Daniel Soleimani, the Difficulties With the Subpart F System of International Taxation: How the Schering-plough Decision Indicates That the Status Quo Is Unclear and Unwise

• Citation: Vol. 60 No. 2
• Publication year: 2010

THE DIFFICULTIES WITH THE SUBPART F SYSTEM OF INTERNATIONAL TAXATION: HOW THE SCHERING- PLOUGH DECISION INDICATES THAT THE STATUS QUO IS UNCLEAR AND UNWISE

ABSTRACT

Complicated subpart F rules govern the taxation of transactions between a U.S. parent company and its foreign subsidiaries. The difficulty with interpreting the subpart F rules and applying them to complex derivative transactions has been the subject of extensive tax literature. Few of the proposed solutions have been simple enough to implement quickly and efficiently without wholesale changes to the subpart F system. This Comment focuses on the inconsistent tax treatment of economically equivalent transactions that currently exists under subpart F and the incentives that this system creates for U.S. companies to engage in expensive tax-planning strategies to avoid subpart F taxation. These tax-planning strategies-used to achieve an economically identical result-cost both the government and U.S. companies unnecessary money.

This Comment uses the Schering-Plough Corp. v. United States decision to highlight the difficulties in properly complying with subpart F and the lengths to which a taxpayer must go to avoid subpart F. It explores the reasons why the subpart F system was created the way that it was, as well as the competing theories on international taxation that led to the subpart F system. This Comment then proposes that economically equivalent transactions should be taxed the same, either by using the transfer pricing rules-currently used to govern asset sales between a parent and its foreign subsidiary-more extensively in governing cash loans and loans of property between a parent and its foreign subsidiary, or alternatively, by treating asset sales between a foreign subsidiary and its domestic parent as a repatriating event-the same way that a loan between a foreign subsidiary and its domestic parent is currently treated-and taxing the entire transaction under subpart F. Either option would give greater consistency to transactions governed by subpart F and would be relatively simple to implement within the political process.

INTRODUCTION .............................................................................................. 505

I. THE SCHERING-PLOUGH CASE ............................................................ 507

II. THE HISTORY AND ENACTMENT OF SUBPART F ................................. 512

A. How Subpart F Became the Law ................................................ 512

B. The Current Subpart F Rules ..................................................... 514

III. THE DIFFERENCE BETWEEN AN INTERNATIONAL TAX SYSTEM BASED ON CAPITAL IMPORT NEUTRALITY AND ONE BASED ON CAPITAL EXPORT NEUTRALITY .......................................................... 518

IV. DIFFICULTIES AND PROPOSED SOLUTIONS TO THE CURRENT

SUBPART F SYSTEM ............................................................................ 521

A. The Debate over the Treatment of Hybrid Entities Under

Subpart F .................................................................................... 521

B. Proposed Academic Solutions to Subpart F ............................... 523

1. Benefits and Drawbacks of Implementing Uncontrolled

CEN ...................................................................................... 523

2. Benefits and Drawbacks of Implementing Uncontrolled

CIN ....................................................................................... 525

V. POSSIBLE REMEDIES TO THE ARBITRARY CLASSIFICATION OF

ASSETS BY THE COURT IN THE SCHERING-PLOUGH DECISION ............ 527

A. The Schering-Plough Transaction: Was It a Sale or a Loan?

Why We Need a Better Way to Tell the Difference ..................... 528

B. Using Theories of Global Taxation to Remedy the Arbitrary

Categorizations of Income Taxed by Subpart F ......................... 530

VI. PROPOSED CHANGES TO SUBPART F: TAXING ECONOMICALLY

IDENTICAL TRANSACTIONS THE SAME ............................................... 531

A. First Proposal ............................................................................. 532

B. Second Proposal ......................................................................... 533

CONCLUSION .................................................................................................. 534

INTRODUCTION

Permitting a taxpayer to control the economic destiny of a transaction with labels would . . . exalt form over substance, thereby perverting the intention of the tax code.¹

Currently, under subpart F of the Internal Revenue Code,²most forms of income earned by a foreign subsidiary of a domestic company³are not taxed until the income is repatriated⁴to the United States. Once the income is repatriated to the domestic parent, the amount of money that has been earned abroad is then usually subject to subpart F taxation. Subpart F provides detailed rules and regulations describing when income earned by a foreign subsidiary is subject to U.S. taxation.⁵

