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December 6, 2010
Federal Income Tax Reform: International Recommendations

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by Robert H. Dilworth

Summary by Tax Analysts®
Robert H. Dilworth has practiced in various locations within and outside the United States since 1966. From September 2005 to February 2007, he served as the Senior Advisor to Treasury's Assistant Secretary for Tax Policy. The views expressed herein are those of the author and do not represent the views of the Treasury Department, any other federal agency, the U.S. government, any firms or clients with which he has been associated, or any of his colleagues who commented on prior drafts.

Reform of the U.S. tax treatment of international business and investment should proceed carefully, not on the basis of sweeping generalizations about the system being broken. Rather than scrap the long-standing architecture of international taxation, we should figure out what is broken and target reform to fix only that.

A. Background

1. Current examination of tax reform alternatives. President Obama has engaged two panels to consider various tax reform alternatives. The first, the Tax Reform Subcommittee of the President's Economic Recovery Advisory Board (PERAB),1 delivered its report in late August.2 The second, the National Commission on Fiscal Responsibility and Reform (Fiscal Commission), delivered its report on December 1.3

The substantive recommendations in this article were originally made to PERAB in a letter dated October 13, 2009. The letter incorporated by reference several additional materials that covered the issues and recommendations at greater length.4 PERAB had imposed rather stringent length constraints on tax reform suggestions.5

2. Ongoing discussions of tax reform: Not a blank slate. The question of the proper federal income tax treatment of income from cross-border trade and investment is not new. The issues involved have been addressed by politicians and their legions of advisers since at least the 1950s.6 The temptation is sometimes apparently irresistible to justify a tax regime change based on the world having changed so much in the past four or five decades that the present system is dangerously out of date.7 Nevertheless, the recommended responses to those changes by those who allege that the system is outdated are often indistinguishable from essentially identical recommendations by the same or similar constituencies at essentially the same points on the political spectrum 40 or 50 years ago.8 Ending deferral,9 territorial exemption,10 runaway plants,11 competitiveness,12 etc., are all part of the jargon of successive generations of tax policy enthusiasts.

More recently, in addition to the work of PERAB and the Fiscal Commission, international tax reform was considered in 2005 by the staff of the Joint Committee on Taxation13 and by a bipartisan panel14 appointed by President George W. Bush. The issues and recommendations in this article were addressed at greater length in a prior article that was prepared in response to the President's Advisory Panel Report and the JCT Options Study.15 The historical antecedents for the current structure are examined in greater depth in that article.

The Obama administration has also proposed some changes in the operation of the foreign tax credit that would nudge the system toward a fundamental change in the allocation of taxing jurisdiction between the countries of business activity (the source country) and of shareholder residence (the residence country). The so-called pooling approach was discussed in a 2009 article that contains a more detailed review of the tax treaty architecture, and the history of that architecture, than does this article.16

3. Author's recommendations. This article contains my recommendations, with references to other articles reflecting my perception of history (and explanations by our progenitors of what they thought they were doing and why they thought they were doing it). This article does not go beyond suggesting components of possible reform of the federal income tax. Sooner or later, of course, the United States will have to add a VAT or other consumption-type tax. When that happens, a corporate income tax will almost certainly be retained, and the recommendations in this article would be germane to that legacy corporate income tax.

B. General Principles

1. Fit the remedy to the problem. The proposed architecture seeks to strike balances and make compromises among competing good ideas (and no doubt a few bad ones). Tax reform should not start over or undertake significant changes without a fairly detailed understanding of what the current regime actually does or does not do, and without first identifying the relationship (if any) between existing provisions and the perceived problem.

2. Check the factual assumptions. The discussion of international tax reform sometimes suffers from an acute information gap. For example, the deferral privilege is routinely described as a subsidy for foreign direct investment and as a subsidy that leads to job migration out of the United States. The description is routinely uttered by experts who apparently have had little or no involvement in or exposure to the decision-making process actually followed by business enterprises.

If job migration is an important worry for the Fiscal Commission (or other advisers to the president and Congress), the first step should be to try to determine why businesses think they make the decisions they do regarding the location of direct investment. The notion that tax motivation is the dominant consideration and that real business factors only may also form part of the direct-investment location decision-making process17 is simply wrong.

I have practiced cross-border business law for more than 44 years both within and outside the United States. For more than 25 years I have concentrated on the taxation of income from cross-border trade and direct investment. The clients I have advised include large U.S. and foreign multinational corporations (MNCs), mid-cap corporations and businesses, and even some human beings. As I said in 2008 at a hearing of the Senate Finance Committee, I have never met a business decision-maker (someone who was actually involved in the decision about where to locate a business that employs people) who would agree that the MNC employer acted to invest somewhere because of an interest-free loan of residual U.S. corporate tax if the company invested in a foreign country rather than in the United States. The tax staff always has been brought in after the basic business decision has been made.

