TAX FOUNDATION

SEMINAR

PROCEEDING S

Assessing U .S . Tax Policies TowardInternational Investment :

An Opportunity for Change

Edited and with an Introduction b y

John McGowan, Ph .D., CPA

The Tax Foundation

TAX FOUNDATION

SEMINAR

PROCEEDINGS

Remarks by the Honorable Hank Brow n

n

Tax Treatment of U .S . Investment Abroadn

Tax Treatment of Foreign Investment in the U .S .

Washington Court Hotel on Capitol Hil lWashington, D C

September 25, 1990

©1990 Tax Foundation. All rights reserved .

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TABLE OF CONTENT S

FOREWORD

INTRODUCTION

SEMINAR SPONSORS

SEMINAR PARTICIPANTS

POLICY COUNCIL

PROGRAM COMMITTEE

KEYNOTE ADDRES S

The Honorable Hank Brow nUnited States Representative from ColoradoMember, Ways and Means Committee

ISSUE OVERVIE W

Edward M. GrahamSenior Research FellowInstitute for International Economics

TAX TREATMENT OF U .S. INVESTMENT ABROAD

Panel Chairman: David M. CrowePartnerCaplin & Drysdale

Raymond HaasInternational Tax Partne rErnst & Young

Murray SchlusselAssistant General Counsel - International TaxFord Motor Company

Peter A. BarnesDeputy International Tax CounselU.S. Department of the Treasury

Q&A

Panel Chairman: Robert N. MattsonAssistant TreasurerIBM

B . Anthony BillingsProfessor of Accounting, Wayne State Universit yTax Foundation Senior Research Fellow

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Richard M. HammerInternational Tax Partner, Price Waterhous eChairman - Tax Committee, U.S. Council for International Business

John F. BrusselTax Director - Internationa lAT&T

TAX TREATMENT OF FOREIGN INVESTMENT IN THE U .S .

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Panel Chairman: Robert Ashby

33Assistant Vice President, Taxe sNorthern Telecom Inc .

Elliot L. Richardson

33Senior Resident PartnerMilbank, Tweed, Hadley & McCloyChairman, Association for International Investmen t

Congressman Philip M. Crane (R-IL)

37House Ways and Means Committee : Trade, Ranking Minority Member

James M. Carter

40Senior Tax Counsel, ICI Americas;Secretary, Organization for the Fair Treatment of International Investmen tBruce R. Bartlett

42Deputy Assistant Secretary for Economic PolicyU.S. Department of the Treasur y

Q&A

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Panel Chairman : John G. Wilkins

47PartnerCoopers & Lybrand

Catherine T. Porter

47PartnerMiller & Chevalier, Chartered

Peter A. Barnes

51Deputy International Tax CounselU.S. Department of the Treasury

Harrison J. Cohen

55Legislation CounselJoint Committee on Taxatio n

Richard Pratt

58Economic CounsellorEmbassy of Great Britain

Appendix 1 - Supplemental Charts to Presentation by Edward Graham

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Appendix 2 - Supplemental Charts to Presentation by Raymond Haas

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Appendix 3 - Supplemental Charts to Presentation by Catherine Porter

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FOREWORD

It is one of the Tax Foundation's guiding principles that the U .S. tax system should not imped e

the free and fair flow of goods, services, and capital. It should not penalize exports and U.S .investment abroad, nor should it adopt policies which restrict imports and foreign investment inthe U.S .

Globalization of international trade and inter-dependencies across national borders are reall y

the dominant characteristics of today's business arena . It is increasingly important, therefore, fo r

federal taxation to be even-handed in respect to those transborder transactions .With the unprecedented expansion of business opportunities and competition, we think i t

may well be time to re-think many of our tax policies towards international investment . Today,unfortunately, the U .S. has the most complex system in the world for the taxation of internationa l

operations . No other country even comes close . If we are to reap the benefits of global economicexpansion, tax policies must allow international investment to flow freely across borders .

The Foundation has greatly expanded its research into the tax treatment of internationa l

investment . A recent Tax Foundation seminar examined the tax policies toward research and

development because the U .S. level of expenditures on R&D has fallen far behind those of ourmajor trading partners .

On September 25, 1990, the Tax Foundation held a seminar entitled "Assessing U .S. TaxPolicies Toward International Investment : An Opportunity for Change" to examine the problemsfor tax policy in this area and to propose viable solutions . It also served as a forum for taxpolicymakers in the public sector to voice their concerns, and for private sector experts, in turn, toremind them of the economic and practical consequences of tax provisions which affect both theforeign earnings of domestic multinationals and the earnings of foreign-owned businessesoperating in the U.S .

Instrumental in putting together the program were James Q . Riordan, co-chairman of the TaxFoundation, along with Bob Hannon and Glenn White, co-chairmen of the Tax Foundation' sProgram Committee . The Foundation's special thanks go to Dr . John McGowan, professor o faccounting at St. Louis University, for editing the proceedings and contributing the introduction .The publication of these proceedings will bring these important viewpoints to a wider audience ,promoting understanding of this critical issue.

Wayne GablePresident

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INTRODUCTION

As the business climate becomes increasingly global and interdependent, the strength of th eU.S. economy is more and more dependent on the efficient international flow of goods, services ,and capital. Federal tax policy plays an important role in shaping international trade andinvestment decisions and economic competitiveness . Therefore, the Tax Foundation saw the needfor promoting a greater understanding of federal tax policies toward international investment andprovided an objective forum with a seminar entitled "Assessing U .S. Tax Policies TowardsInternational Investment : An Opportunity for Change."

The taxation of international transactions can be divided into two major parts : Americansoperating overseas (outbound transactions) and foreigners operating in the United States (in -bound transactions) .

The first part of this seminar is about Americans operating overseas . When American

businesses decide to operate overseas, their overwhelming choice of form is the foreign subsidiary .

When these subsidiaries earn income in the foreign jurisdictions, they usually pay a foreign tax . The

international tax rules of the United States provide for a foreign tax credit for these taxes paid t oforeign governments . However, the U.S. imposes numerous limitations on creditable foreigntaxes .

The U.S. international tax rules also provide generally that a U .S. tax is not levied on foreign

earnings of a U.S. subsidiary unless they are repatriated to the U.S. parent in the form of dividends .Exceptions to this general rule of deferral occur in the following cases : Subpart F income, andpassive foreign investment companies (PFICs) . These areas of international taxation give rise t ovarious controversial issues . Many of these issues are discussed by the speakers in the first half ofthis seminar .

The two panels of this part were chaired by David M . Crowe, Partner in Caplin & Drysdal eand Robert N. Mattson, Assistant Treasurer for IBM, both of whom provided articulate paneldiscussions . Raymond Haas, International Tax Partner for Ernst & Young ; B. Anthony Billings,Professor of Accounting at Wayne State University; and Richard M. Hammer, International Ta xPartner, Price Waterhouse provided an excellent overview of some of the problem areas in theinternational taxation rules for U.S. multinationals. Murray Schlussel, Assistant General Counse l- International Tax for Ford Motor Company, and John F. Brussel, Tax Director - International fo rAT&T, related how their firms have experienced difficulties complying with the U .S. tax rules ofinternational taxation . Additionally, Peter A . Barnes, Deputy International Tax Counsel for th eTreasury, provided some insight into these rules from the perspective of the Treasury Department .

The second session examined the tax treatment of foreign investment in the U .S., or inboundtransactions . American individuals and corporations have long explored other parts of the worldseeking financial gains and opportunities . But the movement of foreign capital here is of mor erecent vintage. As a consequence, the advising of foreign investors is now a larger component o fAmerican practitioners than ever before . The sheer size of the U .S. market makes it attractive t oforeign investors . As a result, foreign persons - and their money - seem destined to play an everlarger role in our economy.

The very participation of foreigners on such a large scale has inevitably sparked the interes tof U.S. fiscal authorities, and now through the media, politicians and the general public hav ebecome involved. The Treasury is concerned that these foreign-owned U .S. companies areavoiding U.S. taxation by using, or abusing as the case may be, the transfer pricing rules . Recentproposals have also included various information reporting rules for U .S. affiliates of foreign-owned companies. More recent bills have included the proposal to tax non-resident aliens and

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foreign corporations on their disposition of stock in U.S. companies .The two panels for this session were chaired by Robert Ashby, Assistant Vice President, Taxe s

for Northern Telecom Inc. and John G. Wilkins, Partner for Coopers and Lybrand. Both of thesepanels provided a stimulating and enjoyable discussion of the taxation of foreign investment in th eU.S .

An overview of inbound foreign investment issues was provided by former Attorney Genera lElliot Richardson, now senior resident partner in the Washington, DC office of Milbank, Tweed ,Hadley & McCloy, and chairman of the Association for International Investment .

Virtually all six of the speakers on these panels agreed that the U .S. should be careful if i tinitiates massive changes in the way foreign-controlled U .S. corporations are taxed. CongressmanPhilip Crane (R-IL), House Ways and Means Committee, Peter A . Barnes, Deputy International TaxCounsel for the U.S. Treasury, Bruce R. Bartlett, Deputy Assistant Secretary for Economic Policyfor the U.S. Treasury, and Harrison J . Cohen, Legislation Counsel for the Joint Committee o nTaxation, provided the perspective from either the Congress or Treasury . James M. Carter, SeniorTax Counsel, ICI Americas, and Catherine T . Porter, partner in Miller & Chevalier, Chartered ,spoke on foreign direct investment in the U .S. from the vantage point of having somewhat of a nadvocacy role for these companies . Finally, speaking as a representative of the country with thelargest amount of foreign direct investment in the U .S., Richard Pratt, Economic Counsellor of th eEmbassy of Great Britain, stated that foreign investment in the U.S. should be viewed in a positiv elight .

On a personal note, I enjoyed the process of editing these presentations and attending thi sseminar sponsored by the Tax Foundation .

John McGowan, Ph.D., CPASt. Louis UniversitySt. Louis, Missouri

John R. McGowan is Assistant Professor of Accounting at St . Louis University, where he teache scourses in taxation and managerial accounting. He received his Ph.D. in Economics/Taxation fromSouthern Illinois University in 1988. Dr. McGowan is the author of numerous research publications andarticles on taxation including: "How U.S. Corporations Can Reduce Their Overall Tax Burden : The Effectof Private Letter Ruling 89029," which appeared in The CPA Journal, July 1990; "A Comparison ofPartnerships and Subchapter S Corporations After the Tax Reform Act of 1986," with D . Joy, whichappeared in the St. Louis University Law Journal, Volume 33, Issue 4, 1989; and "Passive ForeignInvestment Companies and TAMRA (Technical Amendments and Revenue Act of 1988," which appeare din Business and Tax Planning Quarterly, Volume 5, Number 3,1989 .

SEMINAR SPONSORS

Akzo America, Inc .

American Cyanamid Company

American President Companies, Ltd .

American Telephone and Telegraph Company

Atlantic Richfield company

BASF Corporation

Chevron Corporation

E.I. du Pont de Nemours and Company

Eli Lilly and Company

European Community Chamber of Commerce in the United States, Inc .

General Electric Company

Hallmark Cards, Inc .

IBM Corporation

3M Company

Merck & Co., Inc .

Metropolitan Life Insurance Company

Mobil Corporation

Occidental Petroleum Corporatio n

PepsiCo Inc.

Rockwell International Corporatio n

Sears, Roebuck and Co .

Shell Oil Company

Toyota Motor Sales, U .S.A., Inc .

Warner-Lambert Company

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SEMINAR PARTICIPANTS

Robert Ashby is the Assistant Vice President,Taxes, at Northern Telecom Inc . Previously, hewas the Senior Tax Manager with the publicaccounting firm of Price Waterhouse and th eDirector of Research and Planning with Hospi -tal Corporation of America . He received a B .S .in Accounting from Indiana University .Peter A. Barnes is Deputy International TaxCounsel for the U.S. Department of the Treas-ury. Mr. Barnes received a B .A. from theUniversity of North Carolina and a J .D. fromYale University Law School. He clerked for theHonorable Gerhard A . Gesell of the U .S. Dis-trict Court for the District of Columbia Circuitfrom 1980-1981, and was an attorney in theWashington Office of Hughes, Hubbard &Reed from 1981-1986 .Bruce R. Bartlett is currently Deputy AssistantSecretary for Economic Policy (Policy Analy -sis) at the U.S. Department of the Treasury .Before joining Treasury, he was a Senior PolicyAnalyst in the Office of Policy Development a tthe White House and from 1985-1987 he was aSenior Fellow at the Heritage Foundation. Mr .Bartlett holds an M .A. from Georgetown Uni-versity and a B .A. from Rutgers University .B. Anthony Billings is Associate Professor ofAccounting at Wayne State University with hisPh.D. from Texas A&M. He is a Senior Re-search Fellow at the Tax Foundation and hasreceived a grant from the Arthur Young Ta xResearch Foundation to study internationaltax problems . He has completed internshipswith Dow Corning Corporation in Midland ,Michigan, and with 3M Corporation in St .Paul, Minnesota .Hank Brown is a Republican member of theUnited States House of Representatives fro mthe State of Colorado . He is serving his fifthterm, to which he was elected with a 73 percentmajority. He serves on the House Committeeon Ways and Means. Congressman Brownreceived his B .S. from the University of Colo-rado, his J .D. from the University of Colorado,his Masters of Law from George Washingto nUniversity and has passed the CPA exam .

John F. Brussel directs the AT&T InternationalTax Department . Previously, he was the SeniorInternational Tax Attorney at WestinghouseElectric Corporation. Before that, he was a ta xattorney with Ingersoll Rand and also with theOffice of Chief Counsel of the IRS . He holds aB.B.A. from the University of Wisconsin, a J .D .from Fordharn University School of Law an dan LL.M. from Georgetown University LawSchool.

James M . Carter is the Senior Tax Counsel a tICI Americas . He also serves as the Secretary o fthe Organization for Fair Treatment of Interna -tional Investment . Mr. Carter holds an LL .B .from the University of Virginia Law School.Harrison J . Cohen currently serves as the Leg-islation Counsel for the United State sCongress's Joint Committee on Taxation . Pre-viously, he was an attorney with the law firm ofCaplin & Drysdale in Washington, DC. Mr .Cohen received his B .A. & J.D. from the Uni-versity of Chicago .Philip M. Crane (R-IL) is serving his eleventhterm in the United States House of Representa-tives . He is the third ranking Republican on th eWays and Means Committee with jurisdictionover energy, taxes, trade, Medicare, welfarereform and Social Security. He is the RankingMinority Member on the Trade Subcommitteeand is a member of the Health Subcommittee .Congressman Crane holds a B .A. degree inpsychology and history from Hillsdale Colleg eand an M.A. and Ph.D. in history from IndianaUniversity .David M. Crowe is a Partner at Caplin &Drysdale in Washington, D .C. Prior to joiningCaplin & Drysdale, he was an attorney in th eOffice of the International Tax Counsel at theTreasury Department where he served asAssociate International Tax Counsel from1987-1989. He holds a B .A. from the Universityof Virginia, an M.Sc. from the London School ofEconomics, and a J.D./M.P.P.M. from YaleUniversity.

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Edward M. Graham is Senior Research Fello wat the Institute for International Economics . Hehas served on the faculties of Duke University,the University of North Carolina, and th eMassachusetts Institute of Technology, andhas also held positions at the U.S. Departmentof the Treasury and the Organization for Eco -nomic Cooperation and Development. He i scoauthor (with Paul Krugman) of the ac-claimed book Foreign Direct Investment in theUnited States. He holds a bachelor's degreefrom MIT and master's and doctoral degreesfrom Harvard University .

Raymond Haas is International Tax Partner atErnst & Young located in New York. A CPAand attorney licensed in New York, he re-ceived a B.S. from University of Vermont, anM.B.A. from Columbia University GraduateSchool of Business and a J .D. from the Colum-bia University Law School. He is an AdjunctProfessor at the Columbia University Gradu-ate School of Business, and his publicationsinclude The Competitive Burden: Tax Treat-ment of U.S. Multinationals, Tax Foundation ,1988, and How Foreign Buyers Can GetDouble Tax Deductions, Mergers & Acquisi-tions, 1989 .

Richard M. Hammer is International Tax Part-ner at Price Waterhouse and is the Tax Com-mittee Chairman of the U .S. Council for Inter-national Business. He also chairs the TaxCommittee and the Fiscal Committee of theU.S. Business and Industry Advisory Commit -tee to the OECD. Mr. Hammer received hi sB.A. from Princeton University and his M.B.A.from Harvard Graduate School of Busines sAdministration .

Robert N. Mattson is currently AssistantTreasurer of IBM Corporation at Armonk ,N.Y. Previously, he held the positions of direc-tor of taxes, corporate tax counsel, and directo rof planning and development . He received aB.S. in Economics from the University o fPennsylvania's Wharton School of Finance, a nLL.B. and LL.M. in taxation from New YorkUniversity School of Law and worked towar da Ph.D. in International Economics at NewYork University .

Catherine T. Porter is a Partner with the lawfirm of Miller & Chevalier, Chartered . Previ-ously, she was the Tax and Trade Legislativ eAide to United States Senator John H . Chafee(R-RI), Assistant Counsel to the Subcommitteeon Oversight of the House Committee o nWays and Means, and Tax Counsel to theHouse Committee on Small Business .

Richard Pratt is the Economic Counsellor a tthe British Embassy in Washington, D .C. Pre-viously with HM Treasury in London, h eworked in a variety of economic and adminis -trative posts which included the coordinationof the annual UK Budget presented by th eChancellor of the Exchequer and the planningand control of public expenditure . He has alsoworked as a Press Officer in 10 Downin gStreet .

Elliot L. Richardson is the Senior ResidentPartner in Washington Office of Milbank,Tweed, Hadley & McCloy . Previously, he wasthe Secretary of Commerce, the Attorne yGeneral of the United States, Secretary of De-fense, Secretary of Health, Education, an dWelfare and the Under Secretary of State . Mr.Richardson holds an LL.B. from Harvard LawSchool and an A.B. from Harvard College .

Murray Schlussel is the Assistant GeneralCounsel — International Tax of Ford Moto rCompany, Dearborn, Michigan . He is a mem-ber of the New York and Michigan Bar and hasbeen extensively involved in internationa ltaxes since his legislation and regulation serv-ice with the National Office of the IRS in th eearly 1960s. He is an active participant in theInternational Tax Force of the U.S. Chamber ofCommerce, the Tax Committees of the Na-tional Foreign Trade Council and the U .S .Council on International Business .

John G. Wilkins is Coopers & Lybrand's Di-rector of Tax Policy for Economic Analysis i nthe National Tax Services office . He held sev-eral senior Treasury Department positions in-cluding Acting Assistant Secretary (Tax Pol-icy), Senior Advisor to the Assistant Secretary(Tax Policy), and Director of Tax Analysis . Mr.Wilkins earned an A.B., Economics from Dart -mouth College .

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POLICY COUNCIL

James Q . Riordan Richard J. Hiegel Raymond J . SaulnierPresident & CEO Partner Professor Emeritus of Economic sBekaert Corporation Cravath, Swaine & Moore Barnard College - Columbia(Co-Chairman) UniversityKenneth IversonJames C. Miller III Chairman William E. SimonChairman Nucor Corporation PresidentCitizens for a Sound Economy M. Alanson Johnson II John M. Olin Foundation(Co-Chairman) Executive Vice President, Richard L. SmithWayne Gable Treasurer and CFO Senior Vice President & ChiefPresident P. H. Glatfelter Company Financial Office rTax Foundation The Rosewood CorporationWilliam A. LiffersEdward L. Addison Vice Chairman Edward SteinhoffPresident & Chief Executive American Cyanamid Company Vice President of Finance, Chief

Officer Financial OfficerJohn A. LoveThe Southern Company Of Counsel Dow Corning Corporation

Michael Ambler Davis, Graham & Stubbs Steven C. Stryke rGeneral Tax Counsel Paul H . Martzowka Vice President & General TaxTexaco Inc . Executive Vice President Counsel

Roland M. Bixler Manufacturers National Bank Shell Oil Company

President Paul W. McCracken Dominic A. Tarantin oJ-B-T Instruments, Inc. Edmund Ezra Day University Co-Chairman & Managing

Robert T. Blakely Professor Partner

Senior Vice President of Business Administration Price Waterhouse

Tenneco Inc . The University of Michigan Joseph B. Tharp

John C. Burton Richard L . Measelle Executive Vice President and

Arthur Young Professor of Managing Partner Finacial Controller

Accounting & Finance Arthur Andersen & Company BankAmerica Corporatio n

Graduate School of Business Kendyl K. Monroe W. Bruce ThomasColumbia University Partner Vice Chairman - Administratio n

The Hon. Harry F. Byrd, Jr. Sullivan & Cromwell & Chief Financial OfficerUSX Corporatio n

Dennis D. Dammerman Stewart G. Nagle rSenior Vice President of Finance Senior Executive Vice President Hans W. WandersGeneral Electric Company Metropolitan Life Insurance Vice Chairman - Retired

James M. Denny Company The Wachovia Corporatio n

Senior Vice President & Chief James W. Nethercott James W. WirthFinancial Officer Senior Vice President Senior Vice President and Chief

Sears, Roebuck and Company The Procter & Gamble Company Financial OfficerAluminum Company of

Robert A. dePalma Victor B. Noschese AmericaSenior Vice President & Chief Vice Chairman, Tax Services David T. WrightFinancial Officer Ernst & YoungRockwell International Vice Chairman - Taxes

Robert L. Plancher Coopers & LybrandCorporationSenior Vice Presiden t

Gwain H. Gillespie American Brands, Inc.Executive Vice President - Finance John J. Quindlen& Administration Senior Vice President - FinanceUNUM Corporation & Chief Financial OfficerC. Lowell Harriss E. I. du Pont de Nemours &Professor CompanyColumbia University

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PROGRAM COMMITTEE

Robert Harmon Anthony J . Cetta Thomas V. FritzDirector of Government Director & Comptroller Vice Chairman

Relations - Retired First Boston Corporation Ernst & YoungArthur Young & Company John E. Chap oton Albert E. Germain(Co-Chairman) Managing Partner Vice President Taxes & Ta xGlenn White Vinson & Elkins CounselDirector of Tax Department & Ernest S . Christian, Jr. ALCOA

Assistant Secretary Partner Ralph A. GerraThe Dow Chemical Company(Co-Chairman)

Patton, Boggs & Blow Cyrus J . HalpernRalph J. Coselli Director - Federal &

Byrle M. Abbin Assistant General Tax Counsel International TaxesManaging Director, Federal Tax Shell Oil Company AT&T Corporate Headquarter s

ServicesArthur Andersen & Company Dennis J . Crispin Michael A. Hass

Vice President - Employee Director of Taxe sMichael Ambler Benefits, Insurance and Taxes Marsh & McLennan, Inc .General Tax CounselTexaco Inc.

The Boeing Company Michael J . HenryWilliam G. Dakin Chief Counsel - Tax Policy

Christopher W. Baldwin Supervisory Tax Counsel Sun Company, Inc .Director of Taxe sGannett

Mobil Corporation Thomas A. HimesMichael A. DeLuca Vice President

James J . Baldwin Vice President - Taxes BASF CorporationVice President - Taxe sCampbell Soup Company

Household International Martin HoffmanAnthony R. DeSanto Senior Vice President & Tax

Frank J. Bianca Executive Director, Taxes CounselVice President - Taxes Eli Lilly and Company Manufacturers Hanover Trus tAmerican Brands, Inc . CompanyThomas A. DowdB. Anthony Billings Vice President - Corporate Tax Joseph HouseholderAssociate Professor CNA Insurance Companies General Tax Counse lDepartment of Accounting Unocal CorporationWayne State University John E. Easton

Partner Dean HudsonAlan M. Breitman Coopers & Lybrand Vice Presiden tDirector of Taxes & Assistant Southern Company Services,

Secretary Haskell EdelsteinAmerican Cyanamid Company Senior Vice President & General Inc .

Tax Counsel J. P. LaCass eBruce F. Brown Citicorp/Citibank, U.S .A. Director of TaxesVice President and Director, American Presidents

Taxes Patrick J. EllingsworthPhillip Morris Companies Inc . Assistant Tax Officer Companies, Ltd.

