IRC 7701 Check-the-Box Elections for Foreign Pass-Through Entities: Structuring Hybrid Entities for Tax Arbitrage

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A IRC 7701 Check-the-Box Elections for Foreign Pass-Through Entities: Structuring Hybrid Entities for Tax Arbitrage Lowering U.S. Income Tax on Income From Eligible by Electing Tax-Advantaged Treatment TUESDAY, DECEMBER 5, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Cindy Grossman, Partner, Giordani Swanger Ripp and Jetel, Austin, Texas Patrick J. McCormick, J.D., LL.M., Kulzer & DiPadova, Haddonfield, N.J. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

2 Tips for Optimal Quality FOR LIVE EVENT ONLY Sound Quality If you are listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory, you may listen via the phone: dial and enter your PIN when prompted. Otherwise, please send us a chat or sound@straffordpub.com immediately so we can address the problem. If you dialed in and have any difficulties during the call, press *0 for assistance. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted. Viewing Quality To maximize your screen, press the F11 key on your keyboard. To exit full screen, press the F11 key again.

3 Continuing Education Credits FOR LIVE EVENT ONLY In order for us to process your continuing education credit, you must confirm your participation in this webinar by completing and submitting the Attendance Affirmation/Evaluation after the webinar. A link to the Attendance Affirmation/Evaluation will be in the thank you that you will receive immediately following the program. For CPE credits, attendees must participate until the end of the Q&A session and respond to five prompts during the program plus a single verification code. In addition, you must confirm your participation by completing and submitting an Attendance Affirmation/Evaluation after the webinar. For additional information about continuing education, call us at ext. 35.

4 IRC 7701 Check-the-Box Elections for Foreign Pass-through Entities: Structuring Hybrid Entities for Tax Arbitrage Presented by Cindy L. Grossman for Stratfford Publications December 5, C O N G R E S S A V E N U E, S U I T E A U S T I N, T E X A S phone fax W W W. G S R J L A W. C O M

5 Purpose of Check-the-Box Entity Election Before Check-the-Box ( CTB ) - U.S. v. Kintner set out six elements of a corporate entity Presence of associates Objective to carry on business Continuity of life of the entity Centralization of management Limited liability Transferability of interests - The first two characteristics are reflected in corporations and partnerships, so test turned on final 4 elements 3 or more of the last 4 elements present = corporation; 2 or fewer = partnership - Foreign entities were treated as unincorporated, no matter foreign status, and then subjected to Kintner analysis. Kintner factors were determined using local law of the foreign jurisdiction rather than U.S. law. L O O K I N G B E Y O N D O U R B O R D E R S 5

6 Purpose of Check-the-Box Entity Election Complexity and uncertainty ensued under Kintner test - Costly, unclear, burdensome - Larger burden fell on unsophisticated taxpayers - Required constant monitoring of entity s status to understand if classification changed Additional complexity and uncertainty added by appearance of limited liability companies and limited partnerships - Flexibility in entity structure made Kintner test somewhat elective, but analysis remained costly LLC: centralized management and limited liability, but no free transfer of interests, would have default classification as a partnership Notice 95-14: Treasury announced intent to move to elective classification system 1997: CTB regulations under are issued and established eligible entities that could elect partnership/disregarded entity or corporate taxation L O O K I N G B E Y O N D O U R B O R D E R S 6

7 Purpose of Check-the-Box Entity Election Domestic Policy Rationale: - Reduction of compliance burden - Increased simplicity - Reduction of taxpayer s costs, and IRS administrative costs - Establishes certainty no more worrying if a change in circumstances changed entity classification Policy justifications for extending CTB to foreign entities - Reduction of compliance burden, taxpayer s costs, and IRS costs - Increased Simplicity - Increased fairness between sophisticated and unsophisticated taxpayers, which had been exacerbated in foreign context due to complexity of foreign law analysis - Minimize tax-driven business decisions and reduced situations in which desired business decision undermined U.S. tax classification, or vice versa L O O K I N G B E Y O N D O U R B O R D E R S 7

