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By Kenneth J. Krupsky, Esq. Jones Day,Washington, DC
One sometimes hears practitioners say - no doubt colloquially and knowingly imprecisely - that “a disregarded entity is disregarded for U.S. income tax purposes.” On further reflection, we know that “disregarded” sometimes means “disregarded” and sometimes something else, namely “regarded.” We “know,” or at least we worry. And now we know that that worry is justified, at least in one case. What other cases are lurking out there?
On December 19, 2008, the IRS issued proposed regulations (REG-113462-08) providing that for purposes of the “conduit financing” regulations, Regs. §1.881-3, a “person” includes a “disregarded entity” - i.e., a business entity that is disregarded as an entity separate from its single-member owner under the “check- the-box” regulations, Regs. §§301.7701-1 through §§301.7701-3. In other words, when withholding taxes are at issue, and an abusive conduit transaction exists, “disregarded” means “regarded.”
Existing Regs. §1.881-3 generally permits the IRS to disregard the participation of one or more “intermediate entities” in a “financing arrangement” if such entities are acting as “conduit entities.” The effect of this particular “disregard” is to recharacterize the arrangement as a transaction directly between the “regarded” parties, so as to prevent an unwarranted claim to treaty benefits and thereby impose withholding tax on dividends, interest, royalties, etc. under §§871, 881, 1441, and 1442. The litany is that a financing arrangement means a series of financing transactions by which one person (the financing entity) advances money or other property, or grants rights to use property, and another person (the financed entity) receives money or other property, or rights to use property, if the advance and receipt are effected through one or more other persons (intermediate entities). The “disregard” may apply if financing transactions link the financing entity, each of the intermediate entities, and the financed entity.
The existing regulations include the following example (Regs. §1.881-3(e), Ex. 2), which is the basis for the new example in the proposed regulations. FP, a corporation organized in country N, owns all the stock of FS, a corporation organized in country T, and all the stock of DS, a U.S. corporation. Country T, but not country N, has an income tax treaty with the United States. The treaty exempts interest, rents, and royalties paid by a resident of one state (the source state) to a resident of the other state from tax in the source state. On January 1, 1996, FP lends $1,000,000 to DS in exchange for a note issued by DS. On January 1, 1997, FP assigns the DS note to FS in exchange for a note issued by FS. After receiving notice of the assignment, DS remits payments due under its note to FS. The example concludes that the DS note held by FS, and the FS note held by FP, are financing transactions, and together they constitute a financing arrangement. Accordingly, the treaty benefits are not available (although Example 2 does not expressly state this result.)
The proposed regulations add a new Example 3, in which the facts are the same as in the existing Example 2, except that, in addition, FS is an entity that is disregarded as an entity separate from its owner, FP, under the check-the-box regulations. The example concludes that FS is a “person” and therefore may itself be an intermediate entity that is linked by financing transactions to other persons in a financing arrangement. Accordingly, the DS note held by FS and the FS note held by FP are financing transactions, and together constitute a financing arrangement - just as in Example 2.
Phil Morrison aptly points out (see 37 Tax Mgmt. Int'l J. 489 (Aug. 2008)) that the anti-conduit regulations use the term “person” and §7701(a)(1) defines a “person” to include among other things a “company” and a “corporation.” The foreign entity that has been checked is described in Example 2 as a “corporation” for foreign law purposes, but does this mean it is a “person” for U.S. tax purposes? Some apparently have thought that a checked foreign entity -- e.g., an eligible foreign corporation or company -- is not a “person” but is instead a collection of assets. Regs. §301.7701-3(g)(1)(iii) says that when a foreign eligible entity treated as an “association” is checked to become a disregarded entity, then “the following is deemed to occur: The association distributes all of its assets and liabilities to its single owner in liquidation of the association.” Not dispositive, but curious.
The new regulations are proposed to be effective for payments (not merely transactions) made on or after the date of publication of final regulations. The proposed regulations also say that treating a disregarded entity as a person is a “clarification,” suggesting that the IRS may attack prior treaty claims.
Are the new regulations justified? In this instance, the foreign legal entity (FS), which is in the middle of the financing transaction, brings to the party a critical U.S. tax attribute that does not (or rather, the IRS says, should not) vary depending on whether the foreign entity is regarded or disregarded under the check-the-box rules - namely, absent the new regulations, FS's participation in the transaction arguably allows for a treaty claim because of its residency in the treaty country, whether or not it is a “disregarded entity.” Accordingly, the IRS is laying down a rule that checking the box to make FS a disregarded entity should not permit treaty benefits which would be denied, under the existing conduit financing rules, if the box were not checked.
This principle should make us worry, or at least think hard. What other examples can we think of in which there are critical attributes - including U.S. or foreign tax attributes, and U.S. or foreign non-tax legal attributes that have U.S. or foreign tax consequences - that do not (or should not be allowed to) vary depending on whether the box is checked? For example, one can think of numerous examples of “arbitrage” situations, in which a tax result in a foreign country differs from the U.S. tax result, depending on whether the box is checked, although the legal attributes do not vary at all. Are these also potentially subject to IRS challenge?
The proposed regulations tell us that Treasury and the IRS are continuing to study conduit financing arrangements and may issue guidance on certain hybrid instruments -- specifically, transactions where a financing entity advances cash or other property to an intermediate entity in exchange for a hybrid instrument that is treated as debt in the foreign country where the intermediate entity is resident but is not debt for U.S. tax purposes. One possible approach is to treat all transactions involving such hybrid instruments as financing transactions. Another possibility is to identify additional factors to consider in determining when stock in a corporation (or other similar interest in a partnership or trust) may constitute a financing transaction. The additional factors might focus on whether the financing entity had sufficient legal rights to, or other practical assurances regarding, the payment received by the intermediate entity to treat the stock as a financing transaction.
The saga of the check-the-box regulations grows more curious and curious.
This commentary also will appear in the March 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Levine and Miller, 936 T.M., U.S. Income Tax Treaties, and in Tax Practice Series, see ¶7140, U.S. Income Tax Treaties.
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