Affirmative use of entity structure in sourcing studies.

• Author: Miller, Louis J.
• Position: International tax planning concerning business entity structures

In 1996, the IRS issued much-anticipated regulations under Sec. 7701. The so-called "check-the-box" rules substantially alleviated the uncertainty of the prior regulations that, among other things, involved complex legal maneuvering to achieve desired entity characterization. The new rules allow a taxpayer simply to elect whether it chooses, to be taxed as a passthrough entity or as a corporation. In addition, the rules state that a passthrough entity with one owner is a disregarded entity; a passthrough entity with more than one owner is a partnership. The change has proven to be especially useful to corporations with foreign operations. The new rules allow companies more leeway to create favorable tax structures when dealing with the various tax laws of the countries in which they do business. The Service has spent the last three years vigorously challenging many of the foreign tax-planning strategies that have been developed under the new rules. However, there are still planning opportunities that can be legitimately used to meaningfully reduce the taxes of corporations with foreign operations.

Every year, when the chief financial officer of almost any multinational corporation sits down with the company's tax director to review the year, the first question centers on the company's worldwide effective tax rate, followed by a question on how to reduce that rate. The answer to reducing the effective tax rate for the multinational is to maximize foreign tax credit (FTC) usage. An excess credit position means a higher effective tax rate due to inefficient use of foreign taxes paid; an excess limitation position means a higher effective rate due to inefficient use of foreign-source income. Therefore, the optimal worldwide effective tax rate is achieved through close approximation between FTCs and income limitation. Affirmative use of the sourcing rules under Secs. 861-863 can be one of the most effective tools in reducing effective tax rates. Specifically, Sec. 863 (which governs the sourcing of inventory property produced in the U.S.) can often be positively affected through good tax planning. With proper tax planning, a multinational corporation can increase or reduce its mix of foreign-source and domestic-source income, and efficiently use the FTCs that accrue to it.

The sourcing calculation is a complex web of variables. In determining the proper source of income, a corporation must determine whether the gross profit is generated within...