Considerations on whether to check the box for foreign subsidiaries.

• Author: Polantz, Raymond M.

The desire to expand markets and the lure of low foreign labor costs have thrust many small and midsized businesses into the global marketplace. Many now find themselves forming foreign subsidiary corporations, meaning they are navigating the same international tax issues once reserved for large publicly held companies. One of the most fundamental decisions to make early on is how the foreign entity will be treated for U.S. income tax purposes.

The check-the-box regulations simplify entity classification by allowing a taxpayer to choose to be treated as a corporation or transparent entity for U.S. tax purposes. The regulations permit "eligible entities" to choose among various business classifications. Both domestic and foreign entities may be eligible entities if they meet the requirements of the regulations. Specifically, a business entity that is not classified as a per se corporation in Regs. Sec. 301.7701-2(b) is considered an eligible entity under Regs. Sec. 301.7701-3(a).

Eligible entities failing to make an election will be classified under the default rules, which attempt to classify entities as they would most likely classify themselves if an election had been made. Under these rules, foreign eligible entities will be classified depending on whether the owners have unlimited liability. Under Regs. Sec. 301.7701-3(b) (2)(i)(B), a foreign eligible entity whose owner(s) all have limited liability will be considered a corporation. A single-owner foreign eligible entity with unlimited liability will be considered a disregarded entity under Regs. Sec. 301.7701-3(b)(2)(i)(C). A multimember foreign eligible entity that has at least one member with unlimited liability will be considered a foreign partnership under Regs. Sec. 301.7701-3(b)(2)(i)(A).

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Due to legal liability concerns, many U.S. taxpayers will form limited liability eligible entities that have the default classification of a foreign corporation. A foreign eligible entity whose default classification is a corporation can elect to be treated for U.S. tax purposes as either a foreign disregarded entity (if it has one owner) or a foreign partnership (if it has more than one owner). If an entity makes a change in classification, it cannot make a subsequent change for five years. However, Regs. Sec. 301.7701-3(c) (l)(iv) provides that an election by a newly formed eligible entity is not considered a change, meaning that these entities could potentially change their classification within the first five years.

The ability to check or not check the box and choose the U.S. tax treatment of a foreign eligible entity provides U.S. taxpayers the powerful option of electing how to treat their foreign subsidiaries. Whether they check the box will affect both the timing and ultimate U.S. taxation of the foreign income.

Deferral and Timing of Income

In the domestic context, corporate subsidiary income is not imputed immediately to the parent corporation. Rather, the parent corporation is taxed when the subsidiary pays a dividend (except in the case of a consolidated group). The same rules apply to income earned in a foreign subsidiary treated as a foreign corporation; its income is normally deferred from U.S. taxation until it is repatriated (absent any Sec. 951(a) Subpart F income inclusions).

Choosing a tax structure that allows foreign-source income to be deferred from U.S. taxation can be advantageous because of the resulting time-value-of-money benefit. Accepting a foreign eligible...