3. Introduction
In the US, if a business entity conducts foreign activities with the means of a foreign
corporation, it is a Controlled Foreign Corporation (CFC) and the US tax authorities examine
whether there are US shareholders owning minimum 10% of the voting powers of the
foreign corporation and if these US shareholders are the owners of more than 50% of the
voting powers of all stock or 50% of the total value of the foreign corporation.
Normally, the US does not tax foreign income of foreign subsidiaries before it is distributed
to US parent or shareholders or sold. However, subpart F was created to prevent foreign
subsidiaries from continuously deferring their taxes.
In the US, foreign companies’ classification was very complex before 1996. The Kintner tests
were used to determine how to classify a corporation. The ‘check-the-box’ reform was
supposed to clarify and render its practise very easy.
The Treasury Department instituted the check-the-box regulations in 1996 and problems
directly came due to the fact that US multinationals would abuse from its loopholes and
become important non-intended beneficiaries. A company can indeed choose between
being considered as a company or as a partnership. The check-the-box rules gave the
possibility to company groups to create subsidiaries that were treated one way in a foreign
jurisdiction and another by the United States. These hybrid entities manage, like Apple, to
decrease their effective tax rate on foreign income in an industrial manner.
Before, the Kintner rules required to determine 6 characteristics of a corporate entity to
categorize it: the presence of associates, an objective to carry on business, continuity of life,
centralization of management, limited liability and free transferability of interests.3
The Kintner regulations were supposed to be simple but practice showed that many
uncertainties remained when determining whether a company fulfilled the points.5
The IRS and the Government issued proposal for a reform in 1995 to classify entities easily.
The ‘Check-the-Box’ (CTB) regulation was promulgated in 1997 and domestic or foreign
entities could choose to be taxed as a partnership or a corporation. A corporation must fulfil
4. three requirements: the entity must exist separately from its owners, it must be a business
entity11 and it must not be a deemed corporation.
Some foreign entities do not fulfil all requirements and can be disregarded if only one
member is the shareholder and has a personal liability.
The CTB system was supposed to be simple and diminish compliance costs to taxpayers
which did not have to hire a law firm and could determine their tax treatment by
themselves. The IRS’ work has also diminished a lot. There is also more legal certainty for
classification than under the Kintner system whose criteria were sometimes unsure. Analysis
of foreign law was also very difficult due to the amount of work for each foreign jurisdiction.
The CTB was supposed to bring fairness and neutrality for taxpayers without important
planning structures which was only possible for large companies. Under the CTB, income of
a partnership is taxed in the hands of the partners whereas under a corporation, income is
taxed at corporate level.
5. 1. Mechanism
US tax authorities do not tax active business income of CFC but tax some parts of passive
income (subpart F). If the CFC is not taxed at US level, it is called a deferral. This income is
not subject to US taxes until it is paid to US shareholders (dividends or other distribution).
Foreign income benefits thus from a deferral until it is distributed. Subpart F includes
passive income earned by the foreign corporation and kept abroad. Deferral of US taxes can
be useful, for example when the tax rate in the USA is higher than in the foreign country.
The advantage to the US shareholder is that the foreign tax credit is available for foreign
taxes and the indirect foreign taxes of the subsidiaries.1
Subpart F eliminates deferral of US taxes for some kinds of income coming from abroad. US
persons are then taxed according to their pro rata share earned by their CFC. In general, the
US taxes all income from an US citizen or entity. Subpart F treats a US shareholder of a CFC
as if the earnings and profits were actually distributed. Subpart F does not pretend to tax
the CFC but the US shareholder owning at least 10% of the voting stock. Subpart F is divided
in different categorizations.2
Under the CTB system, businesses have to classify their entity under the 8832 Form of the
IRS and it is very easy but tax consequences are very important. There are different classes
of entities. There first one is the ‘Per Se Corporation’ which are non-eligible entities with a
list of per se corporations for each country. Default entity classifications include three kinds
of businesses: corporation, partnership and disregarded entities. For eligible entities, default
classification applies when the entity does not use the CTB system.
A default partnership includes more than one owner and a disregarded entity has only one
owner. For foreign entities, an entity is a corporation if its owners have limited liability, a
partnership if it has more than one owner and one of them does not have limited liability
and a disregarded entity if the single owner does not have limited liability.
