomas:
The American Institute of Certified Public Accountants (AICPA) is pleased to provide our technical comments on the international tax provisions contained in Titles II and III of H.R. 5095, the American Competitiveness and Corporate Accountability Act, as introduced on July 11, 2002, (the Bill). The AICPA is the national professional organization of certified public accountants comprised of more than 350,000 members. Our members advise clients on federal, state, and international tax matters, and prepare income and other tax returns for millions of Americans. They provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America's largest businesses.
We realize that in crafting any tax legislation, there are a multitude of economic, policy, and revenue considerations that must be balanced. Our comments focus only on several technical international tax issues in the proposed legislation.
In general, we support—and are pleased to see—many of the provisions in Title III, which simplify the taxation of U.S. businesses operating abroad. (Please see our comments below on seven specific sections of Title III.) In addition, we have some concerns with Section 201 of Title II, addressing corporate earnings stripping.
A. Title III - Simplification of Rules Relating to the Taxation of United States Businesses Operating Abroad
1. Section 301. Repeal of CFC Rules on Foreign Base Company Sales and Services Income
The AICPA supports Section 301.
The current law Subpart F provisions, originally enacted in 1962, were designed for a world in which foreign trade often comprised commodities and tangible products and in which the U.S. was dominant. The U.S. economy is now a major exporter of knowledge and expertise and now faces much stronger international competition. The AICPA commends changes that support U.S. exporters.
As global cross-border trade grows, it is increasingly difficult for U.S.-controlled multinational companies (USCCs) to compete with foreign-controlled multinational companies (FCCs). The current one-country, one-subsidiary model has been rendered inefficient by the ease of transport and the growth of knowledge businesses, such as software companies and consulting firms that are based on intellectual property and human capital rather than based on bricks and mortar.
For example, many engineering, software design and other contracts are now bid on a global or regional basis. To minimize costs, services and sales are provided from a central location for these multi-country contracts. In order to illustrate, assume a U.K. bank contracts for a new financial system. The contract includes consulting, system design, software development, and installation and training at its branches throughout Europe. A USCC service provider develops the system, performs software design, and stages the hardware at its U.K. subsidiary. The U.K. subsidiary then sells the hardware to each local customer branch and a core group of experienced U.K. staff goes to each bank location for the installation and training. For U.S. taxpayers, this creates Subpart F income that increases their income tax burden.
As provided in Section 301, the elimination of foreign base company sales income and foreign base company services income will put USCCs on a par with FCC competitors and will encourage USCCs to streamline their foreign operations for administrative and economic efficiency, rather than duplicate offshore facilities and staff to minimize U.S. Subpart F income. Accordingly, the Bill would significantly simplify the planning required by USCC foreign operations and would help "level the playing field" as compared to their foreign competitors. Further, we note that the repeal of the foreign base company income rules would not permanently allow USCCs to avoid paying U.S. income tax on the earnings of their foreign subsidiaries. Rather, the repeal would result in the normal taxation of foreign earnings—upon repatriation or upon the disposition of the subsidiary.
2. Section 306. Determination of Foreign Personal Holding Company Income with Respect to Transactions in Commodities
The AICPA supports Section 306, which provides for the exclusion from personal holding company income of the excess of gains over losses from commodity hedging transactions undertaken by controlled foreign corporations (CFCs) with respect to commodities used in their businesses. We note that this same objective appears to be addressed by the proposed regulations [REG-154920-01] released by the IRS on May 10, 2002. This regulatory proposal would also result in commodity hedging transactions by CFCs being excluded from personal holding company income, but it in a slightly different way. It would expand the definition of "producer, processor, merchant, or handler of commodities" to include "a controlled foreign corporation that regularly uses commodities in a manufacturing, construction, utilities, or transportation business." Modifying the Internal Revenue Code (IRC) using this alternative formulation may actually be a simpler approach to accomplishing the same objective.
