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82 BORDERLINE CASE ously noted, merely level the competitive playing field so that U.S.-based corpo- rations can compete in the global marketplace. With respect to the so-called 10-50 basket rule under the pre-1997 law and through a transition period, U.S.-based companies are at a competitive disadvan- tage in cases where they own more than a 10 percent interest, but not more than 50 percent ("a 10-50 joint venture"), of a non-U.S. enterprise. The disadvantage arises because under the 10-50 basket rule, a U.S. company that is a party to such a venture is required to prepare a separate foreign tax credit calculation for each 10-50 joint venture. In jurisdictions where the tax rate applicable to the 10-50 joint venture is greater than the 35 percent U.S. corporate income tax rate, the U.S. shareholder will be unable to credit any taxes above the 35 percent rate against its U.S. income tax liability and thus will incur an increase in tax liability. For example, assume that a $100 dividend is paid from a country with a tax rate of 55 percent. The foreign taxes in excess of the U.S. tax liability would be $44 (~100/0.45) x 35 percent U.S. rate - [~100/0.45) - 100~. On the other hand, where the non-U.S. rate is below the 35 percent U.S. rate, say, 20 percent, then any dividend repatriation from the 10-50 joint venture will result in a residual U.S. income tax (excess of 35 percent U.S. rate and 20 percent foreign rate, i.e., 15 percent) on the dividend distribution. There are two effects of the 10-50 basket rule. First is the paperwork asso- ciated with preparing a separate calculation for each so-called 10-50 joint ven- ture. Second, and more important, because the 10-50 basket rule may result in double taxation or the imposition of residual U.S. tax above the foreign taxes already paid, U.S. companies may not be competitive with their foreign counter- parts. As an illustration, I recall being involved in a negotiating regarding the acquisition of an interest in a company operating outside the United States. The owner would not sell a controlling interest but would sell 49 percent of the busi- ness. The 10-50 rule applying to dividends paid by the joint venture thus altered the economics of the transaction. It needlessly complicates and is detrimental to our competitive position in an increasingly competitive global environment. Con- gress finally recognized these issues and in the Taxpayer Relief Act of 1997 sought to correct them. Effective for tax years beginning after December 31, 2002, a "look through" rule applied for these 10/50 companies. Thus, earnings may be accounted for in the appropriate basket after this date. Dividends paid after the effective date of the Act by 10/50 companies but out of earnings before January 1, 2003 will be aggregated in a single 10/50 basket. This is a welcome step in improving our competitive position. GLOBAL COMPETITION FOR RESEARCH AND DEVELOPMENT INVESTMENTS U.S. international companies are in a far different situation from that of sev- eral decades ago when substantially all the revenues, profits, and income tax

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JOINT VENTURES UNDER U.S. INTERNATIONAL TAX RULES 83 expense of U.S.-based companies were sourced in the United States. In the case of United Technologies Corporation, more than 50 percent of our revenues and profits for 1996 and substantially more than 50 percent of our income tax expense are generated in jurisdictions outside the United States. We and other U.S.-based corporations are now paying significant income tax to foreign governments. This means that the research and development incentives and tax credits available out- side the United States are more important than ever. In these circumstances the United States needs to take a number of steps. First, we should stabilize the research incentives in the Code. The current re- search and experimentation (R&E) tax credit has been extended eight times, in- dicative of its popularity but also a source of great uncertainty as to whether or not the credit will even exist at the end of a taxable year. In view of the extended life and uncertain progress of research and development projects, it is clear that in order for the R&E tax incentive to be effective, companies must be able to rely on the existence of the credit beyond a single taxable year. In this regard, the 1996 Small Business Tax Act took a major step forward; it not only extended the credit but also modified it to take into account the changed economic circumstances of U.S.-based corporations. In this connection, the 1996 act introduced the alterna- tive incremental research credit that is computed on a different base than the regular 20 percent incremental credit, which relies on a historical base period percentage derived from the years 1984-1988. The 1997 Taxpayer Relief Act extended both the regular and alternative incremental research credits. While this is encouraging, from a tax policy perspective, in order to be effective, the R&E credit must be viewed as a long-term and permanent incentive. In addition, the United States must periodically reexamine the mechanism of the credit, as it did recently with the alternative incremental credit, to make sure the credit is working properly as a tax incentive. Now to turn to incentives outside the United States. At least 16 OECD (Organization for Economic Cooperation and Develop- ment) countries in addition to the United States offer significant research and development tax incentives and credits, some of them more generous than those offered in the United States. In addition, these are generally stable incentives that are maintained over an extended period of time and can be relied on by research personnel who typically have a horizon of five to ten years rather than just one tax year. Canada has what I consider to be a very significant R&D tax incentive. To- day, unlike previously, U.S. corporations that are paying significant taxes outside the United States have a choice of where they perform their R&D; if the choice is between the United States and Canada, Canada offers a major advantage. For example, consider a $100 R&D investment made in both jurisdictions. If that amount is invested in the United States the taxpayer receives a deduction equal to the U.S. income tax rate of 35 percent or $35.00. In addition, the U.S. company will receive an R&E tax credit if it meets the requirements for either the regular incremental credit or the new alternative incremental credit. Let us assume that

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84 BORDERLINE CASE the amount of the U.S. credit is equal to 10 percent. If we add the benefit of the tax deduction to the benefit of the tax credit we can see that the taxpayer has realized a benefit of $45.00 or 45 percent with respect to the $100.00 expenditure. Now consider the tax treatment of the same $100.00 investment in R&D in the province of Quebec. Under the Canadian federal and provincial income tax rules a taxpayer investing $100.00 in R&D in Quebec would receive a combined federal and provincial credit of approximately 30 percent. In addition, the tax- payer would be entitled to a deduction at the combined federal and provincial rate of 40 percent on average, resulting in a total benefit of approximately 70 percent or $70. This compares to the $45 benefit in the case of the United States and constitutes a major competitive advantage. Given this choice and other consider- ations being equal, a U.S.-based corporation will choose to make the R&D in- vestment in Canada, reduce its tax burden and its effective tax rate, and maximize its profit. France, Japan, and other countries also have significant R&D tax de- ductions and tax credits. We need to take these incentives into account in evalu- ating our own system and considering changes in it. R&D INCENTIVES AND TAX REFORM Last summer I testified before the House Ways and Means Committee re- garding the international tax rules, their current operation, and the potential im- pact of a flat tax or the USA (unlimited savings allowance) tax. At one point during the hearings, Representative Sam Gibbons of Florida asked the panel of which I was a member whether or not there would be a need for an R&E tax credit in the event a flat tax were passed. Representative Gibbons postulated that under a flat tax, a company would get a current deduction for all expenditures, there would be no allocations of R&D expenses against foreign-source income, and there would be no need for a tax credit. He asked the panel members if they concurred with this conclusion. I responded that there would still be a case for R&D tax incentives under a flat tax. I pointed to countries such as Australia and Malaysia that allow a deduction greater than 100 percent for R&D expenditures. This type of incentive would be compatible with a flat tax. Given the importance of R&D incentives to American industry and economic growth, I would favor a deduction of 150-200 percent for R&D in order to provide what I believe is the appropriate incentive. Finally, we should remember the R&E tax credit is largely a wage credit. Recent studies by the Treasury Department and the Internal Revenue Service confirm that more than 60 cents of each dollar of research expense qualifying for the credit in fact represents salaries and wages paid to U.S. personnel (i.e., engi- neers, scientists, and others) who are located in the United States. We should not forget that the R&E tax credit promotes skilled jobs at home for U.S. citizens.

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