Magazine article The CPA Journal

"Check-the-Box" Regulations Provide U.S. Tax Planning Opportunities for Foreign Operations

Magazine article The CPA Journal

"Check-the-Box" Regulations Provide U.S. Tax Planning Opportunities for Foreign Operations

Article excerpt

On December 18, 1996 the I.R.S. issued final regulations with respect to the classification of domestic and foreign entities as (1) flowthroughs (e.g., branches and partnerships) or (2) corporations (Treas. Reg. section 301.7701-1 through 3). With several exceptions, the regulations follow the proposed regulations previously issued in May, 1996.

Under the old rules, an entity possessing at least three of the following four characteristics was treated as a corporation: Free transferability of interests, unlimited life, centralization of management, and limited liability.

Since the above factors were measured based on the context of local law and organizational documents, these issues were especially troublesome in the foreign area. As a result, the U.S. tax authorities have promulgated a set of simplified rules which reduce much uncertainty in the area.

The regulations effectively make the classification of an entity a matter of choice in most situations. Taxpayers may elect out of default classifications which generally follow "common sense" expectations. Corporate treatment is mandated for domestic entities formed as corporations under U.S. Federal and state law and for a limited specified group of foreign entities.

Summary of New Rules

The finalized regulations pertain to separate business entities. Trusts continue to be governed by the old rules. Certain joint undertakings, such as cost sharing arrangements, are not treated as separate business entities.

Except for certain "grandfathered" entities, the following foreign entities, among a much larger list based on country of organization, are automatically treated as corporations: Australia, Public Limited Company Canada, Corporation and Company France, Societe Anonyme Germany, Aktiengesellschaft Hong Kong, Public Limited Company Japan, Kabushiki Kaisha Mexico, Sociedad Anonima Switzerland, Aktiengesellschaft United Kingdom, Public Limited Company

A Canadian corporation formed under a law which provides for unlimited liability of all of the members is not included.

A foreign business entity not included on this list of "per se foreign corporations" is termed an "eligible entity." A foreign eligible entity with all members having limited liability generally will be treated as a corporation unless an election to the contrary is made. Other foreign "eligible entities" with two or more members by default will be treated as partnerships and those with only one member will be treated as a branch, unless an election is made to the contrary.

The default classification analysis in the foreign area depends on one of the four criteria under the old rules, namely, limited liability. Similar to the old rules, the determination of the existence of limited liability involves an analysis of local law.

Existing Entities

Foreign entities in existence on January 1, 1997 and whose classification is relevant to a U.S. person may retain their claimed classification provided that all the following requirements are met: The entity had a reasonable basis (within the meaning of IRC section 6662) for its claimed classification.

The entity and all its members recognized the Federal tax consequences of any change in the entity's classification within the sixty months prior to January 1, 1997.

Neither the entity nor any member had been notified in writing on or before May 8, 1996 that the classification of the entity was under examination.

The regulations provide specifically that foreign entities on the "per se" list which have been treated by taxpayers as partnerships will continue such treatment provided that

the entity existed on May 8, 1996.

the entity's classification was "relevant" for U.S. tax purposes for any U.S. taxpayer.

no U.S. taxpayer treats the entity as a corporation for tax purposes.

any change in the entity's claimed classification within the 60-month period prior to May 8, 1996, occurred as a result of an organizational change and the tax consequences were recognized by the entity and its members. …

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