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3. Section 311. Interest Expense Allocation Rules
The AICPA supports the adoption of worldwide fungibility in Section 311 and the Bill's amendments to the interest allocation and apportionment rules of IRC Section 864(e). First proposed by the Senate in 1986 but rejected by the House, incorporated in a bill passed by Congress in 1999 but vetoed by the President, and widely supported by commentators, practitioners, and taxpayers alike, worldwide fungibility is a necessary first step in rectifying the distorting and anticompetitive nature of the present-law foreign tax credit (FTC) regime.
As is widely recognized, the present-law interest allocation rules do not fully embody the fungibility principle because these rules ignore the assets and interest expense of foreign affiliates. Under the current system, interest expense of the domestic affiliates is treated as funding the activities of the entire worldwide affiliated group, thereby ignoring the practical reality that foreign entities in the group may (and probably do in fact) directly bear interest expense to finance their own activities. A disproportionate amount of the U.S. group's interest expense accordingly is allocated to foreign-source income, which, in turn, artificially reduces the U.S. group's FTC limitation and results in double taxation of foreign earnings. The double tax burdens created by the current regime put many USCCs at a competitive disadvantage and can distort investment decisions by penalizing foreign investment.
Because the interest allocation rules are intended to reflect fungibility and should not create economic distortions, the rules should take into account interest expense and assets of all affiliated corporations, domestic and foreign. The Bill does this by putting the foreign interest expense and assets of a U.S. corporation on par with domestic interest expense and assets by two means. First, the Bill includes assets of certain foreign corporations for purposes of apportioning the worldwide group's interest expense between foreign and U.S. assets.Second, the Bill includes an allocation method that reduces the amount of interest expense of domestic group members that is allocated to foreign-source income to the extent that foreign group members incur their own interest expense. These mechanisms better reflect fungibility by taking into account both foreign assets and foreign interest expense. Moreover, the proposed rules represent a fairer system through explicitly acknowledging that multinational corporations incur interest expense both domestically and abroad and that domestic indebtedness does not necessarily support foreign activity, at least to the extent that foreign indebtedness also has been incurred. The reforms of the interest allocation regime proposed in the Bill would result in a more economically sensible apportionment of interest expense of USCCs, moderating the double tax burdens created by the present-law rules.
Additionally, the AICPA endorses the one-time election to expand and otherwise update the financial subgroup. Present law allows certain banks and similar corporations to be treated as a separate affiliated group recognizing that the debt structures of such entities are very different than other corporations. The Bill provides an election for a common parent to treat a broader range of corporations, including those engaged in the insurance business and other financing activities, to be includible in the financial subgroup. The financial subgroup is thus expanded and updated to include any entities whose income is at least 80 percent "financial services income" as defined in IRC Section 904(d)(2)(C)(i). This definition recognizes that a company with such income is likely to have a debt structure that is significantly different than most other corporations (such as manufacturing entities, for example) and more akin to those currently included in the definition of "financial corporation." The AICPA thus concurs that it is proper to allow an election for all corporations engaged in analogous financial services businesses to be included in the financial subgroup.
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4. Section 312. Recharacterization of Overall Domestic Loss
The AICPA supports Section 312, dealing with the recharacterization of an overall domestic loss and providing symmetry with IRC Section 904(f) dealing with recapture of an overall foreign loss. We believe that current law raises serious tax policy concerns.
For example, current law actually places USCCs in cyclical industries at a competitive disadvantage when compared to their FCC competitors with respect to operations in the U.S. This is because a USCC experiencing a tax loss must offset foreign-source income (which has often been fully taxed) by the loss and must then pay full U.S. tax on future income, while the FCC experiencing the same loss can carry it forward against future U.S. income since its foreign income is not subject to U.S. tax. As a result, there is an inherent bias for a USCC to pay higher total taxes than an FCC, thus providing a competitive advantage in the United States to the FCC.