Although that anecdotal evidence may be viewed with skepticism by tax policy economists, who may have more confidence in macroeconomic modeling than in direct observation of the decision-making process, the Fiscal Commission or their advisers might nevertheless find it profitable to meet with business decision-makers to determine the extent to which business enterprises think investment location decisions are based on deferral of residual U.S. corporate tax compared with factors such as labor costs, environmental and other nontax regulations, proximity to customers, access to materials and components, an educated work force, and domestic tranquility. If there is a variance between the reasons business decision-makers think they make decisions and the algorithms on which the deferral-subsidy thesis is sometimes based, it might be worth reexamining the simplifying assumptions used in the algorithms.18

3. Intangible property ownership location and business investment locations should not be conflated. The Fiscal Commission should keep in mind the difference between the location of direct investment and the location of ownership of intangible property. Direct investment is often dependent on the exploitation of intangible property, but considerations regarding intangible property ownership location may be quite different from those regarding investment location. The intangible property may be owned by an entity outside both the country of development and the country of exploitation of the property. In contrast, jobs are unlikely to be located outside the country in which the employees work.

4. Examine GAAP accounting for foreign earnings. The Fiscal Commission should also try to measure the extent to which financial accounting for deferred U.S. tax may affect, or perhaps even distort, business decision-making. There appears to be an asymmetry under generally accepted accounting principles between Financial Accounting Standards Board No. 94 (including foreign subsidiary earnings in consolidated earnings based on availability of those earnings to the parent and to the parent's shareholders) and FAS 109 (particularly Accounting Principles Board No. 23) (excluding from the consolidated tax provision any amount of residual U.S. tax on earnings intended to be indefinitely reinvested and not available for distribution to shareholders). At the very least, tax policymakers should engage the FASB members to determine any bases for that asymmetry. Earnings per share likely have a much greater impact on investment location decisions than "cash on cash taxes" or even an economist's present value calculation of cash on cash taxes to be paid in the future.19

5. Simplification should be a secondary goal. The goal of simplification should not be an overriding consideration. Simplification is desirable at this stage in the development of the U.S. international tax regime primarily for two reasons: to enable a reasonably well-informed citizenry and electorate to understand the rules of the road, and to minimize the risk that future tax policymakers will act in ignorance of how the rules actually work and why they work the way they do. Simplification should not be pursued on the facile notion that special interests account for the complexity of the international provisions of the federal income tax or that there is out there somewhere a grand guiding principle comparable to e = mc2. The international tax architecture is complicated because we are a complicated national economy (and society) in a larger universe of a global economy with which we must come to grips.

6. FTC pooling. The Fiscal Commission should consider the administration's fiscal 2010 and 2011 budget proposals to adjust the FTC to operate on a pooling basis. Whatever the political or economic benefits of the proposal, it appears to conflict with many bilateral tax treaties. In the end, the issue may be resolved by consultation with important treaty partners. Any changes in the framework of our global tax posture must be vetted with careful attention to the treaties we have encouraged other countries to enter into, and with attention to the potential impact on other countries' perception of the United States as a reliable treaty partner. The United States need not observe the notion that pacta sunt servanda, but being courteous and diplomatic in American foreign policy (even in tax matters) surely has a place in tax policy.

7. What if the rest of the world copied the United States? The discussion of reforming U.S. taxation of foreign subsidiary earnings routinely ignores the risk of a copycat response by other capital-exporting nations. What would happen, for example, if an Italian manufacturing enterprise were to invest in a U.S. manufacturing enterprise (say, an automobile manufacturer) and the U.S. auto company were to become profitable?20 If Italy were to determine that the undistributed earnings of the U.S. auto company should be subject to tax in Italy (to negate the "subsidy" from deferring Italian tax), would that current taxation (and the corresponding diminution in the incentive to lock out the U.S. auto company's earnings from repatriation to Italy) diminish the availability of earnings to expand U.S. production capacity (and associated employment)? Would the United States then find itself in a conflict of industrial policy priorities with its longtime ally and trading partner? Italy may well have its own fiscal challenges and underemployment concerns that are more important to Italy than increasing employment in Michigan by U.S. affiliates of Italian MNCs. The United States is an important capital importer, and the Fiscal Commission should consider the effect on the United States as a capital importer if it, as a capital exporter, adopts a beggar-thy-neighbor approach to protect against a lockout of foreign earnings. Changes that are more measured than ending deferral, such as eliminating the tax under section 956, would at least open the door to direct investment in the United States by controlled foreign corporations of U.S. MNCs.

