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April 15, 2011
How U.S. Tax Law Encourages Investment Through Tax Havens

Full Text Published by Tax Analysts®

By David S. Miller

David S. Miller is a partner with Cadwalader, Wickersham & Taft LLP. In this report, he catalogues the many ways that federal and state tax law encourages taxpayers to operate through foreign tax haven companies to reduce their federal and state tax liabilities, and he suggests some changes to the law that would eliminate these incentives.

The author would like to thank Ari Brandes for his research, and Jean Bertrand, Shlomo Boehm, William Burke, Mihir Desai, Robert Scarborough, Daniel Shapiro, Daniel Shaviro, and Lee A. Sheppard for their comments. This report was presented to the Tax Forum on October 4, 2010, and at the New York University School of Law Colloquium on Tax Policy and Public Finance on February 3 and the author is grateful to the participants at each for their comments. The original title of the report was "Unintended Consequences: How U.S. Tax Law Encourages Investment in Offshore Tax Havens."

Copyright 2011 David S. Miller.
All rights reserved.

Table of Contents

I. Introduction

II. Deferral


    A. Deferral Under Subpart F

    B. Avoid Subpart F and the PFIC Rules


III. Other Incentives to Invest Offshore

    A. Avoid Miscellaneous Itemized Deductions

    B. Avoid AMT Limitations on Deductibility

    C. Avoid the Taxable Mortgage Pool Rules

    D. Avoid Cancellation of Indebtedness Income

    E. Avoid the 3.8 Percent Medicare Tax

    F. Avoid Itemized Deductions

    G. Avoid State Law Limitations on Deductions

    H. State Tax Deferral

    I. Using the E&P Rules

    J. Avoid FBAR Filings

    K. Avoid UBTI

    L. Permit RICs to Trade Commodities


IV. Hurdles, Costs, and Inconveniences

    A. Section 269 and Economic Substance

    B. Costs of Using a Foreign Corporation

    C. Compliance


V. Suggestions for Improvement

I. Introduction

In his one and only speech on tax policy, President Obama expressed outrage that U.S. taxpayers could organize and operate foreign corporations in tax havens to reduce their U.S. tax liabilities, and he vowed to shut down the "loophole."1 However, the Obama administration later dropped the very proposal the president introduced that day,2 and it has since introduced proposals that actually encourage U.S. taxpayers to operate through foreign tax haven corporations to reduce their federal and state tax liabilities.

For example, the administration's proposal to reduce the value of itemized tax deductions for high-income individual taxpayers will be entirely avoidable by a taxpayer who organizes a foreign corporation and has the foreign corporation incur the itemized deductions that would otherwise have been incurred directly by the taxpayer.3 And by promising regulations under section 871(m) that will provide a safe harbor from withholding on equity swaps, the administration will make it possible for individual U.S. taxpayers to hold their equity portfolios through a tax haven company without being subject to U.S. withholding tax.

In fact, the tax code is riddled with features that allow U.S. taxpayers to reduce their tax liability by operating through tax haven companies. Some of the provisions are historic anomalies. For example, the ability of U.S. taxpayers to use a controlled foreign corporation to effectively claim deductions that could not be claimed directly (by relying on the earnings and profits limitation on inclusions of subpart F income) more reflects the anachronistic legal construct of subpart F than a deliberate tax policy to encourage taxpayers to form offshore corporations.4

Others, like the ability of tax-exempt organizations to avoid debt-financed income by investing through a foreign tax haven blocker corporation that itself borrows, and the ability of U.S. taxpayers to avoid the corporate tax that applies to taxable mortgage pools (TMPs) by organizing their TMPs offshore, are better understood as inadvertent loopholes than thought-out legislative grace.5

Some incentives to operate offshore are indeed intentional. For example, the contract manufacturing regulations that were finalized in 2008 at the end of the Bush administration expressly permit a CFC to shift sales income into a low-tax jurisdiction and avoid current U.S. tax. These regulations sanction the use of a tax haven company to reduce U.S. taxes in the name of competitiveness.6

In this report I catalogue the many ways federal and state tax law encourage taxpayers to operate through foreign tax haven companies to reduce their federal and state tax liabilities, and I do my best to explain the history and policy underlying those rules. Many of the rules I discuss allow U.S. taxpayers to frustrate substantive tax policies by operating through foreign corporations.

I then take the president at his word and assume that absent a compelling policy reason, U.S. taxpayers should not be able to organize and operate foreign corporations to reduce their U.S. federal tax liabilities. I conclude by offering several suggestions to eliminate the inadvertent incentives that encourage U.S. taxpayers to form foreign corporations and operate through them solely for tax purposes. For the most part these suggestions are intended to be low-hanging fruit for Congress and the IRS. Thus, the suggestions do not change fundamental tax policies, and I don't tackle deferral head on. But I do start my discussion there.


II. Deferral

U.S. taxpayers are entitled to defer (and avoid paying tax on) their share of the income of foreign corporations, subject to the limitations of subpart F and the passive foreign investment company rules. Subpart F and the PFIC rules generally reflect a balance between permitting U.S. corporations that operate active businesses abroad to defer their tax liability and requiring current taxation of (that is, denying deferral for) passive investment income and other mobile income -- income that can be easily moved to a tax haven jurisdiction, but that is not connected to an active business in that jurisdiction.7 The ability to defer active income (and the resulting incentive to organize and operate through a foreign corporation) is justified on the basis of competitiveness: If U.S. corporations were required to pay tax currently on their offshore earnings, they could not compete with multinationals headquartered in jurisdictions that either impose no home-country tax on income earned outside their borders or permit deferral until the income is repatriated.8 Deferral (and the resulting incentive to operate through a foreign corporation) is least justifiable when the underlying income is in fact mobile, or local tax can be eliminated or reduced.

Broadly speaking, there are two strategies to maximize deferral. The first, practiced by 10 percent U.S. shareholders of CFCs that are potentially subject to subpart F, is to generate low-taxed income that is not subpart F income. The second strategy is to avoid the CFC and PFIC rules entirely. These strategies are discussed in turn.

A. Deferral Under Subpart F

For 10 percent U.S. shareholders in a CFC, the benefits of deferral are maximized if non-subpart F income can be shifted to a low-tax jurisdiction. This benefit can be multiplied through tax-deductible leverage in the United States.

1. In general. The definitions and scope of the CFC rules are familiar to many practitioners; they are only briefly recounted here.

Subpart F applies to those U.S. persons that own directly, indirectly, or constructively 10 percent or more of the voting power of a CFC. Those shareholders are referred to as "10 percent U.S. shareholders." Very generally, a CFC is a foreign corporation more than 50 percent of the equity of which, measured by vote or value, is owned directly, indirectly, or constructively by 10 percent U.S. shareholders.9 If a corporation is a CFC, the 10 percent U.S. shareholders are generally required to report annually their pro rata share of the CFC's subpart F income.10 Thus, for U.S. taxpayers that are 10 percent U.S. shareholders in a CFC, deferral is achieved by avoiding subpart F income.

2. The magnitude of deferral under subpart F. Subpart F income was intended to represent mobile income -- income that can be moved easily to tax haven jurisdictions.11 Conversely, non-subpart F income -- that is, income entitled to deferral -- was intended to represent immobile income. But, as the following tables suggest, that intent is not reality and U.S. taxpayers are readily able to move non-subpart F income to low-income jurisdictions and achieve deferral.

     Table 1. U.S. Company Foreign Profits Relative to
        Jurisdiction Gross Domestic Producta
 ________________________________________________________

 Weighted average for G-7 countries                  0.6%
 Ireland                                             7.6%
 Cyprus                                              9.8%
 Barbados                                           13.2%
 Luxembourg                                         18.2%
 Island of Jersey                                   35.3%
 Bahamas                                            43.3%
 Marshall Islands                                  339.8%
 British Virgin Islands                            354.7%
 Cayman Islands                                    546.7%
 Bermuda                                           645.7%
 ________________________________________________________

                       FOOTNOTE TO TABLE 1

      a Jane G. Gravelle, "Tax Havens: International
 Tax Avoidance and Evasion," Congressional Research Service,
 R40623 (June 5, 2009), at 14-15, 2009-12902, 2009 TNT 108-36.

                    END OF FOOTNOTE TO TABLE 1

Table 1 suggests that U.S. corporate profits are being disproportionately diverted to tax haven countries, because U.S. companies earn on average more than 1,000 percent more profits in Bermuda compared with G-7 countries based on relative GDP.

          Table 2. Return on Assets (1998)a
 ________________________________________________________

 Average for U.S. manufacturing subsidiaries        8.4%
 Cayman Islands                                    16.7%
 Switzerland                                       17.9%
 Ireland                                           23.8%
 ________________________________________________________

                   FOOTNOTE TO TABLE 2

      a Martin A. Sullivan, "U.S. Citizens Hide
 Hundreds of Billions in Cayman Accounts," Tax Notes,
 May 24, 2004, p. 956, Doc 2004-10866, 2004 TNT 102-4.

                 END OF FOOTNOTE TO TABLE 2

Table 2 also suggests that a disproportionate share of profits is being shifted to low-tax jurisdictions. It is otherwise hard to explain how U.S. subsidiaries in Ireland on average return almost 300 percent more than U.S. subsidiaries generally. Tax Notes contributing editor Martin A. Sullivan estimates that in 2001, more than $107 billion, or 46 percent of the foreign profits of U.S. multinationals, ended up in 11 tax haven jurisdictions with an average tax rate of only 8.1 percent.12


$984 Billion in Undistributed Foreign Earnings for
S&P 500 Companies. By Sector Per 2008 Forms 10-K
(dollars in millions)



Sources: Credit Suisse, "Taxes Going Up: The Obama Budget Proposals," at 5 (Feb. 5, 2010).

The magnitude of deferred tax is stunning. By one estimate, U.S. companies benefit from deferral on at least $1 trillion in offshore profits.13 Economists estimate that ending deferral would generate between $11 billion and $60 billion of revenue each year,14 which could be used to reduce the corporate tax rate by 1.5 percent (from 35 to 33.5 percent).15

The deferral is concentrated in the healthcare, information technology, and energy industries.16

Robert Willens estimates that Pfizer increased its net income in 2009 by 13 percent (from $7.6 billion to $8.6 billion), Eli Lilly by 21 percent (from $3.6 billion to $4.3 billion), and Oracle by 14 percent (from $4.9 billion to $5.6 billion) as a result of deferral.17

3. The instruments of deferral. There are four principal culprits that permit and enhance deferral.

a. Transfer pricing. Kimberly Clausing estimates that $60 billion in U.S. tax revenue is lost through transfer pricing annually,18 and Harry Grubert estimates that about half of the difference between U.S. profits earned in low-tax and high-tax countries is attributable to transfers of intellectual property and intangibles.19 That is, the data suggest that U.S. multinationals routinely develop intellectual property in the United States and then transfer it to a low-tax jurisdiction (such as Ireland) at a favorable transfer price.20 Some of these companies further deduct the research, development, and advertising costs that establish the brand name, which reduces the U.S. multinational's domestic tax cost.21

          Table 3. S&P 500 Companies With Undistributed
            Foreign Earnings Exceeding $20 Billiona

                  (U.S. dollars in billions)
 ____________________________________________________________

                                            2008 U.S. Foreign
         Company                                 Earnings
 ____________________________________________________________

 General Electric Co.                              $75.0
 Pfizer Inc.                                        63.1
 Johnson & Johnson                                  27.7
 Citigroup Inc.                                     22.8
 Chevron Corp.                                      22.4
 Merck & Co.                                        22.0
 Cisco Systems                                      21.9
 IBM                                                21.9
 Procter & Gamble                                   21.0
 ________________________________________________________

                   FOOTNOTE TO TABLE 3

      a Credit Suisse, "Taxes Going Up: The Obama
 Budget Proposals," (Feb. 5, 2010) at 5.

                END OF FOOTNOTE TO TABLE 3

These conclusions have anecdotal support, as recently illustrated by Bloomberg reporter Jesse Drucker.22 Also, studies have shown that one-third of the repatriations under section 965 are in the pharmaceutical industry, and 20 percent are in the computer and electronic equipment industry.23 And the Joint Committee on Taxation has recently documented how six different multinational public companies used transfer pricing with tax haven subsidiaries to minimize their U.S. federal income tax.24

b. Allocation of interest expense. Favorable allocations of interest expense multiply the benefits of deferral.

Under current law, if a U.S. parent borrows to make an equity contribution to a foreign subsidiary that benefits from deferral, the U.S. parent can claim current interest deductions on its debt. That interest expense offsets domestic income, even if the income generated by the borrowing will not be subject to current tax under the CFC rules. Estimates suggest that favorable allocations of interest expense result in the second biggest revenue losses after transfer pricing.25

c. Contract manufacturing and commissionaire arrangements. Contract manufacturing and commissionaire arrangements offer another way to shift income to a low-tax jurisdiction without generating subpart F income.26 Regulations that were finalized at the end of 2008 provide that the sales income earned by a CFC that contributes substantially to manufacturing activities is not subpart F income as long as the CFC does not have a branch in a high-tax jurisdiction where the manufacturing is conducted.27 Moreover, the regulations explain how a CFC may substantially contribute to manufacturing activities conducted by a related high-taxed manufacturer without causing the CFC to have a branch in the manufacturer's jurisdiction.28 Thus, the regulations describe how a CFC located in a low-tax jurisdiction may earn low-taxed non-subpart F sales income by entering into a contract manufacturing agreement with a manufacturer in a high-tax jurisdiction and then "contributing substantially" to that manufacturing activity (for example, by flying executives to the high-tax jurisdiction to oversee the manufacturing). That activity can be structured to avoid creating a branch in the high-tax jurisdiction.

d. Hybrid entities and instruments. The check-the-box election and hybrid instruments and entities are other tools that permit income to be shifted on a tax-free basis to low-tax jurisdictions without generating subpart F income.29

Subpart F was developed when there was more or less worldwide agreement about which entities were subject to an entity-level tax and which were not. Subpart F is premised on that common understanding. Thus, in 1964, if a U.S. multinational organized a low-tax holding company and a series of high-tax subsidiaries and stripped earnings out (and reduced the effective tax rate) of the operating subsidiaries by having them pay interest to the low-tax holding company, the holding company earned subpart F income.

The check-the-box regulations violate that premise. They allow a foreign subsidiary of a CFC to be disregarded for U.S. tax purposes but be "regarded" for local tax purposes. If a high-tax foreign operating subsidiary that is disregarded for U.S. tax purposes pays interest to its CFC parent, and that interest is deductible for local tax purposes, the high-tax operating subsidiary may become a low-tax company, but the low-taxed "interest" income escapes a subpart F taint.30 Similar results can be achieved with instruments that are treated as indebtedness for local law purposes but as equity for U.S. tax purposes. (In that case, again, a foreign subsidiary of a CFC might be treated as paying deductible interest for local law purposes but flow-through dividends for U.S. tax purposes.) Obama had proposed to deny a check-the-box election for offshore subsidiaries but has since relented, and the administration has withdrawn the proposal.31

4. The Bipartisan Tax Fairness and Simplification Act of 2010. On February 23, 2010, Senate Finance Committee member Ron Wyden, D-Ore., and former Sen. Judd Gregg introduced the Bipartisan Tax Fairness and Simplification Act of 2010 (S. 3018), which would effectively end deferral.32 That is a bold and obviously controversial proposal with little prospect of success.33

5. The reports of the President's Economic Recovery Advisory Board and the National Commission on Fiscal Responsibility and Reform. On August 29, 2010, the President's Economic Recovery Advisory Board issued its report on tax reform options. The advisory board took the deferral ball and punted it far. The board's report identified how deferral, coupled with transfer pricing and "expense location," significantly reduce the U.S. tax base, but it then gave equal time to four competing options: (1) a territorial system, (2) a worldwide system with a lower corporate tax rate, (3) a limitation on or the end of deferral with a retention of the current corporate tax rate, or (4) the retention of the current system with a lower corporate tax rate.

