For U.S. owners of foreign businesses, the choice of legal entity is an essential part of operating efficiently overseas. Most jurisdictions have a variety of entity options (for example, corporation, partnership, trust, etc.) that can offer business owners the desired combination of legal and economic attributes.
A U.S. owner of a foreign business, whether he or she lives within or outside of the United States, faces the additional challenge of properly applying the U.S. tax rules, both in terms of substance and in terms of compliance, to a non-U.S. entity.
A chief misconception in this regard is that the classification of a foreign business entity for U.S. tax purposes should follow the classification given under the legal or tax rules of the local jurisdiction. While this seems intuitive, and, in fact, does have some relevance in certain areas of U.S. tax law, the general rule is that the U.S. Internal Revenue Code and Treasury Regulations essentially ignore local law and apply a very specific set of rules to determine the entity's classification for U.S. tax purposes.
The fallout from this discrepancy can be that a foreign company has one classification for foreign legal and tax purposes and a completely different classification for U.S. tax purposes.
The relevance of tax classification
A foreign entity on its own generally should not be impacted by the U.S. tax rules, except mainly in the following two cases:
The foreign entity has U.S. concerns, such as certain U.S. source income or activities within the U.S. that rise to the level of a U.S. trade or business under the U.S. tax rules; or
The foreign entity has a U.S. owner (or member or partner, depending on the type of entity) and such ownership triggers the application of the U.S. tax rules.
If either of these cases is true, then determining the U.S. tax classification of the foreign entity becomes essential in understanding how the U.S. tax rules should apply to the entity and/or its U.S. owners.
In more practical terms, the tax classification of the foreign entity can have a number of important ramifications, including, for example:
The rate of taxation (which may be higher or lower depending on the company's classification);
The timing of taxation (a company, for example, treated as a partnership will see its income flow-through currently to its partners);
The application of tax deferral regimes, such as controlled foreign corporation and a passive foreign investment company regimes (which can impose harsh rules in the case of foreign entities classified as corporation for U.S. tax purposes); and
The extent and breadth of compliance or reporting obligations (additional forms may need to be filed with the IRS or the Treasury Department depending upon the foreign entity's classification for U.S. tax purposes).
The tax ramifications of a foreign entity's classification can be particularly tricky when, as described above, the entity has one classification for U.S. tax purposes and another for local foreign tax purposes. In the case of such a so-called “hybrid” entity, the U.S. and foreign tax rules need to be carefully navigated to prevent double taxation or other potentially tax adverse outcomes.
Starting point for tax classification
While the U.S. tax classification rules are best applied on a case-by-case basis, there are some general concepts that permeate throughout the more specific regulatory provisions. In order to determine a foreign entity's foreign classification, one can follow this three-step process:
First, and most fundamentally, if your business venture involves a co-party, it should be determined whether or not the arrangement between you and the co-party rises to the level of a foreign "entity" (as opposed to just a contractual or co-ownership arrangement).
Second, assuming "entity" status, you should consider whether the foreign entity should be treated as a trust for tax purposes as opposed to a business entity. In very general terms, Treasury Regulation Section 301.7701-4 describes a trust as an entity the purpose of which generally is to vest in trustees the responsibility for the protection and conservation of property for beneficiaries.
Third, assuming "business entity" status, a final set of technical rules are employed to determine whether such entity has the status of a: (i) corporation, (ii) partnership, or (iii) a disregarded entity. While a corporation is generally subject to an additional layer of taxation (i.e., taxation at the entity and shareholder levels), the income of a partnership and disregarded entity generally "passes" or "flows" through currently to its partners or members for tax purposes (i.e., taxation only at the partner or member level).
The classification rules in a nutshell
The U.S. Treasury regulations contain a set of default classification rules for foreign business entities under Treasury Regulation Section 301.7701-3. A foreign business entity is classified as an association/corporation if all of its members have limited liability, and it is classified as a partnership if it has two or more members and at least one member does not have limited liability. If the foreign business entity has a single owner and that owner does not have limited liability with respect to the entity, then the entity is classified as a disregarded entity for U.S. tax purposes.
Under the classification regulations, a so-called "eligible entity" is allowed to elect its tax classification. This election, which is often referred to as "check the box" election (by virtue of checking the box next to the desired classification on the election Form 8832), cannot take effect more than 75 days before the date the election is filed with the IRS, nor can it take effect later than 12 months after the date of the filing. Non-eligible entities are those listed in the regulations that cannot elect out of corporation status.
The ability to choose the tax classification of a foreign business entity offers owners quite a bit of flexibility in terms of structuring foreign business operations in a tax efficient manner. It's important to note, however, that if an election effective date is after the foreign entity's incorporation or creation date, adverse U.S. tax implications may arise. In such case, a tax advisor should be consulted to understand the full tax ramifications of the election both currently and moving forward.