Make Permanent and Further Enhance the Research Tax Credit (Section 41)

Section 41 provides a 20 percent credit for incremental increases in qualified research. In lieu of the regular research credit, taxpayers can elect to calculate the credit using the alternative simplified credit (ASC). The ASC equals 14 percent of qualified research expenses that exceed 50 percent of the preceding three-year average.

Under current law, the research credit is not available for amounts paid or incurred after December 31, 2009. However, Congress has proposed legislation that would temporarily extend the research credit. The House on May 28, 2010, passed the “American Jobs and Closing Tax Loopholes Act of 2010” (H.R. 4213), which would extend the research credit for one year, through the end of 2010. The Senate in June began consideration of H.R. 4213, but was not able to secure the 60 votes needed to approve this legislation. At this time, Congress is expected to consider a retroactive extension of the research credit at some point later this year.

Technological development is an important component of economic growth. Decisions by companies about the location of R&D are critical to U.S. competitiveness. A number of countries, in addition to the United States, provide research tax incentives, and several foreign countries have expanded the scope of their research incentives in recent years.

The status of the U.S. research credit has become uncertain in recent years. For example, Congress allowed the research tax credit to expire at the end of 2007 because of a disagreement between Democrats and Republicans over whether a tax extender package should be offset by revenue-raising tax provisions. Congress in late 2008 enacted a retroactive extension of the research credit as part of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343). Specifically, the legislation:

• Extended the research credit retroactively from January 1, 2008, for two years;
• Modified the Alternative Simplified Credit (“ASC”) by increasing the rate from 12% to 14% for taxable years ending in 2009 (taxable years ending in 2008 remained at 12%);
• Terminated the Alternative Incremental Research Credit (“AIRC”) for taxable years beginning after December 31, 2008.

President Obama has proposed making the research credit permanent as part of the proposed federal budget for FY2011.

Legislation was introduced last year to make the research credit permanent and also increase the ASC to 20%. Senate Finance Committee Chairman Max Baucus (D-MT) and Senator Orrin Hatch (R-UT) have sponsored S. 1203, which would extend the research credit permanently and eliminate the base-period credit after 2010 when the ASC reaches 20%. Similar legislation (H.R. 422) has been introduced by House Ways and Means Committee member Kendrick Meek (D-FL).

The SVTDG supports efforts to extend permanently and further improve the effectiveness of the Section 41 tax credit.

Preserve the Deferral of U.S. Tax on Foreign Earnings

The U.S. imposes tax on companies based on their worldwide income (i.e., both foreign and domestic income). In general, a U.S. corporation does not pay income tax on the active earnings of its foreign subsidiaries until that income is paid to the U.S. parent, typically as a cash dividend. The “deferral” rule generally ensures that foreign subsidiaries of U.S.-based companies pay the same tax rate as their competitors in the country in which they are doing business, and do not pay a U.S. corporate tax rate that often times will be much higher. All of the U.S. trading partners (e.g., OECD countries) either provide deferral or exempt the foreign earnings of their companies from taxation.

Deferring U.S. taxation of foreign subsidiary earnings until the money is repatriated allows U.S. companies to compete on a level playing field with foreign-owned companies in foreign markets. Deferral allows U.S. companies to increase sales in world markets, leading to more and better paying jobs for U.S. workers. Without deferral, U.S. companies would be disadvantaged because they would face higher tax costs than their foreign competitors.

Further restrictions on deferral would reduce the international competitiveness of U.S. companies and their workers relative to foreign competitors and — contrary to certain expressed views — would lead to a loss in U.S. jobs and reduce U.S. living standards. Maintaining deferral is important to ensuring the competitiveness of U.S. multinational companies. Foreign operations of U.S. companies increase the demand for U.S. products and services, thereby leading to more exports from the U.S. and more jobs for its citizens.

