March 2011 (109) – US Classification of Business Vehicles

There is a unanimous concern amongst developed nations for public spending cuts whilst at the same time trying to encourage entrepreneurs to create the new wave of economic growth, thereby filling the employment void which is the inevitable consequence of public spending cuts. David Cameron has pledged the UK coalition Government to provide the right framework for entrepreneurial growth, and the 2011 Budget due to be announced on 23 March is expected to provide the required stimuli. But it is not only entrepreneurs that need the right fiscal legislation to achieve their financial objectives; it is also the investment community which is the major contributor to economic prosperity. In a period where returns on investments are historically low within money markets, it is essential to provide equivalent stimuli to investors, perhaps not by tax cuts which would be contrary to the requirements to reduce the public debt burden, but through legislation which recognises the sometimes double or triple tax burden suffered by the investment community.

To take a simple example, a UK company had been established by the family patriarch many years ago to manufacture furniture. Father died and left his shares to four brothers who carried on the family business until they received an offer to sell the business some ten years ago. The purchasers acquired the company, and the brothers, with considerable funds at their disposal, agreed to invest these into several businesses around the world with which they had become familiar whilst their father was alive. They decided to do so through a UK investment holding company, and selected investee companies in the US, Canada, Italy, France, Poland and Czech Republic. Taking advice from the omnipresent Maurice Brightman, they are informed that the return on their investments will be receivable after deduction of local corporate tax in the investee companies (primary tax charge), then a withholding tax on distributions to the UK company (probably 15%, which is the secondary tax bill), and then a UK corporate tax charge if only the foreign withholding taxes are creditable against the corporate tax charge. And they still do not have the profits in their own hands which would involve a further tax charge, because of their high rate profile, of 32.5%. No small wonder that they are taking a breather before considering these investments.

As with most tax legislation, one can look to the US for a lead as to how to encourage investment without these several layers of taxation. The check-the-box Regulations in the US were first effective in 1997, and this month’s article written by Bob Kiggins of McCarthy Fingar LLP is actually an excerpt from the 2011 edition of ‘International Tax Systems and Planning Techniques’, due to be published in September 2011. It shows the reason behind the Regulations, and the benefits that would be afforded to the investment community should such a system be similarly adopted in other countries. As ever, I would be very interested to receive any comments from our readers, so please click here.

In fact, the check-the-box Regulations may have sprung from a European initiative, being the l975 proposed Directive on the harmonisation of taxes within Europe. This advocated a partial imputation system whereby shareholders could receive a credit for part of the corporate tax charge imposed on the relevant company, and this credit would spread across European companies rather than be isolated solely within domestic legislation. Thus although Germany had a 100% imputation system at one stage, and France a 50% avoir fiscal, the proposed Directive was quite adventurous in recommending a European wide credit. However, as with many European initiatives related to corporate tax harmonisation, the proposed Directive was never adopted, and the imputation systems of taxation seem to have dissolved into a distant memory. The check-the-box system is an even simpler version than the imputation system in that only one level of taxation is incurred at investor level with credits for any corporate tax charges incurred along the way. 

The four brothers may want to create an investment holding company for various reasons. Limited liability springs to mind as being an important reason for having companies, but also the brothers may be thinking about their own succession planning, with the ease of transferring their respective shares between their own children an important consideration.  Also, double tax treaty arrangements often allow distributions to be made between companies in different States subject to a much lower withholding tax (or indeed exemption from withholding tax) than if the distributions were made to individuals or a partnership. Thus the four brothers above could easily have created a UK LLP to invest in the various ventures, but this LLP would not have been able to benefit from double tax treaty arrangements, meaning that the overall tax bill would be higher than if a company were involved.  So the corporate solution is decided upon, but then comes the various layers of taxation to discourage their investment plans – they need to have a reasonable post-tax return for the investment risks they are taking. 

After decades of various governments’ tinkering with the tax system, it is about time that governments looked at ways to encourage both entrepreneurial businesses and the investment community (with today’s global investment opportunities) through innovative laws which encourage investment without necessarily reducing tax rates. It will be interesting to see what the 2011 budget brings in the UK.