The initial classification is obtained when the entity is formed or can be determined through
CTB and a 75 retroactive days can be obtained through the CTB system. For foreign entities,
1 Global Tax and Estate Counsel LLP, CFC and Subpart F Planning, Developing Tax Plans that
Consider the Impacts of Subpart F Provisions
2 Internal Revenue Service, LB&I International Practice service Concept Unit, p 3
6. this can be problematic if owners prefer to be treated as a partnership rather than a
corporation. If the classification is changed, the transaction can be a taxable and it can
become a gain or a loss for the shareholder which can be taxed as ordinary income or
trigger Subpart F income.
Costs can then be very important when the type of classification is changed.
The CTB system was challenged before the courts which confirmed it and partnerships as
well as corporations can be treated as the other for tax purposes.3 Entities can also be
disregarded. A pass-through entity does not pay any tax. The income and losses are directly
transferred to the shareholders’ personal tax returns. Using this method enables to avoid
paying corporate taxes. Combined to the limited liability, it renders this kind of entity very
attractive.
Publicly traded partnerships are taxed as corporations unless 90% of the income is passive.
However, it can be considered as different under the Form 8832.
Hybrid entities have been created, such as limited liability companies, using fiscal loopholes.
They are for example benefiting from their limited liability status but not paying corporate
taxes. The CTB system helps this kind of structure. A single member with a limited liability
company can use under the CTB the disregarded entity statute for federal tax issues and its
activities are taxed at the owner level.4
Sometimes, some States do not agree with the federal tax views, California, for example, for
single-member unincorporated entities which are viewed as corporations. The IRS
determines tax liability according to the CTB classification, including interstate and
international classification.
The CTB system also gives possibility for estate tax planning and personal income tax
planning, for families, for example (trusts, private foundations, charities…).
3 U.S. v. Kintner, 216 F.2d 418 (9th Cir. 1954)
4 Department of the Treasury, Officeof tax policy, The deferral of income earned through US Controlled Foreign
Corporations, p 69
7. Other exceptions to Subpart F:
The CFC look-through rule allows companies to redistribute their active income to other
companies abroad without being taxed. It is not related to subpart F between the years
2005 and 2014 to allow multinationals to take strategic business decisions. The Active
financing income is another exception to the subpart F for banking, financing or insurance
activities realised abroad, even if this income is considered as ‘passive’.
2. Problems
In 1998, the Department of treasure wanted to rectify the CTB system, especially the
subpart F income. However, lobbyists managed to convince the Congress not to change the
system; otherwise, corporate groups would pay higher taxes in the US and in foreign
countries. It worked.
Under the President Obama’s presidency, there were attempts to change the system in
order to recover due taxes. The Congress did not follow his opinion. France and Germany
complain about the CTB system and the OECD does not allow hybrids under the BEPS
project.5
Indeed, international group companies use the CTB system to issue loans which are
disregarded. Income can be shifted from high tax countries to low tax jurisdictions. The
easiest way to do it is to establish a disregarded entity in a low tax country, issuing a loan to
a subsidiary in another country. In the US, the loan and its interests are not recognized but
the foreign jurisdiction sees the disregarded entity as a corporation so that the interests are
deducted. The tax paid in the foreign jurisdiction and the subpart F foreign income is thus
reduced. These structures have grown enormously since the CTB system establishment.6
Hybrid entities are considered when the US classifies an entity as a partnership or
disregarded entity while a foreign country considers it as a corporation. A reverse hybrid
5 Philip D. Morrison, "The Obama Check-the-Box Proposal -- Notice 98-11 Redux," Insights &
Commentary(BNA), July 24, 2009
6Steve Dean, Attractive Complexity: Tax Deregulation, the Check-the-Box Election, and the Future of Tax
Simplification, March 5th, 2014
8. entity is the opposite. If the classification is only elective, if the foreign corporation is not a
per se corporation for the US, a flow-through tax consideration in the US is available and a
hybrid entity is created, thanks to the CTB system.