8 Purpose of Check-the-Box Entity Election Hybrid worries - Hybrid entity: U.S. law classifies the entity as a pass-through, while foreign law classifies as a corporation - Reverse Hybrid: U.S. law classifies the entity as a corporation, while foreign law classifies as a pass-through - Treasury was concerned that inconsistent treatment of an entity between two taxing authorities would lead to gamesmanship, and that CTB regulations made such gamesmanship easier Counterarguments: - CTB is simplification of an already-elective system; Treasury didn t believe CTB would cause use of hybrids to increase or decrease - Advantages of CTB would outweigh any increase in hybrid abuse - Hybrid abuse should be curbed by curbing the abusive transactions in which they engage, and not the entity s ability to elect entity classification - CTB advocates prevailed and the final CTB regulations included both domestic and foreign eligible entities, with a warning: Treasury and the IRS will continue to monitor carefully the uses of partnerships in the international context and will take appropriate action when partnerships are used to achieve results that are inconsistent with the policies and rules of particular Code provisions or of U.S. tax treaties L O O K I N G B E Y O N D O U R B O R D E R S 8

9 Eligible Entities The CTB regulations allow an eligible entity to elect its tax classification An eligible entity is one that: - Exists separately from its owners; - Is not a trust; and - Is not a deemed corporation L O O K I N G B E Y O N D O U R B O R D E R S 9

10 Eligible Entities Deemed corporations: Domestic ( (b)) - Organized as a corporation or joint stock company under federal or state statute - Association (as determined under ) - Insurance company - State-chartered entity conducting banking activities if deposits are FDIC insured - Entity wholly-owned by state or political subdivision thereof - Taxable as a corporation under another provision of the IRC L O O K I N G B E Y O N D O U R B O R D E R S 10

11 Eligible Entities Deemed Corporations: Foreign ( (b)(8)) - The List - Pay attention to the clarifications of the List - Also watch for special rules for certain pre-1997 foreign business entities under (d) that have grandfathered status in some circumstances Careful of loss of grandfathered status due to changes in ownership or affirmative election into corporate status - Be mindful of effective dates for application to foreign entities in the List Ex: Bulgarian Aktsionerno Druzhestvo is only a per se corporation if formed after 1/1/2007 or, if formed prior to such date, 50% of more of its equity interests were transferred to persons not owners as of 1/1/2007 L O O K I N G B E Y O N D O U R B O R D E R S 11

12 Eligible Entities Default classifications of eligible entities: - Domestic: default away from corporate taxation If more than own owner, default to partnership If one owner, default to disregarded entity - Foreign: default to corporate taxation Corporate default if all members have limited liability Partnership default if at least one member has unlimited liability Disregarded entity default if entity has only one member and that member has unlimited liability L O O K I N G B E Y O N D O U R B O R D E R S 12

13

14 IRC 7701 Check-the- Box Elections for Foreign Pass-Through Entities PATRICK J. M CCORMICK, J.D., LL.M. pmccormick@kulzerdipadova.com Follow us

15 Patrick J. McCormick Patrick J. McCormick is an associate with Kulzer & DiPadova, P.A. He earned his J.D. from Vanderbilt University Law School in 2008, and his LL.M. from New York University School of Law in Mr. McCormick specializes in and regularly handles matters covering all areas of international taxation, frequently publishing articles and giving presentations on assorted areas of international tax law. 15

16 Relevance Determination for A foreign entity becomes relevant when its classification affects the liability of any person for federal tax or information purposes. Treas. Reg (d)(1)(i). The date that the classification of a foreign eligible entity is relevant is the date an event occurs that creates an obligation to file a federal tax return, information return, or statement for which the classification of the entity must be determined. Thus, the classification of a foreign entity is relevant, for example, on the date that an interest in the entity is acquired which will require a U.S. person to file an information return on Form Cognizance of the entity s date of relevance is thus vital to maximize United States flexibility. 16

