Corporations Couldn't Wait to 'Check the Box' on Huge Tax Break
A simple rule meant to cut paperwork for U.S. companies has grown into one of the biggest multinational tax breaks around, costing governments billions of dollars in lost taxes each year.
It thrives thanks to determined business support, including a campaign two years ago that forced the Obama administration to retreat from altering it and tax professionals worldwide who exploit its benefits.
The rule is dubbed "check-the-box." It allows U.S. companies to strip profits from operations in high-tax countries simply by marking an Internal Revenue Service form that transforms subsidiaries into what the agency calls a "disregarded entity." Others have labeled them "tax nothings."
Check-the-box allows companies to avoid the normal 35 percent U.S. corporate tax on certain types of income. The Treasury Department estimates that annual revenue losses from check-the-box have hit almost $10 billion. Other countries are also said to lose billions as income is shifted to places with low or no taxes, although there is no official estimate.
The impact of check-the-box goes beyond the drain on government coffers. The rule, along with other tax provisions, has helped fuel explosive growth in foreign investment by American corporations. Since 2004, the earnings that U.S. companies keep overseas have doubled to about $1.8 trillion, U.S. Department of Commerce data show.
These "unrepatriated" earnings, which are not subject to tax while held abroad, figure prominently in Washington's debate about corporate taxes. While President Barack Obama has proposed clamping down on loopholes, business groups and allies in Congress are rallying for a tax holiday on overseas profits and a sharp reduction in the corporate tax rate.
Their argument: The high rate creates a disincentive to invest in jobs at home. U.S. companies with the most profits accumulated abroad tend to invest heavily in research and development that can spur job creation.
Check-the-box is but one of many forms of "tax arbitrage" -- the art of exploiting differences in countries' tax systems. It can reduce taxes all by itself or figure into more complex transactions. As the Financial Times and ProPublica reported Monday, the IRS in recent years has clamped down on what it views as abusive arbitrage deals involving foreign tax credits.
But check-the-box lives on. It is not among loopholes targeted by Obama's new plan. Its untouchable status -- the government has twice tried to kill it and balked -- provides a case study in how a billion-dollar tax break was born by mistake, then protected by the power of the business community.
Now check-the-box is "an open invitation to arbitrage," said David Rosenbloom, director of the international tax program at New York University's School of Law.
Birth of a Tax Break
The original idea was innocent enough -- to cut red tape by making it easier for companies to decide how to categorize their subsidiaries.
In the mid-1990s, U.S. companies were creating a growing number of domestic entities. The new rule said that, by simply checking a box on IRS Form 8832, businesses could declare them as corporations or partnerships.
But within days of its announcement in 1996, tax lawyers were on the phone saying the Treasury Department had overlooked the international ramifications. Inadvertently, the government had provided a way for companies to move profits from subsidiaries in high-tax countries like Germany to Luxembourg, the Caymans or other jurisdictions with lower or no taxes on certain kinds of income. Often, this is done by making royalty or interest payments between operations in different countries.
For decades, the IRS has had anti-abuse rules to make sure such payments could be subject to taxes. However, these rules generally don2019t apply to payments made within a corporation. Check-the-box made it simple for a company to designate a subsidiary as a branch, with no U.S. tax consequences for the income unless it is repatriated.
Joseph Guttentag, international tax counsel at Treasury when check-the-box was introduced, said the government may not have understood, but tax lawyers quickly "saw all the avoidance goodies they could do."
Countries like the U.K. and Germany quickly raised concerns that the rule was stripping earnings from their tax bases. By early 1998, the U.S. said check-the-box was being used to "circumvent" anti-abuse rules.
Treasury proposed new regulations -- and corporate America erupted.
General Electric (GE), PepsiCo (PEP), Morgan Stanley (MS), Merrill Lynch, Monsanto (MON), and other major companies urged Congress to resist the change. The U.S., they said, was trying to be "the tax policeman for the world." Allies in Congress dug in, and Treasury quickly rescinded the proposal.
What followed was a check-the-box boom as multinationals and tax advisers around the globe embraced its benefits.
By March 2000, Treasury reported the existence of nearly 8,000 "disregarded entities." A paper by Heather M. Field, an associate professor at the University of California's Hastings College of the Law in San Francisco, found that tens of thousands more were created between 2001 and 2006.
Check-the-box became an essential tool in tax planning, driving down the average effective corporate tax rate on the foreign income of U.S. businesses by 1 percent to 2 percent between 1996 and 2004, according to a private, unpublished paper by Treasury economist Harry Grubert.
The Netherlands became the preferred place for U.S. companies using check-the-box, according to tax lawyers and government data, although Luxembourg also attracts considerable activity.
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