In 1991, the multinational drug corporation Schering-Plough was faced with a "ballooning" balance sheet as its cash reserves and debt were rising to high levels.⁶Schering-Plough's cash was tied up in its foreign Irish and Swiss subsidiaries, while its domestic parent accumulated the debt.⁷Schering-Plough wanted to get the cash from its foreign subsidiaries to pay down its domestic debt and slow the ballooning of its balance sheet, but also wanted to avoid the significant subpart F taxation that would accompany the simple transfer of these funds from foreign subsidiary to parent.⁸

In an effort to avoid subpart F taxation while still getting lump sum payments from its subsidiaries, Schering-Plough enlisted the help of Merrill Lynch to design a transfer method with the sole goal of deferring taxation.⁹

The transfer method consisted of two waves of contracts, the first in 1991 and the second in 1992.¹⁰Each wave was essentially the same: notional principal contracts¹¹based on a large amount of money that would provide Schering-

Plough with a right to receive a stream of income over twenty years.¹²

Schering-Plough then sold this interest in income to one of its subsidiaries.¹³

That way, Schering-Plough hoped to amortize the lump sum from the subsidiary over the lifetime of the contract, rather than paying taxes on the lump sum all at once.¹⁴

The Internal Revenue Service (IRS) challenged this arrangement, claiming that the transactions were actually loans between Schering-Plough and its foreign subsidiaries.¹⁵The U.S. District Court of New Jersey agreed with the IRS and held that the transactions were loans, which subjected Schering- Plough to a $473 million tax liability.¹⁶The court's analysis in recategorizing the notional principal contracts as loans was extremely complex and detailed, and it is unclear which factors the court used to determine whether the transaction was a loan. The court's analysis highlights the difficulties that exist with the current subpart F system, and the loopholes and tax-planning strategies available as a result of these rules.¹⁷

To fully appreciate the issues in Schering-Plough, an analysis of the two competing theories on international taxation, Capital Import Neutrality (CIN) and Capital Export Neutrality (CEN), is necessary. CIN is an international tax system predicated on the assumption that all businesses in the same country should be taxed at the same rate.¹⁸If all countries had identical rates of taxation for income earned within their borders, then CIN would be achieved.¹⁹

On the other hand, CEN is achieved when a country taxes only its residents on their worldwide income.²⁰Moving toward a system of CEN lessens the problem of categorizing a specific asset for tax purposes because wherever a taxpayer chooses to do business, it would be taxed at the same rate.²¹CEN would eliminate the role that taxes play on where an investor does business and would make efficiency the driving force behind investment.²²

Additionally, to repair the difficulties with subpart F it is important that transactions between a domestic parent and a foreign subsidiary should be treated consistently. There is no reason that the sale of an asset between a parent and its subsidiary should not trigger subpart F income while a loan between the two does. Consistent treatment of these transactions can be achieved by using the transfer pricing rules that currently regulate asset sales between a parent and subsidiary to also regulate loans. Alternatively, if transfer pricing rules are deemed ineffective then asset sales between a subsidiary and parent should be deemed repatriating events under subpart F in the same way that loans are currently treated. This Comment does not endorse which of these two solutions would be more effective but advocates that treating economically identical transactions consistently is imperative, and that one of the two solutions must be adopted to ensure consistent treatment.

Part I of this Comment examines the details and rationale of the Schering- Plough decision. Part II tracks the development of the subpart F system, and describes the details of the subpart F system as it exists today and the various forms of income that are covered under subpart F. Part III explores the competing theories of international taxation and the arguments that proponents of each system use to advocate their positions. Part IV examines the problems and inconsistencies in the current subpart F system and several academics' suggestions on how to better the system.

Part V uses the Schering-Plough case to illustrate how arbitrary some of the distinctions in subpart F are and discusses how moving toward an international tax theory of CEN would lead to more efficient investment decisions. Part VI proposes that the taxation of cash loans from a foreign subsidiary to its domestic parent should be consistent with the taxation of asset sales and property loans between the two. It suggests that one of two alternate...