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 incremental research credit (AIRC), or the alternative simplified credit (ASC). The ASC equals 12 percent of qualified research expenses that exceed 50 percent of the preceding three-year average.

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.

The research credit expired at the end of 2007. Congress failed to pass a one-year extension of the research tax credit 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 may consider a retroactive extension of the research tax credit and other 2007 expiring tax provisions but the timing is unclear. Continued disagreement over revenue offsets could delay consideration of a tax extender bill until late in 2008, possibly during a post-election “lame-duck” session of Congress. A one-year extension of the research credit is estimated to cost approximately $8 billion.

In February 2008, the Administration submitted a fiscal year 2009 budget that includes a proposal to permanently extend the research credit. The President’s budget proposals for fiscal years 2003 through 2008 contained a similar proposal. Permanent extension of the research credit is estimated by the Joint Committee on Taxation to cost approximately $108 billion over 11 years (2008-2018).

In January 2007, Senate Finance Committee Chairman Max Baucus (D-MT) introduced a bill (S. 41, the Research Competitiveness Act) to make the research credit permanent and replace the three current methods of claiming the credit with a 20 percent credit for qualifying research expenses that exceed 50 percent of the average expenses of the prior three years.

In May 2007, House Ways and Means Committee members Sander Levin (D-MI) and Dave Camp (R-MI) introduced a bill (H.R. 2318, the Investment in America Act of 2007) to make the research credit permanent, increase the ASC to 20 percent, repeal the AIRC, and retain the regular credit.

In October 2007, Senate Finance Committee Chairman Max Baucus (D-MT) and Finance Committee member Orrin Hatch (R-UT) introduced a bill (S. 2209, the Research Credit Improvement Act) to make the research credit permanent, gradually increase the ASC to 20 percent, and repeal the regular credit and AIRC. The bill also would require a one-year Treasury study on compliance with substantiation requirements.

The SVTDG supports efforts to extend permanently and further improve the effectiveness of the Section 41 tax credit. The SVTDG recommends that a research tax credit be extended permanently, effective from January 1, 2008 forward, as soon as possible.

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

SecThe United States taxes U.S. 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.

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. Without deferral, U.S. companies would be disadvantaged because they would face higher tax costs than their foreign competitors. The great majority of other developed countries do not tax foreign income, or they defer tax until the money is repatriated.

In October 2007, 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 includes a number of proposals to broaden the corporate tax base, including a proposal to require U.S. multinationals to defer deductions associated with foreign income that has not been repatriated to and taxed in the United States, and to further limit foreign tax credits on foreign income. The proposal is estimated to raise approximately $106 billion. This exceeds the revenue raised by outright repeal of deferral.

The SVTDG believes that the elimination of deferral does not represent good tax policy as it will place U.S. companies on an even weaker footing when competing overseas against non-U.S. companies.

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

The United States taxes U.S. 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 distributed to the U.S. person.

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 ruling (Notice 2007-13) as well as the recent proposed contract manufacturing regulations, generally acknowledge the complexity of the U.S tax system, and are reflective of efforts to import certainty and flexibility into the system.

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 financial service income has been addressed on a temporary basis).

In addition, the subpart F exception for active financing income and the “look-through” rule for payments between related CFCs are scheduled to expire at the end of 2008. The President’s FY 2009 budget submission includes proposals to extend for one year the active financing exception and the CFC look-through rule. The estimated cost is approximately $4.5 billion over 10 years. Senate Finance Committee Chairman Max Baucus (D-MT) and House Ways and Means Select Revenue Measures Subcommittee Chairman Richard Neal (D-MA) have introduced legislation (H.R. 1509 and S. 940) to make the active financing exception permanent. Ways and Means Committee member John Tanner (D-TN) and Finance Committee member Jon Kyl (R-AZ) have introduced legislation (H.R. 3735 and S. 1273) to make the CFC look-through rule permanent. Permanent extension of both provisions is estimated to cost $66 billion over 10 years.

The SVTDG recommends that the foreign base company sales and foreign base company services income rules of subpart F be repealed in their entirety.

Proposed Change to a Territorial Based Income Tax System

The United States taxes U.S. 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 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 November 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 plans 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 January 2005, the Joint Committee on Taxation (JCT) released a report on options to improve tax compliance and reform tax expenditures. The JCT report includes a staff recommendation on a foreign dividend exemption proposal that is estimated to raise approximately $55 billion over 10 years. The JCT recommendation is more onerous than the tax reform panel proposal.

While the territorial tax proposal under the Simplified Income Tax 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. Moreover, this would be a massive project to undertake, resulting in a complete rewrite of the Internal Revenue Code.

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 (39.3 percent) is second highest (after Japan) among the 30 OECD countries, and 11.7 percentage points greater than the OECD average.

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, 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 includes a revenue-neutral proposal to reduce the federal corporate tax rate from 35 percent to 30.5 percent and broaden the corporate tax base.

In December 2007, the Treasury Department released a report on U.S. business taxation and global competitiveness. The report outlines three revenue-neutral approaches to business tax reform: (1) a broad business tax base and a business tax rate of 28 percent with economic depreciation (or 31 percent if accelerated depreciation is maintained); (2) a broad business tax base maintaining current tax rates combined with 35 percent partial expensing for equipment, structures and inventories; and (3) replacing all business taxes with a border-adjustable, subtraction method value-added tax (termed a “business activities tax”) imposed at a tax rate of 5-6 percent.

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.

Codify the “Economic Substance” Judicial Doctrine

The House and Senate have passed competing versions of legislation to codify the economic substance judicial doctrine.

