Presentation to President’s
Advisory Panel on
Federal Tax Reform
International Provisions of the
Internal Revenue Code
March 31, 2005
Willard Taylor
NY12529:385927.2
Outward and Inward Investment

In teaching international tax, it is common
to deal separately with “outward” and
“inward” investment – that is, investment
from and investment into the US
 Export income (e.g., the DISC, FSC, ETI and
domestic production rules) is generally
thought of as a third category

Most of the debate – and complaints –
relate to outward investment
NY12529:385927.2
2
What’s different?

Witnesses on other subjects have spoken
about the complexity and other problems of
the Code

What’s different in the case of “outward”
investment from the US?
NY12529:385927.2
3
What’s different? – cont’d

First, the growth of international trade and
investment have made the US tax rules
much more important than when they took
shape in 1962

NY12529:385927.2
A creditor nation and a modest exporter of
capital in 1962, the US is now a large capital
exporter and importer and also the world’s
largest debtor nation
4
What’s different? – cont’d

*
Second, the different rhetoric and values
that drive the debate on the taxation of
foreign income

Not about fairness to US individuals and
domestic economic efficiency, but

rightly or wrongly, framed as a choice
between “capital export” and “capital
import”
neutrality*
(and
sometimes
“national neutrality”**)
Essentially, which country (residence or source) has the first claim to tax
** Foreign taxes treated as an operating expense, not a tax credit
NY12529:385927.2
5
What’s different? – cont’d

NY12529:385927.2
Third, the probable inability to achieve the
goal of any system for taxing foreign
income without some international consensus on the choice and on rates of tax, at
least among major trading partners
6
What’s different? – cont’d

The capital export/import neutrality debate


Invokes issues of national competitiveness
and world economic welfare
There are other systems in the world for
taxing foreign income  such as a
“territorial” (or exemption) system

NY12529:385927.2
In a pure territorial or exemption system,
foreign income of domestic taxpayers is
simply not taxed and no foreign tax credit
is allowed
7
What’s different? – cont’d

But choosing a different system would not
NY12529:385927.2

solve the complexity and other problems
discussed hereafter or

significantly
debate
change
the
terms
of
the
8
Where are we today?

General agreement that the inability to resolve
competing arguments has resulted in a system for
taxing the foreign income of US taxpayers that is*






not “effective” or “administrable”
“complex, easily avoided by the well advised and a
trap for the poorly advised”
“schizophrenia in the tax system” with “rules that
lack coherence and often work at cross purposes”
“absurd [in its] level of complexity”
a “jerry-rigged system”, and/or
“a cumbersome creation of stupefying complexity”
*In the words of practitioners and academics
NY12529:385927.2
9
Where are we today? – cont’d

NY12529:385927.2
Remarkably, no consensus on the economic
consequences of what we now have –

Does it or does it not make US-owned
businesses less competitive than foreignowned businesses?

Hard to believe that the present complexity
does not make US business less competitive
than it could be in the absence of the
complexity
10
Evolution of Code provisions on “outward”
investment
How did we get to where we are?
 Started in 1954 with a system that, broadly




deferred taxing earnings of US-owned
foreign subsidiaries until repatriated
allowed a foreign tax credit for foreign
income taxes on foreign income, but not in
excess of the US tax on that income
A progression, from 1962 through 2004, of
ever more complicated limitations on


NY12529:385927.2
the deferral of tax, and
the foreign tax credit
11
Evolution of Code provisions on “outward”
investment – cont’d

Because of a concern that the 1954 Code
unfairly favored foreign investment by US
persons over domestic investment,
NY12529:385927.2

The 1962 Act limited the deferral of US tax
on un-repatriated earnings of foreign
subsidiaries

These limitations were expanded in the
1975, 1976 and 1986 Acts
12
Evolution of Code provisions on “outward”
investment – cont’d

Because of a concern that the foreign tax
credit permitted the use of foreign taxes on
one class of income against US tax on
another,
NY12529:385927.2

The 1962 Act created a separate foreign tax
credit “basket” for passive interest income
– taxes on income in that basket could not
be used against US tax on other income

More “baskets” were added in the 1975,
1976, 1984 and 1986 Acts
13
Evolution of Code provisions on “outward”
investment – cont’d

Since the foreign tax credit is limited to the
US tax on foreign source taxable income,
the foreign tax credit rules require an
allocation of expenses

NY12529:385927.2
Including, with modifications
interest
expense
incurred
corporations
in 2004,
by
US
14
Evolution of Code provisions on “outward”
investment – Sources of complexity

What were the sources of complexity resulting
from the limitation on deferral?