Lobbyists said that CTB was only a simplification and that hybrids would not be used in a
different way than before CTB. Advocates of the NY Bar Association said that the advantages
of the CTB would overcome the potential increased use of hybrid entities under the CTB
system. Finally, they also said that there are other available methods to deny hybrid use of
entities.7
In using hybrid structures, the taxpayer takes advantage of the different treatments in the
different jurisdictions to lower its tax base compared to its tax treatment in one Member
State. Tax arbitrage can thus lead to inefficiencies in international situation and reduce
home tax incomes and increase the use of tax havens, shifting profits from countries where
economic activity is realized to others and it promoted by entity classification of the CTB
system.8
The subpart F is part of the CTB system to classify income and neutralize tax deferral benefit
of income transactions made abroad with the use of a subsidiary.9 If there is only a branch,
it is only part of the US parent company as the USA applies a WWI taxation. If foreign
branches make a profit, it will be taxed in the USA. It is not the case for a foreign subsidiary
incorporated under a foreign legal system. There is indeed a separate legal entity distinct
from the US parent. The US cannot tax this kind of profit from a foreign company until it is
repatriated. If the foreign tax rate is lower (which is often the case), a US taxpayer can use
the CTB system to defer taxes on foreign income.
Under Subpart F, benefits awarded by deferral of taxes by taxing American shareholders of
CFC doing business in low tax countries are mitigated. However, hybrid entities can create
inefficiencies like earning stripping with disregarded loans. The US sees a low tax jurisdiction
company as a disregarded entity part of the foreign subsidiary for fiscal purposes. The loan
7 New York State Bar Association, "Report on the 'Check the Box' Entity Classification System Proposed in
Notice 95-14," Doc 95-8285, 95 TNI 172-13, Section III.A (Sept. 5, 1995)
8 Diane M. Ring, "One Nation Among Many: Policy Implications of Cross -Border Tax Arbitrage," 44 B.C. L.
Rev. 79, 85-86 (2002)
9 IRC sections 951-965
9. and its interests are normally classified under subpart F but as they are part of only one
entity (from US perspective), it does not exist. In the foreign country, however, the
corporation in the tax haven is seen as a different corporation and the foreign company can
deduct interests of the loan and reduce its taxable base without affecting subpart F.
Another possibility for taxpayers is the ‘same-country-exception’ of subpart F for the
interests received by an entity from another entity located in the same jurisdiction (there
are thus two foreign subsidiaries in the same country and another company in a tax haven).
For US tax matters, the company located in the tax haven is also disregarded and the
interests’ payments are directly going to the first foreign subsidiary and are disregarded for
subpart F. The second foreign subsidiary can thus deduct paid interests and the subsidiary in
the tax have does not pay high taxes.10
Foreign tax credit is supposed to neutralize double taxation of foreign income by granting a
credit of taxes on income earned abroad and already taxed. In absence of such a credit,
taxpayer would not operate abroad as there would be double taxation and capital export
neutrality would not be respected. Hybrid entities can use this credit for tax avoidance
purposes. If an entity is disregarded by the USA and considered as a corporation under a
foreign State, or the opposite (reverse hybrid entity) another entity can be a subsidiary
recognised by the USA and the US can attribute income to this company whereas it should
be attributed to the flow-through entity. Foreign tax authorities, however, consider that
income is attributed to the first company (disregarded by the US) but the legal liability is
directly attributable to the parent (from the US perspective). The Parent company is then
competent to claim a credit for foreign income even though no income was included under
the CTB system.11
Subpart F can also be extended to foreign entities but it increased the use of hybrids as we
discussed before.12 The CTB system did not erase inefficiencies and difficulties in fiscal
10 Philip R. West, "Re-Thinking Check-the-Box: Subpart F," 83 Taxes 29 (2005), available
athttp://www.steptoe.com/assets/attachments/1245.pdf
11Kenan Mullis, Check-the-Box and Hybrids: A Second Look at Elective U.S. Tax Classification for Foreign Entities
12 Melissa Costa and Nuria E. McGrath, Statistics of Income Studies on International Income and Taxes, in 30
No. 1, SOI Bulletin, 172, 187 (2010), available at http://www.irs.gov/pub/irs-soi/10sumbul.pdf
10. classifications but the new amount of hybrid structures has led to enormous work for tax
authorities and advisors to tackle this issue. The administrative burden is only shifted to this
new problem. Taxpayers now have to spend an important amount of money on tax advisors’
consultations and in maintaining two accounting balance sheets (foreign and domestic).
Proposals to reform the CTB system:
On November 19th, 2013, a proposal was made in the Committee on Finance of the US
Senate to characterize a disregarded entity into a corporation if the entity has a single
owner which is a CFC or if the entity is directly owned by two or more members of an
expanded affiliated group and at least one of these owners is a CFC.