8. What if the rest of the world thought the elimination of deferral would be tantamount to taxing foreign corporations resident in other countries when those corporations have no taxable nexus with the United States? As Prof. Reuven Avi-Yonah has written, when subpart F was originally enacted in 1962, there may have been some speculation that taxing the U.S. shareholder on the undistributed earnings of foreign corporations would violate the basic treaty architecture under which a "foreign" corporation is taxed on business income only in the country in which it operates through a permanent establishment.21 Avi-Yonah wrote that at the time subpart F was enacted, the treaty partner perception was that there was some sort of abuse exception to the basic architecture. The exception came into general acceptance as other countries adopted provisions similar to subpart F.22 What now, if there is no abuse other than the need to discourage the migration of jobs and investment from the United States to other countries (in this case, treaty partners)? Would a perception that the United States abandoned the architecture lead to increased risk of copycat responses?

C. Striking a Balance

The following suggestions are the points on the continuum of choices where I would strike the balance among competing goals. There is more than one wrong answer, and it is important to keep the importance of all this in perspective. American business may be injured by bad choices, but it is unlikely to be brought to its knees. The U.S. job market is unlikely to be favorably affected by increasing the tax on U.S. MNCs, but a popular perception that someone is trying to do something may encourage domestic tranquility even if the jobs do not materialize.23

1. Retain existing core architecture. The United States should tax all business income, domestic or foreign, derived by businesses with a prescribed minimum nexus to the United States, and it should allow an FTC. Business income would consist of items realized by a U.S. taxpayer under U.S. GAAP.

U.S. tax should not be imposed on a U.S. shareholder's unrealized income consisting of undistributed foreign business income of foreign corporations. U.S. tax should be imposed on a U.S. shareholder when it receives a distribution of that income. This would maintain the general global division of taxing jurisdiction between source countries (where the business activity occurs) and the residence countries (where the shareholder-investors reside):

    a. The United States should tax U.S. shareholders on their pro rata share of undistributed foreign personal holding company (FPHC) income to the extent attributable to portfolio investment made by a CFC. A passive foreign investment company-type interest charge should be applied to passive income (undistributed FPHC income) attributable to U.S. shareholder's interest in a non-CFC (10/50 company), when the income is included on distribution to that U.S. shareholder.

    b. The United States should not extend a territorial exemption to any U.S. shareholder's interest in any income of a foreign corporation. All return-on-capital investment (including return on debt or equity capital or intellectual capital) should eventually be taxable in the hands of the U.S. taxpayer-investor, no later than on actual or constructive receipt determined on U.S. GAAP.

2. Eliminate separate regimes for foreign business conducted via foreign corporations versus branches and other passthrough entities. The United States should treat all foreign business activities in which a U.S. corporation has a 10 percent or greater voting equity interest as a separate entity (corporation) rather than variously as a corporation, branch, or other passthrough entity based on the legal form of the business vehicle. This will eliminate electivity of tax regime for foreign business activities of U.S. MNCs, particularly loss passthrough and disregarded transactions between a legal entity and its branch.24

3. Match foreign-related expenses and foreign-related income. Existing law should be modified to apply a matching principle for deductible expenses incurred to produce foreign-related income. All foreign-related income should, in the aggregate, pay for itself. Expenses attributable to foreign-related income, to the extent in excess of aggregate foreign-related income, should not offset otherwise taxable domestic income25:

    a. Extend the current-law approach of expense matching, used for purposes of limiting the maximum FTC, to include not only taxpayers affected by the FTC limitation (based on expense allocations) but also those that do not have FTCs in any particular year sufficient to have an economic effect equivalent to matching.

    b. Without that matching, expenses incurred to produce foreign-related income can offset U.S. corporate tax on the corporation's purely domestic income (if any).

      i. The principal items affected would be interest expense, general and administrative expense, and research and experimentation expense. Allocable interest expense should be calculated by taking CFC indebtedness into account.

      ii. The class of foreign-related income to which those expenses are to be allocated should be drafted broadly (in contrast to the administration's 2010 and 2011 budget proposals, which would match only expenses and foreign income attributable to dividend-producing assets).

    c. A broadly drafted class would consist of all foreign-related income attributable to cross-border business activities, including: (1) undistributed direct investment income; (2) direct investment dividends and related-party interest, rents and royalties from direct investment foreign affiliates; (3) active business royalties from third parties; and (4) export sales income (but see resourcing proposal for export sales and intangible property royalties).

    d. Under the system using a broadly drafted class, deferrable expenses incurred for the production of a broad class of deferred income would be initially larger but would be more readily restored to deductibility if the class includes items normally remitted currently, such as related-party interest and royalties, as well as other foreign-related items taken into account on a current basis, such as export sales income and royalties for U.S.-origin intangible property. Interest and royalties received from foreign-related business would restore deductions for expenses that might have been incurred to generate earnings to be derived by dividends not yet taken into income. The core premise is that if foreign-related business activity pays for itself on a current basis, the United States should count its blessings.