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Income of foreign subsidiaries that was not
eligible for deferral had to be put in categories

Foreign personal holding company income – 1962

Foreign base company sales and services income – 1962

Income from insurance – 1962, 1986 and 1988

Oil related income – 1975

Shipping and aircraft income – 1975

Sales of property that did not produce active income –
1986

Income from commodities transactions – 1986

Income from foreign currency transactions – 1986

Income from a banking or similar business – 1986
15
Evolution of Code provisions on “outward”
investment – Sources of complexity – cont’d

What were the sources of complexity
resulting from the limitation on deferral?

NY12529:385927.2
Host of special rules for

Business rents and royalties

Income from sales or services outside of
the foreign subsidiary’s country of
incorporation

In-country related party
interest, rents and royalties

Income from notional principal contracts
dividends,
16
Evolution of Code provisions on “outward”
investment – Sources of complexity – cont’d

What were the sources of complexity in the
foreign tax credit changes?

Growth in separate “baskets”








NY12529:385927.2
Passive interest income – 1962
Some dividend income – 1984
Foreign oil related income – 1975
All passive income – 1986
High withholding tax interest – 1986
Financial services income – 1986
Shipping and aircraft income – 1986
Dividends from certain non-controlled
corporations – 1986
foreign
17
Evolution of Code provisions on “outward”
investment – Sources of complexity – cont’d

What were the sources of complexity in the
foreign tax credit changes?

NY12529:385927.2
In the “basket” system

The need to identify taxes on specific types of income

To separately allocate expenses to that income

To do this for taxes paid and expenses incurred
through tiers of entities

To relate these calculations to income eligible/not
eligible for deferral
18
Evolution of Code provisions on “outward”
investment – Other provisions

Focusing on the foreign tax credit and the antideferral rules should not diminish the importance
of other legislative changes in the last 50-plus
years – rules for
NY12529:385927.2

International boycotts – 1976

Cross-border mergers and acquisitions – principally,
1976

“Stapled” entities – 1984

Related party factoring income – 1984

“Passive foreign investment companies” – 1986

“Functional currency” and foreign exchange gain or loss
– 1986

Related party transfers of intangibles – 1986

“Dual consolidated losses” – 1986
19
Evolution of Code provisions on “outward”
investment – Regulations, etc.

In evaluating what has happened since
1962, need also to grasp that
NY12529:385927.2

Many statutory changes have since enactment been further amended – in some
cases, reversing the original legislative
solution

Many of the statutory changes were
followed by pages and pages of explanatory
IRS regulations

The IRS on its own has issued significant
regulations affecting outward investment
20
Other developments – the check-the-box
regulations

One specific set of regulations deserves a
comment -- the check-the-box regulations
Provided the ability, for 1997 and later
years, to choose whether an entity would
for tax purposes be a corporation, a branch
or a partnership
 A revolution for foreign operations of US
taxpayers



*
Simplified the task of reporting foreign
income, but
Allowed the use of “hybrid”* branches to
undercut the anti-deferral rules
An entity treated as a corporation for purposes of the foreign country’s tax law but not
for US tax purposes
NY12529:385927.2
21
Evolution of Code provisions on “outward”
American investment – Jobs Creation Act of 2004

What ultimately became the American Jobs
Creation Act of 2004 had the articulated
objectives of simplification and rolling back
some of the anti-deferral rules



Some simplification but more than offset by
the complexity of other newly-enacted
rules
Did not even begin the process of
addressing broad simplification or the
development of coherent rules
Dropped the ball on


NY12529:385927.2
corporate expatriations
“earnings stripping” --- the deductibility of
interest paid to related foreign persons
22
“Inward” Investment
NY12529:385927.2
Evolution of Code provisions on “inward”
investment

Rules on “inward” investment – i.e., US investment by foreign persons
NY12529:385927.2

Big change in US position since 1954 – now a
major importer of capital and the world’s
largest debtor nation

