Decisions, Decisions
The owners of a closely held U.S. business will have to make many difficult decisions during the life of the business. Among the earliest of these is the so-called choice of business entity, the economic (including tax) consequences of which will be felt by the business and its owners for years to come.
Selecting the form of business entity actually requires two decisions.
State Law
One involves the form of organization as a matter of state law; more often than not, the choice is between a corporation and a limited liability company, each of which is a creature of statute.
Tax Law
The other decision[i] concerns the organization’s treatment for purposes of the federal income tax. In general, there are two options.
The owners of the business entity may choose to treat it as a passthrough entity – one that is “fiscally transparent” – the profits of which are taxed to the owners[ii] and not to the entity.
Alternatively, the owners may decide to treat the business entity as a taxable, or “fiscally opaque,” entity. In that case, the profits of the business are taxed to the entity. The owners would only be taxed on those profits that are distributed to them by the entity. Basically, a C corporation.
Factors
Every choice of entity decision requires the consideration of several factors. Among these factors are the following: (i) who will own the entity, (ii) how flexible an economic arrangement will the members require, (iii) will any member’s equity have preference over another’s, (iv) will the business be dependent upon debt, (v) are losses expected to be generated during the early years of the business, (vi) are there certain tax benefits that the owners hope to realize, (vii) are regular distributions anticipated, (viii) what is the likeliest exit scenario for the owners?
Outcomes
Depending upon the responses to these and other questions, the owners of the business may decide that (a) a taxable C corporation will work best for them;[iii] or (b) they may determine that a corporation organized under state law that is treated as a passthrough for tax purposes – an S corporation – is appropriate. Alternatively, the owners may find that (c) the flexible governance of a limited liability company suits them, but they want to be treated as a corporation for tax purposes, either a C or an S corporation.[iv] Finally, the owners may conclude that (d) the best way to accommodate their economic interests is with a limited liability company that is treated as a passthrough for tax purposes; i.e., as a partnership where the entity has at least two members, or as a disregarded entity where there is only one member.
Overseas
As closely held U.S. businesses continue to expand into foreign markets, their owners will have a few more choice-of-entity factors to consider, of which they, and even their advisers, may be unaware.
Assuming the U.S. entity is engaged in business or investment activities in a treaty country[v] – either directly or through a foreign subsidiary – its owners must consider whether, under the terms of the treaty, the entity will be characterized as a “resident” of the U.S. that is eligible to claim certain tax benefits afforded by the foreign jurisdiction.[vi]
The idea that an entity organized under the laws of one of the United States may not be respected as a U.S. resident under the terms of a tax treaty with another country may seem far-fetched.
Unfortunately, that is not the case where the closely held U.S. entity is treated as a passthrough for U.S. tax purposes – i.e., as a partnership (including a limited liability company treated as a partnership), or as an S corporation, neither of which is per se subject to U.S. income tax.
One U.S. taxpayer discovered this to their detriment when the Irish High Court recently decided[vii] that a U.S. business (“LLC”) that was organized under State law as a limited liability company and that was “fiscally transparent” for purposes of the U.S. federal income tax, could not rely on the nondiscrimination provisions of Ireland’s income tax treaty with the U.S. (the “Treaty”) because, according to the High Court, LLC was not considered a “resident” of the U.S. within the meaning of the Treaty.
Taxpayer LLC
All of LLC’s membership interests were owned by its only member, a limited partnership that was also organized in the U.S. under State law (“Limited Partnership”).
Because LLC did not elect under U.S. federal law to be treated as a corporation for U.S. tax purposes,[viii] it was disregarded as an entity separate from Limited Partnership for such purposes, meaning all of LLC’s assets and liabilities, and all of its items of income/gain, deduction/loss, and credit (“tax items”) were treated as belonging to Limited Partnership, as LLC’s only member.[ix]
Thus, these tax items were neither taxed to LLC nor reported by LLC on its own tax return; instead, Limited Partnership reported such tax items on its income tax return.[x]
Limited Partnership
Limited Partnership was owned by six U.S. corporations. Because Limited Partnership did not elect under U.S. federal law to be treated as a corporation for U.S. tax purposes, it default status under the Code was as a partnership.[xi]
Consequently, Limited Partnership was transparent for tax purposes; it did not pay U.S. federal income tax, but each of its partners – the six U.S. corporations – took into account its distributive share[xii] of Limited Partnership’s tax items[xiii] in determining such partner’s U.S. income tax liability.
