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. ANTIDEFERRAL 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 Multinationals ............................................... 205

Conclusion ................................................... 208
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 OldTimer’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

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
viii

3

Id.

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 reexamine the system for taxing U.S. controlled foreign

corporations and to consider some of the options for reform. The Treasury intends for the study

to contribute to a public debate on these issues and invites comments on the study.

II. Structure of the Study

The study examines three basic questions. First, in designing a system pursuant to sound

tax policy, to what extent should foreign income of U.S. taxpayers bear a tax burden similar to

domestic income? Second, how effective is the subpart F anti-deferral regime in achieving sound

tax policy goals? Third, what alternatives are there to subpart F? 

To answer these questions, the study first places subpart F in its historical context and

seeks to determine its legislative aims. The study then examines, from an economic perspective,

various policies for taxing foreign income and considers the extent to which these policies

promote economic welfare. The study then considers whether subpart F has significantly affected

multinational competitiveness. Next, the study examines whether subpart F currently is achieving

its policy goals. The study also examines certain developments that may challenge subpart F in

the future. Finally, the study considers options for change.

III. Basic Concepts

A number of basic terms such as “deferral” and “worldwide” taxation are used throughout

this study and its appendices. However, people may have different understandings of the

meanings of these terms. For purposes of this study, the following section clarifies the meaning of

the term “deferral” and the distinction between what are often called “worldwide” and “territorial”

tax regimes.
ix

4 See Internal Revenue Code (I.R.C.) § 408.

5 See I.R.C. §§ 1271-1275.

6 See I.R.C. § 1259.

7

 Deferral could potentially allow the foreign income to be taxed at a zero effective rate. 

However, U.S. taxpayers are able to benefit from deferral only to the extent the income is not

taxed in a foreign country at a higher rate than the U.S. rate. 

8

 The Kennedy Administration likened deferral to an interest-free loan from the U.S. Treasury. 

See infra Chapter 2, text accompanying note 19. For an alternative view that deferral is better

analyzed as a “forced equity investment” by the U.S. Treasury, see Peroni, Fleming and Shay,

supra note 1, at 464-68 (1999).

9

 Partial territorial taxation is commonly and somewhat misleadingly referred to simply as

“territorial taxation.” Although pure territorial systems are uncommon among developed

A. What is Deferral?

In simple terms, “deferral” is the postponement of current taxation on the net income or

gain economically accrued by a taxpayer. Under U.S. tax law, in some cases deferral is

specifically legislated into existence (e.g., nonrecognition of income contributed to and earned in

retirement plans such as 401(k) plans and IRAs,4 and nonrecognition of gain in corporate

reorganizations under subchapter C of the Internal Revenue Code), while in other cases it is

specifically legislated out of existence (e.g., economic accrual of original issue discount5 and

realization of gain on “short-against-the-box” and similar transactions6). Deferral, however, also

is a result of more basic structural features of the U.S. tax system (e.g., the general principle

under section 1001 that the economic gain in property is only taxable when a realization event

occurs).

This study focuses on one type of deferral that results from a basic structural feature of the

U.S. tax system. The foreign income of a foreign corporation generally is not subject to U.S. tax,

even if the foreign corporation is organized by a U.S. taxpayer who would be subject to full U.S.

taxation on foreign income earned by it directly. Thus, by organizing a foreign corporation, a

taxpayer can, absent special rules, defer U.S. taxation on foreign income until it is repatriated, for

example, as a dividend. In this context, because of the “time value of money” advantage of

postponing payments of tax that otherwise would be due currently, deferral allows the foreign

income to be taxed at a lower effective rate7 than domestic income.8

B. What are Worldwide and Territorial Systems of Taxation?

Countries around the world generally use one of three systems for taxing – or not taxing –

the foreign income of their residents and/or citizens. Under one model, a jurisdiction does not tax

the foreign income of its residents (“pure territorial taxation”) or exempts from tax some, but not

all, of the foreign income of its residents (“partial territorial taxation”).9 Under a second model, a
x

countries, several countries in Central America use a pure territorial system of taxation, as do a

number of countries in South America, Africa and the Middle and Far East. 

10 South Africa, whose tax system is currently based on territorial principles, has recently

proposed moving to a residence based (worldwide) system of taxation to “bring the tax system in

line with generally accepted norms for taxing international transactions.” Department of Finance,

Republic of South Africa, Budget Review 2000 84 (Feb. 23, 2000), available at

<http://www.finance.gov.za>. Israel, too, is currently proposing to move from a system based on

territorial principles to a worldwide system of taxation. See Joel Lubell, Israeli Finance Minister

Presents Second Revised Tax Reform Proposal, 2000 Tax Analysts Worldwide Tax Daily, Oct.

17, 2000, available in 2000 WTD 201-4 (noting that although Israel had dropped other measures

from its proposed tax reform, it was continuing to proceed with its proposal to adopt worldwide

taxation).

11 In both cases, foreign income is not taxed until repatriated. However, under a worldwide

system, foreign income must be earned in a controlled foreign entity to obtain the deferral benefit. 

12 The period over which the income (after tax) earned on the deferred taxes exceeds that deferred

tax amount varies depending upon foreign tax rates, fluctuations in interest rates, etc. In certain

cases, however, it may be as little as ten years.

13 Statement of Financial Accounting Standards No. 109 (“Accounting for Income Taxes”);

Accounting Principles Board Opinion No. 23 (“Accounting for Income Taxes--Special Areas”).

jurisdiction imposes tax on its residents’ foreign income when that income is later repatriated

(“remittance taxation”). Under a third model, a jurisdiction imposes tax on its residents’ foreign

income when earned (“current taxation of worldwide income”). 

Current taxation of worldwide income that is earned directly by domestic persons is the

international norm. It is used by the United States, virtually all of the United States’ major trading

partners, and the overwhelming majority of countries around the world.10 The deferral achieved

by operating abroad through a foreign subsidiary, however, can neutralize the effect of worldwide

taxation. It does so by allowing taxpayers that choose to operate abroad through a certain type of

entity to postpone home country taxation of their foreign income. In such cases, deferral makes

worldwide taxation effectively the same as remittance taxation.11 Moreover, in certain

circumstances, deferral can effectively make what is nominally a worldwide system into a

territorial system. If the tax on income is delayed for a long enough time, the taxpayer’s

investment return on the amount of the deferred taxes will be greater than the amount of the taxes

themselves.12 Accounting standards reflect this result by not requiring accounting for deferred

U.S. tax on multinationals’ foreign income that is expected to be permanently reinvested abroad.13

 Further blurring the distinctions between worldwide and territorial systems, most

jurisdictions with worldwide systems, including the United States, allow a credit against domestic

tax for foreign taxes imposed on the income subject to domestic tax. Under a worldwide system

with a foreign tax credit, an item of foreign income generally is not taxed domestically to the
xi

14 The foreign tax credit reflects the fundamental tax policy decision made by most countries, in

order to prevent double taxation, to give up the right to tax their residents to the extent that the

country where the income is sourced imposes tax and to reserve the right to tax their residents to

the extent that the source country does not impose tax. 

15 See infra Chapter 3, note 59 and accompanying text (residual U.S. tax on repatriated income is

often less than if the United States had a territorial system of taxation because, under a territorial

system, dividends would not bring with them foreign tax credits that can be used to offset the

income on royalties and other payments received from foreign parties).

16 See infra discussion in Chapter 4, section III.C (foreign CFC regimes).

17 In a country that uses a territorial system, anti-deferral rules are more accurately referred to as

“anti-exemption” rules, since the country does not defer foreign income from inclusion in the

domestic tax base, but rather exempts foreign income from inclusion in the domestic tax base.

18 For example, the United Kingdom adopts worldwide taxation for corporations and applies a

remittance system for taxing investment income and capital gains of individuals that are resident

but not domiciled in the United Kingdom. The United States also has elements of a territorial

regime. For example, section 911 modifies U.S. worldwide taxation by allowing U.S. individuals

working overseas to exclude from their U.S. income certain amounts of foreign earned income

and housing costs. Similarly, section 114 excludes from gross income extraterritorial income of a

taxpayer. 

extent it is taxed abroad.14 To the extent that a tax system is territorial, an item of foreign income

is not taxed domestically regardless of whether it is taxed abroad. Thus, the foreign tax credit

system minimizes the differences between a worldwide system and a territorial system to the

extent the foreign tax equals or exceeds the domestic tax (so that no further domestic tax is

owed). In fact, the foreign tax credit system can make worldwide taxation preferable for some

taxpayers.15

Because the deferral that may be achieved by operating through a foreign subsidiary often

neutralizes the effect of worldwide taxation, a substantial and increasing number of our major

trading partners have adopted anti-deferral rules similar to those of the United States.16 In fact,

because of the importance of the anti-deferral concept, even countries such as France, commonly

thought of as having largely territorial systems, have adopted anti-deferral rules.17 

Finally, it should be noted that very few countries employ pure versions of either

worldwide or territorial taxation. Most have elements of both.18

IV. Brief Description of the Subpart F Regime

To understand the discussion of subpart F in this study, it is important to understand its

basic framework as set forth in sections 951-964 of the Internal Revenue Code. This section

briefly describes the major provisions of subpart F. A more detailed description of these

provisions (together with legislative history) is contained in Appendix A. 
xii

19 I.R.C. §§ 957, 951(b). Note that under these definitions it is possible for a foreign corporation

to have majority U.S. ownership but not be a CFC if there are not the requisite number of 10%

shareholders. 

20 I.R.C. §§ 957(c), 7701(a)(30).

21 I.R.C. § 951(a).

22 I.R.C. § 954(c).

23 Certain types of passive income such as interest and other investment income received by a

financial services company or an insurance company are currently subject to a temporary

exception from subpart F. See I.R.C. § 954(h) and (i). This financial services exception is

described in more detail in Chapter 6, section III, infra. Certain types of insurance income

continue to be subject to subpart F, most particularly income that is deflected from the United

States in respect of insurance of U.S. risks by U.S.-owned foreign insurers. See I.R.C. § 953. 

24 Section 954(d)(3) provides that a person is a related person with respect to a CFC if (a) such

person is an individual, corporation, partnership, trust or estate which controls, or is controlled

Subpart F applies to certain income of “controlled foreign corporations” (“CFCs”). A

CFC is a foreign corporation more than 50% of which, by vote or value, is owned by U.S.

persons owning a 10% or greater interest in the corporation by vote (“U.S. shareholders”).19

“U.S. persons” includes U.S. citizens, residents, corporations, partnerships, trusts and estates.20 If

a CFC has subpart F income, each U.S. shareholder must currently include its pro rata share of

that income in its gross income as a deemed dividend.21

The subpart F rules attempt to prevent (or negate the tax advantage from) deflection of

income, either from the United States or from the foreign country in which earned, into another

jurisdiction which is a tax haven or which has a preferential tax regime for certain types of

income. Thus, subpart F generally targets passive income and income that is split off from the

activities that produced the value in the goods or services generating the income. Conversely, 

subpart F generally does not require current taxation of active business income except when the

income is of a type that is easily deflected to a tax haven, such as shipping income, or income

earned in certain transactions between related parties. In related party transactions, deflection of

income is much easier because a unified group of corporations can direct the flow of income

between entities in different jurisdictions.

A major category of subpart F income is foreign personal holding company income

(“FPHCI”).22 This category includes interest, dividends and rents and royalties.23 It also includes

gains from the sale of property that produces passive income or that is held for investment, gains

from commodities transactions, and gains from foreign currency transactions, as well as certain

other income that is, in effect, the equivalent of interest or dividends. Because of its passive

nature, such income often is highly mobile and can be easily deflected. 

The FPHCI provisions contain special rules that apply to certain types of income received

by a CFC from a related person.24 One set of rules treats certain active income as FPHCI if
xiii

by, the CFC or (b) such person is a corporation, partnership, trust or estate which is controlled by

the same person or persons which control the CFC. For this purpose, control is generally defined

as ownership, directly or indirectly, of more than 50 percent of the relevant entity (by vote or

value). 

25 I.R.C. § 954(c)(2)(A).

26 I.R.C. § 954(c)(3)(A)(i). 

27 I.R.C. § 954(c)(3)(A)(ii).

28 See H.R. Rep. No. 1447, 87th Cong., 2d Sess. 62 (1962) (1962 House Report); S. Rep. No.

1881, 87th Cong., 2d Sess. 84 (1962) (1962 Senate Report). 

29 The foreign base company sales income rules prevent deflection of income both from the United

States to a foreign country and from one foreign country to another. Thus, while these rules act

as a back-up to the transfer pricing rules of section 482, they are also concerned with foreign-toforeign deflection.

30 I.R.C. § 954(d).

earned in transactions with related persons. Generally, rents and royalties earned by a CFC in an

active business are excluded from FPHCI.25 This exception does not apply, however, if the CFC’s

rents or royalties are received from a related person. Accordingly, rents and royalties received

from a related person are generally treated as FPHCI, without regard to the nature of the business

activities of the CFC that give rise to the rents and royalties.

Yet another set of rules excludes certain passive income from FPHCI if earned in

transactions with related persons. Under these rules (commonly referred to as the “same country

exception”), if a CFC receives dividends or interest from a related corporation incorporated in the

same country as the CFC and the related corporation has a substantial part of its assets used in a

trade or business in that country, then the dividends or interest will not be classified as FPHCI.26

Further, passive rents and royalties earned by a CFC are excluded from FPHCI if they are

received from a related corporation and the leased or licensed property is used within the CFC’s

country of incorporation.27

Other provisions of subpart F deal with the potential for deflection of income that would

otherwise be considered active. For instance, sales income is active income and subpart F

generally does not apply to active income. However, certain sales income, referred to as foreign

base company sales income (“FBCSI”), is subject to current inclusion under subpart F because,

when the manufacturing function is separated from its sales function, the sales income can easily

be deflected from the jurisdiction in which the major economic activity that produced the value in

the goods occurred, often a high-tax jurisdiction, to a low-tax jurisdiction where the “sales”

activities occur.28 This is particularly true in the case of related party transactions. Thus, the

FBCSI rules29 require current inclusion of income of a CFC from the sale of property (a) that is

purchased from, or on behalf of, or sold to, or on behalf of, a related person, and (b) that is

manufactured and sold for use, consumption or disposition outside the jurisdiction where the CFC

is incorporated.30
xiv

31 Treas. Reg. § 1.954-3(a)(4). 

32 See I.R.C. § 954(d)(2). 

33 As noted in Chapter 6, section III, infra, the recently-enacted financial services exception

exempts financial services businesses (but no other businesses) from the application of these

foreign base company services rules. See I.R.C. § 954(e)(2).

34 I.R.C. § 954(e).

35 1962 Senate Report, supra note 28, at 84.

36 In that case, while the entity performing the services will be compensated, for example, at cost

plus, the entity that has nominally contracted to perform the services will receive the bulk of the

profit. This latter entity would generally be formed in a low-tax jurisdiction.

37 Treas. Reg. § 1.954-4(b)(1)(iv).

38 I.R.C. § 954(f). The shipping income rules cover not only income derived from or in

connection with the use (or hiring or leasing for use) of aircrafts and vessels in foreign commerce

but also income from space and ocean activities (as defined in I.R.C. § 863(d)(2)).

Income from the sale of goods manufactured by the selling CFC is excluded from the

FBCSI rules.31 This exception is provided because, when the CFC performs the manufacturing,

generally, the sales function has not been separated from the manufacturing function. However,

because branches established in a separate jurisdiction can facilitate the deflection of income, the

FBCSI provisions contain a branch rule.32 The branch rule treats income from the sale of goods

manufactured by the CFC as FBCSI in certain cases when the selling and manufacturing

operations have been separated into different tax jurisdictions to obtain a lower rate of tax for the

sales income.

Foreign base company services income is another category of subpart F income that

applies to active income that can be deflected to a low-tax jurisdiction through related party

transactions, in this case, through the performance of services.33 Foreign base company services

income includes income from services performed outside the CFC’s country of incorporation for,

or on behalf of, a related person.34 These rules generally were intended to address circumstances

in which service activities are separated from the other business activities of a corporation into a

separate subsidiary located in another jurisdiction to obtain a lower rate of tax for the services

income.35 This result can occur not only when the CFC performs the services for a related person

but also when a related person assists the CFC to perform the services for an unrelated person.36

Thus, the regulations contain a “substantial assistance” rule under which, if a related person

provides the CFC with substantial assistance contributing to the performance of the services, the

services will be treated as performed for or on behalf of a related person.37

The foreign base company shipping income rules 38 treat shipping income as subpart F

income even if earned in an active business and from a transaction with an unrelated person. 

Congress enacted this provision because of its concern that shipping income is so mobile that it is

likely to escape all tax worldwide. Congress therefore determined that this income should be
xv

39 I.R.C. § 954(g).

40 See S. Rep. No. 494, 97th Cong., 2d Sess. 149-50 (1982) (because of the fungible nature of oil

and the complex structure of oil operations, such downstream activities easily could be shifted to

a foreign subsidiary in a tax haven). 

41 See I.R.C. § 956.

42 There are several other categories of subpart F income (such as income attributable to

participation in an international boycott). However, these provisions were enacted to address

wider foreign policy, rather than tax, concerns and accordingly are not further discussed in this

study.

subject to current taxation. The same concern underlies the foreign base company oil related

income rules,39 which treat most “downstream” oil-related income (e.g., refining income) as

subpart F income despite the fact that such income may be earned in an active business and

entirely from unrelated persons.40

Another provision of subpart F prevents the tax-free repatriation of foreign income

through investments in U.S. property.41 As noted above, income earned by a CFC (other than

subpart F income) generally is subject to U.S. tax when the income is repatriated, for example as a

dividend or a royalty. If the CFC invested the income in the United States, for example, by the

purchase of property or a loan to the parent corporation, the income would be effectively

repatriated in a manner that would escape current tax. Thus, generally, in the case of certain

investments in U.S. property by a CFC, the U.S. shareholder must include in income an amount

calculated by reference to the amount invested in the U.S. property.42
1 See supra Introduction, note 19 and accompanying text for the definition of “controlled foreign

corporation” (or “CFC”). 

2

 By making U.S. or foreign status of a corporation dependent upon the place of organization, this

third feature allows a U.S. taxpayer to choose foreign status for a corporation that it controls

simply by organizing the corporation outside the United States. In this way, the taxpayer can

obtain deferral because only the U.S. source income or income effectively connected with the

conduct of a U.S. trade or business of a foreign corporation is subject to U.S. tax. However,

treatment of a corporation as domestic or foreign based on place of organization is not

fundamental. Rather, it is a rule of operation to make the basic rules work. Changing this rule to

a different test for determining whether a corporation is foreign or domestic, such as

“management or control,” would not eliminate the tension between worldwide taxation and

separate corporate status. Taxpayers would simply adapt their deferral techniques to the new

definition. 

1

CHAPTER 1

WHY SUBPART F WAS ENACTED: DEVELOPMENTS IN THE LAW BEFORE 1962

I. General

The purpose of this chapter is to place subpart F, the anti-deferral regime for U.S.

controlled foreign corporations,1 in historical context by examining the events leading up to its

introduction in 1962. The chapter notes that subpart F is only one of a number of regimes

enacted to respond to the tax avoidance opportunities provided by a tension between the U.S. tax

rules of worldwide taxation and the separate tax status of corporations. Since the enactment of

the first income tax laws, taxpayers have used corporations to avoid the general U.S. tax rule that

subjects the worldwide income of U.S. persons to current taxation. This chapter describes how

Congress has repeatedly acted to restrict deferral when this tax avoidance has occurred. Finally,

the chapter describes how certain tax avoidance techniques that developed in the late 1950s and

early 1960s (together with the economic considerations discussed in the next chapter) provided

the impetus for the enactment of subpart F.

II. The Underlying Need for Anti-Deferral Rules: Structural Tensions in the U.S. Tax

System

Two fundamental but inconsistent features of the U.S. tax system operate to create tax

avoidance potential and, thus, the potential need for anti-deferral rules. The first feature is the tax

treatment of corporations as separate persons and the second is worldwide taxation. In addition,

a third feature, the treatment of a corporation as domestic or foreign under U.S. tax law, operates

together with these two fundamental features to create the tax benefit potential of the rules

treating corporations as separate taxpayers.2
2

3 See, e.g., Moline Properties v. Commissioner, 319 U.S. 436 (1943).

4 See, e.g., Department of the Treasury, Integration of the Individual and Corporate Tax

Systems, Chapter 4 (1992) (“Treasury Integration Study”) (discussion of the Comprehensive

Business Income Tax Prototype). See also Rosemarie Portner, German Government Embarks on

Program for Safeguarding Employment, Economic Growth, 19 Tax Notes Int’l 794 (Aug. 30,

1999) (explaining proposal of German government to tax corporations and unincorporated

businesses in the same way).

5 See infra Appendix A, part 1, section I.B. (development of the treatment of a corporation as a

separate taxpayer under U.S. tax law).

6 See Act of June 30, 1864, ch. 173, § 117, 13 Stat. 223.

7 See Revenue Act of 1913, ch. 16, § II.A (individuals), § II.G (corporations), 38 Stat. 114.

8 See Michael J. Graetz & Michael M. O’Hear, The “Original Intent” of U.S. International

Taxation, 46 Duke L.J. 1021, 1038 n.67 (Mar. 1997).

9

 Current taxation of worldwide income has become a fundamental feature of the U.S. tax system

(although, as stated earlier, the U.S. tax system also includes elements of territoriality). With

respect to its origins, however, certain commentators have noted that “[t]he decision in 1913 to

tax the worldwide income of taxpayers may simply have followed the earlier decision to tax

worldwide income in the 1909 federal excise tax on corporate income.” Id. at 1042 n.85. See

also Appendix A, note 3 (discussing the evolution of the standard for imposing U.S. taxing

jurisdiction in Civil War era tax laws). 

 The treatment of U.S. corporations as separate taxpayers with tax consequences

independent from those of their owners is consistent with the general business law concept of the

“corporate veil.”3 U.S. tax law has generally respected this concept and, under the U.S. classical

tax system, the earnings of a corporation generally are subject to tax in the first instance at the

level of the corporation. The earnings are not taxed at the level of the shareholders until they are

distributed by the corporation. 

There is no overriding reason for U.S. tax law to adopt the position that a corporation is a

separate taxpayer,4 and, indeed, originally it did not.5 As explained in Appendix A, temporary

income tax laws enacted to raise revenue during the Civil War era required individual taxpayers

that held an ownership interest in both incorporated and unincorporated businesses to include in

income their share of the profits, whether or not distributed.6 However, the Revenue Act of 1913

established separate taxing regimes for individuals and corporations.7 The reasons it did so are

not entirely clear, but early and influential proponents of the income tax strongly believed in

separate business taxation, apparently mainly for administrative reasons.8

The second feature, the current taxation of U.S. citizens, residents and corporations on

their worldwide income, also dates from the introduction of the modern income tax in 1913.9 

However, this worldwide taxing jurisdiction applies only to U.S. persons. Foreign persons,

including foreign corporations, are taxable only on income from sources within the United States,
3

10 See I.R.C. §§ 881 and 882.

11 Since 1945, there have been a number of legislative attempts to end deferral (i.e., in effect, to

treat foreign corporations as passthroughs) of which the most recent was the Foreign Income Tax

Rationalization and Simplification Act of 1992, H.R. 5270, 102d Cong., 2d Sess., introduced in

May 1992 by Representatives Rostenkowski and Gradison. There also has been discussion, from

time-to-time, about moving to a territorial system (i.e., abandoning worldwide taxation). 

12 See Hugh Ault and David Bradford, Taxing International Income: An Analysis of the U.S.

System and its Economic Premises, in Taxation in the Global Economy 27 (Assaf Razin and Joel

Slemrod eds., 1990).

13 The current U.S. system of deferral for nonsubpart F income (generally, active business income)

earned through a foreign corporation (as well as the territorial aspects of the U.S. system, e.g.,

section 114) prevents these advantages from being fully realized at present.

or on income that is effectively connected with the conduct of a trade or business within the

United States.10

These two features, which interact with one another to create opportunities to use

corporations to avoid U.S. tax, create the need for anti-deferral rules. First, the generally

applicable rule of current taxation of worldwide income leads taxpayers to search for deferral

vehicles. Second, the treatment of corporations as taxpayers separate from their owners provides

the structural framework for the deferral of U.S. tax, because a U.S. taxpayer may earn income

through a foreign corporation that will not be subject to U.S. tax until the income is distributed by

the foreign corporation to the U.S. taxpayer.

The tension between these features of U.S. law would disappear if the principle of

worldwide taxation were abandoned, or if corporations were treated as passthrough entities. If

the United States decided no longer to tax foreign income, the form in which business was

conducted abroad would become irrelevant for U.S. tax purposes. Likewise, if the United States

decided to tax corporations owned by U.S. citizens and residents as passthrough entities,

worldwide taxation would be fully implemented.11

Taxing U.S. persons currently on their worldwide income is widely regarded as an

important goal for a number of reasons. First, worldwide taxation furthers equity in the tax

system by treating all income the same. As commentators have observed, “since the source of

income has no bearing on its validity as a measure of ability to pay, the tax burden should be

based on ‘worldwide income’.”12 Second, worldwide taxation avoids a perception of unfairness

that would occur if tax reduction were more readily available to those with the ability to invest

offshore. Third, worldwide taxation also supports the principle of economic efficiency, which is

examined at greater length in Chapter 3. If all income, domestic and foreign, is taxed currently

and at the same rate, there is no tax-motivated reason for foreign rather than domestic

investment.13
4

14 A foreign corporation’s foreign source income that is not effectively connected with a U.S.

trade or business will not be subject to two levels of U.S. tax (although there may be foreign tax

at the corporate level).

15 The merits of integration, which are beyond the scope of this study, are addressed in the

Treasury Integration Study, supra note 4.

16 Revenue Act of 1913, § II.A. Subdivision 2.

17 Revenue Act of 1921, ch. 136, § 220, 42 Stat. 227. Under this provision, in lieu of the

additional corporate level tax, shareholders could agree to be taxed on their share of the net

income of the corporation.

Treating corporations as separate taxpayers, however, is also widely regarded as

important, particularly under the so-called “classical” system of taxation used by the United

States. Under such a system, the two separate levels of taxation (on the corporation and

shareholder) are generally considered to go hand-in-hand with the ability to defer the second level

of taxation until distribution. If this second level of tax were not deferred, businesses could be

deterred from operating in corporate form.14 As a practical matter, in the near term, it is likely

that corporations will continue to be treated as separate taxpayers.15

Accordingly, because of the incompatibility of worldwide taxation and the taxation of a

corporation as a separate entity, the conduct of business in corporate form will continue to require

policy determinations on the appropriate scope of the deferral benefit. 

III. The Need for Restrictions on Deferral: Tax Avoidance and Response

A. 1913 to 1934

1. “Formed or Availed Of” Standard

The Revenue Act of 1913 generally treated a corporation as separate from its

shareholders. However, it created an exception in the case of corporations “created or organized,

formed or fraudulently availed of for the purpose of preventing the imposition of” the graduated

surtax on individuals. U.S. shareholders of such corporations were required to include in income

their share of the corporation’s gains and profits, whether or not distributed.16 This provision, a

predecessor to the accumulated earnings tax and personal holding company provisions, limited the

separate entity treatment of a corporation and its shareholders to prevent tax avoidance.

 The Revenue Act of 192117 replaced this provision requiring current inclusion of the

corporation’s undistributed earnings at the shareholder level with one that imposed an additional

income tax directly on corporations formed or availed of to avoid the surtax.
5

18 Revenue Act of 1932, ch. 209, 47 Stat. 169.

19

 See H.R. Rep. No. 708, 72d Cong., 1st Sess. 20 (1932).

20 Revenue Act of 1934, ch. 277, 84 Stat. 680.

21 H.R. Rep. No. 704, 73d Cong., 2d Sess. 1 (1934) (1934 House Report) .

22

 See, e.g., a letter written in 1937, in which the Chairman of Joint Committee on Tax Evasion

and Avoidance (transmitting his report to Congress) observed: “The problem of the personal

holding company has been one requiring the continued attention of Congress beginning with the

Revenue Act of 1913." Report of the Joint Committee on Tax Evasion and Avoidance of the

Congress of the United States, House Doc. No. 337, 75th Cong., 1st Sess. 7 (1937) (1937 Report

of the Joint Committee on Tax Evasion).

23 1934 House Report, supra note 21, at 11.

2. Transfers of Property to Foreign Corporations (Predecessor to Section

367)

U.S. taxpayers were able to defer U.S. tax not only by earning income through a foreign

corporation but also by transferring appreciated property to a foreign corporation in a tax-free

exchange. If the foreign corporation was formed in a jurisdiction that did not impose a tax on the

sale of capital assets, both U.S. and foreign tax would be avoided on the capital gain. The income

could subsequently be repatriated in a tax-free exchange. To address this potential for tax

avoidance, the Revenue Act of 193218 added section 112(k),19 the predecessor to section 367,

which required gain recognition on a transfer of property to a foreign corporation unless, prior to

the exchange, it was established to the satisfaction of the Commissioner that the exchange was not

in pursuance of a plan having as one of its principal purposes the avoidance of tax. 

B. Personal Holding Companies – 1934

The Revenue Act of 193420 contained provisions intended to prevent tax avoidance or

postponement.21 Although the tax avoidance practices Congress identified in 1934 were not

new,22 the 1921 provisions, which required a showing that the corporation was organized or

availed of for the purpose of preventing the surtax on the shareholders, had proved ineffective in

discouraging tax avoidance. Taxpayers often were able to show some need for the accumulation

of profits in the corporation.23 The 1934 House Report explained one of the specific tax

avoidance schemes with which Congress was particularly concerned:

Perhaps the most prevalent form of tax avoidance practiced by individuals with

large incomes is the scheme of the ‘incorporated pocketbook.’ That is, an

individual forms a corporation and exchanges for its stock his personal holdings in

stock, bonds, or other income-producing property. By this means the income from
- 6 -

24 Id.

25 Revenue Act of 1934, § 351.

26 Revenue Act of 1937, ch. 815, 50 Stat. 813.

27 Tax Evasion and Avoidance, Hearings before the Joint Committee on Tax Evasion and

Avoidance, 75th Cong., 1st Sess. (Part1) 1 (1937) (1937 Hearings).

28 1937 Report of the Joint Committee on Tax Evasion, supra note 22, at 1.

the property pays corporation tax, but no surtax is paid by the individual if the

income is not distributed.24

To address this problem, the Revenue Act of 1934 imposed the additional tax on the

undistributed profits of a corporation that fell within the definition of a “personal holding

company,” without regard to the purposes for which the corporation was formed.25 A personal

holding company was defined as a corporation 80 percent of whose gross income for the taxable

year was derived from certain passive income and more than 50 percent of the stock of which was

owned by not more than 5 individuals. The personal holding company regime was intended to

remove the tax benefit available to an individual from earning passive income through a separate

corporation. 

C. Foreign Personal Holding Companies – 1937

In 1937, Congress again sought to address the proliferation of tax avoidance schemes

involving the use of corporations to lower the rate of tax on shareholders’ income. The Revenue

Act of 193726 contained a series of provisions that were based on recommendations by the Joint

Committee on Tax Evasion and Avoidance. This Joint Committee was formed pursuant to a

resolution of Congress to investigate methods of tax evasion and avoidance detailed in a letter

from President Franklin D. Roosevelt to Congress, dated June 1, 1937.27 In his letter, the

President explained:

We face a challenge to the power of the government to collect, uniformly,

fairly, and without discrimination, taxes based on statutes adopted by Congress.

. . . . 

Methods of escape or intended escape from tax liability are many. . . .

. . . .

. . . All are alike in that they represent a determined effort on the part of

those who use them to dodge the payment of taxes which Congress based on the

ability to pay. All are alike in that failure to pay results in shifting the tax load to

the shoulders of others less able to pay and in mulcting the Treasury of the

Government’s just due.28

In a letter accompanying the President's letter to Congress, Henry Morgenthau, the

Secretary of the Treasury, outlined the tax evasion devices that were leading to serious tax base

erosion. Among those devices was the use of foreign personal holding companies established in
- 7 -

29

 Id. at 1-2.

30 1937 Hearings, supra note 27, at 85.

31 1937 Report of the Joint Committee on Tax Evasion, supra note 22, at 17.

32 Id.

33 Id. at 22.

tax havens to avoid tax.29 During the summer of 1937, Roswell Magill, Under Secretary of the

Treasury, testified before the Joint Committee on Tax Evasion and Avoidance that foreign

personal holding companies were used “as a means of siphoning assets and income out of the

United States into foreign countries where there are no income taxes, or where such taxes are

low.”30

Based upon the evidence presented at these hearings, the Joint Committee on Tax Evasion

and Avoidance determined that legislation directed at the device of the foreign personal holding

company was “necessary to protect the revenue and prevent further use of one of the most glaring

loopholes now existing.”31 The Joint Committee noted that jurisdictional and tax collection

problems prevented Congress from enacting a regime parallel to the personal holding company

regime under which a surtax would be imposed directly on the foreign corporation. Thus, the

Joint Committee proposed a method of taxation under which the undistributed income of the

foreign personal holding company would be included in the gross income of shareholders that

were U.S. citizens or residents whether or not this income was distributed to them.32

As enacted by the Revenue Act of 1937, a foreign personal holding company was defined 

as a foreign corporation that met two requirements: (1) more than 50 percent of its stock was

owned by not more than five individuals who were citizens or residents of the United States; and

(2) at least 60 percent of its gross income was derived from dividends, interest, annuities and

other specified passive income. Pursuant to the recommendation of the Joint Committee, the U.S.

shareholders were required to take into income, on a current basis, their pro rata share of the

undistributed net income of the foreign personal holding company.

Although the Joint Committee generally was satisfied that the foreign personal holding

company provisions would address the tax evasion problems raised at the hearings, they also

recognized that this legislation might not be sufficient to address devices involving foreign

corporations that could arise in the future. In its report, the Joint Committee stated that:

[The Committee] also recognizes the complex character of the problem and the

difficulty of framing a tax law which is proof against all the varied and complicated

devices involving the use of foreign entities which legal ingenuity may evolve in the

future. The committee is therefore of the view that it should continue its study of

this problem and should consider other and additional measures which may be

feasible for preventing the use of spurious foreign entities to thwart the intent and

purposes of the revenue laws.33
- 8 -

34 For example, income earned by U.S. investors from their investments abroad as a fraction of

total U.S. GNP increased by 150 percent between 1946 and 1962 (from about 0.4 percent in 1946

to 1.0 percent in 1962). See Economic Report of the President Transmitted to the Congress

January 1964, together with the Annual Report of the Council of Economic Advisers 207 (1964)

(GNP figures); Economic Report of the President Transmitted to the Congress February 2000,

together with the Annual Report of the Council of Economic Advisers 422 (2000) (foreign

investment figures).

35 The top statutory corporate income tax rate was 24 percent in 1940, 31 percent in 1941, 40

percent from 1942-45, 38 percent from 1946-49, 42 percent in 1950, 51 percent in 1951, 52

percent from 1952-63, 50 percent in 1964, 48 percent from 1965-78, 46 percent from 1979-86,

40 percent in 1987, 34 percent from 1988-93, and 35 percent from 1994-present. 

36 For a recent definition of tax havens, see infra Chapter 2, note 12.

37 See Message from the President of the United States Relative to our Federal Tax System, H.R.

Doc. No. 140, 87th Cong., 1st Sess. 6, 26 (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) 146, 166 (1967) (President’s Tax Message); 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, April 20, 1961, 87th Cong., 1st

Sess. (Vol. I) 303, 343 (1961) (1961 Hearings before the House).

38 1961 Hearings before the House, supra note 37, at 303, 343.

39 Rothenberg & Yoder, 928-2nd Tax Management, Subpart F – Foreign Base Company Income

A-3, n.47 (1997) (citing Wall St. J., March 29, 1962, at 1).

D. Prelude to Subpart F: Tax Haven Operations in the 1950s and Early 1960s

In the early years of the income tax, Congress thus focused its attention on attempts by

individuals to obtain deferral benefits. After the Second World War, however, U.S. corporations

made significant inroads into European and other world markets.34 At the same time, domestic

tax rates, which had risen from before the war, stayed at relatively the same levels.35 The

combination of increased foreign business, an incentive to avoid higher domestic tax rates, and the

rise of classical tax havens,36 led to increasing use of deferral by these U.S. corporations. 

Although U.S. businesses previously had been able to benefit from deferral by operating

through a foreign subsidiary in a low-tax country, their use of tax haven corporations to obtain a

tax advantage for income otherwise earned in a high-tax foreign country was a new and rapidly

growing phenomenon.37 The Kennedy Administration’s figures indicated that over one-third of

the approximately 500 American-owned firms in Switzerland had been formed in 1960.38 Of the

1,200 subsidiaries of U.S. corporations in Nassau, Bahamas, in 1962, less than 50 were operated

by employees of the offshore company. The rest were operated for a fee by trust companies and

attorneys. These corporations generally were sales subsidiaries with no foreign economic

activities, which merely booked a sale and took a percentage of profit.39 
- 9 -

40 See Revenue Act of 1962, Hearings Before the Committee on Finance on H.R.10650, 87th

Cong., 2d Sess. (Part I) 98 (1962) (1962 Hearings before the Senate).

41 President’s Tax Message, supra note 37, at 25.

42 1962 Hearings before the Senate, supra note 40, at 98.

43 President’s Tax Message, supra note 37, at 25.

44 Id.

45 Id.

The Kennedy Administration identified a number of artificial or paper transactions through

which profits could be diverted to a subsidiary organized in a tax haven, most of which required

the tax haven subsidiary to act as a middleman.40 For example, the tax haven subsidiary could

acquire the right to license patents developed by the parent or sister corporation, provide the

services of technicians of a corporate affiliate to customers located in another country, acquire the

distribution rights with respect to products manufactured by its affiliates,41 or reinsure the U.S.

risks of its parent.42 Further, dividend and interest payments could be used to move assets or

earnings from a high-tax country to a tax haven (for example, by dividend or interest payments

from a foreign subsidiary in a high-tax jurisdiction to a related party in a low-tax jurisdiction).43 

To illustrate the tax savings available through the use of tax haven subsidiaries, the

Kennedy Administration gave the example of an American company operating through a German

subsidiary.44 Although the tax rate in Germany was 51 percent, this tax rate could be artificially

lowered by diverting half of the profits, through one of the arrangements cited above, to another

subsidiary located in a “tax haven” country, like Switzerland (for example, by establishing a sales

subsidiary in Switzerland and then allowing that sales subsidiary to earn “profit” by buying from

the related German manufacturer and then selling to unrelated third parties, generally located

outside of Switzerland). Assuming the Swiss tax was sufficiently low, the overall tax rate on the

income could be reduced substantially.45

Thus, 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. The Kennedy Administration’s reasons for opposing this type of income deflection are

discussed in Chapter 2.

E. Foreign Investment Companies – 1962

In 1962, in conjunction with the enactment of subpart F, Congress also enacted certain

provisions to address the tax deferral obtained by small investors in foreign investment companies. 

Domestic regulated investment companies (mutual funds) were taxed on their current earnings

unless the company distributed at least 90% of those earnings (and certain other conditions were

met). Thus, at least one level of current tax was imposed at ordinary income tax rates, either at
- 10 -

46 H.R. Rep. No. 1447, 87th Cong., 2d Sess. 72 (1962).

47 Id. 

48 Id. at 72-73.

49 Taxpayers electing this treatment were required currently to include in income their share of

the capital gains of the foreign corporation whether or not distributed. 

50 I.R.C. § 1246(b).

the corporate or investor level. By contrast, foreign investment companies could avoid U.S. tax if

they had no U.S. source income. U.S. investors in such companies generally were taxed only

when they sold the stock. In that case, the gain from the stock sale was taxed at capital gains

rates rather than ordinary income rates. 

During the 1950s, Congress was aware that foreign investment companies were used for

tax avoidance but determined that by the early 1960s, “the seriousness of the problem [had]

increased substantially.”46 In his 1961 tax message to Congress, President Kennedy noted that:

For some years now we have witnessed substantial outflows of capital from the

United States into investment companies created abroad whose principal

justification lies in the tax benefits which their method of operation produces.47

The Kennedy Administration recommended a regime for foreign investment companies

similar to that which it recommended for U.S.-controlled foreign corporations, i.e., current

inclusion of the income of the foreign corporation at the U.S. shareholders’ level.48 Congress,

however, rejected this approach. Instead, the foreign investment company provisions, sections

1246 and 1247, taxed the U.S. shareholders of the foreign investment company at ordinary

income rates on their share of the post-1962 accumulated earnings and profits when they sold the

stock of the company. To avoid the tax at ordinary income rates on post-1962 accumulated

earnings and profits, the taxpayers could elect to have the foreign corporation distribute annually

90 percent of the taxable income (other than capital gains).49 These provisions applied to a

foreign corporation that was either registered as a management or unit investment trust or that

was primarily engaged in investing or trading in securities, when more than 50 percent of the

stock of the corporation was held by U.S. persons.50 Because these provisions applied without

regard to the ownership percentage of each U.S. person, small investors were subject to this

regime. 

IV. Conclusion

From 1913 to 1962, Congress enacted several provisions that responded to circumstances

caused by tensions between worldwide taxation and separate tax status for corporations because

it determined that this tension produced recurring opportunities for tax avoidance. When

Congress was presented with evidence that taxpayers were using corporations to avoid current

U.S. taxation on their worldwide income, it consistently decided that the principle of worldwide

taxation should be reinforced and it acted to restrict some aspect of deferral. Subpart F, described
- 11 -

more fully in the next chapter, was one such reaction in response to techniques for avoiding

worldwide taxation (in this case, particularly involving tax havens) in the late 1950s and early

1960s.
1

 Appendix A contains a more complete discussion of the policy reasons behind the enactment of

subpart F, as well as a discussion of subsequent amendments to subpart F. To determine the

intent behind subpart F, it is necessary to look both at the reasons put forward by the Kennedy

Administration (particularly as those reasons relate to the Administration’s original tax haven

proposals), and the legislative history contained in Committee Reports and Floor Debates. It has

been argued that the Kennedy Administration’s reasons for proposing subpart F are not relevant

to evaluate the regime because Congress did not enact what the Administration proposed. This

argument is based on the premise that, in its evolution from the 1961 proposal to the 1962 statute,

subpart F was altered to reduce the importance of the policy of capital export neutrality. 

However, the changes to the statute made during its passage through Congress did not, as a

practical matter, greatly weaken the capital export neutrality impact of subpart F. See infra

section II.D of this Chapter 2. Thus, to fully understand the intent behind the statute, it is

appropriate to examine the arguments supporting the Kennedy Administration’s original proposal. 

2

 One additional reason given for the enactment of subpart F in 1962 was the balance of payments

deficit. This was a concern because the balance of payments deficit that existed at the time

(caused by an outbound flow of dollars) placed the fixed exchange rate of the dollar under

pressure. As exchange rates now float, however, this factor is not a concern today, and will not

be considered further.

3

 Message from the President of the United States Relative to our Federal Tax System, H.R. Doc.

No. 140, 87th Cong., 1st Sess. 7 (1961), reprinted in Committee on Ways and Means, 90th Cong.,

1

st Sess., Legislative History of H.R.10650, 87th Congress, The Revenue Act of 1962 (Part 1)

147 (1967) (President’s Tax Message).

- 12 -

CHAPTER 2

THE INTENT OF SUBPART F

I. Introduction

The previous chapter placed subpart F in a broad historical context. This chapter

describes the specific policy reasons for the enactment of subpart F that were debated in depth

when subpart F was enacted in 1962.1 These policy reasons include both general tax policy, such

as preventing tax avoidance (through tax haven techniques that reduced both U.S. and foreign

tax), as well as more specific economic policy, such as promoting economic efficiency.2 

II. Concerns Leading to Enactment of Subpart F

A. Preventing Tax Haven Abuse

In his message to Congress in 1961, President Kennedy had proposed to end “tax deferral

privileges in developed countries” and to eliminate “tax haven deferral privileges” in all countries.3

Subpart F, as enacted, contained the President’s proposal to eliminate tax haven deferral because

Congress agreed that tax havens provided an inappropriate tax incentive for U.S. businesses to
- 13 -

4 See 108 Cong. Rec. 17752 (1962) (Remarks of Senator Kerr) (“[T]his bill is beneficial in that it

will stop the drain on our investment which is artificially induced by the low tax rates it is possible

to obtain through the use of tax haven subsidiaries.”).

5 See the President’s Tax Message, supra note 3, at 6. 

6

Id. at 24-25.

7

Id. at 6.

8

Id.

9

Id. This portion of the President’s Tax Message was quoted in both the House and Senate

Reports. See H.R. Rep. No.1447, 87th Cong. 2d Sess. 57 (1962) (1962 House Report); S. Rep.

No. 1881, 87th Cong., 2d Sess.78-79 (1962) (1962 Senate Report).

move capital abroad and that their use should be curtailed.4 It did not, however, include the

proposal to eliminate tax deferral in developed countries.

Tax haven deferral could be distinguished from tax deferral in developed countries

because this second type of tax deferral could have been obtained by taxpayers that were

conducting business operations through non-tax motivated structures and transactions.5 Such

transactions generally occurred in high-tax jurisdictions with tax rates similar to those in the

United States.6 Commenting on his proposal to end tax deferral in developed countries, the

President stressed that:

 

Many American investors properly made use of this deferral in the conduct of their

foreign investment. Though changing conditions now make continuance of the

privilege undesirable, such change of policy implies no criticism of the investors

who utilize this privilege.7

Tax haven deferral, however, was deferral that was maintained for tax avoidance

purposes. Referring to tax haven deferral in his tax message, President Kennedy noted that, “[t]he

undesirability of continuing deferral is underscored where deferral has served as a shelter for tax

escape through the unjustifiable use of tax havens such as Switzerland.”8

Significantly, tax haven deferral included deferral used to avoid either U.S. or foreign

taxes. The type of transactions that the President’s proposal and Committee Reports identified as

giving rise to tax haven deferral were “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 both at home and abroad.”9 The Senate

Finance Committee reported that: 

In the case of foreign income, your committee has been primarily concerned with

ending tax haven abuses; namely, devices to avoid either the United States or
- 14 -

10 1962 Senate Report, supra note 9, at 2. See also 108 Cong. Rec. 17750-51 (1962) (Senator

Kerr describing tax haven abuses as “attempts to avoid U.S. or foreign taxes by the use of

artificial corporate devices or selection of countries for incorporation for tax rather than business

purposes.”).

11 President’s Tax Message, supra note 3, at 7. See also 1962 House Report, supra note 9, at 57;

1962 Senate Report, supra note 9, at 79 (quoting from President’s Tax Message).

12 See President’s Tax Message, supra note 3, at 6. This lack of specificity might be contrasted

with the Organization for Economic Cooperation and Development’s (OECD’s) current project

on harmful tax competition. The OECD specifies four major features of 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. 

See Organization for Economic Cooperation and Development, Harmful Tax Competition: An

Emerging Global Issue, at 22-25 (1998) (“OECD HTC Report”). In general, to be classified as a

tax haven, a country must meet the no or nominal tax criterion, and one of the other three criteria. 

The OECD HTC Report also discusses harmful preferential tax regimes that can exist in countries

that would not be classified as tax havens. The similarity between the characteristics of a tax

haven and a harmful preferential tax regime highlights the fact that a modern diversified

economy’s preferential regime can be almost indistinguishable from a tax haven. As such, the

undesirable effects of tax havens may be replicated by countries that are not tax havens but that

adopt harmful preferential tax regimes.

13 References in this study to U.S.-owned foreign corporations are references to entities that

would be controlled foreign corporations under subpart F.

foreign taxes which could be expected to be imposed under normal business

operating conditions.10

 

Although both the Administration and Congress described these transactions as involving

“tax havens,” neither proposed to deal with the problem by targeting particular countries. Rather,

tax haven deferral was identified by the way in which the deferred income was earned. President

Kennedy’s proposal, and the final subpart F legislation, identify “forms of activities, such as

trading, licensing, insurance, and others, that typically seek out tax haven methods of operation.”11

The Kennedy Administration did not attempt to define the term “tax haven,” other than by

examples such as Switzerland.12

B. Taxing Passive Income Currently

Subpart F also was intended to ensure that all passive income earned by U.S.-owned

foreign corporations13 would be subject to current U.S. tax, whether or not such income was

earned through tax haven operations.

Both the House and Senate Reports stated the reasons for taxing passive income as

follows:
- 15 -

14 1962 House Report, supra note 9, at 62; 1962 Senate Report, supra note 9, at 83..

15 President’s Tax Message, supra note 3, at 6, 33.

16 Revenue Act of 1962, Hearings before the Committee on Finance on H.R. 10650, 87th Cong.,

2d Sess. (Part 1) 103 (1962 Hearings before the Senate).

17 President’s Tax Message, supra note 3, at 1, 6.

18 1962 Hearings before the Senate, supra note 16, Exhibit III, at 177.

Your committee while recognizing the need to maintain active American business

operations abroad on an equal competitive footing with other operating businesses

in the same foreign countries, nevertheless sees no need to maintain deferral of

U.S. tax where the investments are portfolio types of investments, or where the

company is merely passively receiving investment income. In such cases there is no

competitive problem justifying postponement of tax until the income is

repatriated.14

C. Promoting Equity Among Taxpayers

Another fundamental objective of subpart F was to promote equity among U.S. taxpayers. 

In his tax message, President Kennedy stressed the importance of equity to a sound federal tax

system. He noted that deferral undermined equity among U.S. taxpayers because those that

operated abroad, and thus obtained the benefits of deferral, gained a significant tax advantage

over those that operated their businesses exclusively in the United States.15 The Administration

maintained that deferral was akin to a special subsidy to U.S. taxpayers that were sophisticated

enough to conduct business abroad.16 Thus, the President argued that his Administration’s

proposal to end deferral was necessary to achieve greater equity.17

The Administration took the position that to treat taxpayers equitably, the tax policy of the

United States must be based on the concept of tax neutrality (or efficiency). This position was

explained in a report prepared by the Treasury and submitted to the Senate in conjunction with

the testimony of Treasury Secretary Douglas Dillon at April 1962 hearings before the Senate

Finance Committee:

One of the most fundamental of the guiding principles in American income taxation

is that there should be equality in tax treatment of similar groups of taxpayers. 

Applied to corporations, this principle must be interpreted to mean that the income

of any branch or subsidiary of an American corporation operating overseas should

as far as possible be subject to the same corporate income tax rates as the income

of any branch or subsidiary operating at home.18

In a statement accompanying the President’s Tax Message, Secretary Dillon noted that:

There exists, in addition, an important issue of equity which has a significant

bearing on domestic employment and production . . . . With the present deferral
- 16 -

19 President’s Tax Message, supra note 3, at 29-30.

20 See id. at 6. 

21 1962 Hearings before the Senate, supra note 16, Exhibit III, at 173. The Kennedy

Administration recognized that, as long as tax rates differ between countries, two alternative types

of tax neutrality were possible with respect to the foreign income of U.S. companies. Under the

privilege, an American firm contemplating a new investment and finding cost and

market conditions comparable at home and abroad is impelled toward the

investment opportunity overseas. This is so because it would thereafter be able to

finance expansion on the basis of an interest-free loan from the U.S. Treasury,

repayable at the option of the borrower. 

. . . . 

. . . I believe that reasons of tax equity as well as reasons of economic policy

clearly dictate that in the case of investment in other industrialized countries we

should give priority to tax neutrality in the choice between investment here and

investment abroad.19

These equity arguments applied with even more force to U.S.-owned foreign corporations

engaging in tax haven activities. In that case, such entities were not engaging in economic activity

that was fortuitously subject to a lower rate of foreign tax. Rather, they were engaging in taxmotivated activity and gaining benefits not available to domestic corporations.20

D. Promoting Economic Efficiency

One of the Kennedy Administration’s principal economic reasons for seeking to end

deferral entirely was to encourage efficiency based on the concept of tax neutrality. This concept

is closely related to the concept of equity discussed in the previous section. Indeed, in certain

cases, the two terms appear to be used interchangeably. Nevertheless, there is some difference

between the two.

The Treasury view on the role of tax neutrality in promoting economic efficiency was

summed up in a paper presented in conjunction with hearings before the Senate Finance

Committee in April 1962:

Neutrality is a fundamental principle of taxation in the United States. The purpose

of neutrality is to promote equity and the most efficient possible allocation of

existing resources. Ideally, corporate tax rates should everywhere be the same,

assuming roughly equivalent government services. We cannot control foreign tax

rates and the fact that they may contribute to inequities. But we can prevent the

American tax structure from contributing to the artificial diversion of funds to lowtax areas, by taxing the income of our overseas subsidiaries at the same rates as are

applicable to income earned at home. The burden of proof for not following the

general principle of tax neutrality should be on those who wish to continue a

departure from that neutrality.21
- 17 -

first type, capital export neutrality, the foreign income would be taxed at domestic rates, with a

credit for foreign taxes paid. Because the domestic company would pay at least the domestic rate

whether it invested at home or abroad, tax would be eliminated as an investment factor. Under

the second type, capital import neutrality, the foreign income of the domestic company would be

taxed only at foreign rates, thus allowing the domestic company to operate under the same tax

burden as its foreign competitors. For reasons of tax equity and economic policy, the Kennedy

Administration recommended giving priority to capital export neutrality. President’s Tax

Message, supra note 3, at 30.

22 1962 Hearings before the Senate, supra note 16, at 98.

23 The House version of the bill, which itself fell short of what the Administration had requested,

was subsequently cut back by the Senate. However, both the House and Senate measures were

designed to end deferral on income from tax haven operations. See 1962 Senate Report, supra

note 9, at 79.

24 Vol. 108 Cong. Rec. 5320 (1962).

The Secretary of the Treasury, Douglas Dillon, pointed out that the adverse effect on

economic efficiency from the use of tax haven techniques was very significant, since use of those

techniques produced some of the greatest disparities in tax rates:

The existence of these tax-haven operations constitutes a most serious breach in

our principle of tax neutrality, one which is growing by leaps and bounds every

year.22

In enacting subpart F, Congress agreed to a targeted approach, developed with the

assistance of the Treasury Department, that restricted deferral to discourage certain tax avoidance

techniques designed to lower both U.S. and foreign tax. The Committee reports explicitly

endorse the goal of preventing deflection of income to low- or no-tax regimes. Moreover, a

number of the floor speeches in both houses implicitly endorse the efficiency argument in

explaining what the narrower tax haven provisions were intended to achieve. For example, in the

House,23 Representative Ullman, a member of the Ways and Means Committee, explained that:

[T]he foreign income provision of the bill are aimed at . . . the goal of equal tax

treatment of income earned abroad and income earned here in the United States. 

This will be accomplished by eliminating the use of foreign tax havens and closing

other loopholes which allow income earned abroad to escape taxation. 

. . . .

These tax-haven companies are sometimes used as a device through which

to sell -- on paper at least -- products manufactured in this country. This creates

the opportunity for direct escape of U.S. taxes. Other tax-haven companies

market goods produced by U.S.-owned subsidiaries in foreign countries whose

taxes are roughly comparable to our own. In that case the availability of the tax

haven serves directly to lure U.S. manufacturing operations overseas.24
- 18 -

25 Vol. 108 Cong. Rec. 17752 (1962) (remarks of Senator Kerr).

26 See supra note 21 (discussing and comparing capital import neutrality and capital export

neutrality).

27 This point is illustrated by the following exchange between Representative John Byrnes and

Secretary Dillon during the 1961 House hearings on the President’s proposal:

MR. BYRNES. What if we decided to just consider the tax haven problem then

and forget about the rest. Would that take care of the situation?

SECRETARY DILLON. It would take care of the greater part of the problem if

you could devise a series of laws that would cover all possibilities. With the

situation in Europe, we find that the possibilities are pretty well myriad and we

think you would have to develop a very complex body of law which would

probably have to be changed rather frequently in light of experience to keep up

with the legal ingenuity of those who wish to make use of these tax havens.

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, April 20, 1961, 87th Cong., 1st Sess. (Vol. 1) 345 (1961) (1961 Hearings before the

House).

28 President’s Tax Message, supra note 3, at 6.

Similarly, in the Senate, Senator Kerr, the floor manager for the bill, explained:

[T]he President asked us to impose U.S. tax on the profits of all foreign

subsidiaries of U.S. companies. Neither we nor the other body felt that this was

necessary in order to achieve the President’s major purposes. I am convinced that

under this bill we do accomplish those major purposes . . . .

. . . .

. . . .[T]his bill is beneficial in that it will stop the drain on our investment

which is artificially induced by the low tax rates it is possible to obtain through the

use of tax haven subsidiaries.25

The legislative history suggests that the Kennedy Administration believed that the

compromise statute did not, to any significant extent, sacrifice its concerns about capital export

neutrality26 as compared with the Kennedy Administration’s original proposal, but, instead, that it

sacrificed the original proposal’s relative simplicity.27 Capital export neutrality is a concern only

when taxpayers have an incentive to move income offshore because they can obtain a lower rate

of tax on the income. The Kennedy Administration determined that this could happen in two

situations. The first situation arose when taxpayers were conducting business operations in a

foreign jurisdiction with tax rates that were lower than those in the United States.28 The second

situation arose when taxpayers were conducting business operations in a foreign jurisdiction with

tax rates that were comparable to or greater than those in the United States but were able to
- 19 -

29 Id.

30 Id. at 24 (comparing the tax rates of Belgium, Denmark, France, Germany, Italy, the

Netherlands, Sweden, and the United Kingdom and noting that “tax deferral with respect to

profits earned in these countries does not . . . have any material effect on U.S.-owned firms.”). 

See also 1961 Hearings before the House, supra note 27, at 322 (statements of Secretary Dillon

indicating that the Administration mainly intended to address tax haven deferral because it was

primarily this type of deferral that allowed taxpayers to take advantage of significant disparities

between the foreign and U.S. tax rate).

31 See President’s Tax Message, supra note 3, at 7.

32 See Vol.108 Cong. Rec. 17751 (1962) (remarks of Senator Kerr) (“[T]he committee has

carefully screened out of the House provisions those features which would have interfered with

legitimate foreign operations of American controlled corporations.”). Thus, for example, the

Senate version of the bill carved out active rents and royalties received from unrelated persons

and replaced the provision in the House bill requiring current inclusion of earnings not reinvested

in the foreign corporation’s business with a narrower provision that applied to earnings of the

foreign corporation invested in U.S. property.

lower their foreign tax burden artificially through an arrangement involving a tax haven

corporation.29 Subpart F was designed to address the second situation. The Kennedy

Administration did not consider the first situation to be a concern because, in 1962, tax rates in

most developed countries that were not used for tax haven operations were substantially

comparable to the U.S. tax rate, 30 and the Kennedy Administration specifically intended to

encourage investment in lesser developed countries that were not used for tax haven operations.31

 

E. Competitiveness of U.S.-Owned Foreign Corporations

Another issue relevant to the enactment of subpart F was the effect of anti-deferral rules

on the competitiveness of U.S. multinationals. Congress accepted the arguments made during the

hearings that the President’s proposal to end deferral completely would discourage U.S.

businesses from investing abroad, which investment was necessary to stimulate U.S. exports, and

would place U.S.-owned businesses at a competitive disadvantage with foreign-owned businesses. 

Although both the House and the Senate favored a regime that focused on tax haven operations,

the Senate carved out what it perceived to be legitimate foreign operations to respond to concerns

about U.S. competitiveness abroad.32 Thus, the legislation as enacted reflects an attempt to target

arrangements that created tax incentives for capital to move outside the United States while being

narrow in application to avoid unduly harming the competitiveness of U.S. business in the foreign

market.

The Committee reports do not address the competitiveness argument in particular detail. 

Most often, the absence of competitiveness concerns are cited as a reason for restricting deferral

in a particular case. Thus, for example, explaining the provision taxing passive income, both the
- 20 -

33 See supra portions of 1962 House and Senate Reports quoted at the text accompanying note

14.

34 Vol.108 Cong. Rec 17751 (1962) (remarks of Senator Kerr).

35 Vol.108 Cong. Rec.17752 (1962) (remarks of Senator Kerr).

36 See, e.g., a floor debate between Senators Kerr and Javits. Senator Javits had proposed an

amendment that would have treated the EEC as “one country” for purposes of some of the related

party exceptions. Senator Kerr opposed it on the grounds that Switzerland might at some date

join the EEC, which would then allow U.S. multinationals to operate tax free in the EEC while

retaining U.S. deferral privileges. Thus, if Switzerland, Monaco or Liechtenstein joined the EEC:

[I]f a corporation were a resident of Switzerland or Monaco or Liechtenstein, it

would have the privilege under the amendment of selling anything manufactured

anywhere in the world in the European Economic Union, make its profit, and keep

the profit from taxation under our laws or under the impending bill. . . . 

