Check-the-box effects for foreign owners

Editor: Robert Venables, CPA, J.D., LL.M.

The U.S. check–the–box regulations continue to provide certain taxpayers the ability to choose their entity type by allowing eligible entities the choice of being treated as a corporation or as a transparent entity for U.S. tax purposes. This election offers taxpayers great flexibility in tax planning.

Both domestic and foreign entities can make a check–the–box election if they meet the requirements in the regulations (Regs. Secs. 301.7701–1, –2, and –3). A U.S. limited liability company (LLC) would normally be treated as either a disregarded entity or a tax partnership, depending on the number of owners (Regs. Sec. 301.7701–3). These provisions allow taxpayers to elect to treat a U.S. LLC as a corporation for U.S. income tax purposes. From an international tax standpoint, these provisions allow taxpayers to treat a foreign entity whose default classification is a corporation as a foreign disregarded entity or foreign partnership.

A check–the–box election applies exclusively to U.S. income tax law, so it may not seem particularly relevant to non–U.S. taxpayers. However, a closer look shows that the impact of this election can be substantial for non–U.S. taxpayers. The decision of whether to make a check–the–box election may either eliminate or impose U.S. tax and compliance burdens for foreign owners. This is important because foreign taxpayers often seek to minimize their U.S. tax responsibilities whenever possible.

US subsidiary of foreign parent company

LLCs continue to be popular U.S. business entities for various reasons. Many states offer LLCs the legal protection of corporations while treating them as flow–through entities for income tax purposes. With lower setup costs and fewer formal corporate requirements, an LLC can be easier to administer than a corporation for foreign parent companies that often want to minimize U.S. corporate governance requirements. For this reason, LLCs can be appealing for foreign companies establishing U.S. subsidiaries.

Disregarded entity treatment: If an owner forms a wholly owned U.S. LLC, it is considered disregarded and therefore transparent for U.S. income tax purposes (Regs. Sec. 301.7701–3). Because of this tax transparency, the LLC’s activities are considered as performed by the parent company, and any related income and deductions are treated as those of the parent company. This means that if a foreign parent company’s LLC subsidiary is conducting business in the United States, it is treated as if the foreign parent company were conducting the activity itself, creating U.S. income tax and compliance obligations for the foreign corporation.

A foreign parent company of an LLC is required to file Form 1120–F, U.S. Income Tax Return of a Foreign Corporation, to report its effectively connected U.S. trade or business income passed through to it from the LLC. This income will be taxed at the U.S. corporate tax rate of 21%. The tax transparency of a wholly owned LLC generally means that distributions are not taxable to domestic owners at the LLC level for U.S. tax purposes. However, foreign corporations operating through wholly owned LLCs (as well as other U.S. branches) will be subject to the U.S. branch profits tax.

The branch profits tax is a 30% tax on earnings of a foreign corporation’s effectively connected earnings and profits that are earned in the United States through a U.S. branch operation (including a wholly owned LLC). The branch profits tax is applied on the “dividend equivalent amount,” which generally represents the profits of a U.S. branch that are not reinvested by the branch (Secs. 884(a) and (b)). The purpose of the branch profits tax is to align the tax treatment of U.S. branches of foreign corporations with that of domestic corporate subsidiaries. The 30% branch profits tax rate equates to the statutory rate of withholding applicable to dividends paid to foreign owners. Like the treatment of dividend withholding tax, some income tax treaties can lower the standard rate of tax. These are typically the ones that provide for lower withholding rates on dividend income.

While the United States treats LLCs as disregarded entities or tax partnerships, many foreign countries treat them as regarded corporations for cross–border tax purposes. A U.S. LLC in such instances is often referred to as a “hybrid entity” — a business entity that is classified differently by the United States and by the foreign jurisdiction of the parent company. Due to this hybrid nature, distributions from a U.S. LLC subsidiary may be viewed as corporate dividends, notwithstanding the disregarded U.S. treatment. The dividend distributions may be eligible for a participation exemption in the jurisdiction of the foreign parent corporation, meaning those distributions may be tax free in that foreign jurisdiction. If that is the case, the LLC distribution may achieve tax parity with the U.S. treatment of corporate dividends.

C corporation treatment: Instead of accepting default LLC classification, a foreign parent has the option of making a check–the–box election and treating the LLC as a corporation for U.S. income tax purposes. The LLC will then file Form 1120, U.S. Corporation Income Tax Return, and pay tax at the U.S. corporate rate of 21%. Dividends paid to a foreign parent will be subject to a 30% U.S. withholding tax, potentially reduced by treaty. This approach generally removes the hybrid nature of the LLC and aligns the entity’s treatment in the United States and foreign jurisdictions.

Summary: Regardless of whether a foreign parent company holds a U.S. LLC subsidiary as a disregarded LLC or as a check–the–box corporation, the results are similar for many aspects of U.S. and non–U.S. income tax purposes. For U.S. purposes, both will be subject to the 21% corporate tax rate on U.S. income and to a 30% (or lower treaty amount) tax rate on the related dividend income (or dividend equivalent amount under the branch profits tax regime). As discussed earlier, the foreign country’s treatment of U.S. dividends paid to the parent company may differ by jurisdiction, but if a participation exemption is available, the U.S. distributions may be tax free in the foreign jurisdiction, whether from a disregarded entity or a regarded C corporation.

Despite this degree of tax symmetry, opting for check–the–box corporate tax treatment offers at least one significant advantage to the foreign parent company. It eliminates the requirement for the foreign parent company to submit a U.S. income tax return. This is particularly important for foreign taxpayers who place a high value on privacy and seek to remain outside the U.S. tax system. This reason alone may provide enough motivation for foreign owners to make a check–the–box election to treat the LLC as a U.S. corporation.

