Check Yourself

Rumors and speculation are swirling in tax circles that the U.S. Treasury Department may soon issue regulations changing the “check-the-box” rules, the Clinton-era entity classification regime often blamed for the rise of extravagant overseas tax avoidance structures. The move could be used to push the international tax regime, including the tax on global intangible low-taxed income, closer to the model promoted by the Organization for Economic Cooperation and Development for the 15% global minimum tax.

Check-the-box has long been a target for left-leaning critics of the international tax rules, seemingly as clear an example of a true tax loophole as anyone will see in the real world. But as the years went by, it became more and more entrenched in the system, growing into an untouchable third rail of global tax policy.

If Treasury really does move forward with new check-the-box rules, it could be one of the department’s boldest moves in decades. And one of the riskiest.

The history of the check-the-box rules is almost sort of a tax urban legend–something accountants and lawyers tell ‘round the campfire after conferences, with different shades and variations depending on who’s doing the telling. In the 90s, the story goes, determining whether business entities were partnerships, corporations, or other classifications was becoming an impossible headache for the department. Treasury opted to simplify the process by giving businesses the ability to classify themselves by checking a box, literally, on a new form.

Whether they realized it or not, Treasury had opened the door for new avenues of manipulation by taxpayers. Through check-the-box, multinational corporations could turn a foreign subsidiary into a “disregarded” branch of another subsidiary. A foreign subsidiary and a foreign branch probably sound synonymous to most people, but in international tax policy there’s a huge difference. Crucially, subsidiaries can engage in transactions with other subsidiaries, even those in other countries. They can collect royalties, interest and other forms of passive income.

This matters, because royalties and interest are supposed to be captured by Subpart F, the special tax on foreign income enacted during the Kennedy administration. In theory, all passive income earned abroad by a U.S. company through its subsidiaries should be immediately taxed at the full U.S. corporate tax rate, under Subpart F. It’s an anti-abuse rule, since passive income is easily manipulated and can be placed into a low-tax jurisdiction. But check-the-box can in effect cover up that income when it’s earned between two foreign entities–they’re considered just one bigger entity, so there’s no one to earn the income from.

Foreign countries still see two subsidiaries. The entities become a hybrid mismatch arrangement–the optical illusions of the tax world, like #TheDress, appearing as different structures to different tax authorities. An entity in Germany can claim a deduction for royalty payments made to a holding company in Ireland, sidestepping the U.S. rules which are meant to stop this very practice. Or check-the-box could be used to shield a transaction between Ireland and a Caribbean island nation with no corporate taxes at all. (This is where the “Double” part of the Double Irish comes from.)

Treasury pretty quickly issued follow-up regulations to address this potential for abuse. But this provoked a backlash from Congressional Republicans, who claimed that the department was exceeding its authority. (Never mind that Treasury created the check-the-box rules in the first place.) The department eventually agreed to lay off the rules until 2002, by which time there was a Republican administration and the issue was never returned to.

One talking point that Republicans used was that, by seeking to block these hybrid mismatches, Treasury was trying to become the “the tax policeman for the world.”

I always found this phrase fascinating. It’s somewhat counterintuitive, because the rules would have only applied to U.S. companies. What they meant is that the rules sought to block income-shifting from foreign jurisdictions. Not income-shifting from the U.S., which is what you’d think Treasury would be focused on.

Should the U.S. tax authority care if its corporations avoid foreign taxes? The short answer is that Subpart F, enacted by Congress, says it should. It targets all passive income earned by U.S. companies abroad, regardless of whether it’s earned from royalty or interest payments from the U.S. or from any other country. It’s broader and more expansive than a rule which just blocks payments that might reduce a company’s taxable income in the U.S. (After all, it was a compromise from what President Kennedy actually wanted, which was full worldwide taxation.)

Whatever Congress intended with Subpart F, the experience with check-the-box seems to indicate that Treasury should care about foreign-to-foreign profit-shifting, at least a little bit. Check-the-box was associated with many of the biggest cost-sharing arrangements from huge U.S. corporations that would later come under fire from lawmakers and the media. That doesn’t necessarily mean that check-the-box is to blame, though.

A possible lesson from check-the-box is that allowing foreign-to-foreign income-shifting also creates a strong incentive for U.S. companies to erode the U.S. tax base through cost-sharing arrangements or other tax structures exploiting valuable intellectual property.

Foreign countries have also claimed check-the-box encourages erosion of their tax base, as if it weren’t their own tax laws also enabling the erosion. It became something of a bogeyman.

The check-the-box debate gets into starker philosophical questions about the nature of the tax system. Are we trying to ensure that U.S. companies are paying the right amount of tax everywhere, or just on their U.S. income? Maybe there’s something to be said for the U.S. using its clout as the headquarters of so many dominant companies to stamp out tax avoidance everywhere.

