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Business Entity Classification

By Michael B. Nelson, Esq. - Email Editor

Date : July 16, 2009

Dear Valued Reader,

Lawyers and Accountants have long utilized specific types of business entity classifications for providing advantages to their clients, especially from the taxation prospective. Over time, new entities and hybrid entities evolved which gave the Tax Practitioner additional planning and structures for tax, Asset Protection, income recognition and other attributes.  

Even with the four factor test, the Supreme Court’s hope of ending the cases before the courts as "seemingly in a hopeless state of confusion” was continually frustrated for another 61 years. In 1996, the U.S. Treasury enacted the so-called “Check-The-Box” proposed Treasury Regulations. This Regulation allowed the Tax Practitioner’s client to simply check the box on the tax return as to which classification entity the client wished to be taxed under. There was no tax election dilemma; merely checking the box on the tax return. This increased simplicity and certainty as well as the ease of administration for the Internal Revenue Service, “Service”, to identify which entities will be treated as corporations and which will be treated as partnerships (or disregarded entities). The Service was relieved from having to inquire into the specific state law rights and responsibilities of the entity and its members and from having to examine the specific terms included in the entity’s operating agreement.

All seemed well, but as time progressed the simplicity transmuted into complexity and the Service then proceeded to amend the Regulations more than ten times in the thirteen years since their effective date of 1996. Also, the above referred “disregarded entities” gave the Service fits in determining whether a domestic eligible entity with a single owner will be disregarded as separate from its owner, but the “single owner” determination proved to be more complex than anticipated. For example, the Service had to determine whether an entity has a “single owner” if two spouses living in a community property state each hold interests in the entity and whether an entity has a “single owner” if it is owned by a corporation and a disregarded entity that is owned by that corporation.

The slippery issue of the “single owner” problem and the analysis of inadvertent classification changes forced the Service to change from the now established formalistic rule-based approach embodied in the Treasury Regulations and move towards a more substantive analysis. However, this substantive approach departs from the now established bright line Check-The-Box method. With the current economic slump, the Federal Government is looking for more revenue. President Obama is capitalizing on this waning of Check-The-Box rule based method by making a surprising announcement of eliminating these rules as an effort to bring more taxable revenue into the coffers of the U.S. Treasury.

At first blush, you may ask how such elimination will bring more revenue into the Treasury. Your initial though is that we are taking a large step back into more government involvement and litigation in determining whether an entity is a corporation or non-corporation for taxation purposes. However, the White House Press Secretary, Robert Gibbs, outlined how this elimination would be implemented in very vague and ambiguous language:

THE WHITE HOUSE

Office of the Press Secretary

______________________

FOR IMMEDIATE RELEASE May 4, 2009

• Eliminating Loopholes for "Disappearing" Offshore Subsidiaries: Traditionally, U.S. companies have been required to report certain income shifted from one foreign subsidiary to another as passive income subject to U.S. tax. But over the past decade, so-called "check-the-box" rules have allowed companies to make their foreign subsidiaries "disappear" for tax purposes – permitting them to legally shift income to tax havens and make the taxes they owe the United States disappear as well. The Obama administration proposes to reform these rules to require certain foreign subsidiaries to be considered as separate corporations for U.S. tax purposes. This provision would take effect in 2011, raising $86.5 billion from 2011 to 2019.

How does this White House proposal increase revenue? Let’s try to show an example to bring clarity and understanding to a very complex and sophisticated industry usage. The example will focus on a newly created hybrid entity. The Treasury Regulations allows you to utilize the Check-The-Box to select this new entity as either a corporation or to disregard the new entity as an unincorporated branch of another corporation. Although these Treasury Regulations were intended to reach American businesses; they were equally advocated to assist companies to readily create hybrid entities that may be deemed a formal corporation in another country while deemed an unincorporated branch in another country. Note: most countries differ in their definitions of a corporation and a branch entity. Now, this is where the tax benefit is centered to allow businesses to gain tax advantages on an international level as well as reducing U.S. tax burdens. In our example, we know that U.S. companies are not taxed on controlled foreign corporations (CFCs) profits unless these profits are repatriated into the United States. When this repatriation occurs, these proceeds are then currently taxable as dividends, interest or royalties paid by one CFC to another. Note that this rule of current tax payment will not be applied to payments within a corporation; such as branch profits paid to the home office. This is the nexus: U.S. tax law rules apply to payments between related but separate corporations, yet disregard payments from a one corporation’s branch operations to the home office. The net effect of this is to have an invisible payment in reference to U.S. taxation purposes.

The Treasury Regulation, through the Check-The-Box program, provides American Multinationals a strategy to reduce taxes in high tax jurisdictions through a mechanism of transferring income to its related entities in low or no tax jurisdictions. Here is how it works: A Parent Company intends to make investments in what the Treasury Regulations call an “eligible entity”. As the time of this writing, there are 82 “eligible entities”. As I mentioned above, the Treasury Regulations proposed in May 13, 1996 of the Federal Register list a number of categories of domestic organizations which are always classified as corporations and equally provide foreign entities formed in foreign jurisdictions as always being held for U.S. tax purposes as corporations, “eligible entities”. Therefore, deductively, a foreign or domestic entity which is not in a category always classified "eligible entity" and which has two or more owners can elect to be classified as either a partnership or a corporation.

Utilizing the above rules and information, the current Treasury Regulations provides for a company to significantly reduce its tax burden by directing investment funds to finance an investment, via low or no tax jurisdictions. The American Multinational Parent Company funds an equity investment into a wholly-owned Cook Islands affiliate. This Cook Islands affiliate subsequently loans the equity investment to yet another wholly-owned affiliate, this one in the People's Republic of China, the entity is called a “Gufen Youxian Gongsi” (NB: the PRC is one of 82 countries that may be utilized for the tax benefit as noted above). The People's Republic of China’s Gufen Youxian Gongsi entity utilized the loan for an investment opportunity with a payback of interest to the Cook Islands affiliate. The American Multinational Parent Company then “Checks-The-Box” on the People's Republic of China’s Gufen Youxian Gongsi. This causes it to be an unincorporated branch of the Cook Islands subsidiary for U.S. tax purposes, a zero tax jurisdiction. However, the PRC’s government classifies the Gufen Youxian Gongsi as a separate corporation.

Remarkably and as planned, the loan interest payment from the People's Republic of China’s Gufen Youxian Gongsi entity to the Cook Islands entity is not subject to taxation in the Cook Islands, the PRC or the United States. There is not tax liability in the PRC because the loan interest payment is deductible in the PRC. Nor is the interest income taxed in the U.S. because the United States holds the People's Republic of China’s Gufen Youxian Gongsi/Cook Islands entity operation as a single corporation. The income is not taxed in the Cook Islands because there is no tax in the Cook Islands. Therefore, the interest income payment will not be subject to taxation until it is repatriated back to the American Multinational Parent.

Under the current White House proposal, tax would be due immediately on the interest income since the “Check-The-Box” rule would be eliminated and the hybrid entity would retain visibility for U.S. taxation and the utilization of the Cook Island affiliate to finance the PRC investment fund would lose it tax advantages. This new development under the Obama Administration needs to be followed closely and, if so deemed necessary by the Tax Practitioner, other tax planning and strategic alternatives may need to be implemented immediately.

If you have any questions about this subject, please email us at info@trustmakers.com.

Until next time,

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