subpart f - a study

Subpart FA study of intent and efficacy

Brian Masi

Seminar in Taxation, Dr. Patricia NodoushaniBarney School of Business, University of Hartford

February 7, 2011

AC789, February 2011 Masi

Table of Contents

Executive Summary ............................................................................................................................ ii

Section 1: Introduction to Subpart F

1.1. International Taxation .................................................................................................. 1

1.2. Deferral .............................................................................................................................. 2

1.3. The Subpart F Regime .................................................................................................. 3

1.4. Other Anti-Deferral Measures .................................................................................. 6

Section 2: The Enactment of Subpart F

2.1. Presidential Proposal .................................................................................................. 9

2.2. Congressional Hearings ............................................................................................ 11

2.3. Legislative Intent ......................................................................................................... 12

Section 3: Subpart F in Today’s Globalized Economy

3.1. Effect on International Competitiveness .......................................................... 15

3.2. Influence of Other Measures .................................................................................. 17

3.3. Moving Forward ......................................................................................................... 18

Conclusion ........................................................................................................................................... 21

Subpart F – A Study i


Executive Summary

The Subpart F regime, originally born from a proposal by President John F.

Kennedy to end the deferral of income recognition by United States multinational

firms operating in developed countries, is long overdue for reform.1 The law fails to

satisfy neither supporters of deferral elimination, nor supporters of elimination of

anti-deferral measures on the grounds of international competitiveness of US

corporations. Instead, the regime floats in the middle of two ideologies, frustrating

both, while causing compliance issues for the companies that operate under the

prescribed laws.

Perhaps the biggest issue with Subpart F is not that it does not end all

deferral, or that it imposes anti-deferral measures which may hinder competition, it

is that the system under which it operates forces the current inclusion of income.

The deemed dividend is both outmoded and cumbersome. Save wholesale repeal

and reform, the best path forward in improving the current Subpart F system is to

eliminate the deemed dividend, and the issues it causes, and replace the system with

a direct tax of US shareholders of controlled foreign corporations on a pass-through

basis. This reformed system eliminates the complexity of deemed dividends while

falling into a system of tradition within the United States system of taxation, which

contains similar provisions for the shareholders of foreign personal holding

companies and passive foreign investment companies.

1 “The Deemed Dividend Problem,”Avi-Yonah, Reuven S., National Tax Association – Tax Institute of America. Proceedings of the Annual Conference on Taxation 2004 at 251

Subpart F – A Study ii


Section 1: Introduction to Subpart F

1.1. International Taxation

While it can be taken for granted that the United States government has the

right and ability to tax its citizens on their income, the system under which the

United States taxes, a worldwide system, causes considerable complexity for US

individuals and corporations engaged in international commerce. In contrast to a

territorial system of taxation, where the home country of an individual or

corporation taxes only income derived from within its borders, the US taxes its

citizens, corporations, and resident aliens (for these purposes, referred to as US

persons) on their worldwide income.2 Thus, a US person who earns income abroad

is subject to taxation on that income by the United States.

Unlike the territorial system, where income from around the world is taxed

only once by the jurisdiction in which it was earned, the worldwide system can

subject taxpayers to double taxation. As the United States would tax a foreign

individual or corporation on certain types of income sourced within the United

States, a foreign country has the right to tax US persons on their income derived

within the foreign jurisdiction. In this situation, a US person may be subject to

taxation by the foreign country and again by the United States, causing double

taxation. In this situation, the burden falls to the United States government to offer

relief from taxation. Relief is provided to the taxpayer by the Foreign Tax Credit,

which offsets double taxation by offering a direct credit against US tax for foreign

taxes already paid.3 In most simple situations, the US person will only pay the

2 I.R.C. §61 - All references are to the 1986 Internal Revenue Code3 §901

Subpart F – A Study 1


residual tax (the difference between the lower foreign rate and the US rate) or only

pay the foreign tax (if the foreign rate is higher than the US rate).4

1.2. Deferral

Building on the concept of jurisdictional rights of taxation, it also seems

evident that a government cannot tax the citizens (or corporations) of another

country. A basic example shows the logic behind this. The United States government

cannot tax a French corporation engaged in business in France. The United States,

could, however, tax the same French corporation if it conducted business and

earned income in the United States (subject to certain thresholds). This creates an

incentive for US corporations operating abroad. If a US corporation operates a

branch in France, the income earned by the branch is subject to taxation in France

and in the United States. If, however, the US corporation incorporates the branch

into a full French corporation, the theory of jurisdiction states that the income is not

taxable by the United States until that income is repatriated. This phenomenon is

called deferral.