On December 3, 2010, the president's National Commission on Fiscal Responsibility and Reform recommended that the United States adopt a territorial system. Under the commission's proposal, active foreign income would be exempt from tax (rather than only deferred as under current law), but passive foreign-source income could be subject to tax immediately (as under current law).34

Another proposal, by the Debt Reduction Task Force of the Bipartisan Policy Center, which is chaired by former Sen. Pete Domenici and Alice Rivlin, recommended that the United States retain the current worldwide system.35

B. Avoid Subpart F and the PFIC Rules

If the first strategy to maximize deferral is to generate low-tax income that is not subpart F income, the second is to avoid the CFC and PFIC rules entirely.

1. Avoid subpart F. U.S. taxable investors generally may avoid current inclusion under subpart F by retaining less than 10 percent of the voting interests of a foreign corporation, or by ensuring that the combined ownership of all the 10 percent U.S. shareholders (including the taxpayer) does not exceed 50 percent of the vote or value of the foreign corporation.36

The ability of those taxpayers to benefit from deferral does not reflect the affirmative policy judgment that they should be entitled to deferral, but rather the pragmatic view that it would not be practical to require those taxpayers to report the income. Under this premise, if a U.S. taxpayer owns less than 10 percent of a foreign corporation's voting stock, or the 10 percent U.S. shareholders in the aggregate own 50 percent or less of the foreign corporation, it might be difficult for the U.S. shareholders to demand an accounting of the foreign corporation's subpart F income.

But avoiding subpart F is not sufficient to avoid current inclusion (or something worse): The PFIC rules also must be skirted.

2. The PFIC rules generally. The PFIC rules apply to U.S. shareholders of PFICs regardless of the shareholder's percentage ownership or the percentage ownership of all U.S. taxpayers. A foreign corporation is a PFIC if 75 percent or more of its income consists of passive income (which includes dividends, interest, rents, and royalties) or the average percentage of assets held by the corporation during the tax year that produces passive income is at least 50 percent.37

In general, a U.S. taxpayer that invests in a PFIC and makes a timely qualified electing fund (QEF) election38 is required to include in gross income in each tax year (1) as ordinary income the U.S. investor's pro rata share of the PFIC's ordinary earnings, and (2) as long-term capital gain the U.S. investor's pro rata share of the PFIC's net capital gain, whether or not distributed.39 This report refers to a PFIC that is subject to a QEF election as a QEF PFIC.

A U.S. taxpayer that invests in a PFIC and does not make a timely QEF election is potentially subject to significantly worse treatment: Those taxpayers are required to report any gain on the disposition of their interests in the PFIC as ordinary income rather than capital gain.40 Also, those taxpayers are required to compute the tax liability on this gain and any "excess distributions"41 as if the items had been earned ratably over each day in the U.S. shareholder's holding period, and the tax on the items is imposed at the highest ordinary income tax rate for each tax year before the current year to which the items are allocated, regardless of the rate otherwise applicable to the shareholder investor.42 Further, the U.S. investor is subject to a nondeductible interest charge (at the rate for underpayments of tax) as if the income tax liabilities had been due for each prior year.43 Because this regime denies individual investors long-term capital gains rates and because the underpayment rate significantly exceeds the borrowing cost for many investors, unless a PFIC distributes all or substantially all of its income each year and no meaningful appreciation in the value of its stock is expected, U.S. taxable investors in the PFIC overwhelmingly prefer to make a QEF election.

So the PFIC rules generally result in the current U.S. taxation of mobile income. However, the PFIC rules have a notable exception that allows U.S. taxpayers to organize tax haven corporations and defer what is effectively mobile income.

3. The active insurance company exception. Passive income does not include income earned in the active conduct of an insurance business by a corporation that is predominately engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation.44 The legislative history to section 1297 -- but not the statute or the regulations -- provides that a foreign corporation does not satisfy the insurance company exception if it maintains financial reserves in excess of the reasonable needs of its insurance business.45

In the late 1990s hedge fund managers organized offshore insurance companies that issued stock to U.S. investors. The offshore insurance companies wrote some low-risk reinsurance and invested the proceeds of the stock issuance in hedge funds, which they held as reserves. That practice was publicized.46 In April 2000 and again in May 2001, House Ways and Means Committee member Richard E. Neal, D-Mass., introduced legislation that would have denied a deduction for premiums paid by U.S. insurers to related foreign issuers of U.S. risk.47 In 2003, the IRS issued a notice indicating that it would "scrutinize these arrangements."48

In September 2007 the Senate Finance Committee held hearings on foreign reinsurance companies, focusing on the use of reinsurance to strip earnings from U.S. insurance companies to their parent reinsurers located in a tax haven country.49 In July 2009 Neal reintroduced his bill (now H.R. 3424).50

And finally, in the fiscal 2011 and 2012 budget proposals, the administration proposed a variation of the Neal bill.51 Although the Neal bill and the administration's proposal would prevent earnings stripping by U.S. affiliates of offshore reinsurance companies, they would preserve the PFIC exception and U.S. taxpayers' ability to defer their income from offshore reinsurance companies.

Today, there are at least 21 publicly traded offshore reinsurance companies.52 All those companies avoid CFC status and take the position that they are not PFICs. Four of the 21 companies (Willis, ACE, White Mountains, and XL) have several thousand employees each, but the rest have less than 1,000 employees and many have fewer than 200 employees. Many of the employees of the other 17 companies are typically resident in the United States. For example, Partner Re (a Bermuda corporation) has close to 1,000 employees, but there are fewer than 70 in Bermuda, and about 300 in the United States.53 To take another example, Validus, which has a market capitalization of more than $3.6 billion, has only 280 total employees of which only 70 are in Bermuda. (A more traditional reinsurance company, like White Mountains, requires more than 5,000 employees to maintain a smaller market capitalization.54) Some of those 17 companies tout their "fund strategies" as prominently as their underwriting.55

Although the legislative history of section 1297(b)(2) suggests that only the size of a company's reserves is relevant in determining the scope of the active insurance exception,56 subpart F uses the same phrase -- "engaged in the active conduct of an insurance business"57 -- to define the insurance exception from subpart F income. To qualify under the subpart F test, if insurance policies are issued by a CFC and cover risks other than "applicable home country risks" (meaning risks in connection with property or liability arising out of activity in, or the lives or health of residents of, the home country of the insurance company or a qualifying branch),58 to avoid subpart F income, the CFC or its branch must conduct substantial activity in its home country that constitutes substantially all the activities necessary to give rise to the income generated by the contract.59 Moreover, the subpart F test requires that a reinsurer derive 50 percent of its aggregate net written premiums from covering home country risks. That restrictive definition has not yet been applied to the PFIC rules, although the suggestion has been made.60


III. Other Incentives to Invest Offshore

Deferral is no longer the only reason U.S. taxpayers organize and operate through foreign corporations. There are now more than a dozen reasons a U.S. taxpayer might operate through a foreign corporation, even without any deferral.

A. Avoid Miscellaneous Itemized Deductions

U.S. individual taxpayers (as well as trusts and estates) are permitted to deduct miscellaneous itemized deductions only to the extent the deductions exceed 2 percent of their adjusted gross income.61 Miscellaneous itemized deductions are all deductions other than (1) trade or business deductions and the other deductions allowed in determining AGI; and (2) deductions for interest expense, taxes, casualty and theft losses, charitable donations, amortizable bond premiums (and some others listed in section 67(b)).62 Thus, expenses paid to an investment manager to manage an investment portfolio are subject to the 2 percent floor. So an individual with AGI of $5 million who pays $20,000 in management fees on a $10 million portfolio will be denied a deduction entirely for the $20,000 payment unless the individual has more than $80,000 of other miscellaneous itemized deductions.

However, the miscellaneous itemized deduction limitation can be avoided if an individual organizes a foreign corporation to hold a portfolio of securities and causes the foreign corporation to pay the management fees and other miscellaneous itemized deductions that the individual would have incurred directly. Even if the individual is subject to tax on all the net income of the foreign corporation under subpart F or the QEF rules, because a foreign corporation may claim a deduction for miscellaneous income itemized deductions, as long as the corporation has sufficient income to offset the expenses, organizing a foreign corporation to incur the expenses is an effective way to avoid the limitation.

Moreover, under the portfolio interest exemption and the section 864(b)(2) safe harbor, a U.S. individual may organize a foreign corporation to hold and trade a pool of bonds managed by a U.S. manager without incurring federal income or withholding tax. If a U.S. individual organized a foreign corporation to hold U.S. equities, the dividends paid to the foreign corporation would be subject to U.S. withholding tax (and that tax cost could easily exceed the benefit). However, Congress has invited the administration to draft a safe harbor that would exempt substitute dividend payments received by foreign corporations on some U.S. equity swaps from withholding tax.63 Therefore, an individual may very well be able to use a foreign corporation to avoid the miscellaneous itemized deduction limitation for a portfolio of U.S. equity positions without tax cost.

B. Avoid AMT Limitations on Deductibility

Miscellaneous itemized deductions are not deductible for purposes of the alternative minimum tax.64 However, an individual that is subject to the AMT can organize a foreign corporation to incur the expense, use it to offset the foreign corporation's income, and thereby effectively claim the deduction, despite the AMT.

C. Avoid the Taxable Mortgage Pool Rules

The real estate mortgage investment conduit rules contain safeguards to ensure that the phantom income earned by holders of residual interests is taxable in all events.65 Congress created the TMP rules of section 7701(i) to prevent taxpayers from setting up similar entities to evade these rules.66 The mechanism to achieve this result is to treat any entity that looks like a real estate mortgage investment conduit, but is not a REMIC, as a corporation for federal income tax purposes.67 Thus, the TMP rules do provide a significant disincentive to forming a domestic TMP.

However, the TMP rules contain a significant loophole. Rather than provide that a TMP is taxable as a domestic corporation, the rules provide only that a TMP is taxable as a corporation. Thus, a foreign TMP that is not engaged in a trade or business in the United States is not subject to corporate income tax and can be used to create a REMIC-like vehicle that permits the holders of its equity to avoid paying tax on its phantom income.68

Thus, the TMP rules provide a specific incentive for U.S. taxpayers to organize TMPs in foreign tax havens. It is precisely for that reason that collateralized debt obligations (CDOs) of mortgage-backed securities were (and had to be) organized as foreign corporations.69

D. Avoid Cancellation of Indebtedness Income

Cancellation of indebtedness (COD) income arises if a taxpayer, or a party related to the taxpayer, purchases the taxpayer's debt at a discount to the debt's adjusted issue price.70

Section 108(e)(4) contains the related-party rules, which treat a partnership that wholly owns a corporation as related to that corporation.71 Private equity funds are commonly organized as partnerships. Their portfolio companies are generally organized as corporations. Thus, if a private equity fund that is organized as a partnership purchases at a discount the debt of its wholly owned portfolio company (that is treated as a corporation), the portfolio company will realize COD income.

However, two corporations are related for purposes of the COD rules only if five or fewer individuals own more than 50 percent of their vote and value.72 Thus, a private equity fund (treated as a partnership) that wishes to purchase the discounted debt of its wholly owned portfolio company could organize an Irish "section 110 company" (treated as a corporation) that qualifies for the benefits of the Ireland-U.S. tax treaty to purchase the debt.73 As long as five or fewer people do not own more than 50 percent of the vote and value of the private equity fund, the Irish section 110 company will not be treated as related to the portfolio company, and the portfolio company will not realize COD income on the purchase of its debt at a discount by the Irish section 110 company.74

This transaction works because of the mechanical and restrictive definition of relatedness for two corporations, but only if the foreign corporation (the Irish section 110 company) is not subject to meaningful local tax (that is, it is a foreign corporation located in a low-tax jurisdiction) and it benefits from a U.S. tax treaty so that payments of interest to it are exempt from U.S. withholding tax.75

E. Avoid the 3.8 Percent Medicare Tax

Under the Health Care and Education Reconciliation Act of 2010, starting in 2013, new section 1411(c) will impose an additional 3.8 percent tax on individuals, estates, and trusts on the lesser of their net investment income or the portion of their modified AGI76 exceeding $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 otherwise.77 In other words, individuals filing joint returns will generally be subject to an additional 3.8 percent "Medicare tax" on their net investment income (also referred to as unearned income), to the extent that the net investment income, when added to the individual's other modified AGI, exceeds $250,000.

Section 1411(c) defines net investment income to include (1) any gross income from interest, dividends, annuities, royalties, and rents (unless the income is derived from a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities); (2) other gross income derived from a trade or business that is a passive activity or consists of a trade or business of trading in financial instruments or commodities; and (3) net gain attributable to the disposition of property (other than an active non-trading trade or business property), reduced by the deductions that are allowable for federal income tax purposes and are properly allocable to the gross investment income.

Thus, if a high-income individual earns $100,000 of gross interest income in 2013 from a hedge fund, but the interest income is subject to a $20,000 management fee that is a miscellaneous itemized deduction that the individual investor is not otherwise able to deduct, the individual would be subject to an additional Medicare tax of $3,800 ($100,000 x 3.8 percent), even though the investor will receive only $80,000 after payment of the manager's fee (and therefore the investor will bear Medicare tax at a rate of 4.75 percent on his economic income).

However, if the individual invests in a foreign corporation that is a CFC or a QEF PFIC, he would arguably be exempt from the additional Medicare tax on unearned income and, if not exempt, would certainly pay less tax.

First, as a preliminary matter, it is possible that subpart F and QEF inclusions are not subject to the 3.8 percent Medicare tax. The tax applies to interest, dividends, annuities, royalties, and rent, but subpart F and QEF inclusions are not listed. When Congress has intended to treat subpart F and QEF inclusions as dividends, it has done so expressly.78

The IRS has taken seemingly contrary positions on whether subpart F inclusions are dividends. Most recently, in Notice 2004-70 (which deals with whether dividends from foreign corporations qualify as qualified dividend income under section 1(h)(11)(C)), the IRS concluded that "for purposes of section 1(h)(11), subpart F inclusions are not dividends and therefore cannot constitute qualified dividend income." That statement was not based on the policies underlying section 1(h)(11) but simply and exclusively on the fact that "neither section 951(a)(1) nor the corresponding regulations characterize a Subpart F inclusion as a dividend." (The IRS didn't have to address QEF inclusions, because section 1(h)(11)(C)(iii) excludes PFICs from the definition of a qualified foreign corporation.)

However, the IRS took the opposite view on the treatment of subpart F inclusions as dividends when considering whether they give rise to unrelated business taxable income:


    Although the subpart F income will not be distributed and is technically not a dividend, such income can be characterized as a constructive dividend due to the interaction of [sections 951(a)(1)(A)(i) and 951(a)(2), and sections 512(b)(1) and 512(b)(13)] of the Code. These sections produce a situation in which the income would be taxable on the part of shareholders as if it had been distributed by the subsidiary as a dividend, therefore, the income is functionally equivalent to a dividend. Consequently, this income will not be treated as unrelated business taxable income under section 512.79

Finally, while net investment income also includes gross income derived from a passive activity or from a business of trading financial instruments or commodities, it appears that the statute contemplates only the taxpayer's passive activities or trading business.80 Thus, that the PFIC might be engaged in a passive activity or securities trading does not appear to affect the taxpayer. (And, in any event, many hedge funds are investors and are not engaged in a trade or business.)

