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With the steady decrease of corporate tax rates across Europe, U.S. lawmakers are increasingly under pressure to reform the U.S. corporate tax system in order to maintain a favorable corporate environment in the face of increasing tax competition from our European trading partners. This pressure is evident both in recently enacted legislation and in commentary provided by Congress. European tax rates are steadily declining. Ireland has introduced a corporate tax rate of 12.5% on profits from trading activities, and the Netherlands has recently proposed legislation that would lower the country’s corporate tax rate from 31.5% to 26.9%. The decline of corporate tax rates in Europe is likely to continue due to pressure within Europe as a result of the recent admission of 10 new countries to the European Union. In April 2004, the following 10 countries joined the European Union: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, which, by and large, have low tax rate regimes. Aside from reducing statutory corporate income tax rates, many E.U. tax regimes have also implemented other measures to become more attractive to business and investment, such as exempting gains received from subsidiaries from tax in the hands of the parent company. Dividends similarly are either exempt from tax or result in a credit for underlying tax. In addition, a number of the jurisdictions generally have no withholding taxes on dividend payments whether or not the payments are to E.U. member states. These provisions effectively lower the published marginal rates. The United Kingdom, Denmark and Ireland exempt from tax the disposals of substantial shareholdings. Current examples in individual member states The Netherlands recently proposed legislation that would extend loss-relief rules to subsidiaries of Dutch companies resident in other E.U. member states. The changes are expected to be revenue neutral through new restrictions on the deductibility of losses. Additionally, the Netherlands has proposed to abolish its capital tax, levied at 0.55%, on contributions for shares in Dutch companies. Belgium is proposing to promote its economy by introducing a notional interest tax deduction for a company’s capital and to abolish capital duty. In August 2004, Spain introduced legislation to promote itself as a location for finance companies, a move that will complement the existing holding company regime by removing withholding tax requirements in respect of certain preferred participations and other debt instruments. Ireland continues to press ahead on making itself an attractive base with the introduction in 2004 of a holding-company regime exempting gains on the disposal of qualifying shares from tax, supplemented with further changes in 2005, including a reduction in corporate capital duty from 1% to 0.5%. A comprehensive understanding of tax competitiveness of nations recognizes that tax competition goes well beyond pure rate reduction and takes many forms. Thomas F. Field, the publisher of Tax Analysts, has written that “tax competition occurs when a government alters its tax law in an effort to attract business firms, investment flows, or individuals having needed skills. There are many different ways to engage in tax competition. The commonest include tax holidays, cuts in tax rates in comparison with other taxing jurisdictions (or even abolishing some taxes entirely), providing incentives such as accelerated depre-ciation deductions or credits, and exempting from tax some forms of income, such as interest income.” 29 Tax Notes Int’l 1235 (March 31, 2003). Even viewing tax systems as wholes, including all the various credits, deductions and exemptions, we see that foreign nations, especially European nations in which U.S. businesses are heavily invested, are becoming increasingly competitive. A recent article states that “many large businesses, especially with the U.S.’s complex tax structure, use loopholes and shelters to pay far less than the national rates suggest. And the U.S. has recently done its own targeted cutting, such as lowering the tax on manufacturers last year in compensation for a lost export subsidy. But even then the effective U.S. corporate tax rate-what is paid after all the deductions-is above Europe’s average, by as much as 10 percentage points, according to one analyst.” Glenn R. Simpson, “As Europe Cuts Corporate Tax, Pressure Rises on U.S. to Follow,” Wall St. J., Jan. 28, 2005, at A2. This trend of European nations reducing their statutory corporate income tax rate has not gone unnoticed by U.S. policymakers. Congress and the Treasury Department are aware of the negative effects on the U.S. economy of business and investments moving offshore due to increased tax competition. This pressures U.S. lawmakers to make reforms of our own corporate tax system. Several provisions in the American Jobs Creation Act of 2004 are aimed squarely at attracting and retaining business investments in the United States. It