The enactment of “check-the-box” regulations in the US, allowing both foreign and domestic entities to elect their classification as corporations, partnerships or, in the case of single-member entities, disregarded entities for US tax purposes, provides significant planning opportunities to private equity firms with US investors.
These regulations have brought to the forefront of tax structuring opportunities the use of hybrid entities. A hybrid entity is an entity treated as flow-through for tax purposes in one country and as a corporation in another.
Hybrids have many possible uses. For example, a foreign partnership may elect to be treated as a corporation in order to avoid the recognition of unrelated business taxable income by tax-exempt US investors without causing the imposition of an entity-level tax. Subsidiaries of a controlled foreign corporation may elect to be treated as disregarded entities in order to limit or avoid the recognition of interest payments by the subsidiaries to the parent as Subpart F income, even though those payments are deductible in the paying company’s jurisdiction.
However, while the check-the-box regulations have introduced these and other planning opportunities, private equity firms must not be blind to collateral issues raised by these structures. This article focuses on the treatment of hybrid entities for tax treaty purposes.
Tax treaties generally exist to minimize the double taxation that may result when a resident of one country derives income from sources in another country. The US Treasury has issued regulations clarifying when treaty benefits will be available with respect to an item of US source income that is paid to an entity that is fiscally transparent under the laws of one or more other jurisdictions. The regulations generally apply to all treaties, whether or not the treaty specifically mentions partnerships; and they apply regardless of any tax avoidance motive.
Generally treaty benefits are available only if the income is ‘derived’ by a foreign recipient resident in the applicable treaty jurisdiction. An entity will be treated as having derived the income if (i) it is not fiscally transparent with respect to the item of income under the laws of the entity’s jurisdiction, or (ii) the entity is specifically listed in the treaty as a resident of that treaty jurisdiction.
Whether or not the entity itself is fiscally transparent with respect to an item of income, an interest holder of the entity will be treated as having derived the income from the applicable treaty jurisdiction if under the laws of the jurisdiction in which the interest holder is resident, the entity is fiscally transparent and the interest holder is not itself fiscally transparent.
The regulations come in to play only in the case of an entity that is fiscally transparent in at least one relevant jurisdiction. An entity will be considered fiscally transparent only if (under applicable law) inclusion by the interest holders is required whether or not an item of income is distributed to such interest holders and, generally, the character and source of the item in the hands of the interest holders are determined as if such item were realized directly from the same source as the entity. Under these rules, it is possible that both the entity and its interest holders may be treated as having derived the income and therefore be entitled to treaty benefits.
There are no special rules for tax-exempt organizations. Thus, it is possible that treaty protection can be lost when a non-US tax-exempt entity invests in the US through a US limited liability company that is treated as a corporation in the interest holder’s jurisdiction.
An entity that is treated as a domestic corporation for US tax purposes, but as fiscally transparent under the laws of an interest holder’s jurisdiction (a “domestic reverse hybrid entity”) will be subject to tax in the US on US source income at regular US rates, without reduction by virtue of any treaty. Generally, payments by a domestic reverse hybrid entity to foreign interest holders will have the character determined under US law, and a foreign interest holder will be treated as deriving such income (and, therefore, entitled to any reduced rate of tax under a treaty) if it is not fiscally transparent with respect to such income under the laws of its country of organization.
However, under certain circumstances, otherwise deductible payments by a domestic reverse hybrid entity to an 80 percent foreign interest holder (and certain other affiliates) will be re-characterized as nondeductible dividends for all US tax purposes, including determining the rate of withholding on the payment to the foreign interest holder under the applicable treaty.
The regulations contain several examples. One involves a contractual arrangement for the purpose of joint ownership of securities that has no legal personality under the laws of its jurisdiction of formation, although it is treated as a partnership for US purposes. Moreover, the country does not require interest holders to report income currently, but rather when it is distributed. Because of its lack of personality, it is not treated as a resident under the treaty between the country of formation and the US. The example includes interest holders who are residents of the same country as the entity, and those that have no treaty with the US.
The example concludes that the entity is not fiscally transparent, because interest holders are not required to take into account income currently. Moreover, because the entity is not a resident for purposes of the treaty, it cannot claim treaty benefits. Accordingly, there is no tax rate reduction on payments of US source income to the entity. Another example clarifies that had the treaty specifically treated the entity as a resident (e.g., a French FCPR), the FCPR would be entitled to treaty benefits. Although the example doesn’t discuss this, if the entity (in either case) is treated as a fiscally transparent entity in jurisdictions in which other investors reside, then those investors may be entitled to rely on their respective treaties.
These regulations have additional importance to US investors because qualifying dividends received by a citizen or resident of the US are taxed at a favorable rate. Dividends paid by a non-US corporation are treated as qualifying only if the corporation is eligible for the benefits of a comprehensive income tax treaty. In the case of an entity that is treated as a partnership under the laws of the country in which its is formed, but as a corporation for US tax purposes, under the rules described above, treaty benefits may not be available, and distributions (treated as dividends for US tax purposes) paid to US individuals would not be eligible for the reduced dividend tax rates.
Check-the-box elections are not respected in other countries. Accordingly, these rules generally have no impact on whether treaty benefits will be available with respect to non-US source income. For example, German source dividends derived by a US resident through a Guernsey partnership that is treated as a corporation for US purposes should be subject to the reduced rate of withholding under the US-German treaty. There are exceptions, of course.
Certain countries have treated the US limited liability company (which is a flow-through for US purposes) as a non-taxpaying corporation and have denied treaty benefits. Moreover, the current treaty between the US and the UK adopts a rule similar to the regulations described above. It provides that treaty benefits will be available with respect to an entity which at least one country treats as a flow-through vehicle only to the extent that the income is treated as income of a resident of the other treaty country.
The ability to treat an entity as flow-through or as a corporation for US tax purposes, and differently for non-US tax purposes, presents numerous planning opportunities. But, as discussed herein, it is important to determine whether the use of a hybrid entity will prevent the entity or its interest holders from relying on an otherwise applicable tax treaty.