Watch Out for the Expense-deferral Rule

For his part, Reidy says that the administration's characterization of the check-the-box or passive income rule as a "loophole" is "grossly misleading," especially since it relates to a regulatory regime set up during the Clinton Administration.

According to the Treasury Department, the passive income rule is legal. The problem, says the Obama Administration, is that it has resulted in the shift of "billions of dollars in investment from the U.S. to other countries." Essentially, current law allows U.S. businesses to establish foreign subsidiaries in a tax haven, and then categorize income that is shifted between the haven subsidiary and other foreign subsidiaries - for instance through interest on loans - as passive income for the U.S. parent, which subject to U.S. tax.

However, the decade-old check-the-box rule allows U.S. companies to disregard the subsidiaries for tax purposes, so income can be shifted among them without reporting any passive income or paying the attendant U.S. taxes. The Treasury Department provides a hypothetical example to make its point: A U.S. company invests $10 million to build a new factory in Germany. At the same time it sets up three new corporations: one a wholly owned Cayman Islands holding company, the second a German company owned by the holding company that also owns the factory, and the third a Cayman Islands subsidiary, also owned by the holding company.

The Cayman subsidiary makes a loan to the German subsidiary. The interest on the loan is income to the Cayman subsidiary and a deductible expense for the German subsidiary, so income is shifted from the higher-tax region of Germany to the no-tax haven of the Cayman Islands. Under existing U.S. tax law, the income shift would count as passive and taxable income for the U.S. parent. But the passive income rule allows the company to make the two subsidiaries and the passive income "disappear" via a check-the-box option. As a result, the company is able to avoid U.S. and German taxes on its profits, says the Treasury Department.

Obama's proposals are not slated to take effect until 2011, but will spark "spirited debate" among lawmakers in the meantime, says Willens.

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