Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source Income
37 Pages Posted: 22 Feb 2008
When a U.S. person conducts business or investment activity abroad through a foreign corporation in a country that imposes only low rates of tax, the so-called deferral privilege allows the U.S. taxpayer to defer substantial amounts of U.S. tax at the cost of only a small foreign levy. Hence, the deferral privilege operates as a tax subsidy of sorts for U.S. persons with operations in low tax foreign countries and provides a major incentive for U.S. persons to shift their business operations and investments to foreign countries that impose little or no tax on the earnings of the foreign corporations.To prevent abuse, Congress has enacted a number of so-called anti-deferral regimes, which curtail deferral in certain circumstances but leave the privilege intact in a large residual area. These anti-deferral regimes, including the controlled foreign corporation provisions of Subpart F, are among the most complicated provisions in the Internal Revenue Code. Moreover, these anti-deferral rules were created in a different era, when manufacturing activity dominated the domestic and world economies and international trade was a far less significant component of the world economy; thus, the design of these rules has not kept pace with the changing nature of the global marketplace and international investment structures. The anachronistic nature of Subpart F and the other anti-deferral rules in the Code has spawned increasing numbers of intricate planning strategies to avoid the impact of these rules and preserve the deferral privilege.This Article discusses and critiques the various methods for curtailing deferral of U.S. income tax on foreign source income. We conclude that the most effective way to deal with the deferral issue is to treat a foreign corporation as a pass-through entity for U.S. income tax purposes with respect to U.S. persons holding stock in the corporation.The Article begins in Part II with an explanation and theoretical analysis of the deferral incentive. Part III then traces the legislative evolution of the anti-deferral provisions. Part IV is an overview discussion of anti-deferral regimes employed in foreign jurisdictions. Part V is an explanation of why developing a technically sound approach for ending deferral is an important enterprise. Part VI enunciates the criteria we believe should be used in constructing a sound regime for curtailing deferral and explains why we believe that the pass-through approach is the superior one. Parts VII and VIII examine the two principal alternative approaches to revising the anti-deferral regimes, both of which we believe are inferior to our pass-through approach. In Part IX, we present our proposal to treat foreign corporations as pass-through entities with respect to U.S. persons holding stock in such entities and explain how enactment of such a proposal could lead to other reforms in the international tax rules of the United States. Part X focuses on an important and difficult area of any tax reform proposal,namely, transition issues.
Keywords: Taxation, Transnational Taxation, International Taxation
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