International implications of check-the-box regulations.

• Author: Barrett, James H.

The classification of an entity as a corporation or a partnership typically has significant tax consequences to the members owning the entity. Entities taxable as partnerships in the United States are flow-through vehicles that do not pay income tax. Rather, they report such income, gain, loss, deduction, and credits and allocate it to their members. The members then recognize such taxable items as if the items were directly earned by them. Hence, members of entities that are taxable as partnerships in the United States are, for U.S. federal income tax purposes, permitted to directly claim losses and credits (including foreign tax credits) on their tax returns. In contrast, entities that are taxable as corporations are taxable at both the entity level and at the member level. Losses and credits of entities that are taxable as corporations generally do not flow through to members.

For over 30 years, the classification of entities as partnerships or corporations depended upon all the facts and circumstances concerning the entity pursuant to a test known as the "four factors test." On December 18, 1996, the IRS replaced the "four factors test" with regulations known as the "check-the-box" regulations that allow taxpayers to elect whether entities are to be taxable as corporations or partnerships.[1] The check-the-box regulations recognize three types of entities: corporations, partnerships, and single-member entities. Single-member entities are entities that are disregarded for U.S. federal tax purposes.[2] Thus, even where a single-member entity accords limited liability to its owners, the entity is disregarded for U.S. federal tax purposes.

The check-the-box regulations classify all domestic corporations as corporations. All other domestic entities are taxable as partnerships unless they elect otherwise. With regard to foreign entities, generally one entity from each major jurisdiction is deemed to be a "per se entity," that is always taxable as a corporation.[3] All other foreign entities are eligible to elect to be taxable as a partnership or a corporation. Transitional rules apply to entities in existence before January 1, 1997. These rules generally provide for entities to continue their prior classification.[4] In proper cases, foreign "per se entities" that were in existence on May 6, 1996, are entitled to continue to be classified as partnerships.[5] Entities with one owner that otherwise would be classified as partnerships are classified as single-member entities.

The entity classification rules in most foreign jurisdictions are not a liberal as the check-the-box rules Thus, U.S. taxpayers are permitted to choose the U.S. tax classification of most entities even though the foreign jurisdiction may mandate that such entities are always taxable a partnerships or corporations. Base upon the greater certainty and flexibility that exists in the United States in classifying entities as partnerships, single-member entities, or corporations (or associations taxable as corporations), U.S. taxpayers are capable of utilizing: a) foreign entities that are taxable abroad as corporations but are taxable in the United States as partnerships ("hybrids"); or b) foreign entities that are taxable abroad as partnerships but are taxable in the United States as corporations ("reverse hybrids"). The flexibility afforded to taxpayers translates into tax planning opportunities in structuring their U.S. and foreign operations.

Background on Outbound International Tax Planning

Two important aspects of tax planning for U.S.-based foreign operations are deferral and the optimization of foreign tax credits. Deferral can be achieved where foreign investments are owned by foreign corporations. Generally, the taxable income earned by a foreign company is not taxable in the United States until it is repatriated to the corporation's US. corporate parent through the payment of a corporate dividend or a sale of the stock in the foreign subsidiary. Thus, where a foreign company operates in a low tax jurisdiction, the U.S. parent can achieve deferral of U.S. income tax. When a dividend is eventually paid or the stock of a subsidiary is eventually sold, the dividend or sale can entitle the parent corporation to a foreign tax credit that represents the taxes paid to the relevant foreign jurisdictions by the foreign subsidiary.[6]

Because deferral was considered to be unwarranted in certain cases, over the years various anti-deferral provisions have been enacted. The most prominent of these provisions are known as the foreign personal holding company rules, the controlled foreign corporation rules, and the passive foreign investment company rules.[7] These anti-deferral rules generally provide that U.S. members that ultimately own foreign corporations are required to recognize directly certain types of income that are earned by the foreign corporations even though no distributions actually are made to the U.S. members. For example, as discussed below, under the controlled foreign corporation rules, investment income that is earned by a foreign corporation that is wholly-owned by a domestic corporation generally is included in the parent's taxable income for U.S. federal income tax purposes.[8] Hence, deferral tax planning is based largely upon avoiding application of the various anti-deferral regimes.

As discussed above, a dividend paid by the foreign subsidiary of a domestic corporation or the sale of the stock in a foreign corporation by a domestic parent typically is taxable to the domestic parent in the United States. However, under IRC [sections] 902, the dividend or sale normally entitles the domestic parent to a foreign tax credit in the United States for part or all of the taxes paid by the foreign subsidiary abroad.[9] The amount of foreign tax credits that can be generated by a dividend or a sale is subject to numerous limitations. The most significant limitations relate to: a) the amount of earnings that are considered to be repatriated by the dividend or the sale; b) the U.S. parent's domestic and foreign-sourced income; and c) the nature of the foreign subsidiaries' income (e.g., earnings attributable to investment income).[10] Based upon the foregoing, foreign tax credit planning often seeks to: a) minimize a foreign subsidiary's earnings (for US. foreign tax credit purposes) and, thus, increase the foreign taxes that become creditable as the result of the payment of a given dividend payment or stock sale;[11] b) increase a domestic parent's foreign-sourced income and, as...