US Classification of Business Vehicles

Single (Transparent) vs. Double Tax (Opaque) Entities

Throughout the world, there are two basic patterns for taxation of a business entity. First, under what is called the single tax pattern, the income of the entity is taxed only once – typically in the hands of the owner(s). In this pattern the entity is said to be “transparent” for tax purposes. Second, under what is called the double tax pattern, the income is taxed partly in the hands of the entity and partly in the hands of the owners. In this pattern, the entity is “opaque” for tax purposes and the income is subject to double taxation with varying degrees of local law relief (at either the entity or the individual level) from full-blown economic double taxation.

In a purely single country business structure, the domestic legislation will ensure that the income is taxed pursuant to one of the two basic patterns. However, in a cross-border business structure, this is not necessarily the case. If the two countries, due to the differences in their domestic legislation, classify the entity differently for tax purposes, a situation could occur in which one country taxes the income according to the single tax pattern and the other according to a double tax pattern. This phenomenon is referred to, in academic circles, as “asymmetrical” taxation and, in tax planning circles, the entity receiving this disparate classification treatment is called a “hybrid”.

Whether an entity will be taxed by a given country according to a double tax pattern or a single tax pattern is determined by a country’s rules for entity classification.

  • First, the classification determines the person liable to pay the tax.  In the single tax structure, it is the owner. In the double tax structure, it is in the first instance the entity which has the tax liability.
  • Second, the classification impacts the timing of the taxation. In the single tax case, the owner is fully taxed when the income is earned regardless of whether it is distributed to the owner or not. In the double tax case the income is subject to corporate tax at the entity level.  But, subject to controlled foreign corporation legislation, if the income is not distributed when earned then full and final taxation will generally be deferred until distribution at a later point in time than with the transparent (single tax) entity.
  • Third, the classification can also impact the type of income and the type of tax.  Thus, profits run through a business entity are generally business income. Where the profits are run through a transparent (single tax) entity the owner, if he is an individual is subject to personal income tax on the income. On the other hand where the entity is opaque (double tax) the entity is subject to entity level(generally corporate) taxation. This classification can impact on cross border double tax relief or cross border no-tax penalisation as well. Additionally, corporate profits from an opaque entity will generally be treated as dividends(favourably taxed at present in the US at 15% rates) whereas if the person is running the business through an entity classified as transparent, all income will be regarded as business income (subject to tax at full rates in the US of up to 35%).
  • Fourth, the classification impacts the person entitled to cross border double tax relief or no-tax penalties.  In the case of a transparent entity this would be the owner. Conversely, in the case of an opaque entity this would be the entity itself.

Check the Box Regulations

The US essentially allows the persons organising a business entity (the term “business” entity  excludes entities which are deemed as trusts) to elect if the entity will be fiscally transparent (single tax) or opaque (double tax) for US tax purposes. Moreover, the election (called check-the-box) may be made with regard to foreign as well as US entities.

Under check-the-box a business entity may be classified as either a corporation, a partnership, or a so-called disregarded entity. Very simply, if classified as a corporation the entity will be fiscally opaque (i.e. there will be a corporate tax at the level ofthe entity and distributions to owners will be subject to tax, generally as dividends). However, if the election is to treat the business entity as a partnership or a disregarded entity it is fiscally transparent for US tax purposes.

There is not quite carte blanche to make the election for all business entities. Thus, the election may not be made as to certain types of entities that are considered as per secorporations. Apart from business organisations organised as corporations in the US, this per se category includes about 80 listed types of foreign entities (including UK PLCs, German AGs and French SAs). The list entails capital oriented entities that are treated as taxable entities in their home countries.  These per se corporations are perforce opaque for US tax purposes.

Business entities not deemed to be per secorporations are called “eligible entities” (such as UK Ltds, German GmbHs or French Sarls).  If an eligible entity has two or more owners it may elect to be classified as either a corporation (opaque) or a partnership (transparent).  A single owner entity may elect to be either treated as a corporation (opaque) or disregarded (with essentially the same effect as being transparent).

There are default classifications if an election is not made for an eligible entity.  So a business entity with two or more owners, if no election is made, is classified as a partnership (transparent) provided at least one owner is subject to unlimited liability – otherwise if all owners have limited liability it is classified as a corporation (opaque). If there is only one owner, and no election is made, the entity will be fiscally transparent.