The use of deferral by US multi-national corporations is a powerful tool for

avoiding current US taxation of income. This ability, coupled with the use of

subsidiaries in foreign tax jurisdictions, where there is no (such as Bermuda5), or

4 While in most circumstances it is advantageous to make use of the Foreign Tax Credit, provided for under §901, corporations have the option to tax a deduction for foreign taxes paid, as an itemized deduction, per §164(a). Typically, taking the credit for foreign taxes paid is more beneficial as it results in a dollar-for-dollar reduction of tax liability, while the deduction results in a reduced benefit. The decision is made on a yearly basis (per Reg. §1.905-2(a)), but applies to all foreign taxes for the year (Reg. §1.901-1(c)). Further, foreign taxes paid cannot be both deducted and credited in the same year (Reg. §1.901-1(c)). There are additional considerations that may cause the deduction to be more attractive. For instance, the rules concerning overall foreign loss (Reg. §1.904(f)-1) and overall domestic loss (Reg. §1.904(g)-1T), cause recapture and prevent the use of the foreign tax credit.5 “2010 Global Corporate and Indirect Tax Survey,” KPMG, TaxWatch, 2010



low, corporate income tax allows corporations significant latitude in alluding US

taxation. If and when the income is repatriated to the United States, the income

would be subject to US taxation, however, the income could be reinvested abroad

tax-free. This ability, especially the use of tax havens, is the subject of significant

government scorn and the target of several tax regimes aimed at preventing the

practice.

1.3. The Subpart F Regime

Subpart F is an anti-deferral measure enacted in 1962 as part of the Revenue

Act of 1962.6 It targets various types of income earned abroad, seen as abusive or

not in keeping with the principals of tax equity. While deferral is beneficial to

American corporations as it allows them to operate subsidiaries and compete with

foreign corporations in foreign jurisdictions without additional taxes levied, the

opportunity for tax avoidance in the United States persists.7 The more precise

reasoning behind the enactment of Subpart F, through the Revenue Act of 1962, will

be examined in Section 2 of this study.

To grasp the scope and criticisms of Subpart F, it is important to first gain a

basic understanding of the dynamic of the provisions and the mechanics of how the

anti-deferral measures are imposed. One of the basic tenants of the system is the

concept of tax jurisdiction, which prevents the United States government from

directly taxing foreign corporations, or specifically in this case, controlled foreign

6 PL 87-834, Section 12(a)7 “Practical Guide to U.S. Taxation of International Transactions,” Misey & Schadewald, CCH, 2009 at 141



corporations (CFCs).8 This principal is what causes deferral in the first place, and

what, in turn, causes Subpart F to consist of a series of workarounds that allow the

United States government to tax certain foreign-earned income currently, without

waiting for repatriation of income.

With deferral, the foreign income is taxed by the United States when it is

repatriated, for instance, in the form of a dividend from the CFC to the US parent.9

Under Subpart F, certain types of ‘tainted’ income are taxed currently as a ‘deemed

dividend’ paid to the US parent in a Subpart F inclusion.10 The income considered

tainted, according to Subpart F, fits into four categories: Subpart F income (which

has many types); earnings invested in US property; and two types of previously

excluded Subpart F income.11 The first two categories are most important to this

study. Subpart F income includes five different types of income.12 The types of

income included in §952(a) are insurance income, foreign base company income,

some international boycott income, illegal bribes, kickbacks, and other payments

paid by or on behalf of the CFC, or income from countries currently disfavored by

the United States under §901(j). The second type, earnings invested in US property,

is a provision that prevents dividends paid to the US parent from being disguised as

investments or loans.13

8 While a somewhat in-depth and technical definition of what constitutes a CFC exists, for the purposes of this study, a simple portrait of a CFC as a wholly owned foreign subsidiary will suffice. For the purposes of Subpart F, a CFC is defined by §957 of the Internal Revenue Code.9 §862(a)(2)10 §951(a)(2)11 §§951(a)(1) 956, See also “Practical Guide to U.S. Taxation of International Transactions,” Misey & Schadewald at 14312 §952(a)13 §956



