The purpose of the article is to provide a brief historical overview of the circumstances leading up to the enactment of the famous “Subpart F” rules through the year 1962.
Subpart F of Subtitle A, Chapter 1, Subchapter N, Part III of the Internal Revenue Code (IRC Sections 951-965) was first enacted by the U.S. Congress in 1962 in response to the general perception that the then current tax rules as applicable to foreign corporations provided a major tax loophole for U.S. taxpayers to defer the U.S. tax on their foreign-source income as long as this income was earned by foreign corporations.
Prior to Subpart F, the general Code rules allowed U.S. taxpayers to avoid any U.S. tax on the earnings of a foreign corporation owned by these U.S. taxpayers, at least until those earnings were actually distributed or until the disposition of the stock of the foreign corporation. Thus, a U.S. taxpayer could potentially defer U.S. taxation for an indefinite period of time on all profits earned by the foreign corporation by retaining the earnings in the foreign corporation (or, using the earnings in a way other than a taxable distribution, such as a loan or a lease of property).
This situation was also combined with the favorable tax gain rules on the disposition of stock in a corporation. This allowed a U.S. shareholder to pay only a capital gains rate on income earned by a foreign corporation (rather than taxed as ordinary income) through a disposition of appreciated stock in a foreign corporation (if the foreign corporation retained its earnings).
In fact, the only effective limitation on this freedom were the special rules regarding personal holding company taxation. The personal holding company provisions were enacted by Congress in 1934 (these rules are repealed as of this writing) to limit, through imposition of a penalty tax at the corporate level, the practice of transferring passive assets to a corporation, thereby avoiding the high individual income tax rates.
The personal holding company rules, however, originally applied only to U.S. companies and were not effective in a situation where a U.S. person would transfer passive assets to a foreign corporation (because the foreign corporation would be outside the U.S. jurisdiction). This loophole was immediately recognized and utilized with the effect that U.S. passive assets not only escaped the U.S. individual income tax but also U.S. corporate taxes.
In 1937, Congress acted against this loophole by enacting foreign personal holding company (FPHC) rules. There was a key difference between the FPHC and regular personal holding company rules – the regular rules imposed a penalty tax at the corporate level, whereas the foreign rules taxed certain U.S. shareholders directly on the undistributed foreign personal holding company income of such corporations.
Despite the appearances, however, the FPHC mechanism contained significant flaws. First, the rules applied only in special circumstances where more than 50% of a foreign corporation was owned by five or fewer individuals and where more than 50% (60% initially) of the corporation’s gross income was in the form of foreign personal holding company FPHC income. Second, FPHC rules applied only to passive types of income, but not where a foreign corporation also had substantial business income. Third, the FPHC provisions did not apply to US corporations with wholly-owned subsidiaries.
Due to the inadequacy of the FPHC regime and the evidence of significant outflow of U.S. capital overseas in the form of foreign investment (combined with favorable tax treatment of certain countries encouraging this trend), the Kennedy Administration presented to Congress a proposal to enact subpart F rules.
In 1961, the Administration grouped the tax problems associated with improper foreign investment into two categories – tax deferral and tax haven deferral. The first category included tax offenses of U.S. corporation such as using foreign subsidiaries to indefinitely postpone U.S. taxation of foreign income of a foreign subsidiary by reinvesting the foreign earnings in other foreign investments or by establishing a parent-subsidiary loan mechanism (under the then current rules, this arrangement would allow U.S. parent company to obtain foreign subsidiary’s case without triggering U.S. taxation). The second category involved an arrangement where a U.S. corporation would organized a foreign subsidiary in a tax-haven country (at that time, Switzerland, Bahamas or Panama) in order to receive passive income virtually tax-free or set up a base company for sales of products throughout the world without any income being subject to U.S. taxes. The latter problem was exacerbated by various parent-subsidiary mechanisms such as transfer pricing, fee shifting, and so on.
The recommendations of the Kennedy Administration were far-reaching and would virtually eliminate tax deferral practices by taxing U.S. companies (as well as individual shareholders of a closely held corporations) on their current share of the undistributed profits realized in a given year by subsidiary corporations in the developed countries. The original proposal also strived to eliminate the possible tax haven mechanisms throughout the world, including underdeveloped countries.
The Congress, however, was not prepared to go this far in 1962. The subpart F rules that were enacted that year fell short of the Administration’s proposal. The rules contained various exceptions and were not as effective in stopping tax deferral.
It should be noted, however, that numerous changes were enacted by Congress since 1962 with the main effect of widening the effect of the subpart F rules.
In a subsequent article, I will discuss the 1962 rules and how these were amended since then.