17 Relevance Determination for When is obligation to file created? Generally, a foreign corporation engaged in trade or business within the United States during the taxable year is taxable on income effectively connected with the conduct of that trade or business. I.R.C. Section 882(a). Foreign corporations engaged in a United States trade or business at any time during the taxable year must make a return on Form 1120-F. See Treas. Reg (g)(1)(i) Information reporting obligations can also exist for foreign entities; two examples are Form 5471 (for foreign corporations) and Form 8865 (for foreign partnerships). 17

18 Relevance Determination for United States trade or business Case law dictates that, where profit-oriented activities are carried on in the United States which are regular, substantial, and continuous, these activities are properly classified as a United States trade or business, whether carried on directly by the taxpayer or through its agents. U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956); U.S. v. Northumberland Insurance Company, 521 F.Supp. 70 (DNJ 1981). Foreign corporations have been held to have carried on a United States trade or business through a single person acting as a United States agent, even where the agent assumed full responsibility for sales under the relevant contracts. See Revenue Ruling The standard for a United States trade or business is low, resulting in most types of involved business activities being classified as a trade or business. 18

19 Relevance Determination for Form 5471 required for (among others): U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person has acquired 10% of the stock of the corporation or an additional 10% of the outstanding stock. U.S. person who acquires stock making his/her ownership in foreign corporation 10%. U.S. person who had >50% of stock of the foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation. U.S. shareholder who owns stock in a foreign corporation that is a controlled foreign corporation for an uninterrupted period of 30 days or more during any tax year of the foreign corporation, and who owned that stock on the last day of that year. 19

20 Relevance Determination for Form 8865 required for (among others): U.S. person who had a 50% interest in the foreign partnership at any time during the partnership s tax year. U.S. person who at any time during the tax year of the foreign partnership owned a 10% or greater interest in the partnership while the partnership was controlled by U.S. persons each owning at least a 10% interest. U.S. person who contributed property during that person's tax year to a foreign partnership in exchange for an interest in the partnership, if that person either (1) owned at least a 10% interest immediately after the contribution or (2) the value of the property contributed (when added to the value of any other property contributed over the prior 12 months) exceeds $100,000. U.S. person that had a reportable event under section 6046A during that person's tax year. Reportable event: acquisitions, dispositions, and changes in proportional interests. 20

21 Relevance Determination for Where an entity has become relevant without an election being made, late election relief is available. See Revenue Procedure Late election relief is sought through use of Form 8832, with Section II of the form completed. Explanation as to why the entity classification election was not filed on time required 21

22 Relevance Determination for Can seek late election relief if: The entity failed to obtain its requested classification as of the date of its formation (or upon the entity s classification becoming relevant); Either the entity has not filed a federal tax or information return for the first year in which the election was intended because the due date has not passed for that year s federal tax or information return or the entity has timely filed all required federal tax returns and information returns (or if not timely, within 6 months after its due date, excluding extensions) consistent with its requested classification for all of the years the entity intended the requested election to be effective and no inconsistent tax or information returns have been filed by or with respect to the entity during any of the tax years; The entity has reasonable cause for its failure to timely make the entity classification election; and Three years and 75 days from the requested effective date of the eligible entity's classification election have not passed. 22

23 Relevance Determination for Prospective elections can also be made for existing entities. Where a prospective election is made, tax ramifications can occur (based upon the deemed change in entity). If an eligible entity elects to change its classification, the entity cannot change its classification by election for sixty months after the election s effective date. 23

24 Relevance Determination for When elective changes take place in entity classification, certain steps are deemed to have occurred. Where a partnership changes its election to a corporation: p ship is deemed to contribute all of its assets and liabilities to a corporation in exchange for stock of the corporation and immediately thereafter liquidates by distributing the stock to its partners Where a corporation changes to a partnership: corp is deemed to distribute all of its assets and liabilities to its shareholders in liquidation; the SHs immediately contribute the assets and liabilities to a new partnership Where a corporation becomes a disregarded entity: corp is deemed to distribute all of its assets and liabilities to its single owner in liquidation Where a disregarded entity changes to a corporation: DRE owner is deemed to contribute all of the assets and liabilities of the DRE to the corporation in exchange for stock of the corporation 24