Putting restrictions on check-the-box could cut down on the flexibility and jurisdictional mixing that Democrats have claimed that the current, aggregated GILTI tax allows. Biden proposed tightening GILTI, which targets “intangible” income when it’s taxed below 10.5%, into a tighter country-by-country system. Not so coincidentally, this is also what the OECD’s global minimum tax mandates. It’s unlikely that Treasury could dictate a country-by-country system purely through entity classification, but it may be able to get part-way there.

As I mentioned last month, the country-by-country/worldwide issue with GILTI also in large part comes down to the question of foreign income-shifting by U.S. companies. Just how much administrative cost, for both the U.S. government and U.S. businesses, is it worth to end all tax havens?

And the administrative cost in this case could be enormous. Twenty-five-year-old rules are not uprooted easily. Even small changes to the regime could force hundreds of businesses to rewrite tax structures that were not involved in nefarious planning. This in turn would provoke a furious backlash. In 2009, the new Obama administration included a proposal to rescind check-the-box through legislation in its budget recommendations to Congress. Pushback was so strong that the item never re-appeared in the annual document.

The regulations would no doubt also face relentless legal challenges. In theory, since check-the-box was entirely created by regulations, it can be repealed or altered through regulations. But the years of acceptance by Congress, including comprehensive tax bills which seem to take it into account, could be seen as legislative approval. A judiciary which has been increasingly hostile to Treasury’s rule-making authority could be very skeptical of this move, and a reversal would cause even more chaos.

To say nothing of the political blowback. If Republicans take control of Congress next year, one can imagine how aggressively they’ll use Congressional oversight to push back on the regs. The specter of the Section 385 rules likely weighs on Treasury officials–the novel debt-equity rules were issued by the Obama administration in 2014, only to be rescinded by the Trump administration in 2020. (Albeit, only partially, and only after the Tax Cuts and Jobs Act enacted tighter interest deductibility limits into law.)

It’s quite a lot of hassle, for a questionable benefit. It’s unclear just how much changing check-the-box would raise in new revenue, especially after GILTI and other TCJA provisions have targeted the income associated with base erosion. The purpose of new regs might be less revenue-based, and more to show to the world that the U.S. is doing everything it can to follow the commitment it made at the OECD and the G-20 for the 15% global minimum tax, despite Congressional inaction.

The dynamic is kind of the reverse of becoming “the tax policemen for the world.” New rules would be more about following standards set in Paris, not D.C., and reflect a new era of enhanced tax multilateralism and, arguably, less tax sovereignty.

That’s a world that could be coming whether the U.S. agrees or not.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

NEWS OF THE WEEK

The Democratic majority on the House Ways & Means Committee during a Tuesday markup blocked a Republican effort to pry more information from Treasury about its analysis of Pillar One, the other side of the OECD's 2021 global tax overhaul. Pillar One would give countries more power to tax income from transactions in their markets, and the GOP has claimed it'll be a bad deal both for U.S. taxpayers and U.S. businesses. The "resolution of inquiry" co-sponsored by Ways & Means Ranking Member Rep. Kevin Brady (R-Texas) is mostly political theater, but it does show that any bipartisan approval of the agreement--which may be necessary for its implementation--is a long ways away. You can watch the debate here.

A Treasury Inspector General for Tax Administration (TIGTA) report found that taxpayers are lagging on paying the deemed repatriation tax from the 2017 Tax Cuts and Jobs Act, and recommended that the Internal Revenue Service step up enforcement campaigns beyond the "soft letter" approach it has been taking so far. This is mostly targeted towards individual taxpayers who owe the deemed repatriation through S-corps. It could be a potential under-the-radar issue for relatively small businesses dealing with the TCJA's complex transition rules. Those deemed repatriation payments can be paid on an eight-year schedule, so there will be a few more years of headaches with this.

Pascal Saint-Amans, the indefatigable OECD tax policy chief who played a key role in the organization's 2021 and 2015 tax overhaul projects, will become a partner at the London-based public relations/advisory firm Brunswick Group after he leaves the OECD at the end of October. Saint-Amans became the face of these OECD efforts over the past decade--it's tempting try to try to draw some gossip from his departure about the project's current status. But really, it's a natural time for him to move on, and I could say the same about the recent departures from Treasury. But it will be interesting to see if there's any change in direction as both organizations get some new faces involved.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Moon Man, created by Frederick Clyde Davis for the pulp magazine Aces in 1933. Wearing a spherical helmet of one-way glass, police detective Stephen Thatcher fights crime and steals from the criminal and corrupt to redistribute from the poor. Like most pulp heroes, he has no qualms about shooting to kill in his quest, unlike the comic book superheroes that would come later.