S Corps
These U.S. corporations were organized under State’s corporation law.[xiv] Each of the corporations was eligible[xv] and elected to be treated as S Corporations under the Code.[xvi]
Thus, the corporations were not subject to U.S. income tax;[xvii] instead, their tax items passed through to their respective shareholders.[xviii]
Shareholders
The S corporations were owned by five U.S. resident individuals.[xix] Each shareholder took into account, on a pro rata basis,[xx] their share of their respective corporation’s tax items for purposes of determining their U.S. taxable income.
Each S corporation’s tax items represented such corporation’s distributive share of Limited Partnership’s tax items, which were identical to those of LLC’s.
Thus, each individual shareholder included on their U.S. federal income tax return their indirect share of LLC’s tax items; as the High Court stated, “the taxes that would have been payable by [LLC] (had it elected to be taxed as a corporation) are now paid by the five individuals resident in the United States who are the ultimate owners of [LLC].”[xxi]
The Irish Companies
LLC owned three companies that were organized, conducted business, and paid taxes, in Ireland (the “Irish Subs”).
Group Relief
These companies sought “group relief” under Ireland’s tax law, which would have allowed the tax losses of a group member (one of the Irish Subs) to offset the tax profits of another member.
In general, companies may qualify as a “group” for purposes of the foregoing offset rule if they are part of a parent-subsidiary or brother-sister chain of corporations that satisfies a 75% ownership test.
In some cases, this test may be met through indirect ownership, as where the shares of Irish companies comprising the possible group are owned by a parent company that is resident in a country (such as the U.S.) that is party to an income tax treaty with Ireland.[xxii]
In the present case, LLC was formed under the law of State, and was the common parent of the Irish Subs. As indicated, earlier, however, LLC was disregarded (transparent) for U.S. tax purposes, and therein laid the problem.
The Irish tax authorities[xxiii] declined to grant group relief to the Irish Subs based on its finding that LLC was not a resident of the U.S., which disqualified the Irish Subs from constituting an eligible group.
The Treaty
In response, LLC and the Irish Subs asserted that Revenue’s decision to deny group relief violated the nondiscrimination provision of the Treaty.
Nondiscrimination
The purpose of this provision is to ensure that one contracting state (in this case, Ireland) may not tax a resident of the other contracting state (the U.S.) differently from a comparably situated resident of the first state (Ireland).[xxiv]
According to Paragraph 4 of Article 25 of the Treaty:
“Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected herewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned State are or may be subjected.”
An “enterprise of a Contracting States” is defined as an enterprise carried on by a resident of a Contracting State;[xxv] for example, each of the Irish Subs was an Irish enterprise.[xxvi]
Thus, Ireland is prohibited from imposing more burdensome taxation or “connected requirements” on an Irish enterprise that is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the U.S., than the taxation or connected requirements that it imposes on other similar Irish enterprises.[xxvii]
Resident
The Treaty defines the term “resident of a Contracting State”[xxviii] to mean “any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation, or any other criterion of a similar nature.”[xxix]
The term “person” includes an individual, a partnership, and a company.[xxx]
A “company” means any “body corporate” (or an entity that is treated as a body corporate for tax purposes) that is “liable to tax” in the U.S.[xxxi]
Although not defined in the Treaty, the term “body corporate” generally refers to a legal entity that is distinct and separate from its owners, and that has its own rights and obligations.
Liable To Tax
The Treaty does not elaborate upon the meaning of “liable to tax” notwithstanding the term’s significance to the Treaty’s definition of residency.
That said, the U.S. Treasury Department’s Technical Explanation of the Treaty[xxxii] tries to shed some light on the concept.