. . . .

 The . . . amendment would create an irresistible magnet for exportation of

American capital, American business and American jobs, because insofar as the

European Economic Union is concerned, their operations would be practically free

so far as they continued to invest money. 

Vol. 108 Cong. Rec.18596 (1962). Senator McCarthy, in support of Senator Javits, explicitly

made the argument that using a Swiss sales corporation was justified to reduce high European

taxes, and, in so doing, would increase U.S. tax when the income was repatriated. See Vol. 108

House and the Senate Reports33 state that, although generally deferral was necessary to maintain

the competitiveness of active U.S. business, earning passive income abroad did not give rise to the

same concerns and, therefore, did not give rise to a need for deferral.

Senator Kerr also emphasized that, while the purpose of the bill was to remove artificial

incentives to invest abroad through the use of tax haven devices, the legislation was not intended

to affect legitimate overseas operations.34

There is nothing in the bill that interferes with investment abroad which is

made for sound economic reasons. . . . 

. . . .

. . . . [T]his bill does not interfere with sound business investments abroad

which do not make use of tax haven subsidiaries.35

However, the legislative history of subpart F suggests that, in 1962, Congress did not

intend to endorse the view that U.S.-owned foreign corporations should be able to reduce their

foreign tax by any means available, such as shifting income from high-tax to low-tax foreign

jurisdictions. This point is demonstrated by its decision to enact the anti-tax haven provisions

(including the related party rules).36 Congress reached its decision to enact the anti-tax haven
- 21 -

Cong. Rec. 18597 (1962). Senator Kerr, on the other hand, argued that the amendment provided

a strong incentive to invest overseas. The amendment was defeated. See Vol. 108 Cong. Rec.

18598 (1962). 

37 The testimony concerning the foreign provisions of the President’s original proposal are

contained in 1961 Hearings before the House, supra note 27, Vol. IV. See, id. at 2939 for a

specific example (statement of H.S. Geneen, President, International Telephone and Telegraph

Corporation).

38 Although Congress did include provisions within subpart F to promote investment in less

developed countries, these provisions were not intended to address competitiveness concerns but

to encourage development in these countries. See President’s Tax Message, supra note 3, at 7.

39 See, e.g., second paragraph of floor speech of Representative Ullman, quoted supra (text

accompanying note 24), and Separate Views of the Republicans on H.R. 10650, H.R. Rep. No.

1447, 87th Cong. 2d Sess. B24-25 (1962) (Separate Views of Republicans). See also President’s

Tax Message, supra note 3, at 24-25.

40 In only two cases, however, was the tax disparity greater than 12 percentage points: Belgium

and Italy. In Germany, Canada and France it was within 2 percentage points. The U.K. had a

higher corporate rate. 1962 Hearings before the Senate, supra note 16, Exhibit III, Table 2, at

179.

41 It was also influenced by testimony from business leaders that many major trading partners

raised revenue by relying heavily on turnover taxes and other taxes that were not creditable in the

United States. See, e.g., 1961 Hearings before the House, supra note 27, Vol. IV, at 2735-36,

2817, 2850, 3019-20. Therefore, even with a slightly lower corporate rate, without deferral U.S.-

owned foreign businesses might bear a heavier tax burden abroad than comparable U.S.

businesses.

provisions (including the related party rules) despite extensive testimony from the business

community about how foreign competitors were able to lower their taxes in similar ways.37 

Further, the legislative history of subpart F indicates that Congress did not believe

competitiveness concerns compelled it to permit deferral with respect to CFC operations in lowtax jurisdictions.38 This legislative history indicates that Congress (and the Administration)

assumed that U.S.-owned foreign corporations were conducting active businesses only in

countries in which the tax rate was equivalent to that of the United States.39 Congress was aware

that in certain cases the United States’ major trading partners had corporate tax rates slightly

lower than those of the United States.40 However, to avoid discouraging U.S. investment in

active foreign business, Congress was prepared to allow some tax disparity and to forego the

minimal marginal tax it would have collected if deferral had been ended.41 Congress did not,

however, endorse significant tax disparity, except in the specific case of free world developing

countries.

A review of the legislative history of subpart F indicates that Congress did not want to

encourage the earning of low-tax income, apart from the specific circumstances set out in the
- 22 -

42 That Congress viewed competitiveness in this narrower way is implicitly supported by the

reaction of the bill’s opponents. Business leaders complained that the anti-tax haven provisions

would have the effect of stifling foreign investment because it was those tax avoidance techniques

that made U.S. corporations competitive since foreign-owned companies could use these tax

avoidance techniques. See, e.g., 1961 Hearings before the House, supra note 27, Vol. IV, at

2697, 2856, 2916. This view was rejected by the Congress as a whole. 

legislation. Thus, in 1962, Congress understood competitiveness to mean allowing U.S. persons

to continue to invest in other developed countries in which they could profit by exploiting

American know-how and ingenuity. Certainly, Congress decided that currently reporting income

and paying U.S. tax might place the U.S.-owned foreign corporations at some disadvantage. But

Congress does not appear to have understood competitiveness to mean allowing U.S.-owned

foreign corporations in those countries to reduce their foreign tax by shifting income to a low-tax

jurisdiction.42 

III. Conclusions on Intent of Subpart F

Preventing tax haven abuse, taxing passive income currently, promoting equity, promoting

economic efficiency, and avoiding undue harm to the competitiveness of U.S. multinationals all

played important roles in forming subpart F. Although Congress acknowledged the importance of

equity and economic efficiency, as these goals were articulated by the Kennedy Administration,

Congress was concerned that ending deferral completely would place U.S. companies at a

competitive disadvantage in their foreign operations. Concerns about competitiveness thus

prevented Congress from adopting the original 1961 Kennedy Administration proposal, which

would have implemented capital export neutrality more fully by ending deferral on all income. 

Congress also determined, however, that it did not want to permit U.S. multinationals to

use tax haven devices to create a significant tax disparity between foreign and domestic effective

tax rates. Thus, Congress sought to end deferral for income obtained through such devices,

without regard to whether those devices were used to avoid foreign tax or U.S. tax. In particular,

it intended to target devices that created artificial inducements to invest abroad by shifting income

from high-tax jurisdictions (either the United States or high-tax foreign countries) to low-tax

jurisdictions. In addition, because Congress concluded that subjecting passive foreign income to

current tax would not jeopardize the competitive position of U.S. multinationals, Congress also

ended deferral on passive foreign income. 

The relative importance that Congress gave to equity, efficiency and competitiveness is

unclear, however, because Congress may not have considered these criteria to have been in

conflict. Congress heard testimony from the Administration that tax haven devices were the

primary cause of significant disparities between foreign and domestic tax rates, and that

addressing the “tax haven problem” would address most of the Administration’s concerns about

equity and efficiency (albeit at the price of more complexity than the original Administration

proposal). Congress may thus have believed that by ending deferral only in the tax haven context

and with respect to passive income, it addressed the goals of equity and efficiency without unduly

harming competitiveness. 
1

 Although the Kennedy Administration referred to this income shifting as “tax haven deferral,”

the provisions of subpart F also target attempts to shift income to preferential tax regimes in

countries that are not generally considered tax havens. Accordingly, references in this study to

“tax haven deferral” should be understood to include income shifting to countries with preferential

tax regimes. 

2

 For a definition of the term “foreign-to-foreign related party rules,” see infra section IV.A. 

- 23 -

CHAPTER 3

ECONOMIC WELFARE AND THE TAXATION OF FOREIGN INCOME

I. Introduction and Overview

Chapters 1 and 2 described the history of subpart F and explained why it was enacted. A

principal goal of subpart F was to prevent U.S. companies from avoiding tax by shifting income

away from the United States or from foreign non-tax haven countries to foreign tax havens.1 This

chapter now considers whether subpart F improves global and U.S. economic welfare. To do

this, the chapter first looks at the broad question of how to tax foreign investment to maximize

economic welfare. It then looks at the narrower question of how the subpart F foreign-to-foreign

related party rules2 affect global and U.S. economic welfare and U.S. tax revenue.

With respect to the broader question of how to tax foreign investment to achieve

economic policy goals, a careful review of the literature reveals that capital export neutrality is

probably the best policy when the goal is to provide the greatest global economic output. Capital

export neutrality requires structuring taxes so that they are neutral and do not cause investors to

favor either domestic or foreign investment. Put another way, if taxes were structured based on

capital export neutrality, investors would make their investment decisions as if there were no

taxes. Similarly, with respect to national economic welfare, a careful review of the literature

provides no convincing basis for rejecting the conclusions of the basic economic analysis that a

country should tax income from outward foreign investment at a rate that is at least as high as the

tax rate imposed on income from domestic investment. 

Regarding the narrower question of how the subpart F foreign-to-foreign related party

rules affect global economic welfare, this chapter concludes that the subpart F foreign-to-foreign

related party rules do not necessarily improve global economic welfare even though these rules

bring tax rates on some foreign investment closer to the rate on similar U.S. domestic investment. 

The effects of the rules may be uneven, causing tax rates on investments in different foreign

countries to diverge and thereby pushing investment from high-tax to low-tax foreign countries. 

Thus, it is not clear whether, on balance, these rules make taxes more neutral with respect to the

effect on investors’ choices between investments in different countries. 

This chapter further concludes that the effect of the subpart F foreign-to foreign related

party rules on U.S. economic welfare is also uncertain. In the short run, if these rules were

tightened to prevent them from being avoided, real investment may be unaffected, but U.S.
- 24 -

companies may lose more revenue from the increased tax on foreign income than is gained in tax

revenue by the U.S. Government. In the long run, however, tightening the rules may cause U.S.

companies to choose U.S. investment rather than foreign investment, which, depending upon the

extent of this substitution, could produce a net national gain in economic welfare coming both

from greater productivity of U.S. labor and increased U.S. tax collections.

Regarding the question of how the subpart F foreign-to-foreign related party rules affect

U.S. tax revenue, the chapter concludes that, in general, limiting deferral on income from foreignto-foreign related party transactions would increase U.S. tax revenue by reducing the incentive for

capital to leave the United States. Conversely, allowing taxpayers to defer income from foreignto-foreign related party transactions would likely encourage capital to leave the United States in

favor of lower-taxed foreign investment opportunities, reducing the U.S. tax base and U.S. tax

revenue. 

II. A Note on Economic Methodology

A brief description of economic methodology might be helpful to understand the structure

of this chapter. One of the primary objectives of economics is to understand how markets or

other economic systems work and the effects of making changes in those systems. A principal

way to accomplish this objective is to construct a “model” of the market or economic system in

question. 

In this case, the term “model” refers to a precisely defined logical construct, often

expressed in mathematical and/or graphical form. To make a model manageable, the economist 

attempts to identify and represent only the most essential aspects of the economic system,

sometimes in quite simplified terms. The model is then used to examine the effects of policy

changes. To the extent that the model accurately characterizes the important elements of the real

economic system under study, the results are helpful in understanding the operation of the

economic system and the effects of potential policy options. This process is helpful because

frequently the interactions between different components of a model are complex and cannot be

understood without the use of formal means of reasoning, such as mathematical or graphical

systems.

The development of economic understanding in a particular area generally proceeds as

follows. One or two authors first publish articles which set out rather simple models of the

markets or economic systems at issue and explore results within those models. Further progress

is made as other economists (sometimes joined by the original authors in the field) publish articles

that examine the effects of changing one or more of the key simplifying assumptions in the

original model to provide a more accurate representation of the real world. These authors explore

results within their revised models, sometimes confirming the results of the original authors, other

times finding that the different assumptions yield different outcomes in some important dimension. 

Such results sometimes generate debates about which assumptions are most relevant or realistic

and may give rise to further modeling and/or empirical research to attempt to ascertain which

assumptions most closely portray reality.
- 25 -

3

 To measure economic welfare, economists attempt to place an actual dollar value on the

economic well being of individuals. To do this, they consider a number of things besides just the

dollar value of output. For example, if policies are put in place to encourage greater output by

encouraging greater work effort or greater saving, the gain in economic welfare would be smaller

than the increase in output, because the greater saving or work effort would require some

sacrifice by individuals. Global economic welfare refers to the economic well being of all

individuals at home and abroad, whereas U.S. economic welfare refers to the economic well being

of U.S. residents. 

This process goes on continuously. In areas of economic inquiry that are relatively new,

the models may be relatively embryonic, and our understanding of how the markets or economic

systems work may be rudimentary. Other markets or economic systems have been examined

intensively for decades, and a great deal is known about them. Even in these cases, however, new

insights are possible. Indeed, sometimes major changes in our understanding of markets or

policies are brought about through this process. Additionally, changes in the economy may

require revisions in even relatively mature economic models.

Section III of this chapter describes the development of the understanding of how tax

policy, as it applies to foreign investment, affects economic welfare. The purpose of section III is

to review what is known in general about the way to tax income from foreign direct investment to

maximize economic welfare and to provide the conceptual framework for the economic analysis

of the subpart F rules. The economic literature on this topic is fairly extensive and well

developed. The articles by Peggy Musgrave were the seminal contributions, presenting the

original economic models. The subsequent articles cited in this section explored the consequences

of changing aspects of the Musgrave model, sometimes reaching different conclusions about what

might constitute the best tax policy. The discussion evaluates these efforts and the state of

knowledge in this area. It is found that Musgrave’s results have stood the test of time and still

appear to provide the best guide for determining appropriate tax policy. Section IV contains the

economic analysis of the subpart F foreign-to-foreign related party rules. Section V contains

conclusions about the optimal taxation of foreign investment income and about the economic

effect of the subpart F foreign-to-foreign related party rules. 

III. Optimal Taxation of International Investment Income

A. Introduction

This section begins by reviewing studies that seek to determine the tax policies that

maximize global economic welfare. It then reviews studies that seek to determine the tax policies

that maximize U.S. economic welfare, possibly at a cost to other nations.3 Policies that maximize

global welfare are considered first, because maximizing global welfare is probably the best way to

maximize U.S. economic welfare. All nations are likely to do best over the long term by

establishing international tax policies that encourage private investors to make the best use of

resources. Thus, it is probably not advisable to establish policies that promote national short-term

interests at the expense of global economic welfare, because establishing such policies is likely to

encourage other nations to seek to advance their own short-term national interests at the expense
- 26 -

4

 See, e.g., Peggy Brewer Richman, Taxation of Foreign Investment Income, An Economic

Analysis (1963); Peggy B. Musgrave, United States Taxation of Foreign Investment Income, Ch.

7 (1969).

5

 Gary C. Hufbauer, American Enterprise Institute, Hoover Institution Policy Study No.16 A

Guide to Law and Policy, U.S. Taxation of American Business Abroad (1975).

6

 A later section explores how the analysis changes when there is more than one way to finance

investment (for example, through equity or debt) and when there is more than one type of output.

7

 Other economists who derived the best policies within this standard model came to the same

conclusions. See, e.g., Richard E. Caves, Multinational Enterprises and Economic Analysis 229-

31 (1982); Joel Slemrod, Effect of Taxation With International Capital Mobility, in Uneasy

Compromise: Problems of a Hybrid Income-Consumption Tax 115-48 (1988). 

of global economic welfare. The need for a broad global view is particularly evident today in

open economies, such as the United States, which have both substantial inbound and outbound

investment. Further, the United States is often looked upon to provide global leadership in the

policies it adopts.

It is also necessary, however, to determine how taxes on direct foreign investment income

affect U.S. economic welfare. Although maximizing global economic welfare is probably the best

policy for both capital-exporting and capital-importing countries, there may be more than one tax

structure that achieves this goal, and individual countries will not necessarily be indifferent on the

question of which structure should be adopted. For example, taxes on income from foreign direct

investment can be structured so that for the same level of global output and total tax revenue, a

capital-exporting country receives a bigger share or a smaller share of the revenue compared to a

capital-importing country. The international distribution of tax revenue is thus not a matter of

indifference to individual countries. Indeed, it is an important consideration when countries

design their rules for taxing foreign investment. Therefore, this section also examines how taxes

on foreign investment affect U.S. economic welfare. 

B. Promoting Global Economic Welfare

1. The “Standard Analysis”

Studies by Peggy Musgrave4 and Gary Hufbauer5 were among the first to carefully

examine ways to structure international tax policies to maximize global economic welfare. They

each used a basic model in which they assumed that there is only one form of capital investment

used to produce only one type of output,6 that capital is freely mobile between countries, that the

volume of saving is not affected by changes in the rate of return, that each country has its own tax

rate that it applies to all income from investment earned within its borders, and that capitalimporting countries do not change their tax policies in response to tax policy changes in the

capital-exporting country. Analyzing this economic model, both Musgrave and Hufbauer found

that a tax policy maximizes global economic welfare when it is consistent with the principle of

capital export neutrality.7 According to this principle, countries should structure their taxes so
- 27 -

8

 Throughout this section, an investor’s rate of return generally refers to the investor’s riskadjusted rate of return. See, infra, note 10 for further explanation of this concept. 

9

 As discussed in a later section, the conclusions from this analysis may also be relevant for a

country that simultaneously imports and exports capital when there is more than one way to

finance investment. 

10 Of course, this does not mean that the tax-free allocation of capital would yield the highest

actual return on the capital. Instead, it is the investor’s expected returns, adjusted for risk, that

are maximized. Rates of return must be adjusted for risk because the income an investment

actually will generate is not known when the investment is undertaken. Investors generally are

averse to risk, so they generally require a higher expected after-tax rate of return on more risky

investment alternatives. The investor’s satisfaction is thus greatest when the risk-adjusted

expected rates of return are the same among investment alternatives. 

11 This condition would be met, for example, if the capital exporting country taxed foreign source

investment income as it accrued, but allowed a full foreign tax credit (i.e., a credit that was not

limited based on the rate of tax imposed in the capital exporting country) for any investment

income tax paid abroad.

 It is sometimes argued that because capital-exporting countries limit the foreign tax credit on

income from direct foreign investment to the tentative local tax due on the income, true capitalexport neutrality cannot be achieved, so the attempt should be abandoned entirely. However, the

fact that required pretax rates of return may be very high in high-tax capital-importing countries

(resulting in too little investment in these countries) appears to offer little justification for

abandoning capital export neutrality and favoring investment in lower tax countries, where pretax

rates of return presumably are low (resulting in too much investment in these countries).

that investors in a capital-exporting country are indifferent, after taxes, between foreign and

domestic investments that are expected to produce the same pretax rates of return.8 In other

words, international tax policies should be structured so that capital is allocated in the way it

would be without taxes.9

The logic of their analysis (referred to hereafter as the “standard analysis”) is simple and

compelling. First, consider a world without taxes. A fixed stock of privately-owned capital will

be most productive if it is allocated in free, competitive markets by the owners, each

independently seeking to gain the highest return from investment.10 All investors will be satisfied

by their choices only when they cannot expect to increase their returns further by moving

investments from one country to another. In other words, the allocation of capital is optimal

when global output cannot be increased by reallocating capital between countries.

Now, suppose that the income from capital is taxed. Even if the countries each impose

different tax rates, the optimal allocation of capital will still be achieved if each investor faces the

same tax rate regardless of where the investment is placed.11 This will be true because the

investors will be satisfied with their choices only when they can expect to receive the same aftertax return regardless of where they invest. However, because each investor would face the same

tax rate regardless of where the investment is made, the expected pretax return from alternative
- 28 -

12 To optimize the allocation of capital either the low tax rate could be raised or the high tax rate

could be reduced.

investments would also be the same. Thus, the investors will make the same choices they would

have made without taxation. The result is an optimal tax structure that provides the best

international allocation of capital and maximizes global output. 

By contrast, if the investors face different tax rates depending on where they invest, they

will still make investments in such a way that they can expect to receive equal after-tax rates of

return from alternative investments in different countries. However, because they would face

different tax rates depending on where they invest, the rates of return from those alternative

investments would have to differ, before taxes, in order to be equal, after taxes. The investors’

choices would not result in the best allocation of capital because output could be increased if

capital were instead moved from the country where the investors face the lower tax rate (and the

pretax return is lower) to the country where they face the higher tax rate (and the pretax return is

higher).12 This result is explained in more detail in figure 1 and the box below.
- 29 -

The Relationship Between Taxes and the Productivity of Investment

Figure 1 shows why a higher tax rate on investment income in a country tends to be

associated with a smaller amount of investment in the country, and with a higher rate of

productivity per dollar of investment. Each bar represents an investment opportunity. The width

of the bar represents the amount of the investment and the height of the bar represents the total

income the investment produces per dollar of investment, per period. Thus, the area of each bar

represents the income produced by the investment in each period. The investment opportunities

are arranged in descending order, with the most productive opportunities on the left. Investors

will undertake the most productive investments first. Thus, for example, if i is the total amount

of capital invested in the country, the country’s gross domestic product is given by the area of all

the bars to the left of i.

If capital markets are competitive, then any investor can contribute funds to any

investment opportunity, so competition among investors ensures that each receives the rate of

return available on the least profitable investment, but no more than that. In the figure, this rate

of return is r. The country taxes investment income at the rate t, so the after-tax rate of return

received by investors is (1 - t)r. If capital is allowed to move freely among countries and if local

investment stands at i, then this implies that investors are able to get (1 - t)r after taxes on their

investments in other countries. To see how taxes affect local investment and the local rate of

return to investment, consider what happens if the country raises the tax on local investment to

t’, while tax rates on investments in all other countries are unchanged. The tax increase will

cause investors to undertake fewer of the local investment opportunities, until the pretax rate of

return on local investment rises by enough so that the rate of return after tax is again equal to

that available from the offshore investments. For example, if investment that moved away from

the country did little to affect rates of return offshore (a realistic approximation in most cases)

then capital would continue to leave the country until the pretax rate of return rose to r’, such

that (1 - t)r = (1 - t’)r’.
- 30 -

13 Thomas Horst, A Note on the Optimal Taxation of International Investment Income, 94 Q.J. of

Econ. 793-98 (June 1980).

14 Saving clearly is influenced by the level of income. That is, the rate of saving increases as

income levels increase. It is less clear how much saving responds to changes in the rate of

taxation or other changes that would affect an investor’s rate of return on investment. In

principle, changes in an investor’s rate of return will influence the investor’s decision whether to

spend money now or save that money to spend it in the future, and this decision will have an

effect on global output. However, available evidence from an extensive body of empirical study

provides little convincing evidence that the sensitivity of saving to the after-tax rate of return is

large enough to matter in this context. See, e.g., Robert E. Hall, Intertemporal Substitution in

Consumption, 96 J. of Pol. Econ. 339-57 (1988); Douglas Elmendorf, Board of Governors of the

Federal Reserve System, Finance and Economic Discussion Series No. 96-27, The Effect of

2. Criticisms of the Standard Analysis and Responses to Those

Criticisms

a. Adding the Role of Savings

This standard analysis has been criticized in a paper by Thomas Horst,13 because it ignores

the possible effect of taxes on saving.14 Horst added savings behavior to the standard model and
- 31 -

Interest Rate Changes on Household Saving and Consumption: A Survey (1996). Changes in

saving that can be fully explained by changes in income do not alter the conclusions from the

standard analysis. 

15 Horst formalized arguments made earlier by Musgrave, supra note 4.

16 See, e.g., Staff of the Joint Committee on Taxation, Factors Affecting the International

Competitiveness of the United States, Scheduled for Hearings before the Committee on Ways and

Means on June 4-6 and 18-20 and July 16-18, 1991 247-48 (1991).

17 “Pure economic profits” or “economic rents” describes the return to the investor in excess of

the return that the investor would require to undertake the investment (e.g., the return to a

monopolist in excess of the return that would be available in a competitive market). 

18 One can view Horst’s analysis as supporting the view that the goal of capital import neutrality

(the goal of ensuring that investment income earned in the same country faces the same tax rate

regardless of the residence of the investor), rather than capital export neutrality, should be sought

if all countries do not have the same tax rates for investment income. Capital import neutrality

ensures economic efficiency in saving decisions by ensuring that all investors, regardless of where

they reside, have the same incentive to save. Capital import neutrality does not ensure economic

efficiency in the allocation of saving among various investment opportunities around the world,

however. See Rosanne Altshuler, Recent Developments in the Debate on Deferral, 87 Tax Notes

255 (2000). Under the standard analysis, capital export neutrality yields the best result, even

asked how a capital-exporting country should structure its taxes to maximize global output.15 He

concluded that the capital-exporting country should not necessarily set taxes to be consistent with

the principle of capital export neutrality. According to his analysis, the optimum tax rates depend

on the responsiveness, or “elasticities,” of the supply and demand of capital with respect to

changes in the rate of return. Horst found that if the capital demand and supply elasticities are

similar at home and abroad, then taxes should be structured in the capital exporting country so

that income from foreign investment is taxed at a rate between the tax rate imposed on income

from domestic investment and the tax rate imposed by the foreign host country. 

Horst’s analysis has been subject to several criticisms.16 One is that the analysis ignores

any effects of tax changes on tax revenue, and that the conclusions reached by Horst depended on

ignoring these effects. Because countries are constrained in their tax policy by the need to raise

revenue, this has been viewed as a weakness in Horst’s analysis. A second criticism is that the

analysis assumes implicitly that the tax rate on income from domestic investment in the capitalexporting country is fixed, so that only the tax rate on foreign investment income can be changed. 

As demonstrated by later studies discussed below, these criticisms may not be critical if one is

using the analysis only to determine whether the optimal tax on foreign investment income is

higher or lower than the tax on domestic investment income and if the capital exporting country’s

investment does not have a substantial effect on global rates of return. However, Horst’s analysis

also ignores the role of other income taxes, in particular the taxes on labor income (i.e., taxes

imposed on wages) and on pure economic profits.17 Later studies (reviewed below) have shown

that ignoring the role of other income taxes causes the analysis to yield invalid conclusions about

the optimal relative rates of tax on domestic and foreign investment income.18 
- 32 -

when tax rates are different at home and abroad. It doesn’t matter if savers in different countries

face different rates of return, because the rate of return is assumed not to influence saving. 

19 Christopher C. Findlay, Optimal Taxation of International Income Flows, 62 Econ. Rec. 208-14

(1986). 

20 Neil Bruce, A Note on the Taxation of International Capital Income Flows, 68 Econ. Rec. 217-

21 (1992).

21

 Id. 

22 Michael Keen and Hannu Piekkola, Simple Rules for the Optimal Taxation of International

Capital Income, 99 Scandinavian J. of Econ. 447-61 (1997).

23 Assaf Razin and Efraim Sadka, International Tax Competition and Gains from Tax

Harmonization, 37 Econ. Letters 69-76 (1991).

b. Adding a Tax Revenue Constraint

In a somewhat more general analysis, Christopher Findlay19 considered a similar problem

to that addressed by Horst, but Findlay assumed that tax authorities could vary the tax rates on

investment income from both domestic and foreign investments and he recognized that the tax

authorities had to meet a revenue need. Findlay examined, in particular, how countries should

structure taxes on foreign investment income when there is a global revenue constraint and the

capital-importing and capital-exporting country can share the revenue.

Although Findlay’s analysis is broader than Horst’s, he reaches similar conclusions. Like

Horst’s analysis, however, Findlay’s analysis has been subject to criticism for ignoring the role of

other income taxes.20 For example, his analysis ignores the fact that an increase in the tax rate on

investment income that discourages investment probably also would reduce revenue from the

taxes on labor income (because the decrease in investment would also decrease the demand for

labor). 

c. More Recent Studies: Adding Other Income Taxes

In later studies, using even more general analyses, Neil Bruce,21 and Michael Keen and

Hannu Piekkola22 demonstrate that it is important to account for taxes on labor income and on

pure economic profits. In particular, they show that if tax rates on domestic income from labor

and capital, including pure economic profits, are structured optimally in both the capital-exporting

and capital-importing countries, then countries should choose an international tax policy that

follows the principle of capital export neutrality. According to these studies, the tax structure that

allocates capital most efficiently also allows the needed revenue to be raised with the lowest

possible tax rate and therefore the smallest possible saving disincentive. 

In their analysis, Keen and Piekkola assume that both the capital-importing country and

the capital-exporting country seek to maximize global welfare and cooperate to achieve that goal. 

In contrast, Razin and Sadka23 ask what international tax policies countries will choose if they do
- 33 -

24 A number of authors have assumed that this “small country” case is an acceptable

approximation for the United States (i.e., the United States is not large enough to influence global

pretax rates of return). See, e.g., Roy J. Ruffin and Farhad Rassekh, The Role of Direct

Investment in U.S. Capital Outflows, 76 Am. Econ. Rev. 1126-30 (1986).

25 James Mackie and Donald J. Rousslang, Office of Tax Analysis, U.S. Department of Treasury,

The Optimal Taxation of Income From International Investment: A Geometric Analysis (1997) 

(mimeo). 

26

 However, under the so-called “new view,” to the extent corporate investments are made from

retained earnings, the individual-level tax on dividends does not affect the cost of capital. 

not cooperate, but instead each country seeks to maximize only its own national welfare. They

found that if no country is large enough to influence global pretax rates of return,24 then countries

will adopt the system of residence taxation under which capital-importing countries would not tax

inbound foreign investment income and capital-exporting countries would levy the same tax on

income from domestic and foreign investment. The capital-exporting countries would thus adopt

policies consistent with capital export neutrality.

James Mackie and Donald Rousslang25 considered the slightly different problem faced by a

capital-exporting country that wants to set its taxes to maximize global welfare, assuming that the

capital-importing countries will not change their taxes. The authors find that, depending on the

circumstances, the capital-exporting country would impose taxes on foreign investment income at

a rate that is either higher or lower than the tax on domestic investment income. In particular, the

best policy choice for the country will depend on whether it is able to impose optimal taxes on

other types of income besides investment income and on whether its investments are large enough

to influence global rates of return. The authors find that if the country is able to impose optimal

taxes on the other types of income and is not large enough to influence global rates of return on

investment, then it would maximize global welfare by choosing a tax policy that favors domestic

investment over foreign investment. In the more realistic case, however, in which tax authorities

are unable to impose optimal taxes on the other types of income or the country is sufficiently large

that its taxes materially influence global pretax rates of return on investment, the authors found

that there is little reason to believe that the best policy would involve favoring either domestic or

foreign investment income.

d. Adding Corporate and Non-corporate Sectors

Another possible shortcoming of the standard analysis is that it assumes there is only a

single form of capital investment, when in fact there are different forms of capital investment and

they are often taxed at different rates, both at home and abroad. In particular, business income

typically is taxed at the entity or owner level, depending on whether the business is organized as a

corporation. Under a so-called classical system of corporate income taxation (such as the system

used by the United States), corporate profits generally are effectively taxed twice, once when they

are earned by the corporation and again when they are distributed as dividends to individual

shareholders, or realized as capital gains. The analysis that follows assumes that the individuallevel tax raises the cost of capital for corporations.26

 
- 34 -

According to this view, only the individual tax on capital gains affects investment and that tax is

small because of deferral and step-up in basis at death. See, e.g., Department of the Treasury,

Integration of the Individual and Corporate Tax Systems 116-18 (January 1992).

27

 See, e.g., id. at 1-14.

28 In practice, most capital-exporting countries defer the residence-based tax on income earned by

corporate subsidiaries from active business pursuits abroad until the income is repatriated to the

home country, or they exempt the income entirely from the local tax. When a residence-based tax

is applied to the foreign investment income, a credit is usually available for foreign income taxes. 

The deferral feature of such systems violates the condition of capital export neutrality by

providing a preference for foreign investments in low-tax countries. At the same time, the tax

systems in most countries tend to discourage international investment in high-tax capitalimporting countries. The credits allowed for foreign income taxes generally fail to restore capital

export neutrality with respect to investment in high-tax countries, because the capital-exporting

country generally limits the credits to the domestic tax due under the residence principle, although

cross crediting (combining income and tax credits from different foreign investments) can

sometimes restore it. Hence, according to the standard analysis, the current U.S. system, which

provides deferral and limits foreign tax credits to the U.S. tax due on repatriated foreign

investment income, generally violates the principle of capital export neutrality by simultaneously

When corporate income is taxed at a higher rate than income from non-corporate

investment, this differential tax treatment tends to cause too much investment in the noncorporate sector and too little investment in the corporate sector. 27 That is, taxes distort the

decision on whether to undertake investment using the corporate form in favor of using the noncorporate form. The higher corporate taxes can also distort corporate investment financing

choices between equity and debt.

Another way that adding corporate and non-corporate sectors alters the standard analysis

is to increase the importance of the effect tax changes may have on the supply of capital to the

corporate sector. In Horst’s model, this effect comes exclusively from the response of saving to

changes in the after-tax rate of return, since his model contains only one kind of investment. If

the standard analysis is used to prescribe the optimal way to tax income from corporate

investment, however, it must be remembered that the supply of capital to the corporate sector can

vary not only as a result of change in the overall saving, but also as a result of movements of

capital between the corporate and non-corporate sectors. As the prior discussion in this chapter

suggests, however, accounting for the response in the supply of capital to tax changes has no

clear effect on the conclusion that capital export neutrality is the optimal policy for promoting

global economic welfare. 

To apply the principle of capital export neutrality to corporate investment, the capitalexporting country would set the domestic tax on income from corporate investment abroad such

that the total tax on this income (the foreign and domestic taxes combined) is equal to the tax on

income from domestic corporate investment. Under this scheme, a corporation organized in the

capital-exporting country would require the same pretax rate of return for both domestic and

foreign investment.28 
- 35 -

encouraging too much investment in low-tax capital-importing countries and too little investment

in high-tax capital-importing countries.

29 Daniel Frisch, The Economics of International Tax Policy: Some Old and New Approaches, 47

Tax Notes 581-91 (1990).

30 Harry Grubert and John Mutti, Taxing Multinationals in a World With Portfolio Flows and

R&D: Is Capital Export Neutrality Obsolete?, 2 Int’l Tax and Pub. Fin. 439-57 (1995). 

It is possible to reduce the distortion that favors non-corporate investment over corporate

investment by reducing the total tax on income from international corporate investment, by

reducing the total tax on income from domestic corporate investment, or by reducing both taxes

simultaneously. However, reducing only one of these tax rates, while it would reduce the

distortion favoring non-corporate investment, would introduce a distortion in the choice between

domestic and foreign corporate investments. For example, reducing only the tax on foreign

investment income would cause domestic corporate investors to favor a foreign investment over a

domestic alternative that has a higher pretax return. The tax bias against corporate investment, by

itself, does not provide a compelling reason to favor foreign or domestic corporate investments if

the overall goal is to minimize distortions in investment decisions.

e. Adding Portfolio Investment Flows

Daniel Frisch29 has argued that the capital-exporting country should set a lower tax rate on

foreign investment income of corporations if portfolio investment is highly mobile. He has argued

that portfolio mobility allows investors in the capital-exporting country to avoid the local tax on

corporate profits by investing directly in equities of foreign corporations that face a lower

corporate tax rate in the capital-importing country, instead of investing abroad through domestic

corporations that engage in foreign investment. In this case, the capital-exporting country’s

corporate income tax would cause less foreign investment by its domestic corporations, matched

by greater portfolio investments in foreign companies by its domestic residents. If output of

unaffiliated corporations in the capital-importing country and of capital-exporting country

affiliates operating in the capital-importing country are perfect substitutes for each other, an

attempt by the capital-exporting country to levy any tax on its corporation’s foreign investment

income in addition to the tax levied by the capital-importing country would merely cause the

domestic corporations to lose foreign investment opportunities to foreign corporations, because

domestic investors would invest directly in the shares of the foreign corporations. 

Harry Grubert and John Mutti30 question the conclusions reached by Frisch. In Grubert

and Mutti’s model, if taxes on income from U.S. investment abroad were reduced, the price of

output from this U.S. investment abroad would fall relative to both other foreign output and U.S.

domestic output. This would increase the quantity demanded of output from the U.S. foreign

investment at the expense of both U.S. domestic output and other foreign output. The displaced

U.S. domestic output would cause capital to move from the United States to U.S. foreign

investment, whereas the displaced foreign output would cause capital to move from other foreign

producers to U.S. foreign investment. The net effect on economic welfare is ambiguous. 

Grubert and Mutti conclude that even if portfolio capital were perfectly mobile, there is no
- 36 -

31 Grubert and Mutti note that their findings are consistent with those of French and Poterba, who

found that equity ownership is greatly undiversified on a worldwide basis. See id. at 448 (citing

Kenneth French and James Poterba, NBER Working Paper No. 3609, Investor Diversification and

International Equity Markets (1991)).

32 As explained further in note 3, supra, and accompanying text, attempting to maximize national

economic welfare (instead of global economic welfare) may not be in a country’s long-term

economic interests. 

33 Musgrave, supra note 4. 

compelling reason to believe that global welfare would improve if the capital-exporting country

taxes foreign investment income of its corporations at a rate lower than domestic investment

income. In addition, they point out, contrary to Frisch’s views on portfolio mobility, that

investors do not appear to regard equities of foreign corporations as perfect substitutes for

equities of domestic corporations. Indeed, they provide evidence that, in 1992, U.S. residents had

less than four percent of their equity portfolios in foreign shares, and less than six percent of total

U.S. corporate stock is owned by foreigners.31 

3. Conclusion on Maximizing Global Welfare

The literature on optimal taxation of foreign direct investment income suggests that, when

the goal is to maximize global economic welfare, capital export neutrality is probably the best

policy. The basic conclusions of the standard analysis, that the best policy is to impose equal

taxes on domestic and foreign investment income, appear to provide the best guide for

determining appropriate tax policy even when complicating factors introduced by later authors are

considered. Thus, these conclusions still appear valid when the analysis is made more

complicated by considering: (a) the possible effects of changes in the rate of return on the amount

of saving; (b) the existence of different forms of capital investment, such as corporate and noncorporate investment, that are taxed at different rates; or (c) the ability to invest internationally

through portfolio investments in foreign corporations as well as through foreign direct investment

by domestic corporations. 

C. Promoting U.S. Economic Welfare

1. The Standard Analysis

a. General

To maximize its national economic welfare, a country should set tax rates on income from

foreign direct investment (inward or outward) to maximize the sum of the private benefit for local

investors and tax revenue for the local government.32 Using the simple framework of the standard

analysis, Peggy Musgrave33 has shown that, if the capital-exporting country’s investments do not

materially affect global rates of return, it would achieve this optimum if its tax rate on foreign

investment income were set so that local investors were indifferent between investing at home or
- 37 -

34 As used throughout this section, the “total return” to the capital-exporting country is

comprised of the after-tax return to the private investor plus the tax revenue collected by the

capital-exporting country.

35 Expressed mathematically, if DR is the pretax return on a domestic investment, FR is the

pretax return on a competing foreign investment, and tf is the tax imposed by the foreign country

on the foreign investment, national neutrality exists if an investor is indifferent between the two

investments when DR = FR(1- tf). Under these circumstances, the total return to the capitalexporting country from the domestic investment (as defined in note 34, supra), will equal the total

return to the capital-exporting country from the foreign investment (which is net of any foreign

taxes paid). 

36

 For example, assuming a 30 percent foreign tax rate and no credit for foreign taxes, an investor

would be indifferent between a $1000 foreign investment with an expected pretax return of $100

and a competing $1000 domestic investment with an expected pretax return of $70. In this

situation, if the capital-exporting country taxes the income from the foreign investment or the

domestic investment currently and allows a $30 deduction (but no foreign tax credit) for taxes

paid to the foreign country, the investor’s taxable income from either investment will be $70. 

37 Mackie and Rousslang, supra note 25.

38 Martin S. Feldstein and David Hartman, The Optimal Taxation of Foreign Source Investment

Income, 93 Q.J. of Econ. 613-29 (1979). 

39 The total return that the capital-exporting country receives from foreign investments of its

residents is the return after foreign income and withholding taxes.

abroad when the total return34 to the capital-exporting country is the same for each type of

investment. This condition is referred to as national neutrality.35 If this condition is met, a unit of

capital invested abroad brings the same total return to the capital-exporting country as a unit of

capital invested at home. In the standard analysis, the capital-exporting country can achieve

national neutrality by taxing foreign investment income under the residence principle and allowing

only a deduction (rather than a credit) for foreign income taxes. That is, the capital-exporting

country denies deferral of its tax on foreign earnings and provides no foreign tax credit, but allows

the company to deduct foreign income taxes as though they were ordinary business expenses.36

The condition is not met if a credit is given for foreign taxes, or if the residence-based tax on

foreign-source profits is deferred or forgiven. Similarly, James Mackie and Donald Rousslang37

have concluded that the deduction for foreign income taxes (instead of a foreign tax credit) also

maximizes the local welfare of the capital-exporting country if saving responds to the after-tax

rate of return and if non-capital factor incomes are taxed optimally.

b. Adding Market Power and Tax Policies in Other Countries

Martin Feldstein and David Hartman38 have observed that a large capital-exporting

country may be able to take advantage of its market power to obtain a higher total return from its

capital by imposing a higher tax rate on foreign investment than the rate on alternative domestic

investments.39
- 38 -

40 If the foreign investment income is taxed at a lower rate by the capital-importing country, an

increase in the rate will increase tax revenue of the capital-importing country without

discouraging any inward investment. An article by Roger H. Gordon discusses situations in which

a “dominant” capital-exporting country effectively can support capital income taxation in small

capital-importing countries. See Roger H. Gordon, Can Capital Income Taxes Survive in Open

Economies?, 67 J. of Fin. 1159-80 (1992). If the capital-exporting country allows averaging of

income and taxes on foreign source income from different countries, however, the optimum tax

rate for the capital-importing country may differ from the tax rate in the capital-exporting country.

41

 See, e.g., Roger H. Gordon, Taxation of Investment and Saving in a World Economy, 76 Am.

Econ. Rev. 1086-1102 (1986); Slemrod, supra note 7.

42

 See supra note 26 and accompanying text (discussing whether the U.S. corporate income tax

actually causes new corporate investment to be taxed at a higher rate than non-corporate

investment).

For a capital-importing country, the standard analysis implies that the optimal tax policy

depends primarily on the responsiveness of inward investment to the local tax rate. This,

however, depends in turn on the tax rules of the capital-exporting country, as well as the market

power of the capital-importing country. For example, if the capital-exporting country allows a

credit for foreign income taxes, the inflow of capital to the capital-importing country may be little

affected by changes in the local tax rate, as long as it is less than the rate in the capital-exporting

country. In this case, the capital-importing country has the incentive to tax the foreign investment

income under the source principle at a rate that is no lower than that imposed by the capitalexporting country under the residence principle.40

If the capital-exporting country exempts or defers foreign-source profits of its domestic

residents (or allows them to defer the residence-based tax on this income), or if it allows only a

deduction for foreign income taxes, the optimal policy for the capital-importing country is a

matter of balancing the lost revenue from lower taxes on inward investment income against the

benefits of greater inward investment that can be obtained through lower tax rates. The optimum

tax rate of the capital-importing country depends on the responsiveness of inward investment to

the local tax rate. Several authors have shown that, under the following conditions, the optimum

tax rate on inward investment income is zero: (a) the capital-importing country is too small to

affect the rate of return to international investment, (b) capital is perfectly mobile internationally,

and (c) the capital-exporting country does not provide a tax credit for income taxes paid to the

capital-importing country.41 

c. Adding Corporate and Non-corporate Sectors

If corporate investment income is taxed at a higher rate than non-corporate investment

income, the rules for maximizing the local benefit from international investment become more

complicated.42 Under the principle of national neutrality, the capital-exporting country would tax

net foreign source corporate income (income earned abroad after deducting the foreign tax) at the

same rate as it taxes domestic source corporate income. International capital flows would cause

the total rate of return to corporate capital located in the home country (the private return plus
- 39 -

43 There would also be too much investment in the foreign non-corporate sector, and,

accordingly, the total return to the home country would also rise if a dollar were taken from the

foreign non-corporate sector and put into corporate investment at home or abroad. 

44 Gary C. Hufbauer, Institute for International Economics, U.S. Taxation of International

Income, Blueprint for Reform (1992).

45 Grubert and Mutti, supra note 30.

46 They also note that expanding the credit for research and development expenses would be more

effective than Hufbauer’s proposed approach in promoting research and development.

the domestic tax revenue) to be the same as the rate of return from foreign corporate investment

after deducting the foreign tax. Because the corporate investment is taxed more heavily,

however, there would be too much investment in the domestic non-corporate sector. Thus, the

total return to the home country would rise if a dollar were taken from the domestic noncorporate sector and put into corporate investment at home or abroad.43

 

By itself, a distortion in favor of non-corporate over corporate investment provides no

clear reason to favor foreign over domestic corporate investment. For example, eliminating the

domestic tax on income from foreign corporate investment (leaving unchanged the tax rate on

income from domestic corporate investment) would eliminate the difference between the total

domestic returns from investment in the domestic non-corporate sector and corporate investment

abroad, but it would cause domestic corporate investors to favor a foreign investment that yields a

total return to the home country that is lower than the pretax return to the alternative domestic

corporate investment. If the goal is to maximize the local benefit, these distortions (i.e., the

distortions that favor investment that is both domestic and non-corporate) cannot be removed

simultaneously as long as the domestic discrimination against corporate investment exists. 

d. Adding R&D

Gary Hufbauer44 has argued that U.S. tax policy should favor foreign investment with

lower tax rates in order to encourage greater research and development in the United States, and

it should not encourage corporations to move headquarters abroad. He points out that the United

States would benefit from more headquarter service jobs and more jobs in research and

development activities, all of which tend to be higher paying jobs. Grubert and Mutti45 showed,

however, that all of these benefits can be gained by cutting the tax on domestic corporate

investment as well, because such tax cuts would also encourage more research and development

and provide a tax incentive for companies to locate their headquarters in the United States. They

also point out that there should be no presumption that a reduction in the tax on foreign

investment would do more (and that it might well do less) to promote research and development

in the United States than would a reduction in the tax on domestic investment income.46 Thus,

Hufbauer’s argument provides no rationale for structuring taxes to favor foreign over domestic

investment. 
- 40 -

47 Michael P. Devereaux and Glenn Hubbard, American Enterprise Institute, Seminar Series in

Tax Policy, Taxing Multinationals (1999).

48 Horst, supra note 13.

49 Martin Feldstein, NBER Working Paper No. 4689, Taxes, Leverage and the National Return

on Outbound Foreign Direct Investment (1994).

e. Adding Strategic Choices, Imperfect Competition and

Economic Rents

In a recent study, Michael Devereaux and Glenn Hubbard47 have developed a model that

incorporated strategic choices, imperfect competition and economic rents. In their model, if the

host country does not tax the investment income, the capital-exporting country generally would

be better off by deferring the home country tax on direct foreign investment income than by taxing

the income currently. Their approach can be criticized for some of the same reasons as the earlier

work by Horst,48 however, because they ignore any revenue constraints on tax policy, they

assume implicitly that the tax rate on income from local investment in the capital-exporting

country is fixed so that only the tax rate on foreign investment income can be changed, and they

do not account for taxes on other factor incomes, such as labor income taxes. Therefore, their

analysis leaves unanswered the crucial question whether deferral of the residence-based tax on

income from foreign investment would do more to improve national welfare in the capitalexporting country than a reduction in the tax rate on income from domestic investment when

these other factors are considered.

f. Adding Portfolio Investments

Using a different analysis, Martin Feldstein49 has argued that the United States might

realize greater income by taxing foreign investment income at a lower rate than domestic

investment income. He posits a model in which capital is not uniformly mobile internationally. In

his framework, international capital movement is accomplished solely through direct investment

undertaken by companies: other forms of international capital flows (portfolio equity investments

and international debt flows) are assumed to net to zero for each country. Under these

assumptions, outward foreign investment can increase the income of domestic residents, even

when taxes are significant. 

Feldstein’s analysis is as follows. Investment by corporations is financed by debt as well

as by equity. He assumes that the rate of return to equity is higher than the rate of return to debt

and that the corporation therefore makes a profit on investment financed by debt. Also, U.S.

companies investing abroad tend to borrow heavily from foreign lenders. Thus, by taking

advantage of the spread between equity returns and debt payments to foreign lenders, U.S.

companies investing abroad can bring back greater net returns from the exported capital

(including the spread on capital borrowed from foreign lenders), even after paying foreign taxes,

than the pretax income the capital would have earned if it had been invested locally in the United
- 41 -

50 Note that in Feldstein’s analysis, the individual U.S. company making a foreign investment does

not make the foreign investment to gain greater leverage; its leverage presumably is chosen based

on borrowing costs, regardless of where it invests. If the company borrows abroad, however,

there is no adverse effect on borrowing costs of other U.S. companies that compete for the

domestic pool of debt capital.

51 Martin Feldstein, NBER Working Paper No. 4668, The Effects of Outbound FDI on the

Domestic Capital Stock (1994).

52 Ruffin and Rassekh, supra note 24.

53 Ruffin and Rassekh assume all capital is homogeneous. Accordingly, their analysis calls into

question Feldstein’s assumption that U.S. lenders make loans within the United States and foreign

lenders make loans outside the United States. See infra Appendix B (review of literature on

international capital mobility).

States.50 For example, assume a corporation has $100 of equity to invest and can choose

identical, equally leveraged investments either in the United States or abroad. According to

Feldstein’s analysis, if the corporation invests in the United States, borrowing from U.S. lenders,

the total return to the United States would be lower than the return to the United States from the

foreign investment (funded by foreign borrowing), because, in the case of the foreign investment,

the United States would capture the return on the $100 of equity plus the spread on the capital

borrowed from the foreign lenders. 

Feldstein’s conclusions depend on the differences in international mobility of different

types of investment. He cites empirical work51 to support the notion that debt and other portfolio

capital is not internationally mobile. His assumptions about the mobility of foreign direct

investment and portfolio capital flows are not consistent with other empirical research, however,

such as that by Roy Ruffin and Farhad Rassekh,52 who find that U.S. international portfolio flows

and direct investment flows largely cancel each other.53 Moreover, Feldstein does not show that

U.S. economic welfare would be higher, even if debt is internationally immobile, because he does

not account for the cost in terms of increased risk faced by U.S. investors as a result of being

more highly leveraged. 

2. Conclusion on Maximizing National Welfare

The literature on optimal taxation of foreign direct investment income when the goal is to

maximize national economic welfare provides no convincing basis for rejecting the conclusions of

the basic economic analysis that a country should tax income from outward foreign investment at

a rate that is at least as high as the tax rate imposed on income from domestic investment. This

conclusion appears to be valid, even if the possible effects of changes in the rate of return on the

amount of saving are considered, if the country simultaneously imports and exports capital, if it is

recognized that international mobility of capital may be different for equity investments and debt

investments and so international investment offers U.S. domestic residents an opportunity to

become more highly leveraged, and if international investment can be accomplished through
- 42 -

54 In general, interest and dividend payments received from a related corporation organized in the

same country as the controlled foreign corporation and rents and royalties received from a related

corporation for the use of property within the controlled foreign corporation’s country of

organization are excluded from subpart F income. See supra Introduction, section IV (discussion

of foreign personal holding company income rules). 

55 This chapter does not, however, address the foreign base company sales income rules or the

foreign base company services income rules to the extent that these rules apply to the U.S. export

or import of goods or services to or from U.S. affiliates. There are two reasons for not examining

the related party rules as applied to U.S. exports or imports in this study. The first reason is that

these rules, as applied to U.S. exports and imports, mainly prevent income from being shifted

away from the United States through transfer pricing manipulations, whereas the other related

party rules mainly prevent income from being shifted away from foreign host countries. The

second reason is that the related party rules, as applied to U.S. exports, have different effects on

investment incentives than the other related party rules. The related party rules generally

influence foreign investment decisions through their effect on the tax rate on income from foreign

investments. In contrast, the related party rules, as applied to U.S. exports, influence domestic

investment decisions through their effect on the tax rate on profits from production of U.S.

exports.

portfolio investments in foreign corporations as well as through foreign investments by

corporations. 

IV. The Economic Effects of the Foreign-to-Foreign Related Party Rules

A. Introduction

This section examines how the foreign-to-foreign related party rules of subpart F affect

global and U.S. economic welfare and U.S. tax revenue. For purposes of this part, the term

“foreign-to-foreign related party rules” refers to (a) the subpart F rules that treat as foreign

personal holding company income dividends and interest received from a related corporation

organized in a different country than the controlled foreign corporation or rents and royalties

received from a related corporation for the use of property outside of the country where the

controlled foreign corporation is organized,54 (b) the foreign base company services income rules,

and (c) the foreign base company sales income rules.55 The term “foreign-to-foreign related party

transactions” refers to transactions that give rise to income that would be characterized as subpart

F income under the foreign-to-foreign related party rules. When this chapter uses the term

“foreign-to-foreign related party transactions,” however, it is examining the effect of these

transactions in the absence of the application of the rules of subpart F. 

Section III of this chapter considered whether it might be beneficial to tax outbound

foreign investment income at a rate different from that imposed on income from U.S. domestic

investment when there is a single foreign tax rate on the foreign investment income. In this

section, the analysis is expanded to consider how investment may be affected if investors may

choose between investments in various foreign countries with widely divergent tax rates, in order
- 43 -

to take into account the fact that policy decisions may affect the tax imposed on U.S. foreign

investment in some host countries by more than in others. 

B. The Effects on Global Economic Welfare

The foreign-to-foreign related party rules affect global economic welfare to the extent that

they influence business decisions of companies and of individuals. For companies, the rules are

one of the many factors that may influence the decision about where to locate new investment (at

home or abroad, and if abroad, in which foreign country), how much to invest, and whether to

invest in physical assets or to develop new technology. The rules can also affect economic

decisions by individuals about how much to save and whether to invest in corporate or noncorporate enterprises. 

As among these decisions, discussion is limited to focus on how the rules can affect a

company’s decision about where to locate new investment, because this is probably the most

important way the rules can affect economic welfare. The standard framework introduced in the

previous section of the chapter, in which there is only one form of capital investment and saving is

not influenced by changes in the rate of return, is used because the literature does not reveal a

superior approach. Thus, the analysis ignores the possible effect that taxes may have on the total

amount of corporate investment or on the mix of corporate investment between tangible and

intangible assets. In the analysis, global economic welfare improves if greater output can be

produced from the same amount of capital merely by moving it from less productive to more

productive business activities. Finally, it is assumed that foreign governments would not respond

to changes in U.S. tax rules. 

This subsection begins by examining the effect that deferral in general has on the allocation

of investments among countries. The narrower issue of the effects of the foreign-to-foreign

related party rules on this allocation is then considered. 

1. Effects of Deferral on the Allocation of Corporate Investments among

Countries

As discussed previously, under the standard economic analysis, the greatest global output

is achieved if the capital-exporting country follows the principle of capital export neutrality. If the

principle is not applied, for whatever reason, different tax rates may apply to investment income

earned in different countries, so the pretax rates of return may differ among countries. Under

these circumstances, a country with a low tax rate will tend to attract too much capital, whereas a

country with a high tax rate will tend to attract too little capital. In particular, if the total tax rate

(including both home and host country taxes) on investment income in a capital-importing country

is lower than that on investment income in the capital-exporting country, then there will be too

much foreign investment in the capital-importing country. In this case, global output and the

allocation of capital could be improved by increasing the tax rate on the investment income earned

in the capital-importing country. 
- 44 -

56 Appendix C, section I, infra, describes the methods used to calculate these tax rates. As

explained in Appendix C, the tax rate for a country in any year can be misleading, owing to

cyclical losses. The cyclical effects cannot be eliminated by looking only at profitable subsidiaries,

because losses carried forward from a previous year will influence the foreign taxes paid in the

current year. 

57 1996 is the last year for which comprehensive data on foreign operations of U.S. corporations

currently exists. 

To see how closely current tax policies agree with the prescriptions from the standard

analysis, consider the overall averages of the effective tax rates faced by U.S. manufacturing

subsidiaries abroad. These tax rates represent income taxes paid to foreign host countries divided

by the subsidiary’s current taxable income as defined by U.S. tax rules. The income usually is

close to book income.56 The tax rates are displayed in the last column of Table 1 for every other

year from 1980 through 1996.57 The table also provides detail on how the tax rates are

distributed across countries and how that distribution has changed over time. To show the

distribution across countries, the tax rates are grouped into percentiles, according to the assets of

the manufacturing subsidiaries in each country. For example, the table shows that in 1980, 40

percent of the assets were in countries where the average effective tax rate on income of U.S.

manufacturing subsidiaries was less than 29 percent. By 1996, however, 80 percent of the assets

were in countries where the average effective tax rate was less than 29 percent. 
- 45 -

58 This average U.S. tax rate was calculated to be comparable to the foreign tax rates by

conforming U.S. income as closely as possible to book income from domestic investments. For a

detailed discussion of how this rate was calculated, see infra Appendix C, section III.

Table 1

Country Average Tax Rates 1/

Variations Across Countries By Year

Foreign Manufacturing Subsidiaries of U.S. Companies 

(Statistics Weighted By Assets)

Percentiles: Average 

Year Tenth Twentieth Fortieth Sixtieth Eightieth Foreign

Rate

1980 21 % 26 % 29 % 38 % 39 % 33 %

1982 21 26 28 30 45 31 

1984 20 30 36 37 49 35 

1986 18 28 36 38 39 34 

1988 22 26 31 33 34 30 

1990 20 20 27 32 33 27 

1992 13 18 22 29 33 24 

1994 12 17 21 23 29 21 

1996 11 15 20 24 29 21 

1/ This table shows the variation across countries of average tax rates (not including withholding taxes imposed on

repatriated earnings) for manufacturing firms based upon the assets in each country. Each entry in the table is a

tax rate. The row identifies the year and the column identifies the percentile of the distribution for that year. For

example, the cell with an entry of 12 in the column headed “Tenth” and the row labeled “1994" can be read as

follows: In 1994, 10 percent of assets were in countries with average tax rates of less than 12 percent. A country is 

included only if there were more than five manufacturing subsidiaries with positive earnings and profits after taxes

in that country for every year. 

The data in Table 1 show that the average of the foreign host country tax rates on the

income of foreign manufacturing subsidiaries of U.S. companies declined from 33 percent in 1980

to 21 percent in 1996. By comparison, the average tax rate on domestic income of U.S.

manufacturing corporations was 31 percent in 1996.58

Of course, other taxes may be imposed on foreign investment income. Foreign

subsidiaries often distribute part of their earnings to the U.S. parent company, even though this

means incurring withholding taxes in the host country and sometimes a residual U.S. tax. 

However, the effective rate of the residual U.S. tax on foreign earnings is often negative. That is,

the total foreign and U.S. tax on repatriated earnings (including dividends, interest and royalties)
- 46 -

59 For example, Grubert and Mutti, supra note 30, calculated that the residual U.S. tax on foreign

earnings was negative and amounted to a subsidy of 2.6 percent to foreign operations in 1990.

60 Under Treas. Reg. § 1.863-3, income derived from the sale of inventory property produced in

the United States and sold abroad or produced abroad and sold within the United States is

sourced partly within and partly outside the United States under one of the methods provided in

the regulations.

61 Appendix C, section II, infra, explains in detail how this rate was calculated. Because U.S.

companies can combine foreign earnings and foreign taxes on their U.S. tax return when claiming

the foreign tax credit, the total average effective tax rate on overall foreign earnings, including the

repatriation tax, cannot be calculated for individual host countries. 

may be less than the taxes imposed by the foreign host country.59 In particular, the residual U.S.

tax on repatriated earnings often is less than it would be if the United States had a territorial

system that exempted dividends from foreign subsidiaries from U.S. tax. This happens because,

under current U.S. tax rules, foreign income taxes can be credited against the U.S. tax on the fee,

royalty and interest payments that a U.S. parent receives from its foreign subsidiaries. In addition,

under the sales source rules, the U.S. parent can apply excess foreign tax credits against a portion

of the profits from its U.S. export sales.60 In effect, this amounts to rebating part of the taxes the

company pays to foreign governments. No such rebate would be available under a pure territorial

system. Rather, under a territorial system that exempts dividends from active foreign business

earnings and that provides a foreign tax credit only for foreign withholding taxes, all of these

income items would be taxed at the full U.S. corporate income tax rate with a credit only for the

withholding taxes on the fees, royalties and interest.

