H.R. 1865 and the Look-Through Treatment of Payments Between Related Controlled Foreign Corporations

H.R. 1865 and the Look-Through Treatment of Payments Between Related Controlled Foreign Corporations

Updated January 10, 2020
H.R. 1865 and the Look-Through Treatment of Payments
Between Related Controlled Foreign Corporations
The House amendment to the Senate amendment to H.R.
subsidiary (first-tier subsidiary) in a country without taxes
1865, the Further Consolidated Appropriations Act, 2020,
(e.g., the Cayman Islands) could lend money to its own
extended certain expiring provisions, including a number
subsidiary (second-tier subsidiary) in a high-tax country.
that were last extended through 2019 by the Consolidated
The interest payments would be deductible in the high-tax
Appropriations Act of 2016 (P.L. 114-113). This legislation
country, but no tax would be due in the no-tax country.
was signed into law on December 20, 2019 (P.L. 116-94).
Thus, an essentially paper transaction shifts income out of
Among these provisions are the look-through rules, which
the high-tax country. A similar effect might occur if an
allow certain payments between related corporations to be
intangible asset is transferred to the no-tax subsidiary, and
excluded. The Joint Committee on Taxation estimates that
then licensed in exchange for a royalty payment by the
extending the look-through rules for a year will cost $0.7
high-tax subsidiary. Subpart F taxes this income at full
billion.
rates.
The look-through rules were originally enacted in the Tax
Check-the-Box
Increase Prevention and Reconciliation Act of 2005 (P.L.
Methods of avoiding Subpart F taxation were made easier
109-222), for 2006 through 2008, and subsequently
in 1997, when U.S. entity classification rules (to be a
extended.
corporate or noncorporate entity) were simplified by simply
checking a box on a form. These “check-the-box”
General Rules for Taxing Foreign
regulations provided a way to avoid treatment of payments
Subsidiaries of U.S. Parents
as Subpart F income under certain circumstances by
Income earned abroad by foreign-incorporated subsidiaries
allowing firms to elect treatment as an unincorporated
is taxed in full, not taxed at full rates, or not taxed at all. For
entity. They were originally intended to simplify
passive income (such as interest income) and certain types
classification issues for domestic firms and the IRS, but
of payments that can be easily manipulated to reduce
their usefulness in international tax planning quickly
foreign taxes, tax rules require this income earned by
became evident. The Treasury issued regulations in 1998 to
controlled foreign corporations (CFCs) to be taxed
disallow their use to avoid Subpart F, but, after protests
currently. This income is referred to as Subpart F income,
from firms and from some Members of Congress, withdrew
reflecting the part of the tax code where treatment is
them.
specified. Credits against the U.S. tax imposed are allowed
for any foreign taxes paid on this income, and are applied
In the example above, if the high-tax subsidiary is not a
on an overall basis (so that unused foreign taxes in one
direct subsidiary of the U.S. parent but is a subsidiary of the
country can offset taxes paid on income in another country).
Cayman Islands subsidiary (i.e., a second-tier subsidiary),
Other income earned abroad by CFCs is subject to the
the Cayman Islands (first-tier) subsidiary can elect to treat
global intangible low-taxed income (GILTI) provision,
the high-tax subsidiary as if it were a pass-through entity.
which taxes this foreign-source income at half the corporate
This treatment would effectively combine the two
tax rate (10.5%), after allowing a deduction for a deemed
subsidiaries into a single firm. This outcome can be
return of 10% on tangible assets. Credits are allowed for
achieved simply by checking a box, making the high-tax
80% of foreign taxes paid. This rate is scheduled to rise to
subsidiary a disregarded entity under U.S. law. Because
13.125% after 2025.
there are no separate firms, no income is recognized by the
Cayman Islands firm, although the high-tax subsidiary
Thus, some income (Subpart F) is taxed at full rates, some
(second tier) is still a corporation from the point of view of
income (GILTI) is taxed at partial rates, and some income
the foreign jurisdiction in which it operates and can deduct
(the deemed return from tangible assets) is not taxed. (For a
interest in the high-tax jurisdiction.
more extensive discussion of international tax rules, see
CRS Report R45186, Issues in International Corporate
The Look-Through Rules Expand the
Taxation: The 2017 Revision (P.L. 115-97), by Jane G.
Scope of Check-the-Box
Gravelle and Donald J. Marples.)
The check-the-box rules do not work in every circumstance.
For example, if the related firms do not have the same first-
Subpart F Rules
tier parent, check-the-box does not apply. In some cases,
Unless an exception applies, Subpart F income includes
because of foreign countries’ rules about corporate and
dividends, interest, rent, and royalty payments between
noncorporate forms, the check-the-box regulations’
related firms. These items of income are subject to Subpart
classification of some entities as per se corporations made
F because affiliated firms can use them to shift income and
this planning unavailable. In addition, other undesirable tax
avoid tax. For example, without Subpart F a U.S. parent’s
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H.R. 1865 and the Look-Through Treatment of Payments Between Related Controlled Foreign Corporations
consequences (from the firm’s point of view) could occur
The main argument for the provision is to allow firms the
as a side effect of check-the-box.
flexibility to redeploy earnings from one location to another
without having U.S. tax consequences (foreign tax rules are
The look-through rule effectively puts this check-the-box
unchanged). Firms could, for example, accomplish much of
type of planning into the tax code, rather than as a
the treatment of look-through rules (even in the absence of
regulation (which could be altered without legislation), but
check-the-box), but that may involve complex planning and
disconnects it from the regulations’ creation of a
inconvenience. An argument can also be made that in some
disregarded entity. Related firms do not have to have the
cases (for example, with the payment of interest), the profit
parent-child relationship; they can be otherwise related as
shifting is not harming the U.S. Treasury, but rather
long as they are under common control.
reducing taxes collected by foreign governments, as income
is shifted out of high-tax countries into low-tax ones. Some
Arguments For and Against the Look-
might view this last argument as a “beggar-thy-neighbor”
Through Rules
argument, as it facilitates U.S. firms in using tax planning
The main argument against the look-through rules (and
to reduce taxes paid to other countries.
check-the-box as well) is that they undermine Subpart F’s
purpose, which is to prevent firms from using passive and
Jane G. Gravelle, Senior Specialist in Economic Policy
easily shifted income to avoid tax.
IF11392

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H.R. 1865 and the Look-Through Treatment of Payments Between Related Controlled Foreign Corporations

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https://crsreports.congress.gov | IF11392 · VERSION 2 · UPDATED