"CHECK-THE-BOX" REGULATIONS PROVIDE U.S. TAX PLANNING OPPORTUNITIES FOR FOREIGN OPERATIONS

By Tom Anderson, CPA, World Tax & Business Consulting LLC

On December 18, 1996 the I.R.S. issued final regulations with respect to the classification of domestic and foreign entities as (1) flow-throughs (e.g., branches and partnerships) or (2) corporations (Treas. Reg. section 301.7701-1 through 3). With several exceptions, the regulations follow the proposed regulations previously issued in May, 1996.

Under the old rules, an entity possessing at least three of the following four characteristics was treated as a corporation: Free transferability of interests, unlimited life, centralization of management, and limited liability.

Since the above factors were measured based on the context of local law and organizational documents, these issues were especially troublesome in the foreign area. As a result, the U.S. tax authorities have promulgated a set of simplified rules which reduce much uncertainty in the area.

The regulations effectively make the classification of an entity a matter of choice in most situations. Taxpayers may elect out of default classifications which generally follow "common sense" expectations. Corporate treatment is mandated for domestic entities formed as corporations under U.S. Federal and state law and for a limited specified group of foreign entities.

Summary of New Rules

The finalized regulations pertain to separate business entities. Trusts continue to be governed by the old rules. Certain joint undertakings, such as cost sharing arrangements, are not treated as separate business entities.

Except for certain "grandfathered" entities, the following foreign entities, among a much larger list based on country of organization, are automatically treated as corporations:

Australia, Public Limited Company

Canada, Corporation and Company

France, Societe Anonyme

Germany, Aktiengesellschaft

Hong Kong, Public Limited Company

Japan, Kabushiki Kaisha

Mexico, Sociedad Anonima

Switzerland, Aktiengesellschaft

United Kingdom, Public Limited
Company

A Canadian corporation formed under a law which provides for unlimited liability of all of the members is not included.

A foreign business entity not included on this list of "per se foreign corporations" is termed an "eligible entity." A foreign eligible entity with all members having limited liability generally will be treated as a corporation unless an election to the contrary is made. Other foreign "eligible entities" with two or more members by default will be treated as partnerships and those with only one member will be treated as a branch, unless an election is made to the contrary.

The default classification analysis in the foreign area depends on one of the four criteria under the old rules, namely, limited liability. Similar to the old rules, the determination of the existence of limited liability involves an analysis of local law.

Existing Entities

Foreign entities in existence on January 1, 1997 and whose classification is relevant to a U.S. person may retain their claimed classification provided that all the following requirements are met:

* The entity had a reasonable basis (within the meaning of IRC section 6662) for its claimed classification.

* The entity and all its members recognized the Federal tax consequences of any change in the entity's classification within the sixty months prior to January 1, 1997.

* Neither the entity nor any member had been notified in writing on or before May 8, 1996 that the classification of the entity was under examination.

The regulations provide specifically that foreign entities on the "per se" list which have been treated by taxpayers as partnerships will continue such treatment provided that--

* the entity existed on May 8, 1996.

* the entity's classification was "relevant" for U.S. tax purposes for any U.S. taxpayer.

* no U.S. taxpayer treats the entity as a corporation for tax purposes.

* any change in the entity's claimed classification within the 60-month period prior to May 8, 1996, occurred as a result of an organizational change and the tax consequences were recognized by the entity and its members.

* a reasonable basis exists for treating the entity other than a corporation.

* neither the entity nor any member was notified on or before May 8, 1996, that the entity's classification was under examination.

An entity under the above rules will lose its "grandfathered" status when--

* an entity classification election to be treated as a corporation is made.

* an entity treated as a partnership is deemed to be terminated by reason of a sale or exchange of 50% or more of the partnership interests (except with respect to certain related parties) [IRC section 708(b)(1)(B)].

* a partnership is treated as being divided [IRC section 708(b)(2)(B)].

It is unclear whether the I.R.S. would consider the "grandfathered" status lost where there is a significant change with respect to the four factors under the old rules. In such case, a "protective" election may be advisable before any such complications arise.

Taxpayers electing out of a default classification should file a fully completed form 8832, Entity Classification Election, with the service center designated in the form's instructions. The entity must file the form with its tax return. If the entity has no return filing requirement, the form must be filed with the tax returns of its direct and indirect owners.

An election is effective up to 75 days prior to the date of filing. The effective date cannot be later than 12 months after the date of filing.