The present value of the residual, but deferred, U.S. tax on retained earnings of foreign

subsidiaries is often negligible: the longer the tax is deferred, the smaller is its present value. In

1994, the average effective rate of total tax, including the foreign host country income tax, any

foreign withholding taxes, and the residual U.S. tax, on all repatriated foreign earnings in the

general basket, which contains almost all of the earnings from the manufacturing subsidiaries, was

approximately 26 percent.61

This average effective rate of total tax on foreign earnings indicates that the tax rate on

foreign investment income was lower than that on U.S. domestic investment in 1996. Hence, the

standard economic analysis described in the previous chapter implies that the deferral of the

residual U.S. tax on foreign earnings has tended to worsen the global allocation of capital. The

analysis does not imply, however, that just any change in U.S. tax rules that raises the tax on

foreign investment income necessarily would improve the allocation of capital. There are a

number of capital-importing countries, each with its own effective tax rate on investment income,

and a change in U.S. policy that increases the total tax rate for investments in some countries

more than others may improve or worsen the allocation of capital, as discussed further below. 
- 47 -

62 That is, there are likely to be differences in true pretax rates of return (the rates of return

adjusted for the riskiness of investments) that investors expect. Note, however, that data on

reported earnings and amount of investment may poorly reflect these true, expected pretax rates

of return for a number of reasons. One reason is that investment flows tend to bring equality to

the ex ante (i.e., anticipated) rates of return and the observed earnings are ex post, so they do not

reflect risks associated with the investments. Another reason is that reported earnings can be

distorted by income shifting. For example, countries with very low local tax rates often have

observed pretax rates of return that are substantially higher than those in countries with much

higher tax rates, which suggests that income is being shifted to the low-tax jurisdictions. 

63 In other words, in the absence of the subpart F foreign-to-foreign related party rules, income

shifting through foreign-to-foreign related party transactions would reduce taxes on investment in

high-tax jurisdictions more than it would reduce taxes on investment in low-tax jurisdictions. See

infra, note 67 for further explanation. 

64 The reason lower taxes tend to be accompanied by lower pretax rates of return and higher

taxes tend to be accompanied by higher pretax rates of return is explained in the box in section

III.B.1, supra.

2. The Effects of the Foreign-to-Foreign Related Party Rules on the

Allocation of Corporate Investments among Countries

The data in Table 1 show that average foreign tax rates on foreign manufacturing

subsidiaries of U.S. companies differ substantially among countries, which implies that there are

likely to be substantial differences in pretax rates of return investors would expect to earn on new

investments in different countries.62 A method of limiting deferral that primarily reduces the tax

advantage where tax rates are lowest would offer the best chance for improving the global

allocation of capital. This is true because capital moved away from the low-tax countries is more

likely to end up in other countries where the local tax rates, and hence the required pretax rates of

return, are higher. 

The higher the tax rate in the country where the foreign investment is located, the more

the subpart F foreign-to-foreign related party rules tend to raise the total tax rate on foreign

investment income (i.e., by preventing the shifting of income from that high-tax country to a lowtax country).63 As a result, these rules have ambiguous effects on the allocation of capital. The

question is whether raising the rate of tax on investment in countries where the investment is not

particularly low-taxed leads investors to move investments away from those countries to countries

where investment income is taxed at a higher rate and pretax rates of return are higher, or to

countries where the income is taxed at a lower rate and pretax rates of return are lower.64 To the

extent that the investments are moved to countries where the pretax rates of return are higher, the

global allocation of capital tends to improve and global pretax income tends to rise. To the extent

the investments are moved to countries where the pretax rates of return are lower, global pretax

income tends to fall. The net effect on global pretax income is ambiguous, that is, global income

can rise or fall as a result of the investment shifts. The box contains a numerical example that

demonstrates in greater detail how the response of investment flows affects global income and

what determines whether the net effect is likely to be an increase or a decrease in global income. 
- 48 -

The Effect of Foreign-to-Foreign Related Party Transactions on the Allocation of Capital,

Absent the Application of the Subpart F Rules, a Numerical Example

The following example illustrates how foreign-to foreign related party transactions might

affect the allocation of capital among countries. Suppose that investment opportunities of U.S.

companies are divided into three groups: investments in the United States, investments in a hightax foreign country, and investments in a low-tax foreign country. To keep the example as

simple as possible, suppose also that related party transactions are used to reduce only the tax

rate in the high-tax foreign country and that the amount of the tax reduction is small. Finally,

suppose that the effective total tax rate on investment income is 30 percent in the United States,

20 percent in the high-tax foreign country and 10 percent in the low-tax foreign country, and

that the required annual after-tax rate of return for a U.S. corporate investor choosing among

the three locations is 10 percent. 

Under these conditions, to provide the required after-tax return of 10 percent, the

investment in each country would be required to provide a pretax return equal to 10 percent

divided by one minus the tax rate. Thus, the required pretax return would be 14.3 percent in the

United States, 12.5 percent in the high-tax foreign country and 11.1 percent in the low-tax

foreign country. 

Now, suppose that foreign-to-foreign related party transactions can be used to reduce

slightly the tax rate faced by U.S.-owned subsidiaries in the high-tax foreign country. This

would make investment in the high-tax foreign country more attractive compared to investment

in the United States or in the low-tax foreign country, so it would attract capital to the high-tax

foreign county from both the United States and the low-tax foreign country. If equal amounts of

capital were attracted from both locations, there would be an annual net loss in global output

equal to $2 for each $1,000 of investment that moved to the high-tax foreign country. The net

loss is composed of the following elements. There would be a loss of $9 for each $500 of

investment that the high-tax foreign country attracts from the United States (= .125 X $500

minus .143 X $500). However, this loss in output would be partly offset by a gain of $7 of output

for each $500 of investment that the tax reduction would attract from the low-tax foreign country

(= .125 X $500 minus .111 X $500). 

If the high-tax foreign country attracted more capital from the low-tax foreign country

than from the United States, the reduction in effective tax rates achieved through the use of

foreign-to-foreign related party transactions might improve the global allocation of capital. If

the foreign-to-foreign related party transactions reduced the tax rates in the high-tax foreign

country by a large amount, however, then it becomes more likely that such transactions will

worsen the global allocation of capital by attracting more capital from the United States than

from the low-tax foreign country. Thus, capital attracted from the low-tax foreign country would

provide a smaller efficiency gain, whereas capital attracted from the United States would impose

a greater efficiency loss. 
- 49 -

65 As noted previously, references in this part to the “foreign-to-foreign related party

transactions” refer to the effect of those transaction in the absence of the application of the rules

of subpart F. 

66

 See infra Appendix B (review of literature on international capital mobility).

67 The higher the initial foreign tax rate, the more likely it is that foreign-to-foreign related party

transactions will significantly reduce foreign taxes (and thus reduce required pretax rates of

return). Accordingly, taxpayers in high-tax jurisdictions will have a greater incentive to engage in

such transactions. For the same proportional reduction in tax rate in the example set forth above,

the proportional reduction in the required pretax rate of return would be more than twice as great

in the high-tax country as in the low-tax country. Using the tax rates set forth in the example

above, assume that related party transactions allow for a 10 percent reduction in the tax rate in

both the high-tax country and the low-tax country. Thus, the rate of tax in the high-tax country is

reduced from 20 percent to 18 percent, and the rate of tax in the low-tax country is reduced from

10 percent to 9 percent. The required pretax rate of return in the high-tax country would

decrease from 12.5 percent to 12.2 percent, while the required pretax rate of return in the low-tax

country would only decrease from 11.1 percent to 11.0 percent. For small changes, this can be

expressed mathematically in the following manner: the proportional change in the required pretax

rate of return equals t/(1 - t) multiplied by the proportional change in the tax rate, where t is the

initial tax rate. 

Thus, there are two main pieces of information that are needed to evaluate how foreignto-foreign related party transactions65 might affect the global allocation of capital. These are the

effects of the transactions on the required pretax rates of return and the effects on investment in

the various locations. For example, if such transactions reduce tax rates on all foreign

investments below the rate in the United States (and pretax rates of return are thus lower abroad

than at home), and if the main effect on investment is to cause capital to flow from the United

States to the foreign locations, then they would worsen the global allocation of capital. In

contrast, if the transactions reduce tax rates only in countries where taxes are very high (and

pretax rates of return are high), and if the main effect on investment is to cause capital to flow to

these countries away from countries with lower tax rates (and with lower pretax rates of return),

then they would improve the global allocation of capital. There is a great deal of uncertainty

among economists about the mobility of U.S.-owned capital among foreign countries compared

with its mobility between the United States and foreign countries; none of the existing empirical

studies provide such a comparison.66 

It is not known how much foreign-to-foreign related party transactions might alter

required pretax rates of return on foreign investments, though it is reasonable to suppose that the

reduction in foreign taxes that can be accomplished through foreign-to-foreign related party

transactions depends on the initial foreign tax rate. Foreign-to-foreign related party transactions

probably reduce the tax rates by a smaller amount and, hence, reduce the required pretax rates of

return by less in the low-tax foreign countries than in the high-tax foreign countries.67

Accordingly, foreign-to-foreign related party transactions probably pull capital away from the

United States towards both high-tax and low-tax foreign locations and cause U.S.-owned capital

to flow from the low-tax foreign countries to the high-tax foreign countries. The pull on capital
- 50 -

68 This result is illustrated in the numerical example in the box on page 48, supra. 

69 According to data from the U.S. Department of Commerce, in 1994 U.S. manufacturing

parents had domestic assets of $1,164 billion, whereas foreign manufacturing affiliates of U.S.

parents had total assets of $678 billion. See U.S. Department of Commerce, U.S. Direct Foreign

Investment Abroad: 1994 Benchmark Survey, Final Results (1988).

away from the United States to the high-tax foreign countries should be stronger than the pull

away from the low-tax foreign countries to the high-tax foreign countries, because the required

pretax rate of return should decline by more in the high-tax foreign countries compared to the

United States (where it remains unchanged) than compared to the low-tax foreign countries

(where it also declines).68 

Further, the U.S. multinational companies hold much more capital in the United States

than in low-tax foreign countries. In 1994, U.S. manufacturing parents had about 37 percent of

their total manufacturing investment abroad. According to the data in Table 1, only about 10

percent of the foreign investment abroad was in countries with a tax rate of 12 percent or less.69

Thus, if investments in the different countries were equally substitutable (a somewhat arbitrary

assumption), the amount of U.S. domestic investment that would move to the high-tax foreign

countries as a result of effective tax rate changes caused by foreign-to-foreign related party

transactions would exceed the amount of U.S.-owned capital that would move to high-tax foreign

countries from the low-tax foreign countries. Further, there probably would be relatively little

U.S. domestic investment that would move to the low-tax foreign countries. This is because there

is relatively little capital in the low-tax foreign countries, and because the foreign-to-foreign

related party transactions should have little effect on the local required pretax rates of return in

these countries. 

Even if we accept these presumptions about the effects of the foreign-to-foreign related

party transactions, however, it would be difficult to say whether such transactions are more likely

to improve or worsen the global allocation of U.S. manufacturing assets.

C. The Effects of the Foreign-to-Foreign Related Party Rules on U.S. Tax

Revenue and on U.S. Domestic Economic Welfare

1. The Effects on U.S. Tax Revenue

In general, limiting deferral of the U.S. (residual) tax on foreign income would increase

U.S. tax revenue, whether or not it would encourage more domestic and less foreign investment. 

Taxpayers have argued, however, that foreign-to-foreign related party transactions are used only

to reduce foreign taxes and that such transactions actually may increase the U.S. tax revenue by

increasing the residual U.S. tax on repatriated foreign earnings. 

There are several reasons to believe that U.S. tax revenue will be reduced by allowing

taxpayers to defer income from foreign-to-foreign related party transactions, however. First, to

the extent that the foreign tax reductions cause capital to leave the United States in favor of tax-
- 51 -

70 See infra Appendix B (literature review on international capital mobility).

71 A recent study disputes the view that direct foreign investment outflows reduce investment

income subject to U.S. tax. Jason Cummins and Kevin Hassett have recently argued that a

reduction in foreign income taxes may actually cause U.S. multinational companies to expand

investment both at home and abroad. See Jason Cummins and Kevin Hassett, American

Enterprise Seminar Series in Tax Policy, Structural Estimates of Factor Substitution from FirmLevel Panel Data on Multinational Corporations (Feb. 19, 1999) (conference paper). The analysis

ignores the effects on other U.S. companies, however, that may lose investment opportunities to

the multinational companies benefitting from the foreign tax breaks. For example, suppose the

multinational companies expand mostly abroad, but sell most of the increased output in the United

States, displacing U.S. domestic production. Then the net result could be a loss in U.S. domestic

investment. 

72 It has been argued that foreign-to-foreign related party transactions affect only the average tax

rate on investment income and that they therefore do not affect the incentives to shift income,

which depend on the statutory tax rates at the origin and destination. This argument is incorrect. 

The following two examples show how the ability to use foreign-to-foreign related party

transactions encourages a U.S. company to shift income away from the United States, even

though there is no change in statutory tax rates at home or abroad. In the first example, the U.S.

company has a subsidiary in a country with a statutory tax rate higher than that in the United

States. The company would have an incentive to finance part of the subsidiary’s operations with

loans from the U.S. parent, giving interest income to the U.S. parent and an equivalent deduction

from taxable income to the subsidiary. If the company routed the loan through a subsidiary in a

tax haven, the interest payments would be subject to current U.S. tax under subpart F, so there is

no incentive for such routing. However, there is a clear incentive to route the loan through a

hybrid entity in a tax haven, one that appears for U.S. tax purposes to be a branch of the

subsidiary, but to the subsidiary’s host country appears to be a separately incorporated entity. In

this case, instead of generating interest income to the United States, the loan generates interest

income to the hybrid entity, and the income is not subject to current tax under subpart F. In the

second example, the foreign subsidiary effectively splits the profits from its operations with a

hybrid entity by paying a royalty for intangible assets the hybrid got by sharing development costs

with the U.S. parent. In this case, the effective tax rate on a dollar of profits shifted from the U.S.

parent to the subsidiary’s operations is an average of the statutory tax rates of the countries

hosting the subsidiary and the hybrid entity. Without a hybrid arrangement, the royalty payments

would be subject to current U.S. tax under subpart F. 

favored foreign investment opportunities, the transactions reduce total U.S. income and the U.S.

tax base. Though the degree of international capital mobility, and hence the amount of the capital

outflow, are subject to debate,70 taxes are one of many factors that may influence investment

flows.71 

Second, related-party transactions will lead to an increase in the number of locations in

which U.S. investment income faces a tax rate that is lower than the U.S. tax rate. Because

companies have an incentive to attribute as much of their income as possible to locations in which

it will face a lower tax rate,72 the increase in the number of low-tax locations will put additional
- 52 -

73

 See infra Appendix D (review of literature on international income shifting by multinational

corporations).

pressure on administration of U.S. transfer pricing rules. U.S. multinational corporations transfer

hundreds of billions of dollars of goods and services between related parties in the United States

and their foreign subsidiaries annually. Even a small change in the prices charged for these

transfers could create a substantial revenue loss to the United States. The opportunity to make

deductible payments (such as interest or royalty payments) to a low-tax location also reduces the

incentive to make such payments to the U.S. parent company. That U.S. companies appear to

engage in such tax minimization strategies is evident from readily observed tax planning activities

and, in addition, has been substantiated by a number of academic studies.73

Finally, the effects on U.S. tax revenue depend on how the transactions increase profits of

U.S. foreign subsidiaries, on how much of these profits are paid as dividends to U.S. investors,

and on how the U.S. residual tax affects repatriations to the U.S. parent. On average, however,

the residual U.S. tax on foreign source income in the general (“active”) basket is quite small,

suggesting that U.S. investors generally choose not to repatriate earnings if such repatriation will

result in a significant residual U.S. tax liability. Accordingly, it is likely that little revenue can be

expected from any reduction in foreign taxes that might occur as a result of foreign-to-foreign

related party transactions.

2. Effects on U.S. Economic Welfare

As is evident from the discussion in section III, there is no precise consensus among

economists on how best to structure U.S. taxes on foreign investment income when the goal is to

maximize the national economic welfare in the United States. There is, however, no convincing

evidence for the contention that the optimal tax structure would involve taxing foreign investment

income more lightly than domestic investment income. 

If the subpart F foreign-to-foreign related party rules were tightened to eliminate

opportunities for their avoidance, however, the effect that this greater enforcement of the rules

would have on the national U.S. economic welfare is also ambiguous. In the short run, real

investment may be largely unaffected by tightening the rules, in which case the main effect would

be to cause a transfer of revenue from U.S. companies to both the U.S. Government and to

foreign governments. In that case, however, the loss to U.S. companies that use the transactions

would be greater than the gain in U.S. tax revenue, because some companies would structure their

business without foreign-to-foreign related party transactions, thus causing them to pay greater

foreign tax. 

In the long run, however, tightening the foreign-to-foreign related party rules would cause

companies to choose U.S. investment rather than foreign investment, which could produce a net

national gain in economic welfare. The gain would come partly from greater productivity of U.S.

labor, which would accompany the greater domestic investment, and partly from greater U.S. tax

collections (in place of foreign tax collections) on U.S. investment income. 
- 53 -

74 Horst, supra note 13; Devereaux and Hubbard, supra note 47.

75 Hufbauer, supra note 44, and Frisch, supra note 29.

76 Richman, supra note 4; Musgrave, supra note 4; and Hufbauer, supra note 26.

V. Conclusions Relating to Economic Welfare and the Taxation of Foreign Income

A principal goal of subpart F was to promote economic efficiency by preventing U.S.

companies from shifting income away from the United States or from other non-tax-haven

countries to foreign tax havens. This chapter considered whether preventing income shifting from

the United States or other non-tax-haven jurisdictions to foreign tax havens is still a valid

economic goal and how well subpart F (as an economic matter) actually achieves this goal. To do

this, the chapter first examined what is known about the best way to tax international investment

income. It then looked at the narrower question of how the subpart F foreign-to-foreign related

party rules likely affect economic welfare.

A basic economic analysis indicates that capital export neutrality is probably the best

policy for promoting economic efficiency in a tax system that includes taxes on income of capital. 

This standard analysis makes a number of perhaps overly simplistic assumptions in order to

facilitate a rigorous analysis. Researchers advanced our understanding of this issue by examining

whether the conclusions of the standard analysis are sensitive to changes in the assumptions or the

structure of the economic model. A careful review of the literature finds that the implications of

the standard analysis are robust. Previous studies that concluded that foreign investment income

should be taxed at a lower rate than domestic investment income typically have embedded in them

unjustified implicit assumptions about constraints on tax policy. In certain studies, for example,

the tax rate on domestic investment income is fixed and only the tax rate on foreign investment

income can be changed, and factor incomes besides capital income are not taxed.74 Other studies

assume that the development of new technology is not sufficiently promoted through current U.S.

tax treatment of research and development expenditures and that there is no more efficient means

of promoting research and development other than reducing the tax rate on international

investment income.75 Absent such constraints, there appears to be little reason to abandon the

conclusions from the simple, standard analysis, which concludes that foreign investment income

should be taxed no lower than domestic investment income.76

Whether the goal of U.S. tax policy is to maximize the global or the national U.S.

economic welfare, it generally would be beneficial to reduce the disparities in tax rates that cause

investment income earned in foreign countries to be taxed at lower rates than investment income

earned in the United States. This reduction in tax rate disparities should improve the allocation of

capital by encouraging it to move to locations where the pretax rate of return is higher. In

general, reducing such tax rate disparities where they are greatest (in most cases, where the

foreign tax rates are lowest) is even more likely to improve global and U.S. economic welfare. 

On the other hand, the current subpart F foreign-to-foreign related party rules may not in

every case be the most effective way to increase global and U.S. economic welfare. Application
- 54 -

of the foreign-to-foreign related party rules tends to raise the overall tax by more for investments

in high-tax foreign countries than for investments in lower-tax foreign countries. Allowing U.S.

companies to reduce foreign tax burdens through foreign-to-foreign related party transactions

would have an uncertain effect on the global allocation of capital and U.S. economic welfare. The

result depends on how the foreign-to-foreign related party transactions reduce the variation in

effective foreign tax rates, how much they reduce the overall level of these tax rates, and the

response of international investment flows.

The effect of the subpart F foreign-to-foreign related party rules on tax revenue, however,

must also be considered. Because foreign-to-foreign related party transactions reduce foreign

taxes, these transactions make foreign investments more tax-favored. To the extent foreign tax

reductions provide an incentive for capital to move abroad, limiting deferral on income from

foreign-to-foreign related party transactions protects the U.S. tax base. 
1

 In a 1991 committee print prepared for hearings before the House Ways and Means Committee

on U.S. international competitiveness, the Joint Committee on Taxation identified three

definitions of the term competitiveness: trade competitiveness; standard of living competitiveness;

and multinational competitiveness. 

 The JCT defined “trade competitiveness” as “the ability of firms located in the United States to

sell their output in foreign markets and to compete in domestic markets with output produced in

foreign countries.” This definition measures competitiveness by the trade deficit. 

 The second definition identified was “standard of living competitiveness,” which measures

competitiveness by comparing the current and projected future U.S. standard of living with

standard of living data from other countries. The most important factors in this determination are

the productivity growth of U.S. labor and the saving rate of the United States. 

 The third definition was “multinational competitiveness.” This measures competitiveness

by examining the ability of U.S. firms headquartered in the United States with production facilities

abroad to compete in foreign markets with residents of the host country and other multinational

firms based elsewhere. See Staff of the Joint Committee on Taxation, Factors Affecting the

International Competitiveness of the United States, Scheduled for Hearings before the Committee

on Ways and Means on June 4-6 and 18-20 and July 16-18, 1991, 7-8 (1991).

 Of these three types of competitiveness, standard of living competitiveness is most closely

related to the concepts of global and national economic welfare discussed in Chapter 3. Thus,

policies that maximize standard of living competitiveness would likely be very similar to policies

that maximize economic welfare. Policies that focus exclusively on maximizing trade

competitiveness or multinational competitiveness, by contrast, might not necessarily lead to

improvements in global or national economic welfare. For purposes of this study, however,

references to “competitiveness” refer to multinational competitiveness, which is the definition of

competitiveness most often used by the business community in discussing subpart F and is also the

definition that was considered most relevant in the 1962 congressional discussions that led to the

enactment of subpart F. 

- 55 -

CHAPTER 4

COMPETITIVENESS AND THE TAXATION OF FOREIGN INCOME

I. Introduction

When subpart F was enacted, consideration was given not only to its effect on economic

welfare but also its effect on the competitiveness of U.S. business.1 Given the focus on

multinational competitiveness when subpart F was enacted, this chapter evaluates whether subpart

F has materially affected the competitiveness of U.S. business and, in particular, whether subpart

F places U.S.-owned foreign corporations at a tax disadvantage with regard to their foreignowned competitors. For purposes of this chapter, competitiveness is defined as a measure of the

ability of firms headquartered in the United States with production facilities abroad to compete in

foreign markets with residents of the host country and other multinational firms based elsewhere. 

Concerns about competitiveness may conflict with overall economic welfare goals. For example,
- 56 -

2 See 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 (December

11, 1998).

3 See International Institute for Management Development, 2000 World Competitiveness

Yearbook, available at <http://www.imd.ch>, discussed in note 7, infra.

4

 National Foreign Trade Council, The NFTC Foreign Income Project: International Tax Policy

for the 21st Century, Part One: A Reconsideration of Subpart F, at xxii (Washington, 1999)

(“NFTC Study”).

5 The Global 1000, The World’s Most Valuable Companies, Bus. Week 107, 111, 138 (July 10,

2000). By contrast, the countries with the next highest number of companies in the top 100 and

1000 companies were Great Britain and Japan, respectively. Nine British companies were in the

top 100 and 149 Japanese companies were in the top 1000. Id. at 111, 120-22. 

6

 G. Morgenson, Dow Finishes Day over 10,000 Mark for the First Time, N.Y. Times, Mar. 30,

1999, §A, at 1. See also Sinking in Sync: The Global Slowdown Surprises Economists and

Many Companies, Wall St. J., Dec. 21, 2000 at A1 (noting that U.S. GDP accounts for almost 30

percent of world output, up from 26 percent in 1992, and U.S. companies now make up almost

half of all world corporate profits, a 33 percent increase from 1990). 

7

 Overall it seems that on many criteria the United States ranks high in overall competitiveness. 

For example, in two significant surveys of global competitiveness -- the World Competitiveness

the conclusions reached in the prior chapter suggest that a policy that enhances the ability of

domestic companies to compete abroad by subjecting their income from foreign investment to a

lower rate of tax than their income from domestic investment could cause a decrease in overall

economic welfare. Consequently, possible effects on competitiveness must be balanced against

other important factors that must be considered in formulating U.S. international tax policy.2 

II. Has Subpart F Affected Competitiveness?

Multinational competitiveness – the ability of U.S.-owned multinationals to compete with

foreign-owned multinationals – is an amalgam of many factors, only a few of which relate to tax. 

For example, to rank the competitive position of 47 countries for its 2000 global survey, the

Institute for Management Development studied 290 separate factors, of which 14 related to tax.3

It is questionable whether any single feature of a tax system is likely to have a significant effect on

multinational competitiveness. Further, selective use of the available data can give a misleading

impression. For example, it has been noted that in 1960, 18 of the world’s 20 largest

corporations ranked by sales were U.S.-headquartered and that by 1996, this figure had fallen to

8.4 However, a different benchmark can lead to a markedly different conclusion. For example, as

of July 2000, the world’s top 5 companies, 61 of the world’s top 100 companies and 484 of the

world’s top 1000 companies, based on market value, were U.S. corporations.5 Further, U.S.

corporations’ share of worldwide profits rose during the last decade, from 36 percent in 1990 to

44percent in 1998.6 Additionally, the United States, as a general matter, is agreed by almost any

measure to be one of the most competitive countries in the world.7
- 57 -

Yearbook (The World Competitiveness Yearbook 2000, available at <http://www.imd.ch>) and

the World Economic Forum’s Global Competitiveness Report (World Economic Forum, Global

Competitiveness Report (2000), available at <http://www.weforum.org.> (WEF Report)) -- the

United States ranked first and second, respectively. Further, the WEF Report indicates that U.S.

competitiveness is improving: ranked fourth in the world in 1996, the United States improved to

third in 1997 and second in 1999.

8

 In 1996, the average foreign tax rate on such U.S. overseas operations was 10 percentage points

below the average U.S. tax rate on similar domestic investment (21 percent versus 31 percent). 

See supra Chapter 3, section IV.B.1; see also infra Appendix C.

9

 In 1998, United States tax as a percentage of GDP was 28.9%, compared with, for example,

Germany at 37.0% and France at 45.2%. Organization for Economic Co-operation and

Development, Revenue Statistics 1965-1999, at 66 (2000). Moreover, other countries do appear

to regard the U.S. tax system, as a general matter, to impose a lighter tax burden than other

systems. See, e.g., Terence Roth, Paradigm Gained: New Economy Spurs Germany to Break its

Corporate Mold, Wall St. J. Eur., Jan. 28, 2000, available in 2000 WL-WSJE 2944145 (quoting

These statistics, however, provide little evidence about the impact of subpart F on

multinational competitiveness. As noted above, competitiveness depends on many factors, only a

few of which relate to tax. Many non-tax factors could have influenced these figures, such as the

openness of foreign markets and the degree of regulation to which American-owned companies

are subject. Indeed, the available data simply do not provide a reliable basis for evaluating whether

subpart F has affected multinational competitiveness to any significant extent. 

III. Has Subpart F Substantially Affected Comparative Tax Burdens of U.S.

Multinational Corporations?

A. Introduction

Although the available data do not support the conclusion that subpart F has had a

significant effect on competitiveness, some have argued that the U.S. subpart F regime is more

stringent than that of other countries and must necessarily disadvantage U.S.-owned foreign

corporations. This section first considers whether subpart F has materially affected comparative

tax burdens, based on a comparison of tax rates, an admittedly difficult exercise. The section next

examines current trends among foreign countries in addressing the issue of deferral to determine

whether subpart F is consistent with international norms. 

B. Tax Rate Comparison

The available data allow only certain tax rate comparisons. For example, it is possible to

determine the foreign effective tax rates of U.S.-owned foreign corporations. Significantly, these

rates are consistently lower than the effective rates for domestic corporations.8 In addition, the

Organization for Economic Cooperation and Development (OECD) gathers data to determine the

rates of tax in each OECD country as a percentage of GDP. Based on these statistics, the United

States has one of the lowest rates of tax as a percentage of GDP of any OECD country.9
- 58 -

German Finance Minister Hans Eichel as saying: “With the many trans–Atlantic companies now,

we need to be able to compete with the U.S.A. in corporate taxation, or investment will pass us

by.”).

10 As of November, 2000, the following countries, in addition to the United States, had CFC

legislation: Germany (1972); Canada (1972); Japan (1978); France (1980); United Kingdom

(1984); New Zealand (1988); Sweden (1990); Australia (1990); Norway (1992); Finland (1995);

Spain (1995); Indonesia (1995); Portugal (1995); Denmark (1995); Korea (1996); Hungary

(1997); Mexico (1997); South Africa (1997); Estonia (2000); Italy (2000). In addition, Israel is

currently considering CFC legislation. See Joel Lubell, Israeli Finance Minister Presents Second

Revised Tax Reform Proposal, 2000 Tax Analysts Worldwide Tax Daily, Oct. 17, 2000; available

in 2000 WTD 201-4.

11

 See Brian Arnold, Taxation of Controlled Foreign Corporations: An International Comparison, 

40-41 (Canadian Tax Paper No. 78, 1986). 

However, it is hard to compare the tax rates on income from direct U.S. investment in facilities

located outside the United States to the tax rates on income from investment in such facilities

made by non-U.S. persons. This comparison requires that income be measured in the same way

for both foreign and U.S. companies. Foreign and U.S. tax laws have different definitions of

income, allow different deductions and require different accounting methods, resulting in both

differences in income amount and differences in income timing. When income is computed

differently, comparing the effective income tax rates of U.S. and foreign companies will not

accurately reflect the effect of taxes on competitiveness. In short, available data do not allow for

an accurate and comprehensive comparison of effective income tax rates of U.S. companies with

the effective income tax rates of their foreign competitors. 

C. Tax Regime Comparison

In light of the difficulty of directly comparing the tax burden of U.S. and foreign firms

investing abroad, another factor to indicate whether subpart F imposes a competitive burden on

U.S. multinational corporations is the extent to which subpart F is consistent with current

international trends.

When subpart F was enacted in 1962, no other country had a similar anti-deferral regime. 

Currently, virtually all major U.S. trading partners have enacted controlled foreign corporation

(CFC) legislation.10 When subpart F was enacted, U.S. tax rates were high relative to the tax

rates in most other countries, foreign direct investment by residents of the United States

accounted for over half of total international direct investment flows,11 and the United States was

committed to a policy of free trade that foreclosed the possibility of controlling foreign investment

through exchange controls. By contrast, at that time, most other developed countries had

exchange controls that allowed them to monitor foreign direct investment and thus limit the extent
- 59 -

12 See Revenue Act of 1962, Hearings before the Committee on Finance on H.R. 10650, 87th

Cong., 2d Sess. (Part 1) 102, 201 (1962).

13 For example, the United Kingdom suspended currency controls in 1979 (and subsequently

repealed them).

14

 See Daniel Sandler, Tax Treaties and Controlled Foreign Company Legislation, Pushing the

Boundaries 9-11 (2d ed.1998) (Sandler).

15 Organization for Economic Cooperation and Development, Studies in Taxation of Foreign

Source Income, Controlled Foreign Company Legislation, at 18 (1996). For example, the United

Kingdom began work on CFC legislation soon after it suspended exchange controls in 1979 and it

enacted its CFC legislation in 1984. Sweden’s exchange controls expired in 1989 and its CFC

legislation became effective January 1, 1990. South Africa enacted CFC legislation that targeted

investment income in 1997 when it relaxed certain exchange controls and adopted worldwide

taxation for investment income.

16 See Sandler, supra note 14, at 12-13, Table 2.

17 Japan was the first country to adopt this “all or nothing” approach, in 1978.

to which tax havens could be used to defer or avoid domestic tax.12 Thus, in 1962, most other

countries did not need anti-deferral rules to discourage tax motivated offshore investments. 

Within the last two decades, most developed countries have eliminated or relaxed

exchange controls,13 allowing capital to flow offshore. During this period, there has been a

corresponding increase in CFC legislation. Although many different factors have influenced

countries’ decisions to enact CFC legislation, common factors have included: substantial

disparities between the tax rates in those countries and the rates in many capital-importing

countries, a high rate of foreign direct investment, and a lack of exchange controls or other

impediments to the flow of capital abroad.14 When these conditions exist, tax base erosion

becomes a concern. A 1996 OECD study of CFC legislation in 14 OECD countries concluded

that the elimination of foreign exchange controls motivated most of these countries to adopt CFC

legislation.15 Significantly, 15 of the 21 countries that have adopted CFC legislation were among

the 25 jurisdictions with the highest average foreign direct investment outflows between 1990 and

1994.16

Generally, CFC legislation has taken one of two basic approaches. One approach, which

is often referred to as the transactional approach, ends deferral only for certain types of tainted

income, generally passive income and base company income. A second approach, referred to as

the entity approach, ends deferral for all of the income of the CFC, but only if certain conditions

are present.17 These conditions may include, for example, that the CFC is a resident of a tax

haven, that its income is taxed below a certain rate, or that a certain percentage of its income is

from tax haven-type activities. Only seven countries, including the United States, use a
- 60 -

18 Germany, Canada, Australia and Spain use a transactional approach that targets specific types

of income. Denmark and South Africa target only passive income. Under South Africa’s recent

proposal to tax residents on their worldwide income, however, the CFC regime would be

expanded to impute all income of the CFC to resident owners.

19 For a description of the new U.K. CFC provisions, see John Mongan and Michael GordonBrown, U.K. CFC Regime Enters Self-Assessment Era, 19 Tax Notes Int’l 1046 (1999). The

U.K. also announced in its 2000 budget that it would lower the required ownership threshold for

CFC status from more than 50% to 40% in some circumstances. See Michael Swanick, Stephen

N. Mosha and Justin O’Hagan, The Impact of the U.K. Budget 2000 on U.S. Multinationals, 29

Tax Mgmt. Int’l J. 463 (2000). 

20 Section 107 of the Finance Act of 1992 (modifying section 209B of the French Tax Code). See

Patrice Lefevre-Pearon, French CFC Rules- New Guideline, 25 Tax Plan. Int’l Rev., at 3 (August

1998).

21 The new category of tainted income, called income with capital investment character, is subject

to current inclusion in the gross income of 10% German shareholders (even if the foreign

corporation is not German-controlled) if income with capital investment character (generally

portfolio income) is more than 10% of the foreign corporation’s gross income or DM120,000 and

certain other conditions are met. See Juergen Killius, 962 Tax Management, Foreign Income,

Business Operations in Germany A-73 (1996).

22 Section 94, Income Tax Act, RSC 1985, c.1 (5th Supplement), as amended (“ITA”).

23 See ITA §95.

24 See Sandler, supra note 14, at 27.

25 See Way, Brockman, Otsuka & Takagi, 969 Tax Management, Foreign Income, Business

Operations in Japan A-68 (1999).

transactional approach targeting specific types of income.18 The remaining countries apply some

variation of the second approach.

Many of the countries that have enacted CFC laws have found it necessary to tighten their

rules after enactment. For example, the United Kingdom amended its laws, effective July 1, 1999,

to make its CFC laws apply automatically, rather than at the discretion of the Inland Revenue.19 

France amended its CFC regime in 1992 to lower the ownership threshold for attribution from

25% to 10% or an ownership interest greater than or equal to FF150 million and to make the CFC

regime applicable to permanent establishments of French corporations in the same manner as

foreign subsidiaries.20 Germany also amended its CFC provisions in 1992 to add a new category

of tainted income.21 Canada added rules similar to the U.S. PFIC rules in 198422 and, in 1995, it

amended certain definitions to expand the class of income subject to current inclusion under its

CFC regime.23 Japan amended its CFC rules in 1992. Prior to 1992, Japan used a list of tax

haven countries to determine when income was attributed.24 The 1992 amendment replaced the

tax haven list with an effective tax rate test and lowered the ownership threshold for attribution

from 10% to 5%.25
- 61 -

26 Organization for Economic Cooperation and Development, Harmful Tax Competition: An

Emerging Global Issue (1998). Although a full explanation of the OECD HTC Report and the

implementing work being conducted by the member countries is beyond the scope of this report,

the principal goal of the OECD's efforts is to eliminate harmful tax competition, both in member

and non-member countries. See supra Chapter 2, note 12.

The OECD's Report on Harmful Tax Competition (OECD HTC Report) provides another

indication that the international community views effective CFC legislation as important.26 To

address the effects of harmful tax competition, the OECD HTC Report recommends that member

states take certain unilateral, bilateral and multilateral measures. One of the recommendations in

the OECD HTC Report is that countries without CFC legislation adopt such rules, and countries

with CFC legislation expand their existing rules to apply them in a manner that reduces the effects

of harmful tax competition. 

A review of the trends in CFC legislation thus indicates that the concerns about deferral

that made the enactment of subpart F necessary in 1962 have since become relevant in many other

countries as capital barriers have been removed and business has become more international. 

While the specific provisions of each country’s CFC legislation differ, the overall trend indicates

that other countries are increasingly finding it necessary to enact legislation that, like subpart F,

limits deferral of foreign-earned income.

IV. Conclusion on Competitiveness and the Taxation of Foreign Income

Although competitiveness concerns were considered relevant when subpart F was enacted

and continue to be cited in more recent discussions on deferral, the available data provide no

reliable basis for evaluating whether subpart F has had a significant effect on multinational

competitiveness. However, the fact that many countries have recently introduced or strengthened

their CFC regimes suggests that the U.S. policy limiting the deferral of income earned by U.S.-

owned foreign corporations is fully consistent with the policies of our major trading partners and

that foreign multinational corporations are subject to rules that are similar in effect to our subpart

F rules. 
1

 Generally, an entity taxed as a corporation in a foreign jurisdiction but treated as a partnership or

disregarded entity for U.S. tax purposes is referred to as a “hybrid.” An entity taxed as a

partnership or other passthrough in a foreign jurisdiction but treated as a corporation for U.S. tax

purposes is referred to as a “reverse hybrid.” 

- 62 -

CHAPTER 5

AVOIDING THE RULES OF SUBPART F

I. General

Previous chapters have discussed the principal factors that influenced the enactment of

subpart F. These were, principally, preventing tax haven abuse, taxing passive income currently,

promoting equity among taxpayers, promoting economic efficiency and avoiding undue harm to

competitiveness. 

The purpose of this chapter is to examine generally the effectiveness of the specific rules

of subpart F in meeting these goals. Subpart F attempts to achieve its goals through specific rules

that are intended to tax passive income on a current basis and to prevent the deflection of income

to low-tax jurisdictions and other special tax regimes. This chapter considers two illustrative

categories of transactions that avoid the application of those specific rules.

II. Illustrations of Techniques to Avoid Subpart F

A. Hybrid Entity Techniques

The rules of subpart F are largely premised on the assumption that for non-tax reasons

business will be carried on in corporate form (e.g., to limit liability). Even if this assumption still

holds true in the foreign context, it is no longer true in the United States. As a result, subpart F

can be avoided by planning techniques that exploit both the corporate focus of the subpart F

related party rules and the failure of subpart F to address directly inter-branch passive income

payments. These tax avoidance techniques generally involve the use of hybrid entities. A hybrid

entity is an entity that is classified differently for U.S. tax purposes than it is classified for foreign

tax purposes.1

For example, the foreign personal holding company income (FPHCI) rules that relate to

the receipt of passive income, such as interest, do not expressly deal with payments between

“branches” of a single corporation, even if for foreign law purposes the CFC and branch are

respected as two separate entities. The foreign base company sales income (FBCSI) rules, by

contrast, treat a branch of a single corporation as a separate entity in certain circumstances in

order to prevent the deflection of income to a low-tax jurisdiction. This disparity in treatment

between the FPHCI rules and the FBCSI rules can lead to seemingly inconsistent results. For

example, if sales income is shifted from one CFC to a related CFC in a different jurisdiction,
- 63 -

2

 Proposed regulations under section 954 would tax certain hybrid transactions described in this

section. However, such regulations will not have effect until after July 1, 2005, at the earliest. 

See 64 Fed. Reg. 37727 (July 13, 1999).

subpart F income (i.e., FBCSI) may arise. Similarly, if sales income is shifted from one CFC to its

branch in a different jurisdiction, FBCSI may also arise, because the branch may be treated as a

separate corporation under the FBCSI rules. If income is shifted through interest payments from

one CFC to a related CFC in a different jurisdiction, subpart F income (i.e., FPHCI) may arise. If,

however, income is shifted through interest payments from one CFC to its hybrid branch in a

different jurisdiction, subpart F income currently will not arise.2 Given the outcome in the first

three situations, the final result seems anomalous.

The examples below illustrate how hybrid entities have been used to deflect income from a

high-tax jurisdiction to a low-tax jurisdiction and exploit the same country exceptions to the

FPHCI rules.

1. Use of Hybrids to Deflect Income from High-Tax Jurisdictions to

Low-Tax Jurisdictions

A number of hybrid arrangements involve related party payments the purpose of which is

to deflect income from a high-tax jurisdiction to a low-tax jurisdiction while avoiding subpart F. 

For example, assume a U.S. person wholly owns an operating CFC (“CFC1”) in Country A, a

high-tax jurisdiction. To deflect operating income from Country A (where it would be subject to

a high tax) to Country B, a low-tax jurisdiction, the U.S. person could cause CFC1 to establish an

entity (“BR1”) in Country B that would be treated as a corporation in Country A but would be

disregarded for U.S. tax purposes. The U.S. person would then cause BR1 to make a loan to

CFC1. Because Country A would treat BR1 as a corporation, the interest payments from CFC1

to BR1 would be deductible in Country A and, therefore, would reduce the amount of CFC1

operating income that otherwise would be subject to the high tax imposed by Country A. 

Because Country B is a low-tax jurisdiction, the interest payments received by BR1 from CFC1

would be subject to little or no tax in Country B. Finally, because the United States would treat

BR1 as a disregarded entity for U.S. tax purposes, the taxpayer would take the position that the

interest payment between CFC1 and BR1 should be disregarded for U.S. tax purposes, and thus

should not be subpart F income. Accordingly, by exploiting the difference in the U.S. tax

treatment of corporations and disregarded entities, as well as differences in entity classification

among different jurisdictions, the U.S. person takes the position that it is able to deflect operating

income from a high-tax jurisdiction to a low-tax jurisdiction while avoiding the application of the

subpart F rules.

2. Use of Hybrids to Shelter Income From Current Tax in All

Jurisdictions

Hybrid arrangements also have been used to shelter income from taxation in any

jurisdiction. This can be accomplished without the need to deflect the income to a tax haven or

other low-tax jurisdiction. For example, assume a U.S. person owns an operating CFC (“CFC1”)
- 64 -

3

 If the principles of the recent OECD report on partnerships were applied, this might not be the

case. See The Application of the OECD Model Tax Convention to Partnerships (1999).

4

 I.R.C. § 954(c)(3)(A)(i) exempts from FPHCI dividends and interest received from a related

corporation organized under the laws of the same country as the recipient, provided that the

related payor corporation has a substantial part of its assets used in a trade or business in the same

foreign country.

5

 I.R.C. § 954(c)(3)(A)(ii) provides a similar exemption from the FPHCI rules for rents and

royalties received from a related corporation for the use of property within the country in which

the recipient is organized. 

in Country A, a high-tax jurisdiction. To shelter CFC1’s operating income from country A tax

and to avoid subpart F, the U.S. person could establish a reverse hybrid in Country A (“FP1”)

(i.e., an entity that would be treated as a partnership in Country A and a corporation in the United

States). FP1 must be engaged in a trade or business located in Country A. The U.S. person

could then contribute cash to FP1, and cause FP1 to make a loan to CFC1. CFC1 should get a

deduction in Country A for the interest paid to FP1 thereby reducing the amount of CFC1

operating income that otherwise would be subject to high Country A tax. Because, for purposes

of Country A tax, FP1 is a transparent entity, no entity level tax would be imposed on FP1 on the

interest paid to it. Instead, Country A would treat the interest paid to FP1 as actually paid to the

U.S. shareholder. Assuming Country A has an income tax treaty with the United States (and that

the interest paid to FP1 would qualify for treaty benefits3), this interest likely would be subject to

little or no withholding taxes in Country A. Finally, because the United States would treat FP1 as

a Country A corporation, the interest payment between CFC1 and FP1 would not be subpart F

income, pursuant to the same country exception in section 954(c)(3)(A)(i).4 

A U.S. person could achieve the same result by using other deductible payments such as

royalties.5 Thus, by exploiting (1) the difference in the tax treatment of corporations and

partnerships, (2) differences in entity classification among jurisdictions, and (3) the same country

exceptions to the FPHCI rules in section 954(c)(3)(A), a U.S. person is able to use hybrid

structures to shelter foreign source income from current tax in any jurisdiction.

B. Manufacturing Exception to FBCSI

As previously noted, FBCSI is income of a CFC from the sale of personal property that is

purchased from, or on behalf of, or sold to, or on behalf of, a related person where the property is

both manufactured and sold for use outside the CFC’s country of incorporation. If the CFC

manufactures the property that it sells, the sales income generally will not be subject to the FBCSI

rules. The FBCSI rules are intended to prevent the deflection of income from the jurisdiction in

which the goods are manufactured to a low-tax jurisdiction. Thus, when the manufacturing is

carried on by related corporations, the FBCSI rules often will apply. Further, the FBCSI

provisions contain a branch rule, which provides that, even when both the manufacturing and sales

activities are conducted by the CFC, the FBCSI rules may apply if the sales and manufacturing

activities are conducted in separate tax jurisdictions and the effective rate of tax imposed on the
- 65 -

6

 This example is based on the facts of Vetco v. Commissioner, 95 T.C. 579 (1990).

sales income is significantly lower than the rate that would be imposed on such income if the sales

income were subject to tax in the jurisdiction where the manufacturing activities occurred.

One weakness of the FBCSI rules is that they may not apply to some types of transactions

through which income from the sale of goods manufactured in a high-tax jurisdiction can be

diverted to a low-tax jurisdiction, such as certain transactions in which there are no purchases or

sales involving related persons. These transactions are illustrated below.

1. Contract Manufacturing

The first technique relies upon the focus in the FBCSI rules on the owner of the property

being sold. Thus, if at all stages in the acquisition, production, and disposition of the property

from or to unrelated persons, only one CFC holds title to the property (although others may be

involved in manufacturing the property to be sold), then the FBCSI rules will never apply. This is

because there will have been no sale to, from, or on behalf of a related person.

Assume CFC2, a contract manufacturer, is related to CFC1, the selling CFC. CFC1 holds

title to raw materials that are being processed by CFC2, and CFC1 pays CFC2 for processing

them. CFC2 is incorporated and has its operations in a high-tax jurisdiction, while CFC1 is

incorporated and has its operations in a low-tax jurisdiction. The processing takes place outside

of CFC1's country of incorporation. CFC1 purchases the raw materials from an unrelated party

and sells the finished goods to an unrelated party outside CFC1’s country of incorporation. If

CFC1 had instead sold raw materials to CFC2 and then repurchased the manufactured goods from

CFC2, or if CFC1 had purchased finished goods from CFC2, CFC1's resulting sales income would

have been FBCSI. 

However, in this case, the taxpayer takes the position that subpart F does not apply to

CFC1 because there has been no sale to, from or on behalf of a related person. This is despite the

fact that the group of related corporations has managed to reduce income in a high-tax

jurisdiction by splitting off the sales profit into CFC1 and reducing the manufacturer’s profit in

CFC2 (for example, to a small mark-up over costs). Thus, the sales profits have been diverted

within the group to an entity (CFC1) in a low-tax jurisdiction, in the manner that the FBCSI rules

were intended to prevent.6

 The taxpayer might also take the position that the amounts paid to

CFC2 are not foreign base company services income because the goods are manufactured (and

hence the manufacturing services are performed) in the country where CFC2 is incorporated.

2. Commissionaire Arrangements

Another technique to avoid subpart F involves so-called “commissionaire” arrangements. 

In these arrangements, a subsidiary earns commission income for arranging the sales of goods,

rather than taking title to the goods and selling them for a profit. 
- 66 -

Assume CFC1 (often called the “principal”), incorporated and operating in Country A, a

low-tax jurisdiction, owns CFC2 in Country B and CFC3 in Country C. CFC2 manufactures a

product in Country B, a high-tax jurisdiction, from raw materials the supply of which is arranged

by CFC1. CFC1 at all times keeps title to the raw materials. CFC3 “arranges” the sale of the

product in Country C, another high-tax jurisdiction. CFC2 and CFC3 are both compensated for

their costs plus a small mark-up. In this way, most of the profit is kept by CFC1 in the low-tax

jurisdiction. As discussed above, the use of the contract manufacturer (CFC2) in this structure

allows CFC1 to reduce CFC2's manufacturing profit to a small mark-up over cost and to shift

much of the profit to CFC1. The use of the commissionaire (CFC3) allows for an additional

shifting of income to CFC1, thereby enabling CFC1 to keep more profit than it would in a buy-sell

arrangement (i.e., an arrangement in which CFC3 took title before selling the goods and, thus,

arguably, as an economic matter, was entitled to additional profits to reflect the risk of loss, etc.). 

In such a case, the taxpayer might assert that: (a) the sales revenue received by CFC1 is

not FBCSI because the income arises from sales of products that were neither purchased from,

nor sold to, related persons; (b) the cost-plus amount paid to CFC2 is not FBCSI or foreign base

company services income because the goods are manufactured (and hence the manufacturing

services are performed) in the country where CFC2 is incorporated; and (c) the commission

income of CFC3 is not FBCSI or foreign base company services income, because the fees are for

arranging sales for the use, consumption or disposition of the property in CFC3's country of

incorporation. If successful, CFC1 will have shifted income both from the country of manufacture

(i.e., from CFC2) and the country of sale (i.e., from CFC3) to its home country, a low-tax

jurisdiction.

3. Avoiding Application of Foreign Base Company Rules by Using Dual

Resident Corporations

Another technique provides taxpayers with the opportunity to argue for the benefits of

both contract manufacturing and commissionaire arrangements while avoiding subpart F treatment

if the manufacturing country determines tax residence based on something other than the place of

incorporation. 

Assume that CFC2 is a manufacturing corporation incorporated in Country A, a high-tax

jurisdiction. The U.S. parent forms a sister corporation, CFC1, which is a Country A corporation

but non-resident for purposes of Country A’s laws (e.g., because it is managed and controlled in

another country). CFC1 enters into a contract manufacturing arrangement for CFC2 to

manufacture goods from raw materials that CFC1 purchased from the U.S. parent and provided

to CFC2 (thus leaving less profit in CFC2). CFC1 can then sell through a commissionaire (or

branch) established in the country of sale. 

CFC1 will not be taxed on its sales profits in Country A because Country A treats it as a

non-resident. U.S. tax law treats CFC1 as a Country A corporation because it was incorporated

in Country A. For the FBCSI rules to apply, the sales income would have to be derived in

connection with the sale of products both manufactured and sold for use outside CFC1's country

of incorporation (Country A). A taxpayer might take the position that CFC1's sales income is not
- 67 -

FBCSI because the income is derived from the sale of products manufactured in Country A. In

this case, CFC2 will have reduced its tax in country A without corresponding subpart F income in

the hands of CFC1 because of arbitrage between the U.S. and foreign determination of where the

corporation resides.

III. Is Subpart F Still Effective?

The examples in this chapter show that it may be possible to circumvent crucial provisions

of subpart F. In these cases, subpart F may no longer effectively prevent deflection of income. 

The next chapter examines challenges that subpart F faces now and will face in the future.
1

 The entity classification rules of Treas. Reg. §§ 301.7701-1 through -3, popularly known as the

“check-the-box” regulations, allow many entities to elect to be treated as associations taxable as

corporations, partnerships, or disregarded entities (i.e., branches). This is done by checking a box

on Form 8832, rather than by a legal change in corporate status.

2 See infra Appendix A, part 2, section III.B. (prior to Rev. Rul. 88-76, achieving limited liability

outside of corporation/association status was relatively difficult).

- 68 -

CHAPTER 6

CHALLENGES TO SUBPART F: ENTITY CLASSIFICATION, SERVICES AND 

ELECTRONIC COMMERCE

I. Introduction

The last chapter described how parts of subpart F may now be avoided, particularly by the

use of hybrid entities. The creation of these hybrid entities are facilitated by changes in the federal

tax entity classification rules. However, changes in the entity classification rules are not the only

changes that have challenged the current rules of subpart F. The nature of business is also

changing. Subpart F was designed and enacted in the 1960s when the foreign business paradigm

was a manufacturing plant. Since that time, however, services activities have grown significantly

as a percentage of the overall U.S. economy, and this growth appears likely to continue. The

treatment of services under subpart F is already posing a number of challenges to subpart F. 

Further, it is possible now to perceive some of the challenges to subpart F that will be posed by

electronic commerce.

II. Impact of the Check-The-Box Entity Classification Rules1

A. General

As described above, subpart F applies almost exclusively to transactions between one

corporation and another. This in part is a reflection of business conditions that existed in 1962

(when subpart F was enacted), when most U.S. businesses operating abroad chose (or in some

cases, for local law reasons, were required) to operate in corporate form. However, it also

reflects an assumption that the entity classification rules of the Internal Revenue Code would

work in a certain way. For example, at the time, it was assumed that foreign limited liability

entities would be treated as corporations both by the United States and by the foreign country of

incorporation.2 This assumption is no longer valid.

 The most important development in foreign entity classification in the past 40 years has

been the growth in opportunities for creating hybrid entities. As discussed in the prior chapter,

the proliferation of techniques involving hybrids has lessened the effectiveness of the current

subpart F regime. Although not the exclusive source of these planning techniques, the check-thebox regulations, which became effective January 1, 1997, have resulted in significantly increased

use of hybrid entities. 
- 69 -

3

 Treas. Reg. § 301.7701-2(a) (1960).

4

 During the early 1970s, the IRS took the position that entities formed under foreign laws that

used a concept of “incorporated” that was substantially similar to the U.S. concept would be

treated as corporations for U.S. tax purposes, without regard to whether they met the four-factor

test. In 1988, the IRS formally reversed this position, holding that all foreign entities must be

classified under the four-factor test. See Rev. Rul. 88-8, 1988-1 C.B. 403. See also Appendix A,

part 2, section IV.

5 See, e.g., Bruce N. Davis, International Tax Planning under the Final Check-the-Box

Regulations, 26 Tax Mgmt. Int’l J. 3 (1997); David S. Miller, The Tax Nothing, 74 Tax Notes

619 (1997).

6

 Treas. Reg. § 301.7701-2(c)(2).

B. Entity Classification of Foreign Entities

Planning techniques involving hybrids were available to, and used by, taxpayers before the

introduction of the check-the-box regime. Under prior law, entities were classified as

corporations or partnerships for U.S. tax purposes based on the presence or absence of four

characteristics: continuity of life; centralization of management; limited liability; and free

transferability of interests.3 An entity that possessed more than two of these four characteristics

would be classified as an association taxable as a corporation. Entities that had two or less of

these characteristics were classified as partnerships. 

The four-factor test gave taxpayers significant flexibility to employ tax planning techniques

involving hybrids. In particular, with respect to many foreign jurisdictions, it was relatively easy

for taxpayers to create a hybrid partnership by forming an entity that was a corporation under the

national business statute of the jurisdiction, but that lacked continuity of life and free

transferability of interests and, therefore, was a partnership for U.S. tax purposes.4 

Thus, the availability of tax avoidance techniques involving hybrids did not originate with

the check-the-box regulations. However, the check-the-box regulations exacerbated the problem

in three significant ways. First, they eliminated the uncertainty associated with applying the fourfactor test. This reduced the costs and risks associated with hybrid arrangements and thus greatly

facilitated their use. Second, they focused attention on the use of hybrid arrangements. The

result was a considerable increase in design and marketing efforts among tax planners that

introduced hybrid planning techniques to mainstream taxpayers.5 Finally, and perhaps most

importantly, the check-the-box regulations facilitated the formation of a new type of entity (or

non-entity): an entity “disregarded as an entity separate from its owner” (often referred to as a

“disregarded entity”).6 It is the disregarded entity that features prominently in a number of

significant subpart F tax planning techniques.

As a result of the check-the-box regulations, the number of foreign hybrid structures, as

well as the number of taxpayers employing these structures, has increased dramatically. 
- 70 -

7

 All data are provided by the Statistics of Income Division of the Internal Revenue Service. 

These data are based on approximately 25,000 elections under the check-the-box regulations. 

Actual numbers are higher because data from an additional 10,000 elections were not available for

inclusion in this study.

8

 Under prior law, many legal advisors apparently refused to opine that entities could be

disregarded for tax purposes. In 1977, the IRS issued several private letter rulings classifying

certain foreign organizations with single owners as an integral part of their owner for tax

purposes. See Priv. Ltr. Rul. 77-43-060 (July 28, 1977) (classifying a German GmbH); Priv. Ltr.

Rul. 77-43-077 (July 29, 1997) (classifying a French societe à responsabilité limité); Priv. Ltr.

Rul. 77-47-083 (Aug. 26, 1977) (classifying a German GmbH); Priv. Ltr. Rul. 77-48-038 (Aug.

31, 1977) (classifying a German limited liability company); Priv. Ltr. Rul. 78-02-012 (Oct. 11,

1977) (classifying a Brazilian limited liability company). All of these private letter rulings were

withdrawn in November of 1977, and in February of 1978 the IRS issued further guidance that

classified each of these foreign organizations as an association taxable as a corporation.

9

 Services employment has grown steadily relative to manufacturing employment. In 1950, the

ratio of manufacturing employment to services employment was 57 percent. In 1962, it was 48

percent, declining to 41 percent by 1970 and to 18 percent by 1999. Economic Report of the

President Transmitted to the Congress February 2000, together with the Annual Report of the

Council of Economic Advisers 358-59 (2000).

Specifically, the data available as of March 2000 indicate that, since the regulations became

effective, 640 foreign entities have elected to be treated as corporations, 3,920 foreign entities

have elected to be treated as partnerships and 7,875 foreign entities have elected to be treated as

disregarded entities.7 Based upon anecdotal evidence, it appears that prior to 1997, at most a few

hundred foreign entities were being treated by their owners as disregarded entities. Thus, the

growth in disregarded entities has been particularly dramatic. This may be attributable in part to

the considerable doubt as to whether disregarded entity characterization was correct under prior

law.8

A change in the law outside of subpart F has thus had an adverse impact upon its

effectiveness. The data described above suggest that this trend will continue, and perhaps

accelerate, in the future.

III. Subpart F and Services

As noted above, services activities are a significantly greater contributor to the overall

U.S. economy today than when subpart F was originally enacted, and this growth in services

activities seems likely to continue.9 Subpart F was designed principally to deal with

manufacturing industries operating in high-tax, developed countries, rather than with service

industries. The treatment of services is already posing a number of challenges to subpart F. One

example of these challenges is provided by the financial services exception to subpart F under

section 954.
- 71 -

10 A temporary exception from FPHCI treatment is also provided for certain income derived from

a securities dealer business ( I.R.C. §§ 954(c)(2)(C)(ii)) and for certain income derived in the

active conduct of an insurance business (I.R.C. § 954(i)). 

11 P.L. No. 105-34, 111 Stat. 788 (1997).

12 P.L. No. 105-277, 112 Stat. 2681 (1998).

13 The Taxpayer Relief Act of 1997 included a one-year exception from subpart F for certain

income earned by financial services companies. The provision was line-item vetoed by the

President in August 1997 because of concerns that certain of its provisions would permit the use

of tax avoidance techniques, but was reinstated after the Supreme Court ruled that the line-item

veto was unconstitutional in June 1998. In a February 8, 1999 letter to Senator Byron Dorgan,

Assistant Secretary (Tax Policy) Donald Lubick outlined Treasury’s concerns with the active

finance exception as enacted in 1997 and expanded in 1998. See U.S. Treasury Shares Dorgan’s

Concerns about CFC Extenders Provision, 1999 Worldwide Tax Daily, February 19, 1999;

available in 1999 WTD 33-32. The current version of this provision was passed in December

1999, and is effective only for the taxable years of a foreign corporation beginning after December

31, 1998, and before January 1, 2002. For a detailed description of this provision, see infra

Appendix A, part 1, section V.B.11.g. and 12.

