Citizen Works

I. Background

My name is Samuel C. Thompson, Jr., and I am a Professor of Law and the Director of the Center for the Study of Mergers and Acquisitions at the University of Miami School of Law. I am submitting these comments because I have an academic and scholarly interest in (1) inversions, (2) the controlled foreign corporation provisions, and (3) tax shelters, all of which are addressed by H.R. 5095, The American Competitiveness And Corporate Accountability Act of 2002. I do not represent any client that has an interest in these issues, and all of the views expressed on this subject are my own and have not been approved by any other person or organization.

As a young lawyer, I worked in the Treasury's Office of Tax Legislative Counsel and Office of International Tax Policy. As a practicing lawyer for many years, I counseled clients on various issues relating to the Federal income taxation of corporate transactions, international transactions, and tax shelters, including tax shelters involving straddles transactions. As a law professor, I have taught International Taxation for many years, and I have published a casebook on the topic: U.S. Taxation of International Transactions (West Publishing 1994). I have also taught business taxation and my casebook on the topic, Taxation of Business Entities (West Publishing 2001), addresses, inter alia, corporate tax shelters.

I first became interested in inversions and similar transactions in 1998 in connection with a lecture I gave at the University of Cincinnati Law School on Section 367 of the Code. The lecture was published in the University of Cincinnati Law Review: The Impact of Code Section 367 and the European Union's 1990 Council Directive on Tax-Free Cross-Border Mergers and Acquisitions, 66 U. Cin. L. Rev. 1193 (1998). I continued my interest in this subject by publishing in the March 18, 2002 issue of Tax Notes an article entitled: Section 367: a 'Wimp' For Inversions and a 'Bully' For Real Cross- Border Acquisitions, 94 Tax Notes 1505 (March 18, 2002) and 26 Tax Notes International 587 (May 6, 2002) [Section 367: A Wimp and a Bully]. This article was the basis of the Polisher Tax Lecture I gave at the Dickinson Law School on April 24, 2002. I also recently published in Tax Notes and Tax Notes International the following four articles on this subject:

Thompson, Analysis of the Non-Wimpy Grassley/Baucus Inversion Bill, 26 Tax Notes International 741 (May 13, 2002) and 95 Tax Notes 1515 (June 3, 2002);

Thompson, Treasury's Inversion Study Misses The Mark: Congress Should Shut Down Inversions Immediately, 26 Tax Notes International 969 (May 27, 2002) and 95 Tax Notes 1673 (June 10, 2002);

Thompson, Treasury Official Gives Unconvincing Reason for Not Blockading Inversions, 2002 Worldwide Tax Daily 112-15 (June 11, 2002), 95 Tax Notes 1673 (June 10, 2002), and 26 Tax Notes International 1321 (June 17, 2002); and

Thompson, Inversion Hearings Focus on Wrong Issues, 96 Tax Notes 154 (July 1, 2002) and 27 Tax Notes International 193 (July 8, 2002).

I also made a written submission to (1) the House Ways and Means Committee in connection with its hearing on corporate inversion transactions, which was held on June 6, 2002, and (2) the Select Revenue Measures Subcommittee of the Committee On Ways and Means in connection with its hearing on inversions, which was held on June 25, 2002. This written submission is also the basis of an article that will be published shortly.

II. Introduction

Congressman Thomas, the Chairman of the House Ways and Means Committee, has introduced H.R. 5095, the American Competitiveness and Corporate Accountability Act of 2002 (the Thomas Bill). The Summary of the Legislation prepared by the Committee on Ways and Means asserts that the "determination by the World Trade Organization (WTO) that both the Foreign Sales Corporation (FSC) and Extraterritorial Income (ETI) tax structures are illegal export subsidies, coupled with an uncompetitive tax system, indicate that our tax system needs substantial reform." The Summary explains that the legislation:

(1) imposes a 3-year moratorium on inversions, (2) removes the tax incentives for U.S. companies to invert, (3) modernizes, simplifies, and makes competitive our taxation of U.S. multinationals that compete in a global marketplace, (4) eliminates the unintended tax advantages that our tax system bestows on subsidiaries of foreign owned companies operating in the United States, (5) reduces the tax incentives for foreign acquisitions of U.S. businesses, and (6) reduces the use of abusive tax shelters. This comment briefly addresses three aspects of this bill: (1) the anti-inversion provisions, (2) the repeal of the foreign base company sales and services income provisions of the controlled foreign corporation rules, and (3) the tax shelter proposals.

