Subscribers Login  

In an earlier commentary¹ I wrote about the surprising (in an allegedly simple “check-the-box” era) complexity and uncertainty involved in determining, in certain cases, whether or not a business entity, separate from its owners, exists. Such a determination must be made before one can classify a business entity as either an association taxable as a corporation, a disregarded entity (DE), or a partnership, i.e., before one can “check the box” with respect to such entity.

After one checks the box there is also surprising uncertainty regarding whether a DE is truly disregarded as an “entity” for all purposes and whether a DE can still be a “person.” How that uncertainty is resolved can have a significant impact on the application of various provisions.

For example, if a DE is not a person, then arguably the anti-conduit regulations of Regs. §1.881-3 can be easily avoided using DEs. Under the anti-conduit regulations, a financing transaction is defined as, among other things, a transaction pursuant to which a person makes an advance of money or property to a transferee who is obligated to repay the money or property.² If a loan between a DE and its owner (or between two DEs with a single owner) is disregarded for this purpose because a DE is not a person or is not a transferee, then a conduit to reduce or eliminate withholding tax is easy to construct and is unaffected by the anti-conduit regulations. Some taxpayers take this position.

But “entity” and “person” appear not to be congruent terms. Section 7701(a)(1) defines “person” to include, among other things, a “company.” Regs. §301.7701-6 interprets this to include, among other things, an “unincorporated organization or group.” A hybrid (a DE for U.S. purposes) that is, say, a Luxembourg Sarl, should be a “company” and also an “unincorporated organization or group.” Therefore, it likely is also a “person,” even if it checks the box to be disregarded as an entity, unless something in the Code or regulations provides otherwise. I don't see anything in the §301.7701-1, -2, or -3 regulations that deal with “persons” --it's all about “entities,” “business entities,” “corporations,” and “partnerships.” Even if a person is disregarded as an entity separate from its owners, I don't see anything that says it's disregarded as a person. “Entity” and “person” apparently are separate words connoting separate concepts. Thus, while some refer to DEs as “tax nothings,” this commentator, for one, thinks that is wrong or, at a minimum, unclear. A DE may be disregarded as an entity, but it still may be a person.

A relatively recent TAM³, however, disagrees. Among other things, the TAM concludes that foreign taxes paid were not compulsory because the taxpayer failed to take advantage of the U.K. group relief rules. In so holding, the TAM concludes that the “person” on whom foreign law imposes legal liability for foreign taxes is not a DE, but instead the owner of the DE:

Because an election was made to treat Subsidiary as a disregarded entity, Subsidiary is treated as a branch or division of Issuer [its parent] for U.S. tax purposes. See Regs. §301.7701-2(a). Accordingly, Issuer, purportedly a partnership for U.S. tax purposes is the only “person” within the meaning of §7701(a) and the regulations thereunder.

Since “Subsidiary” in the TAM is likely a U.K. limited company, this conclusion is at least mildly surprising given the language of Regs. §301.7701-6 and the fact that nothing in §301.7701-1, -2, or -3 specifically indicates that treating a DE as a branch or division of its owner means that the DE is not a “person.” As implied above with reference to avoidance of the anti-conduit regulations, this is an argument that taxpayers like to make but I would not have expected to see the IRS make it.

If a DE is not a “person” there are other issues that the IRS should be concerned about in addition to avoidance of the anti-conduit rules. There are also issues where a DE must remain an “entity” for the rules to work the way the IRS intends. For example, both the old and the current dual consolidated loss rules use the term “entity” to include a DE. Under former Regs. §1.1503-2(c)(4) a separate unit was defined to “includ[e] an interest in an entity that is not taxable as an association for U.S. income tax purposes.” Emphasis added. The current regulation is virtually the same:

(4) Hybrid entity separate unit. --The term “separate unit” includes an interest in an entity that is not taxable as an association for U.S. income tax purposes but is subject to income tax in a foreign country as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis. [Emphasis added.]

