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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Wednesday, September 28, 2011

'Check-the-Box' Fuels International Tax Avoidance

Pro Publica, Corporations Couldn’t Wait to ‘Check the Box’ on Huge Tax Break:

A simple rule meant to cut paperwork for U.S. companies has grown into one of the biggest multinational tax breaks around, costing the United States and other governments billions of dollars in lost taxes each year.

It thrives thanks to determined business support, including a campaign two years ago that forced the Obama administration to retreat from altering it and tax professionals worldwide who exploit its benefits.

The rule is dubbed “check-the-box.” It allows U.S. companies to strip profits from operations in high-tax countries simply by marking an IRS form that transforms subsidiaries into what the agency calls a “disregarded entity.” Others have labeled them “tax nothings.”

Check-the-box allows companies to avoid the normal 35% U.S. corporate tax on certain types of income. The Treasury Department estimates that annual revenue losses from check-the-box have hit almost $10 billion. Other countries are also said to lose billions as income is shifted to places with low or no taxes, although there is no official estimate.

The impact of check-the-box goes beyond the drain on government coffers. The rule, along with other tax provisions, has helped fuel explosive growth in foreign investment by American corporations. Since 2004, the earnings that U.S. companies keep overseas have doubled to about $1.8 trillion. ...

Check-the-box is but one of many forms of “tax arbitrage”—the art of exploiting differences in countries’ tax systems. It can reduce taxes all by itself or figure into more complex transactions. As the Financial Times and ProPublica reported Monday, the IRS in recent years has clamped down on what it views as abusive arbitrage deals involving foreign tax credits.

But check-the-box lives on. It is not among loopholes targeted by Obama’s new plan. Its untouchable status—the government has twice tried to kill it and balked—provides a case study in how a billion-dollar tax break was born by mistake, then protected by the power of

In the mid-1990s, U.S. companies were creating a growing number of domestic entities. The new rule said that, by simply checking a box on IRS Form 8832, businesses could declare them as corporations or partnerships.

But within days of its announcement in 1996, tax lawyers were on the phone saying the Treasury Department had overlooked the international ramifications. Inadvertently, the government had provided a way for companies to move profits from subsidiaries in high-tax countries like Germany to Luxembourg, the Caymans or other jurisdictions with lower or no taxes on certain kinds of income. Often, this is done by making royalty or interest payments between operations in different countries.

For decades, the IRS has had anti-abuse rules to make sure such payments could be subject to taxes. However, these rules generally don’t apply to payments made within a corporation. Check-the-box made it simple for a company to designate a subsidiary as a branch, with no U.S. tax consequences for the income unless it is repatriated. ...

By March 2000, Treasury reported the existence of nearly 8,000 “disregarded entities.” A paper by Heather M. Field, an associate professor at the University of California’s Hastings College of the Law in San Francisco, found that tens of thousands more were created between 2001 and 2006. ...

Check-the-box continued unchallenged until 2009, when Obama took office. In his first budget proposal, the president made closing tax loopholes a top revenue-raising goal. And in the international area, check-the-box was his top target, the biggest revenue raiser in a list of 11 reforms.

Again, corporate opposition was swift. Philip D. Morrison, a tax lawyer at Deloitte Tax, wrote in a prominent tax journal that the Obama proposal on check-the-box was “ridiculous,” and he faulted the administration for overheated rhetoric and a “deep cynicism.” Morrison said the business community had already fought—and won—this battle in 1998. ... The Obama administration quickly retreated.

(Hat Tip: George Mundstock.)

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The critics of the check-the-box regime for entity classification make a compelling point. But going back to a common law approach to classifying foreign entities, as C corporations versus passthroughs, as under the old Kintner regulations, would not eliminate the abusive international tax planning of which the critics complain. Before the check-the-box regulations came out, everybody was doing this stuff. It just wasn't quite so convenient, and the tax result less certain.

Posted by: Jake | Sep 28, 2011 2:54:01 PM

This is one of my favorite topics. As long as the special interests are able to throw as much money as they can now in order to maintain the status quo, check the box will never go away. Some of the most prolific lobbying expenditures in recent history have been spent protecting these rules.

It would be really interesting to see what might happen if President Obama grew some courage and tried to tackle what is the multi-trillion dollar extra-national cash buildup that is the result international tax arbitrage via the check the box regulations. With more and more companies becoming tax savvy early on in their development, in the quickly diminishing spectrum of the international marketplace, the most valuable assets (IP) are getting tossed overseas before they are developed into billion dollar products. It is an absolute miracle that companies like Apple and to an extent Google (already checking out of America and moving on to greener pastures like Ireland) still develop and create products here in America.

The alternative, however, is potentially very risky. Business models are made on the ability to avoid US corporate income tax by storing assets overseas and building up huge cash supplies outside of the country. I sometimes wonder what it might do to the economy if Congress were to eliminate the check the box structuring schemes from the toolbox of the tax practitioner.... any thoughts??

Posted by: TaxLawyer | Sep 30, 2011 8:32:50 AM