is evident from the legislative history that changes in other nations’ taxing systems are influencing U.S. lawmakers in their formation of current tax policy. The act provides several clear examples of U.S. lawmakers reacting to the trend in global tax legislation to create a more hospitable climate for business investment. Sections 102(a) and (b) of the act provide for the creation of a deduction for U.S. manufacturers to help ease the sting of the repealed export tax benefits that were found to be in violation of World Trade Organization agreements. The legislative history demonstrates the pressure that U.S. lawmakers are feeling to reform the corporate tax system. The conference agreement provides that “the conferees acknowledge that Congress has not reduced the statutory corporate income tax rate since 1986. According to the Organization of Economic Cooperation and Development, the combined corporate income tax rate . . . in most instances is lower than the U.S. corporate income tax rate. Higher corporate tax rates factor into the United States’ ability to attract and retain economically vibrant industries, which create good jobs and contribute to overall economic growth.” The expected trend in U.S. corporate tax policy is revealed in the conference agreement: “The conferees recognize that trading partners of the U.S. retain subsidies for domestic manufacturers and exports through their indirect tax systems. The conferees are concerned about adverse competitive impact of these subsidies on U.S. manufacturers. These concerns should be considered in the context of the benefits of a unified top tax rate for all corporate taxpayers, including manufacturing, in terms of efficiency and fairness.” Other examples in the act of the influence foreign tax competition is having on U.S. tax policy abound. Section 401 modified the rules dealing with interest expense allocation in computing the foreign tax-credit limitation. The House committee report notes that “the U.S. is the only country that currently imposes harsh and anti-competitive interest expense allocation rules,” and the committee “believes that these rules should be modified so that U.S. companies are not discouraged from investing in the U.S.” Certain dividends paid by mutual funds to foreign investors are no longer subject to U.S. withholding tax under � 411. The House committee report notes that “disparate treatment should be eliminated so that U.S. financial institutions will be encouraged to form and operate their mutual funds within the U.S. rather than outside the U.S.” Shipping income taxation is modified under � 415 with the House committee providing that “this provision will provide U.S. shippers the opportunity to be competitive with their tax-advantaged foreign competitors.” Section 801 implements Congress’ attempt to stem the tide of U.S. corporations “inverting” (i.e., reincorporating in another country). The House committee “believes that corporate inversion transactions are a symptom of larger problems with our current uncompetitive system for taxing U.S.-based global businesses and are also indicative of the unfair advantages that our tax laws convey to foreign ownership.” The future of the U.S. corporate tax system We have seen that Congress is aware of many uncompetitive aspects of the current U.S. system of corporate taxation in comparison to many of our trading partners. In response, it has taken affirmative steps to combat some of the offending provisions of the tax code through recent legislation. The legislative history reveals that Congress is aware that more reforms will be needed. There is no shortage of experts willing to suggest solutions to make the United States’ tax system more competitive, including introducing a consumption-based value-added tax similar to the system employed in much of Europe, a flat tax or even a major reform of the current system that could include changing fundamental aspects of U.S. corporate income taxation, such as effectively taxing the global income of U.S. corporations, regardless of where money is earned. What we can be confident of is that regardless of what form eventual reforms take, recent changes in the tax systems of other nations, particularly the examples of significant corporate income tax rate cuts in many European countries, are compelling U.S. lawmakers to enhance the competitiveness of our tax system. This trend is likely to continue. In turn, law firms that advise these competitors in the global marketplace must not only stay abreast of the changes in U.S. tax law. They must also engage in the competitive analysis of the tax systems of numerous jurisdictions and the planning opportunities that can be created as these systems are in a state of dynamic change and development in juxtaposition to each other. Seth Zachary is chairman of Paul, Hastings, Janofsky & Walker. He is resident in the firm’s New York office, where his practice focuses on tax law and business transactions.

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