Inward investment rules

Do not reflect the debate on capital import/export
neutrality

Generally, lack a political constituency for reform

Have remained more constant than the outward
investment rules, taking (again) the 1954 Code as a
starting point
24
Evolution of Code provisions on “inward”
investment – cont’d

In 1954, and for many years prior thereto, the
rules for taxing inward investment consisted of
NY12529:385927.2

A flat 30% tax, collected by withholding at
source, on US “source” dividends, interest,
royalties and like income of a foreign person
that did not otherwise carry on business in the
US

Tax at the regular individual or corporate rate
on the US business income of foreign persons –
that is, on income that was “effectively
connected” with a US business
25
Evolution of Code provisions on “inward”
investment – cont’d

There was (and is) the rule that requires
taxable income from transactions between
commonly-controlled corporations to reflect
arm’s length dealings*


*
Of great importance, because “inward” investment typically is through foreign-owned US
subsidiaries
Apart from the statutory “earnings stripping”
rules, arm’s length pricing is the main rule that
protects the US tax base from mispricing
between US subsidiaries and their foreign
affiliates
Section 482 of the Code
NY12529:385927.2
26
“Inward” investment – What are the
problems? – cont’d

What are the problems in the US taxation of
inward investment?

Complexity – although possibly not to the
same extent as for outward investment

Specific rules that are neither administrable
nor, as a practical matter, are in fact
administered

NY12529:385927.2
Other rules that are out of date – e.g., they
turn on physical presence in the US and the
“source” of income
27
Conclusions
NY12529:385927.2
Are there solutions?

What are the issues with the way the Code and
regulations have evolved?


General agreement that the subpart F and
foreign tax credit rules are “stupefying” in their
complexity and not administrable – the same
could be said about some of the inward
investment rules
No easy solution


NY12529:385927.2
Changing to a territorial or exemption system would
neither simplify nor fundamentally change the terms
of the debate
Nor are all of the 1962-2004 changes, however
complex, “bad” and it would therefore be a mistake
to simply go back to the 1954 Code
29
Are there solutions? – cont’d

Like the system we now have, a territorial
(or exemption) system would have to





NY12529:385927.2
Classify income as foreign or domestic
Distinguish between passive and active
business income
 Address
how passive (or non-exempt)
income will be treated (e.g., no deferral and
a foreign tax credit?)
Distinguish between partially and wholly-US
owned foreign corporations
Allocate expenses between foreign and
domestic, and passive and active business,
income
Enforce arm’s length pricing among affiliates
30
Are there solutions? – cont’d

A territorial system would also have to
NY12529:385927.2

Address
foreign
corporations
branches
of
US

Possibly distinguish between “good” and
bad” foreign tax systems (and systems that
are someplace in between)

Deal with the transition from the existing to
the new system (e.g., what happens to
untaxed retained earnings?)
31
Are there solutions? – cont’d


Simplification is not possible without

In the case of outward investment, a
serious compromise between proponents of
capital export and capital import neutrality

In the case of inward and outward
investment, a serious intent to simplify for
that reason alone
Need also to consider tax treaties and the
desirability of international consensus
NY12529:385927.2
32
Appendix 1
Evolution of Code provisions on
“outward” investment
NY12529:385927.2
Evolution of Code provisions on “outward”
investment

How did we get to where we are?

Historically, the US has


been a foreign tax credit country,

that deferred taxing foreign earnings of foreign
subsidiaries until repatriated, and

classified corporations as foreign or not on the basis
of where incorporated, not where managed or
controlled
Not the only model in the world, but neither was
the US model uncommon at the time
NY12529:385927.2
34
1954 Code

The 1954 Code rules on outward
investment allowed a foreign tax credit for
direct and “indirect”* foreign income taxes

*
Limited to the US tax on foreign source
income, calculated on a country-bycountry basis
Generally, a credit for foreign taxes paid by a foreign corporation on earnings
distributed to a 10% or greater US corporate shareholder
NY12529:385927.2
35
1954 Code – cont’d
Earnings of US-owned foreign corporations
were not taxed until repatriated*
 Further,
certain
branches
of
US
corporations could elect to be treated as
foreign corporations
 There was (and is) a general rule
that
taxable income from transactions between
commonly controlled corporations, whether
US or foreign, must reflect arm’s length
terms**