The direct effect of further limitations on deferral would be to accelerate tax payments by U.S. companies on their affiliates’ foreign operations. Because the U.S. corporate tax rate is among the highest in the world (in 2009, the combined U.S. federal, state and local rate was second highest among all OECD countries), U.S. companies would generally owe additional U.S. tax on their foreign earnings after netting foreign tax credits on the foreign income. U.S.-owned foreign subsidiaries would be significantly disadvantaged relative to their foreign competitors, because U.S. companies would be immediately subject to additional U.S. tax on their foreign income while their foreign-based international competitors could continue to defer or be exempt from additional home-country tax. The tax advantage available to foreign-based competitors would permit them to reinvest more and sell their products at a lower price than their U.S.-owned competitors.

Deferral provides a level playing field for U.S. companies operating abroad with the local foreign competition in those countries. Commerce Department data show that 90% of what is produced abroad by U.S. companies is sold to foreign customers. As sales by U.S.-owned operations abroad increase, demand increases for products made by the U.S. operations of these companies to be exported as well.

In addition to jobs created through exports, foreign operations of U.S. companies increase employment in the U.S. for high-value jobs in research and development, engineering, logistics, finance, and marketing in support of the foreign operations.

If U.S. companies did not operate abroad, U.S. exports would decline — not increase and U.S. companies would reduce U.S. jobs accordingly. Deferral helps U.S. workers compete in the world economy.

President Obama has proposed reforming U.S. international tax rules to address provisions that “reward corporations that retain their earnings overseas” and that encourage companies to “ship jobs overseas.” The Obama Administration has submitted a proposed federal budget for FY2011 featuring provisions that would:

• Require a company generally to defer deductions for U.S. interest expenses “allocable” to foreign income until the deferred foreign income is repatriated. This proposal is estimated to raise $35.5 billion.
• Impose new limitations on foreign tax credits. Specifically, the proposal would restrict foreign tax credits to the average rate of total foreign tax actually paid on total foreign earnings. The proposal also would address mismatches of foreign tax credits and the associated income in a manner similar to, but not the same as, August 2006 proposed regulations. These proposals are estimated to raise $58.7 billion.
• Tax currently “excess returns” associated with transfers of intangibles offshore. This proposal is estimated to raise $15.5 billion.

The SVTDG believes that it is essential to maintain current law tax rules that permit U.S. companies with active foreign earnings to reinvest these earnings in their foreign operations and defer paying U.S. tax until the earnings are paid to the U.S. parent companies, usually in the form of a dividend; to do otherwise would reduce the global competitiveness of U.S. multinational companies. The SVTDG believes that the Obama Administration’s proposals would result in an indirect loss of deferral of foreign earnings and could result in double taxation of such earnings, and as currently written would contribute to a further loss of competitiveness. Furthermore, the SVTDG believes that such changes should not be considered outside of a broader discussion of international tax policy and reform.

Modernizing Subpart F to Increase Global Competitiveness of U.S. Multinational Corporations

The United States taxes U.S. based multinational companies on their worldwide income (i.e., both foreign and domestic income). In general, income earned by a U.S. company through a foreign subsidiary is subject to U.S. tax only when such earnings are repatriated to the United States. However, under the subpart F rules, certain types of income earned by foreign subsidiaries are immediately taxed in the United States regardless of whether the income is actually repatriated.

The subpart F rules were enacted in 1962, a different era of global competitiveness when U.S. companies were dominant globally. The rest of the world is catching up in terms of business competitiveness, while adopting more favorable tax regimes with respect to international business operations. Meanwhile, U.S. international tax rules generally are more complex and more far-reaching in terms of taxing global operations, making it harder for U.S. companies to compete globally. Recent guidance, such as the substantial assistance notice (Notice 2007-13) as well as the recently issued contract manufacturing regulations, generally acknowledge the complexity of the U.S. tax system and the need to modernize subpart F in order to protect the competiveness of U.S. multinationals, and are reflective of efforts to import certainty and flexibility into the system. However, more transitional relief is needed in the implementation of the new guidance. For example, U.S. multinationals that may be adversely affected by the new contract manufacturing regulations may need to undertake costly and time-consuming restructuring (including potential changes to supply chain, HR, and/or IT) in order to comply with the new regulations without incurring significant U.S. taxes. However, the effective date provisions of these regulations in many cases would not provide sufficient time for these companies to complete the restructurings.

