What Goes Around Comes Around: Proposed Regulations Treating U.S. Disregarded Entities as Corporations

Trust Bloomberg Tax for the international news and analysis to navigate the complex tax treaty networks and global business regulations.

Edward Tanenbaum, Esq.

By Edward Tanenbaum, Esq. Alston & Bird LLP New York, New York

It all started with the Foreign Account Tax Compliance Act, affectionately known as “FATCA.” What is regarded as the most extraterritorial application of U.S. tax law has snowballed into a worldwide epidemic of hoped-for transparency.

Initially, many countries bristled at the notion of their home-grown financial entities being “requested” by the United States to police tax evasion on the part of U.S. citizens and residents, but they quickly learned that the concept would also be to their benefit in policing tax evasion by their own citizens and residents. Indeed, some countries, e.g., the United Kingdom, quickly adopted their own versions of FATCA.

Then came the OECD's Base Erosion and Profit Shifting (BEPS) initiative, an initiative that many regard as an attack against “abusive” tax practices of U.S. multinationals, in particular. Transparency took on a broader meaning. And, in an expansion of the FATCA concept, the OECD developed the Common Reporting Standard, which requires financial institutions to report on taxpayer accounts to their respective governments for automatic exchange of information. (Something the United States has not yet bought into, however.)

Shortly after the enactment of FATCA, Treasury and a number of OECD countries developed Intergovernmental Agreements (IGAs). Recognizing the need to reciprocate, and provide information to these other countries, a number of IGAs provided for reciprocity.

And, around the time that FATCA regulations were being issued, the IRS took baby steps to reciprocate with information exchange by issuing final regulations under §6049 addressing the reporting of bank deposit interest paid to nonresident aliens. These regulations mandate reporting of such payments and, in most cases, making such information available to other countries under automatic exchange of information.

So, what has FATCA wrought? First came pressure on the United States to reciprocate with exchange of information under various IGAs. Then came BEPS. Then came CRS. Then came the final §6049 regulations. The sideshow to all of this has been the mounting pressure being put on the United States to put its money where its mouth is in terms of fostering transparency.

The latest pressure point, certainly after the “Panama Papers,” relates to the use by foreign persons of U.S. LLCs and the assertion by many countries that the United States has, for the longest time, been one of the largest tax havens around. Prompted in part by the continuing need to monitor potential tax evasion and other financial crimes by U.S. citizens/residents, prompted by the need to reciprocate and provide information to foreign governments about their citizens’/residents' activities in or with the United States, but, most importantly, prompted by the need to clean up its reputation as a tax haven, Treasury, on May 6, announced a three-fold plan designed to increase transparency in the United States so as to track financial and tax crimes as well as to provide information to foreign countries.

First, Treasury proposed legislation that would require entities to provide information about their beneficial owners at the time the entity is created. Second, under the Bank Secrecy Act, banks would be required to identify those beneficial owners who own 25% or more of an entity. Finally (the subject of this commentary), regulations would be amended to provide that foreign persons operating in the United States via U.S. disregarded entities would now be subject to certain reporting requirements.

The use by foreign persons of U.S. disregarded entities, e.g., the U.S. LLC, for either U.S. or foreign activities has been exponential. In some cases, they are used for limited liability purposes. In some cases, they are used to provide the imprimatur of a U.S. holding vehicle in which business is conducted entirely outside of the United States. In other cases, U.S. parties to certain transactions will insist that a U.S. vehicle be established by a foreign person. In some cases, we are told, they are used to purposely shield certain activities and beneficial owners from disclosure.

How is this accomplished in the last enumerated category? The combination of a few rules (or lack thereof) provide for this result. First, disregarded entities are, in most cases, not subject to the requirement to obtain a taxpayer identification number. Second, the foreign persons/entities who are owners of the disregarded entity may not be required to report on various transactions that are occurring between them as, for example, if neither the LLC nor the foreign entity receives U.S.-source income or is engaged in a U.S. trade or business. The combination of these two elements prevents the IRS from monitoring tax evasion and other financial crimes and prevents the United States from being able to exchange information with foreign countries disclosing their citizens’/residents' identities and activities in the United States.

The proposed regulations would treat a U.S. disregarded entity wholly owned by a foreign person as a separate corporation for certain reporting and recordkeeping purposes. Specifically, §6038A , which requires U.S. corporations to report information about 25% foreign owners and the corporation's transactions with such owners (and other related parties), would apply to foreign-owned U.S. disregarded entities.

The proposed regulations would amend Reg. §301.7701-2 to treat a U.S. disregarded entity wholly owned by a foreign person as a U.S. corporation for purposes of the reporting and recordkeeping requirements of §6038A . The proposed rules, however, would not affect the entity classification framework or a disregarded entity's general treatment for U.S. tax purposes.

Because a foreign-owned U.S. disregarded entity is treated as a U.S. corporation under the proposed rules, it would have to file Form 5472 for “reportable transactions” between the entity and foreign related parties, including its foreign owner. Due to this filing obligation, the entity would have to obtain an EIN by filing Form SS-4, identifying its responsible party. The entity would also be required to maintain adequate records to establish the accuracy of the information return and the proper U.S. tax treatment.

A reportable transaction is any type of transaction described in Reg. §1.6038A-2 , including sales and purchases, borrowings and loans, and rents, interest, royalties, service fees, commissions, or other amounts paid or received in transactions between the corporation and a foreign related party. A “related party” is any direct or indirect 25% shareholder, any person related to the corporation or a 25% shareholder within the meaning of §267(b) or §707(b)(1) , and any other person related to the corporation within the meaning of §482 and regulations thereunder.

In addition, the proposed regulations would provide that any transaction within the meaning of Reg. §1.482-1(i)(7) is a reportable transaction. That provision defines “transaction” to mean “any sale, assignment, lease, license, loan, advance, contribution, or other transfer of any interest in or a right to use any property … or money… [as well as] the performance of any services for the benefit of, or on behalf of, another taxpayer.” The proposed regulations indicate that such transactions include amounts paid or received in connection with forming, dissolving, acquiring, or disposing of the entity, as well as contributions to and distributions from the entity.

These rules would be effective for taxable years ending on or after the date that is 12 months after final regulations are published.

So, after much pressure, transparency is now being brought to the shores of the United States. What goes around has come around.

Copyright © 2016 Tax Management Inc. All Rights Reserved.

Request International Tax