      iii. The core premise of broad grouping is that direct investment income includes not only distributions on equity, but also interest, rents, and royalties from foreign direct investment (10 percent or greater ownership of the payer of the particular kind of return on investment).

    e. Any deferred expenses not restored as deductions in any tax year would be added to basis in the U.S. shareholder's investment in assets intended to produce foreign-related income. If that investment is disposed of or abandoned, the tax benefit of deferred and capitalized deductions would be available subject to any limits on loss deductions generally.

    f. It is likely that no other country applies a comparable matching of otherwise deductible expense to foreign-related income, even broadly defined. To this extent, the proposal may decrease competitiveness of U.S. MNCs with similarly situated foreign MNCs. It would be much less exceptional than matching expenses only against returns on dividend-producing equity investment rather than on all foreign business activities.

4. Repeal foreign base company sales income and foreign base company services income provisions now in subpart F.26 This would make sense only if the comprehensive expense matching proposal described above is also adopted.

5. Retain related-party look-through rule that excludes from subpart F income related-party interest, rents, and royalties paid by foreign affiliates to other foreign affiliates.27 This would recognize that cross-border business is usually conducted across national boundaries. It would update the U.S. tax view to take into account the emergence of the European Union and the North American Free Trade Agreement in the years since enactment of subpart F in 1962.

6. Transfer pricing: Exclude related-party risk-based allocations of income to CFCs, except by treaty. Amend section 482 to exclude allocation of income away from a U.S. affiliate to a foreign affiliate based on the risk borne by that foreign affiliate's capital. Retain those risk-based allocations under bilateral tax treaties (to maintain appropriate apportionment of taxing jurisdiction between the source country and the shareholder-investor's residence country). The affiliate's capital that bears the risk represents the related shareholder's "risk" as the provider of the capital that bears the risk.28 This proposal would require adjustment to accommodate any significant cross-border trade and investment by U.S. MNCs in countries with which the United States does not have treaties, such as Argentina, Brazil, Hong Kong, Singapore, Taiwan, and the Persian Gulf states.29 Some or all of those countries could be identified by an appropriate euphemism for non-tax-havens.

7. Eliminate repatriation tax on arm's-length transactions between a CFC and U.S. affiliates30:

    a. Some proponents of ending deferral base that suggestion on the existence of a tax barrier to repatriation of deferred income. The tax barrier is the residual U.S. tax on the amount to be repatriated. Ending deferral to solve this problem is reminiscent of Jonathan Swift's proposed solution to the famine in Ireland. If the so-called repatriation tax is a real problem, it can be solved without completely repealing deferral and without completely exempting a piece of that income. The more measured step would be to repeal section 956 (investment in U.S. property).

    b. If section 956 were to be repealed, the kind of taxable deemed distributions that would end deferral would be limited to transactions on non-arm's-length terms that would be treated as constructive dividends under general tax principles. CFC acquisition of related-party stock or debt should be treated as a dividend, or not a dividend, under generally applicable tax rules rather than under a special rule for CFCs only. Encouraging external leverage by U.S. MNCs is probably less sensible in 2010 than before the current financial crisis.

8. Retain crediting of foreign taxes against U.S. tax on export sales income (foreign-related income).31 Retain section 863(b) (deemed foreign-source rule for export sales). That income is foreign-related without regard to the passage of title, and foreign income taxes on some parts of the overall pool of foreign-related income should be allowed as a credit against U.S. corporate income tax on the overall pool.

9. Make intangible property royalty sourcing symmetrical with income from export sale of inventory property, except to the extent otherwise provided by treaty.32 All things being equal, there should be no distinction in treatment as foreign-related income of any income derived from an intangible when it is licensed rather than embedded in exported tangible property. If a careful examination (in which MNC decision-makers are at least consulted) confirms that research and development activities will not likely migrate as a result of such a change, symmetry with export property sourcing would be a desirable result. That examination should consider the extent to which alternative locations for R&D are (or are not) parties to tax treaties with the United States. If migration of the R&D activity is a serious risk, the existing system should be retained: U.S.-situs R&D is worth more than symmetry with export sales.

10. Interest from related parties should continue to be foreign-source income eligible for cross-crediting.33 All interest from foreign enterprises in which the interest recipient (or any person that controls, is controlled by, or under common control with the recipient) is a less-than-or-equal-to 10 percent shareholder would be foreign-source income against the U.S. tax on which excess foreign taxes from other foreign direct business investment could be credited. All foreign-source income should also be foreign-related income.

11. Dividends, interest, rents, and royalties from portfolio investment should be ineligible for cross-crediting any foreign income tax imposed on foreign direct investment income.34 Portfolio income should also be segregated from business income for purposes of the expense-matching proposal. Expenses related to foreign-related business income would not be eligible to offset foreign-related portfolio income.

