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International Tax Bulletin (January 1998)

Government Reneges on Subpart F
Application of "Check-the-Box"

By Brian Wainwright, a tax partner in the Palo Alto office of Pillsbury Winthrop Shaw Pittman LLP. If you have or can obtain the Acrobat Reader, you may wish to download our January 1998 International Tax Bulletin (a 126K pdf file), containing the printed version of this article and also available via ftp at ftp.pmstax.com/intl/bull9801.pdf.

This information is only of a general nature, intended simply as background material, omits many details and special rules and cannot be regarded as legal or tax advice.

On January 16, 1998, the Internal Revenue Service ("IRS") released Notice 98-11, announcing that regulations would be proposed that would vitiate the "check-the-box" single member entity rules for purposes of subpart F of the Internal Revenue Code and that such regulations, when adopted, would be effective January 16, 1998.


The "check-the-box" regulations, adopted in December of 1996, drastically changed the rules governing the classification of entities for U.S. federal tax purposes as partnerships or as associations taxable as corporations.[fn. 1] In the international arena, except for certain listed forms of organizations in various countries which are always classified as corporations,[fn. 2] a foreign entity can elect whether to be treated as a partnership (i.e., a pass-through entity) or a corporation for U.S. federal tax purposes.[fn. 3] Moreover, an eligible entity which has but one owner and which elects partnership (i.e., pass-through) treatment is disregarded as a separate entity for U.S. federal tax purposes;[fn. 4] rather, its activities are treated as a sole proprietorship, branch or division of its owner.[fn. 5]

Government Concerns

Treasury and the IRS are concerned that the "check-the-box" regulations facilitate the use of what they refer to as "hybrid branches" to circumvent the anti-deferral regime of subpart F. In the words of Notice 98-11:—

"These arrangements generally involve the use of deductible payments to reduce the taxable income of a controlled foreign corporation (CFC) under foreign law, thereby reducing the CFC's foreign tax and, also under foreign law, the correspondin g creation in another entity of low-taxed, passive income of the type to which subpart F was intended to apply."

Notice 98-11 illustrates the type of arrangements giving rise to concern in the following two examples:—

"Example 1. CFC1 owns all of the stock of CFC2. CFC1 and CFC2 are both incorporated in Country A. CFC1 also has a branch (BR1) in Country B. The tax laws of Country A and Country B classify CFC1, CFC2 and BR1 as separate, non-fiscally transparent entities. CFC2 earns only non-subpart F income and uses a substantial part of its assets in a trade or business in Country A. BR1 makes a transfer to CFC2 that the tax laws of both Country A and Country B recognize as a loan from BR1 to CFC2. C FC2 pays interest to BR1. Country A allows CFC2 to deduct the interest from taxable income. Little or no tax is paid by BR1 to Country B on the receipt of interest.

"If BR1 is disregarded, then for U.S. tax purposes the loan would be regarded as being made by CFC1 to CFC2 and the interest as being paid by CFC2 to CFC1. While interest received by a CFC is normally subpart F income under section 954(c) (foreign person al holding company income), in this case, if BR1 is disregarded, the "same country" exception of section 954(c)(3) would apply to exclude the interest from subpart F income. If BR1 instead were considered to be a CFC, however, this payment would be between two CFCs located in different countries. In that case, subpart F income would arise because the same-country exception would not apply. Thus, if BR1 is disregarded CFC1 will have lowered its foreign tax on deferred income and created a significant tax incentive to invest abroad rather than in the United States. As this arrangement creates income intended to be subpart F income which is not subject to subpart F in this case, the result of the arrangement is inconsistent with the policies and rules of subpart F.

"Example 2. CFC3 is incorporated in Country A. CFC3 has a branch (BR2) in Country B. The tax laws of Country A and Country B classify CFC3 and BR2 as separate, non-fiscally transparent entities. BR2 makes a transfer to CFC3 that the tax laws of both Country A and Country B recognize as a loan from BR2 to CFC3. CFC3, which earns only non-subpart F income, pays interest to BR2 that Country A allows as a deduction against taxable income. Little or no tax is paid by BR2 on the receipt of interest.