Despite the technical uncertainty whether subpart F and QEF inclusions are treated as dividends for purposes of the Medicare tax, it seems clear as a policy matter that they should be (unless they are derived in the ordinary course of an active business conducted by the taxpayer). Otherwise, taxpayers could entirely escape the tax by investing in CFCs and QEF PFICs.81 The policy could be effected by a technical amendment similar to the flush language of section 851(b), or by regulations.

However, even if subpart F and QEF inclusions are subject to the 3.8 percent Medicare tax on unearned income, because management fees reduce E&P, an investor that invests in a foreign corporation and earns $100,000 subject to a $20,000 management fee would be subject to only a $3,040 Medicare tax, rather than the $3,800 in Medicare tax that would have been imposed had the investor directly made the investment and directly incurred the management fees (3.8 percent x $100,000). In other words, the foreign corporation allows an investor to net his investment expenses against other income and gain for purpose of determining the 3.8 percent Medicare tax on unearned income.

F. Avoid Itemized Deductions

The administration's fiscal 2012 budget proposes to limit the value of itemized deductions to 28 percent.82 As with the limitation on miscellaneous itemized deductions, that limitation will be entirely avoidable by a U.S. taxpayer who incurs the expense indirectly through a profitable foreign corporation that uses the expense to reduce its taxable income.

Thus, if a high-income U.S.-resident individual who is unable to deduct itemized deductions causes his wholly owned foreign corporation to incur an expense that would give rise to an itemized deduction for the shareholder but is fully deductible for the corporation, the value of the reduction in the foreign corporation's taxable income will be 35 percent (equal to the highest marginal income tax rate in 2011), plus (starting in 2013) 3.8 percent times any net investment income offset by the expense. If the expense was incurred directly by the U.S. owner, the value of the deduction would be 28 percent or less.

G. Avoid State Law Limitations on Deductions

1. In general. New York state denies residents with AGI of more than $1 million 50 percent of their charitable contribution deduction and all of their other itemized deductions.83 Several other states limit the ability of individuals to claim miscellaneous itemized deductions.84 For high-income residents in New York and those other states, organizing a foreign corporation to incur the expenses will effectively permit the resident to deduct his share of the deductions that would otherwise be denied.

             Table 4. Benefits of Investing in Offshore Corporation
                            vs. Domestic Partnership
 ______________________________________________________________________________

                                                 Domestic           Foreign
       Income                   Distribution     Partnership        Corporation
 ______________________________________________________________________________

       $100,000                   $80,000a
 Federal income tax                              $36,066.96b $28,853.57c
 New York state and city tax                     $12,618.00d        $10,094.40e
 3.8 percent Medicare tax                         $3,800.00f         $3,040.00g
 Aggregate tax                                   $52,484.96         $41,987.97
 After-tax economic income                       $27,515.04h        $38,012.03i
 Effective rate                                       65.61%             52.48%
 Tax savings                                                         $9,971.68

                                                 Domestic          Foreign
      Income                     Distribution    Partnership       Corporation
 ______________________________________________________________________________

      $20,000                        $0j
 Federal income tax                              $7,213.39k                 $0
 New York state and city tax                     $2,523.60l                 $0
 3.8 percent Medicare tax                          $760.00                  $0
 Aggregate tax                                   $10,496.99                 $0
 After-tax economic income                      -$10,496.99                 $0
 Effective rate                                    Infinite                 0%
 Tax savings                                                        $10,496.99
 ______________________________________________________________________________

                              FOOTNOTES TO TABLE 4

      a $100,000 - $20,000 (management fee).

      b ($100,000 x 39.6%) - (28% x $100,000 x 12.618%). (8.97% New
 York state tax plus 3.648% New York city tax.)

      c ($80,000 x 39.6%) - (28% x 80,000 x 12.618%).

      d $100,000 x 12.618%.

      e $80,000 x 12.618%.

      f $100,000 x 3.8%.

      g $80,000 x 3.8%.

      h $80,000 - $52,484.96.

      i $80,000 - $41,987.97.

      j $20,000 - $20,000 (management fee).

      k ($20,000 x 39.6%) - (28% x $20,000 x 12.618%).

      l $20,000 x 12.618%.

                          END OF FOOTNOTES TO TABLE 4

2. An example. The year is 2013. The highest marginal income tax rate is 39.6 percent, the 3.8 percent Medicare tax is in effect, Congress has passed the Obama administration's proposal to limit the value of itemized deductions to 28 percent, and the highest marginal New York state and city tax rate for an individual is the current rate of 12.618 percent.

An individual intends to invest $1 million in a hedge fund that purchases U.S. debt on the secondary market, and he is an investor for U.S. tax purposes. The manager charges a 2 percent investment management fee based on capital invested. The investor is a resident of New York City and his miscellaneous itemized deductions (including his share of the management fee) will not exceed 2 percent of his AGI. Table 4 illustrates the benefits of investing in an offshore corporation as opposed to a domestic partnership. Assume that the offshore corporation is a PFIC and the U.S. investor has made a QEF election for it.

These examples clearly demonstrate the benefit to a New York City resident of investing through a foreign corporation rather than directly. However, the second example in particular does cause some pause. It illustrates a situation in which the taxpayer has not earned any economic income (because the income of $20,000 is offset by an equal amount of expenses), but if the taxpayer invests directly, he is subject to more than $10,000 of tax. An investment through a foreign corporation avoids this tax on phantom income.

The tax arises because the income is offset by management fees, the management fees constitute miscellaneous itemized deductions, and, for this taxpayer, miscellaneous itemized deductions are disallowed.

The denial of deductions for miscellaneous itemized deductions was intended to simplify the tax law and "relieve taxpayers of the burden of recordkeeping" for small amounts.85 Those policies are not in play in these two examples, which involve a single item of significant magnitude.86 As a result, it is worth at least considering whether the result obtained by using a foreign corporation should be the rule rather than the loophole.

H. State Tax Deferral

Some states permit deferral, even for passive income. For example, Hawaii does not impose tax on the income of a PFIC until it is distributed.87 Thus, those states affirmatively encourage their residents to keep their investments abroad.

I. Using the E&P Rules

1. The E&P rules generally. As mentioned above, 10 percent U.S. shareholders in CFCs are required to report and pay tax on their pro rata portion of the CFC's subpart F income, and U.S. taxpayers holding interests in QEF PFICs are required to report and pay tax on the PFIC's ordinary income and net capital gains. However, in each case, inclusions are limited to the extent of the CFC's or PFIC's earnings and profits for the tax year. The concept of E&P is at its heart based on cash flow, "to approximate a corporation's power to make distributions which are more than just a return on investment."88

The E&P limitation effectively permits current subpart F income to be offset by current non-subpart F losses. For example, if a CFC earns $100 of interest income and has a net $100 loss on non-subpart F manufacturing activity, the CFC's U.S. shareholders are not required to recognize the subpart F income.89

Congress has realized that the disparity between the calculation of taxable income and E&P creates shelter potential, particularly for individual shareholders, and in some cases it has adjusted the E&P rules to conform more closely to economic income to prevent taxpayers from sheltering income.90

However, while Congress has denied a variety of deductions, it has failed to conform the E&P rules. This neglect allows taxpayers to use foreign corporations to generate deductions for E&P purposes that are not allowable for federal income tax purposes. These "E&P deductions" may be used to offset the positive earnings and profits of a CFC or a QEF PFIC and effectively allow shareholders to use foreign corporations to produce deductions that otherwise would have been denied. Specific examples follow.

2. Section 382 avoidance. Section 382 limits the amount of net operating losses and specified recognized built-in losses that a corporation can use if it experiences an ownership change.91 As a preliminary matter, it is unclear whether section 382 applies to limit the losses and recognized built-in losses of a foreign corporation that is not engaged in a trade or business in the United States. However, the IRS has suggested that it does, and in any event, section 382 appears to be relevant for purposes of determining subpart F income.92 Nevertheless, section 382 does not appear to limit the reduction of E&P.93 Thus, a foreign corporation is apparently permitted to deduct from E&P its recognized built-in losses even if the foreign corporation experiences an ownership change. Because 10 percent U.S. shareholders of a CFC and U.S. shareholders of QEF PFICs include in income only their pro rata portion of the CFC's or QEF PFIC's current-year earnings and profits, U.S. taxpayers that operate a business through a foreign corporation generally have a greater ability to use losses than had they operated the business directly. The ability to use recognized built-in losses to reduce income for E&P purposes also encourages trafficking in the stock of offshore corporations with built-in losses.

3. Avoid the limitation on the deductibility of personal interest expense. Individuals are not permitted deductions for personal interest expense.94 However, interest expense is deductible without limitations for purpose of determining E&P. Therefore, if an individual shareholder of a foreign corporation causes the foreign corporation to borrow funds, distributes them, and the shareholder uses them for personal purposes, the corporation's interest expense on the borrowing will reduce its E&P and therefore reduce the income that the shareholder reports each year. Accordingly, by having the foreign corporation borrow the funds, the shareholder will effectively be able to indirectly deduct personal interest expense that could not be deducted directly.

4. Avoid the proposal to limit charitable deductions to 12 percent. The National Commission on Fiscal Responsibility and Reform proposed to replace the charitable deduction with a 12 percent nonrefundable tax credit that would be available only to the extent contributions exceed 2 percent of a taxpayer's AGI.95 However, a charitable deduction by a CFC or QEF PFIC fully reduces its E&P,96 thereby providing the shareholder of a profitable CFC or QEF PFIC with an effective deduction of 35 percent (or 38.8 percent, counting the 3.8 percent Medicare tax).

5. Avoid the limitation on the deductibility of organization and syndication expenses. Syndication costs are not deductible or amortizable, and if a company's organization costs exceed $55,000, the organizational costs must be amortized over a 180-month period.97

However, all of a company's syndication and organization costs are fully deductible for purposes of determining E&P, and therefore an individual taxpayer who invests in a foreign corporation with sufficient income will effectively be able to deduct his share of the foreign corporation's organization and syndication expenses.

6. Avoid the straddle rules. The straddle rules extend the time before investors are able to recognize losses on the disposition of a position in a straddle, and they limit the deductibility of interest expense allocable to property that is part of a straddle.98 Those losses and expenses are, however, fully deductible for E&P purposes, and therefore a taxpayer who invests in a foreign corporation with sufficient income can effectively deduct his share of the foreign corporation's straddle losses and interest expense allocable to the straddle.

7. Avoid the limitations on capital loss deductibility. An individual is permitted to deduct only $3,000 of capital losses against ordinary income,99 and corporations cannot deduct any capital losses against ordinary income. However, capital losses of a CFC or QEF PFIC reduce the foreign corporation's E&P without restriction. Therefore, a U.S. investor in a CFC or QEF PFIC will effectively be able to deduct and offset the capital losses of the foreign corporation against the foreign corporation's ordinary income without limitation.

8. Avoid the section 264 limitations on deductibility of interest. In general, section 264(a)(1) denies deductions for premiums on life insurance policies and annuity contracts if the taxpayer is directly or indirectly a beneficiary under the policy or contract. Thus, a U.S. taxpayer that purchases a life insurance policy and directly pays premiums on it will be denied deductions for the premiums.

However, the IRS has ruled that amounts that are disallowed under section 264 still reduce E&P.100 Therefore, if a U.S. taxpayer organizes a foreign corporation to purchase a life insurance policy, although the foreign corporation will be unable to deduct the premium payments, the premium payments will reduce its E&P (assuming it has positive E&P in the year the premiums are paid). That reduction in E&P will in turn reduce the U.S. taxpayer's income inclusions.101

Also, section 264(a)(2)-(4) denies interest expense deductions for interest paid or accrued on indebtedness that is incurred or continued to purchase or carry life insurance and annuity contracts. However, in Example 4 of Rev. Rul. 2004-47, one member of an affiliated group borrowed funds from a third party and lent them to another member of the affiliated group, which purchased tax-exempt bonds. The owner of the tax-exempt bonds was denied interest expense deductions under section 265(a).102 Rev. Rul. 2004-47 provides that the lending member is treated as using the borrowed funds to make a loan to its affiliate (and not to purchase or carry tax-exempt obligations), and therefore the lending member is not also denied interest expense deductions on its third-party loan.103

The statutory language of section 264(a) is virtually identical to the language of section 265(a). Therefore, if a U.S. corporation organizes a foreign corporation, borrows funds, lends those funds to the foreign corporation, and the foreign corporation uses the funds to purchase life insurance, Rev. Rul. 2004-47 appears to provide that the U.S. corporation is not denied interest deductions under section 264(a). The foreign corporation would be denied interest deductions under section 264(a) for the interest paid to its U.S. shareholder, but those payments of interest would still reduce its E&P (and therefore reduce the U.S. shareholder's inclusions). Effectively, the foreign corporation indirectly permits the U.S. shareholder to deduct interest on debt used to purchase a life insurance policy.

Very generally, section 264(f) denies a U.S. taxpayer and its 50 percent controlled and controlling affiliates a portion of their unrelated interest expense if the taxpayer owns life insurance policies with unborrowed cash surrender values.104 A U.S. shareholder that owns a foreign subsidiary that holds insurance policies is potentially subject to interest disallowance under section 264(f).

However, to the extent a member of the controlled group has been disallowed interest deductions under section 264(a), the disallowed interest is not taken into account for purposes of applying section 264(f),105 and the fraction for determining the amount of interest expense to be denied under subsection (f) is adjusted.106 Although the language is not entirely clear, the effect of the adjustment appears to be that section 264(f) is turned off to the extent that interest is denied under section 264(a).107 Under that reading, because the foreign corporation has been denied interest deductions under section 264(a), the U.S. shareholder is not subject to disallowance under section 264(f), even though the U.S. shareholder effectively obtains the benefits of interest deductions through the reduction of the foreign subsidiary's E&P by the interest expense paid to the U.S. shareholder.

9. Avoid the AHYDO rules. An applicable high-yield discount obligation (AHYDO)108 is a debt obligation that is issued by a corporation; will mature more than five years from the date of its issuance; has a yield to maturity that is equal to or exceeds 5 percent more than the applicable federal rate (AFR) in effect for the month during which the debt is issued; and is issued with "significant" original issue discount.109

Generally, the AHYDO rules deny the issuer a deduction for the OID on the AHYDO until interest is actually paid.110 Moreover, if the yield on an AHYDO is greater than the AFR by more than 6 percent, the issuer is disallowed a deduction for the portion of the interest payable on the AHYDO in excess of 6 percent over the AFR (the disqualified portion).111 However, E&P is generally reduced by OID, and the AHYDO rules do not affect E&P calculations. So a U.S. taxpayer can avoid the AHYDO limitations by organizing a foreign corporation to incur the AHYDO debt.

J. Avoid FBAR Filings

The recently finalized foreign bank account report regulations also encourage U.S. taxpayers to organize foreign entities. Quite inadvertently, they permit U.S. persons to entirely avoid their FBAR requirements by organizing foreign entities that beneficially own the U.S. person's foreign financial accounts but don't hold title to the accounts.

By way of background, the Bank Secrecy Act of 1970 provides that the secretary of the Treasury must require U.S. residents and citizens to keep records and file reports when that person makes a transaction (or maintains a relationship) with a foreign financial agency.112

Final regulations issued on February 23, 2011, generally require U.S. citizens, resident aliens, and entities created, organized, or formed under the United States, a state, the District of Columbia, and the U.S. territories and possessions (each a "United States person") to file Form TD F 90-22.1, "Foreign Bank and Financial Accounts Report," for any foreign financial account113 in which they have a financial interest or signature authority.