It should be noted that the IRS hopes to release regulations on substantial assistance “soon.” In light of the above, these forthcoming regulations should provide better transitional relief by providing a more delayed effective date with an option to adopt at an earlier time (Notice 2007-13 indicates that forthcoming regulations would be effective for years beginning on or after January 1, 2007).

Legislation has been enacted to mitigate the negative impact of U.S. subpart F rules on the competitiveness of U.S. multinationals. Recent reforms have sought to narrow the scope of U.S. anti-deferral rules so as not to apply to certain types of active business income. However, the United States continues to impose current taxation on certain active foreign business income. The most important example is the subpart F foreign base company sales and services income rules (active financing income previously has been addressed on a temporary basis).

Congress in 2008 enacted the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), which extended through the end of 2009 both the subpart F exception for active financing income and the “look-through” rule for payments between related CFCs. President Obama has proposed to extend these two provisions through the end of 2011 as part of the Administration’s federal budget for FY2011. The House on May 28, 2010, passed the legislation (H.R. 4213) to extend these provisions for one year, through the end of 2010, but the Senate has not completed action on this legislation. At this time, Congress is expected to consider a retroactive extension of the subpart F exception for active financing income and the “look-through” rule for payments between related CFCs at some point before the end of 2010.

The SVTDG recommends that the foreign base company sales and foreign base company services income rules of subpart F be repealed in their entirety and that the “look-through” rule for payments between related CFCs be permanently extended.

Proposed Change to a Territorial Based Income Tax System

The United States taxes U.S. based multinational companies on their worldwide income, with tax on foreign earnings deferred until repatriated to the U.S. An alternative to this worldwide taxation is a territorial tax system. Under the type of territorial tax system used by many U.S. trading partners, some or all active overseas earnings of their businesses are exempt from taxation in the home country.

In 2005, the President’s Advisory Panel on Federal Tax Reform released its final report. The report’s recommendations include two options: (1) a Simplified Income Tax (SIT) Plan, and (2) a Growth and Investment Tax Plan. The SIT Plan includes adoption of a territorial tax system that generally would exempt from U.S. tax the dividends paid from active earnings of a foreign subsidiary to its U.S. parent corporation.

The panel recommended a territorial tax system to remove tax barriers for U.S. multinationals that hinder the repatriation of foreign earnings to the United States, and to improve the competitiveness of U.S. corporations in their foreign operations. However, the panel’s proposal includes certain potentially negative features that could increase the tax burden on U.S. multinationals, such as disallowing deductions for expenses allocable to the exempt dividends and a potential tax increase on certain foreign royalty and export income.

In December 2007, the Treasury Department issued a report on U.S. business taxation and global competitiveness that discusses an approach for reforming the U.S. international tax system by moving to a territorial tax system. According to the Treasury report, the current tax disincentive to repatriating foreign earnings could be addressed by moving to a territorial tax system.

In June 2008, the Senate Finance Committee held a hearing on international tax reform options, including proposals for a territorial tax system. Congress in the future may consider international tax changes during debate on general reform of U.S. individual and business tax provisions.

While the territorial tax proposal under the SIT Plan would allow simplification of the foreign tax credit rules, it would increase pressure on other rules, including sourcing, transfer pricing, and anti-deferral rules.

The SVTDG believes that the proposal would result in unfavorable tax results to U.S. taxpayers compared to present law and urges that the proposal not be enacted in its current form. Any consideration of a territorial tax system should be done in the context of an overall examination of tax reform options that would ensure the global competiveness of U.S. taxpayers as well as U.S. economic growth. The SVTDG would look forward to actively participating in any dialogue on a broad overhaul of the U.S. tax system.

Corporate Income Tax Rate Reduction

The Tax Reform Act of 1986 lowered the top corporate income tax rate from 46 percent to 34 percent in the belief that lower rates would promote economic growth. In the succeeding 20 years, corporate income tax rate reductions have swept the world but today’s top U.S. rate is 35 percent. Once competitive, the combined federal, state, and local corporate tax rate (39.2 percent) is second highest (after Japan) among the 31 OECD countries, and 13.7 percentage points greater than the OECD average excluding the U.S.

