Tax Neutrality to the Left, International Competitiveness to the Right, Stuck in the Middle with Subpart F
Engel, Keith, Texas Law Review
From 1913 through the 1950s, U.S. multinational corporations operated free from current U.S. income tax to the extent that they conducted operations through foreign subsidiaries. U.S. income tax applied to foreign subsidiaries only when they repatriated income to the United States. As a result, a growing chorus of U.S. multinationals began to shift their operations offshore. In response to the growing erosion of the U.S. tax base, the Kennedy Administration introduced groundbreaking international taxation legislation.
Under the initial Kennedy Administration Proposal, foreign subsidiary activity was generally to trigger current U.S. income tax for the subsidiaries' U.S. multinational shareholders. The aim of this Proposal was simple-global tax neutrality.1 Thus, foreign activities of U.S. multinationals were to be taxed at the same rates imposed on wholly domestic U.S. enterprises, ensuring that wholly domestic enterprises would remain competitive with their U.S. multinational rivals.
The Kennedy Administration Proposal faced serious congressional opposition, primarily on the grounds of international competitiveness.2 The opposition believed that the Proposal would have subjected U.S.owned foreign subsidiaries to higher overall taxes than the taxes imposed on their locally owned foreign competitors. Thus, they believed that foreign local neutrality was necessary to ensure that U.S.-owned foreign subsidiaries would remain competitive abroad.
Both sides soon came to a compromise. Under this compromise (known as "Subpart F"), U.S. multinationals are generally subject to current U.S. income tax to the extent their foreign subsidiaries receive disfavored forms of income. These disfavored forms of income include income from passive investments, such as portfolio stocks and bonds. Disfavored forms of business income are of a more limited nature, mainly involving structures that shift income outside a foreign subsidiary's place of incorporation without significant economic cost.
The modus vivendi under this Subpart F compromise remains largely in place to this day. However, U.S. multinationals have begun engaging in new forms of foreign subsidiary structures (most notably hybrid branch structures) that the Internal Revenue Service (the "Service") believes upsets this compromise. These structures primarily implicate disfavored forms of foreign subsidiary business income. The Service initially responded to these structures by issuing temporary regulations that would have immediately prevented U.S. multinationals from reaping the intended tax benefits.3 However, the Service withdrew these regulations in the face of public pressure,4 eventually reissuing these regulations in proposed form (albeit with a long delayed effective date).5 The controversial nature of this whole affair set off a lengthy debate over the objectives of Subpart F, leading many on both sides of the controversy to question whether the Subpart F regime should be revised as a whole.
The controversy between the Service and taxpayers over Subpart F essentially boils down to three main issues. First, what is the principle behind the Subpart F compromise and does this compromise make any sense from a policy perspective? Second, does the hybrid entity structure violate this intent? And third, if the policy of Subpart F proves wanting, how should Subpart F be redesigned? The purpose of this Article is to explore these issues.
Part II of the Article begins by explaining the basic structural paradigm of the U.S. international taxing system and the resulting tension between global tax neutrality and international competitiveness. Part III reviews the history and statutory language of Subpart F in order to discern how it attempts to balance global tax neutrality against international competitiveness-a discussion surprisingly absent from most of the literature.6 Next, in Part IV, I briefly explore the current debate over hybrid entity structures (as well as a related debate over harmful tax competition). …