*EPF211 02/04/2003
Text: Treasury Urges Tax Code Reforms for WTO Compliance
(Calls for comprehensive re-examination of U.S. tax rules) (1740)

The Bush administration has again called on Congress to overhaul U.S. international tax rules, particularly those that offer tax breaks to certain exporters and which have been ruled inadmissible by the World Trade Organization (WTO).

Following successive WTO rulings against the Foreign Sales Corporation (FSC) and its successor Extraterritorial Income (ETI) Act, the United States faces the possibility of European Union (EU) sanctions on more than $4,000 million worth of U.S. exports a year.

"The United States must comply with the WTO rulings in the FSC/ETI case," Treasury Department said in a February 3 document explaining major revenue-related provisions of President Bush's budget request for fiscal year 2004 (FY2004).

Treasury said that the administration has identified three areas for possible reform, including rules covering investment-type income earned by a foreign subsidiary, foreign tax credits and the allocation of overseas interest expenses.

The administration is also calling for a "complete reexamination" of the tax code to ensure that U.S. rules do not hamper the ability of U.S. businesses to compete successfully around the world, Treasury said.

The text of the Treasury Department's General Explanations of the Administration's Fiscal Year 2004 Revenue Proposals is available on the Web at: http://www.treas.gov/press/releases/reports/bluebook2003.pdf

Following is the section of the report dealing with the WTO's FSC/ETI rulings:

(begin text)

RESPOND TO FOREIGN SALES CORPORATION/EXTRATERRITORIAL INCOME DECISIONS

Current Law

The United States, like several of our major trading partners, operates a worldwide system of income taxation. U.S. citizens and residents, including U.S. corporations, are taxed on all their income, regardless of where it is earned. Income earned from foreign sources potentially is subject to taxation both by the country where the income is earned, the country of source, and by the United States, the country of residence. To provide relief from this potential double taxation, the United States allows taxpayers a foreign tax credit that reduces the U.S. tax on foreign-source income by the amount of foreign income and withholding taxes paid on such income. A U.S. corporation generally is subject to U.S. tax on the active earnings of a foreign subsidiary if and when such income is repatriated as a dividend. However, under the subpart F rules, the U.S. parent is subject to current U.S. tax on certain income earned by a foreign subsidiary, without regard to whether that income is distributed to the U.S. parent.

The extraterritorial income exclusion (ETI) provisions, which provide a partial exemption from tax for income from certain foreign sales and leasing transactions, were enacted in 2000 to replace the foreign sales corporation (FSC) provisions of prior law. In January 2002, the WTO Dispute Settlement Body adopted a final report finding that the ETI provisions, like the prior-law FSC provisions, are inconsistent with WTO rules. The WTO has authorized the imposition of trade sanctions against U.S. exports up to the level of $4 billion per year.

Reasons for Change

The United States must comply with the WTO rulings in the FSC/ETI case. In doing so, our focus should be on the global competitiveness of U.S.-based businesses and American workers and the impact of the U.S. international tax rules. The Administration will work with the Congress to develop and enact legislation that makes meaningful changes to our tax law to satisfy the twin goals of honoring our WTO obligations and preserving the competitiveness of U.S. businesses operating in the global marketplace.

The international provisions of our tax code have not kept pace with the changes in our economy. International tax policy remains rooted in tax principles developed in the 1950s and 1960s. That was a time when America's foreign direct investment was preeminent abroad and competition from imports to the United States was modest. Today, we have a truly global economy, in terms of both trade and investment. The value of goods traded to and from the United States increased more than three times faster than GDP [Gross Domestic Product] between 1960 and 2000, rising to more than 20 percent of GDP. The flow of cross-border investment, both inflows and outflows, rose from 1.1 percent of GDP in 1960 to 15.9 percent of GDP in 2000.

The globalization of the world economy has provided tremendous benefits to consumers and workers. The potential for a world market encourages companies to invest in research that leads to continuous innovation. t one time, the strength of America's economy was thought to be tied to its abundant natural resources. Today, America's strength is its ability to innovate: to create new technologies and to react faster and smarter to the commercialization of these technologies.