This comment argues that the anti-inversion provisions are going in the right direction, the foreign base company sales and services provisions should not be repealed but should be revised to focus more on the significant transfer pricing problem the IRS faces, and the tax shelter proposals should contain a targeted deterrent against loss generator shelters.

III. Right Direction on Inversions

The Thomas Bill would stop pure inversions and penalize other inversions much like the bill introduced in the Senate by Senators Grassley and Baucus (the Grassley/Baucus Bill). The principal difference in the bills is that whereas the Thomas Bill would only impose a three-year moratorium on pure inversions, the Grassley/Baucus bill would impose a permanent ban on pure inversions, would deal more harshly with limited inversions, and would become effective sooner. However, the Thomas Bill would also require the Treasury to study inversions and report to the Congress before December 31, 2004. It is difficult to see a case for not making the prohibition on inversions permanent, but it is also good to see the Thomas Bill move in the direction of the Grassley/Baucus bill. This seems to ensure that pure inversions will be blocked at least for the next three years. I am certain that if the Thomas moratorium is adopted in the conference and inversions reappear after the end of the moratorium, Congress would then act to shut them down permanently. This is why Congress should adopt the permanent prohibition now.

Both the Thomas and Grassley/Baucus bills should be clarified and strengthened in two respects. First, it should be clarified that the bills apply to initial incorporations in tax haven jurisdictions in going public transactions, such as the Accenture and PriceWaterhouse Coopers transactions. The language of the bills seems to reach such transactions, but the point needs to be clarified in either the statute or the legislative history. These transactions can have the same effect as pure inversions and should be treated the same.

Second, both bills have exceptions for acquisitions by foreign acquirors having "substantial business activities" in the foreign country in which the acquiror is organized. While this is basically a sensible exception, it should not apply if the foreign acquiror is organized in a country that is a tax haven, like Bermuda.

I have made these same two points in greater detail in Analysis Of The Non-Wimpy Grassley/Baucus Inversion Bill.

Following the suggestion of the Treasury, the Thomas Bill would also significantly tighten the interest stripping rules of Section 163(j). It would also impose an excise tax on the value of stock options and stock based compensation held by insiders, top executives and directors when a company inverts. Both of these changes are sensible, and the Treasury should consider modifying the Section 367 regulations to make the various gain recognition rules for stock also applicable to stock options.

The Thomas Bill would also require the Treasury to study (1) the effectiveness of the transfer pricing rules in Section 482, and (2) the United States income tax treaties to identify any inappropriate reductions in withholding tax that provide opportunities for shifting income out of the United States and to evaluate whether existing anti-abuse mechanisms are operating properly. Congressman Doggett has introduced a bill that would address the abusive use of treaties, and this study could examine the effectiveness of his bill.

On balance, Congressman Thomas is to be commended for moving in the direction of the Grassley/Baucus bill and in even going further in (1) a broad based attack on interest stripping along the lines proposed by the Treasury, (2) enhancing the reporting requirements for gain recognized in inversion and similar transactions along the lines proposed by the Treasury, and (3) originating the proposal for the taxation of stock options and other stock based compensation in inversion transactions. The Treasury studies of the effectiveness of Section 482 and treaties are also to be commended.

IV. Too Far on Repeal of Foreign Base Company Sales and Services Income Provisions

The Thomas Bill would repeal the foreign base company sales income and foreign base company services income provisions of the controlled foreign corporation provisions. Under these provisions, the foreign base company sales and services income of a controlled foreign corporation (CFC) is generally imputed to the U.S. controlling shareholders (U.S. Parent), thus denying deferral of such income. Foreign base company sales income includes, for example, income earned by a CFC (Foreign Sub 1) on the purchase of property from U.S. Parent, and the sale by Foreign Sub 1 of the property outside of the country in which it is incorporated. Such income can also arise from the purchase by Foreign Sub 1 of property from a sister CFC (Foreign Sub 2) incorporated in another country and the sale of the property outside of Foreign Sub 1's country of incorporation.