High corporate tax rates have a negative effect on economic growth. Research shows that countries with lower corporate income tax rates have over time achieved both higher real wage levels and economic growth rates. Corporate tax rates also affect the ability to attract business investment. High corporate tax rates make domestic investment less attractive and create an incentive for companies to shift high-profit activities abroad.

In October 2007, former House Ways and Means Committee Chairman Charles Rangel (D-NY) introduced a bill (H.R. 3970, the Tax Reduction and Reform Act) to reform the individual and corporate income tax. The bill included a revenue-neutral proposal to reduce the federal corporate tax rate from 35 percent to 30.5 percent and broaden the corporate tax base.

President Obama has expressed an interest in discussing with the business community revenue-neutral options for a corporate rate reduction. However, the Administration’s budgets for FY2010 and FY2011 did not propose a corporate rate reduction, but rather it proposed to use two key components of the business tax reform legislation introduced by former Ways and Means Chairman Rangel in 2007 for general deficit reduction.

The SVTDG would like to promote a dialogue with policy leaders regarding the need for corporate rate reduction and reform. While significant efforts by the Treasury Department and the IRS have been made to minimize much of the complexity associated with our tax system, there is still much more to be done to further this objective. One possible scenario could entail a true reduction in the effective corporate tax rate, thus minimizing many of the issues set forth above, and enabling the federal government to concentrate its efforts on identifying and penalizing tax offenders. The rate reduction would also work toward advancing global competitiveness. The SVTDG would look forward to actively participating in any such dialogue, including discussions addressing specificity about the rate, as well as other areas of the Internal Revenue Code.

Qualified Cost Sharing Arrangements - Inclusion of Stock Option Expenses

The IRS’s position, as articulated in 2003 final regulations (T.D. 9088) and restated in 2009 temporary cost sharing regulations (T.D. 9441), is that the “cost” or “value” of compensatory employee stock options are intangible development expenses and therefore, must be included in the pool of costs to be shared or charged out pursuant to taxpayers’ cost sharing arrangements (CSAs) under Treas. Reg. Sec. 1.482. According to the IRS, requiring stock-based compensation to be taken into account for purposes of CSAs is consistent with the legislative intent underlying Section 482 and with the arm’s length standard.

The inclusion of compensatory stock options in the cost sharing pool was the remaining issue in the Xilinx litigation. In this regard, the Tax Court, in August 2005, held that Xilinx’s cost sharing agreement, which did not include any sharing of cost for stock option expenses, met the arm’s length standard and that unrelated parties would not share the spread or grant date value of stock options. The Tax Court decision addressed years prior to 2003, but nonetheless raises the question of the viability of the final Treasury regulations.

In May of 2009, the Ninth Circuit Court of Appeals, in a 2-1 decision, reversed the Tax Court in Xilinx, holding that the cost sharing regulations in effect for Xilinx’s 1997-1999 tax years require that related companies developing intangibles under a CSA must share all costs associated with the intangible development activity, regardless of what an analysis pursuant to the arm’s length standard demonstrates. Specifically, the court found that the “cost” of stock option compensation must be shared, even though it was established that these costs are not shared in arm’s length arrangements. Xilinx petitioned the Ninth Circuit Court of Appeals for a rehearing en banc.

While the Xilinx case was pending, the IRS tried to advance its position on stock option expenses, despite the lower Xilinx decision, in the 2006 proposed services regulations, which require, among other things, that stock-based compensation be included in the cost of providing services when utilizing a transfer pricing method based on cost. In final services regulations published August 4, 2009 (T.D. 9456), the IRS continued to state that total services costs include all costs in cash or in kind (including stock-based compensation) that are directly identified with or reasonably allocated to the services.

On March 22, 2010, the Ninth Circuit Court of Appeals, in a 2-1 decisions, reversed its decision in Xilinx. The court found that the Section 482 regulations in effect at the time did not require stock option compensation to be included in costs shared under a cost-sharing agreement.