ARCO Herbert J. LernerJames P. Bryant PartnerVice President & Director Stuart S . Flamberg

Corporate Taxes Senior Vice President & Director Ernst & Young

J. C. Penney Company, Inc . of Taxes Jeffrey D . LernerDonaldson, Lufkin & Jenrette, Assistant Vice President - Taxes

Anthony H. Buckman Inc . Burlington Northern RailroadCorporate Tax ManagerToyota Motor Sales, U.S .A. Richard A. Freling John Loffredo

Johnson & Gibbs, P.C . Chief Tax Counse lPeter C . Canellos Chrysler CorporationPartner August W. FrischWachtell, Lipton, Rosen & Katz Vice President & General Tax

CounselWestinghouse Electric

Daniel L. Lundy Richard A. Overton Thomas StapletonSenior Vice President & Director Vice President - Tax Senior Vice President

of Taxes Monsanto Company Metropolitan Life InsuranceITT Corporation CompanyJohn F . Palme rThomas P . Maletta Vice President - Taxes John S . StephanVice President - Taxes Whitman Corporation Senior Vice President & TaxXerox Corporation CounselWilliam ResnickMichael E. Martello Assistant Treasurer and

Bank of America

Assistant Controller & Manager Director, Tax Division Don J. Summaof Taxes E . I . du Pont de Nemours & Professor

Bechtel Group, Inc . Company Monmouth College

Robert N. Mattson Richard P . Roling F. E . WellsAssistant Treasurer Director of Taxes Manager - Tax DivisionIBM Corporation Commonwealth Edison The Procter & Gamble Company

Thomas McHugh Steven L. Rosner John WilkinsPresident Manager, Tax Accounting and PartnerIllinois Business Roundtable Analysis Coopers & Lybrand

D. Bradley McWilliams Pacific Telesis L. L. WilsonVice President, Taxes & Real John J . Ross (retired) General Tax Counsel

Estate General Tax Counsel Unocal Corporatio nCooper Industries, Inc . Chevron Corporation Richard A. WilsonDonald Meier Robert F. Sama Vice President, TaxVice President - Taxes Vice President - Tax Counsel Safeway Stores, Inc .Sara Lee Corporation Gillette Company Neil P. WissingJohn R. Mendenhall David M. Schwartz Vice President & Director ofVice President - Taxes Senior Vice President - TaxesUnion Pacific Corporation Corporate Taxes Weyerhaeuser CompanyM. D. Menssen Crestar Bank Arlo WooleryStaff Vice President, Taxes Bernard M . Shapiro3M National Director, Tax PolicyJoseph Mikelonis Price WaterhouseDirector of Corporate Taxes Andrew F . Shimko, Jr.Eaton Corporation Vice President - Director o fJohn T. Mills Taxes

Vice President - Taxes Manufacturers National Bank

USX Corporation Arnold B . SidmanDavid R . Milton Chamberlain, Hrdlicka, White ,Formerly Vice President & Johnson & Williams

General Tax Counsel Robert SimpsonShell Oil Company Vice President of TaxesR. L. Morris, Jr. Tenneco, Inc.Vice President - Tax Burton B. SmoliarOccidental Petroleum Corp . Associate General CounselDavid P. Norum Ford Motor CompanyVice President - Taxes Edward I . Sproull, Jr.Sears, Roebuck and Company Vice President - TaxLeif H. Olsen AdministrationPresident PPG Industries, Inc.Leif H. Olsen Associates, Inc .

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KEYNOTE ADDRESS

The Honorable Hank BrownUnited States Representative from Colorad oMember, Ways and Means Committee

I thought I would share a few thoughtsquickly on the surprises that are likely to bepart of the budget package. Certainly taxes arepart of that mix.

One of the top items that appear to beincluded in the agenda is the Chairman of th eWays and Means Committee's suggestionswith regard to taxing foreign subsidiaries . It isnot a new area; many of you are experts in itand are familiar with it. But the major focu sthat seems to be the point of discussion is aquestion about the pricing policies used be-tween a parent and a subsidiary; or more pre-cisely, the pricing policy of taxing items tha tare transferred from out of the country, im-ported into the country, or vice versa .

The question is whether those pricin gmechanisms are appropriate or whether theyserve to transfer the recognition of gain out ofone jurisdiction into another. It is very difficultto audit .

Secondly, it is very difficult to defendyourself on a transfer, even if it is totally legiti -mate. When I used to work for a living, Iworked for a company called Monfort . Wewere in the cattle business. We had a feed lo tdivision, the world's biggest cattle feedingoperation, and several packing plants . The feedlot management was always convinced tha twe sold the cattle too cheap to the packingplant. The packing plant was likewise alwaysconvinced that they paid far too much for thos ecattle. That is a phenomenon that is not un-usual, and it exists in many businesses thatimport and export products. So, it is not asimple matter. But it is serious when the majorfocus of the Ways and Means Oversight Sub -committee of Congress has been to sugges tthat mispricing exists and is a major source of

loss of revenue .There is a variety of things that the chair-

man is suggesting have a chance of being put i nthe bill, but I think many of them follow fro mthe findings of the Oversight Subcommittee .And there was a suggestion by the OversightSubcommittee chairman that indeed transfe rpricing is a major villain, at least in terms of lossof revenue. The Administration does supportChairman Rostenkowski's portion of the billthat involves additional reporting require-ments .

Reporting is basically meant to be a nauditing tool as well as an informational tool .Additional reporting is very likely to be a partof any bill. It is not dear, however, that an yrevenue number will be attached to the sug-gestion for additional reporting requirements .

The Administration does not support thesection of the bill that involves taxing the capi -tal gains of foreigners and extending the stat-ute of limitation for foreign-owned U.S. sub-sidiaries . In other words, the suggestion thatyou heard about the tax on capital gains an dthe sale of that stock and other taxes is oppose dby the Administration. That does not mean ,though, that if that is included in the packagethat they will necessarily veto the bill . I suspec tthat if the Administration signs off on thepackage from the summit, it is quite likely t oinclude a number of things they do not like, ye tthey would be in a position of having to sign offon it. They may not like the whole package, atleast one hopes they will not like the wholepackage.

The Commerce Department has testifiedon this as well . They, I think, have likewisesupported the information reports but doexpress concern about the taxing of the sub-

1

International Investmen t

sidiaries' stockWhat is likely to happen? Many of you, I

think, are firmly convinced that logic andthoughtful reasoning are the guiding forces i nthe development of tax policy . For those of youthat think that, I hope you will come andobserve some of our deliberations .

I must tell you that I am convinced, par -ticularly in the foreign taxation area, thosehave not been the guiding hallmarks . I think itis quite likely that something dealing withforeign taxation will be included within abudget package/tax package, if indeed one isconcluded. I think it is likely you will have apackage, and I think it is also likely you will

have something on foreign taxation included .At a minimum, my guess is that you will

see the additional reporting requirements . Also ,I think there is a 50/50 chance that you couldsee a provision for the tax on the foreign trans -fer of ownership added.

But over and above that, I think this is anarea where you will see additional legislativ eattention in an effort to come up with newprovisions to deal with it. Quite frankly, part ofthe problem here is that it is difficult to know ifthe transfer pricing is correct, from both a ninternal and an external point of view . It is als overy difficult to come up with a solution .

2

ISSUE OVERVIEW

Dr. Edward M. GrahamSenior Research Fello wInstitute for International Economic s

Edward Graham, senior research fellow at the Institute for Internationa lEconomics, begins his overview by noting the rapid growth of foreign direc tinvestment in the United States since 1975. He raises the question of whetheror not this is a good thing. On the one hand there is a fear of losing ou reconomic sovereignty as a result of foreign ownership of U.S. assets. Thealternative of foreigners pulling their funds out of the U.S. in these days ofmassive budget deficits could be much worse .

The second issue raised by Dr . Graham is the effect of foreign control in th eUnited States economy. There are numerous ways to measure foreig nownership. Of the whole economy, foreign ownership of non financialcorporations amounts to 14 .7percent. Foreign ownership can also be measuredas a percentage of manufacturing assets owned by foreign-controlled affiliates .Similarly, foreign ownership can be measured as a percentage o fmanufacturing sales or as a percentage of the work force employed byforeign-owned affiliates . Dr. Graham believes the most important indicato rof foreign ownership in the U .S. economy is the percentage of the grossnational product contributed by foreign investors . In 1987, this percentagewas only 3.4 percent.

Dr. Graham points out that when compared to the three major Europea neconomies, the U.S. has the lowest degree offoreign control. France, Germanyand the U.K. all have high degrees of foreign ownership in their economies .In striking contrast to these is the economy of Japan where only a miniscul efraction of the economy is controlled by foreign investors .

Next, Dr. Graham asks whether a high or low degree of foreign ownershipprovides the host country any advantage in international economics an dbusiness. Two conflicting schools of thought are provided to answer thi squestion. Regardless of which school one accepts, Dr . Graham suggests theimplications for U.S. policy are that the U.S. should do nothing to discourageeither inward or outward investment.

Dr. Graham notes that the rate of penetration of Europe by U .S. andespecially Japanese corporations is proceeding at an enormous rate .Interestingly, most European governments seem to be encouraging ratherthan discouraging the Japanese in this trend .

Finally, Dr . Graham suggests some broader themes for discussion in th eensuing talks . First, the Japanese market does seem to be opposed to inboun d

3

International Investmen t

foreign direct investment. This is not viewed in a positive light . Second,should U.S. tax policies be changed in a way that would discourage foreig ndirect investment in the U.S.? Dr. Graham thinks not. Third, should taxpolicy provide either incentives or disincentives for the extension of U.S.firms' activities overseas? Again, Graham is opposed, preferring a morcneutral government policy.

Certainly the big story in terms of globali-zation of business during the last decade hasbeen the increased participation in the U .S. byforeign firms. Maybe the biggest surprise iswhat Chart 1 on page 62 shows regarding for-eign direct investment flows into the Unite dStates from 1975 . A couple of things stand out ,one of which is that from 1980 to 1984, theseflows actually subsided, but from 1984 throughjust last year the rate of foreign direct invest-ment in the United States expanded at a dizzy-ing pace. This has, of course, resulted in allsorts of consternation in the U .S. Congress andelsewhere, which can be summarized in onequestion: Are we losing our economic sover-eignty? The 1990 figures suggest that there isjust a chance that the issue is going to change .In the past year the issue has been, "Who i sselling the heritage of the United States?" Theimplication is that foreign direct investment i screating some sort of economic crisis withi nthe United States. Wait until congressmen findout what will happen if foreigners pull theirfunds out of the United States in the wake o fthe current budget deficit. Such a pullout couldbe a really big story coming up . The futurestory could be, not the increase in foreign di-rect investment, but the lack thereof.

How extensive is foreign control in th eUnited States' economy? This is a tough issu eto get a handle on. Let us just take a very quicklook at some indicators of the extent of thi scontrol. Foreign direct investment is an equityconcept. One way of judging the role of foreigndirect investment in the United States, relativ eto the whole economy, is to examine foreigndirect investment as a percentage of the tota lnet worth of non-financial corporations. This

figure is a fairly high 14.7 percent, by the latestdata. That is a significant amount of foreigncontrol in the U.S. economy (See Chart 2 onpage 63) .

Assets of foreign-controlled manufactur-ing affiliates as a percent of all assets in th emanufacturing sector is 13.9 percent, whilesales of foreign-controlled manufacturing af-filiates is 14.7 percent. However, when youlook at employment of foreign-controlled af-filiates as a percentage of all U .S. employment,the figure drops to 4.0 percent, and indeed ifyou ask how much as a percentage of the grossnational product is value-added by foreigndirect investors in the United States, this figur ewas only about 3 .4 percent in 1987. It has goneup a little bit since then .

Why the discrepancy between the highand low figures? Probably the main reason i sthat foreign direct investment is concentratedin certain sectors of the U.S. economy, primar-ily the manufacturing sector, but other sectorsas well . The service sector, with the exceptio nof banking, is largely untouched by foreigndirect investment.

One of the things that has amused me i sthat those people who want the public to getalarmed about foreign direct investment tendto pull out the high percentages from Chart 2,while those people who want to minimize thisproblem tend to pull out the low figures . Allthe figures are perfectly accurate and legiti-mate. But of course, what the panoply of fig-ures suggests is that there's plenty of scope fo r"lying with statistics" on this issue. What is thetrue extent of foreign control in the U.S. econ-omy? Personally, I think the value-addednumber is probably the most accurate overall

4

Issue Overview

indicator.International business is becoming global ,

and one very important issue is : How does theextent of foreign control in the U.S. economycompare to foreign control in other major econo-mies. What we can see, looking only at themanufacturing sector, is that the extent of for-eign control in the United States actually isconsiderably lower than in any of the thre emajor European economies by several meas-ures. France is a country where there has alsobeen significant grassroots reaction againstforeign control in the economy . Somewhatsurprising to many people is that foreign con-trol in Germany by the sales measure is signifi -cantly higher than the United States, althoug hsomewhat lower by the employment measure .I think the discrepancy is accounted for by th econcentration of foreign direct investment inGermany in rather capital-intensive kinds ofactivities such as chemicals . The United King-dom is a similar story. The case of Japan standsout because the extent of foreign control in theJapanese economy, at least as of 1986 (and Idon't think it has changed a whole lot sinc ethen), is extraordinarily low.

One thing that is reasonable to ask is ,"Does foreign control really make a differ-ence?" So what if Japan has a lower degree o fforeign control, while the other of the G-5 haverelatively high degrees of control? So what if inthe last couple of years foreign control in th eU.S. economy has reached levels approachingthose of the European countries? There arereally two conflicting schools of thought o nthese issues. One school of thought is repre-sented by the thinking of Harvard Universit yBusiness School Professor Michael Porter, aname that has come to be widely recognized .Porter believes that the advantages of firms aredeeply rooted in the culture and economies ofthe home countries of those firms . What Porterwould argue is that many of the Japanes efirms' advantages in the international businessplace come from factors that are intrinsic to theJapanese culture and the Japanese economy .

What is interesting is that Mr. KenichiOhmae, who is a partner of the U.S.-based

consulting firm, McKinsey, but himself a Japa -nese national, has become the most prominen tchallenger of that position. Mr. Ohmae main-tains that in today's world, the competitive-ness of a firm is not determined by any onecountry, but rather by the network of countrie sin which that firm has major operations. In Mr .Ohmae's view, Japanese firms do not have anyparticular advantage by virtue of having bee nrooted in Japanese culture .

What I would like to do is throw one cardon the table and to suggest to Mr . Ohmae, "No,I don't think you are entirely correct on tha tone." Because Japan's foreign direct invest-ment position is so asymmetric, even if thecompetitive position of a firm is determined b yits global network of affiliates, it would appearthat Japanese firms are participating in all o fFrance, Germany, the United Kingdom andthe United States, but that relatively few U .S.and European companies are in a position t ocompete effectively in Japan . So there is anasymmetry that exists there in Japanese versusother firms' global networks .

What does this mean for U.S. policy? Iwould suggest the following : I would suggestfirst that whether you believe in the Porterperspective or whether you believe more in theOhmae perspective, U.S. policy should donothing to discourage either inward or out -ward investment . If indeed advantage flowsfrom the Japanese culture, one conduit by whic hthose advantages can come into the Unite dStates is through Japanese foreign direct in -vestment in the United States. Those whomaintain that Japan is running past the UnitedStates are not being entirely consistent whenthey issue calls to keep Japanese industry outof the United States . To do so just doesn't makeany sense at all . Japanese industry in the Unite dStates will serve as a conduit by which some o fthe advantages of Japanese firms will flow intothis economy . Incidentally, it should flow notjust to U.S. subsidiaries of Japanese firms, bu tto domestically owned firms as well .

But neither should we want to do any-thing to discourage U.S. outward investment .Indeed, U.S. multinationals operations over -

5

International Investmen t

seas still can be a source of strength to the U .S .economy, although perhaps more so unde rOhmae's scenario than Porter's . Benefits fromparticipating in overseas economies can b etransferred into the United States by U .S.-basedmultinationals .

What is absolutely clear, however, is tha tthere is a major argument to be made for afurther opening of the Japanese market t oparticipation by foreign firms ; this is true n omatter which set of reasoning — Porter's orOhmae's — you accept .

I shall further note two things . The first isif flows of foreign direct investment are downin the United states, what is happening else -where? Are they down elsewhere? The answeris no, they are not, particularly not in Europe .In Europe the rate of penetration of the localeconomy by Japanese corporations is proceed-ing at rapid rates and incidentally is generatin gright now some of the same tensions that for-eign direct investment has generated in theUnited States . Nonetheless, the policy of mos tEuropean governments is to encourage theJapanese investment rather than to discourageit, with some minor exceptions .

If the Japanese are running wild in Eu-rope, so are U.S. firms, at least by one impor-

tant measure . Growth of formation of fixedcapital in Europe has significantly outpace dthe growth of national product, the reverse o fwhat has been true in the United States durin g

this same period. But real capital expenditureby European affiliates of U .S. firms has grownstill faster . Indeed if you were to look at anyone set of actors in the European economy thatis responding to Europe's 1992 initiative, thatset of actors would be the local affiliates of U.S .firms, even more than Japanese firms .

My job is simply to raise a few issues. Tosummarize, let me suggest all of the following :1) The Japanese market does, in fact, seem to beclosed to foreign direct investment. Is thatgood or bad? I suggest that it is bad .

Secondly, U.S. policies, especially ta xpolicies, should not be set to discourage for-eign direct investment in the United States . Inparticular, in response to alleged tax abuses byforeign firms, we should avoid fixes that ru nthe risk of discouraging foreign direct invest-ment at a time when it is already falling .

Finally, tax policy should give neitherincentive nor disincentive to the extension o fU.S. firms' activities overseas .

6

SESSION ONE

Tax Treatment of U .S . Investment Abroad — Panel 1

Murray SchlusselAssistant General Counsel - International

TaxFord Motor Company

Peter A. BarnesDeputy International Tax Counse lU.S. Department of the Treasury

David M. Crowe

Panel Chairman : David M. CrowePartnerCaplin & Drysdale

Raymond HaasInternational Tax PartnerErnst & Youn g

We are going to talk about two very dif-ferent sorts of issues today, one of which I havecalled administrative issues — the other, cor epolicy issues .

With respect to administrative issues,there are a number of statutory provisions andregulations that were never scored for revenuewhen enacted. Nobody really thought a whol elot about what they meant, what they implied,or that people would have to comply withthem. They have turned out to be quite anirritant to corporate management; the thingsthat Congress and Treasury could easily fix i fthey wanted to, wouldn't cost much money tofix, and every multinational has a laundry listof little things they would like to have fixed —administrative issues — simplification issues.

I would like to give you my favorite as anexample of that first type of issue and that is therule for translating foreign taxes paid by for-eign subsidiaries of U.S. companies. Before the1986 Tax Act there was a relatively simple rulecalled the Bon Ami Rule, named after an oldtax case involving the cleanser, for translatin gforeign taxes. Basically you took the foreigntaxes that the foreign subsidiary paid and theearnings of that subsidiary and you translatedthem into dollars at the same rate and on theday that these earnings were distributed back,you paid a dividend. You had a spot rate andthe dividend rate translated both taxes and

earnings .A simple rule — it always worked and

nobody complained about it .In 1986 Congress changed it . There was a

conceptual debate, which I won't go through,about how we ought to credit foreign taxes, bu tthe bottom line is the rule was changed. Earn-ings were still translated at the spot rate ; thedividend comes back when your foreign sub-

sidiary pays a dividend back to the U.S. andyou translate those earnings at the spot rat einto dollars. Taxes are now translated at thehistoric rate — the rate in effect on the date theforeign taxes were paid to the foreign jurisdic-tion. It is a payment-by-payment rule. It hascreated an enormous administrative headach efor many U.S. multinationals.

As I said, I won't go into the policy rea-sons behind the change. It is something aboutwhich reasonable people can differ, but I thinkit is fair to say that it has had an effect that is a tthe very least an irritant to many U.S. multina -tionals.

There is no core policy issue at stake in anadministrative issue like that. This issue ofwhat rate you translate the taxes at, along witha number of other issues, is in a package that isup on the Hill now, a simplification package,and I think perhaps we can get Peter Barnes t ocomment at the end on the likelihood of gettin gsome sort of relief with respect to this first typ e

7

International Investmen t

of issue — the administrative issue .The second type of issue we are going to

talk about is basic policy issues that go to thecore of U.S. international tax policy. For ex-ample, the rules for crediting foreign taxes andspecifically the separate baskets . When is itappropriate for the United States to permit acredit for a tax paid with respect with tax o none item of foreign income to offset U.S. taxliability on another item of foreign income ?That goes to the core of what the foreign ta xcredit does .

More importantly, and particularly in thisbudget environment, it costs money to changethose core policy issues . Obviously simplifica-tion proposals and the administrative issues

are going to be easier to get through Congress ,easier to get Treasury to sign on to, but weshouldn't lose sight of the core issues . It isimportant to continue that critical debate, andRaymond Haas will begin the panel with apresentation on these core policy issues .

Raymond Haa s

Raymond Haas, International Tax Partner for Ernst & Young, offers thetax practitioner's perception of the tax treatment of U.S. multinationals . Mr.Haas starts by providing a summary of a previous study he authored,entitled "The Competitive Burden: Tax Treatment of U.S. Multinationals ."The study concluded that the tax laws of the Netherlands, Germany, an dJapan put companies based in those countries in superior competitiv epositions vis-a-vis their U.S. counterparts .

According to Mr. Haas, an important factor in this competitiv edisadvantage is that only the U.S. system disallows tax incentives offered b ydeveloping nations to multinational investors . Another problem is th eforeign tax credit mechanism, which winds up creating instead of preventin gdouble taxation. In addition, frequent changes in U.S. tax law have made itdifficult for companies to effectively plan and administer their internationa ltax compliance .

After the original study, Mr . Haas looked at an additional seven countrie sin a more cursory fashion and has arrived at a similar conclusion: U.S.multinationals have been put at a competitive disadvantage as a result of th etax rules with which they must comply .

Mr. Haas provides numerous examples of these problems : the absence of aU.S. tax sparing credit, the inability of U.S. companies to cross-credit incomeand taxes from foreign operations, the rules for expense allocations, an dloans from foreign affiliates .

About two and a half years ago we pub-

their domestically based companies .

lished "The Competitive Burden : Tax Treat-

Let me start off by summarizing our con -

ment of U.S. Multinationals." What it did was

clusion. It was very simply that the tax laws of

compare how four leading capital exporting

the Netherlands, Germany and Japan wer e

nations taxed the international operations of

competitively superior for companies in thos e

8

countries vis-a-vis the U.S. tax laws applicableto U.S.-based multinationals . There were twoprimary reasons for that conclusion .

The first one was that the U .S. tax system,but not the systems of the other three countries ,overrode and took back the incentives thatforeign countries, particularly developin gnations, gave to developed nation companiesfor investing in those countries.

Secondly, the U .S. tax system unfortu-nately winds up not limiting double taxationby virtue of the foreign tax credit mechanism,but actually, in my opinion, creating doubl etaxation. That is to say, with respect to U.S .companies that have foreign operations thatare taxed at a 34 percent rate in a foreigncountry, taking a general picture of that sort o fa company, it is likely there will still be someresidual tax when those earnings are broughtto from the United States, thereby making aworldwide tax rate of something in excess ofthe U.S. rate.

Was the 1986 Tax Reform Act the stand-alone culprit? I would answer that it was not.The laws for the last 25 or so years have bee npointing in this direction, getting more an dmore technical . In addition to the pure policypoints, one other thing that deserves mentionand perhaps Murray will comment on it in hi sremarks on administrative issues, is that therate of change, both legislatively and adminis -tratively is a) tough to keep up with, b) de-stroys your confidence if you think you knowwhat the rules are, and c) makes plannin ggenerally very difficult. I think that as a policymatter, even though this complexity is not asubstantive issue, it is itself damaging to thecompetitiveness of U.S. companies.

We chose the comparable countries o fJapan and Germany because I think they areperceived as our primary competitors. Wechose the Netherlands for two reasons: (1) italso has many leading multinationals such asUnilever, Shell, and Phillips ; and (2) it has asystem that is diametrically opposed to theU.S. system vis-a-vis international operations .It basically has a territorial system allowing theforeign countries to tax foreign operations and

then letting alone the income that comes backto the mother country .

Was the deck stacked by just picking thes ethree countries? We didn't think it was origi-nally and we concluded to our satisfactionsubsequently that it was not . We looked at a nadditional seven countries in a more cursoryfashion than we did in the original study . Forthe U.K., Canada, Australia, Italy, Switzer-land, France and Belgium, and most of theother major capital exporting nations, ou r

conclusions stick .The U.K. has a tax rate that is approxi-

mately the same as the United States ; we are 34percent, they are 35 percent . But they have amuch different system : (1) you can mix th eforeign taxes coming from different parts ofthe world and different sorts of operations b yhaving what they call a mixing company. Weare not allowed to have that . (2) They do, as apolicy, enter into tax sparing treaties withdeveloping nations .

With respect to Canada and France, thei rsystems are similar to Germany's . That is to saythat with respect to foreign operations con -ducted in the treaty countries, it is basically a nexemption or territorial system, and with re-spect to Switzerland and Belgium, it is verysimilar to the Netherlands and all three coun-tries basically have an exemption system on aworldwide basis and also do not have the anti-deferral rules that the United States has.

Let me just use two examples to illustratethe two primary problems I indicated earlie r(See pages 71 - 73).

