NYU Tax Policy Colloquium, week 6: Jennifer Blouin’s Does Tax Planning Affect Organizational Complexity: Evidence from Check-the-Box: part 1

 Yesterday at the colloquium, Jennifer Blouin presented the above-titled paper (coauthored by Linda Krull). Unfortunately, I can’t post a link to it here, as there are issues relating to data use permission that I hope will be cleared up soon. But the broad contours that I can discuss may nonetheless be of interest.

This blogpost will purely focus on the legal background to the paper’s empirical analysis, which I will discuss in a separate blogpost, part 2, which will follow shortly.

At the end of 1996, the US Treasury issued the by now infamous check-the-box (CTB) regulations, allowing taxpayers simply to elect, for specified legal entities both in the US and abroad, whether such entities would be treated for US federal income tax purposes as corporations or flow-throughs. In the domestic realm, this was a completely uncontroversial simplification. The prior legal regime for classifying, say, limited liability companies (LLCs) under state law had grown to combine tedious burden creation with near-electivity as an effective matter, plus an almost complete lack for the government to try to police the boundary (given, for example, publicly traded partnerships were being taxed as C corporations anyway).

The tricky part that may have reflected a Treasury stumble occurred in the international realm. US companies, by checking the box “open” for specified foreign entities that had only a single owner created “hybridity” of an extremely convenient sort for foreign entities that could be used in overseas tax planning. Previously, one couldn’t do this without some effort to tailor things just right, often leaving residual uncertainty about whether one would succeed in getting the desired effects. But now it was easy and automatic.

A bit of further background before noting how the hybridity worked: The main play related to subpart F, aka the US controlled foreign corporation (CFC) rules. Subpart F can make certain foreign source income (FSI) that is earned abroad by US companies’ CFCs currently taxable to the US companies, via treatment as a presumed dividend back to the US parent that is then deemed to have been reinvested abroad. The subpart F income therefore ceases to be either deferred to the US parent under pre-2017 US law, or exempt subject to GILTI under 2018-and-on US law.

Conceptually speaking, subpart F has two parts. First, by taxing to the US parent the passive income (such as portfolio interest and dividends) that it has earned through its CFCs, it prevents US companies from earning such income tax-free by the simple expedient of earning it offshore (i.e., as FSI of its CFCs).

Subpart F’s second part (conceptually speaking) is deterrence of profit-shifting abroad. For example, what are called the base company sales rules provide that one will have subpart F income if one, say, routes sales to one’s operating CFCs in high-tax countries in such a way as to cause the taxable income to arise in a shell CFC that is located in a low-tax country. This might, for example, involve the use of transfer pricing games to ensure that the shell CFC, rather than the operating CFCs, ends up with a significant piece of the taxable profit despite its doing little or nothing. 

In effect, subpart F’s second conceptual part discourages certain foreign-to-foreign tax planning. In the above scenario, for example, the taxpayer might have been using, say, a Luxembourg CFC to drain off foreign profits that would otherwise have accrued to its German, French, and UK CFCs. Such foreign tax minimization may be pointless, however, if it draws US taxes under subpart F that eliminate the worldwide tax saving. Two possible outcomes are that (a) the US company does all this anyway, saving foreign taxes but increasing its US tax liability due to subpart F, and (b) the US company decides against doing it, in which case there is no subpart F income but it is paying the higher taxes in Germany, France, and the UK that it would otherwise have avoided.

Obviously, there is a big question as to why the US would seek to deter this tax planning. We don’t get the revenues, insofar as they accrue to Germany, France, or the UK rather than to us. But not all of the rationales for doing it are founded on cooperation or reciprocity or altruism. The anti-foreign-tax-planning piece of subpart F may also indirectly increase US tax revenues, by reducing the payoff to companies of replacing US source income with FSI (since the latter may be much easier to on-shift to a tax haven).

With all this in background, consider intra-group interest flows. Suppose, for example, that a Caymans affiliate of the US parent lends $$ to a German affiliate, and the latter then pays interest to the former.  This reduces the German CFC’s taxes (assuming Germany allows the interest deductions despite, e.g., its thin capitalization rules), without any Caymans offset given that it’s a tax haven. But it leads to subpart F income, which looks like Type 1 (passive income -> subpart F income) but is actually Type 2 (foreign tax planning triggers US tax liability, even though the group’s net interest income from the transaction is zero).

And here is where we circle back to CTB. Because it treats a single-owner checked-open foreign entity as transparent (i.e., as merely a branch with no separate tax existence) for US tax purposes, US multinationals can play a fun “hybridity” game to get the best possible tax results in the above transaction. In the above example, Germany allows the interest deductions, but the US does not apply subpart F to the interest flows to the Caymans entity, because there has been no transaction. The US regards the German and Caymans affiliates as the same entity, and you can’t, for tax purposes, pay interest to yourself.

In effect, CTB therefore amount to the partial indirect repeal of subpart F. What I call its “part 1” application to tax gross passive income earned abroad through CFCs remained intact. But what I call its “part 2” application to deter foreign-to-foreign tax planning was effectively repealed for all US companies that went to the trouble (and it wasn’t much) of inserting transparent entities into its structure as needed to prevent subpart F from observing the cash flows that this tax planning involved.

One last bit of background on all this: In 2005, Congress enacted Code section 954(c)(6), which has always had an expiration date but has continually been extended (at present, through 2026). Without running through all the details here, this effectively replicates CTB’s effective repeal of what I call part 2 of subpart F without requiring transparency of the entities that are being used to do it. But it still does require one to do the things (involving the use of entities in both tax haven and non-haven foreign jurisdictions) that subpart F would otherwise have discouraged.

Okay, back to the Blouin-Krull paper. It aims to illuminate certain effects of the adoption of CTB (and perhaps later section 954(c)(6)) in the international realm. These are of two kinds: effects on US firms’ organizational complexity, and on the firms’ US and worldwide tax liability with respect to their US source and foreign source income. But I will use a separate blogpost for that discussion.