Current law also creates an impediment to funding pension and other post-employment benefit plans (e.g. retiree medical) by U.S. companies. This is because the tax deductions for funding these plans can create losses that offset foreign-source income (which has often been fully taxed), rather than carrying forward to offset U.S.-source income. In an effort to mitigate this problem, U.S. companies may delay funding these plans when doing so would result in a tax loss.
U.S. corporations experiencing a domestic loss (as many have in the recent economic downturn), also try to mitigate the adverse impact of current law in other ways. For example, they may avoid remitting dividends to the United States and, instead, invest the funds in foreign operations. This is because current law requires that these dividends (which are foreign-source income) be offset by domestic losses before the use of FTCs. The foreign-source income has in many cases been fully taxed in the country of operations and the U.S. tax on such dividends normally would be offset by FTCs. Application of current law has the result of leaving the company with excess FTCs (for which it may not be able to record a deferred tax asset under generally accepted accounting principles) while reducing the net operating loss carryforward of the company (for which it would be more likely to be able to record a deferred tax asset under generally accepted accounting principles). Thus, the decision to pay dividends while in a net operating loss position often results in a reduction of reported financial results under generally accepted accounting principles. Accordingly, companies generally avoid remitting dividends in such a situation. Instead, they invest the funds in foreign operations. This has the dysfunctional and counterintuitive result of reducing investment in the U.S. economy during an economic downturn. Modifying current law to remove this impediment to the repatriation of foreign earnings would seem likely to increase investment in U.S. operations, thus raising the level of U.S. economic activity and potentially increasing tax revenues.
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5. Section 313. Reduction to 3 Foreign Tax Credit Baskets
Taxpayers currently determine their FTC for nine or more separate limitations or "baskets."6 The AICPA supports Section 313, which would reduce the number of FTC baskets to three. The new baskets would be:
· Passive income and other passive category income.
· Financial services income.
· All other income.
We believe that this provision furthers the Bill's objectives of meaningful simplification of the FTC regime, and that this reduction in the FTC baskets would make the changes to the interest allocation rules and overall domestic loss rules more meaningful. In many cases, the income earned by an FCC investing in the same third country as a USCC would be exempt from home country tax under a variety of exemption methods. In no other country that taxes foreign income is an investor subject to such complex basketing requirements, which—along with the current interest allocation rules and the overall foreign loss rules—dramatically increase the likelihood of double taxation. The simplification offered by this provision would reduce the competitive disadvantages that are imposed on USCCs by the current tax system and make it less likely that excess credits will expire unused, thereby preventing double taxation. The Technical Explanation of the Bill provides that taxes from pre-effective date tax years would be carried over to the appropriate new basket. Excess credits in the shipping basket, for example, would be carried over to the general basket. The Technical Explanation does not, however, discuss the potential recapture of either separate limitation or overall foreign losses from pre-effective date years. For example, if an overall foreign loss was generated before 2003 in the shipping basket, then after 2002 either the overall foreign loss would have to be recaptured out of the general basket or the potential for recapture would be eliminated because no additional shipping income could ever be earned. If it is determined that recapture is appropriate, the AICPA would like to see the recapture occurring over a multi-year period.
The AICPA also respectfully requests that Section 313 (Reduction to three foreign tax credit baskets) and Section 301 (Repeal of CFC rules on foreign base company sales and services income) be enhanced to eliminate interest income derived in leasing operations from the definitions of passive income contained in IRC Section 904(d)(2)(A) and IRC Section 954(c). Currently, U.S. exporters who are not in the active conduct of a banking, financing or similar business may assist their customers with lease financing. This promotes the sales of U.S.-manufactured products abroad. However, interest income generated by leases held by their foreign marketing subsidiaries triggers Subpart F income and falls into the passive basket rather than the general basket. Transactions such as these are distinguishable in intent from the maintenance of offshore funds to reduce U.S. taxation, and should not be characterized as passive income because they relate intrinsically to the CFC's trade or business.