Singapore, a developing nation, welcomesthe introduction of capital and the employ-ment of its people by, among other things,offering a tax holiday . That is a fairly commonphenomenon in many countries throughoutthe world. The question is, what happens to thecompanies from these four countries that setup the identical operation in Singapore. Thebasic facts are that there is a $10 million invest -ment; there is one million dollars of earnings,and Singapore says, "No thanks, we are notgoing to tax you — we appreciate your bring-ing business here and employing our people."

9

International Investment

If you look at Line B, it says statutory taxrate. By the way, the Japan column should read51 percent . It used to be 56 percent. Japan hasreduced their rates to 51 percent. But if youlook at that row, you will see that the statutorytax rate is by far the lowest in the United States .Then you look at lines C, B and E, and you cometo a radically different answer . You see that i nGermany and the Netherlands, there is no taxpaid in either of those two home countries ,even though the dividend is paid back there.

Secondly, in the case of Japan, even thoughits tax rate is 51 percent, the tax paid is actuall y19 percent . But why do we have these results ?

Basically Germany and the Netherlandshave a territorial system, in the case of Ger-many by treaty and in the case of Netherlandsby its internal law. Just say Singapore has theright to tax income — if it doesn't, we are notgoing to tax it when it is brought back to theparent company.

The U.S. and Japan have worldwide sys-tems with foreign tax credit to offset, by way o fdouble tax, the tax paid abroad. Note that inJapan there is a $320,000 foreign tax credit .How can that be when in fact there is no taxpaid to Singapore? The answer is, as a policymatter, Japan has seen fit to encourage invest -ment by its corporations in Singapore andgives a tax credit. A so-called tax sparing creditspares Japanese tax on the tax that could hav ebeen levied by Singapore but was not becauseit was trying to encourage development andbecause Japan has a treaty with Singapore .

It is fair to ask why U.S. policy penalizesa U.S. company that actually repatriates theseearnings back to the United States by levyingthe 34 percent tax. Presumably the remittancehelps the balance of payments and helps tooffset the drag in trade deficits in the overallbalance. Secondly, repatriated profits wouldseem to add to the capital pool available toexpand our productivity in the United States .That is the first example . Again, the principl ehere is that the U.S. overrides the incentivegranted by the foreign country .

In the second example you have a U.S .multinational that has two foreign operations

(See page 72): a 100 percent owned foreignsubsidiary and a 49 percent investment in aforeign company. First of all, the reason the yhave 49 percent may not be voluntary . It maybe that the foreign country precludes a higherdegree of ownership. Secondly, the 49 percen towned operation and 100 percent owned for-eign operations are engaged in the identica lbusiness activity. Thirdly, there is no passiv eincome involved here — it is pure business . Ifyou look at the top half of page 72, what you se eis that the foreign subsidiary is subjected to a 5 3percent tax rate and the 49 percent ownedcompany is subjected to a 15 percent tax rate .Conveniently those average out to 34 percent.The point is that the aggregate foreign taxincurred on this foreign business activity is 34percent — 53 percent in one case and 15 per-cent in the other case . They are all busines sactivities, they are not passive, etc. The ques-tion is, if both these operations distribute alltheir profits back to the U.S. owner, is there anyresidual U.S. tax? The lower left corner of tha tpage 72, the part called "Anticipated Tax Con-sequences," demonstrates that you would an -ticipate no additional U .S. tax. The only U.S .tax would be the $680 you would pay on th eU.S. domestic $2,000 of profit .

Unfortunately, when you go over andapply the actual U.S. rules, you come out witha radically different answer. I don't want to saythat the numbers illustrated on the right bear amathematical relationship to what alway shappens, but it is clear that they illustrate theconcepts of what always happens, for tworeasons .

There is a double tax liability . In this par-ticular case it is $360 or 18 percent, raising th eeffective rate to 52 percent . Again, there is nomagic to the 52 percent. That is just a mathe-matical way of expressing the concept of doubletaxation. The reason for the double taxation istwo-fold: (1) because the 49 percent busines sactivity is in a separate basket, you canno tcross-credit income and taxes of these twoforeign operations — a result that I see abso-lutely no logic in .

Secondly, harder to explain but of per-

10

haps even greater impact, significant parts ofthe U.S. companies' expenses that are not di-rectly chargeable against these foreign opera-tions wind up being allocated and apportionedagainst these foreign dividends, even thoughboth of these foreign operations are self-fi-nancing. If you look at the facts at the top ofpage 72, the interest rate paid abroad in theseforeign subsidiaries is basically the same rat eas a percentage of profit as it is in the Unite dStates . So, for these two reasons, the U.S.company winds up having a significant resid-ual U.S. tax even though these foreign busines sactivities are taxed at 34 percent .

The study also shows that the U.S. has avery different point of view than the othe rcountries concerning some other significant

features of the tax system. All other countries ,and again this includes the other seven nation sthat we subsequently looked at except forAustralia which is in the process of doing so ,engage in tax sparing with developing nations .The United States does not .

Secondly, with respect to the low taxedearnings of foreign subsidiaries, those can b eloaned back up to the domestic parent com-pany in all these other countries without aconstructive dividend .

Thirdly, the act of having the operations ,the profits from foreign operations movedamong other companies on an inter-compan ybasis is typically not something that generatesan end to deferral of tax on those profits .

Mr. Crowe: Peter, would you give your reaction to some of the policy issues Ray has raised ?

Mr. Barnes: When David called me las tweek, he said he wanted me to bring balance tothe panel . I wasn't sure whether that was be-cause you were going to get so much rationa lcomment by the other members that he wantedsome irrational comment from me, but none-theless, I do think there is another perspectiv ethat may fruitfully be shared in this group .

I hope, however, that neither I in theTreasury Department nor the members o fCongress nor the staff members for Congres sare so diametrically opposed to Americanbusinesses as we sometimes are pictured . Iwould like to think we are working together . Infact, I think we are in many respects . Indeed thebasic rule in the U.S. remains that we havedeferral for active business income of U .S . -owned foreign companies . That is often over-looked. We can quarrel over what is active andwhat qualifies for the deferral, but the fac tremains that we don't immediately tax theforeign earned income. The basic rule is defer-ral and we have a lot of work to do to decidehow we compute the amount of that incomeand how we compute what is active income asopposed to inactive income that might not ge tthe deferral.

A couple of other points—there is a resid-ual tax in the U.S., so that the effective tax i sover 34 percent, only where on an item o fincome or category of items of income, theforeign tax has been greater than 34 percent. Iunderstand that the baskets cause taxpayersproblems, and certainly from an administra-tive standpoint there is a lot to be done insimplifying the basket regime . We recognizethat and I think everyone who is involved inthe tax policy process recognizes that . Indeed,if you read through the simplification pam-phlet that came out from Ways and Means inJune, which is a wonderful compendium o fideas, over and over again people say, 'Thereis a problem administratively with the foreigntax credit basket system."

Nonetheless, double tax, I think, meansmore than just somehow, somewhere, you pa ymore than 34 percent. The way our basketsystem works is that you are only paying mor ethan 34 percent if the foreign jurisdictio ncharged you more than 34 percent on someitems of income.

There is one major issue that I think weneed to keep in mind. I understand that this is

11

International Investment

an afternoon devoted to foreign investment i nthe U.S. and U.S. investment abroad, but in asystem that requires some revenues to be raisedthrough taxes, we have to think about theconsequences of reducing the tax burden o nthe group that brought us together today .

The consequence is that more money isgoing to have to be raised from U .S. companiesproviding services and goods to the U .S. mar-ket or the people who remain within the U .S.and export . Their interests are important and Ithink we would create a very serious proble mif we insist on falling to the lowest commo ndenominator of some foreign jurisdiction sothat a U.S.-owned foreign company couldcompete, I hate to say more effectively but,more effectively in that foreign jurisdiction .The result of such an approach would be t oincrease the deficit or to increase the burden onthe U.S. company providing goods and serv-ices for the U.S. market. We cannot ignore theoverall revenue needs .

Tax sparing is an issue that goes back 3 5years. There has been a great deal said about it ,but again I think this is the kind of place whereyou have to put yourselves in the shoes of theU.S. manufacturer who makes widgets i nmiddle America and sells only to middl eAmerica. He sits there and says, "I pay 34percent on my taxes; this other guy not onlydoesn't pay 34 percent, but he doesn't even pay24 percent because he gets credit for a phantomtax that he, in fact, doesn't pay." There is nodiscipline on that system because if it is a tax

not paid, it can be a tax charged at any rate .I would be happy to talk about tax spar -

ing. It has such a lengthy history to it, though,that I think it is simply enough to say we ca nbeat ourselves over the head on tax sparing,but we are wasting our time . I think as a groupwe can move other issues forward on veryproductive fronts, and I would advise us to dothat rather than to fret over tax sparing .

I also want to put in a plug . I think there isa sincere desire by Treasury, by the Hill, and bytaxpayers to do something in terms of theadministrative issues that David mentionedearlier and these foreign tax credit basketquestions. I look with great anticipation to thenext two years in Congress .

Simplification is not going to happen thisfall. But the simplification issues that wer eraised during the spring and compiled by th eWays and Means Committee, and the genuin eenthusiasm for a simplification effort gives mea good feeling about what will happen in 199 1and 1992. It won't be simple and anyone whoholds out too high an expectation is invitingdisappointment. But I think in small bitesaround the edges, we can get meaningfu lsimplification. What I would encourage you todo is not walk away just discouraged by all theproblems that are created for foreign-ownedU.S. companies or U .S.-owned foreign compa -nies, but instead to go back and revisit thesmaller issues that we might usefully addressover the next year.

12

Murray Schlusse l

Murray Schlussel, Assistant General Counsel of International Tax forFord Motor Company, offers examples of practitioners in U .S. firms havingto expend large amounts of money and energy to comply with tax rules fo rU.S. multinationals .

In Mr. Schlussel's view, the most problematic area of ill-conceived ta xrules and Code provisions is SubpartF. The Tax Reform Actof 1986 (TRA '86 )expanded the definition of passive income and eliminated an exemption fromSubpart F for transactions not availed of for the purpose of tax avoidance .Consequently, he has Subpart F income in every single one of his foreignaffiliates .

The creation in 1986 of passive foreign investment companies (PFICs)imposes, for no apparent policy reasons, new levels of complexity o ncompanies with high interest income, not at all unusual in a hyperinflationaryeconomy. Yet another provision of the 1986 Act which has hindered U .S .multinationals' ability to efficiently comply with U .S. tax rules is th eexpansion of the basket rules for the foreign tax credit . Specifically, the 10 -50% basket has caused a significant burden in terms of compliance an dplanning. Like Mr. Haas, Mr. Schlussel cites the interest allocation rules asbeing arbitrary in the way U.S. costs are allocated against foreign sourc eincome.

Mr. Schlussel sees U.S. information reporting requirements as outrageous,especially in comparison with foreign requirements . As a key person in man yjoint ventures, Mr. Schlussel is put in the position of demanding informatio nfrom his foreign affiliates that they do not require . This handicaps all U.S.-based companies in the process of negotiating a joint venture .

Ford Motor Company prides itself onbeing one of the first multinationals ; it is one ofthe biggest and one of the most global. The talkwe had by Ed Graham before shows the kind o fcompetition we are up against, not only agains tthe Japanese and the Europeans, but now th eKoreans and others . Our industry over the lastdecade has seen a fierce competition, a lot ofconsolidation, and we have been searching forappropriate joint ventures . The economics o four industry show that you have to locateyourself in your market ; you must get highvolume to amortize enormous developmen tcosts and high capital costs. Our competitors,

U.S.-based multinationals, European or Asia nbased multinationals, face the same econom-ics .

My job at Ford is to be omniscient . I haveto integrate the tax advice from our local ac -counting firms, law firms, overseas as well a sdomestic, mix up the political process, andadvise management of what the tax impactcould be on going into Hungary as we jus tannounced, Russia, Portugal, Korea or anyplace else. Taxes are only one of those factors .

Businessmen facing these business op-portunities and businessmen trying to ham-mer out a joint venture with an Italian-based

13

International Investmen t

company or a Japanese company or anybod yelse have a lot of things to be concerned with .My input is just one of those elements . I getinvolved in negotiations with the governments ,looking for incentives, looking for eliminatio nof disincentives, trying to work out a deal withthe other side . One of the things I am faced withis how simple and how direct most of the homecountry tax laws are with respect to our pro -spective partners, whether they are French ,Italian, German or Japanese . I come with allthis "baggage" thanks to our people up onCapitol Hill legislating to help me teach for-eigners how taxes ought to be .

I like to think of us as trying to be a racehorse without much handicap weight to carry,but I think our government looks at us as a cashcow to be milked. That is a pretty tough way t orun a race.

I have been involved in more than tendeals for the last two or three years, since th e1986 Tax Act, involving some provisions of th eCode (that really weren't designed to raisemoney but to close some tax loophole becausesomebody read an article somewhere), tha thave really become a major impediment to ou rmaking a deal in a straightforward, efficien tmanner. I will just highlight a couple .

All I am trying to bring across is that I amlike the retail customer of all these governmen tinputs: everybody's grand idea of a bettersociety, how to raise money, cut the deficit, an dall that. Our company, my client if you will ,just wants to be in business, to try to make aliving, to stay in business. We are not in busi-ness to raise taxes; we are not in business toserve the Internal Revenue Service. They are aside line . We are "good citizens" here as we arein Germany, France, and some 30 other coun-tries. We are major components of their econo-mies. We happen to be U.S.-based. Most of ourshareholders are here .

But we are terribly handicapped in justgoing about our business and fighting ourcompetitors in a fair, straightforward wa ybecause, in large part, of ill-conceived tax rulesand Code provisions. For example, in the 1986

Tax Act they tightened up something called

Subpart F income which was generated in theearly '60s to close some tax loopholes on pas-sive income, mostly in tax havens . I can't quar-rel with the basic philosophy of it. One of themost important things though, knowing thatarbitrary rules wouldn't do justice, was anexemption for transactions not availed of toavoid taxes . Well, one of the "nice" things thathappened in 1986 was that we eliminated thatexemption and expanded the definition ofpassive income. As a result, I have Subpart Fincome in every one of my foreign affiliates .Another brilliant thing they did in 1986 was toinvent a PFIC (Passive Foreign Investmen tCompany). It was not designed to raise majorrevenue and in a couple of my tax returns, Ihave had to treat some manufacturing affili-ates with over 20,000 employees as a PFIC ,passive foreign investment company, becaus eof some of these wonderful rules, mostly be-cause we are in hyper-inflationary economieswhere there is a lot of interest income .

Many of these rules were never thoughtout in an integrated way. Somebody had agood idea about some little problem, stuck it i nthe Code, and planned to figure out later whathappens. I am the kind of guy it happens to andhave to explain it to my bosses . A lot of times idon't understand it until after the tax return i sfiled, or while we're doing it . But Subpart Fincome has enormously increased, with nopolicy purpose, the challenge of structurin gdeals or with just continuing to operate, some -thing you have been doing for the last 20 years .And all of a sudden you have a different resultfor some unexplained reason .

As for the basketing that was mentioned ,the worst thing I have faced is the 10 percent to50 percent owned foreign affiliate basket limi-tation on the use of foreign tax credits . I havehad at least five deals where my trying to avoi dhaving this income fall into the deep hole of a10 percent - 50 percent basket has complicateddeals and nearly killed one. In one deal I workedout a way of getting treatment of a subsidiary

in the controlled foreign corporation throug hsome fancy mechanics which cost the otherside money, though eventually we had to pa y

14

for it, all for no good reason. In other deals, likein Russia, we weren't allowed to go after morethan 40 percent ownership . In Mexico, the ruleis that you generally can't get more than 4 0percent ownership in our industry .

You try to make partnerships . Well, gues swhat? Russia doesn't understand partnerships ;it is not in their law. Japan does, Korea does ,but the Japanese and Korean social fiber look sdown upon partnerships. Big prestigiouscompanies can't be partners; it is for a mo mand pop noodle store. So, we can't have part-nerships. I am stuck with a number of jointventures with Japanese and Koreans where Iam in a 10 percent - 50 percent basket . Veryexpensive and for no policy reason — none atall that anybody has explained to me .

Another area which is arbitrary and camein the 1986 Act that kills us in straightforwardstructuring, especially in finance companies, i sinterest allocation — arbitrary methods o fcharging U.S. cost to foreign income . (As anaside, I take a little issue with Peter on abou twhether excess credits are solely a function offoreign rates being more than 34 percent . Whenyou start taking some U .S. costs and allocatingthem to foreign income, you get a differentresult .) It is particularly egregious when yo uare in a finance company that borrows moneyand lends it out; where money is like the "costof good sold ." You buy money wholesale, yousell it retail; you try to make profit on themargin. All those deals are structured on incre-mental costs, yet interest allocation does it onan arbitrary, overall basis. Why don't the yadopt some kind of net interest expense beforethey allocate. They have never explained theirreluctance though we have discussed this whil elegislating the 1986 Act. It's not that people onthe Hill aren't aware of it.

Another area, a final one, has to do withcompliance . When we sit down with foreigncompanies and try to welcome them into th eworld of Ford Motor Company — let's gettogether and design a transmission or a car o rlet's do a truck together — and they get to m yend of the spectrum and talk about taxes an dcompliance and how many accountants they

need to keep all the wonderful records the IRSdemands, they can't believe it . I start sendingthem telexes — I need this information forboycott reports or inventory or depreciation ,or some of the nice rules that we have here —it is really some fun to educate them on why weneed this detail. This is true no matter whatpercentage we own of their companies. Theburden is enormous . The purpose, I don't know .

We just had a meeting two weeks ag owith the IRS. They were encouraging m ymanagement to hire more people to handle theaudits. I would like to have more people .Whether I want to expend their efforts o naudits is another question. But they are reall yupset we don't have an army of people sittingaround waiting to service their audits . A cutelittle anecdote — I tried to explain that one o fthe reasons why we can't serve them is w espend too much time on some silly request —and I showed them one — we had a foreignaffiliate where we owned about 20 percent. Inorder to explain a change in a $142 .00 foreigntax credit (out of hundreds of millions of dol-lars) they had nine questions they wanted t ohave answered which would have taken over40 hours of an accountant's time to go find out .Well, they are entitled to find out all the facts ,yes. But when they are complaining that wecan't service them ; and we spend time o n$142.00, how do we get the other hundreds o fmillions? That kind of mentality, that kind ofanti-foreign income mentality that pervadesthe Code, the regulations, the approach of theagents — I don't know why it is justified . Idon't know what to do to get rid of it, but it isgetting worse.

Another area is the Bon Ami case, reme-dial legislation. For instance, before that chang ewe had to cover taxes paid in 20 affiliates; 20calculations . Now it is over 2,000 . For whatpurpose? I don't know . The difference in taxesis so minuscule . Some purity of legal thought;I don't know. It is just incredible . And try to getour foreign affiliates to do it for us when wehave only a minor interest . Lastly, I will jus tmention the "fun" everybody is having wit hthe White Paper on intercompany pricing

15

International Investmen t

(whenever the Regs are going to come out —

we could focus on things that don't have anyjust more threats) .

basic policy problem or revenue problem, tha tWe welcome simplification . I would hope

just simplify our lives to get along with compe-at least during this era of budget crisis which

tition.will be with us for a couple of decades, at least

16

Peter A. Barnes

Peter Barnes, Deputy International Tax Counsel at the Treasury, began hi sremarks with a reminder that he, along with the staff and members o fCongress, is not diametrically opposed to American business as the pictureis often painted.

He insists that the basic rule of deferral for active business income of U .S .-owned foreign companies remains intact while conceding that the definitio nof active income still needs much clarification .

In Mr. Barnes view, double taxation does not take place when a U .S. firmpays foreign tax at a rate in excess of 34 percent and, in turn, receives a foreig ntax credit at the maximum U.S. rate of 34 percent. He also disagrees with th eassertion that the Subpart F exception was eliminated by the Tax Reform Ac tof 1986. It is still available, now with a more workable objective test .

Mr. Barnes also states that the need to raise revenues through taxatio noften gets lost in these discussions . He suggests setting aside the issue of taxsparing because of the many years of fruitless discussions that have alreadybeen held on this topic .

He clearly sees tax sparing as unfair to purely domestic firms and urges th etax policy community to expand its efforts on more productive fronts .

Finally, Mr. Barnes concludes with some encouragement regardingsimplification. He refers to a June 1990 publication by the House Ways an dMeans Committee as evidence of some genuine enthusiasm for the prospectsof simplification in 1991 and 1992. PH Cs and the 10-50 percent basket are th elikeliest candidates .

When the 1986 Act reduced the U.S. ratesto 34 percent, I think everyone recognized,including the tax payers, that this was going toexacerbate the foreign tax credit problem ofexcess credits.

Given the pre-1986 rules, there is no ques-tion in my mind, and I don't think there is an yquestion in your mind, Murray, Ray, othersout there, that given those rules you couldhave routed a lot of money, passive money,money that was sitting in bank accounts forinvestment but not currently being invested, inways that would have dramatically reducedyour foreign excess credits, but at the cost o fpreventing the U.S. residual tax on U .S. opera-tions .

The loophole tighteners that came from

the 1986 Act have created enormous problems ,but I think there was a sense, an importan tsense, that unless something was done, thesmart tax practitioners, and I include all thepeople in this room, would have figured outways that would have caused an enormousrevenue drain to the U.S. by reducing whatshould have been the U.S. tax on U.S. income .Given that, I don't think that it was irrational tomake the 1986 Act changes, although our tas know is to bring some order to those changesbecause clearly there were problems that re-sulted from them .

For instance, you noted that the prio rSubpart F rule prevented an inclusion underSubpart F from a corporation not availed of t oavoid tax. There is still an escape valve from

17

International Investment

Subpart F. It was simply changed from thesubjective test to an objective test. The subjec-tive test had enormous problems . I am not surethat the objective test has more, in fact, I thinkit has less . There is a mechanical rule that sayswe will decree that you were not availed of t oavoid tax if you follow this mechanical for-mula. So, it is not that we threw out the excep-tion, we simply changed the form of the excep -tion, and I frankly think that the current form

of the exception maybe has a lot of merit to it ,compared to the old rule.

PFIC is a problem. I think everyone knowsthat. It is included on everyone's list of simpli-fication proposals . The problem is that there i sno consensus on what ought to be done t oreform the PFIC rules . But I would see that a sthe most likely candidate, perhaps, for chang eover the next two years. What I would like todo is invite people to help us figure out what aconstructive change is so that PFIC retains it svitality for the group of cases it was intended toreach. I include in that a little bit more than aforeign mutual fund, but not necessarily aforeign active manufacturer. But I think wesort of give a misleading impression of the lawwhen we keep beating on PFIC. There is gen-eral agreement that PFIC needs to be reformedand the question is whether we can build aconsensus on what that change ought to be.

The baskets for 10/50s, agreed, they cre -ate a problem. It means instead of having 6-8 -10 baskets, a major multinational may have 500

baskets or I am told, in one case, 1100 baskets .Again, I think the 10-50 basket issue is one tha tis high on the list for simplification. I wouldpoint out though, that the only time it creates aproblem, so to speak, is when you are eithe rnot being taxed at a 34 percent rate by theforeign jurisdictions and you want to bring inexcess credit so that you then avoid the U.S .residual tax, or when you are being taxed ove r34 percent and you want to use those residua ltaxes — it doesn't of itself create a double tax .

It does affect the averaging and also verymuch affects the administrative problems . Weall agree on that . The administrative problemsof having to allocate expenses and deductionsacross 1,000 baskets instead of across 8 is amonumental problem. I would put that upthere slightly before PFIC as a candidate forreform. On the compliance issues, everyonecan talk about the excesses of agents . In smallareas I think the one thing we all agree on isthat the IRS has an extremely difficult timeauditing a company the size of Ford Moto rCompany, and there we just need to worktogether to get a rational system for you toprovide more information, and for them toscreen that information more intelligently .

I think the group that is in charge of theservice is in tune to this and I would like to se econtinued progress, recognizing that we arenever going to make it simple on the compli-ance side .

Q& A

Q: Would you clarify what you said aboutmerging low rate with high rate corporat eincome?

Barnes: Philosophically I think double taxought to be looked at on an item-by-item basis .That is completely impractical . No one wouldadvocate it in the real world. But, if you ask mewhy is there double tax, I would say it isbecause an item of income has been taxed byboth jurisdictions . The non-controlled 90 2baskets clump a group of items of income .

After putting the income you earn from thisventure, in which you own say 40 percent, in itsown basket, if the foreign jurisdiction taxes it a tless than 34 percent and therefore we impose aresidual tax, I would say there has not beendouble tax in any case because the U .S. tax issimply topping you up to 34 percent . Likewise ,if the foreign jurisdiction taxed you at 40 per-cent, I would not say we are creating double ta xby denying you the chance to use those exces scredits against other income because again, I

18

think in a perfect world, it is item of income b yitem of income. It is completely administra-tively incomprehensible that we would do iton an item of income by item of income basis .So, we have to have groups. Where I have a lotof sympathy on the 902 problem and I thin kmany people do, is that it requires companieslike Ford, Exxon and IBM to have a spread-

sheet of baskets that will extend to the 500 o r1,000 range, spreading costs over a spread-sheet that is 1,000 columns wide. That makesno sense. So, let's go back and revisit thos egrouping rules, and figure out a way that wecan bring the spreadsheet back to a narrowerbasis.

