HOW UNITEDSTATES TAXES INSOURCING COMPANIES

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1 THE HOW UNITEDSTATES TAXES INSOURCING COMPANIES Core International Tax Laws organization for international investment international business investing in america W W W. O F I I. O RG

2 TABLE OF CONTENTS Foreword Executive Summary How Does the U.S. Tax Insourcing Companies? The Latest on Taxes Paid by Insourcing Companies Key International Tax Laws Section 163(j) of the Tax Code Transfer Pricing Double Tax Treaties 13 Tax Liabilities: Insourcing Companies vs. Domestic Multinational Companies 14 Conclusion INSOURCING (in-sôrs-ing) n. When companies based abroad invest in the United States and create jobs for Americans. ORGANIZATION FOR INTERNATIONAL INVESTMENT OFII is a business association representing the U.S. operations of many of the world's largest international companies which Insource over 5 million Americans jobs and support an annual U.S. payroll of over $364 billion. Many OFII members are household names, companies with historic and substantial American operations. OFII advocates for the fair, non-discriminatory treatment of Insourcing companies. We undertake these efforts with the goal of making the United States an increasingly attractive market for foreign investment, which will ultimately encourage international companies to conduct more business and employ more Americans within our borders. Given the recent global financial turmoil, as well as companies' increasing ability to conduct worldwide operations through other jurisdictions, OFII's mission is more critical than ever to sustaining and rebuilding the American economy. STEPTOE & JOHNSON LLP With more than 500 attorneys, Steptoe & Johnson LLP provides counsel and representation to global clients. In more than 60 years of practice, the firm has gained both a national and international reputation for vigorous representation of clients before governmental agencies, successful advocacy in litigation and arbitration, and creative and practical advice in guiding business transactions. Attorneys in practices ranging from tax, government affairs, international trade, and intellectual property, to antitrust, insurance, transportation, telecommunications, and employment law, know the business and regulatory landscapes first-hand and benefit from deep benches of practice-specific trial and appellate lawyers. The firm has offices in Washington, New York, Chicago, Phoenix, Los Angeles, Century City, London, and Brussels. For more information on Steptoe & Johnson LLP, please visit our website at

3 Foreword INSOURCING COMPANIES AND WHY THEY ARE IMPORTANT TO THE U.S. ECONOMY Insourcing companies employ a large segment of the American workforce. In 2006, over 5.3 million Americans worked at Insourcing companies 4.6% of total private-industry employment. Today the United States and many other countries continue to struggle with the capital-markets crisis and economic recession. American workers and their families are facing risk and uncertainty about both jobs and their budgets. Policy makers around the world are striving to resolve the crisis and resume economic growth. Ultimately, renewed U.S. growth will need to be driven by companies in the United States. And some of the most important companies in the United States are Insourcing companies: U.S. operations of companies based abroad. You are familiar with the names Michelin, Philips, Honda, and Nokia. These companies have long been integrated in the U.S. economy. Indeed, even during the recession year of 2008, foreign direct investment in the United States by Insourcing companies remained strong and reached $325.3 billion the highest amount ever. Insourcing companies help strengthen the U.S. economy in many important ways. Start with jobs. Insourcing companies employ a large segment of the American work-force. In 2006, over 5.3 million Americans worked at Insourcing companies 4.6% of total private-industry employment. However, the contributions of Insourcing companies to America extend well beyond their employment count. Next, research and development. Insourcing companies conduct the R&D that is the foundation of discovering new products and processes to expand economic opportunity throughout the U.S. economy. In 2006, Insourcing companies spent $34.3 billion in the United States on R&D over 13.8% of all private-sector American R&D. Then, exports. Insourcing companies export goods and services worldwide and thereby help bridge American workers to the expanding market opportunities beyond U.S. shores. In 2006, Insourcing companies exported $195.3 billion in goods, which was 18.9% of all U.S. goods exported that year. 3

