Congress continues to focus on tax-shelter activity.

Based on a recent spurt of legislative activity, Congressional Democrats believe that corporations and wealthy individuals are sheltering taxable income from the federal government at an alarming rate. Despite evidence that tax-shelter activity is down significantly over the past decade, many Congressional leaders perceive an ongoing problem. Congress is now eyeing legislative proposals to codify the "economic substance" doctrine, and to punish companies with subsidiaries engaging in business activities in "tax haven" countries.

The economic substance doctrine is not new. U.S. tax courts have long understood the importance of evaluating whether businesses are engaging in business transactions for sound economic reasons rather than to lower their tax bills. To help do this, the courts created--and subsequently developed--both an "economic substance" test and a "business purpose" test.

Congressional leaders believe these judicially created tests are too narrow, and have embraced more comprehensive--and vaguely worded--legislative language. As passed by the Senate Finance Committee, the economic substance provision would establish a two-part test on economic substance. The taxpayer must establish that (1) the transaction changes in a meaningful way the taxpayer's economic position; and (2) the taxpayer has a substantial non-federal tax purpose for entering into the transaction.

The proposal is problematic for several reasons. First, it would impose a strict liability underpayment penalty of 30 percent on transactions lacking economic substance. Given that economic substance and business purpose are inherently imprecise, subjective determinations, the penalties are overly harsh. Second, the proposal requires demonstration that the transaction be a reasonable means of accomplishing the taxpayer's non-tax purpose--but there are no guidelines on how this requirement should be interpreted and applied.

Similarly, several legislative proposals have been introduced this year to address perceived abuses involving "tax haven" countries, whose usage, proponents contend, reduces federal revenues by approximately $100 billion. To this end, Sen. Byron Dorgan (D-N.D.) has introduced a bill (S. 396) to treat certain controlled foreign corporations located in specified tax haven countries as domestic corporations for federal tax purposes.

'Offshore Secrecy' Jurisdictions

Moreover, Sen. Carl Levin (D-Mich.) has introduced legislation (S. 681) to establish certain legal presumptions against the validity of transactions involving "offshore secrecy jurisdictions." The bill would grant the Internal Revenue Service more time to review tax returns involving these jurisdictions, and would disallow tax advisor opinions validating transactions involving such jurisdictions. Finally, Rep. Richard Neal (D-Mass.) has introduced a bill (H.R. 1672) to deny the 15 percent tax rate on foreign dividends for companies created or organized in countries lacking "comprehensive" income tax treaty systems.

As drafted, these tax haven proposals are troubling. For one, the list of tax-haven countries in these bills is based on an outdated list prepared by the Organization for Economic Cooperation and Development (OECD) in 2000. Since then, the overwhelming majority of the countries identified have improved their transparency and information exchange.

In fact, only five jurisdictions identified in the original list remain uncooperative. And, those five (Andorra, Liechtenstein, Liberia, Marshall Islands and Monaco) account for approximately 0.1 percent of the $400 billion in income earned by foreign affiliates each year.

These tax haven proposals also ignore why U.S. multinationals establish foreign subsidiaries in low-tax jurisdictions. The subsidiaries are not created simply as a "tax dodge," but to facilitate the free flow of money between and among U.S. multinationals' worldwide operations, helping U.S. companies remain competitive with overseas counterparts, none of whom labor under a worldwide system of taxation. Also, a lower foreign tax burden ensures that U.S. multinationals will pay more in U.S. taxes when foreign-source earnings are repatriated.

While these legislative proposals are just that, the steady rate at which they are being introduced should give the business community pause. On many fronts, Congressional leaders are demonstrating not only that they view the business community as a ready source of taxable income, but that they distrust the way in which business enterprises are managed and governed.

The tax haven proposals discussed above are especially troubling because they incorporate outdated information about tax jurisdictions. The proposals also demonstrate a fundamental misunderstanding of how U.S. multinationals operate, and why forming subsidiaries in low-tax jurisdictions benefits not only the multinationals, but the U.S. treasury.

FEI's Committee on Taxation (COT) will continue to engage policymakers on these important matters. If you would like more information about COT, or would like to join the group, please contact Mark Prysock at FEI.

Mark Prysock ([e-mail]) is Director of Public Affairs and General Counsel in FEI's Washington, D.C, office.