25

26 Planning Opportunities for Application of Kintner was complex, given variance in form of foreign entities (and necessity to analyze foreign law) Entity classification choice here was also still possible: foreign entities could tailor themselves/their formation documents to fit a desired U.S. tax classification under the rules Hybrid concept functionally thus predated the check-the-box rules Check-the-box regulations were an attempt to simplify the entity classification process The check-the-box regulations themselves create significant flexibility for classification, and resultant significant planning opportunities 26

27 Planning Opportunities for Entity classification rules permit the utilization of hybrid entities (i.e. an entity treated as a corporation for foreign tax purposes and a disregarded entity for United States purposes), which can provide great benefits from a global planning perspective. Based on the facts involved, it may be preferable, for example, to elect classification of a foreign entity as disregarded to facilitate transfers between a domestic parent and its foreign subsidiary (instead of making such distributions subject to dividend treatment). Most common election by foreign entities is to not be treated as an entity separate from its owner. 27

28 Planning Opportunities for Example: Treatment of a foreign corporation as a DRE A foreign disregarded entity is treated as a foreign branch for United States tax purposes. Income of a foreign disregarded entity is included in the taxable income of its owner. Importantly, transactions entered into between a disregarded entity and its owner do not give rise to offsetting amounts of income or expense. Assets of the disregarded entity are treated as being owned by the entity s underlying owner. Generally, transactions between the disregarded entity and its owner are ignored for United States tax purposes. 28

29 Planning Opportunities for Hybrid entities are entities which are fiscally transparent for United States tax purposes (i.e. a partnership) but not fiscally transparent for foreign tax purposes (i.e. a corporation). A reverse hybrid entity is one which is fiscally transparent for foreign tax purposes but not fiscally transparent for United States tax purposes. Different types of these entities can exist: An entity can be a corporation for foreign tax purposes but a partnership or disregarded entity for United States purposes. An entity can be a partnership or branch for foreign tax purposes but a corporation for United States tax purposes. 29

30 Planning Opportunities for Foreign entities generally can elect their treatment for United States tax purposes, regardless of their treatment in the country in which they are domiciled. NOTE: As discussed, it is always necessary to verify that a foreign entity is not a per-se corporation; where this is the case, elections for entity classification will not be available. Generally, United States law not concerned with entity classification in the domicile country 30

31 Planning Opportunities for Planning through hybrid entities provides significant opportunities. Can have situations where a transaction is deductible in country A without creating taxable income in the other country Can exploit different tax rules of relevant jurisdictions to reduce/eliminate tax On a macro level, use of hybrid entities provides planning opportunities; option should be explored when a foreign entity becomes (or is anticipated to become) relevant Examples include structuring transactions to maximize foreign tax credits, utilize income tax treaty benefits, and modify application of Subpart F. 31

32 Planning Opportunities for Foreign Tax Credits The foreign tax credit generally is available to United States persons for taxes paid to foreign jurisdictions The foreign tax credit allows the taxpayer to achieve a fair overall effective tax rate, thereby not disincentivizing foreign transactions Can structure transactions involving hybrid or reverse hybrid entities so that eligibility for a foreign tax credit exists without any income inclusion Result has an entirely different effect than what is intended by the foreign tax credit rather than not disincentivizing foreign transactions, it creates incentives for entering into them for nonbusiness reasons 32

33 Planning Opportunities for Tax Treaties Function to reduce a country s taxing authority in situations covered by treaty terms; the United States maintains treaties with over sixty countries. Under treaties, residents of a treaty country can be taxed at a reduced rate, or even exempted from tax, on specified items of income from the other country. Intention, like with foreign tax credits, is to alleviate double taxation Treaties can be utilized in the hybrid context to modify taxes applicable for payments (i.e. withholding taxes) Result again has a different effect than intended 33

34 Income Transfer Opportunities out of Subpart F The Subpart F anti-deferral regime - Disallows U.S. shareholders of controlled foreign corporations operating in low-tax jurisdictions from deferring tax on certain types of income - Section 954(c)(6) look-through rule exempts from Subpart F dividend, interest, rent, and royalty income earned from a related CFC, provided the payment is allocable to non-subpart F income of the payor CFC L O O K I N G B E Y O N D O U R B O R D E R S 34