4 Next, investment. Insourcing companies invest in the property, plant and equipment that U.S. workers need to leverage their talents. In 2006, Insourcing companies undertook $160.2 billion in capital investment 11.3% of total U.S. investment by all corporations. Finally, payroll. All these productivity-enhancing activities contribute to larger average paychecks for employees of Insourcing companies. Total 2006 compensation at U.S. Insourcing companies was $364.2 billion a per-worker average of $68,317. This was 30.9% above average for the rest of the private sector of $52,187. Amidst all this business activity in the United States, Insourcing companies also pay a wide range of federal, state, and local taxes. Don t forget taxes. Amidst all this business activity in the United States, Insourcing companies also pay a wide range of federal, state, and local taxes. For example, in 2006 Insourcing companies paid $50 billion in federal income taxes which was 14.1% of total federal corporate tax receipts that year, a larger share than Insourcing companies share of U.S. employment, capital investment, and R&D. This report provides an overview of how the United States taxes Insourcing companies. Importantly, in order to maintain and encourage additional investment in the United States and maintain and encourage more Insourced jobs, the U.S. tax system should impose taxes fairly and equally on all U.S. businesses regardless of where their parent company is headquartered. PROFESSOR MATTHEW SLAUGHTER Tuck School of Business Dartmouth Hanover, NH 4

5 Executive Summary The U.S. Tax Code is the means by which the U.S. government generates revenue by taxing every American citizen, small business and corporation. Given the impact the U.S. tax code has on stimulating or weakening the American economy, it is essential to have a base-line understanding of key tax principles. How the United States Taxes Insourcing Companies: Core International Tax Laws written by the Organization for International Investment (OFII) and tax counsel, Steptoe & Johnson LLP, is a laymen s guide to understanding the tax code s impact on one significant slice of the U.S. economy the U.S. operations of companies headquartered abroad or Insourcing companies. Over the last 20 years, Insourcing companies have been a consistent and reliable source of American employment supporting over 5 million U.S. jobs nationwide. Inbound investment is vital for continued American competitiveness and new jobs. Maintaining fair and non-discriminatory treatment in the tax code for Insourcing companies is key to investment in the United States. FACT: The United States government taxes all companies that make a profit inside its borders, whether the company has a parent company based in the U.S. or one headquartered abroad. Insourcing companies are taxed just like any other domestic company; in fact, they paid a record $50 billion in corporate income taxes in The amount of tax collected is affected by some core rules, principles and bilateral agreements that are defined below. Section 163 (j) Limits Insourcing companies ability to deduct the cost of borrowing ( interest expense ) from a parent or sister company located outside the U.S. Transfer Pricing Rules Set a fair market price on the sale or exchange of goods and services between affiliated companies, and apply equally to all multinational companies. Double Tax Treaties Help U.S. tax authorities enforce tax laws that apply to corporations with worldwide operations and ensure that those corporations do not face double taxation by two countries. 5

6 How Does the U.S. Tax Insourcing Companies? Insourcing companies are corporations organized under the laws of the United States and, in general, are subject to the same taxes as U.S. headquartered corporations or Domestic companies. These taxes include federal income and excise taxes, as well as various kinds of state and local taxes. TYPE OF TAXES DOMESTIC COMPANIES INSOURCING COMPANIES U.S. Corporate Taxes State Corporate Taxes Payroll Taxes City Taxes Property Taxes ALL U.S. multinational corporations: Pay U.S. federal income tax based on their worldwide net income. Determine their net income by deducting business expenses from their gross income. Determine their tax liability by multiplying net income by their applicable tax rate (generally 35%), and then subtracting creditable foreign taxes and other allowable credits Pay withholding taxes on certain payments, such as interest, dividends, rents, and royalties, made to foreign recipients. U.S. withholding taxes are generally set at 30%, but may be lower if the recipient is located in a country with which the United States has a double tax treaty (more on double tax treaties later). BRANCH OR PARTNERSHIP Some foreign-based corporations may also do business in the United States without forming a U.S. corporation. For example, a foreign corporation may do business through a U.S. branch or partnership. Detailed U.S. tax rules help ensure that these branches and partnerships pay taxes equivalent to what they would pay if they operated in U.S. corporate form. HOW CORPORATE TAX LIABILITY IS DETERMINED FOR ALL U.S. MULTINATIONAL COMPANIES Gross Income - Business Expenses Net Income Net Income X Applicable Tax Rate Pre-Credit Tax Liability Net Income Pre-Credit Tax Liability - Credit for Foreign Taxes Paid and Other Credits Final Tax Liability 6