A. The Financial Services Exception as an Illustration

1. General

Dividends, rents, interest, interest equivalents, and other kinds of typically passive income

are easily deflected to (or realized in) low-tax jurisdictions and thus are susceptible to tax haven

planning. Accordingly, in general, these types of income are considered subpart F income not

eligible for deferral. However, under section 954(h), a temporary exception is provided from

FPHCI treatment for these types of income if derived in the active conduct of a banking,

financing, or similar business.10 This financial services exception, which was first enacted in the

Taxpayer Relief Act of 1997,11 and then extended and modified by the Tax and Trade Relief

Extension Act of 1998,12 reflects Congress’ belief that certain financial service businesses are

active and, therefore, should have the deferral benefits enjoyed by other active businesses.13

 A financial services exception raises three main concerns, however. First, because such

an exception applies to income that is generally intended to be treated as passive income, it is

important to develop a good definition of “active” that can be applied in this context. Second, the

types of entities covered by such an exception may be highly mobile in that they can be relatively

easily located in a tax-favorable jurisdiction completely unrelated to where the recipients of the

services are based. Third, the type of income covered by such an exception is highly mobile in

that it may be easily shifted from jurisdiction to jurisdiction, often without imposition of tax. The

financial services exception in Section 954 attempts to deal with all three of these concerns.
- 72 -

14 Certain types of insurance, for example, can be very mobile: “unlike the direct writing of

insurance, the business of reinsurance is mobile and not subject to uniform regulation. . . . As a

result, reinsurance business has thrived in domiciles having a favorable tax and regulatory

environment such as Bermuda.” Joe Taylor and Andrew Immerman, The Curious Role of Motive

in the Tax Court’s Analysis in UPS, 17 Ins. Tax Rev. 1089, 1091 (1999). See also, e.g., PXRE

Corp. Plans to Join Wave, Move to Bermuda for Tax Benefits, BestWeek, July 12, 1999, at 1. 

15 Staff of the Joint Committee on Taxation, General Explanation of the Tax Legislation Enacted

in 1998 259 (Joint Committee Print 1998).

2. Services and the Distinction Between Active and Passive

The first issue relates to the question of when a business is active and when income is

passive. As noted above, this active/passive distinction is fundamental to subpart F. Congress

found no reason to except passive income earned through a foreign corporation from current

inclusion in the worldwide income of U.S. taxpayers. 

The financial services exception seeks to ensure that the business benefitting from the

exception is active. The CFC must be predominantly engaged in the active conduct of a financial

services business and the CFC must actively earn the income. This test covers the head office and

any branches. It is a facts and circumstances test to be applied with reference to the size of the

CFC, the amount of its revenues and expenses, the number of employees and a series of other

factors. The legislative history also lists a series of illustrative activities that financial services

businesses of certain types generally perform. It makes clear that the CFC “is required to conduct

substantially all of the activities necessary for the generation of income with respect to the

business.” In the case of cross-border business (the amount of which is limited in the case of

finance companies and insurance companies by the “home country requirement”, described

below), further activity requirements are imposed. This is because such income is more mobile

than home country income. In this case, the statute requires the branch (rather than the CFC as a

whole) to perform all of the activities required to generate the income.

The activity rules, however, are imperfect. For example, the insurance industry relies

upon independent third parties to perform many key tasks for it.14 One of these key tasks is

making the investments that produce much of the profit for the business. The explanation of the

legislation provided by the staff of the Joint Committee on Taxation specifically states that one of

the indicative factors of substantial activity is the “making (or arranging for) investments.”15 The

parenthetical language in this portion of the explanation seems specifically to allow outsourcing of

investment activities. When marketing can also be performed by independent contractors and

actuarial analysis provided by separate actuarial firms, many of the major functions of certain

insurance companies can be performed by third parties. As more of these activities are performed

by outside contractors, the insurance company begins to look more like a passive entity.

In the case of finance companies, it may also be difficult to distinguish an active company

from a passive one. The definition of “finance company” is broad enough to encompass the
- 73 -

16 Interestingly, Rosanne Altshuler and Glenn Hubbard demonstrate in a recent paper that the

location of financial services operations became much less correlated to differences in foreign tax

rules once deferral for financial services was ended in 1986. See Rosanne Altshuler and Glenn

Hubbard, The Effect of the Tax Reform Act of 1986 on the Location of Assets in Financial

Services Firms, (Feb. 19, 1999) (conference paper at Taxation of International Investment:

Principles and Policies, American Enterprise Institute). This analysis suggests that, when deferral

was available for financial services businesses, foreign tax rates may have played a significant role

in determining where such businesses chose to locate. 

17 A QBU is defined in I.R.C. § 989(a) as “any separate and clearly identified unit of a trade or

business of a taxpayer which maintains separate books and records.” Because this definition

allows taxpayers some flexibility in determining when a QBU exists, it may give rise to planning

opportunities. 

18

 See I.R.C. § 954(h)(3)(B).

19

 See I.R.C. § 953(e)(3)(B).

incorporated pocket-book of high net worth individuals or a pool of offshore passive assets. For

example, it may be possible for a large multinational with a significant amount of retained foreign

earnings to capitalize a finance company and then have it engage in a few significant transactions

with unrelated persons. While this may be little different from purchasing corporate debt or other

passive assets which would generate subpart F income, in this case the income earned will be

“active” and, thus, not subject to subpart F.

3. Services and Mobility of Enterprise

The statute also attempts to address concerns related to the mobility of the enterprise.16

One of the premises underlying subpart F, as expressed in the legislative history, is that a U.S.-

owned foreign corporation conducting an active business will be in a certain country for valid

business reasons (e.g., to be close to the market, for local content requirement purposes, or to

exploit a skilled workforce). In the case of certain active financial services businesses, however,

the non-tax factors that affect the location of a manufacturing business may not apply, and,

accordingly, the financial services business may be able to choose its location based on tax

considerations rather than non-tax, business considerations. 

The statute attempts to deal with the issue of mobility of enterprise by imposing certain

local country customer requirements on finance companies and insurance companies (but not on

banks or securities dealers) in order for such companies to qualify for the financial services

exception. In the case of a finance company, more than 30% of the gross income of the CFC or

qualified business unit (QBU)17 must arise from transactions with unrelated customers located in

the CFC or QBU’s home country.18 For insurance companies, more than 50% of aggregate net

written premiums must be derived from insurance or reinsurance of home country risks of

unrelated persons (i.e., risks in connection with property, liability for activities, or lives or health

located in the country of the CFC or QBU).19 Furthermore, the income of any one branch of the
- 74 -

20

 See I.R.C. § 953(e)(2)(B).

21 The issue of identifying the location of services is considered further in the section below on

electronic commerce.

22 Financial services income is generally not tied to hard physical assets or people. The factors of

production that give rise to financial services income are cash (which is highly mobile) and risk,

the location of which is inherently unclear. 

23 The statute defines “home country”, in the case of a controlled foreign corporation, as the

country under the laws of which the controlled foreign corporation is created or organized. 

24 See I.R.C. § 954(e)(2).

CFC (including the head office) will only qualify if that branch earns 30% of its net written

premiums in respect of same country risks of unrelated persons.20

Currently, therefore, at least for finance companies and insurance companies, the statute

may limit the ability of businesses to exploit some of their potential mobility. However, this

provision may become less effective in the future as it becomes more difficult to tell where

activities are performed and to which QBU (or QBUs) activities should be attributed. For

example, some of these rules might potentially be circumvented if a taxpayer were to provide

financial services over the Internet and were to argue that it had a QBU in each country in which

there is a customer.21 

4. Services and Mobility of Income

Financial services income is by its nature highly mobile, and it is thus often hard to

determine precisely where such income is earned.22 The statute attempts to address this problem,

for example in the context of “qualified banking or financing income,” by providing that the

income must be “treated as earned by such corporation or unit in its home country for purposes of

such country’s tax laws.”23 This provision was intended to ensure that the income be reported as

earned for tax purposes in the country where it was actually earned as an economic matter. One

weakness in the provision, however, is that, although it may ensure that the items are included in

gross taxable income where they are actually earned, it does not prevent subsequent deflection of

this income for foreign purposes by some of the hybrid transactions described above. Thus, the

amount may be included in gross taxable income but not in the actual net amount on which tax is

imposed.

Additionally, the statute prevents all active financial services income from constituting

foreign base company services income.24 As a result, to the extent that active financial services

income can be earned in a low-tax jurisdiction, such income (unlike other types of services

income) is insulated from treatment as foreign base company services income. 
- 75 -

25 U.S. Treasury, Selected Tax Policy Implications of Global Electronic Commerce § 7.3.5 (1996)

(“Treasury E-Commerce Report”).

B. Conclusion on the Potential Impact on Subpart F of a More Service-Based

Economy

Subpart F does not deal with other service industries in anywhere near the level of detail

of the financial services rules. Nevertheless, despite their level of detail, the financial services

rules do not sufficiently address the mobility of business enterprises or of income, nor do they

adequately distinguish active from passive businesses. However, even if changes were made to

deal properly with services within the current structure of subpart F, the result would be more

complexity. Industry specific lists of factors indicating when a business is active, for example,

would need to be produced and then kept updated. Bright line rules would be replaced by

subjective facts and circumstances tests. This complexity is disadvantageous for both taxpayers

and the government. Complexity may require taxpayers to spend more on compliance (or may

discourage them from complying). Government may also be required to devote more resources

to administering the system, and the complex nature of the law may hinder uniform government

enforcement.

IV. The Challenges to Subpart F Posed by Electronic Commerce

A. General

The previous section noted the difficulties of applying subpart F to the provision of

services generally. The ability of taxpayers to provide services (as well as goods) over the

Internet and through other electronic media will present further challenges to the current subpart

F regime. None of these challenges is entirely new. The increased commercial use of the

telephone, radio, television, and facsimile has contributed to a trend in which the physical location

of the provider of goods and services is less significant and more difficult to determine.

Subpart F must be evaluated by considering where this trend might lead and what

challenges it poses. For example, as the Treasury observed in its 1996 report on electronic

commerce:

If CFCs can engage in extensive commerce in information and services through

Web sites or computer networks located in a tax haven, it may become

increasingly difficult to enforce Subpart F. . . . because it may be difficult to verify

the identity of the taxpayer to whom foreign base company sales income accrues

and the amount of such income. It may be necessary to revise Subpart F or the

regulations thereunder to take these new types of transactions into account.25

In addition to enforcement challenges, electronic commerce and its underlying

technologies also have implications for the content and scope of the substantive subpart F rules. 

This section briefly considers, through examples, whether the current subpart F regime is capable
- 76 -

26 This study does not further address the enforcement or administrative concerns raised by

electronic commerce. These concerns are discussed in Treasury E-Commerce Report, supra note

25, at § 8.

27 See Allen R. Myerson, Ideas and Trends: Virtual Migrants; Need Programmers? Surf Abroad,

N. Y. Times, Jan. 18, 1998, at § IV, 4 (discussing the use of overseas programmers who

telecommute from India, the Philippines, South Africa and elsewhere).

28 Treasury has provided guidance with respect to the proper characterization of payments for one

type of digitized product, computer programs. Treas. Reg. § 1.861-18 provides that a transfer of

a computer program is treated as: (a) the transfer of a copyright right; (b) the transfer of a

copyrighted article; (c) the provision of services; or (d) the provision of know-how, based on all

the facts and circumstances of the transaction. 

of achieving its objectives in a world in which electronic commerce and new technologies seem

sure to play a large role.26 

B. Specific Issues

1. Location of Activities

Electronic commerce may present challenges to the subpart F rules to the extent that such

rules look to where transactions or activities take place. For example, the technologies underlying

electronic commerce make possible new sorts of services, such as Internet access, and make

easier the remote provision of other services, such as remote database access, video conferencing

and remote order processing. With respect to all such services, it is difficult to assign a place of

performance, a factor that is relevant with respect to certain subpart F rules. Similarly, it may be

difficult to ascertain a place of use, consumption or disposition (another factor relevant in the

application of certain subpart F rules) with respect to the sale of digitizable products, such as

images and computer software, delivered electronically. 

New technologies increase opportunities for CFCs to be incorporated in low- or no-tax

jurisdictions. These technologies increase the ease with which employees of a CFC can be located

outside the CFC’s jurisdiction of incorporation, and increase the ease with which certain products

and services can be provided to a CFC.27 They also allow CFCs to provide services to customers

located outside their jurisdiction of incorporation with relative ease. As discussed in the examples

later in this chapter, these developments together increase opportunities for CFCs to earn income

that may not be subpart F income.

2. Classifying Income

Electronic commerce also may pose challenges to the extent subpart F has different rules

for different types of income. For example, under certain circumstances it may be unclear

whether payments for digitized products are treated as payments for a good, a right or a service.28

As discussed in the examples below, results under subpart F may differ significantly depending on

how the payment is classified.
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29 The examples below assume that the CFC is located in a low-tax jurisdiction and that the

United States does not have an income tax treaty with that jurisdiction. The United States is

actively engaged in discussions at the OECD on electronic commerce issues arising under income

tax treaties, including jurisdictional issues (e.g., whether certain activities give rise to a permanent

establishment) and issues relating to the appropriate characterization of activities and income. 

30 This example is not intended to comment on what constitutes the manufacture of software. 

31 If the CFC conducts its software manufacturing activities within its country of incorporation,

the income would be excluded from subpart F income because the FBCSI rules do not apply

where manufacture occurs within the CFC’s country of incorporation. If the CFC conducts the

manufacturing activities through a branch located in a separate tax jurisdiction, the income may be

excluded from subpart F income under the manufacturing exception of Treas. Reg. § 1.954-

3(a)(4) unless the branch rule applies. (The branch rule will treat the sales income as FBCSI if the

CFC conducts the sales and manufacturing activities in separate tax jurisdictions and the sales

income is subject to a significantly lower tax rate than it would have been in the jurisdiction where

the manufacturing occurs. See Treas. Reg. § 1.954-3(b)).

C. Examples of Potential Effects of Electronic Commerce on Subpart F

The following examples illustrate the ways in which electronic commerce and its

underlying technologies may present challenges to subpart F. In most cases, the planning

techniques described in these examples are available in both the electronic commerce and

traditional commerce context. However, because the technologies underlying electronic

commerce allow these techniques to be accomplished more easily and effectively than in

traditional commerce, these techniques have now become more generally available.29

1. Offshore Development, Production, and Sale and Licensing of Goods

The relocation of activities can be used as a subpart F planning technique. As previously

noted, income is foreign base company sales income (FBCSI) if it is derived from the sale of

property that (a) is purchased from, or on behalf of, or sold to, or on behalf of, a related person

and (b) is both manufactured and sold for use outside the CFC’s country of organization. Thus, if

a CFC purchases copies of software from its parent that the parent has developed and produced in

the United States, the income of the CFC from the sales of such software for use outside its

country of incorporation would be FBCSI in its entirety.30 Suppose, however, that the parent

restructures so that its software development and production activities are conducted within the

CFC, rather than the parent. Income from the sale of software manufactured by the CFC and sold

by the CFC to unrelated persons will not necessarily give rise to subpart F income, even with

respect to sales for use outside the CFC’s country of incorporation.31 Thus, by restructuring its

operations, which in this case may mean no more than having software development personnel

transferred on paper from the parent to the CFC, the parent company may isolate offshore at least

some of the profit from the sale of the software. 

The extent to which a U.S. parent could achieve deferral in such a manner, however, 

would depend on where the software development and production and sales of the software were
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32 This U.S. source effectively connected income, however, is excluded from subpart F income. 

See I.R.C. § 952(b).

33 See supra note 27.

34 Treas. Reg. § 1.954-2(d)(1)(i).

35 This exception applies only if the CFC/licensor “through its own officers or staff of employees

located in a foreign country, [maintains and operates] an organization in such country that is

taking place. If the CFC’s development and production activities were kept within the United

States, the CFC may be considered engaged in a U.S. trade or business. If so, the CFC would be

subject to tax in the United States on the income effectively connected with the conduct of that

business.32 Regular and continuous sales of the software into the United States by the CFC would

also likely create a U.S. trade or business. However, sales outside the United States of software

developed and produced by the CFC within the United States likely would not generate income

taxable by the United States under either subpart F or the U.S. trade or business rules, except to

the extent that either the branch rule applies or any such income were deemed to be effectively

connected to any U.S. trade or business of the CFC (for example, the U.S. software

development). Assuming the CFC’s sales income was not effectively connected income, U.S. tax

on income not subject to the branch rule would be deferred. Further, as noted previously, the

technologies underlying electronic commerce make it easier to locate software development

activities outside the United States, through the use, for example, of “virtual migrants.”33

Moreover, it may be possible to prevent regular and continuous sales of the software into

the United States by the CFC from being treated as a U.S. trade or business. If the CFC

advertised its products in the United States and had an agent in the United States that maintained

a stock of inventory from which it regularly filled orders for the public, the CFC likely would be

engaged in a U.S. trade or business. If, however, the CFC advertised solely on the Web and

digitally delivered its products to U.S. customers, then it is less clear that the CFC is engaged in a

trade or business within the United States. If the CFC is not engaged in a U.S. trade or business

under those circumstances, even income from sales into the United States could be isolated

offshore (at least to the extent that inclusions are not required under section 956). 

Finally, the above example also assumes that the sale of the software will be regarded as

the sale of a good. If instead the CFC is considered to license the software to customers, then the

CFC would be considered to receive royalties, not sales proceeds, and the royalties would not be

considered subpart F income if the CFC “has developed, created, or produced, or has acquired

and added substantial value to” the software and if the CFC is “regularly engaged in the

development, creation or production of, or in the acquisition of and addition of substantial value

to” the software.34 Thus, it may be possible for a CFC that purchases software from its parent

and adds substantial value to the software by, for example, customizing the software for unrelated

licensees, to receive royalties that are not subpart F income. In addition, even if a CFC/licensor

does not develop, or add substantial value to, the property it licenses, the CFC may nevertheless

exclude the royalties from subpart F income if it licenses the property as a result of performing

marketing functions.35 
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regularly engaged in the business of marketing, or of marketing and servicing, the licensed

property and that is substantial in relation to the amount of royalties derived from the licensing of

such property.” Treas. Reg. § 1.954-2(d)(1)(ii).

36 I.R.C. § 954(e). In addition, if a related person provides the CFC with substantial assistance

contributing to the performance of the services, the services will be treated as performed for or on

behalf of a related person. See Treas. Reg. § 1.954-4(b)(1)(iv).

37 This example assumes that the parent is not rendering substantial assistance to the CFC within

the meaning of Treas. Reg. § 1.954-4(b)(1)(iv).

38 It may be difficult to manipulate the rules to change the classification from the sale of goods to

the provision of services with respect to computer programs, because Treasury Regulations clarify

the distinction between the sale of goods and the provision of services in the context of computer

software. Treas. Reg. § 1.861-18(d) provides that whether the transfer of a computer program is

treated as the provision of services or otherwise “is based on all the facts and circumstances of the

transaction” including “the intent of the parties . . . as to which party is to own the copyright

rights in the computer program and how the risks of loss are allocated between the parties.” For

example, the regulations provide that, if a developer of computer programs agrees to provide

upgrades of the program when they become available, the developer is not treated as providing

services to its customers. Treas. Reg. § 1.861-18(h), Ex.12. In contrast, if the person

commissioning the creation of the program bears all of the risk of loss associated with its creation

and will own all of the copyright rights in the underlying program when it is completed, the

developer is treated as providing services. Treas. Reg. § 1.861-18(h), Ex.15. With respect to the

provision of other digitizable products, the distinction between the provision of a good and the

provision of a service may not be as clear.

2. Offshore Provision of Services to Unrelated Third Parties

If the sale of the software is characterized not as the sale of a good or as a license but

rather as the provision of services, a different set of rules will apply. Income from the provision

of services is foreign base company services income if the services are performed for or on behalf

of a related person outside the CFC’s country of incorporation.36 If the CFC purchases software

from its U.S. parent, but, instead of selling the software to a third party, either provides services

to unrelated third parties making use of the software or, in the alternative, transfers the software

to the unrelated third party in the form of services, the income the CFC receives likely would not

be foreign base company services income.37 If the sale of the software had been characterized as

the sale of a good, however, it would have been foreign base company sales income because the

income was derived from the purchase of software, which was manufactured outside the CFC’s

country of incorporation, from a related person, the U.S. parent, and sold for use outside the

CFC’s country of incorporation.38 

Problems arising from the distinction between the provision of a good and a service are

not limited to computer programs and may in fact be more acute with respect to digitizable

products other than software. Consider, for example, a reference work, such as a legal treatise or
- 80 -

39 See Priv. Ltr. Rul. 96-33-005 (Aug. 19, 1996).

40 As under the prior example, the foreign base company services income would nevertheless

apply if the parent were rendering substantial assistance to the CFC within the meaning of Treas.

Reg. § 1.954-4(b)(1)(iv).

41 This example assumes that income that was previously earned by people performing certain

functions (e.g., accepting orders) can now be “earned” by machines performing the same

functions.

42 I.R.C. § 954(e).

set of court cases, that previously would have been sold only as a set of bound volumes. The sale

of the bound volumes would have resulted in sales income. Today, a potential purchaser might be

able to choose between a set of bound volumes, a set of CD-ROMs and an on-line database. The

sale of the CD-ROMs may be characterized as the sale of a good.39 However, a taxpayer may

take the position that income arising from the provision of access to an on-line database should be

considered the provision of a service. If so, taxpayers may claim that sales by a CFC to unrelated

third parties of access to an on-line database the CFC purchases from its parent would not

generate subpart F income because the services are not performed for or on behalf of a related

person.40 Similar issues may be implicated with respect to the provision of other services such as

telecommunications services and Internet access.

3. Offshore Provision of Services to Related Parties within the Country

of Incorporation

Electronic commerce and its underlying technologies make it possible to set up CFC

offshore service centers to provide services to related parties.41 Foreign base company services

income includes income from services performed for or on behalf of a related person only if the

services “are performed outside the country under the laws of which the controlled foreign

corporation is organized.”42 Thus, under the current subpart F rules, depending on how the place

where services are performed is determined, taxpayers may claim that formation of such offshore

service centers to service related parties may not generate subpart F income. For example,

assume a U.S. corporate vendor of goods over the Internet establishes a CFC in Country A to

process customer orders and arrange for product delivery outside of Country A through the use

of the CFC’s computer software and servers and other equipment located within Country A. The

U.S. corporate vendor pays CFC a fee for performing these processing and product delivery

services. Unless it is determined that the services are performed outside Country A, the U.S.

vendor may be able to use such an arrangement to isolate offshore income associated with the

processing and delivery function with no corresponding income inclusion under subpart F.

As communication equipment becomes more efficient and reliable, the relationship

between the service provider’s location and the service consumer’s location will be further

weakened. For example, increased use of the Internet, as well as intranets, e-mail and video

conferencing, will make it easier to provide services across vast distances. That increases the
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possibility that rules that are premised on the coincidence of the service provider’s and service

customer’s locations may no longer be adequate.

D. Summary of Possible Effects of Electronic Commerce on Subpart F

Many of the issues identified in this section (e.g., classifying and locating activities and

associated income) are not unique to CFCs engaged in electronic commerce. As noted above,

some of the same issues arise, for example, with respect to CFCs that provide financial services

and businesses involved in more “traditional” activities, such as the development and

manufacturing of tangible goods. Electronic commerce and new technologies do, however, affect

the ease with which structures that are not contemplated by the rules of subpart F can be used.

Furthermore, they affect the interaction between subpart F and the more general international

taxation rules, such as the general source of income rules and the definition of a U.S. trade or

business. 

As planning opportunities become more generally known, offshore companies may

become the operating vehicles of choice for many newly formed electronic commerce companies.

In addition, many U.S. electronic commerce companies are relatively new. Therefore, it may be

possible for them to move offshore without incurring a significant tax liability. These

developments, taken together, may pose greater challenges to subpart F in the future.

V. Conclusions Relating to Challenges to Subpart F 

As noted in Chapter 1, subpart F was intended to address a systemic problem in the U.S.

tax system that created inequity and caused tax base erosion. Many of the specific rules of

subpart F, however, may no longer operate effectively. In addition, weaknesses in these rules are

exacerbated by the new entity classification rules, which have facilitated the creation of hybrid

entities. The growth in service industries is creating new issues that may be difficult to resolve

without adding considerable complexity to the subpart F rules. The challenges that will be posed

by electronic commerce and the Internet are only just beginning to emerge. Thus, although the

policies underlying subpart F may be as important (or more important) today as they were in 1962

(when subpart F was enacted), new developments are already challenging the effectiveness of

subpart F, and these challenges seem likely to increase in the future. 
1 See supra Introduction, section I (quoting Assistant Secretary Lubick). 

2

 The goal of equity is related to the goal of efficiency, discussed below. Over the long-term,

differing treatment of businesses operating solely in the United States and U.S.-based businesses

operating in foreign jurisdictions may not result in unequal treatment of shareholders (who are

free to invest wherever they can get the highest after-tax rate of return), but it could result in a

sub-optimal allocation of investments between the United States and foreign countries. 

3 See, e.g., Peggy Brewer Richman, Taxation of Foreign Investment Income, An Economic

Analysis 11-12 (1963) (residents and citizens who enjoy equal benefits should be taxed at equal

rates for equal income, regardless of source); Hugh Ault and David Bradford, Taxing

International Income: An Analysis of the U.S. System and its Economic Premises, in Taxation in

the Global Economy 27 (Assaf Razin and Joel Slemrod eds., 1990) (because the source of income

has no relationship to the ability to pay tax on that income, the tax burden should be based on

worldwide income). See also Chapter 1, Section II. A more detailed analysis of equity concepts

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CHAPTER 7

CRITERIA AND OPTIONS FOR CHANGE

I. Introduction

This chapter considers options for reforming or replacing the current subpart F regime. 

The fundamental goals of international tax policy provide the appropriate criteria for analyzing

these options. These fundamental goals of international tax policy are (1) meeting our revenue

needs in an equitable manner, (2) promoting economic welfare, (3) minimizing compliance and

administrative burdens, and (4) conforming with international norms to the extent possible. In

addition, as in 1962 when subpart F was enacted, one should also consider whether any policy

option would place undue burdens on the competitive position of U.S. companies.1 To determine

how these goals should be implemented in the specific context of subpart F, this chapter relies

upon the analysis and conclusions set out in the prior chapters of this study. No specific

recommendations about the reform or replacement of subpart F, however, are being made at this

time.

II. Criteria for Evaluating Changes to Subpart F

A. Equity

A core objective of any tax system is to raise the revenue necessary to fund government

functions and services. A perception of unfairness can undermine the willingness of taxpayers to

comply voluntarily with a tax system.2 For a tax system to raise revenue effectively, taxpayers

must believe that the tax burden is being equitably distributed. Taxation on the basis of

worldwide income is grounded in the equitable principle that the tax burden should be imposed

equally on all income, without regard to its source.3 
-83-

in international taxation is beyond the scope of this study. 

Chapter 1 noted that the worldwide taxing jurisdiction of the United States generally

subjects the income from domestic and foreign investment of U.S. citizens and residents to the

same tax burden and provides a foreign tax credit to alleviate double taxation. The foreign tax

credit generally prevents U.S. persons from being unfairly penalized for earning foreign income.

Under current law, however, U.S. businesses continue to be able to limit worldwide taxation of

their foreign income to some extent by separately incorporating their foreign operations in a

foreign tax jurisdiction. To the extent that this arrangement subjects the income from those

foreign operations to a lower tax burden than the income of a U.S. citizen or resident that

conducts activities entirely in the United States or conducts foreign activities in branch form,

equity concerns arise. As discussed in Chapter 2, this basic inequity was one of the principal

reasons that the Kennedy Administration advocated an end to deferral.

 Although narrower than the original Kennedy Administration proposal, subpart F was

intended to reduce this potential inequity by limiting the ability of taxpayers to reduce or eliminate

taxes on income from foreign investment. The subpart F regime operates through specific rules

that are intended to tax passive income on a current basis and to prevent the deflection of income

to low-tax jurisdictions. Chapter 5 discussed some of the rules of this regime that may no longer

operate effectively. One example is the foreign personal holding company income rules, which

have been made less effective by hybrid transactions. Hybrid transactions allow taxpayers to

exploit the differences between U.S. and foreign entity classification to deflect income from a

high-tax country to a low-tax country and to reduce or avoid the overall tax on their foreign

income. Chapter 5 also noted that the foreign base company sales income provisions, which are

intended to prevent the shifting of sales income to low-tax jurisdictions, might be circumvented

through contract manufacturing arrangements. Chapter 6 described how changes in the U.S. and

world economies are posing challenges to subpart F and noted that these challenges are likely to

increase in the future. For example, subpart F generally does not deal with services industries in

any detail, and where subpart F does provide rules (i.e., for financial services income), those rules

may be inadequate to deal with issues relating to the mobility of enterprise and the mobility of

income and may not adequately distinguish between active and passive income. 

To promote the goal of equity, income from domestic investment and income from foreign

investment should be subject to a similar tax burden. To further this goal, some form of antideferral regime is necessary to prevent U.S. taxpayers from using tax avoidance techniques

involving foreign corporations to lower the tax on their income from foreign investment. In

particular, to prevent the shifting of passive income to low-tax jurisdictions, such an anti-deferral

regime should recognize, as Congress did over 60 years ago when it enacted the foreign personal

holding company regime, that foreign passive income should be taxed on a current basis. Further,

any such anti-deferral regime should eliminate inappropriate distinctions between business

conducted in corporate form and business conducted in other forms, such as through partnerships

and disregarded entities. 
-84-

4 See, e.g., Gordon Henderson, Controlling Hyperlexis- The Most Important “Law and . . . .,”43

Tax Law. 177 (1989) (discussing lack of simplicity in the tax law). See also Bayliss Manning,

Hyperlexis: Our National Disease, 71 Nw. U.L. Rev. 767 (1977) (discussing lack of simplicity in

the law more generally).

5

 In this respect, the goal of simplicity is closely related to the goal of equity. That is, to the

extent that the tax system avoids penalizing poorly advised taxpayers or rewarding those who

engage in sophisticated tax planning techniques, the overall tax burden is apportioned more fairly

among all taxpayers. 

B. Efficiency

Another important tax policy objective is economic efficiency or the promotion of

economic welfare. Generally, global economic welfare is promoted when resource allocation

decisions are based solely on which investments are expected to be the most productive. 

Chapter 3 concluded that, whether the goal is to maximize global or U.S. economic

welfare, it is generally beneficial to reduce disparities in tax rates that cause investment income

earned in foreign countries to be taxed at lower rates than investment income earned in the United

States. Chapter 3 also concluded that capital export neutrality, which requires structuring taxes

so that they are neutral and do not cause investors to favor either domestic or foreign investment,

is probably the best policy for promoting economic welfare. Chapter 3 found the efficiency effect

of the subpart F foreign-to-foreign related party rules (even when these rules operate as intended)

to be uncertain.

Thus, to further the goal of promoting economic welfare, it appears that income from

foreign investment should be taxed at the same rate as income from U.S. investment. To the

extent that deferral of foreign income does not result in such tax treatment, it is likely to be

inefficient from an economic perspective. It may be preferable, however, for an anti-deferral

regime to deal directly with tax disparity, rather than using proxies such as the current foreign-toforeign related party rules.

C. Simplicity and Administrability

Promoting simplicity and administrability is another important tax policy goal.4 There are

a number of different aspects of this goal. On a basic level, simplicity can mean that rules are

drafted simply. Rules that are drafted simply, however, may not always be adequate to address

complex situations and thus might undermine administrability. Therefore, a balance must be

struck. In general, however, simple tax rules facilitate voluntary compliance and minimize

administrative costs for taxpayers and government. Further, overly complex rules may create

“traps for the unwary,” which could penalize poorly advised taxpayers.5 

Chapter 6 noted that the business model upon which the foreign base company sales and

services provisions of subpart F are designed – relatively immobile manufacturing operations in

high-tax foreign countries – no longer represents the norm. Rather, the United States is shifting

toward a more service-based economy and one in which business income and income-producing
-85-

activities are increasingly mobile. As a result, new issues are arising with respect to the mobility

of income, the mobility of business enterprise, and the distinction between active and passive

income. Chapter 6 also noted that other economic developments, particularly the rapid growth of

electronic commerce, may give rise to numerous interpretative issues for which the current

subpart F regime provides no clear answers. Specifically, electronic commerce and new

technologies can affect the ease with which structures that are not contemplated by the rules of

subpart F can be used. Furthermore, they can affect the interaction between subpart F and the

more general international taxation rules, such as the general source of income rules and the

definition of a U.S. trade or business. 

 To further the goal of promoting simplicity and administrability, an anti-deferral regime

should provide a clear, simple and coherent distinction between passive and active income (if the

necessity for such a distinction cannot itself be eliminated). To address the increasing mobility of

business activities, alternatives to rules based on the location of business activities may be more

appropriate. Further, in general, an anti-deferral regime should avoid rules that rely heavily on the

form in which transactions are structured. Such rules are often not flexible enough to keep pace

with changing business practices. Attempts to modify the rules to address these changing

business practices may increase complexity (and may nevertheless fail to address the changes in an

adequate and fair manner). For example, to avoid income classification issues that result from the

changing nature of business, to the extent possible an anti-deferral regime should avoid separate

sets of rules for different types of income. 

D. International Norms

To promote the tax policy goal of conforming with international norms, countries should,

to the extent possible, adopt broad tax policies that harmonize with the tax policies generally in

use internationally. The adoption by one country of tax policies that deviate significantly from

international norms can lead to double taxation or double non-taxation. Further, rules that are

inconsistent with those generally in use internationally tend to increase administrative burdens.

Chapter 4 noted that, as more countries have eliminated foreign exchange controls, they

have found it necessary to adopt anti-deferral measures to prevent tax base erosion and to reduce

the effect of harmful tax competition. It also noted that the trend among countries is to enact

controlled foreign corporation (CFC) legislation or tighten existing CFC legislation. Because the

United States was the first country to enact CFC legislation, it has had the longest experience with

the strengths and weaknesses of its regime. 

This study indicates that limiting deferral through an anti-deferral regime is consistent with

international norms, and reforming an existing anti-deferral regime to limit deferral in an

appropriate and effective manner is also consistent with international norms. Although the United

States should continue to set the standard for an appropriate anti-deferral regime, any antideferral regime should, to the extent possible, be designed in a manner that minimizes any
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disharmony with international norms. This well help prevent double taxation, double non-taxation

and increased administrative burdens.

E. Competitiveness 

Multinational competitiveness measures the ability of U.S. firms headquartered in the

United States with production facilities abroad to compete in foreign markets with residents of the

host country and other multinational firms based elsewhere. In 1962, when subpart F was

enacted, Congress considered the effect of any anti-deferral rules on the competitiveness of U.S.

multinationals. Thus, in evaluating any policy options regarding subpart F, one should still

consider any potential effects on competitiveness. 

 Chapter 4 noted, however, that multinational competitiveness is measured by many

factors, only a portion of which relate to the tax burden imposed on a business. In addition,

Chapter 4 noted that the available data provide no reliable basis for concluding that subpart F has

had a significant effect on multinational competitiveness. Chapter 4 also indicates that our major

trading partners all have anti-deferral regimes. Thus, while there is no direct way to measure the

extent to which subpart F has affected multinational competitiveness, it appears that foreign

multinationals are subject to rules that are similar in effect to our subpart F rules. In addition, as

noted in Chapter 4, the United States, as a general matter, is agreed by almost any measure to be

one of the most competitive countries in the world. 

Finally, Chapter 4 found that policies that enhance the ability of a particular firm to

compete may not necessarily promote overall economic welfare. As a result, because

multinational competitiveness may conflict with tax policy goals such as economic efficiency or

equity, the effects on multinational competitiveness, if any, should not be considered in isolation,

but should be weighed against the possible positive effects of implementing the option (such as

promoting economic efficiency).

III. Alternatives

A. General

This section briefly outlines three alternative options to the current subpart F regime for

taxing foreign income and evaluates them against the principles described immediately above. 

Because of the difficulty in measuring how any specific anti-deferral regime would affect

multinational competitiveness, this section will not attempt to analyze this issue separately for

each option. As noted above, any potential effects of any policy option regarding subpart F on

multinational competitiveness would need to be considered in light of the possible positive effects

of implementing the option (such as any improvements in economic efficiency or administrability). 

 
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6

 Other possible reforms are discussed briefly in section III.E of this chapter. One option that is

not discussed in this chapter is the adoption of a territorial system of taxation. As noted in the

introduction to this study, in its purest form, a territorial system completely exempts both the

active and passive foreign income of its residents and provides no foreign tax credit. Few

countries, and no major trading partners of the United States, have such a complete exemption

system. More common is a partial exemption system under which, by treaty or statute, branch

profits and subsidiary dividends are exempted and other foreign source income, e.g., royalty

income, is included in gross income with a credit to offset the foreign tax imposed on this income. 

Countries that use a partial exemption system, such as France, have nevertheless found it

necessary to adopt a CFC regime to prevent base erosion. Thus, an exemption system is not

necessarily an alternative to the implementation of an anti-deferral regime. An analysis of the

merits of an exemption system as compared to a worldwide system of taxation with a foreign tax

credit more appropriately belongs in the context of an examination of methods to avoid double

taxation and is therefore beyond the scope of this study. For an example of a paper examining the

merits of a dividend exemption system, see Harry Grubert and John Mutti, Dividend Exemption

Versus the Current System for Taxing Foreign Business Income (Dec. 6, 1999) (unpublished

paper).

7

 Another approach that could be considered would be to strengthen the effectiveness of the

foreign-to-foreign related party rules. As discussed in Chapter 3, strengthening the effectiveness

of these rules would have an uncertain effect on economic welfare, but would help protect the

U.S. tax base by minimizing the incentive for capital to leave the United States in favor of lowerThe options described below clearly do not (and are not intended to) represent the entire

range of possibilities.6 They merely illustrate certain routes that might be explored. In addition,

for each option, numerous implementation alternatives are possible. Although some of these

alternatives are briefly mentioned, the study does not attempt to examine them in detail.

Option 1 is the repeal of deferral. This could be done in a number of ways. However, the

result in all cases would be to subject foreign income to current U.S. taxation. Option 2 would

tax all active foreign income currently, but at a lower rate of tax than the normal U.S. rates. 

There would be no subsequent tax upon repatriation. Option 3 would retain most of the current

subpart F rules, with the exception of the foreign-to-foreign related party rules. To reduce tax

disparity, however, Option 3 would include an effective tax rate test for active income, which

would require a U.S. shareholder of a CFC to include in income the income of the CFC that was

not otherwise treated as subpart F income if the effective rate of foreign tax on this income were

less than a certain percentage. Under all options, income from passive investment would continue

to be subject to current U.S. tax at full U.S. rates. 

These options thus represent a range of alternatives that could be considered to reform or

replace the current subpart F rules. Option 1 would clearly represent a tightening of the current

anti-deferral regime. Options 2 and 3 may, depending on the specific parameters chosen,

represent either a tightening or a relaxation compared to the current anti-deferral rules.7
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taxed foreign investment opportunities. 

 Alternatively, consideration could be given to relaxing or repealing the foreign-to-foreign related

party rules and making no other significant changes to current subpart F. This approach would,

however, decrease equity between U.S. taxpayers with significant foreign investments and those

without such investments. Further, by relaxing the current anti-deferral rules, this approach

would be out of step with developments in many other countries (which, as previously noted,

have either recently enacted or recently tightened existing CFC legislation). This approach would

also retain much of the complexity of the current subpart F regime while eviscerating the rules

that were designed to prevent excessive tax disparity. Accordingly, unlike the options presented

in this chapter, such an approach does not appear to be a useful alternative to the current regime. 

B. Option 1: Repeal of Deferral

1. Description of Option

There are at least three methods by which deferral could be ended: the full inclusion

method, the branch method, and the domestic corporation method. Under any of these methods,

the income of controlled foreign corporations would be subject to current U.S. taxation. The

differences between the methods, however, might yield somewhat different tax results. Each

method is briefly described below.

 

a. Full Inclusion Method

The full inclusion method would operate in a manner similar to the current subpart F

regime except that all of the net income of the CFC, and not just certain targeted income, would

be includible on a current basis in the gross income of U.S. shareholders as a deemed dividend. 

As under the current regime, a net loss of the CFC could not be used to reduce the U.S.

shareholders’ income. In general, the full inclusion method would achieve significant

simplification over the current subpart F regime. Because all of the income of the CFC would be

includible on a current basis, this method would permit the repeal of certain provisions that

classify subpart F income into different types (e.g., insurance income under section 953 and

foreign personal holding company income and foreign base company income under section 954). 

Other rules, however, would continue to be needed to prevent earnings from being taxed again

when actually distributed to the U.S. shareholders, although such rules could be made significantly

simpler than the current rules under section 959. 

The full inclusion method would also lessen the current form-based distinction between

branches and subsidiaries. However, unlike the branch method (described below), the full

inclusion method would continue to treat the CFC as a separate entity. Therefore, under this

method, net income would continue to be determined at the CFC level and the amount of the

inclusion would be subject to an earnings and profits limitation. Thus, as under the current
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8 See I.R.C. §§ 954(b)(5); 952(c); 964(a).

9

 A qualified business unit (“QBU”) is “any separate and clearly identified unit of a trade or

business of a taxpayer which maintains separate books and records.” I.R.C. § 989. 

10 See I.R.C. § 953(d).

11 Foreign Income Tax Rationalization and Simplification Act of 1992, H.R. 5270, 102d

 Cong., 2d 

Sess. § 202.

regime,8 rules to calculate net income and earnings and profits of the CFC would be necessary. A

determination would have to be made about whether income would be calculated on a

consolidated basis or continue to be calculated on a CFC-by-CFC basis as under current law or,

for example, on a QBU-by-QBU9 basis. 

b. Branch Method

The branch method would treat a CFC as though it were a branch or transparent entity

when it was wholly-owned by a single U.S. shareholder and as a partnership or flow-through

entity when it was owned by multiple U.S. shareholders. Unlike the current subpart F regime,

there would be no need for rules to prevent the double taxation of previously taxed income

because the CFC would not be treated as a separate taxable entity. Rather, the U.S. shareholders

would be treated as earning the income. Thus, unlike the current regime under which net losses

are not included in the income of the U.S. shareholders, the U.S. shareholders would take into

account both the income and losses of the CFC. Rules would be required for apportioning

income, losses, deductions and credits among unrelated U.S. owners of the CFC. Since actual

branches are entitled to the benefits of tax treaties, arguably a CFC taxed under the branch

method also should be entitled to treaty benefits to avoid double taxation. Achieving that result,

however, may require some renegotiation of our existing tax treaties.

c. Domestic Corporation Method

The domestic corporation method would treat a CFC as though it were a domestic

corporation for all purposes of the Internal Revenue Code. Under this method, the CFC itself,

rather than its U.S. shareholders, would be taxed in the United States on its worldwide income. 

This method would allow for the complete repeal of subpart F. An elective version of this regime

currently applies to certain CFCs that are insurance companies.10 Further, an elective version that

would apply to all CFCs has been formally proposed in the past.11 This method might also require

re-negotiation of our tax treaties. Issues raised by this method include: whether controlled

foreign entities should be allowed to consolidate with affiliated domestic corporations; whether

there should be recapture of earnings or gain (and loss) recognition when the corporation is

treated as becoming “domestic”; and other issues similar to those involving the “domestication” of

a foreign entity under a state domestication statute.
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12 The effects of any disincentive to invest in high-tax jurisdictions would presumably be mitigated

to some extent because, within each foreign tax credit basket, some “cross crediting” of foreign

taxes may occur. That is, the disadvantage of high-tax countries in attracting capital would be

lessened somewhat since U.S. companies with investments in low-tax countries could offset the

U.S. tax on income earned in these countries with the taxes paid to the high-tax countries. 

13 The domestic corporation method, however, may raise questions under current international

norms (generally reflected in treaties) relating to the consequences of classification of an entity as

foreign or domestic.

2. Summary Evaluation of Option 1

In terms of the policy principles set forth above, ending deferral would do the most to

promote equity among U.S. taxpayers by ensuring that taxpayers could not limit taxation of

foreign income by separately incorporating their foreign operations. This would further the

equitable principle that a similar tax burden should be imposed on all income, without regard to its

source. Among all of the options considered, ending deferral would also be likely to have the

most positive long-term effect on economic efficiency and welfare because it would do the most

to eliminate tax considerations from decisions regarding the location of investment. Because of

the foreign tax credit limitation, taxpayers expecting to be in an excess credit position would still

have a disincentive to invest in countries where they would be subject to a rate of tax that was

higher than the rate of tax imposed in the United States.12 Depending on the method chosen,

ending deferral could provide considerable simplification as compared to the current subpart F

rules. There would be no need, for example, to distinguish between different types of foreign

income (active vs. passive, manufacturing vs. sales, etc.). In addition, many of the other technical

rules of operation of subpart F could also be eliminated. Further, if consolidation of foreign

operations were an element of this regime, intra-group transactions could be ignored, which

would also represent a simplification of the current rules. 

With regard to the policy objective of conforming to international norms, very few other

countries, and no major U.S. trading partners, have completely eliminated deferral. Ending

deferral would thus set the U.S. regime apart from the regimes of its major trading partners. As

noted above, however, most major U.S. trading partners now have some form of an anti-deferral

regime, and some of these countries have moved recently to tighten their existing regimes. 

Further, a U.S. regime that completely eliminates deferral generally would operate harmoniously

with the tax laws of other countries. For example, ending deferral generally would not lead to

international double taxation because of the availability of the foreign tax credit to offset foreign

taxes on the income subject to current U.S. tax.13 
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14 This option could also be designed using the branch method or the domestic corporation

method described above in the discussion of Option 1. 

15 A decision to subject foreign income to a lower rate of tax would only be made to address the

concerns of those who believed that an outright end to deferral would impose too great a burden

on multinational competitiveness. As previously noted, however, this section does not attempt to

evaluate the effect of any of these proposals on multinational competitiveness. 

C. Option 2: Foreign Income Currently Includible But Subject to a Lower Rate

of Tax

1. Description of Option 2

This option is similar to the full inclusion method, discussed under Option 1, in that it

would operate in a manner similar to the current subpart F regime but would require the U.S.

shareholders to currently include all of the net income of the CFC in gross income as a deemed

dividend.14 Under Option 2, however, the portion of the deemed distribution that was attributable

to the active foreign income of the CFC would be subject to a lower rate of U.S. tax.15 This could

be done in a number of ways. For example, active foreign income could be subject to a lower rate

of U.S. tax (determined as a percentage of either the U.S. shareholder’s marginal rate or the

maximum U.S. rate), with foreign tax credits, or the foreign income could be subject to an even

lower rate of tax, without foreign tax credits. This latter option would represent more significant

simplification because it would narrow the scope of the foreign tax credit. 

If foreign tax credits were allowed, calculations of income and tax could be made under

the current system on a CFC-by-CFC basis or on a QBU or groupwide basis. The portion of the

deemed distribution that was attributable to passive income of the CFC would continue to be

subject to U.S. tax at the U.S. shareholder’s marginal rate. Foreign taxes paid on passive income

could either be creditable against U.S. tax or deductible from taxable income. As under the full

inclusion method of Option 1, there would be no further tax upon the earnings when they were

subsequently distributed to the U.S. shareholders. 

2. Summary Evaluation of Option 2

As discussed above, to enhance equity among U.S. taxpayers, the disparity between the

tax burden borne by domestic income (or income from foreign branch operations) and that borne

by income earned through a foreign corporation should be reduced. Accordingly, the extent to

which this option promotes the goal of equity would depend upon the rate at which the tax on

foreign income is set. To the extent that this option reduces tax disparity compared to the current

subpart F regime (which would depend on the rate of tax imposed on foreign income), it would

enhance economic efficiency.
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16 The foreign base company sales and services rules would continue to include income earned in

connection with sales to, from, or on behalf of related U.S. persons and services performed for or

on behalf of related U.S. persons if the income otherwise fits within the definition of foreign base

company sales or services income.

This option would promote the goal of simplicity by eliminating the tax and reporting

requirements on repatriated income. Further, if consolidation of foreign operations were an

element of this regime, intra-group transactions could be ignored, which would also represent a

simplification of the current rules. In other respects, however, this option would not promote

simplification. To prevent the “exportation” of income or the “importation” of losses, rules would

continue to be needed to determine when income was foreign or domestic. Because passive

income would continue to be subject to tax at regular U.S. rates, it would be necessary to

distinguish adequately between active and passive income. The variant of this option that lowers

the rate but eliminates the foreign tax credit could be viewed as inconsistent with international

norms and could require renegotiation of some U.S. tax treaties.

D. Option 3: Retain Current Subpart F, but End Foreign-to Foreign Related

Party Rules and Add Effective Tax Rate Test Rule Preventing Tax Disparity

1. Description of Option 3

Under this option, current subpart F would be retained but modified by repealing the

foreign-to-foreign related party rules. Thus, the foreign base company sales and services rules

would not include income earned in connection with sales to, from, or on behalf of related foreign

persons and services performed for or on behalf of related foreign persons.16 Further, foreign

personal holding company income would not include dividends, interest, rents and royalties

received from related foreign corporations whether or not the payments were from a corporation

organized in, or for the use of property in, the same foreign country as the CFC. In general, the

other categories of subpart F income would remain unchanged and other subpart F rules would

continue to operate (e.g., investments in U.S. property under section 956, previously taxed

income rules under section 959, earnings and profits limitation under section 952(c), computation

of net income under section 954(b)(5)).

To address the issue of tax disparity, and to counterbalance any adverse effects of the

repeal of the foreign-to-foreign related party rules, an effective tax rate test would be added so

that a U.S. shareholder would be required currently to include in income, as a deemed dividend,

the income of the CFC that was not otherwise treated as subpart F income if the effective rate of

foreign tax on this income were less than a certain percentage. In effect, this rule would create a

new category of subpart F income defined based on the effective tax rate imposed on the income

rather than the type of activity that produced the income. (It may be appropriate to extend this

effective tax rate test to the income of foreign branches of U.S. corporations and partnerships.) It

would have to be determined whether the effective tax rate was to be calculated on a CFC, QBU,
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17 See Treas. Reg. § 1.954-1(d) (2) (effective tax rate determined as the ratio of the U.S. dollar

amount of foreign taxes on an item of income to the U.S. dollar amount of the item of income). 

18 For example, if the effective tax rate of the unit were 10 percent and the effective tax rate

threshold were 25 percent, then an equalization payment of 15 percent would be currently payable

by the U.S. taxpayer. Upon subsequent repatriation, the 10 percent of foreign tax and 15 percent

of equalization payment would both be creditable (subject to foreign tax credit limitation rules,

etc.)

19 Subpart F previously contained a minimum distribution regime. This regime was repealed in

1975. For a brief discussion of the enactment of this regime, see Appendix A, part 1, section

IV.D.

20 For example, as discussed in Chapter 4, Japan uses an effective tax rate test. 

or foreign groupwide basis. To determine the effective tax rate, a test similar to the one used in

the regulations under section 954(b)(4) could be adopted.17 

Alternatively, rather than full inclusion if the effective tax rate test were not met, U.S.

shareholders might be required to make an equalizing payment of tax to the United States

sufficient to bring the effective tax rate on the foreign income up to the threshold rate (with a

credit for foreign taxes as well as for the equalization payment upon repatriation of the foreign

income).18 A similar alternative would be an actual or deemed minimum distribution regime,

under which taxpayers would be required to make distributions (or pay tax on deemed

distributions) from a CFC unless the effective tax rate on the income of the CFC equaled or

exceeded a certain percentage.19

2. Summary Evaluation of Option 3

As with Option 2, the extent to which this option would enhance equity among U.S.

taxpayers would depend on the level at which the effective tax rate was set. If the effect of this

option were to decrease the disparity between the taxation of U.S. income and foreign income,

equity would be enhanced. Similarly, economic efficiency would be enhanced if the effect of this

option were to decrease the disparity between rates of taxation on U.S. income and foreign

income, because taxpayers would have less of an incentive to locate in low-tax countries for tax

reasons. 

Current subpart F conforms with international norms. The addition of an effective tax rate

test, which other countries have also employed, would also conform with international norms.20 It

is unlikely, however, that this option would significantly promote the goal of simplicity. The

current subpart F regime is complicated, and retaining much of the current regime would mean

retaining much of its complexity. Although elimination of the foreign-to-foreign related party

rules could eliminate some complexity, calculating an effective tax rate could add complexity. 

Because the portion of the U.S. shareholder’s subpart F inclusion attributable to passive income
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21 Australia considered a negative listing approach but ultimately rejected it in favor of a positive

listing approach, in part because of the perceived administrative and informational burden of

maintaining a list of jurisdictions to be included on a negative list. See the Honorable P. J.

Keating, M.P., Treasurer of the Commonwealth of Australia, Taxation of Foreign Source Income,

An Information Paper 35 (1989) (forming part of the economic statement delivered by the

Treasurer on April 12, 1989). 

would continue to be subject to tax at regular U.S. rates, the distinction between active and

passive income would need to be retained. 

E. Other Reforms

As already noted, the options described above represent only a sampling of possible

reforms to subpart F. Many other reforms could be considered, some of which could be

incorporated into one or more of the options described above. For example, as suggested above,

the calculations of foreign taxes paid under Option 2 or the effective foreign tax rate under Option

3 could be made on a foreign groupwide basis (rather than on an entity-by-entity basis). To avoid

the formalistic distinctions that currently characterize subpart F (and facilitate avoidance of its

rules), the rules could be amended to provide that all foreign entities, regardless of how they

would otherwise be classified for U.S. tax purposes, would be subject to identical treatment under

subpart F. Alternatively, clearer, more rational rules could be provided with respect to the

treatment of non-corporate entities (e.g., partnerships and branches) under subpart F. 

In addition, other fundamental changes to the U.S. anti-deferral regime could be

considered, similar to the approaches that have been adopted in other countries. For example,

some countries apply some form of a “list” approach to the taxation of foreign income. Under a

“negative” list approach, income earned by an entity incorporated and/or resident in any of the

jurisdictions on the list is currently taxable to the entity’s shareholders. Under a mirror image of

such an approach, a “positive” list approach, if an entity is resident in or incorporated in any of the

jurisdictions on the list, non-passive income of such an entity would automatically qualify for

deferral.21 Other intermediate alternatives could involve combining a list of jurisdictions with an

effective tax rate test, with the result that income earned by an entity in a jurisdiction on the list

would only qualify for deferral if the income was subject to a specified minimum rate of tax.

Other possible reforms relate to the basic active/passive distinction that is currently used in

subpart F. For example, rather than specifying types of income that do not qualify for deferral,

rules could be provided that would specify when income would be considered “active” and would

thereby qualify for deferral. Alternatively, certain types of income could presumptively qualify for

deferral, while other types would qualify only if certain tests (focused on the activity involved in

earning the income) were met. Another alternative would determine whether income was actively

earned based on the ratio of the income to the costs properly associated with earning that income.
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Each of these reforms, as well as numerous others not discussed, could be considered to

amend the existing subpart F regime. Each such reform should be evaluated under the general

international tax policy principles set forth at the beginning of this chapter and the analysis and

conclusions of this study.

IV. Conclusion on Options for Change

Although no specific recommendations for reform or replacement of subpart F are being

made in this study, any subsequent reform of subpart F should be guided by the fundamental goals

of international tax policy discussed in this chapter. To promote the goal of equity, the tax system

should evenly apportion the tax burden between income from domestic and foreign investment. 

Because of its mobility and susceptibility to tax avoidance, foreign passive income should be taxed

on a current basis. Equity concerns, as well as concerns of simplicity and administrability, also

indicate that an anti-deferral regime should avoid inappropriate distinctions between business

conducted in corporate form and business conducted in non-corporate form. To further the goal

of economic efficiency, it is generally beneficial to reduce tax disparity between income from U.S.

investment and income from foreign investment. To promote simplicity and administrability, an

anti-deferral regime should provide a clear, simple and coherent distinction between passive and

active income (if such a distinction is necessary), and should use a more comprehensive approach

in targeting income subject to the anti-deferral rules. To address the increasing mobility of

businesses, rules should, to the extent possible, not be based on the location of business activities. 

Although the tax policy goal of consistency with international norms can be met by a broad range

of anti-deferral regimes, any such regime should avoid rules that may lead to international double

taxation or double non-taxation or radically increase administrative burdens.

 
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CHAPTER 8

RESTATEMENT OF CONCLUSIONS

I. Conclusions

A. Background to Subpart F

To place subpart F in a broad historical context, Chapter 1 considered developments in the

tax laws from 1913 until the enactment of subpart F. As part of this analysis, Chapter 1

considered the extent to which the need for anti-deferral rules was the result of certain structural

features of the U.S. tax system. The chapter concluded that subpart F was not a unique response

to a specific set of tax avoidance problems that are no longer of concern. Rather, subpart F was,

more generally, one in a series of measures addressing tax avoidance problems caused by a

structural tension in the tax system. This tension is caused by the incompatibility of certain

fundamental features of the U.S. tax system, principally the current taxation of worldwide income

and the treatment of corporations as taxpayers and legal persons separate from their owners. 

These incompatible features are still a fundamental part of the U.S. tax system.

B. The Intent of Subpart F

Having placed subpart F in a broad historical context, the study next considered the

specific legislative intent of subpart F. Chapter 2 concluded that the aims of subpart F were to

prevent tax haven abuse, to prevent passive foreign income from escaping current U.S. taxation,

to promote equity between U.S. taxpayers doing business overseas and those doing business in

the United States, and to promote economic efficiency without unduly harming competitiveness.

 Chapter 2 noted that the original 1961 proposal of the Kennedy Administration to end

deferral completely was modified in 1962 because of concerns about the competitiveness of U.S.-

owned foreign corporations. Nevertheless, Congress ultimately determined that U.S. taxpayers

should not be able to use tax-avoidance techniques to obtain a wide disparity between domestic

and foreign tax rates. The relative importance that Congress gave to preserving competitiveness

is unclear, however, because in 1962 U.S. multinationals generally conducted their active foreign

businesses in high-tax jurisdictions and tax haven devices were the primary cause of significant

disparities between U.S. and foreign tax rates. The rules as enacted intended to address such tax

haven devices. Congress heard testimony from the Administration indicating that enactment of

the tax haven rules would largely preserve the benefits of the Administration’s original proposal,

although the Administration warned that limiting its proposal in this manner would likely result in

increased complexity. Consequently, Congress may have believed that, by ending deferral only in

the tax haven context and with respect to passive income, it was addressing the Administration’s

equity and efficiency goals without unduly harming competitiveness. 
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C. Economic Welfare and the Taxation of Foreign Income

Chapter 3 examined economic research discussing the best way to tax foreign income. In

particular, Chapter 3 asked whether global or national economic welfare would be improved by

allowing foreign income to be taxed at a lower rate than domestic income. The chapter

summarized numerous economic analyses concerning this question and concluded that capital

export neutrality is probably the best policy when the goal is to maximize global economic

welfare. Further, whether the goal is to maximize global economic welfare or national economic

welfare, Chapter 3 concluded that there appears to be little reason to abandon the conclusion that

foreign investment income should be taxed no lower than domestic investment income. 

After examining the broader issues, the chapter then examined the foreign-to-foreign

related party rules. The chapter concluded that the current subpart F foreign-to-foreign related

party rules (even if fully effective) have an uncertain effect on economic welfare.

D. Competitiveness and the Taxation of Foreign Income

Chapter 4 considered the issue of multinational competitiveness. The chapter first noted

that promoting multinational competitiveness may conflict with the goal of promoting economic

welfare. It then attempted to evaluate the effect of subpart F on competitiveness and concluded

that the available data do not provide a reliable basis for evaluating whether subpart F has had a

significant effect on multinational competitiveness. Although some have attempted to use

statistics selectively in an attempt to show a decline in U.S. competitiveness, there is no

convincing evidence of such a decline, nor is there convincing evidence regarding what impact, if

any, subpart F may have had on these figures. Further, there are many other statistics that appear

to show, generally, that the U.S. economy is highly competitive.

Chapter 4 also noted that the U.S. tax regime imposes a lower overall tax burden than that

imposed in many other OECD countries. The chapter further determined that most developed

countries did not need anti-deferral rules to discourage tax motivated offshore investments in

1962 because they maintained exchange controls that allowed them to monitor foreign direct

investment. As these countries have eliminated or relaxed exchange controls within the last two

decades, there has been a corresponding increase in CFC legislation to prevent tax base erosion. 

Thus, the current trend in other countries is to implement, or strengthen existing, CFC regimes. 

E. How Effective is Subpart F?

Chapter 5 examined whether subpart F is effectively fulfilling its original goals (discussed

at length in Chapter 2 and summarized above). The chapter concluded that subpart F may in

some cases not be doing what it was intended to do. This is because it may now be possible to

avoid some important provisions of subpart F, due in part to the proliferation of hybrid entities
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and the use of contract manufacturing and other arrangements. Therefore, it may be possible in

some cases to deflect income to low-tax jurisdictions and earn passive income in low-tax

jurisdictions without triggering subpart F. 

