Editor's Note: In January 1997, the U.S.Treasury Department promulgated regulations which, subject to certain limitations, permit entities to elect on what basis they are taxed. As discussed below, the new regulations create significant tax planning opportunities for companies with international operations and U.S. tax reporting obligations.
Background
The U.S. federal income taxation of a business entity depends significantly upon its classification for such purposes. In general, an entity can be taxed as a partnership, corporation or branch, depending on which of these categories it elects. Under former U.S. Treasury regulations, U.S. unincorporated entities (such as U.S. partnerships) and certain non-U.S. entities (such as a Japanese yugen and a German GmbH) were taxable as either a corporation or a partnership based upon a four-factor test. The four-factor test examined whether the entity had a "preponderance" of the following "corporate characteristics": (i) limited liability for its owners; (ii) unlimited life for the entity; (iii) free transferability of the ownership interests in the entity; and (iv) centralization of management of the entity. Under the former regulations, U.S. corporations and certain non-U.S. entities, such as a German aktiengesellschaft, were always treated as corporations for U.S. federal income tax purposes.
The advent of U.S. "limited liability companies" ("LLCs") made clear the limited utility of the four-factor test. As our readers know, an LLC in many respects is identical to a corporation (for example, an LLC can be structured to give its members the limited liability accorded to corporate shareholders), yet can qualify as a partnership for U.S. federal income tax purposes. Qualifying under the four-factor test, however, in effect required an entity to lack two of the four corporate characteristics. This resulted in the inclusion in the transaction structure of terms which would otherwise have not been present (typically, nontransferability of interests and limited life), yielding unnecessary distortions in the parties' relationship and, to some extent, increased transaction costs. In addition, the former regulations did not address the treatment of 100% owned ("single member") entities, and, accordingly, it was unclear whether such entities would be treated for U.S. federal income tax purposes as "branches" of the owner or separate corporations.
To address these and other concerns, in January 1997, the U.S. Treasury Department replaced the four-factor test with a set of new regulations (the "New Regulations"). In general, the New Regulations permit a single-member entity to elect to be taxed as either a corporation or branch of that member, and a two or more-member entity to elect to be taxable as either a partnership or corporation. However, per se corporations, which are listed in the New Regulations, are automatically taxable as corporations for U.S. federal income tax purposes. Per se corporations include all U.S. corporations and Japanese kabushiki kaisha. Japanese yugen are not included in the list of per se corporations, and accordingly can elect to be taxed as either a corporation or partnership (or branch, in the case of a single-owner yugen) for U.S. federal income tax purposes. Entities other than per se corporations formed prior to January 1, 1997 and classified as either partnerships or corporations will continue to be so classified following January 1, 1997, unless they elect otherwise. Most U.S. states, including California and New York, have adopted the approach provided in the New Regulations for entity classification for tax purposes.
Planning Opportunities
Business Considerations
As indicated above, the four-factor test prescribed by the former U.S. entity-classification regulations required an entity to lack two of the four corporate characteristics. However, under the New Regulations, an entity need not satisfy the four-factor test to avoid classification as a corporation for U.S. federal income tax purposes. Thus, the parties to a venture can now form the enterprise based wholly upon the business agreement reached without including objectionable terms required for tax classification purposes. For instance, an LLC will now be treated as a partnership/branch for U.S federal income tax purposes (if its members so elect) even if its members have limited liability, it has an unlimited life, its interests are freely transferable by its members and it is centrally managed.
General Tax Planning
Under both former U.S. entity-classification regulations and the New Regulations, there are several significant distinctions between entities classified as partnerships/branches and corporations for U.S. federal income tax purposes. Most importantly, under U.S. law, corporations are subject to income tax on their earnings. Corporate shareholders are also subject to income tax on such earnings, when the earnings are distributed as dividends. (In the case of a foreign shareholder, such tax is ordinarily withheld from the distribution.) By contrast, partnerships (other than certain "publicly traded partnerships" which are taxable as corporations) and branches are treated as "tax transparent" for U.S. federal income tax purposes - that is, these entities are not subject to entity-level taxation. Instead, their income "flows through" to their members who are subject to tax on their respective shares of such earnings. Thus, investing in a tax transparent entity rather than in a corporation is often preferable because of the elimination of "double taxation." Furthermore, it is generally easier for a U.S. taxpayer to claim foreign tax credits, against its taxable income, for its share of non-U.S. taxes paid by a partnership in which it invests, than for its share of non-U.S. taxes paid by a corporation in which it holds shares.
In view of the "flow through" treatment afforded to partnerships under U.S. federal income tax laws, U.S. taxpayers forming joint ventures with non-U.S. companies often seek to form the venture as a partnership. On the other hand, a non-U.S. company conducting business in the United States typically will prefer to hold its interest in the venture through a U.S. corporate subsidiary, which insulates the non-U.S. company from U.S. federal income tax (except for withholding tax on dividends which may be imposed on dividends from the corporate subsidiary to the foreign parent company) and onerous U.S. reporting obligations. If a non-U.S. company invests in a U.S. venture directly through a U.S. partnership or branch, it will be deemed to be conducting a U.S. trade or business which may not only result in U.S. federal income taxation of the non-U.S. company's income attributable to the partnership, but also of its other U.S. source income (if any) not attributable to the partnership. Furthermore, the non-U.S. company may be subject to the U.S. branch profits tax if it invests directly in a U.S. venture as well as annual U.S. federal income tax (and possibly state income tax) reporting. To meet both the U.S. and non-U.S. partners' tax objectives, the venture will often be conducted through an entity taxable as a partnership (such as an LLC), and the non-U.S. investor will hold its partnership interest through a wholly-owned U.S. subsidiary corporation.
Hybrid Entities
The New Regulations are expected to increase the use of "hybrid entities" by multinational companies. In general, hybrid entities are taxable as corporations, and therefore usually subject to corporate income tax in one jurisdiction while qualifying for tax transparent treatment (that is, as a partnership or branch) in another. In certain instances, the use of hybrid entities produces significant tax savings because of their inconsistent treatment by taxing jurisdictions. For example, a foreign investor's use of a hybrid entity which is taxable as a partnership/branch for U.S. tax purposes and as a corporation in the foreign investor's country of residence could result in the reduction or elimination of taxation on income earned by the hybrid both in the United States and the foreign jurisdiction. In particular, the use of a U.S. single-member entity, such as an LLC, or similar foreign entity, which is disregarded for U.S. federal income tax purposes under the New Regulations, may secure benefits for the member (under an applicable treaty or otherwise) previously unavailable under the former U.S. Treasury Regulations.
Foreign investors should consult counsel, however, when employing hybrid entities. In an effort to reduce what it perceives as abusive use of hybrid entities, the U.S. Treasury Department has recently promulgated regulations to deny otherwise available tax treaty benefits to foreign investors who invest in the U.S. through certain hybrid entities (for example, a U.S. LLC that would be taxable as a corporation in the foreign investor's country of residence). Furthermore, the Clinton Administration has proposed changes to the U.S. tax laws that would provide the U.S. Internal Revenue Service broad discretion to attack perceived abusive transactions involving hybrids.
Conclusion
The New Regulations provide planning opportunities to foreign investors and companies that currently have or are considering multinational operations, including the ability to structure a new business venture without the need to include otherwise undesirable terms and to achieve certain tax results through "tax transparent" entities (such as a single member entity). A foreign investor would be well-advised to consult tax counsel when reviewing its current and proposed multinational operations to determine the most tax-efficient and flexible structure now available under the New Regulations without running afoul of U.S. anti-abuse rules.
Because of the generality of this newsletter, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.