BONUS CONTENT: The History of Subpart F

John F. Kennedy is one of the most beloved former U.S. presidents, less for what he actually accomplished than for the promise he represented. Had he not been killed by an assassin’s bullet sixty years ago, he may well have been remembered as an inconsequential president. While he spoke eloquently about civil rights, only his predecessor, Lyndon Baines Johnson, could get landmark legislation on it through Congress.

In our little world of international taxes, however, Kennedy may be one of the most impactful presidents of the 20th century. His tax agenda, most significantly enacting Subpart F, has come to define much of today’s global tax system. It set precedents about how to best deal with international tax avoidance issues that are still followed.

The origin story of Subpart F is a reminder of how seemingly small decisions and compromises can have substantial effects, both wider and longer-lasting than anyone at the time contemplated. It’s also a demonstration of how the battle with tax avoidance–however it’s defined–is a constant, nearly unwinnable one in the long term. While today’s tax avoidance techniques take advantage of new technologies and the online sphere, they’re uncannily similar to structures which Congress has tried to stamp out for more than a century.

Which is not to say we shouldn’t try. But it does help to take the long, retrospective view.

The context of Subpart F’s enactment was the surge of international investment by U.S. multinationals in the wake of World War II and the Marshall Plan, as well as lingering high corporate and individual income tax rates. (The corporate rate was 52% when Kennedy took office.)

Kennedy, having promised during his campaign to “get America moving again,” in 1961 asked Congress to reform the tax system, especially in regard to international taxes. Aside from more incentives for innovation, Kennedy said the system needed to be updated to nix “certain defects and inequities.”

In his message to Congress, he claimed that U.S. companies used “artificial arrangements between parent and subsidiary regarding intercompany pricing, the transfer of patent licensing rights, the shifting of management fees, and similar practices which maximize the accumulation of profits in the tax haven” to “reduce sharply or eliminate completely their tax liabilities both at home and abroad.”

Sound familiar?

At the time, companies could avoid paying any tax on foreign earnings indefinitely, by deferring the repatriation of that income. Kennedy wanted to end that for most situations–eliminating deferral for “developed” countries and ending “tax haven deferral” anywhere.

Congress balked at a broad end to deferral but ultimately agreed to the latter prohibition, which meant the immediate taxation of passive income from related-party transactions. They sent Kennedy a bill, the Revenue Act of 1962, which created Subpart F (named for its place in the Internal Revenue Code) to capture income from interest, rent and royalties, including some exceptions for when they’re earned through an active business. These types of income were seen as the main problem, as they’re easy to move to a low-tax jurisdiction without much workforce.

Kennedy signed the legislation, stating that it accomplished the broad goals he set out in his original request. But some members of his administration cautioned that ending deferral more broadly would be a simpler solution–in language that some might say turned out to be eerily prescient.

Douglas Dillon, the U.S. Treasury Secretary at the time, said that to use targeted anti-deferral rules, “we think you would have to develop a very complex body of law which would probably have to be changed rather frequently in the light of experience to keep up with the legal ingenuity of those who wish to make use of these tax havens.” (Quote taken from this 2000 Treasury report on Subpart F’s history.)

Subpart F would indeed be changed many times over its 60-year history, although not everyone agrees the changes were always for the better. In particular, the “check-the-box” regulations issued by the Clinton Administration in the late nineties allowed companies, in effect, to shield some foreign-to-foreign related-party transactions that would have otherwise fallen under Subpart F. Those rules were largely criticized, but were allowed to stay in effect and still exist today.

Despite this, sweeping up passive income became a powerful tool for the IRS. And other countries took notice–most have now adapted their own similar rules, called controlled foreign corporation rules, although not all are as strong. Even after the 2017 Tax Cuts and Jobs Act, which eliminated deferral and exempted most foreign income from taxation, the Subpart F regime remains one of the most important parts of the U.S. international tax code.

It could get caught up in a constitutional challenge to the TCJA’s repatriation tax, although at this point the Supreme Court justices seem skeptical. Even the plaintiff in that case argued that Subpart F should be protected, as Congress clearly saw that those types of income could be used to shift income that should have been properly recorded in the U.S.

That central concept has remained one of the guiding principles in international tax discussions, still as relevant today as it was in 1961.

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