* Other than passive income of foreign personal holding companies
** In Section 482 of the Code
NY12529:385927.2
36
1954 Code – cont’d

“Special” provisions were essentially limited to
Western Hemisphere Trade, China Trade Act
and “possessions” corporations


In effect, subsidies for operations in specific
geographic areas
The basic rules had been unchanged for many
years

NY12529:385927.2
In origin, the rules did not respond to any
stated theoretical view – i.e., were not in
response
to
any
capital
export/import
neutrality debate
37
Evolution of Code provisions on “outward”
investment – the 1962 Act

The Kennedy Administration thought that
these rules unfairly favored foreign over US
investment

Sought in 1962 to end deferral for all of the
income of US-owned foreign corporations

NY12529:385927.2
Not pure “capital export neutrality” because
of exceptions – would have retained deferral
for earnings from less developed countries
and also in part for income of export trade
corporations
38
Evolution of Code provisions on “outward”
investment – the 1962 Act – cont’d

Got instead an end to deferral for so-called
“subpart F” income with back-up rules
which treated
NY12529:385927.2

untaxed earnings of a controlled foreign
corporation as repatriated if used to make
“investments in United States property”,
and

gain from the sale of stock of a controlled
foreign corporation as a dividend to the
extent attributable to retained earnings
39
Evolution of Code provisions on “outward”
investment – the 1962 Act – cont’d

Thus, a combination of capital export and
capital import neutrality
NY12529:385927.2

Set the framework for the debate in the
next 50-plus years about which system
was the “better” one

Also put the Code distinctly on the path
to complexity
40
Evolution of Code provisions on “outward”
investment – the 1962 Act – cont’d

What were the sources of complexity resulting
from the limitation on deferral?

NY12529:385927.2
Income of foreign subsidiaries that was not eligible
for deferral had to be put in categories –

Foreign personal holding company income

Foreign base company sales and services income

Income from insurance

Oil related income

Shipping and aircraft income

A host of special rules for

business rents and royalties

income from sales or services outside of the foreign
subsidiary’s country of incorporation

income from a banking, financing or similar business
41
Evolution of Code provisions on “outward”
investment – the 1962 Act – cont’d

The 1962 Act also introduced a separate
foreign tax credit “basket” for foreign taxes on
passive interest income

NY12529:385927.2
Idea was that the foreign tax credit
limitation – which limits the credit to the US
tax on foreign source taxable income –
ought to be applied separately to each
“basket” of income

so that taxes on one basket of income could not
be used to offset US tax on another basket of
income

or, colloquially, no “cross-crediting”
42
Evolution of Code provisions on “outward”
investment – the 1986 Act

What were the sources of complexity in the
1975-1986 tax legislation?

NY12529:385927.2
In the “basket” system,

the need to identify taxes on specific types of income

to separately allocate expenses to that income

to do this for taxes paid and expenses incurred
through tiers of entities

to relate these calculations to income eligible/not
eligible for deferral
43
Evolution of Code provisions on “outward”
investment – the 1986 Act – cont’d

What were the sources of complexity in the
1975-1986 tax legislation?

NY12529:385927.2
The further expansion of the categories of
subpart F income to include, e.g.,

A much broader class of insurance income

Banking, financing and similar income

Foreign oil related income

Commodities income

Shipping income

Foreign exchange gain
44
Evolution of Code provisions on “outward”
investment – the 1975 Act

In 1975, special foreign tax credit rules were
enacted for foreign oil and gas income – ultimately




Credits for taxes on “foreign oil and gas exploration
income” were limited to the US tax rate
Credits for taxes on “foreign oil related income”
were subject to a limitation that was comparable in
intent but different
“Recapture” if foreign oil and gas extraction losses
offset domestic income
Subpart F income expanded in 1975 to include


NY12529:385927.2
foreign base company oil related income
foreign base company shipping (including aircraft)
income
45
Evolution of Code provisions on “outward”
investment – the 1976 Act

The 1976 Act further tightened up what had
been started in 1962 – in 1976
NY12529:385927.2

No more deferral for earnings from less
developed countries

Recapture of foreign losses used to offset
domestic income

Capital gains rate differential taken into
account in the foreign tax credit limitation