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6. Section 314. 10-Year Foreign Tax Credit Carryforward
The 10-year FTC carryforward period proposed in Section 314 would be a significant improvement for taxpayers, as compared to the five-year carryforward period permitted under current law. We are pleased that the provision would allow for varying FTC situations over a longer period of time. We note, however, that unless Congress provides an unlimited carryforward, USCCs may still not repatriate foreign earnings unless they can be reasonably certain FTCs will not expire. We encourage Congress to consider expanding the FTC to an unlimited carryforward.
As a matter of policy, FTCs should be treated in a similar fashion as minimum tax credits (credits arising from the application of the alternative minimum tax (AMT)). Minimum tax credits do not have an expiration date since that could ultimately lead to double taxation of the same income.
The IRC places numerous restrictions on the usage of FTCs, making full utilization of such credits difficult. Congress should grant an unlimited carryover period so that U.S. corporations and individuals avoid double taxation of earnings.
7. Section 315. Repeal of Limitation of Foreign Tax Credit Under Alternative Minimum Tax
Under present law, for AMT purposes, the FTC may only offset 90 percent of a corporate taxpayer's tentative minimum tax. Section 315 repeals this limitation. The AICPA strongly supports this simplification provision.
The AMT is highly complex and requires a separate, second set of calculations of income tax. Successive National Taxpayer Advocates have called for the repeal of the AMT. The present law 90 percent limitation further complicates both complying with, and planning for, the AMT.
The current 90-percent limitation serves to increase the U.S. income tax costs to certain U.S. companies that are both subject to the AMT and export goods and services outside the U.S. Such taxpayers are prevented by the 90-percent limitation from claiming the full recovery of foreign taxes paid on income that is taxed both in the United States (under the AMT) and the foreign jurisdiction. Accordingly, the current limitation results in double taxation.
The 90-percent limitation became a component of the U.S. tax code in 1986. At that time, as stated in the Conference Report, the 90-percent limitation was "designed to prevent U.S. taxpayers with substantial income from using the FTC to avoid all U.S. tax liability." We believe that the current tax policy objectives of simplification, neutrality, and elimination of double taxation are more compelling and override the prior policy objectives of 1986.
Therefore, the AICPA believes there is limited tax policy benefit from the 90-percent limitation and views the double taxation problem for exporters as a significant issue that requires rectification
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B. Title II, Section 201. Reduction in Potential for Earnings Stripping by Further Limiting Deduction for Interest on Certain Indebtedness
In our letter of June 28, 2002, to The Honorable Jim McCrery, Chairman of the Subcommittee on Select Revenue Measures of the House Ways and Means Committee, the AICPA provided comments for the record of the June 25, 2002, House Ways and Means Committee Select Revenue Measures Subcommittee hearing on corporate inversions. We will not repeat comments on that issue here. We do, however, have significant concerns about the Bill's "earnings stripping" provisions found in Section 201—Reduction in potential for earnings stripping by further limiting deduction for interest on certain indebtedness. Our comments on that section follow.
For foreign-owned U.S. companies, the Bill would significantly modify the current U.S. earnings stripping rules under IRC Section 163(j). The Bill would:
· Eliminate the existing 1.5 to 1 debt/equity safe harbor.
· Disallow interest expense that is the greater of: (1) net interest expense over 35 percent of adjusted taxable income, or (2) the corporation's excess domestic disqualified interest (EDDI). EDDI measures the amount of excess related party debt in the U.S. by comparing actual U.S. debt to the amount of worldwide group debt that is attributable to the United States, based on a comparison of U.S. and worldwide assets. An excess of EDDI exists if the U.S. debt/asset ratio exceeds the worldwide ratio.
· In general, reduce disallowed interest expense carryforward from an indefinite period to five years. In the case of EDDI; however, the carryforward is eliminated altogether and deductibility completely denied. In addition, an unused limitation from one year could not be carried over at all.
These changes would generally take effect for tax years beginning after December 31, 2003; however, they would apply to debt incurred in years ending after July 10, 2002, including refinanced debt. In addition, the rules would apply as of March 20, 2002, in the case of certain former U.S. companies that "inverted" after 1996.
