Tax Foundation, Rethinking U.S. Taxation of Overseas Operations: Subpart F, Territoriality, and the Exception for Active Royalties:

• A conflict between those who seek to discourage tax sheltering by requiring U.S. firms to pay taxes on all their activity (“worldwide” system), and those who seek to only tax corporate activity in the U.S. and leave overseas activity to other coun­tries (“territorial” system), led to the enactment of the poorly designed compromise IRS Code Subpart F in 1962.
• Under Subpart F, “active” income can be deferred from U.S. tax until repatriated home, while “passive” income (royalties, interest, dividends) is generally subject to immediate U.S. taxation.
• Since 1996, “check the box” regulations have mitigated many of the harmful effects of Subpart F but political pressure to expand U.S. taxation of overseas activity continues.
• As one example of the complexity of Subpart F, royalty income from active business operations involving related firms cannot be deferred even though it by definition cannot be tax-haven activity.
• The U.S. should consider moving toward a territorial system, and in the meantime should review Subpart F for policies that discourage legitimate overseas business activity.