The introduction of the check-the-box regulations in the late 1990s aimed to simplify tax structures and provide flexibility in the classification of business entities. These regulations allow taxpayers to choose and even change their entity classification. This was a significant departure from the conventional compulsory rules that previously governed the classification of business entities.
The previous rules dating to the 1960s evaluated four main factors to determine entity classification for tax purposes. The rules, which aimed to simplify tax implications and consequences of primarily domestic structures when applied in the foreign context, ultimately complicated documentation and reporting consequences. Nonetheless, taxpayers have shown significant enthusiasm for the check-the-box election.
Sec. 987 Implications
Making an election under the check-the-box regulations allows certain entities with a single owner to be treated as disregarded entities or branches of the U.S. owner for U.S. tax purposes (Regs. Sec. 301.7701-3). As a result, the number of branches classified as separate units conducting business and keeping separate books and records from those of their owners dramatically increased. In a structure with foreign branches, where books and records are maintained in a currency other than that of the U.S. taxpayer, the requirements of Sec. 987 add to the documentation and reporting complexity.
Sec. 987 Background
Sec. 987 was introduced as part of the Tax Reform Act of 1986, P.L. 99-514, and the IRS issued proposed regulations under Sec. 987 in 2006, which replaced proposed regulations it had issued in 1991.Under Sec. 987, a branch is treated as a qualified business unit (QBU); the taxable income or loss of the U.S. taxpayer is determined by calculating the taxable income or loss of the QBU separately and translating the income or loss using the appropriate exchange rate. Sec. 987 further requires the taxpayer to make adjustments for transfers of property between QBUs that have different functional currencies. Transfers of property, whether between QBUs or with the U.S. owner, are treated as remittances from accumulated earnings.
Sec. 987 Gain or Loss
Under the current proposed regulations under Sec. 987, the U.S. taxpayer must recognize exchange gain or loss resulting from remittances from the QBU's accumulated earnings, which is referred to as the equity pool. In general, the equity pool consists of undistributed capital and earnings of the QBU determined in the QBU's functional currency. Additionally, a basis pool must be maintained that consists of the undistributed capital and earnings in the functional currency equity pool translated to the functional currency of the U.S. taxpayer every year (Prop. Regs. Sec. 1.987-5). The Sec. 987 gain or loss is the amount of the remittance from the QBU translated into the U.S. taxpayer's functional currency at the spot rate on the date of the remittance, less the basis associated with the remittance.
Unexpected Outcome
Sec. 987 intercompany transactions, such as intercompany purchases, dividends, and loan payments, are treated as remittances. These remittances give rise to the recognition of Sec. 987 gain or loss, which most U.S. taxpayers overlook when considering the effect of the check-the-box rules. The flexibility in entity classification is initially attractive to U.S. taxpayers; however, they should be sure they consider all aspects when making the election. Aside from the documentation and reporting complexities, keeping a watchful eye on the volatility of currency fluctuation can become a full-time job.
Additional Complexity
Additional reporting complexity applies to an entity organized under the laws of a country outside the United States, which will be taxed under the laws of the country where it is organized as well as under U.S. tax law, depending on the entity's classification status. The result of making a check-the-box election on a foreign entity of a U.S. taxpayer intending to gain disregarded entity treatment will be flowthrough treatment of the foreign entity's income or loss for U.S. tax purposes. As such, the foreign entity is viewed as having dual tax residency, and when losses are involved, the dual-consolidated-loss (DCL) rules under Sec. 1503 apply (Regs. Sec. 1.1503-2). In general, the rules provide that a DCL incurred by a separate unit of the U.S. taxpayer may not be used to offset income of any domestic affiliate on the U.S. return. Exceptions to this general rule include an election by the U.S. taxpayer to use the loss to offset domestic affiliate income on the U.S. return (domestic use election and agreement, or DUE) subject to certain conditions and reporting requirements.
Caution to the Unwary
In addition to the documentation and reporting complexities of making a check-the-box election, U.S. tax opportunities or exposures are likely lurking beneath the surface. Taxpayers should employ careful planning when considering the apparent benefits of checking the box, specifically when dealing with foreign jurisdictions.
EditorNotes
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.