Foreign base company income is also made up of several parts, which can be

viewed as mechanisms of deferral or income shifting.14 The category includes

foreign personal holding company income, foreign base company sales income,

foreign base company services income, and foreign base company oil-related

income.15 The foreign personal holding company income provision primarily targets

passive income earned abroad16 while the remaining three types are derived from

the active conduct of trade or business.17 Foreign base company sales and services

income pertain to earned income relating to related party transactions and

transactions entered into where the final use of the product or service is not in the

same country in which the CFC is incorporated.18 This type of income can be clearly

used as an income deferral mechanism, especially when coupled with incorporation

in a tax haven.

If a US corporation incorporates a subsidiary in Bermuda specifically to sell

to international customers, the CFC is considered a foreign base company and the

sale of goods, to customers in countries other than Bermuda, will be considered

foreign base company sales income and will be subject to a Subpart F inclusion.19 In

the year of the sales, the income from such sales will be included in the income of

the US parent as a deemed dividend from the Bermudian subsidiary.20 As with a true

dividend, the deemed dividend will bring with it a deemed paid foreign tax credit,

14 §§952 95415 §954(a)16 §954(c)17 §§954(d) 954(e) 954(g)18 §§954(d) 954(e)19 §954(d)(1)(B)20 §951(a)(2)(A)(i)



allowing the US parent to offset the effects of double taxation.21 In this instance,

however, because Bermuda has no corporate income tax, there will be no deemed

paid foreign tax credit with the Subpart F inclusion. This effectively eliminates

deferral in this instance. There are, however, many other cases where deferral

continues to exist. The operation of foreign subsidiaries in each of the jurisdictions

in which the US parent sells to customers can eliminate the Subpart F inclusion and

preserve the benefits of deferral.

1.4. Other Anti-Deferral Measures

While Subpart F is broader and more far-reaching, there is another set of

rules that seeks to prevent deferral of income tax for foreign investments. In 1986,

Congress also enacted the Passive Foreign Investment Company (PFIC) regime.22

The PFIC rules were enacted as a second method of anti-deferral measures

primarily aimed at preventing tax deferral of international investments and

preventing the conversion of ordinary income to capital gains, through a

distribution from the foreign corporation.23 The measure works by allowing the

taxpayer the option of treating the corporation as a Qualified Electing Fund (by

making a §1295 election) and including the pro rata share of income as gross

income during the year it was earned.24 If the taxpayer does not make the election,

the foreign corporation is considered a §1291 fund and is subject to special rules

pertaining to excess distributions and dispositions of stock.25

21 §960(a)(1)22 Tax Reform Act of 1986 (PL 99-514)23 “Anti-Deferral and Anti-Tax Avoidance,” Miller, Michael J., International Tax Journal 200824 §1295, See also “Qualified Electing Fund - Instructions for Form 8621,” Internal Revenue Service, 201025 §1291 and Reg. §1.1291-9(j)(2)(iii), See also “Section 1291 Fund- Instructions for Form 8621,” Internal Revenue Service, 2010



While not directly pertaining to deferral, it can be seen that the international

transfer pricing scheme can be used to promote anti-deferral goals by preventing

unjustified income shifting among foreign jurisdictions.26 For instance, without

transfer pricing rules, a corporation operating a foreign subsidiary in a low-tax

jurisdiction could shift income to that jurisdiction by selling goods to the foreign

subsidiary at a price much lower than the market value. As an example, a

manufacturing company produces widgets with a retail price of $1,000 and a cost of

$200. If the parent corporation sells the widgets to the foreign subsidiary for $300,

and the subsidiary resells them for $1,000, $100 of income is taxable in the United

States while $700 is taxed at the lower foreign rate.