The SVTDG recommends, consistent with the result ultimately reached by the Ninth Court of Appeals in Xilinx, that the IRS no longer require U.S. taxpayers to include the cost or value of stock options in the cost pool. The government’s attempt to redefine the well-established “arm’s length” standard is a dangerous road to go down and will impact our relationships with treaty partners.

Cost sharing is under continual attack by the IRS. Cost sharing permits U.S. companies to perform important research and development activities in the U.S. while sharing the financial risks and burdens of such research and development with foreign subsidiaries.

Cost sharing keeps important jobs in the U.S. and allows partial funding of those jobs from subsidiaries outside the U.S.

Tax Treaty Override Legislation

Former House Ways and Means Committee Chairman Charles Rangel (D-NY) on October 25, 2007, introduced the Tax Reduction and Reform Act of 2007 (H.R. 3970), which included a provision that would override treaty benefits for deductible payments made by US subsidiaries of foreign-based companies if the payment were made to an intermediate foreign affiliate that is located in a treaty country. The provision would override the reduced rate of U.S. withholding accorded by the treaty and require a higher withholding rate to be imposed if the foreign parent were incorporated in a tax haven jurisdiction and would have been subject to a higher withholding tax rate had the payment been made directly from the U.S. subsidiary to the foreign parent company. The provision was modified from a previous version passed by the House as part of a farm reauthorization bill (H.R. 2419) to ensure that foreign multinational corporations incorporated in treaty partner countries would not be affected. The Senate Finance Committee opposed the version in the House farm bill, and this provision was dropped from the farm bill as enacted in 2008.

The House on several occasions has since passed legislation including a similar tax treaty override provision. The most recent House approval of this proposal took place on March 24, 2010, when a tax treaty override proposal was included in a small business tax relief bill (H.R. 4849).

The SVTDG believes that such tax treaty override legislation is bad tax policy because it constitutes a breach of our obligations to our treaty partners as well as of international law.

OECD Initiatives on Attribution of Business Profits to a Permanent Establishment

A fundamental part of every comprehensive U.S. income tax treaty is the concept that a resident of one of the contracting states will not be subject to income taxation in the other contracting state on the enterprise’s business profits arising within the other contracting state unless that enterprise has a permanent establishment (PE) in the source country and the profits are attributable to the PE. The purpose of the PE limitation is to promote bilateral trade and investment between residents of the two treaty partners by establishing a relatively objective and substantial threshold of presence in the source country before a resident of the other country is subjected to net income taxation by the source country. The PE principle is also a fundamental part of the model income tax convention developed by the Organization for Economic Cooperation and Development (OECD), an organization of which the United States is a member. The OECD model convention and guidelines established thereunder serve as a model for the formulation of treaty policy by most developed countries. The OECD is engaged in ongoing efforts to review and refine the principles guiding the determination of whether a business enterprise’s activities in a host country (i.e., the country that has taxing jurisdiction by reason of economic nexus of the income) rises to the level of a permanent establishment and, if so, the appropriate methodology for attributing profits to that PE.

In recent years, some tax authorities have taken an expansive view of what constitutes a PE and what profits are attributable to a PE. The issues have been complicated by the issuance of draft guidelines by working parties of the OECD that are proposing new, untried and controversial principles both for the determination of whether a PE exists and, if so, what profits are attributable to the PE. On March 15, 2005, the Committee on Fiscal Affairs of the OECD issued proposed revisions to its commentaries on the model convention that would make clear that when a company’s own activities at a given location may provide an economic benefit to the business of another company, it does not mean that the latter company has a PE as a result.

With the growth of global business and particularly with the rapid development of electronic commerce, the need for certainty, consistency, and clear thresholds before source country taxation is asserted is greater than ever.