19

Tax Treatment of U .S . Investment Abroad — Panel 2

Panel Chairman : Robert N. MattsonAssistant TreasurerIBM

B. Anthony Billing sTax Foundation Senior Research FellowProfessor of Accounting, Wayne Stat e

University

Richard M. HammerInternational Tax Partner, Price Waterhous eChairman - Tax CommitteeU.S. Council for International Business

John F. Brussel

Tax Director - Internationa lAT&T

Robert N. Mattso n

I think the second panel will bring up afew other additional items, but we would liketo deepen and expand on the discussion of th efirst panel. I think it is important to see thatcompetitive impediments are pervasive . Whatyou will get today is not a deep understandin gof each individual provision. I think, though ,what you need is the full impact of what ishappening in the economy. Business is beingimpeded in its active operations outside theUnited States where our competitors in Japanand Europe and elsewhere are not receivin ganywhere near the degree, if any degree, ofimpediment .

I would like to quote a couple of commen-tators . I think the first one I will start with isStan Ross, well-known in the technical spher ein the international tax area . He is a seniorpartner at Arnold & Porter . In a Special Reportin Tax Notes this past April he refers to a signifi -cant transformation of U.S. international U.S.tax policy which has moved from a complex toa super-complex tax regime. I think that is thebest understanding of it. He notes that thebasic policies governing the U.S. taxation ofinternational transactions were essentiallyestablished in the 1960s when the U .S. was acreditor nation, when its multinational corpo-rations dominated global investment, wherethere was a fixed exchange rate system peggedto the U.S. dollar, and the U.S. was at a stron gand positive balance of trade and payments .

The tax changes over the last quarter

century have been piecemeal, and have no tkept pace with the changing economic climate .Much of the balance achieved in the early '60sand the compromises made then have beenlost as these changes have been made. U.S. taxpolicy for international activities, Stan Ros sgoes on to say, has barely begun to take ac -count of these significant developments, andthe 1986 rules were wrong, just plain wrong, inmany respects .

Another commentator, and an interestin gone, is Mr. Koroda, director of the interna-tional tax affairs division of the Japanese Min-ister of Finance, in a published paper at Prince -ton also this past April. Mr. Koroda says, U.S .international tax policy now seems dominatedby the wish to squeeze "as much revenue aspossible from foreign as well as U.S. persons .By the end of the 1980s, only foreign, includin gtheir own foreign-owned U .S. corporations ,were drawing attention from tax policymakers .In 1985, the U .S. became a net external debtorfor the first time since 1914, owing to the con -tinued large scale external deficit . Therefore, itmight be argued that the sudden change in it sU.S. international tax policy is rational in thesense that as a net external debtor, the U.S. canonly gain from stretching its rights as a sourc ecountry to limit, even if other countries retali -ated, their structure for operations outside th eUnited States."

Let's ask, why can this high Japanese taxofficial see the problem so much more clearl y

21

International Investmen t

than our government's tax policymakers?Maybe today we can shed some light on thi squestion .

B. Anthony Billing s

Anthony Billings, Professor of Accounting at Wayne State University ,puts the conflict over the taxation of international investment in its historica lcontext . The U.S . has a policy in place that owes its genesis to the 1962Revenue Act when the economic environment was much different than it istoday. The 1962 Act sought to slow the exportation of the U.S. capitaloverseas .

Dr. Billings cites numerous problems with regard to the taxation offoreignsource income . For example, if a company does business in a hyperinflationaryeconomy, the receipt of too much interest income can yield Subpart F income .Moreover, that company could incur a foreign currency loss from operatin gin the same jurisdiction and be denied the right to offset the loss against theinterest income.

The area of interest allocation is also cited as a problem by Dr. Billings .Certain expenses such as interest charges and research and development ma ybe allocated against foreign source income even though incurred in the U .S.

To deal with these problems, Dr . Billings suggests that U.S. policy doaway with the focus of the early 1960s and adopt an even-handed approac hto cross-border transactions . He also notes the importance of consideringnot just the statutory U.S. tax rate, but also the effective rate and the tax base.On a pro-active note, Dr . Billings suggests that U.S. tax policy providegreater incentives for research and development. He sees the greatest challengesof the 1990s for the U.S. as penetration of Eastern European and Pacific ri mmarkets, increasing our global market share of high-tech products, an dsolving the budget deficit problem .

What I will try to do today is focus some-what on the shortcomings of U.S. trade policy,offer some recommendations, and conclud eby pointing out a few of the challenges I see inthe new economic order for the 1990s whichwe are now more unsure about than ever be-fore .

Research in the last five or ten years hasfocused significantly on differences betweenJapan, the U.S. and West Germany . During thedebates in 1971 and 1985, on foreign sale scorporation provisions, a number of thoughts

were brought out in the Committee reportsabout what other governments are doing toinfluence trade balance. These strategies in-clude such things as protective tariffs, the for-mation of export cartels, the offering of expor tsubsidies, and the lightening of the tax burde non the foreign source income of its multina-tionals .

One may argue that these provisions, to agreat extent, are subject to the body called th eGeneral Agreement on Tariffs and Trade . Butas we have seen, maybe in the last five to ten

22

years, their activities can best be described asan exercise in futility. Given the absence of aninternational policeman, if you will, in trade ,national governments must be sensitive to therealities of the marketplace .

In this regard, the U.S., I think, falls short .We have a policy in place that owes its genesi sto the 1962 Revenue Act when, it was pointe dout earlier, the economic environment wa smuch different than it is today. In 1962 conven -tional wisdom was that U.S. policy, with re-spect to foreign operations, encouraged thebuilding up of South Italy rather than Sout hCarolina, or West Germany rather than Wes tVirginia. Given that wisdom, the 1962 Ac tsought to find ways of slowing down the ex-portation of U.S. capital . For example, a typicalU.S. company that had profits overseas wouldinvest such funds in passive-type activitieswhether for expansion or for later repatriation;that was seen as contributing to the capita ldrain from the U .S. to the European countries .As we know, in the 1990s, especially this year ,there is hardly a day that we read the paperthat we fail to see something else —some othe rbuilding block of the new economic order fall -ing into place. The world is changing so rap -idly; and if we look at the Tax Code, when w edo have changes, we seem to retrogress rathe rthan to progress .

With this in mind, I will point out some o fthe problems with the taxation of foreign sourc eincome, and other areas in which we fail tosupport major economic incentives that arevital to productivity growth, which I think is akey ingredient to the trade position of anynation.

Let's now focus on some of the shortcom-ings in the way foreign source income is taxed.We hear a lot today about tax sparing andmany other issues related to how foreign sourc eincome is taxed. But two of the major problem swe face can be found under Subpart F . Thethird, the allocation rules of 861-A. I will no tbore you with all the details . I will try to giveyou three examples of where I think we hav ethe most problems .

The first relates to Subpart F . Take for

example a typical U.S. company that decides t oinvest abroad in a country, let's say Brazil ,which as you know has hyper-inflated cur-rency. The holding of working capital, as yo uknow, is vital and for a company that holdsworking capital in Brazil, significant interes tincome will be earned because of inflation . Asyou can guess, such income would be treatedas Subpart F income and taxed immediately i nthe U.S. But if that same company has foreigncurrency losses, which again is typical, the los swould not be allowed to offset the interes tincome, but would be treated as foreign cur-rency loss and allocated under section 904-D .The result is that the same transactions occur -ring in the same place are treated markedlydifferently.

Taken to the perverse extreme, if businessis bad, the interest income can outpace manu-facturing income, a company could have all it sincome, both manufacturing and the interestincome, treated as, under the PFIC rules, U .S.source income. That has happened to a lot o fcompanies today in countries with hyper-in-flationary currency .

Another example would be the allocatio nof income under 861-A. As you know, ex-penses such as research and development ,interest charges, and stewardship expensesare allocated, even though they are incurred inthe U.S., against foreign source income . In-deed, for each dollar of foreign source incom eearned by a U.S. company, as much as 30 centsof the U.S.-incurred expenses would be allo-cated against the income .

What are the implications? Because of thi sallocation, no more than about 22 cents of for -eign tax credit would be credited against taxespaid overseas . Even though taxes paid mayhave exceeded 50 cents, the dollar earned at-tracts 30 percent U.S. incurred expenses, andthat reduces the foreign tax credit to 22 cents .The unused credit is carried forward . If rela-tive tax rates do not change radically, then thecredits will expire .

A third example would be a company thatis seeking opportunities to expand abroad ,maybe in the emerging markets of Easter n

23

International Investment

Europe. If funds are needed to, let's say, opennew plants or purchase new equipment, ra-tional behavior would dictate borrowing suchfunds in the country with the lowest interes trate. However, if that company is in limitationunder the foreign tax credit formula, the loss o fforeign tax credit may motivate the companyto seek funds in places other than the U .S., eventhough the best interest rate can be obtainedhere.

These examples, I think, tell a story ofwhat is happening in the foreign area . Thingswere pretty much put together in the early1960s, and in my mind, we have not pro-gressed significantly since then.

With these things in mind, I will offer afew suggestions dealing with these problems .I think to be effective, U.S. policy must hav eboth a passive and a pro-active dimension . Thepassive dimension means starting over—doin gaway with the focus of the early 1960s. Youmay say this is quite drastic, but this is what weneed — a bold, new approach . In this regard,provisions such as Subpart F would at best berepealed or at worst be kept in check .

With respect to the allocation of U .S. in-curred expenses — where do we stop? I thinkat some point we need to draw a line . No othercountry uses this approach. I think this again isone of the things that should be looked at andpossibly be repealed as part of any new legis-lation in the next few years.

Another point that should be consideredwith respect to the passive dimension is thatCongress should refrain from raising the effec-tive corporate rate above what it currently is.One may argue that the U.S. statutory rate islower than many other nations' in the world —34 percent . Someone pointed out that it is 39percent or 40 percent, when we consider th estate income tax. But I think the statutory ratedoes not tell the whole story. As you know, theeffective tax rate is based on a tax base and arate. If we lower the rate but increase the base ,what do we have? A higher tax burden. I thinkthat is something that should be considered i nany new legislation. We may feel very happ ythat the rate stays at 34 percent . But we must be

very careful that the base does not increase t ooffset the low rate .

With respect to the pro-active approach, Ithink several things need attention. We talkedearlier about research and development andcapital spending. Many times companies con-sider research and development projects, ornew plants and equipment, or ways to enhanceproductivity, but in the short term, these ac-tivities will be marginally profitable or proba-bly will sustain a loss . What is done? They areoften abandoned . These investments, however,are needed for long-term economic growth .This is where U.S. policy should at least seek tooffer tax incentives to encourage these activi-ties .

In countries such as Japan and Germany ,significant low interest loans, tax credits and avariety of other programs are offered to en-courage these activities. Even though they arenot profitable over the short run, over the lon grun they do pay for themselves . At present, weoffer no more than a token amount of creditthat has little or no effect on R&D spending .

With respect to the challenges we face inthe 1990s, I think there are three that are themost important . First, we must seek to aggres-sively establish a presence in the emergingmarkets of Eastern Europe and the Pacific rim .Second, we must find ways of reversing th edeclining trend in our global market share ofhigh-technology products . For instance, recen tdata by the National Science Foundation showsthat 10-15 years ago we had a 27.2 percentshare of these sales . That has now been re-duced to 19 .6 percent. Last but not least, weshould find ways of solving the budget deficitproblem. If the U.S. does not meet these chal-lenges, I think the we will be relegated to a rol eof a spectator rather than a world economicleader in the 1990s .

24

Richard M. Hammer

Richard Hammer, speaking on behalf of the U .S. Council for Internationa lBusiness, addresses the transfer pricing rules . He begins his talk with a noteof his frustration with the tax treatment of U.S. multinationals . He feels tha tcurrent tax policy has "run amok," with law changes being enacted withou tserious thought to underlying policy .

Regarding the transfer pricing rules, Mr . Hammer states that the U.S .,along with most of the world, does subscribe to the arms length standard . TheU.S. has made small attempts to reduce the dependence on true marke tcriteria in what is or what is not arms length, such as the DISC/FS Cadministrative pricing formulae . A significant new deviation from the arm slength standard would be the introduction of an arbitrary 50/50 profit spli ton products shipped to U.S. distribution subsidiaries by foreign parents ,something discussed on Capitol Hill recently .

Some foreign fiscal authorities have criticized the so-called fourth metho dof transfer pricing as being a deviation from the arms length standard .Instead, Mr. Hammer asserts that this is nothing more than a "rough cutapproximation" of the proper arms length profit allocation .

Mr. Hammer calls the superroyalty provisions introduced by the Ta xReform Act of 1986 the first major deviation from the arms length standard .This can lead to a problem of complete double taxation . The ultra-highroyalties being paid to the U.S. developer of the intangible property may wellexceed what the foreign jurisdictions will permit under their own rulessubscribing to the arms length standard. It may not be deductible in theforeign jurisdiction, and yet still be subject to tax in the United States .

Introduction - General RemarksI am here today in my capacity as Chair o f

the Taxation Committee of the U .S. Council forInternational Business . We have been terriblyconcerned with the drift of U .S. tax policy vis-a-vis foreign earnings of U .S. multinationalcorporations. Recently, our group, as did manyothers, including those represented here to -day, submitted papers in response to the on -going simplification study initiated by the Ways& Means Committee . I hope the committee isserious about simplification and not justmounting a cosmetic, but substanceless, re-sponse to the crescendo of criticism of our ta xlaw on this point.

Unfortunately, it is more than complexitythat bedevils the U.S. tax law, and the policybehind it, in the foreign area . This is really jus tthe tip of the iceberg. To me, it is more a case o ftax policy run amok, of law changes enactedwithout serious thought given to the underly-ing policy, of a failure to update tax policy tothe modern economic and investment envi-ronment, of overconcentration on stampin gout possible abuses without focusing on ho wsuch amendments fit into the overall scheme .And the pressure for revenue neutrality doesnot help. To me, it is a case of congressionalfailure, perhaps even a complete abdication o fits responsibility in shaping a coherent and

25

International Investmen t

sensible foreign tax policy .

Transfer Pricing

But so much for the soapbox! My assign-ment today is to address the important subjectof transfer pricing, and the policy behind it .Bear in mind, as I discuss this subject, thattransfer pricing affects purely domestic trans-actions, and it impacts inbound as well asoutbound investments . In fact, right now theglare of publicity is on the transfer pricingpractices of foreign multinational corporationsbringing their products into the U.S. market-place. I will not touch on this current contro-versy because of my spot of the program, but Ithink it is disgraceful to witness the manner inwhich the IRS has launched a campaign usin gthe press to publicize its unproven allegations .

Arms Length StandardFrom a general policy perspective, the

U.S. subscribes to the well known "arms length"standard, in the transfer pricing area . Thisgenerally keeps us in step with the rest of theworld, most of whom also adhere very strictlyto the arms length standard.

The U.S. has made more attempts tha nother nations to reduce the dependence on truemarket evidence in establishing what is, or i snot, arms length. So far, these attempts havebeen relatively benign, and restricted to nar-row areas in our code, i .e. the DISC/FSC safehaven or administrative pricing formulae andthe Section 936 profit split concept for posses-sions corporations in calculating their posses-sions tax credit . The latest attempt appearingin the current legislative session to introduc ean arbitrary and rigid 50/50 profit split onproducts shipped to U .S. distribution subsidi-aries by foreign parents is not so benign andlimited so as to escape the notice of othercountries, if it should be enacted in this sessionor later, as an important new deviation of U .S .tax policy from the arms length standard (fol-lowing the superroyalty which I will addres sin a few minutes) . But again this relates toinbound investment, not our panel's focus .

All the earlier attempts to inject formula einto the transfer pricing process (DISC, FSC,

936, etc.) have represented efforts to facilitatethe identification of an arms length transferprice, using what might be called a "rough cutapproximation," rather than any overt attemp tto destabilize or reject the arms length stan-

dard. (I should note parenthetically, at thi spoint, that the DISC provisions, as they werefashioned from 1972-84, did trigger a grea tdeal of foreign criticism . Such criticism was no tso much in the formulary transfer pricin g

mechanism, although the pricing rules cer-tainly contributed to the net overall impact ,but in the fact that the whole DISC concept wasan alleged subterfuge to provide a subsidy toU.S. exporters, contrary to GATT's rules. Nosuch criticism has been leveled against FSC,DISC's successor, which has precisely the sam econceptual pricing mechanism.)

Before moving ahead to the first realbreach of the arms length standard, f shouldmention, in passing, the so-called "fourthmethod" in transfer pricing of goods betweenaffiliates . The rules in this area, as spelled outin 23 year-old regulations, mandate the use o fcomparable uncontrolled transactions (CUT)in establishing an intercompany pricing struc -ture; but in recognition of the difficulty o ffinding third party evidence in many instances ,an alternative to CUT is permitted, a fact andcircumstances approach (the so-called "fourthmethod") may be used to allocate profit/los son a stream of intercompany product sales . Weat the U.S. Council for International Businessdid not believe the availability of this alterna-tive method was a deviation from arms length(as some foreign fiscal authorities have as-serted), but more, as before, a "rough cut"approximation of a proper arms length profi tallocation. In fact, in our recent submission tothe Ways & Means Committee on simplifica-tion in the transfer pricing area, we suggestedthat the policymakers in Treasury and IR Sfashion some more guidance for taxpayers vis-a-vis the fourth method. We said:

"Several so-called fourth methods havebeen resorted to on an ad hoc basis in examina -tions by the Service of transfer pricing issues .These include return on assets, return on eq -

26

uity and the Berry method (ratio of gross profi tto operating costs). The regulations on transfe rpricing should be expanded to describe fourt hmethods and the conditions under which theymay be applied . This will provide for consis-tency in application of these fourth methodsfor both taxpayers and auditing agents ."

So much for "rough cut" approximations !

SuperroyaltyWith the advent of the 1986 Act, we se e

the first deviation from the arms length stan-dard of major impact on the part of the U.S.Congress — the introduction into the Interna lRevenue Code of the now infamous superroy -alty provision dealing with the application ofintercompany transfer pricing concepts to thearea of intangible property rights (so-calledintangibles). Unlike the earlier statutory for-mulary approach to profit allocation, the super-royalty is non-objective and seems, unfortu-nately, open-ended.

In a nutshell, the superroyalty provisionin the statute requires that payments wit hrespect to intangibles transferred to relatedparties, either by way of sales or licenses, mus tbe "commensurate with the income attribut-able to the intangible ." These deceptivelysimple words will become a nightmare for U .S .multinational corporations, as the rules fo renforcing the new concept begin to evolve .Congress was concerned that geographic rightsto intangibles were being licensed or trans-ferred to foreign affiliates before the full valueof the intangible asset was achieved; thus, ifany intangible property turned out to be ablockbuster, a greater than deserved portion ofthe financial rewards would accrue to foreig naffiliates which had not developed the particu -lar intangible, while a less than warrantedportion of the reward would inure to the devel -oper (the U.S. parent). This issue became suc ha bete noire to the framers of our tax law tha tthey insisted, despite much logical and practi-cal opposition, on enacting the ill-conceivedand misguided superroyalty rules .

White Pape rThe White Paper, issued about 2 years

following the 1986 Act, confirmed our wors tfears about the arms length nature of this ne wconcept . Obviously, I do not have time to dwellon the content of the White Paper . It is lengthyand detailed. But its basic theme, trying tobreathe life into the superroyalty in a rationalmanner (an impossible task, I might add), onl yresults in demonstrating why the concept i snot arms length (and not rational) .

Let me give only the briefest of summa-ries for you . The superroyalty should onl yapply to what are considered "high profi tpotential" intangibles. (I should note the paperstates such intangibles are rarely transferred tothird parties.) Since the quantum of profitpotential is not known at the transfer or licenseagreement date, the "commensurate with in -come" standard of the code mandates tha tperiodic upward adjustments to the amount sof royalties or sale prices to be paid to the U .S .developer are required indefinitely into thefuture. Such adjustments are to be made, andthis is key, despite the fact that the arrange-ment was truly arms length at the time it wa sentered into .

The obvious scenario can be foreseen . AUS. multinational corporation develops a ne whigh tech product which it licenses, at arm slength terms, to its local German, French, Japa -nese and UK subsidiaries . These four subsidi -aries manufacture the product using the U .S .parent's technology, and they exert their bestefforts to develop the local market throughpromotion and advertising carried on by thei rlocal staffs . The product turns out to be th eblockbuster that so concerned the U .S. Con-gress . Enter the superroyalty, mandating thatthe U.S. company renege on its arms lengthagreements with the four affiliates and sharefurther in their profits from the sale of the ne wproduct .

Double TaxationThe real concern to the U .S. multinational

corporation in this plain vanilla scenario is th eprospect of international double taxation . Willthe German, French, Japanese and UT( ta xauthorities be willing to grant tax deductibility

27

International Investmen t

to additional royalty/license payments tha tmust occur in conformity with the superroy-alty provision, particularly in light of the factthat the original license agreements were arm slength?

Early indications are that deductibilitymay be hard to come by in most other jurisdic -tions . In my capacity as Chairman of the FiscalCommittee of the Business and Industry Advi-sory Committee to the OECD, I get the sense o f

both the foreign business community (despit e

the fact that superroyalty is a two way street ,i.e., a foreign developer can charge superroy-alty to its U.S. subsidiaries) and the foreignfiscal authorities that they view this provisionas a breach of the sacred arms length principleto which they firmly subscribe. Of course, timewill tell, but my crystal ball tells me that theforeign authorities are not going to roll overand play dead . This bodes badly for U.S. multi-national corporations avoiding the inevitabledouble taxation that loss of deductions forsuperroyalties will entail, and at a time whe nthey are suffering increasing amounts of ex-cess foreign tax credits, it's even more dis-agreeable. Our tax policy in this area is on acollision course with the arms length principle

embodied in the tax policy of our trading part -ners .

DeferralThe history of U.S. tax policy vis-a-vi s

deferral has not been a rational one since 1962 .Prior to 1962, deferral was the standard, withfew exceptions. (The foreign personal hold-ings company provisions only impacted hig hnet worth individual taxpayers and not ourmultinational corporation community.) Inother words, income of U .S.-controlled foreignsubsidiaries was not taxed in the U .S. untilremitted or repatriated . This was a soundapproach and one that was generally subscribedto by all our trading partners. In 1962, theCongress enacted Subpart F, controlled for-eign corporation provisions (to get at tax ha-ven income), the first partial elimination o fdeferral that would impact U.S. multinationalcorporations. But at the time, no real thought

was given to marrying the pre-existing FPHCprovisions and the new CFC provisions, whichcould (and should) have been done. This wasthe first failure of our tax policy in this area .(The 1962 Act also enacted the foreign invest-ment company (FTC) provisions, which did no thave a major sting, as they did not affect defer -ral but converted gain on sale of FIC stock fromcapital gain to ordinary income, quite mean-

ingless today .)In the year following, numerous restruc-

ture amendments were made to the Subpart Fprovision, skewing them away from their origi -nal purpose and policy objective of preventin gabusive use of tax havens. Many of theseamendments were made simply to generaterevenue. Then in 1986, PFIC entered the scene ,ostensibly aimed only at foreign mutual fundtype of investments, but unfortunately drafte d(unintentionally, it says here) so broadly as toinclude CFC and FPHC (and Foreign Invest-ment Corporation) within its orbit . Enter thescene — utter confusion, representing again aCongressional failure to develop a sound andsensible tax policy in the foreign income area .Some approach which uses a single set o fprovisions to eliminate deferral for the abusivetypes of passive income only while continuingdeferral for all other income should be the goal.

The U.S. Council feels that this can best beaccomplished by eliminating the multipl eregimes that now exist for eliminating deferralfor entities that generate passive income (PFIC ,FPHC, and FIC). This could be implementedby keeping the PFIC provisions, albeit withsome modifications, including one key change,and eliminating the other two . This importantchange to the PFIC rules would be the elimina-tion from coverage of all U .S. shareholders ofCFCs (as defined by the statute to be owners o fat least 10 percent of the CFC's voting shares) .At the moment, a proposal is kicking aroundthe Congress to amend the PFIC statutory rule sto eliminate the asset test, retaining only theincome test . We support this amendment aswell, but it doesn't get at the root of the prob-lem.

28

In summary, then, only the PFIC ruleswould apply to all entities generating primar-ily passive income. Other U.S.-controlled for-eign entities should continue to be governedby the CFC rules, also to be modified andperhaps eased . But to retain the integrity of theapproach, passive income would continue toform part of the Subpart F income base, since aU.S. shareholder of a CFC would not be cov-ered by the PFIC rules, if amended in accor-dance with our suggestions.