To prevent these abuses, Congress enacted §482 that requires arm’s-length

treatment in controlled transactions. While the Code does not specify the specific

methods of computing the arm’s-length value of the transaction, the regulations

provide some guidance to ensure that each party to the transaction recognizes

income commensurate with its role.27 While the transfer pricing scheme of §482 is

not directly an anti-deferral measure, it does work to prevent abusive income

shifting, which would result in deferral of income in foreign jurisdictions.

26 “The Subpart F Service Rules,” Tobin, James J. Esq., Tax Management International Journal 2006 at 357. See I.R.C. §48227 Reg. §1.482-4(f)(2)(i)



Section 2: The Enactment of Subpart F

2.1. Presidential Proposal

On April 20, 1961, President John F. Kennedy sent a message to Congress on

Taxation where he outlined a proposal for the elimination of deferral with a primary

focus on the use of overseas tax havens, among other tax-related issues.28 In his

address he brought into the debate the issue of tax equity. While he saw that the

prospects of international investment were favorable to US multi-national

corporations, he saw that the US tax treatment of such investments favored multi-

nationals, leaving purely domestic corporations at a disadvantage.29 Beginning the

section on international taxation, Kennedy said,

Changing economic conditions at home and abroad, the desire to achieve greater equity in taxation, and the strains which have developed in our balance of payments position in the last few years, compel us to examine critically certain features of our tax system which, in conjunction with the tax system of other countries, consistently favor United States private investment abroad compared with investment in our own economy.30

Kennedy’s tax proposal set the tone for the eventual compromise that

resulted in the enactment and codification of Subpart F. His proposal contained five

parts, the most realized pertaining to the elimination of tax deferral in developed

nations, especially in tax havens.31 While well-known tax havens of today were not

28 See President’s Tax Message along with Principal Statement, Detailed Explanation and Supporting

Exhibits and Documents Submitted by Secretary of the Treasury Douglas Dillon in Connection with the President’s Recommendations contained in his Message on Taxation at Hearings conducted by the Committee on Ways and Means, H.R. Doc. No. 140, 87th Cong., 1st Sess. 7-8 (1961), reprinted in Committee on Ways and Means, 90th Cong., 1st Sess., Legislative History of H.R. 10650, 87th Congress, The Revenue Act of 1962, Part 1, 147-48 (1967)29 Id. at 630 Id. 31 President’s 1961 Tax Recommendations, Hearings before the Committee on Ways and Means on the Tax Recommendations of the President Contained in his Message Transmitted to the Congress,



all listed, Kennedy specifically mentioned Switzerland as an ‘unjustifiable’ tax haven.

He believed that the motivation of investment along tax grounds leads to the

misallocation of investment to the overall detriment of economic well-being at home

and abroad.32 Beyond the elimination of tax deferral in developed countries and tax

havens33 Kennedy specifically carved out an exception for the developing world. He

believed that it was the responsibility of the developed world to aid in the

development of the third world, and as such, proposed to allow the continued

deferral of tax in those places. This, coupled with the end of deferral in the

developed world, would provide an incentive for increased investment in these

locations and lead to economic prosperity and development in those countries thus

