Legislative Option to Curtail "Check-the-Box" Planning

Executive Summary

The Joint Committee on Taxation ("JCT") recently presented to the Senate Finance Committee a proposal to curtail the use of "check-the-box" planning with respect to foreign business entities. The proposal would automatically treat as a corporation for U.S. income tax purposes any business entity that is created under foreign law and that has only one owner. The JCT proposal would be bad policy and would hurt the competitiveness of U.S. corporations. The sooner taxpayers enlighten Congress, the better. International tax attorneys at Buchanan Ingersoll PC, in conjunction with the firm's Federal Government Relations Group, are ready to help clients work against adoption of this proposal.

Options to Improve Tax Compliance and Reform Tax Expenditures Report

Recently the Joint Committee on Taxation ("JCT") prepared for Senators Grassley and Baucus of the Senate Finance Committee a report titled "Options to Improve Tax Compliance and Reform Tax Expenditures" (JCS-02-05), issued in response to a request from the senators to present ideas to promote taxpayer compliance and reduce the size of the so-called "tax gap." The title of the report is somewhat misleading, because the report includes a number of proposals that go beyond improving taxpayer compliance or reforming tax expenditures. One such proposal is a proposal to curtail the use of "check-the-box" planning with respect to foreign business entities. The proposal would automatically treat as a corporation for U.S. income tax purposes any business entity that is created under foreign law and that has only one owner.

Since 1997, business entities (whether U.S. or foreign) have generally been able to elect whether they wish to be treated as a "corporation" for U.S. income tax purposes or as a flow-through entity (such as a "partnership," if there are multiple owners, or a branch or division, if there is only one owner). The income of a business entity that is a corporation for U.S. income tax purposes is potentially subject to two levels of tax (at the entity level and the owner level), whereas the income of a business entity that is a flow-through entity is potentially subject to tax only at the owner level (unless the owner is a corporation). Certain business entities are treated as "per se corporations," and no election is permitted with respect to them. The ability to elect the tax treatment of an entity (referred to colloquially as the ability to "check the box") has allowed taxpayers and their advisors to engage in creative tax planning.

For example, in the case of a U.S. corporation that has a first-tier foreign subsidiary that in turn has multiple lower-tier foreign subsidiaries, checking the box with respect to the lower-tier subsidiaries so that they are treated as branches of the first-tier foreign subsidiary can produce very beneficial U.S. tax results. (The first-tier foreign entity remains a corporation so that the U.S. parent corporation is not currently taxed on the first-tier entity's income.) Under the "subpart F regime," certain income realized by a foreign subsidiary (such as certain dividend, rental, royalty, and interest income) is currently taxed to the subsidiary's direct or indirect U.S. shareholders even if the subsidiary has not made any dividend distributions to those shareholders. Adopting a check-the-box structure for the lower-tier foreign subsidiaries (in which those subsidiaries change from separate corporations to branches) means that inter-entity payments have no U.S. tax effects since they become inter-branch payments, and cannot be considered subpart F income. However, adoption of such a check-the-box structure for lower-tier foreign subsidiaries can also result in the loss of certain U.S. tax benefits. Thus, the planning must be done carefully so that the positive effects are maximized and the negative effects are minimized.

The ability to check the box has also been used creatively in the context of the sale of a lower-tier foreign subsidiary by an upper-tier foreign subsidiary. In such a situation, if the upper-tier subsidiary simply sold the stock of the lower-tier subsidiary, that might give rise to subpart F income. However, if the lower-tier subsidiary instead checks the box and becomes a branch of the upper-tier subsidiary, then a sale by the upper-tier subsidiary of the lower-tier entity should be treated as a sale of the assets held by the lower-tier subsidiary, which might produce a much more beneficial U.S. tax result. (Generally speaking, gain from the sale of active business assets does not give rise to subpart F income.) This approach was blessed by the decision in Dover Corp. v. Comr., 122 T.C. 324 (2004), and thus this "check-and-sell" technique should be retained in the tax advisor's arsenal of tax planning techniques.

As stated above, the JCT is proposing that a foreign business entity be treated as a corporation if it has only one owner. The principal reason given by the JCT for this proposal is that it would prevent the first type of creative tax planning discussed above, i.e., checking the box for lower-tier CFCs so that inter-entity payments no longer generate subpart F income. However, a U.S. parent company can achieve the same effect by simply having its first-tier CFC set up branch operations around the world ("the direct branch approach"). One disadvantage of the direct branch approach is that individual branch operations may not have limited liability and thus the parent CFC may not be protected from exposure. The check-the-box approach provides the same U.S. tax benefit as far as subpart F is concerned but also provides liability protection.

It is not clear why the direct branch approach should be acceptable but the check-the-box approach is not. It should make no difference whether the various foreign country operations have limited liability. The principal purpose of subpart F is to currently tax to the U.S. shareholders of a foreign corporation the income earned by the foreign corporation that is not produced as a result of a significant business presence abroad. Thus, a critical factor for subpart F purposes is whether the CFC has income. Under both the direct branch approach and the check-the-box approach, the parent CFC has no income for U.S. income tax purposes when payments are made between branches; thus, check-the-box strategies should raise no subpart F concern.

The JCT proposal would be bad policy and would hurt the competitiveness of U.S. corporations. The sooner taxpayers enlighten Congress the better. International tax attorneys at Buchanan Ingersoll PC, in conjunction with the firm's Federal Government Relations Group, are ready to help clients work against the adoption of this proposal.