“Unchecking the Box” Could Lead to Fierce Debate

President Obama is trying to revive a Clinton-era tax rule that was "almost immediately discredited" when it was proposed 11 years ago.

President Obama’s international tax proposals attempt to accomplish two major goals. First and foremost, the proposals seek to curtail the benefit of deferral of foreign earnings. The proposal does this by limiting the deduction of expenses — other than research and development expenses — that are “associated with” earnings that are eligible for deferral until the income has been repatriated and becomes subject to U.S. tax.

In addition, the President is anxious to revive a controversial pronouncement emanating from the Internal Revenue Service which was issued — and almost immediately discredited — during the Clinton years: The notorious Notice 98-11, 1998-1 C.B. 433. The aim of the notice was to prevent multinational corporations from “abusing” the so-called “check-the-box option.” The option allowed flows of passive income between controlled foreign corporations (CFCs) disappear for purposes of the Subpart F rules. The best way to understand the President’s plans is to review the facts and conclusions set forth in Notice 98-11, the principles of which the President has made clear he seeks to resuscitate.

Notice 98-11 notes that Subpart F was enacted — at the behest of President Kennedy in the Revenue Act of 1962 — to limit the deferral of U.S. taxation of certain income earned outside of the U.S. by CFCs. Limited deferral, however, was retained “to protect the competitiveness” of CFCs doing business overseas.” Under the tax code, transactions of CFCs that involve related persons frequently give rise to “Subpart F income” unless an exception applies.

Notice 98-11 sought to repair the hole in Subpart F created by the so-called “hybrid branch” strategy. The notice explains that a hybrid branch is one that is viewed, under U.S. tax principles, to be part of the CFC. Specifically, the branch is seen, therefore is “fiscally transparent.” However, under the laws of the CFC’s country of incorporation, a  hybrid branch is regarded as an entity separate from the CFC, so it is seen as “non-fiscally transparent.”

Earnings Stripping

The first example set forth in Notice 98-11 provides that CFC-1 owns all of the stock of CFC-2; each such CFC is incorporated under the laws of country Alpha. CFC-1 has a branch (an unincorporated division) called Branch-1 in country Beta. Further, the tax laws of each of Alpha and Beta classify CFC-1, CFC-2, and Branch-1 as separate entities.

In the example, CFC-2 earns only non-Subpart F income. Further, Branch-1 makes a loan to CFC2, and CFC-2, in turn, pays interest on the loan to Branch-1. Under the tax laws of country Alpha, CFC-2 is allowed to secure a tax deduction for the interest it pays to Branch-1 and, we find, “little or no tax is paid by Branch-1 to Beta on the receipt of interest.”

If, in accordance with the check-the-box rules, Branch-1 is disregarded, then for U.S. tax purposes, the loan will be regarded as made by CFC-1 to CFC-2 and therefore the interest will be regarded as paid by CFC-2 to CFC-1.

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