far neglected economically.34

Beyond issues of deferral, Kennedy also outlined four additional proposals

for Congress’ further inspection. The measures included realignment of rules

concerning the taxation of foreign investment corporations to curb substantial

outflows of capital from the United States, ending tax exemptions for Americans

April 20, 1961, 87th Cong., 1st Sess. (Vol. 1) 261 (1961 Hearings before the House)32 Id.33 The OECD has previously, and continues to issue definitions of ‘tax haven’ countries, which are commonly used as a set of guidelines. Previously, the OECD outlined a series of four criteria that determine a tax haven: (1) no or nominal taxation of the relevant income; (2) rules that prevent the effective exchange of information with foreign tax authorities; (3) a lack of transparency in the operation of legislative, legal or administrative provisions; and (4) the absence of a requirement for substantial activity. Over the last decade this definition has been significantly watered down to contain only those countries seemingly standing in the way of effective tax administration. It can be argued that the new set of criteria is toothless and provides any significant guidance in labeling any particular country as a tax haven. The current three factors include: (1) whether there is a lack of transparency; (2) whether there are laws or administrative practices that prevent the effective exchange of information for tax purposes with other governments on taxpayers benefiting from the no or nominal taxation; and (3) whether there is an absence of a requirement that the activity be substantial. OECD, “Tax Haven Criteria” http://www.oecd.org/document/23/0,3343,en_2649_33745_30575447_1_1_1_1,00.html Accessed February 6, 201134 President’s 1961 Tax Recommendations



living and working abroad, elimination of the exclusion of property held abroad

from the estate tax, and eliminating a double allowance of use of foreign tax credits

on dividends paid to US persons from abroad.35 Of these measures, perhaps the most

significant was the complete termination of deferral of income tax of US

multinationals operating foreign subsidiaries in tax havens and developed

countries. Kennedy’s proposal would be sent forward to the House Committee on

Ways and Means for hearings and eventual compromise that would ultimately

preserve deferral, but curb some of the perceived abuses.

2.2. Congressional Hearings

Following the President’s proposal regarding tax deferral, developed

countries, underdeveloped countries, and tax havens, a modified proposal was

developed by the Treasury department for submission to the Committee on Ways

and Means.36 The modified proposal was included in the General Explanation of

Committee Discussion Draft of Revenue Bill of 1961, but the proposal was pushed

back for further discussion in the next session of Congress.37

The modified proposal took into consideration the President’s original

message but made significant changes immediately. The entire consideration of

ending deferral was removed and only the proposal on changes pertaining to the

treatment of income from tax havens was considered.38 Tax haven transactions were

35 Id.36 “The Deferral of Income Earned,” 2000. Department of the Treasury, at 11337 General Explanation of Committee Discussion Draft of Revenue Bill of 1961 Released for Information and Study, August 24, 1961, Prepared for the Committee on Ways and Means by the Staff of the Joint Committee on Internal Revenue Taxation 1, 51 (1961), reprinted in Committee on Ways and Means, 90th Cong., 1st Sess., Legislative History of H.R. 10650, 87th Cong., The Revenue Act of 1962 (Part 1) 567, 617 (1967) (1961 Explanation of Discussion Draft).38 Id.



initially confined to transactions with related parties including “…Income from

purchases, sales, commissions, licensing, dividends, interest, services, and

insurance.”39 Specified further in the document, these types of transactions, forming

the base of the current Subpart F, would include transactions from sources outside

of the country of incorporation of the foreign subsidiary.40 The same Treasury draft

also expanded Kennedy’s notion of a controlled foreign corporation and gave

further detail to his definition. 41

While Douglas Dillon, the Secretary of the Treasury under Kennedy,

continued to advocate for the president’s position on ending all deferral in

developed countries, the legislative agenda set by the House and furthered by the

Senate seemed to sidestep the issue altogether, focusing solely on tax haven issues.42

The Senate also introduced a bill similar to the bill in the House, which provided two

relief provisions. The provisions excluded income from foreign jurisdictions with

tax rates not substantially lower than the US rate, and another provision for

exporting corporation that produced goods within the United States.43

2.3. Legislative Intent

Kennedy’s address became the basis of legislative intent for the enactment of

Subpart F. Although Congress modified his original vision, the importance of curbing

the use of foreign tax havens to permanently escape US taxation in tax motivated

transaction structures was the central theme of the enactment of the tax regime.