It explains that certain investment entities that are nominally “subject to tax,” but that in practice rarely pay tax,[xxxiii] would generally be treated as residents of the country in which they are organized and, therefore, would be accorded treaty benefits. Although the income earned by these entities normally is not subject to U.S. tax in the hands of the entity, the entities are taxable to the extent they do not currently distribute their profits and, therefore, may be regarded as “liable to tax.”
As a corollary to the foregoing, Treasury explained that certain investment vehicles are residents of the Contracting State in which they are organized, even though the tax on the income they derive may be imposed only at the level of their owners.
The High Court
The question before the High Court was whether LLC’s status as a fiscally transparent entity deprived it of the ability to rely on the nondiscrimination provision of the Treaty because LLC was not “liable to tax” in the U.S. and, thus, was not a U.S. resident for purposes of such provision.
According to LLC, it was a resident of the U.S. within the meaning of the Treaty because it was organized in one of the United States, and it was liable to a tax in the U.S. “which corresponds to” the U.S. “corporation tax by virtue of all of its income [being] fully and comprehensively taxed . . . under the . . . Code albeit at the member level.”
From this it followed, or so LLC argued, that the Irish Subs were entitled to the group relief requested and, thus, Revenue’s denial thereof violated the nondiscrimination provision of the Treaty.
Revenue argued that, because of its status as a disregarded entity, LLC was not liable to tax in the U.S. by reason of its organization therein, “even at an abstract level.” Moreover, even though LLC’s income could become subject to tax as income of its ultimate members, the LLC itself would not be liable to tax under the Code.
The Commission
The Court observed that the parties’ “debate” before it focused on the argument that LLC had to be a “resident of a Contracting State” for the nondiscrimination provision of the Treaty to apply.
Before turning to the parties’ respective positions on this issue, the Court considered the decision reached by the Tax Appeals Commission (the “Commission”), the independent administrative body from which Revenue had appealed to the High Court.
The Commission indicated, “based on a literal interpretation,” and “the clear wording,” of the Treaty, that LLC was neither liable to tax in the U.S. nor a resident of the U.S.
The Commission stated that this conclusion was formed notwithstanding the “pragmatic approach” suggested by LLC that in determining residence “one should follow the income all the way up to the five individuals that were subject to U.S. tax” because they were ultimately the taxpayers who would include the income on their U.S. tax returns, would be liable to tax thereon and, thus, could claim the benefits of the Treaty.
Mitigate Administrative Complexities
However, notwithstanding this literal interpretation, and after considering “the technical nuances” of the group relief provisions, as well as what the Commission described as an apparent disconnect between the Code and the Treaty,[xxxiv] the Commission determined that LLC[xxxv] should be considered liable to a tax in the U.S. that corresponds to a corporation tax by virtue of all of its income being fully and comprehensively taxed under the Code, albeit at the member level. the application of a purpose of approach to the interpretation of the Treaty “is not only to avoid double taxation, prevent the evasion of tax and encourage trade but also to mitigate the administrative complexities arising from having to comply with two uncoordinated taxation systems.”
Consequently, the Commission concluded, without considering the nondiscrimination provision of the Treaty, that the Irish Subs qualified for group relief.
The High Court’s Analysis
The Court noted that, in contesting Revenue’s appeal, LLC did not rely on the Commission’s reasoning regarding a “disconnect” between the Code and the Treaty.
Instead, LLC argued that it was in fact liable to tax in the U.S., notwithstanding its status as a disregarded entity for U.S. tax purposes. Thus, LLC stated, it was a U.S. resident and entitled to protection under the Treaty’s nondiscrimination provision.
The Court also noted that both LLC and Revenue accepted there was a difference between the expressions “liable to tax” and “subject to tax.”
One can be liable to tax, the Court explained, even where there is only an “abstract liability” to taxation. This arises, according to the Court, if the Contracting State “may exercise its right to tax the income in question.”
After considering the foregoing distinction between the two phrases, the Court expressed the view (shared by Revenue) that LLC did not even have this abstract liability to tax. The Court added that, under the laws of the U.S., LLC was a disregarded entity – the U.S. “eschewed its ability to exercise any entitlement or right to tax the entity in question.” Unless LLC chose to have its income taxed, the Court continued, LLC was completely outside the U.S. “tax net.”
