Treasury promulgated the check-the-box regulations in 1996 and almost immediately regretted them, because it wasn’t just tax lawyers who were about to benefit -- U.S. multinationals would also be heavy beneficiaries. And not just because of their ability to pick between partnership and corporate entities was now much easier. The check-the-box rules allowed multinationals to create entities that were treated one way in a foreign jurisdiction and another by the United States. These entities, so-called hybrids, are at the core of companies like Apple’s tax strategies, and they have been used to bring about obscenely low effective tax rates (2.3 percent on $700 billion in foreign earnings, according to the Obama administration).
How is that done? Multinationals can use disregarded loans to strip earnings out of high-tax jurisdictions and relocate those profits to low- or even no-tax countries. The simplest structure involves a disregarded entity in a tax haven making a loan to a subsidiary in a foreign jurisdiction. The United States recognizes neither the loan nor the interest payments. The foreign country, however, will view the tax haven entity as a corporation and allow the interest to be deducted as a business expense, thereby reducing both tax paid in the foreign jurisdiction and U.S. subpart F income. Transactions have obviously grown much more complex as companies have become familiar with the check-the-box rules and Treasury’s largely ineffective attempts to tighten them.
Treasury tried to repeal the check-the-box rules in 1998, or at least change how they applied to subpart F income. But businesses were ready. According to the Financial Times, corporate lobbyists successfully persuaded Congress that if check-the-box were eliminated, businesses would be paying higher taxes not just to the United States, but also to high-tax foreign countries such as France. The strategy was successful. Then-Senate Finance Committee Chair William Roth pushed through a nonbinding resolution instructing Treasury to leave the rules alone, and it complied. Check-the-box received legislative blessing in the form of the 2006 look-through rules, according to the Financial Times.
President Obama has led a renewed charge to change the rules. He has argued that the check-the-box rules cost the United States over $10 billion a year in lost taxes. But like almost all of Obama’s budget proposals, his check-the-box reform has languished in Congress and never been seriously considered. The check-the-box rules, now almost 20 years old, seem here to stay in the U.S. tax code.
Enter Europe and the OECD. European governments, particularly France and Germany, have long complained about the check-the-box rules and called for their repeal. Their pleas, like those of Treasury in 1998, have fallen on deaf ears. Now those governments are trying to use the OECD’s base erosion and profit-shifting initiative to combat the abuse of hybrid entities. The leaked draft of the OECD’s hybrid report shows that the organization is trying to create a set of subject-to-tax rules with gateways for financing for a certain kind of hybrid and ordering rules for which rule to apply. The draft approach would shift the debate to whether the arrangement was within the gateway, according to Lee Sheppard. While asking why it took Europe so long to catch up, she says the draft contemplates a hybrid payment rule that would deny a participation exemption when the payment has been deducted by the payer in a financing/funding transaction. The European Commission is considering similar rules.
The check-the-box rules seemed like a good idea at first. The Kintner test was enormously complicated and consumed a lot of compliance resources. But it isn’t clear that check-the-box has made things much simpler. Instead, tax compliance resources have been shifted to create extremely complicated transactions designed to use check-the-box to avoid subpart F inclusion. The check-the-box rules, like the Kintner factor test, continue to favor wealthy, well-advised taxpayers at the expense of both the U.S. treasury and unsophisticated businesses. They don’t seem to have made things that much better after all.