ConclusionThere are many more things that could be

said in the area of deferral . But I should like tonote, in closing, that several other countrieshave adopted a version of the CFC rules, most

of which are less restrictive than ours (Austra -lia, Canada, France, Germany, Japan, NewZealand, United Kingdom). Moreover, none o fthese other countries have adopted multiplesets of provisions to deal with offshore passiveincome, as we have . I am not implying tha tthese other countries are the leaders in interna -tional tax thinking, but we, who at one timewere the leaders in international tax thinking ,have abdicated our leadership position . To-day, our legislative process in the tax area istotally tied to revenue generation and loop -hole closing —losing sight of the logical thread ,the rhythm, that a sound tax policy and taxsystem require.

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International Investment

John F . Brussel

John Brussel, Tax Director - International for AT&T, relates how AT& Thas grown internationally from a few projects overseas in 1983 to a companytoday with over 160 subsidiaries and over 130 controlled foreign corporations .

As with most of the earlier speakers, Mr. Brussel points to the 10 - 50percent basket as being a major problem . This is particularly true for thetelecomunications industry because many foreign markets are dominated b yan established governmental or quasi-governmental agency, giving AT& Tlittle opportunity to form majority-interest joint ventures. Therefore, strategicinvestments made to implement the firm's global strategy fall into the 10% -50% basket and are deemed as having insufficient identity with U.S.shareholders to be treated as units of a worldwide business . Mr. Brusselclearly views these minority interests as units of the worldwide business,and insists that the nature of these activities transcends the ownershi ppercentage held by the U.S. company. He also disagrees with Mr. Barnes'earlier assertion that items o f income should be treated separately . Regardingthe PFIC rules, he thinks the extremely short start-up rules were inappropriate .

Finally, along the lines of Mr. Hammer's earlier remarks, Mr . Brussel saystax policy does not exist today . "What exists in its place," he says, "i srevenue raising. "

Those of you who have followed the his-tory of AT&T know that prior to divestiture,AT&T did not have international operationsother than international long distance whic hhad no particular international tax ramifica-tions . At the time I joined the company in 1983to create an international tax department, AT& Tmerely had a project in Saudi Arabia, a projectin Korea, and seven representative-type of-fices with two or three people laying thegroundwork for penetrating their local mar-kets . Since divestiture, one of the three strate -gic goals of AT&T has been globalization. Todaywe have over 130 controlled foreign corpora-tions and well over 160 subsidiaries, not count -ing our minority interest in Olivetti and itssubsidiaries.

In the early years of our globalizatio neffort, however, we learned that you do notjust walk into a country, particularly one thatalready has a strong telecommunications in-frastructure, and start selling your product .

More often than not, you have to form join tventures to penetrate the market. Virtuallyevery one of our investments has been a strate-gic investment; strategic to the business ofglobalizing AT&T and strategic to being suc-cessful in a global marketplace . Because o ftheir strategic nature, however, all of our jointventures have been formed with well-placedcompanies or governmental or quasi-govern-mental agencies, and we therefore have hadlittle or no control over whether we would b eable to obtain a majority interest in the ven-tures.

U.S. "tax policy" made our task mor edifficult as a result of the creation of the "10 - 5 0percent basket" in the Tax Reform Act of 1986 .The House and Senate versions of the Actgenerally provided for look-through treatmentfor dividends as long as the U .S . shareholderowned directly or indirectly 10 percent of thevoting stock. The conference committeechanged the look-through threshold to require

30

CGC status for look-through treatment andcreated the 10 - 50 percent basket . The state-ment of the managers of the conference com-mittee justified the restriction on the applica -tion of look-through treatment on two bases :

1. In the case of foreign corporations thatare not controlled foreign corporations, thereis insufficient identity of interest with U .S.shareholders to treat non-majority ownershippositions as units of a worldwide business .

2. Minority U.S. shareholders may nothave ready access to the tax and income infor-mation of the foreign corporation which isneeded in applying the look-through rule .

I submit that neither of these bases for the10 - 50 percent basket is persuasive. With re-gard to the first rationale, it is my experiencethat international joint ventures are an ordi-nary and necessary extension of business ac-tivities conducted by U.S. multinationals. Thesebusiness activities are viewed in the same stra-tegic sense regardless of whether there is aminority, majority or no foreign co-venturer .The nature of these activities transcends th eownership percentage held by the U.S. com-pany and the residence of the co-venturer.These activities merely implement the busi-ness strategies of the U.S. companies regard-less of whether the minority position arise svoluntarily, by negotiation, by virtue of locallaw restrictions, or by perceptions as to the bestway to penetrate a foreign market .

With respect to the second rationale, whiletaxpayers in isolated cases may not have readyaccess to the information necessary to appl ythe look-through rules, it is my experience thatin the vast majority of cases such information isavailable. Furthermore, as a normal busines spractice, U.S. taxpayers by contract have re-quired foreign joint venture companies t oprovide them with income and tax-relatedinformation necessary for them to comply wit hU.S. tax laws .

The minority U .S. shareholder of a 10/5 0company is required under current law t oobtain earnings and profits information as wellas extensive foreign tax information in order toproperly compute the indirect foreign tax credit .

It seems inappropriate to argue as a genera lproposition that all this information can beobtained but that the minority U .S. shareholderwon't be able to place the foreign corporation'sincome in the proper foreign tax credit limita -tion basket.

To demonstrate the inconsistent resultscreated by the 10 - 50 percent basket provi-sions, consider the following real-life example :AT&T has a 51 percent interest in a fiber opticjoint venture in Denmark . AT&T also has a 50/50 interest in a fiber optic joint venture i nKorea. They are strategically alike, save for th ecountries in which they do business . They ar eessential to one of our core businesses, and yet,dividends from the Denmark venture will b e

included in our overall limitation basket, whil edividends from our Korean venture will fall

into a separate 10/50 limitation basket . With

respect to both of these ventures, there is suffi -

cient identity of interest with AT&T to treat thenon-majority ownership positions as units o f

AT&T's worldwide business . Therefore, Isubmit that it is proper to include the divi-dends from both ventures along with AT& T'sother active business income in our overalllimitation basket . To do otherwise is completelyillogical .

I should point out also that if our jointventure partner in Korea were a U .S. corpora-tion, or for that matter, another U .S. corpora-tion held a one percent interest in the venture ,we would not have this problem because wewould then have sufficient U .S. ownership,even though AT&T's interests would not havechanged at all . Likewise, if the venture were apartnership or were treated as a partnershi pfor U.S. tax purposes, we would not have thisproblem. I see no logical reason, whatsoever,for either dichotomy.

AT&T is second to none in supporting theneed to move toward a balanced budget in th eUnited States and we support broad-based taxmeasures as one of the ways to accomplish tha tworthy goal. What we oppose, however, is th eappalling lack of movement toward a soundand rational international tax policy . Given therecent developments in Western and Eastern

31

International Investmen t

Europe and the continued direct and indirect

policy which will permit U .S. companies tosupport and often subsidization by foreign

become more competitive in the global mar -governments of their multinational compa-

ketplace.vies, we must develop an international tax

32

SESSION TWO

Tax Treatment of Foreign Investment in the U .S . — Panel 1

Panel Chairman : Robert AshbyAssistant Vice President, TaxesNorthern Telecom Inc.

Elliot L. RichardsonSenior Resident PartnerMilbank, Tweed, Hadley & McCloyChairman, Association for International

Investment

Congressman Philip M. Crane (R-IL)House Ways and Means Committee:Trade, Ranking Minority Member

James M. CarterSenior Tax Counsel, ICI Americas;SecretaryOrganization for the Fair Treatment o f

International Investment

Bruce R. BartlettDeputy Assistant Secretary for Economi c

PolicyU.S. Department of the Treasury

Robert Ashby

I have the distinct pleasure of being the

Before we start these two panels, we woul d

panel chairman of the third panel this after-

like to try to take just a few minutes to get a n

noon. The third and fourth panels will focus

issue overview of the entire area from Mr .

principally on the tax dtreatment of foreign

Elliot Richardson .investment into the U .S. — the inbound trans-actions .

Elliot L . Richardso n

Elliot Richardson, Senior Resident Partner, Milbank, Tweed, Hadley &McCloy, sounds a note of caution as the U .S. considers ways of dealing withthe taxation of inbound transactions . He notes that there are now 26 bill spending before Congress that respond to the emotional uneasiness arouse dby what has frequently been referred to as the "buying of America . "

Mr. Richardson cites figures which show that the return on assets for U .S.-controlled domestic corporations in 1986 was 1 .7 percent, while foreign-controlled U.S. corporations' return was -0.2 percent. On the surface thes efigures may suggest that foreign-owned companies doing business in the U.S.are raiding the tax fisc, but that is not necessarily true .

Mr. Richardson admits that these foreign companies may indeed have th eopportunity to allocate a disproportionate level of expense to the U.S.subsidiary for insurance, interest, freight, etc., but these same policies canequally be used or abused by U.S . transnational corporations operating inother countries .

Again, Mr. Richardson hopes that congressional response should b e

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International Investmen t

tempered by the thought of what other countries may do if we act with acrude and indiscriminate hand in dealing with this problem . In his view, themost useful effort that could now occur is one that seeks to bring about themaximum practicable level of coordination among countries .

I appreciate this opportunity to addressmembers and guests of the Tax Foundation .There are several people back home in Massa-chusetts that would say of me, Elliot Richardso nis a person who never met a tax he didn't like .

Indeed, I was attacked in 1984 in a Senat ecampaign for my insistence at the time that wewere not about to grow our way out of thedeficit. I would encourage those of you as-sembled here who are all experts on this sub-ject, when you adjourn, to move as the cas emay be to Andrews Air Force Base or the Hillor wherever the summit is going on because Ithink those guys are going to need a little help.Nevertheless, I have just made a solemn be twith Ed Graham of the International Instituteof Economics that they will somehow solve theproblem .

In the meantime, what brings us heretoday is in a very real sense a manifestation ofthe consequences of the macro-economic im-balances that have resulted in the fact that ,over a very short period, the United States hasbecome the world's greatest debtor nation . Ofcourse, it is an automatic corollary of that factthat money comes here to buy either U .S. prop-erty or U.S. debt. Whereas a few years ago th efirst section of the discussion here today on th etax treatment of U.S. investment abroad, wouldhave seemed to be just about the only worth -while topic, now we are suddenly in the situ-ation in which the tax treatment of foreigninvestment in the U.S. is a matter of consider-able urgency . It is a matter that belongs in thecontext of the 26 bills now pending on the Hillthat would in one way or another respond t othe emotional uneasiness aroused by what ha sfrequently been referred to as the "buying ofAmerica."

I have testified once and I expect to testifyagain tomorrow on behalf of the Association

for International Investment on proposals tha twould prohibit employees of foreign-ownedU.S. subsidiaries from contributing to a PAC— a somewhat bizarre and probably unconsti-tutional and discriminatory proposition, giventhe fact that the nationality of the share owner -ship of the companies for which they workought not in itself to be a basis for deprivingthose employees from the opportunity to con-tribute to a PAC .

Similar reactions have been manifested inthe Ways and Means Committee as a result ofits Oversight Subcommittee's investigation of36 foreign-owned U.S. distributors of automo-biles, motorcycles, and electronics equipment— companies with some $35 billion in retailsales in 1986. As I am sure all of you here know,the investigation revealed that more than halfof the 36 foreign-controlled U.S. companiespaid little or no federal income tax, whilehandling billions of dollars distributing for-eign-made products in the U.S.

IRS data, however, revealed that the re -turn on assets for U.S.-controlled domesticcorporations for that year was about 1 .7 per-cent, while foreign-controlled U .S. corpora-tions' returns were -0 .2 percent .

One could easily leap to the conclusionthat the foreign-owned U.S. subsidiaries wereevading U.S. taxes on a wholesale basis . But alittle bit more reflection would lead to theconclusion that that may not be so at all .

Let me emphasize that as a representativeof the Association for International Investment,I am not a spokesman for foreign interests .AF TI is an organization dedicated solely to theU.S. national interest in the preservation ofpolicies traditional to the United States thathave favored a climate in which U .S. compa-nies are as free as possible to invest abroad, andin which foreign companies are comparably

34

free to invest here.The tax policies that are addressed to th e

domestic arms of transnational corporationsneed to be seen in a context that seeks, so far aspossible, consistency in the treatment of thosecompanies, wherever they may operate. Take,for example, the whole subject of transfer pric -ing. It is alleged that this is a major source of ta x

avoidance, distorting the foreign-owned U .S.companies' level of profitability . Of course, theforeign parent corporation does have a consid-erable amount of opportunity to determin ewhat price it is going to charge the subsidiary.On the other hand, if the bulk of technology,management, and production takes place inthe foreign country and only the marketing ofthe product takes place in the United States, i tcan be fairly argued that the bulk of the profitsearned should be attributed to the foreigncountry.

Again, it is possible to allocate a dispro-portionate level of expense to the subsidiary o rcharge U.S. subsidiaries more for insurance,interest and freight, than would be charged tounrelated U.S. firms. But of course all of theseare practices that can equally be used or abusedby U.S. transnational corporations operating

in other countries, and the very same charge swere made against American multinationalsoperating in other countries long before thesepractices were seen to be a problem here .

The congressional response, therefore, ha dbetter have in view the question of what othe rcountries may do if we act with a crude andindiscriminate hand in dealing with this prob-lem. The Congress, as you know of cours ebetter than I, has already in the ReconciliationAct of 1989 dealt with some elements of theproblem in order to improve information re -porting by U.S. subsidiaries and branches offoreign corporations . They did this in fourways: by expanding the parties subject to re-porting; requiring records pertaining to re -portable transactions to be maintained in theU.S . ; requiring the designation of a U .S. personas the agent to receive IRS summons ; and byauthorizing the IRS, in its sole discretion, todisallow deductions for payments to a foreign

party and redetermine the cost of goods soldby a foreign parent to a U .S. subsidiary .

Now, the Foreign Tax Equity Act of 1990would extend these provisions to open tax

years, if the records exist, extend the statute o f

limitations, and extend U.S. taxation to a for-eign parent's sale of stock in a U .S. subsidiary .Various ideas, like a value-added tax on goodsimported into the U.S. or an alternative mini-

mum tax, are being talked about .Before we resort to quick fixes, we should

ascertain the nature of the "problem" Con-gress seeks to address . For example, is the"problem" the product of inadequate enforce-ment, or an inherently flawed foreign tax col-lection system? If the former, congressionalattention should be focused on beefing-up theIRS's international enforcement efforts . How-ever, if the latter, Congress's attention shouldinstead be focused on fashioning an alterna-tive tax collection scheme.

We should, I suggest, have steadily in

view the fact that what we are basically dealin gwith is a situation in which the corporatedomicile of the corporation or the place wher ethe preponderance of its shareholders maylive, is increasingly irrelevant to the determi-nation of rational policies . Where the employ-ees are, where the customers are, may be muchmore significant .

In any event, we must reckon with the fac tthat investment decisions will be made withlittle if any regard for national boundaries . The

question of whether to invest in the U.S., Tai-wan, or Malaysia for that matter, is a questionaddressed by a foreign corporation today inmuch the same manner in which a big U .S .company 20 or 30 years ago would have con-sidered whether to invest in Tennessee, Ar-kansas, Mississippi, or South Dakota . Consid-erations of comparative political risk, local taxclimate and so on are the relevant considera-tions. In the tax context, as in others such as theregulation of securities transactions and theaccountability of the corporation in the tech-

nology transfer area, all of that points to thequestion of where responsibility should lieand how harmonization and consistency can

35

International Investmen t

be achieved.I would like to conclude, therefore, with

the thought that the most useful effort thatcould now go forward would be one that seek sto bring about the maximum practicable levelof coordination among countries . I know this isa difficult problem. An example is the treat-ment of disclosure to investors under the secu-rities acts of different countries . It obviouslymakes sense in an era of 24-hour securitiestrading around the world that there should b ethe harmonization of securities laws . And ofcourse a lot remains to be done to achieve this ,including further efforts toward the harmoni-zation of accounting principles. But we need tomake a comparable effort in the tax area also .

Bilateral treaties and mutual negotiatedpolicies are not enough . The willingness of theIRS and the Treasury Department to enter intoagreements with individual multinationals andtheir home country governments is useful as apreliminary step, but we need to go forwardwith a more comprehensive framework ofharmonization as we move toward three grea ttrading blocs — the European Communityafter 1992, North America, japan and the Pa-cific Rim countries — increasingly interde-pendent with each other as the three grea tsegments of a global economy .

36

Congressman Philip M. Crane

Congressman Philip Crane, Ranking Minority Member of the House Way sand Means Committee, states that we are increasingly living in aninternational economy and that foreign investment is a good thing . Hemakes this point by asking the rhetorical question, "Why else would so manyAmerican investors be foreign investors? "

He points out that it was only last year did foreign investment in the U .S.exceed the amount U.S. investors were investing abroad . Mr. Crane alsonotes that most of the bills in Congress have the name japan on them in someway. Japan, with investment of $69 billion in the U .S. is far behind the U.K.,who are number one, with $119 billion in foreign direct investment in the U.S.Congressman Crane argues that the anti-Japanese sentiment is unjustifiedand can be attributed to animosity left over from World War II . He sharesexperiences from his travel in Japan and observes that they learned from th eU.S. to set up a tax system that rewards savings and investment . The U.S.,however, has not heeded its own advice .

Mr. Crane concedes that the transfer pricing issue needs some attention .However, he considers the proposed tax on disposition of U .S. stocks byforeign investors who own 10 percent or more of the stock to be profoundlymisguided.

Let me make just a few observations in anhistorical context on this question of foreigninvestment . That relates to who built this coun-try. We take a lot of understandable pride inthe initiative and the hard work put in bystruggling Americans during our infancy, andup through the better part of the 19th century .The fact of the matter is this nation's morta lenemy, the number one enemy of this countryin those years, was the nation that financed ou rgrowth. And it was a period that witnessed th emost spectacular industrial development th eworld had ever seen. I'm talking about GreatBritain. Great Britain was this country's natu-ral enemy until just on the eve of our entry int oWorld War I . If you were to poll Americans inthat period and ask them who was our naturalenemy, 90 percent would have responded,Great Britain. They turned that around at thesame time that Germans were lobbying andtrying to propagandize in this country to get us

to side with them if we entered the war. TheBritish understood American psychology a littl ebetter and we ended up taking sides with themand as you know, we have been an ally andfriend of Great Britain ever since .

But think of this in terms of say, the post -World War II era until the last couple of years .What if we were in a state of total dependenc efor foreign investment in this country on theSoviet Union? That is the equivalent of thesituation we were in from the time we man-aged to succeed in the independence effort,down until about 1890 .

Now, foreign investment obviously is a

good thing, otherwise why would so manyAmericans be foreign investors? Where in thisdebate, listening to some of those who try t ouse emotion rather than logic and reason toadvance their case for protectionism, wherewere they in condemning the very same actio non the part of Americans investing overseas? I t

37

International Investmen t

was just last year that foreign investment fro mabroad exceeded in this country what we wereinvesting overseas . If it is a bad thing, thenAmericans shouldn't be involved in this either ,right? We should construct tax policies or som ekind of protectionist devices to keep that moneyhere in the United States . The fact of the matteris, we all know that that is unsound economicpolicy .

I had the opportunity to speak to about 60Japanese CEOs in New York City last weekand it was on this very question. One of thethings I pointed out to them, with all duerespect to any New Yorkers present, is that Iam a biased mid-westerner . I was born andgrew up in Chicago, and as a result, I hav ealways viewed New York City as hostile terri-tory, and perhaps the best excuse we had in thecountry for nuclear exchange. I said, "One ofthe benefits of visiting in the Orient is that yourealize that we are still barbarians here in thiscountry. After about 24 hours you start tolower your voice and speak more softly andyou get more polite and you tend to bow andhelp people with the doors — the courtesiesthat we so frequently tend to forget ." I said,"By contrast, walk out on the street from theHelmsley Hotel and note the contrast. The factof the matter is, much of this debate on thisquestion is really Japan-bashing . Those whodon't have logic and facts to support theirposition are resorting to this emotional appea lbecause a lot of Americans still live who re-member December 7, 1941."

I then recommended to my Japaneseaudience that their extraordinary marketingskills should be shifted just a little bit right nowto marketing Japan, the Japanese people, andJapanese culture. They obviously have th eability to do it. They must recognize that in thead hominem debate that protectionists ar etrying to fashion on this question, the Japanes eare the easiest target. I am sure we all knowfriends who served in the South Pacific inWorld War II, and you don't have to scratchmany of them very deep before you elicit somekind of anti-Japanese remark The Japanese areactually far behind the British as far as their

investment in this country. My recollection isthat British investment here is about $119 bil-lion; that of Japan — $69 billion. Japan justwent ahead of the Netherlands for the firs ttime last year.

Where was the condemnation of the Brit-ish? Where was the condemnation of the Dutch?If this issue is a valid issue, then the condemna-tion should be spread evenly amongst all thos ewho would dare to invest in this country .

I submit to you that increasingly we ar eliving in an international economy . We arebound to countries all over the world . Andironically, many of the same people who argueagainst foreign investment in the U.S. are in thevanguard of urging investment from this coun -try in the Soviet Union . We want to help thosepeople make the transition to free markets andthey don't have the capital to do it . The wholefree market world is making investments ove rthere to help those people make the transitio nto membership in the civilized world . I thinkthat is sound policy.

To be sure, there are some areas that Ithink may warrant further study by Congress .One of these is transfer pricing . That may be alegitimate issue, but my distinguished chair-man, Dan Rostenkowski, as you know, has abill that goes beyond that. His bill would socka tax to those foreign investors who own 10percent or more of any American company.That has elicited an immediate response, evenfrom the U.K., which has a higher capital gainstax than we do, but they have suggested thatthere would be reciprocity, and West Germanyand France have indicated the same . I think itis a move in the wrong direction . It is perhapswell-intentioned but I think profoundly mis-guided.

There is one other disturbing problemfacing us. That is, why are we in a positio nwhere we need over $400 billion a year inforeign investment . We were reminded of oneof the reasons when I was with the AmericanProductivity Center on a visit to Japan back i n1981 . Our group was comprised of corporateheads, some academicians, professionals, anda few politicians. We were over there to do the

38

tours and study various successful Japaneseenterprises. At the end of the tours we wouldsit down with a Japanese CEO and direct ques -tions to him. At one facility upon conclusion o four interrogation, the Japanese CEO said ,"Excuse me, but before you leave may I askyou a question?" "Sure," we responded. "Fireaway . "

He said that after the war, America in-sisted that the Japanese send thousands o ftheir people over to our country to study oureconomy so that they could become a majorindustrial power in the shortest possible time.That was in part for our own self-interest . Butit was beneficial to the Japanese, too, as theyreadily acknowledged . He said that one oftheir teams went to the University of Chicagoto discuss the tax question. Bear in mind thatMilton Friedman, a Nobel prize winner, Fried-rich A. Hayek, another Nobel prize winner,and George Stigler, another Nobel prize win-ner, all taught at the University of Chicago .These professors taught them to structure a ta xcode that rewards saving and investment . As aresult, at the time of our visit to Japan theydidn't tax interest, dividends or capital gainsfor all practical purposes. We sat back andmarvelled that as a percentage of persona lincome they were salting away about 20-22percent annually while we were at the bottomof the industrial nations of the world . He thenasked, "Why do you punish your people forsaving and investing?" To which the onl yappropriate answer is, "Because we're jerks ,that's why!"

When my son was in high school, I wa scounseling him as you were all counselled byyour parents and you are still going to counse lyour kids, "Don't squander your pay check a tthe end of the week on instant gratification . Putsomething away for the proverbial rainy day ."Right? My son replied, "Daddy, that's crazy ."He added, "If I blow it at the end of the week

and have a ball they only get at it once. 'By

contrast," he said, "when you invest an after-tax dollar and the corporation makes a profit ,they get at it a second time, and with a divi-dend distribution, they hit it a third time, andfinally when you sell your stock and enjoy acapital gain, they get at it the fourth time."

The ultimate obscenity in the Code i swhen you have the audacity to die and leavethem — they are so filled with rage at theTreasury that they come in and bash you rbereaved spouse and loved ones .

This sick tax code that we have goes bac kto the influence of John Maynard Keynes wh ocounselled the way out of a depression b ystimulating consumption and discouragin gsavings and investment. I think it was mis-guided back in the '30s ; it is profoundly mis-guided today . As a result, we should be look-ing inward in terms of resolving some of th eapprehensions we may feel about foreign in-vestment in this country . There are ways w ecould build the appropriate incentives forsaving and investment in this country b yrewarding people for doing these good thingsrather than punishing them. I think that is thedirection that the Ways and Means Committe eshould be taking in looking at the whole ques-tion. We should encourage Americans to sav eand invest and reward them accordingly fortaking that kind of a positive action rather tha nengage in scapegoating and especially singlingout one country over another the way we aredoing at the present time, implying that thereis some evil conspiracy behind it . The onlyconcession I will make to my chairman, Dann yRostenkowski, is on transfer pricing, but therest I think is sadly misguided .