The Obama administration also released a green book reform connected to the BEPS report
to extend subpart F on foreign base company digital income when a CFC takes advantage of
the IP developed by a company part of its group and that the CFC does not substantially
contribute to the service sold.13
The two exceptionsof relief under the “same country exception” and the “CFC look through” have
been proposed to be denied in the future to prevent hybrid structures from being established.
It is unsure that the Congress will accept these reforms in the future.
13 General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals,Department of the
Treasury,March 2014,pp. 58-59
11. Conclusion
In this paper, it has been explained how the CTB system was created and the use of Subpart
F to prevent CFC from deferring their taxes. The CTB systemalso helped international
groups to develop hybrid entities which enable new tax planning structures with foreign
entities.
These hybrid entities, in cross-border situations, enable tax arbitrage and circumvent some
normally due taxes to the IRS. Some attempts have been made to change the CTB system
but the Congress stopped it and hybrid entities are still unregulated.
Subpart F is maybe not effective due to the complex hybrid structures. It was supposed to
address problems in US tax law but problems are still present and the tax base preservation
at global level should be promoted.
Some reforms should be done in order to tackle these hybrid entities which benefit to US
multinational groups but not to the overall taxing base. This is why the CTB systemis
incompatible with the BEPS project of the OECD which will forbid this kind of structures.
This is a characteristic of the incompatibility of the US tax system and the global tax policy.
This leads to a surprising conclusion. The CTB systemhelps multinational US groups to
operate abroad but does not help the overall economic welfare, especially in the US. The
CEN is respected but at a high cost for the US society. Indeed, the American groups have a
lower taxing rate than the other of the OECD countries.
In order to be more efficient, a CFC rule should treat US and foreign income in the same
manner, which is available at the moment.
12. Bibliography
United States of America, Appellant v. Arthur R. Kintner and Alyce Kintner, Appellees, 216
F.2d 418, 54-2 USTC P 9626, No. 13731, United States Court of Appeals Ninth Circuit, Oct.
14, 1954
Diane M. Ring, One Nation Among Many: Policy Implications of Cross-Border Tax Arbitrage,
44 B.C. L. Rev. 79, 85-86 (2002)
Department of the Treasury, Office of tax policy, The deferral of income earned through US
Controlled Foreign Corporations , December 2000, available at:
http://www.treasury.gov/resource-center/tax-policy/Documents/subpartf.pdf, last visited
on August 28th, 2015
General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals,
Department of the Treasury, March 2014
Global Tax and Estate Counsel LLP, CFC and Subpart F Planning, Developing Tax Plans that
Consider the Impacts of Subpart F Provisions, available at:
http://gtecllp.com/index.php/practice-areas/international-outbound-planning/cfc-and-
subpart-f-planning.htmln last visited on August 28th, 2015
Internal Revenue Service, LB&I International Practice service Concept Unit,
DPL/CU/V_2_01(2013), September 3rd, 2013, available at:
http://www.irs.gov/pub/int_practice_units/DPLCUV_2_01.PDF, last visited on August 28th,
2015
Kenan Mullis, Check-the-Box and Hybrids: A Second Look at Elective U.S. Tax Classification
for Foreign Entities, November 4th 2011,
http://www.taxanalysts.com/www/features.nsf/Articles/58D8A3375C8ECCD18525793E005
5EB9B?OpenDocument, last visited on August 28th, 2015
13. Melissa Costa and Nuria E. McGrath, Statistics of Income Studies on International Income
and Taxes, in 30 No. 1, SOI Bulletin, 172, 187 (2010), available
at http://www.irs.gov/pub/irs-soi/10sumbul.pdf, last visited on August 28th, 2015
New York State Bar Association, Report on the 'Check the Box' Entity Classification System
Proposed in Notice 95-14, Doc 95-8285, 95 TNI 172-13, Section III.A (Sept. 5, 1995)
Philip D. Morrison, The Obama Check-the-Box Proposal, Notice 98-11 Redux, Insights &
Commentary(BNA), July 24, 2009
Philip R. West, Re-Thinking Check-the-Box: Subpart F, 83 Taxes 29 (2005), available at
http://www.steptoe.com/assets/attachments/1245.pdf, last visited on August 28th, 2015
Steve Dean, Attractive Complexity: Tax Deregulation, the Check-the-Box Election, and the
Future of Tax Simplification, March 5th, 2014, available at:
http://taxblog.com/sdean/attractive-complexity-tax-deregulation-check-box-election-
future-tax-simplification/, last visited on August 28th, 2015
