“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.
Robert WillensMay 11, 2009

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.

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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.

While interest received by a CFC is normally Subpart F income (which means it is classified as foreign personal holding company income), in this case the “same country” exception found in Section 954(c)(3) of the tax code would apply to exclude the interest from designation as Subpart F income.1

However, if Branch-1 were considered to be a CFC, the payment of interest would be between CFCs located in different countries and, thus Subpart F income would arise.

Accordingly, if the check-the-box rules are used, Branch-1 is disregarded, and CFC-1 will have lowered its foreign tax on deferred income and created a significant tax incentive to invest abroad. Accordingly, since this arrangement creates income intended to be Subpart F income which is not subject to Subpart F, the result of the arrangement is “inconsistent with the policies and rules of Subpart F.”

The second example contained in Notice 98-11 is virtually identical to the one President Obama recounted in his speech on May 4, 2009, in which he introduced his initiatives. There, CFC-3 is incorporated in Alpha and CFC-3 has a branch (Branch-2) in country Beta.

Once again, the tax laws of each such country classify CFC-3 and Branch-2 as separate entities. Branch-2 makes a loan to CFC-3 and the latter, which earns only non-Subpart F income, pays interest to Branch-2 that Alpha allows as a tax deduction. Little or no tax is paid by Branch-2 on the receipt of interest.

The example notes that if Branch-2 is disregarded, in accordance with the check-the-box rules, U.S. tax law would not recognize the “income flows.” After all, a corporation cannot make a loan to, and pay interest to, itself. By contrast, if this transaction was between two CFCs, the interest would be Subpart F income. As a result, if Branch-2 is disregarded, the CFC at issue here will have lowered its foreign tax on deferred income in a manner wholly inconsistent with the policies and rules of Subpart F.

The past attempts by the IRS’s to rein in the application of the check-the-box rules met with fierce and ultimately decisive opposition. The President’s proposal seeks to revive this debate. His proposal, like that of the IRS some 11 years ago, will provide that, when these sorts of arrangements are undertaken, the branch and the CFCs will be treated as separate corporations for purposes of Subpart F. Accordingly, if the President is successful in implementing his proposals, these types of arrangements would presumably cease to be entered into  because they accomplish few, if any non-tax business objectives.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

1Section 954(c)(3) of the U.S. tax codes provides that foreign personal holding company income does not include interest received from a related person which (1) is a corporation created or organized under the laws of the same foreign country under the laws of which the CFC is created or organized, and (2) has a “substantial part” of its assets used in its trade or business located in such same foreign country.