Paul L. Caron

Sunday, March 2, 2008

Peroni, Fleming & Shay on Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source Income

Robert J. Peroni (Texas), J. Clifton Fleming, Jr. (BYU) & Stephen E. Shay (Ropes & Gray, Boston) have posted Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source Income, 52 SMU L. Rev. 455 (1999).  Here is the abstract:

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

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Steve Shay has spoken on this topic frequently in the years since 1999. See, e.g., his testimony to the Ways and Means Select Revenue Measures Subcommittee in June 2006, available at

Steve et al. are not the only advocates of full inclusion. When JCT Chief of Staff Ed Kleinbard spoke at a BNA luncheon in Washington on 12 February, 2008, one of the themes he touched on was the possibility of implementing a full inclusion system similar in effect to that advocated in this article via limited scope multilateral treaties that address only common rules on residence and a commitment to full inclusion. My thought at the time was that such a system might have a low threshold for implementation because once the U.S. and one of its big trading partners signed on, there could be pressure on other countries to fall into line or risk alienating business.

Posted by: Martin B. Tittle | Mar 2, 2008 8:20:07 PM

"Deferral privilege"? It's a "privilege" not to include income on a foreign asset (stock) that does not produce income until actual payment of dividends? Sounds to me as if the authors are from the school that describes deductions as "tax expenditures." That is, the government rightfully owns all one's income and it can ever-so-generously allow one to keep some part of it, although at a cost to the fisc.

The horrible complexity of the rules could of course be radically simplified. So could the Code itself, by ridding it of all credits and deductions.

The real question is why, given international attention to proper transfer pricing, why the anti-deferral provisions (other than perhaps investment income) exist at all.

Posted by: Daniel Messing | Mar 2, 2008 6:25:54 AM