Repeal of the per country calculation of the
limitation on foreign tax credit – henceforth,
a worldwide calculation
46
Evolution of Code provisions on “outward”
investment – the 1984 Act

The 1984 Act added
NY12529:385927.2

A new foreign tax credit “basket” for
certain dividend income

A rule to prevent US source income from
becoming foreign source when it was
received by a US-owned foreign corporation
and paid out to (or included in income by)
US persons
47
Evolution of Code provisions on “outward”
investment – the 1986 Act

To the separate “baskets” for interest, dividend
and foreign oil and gas income, the 1986 Act added
4 new baskets, in addition to an expanded “passive
income” basket

High withholding tax interest, financial services
income, shipping income and dividends from noncontrolled Section 902 corporations
 In many cases with sub-baskets – e.g., export
financing
income
was
excluded
from
high
withholding tax interest and high-taxed income from
passive income

NY12529:385927.2
The baskets were applied on a look-through basis
to dividends, interest and other income from
foreign subsidiaries
48
Evolution of Code provisions on “outward”
investment – the 1986 Act – cont’d

The 1986 Act also rewrote the rules for
determining foreign source taxable income,
and thus the allowable foreign tax credit


NY12529:385927.2
Required an allocation of domestically-incurred
interest expense to determine foreign source
taxable income

Dramatically affected the foreign tax credit limitation

The allocation reduced foreign source income by an
expense that was not deductible in the foreign
country
Provided statutory rules (replacing 1977
regulations) for the apportionment of R & D
expenses
49
Evolution of Code provisions on “outward”
investment – 1986 Act – cont’d


1986 Act expanded Subpart F to include income from

insurance outside of the foreign corporation’s country
of incorporation

sales of property that did not produce active income

commodities transactions

foreign currency transactions

a banking or similar business

shipping, even though reinvested
In 1988, the insurance rules were amended again to
apply subpart F to “related party insurance income”
of a foreign insurance company owned to the extent
of 25% or more by US shareholders
NY12529:385927.2
50
Evolution of Code provisions on “outward”
investment – Regulations

In evaluating what happened between
1962 and 1986, need to grasp that


NY12529:385927.2
Many of the statutory changes were followed
by pages and pages of explanatory IRS
regulations
Most of the statutory changes have since
enactment been further amended (with
exceptions,
special
rules
and
complex
definitions), in some cases on a regular basis
 A number of the statutory changes (e.g., the
treatment for subpart F purposes of income
from the conduct of a banking or similar
business) reversed, then reversed again, the
original legislative solution
51
Evolution of Code provisions on “outward”
investment – Regulations – cont’d

Apart from the statutory changes, the IRS
independently issued extensive regulations
on a number of major international
subjects, including, e.g.,
NY12529:385927.2

In 1991, the definition of a creditable
foreign income tax

The standards for arm’s length pricing – in
the ‘90s, the IRS embarked on a major and
on-going effort to cover specific situations,
such as transfers of tangible and intangible
property
52
Other developments – the check-the-box
regulations

For 1997 and later years, the classification of an
entity as a corporation, a branch or a partnership
became (under the check-the-box regulations)
largely elective

The check-the-box regulations


Were a simplification for domestic entities, but a
revolution for foreign operations of US taxpayers
The ability to elect to treat foreign entities as
branches or as partnerships has vastly simplified
the task of reporting foreign income, but

NY12529:385927.2
IRS had not thought through the implications of the
check-the-box regulations on foreign operations
53
Other developments – the check-the-box
regulations – cont’d

Elective classification permits

the use of “hybrid”* branches to eliminate foreign
tax


and thus replicate the low-taxed foreign income that
subpart F was directed at
The IRS sought to address “hybrid” entities in the
so-called hybrid branch payment rules, but
Congress objected and these have not been
adopted
*An entity treated as a corporation for purposes of the foreign country’s tax law but not for
US tax purposes
NY12529:385927.2
54
Other developments – the check-the-box
regulations – cont’d

The check-the-box regulations also permit
the separation of foreign taxes from the
underlying foreign income, either through


partnership allocations (which has been
addressed) and
the use of reverse “hybrid” entities*
* An entity treated as a corporation for US tax purposes but as transparent for
purposes of the foreign country’s tax law
NY12529:385927.2
55
Evolution of Code provisions on “outward”
investment – cont’d