In response to LLC’s reference to the “box ticking” (i.e., check-the-box) exercise involved in transforming an LLC from an entity which does not pay tax to one that does, “the simplicity of the process,” the Court stated, “does not in any way undermine the fact that [LLC] is quite disregarded” by the U.S. tax system unless “the relevant box is ticked.”
The Holding
Based on a literal interpretation of the Treaty’s definition of “resident,” the Court stated that it “can only conclude that [LLC] was not resident in the US and therefore not liable to tax in that jurisdiction in the years under appeal.”
The Court rejected the argument that LLC was liable to tax “on the basis that it is within the scope of tax in the U.S., albeit that its profits are taxed at the member level”; this position, the Court responded, ignores the fundamental legal difference between the taxation of a company and the taxation of its members. LLC can be described as fiscally transparent, the Court stated, the tax in respect of its earnings paid by its members, but LLC itself was not liable to tax.
Therefore, the Court decided that LLC was not a resident of the U.S. for purposes of the Treaty, and was not entitled to the protection of the Treaty’s nondiscrimination provision. With that, the Court set aside the Commission’s decision, and denied group relief to the Irish Subs.
Some Observations
Because LLC was fiscally transparent for U.S. tax purposes – it was treated as a partnership – its Irish Subs were not permitted to claim the nondiscrimination benefit of the Treaty and thereby avail themselves of the group relief provided under Ireland’s tax law.
There are other, more frequently encountered contexts – including reduced withholding on dividends – in which the fiscal transparency of a U.S. entity for domestic tax purposes may not be to its owners’ benefit, at least insofar as enjoying treaty benefits is concerned.
In 2013, for example, Germany’s Federal Tax Court decided that a U.S. corporation that had elected to be treated as an S corporation, and that owned 50% of a German resident GmbH (a corporation), should be treated as a U.S. resident under the U.S.-German income tax treaty and thus, qualified for the reduced rate of withholding tax under Art. 10(2) of the treaty for a dividend distributed by a German corporation to a U.S. corporation.[xxxvi]
To reach this outcome, the Federal Tax Court determined that, under German tax law, the S corporation (a passthrough under U.S. tax law) would be treated as the beneficial owner of the dividend paid by the German subsidiary corporation.
A few years later, in 2016, and in response to the above decision, the German legislature sought to deny U.S. S corporations the benefit of reduced withholding on dividends received from German subsidiaries by looking through the S corporation and applying the treaty to the corporation’s noncorporate shareholders, none of whom would qualify for the benefit.[xxxvii]
Last year, however, a lower tax court in Germany followed the above-referenced 2013 decision and ruled that a U.S. S corporation was entitled to the reduced rate of withholding with respect to a dividend paid by its wholly owned German subsidiary corporation (a German GmbH), notwithstanding the fiscally transparent nature of the S corporation under the Code.[xxxviii]
The tax withholding saga experienced by S corporations with German subsidiaries, described above, together with LLC’s dilemma in Ireland, illustrate why it is imperative for a U.S. person to consult with local tax and corporate counsel before establishing a subsidiary corporation in a foreign jurisdiction. Only by considering the unique features of the applicable foreign tax law may the U.S. shareholders accurately account for the economic consequences thereof.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Note these are not described as “first” and “second” decisions, which connotes some order of priority. They are inseparable.
[ii] Without regard to whether or not such profits are distributed to the owners.
[iii] Perhaps they’re thinking about IRC Sec. 1202.
[iv] Checking the box under Reg. Sec. 301.7701-3.
[v] I.e., one that is party to an income tax treaty with the U.S.
[vi] For example, taxation at a reduced rate or exemption from tax on certain items of income sourced in the foreign jurisdiction.
As an aside, most income tax treaties contain what is known as a “saving clause” which prevents a citizen or resident of the U.S. from using the provisions of a tax treaty to avoid taxation of U.S. source income.