The release of Parts I - III of the OECD Report on Attribution of Income to PEs clarifies a few points. First, it is very clear in indicating that the report is not intended to broaden or change in any way the definition of PE in the model treaty. It is limited to Article 7 issues related to how to determine how much income is attributed to a PE once it is established that a PE exists. Second, the Report makes it very clear that if a dependent agent PE exists, it is likely that additional income should be allocated to it based on the methodologies in the Report. These include attributing (i) risks to the geographic locations where the people in the business assuming and managing a particular risk reside; (ii) allocating intangible assets on the basis of the location of risk; and (iii) allocating income on the basis of the location of assets and risks.

On August 22, 2007, the OECD released a revised discussion draft of Part IV (Insurance) of the Report on the Attribution of Profiles to Permanent Establishments. This version replaced a June 2005 draft and made substantial revisions to the reinsurance section, and amended the definition of “key entrepreneurial risk-taking” functions in the earlier draft.

On September 19, 2008, the OECD released its discussion draft on business restructuring. The Discussion Draft addressed several important transfer pricing aspects of the taxation of internal business restructurings. These include:

• the treatment of allocation and transfer of risk among related parties;
• the question of whether and when internal business restructuring transactions require arm’s length compensation or indemnification;
• the question of how transfer pricing rules should be applied to the parties to a business restructuring transaction following the restructuring; and
• the question of whether and when governments have the ability to disregard a taxpayer’s restructuring transaction for purposes of applying transfer pricing rules.

While the Discussion Draft reflected consensus among OECD member countries across many issues, the Draft acknowledged differences of opinion between governments on some critical issues, a lack of consensus the OECD now seeks to narrow or resolve through its continuing deliberations.

The Discussion Draft generated tremendous interest in the business community, as evidenced by more than 400 pages of written comments provided to the OECD. The comments, while generally complimentary, also reflect significant disquiet over some key issues.

The SVTDG welcomes efforts by the OECD and its membership to provide greater clarity and certainty to the definition of a permanent establishment and the attribution of profits thereto and encourages further steps to discourage the assertion of taxing jurisdiction based on inappropriately low levels of activity of a taxpayer in a source country. The SVTDG encourages the U.S. government, as a member of the OECD, to actively promote the goals of certainty and consistency between countries in future OECD guidelines and to serve as a leader in combating inappropriate assertion of taxing jurisdiction by source countries.

Executive Compensation

In July 2009, Senators Carl Levin (D-MI) and John McCain (R-AZ) introduced a bill (S. 1491) intended to align book and tax treatment for stock options by allowing a federal tax deduction only equal to the book deduction for the year. To accomplish this, the bill would end the current Section 83 deduction for stock options, under which a company may deduct an amount equal to the income recognized by the individual when the option is exercised, and would amend Section 162 to provide the new rule. This change generally would apply to stock options exercised after the date of enactment, subject to certain transition rules.

In addition, the bill would modify the treatment of stock option expenses under the Section 41 research credit to conform to the bill’s new deduction. Incentive stock options under Section 421 would not be affected by this bill.

The bill also would subject stock option expensing to the $1 million cap that applies to certain executive compensation under Section 162(m), effective for stock options exercised or granted after the date of enactment.

Senator Levin on June 17, 2010 renewed his call for legislation to limit the deductibility of stock option compensation, releasing new IRS data showing the amount by which business tax deductions exceeded book expense. While the press release issued by the Senate Permanent Subcommittee on Investigations chaired by Senator Levin acknowledges that there is an inherent timing difference between the recognition of the book expense and the claiming of a tax deduction (e.g., the book expense generally precedes the tax deduction, and the book expense is generally spread over a vesting period whereas the entire tax deduction is recognized in one period) the report does not indicate that any attempt was made to reconcile the stock option deduction with the book expense that was recorded for the same stock options.

Separately, Congress has enacted legislation imposing broad limits on the deductibility of compensation for officers, directors, and employees in specific industries. Such limits have been imposed on certain financial institutions as part of the Troubled Asset Relief Program enacted in 2008 and certain health insurance providers as part of health care reform legislation enacted in 2010.

The SVTDG believes that Congress should hold hearings on proposals to impose new limits on deferred compensation, modify Section 162(m), or change the tax treatment of stock option costs before adopting specific proposals.