To focus on the foreign tax credit and subpart F is
not to diminish the importance of other changes in
the last 50-plus years

The enactment in 1976 of the international boycott
rules


The repeated changes, beginning largely in 1976, to
the rules in Section 367


NY12529:385927.2
Apart from reporting, disallow credits and end
deferral and other benefits for income from boycott
operations
These govern the extent to which reorganizations and
exchanges that are tax-free if purely domestic will be
tax-free if a foreign corporation is involved
The 1984 enactment of Section 269B, relating to
foreign corporations whose ownership is “stapled”
to the ownership of a US corporation
56
Evolution of Code provisions on “outward”
investment – cont’d

The 1984 rules that treat income from related
party factoring as interest received from a
related party for subpart F and specified other
purposes

The enactment in 1986 of the “passive foreign
investment company” rules

impose penalty taxes on US shareholders of
broadly-defined “passive foreign investment
companies”

NY12529:385927.2
Co-existed until 2004 with foreign personal holding
company and foreign investment company rules
57
Evolution of Code provisions on “outward”
investment – cont’d
NY12529:385927.2

The 1986 enactment of rules that establish
a “functional currency” and thus foreign
exchange gain or loss for non-functional
currency transactions

The 1986 amendment which specified that
the income from a related-party transfer of
an intangible had to be “commensurate
with” the income from the intangible

The 1986 prohibition on the use of a “dual
consolidated loss” of a “dual resident
corporation” to reduce the income of other
members of a US consolidated group
58
Evolution of Code provisions on “outward”
investment – American Jobs Creation Act of 2004

What ultimately became the American Jobs
Creation Act of 2004 had the articulated objective
of “reforming” subpart F and foreign tax credit
rules – essentially targeting what had happened in
1986 and rolling back some capital export
neutrality rules

There was some simplification
 E.g., the elimination of some “baskets”, of the
foreign personal holding company and foreign
investment company rules

But that simplification was more than offset by the
complexity of other newly-enacted rules, such as
the new elective interest allocation rules
NY12529:385927.2
59
Evolution of Code provisions on “outward” investment – American Jobs Creation Act of 2004 – cont’d

The Act lacked balance and perspective –
did not comprehensively address, or even
begin the process of addressing, broad
simplification or the development of
coherent rules

The provisions of the Act
NY12529:385927.2

were mostly borrowed
inspired wish lists, and
from
industry-

what was ultimately included or not, and its
effective dates, responded to revenue
projections and the lobbies’ influence
60
Evolution of Code provisions on “outward” investment – American Jobs Creation Act of 2004 – cont’d

Dropped the ball on
NY12529:385927.2

the treatment of corporate inversions, and

whether the earnings stripping rules
needed revisions in order to achieve a
different balance between the treatment of
foreign and US-owned US corporations
61
Appendix 2
Inward Investment
NY12529:385927.2
Evolution of Code provisions on “inward”
investment

Rules on “inward” investment – i.e., US
investment by foreign persons
NY12529:385927.2

Do not involve the capital export/import
neutrality debate

Do not, with exceptions, have a political
constituency for reform

Have remained more constant than the
inward investment rules, taking (again) the
1954 Code as a starting point
63
Evolution of Code provisions on “inward”
investment – cont’d

In 1954, and for many years prior thereto,
the rules for taxing “inward” investment
consisted of
NY12529:385927.2

A flat 30% tax, collected by withholding at
source, on US “source” dividends, interest,
royalties and like income of a foreign
person that did not otherwise carry on
business in the US

Tax at the regular individual or corporate
rate on the US business income of foreign
persons – that is, on income that was
“effectively connected” with a US business
64
Evolution of Code provisions on “inward”
investment – cont’d

*
There was (and is) the rule that requires taxable
income from transactions between commonlycontrolled corporations to reflect arm’s length
dealings*

Of great importance, because “inward” investment
typically is through foreign-owned US subsidiaries

Apart from the statutory “earnings stripping” rules,
arm’s length pricing is the main rule that protects
the US tax base from mispricing between US
subsidiaries and their foreign affiliates
Section 482 of the Code
NY12529:385927.2
65
Evolution of Code provisions on “inward”
investment – cont’d