39 Id.40 Id. at 5241 Id. at 5342 “The Deferral of Income Earned,” 2000. Department of the Treasury, at 11443 Id. at 115



While Kennedy saw the use of tax havens as the primary issue, he originally

advocated for the end of deferral in all developed countries because he felt that the

emergence of economic power and essential parity in Europe and Japan would lead

to the diminishment of any real benefit to deferral.44 Indeed, as the tax rates in these

locations came more closely in line with the rates in the United States, the

attractiveness of prolonged deferral was less than substantial.45

Other issues of importance in Kennedy’s address included the misallocation

of capital due to the artificial inducement of investment provided by preferential tax

rates and the inequitable benefit afforded to US multinationals operating abroad.46 It

seems that in making his address, Kennedy held a belief in the efficiency of markets

to drive capital investment to those places that would truly produce the best

returns. Thus, a country that offered reduced tax rates was manipulating investment

by drawing capital based on an other-than-market force. Finally, he made it clear

that for this disparity to continue, multinationals afforded the benefit of tax-free or

reduced tax income were put at a position of advantage over domestic US

corporations operating only at home.47 Kennedy’s address served as the basis for

the legislative action that resulted in Subpart F and can be seen as the driving force

of intent behind the measures. It was only the modifications by Congress that

watered down the anti-deferral/deferral elimination measures and resulted in the

narrowly targeted system that is Subpart F.

44 President’s 1961 Tax Recommendations45 Id.46 Id.47 Id.



Section 3: Subpart F in Today’s Globalized Economy

3.1. Effect on International Competitiveness

One of the greatest criticisms of Subpart F is that it prevents US

multinationals the ability to operate abroad and avail themselves of the greatest

benefits of tax deferral through the use of low-tax jurisdictions. This point of

contention carries significant controversy in that the many competing groups of

influencers hold different stakes in the debate. While the US Treasury typically holds

the position that will best result in revenue for the Federal government, US

multinationals hold the direct opposite position. To maximize profits, it is in the best

interest of multinational corporations to fully exploit tax havens and tax deferral. Of

course that argument assumes that profit maximization, at any cost, is the goal of a

corporation. Between these two bodies, Congress must answer to the powerful

constituency of business while balancing the need of the Treasury for revenue to

fund projects at the top of Congress’ wish list.

While the position that ending deferral will typically hurt US multinationals

on the world stage holds significant sway, there are many other factors at play

internationally that run counter to that belief. While the United States operates a

complex system of targeting specific types of international income (foreign base

company income, for instance) other governments of developed countries take a

much more direct approach to ending deferral. While avoiding the internationally

sticky issue of directly taxing CFCs, many developed countries, including France,

Germany, and Italy tax their domestic corporations on the income of CFCs on a pass-



through basis.48 Although, not technically a direct tax, this method of taxation

effectively eliminates deferral.

The benefit of this methodology is that it avoids the complications of deemed

dividends and treats the CFCs more in line with the rules governing partnerships

and S corporations in the United States. Further, mirroring such a position would

bring the United States in closer parity to at least 23 developed countries that have

anti-deferral rules.49 When many of the most developed countries in the world

already restrain deferral, including pass-through taxation, the argument that

changing the United States’ anti-deferral rules to eliminate complexity or to realize

the original intent, to benefit global economic balance and purely domestic

corporations, seems out of step with current global conditions.

One further consideration is the considerable pressure exerted by

international groups to prevent ‘harmful tax competition’ internationally. The OECD,

which enjoys backing from the United States, published a report in which it pushes

for the elimination of such harmful tax schemes to promote the flow of capital on

economic grounds, rather than tax-based considerations.50 The European Union has

also begun a push to curb similar tax competition among its member nations.51 This

is likely to have significant benefit in leveling the international playing field and

eliminating such harmful competition.52 The pushes by both the OECD, again with

backing from the United States, and the EU to eliminate tax-based competition fall in

48 “The Deemed Dividend Problem,” Avi-Yonah, Reuven S., National Tax Association – Tax Institute of America. Proceedings of the Annual Conference on Taxation 2004 at 25249 “Tax Neutrality to the Left,” Engel, Keith, Texas Law Review 2001 at 155850 Id. at 155751 Id. at 155752 Id. at 1558-1559



line with studies of taxation that show that tax parity internationally is best to foster

the flow of capital and international investment in a way that is truly consistent with

market forces, rather than the artificially induced effects of tax competition.53

3.2. Influence of Other Measures

As reviewed previously, one important factor to consider in examining the

efficacy of Subpart F in preventing unjustifiable income shifting is the role of the

transfer pricing regime currently enacted in §482 of the Internal Revenue Code.