F. Challenges to Subpart F: Entity Classification, Services and Electronic

Commerce

Chapter 6 considered three major challenges to the effectiveness of subpart F: the entity

classification rules of the Internal Revenue Code, the growth of services in the global economy

and electronic commerce. Some of these already have had an effect on subpart F; all of them have

the potential to have still greater effect in the future. The chapter concluded that a number of the

assumptions underlying subpart F are no longer valid. For example, the rules of subpart F are

based on the assumption that relatively immobile manufacturing activities in high-tax foreign

countries are the typical active foreign business operations of U.S. multinationals. Further,

subpart F assumes that these multinationals generally will conduct their active foreign businesses

in jurisdictions with effective tax rates similar to U.S. rates. As such, subpart F deals with the

problem of economic inefficiency caused by a disparity between U.S. and foreign tax rates by

attempting to ensure that U.S. tax is imposed upon transactions that have the effect of stripping

income out of high-tax jurisdictions into low-tax jurisdictions. 

However, Chapter 6 concluded that an immobile manufacturing plant as the primary

model for an active foreign subsidiary may be obsolete and that targeting related party

transactions may no longer be an effective way to address tax disparity. First, the entity

classification rules, and, particularly the check-the-box regulations, have greatly facilitated the

formation of hybrids, which make many of the related party rules less effective. Second, because

the rules preventing income stripping are largely focused on corporation-to-corporation

transactions, they do not (even apart from the issue of hybrids) take into account the differing tax

treatment of branches, joint ventures, partnerships, and other structures. Third, subpart F may not

currently be adequate to prevent services industries from deflecting income to low-tax

jurisdictions and otherwise exacerbating tax disparity, in part because of the difficulty in

distinguishing between active and passive income in a services industry and the difficulty of

defining the location of services. Finally, the growth of electronic commerce is likely to increase

and place subpart F under greater pressure for a number of reasons, including the difficulty in

identifying the location of activities, the difficulty of identifying the nature of the income arising

from transactions, and the increased ease with which offshore activity can be undertaken.

G. Considering Options for Change 

Chapter 7 discussed several options for the reform of subpart F. Although the chapter

made no specific recommendations, it noted that any subsequent reform of subpart F should be

guided by the fundamental goals of international tax policy as those goals were developed from

the conclusions of this study. Thus, Chapter 7 concluded, generally, that to further the goal of
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equity, an anti-deferral regime should contribute to the even apportionment of the tax burden

between income from domestic and foreign investment, it should tax passive income on a current

basis, and it should avoid inappropriate distinctions between the conduct of business in corporate

form and the conduct of business in non-corporate form. To promote the goal of economic

efficiency, an anti-deferral regime generally should reduce the tax disparity between income from

U.S. and foreign investment. To promote simplicity and administrability, an anti-deferral regime

should provide a clear, simple and coherent distinction between passive and active income, and

should use a more comprehensive approach in targeting income subject to the anti-deferral rules. 

To promote the goal of consistency with international norms, a broad range of anti-deferral

regimes are possible, although any such regime should avoid rules that may lead to international

double taxation or double non-taxation or that radically increase administrative burdens. Chapter

7 also noted that the impact of an anti-deferral regime on multinational competitiveness is a

relevant factor but should not be considered in isolation, as it may conflict with the fundamental

policy goals of equity and efficiency.

II. Summary of Conclusions

Subpart F was intended to address problems arising from incompatible features of U.S. tax

law. These features are still incompatible and still in place. The problems they create still exist,

and the need to address these problems is perhaps greater than ever. Because of changes in other

areas of the law and changes in the nature of business, however, in significant ways subpart F may

not effectively address these problems, and it may become less effective in the future.

A careful review of the economic literature reveals that capital export neutrality, which

provides that U.S. and foreign income should be taxed at the same rates, is probably the best

policy when the goal is to maximize economic welfare (although the foreign-to-foreign related

party rules of subpart F may not be maximally efficient in all cases). Therefore, preventing

significant tax disparity should remain an important goal.

An anti-deferral regime continues to be needed to prevent significant disparity between the

rates of tax on U.S. and foreign income, thereby promoting efficiency, preserving the tax base and

promoting equity. 
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REQUEST FOR COMMENTS

The Department of the Treasury invites and welcomes comments on all aspects of this

study. The Treasury particularly solicits the following:

• Comments on whether any of the options outlined in Chapter 7 might form a basis for

reforming or replacing subpart F

• Suggestions for other ways in which subpart F might be changed (or replaced)

• Empirical data which might help to resolve the issues raised in this study

Any submissions should be sent to:

Office of International Tax Counsel

Department of the Treasury, Room 1000

1500 Pennsylvania Avenue, N.W.

Washington, D.C. 20220

Comments may also be sent by e-mail to “subpartf.study@do.treas.gov”.
1

 Revenue Act of 1913, ch.16, 38 Stat. 114.

2

 Current law describes this nexus as income that is either U.S. source or effectively connected

with the conduct of a trade or business in the United States. See I.R.C. §§ 872(a) and 882(b).

3

 Precedent for worldwide taxation was established prior to the Revenue Act of 1913. This

standard appears to have developed through a series of short-term Civil War era revenue laws. 

The first income tax law in the United States during the Civil War period imposed a tax on the

worldwide income of U.S. residents and the U.S. source income of U.S. citizens residing abroad. 

See Act of August 5, 1861, ch. 45, § 49, 12 Stat. 292. A subsequent measure enacted in 1864

broadened the U.S. taxing jurisdiction to include the worldwide income of U.S. citizens and

residents. See Act of June 30, 1864, ch. 173, § 116, 13 Stat. 223. In 1866, Congress again

broadened the U.S. taxing jurisdiction to include not only the worldwide income of U.S. citizens

and residents but also “the income of every business, trade or profession carried on in the United

States by persons residing without the United States, not citizens thereof.” See Act of July 13,

1866, ch. 184, § 9, 14 Stat. 98. 

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APPENDIX A

HISTORICAL REVIEW OF U.S. LAWS RELEVANT TO CURRENT U.S. ANTIDEFERRAL REGIMES AND ENTITY CLASSIFICATION

This appendix presents a summary of the history of U.S. laws relevant to current U.S.

anti-deferral regimes, including subpart F, and federal tax entity classification. 

PART 1. U.S. ANTI-DEFERRAL REGIMES

I. Structural Features of U.S. Tax System Giving Rise to Deferral and the Need for

Anti-Deferral Rules

Since the Revenue Act of 1913,1 which adopted the principles of worldwide taxation of

U.S. citizens and residents, the taxation of corporations as entities separate from their

shareholders, and the taxation of corporations based on country of organization, taxpayers have

had an incentive to defer tax by earning income through corporations over which they maintain

control. The historical development of each of these principles is discussed below.

A. Taxing Jurisdiction of the United States

Since 1913, individuals that are U.S. citizens or residents and corporations organized in

the United States have been subject to tax in the United States on their worldwide income, and

nonresident aliens and foreign corporations have been subject to tax only on income having a

certain nexus2 with the United States.3 To alleviate double taxation, U.S. taxpayers have been
- 102 -

4

 The Revenue Act of 1913, § II.G. (b), allowed corporations to deduct amounts paid “for taxes

imposed under the authority of the United States or of any State or Territory thereof, or imposed

by the Government of any foreign country.” With respect to individuals, however, § II.B. of the

Revenue Act of 1913 allowed a deduction for “all national, State, county, school, and municipal

taxes paid” without any specific reference to “foreign” taxes. The Revenue Act of 1916 made

clear that foreign taxes were deductible in computing individual net income. See Revenue Act of

1916, ch. 463, Title I, § 5(a), 39 Stat. 756.

5 See Revenue Act of 1918, ch. 18, § 222(a) (individuals) and § 238(a) (corporations), 40 Stat.

1057. 

6

 Peggy Brewer Richman, Taxation of Foreign Investment Income, An Economic Analysis 47

(1963).

7 See Revenue Act of 1864, ch. 173, § 117, 13 Stat. 223. Section 117 of the Revenue Act of

1864 provided that “the gains and profits, of all companies, whether incorporated or partnership .

. . shall be included in estimating the annual gains, profits, or income of any person entitled to the

same, whether divided or otherwise.” 

8 See Act of 1864, §§ 120, 122. Section 120 applied to “any bank, trust company, savings

institution and . . . any fire, marine, life, inland insurance company, either stock or mutual . . .

whether specifically incorporated or existing under general laws.” Section 122 applied to “any

railroad, canal, turnpike, canal navigation or slack-water company.” See also Act of July 14,

1870, ch. 255, § 15, 16 Stat. 256.

allowed a deduction, since 1913,4 and a credit, since 1918,5 for foreign taxes paid. The United

States was the first country to adopt a foreign tax credit applicable to all foreign source income to

provide relief from double taxation.6

B. Taxing a Corporation as a Separate Entity

The practice of taxing a corporation as a separate entity evolved through a series of shortterm revenue laws enacted during the latter half of the 19th and early 20th centuries. The first

income tax laws, enacted during the Civil War era, did not recognize the separate tax status of a

corporation. Rather these early revenue laws required individual taxpayers that held an ownership

interest in both incorporated and unincorporated businesses to include in income their share of the

profits of the business, whether or not distributed.7 In addition, under these early revenue laws,

certain banks, trust companies, and insurance companies, whether incorporated or not, were

required to withhold tax on earnings distributed to stockholders or depositors and pay a tax on

certain undistributed amounts added to surplus, and certain transportation companies were

required to withhold tax on interest, dividends and coupons payable.8 
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9

 Revenue Act of 1894, ch. 349, 28 Stat. 553. Section 32 of the Revenue Act of 1894 levied a tax

on the annual net profits of certain enumerated companies including banks, insurance companies

and certain utility companies “and all other corporations, companies, or associations doing

business for profit in the United States, no matter how created and organized, but not including

partnerships.”

10 See P. Hobbs, Entity Classification: The One Hundred-Year Debate, 44 Cath. U.L. Rev. 437,

438-52 (1995) (discussing Revenue Act of 1894).

11 Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601, aff’g on rehearing, 157 U.S. 429 (1895). 

Although the Civil War era tax laws imposed taxes on income, these taxes were treated as indirect

taxes, i.e., duties or excise taxes, thereby avoiding questions about their constitutionality. See

Springer v. United States, 102 U.S. 586 (1880) (the income tax imposed by the Act of 1865 was

not a direct tax but an excise or duty); Pacific Insurance Co. v. Soule, 74 U.S. 433 (1868) (tax

imposed by Act of 1866 is a duty or excise).

12 Revenue Act of 1909, ch. 6, § 38, 36 Stat. 112. This tax was imposed as an excise tax, rather

than a direct tax, to avoid a constitutional challenge.

13 Revenue Act of 1913, § II.A.

14 Revenue Act of 1913, § II.G.

15 See, e.g., Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943); New Colonial Ice Co.

v. Helvering, 292 U.S. 435, 442 (1934); Eisner v. Macomber, 252 U.S. 189, 213-214 (1920). 

The Revenue Act of 18949, was the first income tax law that taxed corporations as a class

without regard to the type of activity in which they were engaged.10 The Revenue Act of 1894

was declared unconstitutional in 1895, however, as a direct tax that was not apportioned among

the States.11 In 1909 Congress again enacted legislation that specifically taxed corporations as a

class by imposing an excise tax on the net income of “every corporation, joint stock company or

association, organized for profit and having a capital stock represented by shares, and every

insurance company.”12

The Revenue Act of 1913, the first income tax law enacted after the 16th Amendment to

the U.S. Constitution was ratified, established separate taxing regimes for individuals and

corporations. Individuals were subject to both a “normal tax” of 1 percent and a graduated rate

surtax.13 Corporations were subject only to the normal tax.14 Subsequent U.S. income tax acts

have followed this model, taxing individuals and corporations under separate regimes, and case

law has confirmed that U.S. tax law generally recognizes a corporation to be a separate taxable

entity from its shareholders.15
- 104 -

16 Revenue Act of 1894, § 32.

17 Revenue Act of 1909, § 38.

18 Revenue Act of 1913, § II.G.

19 Revenue Act of 1918, Title II, Part III, §§ 213 and 233(b).

20 Revenue Act of 1918, Title I, § 1.

21 See I.R.C. §§ 61, 882(b) and 7701(a)(4) and (5). 

C. Taxation of Corporation Based on Country of Organization

Although the short-lived Revenue Act of 1894 based taxing jurisdiction solely on whether

the corporation, company or association was “doing business for profit in the United States,”16

subsequent revenue laws based taxing jurisdiction on U.S. residence as well as U.S. business

activity. For example, the Revenue Act of 1909 imposed the excise tax on corporations

“organized under the laws of the United States” or “organized under the laws of any foreign

country and engaged in business in any State or Territory of the United States.”17 Similarly, the

Revenue Act of 1913 imposed a tax on the income from all sources of corporations “organized in

the United States, no matter how created or organized” and on certain U.S. source income of

corporations “organized, authorized or existing under the laws of any foreign country.”18 The

Revenue Act of 1918 provided that, while gross income generally included income from all

sources, the gross income of a foreign corporation included only income from sources within the

United States19 and defined the term “foreign,” when applied to corporations, to mean “created or

organized outside the United States.”20 The current Internal Revenue Code contains similar

provisions.21

D. Tension Between Worldwide Taxation and the Corporate Veil 

 

Because of the three components of the U.S tax regime discussed above, world-wide

taxing jurisdiction for U.S. citizens and residents, taxation of corporations as separate entities, and

taxation of corporations based on country of organization, the form through which a taxpayer

chooses to earn income can have a significant impact upon its tax liability. Economically identical

transactions can have materially different tax results. For example, a U.S. corporation that

directly conducts a business overseas is taxable on that business income. If the U.S. corporation,

instead, separately incorporates its foreign operations, the foreign subsidiary will not be subject to

tax in the U.S. on this foreign source income. Further, the U.S. parent generally is not subject to

tax in the U.S. on the income of its foreign subsidiary until that income is repatriated through

dividend distributions, except to the extent subpart F or another anti-deferral regime requires the

U.S. parent to include this income currently in its own gross income.
- 105 -

22 Revenue Act of 1913, § II.A. Subdivision 2.

23 50 Cong. Rec. 5318-19 (1913), reprinted in J.S Seidman, Seidman’s Legislative History of

Federal Income Tax Laws, 1938-1861 986 (1938).

II. Anti-Deferral Provisions Prior to 1962

Since 1913, Congress has responded to taxpayers’ use of corporations to defer tax in one

of two ways. It has either imposed an additional tax on the corporation, thus reducing the benefit

of earning the income through a separate entity, or taxed the shareholder on undistributed profits

of the corporation, thus ignoring, to a certain extent, the separateness of the corporation and its

shareholder. For example, the personal holding company regime imposed an additional tax at the

corporate level, while the foreign personal holding company regime and the subpart F regime

taxed shareholders on undistributed profits of the corporation. Since 1913, except during the

period between 1921 and 1937, the Internal Revenue Code has contained provisions that taxed

shareholders on undistributed profits of corporations used to defer income.

A. 1913 to 1934

1. “Formed Or Availed Of” Standard 

 While the Revenue Act of 1913 generally treated a corporation as separate from its

shareholders, it created an exception in the case of corporations “created or organized, formed or

fraudulently availed of for the purpose of preventing the imposition of” the graduated surtax on

individuals. U.S. shareholders of such corporations were required to include in income their share

of the corporation’s gains and profits, whether or not distributed.22 This provision, a predecessor

to the accumulated earnings tax and personal holding company provisions, limited the separate

entity treatment of a corporation and its shareholders to prevent tax avoidance. In Senate floor

debates on the Revenue Act of 1913, Senator Williams explained the need for this provision:

The Senator will see that unless we provide for this evil in some way men might

escape not the normal tax but escape the additional tax by merely forming

themselves, or using a brother, wife, . . . or an office boy. Then, while perfectly

willing to pay the normal tax as a corporation, they would escape the additional

tax by not having their amount distributed by an arrangement so that they could

draw upon the corporation, of course, for whatever they needed. . . . Of course

they could have any arrangement with the corporation they chose, because they

would be the corporation.23
- 106 -

24 Revenue Act of 1921, ch. 136, § 220, 42 Stat. 227.

25 252 U.S. 189 (1920).

26 See H.R. Rep. No. 350, 67th Cong., 1st Sess. 177-78 (1921).

27 Revenue Act of 1932, ch. 209, 47 Stat. 169.

28

 See H.R. Rep. No. 708, 72d Cong., 1st Sess. 20 (1932).

29 Revenue Act of 1934, ch. 277, 48 Stat. 680.

30 H.R. Rep. No. 704, 73d Cong., 2d Sess. 1 (1934) (1934 House Report) .

 The Revenue Act of 192124 replaced this provision requiring current inclusion of the

corporation’s undistributed earnings at the shareholder level with one that imposed an additional

income tax directly on the corporation if it was formed or availed of to avoid the surtax. The

amendment was made after the decision in Eisner v. Macomber25 created doubt about the

constitutionality of taxing shareholders on the corporation’s undistributed earnings.26

2. Transfers to Foreign Corporations

U.S. taxpayers were able to defer U.S. tax not only by earning income through a foreign

corporation but also by transferring appreciated property to a foreign corporation in a tax-free

exchange. If the foreign corporation was formed in a jurisdiction that did not impose a tax on the

sale of capital assets, both U.S. and foreign tax would be avoided on the capital gain. The income

could subsequently be repatriated in a tax-free exchange. To address this potential for tax

avoidance, the Revenue Act of 193227 added a new provision, section 112(k), to the gain

recognition rules.28 Section 112(k), the predecessor to section 367, provided that the

nonrecognition rules would not operate where a foreign corporation was a party to a transaction,

unless, prior to the exchange, it was established to the satisfaction of the Commissioner that the

exchange was not in pursuance of a plan having as one of its principal purposes the avoidance of

tax. 

B. Personal Holding Companies – 1934

The Revenue Act of 193429 contained provisions intended to prevent tax avoidance or

postponement.30 The House Report accompanying the Revenue Act of 1934 explained one of the

specific tax avoidance schemes with which Congress was particularly concerned:

 Perhaps the most prevalent form of tax avoidance practiced by individuals with

large incomes is the scheme of the ‘incorporated pocketbook.’ That is, an

individual forms a corporation and exchanges for its stock his personal holdings in

stock, bonds, or other income-producing property. By this means the income from
- 107 -

31 Id. at 11.

32 See Tax Evasion and Avoidance, Letter from the Chairman of Joint Committee on Tax Evasion

and Avoidance Transmitting Report of the Joint Committee on Tax Evasion and Avoidance of the

Congress of the United States, House Doc. No. 337, 75th Cong., 1st Sess. 7 (1937) (1937 Report

of the Joint Committee on Tax Evasion) (“The problem of the personal holding company has been

one requiring the continued attention of Congress beginning with the Revenue Act of 1913.").

331934 House Report, supra note 30, at 11.

34 Revenue Act of 1937, ch. 815, 50 Stat. 813.

35 Tax Evasion and Avoidance, Hearings before the Joint Committee on Tax Evasion and

Avoidance, 75th Cong., 1st Sess. (Part 1) 1 (1937) (1937 Hearings).

the property pays corporation tax, but no surtax is paid by the individual if the

income is not distributed.31

Although the tax avoidance practices involving personal holding companies that Congress

identified in 1934 were not new,32 the post-1921 anti-avoidance provisions, which required a

showing that the corporation was organized or availed of for the purpose of preventing the surtax

on the shareholders, had proved to be ineffective. Taxpayers often were able to show some need

for the accumulation of profits in the corporation.33 To address this problem, the Revenue Act of

1934 imposed the additional tax on the undistributed profits of a corporation that fell within the

definition of a “personal holding company” without regard to the purposes for which the

corporation was formed. A personal holding company was defined as a corporation, 80 percent

of whose gross income for the taxable year was derived from certain passive income, and more

than 50 percent of the stock of which was owned by not more than 5 individuals. Thus, the

personal holding company regime was intended to remove the tax benefit available to an

individual from earning income through a separate corporation. 

C. Foreign Personal Holding Companies – 1937

In 1937, Congress again enacted legislation to address the proliferation of tax avoidance

schemes that used corporations to lower the rate of tax on shareholders’ income. The Revenue

Act of 193734 (1937 Act) contained a series of provisions that were based on recommendations by

the Joint Committee on Tax Evasion and Avoidance. This Joint Committee was formed pursuant

to a resolution of Congress to investigate methods of tax evasion and avoidance disclosed in a

letter from President Roosevelt to Congress, dated June 1, 1937.35 In his letter, President

Roosevelt explained:

 A condition has been developing during the past few months so serious to the

Nation that the Congress and the people are entitled to information about it. The
- 108 -

36 1937 Report of the Joint Committee on Tax Evasion, supra note 32, at 1.

37 1937 Hearings, supra note 35, at 16.

38 Id.

39 Id.

40 1937 Report of the Joint Committee on Tax Evasion, supra note 32, at 1-2.

41 1937 Hearings, supra note 35, at 85.

Secretary of the Treasury has given me a report of a preliminary study of incometax returns for the calendar year 1936. This report reveals efforts at avoidance and

evasion of tax liability so widespread and so amazing both in their boldness and

their ingenuity that further action without delay seems imperative.36

At hearings before the Joint Committee on Tax Evasion and Avoidance, Henry

Morgenthau, Jr., Secretary of the Treasury, discussed some of the problems the government faced

in addressing tax avoidance devices, including the following:

In the highly competitive situation which exists among expert tax attorneys, plausible

devices spread rapidly and tax evasion and tax avoidance increase without anyone

realizing the extent of the impairment of tax administration until the end of the taxable

year.37

 Vested interests grow up in tax-avoidance devices in the course of time, so that it becomes

very difficult to change them after they receive a semi-respectable standing.38

 Those tax devices which defeat the intent of Congress cost the Government huge sums

which Congress never actually intended to give away.39 

In a letter accompanying the President’s letter to Congress, Henry Morgenthau Jr.,

Secretary of the Treasury, outlined the tax evasion devices that were leading to serious tax base

erosion. Among those devices was the use of foreign personal holding companies established in

tax havens to avoid tax.40

Under Secretary of the Treasury, Roswell Magill, testifying before the Joint Committee on

Tax Evasion and Avoidance, explained that foreign personal holding companies were used “as a

means of siphoning assets and income out of the United States into foreign countries where there

are no income taxes, or where such taxes are low.”41 Under Secretary Magill explained how the

foreign personal holding company had been used as a tax avoidance device:
- 109 -

42 Id. at 29.

43 1937 Report of the Joint Committee on Tax Evasion, supra note 32, at 17.

44 Id.

1. By assignment of income to the foreign personal holding company corporation in order

to avoid taxation of that income in the United States.

 2. By transfer of assets to the foreign personal holding corporation in order to have the

income on the assets paid to a foreign corporation and so reduce the personal tax of the

sole stockholder.

 3. By creating large interest deductions when the sole stockholder of the personal holding

corporation borrows back its capital or its annual income and pays interest thereon.

 4. By consummating abroad in the name of the foreign personal holding corporation a

profitable deal which the sole stock holder negotiated in the United States.

 5. By selling personally held securities to a foreign personal holding corporation to create

a profit in order to offset personal realized losses on securities and step up the cost basis

of the securities sold.

 6. By assigning royalty income to a foreign personal holding corporation, thus avoiding

taxes in the high surtax brackets.42

Based upon the evidence presented at the hearings, the Joint Committee on Tax

Avoidance and Evasion determined that legislation directed at the device of the foreign personal

holding company was “necessary to protect the revenue and prevent further use of one of the

most glaring loopholes now existing.”43 The Joint Committee noted that jurisdictional and tax

collection problems prevented Congress from enacting a regime parallel to the personal holding

company regime, which imposed a surtax directly on the corporation. Thus, the Joint Committee

proposed a method of taxation under which the undistributed income of the foreign personal

holding company would be included in the gross income of shareholders that were U.S. citizens or

residents whether or not this income was distributed to them.44

The 1937 Act defined a foreign personal holding company as a foreign corporation that

met two requirements: (1) more than 50 percent of its stock was owned by not more than five

individuals who were citizens or residents of the United States; and (2) at least 60 percent of its

gross income was derived from dividends, interest, annuities and other specified passive income. 

Pursuant to the recommendation of the Joint Committee, U.S. shareholders were required to take
- 110 -

45 Id. at 22.

46 H.R. Rep. No. 1447, 87th Cong., 2d Sess. 72 (1962) (1962 House Report).

into income, on a current basis, their pro rata share of the undistributed net income of the foreign

personal holding company.

Although the Joint Committee generally was satisfied that the foreign personal holding

company provisions would adequately deal with the tax evasion problems raised at the hearings,

they also recognized that this legislation might not be sufficient to address devices involving

foreign corporations that might arise in the future. In its report, the Joint Committee stated that:

[The Committee] . . . also recognizes the complex character of the problem and the

difficulty of framing a tax law which is proof against all the varied and complicated

devices involving the use of foreign entities which legal ingenuity may evolve in the

future. The committee is therefore of the view that it should continue its study of

this problem and should consider other and additional measures which may be

feasible for preventing the use of spurious foreign entities to thwart the intent and

purposes of the revenue laws. Accordingly, it is the intention of the committee to

consider possible measures for the creation of administration and judicial

procedure, including criminal penalties, to prevent the formation and compel the

dissolution of artificial foreign entities availed of by American citizens and

residents to evade or avoid Federal income taxes, and to make recommendations at

a later date with respect thereto.45

D. Foreign Investment Companies - 1962

In 1962, in conjunction with the enactment of subpart F, Congress enacted certain

provisions to address the tax deferral obtained by small investors in foreign investment companies. 

Domestic mutual funds or regulated investment companies were taxed on their current earnings. 

A domestic regulated investment company, however, was not subject to tax on its earnings if it

distributed at least 90% of those earnings and certain other conditions were met. In any case, at

least one level of tax was imposed, at the investor level. By contrast, foreign investment

companies could avoid U.S. tax if they had no U.S. source income. U.S. investors in such

companies generally were taxed only when they sold the stock, and the gain from the stock sale

was taxed at capital gain rates, rather than ordinary income rates. 

During the 1950s, Congress was aware that foreign investment companies were used for

tax avoidance but determined that by the early 1960s, “the seriousness of the problem [had]

increased substantially.46 In his 1961 tax message to Congress, President Kennedy noted that:
- 111 -

47 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)

(President’s Tax Message). 

48 1962 House Report, supra note 46, at 72-73.

49 President’s Tax Message, supra note 47, at 6-7.

For some years now we have witnessed substantial outflows of capital from

the United States into investment companies created abroad whose principal

justification lies in the tax benefits which their method of operation produces.47

The Kennedy administration recommended a regime for foreign investment companies

similar to that which it recommended for U.S.-controlled foreign corporations, i.e., current

inclusion of the income of the foreign corporation by the U.S. shareholders.48 Congress, however,

rejected this approach. Instead, the foreign investment company provisions, sections 1246 and

1247, taxed the U.S. shareholders of the foreign investment company at ordinary income rates on

their share of the post-1962 accumulated earnings and profits when they sold the stock of the

company. To avoid this treatment, taxpayers could elect to have the foreign corporation

distribute 90 percent of the taxable income other than capital gains. U.S. shareholders who made

this election were, however, required currently to include in income their share of the capital gains

whether or not distributed. These provisions applied to a foreign corporation that was either

registered as a management or unit investment trust or that was primarily engaged in investing or

trading in securities, where more than 50 percent of the stock of the corporation was held by U.S.

persons. U.S. persons included individuals, corporations, partnerships and trusts. Because these

provisions applied without regard to the ownership percentage of the U.S. person, small investors

were subject to this regime. 

III. Subpart F

A. Brief Chronology

Subpart F of the Internal Revenue Code, enacted by the Revenue Act of 1962, was based

on a proposal by President Kennedy outlined in his tax message to Congress on April 20, 1961.49

(President's Tax Message). The President cited “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,” as the reasons to target features of the
- 112 -

50 Id. at 6. 

51 Id.

52 Id. at 7. 

53 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, April 20, 1961, 87th Cong., 1st Sess. (Vol. 1) 261 (1961 Hearings before the House).

54 Id. at 262.

55 Id. at 263.

56 Id. at 263-64.

U.S. tax system that favored U.S. investment abroad over investment in the U.S. economy.50

Among the features of the U.S. tax system targeted in the President's Tax Message was the

availability of tax deferral for American firms operating abroad through foreign subsidiaries, the

income of which was not taxed until repatriated as a dividend.51 The President's Tax Message

recommended elimination of tax deferral in developed countries and, in all countries, "the

elimination of the tax deferral privileges for those forms of activities, such as trading, licensing,

insurance and others, that typically seek out tax haven methods of operation."52

 

Under the President’s proposal, where certain ownership thresholds were satisfied, the

U.S. shareholders of a foreign corporation would include in gross income each year as a deemed

dividend their pro rata share of the corporation’s entire profits for the year.53 As with an actual

dividend, the deemed dividend would carry with it foreign tax credits.54 These current inclusion

rules would not apply with respect to corporations organized in less developed countries,

however, unless they were classified as tax haven corporations.55 A tax haven corporation would

be defined as any corporation that derived more than 20 percent of its income from sources

outside the less developed country in which it was created. Income would be treated as derived

from sources outside the country of incorporation if it fell into one of the following categories: (1)

income from the sale of personal property not produced by the corporation, to the extent the

personal property is sold for consumption outside the country of incorporation; (2) commissions

in connection with the sale of personal property outside the country of incorporation; (3) interest

and dividends from corporations created under the laws of another country; (4) compensation for

certain services rendered outside the country of incorporation; (5) rents or royalties from property

located or used outside the country of incorporation; (6) premiums for the insurance of risks

located outside the country of incorporation; and (7) profits from the operation of international

shipping and aircraft.56

The House Committee on Ways and Means conducted hearings on President Kennedy’s

tax proposal during May and early June of 1961. Following the hearings, the Ways and Means
- 113 -

57 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).

58 Id. at 51.

59 Id.

60 H.R. Rep. No. 1447, 87th Cong., 2d. Sess. (1962).

Committee considered the President’s proposal in executive sessions, during which the Treasury

presented a modified version of the President's proposal.57 The modified Treasury draft, which

was released to the public for comment on July 28, 1961, was prepared in response to suggestions

of committee members and testimony during the hearings.58 The modified Treasury draft did not

incorporate the President’s broader proposal to eliminate deferral for all of the income of a

foreign subsidiary organized in a developed country, but dealt only with ending deferral for

income from tax haven transactions. The modified Treasury draft defined income from tax haven

transactions to include many of the same types of income that were identified as tax haven income

in the President’s original proposal. The modified Treasury draft, however, also required that the

income be derived from transactions with related parties.59

Following a decision to defer action on the President’s proposal until the following

session, a bill reflecting the President’s proposal, H.R. 10650, was introduced into the House on

March 12, 1962, and reported by the Ways and Means Committee on March 16, 1962.60

H.R.10650 was passed by the House on March 29, 1962. The House bill followed the modified

Treasury proposal in targeting tax haven operations. It did not adopt the President's

recommendation to eliminate tax deferral completely in the case of operating companies located in

developed countries. The House bill ended deferral only for earnings attributable to certain

targeted income: (1) income from insuring or reinsuring U.S. risks; (2) income from patents,

copyrights, etc. developed in the United States or acquired in the United States from related

persons; (3) certain passive income; and (4) income from purchases or sales involving related

persons where the property was produced and sold for use outside the foreign corporation’s

country of incorporation. The House bill also provided that the U.S. shareholder would be

subject to tax on the undistributed earnings of the foreign corporation that did not fall into any of

the above-categories to the extent the earnings were not reinvested in substantially the same

business or in a foreign corporation organized in a less developed country where certain

ownership requirements were satisfied.

On April 2, 1962, the Senate Finance Committee began hearings on H.R.10650. On that

date, Douglas Dillon, the Secretary of the Treasury, addressed the Senate Finance Committee,
- 114 -

61 Revenue Act of 1962, Hearings Before the Committee on Finance on H.R. 10650, 87th Cong.,

2d Sess. (Part 1) 99 (1962) (1962 Hearings before the Senate).

62 Committee on Finance, 87th Cong, 2d Sess., Draft of Statutory Language with Accompanying

Explanation of Amendments Proposed by the Secretary of the Treasury on May 10, 1962, to

Sections 13, 15, 16 and 20 of H.R. 10650, III (Comm. Print 1962), reprinted in Revenue Act of

1962, Hearings before the Committee on Finance on H.R. 10650, 87th Cong., 2d Sess., (Part

Eleven) 4415 (1962) (1962 Treasury Draft).

63 Id.

64 Id. at 1-2.

65 Id. at 3.

66 Id.

continuing to push for the complete elimination of deferral for all the income of U.S.-owned

foreign subsidiaries operating in developed countries.61

On May 31, 1962, Secretary Dillon transmitted a draft of statutory language to the Senate

Finance Committee.62 Again, the Treasury draft, which targeted tax haven-type income, was

submitted as an alternative proposal to the President’s broader proposal to eliminate all deferral.63

The Treasury draft differed from the House bill in that it proposed to narrow some of the

categories of income subject to current inclusion. For example, the Treasury draft attempted to

narrow the definition of foreign personal holding company income to include only “passive

income” and “tax haven income.” Passive dividends, interest, rents and royalties were those

received from unrelated persons not in connection with the active conduct of a trade or business. 

Tax haven dividends, interest, rents and royalties were those received from related persons in

connection with income producing activities located outside the recipient’s country of

incorporation.64 Thus, the Treasury draft intended to carve out, as non-passive income,

dividends, interest, rents and royalties derived from the active conduct of activities such as

banking, financing, shipping, insurance and leasing of property, if those activities were conducted

with unrelated persons.65 The Treasury draft also intended to carve out, as non-tax haven income,

dividends, interest, rents and royalties received from related persons organized in the same

country as the recipient, or earned from using property within the recipient’s country of

incorporation. The Treasury draft proposed to replace the provision in the House bill requiring

current inclusion of earnings not reinvested in the foreign corporation’s business with a narrower

provision that targeted earnings of the foreign corporation invested in U.S. property.66 The

Treasury draft proposed to remove the category pertaining to income from U.S. patents and
- 115 -

67 Id. at 2-3.

68 Id. at 2.

69 Id.

70 S. Rep. No. 1881, 87th Cong., 2d Sess. (1962) (1962 Senate Report). 

71 1962 Senate Report, supra note 70, at 79. 

72 108 Cong. Rec. 18594 (1962).

replace it with a separate provision that, in certain circumstances, would tax the gain from the sale

of the U.S. patent.67 

The Treasury draft proposed certain additions to the rules. One such addition was a new

category of income subject to current inclusion, income from performing services for or on behalf

of a related person outside the foreign corporation’s country of incorporation.68 The Treasury

draft also proposed adding a branch rule to the foreign base company sales income provisions to

apply to situations “in which a branch or similar establishment acts in the same manner as a

controlled foreign corporation."69 

On August 16, 1962, the Senate Finance Committee reported out the bill.70 The Senate

Report noted that, although the Senate version of the bill differed in some respects from the

House version, the Senate amendments "like the House bill, also are designed to end tax deferral

on 'tax haven' operations by U.S. controlled corporations."71 The Senate version of the bill

incorporated many of the suggested changes contained in the Treasury draft transmitted on May

31, 1962. However, the Senate version of the bill added two relief provisions. Under the first,

the undistributed income of the foreign corporation was not subject to current inclusion to the

extent the foreign tax paid on the income was not substantially below the U.S. rate. The second

relief provision allowed deferral to continue, subject to certain limitations, for foreign

corporations engaged in export trade when the products they sold abroad were produced or

grown in the United States. 

The bill was debated on the floor of the Senate in late August and early September of

1962. On September 5, 1962, Senator Jacob Javits introduced an amendment that effectively

would have treated the European Economic Community (EEC) as one country for purposes of

the foreign base company sales and services rules.72 Thus, for example, under the amendment, a

controlled foreign corporation organized in an EEC country could have earned income from

selling a product on behalf of a related person that was both manufactured and sold for use in

other countries in the EEC and have avoided the foreign base company sales income rules. This

result could have occurred because the sales and manufacturing activity would have been deemed

to have taken place within the controlled foreign corporation’s country of incorporation. Senator

Javits argued that his amendment was necessary to enable U.S. firms to compete with other
- 116 -

73 108 Cong. Rec. 18597 (1962).

74 108 Cong. Rec. 18598 (1962).

75 President’s Tax Message, supra note 47, at 24.

76 1961 Hearings before the House, supra note 53, at 303, 343; President’s Tax Message, supra

note 47, at 6, 26.

77 1961 Hearings before the House, supra note 53, at 303, 343.

corporations organized in an EEC country.73 This proposed amendment was rejected after

Senator Kerr, the ranking Democratic member of the Senate Finance Committee, argued that,

although the EEC countries could be regarded as one economic entity, they continued to maintain

separate taxing regimes and, thus, the amendment would have allowed controlled foreign

corporations to take advantage of differing tax systems to lower their overall tax contrary to the

purposes of the bill.74

H.R. 10650 was passed by the Senate on September 6, 1962. The conference report on

the bill was filed on October 1, 1962, and the bill was signed into law on October 16, 1962. The

provisions of the legislation as enacted are discussed in part 1, section IV of this Appendix A,

below.

B. Factors Leading to President’s Tax Proposal

 

1. New Opportunity for Tax Deferral Through Tax Haven Operations

As noted above, prior to the enactment of subpart F, U.S. firms were able to obtain

indefinite deferral of U.S. tax on the profits of their foreign subsidiaries that were not subject to

the foreign personal holding company regime because these profits were not subject to tax in the

United States until repatriated through dividend distributions. To the extent the foreign tax rate

was comparable to the U.S. rate, as it was in many of the European countries in the early 1960s,75

deferral provided no particular tax benefit. An incentive to defer U.S. tax on the earnings of a

foreign subsidiary existed only to the extent the foreign tax rate was significantly lower than the

U.S. rate. 

Although U.S. businesses previously had been able to benefit from deferral by operating

through a foreign subsidiary in a low-tax country, their use of tax haven corporations to obtain a

tax advantage for income otherwise earned in a high-tax foreign country was a new and rapidly

growing phenomenon.76 The Administration’s figures indicated that over one-third of the

approximately 500 American-owned firms in Switzerland had been formed in 1960.77 The
- 117 -

78 Id. at 303, 305.

791962 Hearings before the Senate, supra note 61, at 98.

80 President’s Tax Message, supra note 47, at 25.

81 1962 Hearings before the Senate, supra note 61, at 98.

82 President’s Tax Message, supra note 47, at 25.

83 Id.

84 Id.

85 1961 Hearings before the House, supra note 53, at 347; President’s Tax Message, supra note

47, at 6, 29.

Administration’s anti-deferral proposal was largely motivated by its concern about the

proliferation of U.S.-owned tax haven corporations.78

The Administration identified a number of artificial or paper transactions through which

profits could be diverted to a subsidiary organized in a tax haven, most of which required the tax

haven subsidiary to act as a middleman.79 For example, the tax haven subsidiary could acquire the

right to license patents developed by the parent or sister corporation; provide the services of

technicians of a corporate affiliate to a firm located in another country; acquire the distribution

rights of products manufactured by its affiliates;80 or reinsure the U.S. risks of its parent.81

Further, dividend and interest payments could be used to move earnings from a high-tax country,

such as Germany, to a tax haven.82 To illustrate the tax savings available through the use of tax

haven subsidiaries, the Administration gave the example of a U.S. company operating through a

German subsidiary.83 Although the tax rate in Germany was 51 percent, this tax rate could be

artificially lowered by diverting half of the profits, through one of the arrangements cited above,

to another subsidiary located in a tax haven country, such as Switzerland. Assuming the Swiss

tax was 8 percent, the overall tax rate on the income could be reduced to less than 30 percent.84

2. Economic Conditions

Certain economic conditions at the time of the Kennedy administration’s 1961 tax

proposal led the administration specifically to examine tax provisions that encouraged U.S.

taxpayers to move capital outside the United States. First, the United States was experiencing a

deficit in its international balance of payments, which the Administration was concerned would

threaten the stability of the U.S. dollar.85 Second, by the early 1960s, Japan and the countries of

Europe had become economically competitive with the United States, having completed postWorld War II reconstruction of their economies. Thus, the Kennedy Administration determined

that it was no longer necessary, as it had been during the immediate postwar period, to promote
- 118 -

86 President’s Tax Message, supra note 47, at 7, 17, 29.

87 Id. at 7.

88 1962 Hearings before the Senate, supra note 61, at 100-01. The Kennedy Administration

provided figures indicating that, under the most favorable assumptions, a dollar’s worth of

investment in Europe generated 10 cents worth of capital equipment exports, and hence, had the

effect on employment equal to 10 cents invested in the United States while a dollar invested

directly in the U.S. generated 40 cents worth of continuing production. Id. at 100. 

89 Id.

90 President’s Tax Message, supra note 47, at 6-7; 1962 Hearings before the Senate, supra note

61, at 103.

91 Id. at 6.

private investment in these developed countries. 86 The Kennedy administration believed,

however, that the United States continued to have an interest in promoting investment in

underdeveloped countries. Thus, the Administration proposed to allow deferral to continue for

U.S. companies operating through subsidiaries in underdeveloped countries that were not tax

haven corporations.87 

 

3. Efficient Allocation of Resources and Equitable Treatment of U.S.

Taxpayers

The Kennedy Administration argued that deferral encouraged U.S. businesses to make

investment decisions that were not beneficial to the U.S. economy. The Administration presented

evidence to show that artificially stimulated investment in developed countries led to few

additional net exports and therefore did not significantly affect the creation of new jobs in the

United States, while direct investment in the United States significantly benefitted U.S.

employment.88 The Administration noted that U.S. investment in the countries of Latin America

and other less developed countries generated a higher level of U.S. exports and thus was more

beneficial to U.S. employment.89 The Administration maintained that, to the extent deferral

encouraged companies to base investment decisions solely on the tax benefits available, it

interfered with the free market’s efficient allocation of international resources.90

 

The Kennedy Administration also maintained that its proposal to end deferral was

necessary to achieve greater equity among U.S. taxpayers.91 Those U.S. taxpayers that operated

abroad through foreign subsidiaries, and thus obtained the benefits of deferral, gained a significant

tax advantage over U.S. taxpayers that operated their businesses exclusively in the United
- 119 -

92 President’s Tax Message, supra note 47, at 6, 29.

93 1962 Hearings before the Senate, supra note 61, at 103.

94 1962 Hearings before the Senate, supra note 61, Exhibit III, at 177.

95 President’s Tax Message, supra note 47, at 30.

96 Id.

97 Id. See also 1961 Hearings before the House, supra note 53, at 348.

States.92 The Administration therefore maintained that deferral was akin to a special subsidy to

U.S. taxpayers operating in foreign countries.93

The Kennedy Administration took the position that, to encourage resources to be

allocated efficiently and to treat taxpayers equitably, the tax policy of the United States must be

based on the concept of tax neutrality. As explained in a report prepared by the Treasury and

submitted to the Senate in conjunction with the testimony of Douglas Dillon, Secretary of the

Treasury, in April, 1962, hearings before the Senate Finance Committee:

One of the most fundamental of the guiding principles in American income

taxation is that there should be equality in tax treatment of similar groups of

taxpayers. Applied to corporations, this principle must be interpreted to mean that

the income of any branch or subsidiary of an American corporation operating

overseas should as far as possible be subject to the same corporate income tax

rates as the income of any branch or subsidiary operating at home.

Justification of this basic principle, as a principle, is made on two grounds:

(1) it is ‘fair’ or ‘equitable’; and (2) it promotes the most efficient possible

allocation of our own and world resources.94

The Kennedy Administration recognized that, where tax rates differ between countries,

two alternative types of tax neutrality are possible.95 Under capital export neutrality, the foreign

income of a U.S. company is taxed at U.S. rates so that the U.S. company pays at least the U.S.

rate on its income whether it invests at home or abroad. Capital export neutrality thus eliminates

tax as an investment factor.96 Under capital import neutrality, the foreign income of the U.S.

company is taxed only at foreign rates, thus allowing the American investor abroad to be compete

under the same tax burden as foreign-owned companies. The Kennedy Administration conceded

that the two types of neutrality could not be achieved simultaneously, but believed that capital

export neutrality was a more important goal because it achieved the policy objectives of equity

and allowing the free market to control investment decisions.97 
- 120 -

98 1962 Hearings before the Senate, supra note 61, at 102.

99 1961 Hearings before the House, supra note 53, at 322.

100 Id. at 345.

101 Id. at 322, 343.

 

4. Complexity

The Administration repeatedly expressed the position that its proposals were only intended

to discourage tax motivated foreign investment and not legitimate overseas operations. As noted

by Secretary Dillon in hearings before the Senate: “[W]e are concerned only with artificial tax

inducements to invest abroad. We do not wish to impede such investment beyond removing these

special preferences.”98

Nevertheless, the Administration advocated an end to deferral for all of the income of

U.S.-owned foreign subsidiaries operating in developed countries because it believed that a more

narrowly targeted provision could not adequately address every possible use of a tax haven

corporation without undue complexity.99 In his statements in hearings before the House Ways

and Means Committee in May of 1961, Secretary Dillon acknowledged that a proposal directed

only at tax havens would address many of the Administration’s concerns but noted the difficulty

of drafting narrowly targeted anti-deferral provisions:

With the situation in Europe, we find that the possibilities are pretty well myriad

and we think you would have to develop a very complex body of law which would

probably have to be changed rather frequently in the light of experience to keep up

with the legal ingenuity of those who wish to make use of these tax havens.100

The Administration considered its broader proposal to be a simpler and more

comprehensive way to eliminate tax incentives to defer income through tax haven arrangements

while not significantly affecting companies operating in high-tax countries for which the foreign

tax credit would neutralize the tax effect of ending deferral.101

C. Arguments Against Ending Deferral on Tax Haven Income

Certain members of both the House Ways and Means Committee and the Senate Finance

Committee attached dissenting or alternative views to the House and Senate Reports

accompanying H.R. 10650. While some Senators acknowledged that the bill, as modified by the
- 121 -

102 See Additional Views of Senator Eugene McCarthy on H.R. 10650, S. Rep. No. 1881, 87th

Cong., 2d Sess. 353-54 (1962) (Additional Views of Senator McCarthy).

103

 See, e.g., Separate Views of the Republicans on H.R. 10650, H.R. Rep. No. 1447, 87th Cong.,

2d Sess. B23-24 (1962) (Separate Views of House Republicans); Further Views of Hon. Thomas

B. Curtis, H.R. Rep. No. 1447, 87th Cong., 2d Sess. B29, B30, B33 (Views of Representative

Curtis); Additional Views of Senator McCarthy, at 353-54; Dissenting Views of Senators Frank

Carlson, Wallace F. Bennett, John Marshall Butler, Carl T. Curtis, and Thruston B. Morton on

Section 11- Foreign Source Income, H.R. 10650, as Amended by Senate Finance Committee, S.

Rep. No. 1881, 87th Cong., 2d Sess. 359, 370 (1962) (Dissenting Views of Senators).

104

 See Separate Views of House Republicans, supra note 103, at B23.

105 See Separate Views of House Republicans, supra note 103, at B23-24; Dissenting Views of

Senators, supra note 103, at 370. While the Kennedy Administration did not dispute this point, it

argued that most of the developed countries, either through controls on foreign investment, e.g.,

France, or by treating the foreign corporation as a resident for tax purposes, e.g., Germany and

the U.K., effectively prevented their nationals from taking advantage of deferral. See 1962

Hearings before the Senate, supra note 61, at 102 ; 1961 Hearings before the House, supra note

53, at 323. 

106

 See Separate Views of House Republicans, supra note 103, at B25 (tax treaties and favorable

treatment for dividends fosters the use of Swiss marketing subsidiaries by European competitors

of American firms); 1961 Hearings before the House, supra note 53, at 303, 349 (remarks by

Secretary Dillon acknowledging that foreign-owned corporations used structures involving tax

haven corporations far less than American-owned corporations). 

Senate, was less far reaching than the original House version of the bill,102 both Senate and House

minority views had similar concerns about fundamental aspects of the bill as it applied to

controlled foreign corporations. The following is a summary of their arguments. 

 

1. Competitiveness of U.S.-Owned Firms and the Importance of Foreign

Investment 

The primary objection to the measure to end deferral for certain income of controlled

foreign corporations, as expressed by both the House and Senate minority views, was that the

measure would interfere with the ability of U.S.-owned corporations to compete with foreignowned corporations in the world market.103 Opponents of the measure argued that, to be

competitive, U.S.-owned firms must operate under the same tax rules as foreign-owned

corporations.104 Opponents contended that no foreign government imposed tax on undistributed

profits of foreign corporations.105 Conflicting representations were made during the hearings

about whether foreign-owned corporations could use tax haven corporations to benefit from

deferral.106 However, opponents of the measure maintained that, even if U.S.-owned firms
- 122 -

107 See 1961 Hearings before the House, supra note 53, at 349 (remarks of Representative Byrne).

108

 See Views of Representative Curtis, supra note 103, at B31; Additional Views of Senator

McCarthy, supra note 102, at 353; Dissenting Views of Senators, supra note 103, at 358. In an

exhibit presented in conjunction with Secretary Dillon’s testimony before the Senate Finance

Committee, Treasury challenged evidence presented by particular companies that foreign

investment by U.S. businesses had a positive effect on U.S. employment and the balance of

payments. Treasury argued that this evidence was flawed because (1) it represented the behavior

of a single company; (2) the data on capital outflow often included only purchases of stock in a

foreign company and did not necessarily include net increases in inter-company accounts; (3) the

data did not measure sales by foreign subsidiaries abroad that displace actual or potential U.S.

exports; (4) the data included investment in both developed and underdeveloped countries; and

(5) the inflows and outflows being compared, the outflow of new capital and the inflow from

dividends and export receipts for a given period, did not relate to each other because the

dividends and export receipts were generated by investment over several years. See 1962

Hearings before the Senate, supra note 61, at 173-74.

109 See Separate Views of House Republicans, supra note 103, at B21-22 (The provision “would

destroy more than 15 years of effort on the part of prior administrations, both Democrat and

Republican, to promote and expand the opportunity for American business in the world market as

an integral part of the U.S. foreign policy.”) 

110 See Dissenting Views of Senators, supra note 103, at 361.

conducted more tax haven operations than foreign-owned businesses, any competitive advantage

they gained was appropriate.107 Contrary to the position of the Administration that foreign

investment by U.S. business had little positive impact on U.S. employment and on the balance of

payments, opponents argued that exports were favorable to the balance of payments and

stimulated the economy, both creating jobs for U.S. workers and resulting in a dollar return in

excess of the amount invested abroad.108

 Opponents also expressed concern that the anti-deferral measure reversed longstanding

U.S. foreign policy that encouraged private investment abroad,109 and maintained that foreign

assistance continued to be necessary to prevent further aggression from Communist regimes.110 

 

2. Provision Should Not Apply to Avoidance of Foreign Tax

Another criticism of the measure was that, because tax haven corporations often were

used to avoid foreign income taxes, the measure, which would have the effect of preventing

foreign tax avoidance, would increase the revenue of foreign governments more than that of the

United States. It was argued that the United States was not justified in “taxing income earned by

a foreign corporation on transactions occurring outside of the United States merely because of
- 123 -

111 Separate Views of House Republicans, supra note 103, at B24.

112 See Id. at B25.

113

 See Id. at B21; Views of Representative Curtis, supra note 103, at B34; Additional Views of

Senator McCarthy, supra note 102, at 354; Dissenting Views of Senators, supra note 103, at 375-

85. Two memoranda were submitted to the House Ways and Means Committee during the

hearings on the Administration’s proposal. The first, by the Joint Committee on Taxation, took

the position that the provision was not constitutional, relying on Eisner v. Macomber, 252 U.S.

189 (1920). See 1961 Hearings before the House, supra note 53, at 311. The second, by the

Treasury Department, distinguished Eisner v. Macomber and argued that case law supported

taxing controlling shareholders on the undistributed earnings of a corporation where necessary to

prevent tax avoidance. See Id. at 313.

114 See Separate Views of House Republicans, supra note 103, at B27; Additional Views of

Senator McCarthy, supra note 102, at 354; Dissenting Views of Senators, supra note 103, at 384-

86. 

115 See Separate Views of House Republicans, supra note 103, at B25-27; Views of

Representative Curtis, supra note 103, at B34; Dissenting Views of Senators, supra note 103, at

363-65.

116 See Separate Views of House Republicans, supra note 103, at B26, Dissenting Views of

Senators, supra note 103, at 382.

American shareholders,”111 and that avoidance of foreign taxes should not be of concern to the

United States.112 

 

3. Constitutional and Treaty Issues

Opponents of the anti-deferral provision questioned the constitutionality of imposing a tax

on the undistributed income of a foreign corporation.113 Opponents also expressed concern that

the proposal would cause the United States to violate its treaty obligations with foreign

governments.114

4. Complexity and Potential Unintended Consequences

Opponents argued that the provision would cause administrative difficulties and would be

unnecessarily complex and burdensome for taxpayers.115 Opponents also questioned some of the

technical aspects of the provision. For example, opponents argued that, if U.S. shareholders were

being currently taxed on a deemed paid amount, they would want an actual distribution, which

may conflict with the interests of the foreign shareholders.116
- 124 -

117 See Additional Views of Senator McCarthy, supra note 102, at 354; Dissenting Views of

Senators, supra note 103, at 370, 382. 

118 See Separate Views of House Republicans, supra note 103, at B24-25.

119 See Dissenting Views of Senators, supra note 103, at 371.

120 See 108 Cong. Rec. 17752 (1962) (remarks of Senator Kerr) (“[T]his bill is beneficial in that it

will stop the drain on our investment which is artificially induced by the low tax rates it is possible

to obtain through the use of tax haven subsidiaries.”).

121 1962 House Report, supra note 46, at 57; 1962 Senate Report, supra note 70, at 79. As noted

by Senator Kerr during Senate floor debates:

 

The administration has requested that we end deferral of U.S. tax for U.S.-

controlled foreign corporations. This bill does not adopt this principle nor achieve

this objective. Instead, the foreign income provisions of the bill are aimed at a

much more limited objective, which should be acceptable to all – an ending of tax

haven abuses. 

 Opponents expressed concern that the provision would bring about unintended

consequences that would negatively impact the U.S. economy. For example, it was argued that,

because, in any case, the U.S. shareholder would pay tax on the undistributed earnings of its

foreign subsidiary at a rate at least equal to the U.S. rate, the provision invited foreign countries

to increase their taxes on this income to match the U.S. rate. The foreign taxes credits generated

would then “soak up” any residual U.S. tax on the income.117 Opponents also contended that tax

haven earnings should be encouraged because they generated more revenue for the United States

when finally repatriated. Unlike high-taxed earnings for which there is little or no residual U.S.

tax after foreign taxes are credited, the low-taxed earnings from tax havens would yield a residual

U.S. tax.118 Additionally, opponents argued that the provision would encourage U.S. investors to

shift to minority positions in foreign firms causing the United States to lose export benefits it

derived from U.S.-controlled firms, such as the use of U.S. manufacturers.119

D. Subpart F Targets Tax Haven Operations

1. Tax Haven Deferral

President Kennedy’s anti-deferral plan had contained two proposals: the elimination of tax

deferral privileges in developed countries; and the elimination of tax haven deferral privileges in

all countries. While Congress accepted the Kennedy Administration’s second proposal, agreeing

that tax haven abuses provided an inappropriate tax incentive for U.S. businesses to move capital

abroad and should be curtailed,120 it rejected the President’s first proposal to end deferral for U.S.

businesses operating in developed countries.121 Because the final legislation incorporates only the
- 125 -

108 Cong. Rec. 17750 (1962).

122 President’s Tax Message, supra note 47, at 6.

123 Id.

124 The President’s Tax Message, supra note 47, at 6. This portion of the President’s Tax

Message was quoted in both the House and Senate Reports. See 1962 House Report, supra note

46, at 57; 1962 Senate Report, supra note 70, at 78-79. 

tax haven deferral proposal, to understand the scope and purpose of subpart F, it is necessary to

clarify what the Kennedy Administration and Congress included within the concept of tax haven

deferral.

“Tax haven deferral privileges” could be distinguished from “tax deferral privileges in

developed countries,” the target of the President’s first proposal, because tax deferral in

developed countries could have been obtained by taxpayers that were conducting normal business

operations through non-tax motivated transactions. Commenting on his first proposal, the ending

of deferral in developed countries, the President stressed that:

 

Many American investors properly made use of this deferral in the conduct of their foreign

investment. Though changing conditions now make continuance of the privilege

undesirable, such change of policy implies no criticism of the investors who utilize this

privilege.122 

Tax haven deferral, however, was deferral that was not justified on business grounds but was

maintained for tax avoidance purposes. Referring to tax haven deferral, the President’s Tax

Message noted that, “[t]he undesirability of continuing deferral is underscored where deferral has

served as a shelter for tax escape through the unjustifiable use of tax havens such as

Switzerland.”123

Tax haven deferral included deferral obtained to avoid either U.S. or foreign taxes. The

type of transactions that the President’s proposal and Committee Reports identified as giving rise

to tax haven deferral were “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 both at home and abroad.”124 The Senate Finance

Committee reported that: 

In the case of foreign income, your committee has been primarily concerned with

ending tax haven abuses; namely, devices to avoid either the United States or
- 126 -

125 1962 Senate Report, supra note 70, at 2. See also 108 Cong. Rec. 17750–51 (1962) (remarks

of Senator Kerr) (describing tax haven abuses as “attempts to avoid U.S. or foreign taxes by the

use of artificial corporate devices or selection of countries for incorporation for tax rather than

business purposes.”).

126 President’s Tax Message, supra note 47, at 7. See also 1962 House Report, supra note 46, at

57; 1962 Senate Report, supra note 70, at 79 (quoting from President’s Tax Message).

127 1962 House Report, supra note 46, at 57; 1962 Senate Report, supra note 70, at 83.

128 See 108 Cong. Rec. 17751 (1962) (remarks of Senator Kerr). 

foreign taxes which could be expected to be imposed under normal business

operating conditions.125

 

Finally, tax haven deferral was identified by the way income was earned, rather than by

whether income was earned by a corporation organized in a country regarded as a tax haven. 

President Kennedy’s proposal, and the final subpart F legislation, identify “forms of activities,

such as trading, licensing, insurance, and others, that typically seek out tax haven methods of

operation.”126 The Kennedy Administration did not attempt to define the term “tax haven” other

than by example, e.g., Switzerland. Most types of tax haven income described in subpart F, as

originally enacted, shared two common elements. The income was derived (1) from sources

outside the controlled foreign corporation’s country of incorporation, and (2) from transactions

with related persons.

2. Subpart F Attempts to Preserve Competitiveness of U.S. Businesses

Congress accepted the arguments made during the hearings that the President’s broad

proposal would discourage U.S. businesses from investing abroad, which investment was

necessary to stimulate U.S. exports, and would place U.S.-owned businesses at a competitive

disadvantage with foreign-owned businesses.127 Although both the House and the Senate favored

a regime that specifically targeted tax haven operations, the Senate went further than the House

bill in protecting what it perceived to be legitimate foreign operations.128 Thus, the legislation, as

enacted, reflects an attempt to target artificial arrangements that created tax incentives for capital

to move outside the United States while being narrow in application to address concerns about

the competitiveness of U.S. business in the foreign market.

IV. Specific Provisions of 1962 Legislation

A. CFC, U.S. Shareholder, and Current Inclusion Rules

Senate amendments narrowed the class of foreign corporations subject to the rules of

subpart F based on a Treasury proposal that responded to complaints that the rules reached
- 127 -

129 Senate Committee on Finance, 87th Cong., 2d Sess., Draft of Statutory Language, with

Accompanying Explanation, of Amendments Proposed by the Secretary of the Treasury on May

10, 1962, to Sections 13, 15, 16, and 20 of H.R. 10650, at 3 (Comm. Print 1962) (1962

Explanation of Treasury Draft).

130 I.R.C. § 957(a). All section references in this discussion are to the Internal Revenue Code as

in effect during the year of enactment of the provision described.

131 I.R.C. § 951(b). 

132 I.R.C. § 951(a)(1).

133 Both the House and Senate versions of the bill were narrower than the original Treasury

proposal, which would have subjected 10 percent shareholders of newly formed foreign

corporations to current inclusion rules regardless of the percentage of U.S. ownership of the

foreign corporation. 1961 Hearings before the House, supra note 53, at 261.