A U.S. person has a financial interest in a foreign financial account if (1) the U.S. person is the record owner or has legal title; (2) someone other than the U.S. person is the owner of record or holder of title and this other person is acting as agent, nominee, attorney, or in another capacity on behalf of the U.S. person; or (3) the U.S. person owns a substantial interest in an entity and that entity is the record owner or holder of legal title of a foreign financial account.114

There is also an antiabuse rule that provides that a U.S. person who causes an entity to be created for a purpose of evading the FBAR rules is deemed to have a financial interest in any foreign financial account for which the entity is the owner of record or holder of legal title.115

However, the regulations apparently permit a U.S. person to entirely avoid its FBAR requirements by organizing a foreign entity (of which the U.S. person could own all of the equity), and by finding a third party to hold legal title to the entity's foreign financial accounts as agent of the foreign entity.116 In that case, the U.S. person would not be required to file an FBAR because although it owns 100 percent of the vote and value of the foreign entity, the foreign entity is not the record owner or holder of legal title (that is, the attribution rules apply only if the entity is the record owner or holder of legal title).117 Moreover, the agency rule would not require the U.S. person to file an FBAR because the agent is holding title only for the foreign entity, the regulations clearly respect entities (going as far as to respect disregarded entities as entities for FBAR purposes), and foreign entities are not required to file FBARs. Finally, even if the foreign entity were created with the sole purpose of avoiding FBAR reporting, the antiabuse rule would not apply because the antiabuse rule attributes a financial interest back to a U.S. person only if the abusive entity is actually the owner of record or holder of legal title, and in this example the abusive entity is neither.118

K. Avoid UBTI

1. UBTI generally. Pension funds, universities, foundations, and other tax-exempt entities are subject to tax at regular corporate rates on their UBTI.119 UBTI may arise in one of two ways. First, a tax-exempt organization earns UBTI if it engages directly, or indirectly through a partnership, in specified active business activities that are not related to its tax-exempt purposes.120 Second, under the debt-financed income rules of section 514, if a tax-exempt organization borrows money to make an investment, or invests in a partnership that borrows money to make investments, the income or gain from the debt-financed investment is generally UBTI (and is subject to tax) to the proportionate extent of the borrowing, even though the income or gain might otherwise be passive investment income.121

However, a tax-exempt organization may avoid UBTI entirely by investing in a foreign corporation that itself borrows (or invests in a partnership that borrows) and does not engage in activities or make investments that would subject the foreign corporation to U.S. federal corporate income tax or a material amount of U.S. withholding tax. In that case, because the tax-exempt organization does not borrow and earns only dividends or subpart F income from the foreign corporation (which does not give rise to UBTI),122 the tax-exempt organization can entirely avoid the UBTI that would result had it borrowed directly. Those foreign corporations are inevitably organized in the Cayman Islands or another tax haven jurisdiction and are universally referred to as "blockers" because they act to block the UBTI (and for foreign investors any U.S. federal income tax) that would otherwise arise.

Although the use of a blocker is potentially subject to challenge under section 269 and the business purpose doctrine, in three private letter rulings, the IRS respected a tax-exempt organization's blocker when the blocker provided the tax-exempt organization with the following three "non-tax business purposes": (1) an additional layer of limited liability protection, (2) greater flexibility in disposing of the investment (because the general partner's consent was required to transfer the underlying fund but the tax-exempt organization could sell its interest in the blocker without obtaining consent), and (3) management of the tax-exempt organization's investments.123 Those benefits of blockers almost always exist to some extent, but they most often pale next to the tax benefit. Although new questions will arise from the codification of the economic substance doctrine,124 the ability of tax-exempt organizations to avoid debt-financed income by investing through blockers is so universally accepted that it is unlikely the IRS would begin to challenge it.

2. H.R. 3497. On July 31, 2009, House Ways and Means Committee member Sander M. Levin, D-Mich., introduced H.R. 3497, which would exclude from the definition of acquisition indebtedness any indebtedness incurred or continued by a partnership in which a tax-exempt organization is a limited partner (directly or indirectly through another partnership) in purchasing or carrying any share of stock in a corporation, widely held or publicly traded partnership or trust, indebtedness, interest rate, currency or equity notional principal contract, or actively traded commodity.

The bill would therefore eliminate the need for a tax-exempt organization to use a foreign blocker to invest in a hedge fund partnership that in turn borrows to make its investments.

However, the bill would go beyond merely maintaining the status quo and eliminating the inconvenience of investing through a foreign blocker. Under current law, a tax-exempt organization can avoid tax on debt-financed investments through a foreign blocker only to the extent that the blocker is not subject to tax. Thus, if a tax-exempt organization invests today in a foreign blocker that borrows to purchase U.S. dividend-paying equity securities, the tax-exempt organization will be indirectly subject to a 30 percent U.S. withholding tax on its share of dividend income. Under the bill, a tax-exempt organization could avoid that tax by investing directly in a hedge fund partnership.

However, by exempting a tax-exempt organization from UBTI only if it invests through a partnership (but not if it borrows and buys securities directly), the bill creates perverse incentives and invites criticism that it acts to subsidize the hedge fund industry.

L. Permit RICs to Trade Commodities

Regulated investment companies do not generate "good RIC income" by trading in commodities,125 and Congress recently declined to change the law when it enacted the Regulated Investment Company Modernization Act of 2010.126 Nevertheless, the IRS has issued more than 40 private letter rulings (some after enactment of the act) that provide that if a RIC organizes a wholly owned subsidiary in a tax haven jurisdiction to engage in commodity trading, the subpart F income earned by the RIC from its tax haven subsidiary constitutes "good income." The tax haven subsidiaries in those rulings serve no purpose whatsoever other than to permit the RIC to do indirectly what it is not permitted to do directly.127


IV. Hurdles, Costs, and Inconveniences

Enjoying tax benefits by investing through a foreign corporation is possible only if specific hurdles, namely section 269 and the economic substance doctrine of new section 7701(o), are cleared. And even then, there are distinctive costs and inconveniences when using a foreign corporation.

A. Section 269 and Economic Substance

1. Section 269. Section 269(a)(1) provides that if any person or persons directly or indirectly form a corporation, or acquire stock possessing at least 50 percent of the vote or value of a corporation, and the principal purpose for the acquisition is evasion or avoidance of federal income tax by securing the benefit of a deduction, credit, or other allowance that that person would not otherwise enjoy, the IRS may disallow the deduction, credit, or other allowance.128

Could the IRS use section 269 to deny many benefits that an individual, domestic corporation, or tax-exempt organization may obtain by organizing a foreign corporation and investing in it? Probably not.

First, section 269 applies only if the taxpayer (or taxpayers) acquire 50 percent or more of the vote or value of the corporation. So section 269 likely does not apply if U.S. investors hold only a minority investment in a foreign blocker.

Second, even if a U.S. taxpayer (or U.S. taxpayers) acquire control of a foreign blocker, in Commodores Point Terminal Corp. v. Commissioner,129 the Tax Court held that the predecessor to section 269 did not apply when the allowance did not depend on the taxpayer acquiring control. In Commodores Point, the taxpayer acquired 58 percent of Piggly Wiggly Corp. and claimed a dividends paid credit when Piggly Wiggly paid dividends. The IRS sought to invoke the predecessor to section 269 to disallow the credit. The court held for the taxpayer:


    The dividends received credit claimed by petitioner in its 1944 return was in no sense dependent upon petitioner's acquisition of a controlling interest in the Piggly Wiggly Corporation. Petitioner would have received dividends and would have been entitled to claim a dividends received credit proportionately as great from any number of shares less than an amount constituting a controlling interest. There is no evidence nor does respondent suggest that petitioner received its dividends by virtue of its controlling interest.130

Third, several courts have held that section 269 does not apply to a benefit that merely results in deferral of tax, as opposed to a reduction in ultimate tax liability.131 So the formation and use of a CFC merely to defer non-subpart F income does not implicate section 269.

Fourth, as discussed above, the IRS has repeatedly ruled in private letter rulings that it would respect the use of a wholly owned foreign corporation by a tax-exempt organization to avoid UBTI when the foreign corporation provided an added layer of limited liability, provided greater flexibility in disposing of the underlying investment, and permitted management of the taxpayer's investments. These nontax business purposes apply to virtually all investments through foreign corporations. If they are sufficient to allow a tax-exempt organization to establish that the principal purpose for setting up a wholly owned foreign blocker is not the avoidance of federal income tax by securing the benefit of an allowance that the taxpayer would not otherwise enjoy, they must be sufficient for a taxable investor to make the same showing.

Finally, regardless of whether the IRS could assert that section 269 denies the benefits of investing through a foreign corporation, it should not. The benefits of investing through a foreign corporation described in this report are generally applicable, long-standing, pretty clear as a matter of law, and generally reflect a strong historic basis (such as in the E&P limitation to inclusion and inapplicability of the miscellaneous deduction limitation to expenses incurred by a foreign corporation). Section 269 is a blunt and messy weapon: It is fundamentally factual, introduces inherent uncertainty, and if successfully invoked, denies benefits without regard to costs. In short, if the benefits described in this report are inappropriate, the substantive law should be changed.

2. Economic substance. The Health Care Reconciliation Act of 2010 codified the economic substance doctrine. Under new section 7701(o), if the economic substance doctrine is relevant to a transaction, it will be satisfied only if the transaction changes the taxpayer's economic position in a meaningful way (apart from federal income tax consequences) and the taxpayer has a substantial non-federal-tax purpose for entering into the transaction.132 The potential for profit is treated as a substantial nontax purpose only if the current value of the reasonably expected pretax profit from the transaction is substantial compared with the current value of the expected net tax benefits that would be allowed if the transaction were respected.133 Also, fees, other transaction expenses, and foreign taxes are treated as expenses in determining pretax profit.134

If a transaction does not have economic substance under that test, new section 6662(i) imposes a 40 percent penalty on understatements attributable to the transaction, unless the taxpayer has adequately disclosed to the IRS the relevant facts affecting the tax treatment of a transaction, in which case the penalties are 20 percent of the understatement.135

Does an investment through a foreign blocker principally to reduce taxes have economic substance? As long as the underlying investment is entered into for profit, almost certainly yes.

The JCT's explanation of section 7701(o) provides:


    The provision is not intended to alter the tax treatment of certain basic business transactions that, under long standing judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.136

Among the transactions that satisfy this criterion is "a U.S. person's choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment." The JCT cited Siegel v. Commissioner137 as authority for the proposition and included a "but see" citation to Commissioner v. Bollinger.138

In 1956 Sam Siegel planned to enter into a joint venture with a Cuban farmer under which Siegel would invest $25,000 to $30,000 for a 20 percent stake in a Cuban farm. Siegel wished to keep this joint venture separate from his own produce business to limit his personal liability, to protect his reputation and credit, and to protect his license under the Perishable Commodities Act. Siegel thought he would organize a Cuban corporation. He consulted a Miami attorney who recommended that Siegel form a Panamanian corporation instead because of Panama's banking facilities and for tax reasons. Presumably, the Panamanian corporation wouldn't be subject to material Panamanian tax and could permit Siegel to defer his own U.S. taxes. (Subpart F and the PFIC rules had not yet been enacted.)

The venture was wildly successful, and two years later it distributed more than $500,000 in profit to Siegel's Panamanian corporation, where Siegel left it. Nevertheless, the IRS included the distribution directly in Siegel's gross income either because the Panamanian corporation was a sham or because section 269 applied.

In short order, the Tax Court dismissed both arguments. The court grudgingly accepted Siegel's nonbusiness reasons for holding his interests through a corporation139:


    To be sure, we are not so naïve as to think that tax consequences were not taken into account in organizing [the Panamanian corporation], and the record suggests that tax considerations did play a part. The only apparent purpose for the formation of a Panamanian corporation rather than a U.S. corporation was to avoid payment of any tax on the income from the joint venture as it was earned. But, prior to the Revenue Act of 1962, adding section 951 to the 1954 Code, there was a loophole in the Code which permitted that result, and petitioner was free to take advantage of it. The question before us is not to be clouded by the use of a foreign corporation, rather than a domestic corporation, to escape U.S. taxation, except as it may bear on the question whether that corporation was in fact "formed for a substantial business purposes or actually engage[d] in substantive business activity."140

The Tax Court then concluded that because Siegel's corporation was indeed formed for substantial business purposes and actually engaged in substantive business activities, it was not a sham and could not be disregarded.141

Most foreign blockers and other foreign corporations that are formed to make investments have just as much substance as Siegel's corporation, and they provide analogous tax benefits. In light of Siegel and the IRS's private letter rulings approving of foreign blockers to avoid debt-financed income, the IRS would have a difficult time attacking most foreign investment corporations on economic substance grounds. Although the JCT attempted to limit Siegel to the use of a foreign corporation "to make a foreign investment" and that in fact is what the Panamanian corporation was used for, the Tax Court's reasoning is not so limited: The Tax Court held that as long as a foreign corporation is formed for a substantial business purpose or actually engaged in substantive business activity, it would be respected. There is no suggestion that the business must occur outside the United States.142

Finally, for the same reasons that the IRS should not assert section 269 to deny a taxpayer the benefits of investing through a foreign corporation, it should not use the economic substance doctrine. The economic substance doctrine introduces inherent uncertainty into meaningful business decisions. A tax-exempt organization's decision to invest in a leveraged hedge fund through a foreign corporation (as opposed to an unleveraged investment in a hedge fund partnership) always depends (and often depends entirely) on whether the income will be taxable. That answer should be clear, but it will not be if the income is subject to the economic substance doctrine.

B. Costs of Using a Foreign Corporation

Investing through a foreign corporation does present some costs. First, losses of a foreign corporation do not offset the shareholder's income and gain from other sources. Second, any dividends received by the foreign corporation from a U.S. corporation are subject to a 30 percent U.S. withholding tax.143 Third, if the foreign corporation is engaged in a trade or business in the United States, it is subject to a 35 percent federal corporate net income tax, possibly state and local taxes, and potentially a 30 percent branch profits tax. Finally, long-term capital gains do not pass through a CFC.

1. No passthrough of losses. The most significant disadvantage for a U.S. taxable investor that invests in a foreign corporation is the inability to claim losses before a disposition or complete redemption of its interest in the foreign corporation. A U.S. taxpayer may hold several PFICs through a single foreign corporation. In that event, the U.S. taxpayer will have to make a timely QEF election for each PFIC to avoid the denial of capital gains rule and the penalty interest charge.144 (The holding company PFIC is not permitted to make a QEF election on behalf of its shareholders for its PFIC investments.145) For purposes of the PFIC rules, the U.S. taxpayers will be treated as owning directly the PFICs that are owned by the holding company. Moreover, even if a QEF election is made for each PFIC, if one of the underlying PFICs has a loss and another has a gain, the investor will be required to report the gain but will be unable to offset the loss on the other. Instead, the investor's basis in the foreign holding company will increase by its share of the holding company's gain that is reported. Only on a sale or redemption of the taxpayer's interest in the holding company PFIC will the prior income or gain inclusion give rise to reduced capital gain or increased loss.

2. Dividend (and other) withholding tax. Foreign corporations are subject to U.S. withholding tax on dividends, which has been a meaningful disincentive for U.S. taxpayers to hold their U.S. equity portfolios in a foreign corporation. However, equity swaps can be used to avoid the withholding tax, and if regulations under new section 871(m) provide a safe harbor under which equity swaps will be respected, U.S. taxpayers will be able to hold equity portfolios (in swap form) through foreign corporations without U.S. withholding tax.

U.S. withholding tax on other financial instruments held by foreign corporations has also served as a disincentive, but the availability of low-tax vehicles in tax treaty jurisdictions can be used to avoid the withholding tax.