12. Contributions of appreciated property to foreign affiliates should trigger tax on the value of prior deductions against U.S. taxable income. This recommendation is prompted by two distinct considerations. First, the treatment of valuation in the case of outbound transfers of income-producing property in exchange for stock should be symmetrical in economic consequences with similar transactions when the consideration is money or other property. Second, simplification gains would be desirable if available without doing violence to the first consideration.

Income-producing property will often have been purchased or developed with tax deductible expenditures. If that property is shifted to a foreign affiliate without recovering the deductions, there would be an asymmetry between the recommendations that current expenses allocable to foreign-related income be deferred to the extent they exceed foreign-related income. The basic approach now is to capture the fair market value when and if an exit tax is due. Although the current system may be appropriate for some items of property, the search for the FMV of items not normally disposed of in a market is a difficult undertaking. Simplification gains could be achieved by seeking to recapture only prior unrecovered deductions.

For high-value intangible property, expense recapture may be simpler but it may also be asymmetrical with the valuation approach suggested for cost sharing in the development of high-value intangible property. Also, tracking and allocating the costs of developing successful high-value intangible property, and determining how much of the costs of developing unsuccessful intangible property should be borne by the successful intangible property, is likely to erode any simplification gains otherwise available when dealing with property that is unlikely to generate premium returns.

If, despite the undesirable complexity inherent in expense recapture, a regime requiring current recapture of previously deducted costs is adopted, and if it is also important that there be symmetry between the treatment of inframarginal (premium returns) on transferred intangible property transferred for stock and the treatment of the returns by means of a cost-sharing arrangement (with buy-in payments when applicable), the transfer of intangibles for stock should trigger a recovery of previous deductions of expenses incurred in the development, plus a current return for the cost of capital previously incurred to develop the property. The treatment of any value in excess of the development-cost recovery could then be treated consistently with the approach that would apply in a cost-sharing arrangement. The premium return could be realized by the U.S. MNC (capital provider) when it realizes a return on capital investment (dividends) from the transferee CFC. Alternatively, the premium return could be realized over the life of the intangible by relying on a deemed running royalty that is commensurate with income (that is, comparable to the current treatment under section 367(d)).

As with the ongoing discussion of cost sharing, tax policymakers should be cautious in moving to a regime in which U.S.-situs R&D is treated less favorably than foreign-situs R&D. The relevant comparison will include foreign-situs R&D by the U.S. MNC as well as foreign- or U.S.-situs R&D by a foreign MNC. If the same intangible will have a higher value when owned by a foreign MNC than by a U.S. MNC, there is always the risk that portfolio investment capital will follow such a comparative advantage. There are 600,000 foreign students in the United States and 200,000 U.S. students in foreign countries. The opportunity for ideas and capital to come together outside the United States under the sponsorship of non-U.S. MNCs or non-U.S. business or governmental enterprises should be taken into account. The notion that intellectual property is inherently American and cannot "get away" is unlikely to be true in the future. It is something tax policymakers might want to look into.

13. Joint ventures (10/50 companies).35 The guiding principle should be to treat direct investment in CFCs the same as direct investment in noncontrolled foreign direct investment (that is, 10/50 companies). Some modifications must be made regarding portfolio investment income of a 10/50 company.

a. Matching. Expenses incurred by a U.S. corporate taxpayer attributable to direct investments (less than or equal to 10 percent) in non-CFCs should be nondeductible unless and until foreign-related income is included in income by the U.S. shareholder. Any deferred expense attributable to the joint venture investment would in effect be capitalized and added to basis of the U.S. shareholder's investment.

The amount of allocable interest expense would be the amount of deferrable interest incurred by the U.S. shareholder allocable to the joint venture investment. If and to the extent the U.S. shareholder could provide information to support an adequate measurement of foreign affiliate interest expense, the amount of U.S. shareholder allocable interest expense could be reduced in the same manner that U.S. shareholder interest is reduced by interest expense of a CFC. The excess or net allocable interests in any year would then be added to the pool of potentially deductible expenses associated with all foreign-related income.

b. FTC. All foreign taxes on foreign-source business income would be taken into account and allowed to offset all U.S. tax otherwise due for foreign-source business income. As with CFCs, deferred expenses, when restored and deductible, would be subject to limitations comparable to present law that would prevent offsetting foreign income tax on foreign income against U.S. tax on U.S. income (section 904(d)). There should be no separate 10/50 basket.

c. FPHC income. U.S. shareholders would not be taxed on undistributed FPHC income of a non-CFC. Deferred expenses associated with the investment in the 10/50 company would be available as a deduction taxable, if and to the extent of foreign-related income. Deferred expenses would not be grossed up (from time incurred and deferred until restored) by the forgone financial rate of return on disallowed deductions. The PFIC regime should be retained. If a 10/50 company derives specified minimum proportions of portfolio investment income, it would be a PFIC, and shareholders would be subject to an interest-like charge on the tax then imposed on receipt of a distribution. Relief from the interest charge regime would be available to shareholders able to make an effective qualified electing fund election to be taxed currently or undistributed income. Absent PFIC treatment, there would be no special treatment for income derived from a direct investment in a 10/50 company: All income received by a U.S. shareholder should be taken into account and taxed when actually or constructively received under general U.S. tax principles.

