U.S.’ Extraterritorial Tax Schemes

U.S.’ Extraterritorial Tax Schemes By Danwe & Ryan Myers

Content • Overview /History/Legislation • Domestic International Sales Corporation -1971 • Foreign Sales Corporation (FSC) provision -1984 • Extraterritorial Income (ETI) - 2000 • American Jobs Creation Act (AJCA) - 2004 • Major Problems • Economic Implications • Legal Challenges • Paradoxical Challenges & Alternative Perspectives • Alternative Policy Proposals

Overview Domestic International Sales Corporation (DISC) • The DISC was enacted as part of the revenue Act of 1971 (P.L. 92.178), a broad economic package proposed by the Nixon Administration to respond to the economic problems (balance of payment deficits)

Overview/History Domestic International Sales Corporation (DISC) • The objective of such legislation was to: • Stimulate US exports and encourage firms to locate their production for foreign markets in the US rather than abroad. • Counter effect the “deferral” tax benefits (under “residence” system taxation, US taxes apply to both foreign and US-sourced income of parent corporations chartered in the US. ); taxes apply regardless • Offset the perceived tax advantages offered by foreign countries’ “territorial” tax systems.

Overview/History Domestic International Sales Corporation (DISC) • Under DISC provision, corporations could defer 16% to 33% of their export income taxes indefinitely until the capital was repatriated. Under Subpart F (“Counter-deferral”) • Subpart F income is an exception to deferral and only applies to Controlled Foreign Corporations (CFC’s). • A CFC is generally defined as any foreign corporation in which U.S. persons / entities own more than 50 percent of the corporation. For example, a U.S. enterprise that claimed majority ownership of a joint venture with a foreign company did not have the option to defer and exempt its’ foreign-sourced income from U.S. taxes, regardless whether or not it is repatriated.

Overview/History Domestic international Sales Corporation (DISC) • Violation to GATT • GATT's purpose was to reduce the tariffs and other trade barriers as well as discriminatory trade practices. DISC by its nature constituted a direct violation of such non-discriminatory principles, particularly the national treatment principle. • DISC was enacted on December 10, 1971, and went into effect on January 1, 1972. Shortly after, the European Community (EC) initiated proceedings against the DISC provisions under GATT. • Luckily for the US, but unfortunately for the EC, GATT did not have sufficient leverage to force US to comply. In fact, each contracting member had veto power, thus rendering GATT’s enforcement capacity ineffective.

Overview/History Domestic International Sales Corporation (DISC) • EC requested consultation in February,1972 • In May,1973 formal complaint was filed • In November 1976, GATT panel ruled that both elements of U.S. subsidy in both US and Territorial System. The EU and US encountered an impasse. At the same time, the DISC system was being criticized by U.S. lawmakers and special interest groups. Between 1980 and early 1982 the US decided to repeal the DISC and eventually replaced it with the Foreign Sales Corporation (FSC) tax provision in 1984. • Unfortunately, DISC did not serve as a viable solution to U.S.’ balance of payment deficit.

Overview/History Foreign Sales Corporation (FSC) • The FSC provisions were designed to achieve GATT legality • Exporters obtained a tax benefit by selling their exports through a specially qualified subsidiary corporation • Contrast to DISC, FSC provisions required US enterprises to: • -be incorporated outside the United States • -conduct certain management activities or economic processes abroad • -have a board of directors that included at least one person who was not a U.S. resident, • -hold all shareholder meetings outside the United States

Overview/History Foreign Sales Corporation (FSC) • FSC income was exempt from Subpart F’s anti-deferral rules. The combination of exemptions under FSC was no different than under DISC. • EU trade officials claimed that the substance of FSC’s provisions were similar to DISC’s provisions, and thus constituted discriminatory export subsidies. • On November 18, 1997, the EU requested a consultation with the US over the legality of FSC’s provisions, pursuant to WTO’s obligations. • In July 1998, the EU requested the establishment of a dispute settlement Panel

Overview/History Foreign Sales Corporation (FSC) Complaint: • The heart of the EU's complaint was that FSC violated: -Article 3.1(a) of the SCM Agreement, which prohibits provision of subsidies that are "contingent on export performance.“ -Article 1.1, in turn, defines subsidies as a "financial contribution" by a government where "government revenue that is otherwise due is foregone or not collected."

Overview/History Foreign Sales Corporation (FSC) • EU argued that the FSC rules provided specialtax exemptions where export income would otherwise be taxed under Subpart F or as income from the conduct of a U.S. business. The EU also argued that FSC's administrative pricing rules constituted an export subsidy. • US Positions: • The United States, in turn, argued that: -territorial taxation was WTO-legal and that FSC was ‘analogous’ to other WTO members’ territorial tax systems

Overview/History Foreign Sales Corporation (FSC) US Positions: • -GATT Understanding, in conjunction with the SCM Agreement, provided that countries need not tax income derived from "foreign economic processes," which, in part, established the justification for territorial taxation schemes; • -FSC's various foreign economic presence and management requirements linked the tax benefit to foreign economic processes. SCM Agreement gives countries considerable latitude in setting required intra-firm pricing methods; • -FSC's administrative pricing rules merely identified the portion of income attributable to foreign economic processes.