7 The Latest on Taxes Paid By Insourcing Companies Insourcing companies account for over 14 percent of total corporate taxes in the United States, which broadly corresponds with the amount of U.S. business activity they generate. According to the latest IRS statistics, Insourcing companies paid a record $50 billion in federal corporate income taxes in 2006, up 18% from $42.4 billion in Billions of Dollars Source: IRS Corporation Statistics of Income Insourcing companies effective tax rates as a percentage of assets remain similar to those of all taxable corporations at.5% in Tax liability as percentage of assets All Taxable Corporations: Tax/Assests Source: IRS Corporation Statistics of Income U.S. Subsidiaries 7

8 Key International Tax Laws SECTION 163(J) OF THE TAX CODE FOSTERING NEW INVESTMENT: NESTLÉ ACQUISITION & PLANT EXPANSION OF DREYER S Good Food, Good Life. Why you should care: Many businesses borrow investment capital to expand or acquire new operations. In general, a Domestic corporation may deduct interest paid on a loan, whether the interest is paid to a related person (i.e., a parent company) or an unrelated person (i.e., a bank). This is part of the normal course of business. However, concerns over companies artificially reducing tax burdens has led the United States and many other countries to enact so-called thin capitalization rules, which limit the deductibility of interest paid to affiliates. These rules are separate from and in addition to the rules that govern the rate of interest paid to related parties under transfer pricing rules (Section 482). How it works: The U.S. thin capitalization rules are contained in Section 163(j) of the Internal Revenue Code. Section 163(j) limits the deductibility of interest paid to a related company located in another country unless: The corporation has a debt-to-equity ratio of less than 1.5 to 1, or The corporation s net interest expense (interest paid over interest earned) is 50 percent or less of its adjusted gross income. Section 163(j) also limits the deductibility of interest paid to unrelated lenders when a related company guarantees the loan. In theory, Section 163(j) applies to both Domestic firms and Insourcing companies. However, in practice it overwhelmingly targets Insourcing companies. Insourcing companies by their nature (i.e., because they are subsidiaries) are more likely to borrow from a parent company, or use a parent company guarantee for financing. NESTLÉ USA completed its $2.5 billion acquisition of California-based Dreyer s Grand Ice Cream in Nestle USA then invested in a $100 million Bakersfield, California ice cream plant. The 400,000 square-foot plant tripled production capacity, creating six new ice-cream production lines with an annual capacity for 70 million gallons, a 120,000 square-foot freezer warehouse, and a 20-door shipping dock. The net result was the largest ice-cream plant in the United States. The financial support of Nestlé USA s ultimate foreign parent, Nestlé SA, was critical to the completion of the Dreyer's acquisition. The acquisition was undertaken with debt capital from Nestlé SA in Switzerland. This loan was provided under more favorable terms than Nestlé USA could obtain from a bank or third party financer without a Nestlé SA parent guarantee. In fact, the acquisition and resulting plant would not have been affordable if financed with third party capital at the funding rates charged by third party lenders at the time. Nestlé was able to finance this acquisition in an economically viable manner because the thin capitalization rules of section 163(j) did not eliminate the deductibility of its interest. The acquisition, plant expansion, and job creation would have been more costly and might not have happened had the rules been tighter and forced Nestlé USA to borrow from third parties without a parent guarantee. Allowing Nestlé USA a tax deduction for the interest expense, which any domestic corporation would have received, was crucial in making the acquisition and sizable plant building a reality. 8