39

International Investment

James M. Carter

James Carter, Senior Tax Counsel, ICI Americas, suggests a number o fpoints in defense of foreign-owned companies doing business in the U.S.

He begins with a reference to the often quoted negative $1 .5 billion incom efor foreign-owned U.S. companies in 1986 . Mr. Carter points out that thepeople citing this figure invariably fail to mention that these same companiesalso paid $3 billion in U.S. taxes in 1986 . U.S. companies take full advantageof tax laws as they find them . He suggests that foreign-owned U .S. companiesare also entitled to minimize their U.S. taxes .

Mr. Carter discounts the accusation that foreign-owned U .S. companiesare using transfer pricing to eliminate U.S. profits and attributes th eaccusation to the "foreign-bashing" currently in vogue in the press and o nCapitol Hill . He asserts that there is no fiscal authority in the world thatwil lallow a manufacturer to export a product to its foreign subsidiary that doe snot take into account in the price the manufacturing intangibles that wen tinto it.

Finally, Mr. Carter raises the question, "Who is foreign?"He cites statistic swhich show that roughly 40 percent ofIBM's employees are foreign, including18,000 Japanese. Whirlpool employs 48,000 people, mostly non-U.S. in 45countries. He maintains that instead of throwing stones at so-calle dforeigners, we should try to bring some rationality to the U.S. tax scheme .Moreover, Mr. Carter emphasized that we should work on a cooperativebasis with other countries, rather than institute unilateral policies tha tattempt to force the rest of the world to conform to our standards .

Senator Russell Long once wryly observedthat the best tax policy is, "Don't tax you, don' ttax me, tax that man behind the tree." All of asudden, it turns out that the U .S. subsidiariesof foreign-based multinationals are the manbehind the tree. If you believe some of th estatements that have been made in the pressand on Capitol Hill lately, these subsidiariesare in large part responsible for the nationa ldeficit. The figure of $25 billion was mentionedrecently as the amount by which the U .S. sub-sidiaries of foreign-based multinationals havecheated, evaded, or defrauded the U.S. gov-ernment out of taxes. The examples that arebeing given to demonstrate how that is donesimply don't hold water, and I would just liketo call your attention to a few of them.

The statistic that was most often quotedwas the $1 .5 billion negative income for 1986 .That was mentioned by the Chairman of theHouse Ways and Means Committee; it wasmentioned by the House Majority Leader; andit has been mentioned by a number of otherpeople in talking about this problem. Whatthey didn't mention was, at the same time ,those same companies paid three billion dol-lars in U.S. taxes. You hardly ever saw thatfigure mentioned anywhere in the press .

NBC recently did a program, last Frida yin fact, in which they talked about how transferpricing was, in effect, evading taxes . That hasbeen a recurrent theme in the press and onCapitol Hill for some months now. The yearthey are talking about was 1986 and I recall a

40

study that was done by the Citizens for Ta xJustice, and they showed that from 1981 through1984 there were 50 U .S. companies that had acombined total of $56.8 billion in profit andthey paid taxes of -$2.4 billion for that sameperiod. That includes some very prestigiouscompanies : General Electric, Boeing, and manyothers. No one said they were committing taxfraud when that happened . They were simpl ytaking advantage of what every tax advisor inthis room tells his client to do, "Take advan-tage of the tax laws as you find them." And inthat respect the U .S. subsidiary of a foreignmultinational is no different from a U.S. com-pany that is owned by U .S. shareholders.

Right now foreign bashing is pretty muchin vogue in Congress and in the press . Whenthey cite these examples of the way in whichthe transfer pricing works, they will show amanufacturing cost and a distribution cost andthey will show a large, undefined block o fprofit going to the foreign manufacturer .Nowhere in there does anyone mention th eresearch and development that produced tha ttechnology, and the manufacturing intangibles.There is no fiscal authority in the world thatwill allow a manufacturer to export a productto its foreign subsidiary that does not take intoaccount in the price the manufacturing intan-gibles that went into it. If you don't believ ethat, try asking Lilly or Searle or Bausch &Lomb because they have all been to court re-cently on that very principle.

It is further suggested as part of this —and I have to call it a fiction because to me thereis no rational basis for what they are claimingtransfer pricing does — it is also said that theforeign multinationals are trying to transfe rprofits to these other jurisdictions even thoug has we just saw this morning that the tax ratesare higher. Perhaps they are not as much higheras it appears because there are certain practice sthere that permit the profits not to be so heavil ytaxed as the nominal tax rate would make itappear in some foreign jurisdictions. Never-theless, it doesn't make a lot of sense for acompany by transfer pricing to try and transferout of the United States from the 34 percent

bracket into a 50 percent bracket. Rememberthat the foreign companies aren't plagued bythe Section 861 rules. They are not plagued bythe baskets and the PFIC rules that we havebeen hearing so much about that are bein gdealt with by the U .S. companies .

What I would like to recommend is tha tinstead of trying to force the foreign countriesinto using the same kind of rules to tax theirpeople, the U .S. Congress ought to be lookingat how to relieve the tax burden on the U.S . -owned companies .

The fact is that when you start talkin gabout U.S. vs . foreign, what is foreign anyway ?I am told, and somebody here can correct me ifmy numbers are off, but they were in testi-mony that was presented to the Congress, tha troughly 40 percent of IBM's employees areforeign, including 18,000 Japanese . Whirlpool,it was said, employs 48,000 people, mostlynon-U.S. in 45 countries . There are 200 U.S .companies that employ 100,000 people in Sin-gapore, alone, making products to be exportedall over the world .

Now, the question is, who is foreign? Ifyou earn a lot of your profit from a foreignjurisdiction, and if your management policie sare dictated by what it takes to compete in tha tglobal marketplace, you are a global company .Your policies are going to be dictated by whatis the best marketplace in which to operate.You are going to try and save revenue and tak eadvantage of all the tax laws everywhere . I doit for my company and I am sure all of you doit for your companies . In fact, you would beremiss in your duty if you did not do that.

The point I am trying to get at is tha tinstead of throwing stones and calling namesand saying that these nasty old foreigners arecheating us, we ought to try to bring som erationality to the U .S. tax scheme. We ought totry to do it on a cooperative basis and notsimply try to say, that Americans are going t oinstitute unilateral policies that will force therest of the world to conform to our standards .

41

International Investment

Bruce R . Bartlett

Bruce Bartlett, Deputy Assistant Secretary for Economic Policy for theU.S. Treasury, speaks about the general domestic tax system and its effect o nforeign investment . He suggests that domestic tax policy is an importan tinfluence on the level of foreign direct investment . If this policy discouragesdomestic saving needed to finance domestic investment, foreign capita lmust, by definition, fill the gap.

Mr. Bartlett cites statistics which show the decline in the U .S. savings ratefrom an average of 16.3 percent of GNP from 1950-1979 to about 14i percen ttoday. This decline in the savings rate occurred when gross private domesti cinvestment continued at the level of about 16 percent of GNP. Therefore, hesuggests that the flood of foreign investment in recent years is really a directresult of inadequate domestic savings .

The causes for the decline in savings are twofold . First, private savings byhouseholds have declined, and second, negative savings (budget deficits)have risen from less than 1 percent of GNP to 3 .9 percent over the same period .There are a number of ways to increase the levels of savings.

Mr. Bartlett suggests that federal spending could decrease to the level o ftaxation. He views this as a superior option to raising marginal tax rates ,which would tend to discourage savings at the margin . Mr. Bartlett uses thisline of reasoning to support President Bush's proposal to cut the capitalgains tax. With a capital gains cut would come increased realizations o fcapital gains, which would produce new revenues, at least in the short run,and tend to reduce the budget deficit .

Mr. Bartlett also attributes the high increases in foreign direct investmen tto the favorable U.S. investment climate of recent years. He maintains tha tincreasing foreign investment in the U.S. is a sign of strength, not weakness ."Tax policy," stated Mr . Bartlett, "should encourage work, savings andinvestment and take as little out of the taxpayer's pocket as possible ."

Domestic tax policy is an important influ-ence on the level of Foreign Direct Investment .In particular, if domestic saving is insufficien tto finance domestic investment, then by defini-tion foreign capital must fill the . . gap. Obvi-ously, tax policy can affect each side of theequation, either by discouraging domesticsaving or by stimulating investment . In recentyears we have done both, which largely ex-plains the large inflow of foreign capital to th eU.S .

Historically, the U.S. financed domestic

investment from domestic saving. From 1950through 1979, gross private domestic invest-ment averaged 16 percent of GNP and nationa lsaving averaged 16 .3 percent. Thus, duringthis period the U .S. was a net capital exporter .Since 1980, however, the situation has changed .Although gross private domestic investmentwas about the same, averaging 15 .8 percent ofGNP, national saving dropped to just 14 . 1percent, thus leaving a gap of 1 .7 percent whichwas financed through foreign capital inflows .

Thus the flood of foreign investment ,

42

which has so alarmed many people, is reallythe direct result of inadequate domestic sav-ing. Had we not obtained foreign capital w ewould have had less investment, thus lower-ing the standard of living for all Americans .Hence, the real cure for the perceived problemof rising foreign investment in the U.S. is toraise the U.S. saving rate so as to allow domes-tic investment to be financed domestically.

Why has domestic saving not been suffi-

cient to finance domestic investment? Thereare two reasons. First, private saving by house-holds has declined from 5 percent of GNP i nthe period 1950 through 1979, to 3 .8 percentfrom 1980 through 1988 . Second, negativesaving by the federal government rose fromless than one percent of GNP to 3 .9 percentover the same period . By negative saving, I amreferring to the federal budget deficit, whichabsorbs private saving to finance consumptio nby government. Conversely, a budget surpluswould be a net addition to national saving .Indeed, state and local governments have runan aggregate budget surplus of 1 .3 percent ofGNP in recent years, thus helping to offset par tof the deficit at the federal level .

One might conclude from this analysisthat the quickest way to increase national sav -ing would be to eliminate the budget deficit .While this is true, it does make a differencehow this is accomplished. If spending werereduced to the level of taxation, then clearlythis would lead to a decline in governmentconsumption . Since private saving would beunaffected, the decline of negative saving b ythe federal government would be a net addi-tion to national saving. On the other hand, iftaxes are raised there is the danger that suchtaxes would discourage some private saving.This is especially so when many people seemto believe that the best way to raise taxes is byraising the top marginal income tax rate. Suchan action would certainly reduce the incentiv eto save by those with the greatest ability t osave, namely those with upper incomes . It isquite possible, therefore, that even if the defici tdeclines, saving may decline more . As a result,there would be no net increase in national

saving. If there is no increase in saving, thenclearly there will be no reduction in foreigncapital inflows either .

Of course, investment is also affected b yhigher tax rates . If they reduce the rate ofreturn, then investment may fall . If investmentfalls by an amount greater than the fall insaving, then foreign investment will be re-duced. However, it will be reduced at th eexpense of our standard of living . Less invest-ment will mean fewer jobs, lower productivity ,and a lower rate of growth. Thus the price forreducing our dependence on foreign capitalwould be very high indeed .

Ideally, what we want to do is increasedomestic saving and investment . This is whyPresident Bush has been so adamant aboutcutting the capital gains tax. It accomplishesboth goals at once. It will promote investmentbecause the capital gains tax directly affects therate of return on capital investment . And it willpromote saving by increasing the government' srevenue. It does so by unlocking sales of assets ,such as stocks, which people avoid selling inorder to avoid paying the tax. At a lower rate ,many people will realize their gains and thu spay additional taxes.

Unfortunately, too many people continueto view a cut in the capital gains tax as somekind of give-away to the rich. In fact, the capitalgains tax does not in any way affect the wealthof those with capital gains . It only affects theextent to which they pay taxes on such gains .This is because the tax applies only to realizedgains. Gains on assets which are simply heldand not sold are never taxed . Those who be-lieve that a cut in the capital gains tax benefitsthe rich are implicitly assuming that withoutany cut in the rate they would realize the sam eamount of gains as they would with a lowerrate and pay taxes on such gains at the higherrate. Although some gains would have beenrealized even at the higher rate, experiencewith the capital gains rate reductions in 1978and 1981 suggests that enough new realiza-

tions would take place to raise revenue at leas tin the short run.

President Bush has also pressed for a

43

International Investmen t

restoration of savings incentives which werescaled back in the 1986 tax reform. In particu-lar, this legislation reduced the ability to con -tribute before-tax income to individual retire-ment accounts . Although there is still muc hdebate on this subject, the best evidence indi -cates that IRAs were a strong source of newsaving during the 1982 through 1986 period,when they were available to all workers .

Thusfar, I have been talking about foreigninvestment as a residual, resulting from inade-quate saving. While this has largely been thecase in the U.S., it is certainly not the only factoraffecting the level of foreign investment .Clearly, the attractiveness of the U .S. or anycountry as a home for foreign investment isinfluenced by many factors . Together, we migh ttalk about these factors as constituting theinvestment climate .

The investment climate of a nation is thefundamental determinant of foreign invest-ment. If the investment climate is good, invest -ment will be encouraged; if it is bad, it will bediscouraged. From this it logically follows tha twhen one observes an increase in foreign in -vestment, it probably indicates the existence o fa favorable investment climate. Declininginvestment would thus indicate a less favor -able climate . Therefore one can conclude tha tthe rise of foreign investment in the U .S. in the1980s is evidence of an improving investmen tclimate. Conversely, declining foreign invest-ment would be an indicator of a deterioratinginvestment climate .

Although this is a simple argument, it hasfar-reaching implications for policy . It meansthat increasing foreign investment in the U.S. isa sign of strength, not weakness . It also meansthat it is probably impossible to have a stron geconomy without foreign investment, for theonly means of reducing foreign investmentwould be by adopting domestic policies inimi-cal to growth .

In the 1970s, the investment climate in theU.S. deteriorated . In particular, high inflationpushed individuals into higher tax brackets,sharply raising the average marginal tax rate,while corporate taxes also increased as infla -

tion overstated inventory profits and reducedthe real value of depredation allowances .

I emphasize the role of domestic taxation,because I believe that this is the fundamenta l

determinant of the investment climate . How-ever, the exchange rate and government regu-lations are also important elements of the in -vestment climate . In the 1980s all three of thesefactors contributed to the inflow of foreigninvestment to the U .S . :

1. The tax cuts of 1981 sharply lowered themarginal income tax rate while encouraginginvestment through liberalization of busines sdepredation allowances .

2. The dollar increased sharply in value i nthe early 1980s and continued as the world' sreserve currency, making it extremely easy fo rinvestors to move funds from one place toanother .

3. U.S. law does not discriminate betweendomestic and foreign investment, affordingboth national treatment .

For these reasons, the U .S. was an unusu-ally attractive place to invest in the 1980s .Thus, to a large extent, the inflow of foreig ncapital was a sign of confidence in the Ameri-can economy — a sign of strength rather tha nweakness .

Ironically, there are still those who takeexactly the opposite view, seeing the inflow offoreign capital as a liability to be discouraged .It is exactly this view which is, to a large extent,responsible for much of the poverty in th eThird World. Especially in Latin America,foreign investors have been viewed with sus-picion . Severe restrictions were placed on whereand how much foreigners could invest and o nthe repatriation of profits. These countriesbelieved, in adopting such policies, that theywere protecting their sovereignty . In fact, allthey were doing is impoverishing their people .

We now know that Foreign Direct Invest-ment is a powerful engine of growth in theThird World. It brings in desperately neededcapital without the burden of debt which come swith bank loans . It brings in competent man-agers and technical skills often lacking inunderdeveloped countries . And it provides

44

access to foreign markets often denied to them .

Consequently, we are now seeing many na-tions previously hostile to foreign investorsand multinational corporations opening theirborders to them and actively courting them .

It is interesting to note that one of th emajor actions usually taken to improve th ebusiness climate in such countries is a reduc -tion in individual income tax rates. In a studyI did last year, I found that between 1985 and1989, 56 out of 86 countries — over 65 percent— had reduced their top marginal income tax

rate. It turns out that companies are not eagerto invest even where business taxes are quitelow when income taxes on their managers isprohibitive. Moreover, for many developingcountries the best potential source of foreig ninvestment is from their own people, who mayhave taken their capital overseas or move daway themselves to escape confiscatory taxand regulatory policies. This is especially truein Latin America, where so-called flight capital

may equal the total foreign debts of somecountries .

I would argue that the same factors whichmake foreign investment attractive to devel-oping nations make it attractive here as well .

Japanese and other foreign investment is trans-

forming many industries. In autos and elec-tronics, for example, Japanese-owned plants i n

the U.S., employing U .S. workers, achieveproductivity levels similar to those in Japan .Indeed, Honda is now exporting cars made i n

its U.S. plants back to Japan .In conclusion, I would join with the othe r

members of this panel in endorsing the posi-tive view of foreign investment . In any event,the same tax policies which are most congenial

to foreign investment are the same for domes-tic investment. We need a tax policy whic h

encourages work, saving and investment . We

need a tax policy which takes as little out of the

taxpayer's pocket as possible to fund the legiti-

mate and necessary functions of government .

And we need to be sensitive to the interna-tional implications of our tax policies .

We live in an increasingly interdepend-ent world in which capital and labor are rela-tively free to move . The emerging democracie sof Eastern Europe and the struggling econo-mies of the Third World, as well as our tradi-tional competitors in Europe and Asia, are

actively courting foreign investors to improve

growth and the standard of living of their

people. We cannot afford to do less .

Q& A

Q: Most foreign nations eliminate doubletaxation with the tax integration system. Infact, many foreign nations, in Europe in par-ticular, discriminate against U .S. investment intheir countries because we don't have an inte-gration system, which we can trade off . Com-panies do not have the double tax on theircorporate earnings. It seems to me that one ofthe issues that Treasury is looking at, but is notcoming forth in Congress, is that U .S. struc-ture, the U.S. tax system, is out of line with

almost the whole rest of the world . When doyou think the Congressmen will at least beginto understand the need for an integrated taxsystem?

Mr. Crane: "When" is hard to answer.What has me profoundly worried in thesebudget negotiations is if they come up with a

budget package that has, say, a 50 percent tax

increase component, anything can happen —none of it positive. Harking back to the 1986 so-called Tax Reform Act, when we got to confer-ence with the Senate (because their versionwas considerably at variance with our own),trying to reconcile the differences to come u pwith something that was going to be revenue-neutral, there was no real evaluation of th emerits, the long-term merits, of what they wereputting in there. It was just how much moneyis involved. You know, this will get us $1 0

45

International Investment

billion — this will get us $25 billion — put it inthe package. When we're working in theseshort time frames, first you can be assured thatthe Joint Committee on Taxation has don e

studies of a variety of these proposals andthey've probably presented them to the chair-man. Maybe CBO has done some analyses — Idoubt that they would have talked to Treasurybecause they would rather blind-side Treas-ury. But the fact is, they will have done theirhomework and they will know what the dollaramounts are and then we'll get a chairman'smark and the chairman's mark will include thetargeted numbers .

On the minority side, we are going to say ,"Well what the heck is all this?" when we startthumbing through in desperation. Then wewill have say a week to get this off the table andRosty is an imposing chairman . If you are notfamiliar with him, watch him in action whe nhe is under a tight time frame. If he doesn't rapyou down with a gavel, he is liable to rap yo uwith the gavel . So if anyone suggests alteringthe chairman's mark, he better have an alterna-tive revenue raiser that will equal exactly wha tis being taken out . And given that kind of asituation, I think that we're potentially in for anaggravation, a sorry aggravation, of the prob-lems that we have instead of addressing som eof the positive topics that you have suggested .

Mr. Bartlett: I am not working on theintegration study, but I do periodically askMichael Graetz how it's coming. My impres-sion is that in the last few weeks they've had tobasically stop work on it completely to devot eall their resources to analyzing 10 million dif-ferent tax proposals that have come up in thesebudget negotiations . So, my guess is that they'renot going to finish it this year; it will probablybe sometime next year.

Mr. Carter: I just wanted to make a state-ment to Congressman Crane . You were sayingthat you believe that there is a possibility tha tthe transfer pricing issue might be a legitimat eissue. I can't speak for other companies, but Ican speak for my own and I don't think it is aproblem at all in our company. But I would liketo call to your attention the flap about thetransfer pricing issue arose, using those 198 6statistics of 1 .5 million negative income. Andas I pointed out earlier before you came here, a tthe same time, those foreign companies never-theless were paying $3 billion in taxes . Nowthese 1987 statistics of income figures are out,and indicate that the foreign controlled com-panies' income is now up to $5 .6 billion posi-tive and the tax liability is now increased to$4.2 billion . A KPMG Peat Marwick study thatturned up those numbers predicts that it isgoing to continue to rise in future years. Thetrouble is that statistics for income are alwaystwo or three years behind what we are actuall ydealing with. I don't know that it is as big aproblem as it's being made in the press .

Mr. Crane: I would agree with you on thatand that's why I would only recommend hear-ings to find the answers to some of these ques-tions because the last figures that we wer eprovided with on the committee were the 198 6figures. And someone suggested at that timethat you've got start-up costs . So, it is hard toabsolutely determine this, but again it is one ofthose things that when you describe what trans-fer pricing is, yeah, hey, what a cute gimmic kthat is and what a way to avoid paying taxes .When you turn that kind of an argument looseon politicians, beware . It is one of the thingsthat they can take and run with . And that' swhy, as I said, I would prefer to conduct hear-ings and get some of the experts who under-stand this better than we do on the committe eto come forward and testify to see if indeedthere is a basis for any action.

46

Tax Treatment of Foreign Investment in the U .S. Panel 2

Panel Chairman : John G. WilkinsPartnerCoopers & Lybrand

Catherine T. PorterPartnerMiller & Chevalier, Chartered

Peter A. BarnesDeputy International Tax Counse lU.S. Department of the Treasury

John G. Wilkins

Harrison J. CohenLegislation CounselJoint Committee on Taxation

Richard PrattEconomic Counsello rEmbassy of Great Britain

I would like to see if there is some way wecan tie together what we are talking about o nthis panel with comments made at the begin-ning of the day by Professor Graham and someof the comments made by Secretary Bartlett o nthe last panel . Specifically, as we learned ear-lier, outflows of investment have increasedslightly, about $8 billion. Inflows have de-creased dramatically, however, some $100 bil-lion for a total swing since 1989-90 of over $11 0billion, of which about one-half is direct andone-half portfolio investment .

We are finishing a period in the 1980 swhere that was not the case, where there wasincreased demand for U .S. assets, where there

was a relatively strong dollar; imports wer ehigh and exports were low. It was this kind o fpicture that led many in government to ques-tion whether we had the right policies, whethe rwe ought to encouraging or discouraging in -vestment in the U.S .

Now that we see that the value of thedollar is getting weaker, imports may not be sostrong; investment funds may be dropping ;

and possibly higher interest rates coming abou tas a result; and, hopefully not but possiblyslowing growth . I think the question to poli-cymakers is, will they now change their minds;will this encourage them to back off some o fthese harsh legislative positions?

Catherine T . Porter

Catherine Porter, partner in Miller & Chevalier, suggests that part of th eproblem in dealing with the whole foreign investment debate is that it iscarried out on two distinct levels . On one level, the debate can take place i na very detailed and technical way. Tax practitioners are concerned with th etax code, good tax policy and economic studies . Ms. Porter includes theprofessional committee staffs on Capitol Hill and of course the Treasur yDepartment in this group. On the political level of debate, there is th eproblem of explaining these issues to congressmen and the press .

Ms. Porter finds so much prejudice in the Congress against foreig ninvestment that even sympathetic congressmen will not take the lead on th eissue during a budget battle . She predicts that the battle in progress at tha t

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International Investmen t

time will yield only a few negative provisions for foreign investment .As an illustration of how Congress and the media misinform the public o n

this issue, Ms. Porter read the script of a recent NBC News televisio nbroadcast featuring Tom Brokaw and Congressman Richard Gephard texplaining the "transfer pricing scheme ."

One of the things that I was thinking as Ilistened to the other speakers is that we reall yare faced with two levels of the debate on thi sissue of foreign investment.

We've got one level of the debate whichcan be engaged in by those who are interestedin a very detailed and technical analysis . Taxpractitioners who are concerned with the ta xcode and good tax policy, who are interested i neconomic studies, who want to know all theinformation that Edward Graham gave us thi smorning, and all the other statistics that I woul dlike to present to you. The people at the Treas-ury Department and the Joint Tax Committe eare all very interested in the tax policy issues .They want to talk about transfer pricing andSection 482. They want to speak in Code sec-tions and understand all the economic issues,too .