Overview/History Foreign Sales Corporation (FSC) Panel’s Ruling: • On October 8, 1999, the panel ruled:“we consider that the United States has made an unwarranted leap of logic from the proposition that ‘income arising from foreign economic processes may be exempted from direct taxes’ to the proposition that ‘if countries are under no obligation to tax income from foreign economic processes’, then they should be free to exempt all such income or just part of it" • On February 22, 2000, the WTO Appellate Body concurred with panel’s conclusion. • In April 2000, the US complied with the ruling and began the process of “removing” FSC provisions and enacting Extraterritorial Income (ETI) provisions.

Overview/History • ETI • The plan was to conform with WTO obligations by extending tax benefits beyond exports to income from foreign operations. • EU objected to the ETI proposal, but Congress nonetheless passed ETI provisions in November 2000 and President Clinton signed it into law on November 15, 2000 (P.L. 106-519) • Again, the WTO ruled against the US, noting that ETI included US tax law exemptions and thus viewed as an export subsidy. On October 10, 2001, the US appealed the ruling, but the Appellate Body upheld the Panel ruling. • WTO also permitted the complaining party (EU) to impose retaliatory sanctions ( a maximum of $4.043 Billion) in an amount equivalent to EU’s total estimated value of US’ export subsidies to all countries. • The US decided to comply.

Overview/History Transition from ETI to AJCA 2004 • Congress initiated the process of repealing ETI and introduced alternative tax legislation to replace ETI. Meanwhile, EU was still not satisfied with US’ response and threatened to impose authorized sanctions by March 1, 2004 if compliance was not achieved. • On October 7, 2004, the House approved the American Job Creation Act (AJCA) of 2004,and the Senate approved the measure on October 11, 2004. President Bush quickly signed the bill into law (P.L. 108- 357) on October 22, 2004, as part of an attempt to comply with WTO’s ruling. • By October, 2004, the EU's phased-in tariffs had reached 12% (a five percent initial rate in March, followed by 7 subsequent months of 1% increases);however, in response to the US’ intentions to repeal FSC/ETI’s export subsidy provisions, EU Trade Commissioner Lamy stated that he would advise the EU Council of Ministers to suspend sanctions on January 1, 2005, the commencement date of ETI's phase-out.

American Jobs Creation Act of 2004 (AJCA) The 2004 AJCA enacts a new incentive to manufacture in the United States through the provision of a 9% tax deduction for income derived from domestic production activities. The deduction is available to ALL corporations, partnerships, sole proprietorships, cooperatives, and estates and trusts with qualifying production activities income. Unlike FSC/ETI provisions, the AJCA’s tax credits are non-discriminatory as they apply to both domestic and foreign enterprises operating in the US. The deduction is calculated on the lesser of income from domestic production activities or a taxpayer's taxable income.

EU’s & WTO’s Objections to AJCA 2004 • Shortly after realizing that the AJCA 2004 legislation included transitional language and grandfathering clauses, which essentially allowed former ETI tax exemption provisions to remain in effect for eligible US companies’ foreign-sourced income that was generated prior to September 17,2003, the EU filed a subsequent complaint to the WTO, claiming the US has not yet complied with WTO’s FSC/ETI ruling. • September 30, 2005: WTO’s DSB ruled that "to the extent that the United States, by enacting Section 101 of the Jobs Act, maintains prohibited FSC and ETI subsidies through the transition and grandfathering measures at issue, it continues to fail to implement fully the operative DSB recommendations and rulings to withdraw the prohibited subsidies and to bring its measures into conformity with its obligations under the relevant covered agreements."

US’ Response to WTO’s Ruling Accordingto Dan Hunter, a Legal Counsel for USTR’s WTO Division, US Congress and President Bush implemented amendments to the AJCA legislation, which essentially repealed the grandfathering provisions and accelerated the transitional phase-out periods. February 2006: EU indicated that it was satisfied with the modified AJCA legislation and dropped the tariff retaliations against US. However, the EU has claimed that AJCA’s tax credit provisions for agribusinesses constitute violations of WTO’s Agreement on Agriculture. These agribusiness tax credit provisions are not directly related to the issues concerning extraterritorial tax schemes.