Procedure for making the election:

  • Filing of election: To elect a certain status, other than the default classification, an eligible business entity must file an election form (Form 8832) no more than 75 days after and no more than 12 months prior to the date the election is to be effective. In addition, a copy of the election form must be filed with the entity’s tax return for the year the election is effective.
  • Consent requirement: Documentation of unanimous consent of an entity’s membership is not required. Thus, an election can be signed by an authorised officer, manager or member.
  • Subsequent change to election: Once an election has been made, the electing entity may not make a subsequent change of classification for a period of 60 months after the effective date of the initial election(except with the consent of the IRS if there has been a greater than 50% change in the entity’s ownership). Moreover, the limitation does not apply if an entity’s business is actually transferred to another entity (e.g. liquidation into parent, merger, etc).

Special rule for exempt organisations:

Regulations §301.7701-3(c)(1)(iii) provides that “an eligible entity that has been determined to be, or claims to be, exempt from taxation under §501(a) is treated as having made an election under this section to be classified as an association.” It is important to note that many exempt organisations (including employee plans qualifying under §401(a) of the Code) will not be eligible business entities, either because they are properly classified as trusts or because they are non-profit corporations.

Check-the-Box Planning Techniques

Assume a US corporation owns all of EuroCo, a non-US corporation.  EuroCo operates in Country X and is on the US per se list so that it will be deemed a corporation under US law and the law of Country X which has a 45% corporate tax rate. EuroCo has two wholly owned subsidiaries, EuroSub and CypraSub. EuroSub is a Country X operating entity and is also on the per se list and therefore like EuroCo cannot elect its classification for US tax purposes. However, CypraSub, a Country Y entity where the corporate tax rate is 10%, is not on the per se list and can elect its US tax classification under check-the-box. If CypraSub elects to be a single owner entity and hence disregarded for US tax purposes, then its tax items will flow through to its owner, EuroCo.

CypraSub makes a loan to EuroSub when both EuroSub and EuroCo have net profits of $1 million. CypraSub receives a $100,000 interest payment from EuroSub. EuroSub will deduct the $100,000 which, at a 45% tax rate, will result in a $45,000 tax savings in Country X. CypraSub will have $100,000 of interest income leading to $10,000 of tax in Country Y at the 10% rate. This will result in overall foreign tax savings of $35,000.

The US will characterise this as a loan from EuroCo to EuroSub (because CypraSub is disregarded). In the US, because the loan is now deemed as made by a related party located in the same country, the $100,000 in interest received is not immediately subject to US tax.  If CypraSub had not been disregarded, the $100,000 would have been immediately subject to tax in the US.

Or in the case of a US C corporation holding stock in a foreign corporation, Internal Revenue Code (IRC) §§902 or 960 may treat the domestic corporation as having paid taxes actually paid by the foreign corporation. However, IRC §1373(a) prevents an S corporation (eg. USSCo) from qualifying for indirect foreign tax credit under IRC §§902 or 960 by treating the S corporation as a partnership. Moreover, individuals are not permitted to claim foreign tax credits under IRC §902 for income taxes paid by foreign corporations which they own.

Therefore, a primary planning objective of USSCo (or other pass-through entities with individual owners) should be to obtain flow-through treatment (ie. transparent treatment) for the foreign subsidiaries of the S corporation and its qualified subchapter S corporation subsidiaries, to avoid double taxation on these foreign subsidiaries’ earnings.

For example, the effective tax rate on earnings of a Latin American subsidiary (LatinOpCo), which are repatriated to a US S corporation in 2011, could, in some instances, approach 60 percent.  A check-the-box election can be made by USSCo, either to treat LatinOpCo (assuming LatinOpCo is an eligible foreign entity which is not a per secorporation), for US income tax purposes, as disregarded as an entity separate from its owner (where a single owner exists or as a partnership where more than one owner exists). Therefore,  USSCo  (or other pass-through entity with individual owners) will want to consider making check-the-box elections. USSCo can achieve flow-through treatment, and avoid double taxation with respect to LatinOpco, by making the appropriate check-the-box election for US income tax purposes.