d. Foreign base company sales income. No special treatment would be necessary for related-party sales and services income. The repeal generally of foreign base company sales income and foreign base company services income represents a policy decision that is equally applicable to 10/50 companies.

e. FPHC exclusion: Look-through rules should apply to interest, rents, and royalties. No special rules would be necessary, except to distinguish related-party interest, rents, and royalties from portfolio asset income. Those rules would be relevant to PFIC treatment of a 10/50 company.

Any such items of income received by a foreign corporation from a payer in which the recipient (or any person that controls, is controlled by, or under common control with the recipient), holds more than a 10 percent equity interest, would not be treated as portfolio income.

14. Foreign direct investment in the United States should continue to be taxed on effectively connected income:

    a. Branch rules should be replaced by a separate entity rule that would treat all domestic branches as separate corporations.

    b. Interbranch transactions should be treated as intercompany transactions.

    c. Related-party royalties for domestic use of foreign-origin intangible property should be apportioned between domestic and foreign source to the same extent that royalties for the use of U.S.-origin intangible property would be apportioned.

      i. Dividends and interest from domestic corporations should remain U.S. source to the same extent as under current law and subject to U.S. withholding tax except to the extent otherwise provided by treaty.

      ii. This is current law and should not change under the logic of this proposal.

15. Foreign portfolio investment in U.S. business entities: Current law should be retained. Dividends, interest, rents, and royalties should be taxable based on gross income at the appropriate withholding tax rate, subject to treaty relief.

Portfolio interest taxation should eventually be made symmetrical with taxation of dividends paid to nonresident aliens and foreign corporations. The current regime favors foreign portfolio debt investment over foreign portfolio equity investment in domestic business enterprises.

16. Financial institutions.

a. Domestic: Current-law temporary exclusion from subpart F should be made permanent. Assuming that subpart F is amended for industrial and services corporations as recommended above, U.S.-parented MNCs engaged in the active conduct of a banking, financing, or similar business should be symmetrically excluded from the regime taxing U.S. shareholders currently on undistributed FPHC income (income that is not otherwise excluded from foreign personal holding income on the basis of a related-party payer). However, any income deferred from tax would result in a corresponding deferral of deductions for interest, general and administrative expenses, and other expenses incurred to produce that deferred foreign financing business income. Simplifying conventions should be applied to accommodate differences in currencies and other terms (maturities, interest rate basis) applicable to borrowing by those financial institutions and lending by those institutions.

Branches and subsidiaries would be treated as separate entities (corporations) for this purpose. Interbranch transactions should therefore be treated as cognizable intercompany transactions.

b. Foreign parent financial institutions: Domestic branches should be treated as separate corporations. Foreign-parented MNCs engaged in the active conduct of a banking, financing, or similar business that generates U.S.-source income effectively connected should be subject to corporate tax on net income. Branches should be treated as separate corporations. Interbranch transactions should be treated as transactions with tax effect. The branch profits tax should be repealed, because a branch would be treated as a separate corporation.

17. Tax-exempt investors.36 Distributions from foreign MNCs should be made a class of unrelated business taxable income (subject to a contrary provision in a U.S. tax treaty with the country from which a tax-exempt investor receives a dividend). All income from investments in domestic and foreign corporations should be taxed once to the extent attributable to a U.S. tax-exempt investor's interest therein. If a tax-exempt U.S. investor invests in a foreign corporation that is exempt from U.S. corporate income tax, there may be a marginal investment incentive to invest uniquely American capital outside the United States. Treaties could provide otherwise, because treaties are generally concluded with countries with a "meaningful" tax system (or can be adjusted to address features in the tax laws of countries that erode the level of parallelism Treasury thinks necessary to make the tax system meaningful).

18. Bilateral versus multilateral FTC.37 If a tax increase on MNCs with multi-jurisdictional business is thought necessary, the pooling basis proposal should be deferred and a more direct limitation of cross-crediting should be pursued instead. A multilateral FTC regime will not work without a multilateral consensus among the United States and concerned treaty partners. The daunting complexity of the 1986 act's basketing to eliminate cross-crediting between baskets is, of course, at odds with any simplification goals, but probably less so than the proposed pooling basis FTC proposal. Whatever solution is pursued, it should not be based on Humpty Dumpty's argument38 that the words of the treaties mean only what Treasury wants them to mean at any point in time.


1 "Executive Order -- Establishing the President's Economic Recovery Advisory Board" (Feb. 6, 2009) (a group of not more than 17 "distinguished citizens from outside the government" appointed by the president).