Certainly the IRS (and most practitioners) understood (and understand) the use of the word “entity” in this context to include DEs. Likewise, Regs. §1.894-1(d)(1) uses the term “entity” to refer both to regarded as well as disregarded entities:

The tax imposed by sections 871(a), 881(a), 1443, 1461, and 4948(a) on an item of income received by an entity, wherever organized, that is fiscally transparent under the laws of the United States and/or any other jurisdiction with respect to an item of income shall be eligible for reduction under the terms of an income tax treaty to which the United States is a party only if the item of income is derived by a resident of the applicable treaty jurisdiction. For this purpose, an item of income may be derived by either the entity receiving the item of income or by the interest holders in the entity or, in certain circumstances, both. An item of income paid to an entity shall be considered to be derived by the entity only if the entity is not fiscally transparent under the laws of the entity's jurisdiction, as defined in paragraph (d)(3)(ii) of this section, with respect to the item of income. An item of income paid to an entity shall be considered to be derived by the interest holder in the entity only if the interest holder is not fiscally transparent in its jurisdiction with respect to the item of income and if the entity is considered to be fiscally transparent under the laws of the interest holder's jurisdiction with respect to the item of income, as defined in paragraph (d)(3)(iii) of this section. [Emphasis added.]

This rule would make no sense, of course, if the word “entity” was not interpreted as meaning both regarded entities as well as DEs. The context clearly demands it, even if not explicitly stated. Certainly the IRS does not believe that partnerships are treated differently than DEs when Regs. §1.894-1(d)(1) is applied. Each is an “entity” that may or may not be “fiscally transparent” in a particular jurisdiction. But for certainty's sake, Regs. §1.894-1(d)(3)(i) defines “entity” for this purpose:

Entity.--For purposes of this paragraph (d), the term entity shall mean any person that is treated by the United States or the applicable treaty jurisdiction as other than an individual. The term entity includes disregarded entities, including single member disregarded entities with individual owners. [Emphasis in the original.]

So even if the context didn't make such an understanding clear, the regulation itself is very clear. But note that the provision quoted above states that an “entity” for this purpose means a “person” other than an individual, then goes on to state specifically that DEs are entities for this purpose. While the second sentence may have been added for greater clarity, it can also imply that the authors thought it was unclear, for purposes of the first sentence, that a DE is a “person” and therefore felt it necessary to add the second sentence. While this regulation is crystal clear, its very clarity throws other provisions into ambiguity when the words “entity” and “person” are used.

Consider, for example, the proposed §901 regulations on noncompulsory payments.⁴ According to the Preamble to these regulations, commentators have expressed concern with respect to the existing final regulations that when a U.S.-owned “foreign entity” transfers (surrenders) a net operating loss to another “foreign entity,”

foreign taxes paid by the transferor in a subsequent tax year might not be compulsory payments to the extent the transferor could have reduced its liability for those foreign taxes had it chosen not to transfer the net loss in the prior year.⁵

In other words, if UK CFC1 incurs a loss, it would not be permitted to surrender the loss to related UK CFC2 in the current year, but would instead be required to carry forward the loss to reduce potential income in a subsequent year due to this purported “concern.” UK CFC2 would thus be stuck paying U.K. tax in the current year and the U.S. Treasury would be stuck providing a credit for this U.K. tax. This result would obviously conflict with the policy of the noncompulsory payment rule, which is to minimize foreign taxes so as to minimize the foreign tax credit the U.S. government is required to provide. The proposed regulations address this issue by providing the following:

If a U.S. person described in section 901(b) directly or indirectly owns stock possessing 80 percent or more of the total voting power and total value of one or more foreign corporations (or, in the case of a non-corporate foreign entity, directly or indirectly owns an interest in 80 percent or more of the income of one or more such foreign entities), the group comprising such foreign corporations and entities (the “U.S.-owned group”) shall be treated as a single taxpayer for purposes of [the noncompulsory payment test of] paragraph (e)(5) of this section. [Emphasis added.]⁶

Accordingly, under the proposed regulation, if UK CFC1 and UK CFC2 are owned by the same U.S. shareholder, losses could be surrendered between the CFCs without raising a noncompulsory concern.⁷ Losses could also be surrendered to or from a “non-corporate foreign entity.” What is a non-corporate foreign entity? Is it an entity under U.K. law (e.g., a U.K. company) that is treated as a partnership or DE under U.S. law? Or is it an entity (such as a partnership) under U.S. law and not a DE? Under the latter interpretation, would this mean that a U.K. CFC could not surrender a loss to a U.K. company that is a U.S.-owned DE but could surrender the loss to a U.K. company that is a U.S.-owned partnership? What would be the possible rationale for such a distinction? Wouldn't this raise exactly the same policy concerns that the proposed regulation is attempting to address? The proposed §901 regulations should clarify this point. Even better, the IRS might consider clarifying in all relevant areas when a DE should still be treated as either an entity or a person and when it shouldn't.

This commentary also will appear in the August 8, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.