Whether John McCain or Barack Obama becomes the country’s next chief executive, they will need to look not only at tax reform, but international tax reform early in their administration.“We may find it wise to get to [international] tax reform very early,” advised Sen. Max Baucus, D-Mont., chairman of the Senate Finance Committee, during recent Capitol Hill hearings on the issue.

The way the United States taxes the foreign income of U.S. businesses is outdated and not responsive to a global economy, Baucus contends: “In the 1960s — the decade during which many of our current tax rules regarding cross-border activities and investment were first enacted — international trade and investment flows were much less important than they are today.”

“Congress and the new president will need to work together to ensure that the Internal Revenue Code will collect the revenue that we’ll need,” said Baucus. “And at the same time, we’ll need to ensure that American businesses are able to compete in the global economy.”

Joseph Fletcher, a tax partner at the law firm of Morrison & Foerster, agreed. “The current system was enacted at a time when there were only a limited number of true multinationals, and they were generally manufacturing businesses with plants and equipment that couldn’t be easily moved. Today there are many more businesses, including middle-market businesses, that have international operations.”

“And intellectual property, one of our biggest exports, is much easier to move than plants and equipment,” he said.

TO TAX OR NOT TO TAX

Participants at the hearings discussed the relative merits of taxing multinationals in a territorial tax system, which taxes only income earned within its borders, and the U.S. worldwide system, which taxes worldwide income but allows businesses to take a credit against U.S. taxes for taxes paid overseas.

James Hines, a law professor at the University of Michigan, strongly advocated switching from our current modified worldwide system to a territorial system. “Not only does the U.S. subject active foreign business income to domestic taxation,” he said, “but we do so in a manner that strictly limits the ability of taxpayers to claim foreign tax credits and to avoid current U.S. taxation of unrepatriated foreign income.”

Tax attorney Steven Shay opposed territorial taxation: “Skilled tax advisors will always be able to make U.S. income become non-U.S. income if there’s a tax advantage to doing so. If you have the ability to earn materially lower-taxed income, U.S. income is going to become non-U.S. income because that’s what we do.”

During the hearing, Sen. Kent Conrad, D-N.D., proposed a solution that no one addressed but that has been placed on the table in other venues — formulary apportionment.

“Formulary apportionment involves dividing up the right to tax a company’s income between several jurisdictions based on one or more factors, such as sales, payroll and property,” explained Martin Tittle, an Ann Arbor, Mich.-based international tax attorney. “While it would eliminate transfer-pricing problems, it raises other issues, such as when a company’s vendee-vendor relationship should be aggregated with the income of the vendee for formulary purposes.”

THE ISSUE OF SUBPART F

Part of any tax reform proposal must address what to do about Subpart F of the Tax Code, according to Baucus.

Subpart F, enacted in 1962, applies when a U.S. entity runs an active business in a foreign country. It allows the entity to defer paying tax on foreign income until it repatriates the income back to America.

“We go through cycles on this,” said Alan Viard, an economist at Washington D.C.-based think tank the American Enterprise Institute. “Subpart F has been tinkered with since it was first introduced.” He doesn’t believe that any tax-raising measures associated with Subpart F will pass this year due to the threat of a veto, but he said 2009 will be another story.

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