When President Obama proposed international tax reforms on Monday, the biggest surprise was a provision that would prevent parent companies from making foreign affiliates “disappear” for U.S. tax purposes. How do you make an affiliate disappear? Since I have not taken the magicians oath, I’ll tell you. But here’s one clue: It is perfectly legal under the so-called “check-the-box” rules.

Is Obama right to try to make these subsidiaries reappear? I think he is.

First, a bit of history. In 1996, the Treasury issued regulations designed to reduce the paperwork required to classify business entities for tax purposes. The resulting “check-the-box” rules allow corporations to identify an entity as a separate corporation or to “disregard” it as the unincorporated branch of another corporation by simply checking a box on a tax form. While the regulations were targeted at domestic business, they also allowed companies to easily create “hybrid” entities that are considered a corporation by one country but an unincorporated branch by another.

Why would a firm want to create a hybrid entity? It’s complicated, so bear with me.

While American firms don’t pay U.S. tax on profits of their controlled foreign corporations (CFCs) until they bring the profits home, they have to pay U.S. tax immediately on dividends, interest or royalties paid by one CFC to another. That last rule doesn’t apply, however, to payments within a corporation --- for example, from a local branch to the home office. That’s the critical point: U.S. tax rules treat payments between related but separate corporations as real, but completely ignore payments from a single corporation’s branch operations to its home office, making the payment “invisible” for U.S. tax purposes.

Check-the-box allows U.S. multinationals to lower their taxes in high-tax countries by shifting income from affiliates in high-tax countries to affiliates in tax havens. Consider a parent company that plans to invest in Germany. Check the-box lets the firm cut its tax bill by routing capital used to finance the investment through a tax haven affiliate.

Here’s how that strategy might work (the diagram should help). The parent company first injects equity (the investment funds) into a wholly-owned Cayman Islands affiliate. That affiliate then lends the money to another wholly-owned affiliate, this one in Germany. The German firm uses the loan for an investment project and pays interest to the Cayman affiliate. The parent “checks the box” on the German affiliate, making it an unincorporated branch of the Cayman subsidiary for U.S. tax purposes, a “tax nothing.” But the Germany government considers it to be a separate corporation.

What happens to the interest payment from the German firm to the Cayman subsidiary? It’s not taxed anywhere! It’s not taxed in Germany because it’s deductible there. It’s not taxed in the U.S. because we regard the combined German/Cayman operation as a single corporation. And it is untaxed in the Caymans, which has a zero tax rate. The interest payment won’t be taxed until it is paid back to the U.S. parent.

Obama’s proposal would impose current U.S. tax on the interest by making sure the hybrid entity remains visible for U.S. tax purposes. Using the tax haven affiliate to finance the German investment would no longer be advantageous from a tax perspective.

These hybrid structures help companies avoid taxes in another important way. They enable them to move income from intellectual property like patents into tax havens by making the intercompany payment of royalties invisible. For example, a Cayman subsidiary can pay part of its parent’s R&D costs and, in return, receive royalty payments for licensing the resulting technology to another foreign subsidiary. If the parent company underprices the license and inflates royalty payments, it can leave a large amount of the resulting income from the parent’s R&D sitting in the Caymans. Just as with interest payments, the royalties are invisible to the U.S. Treasury because the two affiliates can be treated as one consolidated subsidiary. Research by Harry Grubert and John Mutti suggests that significant amounts of intangible assets have migrated from the United States to foreign countries, a trend probably encouraged by the check-the-box regulations.

The Obama administration has decided to crack down on the aggressive tax planning behavior made possible with hybrids. Interestingly, the result could be more investment in low-tax foreign locations relative to high-tax locations abroad as investment in high-tax foreign locations becomes more costly from a tax perspective. Still, many of these hybrid arrangements were designed only to cut taxes. Closing them down makes sense.