[vii] The Revenue Commissioners vs Susquehanna Int’l Securities Ltd et al, HCRN: 2019/133Rhttps://www.law360.com/tax-authority/articles/1886150/attachments/0
[viii] Reg. Sec. 301.7701-3(c). It did not file IRS Form 8832, Entity Classification Election.
[ix] Reg. Sec. 301.7701-3(b)(1)(ii).
[x] As we will see immediately below, on IRS Form 1065, U.S. Return of Partnership Income.
[xi] Reg. Sec. 301.7701-3(b)(1)(i).
[xii] IRC Sec. 702 and Sec. 704.
[xiii] Reflected on the Sch. K-1 issued to the partners by Limited Partnership.
[xiv] And thus were treated as corporations for U.S. tax purposes. Reg. Sec. 301.7701-2(b)(1).
[xv] IRC Sec. 1361(b)(1). A domestic corporation with only one class of stock and not more than 100 shareholders, each of whom is an individual (or such individual’s estate) or a qualifying trust, and none of whom is a nonresident alien.
[xvi] IRC Sec. 1362; IRC Sec. 1361.
[xvii] IRC Sec. 1363(a).
[xviii] IRC Sec. 1366.
[xix] IRC Sec. 1361(b)(1)(B). The shareholders may have been U.S. citizens or permanent residents.
[xx] IRC Sec. 1366; as reflected on the Sch. K-1 issued by each S corporation to its shareholders. See IRC Sec. 1361(b)(1)(D) and Reg. Sec. 1.1361-1(l) for the one class of stock requirement.
[xxi] The Revenue summed up this situation a little differently, as follows:
“As a result, Federal income tax on the LLC’s income arises only at the level of the ultimate owners i.e., the five US-resident individuals, under the individual income tax imposed by Section 1. No Federal income tax is payable by the LLC, the Partnership, or any of the six S Corporations under the corporate tax imposed by Section 11.”
[xxii] The U.S. and Ireland are parties to the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains (the “Treaty”).
[xxiii] The Revenue Commissioners (“Revenue”).
[xxiv] Art. 25 of the Treaty. Not all differences in tax treatment between residents of the two States are violations of the prohibition against discrimination.
[xxv] Art. 3, Par. 1(c) of the Treaty.
[xxvi] As we will see shortly, under Art. 4 of the Treaty, a resident of a Contracting State includes a company that is liable to tax in such State by reason of being managed, or of having been incorporated, therein.
[xxvii] According to the U.S. Treasury Dept.’s Technical Explanation of the Treaty, it is understood for this purpose that “similar” refers to similar activities or ownership of the enterprise. https://www.irs.gov/pub/irs-trty/iretech.pdf .
[xxviii] Art. 4 of the Treaty.
[xxix] However, the term “resident of a Contracting State” does not include any person who is liable to tax in that State in respect only of income from sources in that State or of profits attributable to a permanent establishment in that State. Par. 2 of Art. 4 of the Treaty.
[xxx] Paragraphs 1(a) of Art. 3 of the Treaty.
[xxxi] Paragraphs 1(b) of Art. 3 of the Treaty.
[xxxii] https://www.irs.gov/pub/irs-trty/iretech.pdf .
[xxxiii] For example, RICs and REITs. Such entities must satisfy a number of requirements under the Code in order to be entitled to their special tax treatment.
[xxxiv] The Commission seems to have been influenced by the much greater reliance of U.S. businesses on limited liability companies as opposed to corporations. “LLC’s are now the most predominant entity in Delaware outnumbering corporations by a factor of 3 to 1.”
[xxxv] Which it determined was a body corporate.
[xxxvi] https://www.ustaxdisputes.com/german-federal-fiscal-court-ruling-potentially-provides-reduced-withholding-rates-to-certain-us-entities/ .
[xxxvii] https://www.mossadams.com/articles/2016/november/german-law-removes-us-s-corporation-tax-benefit .
[xxxviii] https://www.deloitte-tax-news.de/german-tax-legal-news/lower-tax-court-rules-that-dividends-paid-to-us-s-corporation-qualify-for-a-reduced-5-or-wht-under-the-germany-us-dtt.html .
Query what this means for U.S. limited liability companies that organize German corporate subsidiaries.