9 Latest Data Shows No Evidence of Wide-Spread Abuse of Related Company Borrowing In 2004, Congress directed the Treasury Department to study the scope of possible abuses of related-company borrowing. The Treasury Department report, issued in 2007, largely concluded that there was insufficient evidence of Insourcing companies abusing Section 163(j). The latest IRS statistics show: Long-term debt trending downward. Over the last five years, Insourcing companies long-term debt has fallen from 16.5% of assets to 14.3%. Long-term debt comparable with Domestic companies. The latest government data shows that long term debt of Insourcing companies as a percentage of assets is comparable to that of all taxable U.S. companies. In 2006, Domestic companies long term debt as a percentage of assets was 13.2 percent, compared to 14.3 percent at Insourcing companies. Intercompany interest payments have remained flat. Intercompany interest payments were flat between 2000 and 2004, while at the same time Insourcing company assets increased by 31% and net income increased by 37%. In theory, Section 163(j) applies to both Domestic firms and insourcing companies. However, in practice it overwhelmingly targets insourcing companies Billions of Dollars All Other Finance, Insurance, and Real Estate Source: IRS Corporation Statistics of Income 9

10 Transfer Pricing Section 482 of the Tax Code Why you should care: All multinational companies must set a price for the goods, services, and intangibles (i.e., intellectual property) that are transferred between related companies. This is called a transfer price. The cost of items transferred between related companies affects the amount of a corporation s income and deductions, and thus its U.S. tax liability. How it works: The U.S. transfer pricing rules, contained largely in the regulations issued under Section 482 of the Internal Revenue Code, equally apply to Domestic and Insourcing companies; they are subject to heavy penalties if they fail to comply with these rules. Under U.S. law and the laws of most other developed countries, transfer prices must be set at an arm s length level. Arm s length refers to the price a company would pay to an unrelated company for a good or service. If the IRS determines that a price is not arm s length, it may reallocate income, deductions, credits, or other items attributable to the transaction. In some cases, a true arm s length price exists, which can provide a reliable indicator of an accurate cost. As recognized by the IRS regulations, however, this is often not the case. In these cases, a business must conduct an economic analysis to find a range of acceptable prices. SETTING TRANSFER PRICES IN THE REAL WORLD: AKZONOBEL AKZO NOBEL INC., is a U.S. subsidiary of a Dutch-based company that develops and manufactures a wide range of paints, coatings, and specialty chemicals. The company employs over 5,000 peoples in the United States and has $4 billion in U.S. sales. Certain Akzo Nobel subsidiaries manufacture products and sell these products to related distributors that in turn sell the products to their local third party customers. The price one subsidiary charges the related company for the products is called the transfer price. For example, Akzo Nobel manufactures a chemical in the United States that is used in the production of asphalt. Akzo Nobel s U.S. facilities manufacture the chemical and sell it to a Canadian Akzo Nobel affiliate. Akzo Nobel must set a transfer price for the sale to the Canadian affiliate. The Canadian affiliate sells it to customers in Canada who use the chemical to produce asphalt. Setting an arm s length price: In general, Akzo Nobel uses the resale price method to set its transfer prices for specialty chemicals. This method, which is IRS approved, starts with the related distributor s price to its unrelated local customers and reduces that price by a minus percentage. The minus percentage is calculated to produce a profit for the distributor sufficient to cover its expenses and that is equivalent to the profit that a third party company would have made on a comparable distribution transaction. Akzo Nobel has conducted numerous economic studies to determine the profit earned by comparable third party distributors, and uses the results of those studies to set its transfer prices. Further, the company monitors the actual profits of its related distributors and changes transfer prices as necessary to achieve a profit similar to that achieved in comparable transactions. The use of this transfer pricing method by Akzo Nobel is covered by an Advanced Pricing Agreement with the IRS that has been in effect for over 15 years. 10