134 1962 Senate Report, supra note 70, at 240.

135 I.R.C. § 951(a)(1)(A) and (B).

“situations where ownership was widely scattered and no U.S. group was in effective control.”129

As enacted, subpart F defined a controlled foreign corporation (CFC) as a foreign corporation

more than 50 percent of the total combined voting power of which was owned, actually (directly

or indirectly) or constructively, by U.S. shareholders.130 A “U.S. shareholder” was a specifically

defined term meaning a U.S. person that owned, directly, indirectly or constructively, 10 percent

or more of the voting power of the foreign corporation.131 As enacted, the rules applied only to

U.S. shareholders that owned 10 percent of the voting power, direct or indirectly.132 That is,

constructive ownership was not taken into account for purposes of determining the amount of the

inclusion. 

A Senate amendment narrowed the House bill’s definition of controlled foreign

corporation. The House bill would have taken into account all U.S. ownership, not just 10

percent owners, in determining whether the greater than 50 percent threshold was satisfied.133

The House bill also would have made the current inclusion rules apply to U.S. persons that owned

10 percent of the value of the corporation regardless of the amount of voting stock they owned.134

As enacted, subpart F required a U.S. shareholder of a CFC to include currently in gross

income his pro rata share of three different amounts: (1) the subpart F income for the taxable

year; (2) the previously excluded subpart F income withdrawn from investment in less developed

countries for the taxable year; and (3) the foreign corporation’s increase in earnings invested in

U.S. property for the taxable year.135 The amount of subpart F income subject to current

inclusion was limited to the earnings and profits of the CFC less accumulated deficits since 1959,
- 128 -

136 I.R.C. § 952(c).

137 I.R.C. § 952(d).

138 I.R.C. § 959.

139 1962 House Report, supra note 46, at 58.

140 Life Insurance Company Income Tax Act of 1959, Pub. L. No. 86-69, 73 Stat. 112.

141 1962 Senate Report, supra note 70, at 81.

142 I.R.C. §§ 952(a)(1) and 953.

143 I.R.C. § 953(a)(1)(B).

144 1962 Senate Report, supra note 70, at 82. See I.R.C. § 957(b).

not otherwise offset.136 Earnings and profits could also be reduced by deficits of other foreign

corporations in the same chain of ownership.137 To prevent double taxation, actual distributions

were excluded from income to the extent they were paid out of earnings and profits attributable to

amounts that had previously been included in the gross income of the U.S. shareholder under

subpart F.138

B. Two Categories of Subpart F Income: Income from Insuring U.S. Risks and

Foreign Base Company Income 

Subpart F income was defined to include two general categories of income: (1) income

from insuring U.S. risks, and (2) foreign base company income.

1. Income from Insuring U.S. risks

Congress targeted income from insuring U.S. risks because of its concern that certain

insurance income was being diverted through foreign subsidiaries to avoid U.S. taxation.139 In

1959, legislation was enacted that, for the first time in many years, taxed insurance companies on

underwriting income.140 Congress became aware that insurance companies were attempting to

avoid this tax by reinsuring their policies, or placing the initial policies, with their foreign

subsidiaries.141 To address this problem, Congress included income from insuring or reinsuring

U.S. risks within the definition of subpart F income if the associated premiums exceeded 5 percent

of total premiums.142 Certain income from cross-insurance arrangements also was included within

the definition of subpart F income to prevent taxpayers from entering into arrangements to avoid

these rules.143 A special definition of CFC, which used a 25 percent rather than 50 percent

threshold for control, was added to prevent insurance companies from attempting to decontrol to

prevent the application of the subpart F insurance income rules.144 
- 129 -

145 See 1962 House Report, supra note 46, at 58 (describing foreign base company sales income).

146 I.R.C. § 954(a).

147 I.R.C. § 954(c).

148 1962 Senate Report, supra note 70, at 83.

149 See 1962 Explanation of Treasury Draft, supra note 129, at 1-2.

150 1962 Senate Report, supra note 70, at 83.

151 I.R.C. § 954(c)(3).

152 See 1962 Explanation of Treasury Draft, supra note 129, at 1-2 (describing proposal for

related person exceptions to foreign personal holding company income that were adopted by

Senate amendments).

2. Foreign Base Company Income

The foreign base company income rules of subpart F were directed at tax haven

arrangements that were designed “to avoid either U.S. tax or tax imposed by the foreign country”

by exploiting a “multiplicity of foreign tax systems.”145 Foreign base company income consisted

of three categories of income: foreign personal holding company income, foreign base company

sales income, and foreign base company services income.146

a. Foreign Personal Holding Company Income 

Foreign personal holding company income generally included income from portfolio types

of investments and other passive investment income.147 Congress believed that ending deferral for

this type of income would not interfere with competitiveness of U.S. businesses operating

abroad.148 Nevertheless, following a Treasury proposal,149 Congress sought to carve out from this

category income that was neither passive income nor tax haven-type income.150

Congress determined that the following types of investment income were not passive

income, and therefore should be excluded from foreign personal holding company income: (1) 

rents and royalties received from an unrelated person and derived in the active conduct of a trade

or business, and (2) dividends, interest and certain gains derived in the conduct of a banking

business or derived from investments made by an insurance company of its unearned premiums or

reserves.151

Congress also determined that dividends, interest, rents and royalties received by a CFC

from a related person generally should be excluded from foreign personal holding company

income if this income was not “tax haven” type income,152 that is, if it was earned under
- 130 -

153 See 108 Cong. Rec. 18598 (1962) (remarks of Senator Kerr) (the same country exceptions

were included in the bill because all corporations in a single country receive the same tax

treatment). 

154 I.R.C. § 954(c)(4)(A).

155

 See 1962 Senate Report, supra note 70, at 83 (“Your committee saw no reason for taxing the

U.S. shareholders on dividends received by a CFC from a related party where the U.S.

shareholder would not have been taxed if he owned the stock of the related party directly.”). 

156 I.R.C. § 954(c)(4)(C).

157 1962 Senate Report, supra note 70, at 83. See I.R.C. § 954(c)(4)(B).

158 1962 House Report, supra note 46, at 58.

159 1962 Senate Report, supra note 70, at 84.

160

 Id.

circumstances that did not take advantage of two or more foreign tax systems to artificially lower

the tax rate.153 Thus, the foreign personal holding company income rules contained two same

country exceptions applicable to related party payments. The first exception excluded dividends

and interest from foreign personal holding company income that were received from a related

person organized under the laws of the same country as the recipient CFC if the related person

had a substantial part of its assets used in a trade or business located in that country.154 Through

this exception, Congress sought to treat foreign corporations organized in the same country in a

manner similar to a U.S. consolidated group.155 The second exception excluded rents and

royalties that were received from a related person for the use of property within the CFC’s

country of incorporation.156

The foreign personal holding company rules also contained a third related party exception

intended to exclude interest payments between two related financial institutions engaged in normal

business transactions.157 The interest was excluded if both financial institutions conducted

business predominately with unrelated persons.

b. Foreign Base Company Sales Income

The foreign base company sales income provisions were intended to curtail the use of tax

havens to siphon off sales profits of a related corporation to obtain a lower rate of tax for this

income.158 Congress was primarily concerned with situations in which the U.S. parent or a related

U.S. or foreign corporation manufactured the product that the tax haven subsidiary sold (either as

principal or commission agent).159 Thus, the rules focused on purchases or sales transactions

involving related persons where the manufacturing and selling functions were separated into two

different taxing jurisdictions.160 
- 131 -

161 I.R.C. § 954(d)(1).

162 1962 Senate Report, supra note 70, at 84; 1962 House Report, supra note 46, at 62. Although

the intent of Congress to exclude income from the sale of a property manufactured by the CFC is

not specifically reflected in the statutory language, treasury regulations contain a manufacturing

exception to the foreign base company sales income rules based upon this legislative history. See

Treas. Reg. § 1.954-3(a)(4).

163 1962 Senate Report, supra note 70, at 84.

164 See I.R.C. § 954(d)(2). Those regulations are contained in Treas. Reg. § 1.954-3(b).

Foreign base company sales income was defined as income (including commissions)

derived from the purchase of personal property from, or on behalf of, a related person and its sale

to any person or the purchase of personal property from any person and its sale to, or on behalf

of, a related person where the property was both manufactured and sold for use outside the

CFC’s country of incorporation.161 The tax haven abuses with which Congress primarily was

concerned involved mere paper corporations or corporations that performed minimal functions. 

Thus, language in the committee reports makes clear that Congress intended to exclude sales

income from subpart F income if the CFC performed a significant amount of manufacturing (as

distinguished from minor assembly or packaging) with respect to the product that it sold.162

Congress also expanded the foreign base company sales income rules to cover branch

operations. Congress was concerned that the separation of selling and manufacturing activities

could also be accomplished by having the CFC form a branch in a tax haven or incorporate in the

tax haven and form a branch in another country and locate either the sales or manufacturing

function in the branch.163 In certain circumstances (for example, where the CFC’s country of

incorporation and the country where the branch was located both used a territorial system of

taxation) the tax effect would be the same as if the branch were a separate subsidiary organized in

that country. The foreign base company sales income rules thus contained a branch rule that

treated the income attributable to branch operations as foreign base company sales income when

the branch operations had substantially the same effect as if the branch were a separate subsidiary. 

Congress gave the Treasury regulatory authority to determine the specific circumstances under

which the branch rule would apply.164

c. Foreign Base Company Services Income 

The foreign base company services income provisions, like the foreign base company sales

income provisions, were intended to end deferral where a tax haven subsidiary was used to

separate a portion of the active business income of the parent or a related corporation and move it

to a low-tax jurisdiction. Congress was specifically concerned about the use of a tax haven
- 132 -

165 1962 Senate Report, supra note 70, at 84.

166 1962 Explanation of Treasury Draft, supra note 129, at 2.

167 I.R.C. § 954(e).

168 I.R.C. § 954(b)(1).

169 I.R.C. § 954(a)(1)(A)(ii).

subsidiary to separate services from manufacturing activity.165 Senate amendments added the

foreign base company services income provisions in response to Treasury’s concern that, without

them, a serious gap would exist in the foreign base company rules.166 

Foreign base company services income was defined as income derived in connection with

the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial,

commercial, or similar services performed for or on behalf of a related person outside the CFC’s

country of incorporation.167 Because Congress was concerned about the separation of services

and manufacturing activities, it excluded from the definition of foreign base company services

income, income arising from services directly related to, and performed prior to, the sale of 

property that was manufactured by the CFC or income arising from services directly related to an

offer or effort to sell such property. 

d. Exclusions from Foreign Base Company Income 

Subpart F contained special rules that allowed for the reduction or exclusion of foreign

base company income. 

(1) Investments in Less Developed Countries 

Consistent with the Kennedy Administration’s original proposal, the new legislation

provided limited deferral for certain investments in less developed countries. Foreign base

company income was reduced by dividends, interest and net gains from qualified investments in

less developed countries to the extent these amounts were reinvested in qualified investments in

less developed countries.168 Conversely, U.S. shareholders were required to include in gross

income their pro rata share of the amounts withdrawn from investments in less developed

countries for the year.169

(2) Shipping Income
- 133 -

170 I.R.C. § 954(b)(2).

171 1962 Senate Report, supra note 70, at 85.

172 I.R.C. § 954(b)(3).

173 I.R.C. § 954(b)(4).

174 See I.R.C. §§ 951(a)(1)(B), 956.

175 I.R.C. § 956(b).

176 1962 Senate Report, supra note 70, at 88.

The subpart F rules also excluded from foreign base company income amounts derived in

connection with the use of any aircraft or vessel in foreign commerce.170 Congress allowed

deferral to continue for this type of income because it believed that a U.S.-owned maritime fleet

and airlines operating abroad were in the interest of national defense.171

e. Other Special Rules

The subpart F rules provided that if foreign base company income was less than 30

percent of the gross income of the CFC, none of the income was foreign base company income

(de minimis exception) and, if foreign base company income exceeded 70 percent of gross

income, all of the income of the CFC (less deductions) was foreign base company income (full

inclusion rule).172 Senate amendments had raised the de minimis percentage from 20 to 30 percent

and had lowered the full inclusion percentage from 80 to 70 percent.

A special rule also provided an exception for CFCs not availed of to reduce taxes. Under

this rule, foreign base company income did not include any item of income if it was established to

the satisfaction of the Treasury that, with respect to this income, creating the CFC did not have

the effect of substantially reducing income or similar taxes.173

C. Investments in U.S. Property

In addition to insurance income and foreign base company income, the subpart F rules also

required a U.S. shareholder to include in gross income his pro rata share of the CFC’s increase in

earnings invested in U.S. property.174 “U.S. property” included tangible property located in the

United States, stock of a domestic corporation and obligations of a U.S. person, and the right to

use in the United States a patent, copyright, etc.175 In enacting this provision, Congress

recognized that bringing earnings back to the United States through U.S. investments was

substantially equivalent to paying a dividend to the U.S. shareholder.176 Certain property was

specifically excepted from the definition of U.S. property, for example, investments in U.S. bank
- 134 -

177

 Id.

178 1962 Explanation of Treasury Draft, supra note 129, at 3.

179 I.R.C. § 963.

180 1962 Senate Report, supra note 70, at 88.

181 I.R.C. § 970.

182 1962 Senate Report, supra note 70, at 90-91.

accounts and certain loans arising in connection with the sale or processing of property, because

Congress determined that these types of investments were “normal commercial transactions

without intention to permit the funds to remain in the United States indefinitely.”177

 The House bill contained a broader rule that, in addition, would have required U.S.

shareholders to include in income their pro rata share of the corporation’s increase in earnings

invested in property that was not necessary for the active conduct of the trade or business of the

CFC. A Senate amendment eliminated this provision following a Treasury recommendation that

noted the difficulty in determining whether earnings were invested in the same trade or business

and certain other technical difficulties.178

D. Minimum Distribution Rules

Subpart F income was not taxed to the U.S. corporate shareholders if the CFC (or

specified group of related CFCs) met a schedule of minimum distributions of earnings and

profits.179 The higher the effective foreign tax rate on the income, the lower the minimum

distribution that was required to avoid a subpart F inclusion. When the effective foreign tax rate

was 47 percent or more, no minimum distribution was required. A Senate amendment added this

provision to give relief from the subpart F provisions where the foreign tax, combined with the

U.S. tax paid on the distributed income, was not substantially below the U.S. tax rate.180 

E. Export Trade Corporation

Foreign base company income of an export trade corporation was reduced to the extent

this income consisted of export trade income, subject to certain limitations.181 The amount of

foreign base company income that could be deferred was also limited to the amount of income

invested in export trade assets. A Senate amendment added this relief provision to encourage

export trade by giving limited deferral for corporations selling products abroad that were

produced in the United States as long as the income for which deferral was allowed was used to

expand the export trade business.182
- 135 -

183 I.R.C. § 960.

184 I.R.C. § 962.

185 1962 Senate Report, supra note 70, at 92.

F. Foreign Tax Credit

The subpart F rules allowed a U.S. shareholder to obtain a foreign tax credit with respect

to its subpart F inclusion to the same extent it would have been allowed a foreign tax credit upon

an actual distribution.183 Thus, generally the credit was available to a corporate U.S. shareholder

that satisfied certain stock ownership rules. Individuals, however, could also obtain a foreign tax

credit under these rules if they elected to be taxed at corporate rates.184 Congress intended this

provision to give individuals the assurance that their tax burdens would be no heavier than if they

had invested in a domestic corporation doing business abroad.185

V. Significant Amendments to Subpart F Since 1962 Act

A. Overview

Congress rejected the Kennedy Administration’s broad anti-deferral approach, attempting,

instead, to identify specific types of transactions that created artificial tax incentives to move

capital abroad. This targeted approach has resulted in a high level of complexity. As subsequent

administrations have sought to continue the process of specifically identifying tax haven

transactions, the number of categories of subpart F income has grown from 2 to 5. The number

of subcategories of foreign base company income has grown from 3 to 5. Four new categories of

foreign personal holding company income have been added and several of the existing categories

of foreign personal holding company income have been expanded. Certain rules have been added

and later removed, such as section 956A, which required a U.S. shareholder to include in income

currently its pro rata share of the CFC’s excess passive assets. In addition, Congress added a new

anti-deferral regime, the passive foreign personal holding company (PFIC) regime, which

overlapped to some extent with the subpart F regime. New rules were thus required to govern

the interaction of the PFIC rules with subpart F. As Congress has sought to address concerns

about competitiveness, the number and complexity of the exceptions and special rules has also

grown, such as the recent temporary provisions for active financing income.

Congress, at times, has targeted tax haven transactions to raise revenue. For example,

Congress expanded the scope of subpart F in 1975 when it also enacted a series of tax reduction

measures designed to alleviate the high rate of unemployment and declining rate of economic

growth. In 1986, when Congress decreased the tax rate, it amended subpart F by increasing the

number of categories of subpart F income, thereby expanding the tax base. Congress added the
- 136 -

186 P.L. No. 91-172, 83 Stat. 718 (1969).

187 I.R.C. § 954(b)(4).

188 S. Rep. No. 552, 91st Cong., 1st Sess., reprinted in 1969-3 C.B. 423, 606-607.

189 P.L. No. 94-12, 89 Stat. 26 (1975).

190 S. Rep. No. 36, 94th Cong., 1st Sess. 5 (1975). Figures presented by the Senate Finance

Committee indicated that in 1974 the decline in real GNP from the previous year was the largest

956A provisions in 1993, as part of a revenue raising package, when the United States was

experiencing a budget deficit.

In addition, Congress has viewed tax deferral as a tax benefit that may be removed when

taxpayers engage in certain activity such as participation in an international boycott or making

certain illegal payments.

B. Amendments to Subpart F

The amendments to subpart F since 1962 are described in detail below.

1. Tax Reform Act of 1969 

a. Revision of Exception from Foreign Base Company Income

The Tax Reform Act of 1969186 revised the exception under which an item of income was

excluded from foreign base company income if it was established that creation of the CFC in the

country in which it was incorporated did not have the effect of substantially reducing taxes with

respect to the income. The revised rule was a two-pronged test that focused on “purpose” rather

than “effect.” Under the revised rule, foreign base company income did not include income if it

was established that neither the creation or organization of the CFC in the particular country nor

the transaction giving rise to the income had as one of its significant purposes a substantial

reduction of taxes.187 The revised rule recognized that foreign law may require a CFC to dispose

of assets, the gains from which are not taxed under foreign law but which would have been taxed

under U.S. law.188 The formation of the CFC in that country would have the effect, though not

the purpose, of reducing taxes.

2. Tax Reduction Act of 1975

The Tax Reduction Act of 1975189 (1975 Act) was enacted to respond to certain economic

conditions in the United States. In 1974, the United States experienced a sharp decline in

economic activity together with a high unemployment rate.190 The 1975 Act contained provisions
- 137 -

since 1946 and the rate of unemployment was the highest since 1941. Id. at 5-6.

191 Id. at 5.

192 H.R. Conf. Rep. No. 120, 94th Cong., 1st Sess. 70.

193 I.R.C. § 954(f).

194 I.R.C. § 954(b)(2).

that Congress hoped would “check the drastic downward slide in our economy and . . . restore a

rate of economic growth that [would] . . . move [the United States] . . . closer to full

employment.”191 The 1975 Act primarily contained a series of tax reduction measures.

The Senate Finance Committee had proposed an amendment that would have imposed the

current inclusion rules of subpart F on U.S. persons that owned a one percent or greater interest

in a foreign corporation that was owned more than 50 percent by U.S. persons. The conference

report substituted for this Senate amendment “a number of specific measures which substantially

expand the extent to which foreign subsidiaries of U.S. corporations are subject to current U.S.

taxation on tax haven types of income under the . . . subpart F rules of the Code.”192 The

following is a list of the measures substituted by the conference report. 

a. Repeal of Minimum Distribution Exception

The 1975 Act repealed the minimum distribution rule under which the U.S. shareholder

could avoid a subpart inclusion if the CFC (or related group) met a schedule of minimum

distributions.

b. Repeal of Less Developed Country Exception

The 1975 Act repealed the exclusion for interest, dividends and gain derived from certain

investments in less developed countries.

c. Repeal of Shipping Income Exception and Addition of Foreign

Base Company Shipping Income Exception

The 1975 Act repealed the rule that excluded shipping income from foreign base company

income. The 1975 Act also expanded the definition of foreign base company income by adding a

new category, foreign base company shipping income. Foreign base company shipping income

was income from the use or lease of any aircraft or vessel in foreign commerce or from the sale of

any aircraft or vessel used in foreign commerce.193 Shipping income that was reinvested in

shipping operations was excluded from this rule.194
- 138 -

195 I.R.C. § 954(b)(3).

196 P.L. No. 94-455, 90 Stat. 1520 (1976).

197 Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976

(H.R. 10612, 94th Congress, P.L. No. 94-455) 4 (Joint Comm. Print 1976) (1976 Blue Book).

198 S. Rep. No. 938, 94th Cong., 2d Sess. 226 (1976) (1976 Senate Report).

d. Amendment to De Minimis Exception

The 1975 Act modified the de minimis rule, which excluded all of the income of a CFC

from current inclusion under subpart F income if less than 30 percent of its gross income was

subpart F income, by lowering the threshold from“30 percent” to “10 percent.”195

3. The Tax Reform Act of 1976

The Tax Reform Act of 1976196 (1976 Act) contained several provisions regarding the tax

treatment of foreign income. The Joint Committee explained the general principles that guided

Congress:

Congress believed that it is necessary to strike a delicate balance between

encouraging the free flow of capital across national borders and making sure that

the tax laws do not provide excessive incentives for foreign investment instead of

investment in the United States.197

In the 1976 Act, Congress refined and narrowed the definitions of certain categories of

income subject to current inclusion under subpart F and added two new categories of subpart F

income.

a. Investments in U.S. Property

The 1976 Act narrowed the rules of section 956, which taxed to U.S. shareholders the

amount of the increase in earnings of the CFC invested in “U.S. property.” U.S. property

included stock or debt of a U.S. person and tangible property located in the United States, with

certain exceptions. Congress determined that a broad definition of the term had “a detrimental

effect upon our balance of payments by encouraging foreign corporations to invest their profits

abroad.”198

The 1976 Act provided two new exceptions to the definition of U.S. property. The first

exception excluded stock or debt of a domestic corporation if the U.S. shareholder owned less
- 139 -

199 I.R.C. § 956(b)(2)(F).

200 1976 Senate Report, supra note 198, at 226.

201 I.R.C. § 956(b)(2)(G).

202 1976 Senate Report, supra note 198, at 226.

203 1976 Senate Report, supra note 198, at 228.

204 I.R.C. § 954(c)(3)(C).

than 25 percent of the stock of the domestic corporation.199 Congress believed that treating stock

or debt of an unrelated corporation as U.S. property would discourage foreign corporations from

temporarily investing their working capital in U.S. obligations, causing them, instead, to favor

foreign investments, contrary to the purposes of subpart F.200 The second exception excluded

moveable drilling rigs when used on the U.S. continental shelf.201 Congress believed that

including this property in the definition of U.S. property acted as “a disincentive to explore for oil

in the United States.202

b. Repeal of Exclusion for Earnings of Less Developed Country

Corporations for Purposes of Section 1248

Section 1248, which contained rules for treating gain on the sale of stock of a CFC as a

dividend, excluded earnings accumulated by a less developed country corporation from dividend

treatment. The 1976 Act repealed this exception because Congress questioned the effectiveness

of this provision in encouraging investment in less developed countries. Congress believed that an

incentive to invest in such countries should be provided in a manner in which the economic costs

could be measured more accurately.203

c. Exclusion from Subpart F of Certain Earnings of Insurance

Companies

As enacted, subpart F excluded from foreign personal holding company income the

income of a foreign insurance company derived from the investment of unearned premiums or

reserves that were necessary for the proper conduct of its business. The 1976 Act expanded this

exception to apply also to income derived from the investment of surplus of a foreign insurance

company if the surplus had to be retained to satisfy state insurance solvency requirements.204

d. Shipping Profits of Foreign Corporations

Foreign base company shipping income, as enacted by the 1975 Act, included shipping

income without distinguishing whether the income was derived from shipping activities conducted

in or outside the foreign corporation’s country of incorporation. Congress determined that, to be
- 140 -

205 1976 Senate Report, supra note 198, at 230-31.

206 I.R.C. § 952(a)(3).

207 I.R.C. § 952(a)(4).

208 1976 Blue Book, supra note 197, at 282, 288-89.

209 P.L. No. 97-248, 96 Stat. 324 (1982).

210 I.R.C. § 954(g).

211 S. Rep. No. 494, 97th Cong., 2d. Sess. 149-150 (1982).

consistent with the other foreign base company rules, shipping income should not be treated as

tax haven income when the shipping activities were conducted between two points within the

country where the vessel was registered and the CFC was incorporated.205

e. Two New Categories of Subpart F Income

The 1976 Act added two new categories of subpart F income. Subpart F income had

previously included only foreign base company income and insurance income. The first new

category was income from overseas operations in connection with which there had been an

agreement to participate in an international boycott.206 The second category was the amount

equal to illegal bribes, kickbacks and other payments to an employee of any government.207

Congress added these provisions, together with provisions denying foreign tax credit and

Domestic International Sales Corporation (DISC) benefits for these activities. Congress

determined that, like the foreign tax credit and DISC provisions, the deferral of earnings of U.S.-

owned foreign subsidiaries was a tax benefit that should not be made available to taxpayers

participating in international boycotts or making illegal payments to government officials.208

Thus, Congress ended deferral on the earnings of a CFC to the extent they were attributable to

boycott participation or an illegal payment.

4. Tax Equity and Fiscal Responsibility Act of 1982

a. Foreign Base Company Oil Related Income

The Tax Equity and Fiscal Responsibility Act of 1982209 added a new category of foreign

base company income called foreign base company oil related income. This provision treated the

foreign oil related income of a CFC as subpart F income if it was derived from a country other

than the country in which the oil and gas was extracted or consumed.210 Congress enacted this

provision because it was concerned that multinational oil companies earned significant revenues

from activities performed after the oil had been extracted, such as the transporting, “shipping,

refining, trading and retail sales of the petroleum.”211 Congress determined that “because of the
- 141 -

212 Id. at 150.

213 Id.

214 P.L. No. 98-369, 98 Stat. 494 (1984).

215 I.R.C. § 864(d).

216 I.R.C. § 956(b)(3).

217 S. Rep. No. 169 (Vol. I), 98th Cong., 2d Sess. 348 (1984).

fungible nature of oil and because of the complex structures involved, oil income is particularly

suited to tax haven type operations.”212 Congress was concerned that U.S. oil companies paid

little or no U.S. tax on the high revenue of their foreign subsidiaries.213 Accordingly, Congress

ended deferral with respect to foreign oil related income.

5. Tax Reform Act of 1984

a. Related Party Factoring Income

The Tax Reform Act of 1984214 (1984 Act) added a provision that treated related person

factoring income (i.e., any income arising from a trade or service receivable that the CFC

acquired, directly or indirectly, from a related person) as interest on a loan to the obligor under

the receivable. Thus, under this provision, factoring income would be treated as foreign personal

holding company income for subpart F purposes.215 The 1984 Act also amended the definition of

U.S. property to include any trade or service receivable acquired from a related U.S. person.216

Congress recognized that when a factor purchased a receivable at a discount and then

collected on the receivable, the difference between the amount paid and the amount collected was

functionally the equivalent of interest and that this factoring income could easily be shifted to a

tax haven, contrary to the purposes of subpart F. As noted in the Senate Report accompanying

the 1984 Act:

 The purpose of subpart F of the Code is to enforce capital export neutrality by

preventing the shifting of earnings to a jurisdiction having no natural business nexus with

the income and where the income will not be taxed. Otherwise, there would be an

incentive to shift earnings into tax havens and away from the United States. Factoring

income is financing income that can easily be shifted from one country to another even

where the country in which the income is finally earned has no economic nexus with the

underlying transaction.217
- 142 -

218 Id. at 383.

219 I.R.C. § 954(e).

220 I.R.C. §§ 551-558.

221 I.R.C. § 951(d).

222 I.R.C. § 959(e).

Congress also determined that factoring transactions could also be used to accomplish a tax-free

repatriation of low-taxed foreign profits, thus avoiding section 956, which subjects to current

inclusion a CFC’s increase in earnings invested in U.S. property.

b. Insurance of Related Parties

Insurance income, as a category of subpart F income, was limited to income from the

insurance of U.S. risks. Thus, income from the insurance of related party risks outside the United

States was not subpart F insurance income. Congress was concerned that CFCs were able to

“improperly shift income to tax havens” through related party insurance transactions.218 The 1984

Act therefore amended the foreign base company services income rules to specifically treat

insurance services as performed where the risks were located, instead of where the administrative

or investment services were performed, when the primary insured was a related person.219 Income

from insuring related party risks therefore was foreign base company services income when the

risks were located outside the CFC’s country of incorporation even if the administrative or

investment services were performed within that country. 

c. Coordination of Subpart F with Other Rules

The 1984 Act changed the order of applying the subpart F regime and the foreign personal

holding company regime.220 Prior to the 1984 Act, the foreign personal holding company regime

had priority of application to the extent the two regimes overlapped. This rule created ambiguity

about whether amounts to which the foreign personal holding company regime did not apply

could be subpart F income. The 1984 Act changed the rules to give the subpart F regime priority

over the foreign personal holding company income regime.221

The 1984 Act also added a rule coordinating subpart F and section 1248. When a U.S.

shareholder recognized gain on the sale of stock of the CFC that was treated as a dividend under

section 1248, the earnings and profits of the foreign corporation were not reduced as they would

have been upon an actual dividend distribution. Thus, these earnings were subject to taxation

again when distributed. The new rule provided that the amount treated as a dividend under

section 1248 would be treated as an amount that had been previously taxed under subpart F.222

Thus, under the subpart F rules, the amount would not be subject to tax again when distributed.
- 143 -

223 P.L. No. 99-514, 100 Stat. 2085 (1986).

224 Staff of the Joint Committee on Taxation, 100th Cong., 1st Sess., General Explanation of the

Tax Reform Act of 1986 (H.R. 3838, 99th Congress, P.L. No. 99-514) 9 (Joint Comm. Print

1987) (1986 Blue Book).

225 H.R. Rep. No. 426, 99th Cong., 1st Sess. 391 (1985) (1986 House Report). See also S. Rep.

No. 313, 99th Cong., 2d Sess. 363 (1986) (1986 Senate Report).

226 Id. at 366.

6. Tax Reform Act of 1986

The Tax Reform Act of 1986223 (1986 Act) enacted a comprehensive revision of the

Internal Revenue Code, including a set of amendments to the subpart F rules.224 The general

policy guiding Congress in amending subpart F was addressed in the Committee reports to the

1986 Act:

It has long been the policy of the United States to impose current tax when a

significant purpose of earning income through a foreign corporation is the

avoidance of tax. Such a policy serves to limit the role that tax considerations play

in the structuring of U.S. person’s operations and investments. Because movable

income earned through a foreign corporation could often be earned through a

domestic corporation instead, the committee believes that a major motivation of

U.S. persons in earning such income through foreign corporate vehicles often is

the tax benefit expected to be gained thereby. The committee believes that it is

generally appropriate to impose current U.S. tax on such income earned through a

controlled foreign corporation, since there is likely to be limited economic reason

for the U.S. person’s use of a foreign corporation. The committee believes that by

eliminating the U.S. tax benefits of such transactions, U.S. and foreign investment

choices are placed on a more even footing, thus encouraging more efficient (rather

than more tax-favored) uses of capital.225

The 1986 Act narrowed the exceptions to subpart F income, and added to the definition of

subpart F income types of income that Congress considered to be particularly susceptible to

manipulation.226

a. Changes to Foreign Personal Holding Company Income Rules

The 1986 Act amended the foreign personal holding company income rules to target the

types of income that “may sometimes be earned through a foreign corporation in a tax haven
- 144 -

227 Id. at 363.

228 Id.

229 Id. at 364.

230 I.R.C. § 954(c)(1)(B).

231 1986 Senate Report, supra note 225, at 364.

country that bears limited substantive economic relation to the income. . . .”227 Congress

determined that “continued deferral of U.S. tax on such income encourages the movement of the

income abroad at the U.S. Treasury’s expense.”228

(1) Expansion of Definition of Foreign Personal Holding

Company Income 

The 1986 Act amended, or added to foreign personal holding company income, the

following four subcategories of income.

(a) Net Gains on Sales of Property That Does Not

Generate Active Income

Prior to the 1986 Act, foreign personal holding company income included gain from the

sale or exchange of stock and securities, in addition to the underlying income from this property. 

However, gain from the sale of other types of investment property was not foreign personal

holding company income. To remove this inconsistency and to create a more logical approach to

the treatment of gains under the foreign personal holding company rules,229 Congress amended the

rules to provide that foreign personal holding company income included net gains from the

disposition of non-inventory property that gave rise to foreign personal holding company income

(other than amounts excluded under the active rents and royalties exception) or that did not give

rise to income.230

(b) Net Commodities Gains

Prior to the 1986 Act, foreign personal holding company income included net gains from

futures transactions in any commodity. This provision excluded gains by a producer, processor,

merchant or handler of a commodity if they arose from certain bona fide hedging transactions. 

Congress determined that net gains of passive investors from not only futures contracts, but also

other commodities contracts should be included in foreign personal holding company income. 

Congress recognized, however, that commodities transactions constituted an integral part of the

active business of a producer, processor, merchant or handler of commodities.231 Thus, Congress

added an exception for transactions that occurred in the active business of a corporation
- 145 -

232 I.R.C. § 954(c)(1)(C).

233 1986 Senate Report, supra note 225, at 367.

234 I.R.C. § 954(c)(1)(D).

235 1986 Senate Report, supra note 225, at 364.

236 Id.

237 I.R.C. § 954(c)(1)(E).

238 1986 Blue Book, supra note 224, at 967.

239 I.R.C. § 954(c)(2)(B).

substantially all of whose business was that of an active producer, processor, merchant, or handler

of commodities.232 This exception was intended to apply only to corporations actively engaged in

the commodities business as opposed to a corporation whose primary activity was engaging in

financial transactions, such as trading commodities futures.233

(c) Net Foreign Currency Exchange Rate Gains 

The 1986 Act added, as a new category of foreign personal holding company income,

net currency gains attributable to section 988 transactions (transactions in nonfunctional

currency).234 The 1986 Act also added an exception for hedging and other transactions related to

the business needs of a CFC. When subpart F was enacted, in 1962, currency exchange rates

generally were fixed. However, when floating exchange rates began in the early 1970s, taxpayers

began to realize foreign currency gains and losses.235 Congress added this category because it

determined that currency gains and losses easily could be routed through a tax haven CFC.236

(d) Income Equivalent to Interest

The 1986 Act also added as a new category of foreign personal holding company income,

income equivalent to interest.237 Congress sought to prevent taxpayers from avoiding subpart F

on passive interest-type income earned offshore that did not fit within the definition of traditional

interest income.238 

(2) Repeal of Banking Exception

The 1986 Act repealed certain exceptions to the foreign personal holding company income

rules for interest, dividends and gains earned by banks and insurance companies but left a narrow

exception for export financing interest.239 Congress determined that these exceptions had

provided excessive opportunity for interest, dividends and gains earned by banks and insurance

companies to be routed through tax havens because the types of activities conducted by banks and
- 146 -

240 1986 House Report, supra note 225, at 393.

241 Id.

242 Id.

243 See 1986 Senate Report, supra note 225, at 368.

244 See H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-613, 616 (1986) (1986 Conference

Report).

245 I.R.C. § 954(c)(3)(B).

246 1986 House Report, supra note 225, at 394-395.

247

 Id. at 395.

insurance companies could be easily be located in any jurisdiction.240 Congress noted that the

proliferation of U.S.-controlled banking and insurance companies in tax havens supported its

conclusion.241 Congress determined that dividends, interest and gains on stock and securities

were so inherently manipulable that it was inappropriate to allow deferral regardless of the

business of the corporation,242 except in the case of export financing interest. A Senate

amendment that would have allowed the banking exception to continue to apply with respect to

bona fide active banking, financing, and similar operations,243 was rejected.244

(3) Narrowing of Related Person Exception 

The 1986 Act narrowed the exception for certain dividends, interest, rents and royalties

received from related persons. Under the new rules, interest, rent and royalty payments would not

qualify for the exception to the extent that the payments reduced the subpart F income of the

payor.245

b. Repeal of Reinvestment Exclusion for Shipping Income

The 1986 Act repealed the rule that excluded shipping income from subpart F income if it

was reinvested in shipping operations. Congress determined that the exclusion was not

appropriate as a matter of tax policy because no justification existed for treating shipping income

more favorably than other types of subpart F income.246 Further, Congress questioned whether

the interests of the United States were served by promoting investments in foreign-flag shipping

operations, which were seldom taxed by foreign governments.247

Congress also was concerned that a taxpayer could obtain indefinite deferral of tax for

certain income earned outside the jurisdiction of any country, such as income from activities in
- 147 -

248 Id.

249 I.R.C. § 954(f).

250 I.R.C. § 953.

251 1986 House Report, supra note 225, at 395. 

252 I.R.C. § 953(c).

253 1986 Blue Book, supra note 224, at 968.

254 I.R.C. § 953(c)(1).

space or on the ocean floor, when it earned that income through a foreign corporation.248

Accordingly, Congress expanded the definition of foreign base company shipping income to

include income from space or ocean activity.249

c. Expanded Definition of Insurance Income

The 1986 Act broadened the definition of insurance income for subpart F purposes. 

Under prior law, insurance income was defined as income of the CFC from insuring or reinsuring

U.S. risks. Further, foreign base company services income included income from insuring the

risks of a related person outside the CFC’s country of incorporation. The new provision defined

insurance income to include income from insuring or reinsuring risks located outside the CFC’s

country of incorporation whether or not the risks were of a related person.250 Congress expanded

the definition of insurance income for subpart F purposes because “[i]nsurance income generally

represents the type of inherently manipulable income at which subpart F is aimed, since such

income can frequently be routed through a corporation formed in any convenient jurisdiction.”251 

The 1986 Act also added a new category of subpart F insurance income called related

person insurance income that applied to widely held captive insurance companies.252 Congress

was concerned that the insurance income of captive foreign insurance companies (companies

formed to insure the risks of their owners) escaped the subpart F rules because the U.S.

ownership of these companies was often widely dispersed so that these companies did not fall

within the definition of a CFC.253 To address this problem, Congress created as special set of

rules, including a broader definition of “U.S. shareholder” and “controlled foreign corporation,”

for purposes of taking into account captive insurance income.254
- 148 -

255 1986 Blue Book, supra note 224, at 972.

256 Id.

257 Id.

258 1986 Conference Report, supra note 244, at II-623.

259 I.R.C. § 952(c).

260 Qualified activities were activities that gave rise to foreign base company shipping income,

foreign base company oil related income, subpart F insurance income or, in the case of a qualified

financial institution, foreign personal holding company income. I.R.C. § 952(c)(1)(B)(iii).

d. Restriction on Use of Accumulated Deficits and Repeal of

Chain Deficit Rule

Subpart F income is limited to current year earnings and profits. Under prior law, to

determine subpart F income, accumulated deficits of the CFC could reduce current year earnings

and profits. Further, earnings and profits of the CFC could be reduced by current deficits of

another CFC in the chain. Congress determined that the both of these deficit rules allowed CFCs

to shelter too much income from current taxation.255 In the case of the chain deficit rule, a loss

anywhere in the chain could prevent the current taxation of subpart F income earned elsewhere in

the chain even if the loss were in a non-subpart F category or did not relate to the subpart F

income.256 Similarly, under the accumulated deficit rule, prior year deficits of the CFC in a nonsubpart F or unrelated income category could prevent the current taxation of subpart F income.257

Congress was concerned that under the accumulated deficit rule taxpayers could shelter passive

investment income from the subpart F rules by moving those passive investments to a CFC with

prior year deficits.258 The 1986 Act amended the accumulated deficit rules to provide that an

accumulated deficit could reduce subpart F income only to the extent the deficit arose from the

same qualified activity as the activity giving rise to the income to be offset.259 The 1986 Act

defined a qualified activity to include any activity giving rise to certain specified types of subpart F

income.260 The 1986 Act also repealed the chain deficit rule. 

e. Thresholds for Imposition of Current Tax under Subpart f

(1) De Minimis and Full Inclusion Rules

The 1986 Act amended the de minimis and full inclusion rules, under which none of the

income of CFC was treated as foreign base company income if less than 10 percent of its gross

income was foreign base company income and all of its income was treated as foreign base

company income if more than 70 percent of its gross income was foreign base company income. 

Congress considered the 10 percent de minimis threshold to be too high, allowing a substantial
- 149 -

261 1986 Senate Report, supra note 225, at 373.

262 I.R.C. § 954(b)(3).

263 I.R.C. § 954(b)(4).

264 1986 Blue Book, supra note 224, at 983.

265 Id.

266 1986 Senate Report, supra note 225, at 371.

267 I.R.C. § 957(a).

amount of tax haven income to escape tax.261 The new de minimis rule substituted “the lesser of 5

percent of gross income or one million dollars” for the old 10 percent threshold. In addition,

Congress amended the de minimis and full inclusion rules to apply to subpart F insurance income

as well as foreign base company income.262

(2) Exception for Foreign Corporations Not Used to Reduce

Taxes

The 1986 Act amended the rule that excluded income from foreign base company income 

based on a test that focused on whether a “significant purpose” of the transaction was

substantially to reduce taxes. The 1986 Act replaced this subjective test with an objective test. 

Under the objective test, an item of income was excluded from foreign base company income and

insurance income if it was established that the income was subject to an effective rate of foreign

income tax greater than 90 percent of the maximum U.S. corporate rate.263 Congress intended

this new rule to be simpler to apply and to counterbalance provisions of the 1986 Act that

broadened the categories of subpart F income.264 Congress determined that, where no U.S. tax

advantage was gained by routing the income through a foreign corporation, no policy of subpart F

justified the current inclusion of income.265

(3) Expansion of Definition of Controlled Foreign

Corporation

Under prior law, whether U.S. shareholders possessed the requisite greater than 50

percent ownership of a foreign corporation was determined entirely upon voting power. 

Congress determined that these rules were susceptible to manipulation, particularly when the U.S.

shareholder owned less than 50 percent of the voting power but held a majority of the value of the

corporation in nonvoting stock.266 Congress amended the definition of CFC by adding a value test

in addition to the voting power test for purposes of determining stock ownership.267
- 150 -

268 1986 Senate Report, supra note 225, at 372.

269 Id. This problem was highlighted by MCA, Inc. v. Commissioner, 685 F.2d 1099 (9th Cir.

1982), in which royalties paid by a partnership to its controlling CFC partner were excluded from

subpart F income under the active rents and royalties exception. The active rents and royalties

exception did not apply to rent or royalty payments received from a related person. Because the

controlled partnership did not come within the definition of “related person,” the taxpayer was

able to take advantage of this exception.

270 I.R.C. § 954(d)(3).

271 1986 Blue Book, supra note 224, at 1023.

(4) Definition of Related Person

Many of the provisions of subpart F based current inclusion on whether the CFC was

engaged in a transaction with, or was receiving income from, a related person. A “related person”

included an individual, partnership, trust or estate that controlled the CFC or a corporation that

controlled the CFC, was controlled by the CFC, or was controlled by the same persons that

controlled the CFC. Control was defined as greater than 50 percent ownership. In the case of a

corporation, ownership was measured by voting power. Congress determined that these rules

allowed the easy avoidance of related person status.268 Congress also was concerned that income

that would be subpart F income if received by the CFC from a subsidiary corporation would

escape subpart F if received from a controlled partnership.269 The 1986 Act included a controlled

partnership, trust or estate within the definition of “related person.” The 1986 Act also amended

the definition of control to mean 50 percent or greater ownership and, in the case of a

corporation, defined control in terms of both voting power and value.270

f. Passive Foreign Investment Company Regime 

The 1986 Act also added a new anti-deferral regime to supplement existing anti-deferral

provisions (subpart F, the personal holding company rules, the foreign personal holding company

rules, the foreign investment company rules, and the accumulated earnings tax). Because existing

anti-deferral provisions applied only where U.S. persons held a controlling interest in the foreign

corporation, U.S. persons could continue to get the benefits of deferral by investing outside the

United States through non U.S.-controlled foreign corporations. Congress believed that U.S.

persons who invested in passive assets through foreign corporations should not gain a tax

advantage over U.S. investors in domestic investment companies.271 Accordingly, Congress

enacted the passive foreign investment company (PFIC) provisions. 

A PFIC was defined as any foreign corporation if 75 percent or more of its gross income

for the taxable year consisted of passive income or if 50 percent or more of the average value of
- 151 -

272 I.R.C. § 1296 (currently § 1297).

273 1986 Blue Book, supra note 224, at 1023.

274 Id.

275 P.L. 100-647, 102 Stat. 3342 (1988).

its assets consisted of assets that produced passive income.272 A foreign corporation that was a

PFIC could also be a CFC. Congress created two sets of taxing mechanisms for PFICs. The first

set of rules applied to PFICs for which the taxpayer made a qualified electing fund (QEF)

election. Each U.S. person that owned any stock in a QEF was required to include currently in

gross income his share of the QEF’s ordinary earnings and net capital gain. To take into account

U.S. investors that had insufficient liquidity to meet their tax liability and insufficient control to

compel a dividend distribution, U.S. investors in a QEF could also elect to defer payment of U.S.

tax, subject to an interest charge, on undistributed amounts.273 A coordination rule provided that

amounts that would be currently included in the U.S. shareholder’s gross income under both

subpart F and the QEF provisions were to be included in gross income only under subpart F. The

second set of rules required U.S. investors in PFICs that were not QEFs to pay U.S. tax, together

with an interest charge based on the value of tax deferral, when the shareholder disposed of the

stock or received an excess distribution. This rule was intended to take into account U.S.

investors who were unable to obtain sufficient information from the foreign corporation to

compute their annual tax liability.274 

7. Technical and Miscellaneous Revenue Act of 1988

The Technical and Miscellaneous Revenue Act of 1988275 (1988 Act) made a number of

changes to subpart F, most of which were technical corrections to, or clarifications of,

amendments made by the 1986 Act. 

a. Modifications to Subpart F Insurance Income Rules

The 1988 Act made a number of technical corrections to the subpart F insurance income

rules as amended by the 1986 Act. Most of the changes related to the special rules for captive

insurance companies.

b. Modifications to Foreign Personal Holding Company Income

Category

The 1988 Act expanded the definition of foreign personal holding company income to

include the excess of gains over losses from the sales or exchanges of interests in trusts,
- 152 -

276 I.R.C. § 954(c)(1)(B)(ii).

277 I.R.C. § 954(c)(1)(B).

278 I.R.C. § 954(c)(2)(C).

279 I.R.C. § 952(c)(1)(B)(iii).

280 I.R.C. § 952(c)(1)(C).

281 Staff of the Joint Committee on Taxation, Description of the Technical Corrections Act of

1988 (H.R. 4333 and S. 2238) 282 (Joint Comm. Print 1988) (1988 Blue Book).

partnerships and REMICs.276 The 1988 Act also clarified that losses from the sale or exchange of

inventory property could not offset foreign personal holding company income, consistent with the

rule that gains from the sale or exchange of inventory property were not included in foreign

personal holding company income.277 The 1988 Act also provided a new hedging exception for

regular dealers. Under this exception, gains and losses arising out of a bona fide hedging

transaction reasonably necessary to the conduct of the business of being a dealer in such property

were excluded from foreign personal holding company income.278

c. Accumulated Deficits

The 1988 Act modified the 1986 Act accumulated deficit rule, under which, at the U.S.

shareholder level, accumulated deficits of a CFC could offset current year subpart F income if

both the deficit and the subpart F income arose out of the same qualified activity. The 1988 Act

expanded the definition of qualified activity to include an activity giving rise to foreign base

company sales income and foreign base company services income and, in the case of a qualified

insurance company or qualified financial institution, foreign personal holding company income.279

d. Addition of Modified Chain Deficit Rule

The 1988 Act added a new chain deficit rule, to replace the old chain deficit rule that had

been repealed by the 1986 Act. The new chain deficit rule, like the new accumulated deficit rule,

was a narrow rule that allowed overall current deficits of another corporation in the same chain of

ownership and organized in the same country as the CFC to offset the subpart F income of the

CFC if the deficit and the subpart F income arose from the same qualified activity.280 The new

chain deficit rule was intended to address the problem that Congress noted with the old rule, that

a loss could have offset subpart F income in the chain although it might have arisen in a nonsubpart F income category and had no relation to the income that it offset.281
- 153 -

282 I.R.C. § 952(c)(3).

283 1988 Blue Book, supra note 281, at 284.

284 I.R.C. § 955(a)(2)(A).

285 I.R.C. § 954(d)(3).

286 P.L. No. 101-239, 103 Stat. 2106 (1989).

287 I.R.C. § 898.

288 P.L. No. 103-66, 107 Stat. 312 (1993).

289 H.R. Rep. No. 111, 103d Cong., 1st Sess. 1 (1993) (1993 House Report).

e. Computations of Earnings and Profits

The 1988 Act added rules regarding the computation of current earnings and profits of a

CFC. These rules prevented the use of certain accounting methods that accelerated the

recognition of earnings and profits.282 Because subpart F income is limited to current earnings

and profits, the provision was intended to reduce “the possibility that tax haven income will go

untaxed.”283

f. Other Technical Corrections

The 1988 Act also made certain technical corrections to the 1986 Act (1) to clarify that

the withdrawal of previously excluded subpart F income from qualified shipping reinvestments are

taxed only once,284 and (2) to change the threshold for control in the definition of “related person”

back to “more than 50 percent”, to conform it to the definition of control for CFCs.285

8. Revenue Reconciliation Act of 1989

a. Conforming Taxable Year of U.S. Shareholder and Controlled

Foreign Corporation

The Revenue Reconciliation Act of 1989286 added a provision that generally required the

taxable year of the CFC to conform to the majority U.S. shareholder year.287

9. Omnibus Budget Reconciliation Act of 1993

The Omnibus Budget Reconciliation Act of 1993288 (1993 Act) was a comprehensive set

of measures designed to reduce the deficit.289 The provisions affecting CFCs were part of a

revenue raising package.
- 154 -

290 Id. at 691.

291 Id. (footnote omitted).

292 I.R.C. § 956(a).

a. Deferral Ended for Excess Passive Assets

The 1993 Act added a new section 956A, which required a U.S. shareholder to include

currently in gross income his pro rata share of the CFC’s accumulated earnings invested in excess

passive assets. Excess passive assets were determined as the excess of the quarterly average of

passive assets over 25 percent of the quarterly average of total assets for the taxable year. 

Congress determined that such a rule was necessary to restrict the benefits of deferral where

CFCs accumulated excess quantities of earnings and profits and did not reinvest them in active

business assets.290 The House Report explains:

The committee is aware that the deferral of U.S. tax on income of U.S. persons

earned through foreign corporations may tend to favor foreign investment over U.S.

investment, and can provide an incentive to engage in certain tax-haven activities. The

committee understands that prior enactments that permit deferral of U.S. tax on most

types of active business income derived through controlled foreign corporations have been

justified as enhancing the competitiveness of U.S.-owned business operations abroad. In

fact, Congress referred to such concerns in rejecting the President’s proposal to eliminate

all deferral in the Revenue Act of 1962. The committee believes, however, that deferral of

U.S. tax on accumulated active business profits is not necessary to maintain the

competitiveness of business activities conducted by controlled foreign corporations where

such accumulated profits are held in the form of excessive accumulations of passive

assets.291

b. Modifications to Section 956 and 959

The 1993 Act also modified section 956 (investments in U.S. property) to require the

amount included under section 956 to be computed as the lesser of the (1) U.S. shareholder’s pro

rata share of the U.S. property held by the CFC (reduced by prior year section 956 inclusions) or

(2) the U.S. shareholder’s pro rata share of applicable earnings of the CFC. For this purpose, the

U.S. property held by the CFC was no longer determined at year end but instead was an average

amount based on quarterly determinations, similar to section 956A.292

The 1993 Act also modified the rules applicable to previously taxed subpart F income. 

New ordering rules were added to coordinate section 956 and section 956A and a new rule was

added that required actual distributions during the year to be taken into account before amounts
- 155 -

293 I.R.C. § 959(f).

294 I.R.C. § 1296(a) (deleted by the Taxpayer Relief Act of 1997).

295 1993 House Report, supra note 289, at 692.

296 I.R.C. § 1297(e) (currently §1298(e)).

297 I.R.C. § 1293(c).

that would be included under section 956 or section 956A.293 Thus, such distributions would not

be treated as made out of earnings and profits previously included in the U.S. shareholder’s gross

income under section 956 or section 956A (although such distributions could be treated as made

out of earnings and profits previously taxed as subpart F income).

c. Modification to PFIC Rules Affecting CFCs

(1) Measurement of Assets

For purposes of testing a foreign corporation for PFIC status under the asset test (which

treats an entity as a PFIC if the ratio of passive assets to total assets is at least 50 percent) assets

were measured based on value. The 1993 Act amended this rule for PFICs that were also CFCs

to require that the asset test be applied based on the adjusted basis of the assets.294 This

amendment recognized that, unlike investment funds, CFCs generally did not hold marketable

assets.295 The 1993 Act also provided that, for purposes of the asset test, the adjusted basis of

total assets of the CFC was increased to take into account certain research and experimental

expenditures and certain payments for the use of intangible property that is licensed to the CFC.296

(2) Treatment of Previously Taxed PFIC Inclusions

The 1993 Act added a coordination rule for CFCs that were also PFICs under which any

current inclusion under the QEF rules was treated as an inclusion in the U.S. shareholder’s gross

income under subpart F for purposes of the previously taxed income rules of subpart F.297 Thus,

earnings and profits attributable to amounts currently included under the QEF rules would not be

taxed again when actually distributed.
- 156 -

298 P.L. No. 104-188, §1501, 110 Stat. 1755 (1996).

299 H.R. Rep. No. 586, 104th Cong., 2d Sess. 128-129 (1996).

300 Id. at 129.

301 P.L. No. 105-34, 111 Stat. 788 (1997).

302 H.R. Rep. No. 148, 105th Cong., 1st Sess. 308 (1997) (1997 House Report).

303 I.R.C. § 954(c)(1)(F) and (G).

304 1997 House Report, supra note 302, at 543.

10. Small Business Job Protection Act of 1996

a. Repeal of Section 956A

The Small Business Job Protection Act of 1996 repealed section 956A.298 Congress

determined that section 956A added an undue layer of complexity to the subpart F rules and

imposed substantial administrative burdens.299 Congress also determined that, although section

956A was enacted to restrict the benefits of deferral for CFCs accumulating passive assets abroad,

it operated to provide an incentive to invest abroad. Congress determined that the provision

encouraged foreign corporations to engage in costly, non-economic transactions, such as

acquiring otherwise unneeded foreign assets to reduce their percentage of passive assets. 300

11. Taxpayer Relief Act of 1997

The Taxpayer Relief Act of 1997301 (1997 Act) contained a set of tax reduction, tax

simplification and technical corrections provisions. This legislation was originally proposed by

the House pursuant to the Fiscal Year 1998 Budget Resolution which was the result of the

Balanced Budget Agreement between Congress and the President.302

a. Expansion of Categories of Foreign Personal Holding

Company Income and Dealer Exception 

The 1997 Act added two new categories of foreign personal holding company income: (1)

income from notional principal contracts, and (2) payments in lieu of dividends.303 Congress

determined that income from notional principal contracts and stock lending transactions was

economically equivalent to the types of income that were currently included in foreign personal

holding company income.304
- 157 -

305 I.R.C. § 954(c)(2)(C).

306 I.R.C. § 964(e).

307 I.R.C. § 961.

308 I.R.C. § 951(a)(2).

The 1997 Act also added an expanded dealer exception from foreign personal holding

company income.305 Prior to the 1997 Act, the foreign personal holding company provisions

contained no dealer exception for financial instruments referenced to commodities. The new

dealer exception specifically included dealers in financial instruments referenced to commodities.

b. Dividend Treatment for Sale of Lower-Tier CFCS and

Adjustments to Basis of Stock 

The 1997 Act added two new provisions to make the rules for taxing dispositions of stock

of a CFC by an upper-tier CFC conform to those applicable to dispositions of such stock by a

U.S. shareholder. The first provision treated a CFC’s gain from the sale of stock of a lower-tier

foreign corporation as a dividend to the same extent it would have been so treated under section

1248 if the CFC were a U.S. shareholder.306 The dividend income would be subpart F income to

a same-country upper-tier CFC because the exception for same country dividends, under section

954(c)(3)(A)(i), did not apply. For purposes of the foreign tax credit rules, the inclusion in the

U.S. shareholder’s gross income, based on this dividend income, would be characterized by

reference to the nature of the income of the lower-tier foreign corporation.

The second provision added basis adjustment rules applicable to an upper-tier CFC’s basis

in the stock of a lower-tier CFC to parallel the rules that increased a U.S. shareholder’s basis in

the stock of a first-tier CFC when the subpart F income is earned and decreased the basis when

previously taxed income was distributed.307

c. Section 1248 Dividend Treated as Distribution

The 1997 Act added a provision that treated the U.S. shareholder’s section 1248 dividend

as a distribution with respect to the stock, for purposes of the rules that reduced a mid-year

purchaser’s subpart F inclusion by distributions with respect to the stock received by another

person during the year.308
- 158 -

309 I.R.C. § 960(a)(1).

310 1997 House Report, supra note 302, at 528.

311 I.R.C. § 956(c)(2)(J) and (K).

312 I.R.C. § 1297(e).

313 1997 House Report, supra note 302, at 533.

d. Extension of Indirect Foreign Tax Credit to Sixth Tier

The 1997 Act extended the application of the indirect foreign tax credit to taxes paid by

certain fourth-, fifth- and sixth-tier foreign corporations.309 Under prior law, the application of the

indirect tax credit was limited to the first three tiers of foreign corporations. Congress intended

this provision to give relief to certain taxpayers that were reorganizing, or deciding not to

purchase foreign corporations, because of the limitations of the foreign tax credit.310

e. Exception from Definition of U.S. Property for Securities and

Commodities Dealers

The 1997 Act amended the rules pertaining to a CFC’s investment in U.S. property. The

1997 Act added two new exceptions from the definition of U.S. property for certain transactions

entered into by securities dealers or commodities dealers in the ordinary course of business.311

f. PFIC - CFC Overlap

The 1997 Act added a provision that generally treated a PFIC that is also a CFC as not a

PFIC with respect the U.S. shareholders of the CFC.312 The rule applied for the portion of the

shareholder’s holding period after December 31, 1997, during which the corporation was a CFC

and the shareholder was a U.S. shareholder. If the PFIC was not treated as a qualified electing

fund (QEF) with respect to the shareholder, the shareholder did not get the benefit of this overlap

provision unless it first made an election to pay tax and interest charge with respect to the

unrealized appreciation in the stock or the accumulated earnings of the corporation. Congress

added this provision to reduce the complexity caused by the interaction of these two anti-deferral

regimes.313

g. Temporary Exception for Active Banking, Financing or

Insurance Income

The 1997 Act added a temporary exception from foreign personal holding company 

income for certain income derived in the active conduct of a banking, financing or similar business
- 159 -

314 I.R.C. § 954(h).

315 I.R.C. § 954(e)(2).

316 S. Rep. No. 33, 105th Cong., 1st Sess. 89-90 (1987).

317 110 Stat. 1200, 2 U.S.C. § 691 et seq. (1994 ed., Supp. II).

318 Cancellation No. 97-1, Cancellation of Limited Tax Benefit, Report Pursuant to the Line Item

Veto Act, P.L. 104-130, 62 Fed. Reg. 43266 (1997).