2 For the PERAB report, see Doc 2010-19068 or 2010 TNT 167-50.

3 "Executive Order -- National Commission on Fiscal Responsibility and Reform," Feb. 18, 2010, section 5.

4 Written testimony of Robert H. Dilworth before a hearing of the Senate Finance Committee on "The Foundation of International Tax Reform: Worldwide, Territorial, and Something in Between," (June 26, 2008), Doc 2008-14201, 2008 TNT 125-48; Dilworth, "Tax Reform: International Tax Issues and Some Proposals," 35 Int'l Tax J. 5 (2009), available at; and Dilworth, "Proposed Multilateral FTC Pooling and U.S. Bilateral Tax Treaties," Tax Notes, Sept. 21, 2009, p. 1227, Doc 2009-18637, or 2009 TNT 180-8.

5 The PERAB tax subcommittee invitation to submit comments specified a maximum online length of five pages. Several submissions exceeded that length, perhaps because the topics covered in the code currently consume more than 1.2 million words (in comparison with the Bible, which has only about 800,000 words).

6 See, e.g., H.R. 8300, sections 37, 923, and 951-958 (1954); H.R. 5 (1959); Message from the President of the United States Relative to Our Federal Tax System, H.R. Doc. No. 140 (1961), reprinted in House Ways and Means Committee, 90th Cong., 1st Sess., Legislative History of H.R. 10650, the Revenue Act of 1962 (Part 1) (1967) (President Kennedy Message); and statement of Hon. Douglas Dillon, secretary of the Treasury, before the Ways and Means Committee, May 3, 1961, reproduced at Legislative History of the Revenue Act of 1962, at 170 (Dillon Statement).

7 See, e.g., Robert J. Peroni et al., "Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source Income," 52 SMU L. Rev. 455, 458 (1999) (describing the current system of worldwide taxation with deferral as "anachronistic" and proposing a complete end to deferral); National Foreign Trade Council (NFTC), The NFTC Foreign Income Project: International Tax Policy for the 21st Century, vol. 1, iii Preface (1999) ("The foreign competition faced by American companies has intensified as the globalization of business has accelerated. At the same time, American multinationals increasingly voice their conviction that the Internal Revenue Code places them at a competitive disadvantage in relation to multinationals based in other countries."); NFTC, The NFTC Foreign Income Project for the 21st Century, vol. II, at 3 (2001) ("The balance of competing policies reflected in current law has not kept pace with the rapid development of a global economy. Consequently, the NFTC believes it is time for a significant modernization of the U.S. rules, both as they relate to the taxation of foreign subsidiary income (i.e., the anti-deferral, or income acceleration rules of subpart F) and as they relate to foreign tax credit."). "Modernization" points in opposite directions for the different constituencies and should be ignored as a justification for changing things.

8 See, e.g., Prof. Michael J. McIntyre, Statement Before Senate Finance Committee: Collecting Tax From American Resident Individuals and U.S.-Based Multinationals on Income Earned Through Foreign Entities (July 21, 1995), in which McIntyre suggested that the Revenue Act of 1962 was merely a step toward ending deferral. Ending deferral seems never to be anachronistic, whatever the ailment.

9 President Kennedy Message, supra note 6; Dillon Statement, supra note 6.

10 E.R. Barlow and Ira T. Wender, Foreign Investment and Taxation, 247 (1955): "Exemption has been advocated by many companies and by such important groups as the National Foreign Trade Council and the United States Council of the International Chamber of Commerce."

11 Originally proposed by the Nixon administration in 1973 but more recently appropriated by Sen. Byron L. Dorgan, D-N.D. See Treasury Department, "Proposals for Tax Change," 159-168 (1973), reprinted in "General Tax Reform: Hearings on the Subject of General Tax Reform Before the House Committee on Ways and Means," 6901, 7061-7070 (1973)); "Trade Reform: Hearings on H.R. 6767 Before the House Committee on Ways and Means," 156-157, 161-162 (1973) (testimony of Treasury Secretary George P. Schultz). Similar proposals have been introduced in the House and Senate since 1973. Among the pieces of proposed legislation are: H.R. 3545, Omnibus Budget Reconciliation Act of 1987, section 10147 (July 1991); H.R. 2889, American Jobs and Manufacturing Preservation Act of 1991 (July 15, 1991); S. 26, American Jobs and Manufacturing Preservation Act of 1993 (Jan. 21, 1993); S. 2342, Foreign Tax Compliance Act of 1994 (July 29, 1994); S. 1355, American Jobs and Manufacturing Preservation Act of 1995 (Oct. 23, 1995); S. 1596, American Jobs Act of 1996 (Mar. 7, 1996); H.R. 775, American Jobs Act of 1997 (Feb. 13, 1997). More recently, the Senate considered S. 3816, Creating American Jobs and Ending Offshoring Act (Sept. 21, 2010). The 1991 House proposal by then-Rep. Dorgan, H.R. 2889, is discussed in a report of the Joint Committee on Taxation, "Proposal Relating to Current U.S. Taxation of Certain Operations of Controlled Foreign Corporations (H.R. 2889 -- American Jobs and Manufacturing Preservation Act of 1991) and Related Issues," JCS-15-91 (Oct. 1, 1991), Doc 91-8355, 91 TNT 205-10.