For example, death benefits paid on a life insurance contract on a U.S. life are normally subject to a 30 percent withholding tax, but if a U.S. investor holds the policy through an Irish section 110 company or Irish investment unit trust that qualifies for the benefits of the U.S.-Irish tax treaty, the U.S. investor can avoid the U.S. withholding tax without incurring Irish tax.146

3. U.S. trade or business risk. A U.S. taxpayer that holds a portfolio through a foreign corporation exposes itself to the risk that the foreign corporation is treated as engaged in a trade or business in the United States. The consequences of that treatment would be disastrous. The foreign corporation would be subject to a U.S. federal corporate tax on its effectively connected income and would potentially be subject to state and local taxes as well as the branch profits tax.

4. No passthrough of capital gains for an interest in a CFC. CFCs do not permit their U.S. shareholders to receive flow-through treatment of the net (long-term) capital gains of the CFC. Therefore, U.S. individual investors whose portfolios are expected to generate meaningful amounts of long-term capital gain generally avoid owning a 10 percent interest in the foreign corporation (to avoid U.S. shareholder status) or otherwise take steps to avoid CFC status. (QEF PFICs do pass through their net capital gains.147)

5. No U.S. foreign tax credits for individuals or for corporations with less than 10 percent of the voting power. U.S. individuals who invest in a foreign corporation (and U.S. corporations with less than 10 percent of the voting power of a foreign corporation) are not entitled to U.S. FTCs for the foreign taxes paid by the foreign corporation.148

C. Compliance

1. FATCA reporting and withholding requirements. In general, under the Foreign Account Tax Compliance Act of 2009 (FATCA) provisions of the Hiring Incentives to Restore Employment Act (HIRE Act),149 beginning on January 1, 2013, a 30 percent withholding tax will be imposed on U.S.-source interest, dividends, rents, and other fixed or determinable annual or periodic income, and the gross proceeds from the sale or other disposition of any property that produces U.S.-source interest or dividends (for example, stock or debt of a U.S. corporation) that are paid directly or indirectly to a foreign financial institution (FFI), unless that institution enters into an agreement with Treasury.150 (The term "foreign financial institution" includes most foreign hedge funds and other foreign investment vehicles.151)

The agreement that FFIs will be required to enter into with Treasury will require that they report to the IRS the name, address, taxpayer identification number, equity interest value, and the gross receipts and withdrawals for the equity interest in the FFI for each U.S. person and any substantial U.S. owner of a U.S.-owned foreign entity that directly or indirectly holds equity in the FFI (except to the extent provided by the IRS).152 The agreement will also require an FFI to comply with verification and due diligence procedures (including know-your-customer, anti-money-laundering, anti-corruption, and similar rules), reporting requirements, and requests by the IRS for additional information.153 FFIs will be required to attempt to obtain a waiver in any case in which foreign law would otherwise prevent the required reporting, and if the waiver is not obtained within a reasonable time, the FFI must close the account.154

Finally, under their agreements with Treasury, FFIs will be required to (1) deduct and withhold 30 percent from any U.S.-source payment and 30 percent of the gross proceeds from the sale of any U.S. stock or debt instrument paid to any investor that fails to provide the requested information (a recalcitrant investor) or any holder that is itself an FFI and has not entered into a similar agreement with Treasury or (2) elect to receive their U.S.-source payments (including gross proceeds from sales of U.S. stock and debt) subject to 30 percent withholding on the portion that is allocable to the recalcitrant investor or noncompliant FFI.155

Those rules effectively will require an FFI that directly or indirectly receives U.S.-source income to enter into the agreement with Treasury, and they will require that all of the FFI's investors certify whether they are a U.S. person or U.S.-owned foreign entity, even if the FFI does not directly receive any U.S.-source income.

For example, assume that a U.S. investor organizes a foreign corporation to own interests in offshore hedge funds that are treated as foreign corporations for U.S. tax purposes. The foreign corporation will not itself be required to enter into an agreement with Treasury because it will not directly receive U.S.-source payments or the proceeds from the sale of U.S. stocks or securities. However, if one of the underlying offshore hedge funds it owns receives U.S.-source payments, that hedge fund will be required to enter into an agreement with Treasury, and the hedge fund will withhold on payments to the foreign corporation unless the foreign corporation has itself entered into an agreement with Treasury (or complies with other requirements that the IRS may prescribe in the future).156 Moreover, because the foreign corporation is an FFI, it will be required to disclose information about any U.S. person that owns any interest in it.

The 30 percent withholding tax also applies to U.S.-source payments (and the proceeds from the sale of U.S. stocks and securities) made to a nonfinancial foreign entity with a substantial U.S. owner,157 unless the foreign entity provides the withholding agent the name, address, and TIN of its substantial U.S. owners.158

2. Form 926. A U.S. investor that purchases an interest in a foreign corporation for cash is generally required to file IRS Form 926, "Return by a U.S. Transferor of Property to a Foreign Corporation," if immediately after the purchase the investor owns (directly, indirectly, or by attribution) 10 percent or more of the total voting power or total value of the corporation or the investor (or any related person) transfers more than $100,000 to the corporation during the 12-month period ending on the date of that transfer.159

3. Form 5471. A U.S. investor that owns or is treated as owning at least 10 percent of the equity of a foreign corporation, by vote or value, is generally required to file an information return on Form 5471, "Information Return of U.S. Persons With Respect to Certain Foreign Corporations," and provide additional information regarding the corporation annually on Form 5471 if the investor is treated as owning (actually or constructively) more than 50 percent by vote or value of the equity of the corporation.160

4. Form 8621; PFIC annual reporting. Any U.S. investor that is a direct or indirect shareholder of a PFIC must file Form 8621, "Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund," for each year in which the investor recognizes gain on a direct or indirect disposition of PFIC stock, receives specified direct or indirect distributions from a PFIC, or makes specified PFIC-related elections.161

Moreover, in tax years beginning on or after March 18, 2010, any U.S. investor that is a shareholder in a PFIC must file an annual information return containing such information as the IRS may require.162 It is hoped that this annual return will also be on Form 8621, but the IRS has not yet identified the form or the information required to be included.

5. Section 6038D -- information reporting for foreign financial assets. Section 6038D (which was enacted as part of the HIRE Act) requires individual taxpayers to disclose as part of their income tax return the aggregate value of their specified foreign financial assets that exceeds $50,000.163 Specified foreign financial assets include stock in a foreign corporation, unless the stock is held in an account maintained by a U.S. financial institution.164


V. Suggestions for Improvement

1. The E&P limitation on inclusions of subpart F and QEF income allows U.S. taxpayers to use foreign corporations to effectively deduct amounts that could not be deducted directly. That ability frustrates the tax policy underlying the denial of the deductions. The E&P limitation also allows U.S. shareholders in CFCs to avoid subpart F inclusions (sometimes indefinitely).

The E&P limitation on inclusions of subpart F and QEF income should be repealed so that U.S. shareholders of CFCs report subpart F income to the extent of the CFC's taxable income,165 and shareholders in QEF PFICs report all income and net capital gain of the PFIC to the extent of its taxable income and gain.166

To prevent subpart F income from being taxable when there are offsetting losses from non-subpart F operations, prior-year losses could be carried over and used under section 172 to offset current gain.167 The rules that allocate distributions to various pools of E&P could be eliminated, because all distributions would be tax free to the extent of section 951 income inclusions. Distributed amounts in excess of subpart F income would be treated as dividends to the extent of E&P.168 Finally, section 960(a)(1) could be amended to provide that the flow-through of foreign tax paid for FTC purposes is the proportion that the taxable income included under section 951 for the year bears to the total taxable income for the year.169

If that recommendation is not adopted, an alternative suggestion is that the E&P for CFCs and QEF PFICs not be reduced by disallowed deductions and deferred losses. Although this suggestion sounds less radical, it actually would add significant complexity to the E&P calculation and is at odds with the underlying foundation of the E&P concept that E&P simply represents the earned cash available to pay a dividend.

2. Individual U.S. taxpayers should not be able to avoid the limitations on the deductibility of capital losses by investing through foreign corporations. To prevent this, Congress could provide that a CFC or QEF PFIC must report to taxpayers their share of the CFC's or QEF PFIC's capital losses, and those capital losses may be used to offset only capital gains of the CFC or QEF PFIC for that year. Congress could further provide that a taxpayer's share of the capital losses of a CFC or a QEF PFIC carry forward to offset the taxpayer's share of capital gains in future years.

3. Individual U.S. taxpayers should not be able to avoid the limitations on the deductibility of miscellaneous itemized deductions, personal interest expense, or charitable deductions by investing through a foreign corporation. To prevent this, Congress could provide that CFCs and QEF PFICs must report to individual taxpayers (and trusts and estates) the deductions of their CFCs and QEF PFICs that would be itemized deductions or personal interest expense if incurred directly. In turn, the shareholders that are individuals, trusts, or estates would report their share of the gross income and gains (in the case of a CFC) or gross income and net capital gains of a CFC or QEF PFIC, and if the CFC or QEF has net income or net gain, independently report their share of the CFC's or PFIC's deductions, subject to the limitations on the deductibility of the expenses. The S corporation reporting rules could serve as a model for those rules. But before making these changes, Congress should reexamine the miscellaneous itemized deduction limitation because it produces results that are hard to justify as a matter of simplification or otherwise.

4. Once federal law provides for the separate reporting of itemized deductions incurred through a CFC or QEF PFIC, the states that limit the deductibility of itemized deductions should apply their limitations to those deductions.

5. If Congress enacts the Obama administration's proposal to limit the value of itemized deductions to 28 percent for high-income individuals, or the National Commission on Fiscal Responsibility and Reform's proposal to limit charitable deductions, the limitations should apply equally to deductions incurred through a CFC or QEF PFIC.

6. Congress should enact a technical correction to the Health Care Reconciliation Act, or Treasury should write regulations, to clarify that subpart F and PFIC QEF inclusions are subject to the 3.8 percent Medicare tax.

7. The IRS should use the subpart F definition of an active insurance company for purposes of determining whether offshore reinsurance companies qualify for the active insurance company exception from a PFIC under section 1297(b)(2)(B).

8. U.S. persons should not be able to use foreign corporations to avoid their FBAR filing requirements. The FBAR regulations should be amended to provide that a U.S. person has a financial account (and therefore is subject to FBAR reporting) if the U.S. person owns 50 percent of the vote or value of a foreign corporation and that foreign corporation is the beneficial owner of a foreign financial account, regardless of whether the foreign corporation has title to the account. The regulations should also be amended to expand the FBAR antiavoidance rule to provide that a U.S. person that uses an entity with a principal purpose of avoiding the reporting rules should be treated as having a financial interest in any accounts that the entity holds or in which it has a beneficial ownership interest (and therefore is subject to FBAR filing requirements for those accounts).

9. Either Congress should expressly permit RICs to earn "good RIC income" by trading in commodities or the IRS should stop issuing private letter rulings that permit RICs to generate good RIC income by trading in commodities through tax haven subsidiaries that serve no business purpose whatsoever except to allow the RIC to do indirectly what it is not permitted to do directly.

10. Tax-exempt organizations should not be able to avoid federal income tax by investing through foreign corporations. To merely eliminate the current incentive for tax-exempt organizations to organize and invest through foreign corporations, Congress could amend section 514 to provide that income received directly or through a partnership is not debt-financed income to the extent that the income would not have been effectively connected income or subject to U.S. withholding tax if earned by a foreign corporation. More broadly (but also more controversially), Congress should either repeal the debt-financed rules (subject to some special rules to prevent abusive transactions) or retain the debt-financed income rules and apply them through CFCs to treat a tax-exempt U.S. shareholder as having incurred its share of the indebtedness of the CFC. Also, if the debt-financed rules are applied through CFCs, Congress should write a rule that would deem that an investment in a PFIC is entirely debt financed (and that the tax-exempt investor is subject to tax regarding the PFIC to the same extent as a taxable investor) unless the PFIC provides its tax-exempt shareholder with information on the amount of its outstanding indebtedness, in which case the tax-exempt shareholder's allocable share of the indebtedness would be imputed to it (unless the income to which the indebtedness relates is effectively connected to a U.S. trade or business and subject to tax).

11. Under current law, some taxpayers can organize a foreign corporation to purchase the debt of their subsidiaries at a discount and avoid the COD income that would arise for the subsidiary if they bought the subsidiary's debt directly. That ability to avoid the COD income rules arises from the restrictive definition of relatedness in section 108(e)(4), and the most natural way to fix it would be to expand the related-party test in section 108(e)(4). Lee A. Sheppard has suggested that the broad control test in section 482 be used.170 However, even a test that treated two or more corporations as related if 50 percent or more of their voting power is owned by any partnership would significantly limit the ability of U.S. private equity funds to avoid COD income by forming a low-tax foreign corporation to purchase the debt of a portfolio company.

12. The existing TMP rules encourage U.S. investors to use a foreign tax haven company to create a REMIC-like vehicle and avoid the U.S. corporate tax that would otherwise apply to a domestic TMP.

There are four alternative policy decisions that Congress could make regarding tax haven TMPs.

First, Congress could amend section 7701(i) to provide that a foreign TMP is taxable as a domestic corporation. But that would be overkill171 and extraordinarily difficult to enforce.

Second, Congress could expand the rules that apply to TMP REITs and apply them to the U.S. equity owners of foreign TMPs. Those rules would ensure, at a minimum, that any U.S. taxpayer that owns an interest in a foreign TMP would pay tax on its share of the excess inclusion income of the TMP. Imposing the excess inclusion rules on U.S. shareholders of foreign TMPs would diminish the current attractiveness of foreign TMPs over U.S. mortgage REITs but would add significant complexity. (Applying the excess inclusion rules to foreigners that own equity in foreign TMPs would be impossible to police.)

Third, Congress could repeal the TMP rules entirely. In that case, foreign corporations would not offer any particular advantage over U.S. entities. In light of the uncertain policies underlying the TMP rules, there is some appeal to this alternative. (Moreover, REMICs would still offer a tremendous advantage over domestic TMPs because regular interests in REMICs are treated by statute as indebtedness for federal income tax purposes.) Nevertheless, repealing the TMP rules would undermine the REMIC rules and much more phantom income would escape U.S. tax than otherwise. So this alternative would be expected to cost significant revenue without any overriding policy benefit and is therefore particularly unattractive.

Finally, Congress could do nothing. In that instance, the U.S. tax law would continue to encourage U.S. taxpayers to organize foreign corporations to reduce their U.S. tax liability. However, in this single case, the alternatives are worse.


FOOTNOTES

1 See "Remarks by the President on International Tax Policy Reform" (May 4, 2009), available at http://www.whitehouse.gov/the_press_office/Remarks-By-The-President-On-International-Tax-Policy-Reform:

    For years, we've talked about shutting down overseas tax havens that let companies set up operations to avoid paying taxes in America. That's what our budget will finally do. On the campaign, I used to talk about the outrage of a building in the Cayman Islands that had over 12,000 . . . businesses claim this building as their headquarters. And I've said before, either this is the largest building in the world or the largest tax scam in the world. And I think the American people know which it is. It's the kind of tax scam that we need to end. That's why we are closing one of our biggest tax loopholes.

