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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.

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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