This proposal raises serious tax policy concerns. Taxpayers should be able to determine, based on business and tax considerations, the legal entity that will incur debt, as long as the entity has the capacity to bear that debt. Existing laws—both statutory and case law—prevent foreign parent companies from overloading their U.S. subsidiaries with related party debt. If these laws are breached, interest deductions may be disallowed under certain circumstances, and debt may be recast as equity. However, imposition of the formulary limitation contemplated in this proposal, based on the debt/equity ratio of a parent corporation and its worldwide affiliated group as compared to its U.S. subsidiary, in effect imposes an arbitrary limitation with no nexus to economic substance. This may chill inbound investment and would treat similarly situated taxpayers in a dissimilar manner, to the detriment of the U.S. economy.
For example, consider two foreign multinational affiliated groups, one with a low level of debt and the other with a high level of debt. Each is considering expanding into the U.S. by establishing a subsidiary operation. The new operations will be financed in part by a contribution to capital and in part by a loan to the newly incorporated entity. Under these facts, the U.S. businesses will have exactly the same level of debt, but their ability to deduct interest paid to their foreign parent will be very different. In essence, a more than adequately capitalized U.S. subsidiary will be penalized due to the attributes of its foreign parent. Such a result is hard to reconcile with sound tax policy and is inconsistent with arm's length standards and international norms. Accordingly, we recommend that a U.S. taxpayer's ability to deduct interest not be linked to its parent's debt level, and that a debt/equity safe harbor of some type be retained.
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In addition, it appears that this proposal will generate conflicts under many existing tax treaties. The "Associated Enterprise" article of most treaties allocates profits between related entities based on the profits that would have accrued if the conditions made between the two enterprises had been those that would have been made between independent enterprises. Implicit in this article is the understanding that an item of income (e.g., interest) properly taxed by one jurisdiction will give rise to a corresponding item of expense in the other jurisdiction. Moreover, "Non-Discrimination" articles typically provide that nationals of a treaty partner will not be subject to more burdensome taxation than similarly situated U.S. nationals. Further, the Mutual Agreement Procedure article typically provides that taxation not in accordance with the terms of the treaty may be resolved by the competent authorities of the contracting states, specifically by allowing the competent authorities to agree to the same attribution of income, deductions, credits or allowances between taxpayers. It appears, however, that this new proposal could be construed to override all of these treaty provisions, in effect precluding application of the internationally accepted (and U.S.-supported) arm's length standard and subjecting foreign nationals to discriminatory treatment. Such an abrogation of our treaty obligations should not be pursued without first concluding, based on credible evidence, that this proposal addresses a substantial abuse, and that there is not another remedy to address the abuse without overriding U.S. treaty obligations.
Also, this proposal interjects a substantial amount of complexity into an already complex arena, and will impose a significant burden on IRS auditors. For purposes of the proposal, the relative debt/equity ratios of the U.S. entity and the worldwide affiliated group are determined based on the adjusted basis of the assets. The foreign operations will, in almost all cases, maintain calculations of adjusted basis under foreign accounting and tax principles, which may be far different than U.S. principles. Thus, the use of adjusted basis will in many cases not serve the purpose for which it was intended—identifying differences in relative debt levels as a percentage of asset value. Perhaps more importantly, this issue will likely cause significant conflict between U.S. taxpayers and the IRS. In order to perform a thorough audit, the IRS will be compelled to audit all of the books and records of the foreign multinational parent and its subsidiaries covering many years, in most cases a difficult task. We note that no study has been conducted to provide objective evidence demonstrating that earnings stripping is a significant abuse that is not addressed under provisions of current law.
One final point is worth mentioning. It is inevitable that foreign tax authorities, including our treaty partners, will adopt some form of retaliation if this provision is enacted, denying deductions to foreign subsidiaries of U.S. multinational groups for interest paid on related-party loans. The consequences of such retaliation could further disadvantage USCCs.