2 The fiscal 2010 budget contained a proposal to treat some check-the-box foreign entities as corporations for U.S. federal income tax purposes. See Treasury, "General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals" (May 2009), at 28, Doc 2009-10664, 2009 TNT 89-44 (Treasury green book for fiscal 2010). This proposal was dropped from the fiscal 2011 budget. See Treasury, "General Explanations of the Administration's Fiscal Year 2011 Revenue Proposals" (Feb. 2010), Doc 2010-2363, 2010 TNT 21-20 (Treasury green book for fiscal 2011); Barbara Angus et al., "The U.S. International Tax System at a Crossroads," Tax Notes, Apr. 5, 2010, p. 45, Doc 2010-4430, or 2010 TNT 64-4 ("Major modifications in this year's international tax proposals include the elimination of the proposal to curtail use of the check-the-box rules."); and John D. McKinnon, "Plan Would Raise Taxes on Businesses," The Wall Street Journal, Feb. 2, 2010 ("Last year, the Administration's proposal to increase multinational companies' taxes on their overseas earnings by about $210 billion floundered amid furious opposition from business leaders.").

3 Treasury, "General Explanations of the Administration's Fiscal Year 2012 Revenue Proposals" (Feb. 2011), at 131, Doc 2011-3155, 2011 TNT 31-21 (Treasury green book for fiscal 2012) ("Reduce the Value of Certain Tax Expenditures"). This proposal was also part of the 2011 budget. See Treasury green book for fiscal 2011, supra note 2 ("Limit the Tax Rate at Which Itemized Deductions Reduce Tax Liability to 28 Percent"). The proposed increase in the highest marginal rates for individuals has a similar effect.

4 These provisions are discussed in Part III.A.

5 These provisions are discussed in Part III.C and Part III.K.

For an exposé on the use of foreign blockers by the Bloomberg Family Foundation, see Aran Roston, "Bloomberg's Offshore Millions," The New York Observer, Apr. 20, 2010, available at http://www.observer.com/2010/politics/bloomberg%E2%80%99s-offshore-millions. The article quotes former New York District Attorney Robert Morganthau as having "made a lot of effort to shut down that loophole" and as having raised the issue with "four U.S. secretaries of the Treasury."

6 See preamble to REG-124590-07, Doc 2008-4147, 2008 TNT 40-8 ("The use of contract manufacturing arrangements has become a common way of manufacturing products because of the flexibility and efficiencies it affords. Accordingly, updated rules in this area are important to the continued competitiveness of U.S. businesses operating abroad.").

7 See generally Daniel N. Shaviro, Decoding the U.S. Corporate Tax 133 (2009). This is also the balance between capital export neutrality and capital import neutrality. See "Message From the President of the United States Relative to Our Federal Tax System," H.R. Doc. No. 87-140, at 30 (1961).

8 J. Clifton Fleming Jr. et al., "Deferral: Consider Ending It, Instead of Expanding It," Tax Notes, Feb. 7, 2000, p. 837, Doc 2000-3632, 2000 TNT 25-66.

9 Section 957. However, for the purposes of taking into account "insurance income," if more than 75 percent of the foreign corporation's income is subpart F income, the corporation is a CFC if more than 25 percent of the total combined vote or value of the stock is owned directly, indirectly, or constructively by U.S. persons that each possess directly, indirectly, or constructively 10 percent or more of the combined voting power of all classes of voting equity in the corporation. Section 957(b).

10 See section 951.

11 H.R. Conf. Rep. No. 103-213, at 633 (1993) ("Subpart F income typically is foreign income that is relatively movable from one taxing jurisdiction to another and that is subject to low rates of foreign tax relative to the U.S. rate.").

12 Martin A. Sullivan, "U.S. Multinationals Move More Profits to Tax Havens," Tax Notes, Feb. 9, 2004, p. 690, Doc 2004-2725, 2004 TNT 27-4.

13 Jesse Drucker, "American Companies Dodge $60 Billion in Taxes Even Tea Party Would Condemn," Bloomberg.com (May 13, 2010), available at http://www.bloomberg.com/apps/news?pid=20601109&sid=aEfZbpkSLCBQ.

14 Joint Committee on Taxation, "Estimates of Federal Tax Expenditures for Fiscal Years 2009-2013," JCS-1-10 (Jan. 11, 2010), at 29, Doc 2010-631, 2010 TNT 7-22 (ending deferral would generate approximately $11 billion in fiscal 2010, or more than $60 billion from 2011-2015). Harry Grubert and Rosanne Altschuler, "Corporate Taxes in the World Economy," in Fundamental Tax Reform: Issues, Choices, and Implications (2008) ($11 billion for 2002, which Jane Gravelle translates into $26 billion for 2007); Jane G. Gravelle, "Tax Havens: International Tax Avoidance and Evasion," Congressional Research Service (Sept. 3, 2010), at 13-14 (citing estimates of between $11 billion and $14 billion); Kimberly Clausing, "Multinational Firm Tax Avoidance and Tax Policy," 62 Nat'l Tax J. 703 (2009) ($60 billion for 2004, based on applying a 35 percent tax rate to an estimated $180 billion in corporate profits shifted out of the United States); Charles W. Christian and Thomas D. Schultz, "ROA-Based Estimates of Income Shifting by Multinational Corporations," IRS Research Bulletin 58-72 (2005) ($87 billion shifted in 2001, or $30 billion revenue loss based on 35 percent corporate tax rate); Simon J. Pak and John S. Zdanowicz, "U.S. Trade With the World: An Estimate of 2001 Lost U.S. Federal Income Tax Revenues Due to Over-Invoiced Imports and Under-Invoiced Exports" (Oct. 31, 2002) ($53 billion lost revenue in 2001).

15 The President's Economic Recovery Advisory Board, "The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation" (Aug. 29, 2010) at 92, Doc 2010-19068, 2010 TNT 167-50 ("Ending deferral would itself permit a revenue-neutral reduction in the corporate rate by about 1.5 percentage points").

16 Supra note 14.

17 Drucker, supra note 13.

18 See Clausing, supra note 14.

19 Harry Grubert, "Intangible Income, Intercompany Transactions, Income Shifting and the Choice of Locations," 56 Nat'l Tax J. 221 (2003).

20 See JCT, "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," JCX-37-10 (July 20, 2010), Doc 2010-16144, 2010 TNT 139-13 (JCT transfer pricing report).

21 Id.

22 Drucker, supra note 13.

23 Donald J. Marples and Jane Gravelle, "Tax Cuts on Repatriation Earnings as Economic Stimulus: An Economic Analysis," CRS (Jan. 30, 2009), Doc 2009-2132, 2009 TNT 20-24 .

24 JCT transfer pricing report, supra note 20.

25 Grubert, supra note 19.

26 Under a commissionaire arrangement, a subsidiary in a low-tax jurisdiction earns commission income for arranging the sales of goods, rather than taking title to the goods and selling them for a profit. See generally Treasury, "The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study" (Dec. 29, 2000), at 65, Doc 2001-492 , 2001 TNT 1-1 .

27 See reg. section 1.954-3(a)(4).

28 See reg. section 1.954-3(b)(1)(ii)(c)(3)(f), Example 6, and reg. section 1.954-3T(b)(1)(ii)(c)(3)(v), Example 6. See also T.D. 9438, Doc 2008-27115, 2008 TNT 249-5 (making clear that if employees resident in a CFC's low-tax home jurisdiction travel to a high-tax jurisdiction but do not cause the CFC to have a branch in the high-tax jurisdiction, their activities are taken into account for purposes of the substantial contribution test).

29 See generally Treasury, "The Deferral of Income," supra note 26, at 62.

30 See Gravelle, supra note 14, at 13-14.

31 "Remarks by the President," supra note 1.

32 Section 204(c) of S. 3018 provides:


    (c) Deferral of Active Income of Controlled Foreign Corporation. -- Section 952 (relating to Subpart F income defined) is amended by adding at the end of the following new subsection:

      "(e) Special Application of Subpart. -- (1) In General. -- For taxable years beginning after December 31, 2010, notwithstanding any other provision of this subpart, the term 'subpart F income' means in the case of any controlled foreign corporation, the income of such corporation derived from any foreign country."

    "(2) Applicable Rule. -- Rules similar to the rules under the last sentence of subsection (a) and (d) shall apply to this subsection."

33 One might wonder how Wyden and Gregg had the audacity to propose such a thing in the face of objections by 287 U.S. companies and business associations. See Promote America's Competitive Edge Coalition, "280+ Organizations Cite Need for Competitive Tax Policies if American Employers Are to Grow and Create Quality U.S. Jobs" (Mar. 9, 2010) (letter to all members of Congress). The answer appears to be that the bill would also reduce the federal corporate tax rate to 24 percent -- Wyden's leading/biggest corporate contributor is Nike, and Gregg's was Fidelity, and neither company signed the letter. See OpenSecrets.org, available at http://www.opensecrets.org/politicians/contrib.php?cid=N00007724&cycle=2010&type=C&newMem=N&recs=100 and http://www.opensecrets.org/politicians/summary.php?type=C&cid=N00000444&newMem=N&cycle=2010.

34 National Commission on Fiscal Responsibility and Reform, "The Moment of Truth" at 32-33 (Dec. 3, 2010), Doc 2010-25486, 2010 TNT 231-35.

35 The Debt Reduction Task Force, "Restoring America's Future: Reviving the Economy, Cutting Spending and Debt, and Creating a Simple, Pro-Growth Tax System," Bipartisan Policy Center (Nov. 2010), at 35, Doc 2010-24611, 2010 TNT 222-29.

36 Thus, a U.S. person may own as much as 49.9 percent of the vote and value of a foreign corporation without the foreign corporation being treated as a CFC, as long as there is not another U.S. person that owns or is treated as owning 10 percent or more of the voting power of the foreign corporation.

37 Section 1297(a)(2).

38 A taxpayer may make a QEF election for any tax year at any time on or before the due date (determined with regard to extensions) for filing the tax return for the tax year. Section 1295(b)(2). A QEF election is made by attaching the PFIC annual information statement and annual intermediary statement and a completed Form 8621 to the taxpayer's federal income tax return for the year. See reg. section 1.1295-1(f).

39 Section 1293(a). In some cases in which a QEF does not distribute all its earnings in a tax year, the electing U.S. investor may also be permitted to elect to defer payment of some or all of the taxes on the QEF's income, subject to a nondeductible interest charge on the deferred amount. Section 1294.

40 Section 1291(a)(2).

41 An excess distribution is the amount by which distributions during a tax year in respect of the equity interest exceed 125 percent of the average amount of distributions in respect thereof during the three preceding tax years (or, if shorter, the U.S. investor's holding period for the interest). Section 1291(b).

42 See section 1291(a)(1) and (c)(2).

43 Section 1291(c)(3). For purposes of these rules, gifts, exchanges under corporate reorganizations, and the use of the equity interests as security for a loan may be treated as a taxable disposition of the interests. Also, a stepped-up basis in the equity interests is not available on the death of an individual U.S. investor. See prop. reg. section 1.1291-3(b)(1) and 1.1291-3(d)(1); section 1298(b)(6).

44 Section 1297(b)(2)(A) and (B).

45 JCT, "General Explanation of the Tax Reform Act of 1986," JCS-10-87 (May 4, 1987), at 1025; S. Rep. No. 100-445 (1988) ("Income derived by entities engaged in the business of providing insurance will be passive income to the extent the entities maintain financial reserves in excess of the reasonable needs of their insurance business."). See also reg. section 1.801-4(a) (defining life insurance reserves as amounts that are set aside to cover future actuarially predicted liabilities or are otherwise "required by law" if the insurance company is regulated by a state, the District of Columbia, or a U.S. territory).

46 See Hal Lux, "The Great Hedge Fund Reinsurance Tax Game," Institutional Investor (Apr. 1, 2001).

47 H.R. 4192 was introduced in the House by Rep. Nancy L. Johnson and Rep. Richard E. Neal, D-Mass., on April 5, 2000, during the 106th Congress. The Reinsurance Tax Equity Act of 2001, H.R. 1755, was introduced in the House by Johnson and Neal during the 107th Congress. Neal was influenced by the ability of U.S. shareholders of these companies to defer their income. At the time he said:


    When U.S. taxpayers invest in hedge funds, they pay taxes each year at realized profits, usually at the ordinary income tax rates. However, if they invest in shares of an offshore reinsurance company in a tax haven country like Bermuda, they pay nothing on trading profits until they sell shares of the company and those profits are taxed at the capital gains rate. Congress has taken the position several times over the past few years that investors should not get better tax treatment by investing indirectly than they would have gotten if they had made a direct investment in an asset.

See Lee A. Sheppard, "Hedge Funds in Insurance Wrappers," Tax Notes, Sept. 23, 2002, p. 1671, Doc 2002-21691, or 2002 TNT 185-4.

48 Notice 2003-34, 2003-1 C.B. 990, Doc 2003-11699, 2003 TNT 91-49.

49 Charles Gnaedinger, "Finance Committee Elicits Views on Offshore Tax Issues," Tax Notes, Oct. 1, 2007, p. 13, Doc 2007-21895, 2007 TNT 188-2.

50 H.R. 3424, introduced in the House by Neal. See also JCT, "Present Law and Analysis Relating to the Tax Treatment of Reinsurance Transactions Between Affiliated Entities," JCX-35-10 (July 12, 2010), Doc 2010-15458, 2010 TNT 133-12.

51 See Treasury green book for fiscal 2012, supra note 3, at 46 ("Disallow the Deduction for Non-Taxed Reinsurance Premiums Paid to Affiliates"); Treasury green book for 2011, supra note 2, at 45.

52 Validus Holdings Ltd., Platinum Underwriters Holdings Ltd., Everest Reinsurance Holdings Inc., Montpelier Re Holdings Ltd., RenaissanceRe Holdings Ltd., PartnerRe Ltd., Axis Capital Holdings Ltd., Arch Capital Group Ltd., Aspen Insurance Holdings Ltd., Allied World Assurance Co. Holdings Ltd., Maiden Holdings Ltd., Enstar Group Ltd., Endurance Specialty Holdings Ltd., Flagstone Reinsurance Holdings Ltd., XL Capital Ltd., ACE Ltd., American Safety Insurance Holdings Ltd., White Mountains Insurance Group Ltd., Willis Group Holdings PLC, and Syncora Holdings Ltd.

53 PartnerRe Ltd., "Annual Report," at 6 (Feb. 27, 2009).

54 Validus Holdings Ltd., "Annual Report," at 20 (Mar. 1, 2010).

55 See, e.g., Max Re Capital Ltd. Prospectus at 59-60 ("approximately 46 percent of our investment portfolio was invested in our alternative investment portfolio managed by Moore Capital"; describing six different fund strategies, including "Long/Short Equities," "Convertible Arbitrage," "Global Macro," "Merger Arbitrage," "Multi-Strategy Arbitrage," and "Opportunistic Investing").

56 JCT, supra note 45, at 1025; S. Rep. No. 100-445 (1988) ("Income derived by entities engaged in the business of providing insurance will be passive income to the extent the entities maintain financial reserves in excess of the reasonable needs of their insurance business.").

57 Section 952(c)(1)(B)(v).

58 Section 953(e)(3)(B).

59 Section 953(e)(2)(c).

60 See Sheppard, supra note 47.

61 Section 67(a); section 641(b). Moreover, beginning again in 2013, miscellaneous itemized deductions are reduced by the lesser of (i) 3 percent of AGI minus a specified threshold amount and (ii) 80 percent of the amount of the itemized deductions otherwise allowable. Section 68.

62 Section 63(d) (defining itemized deductions as the deductions other than those allowable in arriving at AGI); section 67(b) (defining miscellaneous itemized deductions as specified itemized deductions).

