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Business Entity Classification--Part 2

By Michael B. Nelson, Esq. - Email Editor

Date : August 6, 2009

Dear Valued Reader,

As we referred to in the prior article on Business Classification, the now established rule for determining an entity’s classification for U.S. tax purposes is scheduled for a major shift.  

Just like any expensive machinery, preventative maintenance returns its costs multiple times over. It’s equally true for sophisticated and costly entity structures that are now in place and functioning as expected; providing tax benefits, cash flow, asset protection, and more. Your Plan of preventative maintenance should already be in place as the potential disaster of eliminating Check-The-Box rules nears.

A main business category that will be dramatically affected is intellectual property. Remember that the definitions for intellectual property are broad and may or may not be protected by patent, copyright, trademark, trade secrets or other laws. This includes: inventions, discoveries, trade secrets, trade and service marks, writings, art works, musical compositions and performances, software, literary works, and, but not limited to, architecture. Don’t just look to the formalistic definitions of intellectual property; be creative and you will find a plethora of industries that can be classified as intellectual property.

As we noted in the prior business entity article, Obama’s proposal would impose U.S. taxation on the interest income as well as ensuring that hybrid entities remain visible for taxation. Therefore, using the tax haven affiliate to finance the People’s Republic of China’s investment would no longer be advantageous from a pure taxation view.

It is accepted that embracing hybrid structures provide assistance to companies for avoiding taxes by moving income from intellectual property into tax havens by characterizing inter-company payment of royalties as invisible. Assuming that a Cook Island subsidiary pays a portion of its parent entity’s research and development costs as in-bound royalty payments for licensing the resulting technology to another foreign subsidiary, and the parent company under-prices the license and inflates royalty payments; a large amount of the resulting income from the parent’s R&D will be located in the Cook Islands. Similar to interest payments, royalties are invisible to the U.S. Treasury because the two affiliates are allowed to be treated as one consolidated subsidiary. International tax advisors are aware that sizeable amounts of intangible assets have migrated from the United States to foreign countries with the U.S. Treasury’s unintended assistance of the “Check-The-Box” regulations.

Obama’s increased need for revenues to help bailout and/or run the country has brought his Administrations aggressive tax estoppels concerning hybrids. However, actions by the Administration to “…abolish a range of tax-avoidance techniques by requiring U.S. businesses that establish certain corporations overseas to report them as corporations…” may create increased financial investment in no or low taxation jurisdictions with the counter-weight pointing at high-tax jurisdictions with their costly and intrusive tax legislations. The White House Office of the Press Secretary concluded that closing the above loophole by enacting legislation will begin in the year 2011. With a period just shy of 1 ½ years before the Administration’s proffered legislation, it is indeed time to rethink your financial and tax strategies, create viable options and be ready to enact your particular Plan.

NB: although the Administration’s White House statement of May 4, 2009 contained the enforcement date of January 1, 2011, there is a long history of Presidential tax law changes being enacted with an enforcement date taking effect retroactively from the legislation’s passage into law date. There is no time like the present to begin considering your alternative and establish a successful Plan. If you don’t have a Plan by the end of 2010, then the Government will have the Plan. Remember, who ever has the Plan wins.

Until next time,

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