11 Double Tax Treaties Why you should care: The United States has entered into double tax treaties with foreign countries for over 70 years. Tax treaties are designed to encourage cross-border investment and economic activity. Double Tax Treaties: Provide a way to resolve double taxation disputes between countries. Help tax authorities enforce tax laws for example, treaties help ensure an adequate tax information exchange between countries and incorporate mutual legal assistance provisions for tax enforcement. Reduce barriers to foreign direct investment, such as double taxation and high withholding taxes. How it works: Double taxation occurs when two countries both try to tax a single item of income earned by a corporation. One country may tax the income because the corporation is resident in that country (residence taxation). The other country may tax the income because the activity generating the income occurred within its borders (source taxation). Tax treaties help ensure that people and businesses pay tax in only one jurisdiction. Since tax treaties mainly exist to mitigate double taxation, the United States only enters into them when its treaty partner imposes significant taxes, which creates an environment for double taxation. Also, because tax treaties are partly designed to help facilitate tax enforcement and provide greater certainty regarding the application of tax rules, the United States generally will not enter into a tax treaty unless the other country provides assurances that it can and will exchange information on tax matters. The United States has entered into double tax treaties with foreign countries for over 70 years. Tax treaties are designed to encourage cross-border investment and economic activity. U.S. Approval Process for Considering Tax Treaties: STEP #1: The U.S. Executive Branch and partner country government negotiate the terms of the tax treaty. STEP #2: The United States and the partnering government sign the tax treaty. STEP #3: The U.S. President sends the treaty to the Senate for advice and consent. STEP #4: The Senate Foreign Relations Committee holds a hearing to consider the treaty. STEP #5: The Senate votes on whether to give advice and consent to ratification of the treaty. STEP #6: After advice and consent, the President officially ratifies the treaty. 11

12 UNDERSTANDING THE IMPORTANCE OF TAX TREATIES: THE BASF STORY "We don't make a lot of the products you buy. We make a lot of the products you buy better. " BASF CORPORATION, the U.S. operations of a German company, employs 15,000 people in North America. BASF understands that bringing value to economies worldwide requires both a global outlook and a focused understanding and, most importantly, business leaders who can work across borders. The exchange of employees between the United States and Germany is essential in developing BASF s understanding of how best to serve the U.S. market and bring its American production worldwide. These exchanges give U.S. executives a unique opportunity to broaden their understanding of the company, participate in global decisions and prepare them for a leadership role. The U.S.-German Tax Treaty, including the recently-adopted Protocol, facilitates this important flow of human capital. The United States and Germany each have laws that promote and protect the pensions of their workers, however, these laws are not identical. Although Social Security agreements between the United States and Germany have generally allowed employees to continue participating in their home country s Social Security program, continued coverage in the home employer s pension plan was problematic before adoption of the Treaty Protocol. The mismatch between pension plan requirements created additional costs and risk for an executive considering an international assignment. Staying home, an employee could continue to receive tax free contributions. But if that same employee went abroad, contributions would be subject to tax in the host country and dividends earned on the investments might also be taxed. To compound the problem, these pension contributions and earnings would be taxed again, this time in the country of residence upon retirement when the pension was collected. No foreign tax credit would be available to provide relief from this double taxation. The new Treaty Protocol eases this situation. Germany and the United States now extend reciprocal tax treatment for each country s qualified pension plans. A U.S. employee working in Germany will not pay German tax on contributions made to his qualified U.S. pension, his employer will be entitled to deduct such contributions, and the qualified plan will not be subject to tax on its earnings. Similarly, a German employee working in U.S. will not pay U.S. tax on contributions made to his qualified German pension, his employer will be entitled to deduct such contributions (to the extent allowed under German law), and the qualified plan will not be subject to U.S. tax on its earnings. An employee will only be taxed in the country of residence when the pension is distributed at retirement. These new Treaty protections remove barriers to the flow of personnel between the two countries. UNITED STATES TAX TREATIES IN FORCE AUSTRALIA AUSTRIA BANGLADESH BARBADOS BELGIUM BULGARIA CANADA CHINA CYPRUS CZECH REPUBLIC DENMARK EGYPT ESTONIA FINLAND FRANCE GERMANY GREECE HUNGARY ICELAND INDIA INDONESIA IRELAND ISRAEL ITALY JAMAICA JAPAN KAZAKHSTAN KOREA LATVIA LITHUANIA LUXEMBOURG MEXICO MOROCCO NETHERLANDS NEW ZEALAND NORWAY PAKISTAN PHILIPPINES POLAND PORTUGAL ROMANIA RUSSIA SLOVAK REPUBLIC SLOVENIA SOUTH AFRICA SPAIN SRI LANKA SWEDEN SWITZERLAND THAILAND TRINIDAD AND TOBAGO TUNISIA TURKEY UKRAINE UNITED KINGDOM VENEZUELA 12 The U.S.-U.S.S.R. treaty remains in effect for the following countries: Armenia, Azerbaijan, Belarus, United Georgia, States Kyrgyzstan, Moldova, Tajikistan, Turkmenistan, Tax and Uzbekistan. Treaties