63 Section 871(m)(3)(B). See also Treasury green book for fiscal 2011, supra note 2.

64 Section 56(b)(1)(A)(i).

65 First, the REMIC rules prohibit a REMIC residual interest from being transferred to a governmental entity that is not subject to federal income tax. See section 860E(e)(1) (tax imposed on transfers to disqualified organizations); section 860E(e)(5) (defining disqualified organizations). Second, the portion of the income from a residual that constitutes an "excess inclusion" is subject to tax in the hands of tax-exempt investors and a 30 percent withholding tax in the hands of foreigners, and that portion of the income may not be offset by any unrelated losses or loss carryovers (and is not entitled to an exemption or reduction from withholding tax under a treaty). See section 860E (the taxable income and alternative minimum taxable income may not be less than the excess inclusion income for the year); section 860G(b) (foreigners subject to 30 percent withholding tax). Also, excess inclusion income of an insurance company cannot be offset with an increased deduction for variable contract reserves. Section 860E(f).

66 Very generally, an entity (or portion of an entity) is a TMP if it is not a REMIC and (1) substantially all its assets are debt obligations (or interests in debt obligations); (2) more than 50 percent of those obligations or interests are real estate mortgages; (3) the entity is the obligor under debt obligations with two or more maturities; and (4) payments on those debt obligations bear a relationship to payments on the debt obligations and the obligor holds the assets. See section 7701(i)(2)(A).

67 Special rules exist for real estate investment trusts that are TMPs. Under Treasury regulations (which have not yet been issued), the equity holders of a REIT or registered investment company are subject to the same rules that apply to holders of residual interests in REMICs. These rules are designed to ensure that federal income tax is paid on the excess inclusion income. See section 860E(d).

68 See James M. Peaslee and David Z. Nirenberg, The Federal Income Taxation of Mortgage-Backed Securities 683 (1994) ("Section 7701(i) classifies a TMP as a corporation, but does not say whether the corporation is domestic or foreign. Accordingly, following the usual Code definitions, a TMP organized under U.S. domestic law would be a domestic corporation and any other TMP would be foreign. . . . A foreign TMP would be subject to U.S. tax only on certain passive income from U.S. sources and on income effectively connected with a U.S. trade or business it conducts [and] . . . a foreign corporation whose sole business activity is investing and trading in loans and securities would not itself be subject to any U.S. tax (including withholding tax).").

69 It follows (of course) that if Congress had only provided that a TMP is taxable as a domestic corporation, CDOs of mortgages and mortgage-backed securities would never have existed, the cheap mortgage financing of the 2000's would not have been available, and the housing recession would never have occurred.

70 There are several exceptions to qualifying as COD income, but they often require a quid pro quo, such as a dollar-for-dollar reduction of tax attributes. See generally section 108(b).

71 See section 108(e)(4) (referencing relationships described in section 267(b)); section 267(b)(10) (a corporation and a partnership are related if the same persons own more than 50 percent in value of the corporation and more than 50 percent of the capital interest or the profits interest in the partnership); section 267(c)(1) (stock owned by a partnership is considered as owned proportionately by the partners).

72 See section 108(e)(4); section 267(b)(3) (two corporations are related if they are members of the same controlled group); section 267(f) (defining control group by reference to section 1563(a), but substituting a 50 percent threshold for the usual 80 percent threshold under 1563(a)); section 1563(a)(2) (corporations are related only if five or fewer individuals or trusts own more than 50 percent of the vote and value of the two corporations).

73 The foreign corporation needs a tax treaty to avoid U.S. withholding tax on the interest paid to the foreign corporation. Although the foreign corporation would not be treated as related to the portfolio company for purposes of section 108(e)(4), the two corporations would be related for purposes of section 881(b)(2)(C).

74 See generally Sheppard, "Should COD Income Be Deferred?" Tax Notes, Feb. 16, 2009, p. 823, Doc 2009-3096, or 2009 TNT 29-4.

75 The foreign corporation needs a tax treaty to avoid U.S. withholding tax on the interest paid to the foreign corporation. Although the foreign corporation would not be treated as related to the portfolio company for purposes of section 108(e)(4), the two corporations would be related for purposes of section 881(b)(2)(C).

76 Modified AGI is AGI plus income excluded under section 911(a)(1) (less the deductions disallowed under section 911(d)(6) for the excluded income).

77 Section 1411.

78 See section 851(b) (flush language) (expressly treating amounts included in gross income under section 951(a)(1)(A)(i) or section 1293 as dividends to the extent that under section 959(a)(1) or section 1293(c), there is a distribution out of the E&P of the tax year that is attributable to the amounts so included).

79 LTR 8836037. There are other private letter rulings to this effect (see, e.g., LTR 9407007, 94 TNT 35-47), and one to the contrary (LTR 9043039). Congress cited the private letter rulings that treat subpart F inclusions as dividends favorably in the conference report to the Small Business Job Protection Act of 1996, H.R. Rep. 104-737, at 294 n.50 (Aug. 1, 1996).

80 Section 1411(c)(1)(ii) refers to "other gross income derived from a trade or business" described in section 1411(c)(2); section 1411(c)(2) refers to "a passive activity . . . with respect to the taxpayer," or a trade or business of trading in financial instruments or commodities (emphasis added).

81 The Medicare tax applies only to gross income. If subpart F and QEF inclusions are not themselves subject to the Medicare tax, distributions by a CFC or PFIC are distributions of previously taxed income that are excluded from gross income and the distributions would therefore also escape tax.

See section 959(a) (previously taxed income is excluded from gross income); section 1293(c) (if a taxpayer demonstrates that a distribution from a PFIC is paid out of profits of the company that were included in income under section 1293(a), the distribution is treated as a distribution that is not a dividend and, to the extent of the taxpayer's basis, is not included in gross income).

82 Treasury green book for fiscal 2012, supra note 3, at 131 ("Reduce the Value of Certain Tax Expenditures"). The same proposal was made in 2010. Treasury green book for fiscal 2011, supra note 2 ("Limit the Tax Rate at Which Itemized Deductions Reduce Tax Liability to 28 Percent").

83 For example, in New York, taxpayers with New York AGI that is greater than $1 million are unable to claim New York itemized deductions otherwise allowable except for 50 percent of the amount of their charitable contributions allowed under section 170. See N.Y. Tax Law section 615(f)(3). Only 25 percent of charitable deductions are allowable for taxpayers with New York AGI exceeding $10 million. N.Y. Tax Law section 615(g)(2).

84 Ariz. Rev. Stat. Ann. section 43-1042(A); Ark. Code Ann. section 26-51-436; Calif. Rev. & Tax. Code section 17073; Del. Code Ann. 30 section 1107; Ga. Code Ann. section 48-7-27(a); Hawaii 235-2.3; Idaho Form 40 Instructions; Iowa Admin. Code section 701-41.11; Kan. Stat. Ann. section 79-32,118; Kan. Admin. Regs. section 92-12-27; Ky. Rev. Stat. Ann. section 141.010(11); Md. Code Tax -- Gen. section 10-218(b)(3); Minn. Stat. section 290.01, subd. 19; Minn. Stat. section 290.01, subd. 22; Miss. Code Ann. section 27-7-17(3); Mo. Rev. Stat. section 143.141; Mont. Code Ann. section 15-30-2131; Mont. Code Ann. section 15-30-2132; Neb. Rev. Stat. section 77-2716.01(3); N.D. Cent. Code section 57-38-01(12); Ore. Rev. Stat. section 316.695(1)(c)(A); R.I. Gen. Laws section 44-30-2.6(c)(2)(C); S.C. Code Ann. section 12-6-560; S.C. Code Ann. section 12-6-570; Vt. Stat. Ann. 32 section 5811(21); Va. Code Ann. section 58.1-322(D); Va. Admin. Code 23 section 10-110-143.

85 JCT, supra note 45, at 78.

86 The original proposal contained a floor of only 1 percent and would have raised $13.20 billion. "Report of the Committee on Ways and Means on H.R. 3838 (The Tax Reform Act of 1985)," H.R. Rep. No. 99-426 (Dec. 7, 1985). The final version contained the 2 percent floor and was expected to raise $20.46 billion. JCT, supra note 45, at 81.

87 See Hawaii Rev. Stat. section 235-2.3(b)(29) and (33) (subpart F and the PFIC rules are inoperative); Hawaii Form N-11, p. 23 ("Owners of Certain Foreign Corporation": "Federal law requires that shareholders of [CFCs and PFICs] recognize certain income earned by these companies before the companies distribute dividends. Hawaii has no comparable provisions.").

88 Beck v. Commissioner, 52 T.C. 1, 6 (1969), aff'd per curiam, 433 F.2d 309 (5th Cir. 1970).

89 See Daniel S. Lange et al., "Foreign Corporation Earnings and Profits," 932 2d Tax Management Portfolio A-116 (2008).

90 See section 964(a). Very generally, sections 952(c)(3) and 964(a) provide that a CFC's or QEF PFIC's earnings and profits are determined under the same rules as for domestic corporations, except that adjustments for last-in, first-out recapture and installment sales, and the completed contract method of accounting, are disregarded, and E&P is not decreased by illegal bribes, kickbacks, or other payments described in section 162(c). The first set of adjustments (for LIFO recapture, installment sales, and the completed contract method of accounting) are designed to prevent CFCs from recognizing E&P (but no taxable income) in an early year (and thereby allowing 10 percent U.S. shareholders to avoid a subpart F inclusion in the early year) and taxable income but no current E&P in a later year, allowing 10 percent U.S. shareholders to avoid an inclusion in the later year by reason of the E&P limitation.

91 An ownership change occurs if the percentage of the stock of the loss corporation owned by one or more 5 percent shareholders increased by more than 50 percent by the 5 percent shareholders over a three-year rolling period. See section 382(g).

92 Section 382(e)(3) provides that except as otherwise provided in regulations, in determining the value of any old foreign loss corporation, there is taken into account only items treated as connected with the conduct of a trade or business in the United States.

One could read section 382(e)(3) to mean that foreign corporations that are not engaged in a trade or business in the United States are not subject to section 382. This view would have some support from the legislative history to the repeal of the chain deficit role of section 952(d). One reason for the repeal was that "loss trafficking with respect to foreign corporations is not restricted by any rule corresponding to the special anti-loss trafficking rule (Code sec. 382) applicable to U.S. corporations." See H.R. Rep. No. 99-841, at II-623 (1986).

However, in ILM 200238025, Doc 2002-21385, 2002 TNT 184-65, the IRS suggested that section 382(e)(3) means that the section 382 limitation for a foreign corporation without a U.S. trade or business is zero. And in FSA 003300 (Dec. 17, 1996), the IRS ruled that "section 382 probably would apply in computing a CFC's taxable income under Reg. section 1.952-2(b)."

I thank Robert Scarborough for pointing out this issue and the one discussed in the next footnote.

93 Reg. section 1.312-6(a) provides that E&P is dependent on the taxpayer's method of accounting. If section 382 represented a method of accounting, a section 382 limitation would apply equally to the calculation of E&P. However, the regulations refer only to the cash, accrual, and installment methods of accounting, and the accounting rules governing insurance companies as methods of accounting. And when Congress has intended to defer a loss for E&P purposes, it has done so expressly. See, e.g., section 312(f) (flush language) (losses disallowed under section 1091 do not reduce E&P); section 312(n)(1) (construction period carrying charges do not reduce E&P). Therefore, it appears that section 382 is not treated as a method of accounting for purposes of section 312.

94 See section 163(h). Personal interest expense is any allowable interest expense other than interest property allocable to a trade or business, investment interest, passive activity interest expense, qualified residence interest expense, underpayment interest expense under section 6601, and education loan interest expense.

95 National Commission on Fiscal Responsibility and Reform, supra note 34, at 31.

96 Rev. Rul. 75-515, 1975-2 C.B. 117 ("Charitable contributions in excess of the limitations therefor . . . are allowable in computing earnings and profits.").

97 See section 709(b)(1)(A) and (b)(3); reg. section 1.709-2(a).

98 See sections 1092 and 263(g).

99 Section 1211(b).

100 GCM 36314 ("The proposed revenue ruling concludes that expenses for key man and employee life insurance premiums in excess of cash surrender value, which are nondeductible under Code section 264, reduce corporate earnings and profits. We agree that these expenses clearly deplete the income available for distribution to stockholders and, thus, are a proper reduction of earnings and profits. This point is well-settled and is accepted by the Service."); LTR 7312200210A ("Among the items requiring a downward adjustment in earnings and profits are premiums on term life insurance which are disallowed in computing taxable income by section 264 of the Code.").

101 Because death benefits on a U.S. life insurance policy paid to a foreign corporation are subject to a 30 percent withholding tax, the U.S. taxpayer will probably wish to organize the foreign corporation in a treaty jurisdiction to qualify for benefits under a treaty.

102 Rev. Rul. 2004-47, 2004-1 C.B. 941, Doc 2004-9716, 2004 TNT 89-20. See section 265 (denying interest expense on indebtedness incurred or continued to purchase or carry tax-exempt obligations).

103 See Rev. Rul. 2004-47, Example 4 ("If the funds borrowed by a member of an affiliated group are directly traceable to a loan to another member that is a dealer in tax-exempt obligations, 265(a)(2) does not apply to disallow the interest expense of the lending member, but does apply to disallow a portion of the interest expense of the dealer.").

104 See section 264(e)(5) and (f)(8).

Under section 264(f), a taxpayer's disallowed interest expense is equal to the taxpayer's total interest expense (including the interest expense of its 50 percent controlled and controlling affiliates) multiplied by a fraction, the numerator of which is the "unborrowed policy cash values of life insurance and annuity contracts" and the denominator of which is the sum of the unborrowed policy cash values and the average adjusted bases of all the taxpayer's other assets. Section 264(f)(2).

The term "unborrowed policy cash values" is defined as "the excess of (A) the cash surrender value of such policy or contract determined without regard to any surrender charge, over (B) the amount of any loan in respect of such policy or contract." If the unborrowed policy cash values do not reasonably approximate the policy's actual value, the greater of the amount of insurance company liability or the insurance company reserve for that policy is used instead.

105 See section 264(f)(6).

106 Section 264(f)(6)((A)(ii). The coordination rule states that "the amount otherwise taken into account under paragraph (2)(B) [the denominator] shall be reduced (but not below zero) by the amount of such indebtedness."

107 It appears that loans and other indebtedness incurred or continued to purchase or carry a life insurance or annuity contract are treated as "loans in respect of such policy or contract" and reduce the numerator of the fraction used to calculate disallowed interest expense for purposes of applying section 264(f).

Section 265 contains a coordination rule similar to that contained in section 264. The coordination rule in section 265 unambiguously reduces both the numerator and denominator of the fraction used to calculate disallowance under subsection (b) and therefore reduces the amount of interest expense disallowed under subsection (b) to account for interest expense already disallowed under subsection (a). Congress's intent to provide mitigating, not penalizing, coordination rules to account for previously disallowed interest expense is evidenced in the operation of section 265.

108 See generally section 163(e)(5).

109 See section 163(i).

110 Section 163(e)(5)(A)(iii).

111 Section 163(e)(5)(A)(ii).

112 31 U.S.C. section 5314(a).

113 A foreign financial account includes specified bank accounts, securities accounts, and "other financial accounts" located in a foreign country. See "Draft Instructions to the Report of Foreign Bank and Financial Accounts -- Form TD F 90-22.1 (FBAR)" ("A financial account includes, but is not limited to, a securities, brokerage, savings, demand, checking, deposit, time deposit, or other account maintained with a financial institution (or other person performing the services of a financial institution). . . . A foreign financial account is a financial account that is located outside of the United States.").

