Treasury's long-awaited Subpart F study breaks no new ground, touts ending deferral.

• Author: Aud, Ernest F., Jr.
• Position: Foreign income; anti-deferral rules

Introduction

On December 29, 2000, the U.S. Treasury Department released its long-awaited study on Subpart F. Treasury's stated impetus for undertaking the study was to "reexamine whether Subpart F is the most appropriate -- or effective -- way to tax foreign income."(1) Underlying its interest to revisit the anti-deferral rules is Treasury's perception that recent developments have undermined the ability of Subpart F to serve its intended purpose. In December 1998, Treasury's then Assistant Secretary for Tax Policy, Donald Lubick, announced that Treasury would be undertaking such a study. His announcement came at the close of a year in which Treasury had issued -- and then retreated from -- Notices 98-11 and 98-35, addressing the treatment of so-called hybrid branches in the Subpart F context, and taken other steps aimed at curtailing what it believed to be abuses of Subpart F.

The lengthy study -- which is set forth in seven chapters running more than 100 pages, plus an additional 100 pages of appendices -- begins by tracing the historical development of the Subpart F rules and examines from an economic perspective the various policies available to any jurisdiction with respect to taxing foreign income. The study focuses on the extent to which particular policies would promote economic welfare and also addresses the effect of Subpart F on the competitiveness of U.S. businesses. The study then examines whether Subpart F has achieved its policy goals and whether certain developments may challenge Subpart F in the future. Following this progression, Treasury presents options for replacing or reforming Subpart F.

The following international tax policy principles served as a guide to Treasury in developing these options:

* Meeting the revenue needs determined by Congress in an adequate and fair manner;

* Minimizing compliance and administrative burdens;

* Minimizing distortion of investment decisions through tax considerations;

* Conforming with international norms, to the extent possible; and

* Avoiding placing an undue burden on the competitive position of our nationals.

This article summarizes the Treasury Study and comments on several of its conclusions. We note that Treasury has acknowledged that the conclusions of this study are neither recommendations nor legislative proposals.

Chapter 1: Why Subpart F Was Enacted: Developments In the Law Before 1962

The Treasury Study examines the events that led to the enactment of Subpart F -- information that is then used to attempt to determine the intent of Subpart F when originally enacted.

Anti-deferral rules are necessary, the study says, because of two fundamental features of the U.S. income tax system that operate to allow the avoidance of tax: the treatment of a corporation as a separate person and the imposition of tax on a U.S. person's worldwide income. These two features are inconsistent and have produced an inherent tension in the U.S. income tax system, the study notes, because the treatment of a corporation as a separate person provides taxpayers an avenue to avoid worldwide taxation through the use of a foreign corporation (i.e., the foreign corporation is untaxed on its foreign-source, non-effectively connected income). In a tax system that employs these two fundamental features, the ability to avoid tax is made available unless anti-deferral techniques are implemented.

The Treasury Study concludes that both of these fundamental features of the U.S. tax system are important. It states that worldwide taxation ensures equity in the tax system by treating all income the same, by ensuring that investments are not made for tax-motivated reasons, and by avoiding the perception of unfairness that would occur if tax reduction were more readily available to those with the ability to invest abroad. On the other hand, Treasury recognizes that the treatment of a corporation as a separate person is integral to maintaining the "`classical' system of taxation"(2) where a corporation's earnings are subject to two levels of taxation and there is an ability to defer the second level of taxation until distribution. It is this opportunity to avoid taxation that anti-deferral provisions should attempt to remedy.

The study reviews several different anti-deferral provisions that preceded the Subpart F rules beginning in 1913 and continuing through the 1962 enactment of Subpart F.(3) The study concludes that the "main thrust of the tax avoidance techniques which led to the enactment of Subpart F was the `deflection' of income to low-tax jurisdictions, not only from the United States, but also from foreign high-tax developed countries where the principal value adding activity took place."(4)

By presenting the chronology of the distinct anti-deferral regimes that preceded the enactment of Subpart F, Treasury seeks to illustrate that between 1913 and 1962, Congress acted to thwart attempts by taxpayers to avail themselves of the tax avoidance opportunities presented by the tension between the treatment of corporations as separate persons and the taxation of worldwide income. The study emphasizes that in 1962 Congress acted decisively to enact legislation that would enforce the principle of worldwide taxation by restricting deferral.

Chapter 2: The Intent of Subpart F

Treasury next focused on identifying the specific intent behind the enactment of Subpart F. The study points out that the Kennedy Administration originally "proposed to end `tax deferral privileges in developed countries' and to eliminate `tax haven deferral privileges' in all countries." In 1962, after consideration of President Kennedy's proposal, Congress enacted legislation to end "tax haven deferral," but stopped short of following the Kennedy Administration's proposal to end tax deferral for all income earned in developed countries. The Administration and Congress defined the types of transactions that gave rise to "tax haven deferral" as those "`artificial arrangements' between related corporations that `exploit the multiplicity of foreign tax systems and international agreements in order to reduce sharply or eliminate completely [their] tax liabilities at home and abroad.'"(5) The Treasury Study acknowledges that tax haven abuses greatly contributed to the enactment of Subpart F. Furthermore, the study emphasizes that Congress sought to end deferral for income obtained through such "artificial arrangements" that shifted income from high-tax jurisdictions (either the U.S. or high-tax foreign jurisdictions) to low-tax jurisdictions.(6)

In addition to tax haven abuses, the Treasury Study says that Subpart F was also enacted to tax passive income currently, promote equity among taxpayers, and promote economic efficiency based on the concept of tax neutrality. In this connection, Congress reasoned that taxing passive income currently would not jeopardize the competitiveness of multinationals. When explaining why it had not followed the Kennedy Administration's proposal to end deferral on all income, Congress made clear that it was concerned that an end to all deferral would place U.S. companies at a competitive disadvantage with respect to their foreign investments.

Treasury's report on the intent of Subpart F then concludes that "Congress [in 1962] may have believed that by ending deferral only in the tax haven context (as opposed to ending all deferral) and with respect to passive income, it addressed the goals of equity and efficiency without unduly harming competitiveness."(7)

Chapter 3: Economic Welfare and the Taxation of Foreign Income

Having concluded that in 1962 Congress intended to enact Subpart F in order to prevent income shifting from the U.S. or other foreign non-tax haven jurisdictions to foreign...