The principles that guided tax policy adequately in the past should be reconsidered in today's highly competitive, knowledge-driven economy. In order to ensure the ability of U.S. workers to achieve higher living standards, we must ensure that the U.S. tax law does not operate to hinder the ability of the U.S. businesses that employ those workers to compete on a global scale.

Proposal

Compliance with the WTO decisions in the FSC/ETI case requires substantive changes to our current international tax laws. Replicating the benefits of the FSC and ETI provisions through minor changes to the current-law ETI provisions or through enactment of a similar replacement regime will not bring us into compliance with the WTO rules as analyzed in the decisions. Compliance will require repeal of the ETI provisions. The required changes to our tax law should be coupled with much needed reforms to ensure that our tax law, and our international tax system in particular, does not operate to impose anti-competitive burdens on U.S.-based companies operating in the global marketplace.

We intend to work closely with the Congress to develop and enact the reforms needed to rationalize our international tax rules. The U.S. international tax rules can operate to impose a burden on U.S.-based companies disproportionate to the tax burden imposed by our trading partners on the foreign operations of their companies. The U.S. rules for the taxation of foreign-source income are unique in their breadth of reach and degree of complexity. That complexity itself represents a significant burden that should be addressed.

One area of attention for reform efforts is the subpart F rules. The focus of the subpart F rules is on passive, investment-type income that is earned abroad through a foreign subsidiary. However, the reach of the subpart F rules extends beyond passive income to encompass some forms of income from active foreign business operations. Several categories of active business income are covered by the subpart F rules. For example, under subpart F, a U.S. parent company is subject to current U.S. tax on income earned by a foreign subsidiary from certain sales transactions. Accordingly, a U.S. company that uses a centralized foreign distribution company to handle sales of its products in foreign markets is subject to current U.S. tax on the income earned abroad by that foreign distribution subsidiary. The subpart F rules also impose current U.S. tax on income from certain services transactions performed abroad. While the subpart F rules are intended to differentiate passive or mobile income from active business income, they can operate to subject to current tax some classes of income arising from active business operations structured and located in a particular country for business reasons wholly unrelated to tax considerations.

Another area of focus is the foreign tax credit rules. The rules for determining and applying the current-law foreign tax credit limitation are detailed and complex and can have the effect of subjecting U.S.-based companies to double taxation on their income earned abroad. The current U.S. foreign tax credit regime also requires that the rules be applied separately to separate categories or "baskets" of income. Foreign taxes paid with respect to income in a particular category may be used only to offset the U.S. tax on income from that same category.

Computations of foreign and domestic source income, allocable expenses, and foreign taxes paid must be made separately for each of these separate foreign tax credit baskets, further adding to the complexity of the system.

The expense allocation rules for foreign tax credit purposes can treat interest expense of a U.S. group as relating to the group's foreign subsidiaries even where those subsidiaries are equally or more highly leveraged than the U.S. group. This can result in an over-allocation of interest expense to foreign income, understating foreign income and reducing the foreign tax credit limitation. The rules that apply to taxpayers with overall losses from their domestic operations also can operate to restrict the foreign tax credit. An overall loss in the United States would offset income earned from foreign operations, income on which foreign taxes have been paid, and thus would reduce the U.S. company's ability to claim foreign tax credits for those foreign taxes paid. These limitation rules can have the effect of denying U.S.-based companies the full ability to credit foreign taxes paid on income earned abroad against the U.S. tax liability with respect to that income and therefore can result in the imposition of the double taxation that the foreign tax credit rules are intended to eliminate.

The foregoing are examples of particular areas that deserve attention. A complete reexamination of all of the U.S. international tax rules is needed to ensure that the U.S. tax rules do not adversely impact the ability of American workers and U.S. businesses to compete successfully around the world. Relative to the tax systems of our major trading partners, the U.S. international tax rules can impose significantly heavier burdens on domestically based companies. As we make the changes to our tax law that are needed to comply with WTO rules, we must keep our focus on the objectives served by the FSC and ETI provisions and look to removing biases against the ability of U.S. businesses to compete in today's global economy.

The Administration is committed to working with Congress to satisfy the objectives of meeting our WTO obligations and ensuring that we protect the competitive position of American workers and businesses.

(end text)

(Distributed by the Office of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)

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