Foreign corporation with both US and foreign owners

It is not uncommon for foreign entities to have a mixture of both foreign and U.S. owners. This can result for reasons including the foreign corporation’s need for capital or its desire to attract and incentivize U.S. employees by offering equity participation. Unless it is considered a per se corporation under the regulations, a foreign corporation will be classified as an eligible entity — one permitted to make a check–the–box election. Its default classification will likely be as a corporation because of the legal attributes providing for limited liability of the owners. A check–the–box election will change this default classification and make this entity either a disregarded entity or a foreign partnership for U.S. income tax purposes.

Foreign corporation status: U.S. individual owners may be concerned with the U.S. tax effects of owning a foreign corporation. Foreign corporations may be subject to the U.S. antideferral regime, which prevents U.S. taxpayers from avoiding U.S. tax until profits are distributed. If the U.S. owners own, directly or indirectly, more than 50% of the vote or value of the foreign corporation, the entity will be classified as a controlled foreign corporation (CFC), and the U.S. shareholders will be subject to the Subpart F rules and the rules for net CFC tested income (NCTI), formerly known as global intangible low–taxed income.

Noncorporate taxpayers are generally at a distinct disadvantage regarding CFC tax treatment under both the antideferral and corporate–dividend provisions. They are generally not permitted the benefit of the following provisions that are allowed for certain C corporation owners: (1) the Sec. 250 deduction of up to 40% of their NCTI inclusion; (2) the Sec. 960 indirect tax credit; and (3) the Sec. 245A 100% dividends–received deduction for certain foreign dividends. This disparate treatment can result in tax inefficiency for individual shareholders, absent additional planning.

Non–U.S. owners of foreign corporations are somewhat insulated from the effects of U.S.-source income within the corporation. If a foreign corporation has U.S.-source income, that will affect the foreign corporation but will not extend to the shareholder level. As such, non–U.S. shareholders of foreign corporations generally will not be attributed U.S.-source income from foreign corporations that they own.

Foreign partnership status: For the reasons above, U.S. individual owners of a foreign corporation may be motivated to make a check–the–box election to treat the foreign entity as a foreign partnership for U.S. income tax purposes. If the entity is no longer considered a corporation for U.S. tax purposes, then generally neither the CFC nor other antideferral rules will apply. Foreign partnership income will flow through to them, but they may be permitted a direct foreign tax credit to offset the related U.S. tax on that income. If losses exist, they will flow through to offset other sources of income, provided the partner has sufficient tax basis.

It may seem that non–U.S. owners may be agnostic whether the foreign entity elects partnership treatment for U.S. income tax purposes. If the foreign entity has income only from non–U.S. sources, that could be true because, under the jurisdiction–to–tax principle, the United States generally does not have the jurisdiction to tax nonresidents on foreign–source income, only on their U.S.-source income.

A check–the–box election that treats a foreign corporation as a foreign partnership for U.S. tax purposes could affect foreign shareholders’ U.S. tax treatment. Given the flow–through nature of partnership treatment, any instance of U.S.-source income will expose a partner to it. If a check–the–box election is made, this treatment of the entity as a foreign partnership will create both a tax liability and a filing requirement, which will be a surprise to the investor and something they would likely want to avoid. U.S.-source income can result from either effectively connected trade or business income (ECI) or fixed, determinable, annual, or periodical income (FDAP). The related U.S. tax may not be creditable in the taxpayer’s country of residence.

Foreign companies doing business in the United States will be subject to U.S. tax on ECI (Sec. 882). For nontreaty countries, any U.S. ECI will be considered taxable for U.S. purposes. If the corporation’s home country has an income tax treaty with the United States, the treaty will typically provide a higher threshold for taxation than the domestic tax laws, providing that a U.S. permanent establishment must exist to tax attributable income.

Generally, a permanent establishment is a presence in a country through which the business is wholly or partly carried out. Traditionally, it has been defined as having a branch or office, factory, workshop, or place of management. However, an enterprise may still have a permanent establishment to the extent that an agent has the authority and ability to conclude contracts in the United States and habitually exercises such authority. The determination of a permanent establishment is based on the facts and circumstances related to activities in the country (Organisation for Economic Co–operation and Development Model Tax Convention, Article 5). One way to reduce the risk that a permanent establishment exists is to ensure that a U.S. agent’s authority to conclude contracts and activities associated with contracts is sufficiently limited so that the dependent agent’s activities do not constitute a permanent establishment.

Flexibility but with consequences

The owners and investors in foreign entities may have different tax motivations. U.S. owners may want to make a check–the–box election to treat the foreign entity as a foreign partnership for U.S. tax purposes. As part of their analysis, they may mistakenly believe that since the election is only for U.S. income tax purposes, it will not affect the foreign investors. However, as seen earlier in this item, that is not the case. Special care should be taken to ensure that the tax structure and business operations do not inadvertently create U.S.-source income. Entities treated as foreign partnerships that have foreign partners should be especially mindful of avoiding the creation of a U.S. permanent establishment.

The U.S. check–the–box regulations provide taxpayers the flexibility to choose entity designation for U.S. income tax purposes. This ability can often help owners achieve desired tax results — either in the form of tax efficiency or simplified tax compliance. However, the U.S. tax effects for non–U.S. owners can vary; depending on company structure and the surrounding facts, the election can either simplify their U.S. tax situation or make it more complicated. As with most tax elections, careful analysis should be carried out to ensure the desired results are achieved for all shareholders.

Editor

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio.

For additional information about these items, contact Venables at rvenables@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.