Despite the fact that a transfer pricing system was already effective when Subpart F

was enacted, enforcement of the regime was not significant.54 Today, despite the

lengthy Treasury Regulations in place under §482, the IRS retains significant and

broad authority to examine and adjust transfer pricing allocations made by

taxpayers.55 The ability of the IRS to strictly enforce the arm’s length doctrine of the

transfer pricing laws allows the Treasury significant latitude in adjusting for any

abuses in the shifting of income internationally, in such a way that it could be argued

that, even without Subpart F, the fair distribution of income among jurisdictions is

enforceable.56

3.3. Moving Forward53 E.g. “Taxation of Foreign Investment Income, An Economic Analysis,” Richman, Peggy Brewer, 1963; “United States Taxation of Foreign Investment Income,” Musgrave, Peggy B., 196954 “The Subpart F Service Rules,” Tobin, James J. Esq., Tax Management International Journal 2006 at 35755 Id. While the standard of arm’s length and comparable uncontrolled transactions are established in Reg. §§1.482-1(e)(1) and 1.482-1(e)(2)(i), the taxpayer has the responsibility, per Reg. §1.482-1(c)(1) to select the “best method” for computing transfer pricing. This causes situational ambiguity and subjectivity. To further enforce compliance, §6662(e)(1)(B)(i) imposes a system of penalties on miscalculated transfer prices of a certain magnitude. Further adding to the complication and subjectivity, Reg. §§1.6662-6(b)(3) and 1.6664-4(a) allow for the waiver of penalty of the taxpayer can prove that the position was taken in good faith and on substantial authority.56 Id.



While Subpart F remains entrenched in the tax system of the United States as

an important measure of preserving revenue for the Treasury, the system itself is

deeply flawed. The deemed dividend system, in itself, causes such undue burden and

complexity that, aside from the benefits or shortfalls of anti-deferral concepts

generally, the system is in dire need of reform.

Doing away with the system of deemed dividends and moving to a more

stream-lined system of taxing US multinationals on their pro rata share of income on

a pass-through basis seems an immediate step forward in fixing this issue. Even in

this case, the specifics of Subpart F (the types of income divined by Congress to be

included) could be left intact without damaging the current levels of deferral/anti-

deferral enacted. The benefit, here, would come from reducing complexity in a tax

system wrought with it. Further, this move is not without precedence. As previously

mentioned, not only have many developed nations joined the US in anti-deferral

measures subjecting CFCs to some sort of direct or indirect taxation, but important

developed nations have begun taxing their domestic corporate shareholders on a

pass-through basis.57 Finally, if the US is firm in its convictions not to be led, but to

lead the way in methods of taxation, Congress and the Treasury can rest assured

that such a precedence already exists in the US in the foreign personal holding

companies rules of 1937 and the passive foreign investment companies rules of

1986.58

57 “The Deemed Dividend Problem,”Avi-Yonah, Reuven S., National Tax Association – Tax Institute of America. Proceedings of the Annual Conference on Taxation 2004 at 25258 Id. at 251



However, moving to pass-through treatment is only a stopgap measure to fix

a compromised system of anti-deferral compromise. While minor reforms through

amendments have come over the years, no significant changes have been made to

push the debate toward some final decision.59 In addition, many tax professionals

have given their time to attempting to further the debate in the direction of

eliminating deferral, or to eliminating all anti-deferral measures in the name of

global competitiveness.60 In one significant work of analysis, which perhaps,

perfectly embodies the entire discussion, Keith Engel gives a lengthy discussion of

the history of anti-deferral, yet anticlimactically arrives at the conclusion that the

compromise that is currently faced under Subpart F is all that can be expected.61 He

reasons that because each side is so set in their ways, heels dug in, with their

presumptions unwavering, that no better system could be devised.62 What’s perhaps

worse, is that in some of his minor conciliations, Engel opens up the possibly of

minor changes that could allow for tighter restrictions on deferral, but by adding

considerable complexity.