An elected classification cannot be changed for a minimum period of 60 months following the effective date of the election except where--

* there is a greater than 50% change in ownership and permission is granted by the IRS, or

* the election is made with respect to an existing entity and is effective as of January 1, 1997.

Considerations Involved in the Election

Although the new rules, in themselves, are generally simple and easy to implement, extreme care should be taken prior (1) to making an election or (2) doing nothing.

The analysis, which differs for (1) inbound and (2) outbound situations, involves a determination of the immediate conversion costs and discounted future cash flows.

Inbound Ownership Situations

The issues involving foreign ownership can take many forms. For example, a domestic LLC may, by default, be treated as a partnership, resulting in a U.S. tax return filing responsibility to a foreign member.

A foreign entity with a U.S. branch may become part of a larger foreign entity by default or election. This could have significant tax consequences as illustrated in a case where A, a foreign entity not on the IRS's per se list, has an active branch in the U.S. and has been filing a Form 1120F as a U.S. branch of a foreign corporation. A is wholly owned by a foreign individual, B, who has liability for the debts of A pursuant to foreign law. Under the grandfathering rules, A would continue to be treated as a foreign corporation. However, an election to treat A as a transparency may have significant U.S. tax consequences such as--

* A would be treated as being liquidated.

* B would be required to file a Form 1040NR.

* U.S. branch profits and interest taxes would not be imposed on B since these taxes apply only to foreign corporations, not foreign individuals.

* The U.S. interest expense deduction calculations may radically change since the rules for foreign corporations and individuals differ greatly.

* B may acquire exposure to U.S. estate taxation. That is, since stock in a foreign corporation does not have a U.S. estate tax nexus, this shield from U.S. estate tax may become lost when A becomes a transparent entity.

* B may be subject to U.S. taxation if B sells his interest in A.

* state and local tax burdens may change.

Outbound Ownership Situations Involving a U.S. Individual Owner

The tax burdens of a U.S. individual conducting a trade or business in a foreign country may widely differ depending on the U.S. tax classification of the foreign entity.

For example, A, a U.S. individual, has been conducting business operations in a foreign country through a foreign entity, B, which has been treated as a controlled foreign corporation for U.S. tax purposes. B is not on the list of entities subject to automatic corporate treatment.

A decides to treat B as a transparency with the following actual and possible consequences:

* B would be deemed to be liquidated with A recognizing gain. Part of the gain may be recharacterized as a dividend under IRC section 1248.

* If B is a PFIC (i.e., a passive foreign investment company), A may be subject to additional taxes and interest charges on the deemed liquidation.

* Gains from post-conversion sales by B of capital assets would be subject to the lower U.S. capital gains tax rates available to individuals.

* A may transfer appreciated properties to B without the imposition of an excise tax or recognition of income under IRC sections 367 and 1491. (This may not be available if B is treated as a partnership. This illustrates an area where branch-type classification is preferable to partnership treatment.)

* A would not be required to file Form 5471 for B. The complex bookkeeping for the earnings and profits of a controlled foreign corporation would be eliminated.

* A would recognize the active business income of B on a current basis.

* A can generally utilize any losses from B on a current basis.

* Intercompany transactions become intracompany transactions. This means that transactions between A and B would not be subject to the U.S. transfer pricing rules and the associated penalties. A would not be required to withhold taxes on payments to B of interest, royalties, and other U.S. source income not connected with a U.S. business since these payments would be considered "intracompany" transactions, which are generally disregarded for U.S. tax purposes.

* A would be eligible for foreign tax credit relief from foreign taxes borne by B.

Outbound Situations Involving a U.S. "C" corporate Owner

U.S. corporations with foreign operations would have a separate set of issues with which to deal including the following:

* U.S. "C" corporations are eligible to take an indirect foreign tax credit for income taxes borne by certain foreign corporations of up to three tiers. Having a foreign entity be treated as a transparency may solve problems associated with a limitation on the number of tiers.

* Having a foreign entity in which the U.S. corporation does not have control be treated as a transparency may solve problems associated with the separate foreign tax credit limitation applicable to noncontrolled ("10/50") foreign corporations.

* A transparent foreign entity with current operating losses may subject the U.S. corporation to the dual consolidated loss rules.

* In a tiered structure, the elimination of a company may change the Subpart F income calculations (e.g., where interest is received from another CFC) or the taxation of a foreign personal holding company.

* A Windows 95 program focusing on this issue can be downloaded by accessing http://www.wtbc.com. *

Editor:
Lawrence A. Pollack, JD,LLM,CPA
KPMG Peat Marwick LLP