The Deferral of Income Earned Through U.S. Controlled Foreign Corporations A Policy Study Office of Tax Policy Department of the Treasury December 2000 TABLE OF CONTENTS INTRODUCTION PURPOSE, STRUCTURE, BASIC CONCEPTS, AND DESCRIPTION OF SUBPART F Statement of Purpose ............................................vii Structure of the Study .......................................... viii Basic Concepts ................................................ viii Brief Description of the Subpart F Regime ............................ xi CHAPTER 1 WHY SUBPART F WAS ENACTED: DEVELOPMENTS IN THE LAW BEFORE 1962 General ........................................................1 The Underlying Need for Anti-Deferral Rules: Structural Tensions in the U.S. Tax System ..................................................1 The Need for Restrictions on Deferral: Tax Avoidance and Response ........4 Conclusion ....................................................10 CHAPTER 2 THE INTENT OF SUBPART F Introduction ...................................................12 Concerns Leading to Enactment of Subpart F ..........................12 Conclusions on Intent of Subpart F ..................................22 CHAPTER 3 ECONOMIC WELFARE AND THE TAXATION OF FOREIGN INCOME Introduction and Overview ........................................23 A Note on Economic Methodology .................................24 Optimal Taxation of International Investment Income ....................25 The Economic Effects of the Foreign-to-Foreign Related Party Rules ........42 Conclusions Relating to Economic Welfare and the Taxation of Foreign Income .......................................................53 CHAPTER 4 COMPETITIVENESS AND THE TAXATION OF FOREIGN INCOME Introduction ...................................................55 Has Subpart F Affected Competitiveness? .............................56 Has Subpart F Substantially Affected Comparative Tax Burdens of U.S. Multinational Corporations? .................................57 Conclusion on Competitiveness and the Taxation of Foreign Income ........61 CHAPTER 5 AVOIDING THE RULES OF SUBPART F General .......................................................62 Illustrations of Techniques to Avoid Subpart F .........................62 Is Subpart F Still Effective? .......................................67 CHAPTER 6 CHALLENGES TO SUBPART F: ENTITY CLASSIFICATION, SERVICES AND ELECTRONIC COMMERCE Introduction ...................................................68 Impact of the Check-The-Box Entity Classification Rules .................68 Subpart F and Services ...........................................70 The Challenges to Subpart F Posed by Electronic Commerce ..............75 Conclusions Relating to Challenges to Subpart F .......................81 CHAPTER 7 CRITERIA AND OPTIONS FOR CHANGE Introduction ...................................................82 Criteria for Evaluating Changes to Subpart F ..........................82 Alternatives ...................................................86 Conclusion on Options for Change ..................................95 CHAPTER 8 RESTATEMENT OF CONCLUSIONS Conclusions ...................................................96 Summary of Conclusions .........................................99 APPENDIX A HISTORICAL REVIEW OF U.S. LAWS RELEVANT TO CURRENT U.S. ANTI- DEFERRAL REGIMES AND ENTITY CLASSIFICATION U.S. ANTI-DEFERRAL REGIMES ...............................101 Structural Features of U.S. Tax System Giving Rise to Deferral and the Need for Anti-Deferral Rules .........................101 Anti-Deferral Provisions Prior to 1962 ........................105 Subpart F ..............................................111 Specific Provisions of 1962 Legislation ........................126 Significant Amendments to Subpart F Since 1962 Act .............135 FEDERAL TAX ENTITY CLASSIFICATION .......................163 Background ............................................163 Morrissey, the Changing Resemblance Test and the Kintner Regulations ................................................165 General Changes in the Entity Classification Rules since 1962 .......167 Specific Changes in the Entity Classification Rules for Foreign Entities since 1962 ........................................172 Promulgation and Purpose of the Check-the-Box Regulations .......175 APPENDIX B SURVEY OF QUANTITATIVE ECONOMIC STUDIES THAT EXAMINE THE INTERNATIONAL MOBILITY OF CAPITAL Taxes and U.S. Direct Investment Abroad, Suggestive Evidence of Capital Mobility ...............................................177 Taxes and the Decision to Invest in the United States or Overseas, Additional Evidence of Capital Mobility ................................182 Macroeconomic Research on International Capital Mobility ..............184 Conclusion ...................................................187 APPENDIX C THE MEASUREMENT OF TAX RATES Foreign Effective Tax Rates on the Earnings and Profits of Foreign Manufacturing Subsidiaries of U.S. Multinationals ...........................191 Average Effective Total Tax Rate on Foreign Source Income of U.S. Manufacturing Companies ..................................193 The U.S. Tax Rate on Domestic Income of U.S. Manufacturing Corporations ......................................................195 APPENDIX D SURVEY OF QUANTITATIVE ECONOMIC STUDIES THAT EXAMINE INCOME SHIFTING BY MULTINATIONAL COMPANIES Foreign Tax Rates and Reported Profits: Evidence That Suggests Multinationals Shift Income in Response to Differences in Tax Rules in Foreign Countries ......................................................198 Tax Reforms and Reported Profits: Evidence That Suggests Reported Earnings in a Particular Country Change When the Incentive to Shift Income Changes ......................................................202 Reported Profitability of U.S. Companies and U.S. Affiliates of Foreign Multi- nationals ...............................................205 Conclusion ...................................................208 INTRODUCTION: PURPOSE, STRUCTURE, BASIC CONCEPTS, AND DESCRIPTION OF SUBPART F I. Statement of Purpose On December 11, 1998, Assistant Secretary of the Treasury for Tax Policy, Donald C. Lubick, announced that the Treasury Department would study the U.S. anti-deferral rules contained in subpart F of the Internal Revenue Code. These rules restrict the deferral of tax on foreign income for certain U.S. owners of “controlled foreign corporations” (“CFCs”). Subpart F was enacted in 1962 and, while amended often since then, has retained its basic structure. After nearly four decades, however, Treasury, practitioners, and the business community1 believe it is time to reexamine whether subpart F is the most appropriate – or effective – way to tax foreign income. As Assistant Secretary Lubick noted, “It has been suggested that, at least in some respects, the current deferral rules have failed to adequately take into account significant developments since their enactment. [W]e plan to study the extent to which changes in our anti-deferral rules are warranted.”2 Assistant Secretary Lubick outlined the fundamental international tax policy principles that would guide the Treasury in its evaluation of the options for reforming or replacing the current subpart F regime: In preparation for this study, we have identified some of the principles that have long guided policymakers in determining the appropriate taxation of international income. We doubt that there is significant controversy over what policy principles are appropriate. Although there are differences over the 1 See, e.g., Robert J. Peroni, J. Clifton Fleming, Jr., Stephen E. Shay, Getting Serious about Curtailing Deferral of U.S. Tax on Foreign Source Income, 52 SMU L. Rev. 455, 458 (1999) (“The complex, incomplete, and anachronistic nature of . .[the anti-deferral] rules has prompted us to reconsider the appropriate scope of the U.S. anti-deferral regimes.”); National Foreign Trade Council, The NFTC Foreign Income Project: International Tax Policy for the 21st Century, Part One: A Reconsideration of Subpart F, at viii (Washington, 1999) (“[R]e-evaluation of the balance of policies that underlie subpart F is long overdue.”); David R. Tillinghast, An Old- Timer’s Comment on Subpart F, 98 TNI 61-24 (Mar. 31, 1998) (“Subpart F is now over 35 years old and it may be time to reexamine its policy premises . .”). 2 Hon. Donald C. Lubick, Assistant Secretary (Tax Policy), U.S. Department of the Treasury, Address at the GWU/IRS Annual Institute on Current Issues in International Taxation (Dec. 11, 1998). Assistant Secretary Lubick also described Treasury’s goals in undertaking the study, noting, “We intend to conduct this study in a comprehensive manner, relying on evidence over anecdotes, analysis over agenda. We intend that we shall neither be bound to nor ignore the policies which have guided us for the past three decades. We expect to set forth whatever conclusions a fresh slate review of the evidence leads us to.” vii viii application and relative weight to be given to some of these principles, five policy goals in the international tax area are generally recognized: • Meet the revenue needs determined by Congress in an adequate and fair manner; • Minimize compliance and administrative burdens; • Minimize distortion of investment decisions through tax considerations; • Conform with international norms, to the extent possible; and • Avoid placing an undue burden on the competitive position of our nationals.3 This study is intended to