Editor: Mark Heroux, J.D.
Anyone familiar with a "legal entity rationalization and simplification" probably recalls their first client request to perform this exercise (visualize pages and pages of organization charts, boxes, circles, and checked entities galore). Frequently, this request comes when clients finish an acquisitive streak. However, it is heard more often these days as clients attempt to contain corporate costs and address COVID-19-related shifts in the supply chain and the like. The legal entity rationalization and simplification exercise is about efficiencies — optimizing a legal entity's organizational structure to achieve cost reductions and management of risks, not to mention keeping a legal entity structure attractive for potential acquisition purposes, too.
First and foremost, it is important to understand the business purposes behind each legal entity. Is this entity housing employees? Is it managing other risks in-country? What role does it play in the organization's supply chain? The entity may have been formed way back when, but is it still useful, based on today's facts and circumstances as well as the organization's future needs? Ask if there is duplication in the organizational structure as a result of the acquisitive streak. Ponder structural efficiencies for repatriation tax purposes, with a focus on withholding tax leakage.
Once you've rationalized a legal entity and determined its location from a corporate holding perspective, start your tax analysis efforts to remove legal entities from the structure and align or realign the legal entities via merger, amalgamation, or actual liquidation, as appropriate. Importantly, where multiple jurisdictions are at play, do not forget to assess the tax consequences (income tax or otherwise) of realigning the entities in each jurisdiction in the chain of ownership, particularly because some jurisdictions have indirect transfer tax consequences, while others have stamp duty implications. Further, where real property is involved, consider real estate transfer taxes, which may be similar to those found in Sec. 897 (Foreign Investment in Real Property Tax Act (FIRPTA), P.L. 96-499).
From a U.S. tax perspective, it is prudent to review Secs. 331 (taxable liquidations) and 332 (tax-free liquidations for certain subsidiaries) and the check-the-box rules in Regs. Sec. 301.7701-3, as well as Sec. 367 (for any structuring involving foreign corporations). Note that the check-the-box rules alone do not result in the removal of an entity from the organizational structure for U.S. or foreign purposes, as the check-the-box rules are relevant for U.S. federal income tax purposes only. The various merger provisions under Sec. 368 that may allow legal entities to be combined on a tax-free basis should also be carefully considered.
When assessing which route to take for purposes of eliminating legal entities, thought should be given to the current tax cost associated with the transaction and any related tax implications such as loss of tax basis or other tax attributes such as net operating losses or tax credits that could result. The type of liquidation or direction of a merger could determine whether the organization retains the ability to use certain historical tax attributes going forward or loses tax basis in the stock of an entity, so understanding whether entities hold valuable tax attributes is important as well.
A U.S. or foreign sandwich structure (where a legal entity from a second jurisdiction is interposed between two entities from the same jurisdiction) causes tax inefficiencies and can often be costly to address. A careful analysis of both U.S. and foreign tax implications is necessary to implement potential solutions.
Prepare a cost/benefit analysis in anticipation of implementing a rationalized and simplified structure. Do not go it alone when it comes to legal entity rationalization and simplification; once the internal tax team determines appropriate action, be sure to have an adviser review the plan, at a minimum, to address any adverse tax implications. Along with any tax costs, the review costs need to be considered in the cost/benefit analysis. Lower compliance costs and fewer annual entity registrations represent benefits in the cost/benefit analysis.
Finally, do not forget the reporting, which can sometimes be complex as a result of recent changes to U.S. international compliance forms, informational or otherwise. When changes to a corporate structure are considered, a plan should address compliance obligations for all relevant jurisdictions during the tax analysis phase. Revisiting the compliance obligations closer to the preparation of compliance forms often leads to missed reporting or duplicative time on matters that were previously discussed.
The process of a legal entity rationalization or simplification of a legal organizational chart has numerous moving and interrelated components that need to be considered during each step of the process. A successful project is accomplished through a multidiscipline approach, taking into account operational, legal, and tax implications, to ensure all the risks and issues are considered, with the goal of a clean, efficient structure.
Mark Heroux, J.D., is a tax principal and leader of the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.