Then we have another level of the debat ewhich is a very difficult one . We have a politi-cal level of the debate where we have to try toexplain things to congressman and senatorswho are making decisions about tax policy .The issue of having a "political" level of discus -sion exists whenever one deals with Congress ,whether we are talking about foreign invest-ment or not. But one of the complicating fac-tors with foreign investment is that there i sprejudice against foreign investment. Thereare many different levels of prejudice, andthere are no particularly strong advocates i nfavor of foreign investment in the Congress.Our law firm represents the Organization forthe Fair Treatment of International Investmentwhich is one of the coalitions of foreign-ownedcompanies who lobby on these issues . It is verydifficult to persuade congressmen, such as thoseyou have heard today, Congressmen Brownand Crane, who seem knowledgeable or maybea little sympathetic, to actually take a leading

role on a particular issue . Something else isusually going to be much more important totheir constituents than defending foreign -owned companies in the United States .

So, whenever there is a big budget billwith many issues on the table for discussion ,this is definitely not the number one thing ontheir agenda to defend. They won't becomeexperts and lead or educate their colleaguesabout the fairness and complexity of taxin gforeign investment . Instead, the debate degen-erates into simple grandstanding and a battleof phrases which can be used in televisioncommercials .

There are two anecdotes I would like toshare with you. First, on the way over here inthe cab, I was listening to a radio talk show.Senator Packwood once told me that he alwaysknew when an issue was going to be really ho tif the cab drivers were talking about it . He saidhe knew that Section 89 (a pension provision )was going to be repealed when he was ridin gin a cab to a speech one day and as he got outof the car, the cab driver said, "By the wa ySenator, are they going to repeal Section 89? "He knew that this was a sign that it was gone —when the level of interest had drifted out tha tfar .

Well, this talk show I was listening to o nthe way over was a call-in program. Peoplewere complaining about foreign investment .People were complaining specifically abou tJapanese companies and where they chose t olocate. There were all sorts of statements o fprejudice and misstatements of the facts . Un-fortunately, the telling fact was that the genera lpublic may be prejudiced against or hostiletoward foreigners, especially if they are Japa -nese .

We may not find that the particular budge tbill we are all concerned about today is going

48

to be the death blow to foreign investment . Wemay get by with just some of the complianceprovisions of the Foreign Tax Equity Act in-cluded, and everyone will breathe a sigh of

relief. That sense of relief is part of another sor tof political game that is played frequently . Agroup is threatened with an absolutely hor-rible proposal, and then it feels very happywhen it is only hit by the compliance provi-sions of the Foreign Tax Equity Act . The groupfeels it was just let off the hook because somesort of surcharge on foreign-owned companie sor the 50/50 profit split proposal was notenacted .

The other little anecdote is something tha tJim Carter, on the prior panel, alluded to . Ireally wasn't planning to read this . I hope itdoesn't take too long, but I think it may b eenlightening.

This is what NBC news did with this issueof taxing foreign investment . It just gives you,in a nutshell, the problem of trying to addres sthese complex issues in the "political" forum .We can have a wonderful discussion at an AB Atax section meeting and Harrison will come,and Steve Lainoff and Phil Morrison will comeand there will be a lot of nitty-gritty discus-sions. Or, we can have a debate like the follow-ing television news broadcast :

Program: NBC Nightly NewsDate: September 21, 1990

Tom Brokaw (anchor) : There still is nodeal in sight on reducing the deficit . Mean-while the deficit is not being helped by the fac tthat many U.S. subsidiaries of foreign-ownedcompanies are evading tax in this country .NBC's Diana Koricke reports that this hasgotten the attention of Congress .

(Visual of congressional hearing )Rep. Richard Schulze - PA (R) : We are

going to be called upon not only by the admini-stration but by our summit peers to increas etaxes; I will be damned if I am going to do itwhile billions of dollars are floating overseas .

Diana Koricke reporting: Congress is madand it is not going to take it anymore. A HouseSubcommittee just investigated ten years of

tax avoidance by American subsidiaries offoreign companies . It found more than half ofthem paid no income tax . Japanese companiesare among the worst offenders . The scheme iscalled transfer pricing. This is one way it could

work.(Graphic: Transfer Pricing): Say a Japa-

nese company builds a car for $5,000 . It sells thecar to its own U .S. subsidiary at an artificiallyinflated price of $9,000 . The parent just made a$4,000 profit . An American consumer buys thecar for $10,000. The net result for the U.S .subsidiary after other costs is little or no profitand little or no tax bill, but the Japanese paren tstill has that $4,000 and no taxes due to the U .S .Treasury. The IRS reportedly is investigatingthese companies for illegal transfer pricing .The list reads like a Who's Who of Japan' sbiggest corporate names . A former employeeof Toshiba said that the company's pricing inthe U.S. just did not add up .

Unidentified Man: The book price wasjust some arbitrary figure that they came upwith, I guess to keep their taxes down. Thesystem taken in on trade whatever it would sellfor was all profit and yet the way they ac -counted for it, only half was shown as profit .The other half was arbitrarily called cost. Therewere no costs associated with it .

Koricke: Japanese sales in the United Statesskyrocketed in the mid-1980s, but their de-clared income on which they paid taxes plum -meted .

Rep. Ronnie Flippo - AL (D): The averageworking man and woman in the state of Ala-bama paid more income tax over the last fiv eyears than multinational corporations . Is thatafact or not?

Kenneth Gideon (Assistant Treasury Sec-retary): There are certainly circumstances thatwe are aware of where there has been little o rno tax payment over a substantial period ofyears .

Rep. Flippo: So the answer to that is yes .Gideon: Well, that would be one way t o

put it .Koricke reporting : How have some Japa-

nese companies been able to avoid U .S. tax

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International Investment

payments? One reason is the administration' sreluctance to alienate the Japanese.

Rep. Richard Gephardt (Majority Leader) :It's kind of been a marriage of convenience. Onthe one hand our people here have been wor-ried that we can sell our bonds to foreig ninvestors, and they are the Japanese investorsin many cases . In return for that there is somekind of wink that we won't really enforce ou rtax laws .

Koricke: This kind of sweetheart deal justgoes to show how dependent the United Stateshas become on Japanese money . Americansmust ask whether we want Japanese investor sto buy bonds to support the budget deficit, o rpay taxes to reduce it .

I don't know this person and I don't kno wunder what pressure she was to do such astory, but she didn't call us to talk about thefacts at all.

It is a very frustrating situation that manyof the foreign-owned companies find them-selves in just trying to lobby this issue. So manyof the points have already been brought toyour attention. Foreign-owned companiesemploy lots and lots of people here and theytry to go to their congressmen and say, "We areU.S. citizens — don't disenfranchise us ." Butthey still fall to the bottom of the list when itcomes to having an advocate in the Congress.

The foreign-owned companies which Irepresent do not want unilateral changes in thearms length pricing standards . There have beenmany overtures by the British government andby the German government to sit down in a

multilateral fashion and to try to talk aboutsome of these transfer pricing problems . Therewere some suggestions at the Oversight Sub-committee hearings that might develop int osomething like a Blue Ribbon Commission .This would permit people who are interestedin good tax policy to come up with some solu-tions to problems, that are perceived, or prob -lems that are real, with the way the arms lengthstandard works at the moment .

Please look at Table 1 (page 74) . Thesetables were just given to me early today by LinSmith at Peat Marwick The group that I repre -sent, Or 11I (The Organization for the FairTreatment of International Investment), hadcommissioned Peat Marwick to do a study o fthe taxes paid by foreign-owned companies .Many of you are familiar with this because w ehave been talking about it since July . We sub-mitted some testimony to the Oversight Sub-committee. We talked to the Joint Committeeon Taxation. We talked to the Treasury Depart-ment about it, and I think there is no rea ldisagreement about what the figures show.

Originally we only had 1986 data . Thesetables are updated to have the 1987 data. Myfeeling is that the more people are aware of th eactual facts of what is going on and the extentto which these companies are paying tax, thebetter. Because then we will be talking aboutreal problems, if there are any . We can thentarget our solution to whatever problem ther ereally is . We will not simply be legislating onprejudice or television news stories like the on eI just read to you.

50

Peter A. Barnes

Peter Barnes, Deputy International Tax Counsel for the Treasury, reiterate ssome of his earlier remarks, saying that the U.S. has to be aware that if weenact foreign tax policy initiatives, the foreign countries are likely to initiatecomparable legislation. With respect to superroyalties and the controvers ythey have generated, Mr . Barnes states that just because they are differentdoesn't make them wrong. Whatever rule the Treasury uses to determinewhat the right royalty payment is when a foreign subsidiary of a U .S.company is using U.S.-initiated technology could also be used by the U.S.subsidiary of a foreign parent to allocate income back to the host country.

Mr. Barnes also addresses the earnings stripping legislation that emerge dlast year along with the problem of thin capitalization. He comments on theproposed stock gains tax by saying that many foreign jurisdictions haverules that tax foreigners on the sale of stock in local companies . Finally, Mr.Barnes repeats his invitation for efforts to further the move towar dsimplification .

By my count, in the two hours since I laststood up here, there have been ten people (I a mleaving Bruce Bartlett off), who told you thatthe sky is falling. I guess I am up here toconvince you that's true.

There are four points that I would like tomake that grow out of the conversations wehave had in the last hour. None of the pointsare new, and I don't mean to take a combativeapproach. I want to repeat what I said before :I think we have a lot more in common than w ehave differences . But if this conference is to bemore than something of a pep rally to make u sall feel good — or bad as the case may be — Ithink it's important to see some of the balanceon the other side.

The first point is a point that ElliotRichardson made, which is that the U .S. has tokeep in mind that when we enact foreign ta xpolicy initiatives, foreign countries are likelyto initiate comparable legislation . He used that,I think, as a warning to say, "Hey, at Treasury,let's watch ourselves ." I think it is an appropri-ate warning and we think that is very much th eissue we ought to be keeping in mind as we goforward. That doesn't, however, always coun-

sel me that we shouldn't take action at all ,because somebody else may do something i nresponse.

I take as my first example the Section6038A legislation that was enacted last year .Throughout that process the guiding principle ,the single guiding principle, that Treasury wasconcerned about was what happens when

Germany imposes an identical Section 6038 Aand IBM comes in to talk to us. Is this some-thing we can look Bob Mattson in the eye aboutand say, "Hey, it's not so bad ." I think tha twhen our regulations come out, which is no tgoing to be too far from now, I think the answe ris yes. If you look at the legislation and theregulations that emerge from it, it is going to bea product that we can say that if the foreign ta xadministrators enact this, if they seek to im-pose it on IBM, on Ford, on AT&T, then it' ssomething that we think is legitimate tax pol-icy and legitimate tax administration .

Elliot Richardson was right to raise retali-ation as an issue . All I want to say is I think tha tmany U.S. tax policy people do keep that in theforefront of their minds.

A second example is the superroyalties .

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International Investment

We have been assailed, as you know, by for-eign governments. Ireland has been in th eforefront of that, and the U.K. But many for-eign governments have come in and said, "fou rsuperroyalty rules deviate from internationalnorms — they're terrible, you have to changethem." I think there has been a very construc-tive debate over the last four years between th eU.S., the taxpayers and the foreign govern-ments on this issue, and I don't want to get intothe superroyalties here . I'm happy to do so atanother occasion. But what we recognize, re-peatedly, is that whatever test we come upwith for determining the right royalty pay-ment when a foreign subsidiary of a U .S .company is using U.S. initiated technology ,that same formula should be used, would b eused, and could be used by the U.S. subsidiaryof a foreign parent. And that's a very importantcheck on where we go with our superroyalties .Because, obviously, the U.K., the Dutch, th eJapanese, all have U.S. subsidiaries that areusing foreign initiated research and we havegot to come up with a superroyalty rule that i sgoing to be even-handed, and I think we will .I commend to you Elliot Richardson's warn-ing, but I think it is a warning we have taken toheart and I urge you to remind us to take it t oheart. I think by and large we have enactedpolicies so that we can look the foreign govern-ments in the eye and say they're policies thatwe do not find inappropriate .

The second point I would like to make isthat U.S. tax rules may be different, but thatdoesn't necessarily mean they are wrong, ei-ther wrong morally, wrong philosophically, orwrong theologically. The rules may be differ-ent from the rules that we had in the past orthey may be different from the rules used inforeign jurisdictions, but I would underscorethat simply because rules are different does no tmean that they are wrong.

The first example I would take is the earn-ings stripping legislation that emerged las tyear. Let me make clear — we opposed theearnings stripping bill. Treasury opposed theearnings stripping bill. I don't want anybodywalking out of here and saying Treasury did

not oppose the earnings stripping bill . Thatsaid, let me go on. Thin capitalization is aserious problem in the U.S .; it is a seriousproblem in overseas jurisdictions . Typically ,the foreign way to deal with thin capitalizationis to say that this instrument is not debt butequity, and the stream of payments that accruefrom that instrument are dividends, not inter -est . They may make the recharacterization a tthe outset or they may do it over time . Weclearly keep within our jurisdiction a similarconcept, that certain instruments, althoughcalled debt, are equity .

But the earnings stripping legislation wa san effort to do something different ; to say, no ,the instrument is debt, and the stream of pay-ments is interest . We will simply defer theinterest deduction for a period of time . Thereare very important consequences that flowfrom keeping the character of that payment asinterest rather than the character of that pay -ment being transmuted into a dividend .

We recognized during the 1989 legisla-tion that our approach was different from theapproach used in many foreign jurisdictions .But I think that our approach has much tocommend it. We think that the foreign jurisdic-tions in some cases are recognizing that andthey are looking at our rules . I think right nowone of the serious questions that we have t oface and are facing is how do we match ourearnings stripping rules, which maintain thecharacter of the payment, and rules in theforeign jurisdiction, which has different rules .

But the bottom line point, which is tha tthe U.S. came up with a different approach,doesn't necessarily mean that the U .S. approachwas absolutely wrong. It may, in fact, be a nimprovement and I would suggest that eigh tor ten years from now we revisit the questionof earnings stripping and thin capitalizationand you may find that our system has a lot tocommend it .

I would take a similar point on taxin gstock sales. Let me emphasize, Treasury op-poses the proposal that a capital gains tax belevied when a foreign person sells a 10 percentinterest in a U.S. corporation . We oppose! But

52

let me say that the fact that the U .S. policy, ifthat initiative goes through, will differ in thefuture from our policy in the past, does not inand of itself tell us that the new policy is wrong.Today, we treat sales of assets different fro msales of stock, but many other countries haverules that tax foreigners on the sale of stock i nlocal companies. It is not a heinous thought ininternational tax. And I don't think we movethe debate forward by simply saying this newrule is different. I think it's important for peopleto go beyond that and say, it's different and forreasons A, B, and C, we think it's wrong . I jus tinvite you to have an open mind because Ithink tax policy does evolve and I think inmany instances the simple fact that there ha sbeen a change doesn't tell us one wit abou twhether the change is a good change or a badchange.

We can speak about the pace of the change sand I am very sympathetic to the argumentthat the pace of the changes causes us prob-lems. But that's different from saying tha tbecause it is a change, it is wrong .

The third point I'd like to make is to harpon an old favorite of mine, which is simplifica -tion. I invite you to look in your hearts and tellme whether companies are serious about sim-plification or do we just want to sit here todayand make everybody feel better .

If you are serious about changing U.S. taxpolicy, you are going to go out of here, you'regoing to revisit the pamphlet that was issued i nJune. You are going to revisit the proposalsthat you made and you're going to come upwith packages, not a grand package that re-forms all of international tax, but a packagethat takes a few of these problems . It does it byaccepting the cardinal ground rule of today,which is revenue neutrality . Because if youdon't accept that ground rule — and I alreadysee Dick Hammer shaking his head — you areimplicitly buying into James Carter's poin tthat you aren't taxing you, you aren't taxin gme, you are trying to shift the tax to that manbehind the tree. Somebody is going to pay fo rthat and, frankly, I am disappointed that th ediscussion today has ignored the question of

revenues, because I think we can't ignore th edeficit . If we're going to have a constructiv edebate going forward, we need to keep that inour minds.

The fourth point I would make is to sa yI'm not sure it is a fair statement to say the U .S.is always undermining its companies, but theforeign countries are always helping theircompanies . That implicit view has been ex -pressed several times today .

I take as my point Robert Ashby's homecountry of Canada. For instance, if you look a tthe U.S./Canada Tax Treaty, it has extraordi -narily high withholding rates on interest an droyalties, if you consider that it's a treaty be-tween two developed countries with anenormous flow of technology, interest pay-ments, and everything else back and fort hacross the border.

Why are the rates so high? It's not becaus ethe U.S. wanted them there . The U.S. would beeager to drop the withholding rates on interestand royalties. It's because Canada has said n o— when a U .S. company has a subsidiary inCanada and wants to repatriate royalties orinterest, we are going to extract a fairly sub-stantial withholding tax . I don't point the fin-ger at Canada on this . They have an articulatereason for why they do what they do. We'reworking on the treaty to see if anything can bedone. I don't know if it can .

But the point is, there are lots of countriesthat for lots of reasons make investment deci-sions and tax decisions, and I don't think it i sappropriate for us to assume that the U.S. isalways inhospitable and other countries arealways hospitable, because that's simply no tthe case.

We think that tax policy helps all taxpay -ers best by giving all components of the ta xsystem fair treatment . And I want to stres sagain, remember the U .S. company with U.S .business. When you walk out of here, thinkabout the points you are making, or points youare willing to make, when you sit down withyour neighbor or businessperson who has apurely domestic company. Be sure you arecomfortable in saying, "Look, yes, my deal is

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International Investmen t

the right deal, notwithstanding the fact thatmy deal may have consequences for you."

Most of the people in this room will probablyremember the runaway plants issue that cam e

up a few years ago . Fortunately it was no tenacted, but I don't think runaway plant legis-

lation is gone forever . Frankly, we have to beconscious of the fact that in enacting interna-tional tax policy that will give U .S. companies

a legitimate opportunity to earn income over -

seas, we can't do it in a way that opens us up to

criticism on the runaway plant issues . I daresay that would be very negative for all of us,and I think we would be prudent to keep i nmind the risk of future runaway plant legisla-

tion .

54

Harrison J . Cohen

Harrison Cohen, Legislation Counsel for the joint Committee on Taxation,speaks about problems that inevitably arise when companies that do busines sacross borders have different incentives to provide information . The U.S. hasa tax system that requires companies to get a tremendous quantity of dat afrom overseas operations in order to categorize income for tax purposes . Aslong as we rely on labeling income as dividends, interest, or gains, we wil lneed extensive information reporting to arrive at a dollar and cents figure .

Mr. Cohen acknowledges the valid objections that are raised when thesuggestion is made that the U.S. move away from the arms length standar dfor transfer pricing. However, these objections do not necessarily prove tha tnothing other than the arms length standard can ever be used. Ultimately,taxpayers, Congress, and Treasury may conclude that another standar dwould be superior because it may be inappropriate to ask for reams o fmaterial and to try figure out this illusive arms length price between relate dparties .

On the stock gains tax, Mr. Cohen finds the insistence on taxingdividends, but not stock gains, contradictory . He hastens to add that w eshould not tax the gains in cases where treaties forbid it .

I had heard criticism about some of theproposals that are before Congress now befor eI came here today. I didn't hear many of thepresentations today, but I will take Peter' scharacterization of it.

Think about why we are doing thesethings. I was in a meeting the other day of someforeign legislators with people on the Hill andwe were talking about whether or not transferpricing was a problem as far as they knew.They named a couple of American companiesand said, "They are doing business in ourcountry and they seem to be running all thei roperations, even though they are done in ourcountry, through Bermuda and the Bahamas . "I silently thought to myself, I am proud to be anAmerican tax lawyer . It's possible that compa-nies domiciled overseas would be interested indoing some of the same things with respecteither to their own home country tax systems,or with respect to the U .S. tax system .

I remember talking to people about wh ywe are in the position we are today with H .R.

4308. I started saying this really goes back tolast year . The House thought it was doingsomething not particularly controversial and itgot some heat . The IRS developed what itthought were some suggestive statistics. Theywent public, and members of Congress picke dup on them. Others decided that the statisticswere wrong and came back with some rebut-tal. In addition, I recall a case involving aforeign multinational company that was doin gbusiness over here. The IRS was trying to auditit by reference to some of the records that itkept overseas . A communication was appar-ently sent by the company's home countr y

government saying it is a breach of interna-tional relations between our two nations fo r

the IRS to be asking for this material .

If that is the attitude of companies that d obusiness across borders, and yet we have a ta xsystem that requires the IRS to get that kind o fdata from overseas, then I think that whateverwe think about the data and the inconvenienc eand the inefficiency of requiring reams of in-

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International Investmen t

formation, we will be in a position where w ewill need these compliance related proposalsto force the information out of companies thatwould rather not provide it .

I'd have to say that it is a fair questionwhether that is the best system that we couldhave for taxing cross-border transactions . Infact, there has been a debate for years overwhether using arms length prices betwee nrelated parties and trying to respect those makessense.

As you know, some of the alternativeseven within ordinary 482 practice involve profi tsplit, which determines the profit from an entireoperation, and then divides it between juris-dictions, without regard to what prices unre-lated parties would set at arms length . In fact,studies have been done over the last 10-15years showing that in many cases you can'tfind a comparable price . The inevitable resultof that is that you do look at some sort o funified profit and loss figure and try to divid eit up.

We have heard a lot of criticism aboutideas like that — ideas that depart from th earms length standard. Certainly people arevery harsh in their criticism of the states' uni -tary taxation methods and many do not be-lieve that they provide an equitable or correctdivision of income. They often say that if youwant to know what the worldwide income of acompany is, you will be trying to compareapples and oranges . You would be trying tocompare income computed under U.S prin-ciples with income computed under foreignprinciples. Those problems are valid . On theother hand, they don't prove that that type of asystem, or a system that uses some sort of aproxy for investment or activity in order t odivide up a worldwide profit, is inferior to thearms length system we have now . Ultimatelythe taxpayers, Congress, and Treasury mayconclude that some such system would besuperior, because at some point in the future i tmay not be appropriate to ask for reams ofmaterial and to try and figure out this elusiv earms length price . It may be that a product isonly being traded between related parties

because that's the economically efficient thin gto do. If it was efficient to trade that good o rservice between unrelated parties, there mightactually be an arms length price that you coul dfind .

If you think about why something othe rthan the arms length prices ought not to beused, I think you have to ask yourself in th esame vein why, for example, interest paidbetween related parties is something thatshould clearly be deducted. Peter said all coun-tries have to worry about the problem of thincapitalization . If it's a payment of interest or apayment of royalties, it may be that the geo-graphical nexus of the income related to tha tpayment is sufficiently elusive or theoretica lthat something more concrete would be a mor eappropriate criterion to use. That goes to, forexample, the issue of why we have zero with -holding on interest and we do not have zerowithholding on dividends under our treatypolicy. Of course, interest is deductible anddividends are not.

There seems to be a premium being place don labels . I would think that would be produc-tive of the kind of complexity and splittin ghairs that may have given rise to criticisms ofthe complexity or the burdensomeness of ourtax system. Nevertheless, if we want to have atax system that uses those kinds of distinctionsto reach dollars and cents results, then we haveto be prepared to provide the IRS with the kindof information that is being called for under th eproposals .

Finally, there has been a lot of talk abou tstock gains taxes, and Peter has said Treasur yis definitely not in favor of the stock gains tax .Some of the people here before were not either .But, it also may be hard to distinguish wh ystock gains should not be taxed, whereas divi-dends must be taxed . I think there is a relation -ship between the two when there is a sufficien tlevel of control . It seems that if you own stockin a company that pays no dividends, the resultthat you should be taxed not at all, as opposedto the case where you hold stock that does pa ydividends and you are taxed, is the ultimatecase of bail-out that we used to be concerned

56

about when we had differential rates betweenordinary income and capital gains. There couldbe reasons not to tax gains in specific cases, an dyou will notice that the provision that was putforward in H.R. 4308 did not override treaties ,so it would leave the status quo in those caseswhere the United States and another countryhad together decided not to impose those taxes .But that is simply another example of the kind

of tax issues that must be faced if we're goin gto design a tax system that looks at distinction slike dividends, interest or gains, or looks a tthings like arms length prices between partie sthat do not have arms length relationships, i norder to determine the taxes that ought to bepaid .

57

International Investment

Richard Pratt

Richard Pratt, Economic Counsellor for the Embassy of Great Britain ,expresses his amazement at the degree of self-doubt and lack of confidence inits economy displayed by the U.S. The advance of European countries and ofjapan is a U.S. policy success, not a failure.

Mr. Pratt applies this same thinking to the area of foreign investment. Heexplains that the U.S. is the biggest foreign investor in the U.K., and of all U.S .investment in the European Community, the U.K. takes in approximately 40percent. just as the U.K. welcomes American investors, so too they welcom ethe influx of Japanese talent and production facilities, particularly in th eautomobile industry .