Foreign base company services income arises, for example, where Foreign Sub 1 receives compensation for performing services for U.S. Parent or Foreign Sub 2 outside the country in which Foreign Sub 1 is incorporated. The purpose of these the foreign base company sales and services provisions is to deny the benefit of deferral for active foreign business income that is likely to otherwise be free of tax. To the extent these provisions apply, the parties receive no benefit from aggressive transfer pricing, because the income of both entities is included in the U.S. Parent's income.

The situations in which foreign base company sales or services income arise in transactions occurring between sister foreign subsidiaries are referred to as the "foreign to foreign related party" rules. The National Foreign Trade Council, an industry organization that is the principal advocate for reforming the CFC provisions, has argued in an extensive Study that these "foreign to foreign related party" rules have an adverse effect on U.S. competitiveness in foreign markets. Although the Study goes at length to detail the problems caused by the "foreign to foreign related party rules," the Study, to my knowledge, does not state at any place that there are similar problems with the "domestic parent to foreign sub" provisions of the foreign bases company sales and services provisions. Thus, it is possible for one to be convinced by the case made by the NFTC that the "foreign to foreign related party" rules should be revised or repealed, but there is absolutely no case for repealing the "domestic parent to foreign sub related party" rules of the foreign base company sales and services provisions.

In fact, the "domestic parent to foreign sub related party" rules should be strengthened to apply to all sales of property between domestic parents and foreign subs, without respect to the country of sale. This type of amendment would significantly reduce the potential abuse through the use of aggressive transfer pricing in these transactions. For example, there would be little reason for US Parent to charge Foreign Sub 1, which was located in a tax haven jurisdiction, a below market price for the sale of a widget, because U.S. Parent would be taxed on all of the income from the sale of the widget, without respect to whether the income is earned by U.S. Parent or Foreign Sub 1. Also, there would be little reason for Foreign Sub 1 to charge U.S. Parent an inflated price for a wodget, because the income of both corporations would be subject to tax.

The potential revenue loss from transfer pricing is quite significant, and this is recognized in the provisions of the Thomas Bill requiring the Treasury to study the transfer pricing issues associated with inversions and similar transactions. Further, as Gustafson, Peroni, and Pugh report:

The amounts at stake for the Treasury and taxpayers in transfer pricing controversies are substantial. The IRS estimated a revenue loss of $2.8 billion each year from 1996 through 1998. * * * However, another study estimated that the United States lost over $35.6 billion in income taxes in 1998 due to the manipulation of transfer prices by multinational corporations. * * * Further, the amounts at issue in transfer pricing cases are often very large.

A June 11, 2002 article in the Wall Street Journal illustrates the potential size of these transfer pricing cases:

GlaxoSmithKline PC and the Internal Revenue Service are battling over allegations that the British pharmaceuticals giant improperly avoided a significant portion of U.S. taxes due on billions of dollars in drug sales. * * * Glaxo U.S. spokeswoman Patricia Seif declined to quantify the potential tax liability. But she said the company had made adequate provisions for any adverse ruling and noted that the company's most recent annual report discloses a broader category of potential world-wide tax liabilities and charges of £1.672 billion, or about $2.4 billion. * * * The case is a vivid illustration of how difficult it has become to enforce U.S. tax laws in an era when business is global and the most valuable assets frequently are intangible. The IRS contends that Glaxo's American arm, GlaxoSmithKline Holdings (Americas) Inc., overpaid its British parent for the drugs, thereby artificially reducing U.S. profits and paying less U.S. taxes as a result. The agency maintains that Glaxo understated the importance that its U.S. marketing costs played in the drugs' success in this country. * * *

A 1999 Study by the Staff of the Joint Committee on Taxation of economic issues in international taxation reports that intracompany sales between U.S. parent companies and their foreign subsidiaries is a significant portion of the U.S. merchandise export and import sales:

[I]n 1994, U.S. multinational enterprises shipped $136.1 billion of goods to their foreign affiliates, a figure representing 26 percent of U.S. merchandise exports in 1994. Foreign affiliates of U.S. multinational enterprises [shipped] $113.4 billion of goods to their U.S. parent enterprise, a figure representing 17 percent of U.S. merchandise imports in 1994.

