A simple rule meant to cut paperwork for U.S. companies has grown into one of the biggest multinational tax breaks around, costing the United States and other 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 don’t 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, PepsiCo, Morgan Stanley, Merrill Lynch, Monsanto 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.
The Dutch tax system offers a favorable legal and regulatory environment, including special tax treatment for financial services and for licensing and royalty payments. As a result, multinationals channel trillions of dollars a year through the Netherlands.
A report by the Dutch Central Bank found that the U.S. corporate share of funds flowing in and out of the country via special Dutch entities increased sixfold in recent years. U.S. Commerce data show that U.S. businesses kept $118 billion of income in Dutch holding companies from 2006 to 2009.
In 2004, with overseas earnings piling up, Congress approved a temporary tax holiday that allowed American companies to bring home profits at a rate of 5.25 percent. The largest source of repatriated funds, about $90 billion, came from the Netherlands, according to a 2008 IRS study.
Obama shifts stance
Check-the-box continued unchallenged until 2009, when Obama took office. In his first budget proposal, the president made closing tax loopholes a top revenue-raising goal. And in the international area, check-the-box was his top target, the biggest revenue raiser in a list of 11 reforms.
Again, corporate opposition was swift. Philip D. Morrison, a tax lawyer at Deloitte Tax, wrote in a prominent tax journal that it was "ridiculous" for the Obama administration to claim that check-the-box was an "unintended" loophole because the business community had already fought – and won – this battle in 1998. Morrison faulted the administration for using overheated rhetoric and "deep cynicism" in its portrayal of the rule.
Some of the nation's most influential business groups, including the Business Roundtable, National Association of Manufacturers, National Foreign Trade Council and Chamber of Commerce, quickly criticized the Obama proposals in May 2009 as part of a pro-jobs campaign.
In Congress, tax committee members lined up alongside business leaders, with Rep. Dave Camp of Michigan, the top Republican on the House Ways and Means Committee and now its chairman, saying the proposals would put U.S. corporations on the auction block.
“Ironically, what the president proposes will make it more likely that American companies will be bought by their foreign competitors,” Camp asserted.
The Obama administration quickly retreated.
“They knew the business community was going to push back. What they were really surprised by was how vehemently the business community reacted to it,” said Catherine Schultz, vice president of tax policy for the National Foreign Trade Council.
In early 2010, Treasury Secretary Timothy Geithner informed the Senate’s tax-writing committee that the administration was dropping its attempt to broadly reform check-the-box. Instead, Treasury would focus on combating misuse of the rule as part of other tax-avoidance techniques, including inappropriate foreign tax credits, he said.
“Our goal in these proposals is to limit the role taxes play in business investment decisions by reducing implicit incentives to move jobs and investment overseas,” Geithner testified.
While announcing his deficit-cutting plan last week, Obama faulted the corporate tax system as “riddled with special-interest loopholes” and a high rate that hurts “our competitiveness in the world economy.”
He proposed more than a dozen business-tax reforms, including ending breaks for fossil-fuel development and tightening accounting measures involving foreign income. Although Obama did not mention check-the-box, its business supporters have defended it on Capitol Hill.
On the same day that Obama addressed Congress, an executive from Cargill, the world's largest trader of agricultural commodities, told the Senate Finance Committee about possible reforms to the tax code—but not check-the-box.
Scott M. Naatjes, Cargill’s vice president and general tax counsel, said repealing check-the-box would cause U.S. companies to pay more taxes abroad and make them less competitive. Sixty percent of Cargill’s operations are outside the United States.
The Senate panel also heard testimony from a law professor suggesting that American companies are not so disadvantaged.
Reuven Avi-Yonah, head of the international tax program at the University of Michigan Law School, testified that large European countries have stricter rules when it comes to taxing profits made outside their country. Japan and Germany recently have made it harder for corporations there to avoid taxes or shift income to lower-taxed jurisdictions, he said.
In an earlier interview, Avi-Yonah said it would take a comprehensive approach by Washington to curb the ability of corporations to find new loopholes.
“It’s a problem to only close specific loopholes instead of addressing the issue in a general way,” he said. “Companies simply find new ways to replace the approaches shut down by authorities.”
Meanwhile, check-the-box deals “are going like crazy,” according to one prominent tax lawyer who helps structure such transactions. He declined to be named for fear of jeopardizing his job but added: “I can design these a thousand different ways.”
Correction (9/29/2011):Tax lawyer Philip D. Morrison said in a prominent tax journal that it was "ridiculous'' for the Obama Treasury to claim check-the-box allowed for an "unintended avoidance of current U.S. tax.'' He did not say the Obama proposal to change the tax provision was ridiculous, as stated in the original version of this article published Sept. 27.