In an analysis of Engel’s work, Robert J. Peroni, a proponent of anti-deferral,

suggests that further muddling a system of complexity by adding a system of

59 E.g. Tax Reform Act of 1969, Tax Reduction Act of 1975, The Tax Reform Act of 1976, Tax Equity and Fiscal Responsibility Act of 1982, Tax Reform Act of 1984, Tax Reform Act of 1986, Revenue Reconciliation Act of 1989, Omnibus Budget Reconciliation Act of 1993, Small Business Job Protection Act of 1996, Taxpayer Relief Act of 1997, etc.60 E.g. “Tax Neutrality to the Left, International Competitiveness to the Right, Stuck in the Middle With Subpart F,” Engel, Keith, Texas Law Review 2001; “Deferral of U.S. Tax on International Income: End It, Don’t Mend It—Why Should We Be Stuck in the Middle with Subpart F?,” Peroni, Robert J., Texas Law Review 2001; “The Deemed Dividend Problem,” Avi-Yonah, Reuven S., National Tax Association – Tax Institute of America. Proceedings of the Annual Conference on Taxation 2004; “The Subpart F Service Rules Have Outlived Their Purpose – It’s Time to Move On,” Tobin, James J., Tax Management International Journal 200661 “Tax Neutrality to the Left,” Engel, Keith, Texas Law Review 2001 at 157162 Id.



minimum repatriation (a new system akin to transfer pricing schemes) to guarantee

some repatriation of income only worsens the overall system.63 Peroni finally

concluded, on the basis of the documented evidence of the benefits of export

neutrality (as briefly discussed previously) over import neutrality64 that either

ending the system of deferral entirely, or completely repealing and reworking

Subpart F are the clearest paths to coherent reform.65 I cannot help but agree.

63 “Deferral of U.S. Tax on International Income: End It, Don’t Mend It,” Peroni, Robert J., Texas Law Review 2001 at 161064 The previously mentioned studies examine the benefits of capital-export neutrality as the principal pertains to economic wellbeing. Capital-export neutrality creates a situation where investment domestically has no tax benefits or detriments compared to investment abroad. In this situation, given efficient markets, capital will flow to the investments which will earn the best returns, not those that produce better tax consequences. Conversely, capital-import neutrality favors the rights of individual countries to set the competitive tax rates, which, in some cases, can lead to harmful tax competition.65 “Deferral of U.S. Tax on International Income: End It, Don’t Mend It,” Peroni, Robert J., Texas Law Review 2001 at 1619



Conclusion

When the complexity of tax law dramatically interferes with compliance and

adds to cost in compliance and audit, there is a need for change. This alone is reason

to take significant steps in reforming Subpart F. While the arguments in the vein of

international competitiveness hold considerable weight, they will never win out

fully. Had Congress believed that indefinite deferral would best serve the US public,

such ranging anti-deferral measures would never have been enacted. Thus, an

argument for repealing all such measures seems almost facetious.

While it seems initially ugly, the idea of ending deferral altogether is in line

with the original calls for the measures taxpayers grapple with today. Further,

studies concerning international tax clearly favor capital-export neutrality over

import-neutrality as a means for encouraging efficient investment of capital

abroad.66 This, of course, benefits economic well being at home and abroad. Another

angle of further consideration is the influential stature of the United States on the

world economic stage. As previously mentioned, many developed countries have

followed the United States’ lead in implementing anti-deferral measures. In this area

too, the United States could take the lead in ending deferral and implementing

capital-export neutrality. The potential for a chain reaction could provide enormous

benefit worldwide and take a significant step forward in eliminating harmful tax

competition among nations.

Perhaps now is a perfect time to enter into serious debate about ending

deferral. In January 2011, President Barack Obama put forth the issue of reducing

66 “Taxation of Foreign Investment Income,” supra n. 29



the corporate tax rate in the United States.67 The sting of the end of deferral might be

substantially lessened by a more ‘competitive’ tax rate for all US corporations, not

just the multinationals currently benefiting from reduced worldwide rates.

67 Obama, B. H. Address before a joint session of the Congress on the state of the union, January 25, 2011.