The Senate version is pending in a farm reauthorization bill (H.R. 2419) as a revenue offset for an agriculture tax incentives package. Under the Senate provision, in any case in which a court determines that the economic substance doctrine is relevant to a transaction, the economic substance doctrine would be satisfied only if (1) the transaction changes in a meaningful way (apart from federal income tax consequences) the taxpayer’s economic position, and (2) the taxpayer has a substantial non-federal tax purposes for entering into such transaction. The provision imposes a strict-liability, 30 percent penalty on any understatement of income attributable to a non-economic substance transaction (unless the transaction was disclosed, in which case the penalty is 20 percent). Because it is calculated based on an understatement of income, the penalty is due even if there is no understatement of tax (e.g., due to net operating losses). Public entities required to pay the penalty are required to disclose the penalty in SEC filings. The proposal is effective for transactions entered into after the date of enactment. The Senate provision is estimated to raise approximately $10 billion over 10 years.

The House version was included in a bill (H.R. 4351) to extend individual AMT relief for 2007 and renew 2007 expiring tax provisions. Although similar to the Senate provision, the House version would impose a 40 percent penalty on underpayments attributable to a transaction lacking economic substance (unless the transaction was disclosed, in which case the penalty is 20 percent). The House provision also would increase the threshold for avoiding the substantial understatement penalty to “more-likely-than-not” for larger corporations, with no reasonable cause or disclosure exception. The House provision is estimated to raise $4.1 billion over 10 years.

The courts have long established, through judicial doctrine, the principle of economic substance. The Administration continues to oppose economic substance codification. Treasury and IRS officials have said codification could aid planning by aggressive taxpayers while discouraging legitimate business transactions by less aggressive taxpayers.

The SVTDG believes that codification of the doctrine should be rejected.

Qualified Cost Sharing Arrangements - Inclusion of Stock Option Expenses

The IRS position, as articulated in final regulations (T.D. 9088), 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’ qualified cost sharing arrangements under Treas. Reg. Sec. 1.482. According to the IRS, requiring stock-based compensation to be taken into account for purposes of qualified cost sharing arrangements 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.

The IRS, in 2006, filed a Notice of Appeal with the Tax Court and on January 9, 2007, the Tax Division of the Department of Justice (DOJ), on behalf of the IRS, filed its opening brief to the U.S. Court of Appeals for the Ninth Circuit. The DOJ argues that the arm’s length standard is not to be determined by observing comparable real-world transactions, but rather, by following the definitions set out in Treas. Reg. Sec. 1.482-7(a)(2). A Ninth Circuit panel recently heard oral arguments on the government’s appeal. It still remains uncertain when a final decision will be handed down.

The IRS has tried to further its position on stock option expenses, despite the Xilinx decision, in the final, proposed and temporary services regulations (T.D. 9278), 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.

The SVTDG recommends, particularly in light of the result reached by the Tax Court 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.

Tax Treaty Override Legislation

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 includes a provision that would override treaty benefits for deductible payments made by US subsidiaries of foreign-based companies if the payment is 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 is 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 has been 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 will not be affected. The Senate Finance Committee opposes the version in the House farm bill.

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.

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

IIn 2007, the Senate passed legislation to impose new restrictions on executive compensation. None of these legislatives proposals were enacted but could be revived in 2008.

In February 2007, the Senate passed H.R. 2, the Small Business and Work Opportunity Act of 2007, to increase the federal minimum wage and provide small business tax relief. The cost was offset by several revenue-raising tax provisions, including provisions to further limit nonqualified deferred compensation and expand the scope of the $1 million cap on deductible compensation under section 162(m).

The Senate provision on nonqualified deferred compensation would amend section 409A to impose a dollar cap on the aggregate annual amount of compensation that may be deferred by an individual. The cap would be equal to the lesser of $1 million or the individual’s average annual compensation over the previous five years. If there are any deferrals in excess of this limit, then all deferrals would be subject to current income taxation, interest at the underpayment rate plus one percent, and a 20 percent penalty. The provision generally would be effective for amounts deferred after 2006.

The Senate provision on section 162(m) would expand the definition of “covered employee” to include: (1) any individual who was the CEO of the company at any time during the taxable year (not just the CEO as of the last day of the tax year); (2) the four highest compensated officers for the year; and (3) any individual who previously was a covered employee with respect to the company (or a beneficiary of such person).
The Senate provisions were not included in the conference agreement on the final bill (H.R. 2206). The House Ways and Means Committee held a March 14, 2007 hearing on the Senate revenue-raising tax provisions. Several Democratic and Republican Ways and Means members raised concerns about the Senate provision to limit deferral under nonqualified deferred compensation plans.

The nonqualified deferred compensation could be modified to address several concerns. Possible modifications include eliminating the average of the previous five years to provide a flat $1 million annual cap on deferrals, excluding investment returns up to a market rate of return, excluding mirror plans, and adding a correction mechanism. In addition, the proposed legislation could hit middle managers with defined benefit supplemental retirement arrangements and/or excess section 401(k) deferral arrangements where the benefits provided under the nonqualified plan merely mirrored the qualified plan except that statutory limits on the amount of compensation taken into account for qualified plan purposes are ignored.

The SVTDG believes that Congress should refrain from imposing any new limitations on nonqualified deferred compensation plans until the IRS has had time to implement fully Section 409A. To date, the IRS has only been able to issue final regulations addressing the definition of nonqualified deferred compensation, and the election and distribution rules under Section 409A. IRS must still provide guidance on the funding rules, deferral reporting requirements and penalty calculations. In addition, Congress should hold hearings on proposals to impose new limits on deferred compensation or modify section 162(m) before adopting specific proposals.