"If BR2 is disregarded, then U.S. tax law would not recognize the income flows (neither the loan nor the interest payment) between the CFC and its branch and, therefore, subpart F would not apply. If this transaction were between two CFCs, however, the interest would be subpart F income under section 954(c) and no exception would apply. Thus, if BR2 is disregarded, by use of this arrangement the CFC will have lowered its foreign tax on deferred income in a manner inconsistent with the policies and rules of subpart F."

Treasury and IRS Response

Notice 98-11 states that regulations will be proposed to prevent taxpayers from utilizing hybrid branch arrangements to reduce foreign tax while avoiding the corresponding creation of subpart F income. The regulations will provide that in cases to which they apply, a controlled corporation and its hybrid branch will be regarded as separate corporations for purposes of subpart F. The regulations will be effective not only to hybrid branch arrangements entered into or substantially modified on or after January 16, 1998, but will also apply to such arrangements entered into before that date beginning July 1, 1998.

Subsequent informal pronouncements by IRS and Treasury personnel have been inconsistent and confusing as to the scope of the impending regulations. Some comments suggest a narrow scope dealing only with fact patterns identical or nearly identical to the examples in Notice 98-11, while other comments suggest a broader view. In addition, Notice 98-11 itself states that Treasury and the IRS are aware that similar, and apparently equally undesirable results can be obtained utilizing partnerships and trusts and notes ominously that Treasury and the IRS will address the issues raised in those contexts in separate ongoing regulation projects.


What Treasury and the IRS seek to achieve appears to be a pervasive extension of the so-called "branch rule" of Internal Revenue Code section 954(d)(2), which currently only applies in the context of the foreign base company sales income rules.[fn. 6] If the branch rule is to be extended beyond its statutory scope, a credible argument can certainly be made that it's up to Congress to do it. In addition, the reliance by the government in Notice 98-11 on the reservation of regulatory authority in the check-the-box regulations with regard to international transactions is somewhat disingenuous. The results which seem to be of such concern arose long before adoption of the check-the-box regulations, although admittedly those regulations make it less burdensome to structure arrangements to reach those results. Even Notice 98-11 itself admits that comparable results can be achieved through partnerships and trusts without regard to the "check-the-box" single member entity rules.

Notice 98-11 is an example of in terrorem tax administration which seems to have as its motto, "Better to thwart 1,000 legitimate transactions than to permit one abusive one." The notice is written so ambiguously and could be interpretted so broadly that it raises a host of questions. For example, in addition to partnership and trust structures, what about "real" branches treated as separate taxpayers under foreign law? In those cases, the offensive result arises because there is no separate entity for U.S. tax purposes, without regard to the check-the-box regulations. And what is a deductible payment? Some suggestion has been made that a dividend could be such a payment where under the foreign tax system (e.g., Germany), the payor is entitled to a reduced rate of tax on earnings paid out to shareholders.

It will be interesting to see what the reaction will be to any proposed regulations and what success Treasury will have if it ultimately decides, as has been suggested, that a legislative solution would be the wiser course.


  1. For a discussion of the "check-the-box" regulations see our December 1996 Partnership Tax Bulletin also available in printed Adobe Acrobat format. You can also review Treasury Decision 8697, adopting the regulations and an October 1997 Notice of Proposed Rulemaking, proposing essentially clarifying amendments to the "check-the-box" regulations, both also in Adobe Acrobat format.[return to text]

  2. See Proc.& Admin.Regs. § 301.7701-2(b)(8) for the so-called "per se list" of foreign entities always classified as corporations, including, for example, United Kingdom public limited companies and German Aktiengesellschafts.[return to text]

  3. Proc.& Admin.Regs. § 301.7701-3(a). The regulations call an entity which is permitted to elect its classification an "eligible entity." Id.[return to text]

  4. Proc.& Admin.Regs. § 301.7701-3(a).[return to text]

  5. Proc.& Admin.Regs. § 301.7701-2(a).[return to text]

  6. For a more complete discussion of the section 954(d)(2) branch rule in the context of contract manufacturing, see Contract Manufacturing and Subpart F: IRS Revokes Revenue Ruling 75-7, also part of our January 1998 International Tax Bulletin (pdf format).[return to text]

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