35 Income Transfer Opportunities out of Subpart F: Disregarded Loans Earnings Stripping through disregarded loans - CFC A is a corporation - CFC B is a disregarded entity U.S. Co. - CFC B makes interest payments to CFC A, which would normally be Subpart F income, but because CFC B is disregarded, the transaction is disregarded - Foreign high-tax sub reduces its foreign tax burden with interest deduction; minimal tax on interest income in low tax jurisdiction CFC A (low tax) Loan CFC B (high tax) Interest payments L O O K I N G B E Y O N D O U R B O R D E R S 35

36 Income Transfer Opportunities out of Subpart F: Active Rent U.S. Co. CFC A (low tax) Lessees $Rental income to CFC A Rental income is Subpart F income to CFC A Transaction exploits active rent exception to Subpart F rental income to change rental income into non-subpart F income, but only activities of a CFC s employees are taken into account for the active business test CFC B (high tax) Management services Provided to CFC A CFC B provides management services to CFC A in exchange for management fee CFC B s employees attributed to CFC A by checking the box, thus meeting management requirement of active rent exception L O O K I N G B E Y O N D O U R B O R D E R S 36

37 Income Transfer Opportunities out of Subpart F: Check-and-Sell Dover Corporation, 122 TC 324 (2004) Check-and-Sell technique allows a U.S. parent company to avoid Subpart F inclusion on proceeds from sale of lower-tier CFC subsidiary Original Organization: U.S. Parent Co Organization immediately prior To sale: U.S. Parent Co CFC A (corp) CFC A (corp) CFC B (corp) CFC B (DE) L O O K I N G B E Y O N D O U R B O R D E R S 37

38 Income Transfer Opportunities out of Subpart F: Check-and-Sell Typically, sale of corporate subsidiary stock by a CFC will generate Subpart F income because proceeds will be foreign personal holding company income - FPHCI includes net income from the sale of property that: Gives rise to passive income, Is an interest in a trust, partnership, or real estate mortgage investment conduit, or Does not give rise to any income - FPHCI also includes net proceeds from sale of property that gives rise to income, unless the property is used or held for use in the CFC s trade or business L O O K I N G B E Y O N D O U R B O R D E R S 38

39 Income Transfer Opportunities out of Subpart F: Check-and-Sell Prior to the sale of its stock, CFC B will check the box to become a disregarded entity (assuming it is an eligible entity), at which point a sale of its stock will be treated for U.S. tax purposes as a sale of its assets by CFC A - The check the box election by CFC B is a deemed liquidation under Section Under 381, a parent corporation in a 332 liquidation succeeds to the attributes of the liquidated subsidiary, including its active business - Revenue Ruling confirmed active trade or business requirement is met when subsidiary liquidates The result: CFC A s sale of CFC B s stock is treated for tax purposes as a sale of CFC A s assets used in an active trade or business. Such income is not Subpart F income, and therefore the sale of CFC B s stock avoid Subpart F treatment. L O O K I N G B E Y O N D O U R B O R D E R S 39

40 Income Transfer Opportunities out of Subpart F GILTI Senate version of Tax Cuts and Jobs Act establishes Global Intangible Low-tax Income ( GILTI ) concept Works similarly to Subpart F Patent box apparatus may encourage shifting of tangible and intangible assets offshore using CTB may allow tangible/intangible assets of one CFC to be attributed to a parent CFC, thus skewing GILTI tax calculation by creating larger tangible asset base L O O K I N G B E Y O N D O U R B O R D E R S 40

41 Planning Opportunities for As seen, hybrid entities permit a level of manipulation of rules intended to avoid double taxation. Rather than evening the playing field between domestic and international transactions, hybrids can create reasons to favor international transactions. Also create reasons to enter into transactions rather than merely facilitate transactions for which there are inherent business reasons Given the ability to reduce/eliminate tax as a result of structuring transactions, the Service sought to limit the availability of certain planning techniques. 41