The principal changes in the treatment of “inward”
investment since 1954 have been

The 1966 enactment of rules which eliminated
uncertainties about the tax consequences of, and
thus encouraged, investment in US stocks,
securities and commodities

The 1980 imposition of tax at regular rates on gain
from a sale of an interest in US real estate

NY12529:385927.2
including an interest in a US corporation
predominantly invested in such assets – the so-called
“FIRPTA” tax
66
Evolution of Code provisions on “inward”
investment – cont’d

The imposition in 1984 of withholding by a
purchaser of US real property as a means of
collecting the FIRPTA tax

The 1984 repeal of the 30% withholding tax on
“portfolio” interest paid to unrelated foreign
investors,


reflects the importance of permitting US borrowers
to access foreign capital
The 1984 enactment of a statutory rule for
determining when a non-citizen is a US resident
and therefore subject to full US tax
NY12529:385927.2
67
Evolution of Code provisions on “inward”
investment – cont’d

The 1986 imposition of withholding tax on
a foreign partner’s share of partnership
income attributable to a US business

The 1986 enactment of “source” rules for
international communications and space
and ocean activity income

The 1987 enactment of a statutorily
mandated minimum rate of investment
return for foreign insurance companies
doing business in the US
NY12529:385927.2
68
Evolution of Code provisions on “inward”
investment – cont’d

The 1986 enactment of branch taxes
NY12529:385927.2

Repatriation of profits of a US branch
treated substantially as a dividend from a
US subsidiary

Interest paid by a branch treated
substantially as a payment of interest by a
US subsidiary
69
Evolution of Code provisions on “inward”
investment – cont’d

The 1986 revision to the rules for taxing
transportation income of foreign shipping
and airline companies

Limited
the
historical
“equivalent
exemption”
rule
to
publicly
traded
companies or companies locally owned

Imposed a 4% excise tax on the gross US
source transportation income of a company
not eligible for the exemption to the extent
the income is not taxable as income from a
US business
NY12529:385927.2
70
Evolution of Code provisions on “inward”
investment – cont’d

The 1989 enactment, and 1993 extension to
guaranteed debt, of the “earnings stripping
rules”


Disallow a current deduction for interest
paid to, or on debt guaranteed by, a related
foreign person that would otherwise reduce
taxable income by more than 50%
The 1993 enactment of anti-conduit rules
directed at avoidance of US withholding tax
through the use of tax treaty provisions
NY12529:385927.2
71
Evolution of Code provisions on “inward”
investment – cont’d

The 1996 enactment of rules on
expatriation of individual taxpayers

The 1997 enactment to deal with
withholding on interest, dividend and like
payments to “hybrid” entities
NY12529:385927.2
the
72
“Inward” investment – What are the
problems? – cont’d

What are the problems in the US taxation of inward
investment?

Complexity -- although possibly not to the same
extent as for outward investment
NY12529:385927.2

As in the case of outward investment, many of the
statutory amendments have been followed by
pages and pages of IRS regulations

Other complex regulations have been initiated
without legislative prompting -- e.g., those dealing
with

withholding at source on interest and dividends, and

with the taxation of US branches of foreign banks
73
“Inward” investment – What are the
problems? – cont’d

What are the problems?

Many of the rules are neither administrable nor, as
a practical matter, are in fact administered


NY12529:385927.2
E.g., the PFIC or FIRPTA rules
The rules for determining the taxability of
increasingly important items of income are out of
date – they turn on physical presence and “source”

For example, income from e-commerce and in some
cases from derivatives

Residence-based sourcing does not work in a world
with abundant tax havens
74
“Inward” investment – What are the
problems? – cont’d

Rules for determining arm’s length pricing
for services, intangibles and other items are
not working well

NY12529:385927.2
the so-called advance pricing agreement
program is not an answer
75
Appendix 3
DISCs, FSCs and Domestic
Production
NY12529:385927.2
The DISC regime was enacted in 1971 to
permit deferral of export-related income

US has a history of providing tax benefits for exports
NY12529:385927.2

1962 Act included special rules for “export trade
corporations” – whose qualification as such depended on
US manufacture or production

In 1971, went further and enacted the DISC (“Domestic
International Sales Corporation”) rules – a partial roll
back of the anti-deferral measures in the 1962 Act