Mr. Pratt finds it strange that the U.S. would consider reducing the returnon capital to foreigners investment with a stock gains tax at a time when i tso dearly needs foreign capital. Moreover, he cites the U.S. tendency toconsider the possibility of overriding an existing treaty to be very troublingfor our trading partners.

He also shares how the U.K. deals with the transfer pricing problem . Theysimply assume that companies are manipulating these numbers and go inand make adjustments to their transfer prices to compute .

Let me begin by making the point that theambivalent attitude about foreign investmen tthat we see in the U .S. seems to me to be partlybased on what is, to British eyes at least, a quit eastonishing and completely unjustified lack o fconfidence in the American economy by poli-cymakers here in Washington .

It is a degree of self-doubt, which one seesin newspapers, and it is apparent from hear-ings in Congress . It is based particularly on acomparison between the American and Japa-nese economies, but also on comparisons be-tween the American economic performanceand the European performance. It is unjusti-fied because when you look at the UnitedStates from Europe, you see the largest andmost powerful economy the world has eve rseen. You see American workers — still themost productive in the world — way ahead ofthe European and streets ahead of the Japanes e(when you take the analysis on the basis o foutput per hour across the whole economy) .

The U.S. is the only country capable of mount -ing the operation we see in the Gulf . OtherEuropean countries and the Japanese are clearlygaining ground in the sense that they are be -coming richer, and thus the gap between th eU.S. and the other countries is perhaps nar-rowing. Moreover, the proportion of the worldeconomy that is made up of the Americaneconomy is perhaps declining from say, 40percent after the end of World War II, to 3 0percent now. However, the advance of Euro-pean countries and of Japan represents a suc-cess for U.S. policy and not a failure . The resto -ration of those economies was what the origi-nal Marshall Plan was all about .

These factors reinforce my view that it i sastonishing to see a lack of self-confidenceabout the U .S. economy here in Washington .What is particularly serious is that, in my per-ception, it leads to an uneasiness about theextent of foreign investment from your friend sand allies .

58

I would regard the doubts about foreigninvestment, of course, as being quite unjusti-fied too. As many others have been speakingabout this all day, I won't go through all thepoints I had intended to make. I will, however,just emphasize that we in Britain benefit fromsubstantial foreign investment . The U.S. is thelargest foreign investor in the U.K., and wereceive something like 40 percent of all U.S .investments into the European community .We also take about the same figure of Japaneseinvestments into the European community ;about 40 percent comes into the U.K. By andlarge, I think we welcome that investment .There have been a number of examples ofgreenfield sites opened ; new plants operatedby the Japanese, Americans and others whereproductivity levels, for example in auto manu-facturing, have attained world standard .

Some people in Britain began to think tha twe had become incapable of producing massvolume automobiles. Our auto industry hadsuffered a decline over many years . Japanesecompanies have come to the U .K. with newinvestment, new know-how, new managers .The result is that we have shown we can pro-duce cars competitively . Similarly in electron-ics, we saw our television industry decimatedin the 1960s and 1970s by foreign competition .Now the U.K. is once again a net exporter ofcolor televisions. Japanese investors have comein and built new plants . They have broughtnew management techniques and new invest-ments. They have created a large number o fjobs and a new exporting industry .

We therefore see foreign investment as amajor advantage for us. We find it difficult tosee why there is so much ambivalence about i there in the U.S .

One further point I would make abou tforeign investment is that it increases the tie sbetween our economies . This seems to me to behealthier as it makes us far more dependent oneach other and forces us to look to each other' sinterests . Along with the increasing uneasi-ness about foreign investment, we have seenincreasing concern in the U.S. about whetheror not foreigners are paying their fair share of

tax. For some, the response has been to urge anincrease in tax paid by foreign investors .

Of course, all companies, domestic an dforeign, should pay their fair share of tax . But

I think it fair to point out that the U.S. has acontinuing need for inward flows of foreign

capital as a result of the continuing trade defi-

cit. It seems to be an odd response to thatposition for the U.S. to want to decrease thereturn on that foreign investment by imposinga new level of tax, such as a capital gains tax o ncertain foreign-owned assets, as has recentl ybeen proposed . It seems odd for a country thatneeds a continuing flow of foreign capital to tryand reduce the return on that capital.

Perhaps in the end the U .S. is in the sam e

position as all the rest of us in wanting t o

borrow money but not wanting to pay the full

interest on it !This concern about the tax paid by foreign

investors is perhaps also reflected in the differ -ent attitudes toward the international tax struc-ture and to tax treaties. The U .S. clearly sees theneed to negotiate treaties with other countries .However, when a treaty doesn't work out aswas originally expected by the U.S., then wesometimes see moves to act unilaterally t ochange that treaty to the benefit of the U.S .

Let me demonstrate how this looks to aforeigner by giving you an example from ourown experience. In the U.K. we have a systemfor avoiding double taxation of dividends . Thisinvolves the payment of tax credits to share-holders when they receive their dividends fro mthe companies in which they hold their stocks .When we negotiate tax treaties with countrieswith similar systems, we usually negotiate tha tthe tax credits should be paid to stockholdersfrom that country as well . The U.S. is the onlycountry which doesn't have a similar systembut to whom we pay the tax credit anyway .

Now, why do we do this? Some peopl emay argue that Congressman Crane may haveone answer — because we are jerks. Perhaps itis just because we like the United States somuch. But whatever the reason, my point isthat over the time since we concluded theU.K./U.S. treaty, some analyses have suggested

59

International Investmen t

that the balance of flows of revenue betweenthe U.K. and the U.S. have been very much tothe advantage of the U.S. Despite this, you donot see in the British Parliament a move unilat-erally to override the treaty.

This self restraint causes us to be mostupset when we see proposals in the U .S. to alterthose elements of tax treaties which may not,on their own, work in the favor of the U.S.Other speakers have mentioned earlier bothearnings stripping and unitary taxation . Letme just make a small point about both of those .

The U.K. /U.S. tax treaty is quite clearabout how to deal with earnings stripping.There is a specific provision in the treaty. It isbroadly speaking as Peter Barnes described it .The U.K. deals with earnings stripping pre-cisely in line with that provision . By contrast,the original proposals put forward by the U.S.Congress last year to deal with the problem o fthin capitalization were not consistent with thetreaty. The proposal was quite different . Itmight have been a better way; it might havebeen worse; but it was different from tha twhich we had already agreed in the tax treatyas the way to deal with the problem. The issueis not whether the U .S. Congress had found abetter way or not found a better way. The issuewas and is : Has the United States the rightunilaterally to change the system which wasbuilt into an agreement that both sides reached ?

The answer is quite clearly "No." In theevent, the outcome of the debate about earn-ings stripping last year left it open to the Treas-ury in regulations to produce a system whic hwas consistent with our treaty . Of course wehope they will do so .

The same issue arises with respect t ounitary taxation . It is true that if the entireworld operated a unitary taxation system; ifeverybody had the same formula for decidingwhat profits were attributable to their country;if every country and taxing authority had th esame rules to determine what was income andwhat was deductible, and if every country inthe world had the same accounting standards ;yes, a unitary system might well be made t owork. But a unitary tax regime is not what the

tax treaties assume . The tax treaties assume a narms length system for attributing profits be-tween different jurisdictions . So, when Harri-son Cohen said that it is open to the U .S .Congress and legislators to consider that th earms length method for allocating income ma ybe the wrong way and that another way ismore appropriate, that is all very well . But it isvital to remember that there are other partiesinvolved. These are the foreign treaty partnerswho have all signed tax treaties with the U .S.on the assumption that the arms length systemis the internationally agreed regime . They haveto agree before any change is made .

So, I come back to my point which is thatone does see a tendency to feel in the U .S. thatwhere a tax treaty does not operate in the wayin which it was originally intended, that theright thing to do is take action unilaterally .

I think that I will just go on to say thatsome aspect of this results from the U .S.Constitution, and in particular the leading rol eof the House of Representatives in raising taxes;the leading role of the Senate in ratifying trea -ties; and the role of the Administration innegotiating treaties. It would be impertinentfor me to comment on that . Nevertheless, we asforeigners, tend to get left in the middle . Wecertainly do not regard the U.S. Constitution asjustifying any departure by the U.S. from itsobligations under international law.

Let me just comment on a point that wasmade earlier and then I will come to an end . Wediscussed the allegations of tax cheating byforeign-owned companies. Although the Brit-ish government doesn't accept that the statis-tics submitted to the Oversight Subcommitteedemonstrate that there is widespread tax cheat -ing by foreign-owned companies, I think wewould be stupid to pretend that manipulatio nof transfer pricing does not go on. That is whyin Britain we have staff in the Inland Revenu ewhose sole job is to adjust transfer pricing ofmultinational companies to avoid exactly thiskind of manipulation .

I don't think we do ourselves a favor bysaying that this manipulative activity doesn' tgo on. It clearly does . What I think we ought to

60

do though is accept, and we in Britain hav etaken this view, that if there are multinationa lcompanies that are cheating the U.S., thechances are that they are cheating the U .K. too .So, if we are going to go after them, let's go afterthem together . That is why the British Chancel-lor of the Exchequer has proposed an interna-tional study by the tax authorities of differen tcountries — the authorities that can alread yexchange detailed, confidential tax informa-tion — to determine the cause and extent of ta xavoidance, and then, to find the right way t odeal with it. This multilateral approach seemsto me the right way of dealing with this issueand far more effective than unilateral action byany one country.

Let me end by returning to my first poin twhich is that the ambivalence toward the taxpractices of foreign companies and indeedtoward foreign investment seem to result froma lack of self-confidence in the U .S. economy. Itis odd for a Briton to have to say this to a U.S .audience. But I do urge you to cast aside thislack of self-confidence and accept that this i sthe most powerful economy in the world. Youhave no need to fear foreign investment fromus or indeed from any other country .

61

International Investment

Appendix 1

Chart 1 : FDI Flows to the United State s1976-1990

.11111111111 11978 1980

1982

1984

1986

1988

19901979

1981

1983

1985

1987

198 91990 is projected from 1st half figure s

1976 1977

80

70

60

50

40

30

20

1 0

0

62

Chart2Measures of FDI in the United States

Relative to the US Economy

FDI Stock as a Percentage of the Total

14.7%Net Worth of Non Financial Corporations (1989 )

Assets of Foreign-Controlled Manufacturin gAffiliates as a Percentage of all Asset sof Manufacturing Corporations in the US (1988 )

Sales of Foreign-Controlled ManufacturingAffiliates as a Percentage of all Salesof Manufacturing Corporations in the US (1988 )

Employment of Foreign-Controlled Affiliates

4 .1 %as a Percentage of all US Employment

(1988)

Employment of Foreign-Controlled Manufacturing

8.5%Affiliates as a Percentage of all USManufacturing Employment

(1988)

Value-Added by Foreign-Controlled Affiliates as

3.4%a Percentage of US GNP

(1987)

Note: parantheses indicate the latest year for which base data ar eavailable

Source : E. M . Graham and P. R . Krugman, Foreign Direct Investment i nthe United States, 2nd edition (forthcoming) ; from BEA andCensus Bureau base data

14.7%

12 .2%

63

International Investment

Appendix 2

Tax Foundation SeminarSeptember 25 . 1990

The Competitive Burden :Taxation of U .S. Multinationals

Arthur Young Study Results : Update

Tax reform in Germany, Japan and the Netherlands have resulted i n

many changes. The fundamental answers provided in the study, however ,

remain the same except for the following changes in Germany and Japan.

In the row "Home Country Recognition of Foreign Losses" under th e

column Germany, this should no longer include subsidiaries . In the row

"Overall v . per Country Limitation", under the column "Japan", there is a

per country limitation on the use of foreign tax credits resulting from a ta x

rate in excess of 50% .

Raymond HaasSeptember, 1990

64

THE COMPETITIVE BURDE NTAXATION OF U .S . MULTINATIONALS

ITEM U .S . THE NETHERLANDS

EXEMPTION ORDEFERRAL OF HOME COUNTRY TAX

Exemption of Foreign Busines sPresence Income from Home CountryTax No

(with minor Yesexceptions forForeign Sale sCorporations an dpossessionsoperations )

Inclusion of Foreign Operating

Income, or Dividends fro mControlled Foreign Subsidiaries ,

in Home Country Tax Base Yes No

Loan by Foreign Subsidiary toParent Without Home Country Tax No Ye s

Current Home Country Taxationof "Tainted" Non-Repatriate d

Foreign Subsidiary Earnings Yes No

Home Country Recognitionof Foreign Losses Yes, for branches ; Yes, for branche s

no,

for subsidiaries no, for subsidiaries

JAPAN

GERMAN Y

Generally no (with

Yes, by treat ysignificant exceptions for most develope dfor certain income

and many developin gand exemptions under

countrie stax sparing treaties )

Yes (with certain

No, by treaty forexceptions noted

most developed andabove)

many developingcountries

Yes

Ye s

Yes (but less en-

Yes (but less en -

compassing rules

compassing rule s

than U .S .)

than U .S . )

Yes, for branches and Yes, for branche sdeveloping country

and subsidiarie ssubsidiarie s

ITEM

U .S .

THE NETHERLANDS

JAPAN

GERMANY

FOREIGN TAX CREDIT UTILIZATION

Overall v . per CountryLimitation

Overall, but with

Overall or pe r10 separate

country, * dependingcategories of

upon whether alimitations

treaty applies

Overall

Per country

Availability of Deemed Pai dForeign Tax Credit on Dividends

Yes

No (but not generally Yes

Ye snecessary )

Blending of Foreign Tax Rates o nDifferent Types of Income

No

Yes *

Yes

Ye s

TAX SPARING CREDI T

Tax Sparing Treaties

No

Yes

Yes

Yes

* Applies to Very Limited Categories of Income

Item

Switzerland

Italy

France

Belgium

Yes

Yes

EXEMPTION OR DEFERRA LOI HOME COUNTRY TAX

Exemption of ForeignBranch Incom efrom HomeCountry Tax

Exemption o fDividends fromControlled ForeignSubsidiaries inHome CountryTax Base

No, however possible

Yesexemption fromlocal income tax ,

Inclusion of40% of dividend sfrom foreignsubsidiaries

Either with reducedrate of incom etax or exemptio nunder most taxtreaties.

Yes with respect to90-95% ofdividends

Yes

Yes

Yes

No, generally ,for branches ;No, for subsid-iarie s

Yes

No

Yes

No

Yes, forbranches ;no, for subsid-iaries(may write dow ninvestment )

Loan by ForeignSubsidiary toParent withou tHome Country Tax

Current Home CountryTaxation of"Tainted" non-Repatriated ForeignSubsidiary Earnings

Home CountryRecognition ofForeign Losses

No, with exceptions

Nofor tax haven s

Yes for subsidiaries ;

Yes,forno for branches

branches ;no, for subsid-iaries

Item

Switzerland

Italy

France

Belgium

FOREIGN TAX CREDITUTILIZATION

Overall v . per

Per country and

Per country

Per country

Per country

Country Limitation

category to very

(but generally

and to limited

limited categories

not relevant)

categories of incom e

of income i fbased on tax treaty

Availability of Deemed

No (but not

No

No (but not

Yes, but limited to

Paid Foreign Tax Credit

generally

generally

non-permanent

on Dividends

necessary)

necessary)

participations

Blending of Foreign Tax

No

No

No

Yes

Rates on Different Typesof Income

TAX SPARING CREDI T

Tax Sparing Treaties

Yes

Yes

Yes

Yes

Item Australia(see notes)

Canada UK

EXEMPTION OR DEFERRALOF HOME COUNTRY TAX

Exemption of Foreign

No

No

NoBranch Incomefrom HomeCountry Tax

No

Yes for dividends,

Nopaid out ofactive businessincome in treatycountries; Nootherwis e

Yes (but less

Yes (but less encompassin gencompassing

than U.S. )than U.S . )

Yes, for

Yes, for somebranches ; generally

branches ; no, forno for subsid-

other branches an diaries

all subsidiaries .

Notes re: Australi a• Proposed CFC rules from 7/1/90 .• Income of CFC in designated countries subject to attribution (excluding dividends )• Other foreign source income, including branch income, exempt from tax .

Exemption ofDividends fromControlled ForeignSubsidiaries in Hom eCountry Tax Base

Loan by ForeignSubsidiary toParent withou tHome Country Tax

Yes YesYes ,

Current Home CountryTaxation of"Tainted" non-Repatriated ForeignSubsidiary Earning s

Home CountryRecognition ofForeign Losses

No

Yes, fo rbranches ; no ,for subsidiaries

Item

Australia

Canada

UK

FOREIGN TAX CREDITUTILIZATION

Overall v. perCountry Limitation

Overall Per country Per sourc e

Availability of Deeme dPaid Foreign Tax Crediton Dividends

Yes, for taxabl edividendsgenerally exemptfrom tax base

Yes Yes

Yes, withsome limit s

YesBlending of Foreign TaxRates on Different Type sof Incom e

TAX SPARING CREDIT

Technically, no ;effectively, yes ,through use of firs ttier holding companie s

Tax Sparing Treaties Provisions for ,but no effectivetreaties yet .

Yes Yes

EXAMPLE 1 : HOME COUNTRY TAX CONSEQUENCESFOR DIVIDENDS RECEIVED FROM SUBSIDIARY WIT H

SINGAPORE TAX HOLIDAY

HOME COUNTRY CONSEQUENCE S

U.S .

JAPAN GERMANY NETHERLAND S

A. Dividend

$1,000,000 $1,000,000

$1,000,000

$1,000,000

B. Statutory TaxRate

34% 1

56%2

50%1

35 %

C. Tax Liability

$340,000

$510,000

03

03

D. Foreign TaxCredit 0 (320,000)

E. Tax Payable

$340,000

$190,000 0 0

1 Excludes state/municipal taxes

2 Includes local enterprise tax

3 Effectively exempted

71

Fact:

EXAMPLE 2: ILLUSTRATIADOUBLE TAXATION OF FOREIGN EARNING S

OF U.S. MULTINATIONALS AFTER 1986 TAX REFORM

Multinational has a 100%-owned foreign subsidiary and a 49%-owned foreign corporation which all engage in the sam etype of business operation .

P&L StatementDomesti cOperations

Foreign

100% Foreig nTotal

Subsidiary

49% U.S .Owned Foreig nCorporation

Gross IncomeInterest expenseProfits before tax

Tax 53%15%Combined -34% rat e

Dividendreceived by MNC

$ 4,000 $ 2,000 $

2,000(2,000) (1,000) (1,000)2,000 $ 2,000 1,000 1,000

(530 )SEE BELOW 5150 )

(680 )

;1,320 $ 470 $

8.50

ANTICIPATED TAX CONSEQUENCES _ACTUAL TAX CONSEQUENCE S

Grossed-up Foreign income $

2,000 Grossed up Foreign Income

$ 2,000Domestic Income (less expenses) 2 .000 Domestic Income (less expenses) 2 .00 0Total Income MNC 4,000 Total Income MNC 4,000Tax at 34% X .34 Tax at 34% x .34Domestic Tax Liability 1,360 Domestic Tax Liability 1,360Less Anticipated Foreign Tax Credit (680) Less Foreign Tax Credit (see attached) (320)Anticipated U.S . Tax Liability 680 Residual U.S. tax liability 1,040Plus foreign tax paid gill Plus foreign tax paid 68 QAnticipated Total Tax Liability $

1,360 Total Tax Liability

$ 1,720

Double Tax Liability

$

360 = 18% of foreig nincom e

EXAMPLE 2: U.S . DOUBLE TAXATION AFTER 1986 TAX REFORM(FOREIGN TAX CREDIT CALCULATION )

Fact: Multinational has a 100%-owned foreign subsidiary and a 49% -owned foreign corporation which all engage in the same type ofbusiness operation.

Foreign tax credit limitation - U .S . system now contains two significant feature sthat create double taxation: extensive apportionment of parent company's interestexpense to repatriated foreign operating profits and separate foreign tax credi tlimitations for different "baskets" of income (e .g. non-controlled foreigncorporation and controlled foreign subsidiaries . )

Assumed facts for interest apportionment : assets of multinational corporationitself.

Home country assets

$ 20,000Equity in foreign subsidiary

10,000Equity in uncontrolled foreign corporation 10.000

TOTAL ASSETS

$40,000

NOTE: This results in 50% of interest expense incurred in domestic operation sbeing apportioned against foreign source income .

UNITED STATES

Controlledforeignsubsidiary

Uncontrolledforeignsubsidiary

1 . Foreign Tax Credit Available $

530 $ 150

2. Limitation on foreign tax credit 170 1701,000 - r2 .000 (10 .000/40.000)1 x 1 .360

4,000

3. Foreign Tax Credit (Lesser of 1 and 2) 1~Q 150

\4. Total Foreign Tax Credit Allowed $320

73

International Investment

Appendix 3

Table 1

Net Income and U.S. Tax Liability forForeign Controlled Domestic Corporatiwi .

(Billions of dollars )

1983 1224 1985 1986

Net income

Net income for firmswith income 12.4 15 .4 14.5 12.7 19 . 8

Net deficit for firmswith deficit -10.6 -13.8 -ii .5 -14.3 -14 . 2

Combined net incomeless deficits 1 .8 4.5 3.0 -1.5 5 . 6

Net U.S. tax liability 3 .4 4.5 3.6 3.0 4.2

Vote: detail does not add to total because of rounding.

74

Table 2

Selected Information o nForeign Controlled Domestic Corporation s••

3vb t]1.

by Major Industry Group, 1987

(Dollars amounts in billions)

Industry Nu nber of Returns

TotalAssets

tt,:etWorth

TotalReceipts

Agriculture 1,103 2.1 0.8 1 .2

Mining 1,657 343 19 .2 11.9

Construction 1,013 4.6 0.8 6 .2

Manufacturing

Transportation ,Communications &

4,155 369.5 146.2 265 . 6

Utilities

Wholesale & Retail

1,117 14.7 4.3 15 . 1

Trade

Finance, Insurance,

16,464 130.5 29.1 305.2

& Real Estate 12,399 370.5 46.7 61 .3

Services 6,832 32.5 8.5 19 .8

Total

Combined total ofManufacturing ; Trade;and Finance,Insurance, and

44,862 959.4 255.5 686.8

Real Estate 33,018 870.8 222.0 632. 1

Percent of total 73.6% 90.8% 86 .9% 92.0%

75

International Investment

Table 4

Comparison of .Foreign Ccontr olled Domestic Corporationswith All Other Corporations using Net Incom e

1983 1984 1986, , 1987

Percent of tax returnsreporting positive net incom e

FCDCs 40.6% 40.9% 43.3% 39.0% 41.2%

AOCs 58.6% 5&8% 58.1% 58.4% 573%

Net income less deficitsin billions of dollars

FCDCs 1 .8 4.5 ? .0 -1 .5 5 . 6

AOCs 181 .4 221 .5 229.5 262.8 298.5

Net income less deficitsas a percent of tota lassets

FCDCs 0.3% 0.8% 0.5% -0 .2% 0.6 %

AOCs 1 .9% 2.1% 1 .9% 2.0% 2.1 %

Net income less deficitsas a percent of net worth

1.3% 2.9% 1.7% -0.7% 2.2%FCDCs

AOCs 7.3% 8.2% ? 4% 7.7% 8.4%

76

Table 5

Comparison of Effective Income Tax Rates usin gNet Worth and Total Assets '

1983-87

1983. 1984 1985 1986 1987 Average

Effective U.S. Tax Rate

Total assetsFCDC 0.6 0.8 0 .5 0.4 0.4

0 .5

AOC 0.5 0.6 0.5 0.5 0.5

0 .5

Net worth

FCDC 2.5 2.9 2.0 1 .4 1.6

2.1

AOC 2.0 2.2 1 .9 2.] 2.1

2 . 1

Effective World-wide Tax Rate

1 .0 0 .7 0.5 0.5

0 . 7

Total asset sFCDC 0 .8

AOC 0.7 0.8 0.7 0.7 0.7

0 .7

Net worthFCDC 3.0 3.4 2.4 1 .6 1 .9

2.6

AOC 2.7 3.0 2.7 2.7 2.7

2.8

'The effective world-wide tax rate computation assumes thai reported foreign tax credit sclaimed are equal to foreign taxes paid. To the extent firms are in an excess credit positio nthe world-wide effective tax rate may be understated.

77

International Investment

Table 9

Comparison of Foreign Controlled Domestic Corporationswith MI Other Corporations by Major Industry Grou p

using Cost of Goods as a Fraction of Total Receipt s

1983 1984 198 .S' , 1986 1 05,21

Manufacturin gFCDC .627 .620 .627 .644 .649AOC .659 .650 .635 .618 .64 5

Wholesale & Retai lTrade

FCDC .860 .850 .848 .830 '2 A.v.)

AOC .761 .753 .745 .735 .

Finance, Insurance, an dReal Estat e

FCDC .331 .381 .283 .337 .366AOC .186 .200 .198 .231 .29 1

TotalFCDC .696 .699 .696 .683 .70 1AOC .597 .587 .571 .556 .563

78

MTax Foundatio n

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