319 See Clinton v. City of New York, 524 U.S. 417 (1998).

320 P.L. No. 105-277, 112 Stat. 2681 (1998).

if the CFC was predominately engaged in the active conduct of such business and for income

derived from certain investments of a qualifying insurance company with respect to risks located

within the CFC’s country of incorporation.314 Congress authorized the Treasury to prescribe

regulations under which dividends, interest, income equivalent to interest, rents or royalties

received from a related person were subject to look-through treatment for purposes of these

provisions. The 1997 Act also added a temporary exception from foreign base company services

income for certain income derived from services in connection with the active conduct of a

banking, financing, insurance or similar business.315 

These exceptions applied only for the tax year of a CFC that began within the 1998

calendar year. These exceptions were added because Congress was concerned that the repeal, by

the Tax Reform Act of 1986, of certain foreign personal holding company income exceptions

applicable to the income of banks and insurance companies caused income that was neither

passive nor highly moveable to be treated as subpart F income.316 

President Clinton attempted to cancel these temporary exceptions for active banking,

financing and insurance income by exercising his authority under the Line Item Veto Act.317 The

President gave as reasons for his cancellation that the provisions would have reinstated rules that

had been repealed by the Tax Reform Act of 1986 without adequately addressing the concerns

that led to their repeal and that the provisions “would have decreased Federal receipts, would

have allowed the tax-haven abuses that previously existed, and would have provided preferential

tax treatment to a limited group of taxpayers.”318 These provisions were reinstated, however,

after the Supreme Court held that the cancellation procedures in the Line Item Veto Act were

unconstitutional.319 

12. The Tax and Trade Relief Extension Act of 1998

The Tax and Trade Relief Extension Act of 1998320 (1998 Act) added a set of temporary

provisions that extended and modified the 1997 Act’s temporary exceptions for active banking,
- 160 -

321

 See Ticket to Work and Work Incentives Improvement Act of 1999, P.L. No. 106-170, §

503(a), 113 Stat.1860. 

322 I.R.C. § 954(h). See H.R. Rep. No. 825, 105th Cong., 2d Sess. 1558 (1998).

323 I.R.C. § 954(h)(2).

324 I.R.C. § 954(h)(2)(B).

325 I.R.C. § 954(h)(3)(A).

326 I.R.C. § 953(a)(2) and (e).

financing and insurance income. The 1998 Act temporary provisions, originally in effect only for

the tax year of a CFC that began within the 1999 calendar year, subsequently were extended to

apply to taxable years of a CFC beginning after December 31, 1998 and before January 1, 2002.321

The 1998 Act modifications added certain substantial activity and nexus requirements.

a. Exception from Foreign Personal Holding Company Income 

for Certain Active Banking and Financing Income

 The 1998 Act extended and modified the 1997 Act exception for income derived in the

active conduct of a banking or financing business.322 The 1998 Act tightened these rules by

adding a substantial activity requirement. As modified, the exception applied to the qualified

banking or financing income of an eligible CFC. An eligible CFC was a CFC that was

predominately engaged in the active conduct of a banking, financing or similar business and

conducted substantial activity with respect to that business.323 The 1998 Act provided differing

rules for determining whether a CFC satisfied the “predominately engaged” requirement for CFCs

in the banking business, the securities business or the lending or finance business.324

If the CFC was an eligible CFC, its qualified banking or financing income was excluded

from foreign personal holding company income. Qualified banking or financing income was

defined to impose a nexus requirement which insured that substantially all of the activities in

connection with the transactions were conducted by the CFC or qualified business unit (QBU) in

its home country and that the home country’s tax laws treated the income as earned in that

country.325 

b. Insurance Income

The 1998 Act added a temporary provision that modified the definition of subpart F

insurance income.326 Under prior law, insurance income, generally, was income from insuring

risks located outside the CFC’s country of incorporation. Under the new temporary definition,

insurance income included any insurance income except exempt insurance income. Exempt

insurance income was defined as income derived by a qualifying insurance company that was
- 161 -

327 I.R.C. § 953(e)(1).

328 I.R.C. § 953(e)(2).

329 I.R.C. § 954(i).

330 I.R.C. § 954(c)(2)(C)(ii).

attributable to the issuing of an exempt contract by the CFC (or its qualifying insurance company

branch) and that was treated as earned by the CFC or branch in the home country of the CFC or

branch under that country’s tax laws.327 An “exempt contract” was an insurance or annuity

contract issued with respect to non-U.S. risks.328 The terms “qualifying insurance company,”

“qualifying insurance company branch” and “exempt contract” were defined to ensure that the

CFC has a business nexus with the country in which it was incorporated, or in which its branch

was located and regulated, and that a certain portion of its income was earned from insurance

contracts involving unrelated persons.

c. Exception from Foreign Personal Holding Company Income

for Investments of Insurance Income

The 1998 Act also added temporary rules to extend and modify the 1997 Act exception

from foreign personal holding company income for income from certain investments of an

insurance company.329 The modifications corresponded to the temporary amendments to the

subpart F insurance income rules. Using the same definitions for “qualifying insurance company,”

“qualifying insurance company branch” and “exempt contract” as under the temporary insurance

income rules, the 1998 Act excluded investment income derived by a qualifying insurance

company (or qualifying insurance company branch) if the investment income was received from a

unrelated person and derived from investments made by the CFC or branch of its reserves (or a

certain percentage of surplus) allocable to exempt contracts. Thus, unlike the 1997 Act

temporary rule, which based the exclusion on whether the investment income was earned in

connection with risks located in the home country of the CFC, the 1998 Act temporary rule

allowed investment income earned on the insurance of certain cross border risks to be excluded if

the insurance company or its branch satisfied certain nexus requirements with the home country.

d. Exception for Securities Dealers

The 1997 Act had added a general dealer exception that excluded certain gains from

foreign personal holding company income. The 1998 Act added a new temporary dealer

exception that excluded from foreign personal holding company income certain interest or

dividend (or equivalent) income derived by a securities dealer that was attributable to activities of

the dealer in its country of incorporation.330 
- 162 -

331 I.R.C. § 954(c)(1)(B).

332 I.R.C. § 954(e)(2).

e. Sale of Assets of an Active Financing Business

Generally, foreign personal holding company income includes gains from the sale of

property that gives rise to dividends, interest, rents, etc. The 1998 Act added a new temporary

exception from foreign personal holding company income for gains from the sale of property that

gave rise to income excluded from subpart F income under one of the 1998 Act temporary

exceptions applicable to securities dealers or to active banking or financing income or insurance

income.331

f. Exceptions from Foreign Base Company Services Income

As under the 1997 Act, the 1998 Act included a corresponding exception from foreign

base company services income for services directly related to a transaction entered into by the

CFC that gave rise to income excluded from subpart F income under one of the 1998 Act

temporary exceptions.332
- 163 -

333 Revenue Act of 1913, ch. 16, 38 Stat. 114. 

334 Section II.G. of the Revenue Act of 1913 provided that “the normal tax hereinbefore imposed

upon individuals likewise shall be levied, assessed, and paid annually upon the entire net income

arising or accruing from all sources during the preceding calendar year to every corporation, jointstock company or association, and every insurance company . . . .” For a detailed discussion of

the history of entity classification in the United States prior to 1996, see Patrick Hobbs, Entity

Classification: The One Hundred-Year Debate, 44 Cath. U.L. Rev. 437 (1995).

335 Section II.D. of the Revenue Act of 1913 provided that “any persons carrying on business in

partnership shall be liable for income tax only in their individual capacity, and the share of the

profits of a partnership to which any taxable partner would be entitled if the same were divided,

whether divided or otherwise, shall be returned for taxation and the tax paid . . . .” 

336 Although § II.D. of the Revenue Act of 1913 required trustees, executors and others acting in

a fiduciary capacity “to make and render a return of the net income of the person for whom they

act,” and, in this capacity, subjected them to all the provisions that applied to individuals, it was

not until the Revenue Act of 1916, Ch. 463, § 2(b), 39 Stat. 756, that the tax law specifically

referred to the income received by “estates” and “trusts.” 

PART 2. FEDERAL TAX ENTITY CLASSIFICATION

I. Background

Since the Revenue Act of 1913,333 the Internal Revenue Code has provided different tax

regimes for individuals, corporations,334 partnerships,335 and trusts and estates.336 The manner in

which an entity is taxed thus has turned on how it is classified for federal tax purposes. In many

countries, domestic entities are formed under national business statutes that regulate the form in

which enterprises may carry on a business. Their national tax statutes tax different types of

entities by referencing the classes of entities described in the business statute. In the United

States, with a number of very limited exceptions, e.g., national banks, there are no national

business statutes governing the formation of entities and, accordingly, federal tax law has never

been able to rely on a uniform business law definition of “corporation.” Rather, business entities

are formed under a plethora of state laws, only some of which unambiguously describe

“corporations” or “partnerships.” Thus, federal tax law has sought to develop its own entity

classification rules. 

The term “partnership” is defined in section 7701(a)(2) of the Code to include “a

syndicate, group, pool, joint venture, or other unincorporated organization, through or by means

of which any business, financial operation, or venture is carried on, and which is not, within the

meaning of this title, a trust or estate or a corporation . . . .” Section 7701(a)(2) defines the term

“partner” to include “a member in such a syndicate, group, pool, joint venture, or organization.” 

These definitions have remained virtually unchanged since they were first enacted in the Revenue
- 164 -

337 See Revenue Act of 1932, Pub. L. No. 154, § 1111(a)(3), 47 Stat. 169.

338 H.R. Rep. No. 708, 72d Cong., 1st Sess. 53 (1932). 

339 See Revenue Act of 1918, Pub. L. No. 254, § 1, 40 Stat. 1075. Legislation prior to the

Revenue Act of 1917 treated a “corporation” as separate from a “joint stock company or

association, or insurance company.” See § II.G.(a) of the Revenue Act of 1913. See also Hobbs,

supra note 334, at 450-51 (contending that Congress originally understood “association” to be

synonymous with “joint stock company”).

340 The following exchange between Representative William Borland and Representative John

Garner, during debates on the Revenue Act of 1918, is often cited to demonstrate that Congress

had no precise understanding of the term “association”:

 

Mr. BORLAND. The word ‘corporation’ ordinarily means a legal entity.

 

 Mr. GARNER. I know, but we have changed it. We have undertaken to determine what

a corporation is by stating specifically what it includes, and we say that it includes an

association. Now, if you want to go to the dictionary and find out the definition of

association, well and good. I think it means a number of people, whether organized under

law or voluntarily.

 

56 Cong. Rec. 10418 (1918), reprinted in J.S. Seidman, Seidman’s Legislative History of Federal

Income Tax Laws 1938-1861, 893 (1938). See O’Neill v. United States, 410 F.2d 888, 893-94

(6th Cir. 1969) (quoted language came in the midst of a discussion over deductions for charitable

contributions). 

Act of 1932.337 Congress added these definitions to address the uncertainty existing under prior

law about how certain business organizations, such as syndicates, would report income. As noted

in the House report accompanying the 1932 Act, “[t]he bill does away with this uncertainty by

placing all joint ventures, syndicates, pools, and similar organizations which do not constitute

associations or trusts, in the category of partnerships.”338 

The term “corporation” is defined in section 7701(a)(3) of the Code to include

“associations, joint stock companies, and insurance companies.” This definition, unmodified,

derives from the Revenue Act of 1918. 339 Congress did not provide a definition of the term

“association” and the legislative history provides no specific guidance other than to suggest that

the term includes entities in addition to those incorporated under state law.340 The scope of this

term has been a source of continuing controversy in the entity classification area.
- 165 -

341 See Art. 1502, Regulation No. 45, T.D. 3146 (1920) (associations and joint stock companies

include certain common law trusts and other organizations that do business in an organized

capacity); Art. 1504, Regulation No. 65, T.D. 3640 (1924) (reflecting decision of Hecht v.

Malley, 265 U.S. 144 (1924), by treating operating trusts as associations, regardless of degree of

beneficiaries’ control, where beneficiaries’ activities included more than collecting funds and

making payments to beneficiaries); Art. 21-23, Regulation 64, T.D. 4575 (1935) (trust treated as

an association if it is an arrangement conducted for profit where capital is supplied by

beneficiaries and the trustees are in effect the managers of the arrangement, whether or not

beneficiaries appoint or control trustees). 

342 296 U.S. 344 (1935). 

343 Id. at 359. 

344 Id. at 360. 

345 See Kurzner v. United States, 413 F.2d 97, 101 (5th Cir. 1969). See also Hobbs, supra note

334, at 481-83. 

II. Morrissey, the Changing Resemblance Test and the Kintner Regulations

During the 1920s and 1930s, the Treasury Department issued regulations that defined the

term “association” broadly enough to include unincorporated entities, such as business trusts.341

In Morrissey v. Commissioner,

342 decided in 1935, the Supreme Court upheld the Treasury’s

broad regulatory authority in the area of entity classification as well as the position reflected in its

regulations. The Morrissey Court held that a trust formed to develop and operate golf courses

was taxable as an association. The Morrissey case is significant because it developed an approach

to entity classification that would come to be known as the “resemblance test.” Under this

approach, the Morrissey Court considered those features of a trust created to carry on a business

enterprise that would make the trust analogous to a corporation: the ability to hold title to

property; centralized management; continuity of life upon death of an owner; a structure that

facilitates the transferability of beneficial interest; and limited liability.343 The Court determined

that the business trust at issue was an association because it possessed these features.344

When Morrissey was decided, taxpayers generally sought to avoid corporate status

because it subjected income to two levels of taxation. After Morrissey, however, some taxpayers

began to discover certain tax advantages in being taxed as corporations. For example,

corporations could set up tax-deferred pension plans, which were particularly advantageous at a

time when individual tax rates were significantly higher than corporate rates.345 Professionals that

were unable to incorporate under local law formed unincorporated associations that were

structured to be taxed as associations under the Morrissey resemblance test. In the 1954 case of
- 166 -

346 216 F.2d 418 (9th Cir. 1954). 

347 Id. at 421. 

348 82 F.2d 473 (7th Cir. 1936).

349 See Galt v. United States, 175 F.Supp. 360 (N.D. Tex. 1959); Foreman v. United States, 232

F.Supp. 134 (S.D. Fla. 1964). 

350 Treas. Reg. §§ 301.7701-1 to -11, T.D. 6503, 1960-2 C.B. 409. 

United States v. Kintner,

346 the Ninth Circuit considered whether an unincorporated professional

association formed for the practice of medicine and surgery could be taxed as an association and,

hence, whether its pension plan would qualify for tax-deferred benefits under the Code. In this

case, the government argued against corporate status, taking the position that a professional

association could not be taxed as an association because under local law a corporation could not

engage in the practice of medicine.347 In taking this position, however, the government faced the

difficulty of distinguishing its own regulations, which broadly interpreted the definition of

association, as well the case of Pelton v. Commissioner,

348 which decided, in the government’s

favor, that a clinic organized for the practice of medicine was taxable as an association although

state law did not permit a corporation to practice medicine. The Kintner court rejected the

government’s argument and held that under Morrissey and Pelton, as well as under the Treasury

regulations, the association should be taxed as a corporation. 

In 1960, in response to Kintner and subsequent cases upholding corporate tax treatment

for unincorporated medical associations,349 the Treasury issued new entity classification

regulations.350 These regulations, which came to be known as the Kintner regulations, adopted an

approach to entity classification similar to the resemblance test set forth in Morrissey. The

Kintner regulations identified six corporate characteristics. If an unincorporated organization

possessed more corporate than non-corporate characteristics, it was taxable as an association. In

distinguishing between a trust and a corporation, characteristics common to both trusts and

corporations were ignored. Thus, only two of the six factors were used to differentiate

corporations from trusts: (1) the presence of associates; and (2) the objective to carry on business

and divide the gains therefrom. Similarly, in distinguishing between a partnership and a

corporation, characteristics common to both partnerships and corporations were ignored. Thus,

four factors distinguished a corporation from a partnership: (1) continuity of life; (2)

centralization of management; (3) limited liability; and (4) free transferability of interests. If an

unincorporated entity possessed more than two of the four factors it would be classified as an

association taxable as a corporation. 

The Kintner regulations effectively provided that an entity formed under a state statute

corresponding to the Uniform Partnership Act would not be taxed as an association because it
- 167 -

351 See Treas. Reg. §§ 301.7701-2(b)(3); 301.7701-2(c)(4); 301.7701-2(d)(1) (1960).

352 Treas. Reg. § 301.7701-1(c) (1960). 

353 See Hobbs, supra note 334, at 489 & n.321 (noting that, by 1963, more than 30 states had

enacted legislation allowing for incorporation of professional groups). 

354 See Treas. Reg. § 301.7701-2(h) (1965), T.D. 6797, 1965-1 C.B. 553. 

355 See, e.g., Kurzner v. United States, 413 F.2d 97 (5th Cir. 1969); O’Neill v. United States, 410

F.2d 888 (6th Cir. 1969). 

356 Rev. Rul. 70-101, 1970-1 C.B. 278. The invalid portions of these 1965 regulations were

revoked in 1977. See T.D. 7515, 1977-2 C.B. 482 (revoking Treas. Reg. §§ 301.7701-2(a)(5),

(h)). 

would not possess continuity of life, centralization of management or limited liability.351 Thus,

professional associations could not qualify as associations under the Kintner regulations. The

Kintner regulations also provided that local law would govern in determining whether the legal

relationships satisfied the standards of the regulations.352 In response to the Kintner regulations,

taxpayers successfully lobbied state legislatures to allow professional groups to be incorporated.353

 To address the proliferation of state statutes allowing professional incorporation, the

Treasury issued new amendments to the Kintner regulations in 1965, including a new paragraph

to address professional service organizations.354 The 1965 amendment de-emphasized local law

and defined the corporate characteristics in such a way that a professional corporation generally

could not satisfy them. These regulations were invalidated by many courts,355 and, in 1970, the

IRS issued guidance indicating that it would treat entities formed under state professional

corporation statutes as associations.356 

III. General Changes in the Entity Classification Rules since 1962

A. Growth in Tax Shelters

A significant trend in federal tax law since the enactment of subpart F in 1962 has been the

increasing use of partnerships and other passthrough entities as forms of carrying on business. A

number of non-tax considerations have motivated taxpayers to conduct business through

partnerships, including the flexibility permitted in arrangements between the partners. However,

tax considerations have also played a large part. The formation of limited partnerships increased

rapidly during the 1970s and early 1980s when they were used as tax shelters, providing the
- 168 -

357 See 1986 Blue Book, supra note 224, at 210 (discussion of tax shelter abuses in the early

1980s). 

358 See Treas. Reg. §§ 301.7701-2(b), (c)(4), (d) and (e). See also Larson v. Commissioner, 66

T.C. 159 (1976) (treating real estate tax shelter as partnership under Kintner regulations). In

1977, the Treasury issued proposed regulations that would have classified tax shelter limited

partnerships as associations, but withdrew these regulations two days later. See Prop. Treas.

Reg. §§ 301.7701-301.7703, 42 Fed. Reg. 1038 (1977); 42 Fed. Reg. 1489 (1977) (withdrawal). 

359 See I.R.C. § 469 (limiting passive activity losses and credits and treating an interest in a limited

partnership as presumptively passive); I.R.C. § 465 (extension of at-risk rules to the activity of

holding real property). 

360 See I.R.C. §§ 311, 336 and 337. 

361 See Bruce N. Davis and Steven R. Lainoff, U.S. Taxation of Foreign Joint Ventures, 46 Tax L.

Rev. 165, 179 (1991) ("Foreign Joint Ventures") (discussing planning techniques involving

partnerships after repeal of General Utilities rule). 

362 Prop. Treas. Reg. § 301.7701-2(a), 45 Fed. Reg. 75709 (1980). 

passive investor with deductions and credits to offset other income.357 The government’s attempt

to curtail tax shelter abuses by classifying the limited partnerships as associations was

unsuccessful because the Kintner regulations contained provisions that made it difficult for limited

partnerships to qualify as associations.358 In 1986, Congress addressed tax shelter abuses by

enacting provisions to limit the tax benefits available to passive investors.359

B. LLCs

Partnerships also became an increasingly popular form of conducting business after the

Tax Reform Act of 1986 repealed the General Utilities rule reflected in the Code,360 thus causing

gain to be recognized at the corporate level on the distribution or sale of appreciated corporate

assets.361 As more taxpayers desired to do business in passthrough form, they sought entities that

would combine the advantages of a corporation, e.g., limited liability, with those of a partnership,

e.g., one level of federal tax. The most important vehicle for achieving these aims, and the

catalyst for the “check-the-box” regulations, discussed, infra, has been the Limited Liability

Company (LLC). LLCs provide limited liability protection but were designed to qualify for

classification as partnerships under the Kintner regulations because they lack two of the four 

characteristics that distinguish a corporation from a partnership.

Although the IRS issued proposed regulations in 1980 that would have denied partnership

status to LLCs,362 it withdrew these proposed regulations in 1983 and announced that it would
- 169 -

363 Announcement 83-4, 1983-2 I.R.B. 31. See Foreign Joint Ventures, supra note 361, at 171-

172 (proposed regulations withdrawn in response to severe pressure from private bar). 

364 Wyoming Limited Liability Company Act, Wyo. Stat. §§ 17-15–101 to-136 (1977). 

365 1988-2 C.B. 360. 

366 See Bruce P. Ely and Christopher R. Grissom, 98 STN 216-17 The LLC/LLP Scorecard, 98

State Tax Notes 216-17 (Nov. 9, 1998) (1998 LLC/LLP Scorecard) (list of state LLC statutes).

367 For a list of revenue rulings upholding partnership status for entities created under state LLC

statutes, see Hobbs, supra note 334, at 517 n.521. Many of these revenue rulings, including Rev.

Rul. 88-76, were obsoleted after the issuance of the check-the-box regulations, discussed infra. 

See Rev. Rul. 98-37, 1998-2 C.B. 133.

368 See Moline Properties v. Commissioner, 319 U.S. 436 (1943); Burnet v. Commonwealth

Improvement Co., 287 U.S. 415 (1932). 

369 See Knoxville Truck Sales and Service, Inc. v. Commissioner, 10 T.C. 616 (1948) (after

corporate charter of single owner corporation was revoked entity was held not to be an

association taxable as a corporation because it lacked associates). 

370 136 F.2d 22 (9th Cir. 1943). 

371 See Knoxville Truck Sales and Service, Inc. v. Commissioner, 10 T.C. at 621-22 (trustees in

Lombard acted as directors of a corporation and thus trust resembled a corporation). 

conduct a study of the issues in this area.363 The first state LLC statute was enacted by Wyoming

in 1977364 and considered in Revenue Ruling 88-76,365 which held that an LLC formed under the

Wyoming LLC statute would be classified as a partnership for federal tax purposes. 

Subsequently, every other state has passed an LLC statute366 and the entities formed under many

of these state laws have been held to be partnerships by the IRS.367

C. Single Member Entities

Special entity classification issues have arisen with respect to entities that have only one

owner. While courts have long held that an entity incorporated under state law with a single

stockholder is a corporation for tax purposes,368 courts originally were reluctant to treat an

unincorporated entity with a single owner as an association for tax purposes.369 

In the 1943 case of Lombard Trustees, Ltd. v. Commissioner,

370 the Ninth Circuit held

that a trust with a single beneficiary was taxable as an association. In that case, however, the trust

had several trustees that were associated in the business. Thus, it was unclear whether the

holding of that case was based on the activities of the trustees.371
- 170 -

372 See Priv. Ltr. Rul. 77-43-060 (July 28, 1977) (classifying a German GmbH); Priv. Ltr. Rul. 77-

43-077 (July 29, 1977) (classifying a French societe a responsabilite limitee); Priv. Ltr. Rul. 77-

47-083 (Aug. 26, 1977) (classifying a German GmbH); Priv. Ltr. Rul. 77-48-038 (Aug. 31, 1977)

(classifying a German limited liability company); Priv. Ltr. Rul. 78-02-012 (Oct. 11, 1977)

(classifying a Brazilian limited liability company). For a discussion of these private letter rulings,

see New York State Bar Association, Tax Section, Report on Foreign Entity Characterization for

Federal Income Tax Purposes, 35 Tax L. Rev.167, 202-203 (1980). 

373 See Priv. Ltr. Rul. 77-43-060; Priv. Ltr. Rul. 77-48-038. 

374 1977-1 C.B. 408 (looking to German law to determine that the GmbH had associates and an

objective to carry on business and divide the gains therefrom and applying “single interest” theory

to find other corporate characteristics in classifying as an association a German GmbH owned by

two domestic subsidiaries, each of which was wholly owned by the same corporate parent). 

375 See Priv. Ltr. Rul. 78-06-062 (Nov. 11, 1977) (withdrawing PLR 77-43-060); Priv. Ltr. Rul.

78-06-056 (Nov. 11, 1977) (withdrawing PLR 77-43-077); Priv. Ltr. Rul. 78-06-055 (Nov. 11, 

1977) (withdrawing PLR 77-47-083); Priv. Ltr. Rul. 78-06-057 (Nov. 11, 1977) (withdrawing

PLR 77-48-038); Priv. Ltr. Rul. 78-06-058 (Nov. 11, 1977) (withdrawing PLR 78-02-012). 

376 See Priv. Ltr. Rul. 78-21-147 (Feb. 28, 1978); Priv. Ltr. Rul. 78-21-125 (Feb. 28, 1978); Priv.

Ltr. Rul. 78-21-134 (Feb. 28, 1978); Priv. Ltr. Rul. 78-21-142 (Feb. 28, 1978); Priv. Ltr. Rul. 78-

21-143 (Feb. 28, 1978). 

377 74 T.C. 1266 (1980). 

From July through October of 1977, the IRS issued several private letter rulings

classifying certain foreign organizations with single owners.372 These rulings all concluded that

the foreign organizations lacked “associates with an objective to conduct business and divide the

gain therefrom” and therefore could not be classified as associations or partnerships. Some of the

rulings also specifically determined that the organizations could not be classified as trusts.373

Instead, the rulings concluded that the foreign organizations would be treated as “an integral part”

of the sole owner for tax purposes. In November of 1977, the IRS withdrew each of these private

letter rulings, citing Rev. Rul. 77-214374 for the position that the rulings were “not in accord with

the views of the Service concerning the proper classification of foreign organizations that have

only one beneficial owner.”375 Subsequently, in February of 1978, the IRS issued further guidance

that, on a prospective basis, classified each of these foreign organizations as an association taxable

as a corporation.376

 

In the 1980 case of Hynes v. Commissioner,

377 the Tax Court held that a trust with a

single beneficiary that was carrying on a business for profit had the corporate characteristics of

“associates” and an objective to carry on business for “joint” profit under the Kintner regulations

and was therefore properly classified as an association taxable as a corporation. The Tax Court
- 171 -

378 Id. at 1280. 

379 Id. The Tax Court determined that because the trust clearly had five of the six corporate

characteristics, it would be taxable as an association. Id. at 1286. See Gen. Couns. Mem. 38,707

(May 1, 1981) (IRS will follow Hynes). 

380 T.C. Memo. 1992-371, 63 TCM (CCH) 3201 (1992). 

381 63 TCM at 3201-12. 

382 See Gen. Couns. Mem. 39,395 (Aug. 5, 1985); Priv. Ltr. Rul. 85-33-003 (May 7, 1985). But

see PLRs cited supra in note 375 and 376 (revoking PLRs that treated single member entities as 

branches and treating such entities as separate corporations). 

specifically noted that in reaching its holding it did not treat the trustees as associates.378 Instead,

the Tax Court determined that “where there is a single owner, the regulations are not intended to

require multiple associates or a sharing of profits among them.”379 Thus, under Hynes, a trust

carrying on a business for profit could never be taxable as a trust because it would always possess

the two characteristics that distinguish an association from a trust.

On August 5, 1985, the IRS issued Gen. Couns. Mem. 39,395, which considered how to

classify a trust with a single beneficiary that was formed to conduct business for profit. Following

Hynes, Gen. Couns. Mem. 39,395 determined that the entity could not be treated as a trust. In

examining the four corporate characteristics that distinguish a corporation from a partnership,

Gen. Couns. Mem. 39,395 determined that the entity could not be taxed as an association because

it lacked continuity of life and limited liability. Further, Gen. Couns. Mem. 39,395 determined

that Hynes could not be interpreted to consider a single member entity to have associates in the

partnership sense. Thus, because the entity lacked associates, it could not be taxed as a

partnership. Gen. Couns. Mem. 39,395 concluded that, because the trust could not be classified

for tax purposes as a corporation, a partnership or a trust, the beneficiary should be treated as

making investments through an agent, the trustee. 

 In a 1992 memorandum opinion, Barnette v. Commissioner,

380 the Tax Court considered

whether an entity organized as a GmbH under German law was taxable as a wholly owned

subsidiary or a branch of its parent. The court reasoned that since the absence of “associates” and

an objective to carry on a business for “joint” profit are common to both one-man corporations

and sole proprietorships, these characteristics would be ignored in determining whether the GmbH

possessed a preponderance of the remaining four corporate characteristics under the Kintner

regulations. The court in Barnette determined that the GmbH possessed more corporate than

non-corporate characteristics and therefore was taxable as an association.381

Based on Hynes and Barnette and certain IRS guidance,382 some commentators questioned

whether certain foreign or domestic business entities, such as LLCs, that had a single owner could
- 172 -

383 See, e.g., Jill Darrow, Limited Liability Companies and S Corporations: Deciding Which is

Optimal and Whether to Convert to LLC Status, 48 Tax Law. 1 (Fall, 1994); Francis Wirtz and

Kenneth Harris, Tax Classification of the One Member Limited Liability Company, 59 Tax Notes

1829 (June 28, 1993). 

384 See, e.g., O’Neill v. United States, 410 F.2d 888 (6th Cir. 1969) (entity incorporated under

state law is a corporation for federal tax purposes whether or not it satisfies corporate

resemblance test); Knoxville Truck Sales & Services, Inc. v. Commissioner, 10 T.C. 616 (1948)

(before corporate charter was revoked entity was taxable as a corporation although it did not have

the essential characteristics of an association). 

385 Rev. Rul. 70-101, 1970-1 C.B. 278 (professional service organizations formed under state

corporate statutes will be treated as corporations for tax purposes). See also Gen. Couns. Mem.

39,693 (Jan. 22, 1988) (citing Rev. Rul. 70-101 to support statement that Service generally

confers automatic corporate status on organizations formed under designated domestic corporate

statutes, bypassing application of Kintner regulations). 

be classified as an integral part of the entity that owned them.383 Commentators reasoned that the

entity is carrying on a business and therefore it cannot be a trust. It lacks free transferability of

interests, and continuity of life and therefore cannot be a corporation. Further, it does not have

two partners and, therefore, does not have “associates and an objective to carry on a business and

divide the gains therefrom.” Thus, it cannot be a partnership. Since it cannot be a separate entity

it must be simply a branch or division of its owner. Whether a single member LLC could be so

treated under the Kintner regulations, however, was never specifically addressed by the IRS. 

IV. Specific Changes in the Entity Classification Rules for Foreign Entities since 1962

Although the entity classification rules generally have been applied consistently to both

foreign and domestic entities, one area in which application of the rules has diverged has been in

the classification of entities that are incorporated (or similarly constituted) under a local

incorporation statute (or similar law). Courts have long followed the principle that an entity

organized as a corporation under U.S. state law will be treated as a corporation for federal tax

purposes without the necessity of applying a corporate resemblance test384 and in 1970, the IRS

affirmed this position when it conceded the status of entities formed under state professional

corporation statutes as associations.385 

At that time, the IRS took a similar position with respect to entities formed under foreign

law. On November 13, 1970, the IRS issued Gen. Couns. Mem. 34,376, which determined that

an entity incorporated under the laws of Nigeria, a country whose concept of “incorporated” was

substantially similar to the U.S. concept, would be treated as a corporation for federal tax

purposes without regard to whether it met the standards of the Kintner regulations. On April 6,

1973, the IRS issued Gen. Couns. Mem. 35,294, which went further to conclude that a
- 173 -

386 288 U.S. 476 (1933). 

387 1973-1 C.B. 613. 

388 1973 IRS GCM LEXIS 262, at *11 (July 16, 1973).

389 See Id. at *16-*17. 

390 Gen. Couns. Mem. 36,910 (Nov. 4, 1976). 

Colombian SRL, which was not “incorporated” under U.S. principles, was nevertheless

automatically treated as a corporation for federal tax law purposes because it was a separate

juridical person under Colombian law. Gen. Couns. Mem. 35,294 relied on the 1933 Supreme

Court case of Puerto Rico v. Russell & Co.,

386 which held that a Puerto Rican sociedad en

comandita was taxable as an association because the sociedad was regarded as a legal person

under civil law, although not “incorporated” in the common law sense.

In Rev Rul. 73-254,387 the IRS appeared to limit the position taken in Gen. Couns. Mem.

35,294, holding that the classification of an unincorporated foreign entity was determined under

the Kintner regulations, apparently without regard to whether the entity was regarded as a

separate juridical person under the laws of the foreign country. Rev. Rul. 73-254 provided that,

for purposes of applying the Kintner regulations, the local law of the foreign country would be

applied to determine the legal relationships of the members and their interests in the assets. In an

attachment to Gen. Couns. Mem. 35,294, dated July 16, 1973,388 the IRS tried to reconcile its

holding with the holding of Rev. Rul. 73-254. The attachment reasoned that an entity that was

considered a separate juridical person under the relevant foreign law (even if the entity was not

considered “incorporated” under that law) would have the attributes of an association taxable as a

corporation, and therefore the Kintner regulations would be applied only to organizations that

were not considered separate juridical entities under relevant foreign law.389 In 1976, however,

the IRS revoked Gen. Couns. Mem. 35,294, concluding that a foreign entity would be classified

under the Kintner regulations unless it was “considered ‘incorporated’ as that term is used at

common law.”390 

Following this narrower position, Rev. Rul. 77-214 applied the four factor test in the

Kintner regulations to determine that a German GmbH was taxable as an association. The ruling

specifically noted that the GmbH at issue was a juridical person but that, under German law, a

GmbH could assume the characteristics of an association or a partnership depending on its

memorandum of association. Thus, it could not be automatically treated as a partnership or

corporation for federal tax purposes.
- 174 -

391 Gen. Couns. Mem. 39,693 (Jan. 22, 1988). 

392 1988-1 C.B. 403. 

393 See Rev. Rul. 77-214 (German law contains optional provision that can be modified by

memorandum of association so that GmbH can assume characteristics of a corporation or

partnership). The Limitada, which can be formed under the laws of many civil law countries, and

the Dutch C.V. are also examples of entities that are separately taxable under foreign law but can

be structured to qualify as a partnership for U.S. tax purposes. 

394 See Ronald Harvey, Michael Burke and Susan Shapiro, Uses of Hybrid Entities in the

International Arena , 70 Tax Notes 215 (1996) (Hybrid Entities). 

395 See Foreign Joint Ventures, supra note 361, at 173. 

396 See Hybrid Entities, supra note 394, at 218-222 (discussing planning techniques involving

hybrid entities under foreign tax credit rules and subpart F). 

In 1988, the IRS revoked prior GCMs that gave automatic corporate status to foreign

incorporated entities.391 Shortly thereafter, it issued Rev. Rul. 88-8,392 which specifically held that

all foreign entities are considered to be unincorporated organizations and therefore must always

be classified by application of the four factor test of the Kintner regulations. Rev. Rul. 88-8

considered how to classify a U.K. unlimited company. The ruling noted that the entity was

formed under Great Britain’s “corporation” statute. Nevertheless, the ruling held that the entity

was classified as a partnership for federal tax purposes because it lacked the corporate

characteristics of limited liability and free transferability of interests. 

By requiring all foreign corporate entities to be classified under the Kintner regulations,

Rev. Rul 88-8 facilitated the creation of hybrid entities, i.e., entities that are treated as passthrough entities under the laws of one taxing jurisdiction and as taxable entities under the laws of

another taxing jurisdiction. Many foreign limited liability entities that were treated as separate

entities under foreign law could qualify as partnerships under the four factor test of the Kintner

regulations with sufficient alterations to their organizational documents. For example, German

law allowed for the possibility of incorporating partnership-type features, such as restrictions on

free transferability of interests, in the organizational documents of a GmbH.393

Hybrid entities have been favored by tax planners because they provide greater flexibility

in structuring international operations.394 Practitioners have noted that inconsistent foreign and

U.S. treatment can provide opportunities for worldwide tax reduction.395 The business

advantages of being in foreign corporate solution can be retained while obtaining the benefits of 

pass-through status for U.S. purposes, such as the ability to flow losses through to the U.S.

parent, certain foreign tax credit benefits and the ability to avoid certain provisions of subpart F.396
- 175 -

397 685 F.2d 1099 (9th Cir. 1982). 

398 Prior to 1986, a controlled partnership was not treated as a related person with respect to a

CFC, although a corporation controlled by the CFC would have been so treated. See I.R.C. §

954(d)(3) as in effect prior to 1987. The Ninth Circuit held that the entities were taxable as

partnerships and therefore were not related persons. Thus, the subpart F exception applied. In

1986, Congress amended subpart F to treat controlled partnerships as related persons with respect

to a CFC. See Tax Reform Act of 1986, Pub. L. No. 99-514, § 1221(e), 100 Stat. 2553. 

399 See T.D. 8697, 61 Fed. Reg. 66584 (Dec. 18, 1996). 

400 Treas. Reg. § 301.7701-1.

401 Treas. Reg. § 301.7701-2(b). 

402 Treas. Reg. § 301.7701-3(a).

In MCA Inc. v. United States,

397 partnership status was sought for U.S. tax purposes to

take advantage of certain exceptions to subpart F, as in effect prior to 1987. The taxpayer in

MCA Inc. was able to establish entities in 29 foreign countries that were taxable as separate

entities under local law, but whose organizational documents were intentionally drafted to allow

the entities to qualify as partnerships under the four factor test of the Kintner regulations. In 

MCA Inc., the taxpayer sought to use this structure to take advantage of an exception to subpart

F for certain income received by a CFC from an unrelated person. The taxpayer claimed that the

partnerships controlled by the CFC from which the CFC received payments were not related

persons.398 

V. Promulgation and Purpose of the Check-the-Box Regulations

In 1996, the IRS and Treasury issued regulations that replaced the entity classification

rules of the Kintner regulations with a new set of rules that generally made entity classification

elective.399 These regulations have come to be known as the “check-the-box” regulations.

The check-the-box regulations provide that whether an organization will be recognized as

a separate entity is determined based on federal tax law and does not depend on local law tax

classifications.400 An organization that is a separate entity can be either a trust or a business

entity. The regulations provide a list of business entities that will be treated as per se

corporations, including entities incorporated under a federal or state statute, joint stock

companies, insurance companies, banks, and certain business entities formed under foreign law.401 

Under the check-the-box regulations, a business entity that is not a per se corporation can

choose its classification.402 If the entity has at least two members it can elect to be classified as

either a partnership or an association. If it has only a single member it can elect to be classified as

an association or disregarded as an entity separate from its owner. To minimize the need for
- 176 -

403 Treas. Reg. § 301.7701-3(b). 

404 61 Fed. Reg., at 66584.

405 See 61 Fed. Reg., at 66584 (new regulations replace old rules with “a much simpler

approach”). See also Notice 95-14, 1995-1 C.B. 297, 298 (The purpose of allowing taxpayers to

elect entity classification “is to simplify the rules in order to reduce the burdens on both the

taxpayers and the Service”). Most states have adopted rules that allow LLCs to elect entity

classification, in conformity with the check-the-box regulations. See 1998 LLC/LLP Scorecard,

supra note 366. 

406 See Hybrid Entities, supra note 394. 

elections, the regulations provide default categories.403 For newly formed domestic entities, the

default category is a partnership if there are at least two members, and a disregarded entity if there

is a single member. For newly formed foreign entities, the default category is based on whether

the members have limited liability. If all of the members have limited liability, the entity will be

treated as an association. If not, it will be treated as a partnership or disregarded entity,

depending on whether it has more than one owner. The default category for existing entities was

the status they claimed prior to the effective date of the regulations. 

These new regulations were promulgated because entity classification under the old rules

effectively had become elective in many cases.404 The check-the-box regulations thus formalized

this process in an attempt to provide administrative simplification.405 The regulations greatly

simplified the entity classification process, eliminating the need for a factual analysis under the

Kintner regulations. Further, the regulations resolved certain issues, for example, that a single

member LLC could be treated as an integral part of the entity that owned it, an issue that was

never specifically addressed under the Kintner regulations. 

The regulations have also had the effect of increasing planning opportunities, however. 

Prior to the issuance of the check-the-box regulations, taxpayers generally were able to plan into a

specific entity classification, but the process was expensive, time consuming and often lacked

certainty.406 Because the check-the-box regulations greatly facilitated this process, these

regulations have allowed taxpayers greater flexibility to use entity classification to achieve specific

results under the Code. The ease with which entity classification can now be achieved and the

specific sanction of the disregarded entity classification have created a new set of issues. In the

international context, these issues have principally related to whether taxpayers should be able to

create hybrid entities to take advantage of inconsistent foreign and U.S. tax treatment and

whether the check-the-box regulations can undermine substantive tax law in certain circumstances

to produce inappropriate tax results. 
1

 The term “foreign to foreign related party rules” is defined in Chapter 3, Section IV.A.

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APPENDIX B

SURVEY OF QUANTITATIVE ECONOMIC STUDIES THAT

 EXAMINE THE INTERNATIONAL MOBILITY OF CAPITAL 

To forecast how a change in the subpart F foreign-to-foreign related party rules1 would

affect the global allocation of capital, it is necessary to know how readily international capital

flows respond to changes in the after-tax rates of return at home and abroad. For example, if

capital flows are very responsive to changes in the rates of return, the foreign-to-foreign related

party rules, by raising the effective rate of tax on foreign investment, might prevent substantial

capital outflows from the United States. In that case, weakening or eliminating these rules may

cause capital to flow from the United States to foreign countries and, consequently, reduce

investment and production in the United States.

At this time, however, there is little consensus among economists about the degree of

international capital mobility. Several empirical microeconomic studies suggest that capital flows

respond fairly readily to changes in the rates of return, at least within multinational companies. 

However, a number of macroeconomic studies suggest that international capital flows have

relatively little effect on a nation’s aggregate capital supply.

The purpose of this appendix is to survey economic articles on international capital

mobility. Three bodies of literature are discussed. The first two bodies of literature are

composed of empirical microeconomic studies. The third body of literature is composed of

macroeconomic studies. The first body of literature examines the decision of U.S. multinationals

to invest in one foreign country over another. This body of literature suggests that capital is fairly

mobile internationally. It finds evidence that the distribution of foreign investment of U.S.

multinationals is influenced by inter-country differences in tax rates. The second body of

literature examines the decision of multinationals to invest in the United States or abroad. This

body of literature also supports the notion of capital mobility. It presents evidence that suggests

that the after-tax rates of return influence whether U.S. multinationals invest in the United States

or overseas. The third body of literature, however, suggests that capital may be relatively

immobile internationally, at least in the aggregate.

I. Taxes and U.S. Direct Investment Abroad, Suggestive Evidence of Capital Mobility

The first body of literature, composed of empirical microeconomic studies, contains

evidence that suggests that, between foreign subsidiaries of U.S. multinational companies, capital

flows freely across national borders. Although these studies do not examine the issue of capital
-178-

2

 Jason G. Cummins and R. Glenn Hubbard, The Tax Sensitivity of Foreign Direct Investment:

Evidence from Firm-Level Panel Data, in The Effects of Taxation on Multinational Corporations

(Martin Feldstein, James R. Hines Jr., and R. Glenn Hubbard eds., 1995). 

3

 Harry Grubert and John Mutti, Taxes, Tariffs, and Transfer Pricing in Multinational

Corporate Decision Making, 73 Rev. of Econ. & Stat. 285 (1991). 

4

 James R. Hines, Jr. and Eric M. Rice, Fiscal Paradise: Foreign Tax Havens and American

Business, 109 Q. J. of Econ. 149 (1994).

5

 Rosanne Altshuler, Harry Grubert, and T. Scott Newlon, Has U.S. Investment Abroad Become

More Sensitive to Tax Rates? (Nov. 14-15, 1997) (unpublished paper prepared for the National

Bureau of Economic Research International Taxation Conference).

6

 Rosanne Altshuler and R. Glenn Hubbard, The Effect of the Tax Reform Act of 1986 on the

Location of Assets in Financial Services Firms (February 19, 1999) (unpublished paper prepared

for the American Enterprise Institute Seminar Series in Tax Policy). 

7

 Cummins and Hubbard, supra note 2. 

mobility explicitly, the evidence they present suggests that U.S. multinationals respond fairly

readily to changes in after-tax rates of return on foreign capital. If capital were immobile

internationally, there should be no identifiable relationship between after-tax rates of return in

foreign countries and foreign investment by U.S. multinationals.

This section provides detailed summaries of five papers in this body of literature. Brief

summaries of these papers can be found in Table 1. The first three (Cummins and Hubbard2,

Grubert and Mutti3, and Hines and Rice4) all find that the aggregate distribution of foreign

investment by U.S. multinationals is influenced by inter-country differences in taxes. Specifically,

U.S. multinationals tend to invest more in countries with low tax burdens than in countries with

high-tax burdens. Altshuler, Grubert, and Newlon5 find that the influence of taxes on investment

has risen over time, at least among manufacturing affiliates of U.S. multinational corporations. 

Altshuler and Hubbard6 also find that U.S. companies with foreign subsidiaries consider U.S.

deferral rules when deciding how much to invest overseas. Table 1 contains brief summaries of

these five papers. 

Cummins and Hubbard7 study the relationship between home country taxes, host country

taxes and outbound foreign direct investment by subsidiaries of U.S. multinational firms operating

in high-tax countries. Their analysis is based on data from a panel containing annual observations

for between 282 and 632 foreign subsidiaries over the period from 1980 to 1991. Using these

data, they construct two versions of a model that characterizes the relation between a foreign

subsidiary’s demand for capital and other variables. In the first version, taxes are ignored. The

second version controls for differences in both home and host country taxes. Their results imply

that the second model provides a better characterization of a subsidiary’s demand for capital. 
-179-

8

 The ratio of foreign direct investment to capital measures how the amount of capital acquired

within a specified period compares to total capital.

9

 James R. Hines, Tax Policy and the Activities of Multinational Corporations, in Fiscal Policy:

Lessons from Economic Research, (Alan J. Auerbach ed., 1997).

10 Note that these predictions are based on data for only foreign countries with high tax rates and,

as a result, may not apply to investment in low-tax countries.

11 Grubert and Mutti, supra note 3.

12 Hines and Rice, supra note 4.

Thus, they find that foreign subsidiaries of U.S. multinationals account for inter-country

differences in corporate income taxes when deciding how much to invest. The authors use the

results to predict that a change in a host country tax rate that raises a subsidiary’s cost of capital

by 0.10 will also decrease the subsidiary’s ratio of foreign direct investment to capital by 0.05.8

Alternatively, Hines9 shows that Cummins and Hubbard’s results imply that an increase in host

country taxes that causes a subsidiary’s after-tax cost of capital to increase by 1 percent will

reduce annual investment by that subsidiary by 1 to 2 percent.10

Grubert and Mutti11 examine the relationship between average effective tax rates in host

countries and the stock of net plant and equipment of foreign manufacturing affiliates of U.S.

multinationals in such countries. They examine 1982 data, aggregated by jurisdiction, for a

sample of 33 countries. In 1983, the effective tax rates in some of the countries, such as Canada,

exceeded the comparable U.S. rate. In others, such as Ireland, the effective tax rate was less than

the comparable U.S. rate. The authors estimate the parameters of an equation that explains the

aggregate demand for capital by U.S. multinational manufacturers in a host country as a function

of that country’s gross domestic product, per capita gross domestic product, the tariff rate, and

the country’s average effective tax rate. Their results imply that higher host-country taxes

discourage investment by U.S. manufacturing companies. The authors use their results to predict

that if the tax rate in a host country were to decline such that the after-tax rate of return were to

rise by 1 percent (for a given pretax return), then the stock of net plant and equipment of majority

owned U.S. manufacturing affiliates in that country would increase by 1.96 percent.

Hines and Rice12 build on the work of Grubert and Mutti. They examine aggregate U.S.

foreign direct investment in real capital (plant and equipment) in all industries (not just

manufacturing) and consider a wider selection of countries. Their analysis is based on 1982 data,

aggregated by country, for a sample of 41 countries. In some countries, such as France and

Canada, the average effective tax rate exceeded the comparable U.S. rate in 1982. Rates in other

countries, such as the Cayman Islands and the Bahamas, were significantly below the comparable

U.S. rate. To study the relationship between the stock of net plant and equipment of foreign

affiliates of U.S. companies and average effective tax rates, the authors estimate the parameters of
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13 Hines and Rice estimated a non-linear relationship between investment and changes in the tax

rate, i.e., they believed that U.S. direct investment was more responsive to changes in low tax

rates than high tax rates. They chose to analyze their findings at the mean tax rate.

14 Note that the data set used by Hines and Rice (1994) contained more observations for countries

with low tax rates than were contained in the Grubert and Mutti (1991) data set. This may

explain partly why Hines and Rice found investment to be more sensitive to taxes than Grubert

and Mutti. In their paper, Grubert and Mutti found evidence that suggested that a 1 percentage

point decrease in a low tax rate in a given country would encourage more investment than a one

percentage point decrease in a high tax rate in the same country. In other words, according to

their findings, a decrease in the tax rate from 5 percent to 4 percent should encourage more

investment in a given country than an decrease in the tax rate from 35 percent to 34 percent.

15 Altshuler, Grubert, and Newlon, supra note 5. 

an equation that characterizes the relationship between the demand for capital in a foreign country

by U.S. companies and the tax rate and gross domestic product in that country. They control for

variation in gross domestic product (GDP) because economists generally believe that the demand

for investment is greater in countries with relatively high levels of aggregate output than in

countries with relatively low levels of output. Similar to Grubert and Mutti, Hines and Rice find

that aggregate U.S. direct investment is lower in foreign countries with higher tax rates.13 Their

results suggest that if the tax rate in a host country were to decline such that the after-tax rate of

return rose by 1 percent (given a constant pretax rate of return), then the stock of net plant and

equipment of U.S. affiliates in that country would increase by 2.3 percent. Thus, Hines and Rice

project that foreign direct investment in real capital is more sensitive to changes in taxes than

suggested by Grubert and Mutti.14

Altshuler, Grubert, and Newlon15 extend the literature further by considering whether the

distribution of U.S. foreign direct investment became more sensitive to inter-country differences

in tax rates over time. Their interest in this question stems from two factors. First, production

appears to be becoming more globally integrated over time. In addition, during the 1980s,

corporate taxes fell in several countries including Canada, the United States, the United Kingdom,

France, Belgium, and the Netherlands. To study this question, they examine data on real capital

(inventory, plant, and equipment) of foreign manufacturing affiliates of U.S. multinationals,

aggregated by country, for a sample of 58 countries for 1984 and 1992. There are two

advantages to studying data that spans more than a single year period. First, the authors can

control for unobservable characteristics, such as risk and political instability, which influence

investment and are specific to individual countries. In addition, they can test whether the

responsiveness of investment to taxes changed between 1984 and 1992. Their results suggest that

the sensitivity of investment to taxes increased over time. Specifically, they infer from their

estimates that if a foreign country had reduced its tax rate such that the after-tax rate of return

rose by 1 percent in 1984, investment in real capital in manufacturing affiliates of U.S.
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16 Altshuler and Hubbard, supra note 6. 

17 Pub. L. No. 99-514, 100 Stat. 2553.

18 Note that many multinationals in the financial sector are organized in branch form rather than in

subsidiary form. However, the authors did not take into account the impact of the policy change

on branches. They examined only investment data for subsidiaries.

19 Bond, Boskin and Gale, and others that conducted research in this area during the 1980s, are

discussed in the Hines article, Tax Policy and the Activities of Multinational Corporations.

Hines, supra note 9. See Eric Bond, Tax Holidays and Industry Behavior, 63 Rev. of Econ. &

Stat. 88 (1981); Michael Boskin and William G. Gale, New Results on the Effects of Tax Policy

on the International Location of Investment, in The Effects of Taxation on Capital Accumulation,

(Martin Feldstein ed., 1987).

multinationals in that country would have risen by 1.75 percent. In contrast, they infer that a tax

cut that would have led to the same increase in the after-tax rate of return in 1992 would have

stimulated a much larger increase in investment in manufacturing affiliates in that country (2.77

percent as opposed to 1.75 percent).

Finally, Altshuler and Hubbard16 study the impact of the amendments made by the Tax

Reform Act of 198617 (1986 Act) to the deferral rules of subpart F on the relationship between

investment in foreign financial subsidiaries of U.S. multinationals and average effective tax rates in

foreign countries.18 For their analysis, the authors examine data, aggregated by country, for a

sample of 32 countries in 1984, 1992, and 1994. Because the 1986 Act repealed deferral for

financial service income earned overseas, thus subjecting financial services income to current U.S.

tax at the U.S. shareholder level, the authors conjecture that the local tax rate in a foreign country

should have had smaller impact on overseas investment by foreign subsidiaries in that sector after

1986. To study the effect of the 1986 Act, they estimate the parameters of an equation that

characterizes the value of assets in foreign subsidiaries of U.S. companies in a given host country

as a function of both the average effective tax rate and the gross domestic product in that country

in 1984, 1992, and 1994. Their results are consistent with their conjecture. They find that, in

1984, the aggregate value of assets in financial subsidiaries of U.S. multinationals was higher in

foreign countries with low tax rates than in countries with high tax rates. In contrast, they find

that differences in foreign tax rates did not affect the levels of assets in financial subsidiaries of

U.S. multinationals after the 1986 Act, in 1992 and in 1994.

The five studies covered in this section reflect only recent research on the relationship

between foreign tax rates and investment overseas by U.S. multinationals. However, the central

finding -- foreign taxes affect the distribution of foreign direct investment of U.S. multinationals --

is consistent with that of earlier work.19
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20 David G. Harris, The Impact of U.S. Tax Law Revision on Multinational Corporations’ Capital

Location and Income-Shifting Decisions, 31 J. of Acct. Res. 111 (1993 Supp.).

21 Mihir A. Desai, The Substitutability of Foreign and Domestic Capital: Evidence from TRA

(1999) (unpublished mimeo Harvard Business School).

22 Harris, supra note 20.

II. Taxes and the Decision to Invest in the United States or Overseas, Additional

Evidence of Capital Mobility

The empirical evidence discussed in the first section suggests that capital is fairly mobile

among foreign countries within U.S. multinational corporations. However, it does not indicate

whether capital is mobile within such companies between the United States and foreign countries. 

A second body of literature provides suggestive evidence in this area. Studies in this second body

of literature are briefly summarized in Table 2.

Similar to the papers in the first body of literature, studies in the second body do not

address the issue of capital mobility directly. Rather, they examine how changes in the after-tax

rate of return impact investment in domestic and foreign subsidiaries of U.S. multinationals. The

most current evidence suggests that multinationals invest more overseas and less in the United

States when the rate of return overseas increases relative to the rate in the United States. Such

evidence lends support to the notion that capital is fairly mobile internationally. 

Two studies in this body of literature, Harris20 and Desai21, examine whether U.S.

multinationals responded to the 1986 Act by changing the amount they invested in their domestic

subsidiaries relative to their foreign subsidiaries. The 1986 Act influenced the after-tax rate of

return on U.S. capital in two ways. First, it reduced the U.S. statutory tax rate on corporate

income from 45 percent to 34 percent. This reform effectively raised the U.S. return relative to

the return in other countries. Second, it eliminated the investment tax credit. This reform

effectively lowered the U.S. return. The overall impact of the two changes was to reduce the

after-tax rate of return on U.S. capital relative to that in other countries. Since foreign capital

was relatively more profitable than U.S. capital following the reforms, both Harris and Desai

hypothesized that U.S. multinationals should respond by investing more overseas and less in the

United States after 1986.

Harris22 finds mixed evidence when examining this hypothesis about the impact of the

1986 Act. His analysis consists of two parts. First, he examines the ratio of U.S. investment to

global investment by U.S. multinationals during the 1980s. Consistent with the hypothesis that

such companies should invest less in the United States and more overseas following the 1986 Act,

he finds that the ratio of U.S. investment to global investment of these companies was lower
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23 Desai, supra note 21.

24 The Bureau of Economic Analysis -- the organization responsible for collecting data on U.S.

multinational companies -- defines a majority owned affiliate as one in which the combined

ownership of all U.S. parents exceeds 50 percent.

between 1987 and 1990 than between 1984 and 1986. In the second part of his analysis, he

compares the investment behavior of U.S. multinationals with that of both domestic and foreign

non-multinationals. The purpose of the comparison is to link the surge in foreign investment by

U.S. multinationals with the 1986 Act tax reforms. He reasons that if the investment behavior of

non-multinationals over this period differed from that of U.S. multinationals, then the surge in

foreign investment could stem from the reforms. For the comparison, he regresses investment in a

country by a firm in a given year against the firm’s corporate income that year, the interest rate in

the country that year, and the value of the firm’s assets in the prior year. His results suggest little

difference in investment behavior of U.S. multinationals and foreign and domestic nonmultinationals. Specifically, over the relevant period, U.S. multinationals neither reduced their

U.S. investments by more than U.S. non-multinationals nor invested relatively more overseas than

foreign non-multinationals. He interprets the second part of his analysis to suggest that the

business cycle, not the 1986 Act, caused the surge in foreign investment.

Desai23 builds on the work of Harris and finds evidence that suggests a link between the

increase in foreign investment and the 1986 Act. His analysis also consists of two parts. First,

using aggregate data, he examines annual capital expenditures by U.S. multinationals. Consistent

with his expectations that the reforms should have encouraged such companies to invest more

overseas after 1986, he finds that the portion of capital expenditures undertaken through majorityowned foreign affiliates grew from 17 percent in 1986 to 22.5 percent of total capital

expenditures in 1990.24 Second, he uses regression analysis to determine if this surge in foreign

investment is linked to the1986 Act. Because the 1986 Act reduced the U.S. corporate tax rate,

which caused U.S. multinationals with average foreign tax rates between 34 percent and 46

percent in 1987 to change from excess limitation to excess foreign tax credit status, he argues that

this group of multinationals should have reallocated their investment toward lower tax countries

following the tax reform. Thus, the relative effective tax rate on foreign investment in lower tax

countries for such companies should have been reduced. To test his prediction, using firm-level

data on income, assets, and worldwide sales of 373 U.S. multinationals, he estimates the

parameters of an equation that characterizes the growth rate of a firm’s foreign assets between

1987 and 1990. The results suggest that the surge in foreign investment in the late 1980s is linked

to the 1986 Act.
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25 Jason G. Cummins and Kevin A. Hassett, Structural Estimates of Factor Substitution from

Firm-Level Panel Data on Multinational Corporations (Feb. 19, 1999) (unpublished conference

paper, Seminar Series in Tax Policy, American Enterprise Institute).

26 They also provide evidence that suggests that an individual firm may increase investment in both

locations when the tax on foreign investment is reduced. This so-called “output effect” would

take place because a business would decide to increase the scale of its operations everywhere,

although it would expand by more abroad than at home (the substitution effect). Note that, like

the other papers discussed in this section, their results only characterize the demand for capital by

individual firms.

27 Martin S. Feldstein and Charles Horioka, Domestic Savings and International Capital Flows, 90

Econ. J. 314 (June, 1980). 

Cummins and Hassett25 study firm-level data to measure whether a multinational

enterprise’s foreign demand for capital is a substitute for its domestic demand for capital. This is

an important question because, if multinationals consider them to be substitutes, they will invest

more abroad and less at home when a tax change reduces the cost of foreign capital relative to the

cost of domestic capital. For their analysis, the authors develop a model in which multinationals

produce output at home and abroad using six inputs: domestic labor, domestic capital, domestic

materials, foreign labor, foreign materials, and foreign capital. Using firm-level data on output,

labor, capital, and materials for approximately 200 U.S. multinationals between 1980 and 1995,

they estimate values for production function parameters. Their results suggest that multinationals

consider domestic and foreign capital to be relatively strong substitutes.26

III. Macroeconomic Research on International Capital Mobility

The empirical evidence discussed to this point suggests that capital is fairly mobile among

subsidiaries of U.S. multinational companies. However, it does not shed light on the mobility of

capital held by other types of investors. For example, the evidence provides no hint as to whether

individual U.S. investors or U.S. non-multinational companies adjust their portfolios in response

to a change in the rate of return on foreign capital relative to the rate of return on U.S. capital. A

third body of economic literature addresses this question indirectly. Specifically, studies in this

third body examine whether the aggregate supply of capital in developed countries is mobile

across national borders. Their finding that capital is relatively immobile in the aggregate may

suggest that capital held by other types of investors is not as mobile as that held by multinational

companies. Table 3 contains brief summaries of four articles in this area of the economic

literature. 

Feldstein and Horioka27 examine aggregate savings and aggregate investment in OECD

countries to determine whether capital at the aggregate level can be considered internationally

mobile. The relationship between aggregate investment and national savings is characterized by a
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28 Aggregate investment is the sum of domestic public and private sector investment. National

savings is the sum of domestic public and private sector savings. In a completely closed economy

(i.e., one in which capital does not flow in or out of the country) aggregate investment will always

equal national savings because all investment within the country will come from national savings. 

