A company organized under the laws of a foreign country that does not conduct business in the United States still may be “relevant” for purposes of U.S. taxation. Therefore, it may be necessary to select a federal tax classification to minimize U.S. tax. The tax affairs of a foreign entity may create a disclosure or information reporting obligation, such as Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities, or Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. A foreign entity also may create subpart F income for its U.S. owners if proper entity classification planning is overlooked.
As with eligible domestic entities, a classification election for an eligible foreign entity is made by filing Form 8832, Entity Classification Election. Regs. Secs. 301.7701-1 through -3 (the check-the-box regulations) contain the entity classification rules that should be reviewed before an election is filed. In filing Form 8832, the electing entity must specify whether the election is an “initial classification by a newly formed entity” or a “change in current classification.” Determining which option applies depends on whether the election is made effective as of the date of relevance (or before) or as of a later date.
The applicable rules on the classification of foreign entities and the date a foreign entity becomes relevant for U.S. tax purposes have evolved since the advent of the check-the-box regime in 1996. The Internal Revenue Manual states that, for foreign entities formed after 1996 and before October 21, 2003, a foreign entity has a U.S. tax classification even if that entity is not relevant (see IRM Section 22.214.171.124.1). In other words, the entity had a classification regardless of whether the entity affected what was reported on a U.S. income tax or information return.
That rule was modified by an October 2003 clarification to the regulations. Today, the concept of relevance for a foreign entity is delineated in Regs. Sec. 301.7701-3(d)(1)(i), which provides that a foreign eligible entity’s classification is relevant when its classification affects the liability of any person for federal tax or information purposes.
Under this current regulatory provision, a foreign entity is not deemed to have a federal tax classification until the entity is relevant for U.S. tax purposes. In addition, a foreign entity can become relevant for U.S. tax purposes even if the acquiring entity (e.g., a U.S. company) takes no action with regard to the entity after it is acquired.
Unless the foreign eligible entity elects otherwise, Regs. Sec. 301.7701-3(b)(2) states that the entity will default to:
- A partnership if it has two or more members and at least one member does not have limited liability with respect to the entity’s debts;
- An association (taxable as a corporation) if all members have limited liability; or
- A disregarded entity (not separate from its owner) if it has a single owner that does not have limited liability.
A foreign eligible entity that otherwise is not relevant nevertheless can make itself relevant by affirmatively filing Form 8832 and electing its federal tax classification. The election will stay in place, regardless of whether the electing entity is ever reported on a U.S. return, for five years (see Regs. Secs. 301.7701-3(d)(2) and (3)).
1. How is the date when a foreign entity becomes relevant for U.S. tax purposes determined?
The date is determined by looking to the date the foreign entity will affect what is reported on a U.S. income tax or information reporting return, or the date elected on a Form 8832 filed by the entity, whichever date is earlier. If no Form 8832 is filed, the foreign entity will be deemed to have defaulted to its classification as of the date the entity becomes relevant. This default classification will affect what is reported on a U.S. income tax or information reporting return.
2. What if the foreign entity making the election is not newly formed but was acquired recently as a shelf company?
Assuming that the entity was formed after October 21, 2003, the foreign entity has 75 days following the date it becomes relevant (i.e., the date the entity defaults to its federal tax classification) to file Form 8832 and elect a classification other than its default classification (Regs. Sec. 301.7701-3(c)(1)). This election will constitute an initial election, despite its not being effective as of the date of formation, because the foreign entity had no classification before that date. Note that Rev. Proc. 2002-59, which allows a late-filed Form 8832 to be treated as timely in certain limited situations, cannot be invoked to make the election for a shelf company after the 75-day period because that revenue procedure applies only if the election is effective as of the date the company was formed. Compare Rev. Proc. 2002-59, §4.01(1), with Regs. Secs. 301.7701-3(c)(1)(i) and (ii).
3. What if the foreign entity never has been relevant for U.S. tax purposes but the entity’s owner must start filing a U.S. income tax return for which the entity’s federal tax classification is relevant?
Whether an effective Form 8832 can be filed will depend on the taxpayer’s particular facts and circumstances. If, for example, a foreign individual is physically in the United States for a set number of days during the tax year, the individual may become liable for filing a U.S. tax return for that full tax year. This outcome means that it might be determined only late in the year (after the foreign individual has been present in the United States for the requisite number of days) that a foreign entity owned by the foreign individual effectively became relevant as of the first day of the year.
Under some circumstances, the foreign entity may qualify for “9100 re-lief” under Regs. Sec. 301.9100-3 to make an initial election effective as of the date of formation or as of the date the entity became relevant for U.S. tax purposes. If 9100 relief is not available, other alternatives, including liquidating or restructuring the foreign entity before it otherwise would become relevant, should be considered.
Annette B. Smith is with Washington National Tax Services PricewaterhouseCoopers LLP in Washington, DC
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
If you would like additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.