We thank you for your leadership in this area. The AICPA is pleased to see and support many of the provisions in Title III of H.R. 5095, and we would be happy to offer our further assistance on this legislation. Please contact me at (805) 653-6300; or Andrew Mattson, Chair of the AICPA's International Tax Technical Resource Panel, at (408) 369-2566; or Eileen Sherr, AICPA Technical Manager at (202) 434-9256.
Sincerely,
Pamela J. Pecarich
Chair, Tax Executive Committee
cc: Members of House Ways & Means Committee
Members of Senate Finance Committee
Mr. Jon Traub, Legislative Director to Rep. McCrery
Mr. Bob Winters, Special Counsel, House Ways & Means Committee
Ms. Allison Giles, Majority Chief of Staff, House Ways & Means Committee
Mr. John Kelliher, Chief Counsel, House Ways & Means Committee
Mr. James Clark, Chief Tax Counsel, House Ways & Means Committee
Mr. Greg Nickerson, Tax Counsel, House Ways & Means Committee
Ms. Janice Mays, Democratic Chief Counsel, Ways & Means Committee
Mr. John Buckley, Democratic Chief Tax Counsel, Ways & Means Committee
Mr. John Angell, Staff Director, Senate Finance Committee
Mr. Russell Sullivan, Chief Tax Counsel, Senate Finance Committee
Ms. Maria Freese, Tax Counsel, Senate Finance Committee
Ms. Anita Horn Rizek, Democratic Tax Professional Staff, Senate Finance Committee
Mr. Kolan Davis, Republican Staff Director and Chief Counsel, Senate Finance Committee
Mr. Mark Prater, Republican Chief Tax Counsel, Senate Finance Committee
Mr. Ed McClellan, Republican Tax Counsel, Senate Finance Committee
Ms. Elizabeth Paris, Republican Tax Counsel, Senate Finance Committee
Ms. Lindy L. Paull, Chief of Staff, Joint Committee on Taxation
Mr. H. Benjamin Hartley, Senior Legislation Counsel, Joint Committee on Taxation
Mr. E. Ray Beeman, Legislation Counsel, Joint Committee on Taxation
Mr. David G. Noren, Legislation Counsel, Joint Committee on Taxation
Mr. Oren S. Penn, Legislation Counsel, Joint Committee on Taxation
Mr. Thomas A. Barthold, Senior Economist, Joint Committee on Taxation
Ms. Pamela F. Olson, Assistant Secretary for Tax Policy, Treasury Department
Mr. Rob Hanson, Tax Legislative Counsel, Treasury Department
Ms. Barbara M. Angus, International Tax Counsel, Treasury Department
. See, e.g., Emily S. McMahon, "Interest Expense Allocation After the Taxpayer Refund and Relief Act of 1999," Tax Mgmt Int'l J. 793 (1999); Steven P. Hannes & James Riedy, "Time to Move to a Worldwide Group Approach for Apportioning Interest," 2001 TNT 98-110 (May 21, 2001); Harrison Cohen, et. al., "New ETI Repeal Measure Seeks to Preserve U.S. Businesses' Competitiveness," 2002 WTD 137-14 (July 17, 2002); Marty A. Sullivan, "Interest Allocation Reform: Time to Talk or Time to Act?" 1999 TNT 167-1 (Aug. 30, 1999).
. The AICPA agrees that the 80-percent ownership threshold proposed for both domestic and foreign corporations ensures that the corporations included in a worldwide affiliated group are sufficiently economically related to justify single-entity treatment.
. Separate foreign tax credit limitation categories are currently provided for the following items of income: (1) passive income, (2) high withholding tax interest, (3) financial services income, (4) shipping income, (5) certain dividends received from a noncontrolled section 902 foreign corporation (a "10/50 company"), (6) certain dividends from a domestic international sales corporation or former domestic international sales corporation, (7) taxable income attributable to certain foreign trade income, (8) certain distributions from a foreign sales corporation or former foreign sales corporation, and (9) any other income not described in items (1) through (8) (so-called "general limitation" income).
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