12 See, e.g., H.R. 8300 (1954) and Rep. No. 83-1337, 4102 ("Your committee recognizes that firms doing business abroad may be competing with other enterprises which have lesser taxes to bear, and that such firms may be assuming certain risks that do not prevail in domestic business ventures. It is also impressed by the fact that the present United States tax approach tends to induce heavy foreign taxation of American enterprises."); Dillon statement, supra note 6, at 30 ("It is sometimes contended that if U.S. firms are to compete successfully abroad they must enjoy as favorable a tax treatment as their foreign competitors. . . . But even if this argument were fully valid, it could not be a decisive objection to our proposal. . . . Curtailment of foreign investment which can survive only under the shelter of preferential tax treatment can only be in the U.S. interest and in the interest of the world economy."); PERAB report, supra note 2, at 81-94 (the PERAB report discusses some elements of residual U.S. corporate tax on foreign related income and the effect of those costs on competition with non-U.S. enterprises).

13 JCT, "Options to Improve Tax Compliance and Reform Tax Expenditures," JCS-02-05 (Jan. 27, 2005), Doc 2005-1714, 2005 TNT 18-18 (JCT Options Report).

14 The Bush administration's President's Advisory Panel on Federal Tax Reform is referred to in Dilworth, "Tax Reform," supra note 4, as the Advisory Panel. The November 1, 2005, report will hereinafter be referred to as the panel report.

15 Dilworth, "Tax Reform," supra note 4.

16 See Dilworth, "Proposed Multilateral FTC Pooling," supra note 4.

17 JCT, "Description of Revenue Provisions Contained in the President's Fiscal Year 2010 Budget Proposal, Part Three: Provisions Related to the Taxation of Cross Border Income and Investment," JCS-4-09 (Sept. 2009), Doc 2009-20440, 2009 TNT 176-12 ("The tax analysis described above may be only part of a broader evaluation that U.S. firms engage in when considering whether to invest in the United States or abroad. Many nontax factors, such as labor costs, environmental and other nontax regulations, and proximity to customers, may be important as well."). The error lies in assuming that tax is always a key consideration while basic business economics only may be considered.

18 The questions to be posed to business decision-makers are why enterprises make the investment location decisions they make. This should not be confused with questions about those decision-makers' views of competitiveness or their belief that they want to decrease the tax on corporate income in general or foreign-related income in particular.

19 See Dilworth, "Tax Reform," supra note 4, at 36-39. The references to FAS 94, APB 23, and FAS 109 should eventually be updated to the appropriate references in the recently issued "Codification of Accounting Standards." The substance of FAS 94, APB 23, and FAS 109 was unchanged by that codification, and the older references have been retained in the interest of continuity of understanding by those familiar with the earlier format for GAAP references.

20 A problem all American taxpayers wish to have.

21 Reuven Avi-Yonah, "International Tax as International Law," 57 Tax L. Rev. 483 (2004).

22 Id. at 487-488.

23 However, it may not be in the best interests of American workers to divert attention from the importance of being economically competitive if that distraction were to result from politicians campaigning on the platform that jobs have been lost (by one or another target-rich voter population) because of the tax treatment of U.S. MNCs in general and because of, in particular, the deferral of residual tax on undistributed earnings of foreign subsidiaries.

24 See Dilworth, "Tax Reform," supra note 4, at 21-22, 86-87, and 92.

25 Id. at 46-54, 57-60, and 92-93.

26 Id. at 26-39, 93.

27 Id. at 15-16, 86-87, 94.

28 Id. at 68-73, 94.

29 The euphemisms would presumably be adjusted to take into account concerns about the effective rate of tax on corporate residents as well as comfort with the mechanisms for an exchange of information.

30 See Dilworth, "Tax Reform," supra note 4, at 39-46, 94-95.

31 Id. at 63-65, 95.

32 Id. at 65-68, 95.

33 Id. at 54-57, 60-63, 95.

34 Id. at 84-85, 95.

35 Id. at 87-90, 96.

36 Id. at 90-91.

37 See Dilworth, "Proposed Multilateral FTC Pooling," supra note 4.

38 Lewis Carroll, "Through the Looking Glass and What Alice Found There," ch. 6, quoted in Dilworth, "Proposed Multilateral Tax Pooling," id., at note 42.


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