Challenges Surrounding Repeal of FSC/ETI Provisions • 1) Legal Implications: Violation of WTO’s National Treatment Principle • Under former FSC/ETI provisions (particularly Subpart F), certain foreign subsidiaries of US parent companies were eligible to defer their foreign-sourced income from US taxes, while other US firms were not eligible for such tax exemptions. • Moreover, US subsidiaries of foreign parent companies could not take advantage of the tax loopholes inherited in FSC/ETI, which essentially involved U.S. companies repatriating tax-free foreign-sourced income to the US. Consequentially, US subsidiaries of foreign companies encountered competitive disadvantages in the US. • WTO consistently ruled that these provisions were discriminatory and violated the SCM Agreement. Subsequently, WTO granted EU the authorization to impose retaliatory tariffs against US, amounting to billions of US dollars.

Challenges Surrounding Repeal of FSC/ETI Provisions • 2) Economic & Budget Implications: • Conflict of Interests: From the outset of DISC in 1971, the US government was attempting to preserve a quasi world-wide tax system in order to both stem the pace of outsourcing and secure a sufficient tax revenue base, while simultaneously providing targetedtax exemptions aimed at promoting US companies’ export competitiveness vis-à-vis repeals of double taxation. • According to a CCH tax policy brief, the US government is projected to save approximately $50 billion in taxes from the EPI repeal. Proponents of the repeal argue that these tax savings could be used to pay for AJCA’s temporary tax credit provisions, including the proposed 3% reduction in corporate tax rates from 35% to 32%. Skeptics, on the contrary, note that since AJCA ‘s tax credits will likely be extended and made permanent, the overall costs of AJCA will far exceed the tax savings incurred from the ETI repeal, and hence further exacerbate US’ budget deficits.

Underlying Challenges • Underlying Challenge: US government needs to consider how to replace its world-wide tax system with a territorial tax system that will allow it to both promote US export competitiveness and secure an adequate tax revenue base, of course without violating WTO obligations. • Competitive Disadvantages: • Double Taxation: US, Britain, and Japan are the only countries that apply world-wide tax systems, which puts their parent companies’ foreign subsidiaries at a competitive disadvantage with other MNCs that generally benefit from their respective territorial tax systems and hence avoid double-taxation. • High Corporate Tax Rates: Although AJCA aims to address some of these competitive disadvantages through the provisions of tax credits and minor corporate tax rate reductions (35% to 32%), the US still has the second highest corporate tax rate in comparison to all OECD countries (Japan has the highest corporate tax rate).

Alternative Policy Proposals • 1) Replace World-wide Tax System with Territorial Tax System: • Like most other countries, the US should adopt a territorial tax system that will eliminate the double-taxation on US companies’ foreign-sourced income, which could help: • level the playing field with other MNCs; • encourage US companies to repatriate foreign profits back to the US; and • stem outsourcing of U.S. companies’ business processes to countries where they can avoid double taxation.

Alternative Policy Proposals • 2) Significant Reductions in Corporate Tax Rates: • Although the AJCA includes reductions in US corporate tax rates from 35% to 32%, these rates need to be further reduced to levels that are comparable to the rates of US’ main competitors in EU, Asia, and Latin America. Several EU countries, for example, have corporate tax rates ranging from 15% -25%. • Significant reductions would help stem the pace of outsourcing, encourage US companies to produce exported goods in US, and attract internal foreign-direct investment, all of which could help expand the US tax base and enhance US exports competitiveness.

Questions??? Thank you!!!

Resources: CRS Report Summarizes History of FSC/ETI Controversyhttp://www.taxhistory.org/thp/readings.nsf/ArtWeb/D1E0DCC337B8048385256F860068159E?OpenDocument Corporate Rate Reduction and International Tax Reform: Best Options for FSC/ETI Replacement Legislationhttp://www.heritage.org/research/taxes/wm437.cfm TECHNICAL EXPLANATION OF THE SENATE AMENDMENT TO H.R. 4986, THE "FSC REPEAL AND EXTRATERRITORIAL INCOMEEXCLUSION ACT OF 2000"http://www.house.gov/jct/x-111-00.pdf USA regulations: Senate tax break bill aims to lift sanctions http://mutex.gmu.edu:2048/login?url=http://proquest.umi.com/pqdweb?did=667537911&sid=1&Fmt=3&clientId=31810&RQT=309&VName=PQD "CHALLENGES FOR TAX POLICY IN A GLOBAL ECONOMY" TREASURY ACTING ASSISTANT SECRETARY FOR TAX POLICY JONATHAN TALISMAN REMARKS TO THE IRS/GW ANNUAL INSTITUTE ON CURRENT ISSUES IN INTERNATIONAL TAXATION WASHINGTON, DChttp://www.ustreas.gov/press/releases/ls1068.htm RS20571: The Foreign Sales Corporation (FSC) Tax Benefit for Exporting and the WTO http://www.ncseonline.org/nle/crsreports/international/inter-61.cfm

U.S.’ Extraterritorial Tax Schemes