In an economy that is open to two-way capital flows, aggregate investment within the country

could be made with national or foreign savings, and aggregate savings from the country could be

invested domestically or abroad. Thus national savings will only equal aggregate investment if net

foreign investment (i.e. the difference between foreign savings and foreign investment) is zero.

basic identity in macroeconomics. Specifically, this identity equates aggregate investment with

the sum of national savings and the net flow of international investment.28 Feldstein and Horioka

employ this identity to study the international mobility of capital. They conjecture that if capital

flows unfettered across national borders, then the net flow of international investment should be

either a positive or negative number, rather than zero. In that case, within an individual country

national savings should differ from aggregate investment. Conversely, if capital does not flow

across national borders, i.e., if capital is immobile internationally, the net flow of international

investment should be zero. In that case national savings should equal aggregate investment within

a country. To test their hypothesis, the authors examine data on gross domestic savings, gross

domestic investment, and gross domestic product in 16 OECD countries between 1960 and 1974. 

They estimate the coefficients of an equation that characterizes the ratio of gross domestic

investment to gross domestic product in a country as a function of a constant and the ratio of

gross domestic savings to gross domestic product in that country. They find that domestic

investment is highly correlated with domestic savings. Their estimates suggest that, on average,

89 cents of every dollar saved by residents of OECD countries is invested domestically. They

interpret this result to imply that capital, in the aggregate, is not very mobile across international

borders.

Since Feldstein and Horioka published their work in 1980, several others have studied the

relationship between aggregate savings and investment. An incomplete list of such studies
-186-

29 Martin Feldstein, Domestic Saving and International Capital Movements in the Long Run and in

the Short Run, 21 Eur. Econ. Rev. 129 (1983).

30 Norman S. Fieleke, International Lending in Historical Perspective, New Eng. Econ. Rev. 5

(Nov.-Dec., 1982).

31 Robert G. Murphy, Capital Mobility and the Relationship between Saving and Investment Rates

in OECD Countries, 3 J. of Int’l Money & Fin. 327 (1984).

32 Lawrence H. Summers, Tax Policy and International Competitiveness, NBER Working Paper

Number 2007 (August 1986), available at <http://www.nber.org/pubs.html#papers>.

33 Jeffrey A. Frankel, And Now Won/Dollar Negotiations? Lessons from the Yen/Dollar

Agreement of 1984 90 (January 1990) (working paper in Economics, University of California at

Berkeley).

34 Roger Gordon and A. Lans Bovenberg, Why is Capital So Immobile Internationally? Possible

Explanations and Implications for Capital Income Taxation, 86 Am. Econ. Rev. 1057 (1996).

35 Murphy, supra note 31.

includes: Feldstein29, Fieleke30, Murphy31, Summers32 and Frankel.33 All conclude, similar to

Feldstein and Horioka, that national savings and national investment levels are highly correlated. 

However, there is no consensus among macroeconomists that the proper implication of this

finding is that capital is relatively immobile internationally. 

Many agree with the Feldstein and Horioka interpretation and offer explanations for the

meaning of the phrase “relatively immobile internationally.” For example, some suggest that some

but not all types of capital are mobile. For example, investments by multinational companies, but

not by other types of investors, may be sensitive to changes in after-tax rates of return in foreign

countries. Gordon and Bovenberg34 suggest that, unlike multinationals, individual investors may

prefer to invest in their own countries because they tend to be more familiar with, and better able

to evaluate, domestic than foreign investments. As a result, they probably do not respond to

changes in foreign rates of return. 

Others disagree with the Feldstein and Horioka interpretation and offer explanations as to

why the net flow of international investment in many OECD countries may approach zero even

though capital is mobile internationally. For example, Murphy35 examines whether Feldstein's and

Horioka's findings are linked to an unrealistic assumption about the size of capital markets in

individual countries. Specifically, in their analysis, Feldstein and Horioka assume that the capital

markets in all countries are small relative to the global capital market as a whole. This, in turn,

allows them to assume that neither changes in the supply or demand of capital in a particular

country affects world interest rates. To test whether Feldstein and Horioka's findings could be

explained by this small country assumption, Murphy develops a framework in which global
-187-

36 Summers, supra note 32.

interest rates can be influenced by changes in either the supply or demand of capital in relatively

large countries. While not conclusive, his results suggest that at least a portion of the close

correlation between savings and investment found by Feldstein and Horioka may be due to the

small country assumption. Similarly, Summers36 suggests that the correlation between savings and

investment is explained by fiscal and monetary policies. Specifically, governments tend to control

tax and monetary policies in ways that attempt to maintain a balance between exports and imports

of goods and services. It then follows that net foreign investment tends to approach zero. 

IV. Conclusion

 There is no consensus among economists about whether the global allocation of

investment would be affected much by a change in the subpart F foreign-to-foreign related party

rules. The lack of consensus stems primarily from a disagreement about the international mobility

of capital. Those who believe that capital flows unfettered across national borders would argue

that such a change would significantly affect the global distribution of investment. Specifically,

more would be invested in countries in which the relative after-tax rate of return rose and

relatively less would be invested in jurisdictions in which the after-tax rate of return fell. In

contrast, those who believe capital is relatively immobile internationally would argue that the

impact on the global allocation of investment would be small. The three bodies of literature

examined in this appendix, when viewed together, suggest that changes in the after-tax rate of

return on foreign capital relative to that on U.S. capital might affect investment expenditures of

multinational companies significantly and have a relatively small impact on the total amount

invested at home or abroad. 
-188-

Table 1: Taxes and U.S. direct investment abroad, suggestive evidence of capital mobility

Study Data Results

Cummins and 

Hubbard (1995)

Firm-level data on U.S.

multinationals with

subsidiaries in Canada,

United Kingdom, Germany,

France, Australia, and Japan

between 1980 and 1991. 

Host country and home

country tax information.

U.S. multinationals take into account inter-country differences in

taxes when determining how to allocate capital among their

subsidiaries in relatively high-tax countries.

Forecast: If taxes in a high-tax foreign country change such that a

multinational’s after-tax cost of capital rises by 1 percent, annual

investment in that country by the multinational will fall by 1 to 2

percent.

Grubert and 

Mutti (1991)

Gross domestic product,

population statistics, ad

valorem tariff equivalents,

host country average

effective tax rates, and

aggregate U.S. foreign direct

investment in manufacturing

in a cross section of 33

countries in 1982.

The aggregate distribution of U.S. foreign direct investment in real

capital in manufacturing across countries is explained partly by

differences in host country average effective tax rates. 

Forecast: If the tax rate in a host country declines such that the

after-tax rate of return rises by 1 percent, then the stock of net

plant and equipment of majority owned U.S. manufacturing

affiliates in that country will increase by 1.96 percent.

Hines and Rice

(1994)

Gross domestic product,

population statistics, average

effective tax rates, and

aggregate U.S. foreign direct

investment in a cross section

of 41 countries in 1982.

The aggregate distribution of U.S. foreign direct investment in real

capital across countries is explained partly by differences in

average effective tax rates. 

Forecast: If the tax rate in a host country declines such that the

after-tax rate of return rises by 1 percent, then the stock of net

plant and equipment of U.S. affiliates in all industries in that

country will increase by 2.3 percent. 

Altshuler,

Grubert, and

Newlon (1997)

Data on gross domestic

product, population,

inflation, average effective

tax rates, and book values of

depreciable assets of

manufacturing CFCs,

aggregated by country for a

sample of 58 countries in

1984 and 1992. Trade

regime classification data for

1987.

The aggregate distribution of investment in real capital in foreign

manufacturing affiliates of U.S. multinational companies became

more sensitive to differences in average effective tax rates between

1984 and 1992. 

Estimates: If the tax rate in a host country in 1984 had declined

such that the after-tax rate of return had risen by 1 percent, then

the stock of net plant and equipment of U.S. manufacturing

affiliates in that country would have increased by 1.75 percent. In

contrast, if the tax rate in a host country in 1992 had declined such

that the after-tax rate of return had risen by 1 percent, then the

stock of net plant and equipment of U.S. manufacturing affiliates

in that country would have increased by 2.77 percent. 
-189-

Altshuler and

Hubbard (1999)

Aggregate value of assets of

U.S. controlled foreign

corporations in financial

services and gross domestic

product for a cross section of

32 countries in 1984, 1992,

and 1994 and host country

average effective tax rates. 

The aggregate distribution of assets in foreign financial

subsidiaries of U.S. multinational companies became less sensitive

to differences in host country average effective tax rates following

the Tax Reform Act of 1986. 

Table 2: Taxes and the decision to invest in the United States or overseas, additional 

evidence of capital mobility

Study Data Findings

Harris (1993) Firm-level data on investment,

corporate income, and the value of

existing assets of 377 U.S.

multinationals, 1,965 firms

domiciled in America, and 2,114

firms domiciled in foreign countries

between 1984 and 1990. Statistics

on the U.S. interest rate on Treasury

securities and the London inter bank

offer rate during the same period. 

When examining the decline in U.S.

investment by U.S. multinationals in

the late 1980s , Harris does not find

evidence that links the decline to the

Tax Reform Act of 1986. 

Desai (1999) Aggregate annual data from the

Bureau of Economic Analysis on

capital expenditures and total assets

of U.S. multinationals between 1982

and 1993. Firm-level data on

income, assets, and worldwide sales

of 373 firms between 1987 and

1990. Statistics on foreign tax rates

for 1987. 

In contrast to the work done by

Harris, Desai finds evidence that

suggests the surge in foreign

investment by U.S. multinationals in

the late 1980s is linked to the Tax

Reform Act of 1986.

Cummins and Hassett (1999) Firm-level panel data on output,

capital, labor, and materials, of

nearly 200 U.S. multinationals

between 1980 and 1995.

Domestic and foreign capital are

relatively strong substitutes in

production by U.S. multinationals. 
-190-

Table 3: International capital mobility

Study Data Empirical finding Interpretation

Feldstein and

Horioka

(1980)

Gross domestic

savings, gross domestic

investment, and gross

domestic product data

for 16 OECD countries

between 1960 and

1974.

On average, a $1 increase in

domestic savings causes an

increase in domestic

investment of 89 cents.

Capital is relatively immobile

internationally. 

Gordon and

Bovenberg

(1996)

No data Theoretical analysis Capital is relatively immobile

internationally because of

asymmetric information. 

Murphy

(1984)

Gross domestic

savings, gross domestic

investment, and gross

domestic product data

for 17 OECD countries

between 1960 and

1980.

On average, a $1 increase in

domestic savings causes an

increase in domestic

investment of 90 cents.

Capital is relatively mobile

internationally. High correlation

between domestic savings and

domestic investment is explained

by the fact that some of the

capital markets in countries for

which data are available are large

relative to the global capital

market.

Summers

(1986)

Gross domestic

savings, gross domestic

investment, and gross

domestic product data

for four-year intervals

between 1960 and

1983.

A high correlation exists

between domestic savings and

domestic investment rates. 

Capital is relatively mobile

internationally. He suggests that

the high correlation between

domestic savings and domestic

investment may be explained by

fiscal and monetary policies. 
1

 For a variety of reasons these tax rates may differ from the effective tax rates on all corporations

(both U.S. owned and others) in a given foreign country. 

2

 Section 986 provides the principles for determining taxes that are included in Schedule F. 

3

 Section 964 and the regulations thereunder give a detailed description of the adjustments that

must be made to foreign book income to arrive at the tax definition of earnings and profits.

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APPENDIX C

THE MEASUREMENT OF TAX RATES

This appendix explains how the tax rates referred to in Chapter 3 were measured. Both

the concepts and data sources are described. The appendix is organized into three parts, covering

the measurement of foreign effective tax rates on the earnings and profits of foreign

manufacturing subsidiaries of U.S. multinationals, the measurement of total tax rates on the

foreign source income of U.S. manufacturing companies and the tax rate on domestic income of

U.S. corporations.

I. Foreign Effective Tax Rates on the Earnings and Profits of Foreign Manufacturing

Subsidiaries of U.S. Multinationals

The effective tax rates shown in Table 1 of Chapter 3 and referred to throughout this

paper are tax rates on corporate profits. Foreign effective tax rates are the taxes paid in a given

foreign country divided by the economic income earned in that foreign country. The corporations

for which we calculate foreign tax rates are those manufacturing subsidiaries reporting on Form

5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. Form

5471 is filed by the U.S. parent corporation for each foreign subsidiary that is greater than 10%

owned. Tax rates based on these data are the effective foreign tax rates on corporate profits of

U.S. subsidiaries in their respective foreign countries. These tax rates provide a measure of the

tax on income from investment in a foreign country.1 

The numerator of the foreign tax rate is from Schedule F of Form 5471, and includes

income, war profits, and excess profits taxes paid or accrued. Schedule F includes taxes paid to

countries other than the home country of the subsidiary to the extent that other countries’ laws or

tax treaties give them taxing jurisdiction.2 In 1994 the foreign taxes on manufacturing subsidiaries

of U.S. parents was approximately $13.8 billion.

The denominator of the tax rate, economic income, is the tax code defined earnings and

profits of the firm as reported in Schedule H of Form 5471. In general, these earnings and profits

are calculated by the taxpayer by starting with its foreign book income, converting that to U.S.

generally accepted accounting principles (GAAP), and then converting the GAAP version of

profits to the tax concept of earnings and profits.3 When these conversions are complete the
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4

 Tax defined earnings and profits that exclude firms that have current year losses have frequently

been used in effective tax rate calculation in the economic literature. Recent articles using these

tax rates include: Rosanne Altshuler, and R. Glenn Hubbard, The Effect of the Tax Reform Act of

1986 on the Location of Assets in Financial Services Firms, American Enterprise Institute,

Conference Paper from Taxation of International Investment : principles and Policies, February

earnings and profits that result are a reasonable approximation of economic income. In 1994 the

earnings and profits of foreign manufacturing subsidiaries of U.S. parents was approximately

$64.8 billion.

The average effective tax rate across all countries for 1994 is $13.8 billion divided by

$64.8 billion or approximately the 21 percent shown in the Average Foreign Rate column in Table

1 of Chapter 3.

Country effective tax rates were obtained by dividing the sum of taxes paid or accrued for

the subsidiaries located in a country by the sum of earnings and profits for those same

subsidiaries. The result is a weighted average of the effective tax rates for the subsidiaries; the

weights being the earnings and profits of each subsidiary. Subsidiaries were included in this

calculation for the years in which their after-tax earnings and profits were greater than zero.

Negative earnings and profits has two unwanted effects on the average tax rates. In a loss year,

firms are likely to pay no taxes. Therefore, including loss firms in the tax rate calculation forces

the denominator downward, while having no effect on the numerator of the fraction, thus causing

average tax rates to be higher than they otherwise would be. In years after the loss, taxable

income is forced downward because most countries, like the United States, allow firms to offset

taxable income and thus taxes in other years via a carryover of losses. This carryover generally

has little effect on U.S. tax law defined earnings and profits. Thus, the inclusion of subsidiaries

with loss carryovers may cause the numerator of the tax rate to decrease while having no effect on

the denominator, causing the tax rate in the year in which the carryforward is applied to decrease. 

It would probably be best to follow a firm through time taking into consideration all of its

earnings and profits and all of its taxes over the years in order to calculate a long-term tax rate

that would more accurately reflect the average tax cost of doing business in a foreign country. 

Given the data on foreign subsidiaries currently available that is not possible. Another alternative

measurement would exclude both subsidiaries that have current year losses and those that have

net operating loss carryovers to the current year. This also is not possible because although

subsidiaries with current year losses can be identified, subsidiaries with loss carryovers cannot be

identified. Instead, we have chosen to exclude subsidiaries that have an after tax loss from the

country tax rate calculation only in the year in which they incur that loss. The exclusion of such

firms in the year the losses are incurred causes the country foreign tax rate to be lower than it

would be if such firms were included.4
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19,1999; and Roseanne Altshuler, Harry Grubert and T. Scott Newlon, Has U.S. Investment

Abroad Become More Sensitive to Tax Rates?, NBER, Working Paper 6383, January 1998. 

5When preferences in the tax system that are caused by timing differences such as accelerated

depreciation cause economic income to be larger than statutory income, economic income will

continue to be larger than statutory income as long as investment continues to grow.

 

Country effective tax rates are different from statutory rates. The inclusion of firms with

loss carryovers is one reason for the difference, but there are other reasons. Economic income in

a growing economy is generally larger than taxable income causing the effective tax rate to be

lower than the statutory tax rate.5 Second, the taxes paid or accrued in the numerator of the tax

rate are net of any tax credits, causing the effective tax rate to be lower than the statutory rate. 

Finally, some countries may have laws that allow certain kinds of income to go untaxed. For

example, some countries have tax holidays that allow income during a certain period of time to be

excluded from taxable income. Such income would be included in economic income causing the

effective tax rate to be lower than the statutory rate. 

Table 1 of Chapter 3, Country Average Tax Rates Variations Across Countries By Year,

Foreign Manufacturing Subsidiaries of U.S. Companies, shows the distribution of average country

tax rates that are calculated in the manner described above. The firms included in the calculation

are only those that are classified into the manufacturing industries as reported by the taxpayer on

Form 5471. Each subsidiary is classified into a country based upon the taxpayer reported

country of incorporation. Countries are included separately in the distribution only when there

are more than five manufacturing subsidiaries with positive earnings and profits after taxes in that

country for every year shown in the table. Countries with less than five subsidiaries were

combined into an all other group that was treated like any other country for purposes of

calculating the distribution. Generally, the number of subsidiaries operating in each country

grows over the years. All firms for which information was available was used to calculate the

average country tax rate for a given year, so that a single country may include a different set of

firms in each year.

II. Average Effective Total Tax Rate on Foreign Source Income of U.S. Manufacturing

Companies

The average effective rate of total tax on foreign source income of U.S. manufacturing

companies is calculated by dividing foreign source income, including unrepatriated earnings of

subsidiaries, into the sum of foreign taxes, the U.S. tax on foreign source income, and withholding

tax paid to foreign governments. The total tax rate differs from the country foreign tax rate

because it includes all types of foreign source income in the denominator rather than just earnings

and profits and includes all taxes on that income in the numerator rather than just foreign income

taxes. For example, the total tax rate calculation includes royalty, interest and services income in
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6

 A description of the data from Form 1118 is in Robin A. Robinson and Sarah E. Nutter,

Corporate Foreign Tax Credit, 1994, Internal Revenue Service, Statistics of Income Bulletin 172-

230 (Fall 1998).

7

 Net 863(b) income is gross income less definitely allocable deductions for the general basket as

reported on Schedule F of Form 1118 and less a part of not definitely allocable deductions as

shown on Schedule F. 

the denominator and the foreign withholding taxes and other foreign taxes on that income in the

numerator. The total tax rate provides a broader measure of the tax on income from a foreign

country than does the country tax rate. The measure presented here is the total tax rate on

manufacturing activities. 

The measurement of the total tax rate begins with data from Form 1118, Foreign Tax

Credit - Corporations. Form 1118 must be filed by U.S. taxpayers that claim a foreign tax credit

and includes information concerning the foreign taxes that are eligible for credit as well as foreign

source income that must be used in the calculation of the limitation on the use of the credit.6 In

order to limit the measure to manufacturing activities, only data from Form 1118's filed by

manufacturing corporations are included in the total tax rate measure. 

Taxpayers are required to report foreign taxes and foreign source income in nine separate

categories or “baskets” of income. Only income and taxes from the general basket are used in the

calculation of the total tax rate presented here. The general basket includes most active income

from subsidiaries (other than financial and transportation subsidiaries) including dividends,

interest, royalties, services or other types of income and excludes passive activities such as

portfolio investments.

In 1994, the general basket of manufacturing corporations included approximately $55.9

billion in net foreign source income as reported on Schedule B, Part II of Form 1118. This

amount includes section 863(b) income. Under section 863(b), half of export income may be

treated as foreign source income. Such income is generally not taxed in any foreign jurisdiction

and will be excluded from the calculation of the total tax rate. Section 863(b) net income in the

general basket for 1994 is approximately $6.5 billion.7 This amount is subtracted from net foreign

source income in the general basket.

Earnings and profits of foreign subsidiaries as reported on Form 1118 includes either

income that is distributed as dividends to the United States or income that is deemed distributed

under subpart F, but because of our system of deferral, does not include any retained earnings and

profits that are not subpart F income. In order that the total tax rate cover income from all

foreign manufacturing activities, including both income taxable in the United States in the current

period and income not taxable in the current period but produced in the current period, earnings

and profits of foreign subsidiaries (of U.S. manufacturing parents) in all industries except financial
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services and transportation industries are substituted for the gross value of dividends appearing on

the Form 1118 of U.S. manufacturing corporations. This adjustment increases net foreign source

income by approximately $39.2 billion. After the adjustment the denominator of the total tax rate

fraction is approximately $88.6 billion for 1994. A corresponding adjustment to taxes is

described below.

In 1994, there was approximately $21.7 billion of foreign taxes in the general basket for

U.S. manufacturing firms. Approximately $5.2 billion of these taxes were carried forward from a

previous year. The effective total tax rate should include only taxes on current year’s income, so

taxes carried forward are subtracted from total foreign taxes. 

The U.S. tax on foreign source income is frequently referred to as the residual tax because

it is the amount of U.S. tax liabilities remaining after foreign tax credits. The amount of the

residual tax in the general basket for manufacturing companies is approximately $2.9 billion. 

As mentioned above, the treatment of export income as foreign source income under

section 863(b) results in mismeasurement of foreign source income. It also causes mismeasurement of taxes on that foreign source income. For every dollar of export income treated

as foreign source there is $.35 of mismeasurement of taxes. Approximately $2.3 billion (or 35%

of foreign source income of approximately $6.5 billion) of taxes must be removed from total taxes

to correct this mis-measurement. 

It is necessary to replace foreign income taxes on dividends reported in the general basket

on Form 1118 with foreign income taxes on all earnings and profits of subsidiaries (except

transportation and financial subsidiaries) of manufacturing parents. This corresponds to the

adjustment for deferred income described above. The net adjustment is approximately $6.3 billion. 

The average effective total tax rate on foreign source income of U.S. manufacturing firms

in 1994 is $23.4 billion in taxes divided by $88.6 billion in foreign source income or 26.4 percent. 

III. The U.S. Tax Rate on Domestic Income of U.S. Manufacturing Corporations

The calculation of the 1996 average U.S. tax rate, which is referenced in Chapter 3 of this

study, is described in this section. The U.S. tax rate is the domestic income of manufacturing

firms divided into the U.S. taxes paid on that income. To make the U.S. tax rates on domestic

income as close in definition as possible to the foreign and total tax rates, the domestic tax rates

are calculated from stockholder reports which provide a measure of the companies’ U.S. income

similar in concept to earnings and profits reported for foreign subsidiaries on Form 5471.

The stockholder report information used in the calculation of the U.S. tax rates includes

corporations with positive domestic net income after taxes. It further includes only the

corporations that Compustat has classified into manufacturing industries. However, firms
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8

 In Omer, Molloy and Zieberts, A Measurement of Effective Corporate Tax Rates Using

Financial Statement Information, a detailed description of the tax rate calculation is given. Here,

the tax rate calculation has been altered to obtain domestic figures. 

9Non-federal taxes are included in the numerator of the total tax rate as well to the extent that

they qualify for foreign tax crediting.

included in the manufacturing industries may have significant non-manufacturing activities and it

is not possible to obtain a domestic net income concept that is limited only to manufacturing

activities from the Compustat data. 

The denominator of the U.S. tax rate calculation is domestic pre-tax income (compustat

mnemonic= pidom) with income from consolidated subsidiaries’ common stock not owned by the

parent (mii) removed. The numerator is the sum of U.S. federal (txfed) and state and local (txs)

taxes. This tax rate calculation has been frequently used in the economic literature8. Both federal

and state and local taxes are included in the numerator of the tax rate fraction because they are

both generally included in the denominator of the foreign tax rate fraction.9 A part of the taxes

included in the numerator may be on foreign source income, but the residual U.S. tax on foreign

source income is small relative to total U.S. corporate taxes. 

Less than a quarter of manufacturing firms report domestic pre-tax income as compiled by

Compustat. Only those firms for which Compustat shows domestic pre-tax income separately

have been included in the tax rate calculation. These firms account for approximately 30 percent

of positive net income of manufacturing corporations. Using these concepts for 1996, the

denominator of the U.S. tax rate is approximately $151 billion and the numerator (including state

and local taxes) is approximately $47 billion, yielding a tax rate of approximately 31 percent. The

state and local taxes are approximately $6.0 billion, so that the federal corporate tax rate on

domestic income is approximately 27 percent.
1

 For purposes of this discussion, increased compliance costs in a country generally refer to the

increased taxes associated with rigorous enforcement of the tax laws in that country. Rigorous

enforcement of the tax laws in a country will likely cause taxpayers to be more cautious in

reporting their income and deductions, with the result that more taxable income is likely to be

reported in that country. 

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APPENDIX D

SURVEY OF QUANTITATIVE ECONOMIC STUDIES THAT

EXAMINE INCOME SHIFTING BY MULTINATIONAL COMPANIES

Because tax rules and the cost of complying with such rules differ across countries, an

incentive often exists for multinational companies to reduce costs by shifting income among their

affiliates. For purposes of this appendix, the term income shifting is used to describe

arrangements through which income that, from an economic perspective, is considered to be

earned in one country, is treated as earned in another country for tax purposes. For example,

multinationals may try to maximize income reported in a low-tax country through transfer pricing

arrangements or through deductible payments that strip earnings out of a corporation in a high-tax

country to a related corporation in a low-tax country. To the extent the tax rules of a country

allow such income shifting, or to the extent those tax rules are not strictly and rigorously

enforced, a multinational may have an incentive to shift income. By contrast, an increase in

compliance costs1 in a high-tax country should reduce the incentive to shift income by offsetting

such tax savings.

When evaluating the revenue impact of a proposed change to the subpart F foreign-toforeign related party rules, it is necessary to know whether multinational companies actually

respond to changes in the incentive to shift income. It is also important to know how much

money such companies could shift in response to such a change. If U.S. multinationals were to

significantly increase the amount they shifted out of the United States, the impact on U.S. tax

revenue could be considerable. 

The purpose of this appendix is to survey economic studies on international income

shifting. Three bodies of literature are discussed. Studies in the first body provide evidence that

suggests U.S. multinational companies shift income in response to differences in tax rules in

foreign countries. A few of the studies also estimate the potential magnitude of such shifting. 

Studies in the second body suggest that reported earnings of U.S. multinationals in a particular

country change when the incentive to shift income changes. Studies in the third body of literature

suggest that U.S. subsidiaries of foreign companies transfer relatively little income out of the

United States. No empirical studies to date have examined whether U.S. multinationals change
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2

 T. Scott Newlon, Transfer Pricing and Income Shifting in Integrating Economies (April 3-5,

1997) (unpublished conference paper prepared for the International Seminar in Public Economics

on Reform and Harmonization of Company Taxes in the European Union).

the amount of income reported in the United States in response to changes in U.S. compliance

costs.

I. Foreign Tax Rates and Reported Profits: Evidence That Suggests Multinationals

Shift Income in Response to Differences in Tax Rules in Foreign Countries

When the authors conducted research for the studies in the first body of literature, there

was no consensus that U.S. multinationals actually shifted income among affiliates. Some

believed income shifting was merely a theoretical construct. There was also significant

disagreement about the potential magnitude of such shifting. The purpose of these first studies

was to document evidence that suggested U.S. multinationals actually shifted income in response

to differences in tax rules in foreign countries. Some of the studies also attempted to quantify the

magnitude of such shifting. 

A similar analytical strategy was employed in all papers. Specifically, the authors

conjectured that if income shifting were widely practiced, it then follows that the reported income

of subsidiaries located in low-tax jurisdictions should exceed that of similar size subsidiaries in

high-tax jurisdictions. 

While searching for suggestive evidence of shifting, authors of these studies also

addressed indirectly whether both statutory and average effective tax rates influenced reporting

strategies of multinationals. Statutory tax rates are the actual rates listed in tax codes. Average

effective tax rates are calculated as the ratio of taxes paid to total reported income. Average

effective rates are intended to characterize the combined impact of various provisions of a

particular tax code. Effective rates are influenced not only by changes in statutory rates but also

by changes that affect the tax base (e.g., deductions, and credits) and compliance costs. 

Five studies from this body of literature are discussed in this appendix. The first, a paper

by Newlon2, examines data on unadjusted taxable income and average effective tax rates. He

finds that U.S. foreign subsidiaries located in countries with a relatively low average effective tax

rate tend to report nearly twice as much income as similar size subsidiaries based in countries with
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3

 Harry Grubert and John Mutti, Taxes, Tariffs, and Transfer Pricing in Multinational Corporate

Decision Making, 73 Rev. of Econ. & Stat. 285 (1991).

4

 James R. Hines, Jr. and Eric M. Rice, Fiscal Paradise: Foreign Tax Havens and American

Business, 109 Q. J. of Econ. 149 (Feb., 1994).

5

 David G. Harris, Randall Morck, Joel Slemrod, and Bernard Yeung, Income Shifting in U.S.

Multinational Corporations, in Studies in International Taxation (Alberto Giovannini, R. Glenn

Hubbard, and Joel Slemrod eds., 1993).

6

 Donald J. Rousslang, International Income Shifting by U.S. Multinational Corporations, 29

Applied Econ. 925 (1997).

7

 Newlon, supra note 2.

8

 Grubert and Mutti, supra note 3.

a relatively high average effective tax rate. Grubert and Mutti3, Hines and Rice4, and Harris,

Morck, Slemrod, and Yeung5 also examine the relationship between reported profits and tax rates

(both statutory and average effective tax rates), but use regression analysis to control for other

factors that might affect profitability in foreign countries, like labor costs and economic growth. 

They find that reported earnings of foreign subsidiaries tend to be negatively correlated both with

foreign statutory tax rates and with average effective foreign tax rates. Grubert and Mutti and

Hines and Rice then quantify the amount shifted among affiliates of U.S. multinationals. 

Rousslang6 examines the same issue using a slightly different approach. Specifically, he studies

after-tax rates of return on capital of foreign affiliates of U.S. multinationals on a company-bycompany basis and finds evidence that suggests such firms shift income from countries with a high

average effective tax rate to countries with a low average effective tax rate. Table 1 contains brief

summaries of these studies.

Newlon7 examines the relationship between reported income and average effective tax

rates by collecting data for 1992, aggregated by country, and calculating three normalized

measures of reported income: the ratio of taxable income to assets, the ratio of taxable income to

sales, and the ratio of taxable income to equity. Income data are normalized to adjust for

differences in subsidiary size. Next, he categorizes the income measures by three classes of

average effective tax rates (less than 10 percent, 10 percent to 20 percent, and greater than 20

percent). His findings, shown in table 2, indicate that the unadjusted reported earnings of U.S.

affiliates in countries with a low effective tax rate in 1992 were significantly higher than the

earnings of similar size affiliates in countries with a high average effective tax rate in that year. 

Grubert and Mutti8 reexamine Newlon’s findings. In particular, they question whether

reported income tends to be high in low-tax countries, and vice versa, when other factors that

affect profitability are taken into account. They also question whether statutory tax rates are a
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9

 The difference in statutory rates in two countries is the amount a multinational would save on

each dollar it shifted from one country to another.

10 Hines, Jr. and Rice, supra note 4.

11 Note the Bureau of Economic Analysis -- the organization responsible for collecting data on

U.S. multinational companies -- defines a majority owned affiliate as one in which the combined

ownership of all U.S. parents exceeds 50 percent. 

better determinant than effective tax rates of a multinational’s incentive to shift income.9 For their

analysis, Grubert and Mutti regress two different reported income measures, the ratio of book

income to sales and the ratio of book income to equity, against statutory tax rates and the growth

rate of gross domestic product (GDP). GDP growth was included in the regression to control for

the likelihood that companies in countries with high-growth rates were more profitable on average

than companies in countries with low-growth rates. They also repeat the regression analysis with

average effective tax rates rather than statutory tax rates. They examine data on manufacturing

affiliates of U.S. multinationals in 33 countries for 1982. Their findings corroborate those of

Newlon. Specifically, their findings suggest that affiliates in countries with either a relatively low

statutory or a relatively low average effective tax rate tend to report more income than similar size

affiliates located in countries with either a relatively high statutory or a relatively high average

effective tax rate. Negative correlations between reported income and tax rates are evident even

when differences in economic growth are taken into account. The results also indicate that

statutory tax rates are slightly better determinants of reported foreign earnings than average

effective tax rates.

Hines and Rice10 also examine the relationship between reported income and average

effective tax rates. For their analysis, they regress a non-linear function of aggregate reported

profits in different countries against non-linear functions of labor costs, the value of real assets,

per capita gross domestic product and average effective tax rates. They include labor costs in the

regression to control for the possibility that companies in countries with high wage costs tend to

be less profitable than companies that produce in countries with relatively low labor costs. The

value of real assets is also included to control for the possibility that larger subsidiaries (those with

more assets) tend to earn higher profits than smaller subsidiaries. The authors also used per

capita gross domestic product information as a proxy for worker productivity. Subsidiaries in

countries with relatively productive workers tend to be more profitable than subsidiaries in

countries with less productive workers. The analysis was conducted using data on non-bank

majority owned affiliates11 of U.S. multinationals in 108 countries in 1982. Similar to the findings

of the other studies, the results indicated that reported earnings and average effective tax rates are

negatively correlated even when differences in labor costs, worker productivity, and subsidiary

size are taken into account.
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12 Grubert and Mutti, supra note 3.

13 Hines, Jr. and Rice, supra note 4.

14 Harris, Morck, Slemrod, and Yeung, supra note 5.

15 Rousslang, supra note 6. 

Grubert and Mutti12 and Hines and Rice13 also use their results to estimate how the

amount of income reported as earned by U.S. multinationals might differ in two countries with

different tax rates. For example, Grubert and Mutti estimate that if the statutory tax rate in one

country is 40 percent and 20 percent in another and the average growth rate of GDP in both

countries is 3.94 percent, then reported income in the first country should be about half as much

as that reported in the second country. Specifically, reported book income as a fraction of sales

of affiliates of U.S. multinationals should amount to only 5.6 percent in the country with the 40

percent tax rate and 12.6 percent in the country with the 20 percent rate. Similarly, Hines and

Rice estimate that if the average effective tax rate in one country is one percentage point higher

than in another, then reported income of non-bank majority owned affiliates of U.S. multinationals

in the first country should be 3 percent less than the amount reported in the other country. 

Harris et al.

14 also examine the relationship between reported earnings and foreign

statutory tax rates, but from a slightly different perspective. They hypothesize that a U.S.

multinational with subsidiaries located primarily in high-tax countries should shift less income out

of the United States than a similar size U.S. company with subsidiaries located primarily in lowtax countries. If true, this hypothesis implies that a multinational with subsidiaries based primarily

in high-tax countries should report more U.S. income and pay more in U.S. taxes than a similar

company with subsidiaries based primarily in low-tax countries. To test this hypothesis, the

authors analyzed data on 200 randomly selected U.S. multinationals with foreign manufacturing

affiliates over the period 1984 to 1988. Like the other studies, the authors used regression

analysis to control for non-tax factors that affect profitability, such as research and development

expenses, marketing expenses, wage costs, and the cost of capital. The results, which support

their hypothesis, indicate that U.S. multinationals with subsidiaries located primarily in countries

with a mean statutory tax rate that exceeds the comparable U.S. rate pay more in U.S. taxes over

the five-year period than multinationals with subsidiaries based primarily in countries with a mean

statutory tax rate that falls below the comparable U.S. rate. 

Rousslang15 examines after-tax rates of return on capital to determine if multinationals

tend to shift income from countries with a high average effective tax rate to countries with a low

average effective tax rate. The theory of profit maximization implies that, if multinationals shift

profits to minimize taxes, after-tax rates of return on capital should be high in countries with low

tax rates and low in countries with high tax rates. The after-tax rate of return on capital in a

particular subsidiary is equal to the value of the subsidiary’s taxable income divided by the value

of its assets. If earnings are shifted to that subsidiary, then the after-tax rate of return should be
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relatively high. Similarly, the return should be relatively low if earnings are not shifted to the

subsidiary. To test this theory, Rousslang examines information reported on tax returns in 1988

by U.S. multinational companies about both their assets and their earnings. He found that aftertax rates of return tended to be low for subsidiaries located in countries with a high average

effective tax rate and high for subsidiaries located in countries with a low average effective tax

rate. Thus, his findings also suggest that multinationals shift income. However, it should be

noted that the results could also be explained by risk. If production in low-tax countries tends to

be riskier than production in high-tax countries, the after-tax rates of return on capital should

systematically be higher in low-tax countries than in high-tax countries. 

To summarize, evidence in this body of literature suggests that U.S. multinationals shift

income in response to differences in tax rules in foreign countries. Specifically, such companies

tend to report high earnings in countries with relatively low tax burdens and low earnings in

countries with relatively high tax burdens. Most of the authors also tend to believe that the

incentive to shift income is determined primarily by differences in statutory tax rates across

countries. However, differences in compliance costs, which result in differences in average

effective tax rates, may also influence the amount shifted. Finally, evidence in two of these

studies suggests that considerable earnings could be shifted among affiliates. Grubert and Mutti,

for example, estimate that twice as much income is reported in one country relative to another if

the statutory tax rate in the former is half the size of that in the latter. 

II. Tax Reforms and Reported Profits: Evidence That Suggests Reported Earnings in a

Particular Country Change When the Incentive to Shift Income Changes 

The objective of authors of papers in the second body of literature is to examine whether

multinational companies respond to changes in the incentive to shift income. All employ a similar

research strategy. They conjecture that if multinationals act on the incentive to shift income, then

a policy that reduces the corporate statutory tax rate in a particular country relative to rates in

other countries should encourage more income to be shifted to affiliates in that country. This, in

turn, should cause reported taxable earnings of affiliates in that country to rise. 

While the authors of these papers do not consider the impact of changes in average

effective tax rates on shifting strategies of U.S. multinationals, their findings do indicate that there

is no obvious income shifting response to a change in the average effective tax rate in a particular

country. As background to the discussion in this section, it should be noted that, in theory, the

income shifting response should depend on the factors that influence the average effective rate. 

An average effective tax rate is influenced by changes in the statutory rate, the tax base, and the

enforcement of the tax rules. A policy that changes rates or enforcement of the tax rules should

theoretically affect income shifting while investment incentives that change the tax base should

not. This result may best be demonstrated by example. Suppose the corporate statutory tax rate

is increased in country A. Tax credits for investment are introduced, which reduce the tax base. 

Also assume that no other tax reforms are implemented and the combined impact of the two
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16 David G. Harris, The Impact of U.S. Tax Law Revision on Multinational Corporations’ Capital

Location and Income-Shifting Decisions, 31 J. of Acct. Res. 111 (1993 Supp.). 

17 Kenneth Klassen, Mark Lang, and Mark Wolfson, Geographic Income Shifting by Multinational

Corporations in Response to Tax Rate Changes, 31 J. of Acct. Res. 141 (1993 Supp.). 

18 Pub. L. No. 99-514, 100 Stat. 2553.

19 Harris, supra note 16. 

20 This is because transfer pricing rules are especially difficult to enforce for the exchange of

marketing intangibles and other intangibles that result from research and development.

changes is to reduce the average effective tax rate in country A. If statutory tax rates in other

countries do not change, multinationals should respond to the reforms in country A by shifting

income to foreign countries because companies focus on statutory rate changes rather than on

investment incentives when engaging in income shifting. Assume that a completely different set of

reforms is enacted. For example, authorities offer a reduced tax rate to foreign companies who

agree to produce manufactured goods in country A. Also assume that no other tax changes are

approved either in country A or in other countries. In this case, the average effective tax rate in

country A falls and multinationals should respond by shifting income into country A. Thus, in this

case, a decrease in the average effective tax rate in country A is associated with companies

shifting profits into that country because the average effective tax rate change is caused by a

change in the statutory rate.

Two studies in this body of literature, Harris16 and Klassen, Lang, and Wolfson17, examine

whether U.S. multinationals responded to the Tax Reform Act of 198618 (1986 Act) by changing

the amount of income they reported for tax purposes in both their domestic and foreign affiliates.

The 1986 Act affected both the U.S. corporate statutory tax rate and the U.S. average effective

tax rate. The reform reduced the statutory tax rate on corporate income from 45 percent to 34

percent. The reduction was implemented over the two-year period, 1987 to 1988. Another

provision of the 1986 Act eliminated the investment tax credit. The combined impact of the

decrease in the statutory tax rates and the elimination of the investment tax credit was to increase

the U.S. average effective tax rate. Since, as discussed immediately above, income shifting

strategies are likely to be influenced by statutory tax rates but not investment incentives, both

Harris and Klassen et al. conjecture that U.S. multinationals should have responded to the 1986

Act tax reforms by reporting additional income in affiliates in the United States and less in

affiliates in foreign countries after 1986. Table 3 contains brief summaries of these studies.

Harris19 examines firm-level data to determine if the 1986 Act affected income shifting

strategies of U.S. multinationals. He predicts that if the reform did influence strategies, the

impact on reported U.S. earnings should have been especially strong for intangible-intensive

multinational companies.20 To test this theory, he compares the reported income of U.S.
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21 Klassen, Lang, and Wolfson, supra note 17. 

intangible-intensive multinationals with that of both domestic and foreign intangible-intensive nonmultinationals. He reasons that if U.S. multinationals shifted income in response to the decline in

the U.S. statutory rate, then the trend in their reported income both in the United States and

overseas during the 1980s should differ from that of domestic and foreign non-multinational

companies. Using data for the 1984 to 1990 period, he regresses reported income of a company

in a given country in a given year against its reported income in that country in the previous year,

its total assets in that country in the previous year, and two dummy variables. The first dummy

variable indicates whether or not the company is a multinational. The second specifies whether or

not the company spends a significant amount on marketing and research and development. His

results indicate U.S. multinationals with relatively high marketing and research and development

expenses increased the amount of income they reported in the United States over the 1987 to

1988 period by more than domestic non-multinationals over the same period. In addition, their

reported earnings in affiliates in foreign countries fell by more than the reported earnings of

foreign non-multinationals over the same period. Thus, consistent with his conjecture, his results

suggest that U.S. multinationals responded to the decline in the U.S. statutory rate by reporting

more income in the United States and less overseas. 

 

Klassen, Lang, and Wolfson21 also study the impact of the 1986 Act on reported earnings

of U.S. multinationals. Unlike Harris, however, they examine reported earnings for 1987 separate

from those for 1988. Their analysis, like that employed by Harris, involves a comparison in the

trend in reported earnings of U.S. multinational companies with those of both domestic and

foreign non-multinationals. Their analysis uses data on equity, income tax payments, and assets of

191 U.S. multinationals, 1,446 non-multinational U.S. companies, and 2,095 non-multinational

foreign companies over the 1984 to 1990 period. The regression equation relates the change in

the ratio of taxable income to book equity of a particular company in a given year to several

dummy variables. One dummy variable categorizes the firm as a multinational or a nonmultinational. Another indicates the percentage of the firm’s total assets that were located in each

of four regions (Europe, Canada, the United States, and the rest of the world) over the six-year

period. The results for 1987 but not for 1988 support their conjecture about income shifting. 

Specifically, the results suggest that, in 1987, U.S. multinationals reported a greater increase in

U.S. earnings than were reported by U.S. non-multinational companies. That same year, these

companies reported a larger decline in foreign earnings than were reported by foreign nonmultinationals. The opposite was found to be true for both the comparison with domestic nonmultinationals and foreign non-multinationals in 1988. The authors suggest that the 1988 results

may be explained by the fact that corporate statutory tax rates also fell in several foreign countries

that year. Thus, the response to the decline in foreign statutory tax rates may have simply

outweighed the response to the decline in the U.S. statutory rate. 
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22 See United States General Accounting Office, Tax Administration: Foreign- and U.S.-

Controlled Corporations That Did Not Pay U.S. Income Taxes, 1989-1995 (March, 1999).

23 Id. at 4.

Klassen, Lang, and Wolfson also study the impact of the Canadian and European tax

reforms on reported earnings of U.S. multinationals. Because corporate statutory tax rates rose in

Canada and fell both in the United Kingdom and in France between 1985 and 1986, the authors

conjecture that U.S. multinationals should have responded to these reforms by reporting relatively

more income in Europe and relatively less in Canada over the two-year period. The regression

analysis in this case is identical to that used to study the impact of the U.S. reforms. The same

data are also employed. Consistent with their conjecture, the findings indicate that U.S.

multinationals with assets in both Canada and in Europe reported a larger increase in European

earnings over the two-year period than were reported by European non-multinational companies. 

They also report a larger decline in Canadian earnings than were posted by Canadian nonmultinational companies over that period. 

In summary, evidence from this body of literature suggests that multinationals respond to

changes in the incentive to shift income. Specifically, if the incentive increases because the

statutory tax rate in a particular country falls, multinationals appear to report more income for

affiliates in that jurisdiction. This is evidenced by an increase in reported earnings in that country. 

Similarly, if the incentive is reduced because the corporate statutory tax rate in a particular

country rises, multinationals seem to report fewer earnings for affiliates in that country. Finally,

the findings of these studies indicate that a change in the incentive to shift income does not

necessarily correspond to a change in a particular country’s average effective tax rate. Provisions

in the 1986 Act simultaneously decreased the statutory rate and increased the U.S. average

effective tax rate. Companies responded to the change in the statutory rate, not to the change in

the average effective tax rate, by shifting more income into the United States. 

III. Reported Profitability of U.S. Companies and U.S. Affiliates of Foreign Multinationals

Studies in the third body of literature were motivated by the findings of a study conducted

by the U.S. General Accounting Office.22 In this study, the U.S. General Accounting Office

indicates that the percentage of foreign controlled corporations (FCCs) (i.e., U.S. corporations

more than 50% owned by foreign shareholders) that paid no U.S. taxes between 1989 and 1995

was higher than the percentage of U.S.-controlled U.S. corporations that paid no taxes over the

same period.23 Specifically, the percentage of FCCs that did not pay taxes ranged from 67 percent

to 73 percent while the percentage of U.S.-controlled corporations that did not pay taxes only

ranged from 59 percent to 62 percent. Some claim that the reason more foreign multinationals

are able to avoid paying U.S. taxes than U.S. companies is that foreign multinationals shift much
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24 Harry Grubert, Timothy Goodspeed, and Deborah Swenson, Explaining the Low

Taxable Income of Foreign-Controlled Companies in the United States, in Studies in International

Taxation (Alberto Giovannini, R. Glenn Hubbard and Joel Slemrod eds., 1993).

25 Harry Grubert, Another Look at the Low Taxable Income of Foreign-Controlled Companies in

the United States 1 (1997) (Office of Tax Analysis Working Paper, Number 74), available at

<http://www.treas.gov/ota/otapapers.html>. 

26 Grubert, Goodspeed, and Swenson, supra note 24.

27 Grubert, supra note 25.

of the income they earn in the United States to affiliates in foreign countries. A casual analysis of

unadjusted taxable income data lends support to this claim. Such an analysis indicates that the

average FCC tends to report significantly lower profits than the average U.S. company. Authors

of studies in the third body of literature would disagree. In their studies, the authors attempt to

show that FCCs shift relatively little income out of the United States by providing evidence that

much of the reported difference in profitability is linked to systemic differences between U.S.

companies and FCCs. For example, FCCs may face higher input costs than U.S. companies

because they tend to use more imported parts in production. 

Two studies from the third body of literature are discussed in this appendix. The first

study, Grubert, Goodspeed, and Swenson,24 employs rigorous analysis to explain that a large part

of the difference in profitability between FCCs and other U.S. companies may be caused by

systemic differences between the two. Specifically, they estimate that nearly half of the 1987

differential may be attributable to such systemic differences. The second study, by Grubert,25 also

uses rigorous analysis to examine the 1993 profit differential. He finds that such differences

explain more than half, and perhaps as much as 75 percent, of the differential that year. Table 4

contains brief summaries of these studies. 

Grubert, Goodspeed, and Swenson26 and Grubert27 explain that the taxable income

differential may stem from several factors. For example, foreign multinationals may shift income,

either through transfer pricing or earnings stripping, to subsidiaries in countries in which

corporate statutory tax rates are lower than in the United States. Another possibility is that the

unadjusted ratio of taxable income to assets for FCCs is not comparable to the ratio for U.S.

companies. When managers of FCCs invest in the United States, they generally purchase existing

rather than new plants and equipment. Because the appraised value of an older plant or piece of

machinery tends to rise when it is marked to market, the ratio of taxable income to assets of FCCs

tends to fall when they invest. (The denominator but not the numerator of the ratio rises after the

acquisition.) It is also possible that FCCs face higher start up costs than U.S. companies because

it takes foreign managers time to learn about U.S. markets, resources, and consumers. Finally,

unexpected declines in the value of the dollar relative to other currencies could increase expenses

for foreign firms who rely more heavily than domestic companies on imported parts. 
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Because the portion of the income differential that may be attributable to income shifting

is difficult to measure directly, Grubert, Goodspeed, and Swenson examine firm-level data to

determine what percentage may stem from other factors. The remainder, in their opinion, is the

upper bound of the portion that may stem from income shifting. For their analysis, they examine

two sets of data. The first contains 1987 information on 600 non-financial FCCs and 4,000 nonfinancial U.S. companies. With these data, they regress a firm’s ratio of taxable income to assets

against foreign and industry dummy variables. They also estimate parameters for similar

equations with additional independent variables, such as a firm’s debt to equity ratio and dummy

variables that classify the firm by acquisition date. A comparison of the parameter estimates

generated from the different equations suggests that acquisition dates explain nearly a quarter of

the 1987 differential in taxable income. The second set of data contains information about 110

non-financial FCCs and 1,300 non-financial U.S. corporations over the period 1980 to 1987. 

Using this information, they regress a firm’s ratio of taxable income to assets against several

dummy variables. The dummies classify the firm by age and by industry. Other dummies also

interact with a time trend and with an index of the real value of the dollar. Parameter estimates

from this regression suggest two things. First, the profitability of manufacturing FCCs relative to

that of U.S. manufacturing companies tends to rise over time. Second, wholesale FCCs tend to

be less profitable than U.S. companies when the dollar depreciates unexpectedly because the cost

of imported inputs rises. Combined, these two factors explain another one-fourth of the income

differential. Thus, the authors conclude that at least one-half of the 1987 differential in taxable

income between U.S. companies and FCCs is attributable to factors other than income shifting. 

Grubert both updates the Grubert, Goodspeed, and Swenson analysis with more recent

data and investigates the importance of interest expenses, depreciation costs, dividends, and

royalties. His analysis consists of two parts. First, he updates the earlier work using 1993 rather

than 1987 data for the cross-section regressions and statistics for 1987 to 1993 rather than for

1980 to 1987 for the panel regressions. He finds that many of the same factors that explain some

of the 1987 differential also explain a large portion of the 1993 differential. However, the relative

importance of these factors changes over the five-year period. For example, differences in

acquisition dates account for only 11 percent of the 1993 differential, but 25 percent of the 1987

differential. Differences in ratios of debt to assets explain roughly 16 percent of the 1993

differential, but only one percent of the 1987 differential. Although exchange rate fluctuations do

not explain a significant part of the 1993 differential, the “maturation effect” continues to explain

why many FCCs, especially those involved with manufacturing, tend to be less profitable than

other U.S. companies. In the second part of the paper, Grubert departs from the Grubert,

Goodspeed, and Swenson analysis to consider possible explanations for the difference in the ratio

of taxable income to sales of FCCs and domestic companies. To do this, he runs regressions,

similar to those used to analyze the ratio of taxable income to assets, on both the ratio of taxable

income to sales and the ratio of operating income to sales. (Unlike taxable income, operating

income excludes dividend income and accounts for both interest and depreciation expenses.) He

finds a large part of the differential, 50 percent or more, may stem from the fact that relative to

U.S. companies, FCCs tend to receive fewer dividends and royalties and have higher interest and
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depreciation expenses. Thus, combining the results of the two parts, he concludes that more than

half, and perhaps as much as three-fourths of the taxable income differential, may stem from

systemic differences between domestic companies and FCCs. 

Grubert also compares the profitability of U.S. companies that are only partially foreignowned by with those of that are 100 percent foreign-owned. In his opinion, U.S. companies with

one owner should shift more income than U.S. companies with multiple owners. When more than

one owner is involved, consensus on a particular strategy must be reached before profits can be

shifted from one affiliate to another. Building on this logic, Grubert conjectures that if income

shifting explains a large portion of the profit differential, then 100 percent foreign-owned U.S.

companies should shift more profits out of the United States than similar size U.S. companies that

are only 25 percent to 50 percent foreign owned. This, in turn, implies that if income shifting is

widely practiced by foreign multinationals, then the reported profitability of 100 percent foreignowned U.S. companies should be noticeably lower than that of partially foreign-owned U.S.

companies. Data from U.S. tax forms filed by foreign owned U.S. companies for tax year 1993

are used in the analysis. His findings suggest that there is no noticeable difference between the

reported profitability of U.S. companies that are partially foreign-owned and those that are 100

percent foreign-owned. He interprets this result to reinforce the general finding of this body of

literature – a large percentage of the profit differential is not explained by income shifting. 

In summary, evidence in the third body of literature suggests that foreign multinationals

shift relatively little income out of the United States. Specifically, they find that less than half and

possibly less than one-fourth of the reported difference in profitability of U.S. companies and

FCCs may be due to income shifting. The remainder can be explained by systemic differences,

such as differences in input costs, between these two types of companies. If true, this evidence

seems to suggest that foreign multinational companies do not respond significantly to the

incentive to shift income out of the United States.

IV. Conclusion

Will U.S. tax revenue decline significantly if policymakers approve a change in the foreignto-foreign related party rules? The answer to this question may be yes if the change would also

increase the incentive to shift income. In theory, this incentive should be influenced by differences

in tax rates across countries. Such differences create an opportunity for companies to reduce

their tax liability by shifting income from high-tax countries, like the United States, to low-tax

countries. Evidence discussed in this appendix suggests that U.S. multinationals actually do shift

income in response to such differences in tax rates. The magnitude of such shifting is unclear,

however. Studies that examine data on foreign subsidiaries of U.S. companies suggest that a

significant amount of income is shifted from high-tax to low-tax countries. Other studies that

examine data on U.S. subsidiaries of foreign companies suggest that much less income may

actually be shifted in response to differences in tax rates. These latter studies suggest that at least
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some portion of the initial estimates can be explained by non-tax factors, like the use of expensive

foreign inputs in production. 

Changes in compliance costs in a high-tax country, in theory, should also affect the incentive to

shift income. Specifically, an increase in such costs should reduce the incentive to shift by

offsetting savings associated with reporting income in low-tax countries. Although no empirical

studies to date have examined whether U.S. multinationals respond to changes in compliance

costs by shifting more or less income out of the United States, one would expect that if the

foreign-to-foreign related party rules were changed such that the compliance costs associated with

shifting income from the United States declined, the incentive to shift income from the United

States to foreign countries would increase. This, in turn, could increase the number of companies

that shift income out of the United States and reduce U.S. tax revenue. 
-210-

Table 1: Foreign tax rates and reported profits of subsidiaries of U.S. multinationals

Study Data Findings

Newlon (1997) Information reported on U.S. corporate tax

returns in 1992 about U.S. and foreign tax

liabilities, taxable income, total assets, total

sales, and equity of foreign affiliates of U.S.

multinationals. 

U.S. multinationals tend to report less income in

subsidiaries in countries with a high average effective

tax rate than in similar size subsidiaries in countries

with a relatively low average effective tax rate.

Grubert and

Mutti (1991)

Statutory tax rates, average effective tax

rates, gross domestic product growth rates,

and aggregate measures of book income,

sales, and equity of U.S. manufacturing

affiliates in 33 countries in 1982. 

The distribution of reported income of manufacturing

subsidiaries in foreign countries is correlated negatively

with both the distributions of average effective tax rates

and of statutory tax rates in foreign countries even after

factors that affect profitability are taken into account. 

Regressions based on statutory tax rates tend to have

more explanatory power than those based on average

effective tax rates. 

Hines and Rice

(1994)

Average effective tax rates and aggregate

data on labor, capital, and reported profits

of U.S. non-bank affiliates in 108 countries

in 1982.

U.S. multinationals in non-bank industries tend to

report higher profits in subsidiaries in countries with a

low average effective tax rate than in subsidiaries in

countries with a high average effective tax rate even

after additional factors, which influence profitability,

are taken into account. 

Harris et. al.

(1993)

Pretax profitability, research and

development spending, advertising

spending, depreciation, amortization, rental

expenses, investment tax credits, interest

expenses, and employment information for

200 randomly selected U.S. multinationals

in the manufacturing sector between 1984

and 1988. Mean statutory corporate tax

rates for 1984 and 1988. 

U.S. multinationals in the manufacturing sector with

subsidiaries located primarily in foreign countries with

a mean statutory tax rate that exceeds the comparable

U.S. rate tend to report more U.S. income and pay more

in U.S. taxes than U.S. multinationals in the same

sector with subsidiaries located primarily in foreign

countries with a mean statutory tax rate that falls

beneath the comparable U.S. rate. 

Rousslang

(1997)

Firm-level data on assets, sales, income,

dividend distributions, research and

development expenditures, and tax

payments of foreign affiliates and domestic

operations of U.S. multinationals in the

manufacturing sector in 1988.

Foreign affiliates of U.S. multinationals tend to shift

income earned in countries with a high average

effective tax rate to countries with a low average

effective tax rate. 
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Table 2: Taxes and reported income of foreign subsidiaries of U.S. multinationals, 1992

Category of average 

effective tax rates

Ratio of income

to assets

Ratio of income

to sales 

Ratio of income

to equity

Less than 10 % 0.102 0.098 0.196

10 % - 20 % 0.071 0.058 0.165

More than 20 % 0.054 0.042 0.155

SOURCE: Newlon (1997). 
-212-

Table 3: Tax reforms and reported profits of affiliates of U.S. multinationals 

Study Data Findings

Harris (1993) Firm-level data on income, assets,

and expenses of 375

multinationals, 1,351 U.S. nonmultinationals, and 1,698 foreign

non-multinationals between 1984

and 1990.

Empirical findings support the proposition that

intangible-intensive multinationals responded to

the Tax Reform Act of 1986 by shifting income out

of foreign countries and into the United States. 

Klassen, Lang, and

Wolfson (1993)

Annual, firm-level data on

income, tax payments, and assets

of 191 U.S. multinationals, 1,446

non-multinational U.S. firms, and

2,095 non-multinational foreign

firms between 1984 and 1990.

The findings in this study are also consistent with

the hypothesis that U.S. multinationals shifted

income from subsidiaries in other countries to the

United States in 1987 when the U.S. corporate

statutory tax rate fell. However, in 1988, they find

that these same companies may have shifted

income out of the United States to foreign

countries, even though the U.S. statutory rate

continued to fall that year.

In addition, the results of this study are consistent

with the proposition that U.S. multinationals

shifted income from Canada to Europe between

1984 and 1986 when the Canadian corporate

statutory tax rate rose and French and U.K.

corporate statutory rates fell.
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Table 4: Reported profits of U.S. companies and foreign controlled corporations 

Study Data Finding

Grubert, Goodspeed, and

Swenson (1993)

Firm-level data on income, taxes, assets,

debt, equity, and expenses for a cross

section of 600 non-financial foreign

controlled corporations and 4,000 nonfinancial U.S. companies in 1987. 

Firm-level data for a panel of 110 nonfinancial foreign controlled corporations

and 1,300 non-financial U.S.

corporations for 1980 to 1987.

Approximately 50 percent of the 1987

difference in taxable income between foreign

controlled corporations and U.S. companies

can be attributed to special characteristics of

foreign controlled corporations rather than

transfer pricing.

Grubert (1997) Information reported on U.S. tax returns

between 1987 and 1993 on taxable

income, total assets, and gross receipts by

U.S. companies and by U.S. operations of

foreign controlled corporations.

Firm-level data on income, taxes, assets,

debt, equity, and expenses for a cross

section of 1,208 non-financial foreign

controlled corporations and 4,610 nonfinancial U.S. companies in 1993. 

Firm-level data for a panel of 344 nonfinancial foreign controlled corporations

and 1,588 non-financial U.S.

corporations for 1987 to 1993.

Each year between 1987 and 1993, U.S.

companies reported higher taxable income

than similar size U.S. operations of foreign

controlled corporations.

More than 50 percent, and perhaps as much

as 75 percent, of the difference in taxable

income between foreign controlled

corporations and U.S. corporations can be

explained by systematic differences between

the two types of corporations.