42 Planning Opportunities for Code Sec. 894(c)(1) denies treaty benefits for specified payments from the United States made to hybrid entities. Under the provision, foreign persons are not entitled to any reduced withholding tax rate under any United States income tax treaty on income derived through an entity that is treated as fiscally transparent for purposes of United States taxes if: The income is not treated as income of the person for purposes of the tax laws in the foreign country, The treaty contains no provision relating to the applicability of the treaty to income derived through a partnership, and The foreign country imposes no tax on the distribution of the income from the entity to the person. 42

43 Planning Opportunities for Code Sec. 894(c)(1) s intention was to eliminate certain taxavoidance opportunities available through use of hybrid entities. One example cited by the House and Ways Committee: Through the use of a U.S. limited liability company, which is treated as a partnership for United States tax purposes but as a corporation for Canadian tax purposes, a payment of interest (which is deductible for United States tax purposes) may be converted into a dividend (which is excludable for Canadian tax purposes) 43

44 Planning Opportunities for Code Sec. 894(c)(2) authorized the Service to promulgate regulations to determine the extent to which a taxpayer to which paragraph (1) does not apply shall not be entitled to benefits under any income tax treaty of the United States with respect to any payment received by, or income attributable to any activities of, an entity organized in any jurisdiction (including the United States) that is treated as a partnership or is otherwise treated as fiscally transparent for purposes of this title and is treated as fiscally nontransparent for purposes of the tax laws of the jurisdiction of residence of the taxpayer. Temporary regulations issued in 1997; final regulations issued in

45 Planning Opportunities for The relevant Regulations set forth additional limitations for certain transactions involving hybrid entities (limiting potential for double non-taxation of items of income). [Withholding taxes imposed] on an item of income received by an entity, wherever organized, that is fiscally transparent under the laws of the United States and/or any other jurisdiction with respect to an item of income shall be eligible for reduction under the terms of an income tax treaty to which the United States is a party only if the item of income is derived by a resident of the applicable treaty jurisdiction. Regs. Sec (d)(1) 45

46 Planning Opportunities for Under Regs. Sec (d)(1), an entity is a person (including a single-member disregarded entity) that is treated by the United States or the applicable treaty jurisdiction as other than an individual. The applicable treaty jurisdiction is the country whose income tax treaty with the United States is invoked for purposes of reducing withholding taxes imposed. The term resident shall have the meaning assigned to such term in the applicable income tax treaty. 46

47 Planning Opportunities for Under Regs. Sec (d)(1), an item of income paid to an entity shall be considered to be derived by the entity only if the entity is not fiscally transparent under the laws of the entity's jurisdiction with respect to the item of income. An item of income paid to an entity shall be considered to be derived by the interest holder in the entity only if the interest holder is not fiscally transparent in its jurisdiction with respect to the item of income and if the entity is considered to be fiscally transparent under the laws of the interest holder's jurisdiction with respect to the item of income Notwithstanding the preceding two sentences, an item of income paid directly to a type of entity specifically identified in a treaty as a resident of a treaty jurisdiction shall be treated as derived by a resident of that treaty jurisdiction. 47

48 Planning Opportunities for Three specific situations in which income is treated as derived by a resident of a treaty jurisdiction and subject to the taxing jurisdiction of the resident's jurisdiction and thus considered eligible for treaty benefits. First: an item of income paid to an entity is considered derived by the entity if the entity is not fiscally transparent for the item of income under the laws of the entity's jurisdiction. Second: regardless of whether the entity is found to be fiscally transparent for the item of income under the laws of the entity's jurisdiction, an interest holder in the entity may derive the item if that interest holder can show that under the laws of the interest holder's residence the entity is fiscally transparent for that item of income. However, the interest holder itself must not be considered fiscally transparent for the item of income under the laws of its jurisdiction in order to claim the treaty benefit of that jurisdiction. Third: an item of income paid to a type of entity specifically listed in a treaty as a resident of the treaty jurisdiction is treated as derived by a resident of that jurisdiction. 48