13 How Do the Tax Liabilities of Insourcing Companies Differ From Domestic Multinational Companies? Over the last couple of decades, there has been considerable research conducted to determine whether the U.S. should change how it taxes Insourcing companies. The most comprehensive study of effective tax rates to date was released in January 2009, by Kevin Markle and Doug Shackelford, Corporate Income Tax Burdens at Home and Abroad. The Markle/Shackelford study found that U.S. and European multinationals have roughly equivalent effective tax rates, and Japanese multinationals have somewhat higher effective tax rates. In 2004, Congress asked the U.S. Treasury Department to study the effectiveness of Section 163(j) in preventing the shifting of income outside of the United States. The Treasury Department released the study in 2007 and found insufficient evidence that Insourcing companies (other than a handful of U.S. companies that reincorporated abroad) engaged in wide-spread abuse. Overwhelmingly, this research shows that Insourcing companies do not have a tax advantage under the U.S. laws and there is no evidence to support that overall, Insourcing companies abuse such laws. Research shows that Insourcing companies do not have a tax advantage under the U.S. laws and there is no evidence to support that overall, Insourcing companies abuse such laws. 13

14 Conclusion Don t tax you, don t tax me. Tax that fellow behind the tree. Don t tax you, don t tax me. Tax that fellow behind the tree. SENATOR RUSSELL LONG The late Senator Russell Long from Louisiana is credited with the above comment about how the Congress considers changes to the U.S. Tax Code. Over the next year, Congress will consider numerous initiatives to raise revenue. It is likely that a number of these provisions will have a direct impact on the U.S. economy and its ability to pull out of the current recession. Insourcing companies and their over 5 million American employees are most definitely not the fellows behind the tree. They are a crucial part of the American economy and a means by which the United States can achieve strong economic activity. Treating these companies the same as Domestic firms ensures they remain committed to continued investment in the United States. After all, foreign companies are not all that foreign. They are constituents of every Member of Congress. They are American scientists in Massachusetts, steel workers in Alabama, electronics manufacturers in Illinois and engineers at a new solar facility in Oregon. 14

15 Useful OFII Resources AVAILABLE AT Insourcing Jobs by State Report Latest Trends in Foreign Direct Investment in the United States Insourcing Mergers & Acquisitions by Prof. Matthew Slaughter CONTACT US AT (202)

16 Useful OFII Resources AVAILABLE AT Insourcing Jobs by State Report Latest Trends in Foreign Direct Investment in the United States Insourcing Mergers & Acquisitions by Prof. Matthew Slaughter CONTACT US AT (202)