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OCR for page 75
6
The Virtual Global Electronic Economy
ROBERT N. MATTSON
IBM Corporation
Global business enterprises in the next century will be borderless organiza-
tions built around information networks, flexible work forces, and webs of strate-
gic alliances. In this environment, current U.S. tax policy on international invest-
ment is outmoded. Economic conditions have changed dramatically since the
U.S. tax rules controlling international operations were adopted 35 years ago.
The U.S. economy's percentage of the world gross domestic product (GDP) is
half of what it was 30 years ago. U.S. exports of high-technology goods relative
to those of other OECD (Organization for Economic Cooperation and Develop-
ment) member countries dropped by 40 percent during this period. U.S. outward
direct investment in 1960 was five times inward investment, today, the flows are
about equal (Hufbauer, 1992, Table 1.1~.
Before we can analyze the impact of U.S. tax policy on international invest-
ment, it is necessary to understand three major fundamental changes in the global
business environment (1) globalization, (2) quantum leaps in technology, and
(3) the emergence of a new set of technologically skilled nations. Unfortunately,
none of these changes has ever been considered in the numerous recent piecemeal
changes in U.S. tax law affecting international business.
GLOBALIZATION
Businesses no longer can focus solely on geographical borders. Many large
global companies have increasingly integrated their regional business activities.
It is not uncommon that they conduct their businesses at a Pan-European, Pan-
American (especially after NAFTA [the North American Free Trade Agreementi),
or Pan-Asian level.
75
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76
BORDERLINE CASE
Globalization involves R&D, manufacturing, and the marketing of goods,
services, and know-how on a worldwide level so that geographic boundaries be-
come only impediments. In the past, value was determined by the tangible goods
manufactured in plants located where comparative advantage dictated and the
inputs of capital and labor could be employed.
In the twenty-first century, know-how, ideas, and concepts intangible
goods will drive economic value. The nature of manufacturing in the coming
era of information and high-intangible technologies will, of necessity, require
governments to rethink tax policy. In contrast to the past, when know-how needed
to be dispersed and duplicated at each plant location, globalization will lead to its
centralization and distribution by networks. A contract manufacturing model
with widely dispersed assembled work forces will be cost-effective with central-
ized know-how. At the same time, networks of integrated R&D laboratories have
renewed the interest in cost-sharing arrangements. Governments naturally fear
erosion of their tax base and have not understood this new environment.
Globalization is probably best represented by the emerging virtual corpora-
tion. This is the way in which U.S. global companies and their foreign competi-
tors will operate in the future. These agile entities will have a quick response
capability linked by electronic mail and data exchange. Their manufacturing
units will operate with CAD (computer-aided design) system linkages and will
have portable videoconferencing capability via laptop computer connections.
QUANTUM LEAPS IN TECHNOLOGY
New technologies such as the Internet should not cause governments to enact
special tax regimes or to add electronic "tollbooths." These technologies are
progressions of older communications and knowledge delivery systems such as
the telephone, radio, television, and cable. As electronic commerce evolves, it
will undoubtedly be the most significant contributor to the growth of U.S. ex-
ports in the next century.
Transactions in intangible goods (e.g., software), information, and services
can be accommodated within the tax compliance systems existing today. This
requires great vigilance to prevent such tollbooth taxes as a recently discussed
"bit tax" on the digital "bit" stream over computer telecom, cable, and satellite
proposed by a member of the European Commission's High Level Expert Group
on the Social and Societal Aspects of the Information Society (Soete, 1996~. The
"bit" tax would probably be the most complex tariff ever devised, requiring sig-
nificant technical resources to implement, monitor, and audit and distorting flows
of information dramatically in ways that cannot be foreseen.
Product cycles and time to market are no longer measured in calendar years
but in "web" years (three-month lapse time). Collaborative R&D at labs in nu-
merous time zones on a global basis is the new virtual model for conducting
research and development projects in the corporation of the twenty-first century.
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THE VIRTUAL GLOBAL ELECTRONIC ECONOMY
77
The virtual corporation's units are linked by a new information technology. Sup-
plier and customers are now included in product design, quality assurance, pack-
aging decisions, and other formerly confidential internal processes. The telecom-
munications, cable, television, computer, and energy (electric utilities) industries
are converging into a network-centric business environment.
A static tax code, based on restrictive "source" tax rules and including limi-
tations on foreign tax credits resulting in double tax barriers, will only constrain
investment and high-paying job creation. Information technologies are not just
about making business better, they are about making business possible.
EMERGING TECHNOLOGICAL NATIONS
Hungry for capital investment and offering the virtual corporation low or
tax-free zones, newly developed nations are providing well-trained work forces
with low labor rates. As these nations improve their educational and productive
opportunities, high rates of growth will emerge. Southeast Asia and Eastern Eu-
rope, which offer such assembled work forces, will be attractive to manufacturing
and R&D investments in the era of information networks. Rapid, intangible tech-
nology transfer to almost any place on the globe will be possible with these new
technologies.
These nations will offer advantages for joint venture alliances where few
companies wish to bear the entire risk of such investments, for example, multi-
billion-dollar semiconductor factories, which are being located in countries pre-
viously considered unreliable for this type of investment. U.S. international tax
rules relating to joint venture alliances are equally outmoded and constitute barri-
ers to the way business is conducted. U.S. tax rules penalize foreign joint ven-
tures of U.S. global enterprises by fractionalizing the foreign tax credit rules with
separate "baskets" for each venture.
