To Defer or Not to Defer

To Defer or Not to Defer

By Rufus v. Rhoades

Introduction  As we all know, the United States has adopted a two-tier tax system, when it comes to corporations.  The cornerstone of the system is that the United States taxes a corporation on its income; the United States does not tax the shareholder on the corporation's income.  As a result of that basic concept, a foreign corporation is generally subject to tax only on its U.S. source income. That rule is so fundamental that it applies irrespective of the residence of the shareholders of the foreign corporation; irrespective of the place of operation of the corporation; and irrespective of the seat of management.

Prior to 1962, that rule, coupled with the foreign tax credit rules, provided U.S. corporations with almost total deferral opportunities. As a result, the domestic multinational corporation was able to operate abroad and pay little, if any, U.S. income tax on the income that it earned abroad until it brought that money home as a dividend.

The Kennedy Administration took steps to limit deferral by persuading Congress to adopt the earliest forms of the subpart F regime-the regime that is still very much in operation today. That legislation, however, reflects the ambivalence that so many administrations after Kennedy's have about the concept of deferral.  Under the subpart F rules, some income is totally deferred and other income is not.

Basic Tax Policy   A sound tax policy should meet certain goals: a) it should raise sufficient revenue to allow the government to conduct its affairs; b) it should be fair; c) it should be efficient; and d) it should be simple-at least as simple as possible within the confines of the task at hand.

The Minuses of Deferral  Let's take a look at some of the drawbacks that come with deferral:

  1. Revenue. Almost by definition, deferral is antithetical to raising revenue; the very purpose of deferral is to delay payment of tax to the government.
  2. Fairness. Deferral is not a fair or even-handed largesse. Deferral benefits those corporations that have cross-border operations and does not benefit those that do not. The result is that those businesses that are purely domestic pay a larger percentage of their corporate income in tax than those who can take advantage of deferral. That is not a rational basis for allocating the tax burden.
  3. Efficiency. The rules that have grown around deferral - primarily, Subpart F - are anything but efficient. The Internal Revenue Service's rykubgs abd regykatuibs reqyure struct adgerebce ti arcabe abd frequently obscure rules; those regulations and rulings require the government to spend significant funds to enforce; those rules cost major tax paying corporations untold amounts as they try to meet the demands of those rules.
  4. Simplicity. Nothing is simple about the deferral rules. Just ask any practitioner to explain how the branch rules work in the subpart F context.

The difficulty was, and still is, that no one knows whether or not deferral of taxation on foreign source income is beneficial or harmful. None of us can say with any certainty that total deferral is bad, that a little deferral is better (or worse) and that no deferral is, on balance, the best (or the worst) for the country. Indeed, one surmises that finding consensus on the meaning of "best" (or "worst") in that context would be difficult.

The Pluses of Deferral  From a tax policy standpoint, the deferral approach to tax law does not have any pluses.

Treasury's Position  In late 2000, Treasury jumped into the debate with both feet by issuing its study entitled "The Deferral of Income Earned Through U.S. Controlled Foreign Corporations." The report was rather lengthy (226 original pages) and generated a number of published responses from the bar.  Most were not complimentary, primarily because the study did not do much more than reaffirm Treasury's long-standing view of subpart F that deferral of business income by U.S. taxpayers is not good for the country:

"An anti-deferral regime continues to be needed to prevent significant disparity between the rate of tax on U.S. and foreign income, thereby promoting efficiency, preserving the tax base and promoting equity."

That conclusion, as most practitioners know, is highly judgmental and not supported by objective evidence. We concur that a system that requires immediate taxation of foreign income may prove to be detrimental to the U.S. fisc and the U.S. taxpayer. We also concur, however, that a system where taxation of all truly foreign (as opposed to U.S. source income that is artificially re-sourced to a foreign situs) income is deferred until repatriated may prove to be detrimental to the fisc and to taxpayers. We do not know which of those statements is correct; moreover, no one in Treasury knows either.

An Alternative  An alternative to the current deferral system would be to tax all corporate group income currently, irrespective of whether it is earned by a subsidiary or directly.  Such an approach would meet the policy standards laid out above: it would raise revenue currently on currently earned income; it would be fair to all business taxpayers; it would be far more efficient than the current deferral system; and it would be simpler to administer, both from the taxpayer point of view and the government's.

That "no deferral" approach would not require creating a tax law out of the whole cloth; California has already shown the way-its unitary system is a current tax system on a California business's worldwide income, without consideration of the taxpayer's corporate structure.  Granted, that system would need to be adapted to the federal approach, but that adaptation would be relatively easy to do.

Benefits of No Deferral  Look what such an approach would do to the Internal Revenue Code:

  1. Subpart F could be repealed in its entirety.
  2. IRC Section 367 could be repealed.

  3. Most, if not all, of the transfer pricing issues would disappear.

  4. Congress's continual gnashing of its collective teeth to try to entice multinationals to repatriate their hoards of overseas cash would be a thing of the past.

Those are in addition to the tax policy benefits outlined above.

Drawbacks to Eliminating Deferral

  • Competitiveness. The fairly vociferous objections to eliminating deferral focus on the concept of competitiveness.  The advocates of deferral claim that we would be shooting ourselves in our collective feet by eliminating deferral because none of our competitors tax currently earned income.  Somehow (one is not quite clear just how) that concern translates into loss of overseas business.  The problem with that assertion, however, is that we do not have any objective evidence that current taxation equates to a loss of business for American corporations.
  • Politics. An additional assertion is that repealing deferral is simply politically not going to happen.  That may be true, but the assertion does not go to the question of whether or not we would be prudent to repeal deferral.
  • Upheaval. A further claim is that the upheaval generated by dropping our current partial-deferral system for a no-deferral system would be almost traumatic and costly.  That is very likely an accurate assertion.  Nevertheless, the trauma would be relatively short-lived and the cost a one-time cost, both of which we should be willing to take on.

Conclusion  My basic point in this blog is that deferral is bad policy; it hurts the economy and has no beneficial elements to it.  The current deferral system should be repealed and replaced with something akin to the unitary system.

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