A DISC is a U.S. corporation which devotes 95% of its
activities to exports, and

Usually a “paper” corporation through which its US parent
channels exports

Earnings not taxed until distributed

GATT countries objected to DISCs because the deferral of
domestic tax had the effect of an export subsidiary
77
In response to GATT objections, the US
enacted the FSC provisions in 1984

In 1984, deferral benefits of DISCS were ended –
an interest charge on deferred income

Enacted FSC (“Foreign Sales Corporation”)
provisions to respond to GATT rulings which
approved of tax exemptions for activities “abroad”


A foreign corporation owned by a U.S. exporter

Allowed to contract with a related U.S. entity to produce
all of its products, thus substantially skirting the
“abroad” requirement

”Rule of origin” required imported components to
contribute no more than 50% of the exports’ fair market
value
The WTO found the FSC regime to be an illegal
export subsidiary
NY12529:385927.2
78
ETI was U.S.’s response to the WTO ruling



In 2000, the ETI (“Extraterritorial Income”)
legislation repealed the FSC provisions and
exempted from tax qualifying foreign trade
income, which included

30% of foreign sales and leasing income

1.2% of foreign trading gross receipts

15% of foreign trade income
Like the FSC provision, ETI

Only exempted export income

Retained the 50% rule of origin
The WTO ruled the ETI regime to be illegal in 2002
NY12529:385927.2
79
American Jobs Creation Act of 2004

The American Jobs Creation Act of 2004
responded by phasing-out the ETI system
and phasing-in a reduced rate of tax for
income from qualified domestic production
NY12529:385927.2
80
Appendix 4
US income tax treaties
NY12529:385927.2
US income tax treaties


Treaties cut back on the reach of the Code by,
among other things

reducing the rates of US withholding tax on
dividends, interest, royalties and like items

using a more restrictive “permanent establishment”
test before business income is taxed

limiting the US tax on service income of individuals

providing rules for foreign taxes eligible for credit
Treaties also provide a process for resolving
conflicting tax claims between taxing authorities
NY12529:385927.2
82
US income tax treaties – cont’d

In 1954, the US had some 18 income tax treaties

There are now more than 60, and US negotiations
now generally begin with a “model” treaty

The spread of treaties can only be good, but US
treaties have also become a separate body of
knowledge
NY12529:385927.2

The terms differ materially, in part because entered
into at different times

Limitation-on-benefit articles, which vary from
treaty to treaty, are as complicated as any provision
of the Code
83
Appendix 5
Some possible simplifications
NY12529:385927.2
Simplifications?

Eliminate provisions which are out-of-date or
whose complexity cannot be justified, such as





NY12529:385927.2
Are foreign tax credit limitations on FOGEI and
FORI needed, given the subsequent regulatory
definition of creditable foreign taxes?
Would it be simpler to treat related party factoring
income as interest for all tax purposes?
Are the “anti-conduit” regulations needed now that
most US tax treaties have limitation on benefit
articles?
Can the reach of the PFIC rules be justified?
If “hybrid” entities erode subpart F, shouldn’t the
subpart F rules be revised to accept that? Or, if not,
the check-the-box regulations changed?
85
Simplifications – cont’d

Eliminate provisions which are out-of-date
complexity cannot be justified, including
NY12529:385927.2
or
whose

In light of the repeal of the withholding tax on “portfolio”
interest, do the compliance rules imposed on banks and
other intermediary holders of debt make sense?

If dividend flows can be replicated by derivatives, is there
any point in imposing withholding tax on “portfolio”
dividends?

In the case of a foreign and domestic corporation, do we
need the stapled entities rule in Section 269B?

Can the Section 367 regulations on corporate “inversions”
be eliminated now that Congress has addressed the subject
in Section 7874?

With changes in securities markets, is the bank loan
exception to the portfolio interest exemption still relevant?
86
Simplifications? – cont’d

Eliminate (or move elsewhere) provisions
whose purpose seems more driven by
ideology than sound tax policy
NY12529:385927.2

The FIRPTA tax on sales and dispositions of
US real property (and the related
withholding tax)

The international boycott participation and
related “bad” country rules

The rules relating to dual consolidated
losses of dual resident entities
87