114 The ownership threshold is more than 50 percent of the vote or value for a corporation, more than 50 percent of the interest in profits or capital for a partnership, or a beneficial interest in more than 50 percent of a trust's assets or current income. 31 C.F.R. section 103.24(e)(2)(ii) ("A United States person has a financial interest in each bank, securities or other financial account in a foreign country for which the owner of record or holder of legal title is . . . [a] corporation in which the United States person owns directly or indirectly more than 50 percent of the voting power or the total value of the shares [or] a partnership in which the United States person owns directly or indirectly more than 50 percent of the interest in profits or capital."); 31 C.F.R. section 103.24(e)(2)(iv) ("A United States person has a financial interest in each bank, securities or other financial account in a foreign country for which the owner of record or holder of legal title is . . . [a] trust in which the United States person either has a beneficial interest in more than 50 percent of the assets or from which such person receives more than 50 percent of the income.").

115 31 C.F.R. section 103.24(e)(3) ("A United States person that causes an entity . . . to be created for a purpose of evading [FBAR] shall have a financial interest in any bank, securities, or other financial account in a foreign country for which the entity is the owner of record or holder of legal title.").

116 Sheppard, "FBAR Regulations Preserve Tax Evasion Opportunities," Tax Notes, Mar. 15, 2010, p. 1295, Doc 2010-5096, 2010 TNT 49-1 ("If a nominee holds title to the account on behalf of a foreign corporation that is 50 percent owned by a U.S. person, a hyperliteral reading of the rules would say that no one is required to file FBAR for that account. The antiabuse rule would not catch this case, because it only applies when the entity is the legal owner of the account.").

117 See 31 C.F.R. section 103.24(e)(1) ("A United States person has a financial interest in each bank, securities or other financial account in a foreign country for which he is the owner of record or has legal title whether the account is maintained for his own benefit or for the benefit of others.").

118 See 31 C.F.R. section 103.24(e)(3).

119 Section 511(a)(1); reg. section 1.511-1. See also sections 512 and 513. Charitable remainder trusts must forfeit all their UBTI. Section 664(c)(2)(2) (imposing a 100 percent excise tax on a charitable remainder trust's UBTI).

120 Sections 512(a), 513(a), and section 512(b); reg. section 1.512(b)-1 (excluding from the definition of UBTI specified income, such as capital gains, dividends, royalties, interest income, some rental income, securities lending income, annuities, income from notional principal contracts, loan commitment fees, options, and other "passive investment income"). However, some of these payments do result in UBTI if they arise from related parties and are deductible by them. Section 512(b)(13).

121 Section 514(b) and (c) and section 512(c) (the borrowing activities of a partnership are attributed to its tax-exempt partners for purposes of calculating UBTI).

More specifically, debt-financed property generally includes any income-producing property for which there is acquisition indebtedness at any time during the year (or during the preceding 12 months, if the property is disposed of during the year). Acquisition indebtedness is defined to include (a) "indebtedness incurred in acquiring or improving the property"; (b) "indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement"; and (c) "indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement" (emphasis added). Section 514(b) and (c).

122 See note 79.

123 See LTR 200251016, Doc 2002-27816, 2002 TNT 246-32; LTR 200252096, Doc 2003-96, 2002 TNT 250-78; and LTR 200315028, Doc 2003-9318, 2003 TNT 71-41.

124 Section 7701(o).

125 Rev. Rul. 2006-1, 2006-1 C.B. 261, Doc 2005-25446, 2005 TNT 242-15. "Good RIC income" is income described in section 851 that permits a RIC to qualify as a regulated investment company and claim a dividends paid deduction.

This section borrows heavily from David H. Shapiro and Jeffrey W. Maddrey, "IRS Implicitly Rules on Economic Substance Doctrine and Blockers," Tax Notes, Mar. 21, 2011, p. 1461, Doc 2011-4752, or 2011 TNT 55-6 . I am indebted to David Shapiro for bringing his article to my attention.

126 As Shapiro and Maddrey point out, early versions of the act would have allowed RICs to trade commodities, but the provision was removed by a voice vote in the Senate.

127 Shapiro and Maddrey describe one ruling -- LTR 200743005, Doc 2007-22919, 2007 TNT 199-25 -- in which the IRS recited that the subsidiary was formed to "enhance the performance of its portfolios and to better reflect the pricing of the commodities markets."

128 Section 269 applies to the formation of a new corporation. See James Realty Co. v. United States, 280 F.2d 394 (8th Cir. 1960) (incorporation of a real estate holding company constitutes an acquisition under section 269).

129 11 T.C. 411 (1948).

130 11 T.C. at 417.

In Coastal Oil Storage Co. v. Commissioner, 242 F.2d 396 (4th Cir. 1957), the court held that the predecessor to section 269 did disallow a surtax exemption and minimum excess profits credit when the taxpayer contributed property to a wholly owned subsidiary. Although the Tax Court had held for the taxpayer under the reasoning in Commodore Points, the Fourth Circuit reversed on the grounds that Coastal Oil Storage could claim the surtax exemption and minimum excess profits only by reason of the parent's contribution of property to it and because Congress stated that section 129 (the predecessor to section 269) was intended to deny the surtax exemption and minimum excess profits credit. However, Commodore Points does remain good precedent for tax-exempt organizations that invest in foreign blocker corporations -- the tax-exempt organization's allowance (i.e., exemption from UBTI) is not dependent on contribution of property, and there is no mention of UBTI in the legislative history to section 269.

131 Rocco Inc. v. Commissioner, 72 T.C. 140 (1979) ("a benefit which defers the tax burden does not result ultimately in the avoidance or evasion of tax"); Siegel v. Commissioner, 45 T.C. 566 (1966), acq. 1966-2 C.B. 3 (1966); Bijou Park Properties v. Commissioner, 47 T.C. 207 (1966) (section 269 does not apply when "the benefit involves nonrecognition of income and not a 'deduction, credit or other allowance'"); Cherry v. United States, 265 F. Supp. 969 (C.D. Ca. 1967) ("statutory provisions dealing with non-recognition of gain . . . are not encompassed or rightfully described by the terms 'deduction', 'credit' or 'allowance' and, quite plainly section 269 does not deal with nonrecognition concepts"). Compare reg. section 1.269-1(a) (the term "allowance" refers to anything in the internal revenue laws that has the effect of "diminishing" tax liability) with prop. reg. section 301.6111-3(c)(7) (a "tax benefit includes deductions, exclusions from gross income, nonrecognition of gain . . . , and any other tax consequences that may reduce a taxpayer's Federal tax liability by affecting the amount, timing, character, or source of any item of income, gain, expense, loss, or credit.").

While the IRS has asserted that an acquisition for the purpose of relying on a nonrecognition provision is subject to section 269, the IRS candidly acknowledged that its position is contrary to case law. See, e.g., TAM 200204002, Doc 2002-1932 , 2002 TNT 18-19 ("The Service recognizes the existence of counter authorities to the use of section 269 to prevent nonrecognition treatment. . . . The Service disagrees with these authorities.").

132 Section 7701(o)(1)(A) and (B).

133 Section 7701(o)(2)(A).

134 Section 7701(o)(2)(B). Also, under section 7701(o), any state or local tax income tax effect that is related to a federal income tax effect is treated in the same manner as a federal income tax effect, and a financial accounting benefit is not treated as a nontax purpose for a transaction.

135 Section 6662(i).

136 JCT, "Technical Explanation of the Revenue Provisions Contained in the 'American Workers, State and Business Relief Act of 2010,' as Passed by the Senate on March 10, 2010," JCX-11-10 (Mar. 11, 2010), at 189, Doc 2010-5371, 2010 TNT 48-12.

137 45 T.C. 566 (1966), acq. 1966-2 C.B. 3.

138 485 U.S. 340 (1988).

139 45 T.C. at 574 ("We have accepted the conclusion on the record, although without strong conviction, that [Siegel] was in fact moved by these considerations in substantial part, in incorporating" the Panamanian corporation.).

140 Id. (quoting Aldon Homes Inc. v. Commissioner, 33 T.C. 582, 597 (1959)).

141 The court also concluded that because Siegel's only benefit was deferral, section 269, "by its terms, does not apply here." 45 T.C. at 574.

142 The JCT's "but see" citation to Bollinger with the parenthetical, "agency principles apply to title-holding company under the facts and circumstances," is similarly perplexing. The taxpayer in Bollinger attempted to reduce state taxes by establishing corporations to hold title to certain real property. The documents all made clear that the corporations were acting as agent of a partnership (which was the beneficial owner of the property), and the court held for the taxpayer. While Bollinger might provide support for disregarding a foreign corporation under agency principles, it does not concern the economic substance doctrine.

143 If the foreign corporation fund qualifies for the benefits of an income tax treaty, U.S.-source dividends received by the foreign corporation fund may be eligible for a reduced rate of withholding tax. For example, if the foreign corporation were organized in Ireland as a section 110 company or collective investment unit trust that qualifies for the benefits of the income tax treaty with Ireland, U.S.-source dividends received by the fund would be eligible for a 15 percent rate of withholding. See Convention Between the Government of the U.S. and the Government of Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income and Capital Gains, article 10.

144 See reg. section 1.1295-1(d)(3) (a QEF election applies only to the foreign corporation for which the election was made).

145 See section 1295; reg. section 1.1295-1(d).

146 See Robert A.N. Cudd, "Recent Developments Affecting Life Insurance Investors," Tax Notes, Feb. 8, 2010, p. 751, Doc 2010-728, or 2010 TNT 26-6 (discussing the use of an Irish company to purchase and own life insurance policies and single premium immediate annuities).

147 However, for an investor to make a QEF election, the foreign corporation must agree to make some information available to the investor. See section 1295(a); reg. section 1.1295-1(g).

148 See section 902 (deemed paid FTC available only for domestic corporation that owns 10 percent or more of the voting stock of a foreign corporation).

Finally, borrowing through a foreign corporation rather than directly may reduce a U.S. corporate taxpayer's ability to use its U.S. FTCs, at least until section 894(f) becomes effective (if ever). (I thank William Burke for this observation.)

149 The provisions discussed in this section were originally introduced in FATCA but were enacted as part of the HIRE Act. FATCA was never enacted.

150 Section 1471(a). (The 30 percent withholding tax does not, however, apply to payments on (and the proceeds from) obligations that are outstanding on March 18, 2012. The term "obligations" is not defined in the HIRE Act.)

151 Section 1472(d) broadly defines an FFI to include any foreign entity that (i) accepts deposits in the ordinary course of a banking or similar business, (ii) holds financial assets for the account of others as a substantial portion of its business, or (iii) is engaged (or holds itself out as being engaged) primarily in the business of investing, reinvesting, or trading in financial assets (including securities, partnership interests, commodities, or any interest in such securities, partnership interests, or commodities). Therefore, in addition to foreign investment and commercial banks and foreign insurance companies, most foreign hedge funds, foreign blocker corporations, foreign collateral debt obligation issuers, foreign private equity funds, and other foreign securitization vehicles are treated as FFIs that must enter into an agreement with Treasury or be subject to the withholding provisions. Any FFI that is more than 50 percent owned by an FFI or is greater than 50 percent commonly owned with the financial institution is considered part of the same expanded affiliate group as the FFI and is subject to the same reporting and withholding requirements. Thus, if an FFI enters into an agreement with Treasury, all other FFIs that are also members of the expanded affiliate group are required to comply with the agreement.

152 Section 1471(c)(1).

153 Section 1471(b)(1)(B); see JCT, "Technical Explanation of the Revenue Provisions Contained in Senate Amendment 3310, the Hiring Incentives to Restore Employment Act, Under Consideration by the Senate," JCX-4-10 (Feb. 23, 2010), Doc 2010-3976, 2010 TNT 36-19.

154 Section 1471(b)(1)(F).

155 Section 1471(b)(1)(D) and (b)(3).

156 The foreign corporation will be an FFI. Under section 1471(b)(1)(D), the hedge funds will be required to deduct and withhold on any "passthru payments" (i.e., payments reflecting U.S.-source income) made to an FFI (i.e., the foreign corporation) that fails to enter into an agreement with Treasury.

157 Very generally, a substantial U.S. owner is a 10 percent owner. More specifically, it is: (i) for a corporation, any specified U.S. person that owns, directly or indirectly, more than 10 percent of the vote or value of a corporation; (ii) for a partnership, a specified U.S. person that owns, directly or indirectly, more than 10 percent of the profits interests or capital interests of the partnership; (iii) for a grantor trust, any specified U.S. person that is an owner; or (iv) for a trust that is not a grantor trust, to the extent provided by the IRS, any specified U.S. person that holds, directly or indirectly, more than 10 percent of the beneficial interests in the trust.

A "specified U.S. person" is any U.S. person, other than (i) a corporation whose stock is regularly traded on an established securities market (or any member of the expanded affiliated group (as defined under section 1471(e)(2))) of that corporation, (ii) any section 501(a) tax-exempt organization or an IRA, (iii) the United States and its wholly owned agencies and instrumentalities, (iv) states and possessions, (v) banks, (vi) REITs, (vii) regulated investment companies, (viii) common trust funds, and (ix) charitable remainder trusts. See section 1473(2) and (3).

158 This withholding tax also begins on January 1, 2013, and does not apply to payments on (and the proceeds from) obligations that are outstanding on March 18, 2012.

159 See section 6038B; reg. section 1.6038B-1(b)(3). Failure to file Form 926 subjects the taxpayer to a penalty equal to 10 percent of the fair market value of the property at the time of the exchange, up to a maximum of $100,000, unless the failure was the result of intentional disregard (in which case, there is no maximum). Section 6038B(c)(1) and (2). However, the penalties do not apply if the failure to disclose is the result of reasonable cause and not willful neglect. Section 6038B(c)(2).

160 See section 6038(a) and (e); section 6046(a)(1)(B); reg. section 1.6038-2(a). The penalty for failure to file Form 5471 is $10,000 per year and increases up to $50,000 if the failure is not corrected within 90 days following notification from the IRS. Section 6679(a). The penalty does not apply if the failure is the result of reasonable cause. Section 6679(a)(1).

161 See Instructions to Form 8621; prop. reg. section 1.1291-1(i). There is no specific penalty for failure to file Form 8621.

162 Section 1298(f). See Notice 2010-34, 2010-17 IRB 612, Doc 2010-7577, 2010 TNT 66-7 ("shareholders of a PFIC that were not otherwise required to file Form 8621 annually prior to March 18, 2010, will not be required to file an annual report as a result of the addition of section 1298(f) for taxable years beginning before March 18, 2010").

163 See section 6038D(a). An individual's foreign financial assets are presumed to be worth more than $50,000 unless the individual provides sufficient information to demonstrate the value of the assets. Section 6038D(e).

164 Section 6038D(b)(2)(A).

165 Likewise, investments in the U.S. property would be includable to the extent of taxable income. FTCs would be based on the proportion that the CFC's includable income bears to the CFC's total taxable income for the year.

166 This is not an entirely novel suggestion. See Earnings and Profits Working Group of the American Bar Association, "Elimination of 'Earnings and Profits' From the Internal Revenue Code," 39 Tax Law. 285 (1986). See also Walter J. Blum, "The Earnings and Profits Limitation of Dividend Income: A Reappraisal," 53 Taxes 68 (1975); William D. Andrews, "Out of Its Earnings and Profits: Some Reflections on the Taxation of Dividends," 69 Harv. L. Rev. 1403 (1955-1956).

167 See ABA Earnings and Profits Working Group, supra note 163, at 322-324.

168 Id. at 324.

169 Id. Other technical changes are described in "Elimination of Earnings and Profits."

170 See Sheppard, supra note 74.

171 The REMIC rules ensure that the excess inclusion income that results when a fixed-rate pool of mortgages that is financed with "time-tranched" debt is subject to tax in all events. However, if foreign TMPs were subject to a corporate tax, their income would often be subject to two levels of tax (rather than the single tax imposed by the REMIC rules). Moreover, the TMP rules are far broader than the REMIC rules, so entities that could not even qualify as REMICs would be subject to tax.


END OF FOOTNOTES

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