Treating these intracompany sales as foreign base company sales income would significantly reduce the pressure the IRS faces administering Section 482 in transactions between U.S. parents and their foreign subs. It would, indeed, free up IRS resources to focus more on intracompany transactions between foreign parent companies and their U.S. subs, as illustrated in the GlaxoSmithKline case discussed above. As the Staff of the Joint Committee reports, the level of these foreign parent-domestic sub intracompany transactions is quite significant:

In 1994, large foreign-owned domestic corporations reported sales of tangible goods to related foreign persons (exports) of $70.5 billion, a figure representing 14 percent of total U.S. merchandise exports in 1994. Large foreign-owned domestic corporations reported purchases of tangible goods from related foreign persons (imports) [a la GlaxoSmithKline] of $180 billion, a figure representing 27 percent of total U.S. merchandise imports in 1994.

The Staff Report says: "Thus, in total, in 1994 intra-firm trade accounted for at least 40 percent of U.S. merchandise exports and 44 percent of U.S. merchandise imports." With intracompany transactions accounting for such a large percentage of trade in goods, it seems obvious that any help the IRS can get in reducing the number of transactions that are subject to scrutiny under Section 482 would significantly improve the effectiveness of our overall international tax regime.

In summary, there is no case for repealing the foreign base company sales and services income provisions, although there may be a case for repealing or revising the "foreign to foreign related party" aspects of these provisions. There is a very strong case for extending the "domestic parent to foreign sub" provisions of the foreign base company sales and services income provisions to cover all sales and services without regard to where they occur or are rendered. This would significantly relieve the pressure on Section 482.

V. Not Far Enough on Tax Shelters

The Thomas Bill proposes significant and important changes in the law regarding corporate tax shelters. However, I think the Congress should go much further with at least one type of tax shelter: the loss generator. In this type of tax shelter, parties have, for example, used special allocations in partnerships to generate significant losses for a taxable partner and offsetting significant income for a nontaxable partner, such as a foreign entity. The losses are then used by the taxable partner to offset an unrelated gain, such as the gain from the sale of the stock of a subsidiary.

An important aspect of these transactions seems to be the use of an extraordinary loss generated in a transaction that takes place over a short period of time to offset a realized gain that has accrued over a long period. An approach to these loss generator shelters that would be more direct and effective than the provisions of the Thomas Bill would be to eliminate the ability to offset significant gains that have accrued over a long period with significant losses that have accrued over a short period, unless the taxpayer establishes by clear and convincing evidence that the short term loss arose in a transaction that did not have as one of its objectives the reduction in tax liability.

This approach would require careful definitions of such terms as "significant gains," "long period," "significant losses," and "short period." Also, there would have to be rules prohibiting the conversion of a gain that accrued over a long period into a short period gain. These issues, I believe, could be adequately addressed, and the benefit of adopting such an approach is that it would give the IRS an objective tool to attack these transactions, with the more subjective provisions of the proposed rules as backstops.

As a general matter, I believe it is more efficient for Congress to enact targeted legislation to shut down tax shelters that have been identified, because such action can bring the marketing of such transactions to an immediate halt and also eliminate the uncertainty inherent in litigating these cases even under the proposed rules. I personally have observed the effectiveness of the targeted approach that Congress followed in enacting the straddles provisions in 1981 and 1983. These provisions brought the marketing of straddles tax shelters to a quick end, and the statutory approach has been much more successful than merely relying on the issues to be settled through litigation, even though the IRS has been successful with its litigated positions.

VI. Conclusion

The Thomas Bill is moving in the right direction on inversions; but there is no reason to be gentle with inverters, and for this reason, Congress should move in the direction of the Grassley/Baucus bill. There is absolutely no case for repealing the "domestic parent to foreign sub" provisions of the foreign base company sales and services income provisions. Congress should extend these provisions to all covered transactions between such companies without respect to where the sale ultimately occurs or the services are ultimately rendered. Such an extension would significantly reduce the pressure on Section 482 that the Thomas Bill itself recognizes. Congress should adopt a targeted approach for loss generator tax shelters and should give consideration to following such an approach for other shelters.