Just over a week ago, David Miller of Cadwalader, Wickersham & Taft LLP appeared at our colloquium to present his paper, Unintended Consequences: How U.S. Tax Law Encourages Investment in Offshore Tax Havens. I didn't post on it earlier because I was off at the crack of dawn the next morning to give an international tax policy talk in Washington, and then this week was pretty full.
I would argue that one word in the title should be changed so that it more accurately reflects the paper's content. It should say, after the colon, "How U.S. Tax Law Encourages INCORPORATION in Offshore Tax Havens." That's what the paper is about - not moving actual resources to tax havens, but using foreign incorporation, in a country with very limited if any income taxes, to advance assorted types of fun and games in reducing one's U.S. income tax liability.
A central underlying point of the paper is that an act that may have essentially zero economic substance or significance - establishing a legal entity abroad and then running income and/or deduction items throughout - can have large tax consequences. This might be bad for either of two reasons: (a) people are using foreign incorporation to achieve tax results that we dislike, or (b) even if we don't mind their avoiding a particular result, e.g., because it reflects a bad rule, the avoidance should not be conditioned on pointless paper-shuffling, either because that's wasteful or because not everyone can do it. Rationale (b), of course, is a bit less robust, since it's unclear how hard we should want to fight to curb legal avoidance (even if based on trivial and wasteful paper-shuffling) or bad rules.
A broader underlying point is that U.S. tax law (and that of everyone else) relies, presumably for administrative reasons, on two awkward fictions: that legal entities should be treated (and taxed) as distinct from their owners, and that the notion of corporate residence makes sense (and that where a company is incorporated has any normative interest from a tax policy perspective).
The early part of the paper discusses deferral by U.S. companies with foreign subsidiaries abroad. It cites information that tellingly makes the case about how oddly profitable U.S. multinationals' subsidiaries in tax havens, as distinct from anywhere else, turn out to be, according to the companies' tax accounting. However, while basing deferral on the use of a foreign subsidiary rather than a branch is nonsensical (as proponents of both worldwide and territorial taxation mutually recognize), this does not tell us anything about whether subs should be treated like branches (as under a worldwide system), or branches like subs (which would be step 1 towards establishing a territorial system, although step 2 would be dividend exemption). But David recognizes this, and arguing for a worldwide system was not the paper's agenda.
The main part of the paper describes a huge range of situations in which individuals can change their tax treatment for the better by running things through a tax haven company that is bordering on fictional. But some of the rules that people can avoid have greater merit than others. For example, suppose recent proposals to convert particular itemized deductions into 28 percent credits were enacted. (The aim is to reverse the current approach under which high-bracket individuals get a larger subsidy per dollar deducted, and low-income individuals a smaller one, than those in the 28 percent bracket.) High-income taxpayers might be able to avoid this rule by creating shell entities in the Caymans that would nominally deduct the items, reducing their earnings and profits, and thus eventually the true taxpayer's income at a 35 percent rate. This is a bad result if one believes, as I do, that the 28 percent credit rule might be a good policy change.
But then again, consider high-income individuals' use of the very same trick to avoid the rule denying miscellaneous itemized deductions except to the extent that they exceed 2 percent of the taxpayer's adjusted gross income. This is pretty much a stupid rule that denies deductions for true costs of earning income (e.g., an investment advisor's fee that resulted in the taxpayer's earning includable income). While what's going on is exactly the same, in this case one might be less eager to crack down given the problems with the underlying rule.