CHANGING TAX LANDSCAPE
It is heartening to observe the hands-off policy of the U.S. government in its
review of electronic commerce and the internet (Department of the Treasury,
1996:
These technologies present tremendous opportunities to enrich all of our lives in
so many ways, many of which we are likely not to have envisioned . . . Some
have even speculated that the traditional corporation could itself become obso-
lete in certain cases as "virtual corporations" bring together varying groups of
consultant and independent contractors on a project-by-project basis.
iA more problematic position is reflected in a discussion note submitted to the OECD Committee
on Fiscal Affairs by representatives of the United States, Canada, and Australia in June 1996. It
expressed concern about potential erosion of the tax base because of the increased international mo-
bility of services and capital.
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78
BORDERLINE CASE
One of the greatest impediments to the new global business model is a set of
vastly complex rules enacted in 1962. These rules were unnecessarily made even
more restrictive in the 1986 Tax Reform Act. Subpart F of the Internal Revenue
Code, sections 951-964, was aimed at preventing U.S. multinational companies
from establishing "controlled foreign corporations" (foreign subsidiaries) in tax
havens where they conducted little or no business but "squirreled away" large
sums of money. The income of foreign subsidiaries is generally taxed at source,
and a residual U.S. tax applies when the earnings are repatriated to the United
States. U.S. tax is generally "deferred" until repatriation. Under the credit sys-
tem for foreign taxes paid at the source of the earnings, U.S. tax arises only when
the foreign effective tax rate is lower than the U.S. corporate tax rate of 35 per-
cent, and then only on the residual at the time of repatriation.
Today the U.S. corporate tax rate is high, especially when one considers the
double taxation of corporate earnings, which most developed countries have
eliminated. Many countries, including the United Kingdom and Sweden, have
sharply lower tax rates. Emerging technologically developed nations in Asia
and Eastern Europe offer low labor and tax rates with educated work forces.
They have attracted investments from many global corporations throughout the
world. A great deal of active cross-border sales and services between these
centers is now subject to these subpart F rules in the U.S. tax law. These are
active business investments that were never intended to be penalized by the anti-
deferral rules of subpart F. Nevertheless, these outmoded U.S. tax rules have
raised the tax hurdles on U.S. global companies and interfered with business
investment decisions.
Reforming the international rules under U.S. tax laws is urgently needed.2
The emergence of virtual corporations undertaking active business investment in
newly technological nations linked by information technologies and conducting
electronic commerce heightens this urgency. High-tax countries such as Ger-
many, Italy, and Japan will by necessity have to deal with the "hollowing out" of
their investment base as the decreasing emphasis on boundaries leads to offshore
joint investments. Germany and Italy have just announced tax reform measures
to reduce their corporate taxes. Unfortunately, the United States is now arguably
among high-tax countries. The total income tax burden in the United States is
nearly 40 percent, including state income taxes.
In the twenty-first century, strategic investments will not be made in high-tax
countries. We will have to focus U.S. tax policy on lowering hurdles, barriers,
and impediments to U.S. corporations competing in the global marketplace.
2The Taxpayer Relief Act of 1997 took a small step toward such reform but much more is needed
to secure the competitiveness of American-owned businesses. For example, a proposal to eliminate
punative subpart F treatment of cross-border business transactions within the European Union was
not enacted.
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THE VIRTUAL GLOBAL ELECTRONIC ECONOMY
REFERENCES
79
Hufbauer, G.C. 1992. U.S. Taxation of International Income: Blueprint for Reform. Institute for
International Economics. Washington, D.C.
Soete, L. 1996. Interim Report. European Union: January.
U.S. Department of the Treasury, Office of Tax Policy. 1996. Selected Tax Policy Implications of
Global Electronic Commerce. Washington, D.C.: U.S. Government Printing Office.
OCR for page 80
7
Operating Through Joint Ventures Under
U.S. International Tax Rules: Global
Competition for R&D Investmentsi
KEVIN G. CONWAY
United Technologies Corporation
The international tax rules in the Internal Revenue Code of 1986 ("the
Code"), which are of major importance to companies such as United Technolo-
gies Corporation, were originally designed to level the playing field and ensure
that U.S. corporations could compete on an equal footing with their international
competitors based in other countries. The United States, unlike many other coun-
tries, has adopted a worldwide system of taxation. Under this system, U.S. cor-
porations are subject to both foreign and federal income tax on profits earned
outside the United States. This means that U.S. companies are liable for both
U.S. tax and foreign tax on the same dollar of operating profit. This could result
in U.S. corporations being taxed at a high level that would effectively render
them noncompetitive. To alleviate this situation, the United States has adopted two
major principles. First, under the principle of deferral a U.S. corporation is generally
not subject to U.S. tax on profits earned by its subsidiaries located outside the United
States until these profits are repatriated. The second major principle, the foreign tax
credit, grants U.S. companies a credit against their U.S. tax when income earned
outside the United States and previously subject to foreign income tax is repatriated
to the United States. The credit is limited to the amount obtained by multiplying
the U.S. tax times the fraction obtained by dividing foreign-source income by
total taxable income. Besides leveling the playing field, this limitation is de-
signed to avoid granting a foreign tax credit on U.S.-source income.
Recently, the term "corporate welfare" has been used to describe the interna-
tional tax rules applicable to U.S.-based corporations. Use of the term corporate
welfare is entirely inappropriate to describe the concepts of deferral and the for-
eign income tax credit. These rules do not grant any benefits but rather, as previ
iThe views and opinions expressed herein are solely those of the author.
81
Representative terms from entire chapter:
tax policy
